33 TRADING WITH THE WORLD CHAPTER

33 TRADING WITH THE WORLD CHAPTER
Notes and teaching tips: 4, 9, 22, 30, 40, 52, 53, 64, and 65 To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button To advance to the next slide, click anywhere on the full screen figure. © Pearson Education Canada, 2003

Objectives After studying this chapter, you will able to
Describe the trends and patterns in international trade Explain comparative advantage and explain why all countries can gain from international trade Explain why international trade restrictions reduce the volume of imports and exports and reduce our consumption possibilities Explain the arguments that are used to justify international trade restrictions and show how they are flawed Explain why we have international trade restrictions © Pearson Education Canada, 2003

Silk Routes and Sucking Sounds
Since ancient times, people have expanded trading as far as technology allowed—Marco Polo’s silk route between Europe and China is an example. Many people fear free trade and some predicted a “giant sucking sound” as jobs left Canada and the United States for Mexico under the NAFTA. Why do we trade with other nations? Do tariffs that restrict trade bring any benefits? © Pearson Education Canada, 2003

Patterns and Trends in International Trade
Imports are the good and services that we buy from people in other countries. Exports are the goods and services we sell to people in other countries. The key facts are worth emphasizing: enormous growth in volume of trade and huge two way trade in manufactures. Explain that the balance of trade along with the international borrowing and lending that finances it results from spending and saving decisions in Canada and the rest of the world and is independent of the forces that generate the volume of trade, which this chapter covers. (In a micro course, note that this topic gets covered in macro. In a macro course, note that this topic comes in the next chapter.) © Pearson Education Canada, 2003

Trade in Goods Manufactured goods represent 50 percent of our goods exports and 70 percent of our goods imports. Raw materials and semi-manufactured materials represent 40 percent of our exports and 15 percent of imports. Our largest export and import items are capital goods and automobiles. Goods account for 80 percent of our international trade. The rest is services. © Pearson Education Canada, 2003

Trade in Services International trade in services such as travel, transportation, and insurance is large and growing. Geographical Patterns of International Trade Canada trades with countries all over the world, but its biggest trading partner is the United States, which buys 82 percent of our exports and sells us 71 percent of our imports. The European Union is our second largest trading partner with 10 percent of our exports and 14 percent of our imports. © Pearson Education Canada, 2003

Trends in the Volume of Trade In 1978, we exported 25 percent of our output and imported 25 percent of the goods and services that we bought. In 2001, we exported 43 percent of our total output and imported 38 percent of the goods and services that we bought. © Pearson Education Canada, 2003

Net Exports and International Borrowing The value of exports minus imports is called net exports. In 2001, net exports were $57 billion. When a country exports more than it imports, it lends to foreigners or buys some of their assets. When a country imports more than it exports, it borrows from foreigners or sells them some of its assets. © Pearson Education Canada, 2003

The Gains from International Trade
Comparative advantage is the fundamental force that generates trade between nations. The basis for comparative trade is divergent opportunity costs between countries. Nations can increase the consumption of goods and services when they allocate resources to the production of those goods and services for which they have a comparative advantage. Note that comparative advantage and its basis is explained in Chapter 2. Remind the students and send them back to that chapter for a quick review. There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram, International Economic Problems, John Wiley, 1970, is powerful way to begin. Make up your own version with local flavor and embellishment. Adam Blackbox announces that he has discovered an amazing way to produce low-price, high-quality automobiles. He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, high-quality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love Adam Blackbox. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering low-price, high-quality automobiles is clearly part of the process of achieving greater prosperity for all. [Continued on the notes page for slide #52] You can easily segue from this story to the analysis of Farmland and Mobilia. © Pearson Education Canada, 2003

Opportunity Cost in Farmland Figure 33.1 shows the production possibilities frontier for an imaginary country called Farmland. © Pearson Education Canada, 2003

© Pearson Education Canada, 2003

Without international trade, Farmland produces and consumes 15 billion bushels of grain and 8 million cars at point A. The opportunity cost of a car is 9,000 bushels of grain. © Pearson Education Canada, 2003

Opportunity Cost in Mobilia Figure 33.2 shows the production possibilities frontier for another imaginary country called Mobilia. © Pearson Education Canada, 2003

Without international trade, Mobilia produces and consumes 18 billion bushels of grain and 4 million cars at point A'. The opportunity cost of a car is 1,000 bushels of grain. © Pearson Education Canada, 2003

Comparative Advantage Cars are cheaper for Mobilia to produce than for Farmland, because less grain is given up to produce each car. Grain is cheaper for Farmland to produce than for Mobilia because fewer cars are given up to produce each bushel. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. Farmland has a comparative advantage in producing grain, and Mobilia has a comparative advantage in producing cars. © Pearson Education Canada, 2003

The Gains from Trade: Cheaper to Buy Than to Produce If Mobilia bought grain for the price that Farmland produces it, Mobilia could buy 9,000 bushels of grain for 1 car—a much lower price than the opportunity cost of producing grain in Mobilia. If Farmland bought cars for what Mobilia pays for them, Farmland could buy 1 car for 1,000 bushels of grain—a much lower price than the opportunity cost of producing cars in Farmland. © Pearson Education Canada, 2003

The Terms of Trade The quantity of grain that Farmland must pay Mobilia for a car is called Farmland’s terms of trade with Mobilia. Figure 33.3 shows how the forces of international demand and supply determine the terms of trade and the volume of trade. . © Pearson Education Canada, 2003

With no international trade, Mobilia can produce a car for 1,000 bushels of grain, so at that price, it plans to sell no cars to Farmland. But as the price rises above 1,000 bushels of grain per car the quantity of cars supplied by Mobilia increases. You might be asked where the demand and supply curves in Figure 33.3 came from. The answer is that they are based on the PPFs of Figures 32.1 and 32.2 together with implicit assumptions about preferences for automobiles and grain in the two countries. We need both technology and preferences to generate international demand and supply curves. © Pearson Education Canada, 2003

With no international trade, Farmland can produce a car for 9,000 bushels of grain, so at that price, it plans to buy no cars from Mobilia. But as the price falls below 9,000 bushels of grain per car the quantity of cars demanded by Farmland increases. © Pearson Education Canada, 2003

The equilibrium terms of trade (price) is 3,000 bushels of grain per car and 4 million cars are exported by Mobilia and imported by Farmland. © Pearson Education Canada, 2003

Balanced Trade The number of cars exported by Mobilia equals the number of cars imported by Farmland. Farmland pays Mobilia with 12 billion bushels of grain (four million cars multiplied by 3,000 bushels for each car)—Mobilia imports and Farmland exports 12 billion bushels of grain. Trade is balanced. For each country, the value of exports equals the value of imports—4 million cars are worth the same as 12 billion bushels of grain. © Pearson Education Canada, 2003

Changes in Production and Consumption Farmland buys cars at a lower price than it would pay if it made them itself, and sells its grain at a higher price. Mobilia buys grain at a lower price than it would pay if it grew the grain itself, and sells its cars at a higher price. Everyone gains from trade. The production possibilities frontier illustrates the production possibilities of a country, but it does not show the consumption possibilities of a country that engages in international trade. © Pearson Education Canada, 2003

Figure 33.4 shows how both countries gain from trade. Explain that Figure 33.4 shows how both countries can gain through international trade by taking advantage of divergent opportunity costs of production. Build the story for Farmland and then for Mobilia. Explain that the red line (in both parts of the figure) shows each country’s consumption possibilities. The slope of this line is the terms of trade--3,000 bushels of grain per car. For each country the consumption possibilities line touches the production possibilities frontier at the one point at which the slope of the PPF equals the terms of trade, point B, and this point is where each country produces. Emphasize that the consumption possibilities line lies outside the PPF except for the one point at which it touches the PPF. Each country then trades along its consumption possibilities line to its consumption point C. Emphasize the distinction between production possibilities—the PPF—and consumption possibilities—the red line along which the countries can trade. © Pearson Education Canada, 2003

Calculating the Gains from Trade Farmland increase its consumption of both cars and grain by decreasing car production and increasing grain production until its own opportunity cost of producing cars equals that of the world terms of trade and exchanging grain for cars at those terms of trade. Mobilia increases its consumption of both cars and grain by increasing car production and decreasing grain production until its own opportunity cost of producing cars equals that of the world terms of trade and exchanging cars for grain at those terms of trade. © Pearson Education Canada, 2003

Gains for All Both countries gain by consuming output combinations outside their respective production possibilities frontier. Trade does not create winners and losers. It creates only winners. Farmers selling grain and Mobilians selling cars face increased demand and higher prices. Farmers buying cars and Mobilians buying grain face increased supply and lower prices. © Pearson Education Canada, 2003

Gains from Trade in Reality Gains from trade occur in the real global economy. Canada buys TVs and VCRs from Korea, machinery from Europe, and fashion goods from Hong Kong and in exchange for machinery, grain, lumber, airplanes, computers, and financial services. Everyone gains from this trade. The combination of diverse preferences and economies of scale create comparative advantages that generate a large volume of international trade in similar but differentiated products. © Pearson Education Canada, 2003

