Trade Policy

1. Trade Policy 10

2. Opposition to Free Trade • In 1999, 40,000 activists gathered in Seattle, during a WTO ministerial meeting, condemning all further actions to liberalize world trade. • Resistance to free trade is not only in the US, but it is evident worldwide

3. The Protectionist Viewpoint • Protectionists are against free trade and believe that barriers to trade are needed to promote the welfare of a country

4. The Protectionist Viewpoint • Some protectionist arguments: • The shrinking size of the US market for goods that compete with foreign goods reduces demand for domestic labor • Rising imports contributes to a trade deficit • Vital/strategic industries need protection, e.g., weapons and nuclear energy

5. The Protectionist Viewpoint • Some protectionist arguments: • Free trade leads to environmental degradation and exploitation of the impoverished people of under developed countries

6. The Free Trade Viewpoint • The free trade advocates argue that people are better off when voluntary exchange is allowed • Trade between nations is beneficial as trade between individuals within a country

7. Questions: • Who benefits from trade? Who does trade harm? Do the gains outweigh the losses? • Who are the losers and winners from restricting trade? • Are the arguments for trade restriction economically valid? 7

8. Comparative Advantage Recall from the basic economics principles class: A country has a comparative advantage in a good if it produces the good at a lower opportunity cost than other countries. Countries can benefit from trade if each specializes in and exports the goods in which it has a comparative advantage. 0

9. Comparative Advantage Assume: Two countries: Alpha and Omega Two goods: milk and bread Lets construct the Production Possibilities Curve/ Frontier 0

10. 100 If there is no trade, If there is no trade, Omega chooses Alpha chooses 100 50 this production and this production and consumption. consumption. A B 50 50 25 100 200 Without Trade Alpha Omega Bread Bread 0 Milk 0 Milk

11. 100 The opportunity cost of milk is 0.5 bread (the slope of the PPC) 100 50 A B The opportunity cost of milk is 2 bread 50 50 25 100 200 Comparative Advantage Since the opportunity cost of milk is lower for Alpha, Alpha has a comparative advantage in milk. Similarly, Omega has a comparative advantage in bread. If trade is allowed, Alpha should specialize in milk and Omega should specialize in bread. Alpha Omega Bread Bread 0 Milk 0 Milk

12. 100 With specialization 100 50 A B With Specialization 50 50 25 100 200 Comparative Advantage After specialization they trade. The price of milk cannot exceed 2 bread (Omega’s cost of making it) and cannot fall below 0.5 bread (Alpha’s cost). Assume the terms of trade (the agreed upon prices) are: 1 milk for 1 bread. Where will each country end up? Alpha Omega Bread Bread 200 0 100 Milk 0 Milk

13. Gains from trade • Both countries benefit from trade • A country is better off specializing in the goods it has a comparative advantage in • If a country has a comparative advantage in one (some) good, it will have a comparative disadvantage in the other good(s)

14. Free Trade and Social Welfare Why the opposition to free trade? • Distributional consequences: consumers and producers • We apply the tools of welfare economics to show who gains from free trade

15. The World Price and Comparative Advantage PW = the world price of a good, the price that prevails in world markets PD = domestic price without trade If PD < PW, country has comparative advantage in the good under free trade, country exports the good If PD > PW, country does not have comparative advantage under free trade, country imports the good 0

16. The Small Economy Assumption A small economy is a price taker in world markets: Its actions have no effect on PW. Not always true – especially for the U.S. – but simplifies the analysis without changing its lessons. 0

17. Social Welfare Without Free Trade Without trade: PD = $4Q = 500 P S $4 D Q 500 0 Soybeans Market CS PS

18. With Free trade: An exporting country If PW =$6 The country has a comparative advantage in Soybeans Under free trade domestic consumers demand 300 domestic producers supply 750 exports = 450 P S exports $6 $4 D Q 300 750 500 0 Soybeans Market

19. Social Welfare with Free Trade Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D P S exports $6 gains from trade D Q 0 Soybeans Market A D B $4 C Free Trade raises social welfare of the exporting country

20. P S gains from trade $150 imports D Q 0 With Free trade: An importing country In the absence of trade: CS = A PS = B + C Total surplus=A+B+C With trade: CS = A + B + D PS = C Total surplus= A+B+C+D Plasma TVs A $300 B D C Free Trade raises social welfare of the importing country 20

