slide 1 of 37 modern principles: microeconomics tyler cowen and alex tabarrok copyright © 2010...

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Modern Principles: Microeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Microeconomics • Cowen/Tabarrok

Chapter 8

International Trade

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Introduction• In this chapter we…

Examine why trade is beneficial. Use the supply and demand model

to analyze trade. Evaluate political and economic

arguments that free trade is not necessarily good.

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Why Trade?• Three benefits of trade

1. It allows for division of knowledge.

2. It allows economies of scale and creates greater competition.

3. It increases wealth through the principle of comparative advantage.

• Let’s look at each of these in turn.

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Why Trade?1. Division of Knowledge—Specialization

In a modern economy—more knowledge is used than can reside in a single brain.

• Specialization →↑ knowledge → ↑productivity

• Without trade, specialization is not possible. Trade connects all markets.

• Example: Dog walkers, closet organizers give physicians the time to perfect their skills.

Trade → ↑markets → ↑division of knowledge

• Entrance of China, Eastern Europe, and Russia into world markets → ↑ stock of engineers, scientists → ↑ available knowledge

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Why Trade?2. Economies of Scale and Creating

Competition Economies of Scale—Larger scale

production reduces costs.• Trade → ↑specialization → larger scale

production → economies of scale.• Example: Forming the EU →

↑specialization → larger firms → ↓ prices → EU firms become more competitive in the world market.

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Why Trade?2. Economies of Scale and Creating

Competition (cont.) Trade Creates Competition

• Example: 1980s export restraints by Japanese → ↓ Imports of Japanese cars → Price of Japanese cars ↑ by $1,300 Price of American cars ↑ by $660.

• International competition keeps domestic firms competitive and on their toes. Threat of foreign competition keeps

domestic prices down.

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Why Trade?3. Comparative Advantage

A country has a comparative advantage in producing goods for which it has the lowest opportunity cost.

Allows both trading partners to benefit from trade.

Not to be confused with absolute advantage.

• The ability to produce the same good using fewer inputs than another producer.

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Why Trade?3. Comparative Advantage (cont.)

U.S. requires less labor to produce both → absolute advantage in producing both.

Shirts: Opportunity cost is lowest in Mexico. Computers: Opportunity cost is lowest in U.S. Comparative advantage

• Computers: United States• Shirts: Mexico

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The theory of comparative advantage says that total production of the two countries will be greatest if both countries:

• Produce what they have a comparative advantage in.

• Import the other goods they want. In this case Mexico will produce shirts and

the U.S. will produce computers. Let’s see how this works with some further

calculations.

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With No Trade—Suppose U.S. and Mexico allocate the same amount of labor (12 units) to the production of each good.

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Suppose Mexico completely specializes in producing shirts and the U.S. moves 2 units of labor from producing shirts to computers.

Note: Total production of the two goods is higher thanwithout specialization.

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With specialization, trade can make both countries better off.

U.S. trades one computer for 3 shirts.

Note: With trade both countries are better off, even thoughthe U.S. has an absolute advantage in both goods.

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Comparative Advantage and Wages

• Assume that computers sell for $300 and shirts sell for $100 (consistent with the 3 to one trade).

• Average wage in each country can be calculated by using:

• Let’s use this calculation to see how specialization and trade affects wages.

Labor of UnitsofNumber

nConsumptio Total of Value WageAverage =

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Comparative Advantage and Wages (cont.) Without Trade

With Trade and Specialization

67.216$24

$100)shirts 13()300$computers (13 WageAverage U.S. =

×+×=

50$24

$100)shirts 9()300$computer (1 WageAverage Mexico =

×+×=

50.37$24

$100)shirts6()300$computer (1 WageAverage Mexico =

×+×=

200$24

$100)shirts12()300$computers (12 WageAverage U.S. =

×+×=

Note: Trade and specialization increases wages in both countries

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Adam Smith on TradeIt is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.

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CHECK YOURSELF

What does specialization do to productivity? Why?

How does trade let us benefit from the advantages of specialization?Alex Rodriguez is a very good baseball player. He is probably also good at

mowing his lawn. Why would Alex Rodriguez pay someone else to mow his

lawn rather than do it himself?

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Analyzing Trade with Supply and Demand• We now use the demand and supply model

to determine… The effects of unrestricted trade on...

• Domestic equilibrium price and quantity. • Imports

The effects of tariffs and quotas on the…• Domestic equilibrium price and quantity. • Imports

Let’s turn to the model.

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w/ Free trade:•World price prevails.•Domestic consumption =•Domestic production =

Analyzing Trade with Supply and Demand

Price

Quantity of semiconductors

P no trade

Free tradeequilibrium

tradefree

Stradefree

D QQ −

tradeno

Q

trade freeSQ

Domestic demand

Domestic supply

World supplyWorld price

No tradeequilibrium

Domesticproduction

Domestic consumption

Imports

tradefree

DQtradefree

SQ

trade freeDQ

• imports =

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With Tariff:•World price + tariff prevails.•↓Domestic consumption →•↑Domestic production →

Analyzing Trade with Supply and Demand

Price

Quantity of semiconductors

pno trade

tariffS

tariffD QQ −

tradeno

Q

tariffSQ

Domestic demand

Domestic supply

World supply + tariff

World price+ tariff

Equilibrium w/tariff

↑Domesticproduction

Importsw/ free trade

tariffDQtariff

SQ

tariffDQ

• ↓imports →

World priceWorld Supply

tariff

tradefree

SQ tradefree

DQ

↓ Domestic consumption

Imports w/tariff

• tariff revenue

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The Costs of Protectionism• To simplify we make two assumptions:

1. Tariff eliminates all imports.

2. With free trade, domestic production = zero. Reasonable approximations for sugar.

• A tariff has two effects:1. ↑ domestic production, ↓ domestic

consumption.• Resources are drawn away from more

productive uses to produce sugar.

