What Is This Chapter All About?

INTERNATIONAL TRADE

WHAT IS THIS CHAPTER ALL ABOUT?

This chapter provides a detailed introduction to international trade, including trade patterns in the modern world and the effects of restrictions on trade. The conflict between the macroeconomic benefits of trade and the microeconomic losses associated with imports is emphasized.

In the ever-more-integrated world economy, students need a solid understanding of international trade. The chapter analyzes the impact of trade on production and consumption possibilities in open and closed economies.

Students should be encouraged to approach the chapter as a search for answers to the following key questions:

1. How is the international value of the dollar established?

2. Why do we trade so much?

3. Who benefits and who loses from imports, exports, and changes in the value of the dollar?

NEW TO THIS EDITION

· Updated trade data

· New headline on the Chinese currency

· Analysis of the Euro

· New headline on US steel tariffs

· Living Econ on “Should I travel abroad during a recession?”

LECTURE LAUNCHERS

Where should you start?

1. Stress the importance of trade in student’s lives. One lecture launcher could be to do a quick inventory of items students are wearing or using in class that are imported. How many students look for the "made in USA" label before buying? Are we worse off with imports?

2. Some lecture launching questions for this chapter might be: Should we import items from other countries or should we produce it ourselves? Should other nations purchase items from us or should they produce it themselves? If we should not trade with other nations, should we trade with other states within the union? Should we trade with other people or should we produce everything for our own individual consumption?

Most economists agree that open trade between nations improves the welfare of each nation. However, in the transition period, there will be adjustment costs as the economies adjust to new trading opportunities. This series of questions leads into a discussion on the motivation to trade beginning on page 366.

3. Ask students what goods or services cannot be imported.

Examples would include haircuts, lawn and gardening services, most education, inter-city travel, etc.

4. Ask students if they will specialize in a skill when they graduate or will they produce all of their needs themselves.

Clearly, students will specialize in some skill. To not do so would require that they produce their own fabric, clothing, grow and cut their own lumber, build their own house, refine their own gasoline, generate their own electricity, etc. The idea of specialization is discussed in the section on pursuit of comparative advantage beginning on page 371.

5. How might restrictions to trade between individuals harm their welfare?

An example might be to ask students how they would respond to a law that made the sale and production of alcohol illegal. Some would respond by saying good riddance. Many would say their welfare would be harmed. Certainly a black market would exist for the production and sale of alcohol as it did during the Prohibition in the U.S. creating an environment ripe for organized crime. Use examples like this to discuss what happens to the welfare of nations when trade is prohibited between the nations. Often, black markets are created to allow for illegal trade. Those individuals who do not take advantage of the black market often find their level of welfare reduced.

COMMON STUDENT ERRORS

Many students make these common errors. This same list is included in the student study guide. The first statement in each “common error” below is incorrect. Each incorrect statement is followed by a corrected version and an explanation.

1. A country must have an absolute advantage in order to gain from trade with another country. WRONG!

A country must have a comparative advantage in order to gain from trade with another country. RIGHT!

Mutually advantageous trade requires only that the opportunity costs of producing goods differ between the two countries, ceteris paribus. Another way of stating this is that the production-possibilities curves of the two countries must have different slopes.

2. Foreign trade costs a country jobs. WRONG!

Although jobs may be lost, new ones will be created by the opportunities opened up with trade. RIGHT!

When countries specialize and trade according to the law of comparative advantage, some particular workers and firms may be hurt by imports, but the economy, as a whole, gains by trade. More output per resource input will be attainable. Because the economy is able to reach full employment with trade as well as without trade, there is no reason to assume there will be fewer jobs.

3. A country is well off only as long as it exports more than it imports. WRONG!

Countries may, at times, be well off when they experience a trade surplus: they my also be well off when they have a trade deficit. RIGHT!

Both trade deficits and trade surpluses can be problems if either situation persists for a long period of time. Trade surpluses mean that a country is giving more of its limited, precious resources in trade than it is acquiring from other countries. The currencies of deficit countries tend to depreciate, which means they will be unable to buy as many foreign goods with a unit of currency.

