Archive for the 'Free Trade' Category

Sep 29 2011

Protectionism’s many weaknesses

After our lesson on tariffs and protectionism the other day, one of my year 2 IB Econ students emailed me with a few questions she had not had the chance to ask in class. I thought I’d post my responses here, since they were such good questions!

Question: Hi Mr Welker, I asked this on Monday’s blog about self-sufficiency, but no one answered my question and I have been meaning to ask this in class but I always get distracted and I forget. And perhaps you have already answered this, pardon me if you have.

Since Exports and Investment have a great effect on economic growth, why would a government want to protect its nation by imposing barriers to trade? Because by doing so, foreign firms cannot invest in that nation and potentially create job opportunities and also contribute to that nations GDP since, even though it’s a foreign investment, the revenue is collected by that government.

Answer: Protectionism is not typically aimed at reducing the amount of exports from the nation engaging in it, rather reducing the amount of imports or promoting increased exports. You’re exactly right that exports and investment contribute to aggregate demand (and therefore economic growth and employment) in a nation. But imports are a ‘leakage’ from the nation’s economy, and the greater the level of import spending, the lower a nation’s net exports. A nation with a trade deficit actually experiences negative net exports. The purpose of protectionism is to reduce import spending, or increase export revenues, and thereby increase net exports and aggregate demand and employment in the nation.

As for foreign investment, one of the consequences of a large trade deficit is increased foreign ownership of domestic resources or factors of production. Since a country that imports more than it exports spends more on foreign goods than it earns from the sale of its own goods to foreigners, foreign governments and firms end up with large amounts of that country’s money that is NOT being spent on that country’s goods. Much of this ends up back in the deficit country as foreign investment. Sometimes foreigners will buy government bonds (invest in the deficit country’s debt, in other words), but sometimes the money comes back home as foreigners buying up factories and real estate. Foreign investment may indeed help create jobs at home, but so does domestic investment, and when foreigners invest it means the country’s resources are now owned by interests abroad, which many countries view as a threat to their national and economic security. This can also serve as a justification for protectionism: to prevent foreign ownership of domestic assets.

Question: Also if the country is not exporting, it’s not enjoying the benefits of revenue from exported goods that could boost their economic growth. And anyway, isn’t the point of making money to spend it? Otherwise what is the incentive of being employed and earning an income? Unless of course, one can argue that income earned can then be spent on domestically produced goods.

Again, the purpose of protectionism is not to reduce a country’s exports, rather to reduce its imports and to increase its exports. But you have made a very important observation here that points to a major flaw in the argument for protectionism. The purpose of exporting goods it to make money to spend on imported goods, otherwise, WHY TRADE? A country gains from trade not only because it has a wider market for its own goods, but because the people of the nation have a wider market from which to choose the goods they themselves can consume. When a nation erects barriers to trade, it will ultimately have the effect of reducing not only imports, but possibly the nation’s own exports. Since foreigners earn less money from selling goods to the protected nation, they have less money to spend on that nation’s goods!

All protectionism can hope to do is increase the welfare of particular industries while reducing the welfare of the rest of society. It is rarely justifiable on the grounds that it will increase the total welfare of society as a whole, unless of course the protected industry is one vital to national security, such as the defense sectors or the energy sector (even this one is debatable!)

Question: Or do government spending (through subsidies, and creating job opportunities) and increased consumption due to income gains caused by government intervention overcome these factors and compensate for the lost opportunity of exports and investments.

Increasing government spending to off-set the fall in social welfare resulting from protectionism will only lead to greater inefficiency in society. Government may have to spend more on unemployment benefits for workers whose jobs are lost due to protectionism, which may require higher taxes on those workers whose jobs are being protected. As explained above, one industry’s gain leads to a loss of welfare for society as a whole. This is the problem with protectionism. It favors certain industries but imposes higher prices on consumers and higher costs of production on other industries. It should not be the government’s job to “pick winners and losers” in the global economy. By protecting certain industries, however, government attempts to do just that, but society as a whole loses.

I hope you understand what I am asking for here. Whenever you have time, I would love to hear your perspective.

Maphrida

Great questions, Maphrida!

