C hapter 31 International Trade © 2002 South-Western

2 Economic Principles Absolute Advantage Comparative Advantage Free Trade Tariffs

3 Economic Principles Quotas Customs Unions Free Trade Areas

4 EXHIBIT 1ILLINOIS PRODUCTION POSSIBILITIES CURVE

5 Exhibit 1: Illinois Production Possibilities Curve 1. What is the opportunity cost of producing an additional barrel of oil in Illinois? The opportunity cost of producing an additional barrel of oil is one bushel of corn.

6 Exhibit 1: Illinois Production Possibilities Curve 1. What is the opportunity cost of producing an additional barrel of oil in Illinois? The opportunity cost of an additional barrel of oil is given by the slope of the production possibilities curve in Exhibit 1.

7 Exhibit 1: Illinois Production Possibilities Curve 2. What is the opportunity cost of producing an additional bushel of corn in Illinois? The opportunity cost of producing an additional bushel of corn is one barrel of oil.

8 Intrastate Trade 1. If corn and oil exchange according to their relative opportunity costs, what will one bushel of corn trade for in terms of barrels of oil in Illinois? We know that one barrel of oil must be given up to get one bushel of corn in Illinois. As a result one bushel of corn will trade for one barrel of oil in Illinois.

9 EXHIBIT 2OKLAHOMA PRODUCTION POSSIBILITIES CURVE

10 Exhibit 2: Oklahoma Production Possibilities Curve 1. What is the opportunity cost of producing an additional barrel of oil in Oklahoma? The opportunity cost of producing an additional barrel of oil is bushels of corn.

11 Exhibit 2: Oklahoma Production Possibilities Curve 1. What is the opportunity cost of producing an additional barrel of oil in Oklahoma? The opportunity cost of an additional barrel of oil is given by the slope of the production possibilities curve in Exhibit 2.

12 Exhibit 2: Oklahoma Production Possibilities Curve 2. What is the opportunity cost of producing an additional bushel of corn in Oklahoma? The opportunity cost of producing an additional bushel of corn is 12 barrels of oil.

13 Intrastate Trade 2. If corn and oil exchange according to their relative opportunity costs, what will one bushel of corn trade for in terms of barrels of oil in Oklahoma? We know that 12 barrels of oil must be given up to get one bushel of corn in Oklahoma. As a result one bushel of corn will trade for 12 barrels of oil in Oklahoma.

14 Interstate Trade 1. If Illinois and Oklahoma engage in free trade, which state would export corn and which state would export oil? Since oil producers must give 12 barrels of oil for a bushel of corn in Oklahoma, but need only give one barrel of oil for a bushel of corn in Illinois, Oklahoma oil producers would seek out buyers in Illinois.

15 Interstate Trade 1. If Illinois and Oklahoma engage in free trade, which state would export corn and which state would export oil? Likewise, since a bushel of corn trades for one barrel of oil in Illinois, but trades for 12 barrels of oil in Oklahoma, Illinois corn farmers would seek out buyers in Oklahoma.

16 Interstate Trade Free trade International trade that is not encumbered by protectionist government policies such as tariffs and quotas.

17 EXHIBIT 3PRODUCTION OF CORN AND OIL IN ILLINOIS AND OKLAHOMA, BEFORE AND AFTER FREE TRADE (BUSHELS AND BARRELS)

18 Exhibit 3: Production of Corn and Oil in Illinois and Oklahoma, Before and After Free Trade (Bushels and Barrels) What are the total gains from free trade between Oklahoma and Illinois? By having Illinois specialize in producing corn, and Oklahoma specialize in producing oil, an additional 75 bushels of corn and an extra 200 barrels of oil are produced.

19 EXHIBIT 4CORN AND OIL CONSUMPTION IN ILLINOIS AND OKLAHOMA, BEFORE AND AFTER FREE TRADE (BUSHELS AND BARRELS)

20 Exhibit 4: Corn and Oil Consumption in Illinois and Oklahoma, Before and After Free Trade (Bushels and Barrels) What relative price leads to Oklahoma and Illinois consuming the same quantity of oil after trade? A relative price of three barrels of oil for one bushel of corn will result in both states consuming 300 barrels of oil.

21 Interstate Trade 2. If Illinois and Oklahoma engage in free trade, and if there are aggregate gains from trade, then is it true that nobody loses? No. Oil producers in Illinois are priced out by cheap imports of Oklahoma oil. Likewise corn growers in Oklahoma are priced out by cheap imports of Illinois corn.

22 International Trade International specialization The use of a country’s resources to produce specific goods and services, allowing other countries to focus on the production of other goods and services.

23 EXHIBIT 5PRODUCTION OF CORN AND OIL IN THE UNITED STATES AND MEXICO, BEFORE AND AFTER FREE TRADE (BUSHELS AND BARRELS)

24 Exhibit 5: Production of Corn and Oil in the United States and Mexico, Before and After Free Trade (Bushels and Barrels) What does Mexico specialize in producing in Exhibit 5? Mexico specializes in producing oil.

