GS ECO 2301 CH 7 Comparative Advantage And the Gains from International Trade

A quota is a numerical limit on the quantity of a good that can be imported, and it has an effect similar to that of a tariff.

A quota is imposed by the government of the importing country.

By the end of World War II in 1945, government officials in the United States and Europe were looking for a way to reduce tariffs and revive international trade. To help achieve this goal, they set up the General Agreement on Tariffs and Trade (GATT) in 1948.

Countries that joined the GATT agreed not to impose new tariffs or import quotas. In addition, a series of multilateral negotiations, called trade rounds, took place, in which countries agreed to reduce tariffs from the very high levels of the 1930s.

Remember that positive analysis concerns what is, while normative analysis concerns what ought to be.

Measuring the effect of the sugar quota on the U.S. economy is an example of positive analysis. Asserting that the sugar quota is bad public policy and should be eliminated is normative analysis. The sugar quota—like all other interferences with trade—makes some people better off and some people worse off, and it reduces total income and consumption.

Globalization

The process of countries becoming more open to foreign trade and investment.

Terms of trade

The ratio at which a country can trade its exports for imports from other countries.

A new agreement was negotiated, and in January 1995, the GATT was replaced by the

World Trade Organization (WTO), headquartered in Geneva, Switzerland. More than 150 countries are currently members of the WTO.

Over the past 50 years, many governments have changed policies to facilitate international trade. For example, tariff rates have fallen. A tariff is

a tax imposed by a government on imports into a country.

In North America, most tariffs between Canada, Mexico, and the United States were eliminated following the passage of the North American Free Trade Agreement (NAFTA) in 1994. In Europe, 28 countries have formed the European Union, which has eliminated all tariffs among member countries, greatly increasing both imports and exports

are goods and services produced domestically and sold in other countries.

Trade is simply the act of

buying or selling. One significant difference between domestic trade and international trade is that international trade is more controversial. At one time, nearly all the televisions, shoes, clothing, and toys bought in the United States were also produced here.

Other countries are strong in process technologies, which involve the ability to

improve the processes used to make existing products. For example, Japanese-based firms, such as Toyota and Honda, have succeeded by greatly improving the processes for designing and manufacturing automobiles.

Recall that comparative advantage is

the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.

Some countries are strong in product technologies, which involve

the ability to develop new products. For example, firms in the United States have pioneered the development of such products as radios, televisions, digital computers, airliners, medical equipment, and many prescription drugs.

Where Does Comparative Advantage Come From? Among the main sources of comparative advantage are the following:

1. Climate and natural resources. This source of comparative advantage is the most obvious. Because of geology, Saudi Arabia has a comparative advantage in the production of oil. Because of climate and soil conditions, Costa Rica has a comparative advantage in the production of bananas, and the United States has a comparative advantage in the production of wheat. 2. Relative abundance of labor and capital. Some countries, such as the United States, have many highly skilled workers and a great deal of machinery. 3. Technology. Broadly defined, technology is the processes firms use to turn inputs into goods and services. At any given time, firms in different countries do not all have access to the same technologies. In part, this difference is a result of past investments countries have made in higher education or in supporting research and development. 4. External economies. It is difficult to explain the location of some industries on the basis of climate, natural resources, the relative abundance of labor and capital, or technology. For example, why does southern California have a comparative advantage in making movies or Switzerland in making watches or New York in providing financial services? The answer is that once an industry becomes established in an area, firms located in that area gain advantages over firms located elsewhere.

Why Don't We See Complete Specialization? In our example of two countries producing only two products, each country specializes in producing one of the goods. In the real world, many goods and services are produced in more than one country. For example, the United States, Japan, Germany, China, Canada, Mexico, India, and other countries produce automobiles. We do not see complete specialization in the real world for three main reasons:

1. Not all goods and services are traded internationally. For example, even if Japan had a comparative advantage in the production of medical services, it would be difficult for it to specialize in producing medical services and then export them. 2. Production of most goods involves increasing opportunity costs. Recall that production of most goods involves increasing opportunity costs (see Chapter 2, Section 2.1). Although we didn't include this fact in our example, if the United States devotes more workers to producing wheat, the opportunity cost of producing more wheat will increase. At some point, the opportunity cost of producing wheat in the United States may rise to the level of the opportunity cost of producing wheat in China. When that happens, international trade will no longer push the United States further toward specialization. 3. Tastes for products differ. Most products are differentiated. Smartphones, laptops, cars, and televisions—to name just a few products—have a variety of features. When buying automobiles, some people look for reliability and fuel efficiency, others look for room to carry seven passengers, and still others want styling and high performance.