Discussion Questions:

  1. How might protectionism lead to an increase in aggregate demand and domestic employment?
  2. Why does a large trade deficit lead to a build-up of foreign ownership of domestic factors of production?
  3. Discuss the view that protectionism in the form of tariffs on particular goods helps certain industries but harms the rest of society. Can you imagine an example of a protectionist policy that could increase the welfare of society as a whole?
  4. Explain how a protectionist policy that makes imports more expensive and thus reduces demand for imported goods can ultimately lead to a reduction in demand for the protected country’s exports abroad.

6 responses so far

Aug 25 2011

The joys and sorrows of the strong Swiss franc

Last Friday my favorite podcast, NPR’s Planet Money, did a feature story called “Switzerland’s too Strong for it’s own Good”. The gist of the story is that the uncertainty over budget deficits and the national debt in the US and Eurozone at this time are causing international investors to put their money into the Swiss franc and Swiss franc denominated assets. Switzerland’s reputation for financial discipline and fiscal responsibility makes it a safe-haven for international investors feeling jittery over the large budget deficits in Euro countries and in the United States.

The Planet Money team discusses why the rising value of the franc poses a threat to the Swiss economy. To understand just how much the franc (CHF) has strengthened against the currencies of its trading partners, examine the graph below, which shows the rise (and recent decline) in the value of the CHF against the currency of Switzerland’s neighbors, the Euro.

As can be seen, earlier this year on CHF was worth only around 0.76 euros, but as recently as August 10 one CHF could buy nearly 0.95 worth of goods from Euro countries. Of course, cheaper imports is a benefit to Swiss households, but what we need to realize is that this upward trend in the value of the CHF also means that all Swiss goods are becoming more expensive to European consumers. And here’s the problem with the stronger franc. Over 50% of Switzerland’s output is exported to the rest of the world (meaning a large proportion of Switzerland’s workers depend on strong exports), and the more expensive the country’s currency, the more expensive the goods produced by Swiss businesses become in the countries with which Switzerland trades.

A simple example would help: A Swiss chocolate bar that sells for two CHF would have cost a European consumer only 1.50 euros in February of this year (when one CHF = 0.75 Euro). But in early August the same bar of chocolate would have cost the European consumer 1.90 Euro, an increase in price of nearly 30%. This may not seem like much to a casual observer, but when you realize that Switzerland’s biggest exports are capital goods and financial services, which cost far more than 2 CHF, a 30% price hike placed on foreign consumers is much more noticeable. If a train engine that sold for 1 million Euros suddenly costs a European transport agency 1.3 million Euros, you can imagine such a transaction would become much less appealing, and demand for Swiss rail engines will begin to fall, putting Swiss jobs at risk.

Here on the ground in Switzerland, the effects of the strong franc have definitely not gone unnoticed. One point of discussion in the podcast is the fact that Swiss retailers have strangely not begun lowering the prices for their imported products. For example, one would expect that a bike shop selling bikes made by American companies in Taiwan would be able to lower its price for those bikes as one franc now buys about 30% more US goods than it could earlier this year. Logically, a $1000 bike that used to cost 1,100 CHF for a Swiss bike shop to import now only costs that shop around 800 CHF to import. The Swiss consumer should begin to see lower retail prices reflecting the lower costs to Swiss importers. Strangely, however, this has not materialized, and most retailers have kept their prices at the same level they were before the rise of franc’s value.

Perhaps retailers are unwilling to lower their prices because they are uncertain whether or not the franc will remain strong, and they would not want to have to be in a situation in which the franc suddenly weakens and their costs rise once again. Perhaps retailers are simply enjoying the greater profits resulting from falling costs and the same high prices. However, as a consumer myself living in Switzerland, I would guess that this is not the case, because I and many other people I know here have reduced the quantity of goods we buy from Swiss retailers. In the age of online shopping, it is now cheaper than ever to order goods like bicycles, clothing and electronics from foreign retailers through the internet.

