PART 5
CHAPTER 15
Who gains and who loses when an economy opens up to trade?©Spaces Images/Blend Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Explain and apply the concept of comparative advantage as a basis for trade.
2. LO2Contrast the production and consumption opportunities in a closed economy with that of an open economy using a production possibilities curve.
3. LO3Explain how the price of a tradable good is set in a closed versus an open economy, how the quantities of imports or exports are determined, and discuss who are the winners and losers from trade.
4. LO4Illustrate why trade is often politically controversial, even though it promises to increase total income.
On April 13, 1861, Southern troops fired on Fort Sumter in Charleston harbor, initiating the American Civil War. Less than a week later, on April 19, President Lincoln proclaimed a naval blockade of the South. Code-named the Anaconda Plan (after the snake that squeezes its prey to death), the blockade required the Union navy to patrol the Southern coastline, stopping and boarding ships that were attempting to land or depart. The object of the blockade was to prevent the Confederacy from shipping cotton to Europe, where it could be traded for military equipment, clothing, foodstuffs, and other supplies.
Historians are divided on the effectiveness of the Union blockade in choking off Confederate trade. In the early years of the war, the North had too few ships to cover the 3,600-mile Southern coastline, so “running” the blockade was not difficult. But in the latter part of the war the number of Union ships enforcing the blockade increased from about 90 to more than 600, and sailing ships were replaced with faster, more lethal ironclad vessels. Still, private blockade runners—like the fictitious Rhett Butler in Margaret Mitchell’s Gone with the Wind—attempted to elude the Union navy in small, fast ships. Because the price of raw cotton in Great Britain was between 10 and 20 times what it was in the Confederacy (a differential that indicated disruption in the normal flow of trade), blockade runners enjoyed huge profits when they were successful. But despite their efforts, by 1864 the Southern war effort was seriously hampered by a lack of military equipment and supplies, at least in part as a result of the blockade.
The use of a naval blockade as a weapon of war highlights a paradox in contemporary attitudes toward trade between nations. Presumably, an attempt by a foreign power to blockade U.S. ports would today be considered a hostile act that would elicit a strong response from the U.S. government. Yet one often hears politicians and others arguing that trade with other nations is harmful to the United States and should be restricted—in effect, that the United States should blockade its own ports! In the U.S. presidential elections of 2016, for example, both presidential candidates opposed the Trans-Pacific Partnership (TPP)—an agreement intended to increase trade between Australia, Canada, Japan, Mexico, the United States and seven other, smaller economies—on the grounds that it would cost American jobs. As another example, politicians from both the Republican and Democratic parties occasionally complain about China’s exports to the U.S. Some of them propose taking action against the Chinese government because, they say, it engages in unfair policies that cause Chinese products to sell in the U.S. for prices that are too cheap. So is trade a good thing or not? And if it is, why does it sometimes face determined opposition?
This chapter addresses international trade and its effects on the broader economy. We will begin by reviewing the idea of comparative advantage, which was introduced in Chapter 2, Comparative Advantage. We will show that everyone can enjoy more goods and services if nations specialize in those products in which they have a comparative advantage, and then trade freely among themselves. Furthermore, if trade is unrestricted, market forces will ensure that countries produce those goods in which they have a comparative advantage.
He appreciated the economic benefits of trade.©Clarence Sinclair Bull/John Kobal Foundation/Getty Images
Having shown the potential benefits of trade, we will turn next to the reasons for opposition to trade. Although opening the economy to trade can, in our model, increase economic welfare overall, some groups—such as workers in industries that face competition from foreign producers—may in reality be made worse off. The fact that open trade may hurt some groups creates political pressure to enact measures restricting trade, such as taxes on imported goods (called tariffs) and limits on imports (called quotas). We will analyze the effects of these trade restrictions, along with other ways of responding to concerns about affected industries and workers through direct assistance programs.
Economists understand the frustrations with trade expressed by some groups. Indeed, economists recognize that for a displaced worker who does not expect effective direct government assistance to materialize—for example, because the worker does not expect the government to pass, implement, and sustain the relevant measures—opposing trade may appear a reasonable course of action. However, from an economic point of view that takes into account both the overall size of the economic pie and how it is distributed, providing direct assistance to those who are hurt by increased trade is preferable to blocking or restricting trade.
COMPARATIVE ADVANTAGE AS A BASIS FOR TRADE
Chapter 2, Comparative Advantage, began with the story of the Nepalese cook Birkhaman, a remarkable jack-of-all-trades who could do everything, from butchering a goat to fixing an alarm clock. Yet despite his range of skills, Birkhaman, like most Nepalese, was quite poor. The reason for Birkhaman’s poverty, as we saw in Chapter 2, Comparative Advantage, was precisely his versatility. Because he did so many different things, he could not hope to become as productive in each separate activity as someone who specialized entirely in that activity.
The alternative to a nation of Birkhamans is a country in which each person specializes in the activity at which he is relatively most efficient, or has a comparative advantage. This specialization, combined with trade between producers of different goods and services, allows a society to achieve a higher level of productivity and standard of living than one in which each person is essentially self-sufficient.
This insight, that specialization and trade among individuals can yield impressive gains in productivity, applies equally well to nations. Factors such as climate, natural resources, technology, workers’ skills and education, and culture provide countries with comparative advantages in the production of different goods and services. For example, as we saw in Chapter 2, Comparative Advantage, the large number of leading research universities in the United States gives that nation a comparative advantage in the design of technologically sophisticated computer and mobile hardware and software. Likewise, the wide international use of the English language endows the United States with a comparative advantage in producing popular films and TV shows. Similarly, France’s climate and topography, together with the accumulated knowledge of generations of vintners, provides that country a comparative advantage in producing fine wines, while Australia’s huge expanses of arable land give that country a comparative advantage in producing grain.
The Principle of Comparative Advantage tells us that we can all enjoy more goods and services when each country produces according to its comparative advantage, and then trades with other countries. In the next section we explore this fundamental idea in greater detail.
Climate and long experience give France a comparative advantage in producing fine wines.
PRODUCTION AND CONSUMPTION POSSIBILITIES AND THE BENEFITS OF TRADE
In this section we will consider how international trade benefits an individual country. To do so, we will contrast the production and consumption opportunities in a closed economy—one that does not trade with the rest of the world—with the opportunities in an open economy—one that does trade with other economies. Because we will make use of the production possibilities curve, which was introduced in Chapter 2, Comparative Advantage, we will begin by briefly reviewing that concept. We will look first at the PPC for a two-person economy and then at the PPC for a many-person economy. After reviewing the PPC, we will see how a country’s production possibilities are related to its citizens’ ability to consume in a closed economy versus an open economy.
THE TWO-WORKER PRODUCTION POSSIBILITIES CURVE
Recall that (for a two-good economy) the production possibilities curve (PPC) is a graph that shows the maximum amount of each good that can be produced, at every possible level of production of the other good.1 To see how the PPC is constructed, let’s consider a hypothetical economy, which we’ll call Costa Rica, which has only two workers, Carlos and Maria. Each of these two workers can produce two goods, coffee and computers.
EXAMPLE 15.1The PPC for a Two-Worker Economy
What is the PPC for a two-worker economy?
Two Costa Rican workers, Carlos and Maria, can each produce coffee and computers. Carlos can produce either 100 pounds of coffee or 1 computer per week. Maria can produce either 100 pounds of coffee or 2 computers per week. Both Carlos and Maria work 50 weeks per year. Find the production possibilities curve for Costa Rica.
To construct the PPC for this two-person economy, we ask first how much coffee Costa Rica could produce if both Carlos and Maria worked full time producing coffee. Between them they can produce 200 pounds of coffee per week, so in 50 weeks they could produce 10,000 pounds of coffee. Thus if we plot coffee production on the vertical axis of the graph of Costa Rica’s PPC, the vertical intercept of the PPC will be 10,000 pounds of coffee per year (point A in Figure 15.1). Likewise, if Carlos and Maria produced only computers, between them they could produce 3 computers per week, or 150 computers per year. So the horizontal intercept of Costa Rica’s PPC is 150 computers per year (point B in Figure 15.1).
FIGURE 15.1 Production Possibilities Curve for a Two-Worker Economy.In the portion of the PPC between points A and C, only Maria is producing computers, so the slope of the PPC in that range reflects Maria’s opportunity cost of computers in terms of coffee production forgone. At point C, Maria spends all her time on computers and Carlos spends all his time on coffee. Between points C and B, any additional computers must be produced by Carlos. Thus between points C and B the slope of the PPC reflects Carlos’s opportunity cost of producing computers, in terms of coffee production forgone.
We have found where the Costa Rican PPC intersects the two axes of the graph. To find the rest of the PPC, imagine that Carlos and Maria are producing only coffee (point A in Figure 15.1), when they decide that they would like to have some computers as well. In this situation, which worker should switch from producing coffee to producing computers?
