Chapter Nineteen: Lecture Notes -- International Trade

The notion of free trade has been a controversial topic for centuries. At its core is a sense of nationalism, in that nations want to avoid being harmed by other nations. The problem is that trade issues are very complex and invariably certain people benefit at the expense of others. How do we make sense of this? First, we list common arguments for trade protection and examine how trade protection impacts markets. We then explore the economic theory of comparative advantage and see how trade impacts economic standards of living. After having learned the theory, we revisit and critically assess the arguments for protectionism. Finally, we discuss NAFTA and explore some of the controversies which surrounded that trade pact.

To keep things simple, we view everything from the U.S. point of view so that the U.S. economy is the "domestic" market.

Arguments for Protectionism:

  1. Saves American jobs: By raising the price of imports via tariffs or quotas, American industries are more competitive in the domestic market and, therefore, American workers' jobs will be spared and/or expanded.
  2. Protects infant industries: When industries are just beginning, it makes sense to protect them from the perils of foreign competition at first, until the industry grows and matures. At that time the protection can be lifted and the mature company will able to compete and survive. In other words, the entry costs are so high from foreign competition that trade barriers are necessary to overcome those barriers.
  3. Raises government revenue: Government revenues increase since the U.S. government collects the tariff revenue.
  4. Keeps firms in U.S.: This effect might occur for two reasons. First, firms will face less competition domestically and not feel the pressure to move to low-wage countries. Second, the firm who moves to another country must pay the higher import tax to sell the product in the U.S. and thus may not be as willing to relocate.
  5. Levels the playing field for those firms who adhere to stricter environmental and labor laws.: If firms in the U.S. must adhere to costly environmental regulation and give laborers certain rights and minimum working conditions, then U.S. firms are at a cost disadvantage compared with firms in nations that do not have to adhere to such regulations. Trade protection, therefore, makes the playing field a little more equal.
  6. National security: Certain products--defense secrets and computer technology, for example--are too technologically sensitive to export indiscriminately to nations that the domestic government does not wish to have access to that technology.
  7. Political tit for tat: If my trading partner plays unfairly, why should I play by the rules? The U.S. accuses Japan quite often of unfair trading practices, hence U.S. firms have a right to impose similar unfair trading practices to make trade more equal.
  8. Human rights violations: Trade policy may give the U.S. political leverage in coercing another country to improve its human rights violations (as the U.S. tried unsuccessfully with China).
We explore these theories to see if they hold up under scrutiny. We find that, in general, protectionist policies benefit a few at the expense of many. Protectionism costs consumers billions of dollars each year. Is it worth the costs?




A tariff is a tax on an import. The tariff shields domestic producers from low import prices but it increases consumer prices.

Economic Theory of Protectionism: Tariffs & Quotas

Tariffs

A tariff is a tax on an import. The figure titled "Impact of Tariff on Imports"depicts a simple scenario of a tariff being placed on an imported product, say, automobiles. Before the tariff, equilibrium occurs at point A, in which the price of imported automobiles is P1 and the quanity is Q1. When the tariff is imposed, the supply curve in the import market (S) shifts to the left (S') because the importers now have to pay a tax to the U.S. government, which is an input cost. The equilibrium price of the imported automobile rises to P2 and the equilibrium quantity falls to Q2.

Point A in the chart titled "Impact of Tariff on Domestic Market"depicts the equilibrium in the domestic automobile makret before the tariff is imposed. One the tariff is imposed on the imports, the demand for the domestic good shifts from D to D' because the domestic good is a substitute for the import (see Supply and Demand, Chapter 3). The domestic producer charge a higher price, P2 and sell a larger quantity, Q2.

A tariff causes the price of imports to rise and quantity sold to fall A tariff increases demand for domestic goods because it raises the price of imported substitutes.

TABLE 1
Winners and Losers from Tariffs
WinnersLosers
Domestic producers who
compete with importers		 U.S. consumers who pay a
higher price for imports
Government via increased
tax revenue		 Importers to U.S.

As with most government interventions, some market participants gain (the "winners")while others are harmed (the "losers"). Table 1 summarizes the winners and losers from trade protection via tariffs. Winners include the domestic industries that are protected somewhat from foreign competition, and the government because it collects the tariff revenues. Losers include domestic consumers that pay higher prices for the imported and domestically produced products, and importing firms that pay the tariff and, consequently, sell fewer units in the U.S.