For example, I recently ordered a bicycle from the United States that sells for $1,100 there. At current exchange rates, I was able to order this bike for only 800 CHF from the US. The same bike in Switzerland has a retail price on it reflecting the US dollar/CHF exchange rate of several years ago, and sells for 1,500 CHF. Of course, any imported product is charged a duty by customs, but even after paying around 160 CHF in duties, I still am saving nearly 500 CHF on this bike. The result is Swiss bike shops selling foreign brands have experienced a decline in sales as consumers like myself have chosen to order their good from foreign retailers, whose prices are much lower due to the stronger franc.

As an American working in Switzerland, I also benefit from the strong franc in that all of my debts are in dollars. I own a house in the States, and still have about four years left on my student loans from grad school. The strong franc reduces the burden of these debts and allow me to keep more of my income in Switzerland, sending home less and less money each month to cover the same expenses back home.

The big question on everyone in Switzerland’s minds right now is whether the rise of the franc will continue, or whether it will return to an equilibrium exchange rate against the euro and the dollar closer to levels seen earlier this year. Swiss exporters (chocolate companies, watch makers and train engine manufacturers) are hoping the franc will fall again. Households, on the other hand, will continue to enjoy the cheap online shopping opportunities, and may eventually enjoy cheaper retail products in Switzerland if importers become more comfortable lowering their prices to reflect the lower costs of their imports.

I predict that the rise in the franc is over, but that in the next few months it will reach an equilibrium against the dollar and the euro somewhere well above its historic level (around 1.5 francs per Euro and around 1.1 francs per dollar). I believe the franc will settle around 1.1 CHF per Euro and around 0.85 CHF per dollar. Once these exchange rates have settled and the wild fluctuations of the last month come to an end, Swiss exporters and importers alike will begin adjusting their costs and prices to reflect the more stable equilibrium to which we will become accustomed.

Living and working in one of Europe’s and the world’s strongest, most fiscally sound economies has its advantages. But in a world of free trade and floating exchange rates, panic among investors abroad has the potential to fire a devastating blast into the ship that is a healthy economy like Switzerland’s. But over time, just like in any speculative bubble, the rise in the value of the franc will stop, it will begin to fall once again, and everyone will come to their senses as import and export prices once again begin to reflect the true exchange rates between the franc and the currencies of its trading partners.

Discussion questions: 

  1. Strong is always better, right? A strong army, a strong economy, a strong leader. But when it comes to currencies, strong is often not better. Why is a strong currency potentially harmful to a nation’s economy?
  2. How would an increase in online shopping among Swiss households affect the prices Swiss retailers are able to charge for their imported products?
  3. How would a Swiss exporting firm, such as Rolex (a watch manufacturer) be affected by the rising value of the Swiss franc? What would such a firm have to do to keep its products at a competitive price in foreign markets?

One response so far

Oct 08 2010

The clear and simple gains from trade

Russell Roberts of George Mason University is a well-known advocate of free trade. This article is one of my favorite and certainly one of the clearest explanations of the mutual benefits resulting from free trade that I have read.

Foreign Policy: Why We Trade – by Russ Roberts

To hear most politicians talk, you’d think that exports are the key to a country’s prosperity and that imports are a threat to its way of life. Trade deficits—importing more than we export—are portrayed as the road to ruin… Politicians are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.

This perspective on imports and exports is called mercantilism. It goes back to the 14th century and has about as much intellectual rigor as alchemy, another landmark of the pre-Enlightenment era.

The logic of “exports, good—imports, bad” seems straightforward at first—after all, when a factory closes because of foreign competition, there seem to be fewer jobs than there otherwise would be. Don’t imports cause factories to close? Don’t exports build factories?

But is the logic really so clear? As a thought experiment, take what would seem to be the ideal situation for a mercantilist. Suppose we only export and import nothing. The ultimate trade surplus. So we work and use raw materials and effort and creativity to produce stuff for others without getting anything in return. There’s another name for that. It’s called slavery. How can a country get rich working for others?

Then there’s the mercantilist nightmare: We import from abroad, but foreigners buy nothing from us. What would the world be like if every morning you woke up and found a Japanese car in your driveway, Chinese clothing in your closet, and French wine in your cellar? All at no cost. Does that sound like heaven or hell? The only analogy I can think of is Santa Claus. How can a country get poor from free stuff? Or cheap stuff? How do imports hurt us?

