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15: International trade

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    Chapter 15: International trade

    In this chapter we will explore:

    15.1

    Trade in our daily lives

    15.2

    Canada in the world economy

    15.3

    Gains from trade: Comparative advantage

    15.4

    Returns to scale and dynamic gains

    15.5

    Trade barriers: Tariffs, subsidies and quotas

    15.6

    The politics of protection

    15.7

    Institutions governing trade

    15.1 Trade in our daily lives

    Virtually every economy in the modern world trades with other economies – they are what we call 'open' economies. Evidence of such openness is everywhere evident in our daily life. The world eats Canadian wheat; China exports manufactured goods to almost anywhere we can think of; and Canadians take their holidays in Florida.

    As consumers we value the choice and variety of products that trade offers. We benefit from lower prices than would prevail in a world of protectionism. At the same time there is a constant chorus of voices calling for protection from international competition: Manufacturers are threatened by production in Asia; farmers fight against the imports of poultry, beef, and dairy products; even the service sector is concerned about offshore competition from call centres and designers. In this world of competing views it is vital to understand how trade has the potential to improve the well-being of economies.

    This chapter examines the theory of international trade, trade flows, and trade policy: Who trades with whom, in what commodities, and why. In general, countries trade with one another because they can buy foreign products at a lower price than it costs to make them at home. International trade reflects specialization and exchange, which in turn improve living standards. It is cost differences between countries rather than technological differences that drive trade: In principle, Canada could supply Toronto with olives and oranges grown in Nunavut greenhouses, but it makes more sense to import them from Greece, Florida or Mexico.

    Trade between Canada and other countries differs from trade between provinces. By definition, international trade involves jumping a border, whereas most trade within Canada does not. Internal borders are present in some instances – for example when it comes to recognizing professional qualifications acquired out-of-province. In the second instance, international trade may involve different currencies. When Canadians trade with Europeans the trade is accompanied by financial transactions involving Canadian dollars and Euros. A Canadian buyer of French wine pays in Canadian dollars, but the French vineyard worker is paid in euros. Exchange rates are one factor in determining national competitiveness in international markets. Evidently, not every international trade requires currency trades at the same time – most members of the European Union use the Euro. Indeed a common currency was seen as a means of facilitating trade between member nations of the EU, and thus a means of integrating the constituent economies more effectively.

    It is important at the outset to emphasize that while trade has the potential to improve aggregate well being in the trading economies, this does not mean that every citizen will benefit; some will gain others will lose out. Buyers usually gain as a result of having a wider array of products to purchase at lower prices. Successful producers may benefit from production efficiencies associated with accessing a global supply chain, while others may be squeezed by international competition. The former may export more and employ more workers, the latter may contract and lay off employees.

    15.2 Canada in the world economy

    World trade has grown rapidly since the end of World War II, indicating that trade has become ever more important to national economies. Canada has been no exception. Canada signed the Free Trade Agreement with the US in 1989, and this agreement was expanded in 1994 when Mexico was included under the North America Free Trade Agreement (NAFTA). Imports and exports rose dramatically, from approximately one quarter to forty percent of GDP. Canada is now what is termed a very 'open' economy – one where trade forms a large fraction of total production. In early 2017, Canada and the EU signed a trade agreement - the Comprehensive Economic and Trade Agreement (CETA). Under this agreement tariffs will be phased out or reduced in most areas of trade over a several-year period. Canada also signed the Comprehensive and Progressive Agreement on Trans-Pacific Trade in 2018 that has the same objective of reducing trade barriers between 11 Pacific-Rim member states.

    Smaller economies are typically more open than large economies—Belgium and the Netherlands depend upon trade more than the United States. This is because large economies tend to have a sufficient variety of resources to supply much of an individual country's needs. The European Union is similar, in population terms, to the United States, but it is composed of many distinct economies. Some European economies are equal in size to individual American states. But trade between California and New York is not international, whereas trade between Italy and the Spain is.

    Because our economy is increasingly open to international trade, events in the world economy affect our daily lives much more than in the past. The conditions in international markets for basic commodities and energy affect all nations, both importers and exporters. For example, the prices of primary commodities on world markets increased dramatically in the latter part of the 2000s. Higher prices for grains, oil, and fertilizers on world markets brought enormous benefits to Canada, particularly the Western provinces, which produce these commodities. In contrast, by early 2015, many of these prices dropped dramatically and Canadian producers suffered as a consequence.

    The service sector accounts for more of our GDP than the manufacturing sector. As incomes grow, the demand for health, education, leisure, financial services, tourism, etc., dominates the demand for physical products. Technically, the income elasticity demand for the former group exceeds the income elasticity of demand for the latter. Internationally, while trade in services is growing rapidly, it still forms a relatively small part of total world trade. Trade in goods—merchandise trade—remains dominant, partly because many countries import unfinished goods, add some value, and re-export them. Even though the value added from such import-export activity may make just a small contribution to GDP, the gross flows of imports and exports can still be large relative to GDP. The transition from agriculture to manufacturing and then to services has been underway in developed economies for over a century. This transition has been facilitated in recent decades by the communications revolution and globalization. Globalization has seen a rapid shift in merchandise production from the developed to the developing world.

    Table 15.1 shows the patterns of Canadian merchandise trade in 2018. The US is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of imports. Table 15.2 details exports and imports by type. Although exports of resource-based products account for only about 40 percent of total merchandise exports, Canada is still viewed as a resource-based economy. This is in part because manufactures account for almost 80 percent of US and European merchandise exports and about 60 percent of Canadian exports. Nevertheless, Canada has important strength in machinery, equipment, and automotive products.

