This Document Contains Chapters 7 to 8 Chapter 7 Taxes What’s New in the Fifth Edition? • Updated Business Case and Economics in Action examples. Chapter Objectives • Explain the effect of an excise tax on equilibrium price and quantity. • Explain the connection between price elasticity (of supply and demand) and the incidence of the excise tax, or in other words, who bears the tax burden. • Define the benefits and costs that result from the excise tax. • Explain the difference between regressive and progressive taxes. • Discuss the trade-off between tax equity and tax efficiency. • Discuss the structure of the U.S. tax system. Teaching Tips The Economics of Taxes: A Preliminary View Creating Student Interest • Ask students about the price of gas. Do they know what the current price of gas is? Have they observed the price of gas changing over the past months or years? Now ask them if an increase in the price of gas would change their driving habits. See if they are aware of the federal and state excise tax on gasoline. Consumers pay both a federal gas tax (18.4 cents per gallon since 1997—see the website http://www.gaspricewatch.com/web_gas_taxes.php for data) and a state gas tax (which varies by state—see the websites listed to look up your state). The highest gas tax is just over $0.76 per gallon. Would a decrease of $0.75 gallon change gasoline consumers’ behavior? Remind students that the gasoline tax revenue is used to pay for road maintenance and construction. Ask students if this seems fair. Now ask them what they think has happened to the revenue collected from the gas tax as a result of the increase in the fuel efficiency of the average car. The answer is: revenue has declined. Presenting the Material • Use the example of a $20 excise tax on the sale of motorcycles, as illustrated in the graph below. The tax causes the supply curve to shift to S2 by the amount of the tax. The new equilibrium price is now $1,010. The effect of the excise tax is to push up the equilibrium price to $1,010 from $1,000. This means that buyers are paying $10 more than before, and because sellers are paying the government $20, they are now netting just $990 for each bike sold. Buyers and sellers are bearing an equal burden of the tax: buyers have to pay $10 more than before and sellers net $10 less than before. • Make sure students understand that buyers and sellers will not always share the burden of the tax—it depends on elasticity. Also, the text demonstrates that if the excise tax is imposed on consumers instead of on producers, the effects on price and quantity are the same. Taxing producers is administratively less costly so this explains why producers and not consumers usually pay the excise tax. The Benefits and Costs of Taxation Creating Student Interest • Have students consider examples of goods that the government taxes in ways other than through the sales tax (cigarettes, hotel rooms, alcohol, gasoline). Ask students what characteristics these goods have that make them more likely to be taxed. Is the government, for example, likely to tax necessary goods? Taxed goods tend to be luxuries (hotel rooms) or sin goods (cigarettes and alcohol). Ask students how they feel about a tax on tanning services (adopted in some states already) or a tax on soda (being considered in some states and adopted by the city of Berkeley, CA, in November 2014). Presenting the Material • Have students consider the motorcycle example above by first having them consider a less elastic, steeper supply curve. They should notice that the tax incidence is higher for the supplier. Have them do the same with a less elastic, steeper demand curve. On their graphs, have the students identify what happens to consumer and producer surplus when the excise tax is imposed. Also have them identify the government revenue and the deadweight loss. Make sure they understand that the size of the deadweight loss and the amount of revenue collected depend on elasticity. Tax Fairness and Tax Efficiency/Understanding the Tax System Creating Student Interest • A gasoline tax changes behavior in the gasoline market. Producers and consumers pay the cost of a gasoline tax. Ask students to describe the benefits of a gas tax (e.g., increased revenue for road maintenance causing decreased expenditures on car repairs). What is the opportunity cost if the gas tax were decreased or eliminated? Do the students think it is fair that consumers and producers of gasoline are the ones who (through the gas tax) pay for these benefits? Have the students explain why or why not. • Talk about the fairness of the U.S. tax code. Look up the current marginal tax rates for the federal income tax and ask students if they think the system is fair. You also can present data from text Table 7.5 to discuss the issue of fairness. You can find the 2013 income tax brackets with this link: http://taxfoundation.org/blog/2013-tax-brackets. • Tell students that you are considering levying a tax on the class. Students will be required to “pay” you a certain number of points from their midterm exam. Given that there will be a tax, ask them what they think is the fairest way to tax them. Ask them to consider a flat tax of a certain number of points or