I Answer Chris on Trade Wars

Reader Chris asks,

I am for free trade. I wish everyone was. However, I do wonder if unilateral 'disarmament' of trade barriers is akin to unilateral military disarmament?

In both cases, government's are spending money in a non-productive fashion (at least, not directly) to protect local production.

In both cases, it would be better if everyone disarmed, but it would also be better if each country was slightly better armed than everyone else.

thoughts? please tell me I'm wrong.

I debated about whether or not produce a set of graphs to deal with this question. In the end I decided, mostly in the interest of time, to try to do it verbally. Lets see how I do.

So, the basic Econ 101 answer to the question is that unilateral reduction in our trade barriers would help us.

Why?

When we erect a trade barrier the cost to our consumers is greater than the profit to our companies.

To see this suppose that we were to but a tariff on Chinese toys. Lets assume that currently the average Chinese toy is selling for $10. However, it costs an American company $15 to make the same toy. This means that the Chinese toy makers are completely driving the American toy makers out of business.

So, we decide to put up a tariff on Chinese toys equal to $7. Now a Chinese toy costs $17. With this new tariff the American companies can now safely charge $16 per toy and stay in business. They wind up covering their costs and pocketing $1 per toy in profit.

However, the American consumer winds up paying $16 per toy rather than $10 per toy. That means that each consumer is out $6 but the manufacturer only gets $1 in profit! It cost us $6 just to make $1! There is no way that's in our national interest.

Immediately people will say "But what about the jobs we gained. Its not just about corporate profits."

I'll put aside for a second a discussion of how the labor market actually works and just remind you of this - Each American consumer now has $6 less than before. That means that he or she has to buy $6 less of products. So even though there are more jobs in the American toy industry there are fewer jobs in other industries.

(Not to mention that in reality the $10 that we sent to China gets loaned back to us so that we can buy houses at a low interest rate. Thus, the tariff also hurts the housing industry)

That's the Econ 101 story.


Now as per usual GenEq (General Equilibrium) throws a big monkey wrench into that whole narrative. There are several reasons that I will just sketch.

1) We have to raise taxes to pay for government spending. When we put a tax on something the ultimate cost is split between consumers and producers. If we put a tax on goods from China then Chinese producers will bear part of the burden from the tax. That means that a tariff makes it cheaper for the government to raise money.

2) Tariffs cause redistribution. We may want redistribution. If we do not redistribute via tariffs we have to use some other method. That method will probably involve raising taxes to pay for some sort of subsidy. A tax-subsidy redistribution scheme causes dead weight loss twice, a tariff only once.

3) Tariffs can change the terms of trade. That is, suppose the United States is a big exporter of something. The US government can use a tariff to raise the price of that thing not just in the US but abroad as well. Then we will be exporting a more expensive product which better for us.

So for those reasons and few other more complex ones it is not always the case that trade barriers will make us worse off.

However, as far as I can tell it will almost always be in our interest to take advantage of countries that want to foolishly subsidize their exports. This is the case Greg was talking about this morning. In this case we just get cheap stuff and they pay for it. The only problem I see is if the foriegn subsidy caused serious redistribution issues that were very costly to fix.