    Table 15.1 Canada's Merchandise Trade Patterns 2018
    Country Exports to Imports from
    United States 73.9 64.4
    European Union 7.9 10.5
    China 5.0 7.6
    Mexico 1.6 3.4
    Others 11.6 14.1
    Total 100 100
    Dollar Total 585,255.7 607,205.4
    Source: Adapted from Statistics Canada Table 12-10-0011-01
    Table 15.2 Canadian Trade by Merchandise Type 2017
    Sector Exports Imports
    Farm, fishing, and intermediate food products 6.5 3.0
    Energy products 20.5 5.5
    Metal ores and non-metallic minerals 3.8 2.3
    Metal and non-metallic mineral products 11.9 7.6
    Basic and industrial chemical, plastic and rubber products 6.6 8.5
    Forestry products and building and packaging materials 8.5 4.4
    Industrial machinery, equipment and parts 5.3 9.7
    Electronic and electrical equipment and parts 3.5 11.8
    Motor vehicles and parts 16.3 20.0
    Aircraft and other transportation equipment and parts 3.7 3.7
    Consumer Goods 12.3 21.9
    Special transactions trade 1.1 1.6
    Total 100 100
    Total dollar value in millions 500,892.6 561,425.9
    Source: Adapted from Statistics Canada Table 12-10-0002-01

    15.3 The gains from trade: Comparative advantage

    In the opening chapter of this text we emphasized the importance of opportunity cost and differing efficiencies in the production process as a means of generating benefits to individuals through trade in the marketplace. The simple example we developed illustrated that, where individuals differ in their efficiency levels, benefits can accrue to each individual as a result of specializing and trading. In that example it was assumed that individual A had an absolute advantage in producing one product and that individual Z had an absolute advantage in producing the second good. This set-up could equally well be applied to two economies that have different efficiencies and are considering trade, with the objective of increasing their consumption possibilities. Technically, we could replace Amanda and Zoe with Argentina and Zambia, and nothing in the analysis would have to change in order to illustrate that consumption gains could be attained by both Argentina and Zambia as a result of specialization and trade.

    Remember: The opportunity cost of a good is the quantity of another good or service given up in order to have one more unit of the good in question.

    So, let us now consider two economies with differing production capabilities, as illustrated in Figures 15.1 and 15.2. In this instance it is assumed that one economy has an absolute advantage in both goods, but the degree of that advantage is greater in one good than the other. In international trade language, there exists a comparative advantage as well as an absolute advantage. It is frequently a surprise to students that this situation has the capacity to yield consumption advantages to each economy, even though one is absolutely more efficient in producing both of the goods. This is termed the principle of comparative advantage, and it states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies. This is a remarkable result, and much less intuitive than the principle of absolute advantage. We explore it with the help of the example developed in Figures 15.1 and 15.2.

    Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.

    We will name these two imaginary economies the US and Canada. Their production possibilities are defined by the PPFs in Figure 15.1. Canada can produce 5 units of V or 35 units of F, or any combination defined by the line joining these points. With the same resources the US can produce 8V or 40F, or any combination defined by its PPF1. With no trade, Canadians and Americans consume a combination of the goods defined by some point on their respective PPFs. The opportunity cost of a unit of V in Canada is 7F (the slope of Canada's PPF is 5/35=1/7). In the US the opportunity cost of one unit of V is 5F (slope is 8/40=1/5). In this set-up the US is more efficient in producing V than F relative to Canada, as reflected by the opportunity costs. Hence we say that the US has a comparative advantage in the production of V and that Canada has therefore a comparative advantage in producing F.

    Figure 15.1 Comparative advantage – production
    img477.png
    Canada specializes completely in Fish at 35, where it has a comparative advantage. Similarly, the US specializes in Vegetable at 8. They trade at a rate of 1:6. The US trades 3V to Canada in return for 18F.

    Prior to trade each economy is producing all of the goods it consumes. This no-trade state is termed autarky.

    Autarky denotes the no-trade situation.

    The gains from trade

    We now permit each economy to specialize in producing where it has a comparative advantage. So Canada specializes completely by producing 35F and the US produces 8V. Having done this the economies must now agree on the terms of trade. The terms of trade define the rate at which the two goods will trade post-specialization. Let us suppose that a bargaining process leads to agreement that one unit of V will trade for six units of F. Such a trading rate, one that lies between the opportunity costs of each economy, benefits both economies. This exchange rate lies between Canada's opportunity cost of 1:7 and the US opportunity cost of 1:5. By specializing in F, Canada can now obtain an additional unit of V by sacrificing six units of F, whereas pre-trade it had to sacrifice seven units of F for a unit of V. Technically, by specializing in F and trading at a rate of 1:6 Canada's consumption possibilities have expanded and are given by the consumption possibility frontier (CPF) illustrated in Figure 15.2. The consumption possibility frontier defines what an economy can consume after production specialization and trade.

    Figure 15.2 Comparative advantage – consumption
    img478.png
    Post specialization the economies trade 1V for 6F. Total production is 35F plus 8V. Hence one consumption possibility would be (18,5) for the US and (17,3) for Canada. Here Canada exchanges 18F in return for 3V.

    The US also experiences an improved set of consumption possibilities. By specializing in V and trading at a rate of 1:6 its CPF lies outside its PPF and this enables it to consume more than in the pre-specialization state, where its CPF was defined by its PPF.

    Evidently, the US and Canada CPFs are parallel since they trade with each other at the same rate: If Canada exports six units of F for every unit of V that it imports from the US, then the US must import the same six units of F for each unit of V it exports to Canada. The remarkable outcome here is that, even though one economy is more efficient in producing each good, specialization still leads to gains for both economies. The gain is illustrated by the fact that each economy's consumption possibilities lie outside of its production possibilities2.

    Terms of trade define the rate at which the goods trade internationally.

    Consumption possibility frontier defines what an economy can consume after production specialization and trade.

    Comparative advantage and factor endowments

    A traditional statement of why comparative advantage arises is that economies have different endowments of the factors of production – land, capital and labour endowments differ. A land endowment that facilitates the harvesting of grain (Saskatchewan) or the growing of fruit (California) may be innate to an economy. We say that wheat production is land intensive, that aluminum production is power intensive, that research and development is skill intensive, that auto manufacture is capital intensive, that apparel is labour intensive. Consequently, if a country is well endowed with some particular factors of production, it is to be expected that it will specialize in producing goods that use those inputs. A relatively abundant supply or endowment of one factor of production tends to make the cost of using that factor relatively cheap: It is relatively less expensive to produce clothing in China and wheat in Canada than the other way around. This explains why Canada's Prairies produce wheat, why Quebec produces aluminum, why Asia produces apparel. But endowments can evolve.

    How can we explain why Switzerland specializes in watches, precision instruments, and medical equipment, while Vietnam specializes in rice, tourism and manufactured goods and components? Evidently, Switzerland made a decision to educate its population and invest in the capital required to produce these goods. It was not naturally endowed with these skills, in the same way that Greece is endowed with sun or Saskatchewan is endowed with fertile flat land.

    While we have demonstrated the principle of comparative advantage using a two-good example (since we are constrained by the geometry of two dimensions), the conclusions carry over to the case of many goods. Furthermore, the principle has many applications. For example, if one person in the household is more efficient at doing all household chores than another, there are still gains to specialization provided the efficiency differences are not all identical. This is the principle of comparative advantage at work in a microcosm.

