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Lesson 2: Bridges & Barriers to Trade

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Concepts

trade barrier sanction division of labor
embargo subsidy interdependence
tariff specialization protectionism
quota

Content Standards

Standard 5: Voluntary exchange occurs only when all participating parties expect to gain. This is true for trade among individuals or organizations within a nation, and among individuals or organizations in different nations.

  • Free trade increases worldwide material standards of living.
  • Despite mutual benefits from trade among people in different countries, many nations employ trade barriers to restrict free trade for national defense reasons or because some companies and workers are hurt by free trade.
  • Imports are foreign goods and services purchased from sellers in other nations.
  • Exports are domestic goods and services sold to buyers in other nations.
  • Voluntary exchange among people or organizations in different countries gives people a broader range of choices in buying goods and services.
  • When imports are restricted by public policies, consumers pay higher prices and job opportunities and profits in exporting firms decrease.

Standard 6: When individuals, regions, and nations specialize in what they can produce at the lowest cost and then trade with others, both production and consumption increase.

  • Like trade among individuals within one country, international trade promotes specialization and division of labor and increases output and consumption.
  • As a result of growing international economic interdependence, economic conditions and policies in one nation increasingly affect economic conditions and policies in other nations.
  • Individuals and nations have a comparative advantage in the production of goods or services if they can produce a product at a lower opportunity cost than other individuals or nations.
  • Comparative advantages change over time because of changes in factor endowments, resource prices, and events that occur in other nations.

Standard 17:  Costs of government policies sometimes exceed benefits. This may occur because of incentives facing voters, government officials, and government employees, because of actions by special interest groups that can impose costs on the general public, or because social goals other than economic efficiency are being pursued.

  • Although barriers to international trade usually impose more costs than benefits, they are often advocated by people and groups who expect to gain substantially from them. Because the costs of these barriers are typically spread over a large number of people who each pay only a little and may not recognize the cost, policies supporting trade barriers are often adopted through the political process.

Overview

In spite of general recognition that trade creates wealth, the history of international trade is largely a series of attempts by different nations to gain some elusive advantage in the trading game by erecting trade barriers. In contrast to the general historical trend, the last two decades of the twentieth century were characterized by a growing number of trade agreements and the lowering of trade barriers. The result is that at the turn of the 21st century it was possible to assert that international exchange was freer than at any other time in history. Lesson 2 reviews the vocabulary of trade restriction before analyzing the impact of trade-inhibiting policies and moving on to the more important question of why the urge to erect barriers seems so resistant to the economic logic that restricting trade restricts the creation of wealth.

