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151
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 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.
KEY POINTS:
• The effects 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
9
APPLICATION: INTERNATIONAL
TRADE
152 ❖ Chapter 9/Application: International Trade
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.
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.
Pick a state adjacent to yours. Ask students why we do not seem to worry about
“importing” goods from other states the same way in which we worry about
importing goods from other countries.
Chapter 9/Application: International Trade ❖ 153
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
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.
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.
Figure 1
154 ❖ Chapter 9/Application: International Trade
C. The Gains and Losses of an Exporting Country
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
a. Consumer surplus is equal to: A + B.
b. Producer surplus is equal to: C.
c. Total surplus is equal to: A + B + C.
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.
Chapter 9/Application: International Trade ❖ 155
4. Welfare with Trade
a. Consumer surplus is equal to: A.
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.
a. Thus, with trade, the domestic quantity demanded will not be equal to the domestic
quantity supplied.
Note that there will be both imported and domestically produced textiles sold in this
country. This is true for many imported goods.
156 ❖ Chapter 9/Application: International Trade
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.
b. Producer surplus changes by: –B.
c. Total surplus changes by: +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
Chapter 9/Application: International Trade ❖ 157
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.
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 Tariff (with trade)
a. Consumer surplus is equal to: A + B + C + D + E + F.
Figure 4
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, low-wage jobs.
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
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).
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.
b. However, a tariff raises revenue for the government, whereas a quota creates surplus for
license holders.
c. A quota can potentially cause a larger deadweight loss than a tariff, 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.
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.
Chapter 9/Application: International Trade ❖ 159
country exports a product, domestic producers are made better off, domestic consumers are
made worse off, and the gains of producers outweigh the losses of consumers.
I. Other Benefits of International Trade
1. In addition to increasing total surplus, there are several other benefits of free trade.
2. These include an increased variety of goods, lower costs through economies of scale,
increased competition, and an enhanced flow of ideas.
J.
In the News:
Trade as a Tool for Economic Development
1. Free trade in poor countries is a simple, yet effective, solution to the poverty problem.
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
1. Protecting certain industries may be appropriate if they produce products necessary for
national security.
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.
160 ❖ Chapter 9/Application: International Trade
3. Even if this argument is legitimate, it is nearly impossible for the government to choose
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. 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).
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
3. The North America Free Trade Agreement (NAFTA) and the General Agreement on Tariffs
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
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.
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.
Chapter 9/Application: International Trade ❖ 161
SOLUTIONS TO TEXT PROBLEMS:
2. Figure 1 shows the supply and demand for wool suits in Autarka. With no trade, the price of
Figure 1
3. Lobbyists for the textile industry might make five arguments in favor of a ban on the import
162 ❖ Chapter 9/Application: International Trade
Chapter Quick Quiz
1. a
Questions for Review
1. If the domestic price that prevails without international trade is above the world price, the
2. A country will export a good for which its domestic price is lower than the prevailing world
price. Thus, if a country has a comparative advantage in producing a good, it will become an
3. Figure 2 illustrates supply and demand for an importing country. Before trade is allowed,
consumer surplus is area A and producer surplus is area B + C. After trade is allowed,
Figure 2
4. A tariff is a tax on goods produced abroad and sold domestically. If a country is an importer
5. The arguments given to support trade restrictions are: (1) trade destroys jobs; (2) industries
threatened with competition may be vital for national security; (3) new industries need trade
Chapter 9/Application: International Trade ❖ 163
6. A unilateral approach to achieving free trade occurs when a country removes trade
restrictions on its own. Under a multilateral approach, a country reduces its trade restrictions
Problems and Applications
1. a. Figure 4 illustrates the Canadian market for wine, where the world price of wine is
P
1.
The following table illustrates the results under the heading "
P
1."
b. The shift in the Gulf Stream destroys some of the grape harvest in Europe and raises the
world price of wine to
P
2. The table shows the new areas of consumer, producer, and
total surplus, as well as the changes in these surplus measures. Consumers lose,
producers win, and Canada as a whole is worse off.
2. The impact of a tariff on imported automobiles is shown in Figure 6. Without the tariff, the
price of an auto is
P
W, the quantity produced in the United States is
Q
1S, and the quantity
P
P
CHANGE
164 ❖ Chapter 9/Application: International Trade
Figure 6
Before Tariff
After Tariff
CHANGE
3. a. For a country that imports clothing, the effects of a decline in the world price are shown
in Figure 7. The initial price is
Pw1
and the initial level of imports is
Qd1 – Qs1
. The new
Chapter 9/Application: International Trade ❖ 165
P
w1
P
w2
CHANGE
b. For a country that exports clothing, the effects of a decline in the world price are shown
in Figure 8. The initial price is
P
w1 and the initial level of exports is
Q
s1
– Q
d1
.
The new
P
P
CHANGE
b. While there are many possible answers, one correct answer is: the national-security
argument and the infant-industry argument. The economic rationale for the national-
166 ❖ Chapter 9/Application: International Trade
5. a. Figure 9 shows the market for T-shirts in Textilia. The domestic price is $20 Once trade is
allowed, the price drops to $16 and three million T-shirts are imported.
Figure 9
6. a. Figure 10 shows the market for grain in an exporting country. The world price is
PW
.
Chapter 9/Application: International Trade ❖ 167
7. a. This statement is true. For a given world price that is lower than the domestic price,
b. This statement is false. Quantity demanded would remain unchanged, but buyers would
D
b. The effects of the consumption tax can be seen in the table below:
9. a. When a technological advance lowers the world price of televisions, the effect on the
168 ❖ Chapter 9/Application: International Trade
Figure 13
P
1
P
2
CHANGE
c. If the government places a $100 tariff on imported televisions, consumer and producer
surplus would return to their initial values. That is, consumer surplus would fall by areas
d. It makes no difference why the world price dropped in terms of our analysis. The drop in
10. An export subsidy increases the price of steel exports received by producers by the amount
of the subsidy, s, as shown in Figure 14. The figure shows the world price,
P
Chapter 9/Application: International Trade ❖ 169
for doing so. So domestic companies will sell all the steel they produce abroad, in total
quantity
Q
2S. Domestic consumers continue to buy quantity
Q
1D. The country imports steel in
Figure 14
Thus, it is not a good policy from an economic standpoint because there is a decline in total
surplus.
Without Subsidy
With Subsidy
CHANGE
