International Trade. Chris Edmond NYU Stern. Spring 2007

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1 International Trade Chris Edmond NYU Stern Spring

2 Talking points: Lou Dobbs Television host and vocal critic of exporting jobs : The shipment of American jobs to cheap foreign labor markets threatens not only millions of workers and their families, but also threatens the American way of life. Corporate raiders are breaking down our borders in search of the lowest-price labor available anywhere in the world. For the first time in history, corporations are laying off Americans from well paying jobs and replacing them with low-paid foreign workers... Corporate America isn t doing all this alone: Big business and Washington are in cahoots, trading our nation s livelihood for short-term gain. 2

3 Talking points: Greg Mankiw Professor of Economics, Harvard, and former Bush advisor: The movement of US factory jobs and white-collar work to other countries is part of a positive transformation that will enrich the US economy over time, even if it causes short-term pain and dislocation... Outsourcing is just a new way of doing international trade. More things are tradable than in the past, and that s a good thing. 3

4 Today Overview a parable reasons to trade and gains from trade absolute versus comparative advantage Ricardo s trade model absolute versus comparative advantage painful algebra Trade policy 4

5 A parable I use skilled workers and still to produce cars Great news! I have invented a new way to build a manufacturing plant: can produce same number of cars with fewer workers Price of progress: thousands of workers lose jobs. But after pain and dislocation, most workers get new jobs in other sectors of the economy Gain: consumers get cheaper cars and economy produces more of everything I am an American business hero, yes? The Henry Ford of this era? 5

6 A parable Sorry. I lied. I didn t invent anything All I did was secretly ship the steel to Japan get them to make the autos then imported them back to sell to American consumers I guess I m not an American business hero after-all? Why surely the outcome is just the same? 6

7 Why trade anyway? Countries have different preferences technologies relative amounts of capital and labor input endowments of natural resources, etc We will study differences in technologies (the Ricardian model) but similar arguments apply in all cases 7

8 Gains from trade Benefits from trade consumers buy products from cheaper source, this increases their standard of living scarce resources allocated to most efficient use, this increases aggregate productivity (and average real wages) On average, both countries benefit from trade But does not mean every individual person in both countries benefits Subtle issues of how the aggregate gains from trade are distributed (trade policy) 8

9 Ricardo s trade model: basics Two countries (US, Mexico), two goods (manufactures, services) One input (labor) used to produce both goods Relative productivities different across countries Key idea: trade allows each country to specialize in what it s relatively best at allows scarce labor in each country to be used to best effect increases aggregate productivity in each country both countries better off in aggregate Who specializes in what determined by relative productivities (comparative advantage) 9

10 One unit of labor produces... Absolute advantage Services Manufactures US 20 5 Mexico

11 One unit of labor produces... Absolute advantage Services Manufactures US 20 5 Mexico 5 10 US has absolute advantage in services Mexico has absolute advantage in manufactures Adam Smith s logic: each country should specialize in producing the good in which it has an absolute advantage Problem: what if a country never has an absolute advantage? Is trade bad for that country? 11

12 Problem? One unit of labor produces... Services Manufactures US Mexico 5 5 US has absolute advantage in both manufactures and services Mexico has absolute advantage in nothing 12

13 One unit of labor produces... Comparative advantage Services Manufactures US Mexico 5 5 Ricardo s insight: only comparative advantage matters United States: is 4 times as productive in services is 2 times as productive in manufactures i.e., has a comparative advantage in services i.e., opportunity cost of producing manufactures is high 13

14 Specialization and trade Why does only comparative advantage matter? Countries can specialize and then trade if both countries specialize, production of all goods increase trade allows increase in production of all goods to be shared Details of calculations next 14

15 Who agrees with the following? Comparative advantage we should export goods and services that we can make more efficiently than other countries can make them we should import goods and services that we can make less efficiently than other countries can make them 15

16 Who agrees with the following? NO! Comparative advantage we should export goods and services that we can make more efficiently than other countries can make them we should import goods and services that we can make less efficiently than other countries can make them we should export goods and services that we can make more efficiently than we can make our average good or service we should import goods and services that we can make less efficiently than we can make our average good or service 16

