ch 18 - international trade

7/29/2019 Ch 18 - International Trade

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CH. 18:

INTERNATIONAL TRADE

Olivier Giovannoni

Bard College - Econ 100


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INTRODUCTION

Individuals and countries have been trading since the beginningof time. Think of Marco Polos voyages (c. 1300). Think of you mowing

your neighbors lawn in exchange of his apples. Think of Floridaexporting its oranges to New York in exchange of financial services.

Think of your professor making money teaching economics and using

that money to buy meat. Trade is the main economic activity; trade is

everywhere. Here we focus on internationaltrade.

Trade depends on several factors, including the prices of the productstraded. But there are also trade policies: certain policies or attitudesare more favorable to trade, while other policies limit trade. We will

deal with those after seeing the benefits of trade when trade is not

restricted.

Individuals and countries trade because there are gains from trade,i.e. mutual benefits to trading.

Countries and individuals are not all the same and this is a reasonfor trading; some countries are relatively better at certain things andothers are better at other things. China is good at labor-intensive

products and the US is good at (see next slides)


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INTRODUCTION

How important is trade for the United States?

More and more important in absolute terms

More and more important in relative terms

Still less important in relative terms than a century ago, when the US

was a much more open country.

Openness ratio, in2007 =(X+M)/2Y


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INTRODUCTION


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INTRODUCTION

US trade deficit, 1929 2011

Great depression:

Roosevelt devaluesthe Dollar by 70%

WWII and

collapse in trade

Recovery andMarshall plan

Gold standarduntil 1944

Bretton Woods1944 1971

Floating exchange ratesFixed exchange rates

Trade

liberalizationBooming

economy

China

Joins

WTO


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INTRODUCTION


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Today the majority of trade is manufacturing (55%), while it used to be dominated

by agriculture and minerals. We moved from trading scarce resources to trading

easily reproducible resources.

The 5 largest trading partners with the US in 2008 are Canada, China, Mexico,

Japan and Germany.

whats the pattern?

INTRODUCTION


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The pattern is that the majority of trade is with close and richer countries. This is

called the gravity model:

1. Countries tend to trade with nearby economies

2. Countries trade is proportional to their size (see chart).

Besides size and distance; culture,geography, multinational corporations

explain the pattern of trade. Modern

transportation and communication have

also increased trade dramatically.

Political factors have also influenced trade

in a non trivial way, throughout history.

INTRODUCTION


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COMPARATIVE ADVANTAGES

The economic justification of trade is based on the principle ofcomparative advantages. A comparative advantage is what

individuals, or countries, do the best: I am better at teaching economicsthan you are, but you may be better at playing music. So, it makes

sense that I spend my time doing economics and get my music from

you, while you specialize in music and get your econ from me.

In international trade a comparative advantage is the advantage a

country has in one product over another country. This shows up asa greater productivity (or lower cost) at producing a certain product

than another country.

The intuition is that comparative advantages lead to internationaltrade: I get my pineapples from central America because there

compared to here, the labor cost and climate are better suited to thisactivity; I get my clothes from Asia because clothing is labor-intensive

and labor is cheap in Asia, I get my luxuries from Europe because of

the long traditions, and in return I can export technological goods and

financial services for all this.


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Lets see how comparative advantages work through an example

(see textbook):

We have two products and two countries (for simplification): Japan and

the US, computers and TVs. Both countries have only one factor of

production, labor, which they can use to produce both goods, in the

quantities that they want. Each countries labor force limits its

production possibilities at those maximum values (in millions of units):

Which country has a comparative

advantage in what product?

If the US wants to produce 50 computers, it will have to forego the

production of 50 TVs. So a computer costs a TV, and the opportunity

cost of a computer in the US is 1 TV (=50/50).

The opportunity cost of a computer in Japan is 4 TVs (=40/10).


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The US has a lower (opportunity) cost of producing computers, and we

say that the US has a comparative advantage in computers.

Japan has a lower opportunity cost of producing TVs (=10/40).

It makes sense for the US to specialize in computers and Japan tospecialize in TVs.

But what happens to the pattern of trade when both countriesspecialize in their comparative advantages?


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Recall the PPF. The slope of the PPF is the opportunity cost. The PPFis a line when we have one factor of production, such as here.

The graph below shows the original PPFs, before the countriesspecialized. The US had the choice in producing 50 TVs and zero

computers, or 50 computers and zero TVs. The slope of the PPF, you

will recall, is the opportunity cost of the variable on the X-axis, and we

have calculated that opp.cost comp in the US = 1.

Viceversa,

opp.cost comp in JP = 4.

