CHAPTER OVERVIEW

This chapter introduces the basic principles underlying the global economy.  The United States’ participation in world trade is examined first.   The concept of comparative advantage is introduced as the basis for world trade, and how nations gain from specialization and trade is demonstrated using the production possibilities model.  This is followed by a discussion of foreign currencies and international exchange rates.  Next, the forms and economic impacts of trade barriers are examined, followed by the arguments for protectionism. This leads into a discussion of trade adjustment assistance, offshoring, multilateral trade agreements, and free-trade regions of the globe, including the WTO, the EU, and NAFTA.  The chapter concludes with an update of how well U.S. firms are competing in an increasingly competitive global economy.

INSTRUCTIONAL OBJECTIVES

     1.    Describe how international trade impacts our everyday lives.

     2.    Define trade deficit and trade surplus and describe the U.S. experience.

     3.    Compare the dollar value of U.S. exports and imports of goods and the dollar value of U.S. exports and imports of services.

     4.    List the major imports and exports of the United States.

     5.    Identify the United States’ most important trading partner.

     6.    Summarize the importance of international trade to the U.S. in terms of overall volume.

     7.    Describe the relative importance of U.S. exports of goods when compared to other industrialized countries and the position of the U.S. exports as a percentage of total world trade.

     8.    Explain the principles of comparative advantage, terms of trade, and gains from trade.

     9.    Compute, when given appropriate data, the relative costs of producing two commodities in two countries and determine which nation has the comparative advantage in each good.

 10.    Compute, when given appropriate data, the range for the terms of trade.

 11.    Calculate the potential gains from trade and specialization for each nation and the world when given appropriate data.

 12.    Graph and explain how foreign exchange rates are determined.

 13.    Explain what it means for a currency to appreciate or depreciate, and how a change in the international price of a currency can affect relative price levels and the exports and imports of a nation.

 14.    Explain how U.S. exports create a demand for dollars and a supply of foreign exchange; and how U.S. imports create a demand for foreign exchange and a supply of dollars.

 15.    Describe approximately how much the U.S. dollar is worth relative to other nations.

 16.    Identify at least four ways in which governments interfere with free trade among nations.

 17.    Describe the economic impact of tariffs, including both direct and indirect effects.

 18.    Describe the political reasons that influence governments to impose trade barriers.

 19.    List three arguments in favor of protectionist barriers, and critically evaluate each.

 20.    Summarize the Smoot-Hawley Tariff Act, including its effects on the economy.

 21.    Explain the purpose and function of trade adjustment assistance, as well as criticisms of it.

 22.    Describe offshoring and its effects on the trade position of the U.S.

 23.    Describe the purposes of the GATT and the WTO and explain the criticisms of the WTO.

 24.    Identify the current round of WTO trade negotiations.

 25.    Explain what is meant by a trade bloc or a free-trade zone, and name two regional trade blocs.

 26.    Describe the United States’ recent experience with trade deficits, including the causes and implications of the deficits.

 27.    Define and identify terms and concepts listed at the end of the chapter.

LECTURE NOTES

I.          Trade Facts: Highlights

A.  In 2004 the U.S. had a goods and services trade deficit of $617 billion dollars.  The U.S. was a net exporter of services ($48 billion).

B.   The principal exports of the U.S. are computers, chemicals, semiconductors, consumer durables, and aircraft.  Its main imports are petroleum, automobiles, computers, and clothing.

C.   Canada is the United States’ most important trading partner quantitatively, but the largest trade deficit for the U.S. is with China.

D.  The U.S. is second in the world (to Germany) in the volume of exports, providing about 1/8 of the total. (Global Snapshot 18.1)

E.   Exports of goods make up about 10% of total U.S. output, a much smaller percentage than most industrial nations. (Global Snapshot 18.2)

F.   Although the U.S., Japan, and Western Europe dominate world trade, there are emerging nations around the world that collectively generate substantial international trade such as South Korea, Taiwan, Singapore and China. 