The success of industries in getting the government to erect barriers to foreign competition depends partly on some members of the public knowing the costs of trade barriers but supporting them anyway. However, two other factors are also at work:

1. The costs that tariffs and quotas impose on consumers are large in total but relatively small per person. For example, the sugar quota imposes a total burden of $2.59 billion per year on consumers. Spread across 325 million Americans, the burden is only about $8 per person—too little for most people to worry about, even if they know the burden exists. 2. The jobs lost to foreign competition are easy to identify, but the jobs created by foreign trade are less easy to identify. In other words, the industries that benefit from tariffs and quotas benefit a lot—for example, the sugar quota increases the profits of U.S. sugar producers by $1.38 billion per year—while each consumer loses relatively little. This concentration of benefits and widely spread burdens makes it easy to understand why members of Congress receive strong pressure from some industries to enact tariffs and quotas and relatively little pressure from the general public to reduce them.

Loss of Consumer Surplus 50 cent tariff = A + C + T + D A = Producer Surplus T = Tax Revenue C + D = Deadweight Loss

A = 2 parts Part 1 is square = $0.50 (tariff) x 3B (original domestic produced amount) Part 2 is the small increase (triangle) = 1/2 b*h = .5 * $0.50 (tariff) * 1.5 (increase in domestic supply) = 1.5B + .375B = 1.875B T = Tax Revenue Imported Amount * Tariff = Demand Amount - Domestic Supplied Amount = 7.5 - 4.5 = 3B imported = 3B * .5 = 1.5B C + D = Deadweight C = deadweight (pt 1) C = 1/2 b*h C = .5 * 1.5 (change in domestic supply) * $0.50 (tariff) = 0.375B D = deadweight (pt2) D = 1/2 b*h D = .5 * 1.5 (change from supply demanded at world price to tariff price) * $0.50 (tariff) = 0.375B Deadweight = = 2*0.375B = .75B Consumer Surplus Loss = A + T + C + D = 1.875B + 1.5B + .75B = (4.125B)

Tariffs The most common interferences with trade are tariffs, which are taxes imposed by a government on goods imported into the country. Like any other tax, a tariff increases the cost of selling a good. Figure 7.6 shows the effect of a tariff of $0.50 per gallon on ethanol imports into the United States.

At this higher price, U.S. ethanol producers increase the quantity they supply from 3.0 billion gallons to 4.5 billion gallons. U.S. consumers, though, cut back their purchases of ethanol from 9.0 billion gallons to 7.5 billion gallons. Imports decline from 6.0 billion gallons (9.0 billion−3.0 billion) to 3.0 billion gallons (7.5 billion−4.5 billion). Equilibrium moves from point G to point H. We can conclude that the tariff succeeds in helping U.S. ethanol producers but hurts U.S. consumers and the efficiency of the U.S. economy.

Not all sectors of the U.S. economy are affected equally by international trade. For example, although it's difficult to import or export some services, such as haircuts and appendectomies, a large percentage of U.S. agricultural production is exported.

Each year, the United States exports about 50 percent of its wheat and rice crops and 20 percent of its corn crop. Many U.S. manufacturing industries also depend on trade. About 20 percent of U.S. manufacturing jobs depend directly or indirectly on exports. In some industries, such as pharmaceutical drugs, output is directly exported. In other industries, such as steel, output is used to make other products, such as bulldozers or machine tools, that are then exported. In all, about two-thirds of U.S. manufacturing industries depend on exports for at least 10 percent of jobs.

The Importance of Trade to the U.S. Economy U.S. consumers are buying increasing quantities of goods and services produced in other countries. At the same time, U.S. businesses are selling increasing quantities of goods and services to consumers in other countries.

Figure 7.1 shows that since 1970, both exports and imports have tended to increase as a fraction of U.S. gross domestic product (GDP).

