Chapter 17 International Trade and Finance 5 itself. It can produce three units of beef, trade two of them for a textile unit, and have one extra beef unit left over—or it can trade all three units of beef for one and one-half units of textiles. Japan can produce one unit of textiles and trade it for two units of beef, gaining one textile unit in the process. Both nations can gain from such a trade because each is specializing in the production of a good for which it has a comparative opportunity cost advantage. 2 Even though the United States has an absolute cost advantage in both products, Japan has a comparative advantage in textiles. One unit of textiles costs Japan one unit of beef; the same unit of textiles costs the United States three units of beef. Similarly, the United States has a comparative cost advantage in the production of beef. One unit of beef costs the United States only one-third unit of textiles; it costs Japan a whole unit. If each country specializes in the commodities for which it has a comparative cost advantage, the two nations can save resources for use in further production. TABLE 17.2 Mutual Gains from Trade in Beef and Textiles, United States and Japan United States Japan Total, U.S. and Japan Production and consumption levels before international trade 15 textiles 45 beef 3 textiles 22 beef 18 textiles 67 beef Production levels in anticipation of international trade (complete specialization assumed) 0 textiles 90 beef 25 textiles 0 beef 25 textiles 90 beef At an exchange ratio of 2 beef for 1 textile, United States and Japan agree to trade 40 beef for 20 textiles. Consumption levels after international trade 20 textiles 50 beef 5 textiles 40 beef 25 textiles 90 beef Increased consumption (before-trade consumption levels subtracted) 5 textiles 5 beef 2 textiles 18 beef 7 textiles 23 beef Table 17.2 shows the gains in production each nation can realize under such an arrangement. Before trade, the United States produces 15 units of textiles and 45 of beef; Japan produces 3 units of textiles and 22 of beef. Total production is therefore 18 units of textiles and 67 units of beef. With trade, the United States produces 90 units of beef 2 Specialization in production for the United States and Japan will likely be partial with increasing marginal production costs. With constant-cost or decreasing-cost, the specialization of production may be complete. Chapter 17 International Trade and Finance 6 and Japan produces 25 units of textiles. At an international trade ratio of 1 unit of textiles to 2 units of beef, suppose the two nations agree to trade 40 units of beef for 20 units of textiles. The United States gets more beef—50 units as opposed to 45—and more textiles—20 units as opposed to 15. Japan also gets more of both commodities. Through specialization, total world production has risen from 18 to 25 units of textiles and from 67 to 90 units of beef. Both nations can now consume more of both commodities. In a very important sense, the world’s aggregate real income has increased. The same gain in aggregate welfare is shown graphically in Figure 17.1. On the left side of the figure, the U.S. production possibilities curve extends from 30 units of textiles on the horizontal axis to 90 units of beef on the vertical axis. Japan’s production capability is shown on the right. Without trade, the United States chooses to produce at point a, 15 textiles units and 45 beef units. At an exchange ratio of 2 beef units for one textile unit, the United States can move up and to the left on its production possibilities curve. At the extreme, it will produce at point b, 90 units of beef and no textiles. It can trade along the outer line, exchanging 40 beef units for 20 textile units (point c). Through trade, the United States realizes a gain in aggregate welfare represented by the distance FIGURE 17.1 Production Gains from International Trade The United States can produce any combination of beef and textiles along its production possibilities curve B 1 T 1 (left panel). Without trade, it will choose to produce at point a, 45 units of beef and 15 units of textiles. If given the opportunity to trade two units of beef for one unit of textiles, however, the United States will specialize completely in beef (point b) and trade beef for textiles along the darkened line. Through trade, the United States moves from a to c, exporting 40 units of beef (90 units produced minus 50 consumed) and importing 20 units of textiles. In the process the nation increases its consumption of both beef and textiles, from 45 units of beef and 15 units of textiles to 50 units of beef and 20 units of textiles. (the darkened line does not intersect the horizontal beef axis because the United States cannot get more than 25 units of textiles from Japan.). At the same time trade permits Japan (right panel) to shift its consumption from the black production possibilities curve to the darkened curve. By producing at b 1 and exporting 20 units of textiles in exchange for 40 units of beef, Japan too can expand its