International Trade

Chapter 31

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

1. Summarize the history of U.S. trade.

2. Explain the relationship between specialization and exchange.

3. Define and differentiate between absolute and comparative advantage.

4. List and evaluate arguments for protection.

5. Compare the advantages and disadvantages of tariffs vs. quotas.

6. List and discuss the causes of our trade imbalance.

7. Compare the causes of our trade deficits with Japan and China.

8. Differentiate between free trade in word and deed.

9. Explain how we can reduce our trade deficit.

10. Evaluate the pros and cons of a “Buy American” policy.

11. List and discuss the effects of globalization on our economy.

After this chapter, you should be able to:

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A Brief History of U.S. Trade

U.S. ran trade surpluses before 1975 and deficits after 1975.

U.S. faced increasing trade competition in the 1960s.

U.S. has large, growing trade surpluses on services and large, growing trade deficits on goods.• Trade deficit reached - $708 billion in 2007 before

rebounding a bit in the Great Recession.

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U.S. Balance of Trade, 1970-2009 (in billions)

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U.S. Balance of Trade, 2009

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U.S. Government Trade Policy

Tariff: a tax on imported goods Initially used in U.S. as revenue-raising device After the War of 1812, industries found it hard to meet

British competition. First “protective” tariff in 1816 Tariffs fluctuated widely from 1820s to 1930s;

downward trend after 1930. Today, tariffs average less than 5% of the price of

imported, durable goods. Contemporary support for “free trade” or “fair trade”

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U.S. Tariffs, 1820-2009

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The Theory of International Trade

Specialization and exchange is the basis for international trade.

Based on production possibilities:• Country A specializes in making the products that it can

make most cheaply.• Country B does the same.• When they trade, each country will be better off than they

would if they didn’t specialize and trade.

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Absolute and Comparative Advantage

Absolute advantage: the ability of one country to produce a good/service using fewer resources (at a lower cost) than another country.

• E.g. Brazil can produce more cell phones per hour than Argentina; Argentina can produce more PlayStations per hour than Brazil.

• Idea from Adam Smith

The law of comparative advantage: total output is greatest when each product is made by the country that has the lowest opportunity cost.

• E.g. Even if the U.S. is better at producing rice and refrigerators than Japan, it would be better each focused on what it does relatively better and trade.

• Idea from David Ricardo

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Production Possibilities Curves

At full capacity, Peru can produce 80 bushels or corn or 40 cameras;Pakistan can produce 40 bushels of corn or 80 cameras.

Both countries will gain from trade.

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Production Possibilities Curves

Pakistan can specialize in cameras (point H) and trade;Peru can specialize in corn (point C) and trade.Let’s look at the situation before and after trade.

Before trade: points D and G

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Production and Consumption After Specialization and After Trade

After Specialization: After Trade:

If the terms of trade are 1 camera for 1 bushel of corn, PakistanWill send 40 cameras in exchange for 40 bushels of corn.

Both gained from trade. How much?

Recall that before Specialization (points D and G):

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Questions for Further Discussion

Which country has a comparative advantage in cars and which in TVs?

Suppose the terms of trade were 5 TVs for 2 cars. Why would it pay for France to trade 2 cars in exchange for 5 TVs?

Answer: If France produced both cars and TVs, for every 5 TVs, it would be making 2.5 cars. But if France traded with Spain, France could trade only 2 cars and get 5 TVs in exchange.

France Spain

Cars 10 5

TVs 20 15

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Two General Observations

1. No nation will engage in trade with another nation unless it will gain by that trade.

2. The terms of the trade will fall somewhere between the domestic exchange equations of the two trading nations.

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Absolute Advantage versus Comparative Advantage

Absolute advantage is a comparison of the cost of production in 2 different countries.

Comparative advantage states that total output is greatest when each product is made by the country that has the lowest opportunity cost.

As long as the relative opportunity costs of producing goods differ among nations, there are potential gains from trade even if one country has an absolute advantage in producing everything.

Therefore absolute advantage is not necessary for trade to take place but comparative advantage is.

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The Arguments for Protection

There are four main arguments for protection• Each seems plausible and strikes a responsive chord in

the minds of the American public.• Closer scrutiny will reveal that all four arguments are

essentially pleas by special interest groups for protection against more efficient competitors.

1. The National Security Argument2. The Infant Industry Argument3. The Low-Wage Argument4. The Employment Argument

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1. The National Security Argument

Our dependence on foreign suppliers could make us vulnerable in time of war.

• It is possible that we need to maintain certain defense-related industries.

• What if we depended on foreign suppliers for critical components of entire weapons systems?

• The continued spread of nuclear arms technology may soon make the national security argument much more relevant.

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2. The Infant Industry Argument

American products are no longer produced by infant industries being swamped by foreign giants.

About the best that can be said is that some of our infant industries never matured while others have evolved into senility.

