Chapter 38 - International Trade
chapter thirty-eight
International Trade
CHAPTER OVERVIEW
This chapter builds provides analysis of international trade and protectionism. First, it reviews important facts about world trade. Second, it examines how international specialization based on comparative advantage can mutually benefit participating nations. Third, supply and demand analysis is used to help students understand prices and quantities of imports and exports. Fourth, the economic impact of trade barriers and export subsidies are examined, followed by the arguments for protectionism. Finally, the chapter discusses the creation of free-trade zones and multinational trade agreements as well as the impacts of trade adjustment assistance and offshoring of jobs.
WHAT’S NEW
This was chapter 37 in the 19e.
There are three new Quick Reviews in the chapter.
There are extensive data updates and some reworded of figure captions.
Beyond these changes the chapter is the same as the 19e.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Summarize the importance of international trade to the U.S. in terms of overall volume.
2. List the major imports and exports of the United States.
3. State two economic points that explain why nations trade.
4. 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.
5. Compute, when given appropriate data, the range for the terms of trade.
6. Calculate the potential gains from trade and specialization for each nation and the world when given appropriate data.
7. State the economist’s case for free trade.
8. Explain the relationship between world prices and American export supply curve, and the relationship between world prices and American import demand curve.
9. Explain international equilibrium price and quantity using a two-nation market model for import demand and export supply.
10. Identify four types of trade barriers.
11. Describe the economic impact of tariffs, including both direct and indirect effects.
12. Contrast the economic impact of a quota with that of a tariff.
13. List seven arguments in favor of protectionist barriers, and critically evaluate each.
14. Identify the costs of protectionist policies and their effects on income distribution.
15. Describe the major provisions of the WTO, and explain why some protest against the WTO.
16. Explain how trade adjustment assistance is used to mitigate harmful effects of world trade.
17. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Students can be made more aware of the extent of international trade with some simple exercises such as the following: (a) list all the things that the student owns that were made in another country, and name the countries; (b) list all of the foods eaten that day (week, month) that were imported and name the sources; (c) list all of the friends and relatives you have who are working for an export industry, or for a foreignowned firm, or all the foreign-owned firms in your city or town; (d) if you have several students who always wear baseball caps, have them look at the label. Despite outward appearances, most caps are manufactured outside the U.S.
2. Numerical examples help students to understand the principle of comparative advantage. Using state names instead of country names can help them to see the benefits from trade without the anti-foreign bias that may exist initially.
3. Tell students to assume that tariffs and quotas are enacted only when national defense is affected by the imported good. Then ask them to develop creative arguments to convince Congress that sugar, scissors, textiles, alcoholic beverages, and other products now covered by tariffs or quotas might be essential to national defense. In other words, they are to assume the role of lobbyists for these industries.
4. The “Buy American” campaign is a good topic for class discussion, presentations, or short papers. It is interesting to focus on the automobile industry to illustrate the various aspects to this issue. One question might address the desirability of buying American in the first place. Another question concerns the difficulty in defining what is “American” when it comes to automobiles and many other products. For example, many “Japanese” vehicles are now manufactured in varying degrees in the U.S., while many automobiles produced by the “Big Three” U.S. auto corporations are manufactured outside this country. Which of these can be considered to be American? Robert Reich’s “The Work of Nations” and Thomas Friedman’s “The Lexus and the Olive Tree” are good books on the issue of globalization.
5. “International Economics,” an amusing but very informative comic book explanation of the theory of comparative advantage and also the principles of foreign exchange can be ordered from the New York Federal Reserve Bank’s Public Information Department. Up to 35 copies of the comicbook explanations, four duplicating activity masters, and one teacher’s guide can be obtained free for classroom use. (Write or call them at FRB New York, Public Information Dept., 33 Liberty Street, New York, NY 10045, Ph. 2127916134.) The other Federal Reserve Banks also publish educational booklets on international trade and exchange topics.
STUDENT STUMBLING BLOCK
The principle of comparative advantage is not an easy concept to grasp. Where absolute advantage is involved, the principle is understandable, but it is tougher to grasp a situation such as that in the text example where the U.S. has an absolute advantage in both beef and vegetable production. Work through this example carefully with students. A short, soft-cover book, “The Choice” by Russell Roberts illustrates the principle of comparative advantage in story form and does an excellent job. If you assign a supplementary reading, this is recommended. Another idea is to demonstrate comparative advantage at the personal level. A lawyer may be the best gardener and house painter in town (has an absolute advantage). Still it is to the lawyer’s comparative advantage to specialize in law and hire gardeners and painters.
