Chapter 19. International Trade and Interdependence. Copyright 2011 Pearson Addison-Wesley. All rights reserved.

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1 Chapter 19 International Trade and Interdependence

2 Basic principle of Comparative Advantage A country should produce and specialize in those goods which it can produce for a lower opportunity cost than its trading partners i.e., a country should produce what it is relatively best at producing 19-2

3 Basic Principle of Comparative Advantage Even if an individual is worse at producing everything Two individuals can still benefit from trade because of differing Opportunity Costs Each individual must be relatively better at producing something 19-3

4 Graphical Illustration of Comparative Advantage: Textiles (Tons) US Textiles (Tons) Mexico 10 5 Computers (1000s) Computers (1000s) Using all of its resources, the US can produce either 10 tons of textiles or 30,000 computers. With the same resources, Mexico can produce either 5 tons of textiles or 10,000 computers. 19-4

5 Absolute Advantage Textiles (Tons) US Textiles (Tons) Mexico Computers (1000s) Computers (1000s) US has an ABSOLUTE ADVANTAGE in both goods We can produce more of both goods with the same amount of resources. But we do not have a COMPARATIVE ADVANTAGE in both goods. 19-5

6 Determining Comparative Advantage Comparative Advantage is determined by computing the opportunity cost of 1 unit of each good in each country The country with the lowest opportunity cost per unit has a comparative advantage in the production of that good i.e., it is relatively more efficient to produce that product in that country 19-6

7 T=Textiles (in tons), C=Computers (in 1000s). In the US, 10T=30C (our resources can produce either 10T or 30C). 1T=3C. In Mexico, 5T=10C. 1T=2C. So in Mexico each unit of textiles "costs" 2 computers, while in the US each unit of textiles "costs" 3 computers (1T=3C). Mexico has a COMPARATIVE ADVANTAGE in the production of textiles, because they can produce textiles for a lower opportunity cost. Textiles (Tons) US Textiles (Tons) Mexico 10 5 Computers (1000s) Computers (1000s)

8 In the US, 30C=10T so 1C=(1/3)T In Mexico, 10C=5T, so 1C=(1/2)T Thus the US has a comparative advantage in computer production because we can produce computers for a lower opportunity cost. Textiles (Tons) US Textiles (Tons) Mexico 10 5 Computers (1000s) Computers (1000s)

9 Specialization and Trade To increase efficiency, US should specialize in what we produce most efficiently (Computers) Trade computers to Mexico for what they produce most efficiently (Textiles). Both countries can trade at the international terms of trade of 1T=2.5C and both countries can be better off. International terms of trade are rate at which two goods would exchange in international markets. The international terms of trade are always given to you as part of a comparative advantage problem. 19-9

10 The Consumption Possibilities Curve Constructed by starting at the point where the country specializes entirely in the good in which they have a comparative advantage. The CPC is then extended at the international terms of trade (here 1T=2.5C or 1C=.4T) to find the point on the other axis. In the US, (30C)*(.4)T/C=12T In Mexico, (5T)*(2.5)C/T=12.5C Textiles (Tons) US Textiles (Tons) Mexico Computers (1000s) Computers (1000s)

11 Specialization & trade increases efficiency, makes both countries better off Both countries can now consume more of both goods along their consumption possibilities curves By specializing in producing the good in which they have a comparative advantage and trading this good. Textiles (Tons) Textiles (Tons) US Mexico Computers (1000s) Computers (1000s) 12.5

12 Another example of demonstrating the gains from trade using PPCs and CPCs. Before TRADE: Using a certain amount of resources, the US can produce either 1000 VCRs or 200 Computers. Question: If the price of a VCR is $200, what MUST the price of a computer be? Using the same amount of resources, Korea can produce 800 VCRs or 100 Computers. Question: If the price of a VCR in Korea is 200,000 Won, what is the price of a computer? 19-12

13 Construct Production Possibilities Curves US can produce either 1000 VCRs or 200 Computers. Korea can produce 800 VCRs or 100 Computers

14 PPCs for the US and Korea C US C Korea V V 19-14

15 Determine Comparative Advantage US: 1000V=200C Korea: 800V=100C 1V=1/5C 1V=1/8C Korea has a Comparative Adv. in VCRs 1C=5V 1C=8V US has a Comparative Adv. in Computers 19-15

16 Construct CPCs Given the international terms of trade are 1C=6V, draw Consumption Possibilities Curves (CPCs) for both countries. How do the CPCs show that both countries are better off with trade? 19-16

17 Both countries can consume more of both goods after trade (the CPCs are further out than the PPCs). ITT: (1C=6V) C US C Korea V 800 V 19-17

18 Assumptions behind the Theory of Comparative Advantage As with any theory, C.A. is based upon a series of assumptions Relaxation of these assumptions can result in an economic rationale for PROTECTION, not free trade C.A. basic premise: factor endowments drive trade flows But this is often not accurate 19-18