2. Less is consumed → lower gains from trade.

• Let’s turn to our model again.

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The Costs of Protectionism• Wasted resources and lost gains from trade.Price perpound(in cents)

Quantity(in billions of pounds)

Domestic demand

Domestic supply

World supply +tariff

World price

Free tradeequilibrium

20

20

9

24

U. S. costs

Worldcosts

Value ofwasted resources

World supply

Lost gains from tradeor deadweight loss

Tariffequilibrium

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The Costs of Protectionism• Wasted resources and lost gains from trade. (cont.)Price perpound(in cents)

Quantity(in billions of pounds)

Domestic demand

Domestic supply

World supply +tariff

World price

20

20

9

24

World supply

Value of wasted resources = [(.20 – .09) x 20]/2 = $1.1 billion

$1.1 billion

Lost gains from trade= [(.20 - .09) x (24 – 20)]/2 = $.22 billion

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The Costs of Protectionism• Conclusions

A tariff reduces economic efficiency because…• The supply of goods is no longer sold by the

sellers with the lowest costs.• Because world suppliers are willing to sell for

less, and U.S. consumers are willing to pay more → mutually profitable gains from trade are prevented by law.

U.S. consumers pay more, and workers in other countries (e.g., Brazil), many of whom are poor, lose income.

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The Costs of Protectionism• One final cost: lobbying

The loss to domestic consumers is greater than the gains to domestic producers.

Why then does congress pass tariffs?• Small number of producers → Benefit per

producer is high• Large number of consumers → Loss per

consumer is low.• Result: return from lobbying to producers is

higher than for consumers. Lobbying diverts resources from more

productive activities.

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CHECK YOURSELF

Who benefits from a tariff? Who loses?

Why does trade protectionism lead to wasted resources?

If there are winners and losers from trade restrictions, why do we hear more often from the people who gain from trade restrictions than from the people who lose?

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Arguments Against International Trade• Most Common Arguments

Trade reduces the number of jobs in the U.S. It’s wrong to trade with countries that use child

labor. We need to keep some industries for reasons

of national security. We need to keep some “key” industries

because of beneficial spillovers onto other sectors.

We can increase U.S. well-being with strategic trade protectionism.

• Let’s look at each of these in turn.

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Arguments Against International Trade• Trade and Jobs

Tariffs raise the price of protected goods.• Consumers have less money to spend on

other goods.• Jobs are lost in other industries—these lost

jobs are hard to see. Increased imports into the U.S. result in higher

exports from the U.S.• The U.S. dollars we spend on other country’s

good are used to buy our goods.• Jobs are created in U.S. exporting industries.

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Arguments Against International Trade• Child Labor

Restricting imports made by child labor may do more harm than good.• Children work out of necessity—what else

will they do?• Often the alternative is worse.

Prostitution Scrounging in refuse dumps

Child labor is a poverty problem not a trade problem.

The next figure shows this.

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Arguments Against International Trade

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Arguments Against International Trade• Trade and National Security

Some industries probably should be protected.

Subject to great abuse—almost every industry can make this argument for protection.

Examples:

• Vaccine production?—probably a good idea.

• Mohair?—are you kidding?

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Arguments Against International Trade• Key Industries

Some industries are characterized by large spillovers to other industries• Example: Computer chips are always used in

some other product. Protection benefits a larger number of

firms. Two comments:

• Subsidy is a better option than a tariff.• Hard to determine which industries are key.

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Arguments Against International Trade• Strategic Trade Protectionism

Government helps domestic firms act like a cartel when they sell to international buyers.• May be able to grab a larger share of the

gains from trade than with free trade.• This can be done either with a…

Tax on exports Quotas on exports

• Success is limited by the number of available substitutes. OPEC succeeds because oil has few

substitutes.

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CHECK YOURSELF

Over the past 30 years, most U.S. garment manufacturing has moved overseas, to places such as India and China, where wages are lower. The result of this shift has been a sizeable drop in the number of garment workers in the United States. While bad for these workers, why has this trend been a net benefit for the United States?

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CHECK YOURSELF

What would happen if the U.S. government decided that computer chip manufacturing was a strategic national industry and provided monetary grants to Silicon Valley companies? Trace the effects of this policy on Silicon Valley companies, foreign competitors, the world market for computer chips, and the cost and benefit to U.S. consumers as a whole.

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Trade and Globalization• Globalization is not new

Roman Empire Revitalized trade routes → European

Renaissance “globalization is the advance of human

cooperation across national boundaries.” (Donald Boudreaux)

Periods of increased trade and the spread of ideas have been among the best for human progress.

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• Specialization and trade create enormous increases in productivity. Increases the total sum of knowledge. Takes advantage of economies of scale.

• Comparative advantage—when a country can produce something at a lower opportunity cost. Every person and every country has a

comparative advantage in something.

• Restrictions on trade waste resources. Consumers lose more than producers gain.

Takeaway

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• Wages are determined by productivity. High productivity countries → high wages. Low productivity countries → low wages. Trade raises wages in both countries.

• We have looked at five arguments for protectionism. Some are valid but have limited applicability.

• Globalization is not new. Human progress has accelerated when

countries have become more connected with trade.

Takeaway

slide 1 of 37 modern principles: microeconomics tyler cowen and alex tabarrok copyright © 2010...

Documents

international trade

mexico slide

free trade

benefits of trade

absolute advantage

competition example

international competition

greater competition