Module 8: International Trade

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Until now, we have analyzed the economy as if it were self-sufficient, as if the economy produces all the goods and services it consumes, and vice versa. This is, of course, true for the world economy as a whole. But it’s not true for any individual country.

The model of supply and demand that was developed in preceding modules implicitly assumed self-sufficiency. In other words, if the quantity of a good produced in the country is equal to the quantity of the good consumed, then there are no imports or exports.

Assuming self-sufficiency would have been far more accurate 50 years ago, when the United States exported only a small fraction of what it produced and imported only a small fraction of what it consumed.

Since then, however, both U.S. imports and exports have grown dramatically. Moreover, compared to the United States, other countries engage in far more foreign trade relative to the size of their economies. To have a full picture of how national economies work, we must understand the economics of international trade.

International Trade and Globalization

The United States buys auto parts—and many other goods and services—from other countries. At the same time, it sells many goods and services to other countries. Goods and services purchased from abroad are imports; goods and services sold abroad are exports.

Imports and exports have taken on an increasingly important role in the U.S. economy. Over the last 50 years, both imports into and exports from the United States have grown faster than the U.S. economy as a whole. Panel (a) of Figure 8-1 shows how the values of U.S. imports and exports have grown as a percentage of gross domestic product (GDP). Panel (b) shows imports and exports as a percentage of GDP for a number of countries. It shows that foreign trade is significantly more important for many other countries than it is for the United States. (Japan is one exception.)

Panel (a) illustrates the fact that over the past 52 years, the United States has exported a steadily growing share of its GDP to other countries and imported a growing share of what it consumes. Panel (b) demonstrates that international trade is significantly more important to many other countries than it is to the United States, with the exception of Japan.

Source: Bureau of Economic Analysis [panel (a)] and World Trade Organization [panel (b)].

Foreign trade isn’t the only way countries interact economically. In the modern world, investors from one country often invest funds in another nation; many companies are multinational, with subsidiaries operating in several countries; and a growing number of individuals work in a country different from the one in which they were born. The growth of all these forms of economic linkages among countries is often called globalization.

In the rest of this module, we’ll focus on international trade. Later on, in Section 13, we’ll address other interactions that occur between countries.

Supply, Demand, and International Trade

In Module 3 we learned about comparative advantage, where by definition a country has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that country than for other countries. In this simple model, we used the production possibility frontier (PPF) to show how a country could specialize in one good, trade some of this good for another good, and end up consuming more of both goods. Although the production possibility frontier model allows us to demonstrate gains from trade, to analyze the effects of international trade at a more detailed level and to understand trade policy, it helps to return to the supply and demand model. We’ll start by looking at the effects of imports on domestic producers and consumers, then turn to the effects of exports.

The Effects of Imports

Figure 8-2 shows the U.S. market for auto seats. It introduces a few new concepts: the domestic demand curve, the domestic supply curve, and the domestic or autarky price. Economists use the term autarky to refer to a situation in which a country does not trade with other countries. In Figure 8-2, the autarky price is P_[em]A[/em], and at this price, the quantity consumed domestically is equal to the quantity produced domestically.

Here the world price of auto seats, P_W, is below the autarky price, P_A. When the economy is opened to international trade, imports enter the domestic market, and the domestic price falls from the autarky price, P_A, to the world price, P_W. As the price falls, the domestic quantity demanded rises from Q_A to Q_D and the domestic quantity supplied falls from Q_A to Q_S. The difference between domestic quantity demanded and domestic quantity supplied at P_W, the quantity Q_D − Q_S, is filled by imports.

The domestic demand curve shows how the quantity of a good demanded by residents of a country depends on the price of that good. Why “domestic”? Because people living in other countries may demand the good, too. Once we introduce international trade, we need to distinguish between purchases of a good by domestic consumers and purchases by foreign consumers. So the domestic demand curve reflects only the demand of residents of our own country. Similarly, the domestic supply curve shows how the quantity of a good supplied by producers inside our own country depends on the price of that good. Once we introduce international trade, we need to distinguish between the supply of domestic producers and foreign supply—supply brought in from abroad.

In autarky, with no international trade in auto seats, the equilibrium in this market would be determined by the intersection of the domestic demand and domestic supply curves, point A. The equilibrium price of auto seats would be P_A, and the equilibrium quantity of auto seats produced and consumed would be Q_A.

Now let’s imagine opening up this market to imports. To do this, we must make an assumption about the supply of imports. The simplest assumption, which we will adopt here, is that unlimited quantities of auto seats can be purchased from abroad at a fixed price, known as the world price of auto seats. Figure 8-2 shows a situation in which the world price of an auto seat, P_W, is lower than the price of an auto seat that would prevail in the domestic market in autarky, P_A.

