Micro International Trade Essentials 2 WCC Supply, Demand, and Trade

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1 Micro International Trade Essentials 2 WCC upply, emand, and Trade Absolute advantage, comparative advantage and trade recap The pattern of trade simply refers to which country produces and exports each good. We ve shown that the pattern of trade is determined by comparative advantage, not absolute advantage ifferences in OC determine which country will produce each good, not differences in efficiency Efficiency is important, however. The more efficient a country is, the farther out its F sits, and the greater the quantity of goods and services that are available to its citizens. Also, changes in how efficient a country is at producing one good versus another can change OC, and therefore comparative advantage. In the end though, it is comparative advantage/oc that determines the pattern of trade. Assuming the two countries can agree on terms of trade, both parties will gain from trade. The terms of trade simply refer to the rate at which the two countries will exchange goods. The terms of trade will need to lie between the autarky OC of production in each country. By trading, each ends up with more goods and services by engaging in trade than they do by producing their goods and services on their own. Our unanswered question If both countries benefit from trade, why does anyone object to free trade? While we ve shown that both countries as a whole benefit, we haven t shown that all parties within a country benefit, and in fact they won t. Those individuals damaged by free trade will naturally object. Free trade a situation in which there are no restrictions on trade between countries Basic types of trade restrictions 1) Import tariffs a tax on imports. 2) uotas a numerical upper limit on imports imposed by the importer 3) Voluntary export restraints (VERs) numerical limits imposed by the exporter 4) Nontariff barriers (NTB's) other regulations and practices designed to limit imports international trade essentials 2.docx 1 Revised on: 3/7/2018

2 Tariffs Importers can bring in as much as they would like, provided they are willing to pay the tax. In the U.. export tariffs are unconstitutional. You can in other countries. uotas There is no charge to bring the goods in, but you can only bring in the amount specified by law. uotas may be applied by country. uotas rights, the right to import, are often assigned to a specific company. uotas are a significant source of corruption, especially in developing nations. VERs These really aren t voluntary. The exporter agrees to them in order to avoid more stringent restrictions. They may be less permanent than a tariff or quota as the exporting country could potentially opt out of them in the future. Examples of nontariff barriers Health and safety regulations Europe and frankenfoods omestic content requirements Environmental regulations dolphin safe tuna Buy American campaigns Export subsidies Government loan guarantees to companies international trade essentials 2.docx 2 Revised on: 3/7/2018

3 U.. and Canadian Lumber Markets in Autarky U A C A U A C A U.. Market for Lumber Canadian Market for Lumber Examining why trade occurs using supply and demand diagrams Assume that the U.. and Canada do not currently trade, or at least they do not trade in lumber. The graphs above illustrate the U.. and Canadian lumber markets in autarky. We ll assume both countries use the U.. dollar to make our analysis easier. The autarky lumber price is higher in the U.. than in Canada. If trade were allowed, there would be an opportunity for firms to earn a profit through arbitrage. Remember, countries do not trade, generally speaking. Firms and individuals trade. Arbitrage Arbitrage is the process of buying a good at a known lower price in one market and selling at a known higher price in another market. Unlike speculation, arbitrage doesn t involve risk. Both prices are known. Arbitrage causes prices to equalize across markets. rices in the two markets will only be separated by transaction costs. We ll assume transaction costs are zero. international trade essentials 2.docx 3 Revised on: 3/7/2018

4 U.. and Canadian Lumber Markets in Free trade Equilibrium U A FT FT C A U U A U C C A C U.. Market for Lumber Canadian Market for Lumber Free trade equilibrium conditions 1) U = C = FT 2) ( U U ) = ( C C ) which says (U.. imports) = (Canadian exports) eeing the gains and losses from trade for each country We can use economic surplus to see the overall gains to each country from moving to free trade. Economic surplus (C + ) increases for each country in the graphs below as a result of trade. imultaneously, we can use consumer and producer surplus to see the gains and losses to producers and consumers in each country as a result of this move to free trade. Consumer surplus rises in the U.. as the domestic price falls to FT, while producer surplus shrinks. roducer surplus rises in Canada as the domestic price rises to FT, while consumer surplus shrinks. international trade essentials 2.docx 4 Revised on: 3/7/2018

