Global Markets in Action

Global Markets in Action CHAPTER9 C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Explain how markets work with international trade. 2 Identify the gains from international trade and its winners and losers. 3 Explain the effects of international trade barriers. 4 Explain and evaluate arguments used to justify restricting international trade. 1

9.1 HOW GLOBAL MARKETS WORK Imports are the good and services that we buy from people in other countries. Exports are the goods and services we sell to people in other countries. 9.1 HOW GLOBAL MARKETS WORK International Trade Today The United States is the world s biggest international trader and accounts for 10 percent of world exports and 15 percent of world imports. In 2006, total U.S. exports were $1,466 billion, which is about 11 percent of the value of U.S. production. In 2006, total U.S. imports were $2,229 billion, which is about 17 percent of the value of U.S. expenditure. 9.1 HOW GLOBAL MARKETS WORK The United States trades internationally in goods and services. In 2006, U.S. exports of services were $431 billion (29 percent of total exports) and U.S. imports of services were $349 billion (16 percent of total imports). The largest U.S. exports of goods are airplanes. The largest U.S. imports of goods are crude oil and automobiles. The largest U.S. exports of services are banking, insurance, business consulting and other private services. 2

9.1 HOW GLOBAL MARKETS WORK What Drives International Trade? The fundamental force that generates trade between nations is comparative advantage. The basis for comparative trade is divergent opportunity costs between countries. National comparative advantage as the ability of a nation to perform an activity or produce a good or service at a lower opportunity cost than any other nation. 9.1 HOW GLOBAL MARKETS WORK The opportunity cost of producing a T-shirt is lower in China than in the United States, so China has a comparative advantage in producing T-shirts. The opportunity cost of producing an airplane is lower in the United States than in China, so the United States has a comparative advantage in producing airplanes. Both countries can reap gains from trade by specializing in the production of the good at which they have a comparative advantage and then trading. Both countries are better off. 9.1 HOW GLOBAL MARKETS WORK Why the United States Imports T-Shirts Figure 9.1(a) shows that with no international trade, 1. U.S. demand and U.S. supply determine 2. The U.S. price at $8 a T-shirt and 3. U.S. firms produce at 40 million T-shirts a year and U.S. consumers buy 40 million T-shirts a year. 3

9.1 HOW GLOBAL MARKETS WORK The demand for and supply of T-shirts in the world determine 4. The world price at $5. The world price is less than $8, so the rest of the world has a comparative advantage in producing T-shirts. Figure 9.1(b) shows that with international trade, 5. The price in the United States falls to $5 a T-shirt. 9.1 HOW GLOBAL MARKETS WORK With international trade, 6. Americans increase the quantity they buy to 60 million T-shirts a year. 7. U.S. garment makers decrease the quantity they produce to 20 million T-shirts a year. 8. The United States imports 40 million T-shirts a year. 9.1 HOW GLOBAL MARKETS WORK Why the United States Exports Airplanes Figure 9.2(a) shows that with no international trade, 1. Equilibrium in the U.S. airplane market. 2. The U.S. price is $100 million a airplane and 3. U.S. aircraft makers produce at 400 airplanes a year and U.S. airlines buy 400 a year. 4

9.1 HOW GLOBAL MARKETS WORK The world market for airplanes determines 4. The world price at $150 million an airplane. The world price is higher than $100 million, so the United States has a comparative advantage in producing airplanes. 9.1 HOW GLOBAL MARKETS WORK Figure 9.2(b) shows that with international trade, 5. The price of an airplane in the United States rises to $150 million. 9.1 HOW GLOBAL MARKETS WORK With international trade, 6. U.S. aircraft makers increase the quantity they produce to 700 airplanes a year. 7. U.S. airlines decrease the quantity they buy to 200 airplanes a year. 8. The United States exports 500 airplanes a year. 5

9.2 WINNERS, LOSERS, AND NET GAINS... International trade lowers the price of an imported good and raises the price of an exported good. Buyers of imported goods benefit from lower prices and sellers of exported goods benefit from higher prices. But some people complain about international competition: not everyone gains. Who wins and who loses from free international trade? We measure the gains and losses by examining the effects of international trade on consumer surplus, producer surplus, and total surplus. 9.2 WINNERS, LOSERS, AND NET GAINS... Gains and Losses from Imports 1. With no international trade, the price of a T-shirt in the United States is $8 and 40 million T-shirts a year are bought and sold. 2. Consumer surplus is the area of the green triangle. 3. Producer surplus is the area of the blue triangle. 9.2 WINNERS, LOSERS, AND NET GAINS... With international trade, the price of a T-shirt falls to the 4. The world price of $5. 5. Consumer surplus expands from area A to the area A + B + D. 6. Producer surplus shrinks to the area C. 6

9.2 WINNERS, LOSERS, AND NET GAINS... The area B is transferred from producers to consumers, but 7. Area D is an increase in total surplus. Area D is the net U.S. gains from trade. 9.2 WINNERS, LOSERS, AND NET GAINS... Consumers gain because they pay less, buy more T-shirts, and receive a larger consumer surplus. Producers lose because they receive a lower price, produce fewer T-shirts, and receive a smaller producer surplus. Consumers gain exceeds producers loss, so total surplus increases. 9.2 WINNERS, LOSERS, AND NET GAINS... Gains and Losses from Exports 1. With no international trade, the price of an airplane in the United States is $100 million and 400 million a year are bought and sold. 2. Consumer surplus is the area of the green triangle. 3. Producer surplus is the area of the blue triangle. 7

9.2 WINNERS, LOSERS, AND NET GAINS... With international trade, the price of an airplane rises to the 4. The world price of $150 million. 5. Consumer surplus shrinks to the area A. 6. Producer surplus expands from area C to the area B + C + D. 9.2 WINNERS, LOSERS, AND NET GAINS... The area B is transferred from consumers to producers, but 7. Area D is an increase in total surplus Area D is the net U.S. gains from trade. 9.2 WINNERS, LOSERS, AND NET GAINS... Consumers lose because they pay a higher price, buy fewer airplanes, and receive a smaller consumer surplus. Producers gain because they receive a higher price, produce more airplanes, and receive a larger producer surplus. Producers gain exceeds consumers loss, so total surplus increases. 8

Governments restrict international trade to protect domestic producers from competition. The four sets of tools they use are Tariffs Quotas Other import restrictions Export subsidies Tariffs A tariff is a tax on a good that is imposed by the importing country when an imported good crosses its international boundary. For example, the government of India imposes a 100 percent tariff on wine imported from California. So when an Indian wine merchant imports a $10 bottle of Californian wine, he pays the Indian government $10 import duty. The Effects of a Tariff With free international trade, the world price of a T-shirt is $5 and the United States imports 40 million T-shirts a year. Imagine that the United States imposes a tariff of $2 on each T-shirt imported. The price of a T-shirt in the United States rises by $2. Figure 9.5 shows the effect of the tariff on the market for T-shirts in the United States. 9

Figure 9.5(a) shows the market before the government imposes the tariff. 1. The price is the world price of $5 and 2. The United States imports 40 million T- shirts. Figure 9.5(b) shows the market with the tariff. 3. The tariff of $2 raises the price in the U.S. market to $7. 4. U.S. imports decrease to 10 million a year. 5. U.S. government collects the tax revenue of $20 million a year. Winners, Losers, and Social Loss from a Tariff When the U.S. government imposes a tariff on imported T-shirts: U.S. producers of T-shirts gain. U.S. consumers of T-shirts lose. U.S. consumers lose more than U.S. producers gain. U.S. Producers of T-shirts Gain U.S. producers receive a higher price (the world price plus the tariff), so produce more T-shirts. Producer surplus increases. 10

U.S. Producers of T-shirts Gain U.S. garment makers can now sell T-shirts for a higher price (the world price plus the tariff), so they produce more T-shirts. But the marginal cost of producing a T-shirt is less than the higher price, so the producer surplus increases. The increased producer surplus is the gain to U.S. garment makers from the tariff. U.S. Consumers of T-shirts Lose U.S. buyers of T-shirts now pay a higher price (the world price plus the tariff), so they buy fewer T-shirts. The combination of a higher price and a smaller quantity bought decreases consumer surplus. The loss of consumer surplus is the loss to U.S. consumers from the tariff. U.S. Consumers Lose More than U.S. Producers Gain Consumer surplus decreases and producer surplus increases. But which changes by more? Figure 9.6 illustrates the change in total surplus. 11

Figure 9.6(a) shows the total surplus with free international trade. 1. The world price 2. Imports 3. Consumer surplus 4. Producer surplus 5. The gains from free trade. Total surplus is maximized. 6. The $2 tariff is added to the world price and increases the U.S. price of a T-shirt to $7. The quantity of T-shirts produced in the United States increases and the quantity bought decreases. 7. Imports decrease. 8. Consumer surplus shrinks to the green area. 9. Producer surplus expands to the blue area. Area B is a transfer from consumer surplus to producer surplus. 12

Tariff revenue equals the imports of T-shirts multiplied by the tariff. 10. The tariff revenue is area C. 11.The sum of the two areas labeled D is the loss of total surplus a deadweight loss. Quotas A quota is a quantitative restriction on the import of a good that limits the maximum quantity of a good that may be imported in a given period. The Effects of a Quota With free international trade, the world price of a T-shirt is $5 and the United States imports 40 million T-shirts a year. Imagine that the United States imposes a quota of 10 million on imported T-shirts. Figure 9.7 shows the effect of the quota on the market for T-shirts in the United States. 13

Figure 9.7(a) shows the market before the government imposes the quota. 1. The price is the world price of $5 and 2. The United States imports 40 million T-shirts. Figure 9.5(b) shows the market with the quota. 3. With an import quota of 10 million T-shirts, the supply of T-shirts in the United States becomes S + quota. 4. The price rises to $7. With the higher price, Americans decrease the number of T-shirts they buy to 45 million a year. U.S. garment makers increase production to 35 million T-shirts a year. 5. Imports of T-shirts decrease to the quota of 10 million. 14

Winners, Losers, and Social Loss from a Quota When the U.S. government imposes a tariff on imported T-shirts: U.S. producers of T-shirts gain. U.S. consumers of T-shirts lose. Importers of T-shirts gain. U.S. consumers lose more than U.S. producers gain and importers gain. Figure 9.8 illustrates the winners and losers with a quota. Figure 9.8(a) shows the total surplus with free international trade. 1. The world price 2. Imports 3. Consumer surplus 4. Producer surplus 5. The gains from free trade. Total surplus is maximized. The import quota raises the U.S. price of a T-shirt to $7. The quantity of T-shirts produced in the United States increases and the quantity bought decreases. 6. Imports decrease. 15

7. Consumer surplus shrinks to the green area. 8. Producer surplus expands to the blue area. Area B is a transfer from consumer surplus to producer surplus. 9. Importers profit is the sum of the two areas C. 10.The sum of the two areas labeled D is the loss of total surplus a deadweight loss created by the quota. Other Import Barriers Two sets of policies that influence imports are Health, safety, and regulation barriers Voluntary export restraints Thousands of detailed health, safety, and other regulations restrict international trade. For example, U.S. food imports are examined by the Food and Drug Administration to determine whether the food is pure, wholesome, safe to eat, and produced under sanitary conditions. 16

A voluntary export restraint is like a quota allocated to a foreign exporter of the good. A voluntary export restraint decreases imports just like a quota does but the foreign exporter gets the profit from the gap between the domestic price and the world price. Export Subsidies A subsidy is a payment made by the government to a producer. An export subsidy is a payment made by the government to a domestic producer of an exported good. Export subsidies bring gains to domestic producers, but they result in overproduction in the domestic economy and underproduction in the rest of the world and so create a deadweight loss. 9.4 THE CASE AGAINST PROTECTION Despite the fact that free trade promotes prosperity for all countries, trade is restricted. Three Traditional Arguments for Protection Three traditional arguments for restricting international trade are The national security argument The infant industry argument The dumping argument 17