Why would attempts to reduce trade barriers with the objective of increasing income around the world cause such a furious reaction? The opposition to the WTO comes from three sources.

First, some opponents are specifically against the globalization process that began in the 1980s and became widespread in the 1990s. Second, other opponents have the same motivation as the supporters of tariffs in the 1930s—to erect trade barriers to protect domestic firms from foreign competition. Third, some critics of the WTO support globalization in principle but believe that the WTO favors the interests of the high-income countries at the expense of the low-income countries.

Other Barriers to Trade In addition to tariffs and quotas, governments sometimes erect other barriers to trade. For example, all governments require that imports meet certain health and safety requirements. Sometimes, however, governments use these requirements to shield domestic firms from foreign competition.

For example, a government may impose stricter health and safety requirements on imported goods than on goods produced by domestic firms. Many governments also restrict imports of certain products on national security grounds. The argument is that in time of war, a country should not be dependent on imports of critical war materials. Once again, these restrictions are sometimes used more to protect domestic companies from competition than to protect national security.

The main purpose of most tariffs and quotas is to reduce the foreign competition that domestic firms face.

For many years, Congress has imposed a quota on sugar imports to protect U.S. sugar producers. Figure 7.7 shows the actual statistics for the U.S. sugar market in 2016. The effect of a quota is very similar to the effect of a tariff. By limiting imports, a quota forces the domestic price of a good above the world price.

Figure 7.3 shows that international trade is less important to the United States than it is to many other countries, with imports and exports being lower percentages of GDP.

In some smaller countries, such as Belgium and the Netherlands, imports and exports make up more than half of GDP. In the larger European economies, imports and exports make up one-quarter to one-half of GDP.

The following figure shows the distribution of U.S. imports of goods from China by broad product categories. Many of the products the United States currently imports from China were at one time manufactured in the United States. Chinese firms were able to win a large share of these markets typically by offering goods at lower prices than U.S. firms (or firms in other foreign countries that were also competing in the U.S. market). These lower prices have benefited U.S. consumers.

Lower-income consumers in particular have benefitted from the low prices of textile products, such as clothing, sheets, and towels. Smartphones and other consumer electronics products would have much higher prices if they were assembled in the United States rather than in China and other foreign countries. Because consumers pay lower prices for goods imported from China, they have more of their income available to spend on other goods and services produced in the United States. A family that buys low-price Chinese-made clothes at Walmart can more easily afford to dine out at the local Red Lobster restaurant or to buy fresh fruits and vegetables grown at local farms. In this sense, the losses suffered by U.S. firms (and their workers) that have been forced out of business by Chinese competitors have resulted in gains to other U.S. firms (and their workers).

External economies

Reductions in a firm's costs that result from an increase in the size of an industry.

Why, then, does protectionism attract support, and why has support for protectionist policies increased recently among some policymakers in the United States? Protectionism is usually justified on the basis of one of the following arguments:

Saving jobs Trump and other supporters of protectionist policies argue that free trade reduces employment by driving domestic firms out of business. It is true that when more-efficient foreign firms drive less-efficient domestic firms out of business, jobs are lost, but jobs are also lost when more-efficient domestic firms drive less-efficient domestic firms out of business. Economists have traditionally argued that these job losses are rarely permanent. Protecting high wages. Some people worry that firms in high-income countries will have to start paying much lower wages to compete with firms in developing countries. For the country as a whole, this fear is misplaced, however, because free trade actually raises living standards by increasing economic efficiency. Protecting infant industries. It is possible that firms in a country may have a comparative advantage in producing a good, but because the country begins production of the good later than other countries, its firms initially have higher costs. Producing some goods and services involves substantial "learning by doing." As workers and firms produce more of the good or service, they gain experience and become more productive. Over time, these firms will have lower costs and can charge lower prices. As the firms in the "infant industry" gain experience, they will be able to compete successfully with foreign producers. Under free trade, however, they may not get a chance. Protecting national security. A country will typically not want to rely on other countries for goods that are critical to its military defense. For example, the United States would probably not want to import all its jet fighter engines from China. The definition of which goods are critical to military defense is a slippery one, however. In fact, it is rare for an industry to ask for protection without raising the issue of national security, even if its products have mainly nonmilitary uses.

