Chapter 16 “Policy Toward Trade”

MACROECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 16“Policy Toward Trade”

Learning Objectives • Use the concept of a world price to explain imports, exports, and the gains from trade. • Discuss the GATT and other trade arrangements among countries. • Distinguish among the various barriers to trade that countries might impose. • Assess the arguments for and against protectionist policies. • Examine whether an oil import fee can promote energy security.

16.1ASSESSING THE GAINS FROM TRADE • International trade occurs in response to differences between the domestic price of goods and the world price of goods. • When a country opens it doors to international trade, the price in the domestic market will come to equal that of the world price. • If this adjustment means that the domestic price rises to meet the world price, the country will exports the good. • If the world price causes the domestic price to drop, then the country import the good.

Gains From Imports • Free trade implies that a country’s producers must accept world market prices, which would entail a higher price for some goods and a lower price for others. • Imports allow domestic consumers to pay a lower price for goods. • They also gain by consuming more of the good. • The gains to consumers from imports more than offsets the losses to producers, which reveals that the country as a whole is better off allowing imports.

Imports result from a world price that is below the country’s price prior to trade. The lower price causes consumption to rise and production to fall , with the difference being the amount imported. Equilibrium if no trade Imports Quantity Supplied Quantity Demanded Imports – Effects on Price and Quantity $ Domestic Supply • Price if no trade World Price • • Domestic Demand Quantity

Loss to producers A Gain to consumers B C D Imports Quantity Supplied Quantity Demanded Gains and Losses from Imports $ Domestic Supply The consumer surplus rises from area A to area A + B + C. The producer surplus drops from areas B+ D down to area D. • Price if no trade World Price • • Domestic Demand Quantity

Gains from Exports • In the case of exports, producers win and consumers lose. • Producers win because they sell more at a higher price. • Consumers lose because they must pay a higher world price, and thus consume less. • On balance, the country as a whole gains from international trade by allowing exports. • Both imports and exports lead to more gains than losses.

Exports result from a world price that is above a country’s price prior to trade. The higher price causes a country’s production to rise and consumption to fall by the amount being exported. Equilibrium if no trade Exports Quantity Demanded Quantity Supplied Imports – Effects on Price and Quantity Gains from Exports $ Domestic Supply World Price • • • Price if no trade Domestic Demand Quantity

Loss to producers A B C Gain to producers D Exports Quantity Demanded Quantity Supplied Gains from Exports Gains from Exports $ Domestic Supply World Price • • The country’s consumer surplus drops from areas A+B to only area A. The Producer surplus rises From area D to areas B+ C+D. Price if no trade • Domestic Demand Quantity

16.2TRADE AGREEMENTS • Countries must choose how wide to open their doors to international trade. • An open economy is one that erects no barriers to international trade and investment. • A closed economy shuts itself off from foreign investment and trade. • Countries design their trade policies with an eye towards their own self interest. • Most countries have learned from the Great Depression of the 1930’s that their interest are best served with free trade.

Trade Agreements • Most countries have signed the General Agreement on Tariffs and Trade (GATT), which aims to avoid trade wars and promote free trade. • The GATT has been administered by the World Trade Organization, an arm of the GATT created to settle trade disputes among GATT members and monitor compliance with provisions of the GATT. • The Smoot-Hawley Act of 1930 was passed by the U.S. Congress and imposed high tariffs an imported goods to save jobs. • The surprising result of the act was that unemployment was even higher after its imposition.

Trade Agreements • The GATT negotiations required significant tariff reductions. • They have also placed restrictions on quotas, which limit the quantity of imported products a country allows. • Other non-tariff barriers are also restricted, which is a catch all phrase for the variety of actions a country can take to restrict trade.

Trade Agreements • The Uruguay Round of GATT was ratified by the U.S. and other nations in 1994. • It established the WTO, and dealt with the following thorny issues. • Tariffs • Agricultural subsidies • Services • Intellectual property rights

Regional Trade Blocs • The European Union is an example of a regional trading bloc, which is an agreement that lowers trade barriers among member countries. • The U.S., Canada, and Mexico have also formed a trading bloc by signing the North American Free Trade Agreement (NAFTA). • Trading blocs allows countries to specialize according to comparative advantage, and have a trade creation effect. • Trading blocs also have a trade diversion effect, as product flow between trade bloc countries, that may have been traded with non trade bloc countries.

16.3TRADE POLICY OPTIONS • A tariff is a tax on an imported product. • Demand for imported products is sometimes referred to as residual demand, since it represents what is left over after consumers have bought from domestic suppliers. • Tariffs increase the cost of selling imported products. • This in turn increases the cost of imported goods in the domestic market, and reduces the quantity demanded.

Tariffs • By raising the barriers to entry of foreign products, tariffs can be viewed as a for of price support for domestic producers. • The higher price of imports causes the demand curve to shift to the right for domestic products that are close substitutes. • Tariffs are said to be transparent, meaning that their effects on prices are clear for all to see. • Tariff rates are kept low by GATT.

Tariff raises price and lowers quantity Price rises Tariff Imports decline Tariffs $ Supply plus tariff Supply for abroad • • U.S. demand for imports A tariff on imports helps U.S. producers who can sell at higher prices, but hurts consumer who must pay the higher price. Quantity

Effective U.S. Tariff Rates 1992-2000

Quotas • Import quotas are an alternative to imports tariffs and can accomplish the same goals. • An import quota restricts the quantity of imports directly, and thus cuts off supply from abroad at the quota quantity. • The truncated supply from abroad under a quota leads to an increase in prices at home. • GATT limits the extent to which quotas can be imposed by countries. • It does allow quotas for agricultural products to avoid disruption to countries’ domestic economies.

