Lessons from Chapter 3’s “farmer/rancher” example:

Specialization and trade (according to comparative advantage) makes both parties better off.

Reason for economists’ general preference for free trade and laws that promote free trade (NAFTA) . . .(http://en.wikipedia.org/wiki/NAFTA)

. . . and their opposition to trade barriers, like tariffs and quotas.

Not everyone agrees with this “free trade” philosophy.

One fairly recent case (www.pbs.org/newshour/ . . .)

In March 2002, President Bush imposed tariffs of up to 30% on imported steel in an effort to protect the slumping American steel industry.

These tariffs were repealed in less than two years.(http://www.cbsnews.com/ . . .)

More recently (Sept. 2009): President Obama imposed tariffs on imports of tires from China.(http://washingtonpost.com/ . . .)

Tariff is response to complaint filed with federal trade panel by United Steelworkers union.

U.S. tire industry lost 5,000 jobs in 5 yrs. prior to 2010. Four plants closed.

In favor of tariff: Workers and owners of U.S. tire companies.

Opposed to tariff: Chinese tire companies, U.S. tire importers, U.S. tire companies with plants abroad

Chinese Ministry of Commerce: “Tariff violates World Trade Organization rules.”

World Trade Organization (http://www.wto.org/):

An international organization dealing with global rules of trade among nations.

It’s “rules” are WTO agreements, negotiated and signed by a large majority of the world’s trading nations.

Agreements are legal “ground rules” for international commerce.

WTO serves as a “court” to mediate trade disputes.

Using supply and demand analysis with consumer/producer surplus tools, we will address:

What determines the direction of trade flows?(Why does a country import certain

products and export others?)

How are the gains from trade distributed?(Not uniformly. Some gain; but some

lose. That’s why some in U.S. favor free trade in steel; some oppose it.)

Simplifying assumptions of our analysis:

We’ll look at a hypothetical “small” country -- a change in the country’s trade policy will have only a negligible effect on the world market.

(Let’s call it “Isoland.”)

We’ll consider a homogeneous product -- “steel.”

Only one kind of steel. Domestic (Isolandian) and foreign steel are exactly the same.

We’ll consider two markets:- the “domestic” market (the market for

steel inIsoland)

- the “world” market (the market for steel in the rest-of-the-world; i.e., other than Isoland)

Let’s start with a “no trade” case.Isoland has strict laws prohibiting international trade in steel.

One possibility:

($/ton)

(tons/yr.)Isoland

Dd

Sd

($/ton)

(tons/yr.) World

Dw

Sw

pd

pw

pd < pw is a reflection of the fact that Isoland has a comparative advantage, relative to the rest-of-the-world, in steel production.

(Citizens of Isoland have to give up fewer units of other goods to get a ton of steel than do citizens of the rest of the world.)

(pd > pw would mean that the rest-of-the-world has a comparative advantage relative to Isoland.)

Now consider the “free trade case.” (Imagine that Isoland’s laws prohibiting trade are repealed.)

Isolandian steel producers won’t sell in Isoland at pd when they can get pw on the world market.

Prices of steel in domestic and world markets will have to equalize.

Because Isoland is a “small” country, domestic price does all of the adjusting – increasing to the current level of pw.

(Domestic consumers will have to pay pw in order to buy any steel at all.)

($/ton)

(tons/yr.)

Dd

Sd

domestic quantitydemanded

domesticquantitysupplied

exports

price before trade

price withtrade = pw

Now let’s consider the other possibility:

Before trade (when Isoland’s laws prohibit trade), the domestic price, pd, might be above world price, pw.

pd > pw means the rest-of-the-world has comparative advantage, relative to Isoland.

With free trade (when laws prohibiting trade are repealed), Isolandian consumers won’t buy domestic steel at pd when they can get foreign steel at pw.

Price of steel in Isoland will have to fall to pw.

(Domestic producers will have to sell at pw in order to sell any steel at all.)

($/ton)

(tons/yr.)

