Possibility Curves and
International Trade
“One might even say that the dislocations and distributional
consequences produced by trade are the flip side of the efficiency gains.”
Overview
How do you feel about working on teams? It is a question we have to answer in our personal lives as we
weigh the pluses and minuses of working alone or as part of a team. Some believe that by working together
on teams we can produce more than we can do by working alone, while others focus on the downside of
teams - the loss of independence and the risk of being held hostage by slackers on the team.
This is essentially the same question societies from the beginning of time have had to answer. Should
countries trade with other countries or should they try to protect their domestic industries and produce what
they need on their own? Not surprisingly, we do not all agree on the answer, and in this unit we examine
the evolution of economic theory and policies regarding international trade to better understand today's
debate on international trade policies. In the 1970s unit we will examine how countries keep score when
trading - balance of payments statistics - and the international monetary systems to facilitate the
international exchanges.
A brief history of international trade
Adam Smith believed man had a tendency to truck, barter, and exchange, and it would appear he was on to
something because since the earliest days of civilization people seem to have traded with each other.i Trade
was an important source of power and wealth in ancient civilizations including those in Mesopotamia,
Egypt, Indus Valley and China, and at the center of trade for each was water - the Euphrates River in
Mesopotamia, the Nile River in Egypt, the Indus River in India, and the Yellow River in China. Water was
by far the lowest cost means of transportation in a world without roads and rails. Trade also played an
important role in the rise - and fall of Greece. If you have been to Greece you realize there is little arable
land to support a large population, and certainly not enough to support large cities such as Athens. The rise
of this great ancient power was built on a network of trade routes, but unfortunately for Athens, when they
lost the ability to protect their trade routes, they lost their position of power.
We pick up the story of international trade with the spice trade, since it has been suggested "the history of
spices is the history of trade."ii Spices are at the center of the early trade story because they were easily
transportable due to their high value-to-weight ratio at a time where trade was very slow and risky, and
because the demanders of the spices – Europeans - and the suppliers - modern day Indonesians and
Malaysians - were separated by thousands of miles.
It may be hard in today's world to understand the magnitude of the European demand, but once you think
about life without refrigeration, you can see why so much would be paid for the spices.
Spices preserve, and they also make the poorly preserved palatable, masking the appetitekilling stench of decay. After bad harvests and in cold winters the only thing that kept
starvation at bay was heavily salted meat with pepper. And there was never enough of it.
Thus pepper began the association with gold ... In order to call off their siege of Rome in
408AD, the Visigoths demanded a bounty in gold, silver and pepper. In the Middle Ages
plague added to the demand for medicinal spices; a German price table from the 14th
century sets the value of a pound of nutmeg at seven fat oxen. At the same time
‘peppercorn rents’ were a serious way of doing business. When the Mary Rose, an
English ship that sank in 1545, was raised from the ocean floor in the 1980s, nearly every
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sailor was found with a bunch of peppercorns on his person - the most portable store of
value available.iii
The major beneficiaries from the high prices were the Arabs who worked hard, and generally successfully,
to control the trade well into 14th century.
Spices could change hands a dozen times between their source and Europe, soaring in
value with each transaction, and the Arabs were the greatest of the middlemen. Keen to
keep it that way, they did everything possible to confuse consumers about the spices’
origins. As early as the 5th century BC an Arab cover story fooled Herodotus into
believing that cinnamon was found only on a mountain range somewhere in Arabia. The
spices were jealously guarded by vicious birds of prey, he wrote, which made their nests
of the stuff on steep mountain slopes. Arabs would leave out large chunks of fresh
donkey meat for the birds to take back to their nests, which would crash to the ground
under the weight. The brave Arabs then grabbed the nests, from under the talons of their
previous owners.iv
This was an era where Muhammad began to build an Islamic empire around control of the spice trade, and
at its peak the empire stretched from Europe to China, with Baghdad as the cultural center of a world built
on monopoly profits from that trade. By 900 AD, Baghdad was the world’s largest city and the only one
with a population of one million.v Not surprisingly, there was a strong incentive to break the spice trade
monopoly that had inflated the price of spices in Europe, and often the result was military conflict between
Christian Europe and Islamic Middle East, the most notable being the Crusades.vi
By the mid 15th century, the conflict would enter a new phase. Europe was ready to launch a second front
in the war to weaken the monopoly held by the Arabs who brought the spices to the Mediterranean, and the
Venetians who were the European distributors. Two external events helped break the "bottleneck" in the
spice trade and led to the rise of Western Europe. The first was that fall of Constantinople (Istanbul) to the
Ottoman Empire in 1453, followed by the fall of Egypt in 1517. Venetians had become fabulously wealthy
from the East-West trade, but the rise of the Ottoman Empire effectively closed off the Venetian pipeline of
spices to Europe.
The second was the decision in China to stop its explorations of the Indian Ocean around 1435. Thirty
years earlier, the Chinese under the leadership of Admiral Zheng had begun to sail the Indian Ocean in 500
ft. behemoths that had no rivals in Western Europe. Below are models of a Treasure ship and Christopher
Columbus’ ship and you can imagine that a confrontation between the two would probably have gone well
for the Chinese, so it is very likely the Chinese would have controlled any water-based trade between
Europe and Asia if they had not decided to close down their country and outlaw these treasure ships.
