Trade Issues If one country gains, must the other lose? Think comparative advantage. Do imports reduce employment? Do tariffs/quotas/restrictions save jobs? When might they? Should weak domestic industries be subsidized? Is a trade deficit “bad”? Is a surplus “good”? Does “fair trade” mean that our exports to a country will equal our imports from it?

Historical development of trade theory Mercantilism: get positive trade balance David Hume: specie flow balances payments Absolute advantage (Adam Smith) – Countries benefit from exporting what they make cheaper than anyone else…and buying abroad what they can buy for less Specialization  Division of Labor  Growth Comparative advantage (David Ricardo) – Nations can gain from specialization, even if they lack an absolute advantage

Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one of the goods Output per labor hour NationWineCloth United States 5 bottles20 yards United Kingdom15 bottles10 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour NationWineCloth United States40 bottles40 yards United Kingdom20 bottles10 yards Expect more productive US workers to have higher real wage.

Ricardo’s Comparative Advantage in money prices Comparative advantage Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£5/hr10£0.5020£0.25 : : : : : : : UK1 hr$1010$1.0020$0.50 (at $2.00 = £1)  No reason to buy British stuff

Ricardo’s Comparative Advantage in money prices: British workers take wage cut Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£4/hr10£0.4020£0.20 : : : : : : : UK1 hr$810$0.8020$0.40 (at $2.00 = £1)

Ricardo’s Comparative Advantage in money prices: the pound depreciates Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£5/hr10£0.4020£0.20 : : : : : : : UK1 hr$810$0.8020$0.40 (at $1.60 = £1)

Production possibilities schedules: constant opportunity costs Comparative advantage: autos and wheat Slope = 0.5 = MRT Slope = 2.0 = MRT Wheat When US resources are redeployed from wheat to autos, produce 2 cars for every ton of wheat sacrificed: Oppty cost of 1 Car = ½ Wheat In Canada, Oppty cost of 1 Car = 2 Wheat

Trading under constant opportunity costs Marginal Rates of Transformation in Production: US: 60 wheat = 120 cars  ½ wheat/car CND: 160 wheat = 80 cars  2 wheat/car A B C D E F Trading possibilities line (terms of trade 1:1) A’ B’ C’ D’ Trading possibilities line (terms of trade 1:1) Wheat tt

Production gains from specialization: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

Consumption gains from trade: constant opportunity costs and Terms of Trade = 1:1 (Trade 60 Wheat for 60 Cars) Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain TradeTrade(Loss)

Possible terms of trade – Less than ½ Wheat/Car  US won’t trade – More than 2 Wheat/Car  Canada won’t trade Equilibrium terms of trade: enter DEMAND – The importance of being unimportant large country continues to produce some of everything Terms – of – trade settle at (near) large country’s MRT Small country gains (almost) all Dynamic gains from trade The division of labor is limited by the extent of the market – Economies of scale Global competition  Creative destruction  Efficiency Technology transfer  Growth

Trade restrictions and reduced gains from trade (Limit Oil Imports to 200) A B C tt D E tt’ Crude oil Consumption 1.5:1 terms of trade Production MRT = 5 / 8 : 1

Production possibilities schedule under increasing costs A B Slope 1Auto = 1Wheat Slope 1Auto = 4Wheat Wheat Oppty cost of autos increases as more autos are produced. Why is complete specialization rare?

Trading under increasing costs: US stops short of total specialization in autos A t US (1A = 0.33W) B C D tt (1A =1W) Trading possibilities line Wheat

Trading under increasing costs: Canada stops short of total specialization in wheat. At limit, MRT = 1:1 in both countries. But … A’ t C (1A = 3W) B’ C’ D’ tt (1A =1W) Trading possibilities line Wheat

Additional Considerations Spectrum of comparative advantage Multilateral trade…“triangle trade” Entry barriers/Exit barriers – Irreversible commitments slow adjustments to changes in competitive advantage Outsourcing and its discontents – Costs, costs, costs – Cultural disconnects Pat Mulroy (SNWA): “We’ve brought employees in from back East. It takes them a good year to learn how different the West Coast is.”

Insights and Review Humian adjustment (David Hume, ) An early equilibrium model Suppose one country enjoys a balance of trade surplus – It’s trading partner experiences a deficit “Gold” flows from deficit country to surplus country – The surplus country’s money supply increases – Prices rise in the surplus country The surplus country’s goods become less attractive – It sells less to the other country – It buys more from the other country The balance of trade balances

Insights and Review A country enjoys a comparative advantage in the good for which its opportunity cost of production is low. Trade proceeds as long as the terms of trade (wine/cloth) is less than the wine exporting country’s opportunity cost of producing cloth and greater than the wine importing country’s opportunity cost of producing cloth. – The wine exporting country trades less of its wine for cloth than it would have to sacrifice in autarky – The wine importing country gets more wine for its cloth than it would get in autarky In general, a country’s Terms of Trade equals {Price It Receives for Its Exports}/{Price It Pays for Its Imports} – The closer the terms of trade are to its own opportunity cost, the less a country gains from trade: it may as well not trade – If its demand for the good it imports is high, it will pay a high price for its import and not gain much from trade.

Dynamic Gains from Trade Competitive pressure  Efficiency – Domestic suppliers must compete globally – The firm itself must compete globally Technology transfer  Efficiency Increased extent of the market  Economies of scale  Efficiency

Insights and Review If a country is not competitive because its workers are inefficient or “overpaid” (its costs are high), it can become competitive by – Depreciation of its currency But if its exchange rate is fixed – It pays for its import surplus with “gold” (Hume) – Its wages and prices deflate … while wages and prices in the export surplus country inflate Or – If its workers resist taking wage cuts, they suffer unemployment – Its trade balances because it imports less