The favorable impact of tariffs on domestic firms explains why demand for trade protection is strong. U.S. firms often lobby the government for special treatment in order to ease the competition from foreign producers. As an example, consider the debate over mini-vans' proposed status as trucks. If mini-vans were classified as trucks instead of their current classification as cars, then foreign mini-vans would be much more expensive in the U.S. due to the higher tariffs that are imposed on trucks. Consequently, U.S. car manufacturers would like imported mini-vans to be classified as trucks.



Quotas are restrictions on the quantity of imports allowed to enter the domestic country over a given amount of time.

Import Quotas

Quotas are restrictions on the quantity of imports allowed to enter the domestic country over a given amount of time. Quotas--illustrated by the solid vertical line in the figure titled "Impact of a Quota on Imports"--fix the supply of the foreign market at a certain level. If the equilibrium price in the import market is at P1 before the quota is imposed, the quota restricts the quantity supplied, and thus raises the import price to P2. The quanity of imported products declines from Q1 to Q2.

As the figure titled "Impact of a Quota on Domestic Market" illustrates, the higher import price shifts the demand curve for the domestic product to the right and raises the equilibrium price and quantity from point A to point B. Note that in this case, the government does not collect additional tax revenue. The higher prices for imports mean that the importers themselves are earning the extra revenue associated with the quota policy.

Quotas restrict the quantity of imports causing the price of imports to rise The effect of Quotas on Domestic Markets is similar to the effect of tariffs

TABLE 2
Winners and Losers from Quota Restrictions
WinnersLosers
Domestic producers who
compete with importers		 U.S. consumers who pay a
higher price for products
Foreign producers who
get in under the quota		 Importers who are shut
out of the U.S. market

As with tariffs, quotas produce winners and losers. Winners include domestic producers and the importers who manage to "get in" under the quota restrictions. These importers win because they are able to sell their products at a higher price in the U.S. market. The quota makes the import more scarce. Losers include domestic consumers who pay higher prices for the imported and domestic products, and the importers that are shut out of the market altogether.

When the Japanese automobile manufacturers were being threatened with tariffs from the U.S. in the early 1980s, they responded with a Voluntary Export Restraint (VER) policy. Under this policy, the Japanese importers voluntarily agreed to reduce imports to the U.S. In effect, the Japanese preferred to impose a quota on themselves rather than risk a tariff being slapped on their cars by the U.S. government. In this way, Japanese manufacturers--not the U.S. government--were able to earn the revenue from the higher prices of Japanese cars sold in the U.S. Hondas in particular, sold at a premium in the 1980s.




Comparative advantage dictates that each nation should specialize in those products that it can produce the least inefficiently compared with production in other nations.










One country has an absolute advantage over another nation in producing a given product if it can produce more output with the same amount of resources.

The Economic Argument for Free-Trade

The theoretical justification for free-trade resides in the concept of comparative advantage. Simply stated, comparative advantage dictates that each nation should specialize in those products that it can produce the least inefficiently compared with production in other nations. Every country cannot produce every good or service with high levels of productivity. Some countries are good at producing airplanes, for example, while others are good at producing clothes. If each country specializes in producing what it is relatively good at, then through trading, the world as a whole can have higher standards of living.

Trade is rarely a zero-sum game. When exchange is voluntary, both parties to the exchange perceive that they will be made better off after making the exchange; otherwise, the exchange would not occur. Trade is generally a win-win scenario. My job, for example, is to teach others how economies operate. I produce teaching service and then trade those services for all my other needs like clothing, shelter, and food. By these exchanges, I am made better off. Trading with other countries is no different.

Two different PPFs

An example of gains from trade using the concept of comparative advantage works the following way. Given a certain amount of resources, the U.S. can produce 50 airplanes and 200 shirts. With the same resources, Mexico can produce 20 airplanes and 160 shirts. Notice that the U.S. has an absolute advantage in producing both airplanes and shirts because it can produce more goods than Mexico given the same amount of resources. Does this mean that the U.S. should produce both items and cut off trade with Mexico? The answer is no. The production possibilities frontier for each country is graphed in the figure titled "PPFs for Mexico and the U.S."(assuming that the principle of increasing costs does not apply for simplicity). Notice that the U.S. can produce one plane for every four shirts that it gives up. Mexico can make one plane for every eight shirts that it gives up. Since the opportunity cost for Mexico to produce airplanes is twice that of the U.S., the U.S. has a comparative advantage in making airplanes.

The reverse scenario shows that the U.S. can produce one shirt for every 1/4 plane that it gives up, whereas Mexico can make one shirt for every 1/8 plane it gives up. Because the opportunity cost of producing shirts in the U.S. is twice that in Mexico, Mexico has a comparative advantage in making shirts.

