AAEC 2305 Fundamentals of Ag Economics

AAEC 2305Fundamentals of Ag Economics Chapter 8 International Trade

Objectives • This chapter will help you learn: • How international trade affects the determination of domestic prices, production, and consumption. • How resource endowments and production technology determine a nation’s comparative advantage and thereby its exports and imports. • How international trade policies can be used to alter domestic market equilibrium.

(continued) • About the history of U.S. agricultural trade and the role of agriculture in the GATT and WTO negotiations.

International Trade • International trade is the sale and purchase of goods across national boundaries. • Unrestricted International Trade – If international trade is not restricted, buyers & sellers in one country may purchase goods (& services) from any other country. • Hence – each buyer and seller has the option to make a transaction either in the domestic market or abroad. • The choice depends on where you can get the higher (lower) price if you are selling (buying)

Exchange Rates • Comparing prices at home and abroad is complicated by the fact that prices in other countries are denominated in their home currency. • To compare foreign prices with the domestic price, the foreign-currency-based price is converted into its domestic currency equivalence using the exchange rate.

(continued) • Exchange rates represent the price of one country’s currency in terms of the currency of another country. • These exchange rates are a direct reflection of the supply and demand conditions in currency markets. • With higher interest rates, the value of the dollar strengthens and makes US products more expensive in foreign currencies.

(continued) • With lower interest rates, the value of the dollar weakens and makes U.S. products more price competitive. • Example – assume it costs 600 German Marks to purchase a ton of American wheat valued at $200 (an exchange rate of 3:1) • Suppose monetary policy drives the value of the dollar down to a 2:1 exchange rate (now it only takes two German marks to buy one dollar)

(continued) • The ton of American wheat now costs the German buyer only 400 marks. • With the lower price and other factors held constant, we would expect the Germans to import more American wheat. • This is why American Farmers & Agribusinesses tend to benefit from a weak dollar.

1980’s • When the Fed pursued a tight money policy in 1979 and drove the discount rate to 14%, the value of the dollar rose sharply. • Why? – With high interest rates in America, foreign investors wanted to buy dollar-denominated investments, like bonds, to get those higher interest earnings.

(continued) • While the American consumer benefited from the strong dollar (i.e., foreign products were cheaper), U.S. agricultural exports became uncompetitive in world markets. • The results were dramatic. Total agricultural exports plunged from $44 billion in 1981 to only $26 billion in 1986. • This was the depth of the economic depression in agriculture – primarily a result of changing monetary policies.

World Price • Instead of examining prices from all pontential foreign buyers or sellers, we assume that there is a world price (Pw) made up of the combined markets of all countries in the world. • We will also assume that all prices are expressed in dollars (which is often the case in international transactions) • Furthermore, we will ignore transportation costs to & from the world market so that we can examine the essential features of international trade.

Small-Country Assumption • For almost all commodities, the volume in the world market (total world production) is much larger than the production or consumption of any one country. • Therefore, the trade of any single country has little effect on the world price. • A country that cannot change world prices by altering its exports or imports is called a small country.

(continued) • For commodities where the small country holds, the world market can buy (sell) as much as the economy can produce (purchase) at a given world price. • Hence, if the government does not intervene in international trade, the equilibrium domestic price is equal to the world price. • Since the value of American trade, including agricultural trade, is by far the largest of any nation, it may appear that the U.S. can dominate the world market.

(continued) • However, if we compare U.S. production and trade with the ROW for several important agricultural commodities we find this is not the case. • Since the U.S. is a small country for most agricultural commodities, for the remainder of this discussion we will make the small-country assumption (unless otherwise stated), which is that shifts in domestic demand or supply and trade policy changes do not change world price.

Equilibrium Price with Trade • With no international market, and gov’t policy preventing imports and exports, the equilibrium price (and quantity) is found at the intersection of domestic supply and demand. (sometimes called the closed-economy case)

(continued) • Exports- • Supposed the economy is opened up to international trade, with the world price above the intersection of the domestic supply and demand curves. • Producers can now sell all they can produce on the world market at the higher world price (Pw). Producers will sell to domestic consumers only at this higher price.

(continued) • Since the Pw is higher than in the closed economy – producers expand production and consumers reduce consumption. • Additionally, this quantity differential that would be a surplus in a closed economy is exported. • Although domestic demand does not equal domestic supply – the market is in equilibrium.

(continued) • Imports- • Suppose the Pw is below the intersection of domestic supply and demand. • Consumers can now purchase as much of the commodity as they want at the lower world price. • Domestic producers must lower their prices to compete.

(continued) • Since Pw is lower than the domestic price would be if trade was prohibited, consumers will expand consumption and producers reduce production. • The would-be shortage in a closed-economy is imported.

(continued) • Under the import and export cases, the market is in equilibrium. Producers can sell as much as they want, and consumers can purchase as much as they want, at the market equilibrium price. • With international trade, the market equilibrium price is the world price (Pw).

Shift in the Demand Curve in an Open Economy • The shift in demand and supply curves have different effects in an open economy compared to an economy closed to international trade. • In an open economy, the domestic price and the world price are the same at Pw. Changes in domestic demand do not change the price because the country’s exports are not large enough to alter the world price (small country assumption)

(continued) • Suppose there has been an outward shift in domestic demand. What are the effects to quantity supplied (Qs), quantity demanded domestically (Qd), and quantity exported or imported. • **Refer to in-class examples**

Why Nations Trade: • For nations, differences in productive capacities determine who or which nation specializes in producing various goods and thus international trade flows. • To understand how these differences affect trade flows, we must first examine the benefits from international trade.

(continued) • Exporting is beneficial in that jobs are created and profits are generated. The income produced can be used to buy foreign or domestic goods. • Why would consumers want to consume foreign goods? • 1) It might not be possible to produce the foreign good at home. • 2) It might be cheaper to purchase goods from another country.

Absolute vs. Comparative Advantage • Absolute Advantage – a country has an absolute advantage in the production of a good if it can produce more of that good with a given set of resources than another country. • If one country has an absolute advantage in the production of rice and another country has an absolute advantage in the production of beans, then the trade flows are obvious.

(continued) • Comparative Advantage – a country has a comparative advantage in those goods for which it has the lowest opportunity cost compared to its trading partners. • What is meant by “lowest opportunity cost”? • If countries export those goods and services for which that have a comparative advantage and import goods for which they have a comparative disadvantage – Trade is mutually beneficial to all nations.

(continued) • If all nations were the same, there would be no reason to trade. • However, there are 3 important differences that explain why countries trade. • 1) Resource endowments • 2) Production technologies • 3) Tastes and Preferences

AAEC 2305 Fundamentals of Ag Economics