consumption, from a 1 to c 1 . Chapter 17 International Trade and Finance 7 between points a and c. In other words, international trade permits the United States to consume at a point beyond its own limited production possibilities curve (the black line in the graph). In the same way, Japan realizes a gain in welfare equal to the difference between its consumption before trade, a 1 , and its consumption after trade, c 1 . In the long run, a country’s imports are paid for by its exports. Thus, by engaging in international trade, according to comparative advantage, a country gains by reducing its social opportunity cost. The social opportunity cost of imports is the exports required to pay for the imports. If the resources used to produce exports are less than those required to produce the goods domestically, there is a net social economic gain. The Distributional Effects of Trade As we have seen, even a nation that has an absolute advantage in every production process can benefit from trade. In reality, no such nation exists, but that just underscores the point that even in the unlikeliest of conditions, we can make the case for free trade. Furthermore, if voluntary trade takes place we must assume that both parties perceive that they will gain. Why else would they agree to the arrangement? How much each nation gains depends on the terms of trade—the ratio at which one commodity can be traded or exchanged for another commodity internationally; or on an aggregate basis, it is the ratio of the price of exports to the price of imports. The more favorable a nation’s terms of trade, and therefore its exchange rate, the larger its share of gain in enhanced output. International trade remains a controversial subject, for although nations gain from trade, individuals within those nations may not. Individual gains tend to go to the firms that produce goods and services for export, losses tend to go to the firms that produce goods and services that are imported under free trade. Gains to Exporters Exporters of domestic goods gain from international trade because the market for their goods expands, increasing demand for their products. The increase in their revenue can be seen in Figure 17.2. When the demand curve shifts from D 1 to D 2 , producers’ revenues rise from P 1 Q 2 (point a) to P 2 Q 3 (point b). The more price-elastic or flatter the supply function (S), the larger the change in quantity and the smaller the change in price. The increase in revenues is equal to the shaded L-shaped area P 2 Q 3 Q 2 aP 1 . Producers benefit because they receive greater profits, equal to the shaded area above the supply curve, P 2 baP 1 . Workers and suppliers of raw materials benefit because their services are in greater demand, and therefore more costly. The cost of producing additional units for export is equal to the shaded area below the supply curve, Q 2 abQ 3 . This graph suggests why farmers supported the sales of wheat to the Soviet Union that began in the early 1970s. They complained loudly when the U.S. government suspended sales temporarily for political reasons. Many consumers and members of Congress objected the wheat sales, however, on the grounds that they would increase the domestic price of wheat and therefore of bread. In a narrow sense, consumers of Chapter 17 International Trade and Finance 8 exported products have an interest in restricting their exportation. Yet in the broad context of international trade. Restrictions can work against the private interests of individuals, including even consumers of bread. Trade is ultimately a two-way street. To import goods and services that can be produced more cheaply abroad than at home, a nation must export something else. No nation will continually export part of what it produces without getting something in return. To the extent that exports are restricted to suit the special interests of some group, imports of other commodities also are restricted. Restrictions on the exportation of wheat may hold down the price of bread, but they can also increase the price of imported goods, like radios and television sets. __________________________________ FIGURE 17.2 Gains from the Export Trade The opening up of foreign markets to U.S. producers increases the demand for their products, from D 1 to D 2 . As a result, domestic producers can raise their price from P 1 to P 2 and sell a larger quantity, Q 3 instead of Q 2 . Revenues increase by the shaded area P 2 bQ 3 Q 2 aP 1 . The more price- elastic or flatter the supply function (S), the larger the change in quantity and the smaller the change in price. Losses to Firms Competing with Imports While consumers gain from increased imports, domestic producers may lose from increased competition. Foreign producers can gain a foothold in the domestic market in three ways: (1) by providing a better product than domestic firms; (2) by selling essentially the same product as domestic firms, but at a lower price; and (3) by providing a product previously unavailable in the domestic market. Most people welcome the importation