If the U.S. specializes in the production of airplanes while Mexico specializes in the production of shirts, and then the two nations trade goods, both countries can consume more than before trade. Therefore, each country will be better off than if they live in isolation. This concept of gains from trade is illustrated in the figures titled "U.S. PPF and CPF After Trade" and "Mexico's PPF and CPF After Trade".

Suppose that the world price of airplanes is 6 shirts (the price would have to be within the range of 4 to 8 shirts per airplane). The production possibilities frontier for the U.S. is graphed again in the left-hand figure. Before trade, the U.S. could obtain just 4 shirts by sacrificing the production of one airplane. With trade, however, the U.S. can produce 50 airplanes, but then trade one of them for 6 shirts. In the extreme, the U.S. can trade all 50 airplanes and obtain 300 shirts. Therefore, the consumption possibilities frontier (CPF) for the U.S. rotates along the Y-axis.

Mexico specializes in shirts. As the right-hand figure shows, before trade it can obtain one airplane by sacrificing 8 shirts. With trade, however, Mexico can obtain one airplane by sacrificing just 6 shirts. In the extreme, Mexico can trade all 160 shirts to obtain 26.7 airplanes (160/6). Mexico's consumption possibilities frontier rotates outward along the X-axis. Both countries are better off after trading.

US's CPF lies above its PPF Mexico's CPF lies above its PPF





Typical estimates put the cost to American consumers to save one job through protectionism at $100,000 to $150,000.

If an infant industry is so promising, why won't private financial markets support the firms through the early years?


























Some non-economic justifications for protectionist policies do exist, but purely economic arguments for trade protection are difficult to justify.

Protectionism Revisited

Given the gains from trade, are there any good reasons for protectionism? Let's reexamine the reasons that we listed above.
  1. Saves American jobs: By imposing trade protection, the price of foreign and domestic goods rise. In return, certain American jobs are preserved. However, it is often estimated that the cost to American consumers to save one job through protectionism is $100,000 to $150,000. The reason for the high cost is that all the consumers of a particular product pay a higher price than they otherwise would pay. This is a very inefficient way to save certain jobs. We as a society would do better to pay the affected workers, say, $50,000 each in unemployment compensation per year rather than impose tariffs.
  2. Protects infant industries: This argument sounds reasonable at first glance but is suspect upon further reflection. If the infant industry is so promising within a particular nation, why won't private financial markets support the firms and carry them through the early years? It could be that financial markets don't work well, although that certainly isn't true in the U.S. But even under this scenario, why not grant government subsidies instead of tariff protection? In addition, the infant industry tends not to grow up because the protection rarely ends due to political lobbying from the industry.
  3. Raises government revenue: Although it is true that tariffs raise revenue for the government (though quotas do not directly), this method is a very inefficient way to raise revenue because consumers end up paying for much of the tariff via higher consumer prices. The government could raise an equivalent amount of revenue by raising corporate and/or personal income taxes.
  4. Keeps firms in U.S.: The fallacy of this argument is in assuming that the lost jobs from firms moving overseas or across borders will not be replaced. By allowing production to shift internationally, the U.S. economy can specialize in its comparative advantage and replace the lost jobs with higher skilled, higher paying jobs on average. It can do better as a nation, for example, by allowing clothing production to be done in other countries, while the U.S. focuses on computer software production.
  5. Levels the playing field for those firms who adhere to stricter environmental and labor laws.: This argument is harder to dismiss. It is true that many other nations have environmental and labor laws that are much less stringent than those in the U.S., and hence, it is less costly to produce in those nations. We must be careful, however, to correctly isolate the cost advantages from differing labor and environmental laws. Usually, they are much less costly than we initially believe.

    The rights to form unions, engage in collective bargaining, and guarantee minimum wages and working conditions were hard-fought battles that unions slowly won in U.S. history. These rights, other things equal, increase the cost of labor in the U.S. Many people observe that average Mexian wages are about one-fifth of what wages are in the U.S. It is tempting to attribute the difference to labor laws. If fact, most of the disparity comes from differences in labor productivity. Workers in the U.S. have higher average wages mainly because U.S. citizens can produce more goods and services per hour than can the average worker in Mexico. U.S. workers have the technology and capital to make them more productive. We must not confuse this real productivity difference with differences in labor laws. Labor laws are important, but they are of secondary significance to average productivity in explaining international wage differentials.

    Environmental laws raise the cost of business as well. But meeting environmental regulations are also only one portion of a firm's overall costs. We must avoid attributing too much importance to differences in production costs due to these regulations.

