International Trade and Interdependence · • Both countries can trade at the international terms...

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Chapter 19 International Trade and Interdependence

Basic principle of Comparative Advantage

•  A country should produce and specialize in those goods which it can produce for a lower opportunity cost than its trading partners –  i.e., a country should produce what it is relatively

best at producing

Basic Principle of Comparative Advantage

•  Even if an individual is worse at producing everything – Two individuals can still benefit from trade because

of differing Opportunity Costs – Each individual must be relatively better at

producing something

Graphical Illustration of Comparative Advantage:

•  Using all of its resources, the US can produce either 10 tons of textiles or 30,000 computers.

•  With the same resources, Mexico can produce either 5 tons of textiles or 10,000 computers.

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

Absolute Advantage

•  US has an ABSOLUTE ADVANTAGE in both goods •  We can produce more of both goods with the same amount of resources.

•  But we do not have a COMPARATIVE ADVANTAGE in both goods.

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

Determining Comparative Advantage

•  Comparative Advantage is determined by computing the opportunity cost of 1 unit of each good in each country

•  The country with the lowest opportunity cost per unit has a comparative advantage in the production of that good –  i.e., it is relatively more efficient to produce that

product in that country

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

•  T=Textiles (in tons), C=Computers (in 1000s).

•  In the US, 10T=30C (our resources can produce either 10T or 30C). 1T=3C.

•  In Mexico, 5T=10C. 1T=2C. So in Mexico each unit of textiles "costs" 2 computers, while in the US each unit of textiles "costs" 3 computers (1T=3C).

•  Mexico has a COMPARATIVE ADVANTAGE in the production of textiles, because they can produce textiles for a lower opportunity cost.

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

•  In the US, 30C=10T so 1C=(1/3)T

•  In Mexico, 10C=5T, so 1C=(1/2)T

•  Thus the US has a comparative advantage in computer production because we can produce computers for a lower opportunity cost.

•  To increase efficiency, US should specialize in what we produce most efficiently (Computers) –  Trade computers to Mexico for what they produce most

efficiently (Textiles).

•  Both countries can trade at the international terms of trade of 1T=2.5C and both countries can be better off. –  International terms of trade are rate at which two goods

would exchange in international markets. •  The international terms of trade are always given to you as part of a

comparative advantage problem.

Specialization and Trade

The Consumption Possibilities Curve •  Constructed by starting at the point where the country specializes entirely

in the good in which they have a comparative advantage. –  The CPC is then extended at the international terms of trade (here 1T=2.5C or

1C=.4T) to find the point on the other axis. –  In the US, (30C)*(.4)T/C=12T –  In Mexico, (5T)*(2.5)C/T=12.5C

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

Specialization & trade increases efficiency, makes both countries better off

•  Both countries can now consume more of both goods along their consumption possibilities curves –  By specializing in producing the good in which they have a

comparative advantage and trading this good.

Computers (1000s)

Textiles (Tons)

Computers (1000s)

US Mexico

• •

Another example of demonstrating the gains from trade using PPCs and CPCs.

•  Before TRADE: –  Using a certain amount of resources, the US can

produce either 1000 VCRs or 200 Computers. –  Question: If the price of a VCR is $200, what MUST

the price of a computer be? –  Using the same amount of resources, Korea can

produce 800 VCRs or 100 Computers. –  Question: If the price of a VCR in Korea is 200,000

Won, what is the price of a computer?

Construct Production Possibilities Curves

US can produce either 1000 VCRs or 200 Computers.

Korea can produce 800 VCRs or 100

Computers.

PPCs for the US and Korea

US Korea C

Determine Comparative Advantage

US: 1000V=200C Korea: 800V=100C 1V=1/5C 1V=1/8C

Korea has a Comparative Adv. in VCRs 1C=5V 1C=8V

US has a Comparative Adv. in Computers

•  Given the international terms of trade are 1C=6V, draw Consumption Possibilities Curves (CPCs) for both countries.

•  How do the CPCs show that both countries are better off with trade?

