1.2 Module 17: Supply, Demand, and International Trade

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Imports, Exports, and Wages

Simple models of comparative advantage are helpful for understanding the fundamental causes of international trade. However, 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 17-1 shows the U.S. market for auto seats, ignoring international trade for a moment. It introduces a few new concepts: the domestic demand curve, the domestic supply curve, and the domestic or autarky price.

In the absence of trade, the domestic price is P_A, the autarky price at which the domestic supply curve and the domestic demand curve intersect. The quantity produced and consumed domestically is Q_A. Consumer surplus is represented by the blue-shaded area, and producer surplus is represented by the red-shaded area.

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. As always, both consumers and producers gain from the existence of the domestic market. In autarky, consumer surplus would be equal to the area of the blue-shaded triangle in Figure 17-1. Producer surplus would be equal to the area of the red-shaded triangle. And total surplus would be equal to the sum of these two shaded triangles.

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 17-2 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.

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.

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 17-2. 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.

Now let’s turn to the effects of imports on consumer surplus and producer surplus. Because imports of auto seats lead to a fall in their domestic price, consumer surplus rises and producer surplus falls. Figure 17-3 shows how this works. We label four areas: W, X, Y, and Z. The autarky consumer surplus we identified in Figure 17-1 corresponds to W, and the autarky producer surplus corresponds to the sum of X and Y. The fall in the domestic price to the world price leads to an increase in consumer surplus; it increases by X and Z, so consumer surplus now equals the sum of W, X, and Z. At the same time, producers lose X in surplus, so producer surplus now equals only Y.

When the domestic price falls to P_W as a result of international trade, consumers gain additional surplus (areas X + Z) and producers lose surplus (area X). Because the gains to consumers outweigh the losses to producers, there is an increase in the total surplus in the economy as a whole (area Z).

The table in Figure 17-3 summarizes the changes in consumer and producer surplus when the auto seats market is opened to imports. Consumers gain surplus equal to the areas X + Z. Producers lose surplus equal to X. So the sum of producer and consumer surplus—the total surplus generated in the auto seats market—increases by Z. As a result of trade, consumers gain and producers lose, but the gain to consumers exceeds the loss to producers.

This is an important result. We have just shown that opening up a market to imports leads to a net gain in total surplus, which is what we should have expected given the proposition that there are gains from international trade.

However, we have also learned that although the country as a whole gains, some groups—in this case, domestic producers of auto parts—lose as a result of international trade. 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.

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

The Effects of Exports

Figure 17-4 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.

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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Like imports, exports lead to an overall gain in total surplus for the exporting country but also create losers as well as winners. Figure 17-5 shows the effects of airplane exports on producer and consumer surplus. In the absence of trade, the price of each airplane would be P_A. Consumer surplus in the absence of trade is the sum of areas W and X, and producer surplus is area Y. As a result of trade, price rises from P_A to P_W, consumer surplus falls to W, and producer surplus rises to Y + X + Z. So producers gain X + Z, consumers lose X, and, as shown in the table accompanying the figure, the economy as a whole gains total surplus in the amount of Z.

When the domestic price rises to P_W as a result of trade, producers gain additional surplus (areas X + Z) but consumers lose surplus (area X). Because the gains to producers outweigh the losses to consumers, there is an increase in the total surplus in the economy as a whole (area Z).

We have learned, then, that imports of a particular good hurt domestic producers of that good but help domestic consumers, whereas exports of a particular good hurt domestic consumers of that good but help domestic producers. In each case, the gains are larger than the losses.

International Trade and Wages

So far we have focused on the effects of international trade on producers and consumers in a particular industry. For many purposes this is a very helpful approach. 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.

In the previous module we described the Heckscher–Ohlin model of trade, which states that comparative advantage is determined by a country’s factor endowment. This model also suggests how international trade affects factor prices in a country: compared to autarky, international trade tends to raise the prices of factors that are abundantly available and reduce the prices of factors that are scarce.

We won’t work this out in detail, but the idea is simple. 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.

In addition, the Heckscher–Ohlin model says that a country tends to export goods that are intensive in its abundant factors and to import goods that are intensive in its scarce factors. So international trade tends to increase the demand for factors that are abundant in our country compared with other countries, and to decrease the demand for factors that are scarce in our country compared with other countries. As a result, the prices of abundant factors tend to rise, and the prices of scarce factors tend to fall as international trade grows. In other words, international trade tends to redistribute income toward a country’s abundant factors and away from its less abundant factors.

Trade affects factor markets by raising the wages of highly educated workers and lowering them for unskilled workers.

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As we’ve seen, U.S. exports tend to be human-capital-intensive and U.S. imports tend to be unskilled-labor-intensive. 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. If international trade has the effects predicted by the Heckscher–Ohlin model, its growth raises the wages of highly educated American workers, who already have relatively high wages, and lowers the wages of less educated American workers, who already have relatively low wages. 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.

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.

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, then turn to the reasons governments follow these policies.

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 17-6 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. Figure 17-7 shows the effects on surplus. There are three effects:

When the domestic price rises as a result of a tariff, producers gain additional surplus (area A), the government gains revenue (area C), and consumers lose surplus (areas A + B + C + D). Because the losses to consumers outweigh the gains to producers and the government, the economy as a whole loses surplus (areas B + D).