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Photograph of the display in the China Court of the Ibn Battuta Mall in Dubai. From Wikipedia
In Europe, meanwhile, we were seeing the rise of nation-states - France and Spain replacing the Visigoths
and Franks - and these new nations found themselves involved in increasingly numerous and costly military
wars that created the need for large standing armies of soldiers needing to be paid. To finance their war
machines and build up their gold supply, they tried "rigging" international trade. What emerged was a
system of economic nationalism known as mercantilism that minimized imports that generated outflows of
gold and maximizing exports that creating inflows of gold. This was an era of business-government
"partnerships," where rulers did much to protect domestic industries that supplied the materials and funds to
support the government. This included the building of massive navies to rule the seas, and for those looking
for a good case study, check out the work of Jean-Baptiste Colbert, Finance Minister in France during the
reign of Louis XIV. Colbert helped design a mercantilist system to develop France’s industries and help
Louis XIV amass the sums of gold necessary to build his new home in Versailles – 2,300 rooms
“crammed” into 721,000 ft2, which makes the White House with its 132 rooms and total floor area of
55,000 ft2 seem downright small.
We pick up the story in the mid 1400s in Portugal. Located on the Southwest corner of Europe, Portugal
had a long history of sailing and fishing in the South Atlantic, and under the direction of Prince Henry the
Navigator (1394-1460) the country began to exploit that advantage.vii After many shorter exploratory trips
down the coast of Africa in the latter half of the 15th century, and refinements in ship design and
navigational equipment, the water link between Europe and Asia was finally established when Vasco da
Gama sailed into Calicut (India) under the Portuguese flag in 1498. The impact was dramatic, with the
price of pepper in Lisbon falling to 20 percent of the price in Venice. There was now an alternative to
Venetian spices, and the balance of power would now shift from the Mediterranean to the Atlantic.viii
Spain, also located on the Iberian Peninsula was not as successful at finding a water route to the East since
their funding of Columbus' expedition to India ran into a slight problem - the Americas - on its way to
India. Spain's backing of Magellan's successful circumnavigation in 1519, however, gave it a water route to
India, and these two nations competed with each other for decades until Portugal eventually emerged with
control of the spice trade.ix By 1600 Spain controlled much of South America, the Caribbean including
Cuba, the southern and southwestern parts of the US, and a foothold in the Asia (Philippines). Portugal
controlled Brazil and some outposts in southern Africa, the Arabian Peninsula, India, and a number of
islands in what are now Malaysia and Indonesia.
Next up were the Dutch.
In 1602 they formed the Dutch East India Company (the Vereenigde Oost-Indische
Compagnie, VOC), an association of merchants meant to reduce competition, share risk
and realize economies of scale. Other European countries also formed East India
companies - everyone from Portugal to Sweden to Austria had a go - but none was ever
as successful in the spice trade as the VOC. By 1670 it was the richest corporation in the
world, paying its shareholders an annual dividend of 40% on their investment despite
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financing 50,000 employees, 30,000 fighting men and 200 ships, many of them armed.
The secret of this success was simple. They had no scruples whatsoever.x
The rise of England got a big boost with its defeat of the Spanish Armada in 1588, and by the mid 18th
century, the East India Company was trading extensively in the East and benefiting from its position in the
emerging tea market. It took over control of India and colonial America, that small strip of land along the
eastern shore of North America. England ruled the seas and presided over an empire on which the sun
never set. This was the era when European nations carved up much of the rest of the world into their
colonies to supply them with resources markets for their products.
In the 19th century trade continued to be important, but the nature of the "game" changed. First, the
industrial revolution playing out in England began to generate BIG money, and the balance of power - both
military and industrial - shifted in the direction of industry and away from trade and agriculture. Up to this
point in time, wealth generated by trade accrued primarily to the traders who assumed enormous risks as
they sailed off into the unknown, and that wealth gave them access to power. But as the risks of ocean
travel fell and the size of the manufacturing industry rose, industrialists began to exercise their power. A
good indicator of the shift would be the fate of the Corn Laws that in 1815 imposed tariffs on grain
imported to the UK to protect landowners from competition from cheap imports. By 1850, however, the
balance of power had shifted to the industrialists who managed to get the Corn Act repealed to lower their
costs of production.
Second, in 1775 Adam Smith published The Wealth of Nations in which he offered a very different view of
national wealth. Rather than the gold in a government's Treasury, the true wealth of a nation was the value
of goods produced by the nation's people, and more importantly, Smith identified a way to increase that
wealth. According to Adam Smith, "[t]he greatest improvement in the productive powers of labour, and the
greater part of the skill, dexterity and judgment with which it is any where directed, or applied, seem to
have been the effects of the division of labour."xi Once one accepts this concept of division of labor – each
of us specializing in what we are good at - the question becomes how far to go with specialization? Again
Smith had the answer. "As it is the power of exchanging that gives occasion to the division of labour, so the
extent of this division must always be limited by the extent of that power, or, in other words, by the extent
of the market."xii By expanding the size of the market, production would expand, which would mean
greater efficiencies and a lower average cost. This lower cost, combined with adequate competition, and
consumers would get their goods at the lowest possible prices. It was only a matter of time before national
borders became viewed as somewhat arbitrary.
The person most responsible for advancing the theoretical basis for extending trade beyond national
borders was David Ricardo who introduced the concept of comparative advantage, "one of the crown
jewels of the economics profession." Ricardo’s comparative advantage "proved" that international trade
was a positive-sum game in which both parties would benefit, and he used this theory in opposing the Corn
Laws that were eventually repealed as England moved toward freer, and more open trade. England's
industries were the best in the world, and Ricardo led the movement to reduce trade barriers to enlarge the
market for the output of their factories. They also pushed for establishment of the gold standard, an
international monetary system, to facilitate the expansion of international trade – something we will
examine in some detail in the 1970s unit.
The battle over the Corn Laws in England was not the end of the debate over the value of free trade. That
debate continues today with calls from American and European officials for trade sanctions against China
for its mercantilist policies, and now we will look at some of the arguments for and against free trade.
