1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 32 Comparative Advantage and the Open Economy

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-2 Introduction In early 2010, President Barack Obama announced his intention to double U.S. exports of goods and services by 2015. Ironically, during the same week, a report documented barriers that the Chinese government had established to hinder U.S. exports from entering China. In this chapter, you will learn how nations can gain from both exporting and importing goods and services. You will also learn about tariffs and other mechanisms that governments often utilize to reduce imports.

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-3 Learning Objectives Discuss the worldwide importance of international trade Explain why nations can gain from specializing in production and engaging in international trade Understand common arguments against free trade

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-4 Learning Objectives (cont’d) Describe ways that nations restrict foreign trade Identify key international agreements and organizations that adjudicate trade disputes among nations

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-5 Chapter Outline The Worldwide Importance of International Trade Why We Trade: Comparative Advantage and Mutual Gains from Exchange The Relationship Between Imports and Exports International Competitiveness

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-6 Chapter Outline (cont’d) Arguments Against Free Trade Ways to Restrict Foreign Trade International Trade Organizations

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-7 Did You Know That... Ford Motor Company produces small passenger vans in a factory located in Turkey and ships them to Baltimore, Maryland, where employees strip out the vehicles’ rear seats and replace their rear windows with metal panels? In this way, Ford sells the vehicles in the United States as commercial vans and it avoids a 25 percent tariff on imports of passenger vans. In this chapter, you will learn about the effects of import restrictions on quantities and prices of domestically produced goods and services.

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-8 The Worldwide Importance of International Trade World GDP today is nearly nine times greater than it was at the end of World War II World trade has increased to more than 28 times what it was in 1950

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-9 The Worldwide Importance of International Trade (cont'd) The United States has figured prominently in this expansion of world trade –Imports added up to barely 4% of annual U.S. GDP in 1950 –Today they account for almost 16%

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-10 Figure 32-1 The Growth of World Trade, Panel (a)

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-11 Figure 32-1 The Growth of World Trade, Panel (b)

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-12 Why We Trade: Comparative Advantage and Mutual Gains From Exchange We have learned about the concept of specialization and the mutual gains from trade We can understand gains from trade among nations by understanding output gains from specialization between individuals

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-13 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Scenario (8-hour day) –Ad specialist 2 pages of ad copy/hour 1 art rendering/hour –Computer artist 1 page of ad copy/hour 1 art rendering/hour

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-14 Without Trade (8-hour day) Ad SpecialistComputer Artist Copy Renderings 4 hrs × 2 = 8 4 hrs × 1 = 4 Total 4 hrs × 1 = 4 12 8 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd)

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-15 Ad copy output increases by 4 pages per day With Trade (8-hour day) Ad SpecialistComputer Artist Copy Renderings Total 8 hrs × 2 = 16 8 hrs × 1 = 8 16 8 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd)

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-16 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Comparative Advantage –The ability to produce a good or service at a lower opportunity cost compared with producers

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-17 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Specialization among nations –To demonstrate the concept of comparative advantage, consider a simple two-country, two-good world

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-18 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Production and consumption capabilities in a two-country, two-good world –We show maximum feasible quantities of software and PCs –Using all resources—land, labor, capital, and entrepreneurship

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-19 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) U.S. residents can utilize all their resources to produce 90 units of software or 225 PCs per hour Residents of India are able to utilize all their resources to produce either 100 units of software or 50 PCs per hour

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-20 Table 32-1 Maximum Feasible Hourly Production Rates of Either Commercial Software or Personal Computers Using All Available Resources

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-21 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Comparative advantage –The opportunity cost of producing a PC is lower in the United States than in India 1 PC = 0.4 units of software 1 unit of software = 2.5 PCs –The opportunity cost of producing software is lower in India than the United States 1 PC = 2 units of software 1 unit of software = 0.5 PC

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-22 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Production without trade –Table 32-2 tabulates two possible production choices –“World” output is 55 units of software and 187.5 PCs (per hour)

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-23 Table 32-2 U.S. and Indian Production and Consumption Without Trade

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-24 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) The United States and India will specialize in activities with which they experience a lower opportunity cost In other words, they will specialize in the activity in which they have a comparative advantage

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-25 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Specialization in production –United States will specialize Produce 225 PCs, and no software –India will specialize Produce 100 software units, and no PCs

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-26 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Consumption with specialization and trade –The United States is willing to buy 1 unit of Indian software as long as they provide in exchange no more than 2.5 PCs This is the United States’ opportunity cost of producing 1 unit of software at home

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-27 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Consumption with specialization and trade –India buys a PC from the United States in exchange for no more than 2 units of software This is India’s opportunity cost of producing a PC at home

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-28 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Residents of the two nations agree to a rate of exchange of 1 PC for 1 unit of software –Proceed to trade 75 U.S. PCs for 75 units of Indian software

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-29 Table 32-3 U.S. and Indian Production and Consumption with Specialization and Trade

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-30 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) By specializing and engaging in trade: –The United States consumes 75 units of software imported from India and consumes 150 PCs produced at home –Indian residents consume 25 units of software produced at home and import 75 PCs from the United States

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-31 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Gains from trade –The United States’ gain from specialization and trade is 45 units of software –India can consume 37.5 more PCs –These are net gains

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-32 Table 32-4 National and Worldwide Gains from Specialization and Trade

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-33 International Example: Gains from International Trade in Used Merchandise Sofronis Clerides of the University of Cyprus has estimated the gains to residents of Cyprus from a decision by the Cypriot government to legalize imports of used Japanese cars. He finds that the typical buyer of a used imported vehicle realized a gain from trade of about $2,000.

