1. 37 International Trade McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Some Key Trade Facts U.S. trade deficit in goods $517 billion in 2009 U.S. trade surplus in services $138 billion in 2009 Canada largest U.S. trade partner Trade deficit with China $220 billion in 2009 Exports are 13% U.S. output Dependence on oil LO1 37-2

3. Some Key Trade Facts Principal U.S. exports include: Chemicals Agricultural products Consumer durables Semiconductors Aircraft U.S. provides about 8.5% of world’s exports LO1 37-3

4. Some Key Trade Facts Principal U.S. imports include: Petroleum Automobiles Household appliances Computers LO1 37-4

5. Some Key Trade Facts LO1 37-5

6. Some Key Trade Facts LO1 37-6

7. Economic Basis for Trade Nations, like individuals can gain by specializing in the products they can produce with the greatest relative efficiency and by trading for the goods they cannot produce as efficiently. The reason nations’ trade is because it is beneficial. Three underlying facts help explain why different nations produce different goods and services. LO2 37-7

8. Underlying Facts  Nations’ differ in their endowments of economic resources.  Nation’s have differing levels of technological expertise.  Nation’s have different preferences for certain goods and services.

9. For example, China, which has abundant and inexpensive labor may produce a variety of labor-intensive goods, such as textiles, electronics, clothing, toys, and sporting goods. In contrast, Australia has vast amounts of land and can inexpensively produce such land-intensive goods, as beef, wool, and meat.

10. The U.S. and Germany that have relatively large amounts of capital can inexpensively produce capital-intensive goods, such as airplanes, automobiles, agricultural equipment, machinery, and chemicals.

11. Specialization and international trade increase the productivity of U.S. resources and allow the U.S. to obtain greater total output than otherwise would be possible. These benefits are the result of exploiting both absolute and comparative advantages. LO2 Comparative Advantage 37-11

12. Absolute Advantage A country is said to have an absolute advantage over other producers of a product if it is the most efficient producer of that product, which means it can produce more output from the same amount of resources compared to another country.

13. Comparative Advantage Comparative advantage is achieved when a country can produce a good or service at a lower opportunity cost, compared to other countries.

14. In the early 1800’s David Ricardo stated that a nation does not need an absolute advantage, or total superiority in the efficiency with which it produces goods, in order to benefit from specialization and trade. It needs only a comparative advantage. Ricardo’s idea is illustrated in the example of the CPA vs. the House Painter.

15. CPA vs. House Painter Madison, a CPA, can earn $50 per hour as an accountant while Mason, a house painter, earns $15 per hour. Suppose Madison can paint her house in 30 hours but Mason requires 40 hours to paint the same house. The question is, should Madison paint her own house or pay Mason to do it for her?

16. Madison’s opportunity cost of painting her house is $1500. The cost of hiring Mason is only $600. Madison should specialize in accounting and use some of her earnings to pay Mason to paint the house even though she is faster at painting than Mason is.

17. When it comes to preparing tax returns, Madison can complete one return in 2 hours, while it takes Mason 10 hours. Should Mason complete his own tax return or hire Madison to do it for him? We can see that Mason should hire Madison to complete his tax return rather than do it himself. What is true for our CPA and house painter is also true for nations.

18. 2 Isolated Nations Now let’s take the concept of comparative advantage and apply it to nations. Suppose the world consists of just two nations, the U.S. and Mexico. Also for simplicity, suppose that the labor forces in both countries are of equal size. Each nation can produce both beef and vegetables, but at different levels of economic efficiency. Both nations PPF are shown in figure 37.1a and b.

19. 3 Things About the PPF  Constant costs- the curves are drawn as straight lines, in contrast to the bowed curves in chapter 1. This means we have replaced the law of increasing opportunity cost with the assumption of constant costs.

20.  Different costs- the PPF of each nation reflects different resource mixes and differing levels of technology. The different slopes of each PPF reveal that the opportunity cost of producing beef and vegetables are different for the 2 countries.

21.  U.S. absolute advantage in both- If the U.S. and Mexico use their labor forces to produce either vegetables or beef, the U.S. can produce more of either than Mexico.

22. United States In figure 37.1a, with full employment, the U.S. will operate at some point on its PPF. On that curve, it can increase its output of beef from 0 tons to 30 tons by forgoing 30 tons of vegetables. So the slope of the PPF is 1 (= 30 v/30 b), meaning that 1 ton of vegetables must be sacrificed for each extra ton of beef. 1v = 1b for the U.S.

