Chapter 20

12/3/2023
Ragan: Microeconomics Chapter Outline/Learning Objectives 20.1 Free Trade or Protection? (1 of 2)

Seventeenth Canadian Edition
Section Learning Objectives
• Most governments accept the proposition that a
After studying this chapter, you will be able to
relatively free flow of international trade is desirable.
20.1 Free Trade or Protection? 1. describe the various situations in which a
country may rationally choose to protect some
industries.
• Should a country permit the completely free flow of
Chapter 20 2. discuss the most common invalid arguments international trade, or should it use policies to restrict
in favour of protection.
Trade Policy 3. explain the effects of tariffs and quotas on the
the flow of trade to protect its local producers from
20.2 Methods of Protection
domestic economy. foreign competition?
4. understand why trade-remedy laws are
sometimes just thinly disguised protection. • If some protection is desired, should it be achieved by
20.3 Current Trade Policy 5. distinguish between trade creation and trade
diversion.
tariffs or by non-tariff barriers?
6. discuss the main features of the North
American Free Trade Agreement (which has
recently been modified and renamed as the
United States-Mexico-Canada Agreement).
Copyright © 2023 Pearson Canada Inc. 20 - 1 Copyright © 2023 Pearson Canada Inc. 20 - 2 Copyright © 2023 Pearson Canada Inc. 20 - 3
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20.1 Free Trade or Protection? (2 of 2) The Case for Free Trade The Case for Protection
• A tariff is a tax applied on imports of goods or • Free trade encourages all countries to specialize in • A country engages in trade protection when it
services. producing products in which they have a comparative implements government policy that interferes with free
• Non-tariff barriers (NTBs) are restrictions other than advantage. trade to protect domestic firms and workers from
foreign competition.
tariffs designed to reduce imports. • This pattern of specialization maximizes world
production and maximizes average world living • There are several valid arguments for production.
• Examples of non-tariff barriers: import quotas and
customs procedures that are deliberately standards. • Promoting Diversification
cumbersome • Free trade makes the country as a whole better off, – For a very small country, specializing in the production
even though it may not make every individual in the of only a few products might involve risks that the
country better off. country does not want to take—technology may render
the basic product obsolete, swings in world prices lead
to large swings in national income.
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Protecting Specific Groups Protecting Infant Industries Invalid Arguments for Protection
• Social and distributional concerns may lead to the • Infant industry argument • The following are a sample of arguments frequently
rational adoption of protectionist policies. – The Chinese economy, as an example heard in political debates concerning international
• But the cost of such protection is a reduction in the – Problems with this argument? trade:
country’s average living standards. 1. Keep the money at home
• Earning Economic Profits in Foreign Markets
2. Protect against low-wage foreign labour
• Improving the Terms of Trade – A country can potentially increase its national income
3. Exports are good; imports are bad
– Large countries can sometimes improve their terms of by protecting infant industries and by subsidizing
―strategic‖ firms. 4. Create domestic jobs
trade (and increase their national income) by levying
tariffs on some imported goods. Small countries – Unless carefully applied, such policies can end up
cannot. being redistribution from consumers and taxpayers to
domestic firms, without any benefit to overall living
standards.
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20.2 Methods of Protection Tariffs

Lessons from History 20-1 Tariffs—Explained (1 of 3)
Tariff Wars and The Stark Lessons from the Great Depression
• Under free trade, domestic production is Q0 and
• In 1929, at the start of the Great Depression, governments domestic consumption is Q1.
in many countries adopted protectionist trade policies.
• In the United States, Congress passed a legislation to
• Imports are Q0Q1.
raise tariffs on hundreds of imported goods. • A tariff of $T per unit raises the domestic price
• Other countries retaliated by increasing their own tariffs. to pd.
• The widespread increase in tariffs in the 1930s contributed • Domestic consumption falls to Q3, and domestic
significantly to a reduction in global trade and made the production rises to Q2.
economic situation worse.
• Current US administration is less interested in tariff wars
and has promised to be more supportive of WTO.
Figure 20-1 The Deadweight Loss of a Tariff
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Tariffs—Explained (2 of 3) Tariffs—Explained (3 of 3) Tariffs

• Producer surplus increases by area 1. • The government receives tariff revenue equal to • A tariff:
area 3. – Imposes costs on domestic consumers
• The decrease in consumer surplus is 1 + 2 + 3 + 4.
• The overall loss to the domestic economy is areas – Generates benefits for domestic producers
• Imports fall to Q2Q3. – Generates revenue for the government
2 + 4.
• The sum of areas 2 and 4 is the deadweight loss of • The overall net effect is negative.
the tariff. • A tariff generates a deadweight loss for the economy.
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Trade-Remedy Laws and Non-Tariff

