1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT International Trade 2 nd edition

8-2 Key Concepts Comparative Advantage Terms of trade Opportunity Cost New Trade Theory

8-3 Patterns of World Trade Growth rate in world output and volume of world trade World GDP Trade Volume

8-4 Comparative Advantage Focus on activities in which disadvantage is least Produce good/service with lowest opportunity cost Trade for good with highest opportunity cost Trade benefits all countries Key assumptions Competitive markets Labor and capital can easily be reallocated Stable rate of unemployment Costless transportation China-U.S. example

8-5 Comparative Advantage ALL countries benefit from free trade However, not all countries will be equally well off Gains may not be equal between countries Depends on terms of trade Not all citizens benefit Country is richer as a whole, but some citizens are worse off Should these problems stop trade?

8-6 Terms of Trade Ratio of the price of a country’s exports to the price of a country’s imports Gains from trade rise with terms of trade Example: oil-exporters have recently experienced a strong increase in their terms of trade Application: Prebisch-Singer hypothesis Hypothesis that agricultural prices, fall in value over time… Rising productivity in agriculture low elasticity of demand for agricultural products fall in agricultural prices relative to overall prices and decline in terms of trade Countries should promote non-agriculture sector or fall behind

8-7 Factor Price Equalization Factor price equalization Theorem As trade grows, input prices (wages and the cost of capital) should converge Both within and across countries  Assumes identical inputs  Productivity-adjusted wages different

8-8 Wages, US $, 2000 Source: BLS

8-9 National Competitiveness: Classical Trade Theory Trade is not a zero-sum game Competitiveness concerns imply zero-sum game Focus on comparative advantage, not competitiveness Countries do not go bankrupt Instead of bankruptcy, a country undergoes restructuring of economy Reallocate labor and capital to new industry Trade is not adversarial Caveat: shortrun vs. longrun Example: Mexico’s competitiveness concerns

8-10 International Trade Theory: New Trade Theory Economies of scale are important to some industries Commercial airlines, auto dealers Economies of scale require large production run, and in turn a large market to sell goods If no large market, then… No production of certain goods Less variety What’s one way to increase market size for a good? International Trade

8-11 International Trade Theory: New Trade Theory Example: Suppose two countries with annual market for 1 million autos Before trade: 1 million auto market After trade: 2 million auto market Produce more, at lower cost, and greater variety

8-12 International Trade Theory: New Trade Theory First Mover Advantage If economies of scale is important (i.e. need a large market) and there has been a first mover, then subsequent competitors will face a barrier to entry Not enough market demand left for them to operate at level of economy of scale => cost disadvantage Example: Airbus is spending $14 billion to develop 550 seat commercial plane  Needs to sale 350 planes for venture to be profitable  Demand over next 20 years is for 400 to 600 planes  Room for only one profitable player

8-13 National Competitiveness: New Trade Theory Don’t necessarily need productivity or factor endowment advantage to benefit from trade…if you are the first mover Comparative advantage can be created Carpet industry, Dalton, Georgia Silicon Valley, California Comparative advantage should not be accepted as is Countries should actively promote strategic trade policies Example: Aircraft industry Imperfect competition Increasing returns to scale U.S. vs. Europe: Boeing vs. Airbus

8-14 Strategic New Trade Theory Airbus EnterDon’t Enter Boeing Enter-$100m $500m0 Don’t enter0$500m00 If both firms enter, neither reap lower costs from increasing returns to scale (IRS) $500 million earning potential…if IRS fully used Best strategy is consider what the other firm is going to do

8-15 Strategic New Trade Theory Airbus EnterDon’t Enter Boeing Enter$-100m$100m$500m0 Don’t enter0$700m00 Suppose European government promises $200 million subsidy if Airbus produces planes Regardless of Boeing’s decision, Airbus will now produce…positive earning regardless Boeing either looses $100 million or withdraws at no lost…easy choice $200 million subsidy gave Airbus monopoly profits of $500 million and will help create an European comparative advantage

8-16 Strategic New Trade Theory Airbus EnterDon’t Enter Boeing Enter$100m $500m0 Don’t enter0$500m00 If Europe and U.S. both subsidize $200 million, both firms will produce However, profit includes subsidy Europeans and Americans overpay for aircraft, foreigners benefit Solutions: Cartel: agree to set same prices Move toward niche products Raise the stakes: higher subsidies

8-17 Strategic Trade Theory Paul Krugman Strategic trade policy is tantamount to “beggar thy neighbor” policy Boost national income at expense of other country Likely to provoke retaliation and trade ware Result could be a costly subsidy race between two countries from which other countries benefit What to do if competitor is subsidizing competing industry? Better to establish “rules of the game” than to retaliate WTO Often government intervention is based on special interest rather than strategic trade theory (economies of scale)

8-18 Arguments for Trade Restrictions Political Arguments National Security Protecting Jobs and Industries Retaliation Consumer Protection (health, safety) Furthering Foreign Policy Objectives Economic Arguments Infant Industry Protection Strategic Trade Policy

8-19 Summary Trade is an increasing feature of the world economy Comparative advantage and terms of trade New trade theory Arguments for Trade Restrictions