a tax that is a certain percentage of their exam grade. If they think the tax should be a percentage of their exam grade, should everyone pay an equal percentage? Or should they pay a higher percentage if their grade is higher? Or should they pay a lower percentage if their grade is higher? What makes any of their choices more or less “fair” relative to the others (benefits received, ability to pay)? Use this discussion to lead into the explanation of tax base; tax rate; tax structure; proportional, regressive, progressive taxes; and tax equity. Presenting the Material • Use the example of sales and income taxes to explain and compare tax base and tax structure. Income is the tax base for the income tax, the value of goods sold is the tax base for a sales tax. Everyone pays the same sales tax percentage when they purchase goods and services that include a sales tax, so the sales tax percentage is the tax structure for the sales tax. The tax structure for the income tax requires people in successively higher income brackets pay a higher percentage in taxes (the marginal tax rate). People with higher incomes spend a smaller proportion of their income on goods and services (they save more than lower-income people). Therefore, for sales tax the tax base for those with lower incomes is a higher percentage of their total income. In addition, there is a minimum income below which the income tax rate is 0, so very-low-income people pay no income tax. Use these ideas to help students understand that income taxes tend to be progressive, whereas sales taxes tend to be regressive. Common Student Pitfalls • The difference between who pays the tax and the burden (incidence) of the tax. Students may be unclear about the meaning of the term tax incidence. Explain that it refers to who bears the burden of the tax. In some situations, sellers can pass the tax onto the buyers; in others, they cannot. For example, if the equilibrium price rises from $2 to $2.15, after a tax increase of $0.20, then the seller had to pay $0.05 of the tax, and $0.15 of the tax was paid by consumers. Chapter Outline Opening Example: The Whiskey Rebellion that took place in Pennsylvania in 1794 is discussed. In 1791 a tax was enacted on whiskey distillers in order to raise revenue to repay war debts. The tax was perceived as unfair, and hence there was some rebellion. The example illustrates the idea that taxes are a necessary evil. I. The Economics of Taxes: A Preliminary View A. The effect of an excise tax on quantities and prices 1. An excise tax imposed on the seller causes firms to increase the price for which they are willing to sell the good or service, shifting the supply curve upward. See text Figure 7-2, shown next. 2. Consumers will end up paying a higher price for the good, and as a result, will choose to buy a smaller quantity. 3. The tax drives a wedge between the price paid by the consumer and the after-tax price received by the seller. 4. The tax creates missed opportunities for mutually beneficial transactions. 5. Tax incidence is not a function of who actually pays the tax. It does not matter who pays the government directly, producers or consumers. B. Price elasticities and tax incidence 1. The incidence of an excise tax depends on the price elasticities of demand and supply. 2. Low price elasticities of demand and high price elasticities of supply lead the tax burden to fall on consumers. 3. High price elasticities of demand and low price elasticities of supply lead the tax burden to fall on producers. 4. Elasticity, not who literally pays the tax to the government, determines the incidence of an excise tax. II. The Benefits and Costs of Taxation A. The revenue from an excise tax 1. The revenue collected from an excise tax equals the area of the rectangle, with height = the tax wedge and width = quantity bought/sold under the tax. B. Tax rates and revenues 1. An increase in the tax, or tax rate, may increase or decrease tax revenue depending on what happens to the quantity sold. If supply and demand are relatively inelastic, then the increase in the tax will reduce quantity by a small amount, and tax revenue should rise. C. The costs of taxation 1. Taxes prevent mutually beneficial transactions from happening. 2. Taxes lead to deadweight loss, as illustrated in text Figure 7-9. 3. The lost consumer and producer surplus exceeds the government tax revenue, creating a deadweight loss. 4. Taxes create administrative costs, which include the resources used for its collection, for the method of payment, and for any attempts to evade the tax. D. Elasticities and the deadweight loss of a tax 1. The larger the number of prevented transactions, the larger the size of the deadweight loss. 2. When demand and supply are both relatively inelastic, the deadweight loss is relatively small. 