Dd

Sd

domesticquantitysupplied

domestic quantitydemanded

imports

price before tradeprice withtrade = pw

What determines the direction of trade flows?

When pd < pw (Isoland has comparative advantage in steel), Isoland will export.

When pd > pw (Rest-of-the-world has comparative advantage in steel), Isoland will import.

Consistent with lessons from “farmer/rancher” example.

Now let’s use consumer/producer surplus to illustrate gains from trade and see how they’re distributed.

Consider the exporting country first.

A

B D

C

before trade with trade changeconsumer surplusproducer surplus total surplus

A + B C

A + B + C

AB + C + D

A + B + C + D

- B+ (B + D)

+ D

quantityconsumeddomesticallyquantityproduceddomestically

($/ton)

(tons/yr.)Dd

Sd

price before trade

price withtrade = pw

Now let’s look at the case of an importing country.

before trade with trade changeconsumer surplusproducer surplus total surplus

AB + C

A + B + C

A + B + DC

A + B + C + D

+ (B + D)- B+ D

quantityproduceddomesticallyquantityconsumeddomestically

A

B DC

($/ton)

(tons/yr.)Dd

Sd

price before tradeprice withtrade = pw

Recap:

Regardless of whether the country ends up as an exporter or an importer . . .

. . . there are net gains from trade.

Gains are not uniformly distributed, however. Some gain,. . . some lose,

. . . but gainers’ gains outweigh losers’ losses.

Those who stand to lose from free trade have an incentive to argue for trade barriers.

Tariff: A tax on goods produced abroad and sold domestically.

(. . . like President Obama’s tariff onimports of tires).

Quota: A limit on the quantity of foreign-produced goods that can be sold domestically.

Effects of a tariff . . . on “steel,” let’s say.

For this analysis,- keep “small” country assumption -- Isoland- keep homogeneous good assumption.- take “free trade” as the starting point.- assume that Isoland is an importer of steel to start.

(pw < pd, the domestic price that would prevail if trade were prohibited)- then government of Isoland imposes a tariff (tax on imported steel) of t $/ton.

The tariff will raise the price to Isolandian consumers of foreign-made (imported) steel by t $/ton.

(Wait a minute! In chapter 6 we said that tax burden is shared. Buyers’ price goes up by less than $t/ton?. . . unless supply is perfectly elastic.)

Because steel is a homogeneous good, the price of domestically produced steel will also rise by t $/ton.

(Domestic producers can raise their price when the price of imported steel goes up.)

The market for steel in Isoland:

Sd

Dd

($/ton)

(tons/yr.)

Before thetariff goesinto effect . . .

Q1d

quantity demanded domestically = Q1d tons/yr.

Q1s

quantity produced domestically = Q1s tons/yr.

quantity imported = Q1d - Q1

s tons/yr.

importspw

price (of foreign and domestic steel) = pw $/ton.

The market for steel in Isoland:

price (of foreign and domestic steel) = pw + t $/ton.Q2

d

quantity demanded domestically = Q2d tons/yr.

Q2s

quantity produced domestically = Q2s tons/yr.

quantity imported = Q2d - Q2

s tons/yr.

imports Dd

($/ton)

(tons/yr.)

pw

Q1s Q1

d

SdThe tariffraises the priceof steel byt $/ton.

pw + t

Dd

($/ton)

pw

Q1s Q1

d

Sd

pw + t

Q2s Q2

d (tons/yr.)

Now thewelfare analysis:

consumer surplusproducer surplustariff revenuetotal surplus

w/o tariff w. tariff changeA+B+C+D+E+F

G 0

A+B+C+D+E+F+G

A+B C+G

EA+B+C+E+G

- (C+D+E+F)+C+E

- (D+F)

The tariff resultsin a deadweightloss of D + F.

A

C E

BD

F

G

Dd

($/ton)

pw

Q1s Q1

d

Sd

pw + t

Q2s Q2

d (tons/yr.)

Let’s take a closer look at the deadweight loss.