To answer this question, we need to find the one with a comparative advantage in producing computers. To do this we must calculate opportunity costs. Carlos can produce either 100 pounds of coffee or 1 computer per week. Because producing a computer leaves him one week less to devote to coffee production, which reduces his coffee output by 100 pounds, Carlos’s opportunity cost of producing 1 computer is 100 pounds of coffee. Maria can produce either 100 pounds of coffee or 2 computers per week, so her opportunity cost of producing a computer is 100/2, or 50 pounds of coffee. Because Maria’s opportunity cost of producing a computer is lower than Carlos’s, she has a comparative advantage in producing computers. By the principle of comparative advantage, Maria should be the one to specialize in computer production. For his part, Carlos has a comparative advantage in producing coffee (see Concept Check 15.1), so he should specialize in coffee.
Starting from point A in Figure 15.1, where only coffee is produced, we can imagine that Maria begins to produce increasing numbers of computers. The slope of the line emanating from point A equals Maria’s opportunity cost of producing a computer, OCcomputers, where cost is measured as a negative quantity:
As Maria increases the share of her time devoted to computer production, we move down along the straight line from point A in Figure 15.1. The slope of the PPC is constant in this region at –50 pounds of coffee per computer, Maria’s opportunity cost of computers.
Maria’s time is limited to 50 weeks per year, however, so if she keeps increasing her computer production, she will eventually reach a point at which she produces only computers and no coffee. At that point annual production by the two workers taken together will be 100 computers (produced by Maria) and 5,000 pounds of coffee (produced by Carlos, who spends all his time producing coffee). This combination of production is shown at point C on the production possibilities curve.
Once Maria’s time is fully devoted to making computers, Costa Rica can increase its computer production only if Carlos begins to build some computers, too. However, Carlos’s opportunity cost, measured as pounds of coffee forgone per computer produced, is greater than Maria’s. Hence at point C the slope of the PPC changes, creating a “kink” in the graph. The slope of the PPC to the right of point C is given by
Note that the slope of the PPC to the right of point C is more negative than the slope to the left of point C, so that the PPC declines more sharply to the right of that point. The fact that the opportunity cost of a computer increases as more computers are produced (the Principle of Increasing Opportunity Cost) implies the outwardly bowed shape that is characteristic of a production possibilities curve, as shown in Figure 15.1.
Increasing Opportunity Cost
CONCEPT CHECK 15.1
Example 15.1 showed that Maria has a comparative advantage in producing computers. Show by comparison of opportunity costs that Carlos has a comparative advantage in producing coffee.
THE MANY-WORKER PRODUCTION POSSIBILITIES CURVE
Although the economy considered in Example 15.1 included only two workers, the main ideas apply to economies with more workers. Suppose, for example, that we added a third Costa Rican worker, Pedro, whose opportunity cost of producing computers is higher than Maria’s but lower than Carlos’s. The production possibilities curve for this three-person economy would look something like Figure 15.2. Between points A and C on the PPC shown in Figure 15.2, all computers are produced by Maria, who has the greatest comparative advantage in computer production. Thus the slope of the PPC between points A and C is determined by Maria’s opportunity cost, measured as the amount of coffee production forgone for each additional computer produced.
FIGURE 15.2 Production Possibilities Curve for a Three-Worker Economy.The PPC for a three-person economy has two “kinks,” at points C and D. Between points A and C only Maria produces computers, and the slope of the PPC represents her opportunity cost of producing computers. At point C Maria is spending all her time making computers, so any additional computers will be produced by Pedro, whose comparative advantage is the next greatest. Between points C and D the slope of the PPC is determined by Pedro’s opportunity cost. At point D Pedro is also fully occupied producing computers, so that Carlos must begin producing them if computer production is to increase further. Between points D and B the slope of the PPC reflects Carlos’s opportunity cost.
At point C Maria is dedicating all her time to computer production, so someone else must produce any additional computers. Pedro has the next lowest opportunity cost of producing computers, so (following the Principle of Increasing Opportunity Cost) he begins to produce computers at point C. The slope of the PPC between points C and D is determined by Pedro’s opportunity cost, which is greater (more negative) than Maria’s opportunity cost. At point D in Figure 15.2, Pedro is producing all the computers he can, so finally Carlos begins to produce computers as well. Thus the slope of the PPC between points D and B reflects Carlos’s opportunity cost. Because opportunity cost increases as we move from left to right in the figure, the slope of the PPC becomes more and more negative, leading once again to the outwardly bowed shape.
Increasing Opportunity Cost
By similar logic, we can construct a case in which there are many workers, perhaps millions. With many workers, the part of the nation’s PPC that is associated with each individual worker becomes very small. As a result, the PPC for an economy with many workers has a smoothly bowed shape, as shown in Figure 15.3. With a smoothly curved PPC, the slope at each point still reflects the opportunity cost of producing an additional computer, as illustrated in Figure 15.3. For example, at point C in Figure 15.3, the opportunity cost of producing an extra computer is given by the slope of the line that just touches the PPC at that point. Because computers will be produced first by workers with the greatest comparative advantage (the lowest opportunity cost), the slope of the PPC becomes more and more sharply negative as we read from left to right in the figure.
FIGURE 15.3 Production Possibilities Curve for a Many-Worker Economy.The PPC for a many-worker economy has a smooth, outwardly bowed shape. At each point on the PPC the slope of the curve reflects the opportunity cost, in terms of coffee forgone, of producing an additional computer. For example, the opportunity cost of a computer at point C equals the slope of the line that just touches the PPC at that point, and the opportunity cost of a computer at point D equals the slope of the line that just touches the PPC there. Because the opportunity cost of producing another computer increases as more computers are produced, the slope of the PPC becomes more and more negative as we read from left to right on the graph.
RECAP
PRODUCTION POSSIBILITIES CURVES
· The production possibilities curve (PPC) for a two-good economy is a graph that shows the maximum amount of one good that can be produced at every possible level of production of the other good.
· The slope of a PPC at any point indicates the opportunity cost, in terms of forgone production of the good on the vertical axis, of increasing production of the good on the horizontal axis by one unit.
· The more of a good that is already being produced, the greater the opportunity cost of increasing production still further. Thus the slope of the PPC becomes more and more negative as we read from left to right, imparting the characteristic outwardly bowed shape of the curve.
CONSUMPTION POSSIBILITIES WITH AND WITHOUT INTERNATIONAL TRADE
A country’s production possibilities curve shows the quantities of different goods that its economy can produce. However, economic welfare depends most directly not on what a country can produce, but on what its citizens can consume. The combinations of goods and services that a country’s citizens might feasibly consume are called the country’s consumption possibilities.
The relationship between a country’s consumption possibilities and its production possibilities depends on whether the country is open to international trade. In a closed economy with no trade, people can consume only the goods and services produced within their own country. In a closed economy, then, society’s consumption possibilities are identical to its production possibilities. A situation in which a country is economically self-sufficient, producing everything its citizens consume, is called autarky.
The case of an open economy, which trades with the rest of the world, is quite different. In an open economy, people are not restricted to consuming what is produced in their own country, because part of what they produce can be sent abroad in exchange for other goods and services. Indeed, we will see in this section that opening an economy to trade may allow citizens to consume more of everything. Thus in an open economy, a society’s consumption possibilities are typically greater than (and will never be less than) its production possibilities. We will illustrate this critical point with reference to the two-worker economy studied earlier in the chapter, then briefly consider the more general case of a many-worker economy.
EXAMPLE 15.2Costa Rica’s Consumption Possibilities with Trade
How does opening to trade affect an economy’s consumption possibilities?
Two Costa Rican workers, Carlos and Maria, can produce coffee and computers as described in Example 15.1. Initially the country is closed to trade, and Maria produces only computers, while Carlos produces only coffee. Then the country opens up to trade. World prices are such that 80 pounds of coffee can be traded for 1 computer on the international market and vice versa. How does the opening of Costa Rica to trade affect Maria’s and Carlos’s opportunity to consume coffee and computers?
If Maria is producing only computers and Carlos is producing only coffee, then Costa Rica is at point C on the PPC shown in Figure 15.4 (which is the same as the PPC shown in Figure 15.1). At that point Maria is spending all her time producing 100 computers a year, and Carlos is spending all his time producing 5,000 pounds of coffee a year. If Costa Rica were closed to trade, Maria and Carlos could obtain more coffee only by producing fewer computers. Specifically, starting at point C on the PPC, they could obtain 50 additional pounds of coffee by giving up 1 computer—by having Maria work 1/2 week less on computers and 1/2 week more producing coffee.
FIGURE 15.4 Costa Rica’s Consumption Possibilities with Trade.Without the opportunity to trade, Costa Rica’s consumption possibilities are the same as the Costa Rican PPC, represented by line ACB. With the opportunity to trade, however, Costa Ricans can consume at any point along line FG.
