Unit 4: The Global Economy: International Trade and Development

Unit 4: The Global Economy: International Trade and Development Chapter 12: Trade Theory, Agreements, and Patterns Chapter 13: Financing International Trade Chapter 14: International Trade Issues

Chapter 17: Trade Theory, Agreements, and Patterns • Overview • The importance of trade • Trade restrictions • Canadian trade patterns and policies • Major international trade agreements

The Importance of Trade to Canadians • Throughout history, nations have traded with one another • Selling some of their surplus products • Buying other products that they need • Today, international trade is more important that ever and continues to grow rapidly

The Importance of Trade to Canadians • If we were to focus only on the foods that Canadians like to consume, the list would include: • Oranges from California and Florida • Pineapples from Hawaii • Watermelons from Georgia • Grapes from Chile • Bananas from Costa Rica • Sugar from Jamaica • Kiwi and chestnuts from Italy • Lamb from New Zealand • Coffee from Columbia • Tea from India

The Importance of Trade to Canadians • We are all largely dependent on imports • Goods and services bought from other nations • Canadians also sell a large amount of goods and services to buyers around the world • These exports account for ~40% of Canada’s GDP, amounting to $423 billion in 2000 • Almost 1 in 4 jobs in Canada is directly dependent on exports • In comparison, exports account for only ~10% of GDP in the US • Only 1 in 12 jobs directly depends on exports

The Case for International Trade • The volume and value of global trade continue to grow each year • Why do nations prefer to trade instead of attempting to become more self-sufficient? • Why do they prefer to rely on other nations for certain goods and services instead of developing domestic industries to provide those same goods?

The Case for International Trade • Nations buy goods from other nations for the same reasons that individuals buy from other individuals • No reasonable social being can afford to be totally self-sufficient • The economic costs would be too great • A person can’t independently produce all the food, clothing, construction materials, machines, medicines, entertainment, and information systems that are needed • Your productivity and your standard of living are much higher if you can specialize in what you do best and buy the rest of what you need from others who are specialists at different things

The Case for International Trade • Trade allows industries to specialize • Achieves greater economic efficiency • Improved productivity and the benefits of operating at a large scale usually improve market prices and living standards for people in both the importing and exporting countries • The trend towards increased international trade results in a spread of large-scale transnational enterprises with international markets for their goods and services • All party of an economic trends called globalization

Trade Benefits All Parties • One of the important economic principles of international trade is that both buyer and seller benefit from the transaction

Trade Benefits All Parties • Specialization is often identified as the most important mutual benefit from international trade • Clear economic advantages to allowing nations to concentrate their industrial activity on the mass production of goods for which they have the necessary resources • To truly understand the economic benefits of international trade, we will have to examine two concepts introduced in Chapter 3 • Absolute advantage • Comparative advantage

Absolute Advantage • The concept of absolute advantage can be presented through the following hypothetical situation: • Suppose your neighbor is a highly trained and skilled car mechanic • Able to tune up a car in 20 minutes • But it takes him an entire day to work a computer • You are a highly trained and skilled computer technician • Can correct most computer malfunctions in 20 minutes • But it takes you an entire day to tune up your car

Absolute Advantage • You can both accomplish more, with greater efficiency, if your neighbor were to specialize in auto mechanics and you were to specialize in computer technology • You could pay your neighbor to tune up your car instead of wasting your valuable time doing it yourself • Your neighbor would gladly pay you to set up the computer to perform required tasks • You would both personally benefit from specialization and trade, and your community would become more productive

Absolute Advantage • If an individual, region, or nation can produce something more efficiently than another (by using fewer resources), it is said to have an absolute advantage in making that product • Saskatchewan has an absolute advantage over BC in wheat production • BC has an absolute advantage over Saskatchewan in the manufacture of wood products • If each province has an absolute advantage producing one item, they should specialize in that product and trade with other provinces • Interprovincial trade would benefit all participants and the Canadian economy as a whole

Absolute Advantage • To see if this idea applies globally, we need to use the concept of opportunity cost • Let’s use a hypothetical case involving two fictional nations called Atlantica and Pacifica • Assume these two countries can manufacture only two products: computers and cars • Assume that production costs are constant and there are no transportation costs and no government restrictions on trade

Absolute Advantage • Atlantica can choose to produce either 200 computers or 5 cars every 10 production days • Pacifica can produce either 100 computers or 20 cars in 10 production days • This table clearly outlines the opportunity costs in each nation Table 12.1: Production opportunities: quantity of computers or cars that can be made in 10 production days

Absolute Advantage • In attempting to meet monthly demand for cars and computers, the two nations are able to produce 300 computers and 50 cars when 10 production days are used to make computers, and 20 days are used to make cars Table 12.2: Output of cars and computers per 30 day production cycle, without specialization. Each nation manufactures its own products.