5 Changes in Consumer & roducer urplus When Countries Move to Free Trade C U A U A C FT FT U U A U U U A U Economic urplus for U.. Market for Lumber In Autarky Economic urplus for U.. Market for Lumber Under Free Trade C FT C FT C A C A C C A C C C A C Economic urplus for Canadian Market for Lumber In Autarky Economic urplus for Canadian Market for Lumber Under Free Trade international trade essentials 2.docx 5 Revised on: 3/7/2018

6 There are winners and losers in each country as a result of the move to free trade In the importing nation, consumers of the good win. Anyone who uses that good can now get it at a cheaper price. In the exporting country, producers of the good win. They can now sell their good at a higher price. In the importing country, producers of the good lose. They will receive a lower price and sell fewer units. In the exporting country, consumers of the good lose. They will have to pay more per unit and have fewer units available. Those who lose from free trade will push for restrictions on trade U.. lumber producers and Canadian lumber consumers would both like to see barriers put in place to reduce the trade in lumber. This is a political issue. If they can muster enough political support, they will try to implement tariffs, quotas, or some form of nontariff barrier. Tariffs Assume there are no transaction /transportation costs. Then under free trade, domestic prices equalize in the two countries. Applying a tariff makes trade unprofitable if both countries are at FT. Less importing takes place, and price falls in the exporting country while rising in the importing country. This continues until the prices in the two countries are separated by the amount of the tariff. Remember, taxes/tariffs can be thought of as a wedge. A Tariff as a Wedge U A U T FT Tariff FT C T C A U U A U C C A C U.. Market for Lumber Canadian Market for Lumber international trade essentials 2.docx 6 Revised on: 3/7/2018

7 The small country assumption When evaluating tariffs and quotas, we sometimes assume that one of the countries is a small country. This doesn t mean that its geographically small, or that it has a small population. It means that its imports or exports of a good are too small to affect the world price. o, a country could be a small country with respect to one good, but not another. Making the small country assumption makes the graphical analysis easier, because it means imports and exports do not change the world price. A Tariff in a mall Country K A K T K FT ROW T K A T ROW Kerguelen Island Market for Oil R.O.W. Market for Oil Consider the market for oil in the Kerguelen Islands under free trade The Kerguelen Islands are very small and have an almost nonexistent population. They definitely qualify as a small country. No matter what they do, they cannot change the world price of oil. If trade in oil opens up with the rest of the world (ROW), the price of oil would simply drop to the world price. international trade essentials 2.docx 7 Revised on: 3/7/2018

8 Changes in Consumer & roducer urplus with a Tariff in a mall Country K A K T K FT ROW T K A T ROW Kerguelen Island Market for Oil R.O.W. Market for Oil The market for oil in Kerguelen with a tariff in effect The small country assumption tells us that changes in imports and exports won t affect the world price. Therefore, the price of oil in Kerguelen will simply rise by the amount of the tariff. K T = ROW + tariff Consumer surplus shrinks by an area = roducer surplus increase by an area = 1 The government collects tax revenues equal to area 3. Overall, there is a deadweight loss (WL) = This shouldn t be surprising. If moving to free trade increases economic surplus for a society, then moving away from free trade must lead to a loss of economic surplus. The equivalence of tariffs and quotas hysics: For each and every action, there is an equal and opposite reaction. Economics: For each and every tariff, there is an equivalent quota, and vice versa. An equivalent tariffs and quota raise price by the same amount and restrict imports by the same amount. o, if a tariff raises the price of oil by $20 a barrel and reduces imports to 8 million barrels, the equivalent quota would be an 8 million barrel quota. international trade essentials 2.docx 8 Revised on: 3/7/2018