Construct CPCs

Both countries can consume more of both goods after trade (the CPCs are further out than the PPCs). ITT: (1C=6V)

US Korea C

800 1200

Assumptions behind the Theory of Comparative Advantage

•  As with any theory, C.A. is based upon a series of assumptions

•  Relaxation of these assumptions can result in an economic rationale for PROTECTION, not free trade

•  C.A. basic premise: factor endowments drive trade flows – But this is often not accurate

Arguments for Protectionism, Managed Trade

•  We can lose the comparative advantages our companies developed when they move abroad –  Capital mobility undermines the idea that we can continue

to specialize in what we create

•  Protection can allow industries to grow and/or retool –  Eventually become globally competitive

•  Some industries (those with linkages) are better than others, –  so we should push the economy in certain directions

Arguments for Protectionism, Managed Trade (continued)

•  Some trade is unfair –  Dumping; exclusive arrangements, currency

manipulation –  Which warrants protection in such cases

•  Specialization can be dangerous –  3rd World countries specializing in primary products

have been hurt by trade patterns –  We become more dependent on what happens

elsewhere in the world

Benefits & Costs of Trade

•  Significant general benefits from trade: –  Increased efficiency and productivity improve the standard

of living of most people •  Specific, localized costs from trade:

–  Particular industries, workers and towns are harmed directly by global competition (and these effects can be devastating)

–  We have not developed an effective mechanism to use the broad-based benefits of trade to compensate for the localized costs of trade

•  Globalization may be changing the nature of trade –  Undermining the power of workers so much that the

benefits of trade are skewed much more toward the top

New issues in trade theory

•  Economic Integration •  Free trade areas (lower tariffs), customs

unions (common tariffs), common market (free K & L mobility), economic union (central economic coordination)

•  Increases trade with group members •  Can actually reduce trade with the rest of the

world –  US buys more textiles from Mexico, fewer from India

Alternatives to the Theory of Comparative Advantage

•  The Theory of Comparative Advantage only explains a small part of US trade –  Import of oil, raw materials, labor-intensive goods – Export of agricultural products, high tech goods,

financial services •  But there are many exceptions

– We export and import cars, computers, software, music, food, etc.

FIGURE 19.6 U.S. Goods Export & Import Shares, 2008

Intra-Industry Trade

We trade with countries that 1)  have similar tastes 2)  have similar resource endowments (lots of K) 3)  are geographically close 4)  are open to free trade

We trade with countries that are similar to us, not those with different resource endowments, as implied by the theory of comparative advantage.

Particular companies are internationally competitive

The Political Economy of Trade

•  Whose interests are served by unregulated trade and free trade agreements? – Which of those interests have political and economic

clout? •  Whose interests are served by a strong dollar?

– Which of those interests have political and economic clout?

Trade policies

•  Tariffs: per unit or ad valorem (%)

S(1.1)

P 10% tariff

• Tariffs increase the price of imported goods.

Other trade policies

•  Quotas, Voluntary Export Restraints •  Export Subsidies •  Changing the value of the dollar

– Depreciating the dollar lowers the price of US goods •  Increases the price of imported goods

FIGURE 19.1 The Rapid Growth of Globalization

FIGURE 19.2 Real GDP Growth—1970–2010

FIGURE 19.3 World Trade Volume (goods and services)

TABLE 19.1 GDP and Merchandise Trade by Region, 2006–2008 (Annual % change at constant prices)

TABLE 19.2 World Merchandise Trade by Region and Selected Country, 2008 ($bn and %)

TABLE 19.2 (continued) World Merchandise Trade by Region and Selected Country, 2008 ($bn and %)

TABLE 19.3 World Exports of Commercial Services by Region and Selected Country,2008 ($bn and %)

TABLE 19.3 (continued) World Exports of Commercial Services by Region and Selected Country,2008 ($bn and %)

TABLE 19.4 Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %)

TABLE 19.4 (continued) Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %)

TABLE 19.5 Leading Exporters and Importers in World Trade in Commercial Services, 2008 ($bn and %)

TABLE 19.5 (continued) Leading Exporters and Importers in World Trade in Commercial Services, 2008 ($bn and %)

FIGURE 19.4 International Trade–Goods and Services, Percent of GDP

FIGURE 19.5 Trade Deficit in Goods and Services, Billions of Dollars, Monthly Rate

FIGURE 19.BP.1

TABLE 19.6 Total Country Production

TABLE 19.7 Total World Output Without Trade

FIGURE 19.7 Production Possibilities without Trade

TABLE 19.8 Total World Output with Specialization

TABLE 19.9 Total World Output with Specialization and Trade

FIGURE 19.8 Production Possibilities with Trade

FIGURE 19.9 Monthly U.S. Steel-Product Imports from China

International Trade and Interdependence · • Both countries can trade at the international terms...

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