Quotas reduce the supply of imports and increase the domestic price. The quota truncates supply at the allowable import quantity, causing import supply to be vertical at that point. A quota can have the same effect as a tariff Price rises Quantity allowed by quota Imports decline Quotas Import supply with quota $ Unrestricted import supply • • U.S. demand for imports Quantity

Voluntary Export Restraints • As an alternative to tariffs and import quotas, the U.S. and some other countries have chosen to negotiate voluntary export restraints (VER’s). • With VER’s, individual exporting countries agree to limit the quantities they export. • The multi-fiber agreement currently scheduled for elimination in 2004, sets country by country quotas on clothing exports to the U.S. and some other countries. • The U.S. offers to forego quotas in favor of VER’s to maintain good relations with other governments.

An Assortment of Non-tariff Barriers to Trade. • Most non-tariff barriers to trade do not restrict imports explicitly. • Their effects are less obvious than quotas. • Paperwork and red tape can inhibit trade. • Inspections, which include sampling of imported products can inhibit trade.

16.4THE FREE-TRADE DEBATE • The objections to free trade commonly have limited applicability or are based on questionable logic. • The national defense argument is valid but overused. • Translating national defense into policy requires judgments and debate. • Trade sanctions restrict trade with nations that have policies that our government opposes. • Do trade sanctions punish the wrong people?

The Free-Trade Debate • Some U.S. products are more expensive than foreign products because of the added cost of complying with environmental, health , and safety standards. • The U.S. imposes a tariff to achieve a level playing field. • Higher level of pollution for some countries is a normal good, since more environmental quality is demanded as the income in a country rises. • Poorer countries have a higher opportunity cost of environmental quality, and might specialize in industries with a higher pollution content.

The Free-Trade Debate • Dumping is defined as the selling of a good for less than it cost to produce. • Dumping may occur for many reasons. • A company may have overestimated demand for its product, and so for itself stuck with too much product and have a clearance sale. • It may be covering its operating expenses, but not the cost of capital or other fixed cost. • In these cases, even though the company loses money, it would lose more if it did not sell.

The Free-Trade Debate • Dumping occurs within a country, as well as in international trade. • Dumping is illegal across countries according to the GATT. • The U.S. presumes dumping whenever whenever a foreign company charges less in the U.S. than it does at home, irrespective of its cost. • Strategic dumping is dumping that aims to drive the competition out of business so that the firms doing the dumping can monopolize output and drive prices up in the future.

The Free-Trade Debate • Developing countries often try to nurture new industries they hope will one day become the source of export earnings. • These infant industries are thought to need protection in the rough world marketplace. • The infant industry argument unconvincing if markets function efficiently. • In the free marketplace, venture capitalist and other private investors will often support firms through many years of losses. • Governments around the world support infant industries that never grow up.

The Free-Trade Debate • By requiring government subsidies to stay afloat, and by charging prices above those in the rest of the world, such infant industries have proven to be expensive for governments and consumers alike.

28.4 EXPLORE & APPLYEnergy Security • The U.S. economy consumes tremendous amounts of oil. • About 777 million gallons per day as of January 2002. • The U.S. is vulnerable to political instability in the middle east and in other oil-exporting countries. • The U.S. is a source of income to Middle Eastern countries with interest hostile to those of the U.S.

Energy Security • The external cost of imports are not reflected in the price paid by importers. • To internalize them, the U.S. could impose an oil import fee. • An oil import fee is a common name for a tariff when applied to oil. • Since oil is a non-renewable resource, opponents of oil import fees say such a fee would “drain” America first.

Energy Security

free trade open economy General Agreement on Tariffs and Trade (GATT) World Trade Organization (WTO) tariff Smoot-Hawley Act quotas non-tariff barriers trading bloc North American Free Trade Agreement trade creation effect Terms Along the Way

trade diversion effect voluntary export restraints Dumping strategic dumping infant industries Terms Along the Way (continued)

Test Yourself • When a country imports a good, it will • gain more in consumer surplus than it loses in producer surplus. • gain more in producer surplus than it loses in consumer surplus. • find that its gain of consumer surplus is exactly offset by its loss of producer surplus. • Find that its gain of producer surplus is exactly offset by its loss of consumer surplus.

Test Yourself 2. The GATT was created in response to • the Great Depression of the 1930’s. • the cold war of the 1950’s and 1960’s. • Reagonomics, the economic policies of President Regan in the 1980’s. • President Clinton’s desire to forge closer relationships with China in the 1990’s.

Test Yourself 3. The World Trade Organization • is a trading bloc that consist of the United States and the countries of Japan and China. • has many member countries, but not the United States. • competes with GATT for members, with about half the world’s countries belonging to the GATT and the other half belonging to the World Trade Organization. • is a component of the GATT that administers the GATT Agreement.

Test Yourself 4. An import tariff shifts the _________ curve of imports upward and __________ the price of the good paid by the consumer. • supply;increases • supply;decreases • demand;decreases • demand;increases

Test Yourself 5. Which is an example of a voluntary export restraint? • A tariff. • A quota. • The multi-fiber agreement. • The GATT.

Test Yourself 6. Which of the following is NOT offered as a reason to restrict trade? • Infant industries. • Dumping. • Level playing field. • Comparative advantage.

The End! Next Chapter 17 “Economic Development"

Chapter 16 “Policy Toward Trade”