Lessons from Chapter 3

1

• Lessons from Chapter 3s farmer/rancher
  example
• Specialization and trade (according to
  comparative advantage) makes both parties better
  off.
• Reason for economists general preference for
  free trade and laws that promote free trade
  (NAFTA) . . .
• (http//en.wikipedia.org/wiki/NAFTA)
• . . . and their opposition to trade barriers,
  like tariffs and quotas.
• Not everyone agrees with this free trade
  philosophy.

2

• One fairly recent case (www.pbs.org/newshour/ . .
  .)
• In March 2002, President Bush imposed tariffs of
  up to 30 on imported steel in an effort to
  protect the slumping American steel industry.
• These tariffs were repealed in less than two
  years.
• (http//www.cbsnews.com/ . . .)
• More recently (Sept. 2009) President Obama
  imposed tariffs on imports of tires from China.
• (http//washingtonpost.com/ . . .)

3

• Tariff is response to complaint filed with
  federal trade panel by United Steelworkers union.
• U.S. tire industry lost 5,000 jobs in 5 yrs.
  prior to 2010. Four plants closed.
• In favor of tariff Workers and owners of U.S.
  tire companies.
• Opposed to tariff Chinese tire companies, U.S.
  tire importers, U.S. tire companies with plants
  abroad
• Chinese Ministry of Commerce Tariff violates
  World Trade Organization rules.

4

• World Trade Organization (http//www.wto.org/)
• An international organization dealing with global
  rules of trade among nations.
• Its rules are WTO agreements, negotiated and
  signed by a large majority of the worlds trading
  nations.
• Agreements are legal ground rules for
  international commerce.
• WTO serves as a court to mediate trade disputes.

5

• Using supply and demand analysis with
  consumer/producer surplus tools, we will address
• What determines the direction of trade flows?
• (Why does a country import certain
  products and export others?)
• How are the gains from trade distributed?
• (Not uniformly. Some gain but some
  lose. Thats why some in U.S. favor free trade
  in steel some oppose it.)

6

• Simplifying assumptions of our analysis
• Well look at a hypothetical small country --
  a change in the countrys trade policy will have
  only a negligible effect on the world market.
• (Lets call it Isoland.)
• Well consider a homogeneous product -- steel.
• Only one kind of steel. Domestic (Isolandian)
  and foreign steel are exactly the same.

7

• Well consider two markets
• - the domestic market (the market for steel
  in Isoland)
• - the world market (the market for steel in
  the rest-of-the-world i.e., other than Isoland)
• Lets start with a no trade case.
• Isoland has strict laws prohibiting
  international trade in steel.

8
One possibility
9

• pd lt pw is a reflection of the fact that Isoland
  has a comparative advantage, relative to the
  rest-of-the-world, in steel production.
• (Citizens of Isoland have to give up fewer units
  of other goods to get a ton of steel than do
  citizens of the rest of the world.)
• (pd gt pw would mean that the rest-of-the-world
  has a comparative advantage relative to Isoland.)

10

• Now consider the free trade case. (Imagine
  that Isolands laws prohibiting trade are
  repealed.)
• Isolandian steel producers wont sell in Isoland
  at pd when they can get pw on the world market.
• Prices of steel in domestic and world markets
  will have to equalize.
• Because Isoland is a small country, domestic
  price does all of the adjusting increasing to
  the current level of pw.
• (Domestic consumers will have to pay pw in order
  to buy any steel at all.)

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12

• Now lets consider the other possibility
• Before trade (when Isolands laws prohibit
  trade), the domestic price, pd, might be above
  world price, pw.
• pd gt pw means the rest-of-the-world has
  comparative advantage, relative to Isoland.
• With free trade (when laws prohibiting trade are
  repealed), Isolandian consumers wont buy
  domestic steel at pd when they can get foreign
  steel at pw.
• Price of steel in Isoland will have to fall to
  pw.
• (Domestic producers will have to sell at pw in
  order to sell any steel at all.)

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14

• What determines the direction of trade flows?
• When pd lt pw (Isoland has comparative advantage
  in steel), Isoland will export.
• When pd gt pw (Rest-of-the-world has comparative
  advantage in steel), Isoland will import.
• Consistent with lessons from farmer/rancher
  example.
• Now lets use consumer/producer surplus to
  illustrate gains from trade and see how theyre
  distributed.

15
Consider the exporting country first.
A B
A
- B
C
B C D
(B D)
A B C
A B C D
D
16
Now lets look at the case of an importing
country.
A
A B D
(B D)
B C
C
- B
A B C
A B C D
D
17

• Recap
• Regardless of whether the country ends up as an
  exporter or an importer . . .
• . . . there are net gains from trade.
• Gains are not uniformly distributed, however.
• Some gain,
• . . . some lose,
• . . . but gainers gains outweigh losers
  losses.

18

• Those who stand to lose from free trade have an
  incentive to argue for trade barriers.
• Tariff A tax on goods produced abroad and sold
  domestically.
• (. . . like President Obamas tariff
  on imports of tires).
• Quota A limit on the quantity of
  foreign-produced goods that can be sold
  domestically.

