Feenstra Int. Trade Book PDF
Feenstra Int. Trade Book PDF
Feenstra Int. Trade Book PDF
MANUAL
for use with
international
trade second edition
Philip Luck
University of California, Davis
WORTH PUBLISHERS
INSTRUCTORS MANUAL
by Philip Luck
for use with Feenstra/Taylor: International Trade, Second Edition
The contents, or parts thereof, may be reproduced for use with International Trade,
Second Edition by Robert C. Feenstra and Alan M. Taylor, but may not be reproduced
in any form for any other purpose without prior written permission of the publisher.
Worth Publishers
41 Madison Avenue
New York, NY 10010
www. worthpublishers. com
CONTENTS
Preface iv
Part One
Introduction to International Trade
Chapter 1 Trade in the Global Economy 1
Part Two
Patterns of International Trade
Chapter 2 Trade and Technology: The Ricardian Model 11
Chapter 3 Gains and Losses from Trade in the Specific-Factors Model 33
Chapter 4 Trade and Resources: The Heckscher-Ohlin Model 45
Chapter 5 Movement of Labor and Capital between Countries 63
Part Three
New Explanations for International Trade
Chapter 6 Increasing Returns to Scale and Monopolistic Competition 83
Chapter 7 Offshoring of Goods and Services 101
Part Four
International Trade Policies
Chapter 8 Import Tariffs and Quotas under Perfect Competition 117
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 143
Chapter 10 Export Subsidies in Agriculture and High-Technology Industries 165
Chapter 11 International Agreements: Trade, Labor, and the Environment 185
iii
PREFACE
The purpose of this Instructors Manual is to provide supplemental materials for Interna-
tional Economics, Second Edition by Robert C. Feenstra and Alan M. Taylor. The
chapters closely follow the layout of the chapters in the textbook. Each chapter is divided
into sections:
Notes to Instructor
Lecture Notes
Teaching Tips
In-Class Problems
The Notes to Instructor section is further divided into two subsections: Chapter Summary
and Comments. The Chapter Summary contains a brief overall synopsis of the chapter. The
Comments provide suggestions for presenting the material to your students. This section
also serves to highlight important aspects of the textbook chapter.
The Lecture Notes section corresponds directly to the outline of the chapter. In addi-
tion to a comprehensive summary of the textbook chapter, this section provides alterna-
tive examples, particularly in the numerical presentations.
The Teaching Tips consist of four or five activities per chapter that instructors can uti-
lize in lectures, for in-class group work, or as take-home assignments.
The In-Class Problems section offers additional questions that may be used in class or
assigned as homework. The problems will help your students understand the key con-
cepts and apply the models presented in the textbook chapter. Detailed answers to these
problems are provided at the end of each chapter.
I hope that the resources in this manual will be of help to you, and I welcome any
suggestions and comments.
ACKNOWLEDGMENTS
Worth Publishers is indebted to Philip Luck (University of California, Davis) for author-
ing the second edition of the Intructors Manual. We would like to thank Alyson Ma for
authoring the first edition of the Instructors Manual and for providing invaluable guidance
for the second eition. Thanks also to Tony Lima (University of California, East Bay) for
thoroughly reviewing this material, and to Jaclyn Castaldo, Stacey Alexander, and Laura
McGinn for their assistance in producing this volume.
iv
Trade in the Global Economy
1
Notes to Instructor
Chapter Summary
Chapter 1 introduces the concept of globalization, which involves the flow of
goods, services, people, firms, and capital across borders. This chapter highlights
the difference in the flow of goods and services as well as foreign direct invest-
ment across borders versus the movement of people. We learn in this chapter
that a substantial portion of the world trade in goods and services occurs be-
tween industrial countries. This interdependence among the industrial coun-
tries is even more pronounced when we examine foreign direct investment.
But motivated by concerns that the workers from low-wage countries moving
to industrial countries will decrease the wages of their less-skilled workers, many
wealthier nations have government policies that discourage migration. In addi-
tion, we also learn that globalization is not a new phenomena and that the world
experienced tremendous trade growth in the late nineteenth and early twenti-
eth centuries with improvements in transportation.
Comments
This chapter serves as an introduction to the international trade section of the
textbook. You may also choose to skip over this first chapter because Chap-
ter 2 is written as a secondary introduction with an example that is reexam-
ined in later chapters. The topic of international trade could be motivated by
asking the students to consider their typical day from the moment they wake
up to the time they arrive at class. For example, the coffee they consume is
made from beans grown in Brazil or Vietnam. The clothes they wear are as-
sembled by workers in the Philippines. The iPod they listen to on the way to
class is made in China, and so forth.
1
2 Chapter 1 Trade in the Global Economy
Lecture Notes
Introduction
The explosion of the Eyjafjallajokull in 2010 created a massive disturbance to
international trade. By halting the transport of many goods, this geological
event demonstrated the importance of trade in our global economy. It has
been estimated that the disruption in air freight for two weeks generated lost
revenues from $16 to $27 billion for goods imported to the United States
from Europe, and $20 to $26 billion for goods exported from the United
States to Europe; all of which is lost revenue from trade in goods. The lost
revenue from canceled flights between the United States and Europe was
roughly $3. 2 billion in lost service trade. This book studies the trade in goods
and services and studies the forces that determine these flows.
If we only consider merchandise goods, then the largest exporter in 2009
was China with $1. 3 trillion. In second and third place were Germany ($1. 17
trillion) and the United States ($900 billion), respectively. However, this is
only part of international trade. In 2009, the United States exported $0. 5 tril-
lion in services exports. When we combine the export of goods and ser-
vices, the United States was the largest exporter at $1. 55 trillion. The next
five countries in descending order were Germany, China, Japan, the United
Kingdom, and France.
Countries engage in trade for many reasons. In Chapters 2 through 11, we
find that nations benefit from international trade when there are differences
in opportunity costs between trading partners. We examine the winners and
losers of international trade when factors are specific to certain productions.
We determine the impact of migration and flow of capital or foreign di-
rect investment on wages at home and abroad. We also investigate actions
taken by governments to encourage or discourage the flow of trade, migra-
tion, and foreign direct investment. The consequences of government inter-
ventions are discussed.
1 International Trade
In the first half of the textbook we assume that each country maintains a
balanced trade. One of the reasons is that macroeconomic conditions dealing
with high spending and low savings, which leads to a trade deficit, are dis-
cussed later in the textbook. The second reason is that there are issues in terms
of the official statistics used to calculate the bilateral trade balance.
H E A D L I N E S
An iPod Has Global Value. Ask the (Many) Countries
That Make It
This article discusses the problems with reporting bilateral trade ows between countries due
to the difference between the sale price of an export and the value a country adds. The ex-
ample in this article is the Apple iPod, which are imported from China at a price around
$150, yet most of the parts assembled in China are themselves imported from other coun-
tries. The assembly of the 451 parts that currently takes place in China accounts for only
about $4 of the total cost of the iPod. This article demonstrates why the bilateral trade
decit between the U.S. and China may be a misleading statistic.
APPLICATION
Is Trade Today Different from the Past?
Both the volume and composition of international trade has changed greatly
over the past century. The change in the composition of trade can be made
clear by dividing trade into several groups, as is done in Figure 1-1. From Fig-
ure 1-1(a), we can see that U. S. trade has shifted away from agriculture and
raw materials and toward manufactured goods. From 1925 to 2009, U. S. im-
ports of food, feeds, and beverages and industrial supplies and materials de-
clined from 90% to 35% of imports. From Figure 1-1(b), we see that the ex-
port share of these same categories also fell from 80% to 40% over the same
period. Figure 1-1 also shows that the import and export of capital goods plus
consumer goods grew steadily; imports rising from 10% to 65% and exports
from 20% to 60%.
N E T W O R K
The following table shows the world exports of goods and services from 1995 to 2005 in
billions of current dollars.
World Exports, 19952005
(In billions of U.S. current dollars)
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Merchandise
Goods 5,164 5,401 5,589 5,499 5,709 6,452 6,186 6,486 7,578 9,203 10,431
Services 1,185 1,271 1,320 1,350 1,405 1,491 1,493 1,601 1,828 2,186 2,414
Trade with Asia The amount of trade that occurs between Europe and Asia
and the United States and Asia is also considerable. In 2006, exports from Asia
to the United States were $659 billion. China was the largest exporter to the
U. S. in 2006 (selling $288 billion) followed by Japan ($148 billion) and South
Korea ($46 billion). In addition, if we include trade in services we will find
more exports from Asia to the United States (and Europe), given the increased
use of outsourcing by American and European firms in countries such as India.
Other Regions The oil exported by countries in the Middle East, along with
Russias export of oil and natural gas, contribute 9% to world trade. By con-
trast, the African countries add only 3% to world trade.
Barriers to Trade
Another reason why the trade/GDP ratio differs across countries is because
there are factors that influence the amount of goods and services that are
Chapter 1 Trade in the Global Economy 5
H E A D L I N E S
A Sea Change in Shipping 50 Years Ago
The introduction of shipping containers by Malcom McLean in 1956 dramatically reduced
transportation costs, transforming international trade in merchandise goods. As an example,
loading and unloading increased from 0.627 tons per man hour in 1959 to 4,234 tons per
man hour in 1976, with the rates even higher today.
Map of Migration
The number of individuals living legally or illegally in their nonnative
country in 2005 is shown in Figure 1-6. In this figure, arrows from one
country to another indicate the movements of individuals from one location
to the other, with large (small) migration indicated by heavy (dashed) lines.
Bold arrows denote the similar movements from World into Asia, Africa, and
Latin America (for those whose country of origin is unknown).
Unlike like trade, in which the majority occurs between rich countries,
more migration takes place among less wealthy nations. In 2005, 53.1 of the
195 million migrants were located in Asia, while another 17. 1 million mi-
grants called Africa home. It is likely that many of the immigrants relocated
within the same continent in search of employment or for other reasons.
Although barriers to trade are decreasing over the years, this is not the case
for migration. The flow of people across borders is highly restricted by im-
migration policies in Europe and the United States, partly because of fears that
the migrants from low-wage countries will cause the wages for a countrys
own less-skilled workers to decline. However, even with the limitation on
migration, individuals in low-wage countries may improve their living stan-
dard by working in export industries in which international trade acts as a
substitute for their movement of labor across borders.
European and U.S. Immigration With the increase in the number of coun-
tries joining the European Union, some of the original members are discour-
aging migration from the new lower-wage members by not accepting work-
ers from these countries. Immigration policy is also a frequent topic of debate
in the United States because of concerns that the influx of illegal immigrants
from Mexico will drive wages down for American workers.
FDI Inows (in Billions of U.S. Dollars) by Host Region and Major Host
Economy, 20042006
Host Region/Economy 2004 2005 2006a Growth Rates
(%)
Japanese car manufacturers built plants in the United States. A second rea-
son for horizontal FDI is that owning a foreign subsidiary allows companies
to gain better access to the local economy. A third reason is that companies
may draw on technical expertise available in the area by locating near other
established firms.
Vertical FDI Vertical FDI occurs when a firm in an industrial country
builds or purchases a plant in a developing country. One of the advantages of
establishing a plant in a developing country is to lower production costs by
hiring low-wage workers.
European and U.S. FDI Nearly one-half, or $5. 6 trillion, of the total world
stock of FDI was in Europe in 2006. Examples of European direct invest-
ments in the United States include the merger of Daimler-Benz and Chrysler
corporations in 1998, which became DaimlerChrysler. Chrysler was then
owned by an American financial company, Cerberus Capital Management,
from 2007 until 2009, when it was once again a source of European direct in-
vestment when it was sold to Italian automaker Fiat. An example of an Amer-
ican direct investment in Europe is the acquisition of Jaguar and Volvo by Ford
Motor Company in 1989 and 1999, respectively. The table on p. 7 shows FDI
inflows from 2004 to 2006.
FDI in the Americas There are also substantial stocks of FDI in the United
States, Canada, and Latin America. Although high, they are substantially lower
than the amount between Europe and the United States. Direct investment
from the United States in Canada totaled $246 billion in 2006, while from
Canada to the United States FDI was $159 billion. In addition, most of the
$403 billion in FDI from the United States in Latin America is in Mexico. An-
other large recipient of FDI in Latin America is Brazil. FDI to Mexico and
Brazil are examples of vertical FDI, in which firms in the United States, Japan,
and Europe relocate the production process to the low-wage countries to re-
duce costs.
FDI with Asia The stock of direct investment to Asia has been increasing,
with the bulk of it going to China.
The United States and Europe have a direct investment stock of $151 and
$130 billion, respectively, in the rest of Asia (which excludes Japan). These
stocks are an example of vertical FDI.
In addition to receiving direct investments, there has also been a growing
trend of FDI outflow from Asia to the United States and Europe. This
reverse-vertical FDI is motivated by firms in developing countries such as
China purchasing established companies based in industrial countries as ways
to acquire management and technological knowledge.
Chapter 1 Trade in the Global Economy 9
3 Conclusion
The first half of this book, namely Chapters 1 to 11, focuses on the flow of
goods, services, people, and capital across borders. We see that a substantial
amount of trade occurs between industrial countries, although this amount is
much less than the flow of foreign direct investment among these rich na-
tions. We also learn that the movement of people across borders is greatly re-
stricted as compared with trade in goods and services. We examine the im-
pact of government policies on globalization. In the second half of this book,
we explore financial aspects of the international economy. One of the topics
we study is how macroeconomic policies influence exchange rates, which
are the price of each countrys currency.
Teaching Tips
Tip 1: This chapter introduces students to trade; who trades, how much, and
what they trade. To stimulate students thinking about the causes of trade, ask
them to review Figure 1-2 and Table 1-1 and write down reasons why some
regions trade more than others. Why do the United States and Canada trade
so much? Why is trade with Africa so low? What explains the relatively high
trade volume of the Middle East?
Tip 2: The financial crisis that began in 2008 is not a major part of this book,
but its enormous impact on international trade warrants some discussion. Ask
students to search for and read Richard Baldwins Vox article The Great Trade
Collapse: What Caused It and What Does It Mean? or do other research on
the great trade collapse. Then students can discuss their opinions regarding
the cause of the trade collapse.
IN-CLASS PROBLEMS
1. What is the difference between horizontal and 2. Provide reasons for the resurgence of trade that led
vertical FDI? to the second golden age.
Answer: Horizontal FDI refers to the type of di- Answer: Reasons include the end of World War
rect investment between industrialized countries as II, reductions in tariffs following the formation of
ways to avoid trade barriers, gain better access to the General Agreement on Tariffs and Trade, and
the local economy, or draw on technical expertise improvements in transportation with the invention
in the area by locating near other established of the shipping container.
firms. Vertical FDI, by contrast, occurs when a
firm in an industrialized country lowers cost by re-
locating the production process to low-wage
countries.
Trade and Technology:
2
The Ricardian Model
Notes to Instructor
Chapter Summary
Chapter 2 leads Part II on Patterns of International Trade by introducing the
Ricardian model. The three key lessons of the Ricardian model are (1) com-
parative advantage determines the pattern of trade; (2) there are mutual gains
from trade; and (3) wages are determined by absolute advantage. The snow-
board example in the beginning of the chapter serves as an introduction to all
the trade chapters (Chapters 27), allowing the instructor to skip Chapter 1 if
desired.
Comments
Although most students may be familiar with the concept of comparative ad-
vantage from principles of microeconomics, it is a good idea to reintroduce
this concept because many students find it challenging. This chapter also pro-
vides a more in-depth analysis of the Ricardian model by covering the deter-
mination of relative prices as well as the relationship between wages and
absolute advantage. The latter is particularly interesting as it is not covered in
most trade textbooks. A corresponding application provides convincing evi-
dence regarding a countrys level of technology and wages.
11
12 Chapter 2 Trade and Technology: The Ricardian Model
Lecture Notes
Introduction
Most manufactured products are traded between countries, including the
snowboard. In 2005, the United States imported 1. 34 million snowboards
worth $58. 8 million from 20 different countries. In 2009, the value of snow-
board imports to the United States fell to $38. 4 million; this drop was due in
part to the global recession. The top 12 countries selling snowboards to the
United States are shown in Table 2-1, with China at the top of the list, fol-
lowed by Austria, Canada, Mexico, Spain, Poland, Tunisia, France, Germany,
Taiwan, Bulgaria, and Switzerland. But why does the United States purchase
snowboards from these countries at all when it has the resources and tech-
nology to produce the snowboards itself? To answer this question and under-
stand why countries trade goods with each other, we examine the reasons for
trade. These trade determinants include proximity (geographic distance be-
tween countries), natural resources (land, labor, and capital), offshoring,
and differences in level of technology. This chapter focuses mainly on the lat-
ter reason, technology differences across countries, otherwise known as the
Ricardian model after nineteenth-century economist David Ricardo. The
level of technology used by a country determines the pattern of trade and the
wages paid to labor.
Proximity
The proximity of Canada to the United States means lower transportation
costs relative to trade between the United States and countries in Asia or
Europe. This close distance between the two neighboring countries may
explain why Canada is not only one of the top exporters of snowboards to
the United States but also its largest trading partner. Proximity may also be
the reason why Europeans countries mainly trade with each other, whereas
Japan or China is the largest trading partner for many Asian countries.
Countries located in close proximity of one another often join into a free-
trade area to promote trade by eliminating barriers to trade such as tariffs
and quotas.
Resources
Given the proximity between the United States and Mexico, we would ex-
pect the value of snowboard exports from Mexico to be greater than one half
that of Canada, which is equally close to the United States. The reason may
lie in the fact that, in contrast to Mexico, Canada has cold snowy mountains
ideal for snowboarding. Canadas geographic resource is another reason for
trade. Other resources are land, which also provides minerals; labor re-
sources of various education and skills; and capital, such as machinery and
infrastructure. Land, labor, and capital are often referred to as factors of pro-
duction because these resources are used to produce goods and services. Fa-
vorable geographic conditions also help to explain the appearance of some of
Chapter 2 Trade and Technology: The Ricardian Model 13
the other top 12 exporters of snowboards to the United States, namely, Aus-
tria, France, Switzerland, Spain, and Bulgaria.
Although Mexico and Taiwan may not have mountains with ski resorts
to help them develop a snowboarding industry, their low snowboard prices
may explain their place as the fourth and tenth largest sellers of snowboards
to the United States, respectively. In 2009 the price of snowboards from
Tunisia and Taiwan were $34 and $31, respectively, compared with Switzer-
land at $113, Germany at $227, and France at $27. Tunisia and Taiwan are
able to sell at considerably lower prices because the snowboards imported
from these countries are unfinished. The process of spreading production
across several countries by a company that imports the unfinished goods for
further processing is known as outsourcing.
Absolute Advantage
Although Germany also has a natural resource, given by the Alps on its south-
ern border, the reason it is the ninth largest exporter of snowboards to the
United States may be better explained by its advanced technology. As a world
leader in the production of many manufactured goods, Germany has an ab-
solute advantage in producing snowboards because it has the best technology
to produce the good. However, this raises the question as to why the United
States imports about four times more snowboards from China, a country with
less-advanced technology relative to Germany. Indeed it is also puzzling why
the United States, with technology equal to that of Germany, would import
snowboards from either country rather than producing snowboards on its own.
S I D E B A R
By incorporating the production of icewine, rst developed in able to create a new comparative advantage in producing this
Germany in 1794, to its cold climate of Niagara Falls, Canada is sweet dessert wine.
Comparative Advantage
To determine trade patterns, we need to examine the relative rather than
absolute differences in technology between countries. To gain a better un-
derstanding of the topic, we turn to the concept of comparative advantage,
introduced by David Ricardo using a simple example consisting of two coun-
tries (Portugal and England) trading two goods (wine and cloth). Ricardo al-
lowed Portugal to have the best technology or absolute advantage in the
production of both goods. In contrast, although England is capable of pro-
ducing both goods, it is relatively more difficult for England to produce wine.
Given Ricardos assumption that England is better at producing cloth than
wine, England has a comparative advantage in the production of cloth and
should export cloth to Portugal. In exchange for the cloth from England, Por-
tugal should export wine because it has a comparative advantage in the pro-
duction of that good.
14 Chapter 2 Trade and Technology: The Ricardian Model
The concept of comparative advantage may explain why the United States
imports more snowboards from China than Germany even though China has
less-advanced technology in the production of snowboards relative to
Germany or the United States. The remainder of the chapter provides more
detail about this fundamental theory in international trade.
N E T W O R K
The link provided (http://tse.export.gov/TSE/TSEOptions.aspx?ReportID=2&Referrer=
TSEReports.aspx&DataSource=NTD) connects to detailed U.S. trade data published by the
International Trade Administration, U.S. Department of Commerce. After choosing a prod-
uct, examine the top ten countries exporting the product to the United States and pro-
vide the reasons for trade.
S I D E B A R
2 Ricardian Model
This section provides a detailed example of the Ricardian model with the
United States as the home country trading wheat and cloth. As a leading ex-
porter of wheat, the model should show that the United States (Home) ex-
ports wheat and imports cloth.
Bushels of Wheat Produced Per Hour Yards of Cloth Produced Per Hour
Home country 6 4
Chapter 2 Trade and Technology: The Ricardian Model 15
Figure 2-1
Cloth, QC
(yards)
MPLC L
200 QG 1
QG 2/3
Figure 2-2
Cloth, QC
(yards)
C
B
200 D
A U2
100
U1
U0
Opportunity Cost of
MPL*W MPL*C
Bushels of Wheat Produced Per Hour Yards of Cloth Produced Per Hour
Foreign country 3 3
Figure 2-3
Cloth, Q *C
(yards)
MPL *C L*
300
Opportunity Cost of
Figure 2-4
Cloth, Q*C
(yards)
300
A*
150
U*1
flected by the lower relative price of wheat at Home (PW / PC 2/3) com-
pared with Foreign.
APPLICATION
Comparative Advantage in Apparel, Textiles, and Wheat
Table 2-2 shows that a worker in the United States generates seven times
more apparel sales and 16 times more textiles sales per year than a worker in
China. With its absolute advantage in the production of both industries, why
does the United States import apparel and textiles from China and other Asian
countries? The answer has to do with the fact that a typical grain farmer in
the United States is 275 times more productive than a farmer in China. With
its absolute and comparative advantage in the production of grain, the United
States exports grain to China in exchange for apparel and textiles.
PW MPLW
3 6 9
1 PW MPLW PC MPLC.
PC MPLC 4 4 8
Because of the higher wages in the wheat industry, no cloth is produced and
the home country fully specializes in the production of wheat.
International Trade Starting from Homes production point (point B in
Figure 2-5), we know that with the international relative price of wheat at
3/4, Home can export 1 bushel of wheat in exchange for 3/4 yard of cloth
from Foreign. Tracing out Homes international trade gives the international
trade line shown as BC in Figure 2-5. The international trade line implies a
new budget constraint for the home country that has a steeper slope than
Homes PPF. With the higher budget constraint (international trade line),
Home is able to choose a consumption point (point C ) that is on a higher in-
difference curve (U2). Therefore, Home gains from trade by obtaining a
higher utility with international trade than under no-trade.
Pattern of Trade and Gains from Trade With the international relative
price of wheat at 3/4, Home produces 300 bushels of wheat (point B) but
consumes only 100 bushels (point C). The extra 200 bushels are exported to
the foreign country in exchange for 150 yards of cloth. The value of the
wheat in terms of cloth is determined by multiplying the international rela-
tive price of wheat by the amount of wheat export, (3/4) 200 150 yards
of cloth. Because the value of exported wheat is equal to the value of im-
ported cloth, trade in the home country is balanced.
The results for the foreign country produce trade patterns that are oppo-
site those of the home country because the international relative price of
wheat is less than the foreign no-trade relative price of wheat. Workers in the
foreign country will flock to the cloth industry as producers in this industry
take advantage of the higher international relative price of cloth (reciprocal of
Figure 2-5
Cloth, QC
(yards)
U2
200
C
150
Slope 3/4
100
A
U1
B
100 150 300 Wheat, QW (bushels)
Production and
Consumption Production Trade Consumption
Home 150 bushels 300 bushels Export 200 bushels 100 bushels
of wheat of wheat of wheat of wheat
Figure 2-6
Cloth, Q *C
(yards)
B*
300
C*
150 Slope 3/4
A*
U*2
U*1
APPLICATION
Labor Productivity and Wages
Using value-added per hour as the measure for labor productivity, we see from
Figure 2-7 that there is a relationship between labor productivity and wages.
Of the seven countries presented, the United States has the highest level of
productivity and enjoys the highest wage, whereas Taiwan has the lowest level
of productivity and thus receives the lowest wage. Figure 2-8 shows the labor
productivity and wages over time for each of the seven countries. The graphs
show a close connection between labor productivity and wages, with both ris-
ing over time.
Figure 2-9
Cloth, QC Relative
(yards) price of
wheat,
U2 PW / PC
Home exports
200
C Slope 3/4
150 3/4 C
100
A
2/3 A B
U1
B
100 150 300 0 150 200
(a) Home production and consumption (b) Home export supply of grain
1, Foreign could either consume all of the wheat and cloth it produces on its
own (points A* and A* in panels (a) and (b) of Figure 2-10, respectively) or
specialize in the production of cloth by producing 300 yards and exporting
150 yards to the home country (points B* and B* in panel (a) and points A*
and B* in panel (b)). Because wages are equal across the two industries, For-
eign could produce anywhere on its PPF between points A* and B*, which
gives the flat segment of the import demand curve when the international rel-
ative price of wheat equals the foreign countrys no-trade relative price. As
the relative price of wheat decreases, for example from 1 to 3/4, the foreign
country will specialize in cloth and import more wheat, leading to the down-
ward-sloping import demand curve for wheat. The flat portion of the import
demand is unique to the Ricardian model because of the straight-line pro-
duction possibilities frontier.
Figure 2-10
C *
3/4
C*
150
A*
(a) Foreign production and consumption (b) Foreign import demand for grain
Figure 2-11
Relative
price of
wheat,
PW / PC
Home exports
3/4 C
2/3
Foreign imports
APPLICATION
The Terms of Trade for Primary Commodities
In 1950, economists Ral Prebisch and Hans Singer hypothesized that over
time, the price of primary commodities such as agricultural products and min-
erals would decline relative to the price of manufactured goods. The decline
of primary commodities would lead to a worsening of the terms of trade for
developing countries, the source of most of these products. The three graphs
in Figure 2-12 show that the relative price of primary commodities has in-
creased, decreased, and remained roughly the same over time, depending on
the product traded.
5 Conclusion
The Ricardian model consists of the simple concept that the pattern of trade
is determined by comparative advantage. By exporting the good in which a
country has the lowest opportunity cost relative to producing another good,
the country could benefit from participating in international trade by con-
26 Chapter 2 Trade and Technology: The Ricardian Model
TEACHING TIPS
Tip 1: Comparative Advantage
Comparative advantage is perhaps the most important concept in interna-
tional trade. Therefore, it warrants substantial treatment in this course. Ask
students to break into groups or work on their own to come up with addi-
tional example of comparative advantage that need not relate to international
trade. Discussing examples, such as lawyers paying landscapers to mow their
lawns, may help students better grasp the concept.
Here are some examples of goods and their harmonized system codes for
students. After students click the Change button under Product, tell them
to be sure to click the HS Radio button before they look for HS Codes.
To enter the six-digit codes below, they will need to click the Product Code
tab in the Select Products for Report dialog box.
Harmonized System
Product Description
Codes (HS Codes)
480300 Toilet or facial tissue stock, towel or napkin stock and similar
paper of a kind used for household or sanitary purposes,
cellulose wadding and webs
IN-CLASS PROBLEMS
1. What determines the pattern of international trade constant. The Ricardian model ignores the role of
between two countries in the Ricardian model? land and capital so there are no diminishing re-
Answer: The pattern of trade is determined by turns.
comparative advantage. The country with a com- 4. Refer to the following table and assume that the
parative advantage in the production of a product total labor supply in Taiwan is 4 and the total labor
will export the good. supply in Vietnam is 8.
2. Using the Ricardian model, explain why American
Absolute
workers receive higher wages in the production of
Taiwan Vietnam Advantage
automobiles than Chinese workers.
Number of telephones 10 5 ?
Answer: American automobile workers receive produced per hour
higher wages than Chinese automobile workers
because the United States has an absolute advan- Number of radios 50 10 ?
tage in the production of many goods, including produced per hour
automobiles.
Comparative advantage ? ?
3. Why is the production possibilities frontier a
straight line in the Ricardian model? a. What is the opportunity cost of 1 unit of
Answer: The production possibilities frontier is a telephones in terms of radios in Taiwan? In
straight line in the Ricardian model because of the Vietnam?
assumption that the marginal products of labor are
28 Chapter 2 Trade and Technology: The Ricardian Model
Answer: See the following table. e. Will Taiwan and Vietnam trade if the interna-
tional relative price of telephone is 3? Briefly
Opportunity Cost of explain why or why not.
1 Telephone 1 Radio Answer: Because the no-trade prices are PTTai /
(In Terms of Units (In Terms of Units PRTai 5 in Taiwan and PTThailand / PRThailand 2 in
of Radio Given up) of Telephone Given up) Vietnam, two countries will engage in trade if
Taiwan 5 1/5 the international relative price of telephone is
Vietnam 2 1/2 3. In particular, Vietnam will export tele-
phones because the international relative price
b. Determine whether each of the following of telephone is higher than its no-trade equi-
statements is true or false. Provide a brief ex- librium price. By contrast, Taiwan will import
planation of why it is true or false. telephones because the international relative
i. Taiwan has an absolute advantage in the price of telephone is lower than its no-trade
production of both telephones and radios. equilibrium price.
Answer: TRUE: Taiwan can produce 5. Refer to the following table in answering the
more of both goods per hour than questions that follow. Assume each country has
Vietnam. 100 laborers.
c. If the two countries engage in international b. Using the Ricardian model, would trade be-
trade, what will Taiwan produce and how tween Australia and the United States be mu-
many? tually beneficial? Briefly explain why or why
not.
Answer: Because Vietnam has the lower op-
portunity cost in the production of telephones Answer: Australia and the United States will
and hence comparative advantage in producing not engage in trade because there are no dif-
this good, Taiwan has a comparative advantage ferences in opportunity costs between the two
in the production of radios. Thus, Taiwan will countries, so there are no opportunities to gain
specialize in the production of radios. Taiwan from trade according to the Ricardian model.
will produce 50 4 200 per hour.
Opportunity Cost of
d. What is the real wage in Taiwan in terms of ra-
dio? What is the real wage in Vietnam in terms 1 Pound of Beef 1 Bushel of Wheat
(In Terms of Bushels (In Terms of Pounds
of telephone? of Wheat Given Up) of Beef Given Up)
Answer: The real wage in Taiwan in terms of Australia 3 1/3
radio is MPLTRai 50 units of radio. The real United States 3 1/3
wage in Vietnam in terms of telephone is
T 5 units of telephone.
MPLViet
Chapter 2 Trade and Technology: The Ricardian Model 29
6. Would your answers to problem 5 be different if a product of labor in boots. Would China and
worker in the United States became more produc- France continue to trade? Briefly explain why.
tive and could produce 70 pounds of beef or 140 Answer: Although the new technology
bushels of wheat per hour? would allow workers in France to be more
Answer: With the increase in productivity in the productive, France will continue to trade with
United States, the two countries now have differ- China as long as there are differences in op-
ences in opportunity costs and will find trade mu- portunity costs between the two countries.
tually beneficial. 8. Some Americans fear that as countries such as
China and India become more productive in in-
Opportunity Cost of dustries such as computer and computer program-
1 Pound of Beef 1 Bushel of Wheat ming, once dominated by the United States, the
(In Terms of Bushels (In Terms of Pounds wages of workers in the United States will fall.
of Wheat Given Up) of Beef Given Up) Should U. S. workers fear foreign competition?