Key Points

Trade Restrictions – Erecting Barriers to Trade

  1. There is general agreement among economists that trade creates wealth.
    • Restricting trade thus reduces the growth of wealth.
    • Although trade barriers take many forms, the most common are tariffs and quotas.
      • Both limit competition and trade and therefore reduce overall wealth.
  2. A tariff is an import tax.
    • While a tariff generates government revenue, its more important effect is to raise the price of the imported product.
    • Its purpose is to “protect” the domestic product from competition by insuring that foreign products are the higher-priced, and therefore less desirable, alternative.
  3.  A quota is a limitation on the quantity of a product that may be imported.
    • Although its effect is indirect, a quota is similar to a tariff in that it raises the price of the imported product.
      • Restricting the supply puts upward pressure on the price of the import, making the domestic product the lower-priced alternative.
    • Unlike tariffs, quotas do not generate government revenue.
  4. The arguments for tariffs and quotas focus on the “protection” of domestic industries.
    • The “infant industries” argument suggests that new industries need time to establish themselves without the pressure of foreign competition. Questionable assumptions of this argument include:
      • That there are necessarily higher costs in the start-up phase of an industry and that there is good reason for a domestic firm to enter a market being served by imports.
        • If there is insufficient profit potential to attract a domestic producer to bear the start-up costs (whatever their level), it seems reasonable to continue to allow the market to be served by foreign producers.
      • To protect the domestic producer with tariffs or quotas decreases supply, raises prices to consumers and thereby subsidizes the income of the domestic industry.
      • Lower-priced foreign labor gives foreign producers an unfair advantage.
        • Lower-priced foreign labor is a reflection of lower productivity. Higher domestic wages are a function of the higher productivity of U.S. workers. The higher output per man-hour by domestic workers makes their product competitive with imports.
        • We frequently find that similar products are produced both overseas and domestically for consumption in the U.S.
          • Baseball caps are a good example. Many are made in low-wage nations like Sri Lanka but others are made in Oklahoma City. Oklahoma City hat makers compete with Sri Lanka because the American workers are more technically skilled and can use sophisticated machinery to do what Sri Lankan workers do by hand or with old equipment.
    • The “essential industries” argument suggests that there are some sectors of our economy (agriculture or plane manufacturing, for example), that are essential to the defense and well-being of our country.
      • This argument is built on the presumption that economic self-sufficiency is desirable and that the interdependence engendered by international trade weakens the United States, especially in times of war.
      • The questionable assumption of this argument is that dependence on foreign production will leave the U.S. vulnerable in times of need because foreigners will have the ability to withhold key products.
        • Historically, this has proven not to be the case.
        • It’s important to remember that interdependence is a two-way street.
        • Most importantly, the question of what constitutes a “key” industry is difficult to answer.
          • It’s not always possible to determine or agree on what industries are essential or will be essential in the future.
          • There are huge incentives for industries to lobby for an “essential” designation, regardless of their actual role, which should make us skeptical of any such designation.
    • The “trade-costs-jobs” argument suggests that imports allow low-wage foreign producers to “steal” domestic jobs.
      • Questionable assumptions of this argument include:
        • The mistaken belief that foreign wage rates are something other than a reflection of differences in productivity, and
        • The belief that replacement of domestic production with foreign production reduces the total number of jobs in the United States.
          • Bureau of Labor Statistics data indicates that during the 1990s period of falling trade barriers, employment in the U.S. rose by over 15 million, the number of unemployed fell, and the percentage of unemployment fell.
  5. Other forms of trade restrictions and interference include anti-dumping policies, embargoes, sanctions, and subsidies.
    • “Dumping” is said to occur when a foreign producer sells a product in the U.S. at a price below production cost.
      • If domestic producers believe that foreign competition is “dumping,” they can call for U.S. Dept. of Commerce investigation. If the government finds merit to the claim, a tariff or fine is levied to make the import competitive with the domestic product.
      • The theory suggests that foreign firms do this with the intent of driving domestic producers out of business and then raising prices.
        • The problem with this line of reasoning is that it ignores the reality that high-priced imports call domestic producers back into the market.
          • Attracted by the profit potential, domestic competitors re-enter the market.
      • The other problem is the difficulty of establishing even one confirmed case of dumping.
        • Usually, the standard for dumping is if the product sells for less in the U.S. market than in its home market. However, this price differential may have very little to do with the cost of production.
          • Demand may raise the price in a foreign market, even though costs of production may be lower than they are in the U.S.
        • We often see domestic products selling for different prices in different regions of the country, and we aren’t suspicious.
          • Regional price differences usually occur because demand – for snow shovels or suntan lotion for example – is either higher or more responsive to price changes in some places than in others.
        • The lack of any way to definitively prove that dumping is occurring means that the determination is often arbitrary, reflecting effort by a domestic producer to gain a competitive advantage.
