International Trade 26.1
26 c h a p t e r
IMPORTANCE OF INTERNATIONAL TRADE In a typical year, about 15 percent of the world’s output is traded in international markets. Of course, the importance of the international sector varies enormously from place to place across the world.
Some nations are almost closed economies (no interaction with other economies), with foreign trade equaling only a very small proportion (perhaps 5 percent) of total output, while in other countries, trade is much more important. In the last three decades, the sum of U.S. imports and exports has increased from 11 percent of GDP to roughly 30 percent.
In addition, incoming and outgoing investments (capital flows) have risen from less than 1 percent to roughly 3 percent of GDP. In Germany, roughly 30 percent of all output produced is exported, while Ireland and Belgium each export more than 70 percent of GDP.
U.S. exports include capital goods, automobiles, industrial supplies, raw materials, consumer goods, and agricultural products. U.S. imports include crude oil and refined petroleum products, machinery, automobiles, consumer goods, industrial raw materials, food, and beverages.
TRADING PARTNERS In its early history, U.S. international trade was largely directed toward Europe and to Great Britain in particular. Now the United States trades with a number of countries, the most important of which are shown in Exhibit 1. The single most important U.S. trading partner is Canada, accounting for roughly one-fifth of the imports and one-fourth of the exports. Trade with Japan, Mexico, Germany, China, Taiwan, and the United Kingdom is also particularly important. Exhibit 3 illustrates the significance of U.S. trade with China.
580 CHAPTER TWENTY-SIX | International Trade The Growth in World Trade s e c t i o n 26.1 _ What has happened to the volume of international trade over time?
_ Who trades with the United States?
_ What does the United States import? Export?
Top Five Trading Partners— Exports of Goods in 2001 Rank Country Percent of Total 1 Canada 22.4% 2 Mexico 13.9 3 Japan 7.9 4 United Kingdom 5.6 5 Germany 4.1 SOURCE: CIA, The World Factbook 2003.
Top Five Trading Partners— Imports of Goods in 2001 Rank Country Percent of Total 1 Canada 19.0% 2 Mexico 11.5 3 Japan 11.1 4 China 8.9 5 Germany 5.2 Major U.S. Trading Partners SECTION 26.1 EXHIBIT 1 The Growth in World Trade 581 By Claudia Eller and Lorenza Muñoz With roughly 50% of their annual revenues coming from overseas, Hollywood studios try to tailor campaigns to local tastes and sensibilities.
Some blockbusters such as Spider-Man and the Star Wars movies virtually sell themselves because of the simplicity of their plots, their muscular action scenes and dazzling special effects.
But most of Hollywood’s exports require the sensibilities of a cultural anthropologist to understand the nuances and norms of countries around the globe.
“It isn’t one world when it comes to laughing, crying or being frightened,” said industry veteran Warren Lieberfarb, president of Warner Home Video. “There is not one homogeneous appetite for American movies, and that is what poses this huge challenge for the U.S. studios.” Domestic comedies rarely catch fire abroad—even when headlined by such major stars as Adam Sandler and Jim Carrey.
The jokes often don’t translate well.
During the last decade, as the U.S. market has plateaued, foreign territories have become increasingly important to the studios. Roughly 50% of their annual theatrical revenue comes from overseas. Sometimes it can be far more. Last year’s blockbuster Harry Potter and the Sorcerer’s Stone earned more than twice as much on foreign soil—$651 million—as it did here.
That’s the equivalent of six hits in the U.S.
SOURCE: Los Angeles Times, October 2, 1992, p. A26.
