Chapter 19

International Trade

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2006 Thomson/South-Western

Profile of Imports and Exports

U.S. exports of goods and services amounted to about 10% of GDP in 2003 U.S. imports of goods and services were 14% relative to GDP in 2003 Raw materials
Oil and metals major imports Agricultural products major exports
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Profile of Imports and Exports

Canada, Mexico, Japan, Great Britain, and Germany are major importers of U.S. goods/services Canada, China, Mexico, Japan, and Germany are major exporters of goods/services to U.S.

Exhibit 1: Composition of U.S. Merchandise Exports

Exhibit 1: Composition of U.S. Merchandise Imports

Exhibit 2: U.S. Production as a Percentage of U.S. Consumption

Exhibit 3: Production Possibilities

The U.S. has an absolute advantage, can produce more of both with fewer resources than other producers require But following the law of comparative advantage, the U.S. is the low cost producer, with 7 a comparative advantage in the production of clothing, while Izodia has a comparative advantage in the production of food

Exhibit 4: Production Possibilities Without Trade

Autarkey equilibrium

Autarkey equilibrium

Exhibit 4 illustrates the possible combinations of food and clothing that each country can produce and consume if all resources are fully and efficiently employed and there 8 is no trade: Autarky is the situation of national self-sufficiency. The fact that both PPFs are straight lines implies a constant opportunity cost.

Terms of Trade
Before the countries can trade, the terms of trade must be established Terms of trade refers to how much of one good exchanges for a unit of another good Suppose that market forces dictate that 1 unit of food trades for 1 unit of clothing

Exhibit 5: Production (and Consumption) Possibilities Frontiers with Trade

U.S. preferred combination

Izodian preferred combination

The U.S. consumption possibilities frontier stops at 400 million units of clothing because that is the most that Izodians can produce With production and specialization, the U.S. produces 600 units of food, consumes 400 units, and exchanges the rest for 200 million units of Izodian clothing. 10 Izodians produce 400 units of clothing, wear 200 million units, and exchange the rest for 200 million units of U.S. food

Summary
The only constraint on trade is that, for each good, total world production must equal total world consumption Specialization and trade allow both countries to consume more of both goods

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Reasons for International Specialization

Differences in Resource Endowments
Economies of Scale Differences in Tastes

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Tariffs
Tariff: a tax on imports and can be either specific or ad valorem
Specific tariff is a fixed fee amount, for example a tariff of $5 per barrel of oil Ad valorem tariff is a percentage of the price of imports at the point of entry

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Exhibit 6: Effect of a Tariff

Consumers loss of surplus is the sum of areas a, b, c, and d. Area a represents an increase in producer surplus. Area b is a net U.S. welfare loss. Area c shows government revenue from the tariff. Area d reflects the loss of consumer surplus resulting from the drop in consumption. The net welfare loss to the U.S. economy consists of areas b and d.

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Import Quotas
Import quota: a legal limit on the quantity of a particular commodity that can be imported Usually target imports from certain countries To have an impact on the domestic market, or to be effective, a quota must restrict imports to less than the amount imported with free trade

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Exhibit 7: Effect of a Quota

After the quota, the new U.S. price, $0.15 per pound, is determined by the intersection of the new supply curve, S', with the U.S. demand curve, D.

The blue shaded areas show the loss in consumer surplus captured by domestic producers and those permitted to fulfill the quota. The pink-shaded triangles illustrate the net 16 welfare cost of the quota on the U.S. economy.

Exhibit 7: Effect of a Quota

Area a represents a transfer from U.S. consumers to U.S. producers. Triangular area b reflects a net loss - the amount by which the cost of producing an extra 10 million pounds of sugar in the United States exceeds the cost of buying it from abroad. Rectangular area c shows the gain to those who can sell foreign-grown sugar at the higher U.S. price instead of the world price. Area d also reflects a net lossa reduction in consumer surplus as consumption falls because of the price increase.
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Quotas in Practice
Quota rights are awarded to exporters through a variety of means By rewarding domestic producers with higher prices and foreign producers with the right to sell goods to the United States, the quota system creates two groups intent on securing and perpetuating these quotas
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Tariffs and Quotas Compared

Since the tariff and the quota in our example had identical effects on the price, they reflect the same change in quantity demanded U.S. consumers suffer the same loss of consumer surplus and U.S. producers reap the same gain of consumer surplus The primary difference: the revenue from the tariff goes to the domestic government, whereas the revenue from the quota goes to whoever secures the right to sell foreign goods in the U.S. market
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Tariffs and Quotas Compared

If quota rights accrue to foreigners, then the domestic economy is worse off with a quota than with a tariff Even if quota rights go to domestic importers, quotas, like tariffs, still increase the domestic price, restrict quantity and reduce consumer surplus Quotas and tariffs also encourage foreign governments to retaliate with quotas and tariffs of their own
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Other Trade Restrictions

Export subsidies: encourage firms to export Low-interest loans to foreign buyers: promote exports of large capital goods Domestic content requirements: specify that a certain percentage of a final goods value must be produced domestically Other requirements concerning health, safety, or technical standards: often discriminate against foreign goods
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GATT
General Agreement on Tariffs and Trade GATT an international tariff-reduction treaty adopted in 1947 that resulted in a series of negotiated rounds aimed at freer trade
Adopted by 23 countries, including the United States Treat all member nations equally with respect to trade Reduce tariff rates through multinational negotiations Reduce import quotas Set the stage of many trade rounds which offer a package approach rather than an issue-by-issue approach to trade negotiations
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Trading Rounds
Most early GATT trade rounds aimed at reducing tariffs The Kennedy Round in the mid-1960s included new provisions against dumping Recent Uruguay round created the World Trade Organization to take over from GATT