If Costa Rica opens up to trade, however, then Maria and Carlos can get 80 pounds of coffee in exchange for 1 computer simply by trading computers for coffee on the international market. In other words, they can get an extra 80 pounds of coffee for each computer they give up. To illustrate the degree to which the opportunity to trade benefits Costa Rica, recall from Example 15.1 that with no trade, Maria’s and Carlos’s maximum coffee consumption is 10,000 pounds per year (the vertical intercept of the Costa Rican PPC). With the opportunity to trade, however, Maria can trade the 100 computers produced at point C for 8,000 pounds of coffee (80 pounds of coffee per computer × 100 computers). Together with the 5,000 pounds of coffee Carlos produces, the coffee obtained through trade raises Costa Rica’s maximum annual coffee consumption from 10,000 to 13,000 pounds per year, as indicated by point F in Figure 15.4. Because trade creates the possibility for Costa Rica to consume as much as 13,000 pounds of coffee per year, point F is included in Costa Rica’s consumption possibilities, though it would have been unattainable to the Costa Ricans before the opening up of trade.
Furthermore, with the opportunity to trade, Maria and Carlos can consume any combination of coffee and computers represented on the straight line between points F and C in Figure 15.4. This straight line has a slope of –80 pounds of coffee per 1 computer, which is the rate at which the two goods can be exchanged on the international market. So, simply by trading computers for coffee, Maria and Carlos can improve their consumption possibilities at any point except C, where their production and consumption possibilities are the same.
Suppose instead that, starting from point C on Costa Rica’s PPC, Maria and Carlos decide they want to consume more computers rather than more coffee. With no ability to trade, the opportunity cost of obtaining 1 more computer at point C would be 100 pounds of coffee—that is, the amount of coffee that would be lost by having Carlos work 1 more week at producing an extra computer, and hence 1 week fewer at producing coffee. With trade, however, Costa Ricans can obtain an extra computer at the cost of only 80 pounds of coffee (the price of computers on the international market). In the extreme, if they wanted to consume only computers, the Costa Ricans could trade the 5,000 pounds of coffee Carlos produces at point C for 5,000/80 = 62.5 computers, for a total consumption (with the 100 computers Maria produces) of 162.5 computers. This maximum consumption amount is indicated by point G in Figure 15.4. Comparing point G with point B, we can see that the opportunity to trade increased Costa Rica’s maximum consumption of computers from 150 to 162.5. (Consuming 162.5 computers a year means consuming 325 computers every two years.)
Furthermore, by trading various amounts of coffee for computers, Costa Ricans can consume any combination of computers and coffee on the straight line between points C and G in Figure 15.4. Like the segment FC, segment CG has a slope equal to –80 pounds of coffee per 1 computer, reflecting the rate at which coffee can be traded for computers on the international market. Note that since segments FC and CG have the same slopes, the line FG is a straight line. The line FG represents Costa Rica’s consumption possibilities—the combinations of coffee and computers that Carlos and Maria might feasibly consume—when the Costa Rican economy is open to trade. By comparing Costa Rica’s consumption possibilities without trade (line ACB) and with trade (line FG), we can see that Maria and Carlos have a wider range of consumption opportunities when their economy is open.
CONCEPT CHECK 15.2
Prior to the opening of trade, suppose that Costa Rican residents consumed 80 computers per year. How much coffee were they able to consume each year? Suppose that the Costa Ricans open up to trade, but they choose to continue to consume 80 computers per year. Now how much coffee can they consume? In answering, use the PPC and consumption possibilities we found in Example 15.2. Does opening to trade make the Cost Ricans better off?
The same points just made in Example 15.2, which illustrates a two-worker economy, apply in the case of a many-worker economy. Figure 15.5 shows this more general case. With many workers, the PPC (curve ACB in the figure) is smoothly bowed. Point A, where the PPC intercepts the vertical axis, indicates the maximum amount of coffee the economy can produce, and point B, the horizontal intercept of the PPC, shows the maximum number of computers the economy can produce. The intermediate points on the PPC represent alternative combinations of coffee and computers that can be produced. As in the two-worker economy, the slope at each point on the PPC indicates the opportunity cost of producing one additional computer. The more computers that are already being produced, the greater the opportunity cost of increasing computer production still further. Hence the slope of the PPC becomes increasingly negative as we read from left to right.
FIGURE 15.5 Consumption Possibilities in a Many-Worker Economy.The PPC for a many-worker economy is the smooth, outwardly bowed line ACB. If the country is open to trade, its consumption possibilities lie on the line FG, which just touches the PPC at point C. The slope of this line equals the rate at which coffee can be traded for computers at world prices. The country maximizes its consumption possibilities by producing at point C and then trading so as to reach its most desired point on line FG.
Line FG shows the consumption possibilities for this economy if it is open to trade. This line has two key features. First, it is drawn so that it just touches the PPC, at point C in Figure 15.5. Second, the slope of line FG is determined by the relative prices of coffee and computers on the world market. Specifically, as in the two-worker case (Figure 15.4), the slope of line FG tells us how much coffee must be exchanged on world markets to obtain an additional computer.
With access to international trade, Costa Rica can consume the greatest amount of both coffee and computers by producing at point C on the PPC and trading on the international market to obtain the desired combination of coffee and computers on line FG. (The exact combination of coffee and computers Cost Ricans will choose depends on the needs and wants of the population.)
Why should the Costa Ricans produce at point C? At point C, and only at that point, the slope of the PPC equals the slope of the consumption possibilities line, FG. Hence only at point C is the opportunity cost of increasing domestic computer production equal to the opportunity cost of purchasing an extra computer on the world market. If the opportunity cost of producing a computer domestically exceeded the opportunity cost of purchasing a computer on the world market, Costa Rica would gain by reducing its computer production and importing more computers. Likewise, if the opportunity cost of producing a computer domestically were less than the opportunity cost of purchasing a computer abroad, Costa Rica would gain by increasing computer production and reducing computer imports. Costa Rica’s best production combination, therefore, is at point C, where the domestic and international opportunity costs of acquiring an extra computer, measured in terms of coffee forgone, are equal.
We have already stated the general conclusion that can be drawn from this analysis. Once again, by opening itself up to trade, a country can consume more of every good than if it relied solely on its own production (a situation of autarky). Graphically, the consumption possibilities line in Figure 15.5 lies above the production possibilities curve, showing that through trade, Cost Rica can consume combinations of computers and coffee that would not be attainable if its economy were closed to trade.2
RECAP
CONSUMPTION POSSIBILITIES AND PRODUCTION POSSIBILITIES
· A country’s consumption possibilities are the combinations of goods and services that its citizens might feasibly consume.
· In an economy that is closed to trade, residents can consume only what is produced domestically (a situation of autarky). Hence, in a closed economy, consumption possibilities equal production possibilities.
· The residents of an open economy can trade part of what they produce on international markets. According to the principle of comparative advantage, trade allows everyone to do better than they could otherwise. Thus, in an open economy, consumption possibilities are typically greater than, and will never be less than, production possibilities.
· Graphically, consumption possibilities in an open economy are described by a downward-sloping line that just touches the production possibilities curve (PPC). The slope of this line equals the amount of the good on the vertical axis that must be traded on the international market to obtain one unit of the good on the horizontal axis. A country maximizes its consumption possibilities by producing at the point where the consumption possibilities line just touches the PPC, and then trading so as to reach its most preferred point on the consumption possibilities line.
A SUPPLY AND DEMAND PERSPECTIVE ON TRADE
To this point we have shown that a country can improve its overall consumption possibilities by trading with other countries. In this section we will look more carefully at how international trade affects supply and demand in the markets for specific goods. We will see that when it is costly for workers and firms to change industries, opening up trade with other countries may create groups of winners and losers among producers even as it helps consumers.
Let’s see how trade affects the markets for computers and coffee in Costa Rica. Figure 15.6 shows the supply and demand for computers in that country. As usual, the price is shown on the vertical axis and the quantity on the horizontal axis. For now, think of the price of computers as being measured in terms of coffee rather than in terms of dollars (in other words, we measure the price of computers relative to the price of the other good in the economy). As usual, the upward-sloping curve in Figure 15.6 is the supply curve of computers, in this case for computers produced in Costa Rica; and the downward-sloping curve is the demand curve for computers by Costa Rican residents. The supply curve for computers in Costa Rica reflects the opportunity cost of supplying computers (see Chapter 3, Supply and Demand). Specifically, at any level of computer production, the relative price at which Costa Rican firms are willing to supply an additional computer equals their opportunity cost of doing so. The demand curve, which tells us the number of computers Costa Ricans will purchase at each relative price, reflects the preferences and buying power of Costa Rican consumers.
FIGURE 15.6 The Market for Computers in Costa Rica.If Costa Rica is closed to international trade, the equilibrium price and quantity of computers are determined by the intersection of the domestic supply and demand curves at point E. But if Costa Rica is open to trade, the domestic price of computers must equal the world price. At that price, Costa Ricans will demand qD computers, but domestic producers will supply only qS computers. Thus qD – qS computers must be imported from abroad.