THE PLOTS THICKEN IN FOREIGN MARKETS In The NEWS Film Distributor, year Domestic gross Foreign gross (millions) (millions) Harry Potter and the Sorcerer’s Stone Warner Bros., 2001 $317.0 $651.1 Spider-Man Sony, 2002 403.7 405.9 Star Wars: Attack of the Clones Fox, 2002 301.9 332.0 Ocean’s Eleven Warner Bros., 2001 183.4 263.3 Pearl Harbor Disney, 2001 198.5 251.3 The World Is Not Enough MGM, 2000 126.9 234.7 Tomorrow Never Dies MGM, 1998 125.2 213.7 Ice Age Fox, 2002 176.3 197.0 A.I. Warner Bros., 2000 78.6 156.4 Moulin Rouge Fox, 2001 57.3 118.2 How the Grinch Stole Christmas Universal, 2000 260.0 81.0 Big Daddy Sony, 2001 163.0 71.3 Lilo & Stitch Disney, 2002 143.5 69.6 The Fast and the Furious Universal, 2001 145.0 65.0 A Different World SECTION 26.1 EXHIBIT 2 Hollywood continues to struggle with how to sell its movies in the international marketplace. What plays in Peoria may not play in Paris.
SOURCE: Times Research 582 CHAPTER TWENTY-SIX | International Trade 1. The volume of international trade has increased substantially in the United States over the last 30 years. During that time, exports and imports have grown from 11 percent to 30 percent of GDP.
2. Our single most important trading partner, Canada, accounts for roughly one-fourth of our exports and almost one-fifth of our imports. Trade with Japan, Mexico, China, Germany, the United Kingdom, France, and Taiwan is also particularly important to the United States.
3. U.S. exports include capital goods, automobiles, industrial supplies, raw materials, consumer goods, and agricultural products. U.S. imports include crude oil and refined petroleum products, machinery, automobiles, consumer goods, industrial raw materials, food, and beverages.
1. Why is it important to understand the effects of international trade?
2. Why would U.S. producers and consumers be more concerned about Canadian trade restrictions than Swedish trade restrictions?
s e c t i o n c h e c k http://sextonxtra.swlearning.com To work more with this Chapter’s concepts, log on to Sexton Xtra! now.
EXHIBIT 3 Reprinted with permission of the Federal Reserve Bank of Dallas.
The United States Stocking Up on Chinese Goods Top Imports (billions of dollars) 8.6 Shoes 6.1 Toys 5.6 Input-output units 5.1 Data processing machine parts 3.2 VCRs 2.6 Wood furniture 2.0 Transmission equipment 1.7 Data storage units 1.6 Christmas items 1.6 Video games 1.6 Telephone sets 1.4 Sweaters and pullovers Top Imports (percentage of all imports) 88 Radios 87 Christmas and festive items 83 Toys 70 Leather goods 67 Shoes 67 Handbags 65 Lamps and lights 64 Cases for cameras, eyeglasses, etc.
60 Drills, power tools 56 Household plastics 54 Sporting goods 53 Ceramic kitchenware You don’t have to shop at Pier 1 Imports to see “Made In China.” A trip to just about any major U.S. retailer—Wal-Mart, Best Buy, Toys ‘R’ Us, Banana Republic—will turn up troves of Chinese imports that we enjoy in everyday life. It adds up to roughly 10 percent of overall U.S.
imports, up from just 0.5 percent in 1980. The U.S. gets 88% of imported radios from China and 83% of imported toys. In 2002, the United States imported eight billion dollars in shoes from China. What would we do without China? Pay more and have less, that’s for sure.
SOURCE: Annual Report 2002, Federal Reserve Bank of Dallas.
SECTION 26.1 Made in China ECONOMIC GROWTH AND TRADE Using simple logic, we conclude that the very existence of trade suggests that trade is economically beneficial. This is true if we assume that people are utility maximizers and are rational, intelligent, and engage in trade on a voluntary basis. Because almost all trade is voluntary, it would seem that trade occurs because the participants feel that they are better off because of the trade. Both participants of an exchange of goods and services anticipate an improvement in their economic welfare. Sometimes, of course, anticipations are not realized (because the world is uncertain), but the motive behind trade remains an expectation of some enhancement in utility or satisfaction by both parties.
Granted, “trade must be good because people do it,” is a rather simplistic explanation. The classical economist David Ricardo is usually given most of the credit for developing the economic theory that more precisely explains how trade can be mutually beneficial to both parties, raising output and income levels in the entire trading area.
