Frank & Bernanke 3rd edition, 2007 Ch. 9: International Trade

Comparative Advantage The principle of comparative advantage tells us that we can all enjoy more goods and services when each country produces according to its comparative advantage, and then trades with other countries.

Computers (number/year) Production Possibilities Curve for a Many-Worker Economy B C A D Observations The OC of producing an additional unit = the slope of the line that touches the point OC will increase as output of on good increases 100,000 40,000 1,000 2,000 Coffee (pounds/year) Computers (number/year)

Production and Consumption Possibilities and the Benefits of Trade In a closed economy: Society’s production possibilities = consumption possibilities. If a country is self-sufficient, it is called autarky. In an open economy: The society’s consumption possibilities are typically greater than its production possibilities.

Buying and Selling in World Markets Computers/year Coffee (pounds/year) B C A D Assume: Producing at D Closed economy World price of coffee = $10/lb and computer = $500 120,000 100,000 1,000 50,000 2,000 2,400 150,000 3,000

Buying and Selling in World Markets Computers/year Coffee (pounds/year) B C A D F Observation: Sell 2,000 computers @ $500 Take the $1million and buy 100,000 pounds of coffee Consumption possibilities of 150,000 is greater than PPC without trade E 150,000 120,000 100,000 1,000 50,000 2,000 2,400 3,000 Consumption possibilities Production possibilities

Buying and Selling in World Markets Computers/year Coffee (pounds/year) B C A D F Observation: Start at D Sell 50,000 lbs of coffee Buy 1,000 computers with the $500,000 Pt F is possible with trade but not on the PPC E 150,000 120,000 100,000 1,000 50,000 2,000 2,400 3,000 Consumption possibilities Production possibilities

Optimal Production Mix for an Open Economy 160,000 L Consumption possibilities 150,000 E 50 lbs of coffee trades for 1 computer LM = consumption possibilities G is the optimal combination for Costa Rica Costa Rica can use trade to locate anywhere along LM A 120,000 100,000 C G Coffee (pounds/year) 50,000 D Production possibilities B F M 1,000 2,000 2,400 3,000 3,200 Computers/year

Optimal Production Mix for an Open Economy 160,000 L Consumption possibilities 150,000 E Why produce at G? Slope of the PPC = LM Domestic and international opportunity costs of acquiring an extra computer (in terms of forgone coffee) are equal A 120,000 100,000 C G Coffee (pounds/year) 50,000 D Production possibilities B F M 1,000 2,000 2,400 3,000 3,200 Computers/year

A Straight-Line PPC A B C D 800 600 Coffee (pounds/year) 200 200 600 Observation The tradeoff between coffee and tea is constant at any point on the PPC 800 B 600 Coffee (pounds/year) C 200 D 200 600 800 Tea (pounds/year

Two Consumption Possibilities Curves Tea (pounds/year Coffee (pounds/year) B C A D’ 600 200 800 1,600 D Islandia produces at A Islandia can use the money earned from selling 800 lbs of coffee to choose any combination on AD’ Consumption possibilities curve when the world price of coffee is twice the world price of tea

Two Consumption Possibilities Curves Tea (pounds/year Coffee (pounds/year) B C A 600 200 800 1,600 D Islandia produces at D Islandia can choose any combination on A’D Consumption possibilities curve when the world price of tea is twice the world price of coffee A’

Consumption Possibilities With and Without International Trade With a bow-shaped PPC consumption possibilities is typically maximized by producing where the PPC is tangent to the consumption possibilities line. With a straight-line PPC production is completely specialized.

Does “cheap” foreign labor pose a danger to high-wage economies? Scenario U.S. and Fredonia produce software and beef. Real wages in Fredonia are lower than in the U.S. Fredonia is half as productive as the U.S. in beef production. Fredonia is one-tenth as productive in software production.

Does “cheap” foreign labor pose a danger to high-wage economies? Outcome Fredonia has a comparative advantage in beef. U.S. has a comparative advantage in software. The U.S. will trade software for beef and increase its consumption of both. Employment in the software industry in the U.S. increases and employment in the beef industry will decrease.

The Market for Computers in Costa Rica 2,000 4,800 2,400 1,400 400 Domestic demand supply Consumer surplus without trade = $1mil/yr Producer surplus 1,000 E Domestic demand supply Consumer surplus with trade = $1.96mil/yr Producer surplus with trade = $360K/yr World price 2,000 4,800 E F 1,200 2,800 Computer Imports Computer per year Without Trade Computer per year With Trade

A Supply and Demand Perspective on Trade If the price of a good or service in a closed economy is greater than the world price, and that economy opens itself to trade, the economy will tend to become a net importer of that good or service.