          • Example: In the late 1980s, domestic golf cart producers claimed that Poland was dumping carts on the U.S. market. The Department of Commerce then had to determine the “price” of production in a communist country that had administered prices. To do this, they used a “constructed value,” estimating the cost and then adding a percent profit to determine the producer’s home country market price equivalent. Absent market wages, the Commerce Department used labor rates in Spain and applied them to the estimated length of time for Polish workers to make golf carts.  (Polish golf cart story taken from The Choice – A Fable of Free Trade and Protectionism, by Russell Roberts. Upper Saddle River, NJ: Prentice Hall, 2001, p. 78.)
    • Trade sanctions are a diplomatic tool used to apply pressure to a country without engaging in armed conflict.
      • The general category “trade sanctions” includes embargoes, boycotts, and denial of financial relations.
        • As President Woodrow Wilson noted in 1919, “A nation boycotted is a nation that is in sight of surrender. Apply this economic, peaceful, silent deadly remedy and there will be no need for force. It is a terrible remedy.”
        • The current list of U.S. sanctions covers over 25 countries and is estimated to cost the U.S. economy $20 billion annually in lost exports.
          • (“Sanctions-Happy USA,” by Gary Clyde Hufbauer, Jeffrey Schott, and Kimberly Elliott, in International Economics and International Economic Policy – A Reader, ed. by Philip King Irwin. New York: McGraw-Hill, 2000.)
      • An embargo is a prohibition on the export of specified goods to a specified country.
        • An embargo is usually a political tool intended to change particular actions or policies of the embargoed nation.
          • Examples of targeted policies include human rights violations, support of terrorists, and political oppression.
          • Countries currently or recently under U.S. embargo for some or all trade include Iran, Cuba, Sudan, Syria and North Korea.
    • The record of U.S. use of trade sanctions over the past century indicates that President Wilson’s characterization of sanctions as a “terrible remedy” has proven prophetic in ways he didn’t envision:
      • While sanctions do seem to have forced change in some instances (the most notable being the end of apartheid in South Africa), they have for the most part proven ineffective and, indeed, often inflict harm on unintended targets.
        • They inflict a high cost on the U.S. economy in lost export revenue and jobs.
        • They are often ineffective because they are aimed at totalitarian governments that aren’t responsive to world opinion.
        • Leaders of sanctioned nations prove willing to allow sanctions to inflict suffering on their people while increasing their own grip on power.
          • U.S. sanctions have helped drive down living standards in Cuba to desperate levels almost equaling those of Haiti.
    • Trade subsidies help domestic producers by allowing them to sell their products (exports) at a competitive price on the world market.
      • Political support for trade subsidies grows from the assumption (often unfounded) that protecting or fostering export industries creates jobs in the exporting country.
      • While jobs may be created in export industries, the overall impact of a subsidy is to lower the price of the product for international buyers.
        • In effect, domestic taxpayers are paying part of the price.
          • The French and British governments subsidized the development of the airbus, successfully creating airline manufacturing jobs in Europe, while providing companies world-wide with airplanes paid for, in part, by French and British tax payers.
  6.  The persistence of trade restrictions throughout history is best explained by the fact that while such policies limit the creation of wealth in general, they actually increase wealth and income for specific producers and industries.
    • Public choice theory, with its insights into the incentives created by dispersal of benefits and costs, helps us understand the resistance of public policy makers to freeing trade.
    • Current example: The NAFTA removal of tariffs on Mexican apples has increased the supply of apples in the U.S. markets, causing the price to fall.
      • While the consumers who buy more apples at lower prices are beneficiaries of the wealth created, apple growers are facing lower market prices and many fear bankruptcy.
    • The resulting situation of concentrated costs and diffuse benefits creates different incentives for producers than for consumers.
      • The relatively small number of apple growers stands to lose many thousands of dollars as a result of NAFTA tariff reductions. It should not be surprising that growers oppose NAFTA and were willing to spend time, energy, and money to make their opposition known in Washington.
      • On the other hand, a relatively large number of consumers benefits in the form of lower apple prices. However, the total benefit to any single consumer offers little incentive to organize or to dedicate time, energy, and money to lobbying for further reductions
  7. Trade Agreements – Clearing Bridges for Trade:  Trade agreements are simply reductions and/or removal of trade barriers among countries. While simple bilateral agreements are a step in the right direction, the complexities of the modern international market (see lesson 6) mean that trade organizations are necessary for significant freeing of trade.
    • Forging trade agreements is really the process of removing barriers rather than building bridges.
      • In a perfectly free-trade world, there need only be clear property rights and the rule of law for trade to occur and proliferate.
        • A long history of trade-protectionism throughout the world means that we now must engage in the process of agreeing to remove the barriers to trade that were erected in years past.
        • The best known trade organizations today are:
          • WTO, the World Trade Organization (formerly GATT, the General Agreement on Tariffs and Trade),
          • EU, the European Economic Union, and
          • NAFTA, the North American Free Trade Association.
          • WTO – The World Trade Organization
  8. The World Trade Organization (WTO) was formed from the 100 member General Agreement on Tariffs and Trade (GATT), organized in 1986.
    • In 1993, GATT reached agreements reducing tariff barriers among member nations by 40%.
    • In 1997, GATT members formed the World Trade Organization.
    • The successor organization, WTO, has much broader agreements and mandates for negotiation and the resolution of trade disputes.
