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International Trade

CHAPTER

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© 2003 South-Western/Thomson Learning

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Profile of Imports and ExportsU.S. exports of goods and services amounted to about 12% of GDP in 2000

High-technology products, such as computer software and hardware, aircraft, telecommunications equipmentIndustrial supplies and materialsAgricultural productsEntertainment products such as movies and recorded music

The big change over the last 25 years has been a growth in the dollar value of machinery exports

nearly half the capital goods produced in U.S. are exported

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Profile of Imports and Exports

U.S. imports of goods and services were 14% the size of GDP in 2000

Manufactured consumer goods such as automobiles from Japan and GermanyCapital goods such as high-tech printing presses from GermanyOilMetals such as lead, zinc, and copper

Major change in U.S. imports over the last 25 years has been the increase in spending on foreign oil

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Profile of Imports and Exports

Major trading partners of the U.S.

Canada is the largest followed by Mexico and Japan

Other key trading partners include Germany, Great Britain, South Korea, France, Hong Kong, Italy and Brazil

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Production Possibilities Without Trade

Suppose that we have two countries, United States and Izodia who produce two goods, food and clothing

The U.S. has 100 million workers and Izodia has 200 millionRecall that the production possibilities table / curve assumes full employment of all resources and a fixed state of technology

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Production Possibilities Without Trade

In our example, each U.S. worker can produce more of both clothing and food than can the Izodian worker U.S. has an absolute advantage in the production of both goods

Recall that having an absolute advantage means being able to produce something with fewer resources than other producers require

However, so long as the opportunity cost of production differs between two countries, there are gains from specialization and trade

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Consumption Possibilities Based on Comparative Advantage

The opportunity cost of producing 1 more unit of food in the U.S. is ½ unit of clothing, compared to 2 units of clothing in Izodia Law of comparative advantage says that each country should specialize in producing the good with the lower opportunity costThus, the U.S. should produce food and Izodia should produce clothing U.S. exports food and imports clothing while Izodia exports clothing and imports food

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Consumption Possibilities Based on Comparative Advantage

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

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SummaryUnited States

Without trade U.S. citizens produce and consume 240 million units of food and 180 million units of clothingWith trade they produce 600 units of food, consume 400 and exchange the remaining 200 units in return for 200 million units of clothing

IzodiansWithout trade, produce and consume 120 million units of food and 160 million units of clothingWith trade, they wear 200 million units of clothing and exchange the remaining 200 million units for 200 million units of food

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SummaryThe only constraint on trade is that, for each good, total world production must equal total world consumption

In our two-country world, this means that the amount of food the United States exports must equal the amount of food Izodia imports

The same is true for Izodia’s exports of clothing

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SummarySpecialization and trade allow both countries to consume more of both goods

Without specialization, total world food and clothing production were 360 and 340 million units, respectively

After specialization, the two countries produce 600 million units of food and 400 million units of clothing

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Reasons for International Specialization

How do we know what each country should produce and what goods should be traded?

Differences in Resource Endowments

Economies of Scale

Differences in Tastes

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Differences in Resource Endowments

Trade is often prompted by differences in resource endowments, especially with respect to labor and capital

Countries differ not only in their amounts of labor and capital but in the qualities of those resources, including having an educated labor forceSimilarly, capital that reflects the most recent technological developments is more productive than obsolete capitalThe productivity of both labor and capital differ because of educational levels of the work force and because of technologically sophisticated capital

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Differences in Resource Endowments

Some countries are blessed with an abundance of fertile land and favorable growing seasons•For example, the United States has

been called the “bread-basket of the world” because of its rich farmland

•Honduras has the ideal climate for growing bananas; Columbia, Brazil, and Jamaica have the best climate for coffee

•Differences in seasons across countries also serve as a basis for trade

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Economies of ScaleWhenever production is subject to economies of scale (long-run average cost falls as firms expand production), countries can gain from trade if each nation specializes

Such specialization allows each nation to produce at a greater output rate a decline in average production costs

The primary reason for establishing the single integrated market in Western Europe

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Differences in TastesEven if all countries had identical resource endowments and combined those resources with equal efficiency

Each country would still gain from trade so long as tastes and preferences differed among countries

English like tea, Americans like coffeeSoft drinks are more popular in America than in Western EuropeFrench drink more wine, while Germans prefer beer

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Trade Restrictions

Despite the benefits of international trade nearly all countries at one time or another erect barriers to impede or block free trade among nations

Two primary trade restrictions areTariffsQuotas

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Tariffs

Tariff is 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 oilAd valorem tariff is a percentage of the price of imports at the point of entry

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Import QuotasAn import quota is 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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Quotas in PracticeQuota rights are awarded to exporters through a variety of meansBy 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

Lobbyists for foreign producers work Congress seeking the right to export to the United StatesThis support, coupled with a lack of opposition from consumers has resulted in quotas that have lasted for decades

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Tariffs and Quotas ComparedSimilarities and differences