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-34 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Specialization is the key –Specializing in producing goods for which a nation has a comparative advantage allows for greater efficiency –Production capabilities increase, making possible greater worldwide consumption through international trade

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-35 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Observations on specialization and trade –Not everyone gains from trade –Cannot “run out of exports” –Every country will always have a comparative advantage in something

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-36 Why We Trade: Comparative Advantage and Mutual Gains From Exchange (cont'd) Other benefits from international trade: the transmission of ideas –New goods, services spread –New processes transmitted –Intellectual property introduced

37. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-37 Figure 32-2 World Trade Flows

38. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-38 Why Not … obtain gains from trade by subsidizing exports and discouraging imports? Government subsidies for exports and policies induce domestic and foreign firms to specialize in production of items based on government incentives or disincentives rather than actual opportunity costs (comparative advantages). As a consequence, industries receive transfers from taxpayers, but society as a whole does not experience true gains from trade.

39. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-39 The Relationship Between Exports and Imports In the long run, imports are paid for by exports Any restrictions on imports ultimately reduce exports When a country engages in trade, it is not competing against the other countries All nations stand to benefit from trade

40. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-40 International Competitiveness Questions –Is the United States falling behind? –Do we need to stay competitive internationally? –What does global competitiveness really mean?

41. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-41 International Competitiveness (cont'd) Answer –The United States leads in overall productive efficiency, according to the Institute for Management Development in Lausanne, Switzerland

42. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-42 International Competitiveness (cont'd) Reasons for this ranking: –Widespread entrepreneurship –Economic restructuring –Investment in information-technology –Sophisticated financial system –Large investments in scientific research

43. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-43 International Example: Can Africa’s International Competitiveness Be Improved? Despite abundant resources in the heart of Africa, most African railways and roads are in poor conditions, leading to high transportation costs and a long time in shipping containers. A French firm, Bolloré, is trying to improve Africa’s international competitiveness by creating “trade corridors” of riverways that can substantially reduce shipping times and costs.

44. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-44 Arguments Against Free Trade Infant Industry Argument –The contention that tariffs should be imposed to protect from import competition an industry that is trying to get started –Presumably, after the industry becomes technologically efficient, the tariff can be lifted

45. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-45 Arguments Against Free Trade (cont'd) Dumping –Selling a good or a service abroad below the price charged in the home market or at a price below its cost of production

46. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-46 Arguments Against Free Trade (cont'd) Protecting domestic jobs –Do imports reduce jobs? Gould/Woodbridge/Ruffin study – no casual link between the rate of imports and unemployment In half of the cases studied, when imports rose, unemployment fell

47. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-47 Arguments Against Free Trade (cont'd) The cost of protecting U.S. jobs –Restrictions on textiles and apparel goods cost U.S. consumers $9 billion a year Cost $50,000 a year for each $20,000 job saved –Restriction on imports of Japanese cars Cost $160,000 per year for each job saved in the auto industry

48. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-48 Arguments Against Free Trade (cont'd) The cost of protecting U.S. jobs –Glass industry restrictions Cost $200,000 per year per job saved –Steel industry restrictions Cost $750,000 per year per job saved

49. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-49 Arguments Against Free Trade (cont’d) Emerging arguments against free trade –Environmental concerns –Genetic engineering –New diseases National defense –Exports of new technology

50. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-50 Ways to Restrict Foreign Trade Quota System –A government-imposed restriction on the quantity of a specific good that another country is allowed to sell in the United States –In other words, quotas are restrictions on imports, usually applied to one or several specific countries

51. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-51 Figure 32-3 The Effect of Quotas on Textile Imports

52. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-52 Ways to Restrict Foreign Trade (cont’d) Voluntary quotas –Voluntary Restraint Agreement (VRA) An official agreement with another country that “voluntarily” restricts the quantity of its exports –Voluntary Import Expansion (VIE) An official agreement with another country in which it agrees to import more from the United States

53. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-53 Ways to Restrict Foreign Trade (cont'd) Tariffs –Tax on imported goods Benefits import-competing industries Harms consumers by raising prices

54. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-54 Figure 32-4 The Effect of a Tariff on Japanese- Made Laptop Computers, Panel (a) Japanese-made notebook computers

55. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-55 Figure 32-4 The Effect of a Tariff on Japanese- Made Laptop Computers, Panel (b) U.S.-made notebook computers

56. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-56 Ways to Restrict Foreign Trade (cont'd) Tariffs in the United States –Have varied widely on imported goods –Highest rates in twentieth century occurred with passage of Smoot-Hawley Tariff in 1930

57. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-57 Ways to Restrict Foreign Trade (cont’d) The Trade Expansion Act of 1962 gave the president the authority to reduce tariffs by up to 50% The Trade Reform Act (1974) allowed further reductions The Trade and Tariff Act (1984) resulted in the lowest tariff rates ever

58. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-58 Ways to Restrict Foreign Trade (cont’d) All of these trade agreement obligations were carried out under the General Agreement on Tariffs and Trade (GATT) –An international agreement established in 1947 to further world trade by reducing barriers and tariffs –The GATT was replaced by the World Trade Organization in 1995

59. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-59 Figure 32-5 Tariff Rates in the United States Since 1820

60. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-60 Ways to Reduce Foreign Trade (cont’d) General Agreement on Tariffs and Trade –An international agreement established in 1947 to further world trade by reducing barriers and tariffs –GATT was replaced by the World Trade Organization in 1995 –In 2002, the U.S. government proposed eliminating all tariffs on manufactured goods by 2015

61. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-61 International Trade Organizations The World Trade Organization (WTO) –The successor organization to GATT that handles trade disputes among its member nations

62. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-62 International Trade Organizations (cont'd) The World Trade Organization (WTO) –Most important international trade organization, with largest membership –Fostered most important and far-reaching global trade agreement covering Financial institutions; including banks, insurers and investment companies

63. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-63 International Trade Organizations (cont'd) Regional Trade Bloc –A group of nations that grants members special privileges –Examples include the European Union, NAFTA, and the Association of Southeast Asian Nations

64. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-64 International Trade Organizations (cont'd) Some economists worry that regional blocs could lead to a reduction in members’ trade with nations outside their blocs Trade Diversion – the shifting of trade from countries outside a regional trade bloc to nations within a bloc Most evidence, however, indicates that regional trade blocs have promoted trade instead of hindering it

65. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-65 International Trade Organizations (cont'd) Numerous studies have found that as countries from around the world have become more open to trade, they have tended to join regional trade blocs that promote even more openness

66. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-66 International Trade Organizations (cont'd) Trade Deflection –Moving partially assembled products into a member nation of a regional trade bloc, completing assembly, and then exporting them to other nations within the bloc, so as to benefit from preferences granted by the trade bloc –The primary issue associated with regional trade blocs

67. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-67 International Trade Organizations (cont'd) Rules of Origin –Regulations that nations in regional trade blocs establish to delineate product categories eligible for trading preferences –Used in regional trade agreements in order to reduce incentives for trade deflation

68. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-68 Figure 32-6 The Percentage of World Trade Within Regional Trade Blocs

69. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-69 International Policy Example: Does the Spread of Regional Trade Blocs Reduce Protectionism? Scott Baier of Clemson University and Jeffrey Bergstrand of the University of Notre Dame found that within a few years after nations join regional trade blocs, their governments gradually tend to become less protectionist. Thus, the overall net effect of joining a regional trade bloc is greater trade with nations outside the bloc as well as with countries that are co- members of the bloc.

70. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-70 You Are There: Union Workers Find Themselves on Opposing Sides on Trade Recently, the U.S. government passed a law that prohibits Mexican commercial trucks from traveling on U.S. highways. This law may prevent Mexican truckers from competing with U.S. truckers as intended, thus perhaps saving some American jobs. However, as the Mexican government has retaliated for the ban on Mexican trucks by imposing tariffs on Mexican imports of U.S.- manufactured paper, workers in the paper industry may suffer.

71. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-71 Issues & Applications: A U.S. Effort to Expand Exports While Reducing Imports President Obama has announced a trade policy to double U.S. exports by 2015. Some of his advisors have suggested that the government should “promote exports” by increasing export subsidies. A few months before the trade policy announcement, the U.S. government imposed a new 35 percent tariff on Chinese-manufactured tires.

72. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-72 Issues & Applications: A U.S. Effort to Expand Exports While Reducing Imports (cont’d) Gains from trade are not achieved by promoting certain industries and protecting others: –Policies to promote exports, such as subsidies, transfer resources from taxpayers to subsidized firms. –Policies to reduce imports, such as tariffs, directly inhibit the realization of gains from trade by restraining domestic consumption possibilities.

73. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-73 Summary Discussion of Learning Objectives Worldwide importance of international trade –World trade has grown faster than total world GDP Why nations can gain from specializing in production and engaging in trade –Comparative advantage

74. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-74 Summary Discussion of Learning Objectives (cont'd) Arguments against free trade –Infant industry –Dumping –Environmental concerns –National defense Ways that nations restrict foreign trade –Tariffs –Quotas

75. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 32-75 Summary Discussion of Learning Objectives (cont'd) Key international agreements and organizations –GATT –WTO –More than 230 regional trade blocs NAFTA European Union