Unit 13: International Trade

Jim’s Guide for Unit 13:  International Trade

picture of economist Henry GeorgeFree trade consists simply in letting people buy and sell as they want to buy and sell. Protective tariffs are as much applications of force as are blockading squadrons, and their objective is the same to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading.

Henry George,
Protection or Free Trade 1886


In this unit we return to the basic economic principles we studied back in the beginning in Part I. In Part I, we studied the economic problem, production possibilities, and comparative advantage. We studied how comparative advantage leads to trade, trade leads to markets, and markets are the interplay of demand and supply. In this unit, we return to these fundamental principles but we will discuss them in a new context: trade between people of different nations.

In this unit, we have this main objective: describe and analyze the concept of comparative advantage and the effects,costs, and benefits of both restricted and unrestricted international trade

“International Trade” Is Still Just Trade — Comparative Advantage Rules!

What we’re discussing and analyzing in this unit is trade that occurs between people in different countries. Such trade includes,for example, when a Japanese auto company manufactures a car in Japan but ships it and sells it to a buyer in the United States. Or when a Hollywood movie studio produces a movie but sells to broadcasters in a European or Middle-Eastern nation. Or when a company in Latin America stitches together clothing and sells it U.S. retailers such as Wal-Mart. Economists typically (and not surprisingly) call such transactions “International” trade.

International trade has always been a hot topic in politics. But, international trade is often mis-understood and perceived as being different from ordinary all-inside-this-country trading. Unfortunately, the language used by politicians and news reporters describes international trade in terms of one country trading with another country.But it’s not really this way.Actually, private households and firms in one country make deals with private households and firms in another country. Each nation, as represented by its government, is not doing the trading. In other words, America doesn’t trade with Japan, instead individual Americans make deals with Japanese individuals.

International trade is simply trade between people who live in different countries or nations. Looked at this way, we can understand the motivation to trade and the benefits from trade. It’s just like any other form of trade. Trade happens when two people negotiate an exchange that makes both of them better off. Trade is mutually beneficial (assuming the traders are acting voluntarily).

The same principle that governs trade locally governs trade internationally — comparative advantage. (if the concept of comparative advantage seems only vaguely familiar at this point, I suggest you go refer to Unit 3 for a refresher!). Economic theory teaches us that international trade is a win-win proposition – both the buyer and seller will benefit. Therefore, if we observe trade happening between people in two different countries, the people in both countries will benefit. It doesn’t matter if one country is “rich” and the other “poor”. Both benefit. Granted, one may benefit more than the other depending upon the terms of trade negotiated, but both still benefit.

What is “Free Trade”?

Economists use the term “free trade” to describe the unrestricted ability to make transactions between private parties in different countries. In other words, free trade is just the existence of a free market between people in different countries. As we saw in Unit 3, a free market and trade is based on comparative advantage and voluntary transactions — it’s simply supply and demand. Free markets coordinate the profit-seeking production of firms with the utility-maximizing needs of consumers. Of course markets perform this coordination function very efficiently through the use of prices and price changes.

Economists are generally very supportive of free trade. They support free trade not just because the theory says people benefit in countries, but also because experience validates the theory. The economic history of most countries supports the idea that free trade is, in general, a very good thing. In Europe in the 19th century, those nations that encouraged free trade with the fewest trade barriers grew the fastest. Many economic historians attribute much of the economic success of the United States in the last 220 years to America being a giant free-trade zone (the U.S. Constitution prohibits trade barriers between the states). Further evidence is attested by the Great Depression of the 1920’s and 1930’s. In The Great Depression, the economies of the large Western industrialized economies shrunk and unemployment jumped to 33% or higher. A major cause of the The Great Depression was the collapse of the world trading system in World War I with governments raising tariffs, quotas, and other barriers to trade.

Despite the track record of free trade policies, governments have historically attempted to severely restrict the ability of their people to trade with people of other countries.

Barriers to Trade: Government and Special Interests Strike Back With Tariffs and Quotas

Unfortunately, the concept of trade as being mutually beneficial is sometimes lost when the proposed exchange takes place with people in some other country rather than our own community. Because of this misunderstanding, some people oppose or try to stop international trade. We will study the arguments they use in this chapter and try to evaluate them economically. The two most common tools to restrict trade are tariffs (taxes) and quotas (quantity restrictions).

Historically, (as in long, long ago), international trade was primarily limited by the cost and inability to travel, communicate, and transport goods for long distances. For example, Marco Polo was willing to bring spices, spaghetti, and gunpowder back from China to Europe on the backs of camels and mules in the middle ages. Fresh fruits and large heavy goods couldn’t make the trip. Today, though, transport and communication is cheap, easy, and getting easier. What can economically be traded is growing. Yet, there are still often barriers to increased trade. Most of these barriers have been put in place by governments responding to the special interests and arguments of groups of people. As we saw in Units 8-11, most firms do not wish to compete. They would prefer monopoly or oligopoly to competition. Competition means lower prices and smaller economic profits. When the competition comes from firms in another country, firms often choose to lobby the government to simply restrict trade rather than try to compete.

Yet governments have also made some efforts to eliminate these barriers to trade. The most notable efforts to reduce trade barriers have the GATT and the World Trade Organization (WTO). You read about these carefully in the text.

The Nobel prize-winning economist George Stigler once remarked that the fact that tariffs and trade restrictions are still used by most countries is proof that economists have zero influence on actual policy-making. What Stigler referred to is the near-unanimous agreement among economists worldwide and of all political persuasions that trade restrictions are harmful. Unfortunately, while the elimination of all trade restrictions would undoubtedly improve the overall well-being every country that participated, it wouldn’t be a painless transition for some people. Often the people most likely to suffer immediate loss from reduced trade restrictions are the most vocal and most politically connected.