International Trade Restrictions
Governments restrict international trade to protect domestic producers from competition by using two main tools Tariffs Nontariff barriers A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary. A nontariff barrier is any action other than a tariff that restricts international trade. © Pearson Education Canada, 2003

The History of Tariffs Figure 33.5 shows Canada’s average tariff rate The tariff was high until the 1930s. Tariffs have fallen over the past 70 years. © Pearson Education Canada, 2003

The General Agreement on Tariffs and Trade (GATT) is an agreement between nations to have a series of trade negotiations, or “rounds,” to reduce tariffs on international trade. Canada joined GATT in 1947. Subsequent rounds of the GATT occurred in the 1960s, late 1970s and 1980s, resulting in gradual decline in the average tariff rate in Canada. © Pearson Education Canada, 2003

The Uruguay round was the most ambitious and lead to the creation of the World Trade Organization (WTO). Canada became a WTO member in 1994. WTO membership brings greater obligations to follow the GATT rules governing trade. © Pearson Education Canada, 2003

In 1994, Canada became party to the North American Free Trade Agreement (NAFTA), under which trade barriers between Canada, Mexico and the United States are being lowered. The European Union (EU) is an organization of European countries that have agreed to eliminate trade barriers among them. The Asia-Pacific Economic group (APEC) is another agreement to reduce trade barriers among East Asian countries, including China. © Pearson Education Canada, 2003

How Tariffs Work Tariffs increase the price that consumers of the importing country must pay for imported goods or services. Figure 33.6 uses the Farmland and Mobilia example to illustrate the effects of a tariff on car imports into Farmland. The formal analysis in this section is straightforward. In a micro sequence, you might want to draw parallels between tariffs and taxes. © Pearson Education Canada, 2003

The supply of cars to Farmland decreases because the tariff must be added to the price at which Mobilia is willing to supply a given quantity. The price rises, the quantity falls, and the government collects the tariff revenue. © Pearson Education Canada, 2003

The supply curve shifts leftward and the vertical distance between the free-trade supply curve and the new supply curve equals the amount of the tariff. The price of a car in Farmland rises. The quantity of cars imported by Farmland decreases. The Farmland government collects tariff revenue. Resources use is inefficient. The value of exports changes by the same amount as the value of imports and trade remains balanced. © Pearson Education Canada, 2003

Nontariff Barriers There are two main types of non-tariff barriers to trade. A quota is a quantitative restriction on the import of a particular good, which specifies the maximum amount of the good that may be imported in a given period of time. A voluntary export restraint (VER) is an agreement between two governments in which the government of the exporting country agrees to restrain the volume of its own exports. © Pearson Education Canada, 2003

How Quotas and VERs Work Figure 33.7 uses the Farmland and Mobilia example to illustrate the effects of a quota on automobiles imported into Farmland. © Pearson Education Canada, 2003

The quota limits the quantity that may be imported. At the quota quantity, buyers are willing to pay more than the price that sellers are willing to accept. Importers profit by buying at a lower price than the price at which they sell. © Pearson Education Canada, 2003

A quota can generate the same price, quantity, and inefficiency as a tariff but with a quota, the importer makes an economic profit equal to what the government receives as tariff revenue with a tariff. A VER is similar to a quota except that the exporter captures the economic profit. © Pearson Education Canada, 2003

The Case Against Protection
Despite the fact that free trade promotes prosperity for all, trade is restricted. It is often argued that international trade should be restricted to Protect national security Protect infant industries Punish dumping None of these arguments bear scrutiny. [Continuing the story of Adam Blackbox.] The press becomes increasingly curious about what is going on in the giant New England auto plant. Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer. He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles. The gains from trade are like a technological advance. Adam Blackbox expanded the nation’s consumption possibilities just like a technological advance might have done. But he didn’t expand production possibilities. Use this fable to generate a classroom discussion of questions such as: Why did the president and Congress accept Adam Blackbox when they thought he had expanded production possibilities but not when the discovered that he had “only” expanded consumption possibilities? © Pearson Education Canada, 2003

Other fatally flawed arguments for protection are that it Saves jobs Allows us to compete with cheap foreign labour Brings diversity and stability to our economy Penalizes nations with lax environmental standards Protects national culture Prevents rich nations from exploiting poor ones There is a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. The full text is reproduced at You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities. If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, Updated and Revised Edition, 2000, Prentice Hall (ISBN: ). The books tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialog between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism. © Pearson Education Canada, 2003