17 Ricardo s trade model: details Each good produced with labor and sector-specific productivity Y M = A M L M Y S = A S L S Total labor force L with L M + L S = L Production possibilities Y M A M + Y S A S = L Internal opportunity cost, measured by slope of production possibility frontier Y S = A S L A S A M Y M (relative productivities) 17

18 Production possibilities Y S Production possibilities frontier Y S = A S L A S A M Y M A S L slope is A S A M A M L Y M 18

19 Production possibilities Example: as before, one unit of labor produces Services Manufactures A S for US US 20 5 A M for US A S for Mexico A Mexico 5 10 M for Mexico 19

20 Relative productivities and prices How should labor be allocated? an investment problem where are the returns greatest? if labor switched from manufactures to services dy S dy M = A S A M when is this worthwhile? when return is high enough! i.e., when p M p S > A S A M For open economy, relevant return is world relative price 20

21 Consumers maximize utility Consumers preferences represented by utility function u(c M, C S ) = C θ M C 1 θ S, 0 < θ < 1 subject to budget constraint p M C M + p S C S = wl choosing C M, C S to max utility subject to constraint gives demand functions C M = θ wl p M C S = (1 θ) wl p S 21

22 Firms maximize profits Firms maximize profits Profits M = p M A M L M wl M Profits S = p S A S L S wl S if both produced (they need not be!) p M A M = w p S A S = w 22

23 Equilibrium Consumers maximize utility Firms maximize profits Prices are such that markets clear if no trade if free trade C M = Y M C S = Y S CM = Y M CS = YS C M + C M = Y M + Y M C S + C S = Y S + Y S 23

24 Numerical example: inputs UNITED STATES MEXICO A M 10 5 A S 20 5 L θ

25 Numerical example: outcomes p S /p M w C M C S p S /p M w CM CS No Trade Free Trade UNITED STATES (dollar) MEXICO (peso)

26 Numerical example: outcomes p S /p M w C M C S p S /p M w CM CS No Trade Free Trade UNITED STATES (dollar) 1.00 (dollar) MEXICO (peso) 0.33 (dollar)

27 Numerical example: jobs and net exports No Trade Free Trade M S M S UNITED STATES Employment Production Consumption Net exports MEXICO Employment Production Consumption Net exports

28 What have we learned so far? Trade increases production and consumption of both goods (expanded possibilities due to specialization) Average productivity determines a country s real wages Relative productivities determine which country produces what goods Trade acts like a sector-specific productivity shock induces reallocation of labor across sectors US specializes in services (manufacturing jobs lost) Mexico specializes in manufactures (service jobs lost) but average real wages increase Next: distributing the gains from trade 28

29 Policy questions Is trade beneficial for all countries? yes Are gains uniformly distributed across countries? no: does this matter? In each country, does everybody gain? no: some win and some lose, but the winners win more than the losers lose Who wins and who loses? 29

30 Why are so many against trade? Losses are visible and concentrated e.g., whole industries lost Gains are less evident and dispersed consumers pay lower prices of goods and services other companies pay less for inputs Example: US steel tariffs 30

31 Trade policies Many ways to restrict trade tariffs (taxes on imported goods) quotas (on imported goods) subsidies to domestic producers health and safety standards, environmental standards, etc Are any of these a good idea? When? 31

32 Tariffs Are tariffs good for us? higher prices for consumers and for producers using intermediate goods inefficient production: distorts allocation of demand, supply note: true even if other countries use tariffs Bastiat: rocks in the harbor! 32

33 Should we subsidize local producers? Subsidies helps them compete with foreign producers costs consumers money maybe better than tariffs, but only if done in a lump-sum fashion (so prices are not distorted) 33

34 Agricultural subsidies Subsidy per Farmer Norway $33,000 Switzerland $32,000 Japan $26,000 United States $21,000 European Union $17,000 Source: Economist Intelligence Unit,

35 Agricultural subsidies Some examples US spends $10.7 million per day subsidizing cotton farmers (3 times total aid to sub-saharan Africa) EU dairy subsidy per cow $913 (114 times per capita aid to sub-saharan Africa) Japan dairy subsidy per cow $2700 (5 times per capita income in sub-saharan Africa) In total, rich countries spend $311 billion subsidizing farmers against $52 billion in aid to all countries 35

