Unit 4: International Economics Unit Overview 4.1 Reasons for trade Differences in factor endowments Variety and quality of goods Gains from specialization Higher level extension topic >>Absolute and comparative advantage (numerical and diagrammatic representations) >>opportunity cost >>limitations of the theory of comparative advantage 4.2 Free trade and protectionism Definition of free trade Types of protectionism Tariffs Quotas Subsidies Voluntary Export Restraints (VERs) Administrative obstacles Health and safety standards Environmental standards Arguments for protectionism Infant industry argument Efforts of a developing country to diversify Protection of employment Source of government revenue Strategic arguments Means to overcome a balance of payments disequilibrium Anti-dumping Arguments against protectionism Inefficiency of resource allocation Costs of long-run reliance on protectionist methods Increased prices of goods and services to consumers The effect of protected imports on export competitiveness Blog posts: "Free trade" Blog posts: "Protectionism" Blog posts: "International trade" Blog posts: "Barriers to trade" www.welkerswikinomics.com 1
Reasons for Trade Introduction Abraham Lincoln was once advised to buy cheap iron rails from Britain to finish the transcontinental railroad. He replied, "It seems to me that if we buy the rails from England, then we've got the rails and they've got the money. But if we build the rails here, we've got our rails and we've got our money." To paraphrase: "If I buy meat from the butcher, then I get the meat and he gets my money. But if I raise a cow in my backyard for three years and slaughter it myself, then I've got the meat and I've got my money." Why don't we keep cows in our backyard? 1. Why do nations trade? 2. What is specialization? 3. How does a nation determine what it should specialize in? 4. How do nations benefit from trade? Blog post: "The Lord of the Ring of Free Trade" www.welkerswikinomics.com 2
Reasons for Trade Introduction "You could say that globalization, driven not by human goodness but by the profit motive, has done far more good for more people than all the foreign aid and soft loans provided by well-intentioned governments and aid agencies." -Paul Krugman What evidence is there to support Krugman's claim? What evidence is there to refute it? Group A: Research and find data or an article that supports the statement. Group B: Research and find data or an article that refutes the statement. www.welkerswikinomics.com 3
Reasons for Trade Why do nations trade? Why do nations trade? Three facts help answer this question: Uneven distribution of natural, human and capital resources Efficient production requires different combinations of resources People may simply prefer products made in other countries due to non-price attributes Labor-intensive goods -Examples: -Where? Land-intensive goods -Examples: -Where? Capital-intensive goods -Examples -Where? www.welkerswikinomics.com 4
Reasons for Trade Comparative Advantage Opportunity cost: the cost to society of producing a particular good is what it could have produced with those resources instead. The opportunity cost is what was given up in order to produce something. Comparative advantage: When a country can produce a good or service at a lower domestic opportunity cost than a potential trading partner. Absolute advantage: When a country can produce a particular good or service more efficiently than another country. Fewer resources are required to produce a particular good. The principle of comparative advantage: says that total output will be greatest when each nation produces the good for which it has the lowest domestic opportunity cost. Nations should specialize in the goods they produce at the lowest opportunity cost, and trade with other nations for other goods in which they do not have a comparative advantage. www.welkerswikinomics.com 5
Reasons for Trade Comparative Advantage Define absolute advantage: The ability of a particular person or a country to produce a particular good with fewer resources than another person or country Explain the principle of comparative advantage: Total global output will be greatest when each good is produced by the nation that has the lowest opportunity cost domestically for that good. Blog posts: "Comparative advantage" www.welkerswikinomics.com 6
Reasons for Trade Comparative Advantage country goods Televisions Financial services China 50 40 UK 10 30 Who has the absolute advantage in television production? Financial services?. Who has the comparative advantage in television production? Financial services?. How do you know? Should trade take place? If so, who should produce what? Illustrate the PPCs for the UK and China before and after trade. www.welkerswikinomics.com 7
Reasons for Trade Comparative Advantage TVs 50 10 PPC for China and the UK China UK 30 40 Financial services PPC analysis: Clearly China has an absolute advantage in both TVs and financial services. With its existing resources, China can produce more TVs and more financial services than the UK. Should China and the UK trade? If so, who should specialize in what? China can either produce 50 TVs or 40 financial services. To produce one TV it must give up 0.8 financial services. 1 financial service "costs" China 1.25 TVs the UK can either produce 10 TVs or 30 financial services. To produce 1 TV it must give up 3 financial services. 1 financial service only "costs".33 TVs. Financial services "cost" the UK less than they do China. TVs "cost" China less than they do the UK. China should produce TVs, the UK financial services www.welkerswikinomics.com 8