The Market for Coffee in Costa Rica 100,000 240,000 12 7 4 Domestic demand supply Consumer surplus without trade = $250K/yr Producer surplus without trade = $150K/yr E 100,000 12 7 4 Domestic demand Consumer surplus with trade = $40K/yr Producer surplus with trade = $600K/yr E supply World price F 40,000 200,000 240,000 Coffee exports 10 Coffee (pounds/year) Without Trade Coffee (pounds/year) With Trade

A Supply and Demand Perspective on Trade If the price of a good or service in a closed economy is lower than the world price, and that economy opens itself for trade, the economy will tend to become a net exporter of that good or service.

Mutually Beneficial Gains from Trade Countries will profit by exporting the goods and services for which they have a comparative advantage. The revenue from the exports are used to import goods and services for which they do not have a comparative advantage. The markets will ensure that goods will be produced where opportunity cost is lowest. The consumption possibilities will be maximized.

Price of computers ($/computer) Exercise Computers per year Price of computers ($/computer) 200 Domestic supply World price demand 500 800 1,200 600 2,100 2,400 Question Given the graph shown, what impact would trade have on producer and consumer surplus?

Winners and Losers from Trade Consumers of imported goods Producers of exported goods Losers Consumers of exported goods Producers of imported goods

Protectionism Protectionism Tariff Quota Other The view that free trade is injurious and should be restricted Tariff A tax imposed on an imported good Quota A legal limit on the quantity of a good that may be imported Other Red-tape barriers Regulations

Import Tariff on Computers 1,000 1,200 Domestic supply World price demand 4,800 400 2,400 E 2,800 Imports without tariff Price of computers ($/computer) 1,200 World price + tariff 1,600 2,400 Computers per year

The Market for Computers after the Imposition of an Import Tariff Consumer surplus with tariff = 1.44K/yr Domestic supply 2,400 Tariff revenue = $160K/yr E Price of computers ($/computer) World price + tariff 1,200 1,000 World price Imports with tariff 400 Domestic demand Producer surplus with tariff = 640K/yr 1,200 1,600 2,400 2,800 4,800 Computers per year

Price of computers ($/computer) Exercise Domestic supply 3,600 Question Given the graph shown, how will a tariff of $300 per computer affect total economic surplus? 2,100 Price of computers ($/computer) 1,500 World price 1,200 600 Domestic demand 200 300 500 700 800 1,200 Computers per year

Protectionist Policies What do you think? Why did President George W. Bush support the imposition of tariffs on steel imported into the United States?

Protectionist Policies Quotas Legal limit on the number or value of foreign goods that can be imported Can be enforced by issuing permits

Imposition of an Import Quota 1,200 2,800 Imports with free trade = 1,600 computers/yr 1,000 Domestic supply World price Domestic demand 4,800 2,400 E 1,400 2,000 400 1,200 1,600 2,400 Domestic supply + quota F Price of computers ($/computer) Computers per year

The Market for Computers after the Imposition of an Import Quota Domestic supply Consumer surplus with quota = $1,440K/yr 2,400 1,200 1,600 2,400 Domestic supply + quota F E Economic rent to holders of import licenses = $80K/year 1,400 Price of computers ($/computer) 1,000 World price Imports = 800 computers/year 400 Domestic demand Producer surplus with quota = $640K/yr 1,200 2,800 4,800 2,000 Computers per year

Quotas & Tariffs Market effects are the same. Tariffs generate tax revenue. Quotas generate revenue for the firms that hold an import license.

Quotas Who benefited from and who was hurt by voluntary export restraints on Japanese automobiles in the 1980s?

The Inefficiency of Protectionism Trade barriers are inefficient and reduce the size of the economic pie. Because trade barriers benefit certain groups, and these groups may be well organized, they may be successful in lobbying for trade barriers. The gains from trade could be used to assist groups that have been hurt by trade.

Outsourcing A term increasingly used to connote having services performed by low-wage workers overseas Outsourcing of services to low-wage foreign workers is exactly analogous to the importation of goods manufactured by low-wage foreign workers.

Outsourcing Characteristics of Jobs that are Less Susceptible to Outsourcing Less rules-based jobs “Face-to-Face” complex communication jobs Jobs that require the worker to be physically present

Outsourcing Responding to changing economic conditions requires the ability to adapt quickly to new circumstances. Education provides the means to develop a comparative advantage that is not rules-based and does require complex face-to-face communication.