Trade Policy 10

Opposition to Free Trade•In 1999, 40,000 activists gathered in

Seattle, during a WTO ministerial meeting, condemning all further actions to liberalize world trade.

•Resistance to free trade is not only in the US, but it is evident worldwide

The Protectionist Viewpoint•Protectionists are against free trade and

believe that barriers to trade are needed to promote the welfare of a country

The Protectionist Viewpoint•Some protectionist arguments:

▫The shrinking size of the US market for goods that compete with foreign goods reduces demand for domestic labor

▫Rising imports contributes to a trade deficit▫Vital/strategic industries need protection,

e.g., weapons and nuclear energy

The Protectionist Viewpoint•Some protectionist arguments:

▫Free trade leads to environmental degradation and exploitation of the impoverished people of under developed countries

The Free Trade Viewpoint•The free trade advocates argue that

people are better off when voluntary exchange is allowed

•Trade between nations is beneficial as trade between individuals within a country

Questions:

• Who benefits from trade? Who does trade harm? Do the gains outweigh the losses?

• Who are the losers and winners from restricting trade?

• Are the arguments for trade restriction economically valid?

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8

Comparative Advantage•Recall from the basic economics principles

class:

A country has a comparative advantage in a good if it produces the good at a lower opportunity cost than other countries.Countries can benefit from trade if each specializes in and exports the goods in which it has a comparative advantage.

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Comparative Advantage•Assume:

▫Two countries: Alpha and Omega▫Two goods: milk and bread

•Lets construct the Production Possibilities Curve/ Frontier

Without Trade

Milk

50

100

100

200

A

0

Bre

ad

If there is no trade, Alpha chooses

this production and consumption.

Milk

100

50

50

25

B

0

Bre

ad If there is no trade,

Omega chooses this production and

consumption.

Alpha Omega

Comparative Advantage

Milk

50

100

100

200

A

0

Bre

ad

The opportunity cost of milk is 0.5 bread (the slope of the PPC)

Milk

100

50

50

25

B

0

Bre

ad

The opportunity cost of milk is 2 bread

Alpha Omega

Since the opportunity cost of milk is lower for Alpha, Alpha has a comparative advantage in milk. Similarly, Omega has a comparative advantage in bread. If trade is allowed, Alpha should specialize in milk and Omega should specialize in bread.

Comparative Advantage

Milk

50

100

100

200

A

0

Bre

ad

With Specialization

Milk

100

50

50

25

B

0

Bre

ad

With specialization

Alpha Omega

After specialization they trade. The price of milk cannot exceed 2 bread (Omega’s cost of making it) and cannot fall below 0.5 bread (Alpha’s cost). Assume the terms of trade (the agreed upon prices) are: 1 milk for 1 bread.

200

100

Where will each country end up?

Gains from trade•Both countries benefit from trade•A country is better off specializing in the

goods it has a comparative advantage in•If a country has a comparative advantage

in one (some) good, it will have a comparative disadvantage in the other good(s)

Free Trade and Social WelfareWhy the opposition to free trade?•Distributional consequences: consumers

and producers•We apply the tools of welfare economics

to show who gains from free trade

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The World Price and Comparative Advantage

•PW = the world price of a good, the price that prevails in world markets

•PD = domestic price without trade •If PD < PW,

▫country has comparative advantage in the good

▫under free trade, country exports the good•If PD > PW,

▫country does not have comparative advantage

▫under free trade, country imports the good

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The Small Economy Assumption•A small economy is a price taker in world

markets: Its actions have no effect on PW. •Not always true – especially for the U.S. –

but simplifies the analysis without changing its lessons.

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Social Welfare Without Free Trade

Without trade:

PD = $4 Q = 500

P

QD

S

$4

500

Soybeans Market

CS

PS

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With Free trade: An exporting countryIf PW =$6The country has a comparative advantage in Soybeans

Under free trade▫domestic

consumers demand 300

▫domestic producers supply 750

▫exports = 450

P

QD

S

$6

$4

500

300

exports

750

Soybeans Market

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Social Welfare with Free TradeWithout trade,CS = A + BPS = CTotal surplus

= A + B + CWith trade, CS = APS = B + C + DTotal surplus

= A + B + C + D

P

QD

S

$6

$4

exportsA

B D

Cgains from trade

Soybeans Market

Free Trade raises social welfare of the exporting country

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In the absence of trade: CS = APS = B + CTotal

surplus=A+B+CWith trade:CS = A + B + DPS = CTotal surplus= A+B+C+D

P

QD

S

$150

$300

Plasma TVs

A

B D

C

gains from trade

imports

With Free trade: An importing country

Free Trade raises social welfare of the importing country

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Other Benefits of International Trade•Product Variety: Consumers enjoy

increased variety of goods.•Economies of scale: Producers who sell to

a larger market, may achieve lower costs by producing on a larger scale.