The opportunity cost of producing auto parts is higher in the United States than in Mexico.

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Given that the world price is below the domestic price of an auto seat, it is profitable for importers to buy auto seats abroad and resell them domestically. The imported auto seats increase the supply of auto seats in the domestic market, driving down the domestic market price. Auto seats will continue to be imported until the domestic price falls to a level equal to the world price.

The result is shown in Figure 8-2. Because of imports, the domestic price of an auto seat falls from P_A to P_W. The quantity of auto seats demanded by domestic consumers rises from Q_A to Q_D, and the quantity supplied by domestic producers falls from Q_A to Q_S. The difference between the domestic quantity demanded and the domestic quantity supplied, Q_D − Q_S, is filled by imports.

Having the ability to buy more of a good at a lower price is a gain to consumers, while the decrease in quantity supplied results in a loss to producers. As we’ll see shortly, the fact that international trade typically creates losers as well as winners is crucial for understanding the politics of trade policy.

Opening up a market to imports and exports leads to a net gain in total surplus, but creates losers as well as winners.

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We turn next to the case in which a country exports a good.

The Effects of Exports

Figure 8-3 shows the effects on a country when it exports a good, in this case airplanes. For this example, we assume that unlimited quantities of airplanes can be sold abroad at a given world price, P_W, which is higher than the price that would prevail in the domestic market in autarky, P_A.

Here the world price, P_W, is greater than the autarky price, P_A. When the economy is opened to international trade, some of the domestic supply is now exported. The domestic price rises from the autarky price, P_A, to the world price, P_W. As the price rises, the domestic quantity demanded falls from Q_A to Q_D and the domestic quantity supplied rises from Q_A to Q_S. The portion of domestic production that is not consumed domestically, Q_S − Q_D, is exported.

The higher world price makes it profitable for exporters to buy airplanes domestically and sell them overseas. The purchases of domestic airplanes drive the domestic price up until it is equal to the world price. As a result, the quantity demanded by domestic consumers falls from Q_A to Q_D and the quantity supplied by domestic producers rises from Q_A to Q_S. This difference between domestic production and domestic consumption, Q_S − Q_D, is exported.

Having the ability to sell more of a good at a higher price is a gain to producers, while the decrease in quantity demanded results in a loss to consumers. So, just like imports, exports create losers as well as winners.

International Trade and Wages

So far we have focused on the effects of international trade on producers and consumers in a particular industry. However, producers and consumers are not the only parts of society affected by trade—so are the owners of factors of production. In particular, the owners of labor, land, and capital employed in producing goods that are exported, or goods that compete with imported goods, can be deeply affected by trade.

Moreover, the effects of trade aren’t limited to just those industries that export or compete with imports because factors of production can often move between industries. So now we turn our attention to the long-run effects of international trade on income distribution—how a country’s total income is allocated among its various factors of production.

To begin our analysis, consider the position of Maria, an accountant at Midwest Auto Parts, Inc. If the economy is opened up to imports of auto parts from Mexico, the domestic auto parts industry will contract, and it will hire fewer accountants. But accounting is a profession with employment opportunities in many industries, and Maria might well find a better job in the aircraft industry, which expands as a result of international trade. So it may not be appropriate to think of her as a producer of auto parts who is hurt by competition from imported parts. Rather, we should think of her as an accountant who is affected by auto part imports only to the extent that these imports change the wages of accountants in the economy as a whole.

The wage rate of accountants is a factor price—the price employers have to pay for the services of a factor of production. One key question about international trade is how it affects factor prices—not just narrowly defined factors of production like accountants, but broadly defined factors such as capital, unskilled labor, and college-educated labor.

The prices of factors of production, like the prices of goods and services, are determined by supply and demand. If international trade increases the demand for a factor of production, that factor’s price will rise; if international trade reduces the demand for a factor of production, that factor’s price will fall.

Now think of a country’s industries as consisting of two kinds: exporting industries, which produce goods and services that are sold abroad, and import-competing industries, which produce goods and services that are also imported from abroad. Compared with autarky, international trade leads to higher production in exporting industries and lower production in import-competing industries. This indirectly increases the demand for the factors used by exporting industries and decreases the demand for factors used by import-competing industries.

The United States has a comparative advantage in producing high-technology goods, like airplanes and computer chips, that require skilled labor whereas newly industrialized countries like China have a comparative advantage in producing unskilled, labor-intensive products, such as clothing and consumer electronics. In the United States the result is an increase in the demand for the skilled labor used by the exporting industries and a decrease in the demand for the less skilled labor used by the import-competing industries.

This suggests that the effect of international trade on U.S. factor markets is to raise the wage rate of highly educated American workers and reduce the wage rate of unskilled American workers.

This effect has been a source of much concern in recent years. Wage inequality—the gap between the wages of high-paid and low-paid workers—has increased substantially over the last 30 years. Some economists believe that growing international trade is an important factor in that trend. But keep in mind another phenomenon: trade reduces the income inequality between countries as poor countries improve their standard of living by exporting to rich countries.

Trade benefits highly educated American workers when exporting industries demand more skilled labor and wages increase.

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The effects of trade on wages in the United States have generated considerable controversy in recent years. Most economists who have studied the issue agree that growing imports of labor-intensive products from newly industrializing economies, and the export of high-technology goods in return, have helped cause a widening wage gap between highly educated and less educated workers in this country. However, most economists believe that it is only one of several forces explaining the growth in American wage inequality.

SKILL AND COMPARATIVE ADVANTAGE

In 1953 U.S. workers were clearly better equipped with machinery than their counterparts in other countries. Most economists at the time thought that America’s comparative advantage lay in capital-intensive goods. However, data showed that goods the United States exported were slightly less capital-intensive than goods the country imported.

The explanation for this finding depends on the definition of capital. U.S. exports aren’t intensive in physical capital—machines and buildings. Instead, they are skill-intensive—that is, they are intensive in human capital. U.S. exporting industries use a substantially higher ratio of highly educated workers to other workers than is found in U.S. industries that compete against imports. For example, one of America’s biggest export sectors is aircraft; the aircraft industry employs large numbers of engineers and other people with graduate degrees relative to the number of manual laborers. Conversely, we import a lot of clothing, which is often produced by workers with little formal education.

In general, countries with highly educated workforces tend to export skill-intensive goods, while countries with less educated workforces tend to export goods whose production requires little skilled labor.

Figure 8-4 illustrates this point by comparing the goods the United States imports from Germany, a country with a highly educated labor force, with the goods the United States imports from Bangladesh, where about half of the adult population is still illiterate. In each country industries are ranked, first, according to how skill-intensive they are. Next, for each industry, we calculate its share of U.S. imports. This allows us to plot, for each country, various industries according to their skill intensity and their share of U.S. imports.

Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review 94, no. 1 (2004): 67–97.

In Figure 8-4, the horizontal axis shows a measure of the skill intensity of different industries, and the vertical axes show the share of U.S. imports in each industry coming from Germany (on the left) and Bangladesh (on the right). As you can see, each country’s share of U.S. imports reflects its skill level. The curve representing Germany slopes upward: the more skill-intensive a German industry is, the higher its share of U.S. imports. In contrast, the curve representing Bangladesh slopes downward: the less skill-intensive a Bangladeshi industry is, the higher its share of U.S. imports.

The Effects of Trade Protection

Ever since the principle of comparative advantage was laid out in the early nineteenth century, most economists have advocated free trade. That is, they have argued that government policy should not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand.

Despite the free-trade arguments of economists, however, many governments use taxes and other restrictions to limit imports. Less frequently, governments offer subsidies to encourage exports. Policies that limit imports, usually with the goal of protecting domestic producers in import-competing industries from foreign competition, are known as trade protection or simply as protection.

Let’s look at the two most common protectionist policies, tariffs and import quotas.

The Effects of a Tariff

A tariff is a form of excise tax, one that is levied only on sales of imported goods. For example, the U.S. government could declare that anyone bringing in auto seats must pay a tariff of $100 per unit. In the distant past, tariffs were an important source of government revenue because they were relatively easy to collect. But in the modern world, tariffs are usually intended to discourage imports and protect import-competing domestic producers rather than to serve as a source of government revenue.

The tariff raises both the price received by domestic producers and the price paid by domestic consumers. Suppose, for example, that our country imports auto seats, and an auto seat costs $200 on the world market. As we saw earlier, under free trade the domestic price would also be $200. But if a tariff of $100 per unit is imposed, the domestic price will rise to $300, because it won’t be profitable to import auto seats unless the price in the domestic market is high enough to compensate importers for the cost of paying the tariff.

Figure 8-5 illustrates the effects of a tariff on imports of auto seats. As before, we assume that P_W is the world price of an auto seat. Before the tariff is imposed, imports have driven the domestic price down to P_W, so that pre-tariff domestic production is Q_S, pre-tariff domestic consumption is Q_D, and pre-tariff imports are Q_D − Q_S.

A tariff raises the domestic price of the good from P_W to P_T. The domestic quantity demanded shrinks from Q_D to Q_DT, and the domestic quantity supplied increases from Q_S to Q_ST. As a result, imports—which had been Q_D − Q_S before the tariff was imposed—shrink to Q_DT − Q_ST after the tariff is imposed.

Now suppose that the government imposes a tariff on each auto seat imported. As a consequence, it is no longer profitable to import auto seats unless the domestic price received by the importer is greater than or equal to the world price plus the tariff. So the domestic price rises to P_T, which is equal to the world price, P_W, plus the tariff. Domestic production rises to Q_ST, domestic consumption falls to Q_DT, and imports fall to Q_DT − Q_ST.

A tariff, then, raises domestic prices, leading to increased domestic production and reduced domestic consumption compared to the situation under free trade.

The Effects of an Import Quota

An import quota, another form of trade protection, is a legal limit on the quantity of a good that can be imported. For example, a U.S. import quota on Mexican auto seats might limit the quantity imported each year to 500,000 units. Import quotas are usually administered through licenses: a number of licenses are issued, each giving the license-holder the right to import a limited quantity of the good each year.

An import quota has the same effect as a tariff, with one difference: the money that would otherwise have been government revenue becomes quota rents, or earnings that accrue to license-holders.

Look again at Figure 8-5. An import quota that limits imports to Q_DT − Q_ST will raise the domestic price of auto parts by the same amount as the tariff we considered previously. That is, it will raise the domestic price from P_W to P_T. This difference between P_T and P_W now goes to the license-holder.

Who receives import licenses and so collects the quota rents? In the case of U.S. import protection, the answer may surprise you: the most important import licenses—mainly for clothing, to a lesser extent for sugar—are granted to foreign governments.

Because the quota rents for most U.S. import quotas go to foreigners, the cost to the nation of such quotas is larger than that of a comparable tariff (a tariff that leads to the same level of imports).

Challenges to Globalization

We have seen that international trade produces mutual benefits to the countries that engage in it. The forward march of globalization over the past century is generally considered a major political and economic success. Economists and policy makers alike have viewed growing world trade, in particular, as a good thing.

We would be remiss, however, if we failed to acknowledge that many people are having second thoughts about globalization. To a large extent, these second thoughts reflect two concerns shared by many economists: worries about the effects of globalization on inequality and worries that new developments, in particular the growth in offshore outsourcing, are increasing economic insecurity.

Globalization and InequalityWe’ve already mentioned the implications of international trade for factor prices, such as wages: when wealthy countries like the United States export skill-intensive products like aircraft while importing labor-intensive products like clothing, they can expect to see the wage gap between more educated and less educated domestic workers widen.

Economists and policy makers view growing world trade as a positive, but not everyone agrees.

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Thirty years ago, this wasn’t a significant concern, because most of the goods wealthy countries imported from poorer countries were raw materials or goods where comparative advantage depended on climate. Today, however, many manufactured goods are imported from relatively poor countries, with a potentially much larger effect on the distribution of income.

Trade with China, in particular, raises concerns among labor groups trying to maintain wage levels in rich countries. Although China has experienced spectacular economic growth since the economic reforms that began in the late 1970s, it remains a poor, low-wage country: wages in Chinese manufacturing are estimated to be only about 6% of U.S. wages.

Meanwhile, imports from China have soared. In 1983 less than 1% of U.S. imports came from China; by 2012, the figure was 18%. There’s not much question that these surging imports from China put at least some downward pressure on the wages of less educated American workers.

OutsourcingChinese exports to the United States overwhelmingly consist of labor-intensive manufactured goods. However, some U.S. workers have recently found themselves facing another form of international competition. Outsourcing, in which a company hires another company to perform some task, such as running the corporate computer system, is a long-standing business practice. Until recently, however, outsourcing was normally done locally, with a company hiring another company in the same city or country.

Now, modern telecommunications make it possible to engage in offshore outsourcing, in which businesses hire people in another country to perform various tasks. The classic example is a call center: the person answering the phone when you call a company’s 1-800 help line may well be in India, which has taken the lead in attracting offshore outsourcing. Offshore outsourcing has also spread to fields such as software design and even health care: the radiologist examining your X-rays, like the person giving you computer help, may be on another continent.

Offshore outsourcing is relatively small compared with more traditional trade.

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Although offshore outsourcing has come as a shock to some U.S. workers, such as programmers whose jobs have been outsourced to India, it’s still relatively small compared with more traditional trade. Some economists have warned, however, that millions or even tens of millions of workers who have never thought they could face foreign competition for their jobs may face unpleasant surprises in the not-too-distant future.

Do these challenges to globalization undermine the argument that international trade is a good thing? The great majority of economists would argue that the gains from reducing trade protection still exceed the losses. However, it has become more important than before to make sure that the gains from international trade are widely spread. And the politics of international trade is becoming increasingly difficult as the extent of trade has grown.

MODULE 8 Review

Check Your Understanding

Assume that in autarky the equilibrium price of a good in the domestic market is $10, the world price of the same good is $8, and the country opens up to trade. Then answer the following questions.