International Trade

Comparative Advantage

From David Ricardo's idea in 1817 to the steel tariffs of 2018, we're looking at why nations focus on making particular things, how tariffs mess up the market, and where the loss of potential value is hidden.

After China joined the World Trade Organization in 2001, the amount of goods China sold to the United States went from $102 billion to $399 billion in ten years. By 2006, Walmart alone was bringing in about $27 billion a year of Chinese products: electronics, clothes, toys, furniture, all at prices American companies couldn't meet. Factories making cloth in North Carolina closed, and furniture factories in Virginia did the same. Politicians from both parties wanted tariffs. But the Peterson Institute's economists figured that by 2010, the relationship with China was saving the typical American family around $850 a year because things were cheaper. While the benefits and costs aren't shared equally, the overall effect is positive, and the reason for this goes back to what David Ricardo explained in 1817.

'Absolute advantage' means one country can make something with fewer resources than another; for example, China makes more steel per hour worked than most countries. But absolute advantage doesn't decide what countries will trade. Comparative advantage does; the country with the lowest opportunity cost for a product should be the one to make it. Even if China is better at making both electronics and textiles than Vietnam, both countries will be better off if they each do what they have the lowest opportunity cost for. Vietnam's lots of cheap workers mean it doesn't have to give up as much to make textiles, while China's modern factories mean it doesn't have to give up as much to make electronics. They focus on their strengths, they trade, and the world as a whole makes more things. They both end up with a selection of goods that would have been impossible to have if they had tried to make everything themselves.

Ricardo figured all this out over two centuries ago and it's still the basic principle behind every trade question on the AP Macroeconomics exam.

Gains from Trade

Without trade, a country can only have what it makes—along its 'production possibilities curve'. No Colombian coffee for Americans, and no precision German engineering for Brazil. Economists call this 'autarky', and it's a really bad way to run an economy.

Trade breaks through that limit. Colombia has the perfect weather and height for arabica coffee beans, so it sells coffee (where its comparative advantage is huge) and buys machinery that it would only be able to make at a massive cost. Germany, with its engineering facilities, does the opposite. Both end up being able to have combinations of things that are outside of what each could have made on their own, combinations that are simply impossible when you're completely self-sufficient. The math isn't hard; when both sides willingly exchange, they both have more than they could have had if they hadn't traded.

The benefits come from focusing on what each country is best at, and moving resources towards those things. The extra stuff that's made is then divided according to the 'terms of trade' - just the price at which countries swap goods. As long as the terms of trade are between each country's own costs, both get something out of the deal. If the terms of trade match one country's costs exactly, that country doesn't benefit and the other gets all the extra value. So how the terms of trade are decided determines how the benefits are split. But trade theory says the total value available is always bigger than what either country could have produced by themselves.

Imports and Exports with World Prices

When a country lowers its trade barriers, the price of a product within that country moves closer to the global price, which is the price on international markets determined by worldwide supply and demand.

If the global price of rice, for example, is lower than the usual price in the United States, American customers can get rice from places like Thailand or Vietnam for less than from U.S. farmers. At the lower global price, Americans want to buy more rice than American farmers are willing to sell, and imports make up the difference. Because buyers are paying less, consumer surplus goes up. Domestic farmers, however, receive a lower price for less product, so their producer surplus goes down. Overall, though, total surplus increases, with the gains for consumers being larger than the losses for producers; this is the basic reason for saying free trade is efficient.

If the global price is higher than the U.S. price, things change. American soybean farmers, who are among the most efficient in the world, can sell their soybeans at that higher global price. At that price, they will produce more than American buyers want, and the extra amount will be exported. Producer surplus increases, consumer surplus decreases (Americans pay more for the product), but the total surplus still goes up, because the producer gain is greater than the consumer loss.

The horizontal teal line on the graph shows the world price. Move the slider to see how imports and exports change as the world price goes up or down in relation to the U.S. price.

Tariffs

In March 2018, President Trump imposed a 25% tax on imported steel and a 10% tax on imported aluminum, using Section 232 of the Trade Expansion Act and claiming it was for national security. The steel tax pushed the price of steel within the U.S. up, above the world market price. On the graph, the purple line illustrates this new price: the global price plus the tax on each unit.

Four things happen at the same time: domestic steel companies increase production (steel mills that couldn't compete at the world price now can, and Nucor and U.S. Steel both showed they were using more of their capacity shortly after), consumers buy less (Ford said steel would cost them an extra $1 billion in 2018, and construction and appliance companies faced similar difficulties, passing some costs to customers and reducing their profits on others), imports decrease because the amount of steel made in the U.S. and what people want to buy are closer together, and the government gets money from the tax, equal to the tax percentage multiplied by the amount of steel still being imported. You can move the tax slider on the graph to see how all four of these effects move together.

