Here's a conundrum for you. If trade is such a good thing for all nations, why does so many nations engage in protectionist trade practices? Like imposing tools, like tariffs and quotas to block the import of goods into their countries. The answer lies in the often difficult politics of protectionism, and the winners and losers that may arise when a country opens itself up to trade. To better understand the politics of protectionism, let us return in our time machine to another meeting between David Ricardo and the European trade ministers. It is now two years after these trade ministers had voice their support for free trade. David Ricardo with his theory of comparative advantage resoundingly won the argument in favor of trade. And trade between America and Europe is now flourishing in our example. Because of such trade, there is considerable good news for Europe. Its clothing industry has expanded dramatically on the wings of heavy exports to America, and profits in the industry are soaring. On the other hand, there is bad news as well. Because of a flood of American food exports into Europe, thousands of European farmers have been put out of work. And here's the political problem, this unemployment in the farm sector has provoked considerable unrest. Even as the flames of Europe's discontent over trade with America have been stoked by newspaper editorials that have called for throwing Europe's political leaders out of office. Moreover, these very same newspapers and a variety of forum organizations have called for the imposition of strict quotas or tariffs on American food imports so as to protect Europe's beleaguered farming sector. In fact, this is an age old problem faced by political leaders who support free trade. The underlying problem is this, even in the case where free trade provides gains from trade that will make a nation better off, there will still be winners and losers. Sometimes big losers as an economy adjust to freer trade. Clearly in our example, while Europe's clothing manufacturers and the workers in that industry are doing quite well, Europe's farmers are on the ropes and clamoring politically for help. Against the backdrop of this kind of political struggle, now let me ask you this very interesting and challenging question. If a nation decides to protect an industry from a flood of imports, which is better from a political perspective: the use of a tariff or the use of a quota? To put this another way, will a tariff or quota be more likely to pass politically once the decision is made to protect the affected industry. So see if you can think this problem through. Like I said, it is really interesting, but it is also highly relevant to the real world. Jot down your ideas and when you're ready, let's move on. Okay, so which is often the preferred tool to protect a domestic industry? A tariff or a quota? The perhaps surprising answer is a quota. And the reason may be found in this figure which illustrates the domestic market for food in Europe. You can see that equilibrium in this market without trade occurs at point A at a price of $8 and quantity of 200. Now suppose that trade is allowed and food for import is available in an unlimited amount from the rest of the world at a price of $4 per unit. How might you represent this in our figure? Take a minute to think about that before moving on. Okay, we can represent the world's supply curve for food by this red horizontal line. Do you see the logic of this? Now given this situation please answer these questions. What will be the price of food to European consumers? What will be the quantity of American imports and the value of those imports? And what will be the level of domestic food production in Europe. See if you can really nail this. So think carefully about these questions and jot down your answers before moving on. Well in the absence of any transport costs, the food price in Europe must be equal to the world price of $4. Now at this price, you can see that domestic European production will be measured by the line segment B C and will be 100 units. And note also that this output is considerably less than before free trade with America began. Now, at the same time American food exports to Europe can be measured by the line segment C D. And you can see that these exports are equal to 200 units. And this is important, please also note that the revenues from the sale of these American exports to Europe are equal to the shaded area C D E F. Do you see that? Take a minute to really grasp where we are so far in the analysis before moving on. Now suppose that Europe's angry farmers are able to successfully lobby European trade ministers for the imposition of a protectionist tariff of say, $2 per unit of food. What happens now to domestic production and American exports into Europe in this figure? To put this another way, how much will domestic production rise because of the tariff and how much will American exports fall? And as you try to answer this important question, please also try to figure out a way to calculate the increase in profits that domestic foreign producers in Europe will experience as a result of the tariffs. As well as the size of the loss that European food consumers will experience. So take a few minutes now to figure all of this out before moving on. So how much does domestic farm production rise? You can see in the figure that the increase in production will be 50 units. And in the figure, you can also measure the increase in profits for the European farmers by the shaded area B C H G. Do you see that result clearly? Please study the graph for a moment as you also contemplate this question: How might you measure the loss to Europe's food consumers from the imposition of the tariff? Please write down or draw your answers before moving on. So how much do European food consumers lose from the imposition of the tariffs? This loss may be measured by the area of B D I G. And the important thing to note is that this loss comes for two reasons. Not only do consumers have to pay $6 for every unit of food they buy instead of $4, they also as a group consume less food. What is interesting politically about this tariff situation so far is that it illustrates a principle identified long ago by political scientists and public choice scholar, Mancur Olson Jr. In a famous book called The Logic of collective action, Olson identified the principle of concentrated benefits versus diffused costs to argue that minority interest groups can often gain at the expense of diffused majority interests. In this case, a relatively small number of European farmers are able to lobby successfully for a very concentrated benefit in the form of lucrative gains from a tariff on American food imports while the costs of the tariff are spread out over a much larger and diffuse majority of European food consumers. This is not the only interesting political lesson of our example of the economics of tariffs and quotas however. Indeed, there is an even more intriguing aspect of this story that speaks directly to the question of why quotas are often preferred to tariffs in the political arena. That will be the focus of our next module. So please make sure you understand all of the elements of our trade analysis so far and go back and review this very rich material if you need to. Then when you're ready, let's move on to what should be a very fun module.