of a previously unavailable product, but producers who face competition from foreign suppliers have an incentive to object to importation. If imports are allowed, the domestic supply of a good increases. Domestic competitors will sell less, and they may have to sell at a lower price. In short, the employment opportunities and real income of domestic producers decline as a result of foreign competition. Figure 17.3 shows the effects of importing foreign textiles. Without imports, demand is D and supply is S 1 . In a competitive market, producers will sell Q 2 units at a price of P 2 . Total receipts will beP 2 x Q 2 . The importation of foreign textiles increases the supply to S 2 , dropping the price from P 2 to P 1 . Because prices are lower, consumers increase their consumption from Q 2 to Q 3 and get more for their money. The more price- elastic or flatter the demand curve (D), the greater the change in quantity and the smaller the change in price. Chapter 17 International Trade and Finance 9 __________________________________________ FIGURE 17.3 Losses from Competition with Imported Products The opening up of the market to foreign trade increases the supply of textiles from S 1 to S 2 . As a result, the price of textiles falls from P 2 to P 1 , and domestic producers sell a lower quantity, Q 1 instead of Q 2 . Consumers benefit from the lower price and the higher quantity of textiles they are able to buy, but domestic producers, workers and suppliers lose. Producers’ revenues drop by an amount equal to the shaded area P 2 abP 1 . Workers’ and suppliers’ payments drop by an amount equal to the shaded area Q 2 abQ 1 . Starting at point c, a tariff or tax equal to ad is levied, shifting the supply curve from S 2 , S 1 . In an industry whose costs are increasing, the increase in price from P 1 to P 2 in the importing country is less than the increase in the tariff (ad), because a price fall in the exporting country absorbs some of the burden of the duty. __________________________________ Domestic firms, their employees, and their suppliers lose. Because the price is lower, domestic producers must move down their supply curve (S 1 ) to the lower quantity Q 1 . Their revenues fall from P 2 Q 2 to P 1 Q 1 . In other words, the revenues in the shaded L-shaped area P 2 a Q 2 Q 1 bP 1 are lost. Of this total loss in revenues, owners of domestic firms lose the area above the supply curve, P 2 abP 1 . Workers and suppliers of raw materials lose the area below the supply curve, Q 2 abQ 1 . This is the cost domestic firms would incur in increasing production from Q 1 to Q 2 , the payments that would be made to domestic workers and suppliers in the absence of foreign competition. If workers and other resources are employed in textiles because it is their best possible employment, the introduction of foreign products can be seen as a restriction on some workers’ employment opportunities. In summary, while international trade lowers import prices and raises export prices in the domestic nation, the net impact is a reduced social opportunity cost curve that expands total output and consumption opportunities. The Effects of Trade Restrictions Such as Tariffs and Quotas Because foreign competition hurts some individuals, domestic producers, workers, and suppliers have an incentive to seek government restrictions on the imports of tradables. Of course, some industries such as communications, services, and utilities are largely insulated from foreign competition without trade restrictions. Two forms of protection are commonly used, tariffs and quotas. A tariff is a special tax or duty on imported goods that can be a percentage of the price (ad valorem duty) or a specific amount per unit of the product (specific duty). A tariff may be imposed to raise money for the Chapter 17 International Trade and Finance 10 levying country—typically, revenues are modest on commodities not produced in the levying country—or in the more likely case, to protect some industry against the cold winds of competition. A quota is a physical or dollar value limit—mandatory or voluntary—on the amount of a good that can be imported or exported during some specified period of time. There are other nontariff barriers such as controlling the flow of foreign exchange, licensing requirements, health, quality, or safety restriction and regulations on products. If tariffs are imposed on a foreign good such as textiles, the supply of textiles will decrease—say, from S 2 to S 1 in Figure 17.3—and the price of imports will rise. Domestic producers will raise their prices too, and domestic production will go up. If the tariff is high and all foreign textiles are excluded, the supply will shift all the way back to S 1 . A tariff will have a more modest effect, shifting the supply curve only part of the way back toward S 1 . The price of textiles will rise and domestic producers will expand their production, but imports will continue to come into the country. How much the price rises and the quantity falls after the imposition of the tariff depends