25 EXHIBIT 6CORN AND OIL CONSUMPTION THE THE UNITED STATES AND MEXICO, BEFORE AND AFTER FREE TRADE (BUSHELS AND BARRELS)

26 Exhibit 6: Corn and Oil Consumption in the United States and Mexico, Before and After Free Trade (Bushels and Barrels) What relative price leads to Mexico and the United States consuming the same quantity of corn after trade in Exhibit 6? Four barrels of oil for one bushel of corn.

27 Absolute and Comparative Advantage Absolute advantage A country’s ability to produce a good using fewer resources than the country it trades with.

28 Absolute and Comparative Advantage Comparative advantage A country’s ability to produce a good at a lower opportunity cost than the country with which it trades.

29 Absolute and Comparative Advantage 1. In the example of corn and oil trade between the United States and Mexico, what was the United States’ comparative advantage? The opportunity cost of producing one bushel of corn in the United States is three barrels of oil.

30 Absolute and Comparative Advantage 1. In the example of corn and oil trade between the United States and Mexico, what was the United States’ comparative advantage? The opportunity cost of producing one bushel of corn in Mexico is 12 barrels of oil.

31 Absolute and Comparative Advantage 1. In the example of corn and oil trade between the United States and Mexico, what was the United States’ comparative advantage? The United States has a comparative advantage in growing corn because it can do so at a lower opportunity cost than Mexico.

32 Absolute and Comparative Advantage 2. In the example of corn and oil trade between the United States and Mexico, what was Mexico’s comparative advantage? Using the same process as that used for the United States, we find that Mexico has a lower opportunity cost for producing oil.

33 Absolute and Comparative Advantage 3. What determines how much each country gains from free trade? The relative price of the goods being traded.

34 EXHIBIT 7CORN AND OIL CONSUMPTION IN THE UNITED STATES AND MEXICO, UNDER CONDITIONS OF NO TRADE AND FREE TRADE

35 Exhibit 7: Corn and Oil Consumption in the United States and Mexico, Under Conditions of No Trade and Free Trade 1. If a bushel of corn trades for four barrels of oil, how much of its oil must Mexico keep for itself, and how much must it trade for corn, in order to get 200 bushels of corn from the United States? Mexico must trade 800 barrels of oil with the United States in order to get 200 bushels of corn.

36 Exhibit 7: Corn and Oil Consumption in the United States and Mexico, Under Conditions of No Trade and Free Trade 2. If a bushel of corn now trades for five barrels of oil, how much of its oil must Mexico keep for itself, and how much must it trade for corn, in order to get 200 bushels of corn from the United States? Mexico must trade 1000 barrels of oil with the United States in order to get 200 bushels of corn.

37 Exhibit 7: Corn and Oil Consumption in the United States and Mexico, Under Conditions of No Trade and Free Trade 3. When the relative price of a bushel of corn rises from four to five barrels of oil, which country is better off and which country is worse off? Mexico is worse off because it must trade an extra 200 barrels of oil just to keep getting 200 bushels of corn from the United States.

38 Exhibit 7: Corn and Oil Consumption in the United States and Mexico, Under Conditions of No Trade and Free Trade 3. When the relative price of a bushel of corn rises from four to five barrels of oil, which country is better off and which country is worse off? The United States is better off because it gets an extra 200 barrels of oil for the same 200 bushels of corn it exports to Mexico.

39 Absolute and Comparative Advantage During the colonial period, European colonial powers used their political power to manipulate trade prices so that most all of the gains from trade were shifted to them.

40 Calculating Terms of Trade Imports Good and services bought by people in one country that are produced in other countries.

41 Calculating Terms of Trade Exports Good and services produced by people in one country that are sold in other countries.

42 Calculating Terms of Trade Terms of trade The amount of a good or service (export) that must be given up to buy a unit of another good or service (import). A country’s terms of trade is measured by the ratio of the country’s export prices to its import prices.

43 EXHIBIT 8JAPANESE MOTORCYCLE AND BOLIVIAN TIN EXPORTS

44 Exhibit 8: Japanese Motorcycle and Bolivian Tin Exports What happens to Bolivia’s terms of trade as a result of the changes shown in panels a and b in Exhibit 8? The price of Japanese motorcycles rises in panel a, while the price of Bolivian tin falls in panel b.

45 Exhibit 8: Japanese Motorcycle and Bolivian Tin Exports What happens to Bolivia’s terms of trade as a result of the changes shown in panels a and b in Exhibit 8? As a result, Bolivia’s terms of trade equation goes from (6,000/6000)x100 = 100 in 1987, to (5,000/7,500)x100 = 66.7 in 1995.

46 Exhibit 8: Japanese Motorcycle and Bolivian Tin Exports What happens to Bolivia’s terms of trade as a result of the changes shown in panels a and b in Exhibit 8? Bolivia’s terms of trade have deteriorated. Bolivia’s exports end up with only 67 percent of their former purchasing power.

47 EXHIBIT 9LDC TERMS OF TRADE FOR 1998 (1995 = 100) Source: World Development Indicators, 2000, The World Bank.

48 Exhibit 9: LDCs Terms of Trade for 1999 (1995=100) Which of the countries shown in Exhibit 9 have experienced the smallest deterioration in its terms of trade between 1995 and 1999? Ethiopia’s terms of trade declined the least during that time period.