If the Costa Rican economy is closed to international trade, then market equilibrium occurs where the domestic supply and demand curves intersect, at point E in Figure 15.6. The equilibrium price will be p and the equilibrium quantity, q.
If Costa Rica opens its market to trade, however, the relevant price for computers becomes the world price of computers, the price at which computers are traded internationally. The world price for computers is determined by the worldwide supply and demand for computers. If we assume that Costa Rica’s computer market is too small to affect the world price for computers very much, the world price can be treated as fixed, and represented by a horizontal line in the figure. Figure 15.6 shows the world price for computers as being lower than Costa Rica’s closed-economy price.
If Costa Ricans are free to buy and sell computers on the international market, then the price of computers in Costa Rica must be the same as the world price. (No one in Costa Rica will buy a computer at a price above the world price, and no one will sell one at a price below the world price.) Figure 15.6 shows that at the world price, Costa Rican consumers and firms demand qD computers, but Costa Rican computer producers will supply only qS computers. The difference between the two quantities, qD ‒ qS, is the number of computers that Costa Rica must import from abroad. Figure 15.6 illustrates a general conclusion: If the price of a good or service in a closed economy is greater than the world price, and that economy opens itself to trade, the economy will tend to become a net importer of that good or service.
A different outcome occurs in Costa Rica’s coffee market, shown in Figure 15.7. The price of coffee (measured relative to the price of computers) is shown on the vertical axis, and the quantity of coffee on the horizontal axis. The downward-sloping demand curve in the figure shows how much coffee Costa Rican consumers want to buy at each relative price, and the upward-sloping supply curve how much coffee Costa Rican producers are willing to supply at each relative price. If Costa Rica’s economy is closed to trade with the rest of the world, then equilibrium in the market for coffee will occur at point E, where the domestic demand and supply curves intersect. The quantity produced will be q and the price p.
FIGURE 15.7 The Market for Coffee in Costa Rica.With no international trade, the equilibrium price and quantity of coffee in Costa Rica are determined by the intersection of the domestic supply and demand curves (point E). But if the country opens to trade, the domestic price of coffee must equal the world price. At the higher world price, Costa Ricans will demand the quantity of coffee qD, less than the amount supplied by Costa Rican producers, qS. The excess coffee supplied by Costa Rican producers, qS – qD, is exported.
Now imagine that Costa Rica opens its coffee market to international trade. As in the case of computers, if free trade in coffee is permitted, then the prevailing price for coffee in Costa Rica must be the same as the world price. Unlike the case of computers, however, the world price of coffee as shown in Figure 15.7 is higher than the domestic equilibrium price. How do we know that the world price of coffee will be higher than the domestic price? Recall that the price of coffee is measured relative to the price of computers, and vice versa. If the price of computers relative to the price of coffee is higher in Costa Rica than in the world market, then the price of coffee relative to the price of computers must be lower, as each price is the reciprocal of the other. More generally, as we saw in Chapter 2, Comparative Advantage, when two people or two countries trade with each other, neither can have a comparative advantage in every good and service. Thus, in an example with only two goods, if non-Costa Rican producers have a comparative advantage in computers, reflected in the lower cost of computers relative to coffee in the world market, then Costa Rican producers must have a comparative advantage in coffee. By definition, this comparative advantage implies that the opportunity cost of coffee in terms of computers must be lower in Costa Rica than in the rest of the world.
Figure 15.7 shows that at the world price for coffee, Costa Rican producers are willing to supply qS coffee, while Costa Rican consumers want to purchase a smaller amount, qD. The difference between domestic production and domestic consumption, qS ‒ qD, is exported to the world market. The general conclusion of Figure 15.7 is this: If the price of a good or service in a closed economy is lower than the world price, and that economy opens itself to trade, the economy will tend to become a net exporter of that good or service.
These examples illustrate how the market translates comparative advantage into mutually beneficial gains from trade. If trade is unrestricted, then countries with a comparative advantage in a particular good will profit by supplying that good to the world market and using the revenue earned to import goods in which they do not have a comparative advantage. Thus the workings of the free market automatically ensure that goods will be produced where the opportunity cost is lowest, leading to the highest possible consumption possibilities for the world as a whole.
WINNERS AND LOSERS FROM TRADE
If trade is so wonderful, why do politicians so often resist free trade and “globalization”? The reason is that although free trade benefits the economy as a whole, specific groups may not benefit. Groups who are hurt by trade, and the politicians they elect, may support policies that restrict the free flow of goods and services across borders.
The supply and demand analyses shown in Figures 15.6 and 15.7 are useful in clarifying who gains and who loses when an economy opens up to trade. Look first at Figure 15.6, which shows the market for computers in Costa Rica. When Costa Rica opens its computer market to international competition, Costa Rican consumers enjoy a larger quantity of computers at a lower price. Clearly, Costa Rican computer users benefit from the free trade in computers. In general, domestic consumers of imported goods benefit from free trade. However, Costa Rican computer producers and their workers will not be so happy about opening their market to international competition. The fall in computer prices to the international level implies that less efficient domestic producers will go out of business, and that those who remain will earn lower profits. Unemployment in the Costa Rican computer industry will rise and may persist over time, particularly if displaced computer workers cannot easily move to a new industry. The wages paid to Costa Rican computer workers will also fall, reflecting the lower relative price of computers. We see that, in general, domestic producers of imported goods, and workers in imported-good sectors, are hurt by free trade.
Consumers are helped, while producers and workers are hurt, when imports increase. The opposite conclusions apply for an increase in exports (see Figure 15.7). In the example of Costa Rica, an opening of the coffee market raises the domestic price of coffee to the world price and creates the opportunity for Costa Rica to export coffee. Domestic producers of coffee benefit from the increased market (they can now sell coffee abroad as well as at home) and from the higher price of their product. Domestic workers in the coffee sector benefit too, as they are more in demand. In short, domestic producers of exported goods, and workers in exported-good sectors, benefit from free trade. Costa Rican coffee drinkers will be less enthusiastic, however, since they must now have to pay the higher world price of coffee, and can therefore consume less. Thus domestic consumers of exported goods are hurt by free trade.
Free trade is efficient in the sense that it increases the size of the pie available to the economy. Indeed, the efficiency of free trade is an application of the Equilibrium Principle: Markets in equilibrium leave no unexploited opportunities for individuals. Despite the efficiency of free trade, however, some groups may lose from trade, which generates political pressures to block or restrict trade. In the next section we will discuss the major types of policy used to restrict trade.
Equilibrium
The Economic Naturalist 15.1
What is the China trade shock?
The China trade shock, a term most commonly associated with economists David Autor, David Dorn, and Gordon Hanson, is used to describe the dramatic change in international trade patterns that resulted from China’s rise as a major player in the global economy over the past few decades.
In a series of influential studies, these economists and their collaborators investigated the costs of the shock to U.S. workers. They found that employment has fallen in U.S. industries and regions most exposed to import competition from China—something that our theory in this chapter helps explain. However, they did not find strong evidence of simultaneous offsetting employment increases in other sectors in the same regions, suggesting that the transition of workers into sectors in which the U.S. has comparative advantage has been neither quick nor easy—something that the theory does not emphasize.
Overall, these economists conclude that workers’ adjustment to trade shocks is often a slow and difficult process, and that local labor-force participation rates and unemployment rates in affected regions may take a decade or more to recover. Moreover, the slow adjustment means that trade shocks could lead to prolonged economic and social problems in affected communities.
While the research underlying these conclusions is still new and is still being examined, it serves as a reminder that for many workers, the short-term costs of trade may outweigh the short-term benefits. While opposition to trade among such workers is understandable, we should not conclude that the overall costs of trade outweigh the overall benefits. Rather, as these economists conclude in one of their studies:
“Better understanding when and where trade is costly, and how and why it may be beneficial, is a key item on the research agenda for trade and labor economists. Developing effective tools for managing and mitigating the costs of trade adjustment should be high on the agenda for policymakers and applied economists.”3
RECAP
A SUPPLY AND DEMAND PERSPECTIVE ON TRADE
· For a closed economy, the domestic supply and demand for a good or service determine the equilibrium price and quantity of that good or service.
· In an open economy, the price of a good or service traded on international markets equals the world price. If the domestic quantity supplied at the world price exceeds the domestic quantity demanded, the difference will be exported to the world market. If the domestic quantity demanded at the world price exceeds the domestic quantity supplied, the difference will be imported.
· Generally, if the price of a good or service in a closed economy is lower than the world price and the economy opens to trade, the country will become a net exporter of that good or service. If the closed-economy price is higher than the world price and the economy opens to trade, the country will tend to become a net importer of the good or service.
