1. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. INTERNATIONAL TRADE POLICY, COMPARATIVE ADVANTAGE, AND OUTSOURCING INTERNATIONAL TRADE POLICY, COMPARATIVE ADVANTAGE, AND OUTSOURCING Chapter 17

2. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-2 Today’s lecture will: Present some important data of trade. Explain the principle of comparative advantage. Discuss three determinants of the terms of trade. Explain why economists’ and laypeople’s views of outsourcing differ.

3. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-3 Today’s lecture will: Explain why the U.S. is losing some of its comparative advantage. Discuss three policies countries use to restrict trade. Explain why economists generally oppose trade restrictions. Explain how free trade associations both help and hinder international trade.

4. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-4 Increasing but Fluctuating World Trade World trade was 50% of GDP in 1928, 20% in 1950 and 200% today. World trade fluctuates as world output and trade restrictions change. The importance of trade differs among nations.

5. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-5 Differences in the Importance of Trade Total OutputExport RatioImport Ratio Netherlands$ 46162%57% Canada95944%40% Germany2,27136%32% Italy1,55027%26% France1,66127%25% United Kingdom1,66626%28% Japan3,58211%10% United States11,00010%14%

6. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-6 What and With Whom the U.S. Trades The majority of U.S. exports and imports involve manufactured goods. The primary trading partners of the U.S. are Canada, Mexico, the European Union, and Pacific Rim countries. U.S. imports have exceeded exports in recent years.

7. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-7 U.S. Exports by Region, 2004 Canada 23% Mexico 14% European Union 21% Pacific Rim 26% Other 6% Central and South America 7% OPEC 3% Total = $819 billion

8. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-8 U.S. Imports by Region, 2004 Canada 17% Mexico 11% European Union 19% Pacific Rim 33% Other 6% Central and South America 7% OPEC 6% Total = $1,470 billion

9. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-9 The Changing Nature of Trade The nature of trade is continually changing both in terms of countries with which we trade and the goods and services traded. U.S. imports from China, India, and other East Asian countries have recently increased substantially. Previously we imported manufactured goods and raw materials from these countries; today we import high tech manufactured goods.

10. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-10 The Changing Nature of Trade As technological changes in telecommunications reduce costs, foreign countries will be able to provide more services. Customer service calls for U.S. companies are often answered in India. This trade in services is often called outsourcing.

11. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-11 Is Chinese and Indian Outsourcing Different that Previous Outsourcing? Using overseas suppliers is not a new development in trade. The difference is the potential size of outsourcing to India and China with combined populations of 2.5 billion educated people. Because technology is growing in these countries, the U.S. economy must develop new technologies to remain competitive.

12. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-12 Balance of Trade Balance of trade – the difference between the value of exports and the value of imports.  Trade deficit – imports > exports  Trade surplus – exports > imports The U.S. has a significant trade deficit of approximately 5% of GDP. The U.S. is financing its trade deficit by selling off financial assets, stocks and bonds, and real assets, corporations and real estate.

13. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-13 The Principle of Comparative Advantage The principle of comparative advantage states that as long as the relative opportunity costs of producing goods differ among nations, there are potential gains from trade. Some of the gains from trade will go to traders who facilitate trade.

14. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-14 Comparative Advantage: Saudi Arabia and the U.S. U.S. 20 406080100120140 1000 800 600 400 200 Oil Food A B C D E F Saudi Arabia Saudi Arabia has a comparative advantage in oil because it can produce 10 times as much oil as food. Saudi Arabia should produce 1000 barrels of oil. 400200 20 40 60 80 100 120 140 6008001000 Food Oil A F E D C B The U.S. has a comparative advantage in food because it can produce 10 times as much food as oil. The U.S. should produce 1000 tons of food.

15. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-15 The Gains from Trade A trader, I.T., arranges for Saudi Arabia to trade 500 barrels of oil to the U.S. for 120 tons of food. The U.S. will trade 500 tons of food to Saudi Arabia for 120 barrels of oil. I.T., the trader keeps 380 barrels of oil and 380 tons of food. Production Consumption S.A. U.S. S.A. U.S. I.T. Oil (barrels) 1000 0 500 120 380 Food (tons) 0 1000 120 500 380

16. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-16 The Gains from Trade 20 406080100120140 1000 800 600 400 200 Oil Food A B C D E F Saudi Arabia G After trade Saudi Arabia is consuming 500 barrels of oil and 120 tons of food, point G, beyond its original production possibilities. 400200 20 40 60 80 100 120 140 6008001000 Food Oil A F E D C B U.S. H After trade the U.S. is consuming 120 barrels of oil and 500 tons of food, point H, beyond its original production possibilities.

17. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-17 Dividing up the Gains from Trade The more the competition, the less the trader gets. Smaller nations get a larger proportion of the gain than larger nations. Nations producing goods with economies of scale get a larger gain from trade.

18. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-18 Comparative Advantage in Today’s Economy If trade is good, why do so many people oppose it?  The gains of trade, lower prices, are harder to see than the cost, lost jobs.  The public believes that lower wages in other countries give them the comparative advantage in everything, so we will lose all jobs.  Laypeople usually think of trade only in manufactured goods.

19. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-19 Comparative Advantage in Today’s Economy The U.S. has the comparative advantage in facilitating trade, which generates jobs in the U.S. in research, management, advertising, and the distribution of goods. Trade increases income abroad, increasing demand for U.S. exports. The concentrated nature of the costs of trade and the dispersed nature of benefits present a challenge to policy makers.

20. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-20 Other Sources of U.S. Comparative Advantage Skills of the U.S. labor force make it highly productive. U.S. government institutions are stable and relatively non-corrupt. U.S. physical and technological infrastructure is the best in the world. English is the international language of business. Wealth from past production makes the U.S. the world’s largest consumer.

21. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-21 Other Sources of U.S. Comparative Advantage The U.S. has many natural resources. Cachet – the U.S. is a cultural trendsetter. Inertia – the current place of production has an advantage over other potential places because it is familiar. U.S. companies hold a large number of intellectual property rights. The U.S. has a relative open immigration policy.

22. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-22 Inherent and Transferable Comparative Advantage Inherent comparative advantages – comparative advantages based on factors that are relatively unchangeable, such as resources and climate. Transferable comparative advantages – comparative advantages based on factors that can change relatively easily, such as capital, technology, and types of labor. Whether a country can maintain a much higher standard of living in the long run depends in part on whether its comparative advantage is inherent or transferable.

23. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-23 The Law of One Price The law of one price – in a competitive market there will be pressure for equal factors to be priced equally. If factor prices aren’t equal, firms reduce costs by reorganizing production in countries with lower factor prices. Convergence hypothesis – the tendency of economic forces to eliminate transferable comparative advantage.

24. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-24 Methods of Equalizing Trade Balances Adjustments eventually occur to make surplus countries less competitive and deficit countries more competitive. Wages rise in the surplus countries, making their goods more expensive. The exchange rate of the deficit country falls and makes its goods less expensive.

25. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-25 Varieties of Trade Restrictions Tariffs Quotas Voluntary restraint agreements Embargoes Regulatory trade restrictions Nationalistic appeals

26. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-26Tariffs Tariffs (customs duties) are taxes governments place on internationally traded goods, encouraging the consumption of domestic goods. The Smoot-Hawley Act of 1930 raised tariffs to 60%, causing other countries to respond with similar trade restrictions. General Agreement on Tariffs and Trade (GATT) was established in 1947 to reduce trade barriers. The World Trade Organization (WTO) was established in 1995 to promote free and fair trade.

27. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-27Quotas Quotas are quantity limits placed on imports. Both tariffs and quotas increase price and reduce quantity. Under a tariff, the government collects the tariff revenue. With a quota, the domestic price increases, and the importer, not the government, gets the revenue.

28. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-28 Tariff revenue Tariffs When the Domestic Country is Small 2.00 2.50 Initial imports Domestic supply Domestic demand $3.00 100 125 175 200 Price Quantity World price = $2 World price with tariff = $2.50 t = $.50

29. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-29 Quotas When the Domestic Country is Small Price Quantity 2.00 2.50 Quota Domestic supply Domestic demand $3.00 100 125175 200 World supply with quota World price=$2= World supply

30. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-30 Voluntary Trade Agreements Voluntary trade agreements are agreements to limit exports. To avoid the imposition of new tariffs on their goods, countries often voluntarily restrict their exports. The quantity of imports decreases and the price of the good increases, helping domestic producers.

31. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-31Embargoes An embargo is a total restriction on import or export of a good. Embargoes are usually established for international political reasons rather than for economic reasons. The U.S. has imposed embargoes on Iraq, Iran, Libya, and Cuba.

32. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-32 Regulatory Trade Restrictions and Nationalistic Appeals Regulatory trade restrictions are government-imposed procedural rules that limit imports. Some regulatory restrictions are legitimate, but others are designed simply to make importing more difficult. Nationalistic appeals, such as the “Buy American” campaign are also intended to limit trade.

33. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-33 Reasons for Trade Restrictions Unequal internal distribution of the trade gains Haggling by companies over the trade gains Haggling by countries over trade restrictions Specializing production: learning by doing and economies of scale Macroeconomic aspects of trade National security International politics Increased revenue from tariffs

34. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-34 Unequal Distribution of Trade Gains Benefits of trade are generally widely spread among the entire population, but costs often fall on specific small groups. Setting up tariffs or quotas to save domestic jobs costs the economy money. Governments may institute trade adjustment assistance programs – programs designed to compensate losers for reductions in trade restrictions.

35. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-35 Why Economists Generally Oppose Trade Restrictions Free trade increases total output globally. International trade provides competition for domestic companies. Restrictions based of national security are often abused or evaded. Trade restrictions are addictive.

36. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-36 Institutions Supporting Free Trade Free trade associations – groups of nations that allow free trade among its members and put up trade barriers against all other nations. The European Union (EU) and the North American Free Trade Association (NAFTA) are examples. Countries strengthen trading relationships with most-favored nation status – those countries will be charged as low a tariff on its exports as any other country.

37. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-37Summary The nature of trade is continually changing. The U.S. is importing more and more high-tech goods and services from India and China and other East Asian countries. Outsourcing, a form of trade, is a larger phenomenon today compared to 30 years ago because the countries where jobs are outsourced – China and India – are much larger. According to the principle of comparative advantage, as long as the relative opportunity costs of producing goods differ among countries, there are potential gains from trade.

38. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-38Summary The more competition exists in international trade, the less the trader gets and the more the involved countries get. Once competition prevails, smaller countries tend to get a larger percentage of the gains from trade than do larger countries. Gains from trade go to countries that produce goods that exhibit economies of scale. The gain from trade in the form of low consumer prices tend to be widespread and not easily recognized, while the costs in jobs lost tend to be concentrated and readily identifiable.

39. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-39Summary The United States has comparative advantages due to its skilled workforce, its institutions, and its language, among other things. The U.S. established comparative advantages during the two world wars, which is slowly eroding. Trade restrictions include tariffs and quotas, embargoes, voluntary restraint agreements, regulatory trade restrictions, and nationalistic appeals.

40. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-40Summary Economists generally oppose trade restrictions because of the history of trade restrictions and their understanding of the advantages of free trade. The World Trade Organization is an international organization committed to reducing trade barriers. Free trade associations, such as the European Union, help trade by reducing barriers to trade among member nations.

41. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17-41 Review Question 17-1 Suppose that using all of their resources, South Carolina can produce 90 tons of apples or 30 tons of peaches in a day. Washington can produce 120 tons of apples or 15 tons of peaches in a day. Can these states benefit from trade? If so, explain why. According to the principle of comparative advantage, these states can benefit from trade. Washington should specialize in apples because they can produce 8 times as many apples as peaches and South Carolina should produce peaches because they can only produce 3 times as many apples as peaches. Review Question 17-2 Explain the adjustments that will eventually occur in countries that have persistent trade deficits. Deficits occur because imports are greater than exports. Wages in the deficit country will eventually fall relative to wages in surplus countries, causing costs and then prices of that country’s goods and services to decrease and exports increase. Exchange rates in the deficit country may fall, making their products cheaper in foreign countries.