II.        Comparative Advantage and Specialization

A.  The U.S. is referred to as an “open economy” when it is placed in the global economy.

B.   Adam Smith observed in 1776 that specialization and trade increase the productivity of a nation’s resources.  His observation related to the principle of absolute advantage whereby a country should buy a good from other countries if they can supply it cheaper than we can.

C.   Basic principle of comparative advantage was first observed and explained in early 1800s by David Ricardo.  This principle says that it pays for a person or a country to specialize and exchange even if that person or nation is more productive than potential trading partners in all economic activities.  Specialization should take place if there are relative cost differences in production of different items.

D.  Example:  A CPA can paint her house faster and better than a painter.  She earns $50 per hour as accountant and can hire a painter for $15 per hour.  The CPA can do the painting job in 30 hours; it takes the painter 40 hours.  Should she hire the painter?  On economic grounds, the opportunity cost is greater for the accountant to paint her house.  She is better off to specialize in accounting rather than sacrifice 30 x $50, or $1500, to paint her house, when she can hire the painter for 40 x $15, or $600.  The accountant will gain, and the painter will also gain because he is very inefficient in accounting.  It may take him 10 hours to prepare his tax return, which would mean 10 x $15, or $150, in opportunity cost, whereas the accountant could probably complete the forms in 2 hours for a cost of $100.  This example shows that even if a person (the accountant) has an absolute advantage in production of two products (painting and accounting), it is still advantageous to specialize and trade.  The same is true for nations.

E.   Comparative advantage and terms of trade:  Tables 18.1 and 18.2 illustrate the principle of comparative advantage for two countries, U.S. and Mexico, with a simplified example.  In Mexico, the opportunity cost of 1 ton of soybeans is giving up 4 tons of avocados (5S=20A).  In the U.S., the opportunity cost of 1 ton of soybeans is 3 tons of avocados (10S=30A).  In other words, the comparative cost of soybeans is less in U.S. than in Mexico when the alternative is producing avocados.  Thus the U.S. should specialize in soybeans, and Mexico should specialize in avocados.

1.   If the two nations specialize according to comparative advantage, then to get the other product they must trade.  A nation has a comparative advantage in some product when it can produce that product at a lower domestic opportunity cost than can a potential trading partner. 

2.   Table 18.3 summarizes which nation has a comparative advantage in each product.

3.   The rate of exchange of these two products will be determined through negotiation; the outcome is called the terms of trade. 

4.   The terms of trade will be limited by the relative costs of production within each country.  The U.S. will not forgo more than 1 ton of soybeans to get 3 tons of avocados and Mexico will not give up more than 4 tons of avocados for 1 ton of soybeans. 

5.   Somewhere between these limits, trade is possible.  In the text example, the terms of trade are assumed to be 3.5 tons of avocados for each ton of soybeans.  Americans would specialize in soybeans only if they could obtain more than 3 tons of avocados for 1 ton of soybeans by trading with Mexico.

F.   Gains from specialization and trade:

1.   Table 18.4, column 1, shows the (hypothetical) optimal outputs for Mexico and U.S. in soybeans and avocados before specialization and trade.

2.   Column 2 of Table 18.4 shows the amount each country produces when it specializes.

3.   Column 3 of Table 18.4 shows quantities in each country after trade takes place at the rate of 1S = 3.5A.

4.   Mexico will give up 35 tons of avocados for 10 tons of U.S. soybeans.

5.   Now each country will have more than they had originally:  Mexico now has 25 tons of avocados left plus 10 tons of soybeans.  U.S. now has 35 tons of avocados and keeps 20 tons of soybeans.  Mexico has gained 1 ton of each; U.S. has gained 2 tons of avocados and 1 ton of soybeans, and these gains have occurred using the same resources as before specialization.

6.   This example illustrates that specialization and trade can improve overall output even when one country (U.S.) can produce more of both items compared to the other without trade.  Specialization and trade have the same effect as an increase in resources or technological progress. 