36 Offshoring What do you think? 36

37 The biggest absolute offshorers Millions of US dollars Rank Country Business Services Rank Country 1 United States 40,929 2 Germany 39,113 3 Japan 24,714 4 Netherlands 21,038 5 Italy 20,370 6 France 19,111 9 United Kingdom 16, India 11, China 7, Russia 4,583 Computer and Information Services Source: Amiti and Wei. 37

38 The biggest absolute offshorers Millions of US dollars Rank Country Business Services Rank Country Computer and Information Services 1 United States 40,929 1 Germany 6,124 2 Germany 39,113 2 United Kingdom 2,602 3 Japan 24,714 3 Japan 2,148 4 Netherlands 21,038 4 Netherlands 1,586 5 Italy 20,370 5 Spain 1,572 6 France 19,111 6 United States 1,547 9 United Kingdom 16,184 9 France 1, India 11, China 1, China 7, Russia Russia 4,583 Source: Amiti and Wei. 38

39 The biggest relative offshorers Percentage of local GDP Rank Country Business Services Rank Country Computer and Information Services 1 Angola Cyprus Congo Luxembourg Mozambique Moldova Ireland Belgium Vanuatu Guyana India Germany Germany Russia France United Kingdom Russia China United Kingdom France China Japan Japan United States United States 0.39 Source: Amiti and Wei. 39

40 The biggest absolute inshorers Millions of US dollars Rank Country Business Services Rank Country Computer and Information Services 1 United States 58,794 1 Ireland 10,426 2 United Kingdom 36,740 2 United Kingdom 5,675 3 Germany 27,907 3 United States 5,431 4 France 20,864 4 Germany 5,185 5 Netherlands 20,074 5 Spain 2,487 6 India 18, France 1,191 8 Japan 17, Japan 1, China 10, China Russia 2, Russia 137 Source: Amiti and Wei. 40

41 The biggest relative inshorers Percentage of local GDP Rank Country Business Services Rank Country Computer and Information Services 1 Vanuatu Ireland Singapore Cyprus Hong Kong Luxembourg Papua New Guinea Costa Rica Luxembourg Belgium India United Kingdom United Kingdom Germany France France Germany United States China China Russia Russia United States Japan Japan 0.44 Source: Amiti and Wei. 41

42 Business services Billions of US dollars Source: Amiti and Wei. 42

43 Computer and information services Billions of US dollars Source: Amiti and Wei. 43

44 Bottom line In dollar terms But the US is a big offshorer of services offshoring of services has been steadily increasing as a share of GDP, services offshoring is a very small deal the US is a net inshorer of services and the balance has been moving in the US s favor for decades 44

45 Talking points Free trade is beneficial only if your country is strong enough to stand up to foreign competitors. First it was manufacturing jobs to go. Now it is service jobs. What next? Soon there won t be enough jobs left for us? 45

46 Talking points Free trade is beneficial only if your country is strong enough to stand up to foreign competitors. First it was manufacturing jobs to go. Now it is service jobs. What next? Soon there won t be enough jobs left for us? Does trade cost us jobs? trade is about what the jobs are, not how many trade is a small factor in overall job creation and destruction: in US, about 7 million people become unemployed and 7 million people become employed every quarter... 46

47 Talking points Foreign competition based on low wages is unfair and hurts our workers 47

48 Talking points Foreign competition based on low wages is unfair and hurts our workers but remember: their real wages are low because their productivity is low... 48

49 Talking points Trade exploits workers in undeveloped countries, forcing them to work for lower wages and in worse conditions than their counterparts in the developed world 49

50 Questions for you Would you hire workers for $2 a day in Cambodia? pollute developing country, even though obeying their environmental laws? outsource to a foreign company that uses prison labor? bribe local officials to counter bribes by competitors? 50

51 What have we learned today? In aggregate free trade benefits all countries consumers buy from cheapest source specialization in goods and services with comparative advantage inputs allocated to most efficient uses, productivity increases But within each country most people (e.g., all consumers) gain some people (e.g., displaced workers) lose gains are larger than losses key issue: how to compensate losers and so make transition as painless as possible 51

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