R. GLENN HUBBARD Macroeconomics FOURTH EDITION ANTHONY PATRICK O’BRIEN

2 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Comparative Advantage and the Gains from International Trade CHAPTER 7 Chapter Outline and Learning Objectives 7.1The United States in the International Economy 7.2Comparative Advantage in International Trade 7.3How Countries Gain from International Trade 7.4Government Policies That Restrict International Trade 7.5The Arguments over Trade Policies and Globalization

3 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Discuss the role of international trade in the U.S. economy. 7.1 LEARNING OBJECTIVE The United States in the International Economy

4 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Tariff A tax imposed by a government on imports. Imports Goods and services bought domestically but produced in other countries. Exports Goods and services produced domestically but sold in other countries.

5 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Importance of Trade to the U.S. Economy Figure 7.1 International Trade Is of Increasing Importance to the United States Exports and imports of goods and services as a percentage of total production—measured by GDP—show the importance of international trade to an economy. Since 1970, both imports and exports have been steadily rising as a fraction of U.S. GDP.

6 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall U.S. International Trade in a World Context Figure 7.2 The Eight Leading Exporting Countries, 2010 The United States is the leading exporting country, accounting for 9.7 percent of total world exports. The values are the shares of total world exports of merchandise and commercial services.

7 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 7.3 International Trade as a Percentage of GDP International trade is still less important to the United States than to most other countries.

8 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Understand the difference between comparative advantage and absolute advantage in international trade. 7.2 LEARNING OBJECTIVE Comparative Advantage in International Trade

9 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall A Brief Review of Comparative Advantage Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Comparative Advantage in International Trade Table 7.1 An Example of Japanese Workers Being More Productive Than American Workers Output per Hour of Work Cell PhonesTablet Computers Japan126 United States24

10 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Absolute advantage The ability to produce more of a good or service than competitors when using the same amount of resources. Table 7.2 The Opportunity Costs of Producing Cell Phones and Tablet Computers The table shows the opportunity cost each country faces in producing cell phones and tablet computers. For example, the entry in the first row and second column shows that Japan must give up 2 cell phones for every tablet computer it produces. Opportunity Costs Cell PhonesTablet Computers Japan 0.5 tablet computer2 cell phones United States 2 tablet computers0.5 cell phone

11 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how countries gain from international trade. 7.3 LEARNING OBJECTIVE How Countries Gain from International Trade

12 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Autarky A situation in which a country does not trade with other countries. Table 7.3 Production without Trade Production and Consumption Cell PhonesTablet Computers Japan 9,0001,500 United States 1,5001,000 Increasing Consumption through Trade Terms of trade The ratio at which a country can trade its exports for imports from other countries. Countries gain from specializing in producing goods in which they have a comparative advantage and trading for goods in which other countries have a comparative advantage.

13 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Table 7.4 Gains from Trade for Japan and the United States

14 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Why Don’t We See Complete Specialization? We do not see complete specialization in the real world for three main reasons: Not all goods and services are traded internationally. Some services are difficult to export, such as medical care. Production of most goods involves increasing opportunity costs. If a country devotes more workers to producing a good, the opportunity cost of producing more of that good will increase, causing the country to stop short of complete specialization. Tastes for products differ. Most products are differentiated. As a result, countries may each have a comparative advantage in producing different varieties of a particular product. Don’t Let This Happen to You Remember That Trade Creates Both Winners and Losers Trade is a win–win situation for all countries that participate, but some individuals always lose. Your Turn: Test your understanding by doing related problem 3.12 at the end of this chapter. MyEconLab Countries do not produce goods—firms do, and some lose. The losers are likely to try to convince their governments to interfere by barring imports of the competing products from the other country or by imposing high tariffs on them. Does Anyone Lose as a Result of International Trade?

15 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Where Does Comparative Advantage Come From? Among the main sources of comparative advantage are the following: Climate and natural resources. Geology can create comparative advantage. Relative abundance of labor and capital. Some countries have a comparative advantage in producing goods requiring highly skilled workers and sophisticated machinery, while others have a comparative advantage requiring unskilled workers and relatively simple machinery. Technology. Broadly defined, technology is the process firms use to turn inputs into goods and services. Some countries are strong in product technologies, which involve the ability to develop new products. Other countries are strong in process technologies, which involve the ability to improve the processes used to make existing products. External economies. Once an industry becomes established in an area, firms that locate in that area gain advantages over firms located elsewhere. External economies Reductions in a firm’s costs that result from an increase in the size of an industry.