    Application Box 15.1 The one hundred mile diet

    In 2005 two young British Columbians embarked on what has famously become known as the 'one hundred mile diet'—a challenge to eat and drink only products grown within this distance of their home. They succeeded in doing this for a whole year, wrote a book on their experience and went on to produce a TV series. They were convinced that such a project is good for humanity, partly because they wrapped up ideas on organic farming and environmentally friendly practices in the same message.

    Reflect now on the implications of this superficially attractive program: If North Americans were to espouse this diet, it would effectively result in the closing down of the midwest of the Continent. From Saskatchewan to Kansas, we are endowed with grain-producing land that is the envy of the planet. But since most of this terrain is not within 100 miles of any big cities, these deluded advocates are proposing that we close up the production of grains and cereals exactly in those locations where such production is extraordinarily efficient. Should we sacrifice grains and cereals completely in this hemisphere, or just cultivate them on a hillside close to home, even if the resulting cultivation were to be more labour and fuel intensive? Should we produce olives in greenhouses in Edmonton rather than importing them from the Mediterranean, or simply stop eating them? Should we sacrifice wine and beer in North Battleford because insufficient grapes and hops are grown locally?

    Would production in temperate climates really save more energy than the current practice of shipping vegetables and fruits from a distance—particularly when there are returns to scale associated with their distribution? The 'one hundred mile diet' is based on precepts that are contrary to the norms of the gains from trade. In its extreme the philosophy proposes that food exports be halted and that the world's great natural endowments of land, water, and sun be allowed to lie fallow. Where would that leave a hungry world?

    Table 15.1 shows the patterns of Canadian merchandise trade in 2008. The United States was and still is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of Canadian imports. Table 15.2 details exports by type. Although exports of resource-based products account for only about 40 percent of total exports, Canada is now viewed as a resource-based economy. This is in part because manufactured products account for almost 80 percent of US and European exports but only about 60 percent of Canadian exports. Nevertheless, Canada has important export strength in machinery, equipment, and automotive products.

    15.4 Returns to scale and dynamic gains from trade

    The theory of comparative advantage explains why economies should wish to trade. The theory is based upon the view that economies are 'inherently' different in their production capabilities. But trade is influenced by more than these differences. We will explore how returns to scale may be exploited to generate benefits from trade, and also how economies might gain from one-another by learning as a result of trading. This learning can increase domestic productivity.

    Returns to scale

    One of the reasons Canada signed the North America Free trade Agreement (NAFTA) was that economists convinced the Canadian government that a larger market would enable Canadian producers to be even more efficient than in the presence of trade barriers. Rather than opening up trade in order to take advantage of existing comparative advantage, it was proposed that efficiencies would actually increase with market size. This argument is easily understood in terms of increasing returns to scale concepts that we developed in Chapter 8. Essentially, economists suggested that there were several sectors of the Canadian economy that were operating on the downward sloping section of their long-run average cost curve.

    Increasing returns are evident in the world market place as well as the domestic marketplace. Witness the small number of aircraft manufacturers—Airbus and Boeing are the world's two major manufacturers of large aircraft. Enormous fixed costs—in the form of research, design, and development—or capital outlays frequently result in decreasing unit costs, and the world marketplace can be supplied at a lower cost if some specialization can take place. Facebook is the giant in social media. Entertainment streaming companies like Netflix, Amazon, Disney and Hulu are few in number because of scale economies. Consider the specific example of automotive trade. In North America, Canadian auto plants produce different vehicle models than their counterparts in the US. Canada exports some models of a given manufacturer to the United States and imports other models. This is the phenomenon of intra-industry trade and intra-firm trade. How can we explain these patterns?

    Intra-industry trade is two-way international trade in products produced within the same industry.

    Intra-firm trade is two-way trade in international products produced within the same firm.

    In the first instance, intra-industry trade reflects the preference of consumers for a choice of brands; consumers do not all want the same vehicle, or the same software, or the same furnishings. The second element to intra-industry trade is that increasing returns to scale characterize many production processes. Let us see if we can transform the returns to scale ideas developed in earlier chapters into a production possibility framework.

    Figure 15.3 Intra industry trade
    img479.png
    Hunda can produce either 100,000 of each vehicle or 40,000 of both in each plant. Hence production possibilities are given by the points A, Z, and B. Pre-trade it produces at Z in each economy due to trade barriers. Post-trade it produces at A in one economy and B in the other, and ships the vehicles internationally. Total production increases from 160,000 to 200,000 using the same resources.

    Consider the example presented in Figure 15.3, where the hypothetical company Hunda Motor Corporation currently has a large assembly plant in each of Canada and the US where it produces two types of vehicles; sedans and sports utility vehicles (SUVs). Intially, restrictions on trade in automobiles, in the form of tariffs, between the two countries make it too costly to ship models across the border. Hence Hunda produces both sedans and SUVs in each plant. But for several reasons, switching between model production is costly and results in reduced output. Hunda can produce 40,000 vehicles of each type per annum in its plants, but could produce 100,000 of a single model in each plant, using the same amount of capital and labour. This is a situation of increasing returns to scale, and in this instance the scale economies are what make gains from trade possible - as opposed to any innate comparative advantage between the economies. If trade barriers against the shipment of autos across national boundaries can be eliminated, then Hunda can take advantage of scale economies in each plant and increase its total production without using more capital and labour.

    As this example implies, an opening up of trade increases the potential market size, and producers who experience increasing returns to scale stand to benefit from an enlarged market because their potential unit costs fall. Returns to scale are not limited to finished goods. Returns to scale characterize the production of many intermediate goods, which are goods used to produce other final goods or services. Manufacturers rarely produce all of the components entering their final products; they have supply chains for components that comprise numerous suppliers. In the automotive industry transmissions, gearboxes and seats are such intermediate goods. If either returns to scale, or comparative advantage, characterize their supply then there are gains to trade in these goods. In the context of the North American Free Trade Agreement (NAFTA). and its most recent form (the US Mexico and Canada Agreement - USMCA), automotive parts as well as automobiles can be shipped free of tariffs across borders provided that they satisfy regional value content (RVC) rules. We observe, for example, transmissions being produced in Ontario and seats in Mexico, and these goods are also shipped freely within North America provided they satisfy the RVC rules. Scale economies characterize transmission manufacture, and comparative advantage characterizes seat production – labour costs are lower in Mexico, and seats are labor intensive.