4. Countries tend to enter into trade to get things they cannot produce themselves. WRONG!

Countries very often trade for things they could produce themselves. RIGHT!

Be careful! Countries often trade for things they could produce themselves because the relative costs of domestic production would be prohibitive. Take baskets as an example. Producers in the U.S. could certainly produce baskets if they really wanted to. The technique is not difficult to learn and the materials are abundant. But baskets do not lend themselves to machine production, and hand labor is expensive here. The cost in terms of goods forgone would be tremendous. (So would the price of the baskets.) We’re better off specializing in something like computers, where we have a comparative advantage, and trading for baskets, where we clearly do not have a comparative advantage.

5. The effects of protection against imported items affect only workers in the protected industry and the domestic consumers of the protected commodity. WRONG!

When domestically produced items are protected from imports, many different markets are affected by the protection. RIGHT!

Protection and output changes in any market are bound to set off additional changes in related markets. Higher prices for a protected product lead consumers to seek out substitutes with lower prices. This should increase the demand for the substitute and set off a host of other changes in related markets. In the case of sugar, corn based high-fructose corn syrup has replaced sugar to such an extent that corn growers, fearing a reduction in the demand for their output, now lobby their congressional delegations to maintain the sugar quota! Similar impacts can be expected in the markets of foreign producers.

HEADLINES

There are five Headline boxes in this chapter. Their titles and the concepts they illustrate are:

"Exports in Relation to GDP" (Export Ratios)

This table shows the relative significance of exports, as a percentage of GDP, for a number of nations. U.S. export dependence is low by international standards. The ratio of exports to total output is a measure of trade dependence. Most countries are much more dependent on trade than the United States.

"Whining over Wine" (Import Competition)

This Headline discusses a proposed bill that could slap higher tariffs on imported wine. Wine growers complain that foreign competitors are unfairly subsidized so protectionist measures are called for.

"A Litany of Losers" (Trade Resistance)

This Headline contains excerpts from several institutions and organizations concerning protectionism and reasons for trade barriers.

"Sugar Quota a Sour Deal" (Import Quotas)

Protectionism in the sugar industry costs consumers and workers while few benefit. However, the 12,000 domestic sugar beet growers have convinced Congress that their industry deserves protection.

“China Quickly Rebuffs Pressure From U.S. to Strengthen Its Currency” (Currency Depreciation)

In order to reduce imports from China, US Treasury Secretary Snow (and European Central Bank president Duisenberg) have pressured China to allow the Chinese yuan to rise in value. China said it won’t.

“Bush Sets Tariffs on Steel Imports” (Tariffs)

In 2002, President Bush imposed quotas on up to 30 percent of imported steel. The decision was a hailed by steel produces but was seen as a blow to steel-consuming industries and is anticipated to cost consumers $8 billion.

ANNOTATED CONTENTS IN DETAIL

I. U.S. Trade Patterns

A. Imports

1. Definition: Imports – Goods and services purchased from foreign sources.

2. The U.S. imports over $1.2 trillion of goods and services.

3. Total imports account for 13% of total GDP

4. Examples of imports include: Nearly all of the coffee consumed in the U.S., all the balls used in professional baseball, PlayStation 2 machines and games, Apple Computers.

B. Exports

1. Definition: Exports – Goods and services sold to foreign buyers.

2. In 2002, exports were just under $800 billion

3. Exports account for approximately 12% of total output.

4. Goods and services exported from the U.S. included farm products, tobacco, machinery, aircraft, automobiles and parts, raw materials, chemicals, tourism, insurance and software.

C. Headline: "Exports in Relation to GDP" (Export Ratios)

This table shows the relative significance of exports, as a percentage of GDP, for a number of nations. U.S. export dependence is low by international standards. The ratio of exports to total output is a measure of trade dependence. Most countries are much more dependent on trade than the United States.

D. Trade Balances (Table 17.1)

1. Formula:

2. Trade deficit

Definition: Trade deficit – The amount by which the value of imports exceeds the value of exports in a given time period.

