Hill – Mankiw 9th Edn Chapter 9: Application: International Trade
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 9 – Application: International Trade
Here are some things to consider while reading this chapter. Note that some of the issues about the gains from trade raised in the Commentary in Chapter 3 recur here.
- If total surplus increases, is society as a whole better off?
This question, or the flipside (‘If total surplus decreases, is society as a whole worse off?’), arises repeatedly in the examination of economic policy. Virtually all policy changes leave some worse off and others better off. In the model used to examine trade policies in this chapter, lower tariffs (or other barriers to trade) result in an increase in total surplus when the initial and final equilibria are compared.
Mankiw writes: “the gains of the winners exceed the losses of the losers, so the winners could compensate the losers and still be better off. In this sense, trade can make everyone better off… In practice, compensating the losers from international trade is rare. Without such compensation, opening an economy to international trade expands the size of the economic pie but can leave some people with a smaller slice” (p. 172, emphasis in original).
This is why, as explained in the Commentary on Chapter 3, a value judgement is needed to determine whether society as a whole is better off or worse off. The sizes of the gains and losses and the characteristics of those who experience them could play a role in that judgement.
(i) Efficiency as the final goal of economic policy?
Is potential compensation for those made worse off enough to say that the country as a whole is better off? This seems to be the value judgement made by Mankiw’s imaginary team of Isolandian economists who advise their president about trade policy. They write: “The best policy, from the standpoint of economic efficiency, would be to allow trade without a tariff” (p. 175).
But why shouldn’t equity and fairness be taken into consideration? As mentioned in the Commentary on Chapter 3, differences in value judgements between economists and the general public probably explain their different attitudes towards trade policy. But Mankiw never raises the possibility that the losses experienced by one group could be given greater weight than the gains received by others.
(ii) Why is trade policy controversial?
Mankiw explains: “Whenever a policy creates winners and losers, the stage is set for a political battle. Nations sometimes fail to enjoy the gains from trade because the losers from free trade are better organized than the winners. The losers may turn their cohesiveness into political clout and lobby for trade restrictions such as tariffs or import quotas” (p. 172).
Here, the minority defeats the majority just because they are better organized, not, for example, because they have a case to make that they bear burdensome losses – losses for which they and their community (which also suffers) will receive little or no compensation. For students who have accepted economic efficiency as the final goal, a political process that produces this outcome will surely seem unfair.
(iii) Are tariff reductions more about redistribution than efficiency gains?
A movement to free trade eliminates the deadweight losses from the tariff (as illustrated in Figure 4). How big are these deadweight losses? As explained in Chapter 9, the deadweight loss of a tax is proportional to the square of the tax rate. In industrialized countries, average tariffs are low, implying that the gains from further reducing tariffs are small. According to one estimate, the gains to the United States of a global move to free trade are about 0.1 percent of GDP, with most of those gains coming from the reduction of other countries’ tariffs against US exports (cited by Rodrik 2011, loc. 1094).
In his 2011 book The Globalization Paradox, Mankiw’s Harvard colleague, Dani Rodrik, points out that the flipside of the gains from trade is income redistribution as resources are reallocated. As the net gain get smaller and smaller, income redistribution gets proportionately larger. He writes: “For example, in an economy like the United States, where average tariffs are below 5 percent, a move to complete free trade would reshuffle more than $50 of income among different groups for each dollar of efficiency or ‘net’ gain created!”
Is society as a whole better off if Jack gets $51 and Jill loses $50? Rodrik remarks: “It is unlikely that we would countenance so much redistribution in other policy domains without at least some assurance that the process conforms with our conceptions of distributive justice” (2011, loc. 1068). We would want to know who Jack and Jill are and how this redistribution came about. “Two questions are of particular importance. Are the gains too small relative to the potential losses to low-income or other disadvantaged groups that may have little recourse to safety nets? And does the trade involve actions that would violate widely shared norms or the social contract if carried out at home – such as employing child labor, repressing labor rights, or using environmentally harmful practices?” (2011, loc. 1074).
- What happens to workers displaced because of changes in trade or trade policy?
Mankiw’s text fails to describe the evidence, preferring storytelling instead. In the conclusion to the chapter, Mankiw describes the experience of displaced workers in the fictional country of Isoland which starts to import textiles and export wheat: “Workers who had previously produced textiles experience some hardship when their factories close, but they eventually find work in other industries. Some become farmers and grow [wheat]… Others enter new industries that emerge as a result of higher Isolandian living standards” (p. 182).
This story mirrors the model’s implicit assumption that productive resources such as labour, capital (e.g. machinery and buildings), and land are ‘homogeneous’, meaning that they are interchangeable and can move and be employed anywhere. Other models, considered in international trade textbooks, recognize that productive resources may be ‘sector specific’. In plain English, textile machinery cannot be transformed into farm machinery; textile workers may have no skills as farmers and may have to settle for low skilled occupations with lower wages.
