Terms Flashcards
Tradeoffs
-To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another.
-ex. One classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect itself from foreign aggressors, the less it can spend on consumer goods (butter) to raise its standard of living.
opportunity costs
-whatever must be given up to obtain some item
-Ex.
The opportunity cost of working at your part-time job is the $100 you earn, but the time you lose (8 hours) could have been spent attending a concert or studying for an exam. Similarly, the opportunity cost of attending the concert is the $100 you could have earned and the study time you missed, while the opportunity cost of studying is the money and fun you forgo by not working or attending the concert.
rational decision making
-people who systematically and purposefully do the best they can to achieve their objectives, given the available opportunities
-Rational decision-making is the process of making choices that are logical and aim to maximize benefits, based on the information available and personal preferences. The idea is that individuals carefully weigh the costs and benefits of each option and choose the one that provides the greatest overall benefit.
-Rational decision-making assumes that people act in their best interest, have clear preferences, and can think logically to make the best possible choice. However, in practice, decisions are often affected by factors like limited information, time constraints, or emotions, which can sometimes lead to less-than-ideal choices.
marginal decision-making (change, costs, and benefits)
-a small incremental adjustment to a plan of action
-Marginal decision-making involves thinking about small, incremental changes rather than big, all-at-once decisions. When making a choice, you compare the marginal costs (the additional costs of doing one more unit of something) with the marginal benefits (the extra benefits you get from that same small increase). For example, if you’re deciding whether to study for an extra hour, the marginal cost could be the time you lose for other activities, like relaxing or socializing. The marginal benefit would be the extra improvement in your exam score from that hour of study. A rational decision is made by choosing to do something only if the marginal benefits outweigh the marginal costs. In other words, you make decisions based on small changes, weighing whether the extra benefit is worth the extra cost.
The invisible hand
-1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes.
-Smith’s insight has an important corollary: When a government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the decisions of the households and firms that make up an economy. This corollary explains why taxes adversely affect the allocation of resources: They distort prices and thus the decisions of households and firms.
-Smith is saying that participants in the economy are motivated by self-interest and that the “invisible hand” of the marketplace guides this self-interest into promoting general economic well-being.
-The “invisible hand” is a metaphor for the way the market naturally adjusts and balances itself without central planning, as long as there’s competition, supply, and demand. It suggests that when individuals are free to act in their own self-interest, the overall result can be an efficient allocation of resources and improved welfare for society.
The productions possibilities model
-a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology
The meaning of comparative advantage
-the ability to produce a good at a lower opportunity cost than another producer
Determining comparative advantage and the gains from trade
–The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good in which he or she has a comparative advantage, total production in the economy rises. This increase in the size of the economic pie can be used to make everyone better off.
-Comparative advantage is the idea that countries (or individuals) should focus on producing the goods they can make most efficiently, or with the lowest cost, and trade with others to get the things they cannot produce as easily. Each country has a different set of resources, so one might be better at producing wheat while another is better at producing cloth. The country with the lowest cost for making wheat has a comparative advantage in wheat production, and the one with the lowest cost for making cloth has a comparative advantage in cloth. By specializing in what they do best and trading with each other, both countries can get more of both goods than if they tried to make everything themselves. This is called the gains from trade, where both parties are better off because they are using their resources more efficiently.
Demand and quantity demanded
Demand refers to the overall desire for a good or service in the market, based on factors like price, income, and consumer preferences. It shows how much of a product people are willing to buy at different prices. Quantity demanded, on the other hand, is the specific amount of a good or service that people are willing to buy at a particular price. If the price of a product goes down, the quantity demanded usually increases because more people are willing to buy it. However, if the price goes up, the quantity demanded generally decreases. So, while demand refers to the entire relationship between price and the amount people are willing to buy, quantity demanded is the amount at a specific price point.
Supply and quantity supplied
Supply refers to the total amount of a good or service that producers are willing to sell in the market at different prices. In general, as the price of a product increases, producers are more willing to supply more of it because they can make a higher profit. Quantity supplied, on the other hand, is the specific amount of a good or service that producers are willing to sell at a certain price. If the price rises, the quantity supplied usually increases, and if the price falls, the quantity supplied usually decreases. So, while supply looks at the overall relationship between price and the amount producers are willing to sell, quantity supplied refers to the amount offered at a particular price.
