Unit 16

International Trade and Commercial Policy

International trade is a part of daily life. Britons drink French wine, Americans drive Japanese cars, and Russians eat American chicken. If this is unremarkable, why is there a separate branch of economics devoted to international trade? Why is trade between the UK and France different from trade between London and Birmingham?

There are two reasons. First, because international trade crosses national frontiers, governments can monitor this trade and treat it differently. It is hard to tax or regulate goods moving from London to Birmingham but much easier to impose taxes or quota restrictions on goods imported from Taiwan or Japan. Governments have to decide whether or not such policies are desirable.

Second, international trade involves the use of different national currencies. A British buyer of American wine pays in sterling but the American vineyard worker is paid in dollars. International trade involves international payments.

Countries trade with one another because they can buy foreign goods at a lower price than it costs to make the same goods at home. How can it be possible for all countries? The basis of international trade is exchange and specialization. International differences in the availability of raw materials, other factors of production such as labour, and technology, lead to international differences in production costs and goods prices. Through international exchange, countries supply the world economy with the commodities that they produce relatively cheaply and demand from the world economy the goods that are made relatively cheaply elsewhere.

International trade has been playing an increasingly important part in national economies. The industrialized countries have about two-thirds of world exports, world income, and world imports. World trade is very much organized around these countries. Half of all international trade takes place between these countries and they are also the most important export markets for LDCs. About 40 per cent of world trade is in primary products, the remaining 60 per cent in manufactures. These facts help explain some of the key issues in world trade.

LDCs worry that the industrial countries are exploiting them by buying raw materials at a low price and sending them back, in the form of manufactures, at a much higher price. Producers of coffee, sugar, copper, and many other products would like to be able to copy OPEC and triple the price of their primary products without suffering a significant reduction in the quantities demanded. The LDCs want to make their own manufactured goods and export them to the industrial countries. Brazil, Mexico, and Taiwan already have major manufacturing industries. But exports to industrial countries have led to complaints in industrial countries that jobs are being threatened by competition from cheap foreign labour.

In some industries, such as motor cars and steel, established producers in the UK, the United States, and even Germany are being undercut by efficient modern producers, especially the Japanese. Should the Japanese exports be restricted to prevent massive job losses in Western Europe and North America, or should these countries take advantage of cost reductions in Japan? These are the kind of issues that we shall be examining.

We start by showing the benefits of trade when there are international differences in the opportunity cost of goods. The opportunity cost of a good is the quantity of other goods that must be sacrificed to make one more unit of that good. The law of comparative advantage states that countries specialize in producing and exporting the goods that they produce at a lower relative cost than other countries. There are many reasons why opportunity costs or relative costs may differ in different countries. We begin with a very simple model in which technology or productivity is the source of the difference. Suppose there are two countries, the United States and the UK, producing two goods, video recorders and shirts. We pretend that labour is the only factor of production and there are constant returns to scale. It takes 30 hours of American labour to produce one video and 5 hours to produce one shirt. UK labour is less productive. It takes 60 hours of British labour to produce one video and 6 hours to produce one shirt. Notice that American unit labour requirements are absolutely lower for both goods than those in the UK. But American labour is relatively more productive in videos than in shirts. It takes twice as many labour hours to produce a video in the UK as it does in the United States but only 6/5 times as many hours to produce a shirt. And it is these relative productivity differences that are the basis for international trade. If each country concentrates on producing the good that it makes relatively cheaply, the two countries together can make more of both goods. Trade leads to a pure gain and this additional output can be shared between the two countries. Second, the free market will provide the right incentives for this beneficial trade to actually take place.

The countries are allowed to trade. Since they use different currencies, a foreign exchange market must be set up and an equilibrium exchange rate established. Regardless of a country’s domestic production costs or absolute advantage in producing goods more cheaply, there always exists an exchange rate that will allow that country to produce at least one good more cheaply than other countries when all goods are valued in a common currency. At the equilibrium exchange rate, the country must have at least one good it can export to pay for its imports.

This pattern of trade and production illustrates the law of comparative advantage. Countries specialize in producing the goods that they can make relatively cheaply. Although we noted that the United States has a lower absolute labour requirement for both goods, the relative cost of videos is lower in the United States, and the relative cost of shirts higher, than in the UK.

In the United States, where videos cost $180 and shirts $30, videos are 6 times the price of shirts. In the UK, where shirts cost 12 pounds and videos 120 pounds, videos are 10 times the price of shirts. Making videos costs less relative to shirts in the United States than it does in the UK. The opportunity cost of videos is lower in the United States, which must give up 6 shirts to make another video. Conversely, the opportunity cost of shirts is lower in the UK than in the United States. The UK must give up 1/6 of a video to make another shirt. The law of comparative advantage says that the UK will specialize in shirts, which have a low opportunity cost for UK producers, and the United States will specialize in videos, which have a low opportunity cost for US producers.