Major arguments for free trade
We can visualize the pro trade argument with production possibility curve diagrams that you should have
seen in ECN201. In our simple example, we have only two goods - shelter and food - and two nations
whose leaders justify their existence by improving their citizens’ well being. They do this by expanding the
possibilities open to the people, and in the graph below the blue line is the Possibility Curve for Country X
that represents the initial possibilities open to the people. Given existing resources and technology, it is
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possible to achieve any point on the line if all of the resources are utilized, but it is impossible to achieve
any point outside of the line. The desires on the part of the people for more will keep pressure on the ruler
to increase output that is reflected in an outward shift in the possibility curve that would make B possible.
And there are only three ways to expand a country’s possibilities and allow people to consume more.
Resource Acquisition
Production Efficiency
Option I: Resource Acquisition
In the pre-industrial, zero-sum society of Alexander the Great, Genghis Khan, and the Caesars, the only
means to expand an empire's income (shift out the possibility curve to reach point B) was the acquisition of
resources through territorial expansion. The acquisition of resources shifts a nation's production possibility
curve outward so B would now be attainable - a shift from the blue line to the red line in the graph below.
For those aware of China's size today (20% of the world's population), and its ambitions for growth, this is
an uncomfortable view of the world first identified by Paul Kennedy in The Rise and Fall of the Great
Powers. Kennedy sees the expansion in size necessary to move the possibility curves creating the need for
greater expenditures on 'unproductive' ventures designed to defend and control the territory. Stated
somewhat differently, the territorial expansion sets the empire on a path where the empire eventually
outgrows its ability to control itself and it implodes - what he identified as imperial overstretch.
Option II: Production Efficiency
Adam Smith offered an alternative model of progress / growth. Territorial expansion was no longer
necessary for economic growth since a nation could expand its possibilities by getting more output from
existing resources. In the diagram below the impact on the possibility curve of an increase in productivity
in the production of shelter is represented with the new red line. With existing resources we can now attain
what was originally unattainable (pt. B). If productivity growth affected both sectors equally, the curve
would shift outward very much like what we saw with territorial expansion. The good news for China’s
neighbors is that now China could achieve its desired economic growth by a more efficient allocation of its
resources rather than territorial expansion. This is why US policy officials encouraged China’s move from
communism to capitalism as a way of utilizing its resources. By making this change China would increase
its growth rate, and the double-digit growth rate figures for the past few decades supports their claim.
Option III: Trade
At this point we have a set of self-sufficient countries with no interaction between them, but let's carry the
specialization concept a bit further, beyond national borders. David Ricardo, following the logic of Smith,
identified trade as another means to expand the possibility curves, and to see how this happens we have to
make a distinction between the production possibility curve (what people of the country can produce) and
the consumption possibility curve (what people of the country can consume).
In the example below, the blue line represents the possibilities open to country X in isolation. The
combination of shelter and food at point A are attainable if resources are used efficiently, but point B is
unattainable. Or is it? What if someone (another country maybe) came along and proposed that country X
specialize in the production of food and then trade food for shelter along the red possibility curve? Clearly
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point B is now reachable and the country now has another means for expanding the possibilities open to its
people. To understand why this deal might be on the table, we need to delve further into the trade model
and the concept of comparative advantage.
Trade
David Ricardo introduced the concept of comparative advantage during the early industrialization of
England when it seemed legitimate to question why England would want to trade with other countries such
as Portugal. Was there any mutual advantage to trade in wine and cloth between the two countries? If we
updated the argument we might look today at the US and Saudi Arabia and the trade in wheat and oil. A
classic example of comparative advantage is the lawyer who happens to also be very good at typing, better
in fact than the secretary. Should the lawyer do the typing, or should the lawyer stick to "lawyering" and
the secretary stick to typing? Comparative advantage suggests the lawyer stick to the law and pay the
secretary for the typing with the money earned from those billable hours and still have some “profit” left
over. To see how it works, we'll look at a simple example in which we use some actual numbers.
First, the production possibility curves of the two countries appear below. Country X can use its resources
to produce along the blue possibility curve. If it devoted all of its resources to production of food, it can
produce 5,000 units of food. If it chose to specialize in shelter it can produce 2,500 units of shelter. In this
situation you would expect the price of a unit of shelter to cost twice as much as a unit of food since twice
as much food (5000) can be produced as shelter (2500).
Country Y, meanwhile, can produce anywhere along the red possibility line. If all of Country Y's resources
were devoted to production of shelter, it can produce 2,000 units, while it can produce 1000 units of food if
it specialized in food production. With these possibilities, the price of a unit of food would be twice as
much as a unit of food. If we used the same logic we would see that a unit of food in Country Y is twice as
costly as a unit of shelter. In this world of no trade, people in Country X would think Shelter was
expensive, while in Country Y people would see food as expensive.
Now the question is: can you devise a "deal" where both countries willingly engage in trade that benefits
both of them? If you can devise such a deal, then you have made the argument for free trade. The secret to
the deal is in those prices, and to see how it works, assume both countries were offered an opportunity to
trade one shelter for one cloth so the price of the two would be equal. Think about what you would do
when faced with this offer if you were Country X. If you were, you would see that the price of food and
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shelter are the same if you trade, while with no trade shelter is twice as expensive. In this situation you
would want to buy shelter from abroad. And if I were Country A, I would want to buy food from abroad
because it is cheaper. So, we have a deal – Country X exports food and imports shelter, while Country Y
exports shelter and imports food.
The deal shows up in the diagram below where we have now added consumption possibility lines (dotted
lines). These lines are drawn with a slope of -1 representing the 1-1 trade offer. The best strategy for
Country X would be to expand its food industry and shut down its shelter industry. In fact it would
specialize in production of food so it would produce 5000 units of food and 0 units of shelter and then trade
along the dotted consumption possibility line to obtain shelter. If Country X decided to trade all of its food
for shelter it could obtain 5000 units of shelter, more than the 2500 without trade.
