MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1. MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition International Trade

2. Key Concepts • Comparative Advantage • Terms of trade • Opportunity Cost • New Trade Theory

3. Patterns of World TradeGrowth rate in world output and volume of world trade Trade Volume World GDP

4. Comparative Advantage • Focus on activities in which disadvantage is least • Produce good/service with lowest opportunity cost • Trade for good with highest opportunity cost • Trade benefits all countries • Key assumptions • Competitive markets • Labor and capital can easily be reallocated • Stable rate of unemployment • Costless transportation • China-U.S. example

5. Comparative Advantage • ALL countries benefit from free trade • However, not all countries will be equally well off • Gains may not be equal between countries • Depends on terms of trade • Not all citizens benefit • Country is richer as a whole, but some citizens are worse off • Should these problems stop trade?

6. Terms of Trade • Ratio of the price of a country’s exports to the price of a country’s imports • Gains from trade rise with terms of trade • Example: oil-exporters have recently experienced a strong increase in their terms of trade • Application: Prebisch-Singer hypothesis • Hypothesis that agricultural prices, fall in value over time… • Rising productivity in agriculture • low elasticity of demand for agricultural products fall in agricultural prices relative to overall prices and decline in terms of trade • Countries should promote non-agriculture sector or fall behind

7. Factor Price Equalization • Factor price equalization Theorem • As trade grows, input prices (wages and the cost of capital) should converge • Both within and across countries • Assumes identical inputs • Productivity-adjusted wages different

8. Wages, US $, 2000 Source: BLS

9. National Competitiveness: Classical Trade Theory • Trade is not a zero-sum game • Competitiveness concerns imply zero-sum game • Focus on comparative advantage, not competitiveness • Countries do not go bankrupt • Instead of bankruptcy, a country undergoes restructuring of economy • Reallocate labor and capital to new industry • Trade is not adversarial • Caveat: shortrun vs. longrun • Example: Mexico’s competitiveness concerns

10. International Trade Theory: New Trade Theory • Economies of scale are important to some industries • Commercial airlines, auto dealers • Economies of scale require large production run, and in turn a large market to sell goods • If no large market, then… • No production of certain goods • Less variety • What’s one way to increase market size for a good? • International Trade

11. International Trade Theory: New Trade Theory • Example: • Suppose two countries with annual market for 1 million autos • Before trade: 1 million auto market • After trade: 2 million auto market • Produce more, at lower cost, and greater variety

12. International Trade Theory: New Trade Theory • First Mover Advantage • If economies of scale is important (i.e. need a large market) and there has been a first mover, then subsequent competitors will face a barrier to entry • Not enough market demand left for them to operate at level of economy of scale => cost disadvantage • Example: Airbus is spending $14 billion to develop 550 seat commercial plane • Needs to sale 350 planes for venture to be profitable • Demand over next 20 years is for 400 to 600 planes • Room for only one profitable player

13. National Competitiveness: New Trade Theory • Don’t necessarily need productivity or factor endowment advantage to benefit from trade…if you are the first mover • Comparative advantage can be created • Carpet industry, Dalton, Georgia • Silicon Valley, California • Comparative advantage should not be accepted as is • Countries should actively promote strategic trade policies • Example: Aircraft industry • Imperfect competition • Increasing returns to scale • U.S. vs. Europe: Boeing vs. Airbus

14. Strategic New Trade Theory • If both firms enter, neither reap lower costs from increasing returns to scale (IRS) • $500 million earning potential…if IRS fully used • Best strategy is consider what the other firm is going to do

15. Strategic New Trade Theory • Suppose European government promises $200 million subsidy if Airbus produces planes • Regardless of Boeing’s decision, Airbus will now produce…positive earning regardless • Boeing either looses $100 million or withdraws at no lost…easy choice • $200 million subsidy gave Airbus monopoly profits of $500 million and will help create an European comparative advantage

16. Strategic New Trade Theory • If Europe and U.S. both subsidize $200 million, both firms will produce • However, profit includes subsidy • Europeans and Americans overpay for aircraft, foreigners benefit • Solutions: • Cartel: agree to set same prices • Move toward niche products • Raise the stakes: higher subsidies

17. Strategic Trade Theory • Paul Krugman • Strategic trade policy is tantamount to “beggar thy neighbor” policy • Boost national income at expense of other country • Likely to provoke retaliation and trade ware • Result could be a costly subsidy race between two countries from which other countries benefit • What to do if competitor is subsidizing competing industry? • Better to establish “rules of the game” than to retaliate • WTO • Often government intervention is based on special interest rather than strategic trade theory (economies of scale)

18. Arguments for Trade Restrictions • Political Arguments • National Security • Protecting Jobs and Industries • Retaliation • Consumer Protection (health, safety) • Furthering Foreign Policy Objectives • Economic Arguments • Infant Industry Protection • Strategic Trade Policy

19. Summary • Trade is an increasing feature of the world economy • Comparative advantage and terms of trade • New trade theory • Arguments for Trade Restrictions