Anti-globalization Many of those who protest at WTO meetings distrust globalization

Some believe that free trade and foreign investment destroy the distinctive cultures of many countries. As developing countries began to open their economies to imports from the United States and other high-income countries, the imports of food, clothing, movies, and other goods began to replace the equivalent local products. Globalization has also allowed multinational corporations to relocate factories from high-income countries to low-income countries. These new factories in Indonesia, Malaysia, Pakistan, and other countries pay much lower wages than are paid in the United States, Europe, and Japan and often do not meet the environmental or safety regulations that are imposed in high-income countries. Some factories use child labor, which is illegal in high-income countries. Some people have argued that firms with factories in developing countries should pay workers wages as high as those paid in high-income countries. They also believe these firms should abide by the health, safety, and environmental regulations that exist in the high-income countries.

The figure shows the situation of autarky, where the United States does not trade with other countries. The equilibrium price of ethanol is $2.00 per gallon, and the equilibrium quantity is 6.0 billion gallons per year.

The blue area represents consumer surplus, and the red area represents producer surplus.

The Gains from Trade The first discussion of comparative advantage appears in On the Principles of Political Economy and Taxation, a book written by the British economist David Ricardo in 1817. Ricardo provided a famous example of the gains from trade, using wine and cloth production in Portugal and England.

The following table is adapted from Ricardo's example, with cloth measured in sheets and wine measured in kegs:

Shifting production to the more efficient country—the one with the comparative advantage—increases total production.

The key point is: Countries gain from specializing in producing goods in which they have a comparative advantage and trading for goods in which other countries have a comparative advantage.

The High Cost of Preserving Jobs with Tariffs and Quotas The sugar quota is not the only government policy that imposes a high cost on U.S. consumers to save jobs at U.S. firms.

The tariff on shoe imports has been estimated to cost U.S. consumers $300,000 per year for each job saved just for women's shoes and rubber shoes. In 2009, the United States imposed a tariff on imports of Chinese tires. As a result, U.S. consumers spent about $1.1 billion more per year on tires. The tariff saved an estimated 1,200 jobs in the U.S. tire industry, at a cost of $900,000 per year per job saved.

Now suppose that the United States begins importing ethanol from Brazil and other countries that produce ethanol for $1.00 per gallon. Because the world market for ethanol is large, we will assume that the United States can buy as much ethanol as it wants without causing the world price of $1.00 per gallon to rise.

Therefore, once imports of ethanol are allowed into the United States, U.S. firms will not be able to sell ethanol at prices higher than the world price of $1.00, and the U.S. price will become equal to the world price. With the price lowered from $2.00 to $1.00, U.S. consumers increase their purchases from 6.0 billion gallons to 9.0 billion gallons. Equilibrium moves from point F to point G. In the new equilibrium, U.S. producers have reduced the quantity of ethanol they supply from 6.0 billion gallons to 3.0 billion gallons. Imports will equal 6.0 billion gallons, which is the difference between U.S. consumption and U.S. production. We can conclude that international trade helps consumers but hurts firms that are less efficient than foreign competitors.

China has a comparative advantage in the production of goods, such as furniture, clothing, and children's toys, that require unskilled workers and small amounts of simple machinery. In fact, many economists believe that the surge in Chinese imports to the United States and other countries following China's admittance to the World Trade Organization (WTO) was fueled by the low cost of producing manufactured goods using low-wage, unskilled workers.

These workers had become available to manufacturing firms after economic reforms allowed large numbers of workers to leave unproductive collective farms and state-owned companies for higher-paid factory work.

U.S. International Trade in a World Context The United States is the second-largest exporter in the world, just behind China, as Figure 7.2 illustrates. Six of the other seven leading exporting countries are also high-income countries. Although China is still a relatively low-income country, the rapid growth of the Chinese economy over the past 35 years has resulted in its becoming the largest exporter.

Three of the top exporting countries are in East Asia, four are in Western Europe, and one is in North America.

Why have businesses around the world increasingly looked for markets in other countries? Why have consumers increasingly purchased goods and services made in other countries? People trade for one reason:

Trade makes them better off. Whenever a buyer and seller agree to a sale, they must both believe they are better off; otherwise, there would be no sale. This outcome must hold whether the buyer and seller live in the same city or in different countries. As we will see, governments are more likely to interfere with international trade than they are with domestic trade, but the reasons for the interference are more political than economic.

