Economic Reasoning, Lecture 4

Tariffs and Trade Restrictions

Foreign Trade

●The most important principle to remember in thinking about tariffs is one we covered in the first lecture.

●Whenever you make an exchange, you want what you are getting more than what you are giving up. Both parties to an exchange expect to benefit.

●This is no different for foreign trade. This rule doesn’t just apply to trades within one country.

Benefits of Trade

●We know that whenever an exchange takes place, the parties expect to benefit. But this doesn’t tell us how important exchange is.

● In fact, it is extremely important. Imagine if you had to grow all your own crops, build a house, make clothes, etc., entirely by yourself. Almost nothing would be produced, and many people would be completely helpless.

Division of Labor

●If people specialize in particular jobs and trade with one another instead of producing everything by themselves, they will be able to produce much more.

●Why is this?●People have different abilities. If they

specialize in what they do best, they can make more than if each person does a little of everything

Division of Labor Continued

●Particular places are more suitable for producing certain things than others. Obviously, you can’t mine gold or coal if these materials aren’t around. Not all areas are good for farmland.

●Besides natural differences,people who specialize in one or a few activities get better at them.

More Division of Labor

●Division of labor makes possible large accumulations of tools and machinery. These are called capital goods. Self-sufficient individuals couldn’t do this.

●Also, division of labor makes possible economies of scale. Remember the discussion in the last lecture of the law of diminishing marginal returns. Sometimes, there can be increasing returns to scale.

Division of Labor and International Trade

●How far can increases in productivity caused by the division of labor go?

● If trade is blocked, this limits the division of labor. “The division of labor is limited by the extent of the market” ( Adam Smith)

●Of course this applies to trade between countries. Tariffs and other trade restrictions, such as import quotas, limit the international division of labor.

●A tariff is a tax on trade.

Ricardo’s Law of Comparative Costs

●You might think that there is a limit to successful trades. Suppose that you are better at growing both apples and oranges than I am. Why would you trade with me, to get either apples or oranges? Won’t you get more by just relying on your own production?

Ricardo’s Law Continued

●Ricardo showed that this isn’t true. Even if you are better than me in producing both apples and oranges, it will be to your advantage to specialize in the good that you have the bigger advantage in producing.

●Suppose you can harvest a lot more apples than I can, but only a few more oranges. Then, it will be to your advantage to specialize in apples and to my advantage to specialize in oranges. I have a comparative advantage in oranges, but an absolute disadvantage.

Still More Ricardo’s Law

●Here is an easier way to see the point of Ricardo’s Law. Suppose that you are a very highly paid lawyer and also a skilled amateur carpenter. You would probably be better off to hire a carpenter to do household repairs, even if you could do a better job yourself.

An Objection

●Some people who don’t like free trade have raised an objection to Ricardo’s Law. Paul Craig Roberts is one of these.

●The Law is about cases where there is a difference in productivity. Sometimes the reason for this difference is that that there are more capital goods in one place than another.

The Objection Continued

●The objection is that the law depends on holding capital goods fixed. Without this assumption, the capital goods might move out of the less productive area entirely.

●The proper response to this is, “so what?” It isn’t a good objection to a theory that it applies only in certain conditions.

Mises and the Law of Association

●Mises pointed out that the law of comparative costs isn’t limited to cases with fixed capital goods, as in Ricardo’s example.

●It can apply in any case where people of different abilities engage in trade. Ricardo’s examples are just part of a general Law of Association.

Tariffs and Trade Restrictions

●Given that we know trade only takes place when everyone involved in the trade expects to benefit, the problem with tariffs and trade restrictions is obvious.

●Tariffs prevent people from acting to their own advantage.

●Tariffs interfere with the international division of labor.

An Objection

●The most popular objection to this standard objection to tariffs is, “Not so fast! Even if the parties to a trade expect to benefit from it, what about third parties? If foreign car sellers undersell American car makers and drive them out of business, the manufacturers and the workers they employ are made worst off. Free trade doesn’t make everyone better off.”

Hazlitt’s Answer

●It’s true that people in the American car industry will be worse off under free trade than under a tariff. But it doesn’t follow that total American employment will fall.

●The argument that free trade has bad effects on a country commits the broken window fallacy. Consumers who pay lower prices for foreign cars have more money to spend on other things. There will be no loss in employment. In fact, employment will go up, because with free trade, resources are used efficiently.

Response to Hazlitt

●The pro-tariff advocate is not yet silenced. He can say, “All right, Total employment won’t go down. But American employment will. The money spent on foreign cars leaves America. It may help employment in another country, but what good does that do us?”

Another Answer

●This objection is also wrong. When dollars are sent abroad, what are the buyers going to do with the American money?

●They must either spend the money on American goods or exchange the American money with those who intend to use it to buy American goods. When money is spent on American goods, this increases American employment. Exports pay for imports.

The Balance of Trade

●Another possibility is that foreign holders of American money invest it in the United States. This again creates American jobs.

●If the foreign holders of American money don’t do any of these things, then they would be giving away the goods that American have imported.

The Balance of Trade Continued

●People often talk about an “unfavorable” balance of trade. This is a situation in which exports are less than imports.

●There is nothing bad about this. Either foreign money will be invested in America or the goods are being given away.

●There are some complications when foreign debt affects the value of money, but that is a difficult topic.

Another Objection

●So far, we have been arguing that free trade doesn’t reduce employment. To the contrary, trade expands the division of labor and thus increases productivity and employment.

●Someone might object, “Even if free trade makes the economy better off, some people are hurt by free trade. What about them?”

A Questionable Assumption

●This objection rests on taking all the people in a particular nation as an important unit in economic analysis.

●Rothbard pointed out that for economics, there is nothing special about the nation. If tariffs are supposed to protect particular national industries from foreign competition, why not tariffs for cities or neighborhoods? If firms that are put out of business by competitors within a country don’t get compensation, why does this change when the competition is foreign?

Dumping

●Sometimes, defenders of tariffs claim that foreign competitors of American firms get subsidies from their governments and are able to drive the American firms out of business by selling below cost.

●But this benefits American consumers. Why are the firms entitled to protection, when domestic firms are not? Economic competition is about serving consumers. It is not a race that must have a “fair” starting point.

Infant Industries

●One argument for tariffs is that a new industry often can’t immediately compete with well-established foreign firms.

●If it receives protection for a while, it will gain experience and can then compete effectively.

Infants Continued

●Such subsidies raise prices for consumers. Again, this argument commits the broken window fallacy.

●Further, why is it desirable to build up a firm faster then the unhampered market would do? People who think such a firm will be profitable are free to finance it privately.