19 Arguments for Protectionism, Managed Trade We can lose the comparative advantages our companies developed when they move abroad Capital mobility undermines the idea that we can continue to specialize in what we create Protection can allow industries to grow and/or retool Eventually become globally competitive Some industries (those with linkages) are better than others, so we should push the economy in certain directions 19-19

20 Arguments for Protectionism, Managed Trade (continued) Some trade is unfair Dumping; exclusive arrangements, currency manipulation Which warrants protection in such cases Specialization can be dangerous 3 rd World countries specializing in primary products have been hurt by trade patterns We become more dependent on what happens elsewhere in the world 19-20

21 Benefits & Costs of Trade Significant general benefits from trade: Increased efficiency and productivity improve the standard of living of most people Specific, localized costs from trade: Particular industries, workers and towns are harmed directly by global competition (and these effects can be devastating) We have not developed an effective mechanism to use the broad-based benefits of trade to compensate for the localized costs of trade Globalization may be changing the nature of trade Undermining the power of workers so much that the benefits of trade are skewed much more toward the top 19-21

22 New issues in trade theory Economic Integration Free trade areas (lower tariffs), customs unions (common tariffs), common market (free K & L mobility), economic union (central economic coordination) Increases trade with group members Can actually reduce trade with the rest of the world US buys more textiles from Mexico, fewer from India 19-22

23 Alternatives to the Theory of Comparative Advantage The Theory of Comparative Advantage only explains a small part of US trade Import of oil, raw materials, labor-intensive goods Export of agricultural products, high tech goods, financial services But there are many exceptions We export and import cars, computers, software, music, food, etc

24 FIGURE 19.6 U.S. Goods Export & Import Shares,

25 Intra-Industry Trade We trade with countries that 1) have similar tastes 2) have similar resource endowments (lots of K) 3) are geographically close 4) are open to free trade We trade with countries that are similar to us, not those with different resource endowments, as implied by the theory of comparative advantage. Particular companies are internationally competitive 19-25

26 The Political Economy of Trade Whose interests are served by unregulated trade and free trade agreements? Which of those interests have political and economic clout? Whose interests are served by a strong dollar? Which of those interests have political and economic clout? 19-26

27 Trade policies Tariffs: per unit or ad valorem (%) P 10% tariff S(1.1) S D Q Tariffs increase the price of imported goods

28 Other trade policies Quotas, Voluntary Export Restraints Export Subsidies Changing the value of the dollar Depreciating the dollar lowers the price of US goods Increases the price of imported goods 19-28

29 FIGURE 19.1 The Rapid Growth of Globalization 19-29

30 FIGURE 19.2 Real GDP Growth

31 FIGURE 19.3 World Trade Volume (goods and services) 19-31

32 TABLE 19.1 GDP and Merchandise Trade by Region, (Annual % change at constant prices) 19-32

33 TABLE 19.2 World Merchandise Trade by Region and Selected Country, 2008 ($bn and %) 19-33

34 TABLE 19.2 (continued) World Merchandise Trade by Region and Selected Country, 2008 ($bn and %) 19-34

35 TABLE 19.2 (continued) World Merchandise Trade by Region and Selected Country, 2008 ($bn and %) 19-35

36 TABLE 19.3 World Exports of Commercial Services by Region and Selected Country, 2008 ($bn and %) 19-36

37 TABLE 19.3 (continued) World Exports of Commercial Services by Region and Selected Country,2008 ($bn and %) 19-37

38 TABLE 19.4 Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %) 19-38

39 TABLE 19.4 (continued) Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %) 19-39

40 TABLE 19.4 (continued) Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %) 19-40

41 TABLE 19.4 (continued) Merchandise Trade: Leading Exporters and Importers, 2008 ($bn and %) 19-41

42 TABLE 19.5 Leading Exporters and Importers in World Trade in Commercial Services, 2008 ($bn and %) 19-42

43 TABLE 19.5 (continued) Leading Exporters and Importers in World Trade in Commercial Services, 2008 ($bn and %) 19-43

44 FIGURE 19.4 International Trade Goods and Services, Percent of GDP 19-44

45 FIGURE 19.5 Trade Deficit in Goods and Services, Billions of Dollars, Monthly Rate 19-45

46 FIGURE 19.BP

47 TABLE 19.6 Total Country Production 19-47

48 TABLE 19.7 Total World Output Without Trade 19-48

49 FIGURE 19.7 Production Possibilities without Trade 19-49

50 TABLE 19.8 Total World Output with Specialization 19-50

51 TABLE 19.9 Total World Output with Specialization and Trade 19-51

52 FIGURE 19.8 Production Possibilities with Trade 19-52

53 FIGURE 19.9 Monthly U.S. Steel-Product Imports from China 19-53

54 19-54