3. See text Figure 7-10 on the next page for a summary of the relationship between the size of the deadweight loss and elasticity. III. Tax Fairness and Tax Efficiency A. Two principles of tax fairness 1. The benefits principle states that those who benefit from public spending should bear the burden of the tax that pays for it. 2. The ability-to-pay principle states that those with greater ability to pay a tax should pay more. B. Equity versus Efficiency 1. Lump-sum taxes don’t distort incentives. They are efficient but perceived to be less fair. 3. There is a trade-off between equity and efficiency. The tax system can be made more efficient only by making it less fair. IV. Understanding the Tax System A. Tax bases and tax structure 1. The tax base determines how a person pays tax; the tax structure specifies how the tax depends on the tax base. 2. Several different types of taxes are used: income tax, payroll tax, sales tax, profit tax, and wealth tax. 4. Taxes are either proportional, progressive, or regressive. B. Equity, efficiency, and progressive taxation 1. The progressive tax system is viewed by many as more fair. 2. The progressive tax system creates an incentive problem. As your income rises, the tax rate rises, creating a disincentive to work harder and earn more income. C. Taxes in the United States 1. Personal income tax: at the federal and state level. 2. Payroll tax: paid by employers and employees, and used to cover social security and Medicare expenses. 3. Sales taxes: at the state and local level. 4. Overall: somewhat progressive. D. Different taxes, different principles 1. The United States has a mixture of progressive and regressive taxes because the different levels of government institute different types of taxes. Case Studies in the Text Economics in Action Who Pays the FICA?—This EIA explains the Federal Insurance Contributions Act (the payroll tax). This tax pays for Social Security and Medicare. Ask students the following questions: 1. How much of the FICA tax is levied on each group in the economy? (Half is paid by workers and half by employers.) 2. Where does the incidence of the FICA tax fall and why? (On workers, because the price elasticity of supply for labor is high.) Taxing Tobacco—This EIA looks at cigarette taxes and uses the data from states to show the result of large increases in tax rates on tax revenues. Ask students the following questions: 1. What does analysis of the cigarette market tell us about the price elasticity of demand for cigarettes? (It is inelastic.) 2. How is tax revenue affected when the cigarette tax is increased? Explain why. (It increases because price elasticity of demand for cigarettes is low.) Federal Tax Philosophy—What tax principle underlies our tax system? This EIA explains the ability-to-pay principle underlying our income tax system and the benefits principle underlying FICA and explains the differences between the two principles. Ask students the following questions: 1. Which federal taxes make up the largest percentage of federal revenue? (Income tax, payroll tax.) 2. What is the difference between the two taxes in terms of who pays them? (The richest families pay a higher share of the income tax; high-income families don’t pay much more than middle-class families in payroll taxes.) State Tax Choices—Looks at the tax policies in Texas and California and how those policies are distributed among the income levels. Ask the students the following questions: 1. What are the tax policies for California versus Texas? (California—Income tax rate up to 13.3%, with tax breaks for lower-income people. Texas: No income tax.) 2. How do the choices of tax policies affect the average tax rates in each state? (California has a lower average tax rate, whereas Texans at higher incomes pay much lower percentages of their incomes in taxes.) For Inquiring Minds French Tax Rates and L’Arc Laffer—This FIM discusses the Laffer curve, which suggests that at some point the tax rate becomes so high that further increases in the rate will reduce tax revenue collected. A 1997 change to the French tax law illustrates the concept. Taxing Income versus Taxing Consumption—This FIM discusses the difference between taxing income and taxing consumption. Taxing consumption instead of income encourages people to save more. Global Comparison You Think You Pay High Taxes?—This global comparison presents data on taxes paid as a percentage of GDP for seven different countries. Business Case Microsoft’s Internal Carbon Tax—This business case explains how Microsoft measures internal profitability in divisions by considering the carbon dioxide produced by the production of each units good. The carbon tax measures the carbon dioxide produced and is monetized and included in the costs in the profit function. Web Resources The following websites provide data related to the U.S. tax system: The Tax Foundation: https://taxfoundation.org/data/ Information about state gasoline taxes: https://taxfoundation.org/state-tax/oil-gas-transportation-taxes/ Information about federal and state gas taxes: http://www.gaspricewatch.com/web_gas_taxes.php The Internal Revenue Service: https://www.irs.gov/news-events Handout 7-1 Date_________ Name____________________________ Class________ Professor________________ The Impact of Taxes (15–20 minutes) Find three classmates to work with. In your group decide one student who will play the role of business groups, one student who will play the role of an environmental group, one who will play the role of government, and the last who will play the role of U.S. consumers. The graphs below represent two different