    Content requirements apply to some goods under the NAFTA/USMCA. In the case of vehicles and their components, NAFTA required a 62.5% regional value content - that is, to be imported into one of the NAFTA signatories free of tariffs, 62.5% of the vehicle value had to be attributable to production in one of the three economies. This requirement was designed to prevent the members from using an excessive amount of components from low-wage economies and thereby undermine production of parts and vehicles in North America. The USMCA raises (by the year 2023) the regional value component (RVC) to 75% for most vehicles (70% for heavy trucks), and the RVC to between 65% and 75% on vehicle parts.

    Supply chain: denotes the numerous sources for intermediate goods used in producing a final product

    Intermediate good: one that is used in the production of final output

    Regional value content: requires that a specified percentage of the final value of a product originate in the economies covered in the Agreement.

    Dynamic gains from trade

    The term dynamic gains denotes the potential for domestic producers to increase productivity as a result of competing with, and learning from, foreign producers.

    Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.

    Production processes in reality are seldom static. Innovation is constant in the modern world, and innovation is manifested in the form of productivity improvements. An economy's production possibility frontier is determined by its endowments of capital and labour and also the efficiency with which it uses those productive factors. Total factor productivity defines how efficiently the factors of production are combined. Research suggests that in developed economies this productivity increases by about 1% per annum. This means that more output can be produced using the same amounts of capital and labour because production is being carried out more efficiently. In graphical terms, such productivity improvements effectively push out an economy's production possibility frontier by 1% per annum. For economies in the process of development, this productivity growth may be as high as 3% or 4% per annum – for the reason that these economies can observe and learn from economies that are ahead of it technologically.

    Freer trade forces domestic firms to compete with foreign firms that may be more productive. Domestic firms that can learn and adapt to competition by becoming more efficient will survive, firms that cannot adapt will not. Inevitably, there will be winners and losers in the production sector of the economy, whereas in the consumption sector most consumers should be winners.

    Total factor productivity: a measure of how efficiently the factors of production are combined.

    15.5 Trade barriers: Tariffs, subsidies and quotas

    Despite the many good arguments favoring free or relatively free trade, we observe numerous trade barriers. These barriers come in several forms. A tariff is a tax on an imported product that is designed to limit trade and generate tax revenue. It is a barrier to trade. An import quota is a limitation on imports; other non-tariff barriers take the form of product content requirements, and subsidies. By raising the domestic price of imports, a tariff helps domestic producers but hurts domestic consumers. Quotas and other non-tariff barriers have similar impacts.

    A tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue.

    A quota is a quantitative limit on an imported product.

    A trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.

    Non-tariff barriers, such as product content requirements, limit the gains from trade.

    Application Box 15.2 Tariffs – the national policy of J.A. MacDonald

    In Canada, tariffs were the main source of government revenues, both before and after Confederation in 1867 and up to World War I. They provided 'incidental protection' for domestic manufacturing. After the 1878 federal election, tariffs were an important part of the National Policy introduced by the government of Sir John A. MacDonald. The broad objective was to create a Canadian nation based on east-west trade and growth.

    This National Policy had several dimensions. Initially, to support domestic manufacturing, it increased tariff protection on foreign manufactured goods, but lowered tariffs on raw materials and intermediate goods used in local manufacturing activity. The profitability of domestic manufacturing improved. But on a broader scale, tariff protection, railway promotion, Western settlement, harbour development, and transport subsidies to support the export of Canadian products were intended to support national economic development. Although reciprocity agreements with the United States removed duties on commodities for a time, tariff protection for manufactures was maintained until the GATT negotiations of the post-World War II era.

    Tariffs

    Figure 15.4 describes how tariffs operate. We can think of this as the Canadian wine market—a market that is heavily taxed in Canada. The world price of Cabernet Sauvignon is, let us say, $10 per bottle, and this is shown by the horizontal world supply curve at that price. To maintain simplicity, we will neglect any taxes on alcohol here other than the tax represented by the tariff. The international supply curve is horizontal because the domestic market accounts for only a small part of the world demand for wine: we are sufficiently small that international producers can supply us with any amount we wish to buy at the world price. The Canadian demand for this wine is given by the demand curve D, and Canadian suppliers have a supply curve given by S (Canadian Cabernet is assumed to be of the same quality as the imported variety in this example). The effective supply curve in the Canadian market is now BCM. At a price of $10, Canadian consumers wish to buy img480.png litres, and domestic producers wish to supply img481.png litres. The gap between domestic supply img481.png and domestic demand img480.png is filled by imports. This is the free trade equilibrium.

    Figure 15.4 Tariffs and trade
    img482.png
    At a world price of $10 the domestic quantity demanded is QD. Of this amount Qs is supplied by domestic producers and the remainder by foreign producers. A tariff increases the world price to $12. This reduces demand to img483.png; the domestic component of supply increases to img484.png. Of the total loss in consumer surplus (LFGJ), tariff revenue equals EFHI, increased surplus for domestic suppliers equals LECJ, and the deadweight loss is therefore the sum of the triangular areas CEI and HFG.

    If the government now imposes a 20 percent tariff on imported wines (or a $2 per bottle tax), foreign wine sells for $12 a bottle, inclusive of the tariff. The effective supply curve in the Canadian market becomes BEK. The tariff raises the domestic 'tariff-inclusive' price above the world price, and this shifts the international supply curve of this wine upwards. By raising wine prices in the domestic market, the tariff protects domestic producers by raising the domestic price at which imports become competitive. Those domestic suppliers who were previously not quite competitive at a global price of $10 are now competitive. The total quantity demanded falls from QD to img483.png at the new equilibrium F. Domestic producers supply the amount img485.png and imports fall to the amount img486.png. Reduced imports are partly displaced by those domestic producers who can supply at prices between $10 and $12. Hence, imports fall both because total consumption falls and because domestic suppliers can displace some imports under the protective tariff; the amount img487.png.

    Since the tariff is a type of tax, its impact in the market depends upon the elasticities of supply and demand, (as illustrated in Chapters 4 and 5). The more elastic is the demand curve, the more a given tariff reduces imports. In contrast, if it is inelastic the quantity of imports declines less.

    Costs and benefits of a tariff

    The costs of a tariff come from the higher price to consumers, but this is partly offset by the tariff revenue that goes to the government. This tariff revenue is a benefit and can be redistributed to consumers or spent on goods from which consumers derive a benefit. But there are also efficiency costs associated with tariffs—deadweight losses, as we call them. These are the real costs of the tariff, and they arise because the marginal cost of production does not equal the marginal benefit to the consumer. Let us see how these concepts apply with the help of Figure 15.4.

