Pre-Reading

Reading 3: Why Nations Trade ^[1]

Why Nations Trade

One might argue that the best way to protect workers and the domestic economy is to stop trading with other nations. Then the whole circular flow of inputs and outputs would stay within our borders. But if we decided to do that, how would we get resources like coffee beans? Most countries simply can’t produce everything they need, and they can’t manufacture some products, such as steel and most clothing, at the low costs they’ve become accustomed to. The fact is that nations—like people—are good at producing different things: you may be better at programming a computer than repairing a car. In that case, you benefit by “exporting” your computer skills and “importing” the car repairs you need from a good mechanic. Economists refer to specialization like this as advantage.

Absolute Advantage

A country has an absolute advantage when it can produce and sell a product at a lower cost than any other country or when it is the only country that can provide a product. China is known for having an absolute advantage in most manufacturing. The United States, for example, has an absolute advantage in reusable spacecraft and other high-tech items.

Suppose that the United States has an absolute advantage in air traffic control systems for busy airports and that Brazil has an absolute advantage in coffee. The United States does not have the proper climate for growing coffee, and Brazil lacks the technology to develop air traffic control systems. Both countries would gain by exchanging air traffic control systems for coffee.

Comparative Advantage

Even if the United States had an absolute advantage in both coffee and air traffic control systems, it should still specialize and engage in trade. Why? The reason is the principle of comparative advantage, which says that each country should specialize. When they do, they can focus on things they can produce inexpensively or easily and import the other products. This specialization ensures more things will be produced globally and at lower prices.

For example, India and Vietnam have a comparative advantage in producing clothing because of lower labor costs. Japan has long held a comparative advantage in consumer electronics because of technological expertise. The United States has an advantage in computer software, airplanes, some agricultural products, heavy machinery, and jet engines.

Thus, comparative advantage acts as a stimulus to trade. When nations allow their citizens to trade whatever goods and services they choose without government regulation, free trade exists. Free trade is the policy of permitting the people and businesses of a country to buy and sell where they please without restrictions. The opposite of free trade is protectionism. This is when a nation protects its home industries from outside competition by establishing tariffs and import limits. In the next section, we’ll look at the various barriers, some natural and some created by governments, that restrict free trade.

The Fear of Trade and Globalization

The continued protests during meetings of the World Trade Organization show that many people fear world trade and globalization. What do they fear? Some of the negatives of global trade are as follows:

• Millions have lost jobs due to imports or to production shifting abroad. Most find new jobs, but often those jobs pay less.
• Millions of others fear losing their jobs, especially at those companies operating under competitive pressure.
• Employers often threaten to export jobs if workers do not accept pay cuts.
• Service and office jobs are increasingly vulnerable to operations moving abroad.

Sending domestic jobs to another country is called outsourcing. Many U.S. companies, such as Dell, IBM, and AT&T, have set up call centers that help customers in India, the Philippines, and other countries. Now even engineering and research and development jobs are being outsourced.

So is outsourcing good or bad? If you happen to lose your job, it’s obviously bad for you. However, some economists say it leads to cheaper goods and services for consumers because costs are lower. Also, it should stimulate exports to fast-growing countries. No one knows how many jobs will be lost to outsourcing in coming years. According to estimates, almost 2.4 million U.S. jobs were outsourced in 2015¹¹.

Benefits of Globalization

A closer look reveals that globalization has been the engine that creates jobs and wealth. Benefits of global trade include the following:

• Productivity grows more quickly when countries produce goods and services in which they have a comparative advantage. Living standards can increase faster. One problem is that big G20 countries have added more than 1,200 restrictive export and import measures since 2008.
• Global competition and cheap imports keep prices down, so inflation is less likely to stop economic growth. However, in some cases this is not working because countries manipulate their currency to get a price advantage.
• An open economy spurs innovation with fresh ideas from abroad.
• Through infusion of foreign capital and technology, global trade provides poor countries with the chance to develop economically by spreading prosperity.
• More information is shared between two trading partners that may not have much in common initially, including insight into local cultures and customs, which may help the two nations expand their collective knowledge and learn ways to compete globally¹².

