International Trade and Trade Policy

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International Trade and Trade Policy

• Applying Comparative Advantage and Supply and
  Demand
• Chapter 9

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Major Issues

• Why trade with other nations (regions)?
• Recognizing comparative advantage
• Benefits and costs
• Effects of tariffs, quotas, and other impediments
  to trade
• Subsidies as alternative to tariffs or quotas

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Why Trade?

• Take advantage of specialization and division of
  labor
• Not much controversy among economists over the
  benefits of free trade in the long run. Consider
  the U.S or the European Union.
• Controversy arises about moving to freer trade or
  putting restrictions on trade, because these
  changes generate winners and losers.

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Principle of Comparative Advantage (CA)

• The producer who has the smaller opportunity cost
  of producing a good is said to have a comparative
  advantage in producing that good compared to
  other producers.
• Applies to regions and countries as well as
  individuals and firms.
• Some examples Eastern Kentucky and Bluegrass,
• Colorado and Iowa, U.S and Haiti
• U.S. and Mexico, U.S and Japan

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Applying CA to Regions

• In the same way that Mike and Paddy were able to
  increase total output by specializing according
  to the principle of CA, so also can regions
  increase joint output through their people
  following CA.

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Gains from Specialization

• Country A can produce 24 units of nuts and zero
  coffee or zero nuts and 12 units of coffee or any
  combination in between. The reverse is true in
  Country B.
• If country A produces one less unit of coffee, it
  can produce two more units of nuts. If country B
  produces one less unit of nuts, it can produce
  two more units of coffee. Result one more unit
  of nuts and one more unit of coffee available for
  consumption!

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PPF when OC Varies Continuously
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PPF for a Small Island Nation
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How Trade Expands the Consumption Menu
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IT and Supply and Demand

• What happens in the market for a good when a
  country goes from autarky to free trade in the
  good?
• How do trade restrictions such as a tariff or a
  quota affect the equilibrium in the market for a
  good?

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A Classic Case The Corn Laws

• United Kingdom passed a law in 1815 banning the
  importation of grain, including wheat. The law
  was repealed in 1846.
• In 1846, the wheat market in Great Britain went
  from autarky to free trade.

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Autarky in the wheat market

• Assume
• The countrys wheat market is isolated in that
  there is no trade in wheat with the rest of the
  world.
• The market for wheat consists of the buyers and
  sellers of the country.
• Domestic Price adjusts to balance Demand and
  Supply.

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Equilibrium Without Trade

• When an economy cannot trade in world markets,
  the price adjusts to equilibrate domestic supply
  and demand.
• Equilibrium price of 8 and quantity of 30.
• Consumer (buyer) surplus (12-8)30/260
• Producer (seller) surplus (8-2)30/290
• TOTAL SURPLUS OR economic benefit 150

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Impacts of International Trade

• If the country decides to engage in international
  trade will it be an importer or exporter of
  wheat?
• Who will gain from free trade in wheat and who
  would lose?
• Will gains from trade exceed losses?

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Determinants of IT

• If a country has a comparative advantage relative
  to other counties, then the domestic price will
  be below the world price and the country will be
  an exporter of the good.
• If the rest of the world has a comparative
  advantage, then the domestic price will be higher
  than the world price and the country will be an
  importer of the good.

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International Trade Example - Importer

• Since the world price of wheat is lower than the
  U.K. price, the U.K would be an importer of
  wheat, when trade is permitted.
• U.K consumers will want to buy the lower priced
  wheat at the world price.
• U.K producers of wheat will have to lower their
  output until the supply price is equal to the
  world price.

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Free IT Winners and Losers

• When a country allows trade and becomes an
  importer of a good, domestic consumers of the
  good are better off. They pay a lower price.
• However, domestic producers of the good are worse
  off. They receive a lower price.

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Computing the Gain from Trade

• World price is 4.
• Price in U.K. falls to 4. Quantity supplied by
  U.K. producers is 10 while quantity demanded is
  60. Imports of 50 fill the gap.
• Consumer surplus (12-4)60/2 240
• Producer surplus (4-2)10/2 10
• Economic benefit 240 10 250
• Gain from free trade 250 150 100

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Free Trade Winners and Losers

• When a country allows trade and becomes an
  exporter of a good, domestic producers of the
  good are better off. They receive a higher
  price.
• However, domestic consumers of the good are worse
  off. They pay a higher price.