THE PRINCIPLE OF COMPARATIVE ADVANTAGE Ricardo’s theory of international trade centers on the concept of comparative advantage. A person, a region, or a country can gain by specializing in the production of the good in which they have a comparative advantage. That is, if they can produce a good or service at a lower opportunity cost than others, we say that they have a comparative advantage in the production of that good or service. In other words, a country or a region should specialize in producing and selling those items that it can Comparative Advantage and Gains from Trade 583 Comparative Advantage and Gains from Trade s e c t i o n 26.2 _ Does voluntary trade lead to an improvement in economic welfare?
_ What is the principle of comparative advantage?
_ What benefits are derived from specialization?
It is mere common sense that if one country is very good at making hats, and another is very good at making shoes, then total output can be increased by arranging for the first country to concentrate on making hats and the second on making shoes. Then, through trade in both goods, more of each can be consumed in both places.
That is a tale of absolute advantage. . . . Each country is better than the other at making a certain good, and so profits from specialization and trade. Comparative advantage is different: a country will have it despite being bad at the activity concerned. Indeed, it can have a comparative advantage in making a certain good even if it is worse at making that good than any other country.
This is not economic theory, but a straightforward matter of definition: a country has a comparative advantage where its margin of superiority is greater, or its margin of inferiority smaller.
When people say of Africa, or Britain, or wherever, that it has no comparative advantage in anything, they are simply confusing absolute advantage (for which their claim may or may not be true) with comparative advantage (for which it is certainly false).
Why does this confusion over terms matter? Because the case for free trade is often thought to depend on the existence of absolute advantage and is therefore thought to collapse whenever absolute advantage is absent. But economics shows that gains from trade follow, in fact, from comparative advantage.
Since comparative advantage is never absent, this gives the theory far broader scope than more popular critics suppose.
In particular, it shows that even countries which are desperately bad at making everything can expect to gain from international competition. If countries specialize according to their comparative advantage, they can prosper through trade regardless of how inefficient, in absolute terms, they may be in their chosen specialty.
SOURCE: The Economist, January 27, 1996, pp. 61, 62. (c) 1996 The Economist Newspaper Group Inc. Reprinted with permission. Further reproduction prohibited. http://www.economist.com.
THE MIRACLE OF TRADE In The NEWS produce at a lower opportunity cost than other regions or countries.
Comparative advantage analysis does not mean that nations or areas that export goods will necessarily be able to produce those goods or services more cheaply than other nations in an absolute sense. What is important is comparative advantage, not absolute advantage. For example, the United States may be able to produce more cotton cloth per worker than India can, but that does not mean the United States should necessarily sell cotton cloth to India. For a highly productive nation to produce goods in which it is only marginally more productive than other nations, the nation must take resources from the production of other goods in which its productive abilities are markedly superior.
As a result, the opportunity costs in India of making cotton cloth may be less than in the United States. With that, both can gain from trade, despite potential absolute advantages for every good in the United States.
COMPARATIVE ADVANTAGE AND THE PRODUCTION POSSIBILITIES CURVE In Exhibit 1, we see the production possibilities curves for two individuals, Wendy and Calvin.
Wendy and Calvin can produce either food or cloth. In Exhibit 1, we see that if Wendy devotes all her resources to producing food, she can produce 30 pounds of food; if she devotes all her resources to producing cloth, she can produce 10 yards of cloth. In Exhibit 1, we see that when Calvin uses all his resources to produce food, he only produces 10 pounds; but when he uses all his resources to produce cloth, he can produce 30 yards. In this example, Wendy actually has an absolute advantage in food, while Calvin has an absolute advantage in cloth. However, as we shall see, it would not affect the result if Calvin could only produce 2 pounds of food and 6 yards of cloth.
For simplicity, let’s assume that each producer operates on a straight-line production possibilities curve (PPC), and each initially chooses to divide her or his productive resources between these products to produce 7.5 pounds of food and 7.5 yards of cloth—although any amount of each good within their respective PPCs could have been produced.
Wendy can produce food at a lower opportunity cost than Calvin. When Wendy produces 30 pounds of food, it costs only 10 yards of cloth.