Australia 3 1/3 Briefly explain why or why not.
United States 2 1/2
Answer: Suppose the initial productivity in China
and the United States is given by the middle col-
7. Answer the questions below using the information umn in the table below. In this case, the United
given in the following table. States has an absolute advantage in the production
of both computer programs (programs) and wheat.
France China China has a comparative advantage in producing
wheat whereas the United States has a comparative
Pairs of boots produced per hour 4 8
advantage in the production of computer programs.
Bottles of wine produced per hour 2 16
Initial New
Comparative advantage ? ?
United United
China States China States
a. Which country has a comparative advantage in
the production of boots? Numbers of 1 10 5 10
programs
Answer: China has a comparative advantage produced per hour
in producing boots because it has a lower op-
portunity cost in producing boots (MPLChinaB Bushels of 10 50 10 50
MPLW China
1/2 MPLFrance
B / MPLWFrance
2). wheat produced
per hour
Opportunity Cost of
France 2 1/2
China 10 1/10
b. Provide the range of the international relative
United States 5 1/5
price of wine at which the two countries
would trade.
Answer: The range of the international rela-
tive price of wine at which the two countries Suppose that the world relative price of computer
would trade would be between their no-trade program is 8. Then the initial U. S. wage is given
China
relative prices, which are PW / PBChina 2 and by the following:
PW / PB 1/2 in China and France, re-
France France
MPLP 10 numbers of program
spectively.
Initial U. S. wage or
c. Suppose that researchers in France discover a (PP / PW) MPLP 80 bushels of wheat
new technology that doubles the marginal
30 Chapter 2 Trade and Technology: The Ricardian Model
Now lets assume that China becomes more pro- Answer: The United States has a comparative
ductive in producing computer programs although advantage in producing rice.
everything else remains constant, as given by the c. What is the lowest international relative price
column on the right in the above table. Now of tequila Mexico is willing to accept in order
China has a comparative advantage in producing to engage in trade with the United States?
computer programs. Briefly explain why.
Answer: The international relative price of
New Opportunity Cost of
tequila must be at least 5/7 in order for Mex-
1 Number of Programs 1 Bushel of Wheat ico to engage in trade. This is because Mex-
(In Terms of Bushels (In Terms of Numbers icos no-trade relative price of tequila is 5/7.
of Wheat Given Up) of Program Given Up)
10. Use the information provided in problem 9 but
China 2 1/2
suppose the number of laborers in the United
United States 5 1/5 States is 300 while the number of laborers in Mex-
ico remains the same at 2.
a. Determine the terms of trade for the United
Suppose the new world relative price of computer
States.
program is 4.
Answer: The United States exports rice, so its
(PW / PP) MPLW 12. 5 numbers of program
term of trade is (PR / PT).
New U. S. wage or
b. Which country gains more from trade? Briefly
MPLW 50 bushels of wheat explain why.
This example shows that when China increases Answer: Given the relative size of the two
productivity in computer programming, wages of countries, the world relative price will be
workers in the United States fall in terms of wheat closer to the no-trade relative price of tequila
and rise in terms of computer programs. The gain in the United States so that Mexico gains
in terms of number of computer programs results more from trade.
from the lower world relative price of computer
11. Provide an example of how the mercantilist school
programs.
of thought continues to exist today.
9. Refer to the following table. Assume there are two
Answer: The mercantilist school of thought con-
workers in Mexico and three workers in the
tinues to exist in countries such as the United
United States.
States in which certain groups favor limiting im-
ports while pushing for exports.
Mexico United States
12. Suppose there are two countries producing two
Bottles of tequila 7 5
produced per hour goods using only labor. Refer to the following
table to answer the questions.
Pounds of rice 5 10
produced per hour Italy France Absolute
Advantage
Comparative advantage ? ?
Pairs of shoes 6 3 ?
produced per hour
a. Determine the pretrade relative price of
Bottles of wine 2 1 ?
tequila in Mexico and the United States. produced per hour
Answer: The pretrade relative price of tequila
in Mexico and the United States are PMexico / Comparative advantage ? ?
T
PRMexico 5 / 7 and PU.S. U.S.
T / PR 2 in Mexico
and the United States, respectively.
a. Which country has absolute advantage in the
b. Given your answer in part (a), which country production of shoes? Wine?
has a comparative advantage in the production
Answer: Italy has an absolute advantage in the
of rice?
production of shoes and wine.
Chapter 2 Trade and Technology: The Ricardian Model 31
b. Which country has a comparative advantage in c. Does Italy gain from trading with France?
the production of shoes? Wine? Briefly explain why or why not using the Ri-
Answer: Because the countries have the same cardian model.
opportunity costs in terms of shoes neither Answer: Without differences in opportunity
country has a comparative advantage in the costs, there are no gains from trade according
production of shoes. Same goes for the pro- to the Ricardian model.
duction of wine.
Gains and Losses from Trade
3
in the Specific-Factors Model
Notes to Instructor
Chapter Summary
Chapter 3 examines the gains and losses from trade for labor, capital, and
of production.
landowners. We no longer assume that labor is the only factor of production.
The model presented is the specific-factors model, in which labor and land
are used in agriculture whereas labor and capital are used in manufacturing.
Comments
The video Is Wal-Mart Good for America?, available through PBS. org, provides
an excellent example of winners and losers of trade. It begins with an annual
shareholders meeting where everyone in attendance is excited about Wal-
Mart. Then it takes a look at the impact on American suppliers and workers
when Wal-Mart switches to Chinese suppliers in efforts to lower cost. Dis-
cussions after the video could be stimulated by asking questions such as
whether Wal-Mart and other American businesses should be restricted from
purchasing from foreign suppliers. Although some students may comment
that most consumers at Wal-Mart are from lower-income households, it may
be useful to remind them that the video also mentions that Chinese-made
televisions are also sold in retail stores such as Best Buy and Circuit City.
33
34 Chapter 3 Gains and Losses from Trade in the Specific-Factors Model
Lecture Notes
Introduction
The chapter begins with an example of violent protests against Bolivias ex-
port of natural gas by its indigenous Indians. The protests led to the replace-
ment of the president and a referendum ensuring more benefits to Bolivias
people at the expense of foreign companies. The example brings up the issue
that in the real world there are both winners and losers when a country en-
gages in trade even though the overall gains from those who benefit from
trade generally exceed the losses of those who are harmed.
1 Specific-Factors Model
APPLICATION
How Large Are the Gains from Trade?
The United States experienced the reversal of gains from trade when the
U. S. Congress imposed an embargo on trade with Britain between Decem-
ber, 1807, and March, 1809. The gains from trade for the United States would
have been at least 5% of GDP without the embargo. Put another way, the em-
bargo cost the United States more than one third of the value of exports.
In another example, Japan experienced gains from trade when it engaged
in international trade in 1859 after 200 years of self-imposed autarky. Japans
gains from trade are estimated to be about 4% to 5% of GDP.
2 Earnings of Labor
Determination of Wages
To determine the impact of international trade on wages in the two sectors,
we put the marginal product of labor for agriculture and manufacturing on
the same graph, as shown in Figure 3-4. The horizontal axis denotes the to-
tal amount of labor, L, with the amount of labor used in manufacturing, LM,
measured from left (0M) to right, and the amount of labor used in agriculture,
LA, measured from right (0A) to left.
Equilibrium Wage The equilibrium wage is given by the intersection of the
marginal product of labor in each sector multiplied by its respective price.
With the equilibrium wage at point A, the economy uses 0ML units of labor
in manufacturing and 0AL units of labor in agriculture.
wage, W , at point B. With the new equilibrium wage, the amount of labor
used in manufacturing increases from 0ML to 0ML and the amount of labor
used in agriculture falls from 0AL to 0AL.
Effect on Real Wages To understand the impact of the new equilibrium
wage on the labor, we note that workers can afford to buy more food because
its price has not changed although wage has increased. Namely, the real wage
has increased for labor in terms of food, W / PA W / PA.
To see whether labor gains or loses in terms of manufactures, we need
to compare the increase in wage relative to the increase in the price
of manufacture, PM. From Figure 3-5 we see that the increase in wage
from W to W is less than the vertical increase of PA MPLA given by
PM MPLM or W PM MPLM. Dividing both sides by the initial
wage W gives
W PW MPLM PM
,
W PM MPLM PM
where the term on the left-hand side is the percentage change in wages and
the term on the right-hand side is the percentage change in the price of man-
ufactured goods. Because the percentage increase in wage is less than the per-
centage increase in the price of manufactured goods, the amount of manu-
factured goods workers can now purchase is less than that before the country
engaged in trade. This means that the real wage has fallen for labor in terms
of manufactures, W / PM W / PM.
Overall Impact on Labor Whether labor is better off or worse off due to
the increase in the price of manufactures depends on whether the individ-
ual prefers to purchase more manufacturing goods or food. The key point
is that with the specific-factors model, an increase in the price of manufac-
tured goods results in an ambiguous effect on the well-being of labors since
the effect on real wage is undefined.
Unemployment in the Specific-Factors Model Although it is often cited in
the news that international trade causes unemployment, we do not see this re-
sult in the specific-factors model. One possible reason is that this model does
not incorporate unemployment, a macroeconomic phenomenon caused by
business cycles. Another reason could be that people who lose their jobs due
to import competition are able to find new jobs within a reasonable frame of
time such that unemployment is not an issue.
APPLICATION
Manufacturing and Services in the United States:
Employment and Wages across Sectors
In most industrial countries such as the United States, the service sector is
large relative to manufacturing, particularly compared with agriculture. For
the United States, employment continues to shift away from manufacturing
and into the service sector. As shown in Figure 3-6, whether measured in
terms of the number of workers or as a percentage of total employment, em-
ployment in manufacturing has been on the decline since the 1970s. From
Figure 3-7 we see that, although the real hourly earning of produc-
tion/manufacturing workers is higher than those of services as a whole, this is
Chapter 3 Gains and Losses from Trade in the Specific-Factors Model 37
not the case if we disaggregate information service from overall general ser-
vices, which includes retail.
Moreover, a closer look at employment in manufacturing and services
shows that between 2003 and 2005, 0. 8 million workers were displaced or laid
off in manufacturing as compared with 2. 3 million in services. More notably,
Table 3-1 shows that of the 64% of the manufacturing workers that were re-
employed by January 2006, about half (49%) earned less in their new jobs,
whereas 68% of the displaced workers in services that were re-employed by
January 2006, 56% of them earned the same or more in their new jobs.
APPLICATION
Trade Adjustment Assistance Programs:
Financing the Adjustment Costs of Trade
We often talk about how an economy can benefit by engaging in interna-
tional trade. However, it is clear that not all sectors within the economy en-
joy the overall gains from trade. The question then is whether it is the role of
the government to temporarily assist those who lose their jobs due to foreign
competition. In the United States, workers displaced by import competition
may qualify for compensation through the Trade Adjustment Assistance (TAA)
program. In addition, there is a special TAA program for those laid off due to
competition from Canadian or Mexican imports under the North American
Free Trade Agreement (NAFTA).
H E A D L I N E S
Service Workers Are Now Eligible for Trade Adjustment
Assistance
The Trade Adjustment Assistance (TAA) program, which was introduced by President Kennedy
in 1962, was brought into the twenty-rst century by the stimulus bill passed in 2009. TAA
was changed in three major ways: more workers are now eligible and service workers are now
fully eligible; training support was raised from $220 to $575 million; and the bill created a
special Labor Department TAA ofce to ensure eligible workers are aware of their options.
Payments to capital PM QM W LM
Numerical Example
Suppose the payments to labor and capital in manufacturing and agriculture
are given by the following:
Manufacturing: Sales revenue PM QM $50
Payments to labor W LM $30
Payments to capital RK K $20
.
RK RK K
Substituting the information above gives,
R K 20% 50 10% 30
MMMMMMMMMM
35%.
RK 20
We get that the percentage increase in the rental on capital, 35%, is far greater
than the percentage increase in the relative price of manufacturing, 20%.
Change in the Rental on Land To obtain the change in the rental on land,
we start with its formula,
PA Q A W L A
RT ,
T
and in a similar approach for the rental on capital, we include the percentage
changes for the price of agriculture (PA / PA), wage (W / W ), and rental
40 Chapter 3 Gains and Losses from Trade in the Specific-Factors Model
on land (RT / RT). Given our assumption that the price of agriculture re-
mains fixed, we can substitute in zero for the percentage change in the agri-
culture price and rewrite the equation for the percentage change in rental on
land as
W
W LA
RT W
.
RT RK T
Using the data for agriculture, we get that the fall in the land rent (15%)
exceeds the percentage increase in the wage (10%) as follows:
RT 10% 30
15%.
RT 20
Note that had the share of revenue received by labor been lower than the
share of revenue received by land, the decrease in the rental on land would
have been smaller.
General Equation for the Change in Factor Prices We can summarize
our finding of the impact of a short-run change in factor prices with the
following,
RT / RT 0 W / W PM / PM RK / RK, for PM
and
RK / RK PM / PM W / W 0 RT / RT, for PM.
Real rental Change in the real Real rental
on capital falls wage is ambiguous on land rises
In other words, the changes in the earnings of the specific factors are dramatic
when relative prices fluctuate due to international trade. The reason is that,
unlike labor, which is mobile between the sectors, the specific factors can only
be employment in the particular industry.
APPLICATION
Prices in Agriculture
The prices of agriculture products such as cotton, palm oil, rice, sugar, rubber,
wheat, and wool have declined as countries become productive in growing
crops, which results in an increase in the global supply. The specific-factors
model predicts that landowners, like the farmers, lose in real terms due to the
decrease in the relative price of agriculture.
Coffee Prices The price of coffee fluctuates greatly because the beans are
only grown in developing countries. Shown in Figure 3-8, the real, whole-
sale prices of coffee often fluctuate. The world coffee prices reached as high
as $3. 00 per pound in 1986 to a low of 50 per pound in 2001. The swing
in the world coffee prices is due to excess exports from Vietnam and Brazil.
As predicted by the specific-factors model, the dramatic fluctuation in the
world price of coffee causes huge swings in the real incomes of land owners
in coffee-growing regions in Central America and Asia.
Fair-Trade Coffee To assist the coffee growers in the developing countries,
TransFair USA, an import group, engages in fair-trade coffee by avoiding
the middlemen and ensuring a minimum price for the farmers. The
fixedfair-trade price is a form of insurance against large fluctuations in the
world price, thereby allowing the farmers a more stable source of income.
The fair-trade price protects the farmers in a manner similar to the govern-
ment policy in industrialized countries except that consumers have the option
to purchase the higher-priced product.
H E A D L I N E S
Rise in Coffee Prices
Great for Farmers, Tough on Co-ops
Fair-trade cooperatives had difculties obtaining deliveries from member farmers when the
price of coffee beans rose above their agreed fair-trade price of $1.26 per pound. The co-
ops leader convinced the farmers to deliver the coffee by drawing on their sense of loyalty.
4 Conclusion
The specific-factors model is a short-run model in which labor is perfectly
mobile between industries although other inputs such as land and capital are
specific to the industry in which the factor is used. Under these assumptions,
the factor specific to the import-competing industry loses in terms of its abil-
ity to purchase the goods produced because of the drop in its relative price
from opening to trade. Because the factor facing import competition is im-
mobile, owners of the specific factor experience a fall in the real rental. By
42 Chapter 3 Gains and Losses from Trade in the Specific-Factors Model
contrast, the factor specific to the export industry gains in real terms because
its relative price rises when the economy opens to trade. Unlike the specific
factors, labor avoids extreme changes in wage because it is able to move be-
tween industries. However, when an economy engages in trade, the impact of
the change in the relative price has an ambiguous effect on labor. More
specifically, for labor, whether there are gains or losses from international trade
depends on its preferences because the real wage rises in terms of one good
but falls in terms of the other good.
TEACHING TIPS
IN-CLASS PROBLEMS
1. Use the following information to answer the ques- 2. Summarize your finding in problem 1 using nota-
tions below. tional format.
Payments to capital RK K 75 Real rental Change in the real Real rental
on capital falls wage is ambiguous on land rises
Barley: Sales revenue PB QB 150 3. If, instead of the situation given in problem 1, the
Payments to labor W LB 70 price of computers was to fall, would landowners
or capital owners be better off? Explain. How
Payments to land RT T 80 would the decrease in the price of computers ef-
fect labor? Explain.
Holding the price of computers constant, suppose
the percentage increase in the price of barley is Answer: Similar to the situation given in problem
10% and the percentage increase in wage is 5%. 1, capital owners would be worse off because the
rental on capital would fall by more than the de-
a. Determine the impact of the increase in the
crease in the computer price. Landowners would
price of barley on the rentals on land.
be better off as the rental on land rises even with-
Answer: out the increase in the price of barley. The effect
on labor because of the decrease in the price of
RT (PB / PB) PB QB (W / W ) W LB
computers is also ambiguous. Wages fall, so labor is
RT RT T worse off in terms of barley, but because the drop
in wage is less than the percentage decrease in the
RT 10% 150 5% 70 manufactured good, labor gains in terms of com-
14. 4%. puters.
RT 80
b. Determine the impact of the increase in the RK / RK PC / PC W / W 0 RT / RT,
price of barley on the rentals on capital. for PM.
Answer: Real rental Change in the real Real rental
0 QC W LC on capital falls wage is ambiguous on land rises
RK
K
4. What is fair trade?
RK W W LC
RK W RK K
Answer: Fair trade is the process by which non-
governmental organizations such as TransFair USA
assist farmers in developing countries by selling
RK 75
5% 5%.
RK 75
agricultural commodities such as coffee beans di-
rectly to consumers in industrial countries. By
avoiding the local buyers, millers, shippers, and
c. Determine the impact of the increase in the
other middlemen, these import groups are able to
price on the welfare of labor.
ensure a minimum price for the farmers.
Answer: The impact of the increase in the
price of barley on the welfare of labor is am-
biguous because labor gains in terms of com-
puters because the price of computers re-
mained constant, while wages increased by
5% but lost in terms of barley because the
percentage increase in barley is higher than
the percentage change in wage.
44 Chapter 3 Gains and Losses from Trade in the Specific-Factors Model
5. Ashland is considering whether to engage in the the service industries relative to the manufacturing
international trade of rice and furniture. Suppose industries, 68% of the workers in the service indus-
that the world price of rice is lower than Ashlands try found employment by January 2008, with 56% of
no-trade price but its no-trade furniture price is those newly employed workers earning the same or
lower than the world price. Assume that land is more in their new jobs. By contrast, 64% of the dis-
specific to the production of rice and that labor is placed workers in manufacturing were re-employed
free to move across sectors. Do you think the by January 2006 and only 51% received the same or
landowners will support the move to free trade? higher pay in their new positions.
Explain. 8. Assuming that labor is mobile, is it true that wages
Answer: Landowners will not support the move always must be equal across the sectors in the
because the world price of rice is lower than Ash- specific-factors model?
lands no-trade price. By engaging in trade, the Answer: Yes, labor will continue to shift from the
landowners would be worse off because the rental low-wage sector to the high-wage sector until the
on land will fall due to the decrease in the price of wages are equalized.
rice.
9. Home, a small, open economy, uses a mobile fac-
6. When labor shifts from agriculture to manufactur- tor (labor) and two specific factors (drylands and
ing, why does the marginal product of capital in- wetlands) to produce two goods, cactus and rice.
crease while the marginal product of land falls? Dryland is only productive in growing cactus and
Answer: When labor shifts from agriculture to wetlands can only grow rice. Suppose the world-
manufacturing, the marginal product of land falls relative price of cactus is higher than Home. De-
because there are fewer laborers to work on each termine the effect of this price increase on the real
acre of land. By contrast, the increase in the quan- wage and real returns on the different types of
tity of labor used in manufacturing will raise the land.
marginal product of the capital because there are Answer: Because the world-relative price of cac-
more laborers available to work on the machinery. tus is higher than Home, the small country will ex-
7. Between 2005 and 2007, displaced workers in the port cactus, which will lead to an increase in the
service industries are better off relative to those in real rental on drylands. Real wage will increase in
the manufacturing industries. Comment. terms of rice because of the increase in the price
Answer: According to Table 3-1, although the of cactus but will fall in terms of cactus because the
number of workers displaced between 2005 and percentage rise in the price of cactus is higher than
2007 is significantly higher (more than double) in the percentage increase in wage.
Trade and Resources:
4
The Heckscher-Ohlin Model
Notes to Instructor
Chapter Summary
This chapter presents the Heckscher-Ohlin model with two factors (capital
and labor), two goods (computers and shoes), and two countries (Home and
Foreign). A test of the model is discussed with Leontief s paradox. Addition-
ally this chapter, like the last, discusses the affect of trade on factor prices. The
sign test in the Heckscher-Ohlin model is discussed in the Appendix.
Comments
Note that this chapter covers only two theorems of the Heckscher-Ohlin
modelthe Heckscher-Ohlin theorem and the Stolper-Samuelson theo-
rem. The other two theoremsthe Rybczynski theorem and Factor Price
Insensitivityare deferred to the next chapter, in an effort to break the ma-
terial into smaller pieces.
Unlike the previous chapters, a discussion of the theory is followed by an
empirical test. This concept is possibly new to students and could be high-
lighted to generate interest in the topic. Moreover, although students are
quite familiar with graphing supply and demand from their principles course,
place emphasis on teaching the export supply and import demand curves,
particularly because the derivation of these curves requires an understanding
of the relationship between the no-trade and free-trade relative prices. Sim-
45
46 Chapter 4 Trade and Resources: The Heckscher-Ohlin Model
ilarly, the topic of relative demand and supply may also benefit from addi-
tional attention as the shift of the curves due to changes in the relative price
may not be immediately obvious to the students because the curves are in ra-
tios (i. e. , horizontal axis gives the ratio of labor to capital and the vertical
axis has the ratio of wage to rental on capital).
Lecture Notes
Introduction
We begin the chapter with a comparison between the Ricardian model, in
which trade occurs due to differences in technology between countries giv-
ing rise to their comparative advantage, and the Heckscher-Ohlin model,
in which uneven distribution in resources leads countries to trade with one
another. The Heckscher-Ohlin model also differs from the specific-factors
model in that factors of production can move between industries because the
model is set in the long run. The model was developed to explain the golden
age of international trade between 1890 and 1914, during which there was
an increase in the ratio of trade to gross domestic product (GDP) coinciding
with improvements in transportation.
1 Heckscher-Ohlin Model
The Heckscher-Ohlin model consists of two factors (capital and labor), two
goods (computers and shoes), and two countries (Home and Foreign). The
) in an economy is given by the sum of the capital
total amount of capital (K
used in shoes, KS, and computers, KC. The total available labor (L ) in the
economy is synonymously equal to the labor used in shoes, LS, and comput-
ers, LC.
where the horizontal axis gives the ratio of labor to capital used in produc-
tion and the vertical axis denotes the ratio of the labor wage to the capital
rental.
Assumption 3: Foreign is labor abundant, by which we mean that the labor/
capital ratio in Foreign exceeds that in Home, L* / K* L /K
. Equiva-
lently, Home is capital abundant, so that K / L K *
/
L *
.
The third assumption distributes the resources unevenly across the two
countries, with Home being capital-abundant whereas Foreign is labor-
abundant.
Assumption 4: The final outputs, shoes and computers, can be traded inter-
nationally, but labor and capital do not move between countries.
The forth assumption allows the final goods to move between the coun-
tries but not the factors of production.
Assumption 5: The technologies used to produce the two goods are identi-
cal across the countries.
From the fifth assumption, we see that each good is produced using the
same technology across the two countries. In other words, across both coun-
tries, each industry has the same factor intensity.
Assumption 6: Consumer tastes are the same across countries, and prefer-
ences for computers and shoes do not vary with a countrys level of income.
The sixth assumption implies that although the poorer country would con-
sume less of both goods than the richer country, the ratio of shoes to com-
puters expenditure is the same across both countries.
APPLICATION
Are Factor Intensities the Same across Countries?
In the United States, footwear production is more capital-intensive than call
centers because of the expensive automated-manufacturing machines used
by a New Balance plant. However, there is a reversal of factor intensities
in India, where call centers are more capital-intensive than footwear pro-
duction using labor-intensive sewing machines. Another example of a re-
versal of factor intensities between countries is in the agriculture sector.
Although farmers in the United States use costly computerized equipment
to cultivate their farms, their counterparts in developing countries use little
or no mechanized equipment because labor is cheap relative to the cost of
capital.
N E T W O R K
The New Balance Web site can be found through the following link:
http://www.newbalance.com. In addition to producing shoes, the company makes apparel,
eyewear, headwear, sport bags, tness equipment, and shoe- and apparel-care products.
48 Chapter 4 Trade and Resources: The Heckscher-Ohlin Model
No-Trade Equilibrium
Production Possibility Frontiers Figure 4-2 shows the production possibil-
ity frontiers (PPFs) for Home in panel (a) and Foreign in panel (b). The
bowed-out PPF is biased toward computer (on the horizontal axis) for Home
because Home is capital-abundant and the production of computers is capital
intensive. For Foreign, the PPF skews more toward shoes (on the vertical axis)
because shoe production is labor intensive and Foreign is labor abundant.
Indifference Curves With the assumption of common consumer tastes
across the countries, we add an identical indifference curve to each countrys
PPF. The tangency of the indifference curve and the PPF gives the relative
price of computers for Home, (PC / PS )A, and Foreign, (P C* / P*S)A *, in panels
(a) and (b), respectively.
No-Trade Equilibrium Price The no-trade equilibrium for Home is at point
A, with production of computers and shoes given by QC1 and QS1. The no-
trade equilibrium for Foreign is shown by point A *, at which outputs are de-
noted by Q *C1 for computers and Q *S1 for shoes. The slope of the price line
is relatively steeper for Foreign than for Home, reflecting the higher relative
price of computers in the labor-abundant country.
Free-Trade Equilibrium
Home Equilibrium with Free Trade With free trade, the equilibrium relative
price of computers is between the no-trade relative prices found at Home and
Foreign. More specifically, panel (a) of Figure 4-3 shows that the free-trade
equilibrium price of computers, (PC / PS )W, is steeper than the no-trade price
at Home (see Figure 4-2) because its no-trade price is lower than that of the
foreign country. Given the higher world relative price, Home further special-
izes in the production of computers by moving from point A to point B, where
QC2 QC1 and QS2 QS1 . By engaging in trade, Home can consume on a
higher indifference curve at point C. Using points B and C, we can create a
trade triangle, where the height represents the amount of shoes imported
(QS3 QS2 ) by Home and the base gives export of computers (QC2 QC3 ).
Panel (b) of Figure 4-3 shows the Home exports of computers versus the rel-
ative price. The Home relative price without trade given by point A in panel
(a) corresponds to point A in panel (b) with zero computer exports. Given the
higher free-trade relative price, Home exports the difference between the
amounts produced and consumed, shown by point D in panel (b). Home ex-
port supply curve of computers is derived from connecting points A and D.
Foreign Equilibrium with Free Trade In panel (a) of Figure 4-4, the Foreign
no-trade equilibrium is at point A *. Because the Foreign no-trade relative
price is higher than at Home, the world equilibrium price of computers, (PC /
PS )W, is flatter than the no-trade Foreign price, (P C* / P*S)A *. Facing a lower rel-
ative price of computers under free trade, Foreign will increase the production
of shoes by moving from point A *, (Q *C1 , Q *S1 ), to point B *, (Q *C2 , Q *S2 ), such
that Q *S2 Q *S1 and Q *C2 Q *C1 . Engaging in trade at the world relative price,
Foreign consumes at a higher indifference curve at point C *, (Q *C3 ,
Q *S3 ). Connecting points B * and C *, we form a trade triangle similar to that
at Home except now the base is Foreigns imports of computers and the height
Chapter 4 Trade and Resources: The Heckscher-Ohlin Model 49
Many of these explanations focus on the importance of more than two fac-
tors or the ability of factors (such as skilled vs. unskilled labor). In the re-
mainder of this section, we discuss research aimed to redo Leontief s test to
incorporate these additional complexities.
Effective Arable Land The effective amount of arable land is defined as the
actual arable land in a country times its productivity in agriculture. After ac-
counting for the differing productivities in arable land, we find that the
United States is neither abundant nor scarce in effective arable land because
its share of the world total is about equal to its share of the worlds GDP. This
conclusion is verified by the data. From Table 4-2 we can see that even
though the U. S. is a net exporter of agricultural goods, it is some years a net
exporter and some years a net importer of food.
H E A D L I N E S
China Drawing High-Tech Research from the
United States
Applied Materials, a U.S. rm that is currently the worlds largest supplier of equipment used
to make semiconductors, has built its newest and largest research labs in Beijing, China. Ap-
plied Materials is just one of many rms tapping into Chinas huge markets and its abundant,
cheap, and highly skilled engineers.
The relative demand or demand for labor relative to capital, shown on the
right-hand side, is a weighted average of the labor/capital ratio in each indus-
try. The weighted average is calculated by multiplying the labor/capital ratio
52 Chapter 4 Trade and Resources: The Heckscher-Ohlin Model
for each industry (LC / KC and LS / KS ) by the shares of total capital employed
in each industry (KC / K and KS / K ).
The equilibrium relative wage at Home is determined by the intersection
of the relative supply and relative demand curves at point A as shown in Figure
4-10. Because the relative supply curve depends on the total amount of fac-
tor resources in the economy and not on the relative wage, it is represented
by a vertical line. The economy-wide relative demand for labor (RD curve)
is an average of the demand for labor relative to capital in each industry.
Increase in the Relative Price of Computers Because of free trade, Home
faces a higher relative price of computers, which drives it to further specialize
in the production of computers, shifting away resources from the production
of shoes. The increase in the production of the capital-intensive good (com-
puters) leads to a change in the relative demand for labor. More specifically,
for the relative demand for labor in the economy, we put more weight toward
computers, a rise in (KC / K ), and less weighted toward the shoe industry, a
fall in (KS / K ), because capital has shifted to the computer industry. Figure
4-12 shows this change in the weights as a leftward shift of the relative de-
mand curve from RD1 to RD2, giving the new equilibrium at point B.
With production specializing in computers, the fall in the relative demand
for labor in the shoe industry causes a decrease in the relative wage from
(W / R)1 to (W / R)2. The lower relative wage in turn induces an increase in
the number of workers hired per unit of capital in each industry, shown by the
movement along the relative demand curves for shoes (from (LS/KS)1 to
(LS/KS)2) and computers (from (LC/KC)1 to (LC/KC)2). Thus, the increase in
the relative price of computers resulting from free trade leads to a rise in the
labor/capital ratio in both industries. The rise in the labor/capital ratio in
both shoes and computers results from labor being freed up as production
shifts from shoes to computers. In particular, the additional labor per unit of
capital released from the shoes exceeds the requirement necessary to operate
the capital in computers. The change in the relative supply and relative de-
mand due to an increase in the relative price of computers can be summarized
by the following:
L LC KC LS KS
K KC
K KS
K
Relative Supply
No change
Relative Demand
No change in total
PS Q S W L S
R , for shoes
KS
We now add in the information pertaining to the increase in the price of
computers:
PC QC W LC
R , for computers
KC
0 QS W LS
R , for shoes
KS
Rewriting the previous equations in terms of percentage changes, we have
the following:
R PC PC Q C W W LC
R PC
R KC W
, for computers
R KC
R W W LS
0
R W
, for shoes
R KS
where PC / PC is the percentage change in the price of computers, W /
W is the percentage change in the wage, and R / R is the percentage change
in the rental on capital.