    Consumer surplus is the area under the demand curve and above the equilibrium market price. It represents the total amount consumers would have been willing to pay for the product, but did not have to pay, at the equilibrium price. It is a measure of consumer welfare. The tariff raises the market price and reduces this consumer surplus by the amount LFGJ. This area measures by how much domestic consumers are worse off as a result of the price increase caused by the tariff. But this is not the net loss for the whole domestic economy, because the government obtains some tax revenue and domestic producers get more revenue and profit.

    Government revenue accrues from the domestic sales of imports. On imports of img488.png, tax revenue is EFHI. Then, domestic producers obtain an additional profit of LECJ—the excess of additional revenue over their cost per additional bottle. If we are not concerned about who gains and who loses, then there is a net loss to the domestic economy equal to the areas CEI and HFG.

    The area HFG is the consumer side measure of deadweight loss. At the quantity img483.png, the production cost of an additional bottle is less than the value placed on it by consumers; and, by not having those additional bottles supplied, consumers forgo a potential gain. The area CEI tells us that when supply by domestic higher-cost producers is increased, and supply of lower-cost foreign producers is reduced, the corresponding resources are not being used efficiently. The sum of the areas CEI and HFG is therefore the total deadweight loss of the tariff.

    In the real world we should also be interested in the magnitude of the financial amounts involved here: In particular, how much more do consumers pay with the tariff in place, relative to the additional amounts going to domestic suppliers/corporations? How much tax revenue is generated? How many jobs are created domestically as a result of 'distorting' the market? Regardless of the magnitude of the two deadweight loss areas, which represent the net cost of the tariff, we should be interested in whether the owners of capital gain at the expense of consumers.

    Tariffs by country of origin - trade diversion

    The imposition of tariffs is governed by the World Trade Organization (WTO). Tariffs are permitted under the WTO rules in specific circumstances: if a particular economy is deemed to be subsidizing exports, and those exports have employment impacts on the destination economy, then a 'retaliatory' tariff may be imposed. A related justification is dumping. It is frequently difficult to prove subsidization or dumping by an exporting economy. An example of such a tariff was one placed by the US on washing machines originating in China in 2016, on the basis of a dumping claim by the United States. The immediate result of this was that the manufacturers located in China switched most of their production to other plants they owned in Vietnam and Thailand. In this particular instance there was virtually no impact on the retail price of washing machines in the US.

    Dumping is a predatory practice, based on artificially low costs aimed at driving out domestic producers.

    The traditional theory of tariffs described in 15.4 implicitly assumes that production and employment increase in the importing economy as a result of domestic production displacing imported goods. This analysis assumes that the tariff is imposed on a particular commodity, regardless of its economy of origin.

    Production subsidies

    Figure 15.5 illustrates the effect of a subsidy to a domestic supplier. As in Figure 15.4, the amount QD is demanded in the free trade equilibrium and, of this, QS is supplied domestically. With a subsidy per unit of output sold, the government can reduce the supply cost of the domestic supplier, thereby shifting the supply curve downward from S to img137.png. In this illustration, the total quantity demanded remains at QD, but the domestic share increases to img485.png.

    Figure 15.5 Subsidies and trade
    img489.png
    With a world supply price of P, a domestic supply curve S, and a domestic demand D, the amount QD is purchased. Of this, Qs is supplied domestically and (QDQs) by foreign suppliers. A per-unit subsidy to domestic suppliers shifts their supply curve to img137.png, and increases their market share to img484.png.

    The new equilibrium represents a misallocation of resources. When domestic output increases from QS to img485.png, a low-cost international producer is being replaced by a higher cost domestic supplier; the domestic supply curve S lies above the international supply curve P in this range of output.

    Note that this example deals with a subsidy to domestic suppliers who are selling in the domestic market. It is not a subsidy to domestic producers who are selling in the international market – an export subsidy.

    This subsidy comes with a cost to the domestic economy: Taxpayers-at-large must pay higher taxes to support this policy; and each dollar raised in tax itself has a deadweight loss, as we examined in Chapter 5.

    Quotas

    A quota is a limit placed upon the amount of a good that can be imported. Consider Figure 15.6, where again there is a domestic supply curve coupled with a world price of P. Rather than imposing a tariff, the government imposes a quota that restricts imports to a physical amount denoted by the distance quota on the quantity axis. The supply curve facing domestic consumers then has several segments to it. First it has the segment RC, reflecting the fact that domestic suppliers are competitive with world suppliers up to the amount C. Beyond this output, world suppliers can supply at a price of P, whereas domestic suppliers cannot compete at this price. Therefore the supply curve becomes horizontal, but only up to the amount permitted under the quota—the quantity CU corresponding to quota. Beyond this amount, international supply is not permitted and therefore additional amounts are supplied by the (higher cost) domestic suppliers. Hence the supply curve to domestic buyers becomes the supply curve from the domestic suppliers once again.

    Figure 15.6 Quotas and trade
    img490.png
    At the world price P, plus a quota, the supply curve becomes RCUV. This has three segments: (i) domestic suppliers who can supply below P; (ii) quota; and (iii) domestic suppliers who can only supply at a price above P. The quota equilibrium is at T, with price img491.png and quantity img483.png; the free-trade equilibrium is at G. Of the amount img483.png, quota is supplied by foreign suppliers and the remainder by domestic suppliers. The quota increases the price in the domestic market.

    The resulting supply curve yields an equilibrium quantity img492.png. There are several features to note about this equilibrium. First, the quota pushes the domestic price above the world price (img491.png is greater than P) because low-cost international suppliers are partially supplanted by higher-cost domestic suppliers. Second, if the quota is chosen 'appropriately', the same domestic market price could exist under the quota as under the tariff in Figure 15.4. Third, in contrast to the tariff case, the government obtains no tax revenue from the quotas. The higher market price under a quota means that the price per unit received by foreign suppliers is now img491.png rather than P. De facto, instead of tax revenue being generated in the importing economy, the foreign supplier benefits from a higher price. Fourth, inefficiencies are associated with the equilibrium at img492.png. These inefficiencies arise because the lower-cost international suppliers are not permitted to supply the amount they would be willing to supply at the quota-induced market equilibrium. In other words, more efficient producers are being squeezed out of the market by quotas that make space for less-efficient producers.

