18.1 Benefits from Specialization and Trade

• Shirtland and Chipland Example:

  • In a single day, Shirtland can produce a maximum of either 108 shirts or 36 chips, whereas Chipland can produce a maximum of either 120 shirts or 120 computer chips. The opportunity cost of chips for Shirtland is 3 shirts and for Chipland it is 1 shirt.

• If Shirtland and Chipland are each self-sufficient:

  • The production possibilities curve shows all the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used.

  • We assume the curve is a straight line, indicating a constant trade-off between the two goods.

  • The following Shirtland’s combination of chips and shirts are possible:

    • All shirts and no chips: point a. If Shirtland uses all its resources to produce shirts, it will produce 108 shirts per day.

    • All chips and no shirts: point d. If Shirtland uses all its resources to produce chips, it will produce 36 chips per day.

    • Equal division of resources: point b. Shirtland could divide its resources between shirts and chips to produce 54 shirts and 18 chips each day.

• All the other points on the line connecting points a and b are also feasible.

  • In Chipland, the trade-off is one shirt per computer chip: The opportunity cost of one chip is one shirt, so the slope of the production possibilities curve is negative 1.0.

  • Each nation could decide to be self-sufficient, picking a point on its production possibilities curve and producing everything it wants to consume.

• The nation with the lower opportunity cost has a comparative advantage in producing that good.

• It is comparative advantage that matters for trade-not absolute advantage, the ability of a nation to produce a particular good at a lower absolute cost than that of another nation.

• For example, the chips produced in Chipland have a comparative advantage in the production of chips because Chipland sacrifices fewer shirts to produce one chip, Chipland should produce chips.

• Terms of trade is the rate at which units of one product can be exchanged for units of another product.

• Under free trade, each nation will begin to specialize in a single good, causing considerable changes in the country’s employment in differ industries.

  • In Chipland, the chip industry doubles in size-output increases from 60 to 120 chips per day- while the shirt industry disappears.

    • Workers and other resources will leave the shirt industry and move to the chip industry.

    • In Shirtland, the workers and other resources move from one chip industry to the shirt industry.

• Switching from self-sufficiency to specialization and trade increases consumption in both nations, so on average people in each nation benefit from free trade while some people are harmed in both nation.

  • In Chipland, people in the shirt industry will lose their jobs when the shirt industry disappears. Some workers can easily move into the expanding computer chip industry and free trade is likely to be beneficial. However, other shirt workers will be unable to make the move to the chip industry and will be forced to accept lower-paying jobs or face unemployment.

18.2 Protectional Policies

• The domestic supply curve shows the quantity of shirts supplied by firms in Chipland.

  • The total supply curve for shirts, which shows the quantity supplied by both domestic firms and foreign firms, lies to the right of the domestic supply curve.

  • At each price, the total supply of shirts exceeds the domestic supply because foreign firms supply shirts.

  • The demand curve from domestic residents intersects the total supply surge at a price of $12 per shirt and a quantity of 80 shirts. Since this price is below the minimum price for domestic firms, domestic firms produce no shirts, and all the shirts in Chipland are imported from Shirtland.

• If Chipland bans imported shirts, the foreign suppliers will disappear from the shirt market, so the total supply of shirts will be the domestic supply.

• The decrease in supply resulting from the import ban increases the price consumers have to pay for shirts and decreases the quantity available for them to pay.

• Import quota is a government imposed limit on the Quinn of a good that can be imported. It is illegal under international trading rules.

• To get around international trading rules, an exporting country would have to agree to a voluntary export restraint (VER) which is a scheme under which an exporting country voluntarily decreases its exports.

• A VER produces winners and losers.

  • The winners include foreign and domestic shirt producers p.

  • The losers are consumers, who pay a higher price for shirts.

• In some cases, the government issues import licenses, which are rights issued by a government, to import goods to some citizens. Since import licenses provide profits to the holder, they are often awarded to politically powerful firms or individuals and some may bribe government officials to obtain them.

• An alternative to a quota or a VER is an import tariff, which is a tax on an imported goods

• An import quota allows importers to buy shirts from foreign suppliers at a low price. In other words, importers make money from the quota.

• Under a tariff, the government gets the money.