Substituting the numbers given and subtracting one equation from the
other, we get:
R 150 W 50
5% , for computers
R 100 W 100
R W 100
W 50
Minus: 0 , for shoes
R
150 W 150
Equals:
0 5% ,
100 W 100
which gives the change in wages as
W 7. 5%
5%.
W 1. 5
In other words, a 5% increase in the price of computers resulting from free
trade leads to a fall in the wage by 5%. This means that the real wage,
Chapter 4 Trade and Resources: The Heckscher-Ohlin Model 55
Solving the equation, we get that the rental on capital increases by 10%
when the price of computers rises by 5%. The capital owner is better off from
trade because the rental percentage increased by more than the percentage in-
crease in the price of computers. In addition, with the price of shoes re-
maining constant while the rental on capital increases, the capital owner also
gains in terms of shoe-purchasing power.
General Equation for the Long-Run Change in Factor Prices The long-run
results due to an increase in the price of computers are given by the following:
W / W 0 PC / PC R / R
APPLICATION
Opinions toward Free Trade
Workers attitudes toward limitations on free trade depend on whether we are
in the short run or long run. More specifically, assuming that workers earn a
portion of the rental on the specific factor in their industry, the short-run spe-
cific-factor model predicts that workers in export industries will be against
placing limits on free trade because the specific factor in their industry gains,
whereas workers in import industries will favor limits on free trade because
the specific factor in that industry loses. Therefore, in the short run, whether
workers support or oppose free trade depends on the industry of employ-
ment. By contrast, from the long-run Heckscher-Ohlin model, an increase in
the relative price of the good exported benefits the factor of production used
intensively while harming the other factor, regardless of the industry in which
the factors are employment.
In 1992, the National Election Studies (NES) conducted a survey asking
Americans whether they support or oppose free trade. The results indicated
that the industry of employment does not provide strong evidence in ex-
56 Chapter 4 Trade and Resources: The Heckscher-Ohlin Model
plaining the respondents attitudes toward free trade. Instead, workers skill
level, measured by their wages or years of education, was more important. In
other words, as predicted by the Heckscher-Ohlin model, skilled workers fa-
vor free trade and workers with lower wages or fewer years of education tend
to support import restrictions.
In addition to skill level, the survey also shows that home ownership plays
a role in workers attitudes toward limits on free trade. In particular, home-
owning workers in communities facing import competition are more likely to
oppose free trade. However, workers who own homes in communities where
the industries benefit from export opportunities are likely to support free
trade. By considering a house as a specific factor, the results of the NES sur-
vey supports the short-run specific-factors model in which workers value the
returns on their housing asset similar to the way in which owners of specific-
factors facing import competition are concerned about the rental earned by
their factor of production.
4 Conclusion
By focusing on the relative amount of labor and capital used in production,
the Heckscher-Ohlin model predicts the gainers and losers in each country
when it engages in international trade. More specifically, the model suggests
that the factor used intensively in the production of the export good experi-
ences real term gains when its relative price increases as a result of trade, al-
though the other factor suffers a real loss in terms of its ability to purchase ei-
ther good.
TEACHING TIPS
ure 4-6, which is available through the World Banks World Development In-
dicators (http://data. worldbank. org/data-catalog).
Ask student to look up data on GDP, labor force, arable land, and re-
searchers in R&D for four countries not listed in Figure 4-6. Students can
then predict trade flows based on the relative abundance of these factors and
the goods for which they are used intensively.
IN-CLASS PROBLEMS
1. What is paradoxical about the results of Leontief s For beer: R / R [(PB / PB )PBQB
test of the Heckscher-Ohlin model? (W / W)WLB )] / RKB
Answer: According to the Heckscher-Ohlin
[(0%)(80) (W / W)
model, the United States, a capital-abundant coun-
try, is predicted to export the capital-intensive
(30)] / 60
good. However, data for 1947 show that the capi- (W / W)(30/60)
tal/labor content of import for the United States
was larger than its exports. Equating the sarong equation with the beer
equation:
2. Suppose Indonesia and Canada trade in sarongs
and beer. Use the following data for Canada to (W / W)(30 / 60)
answer the questions: 50% (W / W)(80 / 40)
Sarongs: Sales revenue PS QS $80 1. 5(W / W) 50%
Payments to labor W LS $80 W / W 33. 33%
Payments to capital R KS $40 So that R / R (W / W)(30 / 60)
16. 67%
Percentage increase in the price
PS / PS 25% c. Compare the magnitude of the percentage in
the rental on capital in part (b) with that of
Beer: Sales revenue PB QB $80 labor.
Payments to labor W LB $30 Answer: The percentage change in the rental
of capital is lower than the percentage increase
Payments to capital R KB $60 in the price of sarongs, although the percent-
age change for wages is higher. We can sum-
Percentage increase in the price
marize the results as follows:
PB / PB 0%
a. Which industry is labor intensive? R / R 0 PS / PS W / W
3. Consider two countries, Spain and Italy, where the 5. Belgium is relatively well endowed with skilled
only two factors of production are capital and la- workers compared with China, which is relatively
bor. Spain has 100 units of capital and 400 units of well endowed with unskilled workers. Assume
labor and Italy has 200 units of capital and 100 that the production of pharmaceutical products in-
units of labor. Both countries produce two goods, tensively uses skilled workers and the production
cheese and suits. The labor share in total produc- of toys intensively uses unskilled workers.
tion costs is 75% for cheese but only 25% for suits. a. Which country would you expect to have a
Show the following: higher relative wage in skilled labor with no
a. Italy is capital-abundant. trade?
Answer: Because the labor/capital ratio is Answer: Belgium has a lower relative wage in
higher in Spain than Italy (i. e. , L S
S / K skilled labor. This is because skilled workers are
L I 400 / 100 100 / 200), we say that
I / K in relative great supply in Belgium and so their
Spain is labor abundant and Italy is capital wages are relatively lower; vice versa for China:
abundant. Skilled workers are in relatively low supply in
b. Suits are capital intensive. China, so wages are relatively higher.
Answer: Cheese is more labor-intensive than b. Which country has the higher relative price of
suits because the share of total revenue paid to pharmaceutical products prior to trading?
labor in the former (75%) is more than that Answer: Goods whose manufacture inten-
share in the latter (25%). sively uses skilled workers (pharmaceuticals)
c. Under free trade, Italy will export suits. will be relatively less expensive in Belgium.
Answer: The no-trade relative price of suits c. Under free trade, which country experiences
in Italy is lower than the free-trade relative an increase in the relative wage of skilled
price because Italy is capital-abundant. Ac- workers? Explain.
cording to the Heckscher-Ohlin theorem, Answer: Belgium experiences an increase in
when the two countries engage in trade, Italy the relative wage of skilled workers because
will export the good that uses intensively the the world relative price of pharmaceuticals is
factor of production it has in abundance. higher than its no-trade relative price.
Therefore, Italy will export suits. 6. Consider two countries, Xeno and Zilo, engaging in
4. Suppose two countries, Greece and Australia, pro- free trade with one another. Each country uses two
duce wine and wheat using labor and capital as factors, capital and labor, to produce two goods, trains
factors of production. Suppose Greece is capital- and hats. Assuming that Xeno exports trains and
abundant and wheat production is labor-intensive. Zilo exports hats, reproduce Figures 4-2, 4-3, and 4-
For each of the following, indicate whether there 4 for each country and determine the world relative
is an increase, decrease, no change, or unable to de- price of trains in a figure similar to Figure 4-5.
termine as the two countries shift from no-trade to Answer: See figures on following pages.
free trade.
Answer:
Greece Australia
Relative price of
UZ
trains, slope
Q XH1 UX ( P ZT / P ZH ) A Z
AX
Q XT1 Output of t of
trains, Q XT Q ZT1 Output of
Q XT
trains, Q ZT
World price
line, slope
Output ( PT / PH )W Relative
of hats, price of
Q XH trains,
PT / PH
Xeno export
Xeno
consumption supply curve
for trains
Q XH3 CX
D
Hat ( PT / PH )W
Xeno
imports AX production
Q XH2 BX ( P XT / P XH ) A A
World price
Output line, slope Relative
of hats, ( PT / PH )W price of
Q ZH trains,
PT / PH
Zilo AZ
BZ production ( P ZT / P ZH )
Q ZH2
Hat DZ
AZ ( PT / PH )W
exports
CZ
Q ZH3 Zilo import
Zilo
consumption demand
curve for
D
a. Which country is relatively capital-abundant?
(PT / PH )W Explain.
Answer: Vietnam is labor-abundant because
(P X /P X )AX
Zilo the labor/capital ratio in Vietnam exceeds that
imports
V / KV LC / K
C.
T H
in China. Namely, L
b. Which country will export textile? Explain.
Answer: Vietnam will export textile because
Q W
Quantity of it is labor-abundant.
trains
(Q XT2 Q XT3 ) c. In Vietnam the production of which good de-
(Q ZT3 Q ZT2 )
creases under trade? In China?
Answer: In Vietnam the production of televi-
Figure 4-5 Determination of the Free Trade World sions will decrease, whereas the production of
Equilibrium Price textile will decrease in China.
d. In China, is the relative price of televisions
7. Compare the basis for trade between the Ricardian higher under free trade or no trade? Explain.
model and Heckscher-Ohlin model. Answer: The relative price of televisions is
a. List the main assumptions of each model. higher under free trade than no trade because
China is capital-abundant relative to Vietnam
Answer: In the Ricardian model, the mar- and the production of television is capital-
ginal products of labor are constant because intensive.
production does not include land or capital.
In the Heckscher-Ohlin model, factors of pro- e. Which group benefits from trade in China? In
duction include labor and capital: Both factors Vietnam?
are free to move between the two industries Answer: From the Stolper-Samuelson theo-
but not across countries. Moreover, technolo- rem, the real rental on capital will increase so
gies used in the production of the two goods that capital owners in China and labor in Viet-
are identical across the countries. nam will benefit.
b. How do the assumptions lead to differences in 9. Suppose Ireland and Canada produce two goods,Y
the pattern of trade between countries in each and X. Assume that good Y is labor intensive and
of the models? good X is capital intensive.
Answer: In the Ricardian model, comparative Canada
Output of Y, QY
Ireland a. Ireland
Output of Y, QY
Output of Y, QY
BI
AI
CI
Output of X, QX Output of X, QX
Given the above PPFs, which country is relatively c. Which good will Ireland export? What about
labor-abundant? Capital-abundant? Explain. Canada? Explain.
Answer: Canada is capital-abundant whereas Answer: Ireland will export the labor-
Ireland is labor-abundant because Canadas intensive good, Y, because it has an abundance
PPF is biased toward the capital-intensive of labor whereas Canada will export good X,
good whereas Irelands PPF is biased toward which uses intensively its capital abundance.
the labor-intensive good.
d. Compare the relative factor prices in the two
b. Suppose the countries have identical prefer- countries before and after trade.
ences. Show the no-trade equilibrium and the
Answer: The Stolper-Samuelson theorem
free-trade equilibrium. Be sure to label the
predicts that capital will experience an increase
production and consumption points for both
in real earnings in Canada due to the increase
economies.
in the relative price of good X when the two
Answer: See the following figures in which countries trade. The situation would be re-
the no-trade equilibrium is denoted by point versed in Ireland, where the relative price of
A. The production and consumption points good X will decrease relative to its no-trade
with trade are represented by B and C, respec- equilibrium price so that capital prices will de-
tively. crease although wages will increase.
Canada e. Comment on the overall welfare in both
Output of Y, QY
countries.
Answer: Although the factor not in abun-
dance in each country will experience a loss
when the two countries trade, overall both
countries are better off with international
trade because they are able to consume outside
their production possibilities frontiers.
CC
10. Professionals and highly educated workers are
more likely to oppose limits on free trade as com-
pared with high-schooleducated workers because
AC they have a better understanding of international
BC trade. Comment.
Answer: This statement is likely to be incorrect
Output of X, QX for the United States because the United States is
relatively abundant in skilled labor as compared
with trading partners such as China or India.
62 Chapter 4 Trade and Resources: The Heckscher-Ohlin Model
Therefore, the Stolper-Samuelson theorem pre- Answer: Without trade, the relative price of
dicts that professionals and other skilled workers wine would be cheaper in France than Ger-
will gain in real earnings because the United States many because France is labor-abundant as
will export the goods that use intensively the fac- compared with Germany.
tor of production it has in abundance (i. e. , skilled d. Now, suppose the two countries trade with
labor). one another. What will happen to the relative
11. Suppose two countries, France and Germany, use price of wine in France? In Germany?
only capital and labor for production. France has Answer: With free trade, the relative price of
2,050 units of capital and 916 units of labor and wine will increase in France and decrease in
Germany has 816 units of capital and 270 units of Germany.
labor. Both countries produce two goods, cars and
wine. In Germany, there are 366 units of capital e. What is the effect of free trade on labor in
and 135 units of labor employed in the wine in- France? On capital owners in France?
dustry. In France, there are 926 units of capital and Answer: Wages in France will increase due to
618 units of labor employed in the wine industry. the rise in the relative price of wine. By con-
a. Which country is labor-abundant? Which trast, the rental on capital will fall.
country is capital-abundant? f. What are the effects of free trade on wage and
Answer: Because the labor/capital ratio is rental on capital in Germany?
F / K
higher in France than Germany (i. e. , L F Answer: The situation would be reversed in
L G G
/ K 916/2050 270/816), we say Germany, where the decrease in the relative
that France is labor-abundant and Germany is price of wine would lead to a decrease in wage
capital-abundant. and a rise in the rental on capital.
b. Which industry is labor-intensive in Ger- g. With the opening of trade, what is most likely
many? Which industry is capital-intensive in to occur in terms of the production of cars in
Germany? France? In Germany?
Answer: In Germany, the car industry is cap- Answer: The production of cars is likely to
ital-intensive and the wine industry is labor- decrease in France as it uses labor more inten-
intensive (i. e. , LW / KW LC / KC 135 / sively to increase the production of wine. For
366 135 / 450) Germany, the production of cars will increase
c. Suppose that France and Germany do not en- because it will export cars by intensively using
gage in international trade. Assuming the its abundance of capital.
countries have identical preferences, which
country would have the cheaper relative price
of wine?
Movement of Labor and
5
Capital between Countries
Notes to Instructor
Chapter Summary
Chapter 5 studies the impact of immigration and foreign direct investment on
wages and returns on rental of land and capital to the foreign and host coun-
tries. Using the short-run specific-factors model, we examine how the move-
ment of labor between countries leads to a decline in the host country wage
following the inflow of labor. By contrast, the long-run model shows that the
increase in foreign labor supply does not result in a change in the host coun-
try wage. The short- and long-run models also explain the returns to capital
due to foreign direct investment.
Comments
This chapter covers the Rybczynski theorem and Factor Price Insensitivity,
which were not covered in the previous chapter. Note that Factor Price
Equalization is not dealt with except in problems 7 and 8.
This chapter bridges the gap between the short-run model (the specific-
factors from Chapter 3) and the long-run model (the Heckscher-Ohlin model
from Chapter 4). This allows an optional discussion of policies issues early on.
Immigration is not often discussed in textbooks and is exciting to teach. As
part of the lecture on foreign direct investment (FDI), it may be useful to read
out loud the article by Paul Krugman titled, The Myth of Asias Miracle.
63
64 Chapter 5 Movement of Labor and Capital between Countries
The students may think that the article is about Bill Clinton after he was
newly elected and the race between East and West, where the East is Asia.
However, toward the end they realize that it is actually in reference to John
Kennedy and the East is the Soviet Union. This leads to a discussion of how
Singapore, similar to the Soviet Union, experienced a depressed rate of return
to capital as a result of the inflow of FDI.
Lecture Notes
Introduction
During May and September, 1980, 125,000 Cubans left the port of Mariel,
Cuba, for Miami, which increased the host citys population by about 7%.
Despite the large supply of low-skilled immigrants from Cuba, the wages of
low-skilled workers in Miami did not vary much relative to the national
trend.
Another example contradicting the fall in wages is the migration of
670,000 Russian Jews to Israel from late 1989 to 1996. The rise in the sup-
ply of highly skilled immigrants from Russia not only increased Israels pop-
ulation by 11% but also led to an increase in the wages of high-skilled work-
ers in Israel during the same period. A similar rise in the supply of highly
skilled workers occurred in Europe and the United States between the 1800s
and 1900s. In the following section, we examine whether these two cases pro-
vide evidence contrary to the basic principles of supply and demand.
of the two marginal product curves gives the Home equilibrium wage and
shows that 0ML units of labor are used in manufacturing and 0AL units of la-
bor are used in agriculture. Because wages are equalized across the two sec-
tors, there is no incentive for labor to move between the industries.
Effect of Immigration on the Wage in Home As a contrast, we assume that
the wage in Foreign, W *, is less than that at Home, W. The higher wage entices
Foreign workers to move to Home, thereby increasing the Home workforce
by the number of immigrants, L. The increase in the amount of labor from
Foreign is shown as the expansion of the horizontal axis in Figure 5. 2, where the
origin for the agriculture industry shifts rightward from 0A to 0A by the amount
L. Coinciding with the rightward movement of the agriculture origin is
a parallel shift of the marginal product curve PA MPLA to (PA MPLA) by
the amount of the increase in Home workforce, L. The intersection of
(PA MPLA ) and PM MPLM gives the new equilibrium Home wage at point
B. Because both sectors absorb the additional workers (0ML 0ML and
0AL 0AL), the marginal product of labor in both industries declines, lead-
ing to a lower wage relative to premigration.
APPLICATION
Immigration to the New World
In 1870, the real wages of the New World, which included countries in North
and South America and Australia, were nearly three times higher than the Old
World, or Europe, as shown in Figure 5-3. Encouraged by the high wages and
new opportunities, about 30 million Europeans migrated to the New World be-
tween 1870 and 1913. Due to the large influx of new workers, the wages in the
New World grew slower relative to those of the Old World. By 1913, European
wages increased to half that of the New World. Figure 5-3 also shows forecasts
of the real wages without the immigration. The comparison of the estimated
wage growth with the actual indicates that wages in the New World grew slower
and wages in Europe increased faster due to emigration.
APPLICATION
Immigration to the United States and Europe Today
Immigration continues to take place today, but rather than from Europe to the
New World, workers are moving from developing countries to the richer in-
dustrialized countries. Policies toward immigration have changed over the
years in the wealthier host countries. For example, during the 1960s and
1970s, some European countries welcomed workers to fill shortages in un-
skilled jobs. The more recent policy in the European Union continues to re-
cruit workers but the aim is for high-skilled labor.
The policy toward immigration is also hotly debated in the United States.
Although most of the focus has been on the influx of illegal immigrants to the
country, many unskilled workers enter under the special visa programs to fill
voids in the agriculture sector as crop harvesters. In addition, a number of
skilled workers such as engineers and scientists are granted special privileges
to work in the United States.
The pattern between the number of immigrants and educational level is
shown in Figure 5-4 for the United States. The graphical analysis indicates
that contrary to the public debates, immigrants scarcely compete with most
66 Chapter 5 Movement of Labor and Capital between Countries
domestic workers with mid levels of education. Instead, the foreign workers
vie for jobs primarily held by the lowest and highest ends of the educational
levels. In other words, although illegal immigrants may pose a threat to the
lowest-educated workers, those with the highest educational level are in com-
petition with legal migrants under the special H-1B visas.
Using an extension of the specific-factors model to accommodate for la-
bor with different educational levels, we find that between 1990 and 2004 the
inflow of workers to the United States resulted in a drop in wages of high-
school dropouts by 9%. The wages of college graduates fell by 5% whereas
most U. S. workers with mid-level educations saw their wages fall by 1% to
2. 4% for those with some college versus high school degree, respectively.
H E A D L I N E S
Europe Sours on Labor Migration
Following the expansion of the European Union in 2004 to include many Eastern European
countries, thousands of migrant workers from Asia found work in Eastern European countries
like Poland and the Czech Republic. These vacancies were created when countries like Great
Britain and Ireland welcomed the inow of cheap Polish and Czech labor to work in indus-
tries like construction and services. Wages paid were modest by the standards of developed
Europe and yet were often three times as high as wages garnered back in Eastern Europe. A
system that worked so well for all involved has seen its rst major test in the recent global
economic crisis. With high unemployment plaguing Great Britain, Spain, and other European
countries, governments are under pressure to limit if not reverse migrations ows.
N E T W O R K
According to the U.S. Citizenship and Immigration Services, the H-1B is a nonimmigrant
classication used by an alien who will be employed temporarily in a specialty occupation
or as a fashion model of distinguished merit and ability. In scal year (FY) 2004, the law
limited the number of foreigners who may be issued an H-1B visa to 65,000.
of constant prices and fixed specific factors in the short run, Home will pro-
duce at point B on the new PPF.
employed in the computer industry have declined (OCK OCK and OCL
OCL). Because the movement of labor and capital between shoes and com-
puters leaves the labor/capital ratio unchanged, the line OSB parallels the line
OSA and has the same slope. More important, the constant labor/capital ra-
tios across the two industries imply that the marginal products of labor and
capital remain unchanged. Thus, contrary to the short-run case, the inflow of
labor does not change wage and rentals on capital in the long run where all
factors of production are mobile.
Effect of Immigration on Industry Outputs Furthermore, in the short-
run, in which the specific factors are fixed, an increase in the supply of la-
bor leads to an increase in the output of both goods. By comparison, be-
cause the increase in labor endowment is absorbed entirely into the
labor-intensive industry in addition to some capital and labor from the cap-
ital-intensive industry, the output of shoes rises in the long run and com-
puter production falls. The increase in shoe output is reflected by the new
Home equilibrium at point B in Figure 5-9, where the unchanged relative
price of computers is just tangent to the outermost PPF. Note that this new
PPF is biased in the direction of shoes because of the increase in the en-
dowments devoted to the shoes industry. The long-run result of factor
movement on output is given by the following theorem:
Rybczynski theorem: An increase in the amount of a factor found in an economy
will increase the output of the industry using that factor intensively, and decrease the out-
put of the other industry.
APPLICATION
The Effects of the Mariel Boat Lift
on Industry Output in Miami
Recall that the Cuban refugees arriving in Miami in 1980 were predominately
less skilled relative to those in the Host city. With the large inflow in unskilled
workers, according to the Rybczynski theorem there should be an increase in the
outputs of the unskilled-laborintensive industries in Miami and a fall in the pro-
duction of the skilled-intensive industries. Figure 5-10 shows the real-
valueadded per capita for Miami and the average for comparison cities in the
apparel industry and high-skilled industries in panels (a) and (b), respectively.
Panel (a) provides some evidence of the results predicted by the Rybczynski
theorem. Namely, although the real-valueadded per capita in the apparel in-
dustry fell between 1972 and 1996, the rate of decline was slower for Miami rel-
ative to the comparison cities after the boatlift in 1980. Support for the
Rybczynski theorem can also be found in panel (b), which shows that the
real-valueadded per capita in skilled-intensive industries experienced a
greater drop in Miami after 1980 as compared with similar cities.
Chapter 5 Movement of Labor and Capital between Countries 69
However, another reason why wages did not change in Miami could be that
the city adopted the use of computers more slowly relative to the rest of the
country during the period of skill-biased technological change. Although
the national trend led to an increase in the demand for high-skilled workers
and a reduction in the employment of low-skilled workers in the 1980s, many
industries in Miami employed low-skilled workers such as the Mariel refugees
instead of moving to computer technologies. Therefore it is possible that the
absorption of the refugees in the apparel industry as well as other industries
such as manufacturing and services caused the wage to remain unchanged
rather than the explanation offered by the Rybczynski theorem.
APPLICATION
Immigration and U.S. Wages, 1990 to 2004
The impact of migrants on the wages of U. S. workers by education attain-
ment is presented in Table 5-1 for years 1990 to 2004. Part A gives the esti-
mated effect due to total migration and part B provides the estimates due only
to illegal immigrants. The findings offered in the first row of part A are cal-
culated based on the short-run specific-factors model, where capital and land
are fixed across industries. The estimates indicate that the inflow of foreign
labors have the largest negative impact on workers with less than 12 years of
education, followed by those with a college education. On average, the im-
pact of immigration on U. S. wages is 3. 2%.
The results are different when we remove the short-run assumption by al-
lowing capital to grow in each industry such that the real rental on capital re-
mains constant. By employing the additional workers with increased capital,
the estimated effect of immigration on U. S. wages is only negative on high-
school dropouts and those with a college education. More important, rather
than declining, U. S. wages increased by an average of 0. 3% as a result of the
immigration. These estimates are available in the second row of part A.
Turning to part B, the estimates suggest that only wages of those least educated
are negatively impacted by the inflow of illegal immigrants. With the absorption
of the illegal workers along with capital growth in each industry, all U. S. work-
ers with at least a high-school degree gain from illegal immigration.
N E T W O R K
According to CzechInvest, the Investment and Business Development Agency, the Czech Re-
public has received approximately U.S. $40 billion in FDI since 1990. The following table
shows the inow of FDI between 2003 and 2005. Most FDIs have been made by Western Eu-
ropean countries.
$ % $ % $ %
In addition, most of the FDI owed into the manufacturing sector as shown in the follow-
ing table:
Economic Activity $ % $ % $ %
Greenfield Investment
In the following sections we focus on greenfield investments rather than ac-
quisitions. We treat the purchase of a new foreign building in the same way
as the movement of labor between countries. Doing so allows us to deter-
mine the impact of cross-country capital flows on the wage and rentals on
land and capital.
the upper right corner denotes that the amount of labor and capital devoted
to computers is measured by OCL and OCK, respectively.
Suppose that the amount of capital in the economy increases due to an in-
flow of FDI. The increase expands the right and left sides of the box in panel
(a) of Figure 5-13 and shifts the origin up to OC . The new allocation of fac-
tors between the industries is shown at point B. Now the labor and capital
used in the shoe industry are measured by OSB, which is shorter than the line
OSA. Therefore, less labor and less capital are used in the production of
footwear, and shoe output falls. The labor and capital used in computers are
measured by OC B, which is longer than the line OCA. Therefore, more la-
bor and more capital are used in computers, and the output of that industry
rises.
Effect of FDI on Outputs and Factor Prices The increase in the amount of
capital due to inward FDI is represented by the expansion of the vertical axis
where the origin for the computer industry shifts upward from OC to OC .
The new allocation of factors between the industries given by point B corre-
sponds to greater amounts of labor and capital dedicated to the capital-
intensive computer industry and a reduction in the endowments devoted to
the labor-intensive shoe industry. As predicted by the Rybczynski theorem,
the output in shoes falls and computer production enlarges, as shown in panel
(b) of Figure 5-13. Moreover, with no change in the capital/labor ratios across
the two industries, the wage and the rental on capital remain unchanged.
Similar to the inflow of labor, the results of the long-run model show that an
increase in capital does not impact the price of either factor.
APPLICATION
The Effect of FDI on Rentals and Wages in Singapore
Many countries have policies to attract foreign investments. One such coun-
try is Singapore, which for many years encouraged foreign firms to invest in
its electronics industry through the establishment of subsidiaries within its
borders. Table 5-2 presents the estimated effect of the inflow of FDI on the
real rental and wages in Singapore for 1970 to 1990. Over this period, the
overall capital/labor ratio grew about 5% per year. With the increase in cap-
ital relative to labor, the real rental on capital fell by 3. 4% each year as shown
in part A. On the flip side, the boost in capital available to each worker in-
creased the marginal product of labor such that the real wage grew by 1. 6%
per year. More specifically, these estimates are consistent with the short-run
specific-factors model, which predicts that the increase in capital due to FDI
would lead to a fall in the rental on the specific factors (capital) and an in-
crease in the wage paid to the mobile factor (labor).
Alternatively, the rental on capital can be measured as the price, PK, of the
capital equipment multiplied by the interest rate, i, earned had the capital
been invested in other forms of asset plus its rate of depreciation, d. Namely
the rental on the capital equipment calculated as PK (i d) is equivalent to
the return on a financial asset from renting out the equipment. Part B gives
the estimates on the growth rate in the real rental using three different inter-
est rates. The real rental is given by the following formula:
R PK
(i d)
P P
Chapter 5 Movement of Labor and Capital between Countries 73
where P is the overall price index. Using the bank lending rate for i, the real
rental is estimated to grow by 1. 6% per year as shown in the first row. With
the return on equity as the interest rate, the second row shows that the real
rental to fall by 0. 2% each year between 1971 and 1990. The third row shows
the real rental to decline by 0. 5% each year when the earningsprice ratio is
used as the interest rate.
Altogether the alternative calculations for the rental on capital contradict
the results of part A, suggesting a lack of evidence that the rental on capital fell
as predicted by the short-run specific-factors model. However, these results
do not clearly verify the long-run specific-factors model. In particular, part B
also shows the real wage in Singapore over the same period. Contrary to the
predictions of the long-run specific-factors model, instead of remaining con-
stant, real wages grew between 2. 7% and 3. 6% per year, varying by the in-
terest rate used. The growth of the real wages coupled with the relatively sta-
ble real rental on capital may indicate that productivity growth occurred in
Singapore, which increased the marginal product of labor.
H E A D L I N E S
The Myth of Asia Miracle
The article gives the reader the impression that the United States and Europe are concerned
about rising competition from Asia due to the amount of capital accumulation in the region.
In addition, it alludes to a pledge madepossibly by Bill Clintonto meet the new chal-
lenge. However, it turns out that the Eastern economy is the Soviet Union and the technol-
ogy challenge resulting from the launch of Sputnik. Moreover, the president in reference is
John Kennedy. From this, Krugman drives the point that the competition facing the Western
economies resulting from the economic growth of the Asian countries is not new.
S I D E B A R
Immigrants and their Remittances
For some countries, remittances or earnings sent back to Home due in part to the global recession. Table 5-3 shows the remit-
by immigrants are an important source of income. The estimated tances versus net foreign aid received by some developing coun-
remittances in 2008 were $336 billion, up from $289 billion in tries in 2007. For these countries, remittances accounted for a
2007. World remittances then declined to $316 billion in 2009 larger source of income than ofcial aid.
Chapter 5 Movement of Labor and Capital between Countries 75
World Gains from Migration The sum of triangles ABC and A*BC rep-
resenting Home and Foreign gains, respectively, gives the larger triangle
A*AB, which denotes the increase in the world gross domestic product
(GDP) due to immigration. For example, when the first migrant leaves
Foreign for Home, the GDP in the former country falls by W * whereas
that in the latter increases by W. The gain in world welfare due to the
movement of the first migrant is equal to the difference between the Home
and Foreign wages.
APPLICATION
Gains from Migration
It is estimated that the net gain due to immigration is about 0. 1% of GDP
where the migrants are assumed to make up approximately 10% of the U. S.
workforce and compete for domestic jobs. The 0. 1% net GDP gain trans-
lates into an estimate of 2% gains for capital and 1. 9% loss for domestic la-
bor. The relatively small size in GDP gain compared with the transfer of
income from labor to capital helps to explain the focus on potential harm
to labor instead of overall increases in welfare in debates over immigration
policies.