D is a loss due to“over-production”:Domestic producerssupply Q2

s - Q1s tons/yr.

that could be producedat lower opportunitycost abroad.

F is a loss due to “under-consumption”: Q1d - Q2

d tons/yr.are not consumed, even though willingness to pay exceeds(foreign) opportunity cost of production.

D

F

Let’s review the tariff’s effects.

When the tariff is imposed:

Domestic (Isolandian) producers gain -- they sell more at a higher price. (That’s the point. Tariffs are supposed to help domestic producers.)

Domestic (Isolandian) consumers lose -- they consume less at a higher price.

Some of domestic consumers’ loss . . .

. . . is recaptured by domestic producers (area C),

. . . some shows up as tariff revenue (area E),

. . . but some is not recaptured; it’s the deadweight loss (areas D and F).

For the economy as a whole (considering just the maximization of total surplus), the tariff is bad policy.

What about a quota?

Suppose that, instead of a tariff = t $/ton, the government limited steel imports to Q2

d - Q2s

tons/yr.

A little more complicated, but here’s the bottom line:

Effects very similar to that of the tariff.

In particular . . .

. . . same effect on price (increase to pw + t $/ton),. . . same effects on quantities produced and

consumed domestically, and. . . same effects on consumer and producer surplus.

The only difference:What happens to the tariff revenue (area E)?

Government would achieve import restriction by issuing licenses to import Q2

d - Q2s tons/yr. --

no more.

Holders of these licenses could buy foreign steel at pw on world market and resell it at pw + t in Isoland.

What was tariff revenue becomes profit for import license holders . . .

. . . unless, of course, government charges a price for the licenses.

Now back to the tariff. The lesson is that tariffs are bad policy.

So why do we have tariffs?

Shouldn’t our nation’s leaders recognize that tariffs are bad policy and just say “No!”?

A couple of possibilities:

Maybe there are some good reasons for tariffs (or other kinds of trade barriers) -- more on this later.

Or, maybe those who stand to gain from the tariff (workers and owners of domestic firms) have more political clout than those who stand to lose (domestic consumers).

Total gains/losses vs. per capita gains/losses and incentives to lobby.

An example using some hypothetical numbers:Loss from tire tariff in U.S. = higher prices for consumers of tires:$2/person/year x 300,000,000 people in U.S. =

total loss of $600,000,000/year

Gains from tire tariff in U.S. = greater job security for tire industry workers (valued at $10K/worker/year):

$10,000/worker/year x30,000 workers in U.S. tire industry =

total gain of $300,000,000/year.

Total loss is twice as great as total gain.

But per capita loss ($2/loser) is trivial compared to per capita gain ($10,000/gainer).

Potential gainers have much more incentive to lobby than potential losers.

Arguments (some valid; some bogus) for trade barriers:

“Jobs” argument:

Permitting imports will reduce domestic production of the good and reduce employment in the domestic industry.

“National security” argument:

For certain products, production capacity must be maintained because it is vital in times of crisis.

“Infant-industry” argument:

Sometimes new industries need temporary protection from import competition to help them get started.

“Protection-as-a-bargaining-chip-or-weapon” argument:

The only way to convince our trading partners to drop their trade barriers may be to threaten them with trade barriers of our own.

“Unfair competition” argument

Foreign governments sometimes subsidize their export industries. U.S. industries only want a “level playing field.”

(This was probably the main argument used to support the Bush administration steel tariffs.)

Now back to President Obama’s tire tariff . . .

Some argue that:

China is guilty of “predatory trade practices.”

Our tire tariff may be bad policy, but it sends the right message.

For a defense of Obama tire tariff (using “Protection as a weapon” argument) see:

http://www.washingtonpost.com/ . . .

One risk of imposing trade barriers:

Trigger “tit-for-tat” retaliation and a “trade war.”

Just this past September:

China imposed a steep tariff on U.S. poultry(http://www.nytimes.com . . . )

Poultry is one of the few categories in which the U.S. runs a trade surplus with China.