23. Mexico Our constant cost assumption means that this exchange relationship prevails for all possible moves from 1 point to another along the U.S. PPF. In Mexico, 20 tons of vegetables must be given up to obtain 10 tons of beef, so the slope is 2. 2v = 1b for Mexico

24. Vegetables (Tons) 30 25 20 15 10 5 0 35 40 45 5101520 Beef (Tons) Vegetables (Tons) 30 25 20 15 10 5 0 35 40 45 51015202530 Beef (Tons) (a) United States (b) Mexico 12 18 8 4 A Z Comparative Advantage LO2 37-24

25. Self-Sufficiency Output Mix If the U.S. and Mexico are isolated and self sufficient, then each country must choose some output mix on its own PPF. It will select the combination that provides the greatest total utility or satisfaction. Let’s assume the U.S. chooses point A as their optimal mix and Mexico chooses point Z for theirs. These choices are reflected in column 1 of Table 37.1. LO2 37-25

26. Comparative Advantage LO2 37-26

27. Specializing Based on CA A producer has a comparative advantage if it can produce that product at a lower opportunity cost than other producers. In our example, The U.S. has an absolute advantage over Mexico in producing both vegetables and beef, but what actually matters is whether the opportunity costs of producing the two products differ in the two countries. LO2 37-27

28. If they do, then each nation will enjoy a comparative advantage in one of the products. As a result, total output can increase if each country specializes in the good in which it has the lower opportunity cost. In our example, the U.S. has a lower opportunity cost for beef, because it must forgo only 1 ton of vegetables, whereas Mexico must forgo 2 tons of vegetables.

29. Mexico has the lower opportunity cost for vegetables because it sacrifices only ½ ton of beef for each ton of vegetables, while the U.S. must forgo 1 ton of beef for each ton of vegetables.

30. U.S. Beef/Mexico Veggies Comparative advantage then dictates that the U.S. should specialize in beef and Mexico should specialize in vegetables. This situation is summarized in Table 37.2, column 2.

31. More Total Output A comparison of columns 1 and 2 in Table 37.1 verifies that specialized production enables the world to obtain more output from its fixed amount of resources. The world ends up with 4 more tons of beef and 4 more tons of vegetables than it would if each nation had been self sufficient.

32. Terms of Trade The terms of trade reflect the exchange ratio at which the U.S. and Mexico will find it beneficial to trade. The question is can each nation “get a better deal” by specializing and trading than it could if it opted instead for self sufficiency. LO2 37-32

33. Because 1b =1v in the U.S., it must get more than 1 ton of vegetables for each ton of beef it exports in order to gain. Similarly, because 1b = 2v in Mexico, Mexico must obtain 1 ton of beef by exporting less than 2 tons of vegetables if it is to benefit.

34. The Actual Exchange Rate? The actual exchange rate depends on world demand and supply for the 2 products. If overall world demand for vegetables is weak relative to its supply and if the demand for beef is strong relative to its supply, the price of vegetables will be lower and the price of beef will be higher. The exchange rate will likely settle nearer the 1b =2v figure the U.S. prefers.

35. If the opposite is true, the exchange ratio will likely be closer to the 1b = 1v level favorable to Mexico. The only thing we can say with certainty at this point is that the terms of trade will be somewhere in between each nations domestic opportunity cost ratio.

36. Gains from Trade Let’s suppose the international terms of trade are 1b = 1½v. In figure 37.2 our trading possibilities line shows the amounts of the 2 products that a nation can obtain by specializing in 1 product and trading for the other. The U.S. will specialize completely in beef, at point B, and Mexico will specialize completely in vegetables at point V.

37. Trading Possibilities Line Given our terms of trade, the U.S. can now get 1½ tons of vegetables for every ton of beef. Trading possibilities line BV’ thus represents the 1b = 1½v trading ratio. Likewise, for Mexico its trading possibilities line is now vb’.

38. By specializing on the basis of comparative advantage and by trading for goods that are produced in the nation with greater domestic efficiency, the U.S. and Mexico can achieve combinations of beef and vegetables beyond their own individual PPF. Specialization according to comparative advantage results in a more efficient allocation of world resources, and larger outputs of both products are therefore available to both nations.

39. Point A’ and Z’ U.S. exports 10 tons of beef to Mexico and receives 15 tons of vegetables in return, reflected by point A’ in figure 37.2. Mexico exports 15 tons of vegetables to the U.S. and receives 10 tons of beef, shown by point Z’ in figure 37.2.

40. Superior Positions Points A’ and Z’ in figure 37.2 are superior economic positions to points A and Z. We know that a nation can expand its PPF by expanding the quantity and quality of its resources or realizing technological progress. We have now established that international trade can enable a nation to circumvent the output constraint illustrated by its PPF.