Canada, the largest trading partner of the United States, reacted to passage of the Smoot-Hawley Tariff Act by enacting large increases in tariffs on U.S. imports. Other countries raised tariffs as well, resulting in a trade war that led to

a sharp decrease in global trade and helped increase the severity of the Great Depression of the 1930s. Since the end of World War II in 1945, the United States and most other countries have greatly reduced tariffs on most goods. But the United States continues to impose high tariffs on shoes 85 years after the passage of Smoot-Hawley. During that time, employment in the U.S. shoe industry has fallen from 275,000 workers to fewer than 15,000, as more than 98 percent of the shoes sold in the United States are imported. The total cost to U.S. consumers from higher shoe prices due to the tariff is more than $2 billion per year.

Autarky

a situation in which a country does not trade with other countries Assume that in autarky, each country has 1,000 hours of labor available to produce the two goods, and each country produces the quantities of the two goods shown in Table 7.3. Because there is no trade, these quantities also represent consumption of the two goods in each country.

A voluntary export restraint (VER) is

an agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country. In the 1980s, the United States and Japan negotiated a VER that limited the quantity of automobiles the United States would import from Japan. The Japanese government agreed to the VER primarily because it was afraid that if it did not, the United States would impose a tariff or quota on imports of Japanese automobiles. Quotas and VERs have similar economic effects.

Gains from Unilateral Elimination of Tariffs and Quotas It is easier for policymakers to gain political support for reducing or eliminating tariffs or quotas if it is done as part of

an agreement with other countries that requires those countries to eliminate some of their tariffs or quotas. But as the example of the sugar quota shows, the U.S. economy would experience a gain in economic surplus from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas.

Imports are

goods and services purchased domestically that have been produced in other countries. In the 1930s, the United States charged an average tariff rate above 50 percent. Today, the rate is less than 1.5 percent.

Opportunity cost is the

highest-valued alternative that must be given up to engage in an activity. People, firms, and countries specialize in economic activities in which they have a comparative advantage. In trading, we benefit from the comparative advantage of other people (or firms or countries), and they benefit from our comparative advantage.

Logrolling refers to

members of Congress promising to support each other's legislation. In this case, a member of Congress from a district with many dairy farms who wanted the tariff on milk increased would seek out a member of Congress from a district with shoe factories and negotiate along these lines: "If you vote to increase tariffs on milk, I'll vote to increase tariffs on shoes." The law Congress finally passed in 1930, the Smoot-Hawley Tariff Act, raised tariffs to the highest level in U.S. history. As a percentage of the value of imports covered by the law, tariffs reached nearly 60 percent.

Remember That Trade Creates Both Winners and Losers The following statement is from a Federal Reserve publication: "Trade is a win-win situation for all countries that participate." People sometimes interpret statements like this to mean that there are no losers from international trade. But

notice that the statement refers to countries, not individuals. When countries participate in trade, they make their consumers better off by increasing the quantity of goods and services available to them. As we have seen, however, expanding trade eliminates the jobs of workers employed at companies that are less efficient than foreign companies. Trade also creates new jobs at companies that export products to foreign markets. But it may be difficult for workers who lose their jobs because of trade to easily find others. That is why in the United States the federal government uses the Trade Adjustment Assistance (TAA) program to provide funds for workers who have lost their jobs due to international trade.

One way to avoid logrolling when passing tariff laws is for Congress to give the president fast-track authority when negotiating trade agreements with other countries. Under fast-track authority

once the president has finished negotiating an agreement with other countries, Congress can either pass or reject the agreement but cannot change any of its provisions. Fast-track authority would have prevented the vote trading that occurred during the Congressional deliberations over Smoot-Hawley. Some members of Congress have recently become skeptical about the merits of free trade, so it seems less likely that Congress will grant presidents fast-track authority in the future.