To understand the arguments for free trade better, imagine taking the arguments for & against trade restrictions and imagine them applied to trade between the United States. Imagine if each state had the power to legislate tariffs, quotas, and restrictions.California wine growers have clearly unfair advantage over the vineyards in Michigan. Maybe we should put a quota on California wines to protect the Michigan wine industry. Likewise, it would be easy to imagine Michigan implementing a protective tariff against Toyotas made in Kentucky or Nissans made in Tennessee because those states compete “unfairly” with non-union labor. It would be easy to then imagine Tennessee “retaliating” with a quota on the importation of Detroit-made vehicles. But it wouldn’t stop with cars. Tennessee would no doubt want to “punish” Michigan for attempting to keep out Tennessee vehicles and would then retaliate with a tariff or quota to restrict the sale of Michigan-made Kellogg’s cereals in Tennessee. Michigan would then retaliate with a prohibitive tariff on “imports” of country music or Jack Daniels whiskey. And on and on. The eventual outcome of such inter-state trade barriers would be to raise the prices and costs of production of most goods. It’s not even clear that there would be any more employment or more stable employment. What clearly would happen is that consumers in all states would fewer goods available and those goods would cost much more.

We Need Truth-in-Advertising for “Free” Trade

George Stigler believed economists have had no influence because trade policies don’t support what economists describe as free trade. Unfortunately, we have had a little, but not enough influence. It seems that most politicians these days want to be perceived as supporting “free trade”, whether they do or not. As a result, we have a very large number of new laws, treaties, and arrangements that are all usually called “free trade”. For example, the reduced tariff zone for the US, Mexico, and Canada is called NAFTA: the North American Free Trade Zone. And yet, NAFTA has added a large number of trade restrictions and costs to trading. In the U.S., Congress and the President often claim to be “promoting” free trade by eliminating tariffs on particular goods from particular countries, but often such “free trade agreements” also implement restrictive quotas for many goods in place of the tariffs. As usual, in politics it’s all about the “spin”, but real economic activity responds to actual legal restrictions, not political spin.

Take the Shirt (or Jeans) You Are Wearing: The Example of “Free Trade” Clothing

A good specific example is clothing. A large percentage of the everyday-clothing Americans buy and wear is assembled (sewn) in factories in Mexico, Central America, the Caribbean, or eastern Asia. These factories often use labor that is paid the equivalent of a few dollars a day. The factories are located in what are called “free trade zones” by both governments. In reality these “free trade zones” are simply factories where the local government agrees to not charge tariffs on cloth being imported from the US, as long as the stitched clothing is not charged a tariff going back to the US. An additional restriction is that the clothing made in these factories is not to be sold locally in the nations where it is being sewn. They can sew it, but they can’t buy it or wear it. US textile workers, of course, object to these arrangements since the superior productivity of US workers isn’t enough to fully overcome the difference in wages. In response to US workers’ objections (with the support of US stores & corporations), the US places quota limits on the imports of these clothing items.

The net effect of these so-called “free trade” arrangements is anything but true free trade. The quotas are always set below the quantities that US consumers buy. The same companies who produce in the US are the ones who also produce the ‘imported’ goods. In reality, the goods aren’t imports at all. They same company that shipped the cloth to Central America owned it the whole time and is the one bringing it back and selling it. The company didn’t trade with anyone. It simply opened a factory that doesn’t have to pay the same wages as it’s US factories. Yet, the company sells both the ‘imported’ and ‘US’ goods without any differentiation.

The effect of the quota hurts both US consumers and the foreign workers. Without the quota, the foreign workers’ wages would rise from the increased demand for their products. As it is, with a fixed limit on employment, workers must compete against each other for the limited jobs. Wages stay very low. In the US, consumers pay the price that is established by the marginal supply — in other words, we pay the price based on the cost of production in the US. US consumers get to pay the higher US-based price, but get the lower-cost goods in many cases. The foreign workers get to make the goods, but they don’t get paid fully for them. Where’s the difference between the lower cost and the higher price — that’s the profits that the manufacturers and stores make. Of course, persuading the politicians to implement the policies wasn’t cheap either, so they get some of it.

The bottom-line is: true free trade works in theory, and in the limited situations that meet the requirements of theory, it is a net benefit, for both rich countries and poor countries.

TIP: on a quiz or exam, you should answer according to the accepted theory of free trade!

Unfortunately, true free trade is nowhere near as common as the some believe. A significant indication of how “free trade” is actually the exception lies not only in the rules, tariffs, and treaties that governments have implemented, but also in a close look at the trading parties involved.  The reality in today’s “globalized” markets is that the majority of trade that crosses international borders is actually transactions between two corporate entities that are owned by the same corporate parent.  An example of this is an oil corporation in one country that sells crude oil to a refining company in another country, but the two companies are actually subsidiaries of the same parent global oil corporation.  Another example might be Ford Motor Company.  Ford Motor Canada makes and sells engines. It sells them to Ford Motor USA which installs them in new cars in the US. Both entities are sub-units owned and controlled by a single corporate parent: Ford Motor Co.  It is the parent company that controls quantities, prices, etc.  The apparent “trading partners” have no decision-making authority.

I believe that whether we help the world’s children should be the true litmus test of globalisation.
Gordon Brown, Chancellor of the Exchequer (now Prime Minister of the U.K.)Speech to UN General Assembly Special Session on Children 2002

To finish this unit, be sure to:

  1. Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
  2. Take a look at any tutorials, videos, or articles in Closer Look
  3. Try the practice quiz
  4. Complete the Graded assignments in your school’s Learning Management System