1. The higher domestic price increases producer surplus, a gain equal to area A.
2. The higher domestic price reduces consumer surplus, a reduction equal to the sum of areas A, B, C, and D.
3. The tariff yields revenue to the government. How much revenue? The government collects the tariff—which, remember, is equal to the difference between P_T and P_W on each of the Q_DT − Q_ST units imported. So total revenue is (P_T − P_W) × (Q_DT − Q_ST). This is equal to area C.

The welfare effects of a tariff are summarized in the table in Figure 17-7. Producers gain, consumers lose, and the government gains. But consumer losses are greater than the sum of producer and government gains, leading to a net reduction in total surplus equal to areas B + D.

An excise tax creates inefficiency, or deadweight loss, because it prevents mutually beneficial trades from occurring. The same is true of a tariff, where the deadweight loss imposed on society is equal to the loss in total surplus represented by areas B + D.

Tariffs generate deadweight losses because they create inefficiencies in two ways:

1. Some mutually beneficial trades go unexploited: some consumers who are willing to pay more than the world price, P_W, do not purchase the good, even though P_W is the true cost of a unit of the good to the economy. The cost of this inefficiency is represented in Figure 17-7 by area D.
2. The economy’s resources are wasted on inefficient production: some producers whose cost exceeds P_W produce the good, even though an additional unit of the good can be purchased abroad for P_W. The cost of this inefficiency is represented in Figure 17-7 by area B.

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.

A quota on sales has the same effect as an excise tax, with one difference: the money that would otherwise have accrued to the government as tax revenue under an excise tax becomes license-holders’ revenue under a quota—this revenue is also known as quota rents. Similarly, 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 to license-holders.

Look again at Figure 17-7. 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. However, area C will now represent quota rents rather than government revenue.

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

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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). In Figure 17-7 the net loss to the United States from such an import quota would be equal to areas B + C + D, the difference between consumer losses and producer gains.

Challenges to Globalization

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 Inequality

We’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. 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.

Outsourcing

Chinese 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.

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.

Offshore outsourcing is relatively small compared with more traditional trade.

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Concerns about income distribution and outsourcing, as we’ve said, are shared by many economists. There is also, however, widespread opposition to globalization in general, particularly among college students.

What motivates the antiglobalization movement? To some extent it’s the sweatshop labor fallacy: it’s easy to get outraged about the low wages paid to the person who made your shirt, and harder to appreciate how much worse off that person would be if denied the opportunity to sell goods in rich countries’ markets.

It’s also true, however, that the movement represents a backlash against supporters of globalization who have oversold its benefits. Countries in Latin America, in particular, were promised that reducing their tariff rates would produce an economic takeoff; instead, they have experienced disappointing results.

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.

!world_eia!BEEFING UP EXPORTS

In December 2010, negotiators from the United States and South Korea reached final agreement on a free-trade deal that would phase out many of the tariffs and other restrictions on trade between the two nations. The deal also involved changes in a variety of business regulations that were expected to make it easier for U.S. companies to operate in South Korea. This was, literally, a fairly big deal: South Korea’s economy is comparable in size to Mexico’s, so this was the most important free-trade agreement that the United States had been party to since NAFTA. (As you’ll recall, the North American Free Trade Agreement, or NAFTA, is an agreement signed in 1993 by the United States, Mexico, and Canada, that removes all barriers to trade among these three countries.)

The 2010 trade agreement between South Korea and the United States was the most important free-trade deal since NAFTA.

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What made this deal possible? Estimates by the U.S. International Trade Commission found that the deal would raise average American incomes, although modestly: the commission put the gains at around one-tenth of one percent. Not bad when you consider the fact that South Korea, despite its relatively large economy, is still only America’s seventh-most-important trading partner.

These overall gains played little role in the politics of the deal, however, which hinged on losses and gains for particular U.S. constituencies. Some opposition to the deal came from labor, especially from autoworkers, who feared that eliminating the 8% U.S. tariff on imports of Korean automobiles would lead to job losses.

But there were also interest groups in America that badly wanted the deal, most notably the beef industry: Koreans are big beef-eaters, yet American access to that market was limited by a 38% Korean tariff.

And the Obama administration definitely wanted a deal, in part for reasons unrelated to economics: South Korea is an important U.S. ally, and military tensions with North Korea had been ratcheting up. So a trade deal was viewed in part as a symbol of U.S.–South Korean cooperation. Even labor unions weren’t as opposed as they might have been.

It also helped that South Korea—unlike Mexico when NAFTA was signed—is both a fairly high-wage country and not right on the U.S. border, which meant less concern about massive shifts of manufacturing. In the end, the balance of interests was just favorable enough to make the deal politically possible.

Module 17 Review

Check Your Understanding

A few years ago, the United States imposed tariffs on steel imports, which are an input in a large number and variety of U.S. industries. Explain why political lobbying to eliminate these tariffs is more likely to be effective than political lobbying to eliminate tariffs on consumer goods such as sugar or clothing.