Import Quotas Tariffs Versus Quotas: An Application Barriers
• A direct quantity • In general, a quota and a volume-equivalent tariff • Some non-tariff barriers (NTBs) were originally
restriction raises the have different welfare implications for the two created to remedy certain legitimate problems in
price received by foreign countries. trade.
suppliers of the good.
– Exporting country prefers a quota • Dumping
• A tariff leaves the – Importing country prefers a tariff – Form of price discrimination
foreign suppliers’ price
unchanged. • In the U.S.-Canadian softwood lumber dispute, both – Dumping, if it lasts indefinitely, can be a gift to the
tariffs and quotas were used. receiving country.
• A quota is worse than a
• Canada preferred having import quotas imposed on – Its consumers get goods from abroad at lower prices
tariff for the importing
Canadian lumber exporters rather than having the than they otherwise would.
country. Figure 20-2 The Deadweight Loss of an Import Quota
same export reduction accomplished by a U.S. tariff.
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Dumping Climate Policy Confronts Trade Policy 20.3 Current Trade Policy
• Antidumping laws were first designed to permit countries to • Policies designed to reduce GHG emissions, raise costs • The GATT and the WTO
respond to predatory pricing by foreign firms. for firms. – The General Agreement on Tariffs and Trade (GATT)
• More recently, they have been used to protect domestic • Imports from countries without equivalent policies are was created in 1947.
firms against any foreign competition. unfairly competing against their domestic products. – The principle of the GATT was that each member
• Countervailing Duties • One option is to impose ―carbon tariffs‖ on imports to country agreed not to make unilateral tariff increases.
– A countervailing duty is a tariff imposed by one adjust cost. – The GATT was replaced by the World Trade
country to offset the effects of specific subsidies Organization (WTO).
• Such border carbon adjustments (BCAs) can be used to
provided by foreign governments. protect firms’ competitive positions. – Through various ―rounds‖ of negotiations, the average
– Used to offset the effects of foreign export subsidies, level of tariffs has declined considerably since 1947.
• It is not yet clear whether or how WTO rules may be
but often they are thinly disguised protection.
modified to permit the use of BCAs.
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Regional Trade Agreements (1 of 2) Regional Trade Agreements (2 of 2) Trade Creation and Trade Diversion (1 of 2)
• Regional agreements seek to liberalize trade over a • A customs union is a group of countries that agree to • A major effect of regional trade liberalization is to alter
much smaller group of countries than the WTO have free trade among themselves and a common set the pattern of production and trade as countries
membership. of barriers against imports from the rest of the world. reallocate their resources toward the production of
goods in which they have a comparative advantage.
• Three standard forms of regional trade-liberalizing • A common market is a customs union with the added
agreements are free trade areas, customs unions, and provision that labour and capital can move freely • Trade creation is a consequence of reduced trade
common markets. among the members. barriers among a set of countries whereby trade within
the group is increased and trade with the rest of the
• A free trade area (FTA) is an agreements among two
world remains roughly constant.
or more countries to abolish tariffs on trade among
themselves while each remains free to set its own • Trade creation represents efficient specialization
tariffs against other countries. according to comparative advantage.
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The North American Free Trade

Trade Creation and Trade Diversion (2 of 2) Agreement Other Major Provisions (1 of 2)
• Trade diversion is a consequence of reduced trade • NAFTA dates from 1994 and is an extension of the 1. All tariffs on trade between Canada, the United
barriers among a set of countries whereby trade within 1989 Canada-U.S. Free Trade Agreement. States, and Mexico were eliminated as of 2010.
the group replaces trade that used to take place with
• NAFTA was replaced in 2020 by the United States- 2. The principle of national treatment applies to foreign
countries outside the group.
Mexico-Canada Agreement (USMCA). investment once it enters a country.
• From the global perspective, trade diversion
• NAFTA is guided by the fundamental principle of 3. Some restrictions on trade and investment are not
represents an inefficient use of resources.
national treatment. eliminated by the agreement. Examples in Canada
• The main argument against regional trade are supply-managed agricultural products and
• A key provision of NAFTA is its dispute-settlement
agreements is that the costs of trade diversion may cultural industries such as magazine and book
mechanism.
outweigh the benefits of trade creation. publishing.
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Applying Economic Concepts 20-1

Other Major Provisions (2 of 2) Results Canadian Wine: A Free-Trade Success Story
4. Trade in most non-agricultural service industries is • Industry restructured in the direction of greater export • Before the Canada-US FTA was signed in 1989,
liberalized and subject to the principle of national orientation in all three countries, and trade creation Canadian wine industry was heavily tariff protected.
treatment. occurred. • The Canadian wine producers were also required by law
5. A significant amount of government procurement is • The flow of trade among the three countries increased to use only domestically grown grapes.
open to cross-border bidding, though a large part is markedly, but especially so between Canada and the • With few notable exceptions, Canadian wine makers
still exempt from NAFTA (and the new USMCA). United States. produced mainly cheap, low-quality products.
• The volume of inter-industry trade also increased. • When tariff was removed under FTA, Canadian wines
• The greatest potential for trade diversion is with started competing with imported wines in the medium-
Mexico, which competes in the Canadian and U.S. quality range.
markets with a large number of products produced in • Now Canadian wineries also produce higher quality
other low-wage countries. wines.
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12/3/2023

Ragan: Microeconomics Chapter Outline/Learning Objectives 20.1 Free Trade or Protection? (1 of 2)

20.2 Methods of Protection Tariffs

Tariffs—Explained (2 of 3) Tariffs—Explained (3 of 3) Tariffs

Trade-Remedy Laws and Non-Tariff

The North American Free Trade

Applying Economic Concepts 20-1

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