· Consumers of imported goods, producers of exported goods, and workers in exported-good sectors benefit from trade, whereas consumers of exported goods, producers of imported goods, and workers in imported-good sectors are hurt by trade. Those groups that are hurt, and the politicians they elect, may support enacting barriers to trade.
TRADE WINNERS AND LOSERS
Winners
· Consumers of imported goods
· Producers of exported goods
· Workers in exported-good sectors
Losers
· Consumers of exported goods
· Producers of imported goods
· Workers in imported-good sectors
PROTECTIONIST POLICIES: TARIFFS AND QUOTAS
The view that free trade is injurious and should be restricted is known as protectionism. Supporters of this view believe the government should attempt to “protect” domestic markets by raising legal barriers to imports. (Interestingly, protectionists rarely attempt to restrict exports, even though they hurt consumers of the exported good.) Two of the most common types of such barriers are tariffs and quotas. A tariff is a tax imposed on an imported good. A quota is a legal limit on the quantity of a good that may be imported.
TARIFFS
The effects of tariffs and quotas can be explained using supply and demand diagrams. Suppose that Costa Rican computer makers, dismayed by the penetration of “their” market by imported computers, persuade their government to impose a tariff—that is, a tax—on every computer imported into the country. Computers produced in Costa Rica will be exempt from the tax. Figure 15.8 shows the likely effects of this tariff on the domestic Costa Rican computer market. The lower of the two horizontal lines in the figure indicates the world price of computers, not including the tariff. The higher of the two lines indicates the price Costa Rican consumers will actually pay for imported computers, including the tariff. We refer to the price of computers including the tariff as pT. The vertical distance between the two lines equals the amount of the tariff that is imposed on each imported computer.
FIGURE 15.8 The Market for Computers after the Imposition of an Import Tariff.The imposition of a tariff on imported computers raises the price of computers in Costa Rica to the world price plus tariff, pT, represented by the upper horizontal line. Domestic production of computers rises from qS to q′S, domestic purchases of computers fall from qD to q′D, and computer imports fall from qD – qS to q′D – q′S. Costa Rican consumers are worse off and Costa Rican computer producers are better off. The Costa Rican government collects revenue from the tariff equal to the area of the pale blue rectangle.
From the point of view of domestic Costa Rican producers and consumers, the imposition of the tariff has the same effects as an equivalent increase in the world price of computers. Because the price (including the tariff) of imported computers has risen, Costa Rican computer producers will be able to raise the price they charge for their computers to the world price plus tariff, pT. Thus the price Costa Rican consumers must pay—whether their computers are imported or not—equals pT, represented by the upper horizontal line in Figure 15.8.
The rise in the price of computers created by the tariff affects the quantities of computers supplied and the quantities demanded by Costa Ricans. Domestic computer producers, facing a higher price for computers, increase their production from qS to q′S (see Figure 15.8). Costa Rican consumers, also reacting to the higher price, reduce their computer purchases from qD to q′D. As a result, the number of imported computers—the difference between domestic purchases and domestic production—falls from qD – qS to q′D ‒ q′S.
Who are the winners and the losers from the tariff, then? Relative to an environment with free trade and no tariff, the winners are the domestic computer producers, who sell more computers and receive a higher price for them. The clearest losers are Costa Rican consumers, who must now pay more for their computers. Another winner is the government, which collects revenue from the tariff. The blue area in Figure 15.8 shows the amount of revenue the government collects, equal to the quantity of computer imports after the imposition of the tariff, q′D – q′S, times the amount of the tariff.
EXAMPLE 15.3A Tariff on Imported Computers
What are the effects of a tariff on trade?
Suppose that the Costa Rican market for computers is represented by Figure 15.9. Thus, if the Costa Rican economy is closed to trade, the equilibrium price for computers would be $2,000, and 2,000 computers would be bought and sold in the Costa Rican computer market every year (point E). Assuming that the world price of computers is $1,400, how would this market be affected by opening to trade, and how would it be affected by the imposition of a tariff of $400 per computer?
FIGURE 15.9 The Market for Computers in Costa Rica after the Imposition of an Import Tariff.A tariff of $400 per computer raises the price of computers by $400 and reduces imports by 400 computers per year.
If the economy opens to trade, the domestic price of computers must equal the world price of $1,400. At this price, the domestic quantity demanded is 2,300 computers per year and the domestic quantity supplied is 1,700 computers per year. Imports equal the difference between the domestic quantities demanded and supplied, or 2,300 ‒ 1,700 = 600 computers per year.
The imposition of a tariff of $400 per computer raises the price from $1,400 to $1,800. This price rise causes Costa Rican computer producers to increase their production from 1,700 to 1,900 computers per year, and it causes Costa Rican consumers to reduce their computer purchases from 2,300 to 2,100. As a result, the number of imported computers—the difference between domestic purchases and domestic production—falls from 600 to 200 (2,100 ‒ 1,900).
Thus the tariff has raised the price of computers by $400 and reduced imports by 400 computers per year. The tariff revenue collected by the government is $400 per imported computer times 200 computers per year = $80,000 per year.
QUOTAS
An alternative to a tariff is a quota, or legal limit, on the number or value of foreign goods that can be imported. One means of enforcing a quota is to require importers to obtain a license or permit for each good they bring into the country. The government then distributes exactly the same number of permits as the number of goods that may be imported under the quota.
How does the imposition of a quota on, say, computers affect the domestic market for computers? Figure 15.10, which is similar to Figure 15.8, illustrates the effect of a quota on imported computers. As before, assume that at first there are no restrictions on trade. Consumers pay the world price for computers, and qD – qS computers are imported. Now suppose once more that domestic computer producers complain to the government about competition from foreign computer makers, and the government agrees to act. However, this time, instead of a tariff, the government imposes a quota on the number of computers that can be imported. For comparability with the tariff analyzed in Figure 15.8, let’s assume that the quota permits the same level of imports as entered the country under the tariff: specifically, q′D – q′S computers. What effect does this ruling have on the domestic market for computers?
FIGURE 15.10 The Market for Computers after the Imposition of an Import Quota.The figure shows the effects of the imposition of a quota that permits only q′D – q′S computers to be imported. The total supply of computers to the domestic economy equals the domestic economy equals the domestic supply curve shifted to the right by q′D – q′S units (the fixed amount of imports). Market equilibrium occurs at point F. The effects of the quota on the domestic market are identical to those of the tariff analyzed in Figure 15.8. The domestic price rises to pT, domestic production of computers rises from qS to q′S, domestic purchases of computers fall from qD to q′D, and computer imports fall from qD – qS to q′D – q′S. The quota differs from the tariff in that under a quota system the government collects no revenue.
After the imposition of the quota, the quantity of computers supplied to the Costa Rican market is the production of domestic firms plus the q′D – q′S imported computers allowed under the quota. Figure 15.10 shows the quantity of computers supplied inclusive of the quota. The total supply curve, labeled “Domestic supply plus quota,” is the same as the domestic supply curve shifted q′D – q′S units to the right. The domestic demand curve is the same as in Figure 15.8. Equilibrium in the domestic market for computers occurs at point F in Figure 15.10, at the intersection of the supply curve including the quota and the domestic demand curve. The figure shows that, relative to the initial situation with free trade, the quota (1) raises the domestic price of computers above the world price, to the level marked pT in Figure 15.10; (2) reduces domestic purchases of computers from qD to q′D; (3) increases domestic production of computers from qS to q′S; and (4) reduces imports to q′D ‒ q′S, consistent with a quota. Like a tariff, the quota helps domestic producers by increasing their sales and the price they receive for their output, while hurting domestic consumers by forcing them to pay a higher price.
Interestingly, under our assumption that the quota is set to permit the same level of imports as the tariff, the effects on the domestic market of the tariff (Figure 15.8) and the quota (Figure 15.10) are not only similar, they are equivalent. Comparing Figures 15.8 and 15.10, you can see that the two policies have identical effects on the domestic price, domestic purchases, domestic production, and imports.
Although the market effects of a tariff and a quota are the same, there is one important difference between the two policies, which is that a tariff generates revenue for the government, whereas a quota does not. With a quota, the revenue that would have gone to the government goes instead to those firms that hold the import licenses. A holder of an import license can purchase a computer at the world price and resell it in the domestic market at price pT, pocketing the difference. Thus with a tariff the government collects the difference between the world price and the domestic market price of the good; with a quota, private firms or individuals collect that difference. Why then would the government ever impose a quota rather than a tariff? One possibility is that the distribution of import licenses is a means of rewarding the government’s political supporters. Sometimes, international political concerns may also play a role (see Economic Naturalist 15.2 for a possible example).
EXAMPLE 15.4Effects of an Import Quota
What are the effects of an import quota on trade?
Suppose the supply of and demand for computers in Costa Rica, as well as the world price of computers, are as given in Figure 15.11. Suppose that the government imposes a quota of 200 on the number of computers that can be imported. What effect would this have on the domestic market for computers (relative to the free-trade alternative)?