taxes: a tax on gasoline and a tax on gas-guzzling cars. Draw the effect of the tax on the market for each, and then label the effect of the tax on the group you represent. Do you prefer a tax on gasoline or a tax on gas-guzzling cars? Answers: The tax on gasoline hits consumers harder—the equilibrium price rises more. However, gasoline and gas-guzzling cars are complementary goods and the higher price on gasoline will reduce the popularity of large cars. Businesses absorb more of the tax in the case of the tax on gasoline. Environmental groups may favor the tax on gas-guzzling cars because it results in a large drop in the quantity demanded. Governmental views may vary: the gasoline tax will affect more buyers, but depending on the amount of the tax, the higher price on the cars may generate higher revenues. Handout 7-2 Date_________ Name____________________________ Class________ Professor________________ Who Pays the Tax? Think of circumstances in which a seller can pass the full amount of an excise tax onto consumers. Use graphs to explain your answer where necessary. Do you think your state excise tax on gasoline is completely passed onto consumers? Why or why not? Those Pesky Excise Taxes If these products had an excise tax placed on them, who would wind up paying the tax and why? • Gasoline • Super Bowl tickets • Luxury cars Answers: Who Pays the Tax? Most students will understand that the more inelastic the demand, the more the tax can be pushed onto consumers. However, supply elasticity is also relevant here: The more elastic the supply is, the more sellers can transfer the tax to consumers. The state excise tax on gasoline would not be completely passed onto customers because the demand for gasoline is not perfectly inelastic. People will alter their driving habits as a tax increases. Those Pesky Excise Taxes If these products had an excise tax placed on them, who would wind up paying the tax and why? • Gasoline (Inelastic demand and inelastic supply in the short run—the buyer will pay more of the tax.) • Super Bowl tickets (Inelastic supply, elastic demand—the seller pays more of the tax.) • Luxury cars (Elastic supply and elastic demand.) Chapter 8 International Trade What’s New in the Fifth Edition? • Updated cases • Handouts to use in class Chapter Objectives • Explain how comparative advantage leads to mutually beneficial international trade. • Discuss the sources of international comparative advantage. • Explain who gains and who loses from international trade, using supply and demand. • Explain why the gains from international trade exceed the losses, using supply and demand. • Explain how tariffs and quotas reduce total surplus and create a deadweight loss. • Discuss the reasons governments often engage in trade protection and how international agreements result in less trade protection. Teaching Tips Comparative Advantage and International Trade Creating Student Interest • Ask students to write down five imported goods they have purchased. If they need help, suggest that they check the tags on their clothing! • Ask students why they did not produce their own breakfast. Why did it make more sense to purchase their breakfast from people who specialize in the production of breakfast foods? Ask students if they can identify some of the goods the United States exports. Ask them also who they think our biggest trade partners are. You can find current data online. A place to start is https://www.trade.gov/. • Presenting the Material • Students sometimes perceive that trade is unfair. Ask them if they think free trade is a good thing. They might be good economists and say yes. They might say trade is unfair because we lose jobs; point out that we also gain jobs. They might say trade is unfair to the poor countries because the workers are paid such low wages; point out that the poor country actually benefits by being able to expand production and export goods. • Use Handout 8-1 to give an example of gains from trade. Supply, Demand, and International Trade Creating Student Interest • Ask students to give examples of products that are associated with a specific country (wine and France, clothing and China, diamonds and South Africa, United States and food, Switzerland and watches). Why do they think we buy goods from these other countries rather than producing them ourselves? (The goods would cost more if we tried to produce them. Some we would not be able to produce at all and others would be of lower quality.) Presenting the Material • To explain the impact of imports on domestic supply and demand, guide students through the logical steps that follow. Assuming that the world price is below the domestic price, ask: ○ What do imports do to the domestic supply of auto parts? (The domestic supply decreases but the total supply increases.) ○ What does the increased supply of imported auto parts do to the domestic price of auto parts? (It causes it to fall.) ○ What does the lower price of auto parts do to domestic producers’ incentive to produce? (They have less incentive to produce.) ○ What does the lower price of auto parts do to the quantity demanded by domestic consumers? (The quantity demanded increases.) ○ Does the amount of consumer surplus increase