19

• Effects of a tariff
• . . . on steel, lets say.
• For this analysis,
• - keep small country assumption -- Isoland
• - keep homogeneous good assumption.
• - take free trade as the starting point.
• - assume that Isoland is an importer of steel to
  start.
• (pw lt pd, the domestic price that would prevail
  if trade were prohibited)
• - then government of Isoland imposes a tariff
  (tax on imported steel) of t /ton.

20

• The tariff will raise the price to Isolandian
  consumers of foreign-made (imported) steel by t
  /ton.
• (Wait a minute! In chapter 6 we said that tax
  burden is shared. Buyers price goes up by less
  than t/ton?
• . . . unless supply is perfectly elastic.)
• Because steel is a homogeneous good, the price of
  domestically produced steel will also rise by t
  /ton.
• (Domestic producers can raise their price when
  the price of imported steel goes up.)

21
The market for steel in Isoland
Before the tariff goes into effect . . .
quantity imported Q1d - Q1s tons/yr.
22
The market for steel in Isoland
price (of foreign and domestic steel) pw t
/ton.
quantity imported Q2d - Q2s tons/yr.
23
Now the welfare analysis
The tariff results in a deadweight loss of D F.
- (CDEF)
ABCDEF
AB
C
G
CG
0
E
E
ABCDEFG
ABCEG
- (DF)
24
Lets take a closer look at the deadweight loss.
25

• Lets review the tariffs effects.
• When the tariff is imposed
• Domestic (Isolandian) producers gain -- they sell
  more at a higher price. (Thats the point.
  Tariffs are supposed to help domestic producers.)
• Domestic (Isolandian) consumers lose -- they
  consume less at a higher price.

26

• Some of domestic consumers loss . . .
• . . . is recaptured by domestic producers (area
  C),
• . . . some shows up as tariff revenue (area E),
• . . . but some is not recaptured its the
  deadweight loss (areas D and F).
• For the economy as a whole (considering just the
  maximization of total surplus), the tariff is bad
  policy.

27

• What about a quota?
• Suppose that, instead of a tariff t /ton, the
  government limited steel imports to Q2d - Q2s
  tons/yr.
• A little more complicated, but heres the bottom
  line
• Effects very similar to that of the tariff.

28

• In particular . . .
• . . . same effect on price (increase to pw t
  /ton),
• . . . same effects on quantities produced
  and consumed domestically, and
• . . . same effects on consumer and producer
  surplus.
• The only difference
• What happens to the tariff revenue (area E)?

29

• Government would achieve import restriction by
  issuing licenses to import Q2d - Q2s tons/yr. --
  no more.
• Holders of these licenses could buy foreign steel
  at pw on world market and resell it at pw t in
  Isoland.
• What was tariff revenue becomes profit for import
  license holders . . .
• . . . unless, of course, government charges
  a price for the licenses.

30

• Now back to the tariff. The lesson is that
  tariffs are bad policy.
• So why do we have tariffs?
• Shouldnt our nations leaders recognize that
  tariffs are bad policy and just say No!?
• A couple of possibilities
• Maybe there are some good reasons for tariffs (or
  other kinds of trade barriers) -- more on this
  later.

31

• Or, maybe those who stand to gain from the tariff
  (workers and owners of domestic firms) have more
  political clout than those who stand to lose
  (domestic consumers).
• Total gains/losses vs. per capita gains/losses
  and incentives to lobby.
• An example using some hypothetical numbers
• Loss from tire tariff in U.S. higher prices
  for consumers of tires
• 2/person/year x 300,000,000 people in U.S.
• total loss of 600,000,000/year

32

• Gains from tire tariff in U.S. greater job
  security for tire industry workers (valued at
  10K/worker/year)
• 10,000/worker/year x
• 30,000 workers in U.S. tire industry
• total gain of 300,000,000/year.
• Total loss is twice as great as total gain.
• But per capita loss (2/loser) is trivial
  compared to per capita gain (10,000/gainer).
• Potential gainers have much more incentive to
  lobby than potential losers.

33

• Arguments (some valid some bogus) for trade
  barriers
• Jobs argument
• Permitting imports will reduce domestic
  production of the good and reduce employment in
  the domestic industry.
• National security argument
• For certain products, production capacity must
  be maintained because it is vital in times of
  crisis.

34

• Infant-industry argument
• Sometimes new industries need temporary
  protection from import competition to help them
  get started.
• Protection-as-a-bargaining-chip-or-weapon
  argument
• The only way to convince our trading partners to
  drop their trade barriers may be to threaten them
  with trade barriers of our own.

35

• Unfair competition argument
• Foreign governments sometimes subsidize their
  export industries. U.S. industries only want a
  level playing field.
• (This was probably the main argument used to
  support the Bush administration steel tariffs.)

36

• Now back to President Obamas tire tariff . . .
• Some argue that
• China is guilty of predatory trade practices.
• Our tire tariff may be bad policy, but it sends
  the right message.
• For a defense of Obama tire tariff (using
  Protection as a weapon argument) see
• http//www.washingtonpost.com/ . . .

37

• One risk of imposing trade barriers
• Trigger tit-for-tat retaliation and a trade
  war.
• Just this past September
• China imposed a steep tariff on U.S. poultry
• (http//www.nytimes.com . . . )
• Poultry is one of the few categories in which the
  U.S. runs a trade surplus with China.