on how price-elastic or flat the demand curve (D) is. The more elastic D is, the greater the fall in quantity and the greater the rise in price. The imposition of a duty can cause the taxed good in the importing country to increase by exactly the amount of the duty, less than the duty, or in the extreme case, not at all (depending on price elasticity). In the most likely case (of increasing cost conditions and a rising supply curve) a tariff will cause the price to increase in the importing country by less than the amount of the duty as the price falls in the foreign country. The tariff will cause the domestic and foreign price to differ by exactly the amount of the tariff, but the price increase in the importing country is equal to the tariff minus fall in price in the exporting country. Thus, in Figure 17.3, starting from point c, the increase in the price in the importing country from P 1 to P 2 is less than the tariff equal to ad, shifting the supply curve from S 2 to S 1 as part of the duty is shifted to the exporting country where the price falls. For instance, a tariff of $3 per unit may cause the import price to rise by $2 and the export price to fall by $1 with both nations absorbing part of the burden of the tariff. Who bears the biggest burden is a matter of relative price elasticity, just as whether buyers or sellers bear the burden of a domestic excise tax. As always, the more inelastic the demand of the buyers and the more elastic the supply of the sellers, the bigger burden of any tax—domestic (e.g., excise) or foreign (e.g., an import duty)—that falls on the buyers. A quota has the same general effect as a tariff, although its price-cost effect can be much more drastic. They both reduce the market supply, raise the market price, a encourage domestic production, thereby helping domestic producers and harming domestic consumers. A quota, however, can sever international price-cost links because the market mechanism for relating the prices of different nations is artificially stopped from functioning. Nonetheless, quotas are sometimes imposed by nations because they are a more certain and precise technique of control, and can be changed by administrative decree. There are three main differences between quotas and tariffs. First quotas firmly restrict the amount of a product that can be imported, regardless of market conditions. A quota may specify how much oil may be imported each day or how much sugar may be imported each year. Tariffs, on the other hand, permit any level of importation for which Chapter 17 International Trade and Finance 11 consumers are willing to pay. Thus, if demand for the product increases, imports may rise. (There is a hybrid called a “tariff quota” that sets a fixed limit on importation or exportation.) The first Reagan administration imposed quotas on steel, copper, textiles, and autos from Japan. In 1984 the so-called voluntary restraint program forced Japan to restrict auto sales in the United States to 1.84 million cars. Foreign cars now represent about 25 percent of U.S. sales. Because Japanese supply was not allowed to keep pace with the rapidly expanding U.S. demand, the price of Japanese cars rose, more expensive models were imported, and consumers faced longer waiting lists for Japanese cars. The price of American cars also rose. These consequences led to the termination of the voluntary restraint program in 1985. The second major difference between tariffs and quotas is that quotas are typically specified for each important foreign producer. Otherwise, all foreign producers would rush to sell their goods before the quota was reached. When quotas are rationed in this way, more detailed government enforcement is required. Tariffs place no such restrictions on individual producers. Moreover, the tariff is collected by the government in custom duties while price enhancement with a quota goes as a windfall gain to the fortunate few with import licenses. Finally, quotas enable foreign firms to raise their prices and extract more income from consumers. One economist estimated that the Reagan administration’s voluntary restraint program permitted Japanese auto producers to raise their prices high enough to take an additional $2,500 per car, or $5 billion, out of the American market. 3 As a result of the protectionist shield, U.S. automakers raised domestic car prices $1,000 per car, or $8 billion per year, in 1984 and 1985. Tariffs, on the other hand, force foreign firms to lower their prices to offset the increase from the tariff. They also generate income for the federal government. Although tariffs and quotas promote a less efficient allocation of the world’s scarce resources, because of the private benefits to be gained from tariffs and quota, we should expect an industry to seek them as long as their market benefits exceed their political cost. Politicians are likely to expect votes and campaign contributions in return for tariff legislation that generates highly visible benefits to special interests. Producers (and labor) will usually make the