•Foster competition: Competition from abroad may reduce market power of domestic firms, which would increase total welfare.

•Trade enhances the flow of ideas, facilitates the spread of technology around the world.

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Then Why All the Opposition to Trade?

• Trade creates winners and losers.• The winners from trade could compensate

the losers and still be better off. • Yet, such compensation rarely occurs.• The losses are often highly concentrated

among a small group of people, who feel them acutely. The gains are often spread thinly over many people, who may not see how trade benefits them.

• Hence, the losers have more incentive to organize and lobby for restrictions on trade.

International Trade Restrictions•Despite the benefits of free trade,

governments have often imposed barriers to trade

•Trade Barriers:▫Tariff: a tax on foreign goods ▫Quota: a limit on the quantity of imports▫Voluntary restraint agreements▫Embargoes: banning trade with a country▫Standards: environmental, health or safety

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Analysis of a Tariff on Cotton ShirtsPW = $20Free trade:buyers demand 80sellers supply 25imports = 55

T = $10/shirtprice rises to $30buyers demand 70sellers supply 40imports = 30

$30

P

QD

S

$20

25

Cotton shirts

40 70 80

importsimports

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Welfare effects of a tariffFree tradeCS = A + B + C

+ D + E + FPS = GTotal surplus = A +

B + C + D + E + F + G

TariffCS = A + BPS = C + GRevenue = ETotal surplus = A +

B + C + E + G

$30

P

QD

S

$20

25 40

AB

D EG

FC

70 80

Cotton shirts

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D = deadweight loss from substituting towards domestic shirts

F = deadweight loss from the under-consumption of shirts

$30

P

QD

S

$20

25 40

AB

D EG

FC

70 80

Cotton shirts

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Analysis of a Quota on Cotton Shirts

Quota= 30 shirtsAt the price of $20,

there is a shortageIn equilibrium, imports

have to equal 30buyers demand 70sellers supply 40Price rises to $30

The quota of 30 shirts has the same effect as a tariff of $10

$30

P

QD

S

$20

25

Cotton shirts

40 70 80

imports

imports

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Arguments for Restricting Trade1. The jobs argument

Trade destroys jobs in industries that compete with imports.

Economists’ response:Look at the data to see whether rising imports cause rising unemployment…

29U.S. Imports & Unemployment, Decade averages, 1956-2005

0%2%4%6%8%

10%12%14%16%19

56 -65

1966 -75

1976 -85

1986 -95

1996

-200

5

Imports (% of GDP)

Unemployment (% of labor force)

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Arguments for Restricting Trade1. The jobs argument

Trade destroys jobs in the industries that compete against imports.

Economists’ response:Total unemployment does not rise as imports rise, because job losses from imports are offset by job gains in export industries. Even if all goods could be produced more cheaply abroad, the country need only have a comparative advantage to have a viable export industry and to gain from trade.

Should policy makers aim at protecting jobs?

“…a U.S. businessman visiting China ….came upon a team of 100 workers building a dam with shovels. He commented to a local official that, with an earth-moving machine, a single worker could build the dam in an afternoon. The official replied, "Yes, but think of all the unemployment that would create.""Oh," said the businessman, "I thought you were building a dam. If it's jobs you want to create, then take away their shovels and give them spoons.” Glassman, James K. "The Blessings of Free Trade," The Cato Institute, May 1, 1998. 27 Jan 2010

Job Protection Argument

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Arguments for Restricting Trade2. The national security argument

An industry vital to national security should be protected from foreign competition, to prevent dependence on imports that could be disrupted during wartime.

Economists’ response:Fine, as long as we base policy on true security needs. But producers may exaggerate their own importance to national security to obtain protection from foreign competition.

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Arguments for Restricting Trade3. The infant-industry argument

A new industry argues for temporary protection until it is mature and can compete with foreign firms.

Economists’ response:Difficult for government to determine which industries will eventually be able to compete and whether benefits of establishing these industries exceed cost to consumers of restricting imports. Besides, if a firm will be profitable in the long run, it should be willing to incur temporary losses.

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Arguments for Restricting Trade4. The unfair-competition argument

Producers argue their competitors in another country have an unfair advantage, e.g. due to government subsidies.

Economists’ response:Great! Then we can import extra-cheap products subsidized by the other country’s taxpayers. The gains to our consumers will exceed the losses to our producers.

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Arguments for Restricting Trade5. The protection-as-bargaining-chip argument

Example: The U.S. can threaten to limit imports of French wine unless France lifts their quotas on American beef.

Economists’ response:The threat to limit imports is not a credible threat since it reduces welfare in the US.

$8

6

4

2

20 40 60 80lbs of chocolate

D

S