Different countries will have a comparative advantage in different goods and will tend to specialize in producing these goods for the world economy. It explains why the UK exports cars to Hong Kong and imports textile from Hong Kong. It does not explain why the UK exports cars (Rovers, Jaguars, etc.) to Germany while simultaneously importing cars (Mercedes, Audis, etc.) from Germany. Yet in practice there is a great deal of intra-industry trade, or trade in goods made within the same industry.

Of course, a Jaguar is not exactly the same commodity as Fosters lager. We are now discussing industries each making a wide range of different, and highly substitutable, products which enjoy some brand allegiance. In analyzing intra-industry trade, we must take account of three factors. First, consumers like a wide choice of brands. They don’t want to have exactly the same car or radio as everyone else. Second, there are important economies of scale. Instead of each country trying to make small quantities of each brand in each industry, it makes sense for the UK to make Jaguars, West Germany to make Mercedes, and Sweden to make Volvos, and swap them around through international trade. Third, the tendency to specialize in a particular brand, to which the demand for diversity and the possibility of scale economies gives rise, is limited by transport costs. Intra-industry trade between Germany and Sweden is likely to be larger than intra-industry trade between Germany and Japan. The more closely markets are integrated, and the lower are obstacles to trade — in terms both of distance and tariffs — the larger is the extent of intra-industry trade we expect.

Japan’s trade is substantially one-way. Primary commodities are imported and manufactures are exported. There are very few industries in which Japan is simultaneously importing and exporting. Hence the index of intra-industry trade is low for most goods.

In contrast, the European Community has a more diversified resource endowment and is a more integrated market, in which distance, information barriers, and tariffs are relatively unimportant. Intra-industry trade is extensive and the value of the index is high for most commodities. The gain from trade arises less from the exploitation of differences in relative prices across countries than from the increase in diversity and specialization in brands, with the consequent reductions in unit costs through the economies of scale that a larger international market allows.

The world economy gains when countries first begin international trade: some trade is better than no trade. But that does not mean that everything that happens in the world economy makes everyone better off. We now give two examples of the conflicts to which international trade gives rise.

At the end of the nineteenth century, the invention of refrigeration enabled Argentina to become a supplier of frozen meat to the world market. Argentina’s exports of meat, non-existent in 1900, had risen to 400,000 tons a year by 1913.

Who gained and who lost? In Argentina the entire economy was transformed. Cattle grazers and meat exporters attracted resources. Owners of cattle and land gained; other land users lost out because, with higher demand, land rents increased. Argentine consumers found their steaks becoming more expensive as meat was shipped abroad. Although Argentina’s GNP increased significantly, the benefits of trade were not equally distributed. Some people in Argentina were worse off.

In Europe and the United States, cheaper beef made consumers better off. But beef producers lost out because beef prices fell. Effects on producers of other commodities were probably small.

Refrigeration opened up the world economy to Argentinean beef producers. As a whole, the world economy gained. In principle, it would have been possible for the gainers to compensate the losers and still have something left over. But in practice, gainers do not often offer compensation to losers. So some people lost out. In this example the major losers were beef producers elsewhere in the world, and other users of land in Argentina.

The second example is the UK car industry. As recently as 1971, imports of road vehicles accounted for only 15 per cent of the domestic market while exports of road vehicles were 35 per cent of the sales of UK vehicle manufacturers. Since 1971 exports have become even more important to UK car manufacturers, chiefly because they have rapidly been losing their share of the domestic market to foreign imports from other countries such as Japan. By 1984 imports accounted for 51 per cent of the UK market for road vehicles.

UK buyers and producers of foreign cars have benefited from the increase in UK imports of cheaper foreign cars. But the Rover Group, the major UK car producer, had a tough time in the 1970s and there were massive redundancies among its workforce. In consequence, the UK government has been under pressure to restrict UK imports of cars to prevent further job losses in the car industry.

Restricting car imports to the UK would help the UK car industry but raise car prices to UK consumers of cars. Should the government heed the wishes of producers or consumers? More generally, how should we decide whether to restrict imports or have free unrestricted trade in all goods? Let’s move from positive economics, the analysis of the reasons for, and the pattern of, world trade, to normative economics, the study of how the government should choose its commercial policy. Commercial policy is government policy that influences international trade through taxes or subsidies or through direct restriction on imports and exports.

The most common type of trade restriction is a tariff or import duty. A tariff requires the importer of a good to pay a specified fraction of the world price to the government. With a 20 per cent tariff on cars and a world price of 2000 pounds, for example, a car importer would not only have to pay the foreign producer 2000 pounds but would also have to pay the government 400 pounds (0.2 times 2000 pounds). The total cost of the car to the importer would be 2400 pounds. This is the minimum price at which the importer could afford to sell the car in the domestic market. In general, if it is the tariff rate, expressed as a decimal fraction (e.g. 0.2), the domestic price of imported goods will be (1+t) times the world price of imported good.

By raising the domestic price of imports, a tariff helps domestic producers but hurts domestic consumers.