We don’t export to create jobs. We export so we can have money to buy the stuff that’s hard for us to make—or at least hard for us to make as cheaply. We export because that’s the only way to get imports. If people would just give us stuff, then we wouldn’t have to export. But the world doesn’t work that way.

It’s the same in our daily lives. It’s great when people give us presents—a loaf of banana bread or a few tomatoes from the garden. But a new car would be better. Or even just a cheaper car. But the people who bring us cars and clothes and watches and shoes expect something in return. That’s OK. That’s the way the world works. But let’s not fool ourselves into thinking the goal of life is to turn away bargains from outside our house or outside our country because we’d rather make everything ourselves. Self-sufficiency is the road to poverty.

And imports don’t destroy jobs. They destroy jobs in certain industries. But because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones. That’s why we trade—to leverage the skills of others who can produce things more effectively than we can, freeing us to make things we otherwise wouldn’t be able to afford.

Discussion Questions:

  1. “Self-sufficiency is the road to poverty” – Discuss…
  2. Explain the logical economic fallacy of the mercantilist philosophy of “exports good, imports bad”
  3. “…because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones”. What basic economic principle is Professor Roberts alluding to here?

77 responses so far

Oct 07 2010

US / China Trade War – Could this be the beginning?

This post was originally published on September 15, 2009. It is being reposted today for my year 2 IB Econ students, who are studying free trade and protectionism as part of Unit 4 of the IB Econ course.

US president Barack Obama made a speech directly to Wall Street today. In his speech, Obama reflected on the many lessons America has learned in the last year since the financial crisis began. He urged his audience of investors, bankers and brokers that

“Normalcy cannot lead to complacency,” Obama said. “Unfortunately, there are some in the financial industry who are misreading this moment. Instead of learning the lessons of Lehman and the crisis from which we are still recovering, they are choosing to ignore them.”

“They do so not just at their own peril, but at our nation’s,” the president added.

In addition to his warnings about the threat posed by overly risky financial markets to the US economy, President Obama expressed his commitment to free trade and “the fight against protectionism”.

Obama says:

…enforcing trade agreements is part and parcel of maintaining an open and free trading system.

The enforcement of existing trade agreements Obama refers to is his way of justifying a decision his administration made over the weekend that actually limits free trade between America and one of its largest trading partners, China.

Trade relations between two of the world’s biggest economies deteriorated after Barack Obama, US president, signed an order late on Friday to impose a new duty of 35 per cent on Chinese tyre imports on top of an existing 4 per cent tariff.

In his first big test on world trade since taking office in January, Mr Obama sided with America’s trade unions, which have complained that a “surge” in imports of Chinese-made tyres had caused 7,000 job losses among US factory workers.

So, in his speech today, Obama decries protectionism and calls for expanded trade and free trade agreements which are “absolutely essential to our economic future”. But only three days ago, he supported a blatantly protectionist measure aimed at keeping foreign produced goods out of America in order to save a few thousand American jobs.

Obama’s decision is a bad one for several reasons. As an economics teacher, I will turn firstly to a diagram for an illustration of the net loss to the American people of higher tariffs on imported tires:
Tire protection

The key point to notice in the above graph is that a tariff on imported tires results in a net loss of welfare in America. The blue area represents the increase in the welfare of tire manufactures (this could be interpreted as the jobs saved in the tire industry and the profits earned due to higher prices); the black areas, on the other hand, are welfare loss. Since all tire consumers in America pay more for their tires due to the 35% tariff, real income is affected negatively for the nation as a whole.

One effect of the protectionist policy the graph does not illustrate, and perhaps the most serious negative impact of the tariff on America, is the response the Chinese are likely to take to what they interpret as a violation of existing free trade agreements between the US and China.

“This is a grave act of trade protectionism,” Mr Chen said in a statement. “Not only does it violate WTO rules, it contravenes commitments the US government made at the [April] G20 financial summit.”

Beijing said it had requested WTO-sanctioned consultations with the US over Washington’s new duties on tyres. Yao Jian, a commerce ministry spokesman, said the duties were in ”violation of WTO rules”.