LECTURE NOTES
I.Learning objectives – After reading this chapter, students should be able to:
A.List and discuss several key facts about international trade.
B.Define comparative advantage, and demonstrate how specialization and trade add to a nation’s output.
C.Describe how differences between world prices and domestic prices prompt exports and imports.
D.Analyze the economic effects of tariffs and quotas.
E.Analyze the validity of the most frequently presented arguments for protectionism.
F.Identify and explain the objectives of GATT, WTO, EU, Euro Zone, and NAFTA and discuss offshoring and trade adjustment assistance.
II.Some Key Trade Facts
A.The U.S. has a trade deficit in goods (exports exceed imports); in 2012 the trade deficit in goods was $735 billion.
B.The U.S. has a trade surplus in services ($196 billion in 2012).
C.The principal exports of the U.S. include chemicals, semiconductors, consumer durables, aircraft, and agricultural products. Its main imports are petroleum, automobiles, computers, household appliances, and metals.
D.The U.S. exports many of the “same” goods it imports. (Intra-industry trade)
E.Canada is the United States’ quantitatively most important trading partner (20% of U.S. exports; 15% of U.S. imports).
F.The U.S. had a $315 billion trade deficit with China in 2012.
G.U.S. dependence on foreign oil is reflected in its $181 billion in imports from OPEC nations in 2012 while exporting $82 billion in goods to those countries.
H.The U.S. leads the world in the volume of exports and imports. China, Germany, the U.S., Japan, and the Netherlands are the world’s top five exporters; U.S. exports of goods make up about 8.1% of the world’s exports.
I.U.S. exports of goods and services (on a national income account basis) comprise 14% of total U.S. output.
J.China is now a major trading country with $2.05 trillion in exports in 2012. South Korea, Taiwan, and Singapore are also large traders.
K.International trade and finance link economies. Economic change in one part of the world has repercussions for countries around the globe.
L.International trade and finance is often at the center of debates of U.S. economic policy.
III.The Economic Basis for Trade
A.International trade is a way nations can specialize, increase the productivity of their resources, and realize a larger total output than they otherwise would.
B.Two points amplify the rationale for trade.
1.The distribution of economic resources among nations is uneven.
- Efficient production of various goods requires different technologies or combinations of resources.
- Products are differentiated among nations and some people prefer imports.
C.Interaction of these points can be illustrated.
1.China has a large labor force and can specialize in labor-intensive goods.
2.Australia has an abundance of land relative to human and capital resources and can cheaply produce land intensive agricultural products. Mexico’s climate and unskilled labor force means they can produce vegetables at a low cost.
3.Industrially advanced nations like the U.S. and Germany are in a position to produce capitalintensive goods.
D.As national economies evolve, the resource base may be altered affecting the relative efficiency with which nations can produce various goods and services.
IV.Comparative Advantage
A.With trade a country allocates more resources and produces a larger output in exporting industries with fewer resources and output in the importing industries.
B.The basic principle of comparative advantage rests on differing opportunity costs of producing various goods and services allows countries to specialize, increasing productivity of resources and increasing output.
C.An example of comparative advantage is developed in Figure 38.1 and Table 38.1 comparing an imaginary example using the U.S. and Mexico, where the labor forces of the two countries are assumed to be of equal size.
1.Before trade, both nations are self-sufficient in beef and vegetables and produce at the levels shown in Figure 38.1 on their PPCs. There are three important points to realize with regard to their production possibilities curves:
a.Constant costs – the linear production possibilities “curves” assume constant opportunity costs (implying resources are perfectly substitutable).
b.Different costs – Different resource mixes and technology generates different opportunity costs between the two nations.
c.U.S. has the absolute advantage in both goods – given the assumption of equal sized labor forces, Figure 38.1 illustrates a case where the U.S. is more productive (can produce at lower cost) in producing both of the goods.
2.The principle of comparative advantage says that total output will be greatest when each good is produced by the nation that has the lower opportunity cost. The U.S. has a comparative advantage in beef production and should specialize in beef, and Mexico should specialize in vegetables as one would expect.
3.Note in Table 38.1 that after specialization there will be more beef and more vegetables in total than the totals before specialization. Total beef production rose from 26 units of beef to 30 units of beef; vegetable production rose from 16 to 20.
