9 Application: International Trade P R I N C I P L E S O F F O U R T H E D I T I O N This relatively short chapter has a few main objectives. Welfare analysis of free trade in a good that a country exports, relative to no trade. Welfare analysis of free trade in a good that the country imports, relative to no trade. Welfare analysis of a tariff, relative to free trade in a good the country imports. The most common arguments for restricting imports, and the economist’s response to each. I encourage you to bring to your students’ attention several interesting items in the book itself. There’s a new “In the News” box on the 2005 expiration of U.S. quotas on textile products from China. In another new “In the News” box, George Will addresses the outcry over Mankiw’s famously-misquoted statement about outsourcing. The chapter’s conclusion makes an effective point about international trade by comparing it to technological progress. In addition, one of the macro chapters of this textbook has a new “In the News” box that you should try to obtain for possible use with this chapter. In it, the Presidents of two African nations use sound economics to explain why the farm subsidies of rich countries are contributing to the impoverishment of millions of African farmers. The article is very well-written, effective, and impassioned. It appears in the chapter entitled “Production and Growth,” chapter 25 in the complete Principles of Economics textbook, and chapter 12 in the Principles of Macroeconomics split.

In this chapter, look for the answers to these questions: What determines how much of a good a country will import or export? Who benefits from trade? Who does trade harm? Do the gains outweigh the losses? If policymakers restrict imports, who benefits? Who is harmed? Do the gains of the policy outweigh the losses? What are some common arguments for restricting trade? Do they have merit? CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Introduction Recall from Chapter 3: A country has a comparative advantage in a good if it produces the good at lower opportunity cost than other countries. Countries can gain from trade if each exports the goods in which it has a comparative advantage. Now we apply the tools of welfare economics to see where these gains come from and who gets them. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

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 CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

The Small Economy Assumption A small economy is a price taker in world markets: Its actions have no affect on PW. Not always true – especially for the U.S. – but simplifies the analysis without changing its lessons. When a small economy engages in free trade, PW is the only relevant price: No seller would accept less than PW, because she could sell the good for PW in world markets. No buyer would pay more than PW, because he could buy the good for PW in world markets. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

A Country That Exports Soybeans Without trade, PD = $4 Q = 500 PW = $6 Under free trade, domestic consumers demand 300 domestic producers supply 750 exports = 450 P Q Soybeans D S exports $6 300 750 $4 500 Fun soybean facts (all for 2004): U.S. farmers grew 3.1 billion bushels of soybeans. The average price was $5.65/bushel, for a total of nearly $18 billion. The U.S. exported 1.1 billion bushels, comprising nearly half of international trade in soybeans. China purchased $2.3 billion worth of U.S. soybean exports, making China the U.S. soybean farmer’s biggest foreign customer. Japan was second with $1.0 billion in purchases. Source: American Soybean Association, http://www.soystats.com/ You might alert your students that, in just a moment, they will be asked to do some analysis very similar to this analysis. This will make them pay close attention. In this case, PD < PW, so this country will export soybeans. The quantity of exports is simply the difference between the domestic quantity supplied and the domestic quantity demanded at the world price. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

A Country That Exports Soybeans 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 Q Soybeans D S exports A $6 D B gains from trade $4 C Trade benefits soybean producers, because they can sell at a higher price. Producer surplus rises by the area B + D. Trade makes domestic buyers worse off, because they have to pay a higher price. Consumer surplus falls by the area B. The gains to producers are greater than the losses to consumers, so trade increases total welfare: total surplus rises by the amount D. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

A C T I V E L E A R N I N G 1: Analysis of trade Without trade, PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. P Q Plasma TVs D S $3000 400 The two preceding slides show students the analysis of trade when the country exports. The next step is to cover the analysis of trade when the country imports the good. Instead of lecturing on this material, I suggest you have students work on this exercise, which students to do this analysis themselves. It’s an activity that breaks up the lecture and gives students a chance to apply the techniques you’ve just presented. I suggest you have students work on it in pairs. Give them about 5 minutes, then go over the answers on the following two slides. While students are working, circulate around the room and offer to assist any students that ask for help. This will also give you a sense of how well students are understanding the material. If you prefer to lecture on the material instead, replace these slides with the two “hidden” slides that immediately follow the CHAPTER SUMMARY. You will then have to “unhide” those slides by unselecting “Hide Slide” from the “Slide Show” drop-down menu. $1500 200 600 7

A C T I V E L E A R N I N G 1: Answers Under free trade, domestic consumers demand 600 domestic producers supply 200 imports = 400 P Q Plasma TVs D S $3000 PD > PW, so this country will import plasma TV sets from abroad. The quantity of imports is simply the difference between the quantity demanded by domestic consumers and the quantity supplied by domestic firms at the world price. $1500 200 600 imports 8

