978-1305971509 Chapter 9 Lecture Notes

WHAT’S NEW IN THE EIGHTH EDITION:

Two new features have been added, an In the News feature on “Trade as a Tool for Economic

Development” and an Ask the Experts feature on “Trade Deals.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 what determines whether a country imports or exports a good.

 who wins and who loses from international trade.

 that the gains to winners from international trade exceed the losses to losers.

 the welfare e ects of tari s and import quotas.

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on a password-protected website or school-approved learning management system for classroom use.

9APPLICATION:

INTERNATIONAL TRADE

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 the arguments people use to advocate trade restrictions.

CONTEXT AND PURPOSE:

Chapter 9 is third in a three-chapter sequence dealing with welfare economics. Chapter 7

introduced welfare economics: the study of how the allocation of resources a ects economic

well-being. Chapter 8 applied the lessons of welfare economics to taxation. Chapter 9

applies the tools of welfare economics from Chapter 7 to the study of international trade, a

topic that was 9rst introduced in Chapter 3.

The purpose of Chapter 9 is to use welfare economics to address the gains from trade

more precisely than in Chapter 3, which discussed comparative advantage and the gains

from trade. This chapter develops the conditions that determine whether a country imports

or exports a good and discusses who wins and who loses when a country imports or exports

a good. This chapter will show that when free trade is allowed, the gains of the winners

exceed the losses of the losers. Because there are gains from trade, restrictions on free

trade reduce the gains from trade and cause deadweight losses similar to those generated

by a tax.

KEY POINTS:

 The e ects of free trade can be determined by comparing the domestic price before

trade with the world price. A low domestic price indicates that the country has a

comparative advantage in producing the good and that the country will become an

exporter. A high domestic price indicates that the rest of the world has a comparative

advantage in producing the good and that the country will become an importer.

 When a country allows trade and becomes an exporter of a good, producers of the good

are better o , and consumers of the good are worse o . When a country allows trade

and becomes an importer of a good, consumers are better o , and producers are worse

o . In both cases, the gains from trade exceed the losses.

 A tari —a tax on imports—moves a market closer to the equilibrium that would exist

without trade and, therefore, reduces the gains from trade. Although domestic producers

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Chapter 9/Application: International Trade ❖ 153

are better o and the government raises revenue, the losses to consumers exceed these

gains.

 There are various arguments for restricting trade: protecting jobs, defending national

security, helping infant industries, preventing unfair competition, and responding to

foreign trade restrictions. Although some of these arguments have merit in some cases,

most economists believe that free trade is usually the better policy.

CHAPTER OUTLINE:

I. The Determinants of Trade

A. Example used throughout the chapter: The market for textiles in a country called

Isoland.

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on a password-protected website or school-approved learning management system for classroom use.

Point out that international trade issues are no di erent from trading as it

applies to individuals within a community or between states and regions

within a country. The gains from trade between countries occur for the

same reasons that we observe gains from trade between individuals.

Pick a state adjacent to yours. Ask students why we do not seem to worry

This chapter may be di@cult to teach and very di@cult for students to

understand and accept. Be prepared for a skeptical reaction from students

who have been told that free international trade is detrimental to a

country. For various historical, cultural, and political reasons, free trade

has few defenders outside of the economics profession.

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B. The Equilibrium without Trade

1. If there is no trade, the domestic price in the textile market will balance supply

and demand.

2. A new leader is elected who is interested in pursuing trade. A committee of

economists is organized to determine the following:

a. If the government allows trade, what will happen to the price of textiles and

the quantity of textiles sold in the domestic market?

b. Who will gain from trade, who will lose, and will the gains exceed the losses?

c. Should a tari (a tax on imported textiles) be part of the new trade policy?

C. The World Price and Comparative Advantage

1. The 9rst issue is to decide whether Isoland should import or export textiles.

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Figure 1

Chapter 9/Application: International Trade ❖ 155

a. The answer depends on the relative price of textiles in Isoland compared with

the price of textiles in other countries.

b. De9nition of world price: the price of a good that prevails in the world

market for that good.

2. If the world price is greater than the domestic price, Isoland should export

textiles; if the world price is lower than the domestic price, Isoland should import

textiles.

a. Note that the domestic price represents the opportunity cost of producing

textiles in Isoland, while the world price represents the opportunity cost of

producing textiles abroad.

b. Thus, if the domestic price is low, this implies that the opportunity cost of

producing textiles in Isoland is low, suggesting that Isoland has a comparative

advantage in the production of textiles. If the domestic price is high, the

opposite is true.

II. The Winners and Losers from Trade

A. We can use welfare analysis to determine who will gain and who will lose if free trade

begins in Isoland.

B. We will assume that, because Isoland would be such a small part of the market for

textiles, they will be price takers in the world economy. This implies that they take

the world price as given and must sell (or buy) at that price.