The first row of part A in Table 5-4 shows that the gains are higher (0. 4%
of GDP) if we assume the low-skilled work provided by the immigrants com-
plements those of the higher-skilled U. S. population. The gains are even
higher using estimates from household workers as shown in the second row.
More specifically, the net GDP gain would be about 1. 2% to 1. 4% if low-
skilled foreign labors substitute high-skilled domestic individuals by perform-
ing household work.
The estimated worldwide gains due to immigration are shown in part B.
The result in the first row indicates that a 3% flow of workers from develop-
ing to developed countries increases world GDP by 0. 6%. The remaining
findings in part B consider the enlargement of the European Union (EU), tak-
ing into account differences in technology across countries and allowing for
full mobility. The estimates suggest that the original 15 EU countries double
in productivity with the addition of the new members. Over time, the ben-
efits to the EU countries continue to rise due to the movement of capital and
labor from Eastern Europe.
move from Home to Foreign. Due to reasoning similar to that of the move-
ment of labor, the benefits to Home (Foreign) from the capital outflow (in-
flow) can be illustrated by the triangle ABC (A*BC). The sum of Home and
Foreign gains gives the world welfare improvement due to foreign direct in-
vestment, denoted by triangle A*BA.
5 Conclusion
This chapter examines the impact of labor and capital mobility on the Home
and Foreign country in the short and long run using the specific-factors
model. In the short run, the inflow of foreign workers reduces the marginal
product of labor, which in turn decreases wage in the host country. However,
due to the decrease in the payment to labor, the rentals on capital and land
rise. These results explain the opposition to immigration by labor groups, al-
though policy toward fewer labor restrictions are supported by landowners
and capital owners. In the long run, when labor as well as capital is mobile
between the industries, the wage does not necessary fall in contrast to the
short-run case. The reason is that there is an expansion in the output of the
industry that uses the labor intensively and a contraction in the other indus-
try leading to full employment without a change in the labor/capital ratio.
The cross-border movement of capital, also known as foreign direct invest-
ment (FDI), leads to an analogous effects on the Home and host countries as
immigration. Namely, the increased supply of capital from abroad lowers the
rental on capital in the short run. At the same time, the rental on land de-
creases and the surge in capital raises the marginal product of labor, which
causes wage to rise. However, as in the case with immigration, capital mobil-
ity does not lead to changes in wage and the rental on capital in the long run.
There are gains to the host country from the movement of labor and cap-
ital across borders. The gains to the home country result from paying the fac-
tors of production less than its full contribution to GDP. The source country
also benefits from the remittances or earnings received by the factors in the
host country. The overall gains in the world are the sum of the welfare in-
creases across the countries.
TEACHING TIPS
IN-CLASS PROBLEMS
1. Obtain information pertaining to the U. S. Direct 2. Name the top nine countries investing in the
Investment Position Abroad on a Historical-Cost United States using data from the Historical-Cost
Basis from the Bureau of Economic Analysis Basis. Is your list of countries the same as that of
(http://www. bea. gov/). Name the top ten coun- problem 1? What may account for the differences?
tries receiving FDI from the United States. Com- Answer: The top nine countries investing in the
ment on your list. Are the countries the same over United States from 1990 to 2005 are given in the
the years? table below. Most countries receiving FDI from
Answer: The top ten countries receiving FDI the United States as listed in problem 1 are also the
from the United States from 1990 to 2005 are top ten countries investing in the United States.
given in the table below. For the most part, the As mentioned in this chapter, this type of invest-
top ten countries are the same over the years. All ment is called horizontal FDI. Note that Bermuda
the countries on the list, with the exception of and Mexico are replaced by Sweden and France.
Bermuda, are industrialized countries. The invest-
ment in Mexico is considered vertical FDI, in FDI into the U.S. by Country
which U. S. multinationals move production on a Historical-Cost Basis
within the borders of its southern neighbor to cut Country 2009
costs by using lower Mexican wages. By contrast,
World 2,319,585
Bermuda receives FDI from the United States be- Japan 271,883
cause of its tax policies. Germany 259,612
Canada 251,162
France 212,614
U.S. Direct Investment Abroad
Netherlands 118,984
on a Historical-Cost Basis Bermuda 92,588
Country 2009 Switzerland 88,448
Australia 48,353
World 3,508,142 Spain 47,480
Netherlands 471,567
United Kingdom 471,384
Canada 259,792
Bermuda 245,671
Luxembourg 174,092
Ireland 165,924
Switzerland 148,239
United Kingdom Islands, Caribbean 141,527
Germany 116,832
Australia 106,370
Chapter 5 Movement of Labor and Capital between Countries 79
U.S. Direct Investment Abroad by Industry on a Historical-Cost Basis, millions of U.S. dollars (20052009)
2005 2006 2007 2008 2009
FDI in the United States by Industry on a Historical-Cost Basis, millions of U.S. dollars (20052009)
2005 2006 2007 2008 2009
4. Why might a labor group support limitations on Answer: In the short run, an outflow of FDI decreases
the outflow of FDI? the amount of capital available per worker. This lowers
the marginal product of labor resulting in a fall in the
equilibrium wage.
80 Chapter 5 Movement of Labor and Capital between Countries
5. According to Table 5-3, for some countries remit- the output of that industry goes up. By con-
tances account for a larger source of income than trast, less labor and less capital are devoted to
foreign aid. Should these countries have policies the production of food, leading to a fall in the
to encourage emigration? Explain. output in this industry. As predicted by the
Answer: In the short run, emigration would de- Rybczynski theorem, the additional capital in-
crease the available labor leading to a higher mar- creased the output of the capital-intensive in-
ginal product of labor and higher wages in the for- dustry (televisions) and decreased the output
eign country. In addition, if remittances are a of the labor-intensive industry (food).
significant source of income for the foreign coun- b. How has wage changed in terms of food and
try, then it is likely that emigration policies would televisions?
be encouraged. Answer: Because the capital-intensive indus-
6. Assume that Mexico receives an inflow of FDI. try (televisions) absorbed the additional capital
Suppose two factors (labor and capital) are used in along with the shift of labor from the labor-
the production in two industries (food and televi- intensive industry, the capital/labor ratios re-
sions). Further assume that televisions are capital- mained constant. With the capital/labor ratios
intensive as compared with food. Use the long- unchanged across the two industries, the wage
run specific-factors model to answer the following is also unchanged. With constant factor prices,
questions. wage does not change in terms of either food
a. Show the impact of the inflow of FDI on or televisions.
Mexico in an illustration similar to Figure 7. Only developing countries compete for FDI.
5. 13 with output of food (televisions) on the Comment.
vertical (horizontal) axis. What happens to the Answer: Competition for FDI takes place among
output of each good? developing as well as developed countries. An ex-
Answer: Due to the inflow of FDI, more la- ample is the generous incentive package offered by
bor and more capital are in televisions so that Kentucky to Toyota Motor Corporation in 1985.
Output of
food, QF
Relative price of
televisions, PTV / PF
Mexico PPF
A
Shift in Mexico
PPF due to FDI
B
Output of
televisions,
QTV
Chapter 5 Movement of Labor and Capital between Countries 81
8. The following table shows the flow of FDI for se- stantially. What is the impact of this flow of capi-
lect countries between 1985 and 2008. Over this tal on wages in China according to the short-run
period, the inflow of FDI to China increased sub- specific-factors model?
Answer: In the short run, the inflow of capital b. Suppose that foreign owners of domestic cap-
raises the marginal product of labor in the capital- ital decide to decrease their investment. Illus-
specific industry. With prices held constant, the trate the effects of this change in a box dia-
equilibrium wages in China increase initially in gram. Does output in each industry increase,
the capital-specific industry and eventually across decrease, or stay the same? Do wages increase,
both sectors as wages become equalized. decrease, or stay the same in each industry?
9. Consider a long-run model for a country produc- Answer: The effect of decreasing FDI is
ing two products (digital cameras and baskets) us- equivalent to a decrease in capital in this
ing two factors (capital and labor). model of two products and two factors. To as-
a. Which good would you expect to be capital- certain changes in industry output, recall the
intensive? Which good would you expect to Rybczynski theorem: A decrease in a factor
be labor-intensive? Why? will decrease the output of the industry for
which that factor is intensive and increase the
Answer: We define a capital-intensive good output of the other industry. In this case, the
(in contrast to a labor-intensive good) as the decrease in FDI decreases the output of capital-
one having a higher capital/labor ratio. One intensive digital cameras and increases the out-
would expect digital cameras to be capital- put of labor-intensive baskets. Because wage is
intensive due to the relatively high proportion determined in each industry by the ratio of
of machinery, knowledge, and technology that marginal products of labor (which are un-
combine to produce the final good. Con- changed because the capital/labor ratio does
versely, baskets typically require more manual not change), there is no change in wages due
skill; hence, we would expect them to be to the decrease in capital in this model.
labor-intensive relative to digital cameras.
82 Chapter 5 Movement of Labor and Capital between Countries
L LDC ODC
ODC
KDC
K K
B
A
K K
KB
OB LB L
10. Suppose a country has two specific factors, land b. on the real return of the mobile factor of pro-
and capital. Land is an input in the production of duction?
corn. Capital is used only in the production of Answer: Wages increase because the addi-
rockets. A third factor, labor, is mobile between tional capital raises the marginal product of
the two sectors. Holding all else constant, what is labor.
the effect of an increase in the amount of available
capital c. on the output of corn and rockets?
a. on the real return on capital? Answer: According to the Rybczynski theo-
rem, an increase in the amount of capital will
Answer: The increase in capital leads to a de- raise the output of the industry using that fac-
crease in its real return in the short run be- tor (rockets) and decrease the output corn,
cause there is more capital available per unit of which is land specific.
labor, which lowers the marginal product of
capital.
Increasing Returns to Scale
6
and Imperfect Competition
Notes to Instructor
Chapter Summary
In this chapter, we examine a model in which countries benefit from trade
when there is increasing returns to scale in production. Producers gain by
moving down their average cost curve and consumers are able to enjoy more
product varieties. We show how well the monopolistic competition model
holds in empirical applications. One application deals with the impact of the
North America Free-Trade Agreement, from the viewpoint of Canada, Mex-
ico, and the United States. We also use the gravity equation to determine the
importance of economic size and distance in the amount of trade between
two countries.
Comments
By now the students have a good understanding of the concept of compara-
tive advantage as the basis for trade. To get them thinking about the monop-
olistic competition model and product differentiation, find out how many stu-
dents prefer Coca Cola versus Pepsi Cola. Then name products that are traded
between developed countries. For example, the United States exports and
imports wine and beer. With the exception of increasing returns to scale in
production, the material in this chapter is likely to be new to many students,
particularly topics such as the gravity equation. For classes in which calculus
83
84 Chapter 6 Increasing Returns to Scale and Imperfect Competition
Lecture Notes
Introduction
Due to proximity, resources, and comparative advantage, the United States im-
ported snowboards from twenty different countries in 2009, although export-
ing very little in return. By contrast, the United States imported golf clubs
valued at $284 million from twenty-five countries and exported $226 million
of the product to about eighty-three countries in 2009. Panel (a) of Table 6-
1 shows that China is the top-selling country of golf clubs to the United
States, with $254 million sold with an average price of $18 each. Thailand
comes in at a distant second at $14 million; however, its average price is con-
siderably higher at $102 each. The variation in wholesale price among the top
twelve selling countries captures the differences in the quality of the clubs
with Thailand as the leader. Although Canada takes the number eleven spot
on the list of top U. S. -importing countries, it ranks number one among the
countries in which the United States exports golf clubs. Aside from Canada,
seven other countries on the top importing list (Japan, United Kingdom,
South Korea, Australia, Hong Kong, Malaysia, and Taiwan) are also among the
top twelve buyers of American golf clubs. The quality of golf clubs exported
from the United States, although higher than most of the clubs imported, also
varies: the average price per club ranges from $75 to $104.
To explain why the United States is both an importer and exporter of golf
clubs, we introduce a market structure called monopolistic competition
whereby countries trade goods that are similar but not identical to each other.
In other words, a firm is able to maintain some monopoly power by differen-
tiating its products from those of its competitor. An empirical application of
the amount of trade involving imports and exports of different product vari-
eties, also known as intra-industry trade, is also discussed. A second em-
pirical application, the gravity equation, explains the high volume of trade
that takes place between large countries. Last, we examine how increasing re-
turns of scale allow countries to trade with one another despite nearly iden-
tical technologies and factor endowment.
Monopoly Equilibrium
Recall from your principles course that as the sole producer in a market, the
demand curve faced by the monopolist is the industry demand curve. As
shown in Figure 6-1, the industry demand curve, D, is downward sloping,
which means that the monopolist must lower its price to sell an additional
unit of output. With the fall in price, the extra revenue received from the ad-
ditional unit is less than the price so that the marginal revenue curve, MR, lies
below the demand curve. Similar to perfectly competitive firms, the monop-
Chapter 6 Increasing Returns to Scale and Imperfect Competition 85
Figure 6-1
Price
Monopoly
A equilibrium
PM
Marginal
cost, MC
Marginal Industry
MR MC
revenue, MR demand, D
QM Quantity
Monopoly Equilibrium
Figure 6-2
Price
B A
P1
Industry demand
C C
P2 curve, D
Q2 Q4 Q1 Q3 Quantity
Assumption 4: Firms can enter and exit the industry freely, so monopoly
profits are zero in the long run.
Similar to perfect competition, free entry and exit drives monopoly prof-
its to zero in the long run.
Figure 6-4
Price
P0
AC
d0
MC
mr0
Q0 Quantity
Figure 6-5
Price
Short-run equilibrium
without trade
D/NA
P0
Long-run equilibrium
A without trade
PA
AC
MC
d1
mr1 d0
Q1 Q0 Quantity
from dividing the total market demand, D, by the number of firms in autarky,
N A, reflects the quantity demanded faced by each firm when all competitors
charge the same price. The D/N A curve is steeper (less elastic) than the indi-
vidual demand curve, d1. This means that a drop in price by one firm will lead
to a greater increase in quantity demanded than when all firms equally lower
their prices. The reason is that when one firm decreases its price, it is able to
attract more consumers away from competitive firms than when all firms drop
their prices equally.
Figure 6-6
Price
D/NA
A
PA B
P2
B d2
AC
MC
mr2
Q1 Q 2 Q2 Quantity
Figure 6-7
Price
D/N T
A
PA
C
PW
AC
d3
MC
mr3
Q1 Q3 Quantity
enue curve, mr3, with the marginal cost curve gives the long-run equilibrium
with trade at point C, where all firms earn zero monopoly profits (i. e. , price is
equal to average costs). With international trade, remaining firms are able to take
advantage of increasing returns to scale by decreasing their average costs because
they each face a higher demand share. At the same time, the rise in the num-
ber of products increases competition, which causes the firms to reduce prices.
More specifically, in the long run with trade, P W P A whereas Q3 Q1.
Chapter 6 Increasing Returns to Scale and Imperfect Competition 91
Gains from Trade In general, consumers gain as a result of trade under mo-
nopolistic competition. In particular, consumers benefit because of the re-
duction in the price. Furthermore, assuming the variety is valued, they are
better off by being able to choose from products produced both at Home and
in Foreign. Surviving firms improve their productivity by taking advantage of
increasing returns to scale to reduce their average costs.
Adjustment Costs from Trade Nevertheless, to fully examine the overall ef-
fect of trade when firms compete under imperfect competition, we need to
also analyze the short-run adjustment costs faced by exiting firms.
H E A D L I N E S
What Happened When Two Countries Liberalized Trade?
Pain, Then Gain.
Using detailed data on Canadian industries and individual companies, Treer examined the
impact of trade liberalization between two rich countries. Namely, he analyzed the effect of
the removal or reduction in tariffs on Canada with the formation of CUSFTA. Treer found
that industries highly protected by tariffs experienced the most harm following the reduc-
tion of trade barriers, with employment falling by 12%. The lost employment from less-
productive rms going under was offset by the hiring of new workers by more productive
manufacturers that improved their operations as well as expanded in the United States.
Through competition with U.S. rms, formerly sheltered industries increased labor produc-
tivity by 15%. Treer further noted that at least half of the productivity increase was due to
92 Chapter 6 Increasing Returns to Scale and Imperfect Competition
the closing of inefcient plants. More signicantly, the long-run rise in productivity can also
be attributed to the adoption of superior operating practices.
H E A D L I N E S
NAFTA Turns 15, Bravo!
This article celebrates the fifteenth anniversary of NAFTA, and all that this agreement has
done to promote trade between the United States and Mexico. Bilateral trade between the
United States and Mexico increased from $81.5 billion in 1993 to $347 billion in 2007, which
the author attributes in large part to NAFTA. The benefits cited by this article mirror those
discussed in this chapter: both lower prices due to increasing returns to scale and greater
product variety benefitting U.S. and Mexican consumers alike.
Gains and Adjustment Costs for the United States under NAFTA
To examine the gains and losses in the United States from the entry of its
southern neighbor into the free-trade agreement, we begin by noting that
consumers, as well as some U. S. firms, receive benefits from the expansion of
product varieties from Mexico. Next, we compare the long-run gains in con-
sumer surplus due to the increase in import varieties with the short-run ad-
justment costs faced by competing firms.
Expansion of Variety to the United States Due to reduction in trade barri-
ers, the variety of products imported from Mexico substantially increased. Table
6-3 shows that between 1990 and 2001, Mexicos export variety to the United
States grew, on average, at an annual rate of 2. 2%. In the wood and paper in-
dustry the rate was 2. 6% per year and in petroleum and plastics the annual
rate of growth was 2. 5%. Electronics grew more rapidly at 4. 6%.
In addition to Mexico, the raise in product varieties from all countries be-
tween 1972 and 2001 resulted in an increase in consumer surplus that is
equivalent to a reduction in import prices by 1. 2% per year. The benefits to
consumers from the growth of import varieties over the first 9 years of
NAFTA are estimated to be $49. 5 billion.
Adjustment Costs in the United States Short-run adjustment costs consist
of the exiting of domestic firms due to foreign competition. As firms leave
the manufacturing industry, workers become temporarily unemployed. Un-
der U. S. trade laws, these displaced workers are entitled to temporary support
by claiming for Trade Adjustment Assistance (TAA). From 1994 to 2002,
approximately 525,000 workers lost their jobs due to import competition
from Canada or Mexico under NAFTA. In comparison with the annual
number of manufacturing workers displaced between January 1999 and De-
cember 2001, the NAFTA layoff of 58,000 workers per year amounts to 13%
of the total displacement in U. S. manufacturing.
Alternatively, we can evaluate the short-run adjustment costs by comparing
the lost wages of displaced workers with the long-run gains in consumer sur-
plus. We simplify the calculations by assuming that all workers require 3 years
to obtain a new job. Multiplying the average yearly earning in manufactur-
ing in 2000 ($31,000) by three we get that the wage lost due to displacement
is $93,000 per worker. It follows that the annual adjustment costs equal $5. 4
billion (58,000 workers annually displaced multiplied by $93,000 per
worker). Although the private NAFTA costs of $5. 8 billion is nearly equal to
the consumer gains of $5. 5 billion, overall, U. S. consumers are better off due
94 Chapter 6 Increasing Returns to Scale and Imperfect Competition
N E T W O R K
Group Eligibility Requirements: TAA
Workers company produces a product.
A required minimum of the workforce has been laid off in the 12 months preceding the
date of the petition or is threatened with layoffs (three workers in groups of fewer than
50, or 5% of the workforce in groups of 50 or more)
One of the following:
Increased imports contributed importantly to an actual decline in sales or production
and to a layoff or threat of a layoff; or
There has been a shift in production to certain countries outside the United States;
or
There has been a shift in production outside the United States and there has been or
is likely to be an increase in the import of like or similar articles; or
Loss of business as a supplier of component parts, a nal assembler, or a nisher for
a TAA-certied rm contributed importantly to an actual decline in sales or produc-
tion, and to a layoff or threat of a layoff.
Under Section 113 of the Trade Adjustment Assistance Reform Act of 2002 (PL 107-210),
workers may be eligible to apply for TAA services if they were laid off as a result of in-
creased imports or if their companies shifted production out of the United States to certain
foreign countries. In 2009, President Obama revised the TAA as part of the American Recov-
ery and Reinvention Act of 2009 (the stimulus bill). The TAA benets were increased and all
service sector employees are now eligible for assistance.
As an example, we use the information that the value of import for yachts
in 2009 is $. 802 billion and export is $1. 436 billion. The minimum of im-
ports and exports is $. 802 billion with an average of (. 802+1. 436) =
$1. 119 billion. Thus, $. 802 / $1. 119 = 72% of the U. S. trade in yachts in-
volves imports and exports. Table 6-4 shows other examples of intra-industry
trade in the United States.
APPLICATION
The Gravity Equation for Canada and the United States
Panel (a) of Figure 6-9 shows the trade between U. S. states and Canadian
provinces in 1993 with the gravity term ( GDP1GDP2 / dist 1. 25) as a loga-
rithmic scale on the horizontal axis and the value of export also in logarith-
mic scale (in millions of U. S. dollars) from a Canadian province to a U. S.
state (or vice versa) on the vertical axis. With data from 30 states and 10
provinces, the points in panel (a), which represent the trade flow and gravity
term between a particular state and province, show that trading partners with
a higher gravity term have more trade with one another. By including a line
96 Chapter 6 Increasing Returns to Scale and Imperfect Competition
of best fit to the set of points, we get that the constant term B 93. In
other words, the predicted amount of trade between a U. S. state and a Cana-
dian province is $93 million when the gravity term equals one.
5 Conclusions
In contrast to classical trade models such as the Ricardian model and the
Heckscher-Ohlin model, we find that two seemingly identical countries can
benefit from trading with one another when we remove the assumption of
perfect competition. Under monopolistic competition, the doubling of the
market size with free trade motivates firms to attract consumers away from
their competitors by lowering their prices. However, the collective movement
to lower prices by all firms leads to negative profits for everyone and causes
some to exit the industry. With an increase in the market share relative to free
trade, the surviving firms raise the quantity supplied, which allows them to
take advantage of increasing returns to scale and lower their average costs.
Due to the reduction in their average costs, firms lower their prices, which in-
creases consumer surplus in the importing country. Moreover, the increase in
the number of firms resulting from trade implies that there is an expansion in
the variety of products available to consumers.
Despite potential for long-term gains to consumers in the form of lower
prices and increased variety and to remaining producers from greater effi-
ciency, a comparison of the short-run adjustment costs to workers displaced
due to the exiting of some firms is necessary to fully examine the effect of tar-
iff reductions following the formation of regional trade agreements. In gen-
eral, the long-run gains are likely to exceed the short-run adjustment costs if
the diversion of imports from an outside member to an inside member is less
than the creation of trade between countries in the newly formed regional
agreements.
This chapter also shows that when a firm has market power, possibly due
to a tariff or high transport costs, it can behave as a discriminating monopoly
by charging consumers at Home a different price than those in the Foreign
Chapter 6 Increasing Returns to Scale and Imperfect Competition 97
TEACHING TIPS
IN-CLASS PROBLEMS
1. How does increasing returns to scale lead to gains 4. Refer to the gravity equation.
from trade under monopolistic competition? a. Why is trade greater between two large trad-
Answer: Through trade, firms are able to expand ing partners?
their outputs by selling in the Foreign market. Answer: Large economies produce more
With the rise in the number of product varieties product varieties. Thus, when two countries
available, competition increases in the importing trade differentiated product as is the case in the
country, which drives prices to fall. Although monopolistic competition model, the larger
some firms exit the market because of the losses countries will have more to export. More-
resulting from the lower prices, the remaining over, larger economies will also have a higher
firms are able to reduce their average costs through import demand for the number of product va-
increasing returns to scale by expanding their out- rieties. Thus, trade is greater between two
put. Consumers in the importing country gain large countries.
from the lower prices charged by firms as a result
of the decrease in average costs. Consumers also b. How does distance between trading partners
benefit from the increase in the product varieties. influence the amount of trade?
2. Portland and Aleland are two identical countries. Answer: Distance influences the amount of
Beer manufacturers in each country compete un- trade because the closer are the trading part-
der monopolistic competition. ners in proximity, the lower transportation
costs, which results in more imports and ex-
a. Suppose the two countries engage in trade. ports.
Determine the impact of free trade on con-
sumers in Portland. 5. In the monopolistic competition model, would
you expect prices to be higher or lower as the
Answer: Consumers in Portland will gain number of firms increases? Briefly explain why.
from an increase in the varieties of beer avail-
able through importing. Additionally, prices Answer: As the number of firms increases, there
will fall due to the increased competition. will be more product varieties available to the con-
sumers. Due to the increase in competition, the
b. How does trade affect the welfare of domestic demand curve for the existing firms become more
producers in Portland? elastic and the demand for each variety decreases,
Answer: By selling abroad, the producers in leading to a fall in prices.
Portland will be able to lower their average 6. Assume a firm has the following costs:
costs through increasing returns to scale.
However, they will face greater competition in Fixed costs: $100
their local market due to new varieties avail- Marginal costs: $50/unit
able from the import of beer from Aleland. As a. Fill in the missing information on the follow-
a result of the competition from Aleland, con- ing chart:
sumer demand for their variety decreases, thus
driving their prices down. Total Costs Average
3. What had Canada expected to gain from forming Variable Variable Costs
costs Costs Total Cost/
the CUSFTA with the United States? Quantity, Q Q MC Fixed Costs Quantity
Answer: Relative to the United States, the Cana-
5
dian market is small. By forming CUSFTA with
its larger southern neighbor, Canada expected to 25
be able to expand production by serving the big- 50
ger market, which in turn would allow the firms to
80
lower their costs through increasing returns to
scale. 120
165
215
270
Chapter 6 Increasing Returns to Scale and Imperfect Competition 99
Notes to Instructor
Chapter Summary
The topic of offshoring is discussed in this chapter through a model and var-
ious case studies. The chapter examines whether offshoring or the shift to-
ward skill-biased technological equipment explains the increase in the de-
mand for high-skilled labor in the United States. There is a discussion of the
potential loss of U. S. comparative advantage to countries such as China and
India. Winners and losers of offshoring are also identified.
Comments
Offshoring is a deeply debated topic. Therefore, it is likely that your students
have some ideas about the impact of offshoring on their futures or someone
they know. After reminding them of what they have learned thus far about
the potential gains from international trade, ask your students whether they
support policies to limit offshoring. To motivate the topic, the video Out-
sourcing: White Collar Exodus provides an in-depth look at the growing use
of service outsourcing, particularly focusing on call centers in India.
This chapter uses the concept of production possibilities frontiers (PPFs) in
examining the model of outsourcing. The students should be reminded that
the PPF now refers to the production possibilities for a firm rather than an
economy. In addition, isoquants are presented. Briefly discuss the similarity
101
102 Chapter 7 Offshoring of Goods and Services
Lecture Notes
Introduction
Offshoring materials, parts, components, and services necessary to produce
the simplest to the most sophisticated products is common. Technically, off-
shoring is defined as the provision of a service or the production of various
parts of a good in different countries that are then used or assembled into a
final good in another location. Offshoring differs from traditional models of
international trade (Ricardian and Heckscher-Ohlin) in that it involves trade
of intermediate inputs rather than final goods. Unlike final goods, intermedi-
ate inputs may cross numerous borders before being integrated into a product
that is sold either to the domestic or foreign market. The popularity of off-
shoring is largely due to the cost reduction of international services, such as
transportation and communications. One of the newest forms of offshoring
is the outsourcing of business services such as accounting, auditing, human
resources, order processing, telemarketing, and after-sales service to foreign
countries.
S I D E B A R
1 A Model of Offshoring
We begin the formal model of offshoring by ranking skill intensity of activi-
ties involved in producing a good. Panel (a) of Figure 7-2 presents the pro-
duction process in chronologic order, namely, from research and development
to marketing and after-sales service. By contrast, panel (b) gives the rank of
the activities based on the ratio of high-skilled to low-skilled labor required
in the process with assembly as the least skilled-intensive part of the produc-
tion to research and development the most skilled intensive.
will use the value chain to determine which activities a firm is most likely to
outsource to maintain competition.
Relative Wage of High-Skilled Workers Letting WL (WH ) denote the wage
of low-skilled (high-skilled) labor at Home, whereas W L*(WH* ) represents
those in Foreign, we make the assumption that compared with Home, wages
in Foreign are less (W L* WL and WH* WH ) and the relative wage of low-
skilled labor is lower (W L* / WH* WL / WH ).
For example, consider Home as the United States, where the average wage
of production workers was 37% less than nonproduction workers in 1988.
Foreign can be viewed as Mexico, where production workers earned 55% less
in average wage than nonproduction workers in the same period.
Costs of Capital and Trade In deciding whether to outsource certain ac-
tivities in its production process, a firm must weigh the savings in labor cost
achieved by shifting to the lower-wage Foreign country against the additional
costs associated with doing business abroad. These trade costs include phys-
ical capital of a foreign plant or factory, transportation and communication,
and Foreign-imposed tariffs. To simplify the firms decision process to base
only on the savings in labor costs, we assume that regardless of the source, all
trade costs apply uniformly across all activities in the value chain.
Slicing the Value Chain Given our assumptions, the firm will maintain the
more labor-intensive activities at Home and shift the most labor-intensive ac-
tivities abroad. Referring to panel (b) of Figure 7-1, the firm is slicing the value
chain by shifting all activities to the left of the vertical line A to Foreign.
Relative Demand for Skilled Labor Adding the demand for high-skilled and
low-skilled labor in the activities to the right of line A, we obtain Homes rela-
tive demand for high-skilled labor as illustrated in Figure 7-2, where the hori-
zontal axis is the relative demand for skilled labor, H / L, and the vertical axis
gives the relative wage of high-skilled labor, WH / WL. The downward-sloping
relative demand curve reflects the inverse relationship between higher relative
wage for high-skilled labor and the Home firms quantity demand for high-
skilled labor as compared with low-skilled labor. Namely, the Home firms are
likely to substitute less-skilled labor in some activities for skilled labor in re-
sponse to an increase in the relative wage of the latter. To derive the relative de-
mand for high-skilled labor in Foreign, we similarly add up the demand for
high-skilled, H*, and low-skilled, L *, labor for all activities to the left of line A.
The relative demand for skilled labor in Foreign, H * / L *, against the relative
wage, WH* / WL* , is presented in panel (b). By adding a relative supply curve to
each respective diagram, we are able to determine the equilibrium relative wage
given by points A and A * at Home and Foreign, respectively.
Change in Home Labor Demand and Relative Wage Due to the decline
in trade costs, the Home firm will be motivated to shift more activities in the
value-chain to Foreign. In other words, Home will move the next-least-
skilled-intensive production processes abroad as illustrated by the area between
lines A and B in Figure 7-3. These activities, although more skilled-intensive
than those sent to Foreign before the fall in trade costs, are still less skilled in-
tensive than those kept at Home. Therefore, the average range of activities
performed at Home becomes even more skilled intensive. Consequently, the
ratio of high-skilled to low-skilled labor increases at Home as shown by the
rightward shift of the relative demand curve in panel (a) of Figure 7-4. The
intersection of the relative supply curve with the new relative demand curve
gives the new equilibrium point B, where the relative wage of high-skilled la-
bor has increased due to additional offshoring.
Change in Foreign Labor Demand and Relative Wage Similarly, the av-
erage range of activities in Foreign is now more skilled-labor intensive due to
the additional offshoring done by the Home firm. Although the newly out-
sourced activities (between lines A and B) are less skilled intensive as compared
with those maintained at Home (to the right of line B), these production
processes are more skilled intensive than the activities originally outsourced to
Foreign (those to the left of line A). As a result, the relative demand for high-
skilled labor in Foreign also increases as illustrated by panel (b) of Figure 7-4.
