TCO 8

1. TCO 8 Given hypothetical production possibilities curves for two countries, the only two products that can be produced in each country, and the exchange ratio, graphically demonstrate how both countries would be better off from specialization and trade. • Explain the theories of absolute advantage and comparative advantage. • Describe how comparative advantage can be the basis or trade. • Illustrate the use of the production possibilities curve in analyzing international trade. • Explain the barriers to trade. • Provide several arguments for and against protectionism.

2. U.S. Trade Before 1975 • We ran trade surpluses before 1975 and trade deficits after 1975 • We faced increasing trade competition in the 1960s • We have been running large and growing trade surpluses on services and growing trade deficits on goods

3. U.S. Trade Since 1975 • By the late 1970s U.S. trade deficits were mounting • By 1984 they crossed the $100 billion mark • In 2002 the U.S. trade deficit reached $435 billion • The U.S. trade deficit is expected to pass $500 billion in 2003

4. U.S. Government Trade Policy • Initially the tariff was purely a revenue-raising device • After the War of 1812 the tariff took on a protective tinge • During the great depression, virtually every industrial power raised its tariffs to keep out foreign goods • This caused world trade to dwindle to a fraction of what it had been and probably made the depression a lot worse

5. International Trade • Almost everyone seems to support free trade • Many Americans, especially labor unions and environmentalists, prefer what they call “fair trade” • Economic reasoning argues strongly for free trade

6. Specialization and Trade • Specialization is the basis for international trade • 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

7. Production Possibilities Curves The U.S. has to give up 20 copiers to get 10 VCRs 2 copiers = 1 VCR To get 10 copiers South Korea has to give up 20 VCRs 1 copier = 2 VCRs

8. Domestic Exchange Equations U.S. 2 copiers = 1 VCR S.K. 1 copier = 2 VCRs Intuition tells us that it that it would be best for each country to produce what it does best and to trade with the other

9. Domestic Exchange Equations U.S. 2 copiers = 1 VCR S.K. 1 copier = 2 VCRs Obviously the U.S. would be unwilling to trade more than two copiers for one VCR. However, if S.K. offered more than 1 VCR for 2 copiers this would be a better deal If the U.S. used its resources to produce 2 copiers and trade them for more than 1 VCR it would be better off than it would have been using the same resources to produce just 1 VCR Obviously, S.K. would be unwilling to trade 2 VCRs for anything less than 1 copier. If S.K. could trade 2 VCRs and get more than one copier in exchange it would be better off making VCRs and trading some of them for copiers

10. Two General Observations • No nation will engage in trade with another nation unless it will gain by that trade • The terms of the trade will fall somewhere between the domestic exchange equations of the two trading nations

11. Absolute Advantage • Absolute advantage is the ability of a country to produce a good or service at a lower cost than its trading partners • In the previous example, the bottom line is that Americans can buy South Korean VCRs at half the price that American producers would charge • Thus the South Koreans have an absolute advantage in making VCRs • They are better at making VCRs than we are

12. Comparative Advantage U.S. 2 copiers = 1 VCR S.K. 1 copier = 2 VCRs • In the U.S. the opportunity cost of producing 1 VCR is 2 copiers • In S.K. the opportunity cost of 1 VCR is ½ of one copier • The opportunity cost of producing VCRs is lower in S.K • Likewise, the opportunity cost of producing copiers is lower in the U.S.

13. Comparative Advantage • In the U.S. the opportunity cost of producing 1 VCR is 2 copiers • In S.K. the opportunity cost of 1 VCR is ½ of one copier • The opportunity cost of producing VCRs is lower in S.K • Likewise, the opportunity cost of producing copiers is lower in the U.S. • The law of comparative advantage states that total output is greatest when each product is made by the country that has the lowest opportunity cost

14. Absolute Advantage versus Comparative Advantage • You can’t compare absolute advantage and comparative advantage any more than you can compare apples and oranges • Absolute advantage is a comparison of the cost of production in two different countries • Comparative advantage states thattotal output is greatest when each product is made by the country that has the lowest opportunity cost

15. Absolute Advantage versus Comparative Advantage • 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

16. Four Main Arguments for Protection • The National Security Argument • The Infant Industry Argument • The Low-Wage Argument • The Employment Argument

17. Tariffs or Quotas • A tariff is a tax on imports • The government gets the resulting revenue • A tariff affects all foreign sellers equally. Efficient foreign producers will be able to pay a uniform tariff. Less efficient producers will not • A quota is a limit on the import of certain goods • Import quotas produce no federal revenues • Imports quotas are directed against particular sellers on an arbitrary basis • Arbitrary quotas may allow relatively inefficient producers in and keep out more efficient producers

18. Export Subsidies • Several countries subsidize their export industries • This makes their products cheaper • Many Americans complain that this gives foreign competitors an “unfair advantage” • Subsidies are a relatively minor expedient in the United States

19. Our Balance of Trade • Our balance of trade compares the dollar value of merchandise and services we buy from foreigners with the dollar value of the merchandise and services they buy from us • Our balance of trade is our country’s record of all transactions between its residents and the residents of all foreign nations

20. What Are the Causes of Our Trade Imbalance • We have been losing market share both at home and abroad • The biggest culprits are our oil bill and our deficits with Japan and China

21. What Are the Causes of Our Trade Imbalance • The Rise of the Dollar • A rising dollar makes our exports more expensive and our imports cheaper • Our Low Saving Rate • Americans have become notoriously poor savers averaging less than 5 percent of their disposable income since the mid-1980s • If you don’t save, you can’t invest • If you don’t invest, you don’t grow • American business firms have been left with one choice, borrow from foreigners • Foreigners have come here only because of our high interest rates

22. What Are the Causes of Our Trade Imbalance • The High Cost of Investment for Capital Goods • Mainly because of our low savings rate and partially because of the huge federal budget deficits, high real interest rates have discouraged investment in plant and equipment as well as in technological innovation • High Defense Spending • Today the United States spends more on defense than the rest of the world put together • Can we afford to do this?

23. What Are the Causes of Our Trade Imbalance • Our Failing Educational System • The American educational system, once second to none, is now second to practically everyone’s • About one-third of all college freshman need remedial work in reading, writing, and arithmetic • This is why we used to go to K through 12 • Almost every college has special classes for students unprepared to do college work • One million new functional illiterates every year are not exactly job candidates for today’s high tech economy

24. What Are the Causes of Our Trade Imbalance • The Role of Multinationals • Since the 1960s multinational corporations began to move their manufacturing operations to take advantage of lower wages available in low wage countries • Capital has long been much more mobile than labor, and that capital has been flowing very rapidly to low wage nations • Our import business is dominated by our own multinational corporations that have shifted their production overseas and put their name on the goods that are produced in other nations

25. What Are the Causes of Our Trade Imbalance • Relative Growth Rate • Since 1995 we have had one of the highest rates of economic growth of any industrial nation • Countries with high economic growth rates import more goods and services than they would if they had low growth rates • At the same time demand for U.S. exports has been lagging due to low growth rates in other industrial nations

26. What Can We Do? • Devalue the dollar - this would make our exports cheaper while imports would become more expensive • Put a lid on consumption • Save more • Bring back the tax-free IRA • Decrease defense spending • Really educate our workforce • Protectionist legislation is a real possibility if our foreign competitors are, in fact, dumping goods below cost on our shores