3. Trade surplus

Definition: Trade surplus – The amount by which the value of exports exceeds the value of imports in a given time period.

4. Any imbalance in trade in the world must be offset by reverse balances elsewhere in the world.

5. The U.S. typically has a merchandise deficit and a services surplus - overall trade deficit (Table 17.1)

6. Bilateral Merchandise Trade Balances (Table 17.2)

II. Motivation to Trade

A. Specialization increases total world output.

B. Gains from trade - The gain from trade will be increased world output and thus a higher standard of living in both countries.

C. Production and Consumption Without Trade (Figure 17.1)

1. Production possibilities

Definition: Production possibilities – The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology.

a. The production-possibilities curve defines the limits to what a country can produce.

b. In the absence of trade, a country cannot consume more than it produces.

2. Consumption possibilities

Definition: Consumption possibilities – The alternative combinations of goods and services that a country could consume in a given time period.

3. Without trade, a country’s consumption possibilities equal its production possibilities.

4. With trade, a country’s consumption possibilities exceed its production possibilities.

D. Trade Increases Specialization and World Output

1. The changing mix of output results in a higher total level of output.

2. International trade allows each country to focus on what it does best.

3. The gains from trade are due to increased output in all trading nations resulting from specialization in production (Table 17.3).

III. Comparative Advantage - How does each country decide which good to specialize in?

Definition: Comparative Advantage – The ability of a country to produce a specific good or service at a lower opportunity cost than its trading partners.

A. Opportunity costs

1. Definition: Opportunity costs – The most desired goods or services that are forgone in order to obtain something else.

2. A country should specialize in what it is relatively efficient at producing, that is, goods for which it has the lowest opportunity costs.

3. Comparative advantage refers to the relative (opportunity) cost of producing particular goods.

4. World output and, thus, the potential gains from trade are maximized when each country pursues comparative advantage.

B. Absolute Costs Don't Count

1. Absolute advantage

Definition: Absolute advantage – The ability of a country to produce a specific good with fewer resources (per unit of output) than other countries.

2. It is not the absolute monetary cost of production that determines a nations comparative advantage. Rather it is the opportunity costs.

IV. Terms of trade

Definition: Terms of trade – The rate at which goods are exchanged; the amount of good A given up for good B in trade.

A. Limits to Terms of Trade

1. A country will not trade unless terms of trade are superior to domestic opportunity costs.

2. The terms of trade between any two countries will lie somewhere between their respective opportunity costs in production.

B. The Market Mechanism

1. Import/export decisions left up to market decisions of consumers and producers.

2. Market participants tend to focus on prices.

3. The terms of trade, like the price of any good or service, will depend on the willingness of market participants to buy or sell at various prices.

V. Protectionist Pressures

A. Microeconomic Losers

1. Workers and producers who compete with imported products - who work in import-competing industries - have an economic interest in restricting trade.

2. Trade redistributes income from import-competing industries to export industries.

3. Trade not only alters the mix of output but also redistributes income from competing industries to export industries.

B. Headline: "Whining Over Wine" (Import Competition) - This Headline discusses a proposed bill that could slap higher tariffs on imported wine. Wine growers complain that foreign competitors are unfairly subsidized so protectionist measures are called for.

C. Headline: "A Litany of Losers" (Trade Resistance)

This Headline contains excerpts from several institutions and organizations concerning protectionism and reasons for trade barriers.

D. The Net Gain

1. Microeconomic gains from trade are greater than the microeconomic losses.

2. Trade restrictions designed to protect special microeconomic interests reduce the total gain from trade.

VI. Barriers to Trade

A. Tariffs

Definition: Tariffs – A tax (duty) imposed on imported goods.

1. 50% of all U.S. imports (over 9,000 different products) are subject to tariffs.

2. The average tariff is 5% although individual tariffs vary widely.

3. A tariff on imported goods makes them more expensive to domestic consumers and thus less competitive with domestically produced goods.