The increase in the Foreign high-skilled to low-skilled labor ratio raises the rel-
ative wage of skilled labor given by the new equilibrium at point B *.
APPLICATION
Change in Relative Wages across Countries
The wage differential between high-skilled and low-skilled workers in devel-
oped countries such as the United States, Japan, the United Kingdom, and
Sweden, as well as less-developed countries such as Mexico and Chile, has in-
creased since the early 1980s. This change in wages is consistent with the pre-
diction of the offshoring model.
Change in Relative Wages in the United States A comparison of the
wage movements in the manufacturing industries allows us to more accu-
rately attribute each factor toward explaining the widening wage differen-
tial experienced in the United States. We consider production workers to
be blue collar workers and nonproduction workers to be white collar
workers.
Relative Wage of Nonproduction Workers From Figure 7-5, we see that
the average annual earnings of nonproduction workers relative to production
workers in U. S. manufacturing did not follow any particular trend between
1958 and 1967. The average annual earnings ratio exhibited a downward
trend from 1968 to 1983. This decline is attributed to an increase in the sup-
ply of college graduates in nonproduction jobs. However, starting from 1983,
nonproduction wage increased relative to production wage.
Relative Employment of Nonproduction Workers Figure 7-6 shows the
relative employment of nonproduction to production workers in U. S.
manufacturing from 1958 to 2001. Until the early 1990s, there was a rise in
the nonproduction employment ratio. Then the trend reversed itself until
Chapter 7 Offshoring of Goods and Services 105
Gains from Offshoring within the Firm The gain the Home firm experi-
ences through offshoring is measured by the increase in the amount of final
good it produces, namely, the difference between Y0 and Y1. More specifically,
the firm has become more productive because it is capable of producing more
final goods using the same total endowment of high-skilled and low-skilled
labor as in the absence of offshoring. The firm achieves this higher produc-
tivity by focusing on R&D and offshoring components assembly to Foreign,
where the low-skilled-intensive activity is cheaper. This cost savings, reflected
by the lower price in the final product, gives one of the general conclusions
that there are gains from offshoring when Home faces a different relative price
compared with the no-trade case.
Terms of Trade
To further understand Paul Samuelsons comment, we need to reintroduce the
concept of terms of trade. Recall that the terms of trade is given by a coun-
trys export price divide by the price of its imports. For any country, a rise in
its terms of trade means that it is either receiving a higher price for its exports
or is able to purchase its imports at a lower price.
Fall in the Price of Components Suppose Foreign improves its productivity
in components production, leading to a fall in the world-relative price. As an
importer of components, Home experiences a rise in its terms of trade due to
the fall in the relative price of components. With an even flatter world-relative
price, (PC / PR ) W2 as shown in Figure 7-11, the Home firm dedicates more
resources to R&D by moving to point B along its PPF and producing a
greater amount of final goods given by point C on Y2. Thus, due to the fall
in the price of components production, the Home firm enjoys additional ben-
efits through offshoring.
Fall in the Price of R&D Lets examine the case in which the world-relative
price of R&D falls instead of components production. Illustrated in Figure
7-12, the fall in world-relative price of R&D means that Home faces a steeper
price line, (PC / PR ) W3, compared with the situation before the decline in the
price of R&D. With the decline in the world-relative price, the Home firm
shifts some of its resources from R&D to components production, moving
from point B to point B. It follows that the firms final output falls from
point C on isoquant Y1 to point C on isoquant Y3. The fall in the price of
R&D leads to losses for the Home firm because the terms of trade at Home
worsened compared with the initial offshoring equilibrium. Notice that be-
cause Y3 is still higher than Y0 (final output absence of trade) Home still gains
from offshoring as compared with the no-trade equilibrium at point A. Thus,
although Home is worse off when its terms of trade fall, it is still better off
than in the absence of offshoring. However, as noted by Paul Samuelson, un-
like traditional trade in final goods, a fall in the terms of trade with offshoring
could have a negative impact on the Home country in that the gains of the
winners may not be large enough to compensate the losses of the losers. This
issue becomes particularly pertinent as countries such as China and India gain
comparative advantage in activities once dominated by the United States.
108 Chapter 7 Offshoring of Goods and Services
S I D E B A R
APPLICATION
U.S. Terms of Trade and Service Exports
Merchandise Prices Figure 7-13 shows the U. S. terms of trade for mer-
chandise goods, excluding petroleum. Between 1987 and 1994, the terms of
trade worsened for the United States. From 1994 through 2008, the United
States has benefitted from imports of intermediate inputs and final goods due
to the rise in the terms of trade, but there has been a slight dip since 2009.
Service Prices We can examine a similar study in U. S. terms of trade for ser-
vices using international prices on air travel, available from 1995. The air-travel
terms of trade, equal to the price foreigners pay traveling on U. S. airlines di-
vided by the price Americans pay on Foreign airlines, does not exhibit any sys-
tematic patterns before 2002. From 2002 to 2005, the data indicate increasing
gains from trade for the United States in air travel. Since then U. S. terms of
trade in air-travel has been generally falling, though somewhat erratically.
Service Trade Because prices are not available for services other than air travel,
we will use the amount of service traded to examine whether there is any evi-
dence to support Paul Samuelsons comment. Table 7-2 shows that the United
States enjoyed a surplus in service trade in 2008 worth about $160 billion. In
particular, it can be noted that the United States has a comparative advantage in
traded services given that exports exceed imports in most categories listed in
Table 7-2. Figure 7-14 presents the combined trade surpluses in computer and
information services, other business services, and financial services for the United
States, the United Kingdom, and India since 1982. The U. S. surplus steadily
grew in lock step with the surplus of the United Kingdom until about 1995.
Since that time, the U. K. surplus has grown faster than that of the United States.
Over the past decade, India has quickly become a world competitor with nearly
all of their surplus coming from exports of computer and information services.
H E A D L I N E S
How to Destroy American Jobs
This article argues against President Obamas proposed reform of the U.S. international tax
system, which would increase taxes paid by multinational corporations on prots made over-
seas. It is argued that instead of promoting U.S. job creation, as is intended, this tax in-
crease would destroy U.S. jobs. The author argues that multinational employment overseas
is often a complement rather than a substitute for U.S. employment, an argument which is
born out in the data. Over the past two decades, employment by foreign afliates of multi-
national corporations has increased by only slightly more than domestic employment by par-
ent corporations. Additionally, U.S. multinationals are responsible for large amount of U.S.
private sector R&D and productivity gains.
H E A D L I N E S
Caterpillar Joins Onshoring Trend
Following an extended period of globalization, many rms are beginning to see disadvan-
tages to offshoring, such as transportation costs, complications in supply chains, and issues
of quality. One such company, Caterpillar, is considering bringing some of its manufactur-
ing back to the United States in a move being called onshoring. Weakness of the U.S. dol-
lar has made it difcult for companies like Caterpillar to import products from overseas to
be sold in the United States. While other rms like General Electric are moving operations
back to the United States by negotiating more favorable labor agreements.
N E T W O R K
The Harsh Truth About Offshoring
Paul Craig Roberts, former Assistant Treasury Secretary under President Reagan, cast doubts
on whether there are any gains from offshoring. He stated that the traditional theory of
comparative advantage does not apply to offshoring because modern-day trade in goods and
services is based on acquired knowledge rather than differences in technology and capital.
More specically, Roberts claimed that because offshoring is driven by absolute advantage,
countries such as India and China will ultimately gain whereas the First World will lose. He
110 Chapter 7 Offshoring of Goods and Services
reasoned that the Asian countries have an excess supply of skilled and educated labor that,
coupled with capital, technology, and business know-how from the First World, will give
them the competitive edge over higher cost labor in the latter countries. Therefore, the
First World will lose out not only in terms of ability to compete in labor costs but also in-
ability to replace lost industries and jobs.
4 Conclusion
This chapter provides a trade theory that helps explain the increasing use of
outsourcing in the manufacturing and service industries. Offshoring differs
from the traditional trade models in that it involves the movement of inter-
mediate input across borders rather than final goods. In particular, various
stages of the production process are ranked according to the requirement of
low-skilled relative to high-skilled labor. With the assumption that the rela-
tive wage of low-skilled labor and general wages are lower in Foreign, the firm
will outsource the less-skilledintensive activities abroad and continue to fo-
cus on the more-skilledintensive activities at Home. Due to a decline in the
cost of capital or trade in Foreign, the Home firm will outsource the next
least-skilledintensive activities on the value chain. These additional activities
outsourced will raise the ratio of high-skilled to low-skilled labor in Foreign
and at Home.
The model also examines the impact of a change in the terms of trade for
Home relative to the initial offshoring equilibrium. An improvement in the
terms of trade will lead the Home firm to outsource even more of the low-
skilled-intensive activities, leading to an increase in the relative wage of high-
skilled labor and higher output of the final products. By contrast, a worsen-
ing of the terms of trade will trigger the firm to cut back on the
Chapter 7 Offshoring of Goods and Services 111
TEACHING TIPS
1
Data from Recent Trends in U.S. Services Trade, International Trade Commission 2009 Annual Report
(http://usitc. gov/publications/332/pub4084. pdf)
112 Chapter 7 Offshoring of Goods and Services
IN-CLASS PROBLEMS
1. What are the main differences between the off- for service offshoring because the wages of educated
shoring phenomena in manufacturing versus workers are lower relative to those in the United
services? States. Moreover, manufacturing offshoring of in-
Answer: Manufacturing involves low-skilled- termediate inputs may be traded across borders sev-
intensive labor such as the assembly of goods. eral times. Due to the slicing of production process,
Therefore, offshoring in manufacturing entails the each country involved must have reliable infrastruc-
movement of low-skilled-intensive activities over- tures, such as efficient road and transport networks.
seas and occurs in countries with low-wage low- 2. In a graph similar to Figure 7-10, illustrate the no-
skilled labor. By contrast, services offshoring, par- trade equilibrium, A *, for the Foreign firm.
ticularly of business services such as accounting, a. Supposing Foreign engages in international
auditing, human resources, order processing, tele- trade, add the world-relative price of compo-
marketing, and after-sales service for computer pur- nents to your graph. Indicate the Foreign firms
chases uses high-skilled-intensive labor. Although resource allocation and production of the final
offshoring in services also take place in low-wage goods when it faces the new price line.
countries, these activities are performed by high-
skilled labor. As such, India is a favored destination Answer: See the following figure, where the
new equilibrium is B * and C *.
R&D
C*
Foreign firm
imports of R&D Y *1
A*
Y *0
Components
b. Illustrate the gains or losses faced by the firm Answer: See the following figure, where the new
relative to the initial offshoring equilibrium, equilibrium is B * and C *.
assuming a fall in the price of components.
R&D
C*
C*
Y1
Foreign firm A*
imports of R&D Y2
B* Y0
3. Reproduce part (a) of problem 2. Then, illustrate Answer: See the following figure, where the new
the gains or losses faced by the firm relative to the equilibrium is B * and C *.
initial offshoring equilibrium, assuming a fall in
the price of R&D.
R&D
C*
Y3
Foreign firm A* Y1
imports of R&D
Y0
B*
B* Slope = (PC / PR) W1
Components
4. Use the simplified offshoring model with two ac- 1/3 in Techland. Because W LP / W SP
tivities and the information below to answer the W LT / W ST, the relative wage of low-skilled labor
following questions. is higher in Techland.
Two countries: Techland and Prodland b. Suppose the two countries engage in trade.
Two activities: Assembly, which is low-skilled-labor Which activity will Techland outsource? Ex-
intensive, and product development, which is plain.
high-skilled-labor intensive Answer: With a higher relative wage for low-
skilled labor, Techland will outsource assembly,
Final good: JPod which is the most low-skilled-labor intensive,
and keep the high-skilledlabor intensive ac-
Prodland: W LP 1,000, W SP 5,000 tivity of product development at home.
Techland: WTL 30,000, W ST 90,000 c. Draw relative labor supply and demand dia-
The costs of capital and trade are uniform across grams for Prodland and Techland on separate
production activities. graphs.
a. Which country has the higher relative wage of Answer: See the figures below.
low-skilled labor?
Answer: The relative wage for low-skilled
workers is W PL / W PS 1,000 / 5,000 1/5 in
Prodland and W LT / W ST 30,000 / 90,000
High-Skilled/Low-Skilled Labor, H P/LP
Prodland supply
Techland supply
AP
AT
Prodland demand
Techland demand
High-Skilled/Low-Skilled Wages W SP /W LP T T
High-Skilled/Low-Skilled Wages W S / W L
d. Suppose the cost of capital in Prodland de- labor. The relative wage of high-skilled labor
creases. What do you expect will happen to increases with the new equilibrium relative la-
the relative wage in each country? bor supply and demand.
Answer: When the cost of capital declines in In Prodland, the relative wage of high-skilled
Prodland, it becomes more profitable for Tech- labor also rises because the activity newly out-
land to outsource additional assembly activities sourced from Techland is more high-skilled-
abroad. The activity that remains in Techland labor intensive, on average, than the assembly
is now greater in high-skilled-labor intensity, work previously performed in the country.
on average, relative to the set of activities Therefore, the relative demand for skilled labor
newly outsourced to Prodland, leading to an likewise increases in Prodland.
increase in the relative demand for high-skilled
Chapter 7 Offshoring of Goods and Services 115
5. In 2005 there were 127 legislations proposed by 40 defining the proposed legislations is from the Na-
states to restrict offshoring. The following table tional Foundation for American Policy.
SCB: State Contract Ban Prohibit work on state contracts to be performed overseas or by individuals not
authorized to work in the United States
CCR: Call Center Restrictions Require operators to identify their location in some manner
HDR: Health Care and/or Data Transfer Restrictions Ban or require an opt-in for data to be processed outside of the United States
TAR: Trade Agreement Restriction State not be party to international trade agreements on procurement
ISP: In-State Preference In-state preference for state contracts
SAR: Development Assistance Restrictions Development assistance restriction for outsourcing companies
9DN: 90-Day Notice 90-day notice for transferring 25% of workforce
LSW: Location of State Work Report on location of state work
NO: Notication of Outsourcing Notication to worker of outsourcing
OCF: Outsourcing Compensation Fund Outsourcing compensation fund for employees
Answer: Potential winners would be those whose 6. What impacts will the offshoring restrictions in
jobs are banned from being outsourced. The losers problem 5 have on industry competitiveness in the
would be firms that are unable to reduce costs by proposed states?
shedding their less skilled-intensive activities. Answer: The competitiveness of the industry fac-
Consumers would also lose from having to pay a ing the offshoring restrictions in the proposed
higher price for the final product because the firms states would be challenged. According to the off-
are restricted from lowering their costs through shoring model presented in this chapter, the firms
offshoring. faced with the ban would not be able to attain the
116 Chapter 7 Offshoring of Goods and Services
higher isoquants by subcontracting their less 8. How does trade today differ from the past?
skilled-intensive activities to outside sources. Their Answer: There is more trade today than in the
production would occur at the no-trade equilib- past. In addition, between 1925 and 1950, two cat-
rium on their PPF. egories, (1) foods, feeds, and beverages and (2) in-
7. Referring to problem 5, would the proposed leg- dustrial supplies and materials, accounted for 90%
islation be as restrictive if the services were out- of imports and 80% of exports in the United
sourced to another state (domestic offshoring) States. By 2005, the shares of these two categories
rather than across international borders (foreign decreased to 35% for imports and exports. With
offshoring)? Comment on the welfare of the states the recent increased use of offshoring, the share of
involved. automotive and capital and consumer goods in
Answer: Offshoring to another state is likely to U. S. imports and exports increased from 10% and
elicit a significantly less-restrictive response because 15%, respectively, in 1925 to 65% in 2005. More-
the endangered jobs would be maintained within over, trade today involves not only final goods but
the United States borders. Assuming that the home also intermediate goods that often cross several
state has a higher relative wage of low-skilled labor, borders before reaching their final destination.
the increased demand for high-skilled-intensive la-
bor from offshoring the less skilled-intensive activ-
ities will drive the relative wage of high-skilled la-
bor higher at Home. Likewise, the relative wage of
skilled labor will rise in the host state as long as the
outsourced activities are more skilled-labor inten-
sive relative to those currently performed.
Import Tariffs and Quotas
8
under Perfect Competition
Notes to Instructor
Chapter Summary
This chapter examines the impact of import tariffs on the welfare of the im-
porting country, exporting country, and world. The welfare implications are
different depending on whether the importing country is small or large. Rea-
sons for the popularity of tariffs are discussed as well as the role of the Gen-
eral Agreement on Tariffs and Trade (GATT)/World Trade Organization
(WTO). In addition to tariffs, there is also a discussion of the use of an im-
port quota as a barrier to trade.
Comments
To help students understand the impact of import tariffs on Home welfare un-
der the small- and large-importing country cases, it would be useful to briefly
review how consumer and producer surplus changes when a tax is imposed
with a perfectly elastic supply curve and an upward-sloping supply curve.
Lecture Notes
Introduction
In 2009, President Obama imposed a safeguard tariff on imports of tires
from China. This tariff was requested by the United Steelworkers of America
117
118 Chapter 8 Import Tariffs and Quotas under Perfect Competition
and is an example of using trade policy to protect the American tire work-
ers. A few years earlier, President Bush imposed a similar safeguard tariff on
imports of steel.
As a member of the WTO, the United States is governed by policies to pro-
mote free trade between nations by lowering tariffs and other barriers to
trade. In this chapter, we examine why countries apply import tariffs or im-
port quotas (limits on imports), and the welfare implications of these tariffs
on the importing country, exporting country, and the world under the as-
sumption of perfect competition. In addition, we compare the effect of an
import quota with that of a tariff.
N E T W O R K
There are 149 members as of December 11, 2005.
S I D E B A R
Key Provisions of the GATT ARTICLE XVI: Subsidies
The article presented in this section states the goal of the GATT A member must notify contracting parties of its intention to as-
and the corresponding main articles. Namely, the objective of sist its importing or exporting industries through a subsidy un-
the GATT is for member countries to achieve mutual benets der Article XVI.
through the reduction of tariffs and other barriers to trade.
ARTICLE XIX: Emergency Action on
ARTICLE I: General Most- Imports of Particular Products
Favoured-Nation Treatment As mentioned previously, Article XIX gives permission to a con-
Under Article I, a member country may not engage in discrimina- tracting party to prevent or remedy any conditions as to cause
tory practices such as extending privileges to its most-favored na- or threaten serious injury to the importing country by removing
tion without offering these favors to all other contracting parties. its obligation to lower tariff on the exporting country.
Figure 8-1
Price Price
CS
S
PS
P2
P1
P0
D
D2 D1 Quantity S0 S1 Quantity
Home Welfare
Using the concept of consumer and producer surplus, we will return to our
simple world of two countries to examine how trade affects the total welfare
at Home.
No-Trade Panel (a) of Figure 8-2 shows that in the absence of trade, the in-
tersection of supply and demand gives the equilibrium quantity, Q0, and equi-
librium price, P A. CS is the region beneath the demand curve and above P A
in panel (a) or area a in panel (b). PS is represented by the section above the
supply curve and below P A in panel (a) or area (b c) in panel (b). The Home
welfare is the sum of consumer and producer surplus, which equals CS PS
in panel (a) or area (a b c) in panel (b). Home is better off the greater
the amount of consumer and producer surplus.
Free Trade for a Small Country We will now allow Home to engage in in-
ternational trade. Suppose that Home is an importer much too small to impact
the world price by the amount it purchases. Given the fixed world price, P W,
122 Chapter 8 Import Tariffs and Quotas under Perfect Competition
Figure 8-2
Price Price
S S
CS
a
A
PA PA
b
PS d
PW
D c
Q0 Quantity S1 D1 Quantity
Imports = M1
which is lower than its autarky price of P A, consumers at Home will increase
the quantity demanded to D1, whereas producers will decrease the quantity
supplied to S1. The excess demand, given by the difference between D1 and
S1, is satisfied via imports, M1.
Gains from Trade Lets turn to panel (b) to determine the gains from trade.
Under free trade, consumers are better off because they pay a lower price, P W,
relative to autarky, P A. Due to the decrease in price and increase in quantity
demanded, consumer surplus enlarges by the amount (b d). By contrast, pro-
ducers at Home are worse off because the price they received decreased from
P A in the absence of trade to P W under free trade. Due to the reduction in
price received, the quantity supplied decreases.
The drop in price results in a loss of area b for producers. By summing up
the gains of the consumers, (b d), with the losses of producers, area b, we
can calculate the net effect of trade on Home welfare as follows:
Rise in consumer surplus: (b d)
Fall in producer surplus: b
Net effect on Home welfare: d
Because the rise in consumer surplus is greater than the fall in producer
surplus (i. e. , (b d) b) the overall impact of trade on Home welfare is
positive.
The triangle d denotes the gains from trade Home receives by importing un-
der free trade.
Chapter 8 Import Tariffs and Quotas under Perfect Competition 123
Figure 8-3
Price Price
S
A
PA
A
B
PW
M
D
S1 Q0 D1 Quantity 0 M1 Imports
(a) Home market (b) Import market
Figure 8-4
Price Price
S
A
C
PW + t X *+ t
B
PW X*
M
D
S1 S2 D2 D1 Quantity M2 M1 Imports
the import tariff will have an effect on the price paid by the consumer as well
as the prices received by the local and foreign producers. We assume that the
product is homogenous, whether produced at Home or exported from
Foreign.
Due to the import tariff in the amount of t per unit, the price of the im-
port increases from P W to P W t in panel (a), which corresponds to an up-
ward shift of the export supply curve by size of the tariff to X * t in panel
(b). At the higher price, quantity demanded falls from D1 to D2 as shown in
panel (a). By contrast, the quantity supplied increases from S1 to S2 because
additional producers now find it profitable to supply in the market. Namely,
at P W, producers with marginal costs greater than the free-trade price would
not be able to compete. However, with the higher price induced by the tar-
iff, producers whose marginal costs exceed P W but are less than or equal to
P W t can now domestically supply their product. With the decrease in the
quantity demanded and the increase in the quantity supplied, it follows that
the amount imported, M2, has fallen, as shown in panel (b).
Effect of the Tariff on Consumer Surplus Recalling that consumer surplus
is the difference between what the consumers are willing to pay, represented by
the demand curve, minus what they actually pay, we will determine the effect
of the import tariff on the welfare of the consumers at Home. Because the tar-
iff raised the price paid by consumers from P W to P W t, consumer surplus is
no longer the area under the demand curve and above P W but instead is the
smaller area under the demand curve and above P W t. The resulting loss in
consumer surplus is denoted by area (a b c d) in Figure 8-5.
Effect of the Tariff on Producer Surplus Contrary to the situation for con-
sumers, producer surplus increases as a result of the import tariff. To see this,
recall that producer surplus is the area between the price received and the
marginal cost of production, given by the supply curve. In particular, the tar-
iff raises the price the sellers receive from P W to P W t so they gain the ad-
ditional area labeled a in Figure 8-5.
Chapter 8 Import Tariffs and Quotas under Perfect Competition 125
Figure 8-5
Price Price
S
b A d b+d
PW+ t X*+ t
a c c
X*
PW
M
D
S1 S2 D2 D1 Quantity M2 M1 Imports
S I D E B A R
Safeguard Tariffs
The U.S. Trade Act of 1974 describes conditions under which tar- Section 421 applies only to China and was added by the United
iffs can be applied in the United States. Two sections that deal States upon Chinas entry into the WTO in 2001. Under Section
with safeguard tariffs are Section 201 and Section 421. 421, tariffs can be imposed against China if the U.S. International
Section 201 states that a tariff can be imposed if the U.S. In- Trade Commission determines that rising imports from China cause
ternational Trade Commission determines that rising imports have market disruption, which are a signicant cause of material in-
been a substantial cause of serious injury, or threat therefore, to jury or threat of material injury Section 421 denes signi-
the U.S. industry Section 201 denes substantial cause to cant cause such that a tariff can be applied even when rising im-
mean that rising imports are the most important cause of injury ports from China are not the most important cause of injury.
to the U.S. industry.
APPLICATION
U.S. Tariffs on Steel and Tires
U. S. steel and tire tariffs are examples of politically motivated safeguard tar-
iffs, applied despite their deadweight loss. We now formalize this notion of
deadweight loss with the example of the U. S. steel tariff, and then compare
it to the recent tire tariff.
The 2002 tariff on steel was imposed under Section 201 of the U. S. Trade
Act, which has a safeguard provision similar to the escape clause in Arti-
cle XIX of the GATT for importers facing serious injury, or threat thereof
from foreign competition.
As part of his re-election campaign to the steel-producing states of Penn-
sylvania, West Virginia, and Ohio, President George W. Bush made promises
to protect the steel industry. Upon his victory, President Bush requested the
U. S. International Trade Commission (ITC) to initiate a Section 201 inves-
tigation for the steel industry. The ITC in turn recommended to the Presi-
dent that the tariffs be imposed. In March 2002, the President placed tariffs
on steel, ranging from 8% to 30%, but exempted countries that have free-trade
Chapter 8 Import Tariffs and Quotas under Perfect Competition 127
agreements with the United States (i. e. , Canada, Mexico, Jordan, and Israel)
as well as 100 small developing countries that export lesser amounts of steel
to the United States. The tariffs were to be imposed for 3 years, declining
with each subsequent year.
N E T W O R K
According to the guidelines of Section 201 of the U.S. Trade Act of 1974, the ITC has 120
days from the time a complaint is led to make its injury nding. For more complicated
cases, the ITC is allowed 150 days. Any recommendations, along with the report, must be
submitted to the president within 180 days after receipt of the petition.
TA-421-7 July 2009 China Passenger vehicle U.S. Steel, Paper and
and light truck Forestry, Rubber,
tires Manufacturing, Energy,
Allied Industrial and
Service Workers
International Union
TA-421-6 October 2005 China Circular welded Allied Tube and Conduit
nonalloy steel Corp.; IPSCO Tubulars,
pipe from China Inc.; Maruichi American
Corp.; Maverick Tube
Corp.; Sharon Tube Co.;
Western Tube Conduit
Corp.; Wheatland Tube
Co.; and the United
Steelworkers of America,
AFL-CIO
TA-421-5 March 2004 China Uncovered American Innerspring
innerspring units Manufacturers (AIM)
from China
Source: U.S. International Trade commission, 2006.
Deadweight Loss due to the Steel Tariff To calculate the deadweight loss
due the tariff on steel, we will define the corresponding triangle b d in
panel (b) of Figure 8-5 as
1
DWL 2 DP M
where M is the change in import (base of triangle) and DP is the increase in
the domestic price (height of the triangle) following the import tax (i. e. , DP
t). To measure the deadweight loss relative to the value of imports P W M, we
multiply the right-hand side by the percentage tariff, t / PW. Re-arranging gives:
DWL t M t
1 1
% M.
PW M 2 PW M 2 PW
Next we substitute in the percentage increase in price with the average tar-
iffs of 30% (i. e. , t / P W 0. 3) and the 30% decrease in the quantity of steel
imported during the first year of the tariff (i. e. , % M 0. 3) and get,
128 Chapter 8 Import Tariffs and Quotas under Perfect Competition
DWL
12(0. 3 0. 3) 0. 045, or 4. 5% of the import value.
PM
Averaging the value of steel imports before ($4. 7 billion) and after ($3. 5
billion) tariff placement gives a 2-year average of $4. 1 billion. Multiplying the
calculated deadweight loss of 4. 5% to the average import value of $4. 1 bil-
lion, we get that the net annual loss to the United States due to the tariffs on
steel was $185 million.
Response of the European Countries As expected, those in the steel-
producing industry gained from the tariff, whereas consumers of steel opposed
the higher price. However, it was the threat of tariff retaliation by exporting
countries, which included 25 members of the European Union along with
Japan, South Korea, China, Norway, Switzerland, New Zealand, and Brazil,
that led President Bush to suspend the steel tariff on December 5, 2003. The
potential tariff war ended the steel tariff 19 months after it was imposed
rather than 3 years originally planned. Through the dispute settlement
procedure, the exporting countries received permission from the WTO to
impose tariffs against U. S. exports. The WTO ruled that because the United
States failed to prove serious injury to its steel industry due to a sudden in-
crease in import competition, it was ineligible for Article XIX protection.
Tariff on Tires The tariff on tires imported from China was announced on
September 11, 2009. The tariff is to last three years and follow a declining
schedule of 35 percent in the first year, then 30 percent, and then 25 percent
in the third year.
One key difference between this tariff and that imposed on steel by Presi-
dent Bush is that the tire tariff applied only to imports from China. This is
because the tariff was applied under Section 421 of U. S. trade law. Section
421 was added to U. S. trade law when China joined the WTO in 2001. The
tariff on tires marks the first time Section 421 was ever used.
Another key difference is who supported the tariff. As mentioned previ-
ously, U. S. steel producers supported the tariff on steel, whereas no tire pro-
ducers operating in the United States joined the petition against Chinese
tires. This is because, of the ten producers of tires in the United States, seven
of them also produce tires in China.
market. To derive the Foreign export supply curve, we will refer to panel (a)
of Figure 8-6, which shows the Foreign demand and supply curves, denoted
by D * and S *, respectively. Without trade, the Foreign equilibrium price, P A *
is at point A * in panel (a) or correspondingly represented by point A * in
panel (b) where exports are zero. As Foreign opens up to trade, it will export
the amount X *1 S *1 D *1 because the world price, P W, is higher than its
autarky price of P A *. The upward-sloping Foreign export-supply curve is ob-
tained by connecting points A * and B *, where the latter is given by the
amount exported at the world price of PW. Combining the Foreign export
supply curve, X *, and Home import demand curve, M, we get the free-trade
price, P W, as shown in panel (b).
Figure 8-6
Price Price
PA X*
D* S*
B*
PW
P A* M
A*
A*
Figure 8-7
Price Price
S X *+ t
b+d
A t X*
C
P* + t
a b c d B*
PW
e e f
P*
C*
D M
S1 S2 D2 D1 Quantity M2 M1 Imports
Terms of Trade Recall that a countrys terms of trade is defined as the ratio
of its export price to its import price. With the fall in the import price rela-
tive to the initial world price, P W, Home experiences a gain in its terms of
trade.
Home Welfare To examine whether the gain in the terms of trade leads to
an increase in welfare at Home, we will analyze the impact of the tariff on the
consumers, the producers, and the government. From panel (a) of Figure 8-
7, we see that the loss in consumer surplus due to the higher Home price is
given by the areas (a b c d). The benefit to producers arising from the
price increase is the gain in producer surplus denoted by area a. Lastly, the
benefit to the government is equal to the amount of the tariff t multiplied by
the amount of Home imports, M2. The tariff revenue, t M2, is represented
by the areas (c e). Summing up the loss of the consumers with the gains of
the producers and government gives the overall impact of the tariff as follows:
Fall in consumer surplus: (a b c d)
Rise in producer surplus: a
Rise in government revenue: (c e)
Net effect on Home welfare e (b d)
As in the small-country case, the triangle (b d) indicates the deadweight loss
due to the tariff. However, contrary to the small country, the large country
gains area e because it is able to shift part of the burden of the tariff to the For-
eign exporters. Area e gives a measure of the terms-of-trade gain due to the
Chapter 8 Import Tariffs and Quotas under Perfect Competition 131
tariff. It follows that Home would be better off with the tariff if e is greater
than (b d) and worse off if e is smaller than (b d).
