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Application: International Trade

Preface

If you check the labels on the clothes you are wearing, you will probably find that some were made in another country. A century ago, the textile and clothing industry was a major part of the U.S. economy, but that is no longer the case. Faced with foreign competitors that can produce quality goods at low cost, many U.S. firms found it increasingly difficult to produce and sell textiles and clothing at a profit. As a result, they laid off their workers and shut down their factories. Today, most of the textiles and clothing that Americans consume are imported.

The story of the textile industry raises important questions for economic policy: How does international trade affect economic well-being? Who gains and who loses from free trade among countries, and how do the gains compare to the losses? 

Chapter 3 introduced the study of international trade by applying the principle of comparative advantage. According to this principle, all countries can benefit from trading with one another because trade allows each country to specialize in doing what it does best. But the analysis in Chapter 3 was incomplete. It did not explain how the international marketplace achieves these gains from trade or how the gains are distributed among the various economic participants.

We now return to the study of international trade to tackle these questions. Over the past several chapters, we have developed many tools for analyzing how markets work: supply, demand, equilibrium, consumer surplus, producer surplus, and so on. With these tools, we can learn more about how international trade affects economic well-being.

9-1 The Determinants of Trade

Consider the market for textiles. The textile market is well suited to studying the gains and losses from international trade: Textiles are made in many countries around the world, and there is much world trade in textiles. Moreover, the textile market is one in which policymakers often consider (and sometimes implement) trade restrictions to protect domestic producers from foreign competitors. Here we examine the textile market in the imaginary country of Isoland.  

9-1a The Equilibrium without Trade

As our story begins, the Isolandian textile market is isolated from the rest of the world. By government decree, no one in Isoland is allowed to import or export textiles, and the penalty for violating the decree is so large that no one dares try.

Because there is no international trade, the market for textiles in Isoland consists solely of Isolandian buyers and sellers. As Figure 1 shows, the domestic price adjusts to balance the quantity supplied by domestic sellers and the quantity demanded by domestic buyers. The figure shows the consumer and producer surplus in the equilibrium without trade. The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive from participating in the textile market.

Now suppose that, in a political upset, Isoland elects a new president. The president campaigned on a platform of “change” and promised the voters bold new ideas. Her first act is to assemble a team of economists to evaluate Isolandian trade policy. She asks them to report on three questions:  

  • If the government allows Isolandians to import and export textiles, what will happen to the price of textiles and the quantity of textiles sold in the domestic textile market?
  • Who will gain from free trade in textiles and who will lose, and will the gains exceed the losses?
  • Should a tariff (a tax on textile imports) be part of the new trade policy?

After reviewing supply and demand in their favorite textbook (this one, of course), the Isolandian economics team begins its analysis.

9-1b The World Price and Comparative Advantage

The first issue our economists take up is whether Isoland is likely to become a textile importer or a textile exporter. In other words, if free trade is allowed, will Isolandians end up buying or selling textiles in world markets?

To answer this question, the economists compare the current Isolandian price of textiles to the price of textiles in other countries. We call the price prevailing in world markets the world price. If the world price of textiles is higher than the domestic price, then Isoland will export textiles once trade is permitted. Isolandian textile producers will be eager to receive the higher prices available abroad and will start selling their textiles to buyers in other countries. Conversely, if the world price of textiles is lower than the domestic price, then Isoland will import textiles. Because foreign sellers offer a better price, Isolandian textile consumers will quickly start buying textiles from other countries.

In essence, comparing the world price with the domestic price before trade reveals whether Isoland has a comparative advantage in producing textiles. The domestic price reflects the opportunity cost of textiles: It tells us how much an Isolandian must give up to obtain one unit of textiles. If the domestic price is low, the cost of producing textiles in Isoland is low, suggesting that Isoland has a comparative advantage in producing textiles relative to the rest of the world. If the domestic price is high, then the cost of producing textiles in Isoland is high, suggesting that foreign countries have a comparative advantage in producing textiles.