Country Y, meanwhile, would specialize in shelter and trade for food along the 'consumption' possibility
line that would be outside of the production possibility line.
If the countries specialized in what they did best (food in X and shelter in Y), they would each back along
the dotted consumption possibility lines. In doing this they would each be able to reach points that were
unreachable without any trade.
What this analysis of trade has done is extend the concept of specialization beyond national boundaries.
Country X has the comparative advantage in food and Country Y has the comparative advantage in shelter,
and they both benefit from specialization and trade. This simple concept of comparative advantage is at the
heart of the argument made by the proponents of free trade that has been reflected in international trade
agreements (GATT and the WTO) and regional trade agreements (NAFTA), and we will explore these
agreements in more detail in the 1970s unit. It is also why the majority of economists favor international
trade – because the benefits of trade outweigh the costs.
Comparative advantage has proved to be a powerful argument for free trade, but it has not been the only
one. Some of the other arguments are briefly mentioned below.
1.
2.
Power of competition. Most economists tend to believe in the power of markets and the importance of
healthy competition that international trade tends to promote. Once the decision has been made to
allow imported cars into the US, consumers' options are increased. For example, when I was young the
family car was always in the "shop" getting worked on, and we accepted it. That all changed, however,
with the introduction of Japanese cars to the US market that promised, and delivered, greatly improved
service records.
National security. There are numerous examples of wars fought over trade - the Peloponnesian War
fought between Athens and Sparta, the Opium War fought between England and China, and possibly
the US Civil War - but trade can also replace military conflict. If you are involved in trade with a
country then there is a cost to waging war – the loss of the market or resource - and maybe the cost is
enough to discourage the war. Thomas Friedman, in The Lexus and the Olive Tree, dramatized the
point when he wrote that countries with McDonalds franchises do not wage war on each other. While it
is not quite true, the reality is the web of trade networks raises the costs to anyone considering waging
war.
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3.
4.
5.
6.
7.
Lower costs / economies of scale. Size matters when it comes to production, and as the volume of
production increases when firms begin to export, the average cost of production may drop – what we
call economies of scale.
Increased variety of goods. Wine can be produced in the US, but not French wine, and you are not
likely to get much orange juice from domestic oranges in the UK. Trade allows consumers access to
products that would either be too expensive or nonexistent without trade.
Innovation. Openness to the international trade in goods is related to openness to the international
trade in ideas and technology, and this can be a catalyst for growth.
Economic growth. Economists, following the lead of Adam Smith and Ricardo, tend to believe that
there are some real output / income gains from the specialization that accompanies trade.
Lower prices. One of the main arguments for trade is that the price of imported goods will fall which
will be a benefit to domestic consumers. If oranges are very expensive in the UK because they need to
be grown in hot houses, then opening up trade with South Africa will reduce the price of oranges paid
by consumers in the UK.
Not everyone, however, benefits from trade and not everyone supports free trade, so now we will look at
some of the arguments against free trade.
Major arguments against free trade
1.
2.
3.
4.
5.
Job loss. At the top of the list would be jobs because there is no question jobs are lost as a result of
trade. These jobs are often highly visible and easily linked to international trade. You see it in every
story of a company shutting down its American plant and moving production to a cheaper, foreign
location. What does not often make it to the news, however, are the jobs that are created here for
workers making goods to be sold abroad. There are many of these jobs, but because news tends to
focus on plant shutdowns rather than openings, the public sees job losses as the byproduct of freer
trade, which explains why there is a wide gap between public support for protectionist policies and
economists’ support of free trade.
Unfairness of trade. Some oppose international trade simply because they oppose the globalization
process they see as unfair. To many, especially those in the world's poorer countries, globalization is
seen as "rigged" to favor rich countries that control the international organizations that govern
international exchanges. Others believe free trade in raw materials discourages economic growth and
development. When asked to identify sources of national wealth, natural resources are always high on
the list, but in countries with an abundance of resources in Africa and the Middle East we often find
people living under autocratic rule in seemingly endless conflict. The valuable resource – diamonds or
gold – will be mined and shipped to the world's richer countries that will ship money that ends up in
the pockets of a corrupt and brutal regime that devotes more resources to preserving its control of the
natural resource than to the improvement of living standards of its people.
Infant industry: Some believe it is in a nation's self interest to protect certain industries because a
country's domestic industry may be temporarily unprepared to compete with existing producers.
Imagine being in Korea contemplating creating a domestic producer of airplanes. This is an important
industry, but it would be virtually impossible for a new firm in Korea to take on Boeing or Airbus, the
two industry giants. Given what we have seen in other industries such as automobiles and electronics,
it is reasonable to believe Korea could eventually compete. All Korea’s firms would need is some
protection for a limited amount of time to become competitive. The downside of this argument is that
the infants often never grow up; never reach the point where they can survive on their own.
National security. Think of the aircraft in our air force, or the software guiding our smart bombs.
These are too important to the war effort to rely on foreigners to produce them because their supply
could be disrupted. This makes some sense, but where to draw the line between industries that are
important to national security, and those that are not.
Race to the bottom. There is concern that free trade has set the world on a race toward the bottom.
Corporations are concerned with profit, and free trade has allowed them to avoid tough labor and
environmental standards by relocating production facilities to locations where regulations are minimal,
or nonexistent. If the Department of Labor enforces child labor laws restricting the work of children,
something the US did not have until the late 1930s, then why not move to where there are no such
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6.
limitations. And what about those high wages earned by labor whose rights to organize are protected?
They can be avoided by simply moving operations to a country where there are no such protections.