However, when Calvin produces only 10 pounds of food, it costs 30 yards of cloth. Wendy, then, can produce food at a lower opportunity cost than can Calvin, but Calvin can produce cloth at a lower opportunity cost than Wendy cam. When Calvin produces 30 yards of cloth, it costs him 10 pounds of food; and when Wendy produces 10 yards of cloth, 584 CHAPTER TWENTY-SIX | International Trade Renee, a successful artist, can complete one painting in each 40-hour workweek. Each painting sells for $4,000. As a result of her enormous success, however, Renee is swamped in paperwork. To solve the problem, Renee hires Drake to handle all the bookkeeping and typing associated with buying supplies, answering inquiries from prospective buyers and dealers, writing art galleries, and so forth. Renee pays Drake $300 per week for his work. After a couple of weeks in this arrangement, Renee realizes that she can handle Drake’s chores more quickly than Drake does. In fact, she estimates that she is twice as fast as Drake, completing in 20 hours what it takes Drake 40 hours to complete. Should Renee fire Drake?
Clearly Renee has an absolute advantage over Drake in both painting and paperwork because she can do twice as much paperwork in 40 hours as Drake can, and Drake can’t paint well at all. Still, it would be foolish for Renee to do both jobs. If Renee did her own paperwork, it would take her 20 hours per week, leaving her only 20 hours to paint.
Because each watercolor takes 40 hours to paint, Renee’s output would fall from one painting per week to one painting per two weeks.
When Drake works for her, Renee’s net income is $3,700 per week ($4,000 per painting minus $300 in Drake’s wages); when Drake does not work for her, it is only $2,000 per week (one painting every two weeks). While Renee is both a better painter and better at Drake’s chores than Drake, it pays for her to specialize in painting, in which she has a comparative advantage, and allow Drake to do the paperwork. The opportunity cost to Renee of paperwork is high. For Drake, who lacks skills as a painter, the opportunity costs of doing the paperwork are much less.
COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE USING WHAT YOU'VE LEARNED A Q it costs 30 pounds of food. Calvin, then, is the lowest- cost producer of cloth.
To demonstrate our point about comparative advantage, we have overlapped the two production possibility curves in Exhibit 1. At point A, we see that Wendy produces 7.5 pounds of food and 7.5 yards of cloth, and Calvin produces 7.5 yards of cloth and 7.5 pounds of food. However, if each specialized and pursued his or her comparative advantage, the goods each can produce at the lowest opportunity cost, then Wendy could produce 30 pounds of food and Calvin could produce 30 yards of cloth, point B. That is, by specializing, Wendy and Calvin have produced 30 units of each good rather than 15 units, using the same amount of total resources. Now if Wendy does not want all food and Calvin does not want all cloth, they can trade with each other. In fact, if Wendy trades half of her food for half of Calvin’s cloth, then each will have 15 units of food and cloth. This is 7.5 more pounds of food and 7.5 more yards of cloth than they had before specialization and trade. That is, if they choose to consume equal amounts of both products, after specialization and trade, their new consumption point is at point C—outside their original PPCs.
By specializing in products in which they have a comparative advantage, individuals, regions and countries can increase their total production—and it is trade that allows people to specialize in those activities they do best. Follow the adage: do what you do best and trade for the rest.
REGIONAL COMPARATIVE ADVANTAGE In the last section, using a production possibilities curve, we saw how Wendy and Calvin could benefit from specialization and trade. The principle of comparative advantage can be applied to regional markets as well. In fact, trade has evolved in large part because different geographic areas have different resources and therefore different production possibilities. The impact of trade between two areas with differing resources is shown in Exhibit 2. To keep the analysis simple, suppose two trading areas exist that can produce just two commodities, grain and computers. A “trading area” may be a locality, a region, or even a nation, but for our example, suppose we think in terms of two hypothetical regions, Grainsville and Techland.
Grainsville and Techland have various potential combinations of grain and computers they can produce.
For each region, the cost of producing more grain is the output of computers that must be forgone, and vice versa. We see in Exhibit 2 that Comparative Advantage and Gains from Trade 585 Food (pounds) Cloth (yards) 0 30 20 15 10 7.5 7.5 10 15 20 30 C B A Wendy's PPC Calvin's PPC Total production with specialization Specialization and Trade SECTION 26.2 EXHIBIT 1 Before Trade Point A—Without specialization, say that Wendy and Calvin each choose to produce 7.5 pounds of food and 7.5 yards of cloth.
