Application: International Trade

Chapter 9 Application: International Trade

Introduction . In Chapter 3 we claimed that international trade makes trading parties better off because it allows specialization and promotes efficiency. To show this we used a simple 2x2 model. . Now we will use the concepts of consumer and producer surplus to analyze in detail exactly who benefits from trade and by how much total welfare changes under free trade. . Additionally we will explore why trade is very often limited through tariffs and quotas.

The Determinants of Trade . When a country is closed to international trade all production is based on domestic resources and all potential markets for firms are limited to domestic consumers. This is autarky. . Even though very few countries are effectively economically isolated there is usually a discrepancy between the domestic price of most goods and their world price: - A high domestic price represents a large opportunity cost of producing a good domestically while a low world price represents a small international opportunity cost of production. - In practical terms, comparing domestic and world prices is the same as comparing opportunity costs and so determining the comparative advantage for a particular good.

. Whether the world price for a particular good is higher or lower than the domestic price is going to determine which way trade will flow and, most importantly, who will benefit from it.

The Winners and Losers from Trade . Let us look at the most interesting possible scenarios for international trade: when the world price is above the domestic price and when the world price is below the domestic price.

The Gains and Losses of an Exporting Country . It is easy to see that when the world price of a good is above the domestic price, under free trade domestic producers will have an incentive to export part of their production: - We can look at this scenario as imposing an effective price floor on this particular good. Domestic producers will refuse to sell their output at a price below the world price. - Consumers will reduce their quantity demanded, therefore losing part of their surplus. - Producers will increase their quantity supplied, exporting some and enlarging their surplus. . The country overall is better off because total surplus has increased but this has been achieved at the expense of some people, namely, consumers. . For the sake of efficiency this country would be better off by selling their output at the highest possible, world, price and re-investing the profits in their own economy.

The Gains and Losses of an Importing Country . It is easy to see that when the world price of a good is below the domestic price, under free trade domestic consumers will have an incentive to import part of their consumption: - We can look at this scenario as imposing an effective price ceiling on this particular good. Domestic consumers will refuse to buy this good at a price above the world price. - Consumers will increase their quantity demanded, importing some of the good, and so enlarging their surplus. - Producers will decrease their quantity supplied, therefore losing part of their surplus.

. Again, the country overall is better off because total surplus has increased but this has been achieved at the expense of some people, namely, producers. . For the sake of efficiency this country would be better off by buying this good at the lowest possible, world, price and using the savings for additional domestic consumption.

. And here is the catch, why do so many countries restrict trade by using tariffs (i.e.: taxes on imports) and quotas (i.e.: limits to the maximum quantities of goods allowed to be imported)? . We will review the arguments for restricting trade later on but first let’s look at the impact of these measures on the economic welfare of a country.

The Effects of a Tariff . A tariff, like any other tax, will effectively raise the final selling price of the good: - Consumers will suffer: as the quantity demanded decreases they lose part of their surplus. - Producers will benefit: as the quantity supplied increases they gain surplus. - The Government will collect revenue (determined by tax and volume of imports.) - The presence of the tax will generate, as we already know, a deadweight loss.

. A tariff is clearly a tax levied on consumers of an imported good that benefits non-competitive domestic producers and generates a very easy to collect and monitor revenue for governments. The Effects of an Import Quota . An import quota is a limit on the quantity of a good that can be imported into a country. . The graphical analysis of this trade-constraining measure is somehow less intuitive but the outstanding conclusions are clear: - Consumers will suffer: as the quantity demanded decreases they lose part of their surplus. - Producers will benefit: as the quantity supplied increases they gain surplus. - There is no Government collecting revenue in this case. Governments usually sell these quotas to cronies or, alternatively, manage to convince foreign producers to limit exports. - Nonetheless, there is a deadweight loss because the free market outcome is altered.

. Import quotas can have potentially larger negative effects on welfare than tariffs because the surplus captured by the quota-permit holders is not transformed into public revenue. . If the government were to sell these quotas at their true market value then they will act exactly as tariffs. Quotas are the ultimate political gift to cronies and party supporters

The Arguments for Restricting Trade . We have seen that whenever the world price for a good is below the domestic price and imports are restricted –whether through tariffs or import quotas, consumers lose welfare and deadweight losses are incurred. So why are tariffs so prevalent in economic history? . There is a large array of traditional arguments to restrain trade which are as old as time itself: a) The Jobs Argument. External competition will drain jobs away from home. Although this is true for some inefficient industries in the long-run we are better off producing according to our comparative advantage (e.g.: producing T-shirts vs. producing microchips.) b) The National-Security Argument. Some goods are of strategic value and therefore we can not depend on foreigners to supply them. True, but how often is that the case (e.g.: cars)? c) The Infant-Industry Argument. We will just impose tariffs temporarily, until our domestic producers get up to par with foreigners. This is the wrong incentive and it is rarely eliminated. d) The Unfair-Competition Argument. If foreigners sell their goods under production cost we will force the price up with tariffs. Fairly stupid for both parties and unsustainable. e) The Protection-as-a-Bargaining-Chip Argument. This is somehow new. If the foreign country does not change its ways I will impose a tariff. Why will this strategy work when the threat is as harmful for domestic consumers as it is for foreign producers?