or decrease? (It increases.) ○ What happens to domestic producer surplus? (It falls.) • To explain the impact of exports on domestic supply and demand, guide students through the logical steps provided. Assuming that the world price is higher than the domestic price, ask: ○ What will domestic producers want to do? (Export and earn the world price.) ○ What does the quantity exported do to the domestic price? (It increases the domestic price.) ○ What does a higher domestic price do to the quantity consumed domestically? (Quantity demanded will fall.) ○ What has happened to the domestic consumer surplus? (It has fallen.) ○ What has happened to the domestic producer surplus? (It has increased.) • Use Handout 8-2 to provide an example. • After discussing the effect of trade on the export-and import-competing industries, you may wish to discuss the effect of trade on wages. Students were introduced to the labor market in Chapter 5 when price floors were explained. Think of the import and export markets as using two different types of labor. Demand for labor will increase in the export market and decrease in the import market. The Effects of Trade Protection Creating Student Interest • Have students brainstorm reasons why a country (or a group within a country) might want to impose a tariff. • Students are often unaware of the tariffs that are imposed by the United States and other countries. To find information about tariffs imposed by the United States, go to www.usitc.gov. Students will be both surprised at and interested in the information you present. Presenting the Material • Before illustrating the impact of a tariff with a supply and demand graph, ask students to track the impact of a tariff. Assume that the world price of steel is lower than the domestic price of steel. A tariff will: ○ Decrease the quantity of imported steel. ○ Raise the domestic price of the steel. ○ Reduce the quantity demanded by steel buyers. ○ Increase the profits of domestic producers of steel. ○ Increase employment in the domestic steel industry. ○ Generate consumer losses that exceed producer and government gains. The Political Economy of Trade Protection Creating Student Interest • Show students (or have them view prior to class) the websites of the U.S. Business and Industry Council (http://www.americaneconomicalert.org/) and the Cato Institute (http://www.cato.org/pubs/policy_report/v23n4/freetrade.pdf), which show their views on free-trade policy. Ask students why they think these two groups have such different views of protectionism versus free trade. • Ask students why there are protests at meetings of the World Trade Organization. • Workers in the flower market in Colombia are exposed to 27 different types of pesticides. Ask students if we can improve their working conditions by refusing to buy imported flowers. Presenting the Material • Discuss the rationale for trade protection and talk about the weaknesses of each of these arguments. Arguments for protection Arguments for protection Problems with protectionist arguments 1. National security. The United States does not want to depend on an import that is necessary for national defense. Some industries, such as sugar, have argued for protection based on national security grounds, a clearly spurious argument. 2. Job creation. The United States wants to limit the number of jobs lost to trade. Jobs lost in import-competing industries are offset by job gains in export-competing industries. Countries often retaliate against a tariff by enacting tariffs on American goods. 3. Infant industries. Some industries need protecting until they are more fully developed and ready to compete in global trade. It is difficult to determine when an industry emerges from an “infant” position. Common Student Pitfalls • Absolute versus comparative advantage. Students are often confused about the difference between absolute and comparative advantage. Absolute advantage refers to a country’s ability to produce a good (with given inputs). Comparative advantage refers to a country’s ability to produce a good at a lower opportunity cost. Just because one country may be better able to produce all goods doesn’t mean that other countries shouldn’t produce at all. (That would be a waste of resources!) They should produce the goods and services that they can produce relatively well (“least worse”). Opportunity cost is used to identify what a country can do relatively better (i.e., at lower opportunity cost). You can liken this example to students completing a group project. One student might be much better at all tasks, but that doesn’t mean that the other students should do nothing—that would lead to inefficient production (a low grade). The group is better off if students find what each can do relatively better and each contributes that production to the group. • Calculating comparative advantage. Students may wonder why the PPFs in this chapter are straight lines rather than curves convex to the origin. Point out that we drop the assumption of diminishing returns when discussing international trade. Students easily get confused when doing numerical problems to determine which country has the comparative advantage. Carefully review several examples, showing