As we saw in Chapter 3, trade among nations is ultimately based on comparative advantage. That is, trade is beneficial because it allows each nation to specialize in doing what it does best. By comparing the world price with the domestic price before trade, we can determine whether Isoland is better or worse than the rest of the world at producing textiles.

9-2 The Winners and Losers from Trade

To analyze the welfare effects of free trade, the Isolandian economists begin with the assumption that Isoland is a small economy compared to the rest of the world. This small-economy assumption means that Isoland’s actions have little effect on world markets. Specifically, any change in Isoland’s trade policy will not affect the world price of textiles. The Isolandians are said to be price takers in the world economy. That is, they take the world price of textiles as given. Isoland can be an exporting country by selling textiles at this price or an importing country by buying textiles at this price.

The small-economy assumption is not necessary to analyze the gains and losses from international trade. But the Isolandian economists know from experience (and from reading Chapter 2 of this book) that making simplifying assumptions is a key part of building a useful economic model. The assumption that Isoland is a small economy simplifies the analysis, and the basic lessons do not change in the more complicated case of a large economy  

9-2a The Gains and Losses of an Exporting Country

Figure 2 shows the Isolandian textile market when the domestic equilibrium price before trade is below the world price. Once trade is allowed, the domestic price rises to equal the world price. No seller of textiles would accept less than the world price, and no buyer would pay more than the world price.  

After the domestic price has risen to equal the world price, the domestic  quantity supplied differs from the domestic quantity demanded. The supply  curve shows the quantity of textiles supplied by Isolandian sellers. The demand  curve shows the quantity of textiles demanded by Isolandian buyers. Because  the domestic quantity supplied is greater than the domestic quantity demanded,  Isoland sells textiles to other countries. Thus, Isoland becomes a textile exporter. 

Although domestic quantity supplied and domestic quantity demanded differ,  the textile market is still in equilibrium because there is now another participant  in the market: the rest of the world. One can view the horizontal line at the world  price as representing the rest of the world’s demand for textiles. This demand  curve is perfectly elastic because Isoland, as a small economy, can sell as many  textiles as it wants at the world price. 

Consider the gains and losses from opening up trade. Clearly, not everyone  benefits. Trade forces the domestic price to rise to the world price. Domestic producers of textiles are better off because they can now sell textiles at a higher price,  but domestic consumers of textiles are worse off because they now have to buy  textiles at a higher price.    


9-2b The Gains and Losses of an Importing Country

Now suppose that the domestic price before trade is above the world price. Onceagain, after trade is allowed, the domestic price must equal the world price. AsFigure 3 shows, the domestic quantity supplied is less than the domestic quantity demanded. The difference between the domestic quantity demanded and thedomestic quantity supplied is bought from other countries, and Isoland becomesa textile importer.

In this case, the horizontal line at the world price represents the supply of therest of the world. This supply curve is perfectly elastic because Isoland is a smalleconomy and, therefore, can buy as many textiles as it wants at the world price.

  • When a country allows trade and becomes an importer of a good, domesticconsumers of the good are better off, and domestic producers of the good areworse off.
  • Trade raises the economic well-being of a nation in the sense that the gains ofthe winners exceed the losses of the losers.

Having completed our analysis of trade, we can better understand one of theTen Principles of Economics in Chapter 1: Trade can make everyone better off. IfIsoland opens its textile market to international trade, the change creates winnersand losers, regardless of whether Isoland ends up exporting or importing textiles.In either case, however, the gains of the winners exceed the losses of the losers, sothe winners could compensate the losers and still be better off. In this sense, tradecan make everyone better off. But will trade make everyone better off? Probablynot. In practice, compensation for the losers from international trade is rare. Without such compensation, opening an economy to international trade is a policy thatexpands the size of the economic pie, but it can leave some participants in theeconomy with a smaller slice.