9 Changes in roducer & Consumer urplus for a uota in a mall Country K A K K FT ROW K A ROW Kerguelen Island Market for Oil R.O.W. Market for Oil The nonequivalence of tariffs and quotas Assume that the Kerguelen Islands implement an import quota equal to (K K) from the tariff example. rice will rise to the same level as when they implemented the tariff. Consumer surplus will still fall by an area = roducer surplus will still rise by an area = 1. However, the government will not collect tariff revenue = 3. The WL is now are uotas can be more harmful than equivalent tariffs. Where does this go? It might go to: Foreign firms as extra profit. Then, yes, area 3 I lost to Kerguelen. It might go to whomever was granted the quota rights as a rent. Then it depends on where the quota right holder lives and spends their money. It could potentially be auctioned off. In which case it would raise approximately area 3 in revenue for the government. VERs are like quotas in which are 3 flows to the foreign producer as excess profits. international trade essentials 2.docx 9 Revised on: 3/7/2018

10 Rationales for interference 1) Military self sufficiency Which goods are truly critical for self sufficiency? 2) iversification for stability The U.. is not a banana republic with only one export. Nor is it audi Arabia. 3) Creation and protection of domestic jobs You often are robbing eter to pay aul. Tariffs on steel may protect steel jobs, but cost automobile jobs. Retaliatory tariffs are a real possibility. 4) rotection of infant industries rotection often fosters inefficiency. How does the government choose winners? Temporary tariffs last a long time. 5) umping Everyone wants fair trade. We want everyone to play by the same rues. umping refers to selling either below the cost of production or selling for less than it would be sold in the home country. umping can be difficult to detect in practice as it is difficult to know another producer s costs. umping is beneficial to some parties in the dumped on country. 6) Cheap foreign labor This is some countries basis for comparative advantage. Ours is advanced technology. A Brief History of Trade Agreements Reciprocal Trade Agreement Act of 1934 presidential authority to reduce tariffs bilateral in nature Generalized Agreement on Trade and Tariffs (1947) GATT was a series of multilateral trade negotiation rounds The first round was Anency Round (1949). The last round was the Uruguay Round ( ). The Uruguay Round established the World Trade Organization international trade essentials 2.docx 10 Revised on: 3/7/2018

11 General goals of GATT 1) articipants focused on lowering tariffs. 2) They also sought to establish a universal, multilateral, rather than bilateral, framework for trade. It generally prohibited discrimination among members. Members were granted most favored nation (MFN) status. 3) articipants also sought to eliminate quotas and subsidies. WTO The WTO has expanded from simply looking at merchandise trade to include services and especially intellectual property WTO rules cover books, movies, computer programs. eveloping nations have a longer time frame to comply. European Economic Community (Common Market) 1958 The Common Market evolved in a series of steps designed to bring closer economic integration among its members, much like states within the United tates. In a stepwise fashion, it sought, and has achieved, the following over time. 1) Reduction of internal tariffs 2) Establishment of common external tariffs 3) Free capital and labor mobility 4) Coordination of agricultural, transportation policy, etc. 5) A Common currency the euro 6) Common monetary policy conducted by the European Central Bank U.. Canada Free Trade Agreement 1989 This agreement was designed to counter Common Market. It reduced tariffs and barriers to trade on many goods. It also cleared the way for cross border investment. Never really cleared up disagreements over softwood lumber. Trade movements depended on swings in currency values. reempted by NAFTA. North American Free Trade Agreement This agreement covered Canada, the U.. and Mexico. It was designed to further reduce barriers to trade. Again, it was also designed to counter the Common Market. It was further intended to force Japan into lowering barriers. international trade essentials 2.docx 11 Revised on: 3/7/2018

12 ownsides Opponents argue that NAFTA led to job losses among lower wage/skill workers. They also argue that it led to penetration of the U.. markets when Japanese and Korean companies established plants along the border, maquiladoras. Opponents also argue that it led to increased pollution along U.. border, as Mexico had lower environmental standards. Upsides roponents cite the standard free trade argument. It allows goods and services to be produced at the lowest possible OC. roponents further argue that it improved our competitiveness with respect to the rest of the world. They note increased sales of agricultural products to Mexico as well. roponents argue that it reduced immigration. Jobs in Mexico reduce the incentive for moving to the U.. They argue that it increased political stability in the region. international trade essentials 2.docx 12 Revised on: 3/7/2018