Lecture Outlines - Week 12

International Trade (Ch. 17 of Schiller)

Consider the extent to which in your daily life you are dependent upon goods and services produced by others in the community, or state, or the national economy, or even the global economy. How about listing the ones you encountered today before you came in to the University?

Basics:

What are imports?

What are exports?

What percentage of the US economy is made up of either imports or exports?

The balance of trade is (exports - imports).

When do we have a trade surplus? Deficit?

What is the US balance of trade? Is it larger for manufactured goods or for services? Why?

With what countries do we have the largest trade deficit?

The Economic Theory of Trade

Thus to understand trade, which is the fundamental that underlies so much of our lives, and which forms the basis for market exchange, we need to understand the gains from trade -- what they are and where they come from.

ILLUSTRATIVE EXAMPLE:

Suppose that there are two hunter/gatherer societies that occupy adjacent but different territories. To make the example simple, suppose the two societies each have 100 working-age people in them, and working-age people are not specialized within a given society. Suppose that the Purple Society has a territory rich in fishery resources, but poor in nuts and grains, and conversely the Orange Society has a territory rich in nuts and grains, but poor in fish.

Let's characterize these two societies' production possibilities frontiers:

Purple Society: A typical working-age person can catch, on average 0.10 pounds of fish in an hour, or gather 0.025 pounds of nuts and grains in an hour. Thus as a group they can produce 10 pounds of fish in an hour, or gather 2.5 pounds of nuts and grains in an hour. The group can allocate their time in any way they choose between the two activities.

Orange Society: A typical working-age person can catch, on average, 0.04 pounds of fish in an hour, or gather 0.12 pounds of nuts and grain in an hour. Thus as a group they can produce 4 pounds of fish in an hour, or 12 pounds of nuts and grain in an hour. The group can allocate their time in any way they choose between the two activities.

Sketch out the relevant PPF curves for the Purple and Orange Societies for a 10-hour working day. Remember, to keep the example simple there is no specialization of labor within a given society.

CASE 1: NO TRADE

Assume that each society divides their time in half between the two types of activities (they can divide it in any way, really, depending on their preference).

What is the total consumption of fish and nuts/grains by the two societies?

70 pounds of fish and 72.5 pounds of nuts and grains

CASE 2: TRADE

First we must determine what each society will specialize in.

The Law of Comparative Advantage provides guidance in determining what people or firms specialize in. Simply stated, when comparing potential trading partners, the producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Purple Society:

What is the opportunity cost (what must be given up) of producing one pound of fish?

Answer: It takes a member of the Purple Society working 10 hours, on average, to catch 1 pound of fish (10 hrs. X 0.1 lb/hr = 1 lb). If instead that 10 hours were spent gathering nuts and grain, on average, 1/4 of a pound of nuts and grain could be gathered. Thus the opportunity cost of catching 1 pound of fish is 1/4 of a pound of nuts and grain for the Purple Society.

Orange Society:

What is the opportunity cost (what must be given up) of producing one pound of fish?

Answer: It takes a member of the Orange Society 25 working hours, on average, to catch 1 pound of fish (25 hours X 0.04 lb/hr = 1 lb). If instead that 25 hours were spent gathering nuts and grain, on average, 3 pounds of nuts and grain could be gathered, Thus the opportunity cost of catching 1 pound of fish is 3 pounds of nuts and grain for the Orange Society.

Which society has a comparative advantage in catching fish?

Exercise:

Do the same computation to determine the opportunity cost of gathering 1 pound of nuts and grain to determine which society has the comparative advantage in gathering nuts and grain.

Purple Society: Takes 40 hours to gather 1 pound of nuts/grain. Opportunity cost of that 1 pound of nuts/grain is 4 pounds of fish.

Orange Society: Takes 8.333 hours to gather 1 pound of nuts and grain. Opportunity cost of that 1 pound of nuts/grain is 1/3 pound of fish.

Note: The Orange Society has a comparative advantage in gathering nuts/grain, as we would expect, since their opportunity cost is lower.

If the Purple Society specializes in catching fish, and if the Orange Society specializes in gathering nuts and grain, what is the total production of these food items for an average day?

Purple Society: 1000 person-hours of effort catching fish, on average, will yield 100 pounds of fish each day.

Orange Society: 1000 person-hours of effort gathering nuts/grain, on average, will yield 120 pounds of nuts/grain each day.

Compare this total production of food to that which would occur in the absence of trade. What are the total gains from trade?

Terms of Trade:

In the context of barter, what relative price might you expect? Hint: The Orange Society will not pay more than 3 pounds of nuts/grain for a pound of fish (why?), and the Purple Society will not accept less than 1/4 pound of nuts/grain for each pound of fish (why?). If the barter price of a pound of fish is 1.5 pounds of nuts/grain, how are the gains from trade divided?

The terms of trade refers to the relative price of one trade good in terms of the other. If money is used in trade, then instead of relative prices, we will have a money price for the terms of trade. The economics are no different. We can predict the range of possible trade prices as being between each trader's opportunity cost.

Note: Trade will not occur unless the terms of trade (the relative prices) are superior to each potential trader's opportunity cost.

Absolute Advantage:

What is absolute advantage? Provide a concrete example. Is there still comparative advantage and trade even when there is an absolute advantage? Why?

Absolute advantage refers to a situation in which one trading party is generally more productive than the other, and thus can produce a given output with fewer inputs.

Barriers to Trade:

Tariffs: Taxes on imported goods. Tariffs are frequently used to protect a domestic industry from foreign competition that can operate at a lower opportunity cost. Tariffs can be used against a country that has created a comparative advantage by having few health, labor, safety, or environmental protections, thus lowering their costs of production. Tariffs reduce the volume of imports and raise domestic prices.

Quotas: Quotas are a maximum amount of a good that can be imported into a country. They work like tariffs in reducing the quantity imported and raising domestic prices. We had voluntary quotas for Japanese cars in the 1980s.

Politically, domestic producers often have the power to force governments to erect tariff or quotas as protectionist measures to raise domestic profits. Exporting firms that suffer because of tariffs then lobby their government to erect similar tariff or quota barriers. Thus it is easy to end up with very limited international trade because of reciprocal trade barriers. In 1947 the average tariff was 40 percent of the trade price. Free-trade agreements such as GATT/WTO have led to average tariff rates falling to 3.9 percent.

Currency Devaluation:

When Japanese cars are imported into the US, ultimately the sales revenue must be converted into yen on order to flow back to Japan. This involves a foreign exchange transaction, where dollars are traded for yen. Thus if we import lots more from Japan than they import from us, there will be a growing shortage of yen, and a surplus of dollars, in the foreign exchange market. This will tend to cause the "price" of yen in terms of dollars to rise, which means that the US dollar loses value relative to the yen. Ultimately this will mean that the dollar price of goods imported from Japan must rise, or Japanese firms must accept lower profits.

Exchange Rates

Thus if the US dollar becomes worth fewer yen, we cannot afford to import as much from Japan, while conversely Japanese can afford to buy more US goods and services (like vacations to Hawai'i).

Thus currency devaluation can be used as a form of domestic protectionism, or to promote exports.