Reasons for Trade Comparative Advantage Practice with Comparative Advantage: Two countries: United States Korea Two goods: Apples Cell phones apples 39 PPC - USA apples 24 PPC - Korea Absolute advantage? Apples: Cell phones: Comparative advantage? Apples: Cell phones: 13 cell phones 12 cell phones How much do apples "cost"? How much do cell phones "cost" in the US? -> 1a = 1/3c in Korea? -> 1a = 1/2c in the US? -> 1c = 3a in Korea? -> 1c = 2a Should the countries trade? Why or why not? www.welkerswikinomics.com 9
Reasons for Trade Gains from Trade 39 Trading possibilities line USA 36 Trading possibilities line Korea apples apples 24 13 cell phones 19.5 12 cell phones United States: Specialize in apples -> trade apples for cell phones with Korea. Korea should be willing to trade 1 apple for anything up to, but not beyond, 1/2 cell phone. Before trade, 1 apple could only be get America 1/3 cell phone. The US has gained from trade. Korea: Specialize in cell phones -> trade cell phones for apples with the US. The US should be willing to exchange up to three apples for one cell phone. Before trade, Korea could only get two apples for each cell phone it gave up. Korea has gained from trade. www.welkerswikinomics.com 10
Reasons for Trade Gains from Trade 30 PPC for Mexico and USA Soybeans 20 15 A USA Mexico Mexico Soybeans 15 Avocados 60 10 B USA 30 90 20 30 60 90 Avocados Suppose the US and Mexico had been producing at points A and B before trade: -What was total output of soybeans? Avocados? Suppose the countries specialize and trade based on comparative advantage: -What is the total output of soybeans? Avocados? -What are the "gains from trade"? www.welkerswikinomics.com 11
The economic argument FOR free trade, in a nutshell: Through free trade based on the principle of comparative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material well-being than it can without free trade. Discussion Questions: Introduction How may free trade help less economically developed countries? How may free trade help more economically developed countries? How could it hurt both LEDCs and MEDCs? How could free trade lead to a loss of jobs in one country and create new jobs at the same time (in the SAME country)? NCEE Workbook Activity 50: Economic Efficiency and Gains from Trade www.welkerswikinomics.com 12
Impact of Free Trade Questions: Without trade, how many cars would American firms produce? P US Automobile Market (with trade) S d Why is S world horizontal? Why is P w less than P d? With trade, how many cars will American firms produce? P d How many cars will be imported with free trade? P w S world Who benefits from free trade? D d Who is harmed by free trade? Q 1 Q e Q 3 Q Is society as a whole better or worse off with free trade? How do you know? Give one argument for free trade and one against, referencing the diagram www.welkerswikinomics.com 13
Impact of Free Trade Based on simple supply/demand analysis, there are winners and losers from free trade. Draw a supply and demand diagram for a good that is manufactured domestically but also imported to your home country. P Show the domestic price and quantity before trade Show the domestic price and quantity after trade Illustrate the impact of trade on total welfare (consumer and producer surplus) in the economy Identify who benefits and who loses from free trade in this particular market in your country and in the countries where the good is imported Q from. Based on your diagram, formulate an argument in favor of protecting the domestic market for the good you chose. www.welkerswikinomics.com 14
Impact of Free Trade P Milk market in Switzerland S d Before trade: Domestic producers produce Qe and sell at a price of Pd Total welfare is represented by the red shaded area. P d P w Q 1 Q e Q 3 S world Winners: Domestic consumers and foreign producers. Foreign household should benefit as well due to increased demand for exports, meaning higher AD and higher incomes. Losers: Domestic producers and their employees. Forced to compete and sell milk at lower price. Must lower wages or lay off workers. Producer surplus declines. D d Q After trade: Market becomes perfectly competitive, which means domestic producers no longer have ability to control price by increasing or decreasing output. The world price is lower due to more competition from overseas milk farmers. Lower price prompts domestic milk farmers to decrease Q s to Q 1 Q d increases to Q 3. Since there is domestic shortage at P w imports will equal Q 3 -Q 1. Total welfare in this society increases from red area to the red and gray shaded areas. www.welkerswikinomics.com 15
Barriers to Trade In order to "protect" domestic industries, governments create barriers to trade: Revenue tariff: A revenue tariff is a tax placed on a good produced overseas and sold domestically. The purpose of such a tariff is to raise government revenue, but the effect is to make foreign goods less attractive to consumers. Protective tariff: designed to shield domestic producers from foreign competition. Put foreign producers at a competitive disadvantage in selling in domestic markets. Should shift world supply up, increasing price. Import quota: Import quotas specify the maximum amount of a commodity that may be imported from abroad into a country in any period. The purpose is to limit the supply of imported products, to keep domestic prices higher and domestic producers in business. www.welkerswikinomics.com 16