Free trade

or trade between countries without government restrictions, makes consumers better off. We can expand on this idea by using the concepts of consumer surplus and producer surplus

Absolute advantage is the ability to

produce more of a good or service than competitors when using the same amount of resources. Comparative Advantage China has to give up 12 smartphones for every 6 bushels of wheat it produces. Therefore, the opportunity cost to China of producing 1 more bushel of wheat is 12/6, or 2 smartphones. If the United States switches one hour of labor from smartphones to wheat, production of smartphones falls by 2, and production of wheat rises by 4 bushels. Therefore, the opportunity cost to the United States of producing 1 more bushel of wheat is 2/4, or 0.5 smartphone.

President Trump has argued that the best response to the difficulties caused by rising imports is either to renegotiate trade agreements with other countries in order to protect U.S. firms and workers or to impose tariffs on imports. Some policymakers and economists, though, believe that protecting U.S. firms will

raise prices U.S. consumers pay and will also raise the costs to U.S. firms that buy inputs from foreign firms. In addition, because automation—the replacement of workers by robots, computers, and other capital—has increased in manufacturing, it is unlikely that increased production of manufactured goods in the United States would reverse the long-run decline in manufacturing employment. Some policymakers and economists support expanded use of Trade Adjustment Assistance (TAA), which is a federal government program that provides funds to workers who have lost their jobs as a result of competition from foreign imports. The funds can be used for job training, job searches, relocations to find new jobs, payments for health insurance, and replacement of lost wages.

Dumping In recent years, the United States has extended protection to some domestic industries by using a provision in the WTO agreement that allows governments to impose tariffs in the case of dumping. Dumping is

selling a product for a price below its cost of production. Using tariffs to offset the effects of dumping is controversial, despite being allowed under the WTO agreement. In practice, it is difficult to determine whether foreign companies are dumping goods because the true production costs of a good are not easy for governments to calculate. As a result, the WTO allows countries to determine that dumping has occurred if a product is exported for a lower price than it sells for on the home market. There is a problem with this approach, however. Often there are good business reasons for a firm to sell a product for different prices to different consumers. Firms also use "loss leaders"—products that are sold below cost, or even given away free—when introducing a new product or, in the case of retailing, to attract customers who will also buy full-price products. For example, during the holiday season, Walmart sometimes offers toys at prices below what it pays to buy them from manufacturers. It's unclear why these normal business practices should be unacceptable when used in international trade.

In the 1940s, most international trade was in goods, and the GATT agreement covered only goods. In the following decades, trade in services and products incorporating intellectual property,

such as software programs and movies, grew in importance. Many GATT members pressed for a new agreement that would cover services and intellectual property, as well as goods.

But David Autor of the Massachusetts Institute of Technology and other economists studying the effects of the China shock on the U.S. economy point out that the firms most hurt by Chinese imports have been concentrated in certain states, particularly in

the Midwest and Southeast. As noted in the chapter opener, some cities in these areas have been devastated as local manufacturing plants have closed and workers have had difficulty finding other jobs. Dissatisfaction among these workers played a significant role in the 2016 presidential election. As the following figure shows, the fraction of U.S. workers employed in manufacturing began declining long before the China shock began. In 1944, nearly 38 percent of U.S. workers were employed in manufacturing. At the start of the surge in imports from China in 2001, only about 12 percent were. Autor, David Dorn of the University of Zurich, and Gordon Hanson of the University of California, San Diego estimate that between 1999 and 2011, the China shock resulted in the loss of 2.4 million jobs and may have accounted for 25 percent of the decline in manufacturing jobs during those years.

Anti-globalization Many of those who protest at WTO meetings distrust globalization (cont) Old-Fashioned" Protectionism The anti-globalization argument against free trade and the WTO is relatively new. Another argument against free trade, called protectionism, has been around for centuries. Protectionism is

the use of trade barriers to shield domestic firms from foreign competition. Some of the recent opposition to free trade in the United States appears to be protectionist. For as long as international trade has existed, governments have attempted to restrict it to protect domestic firms.

GDP is the

value of all the final goods and services produced in a country during a year. World trade declined sharply during the severe worldwide recession of 2007-2009 and has grown relatively slowly since that time. The slowdown in trade seems to have been caused by slower income growth in some countries, including China, Brazil, and many countries in Europe, combined with some firms deciding to produce fewer of their products in foreign countries.

International trade has grown tremendously over the past 50 years, due primarily to three factors:

• the decreasing costs of shipping products around the world, • the spread of inexpensive and reliable communications, and changes in government policies.