necessary contributions, because the elimination of foreign competition promises increased revenues in the protected industries. The difference between the increase in profits due to import restrictions and the amount spent on political activity can be seen as a kind of profit in itself. Surprisingly, protectionism may sometimes also be supported by exporters, as a tariff or quota can stimulate net exports. Since protectionism also causes the exchange rate to appreciate, however, this discourages exports and offsets partially or wholly the tariff- driven increase in net exports. Consumers, on the other hand, have reason to oppose tariffs or quotas on imported products. Such legislation inevitably causes prices to rise, as a tariff amounts to a subsidy to the domestic producer of the dutiable product, paid for largely by the consumers of that product in the form of higher prices. Consumers typically do not offer 3 Robert Crandell, “Assessing the Impact of the Automobile Export Restraints upon U.S. Automobile Prices,” mimeo, Brookings Institution, December 1985. Chapter 17 International Trade and Finance 12 very much resistance, however, because the effects of tariffs and quotas are hard to perceive. Unlike a sales tax, the cost of a tariff is not rung up separately at the cash register, and many consumers do not reason through the complex effects of a tariff on consumer prices. In fact, many if not most, consumers feel that tariffs on foreign automobile, steel, or copper producers are good for the nation and for themselves. “Buy American’’ slogans and advertisements emphasizing the need to preserve American jobs are generally effective in swaying public opinion. One comprehensive investigation showed that protection in thirty-one countries cost consumers $53 billion in 1984, while providing only $40 billion in benefits to the producers. 4 As a group, consumers have less incentive to oppose tariffs than industry has to support them, as the costs to individual consumers and taxpayers are negligible and largely hidden. The benefits of a tariff accrue principally to a relatively small group of firms, whose lobby may already be well entrenched in Washington. These firms have a strong incentive to be fully informed on the issue and to make campaign contributions, but the harmful effects of a tariff are diffused over an extremely large group of consumers. The financial burden any one consumer bears may be very slight, particularly if the tariff in question is small, as most tariffs are. As result, the individual consumer has little incentive to become informed on tariff legislation or to make political contributions to lobbies that support such legislation. Although consumers as a whole may share an interest in opposing tariffs, collective action must still be undertaken by individuals—and individuals will not incur the cost of organizing unless they expect to receive compensating private benefits. At some level of increased cost, of course, consumers will find the necessary incentive to oppose tariff legislation. For this reason Congress rarely passes tariffs high enough to make importation totally unprofitable. Even low tariffs reduce the nation’s real income while redistributing it toward protected sectors. The size of the pie is reduced, but the protected few get a bigger slice. In spite of all the impediments to free trade imposed by U.S. economy, there has been a substantial increased in our dollar volume of imports and exports over the last thirty years. Similarly, world trade has increase in the last three decades. Over 15 percent of the world’s production is now consumed in a different nation than where it was produced. Put differently, the dollar value of imports to all countries has increased tenfold since 1960. According to Alan S. Blinder, 5 the case against protectionism, described as a negative-sum game, where the losing consumers lose more than the winning protected producers win, involves even more problems. There are four other problems with trade restrictions. First, protectionism allows high-cost producers that would otherwise fail to survive. Second, trade restrictions have a habit of affecting other industries. For example, automobiles need protection because the ball bearings, steel, and textiles that provide inputs to automobiles are protected. Third, foreign nations often retaliate against protectionism. Tit-for-tat is the modus operandi in international trade: Country A raises barriers on product X because Country B did it to product Y. Fourth, trade restrictions 4 Gary C. Hufbauer, et al., Trade Protection in the United States: 31 Case Studies (Washington, D.C.: Institute for International Economics 1986). 