The losers are the workers who have been replaced by sweatshop workers toiling in factories for long
hours under harsh conditions for a mere pittance. Similarly, if the EPA sets a costly pollution standard
in the US, then why not move production to where regulations on pollution do not exist? More recently
some environmentalists have raised concerns about the growth of trade because it raises the carbon
content of tradable goods, and this is damaging the environment. For example, imagine the carbon
footprint of those fruits and vegetables that arrive at the local grocery store in the winter months on
cargo planes from South America.
Loss of diversity. Opponents of free trade object to the fact that multinationals such as McDonalds,
Coke, and the Gap drive local companies out of business that results in the loss of many cultures. To
these opponents of free trade, a vision of the world's future can be seen in the US's past. Where there
once was a strong local culture in our cities, the free movement of people and goods across the country
has produced a collection of undifferentiated cities dominated by national chains and box stores. And
you can see it happening internationally today as young people around the world wear their jeans and
T-shirts, talk on cell phones, eat at McDonalds, and drink Coke. This is what struck Thomas Friedman,
author of The World is Flat, when he found himself in India and believing he was in America.
We have now looked at some of the major arguments for and against free trade, and now we will examine
some of the policies that affect trade. The fact is that free trade is not nearly as frequent as you might be led
to believe. We live in a world of managed trade and now we will examine trade policies that have been
developed to "manage" that trade.
Tools for managing trade
There are a number of policies that affect a country's international trade - some where the impact is a
byproduct of a non trade policy, and some that are designed to influence trade. One example of the former
would be energy policies in the US. In the early 2000s there was considerable concern about the enormous
US trade deficit, and a good deal of that deficit was attributable to oil imports. The decision by the Obama
administration to spend some of the stimulus money on exploration of alternative energies would reduce
US dependence on foreign oil that would reduce US imports and reduce the trade deficit. There are
numerous other policies that have an indirect impact on trade, but here we will focus attention on policies
that are more directly related to international trade. Generally these policies fall into three categories,
tariffs, non-tariff barriers to trade, and one non-tariff barrier that gets special attention, quotas. We'll begin
with tariff.
Tariffs: Tariffs are simply sales taxes imposed on internationally traded goods. If you want to buy a car in
a country that had imposed a tariff of 20% on imported vehicles, then the $20,000 imported vehicle will
cost you the $20,000 plus the $4,000 tariff. You can see why domestic industries would argue for tariff
since the tariff adds $4,000 to the cost of the vehicle, and you can be assured the domestic companies
would probably use the tariff to raise prices on domestically produced vehicles.
Import quotas: Quotas are quantitative restrictions on the volume of trade. Included here would be
voluntary restraint agreements such as Japan's agreement to limit the number of cars it exported to US, or
the Multifibre Agreement of the mid 1970s that established quotas on imports into the US of textiles and
apparel from various countries around the world.
Tariffs and quotas can achieve the same level of imports by driving up the price of the imported goods. The
difference between the two is who benefits from the restrictions. A tariff system will create tariff revenues
that accrue to the government, which is why governments like tariffs. A quota meanwhile, increases the
scarcity of the good and drives up its price, but now the producers benefit from the higher prices. This is
why many industries tend to prefer quotas.
There are a number of additional, non-tariff barriers to trade, a few of which are identified below.
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Administrative rules: Countries impose administrative rules designed to protect its people, and many times
this affects international trade. Included here would be a wide array of rules designed to increase the
difficulty, and cost, of getting a product into a country. One would be a domestic content rule that would
require any imported product, cigarettes to Australia, for example, to contain a certain percentage of
domestic tobacco. You could establish time-consuming and expensive quality testing and safety standards,
or establish import licenses or import state enterprises that control imports. Here are a few of the more
notable examples.
1.
2.
3.
4.
The EU limited the importation of meat fed with growth-inducing hormones on health
grounds. This sounds like a health policy, but since the US extensively uses these hormones it
in effect was a policy that targeted US meat exports - at least this is what the US says. The
result has been a long-running battle between the EU and US.
The US and Canada have different building codes regarding standards for plywood, and by
imposing tougher standards, the US in effect excluded Canadian plywood exports to the US.
France at one point required that all VCR imports be inspected in Toulouse, a city far
removed from any entry port or major market. The result was an increase in the costs of the
imported VCRs.
Europe, beginning with Germany's Blue Angel program in 1997, began imposing labeling
requirements that were viewed as restricting trade because it made it more costly for other
exporters to sell in Europe.
Export subsidies: money or tax breaks governments give to firms that export. The money would reduce the
firm's production cost and allow price cuts that would improve the competitiveness of the exporting
industry.
Import subsidies: money or tax breaks governments give to firms that cannot compete with foreign firms.
The money would reduce the firm's production cost and allow price cuts that would improve the
competitiveness of the domestic industry.
Anti dumping legislation: in microeconomics you study predatory pricing where one firm temporarily
lowers price below cost to drive out competitors. The international trade version of this is dumping, and a
country that felt its firms where competing against foreign firms employing this tactic could impose
penalties on the imports.
Currency manipulation: the cost of an exported good depends upon both the costs of production and the
exchange rate - the price of a country's currency. China, which ran massive trade surpluses in the early
2000s, was accused by many of generating these surpluses by keeping its currency undervalued.
We have now looked at the arguments for and against international trade, as well as the policies used to
alter the flow of goods and services, and now it is time to look at the evolution of trade policy.