how to calculate opportunity cost and then how opportunity cost determines comparative advantage. Students may be unclear about the meaning of autarky. Explain that it refers to a situation in which the public policy of a country is not to engage in international trade. The country would be completely self-sufficient. Students need to understand that specialization is the key to the increase in world output as a result of trade. Explain that when countries produce a good for which they have a comparative advantage, world output increases. • The effects of protectionism. Students think that protectionist measures do not have reciprocal effects. Explain that U.S. tariffs can trigger retaliation from its trading partners. Trade wars can reduce exports and hurt economic growth. Students think that trade hurts all American jobs. Make the distinction between import-competing industries, where jobs are lost, and exporting industries, where jobs are added as a result of trade. Many students believe that global corporations exploit labor in the countries where they hire labor. The text argues that most of these jobs pay relatively higher wages than the prevailing domestic wages. Chapter Outline Opening Example: The opening story discusses where the iPhone is made. Apple is an American company but they outsource the manufacturing of the phone. The iPhone is assembled in China, but the raw materials and parts used to make the phone come from all over the world. I. Comparative Advantage and International Trade I. Comparative Advantage and International Trade A. Production possibilities and comparative advantage, revisited 1. A country has a comparative advantage in producing a good if the opportunity cost of producing the good is lower for that country than for other countries. 2. The Ricardian model of international trade analyzes international trade under the assumption that opportunity costs are constant. 3. International trade allows each country to specialize in producing the goods for which it has a comparative advantage. This leads to gains from trade in each country. 4. The text develops a numerical example of the production of phones and trucks by the United States and China to review the theory of comparative advantage. B. The gains from international trade 1. The text uses graphs and tables (Figure 8-3 and Table 8-2) to illustrate the gains from trade. With trade, both countries are able to consume more of both goods. 2. The consumption choices of countries reflect both the preferences of its residents and the relative prices in international markets. 3. Supply and demand determine the actual relative prices in international trade. C. Comparative advantage versus absolute advantage 1. The United States imports phones from China even though workers in the United States are more productive than workers in China, meaning it takes fewer labor hours to produce the phones in the United States than in China. 2. Trade is based on comparative advantage and not absolute advantage. Labor productivity in China in other industries is likely to be even lower than in the electronics industry. 3. A country’s wage rates reflect its labor productivity. China’s wages are lower than the United States’ wages because workers are less productive. This gives China a comparative advantage in producing labor-intensive goods like electronics. 4. The pauper labor fallacy is a common misperception. This fallacy suggests that when a country with high wages imports goods produced by low-wage workers, this must hurt the standard of living of workers in the high-wage country. 5. The sweatshop labor fallacy is another misperception. This fallacy suggests that trade must be bad for workers in poor exporting countries because the worker’s wages are so low in comparison to that of the rich country. D. Sources of comparative advantage 1. Differences in climate. For example, tropical countries grow and export tropical products such as coffee, sugar, and bananas, whereas countries in temperate zones export crops such as wheat and corn. 2. Differences in factor endowments. a. According to the Heckscher–Ohlin model, a country has a comparative advantage in a good whose production is intensive in the factors that are abundantly available in that country. b. The opportunity cost of a given factor is low for a country that possesses an abundance of that factor. c. International specialization of production is often incomplete: Countries often maintain some domestic production of a good that they import. 3. Differences in technology. Superior production techniques can lead to comparative advantages, though it is somewhat mysterious why technology differs between countries. II. Supply, Demand, and International Trade A. The effects of imports 1. In autarky, the equilibrium in a market is determined by the intersection of the domestic demand and domestic supply curves. 2. As a result of imports, domestic consumers gain and domestic producers lose, but the gain to consumers exceeds the loss to producers. This is illustrated in text Figure 8-7, shown here. 3. Note that although a country as a whole gains from trade, some groups lose. B. The effects of exports 1. Exports also lead to an overall gain in total surplus for the exporting country. 