      • By mid-year 2005, the WTO had 149 member nations and others were lobbying to join.
    • The broader issues of WTO debate now reach beyond tariffs to include the environment (gasoline formulas), intellectual property (software), and health (pricing of essential medicines).
      • This broader agenda has brought greater public awareness of the WTO, one result being an increase in protest against the dismantling of trade restrictions.
  9. The European Economic Union (EU), composed of the major nations of Western Europe, had removed nearly all tariffs and quotas among member nations by 1993.
      • Members of the EU in 2012 include:
        • *Countries not in the European Monetary Union. Note that a number of countries, while participating in the EU and benefiting from its freer trade, are not members of the European Monetary Union and do not use the euro or accept EU monetary policies.
    • Austria
    • Belgium
    • Bulgaria
    • Cyprus
    • Czech Republic
    • Denmark
    • Estonia
    • Finland
    • France
    • Germany
    • Greece
    • Hungary
    • Ireland
    • Italy
    • Latvia
    • Lithuania
    • Luxembourg
    • Malta
    • Netherlands
    • Poland
    • Portugal
    • Romania
    • Slovakia
    • Slovenia
    • Spain
    • Sweden
    • United Kingdom
    • Belief that EU policies were successful for all member nations led to the introduction of a common currency, the euro, and to the consolidation of monetary policy in the hands of the European Parliament and the EU Central Bank.
      • The importance of the euro lies in the reduction of transaction costs – and the consequent increase in trade – that accompanies the use of a common currency.
      • To date, the euro seems well accepted in spite of the diverse cultures and language groups of the member nations.
        • The glaring exception has been the United Kingdom, which has chosen not to be part of the monetary union because of resistance to giving up the English pound sterling and because of concern over the long-term strength of the euro.
      • European Monetary Union members hoped that the euro would prove to be stronger than the U.S. dollar, but in late 2001 (with the anticipated introduction of euro banknotes), the euro was trading at approximately 1.2 to the U.S. dollar. However, by 2006 the Euro was trading at 88 cents to the U.S. dollar
        • Despite the inevitable problems of working out cooperation between large numbers of nations, the fact that many eastern European and former Soviet Bloc countries are continuing to petition for membership is testimony that the EU is performing its function in increasing trade and wealth among its members.
  10.  The creation of NAFTA (North American Free Trade Agreement) in 1994 was an attempt to spread to Mexico the benefits that had been realized by the elimination of tariffs between the U.S. and Canada.
    • In 1989, the Canadian – U.S. Free Trade Agreement went into effect, providing for completely duty-free trade by 1998.
    • NAFTA was proposed by the Mexican government of President Carlos Salinas in 1990 to increase trade between Mexico and both the United States and Canada.
      • NAFTA has resulted in an increased volume of trade among all 3 nations, but most notably between Canada and Mexico.
        • According to the International Trade Administration, U.S. – Mexico trade increased approximately134% from 1993-2003 and U.S. – Canada trade increased about 69% in the same period.
    • The NAFTA proposal sparked a great deal of debate that continues today.
      • Because of the great disparities of wealth in the 3 nations, U.S. opponents feared the loss of jobs to the low-wage Mexican labor force.
        • In reality, the shifting of low-skill jobs to Mexico had already begun, and was likely to continue, with or without NAFTA.
          • Differences in productivity rather than trade agreements were responsible for the migration of low-skill jobs to Mexico.
        • The shifting of jobs based on productivity differences did not, and does not, result in fewer total jobs.
      • A second concern related to the belief that greater environmental damage would result from industries relocating to Mexico to escape American pollution control regulation.
        • There is no evidence that this has, in fact, taken place. Studies referenced by Michael J. Ferrantino of the International Trade Administration suggest that firms appear to move in response to labor-productivity concerns rather than to escape environmental regulation.
          • (“International Trade, Environmental Quality and Public Policy” by Michael J. Ferrantino, in International Economics and International Economic Policy – A Reader, ed. by Philip King Irwin. New York, NY: McGraw-Hill, 2000.)
        • Additionally, there is evidence that firms that do relocate take with them the technology of their home country. In effect, the host nation thus imports higher pollution standards by attracting foreign firms.
  11. The freeing of trade in the late 20th /early 21st century has not been restricted to the western hemisphere; U.S. efforts to reduce or remove trade barriers with Asian countries continue, but are often complicated by social and political issues.
    • Japan, Korea, and (increasingly) China are important U.S. trading partners.
    • Issues that add to the complexity of negotiations include:
      • patent rights – especially to intellectual property;
      • labor issues, including child labor and slavery;
      • human rights concerns; and
      • pollution and resource management issues.

Caveats and Conclusions

It is difficult to quantify exactly how much wealth has been created by international trade. Because trade encourages specialization, which in turn causes increases in productivity, some of what are referred to as gains from trade are actually gains from increased productivity. Since both trade and productivity contribute to wealth, it isn’t always clear which caused what portion of the increase. It must also be acknowledged that although international trade is freer than at any time in our history, significant barriers remain. The world is still entangled in tariffs and quotas, and currently confronts economic, environmental, cultural, and human rights issues in trying to create more bridges to the wealth that trade creates. The caveats acknowledged, it is important to emphasize that the relationship between the trend toward freer trade and the growing wealth of participating nations is both real and significant.

Lesson 2 Activities: