It’s natural for the citizens of a country to say, “We can make food, clothing, and almost everything we need. Why should we buy these goods from other countries and send our money overseas?” Module 4 explained the answer to this question: because specialization and trade make larger quantities of goods and services available to consumers. Yet the gains from trade are often overlooked, and many countries have experimented with a closed economy. Examples from the last century include Germany from 1933−1945, Spain from 1939−1959, Cambodia from 1975−1979, and Afghanistan from 1996−2001. The outcomes of these experiments were disappointing. By trying to make too many different products, these countries failed to specialize in what they were best at making; as a result, they ended up with less of most goods than trade would have provided.

Every country now has an open economy, although some economies are more open than others. Figure 44.1 shows expenditures on imports as a percentage of GDP for select countries, which ranged from 14% in Brazil to 178% in Singapore. Several factors affect a country’s approach to trade. Beyond the natural tendency for each country to want to make everything, special circumstances can limit the options for trade. For example, high transportation costs hinder trade for countries with primitive transportation systems as well as for countries that specialize in heavy, low-priced commodities such as bricks, drinking water, watermelons, or sand. Countries are wary of specialization that would make them overly reliant on other countries, because relationships with those countries could sour. And, as a matter of national pride, countries may prefer to make certain products on their own despite comparative disadvantages, such as food, art, weapons, and products that showcase technical know-how.

International trade can also have its casualties. As production shifts toward a country’s comparative advantage, many workers in declining industries will lose their jobs, and will remain structurally unemployed until or unless they can obtain the skills required in other industries. For example, as the United States imported more clothing from countries with a comparative advantage in textiles, workers in the Fruit of the Loom factory in Campbellsville, Kentucky, were among many who lost their jobs. Fortunately, the unemployment rates in Campbellsville and in the United States as a whole rose only temporarily. Many of these workers were able to adapt to the requirements of growing industries such as construction, automotive parts, health care, and software design, and were able to secure new jobs as a result.

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Some industries may not initially be competitive at the international level, but they could attain a comparative advantage after a period of protection from lower-priced imports. This is the motivation for protectionism, the practice of limiting trade to protect domestic industries. Tariffs and import quotas are the primary tools of protectionism.

The imposition of tariffs, which are taxes on imports, helps domestic industries and provides revenue for the government. The bad news is that tariffs make prices higher for domestic consumers and can spark trade wars. Early in American history, tariffs provided a majority of the revenue for the U.S. government, reaching a high of 97.9% in 1825. As the benefits of free trade came to light, and income and payroll taxes were adopted in the early 1900s, the use of tariffs diminished. By 1944, tariff revenue amounted to only about 1% of federal government revenue, which is still the case today.

Consider the U.S. market for ceramic plates, a hypothetical version of which is shown in Figure 44.2. The upward-sloping supply curve shows the supply from U.S. firms. The demand curve is for U.S. consumers only. If the United States had a closed economy, 5 million plates would sell for the no-trade equilibrium price of $15 each. However, suppose that an unlimited quantity of plates could be imported for the equilibrium price in the world market, $9. In the absence of trade restrictions, domestic firms would be unable to charge more than the world price. At the $9 world price, domestic firms would be willing to supply 3 million plates, but domestic consumers would demand 7 million. Four million imported plates would make up the difference between the 7 million plates demanded and the 3 million supplied in the domestic market.

Now suppose that the U.S. imposes a tariff of $3 per imported ceramic plate. As shown in Figure 44.3, that would effectively raise the curve that represents the supply from the rest of the world by $3. For every imported plate, the required payment would be $9 to the foreign suppliers plus $3 for the tariff, for a total of $12. Domestic firms would now be able to charge up to $12, for which they would be willing to supply 4 million plates, an increase of 1 million compared to the no-tariff situation. Domestic consumers would demand 6 million plates for $12, a decrease of 1 million from the no-tariff situation. Two million plates would be imported to make up the difference between the domestic supply of 4 million and the domestic demand of 6 million plates. Note that this is a drop of 2 million from the 4 million plates imported without the tariff. The tariff revenue would be 2 million × $3 = $6 million, as represented by the shaded rectangle in the figure.

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An import quota is a limit on the quantity of a good that can be imported within a given period. By restricting the supply of imports, import quotas reduce the equilibrium quantity and increase the equilibrium price. Like tariffs, quotas help domestic firms compete with foreign suppliers, but they also cause prices to be higher for domestic consumers. Consider sugar, which Americans consume at a rate of about 11 million tons per year. To protect domestic sugar cane and sugar beet farmers, the U.S. Department of Agriculture (USDA) sets a quota for the amount of sugar that can be imported—1.2 million tons in 2014—before a substantial tariff is applied.

Suppose that the United States imposes an import quota of 2 million ceramic plates. That quota would prevent a trade equilibrium at the intersection of U.S. consumers’ demand and the supply from the rest of the world because, as we saw in Figure 44.2, that equilibrium would require imports of 4 million plates. Instead, consumers would face the pink supply curve in Figure 44.4, which represents the U.S. supply plus the 2 million plates that could be imported with the quota. Imports would not be available for less than $9, so the pink U.S.-plus-quota supply curve does not extend below a price of $9. The equilibrium price with the quota is $12. Six million plates would be sold at that price, 4 million of which would be made domestically. Notice that the quota of 2 million plates would have the same effect on the price, imports, and domestic supply as the $3 tariff. One difference is that with the quota, no tariff revenue would be collected.

The use of tariffs and import quotas is seldom one-sided. When one country erects a trade barrier against another, retaliation is common. For instance, after the Obama administration imposed a tariff on tires imported from China, China threatened to cut off imports of chickens from the United States. Escalating trade wars can obliterate the gains from trade, which motivates many countries to move in the opposite direction and negotiate the elimination of trade barriers. Trade agreements such as the North American Free Trade Agreement and the Dominican Republic–Central America Free Trade Agreement limit the use of tariffs, quotas, regulations, and other impediments to trade among the economies involved. As discussed in the FYI that follows, these agreements can provide substantial benefits to citizens in the participating countries

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