2. As a result of exports, domestic consumers lose and domestic producers gain, but the gain to producers exceeds the loss to consumers. This is illustrated in text Figure 8-9, shown next. C. International trade and wages 1. International trade tends to raise the prices of factors that are abundantly available and reduce the prices of factors that are scarce. 2. U.S. exports tend to be human-capital-intensive and U.S. imports tend to be unskilled-labor-intensive. This suggests that international trade raises the wage rate of highly educated workers and reduces the wage rate of unskilled workers in the United States. 3. Trade reduces the income inequality between countries as poor countries benefit from being able to export to rich countries. III. The Effects of Trade Protection A. The effects of a tariff 1. In the past, tariffs were an important source of government revenue because they were relatively easy to collect. 2. Today, tariffs are usually intended to discourage imports and protect import-competing domestic producers. 3. Tariffs raise both the price received by domestic producers and the price paid by domestic consumers. 4. With a tariff, producers gain, consumers lose, and the government gains, but consumer losses are greater than the sum of producer and government gains. There is a net reduction in total surplus. This is illustrated in text Figure 8-11, shown next. B. The effects of an import quota 1. Import quotas are similar to tariffs, except that the money that would otherwise have been government revenue becomes quota rents to license holders. IV. The Political Economy of Trade Protection A. Arguments for trade protection 1. There are three common arguments for trade protection. a. National security: Overseas sources of crucial goods such as oil are vulnerable to disruption, so a country should be self-sufficient in these goods. b. Job creation: Import-competing industries create jobs. c. Infant industry argument: New industries need a temporary period of trade protection to become established. B. The politics of trade protection 1. Much trade protection has little to do with these arguments. 2. Trade protection usually reflects the political influence of import-competing producers. 3. Producers are usually a smaller and more cohesive body than the consumers who lose from trade restrictions. Thus, producers wield more political influence. C. International trade agreements and the World Trade Organization 1. Trade protection hurts domestic consumers and foreign export industries. Therefore, countries care about each other’s trade policies. 2. International trade agreements often are overseen by the World Trade Organization. An important trade agreement is the North American Free Trade Agreement (NAFTA). D. New challenges to globalization 1. Globalization and inequality—there is concern that globalization is leading to more wage inequality in the United States. 2. Outsourcing and economic insecurity. a. Concerns about income distribution and outsourcing have led to an antiglobalization movement. Case Studies in the Text Economics in Action How Hong Kong Lost Its Shirts—This EIA explains how Hong Kong was able to prosper over the last 60 years and achieve a level of per capita GDP that is very close to that of the United States. Ask students the following questions: 1. In 1980, in what type of goods did Hong Kong have a comparative advantage? (Clothing.) 2. Why has their comparative advantage changed over the last 30 years? (Clothing production is a labor-intensive, low-technology industry and Hong Kong is no longer a poor, labor-intensive country.) Trade, Wages, and Land Prices in the Nineteenth Century—This EIA looks at trade in the 1800s between land-abundant countries such as the United States and Canada and land-scarce countries (Europe). Ask students the following questions: 1. What triggered the explosion of international trade after the 1870s? (The invention of the steam engine and the expansion of railroads.) 2. What happened to the price of agricultural products in land-intensive countries? (Agricultural exports reduced the domestic supply and caused the price to rise.) 3. What happened to the price of land in England? (It fell as agricultural imports increased.) 4. Who were the winners and losers from this change? (Workers in Europe enjoyed cheaper food and landowners were hurt by falling land prices.) Trade Protection in the United States—This EIA explains that the United States generally follows a policy of free trade, with the exception of agricultural products. Ask students the following questions: 1. Which agricultural products are subject to the greatest trade restrictions? (Ethanol and dairy.) 2. Do trade restrictions impose a large cost on the U.S. economy? (No, the average tariff level and the overall costs to the economy have both fallen sharply in the last 20 years.) Solar Disputes—This EIA discusses the imposition of tariffs on solar panels made by China. Ask students the following questions: 1. What is an argument in support of the protective tariffs on imported solar panels? (Solar panel production is an infant industry in the United States, requiring protection for it to be successful.) 