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WHAT’S NEW IN THE SEVENTH EDITION:
A new
In the News
feature on “Threats to Free Trade” has been added.
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 effects of tariffs and import quotas.
➢ 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 affects 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 first 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
9
APPLICATION: INTERNATIONAL
TRADE
Chapter 9/Application: International Trade ❖ 161
KEY POINTS:
• The effects of free trade can be determined by comparing the domestic price without trade to 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
off, and consumers of the good are worse off. When a country allows trade and becomes an importer
of a good, consumers are better off, and producers are worse off. In both cases, the gains from trade
exceed the losses.
• 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, 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.
B. The Equilibrium without Trade
1. If there is no trade, the domestic price in the textile market will balance supply and demand.
This chapter may be difficult to teach and very difficult 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.
Point out that international trade issues are no different 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.
162 ❖ Chapter 9/Application: International Trade
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?
C. The World Price and Comparative Advantage
1. The first issue is to decide whether Isoland should import or export textiles.
a. The answer depends on the relative price of textiles in Isoland compared with the price
of textiles in other countries.
b. Definition 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.
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.
Figure 1
Chapter 9/Application: International Trade ❖ 163
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
3. Welfare without Trade
a. Consumer surplus is equal to: A + B.
Figure 2
Have students come to the board and label the areas of consumer and producer
surplus after you have drawn each of the figures. This should not be a problem as
they are likely familiar enough with consumer and producer surplus after completing
Chapters 7 and 8.
164 ❖ Chapter 9/Application: International Trade
b. Producer surplus is equal to: C.
c. Total surplus is equal to: A + B + C.
4. Welfare with Trade
5. Changes in Welfare
a. Consumer surplus changes by: –B.
6. When a country exports a good, domestic producers of the good are better off and domestic
consumers of the good are worse off.
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
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.
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 ❖ 165
3. Welfare without Trade
a. Consumer surplus is equal to: A.
4. Welfare with Trade
a. Consumer surplus is equal to: A + B + D.
5. Changes in Welfare
a. Consumer surplus changes by: +B + D.
6. When a country imports a good, domestic consumers of the good are better off and domestic
producers of the good are worse off.
Figure 3
166 ❖ Chapter 9/Application: International Trade
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 tariffs and quotas.
F. The Effects of a Tariff
1. Definition of tariff: a tax on goods produced abroad and sold domestically.
2. A tariff raises the price above the world price. Thus, the domestic price of textiles will rise to
the world price plus the tariff.
4. Welfare before the Tariff (with trade)
a. Consumer surplus is equal to: A + B + C + D + E + F.
b. Producer surplus is equal to: G.
Figure 4
Point out that during the 1990s with open trading (for example, the passage of
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 total well-being of society is increased.
Chapter 9/Application: International Trade ❖ 167
5. Welfare after the Tariff
a. Consumer surplus is equal to: A + B.
6. Changes in Welfare
a. Consumer surplus changes by: –C - D - E - F).
b. Producer surplus changes by: +C.
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 tariffs.
a. Both tariffs 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.
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 off, domestic consumers
are made better off, and the gains of consumers outweigh the losses of producers. If a
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 imposed.
168 ❖ Chapter 9/Application: International Trade
I.
In the News: Threats to Free Trade
1. In the wake of the recent deep recession, policymakers around the world imposed trade
restrictions.
2. This article from
The
Wall Street Journal
describes the increase in protectionist policies.
J. Other Benefits of International Trade
1. In addition to increasing total surplus, there are several other benefits of 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 off 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.
C. The National-Security Argument
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.
Chapter 9/Application: International Trade ❖ 169
E. The Unfair-Competition Argument
1. It is unfair if firms in one country are forced to comply with more regulations than firms in
another country, or if another government subsidizes the production of a good.
F.
In the News: Second Thoughts about Free Trade
1. Some economists worry about the impact of international trade on the distribution of income.
2. This article from
The New York Times
expresses such concerns.
G. 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.
H.
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 Tariffs
and Trade (GATT) are multilateral approaches to reducing trade barriers.
Make sure that you point out the conclusion in this chapter. The chapter ends with a
very effective parable about the discovery of comparative advantage, its adoption, its
beneficial consequences, and finally, its abandonment for political reasons.
170 ❖ Chapter 9/Application: International Trade
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Since wool suits are cheaper in neighboring countries, Autarka would import suits if it were to
allow free trade.
2. Figure 1 shows the supply and demand for wool suits in Autarka. With no trade, the price of
suits is 3 ounces of gold, consumer surplus is area A, producer surplus is area B + C, and
Figure 1
3. Lobbyists for the textile industry might make five arguments in favor of a ban on the import
of wool suits: (1) imports of wool suits destroy domestic jobs; (2) the wool-suit industry is
vital for national security; (3) the wool-suit industry is just starting up and needs protection