A C T I V E L E A R N I N G 1: Answers Without 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 P Q Plasma TVs D S gains from trade A $3000 B D Trade benefits consumers in this case, because it allows them to buy plasma TVs at lower prices, so more consumers can afford plasma TVs if imports are allowed. The gains to consumers appear on the graph as the area (B+D), which represents the increase in consumer surplus when the country allows trade. In this example, trade harms domestic producers, because they now must sell their plasma TVs at a lower price. As a result, they produce a smaller quantity, earn less revenue, and likely let go of some of their workers. These losses are represented on the graph by the area B , which represents the fall in producer surplus resulting from trade. As the graph shows, the gains to consumers outweigh the losses to producers: total surplus increases by the amount D, which represents the gains from trade in plasma TV sets. $1500 C imports 9

Summary: The Welfare Effects of Trade rises falls exports PD < PW rises falls imports PD > PW direction of trade consumer surplus producer surplus total surplus Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Other Benefits of International Trade Consumers enjoy increased variety of goods. Producers sell to a larger market and may achieve lower costs through economies of scale. Competition from abroad may reduce market power of some firms, which would increase total welfare. Trade enhances the flow of ideas, facilitates the spread of technology around the world. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Then Why All the Opposition to Trade? Recall one of the Ten Principles: Trade can make everyone better off. 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. In December 2005, thousands of protestors gathered outside the meeting place of the World Trade Organization talks in Hong Kong. Some protests turned violent, and police made 900 arrests. Mankiw addresses the issue of opposition to trade very nicely in the “Ask the Author” video for Chapter 3. The “Ask the Author” videos are available at the Mankiw Xtra website. You may need a username and password; you can get them from your Thomson/South-Western sales rep. There is one “Ask the Author” video clip per chapter. Each video is about 2 minutes. In each, Mankiw addresses a question submitted by a student. I encourage you to check out these videos, and consider showing some of them in your class. The videos for Chapter 3 and Chapter 9 both go very nicely with the material in this PowerPoint. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Tariff: An Example of a Trade Restriction Tariff: a tax on imports Example: Cotton shirts PW = $20 Tariff: T = $10/shirt Consumers must pay $30 for an imported shirt. So, domestic producers can charge $30 per shirt. In general, the price facing domestic buyers & sellers equals (PW + T ). CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Analysis of a Tariff on Cotton Shirts P Q 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 Cotton shirts D S $30 40 70 $20 25 80 imports imports CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Analysis of a Tariff on Cotton Shirts 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 Q deadweight loss = D + F Cotton shirts D S A B $30 The tariff benefits domestic producers, by allowing them to sell for a higher price. Producer surplus increases by C. The tariff makes consumers worse off, because they have to pay a higher price. Consumer surplus falls by C + D + E + F. The tariff generates revenue for the government equal to E. The losses from the tariff exceed the gains, so total welfare falls. The tariff reduces total surplus by (D + F). 40 70 C E D F $20 25 80 G CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Analysis of a Tariff on Cotton Shirts P Q D = deadweight loss from the overproduction of shirts F = deadweight loss from the under-consumption of shirts deadweight loss = D + F Cotton shirts D S A B $30 A tariff is a tax. Like the taxes we studied in the preceding chapter, the tariff causes a deadweight loss because it distorts incentives. Here, the tariff causes the economy to devote more resources to a good that could be produced at lower opportunity cost in other countries. This causes a deadweight loss, represented on the graph by the area D. Also, the tariff gives consumers an incentive to purchase a smaller quantity. The result is a deadweight loss, area F on the graph. 40 70 C E D F $20 25 80 G CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Import Quotas: Another Way to Restrict Trade An import quota is a quantitative limit on imports of a good. Mostly, has the same effects as a tariff: raises price, reduces quantity of imports reduces buyers’ welfare increases sellers’ welfare A tariff creates revenue for the govt. A quota creates profits for the foreign producers of the imported goods, who can sell them at higher price. Or, govt could auction licenses to import to capture this profit as revenue. Usually it does not. The 4th edition of the textbook replaces the graphical analysis of a quota with an FYI box. This slide is based on that box. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