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Winners and Losers From Free International Trade

• Trade raises the economic well-being of the
  nation.
• The net change in total surplus is positive.
• The total surplus is the sum of the consumer
  surplus and the producer surplus. How do we
  figure out the total surplus?

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Gains from Free Trade in U.K.

• At a price of 8 per unit, consumer surplus is
  (12-8)x30/260 and producer surplus is
  (8-2)x30/290 for a total surplus of 150.
• At 4, consumer surplus is (12-4)x60/2240 while
  producer surplus is (4-2)x10/210 for a total of
  250.
• The net gain is 100.

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Volume of Trade

• The volume of international trade has grown
  substantially over time
• Most nations produce less than a small fraction
  of the total supply of any good or service, which
  allows these nations to benefit from the
  differences in domestic opportunity costs and
  global opportunity costs

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Why Trade Barriers?

• If exchange is beneficial, why does anyone oppose
  it?
• International trade does increase the total value
  of all goods and services, but certain industries
  may be harmed
• E.G. Concerns over NAFTA
• U.S. consumers would benefit from lower prices
• But, some thought that the U.S. would lose some
  unskilled jobs to Mexico, which, however, has not
  been shown

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Arguments for Restricting Trade

• Arguments Against Free Trade
• Jobs
• National Security
• Infant Industry
• Unfair-Competition
• Protection-as-a-Bargaining-Chip

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Trade Restrictions

• Have demonstrated the gains from free trade. Now
  want to look at the issue of protectionism or
  restrictions on trade.
• Major Kinds Tariff, Quota, and Regulation
• Tariff tax on imports of a good
• Quota limits the amount of good imported
• Regulation health, transport, other

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The Welfare Effects of a Tariff

• A tariff is a tax on imported goods.
• A tariff raises the price of imported goods,
  above the world price by the amount of the
  tariff.
• Domestic suppliers of the good with the tariff
  are gainers while domestic consumers of the good
  are losers.

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The Welfare Effects of a Tariff

• Like any tax on the sale of a good, an import
  tariff distorts incentives and pushes the
  allocation of scarce resources away from the
  efficient point.
• Raises domestic prices and encourages more
  domestic production of the good.
• Higher domestic prices reduces the amount
  purchased by domestic consumers

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The Cost of a Tariff

• At a price of 6 per unit, consumer surplus is
  (12-6)x45/2135, producer surplus is
  (6-2)x20/240, and government revenue is
  (45-20)250 for a total surplus of 225.
• In free trade, consumer surplus is (12-4)x60/2
  240 while producer surplus is (4-2)x10/210 for a
  total of 250.
• The net gain is - 25. Tariff causes an
  economic loss of 25

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An Import Quota

• A quota is a quantitative restriction on imports
  in the sense that a limited quantity of the good
  is allowed into the country.
• Qualitative effect of a quota is the same as that
  of a tariff. However, the difference in price
  between the domestic market and the world market
  accrues to the holder of the import license. (Can
  lead to corruption!)

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Effects of Quota

• In our example, quota restricts imports to 25.
  This appears as a horizontal addition to the
  domestic supply curve above the world price.
• Relative to free trade, price in importing
  country is increased to 6, imports are reduced
  to 25, and domestic output is increased from 10
  to 20. Value of an import license 2 times
  quantity authorized.

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Tariffs, Quotas, and Subsidies

• What is the difference between the effects of a
  tariff and a quota? The government receives the
  revenue from the tariff, while that revenue
  accrues to the importer under a quota. Who
  decides who can import? If import quota rights
  are auctioned, government can capture that
  revenue.
• An alternative to a tariff is a per unit subsidy
  to domestic producers. Consider a 2 per bushel
  subsidy.

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Welfare Cost of a Subsidy

• At a price of 4, consumer surplus is
  (12-4)60/2 240, producer surplus is
  (4-0)x20/240, and government revenue is negative
  2x2040 because of the subsidy. The total surplus
  is 240 compared with 250 under free trade.

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Conclusion... A Parable of Free Trade

• Throughout its history, the United States has
  allowed unrestricted trade among the states, and
  the country as a whole has benefited from the
  specialization that trade allows.