Now let’s examine some of the most frequently heard arguments in favour of tariffs. The first-best argument is a case where a tariff is the best way to achieve a given objective. Second-best arguments are cases where the policy would indeed be beneficial but where there is another policy that would be even better if only it could be implemented. If possible we should always use first-best policies, but sometimes we have to make do with second-best ones. Non-arguments are cases in which the claimed benefits are partly or completely fallacious.

Under free trade, each individual buys imports up to the point at which the benefit to that individual equals the world price the individual must pay. Since the collective cost of the last import exceeds its world price, the cost of that import to society exceedds its benefit. There are too many imports. Society will gain by restricting imports until the benefit of the last import equals its cost to society as a whole. When the tariff is set at the level required to achieve this, it is called the optimal tariff. Only when a country does not bid up the world price of its imports is the cost to society of the last unit imported equal to the world price. Then and only then is the optimal tariff zero. There is no longer any reason to discourage imports. That is the case for free trade under those circumstances.

We now introduce the principle of targeting. The principle of targeting says that the most efficient way to attain a given objective is to use a policy that influences that activity directly. Policies that attain the objective but also influence other activities are second-best because they distort these other activities. The optimal tariff is a first-best application of the principle of targeting precisely because the source of the problem is a divergence between social and private marginal costs in trade itself. That is why a tariff on trade is the most efficient solution. The arguments for tariffs that we now examine are all second-best because the original source of the problem does not directly lie in trade.

Suppose society wishes to preserve inefficient farmers or craft industries. It believes that the old way of life, or sense of community, should be preserved. Therefore it levies tariffs to protect such groups from foreign competition. But there is a cheaper way to attain this objective. A tariff helps domestic producers but also hurts domestic consumers through higher prices. A production subsidy would still keep farmers in business and, by tackling the problem directly, would avoid hurting consumers.

Some poor countries believe it is wrong to allow their few rich citizens to buy Rolls-Royces or luxury yachts when society needs its resources to stop people starving. A tariff on imports of luxuries will reduce their consumption but, by raising the domestic price, may also provide an incentive for domestic producers to use scarce resources to produce them. A consumption tax tackles the problem directly, and is a more efficient tool.

Some countries believe that, in case there is a war, it is important to preserve domestic industries that produce food or jet fighters. Again, a production subsidy rather than an import tariff is the most efficient way to meet this objective.

One of the most common arguments for a tariff is that a tariff is needed to allow infant industries to get started. Suppose there is learning by doing. Only by actually being in business will firms learn how to reduce costs and become as efficient as foreign competitors. A tariff is needed to provide protection to new or infant industries until they have mastered the business and can compete on equal terms with more experienced foreign suppliers.

Society should invest in new industries only if they are socially profitable in the long run. The long-run benefits must outweigh the initial losses during the period when the infant industry is producing at a higher cost than the goods could have been obtained through imports. But in the absence of any divergence between private and social costs or benefits, an industry will be socially profitable only if it is privately profitable.

If the industry is such a good idea in the long run, society should begin by asking why private firms can’t borrow the money to see them through the early period when they are losing out to more efficient foreign firms. If the problem is that banks or other lenders are not prepared to risk their money, society should ask whether the industry is such a good idea after all. And if the industry does make sense but there is a problem in the market for lending, the principle of targeting says that the government should intervene by lending money to private firms.

Failing this, a production subsidy during the initial years is still better than a tariff, which also penalizes consumers. And the worst outcome of all is the imposition of a permanent tariff which allows the industry to remain sheltered and less efficient than its foreign competitors long after the benefits of learning-by-doing are supposed to have been achieved.

So far, we have looked only at restrictions on imports. But countries also use commercial policy to boost exports. This can vary from outright subsidy to cheap credit or exemption from certain domestic taxes. Just as with a tariff, an export subsidy is usually a second-best policy. Even if the country did wish to increase its output of, say, computers, it would be cheaper to use a production subsidy, but avoiding the rise in the domestic price.

Notes

1. LDCs (less developed countries) — менее развитые страны;

2. primary products — профилирующие продукты;

3. manufactures — продукция обрабатывающей промышленности;

4. without suffering a significant reduction in the quantity demanded — без заметного сокращения спроса;

5. equilibrium exchange rate — валютный курс равновесия (уравновешивающий внешние расчеты страны);

6. opportunity cost (s) — альтернативные издержки, издержки неиспользованных возможностей (отражающие лучшие альтернативные возможности использования ресурсов);

7. highly substitutable — легко взаимозаменимые;

8. economies of scale — экономия, обусловленная ростом масштаба производства, эффект масштаба;

9. resource endowment — ресурсный вклад;

10. GNP (Gross National Product) — валовый национальный продукт;

11. had a tough time — переживала трудные времена;

12. heed the wishes — внимательно относиться к желаниям;

13. principle of targeting — принцип таргетинга (определения контрольных цифр, экономических ориентиров);

14. by tackling the problem directly — немедленно взявшись за решение этой проблемы;

15. suppose there is learning by doing — допустим, что нельзя научится что-то делать, не начав это делать;

16. failing this — если это сделать не удастся.