The determinants of demand: what causes demand to change
The determinants of demand are the factors that can cause demand for a good or service to increase or decrease. One key factor is price—as the price of a product decreases, demand usually increases, and as the price rises, demand tends to decrease. Another factor is income; when people have more money, they tend to buy more goods and services, which increases demand. Consumer preferences also play a role; if something becomes more popular or fashionable, demand for it can go up. The price of related goods can affect demand too. For example, if the price of a substitute product (like tea for coffee) goes up, demand for the original product (coffee) may increase. Finally, expectations about future prices can influence current demand. If people expect prices to rise in the future, they might buy more now, increasing demand. These factors, among others, help explain why demand changes over time.
The determinants of supply: what causes supply to change
The determinants of supply are factors that can cause the supply of a good or service to increase or decrease. One key factor is price—when the price of a product rises, producers are usually willing to supply more because they can make more profit. Production costs also affect supply; if it becomes cheaper to make a product (due to lower costs for materials or labor), supply increases. On the other hand, if production costs rise, supply tends to decrease. Technology plays a big role too; new technology can make production more efficient, leading to an increase in supply. Additionally, government policies like taxes, subsidies, or regulations can influence supply. For example, a tax on a product may reduce the supply, while a subsidy could increase it. Lastly, expectations about future prices can affect how much producers are willing to supply now; if they expect prices to rise in the future, they might hold back some of their product, reducing current supply. These factors all influence how much of a good or service producers are willing and able to offer in the market.
Market equilibrium, shortages and surplus
-equilibrium:a situation in which the market price has reached the level at which quantity supplied equals quantity demanded
-shortages: a situation in which quantity demanded is greater than quantity supplied
-surplus: a situation in which quantity supplied is greater than quantity demanded
Market equilibrium is the point where the quantity of a good or service that producers are willing to supply exactly matches the quantity that consumers want to buy, at a certain price. This price is called the equilibrium price, and at this price, there is neither a shortage nor a surplus. If the price is set too high, a surplus occurs, meaning producers are willing to supply more than consumers are willing to buy, and there are extra goods left unsold. If the price is set too low, a shortage happens, meaning consumers want to buy more than producers are willing to supply, leading to a lack of goods available. In both cases, market forces (supply and demand) work to adjust the price until the market returns to equilibrium, where the amount supplied equals the amount demanded.
The effects of changes in demand or supply on market price and quantity
Changes in demand or supply can affect the market price and quantity of a good. When demand increases (for example, because a product becomes more popular), consumers are willing to buy more at any price, so the price tends to rise. As the price goes up, producers are willing to supply more, which increases the quantity available in the market. On the other hand, if demand decreases (like when a product goes out of style), the price usually falls, and the quantity sold also decreases.
When supply increases (due to lower production costs or better technology), more goods are available at every price, so the price tends to fall. As the price decreases, consumers buy more, increasing the quantity sold. If supply decreases (perhaps because of higher costs or fewer producers), the price usually rises, and the quantity available in the market falls. In both cases, changes in demand or supply cause shifts in the market price and quantity, adjusting the market to new conditions.
The meaning and determinants of elasticity
-a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants
Elasticity measures how much the quantity demanded of a good changes when its price changes. If the quantity demanded changes a lot when the price changes, the demand is elastic. If it changes only a little, the demand is inelastic. Several factors influence this.
First, if there are close substitutes for a good, demand tends to be more elastic. For example, if the price of butter goes up, people can easily switch to margarine, so the demand for butter drops a lot. But if a good doesn’t have substitutes, like eggs, the demand is less elastic.
Second, whether the good is a necessity or a luxury affects its elasticity. Necessities, like medicine, usually have inelastic demand because people still need them even if the price goes up. Luxuries, like sailboats, have elastic demand because people can choose not to buy them if the price rises.
Third, the definition of the market matters. A more specific market, like vanilla ice cream, tends to have more elastic demand because there are many other flavors people can choose from. But a broad market, like food in general, has less elastic demand because people still need food even if prices go up.
