Chapter 20: International Trade

Take a moment to think about the clothes you are wearing right now. Do you know where each piece was made? In the U.S.? Mexico? China? Chances are that at least one piece of clothing was not made in the United States. In fact, many of the goods and services you use are produced outside of the U.S. In this chapter we focus on U.S. trade patterns and why trade is beneficial to nations. However, not everyone perceives international trade as beneficial. We also examine the debate between those who think we should favor U.S.-made goods and services (protectionists) and those who advocate free trade.

I.  An Overview of U.S. Trade

As mention in Chapter 18, the U.S. runs a trade deficit, and has done so since 1970:

The U.S. typically runs a deficit in goods and a surplus in services, with a combined trade deficit overall.
In terms of total trade VOLUME, our top trading partners in 2000 are

The trade balance with individual nations varies greatly.

In terms of what is traded, the largest categories for U.S. goods include commercial aircraft & parts, auto parts, computers, and agricultural products. The largest categories for imports include cars, oil, and apparel (shoes & clothes).

In total the U.S. exports about 10% of it's output. Smaller industrialized countries like Canada and South Korea rely more heavily on exports, exporting about 38% of their GDP. Oil-rich nations like Saudi Arabia also export a large fraction of their GDP (over 40%).

However U.S. dependence on exports as a source of demand varies dramatically by industry. U.S. farmers exports up to half of their wheat crop. Boeing sells over 25% of its airplanes to foreign buyers. A disruption in international trade may have virtually no effect on some industries, but be devastating to others.

II.  The Gains from Trade

Comparative and Absolute Advantage

As we noted in Chapter 18, trade is beneficial for all nations because it allows each nation to specialize. This specialization increases total world output and allows trading nations to enjoy a higher standard of living relative to the case of no trading.

To demonstrate the economics gains from international trade, let's consider an example. Suppose we are looking at two goods: waffles and sweaters. Consider the following production possibilities for the United States and Belgium:

Comparing these two production possibilities tables, there are a couple of important observations:

If both countries devoted all of their resources to the production of sweaters, The U.S. can produce more sweaters than Belgium. The U.S. has an absolute advantage in sweaters. If both countries devoted all of their resources to the production of waffles, then Belgium can produce more waffles than the U.S. Belgium has an absolute advantage in waffles. (You had to know that was coming.)

However, what really counts here is the opportunity cost. For the United States, to produce 25 million sweaters, it must give up 100 million waffles, or

1 sweater = 4 waffles.

For Belgium, 10 million sweaters cost 120 waffles, or

1 sweater = 12 waffles.

Belgium must give up 12 waffles to make a sweater, while the U.S. must give up only 4 waffles. So the opportunity cost of 1 sweater is lower in the U.S. than in Belgium. This means that the U.S. has a comparative advantage in sweaters. Conversely, Belgium has a comparative advantage in waffles.

It is comparative advantage that drives the gains from trade. Even if the U.S. had an absolute advantage in both sweaters and waffles, it could still gain from specializing in the good in which it has a comparative advantage. This explains why the U.S. trades with poorer countries.

Now let's examine how the U.S. and Belgium will gain from trade.

Case 1: Without Trade

Without any trade with the outside world, each nation is limited to what it can produce domestically. So the production possibilities are identical to the consumption possibilities for both the United States and Belgium, and for any closed economy. Suppose the U.S. is consuming at point C, at 200 million waffles and 50 million sweaters:

Suppose Belgium is consuming at point X, at 240 million waffles and 20 sweaters :

Without any trade, Belgium and the U.S. could chose any point on or inside their production possibilities curve.

Case 2: With Trade

Now suppose that the U.S. and Belgium are going to specialize in what they do best (their comparative advantage) and trade with each other.

The U.S. will specialize in sweaters, producing at point A: 100 million sweaters and no waffles.

Belgium will specialize in waffles, producing 480 million waffles and no sweaters.

Suppose both nations agree to the following trade: 40 million sweaters for 220 million waffles

With trade, the U.S. will consume 60 million sweaters (after giving 40 million to Belgium) and 220 million waffles (from Belgium):

Note how trade allows the U.S. to consume OUTSIDE its production possibilities. This is due to the benefits of specialization.

Belgium will consume 40 million sweaters (from the U.S.) and 260 million waffles (after giving 220 million to the U.S.):

Note again how trade allows Belgium to consume OUTSIDE its production possibilities.

To summarize:

Trade makes both nations better off, due to the gains from specialization.

III.  The Terms of Trade

In the previous example, I have gave you the terms of trade: 40 million sweaters for 220 waffles. Or in other words, 1 sweater for 5.5 waffles. How do nations decide this? In most cases the decision is made by firms and consumers using markets. However the domestic production possibilities do tell us the acceptable range for the terms of trade.