16 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Comparative Advantage over Time: The Rise and Fall—and Rise— of the U.S. Consumer Electronics Industry A country may develop a comparative advantage in the production of a good, and then, as time passes and circumstances change, the country may lose its comparative advantage in producing that good and develop a comparative advantage in producing other goods. For several decades, the United States had a comparative advantage in the production of consumer electronic goods, such as televisions, radios, and stereos. The comparative advantage of the United States in these products was based on having developed most of the underlying technology, having the most modern factories, and having a skilled and experienced workforce. Gradually, however, other countries, particularly Japan, gained access to the technology, built modern factories, and developed skilled workforces. By 2011, however, as the technology underlying consumer electronics had evolved, comparative advantage had shifted again, and several U.S. firms had surged ahead of their Japanese competitors. Once a country has lost its comparative advantage in producing a good, its income will be higher and its economy will be more efficient if it switches from producing the good to importing it, as the United States did when it switched from producing televisions to importing them.

17 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Analyze the economic effects of government policies that restrict international trade. 7.4 LEARNING OBJECTIVE Government Policies That Restrict International Trade

18 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Free trade Trade between countries that is without government restrictions. Figure 7.4 The U.S. Market for Ethanol under Autarky This figure shows the market for ethanol in the United States, assuming autarky, where the United States does not trade with other countries. The equilibrium price of ethanol is $2.00 per gallon, and the equilibrium quantity is 6.0 billion gallons per year. The blue area represents consumer surplus, and the red area represents producer surplus.

19 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 7.5 The Effect of Imports on the U.S. Ethanol Market When imports are allowed into the United States, the price of ethanol falls from $2.00 to $1.00. U.S. consumers increase their purchases from 6.0 billion to 9.0 billion gallons. Equilibrium moves from point F to point G. U.S. producers reduce the quantity of ethanol they supply from 6.0 billion to 3.0 billion gallons. Imports equal 6.0 billion gallons, which is the difference between U.S. consumption and U.S. production. Consumer surplus equals the areas A, B, C, and D. Producer surplus equals the area E. Government policies that restrict trade usually take one of two forms: tariffs or quotas and voluntary export restraints.

20 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 7.6 The Effects of a Tariff on Ethanol Without a tariff on ethanol, U.S. producers will sell 3.0 billion gallons of ethanol, U.S. consumers will purchase 9.0 billion gallons, and imports will be 6.0 billion gallons. The U.S. price will equal the world price of $1.00 per gallon. The $0.50-per-gallon tariff raises the price of ethanol in the United States to $1.50 per gallon, and U.S. producers increase the quantity they supply to 4.5 billion gallons. U.S. consumers reduce their purchases to 7.5 billion gallons. Tariffs Equilibrium moves from point G to point H. The ethanol tariff causes a loss of consumer surplus equal to the area A + C + T + D. The area A is the increase in producer surplus due to the higher price. The area T is the government’s tariff revenue. The areas C and D represent deadweight loss.

21 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Quotas and Voluntary Export Restraints Quota A numerical limit a government imposes on the quantity of a good that can be imported into the country. Voluntary export restraint (VER) An agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country. Measuring the Economic Effect of the Sugar Quota We can use the concepts of consumer surplus, producer surplus, and deadweight loss to measure the economic impact of the sugar quota.

22 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 7.7 The Economic Effect of the U.S. Sugar Quota Without a sugar quota, U.S. sugar producers would have sold 4.7 billion pounds of sugar, U.S. consumers would have purchased 27.5 billion pounds of sugar, and imports would have been 22.8 billion pounds. The U.S. price would have equaled the world price of $0.28 per pound. Because the sugar quota limits imports to 5.3 billion pounds (the bracket in the graph), the price of sugar in the United States rises to $0.53 per pound, and U.S. producers supply 15.9 billion pounds. U.S. consumers purchase 21.2 billion pounds rather than the 27.5 billion pounds they would purchase at the world price. Without the import quota, equilibrium would be at point E; with the quota, equilibrium is at point F. The sugar quota causes a loss of consumer surplus equal to the area A + B + C + D. The area A is the gain to U.S. sugar producers. The area B is the gain to foreign sugar producers. The areas C and D represent deadweight loss. The total loss to U.S. consumers in 2010 was $6.08 billion.