41. Table 37.1 summarizes the transactions and outcomes in our analysis.

42. Vegetables (Tons) 30 25 20 15 10 5 0 35 40 45 5101520 Beef (Tons) Vegetables (Tons) 30 25 20 15 10 5 0 35 40 45 51015202530 Beef (Tons) Gains from Trade (a) United States (b) Mexico 12 18 8 4 A Z A’ Z’ V V’ W v b b’ Trading Possibilities Line Trading Possibilities Line B LO2 37-42

43. Trade with Increasing Costs Let’s consider the effect of allowing increasing opportunity costs to enter the picture. Assume that initially the U.S. and Mexico had the same ratios of 1b =1v and 1b = 2v as before. As the U.S. begins to expand beef production, its cost of beef will rise; it will have to sacrifice more than 1 ton of vegetables to get 1 additional ton of beef. LO2 37-43

44. Resources are no longer perfectly adaptable between alternative uses. Similarly, for Mexico as it expands vegetable production it will find that its cost ratio begins to rise. Sacrificing 1 ton of beef will free resources that are capable of producing only something less than 2 tons of vegetables.

45. As the U.S. cost ratio falls from 1b =1v and the Mexico ratio rises from 1b = 2v, a point will be reached where the cost ratios are equal in the two nations, perhaps at 1b = 1¾ v. At this point the underlying basis for further specialization and trade has disappeared, and further specialization is uneconomical.

47. The primary effect of increasing opportunity costs is less than complete specialization. For this reason, we often find domestically produced products competing directly against identical or similar imported products within a given economy.

48. The Case for Free Trade The case of free trade reduces to one compelling argument. The world economy can achieve a more efficient allocation of resources and a higher level of material well-being than it can without free trade. Government trade barriers lessen or eliminate gains from specialization. If nations cannot trade freely, they must shift resources from efficient to inefficient uses to satisfy their diverse wants.

49. One side benefit of free trade is that it promotes competition and deters monopoly. The increased competition from foreign firms forces domestic firms to find and use the lowest-cost production techniques. And finally, free trade gives consumers a wider range of product choices.

50. Trade Barriers and Export Subsidies While a nation as a whole gains from trade, trade may harm particular domestic industries and their workers. Those industries might seek to preserve their economic positions by persuading their respective governments to protect them from imports. LO4 37-50

51. Indeed, the public may be won over by the apparent plausibility and the patriotic ring of their arguments. These impediments to free international trade can take several forms.

52. Tariffs 1.Tariffs- are excise taxes or “duties” on the dollar values or physical quantities of imported goods. LO4 37-52

53. Revenue vs. Protection  Revenue Tariff- is usually applied to a product that is not being produced domestically, for example, tin, coffee, or bananas. Rates on revenue tariffs tend to be modest and are designed to provide the Federal government with revenue.

54.  Protective Tariff- is implemented to shield domestic producers from foreign competition. These tariffs impede free trade by increasing the prices of imported goods and therefore shifting sales toward domestic producers. Although protective tariffs are usually not high enough to stop the importation of foreign goods, they put foreign producers at a competitive disadvantage.

55. Import Quotas 2.Import Quotas- are a limit on the quantities or total values of specific items that are imported in some period. Once a quota is filled, further imports of that product are choked off. Import quotas are more effective than tariffs in impeding international trade. LO4 37-55

56. Non-tariff Barrier (NTB) 3.Non-tariff Barrier (NTB)- includes onerous licensing requirements, unreasonable standards pertaining to product quality, or simply bureaucratic hurdles and delays in customs procedures.

57. Voluntary Export Restriction (VER) 4.Voluntary Export Restriction (VER)- is a trade barrier by which foreign firms “voluntarily” limit the amount of their exports to a particular country. VER’s have the same effect as import quotas and are agreed to by exporters to avoid more stringent tariffs or quotas.

58. Export Subsidies 5.Export Subsidies- consists of a government payment to a domestic producer of export goods and is designed to aid that producer. By reducing production costs, the subsidies enable the domestic firm to charge a lower price and thus to sell more exports in world markets.

59. The Case for Protection Despite the logic of specialization and trade, there are still protectionists in some union halls, corporate boardrooms, and congressional conference rooms. What arguments do protectionists make to justify trade barriers? LO5 37-59

60. Military Argument 1.Military Self-Sufficiency Argument- The argument here is not economic but political-military. Protective tariffs are needed to preserve or strengthen industries that produce the materials essential for national defense.

61. All people in the United States would agree that relying on hostile nations for necessary military equipment is not a good idea, yet the self-sufficiency argument is open to serious abuse. Nearly every industry can claim that it makes direct or indirect contributions to national security and hence deserves protection from imports.

62. Diversification Argument 2.Diversification for Stability Argument- Highly specialized economies such as Saudi Arabia and Cuba are dependent on international markets for their income. Tariff and quota protection are allegedly needed in such nations to enable greater industrial diversification.