• Textiles, steel, clothing, and automobiles may be in the senile category.

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3. The Low-Wage Argument

How can American workers compete with foreigners who are paid sweatshop wages in labor intensive industries?

• There is no reason for American firms to compete with foreign firms in these industries.

• We should import labor-intensive goods and produce goods and services in which we can excel and compete.

• We should use the proceeds to buy the goods and services produced by people who are forced to work for very low wages.

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4. The Employment Argument

The flood of imports throws millions of Americans out of work.

• But if we restrict imports, the governments of our foreign competitors will restrict our exports.

• By curbing imports, we will be depriving other nations of the earnings they need to buy our exports.

• If we restrict our imports, our exports will go down as well. We would just lose the jobs connected with these lost

exports. Which would be best? Lose the jobs of workers who work

for companies who can’t or won’t compete or lose the jobs of workers who work for companies who can compete but can’t export their products because of restrictions we ourselves caused?

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Tariffs or Quotas?

Tariff: a tax on imports• The government gets the resulting revenue,• Affects all foreign sellers equally. Efficient foreign producers

will be able to pay a uniform tariff; less efficient producers will not.

Quota: a limit on the import of certain goods• Produces no federal revenue.• Directed against particular sellers on an arbitrary basis.• May allow relatively inefficient producers in and keep out

more efficient producers.

Both tariffs and quotas raise the price that consumers in the importing countries must pay.

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Tariffs or Quotas?

A tariff, like any other excise tax, causes a decrease in supply.

Tariffs are considered better than quotas.

Economists call for as much “free trade” as possible.

Tariff = $50 S1 to S2

Price rises from $200 to $245Q falls from 2.25 to 21. million

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What Are the Causes of Our Trade Imbalance?

1. We are a nation of consumption junkies.• We are borrowing over $2B a day to finance consumption; we are

poor savers.

2. Huge imports of oil

3. Our failing educational system• Many of our STEM students are foreigners.

4. Multinationals in pursuit of low-wage labor

5. Relative growth rate• Countries with high growth rates (U.S. from 1995 – 2007) have

high imports.

6. Our shrinking manufacturing base since the 1960s• Also, in recent years, the high value of the U.S. dollar vis-à-vis the

Chinese yuan has made the price of U.S. exports relatively high.

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Our Trade Deficit with Japan and China

Many goods made in other parts of Asia are now manufactured in China.

Japan tries to compete aggressively on both price and quality (pick winners; emulate best practices).

Our trade deficits with these 2 countries, especially China, have risen.

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U.S. Trade Deficit with Japan and China, 1995-2009

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Japanese Trading Practices

The Japanese consumer has long accepted a lower standard of living because it was necessary for the greater economic good.

• They are willing to pay more for goods they produce when they could have them cheaper if they imported the same good.

• Can you imagine Americans being willing to make that kind of sacrifice?

Americans would not stand for restricting Japanese imports because they are addicted to Japanese goods.

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Trade with China and Japan, cont.

We began trading with China in the mid-1970s. We import so much from China because U.S. retailers

are seeking the cheapest goods available and are finding them in China.

While Japanese gains in production have led to U.S. job losses, there is less evidence of China’s rising exports on U.S. jobs.

The Chinese and Japanese governments both insist on licensing agreements and transfer of technology as the price for agreeing to imports from the U.S.

Agreements are bypassed when the Chinese make unauthorized copies of American movies, CDs, and computer software.

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Final Words: Free Trade in Word and Deed, and Reducing Our Trade Deficit

U.S. politicians, especially Presidents, advocate the principle of free trade. Members of the EU call out advocacy hypocritical!

• March 2002 - December 2003: U.S raised tariffs on imported steel.

• U.S. has huge agricultural subsidies.• Fall 2009: President Obama imposed a 35% tariff on Chinese

tires due to a loss of 5,000 jobs in U.S. How can we reduce our overall trade deficit?

1. We need to maintain our high rate of productivity growth and keep improving the quality of American goods and services.

2. We need to lower our dependence on oil imports by raising the tax on gasoline.

3. We need to do something about our rapidly rising trade deficit with China.

4. We need to face up to the fact that we are a nation of consumption junkies.

Maybe try to use the internet which makes it much easier to provide services of all types?

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Current Issue 1: Buy American?

Are we as a nation becoming more inclined to “buy American?”

• Especially after 9/11?

The bottom line: Americans are consumers first, while paying just lip service to economic nationalism.

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Current Issue 2: Globalization

Globalization defined: the unimpeded flow of goods and services, labor and capital, across national borders.

The pace of globalization has accelerated with the decline in shipping costs, vast improvements in communications, the end of the Cold War, and the development of the Chinese economy.

Globalization is controversial because of the off-shoring of millions of jobs to low-wage countries.

Will those jobs return to the U.S.? Not likely.