The Global Economy - Fred E. Foldvary

International trade is an application of the more general
principle of exchange.

A major principle in exchange is "gain from trade".
People trade things because of different subjective values.

A "gain from trade" is the additional in utility that takes
place when parties exchange goods.

Two parties always gain from a voluntary exchange.

Goods can be equal in market value, but unequal in marginal utility.

Utility is the satisfaction obtained from a good or the importance of a good.

Marginal utility is the utility obtained from one more unit.

After some quantity, marginal utility diminishes.
The principle of diminishing marginal utility:
the marginal utility of goods eventually diminishes with increasing quantity.

Exchange among countries has the same principles as among individuals.

The most obvious type of gain is an absolute advantage,
the ability to produce a greater quantity of some product than
another agent, using the same inputs.

A more general reason for gains from trade is comparative


Comparative advantage is in opportunity costs.

Here's a practical application for business.

Suppose a lawyer can earn $100 per hour doing legal work, and

she can type 100 words per minute.

Suppose a secretary can be hired for $10 per hour, but he can

only type 50 words per minute.

The lawyer has an absolute advantage in typing. Should she

hire the secretary anyway?

Yes, because the secretary has a relative advantage in typing.

If she does her own typing, she saves $20 per hour (from two

secretaries), but loses $100 in legal work, for a net loss of $80.

She is better off hiring two secretaries to do what he could

do in an hour.

The same principle applies to trade between countries.


US makes $100 computer value per 2 labor hours.

US makes $100 television per 3 labor hours.

Japan makes $100 computer per 1.5 labor hour.

Japan makes $100 television per 1 labor hour.

Without trade: US needs 5 hours, Japan 2.5 hours.

With trade:

For one TV, Japan can a import a computer; saves .5 hour.

US should sell computers. Exchange for TV. Saves 1 hour.

Japanese works 2 hours for a TV and computer.

US works 4 hours for a TV and computer.

With extra hour, can produce more, or have more leisure.

Comparative advantage is not a given, but can be created, and


The theory of comparative advantage is dynamic,

as both natural and created advantages change over time.

Free trade is the exchange of goods without any trade barriers

such as quotas and tariffs.

Trade barriers consist in interference by government, such as

quotas, tariffs, and restrictions.

These allegedly "protect" domestic industries.

Protectionism is trade limitation, the doctrine of having

trade barriers.

The three basic types of trade limitation are tariffs,

quotas, and arbitrary regulations.

A tariff or import duty is a tax on imported goods.

Tariffs raise the price of the good,

reducing the quantity demanded and thus reducing the amount

imported and making domestic production more profitable.

An import quota is a limitation on the quantity of an import,

which enables domestic producers to raise their prices.

There are also nontariff barriers such as regulations,

such as requiring products to meet certain standards,

which often don't have anything to do with consumer protection.

With barriers, consumers are worse off, due to the higher

prices and lower quantities of the goods.

There is less competition.

Does trade limitation promote employment and higher wages?

Why continuing controversy?

Because powerful pecuniary interests are involved.

They present one-sided, incomplete arguments.

But fair-minded people also disagree on it, so the question

then is, can economics supply a sound argument for one case?

Advocates of protection say it furnishes employment,

without asking how employment comes about.

They say that protection maintains the rate of wages,

without explaining what determines the rate of wages.

What is the origin of the wage level?

The marginal productivity of labor, what labor adds to the

value of goods.

Just because some workers get displaced does not by itself

cause general unemployment or low wages.

If protectionism is really beneficial, why not apply it

domestically, universally?

Workers know that what prevents them from successfully

demanding higher wages is competition from other workers.

So workers favor being shielded from competition by tariffs.

But if a wage is equal to the value it contributes to

production, then why should wages need protection?

Protectionism asserts a general law of trade limitation.

Ultimately trade limitation would require consumers to buy

goods only from the highest priced producers.

The result: a decrease in total production.

Also: tariffs lead to evasion and corruption (like other taxes

on transactions).