China said it would now investigate imports of US poultry and vehicles, responding to complaints from domestic companies.

The problems with protectionism are myriad. Clearly American consumers suffer through higher tire prices. In addition, Chinese manufacturers will see sales fall as their product becomes less competitive in the US market. According to the CCTV report below, as many as 9,000 workers in the Chinese tire industry will lose their livelihoods due to declining demand from the US. But the unforseen effects of the US tariff on Chinese tires is the retaliatory measures China will almost certainly take. If China imposes new tariffs on American automobiles and poultry, the scenario in the graph above will be reversed, and Chinese consumers will face higher prices, Chinese car and poultry producers will experience rising sales, while the American auto worker and chicken farmer will suffer.

Free trade tends to result in net benefits for economies that choose to participate in it. American tire manufacturers are certainly harmed by cheap Chinese imports; however, America as a whole benefits through cheaper goods, more consumer surplus, higher incomes in China and therefore greater demand for imports of products made in America. The road to protectionism is a dangerous path to take for the Obama administration. Justifying these new tariffs by claiming that they “enforce existing free trade agreements” is a political maneuver aimed at covering up the truth, which is that the Obama administration has sided with a special interest group to save a few thousand jobs and garner political favor at a time when 700,000 American jobs are being lost each month. By doing so, he is calling into question his own commitment to free trade, and harming America’s image as a global proponent of global economic integration.

Discussion Questions:

  1. Why is the Chinese government so upset about a new tax on such an insignificant product as automobile tires?
  2. “Self-sufficiency is the road to poverty”: Do you agree?
  3. Some would say that it is a small price to pay for Americans to face higher prices for one product like tires in order to “save” 7,000 Americans’ jobs. Would you agree? Why or why not?
  4. If 7,000 Americans were to lose their jobs due to free trade with China, what would we call the type of unemployment experienced by these workers? Is this the same type of unemployment experienced by the 700,000 workers who have lost their jobs each month during the last year of recession in the United States?

33 responses so far

Oct 04 2010

The high cost of tariffs

CBC News – Money – Shipping industry gets tariff break

A tariff is a tax on imported goods or services aimed at raising the price of foreign products to make domestically produced substitutes more attractive to consumers. A tariff is a form of protectionism, which we study in unit 4.1 of the IB Economics course.

Tariffs are appealing to policymakers as a tool for protecting domestic firms from foreign competition. Used wisely, a barrier to trade such as a tariff can promote the development of certain vital industries in the domestic economy that might otherwise not exist due to the existent of more efficient, lower cost foreign competition. Tariffs benefit domestic producers but harm domestic consumers, who must pay a higher price for the imported good than they would have to under purely free trade.

The Canadian government has, until recently, charged a 25% tariff on cargo ships, tankers and large ferries built in foreign countries. As of this month, however, this tariff is being removed.

Imported cargo ships, tankers and large ferries will no longer be subject to a 25 per cent tariff, Finance Minister Jim Flaherty announced Friday.

The measure is aimed at making it cheaper for Canadian shipowners to replace aging fleets with more modern and more efficient vessels.

Waiving the tariff will save the industry $25 million a year for the next 10 years, the government estimates.

“These were tariffs that don’t serve any purpose because … the ships to which they apply are not capable of being made competitively in Canada,” Flaherty told reporters…

The effects of a tariff in the Canadian ship market can be illustrated using a simple supply and demand diagram. The diagram below shows the Canadian ship market before the removal of the 25% tariff and after its removal.

The domestic supply and demand curves for ships in Canada are shown above. Notice that the domestic equilibrium price for ships in Canada without trade is very high. This is because Canadian ship builders have high costs of production and therefore would require a very high price in order to be able to build ships domestically.

So where do Canadian ship buyers get their ships from? The article mentions that one Canadian company bought ships from a Turkish ship builder. Besides Turkey, some of the other countries that specialize in ship production include Denmark, South Korea, China and Japan. The world supply of ships is represented by the blue line. In a purely free trade environment, the price of ships in Canada is determined by the intersection of domestic demand and world supply, at a price of Pw.