    Having addressed these issues, there may be some justification for trade protection if comparative advantage is distorted by labor and environmental regulations. There are at least two ways to approach the problem. One is to erect protective barriers. The other is to encourage trading partners to improve their labor and environmental laws. The second strategy is a longer-term approach that gives the U.S. less control over the outcome. But if free trade raises incomes in a poorer nation and labor and environmental laws are luxury goods, then over time international labor and environmental laws may improve.

  6. National security: National security may indeed be a good reason to limit trade. Usually the scope of this limitation, however, is very narrow and focused. National security concerns will not widely disrupt free trade.
  7. Political tit for tat: Adopting protective measures because trading partners are not playing fair may force the trading partners to open their economies up. There may be times when this policy is justified. However, it should be used as a last resort. Moreover, the end goal of these types of measures is to have more free trade, not less.
  8. Human rights violations: As with political tit-for-tat measures, using trade policies as leverage for improving human rights may sometimes be justified. There is an on-going discussion, however, of the advantages of engaging in trade with a nation rather than taking a more combative approach and erecting trade barriers. One can make a case for either approach. If the domestic economy engages in more trade with the other country, the two countries become mutually dependent on one another. In that respect, the domestic economy may be able to influence that country more than by reducing its economic presence in the country. However, the threat of sanctions may induce a nation to improve its human rights abuses more quickly and directly.

In sum, some non-economic justifications for protectionist policies do exist. The U.S. government may wish, for example, to protect its sensitive technology or influence another country's human rights policies. But purely economic arguments for trade protection are difficult to justify. Protectionist policies hurt more people than they help, and our economy is less efficient because of it.

......

NAFTA

The North American Free Trade Agreement (NAFTA) was a pact implemented in 1994 between the U.S., Mexico, and Canada which eliminated or will eliminate most of the tariffs and other trade restrictions between the countries.

Impacts of NAFTA

The initial impacts of NAFTA were, all else equal, to lower the prices of goods and services sold across the three countries' borders. Because Mexico had far higher tariffs than the U.S., the prices of U.S. goods sold in Mexico fell relatively more than Mexican products sold in the U.S. At least two groups benefited from NAFTA: consumers in all three countries who purchased goods and services at lower prices, and exporters that benefited from an increased demand (due to lower prices) abroad.

Then Why All the Fuss?

Not all the news was rosy for NAFTA. As with all trade issues, there were losers. The losers were primarily those companies who benefited from the trade protection before NAFTA. For instance, clothing manufacturers in the U.S. were able to survive partly because of the higher prices of imported clothes from Mexico. Mexican firms which produced automobiles, software, and many other advanced products were threatened by NAFTA because they now face stiffer competition from U.S. producers. A further adjustment to each country's comparative advantage occurred. Those firms that cannot compete in the more competitive environment will not survive. The potential losers from NAFTA made a lot of noise in their resistance to the treaty. Economic theory shows, however, that ultimately the winners from free trade will outweigh the losers.

Many people were also concerned about the lax labor and environmental laws that Mexico has in comparison with those in the U.S. To win passage of NAFTA, the final legislation included "side agreements" that attempted to address these issues. In particular, the Clinton administration negotiated the North American Agreement on Labor Cooperation and the North American Agreement on Environmental Cooperation. The goal of the environmental cooperation is to assist both countries in designing and financing environmental infrastructure projects in the border region. The labor side agreement established a federal government level office in each country called the National Administrative Office (NAO). One of its functions is to receive public complaints about lack of enforcement of labor laws in the home country. Many people viewed these side agreements as insufficient, and hence their opposition to NAFTA remained.

Recent studies of the impact of NAFTA on the U.S. economy have confirmed what many economists were predicting from the outset: both the benefits and the costs from NAFTA are small. In other words, some jobs have been lost and some gained, but the total number of job losses and gains as a percentage of the U.S. labor force has been tiny. To date, the disruption from NAFTA has been much quieter than the loud debate over passage of the trade pact itself. Trade between the three North American countries, however, has increased significantly since 1994.

NAFTA Links

  • NAFTA and Maquiladoras: Is the Growth Connected? William C. Gruben and Sherry L. Kiser argue in this 2001 publication from the Federal Reserve Bank of Dallas that NAFTA is not responible for the growth in Maquiladora employment after 1994.

  • The Impact of NAFTA on the United States by Mary E. Burfisher, Sherman Robinson and Karen Thierfelder (Journal of Economic Perspectives, Winter 2001) argues that NAFTA's effects on the U.S. are positive but small.

  • NAFTA at Seven contains links to three reports that show that NAFTA has failed to improve the economic conditions of North American working people.
...... Copyright © 1996-2006 OnlineTexts.com - All Rights Reserved