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Trade Issues

Trade Issues. If one country gains, must the other lose? Think comparative advantage. Do imports reduce employment? Do tariffs/quotas/restrictions save jobs? When might they? Should weak domestic industries be subsidized? Is a trade deficit “bad”? Is a surplus “good”?

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Trade Issues

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  1. Trade Issues • If one country gains, must the other lose? • Think comparative advantage. • Do imports reduce employment? • Do tariffs/quotas/restrictions save jobs? • When might they? • Should weak domestic industries be subsidized? • Is a trade deficit “bad”? Is a surplus “good”? • Does “fair trade” mean that our exports to a country will equal our imports from it?

  2. Historical development of trade theory • Mercantilism: get positive trade balance • David Hume: specie flow balances payments • Absolute advantage (Adam Smith) • Countries benefit from exporting what they make cheaper than anyone else…and buying abroad what they can buy for less Specialization  Division of Labor  Growth • Comparative advantage (David Ricardo) • Nations can gain from specialization, even if they lack an absolute advantage

  3. Absolute & Comparative Advantage • Absolute advantage: each nation is more efficient in producing one of the goods • Output per labor hour • Nation WineCloth • United States 5 bottles 20 yards • United Kingdom 15 bottles 10 yards • Comparative advantage: the US has an absolute advantage in both goods • Output per labor hour • Nation WineCloth • United States 40 bottles 40 yards • United Kingdom 20 bottles 10 yards • Expect more productive US workers to have higher real wage.

  4. Comparative advantage Ricardo’s Comparative Advantage in money prices Cloth (yards) Wine (bottles) Nation LaborWage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 : : : : : : : UK 1 hr $10 10 $1.00 20 $0.50 (at $2.00 = £1)  No reason to buy British stuff

  5. Ricardo’s Comparative Advantage in money prices: British workers take wage cut Cloth (yards) Wine (bottles) Nation LaborWage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £4/hr 10 £0.40 20 £0.20 : : : : : : : UK 1 hr $8 10 $0.80 20 $0.40 (at $2.00 = £1)

  6. Ricardo’s Comparative Advantage in money prices: the pound depreciates Cloth (yards) Wine (bottles) Nation LaborWage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.40 20 £0.20 : : : : : : : UK 1 hr $8 10 $0.80 20 $0.40 (at $1.60 = £1)

  7. Comparative advantage: autos and wheat Production possibilities schedules: constant opportunity costs Slope = 2.0 = MRT Slope = 0.5 = MRT In Canada, Oppty cost of 1 Car = 2 Wheat When US resources are redeployed from wheat to autos, produce 2 cars for every ton of wheat sacrificed: Oppty cost of 1 Car = ½ Wheat Wheat Wheat

  8. Trading under constant opportunity costsMarginal Rates of Transformation in Production:US: 60 wheat = 120 cars  ½ wheat/carCND: 160 wheat = 80 cars  2 wheat/car Trading possibilities line (terms of trade 1:1) B’ Trading possibilities line (terms of trade 1:1) tt D’ C’ E Wheat Wheat A’ C A F tt B D

  9. Comparative advantage Production gains from specialization: constant opportunity costs Before After Net Gain Specialization Specialization (Loss) AutosWheat AutosWheatAutosWheat US 40 40 120 0 80 -40 Canada 40 80 0 160 -40 80 World 80 120 120 160 40 40

  10. Comparative advantage Consumption gains from trade: constant opportunity costs and Terms of Trade = 1:1 (Trade 60 Wheat for 60 Cars) Before After Net Gain Trade Trade (Loss) AutosWheat AutosWheatAutosWheat US 40 40 60 60 20 20 Canada 40 80 60 100 20 20 World 80 120 120 160 40 40

  11. Possible terms of trade • Less than ½ Wheat/Car  US won’t trade • More than 2 Wheat/Car  Canada won’t trade Equilibrium terms of trade: enter DEMAND • The importance of being unimportant • large country continues to produce some of everything • Terms – of – trade settle at (near) large country’s MRT • Small country gains (almost) all Dynamic gains from trade • The division of labor is limited by the extent of the market • Economies of scale • Global competition  Creative destruction  Efficiency • Technology transfer  Growth

  12. tt’ E D Trade restrictions and reduced gains from trade(Limit Oil Imports to 200) tt C Production Poss @ MRT = 5/8 : 1 Consumptionpossibilities @ 1.5:1 terms of trade A Crude oil B

  13. Why is complete specialization rare? Production possibilities schedule under increasing costs Slope 1Auto = 1Wheat A Slope 1Auto = 4Wheat Wheat B Oppty cost of autos increases as more autos are produced.

  14. Trading possibilities line C D B tt (1A =1W) Trading under increasing costs: US stops short of total specialization in autos A tUS (1A = 0.33W) Wheat

  15. Trading possibilities line B’ C’ tt (1A =1W) D’ Trading under increasing costs: Canada stops short of total specialization in wheat.At limit, MRT = 1:1 in both countries. But … tC (1A = 3W) Wheat A’

  16. Additional Considerations • Spectrum of comparative advantage • Multilateral trade…“triangle trade” • Entry barriers/Exit barriers • Irreversible commitments slow adjustments to changes in competitive advantage • Outsourcing and its discontents • Costs, costs, costs • Cultural disconnects • Pat Mulroy (SNWA): “We’ve brought employees in from back East. It takes them a good year to learn how different the West Coast is.”

  17. Insights and Review Humian adjustment (David Hume, 1711-1776) An early equilibrium model Suppose one country enjoys a balance of trade surplus • It’s trading partner experiences a deficit “Gold” flows from deficit country to surplus country • The surplus country’s money supply increases • Prices rise in the surplus country The surplus country’s goods become less attractive • It sells less to the other country • It buys more from the other country The balance of trade balances

  18. Insights and Review A country enjoys a comparative advantage in the good for which its opportunity cost of production is low. • Trade proceeds as long as the terms of trade (wine/cloth) is less than the wine exporting country’s opportunity cost of producing cloth and greater than the wine importing country’s opportunity cost of producing cloth. • The wine exporting country trades less of its wine for cloth than it would have to sacrifice in autarky • The wine importing country gets more wine for its cloth than it would get in autarky • In general, a country’s Terms of Trade equals {Price It Receives for Its Exports}/{Price It Pays for Its Imports} • The closer the terms of trade are to its own opportunity cost, the less a country gains from trade: it may as well not trade • If its demand for the good it imports is high, it will pay a high price for its import and not gain much from trade.

  19. Dynamic Gains from Trade • Competitive pressure  Efficiency • Domestic suppliers must compete globally • The firm itself must compete globally • Technology transfer  Efficiency • Increased extent of the market  Economies of scale  Efficiency

  20. Insights and Review • If a country is not competitive because its workers are inefficient or “overpaid” (its costs are high), it can become competitive by • Depreciation of its currency But if its exchange rate is fixed • It pays for its import surplus with “gold” (Hume) • Its wages and prices deflate … while wages and prices in the export surplus country inflate Or • If its workers resist taking wage cuts, they suffer unemployment • Its trade balances because it imports less

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