In the News: Textile Imports from China On 12/31/2004, U.S. quotas on apparel & textile products expired. During Jan 2005: U.S. imports of these products from China increased over 70%. Loss of 12,000 jobs in U.S. textile industry. The U.S. textile industry & labor unions fought for new trade restrictions. The National Retail Federation opposed any restrictions. November 2005: Bush administration agreed to limit growth in imports from China. If you can spend a few extra minutes of class time on this, you might consider the following: Show the first bit of text, which states the expiration of the quotas. Then ask students to take a few moments and write down all of the different groups that would be affected by the expiration of the quotas. Ask which of these groups would be most likely to fight for reinstatement of the quotas. Better yet, have them work in pairs. After a couple minutes, ask for volunteers to share their answers. The typical responses would be: U.S. textile producers and workers would be hurt, would fight for new restrictions. U.S. consumers would benefit. Other possible responses: The U.S. retail sector (e.g. Gap stores) would benefit, and would oppose new restrictions. Senators and Congressmembers from states with significant textile production would likely argue for new restrictions on imports from China. The statistics on this slide came from: “Free of Quota, China Textiles Flood the U.S.” New York Times, 3/10/2005, pp.A1 and C6. A condensed version of this excellent article appears in the textbook itself as a new “In the News” box. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

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… CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

U.S. imports & unemployment, decade averages, 1956-2005 16% imports (% of GDP) 14% 12% 10% 8% unemployment (% of labor force) 6% 4% By using decade averages, the short-term noise and fluctuations average out, which makes the long-term trends easier to see. In most periods, rising imports are accompanied by falling, not rising unemployment. Note: This data does not appear in the textbook. I include it here because I think it is effective. But it is not supported in the Test Bank or Study Guide, so please feel free to omit this and the preceding slide if you wish. Data source: FRED database, St Louis Federal Reserve, http://research.stlouisfed.org/fred2/ and my calculations. (I constructed imports as a percentage of GDP from quarterly, nominal, seasonally adjusted data. Then I computed simple averages of the two series over each of the decades shown in the graph.) 2% 0% 1956 -65 1966 -75 1976 -85 1986 -95 1996 -2005

Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in the industries that compete against imports. Economists’ response: 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. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

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. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

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 govt 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. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Arguments for Restricting Trade 4. The unfair-competition argument Producers argue their competitors in another country have an unfair advantage, e.g. due to govt 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. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

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: Suppose France refuses. Then the U.S. must choose between two bad options: A) Restrict imports from France, which reduces welfare in the U.S. B) Don’t restrict imports, and suffer a loss of credibility. Of course, this argument and response are meant to apply more generally than in the specific example described. But most non-economics majors more easily learn a general concept if they start with a specific, graspable example than with the general concept itself. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Trade Agreements A country can liberalize trade with unilateral reductions in trade restrictions multilateral agreements with other nations Examples of trade agreements: North American Free Trade Agreement (NAFTA), 1993 General Agreement on Tariffs and Trade (GATT), ongoing World Trade Organization (WTO) est. 1995, enforces trade agreements, resolves disputes The WTO website (http://www.wto.org) has useful information. Especially worthwhile for students is the section “Common misunderstandings about the WTO.” CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

CHAPTER SUMMARY A country will export a good if the world price of the good is higher than the domestic price without trade. Trade raises producer surplus, reduces consumer surplus, and raises total surplus. A country will import a good if the world price is lower than the domestic price without trade. Trade lowers producer surplus, but raises consumer and total surplus. A tariff benefits producers and generates revenue for the govt, but the losses to consumers exceed these gains. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

CHAPTER SUMMARY Common arguments for restricting trade include: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. Some of these arguments have merit in some cases, but economists believe free trade is usually the better policy. CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

A Country That Imports Plasma TVs Without trade, PD = $3000 Q = 400 PW = $1500 Under free trade, domestic consumers demand 600 domestic producers supply 200 imports = 400 P Q Plasma TVs D S $3000 400 This and the following slide cover the same material in Active Learning Exercise 1. I provide these slides in case you wish to lecture on this material instead of having students work the exercise. To do this, simply delete the three orange and yellow slides titled “Active Learning 1” and replace them with this and the following slide. Then, “unhide” these slides by unselecting “Hide Slide” from the “Slide Show” drop-down menu. In this case, PD > PW, so this country will import plasma TV sets from abroad. The quantity of imports is simply the difference between the quantity demanded by domestic consumers and the quantity supplied by domestic firms at the world price. $1500 200 600 imports CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

A Country That Imports Plasma TVs Without 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 P Q Plasma TVs D S gains from trade A $3000 B D Trade benefits consumers in this case, because it allows them to buy plasma TVs at lower prices, so more consumers can afford plasma TVs if imports are allowed. The gains to consumers appear on the graph as the area (B+D), which represents the increase in consumer surplus when the country allows trade. In this example, trade harms domestic producers, because they now must sell their plasma TVs at a lower price. As a result, they produce a smaller quantity, earn less revenue, and likely let go of some of their workers. These losses are represented on the graph by the area B , which represents the fall in producer surplus resulting from trade. As the graph shows, the gains to consumers outweigh the losses to producers, as total surplus increases by the amount D, which represents the gains from trade in plasma TV sets. $1500 C imports CHAPTER 9 APPLICATION: INTERNATIONAL TRADE