Lastly, over time, the demand for a good can become more elastic. In the short term, people may not change their behavior much when prices rise, but over time, they can find alternatives or change their habits, making demand more elastic in the long run.
These factors—substitutes, necessity vs. luxury, market definition, and time—determine how responsive the demand for a product is to price changes.
Calculating elasticity
Price Elasticity of Supply (PES)= %changeinprice/%changeinquantitysupplied
%changeinquantitysupplied= (NewQuantitySupplied−OldQuantitySupplied/OldQuantitySupplied) (×100)
%changeinprice= (NewPrice−OldPrice /OldPrice) ×100
Modeling and interpreting the market effects of an tax: the tax wedge model
The tax wedge model is a way to show how taxes affect the market, particularly the price buyers pay and the price sellers receive. When the government imposes a tax on a good, it creates a difference, or wedge, between the price that consumers pay and the price that producers receive. This is because part of the price goes to the government in the form of the tax, leaving less money for both the buyer and the seller.
The tax typically causes the price consumers pay to rise and the price producers receive to fall. The size of this tax wedge depends on the tax rate and how much the demand and supply curves are affected by the tax. If demand is more inelastic (meaning consumers don’t reduce their quantity demanded much when prices rise), consumers will bear more of the tax. If supply is more inelastic (meaning producers can’t easily change how much they produce), producers will bear more of the tax.
Modeling and interpreting the market effects of minimum wage and rent control laws.
Both minimum wage and rent control laws are examples of government-imposed price controls, which include price floors and price ceilings. A price floor sets a minimum price that can be charged for a good or service, and the minimum wage is an example of this in the labor market. When the government sets the minimum wage above the equilibrium wage, it creates a price floor. This leads to unintended consequences such as unemployment, as employers may not be willing to hire as many workers at the higher wage, resulting in a surplus of labor where more people are seeking jobs than there are positions available. On the other hand, a price ceiling sets a maximum price that can be charged for a good or service, and rent control is an example of this in the housing market. If rent is controlled below the equilibrium price, it creates a price ceiling. This causes shortages in housing because more people want to rent at the lower price, but fewer landlords are willing to offer rental units at that price. Additionally, landlords may reduce the quality of their properties since they are receiving less income from rent, leading to deteriorating housing conditions. In both cases, these price controls disrupt the natural functioning of supply and demand, leading to inefficiencies such as unemployment and housing shortages.
Determinants of the burden of a tax: dead weight loss
-definition:the fall in total surplus that results from a market distortion, such as a tax
The deadweight loss of a tax refers to the loss of economic efficiency that occurs when a tax prevents mutually beneficial transactions from happening in the market. The size of this deadweight loss is determined by the elasticities of supply and demand, which measure how sensitive buyers and sellers are to changes in price. When either supply or demand is more elastic, the deadweight loss tends to be larger. This happens because both buyers and sellers are more likely to change their behavior in response to a tax, reducing the number of transactions that occur at the equilibrium price.
For example, if the supply curve is more elastic, meaning that producers can easily adjust the quantity they supply in response to price changes, then the deadweight loss will be larger because producers will reduce the amount they are willing to sell when a tax increases their costs. Similarly, if the demand curve is more elastic, meaning that consumers are more responsive to price changes, they will reduce their quantity demanded significantly when the tax increases the price they must pay, leading to a larger deadweight loss.
In contrast, when supply or demand is inelastic, the deadweight loss is smaller. This is because either producers or consumers are less responsive to price changes and will not significantly change the quantity bought or sold in the market. For example, if the supply of a good is inelastic, producers may not reduce the amount they supply by much even if the tax raises their costs, leading to a smaller reduction in the number of transactions.
This relationship between elasticity and deadweight loss is important in understanding how taxes affect the economy. The more elastic the supply and demand curves, the more the tax distorts the market, leading to a larger deadweight loss. On the other hand, if supply and demand are relatively inelastic, the tax will cause a smaller distortion, and the deadweight loss will be lower. This is why economists debate the size of the deadweight loss, especially in the context of labor taxes, where some argue that labor supply is relatively inelastic, and others believe it is more elastic, depending on factors like the ability to work more hours or the choice to enter the underground economy. Understanding these elasticities helps determine the efficiency of taxation and the cost of government programs that rely on tax revenue.