49 EXHIBIT 10TERMS OF TRADE VOLATILITY FOR LDCS: 1990–98 (1995 = 100) Source: World Development Indicators, 2000, The World Bank.

50 Exhibit 10: Terms of Trade Volatilities for LDCs: 1998 Which of the countries shown in Exhibit 10 experienced the largest gain in their terms of trade during the 1990s? Guatemala’s terms of trade increased by 20 percent between 1990 and 1998.

51 EXHIBIT 11PERCENTAGE DISTRIBUTION OF EXPORTS TO DEVELOPED, LDCs, AND OTHER ECONOMIES: 1999 Source: Direction of Trade Statistics, Yearbook 2000 (Washington, D.C.: International Monetary Fund, 2000).

52 Exhibit 11: Percentage Distribution of Exports to Developed, LDCs, and Other Economies: 1999 What percentage of exports from LDCs actually went to other LDCs? a percent. b percent. c. 67 percent.

53 Exhibit 11: Percentage Distribution of Exports to Developed, LDCs, and Other Economies: 1999 What percentage of exports from LDCs actually went to other LDCs? b percent.

54 EXHIBIT EXPORTS AND IMPORTS OF THE MAJOR DEVELOPED ECONOMIES ($ BILLIONS) Source: Direction of Trade Statistics, Yearbook 2000 (Washington, D.C.: International Monetary Fund, 2000).

55 Exhibit 12: 1999 Exports and Imports of the Major Developed Economies ($ Billions) True or false: Japan was the world’s leading exporter among the developed countries in 1999 (measured in $). False. The United States was the world’s leading exporter.

56 EXHIBIT U.S. TRADE WITH ITS MAJOR TRADING PARTNERS ($ BILLIONS) Source: Direction of Trade Statistics, Yearbook 2000 (Washington, D.C.: International Monetary Fund, 2000).

57 Exhibit 13: 1999 U.S. Trade with Its Major Trading Partners ($ Billions) Complete the sentence: _____ was the United States’ largest trading partner in 1999 (measured in $).

58 Exhibit 13: 1996 U.S. Trade with Its Major Trading Partners ($ Billions) Complete the sentence: Canada was the United States’ largest trading partner in 1996 (measured in $).

59 Do We Need Protection Against Free Trade? 1. What is the national security argument for against free trade? Key domestic industries need to be protected so that if war breaks out with our trading partners, we are still able to produce during a time of crisis.

60 Do We Need Protection Against Free Trade? 2. What is the infant-industries argument against free trade? It takes time for new (“infant”) industries to gain expertise, and during that time it is fair and reasonable to protect those industries from international competition.

61 Do We Need Protection Against Free Trade? 3. How long should infant- industries be protected from free trade? There is no clear answer, certainly not from the industries being protected. Infant industry protection is easily abused.

62 Do We Need Protection Against Free Trade? 4. If domestic industry is not protected from imports from low- wage countries, who gains and who loses? Domestic producers and workers in this industry lose, while domestic consumers gain from lower prices.

63 Do We Need Protection Against Free Trade? Dumping Exporting a good or service at a price below its cost of production.

64 The Economics of Trade Protection? Tariff A tax on an imported good.

65 EXHIBIT 14TARIFF-RESTRICTED TRADE

66 Exhibit 14: Tariff-Restricted Trade Which of the following occur as a result of a tariff? a. Domestic prices rise. b. The quantity imported falls. c. Domestic production increases.

67 Exhibit 14: Tariff-Restricted Trade Which of the following occur as a result of a tariff? a. Domestic prices rise. b. The quantity imported falls. c. Domestic production increases.

68 The Economics of Trade Protection? Quota A limit on the quantity of a specific good that can be imported.

69 EXHIBIT 15QUOTA-RESTRICTED TRADE

70 Exhibit 15: Quota-Restricted Trade True or false: Quota protection causes domestic prices to fall and increases the quantity of imported goods. False. Quota protection increases domestic prices and limits the quantity of imports.

71 Negotiating Tariff Structures GATT (General Agreement on Tariffs and Trade) A trade agreement to negotiate reduction in tariffs and other trade barriers and to provide equal and nondiscriminating treatment among members of the agreement.

72 Negotiating Tariff Structures Customs union A set of countries that agree to free trade among themselves and a common trade policy with all other countries.

73 Negotiating Tariff Structures Free trade area A set of countries that agree to free trade among themselves but are free to pursue independent trade policies with other countries.

74 EXHIBIT 16AVERAGE U.S. TARIFF RATES ON IMPORTS Source: Economic Report of the President, January 1989 (Washington, D.C.: U.S. Government Printing Office, 1989), p. 152.

75 Exhibit 16: Average U.S. Tariff Rates on Imports What was the average U.S. tariff rate in ? a percent. b percent. c. 5.9 percent.

76 Exhibit 16: Average U.S. Tariff Rates on Imports What was the average U.S. tariff rate in ? c. 5.9 percent.