The amber triangles on the graph show deadweight loss - surplus that is completely destroyed and doesn't help anyone. Not customers, not producers, not even the government.

The triangle on the left is production-side deadweight loss. U.S. steel mills are now making steel that costs more to create than the global price at which it could have been bought. A U.S. steel plant spending $650 a ton for steel that other countries sell for $500 is wasting resources. The tax made this expensive production profitable by protecting it from competition.

The triangle on the right is consumption-side deadweight loss. Buyers who would have bought the steel at the global price aren't willing to pay the higher price (with the tax) and stop buying it altogether. A construction company that would have started a project if steel was $500 a ton now cancels it at $650. That value is simply lost.

The purple rectangle between the two triangles is the tariff revenue. This revenue is a movement of funds from consumers to the government, and isn't a loss to the economy as a whole because the money is still circulating. It can be spent or given out. But the two triangles do represent surplus that is destroyed, and isn't recovered. Economists therefore say tariffs lower the total surplus in the domestic market.

Quotas

Instead of a tax on imports, a government can simply limit the quantity. A quota is a specific, maximum number of imports allowed. In the early 1980s, the Reagan administration pushed Japan to agree to "voluntary export restraints," meaning they would limit car shipments to the United States to 1.68 million each year. Currently, the European Union still has limits (quotas) on certain farm goods coming from countries that aren't part of the EU.

Quotas and tariffs both have the same basic effect on the market: prices go up within the country, fewer goods are imported, production within the country increases, and consumers get less benefit from purchases. However, the important thing that's different is who gets the extra money. With a tariff, the government collects the difference between the price of the item in our country and the price in the rest of the world, on every item that's imported. With a quota, the people or companies who have the permission to import (the import licenses) get that extra money – this is called quota rents. The rent for each item is the difference between the higher price in our country and the world price, and when you multiply that by the number of items allowed in, that's the total rent.

If the government sold the import licenses to the highest bidder, they would get the rent, and the quota would work the same as a tariff. But usually licenses are given to companies with good political connections, and for free. This makes quotas less clear and harder for people to examine. The problem remains the same, but instead of the government getting the money, private companies do.

AP Exam Topics

On the AP Macroeconomics exam, questions about trade make up about 10-15% of the test. The most frequent topics are:

- Working out comparative advantage using a production possibilities table or how much each worker makes, and then deciding which country will sell which goods (and you will definitely have to calculate opportunity costs).
- Figuring out if a country will import or export something once trade is allowed, depending on whether the world price is higher or lower than the price within the country.
- The entire chain of effects from a tariff: how prices go up, how much is bought and sold changes, how many imports happen, how consumer and producer surplus changes, how much money the government makes, and the two deadweight loss triangles.
- Tariffs versus quotas (specifically who gets the money from them - the government or those with import licenses).
- The idea that free trade provides the most total benefit, and trade restrictions reduce it, though the way that benefit is shared between producers, consumers, and the government is different.
- Arguments for protecting industries (like helping new industries get started, national security, or stopping "dumping" – selling goods at a very low price). The AP exam considers these protections as narrow situations, not a challenge to the idea of comparative advantage.

Worked Example

Let's look at an example. In the domestic steel market, the price and amount of steel made are both 60 dollars and 50 units. Steel elsewhere in the world costs 40 dollars a unit. What happens when trade begins, and then when the government adds a 10 dollar tariff?

With free trade, at 40 dollars, people in the country want to buy 70 units of steel (because it's cheaper), but domestic steel companies will only make 30 units (many can't make a profit at that price). Imports will cover the remaining 40 units (70 minus 30). Consumers benefit from the cheaper price. Domestic steel producers sell less and make less profit. But consumers benefit more than producers lose, so overall benefit goes up compared to if we didn't trade.

If a 10 dollar tariff is added, the price in the country goes to 40 + 10 = 50 dollars. People now want to buy 60 units, and domestic steel companies will make 40 units (more can make a profit at 50 dollars). Imports are cut in half: 60 - 40 = 20 units.

The government gets 10 dollars for each of the 20 imported units, which is 200 dollars. (On a graph this would be a purple rectangle and shows money moving from consumers to the government).

Two triangles will show deadweight loss. On the production side, domestic steel companies now make steel for between 40 and 50 dollars a unit, when they could have been imported for 40 dollars. This wastes resources on making steel inefficiently. On the consumer side, buyers who would have bought at 40 dollars won't pay 50 dollars, and so won't buy, and those sales are lost.

This is the pattern for all tariff questions on the AP exam. Prices go up, domestic production increases, consumption goes down, imports decrease, the government gets money, and there are two triangles of deadweight loss.