Non-tariff barriers: Barriers to Trade Voluntary Export Restraints (VERs): an agreement between two nations to limit trade in particular commodities so that the producers in one nation can remain in business providing commodities to the domestic market, rather than be forced to compete with more efficient foreign producers. Administrative obstacles: "the red tape" that governments may erect when free trade agreements limit the imposition of tariffs and quotas. May include overly burdensome quality controls, safety regulations, living-wage and other workplace standards to be met by foreign producers. If foreign producers cannot meet these standards, their products are forbidden from being sold domestically. May include environmental, health and safety standards. Subsidies: Payments from the government to producers, for example farmers, in order to reduce the costs of production. Meant to lower the price of domestic goods to consumers, could have the effect of keeping foreign goods out of domestic market. Dumping: the act of a manufacturer in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production www.welkerswikinomics.com 17
Impact of a protective tariff: Before tariff: Domestic producers supply Q 1 Demand is Q 4 country imports Q 4 -Q 1 Barriers to Trade P US Automobile Market (with tariffs) S domestic After tariff: World supply shifts up as foreigner producers face higher cost to sell their cars P w increases to P w+t Domestic producers supply Q 2 country imports Q 3 - Q 2 Blue area represents CS that is transferred to PS due to higher price of cars Gov't tariff revenue equal to yellow area. DWL equal to black triangles P w+t P w 0 Gov't rev. DWL Q 1 Q 2 Q 3 Q 4 S world + tariff S world D domestic Q Total world efficiency in automobile production declines by an amount represented by the black triangles. Americans now pay more for their cars and have fewer to choose from. www.welkerswikinomics.com 18
Quick Quiz Explain two benefits (gains) which might arise from international trade. (Total 10 marks) Students might explain the benefits in terms of any two of the following: a more efficient allocation of resources the principle of absolute and comparative advantage enlargement of markets greater employment prospects possibility of economies of scale international competition and the overcoming of abuse of monopoly power greater choice for consumers. Some answers might be framed entirely in terms of comparative advantage and if this is done fully and well and at least two distinct points are made, it should be possible to earn full marks. Using an appropriate diagram, explain who gains and who loses from the introduction of a tariff. (Total 10 marks) definition of a tariff diagrammatic representation of a tariff illustration of impact of tariff on the government and analysis illustration of impact of tariff on the consumer and analysis illustration of impact of tariff on the producer and analysis www.welkerswikinomics.com 19
Impact of a protective subsidy: A subsidy to domestic producer is a payment to from the gov't to the firm per unit of output. Barriers to Trade P US Automobile Market (with subsidy) S domestic S w/ subsidy Before subsidy: domestic producers supplied Q 1 Demand was Q 3 country imported Q 3 - Q 1. DWL After subsidy: Subsidy increases the price producers receive. Increases producer surplus by blue area. costs taxpayers amount equal to blue + black area. Domestic output increases to Q 0 2 country imports only Q 3 - Q 2. P s P w Subsidy Q 1 Q 2 Q 3 S world D domestic Q Black triangle represents DWL to society. Cost of subsidy exceeds benefits to society, therefore there is a total loss of welfare. Consumers will still pay Pw, so there's no gain nor loss of consumer surplus. But since their tax dollars are being used to subsidize inefficient domestic producers, society as a whole is worse off after the subsidy. www.welkerswikinomics.com 20
Impact of a protective quota: Before the quota: Domestic producers supplied Q 1 Demand was Q 4 country imported Q 4 - Q 1 Barriers to Trade P US Automobile Market (with quota) S domestic S w/ quota Gov't sets a quota of Qu foreign autos At P w, domestic output is still Q 1, but imports are reduced to Q 1 -Q 2 At P w there is excess demand of Q 4 -Q 2. The shortage leads to an increase in the price to P q, higher price attracts new domestic producers into the market, shifting S d out to S w/quota. Domestic producers now produce 0- Q 1 and Q 2 -Q 3. P q P w 0 Q 1 Qu Q 2 Q 3 Q 4 DWL S world D domestic Q Consumers buy fewer cars and pay a higher price. Purple and pink areas used to be CS and are now PS. Blue are is now PS for foreign producers who are getting a higher price for their cars. Gray area is DWL since it used to be CS but is now lost welfare. This triangle represents a net loss of world efficiency resulting from the restriction of free trade. www.welkerswikinomics.com 21
Barriers to Trade P US Automobile Market (with tariffs) S domestic Gov't rev. P w+t S world + tariff P w S world DWL D domestic 0 Q 1 Q 2 Q 3 Q 4 Q www.welkerswikinomics.com 22