A tariff has the same effect as an increase in transaction and

transportation costs.

Would it benefit an economy to have higher transaction costs?

Are we better off with higher commuting costs?

Why a country? No economic basis.

Example of free trade within the US.

Protection implies the smallest possible political units.

The cause of the trade which a tariff aims to prevent

is the desire of Americans to buy foreign goods.

Trade limitation is aimed at domestic producers.

Early accumulations of wealth occurred not in isolated areas

but where there was much trade.

Taxes: direct and indirect.

Direct: the agent taxed bears the burden.

Indirect: the agent taxed passes the burden to others.

Property tax: direct. Sales (excise) tax: indirect.

The store or importer is taxed; the customer pays it.

Income tax: economically direct. Legally indirect.

US Constitution: direct taxes apportioned to population.

Indirect taxes must be uniform.

16th Amendment did not repeal these clauses.

Hence, US income tax declared to be indirect,

on the activity of earning an income, measured by the income.

Corporate income tax indirect on the privilege of

operating as a corporation.

"Tariff" from Spanish town Tarifa, where Moors collected

duties. Of course, tariffs existed long before.

If we have tariffs for revenue as an optimal, normative

policy, then the question is, are sales taxes in general optimal.

Which taxes best promote international trade and domestic


Sales taxes that raise substantial revenue require expensive

enforcement and complex regulations.

With tariffs, you need to guard the border, as you do also

to restrict immigration. Goods must be searched.

Even then, much gets smuggled. E.g. drugs.

Restrictions lead to bribery and evasion.

The economic cost of a tax is not the money paid.

It is the excess burden - the social cost.

The extra charge or restriction alters what people would

normally want, so it reduces welfare.

By increasing costs, it reduces consumption, enterprise, and

employment. These lost opportunities are the social cost.

Taxes take more from the public than what government gets,

creating an excess burden.

Sales taxes are also regressive: a greater proportional

burden on the poor than the rich.

Indirect taxes favored by government because the public does

not realize it is being taxed and could not calculate the amount.

The excise tax is included in the price of goods.

Income and sales taxes favor large enterprises with accountants

and lawyers who can handle the requirements.

All the problems which apply to excise or indirect taxes apply

also to import duties.

Question of the optimal tax.

Three factors: land, labor, capital goods.

Three stages: income, wealth, spending.

Analyze by factor. Rent, wages, capital goods.

What determines rent and wages?

Dynamic model shows the origin of rent.

A tax on rent: 1) equalizes income; 2) makes production more

efficient; 3) has no excess burden.

Fixed supply, so rent determined by demand.

Tax only reduces the price of land. Rent is not passed on.

Hence, taxes on other factors are suboptimal.

Taxes on stages take from all three factors.

Optimal tax: on rent.

Tariffs for Protection.

Protection, or trade limitation, has the goal or end of

encouraging domestic industry.

National defense: a separate goal.

If we have that end, are tariffs the best means?

Alternative: bounties or subsidies.

A subsidy lets us determine the actual cost.

Borne by taxpayers as a whole.

Tariffs injure consumers and other industries selectively.

Trade limitation is "a clumsy and extravagant mode of giving

encouragement that could be given much better and at much less cost

by bounties or subsidies."

Question: is free trade right in theory but not in practice?

But "theory" means an explanation of phenomena.

If a proposition not in accord with facts, not theory.

Conjecture, hypothesis, theory.

Much of what is called "theory" is really conjecture.

In this class, theory means warranted by logic and evidence.

Free trade can be enacted, but perfect protection is

impossible. Requires detailed knowledge no one has.

In practice, special interests use protection for their own

interests: transfer seeking.

Argument for infant industries, but

US no longer an infant, and

infants can receive private investment.

Often, decaying industries get the protection.

Policy of encouraging: industrial policy generally.

But, problem of knowing what to encourage.

Protection from competition may encourage inefficiency.

If we transfer resources to one industry,

we transfer resources away from other industries.

If the goal is to encourage industry, why is it burdened with