The International Economy

1. The International Economy

2. Topics Elements of interdependence Forces driving globalization Waves of globalization Impacts of globalization Comparative advantage Common Fallacies Competitiveness and trade

3. Elements of interdependence Trade: Goods Services Raw materials Energy Patterns of trade Trade of manufactured/finished goods

4. Elements of interdependence Finance: foreign debt, foreign investment, exchange rates Development loans from IMF & World Bank Sector specific development Services WTO�services have become a priority Advanced nations are becoming dependant on services

5. I. Elements of interdependence Business: multinational corporations, global production Outsourcing Demand for protection of markets in countries

6. II. Forces driving globalization Technological change: Production�during the 1700 and 1800�s it was difficult to conduct multinational operations The industrial revolution, the steam engine, increasing productivity, etc� All lead to an increase in production using the same inputs (labor)

7. II. Forces driving globalization 2. Communication & Information as communications grew, the dissemination of information increased the demand for communication

8. II. Forces driving globalization Transportation Pipelines Freight and cargo across borders No longer sails/steam powered ships

9. II. Forces driving globalization Liberalization of trade & investment Tariff barrier reductions GAAT�after WWII eliminated the gold standard, and created monetary rules Lead to a reduction in tariff�s Reduction in tariff�s after WWII was used by developed countries, less advanced countries fell behind facing higher tariffs.

10. II. Forces driving globalization Problem with GAAT was that it was only a general agreement, no real commitment was made by participants. It was not until 1982 that the WTO was created During the 1980�s and 1990�s there were huge liberalization of financial transactions The end of the soviet block spurred market liberalization and opened up trade and investment from foreign countries

11. II. Forces driving globalization Liberalized financial transactions International financial markets

12. III. Waves of Globalization First wave: 1870�1914 Sparked by falling tariff barriers Improved transportation, reduced transportation costs Countries that participated (such as the U.S.) became the richest in the world Brought to an end by WWI and the great depression Second wave: 1945�1980 Again sparked by falling transportation costs Agreements to lower barriers again Rich countries move toward trade specialization Poor nations left behind

13. III. Waves of Globalization Third wave: 1980�Present Growth of emerging markets International capital movements regain importance Exports of goods and services as percent of GDP, 2001 Must consider the size of the economy, and the amount trade relative to the size of its economy

14. III. Waves of Globalization Leading trading partners of US in 2000 Gravity model�examines trade flows and proximity to countries to each other Proximity�transaction costs are lower Understanding of partner (culturally, etc�) Trade of services with China will expand due to Olympics and a desire to grow

15. IV. Impact of interdependence Overall higher standard of living Increases the overall standard of living�increases GDP Provides access to raw materials & energy not available at home Dependence on raw materials leads to interdependence between countries

16. IV. Impact of interdependence Access to goods & components made less expensively elsewhere (access to foreign markets) For national security (or other reasons) a country will use tariffs to make prices of foreign goods higher, causing prices of goods to increase across the entire market

17. IV. Impact of interdependence Access to financing and investment not available at home Encourages/promotes flexible foreign investment International competition encourages efficiency Leads to comparative advantage�countries produce what it is most efficient at producing

18. IV. Impact of interdependence other impacts�good & bad Curtails inflationary pressure at home More trade lowers domestic price inflation (price reaches actual equilibrium price) Limits domestic wage increases Wage tends to fall as foreign markets gain some skill Causes an equalization of wages (although not complete); slow growth of wages in developed countries, and faster growth in less developed countries

19. IV. Impact of interdependence Makes economy vulnerable to external disturbances E.g. the oil shocks of the 1970�s Stock markets get nervous from these disturbances Limits the impact of domestic fiscal/monetary policy on economy Tax cuts may only have limited effects due to larger international markets influences on price and wages (interdependence leads to openness)

20. IV. Impact of interdependence In addition, globalization has controversial international consequences A movement toward equalization of commodity prices A qualified movement toward convergence of per capita income Measure of wealth & purchasing power Movement of equalization of real factor prices

21. IV. Impact of interdependence Shifts in output mix of country to reflect comparative advantage Growing access to technology or sources of technology Main vehicle of development in new technology�multinational corporations disseminate the technology

22. IV. Impact of interdependence Improved quality of goods and services available to consumers and firms A complex mix of increased competition and growing concentration of firms Leads to fewer firms competing the markets Changes in equality and incidence of poverty Not clear when interdependence increases of decreases poverty levels

23. V. Common fallacies of international trade (mercantilists views) �trade is a zero sum game� trade can bring benefits to both partners �imports bad, exports good� if you buy nothing from other countries, they have no income to buy from you �Tariffs and quotas save jobs� Cutting imports makes it harder to export, so other jobs are lost (example of protectionism)

24. VI. Competitiveness & trade Several levels Firms, markets, countries Main objectives of any nation is to generate a high and rising standard of living No nation can efficiently produce everything it needs itself International trade allows countries to focus on producing what they make efficiently

25. VI. Competitiveness & trade Inefficient sectors will be squeezed out Sectors open to competition become more efficient and productive Conclusion: the more open an economy is, the more competitive it is. Competitiveness of an industry depends upon its capital stock, skill of its workers, and the availability of raw materials On the firm level, competitiveness is determined by productivity