4.Since each nation would like some of both goods, they will now have to trade. The terms of trade will be limited by the original cost conditions in each country. For example, in the U.S. 1 beef = 1 vegetable, so the U.S. will not give up more than 1 beef for each vegetable. Similarly, in Mexico 1 beef = 2 vegetables, so Mexico will not trade more than 2 vegetables for 1 beef. These two facts set the limits to the terms of trade. The rate of exchange will be somewhere between 1 and 2 vegetables for each beef (Key Graph 38.2 illustrates these possibilities graphically). The actual terms of trade within these limits will depend on each country’s negotiating power and world demand and supply conditions for these products.
5.The gains from trade can be shown by selecting any trade ratio within the limits. The text selects 1B = 1-1/2V. If the U.S. chooses to trade 10 tons of beef for 15 tons of vegetables, both nations will be better off than they were when they were selfsufficient. Specialization and trade have improved the productivity of their resources.
6.As a result of specialization and trade, both countries can have more of both products.
7.The above example assumes constant cost industries, which would not be the case in the real world. Rather, as the U.S. begins to expand beef production, its relative costs will rise and likewise with costs of vegetable production in Mexico. The effect of increasing costs is that complete specialization will probably not occur with many products.
D.Consider This…A CPA and House Painter
1.In this example, the CPA is absolutely more productive than the house painter, but has a higher opportunity cost for painting the house because of the wages sacrificed by painting instead of accounting.
2.The best allocation of resources is for the CPA to hire a painter because the opportunity cost is lower, similar to how countries determine the goods they will produce and the ones that they will import.
E.The case for free trade is restated in the text: Through free trade, based on the principle of comparative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material wellbeing. Both countries gain more of both goods. See Figure 38.2 (Key Graph)
1.One side benefit from free trade is that it promotes competition and deters monopoly power.
- Another side benefit may occur as specialization increases the production possibility curve by raising the productivity of the resources devoted to producing certain goods.
- Free trade links national interests, potentially breaking down national animosities.
F.Consider This…Misunderstanding the Gains from Trade
1.Counter to common myths the true gain from international trade is not an increase in employment in the export sector, but an increase in total output.
2.International trade enables a country to have a total output that is greater than its PPC.
V.Supply and Demand Analysis of Exports and Imports
A.This analysis helps us understand how prices and quantities of exports and imports are determined in world markets.
1.The equilibrium world price derives from the interaction of world supply and demand.
2.The equilibrium domestic price is determined by domestic supply and demand. It is the price that would prevail in a closed economy with no international trade.
3.When economies are open to trade, differences between world and domestic prices form the basis for exports or imports.
B.Supply and demand in the U.S.
1.Assume first that there are no trade barriers that Canada is the only other nation in the world, that aluminum is the product in question, and that there are no international transportation costs, to keep the analysis simple.
2.Figure 38.3a shows the domestic supply and demand curves for aluminum in the U.S. with an equilibrium price of $1 per pound and an equilibrium quantity of 100 million pounds.
3.If the world price exceeds $1, American firms will increase production and export the excess output to the rest of the world (Canada).
a.If the world price is $1.25, then American producers will supply 50 million pounds for export. (See Figure 38.3)
b.If the world price rises to $1.50, Americans will have 100 million pounds to export, because domestic consumers will buy only 50 million pounds at that price.
c.The American export supply curve is found in Figure 38.3b by plotting the domestic surpluses occurring at world prices above the $1 domestic equilibrium price. When world prices rise relative to American domestic prices, U.S. exports rise.
4.U.S. import demand will be shown by the Figure 38.3b plot of the excess domestic demand created if prices fall below the $1 domestic equilibrium price. The downsloping curve shows the amount of aluminum imported by the U.S. at prices below the $1 American domestic price. When world prices fall relative to domestic prices, American imports rise.
C.Supply and demand of aluminum in Canada can be depicted in a similar manner, as shown in Figure 38.4. The prices have been converted into U.S. dollar equivalents using the exchange rate mechanism discussed in Chapter 39 (next chapter).
1.Canada’s import demand curve represents domestic shortages in Canada when the world price falls below the $.75 domestic Canadian price.
2.Canada’s export supply curve represents domestic surpluses in Canada when the world price is above the $.75 Canadian domestic price.
D.Determination of the equilibrium world price, of exports and imports is illustrated in Figure 38.5.
1.Equilibrium occurs in this two-nation model where one nation’s import demand curve intersects another nation’s export supply curve. In this example, this occurs at a price of $.88.
2.At the $.88 world price, the domestic prices in both Canada and the U.S. will also be $.88.