The National Security Argument The national security argument is that a country must protect domestic industries that make defence equipment and armaments, and those industries that provide the raw material necessary for defence production. The argument is flawed for two reasons: (1) In time of war, there is no industry that does not contribute to national defence, so it is a plea for economic isolation. (2) It is less inefficient to subsidize defence than to restrict trade with a tariff. © Pearson Education Canada, 2003

The Infant Industry Argument The infant-industry argument is that it is necessary to protect a new industry from import competition to enable it to grow into a mature industry that can compete in world markets. This argument is based on the concept of dynamic competitive advantage, which can arise from learning-by-doing. © Pearson Education Canada, 2003

Learning-by-doing is a powerful engine of productivity growth, but this fact does not justify protection. Government action is needed to encourage learning-by-doing only when its benefits spill over to other parts of the economy. And even in this case, it is more efficient to subsidize an infant industry than to protect it by restricting trade. © Pearson Education Canada, 2003

The Dumping Argument Dumping occurs when foreign a firm sells its exports at a lower price than its cost of production. Dumping is seen as a justification for a tariff to prevent a foreign firm driving domestic firms out of business and then raising its price. This argument is flawed because: It is virtually impossible to determine a firm’s costs; If there was a natural global monopoly, it would be more efficient to regulate it than to impose a tariff against it. © Pearson Education Canada, 2003

Saves Jobs The idea that buying foreign goods costs domestic jobs is wrong. It destroys some jobs and creates other better jobs. It also increases foreign incomes and enables foreigners to buy more domestic production. Protection to save particular jobs is very costly. © Pearson Education Canada, 2003

Allows us to Compete with Cheap Foreign Labour The idea that a high-wage country cannot compete with a low-wage country is wrong. Low-wage labour is less productive than high-wage labour. And wages and productivity tell us nothing about the source of gains from trade, which is comparative advantage. © Pearson Education Canada, 2003

Brings Diversity and Stability The idea that protection brings diversity of production and greater stability of income is wrong. A nation can achieve diversity and stability through its international investments © Pearson Education Canada, 2003

Penalizes Lax Environmental Standards The idea that protection is good for the environment is wrong. Free trade increases incomes and poor countries have significantly lower environmental standards than rich countries. These countries cannot afford to spend as much on the environment as a rich country can and sometimes they have a comparative advantage at doing “dirty” work, which helps the global environment achieve higher environmental standards. © Pearson Education Canada, 2003

Protects National Culture The idea that trade restrictions protect the national culture is wrong. This argument is heard a great deal in Canada and the European countries. Many countries are afraid of the “Americanization” of their culture through the prominence of American films, television programs, art, literature, and even cuisine in world markets. © Pearson Education Canada, 2003

Protecting “cultural” industries is a form of rent seeking, using cultural identity to eliminate competition from other culturally related goods and services. The surest way to eliminate a culture is to impoverish a nation. © Pearson Education Canada, 2003

Prevents Rich Countries from Exploiting Poorer Countries The idea that trade restrictions prevent rich countries from exploiting poorer countries is wrong. Free trade is the best way of raising wages and improving working conditions in poor countries. Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains. Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade. Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage. © Pearson Education Canada, 2003

The most compelling argument against protection is that it invites retaliation. We saw retaliation when the United States raised its tariffs during the Great Depression. And we see it today as the world reacts to high U.S. tariffs on steel and agriculture. International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity can be achieved only through free trade among nations, and that the surplus generated is more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that it is the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale. There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. Emphasize that economists are overwhelmingly agreed that there is no good argument against free trade. © Pearson Education Canada, 2003

Why Is International Trade Restricted?
The two key reasons why international trade is restricted are Tariff revenue Rent seeking © Pearson Education Canada, 2003

Tariff Revenue It is costly for governments to collect taxes on income and domestic sales. It is cheaper for governments to collect taxes on international transactions because international trade is carefully monitored. This source of revenue is especially attractive to governments in developing nations. © Pearson Education Canada, 2003

Rent Seeking Rent seeking is lobbying and other political activities that seek to capture the gains from trade. Despite the fact that protection is inefficient, governments respond to the demands of those who gain from protection and ignore the demands of those who gain from free trade because protection brings concentrated gains and diffused losses. © Pearson Education Canada, 2003

Compensating Losers The gains from free trade exceed the losses, and sometimes free trade agreements address the issue of the distribution of gains from trade by compensating those who lose from free trade. For example, under NAFTA, a $56 million fund was created to support and retrain workers who lot their jobs from foreign competition resulting from the agreement. © Pearson Education Canada, 2003

33 TRADING WITH THE WORLD CHAPTER

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