1. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. INTERNATIONAL TRADE POLICY, COMPARATIVE ADVANTAGE, AND OUTSOURCING INTERNATIONAL TRADE POLICY, COMPARATIVE ADVANTAGE, AND OUTSOURCING Chapter 16

2. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-2 Today’s lecture will: Present some important data of trade. Explain the principle of comparative advantage. Discuss three determinants of the terms of trade. Explain why economists’ and laypeople’s views of trade differ.

3. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-3 Today’s lecture will: Distinguish between inherent and transferable comparative advantages. Discuss three policies countries use to restrict trade. Explain why economists generally oppose trade restrictions. Explain how free trade associations both help and hinder international trade.

4. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-4 Differences in the Importance of Trade Total OutputExport RatioImport Ratio Netherlands$ 71063%56% Germany3,03630%31% Canada1,35732%28% Italy1,95024% France2,37022%24% United Kingdom2,55320%26% Japan4,59913%11% United States13,900 8%14%

5. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-5 U.S. Exports by Region, 2006 Canada 23% Mexico 13% European Union 21% Pacific Rim 25% Other 5% Central and South America 9% OPEC 4% Total = $1,024 billion

6. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-6 U.S. Imports by Region, 2006 Canada 16% Mexico 11% European Union 18% Pacific Rim 33% Other 7% Central and South America 7% OPEC 8% Total = $1,859 billion

7. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-7 The Changing Nature of Trade As technological changes in telecommunications reduce costs, foreign countries will be able to provide more services. Customer service calls for U.S. companies are now more frequently answered in India. This trade in services is often called outsourcing.

8. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-8 Is Chinese and Indian Outsourcing Different than Previous Outsourcing? Using overseas suppliers is not a new development in trade. The difference is the potential size of outsourcing to India and China with combined populations of 2.5 billion people. Because technology is growing in these countries, the U.S. economy must develop new technologies to remain competitive.

9. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-9 Balance of Trade Balance of trade – the difference between the value of exports and the value of imports.  Trade deficit – imports > exports  Trade surplus – exports > imports The U.S. has a significant trade deficit of approximately 5% of GDP. The U.S. is financing its trade deficit by selling off financial assets, stocks and bonds, and real assets, corporations and real estate.

10. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-10 Comparative Advantage: Saudi Arabia and the U.S. U.S. 20 406080100120140 1000 800 600 400 200 Oil Food A B C D E F Saudi Arabia Saudi Arabia has a comparative advantage in oil because it can produce 10 times as much oil as food. Saudi Arabia should produce 1000 barrels of oil. 400200 20 40 60 80 100 120 140 6008001000 Food Oil A F E D C B The U.S. has a comparative advantage in food because it can produce 10 times as much food as oil. The U.S. should produce 1000 tons of food.

11. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-11 The Gains from Trade A trader, I.T., arranges for Saudi Arabia to trade 500 barrels of oil to the U.S. for 120 tons of food. The U.S. will trade 500 tons of food to Saudi Arabia for 120 barrels of oil. I.T., the trader keeps 380 barrels of oil and 380 tons of food. Production Consumption S.A. U.S. S.A. U.S. I.T. Oil (barrels) 1000 0 500 120 380 Food (tons) 0 1000 120 500 380

12. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-12 The Gains from Trade 20 406080100120140 1000 800 600 400 200 Oil Food A B C D E F Saudi Arabia G After trade Saudi Arabia is consuming 500 barrels of oil and 120 tons of food, point G, beyond its original production possibilities. 400200 20 40 60 80 100 120 140 6008001000 Food Oil A F E D C B U.S. H After trade the U.S. is consuming 120 barrels of oil and 500 tons of food, point H, beyond its original production possibilities.

13. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-13 Comparative Advantage in Today’s Economy If trade is good, why do so many people oppose it?  The gains of trade, lower prices, are harder to see than the cost, lost jobs.  The public believes that lower wages in other countries give them the comparative advantage in everything, so we will lose all jobs.  Laypeople usually think of trade only in manufactured goods.

14. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-14 Comparative Advantage in Today’s Economy The U.S. has a comparative advantage in facilitating trade, which generates jobs in the U.S. in research, management, advertising, and the distribution of goods. Trade increases income abroad, increasing demand for U.S. exports. The concentrated nature of the costs of trade and the dispersed nature of benefits present a challenge to policy makers.

15. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-15 Other Sources of U.S. Comparative Advantage High-level skills make the U.S. labor force highly productive. U.S. physical and technological infrastructure is the best in the world. Wealth from past production makes the U.S. the world’s largest consumer. U.S. companies hold a large number of intellectual property rights. The U.S. has a relative open immigration policy.

16. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-16 Inherent and Transferable Comparative Advantage Inherent comparative advantages are based on factors that are relatively unchangeable, such as resources and climate. Transferable comparative advantages are based on factors that can change relatively easily, such as capital, technology, and types of labor. Whether a country can maintain a much higher standard of living in the long run depends in part on whether its comparative advantage is inherent or transferable.

17. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-17 The Law of One Price The law of one price – in a competitive market there will be pressure for equal factors to be priced equally. If factor prices aren’t equal, firms reduce costs by reorganizing production in countries with lower factor prices. Convergence hypothesis – the tendency of economic forces to eliminate transferable comparative advantage.

18. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-18 Methods of Equalizing Trade Balances Adjustments eventually occur to make surplus countries less competitive and deficit countries more competitive. Wages rise in the surplus countries, making their goods more expensive. The exchange rate of the deficit country falls and makes its goods less expensive.

19. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-19 Varieties of Trade Restrictions Tariffs – taxes on imports Quotas – quantity limits placed on imports Voluntary restraint agreements Embargoes Regulatory trade restrictions Nationalistic appeals

20. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-20 Tariff revenue Tariffs When the Domestic Country is Small 2.00 2.50 Initial imports Domestic supply Domestic demand $3.00 100 125 175 200 Price Quantity World price = World supply World price with tariff = $2.50 t = $.50

21. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-21 Quotas When the Domestic Country is Small Price Quantity 2.00 2.50 Quota Domestic supply Domestic demand $3.00 100 125175 200 World supply with quota World price=$2= World supply

22. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-22 Reasons for Trade Restrictions Unequal internal distribution of the trade gains Haggling by companies over the trade gains Haggling by countries over trade restrictions Specialized production: learning by doing and economies of scale Macroeconomic aspects of trade National security International politics Increased revenue from tariffs

23. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-23 Why Economists Generally Oppose Trade Restrictions Free trade increases total output globally. International trade provides competition for domestic companies. Restrictions based on national security are often abused or evaded. Trade restrictions are addictive.

24. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-24 Institutions Supporting Free Trade Free trade associations – groups of nations that allow free trade among its members and put up trade barriers against all other nations. The European Union (EU) and the North American Free Trade Association (NAFTA) are examples. Countries strengthen trading relationships with most-favored nation status – those countries will be charged as low a tariff on its exports as any other country.

25. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-25Summary The nature of trade is continually changing. The U.S. is importing more and more high-tech goods and services from India and China and other East Asian countries. Outsourcing, a form of trade, is a larger phenomenon today compared to 30 years ago because the countries where jobs are outsourced – China and India – are much larger. According to the principle of comparative advantage, as long as the relative opportunity costs of producing goods differ among countries, there are potential gains from trade.

26. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-26Summary The more competition exists in international trade, the less the trader gets and the more the involved countries get. Once competition prevails, smaller countries tend to get a larger percentage of the gains from trade than do larger countries. Gains from trade go to countries that produce goods that exhibit economies of scale. The gain from trade in the form of low consumer prices tend to be widespread and not easily recognized, while the costs in jobs lost tend to be concentrated and readily identifiable.

27. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-27Summary The United States has comparative advantages due to its skilled workforce, its institutions, and its language, among other things. The U.S. established comparative advantages during the two world wars, which is slowly eroding. Trade restrictions include tariffs and quotas, embargoes, voluntary restraint agreements, regulatory trade restrictions, and nationalistic appeals.

28. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-28Summary Economists generally oppose trade restrictions because of the history of trade restrictions and their understanding of the advantages of free trade. The World Trade Organization is an international organization committed to reducing trade barriers. Free trade associations, such as the European Union, help trade by reducing barriers to trade among member nations.

29. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 16-29 Review Question 16-1 Suppose that using all of their resources, South Carolina can produce 90 tons of apples or 30 tons of peaches in a day. Washington can produce 120 tons of apples or 15 tons of peaches in a day. Can these states benefit from trade? If so, explain why. According to the principle of comparative advantage, these states can benefit from trade. Washington should specialize in apples because they can produce 8 apples for every peach and South Carolina should produce peaches because they can only produce 3 apples for every peach. Review Question 16-2 Explain the adjustments that will eventually occur in countries that have persistent trade deficits. Deficits occur because imports are greater than exports. Wages in the deficit country will eventually fall relative to wages in surplus countries, causing costs and then prices of that country’s goods and services to decrease and exports increase. Exchange rates in the deficit country may fall, making their products cheaper in foreign countries.