(this is a steeper slope).60

U.S. productionpossibilities frontier

SN

J

60

50

40

30

10

Japaneseproductionpossibilitiesfrontier

100 20 30 40 50

20Telev

ision

Sets

Computers

U


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Now, lets say each country specializes in its comparative advantage

and trades. Japan produces TVs and the US produces computers.That way each country is made more efficient.

But both countries want to consume both products! The only way to

achieve this is by trading your now-efficiently-made production.

But if countries trade, we need to introduce another variable: the rate at

which one product exchanges for another. Lets say that that price is 2,

that is, one computer is twice more expensive than a TV. This is anarbitrary value, but in theory the international price of a computer

should fall in between the opportunity costs of a computer in each

country.

It used to be that, before trade, the US had to give up the production of

1 computer if it wanted to produce one additional TV. Now the US only

produces computers, and trades some of them. Now the US can give

up one computer, trade it with Japan, and get two TVs. This is the gain

from trade for the US.

What is the gain from trade for Japan?


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We say that trade is an indirect method of production. Specializing inyour comparative advantage and trading leads to gains from trade:

1. Higher efficiency, productivity and therefore living standard,

2. Enlarged consumption possibilities: the PPF rotates to the right.

U

U.S. productionpossibilities

100

90

80

70

60

50

4030

20

10

A

6050402010

U.S. consumptionpossibilities

S

300

Television

Sets

Computers

UNITED STATES

Japanese productionpossibilities

100

90

80

70

60

50

4030

20

10

J

6050402010

Japanese consumptionpossibilities

PN

300

Television

Sets

Computers

JAPAN


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The above was describing a simple phenomenon, called comparativeadvantages, which provides a rationale for countries to trade.

Each country has a comparative advantage.

Each country should specialize in their comp. adv.

Each country will experience gains from trade (and the more tradethere is, the more gains from it).

The consequence is that free trade makes everybody better off! andwe should promote free trade!

The theory of comparative advantages is the reason why you hear thoseslogans everywhere.

What may surprise you is that this result holds true even for a countrywhich has an absolute disadvantage (i.e. a country which is lessproductive than other countries in each sector of its economya countrygood at nothing). A country with an absolute disadvantage everywhereshould still specialize in whatever it the least bad and if so it will benefit

from trade.


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LIMITATIONS

Now, a note of caution the gains from trade have only been provento exist in a very simplified framework, assuming especially

1. perfect competition2. no transportation costs

3. only one factor of production (labor)

4. same resource endowments

5. countries have the same technology

6. free trade

Some of those assumptions can be relaxed and the previous resultsstill hold (1 and 2).

(3, 4 or 5): If there are several factors of production (add capital and

natural resources) and/or different resource endowments, free tradehas been proven to still be good but also to lead, within each countrytrading, to losers and winners from trade. Some people will benefit,other people dont. Such are the results ofthe Heckscher-Ohlin-Samuelson model: international trade will promote a greater well-being overall but at the cost of greater economic inequalitywithin

nations.


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LIMITATIONS

(6): of course trade is never completely free.A great historicalexample is Mercantilism. For a very long time (c.1500-c.1800) trade

was perceived as a one way street: there were winners from trade (thecountries exporting) and there were losers from trade (the countries

importing). There was only one advantage in trading, people thought,

and it was to accumulate riches (namely gold) through exports.

Mercantilism is defined as this willingness to export but not to import.

So all was done to encourage exports and all was done to discourageimports. This was the thinking of the Spanish and Portuguese

conquistadors for instance, but the mercantilist ideology spread all over

Europe, and presided over the economic thinking of European rulers of

the timeand to some extent still prevail in Germanys thinking today.

Trouble is, not everybody can be an exporter! The more certaincountries want to be exporters, the more other countries will be

importers. Mercantilistic attitudes creates a polarized, unequal andunstable world.

Today there are mainly 3 exporters: Germany, China and Japan, while

the US and the UK are the main importers.


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Source: OECD, p. 9

Trade balance(international comparison)
http://www.oecd.org/dataoecd/32/24/45968339.pdfhttp://www.oecd.org/dataoecd/32/24/45968339.pdf


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LIMITATIONS

The trouble with the picture above is that we see the emergence of a clear

group of exporters and a clear group of importers.

Importers use their own currency to pay exporters for their products

Exporters accumulate foreign currencies (i.e. China accumulates

dollars).

Thus international trade imbalance leads huge flows of money around the

world. And those flows of money can be destabilizing by creatingbubbles. Fueling a real estate boom in China or a financial bubble in theUS.