Foreign and World Welfare By contrast to Home, exporters in Foreign suf-
fer a loss given by (e f ) in panel (b). Although the terms-of-trade gain for
Home is offset by the terms-of-trade loss by Foreign (i. e. , area e), areas (b
d f ) remain undistributed. Therefore, areas (b d f ) represent the net
loss in world welfare or world deadweight loss. Moreover, because the gain of
Home due to the tariff is at the expense of Foreign, the imposition of the tar-
iff is also referred to as a beggar thy neighbor policy.
Optimal Tariff for a Large Importing Country We have found that a large
importer might gain by imposing an import tariff, but have not yet determined
what level of tariff a country should apply in order to maximize welfare.
Optimal Tariff To clearly calculate the effect of the tariff on U. S. welfare,
we will need to incorporate the concept of the optimal tariff, the duty which
maximizes the increase in welfare for the importing country. To begin with,
our theory tells us that a large importing country can increase its welfare by
imposing a tariff. Starting from the left of Figure 8-8, relative to free trade de-
noted by point B, we see that Home can increase its welfare by applying a tar-
iff on foreign exports. The welfare continues to increase until it reaches the
highest point corresponding to the optimal tariff. After point C, any addi-
tional increases in the amount of the tariff results in a decline in Home wel-
fare. A tariff is called a prohibitive tariff if it is so large that trade is prevented
(see point A).
Optimal Tariff Formula The formula for the optimal tariff is:
1
Optimal tariff *
EX
where E X* is the elasticity of export supply, which measures the percentage
change in the quantity exported due to a percentage change in the world price
Figure 8-8
Importers
welfare
B
Free trade
B
A
No trade
APPLICATION
U.S. Tariffs on Steel Once Again
We will re-examine the effect of the steel tariff on U. S. welfare assuming that
it is a large country. Namely, the United States has an impact on the Foreign
export price because it is a large importer of steel. It is important to note,
however, that all welfare gains in the United States come at the expense of ex-
porting countries. If all countries impose such tariffs all terms-of-trade gains
would be eliminated and only deadweight loss would remain. Avoiding such
an outcome is one of the main goals of the WTO.
Optimal Tariffs for Steel With the established formula, we can now deter-
mine the impact of the tariffs on the steel industry using the export supply
elasticities presented in Table 8-2.
For the steel products classified under iron and nonalloy steel flat-rolled
products and iron and steel tubes, pipes, and fittings, the export supply elas-
ticities are large. Taking the inverse of the export supply elasticity for each of
these product categories, we can calculate the optimal tariffs and compare
them with the actual tariffs. For iron and nonalloy steel flat-rolled products,
the optimal tariff is 1 / 750 0%, which is the nearly the same as the actual
tariff. The optimal tariff for iron and steel tubes, pipes, and fittings is 1 / 90
1%. Because the actual tariff was between 13% and 15%, the deadweight
loss from the tariff was greater than the terms-of-trade gain so that the United
States experienced an overall loss in welfare from the duty imposed on this
product. In other words, the high elasticity of export supply suggests that the
United States is a small country when it comes to the imports of iron and steel
tubes, pipes, and fittings. As such, welfare in the United States would have
been highest under free trade.
The first three items have small elasticities of export supply. Therefore, the
United States is a large country relative to other countries in importing these
products such that the optimal tariffs, given by the third column, are very
high. As an example, U. S. welfare would be maximized if the government
levied a tariff of 1 / 0. 27 370% on alloy steel flat-rolled products. For these
three products, the improvement in terms of trade exceeded the deadweight
loss from applying the tariff. As a result, the United States increased its wel-
fare relative to free trade by imposing the import duty. However, the gains
would have been greater had the actual tariff been much higher.
5 Import Quotas
After more than three decades from its inception in 1974, the system of im-
port quotas known as the Multifibre Arrangement (MFA) came to an end
Chapter 8 Import Tariffs and Quotas under Perfect Competition 133
H E A D L I N E S
Banana Wars
The banana wars, which started back in 1993, have come to an end. The banana wars began
when the European Union set quotas favoring banana imports from the Ivory Coast, the
Windward Islands, and other former colonies. These preferential policieswhose aims were
to assist the development of former colonieswere challenged by American banana compa-
nies and the Latin American countries where bananas were grown. The suit, which several
times over the intervening sixteen year threatened to cause a full-blown trade war, nally
ended in late 2009. In December 2009, the EU agreed to reduce the tariff on Latin Ameri-
can bananas by 35 percent over the next seven years.
H E A D L I N E S
Sweet Opportunity
In an effort to protect American farmers from import competition, the United States imposes
import quotas on foreign sugar. As a result of the restriction, the domestic sugar price has
been two to three times higher than the world price for the past 25 years. Moreover, the gov-
ernment guarantees the farmers a break-even price by allowing them to sell their excess to
the U.S. Department of Agriculture (USDA). However, the sugar program may need to change
given that the world price of sugar has now risen to the U.S. level and a shortage exists in
the United States. Under the current condition, the U.S. government could potentially re-
move the import quota, which would improve domestic welfare without inicting huge costs
to the USDA. Not surprisingly, the U.S. sugar producers have a strong incentive to maintain
the status quo by lobbying for limits on trade expansion.
Due to the rent-seeking activities, the net welfare loss is greater with the
quota than a tariff.
3. Auctioning the Quota The third possibility is for the Home government
to auction off the quota licenses. Assuming that the value the government ac-
crued from the auction is equal to area c, then the net effect of the quota is
the same as that of a tariff as given by the following:
Fall in consumer surplus: abcd
Rise in producer surplus: a
Auction revenue earned at Home: c
Net effect on welfare: (b d)
4. Voluntary Export Restraint The fourth possibility is the case in which
the Foreign country initiates the quota. Namely, Foreign voluntarily puts lim-
its on the amount it exports to Home. These self-imposed restrictions are re-
ferred to as voluntary export restraint (VER) or voluntary restraint
agreement (VRA). Because the quota rents are collected by foreign pro-
ducers, the loss in Home welfare is greater than a tariff as the summation of
the losses and gains below shows:
Fall in consumer surplus: (a b c d)
Rise in producer surplus: a
Net effect on Home welfare: (b c d)
Although a VER clearly results in a greater negative net effect on Home wel-
fare relative to an import tax, by transferring the quota rents to the Foreign
exporter, a tariff or quota war may be prevented by imposing the voluntary
trade restriction.
APPLICATION
China and the Multibre Arrangement
The long standing MFA came to an end on January 1, 2005. The system of
import quotas protected the apparel industry in the industrialized countries by
specifying the amount of each product the developing countries could ex-
port. The end of the MFA meant that exporters no longer needed to hold
136 Chapter 8 Import Tariffs and Quotas under Perfect Competition
6 Conclusion
This chapter examines the effect of trade barriers such as tariffs on the wel-
fare of the importing country, exporting country, and world. Reasons why
importing countries impose the barriers to trade include politics, raising gov-
ernment revenue, and increasing welfare for the large-country case. The
analysis shows that although a small country always loses with a tariff, a large
country may improve its terms of trade by shifting some of the burden of the
duty to foreign exporters. Similar to a tariff, an import quota raises the do-
Chapter 8 Import Tariffs and Quotas under Perfect Competition 137
TEACHING TIPS
IN-CLASS PROBLEMS
1. LobbyInc is a firm that specializes in lobbying the b. What is the net effect of their activities on the
government on behalf of special interest groups. welfare of the domestic sugar market?
Suppose the sugar producers recently hired Lob- Answer: The net effect of their rent-seeking
byInc to help them obtain the rights to the sugar activities would be a fall in domestic welfare
quota licenses. by the amount represented by areas b c d
a. What is the maximum the domestic sugar pro- in Figure 8-9.
ducers are willing to pay LobbyInc for their 2. Suppose Home is a large country whose supply
services? Explain. and demand curves are given by the left of the fol-
Answer: The sugar producers are willing to lowing figure.
pay up to the amount of the quota rent, or area
c, in Figure 8-9. Any amount greater would
result in a smaller producer surplus than the
benefits of the quota licenses.
Price Price
16 S
X* + t
8 8 X*
7
5 b d
e
3
D 2 M
1
4 6 7 8 12 Quantity 2 8 Import
a. Assume the world price is P W $5. Deter- c. Determine the terms of trade for Home with
mine the consumer and producer surplus un- the tariff.
der free trade. Answer: Homes terms-of-trade gain is de-
Answer: noted by area e in the figure. Namely it is
Consumer surplus under free trade: equal to 4[ (8 6)(5 3)].
1 d. Does Home welfare increase or decrease due
CS
2
12 (16 5)
to the tariff? Explain.
CS 66
Answer: To determine whether Home wel-
Producer surplus under free trade: fare increases or decreases, we need to com-
1
PS =
2
4 (5 1) pare the terms-of-trade gain with the dead-
PS = 8 weight loss that results from the tariff (i. e. ,
Home is better off if area e is greater than ar-
Total surplus: 66 + 8 = 74 eas b d).
b. Suppose the government at Home government
imposes a tariff in the amount of $4 (i. e. , t Areas b d:
$4). What is the new Home price? What is the 1 1
price received by the foreign exporters? b d 2 (6 4) (7 5)
2
(12 8) (7 5)
Answer: Because Home is a large country, it
does not face a horizontal export supply bd24
curve. Rather, Home is able to have an impact
on the world price. With a tariff of $4, the bd6
new Home price is $7 whereas the price re- Because area e equals 4 in part (c), whereas ar-
ceived by the Foreign exporters is $2. eas b d equal 6, then Home is worse off with
a tariff of $4.
Chapter 8 Import Tariffs and Quotas under Perfect Competition 139
3. Refer to problem 2. At what amount would the Answer: Setting S D gives P 9 and Q
tariff be considered prohibitive? Explain. 18.
Answer: A tariff in the amount of $6 would be b. Suppose Aoslia decides to engage in trade.
prohibitive because it would raise the price paid by Determine the quantity demanded, quantity
consumers to the no-trade equilibrium level. As a supplied, and import given the world price of
result, imports would be zero. $6 per bushel of corn.
4. Aoslia is a small country that takes the world price Answer: Given P W 6, we have that D1
of corn as given. Its domestic supply and demand 45 3(6) 27 and S1 3(6) 9 9, so
for corn is given by the following: M1 D1 S1 27 9 18.
c. If the Aoslia government imposes a tariff in the
D 45 3P amount of $1 (i. e. , t $1), what is the new
S 3P 9 domestic price? What is the amount imported?
Answer: The new domestic price is P W
a. Assume initially that Aoslia does not open to
t 7 so D2 45 3(7) 24 and S2 3(7)
trade. What is the autarky equilibrium price
9 12 so M2 D2 S2 24 12 12.
and quantity?
Price Price
S
15
9
7 X* + t
6 X*
3
D M
9 12 18 24 27 Quantity 12 18 Import
d. Determine the effect of the tariff on the Aoslian e. Calculate the terms-of-trade gain. What is the
consumers, producers, and government. net effect of the tariff on Aoslias welfare?
Answer: Explain.
Consumer surplus Consumer surplus Answer: Aoslia does not have a terms-of-
without tariff: with tariff: trade gain because it faces a perfectly elastic
(i. e. , horizontal) export supply curve. This
1 1 means that the entire burden of the tariff falls
CS 2 27 CS 2 24
on its consumers.
(15 6) (15 7)
CS 121. 5 CS 96 Fall in consumer surplus: 25. 5
Producer surplus Producer surplus Rise in producer surplus: 10. 5
without tariff: with tariff:
Rise in government revenue: 12
1 1
PS 9
2
PS 12
2 Net effect on Home welfare: 3
(6 3) (7 3)
5. Refer to problem 4. Suppose the Aoslian govern-
PS 13. 5 PS 24 ment applies an import quota that limits imports
Government Government to 12 bushels.
without tariff: with tariff: a. Determine the quantity demanded, quantity
supplied, and new domestic price with the
Government 0 Government quota.
(24 12) (7 6)
Government 12
140 Chapter 8 Import Tariffs and Quotas under Perfect Competition
Price Price
S
X* + t
X*
P2 + t
a b c d b+d
P1
e e f
P2
D M
S1 S2 D1 D2 Quantity M2 M1 Import
a. Will the price of tortillas in the United States moval of the tariff, the price of tortillas will
fall by the exact amount of the tariff? Explain. fall, but by less than 25%.
Answer: Because the United States is a large b. What is the impact of the NAFTA on U. S.
country, a portion of the tariff was absorbed by tortilla producers, Mexican tortilla producers,
Mexico. As such, consumers in the United and U. S. tortilla consumers?
States did not experience the entire hike in the Answer: U. S. tortilla producers received a
import price due to the tariff. With the re- higher price under the tariff, so they are worse
Chapter 8 Import Tariffs and Quotas under Perfect Competition 141
off with the removal of the tariff. Mexican quantity supplied following the raise in the do-
tortilla producers receive a higher price under mestic price with the tariff. From Figure 8-5, we
NAFTA whereas U. S. tortilla consumers are see that the additional units, S2 S1, are supplied
able to purchase the good at a lower price, so by the Home producers with higher marginal costs
both of these groups benefit from the elimina- than foreign exporters producing at the world
tion of the tariff. price. The loss results regardless of the size of the
c. Removal of the tortilla tariff under NAFTA importing country.
has increased welfare for the United States. 11. Why is tariff revenue less important as a source of
Comment. income for the U. S. governments relative to some
Answer: The statement is true only if the gain developing countries?
in terms-of-trade (area e) under the tariff was Answer: Unlike some developing countries, the
smaller than the deadweight loss (b d) so high- and middle-income countries are able to
that the tariff removal corrects the negative obtain a net increase in tax revenue by switching
impact of the trade barrier on U. S. welfare. to hard-to-collect taxes such as income and value-
8. What is the role of the most-favored nation added taxes. The reason maybe that the penalty for
clause in helping to eliminate discriminatory treat- individuals and firms failing to accurately report
ment in international commerce? their earnings are sufficient to obtain the necessary
information in countries such as the United States
Answer: Article I of the key provisions of the compared with the developing countries. By con-
GATT states that nations must apply the same tar- trast, because all imports are subject to customs in-
iff to all members of the WTO. This most-fa- spection upon arrival to a countrys port, import
vored nation clause helps to eliminate discrimina- tariffs are easy to collect for a developing country.
tory practices by requiring that all WTO countries
be treated equally. Namely, a country must extend 12. What causes the Foreign-export supply curve to
the same tariff to all members of the WTO as it slope upward?
would to its most-favored trading partner. Answer: The Foreign-export supply gives the
9. The government is more concerned about pro- amount exporters in Foreign are willing and able
ducer surplus than consumer surplus if it levies an to supply internationally at each world price.
import tariff that raises the domestic price. Com- When the world price, P W, is higher than Foreigns
ment. no-trade price, the quantity supplied by producers
in Foreign, S *1, exceeds the quantity demanded by
Answer: This comment is true if the country is a consumers in Foreign, D *1, as illustrated by Figure
small importer because the loss in consumer sur- 8-6. This excess supply or surplus (X *1 S *1
plus outweighs the gain in producer surplus from D *1 ) is the amount available for the international
the import tax even if the government were to re- market. As the world price rises, the quantity de-
distribute the tariff revenue to the consumers. manded by Foreign consumers decreases even fur-
Moreover, the comment is also true if the country ther, whereas the quantity supplied by Foreign
is a large importer that has the potential to impact producers increases, resulting in a greater quantity
the world price. If the terms-of-trade gain is larger of export supply. The direct relationship between
than the deadweight loss and the government re- the world price and the quantity of export supply
distributes the tariff revenue to the consumers, gives the curve its upward slope.
consumers and would still lose relative to free trade
because some of the consumer surplus is trans- 13. Graphically show the effect of a United States-
ferred to the producers as a result of the higher imposed tariff on world welfare, assuming that the
price induced by the tariff. United States is a small country. How does your
result differ if the United States is a large country?
10. What is an efficiency loss? Does it only occur
when small country imposes a tariff? Answer: In addition to the deadweight loss equal
to area b d, there is an additional amount equal
Answer: The efficiency loss or production loss re- to area f if the United States is a large country.
sults from the Home producer increasing the
142 Chapter 8 Import Tariffs and Quotas under Perfect Competition
X* + t
Price Price
X*
X* + t
b+d b+d
X*
f
M M
Imports Imports
14. If the Foreign export supply is perfectly elastic, Answer: A perfectly elastic Foreign export supply
what is the optimal tariff Home should apply to curve implies that the importing country is small.
increase welfare? Explain. Therefore, the optimal tariff for Home is to set the
tariff to zero (i. e. , not impose an import tax) be-
cause it does not have a terms-of-trade gain but
suffers a deadweight loss.
Import Tariffs and Quotas
9
under Imperfect Competition
Notes to Instructor
Chapter Summary
This chapter examines the impact of import tariffs and quotas under imper-
fect competition (i. e. , either home monopoly or foreign monopoly). It first
contrasts the effects of a tariffs and quota on the economic welfare of the
home country when there is a home monopoly. One application of that case
is infant industry protection, which is discussed in theory and through sev-
eral country studies. Then the effects of a tariff are examined when the ex-
porting firm in the foreign country is a monopolist. The chapter also discusses
the effect of dumping and antidumping duties on the home country.
Comments
This chapter offers a number of interesting applications that link theory and
real-world events. In addition, the questions at the end of the chapter refer
students to the International Trade Association (ITA) and World Trade Orga-
nization (WTO) Web sites to examine dumping petitions. The timely and in-
teresting examples as well as the references to data sources will help the stu-
dents have a clearer understanding of the material. In the section on infant
industry, encourage students to express their views on the benefits of the pro-
tection prior to presenting the net effects on Home welfare.
143
144 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
Lecture Notes
Introduction
Though most economists agree that tariffs and quotas usually reduce general
economic welfare, there is a long history of countries using tariffs and quotas.
The United States has had high tariffs for large periods of its history, reaching
as high as 50 pecent in the 1800s. More recently, China had tariffs of 80 to
100 percent on passenger cars, which greatly limited the imports of automo-
biles, leading to joint ventures between foreign firms and local partners pro-
ducing outdated models at very high prices. To understand why China or any
other country may choose to apply tariffs and quotas despite the resulting loss
in consumer surplus, we will assume that firms operate under imperfect com-
petition where they have some market power, beginning with the case in
which the home firm is a monopolist.
We then examine the effect of a tariff applied by a small importing coun-
try on its welfare when the foreign exporting firm is a monopolist. Contrary
to the situation in which the home firm is a monopoly, the importing coun-
try may experience a terms-of-trade gain similar to the large-country case
by imposing a tariff on the sole foreign producer.
A country may protect its domestic firms by imposing a tariff on a foreign
competitor engaged in dumping. Under WTO rules, an importing country is
permitted to respond with a tariff when a foreign firm sells a product more
cheaply abroad than it does in its local market or at less than the cost of pro-
duction. Charges of dumping have increased in popularity in recent years not
only in developed but also in developing countries as alternatives to safe-
guard tariffs that are allowed in the guidelines of the WTO.
We then return to the Chinese governments protection of its infant in-
dustry, namely, the automobile sector, by analyzing the impact of the tariffs
and quotas on the domestic consumers and producers.
No-Trade Equilibrium
The Home demand curve, D, and the monopolists marginal cost curve, MC,
are illustrated in Figure 9-1. To maximize profit, the Home monopolist sets
marginal revenue, MR, equal to MC, selling quantity, Q M, at price, P M.
Comparison with Perfect Competition Suppose Home consisted of many
firms selling the same product and that the industry marginal cost equals the
monopoly marginal cost in Figure 9-1. Then market equilibrium yields the
quantity Q C and price P C, where the supply, given by the industry MC, equals
demand. Therefore, without trade, consumers pay a higher price for fewer
units of the product under a monopoly.
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 145
Figure 9-1
Price
A
PM MC
B
PC
MR D
QM QC Quantity
Free-Trade Equilibrium
Suppose that Home is a small country. Under free trade, the monopolist may
not charge a price higher than P W because consumers can meet their demand
via imports at the given world price. With the constant price per unit, the
monopolists marginal revenue curve is horizontal at the world price, which is
also the Foreign export supply curve, X *. Equating marginal revenue, MR *,
to marginal cost at point B, the profit-maximizing quantity for the Home
producer is S1. Because there is excess demand at the world price, the amount
M1 D1 S1 is imported from abroad.
Figure 9-2
Price
PM A MC
PW X*= MR*
B
MR D
Q M S1 D1 Quantity
Figure 9-3
Price
MC
b C d
PW + t
X* + t = MR*
a c
PW X*
B
S1 S2 D2 D1 Quantity
Figure 9-4
Price
Quota, M2
MC
P3
C
PW + t
B
PW
E
D
D M2
MR
S3 S1 S2 D3 D2 D1 Quantity
APPLICATION
U.S. Imports of Japanese Automobiles
We previously mentioned that during the 1980s the government in Japan lim-
ited the quantity of Japanese automobiles exported to the United States. We
now examine in detail the impact of this voluntary export restraint (VER) on
U. S. welfare, beginning with the state of the economy during that period.
In the early 1980s, the United States was in a deep recession, which led to
fewer investments by firms and less spending on consumer durables like auto-
mobiles. Following the subsequent rise in unemployment, the United Auto-
mobile Workers applied for Section 201 protection with the U. S. Interna-
tional Trade Commission (ITC) in June 1980. Ford Motor Company
followed suit two months later. The auto industry, however, did not receive
protection because the U. S. ITC determined that the U. S. recession was a
more important cause of injury than the increased imports.
Undeterred by the failure to obtain Section 201 protection, several con-
gressmen from auto states introduced a bill to restrict import competition but
particularly those from Japan. Shortly before the scheduled revision for the
bill by the Senate Finance Committee, the Japanese government announced
that it would voluntarily impose limits on the sales of automobiles in the
U. S. market. The quota was initially set at 1. 83 million autos beginning April
1981. Although the limit was later raised to an annual amount of 2. 51 mil-
lion vehicles, it ceased to be binding after 1987 when the Japanese automak-
ers shifted their production to the United States.
Price and Quality of Imports As shown in Figure 9-5, under the VER, the
average price of imported Japanese cars increased by about $2,900 between
1980 and 1985. A third of the price increase ($1,100) was due to quota rents
earned by Japanese producers. With the exception of about $150 reflecting
inflation, the rest ($1,650) was the result of improvements in the quality of the
imported Japanese cars (i. e. , weight, horsepower, transmission, etc. ).
Quota Rents The rent earned by the Japanese producers is found by multiply-
ing the quota rents of $1,100 per car by the imports of about 2 million cars. The
total estimated rent of $2. 2 billion is lower than the annual cost shown in Table
8-4, particularly if we account for the increase in the price of European cars.
Price of U.S. Cars In addition to the price increase in Japanese cars due to the
VER, the price of European cars sold in the U. S. market also rose as a result
of lessened competition from Japanese automakers. Moreover, from Figure
9-6, it is clear that U. S. automobile producers likewise benefited from the ex-
port quota as the average price of American cars rose from $4,200 in 1979 to
$6,000 in 1981. However, only a fraction of the price increase in U. S. auto-
mobiles can be attributed to quality upgrading. Most was due to the market
power retained by the U. S. producers following the import restriction on
Japanese automobiles.
The GATT and WTO Contrary to an import quota, the restraint of Japanese au-
tomobile exports did not violate Article XI of the GATT because the VER was
enforced by Japan rather than the United States. Consequently the use of
VERs increased in popularity in the 1980s and early 1990s as GATT members
sought ways to limit foreign competition without using import quotas. The es-
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 149
tablishment of the WTO in 1994 closed the loophole created by the VERs by
preventing all members from entering into such voluntary arrangements.
Foreign Monopoly
We will extend the previous example by assuming that the Foreign firm is a
monopolist in its local and export markets. In addition, we will assume that
the Foreign firm has constant marginal costs. Focusing only on the Home
market, the downward-sloping demand curve, D, faced by the Foreign-
exporting monopolist is shown in Figure 9-7.
Free-Trade Equilibrium Without barriers to trade, the Foreign monopolist ex-
ports X1, where the Home marginal revenue, MR, equals marginal costs, MC *,
at point A.
Effect of a Tariff on Home Price With the fixed tariff in the amount of
t dollars, the marginal cost of exporting to the Home market increases to
MC * t as shown in Figure 9-7. Given the higher marginal costs, the For-
eign firm decreases exports to X2. This corresponds to the intersection of the
new marginal costs curve with the marginal revenue curve at point B, lead-
ing to an increase in the import price to P2.
In situations in which the marginal revenue curve is steeper than the Home
countrys demand curve, the importing country may experience a terms-of-
trade gain because the increase in the import price from P1 to P2 is less than
the amount of the tariff, t. To prevent the quantity exported from falling be-
low X2, the Foreign firm absorbs part of the tariff and passes through only a
portion of it to the Home price. Thus, the net-of-tariff price (i. e. , P3
P2 t) received by the Foreign exporter is lower than the pretariff level. As
in the large-country case analyzed in Chapter 8, the Home country bene-
fits from the application of the duty; however, the reasoning for the terms-of-
trade gain differs with a Foreign monopolist.
Effect of the Tariff on Home Welfare To determine the effect of the tariff
on Home welfare, note that the increase in the import price reduces consumer
surplus by the area (c d), as illustrated in Figure 9-7. Home producer sur-
plus is unaffected as there are no domestic firms by assumption. The revenue
collected by the government equals the amount of the tariff multiplied by the
units of Foreign exports, or area (c e). Summing up the effect of the tariff
on consumers and the government gives:
Fall in Home consumer surplus: (c d)
Rise in Home government revenue: (c e)
Net change in Home welfare: (e d)
150 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
where Home is better off with the tariff if the terms-of-trade gain denoted by
area e is greater than the deadweight loss represented by area d. Recall that the
results are conditional on having a marginal revenue curve that is steeper than
the demand curve.
APPLICATION
Import Tariffs on Japanese Trucks
Initially, compact trucks imported from Japan mainly consisted of cab/chassis,
which were classified as parts of trucks, requiring some final assembly in the
United States before selling to consumers. Under this system, the Japanese
compact trucks were subject to a 4% tariff. On August 21, 1980, prompted by
the U. S. Congress, the U. S. Customs Service reclassified the Japanese com-
pact trucks as complete or unfinished trucks, subjecting the imported goods
to a 25% tariff, which remains in effect today.
A study on the increased tariff on compact trucks provides evidence in sup-
port of the theory presented above. Namely, the results of the study suggest
that the Japanese producers passed through 12% of the tariff to U. S. con-
sumer prices. The remaining 9% were absorbed by the exporters. Due to the
reclassification of the imported compact trucks from Japan, the United States
experienced a terms-of-trade gain as predicted.
H E A D L I N E S
The Chickens Have Come Home to Roost
This article argues that the current troubles of the big three U.S. automobile producers is
linked to the 25-percent tariff on lightweight trucks, which was born out of an accident of
history. With the recent rise in fuel prices, U.S. manufacturers have seen a drop in demand
for SUVs and small trucks, which were once a major source of profits due to a 25-percent tar-
iff on imported lightweight trucks. This tariff dates back to the chicken wars of the 1960s.
When the U.S. chicken producers were denied access to European markets, the United States
retaliated by imposing a 25-percent tariff aimed at German automaker Volkswagen. Since
GATT rules required that all retaliatory tariffs be nondiscriminatory, the tariff was applied to
all lightweight truck imports, and it still applies today.
in the low-price home market and those in the high-price foreign market. As
a result, the foreign firm acts as a discriminating monopoly by charging
different prices in the two markets. The downward-sloping demand curve,
D*, faced by the foreign monopoly in its local market is given in Figure 9-8,
along with the corresponding marginal revenue curve, MR*. Due to intense
competition, the foreign monopolists demand curve in the home market is
horizontal where P = MR.
Equilibrium Condition To maximize profit, the foreign firm produces Q1 at
point B, where marginal costs equal the export marginal revenue, MR. Of the
amount produced, Q2 units are sold locally. Note that the local quantity, Q2,
given by point C, corresponds to the intersection of local and export marginal
revenue curves, where the latter equals the foreign firms marginal cost of the
last unit produced at point B. Because the profit-maximizing price, P*,
charged in the local market is higher than that in the export market, P, the
foreign firm is dumping by definition.
The Profitability of Dumping Furthermore, Figure 9-8 also shows that the
foreign monopoly is dumping when defined by the export price set below the
average cost of production. More specifically, the average cost of production
for output, Q1, is AC1. We see that the foreign firm is dumping given that the
local price, P*, is above the average cost whereas the export price, P, is below.
The firms total costs equal the sum of its fixed and variable costs:
Total Costs = $15 10 + $150 $300.
Variable Fixed
Cost Cost
It follows that its average costs are ($300 / 10) = $30, and profits from selling
only in the local market are:
$35 10 $300 = $50.
H E A D L I N E S
China Escalates Trade Fight over European Shoe Tariff
This article discusses the recent antidumping duties imposed against China by the European
Union on footwear. While some have welcomed the duties, many have opposed them, in-
cluding the European Footwear Alliance, which represents many global footwear producers.
It is argued that these duties hurt consumers and businesses by pushing up prices. The al-
liance claims its members have paid around $1.2 billion in antidumping duties over the past
three and a half years.
be nullified. However, doing so would decrease profits because the Foreign firm
would be charging a price above the profit-maximizing level in the exporting
market.
The net effect on Home welfare due to the increase in the import price
resulting from the Foreign firms response to the antidumping duty is largely
negative. More specifically, we see from Figure 9-11 that the rise in the im-
port price from P1 to P2 leads to a loss in consumer surplus equaling the area
(a b c d). The gain in producer surplus from the import protection is
denoted by the area a. The tariff revenue is zero because the Foreign firm is
no longer dumping, given that it has raised the export price to that of its lo-
cal market price.
Fall in Home consumer surplus: (a b c d)
Rise in producer surplus: a
Net change in Home welfare: (b c d)
Thus, the overall effect of the exporting firms response to the antidump-
ing duty is a net loss for the Home country represented by area (b c d).
Without any government revenue, the loss generated by the antidumping duty
is greater than the deadweight loss of a fixed tariff, which would have been
area (b d).
Despite the negative net effect of the antidumping duty on the importing
country, charges of Foreign dumping have become increasingly popular. The
reason is that the threat of an antidumping duty often leads Foreign competi-
tors to raise their prices, which reduces competition for domestic firms in the
same market.
APPLICATION
Antidumping/Countervailing Duties
versus Safeguard Tariffs
The safeguard provision in Article XIX of the GATT and Section 201 of
the U. S. trade law, discussed in Chapter 8, allows a domestic firm temporary
relief from foreign competition when it is determined that rising imports are
the most important cause of serious injury, or threat thereof, to the domes-
tic industry. Due to the difficulty of obtaining a tariff recommendation on
competing imports, only 19 cases were filed in the United States between
1980 and 1989, as shown in Table 9-1. Seven of the 19 cases were recom-
mended to the president and only five were affirmed for tariff protection.
From 19902009 only an additional 12 cases were filed.
In contrast to the infrequent use of safeguard or escape clauses, more than
400 antidumping cases were filed in the United States in the same period.