21. Other Benefits of International Trade Product Variety: Consumers enjoy increased variety of goods. Economies of scale: Producers who sell to a larger market, may achieve lower costs by producing on a larger scale. Foster competition: Competition from abroad may reduce market power of domestic firms, which would increase total welfare. Trade enhances the flow of ideas, facilitates the spread of technology around the world. 0

22. Then Why All the Opposition to Trade? Trade creates winners and losers. The winners from trade could compensate the losers and still be better off. Yet, such compensation rarely occurs. The losses are often highly concentrated among a small group of people, who feel them acutely. The gains are often spread thinly over many people, who may not see how trade benefits them. Hence, the losers have more incentive to organize and lobby for restrictions on trade. 0

23. International Trade Restrictions • Despite the benefits of free trade, governments have often imposed barriers to trade • Trade Barriers: • Tariff: a tax on foreign goods • Quota: a limit on the quantity of imports • Voluntary restraint agreements • Embargoes: banning trade with a country • Standards: environmental, health or safety

24. Analysis of a Tariff on Cotton Shirts PW = $20 Free trade: buyers demand 80 sellers supply 25 imports = 55 T = $10/shirt price rises to $30 buyers demand 70 sellers supply 40 imports = 30 P imports S $30 $20 imports D Q 40 25 80 70 0 Cotton shirts

25. Welfare effects of a tariff Free trade CS = A + B + C + D + E + F PS = G Total surplus = A + B + C + D + E + F + G Tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B + C + E + G P S $30 $20 D Q 40 25 80 70 0 Cotton shirts A B C E D F G

26. D = deadweight loss from substituting towards domestic shirts F = deadweight loss from the under-consumption of shirts P S $30 $20 D Q 40 25 80 70 0 Cotton shirts A B C E D F G

27. Analysis of a Quota on Cotton Shirts Quota= 30 shirts At the price of $20, there is a shortage In equilibrium, imports have to equal 30 buyers demand 70 sellers supply 40 Price rises to $30 The quota of 30 shirts has the same effect as a tariff of $10 P imports S $30 $20 D imports Q 40 25 80 70 0 Cotton shirts

28. Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in industries that compete with imports. Economists’ response: Look at the data to see whether rising imports cause rising unemployment… 0

29. U.S. Imports & Unemployment,Decade averages, 1956-2005 0 16% Imports (% of GDP) 14% 12% 10% 8% Unemployment (% of labor force) 6% 4% 2% 0% 1976-85 1986-95 1956-65 1966-75 1996-2005

30. Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in the industries that compete against imports. Economists’ response: 0 • Total unemployment does not rise as imports rise, because job losses from imports are offset by job gains in export industries. • Even if all goods could be produced more cheaply abroad, the country need only have a comparative advantage to have a viable export industry and to gain from trade.

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

32. Arguments for Restricting Trade 2. The national security argument An industry vital to national security should be protected from foreign competition, to prevent dependence on imports that could be disrupted during wartime. Economists’ response: Fine, as long as we base policy on true security needs. But producers may exaggerate their own importance to national security to obtain protection from foreign competition. 0

33. Arguments for Restricting Trade 3. The infant-industry argument A new industry argues for temporary protection until it is mature and can compete with foreign firms. Economists’ response: Difficult for government to determine which industries will eventually be able to compete and whether benefits of establishing these industries exceed cost to consumers of restricting imports. Besides, if a firm will be profitable in the long run, it should be willing to incur temporary losses. 0

34. Arguments for Restricting Trade 4. The unfair-competition argument Producers argue their competitors in another country have an unfair advantage, e.g. due to government subsidies. Economists’ response: Great! Then we can import extra-cheap products subsidized by the other country’s taxpayers. The gains to our consumers will exceed the losses to our producers. 0

35. Arguments for Restricting Trade 5. The protection-as-bargaining-chip argument Example: The U.S. can threaten to limit imports of French wine unless France lifts their quotas on American beef. Economists’ response: The threat to limit imports is not a credible threat since it reduces welfare in the US. 0

36. $8 6 4 2 S D 20 40 60 80 lbs of chocolate