Determinants of the distribution of the burden of a tax: who bears the burden of a tax?
The distribution of the burden of a tax, known as tax incidence, depends on the elasticities of supply and demand. If demand is inelastic, meaning consumers are less responsive to price changes, they will bear a larger share of the tax burden, as they will continue to buy the good even if the price increases. Conversely, if demand is elastic, meaning consumers are more sensitive to price changes, producers will bear a larger portion of the tax burden to avoid losing customers. Similarly, if supply is inelastic, meaning producers cannot easily adjust production, they will bear more of the tax burden. However, if supply is elastic, producers can adjust more easily and will pass more of the tax onto consumers by raising prices. In general, the more inelastic the side of the market (either demand or supply), the greater the share of the tax burden that side will bear.
Welfare economics model
Welfare economics is a branch of economics that focuses on the well-being of individuals in society and how resources are allocated to improve overall social welfare. It uses market efficiency to analyze how the allocation of goods and services affects economic welfare. The welfare economics model primarily focuses on concepts like consumer surplus, producer surplus, and total surplus (or economic surplus), which together measure the overall benefit to society from the market’s functioning.
In a perfectly competitive market, the equilibrium price and quantity are determined where the demand curve intersects the supply curve. At this point, the total welfare of society is maximized because the amount that consumers are willing to pay for a good (consumer willingness to pay) matches the cost of producing that good (producer cost). The consumer surplus represents the difference between what consumers are willing to pay and what they actually pay, reflecting the benefit to consumers from buying a good at a lower price than they were willing to pay. Producer surplus represents the difference between the price producers receive and the minimum price they are willing to accept, reflecting the benefit to producers from selling at a price higher than their cost of production.
The sum of consumer surplus and producer surplus is called total surplus, and it represents the total benefits to society from the exchange of goods and services in a market. This is the ideal outcome in welfare economics, as it indicates that resources are allocated efficiently.
When markets are not perfectly competitive, or when there are market failures like taxes, subsidies, or price controls (price ceilings and floors), deadweight loss can occur. Deadweight loss is the reduction in total surplus that occurs when the market is not operating at equilibrium, and it reflects the loss of welfare due to inefficient allocation of resources. For example, a tax can reduce the quantity of a good sold, leading to a deadweight loss because both consumer and producer surpluses are reduced by the tax.
In summary, the welfare economics model analyzes how market outcomes, like price and quantity, affect the well-being of consumers and producers. It emphasizes the importance of market efficiency and total surplus in determining how well resources are allocated to maximize overall social welfare. When markets operate efficiently, total surplus is maximized, but inefficiencies such as taxes or market failures reduce this surplus, leading to deadweight loss.
Consumer and producer surplus: meaning and graphic representation
Consumer Surplus: This is the difference between the highest price a consumer is willing to pay for a good or service and the price they actually pay. It represents the benefit or satisfaction consumers receive when they are able to purchase a product for less than what they were willing to pay. Graphically, consumer surplus is the area between the demand curve and the price level, above the equilibrium price and below the demand curve. It forms a triangle on the graph.
Producer Surplus: This is the difference between the price a producer receives for a good and the minimum price they are willing to accept for that good, which covers their production costs. It represents the benefit producers receive from selling at a price higher than their cost of production. Producer surplus is graphically represented as the area between the supply curve and the price level, below the equilibrium price and above the supply curve. This area also forms a triangle.
Graphic Representation:
In a standard supply and demand graph, where the quantity is on the horizontal axis and the price is on the vertical axis, the equilibrium price is where the supply curve and demand curve intersect. At this point, the market clears, meaning the quantity demanded equals the quantity supplied.
Consumer surplus is the area above the equilibrium price and below the demand curve. It reflects the extra value consumers get by paying less than they are willing to.
Producer surplus is the area below the equilibrium price and above the supply curve. It reflects the extra value producers get by receiving more than their minimum acceptable price.
Together, consumer surplus and producer surplus make up the total economic surplus or total surplus, which represents the total benefit to society from the production and consumption of a good or service.