The reason for their popularity is the procedure necessary for tariff protection
is relatively easier. In an antidumping case the Department of Commerce
(DOC) first determines whether the imported good is sold at less than fair
value compared with the exporting firms own market price or the average
cost of production. The duties are applied when the ITC determines that the
import caused material injury to the domestic industry. This condition is
less strict than the guideline necessary for the safeguard tariff, which requires
that the rising import be a substantial cause of serious injury. Moreover, the
154 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
President does not need to approve the case before the antidumping duty can
be applied. As a result, approximately 550 of the 1,200 antidumping cases re-
ceived tariff protection.
Aside from those cases in which duties were applied, about 450 cases were
rejected and the remaining cases, approximately 150, were withdrawn before
the final ruling. By withdrawing the case, the domestic producer, via a DOC
intermediary, can coordinate with the Foreign competitor on prices and mar-
ket shares. Through their coordinated efforts, the market price in the import-
ing country rises.
The incentive to file dumping claims becomes evident when we note their
potential benefits to the domestic producer. Namely, there is a relatively high
success rate of obtaining tariff protection. Furthermore, a domestic firm is
given permission to coordinate prices and market shares with its Foreign
competitor once the case is withdrawn. Import competition is also lessened
when a case is unsuccessful. The reason is that imports often decrease during
the DOC or ITC investigation.
Free-Trade Equilibrium
To more formally develop the case for infant industry protection, we will re-
fer to Figure 9-10, where panel (a) shows the Home firms current average
cost curve. By increasing its output today, the Home firm is able to cut its
costs in the future. As illustrated in panel (b) of Figure 9-10 the Home firms
future average cost curve is lower relative to the one in panel (a). Note that
we assume the Home is a small-importing country.
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 155
Figure 9-10
Price MC Price
MC
AC
PW + t AC
b d
PW
e
D D
S1 S2 D2 D1 Quantity S3 D1 Quantity
Equilibrium Today Today, the industry faces the world price of P W under free
trade as shown in panel (a). Given P W and the average cost curve, labeled AC, the
industry would suffer loss if it produces at S1 because its cost per unit is greater
than the price received. Therefore, the firm would choose not to produce.
Tariff Equilibrium
However, if the government imposes a tariff in the amount of t to protect the
infant industry, then the domestic price raises from P W to P W t, which
equals the firms average total cost.
Equilibrium Today At the higher price, the industry earns zero profit rather
than a loss. Consequently, the industry produces S2 and through learning by
doing, it will be able to become more efficient.
Equilibrium in the Future The resulting future efficiency is represented by
the lower average cost curve labeled AC in panel (b). With the lower aver-
age costs, the industry no longer requires the tariff protection to compete in
the future.
Effect of the Tariff on Welfare To analyze the effect of the tariff on welfare,
we need to compare the deadweight loss today due to the tariff, denoted by
the triangles (b d) in panel (a) of Figure 9-10 and the future gain in pro-
ducer surplus represented by area e in panel (b). The infant industry protec-
tion is successful if e is greater than (b d). The deadweight loss caused by
the tariff protection imposed today is not justified if e is less than (b d).
156 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
APPLICATION
Examples of Infant Industry Protection
The three examples of infant industry protection we examine include two
from developing countries (i. e. , automobile industry in China and computer
industry in Brazil) and another from the United States (i. e. , protection for the
Harley-Davidson motorcycles in the 1980s).
H E A D L I N E S
Shanghai Tie-Up Drives Prots for GM
This article discusses how the Chinese automobile market may play a key role in the future
of General Motors. In 2009, while domestic sales fell by 30 percent, those in China grew by
66 percent. In addition to the role that Chinese consumers appear to be playing in decid-
ing the fate of GM, so too do GMs Chinese partners. In exchange for Chinese backing for
their expansion in Asia, GM relinquished majority control of Shanghai General Motors to its
partner, Shanghai Automotive Industry.
H E A D L I N E S
Thanks to Detroit, China Is Poised to Lead
In response to erce competition, automakers are now shifting to produce their latest mod-
els in China rather than outdated versions as in the past. These models include the Honda
Civic and Toyota Prius. Ford Motor recently built a technologically advanced production line
next to its rst one in western China. Similar to Ford Motor, other American, European, and
Japanese automobile manufacturers are incorporating their best technology in their Chinese
plants to compete with one another as well as local rms. Although some foreign rms are
expanding in China mainly to serve the domestic market, others are exporting from the de-
veloping country. However, there are potential risks for the foreign rms from producing in
China. One of the main concerns is the transfer of proprietary technology to local rms, par-
ticularly with the announcement by General Motors joint venture partner, Shanghai Auto-
motive, that it would begin selling to the domestic market under its own brand name.
Computers in Brazil
Between 1977 and the early 1990s, the Brazilian military government pro-
tected its domestic computer industry through a ban on imports of personal
computers (PCs) and computer parts. In addition, they prevented foreign
firms from producing computers in Brazil. Brazilian firms reverse engineered
IBM PCs and used locally supplied parts to produce the computers. Due to
a combination of the time requirement to reverse engineer the product and
the use of higher cost inputs from local suppliers, the cost of production was
greater in Brazil than the United States.
Prices in Brazil Computer prices, adjusting for improvements in speed, stor-
age, and so forth, are shown in Figure 9-11 for Brazil and the United States
for 1982 to 1992. The effective price of computing power fell rapidly in the
United States between 1982 and 1988. Brazil, however, did not achieve the
same low prices as the United States during the same period. More specifi-
cally, by 1992, Brazil was able to achieve the effective prices of computers that
the United States had already established in 1988. This large gap in prices be-
tween Brazil and the United States indicates that Brazil would not have been
able to successfully produce computers without the tariff protection.
Consumer and Producer Surplus The effect of the tariff protection on
Brazilian welfare is presented in Table 9-3. The calculations show that com-
158 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
puter prices in Brazil were nearly twice as high as those in the United States
in 1984. In the same year, the $29 million gained in producer surplus by
Brazilian computer producers did not outweigh the loss of $80 million in
consumer surplus. The net loss of $51 million (CS PS) accounted for 0. 2%
of the Brazilian gross domestic product (GDP) that year. The net loss peaked
at 0. 6% of GDP along with sales in 1986.
Other Losses The losses due to the protection of the Brazilian computer in-
dustry weigh heavily on both producers using computers for production and
individual users. The increasing dissatisfaction prompted Fernando Collor de
Mello to promise an end to the infant industry protection during his presi-
dential campaign. The failure of the Brazilian computer industry to effectively
compete without import tariffs illustrates the difficulties involved in nurtur-
ing an infant industry through temporary protection.
DWL 1 t
W %M
PM 2 P
Using the data on heavyweight motorcycles presented in Table 9-2, we can
calculate that the average quantity imported between 1982 and 1983 is
(164 139) / 2 151 thousand, which equates to a percentage drop of 17%
((164 139) / 151 0. 17). Substituting in the numbers to our formula, we
get that the deadweight loss relative to the import value in 1983 is:
DWL
12 (0. 45 0. 17) 0. 038, or 3. 8%.
PM
Summing up the annual net losses over the tariff of four years period gives
a total loss of $112. 5 million.
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 159
Future Gain in Producer Surplus Next we will calculate the future gain in
producer surplus to compare the value to the deadweight loss of $113 million.
More specifically, we will measure the future gains in producer surplus by exam-
ining Harley-Davidsons stock market value during the removal of the tariff pro-
tection. Harley-Davidsons initial public offering in July 1986 was 2 million
shares at $11 per share. In June 1987, Harley-Davidson issued an additional 1. 23
million shares at $16. 50 per share. Adding the first public offering of $22 mil-
lion to the second offering of $20. 3 million and its debt of $70 million, we see
that Harley-Davidsons producer surplus in present discounted value is $112. 3
million. These calculations show the deadweight loss is approximately equal to
the future gain in producer surplus. However, after the second stock offering,
Harley-Davidsons stock price increased to $19 per share. With the higher stock
price, the future gain in producer surplus is estimated to be $131 million, which
clearly exceeds the loss in consumer surplus.
Was Protection Successful? Our calculations imply that the tariff protection
increased welfare for the United States because the deadweight loss is less than
the future gain in producer surplus. However, there are doubts as to whether
the heavyweight motorcycle tariff was indeed successful. If Harley-Davidson
had not been able to survive without the tariff, the protection was successful.
This may have been the case because they were on the verge of bankruptcy a
week before the tariff protection. However, Harley-Davidsons chairman
stated that the tariff did not offer much protection because Japanese produc-
ers downsized their motorcycles to 699 cc to evade the tariff.
6 Conclusions
We examine the effect of trade barriers, such as tariffs and quotas under im-
perfect competition, on the welfare of the importing country in this chapter.
With a tariff, a Home monopolist benefits from the increase in price just as
perfectly competitive firms. By contrast, the impact of an import quota on the
Home prices and quantity is different from that of a tariff under imperfect
competition with a domestic monopoly. In other words, the price paid by
consumers is higher under an import quota than a tariff because the Home
monopoly is sheltered from foreign competition, which allows the firm to
exercise its market power. Additionally, the quantity supplied by the sole
Home producer is lower with the quota than a tariff.
Moreover, we also found that a Foreign monopolist facing a fixed tariff will
absorb a portion of the tariff to prevent a large decrease in the quantity ex-
ported. As a result, the full amount of the tariff does not pass through in the
import price. Therefore, by imposing a tariff under conditions in which the
marginal revenue curve is steeper than demand, the importing country expe-
riences a terms-of-trade gain similar to that of a large country.
We also analyzed the response of the importing country when a foreign
firm engages in dumping. Although import quotas are prohibited under
WTO guidelines, an importing country is allowed to levy an antidumping
duty against a foreign exporter when the exporting firm is found dumping.
More specifically, the foreign firm is dumping if it charges a lower price in the
export market than its own local market or prices below the average cost of
160 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
TEACHING TIPS
IN-CLASS PROBLEMS
1. Explain why the removal of an import quota by a lowing scenarios, rank each from best to worst in
small country where there is only one producer terms of the importing countrys welfare. Explain.
leads to a greater gain for consumers than a simi- i. Free trade
lar country where firms operate under perfect
competition. ii. Foreign dumping
Answer: Under imperfect competition, an import iii. Foreign dumping with an antidumping duty
quota allows the monopoly to retain its market iv. Coordination between the foreign and domes-
power. Therefore, prices are higher and the quan- tic producers after the antidumping petition is
tity supplied by the home firm is lower compared withdrawn
with the case of perfection competition with a Answer: ii iii i iv. Foreign dumping is the
quota. As a result, the removal of the import quota best in terms of the importing countrys welfare
would lead to a larger welfare gain for consumers because it decreases the price consumers pay.
because they face a higher price under the mo- Moreover, the gain in consumer surplus generally
nopoly than perfect competition. exceeds the loss in producer surplus so that the net
2. What is the effect on welfare when a foreign ex- effect is positive. Foreign dumping with an an-
porter dumps a product in the U. S. market? tidumping duty is better than free trade if the duty
Answer: Due to the terms-of-trade gain from the raises the import price to the free-trade level. The
lower import price, consumers are better off when reason is that the small country would import the
the foreign exporter dumps a product in the U. S. same amount as it would under free trade but it
market. The domestic producers are worse off be- gains the antidumping duty. Coordination be-
cause they decrease the quantity supplied as a re- tween the foreign and domestic producers is likely
sult of the decrease in price. Overall, the net effect to be the worst in terms of welfare because the
on welfare is positive because the gains by con- collusion would lessen competition.
sumers (areas b c d in Figure 9-9) is likely to 4. The following figure shows the top ten countries
be larger than the loss in producer surplus (area a). cited in antidumping cases by the United States
3. Suppose the commerce department in a small im- from 1980 to 2004. Is there a relationship between
porting country recently found that an exporter is the frequency of being cited in an antidumping case
dumping potatoes in the economy. Given the fol- and the volume of U. S. imports from a country?
Top 10 Countries Cited in Antidumping Cases, by Number of Cases, Fiscal Years 1980-2004, Cumulative
Germany Korea
5.9% 6.1%
Taiwan Japan
5.6% 10.0%
Canada
4.7%
Brazil China
4.5% 10.0%
Italy
4.2%
France
3.6%
Mexico
3.4%
All others
42.1%
Source: U.S. ITC, Import Injury Investigations Case Statistics (FY 1980-2004), Figure 11
162 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
Top Ten Suppliers of U.S. Imports in 2004 ITC, although smaller than that for the DOC, is
still over 50%. Therefore, the data would suggest
Rank Country
that it is relatively easy to obtain import produc-
1 Canada tion through an antidumping case. As we learned
2 China
in this chapter, a domestic firm may withdraw its
3 Mexico
4 Japan claim before a ruling because the act of the peti-
5 Germany tion often leads the foreign competitor to raise the
6 United Kingdom import price. Moreover, the withdrawal of the
7 South Korea case allows the foreign and domestic firms to co-
8 Taiwan
ordinate their output decisions.
9 France
10 Malaysia 6. Refer to Application: U. S. Imports of Japan-
Source: U.S. Department of Commerce, International Trade Administration, Table 11, ese Automobiles in answering the following
2006.
questions:
a. Why did the United Automobile Workers
Answer: With the exception of the United King- (UAW) and Ford Motor Company fail to re-
dom and Malaysia, the top ten countries cited in ceive protection from foreign competition
antidumping cases by the United States from 1980 from the ITC?
to 2004 are also the top ranked U. S. imports in Answer: To receive protection under Article
2004. Thus, it is likely that there is a relationship XIX of GATT and Section 201 of U. S. trade
between the frequency of being cited in an an- laws, the UAW and Ford Motor Company
tidumping case and the volume of U. S. imports must have suffered serious injury where im-
from a country. port competition was the substantial cause.
5. The following table provides data on antidumping Namely, the serious injury due to competing
investigations in the United States from 1980 to imports was not less than any other cause.
2004. Does the information indicate that it is rel- They failed to receive the protection because
atively easy to obtain import protection through the ITC determined that the U. S. recession
an antidumping case? Explain. Why do petitioning was a more important cause of injury to the
firms withdraw their claims before a decision is auto industry than were increased imports.
made? b. What is the impact on American consumers
Antidumping Investigations, 19802008 due to the voluntary export restraint (VER)
imposed by Japans Ministry of International
Number %
Trade and Industry (MITI) to limit the num-
Withdrawn before DOC determination 63 5 ber of Japanese cars exported to the United
DOC determination States? More specifically, how did the VER af-
Afrmative 876 82
fect prices and quality of the foreign and do-
Negative 193 18
Total 1069 100 mestic cars?
Withdrawn after afrmative 153 14 Answer: The VER limited foreign competi-
DOC determination but before
tion, which raised the price of domestic cars
ITC determination
ITC determination without much upgrading in terms if quality.
Afrmative 461 67 Prices of Japanese cars also rose between 1980
Negative 230 33 and 1985. However, over 50% of the rise in
Total 691 100 the price of Japanese cars was due to quality
DOC, Department of Commerce; ITC, International Trade Commission. improvements. The export limitation on
Source: U.S. ITC, Import Injury Investigations Case Statistics (FY 19802008),
Table 3, 2010. quantity created an incentive for the Japanese
producers to sell more expensive models to
the United States.
Answer: The data indicate that from 1980 to 7. Determine the net impact on Homes welfare
2008, 82% of the 1069 cases filed received an affir- when it imposes a tariff of $2 on the Foreign mo-
mative determination from the DOC. The per- nopolist using the following figure.
centage of cases voted in the affirmative by the
Chapter 9 Import Tariffs and Quotas under Imperfect Competition 163
Price
11
10
C d
9
e
MC* + t
B
6
t
MC*
4
A
D
MR
7 10 Foreign exports
Answer: With a tariff of $2 per unit, the Foreign duty order or countervailing duty order will be
monopolist sets MR MC t so that price equals imposed to offset the dumping or subsidies. When
$11 while the quantity supplied is 7. an antidumping or countervailing duty order is
area c 7 (11 10) area e 7 (10 9) imposed, the DOC instructs the Bureau of Cus-
toms and Border Protection to assess antidumping
area c 7 area e 7 or countervailing duties on imports of the product
1
area d (11 10)
2
area d 1. 50 into the United States to offset the unfair trade
(10 7) practice.
9. How is the amount of the antidumping duty de-
Fall in Home consumer surplus: 8.50
termined?
Rise in Home government revenue: 14 Answer: The amount of an antidumping duty is
Net change in Home welfare: 6.50 the difference between the Foreign firms local
price and its export price.
Therefore, the net change in Home welfare is
10. Who may petition for relief from foreign dumping
positive.
in the United States?
8. Name the U. S. government agencies and their
Answer: Under this law, U. S. industries may pe-
roles in determining whether to apply antidump-
tition the ITC and DOC for relief from unfairly
ing or countervailing duties on foreign firms.
priced (dumped) and subsidized imports.
Answer: The International Trade Commission
11. Name the countries that have filed antidumping
(ITC) and the U. S. Department of Commerce
claims against the United States. You can find this
(DOC) are responsible for conducting antidump-
information by going to the Web site of the U. S.
ing and countervailing duty investigations. If the
Department of Commerce International Trade
DOC finds that an imported product is dumped or
Administration given by the following link
subsidized and the ITC finds that a U. S. industry
(http://ia. ita. doc. gov/trcs/foreignadcvd/index
producing a like product is materially injured or
. html) and clicking on Case Archives.
threatened with material injury, an antidumping
164 Chapter 9 Import Tariffs and Quotas under Imperfect Competition
Answer: The list of countries as of July 2009 is as 12. Refer to problem 11. Examine the Chinese im-
follows: port of Acipic Acidacrylates from the United
States. What other countries did China claim were
Albania India Pakistan
dumping Acipic Acidacrylates? When did China
Argentina Indonesia Panama
Australia Israel Peru initiate the antidumping duty petition? What was
Brazil Jamaica Philippines the final decision? Was a duty applied? If so, how
Canada Japan South Africa much? What is the current status of the antidump-
Chile Jordan Taiwan ing duty?
China PRC Korea, South Thailand
Colombia Malaysia Turkey Answer:
Costa Rica Mexico Ukraine
European Union New Zealand Uruguay
Norway Venezuela
13. Refer to problem 11. Examine Indias import of so, how much? What is the current status of the an-
Phenol from the United States. What other coun- tidumping duty?
tries did India claim were dumping Phenol? When Answer:
did India initiate the antidumping duty petition?
What was the final decision? Was a duty applied? If
14. In regards to New Suspension Agreement ~ Fresh Mexico in the United States during the winter sea-
Tomatoes from Mexico (http://ia. ita. doc. gov/ son (October 23June 30) will be $0. 2169/lb. The
tomato/), the Import Administration states that reference price for the summer season (July 1
October 22) will remain at $0. 172/lb.
. . . On December 4, 2002, the Department of
Commerce and producers/exporters accounting for Who will gain from this agreement? Who will lose
substantially all imports of fresh tomatoes from from this agreement? Explain.
Mexico signed this agreement suspending the an- Answer: Tomato producers in the United States
tidumping investigation on fresh tomatoes from will gain from the agreement due the decrease in
Mexico. The basis for the agreement was a com- competition from Mexico although the U. S. con-
mitment by each signatory producer/exporter to sumers will lose because of the higher price.
sell the subject merchandise at or above the refer- 15. Why is the equilibrium quantity and price the
ence price, which will eliminate completely the in- same with a home monopoly and perfect compe-
jurious effects of exports of fresh tomatoes to the tition under free trade?
United States.
Pursuant to section IV. G. of the 2002 Suspen- Answer: Under free trade, consumers are able to
sion Agreement on Fresh Tomatoes from Mexico, purchase the homogenous product from the For-
the Department of Commerce has conducted an eign firm if the domestic monopoly charges a
analysis of the reference prices. Effective November price above the world price. As a result of the for-
1, 2003, the reference price below which signatories eign competition, the domestic monopoly loses its
to the agreement may not sell fresh tomatoes from market power and views the world price as its de-
mand curve.
Export Subsidies in
10
Agriculture and High-
Technology Industries
Notes to Instructor
Chapter Summary
The trade policy we examine in this chapter is one that promotes exports, of-
ten at the expense of domestic consumers. Export subsidies are used by many
countries, developed and developing, to increase the competitive efforts of do-
mestic producers. In this chapter, we discuss the impact of export subsidies in
the agricultural and high-tech industries on domestic and world welfare.
Generally, for a small country, the use of agricultural export subsidies benefits
domestic producers through increased production and higher prices but hurts
consumers in terms of the rise in price paid. For a large country, in addition
to the deadweight loss from the decline in consumer surplus and production
inefficiency, the exporting country experiences a terms-of-trade loss resulting
from the decrease in world price driven by the additional exports. The effect
of export subsidies in high-tech industries depends on whether the govern-
ment assistance succeeds in preventing entry.
Comments
In presenting export subsidies, this chapter covers a number of topics, includ-
ing the World Trade Organization (WTO) and game theory. Therefore, it may
be worthwhile to present an overview of the topic so that students understand
the main theme. Namely, start by discussing the agreements proposed during
165
166 Chapter 10 Export Subsidies in Agriculture and High-Technology Industries
the Geneva and Hong Kong meetings of the WTO and elicit reasons why a
government may use export subsidies under perfect and imperfect competi-
tion. Then, under perfect competition, explain the impact of an export sub-
sidy on a small country versus a large country. Contrast the impact of the ex-
port subsidy with a production subsidy. Return to the use of export subsidies
under imperfect competition.
Lecture Notes
Introduction
Reminiscent of earlier meetings, the Geneva gathering of the 152 members
of the WTO in July 2008 was met with protests. The root of the recent ob-
jections was due to proposals to eliminate agricultural support used in many
countries such as South Korea, Japan, Europe, and the United States, which
inflates the price of their crops while depressing the world prices. Proponents
of the removal of the agricultural support consisted of exporters in land-rich
developing countries, such as Brazil, India, and China, that were hurt by the
low prices. However, the current regimes of tariff and subsidy benefit land-
poor developing countries capable of importing the agricultural products at
the lower prices.
Domestic Farm Supports The Hong Kong meetings also initiated steps to-
ward the removal of domestic farm supports. Although not directly tied
to exports, domestic assistance given to farmers may indirectly affect exports
by lowering the costs of production.
Cotton Subsidies Of all the agricultural products, the WTO members fo-
cused on cotton because many low-income African countries export this
crop. Under the agreement, the United States will work toward eliminating
its export subsidies to cotton growers and reduce other domestic farm sup-
ports. Furthermore, producers in West African and other least-developed
countries (LDCs) are granted unrestricted access in their cotton exports.
H E A D L I N E S
Developing Countries Split over WTO Farm Protection
This article discusses the disagreement of developing countries over proposed special prod-
uct and special safeguard mechanisms, which have been proposed for agricultural products
during the Geneva meeting of the WTO. These special safeguards aim to protect developing
countries concerned about removing tariffs on imported agricultural goods. The safeguards
exempt some special products from tariff removal and develop mechanisms to allow coun-
tries to use temporary tariffs to counter sudden changes in prices or quantities of imports.
Developing countries have been unable to agree on this matter because some fear their ex-
ports will be harmed if safeguard mechanisms can be too easily applied, while others fear
that for their local producers as a result of increased import competition.
large country (X1 S1 D1) is equal to the amount imported by the For-
eign country as illustrated in Figure 10-2.
APPLICATION
Who Gains and Who Loses?
We can predict the winners and losers when the export and indirect subsidies
are eliminated by 2013.
170 Chapter 10 Export Subsidies in Agriculture and High-Technology Industries
Gains With the removal of the export subsidies by industrialized countries in-
cluding Europe and the United States, the world agricultural prices should in-
crease to their free-trade levels to the benefit of exporters in developing coun-
tries like Brazil, Argentina, Indonesia, and Thailand. Additionally, the
deadweight and terms-of-trade losses would be reversed for the industrial coun-
tries with the abolishment of the export subsidies and import tariffs in agricul-
ture.
Losses By contrast, the higher agricultural prices would hurt food-importing
countries, many of whom are poor nations. Empirical studies show that the
current system of agricultural supports lifts the per-capita income of over 50
of the 77 developing nations. In addition, farmers in the United States and
Europe would lose their competitive edge in the international markets and
would be worse off with the abolishment of the subsidies.
Food Aid Unlike the elimination of export subsidies, the removal of indirect
subsidies such as food aid would help developing countries. Championed by
European countries, which substitute food aid for cash, the understanding is
that when the United States sends food to regions not in need, the excess sur-
plus drives down the local prices, harming the regional producers. Similar re-
sults occur when used clothing is donated to some African nations.
H E A D L I N E S
G8 Shifts Focus from Food Aid to Farming
This article describes a new food security initiative announced by the G8 countries, which
commits more than $12 billion for agriculture development. This announcement marks a
change in Washingtons approach to ghting hunger. For decades the focus had been on food
aid, while this new program aims to combat the root cause of hunger and the lack of domes-
tic production. This move, stressing sustainability, could harm U.S. farmers. The United States
currently supplies nearly $2 billion in food aid (mostly grown in the United States) each year.
H E A D L I N E S
Hunger and Food Security Back on Political Agenda
This article expresses skepticism about the promises announced by the G8 discussed in the
previous Headlines. The author discusses the poor record in making good on promises by the
G8 and other groups and asks if the promised $12 billion will be new funds or simply a
repackaging of previously promised, and yet delivered, funds. The author applauds the sen-
timent but reminds us that it has been over thirty-ve years since Henry Kissinger pledged
at the rst such summit that within ten years, no child will go to bed hungry.
smaller net negative effect on Home, Foreign, and the world welfare compared
with direct export subsidies.
Summary As such, production subsidy is of less concern to the WTO than
other forms of domestic agricultural support.
$10 $0
Produce
$10 $75
Boeing
$75 $0
Not Produce
$0 $0
Chapter 10 Export Subsidies in Agriculture and High-Technology Industries 173
Nash Equilibrium The outcome of the game is obtained when each firm
makes the best possible decision given the action of its rival. The strategies
corresponding to the best response for both players is the Nash equilib-
rium.
Best Strategy for Boeing To determine the equilibrium outcome, we will
begin by determining Boeings best response given every possible action that
Airbus could take. Focusing on the left column, where Airbus chooses to pro-
duce, Boeing must decide between producing and receiving a negative profit
of $10 million, given by the upper-left quadrant, or not producing and hav-
ing no profits, as presented in the lower-left quadrant. Thus, Boeing is better
off by not producing when Airbus produces. The column on the right refers
to the case in which Airbus does not produce. If Boeing produces and Airbus
does not, it earns a profit of $75 million. If Boeing also refrains from produc-
ing, its earnings are zero. Given these two choices, Boeing will produce.
Boeings best response for each possible action Airbus could take is indicated
by the circles in the following reproduction of the payoff matrix.
Airbus
$10 $0
Produce
$10 $75
Boeing
$75 $0
Not Produce
$0 $0
Best Strategy for Airbus The best response for Airbus is obvious given that
the payoffs are symmetric for the two firms, but we will proceed in steps sim-
ilar to those for Boeing for a better understanding. Starting with the upper
row where Boeing produces, Airbus would do better by refraining from pro-
ducing and receiving no profit than to produce and lose $10 million. At the
lower row, corresponding to Boeings strategy not to produce, Airbus would
earn $75 million by producing, which is preferable to zero profit from not
producing. Airbus best responses are also denoted by circles in the previous
figure.
Multiple Equilibria The quadrants with the two circles (i. e. , the upper-right
and bottom-left quadrants) give each firms best response contingent on all
possible strategies taken by its rival. Therefore, the Nash equilibriums are for
Boeing to produce and Airbus not to produce as well as for Boeing not to pro-
duce when Airbus produces. To understand the motivation for the use of ex-
port subsidies by the European government, we will make the realistic as-
sumption that Boeing has the first-mover advantage. Namely, by deciding
to produce before Airbus, Boeing will earn profits of $75 million because its
competitor would prefer not to produce rather than lose $10 million. How-
ever, by supporting Airbus through an export subsidy such as cash payments,
174 Chapter 10 Export Subsidies in Agriculture and High-Technology Industries
the government in Europe could affect the Nash equilibrium by altering the
payoff Airbus receives.
H E A D L I N E S
Airbus, China and Quid Pro Quo
With only a third of the Chinese market, Airbus is aiming to break Boeings dominance in
supplying airplanes to China. The European aircraft producer has strategically negotiated
plans to manufacture its A320 passenger plane in the growing Asian country in an effort to
increase Chinese demand. Although Boeing has no plans to develop a direct presence in
China, the American producer is not completely losing orders to Airbus, partly because some
of its engines are from General Electric, which has many Chinese partnerships.
$15 $0
Produce
$10 $75
Boeing
$100 $0
Not Produce
$0 $0
Best Strategy for Airbus To uncover the outcome of this new game, we will
need to determine each firms best strategy. For Airbus, we see that it will
now produce even if Boeing produces because it will receive the profit of $15
million compared with nothing if it does not produce. Moreover, Airbus will
definitely produce if Boeing does not produce because a profit of $100 mil-
lion is preferable to zero profit. Thus, the subsidy alters Airbus strategy such
that it will always choose to produce, regardless of Boeings action.
Best Strategy for Boeing Note that the payoff for Boeing is the same as the
original game because we are assuming that only Airbus receives the subsidy.
Therefore, Boeings best response is identical to that before the subsidy to
Airbus. Namely, Boeing will not produce if Airbus produces, and it will pro-
duce if Airbus does not produce.
Nash Equilibrium The new Nash equilibrium is given by the bottom-left
quadrant, where Boeing does not produce while Airbus produces. It follows
Chapter 10 Export Subsidies in Agriculture and High-Technology Industries 175
that the subsidy helped the governments of Europe in shifting the equilibrium
so that Airbus is now the only producer rather than Boeing.
European Welfare In calculating the impact of the subsidy on European
welfare, we can disregard the effect on domestic consumers because the air-
planes are produced for China. The gain in producer surplus for Airbus is
$100 million because it will produce with the assistance of the subsidy. The
cost of the subsidy to the European governments is $25 million. Summing up,
we have that the net effect of the subsidy is:
Gain in producer profits: 100
Cost of export subsidy: 25
Net gain in European welfare: 75
In this case, the subsidy led to an overall increase in European welfare be-
cause the gain in profits for Airbus from producing outweighs the cost.
$10 $0
Produce
$10 $100
Boeing
$75 $0
Not Produce
$0 $0
176 Chapter 10 Export Subsidies in Agriculture and High-Technology Industries
$15 $0
Produce
$10 $100
Boeing
$100 $0
Not Produce
$0 $0
Best Strategy for Airbus With the subsidy, Airbus will now produce to earn
the $15 million in profits rather than receiving zero from staying out of the
market.
Summary The net negative effect follows because although the subsidy suc-
ceeded in allowing Airbus to enter the market, the profits earned by the
European producer were not large enough to cover the cost of the assistance.
More specifically, the gains to Airbus were not enough to offset the cost of the
subsidy because Boeing did not exit the market compared with the case in
which the American producer did not have a cost advantage.
Chapter 10 Export Subsidies in Agriculture and High-Technology Industries 177
APPLICATION
Subsidies to Commercial Aircraft
Boeing and Airbus have been receiving various types of subsidies from the
United States and Europe, respectively, for many years. In the United States,
the government supports include research and development (R&D) for mili-
tary aircrafts that were later used in the development of the civilian versions.
The assistance provided by the European government was directly used to
fund R&D for new aircrafts. Both governments also indirectly helped their
domestic producers by offering low-interest loans to aircraft purchasers.
1992 Agreement In recognition of the costly nature of these strategic be-
haviors, the United States and European governments reached an agreement
in 1992 to limit the use of subsidies. As shown in Table 10-2, the provisions
of the agreement include limiting direct subsidies to 33% of R&D expendi-
ture for a new aircraft and indirect subsidies to less than 5% of annual sales.