Specialization and Trade Point B—Wendy and Calvin’s total production if they specialize: Wendy produces 30 pounds of food, and Calvin produces 30 yards of cloth.
Point C—If Wendy and Calvin split equally their total production after specialization, they will each have 15 pounds of food and 15 yards of cloth.
Techland can produce more of both grain (40 bushels) and computers (100 units) than Grainsville can (30 bushels and 30 units, respectively), reflecting perhaps superior resources (more or better labor, more land, and so on); this means that Techland has an absolute advantage in both products.
Suppose that, before specialization, Techland chooses to produce 75 computers and 10 bushels of grain per day. Similarly, suppose Grainsville decides to produce 12 computers and 18 bushels of grain.
Collectively, then, the two areas are producing 87 computers (75 1 12) and 28 bushels of grain (10 1 18) per day before specialization.
Now, suppose the two nations specialize. Techland decides to specialize in computers and devotes all its resources to making that product. As a result, computer output in Techland rises to 100 units per day, some of which is sold to Grainsville.
Grainsville, in turn, devotes all its resources to grain, producing 30 bushels of grain per day and selling some of it to Techland. Together, the two areas are producing more of both grain and computers than before—100 instead of 87 computers and 30 instead of 28 bushels of grain. Both areas could, as a result, have more of both products than before they began specializing and trading.
How can that happen? In Techland, the opportunity cost of producing grain is very high—25 computers must be forgone to get 10 more bushels of grain. The cost of one bushel of grain, then, is 2.5 computers (25 divided by 10). In Grainsville, by contrast, the opportunity cost of producing six more units of grain is six units of computers that must be forgone, so the cost of one unit of grain is one unit of computers. In Techland, a unit of grain costs 2.5 computers, while in Grainsville the same amount of grain costs only one computer. Grain is more costly in Techland in terms of the computers forgone than in Grainsville, so Grainsville has the comparative advantage in the production of grain, even though Techland has an absolute advantage in grain.
With respect to computers, an increase in output by 25 units, say from 25 to 50 units, costs 10 bushels of grain forgone in Techland. The cost of one more computer is 0.4 bushels of grain (10 divided by 25). In Grainsville, an increase in computer output of six units, say from 12 to 18, is accompanied by a decrease in grain production by six bushels as resources are converted from grain to computer manufacturing. The cost of one computer is one bushel of grain. Computers are more costly (in terms of opportunity cost) in Grainsville and cheaper in Techland, so Techland should specialize in the production of computers.
Thus, by specializing in products in which it has a comparative advantage, an area has the potential of having more goods and services, assuming it trades the additional output for other desirable goods and services others can produce at a lower opportunity cost. In the scenario presented here, the people in Techland would specialize in computers, and the people in Grainsville would specialize in farming (grain). We can see from this example that specialization increases the division of labor and increases the interdependence of one group of people on others.
586 CHAPTER TWENTY-SIX | International Trade Production Possibilities, Techland and Grainsville SECTION 26.2 EXHIBIT 2 Grain Computers Region (bushels per day) (units per day) Techland 0 100 10 75 20 50 30 25 40 0 Grainsville 0 30 6 24 12 18 18 12 24 6 30 0 Before Specialization Techland 10 75 Grainsville 18 12 Total 28 87 After Specialization Techland 0 100 Grainsville 30 0 Total 30 100 THE IMPORTANCE OF TRADE: PRODUCER AND CONSUMER SURPLUS Recall from Chapter 7 that the difference between the most a consumer would be willing to pay for a quantity of a good and what a consumer actually has to pay is called consumer surplus. The difference between the lowest price a supplier would be willing to supply a quantity of a good or service for and the revenues a supplier actually receives for selling it is called producer surplus. With the tools of consumer and producer surplus, we can better analyze the impact of trade. Who gains? Who loses? What happens to net welfare?