Changes in consumer and producer surplus
Consumer surplus is the extra benefit consumers get when they pay less for something than they were willing to, and producer surplus is the extra benefit producers get when they sell something for more than it cost them. When prices go up, consumer surplus goes down because people have to pay more, and producer surplus goes up because they make more money. If prices go down, the opposite happens: consumer surplus increases and producer surplus decreases. Things like taxes or subsidies can also change how much consumers and producers benefit.
The wedge model: graphing the effects of a tax
(try it out on paper)
Before the Tax: The market is in equilibrium where the supply curve (upward sloping) intersects with the demand curve (downward sloping). At this point, consumers and producers agree on a price and quantity.
After the Tax: A tax is placed on either consumers or producers. This shifts either the supply curve (if the tax is on producers) or the demand curve (if the tax is on consumers). The new equilibrium occurs at a different price and quantity.
Price Paid by Consumers: After the tax, consumers end up paying a higher price than before the tax, because part of the tax burden is passed onto them.
Price Received by Producers: Producers receive a lower price than before the tax, as the other part of the tax is paid by them.
The Wedge: The difference between the price consumers pay and the price producers receive is the “wedge” created by the tax. This wedge represents the tax burden, and it leads to a decrease in the quantity traded in the market, which is called a deadweight loss because fewer transactions occur than in the tax-free market.
The determinants of the magnitude of dead weight loss
The size of deadweight loss depends on the elasticity of supply and demand. If demand or supply is elastic (more responsive to price changes), deadweight loss is larger because consumers or producers will adjust their behavior significantly when the price changes. A larger tax also increases deadweight loss by creating a bigger gap between the price consumers pay and the price producers receive, leading to fewer transactions. In markets that are more competitive, price changes tend to cause greater inefficiency. In short, deadweight loss is greater when both supply and demand are elastic and when the tax is larger.
Tax rates and tax revenue: the Laffer curve
The Laffer Curve suggests that there is an optimal tax rate that maximizes government revenue. If tax rates are too high, people may be discouraged from working or investing, leading to lower revenue. On the other hand, lowering tax rates could encourage more economic activity, potentially increasing tax revenue. In the 1980s, economist Arthur Laffer and President Ronald Reagan argued that high tax rates were harming the economy, and that reducing taxes would stimulate growth, even increasing tax revenue in the process. However, many economists remain skeptical, believing that tax cuts usually reduce revenue. The Laffer Curve highlights that the effects of tax changes depend not just on the tax rate itself, but on how they affect people’s behavior.
The Laffer Curve shows the relationship between tax rates and tax revenue. It suggests that there is an optimal tax rate that maximizes revenue. At very low tax rates, increasing taxes will raise more revenue because people are willing to work and produce more. However, at very high tax rates, raising taxes further can actually reduce revenue because it discourages work, investment, and production. This is because higher taxes can reduce the incentive for people to earn or produce, leading to less overall economic activity. The Laffer Curve illustrates that there is a point where higher tax rates result in less revenue, and the goal is to find a balance between tax rates that encourages economic activity and generates sufficient revenue.
Free trade and comparative advantage
Free trade refers to a system in which goods and services can be traded across borders without restrictive tariffs, quotas, or other government-imposed barriers. The idea behind free trade is that countries should be able to exchange goods and services with minimal interference from governments, allowing them to specialize in the production of goods in which they are most efficient and to gain access to goods that are produced more efficiently elsewhere.
The case for free trade can be made even stronger, however, because there are several other economic benefits of trade beyond those emphasized in the standard analysis. In a nutshell, here are some of these other benefits:
Increased variety of goods: Goods produced in different countries are not exactly the same. German beer, for instance, is not the same as American beer. Free trade gives consumers in all countries greater variety to choose from.
Lower costs through economies of scale: Some goods can be produced at low cost only if they are produced in large quantities—a phenomenon called economies of scale. A firm in a small country cannot take full advantage of economies of scale if it can sell only in a small domestic market. Free trade gives firms access to larger world markets, allowing them to realize economies of scale more fully.
Increased competition: A company shielded from foreign competitors is more likely to have market power, which in turn gives it the ability to raise prices above competitive levels. This is a type of market failure. Opening up trade fosters competition and gives the invisible hand a better chance to work its magic.
