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  • Abiye Alamina

Splitting the Gains from Trade

One of the arguments in the trade debate has centered on the assumption that trade between the US and China for instance, has benefitted China a whole lot more than it has the US.

As a result the argument is that by imposing these tariffs we create a more level playing field by limiting that benefit and in the process ensuring that US workers are protected.

As I have stated in a recent blog post, trade is simply a mutually beneficial exchange among willing parties, the only difference being it occurs across international borders. To limit this is both to limit the freedom of choice and to reduce our welfare in the aggregate.

There is no presumption that everyone wins equally from trade. In the aggregate, the trading parties/ countries gain, but how that gain is split is dependent on the relative strengths of demand for the traded goods in question.

It is therefore to be expected that if for some or many trade transactions, that US trade partners have benefitted more than the US, that the imposition of tariffs would hurt them more. Yes, but it would still hurt the US as well.

An Illustration

Suppose that trade between the US and China comprised of just soybean exports from the US and steel imports from China. To focus the analysis suppose that while we could compute the prices of these in some currency, we bypass this to simply express the price of a bushel of soybeans in terms of million metric tons of crude steel. So we will proceed by using such relative prices.

Suppose again for the sake of focusing on the main issue (and not for accuracy purposes) that if the US was to produce both products, that because resources will be used up in doing this that a metric ton of crude steel would have resulted in our giving up 1000 bushels of soybeans. However in China, the production of a metric ton of crude steel results in them having to give up only 500 bushels of soybean production.

By the principles of comparative advantage it is cheaper relatively to produce soybeans in the US and to trade for steel from China, and for China to produce steel and trade for Soybeans from the US. This specialization will not be complete, but it will lead to the dynamics where we find ourselves importing more steel than we produce, and producing soybeans for domestic and export purposes.

If the actual trade, given the domestic production possibilities, results in a situation where for every metric ton of crude steel we import, we export 900 bushels of soybeans to China, we can immediately see how both countries gain from trade:

China gains by getting more soybeans than they could produce by foregoing some steel production, since for every metric ton of steel they produce and export, they get 400 more bushels of soybeans from the US.

Similarly the US gains by having to export less soybeans to China for every metric ton of steel we import, compared to if we were going to produce steel on our own. Our soybean gain is 100 bushels produced and saved at that trade.

The only 'problem' is that China apparently gains more than the US does, but both countries do gain. The question is, why is the trade this lopsided and not rather that we ended up exporting say 600 bushels of soybeans for every metric ton of steel we import (a situation in which by analogous reasoning both countries also gain, but now the US gains more than China does)?

The answer lies simply in the fact that we want steel a whole lot more than China wants soybeans. It could be purely from preferences or it could be that China has many other alternatives to soybeans or/ and that there are other countries that it can get soybeans from, whereas the US does not have as many options for steel imports (this is not the actual situation, but we are keeping the analysis focused to get the idea).

Other than pure preferences, or the availability of alternatives, the relative strength of demand is more than likely related to another interesting dynamic: The fact that there are actual currency transactions behind the soybean and steel trades, and the US budget deficit.

Whenever the US government runs budget deficits by borrowing, it puts an upward pressure on domestic interest rates, which causes the US dollar to appreciate in value in the forex market. To the extent that some of that debt is purchased by China, it makes Chinese products (exports) relatively cheaper for Americans and our products (their imports) relatively more expensive for them. The result again reinforces greater demand for their exports and so a higher relative price, which would explain why they might gain more from the trade relation than we do.

The trade deficit is not unrelated to our federal government budget deficits, and these are projected to grow rapidly, under current law, over the next decade in a best case scenario.

Imposing Tariffs

Tariffs do not correct the relative demand problem. Like a price control, they simply redistribute inefficiently, wealth from consumers and other business importers to select import competing firms.

In theory, there are some mitigating situations where the net effect of such tariffs is to provide the imposing country with an increase in welfare, however such circumstances typically require the tariff to either be very small, or/ and the foreign firm to absorb much of the tariff rather than pass it on (as in cases of assumed dumping).

Both cases do not provide support as intended to local producers but simply extract terms of trade gains from the foreign country as part of tariff revenues. These countries are only more likely then to retaliate, as they have in the past, and which they have already begun to threaten that they would, should the Trump steel and aluminum tariffs be implemented.

It is possible that the Trump administration in assuming that this is a trade war that "we will win easily" is assuming that the foreign countries by losing a whole lot more, will react more congenially, however they only need to let the war play out, the mere fact that we also will lose, and are a democracy that is very sensitive to these losses, will be enough to force our hand back.

The important policy question then in light of the fact that we will obviously be hurt from the tariffs, is, what is to be gained from such a protectionist policy that reflects pure partisan redistribution while the rest of the country is hung out to dry?


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