International Trade and Economics of Less: The Cheap Labor Fallacy

The "Cheap Labor" Fallacy One common argument in favor of protectionism is that American workers should be insulated against competition from "cheap foreign labor." For example, textile workers in the United States complain that products produced in other nations using inexpensive labor are selling in the United States for very low prices, thereby reducing sales of domestic textiles. They contend that it's unfair for nations that use cheap labor to compete with them and cause them to lose their jobs. The strong implication of their argument is that the foreign firms exploit their workers unfairly by underpaying them. There are a number of fallacies in this argument. First, foreign workers, particularly in less developed nations, typically are less productive than American workers, because they often work with less capital equipment and less modern technology. These workers therefore are not necessarily "underpaid" or exploited in any sense. Their low wages are attributable to low productivity. Second, this argument ignores the basis for gains from foreign trade, which come from a nation's comparative advantage in producing an item. The source of the competitive advantage could be relatively abundant labor! The abundant labor supply with skills to produce certain goods, such as textiles, lowers the cost of producing textiles in terms of other goods. Naturally, an abundant labor supply means cheap labor. The "cheap labor" argument simply takes the reason for a nation's comparative advantage and tries to use it as an excuse not to benefit from the exporting nation's low marginal costs and prices! It really sidesteps the main issues involved in the arguments for or against free foreign trade. The basis for gains from international trade is comparative advantage rather than absolute advantage. Instruments of Protectionism: Tariffs Those who favor protecting domestic industries against foreign competition often support a tariff, a tax on imported goods, as a means of making imported goods less attractive to domestic consumers. It's easy to show how a tariff works using simple supply and demand analysis. Assume that in the absence of any tariffs, imported cars sell at an average price of $10,000 in the United States. At that price 3 million cars per year are sold. The graph in Box 14 shows that the initial market equilibrium for foreign cars corresponds to point E,, at which the demand and initial supply curves for foreign cars intersect. If a tariff is placed on foreign cars sold in the United States, the cost of selling foreign cars in the United States increases. Suppose the tariff is $1,000 per car. The marginal cost of selling an imported car increases from its initial level by $1,000. The supply curve shifts upward by $1,000, reflecting the increase in cost. The new market equilibrium corresponds to point Ez, at which the new supply curve just intersects the demand curve. The tariff has the following effects in the market for foreign cars: 1. The price of foreign cars increases. In the graph in Box 14 the price goes up from $10,000 to $10,800. The extent of the price increase depends on the price elasticities of demand and supply for foreign cars. Other things being equal, the more inelastic the demand for foreign cars, the greater the increase in price. 2. The price received by foreign sellers of cars declines from its previous level. In Box 14 the price received by foreign sellers for each car sold is the $10,800 paid by buyers less the $1,000 tariff per car. The sellers' net price after payment of the tariff is only $9,800, which is $200 less per car than they enjoyed before the tariff was imposed. Foreign producers therefore don't benefit from the increase in the market price for their cars caused by the tariff. In fact, the profitability of selling cars in the U.S. market declines after the tariff is imposed. The impact of the price decline on foreign sellers depends on the price elasticities of demand and supply for foreign cars. In general, both foreign manufacturers and their U.S. dealers suffer a reduction in income as a result of the tariff. 3. As a result of the increase in price, the annual quantity of foreign cars demanded decreases. In Box 14, as a result of the tariff, the annual quantity sold declines from 3 million to 2.5 million cars per year. The more elastic the demand for foreign cars, the greater the reduction in annual sales as a result of the tariff. 4. The tariff collects revenue that can be used to reduce reliance on other taxes, to increase government spending, or to reduce government budget deficits and debt. In this case the annual revenue collected from the tariff is $1,000 multiplied by the 2.5 million cars sold, which is $2.5 billion. Note that the greater the reduction in sales of the foreign goods as a result of the tariff, the less revenue the tariff collects. In effect, tariffs that do a good job of protecting domestic producers from foreign competition are poor revenue producers because they cause sharp reductions in imports. How does a tariff benefit domestic producers? The graph in Box 15 shows the demand for and supply of domestic cars. Assume that before the tariff is imposed the average price of domestic cars is also $10,000 and that domestic cars are perfect substitutes for foreign cars. Of course, this is a simplification because there are quality differences between domestic and foreign cars that often lead buyers to prefer cars of one producer, foreign or domestic, over those of other producers. Differences in quality allow prices for various models to differ. However, the basic point of the impact of a tariff on domestic producers can be brought out even though quality differences are ignored. The increase in the price of foreign cars resulting from the tariff increases the demand for domestic cars, because domestic cars are a more attractive buy after the tariff is imposed. However, the increase in demand will increase the price of U.S. cars. In fact, if the two goods are perfect substitutes, the price of U.S. cars must go up to exactly $10,800. In Box 15 the effect of the tariff is to shift the market equilibrium for domestic cars from point E, to Ez. Annual sales increase from 5 million to 5.3 million cars. The impact of the tariff on the domestic market can be summarized as follows: 1. The price of domestic cars increases, and the annual quantity sold goes up. This makes consumers worse off. In fact, as a result of the general increase in the price of cars caused by the tariff, the aggregate (foreign plus domestic) annual quantity sold will decline. 2. In the short run the profits of domestic automobile manufacturers will increase. Also, owners of specialized inputs and workers with specialized skills will benefit from the tariff as the prices received for specialized input services and wages increase in response to the increase in demand. In general, prices will remain higher than they would have been in the absence of a tariff. In short, tariffs tend to increase the prices of both domestic and foreign goods. This redistributes income to domestic producers and owners of specialized inputs used in domestic production. Foreign producers suffer a decrease in sales, and domestic consumers suffer a decrease in real income. Government gains the revenue collected with the tariff.