Increased productivity: When a nation opens up to international trade, the most productive firms expand their markets, while the least productive are forced out by increased competition. As resources move from the least to the most productive firms, overall productivity rises.
Enhanced flow of ideas: The transfer of technological advances around the world is often thought to be linked to the exchange of the goods that embody those advances. The best way for a poor agricultural nation to learn about the computer revolution, for instance, is to buy some computers from abroad rather than trying to make them domestically.
Thus, free trade increases variety for consumers, allows firms to take advantage of economies of scale, makes markets more competitive, makes the economy more productive, and facilitates the spread of technology. If the Isolandian economists also took these benefits into account, their advice to the president would be even more forceful.
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Comparative advantage is the principle that explains how countries can gain from trade even if one country is less efficient than another in the production of all goods. It suggests that countries should specialize in producing goods in which they have the lowest opportunity cost and then trade with others to obtain the goods they produce less efficiently.
In essence, comparing the world price with the domestic price before trade reveals whether Isoland has a comparative advantage in producing textiles. The domestic price reflects the opportunity cost of textiles: It tells us how much an Isolandian must give up to obtain one unit of textiles. If the domestic price is low, the cost of producing textiles in Isoland is low, suggesting that Isoland has a comparative advantage in producing textiles relative to the rest of the world. If the domestic price is high, then the cost of producing textiles in Isoland is high, suggesting that foreign countries have a comparative advantage in producing textiles.
The welfare economics of free trade
The welfare economics of free trade explores how international trade affects the economic well-being of individuals, industries, and entire countries. It looks at the changes in consumer surplus, producer surplus, government revenue, and overall national welfare. Free trade generally increases consumer surplus, as consumers benefit from lower prices and more variety in goods. For producers, the effects are mixed: domestic producers may face competition and see their surplus decrease in industries with less competitive advantages, while producers in sectors with a comparative advantage (e.g., export-oriented industries) can benefit from higher prices and expanded markets. Economic efficiency is also enhanced, as free trade allows resources to be allocated based on comparative advantage, leading to more efficient production and consumption globally.
Regarding government revenue, free trade typically reduces income from tariffs or trade restrictions, though overall economic growth may offset this loss by increasing tax revenues in other areas, such as income and corporate taxes. The welfare effects of free trade depend on whether a country is importing or exporting. When opening up to imports, consumers gain from lower prices, but domestic producers face competition, which can reduce their surplus. In contrast, opening up to exports can increase producer surplus by allowing access to higher world prices, but it may also raise prices domestically, reducing consumer surplus.
Despite the overall increase in national welfare, the benefits of free trade are not evenly distributed, which can create distributional challenges. Workers and industries facing foreign competition may suffer job losses or wage reductions, leading to unemployment or greater inequality, especially if there are no retraining programs or social safety nets. Protectionist policies, such as tariffs or subsidies, may help certain industries in the short term but often lead to inefficiencies, reducing overall welfare in the long run. While these short-term gains are politically appealing, they generally distort market outcomes and harm consumers.
In conclusion, although free trade leads to overall gains in economic welfare by increasing efficiency, lowering prices, and expanding access to goods, it can create challenges for specific groups. Policymakers must balance these effects, possibly through compensation or retraining programs for those adversely affected by trade. Nevertheless, the broad consensus is that free trade enhances national welfare by promoting competition, reducing costs, and improving resource allocation.
Modeling the welfare effects of tariffs and quotas
A tariff on imports raises the price of foreign goods, which leads to several key economic effects in the domestic market. Before the tariff, the domestic price of textiles equals the world price, and total surplus is the sum of consumer surplus, producer surplus, and government revenue (which is zero under free trade). Consumer surplus is the area between the demand curve and the world price, while producer surplus is the area between the supply curve and the world price. When the tariff is imposed, the price consumers pay increases, which reduces the quantity demanded and raises the quantity supplied domestically. Domestic producers benefit from the higher price, so producer surplus increases, while consumer surplus decreases due to the higher prices and reduced consumption. The government collects revenue from the tariff, which equals the tariff rate times the quantity of imports after the tariff is imposed. This revenue is represented by the area between the tariff-inclusive price and the world price, multiplied by the post-tariff quantity of imports.