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The World Trade Organization

Permanent institution located in Geneva, Switzerland
Includes services and trade-related aspects of intellectual property, such as books, movies, and computer programs Under the most-favored-nation clause, each WTO member must offer all other member countries the same trade concessions offered to any member country Average tariffs will fall from 6% to 4% Includes a dispute settlement body that should be faster, more automatic, and less susceptible to blockage than GATT 24

Common Markets
European Union.
Began in 1958 and now has expanded to 25 nations Intended to create a barrier-free European market in which goods, services, people, and capital are free to flow to their highest-valued use without restrictions Twelve members of the European Union have adopted a common currency, the euro, that replaced national currencies in January 2002
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Common Markets
Other trading blocs
The Association of Southeast Asian nations: ASEAN South Africa and its four neighboring countries: Southern African Customs Union Half dozen Latin American countries: Mercosur United States, Canada, and Mexico: NAFTA
Mexico hopes to increase U.S. investment by guaranteeing dutyfree access to U.S. markets to those who build manufacturing plants in Mexico The U.S. wants access to Mexicos 100 million people and its huge oil reserves U.S. would like to bolster Mexicos move toward a marketoriented economy

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National Defense Argument

Industries are said to be in need of protection from import competition because their production is vital in time of war protection is in the national interest Trade restrictions may shelter the defense industry, but other methods, might be more efficient
Government subsidies Government could stockpile basic military hardware so that maintaining an ongoing productive capacity would become less essential

Problem with this argument is that most industries can make this same argument
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Infant Industry Argument

Rationale here is to protect emerging domestic industries from foreign competition
In industries where a firms average cost per unit falls as production expands, new domestic firms may need protection from foreign competitors until they reach sufficient size to achieve sufficient economies of scale

How should government identify which industries merit protection, and when do they become old enough to look out for themselves?
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Infant Industry Argument

The very existence of protection may foster inefficiencies that firms may not be able to outgrow

The immediate cost of such restrictions is the net welfare loss from higher domestic prices Which may become permanent if the industry never realizes the expected economies of scale
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Antidumping Argument
Dumping is selling a commodity abroad at a price that is below its cost of production or below the price charged in the home market critics argue that a tariff should be imposed to raise the price of dumped goods Key question: Why should U.S. consumers be prevented from buying products for as little as possible even if these low prices are the result of a foreign subsidy?
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Antidumping Argument
If the dumping is persistent, the lower price may increase consumer surplus by an amount that more than offsets losses to domestic producers there is no good reason why consumers should not be allowed to buy imports for a persistently low price An alternative form of dumping, termed predatory dumping, is the temporary sale of an export at a lower price in order to drive out competing producers in that foreign market
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Jobs and Income Argument

One of the more common arguments is that they protect U.S. jobs and wage levels Problem: other countries will likely retaliate by restricting their imports to save their jobs with the net result that international trade is reduced
Wage rates in other countries, especially developing countries, are often a small fraction of wages in the U.S. Wages represent just one component of the total production cost and may not necessarily be the most important
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Jobs and Income Argument

What is important is not wage rates per se, rather it is the labor cost per unit of output which depend on both the wage rate and labor productivity Wage rates are high in the United States partly because labor productivity remains the highest in the world
Conversely, lower wages in many competing countries can be partially traced to workers lack of education and training, the meager amount of physical capital available to each worker, and a business climate that is less stable and less attractive
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Declining Industries Argument

Where an established domestic industry is in jeopardy of being displaced by lower-priced imports, there could be a rationale for temporary import restrictions to allow the orderly adjustment of the domestic industry This is particularly true when there are many industry-specific resources

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Declining Industries Argument

The protection offered should not be so generous as to encourage investment in the industry Free trade may displace some U.S. jobs through imports, but it also creates U.S. jobs through exports Where foreign competition appears to have displaced U.S. workers, many foreign companies have built plants in the United States and employ U.S. workers
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Problems with Protection

Protecting one state of production often requires protecting downstream stages of production The cost of protection includes not only the welfare loss arising from the higher domestic price, but also the cost of the resources used by domestic producers and groups to secure the favored protection the cost of this rent seeking lobbying fees, propaganda, legal actions can equal or exceed the direct welfare loss from the restrictions
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Problems with Protection

A third problem with imposing trade restrictions is that other countries often retaliate, thus further reducing the gains from trade A final problem with trade restrictions is the costs of enforcing the myriad quotas, tariffs, and other restrictions Also run into the practice of port shopping where foreign producers and U.S. importers shop to see where inspections are most lax
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Import Substitution
The country manufactures products that until then had been imported and imposes tariffs and quotas to protect these industries Popular for several reasons
Demand already existed for these products Provides infant industries with a protected market Those who already supply capital, labor and other resources to the favored industries gain

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Import Substitution
Problems
Reduces the gains from specialization and comparative advantage Low-cost foreign goods with high-cost domestic goods Since they are shielded from foreign competition, domestic industries fail to become efficient Encourages retaliation from other countries

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Export Promotion
A development strategy that concentrates on producing for the export market Preferable approach because the emphasis is on comparative advantage and trade expansion rather than trade restriction Also forces producers to grow more efficient to compete on world markets
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