Free Trade Versus Trade Barriers

1. Basis for Trade: Opportunity Cost and Comparative Advantage

If you recall, the key idea about gains from trade is that trade allows countries to enjoy more of both goods being traded and allows them to move beyond their previous resource and productivity constraints.

Both goods can be produced at the lowest opportunity cost, which is the sacrifice made by choosing one value over another, or the value of the foregone opportunity.

We decide who produces what based on comparative advantage, which deals with this concept of opportunity cost, or what we give up.

EXAMPLE

Whenever the United States decides to devote resources like land, labor, and capital to produce textiles, we give up the opportunity to use those resources to produce something else, such as cars. Therefore, what is given up is our opportunity cost.

Comparative advantage, then, is essentially the advantage conferred to a country because of one good’s production relative to another.

hint

Another way of thinking of comparative advantage is by asking, “Who gives up less?”

When countries specialize in the goods or services for which they have the lower opportunity cost—meaning they enjoy a comparative advantage—then both countries benefit.

EXAMPLE

If the United States decided to devote its resources to producing textiles instead of cars, we would give up a lot more in terms of cars than Mexico would, considering the technology and the skill level of our workforce compared to that of Mexico. In this case, Mexico would enjoy the comparative advantage in textiles because it does not give up as much when it devotes its resources to textile production. The United States, then, would enjoy the comparative advantage in cars.

terms to know

Opportunity Cost

The sacrifice made by choosing one value or opportunity over another; the value of a forgone opportunity.

Comparative Advantage

Advantage conferred to a country because of one good’s production relative to another.

2. The Debate Over Free Trade

Theoretically, free trade benefits all countries. However, not everyone agrees.

There are a variety of arguments that have been presented in the media for trade barriers (which we will cover in another section), such as the following:

• Concerns about domestic jobs, which is the primary issue
• Environmental concerns
• Concerns about international labor standards
• Trade being unfair to poor countries
• Other countries benefiting more than the United States

3. Trade With Full Employment

Remember, the basis for free trade is that both nations benefit when specializing in whatever they enjoy the comparative advantage in.

For instance, in our previous example, we decided that the United States should produce cars because it gives up fewer textiles when it does that and Mexico should produce textiles because it gives up fewer cars.

However, the advantages and gains from trade were calculated based on scenarios assuming the full employment of resources in both nations.

Full employment is defined being as equal to the point at which an economy exhibits a natural rate of unemployment, usually around 5%. It occurs when the economy is at its long-run supply capacity.

A production possibility frontier (PPF) shows the maximum combination of two goods that can be produced when an economy’s resources are being utilized.

alt=The line graph illustrates the production possibility frontier or PPF for the maximum combination of cars and textiles that can be produced in Mexico and the United States if they use all their resources. The x-axis represents the number of cars that can be produced, and the y-axis represents the number of textile items that can be produced. The PPF curve for Mexico indicates that it can produce a maximum combination of 4 textile items and 8 cars. The PPF curve for the United States indicates that it can produce a maximum combination of 7 textile items and 21 cars.]

The x-intercept shows how many cars can be produced when all resources are devoted to car production. In this case, it is 21 for the United States or 8 for Mexico.

The y-intercept shows how many textiles can be produced with a specialization in textiles—again, seven million in the case of the United States or four million in the case of Mexico.

This PPF, then, shows a trade-off. It shows how many of one good we have to give up when we want one more of the other good.

EXAMPLE

For every one textile that the United States decides to produce, it gives up the ability to produce three cars. Why does it give up three cars? Because we are assuming that resources are fully utilized and fully employed, so if it wants to produce one more textile, it will need to take resources out of cars and put them into textiles.

term to know

Full Employment

Defined as being equal to the point at which an economy exhibits a natural rate of unemployment; occurs when the economy is at its long-run supply capacity.

4. Trade With Unemployment

However, what if the United States were in a recession? This would be represented by a production level somewhere inside the curve where it is not actually producing a maximum combination.

This means that some resources are unemployed and the economy is operating at less than its capacity.

So, if the United States switched from focusing all resources on the production of cars back to the production of textiles, it could utilize currently unemployed workers and other resources.

In a way, then, it would not have to give anything up; there is no opportunity cost. This particular trade-off situation is void because, with unemployment, we do not have to give anything up to produce textiles. There are people who want jobs and do not currently have them.

In this case, producing textiles domestically could actually raise the United States’ GDP now.

Remember, unemployment is measured as the percentage rate of the number of individuals that would like to work and are an active part of the labor force to the number of individuals that comprise the active labor force.

So, if we have people who are unemployed, are not being utilized, and want to work, we can employ them if we start producing textiles.

Since the idea of comparative advantage no longer applies, this situation presents an argument for a nation to set up trade barriers, which we will cover next.

term to know

Unemployment

Measured as the percentage rate of the number of individuals that would like to work and are an active part of the labor force to the number of individuals that comprise the active labor force.

5. Trade Barriers

Trade barriers focus on protecting a domestic industry from competition. They are defined as the barriers to free-market pricing set in place to confer an advantage to a country.

EXAMPLE

Taxes and subsidies count as trade barriers.

term to know

Trade Barriers

Barriers to the free market pricing set in place to confer an advantage to a country; examples include taxes and subsidies.

5a. Pros and Cons

Are trade barriers good or bad? Well, there is much disagreement on the topic, but most people can agree that when an economy is fully employed, trade barriers are unnecessary and counterproductive. In keeping with the theories of comparative advantage and gains from trade, note the following:

• Free trade and specialization allow for resources to be used most efficiently.
• Free trade helps economies that are fully employed to achieve economic growth and move beyond their previous production capacities.

Critics, though, point out that trade barriers still have some issues.

• Some say they are bad for the global economy overall.
• Others say they may only serve special interest groups, like specific industries that are lobbying for protection from foreign competition. *They can reduce the incentive for domestic firms to produce more efficiently because when we put up trade barriers, competition is reduced and domestic firms do not have the incentive to do better, make products less expensive, and so forth.
• Trade barriers are difficult to remove once the economy has improved because, again, industries get accustomed to those trade barriers being there.