They agreed to eliminate production subsidies and restrict the use of low-in-
terest loans. This agreement came into jeopardy with the development of a
new wide-body aircraft by Airbus called the A380, when the European gov-
ernments (France, Germany, The Netherlands, Belgium, Spain, Finland, and
the United Kingdom) provided low-interest loans that covered more than
33% of the expected development costs. In 2005, the United States and the
European Union both filed claims with the WTO accusing the other of il-
legally subsidizing their respective aircraft producer.
The Superjumbo By exceeding the limit set by the 1992 agreement, the
European governments risked retaliation by the United States. However, their
strategic behavior may have been worthwhile since Airbus is now the only
producer of the new double-decker aircraft.
H E A D L I N E S
W.T.O. Says Aid to Airbus for A380 Was Illegal
A report by the World Trade Organization determined that Airbus received nearly $13 billion
in illegal subsides in developing the A380 superjumbo jet. The report also found that the EU
did not systematically abuse global trade rules which was enough for both the United
States and EU ofcials to claim victory. The ruling may require Airbus to repay its loans on
commercial terms or restructure them. The EU has led a countersuit accusing Boeing of re-
ceiving illegal nancing in the form of U.S. military contracts.
National Welfare In particular, if the profits earned by Airbus from the A380
outweigh the cost of the subsidy, European welfare will rise. As of January
2010, Airbus has delivered only 25 of the 202 aircrafts ordered. It is believed
that Airbus needs to sell 250 jets to cover its development costs, and it con-
tinues to experience delays in delivery.
Boeing is also having difficulties in the production of the 787 Dreamliner,
which was originally scheduled for delivery in 2008 but only completed its
first unit in December of 2009.
Additionally, Boeing will be competing directly with Airbus with the A350
wide-body jet.
178 Chapter 10 Export Subsidies in Agriculture and High-Technology Industries
H E A D L I N E S
Dreamliner Production Gets Closer Monitoring
This article chronicles the problems that Boeing faces in getting their 787 Dreamliner back
on track after six years of work. The problems with the Dreamliner have stemmed from the
aggressive outsourcing of its manufacturing process. Boeing gave unprecedented control to
independent suppliers and has experienced serious problems in quality of components. Boe-
ings problems have been compounded because it reduced its own engineering staff and is
now stretched too thin to address its many problems.
6 Conclusions
Many countries use export subsidies to boost the competitiveness of their do-
mestic producers in the international market. Among the goals of the WTO
meeting in Hong Kong was the elimination of the use of agricultural export
subsidies, particularly by industrialized countries. On a global scale, the flood
of excess supply due to the export subsidy depresses world crop prices, which
harms food exporters in developing countries. Domestically, the export sub-
sidies raise the income of farmers at the expense of consumers. For a small
country, the deadweight loss of an export subsidy is similar to that of a tariff.
By contrast, the welfare implication of an export subsidy is different from a
tariff for a large country. More specifically, although the large country may
experience a terms-of-trade gain through an import tariff, it would have a
terms-of-trade loss under an export subsidy. Furthermore, compared with an
export subsidy, the losses due to a production subsidy are less severe. The rea-
son is that production subsidies have a smaller impact on world prices because
domestic consumption remains unchanged when additional payments are
made for each unit of output regardless of the residence of the consumer. In
the high-tech industry, where few firms compete under imperfect competi-
tion, the use of export subsidies may increase a countrys welfare.
TEACHING TIPS
IN-CLASS PROBLEMS
1. What are export subsidies? Why do countries use ket share by providing the European aircraft pro-
them? Provide examples of such support pro- ducer with a subsidy of $40 million for R&D.
grams. a. Redraw the payoff matrix and find the Nash
Answer: An export subsidy is a payment given by equilibrium.
the government to firms for every unit exported. Answer: With the $40 million subsidy for
By subsidizing the firm, the government encour- R&D, the dominant strategy for Airbus is to
ages the domestic firm to produce more in a par- invest. Now there is only one Nash equilib-
ticular industry. Examples include the sale of dis- rium, in which Boeing will not invest while
counted milk to Canadian processors under the Airbus invests. The payoffs are $90 million for
Commercial Export Milk (CEM) program to assist Boeing and $140 for Airbus.
the dairy industry. Another is the payment of 50
euros per ton of harvested sugar beets to European
Airbus
farmers by the Common Agricultural Policy
(CAP). Cotton farmers in the United States are
paid for the production of cotton and benefit in- Invest Not Invest
directly through subsidies given to agribusiness
and manufacturers buying the American cotton. 100 80
Invest
140 80
b. What is the change in consumer surplus due
90 90 to the subsidy?
Answer: The loss in consumer surplus is
equal to areas a b.
b. How do these subsidies affect welfare in the
United States and Europe? Area a 30 (175 150) 750
Answer: The net effect of the R&D subsidies 1
Area b
2
(60 30) (175 150) 375
on the United States and Europe can be sum-
marized as follows: Loss in consumer surplus: 1125
c. What is the gain/loss in producer surplus with
European Welfare United States Welfare
the subsidy?
Gain in producer prots: Gain in producer prots: 110
100 Answer: The gain in producer surplus is equal
to areas a b c.
Revenue cost of subsidy: 40 Revenue cost of subsidy: 40
1
Area a b c 120 (175 150)
2
Net gain in European Net gain in United States
welfare: 60 welfare: 70
(150 120) (175 150) 3375
D S
D b d
5500
25 40 50 70 100 Quantity a c
S 5000
e
Area a 25 (15 12) 75 4500
1
Area b
2
(40 25) (15 12) 22. 5 4000
Loss in consumer surplus: 97. 5
1
Area a b c 70 (15 12)
2
(100 70) (15 12) 255 75 150 350 375 Quantity
(1000s)
Demand without export subsidy: Answer: Consumers would support the re-
moval of the export subsidy because they would
D 900,000 150P be better off with the lower domestic price,
900,000 150(5,000) whereas producers would oppose it because
they are worse off by receiving less per unit.
D 150,000 9. Consider a small exporting country. Compare the
cost to the government and the net effect on wel-
Demand with export subsidy: fare between an export and production subsidy in
D 900,000 150P the amount of s per unit.
10. Suppose Home is a small country trading with a ranking the following situations. Be sure to justify
large exporter. The supply and demand curve for your ranking.
Home is illustrated by the following figure, where (1) Home without the Foreign export subsidy.
PW denotes the free-trade world price. Assume
that the Foreign government supports its producer (2) Home with the Foreign export subsidy.
with an export subsidy that lowers the world price (3) Home with the Foreign export subsidy and
to P *. the countervailing duty.
Answer: If Home levies a countervailing duty that
Home
Price S raises the import price back to PW, producers
D
would experience a gain equal to area a, whereas
the loss to consumers is given by areas a b
c d. The government receives area c in tariff rev-
enue with the countervailing duty. Therefore, the
PW ranking is as follows from best to worst in terms of
P*
a b c d Homes welfare: (2) (3) (1).
11. Recall that WTO guidelines allow an importing
country to impose a countervailing duty to raise the
price of the imported good in response to illegal
government support such as an export subsidy on
S2 S1 D1 D2 Quantity the part of the exporting country. Go to the WTO
Web site given by the link, http://www. wto
Should Home consider levying a countervailing . org/english/tratop_e/scm_e/scm_e. htm, to deter-
duty that would raise the import price back to PW mine which five sectors were the subject of the
(i. e. , the level without the subsidy)? Answer by largest number of claims with the WTO in 1995 to
2005.
Answer:
Countervailing Sectoral Distribution of Measures: By Reporting Member 01/01/199501/12/2009
Reporting Total XV IV VII XVI II VI XI V I III X IX VIII XII XIII XIV XVII XVIII XIX XX XXI ...
Member
Argentina 4 2 1 1
Australia 2 2
Brazil 7 1 1 5
Canada 15 12 1 1 1
Chile 2 2
Costa Rica 1 1
European
Union 25 7 5 4 2 5 1 1
Japan 1 1
Mexico 8 7 1
New Zealand 4 4
Peru 3 1 1 1
South Africa 5 2 1 1 1
Turkey 1 1
United
States 60 36 2 2 4 1 5 1 4 1 3 1
Venezuela,
Bolivarian
Republic of 1 1
Total 139 65 13 10 10 8 8 7 5 4 4 3 2
Parameters
Notes to Instructor
Chapter Summary
This chapter shows that without international agreements, countries have a
strong incentive to choose policies that could result in the prisoners dilemma.
Namely, a country would impose tariffs to benefit its own welfare. When all
countries act in the same manner, world welfare decreases due to the dead-
weight loss created from the trade restrictions. To avoid this outcome, multilat-
eral agreements such as the World Trade Organization (WTO) promote free
trade by requiring members to reduce tariffs. This chapter also presents the dif-
ference between regional trade agreements such as free-trade areas and customs
unions. The discussion on regional trade agreements details the impact on wel-
fare when international pacts lead to either trade creation or trade diversion.
Also discussed in this chapter are international agreements on labor and the
environment. Global agreements on labor are controversial because they re-
quire judgment and comparison of labor standards across countries. Pressures
from consumers and unions are changing the behaviors of firms to take on
corporate responsibility in the manufacture of products under their logos. In-
ternational agreements on the environment help to avoid outcomes such as
the tragedy of the commons in which exhaustible resources like fish are over-
harvested due to the lack of clearly defined property rights for the common
property. In addition, the treaties also set guidelines for pollution emission.
Without the international agreements, a country may fail to regulate its pol-
185
186 Chapter 11 International Agreements: Trade, labor, and the Environment
lution emission when the pollutant is not local. More specifically, if the pol-
lutant is global, a country may choose not to regulate since it endures only
part of the harmful effect of its pollution. When all countries behave collec-
tively, world welfare decreases with the increased pollution.
Comments
This chapter presents topics that allow for class discussions. Although the ben-
efits of multilateral agreements over regional trade agreements are clear, stu-
dents may be divided over international agreements pertaining to labor and
the environment. Encourage students to voice their opinions, especially
whether they would pay more for a product to ensure good labor standards.
Issues relating to the environment are particularly interesting because the
chapter presents examples that show how free trade can harm the available
natural resources. In NET WORK, students are asked to find examples of
corporate responsibility. A good example is the deal between McDonalds and
Greenpeace to protect the Amazon rainforest by having the fast-food giant
agree to stop selling chicken fed on soya grown in deforested areas.
Lecture Notes
Introduction
In 1999, environmental and political interest groups gathered in Seattle, Wash-
ington, to protest the meeting of the WTO. The activists voiced their dis-
content with the making of WTO rulings that would affect U. S. regulations.
In addition to direct guidelines governing the reduction of tariffs, the WTO
also discussed other issues that have an indirect affect on trade. One such is-
sue is the formation of a panel in which countries excluded from a foreign
market due to unreasonable environmental standards could bring a dispute be-
fore the WTO.
Through the WTO, countries can avoid losses by agreeing to reduce tariffs
and move toward free trade. Aside from the international agreements to cut
import taxes, countries also form pacts on issues relating to labor and the en-
vironment. These agreements aim to protect the rights of workers as well as
the environment from overharvesting of exhaustible resources and emissions
of pollutants.
ment (NAFTA) between the United States, Canada, and Mexico. Countries
can also engage in bilateral agreements. The United States has many, includ-
ing separate pacts with Australia, Jordan, Morocco, and Peru, and new agree-
ments are planned with South Korea, Panama, and Colombia. Some South
American countries are joined by the Mercosur (Argentina, Brazil, Paraguay,
Uruguay, and Venezuela). Formed in 1989, the Asia-Pacific economies have
an agreement known as the Asia-Pacific Economic Cooperation or APEC
(Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan,
Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Rus-
sia, Singapore, South Korea, Taiwan, Thailand, United States, and Vietnam).
There are many free-trade agreements between countries, numbering over
200.
Nash Equilibrium Working out the solution of the game, we find that both
countries will impose a tariff even though they are clearly better off when nei-
ther impose the trade restriction. Given their payoffs, each country does not
have an incentive to individually move toward free trade because e (b d).
By acting on its own, a country is worse off by removing its import tax be-
cause the loss from not imposing a tariff when its rival does (e f ) is greater
than the loss (b d f ). This result is often referred to as the prisoners
dilemma. Namely, the Nash equilibrium of both countries imposing their op-
timal tariff is an undesirable outcome for all parties. However, the outcome is
the best strategy for each country given that its rival will impose a tariff. Such
undesirable outcomes can be avoided by having countries enter into trade
agreements.
Trade Agreement By entering into a trade agreement such as the WTO, the
prisoners dilemma outcome is eliminated because all members agree to re-
duce or avoid imposing tariffs on one another.
Rules of Origin Although a free-trade area allows each country the flexibil-
ity to impose different tariffs on the rest of the world, it creates an incentive
for a nonmember country to take advantage of the duty-free zone by first ex-
porting to the member with the lowest tariff. To counter this problem,
NAFTA members trade areas establish rules of origin that require each
product to contain enough North American content to qualify for duty-free
access. In other words, a product originating from a nonmember country
must go through further processing in a member country before it may be
Chapter 11 International Agreements: Trade, labor, and the Environment 189
traded within the free-trade area without being taxed. The content require-
ment is determined by value added or the use of some key inputs.
H E A D L I N E S
China-ASEAN Treaty Threatens Indian Exporters
This article discusses how the new China-ASEAN free-trade agreement, which took effect
January 1, 2010, could negatively impact Indias exporters as a result of trade diversion.
India currently faces tariffs on exports to China, which will make it difficult to compete
with duty-free goods from ASEAN countries. The new free-trade area, which involves eleven
countries with a total population of nearly 1.9 billion people, will likely increase pressure
on India to sign a similar agreement with ASEAN and China in the near future.
U.S. Tariff
0% 15% 25%
Price
SHonduras + t
SHonduras
S Honduras
B C A
PChina + t SChina + t
a b c d e
D
PChina SChina
Mus
Q2 Q3 Q1 Import Quantity
Interpretation of the Loss Thus, the net effect of the regional trade agree-
ment on the United States and Honduras is negative. In particular, the loss in
tariff revenue to the United States outweighs the gain to Honduras from be-
ing able to import duty free to the latter. The net loss denoted by area c re-
sults from diverting trade from a more efficient producer (China with mar-
ginal costs of PChina) to one with rising marginal costs (Honduras) for imports
Q3 Q2. Area c is similar to the efficiency loss that arises when a small
country imposes a tariff, except that in this case, it is caused by the removal of
a tariff between countries of a regional agreement.
Not All Trade Diversion Creates a Loss It should be noted that the result
of the previous example is not a necessary condition. Namely, members of a
192 Chapter 11 International Agreements: Trade, labor, and the Environment
regional trade agreement may experience gains from removing a tariff despite
any trade diversions. To see this, let us suppose that after joining CAFTA-DR,
Honduras improves its jewelry production, which leads to a rightward shift of
the supply curve to SHonduras. The new postCAFTA-DR equilibrium is now
at point D at the price of PChina. There is an increase in imports relative to the
free-trade quantity, Q1, and the entire amount comes only from Honduras.
Although there are no tariff revenues to collect, the gain to American con-
sumers from the lower price given by area (a b c d e) more than
compensates the loss to the U. S. government. The overall effect of the re-
gional agreement on U. S. welfare can be summarized by the following:
Gain in consumer surplus: (a b c d e)
Loss in tariff revenue: (a b c d )
Net gain in U. S. welfare: e
Aside from the net gain of area e in the United States, producers in Hon-
duras benefit from improving its production efficiency, which allows it to in-
crease exports to the American market. Therefore, countries may be better off
under a regional trade agreement provided that the amount of trade diversion
is less than the amount of trade creation.
APPLICATION
Trade Creation and Diversion for Canada
The gains and losses for Canada from joining the Canada-U. S. Free Trade
Agreement (CUSFTA) are examined by economist Daniel Trefler. Using
data from 1989 to 1996, Trefler found that the reduction in Canadian tariffs
on U. S. goods increased imports by 54 percent, which we consider trade
creation. Trefler also found that Canadas demand for imports from the rest
of the world dropped by 40 percent, which we consider trade diversion.
Weighting these changes by the relative share of imports from the United
States (80 percent of Canadian imports) and imports from the rest of the
world (20 percent of Canadian imports), Trefler found that trade creation
outweighed trade diversion. This result implies that Canada is better off un-
der the free-trade agreement with the United States.
H E A D L I N E S
Wal-Mart Orders Chinese Suppliers to Lift Standards
In order to improve its reputation, Wal-Mart has recently required its more than one thou-
sand Chinese suppliers to meet strict environmental and social standards. Suppliers are
required to demonstrate compliance with Chinese environmental laws, improve energy ef-
ficiency, and disclose the names and locations of all factories involved in production.
N E T W O R K
Ernst & Young practices corporate responsibility through their relationship with key suppli-
ers. The environmental management of their suppliers is one of the criteria in their selec-
tion of their supply chain partner.
The Walt Disney Company implements the International Labor Standards (ILS) program to
protect the interests of workers engaged in the manufacture of Disney merchandise. To pro-
mote compliance with the strict codes of conduct for their licensees and manufacturers,
Disney undertakes educational, monitoring, and remediation efforts. In the event of a viola-
tion, Disney works with the concerned factory to remedy the situation and will terminate
the use of the factory if necessary.
194 Chapter 11 International Agreements: Trade, labor, and the Environment
fishermen but rather that the United States failed to provide notice and consul-
tation with the exporting countries involved. By working with the Asian pro-
ducers, the 2001 ruling of the WTO established that the United States could
continue to adopt its requirements for turtle-safe nets for exporters.
Gasoline from Venezuela and Brazil In the case against the United States
concerning gasoline from Venezuela and Brazil, the GATT/WTO ruled in
1996 that the import restriction was illegal because the 3-year grace period
given to domestic producers to meet the Clear Air Act goals was not extended
to the foreign producers.
Biotech Food in Europe In 2006, the United States, along with Argentina and
Canada, won their case with the WTO against the European Union regarding
a ban on genetically modified food. The WTO ruled that import restrictions
must be based on scientific risk assessments rather than precautionary reasons.
Summary of GATT/WTO Cases The outcomes of the cases presented in
Table 11-3 suggest that environmental concerns are recognized by the WTO.
More specifically, protests at the Seattle meetings and lobbying activities by
environmentalists shift public opinion and influence WTO rulings in favor of
environment protection.
H E A D L I N E S
The Power of Big Corn
Due to the U.S. import restriction on sugar cane, ethanol producers use corn, which requires
more energy than the sugar-based version. This is because corn requires fertilizers and is
harsh on the soil. The removal of the import quota on U.S. sugar would be better for the en-
vironment.
the latter was higher relative to the former. Thus, the trade restriction harmed
the environment by shifting consumer demand to larger cars requiring more
energy and emitting greater carbon dioxide.
H E A D L I N E S
Europe Leans Toward Bluen Trade Ban
In 2009, Monaco suggested that bluen tuna be placed on the endangered species list,
which would ban the international trade of the tuna. Though the bluen tuna is thought by
many experts to be close to extinction, there is much opposition to placing the sh on the
endangered species list. Opposition has come from the shing industry, which stands to lose
if this sh, used extensively in sushi, was to be made illegal to trade. It is also expected
that Japan will come out in opposition to the ban.
better off because of lower pollution but producers bear the higher cost from the
installation of special equipment. If both countries regulate, we are at the top-
left quadrant, in which consumers in each country experience a gain and pro-
ducers suffer a loss. Instead if Home (Foreign) regulates but Foreign (Home)
does not then the result is the top-right (bottom-left) quadrant such that both
producers and consumers are worse off at Home (Foreign). In contrast, Foreign
producers gain, whereas Foreign consumers suffer a loss, when Home regulates
but Foreign does not require pollution reduction. Lastly, both countries will have
a net loss if neither regulates pollution, as given by the bottom-right quadrant.
Nash Equilibrium From the perspective of a particular country, say Home,
if the pollutant is global, the gain to its producers from nonregulation may
outweigh loss to its consumers because some of the substance would cross
borders to Foreign. Consequently, the Nash equilibrium would be that both
countries do not regulate their emissions because neither country has an in-
centive to impose the higher cost on its producers. Without any regulations,
consumers in both countries suffer a larger loss than the small gains to the pro-
ducers in either country.
Multilateral Agreements To avoid the prisoners dilemma outcome in
which countries do not regulate their pollution emissions, countries engage
in multilateral agreements such as the Montreal Protocol on Substances that
Deplete the Ozone Layer. As a result of the Montreal Protocol, a ban on the
use of chlorofluorocarbons (CFCs) has been in placed since 1989.
APPLICATION
The Kyoto Protocol and the Copenhagen Accord
Building on the 1992 United Nations (UN) treaty on climate change, repre-
sentatives from many nations met in Kyoto, Japan, in December 1997 to dis-
cuss nonbinding targets aimed at reducing emissions of greenhouse gases. The
Kyoto Protocol focused mainly on the reduction of carbon dioxide (CO2).
The agreement, endorsed by more than 160 countries, set different reduction
targets for each country. When the treaty came into effect on February 16,
2005, the United States remained the only major industrial country choosing
not to ratify the treaty. In a speech given by President George W. Bush, the
reason the United States abstained from the Kyoto Protocol was due to (1) a
lack of understanding of all the consequences of policy actions dealing with
global warming; (2) the large negative impact on the U. S. economy from
switching to activities that reduce CO2 emission; (3) the exclusion of devel-
oping countries such as China and India in the discussion; and (4) the possi-
bility that other methods to limit greenhouse gas emissions exist. The Copen-
hagen Climate summit twelve years later, which brought together 119
countries, was thought to be an important opportunity to pick up where Ky-
oto left off. Unfortunately, the meetings ended with only modest goals called
the Copenhagen Accord. The accord stated that: (1) further increases in
global temperature should be kept below two degrees centigrade; (2) indus-
trialized countries will submit goals for greenhouse gas emission reduction;
and (3) a fund should be established to finance the needs of developing coun-
tries in fighting the effect of climate change. However, without any means of
enforcement these already modest goals seem to be quite trivial.
198 Chapter 11 International Agreements: Trade, labor, and the Environment
H E A D L I N E S
Dismal Outcomes at Copenhagen Fiasco
This article discusses the limited success of the Copenhagen Accord and suggests a way for-
ward for global climate change. The author suggests that Copenhagens failure was due in
part to the inability of participants to unpack the problem they faced. By trying to do too
much in too rigid a framework, little was actually accomplished. Though a global cap and
trade system for greenhouse emission might be the rst best solution, progress should not
be held captive in the name of cap and trade. Collective action and aid for developing coun-
tries are both very important, but need not both be decided at the same time.
4 Conclusion
This chapter explains how international agreements are necessary to avoid
outcomes that would make countries worse off. A multilateral agreement
such as the WTO promotes free trade by requiring all members to lower or
reduce their tariffs. Without the international agreement, countries have an
incentive to use tariffs to their own benefit. However, when all countries be-
have similarly, the outcome known as the prisoners dilemma results, in which
all trading partners experience losses due to the trade restrictions.
Another type of international agreement on trade is the regional trade
agreements. These agreements are also referred to as preferential trade agree-
ments because they violate the MFN principle of the WTO by excluding
nonmembers from enjoying the tariff reduction. Such agreements may make
member countries worse off when they switch from the lowest cost produc-
ers that are excluded from the agreement. The resulting trade diversion has a
negative impact on the welfare of the member countries in terms of higher
prices and loss of tariff revenues.
International agreements on labor promote standards that protect the rights of
workers. An example is the North American Agreement on Labor Cooperation
(NAALC) formed between Canada, Mexico, and the United States. Proper la-
bor standards are also upheld due to pressure from consumers and unions.
Global agreements also exist for the environment. One of the main pur-
poses of these agreements is to promote free trade while protecting the envi-
ronment. Another is to prevent the near-extinction or extinction of ex-
haustible resources such as fish through export bans and restrictions. The
limitations set by international agreements such as the Convention on Inter-
national Trade in Endangered Species help to avoid the phenomena known as
the tragedy of the commons, in which each country overharvests the com-
mon resources. Countries also have international agreements on pollution
emissions. Without such agreements to cut pollutants like CO2, the prisoners
dilemma outcome may result, in which all countries fail to regulate the
amount of pollution they contribute to the environment.
Chapter 11 International Agreements: Trade, labor, and the Environment 199
TEACHING TIPS
IN-CLASS PROBLEMS
1. How does trade creation and trade diversion in- price of PPoland, imports would expand to X2
crease and/or decrease economic welfare? (D2 S2). The loss in producer surplus due to the
Answer: Trade creation increases economic wel- drop in price is area a. In comparison, the gain to
fare because a member country imports a product consumer surplus is given by areas a b c d.
from another member rather than producing the Without the import tax the Belarusian govern-
good for itself at a higher cost. In comparison, ment loses areas c e. To summarize, the net ef-
when a member country switches from the lowest fect on the Belarus welfare from joining the EU is
cost producer excluded from the international as follows:
agreement to another member country, trade di-
version decreases economic welfare. Gain in consumer surplus: (a b c d)
2. Suppose Belarus, a small country, imposes a tariff in Loss in producer surplus: a
the amount of t per unit on imported coal. As-
sume that it imports coal from Ukraine rather than
Loss in tariff revenue: (c e)
Poland because the former has a lower net-of-tariff Net effect in Belarus welfare: (b d) e
price. Furthermore, suppose that the Belarusian
government is considering whether to apply for Thus, Belarus would be better off joining the EU
membership to the European Union. As a mem- if (b d) e. Namely, the gain in consumer sur-
ber of the EU, Belarus would have to remove its plus outweighs the loss in tariff revenue.
tariffs on all countries within the customs union, 3. Suppose the United States could import footwear
such as Poland. Using the following figure, analyze from Thailand at the price of $20 per pair or from
the welfare effect of EU membership on Belarus. Mexico at $24 per pair. The domestic price of
footwear in the United States is $35. Suppose
Home
Price D S prior to NAFTA, the U. S. customs imposed a
50% tariff on all footwear entering the country.
Would the United States import footwear? If yes,
from which country? Why?
Answer: Before NAFTA, the United States would
PPoland + t import footwear from Thailand because even with
the 50% tariff the price of the product from the
PUkraine + t
a b c d Asian country, $30, would still be lower than the
PPoland domestic price of $35. It would not import
e
PUkraine footwear from Mexico before the formation of
NAFTA because the price with the tariff, $36, is
higher than its domestic price.
4. Under Article XIV of the GATT, regional trade
agreements are permitted provided that countries
S2 S1 D1 D2 Quantity within the arrangement do not change their tariffs
against outside members. Because the tariffs on
nonmember countries are unchanged while those
X1
levied on partners in the pact are removed or re-
duced, the formation of free-trade areas and cus-
X2 toms unions leads to an overall increase in the
gains from international trade. Comment.
Answer: Currently, the price faced by Belarus Answer: The statement would be correct if the
with the per-unit tariff is PUkraine t. At this price, formation of the regional trade agreement does
quantity demanded is given by D1, whereas quan- not lead a member country to substitute a low-
tity supplied is denoted by S1 so that the amount cost producer excluded from the agreement with
imported is X1 D1 S1. As a member of the another member supplying at a higher cost. In
EU, Belarus would import from Poland rather than other words, regional trade agreements would re-
Ukraine because the tariff removal from the for- sult in an overall increase in the gains from inter-
mer would result in a lower price. At the reduced
Chapter 11 International Agreements: Trade, labor, and the Environment 201
national trade as long as the amount of trade cre- a. Does the proposal lead to trade creation or
ation is greater than trade diversion. trade diversion? Explain.
5. How do regional trade agreements violate the Answer: The proposal would lead to neither
most-favored nation principle of the GATT/ trade creation nor trade diversion since the
WTO? United States would continue to import ba-
Answer: The most-favored nation principle of the nanas from Nicaragua at $0. 35 per pound in-
GATT/WTO requires each country to extend to clusive of the 25% tariff.
all members the same preferential treatment en- b. If the banana tariff was doubled, would there
joyed by its most-favored trading partner. With be trade creation or trade diversion?
the regional trade agreements, members of the Answer: If the tariff doubled, there would be
agreement trade with zero tariffs but import taxes trade diversion because the United States
are imposed on countries outside the region. For would start to import bananas from Angola
example, although Canada, China, and the United rather than Nicaragua because the price from
States are all members of the WTO, goods ex- the former at $0. 50 per pound would be
changed between Canada and the United States cheaper than the latter at $0. 42 per pound.
are duty free because both belong to NAFTA, However, the price exclusive of the tariff is
whereas products from China are subject to tariffs. lower for bananas from Nicaragua, so the
6. What is the relationship among regional trade United States is diverting trade from a lower-
agreements, free-trade areas, and customs unions? cost producer to one with a higher cost.
What are the similarities and differences between c. Assuming that the banana tariff is 50%, what is
the latter two? How do they impact world welfare? the net effect of the proposal on U. S. con-
Answer: Free-trade areas and customs unions are sumers, U. S. producers, U. S. government,
two different types of regional trade agreements. and the world welfare?
In a free-trade area, members of the agreement re- Answer: Because the foreign producers sup-
duce or remove tariff on goods traded between plied the bananas (Nicaragua before and Angola
them but maintain different duties on imports after the tariff increase), the net effect on U. S.
from the rest of the world. Similar to a free-trade producers is nil. U. S. consumers pay a higher
area, members of a customs union also trade duty price under the proposal so they are worse off.
free with one another. The difference is that coun- The U. S. government also experiences a loss
tries in a customs union have a uniform tariff on with the proposal since they would lose the tar-
imports from nonmembers. Depending on iff revenue. Therefore the net effect of the pro-
whether these regional trade agreements lead to posal would be negative for the United States
trade creation or trade diversion, they may have a due to the trade diversion. The net effect on
positive or negative impact on world welfare. world welfare is also likely to be negative since
7. Explain how the elimination of the system of quo- the gain to the Angola producer will be small
tas under the Multifibre Arrangement (MFA) compared with the losses faced by the
should reverse some of the trade diversion caused Nicaraguan producers and the United States.
by regional agreements such as NAFTA? 9. Adanac, a small country, is considering whether to
Answer: Under NAFTA, Mexico is given prefer- join the regional trade agreement known as RTA-
ential tariffs relative to lower-cost producers such R-US. Currently, it can import tires from coun-
as China on U. S. textile imports. Thus, the re- tries outside the regional agreement at the price of
moval of the MFA should redirect trade to China, $20 each or from those inside the pact at $40 each.
thereby reversing some of the trade diversion. In addition, Adanac has a 50% tariff on all im-
8. Suppose the United States imports 1,000 pounds ported tires. Predict whether Adanacs decision to
of bananas from Nicaragua at $0. 28 per pound. join RTA-R-US will lead to any trade diversion
Due to a 25% tariff, the consumer price in the or trade creation. Explain.
United States is $0. 35 per pound. Farmers in the Answer: Even if Adanac joins RTA-R-US, it will
United States can provide the bananas at a price of continue to import tires from countries outside the
$0. 40 per pound. Furthermore, suppose that the regional agreement because the price with the tar-
proposal to eliminate tariffs on the 50 poorest na- iff ($20 50% $20 $30) is still lower than the
tions passes. As a result, Angola devotes more re- price from those inside the pact. Thus, there will
sources to the production of bananas and can sup- neither be any trade diversion nor trade creation.
ply the fruit at $0. 40 per pound.