C. The Gains and Losses of an Exporting Country

1. If the world price is higher than the domestic price, Isoland will export textiles.

Once free trade begins, the domestic price will rise to the world price.

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156 ❖ Chapter 9/Application: International Trade

2. As the price of textiles rises, the domestic quantity of textiles demanded will fall

and the domestic quantity of textiles supplied will rise. Thus, with trade, the

domestic quantity demanded will not be equal to the domestic quantity supplied.

3. Welfare without Trade

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Figure 2

Have students come to the board and label the areas of consumer and

producer surplus after you have drawn each of the 9gures. This should not

be a problem as they are likely familiar enough with consumer and

producer surplus after completing Chapters 7 and 8.

Chapter 9/Application: International Trade ❖ 157

a. Consumer surplus is equal to: A + B.

b. Producer surplus is equal to: C.

c. Total surplus is equal to: A + B + C.

4. Welfare with Trade

a. Consumer surplus is equal to: A.

b. Producer Surplus is equal to: B + C + D.

c. Total surplus is equal to: A + B + C + D.

5. Changes in Welfare

a. Consumer surplus changes by: –B.

b. Producer surplus changes by: +B + D.

c. Total surplus changes by: +D.

6. When a country exports a good, domestic producers of the good are better o

and domestic consumers of the good are worse o .

7. When a country exports a good, total surplus is increased and the economic

well-being of the country rises.

D. The Gains and Losses of an Importing Country

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158 ❖ Chapter 9/Application: International Trade

1. If the world price is lower than the domestic price, Isoland will import textiles.

Once free trade begins, the domestic price will fall to the world price.

2. As the price of textiles falls, the domestic quantity of textiles demanded will rise

and the domestic quantity of textiles supplied will fall.

a. Thus, with trade, the domestic quantity demanded will not be equal to the

domestic quantity supplied.

b. Isoland will import the di erence between the domestic quantity demanded

and the domestic quantity supplied.

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Figure 3

Note that there will be both imported and domestically produced textiles

sold in this country. This is true for many imported goods.

Chapter 9/Application: International Trade ❖ 159

3. Welfare without Trade

a. Consumer surplus is equal to: A.

b. Producer surplus is equal to: B + C.

c. Total surplus is equal to: A + B + C.

4. Welfare with Trade

a. Consumer surplus is equal to: A + B + D.

b. Producer surplus is equal to: C.

c. Total surplus is equal to: A + B + C + D.

5. Changes in Welfare

a. Consumer surplus changes by: +B + D.

b. Producer surplus changes by: –B.

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160 ❖ Chapter 9/Application: International Trade

c. Total surplus changes by: +D.

6. When a country imports a good, domestic consumers of the good are better o

and domestic producers of the good are worse o .

7. When a country imports a good, total surplus is increased and the economic

well-being of the country rises.

E. Trade policy is often contentious because the policy creates winners and losers. If the

losers have political clout, the result is often trade restrictions such as tari s and

quotas.

F. The E ects of a Tari

1. De9nition of tarif: a tax on goods produced abroad and sold domestically.

2. A tari raises the price above the world price. Thus, the domestic price of textiles

will rise to the world price plus the tari .

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Point out that during the 1990s with open trading (for example, the

passage of NAFTA), the U.S. economy achieved and maintained full

employment even as large quantities of imported goods entered the

United States. Most of the jobs that “left the country” were low-skill,

Be prepared for students to argue that trade cannot be good for everyone.

More than likely at least one of your students will know an individual who

lost his or her job when a factory closed and moved to another country.

Take this opportunity to point out that this individual is one of the “losers,”

but remind the class that the gains from trade exceed the losses, so the

Chapter 9/Application: International Trade ❖ 161

3. As the price rises, the domestic quantity of textiles demanded will fall and the

domestic quantity of textiles supplied will rise. The quantity of imports will fall

and the market will move closer to the domestic market equilibrium that occurred

before trade.

4. Welfare before the Tari (with trade)

a. Consumer surplus is equal to: A + B + C + D + E + F.

b. Producer surplus is equal to: G.

c. Government revenue is equal to: zero.

d. Total surplus is equal to: A + B + C + D + E + F + G.

5. Welfare after the Tari

a. Consumer surplus is equal to: A + B.

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Figure 4

162 ❖ Chapter 9/Application: International Trade

b. Producer surplus is equal to: C + G.

c. Government revenue is equal to: E.

d. Total surplus is equal to: A + B + C + E + G.

6. Changes in Welfare

a. Consumer surplus changes by: –C – D – E – F).

b. Producer surplus changes by: +C.

c. Government revenue changes by: +E.

d. Total surplus changes by: –D – F.

G. FYI: Import Quotas: Another Way to Restrict Trade

1. An import quota is a limit on the quantity of a good that can be produced abroad

and sold domestically.