5 Alan Blinder, Hard Heads, Soft Hearts (Reading, Mass.: Addison-Wesley, 1987), pp. 118-119. Chapter 17 International Trade and Finance 13 aren’t really job-saving or job-creating, but job-swapping. Protectionism raises the exchange rate, hurting exports in unprotected industries. Because in the long run the value of exports must be equal to the value of imports, we end up swapping jobs in efficient unprotected industries. The Case for Free Trade We have seen how international trade can on balance increase the total incomes of the nations engaged in it, although export producers gain and import-substitute producers lose. By extension, we can conclude that anything that restricts the scope of trade between nations generally reduces their real incomes. To the extent that trade is a two- way street—that exports trade for imports, at least in the long run—a reduction in imports brings a reduction in exports. From our imports the Japanese get the dollars they need to buy American exports. If we reduce our imports, they will have fewer funds with which to buy from us. For this reason, U.S. farmers, who sell approximately one-third of their crops in foreign markets, actively opposed the protectionist movement led by textiles, steel, and copper firms in the 1980s. Yet what is true for one sector of the economy is not necessarily true for all. If all sectors are protected by tariffs, it is possible (but not inevitable) that all experience a drop in real income. Figure 17.4 illustrates the case of an economy with two industries, automobiles and textiles. Both industries must compete with imports. If neither seeks protection, both will operate in cell I, at a combined real income of $50 ($20 for the textiles industry and $30 for the automobile industry). If the textiles industry seeks protection but the auto industry does not, they will move to cell II, where tariffs raise the textiles industry’s income from $20 to $23. The automotive sector’s income falls to $25, so that the two industries’ combined real income falls to $48. Consumers get fewer textiles at a higher price. Similarly, if the auto industry seeks protection while the textiles industry does not, the economy will move from cell I to cell III. Again, total real income falls from $50 to $49, but this time the auto industry is better off. Its income rises from $30 to $34, while the textiles industry’s income falls to 15. Obviously, if one industry seeks protection, the other has an incentive to follow suit. If the textiles industry counters with a tariff of its own, the economy will move from cell III to cell IV, and the industry’s real income will rise from $15 to $17. Without some constraint on both sectors, then, each has an interest in seeking protection regardless of what the other does. Yet if the economy winds up in cell IV, total real income will be lower than under any other conditions: only $43. Obviously the best course for the economy as a whole is to prohibit tariffs altogether, and in an economy with only two sectors, the cost of reaching an agreement is manageable. In the real world, however, there are many economic sectors, and the costs of reaching a decision are much greater. In Figure 17.4, both industries end up with lower real incomes in cell IV, but in reality, the effects of multiple tariffs will be different in different sectors of the economy. Although total real income will fall, several sectors may realize individual gains. Chapter 17 International Trade and Finance 14 Consider Figure 17.5. Although total real income falls from cell I ($50) to cell IV ($48), the auto sector’s income rises (from $30 to $31). In this case the textile sector bears the brunt of tariff protection, and the auto sector has a compelling interest in obtaining protective tariffs. The sectors of the economy that are most adept at manipulating the political process will be the least willing to accept free trade. Although it is true that for a nation some trade is better than no trade, it is not necessarily true that free trade is better than restricted trade. Even though protectionism promotes economic inefficiency in the aggregate, a nation may under certain conditions act like a monopolist and improve its share of the gains through trade restrictions. Similarly, the owners of relatively scarce factors of production may be better off with little or no trade. FIGURE 17.4 Effects of Tariff Protection on Individual Industries: Case 1 If neither the textiles nor the automobiles industry obtains tariff protection, the economy will earn its highest possible collective income (cell I), but each industry has an incentive to obtain tariff protection for itself. If the textiles industry alone seeks protection (cell II), its income will rise while the auto industry’s income falls. If the auto industry alone seeks protection, its income will rise while the incomes of textiles income industry falls. If both obtain protection, the economy will end up in cell IV, its worst possible position. Income in both sectors will fall. ______________________________________________________________________________________ . are typically specified for each important foreign producer. Otherwise, all foreign producers would rush to sell their goods before the quota was reached Tariffs, on the other hand, force foreign firms to lower their prices to offset the increase from the tariff. They also generate income for the federal government.