1. Chapter 18: International Trade

2. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 2004 Trade Facts Principal U.S. trade exports include chemicals, semiconductors, consumer durables, computers and generating equipment. Principal imports include automobiles, petroleum, computers, household appliances, and clothing. Canada is the U.S.’s most important trading partner.

3. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 2004 Trade Facts The U.S. has a sizable trade deficit with China. The U.S. dependence on foreign oil is reflected in its trade with members of OPEC. The U.S. leads the world in the combined volume of exports and imports. Exports of goods and services make up about 10% of total U.S. output.

4. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Comparative Advantage and Specialization Specialization and trade increase the productivity of a country’s resources and allow for greater total output and income. Comparative advantage allows us to determine who should produce what. Specialization results in more efficient production. The terms of trade, or the rate at which units of one product can be exchanged for units of another product, can make both countries better off.

5. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example Consider two goods, avocados and soybeans, produced by two countries, Mexico and the U.S. Suppose that each country must give up a constant amount of one product to secure a certain increment of the other product. This is called constant costs. Furthermore, assume that both countries’ labor forces are of equal size.

6. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example Table 18.1 Table 18.2

7. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example A country has an absolute advantage if can produce more of a product than another country given its fixed resources in a specified time period. A country has a comparative advantage if it has a lower relative or comparative cost than that of another country.

8. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example The U.S. has an absolute advantage in producing both products since it can produce more of both goods than Mexico, assuming that the labor forces are of equal size. The U.S. can produce 30 tons of soybeans while Mexico can produce 15 tons. Also, the U.S. can produce 90 tons of avocados compared to Mexico’s 60 tons.

9. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example The U.S. has a comparative advantage over Mexico in soybeans. For the U.S., 1S ≡ 3A; for Mexico, 1S ≡ 4A Soybeans are relatively cheaper in the U.S. Mexico has a comparative advantage over the U.S. in avocados. 1 ton of avocados costs 1/4 ton of soybeans in Mexico, which is less than the cost in the U.S. (1A ≡ 1/3S).

10. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Production Possibilities Analysis Example If the U.S. specializes in soybean production while Mexico specializes in avocado production and both agree on the terms of trade, both countries will gain from specialization and trade.

11. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Trade with Increasing Costs If resources are no longer perfectly substitutable between alternative uses, resources less and less suitable to the production of one good must be allocated to the production of the other good in expanding the other good’s output. The primary effect of increasing opportunity costs is less-than-complete specialization.

12. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Foreign Exchange Market A foreign exchange market is a market in which foreign currencies ware exchanged and relative currency prices are established. An exchange rate is the rate at which one currency trades for another. Buyers and sellers interacting in international markets will exchange currencies through the foreign exchange market.

13. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Exchange Rates In the market for foreign currency, the intersection of the demand for foreign currency and the supply of foreign currency determine the exchange rate.

14. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Exchange Rates

15. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Depreciation ad Appreciation Depreciation (of a currency) means a decrease in the value of a currency relative to another currency Appreciation (of a currency) means an increase in the value of a currency relative to another currency

16. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Determinants of Exchange Rates Factors that cause a country’s currency to appreciate or depreciate are: Tastes Relative Income Relative Price Levels Relative Interest Rates Speculation

17. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Government and Trade Governments sometimes try to restrict the free flow of imports or encourage exports in order to protect domestic industries.

18. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Government and Trade Trade protections and subsidies are designed to shield domestic producers from foreign competition. These include: tariffs import quotas nontariff barriers (NTBs) voluntary export restriction (VER) export subsidies

19. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Economic Impact of Tariffs Direct Effects Higher prices reduce quantity demanded but increase quantity supplied. Foreign producers are hurt by tariffs. Government gains revenue from tariffs.

20. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Economic Impact of Tariffs Indirect Effects Domestic firms using the protected good as inputs are hurt. Competition is reduced in protected industries. Foreigners sell fewer imports; thus, they buy fewer exports. As a result, U.S. export industries earn less. Tariffs reduce efficiency and the world’s real output.

21. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Net Costs of Tariffs The gains that U.S trade barriers produce for protected industries and their workers come at the expense of much greater losses for the entire economy. The result is economic inefficiency.

22. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Three Arguments for Protection Three arguments for trade protection have persisted for decades in the U.S. They are: Increased Domestic Employment Argument Cheap Foreign Labor Argument Protection-against-Dumping Argument Dumping: the sale of products in a foreign country at prices either below costs or below the price charged at home.

23. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Trade Adjustment Assistance In 2002, the U.S. passed the Trade Adjustment Assistance Act, which aids workers affect by international trade. Workers displaced by imports or plant relocations abroad may qualify. Assistance comes in the form of cash, education and training benefits, health care subsidies, and wage subsidies for those age 50 and older.

24. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Multilateral Trade Agreements and Free-Trade Zones One of the benefits of free trade is lower tariffs. Countries have come together to create multilateral trade agreements and free- trade zones (or trading blocs) to help reduce or eliminate barriers to trade.

25. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Multilateral Trade Agreements and Free-Trade Zones General Agreement on Tariffs and Trade (GATT) 1947-1993 World Trade Organization, (WTO) 1993 GATT’s successor European Union Trade bloc, or free-trade zone North American Free Trade Agreement (NAFTA) 1993

26. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. U.S. Trade Deficits The U.S. has experienced large and persistent trade deficits since 1994. In 2004, the trade deficit on goods was $665 billion and the trade deficit on goods and services was $617 billion.

27. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Causes of the Trade Deficits There are several reasons for these large trade deficits: Strong growth in U.S. income that accompanies economic growth resulting in increased spending on imported goods Large trade deficits with China have emerged A declining U.S. saving rate

28. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Implication of U.S. Trade Deficits Increased Current Consumption The U.S. receives more goods and services from abroad, thus augmenting the standard of living. Increased U.S. Indebtedness Trade deficits must be financed by borrowing from the rest of the world, selling off assets, or dipping into foreign currency reserves. Downward Pressure on the Dollar The dollar depreciates as dollars flood the currency market.