FIGURE 15.11 The Market for Computers in Costa Rica after the Imposition of an Import QuotaA quota of 200 computers per year raises the price of computers by $400 and reduces imports by 400 computers per year.
After the quota is imposed, the equilibrium in the domestic market occurs at point F in the figure. As the figure shows, relative to free trade, the domestic price increases to $1,800 per computer, domestic purchases of computers decrease to 2,100, domestic production of computers increases to 1,900, and imports decrease to 200 (the difference between the 2,100 computers demanded and the 1,900 computers domestically produced).
Note that the domestic price, domestic production, and domestic demand are the same in Examples 15.3 and 15.4. Thus, under the assumptions we made, the tariff and the quota have the same effects on the domestic market for computers. The only difference between the two policies is that with a quota, the government does not get the tariff revenue it got in Example 15.3. That revenue goes instead to the holders of import licenses, who can buy computers on the world market at $1,400 and sell them in the domestic market at $1,800.
The Economic Naturalist 15.2
Who benefited from and who was hurt by voluntary export restraints on Japanese automobiles in the 1980s?
After the oil price increases of the 1970s, American consumers began to buy small, fuel-efficient Japanese automobiles in large numbers. Reeling from the new foreign competition, U.S. automobile producers petitioned the U.S. government for assistance. In response, in May 1981 the U.S. government negotiated a system of so-called voluntary export restraints, or VERs, with Japan. Under the VER system, each Japanese auto producer would “voluntarily” restrict exports to the United States to an agreed-upon level. VER quotas were changed several times before the system was formally eliminated in 1994. Who benefited from, and who was hurt by, VERs on Japanese automobiles?
Several groups benefited from the VER system. As should be expected, U.S. auto producers saw increased sales and profits when their Japanese competition was reduced, and U.S. auto workers benefited too. But Japanese automobile producers and workers also profited from the policy, despite the reduction in their U.S. sales. The restrictions on the supply of their automobiles to the U.S. market allowed them to raise their prices in the U.S. market significantly—by several thousand dollars per car by the late 1980s, according to some estimates. From an economic point of view, the VERs functioned like a tariff on Japanese cars, except that the Japanese automobile producers, rather than the U.S. government, got to keep the tariff revenue. A third group that benefited from the VERs was European automobile producers and workers, who saw U.S. demand for their cars rise when Japanese imports declined.
The biggest losers from the VER system were clearly American car buyers, who faced higher prices (particularly for Japanese imports) and reduced selection. During this period dealer discounts on new Japanese cars largely disappeared, and customers often found themselves paying a premium over the list price. Because the economic losses faced by American car buyers exceeded the extra profits received by U.S. automobile producers (some of which may pass to workers too), the VERs produced a net loss for the U.S. economy that at its greatest was estimated at more than $3 billion per year.
The U.S. government’s choice of a VER system, rather than a tariff or a quota, was somewhat puzzling. If a tariff on Japanese cars had been imposed instead of a VER system, the U.S. government would have collected much of the revenue that went instead to Japanese auto producers. Alternatively, a quota system with import licenses given to U.S. car dealers would have captured some revenue for domestic car dealers rather than Japanese firms. The best explanation for why the U.S. government chose VERs is probably political. U.S. policymakers may have been concerned that the Japanese government would retaliate against U.S. trade restrictions by imposing its own restrictions on U.S. exports. By instituting a system that did minimal financial harm to—or even helped—Japanese auto producers, they may have hoped to avoid retaliation from the Japanese.4
Tariffs and quotas are not the only barriers to trade that governments erect. Importers may be subject to unnecessarily complex bureaucratic rules (so-called red tape barriers), and regulations of goods that are nominally intended to promote health and safety sometimes have the side effect, whether intentionally or unintentionally, of restricting trade. One example is European restrictions on imports of genetically modified foods. Although these regulations were motivated in part by concerns about the safety of such foods, they also help to protect Europe’s politically powerful farmers from foreign competition.
Who benefited from “voluntary” export restraints on Japanese cars?©Toshifumi Kitamaura/AFP/Getty Images
THE INEFFICIENCY OF PROTECTIONISM
Free trade is efficient because it allows countries to specialize in the production of goods and services in which they have the greatest comparative advantage. Conversely, protectionist policies that limit trade are inefficient—they reduce the total economic pie. (Recall the Efficiency Principle introduced in Chapter 3, Supply and Demand, that efficiency is an important social goal.) Why, then, do governments adopt such policies? The reason is similar to why some city governments impose rent controls (see Chapter 3, Supply and Demand). Although rent controls reduce economic welfare overall, some people benefit from them—namely, the tenants whose rents are held artificially below market level. Similarly, as we have seen in this section, tariffs and quotas benefit certain groups. Those who benefit from these restrictions (such as firms facing import competition, and the workers in such firms) may support politicians who promise to enact the restrictions.
Efficiency
The fact that free trade is efficient suggests an alternative to trade restrictions, however. Because eliminating restrictions on trade increases the overall economic pie, in general the winners from free trade will be able to compensate the losers in such a way that everyone becomes better off. Government programs that assist workers displaced by import competition are an example of such compensation. They include programs to expand job training and re-training opportunities, especially for the less educated, who are more likely to be hurt by competition from abroad; to provide transition assistance for displaced workers, including support for internal migration within the U.S. from regions with declining industries to regions with expanding industries; to mitigate residential and educational segregation and increase the access of those left behind to employment and educational opportunities; and to promote community redevelopment in regions with declining industries.
While by no means an easy task, developing and improving such programs, and making them widely available, could do a lot to help those who lose from trade. Spreading the benefits of free trade—or at least reducing its adverse effects on certain groups—reduces the incentives of those groups to oppose free trade.
Although we have focused on the winners and losers from trade, not all opposition to free trade is motivated by economic interest. For example, many who oppose further opening to trade cite environmental concerns. Protecting the environment is an important and laudable goal, but once again the Efficiency Principle suggests that restricting trade may not be the most effective means of achieving that goal. Restricting trade lowers world income, reducing the resources available to deal with environmental problems. (High levels of economic development are in fact associated with lower, not higher, amounts of pollution.) Furthermore, much of the income loss arising from barriers to trade is absorbed by poor nations trying to develop their economies. For this reason, leaders of developing countries are among the strongest advocates of free trade.
The Economic Naturalist 15.3
What is fast track authority?
In practice, trade agreements among countries are very complex. For example, agreements usually spell out in great detail the goods and services for which tariffs are being reduced or quotas are being expanded. Trade negotiators must also take into account barriers to trade other than explicit tariffs or quotas, such as rules that require a country’s government to buy only from domestic suppliers. Because trade negotiations can be so complex, having each country’s legislature vote on each item in a proposed trade agreement is not practical.
In the United States, the solution to this problem has been for the Congress to vote to give the president fast track authority. Under this authority, the executive branch is given discretion to negotiate the terms of a proposed trade agreement. Congress then has the opportunity to vote the agreement up or down, but it cannot amend the proposal or accept only certain parts of it.
Fast track authority has been successfully used by presidents of both parties to negotiate trade agreements. However, the granting of fast track authority itself can be contentious, reflecting political concerns about trade and globalization. In 2015, for example, Democrats strongly resisted President Obama’s request for fast track authority to negotiate a trade agreement with a number of countries.
RECAP
PROTECTIONIST POLICIES: TARIFFS AND QUOTAS
· The view that free trade is injurious and should be restricted is called protectionism.
· The two most common types of trade barriers are tariffs, or taxes on imported goods, and quotas, legal limits on the quantity that can be imported. A tariff raises the domestic price to the world price plus the tariff. The result is increased domestic production, reduced domestic consumption, and fewer imports. A quota has effects on the domestic market that are similar to those of a tariff. The main difference is that under a quota, the government does not collect tariff revenue.
· Trade barriers are inefficient; they reduce the overall size of the economic pie. Thus, in general, the winners from free trade should be able to compensate the losers in such a way that everyone becomes better off. Government programs to help workers displaced by import competition are an example of such compensation. They are not easy to develop and implement. Without effective compensation, however, opposition to trade by those who are hurt by it may lead to the inefficiency brought by protectionism.