However, the overall welfare of the economy declines because the tariff creates inefficiency. Deadweight loss occurs due to two reasons: overproduction and underconsumption. Overproduction happens because domestic producers increase output even though the cost of producing these extra textiles exceeds the cost of importing them at the world price. Underconsumption happens because consumers reduce their purchases of textiles, even though the value they place on them (shown by the demand curve) is higher than the price they pay after the tariff. The total deadweight loss is represented by two triangles (areas D and F), which reflect these inefficiencies. While the tariff generates revenue for the government and benefits domestic producers, it leads to a reduction in total surplus, as consumer losses and deadweight loss outweigh the gains. Thus, the tariff results in a net loss of welfare, as it distorts the allocation of resources and moves the economy away from the optimal equilibrium that would be achieved under free trade.
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Import quotas are another way countries restrict trade, and they produce effects similar to those of tariffs. Like tariffs, quotas raise domestic prices by limiting the quantity of goods that can be imported. Under a quota system, the government sets a limit on the number of textiles that can be imported, which leads to an increase in the domestic price of textiles. Domestic producers benefit from the higher price, as they are now able to sell more textiles at a higher price. However, consumers are worse off because they face higher prices and consume fewer textiles. While tariffs generate government revenue, quotas do not directly raise revenue for the government; instead, they create quota rents, which are the profits earned by the holders of import licenses. These rents are the difference between the domestic price (after the quota is imposed) and the world price, which accrues to those with the right to import the restricted goods.
In terms of welfare, quotas have similar effects to tariffs. Consumer surplus decreases because consumers must pay higher prices and consume fewer goods. Producer surplus increases because domestic producers can sell more at higher prices. However, unlike tariffs, the government does not directly benefit from the quota; instead, the gains from restricted imports go to those holding the import licenses, which could be domestic firms or foreign exporters, depending on how the quota is allocated. The deadweight loss is also present with quotas, arising from the inefficiencies caused by overproduction (domestic producers making textiles at higher costs than the world price) and underconsumption (consumers paying higher prices but purchasing less than they would at the world price). If the government were to auction off import licenses or charge fees for them, the quota could generate government revenue, and its welfare effects would be nearly identical to those of a tariff. In practice, however, many countries do not sell import permits, leading to the inefficiency of foreign firms benefiting from quota rents instead of the domestic government. Thus, both tariffs and quotas restrict trade, raise prices, reduce consumer welfare, increase producer welfare, and lead to deadweight loss, but quotas primarily benefit those who control the import licenses rather than the government.
Arguments against free trade (Jobs)
- The Jobs Argument
Opponents of free trade often argue that trade with other countries destroys domestic jobs. In our example, free trade in textiles would cause the price of textiles to fall, reducing the quantity of textiles produced in Isoland and thus reducing employment in the Isolandian textile industry. Some Isolandian textile workers would lose their jobs.
Yet free trade creates jobs at the same time that it destroys them. When Isolandians buy textiles from other countries, those countries obtain the resources to buy other goods from Isoland. Isolandian workers would move from the textile industry to those industries in which Isoland has a comparative advantage. The transition may impose hardship on some workers in the short run, but Isolandians as a whole would still enjoy a higher standard of living.
Opponents of trade are often skeptical that trade creates jobs. They might respond that everything can be produced more cheaply abroad. Under free trade, they might argue, Isolandians could not be profitably employed in any industry. As Chapter 3 explains, however, the gains from trade are based on comparative advantage, not absolute advantage. Even if one country is better than another country at producing everything, each country can still gain from trading with the other. Workers in each country will eventually find jobs in an industry in which that country has a comparative advantage.
Arguments against free trade (National Security)
The National-Security Argument
When an industry is threatened with competition from other countries, opponents of free trade often argue that the industry is vital to national security. For example, if Isoland were considering free trade in steel, domestic steel companies might point out that steel is used to make guns and tanks. Free trade would allow Isoland to become dependent on foreign countries to supply steel. If a war later broke out and interrupted the foreign supply, Isoland might be unable to quickly produce enough steel and weapons to defend itself.