The world price of ships is completely unresponsive to changes in demand from Canadian ship buyers. This explains why world supply is horizontal. Since the Canadian market makes up such a small proportion of the total market for ships, an increase in demand in Canada will have no impact on the world price of ships. Therefore, the world supply curve as seen by Canada ship buyers is perfectly elastic. Canadian ship buyers can buy as few ships or as many ships as they like without affecting world price.

A tariff is a tax, and a tax is a determinant of supply. A tariff of 25% increases the costs of imported ships, and shifts the world supply curve upwards. This raises the price of imported ships, and decreases the quantity demanded of ships in Canada from Q3 to Q2 ships. Notice that at the higher world price of Pwt, there are a few domestic ship builders in Canada willing and able to produce and sell ships, so domestic quantity supplied increases from 0 to Q1.

The existence of a tariff reduces the number of imported ships in Canada from 0Q3 to Q1Q2. Domestic producers of ships, who without protection would not be able to compete and therefore produce zero ships, instead produce Q1 and enjoy producer surplus represented by the triangle X. The Canadian government collects taxes on the imported ships represented by the area Z, found by multiplying the number of imported ships (Q1Q2) by the amount of the tariff (Pwt-Pw).

The tariff on imported ships did little good for the Canadian ship market. Canadian ship builders were already uncompetitive and benefited little if at all. While the government did earn revenues from the tax, the net effect on the market was a loss of welfare represented by the triangles labelled Y in the graph above. These gray areas represent the net welfare loss (or dead weight loss) of the ship tariff.

The consumers of ships, which are in fact Canadian companies that produce other goods and services, such as the ferry companies that provide access to Canada’s several remote coastal and island communities, were clearly harmed by the 25% tariff, since the price of ships is a resource cost and the tariff translated into lower supply and higher prices for consumers of ferry services. The tariff’s effect on ship buyers in Canada is visible in the graph above. At a price of Pw, the total consumer surplus in the ship market is the area of VXYZ. With the higher price resulting from the tariff, however, consumer surplus is only the are V, while producer surplus increased only to the area X and government surplus (the tax revenue from the tariff) is area Z. The net effect, however, is a loss of total welfare of the triangles labelled Y.

The tariff’s removal, on the other hand, increases the welfare of ship consumers back to VXYZ, eliminating the dead weight loss and increasing total welfare and efficiency in the ship market. This also benefits the customers of the companies that buy ships, including ferry passengers, as evidenced in the article

“The duty remission to BC Ferries will allow it to implement a two per cent rate reduction for its users later this month, the Finance Department said.”

A tariff on imports is a protectionist measure aimed at increasing domestic producer surplus in a market in which domestic firms face competition from lower cost foreign producers. However, it should be observed that a tariff generally creates a net loss of welfare for society as a whole, as the consumers of the taxed good face a higher price and demand a lower quantity of output. While a tariff reduces imports may increase domestic production, the benefit to producers comes at the cost of lost consumer surplus and a net loss of welfare in the market as a whole. The tariff also leads to allocative inefficiency in a market, as domestic resources are over-allocated towards the production of a good on which imports are subject to tariffs.

Removing tariffs on ships increases the benefit to ship buyers, who in turn pass that benefit on to their own customers, lowering the prices of important services such as shipping and ferry service to Canadian consumers. In addition, foreign producers of ships increase their sales in Canada and experience greater demand, benefiting foreign producers and workers. The increase in foreign income may mean more demand for Canada’s exports in turn, increasing employment in other sectors of the Canadian economy in which they do have a comparative advantage over their trading partners. Overall the elimination of tariffs increases total welfare, eliminates dead weight loss, and leads to a more efficient allocation of a nation’s resources towards the goods it is able to competitively produce in the global economy.

Discussion Questions:

  1. What was the intended purpose of the 25% tariff on imported ships? Was this a valid reason to tax foreign built ships?
  2. Who are the various “stakeholders” affected by a tariff on imported ships. Try to identify five different stakeholders who are affected by the tariff and its removal.
  3. Why does the removal of a tariff improve allocative efficiency in a country? Does it also improve productive efficiency?

15 responses so far

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