2013 -- lecture summary for Chapter 32

International Trade

Important: the two main concepts here -- comparative advantage and the use of the supply and demand model -- were covered earlier in the term, in the textbook in chapter 2 pp 47-49 and chapter 3 pp 62-78. It would be a good idea to review that material which is anyway vital for your final.

The basis for international trade is exactly the same as the basis for exchange between individuals or localities within a single country, i.e. specialization in accordance with comparative advantage, exchange, and division of labor allows a higher standard of living for all participants (even lawyers and doctors who are very good typists rarely do their own typing). What makes international trade different is that it takes place between economies with different governments, and therefore usually involves differing currencies (not covered until chapter 33), taxes and rules and regulations, and considerable barriers to movements of labor and other inputs (and therefore differences in wages etc).

Quantitatively, importance of international trade tends to vary with size of economy in question, being smaller for large economies (because they typically have a wider variety of resources than smaller economies, and because for much of the land area of a large economy transport costs imply exchange with another national producer will be cheaper than with a foreign producer). Thus international trade is quantitatively less important as % of GDP in the US than in most other economies, because the US is bigger; but the importance has been growing, and now (exports plus imports) are over one quarter of GDP in the US.

The principle of comparative advantage states that if each producer specializes in the production of the good for which s/he is the low opportunity cost producer, relatively, and exchanges for other goods, all participants will be better off. You need to know how to figure out from a table who specializes in (and therefore exports) what; i.e. figure out opportunity costs (how much of the other good is given up if production shifts to produce one more unit of this good).

Another way to think of it is that without trade, goods would exchange within each country at their opportunity cost ratios; the possibility of trade gives an alternative set of prices, i.e. exchange ratios for the goods. The existence of different price ratios is always enough to make mutually beneficial trade possible: if you can buy low and sell high, you make a profit.

If you think of production possibility curves for two countries, mutually beneficial trade will be possible unless without the trade both countries would be producing at points on the PPC where the slope of the PPC was the same in each country. The slope of the PPC measures the opportunity cost ratio, so if the slopes differ, opportunity cost ratios differ, and mutually beneficial trade is possible. Trading with another country is a way to permit consumption at a point outside the production possibility curve -- i.e. if you can trade with another country and thereby change the ratio at which one good can be converted into another, a country no longer has to consume on or inside its production possibility curve, but can produce and then trade to get to a consumption point outside the PPC (not any point; just ones it can trade to).

Although in voluntary exchange both parties must gain, the division of the gains need not be equal: one party may gain much more than the other does. But if the trade is voluntary, both parties to the trade are gaining, i.e. better off than they were before the trade. Note that when thinking about international trade, rather than trade between two individuals, although the individuals doing the trading in the two countries must gain relative to no international trade, other individuals may well lose; but the market value of the gains will usually be larger than that of the losses [e.g. when the US imports cars, car buyers gain; but car producers in the US may lose. The gains to car buyers are larger than the losses to car producers].

Simple supply and demand diagrams/models can clarify lots of issues about imports and exports.

Imports in effect happen if the world price is below what the domestic price would be in the absence of international trade. Thus imports in effect increase supply, and they will lower prices, expand consumption, but lower domestic production. Consumers gain, domestic producers lose, foreign producers gain (foreign consumers lose if the foreign price rises, which it will).

Exports happen if the world price is above what the domestic price would be in the absence of international trade. They in effect increase demand, and thus raise domestic prices and production, but lower domestic consumption. Consumers lose, producers gain (but foreign consumers gain, foreign producers lose).

There is in the long run and in the aggregate a link between exports and imports: export demand will only exist if foreigners have the purchasing power to buy US goods, which require that they can sell something to the US in order to get that purchasing power. In other words, foreigners only sell us things because there are things of ours they want to buy; if we restrict their ability to sell things to us, they will not be able to buy as much of what we make. [Exports minus imports] are part of aggregate demand, and thus it looks as though restricting imports would increase aggregate demand; but this cannot work in the long run, because if our imports are reduced, eventually our exports must also go down because foreigners will have no way to pay for as much of our goods (i.e. our exports) as before.

International trade encounters many, many, kinds of barriers. The three most important types are tariffs (taxes on imports), quotas (quantitative restrictions on imports), and VERs (Voluntary Export Restraints, just like a quota except imposed by the exporter, under threat of a quota, in order to avoid a showdown which would threaten international agreements). The major differences concern transparency (i.e. how easy it is to figure out what is happening) and the distributional consequences (i.e. who gains and who loses).

Any import restriction raises domestic price, lowers domestic consumption, and increases domestic production, if it is effective. Good diagrams are on pp. 858 and 859 of the textbook. Domestic producers gain, domestic consumers and foreign producers lose. With a tariff, there is revenue to government; with an equivalent quota, what would have gone to government as tariff revenue instead goes to whoever gets the import permits; with an equivalent VER, it goes to whoever gets the export permits [these statements are all for fully competitive supply both domestically and overseas; if there is monopoly, the story is potentially a lot different]. In all three cases, there is (as with any tax or distortion that makes the price in the market different from the price that would prevail if there was no tax or distortion and pure, free, competition) a deadweight or efficiency loss (triangles U and V in the diagrams).

Why barriers, i.e. why "protection"? Historically, there were some reasonable possible arguments in some cases (e.g. national defense, infant industry). However, there seem few plausible cases now in the US. Why, then?? The usual explanation concerns the distribution of costs and benefits, and transparency. Benefits of protection go to producers, i.e. workers and owners of firms in protected industries. These gainers often are very concentrated geographically, socially, and in terms of interests, and therefore they make their views known, especially to politicians; plus the potential costs to them of losing their protection are easy to see -- firms closing down, workers losing jobs — and usually large to each individual who might lose. The costs of protection are paid by all consumers of the protected goods, in small amounts that are not obvious: e.g. restrictions on clothing imports make the prices of all clothing, including that made in the US, higher -- but who knows by how much? Consumers do not know how much they would gain if the import restrictions were removed, and anyway it would not be much each (in the case of apparel and clothing, in the US it would probably average about $60 per person per year) compared to the potential costs perceived by those who might lose their jobs. So politically you have a classic special interest effect -- there are strong incentives for those who benefit from protection to lobby for it, but very weak incentives for those who lose from protection to object to it.