Economists acknowledge that protecting key industries may be appropriate when there are legitimate concerns over national security. Yet they fear that this argument may be used too readily by producers eager to gain at consumers’ expense.
One should be wary of the national-security argument when it is made by representatives of industry rather than the defense establishment. Companies have an incentive to exaggerate their role in national defense to obtain protection from foreign competition. A nation’s generals may see things very differently. Indeed, when the military is a consumer of an industry’s output, it would benefit from imports. Cheaper steel in Isoland, for example, would allow the Isolandian military to accumulate a stockpile of weapons at lower cost.
Arguments against free trade (Infant Industry)
The Infant-Industry Argument
New industries sometimes argue for temporary trade restrictions to help them get started. After a period of protection, the argument goes, these industries will mature and be able to compete with foreign firms. Similarly, older industries sometimes argue that they need temporary protection to help them adjust to new conditions.
Economists are often skeptical about such claims, largely because the infant-industry argument is difficult to implement in practice. To apply protection successfully, the government would need to determine which industries will eventually be profitable and decide whether the benefits of establishing these industries exceed the costs of this protection to consumers. Yet “picking winners” is extraordinarily difficult. It is made even more difficult by the political process, which often awards protection to industries with the most political clout. And once a politically powerful industry is protected from foreign competition, the “temporary” policy can be hard to remove.
In addition, many economists are skeptical about the infant-industry argument in principle. Suppose, for instance, that an industry is young and unable to compete profitably against foreign rivals, but there is reason to believe that the industry can be profitable in the long run. In this case, firm owners should be willing to incur temporary losses to obtain the eventual profits. Protection is not necessary for an infant industry to grow. History shows that start-up firms often incur temporary losses and succeed in the long run, even without protection from competition.
Arguments against free trade (Unfair-Competition)
The Unfair-Competition Argument
A common argument is that free trade is desirable only if all countries play by the same rules. If firms in different countries are subject to different laws and regulations, then it is unfair (the argument goes) to expect the firms to compete in the international marketplace. For instance, suppose that the government of Neighborland subsidizes its textile industry, thus lowering the costs of production for Neighborland’s textile companies. The Isolandian textile industry might argue that it should be protected from this foreign competition because Neighborland is not competing fairly.
Would it, in fact, hurt Isoland to buy textiles from another country at a subsidized price? To be sure, Isolandian textile producers would suffer, but Isolandian textile consumers would benefit from the low price. The case for free trade is the same as before: The gains of the consumers from buying at the low price would exceed the losses of the producers. Neighborland’s subsidy to its textile industry may be a bad policy, but it is the taxpayers of Neighborland who bear the burden because they have to pay for the subsidy. Isoland benefits from the opportunity to buy textiles at a subsidized price. Rather than objecting to the foreign subsidies, perhaps Isoland should send Neighborland a thank-you note.
Arguments against free trade (The Protection-as-a-Bargaining-Chip Argument)
The protection-as-a-bargaining-chip argument suggests that trade restrictions can be used strategically in negotiations to remove existing trade barriers. For example, Isoland might threaten to impose a tariff on textiles unless Neighborland removes its tariff on wheat. The idea is that the threat will prompt Neighborland to reduce its tariff, leading to freer trade. However, this strategy can backfire if the threat doesn’t work. Isoland would then face a choice between imposing a tariff, which harms its own welfare, or backing down, which could damage its international standing.
Regarding trade agreements, countries can pursue unilateral or multilateral approaches. The unilateral approach involves removing trade restrictions independently, as countries like Great Britain, Chile, and South Korea have done. The multilateral approach, however, involves negotiating with other countries to reduce trade barriers globally. Key examples include the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT), now overseen by the World Trade Organization (WTO). Multilateral agreements have the potential to create broader free trade by reducing tariffs not just at home, but abroad as well. However, if negotiations fail, it can lead to more trade restrictions than a unilateral approach would.
A political advantage of the multilateral approach is that it can align interests across industries. For instance, if Isoland agrees to reduce its textile tariff in exchange for Neighborland reducing its wheat tariff, powerful groups like wheat farmers in Isoland may support the deal, even if textile producers oppose it. This makes it easier to build political support for trade liberalization through multilateral negotiations.
