International Trade ECO 285 – Macroeconomics – Dr. D. Foster

International Trade Basis for trade: Comparative Advantage Who has the lower “opportunity cost?” Mistaken basis for trade: Absolute Advantage Who has the lower resource cost?

Example: Absolute Advantage Consider Senegal and Peru: Who can more cheaply produce wool? Who can more cheaply produce beef? # = pounds

Example: Comparative Advantage Reconsider Senegal and Peru: What does it “cost” to produce wool? What does it “cost” to produce beef?

Comparative Advantage Opportunity costs in Senegal and Peru: With trade, wool would “sell” for . . .? With trade, beef would “sell” for . . .? Price = Terms of Trade; say 1# W=2# B

Trade Observations Not all countries have absolute advantages. All countries do have comparative advantages. Country size is irrelevant. Opportunity cost = what you give up. The international trading price of goods is called the “terms of trade.” Back to Senegal/Peru trade example: Assume without trade, resources are split evenly. Senegal always wants 50,000 #B; Peru always wants 25,000 #W.

Advantages to Trade A - the “no trade” outcome; production=consumption #Wool #Wool Senegal Peru B 40,000 50,000 A A 50,000 20,000 25,000 37,500 B # Beef # Beef 100,000 75,000 A - the “no trade” outcome; production=consumption B - the specialized production outcome, with trade

Advantages to Trade A - the “no trade” outcome; production=consumption #Wool #Wool Senegal Peru B 40,000 50,000 C 50,000 25,000 C 50,000 25,000 B # Beef # Beef 100,000 75,000 A - the “no trade” outcome; production=consumption B - the specialized production outcome, with trade C - the consumption outcome, with trade.

Advantages to Trade Before trade, world production was: Wool: 45,000 lbs. Beef: 87,500 lbs. With trade, world production has become: Wool: 50,000 lbs. Beef: 100,000 lbs. Gains to trade: Wool: +5,000 lbs. Beef: +12,500 lbs.

Effects of Trade Barriers In Senegal, unrest among the shepherds. Workers must relocate. Owners must relocate. Politicians seek to “protect” domestic producers. Here, wool . . . Consider a trade barrier – an import quota.

Policy - Import Quota Limit imports to 10,000 pounds of wool. Senegal #Wool Peru They can only trade 20,000#, so they only produce 70,000# B. Use remaining resources to produce 12,000 # W. They can only trade 10,000#, so they only produce 35,000#. 40,000 50,000 This takes 70% of their RUs, so rest is used to produce beef. Trade 20,000# B for 10,000# W. Q They can only get 20,000# B in trade. Q* 35,000 22,000 25,000 Q* Q 12,000 # Beef # Beef 100,000 75,000 50,000 22,500 70,000 42,500 Limit imports to 10,000 pounds of wool. Now, neither can completely specialize. Each has a lower standard of living. World production: Wool: 47,000# Beef: 92,500#

Advantages to Trade & Disadvantages to Trade Barriers Before trade, world production was: Wool: 45,000 lbs. Beef: 87,500 lbs. With trade, world production was: Wool: 50,000 lbs. Beef: 100,000 lbs. With quota, world production was: Wool: 47,000 lbs. Beef: 92,500 lbs.

International Trade Basis for trade: Comparative Advantage Who has the lower “opportunity cost?” Every country has a C.A. in some good. Mistaken basis for trade: Absolute Advantage Who has the lower resource cost? Not every country has an A.A. in some good.

Trade Lessons We trade on the basis of our comparative advantage. Everyone has a comparative advantage. Trade raises our material standard of living. Trade barriers lower our standard of living. Responding to trade barriers in kind makes us worse off.

Trade Barriers Import quotas to keep foreign goods out. Tariffs that serve as a tax on foreign goods. Subsidies for producers of export goods. Impose standards on foreign goods ( costs). The false rhetoric of protection: cheap foreign labor, infant industry, national defense, beggar-thy-neighbor

Bob Murphy on the 5 most common myths about free trade. We have free trade. When our “free” trade bills are 1000 pages … Trade deficits are bad. The trade flow is equally offset by the capital flow. Trade only helps poorer countries. Does “Buy American” make us richer? Not “us!” Free trade destroys jobs. Odd sentiment vis-á-vis Texas & Mexico; Bastiat & candlemakers. Free trade creates jobs. No, it raises average wages and our standard of living.

aka Merchandise Trade Balance Trade Fundamentals We have different categories of trade: Goods Services Financial Account Value of assets. Net change in securities. Other. Balancing error aka Merchandise Trade Balance Net Exports, “Current Account”, aka Trade Balance Balance of Payments Goods Ex Im Services Ex Im Trade balance Feb 2017: (128.5 b – 193.4 b) + (64.4 b – 43.0 b) = -65.0 + 21.4 = -43.6 b

Trade Fundamentals Financial Account Current Account

The Role of Trade in the Government’s Budget Recall from the circular flow, spending = income GDP = NI C + I + G + (Ex-Im) = C + S + T Rearrange: G = T + (S-I) + (Im-Ex) All government spending comes from: Tax revenue raised. Net private sector savings. Net foreign sector savings. [i.e., the trade deficit] Or, (G-T) = (S-I) + (Im-Ex) The gov’t deficit = crowded out investment + trade deficit

International Trade ECO 285 – Macroeconomics – Dr. D. Foster