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- [Alex] Okay, now we're going to discuss international trade
and how to model international trade using demand and supply.
We'll also look at how to model the consequences of a tariff,
a tax on trade.
We'll look at the consequences and also the cost of the tariff
and the cost of protectionism in general.
By the way, remember when we did demand and supply,
I said that these concepts are really, really important?
Well now you see why: it's because we're simply applying
the same tools over and over again.
So if you understand the fundamentals,
then the applications become much, much easier.
So do make sure you understand the fundamentals.
Okay, let's get going.
First, some quick definitions.
Protectionism: This is the economic policy
of restraining trade through tariffs, quotas,
or other regulations that burden foreign producers
but not domestic producers.
In particular, a tariff is simply a tax on imports
and a quota is a quantity restriction on imports.
For example, a quota may say you're only allowed
to import 10,000 automobiles from Japan.
Okay, let's get right into it.
Here is the domestic supply curve.
This is the supply curve of the home country firms.
If we're thinking about the US,
this is the supply curve from US firms.
Here is the demand curve, domestic demand,
this is demand from US consumers.
If we had no international trade then as usual,
we would find the equilibrium where the quantity demanded
is equal to the quantity supplied.
That would give us the price with no international trade
and the quantity both produced and consumed
with no international trade down here.
Now let us suppose that the consumers in this country
can go out into the world and they can buy
as much of these semi-conductors as they want at the world price.
So in that case if we had complete free trade,
consumers would be able to buy as much as they want
at the world price or as given by this world supply curve.
The free trade equilibrium, then, would involve greater consumption.
That is, at the high price
with no international trade, the quantity demanded is here.
With international trade,
consumers get to buy at the lower world price
so their quantity demanded increases.
In terms of the diagram
the quantity demanded will increase to QD free trade.
So domestic consumption is equal to this distance
or domestic consumption is equal
to the quantity demanded with free trade.
Now what about production?
Well, the domestic producers can only charge
as much as the world producers.
They can't charge a higher price.
So when the world price falls,
when domestic consumers are able to buy at the world price,
domestic producers can only sell at the world price,
and they're going to be less willing to sell.
So the domestic production will fall,
domestic production will fall to this lower amount right here.
At a lower price
the domestic suppliers are only willing to produce
a less amount or lower amount as given by QS free trade.
Now notice that domestic consumption is QD free trade,
domestic production is QS free trade
and demanders are demanding
more than the domestic suppliers are willing to supply.
The difference of course is made up by imports.
So with trade, domestic consumption will be at QD free trade.
Some of that will come from imports
and some of that will come from domestic suppliers.
That's it. That's our analysis of international trade
using supply and demand.
Now make sure you understand each step in this diagram
because the next slide,
when we're going to add tariffs
it's going to make the diagram more complicated.
Each step is actually simple,
each step is actually no different
than the ones we've already done,
but the diagram will look a little bit messier.
So if you need to go through this slide again
make sure you understand each step along the way.
Okay let's do the same diagram
but now we're going to do it with a tax or a tariff.
Let's remember that here is the quantity
demanded with free trade,
here is quantity supplied with free trade.
The difference between the quantity demanded
and the quantity supplied domestically
is of course imports, so this is imports with free trade,
this distance right here.
Now, a tariff is simply a tax on imports.
What the tariff does is it raises the world price
by the amount of the tariff or the tax.
So the world supply curve or the world price shifts up
until we get to the new equilibrium.
Of course what this means is at a higher price
domestic consumers are going to demand a lower quantity.
Domestic consumption falls from Q free trade
to Q quantity demanded with the tariff.
Domestic production falls by this amount,
or let's just add that to the diagram,
domestic consumption falls from here to here.
Okay, what about domestic production?
Well with a higher price, domestic suppliers
are now willing to supply more.
Here is the price of the world price,
here's the world price.
With a higher world price domestic suppliers
are willing to supply more up until this point.
Let's add that to the diagram.
Domestic production is going to increase
from the quantity supplied with free trade
to the quantity supplied with the tariff
or again just putting that into the diagram
it's going to increase from here to here
along the domestic supply curve.
But what about imports?
Imports remember are the difference
between the quantity demanded and the quantity supplied.
The quantity demanded with the tariff is here,
the quantity supplied is here,
so imports are the difference which is this distance right here.
So notice that imports have fallen.
Final thing to add, a tariff is just a tax on imports,
this is the quantity of imports,
this is the amount of the tax or the tariff.
So the tariff will also generate some revenues.
This is the revenue from the tariff
which is going to go to the government.
It's the tax or the tariff amount
times the quantity of imports with a tariff,
so this is revenue that flows to the government.
Okay, that's it, that's analysis of tariffs,
now what I want to do
is say what are the welfare consequences of this?
The welfare consequences are going to depend
upon this factor the domestic production falling
and this factor the domestic consumption increasing.
Let's take a closer look.
Okay let's take a look at the welfare costs
and here I'm going to look at the net costs.
What I mean by that is we could actually find the cost
in two different ways.