SUMMARY
· According to the Principle of Comparative Advantage, the best economic outcomes occur when each nation specializes in the goods and services at which it is relatively most productive and then trades with other nations to obtain the goods and services its citizens desire. (LO1)
· The production possibilities curve (PPC) of a country is a graph that describes the maximum amount of one good that can be produced at every possible level of production of the other good. At any point the slope of a PPC indicates the opportunity cost, in terms of forgone production of the good on the vertical axis, of increasing production of the good on the horizontal axis by one unit. The more of a good that is already being produced, the greater the opportunity cost of increasing production still further. Thus the slope of a PPC becomes more and more negative as we read from left to right. When an economy has many workers, the PPC has a smooth, outwardly bowed shape. (LO2)
· A country’s consumption possibilities are the combinations of goods and services that might feasibly be consumed by its citizens. In a closed economy—one that does not trade with other countries—the citizens’ consumption possibilities are identical to their production possibilities. But in an open economy—one that does trade with other countries—consumption possibilities are typically greater than, and never less than, the economy’s production possibilities. Graphically, an open economy’s consumption possibilities are described by a downward-sloping line that just touches the PPC, whose slope equals the amount of the good on the vertical axis that must be traded to obtain one unit of the good on the horizontal axis. A country achieves its highest consumption possibilities by producing at the point where the consumption possibilities line just touches the PPC and then trading to obtain the most preferred point on the consumption possibilities line. (LO2)
· In a closed economy, the relative price of a good or service is determined at the intersection of the supply curve of domestic producers and the demand curve of domestic consumers. In an open economy, the relative price of a good or service equals the world price—the price determined by supply and demand in the world economy. If the price of a good or service in a closed economy is greater than the world price and the country opens its market to trade, it will become a net importer of that good or service. But if the closed-economy price is below the world price and the country opens itself to trade, it will become a net exporter of that good or service. (LO3)
· Although free trade is beneficial to the economy as a whole, some groups—such as domestic producers of imported goods, and workers in imported-good sectors—are hurt by free trade. Groups that are hurt by trade may support political candidates who promise to impose protectionist measures, such as tariffs or quotas. A tariff is a tax on an imported good that has the effect of raising the domestic price of the good. A higher domestic price increases domestic supply, reduces domestic demand, and reduces imports of the good. A quota, which is a legal limit on the amount of a good that may be imported, has the same effects as a tariff, except that the government collects no tax revenue. (The equivalent amount of revenue goes instead to those firms with the legal authority to import goods.) Because free trade is efficient, the winners from free trade should be able to compensate the losers so that everyone becomes better off. Thus policies to assist those who are harmed by trade, such as assistance and retraining for workers idled by imports, are usually preferable to trade restrictions. (LO4)
KEY TERMS
autarky
closed economy
consumption possibilities
open economy
protectionism
quota
tariff
world price
REVIEW QUESTIONS
1. Imagine that, all else equal, it takes U.S. workers a quarter of the time it takes Chinese workers to design a new mobile-phone model. Also, imagine that it takes U.S. workers half the time it takes Chinese workers to produce a million pieces of the new model. Which of the two countries has absolute advantage, and which has comparative advantage, in designing a new model? In producing it? (LO1)
2. Sketch a PPC for a four-worker economy that produces two goods, hot dogs and hamburgers. Give an economic interpretation of the vertical intercept, the horizontal intercept, and the slope of the graph. (LO2)
3. What is meant by the “consumption possibilities” of a country? How are consumption possibilities related to production possibilities in a closed economy? In an open economy? (LO2)
4. A small, open economy is equally productive in producing coffee and tea. What will this economy produce if the world price of coffee is twice that of tea? Half that of tea? What will the country produce if the world price of coffee happens to equal the world price of tea? (LO3)
5. True or false: If a country is more productive in every sector than a neighboring country, then there is no benefit in trading with the neighboring country. Explain. (LO3)
6. Show graphically the effects of a tariff on imported automobiles on the domestic market for automobiles. Who is hurt by the tariff and why? Who benefits and why? (LO4)
7. Show graphically the effects of a quota on imported automobiles on the domestic market for automobiles. Who does the quota hurt and who benefits? Explain. (LO4)
PROBLEMS
1. An economy has two workers, Anne and Bill. Per day of work, Anne can pick 100 apples or 25 bananas, and Bill can pick 50 apples or 50 bananas. Anne and Bill each work 200 days per year. (LO1, LO2)
a. Which worker has an absolute advantage in apples? Which has a comparative advantage? Calculate each worker’s opportunity cost of picking an additional apple.
b. Find the maximum number of each type of fruit that can be picked annually in this economy, assuming that none of the other type of fruit is picked. What is the most of each type that can be picked if each worker fully specializes according to his or her comparative advantage?
c. Draw the PPC for annual production in this economy. Show numerical values for the vertical intercept, the horizontal intercept, and the slopes of each segment of the PPC.
2. A developing economy requires 1,000 hours of work to produce a television set and 10 hours of work to produce a bushel of corn. This economy has available a total of 1,000,000 hours of work per day. (LO2)
a. Draw the PPC for daily output of the developing economy. Give numerical values for the PPC’s vertical intercept, horizontal intercept, and slope. Relate the slope to the developing country’s opportunity cost of producing each good. If this economy does not trade, what are its consumption possibilities?
b. The developing economy is considering opening trade with a much larger, industrialized economy. The industrialized economy requires 10 hours of work to produce a television set and 1 hour of work to produce a bushel of corn. Show graphically how trading with the industrialized economy affects the developing economy’s consumption possibilities. Is opening trade desirable for the developing economy? (Hint: When it opens to trade, the developing economy will be fully specialized in one product.)
3. Suppose that Costa Rican worker Carlos can produce either 100 pounds of coffee or 1 computer per week, and a second worker, Maria, can produce either 150 pounds of coffee or 1 computer per week. Both Carlos and Maria work 50 weeks per year. (LO2)
a. Find the PPC for Costa Rica. Give numerical values for the graph’s intercepts and slopes. How much of each good is produced if each worker fully specializes according to comparative advantage?
b. World prices are such that 1 computer trades for 125 pounds of coffee on international markets. If Costa Rica is open to trade, show Costa Rica’s consumption possibilities graphically. What is the most of each good that Costa Ricans can consume when the economy is open? Compare to the situation when the economy is closed.
c. Repeat part b under the assumption that 1 computer trades for 80 pounds of coffee on world markets.
4. Suppose that Carlos and Maria can produce coffee and computers as described in Problem 3. A third worker, Pedro, joins the Costa Rican economy. Pedro can produce either 140 pounds of coffee or 1 computer per week. Like the other two workers, Pedro works 50 weeks per year. (LO2)
a. Find the PPC for Costa Rica. Give numerical values of the PPC’s intercepts and slopes.
b. Find Costa Rica’s consumption possibilities if the country is open and 1 computer trades for 125 pounds of coffee on world markets. What is the most of each good that Costa Ricans can consume when the economy is open? Compare to the situation when the economy is closed.
c. Repeat part b assuming that 1 computer trades for 200 pounds of coffee on world markets.
5. Suppose that a U.S. worker can produce 1,000 pairs of shoes or 10 industrial robots per year. For simplicity, assume there are no costs other than labor costs and firms earn zero profits. Initially, the U.S. economy is closed. The domestic price of shoes is $30 a pair, so that a U.S. worker can earn $30,000 annually by working in the shoe industry. The domestic price of a robot is $3,000, so that a U.S. worker can also earn $30,000 annually working in the robot industry.
Now suppose that the U.S. opens trade with the rest of the world. Foreign workers can produce 500 pairs of shoes or 1 robot per year. The world price of shoes after the U.S. opens its markets is $10 a pair, and the world price of robots is $5,000. (LO3)
a. What do foreign workers earn annually, in dollars?
b. When it opens to trade, which good will the United States import and which will it export?
c. Find the real income of U.S. workers after the opening to trade, measured in (1) the number of pairs of shoes annual worker income will buy and (2) the number of robots annual worker income will buy. Compare to the situation before the opening of trade. Does trading in goods produced by “cheap foreign labor” hurt U.S. workers?
d. How might your conclusion in part c be modified in the short term, if it is costly for workers to change industries? What policy response might help with this problem?
6. The demand and supply for automobiles in a certain country is given in the following graph. (LO2, LO3, LO4)
a. Assuming that the economy is closed, find the equilibrium price and production of automobiles.
b. The economy opens to trade. The world price of automobiles is $8,000. Find the domestic quantities demanded and supplied and the quantity of imports or exports. Who will favor the opening of the automobile market to trade, and who will oppose it?
c. The government imposes a tariff of $2,000 per car. Find the effects on domestic quantities demanded and supplied.
d. As a result of the tariff, what will happen to the quantity of imports or exports, and what is the revenue raised by the tariff. Who will favor the imposition of the tariff, and who will oppose it?
7. Suppose the domestic demand and supply for automobiles is as given in Problem 6. (LO2, LO3, LO4)
a. The economy opens to trade. The world price of automobiles is $10,000. Find the domestic quantities demanded and supplied and the quantity of imports or exports.
b. Now assume that the government imposes a quota on automobile imports of 2,000 cars. What will happen to the quantity of imports or exports?
c. Who will favor the imposition of the quota, and who will oppose it?