2. Import quotas are much like tari s.

a. Both tari s and quotas raise the domestic price of the good, reduce the

welfare of domestic consumers, increase the welfare of domestic producers,

and cause deadweight losses.

b. However, a tari raises revenue for the government, whereas a quota creates

surplus for license holders.

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Chapter 9/Application: International Trade ❖ 163

c. A quota can potentially cause a larger deadweight loss than a tari ,

depending on the mechanism used to allocate the import licenses.

H. The Lessons for Trade Policy

1. If trade is allowed, the price of textiles will be driven to the world price. If the

domestic price is higher than the world price, the country will become an importer

and the domestic price will fall. If the domestic price is lower than the world price,

the country will become an exporter and the domestic price will rise.

2. If a country imports a product, domestic producers are made worse o , domestic

consumers are made better o , and the gains of consumers outweigh the losses

of producers. If a country exports a product, domestic producers are made better

o , domestic consumers are made worse o , and the gains of producers outweigh

the losses of consumers.

3. A tari would create a deadweight loss because total surplus would fall.

I. Other Bene9ts of International Trade

1. In addition to increasing total surplus, there are several other bene9ts of free

trade.

2. These include an increased variety of goods, lower costs through economies of

scale, increased competition, and an enhanced Oow of ideas.

J. In the News: Trade as a Tool for Economic Development

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on a password-protected website or school-approved learning management system for classroom use.

This section provides a good opportunity to review what the students

have learned thus far about trade. You should reinforce the idea that total

surplus rises when trade is introduced, but falls once trade restrictions are

164 ❖ Chapter 9/Application: International Trade

1. Free trade in poor countries is a simple, yet e ective, solution to the poverty

problem.

2. For more than two decades, the global poverty rate has been decreasing about 1

percent per year due to free trade.

III. The Arguments for Restricting Trade

A. The Jobs Argument

1. If a country imports a product, domestic producers of the product will have to lay

o workers because they will decrease domestic output when the price declines

to the world price.

2. Free trade, however, will create job opportunities in other industries where the

country enjoys a comparative advantage.

B. In the News: Should the Winners from Free Trade Compensate the Losers?

1. In light of the jobs argument, some people argue for taxpayer-subsidized

retraining programs to help those who lose their jobs due to free trade.

2. This opinion piece from The New York Times focuses on the net gains from trade

and argues for no compensation for the losers from trade by drawing parallel

examples from daily life.

C. The National-Security Argument

1. Protecting certain industries may be appropriate if they produce products

necessary for national security.

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Chapter 9/Application: International Trade ❖ 165

2. In many of the cases for which this argument is used, the role of the particular

market in providing national security is exaggerated.

D. The Infant-Industry Argument

1. New industries need time to establish themselves to be able to compete in world

markets.

2. Sometimes older industries argue that they need temporary protection to help

them adjust to new conditions.

3. Even if this argument is legitimate, it is nearly impossible for the government to

choose which industries will be pro9table in the future and it is even more di@cult

to remove trade restrictions in an industry once they are in place.

E. The Unfair-Competition Argument

1. It is unfair if 9rms in one country are forced to comply with more regulations than

9rms in another country, or if another government subsidizes the production of a

good.

2. Even if another country is subsidizing the production of a product so that it can be

exported to a country at a lower price, the domestic consumers who import the

product gain more than the domestic producers lose.

F. The Protection-as-a-Bargaining-Chip Argument

1. Threats of protectionism can make other countries more willing to reduce the

amounts of protectionism they use.

2. If the threat does not work, the country has to decide if it would rather reduce the

economic well-being of its citizens (by carrying out the threat) or lose credibility in

negotiations (by reneging on its threat).

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G. Case Study: Trade Agreements and the World Trade Organization

1. Countries wanting to achieve freer trade can take two approaches to cutting trade

restrictions: a unilateral approach or a multilateral approach.

2. A unilateral approach occurs when a country lowers its trade restrictions on its

own. A multilateral approach occurs when a country reduces its trade restrictions

while other countries do the same.

3. The North America Free Trade Agreement (NAFTA) and the General Agreement on

Tari s and Trade (GATT) are multilateral approaches to reducing trade barriers.

4. The rules established under GATT are now enforced by the World Trade

Organization (WTO).

5. The functions of the WTO are to administer trade agreements, provide a forum for

negotiation, and handle disputes that arise among member countries.

H. Ask the Experts: Trade Deals

1. 93 percent of economic experts agreed that past trade deals have bene9ted most

Americans, while the remaining 7 percent are uncertain.

2. 49 percent of economic experts agreed that it is a bad policy to refuse to trade

unless environmental and labor concerns are addressed because trade

restrictions cause large market distortions. 25 percent disagreed and 26 percent

were uncertain.

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Make sure that you point out the conclusion in this chapter. The chapter

ends with a very e ective parable about the discovery of comparative

advantage, its adoption, its bene9cial consequences, and 9nally, its

abandonment for political reasons.