We can now see why the debate over trade policy is often contentious. Whenever a policy creates winners and losers, the stage is set for a political battle.Nations sometimes fail to enjoy the gains from trade because the losers from freetrade are better organized than the winners. The losers may turn their cohesivenessinto political clout and lobby for trade restrictions such as tariffs or import quotas.

9-2c Effects of a Tariff

The Isolandian economists next consider the effects of a tariff—a tax on importedgoods. The economists quickly realize that a tariff on textiles will have no effect ifIsoland becomes a textile exporter. If no one in Isoland is interested in importingtextiles, a tax on textile imports is irrelevant. The tariff matters only if Isolandbecomes a textile importer. Concentrating their attention on this case, the economists compare welfare with and without the tariff.

Figure 4 shows the Isolandian market for textiles. Under free trade, thedomestic price equals the world price. A tariff raises the price of imported textilesabove the world price by the amount of the tariff. Domestic suppliers of textiles,who compete with suppliers of imported textiles, can now sell their textiles forthe world price plus the amount of the tariff. Thus, the price of textiles—bothimported and domestic—rises by the amount of the tariff and is, therefore, closerto the price that would prevail without trade.

9-2d The Lessons for Trade Policy

The team of Isolandian economists can now write to the new president:

Dear Madam President,

You asked us three questions about opening up trade. After much hard work,we have the answers.

Question: If the government allows Isolandians to import and export textiles,what will happen to the price of textiles and the quantity of textiles sold in thedomestic textile market?

Answer: Once trade is allowed, the Isolandian price of textiles will be driven toequal the price prevailing around the world.

If the world price is now higher than the Isolandian price, our price will rise.The higher price will reduce the amount of textiles Isolandians consume andraise the amount of textiles that Isolandians produce. Isoland will, therefore,become a textile exporter. This occurs because, in this case, Isoland has a comparative advantage in producing textiles.

Conversely, if the world price is now lower than the Isolandian price, ourprice will fall. The lower price will raise the amount of textiles that Isolandiansconsume and lower the amount of textiles that Isolandians produce. Isolandwill, therefore, become a textile importer. This occurs because, in this case,other countries have a comparative advantage in producing textiles.

Question: Who will gain from free trade in textiles and who will lose, and willthe gains exceed the losses?

Answer: The answer depends on whether the price rises or falls when tradeis allowed. If the price rises, producers of textiles gain, and consumers of textiles lose. If the price falls, consumers gain, and producers lose. In both cases,the gains are larger than the losses. Thus, free trade raises the total welfare ofIsolandians.

Question: Should a tariff be part of the new trade policy?

Answer: A tariff has an impact only if Isoland becomes a textile importer. Inthis case, a tariff moves the economy closer to the no-trade equilibrium and,like most taxes, causes deadweight losses. A tariff improves the welfare ofdomestic producers and raises revenue for the government, but these gains aremore than offset by the losses suffered by consumers. The best policy, from thestandpoint of economic efficiency, would be to allow trade without a tariff.

We hope you find these answers helpful as you decide on your new policy.

Your faithful servants,

Isolandian economics team

9-2e Other Benefits of International Trade

The conclusions of the Isolandian economics team are based on the standard analysis of international trade. Their analysis uses the most fundamental tools in theeconomist’s toolbox: supply, demand, and producer and consumer surplus. Itshows that there are winners and losers when a nation opens itself up to trade,but the gains of the winners exceed the losses of the losers.