We could look at the costs and the benefits to the consumers,
the costs and benefits to the producers,
the cost and benefits to government.
We could sum all those up, that would give us the net cost.
I want to jump straight to the net welfare costs
of protectionism and I'm going to do that
by focusing on the real factors which change
and these are two;
first domestic consumption as I said falls,
second domestic production increases.
Notice I haven't said anything here
about the revenue from the tariff,
that's because that's a cost to consumers,
they've got to pay more
but it's a benefit to the government,
they have this revenue that nets out
so it's not going to affect the net welfare.
Instead the net welfare
is going to depend upon these two real changes.
What I'm going to show is that both of these effects
somewhat surprisingly reduce welfare.
Why is this? Well domestic consumption falls,
the reason that reduces welfare
is because there are lost gains from trade
and I'll say more about that in a minute.
Second, domestic production increases,
you might think that's a good thing, except, however,
we're going to have wasted resources
because the domestic producers have higher costs
than the world producers.
On a net level there's going to be
more resources going to production than are necessary,
there's going to be wasted resources.
Can we measure the value of these losses?
In fact we can and I'll show that in the next slide
in a little bit more detail.
In order to focus on the welfare costs,
I'm going to make two simplifying assumptions.
First I'm going to assume that the world price is so low
that if there were complete free trade
there would be no domestic supply whatsoever.
Think about a good like sugar,
if we had complete free trade in sugar
we in the United States
would probably import all of our sugar.
It's simply much more expensive to produce sugar in Florida
than it is to produce sugar in a country such as Brazil.
The problem is is that in Florida
the opportunity cost of land is very high
and the climate in Florida is not ideal for growing sugar
so you have to invest more real resources
to produce sugar in Florida
than you do to produce sugar in Brazil.
So if we had complete free trade, there would be no domestic supply.
I'm also going to assume that with the tariff or the tax
that it raises the cost of imports so much
that there are no imports,
that it's simply too expensive to import the good.
Again this is actually quite accurate or quite similar
to what we have for the case of sugar.
With this very high tariff,
the entire domestic consumption is produced by domestic suppliers.
Our tariff equilibrium is given by this point
and notice that domestic consumption is lower.
Okay, so what are the costs of the tariff?
There are two.
First of all the lost gains from trade.
The demand curve can be read as the willingness to pay.
This is the willingness to pay for sugar
by domestic consumers.
The world supply curve can be read as the cost of producing sugar.
This is the price at which world suppliers
are willing to supply the sugar.
So there's lots of gains from trade here.
Consumers are willing to pay more than the suppliers require
in order to produce the good.
So by getting together
the consumers and the world suppliers
can earn these gains from trade.
With the tariff however, that's not possible.
With the tariff, we have reduced consumption
and with that reduced consumption is lost gains from trade
given by this purple area.
What else?
Well the US supply curve can be read as US costs.
So what happens with the tariff
is that instead of producing the sugar in Brazil
where it's cheap to produce sugar
we produce the sugar in Florida
where it's expensive to produce sugar
where we have to invest
more real resources in producing sugar.
We've got to invest more in irrigation,
more in valuable land, more in fertilizer.
So these are wasted resources, when the domestic industry expands.
Because of the tariffs we invest more resources
in producing sugar than are necessary.
It would be cheaper,
we would be able to import sugar using fewer resources.
We would be able to produce that sugar internationally
using fewer resources than we can produce it
in the United States.
What the tariff does is it switches production
from the low-cost world producers
to the high-cost domestic producers,
and that generates wasted resources.
Now in fact, with these numbers we can calculate the sizes
or the amount of these wasted resources.
What economists do quite often is they make assumptions
about these supply curves and these demand curves
and they can make some of these calculations.
Let's take a quick look.
So with these numbers, we can calculate these areas.
This triangle for example is half base times height.
So the base is 20, this is a base of 20.
The height is 20 minus 9, there's the 20, there's the 9.
So the area of the triangle is half base times height
or 1.1 billion.
What about the deadweight loss triangle?
You do the same calculation it's 0.22 billion.
So with these kind of numbers
we can find out the cost of the sugar tariff
are $1.32 billion
and economists do these kinds of calculations all the time.
Okay, let's summarize and point out some further reading.
First, tariffs increase prices to consumers
so domestic consumption falls and that creates a deadweight loss.
Second, tariffs divert production from low-cost world producers
to high-cost domestic producers and that wastes resources.
Now I haven't said much here
about the distribution of the losses and gains,
exactly who benefits and who loses.
Let me give you just a short story.
Tariffs are bad for consumers who have to pay more,
they're good for domestic producers who get to expand production.
They're bad overall precisely because of these two reasons
which I've just described.
If you want to look in detail, I focused on the bad overall,
if you want more detail on dividing in between consumers and producers
and the political economy of this,
take a look at lots of different textbooks
but the one of course I would recommend,
Cowan and Tabarrok, Modern Principles of Economics,
that will go into more detail on the distribution.
Thanks.
- [Narrator] If you want to test yourself
click Practice Questions.
Or, if you're ready to move on just click Next Video.
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