2. Was there another reason why the solar industry in the United States may have been protected? (It was a politically connected industry.) For Inquiring Minds Increasing Returns to Scale and International Trade—This FIM explains how increased productivity with larger quantities can lead to a comparative advantage and international trade. Global Comparison Productivity and Wages Around the World—Wages and productivity are used to explain the pauper labor argument and sweatshop labor argument fallacies. Business Case Li & Fung: From Guangzhou to You—This business case discusses Li & Fung, an export broker that brings together manufacturers in Hong Kong and foreign buyers. Li & Fung will help the foreign buyer design the product, find the lowest-cost way to manufacture it, and then order it on the foreign buyer’s behalf. Web Resources The following websites provide information related to international trade. Foundation for Economic Education on comparative advantage, opportunity cost and fantasy football: https://fee.org/articles/fantasy-football-opportunity-cost-and-comparative-advantage/. The U.S. Business and Industry Council is an organization “fighting for American companies and American jobs.” Their website presents arguments for protectionism and includes a live U.S. trade deficit counter. Go to: http://americaneconomicalert.org/ticker_home.asp. Handout 8-1 Date_________ Name____________________________ Class________ Professor________________ Consider the following possibilities of production for the United States and Canada. One possibility The other possibility United States Wheat 30 0 Autos 0 60 Canada Wheat 80 0 Autos 0 40 Who has an absolute advantage in producing autos? Who has an absolute advantage in producing wheat? Who has the comparative advantage in the production of autos? Who has the comparative advantage in the production of wheat? Complete the following table by indicating the opportunity cost of wheat in terms of autos and the opportunity cost of autos in terms of wheat for both the United States and Canada. Product United States (opportunity cost) Canada (opportunity cost) 1 bushel of wheat 1 auto What would be effective terms of trade for the United States and Canada? Answers: Who has an absolute advantage in producing autos? Who has an absolute advantage in producing wheat? The United States has the absolute advantage in producing autos, and Canada has the absolute advantage in producing wheat. Who has comparative advantage in the production of autos? Who has comparative advantage in the production of wheat? The United States has the comparative advantage in auto production and Canada has the comparative advantage in wheat production. Complete the following table by indicating the opportunity cost of wheat in terms of autos and the opportunity cost of autos in terms of wheat for both the United States and Canada For the United States: 30 wheat = 60 autos 1 wheat costs 2 autos For Canada: 80 wheat = 40 autos 1 wheat costs ½ auto Or use a table: Product United States (opportunity cost) Canada (opportunity cost) 1 bushel of wheat 60/30 = 2 autos 40/80 = ½ auto 1 auto 30/60 = ½ bushel of wheat 80/40 = 2 bushels of wheat What would be effective terms of trade for the United States and Canada? The United States and Canada will agree on the terms of trade between autos and wheat that meets the following conditions: ½ auto < 1 wheat < 2 autos If they agree to trade 1 bushel of wheat for 1 auto, each country will gain from trade. Canada will specialize in the production of wheat and export wheat. If Canada gets more than ½ auto for each unit of wheat, it gains. The United States will import wheat at a price that is cheaper than what it costs the United States to produce it. Handout 8-2 Date_________ Name____________________________ Class________ Professor________________ Imported Sweets? Assume that the world price of sugar is lower than the domestic price of sugar and that there are no barriers to trade. What will happen to consumers and producers of sugar in the domestic market? Caribbean countries have a comparative advantage in the production of sugar, yet the United States blocks their imports. What are the impacts of the quota on sugar on consumers and producers in the United States? How would doing away with sugar quotas help poor countries? Answers: Assume that the world price of sugar is lower than the domestic price of sugar and that there are no barriers to trade. What will happen to consumers and producers of sugar in the domestic market? Buyers of sugar will import the cheaper sugar from abroad. Domestic producers of sugar will have less incentive to produce sugar as the domestic price falls to world levels. Caribbean countries have a comparative advantage in the production of sugar, yet the United States blocks their imports. What are the impacts of the quota on sugar on consumers and producers in the United States? Sugar prices in the United States are twice the world level. How would doing away with sugar quotas help poor countries? They gain income from exporting products for which they have a comparative advantage. Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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