63. That way, these economies will not be so dependent on exporting one or two products to obtain the other goods they need. Such goods will be available domestically, thereby providing greater domestic stability. There is some truth in this diversification argument, but the argument has little or no relevance to the United States and other advanced economies.

64. Infant Industry Argument 3.Infant Industry Argument- this argument contends that protective tariffs are needed to allow new domestic industries to establish themselves and give these young industries a chance to develop and become efficient producers. There are some logical problems with this argument.

65. In the developing nations it is difficult to determine which industries are the infants that are capable of achieving economic maturity and therefore deserving protection. Also, protective tariffs may persist even after industrial maturity has been realized.

66. Dumping Argument 4.Protection Against Dumping Argument- this argument contends that tariffs are needed to protect domestic firms from “dumping” by foreign producers. Dumping is the sale of a product in a foreign market at prices either below cost or below the prices commonly charged at home.

67. Economists cite two plausible reasons for this behavior. First, with regard to below- cost dumping, firms in country A may dump goods at below cost into country B in an attempt to drive their competitors in country B out of business.

68. Second, dumping that involves selling abroad at a price that is below the price commonly charged in the home country may be a form of price discrimination, which is charging different prices to different customers. Because dumping is an “unfair trade practice,” most nations prohibit it, but relatively few documented cases of dumping occur each year.

69. Increased Domestic Employment Argument 5.Increased Domestic Employment Argument- arguing for a tariff to “save U.S. jobs” becomes fashionable when the economy encounters a recession. In this argument, reducing imports will divert spending on another nation’s output to spending on domestic output. Thus, domestic output and employment will rise. This argument has several shortcomings.

70. While imports may eliminate some U.S. jobs, they create others. Nations adversely affected by tariffs and quotas are likely to retaliate, causing a trade war that will choke off trade and make all nations worse off.

71. Cheap Foreign Labor Argument 6.Cheap Foreign Labor Argument- this argument says that domestic firms and workers must be shielded from the ruinous competition of countries where wages are low. If protection is not provided, cheap imports will flood U.S. markets and the prices of U.S. goods, along with the wages of U.S. workers, will be pulled down.

72. The cheap foreign labor argument suggests that, to maintain its standard of living, the U.S. should not trade with low-wage Mexico. What if it does not trade with Mexico? Will wages and living standards rise in the United States?

73. No. To obtain vegetables, the U.S. will have to reallocate a portion of its labor force from its relatively more-efficient beef industry to its relatively less-efficient vegetable industry.

74. As a result, the average productivity of U.S. labor will fall, as will real wages and living standards. Another problem with this argument is that its proponents incorrectly focus on labor costs per hour when what really matters is labor costs per unit of output.

75. U.S. worker = $20/hour Mexican worker = $4/hour Differences in productivity typically mean that labor costs per unit of output are often nearly identical despite huge differences in hourly labor costs.

76. The U.S. worker produces 20 units of output per hour, whereas the Mexican worker produces 4 units of output per hour. Dividing the total cost by total output give us the cost per unit ($20÷ 20= $1).

77. As you can see, the lower wage rate per hour at the Mexican factory does not translate into lower labor costs per unit, meaning that it won’t be able to undersell its U.S. competitor just because its workers get paid lower wages per hour.

78. Multilateral Trade Agreements Aware of the detrimental effects of trade wars and the general weaknesses of arguments for trade protections, nations have worked to lower tariffs worldwide. Here are some examples of these efforts. LO5 37-78

79. GATT 1.General Agreement on Tariffs & Trade(GATT)- In 1947, 23 nations, including the U.S., signed this agreement. The agreement was based on 3 principles. Equal, nondiscriminatory trade treatment for all member nations Reduction of tariffs by multilateral negotiations The elimination of import quotas LO5 37-79

80. WTO 2.World Trade Organization(WTO)- oversees trade agreements reached by the member nations, and rules on trade disputes among them. LO5 37-80

81. European Union 3.The European Union(EU)- Countries have also sought to reduce tariffs by creating regional free-trade zones. As of 2007, there are 27 nations that comprise the EU. LO5 37-81

82. The EU has abolished tariffs and import quotas on nearly all products traded among the participating members and established a common system of tariffs applicable to all goods received from nations outside the EU.

83. One of the most significant accomplishments of the EU was the establishment of the so-called Euro Zone. As of 2010, 16 members use a common currency, called the euro.

84. NAFTA 4.North American Free Trade Agreement(NAFTA)- In 1993 Canada, Mexico, and the United States created a major free-trade zone. NAFTA has eliminated tariffs and other trade barriers for most goods and services. LO5 37-84