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?

Consider Senegal and Peru: Example: Absolute Advantage 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 B - the specialized production outcome, with trade #Wool # Beef Senegal 40, ,000 50,00020,000 #Wool # Beef Peru 50,000 75,000 37,500 A A B B 25,000

Advantages to Trade A - the “no trade” outcome; production=consumption B - the specialized production outcome, with trade C - the consumption outcome, with trade. #Wool # Beef Senegal 40, ,000 #Wool # Beef Peru 50,000 75,000 B BC50,000 25,000 C50,000 25,000

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 two trade barriers – an import quota and a tariff.

Policy #1 - Import Quota 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# #Wool # Beef Senegal 40, ,000 #Wool # Beef Peru 50,000 75,000 Q Q Q* 50,000 22,000 Q* 42,500 25,000 35,000 22,500 They can only trade 10,000#, so they only produce 35,000#. This takes 70% of their RUs, so rest is used to produce beef. They can only get 20,000# B in trade. 70,000 12,000 They can only trade 20,000#, so they only produce 70,000# B. Trade 20,000# B for 10,000# W. Use remaining resources to produce 12,000 # W.

Policy #2 - Tariff Tariff (tax) changes ToT: 1# W = 2.25# B Tax goes to government of Senegal. But, still no domestic wool production! #Wool # Beef 40, ,000 #Wool # Beef 50,000 75,000 F F F* 50,000 22,222 F* 48,611 25,000 47,222 Senegal Peru 4,167 World production: Wool: 47,222# Beef: 100,000# 50,000# B now “cost” 22,222# W!! (50,000/2.25) But, 22,222# wool will still earn Peruvians 44,444# beef.

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 tariff, world production was: Wool: 47,222 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. 1.We have free trade.  When our “free” trade bills are 1000 pages … 2.Trade deficits are bad.  The trade flow is equally offset by the capital flow. 3.Trade only helps poorer countries.  Does “Buy American” make us richer? Not “us!” 4.Free trade destroys jobs.  Odd sentiment vis-á-vis Texas & Mexico; Bastiat & candlemakers. 5.Free trade creates jobs.  No, it raises average wages and our standard of living.

Trade Fundamentals We have different categories of trade: GoodsServices Financial Account Value of assets.Value of assets. Net change in securities.Net change in securities. Other.Other. Balancing error 2013 Q4: (405.4 b – b) + (173.7 b – b) b – 92 b Net Ex: Feb. 2015: (125.6 – 180.8) + (60.6 – 40.9) = b Merchandise Trade Balance Net Exports, aka Current Acct. Balance of Payments Goods Ex Im Services Ex Im Net Financial error

Current Account Financial Account Trade Fundamentals

The Role of Trade in the Government’s Budget GDP = C + I + G + (Ex-Im) NI = C + S + T … and by definition GDP=NI [National income] 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