III.       The Foreign Exchange Market

A.  In a foreign exchange market, various national currencies are exchanged for one another so that international trade can take place.  Germans want euros, Mexicans want pesos, and the Japanese want yen when they sell their products.

B.   Two points require emphasis with respect to these markets.

1.   Real‑world foreign exchange markets are competitive, with large numbers of buyers and sellers dealing with a standardized product, the currency of some country.

2.   Exchange rates link domestic (one country’s) prices with all foreign prices.  They enable you to translate the price of foreign products into dollars.  For example, if the dollar/yen exchange rate is 1 cent/per yen, a Sony T.V. set priced at ¥20,000 will cost an American $200 = (20,000 x .01).

            C.   Global       Snapshot 18.3 provides a sampling of exchange rates of foreign currencies per U.S.                               dollar as of April 2005.

D.  The dollar‑pound exchange market is depicted in Figure 18.1.  The demand for British pounds and the supply of pounds curve will establish the equilibrium dollar price of pounds.

      1.   The demand-for-pounds curve is negatively sloped – If pounds become less expensive,       holders of U.S. dollars will want to buy more of them because British goods will have         become relatively less expensive.

      2.   The supply-of-pounds curve is positively sloped – When the dollar price of a pound rises    (meaning dollars have become cheaper), holders of pounds will want more U.S. dollars     (because U.S. goods are now cheaper) and are willing to provide more pounds to get         them.

E.   Changing rates: Appreciation and Depreciation.

1.   If the dollar price of pounds rises, that means the dollar has depreciated relative to the pound.  The result is that British goods would become more expensive to Americans and U.S. products would become less expensive to Britons. 

2.   If the opposite occurred and the dollar price of pounds falls, then the dollar has appreciated relative to the pound.  Americans will purchase a greater quantity of British products because they have become less expensive in dollar terms. 

            F.   Determinants of Exchange Rates

                  1.   Three general factors combine to appreciate or depreciate a currency:

                        a.   If the demand for a nation’s currency increases, the currency will appreciate; if                                            demand falls, the currency will depreciate.

                        b.   If the supply of a nation’s currency increases, the currency will depreciate; if supply                                          fall, the currency will appreciate.

                        c.   If a country’s currency appreciates (depreciates), some foreign currencies have                                             depreciated (appreciated) relative to it.

                  2.   Factors that shift the demand or supply curve for a currency:

                        a.   Tastes – increased preference for the goods of a country will increase demand for the                                  currency needed to buy those goods and appreciate that country’s currency.  At the                                                  same time, the importing nations are supplying more of their currency, causing them                                                 to depreciate relative to the nation with the preferred goods.

                        b.   Relative income – An increase in a nation’s relative income will increase its demand                                           for imports, increasing the demand for foreign currency.  The appreciation in the                                                foreign currency means the rising relative income is causing depreciation in the                                                   domestic currency.

                        c.   Relative price levels – An increase in the domestic price level relative to foreign                                                 price levels will cause a currency to depreciate as the nation supplies more of its                                                 currency to buy foreign goods, and foreign buyers demand less of the currency.

                        d.   Relative interest rates – A nation with rising relative interest rates will attract                                                  financial investment.  This will increase the demand for the currency and cause an                                                   appreciation.  Foreign investors will increase the supply of their currencies to the                                                      market, causing theirs to depreciate.

                        e.   Speculation – If currency speculators believe that a currency will appreciate, they                                               will purchase more of that currency now in an attempt to reap profits when they sell                                                 them in the future.  This effort increases the demand for the currencies projected to                                            appreciate, causing them to appreciate in a self-fulfilling prophecy.

IV.       Government and Trade

A.  Types of barriers:

      1.   Protective tariffs are implemented to insulate domestic producers from foreign competition by raising import prices.

      2.   Import quotas specify the maximum amounts of imports allowed in a certain period of time.  Low import quotas may be a more effective protective device than tariffs, which do not limit the amount of goods entering a country.