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TRADE POLICIES

Outside of mercantilism, what restriction of trade do we see? These days,

there arent that many trade restrictions on average. International trade

has become quasi-free because mosteconomies trade within theregulations of the World Trade Organization (WTO), whose agenda isto promote free trade. For instance, the average tariffs on productssubject to tariffs entering the US these days is5%.

But for certain products or certain countries, we can see free traderestrictions. There are mostly 4 types:

1. Import tariffs are a policy to tax imports (therefore making them moreexpensive, so that hopefully the quantities imported are reduced)

2. Export subsidies are policies that favor exports by making them

cheaper.

3. Quotas are policies aimed at limiting the quantities a country imports,i.e. decree that no more than 1mil Korean cars should enter the US.

4. Exchange rate manipulation is a technique equivalent to imposingtariffs and subsidies at the same time. All countries having a fixed

exchange rate fall in this category.


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TRADE POLICIES

Economic analysis shows that free trade is almost always a betteroutcome than the alternative. Tariffs, subsidies, quotas all result in

higher prices and lower welfare than with free trade.On the other hand some special interventions may be necessary:

when countries experience monetary troubles or financial crises, free

trade can be a problem in the short run (if the exchange rate is fixed orif there is money fleeing out of a country).

some industries, especially in lesser developed countries, should be

protected until they are competitive enough on the international scene

(this is called the infant industry argument).

some sectors may also not need complete trade liberalization, because

they are strategic sectors (should we allow foreign nations to controlour ports and provide airline security?).

sometimes also, certain sectors need to be encouraged (with

subsidies) because they yield positive externalities.

But overall free trade is a better alternativenot a perfect

situation in all instances, just a better alternative.


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EXCHANGE RATES

Besides comparative advantages and trade policies, what else explains

the pattern of trade? The exchange rate matters a lot.

In a simplified way an exchange rate is defined as the price ratio betweentwo countries:

$/ = $

The exchange rate represents how many dollars I need to get one Euro

coin in exchange.If the value of the exchange rate goes up, it takes more dollars to getthe same Euro coin in exchange, so that the Dollar depreciates as$/ .

From this definition we can derive

$ = . $/. This represents the price in dollars of a product made in

Europe whose price has been converted into Dollars using the

exchange rate. In other words, this is the price of imports. We see that

as $/ the price of imports go up. We expect the quantities imported

to go down.


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EXCHANGE RATES

= $/$/. This represents the price in Euros of a product made in

the US whose price has been converted into Euros. In other words, this

is the price of exports. We see that as $/ the price of imports goesdown. We expect the quantities exported to go down.

Summarizing: a depreciation of the dollar increases our exports bymaking them cheaper abroad, while at the same time a depreciationof the dollar decreases our imports by making them more expensiveat home.

So: a depreciation of the dollarimproves the trade balance.

Or: A trade deficit requiresa currency depreciation.

$/

M

X

Trade deficit


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EXCHANGE RATES

In practice, where do the exchange rate come from?

1. In a flexible exchange rate system, the exchange rate is

determined on foreign exchange market (FX market). This is theplace where all the demand and supply for currencies are

summarized.

If investors perceive higher returns (more profits, more growth) in

the US, investors will sell their holdings denominated in other

currencies and decide to invest in Dollars. This bids up the price ofthe Dollar, and the dollar strengthens ($/ falls).

If investors perceive that the US is a risky country with a bad

economy and few profit opportunities, investors will turn their back

to the US, sell their dollar-denoninated assets and invest

somewhere else. The value of the dollar falls ($/ increases).

Terminology: in a flexible exchange rate system we say that thecurrency appreciates or depreciates

C G S


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EXCHANGE RATES

2. But sometimes a currency cannot appreciate or depreciate, because it

is fixed or pegged to another currency. This is a policy put in place

by many Latin American as well as Asian countries. Why do countries fix/peg their exchange rate? Because their major

trading partners are the US or other countries pegged to the Dollar.

By adopting a fixed exchange rate or peg, countries can reduce the

exchange rate riskwhereby the value of exports fluctuates with

the exchange rate (see price of exports equation above) How do countries manipulate their exchange rates? The value of

the currency should ultimately reflect the health of a countrys

economy. When Asian countries are growing faster than the US,

their currencies should appreciate. How can they then maintain a

fixed exchange rate / peg? Well as China is growing, to prevent anappreciation of the Renminbi, China has to sell its own currency to

buy US dollars. This way the Renminbi is bid down and the dollar

is bid up which maintains a fixed exchange rate. This is called

exchange rate manipulation. And yes, sometimes countries

promote an undervalued exchange rate this way, because a weakcurrency promotes their exports!

ch 18 - international trade

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