In his book, Dani Rodrik notes that the long-term earnings of displaced workers are permanently lower. “Such income losses are estimated to lie between 8 and 25 percent of pre-displacement earnings in the United States.” He adds: “Any temporary adjustment costs – such as transitional unemployment or a dip in earnings below their long-run level – would be additional to these losses” (2011, loc. 1037).
The effect of import increases on employment in import-competing industries has been extensively studied in the United States in recent years. The growth of Chinese exports of manufactured goods began with economic reforms in the early 1990s and accelerated after China was admitted to the World Trade Organization at the end of 2001. This allowed its exports access to the markets of WTO members at lower tariff rates. The rapid increase in American imports of Chinese manufactured goods continued until 2010. Its effects on American manufacturing industries and employment have been dubbed the ‘China Shock’.
In a 2016 study Daron Acemoglu and co-authors concluded that 2-2.4 million American workers had lost their jobs, either directly or indirectly, due to increased Chinese import competition between 1999 and 2011. Traditional models assume that such displaced workers can easily move between different industries and between different parts of the country, as in the story Mankiw tells about Isolandian workers. However, American studies of the China Shock found that “labor-market adjustment to trade shocks is stunningly slow, with local labor-force participation rates remaining depressed and local unemployment rates remaining elevated for a full decade or more after a shock commences” (Autor et al. 2016, p. 235).
Particularly hard-hit are less-educated lower-wage workers, who experience disproportionate reductions in lifetime earnings and a greater chance of leaving the labour force relative to higher-wage coworkers. Their losses spillover into their communities, affecting local businesses.
David Autor and co-authors’ 2021 follow-up paper found that these effects persisted up to 2019, the most recent data they had available. They write: “Labor markets more exposed to import competition from China experienced more plant closures; larger declines in manufacturing employment, employment-population ratios, earnings for low-wage workers, housing prices, and tax revenues; and larger increases in childhood and adult poverty, single-parenthood, and mortality related to drug and alcohol abuse, as well as greater uptake of government transfers”. However, the transfers only minimally offset the losses in income (Autor et al. 2021, pp.1-2).
Nationally, the gains from the increased trade with China are estimated to be small: about 0.2% of average real incomes. Combined with the losses experienced in many localities, areas in which a third of the continental US population lives could have experienced net losses (Autor et al. 2021, p. 46).
All this underscores the importance of having information about who gains, who loses, and by how much, to judge whether the country as a whole is better off as a result of the change in trade.
- Tariff policy in American economic history
In the conclusion to the chapter, Mankiw writes: “Economists view the United States as an ongoing experiment that confirms the virtues of free trade. Throughout its history, the United States has allowed unrestricted trade among the states, and the country as a whole has benefited from the specialization that trade allows.… The world would similarly benefit from free trade among countries” (p. 182, my emphasis).
No country has ever levied tariffs on trade within its borders, so the real question is whether throughout its history US tariff policy “confirms the virtues of free trade”. But Mankiw says nothing about actual historical experience.
Like almost all currently industrialized countries, industry in the United States grew up behind tariff walls. Cambridge University’s Ha-Joon Chang writes that “the most ardent user of infant-industry promotion strategy was probably the United States”. He quotes a well-known economic historian who called it “the mother country and bastion of modern protectionism” (2002, p. 78). The purpose of this policy was to steer the direction of economic development and to alter comparative advantage. Unlike the textbook model, where the pattern of comparative advantage is fixed, countries’ comparative advantage changes over time as quantities of factors of production change and technology changes.
From 1865 until 1900, tariffs on dutiable imports averaged 40 to 50 percent, and remained high until after World War II (Levy 2021, p. 212; 480). Only when the United States was the world’s preeminent industrial power did average tariffs begin to fall to low levels.
In his brief discussion of the idea of infant industries, Mankiw throws cold water on the idea, saying nothing about any country’s historical experience (p. 178). Why have these facts been omitted?
- Is trade really just like technological progress?
Mankiw concludes the chapter with a parable that describes trade as analogous to technological change (p. 182). His argument: technological change produces gains for some and losses for others, just like changes in trade policy. If we accept that, on balance, technological change leads to net benefits for society as a whole, we should conclude the same for trade policy.
This seems persuasive, but let’s have a closer look.
(i) Does everyone have a higher standard of living?
In Mankiw’s parable, the country (Isolandia) produces two goods (wheat and textiles) and the reader is asked to imagine an invention that uses wheat as an input and produces textiles more cheaply than was possible before. “[T]he lower cost of textiles allows all Isolandians to enjoy a higher standard of living” (p.182, my emphasis).