Barriers to Trade

International trade is carried out freely by both businesses and governments—as long as no one puts up trade barriers. In general, trade barriers restrict how firms sell to one another in foreign markets. The major obstacles to international trade are natural barriers, tariff barriers, and non-tariff barriers.

Natural Barriers

Natural barriers to trade can be either physical or cultural. For instance, even though raising beef in the relative warmth of Argentina may cost less than raising beef in the bitter cold of Russia, the cost of shipping the beef from South America to Russia might drive the price too high. Distance is thus one of the natural barriers to international trade.

Language is another natural trade barrier. People who can’t communicate effectively may not be able to negotiate trade agreements or may ship the wrong products or goods.

Tariff Barriers

A tariff is a tax imposed by a nation on imported goods. It may be a charge per unit, such as per barrel of oil or per new car; it may be a percentage of the value of the goods, such as 5 percent of a $500,000 shipment of shoes; or it may be a combination. No matter how it is assessed, any tariff makes imported goods more costly, so they are less able to compete with domestic products.

Protective tariffs make imported products less attractive to buyers than domestic products. The United States, for instance, has often had protective tariffs on imports, such as some food and clothing. In March of 2018 the Trump administration added tariffs on steel and aluminum from most countries. On the other side of the world, Japan imposes a tariff on U.S. cigarettes that makes them cost 60 percent more than Japanese brands. U.S. tobacco companies believe they could get as much as a third of the Japanese market if there were no tariffs on cigarettes. With tariffs, they have under 2 percent of the market.

Arguments for and against Tariffs

In the United States, tariffs have been debated since 1789. The main arguments for tariffs include the following:

• Tariffs protect new industries. A tariff can give a struggling new industry time to become an effective global competitor.
• Tariffs protect local jobs. Unions and others say tariffs keep foreign labor from taking away local jobs.
• Tariffs aid in military preparedness. Tariffs should protect industries and technology during peacetime that are vital to the military in the event of war.

The main arguments against tariffs include the following:

• Tariffs discourage free trade, and free trade lets the principle of competitive advantage work most efficiently.
• Tariffs raise prices, thereby decreasing consumers’ purchasing power. In 2017, the United States imposed tariffs of 63.86 percent to 190.71 percent on a wide variety of Chinese steel products. The idea was to give U.S. steel manufacturers a fair market after the Department of Commerce concluded that foreign companies had an unfair advantage because of government support. It is still too early to determine what the effects of these tariffs will be, but higher steel prices are likely. Heavy users of steel, such as construction and automobile industries, will see big increases in their production costs. It is also likely that China may impose tariffs on certain U.S. products and services and that any negotiations on intellectual property and piracy will be slowed¹³.

Nontariff Barriers

Governments also use other tools besides tariffs to restrict trade. One type of nontariff barrier is the import quota, or limits on the quantity of a certain good that can be imported. The goal of setting quotas is to limit imports to a specific amount of a given product. The United States protects its shrinking clothing industry with quotas. A complete list of the commodities and products subject to import quotas is available online at the U.S. Customs and Border Protection Agency website¹⁴.

A complete ban against importing or exporting a product is an embargo. Often embargoes are set up for defense purposes. For instance, the United States does not allow various high-tech products, such as supercomputers and lasers, to be exported to countries that are not allies. Although this embargo costs U.S. firms billions of dollars each year in lost sales, it keeps enemies from using the latest technology in their military hardware.

Government rules that give special privileges to domestic manufacturers and retailers are called buy-national regulations. One such regulation in the United States bans the use of foreign steel in constructing U.S. highways. Many state governments have buy-national rules for supplies and services. In a more subtle move, a country may make it hard for foreign products to enter its markets by establishing regulations that are different from generally accepted international standards, such as requiring bottles to be quart size rather than liter size.