ANSWERS TO CONCEPT CHECKS
1. 15.1 The opportunity cost of producing coffee equals the number of computers given up for each extra pound of coffee produced. Carlos can produce either 100 pounds of coffee or 1 computer per week, so his opportunity cost is given by
Maria can produce either 100 pounds of coffee or 2 computers per week, so her opportunity cost is
Since each pound of coffee Carlos produces requires the sacrifice of 1/100 of a computer, while each pound of coffee produced by Maria sacrifices 1/50 of a computer, Carlos has the smaller opportunity cost of producing coffee. Thus he has a comparative advantage in producing coffee. (LO2)
2. 15.2 When the economy is closed, the Costa Ricans can obtain 80 computers by having Maria work 40 weeks making computers. If Maria works the remaining 10 weeks producing coffee and Carlos works 50 weeks producing coffee, the Costa Ricans will be able to consume (10 + 50) × 100 = 6,000 pounds of coffee per year.
The world price of computers is 80 pounds of coffee, which is greater than Maria’s opportunity cost of producing computers but less than Carlos’s opportunity cost. Thus if the economy opens to trade, Maria will specialize in computers and Carlos will specialize in coffee. If Maria produces 100 computers, 80 of which are consumed domestically, 20 computers are available for export. Because a computer is worth 80 pounds of coffee on the world market, the 20 exported computers can be traded for 1,600 pounds of coffee. Carlos still produces 5,000 pounds of coffee. Total coffee consumption in Costa Rica is thus 1,600 + 5,000 = 6,600 pounds. Opening to trade has allowed the Costa Ricans to consume 10 percent more coffee at no sacrifice in computers. (LO2)
1For a many-good economy, the PPC shows the maximum amount of each good that can be produced at any level of production of all the other goods. Focusing on the two-good case allows us to draw the figures on the two-dimensional page. Our conclusions apply to the many-good case, however.
2The single point at which consumption possibilities do not lie above production possibilities in Figure 15.5 is at point C, where production possibilities and consumption possibilities are the same. If Costa Rican residents happen to prefer the combination of computers and coffee at point C to any other point on FG, then they realize no benefit from trade.
3David Autor, David Dorn, and Gordon Hanson, “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade,” Annual Review of Economics, vol. 8, October 2016, 205–240.
4Former president Reagan’s autobiography confirms that policymakers were concerned that an alternative method of limiting Japanese imports would provoke the Japanese into taking measures to limit U.S. exports to Japan. See Ronald Reagan, An American Life, New York: Simon and Schuster, 1990, p. 274.
CHAPTER 15 APPENDIX
An Algebraic Approach to Trade Analysis
Thus far, we have used a graphical approach to show how international trade and various restrictions on trade affect economic welfare. In this appendix, we illustrate how the same issues can be approached in an algebraic framework.
EXAMPLE 15A.1A Tariff on Imported Computers
What are the effects of a tariff on trade?
Suppose the demand for computers by Costa Rican consumers is given by
QD = 3,000 − 0.5PC,
where QD is the annual quantity of computers demanded and PC is the price per computer in dollars. The supply of computers by domestic Costa Rican producers is
QS = 1,000 + 0.5PC,
where QS is the annual quantity of computers supplied.
a. Assuming that the Costa Rican economy is closed to trade, find the equilibrium price and quantity in the Costa Rican computer market.
b. Assume the economy opens to trade. If the world price of computers is $1,500, find annual Costa Rican consumption, production, and imports of computers.
c. At the request of domestic producers, the Costa Rican government imposes a tariff of $300 per imported computer. Find Costa Rican consumption, production, and imports of computers after the imposition of the tariff. How much revenue does the tariff raise for the government?
a. To find the closed-economy price and quantity, we set supply equal to demand:
1,000 + 0.5PC = 3,000 − 0.5PC.
Solving for PC gives the equilibrium price, equal to $2,000 per computer. Substituting this equilibrium price into either the supply equation or the demand equation, we find the equilibrium quantity of computers in the Costa Rican market, equal to 2,000 computers per year. This equilibrium price and quantity correspond to a point like point E in Figure 15A.1.
FIGURE 15A.1 The Market for Computers in Costa Rica.
b. If the economy opens to trade, the domestic price of computers must equal the world price, which is $1,500. At this price, the domestic quantity demanded for computers is 3,000 – 0.5(1,500) = 2,250 computers per year; the domestic quantity supplied is 1,000 + 0.5(1,500) = 1,750 computers per year. These quantities correspond to qD and qS, respectively, in Figure 15A.1. Imports equal the difference between domestic quantities demanded and supplied, or 2,250 – 1,750 = 500 computers per year.
c. The imposition of a tariff of $300 per computer raises the price from $1,500 (the world price without the tariff) to $1,800. To find Costa Rican consumption and production at this price, we set the price equal to $1,800 in the demand and supply equations. Thus the domestic quantity demanded is 3,000 – 0.5(1,800) = 2,100 computers per year; the domestic quantity supplied is 1,000 + 0.5(1,800) = 1,900 computers per year. Imports, the difference between the quantity demanded by Costa Ricans and the quantity supplied by domestic firms, is 2,100 – 1,900 = 200 computers per year. Thus the tariff has raised the price of computers by $300 and reduced imports by 300 computers per year. The tariff revenue collected by the government is $300/imported computer × 200 computers/year = $60,000 per year.
CONCEPT CHECK 15A.1
Repeat parts (b) and (c) of Example 15A.1 under the assumption that the world price of computers is $1,200 (the tariff is still $400). What happens if the world price is $1,800?
EXAMPLE 15A.2Effects of an Import Quota
What are the effects of an import quota on trade?
Suppose the supply of and demand for computers in Costa Rica is as given in Example 15A.1, and the government imposes an import quota of 200 computers. Find the equilibrium price in the domestic computer market, as well as the quantities produced by domestic firms and purchased by domestic consumers.
The quantity of computers supplied by domestic Costa Rican producers was stated in Example 15A.1 to be 1,000 + 0.5PC. The quota allows 200 computers per year to be imported. Thus the total quantity of computers supplied, including both domestic production and imports, is 1,000 + 0.5PC + 200, or 1,200 + 0.5PC. Setting the quantity supplied equal to the quantity demanded, we get
1,200 + 0.5PC = 3,000 − 0.5PC.
Solving for PC, we find that the price of computers in the domestic Costa Rican market is $1,800. Domestic production of computers is 1,000 + 0.5(1,800) = 1,900 computers per year, while quantity demanded domestically is 3,000 – 0.5(1,800) = 2,100 computers per year. The difference between domestic quantity demanded and domestic production, 200 computers per year, is made up by imports.
Note that the domestic price, domestic production, and domestic demand are the same in Examples 15A.1 and 15A.2. Thus the tariff and the quota have the same effects on the domestic market for computers. The only difference between the two policies is that with a quota, the government does not get the tariff revenue it got in Example 15A.1. That revenue goes instead to the holders of import licenses, who can buy computers on the world market at $1,500 and sell them in the domestic market at $1,800.
PROBLEMS
1. The demand for automobiles in a certain country is given by
D = 12,000 − 200P,
where P is the price of a car. Supply by domestic automobile producers is
S = 7,000 + 50P.
(LO2, LO3, LO4)
a. Assuming that the economy is closed, find the equilibrium price and production of automobiles.
b. The economy opens to trade. The world price of automobiles is 18. Find the domestic quantities demanded and supplied and the quantity of imports or exports. Who will favor the opening of the automobile market to trade, and who will oppose it?
c. The government imposes a tariff of 1 unit per car. Find the effects on domestic quantities demanded and supplied and on the quantity of imports or exports. Also find the revenue raised by the tariff. Who will favor the imposition of the tariff, and who will oppose it?
d. Can the government obtain the same results as you found in part c by imposing a quota on automobile imports? Explain.
2. Suppose the domestic demand and supply for automobiles is given by Problem 1. The world price of automobiles is 16. Foreign car firms have a production cost of 15 per automobile, so they earn a profit of 1 per car. (LO3, LO4)
a. How many cars will be imported, assuming this country trades freely?
b. Now suppose foreign car producers are asked “voluntarily” to limit their exports to the home country to half of free trade levels. What will be the equilibrium price of cars in the domestic market if foreign producers comply? Find domestic quantities of cars supplied and demanded.
c. How will the “voluntary” export restriction affect the profits of foreign car producers?
ANSWERS TO CONCEPT CHECKS
15A.1If the world price of computers is $1,200, domestic demand for computers is 3,000 − 0.5(1,200) = 2,400 computers. Domestic supply is 1,000 + 0.5(1,200) = 1,600 computers. The difference between the quantity demanded and the quantity supplied, 800 computers, is imported. A tariff of $400 raises the domestic price of computers to $1,600. Now domestic demand is 2,200 and domestic supply is 1,800. The difference, 400 computers, equals imports. Revenue for the government is ($400/computer) (400 imported computers) 5 $160,000. If the world price of computers is $1,800 and there is no tariff, domestic demand is 2,100; domestic supply is 1,900; and imports are 200. A tariff of $400 raises the world price to $2,200, which is greater than the domestic price when there is no trade ($2,000). No computers are imported in this case and no tariff revenue is raised. (LO3)