9.4 THE CASE AGAINST PROTECTION The National Security Argument The national security argument is that is that a country must protect industries that produce defense equipment and armaments and those on which the defense industries rely for their raw materials and other intermediate inputs. This argument for protection can be taken too far. 9.4 THE CASE AGAINST PROTECTION The Infant-Industry Argument The infant-industry argument is that it is necessary to protect a new industry from import competition to enable it to grow into a mature industry that can compete in world markets. This argument is based on the concept of dynamic competitive advantage, which can arise from learningby-doing. Learning-by-doing is a powerful engine of productivity growth, but this fact does not justify protection. 9.4 THE CASE AGAINST PROTECTION The Dumping Argument Dumping occurs when foreign a firm sells its exports at a lower price than its cost of production. Two reasons why a firm might engage in dumping are Predatory pricing when a firm sells below cost in the hope of driving out competitors Subsidy a firm receiving a subsidy can sell profitable at price below cost. 18

9.4 THE CASE AGAINST PROTECTION This argument does not justify protection because 1. It is virtually impossible to determine a firm s costs; 2. If there was a natural global monopoly, it would be more efficient to regulate it than to impose a tariff against it. 3. If the market is truly a global monopoly, better to regulate it rather than restrict trade. 9.4 THE CASE AGAINST PROTECTION Four Newer Arguments for Protection Other common arguments for protection are that it Saves jobs Allows us to compete with cheap foreign labor Brings diversity and stability Penalizes lax environmental standards 9.4 THE CASE AGAINST PROTECTION Saves Jobs The idea that buying foreign goods costs domestic jobs is wrong. Free trade destroys some jobs and creates other better jobs. Free trade also increases foreign incomes and enables foreigners to buy more domestic production. Protection to save particular jobs is very costly. 19

9.4 THE CASE AGAINST PROTECTION Allows Us to Compete with Cheap Foreign Labor The idea that a high-wage country cannot compete with a low-wage country is wrong. Low-wage labor is less productive than high-wage labor. And wages and productivity tell us nothing about the source of gains from trade, which is comparative advantage. 9.4 THE CASE AGAINST PROTECTION Brings Diversity and Stability A diversified investment portfolio is less risky than one that has all of its eggs in one basket. The same is true for an economy s production. A diversified economy fluctuates less than an economy that produces only one or two goods. But big, rich, diversified economies like those of the United States, Japan, and Europe do not have this type of stability problem. 9.4 THE CASE AGAINST PROTECTION Penalizes Lax Environmental Standards The idea that protection is good for the environment is wrong. Free trade increases incomes and poor countries have lower environmental standards than rich countries. These countries cannot afford to spend as much on the environment as a rich country can and sometimes they have a comparative advantage at doing dirty work, which helps the global environment achieve higher environmental standards. 20

9.4 THE CASE AGAINST PROTECTION Why Is International Trade Restricted? The key reason why international trade restrictions are popular in the United States and most other developed countries is an activity called rent seeking. Rent seeking is lobbying and other political activity that seeks to capture the gains from trade. You ve seen that free trade benefits consumers but shrinks the producer surplus of firms that compete in markets with imports. 9.4 THE CASE AGAINST PROTECTION Those who gain from free trade are the millions of consumers of low-cost imports. But the benefit per individual consumer is small. Those who lose are the producers of import-competing items. Compared to the millions of consumers, there are only a few thousand producers. 9.4 THE CASE AGAINST PROTECTION Because the gain from a tariff is large, producers have a strong incentive to incur the expense of lobbying for a tariff and against free trade. Because each consumer s loss is small, consumers have little incentive to organize and incur the expense of lobbying for free trade. The gain from free trade for any one person is too small for that person to spend much time or money on a political organization to lobby for free trade. 21

9.4 THE CASE AGAINST PROTECTION Each group weighs benefits against costs and chooses the best action for themselves. But the group against free trade will undertake more political lobbying than will the group for free trade. 22