The track record on trade policy
We pick up the story of US trade policy with Alexander Hamilton, the first Secretary of the US Treasury
and one of the greats in US history. Hamilton is probably most remembered for his call for the
establishment of a central bank for the new country, or the duel he lost to Aaron Burr, but he also wrote the
Report on Manufactures in which he made an appeal for policies to protect the country's infant
manufacturing industries. The Whig Party promoted this "American system" of protectionist policies as an
alternative to the "British system" of free trade proposed by Adam Smith and supported in the US by the
Democrats. This battle over trade policies continues, and to get a sense of how the battle went, check out
the diagram below of US tariff rates since 1820. The two lines are there because some goods had no duties
and when we look at all imports, the tariff rate (tariff revenue/value of imports) is smaller because the
denominator is bigger. For much of the pre Civil War period the free trade side was winning as tariff rates
trended downward.
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Things changed dramatically following the US Civil War when tariffs rose substantially. Before the war the
North was the center of industry and its representatives pushed for higher protective tariffs, while the
agricultural South that needed to import their manufactures supported lower tariffs. Once the bills for the
war started to build, and the Southern senators left DC, tariffs were more than doubled, and remained
relatively high for the remainder of the century as the Republicans, the party of Northern money, held a
virtual lock on the presidency. The US had essentially adopted a mercantilist approach to trade captured in
the statement attributed to president Abraham Lincoln.
When we buy the manufactured goods abroad, we get the goods and the foreigners get
the money. When we buy the manufactured goods at home, we get both the goods and the
money.
Things changed again with the election of the Democrat Woodrow Wilson in 1912. Tariffs dropped
sharply, but with the return of Republicans to the White House with the 1920 election of Calvin Coolidge,
tariffs rose again. The onset of the Great Depression did what most severe economic times do - it generated
bipartisan support for protectionist policies that produced the Smoot-Hawley tariff in 1930. Some of the
impact of the tariff was "missed," however, because since the 1870s an increasing share of trade was not
subject to tariffs, which explains the widening gap between the two lines.
The impact of the tariffs on US trade can be seen in the second diagram. In the 50-odd years of Republican
rule from the mid 1860s to the mid 1910s, exports in the US had expanded by a multiple of five - the index
rose from 1 to 5 during that time. This was less of an increase than during the 8 years of Woodrow Wilson's
presidency and WW I. The export index dropped sharply, however, after the tariff increases of the early
1920s and the 1930 Smoot-Hawley tariff.
Things would change again after WW II. In July of 1944 at Bretton Woods, New Hampshire the Allied
countries’ finance leaders met to design an international monetary system to end the chaos of the 1930s.
What emerged was the Bretton Woods agreement - a new international order centered around three new
international institutions. To facilitate the expansion of international trade and remove the tariff and
nontariff barriers to trade, the International Trade Organization (ITO) was proposed, but the US refused to
sign, so it was replaced by the General Agreement on Trade and Tariffs (GATT) that was quite successful
at reducing tariff levels in a series of multi-year international conferences - called rounds (History of GATT
rounds) - the Kennedy Round (1962-67), the Tokyo Round (1973-79), and the Uruguay Round (1986-94).
GATT only dealt with the trade in goods and ignored services that were becoming an increasingly large
share of trade of the world's rich countries, and finally, in 1995, GATT was replaced by the World Trade
Organization (WTO) that accepted China as a member in 2001.
In addition to these multilateral agreements of GATT and the WTO, there are also regional, or bi-lateral,
agreements that further reduced trade barriers between specific partners. The most notable of these is the
North American Free Trade Agreement (NAFTA) that lowered the trade barriers between Canada, Mexico,
and the US.
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The results were impressive. Lower trade barriers resulted in an explosion of international trade. In the
graph below are indexes for world exports, world exports of manufactures, and GDP (WTO data). In 2007,
world GDP was about 8 times larger than it was in 1950, the result of a 3.8% average annual growth rate.
World exports, meanwhile were 220 time higher and world manufacturing exports were 414 higher in 2007
than 1950, the result of annual growth rates of 10% and 11%.
Not all counties, however, joined the network of trading countries after WW II. At that time there were
two models for growing an economy - export-led growth and import-substitution led growth. Supporters
of free trade followed the export-led approach promoted by the US and built up successful export
industries, while opponents of free trade followed the import-substitution model and attempted to develop
their own steel and auto industries rather than importing steel and autos. Asia provides a good case study on
the relative merits of the two approaches. Japan and the Asian Tigers (Hong Kong, Singapore, South
Korea, and Taiwan) adopted the export-led approach, while China, because it was a communist country,
and India, because of its colonial history, chose import-substitution as a strategy for growth. Mao, in China,
and Gandhi, in India, believed the secret to sustained growth in their countries was to develop domestic
industries, so households would substitute the output of domestic factories for the output of foreign
factories. They wanted no part of a system controlled by the US. It is clear from the left-side graph that the
export-led strategy produced substantially higher growth rates in the 1950-1980 period.
In the right hand graph is also clear that there was a substantial increase in the growth rate of China and
India despite the fact the world growth rate was lower. The speed up in growth was attributed primarily to
increased openness of the two countries, especially in China where Deng Xiaoping adopted the export-led
growth model and opened China up to companies from around the world who wanted to take advantage of
China's cheap labor and set up factories to produce goods to be exported to the world. The rest as they say,
is history.
Despite the successes in China and India, the expansion of international trade was not greeted by all as a
good thing, and things turned ugly at the December 1999 WTO meetings that were shut down in street
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protests known as "The Battle in Seattle." More recently there have been rising worries about trade in the
US and Europe as the relocation of manufacturing industries that accompanied the growth in trade has
spread to the service sector that is far bigger than the manufacturing sector. In a later unit, we will look at
the future of international trade, and its likely impact on us.