    Application Box 15.3 Cheese quota in Canada

    In 1978 the federal government set a cheese import quota for Canada at just over 20,000 tonnes. This quota was implemented initially to protect the interests of domestic suppliers. Despite a strong growth in population and income in the intervening decades, the import quota has remained unchanged. The result is a price for cheese that is considerably higher than it would otherwise be. The quotas are owned by individuals and companies who have the right to import cheese. The quotas are also traded among importers, at a price. Importers wishing to import cheese beyond their available quota pay a tariff of about 250 percent. So, while the consumer is the undoubted loser in this game, who gains?

    First the suppliers gain, as illustrated in Figure 15.6. Canadian consumers are required to pay high-cost domestic producers who displace lower-cost producers from overseas. Second, the holders of the quotas gain. With the increase in demand for cheese that comes with higher incomes, the domestic cheese price increases over time and this in turn makes an individual quota more valuable.

    In the 2018 United States Mexico Canada Agreement, a slight increase in access to Canadian markets was granted in return for a corresponding increase in access to the US market.

    15.6 The politics of protection

    Objections to imports are frequent and come from many different sectors of the economy. In the face of the gains from trade which we have illustrated in this chapter, why do we observe such strong opposition to imported goods and services?

    Structural change and technology

    In a nutshell the answer is that, while consumers in the aggregate gain from the reduction of trade barriers, and there is a net gain to the economy at large, some individual sectors of the economy lose out. Not surprisingly the sectors that will be adversely affected are vociferous in lodging their objections. Sectors of the economy that cannot compete with overseas suppliers generally see a reduction in jobs. This has been the case in the manufacturing sector of the Canadian and US economies in recent decades, as manufacturing and assembly has flown off-shore to Asia and Mexico where labour costs are lower. Domestic job losses are painful, and frequently workers who have spent decades in a particular job find reemployment difficult, and rarely get as high a wage as in their displaced job.

    Such job losses are reflected in calls for tariffs on imports from China, for example, in order to 'level the playing field' – that is, to counter the impact of lower wages in China. Of course it is precisely because of lower labour costs in China that the Canadian consumer benefits.

    In Canada we deal with such dislocation first by providing unemployment payments to workers, and by furnishing retraining allowances, both coming from Canada's Employment Insurance program. While such support does not guarantee an equally good alternative job, structural changes in the economy, due to both internal and external developments, must be confronted. For example, the information technology revolution made tens of thousands of 'data entry' workers redundant. Should producers have shunned the technological developments which increased their productivity dramatically? If they did, would they be able to compete in world markets?

    While job losses feature heavily in protests against technological development and freer trade, most modern economies continue to grow and create more jobs in the service sector than are lost in the manufacturing sector. Developed economies now have many more workers in service than manufacture. Service jobs are not just composed of low-wage jobs in fast food establishments – 'Mcjobs', they are high paying jobs in the health, education, legal, financial and communications sectors of the economy.

    Successful lobbying and concentration

    While efforts to protect manufacture have not resulted in significant barriers to imports of manufactures, objections in some specific sectors of the economy seem to be effective worldwide. One sector that stands out is agriculture, where political conditions are conducive to the continuance of protection and what is called 'supply management' – domestic production quotas. The reason for 'successful' supply limitation appears to rest in the geographic concentration of potential beneficiaries of such protection and the scattered beneficiaries of freer trade on the one hand, and the costs and benefits of political organization on the other: Farmers tend to be concentrated in a limited number of rural electoral ridings and hence they can collectively have a major impact on electoral outcomes. Second, the benefits that accrue to trade restriction are heavily concentrated in the economy – keep in mind that about two percent of the population lives on farms, or relies on farming for its income. By contrast the costs on a per person scale are small, and are spread over the whole population. Thus, in terms of the costs of political organization, the incentives for consumers are small, but the incentives for producers are high.

    In addition to the differing patterns of costs and benefits, rural communities tend to be more successful in pushing trade restrictions based on a 'way-of-life' argument. By permitting imports that might displace local supply, lobbyists are frequently successful in convincing politicians that long-standing way-of-life traditions would be endangered, even if such 'traditions' are accompanied by monopolies and exceptionally high tariffs.

    Valid trade barriers: Infant industries and dumping?

    An argument that carries both intellectual and emotional appeal to voters is the 'infant industry' argument. It goes as follows: New ventures and sectors of the economy may require time before that can compete internationally. Scale economies may be involved, for example, and time may be required for producers to expand their scale of operation, at which time costs will have fallen to international (i.e. competitive) levels. In addition, learning-by-doing may be critical in more high-tech sectors and, once again, with the passage of time costs should decline for this reason also.

    The problem with this stance is that these 'infants' have insufficient incentive to 'grow up' and become competitive. A protection measure that is initially intended to be temporary can become permanent because of the potential job losses associated with a cessation of the protection to an industry that fails to become internationally competitive. Furthermore, employees and managers in protected sectors have insufficient incentive to make their production competitive if they realize that their government will always be there to protect them.

    In contrast to the infant industry argument, economists are more favourable to restrictions that are aimed at preventing dumping.

    Dumping may occur either because foreign suppliers choose to sell at artificially low prices (prices below their break-even price for example), or because of surpluses in foreign markets resulting from oversupply. For example, if, as a result of price support in its own market, a foreign government induced oversupply in butter and it chose to sell such butter on world markets at a price well below the going ('competitive') world supply price, such a sale would constitute dumping. Alternatively, an established foreign supplier might choose to enter our domestic market by selling its products at artificially low prices, with a view to driving domestic competition out of the domestic market. Having driven out the domestic competition it would then be in a position to raise prices. This is predatory pricing as explored in the last chapter. Such behaviour differs from a permanently lower price on the part of foreign suppliers. This latter may be welcomed as a gain from trade, whereas the former may generate no gains and serve only to displace domestic labour and capital.

    Protectionism in the age of pandemics

    The year 2020 will be remembered in history as the year of the coronavirus pandemic. An uncountable number of men and women died all across the globe as a result of contracting COVID-19, the respiratory disorder brought on by an attack of the coronavirus. In the absence of a vaccine, health authorities the world over implemented a twin policy of social distancing and quarantining (or self-isolation). The world economy went into a tailspin, as huge fractions of the labor force were laid off. Trade patterns were disrupted and serious shortages of personal protection equipment (PPE - masks, visors, gowns), ventilators and drugs emerged. The world demand for PPE and ventilators skyrocketed. But the production of PPE was concentrated in China; most western economies did not have the necessary productive capacity to supply even non-pandemic requirements. Bidding wars erupted amongst countries and hospitals as they vied for supply, while domestic producers of some products added to their production capacity.