Since the tariff and the quota in our example had identical effects on the price, they reflect the same change in quantity demandedU.S. consumers suffer the same loss of consumer surplus and U.S. producers reap the same gain of consumer surplusThe primary difference is that 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 tariffHowever, even if quota rights go to domestic importers, quotas, like tariffs, still increase the domestic price, restrict quantity reduce consumer surplusQuotas and tariffs also encourage foreign governments to retaliate with quotas and tariffs of their own shrinking U.S. export markets loss in welfare is greater than shown in Exhibits 5 and 6

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Other Trade RestrictionsExport subsidies encourage firms to exportLow-interest loans to foreign buyers promote exports of large capital goodsDomestic content requirements specify that a certain percentage of a final good’s value must be produced domesticallyOther requirements concerning health, safety, or technical standards often discriminate against foreign goods

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Multilateral Agreement

After World War II, the United States invited its trading partners to negotiate less stringent restrictions and the result was GATT

General Agreement on Tariffs and Trade – GATT – is an international tariff-reduction treaty adopted in 1947 that resulted in a series of negotiated “rounds” aimed at freer tradeAdopted by 23 countries, including the United States

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Multilateral AgreementEach member of GATT agreed to

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 RoundsMost early GATT trade rounds aimed at reducing tariffs

The Kennedy Round in the mid-1960s included new provisions against dumping

Dumping refers to selling a commodity abroad at a price that is below its cost of production or below the price charged in the domestic market

The most recent round in Uruguay created the World Trade Organization to take over from GATT

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The World Trade OrganizationThe WTO is a permanent institution located in Geneva, Switzerland

Whereas GATT involved only merchandise trade, the WTO includes services and trade-related aspects of intellectual property, such as books, movies, and computer programsUnder the most-favored-nation clause, each WTO member must offer all other member countries the same trade concessions offered to any member countryAverage 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

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Common MarketsNumerous countries have tried to develop free-trade pacts of their own

The largest and best known of the free-trade zones being formed is the European Union.• This began in 1958 with a half-dozen countries

and now has expanded to more than a dozen• The idea was 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 replaces national currencies in January 2002

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Common MarketsOther trading blocs

The Association of Southeast Asian nations: ASEANSouth Africa and its four neighboring countries: Southern African Customs UnionHalf dozen Latin American countries: MercosurUnited States, Canada, and Mexico: NAFTA• Mexico hopes to increase U.S. investment by

guaranteeing duty-free access to U.S. markets to those who build manufacturing plants in Mexico

• The U.S. wants access to Mexico’s 100 million people and its huge oil reserves

• U.S. would like to bolster Mexico’s move toward a market-oriented economy

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Arguments for Trade RestrictionsTrade restrictions often appear to be little more than welfare programs for the domestic producers they protectFurther, it would be more efficient simply to transfer money from domestic consumers to domestic producersThe problem with this is that such a blatant transfer would be politically unpopularThus, various arguments have been advanced in support of these trade restrictions

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Arguments for Trade Restrictions

National Defense Argument

Infant Industry Argument

Antidumping Argument

Jobs and Income Argument

Declining Industries Argument

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National Defense ArgumentIndustries 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

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National Defense Argument

The problem with this argument is that most industries can play some role in national defense with the result that this argument gets out of hand

For example, wool producers benefited from protective policies because wool was used in military uniforms

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Infant Industry Argument

The rationale here is to protect emerging domestic industries from foreign competition

In industries where a firm’s 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

One problem here is how to identify which industries merit protection, and when do they become old enough to look out for themselves?

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Infant Industry ArgumentThe 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 ArgumentDumping 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 priceAn 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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Antidumping Argument

Problem: when dumpers attempt to take advantage of their monopoly position by raising price, other firms, either domestic or foreign, may enter the market and sell for less

It is also possible that dumping may be sporadic, as firms occasionally sell at a discount to unload excess inventories in which case it is of little concern

The Trade Agreements Act of 1979 effectively eliminates all dumping by imposing a tariff whenever a good is sold for less in the U.S. than in its home market

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Jobs and Income Argument

One of the more common arguments is that they protect U.S. jobs and wage levelsProblem: 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 ArgumentWhat 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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Jobs and Income ArgumentOver time, as labor productivity in developing countries increases, wage differentials will narrow

The increasingly global nature of multinational firms will increase the amount of capital and technology to workers in developing countries

To some extent this has already occurred in the stereo and consumer electronics market, and General Motors is planning to make more cars in Mexico

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Declining Industries ArgumentWhere 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 industryFree trade may displace some U.S. jobs through imports, but it also creates U.S. jobs through exportsWhere 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

Trade restrictions raise a number of problems in addition to the ones already mentioned

First, protecting one stage of production often requires protecting downstream stages Second, the cost of protection includes not only 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

Third, other countries often retaliate, thus further reducing the gains from tradeFinally, 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 versus Export Promotion

Developing countries have two options with respect to the transformation from the production of raw materials and agriculture to manufacturing

Import SubstitutionExport Promotion

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Import Substitution

The country manufactures products that until then had been imported and imposes tariffs and quotas to protect these industriesPopular for several reasons

Demand already existed for these productsProvides infant industries with a protected marketThose who already supply capital, labor and other resources to the favored industries gain

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Import Substitution

ProblemsReduces the gains from specialization and comparative advantageLow-cost foreign goods with high-cost domestic goodsSince they are shielded from foreign competition, domestic industries fail to become efficientEncourages 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