Conclusion
There is no simple, or universally accepted, answer to the question: to trade, or not to trade. What we do
know is trade is disruptive and not everyone "wins." There are some gains from trade, but they come at a
cost - another example of the "no free lunch" rule. "[T]he benefits of international economic integration
comes with 'strings' attached: the 'price' of free trade in goods, services, and capital is that international
markets get greater say about the way national economies are managed and their wealth is
distributed."xiii The gains from trade come from industries shutting down their operations in one country
and opening them up in another country, which is why you “might even say that the dislocations and
distributional consequences produced by trade are the flip side of the efficiency gains.”xiv There was also no
mention of the distribution of the gains from trade. World output will be increased and prices will fall, but
who receives the extra output, and who benefits most from the lower prices? One general rule is - small is
good. Smaller trading countries have a smaller impact on any world prices so the opening up of trade in
those countries will not affect the prices of tradable goods. When they decide to export to the world the
extra supply has no impact on world prices, while if a large country floods the world market with their
exports, it would drive down the price of those exports and reducing the benefits from the trade.
There was also no discussion of the distribution of costs and benefits of trade within a country. The
specialization that produces the extra output means that in each country there will be job losses as resources
are shifted to the export sector. The assumption is always that the extra output generated by trade would
allow for those who lost their jobs to be compensated for their loss, but this seldom happens. At most what
we find are some forms of trade readjustment allowances that are similar to unemployment benefits temporary payments made to workers whose jobs disappeared as a result of international trade.
There has also been no mention of the role played by the traders. International trade does not just take
place, it requires someone to orchestrate it - and that is where the traders come in. Think about those Nike
shoes that cost more than $100 in the US, the same ones that probably cost less than $10 to produce in
China. This gap between sellers and buyers prices is huge, and it gives you some sense of where the real
value of international trade goes. It goes to the distributors who get the product to market, and the
marketers who have "created" the brands' value in the minds of consumers.
And finally, the comparative advantage model never takes account of the fact that there will be trade
imbalances, but those imbalances exist and they can be huge. In 2007, for example, China and Saudi
Arabia's trade surpluses equaled approximately $150 and $250 billion, while the US was running a trade
deficit exceeding $800 billion. The proponents of trade really discuss neither how these imbalances arise
nor how they will be dealt with - issues we will address in the 1970s unit.
13
14
Trade
i
For those interested in a history of trade, you should read Bernstein's book, A Splendid Exchange
"A Taste of Adventure," The Economist, December 19, 1998
iii
"A Taste of Adventure," The Economist, December 19, 1998
iv
"Not everyone was fooled. In the 1st century AD the Roman historian Pliny grew concerned at the way the empire’s
gold flowed ever to the east, and set out to expose the truth and undercut the Arab monopolists, who he reckoned to be
selling pepper at prices a hundred times what they paid for it in India. It did not help that the gluttonous Romans were,
in the words of Frederic Rosengarten, a spice historian, ‘the most extravagant users of aromatics in history.’ They used
spices in every imaginable combination for their foods, wines and fragrances. Legionaries headed off to battle wearing
perfume. The rich slept on pillows of saffron in the belief that it would cure hangovers." ("A Taste of Adventure,")
In a recent archeological find on the Red Sea in Egypt, researchers "unearthed the most extensive remains to date from
sea trade between India and Egypt during the Roman Empire, adding to mounting evidence that spices and other exotic
cargo traveled into Europe over sea as well as land. "Along with the rest of Egypt, Berenike ( the newly discovered
Roman era town on the Red Sea) was controlled by the Roman Empire during the first and second centuries. During the
same period, the overland route to Europe from India through Pakistan, Iran and Mesopotamia (today's Iraq) was
controlled by adversaries of the Roman Empire, making overland roads difficult for Roman merchants. Meanwhile,
Roman texts that address the relative costs of different shipping methods describe overland transport as at least 20
times more expensive than sea trade," so there was a strong incentive to find a water route for the trade. For more on
this discovery check out "Archaeologists Uncover Ancient Maritime Spice Route Between India, Egypt," PopularScience, April 2, 2004
v
George Modelski’s (2003) World Cities, -3000 to 2000, Washington, DC: FAROS 2000.
vi
And if the parallels between the European's addiction to spices and the US addiction to oil doesn't get your attention,
look at the role played by religion and maybe you can believe, as some do, the fall of communism unleashed the
suppressed clash of civilizations and the US invasion of Iraq is a modern-day crusade. Again, as described in The
Economist:
Resentment against the Arab stranglehold had led Rome to launch an invasion of Arabia in 24BC,
an ill-fated expedition that ended in humiliation. But where military means failed, market
intelligence prevailed. In 40AD, Hippalus, a Greek merchant, discovered something the Arabs had
long tried to obscure: that the monsoons which nourish India’s pepper vines reverse direction midyear, and that trips from Egypt’s Red Sea coast to India and back could thus be shorter and safer
than the empire had imagined. Roman trade with India boomed: the Arab monopoly broke.
Early in the 7th century, an obscure spice merchant named Muhammad re-established Arab
dominance of the spice trade by introducing an aggressive, expansionary Islam to the world. When
the Muslims took Alexandria in 641AD, they killed the trade which had long flourished between
Rome and India. As they tightened their grip on the business over the next few centuries, prices in
Europe rose dramatically. During the Middle Ages, spices became a luxury that only a few in
Europe could afford. This was bad news for the poor and good news for Venice. Its shrewd
merchants struck a deal with the Arabs that made them the trade’s preferred, indeed almost
exclusive, European distributors. Even during the crusades, the relationship bought wealth to all
concerned.