    Following this chaos, we ask if self-sufficiency would not be a better model than open trade. Would a world where each country ensured it had the production capacity to produce these necessities in times of emergency not be superior to one where global supply chains characterize everything from computers to generic drugs? India is a major producer of generic drugs and the components for such drugs. The demand for anti-biotics and pain killers also rocketed upwards with the pandemic.

    There is more than one way to plan for a pandemic, and such planning should not involve a generalized move to self-sufficiency on the part of the global economy. One strategy is to build up inventories of PPE and ventilators domestically. This is costly, but for the most part feasible. It does not represent a complete solution because technology changes will make 30-year old ventilators sitting in inventory redundant for the next pandemic. In addition, most medications have a limited shelf life. Hence one solution is to maintain and rotate substantial inventories of emergency equipment using existing supply chains, and benefit from the efficiencies that are built into these chains.

    A second option is to maintain excess production capacity on the part of domestic manufacturers of critical pandemic products. Maintaining such capacity should be considered at least partially as a social cost; pandemics ravage societies, not just individuals, and therefore society should undertake part of the cost of insuring against them.

    A more general argument against global trade comes in the form of protecting food supplies. In the early 2000s an increase in global cereal prices led some economies to limit exports of specific crops on account of the fact that global demand was pushing prices to a level that low-income consumers could not afford. But such a policy may threaten consumers in other low-income economies whose demands have not changed in a context of reduced supplies. The reality is that world food supply is adequate for world consumption, even in the presence of disruptions. It is also the case that certain economies have huge advantages in producing specific kinds of food. For example, Canada, the US and the Ukraine produce cereals very economically. Mountainous regions are unsuitable for this production. It would benefit no economy for these economies to lower their production of grains to the point where they produced only enough for their own production. By the same reasoning, warmer climates produce fruits, coffee beans, olives etc that cannot easily be produced in many regions suited to wheat. The gains to specialization in the world economy are enormous. Where food shortages occur we frequently encounter the scourges of drought or war or political upheaval, and these conditions inhibit the distribution of foodstuffs.

    What about supply chains? If motherboards produced in China are not being exported in sufficient quantities then indeed production of computers in North America will suffer. But to infer from this that North America should decide to produce all of its computer components in North America is illogical. First, in the time of a pandemic, if certain economies in the supply chain are on lockdown, we cannot be sure that the domestic economy would not be on lockdown simultaneously. Second, the cost to moving the production of all computer parts to North America would likely double the cost of computer hardware - including cell-phones. Perhaps a disruption to our supply chains is something we need to bear in extraordinary times. In case it requires emphasis, most producers in supply chains have incentives to produce and sell. If they do not they will die economically.

    The energy sector of every economy is impacted with the outbreak of a pandemic. This is because the demand for fuel (primarily oil) declines following policies of social distancing, limits on permissible travel, and the closure of some production facilities that depend upon oil. In North America, as we saw in Chapter 4 earlier, the price of oil declined from US $60 per barrel to US $20 in the space of two months in early 2020. Since production costs are higher in both Canada and much of the US than in Saudi Arabia, the North Sea and Russia, producers in North America were squeezed. Many were no longer able to cover their full production costs, and forced to cease drilling and recovering oil. Inevitably there was a clamor for protection. Producers sought tariffs on competing oil: Tariffs would increase the price of cheaper-to-produce foreign oil and enable domestic producers to survive.

    While protection might seem like a 'sensible' policy in this instance, the fact is that unilateral tariffs usually invite reprisals, and raise the danger of a trade war with ever-expanding counter protectionism. In contrast to the case of a shortage of medical supplies, the energy sector in Canada suffered from a glut of world oil supply. The domestic issue is not about the health of consumers (as in the case of medical supplies), it is about the health of producers.



    To conclude: a pandemic is a profoundly serious event and such events inflict major costs on all societies. There are no magic bullets in the form of low-cost ideal economic policies to counter viral warfare. The key to policy making is to recognize constraints and recognize an attack as soon as possible. A wholesale move to insulate the domestic economy is ill-conceived. Comparative advantage confers enormous benefits to all nations. Specific policies should take the form of inventory management and excess production capacity in specific sectors of the economy.

    15.7 Institutions governing trade

    In the nineteenth century, world trade grew rapidly, in part because the leading trading nation at the time—the United Kingdom—pursued a vigorous policy of free trade. In contrast, US tariffs averaged about 50 percent, although they had fallen to around 30 percent by the early 1920s. As the industrial economies went into the Great Depression of the late 1920s and 1930s, there was pressure to protect domestic jobs by keeping out imports. Tariffs in the United States returned to around 50 percent, and the United Kingdom abandoned the policy of free trade that had been pursued for nearly a century. The combination of world recession and increasing tariffs led to a disastrous slump in the volume of world trade, further exacerbated by World War II.

    The WTO and GATT

    After World War II, there was a collective determination to see world trade restored. Bodies such as the International Monetary Fund and the World Bank were set up, and many countries signed the General Agreement on Tariffs and Trade (GATT), a commitment to reduce tariffs progressively and dismantle trade restrictions.

    Under successive rounds of GATT, tariffs fell steadily. By 1960, United States tariffs were only one-fifth of their level at the outbreak of the War. In the United Kingdom, the system of wartime quotas on imports had been dismantled by the mid-1950s, after which tariffs were reduced by nearly half in the ensuing 25 years. Europe as a whole moved toward an enlarged European Union in which tariffs between member countries have been abolished. By the late 1980s, Canada's tariffs had been reduced to about one-quarter of their immediate post-World War II level.

    The GATT Secretariat, now called the World Trade Organization (WTO), aims both to dismantle existing protection that reduces efficiency and to extend trade liberalization to more and more countries. Tariff levels throughout the world are now as low as they have ever been, and trade liberalization has been an engine of growth for many economies. The consequence has been a substantial growth in world trade.

    NAFTA, the USMCA, the EU, the CETA, and the TPP

    In North America, policy since the 1980s has led to a free trade area that covers the flow of trade between Canada, the United States, and Mexico. The Canada/United States free trade agreement (FTA) of 1989 expanded in 1994 to include Mexico in the North American Free Trade Agreement (NAFTA). The objective in both cases was to institute freer trade between these countries in most goods and services. This meant the elimination or reduction of tariffs and non-tariff barriers over a period of years, with a few exceptions in specific products and cultural industries. A critical component of the Agreement was the establishment of a dispute-resolution mechanism, under which disputes would be resolved by a panel of 'judges' nominated from the member economies. Evidence of the success of these agreements is reflected in the fact that Canadian exports have grown to more than 30 percent of GDP, and trade with the United States accounts for the lion's share of Canadian trade flows. NAFTA was updated and replaced in 2018 and the new agreement is termed the United States Mexico Canada Agreement.