• A restriction on imports is likely to lead to further restrictions on trade.

• If a trade war happens, the two countries would be forced to scale back their consumption.

• Many import restrictions have led to retaliatory policies and lessened trade like the Smoot-Harley Tariff Act of 1930.

  • When the United States increases its average tariff on imports to 59%, its trading partners retaliated with higher tariff on U.S products. In result, trade war reduced international trade and deepened the worldwide depression of the 1930s.

• Import restrictions create an incentive to smuggle goods.

18.3 What Are the Rationales for Protectionist Policies?

• One of the most basic arguments for protectionism is that it shields workers in industries that would be hurt by trade.

• If the United States were to reduce existing tariffs on textiles, domestic manufacturers could not compete. They would have to close their factories and lay off workers.

• Politicians from that region will try to keep tariffs in place to prevent temporary unemployment and changes in employment patterns in their areas which may cause major economic losses for the economy. The result of this production will be less-efficient production, higher prices, and lower consumption for the United States.

• Learning by doing is the knowledge and skills workers gain during production that increase productivity and lower cost.

• Infant industries are the industries that are at an early stage of development.

• A tariff shields a young industry from the competition of its mature rivals. After the infant industry “grows up”, the tariff can eventually be eliminated because the industry is able to compete.

• A problem with protecting an infant industry is that once a government gives an industry tariff protection, it is difficult to take the protection away.

• If the production of a particular good requires extremely large economies of scale, the world market will support only a few or just one firm.

  • In this case a nation might be tempted to adopt policies to ensure a company within its border will end up being the world monopolist.

• If both nations subsidize their domestic firms, both firms will enter the market and lose money. Also, the taxpayers in both countries will then have to pay for the subsidies. Second, a nation may pick the wrong industry to subsidize.

18.4 A Brief History of International Tariff and Trade Agreements

• Today, the average U.S. tariff is 4.6 percent of the value of imported goods, a rate close to the average tariffs in Japan and most European nations but very low by historical standards.

• When the Smoot-Hawley tariffs were implemented in the 1930s, the average U.S. tariff was a whopping 59% of a product’s price.

• The General Agreement on Tariffs and Trade (GATT) is an international agreement established in 1947 that has lowered trade barriers between the United States and other nations.

• The World Trade Organization (WTO) is an organization established in 1995 that oversees GATT and other international trade agreements, resolves trade disputes, and holds forums for further rounds of trade negotiations.

• The North American Free Trade Agreement (NAFTA) took effect in 1994 and was implemented over a 15-year period. It eliminates all tariffs and other trade barriers between Canada, Mexico, and other United States.

• The European Union (EU) was designed to remove all trade barriers within Europe and create a single market.

• The leaders of 18 Asian nations have formed an organization called Asian Pacific Economic Cooperation (APEC). In 1994, APEC signed a non-binding agreement to reduce trade barriers among nations.

• The Dominican Republic-Central American Free Trade Agreement (DR-CAFTA) promotes trade liberalization between the United States, the Dominican Republic, and five Central American countries.

18.5 Recent Policy Debates and Trade Agreements

• Dumping is a situation in which the price a firm charges in foreign market is lower than either the price it charges in its home markets or the production cost which is illegal under international trade agreements.

• A firm dump would charge a low price in foreign market because of price discrimination.

• Price discrimination is the price of selling a good at different prices to different consumers.

• If a firm has a monopoly in its home market but faces strong competition in a foreign market, it will naturally charge a higher price in the home market. The firm is using its monopoly power to charge higher prices to its consumers at home and charge lower prices to consumers abroad where it faces competition.it minimizes the firm's profits.

• Predatory Pricing is a firm that sells a product at a price below its production cost to drive a rival out of business and then increases the price.

• Increased trade would lead to worldwide environmental degradation.

• Under current WTO rules, a country can adopt any environmental standard it chooses, as long it does not discriminate against foreign producers.

• The United States can’t ban imported goods produced by factories that generate air or water pollution in other countries.

• Countries differ in the value they place on the environment.

  • For instance, a poor nation may be willing to tolerate more pollution if it means attaining a higher standard of living for its citizens.

• Outsourcing are firms producing components of their olds and services in other countries.