Yet as Mankiw shows in Figure 2 (p. 170), the price of the good that is being exported (wheat in this example) goes up. People who like to spend a lot of money on bread and mend their old clothes could find themselves with a lower standard of living. This rhetorical device – focusing attention on the good whose relative price has gone down – is so commonly used in textbooks it has a name. In his critique of poor arguments for free trade, Robert Driskill labels it “cherry picking implications: the ‘lower price’ fallacy” (2012: 19).
(ii) Why people could feel differently about technological change and international trade
Now to the central point of the parable: because “all Isolandians” supposedly enjoy a higher standard of living, this technological change is celebrated. “Everyone understands that the displacement of workers in outmoded industries is an inevitable part of technological progress and economic growth”. When the ‘technological change’ is revealed to have been international trade, it is rejected and the gains from trade are perversely thrown away. The reader is invited to conclude that the mix of gains and losses from international trade are no different than those from technological change. In both cases people should conclude that society is better off, despite the costs borne by some.
Dani Rodrik explains why the effects of trade and of technological progress might be judged differently (2011, Chapter 3; also, Rodrik 2012). One fundamental point is that ongoing technological change could leave different groups worse off at different times. “[W]hen we expect redistributive effects to even out in the long run, so that everyone eventually comes out ahead, we are more likely to overlook reshufflings of income… When, on the other hand, the forces of trade repeatedly hit the same people – less educated, blue-collar workers – we may feel less sanguine about globalization” (Rodrik 2012).
It’s an empirical question as to whether technological change impacts different groups at different times or, as in his characterization of changes in trade, repeatedly hits the same socioeconomic groups. For example, one aspect of technological change, automation, seems to have had the greatest impact on relatively less educated and lower paid workers, although that may be different in the future.
Mankiw’s parable also assumes that only the outcome matters. However, people also care about procedural fairness – how the outcome came about. Suffering a loss as a result of a government decision (e.g. tariff reductions) may be considered unfair, while losses resulting from changed market circumstances are risks that everyone faces.
Rodrik writes that in the case of technological change, people are more likely to assume that new technologies are developed by firms playing by the same rules of the game, so procedural fairness issues do not arise. However, “differences in institutional arrangements across nations generate opposition and create frictions in international trade” (Rodrik 2011, loc. 1087).
Firms abroad can obtain a competitive advantage not only because they are more productive or labor is more abundant (and hence cheaper), but also because they prevent their workers from engaging in collective bargaining, they have to comply with lower health and safety standards, or they are subsidized by their governments. (2011, loc. 1081)
Mankiw explicitly rejects this last point. If foreign governments subsidize their exporters, domestic workers and business owners experience losses. But Mankiw suggests sending a “thank-you note” to the foreign governments, because the benefits to consumers outweigh those losses (p. 179). This makes clear his value judgement that only efficiency (i.e. total surplus) matters. The general public seems to take a different view and governments may use their power under international trade law to offset those subsidies with tariffs.
Finally, as discussed earlier, as tariffs get ever lower, the net gains available rapidly shrink in comparison to income redistribution. In contrast, the benefits from technological change are not “self-limiting. Technology has been the fountain of human economic progress since the Industrial Revolution, and there is no reason to suspect that it won’t be in the future” (Rodrik 2011., loc. 1094).
- Missing in Action
Some important things get no mention at all. The following is a selection, by no means complete.
(i) The assumptions behind the model used and alternative models of international trade
The text presents only one model of international trade. Many assumptions lie hidden in the background which are made explicit in international trade textbooks. For example, technological knowledge in each country is given. Factors of production (labour and capital) do not move internationally. The products produced domestically are identical to those produced abroad. Every industry consists of firms which are small relative to the size of the market, and none have any ability to set their own prices. Similarly, each country is assumed small relative to the size of the world economy; there is a given world price which a country’s policies does not influence.
If just this last assumption is changed, a tariff reduction could decrease total surplus. A tariff reduction increases both imports and exports. If changes in a country’s exports significantly affect the world price (e.g. Ukrainian wheat exports affecting the world wheat price), an increase in exports could drive down the world price of the exported good sufficiently to reduce total surplus. This happens because to get a given amount of the imported good, the country must export a larger quantity of the exported good.
The short section “Other Benefits of International Trade” (on p. 176) mentions features of alternative models. The benefits of “lower costs through economies of scale” and “increased competition” describes markets with large firms that choose their own prices and produce products that differ from each other (e.g. auto companies). Trade textbooks show that such a setting can result in an arbitrary pattern of specialization in which the idea of comparative advantage is not relevant. A country can end up specializing and exporting a particular good if its firm/firms started producing that good before others do, taking advantage of economies of scale to lower costs, leaving no room in the market for new entrants from other countries. It will not necessarily be the country that could produce that good most cheaply, so that the resulting specialization in production need not use the world’s scarce resources in the most efficient way.