The demand curve represents maximum prices that consumers are willing and able to pay for different quantities of a good or service; the supply curve represents minimum prices suppliers require to be willing to supply different quantities of that good or service. For example, in Exhibit 1, for the first unit of output, the consumer is willing to pay up to $7 and the producer would demand at least $1 for producing that unit. However, the equilibrium price is $4, as indicated by the intersection of the supply and demand curves. It is clear that the two would gain from getting together and trading that unit because the consumer would receive $3 of consumer surplus ($7 2 $4), and the producer would receive $3 of producer surplus ($4 2 $1).
Both would also benefit from trading the second and third units of output—in fact, from every unit up to the equilibrium output. Once the equilibrium output is reached at the equilibrium price, all the mutually beneficial opportunities from trade between suppliers and demanders will have taken place; the sum of consumer surplus and producer surplus is maximized.
It is important to recognize that the total gain to the economy from trade is the sum of consumer and producer surplus. That is, consumers benefit from additional amounts of consumer surplus, and producers benefit from additional amounts of producer surplus.
Supply and Demand in International Trade 587 1. Voluntary trade occurs because the participants feel that they are better off because of the trade.
2. A nation, geographic area, or even a person can gain from trade if the good or service is produced relatively cheaper than anyone else can produce it. That is, an area should specialize in producing and selling those items that it can produce at a lower opportunity cost than others.
3. Through trade and specialization in products in which it has a comparative advantage, a country can enjoy a greater array of goods and services at a lower cost.
1. Why do people voluntarily choose to specialize and trade?
2. How could a country have an absolute advantage in producing one good or service without also having a comparative advantage in its production?
3. Why do you think the introduction of the railroad reduced self-sufficiency in the U.S.?
4. If you can wash the dishes in two-thirds the time it takes your younger sister to wash them, do you have a comparative advantage in washing dishes compared to her?
s e c t i o n c h e c k Supply and Demand in International Trade s e c t i o n 26.3 _ What is consumer surplus?
_ What is producer surplus?
_ Who benefits and who loses when a country becomes an exporter?
_ Who benefits and who loses when a country becomes an importer?
FREE TRADE AND EXPORTS—DOMESTIC PRODUCERS GAIN MORE THAN DOMESTIC CONSUMERS LOSE Using the concepts of consumer and producer surplus, we can graphically show the net benefits of free trade. Imagine an economy with no trade, where the equilibrium price, PBT, and the equilibrium quantity, QBT, of wheat are determined exclusively in the domestic economy, as seen in Exhibit 2.
Suppose that this imaginary economy decides to engage in free trade. You can see that the world price (established in the world market for wheat), PAT, is higher than the domestic price before trade, PBT. In other words, the domestic economy has a comparative advantage in wheat because it can produce wheat at a lower relative price than the rest of the world. So this wheat-producing country sells some wheat to the domestic market and some wheat to the world market, all at the going world price.
The price after trade (PAT) is higher than the price before trade (PBT). Because the world market is huge, the demand from the rest of the world at the world price (PAT) is assumed to be perfectly elastic. That is, domestic wheat farmers can sell all the wheat they want at the world price. If you were 588 CHAPTER TWENTY-SIX | International Trade Price $8 7 6 5 4 3 2 1 Quantity 0 S D 1 2 3 4 CS PS CS PS CS PS Consumer and Producer Surplus SECTION 26.3 EXHIBIT 1 Consumer surplus is the difference between what a consumer has to pay ($4) and what the consumer is willing to pay. For unit 1, consumer surplus is $3 ($7 2 $4). Producer surplus is the difference between what a seller receives for selling a good or service ($4) and the price at which the seller is willing to supply that good or service. For unit 1, producer surplus is $3 ($4 2 $1).
Domestic Gains and Losses from Free Trade (exports) Area Before Trade After Trade Change Consumer Surplus (CS) a1 b 1 c a 2( b1c) Producer Surplus (PS) e 1 f b1 c 1 d 1e 1 f 1 b 1 c 1 d Total Welfare from trade (CS 1 PS) a 1 b 1 c 1e 1 f a 1 b 1 c 1 d 1e 1 f 1 d PAT PBT QBT QS AT QD AT SDOMESTIC DDOMESTIC Price of Wheat (domestic) Price of Wheat (world) Quantity of Wheat (domestic) Exports a b d c World Price Net domestic gain from trade PWORLD SWORLD DWORLD Quantity of Wheat (world) 0 0 e f Free Trade and Exports SECTION 26.3 EXHIBIT 2 Domestic producers gain more than domestic consumers lose from exports when there is free trade. On net, domestic wealth rises by area d.