    The European Union was formed after World War II, with the prime objective of bringing about a greater degree of political integration in Europe. Two world wars had laid waste to their economies and social fabric. Closer economic ties and greater trade were seen as the means of achieving this integration. The Union was called the "Common Market" for much of its existence. The Union originally had six member states, and as of 2019 the number is 28, with several other candidate countries in the process of application, most notably Turkey. The European Union (EU) has a secretariat and parliament in Bruxelles. The UK intends to exit the EU as of late 2019.

    Canada has concluded a free trade agreement with the European Union that is termed the Comprehensive Economic and Trade Agreement (CETA). It has the objective of implementing free trade between the two negotiating parties, though there remain some exceptions, for example agriculture.

    The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) is a trading agreement between Canada and ten other Pacific-Rim economies that came into being in 2018. Negotiations for a Trans Pacific Partnership treaty were complete by 2016. Those negotiations involved 12 Pacific Rim economies including Canada and the United States, but excluding China. The Obama presidency appeared ready to sign the treaty, however the Trump presidency (and also the Democratic candidate for president of the US, Hillary Clinton) decided that the Partnership was not in the interests of the United States and withdrew its affiliation. The remaining 11 economies reached an agreement to implement the partnership in December 2018.

    Key Terms

    Autarky denotes the no-trade situation.

    Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.

    Terms of trade define the rate at which goods trade internationally.

    Consumption possibility frontier defines what an economy can consume after production specialization and trade.

    Intra-industry trade is two-way international trade in products produced within the same industry.

    Intra-firm trade is two-way trade in international products produced within the same firm.

    Supply chain: denotes the numerous sources for intermediate goods used in producing a final product.

    Intermediate good: one that is used in the production of final output.

    Content requirement: requires that a specified percentage of the final value of a product originate in the producing economy.

    Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.

    Total factor productivity: how efficiently the factors of production are combined.

    Tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue. It is a barrier to trade.

    Quota is a quantitative limit on an imported product.

    Trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.

    Non-tariff barriers, such as product content requirements, limits the gains from trade.

    Dumping is a predatory practice, based on artificial costs aimed at driving out domestic producers.

    Exercises for Chapter 15

    EXERCISE 15.1

    The following table shows the labour input requirements to produce a bushel of wheat and a litre of wine in two countries, Northland and Southland, on the assumption of constant cost production technology – meaning that the production possibility curves in each are straight lines. You can answer this question either by analyzing the table or developing a graph similar to Figure 15.1, assuming each economy has 4 units of labour.

    Labour requirements per unit produced
    Northland Southland
    Per bushel of wheat 1 3
    Per litre of wine 2 4
    1. Which country has an absolute advantage in the production of both wheat and wine?

    2. What is the opportunity cost of wheat in each economy? Of wine?

    3. What is the pattern of comparative advantage here?

    4. Suppose the country with a comparative advantage in wine reduces wheat production by one bushel and reallocates the labour involved to wine production. How much additional wine does it produce?

    EXERCISE 15.2

    Canada and the United States can produce two goods, xylophones and yogurt. Each good can be produced with labour alone. Canada requires 60 hours to produce a ton of yogurt and 6 hours to produce a xylophone. The United States requires 40 hours to produce the ton of yogurt and 5 hours to produce a xylophone.

    1. Describe the state of absolute advantage between these economies in producing goods.

    2. In which good does Canada have a comparative advantage? Does this mean the United States has a comparative advantage in the other good?

    3. Draw the production possibility frontier for each economy to scale on a diagram, assuming that each economy has an endowment of 240 hours of labour, and that the PPFs are linear.

    4. On the same diagram, draw Canada's consumption possibility frontier on the assumption that it can trade with the United States at the United States' rate of transformation.

    5. Draw the US consumption possibility frontier under the assumption that it can trade at Canada's rate of transformation.

    EXERCISE 15.3

    The domestic demand for bicycles is given by P=36–0.3Q. The foreign supply is given by P=18 and domestic supply by P=16+0.4Q.

    1. Illustrate the market equilibrium on a diagram, and illustrate the amounts supplied by domestic and foreign suppliers in equilibrium.

    2. If the government now imposes a tariff of $6 per unit on the foreign good, illustrate the impact geometrically.

    3. In the diagram, illustrate the area representing tariff revenue.

    4. Optional: Compute the price and quantity in equilibrium with free trade, and again in the presence of the tariff.

    EXERCISE 15.4

    1. In Exercise 15.3, illustrate graphically the deadweight losses associated with the imposition of the tariff.

    2. Illustrate on your diagram the additional amount of profit made by the domestic producer as a result of the tariff. [Hint: Refer to Figure 15.4 in the text.]

    EXERCISE 15.5

    The domestic demand for office printers is given by P=40–0.2Q. The supply of domestic producers is given by P=12+0.1Q, and international supply by P=20.

    1. Illustrate this market geometrically.

    2. If the government gives a production subsidy of $2 per unit to domestic suppliers in order to increase their competitiveness, illustrate the impact of this on the domestic supply curve.

    3. Illustrate geometrically the cost to the government of this scheme.

    EXERCISE 15.6

    Consider the data underlying Figure 15.1. Suppose, from the initial state of comparative advantage, where Canada specializes in fish and the US in vegetable, we have a technological change in fishing. The US invents the multi-hook fishing line, and as a result can now produce 64 units of fish with the same amount of labour, rather than the 40 units it could produce before the technological change. This technology does not spread to Canada however.

    1. Illustrate the new PPF for the US in addition to the PPF for Canada.

    2. What is the new opportunity cost (number of fish) associated with one unit of V?

    3. Has comparative advantage changed here – which economy should specialize in the production of each good?

    EXERCISE 15.7

    The following are hypothetical (straight line) production possibilities tables for Canada and the United States. For each line required, plot any two or more points on the line.

    Canada United States
    A B C D A B C D
    Peaches 0 5 10 15 Peaches 0 10 20 30
    Apples 30 20 10 0 Apples 15 10 5 0
    1. Plot Canada's production possibilities curve.

    2. Plot the United States' production possibilities curve.

    3. What is each country's cost ratio of producing peaches and apples?

    4. Which economy should specialize in which product?

    5. Plot the United States' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.

    6. Plot the Canada' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.

    7. Suppose that the optimum product mixes before specialization and trade were B in the United States and C in Canada. What are the gains from specialization and trade?


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