The rest of Europe did not care at all for the Muslim Curtain, as the Islamic empire separating west
from east came to be called, or for the Venetians. The final blow came in 1453 when the Ottoman
Turks took Constantinople, shutting down the small overland trade that had previously evaded the
Arab-Venetian monopoly. The Egyptians, gatekeepers of the trade with Venice, felt confident
enough to impose a tariff amounting to a third of the value of spices passing through their fingers.
ii
vii
. By mid century Portugal had established control over the Madeira, Azores, and Cape Verde islands where,
following the lead of the Venetians in the Mediterranean, they were able to develop a sugar industry built upon slave
labor, a lucrative slave trade that, between 1500 and 1870 would transport nearly half of the 9.4 million slaves shipped
from Africa to the Americas, and a booming trade in gold.
viii
"If historyís modern age has a beginning, this is it. Europe’s ignorance of, and isolation from, the cosmopolitan
intellectual and commercial life of Asia were ended forever. With ships, weaponry and a willingness to use them both,
the countries of Europe were about to colonize the rest of the world. To support this expansion, its merchant classes
would invent new forms of commercial credit and the first great corporations, vital parts of capitalism’s operating
system, and spread their trading networks across the seven seas. And what did the men shout as they came ashore? 'For
Christ and spices!'" ("A Taste of Adventure,")
ix
The situation at the outset of the 17th century can be seen in the map, The Age of Discovery 1340-1600 from the
Historical Atlas by William R. Shepherd.
x
"The VOCís first conquest was the Banda archipelago. Unlike the sultans of the clove islands, who relished the
attention lavished upon them by their European suitors and the opportunities for mischief that came with it, the fiercely
independent Islamic merchants of the Bandas had never allowed Spain or Portugal to build forts on their islands: they
15
insisted on their freedom to trade with all nations. This independence proved their undoing, since it encouraged the
VOC to put the nutmeg trade first on its order of business.
For a taste of Bandaís romance nothing beats a trip to Run, an explosion of nutmeg trees in the middle of a turquoise
sea. Reaching it after a night aboard ship is a magical experience; scores of dolphins dart about your bow-wave as the
first glints of sunrise streak across the sky. It feels much as it must have done when English adventurers first claimed
the place, making it the country’s first colony anywhere. Not much of a colony, it must be said: the island is so small
that even a modest fishing vessel can come ashore only at high tide. Yet this seemingly insignificant toe-hold in
nutmeg-land so exercised the Dutch that they traded away a promising young colony on the other side of the world to
secure it. That island was New Amsterdam, now better known as Manhattan.
The purchase of Run demonstrates the VOC’s persistence; it does not do justice to the company’s cruelty (normally,
but not exclusively, meted out to non-Europeans). Its most successful head, Jan Pieterszoon Coen, had earlier
convinced the reluctant Bandanese of his firm’s God-given right to monopolise the nutmeg trade in a more typical
style: he had had every single male over the age of fifteen that he could get his hands on butchered. Coen brought in
Japanese mercenaries to torture, quarter and decapitate village leaders, displaying their heads on long poles. The
population of the isles was 15,000 before the VOC arrived; 15 years later it was 600.
When they turned to the clove trade the Dutch had no time for the squabbling politics of Ternate and Tidore. The VOC
uprooted all the Sultansí clove trees and concentrated production on Ambon, an island where its grip was tight. By
1681, it had destroyed three-quarters of all nutmeg trees in unwanted areas and reorganised farming into plantations. It
imposed the death penalty on anyone caught growing, stealing or possessing nutmeg or clove plants without
authorisation. It drenched every nutmeg with lime before export, to ensure that not one fertile seed escaped its clutches.
Yet high on its hillside Afo lives to tell its tale.
Climb through the dense, aromatic forests that cover the steep slopes of Ternate’s volcano, and you will find this living
testament to the ultimate futility of monopoly. Nearly 40 metres tall and over 4 metres round, Afo is the world’s oldest
clove tree, planted in defiance of the Dutch ban nearly four centuries ago. Despite the VOCís extreme precautions,
Afoís sister seedlings, stolen in 1770 by an intrepid Frenchman (curiously, named Poivre), ended up flourishing on the
Seychelles, Reunion and especially Zanzibar, which later became the world’s largest producer of cloves. By the end of
the 18th century the emergence of these rivals had broken the Dutch monopoly for good.
By that time the VOC was already a hollow mockery of its original ghastly self. As early as the end of the 17th century,
careful analysis of the books shows that its volume of trade was reducing every year. Even a monopoly so ruthlessly
enforced could not help but leak, and the VOC’s overheads were hugeótens of thousands of employees, garrisons, warships. Decades of easy rents had created a corrupt and inefficient beast. By 1735, dwindling spice income had been
overtaken by textiles in the company’s profit column. In 1799, the most vicious robber baron of them all met its final
end. The VOC went bankrupt." ("A Taste of Adventure,")
9a. The House of Commons, in 1813, had recommended that foreign-grown corn should be excluded from England
until the price of domestic corn hit a specified price - 80 shillings. Its proponents, including Thomas Malthus, argued
that it was necessary to prop up the price of corn because this would prop up the earnings of farmers and the landlords,
and they would then be able to purchase the manufactured goods. They also argued that the manufacturers simply
wanted lower corn prices so they could drive down wages and increase their profit. It was a moot point until peace
arrived in 1814 and the price of corn dropped sharply, prompting passage of the Corn Laws that raised the price of corn
in England.
xi
Adam Smith, The Wealth of Nations, Vol. I, Book I, Chapter I, p5
xii
Adam Smith, The Wealth of Nations, Vol. I Book I Chapter III p19
If you look closer at Adam Smith's work you find the key to productivity growth was specialization - the division of
labor. Smith used the example of the pin factory to demonstrate the potential growth associated with specialization. If
production could be broken down into separate tasks where people could get 'real good' at what they do, then they
could produce far more pins then they could working alone.
xiii
12. Dani Roderik Symposium on Globalization in Perspective: An Introduction Journal of Economic Perspectives,
1998
xiv
12. ibid
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