Recall that the tradeoff for domestic production in the U.S. is 1 sweater for 4 waffles.
Recall that the tradeoff for domestic production in Belgium is 1 sweater for 12 waffles.

So the U.S. will demand more than 4 waffles for 1 sweater, while Belgium will pay anything less than 12 waffles for a sweater. Thus the terms of trade that are mutually acceptable to Belgium and the U.S. are in the range:

4 waffles < 1 sweater < 12 waffles.

IV.  Barriers to Trade

For various reasons (discussed below) nations may elect not to allow the free flow of goods and services across borders. There are several approaches to restricting the access of foreign producers to U.S. markets.

An embargo simply prohibits the importing and/or exporting of goods and services. The U.S. has enforced a trade embargo (imports and exports) with Cuba since Fidel Castro took power in 1959. There are export restrictions on certain U.S. technology that could be used in weapons-making. In 1984, the U.S. banned grain exports to the Soviet Union in response to their invasion of Afghanistan.

A more common trade restriction is a tariff, which is a tax on imported goods. The idea behind a tariff is to increase the price of imported goods, making domestic goods more attractive by comparison. Domestically, tariffs benefit certain producers at the expense of many consumers. Although the trend is toward declining tariffs worldwide, there are currently tariffs in the U.S. on imported clothing, orange juice, and liquor that cost consumers millions of dollars a year in higher prices. While tariff supporters argue that tariffs save domestic jobs, other nations typically retaliate with tariffs of their own, costing jobs in U.S. export industries.

An alternative to a tariff is to directly restrict the quantity of imported goods. This restriction is known as a quota. In the U.S. quotas affect slightly over 10 percent of our imports. The quotas on imported sugar costs consumers over $1 billion per year in higher food prices. Quotas also invite retaliatory action, so in recent years the U.S. government has negotiated "voluntary" restrictions on imports such as shoes, TVs, steel, cars with other countries. Voluntary or not, the effect is still higher prices for consumers.

V.  Protectionism vs. Free Trade

If the gains from trade are so obvious why would people even consider erecting trade barriers? The answers lies in the fact that even though both the U.S. and Belgium experience net gains from trade, in each country there are winners and losers. Free trade is most beneficial to U.S. sweater-producers and Belgium waffle-producers, along with consumers in both nations. However some of these gains will come at the expense of U.S. waffle-producers and Belgium sweater-producers. So trade results in a net gain but it redistributes income from import-competing industries (like steel) to export industries (like commercial aircraft).

In general, workers and firms that compete with imported products are going to be in favor of restricting trade. There are other arguments in favor of trade barriers as well:

Despite these arguments, the momentum globally has been for lower trade barriers through multinational trade pacts. In fact, in the 1992, 1996, and 2000 U.S. presidential elections both the Republican and Democrat candidates favored free trade agreements.

For the U.S. the two largest trade agreements are the North American Free Trade Agreement (NAFTA) with Mexico and Canada and the latest General Agreement on Tariffs and Trade (GATT) which includes 117 nations.

NAFTA was first negotiated with the U.S. and Canada, and there was no controversy about it. The 1992 agreement that added Mexico generated considerably more controversy, with concerns about cheap Mexican labor and Mexico's poor environmental record. NAFTA calls for the elimination of all tariffs between Canada, the U.S., and Mexico by 2007. NAFTA will (and already has) cost the U.S. jobs in textile industries, but also creates jobs in the financial and telecommunications industries.

The GATT treaty originated in 1947 and is periodically renegotiated to further reduce trade barriers. The latest treaty signed in 1994 also created the World Trade Organization (WTO) to enforce the rules of the treaty. Many groups in the U.S. (led by 2000 Reform Party presidential candidate Pat Buchanon) oppose the WTO on the groups that it cedes control over domestic trade policy and thus U.S. interests to global organization. However, the WTO has since ruled in our favor in several trade disputes with Europe.

Another large trade pact that does not directly involve the U.S. is the European Union (EU). The pact eliminates border restrictions among 15 European nations, including trade barriers. Starting in 1999, 11 nations of the EU are attempting to move toward the use of 1 currency, the euro.

FYI: Related Links

America's Maligned and Misunderstood Trade Deficit A 1998 article about the myths surrounding the U.S. trade deficit.

The Case for Free Trade A ringing endorsement of free trade from Nobel Laureate Milton Friedman and his wife Rose Friedman.

Policy debate: Does the U.S. economy benefit from foreign trade? A debate about the merits of free trade vs. protection of domestic industries.

Policy debate: Does the U.S. economy benefit from the WTO? This is related to the debate above, but with some unique issues about ceding control of trade issues to a global, rather than a national, authority.

Public Citizen Global Trade Watch This site offers points-of-view that are decidedly anti-trade. Public Citizen was founded by Ralph Nader, consumer advocate and Green Party presidential candidate in 2000.

U.S. Census Bureau Foreign Trade Statistics A large collection of trade statistics