The case for free trade can be made even stronger, however, because there areseveral other economic benefits of trade beyond those emphasized in the standard analysis. In a nutshell, here are some of these other benefits:

  • Increased variety of goods. Goods produced in different countries arenot exactly the same. German beer, for instance, is not the same as American beer. Free trade gives consumers in all countries greater variety tochoose from.
  • Lower costs through economies of scale. Some goods can be produced atlow cost only if they are produced in large quantities—a phenomenon calledeconomies of scale. A firm in a small country cannot take full advantage ofeconomies of scale if it can sell only in a small domestic market. Free tradegives firms access to larger world markets and allows them to realize economies of scale more fully.
  • Increased competition. A company shielded from foreign competitors is morelikely to have market power, which in turn gives it the ability to raise pricesabove competitive levels. This is a type of market failure. Opening up trade fosters competition and gives the invisible hand a better chance to work its magic.
  • Enhanced flow of ideas. The transfer of technological advances around theworld is often thought to be linked to the trading of the goods that embodythose advances. The best way for a poor agricultural nation to learn aboutthe computer revolution, for instance, is to buy some computers from abroadrather than trying to make them domestically.Thus, free international trade increases variety for consumers, allows firms totake advantage of economies of scale, makes markets more competitive, andfacilitates the spread of technology. If the Isolandian economists also took theseeffects into account, their advice to the president would be even more forceful.

Thus, free international trade increases variety for consumers, allows firms totake advantage of economies of scale, makes markets more competitive, andfacilitates the spread of technology. If the Isolandian economists also took theseeffects into account, their advice to the president would be even more forceful.

9-3 The Arguments for Restricting Trade

The letter from the economics team starts to persuade the new president ofIsoland to consider allowing trade in textiles. She notes that the domestic priceis now high compared to the world price. Free trade would, therefore, cause theprice of textiles to fall and hurt domestic textile producers. Before implementingthe new policy, she asks Isolandian textile companies to comment on the economists’ advice.

Not surprisingly, the textile companies oppose free trade in textiles. Theybelieve that the government should protect the domestic textile industry from foreign competition. Let’s consider some of the arguments they might give to support their position and how the economics team would resp

9-3a The Jobs Argument

Opponents of free trade often argue that trade with other countries destroysdomestic jobs. In our example, free trade in textiles would cause the price of textiles to fall, reducing the quantity of textiles produced in Isoland and thus reducing employment in the Isolandian textile industry. Some Isolandian textileworkers would lose their jobs.

Yet free trade creates jobs at the same time that it destroys them. When Isolandians buy textiles from other countries, those countries obtain the resources tobuy other goods from Isoland. Isolandian workers would move from the textile industry to those industries in which Isoland has a comparative advantage. Thetransition may impose hardship on some workers in the short run, but it allowsIsolandians as a whole to enjoy a higher standard of living.

Opponents of trade are often skeptical that trade creates jobs. They mightrespond that everything can be produced more cheaply abroad. Under free trade,they might argue, Isolandians could not be profitably employed in any industry.As Chapter 3 explains, however, the gains from trade are based on comparativeadvantage, not absolute advantage. Even if one country is better than anothercountry at producing everything, each country can still gain from trading with theother. Workers in each country will eventually find jobs in an industry in whichthat country has a comparative advantage.

9-3b The National-Security Argument

When an industry is threatened with competition from other countries, opponents of free trade often argue that the industry is vital to national security. Forexample, if Isoland were considering free trade in steel, domestic steel companiesmight point out that steel is used to make guns and tanks. Free trade would allowIsoland to become dependent on foreign countries to supply steel. If a war laterbroke out and the foreign supply was interrupted, Isoland might be unable toproduce enough steel and weapons to defend itself.

Economists acknowledge that protecting key industries may be appropriatewhen there are legitimate concerns over national security. Yet they fear that thisargument may be used too quickly by producers eager to gain at consumers’expense.

One should be wary of the national-security argument when it is made by representatives of industry rather than the defense establishment. Companies havean incentive to exaggerate their role in national defense to obtain protection fromforeign competition. A nation’s generals may see things very differently. Indeed,when the military is a consumer of an industry’s output, it would benefit fromimports. Cheaper steel in Isoland, for example, would allow the Isolandian military to accumulate a stockpile of weapons at lower cost.




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