26. VII. Conclusions on globalization Advantages Productivity increases faster when countries produce according to its comparative advantage Global competition and cheap imports keep prices low and inflation at bay An open economy encourages technological development and innovation with ideas from abroad

27. VII. Conclusions on globalization Jobs in export industries pay more than those in import-competing industries Free movement of capital gives the US access to foreign investment and keeps interest rates low

28. VII. Conclusions on globalization Disadvantages Millions of US jobs lost to imports or production abroad; those displaced find lower paying jobs Millions of other Americans fear being laid off Workers face pressure for wage concessions under the threat of having the jobs moved abroad

29. VII. Conclusions on globalization Service and white-collar jobs are joining blue-collar one in being vulnerable to moving overseas US workers can lose their competitiveness when firms build state of the art factories in low wage countries, making them as productive as plants in the US

30. Quick Write Formulate your argument for or against globalization. Is globalization a good thing or a bad thing for the American economy? Support your opinion with facts from today�s lecture.

31. Foundations of Modern Trade Theory

32. Topics Mercantilism Absolute Advantage (Adam Smith) Comparative Advantage (David Ricardo) PPF and its MRT

33. I. Mercantilism (1500�s � 1800�s) Regulation to ensure a positive trade balance is the key defining issue Key to nations welfare is a strong foreign trade sector Maximize profits Produce as much as possible and sell as much as possible to other countries Limit imports with tariffs and subsidies

34. I. Mercantilism (1500�s � 1800�s) End result is more silver and gold To encourage a positive trade surplus governments imposed tariffs, quotas, and other commercial policies that restricted trade Adam Smith based his theory off the mercantilists value of labor theory

35. I. Mercantilism (1500�s � 1800�s) Critics: these ideals are possible only for the short term and they assume a static world economy

36. II. Absolute Advantage (Smith) Countries benefit from exporting what they produce cheaper than anyone else Smith considered the �productivity of factor inputs� the major determinant of production costs These factor inputs differ across nations because of natural and acquired advantages

37. II. Absolute Advantage (Smith) Smith only considered labor Quantity of labor needed for per hour production (labor costs / hour) Labor theory of value In each nation labor is homogeneous and the only factor of production The cost or price of a good is determined solely on the basis of the amount of labor needed for production

38. II. Absolute Advantage (Smith) Absolute Advantage�trading principle The absolute advantage in a 2 nation world where each country produces the same two goods. international trade and specialization will be mutually beneficial when one nation has an absolute cost advantage in producing one good and the other nation has an absolute cost advantage in the production of another good

39. II. Absolute Advantage (Smith) Trade is mutually beneficial Only trade when you have an absolute cost advantage Opportunity costs will be measured (i.e. resource costs) in the domestic ratio of one good to another Assume full employment and most efficient use resources (production is along the PPF) Last step is to agree on exchange rates

40. II. Absolute Advantage (Smith) Each country will specialize in the product that it can produce more cheaply Other commodities are obtained through trade Limits of mutually beneficial trade Based on range of prices agreed upon Limits are found through the opportunity costs within a country If countries cannot agree on price that exceed their own costs they will not trade Both countries will gain, but it is unlikely they will gain equally

41. II. Absolute Advantage (Smith) But: nations without an absolute advantage in the production of a product do not gain from trade Conclusion: Both countries gain; however if one country is absolutely better at the production of both goods then Smith�s trade theory states that there is no basis for mutually beneficial trade

42. III. Comparative Advantage (Ricardo) Relative costs determine comparative advantage Interested in the degree of the advantage (relative cost difference) Smith states that a country is better or not, and if not there is no basis for trade

43. III. Comparative Advantage (Ricardo) Nations gain from specialization, even if they lack an absolute advantage Comparative advantage refers to the degree of advantage so country A can have an absolute advantage over country B in the production of both good X and Y But the degree of the advantage by country A can have an absolute advantage over country B in the production of both good X and Y There is no basis for trade in comparative advantage if ratios are exactly the same

44. III. Comparative Advantage (Ricardo) Highlights of Ricardo�s model There are 2 ways to determine comparative advantage Comparing production costs (opportunity costs) Comparing productivity across industries or countries Defining feature�only thing that is different between countries is the level of technology. Trade occurs due to the differences in production technology

45. III. Comparative Advantage (Ricardo) Trade benefits all parties Even a technologically inferior country can benefit from free trade A developed country can compete against some low wage foreign country

46. III. Comparative Advantage (Ricardo) Assumptions of Ricardo�s model There are only 2 countries and 2 homogeneous goods Labor is only factor of production Fixed endowment Labor is homogeneous and fully employed

47. III. Comparative Advantage (Ricardo) Labor is not mobile (no immigration), but perfectly (and costlessly) mobile within a country Constant returns to scale�technology and production in both commodities and both countries Technology is constant within a country but can differ between countries

48. III. Comparative Advantage (Ricardo) Perfect competition exists in both countries No barriers to trade Zero transportation costs Rational agents assumption Firms maximize profits/minimize costs Consumers maximize utility

49. QuickQuiz