Barriers to Trade P US Automobile Market (with subsidy) S domestic S w/ subsidy DWL P s S world D domestic 0 Q 1 Q 2 Q 3 Q www.welkerswikinomics.com 23
P Barriers to Trade US Automobile Market (with quota) S domestic S w/ quota P q DWL P w Qu S world D domestic 0 Q 1 Q 2 Q 3 Q 4 Q www.welkerswikinomics.com 24
Barriers to Trade Evaluating the effects of trade barriers: Direct effects What direct effect will a tariff that raises the price of a commodity in the domestic market have on: domestic consumers? Indirect effects What indirect effects might the introduction of a tariff have on: domestic consumers? domestic producers of the commodity? domestic producers? domestic producers of other products? foreign producers? domestic incomes? foreign incomes? domestic government? Global allocative efficiency? Is a tariff a regressive, progressive, or proportional tax? Who is affected more, rich or poor? Practice Barriers to Trade: NCEE Workbook Activity 51 www.welkerswikinomics.com 25
Protecting domestic employment: Protecting the economy from low-cost labor: Protecting an infant industry: To avoid the risks of over-specialization: Strategic reasons: Protection against dumping : To protect product standards: To raise government revenue: To correct a balance of payments deficit: Barriers to Trade Arguments for protectionism: Despite the apparent economic benefits free trade brings, there are still many who oppose it on several grounds. Which of these arguments for protectionism do you feel are most valid? Discuss with a partner... www.welkerswikinomics.com 26
Arguments against protectionism: Most economists today acknowledge the value of free trade. Their opposition to protectionism rests on the following grounds: Protectionism leads to... Barriers to Trade Higher prices for producers and consumers: Less choice for consumers: Less competition, less efficiency: Distorts comparative advantage, less efficient allocation of resources, total world output declines: May hinder economic growth: Which of these arguments against protectionism do you feel are most valid? Discuss with a partner... www.welkerswikinomics.com 27
Barriers to Trade Points to consider in evaluation of protectionism: 1. The European Union has prospered as trade barriers have been eliminated. 2. The world economy has grown under the trend toward more tariff reduction since the mid-1930s. 3. High tariffs were a factor in causing the Great Depression. 4. Nations with high protectionist policies have slower growth than those with no barriers. Find an article from the current press relating to a free trade agreement (FTA). Read and discuss with your partners at your table. On a poster, identify the following points: What are the pros and cons of the Free Trade Agreement discussed in your article? What are the alleged benefits of the agreement being discussed? Who are the opponents of free trade and what are their arguments? Who are the supporters of free trade and what are their arguments? Possible articles: Korea, EU Look Forward to Progress in Free Trade Talks Bush: New Free Trade Deals Will Strengthen U.S. Economy, Create Jobs India-Sri Lanka Free Trade Agreement (FTA): Success and the road ahead Rice Pushes for Free Trade Pacts Smart trade, the Clinton way Peru's president embraces free trade www.welkerswikinomics.com 28
Barriers to Trade Conflicting views Follow the links below for some ideas from the opposing sides: Evaluate the video or article: 1) what views on trade are expressed in the video? 2) Are there biases expressed by the people in the video? If so, what are they? 3) Evaluate the arguments for or against free trade made in the video. Make Trade Fair - by Oxfam http://www.youtube.com/watch?v=9mgpep8hass Lou Dobbs on the dangers of trade http://www.youtube.com/watch?v=0mkibmcvrwq Joseph Stiglitz on globalization http://www.youtube.com/watch?v=pdgc5bemjxo More Lou Dobbs with guest David Sirota http://www.youtube.com/watch?v=wxxiqklh7p0&feature=related Columbian FTA, why it's good for America http://www.youtube.com/watch?v=n6gjbbtoioa Ambassador to Columbia on the Benefits of Free Trade http://www.youtube.com/watch?v=ffu4cj8iodg Kenyans want trade not aid http://www.youtube.com/watch?v=mt_asiufqty Obama vs. McCain on Free Trade - 3rd Debate http://www.youtube.com/watch?v=thd6n_imkki www.welkerswikinomics.com 29
Barriers to Trade Quick Quiz: Who benefits from protectionism? Who is hurt? Why do most economists agree that free trade is beneficial overall? Protectionism Benefits: Domestic producers may benefit b/c they receive a higher price for their output. The federal government may gain through revenue from tariffs. Hurts: Consumers are harmed b/c they pay higher prices for goods produced by the protected industry. Foreign producers are hurt b/c they are not able to sell their as much of their output as they would be able to otherwise, so their profits are reduced. Economists oppose most protectionism because: In most cases, the costs of protectionism exceed the benefits. Consumers are hurt by the higher prices they pay, while producers often benefit less. Also, industry employs large amounts of economic resources in rent-seeking as they lobby congress to erect barriers to trade. In most cases, protectionism results in deadweight loss for society, meaning economic inefficiency. Blog post: "Excuse me China, could you lend us another billion?" www.welkerswikinomics.com 30
Attachments APMacroUnits56.pdf APMacroUnits56 11795.jnt