World Market Domestic Market a wheat farmer in Nebraska, would you rather sell all your bushels of wheat at the higher world price or the lower domestic price? As a wheat farmer, you would surely prefer the higher world price. But this is not good news for domestic cereal and bread eaters, who now have to pay more for products made with wheat, because PAT is greater than PBT.
Graphically, we can see how free trade and exports affect both domestic consumers and domestic producers. At the higher world price, PAT, domestic wheat producers are receiving larger amounts of producer surplus. Before trade, they received a surplus equal to area e 1 f; after trade, they received surplus b 1 c 1 d 1 e 1 f, for a net gain of area b 1 c 1 d. However, part of the domestic producer’s gain comes at domestic consumer’s expense. Specifically, consumers had a consumer surplus equal to area a 1 b 1 c before the trade (at PBT), but they now only have area a (at PAT)—a loss of area b 1 c.
Area b reflects a redistribution of income, because producers are gaining exactly what consumers are losing. Is that good or bad? We can’t say objectively whether consumers or producers are more deserving. However, the net benefits from allowing free trade and exports are clearly visible in area d. Without free trade, no one gets area d. That is, on net, members of the domestic society gain when domestic wheat producers are able to sell their wheat at the higher world price. Although domestic wheat consumers lose from the free trade, Supply and Demand in International Trade 589 The $229 billion worth of trade between the United States and Mexico resulting from NAFTA has improved life on both sides of the border.
• Wages have grown 150 percent for Mexican truck drivers and overall unemployment has fallen below two percent.
• Recent elections in Mexico installed a new leadership who wants to improve U.S.-Mexico political and social relations.
• Mexico has made it possible to extradite drug traffickers to face criminal charges in the United States.
• Mexico has pledged to stop publicly defending Cuba’s poor human rights record.
• Although Mexican officials have pledged to find solutions to immigration problems, it is predicted that within 10 years the rising prosperity in Mexico resulting from free trade will reduce illegal immigration to the United States anyway.
• More than 200,000 new jobs have been created in the U.S. economy as a direct result of NAFTA, surpassing Clinton administration prediction.
• Americans also benefit from low-priced Mexican goods, such as produce, computers, and cars.
• Legislation is under way to allow private investment in electricity production—meaning new power plants and potential gains for power-starved areas of the United States.
BIG GAINS FOR MEXICO FROM FREE TRADE GLOBAL WATCH In 1993, the North American Free Trade Agreement (NAFTA) was passed. This lowered the trade barriers between Mexico, Canada, and the United States.
Proponents of freer trade, especially economists, viewed the agreement as a way to gain greater wealth through specialization and trade for all three countries—one of our ten powerful ideas. Opponents thought the agreement would take away U.S.
jobs and lower living standards or, in the words of former presidential candidate Ross Perot, that there would be “a giant sucking sound.” SOURCE: Editorial, “Bush Border Crossing Salutes U.S.-Mexican Trade Gains,” USA Today, February 16, 2001, and http://www.ncpa.org.
© Keith Dannemiller/CORBIS Saba.
those negative effects are more than offset by the positive gains captured by producers. Area d is the net increase in domestic wealth (the welfare gain) from free trade and exports.
FREE TRADE AND IMPORTS Now suppose that our economy does not produce shirts as well as other countries of the world. In other words, other countries have a comparative advantage in producing shirts. This means that the domestic price for shirts is above the world price.
This scenario is illustrated in Exhibit 3. At the new, lower world price, the domestic producer will supply quantity QS AT. However, at the lower world price, the domestic producers will not produce the entire amount demanded by domestic consumers, QD AT. At the world price, reflecting the world supply and demand for shirts, the difference between what is domestically supplied and what is domestically demanded is supplied by imports.
At the world price (established in the world market for shirts), we assume the world supply curve to the domestic market is perfectly elastic— that the producers of the world can supply all that domestic consu...
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