23 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The High Cost of Preserving Jobs with Tariffs and Quotas Product Number of Jobs Saved Cost to Consumers per Year for Each Job Saved Benzenoid chemicals Luggage Softwood lumber Dairy products Frozen orange juice Ball bearings Machine tools Women's handbags Canned tuna , , $1,376,435 1,285,078 1,044, , , , , , ,640 Table 7.5 Preserving U.S. Jobs with Tariffs and Quotas Is Expensive

24 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Table 7.6 Preserving Japanese Jobs with Tariffs and Quotas Is Also Expensive Product Cost to Consumers per Year for Each Job Saved Rice Natural gas Gasoline Paper Beef, pork, and poultry Cosmetics Radio and television sets $51,233,000 27,987,000 6,329,000 3,813,000 1,933,000 1,778, ,000

25 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Gains from Unilateral Elimination of Tariffs and Quotas Some politicians argue that eliminating U.S. tariffs and quotas would help the U.S. economy only if other countries eliminated their tariffs and quotas in exchange. It is easier to gain political support for reducing or eliminating tariffs or quotas if it is done as part of an agreement with other countries that involves their eliminating some of their tariffs or quotas. But as the example of the sugar quota shows, the U.S. economy would gain from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas. Other Barriers to Trade In addition to tariffs and quotas, governments sometimes erect other barriers to trade, such as stricter health and safety requirements on imported goods. Many governments also restrict imports of certain products on national security grounds.

26 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Evaluate the arguments over trade policies and globalization. 7.5 LEARNING OBJECTIVE The Arguments over Trade Policies and Globalization

27 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall To reduce tariffs and revive international trade after World War II, government officials in the United States and Europe set up the General Agreement on Tariffs and Trade (GATT) in A series of multilateral negotiations, called trade rounds, took place, in which countries agreed to reduce tariffs from the very high levels of the 1930s. In the following decades, trade in services and in products incorporating intellectual property, such as software programs and movies, grew in importance and in January 1995, GATT was replaced by the World Trade Organization (WTO). World Trade Organization (WTO) An international organization that oversees international trade agreements.

28 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Why Do Some People Oppose the World Trade Organization? Globalization The process of countries becoming more open to foreign trade and investment. The opposition to the WTO comes from three sources: 1. Some opponents are specifically against the globalization process that began in the 1980s and became widespread in the 1990s. 2. Other opponents have the same motivation as the supporters of tariffs in the 1930s—to erect trade barriers to protect domestic firms from foreign competition. 3. Some critics of the WTO support globalization in principle but believe that the WTO favors the interests of the high-income countries at the expense of the low-income countries.

29 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Anti-Globalization Many of those who protest at WTO meetings distrust globalization. Some believe that by increasing the variety of products available to consumers in developing countries, free trade and foreign investment destroy the distinctive cultures of those countries. Globalization has also allowed multinational corporations to relocate factories from high-income countries to low-income countries. Some people have argued that firms with factories in developing countries should pay workers wages as high as those paid in high-income countries, abiding by the same health, safety, and environmental regulations. The governments of most developing countries have arguments against these proposals.

30 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Protectionism The use of trade barriers to shield domestic firms from foreign competition. “Old-Fashioned” Protectionism Saving jobs. Supporters of protectionism argue that free trade reduces employment by driving domestic firms out of business. Protecting high wages. Some people worry that firms in high-income countries will have to start paying much lower wages to compete with firms in developing countries. Protecting infant industries. Others argue that under free trade, established foreign producers can sell their products at a lower price and drive domestic producers out of business before they gain enough experience to compete. Protecting national security. It is rare for an industry to ask for protection without raising the issue of national security, even if its products have mainly nonmilitary uses. Protectionism is usually justified on the basis of one of the following arguments:

31 of 31 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Dumping Dumping Selling a product for a price below its cost of production. Positive analysis concerns what is. Normative analysis concerns what ought to be. The success of industries in getting the government to erect barriers to foreign competition depends partly on some members of the public knowing the costs of trade barriers but supporting them anyway. However, two other factors are also at work: Positive versus Normative Analysis (Once Again) 1.The costs tariffs and quotas impose on consumers are large in total but relatively small per person. 2.The jobs lost to foreign competition are easier to identify than are the jobs created by foreign trade.