(ii) Multinational enterprises (MNEs)
MNEs produce a third of world GDP and account for two-thirds of international trade (De Backer et al 2019, p.1). Yet their existence goes unmentioned in standard texts, including Mankiw’s. Would drawing students’ attention to the existence and activities of such large firms make it harder to believe that the perfectly competitive model, with its small price taking firms, should be the default model of markets?
Ignoring MNEs also implicitly assumes that there is no need to distinguish between whether a firm is domestically owned or foreign owned. Yet governments appear not to believe this, frequently prohibiting or restricting foreign ownership, particularly in sectors where cultural and political sovereignty or important, such as military industries, commercial banking, telecommunications, the media and publishing industries.
MNEs have played an important role in shaping international trade, investment, and intellectual property agreements. Joseph Stiglitz points out that American negotiators largely ask for what American multinationals want: “access to cheap labor, without environmental and labor protections. The corporations also liked the fact that threats to move their factories abroad weakened workers’ bargaining power”, keeping wages down. These agreements, such as NAFTA, “helped ensure the property rights of investments made in developing countries, for this made their threats to relocate their plants in these cheap-labor countries more credible. When they [the negotiators] drafted the provisions concerning intellectual property rights, they … were thinking about what would increase the profits of America’s big corporations, and especially its large drug and entertainment companies—even if it increased the prices that American consumers had to pay” (Stiglitz 2017, p. xxi).
(iii) So called ‘free trade agreements’ are about much more than just lowering tariffs
As just noted, they also deal with rules about foreign investment, protection of intellectual property (e.g. patents, copyright, trademarks), as well as government purchases of goods and services, competition policy, and regulations protecting people, plants and animals from disease or contaminants. For this reason, Stiglitz prefers the term ‘managed trade’ instead of ‘free trade’ The textbooks’ simple story about net gains from tariff reductions misses much of what is really in actual agreements.
(iv) Countries’ relative power in setting and playing by the rules of international trade
GATT negotiations that established the WTO were dominated by negotiators from a few high-income countries who advocated for the interests of their MNEs. One result was the establishment of TRIPS (Trade Related Aspects of Intellectual Property Rights), administered by the WTO, which increased the protection given to the intellectual property largely held by the MNEs from those countries. The result was increased MNE profits, with people in developing countries particularly worse off. Why should the WTO administer an intellectual property agreement? According to Stiglitz, it’s so that any violations can be punished by trade sanctions, a powerful tool for large high-income countries to use against developing countries (2017, p. 41).
Large countries can also exert power over smaller countries by violating or threatening to violate the rules unless their demands are met. This was recently illustrated by the Trump administration’s tariffs on aluminum and steel imports from Canada and Mexico during the renegotiation of NAFTA. Canada and Mexico retaliated with similar tariffs, but the relative sizes of the countries meant that the advantage lay with United States.
Acemoglu, Daron, David Autor, David Dorn, Gordon Hanson, and Brendan Price (2016) “Import Competition and the Great US Employment Sag of the 2000s”, Journal of Labour Economics, 36(1, pt.2): S141-98.
Autor, David, David Dorn, and Gordon Hanson (2016) “The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade”, Annual Review of Economics, 8: 205-40.
Autor, David, David Dorn, and Gordon Hanson (2021) “On Persistence of the China Shock”, Brookings Papers on Economic Activity, BPEA Conference Drafts, September 9.
Chang, Ha-Joon (2002) “Kicking Away the Ladder: An Unofficial History of Capitalism, Especially in Britain and the United States”, September-October, Challenge, 45(5): 63-97.
De Backer, Koen, Sébastien Miroudot, Davide Rigo (2019) “Multinational enterprises in the global economy: Heavily discussed, hardly measured”, VOX, CEPR Policy Portal September 25, available at https://voxeu.org/article/multinational-enterprises-global-economy
Driskill, Robert (2012) Deconstructing the argument for free trade: A case study of the role of economists in policy debates, Economics and Philosophy, 28: 1-30.
Levy, Jonathan (2021) Ages of American Capitalism, Random House Publishing Group, Kindle Edition.
Rodrik, Dani (2011) The Globalization Paradox: Democracy and the Future of the World Economy. W.W. Norton & Company. Kindle Edition.
Rodrik, Dani (2012) “Free-Trade Blinders”, Project Syndicate, March 9, available at https://www.project-syndicate.org/commentary/free-trade-blinders-2012-03
Stiglitz, Joseph (2018) Globalization and Its Discontents Revisited: Anti-Globalization in the Era of Trump W. W. Norton & Company.