      3.   Nontariff barriers refer to licensing requirements, unreasonable standards, or bureaucratic red tape in customs procedures.

      4.   Voluntary export restrictions are agreements by foreign firms to “voluntarily” limit their exports to a particular country.  Canada has voluntary limits on its softwood lumber exports to the United States.

      5.   Export subsidies are payments to domestic producers of export goods.  They reduce production costs and allow producers to lower prices and export more in world markets.

B.   Economic impact of tariffs – direct effects

1.   When the tariff is imposed, domestic consumption declines. (Law of demand)

2.   Domestic production will rise because the price has risen. (Law of supply)

3.   Imports fall, hurting foreign producers.

4.   Government tariff revenue will represent a transfer of income from consumers to government.

            C.   Economic impact of tariffs – indirect effects

                  1.   Domestic producers that rely on imported inputs face higher costs and will produce less                                     with tariffs on those inputs.

                  2.   Reduced foreign competition reduces the incentives to innovate in production techniques                             and new products.

                  3.   Relatively efficient export industries are made to contract; relatively inefficient                                                   industries are encouraged to expand.

            D.  Net costs of tariffs

                  1.   Tariffs raise prices in three ways:

                        a.   Prices of imported products rise.

                        b.   Consumers shift to higher-priced domestically produced goods.

                        c.   Prices of domestically produced goods rise because of reduced import competition.

                  2.   In addition to the direct and indirect efficiency losses already identified, companies                                      devote significant resources to gaining or maintaining tariff protection.  These resources                                           are diverted from more socially desirable purposes.

E.   Why do governments enact trade barriers?

1.   They don’t understand the benefits from international trade and see only the damage in certain industries that can’t compete successfully with imports.

2.   Political considerations are important because consumers don’t see the effects of a tariff or quota directly, but they do see the impact of import competition on some workers.  Also, the benefits of free trade tend to be spread among all consumers, but the benefits of a protective policy are realized almost immediately in the short run by the affected industry may have a large and vocal stake in the outcome.

            F.   Illustrating the Idea: Buy American?

                  Taken to its logical conclusion, the argument to “buy American” is a case for total self-                          sufficiency, a condition that would leave most if not all of us worse off.

V.        Three Argument for Protectionism

            A.  Military self‑sufficiency may be a valid political‑economic argument for protecting        industries that are critical to national defense.  Likewise, protecting “infant industries” may       have some merit.  The three that follow are commonly cited yet generally unsupported by       economic theory:

B.   Increasing domestic employment is the most popular reason for protection, but there are important shortcomings associated with this reasoning.

1.   Imports may eliminate some jobs, but they create others in the sales and service industries for these products.

2.   The fallacy of composition applies here.  The imports of one nation are the exports of another.  By achieving short‑term employment goals at home, the trading partner may be made weaker and less able to buy the protectionist nation’s products.

3.   Retaliation is a risk that occurred in the 1930s when high tariffs were imposed by the U.S. Smoot‑Hawley Tariff Act of 1930.  Protectionism against American goods will hurt our export industries.  Such trade wars still erupt today although the WTO helps to eliminate the problem.

C.   Protection is said to be needed against the competition from cheap foreign labor.  However, this argument is not valid.  It is mutually beneficial for rich and poor to trade with one another.  By not trading, we don’t raise our living standards at all, but we will decrease them by shifting labor into inefficient areas where the foreign labor could have produced the items more efficiently.

D.  Protection against “dumping” is another argument for tariffs when nations “dump” excess products onto U.S. markets at below cost.

1.   These firms may be trying to drive out U.S. competition.

2.   Dumping can be a form of price discrimination.

3.   Dumping is a legitimate concern and is prohibited under trade laws of the U.S. and many other nations.  The Federal government has the right to impose antidumping duties (tariffs) on the goods that were “dumped,” but it may be difficult to prove the below‑cost sales in the first place.  It is sometimes difficult to distinguish between dumping and comparative advantage.