Absolute Advantage • In the first 10 production days, Atlantica manages to produce twice as many computers as Pacifica (200 vs. 100) • Atlantica has an absolute advantage over Pacifica in computer production • In the remaining 20 production days, Pacifica manages to produce four times as many cars as Atlantica (40 vs. 10) • Pacifica has an absolute advantage over Atlantica in car production • Atlantica should specialize in computer production and trade some to Pacifica for cars • In order to understand why, we must consider opportunity costs

Absolute Advantage • In one month, Pacifica could produce either 300 computers or 60 cars • 300 computers are as valuable as 60 cars since they both consume 30 days of production time • The opportunity cost of producing 60 cars is the 300 computers that must be sacrificed in order to produce them • Each car that Pacifica produces will cost the nation 5 computers

Absolute Advantage • To Atlantica, 600 computers are as valuable as 15 cars, since either is achieved in the same production time (30 days) • The opportunity cost of producing 600 computers is the 15 cars that must be sacrificed • Each car Atlantica produces will cost the nation 40 computers • Clearly Atlantica can’t afford to produce cars because it will be forced to sacrifice far too many computers

Absolute Advantage • As a result of each nation’s putting its absolute advantage to use, the total production of both cars and computers has increased through specialization • During the same 30-day production cycle, 300 additional computers and 10 additional cars have been produced Table 12.3: Output of cars and computers per 30 day production cycle, with specialization. Each nation uses its absolute advantage.

Absolute Advantage • However, there are no new cars available for purchase in Atlantica and no computers available in Pacifica • The two nations must arrange to trade some cars for computers in trade terms that are acceptable to both nations • Acceptable trade terms generally requires the benefits of specialization to be shared by both partners • The two nations agree to trade 200 computers for 15 cars Table 12.4: Output of cars and computers per 30 day production cycle, after specialization and trade.

Absolute Advantage • Clearly the productive efficiency of both nations has been improved by specialization and trade • More computers and cars are available each month to consumers in both trading nations • Over time, it’s likely the quality and price of both products will also improve as a result of specialization and trade

Comparative Advantage • Do specialization and trade continue to provide similar economic benefits when one nation has an absolute advantage in the production of both goods being traded? • The answer is, surprisingly, yes • To understand why, we must explore the concept of comparative advantage • First outlined by David Ricardo (Chapter 3) almost 200 years ago • Even if one nation has an absolute advantage in every field of production, chances are that it will have a greater advantage in some fields than in others • These differences in relative efficiencies, or comparative advantage, are all that is required to make specialization and trade economically beneficial for individuals, regions, and nations

Comparative Advantage • Suppose you are one of the best world processors and lawyers in the community • Since you can earn more money as a lawyer, you would be wise to concentrate on law and hire someone else to do your word processing • An hour spent word processing can’t be spent in the courtroom • The opportunity cost of word processing is too high for you to attempt to be self-sufficient in both areas • You have a comparative advantage (relative to others) in the practice of law • You also have a comparative advantage (relative to others) in word processing

Comparative Advantage • Let’s illustrate this principle with another series of hypothetical production tables • The nation of Floren has an absolute in the production of both cars and computers • Its advantage over Guilder in computer production is at the ratio of 2:1 • Its advantage over Guilder in car production is at the ratio of 4:1 • Floren has a relatively greater absolute advantage (or comparative advantage) in car production Table 12.5: Output of cars and computers per 30 day production cycle, without specialization. Each nation manufactures its own products.

Comparative Advantage • In one month, Floren could produce either 600 computers or 60 cars • 600 computers are as valuable as 60 cars since they both consume 30 days of production time • The opportunity cost of producing 600 computers is the 60 cars that must be sacrificed in order to produce them • Each computer that Floren produces will cost the nation 0.1 of a car

Comparative Advantage • To Guilder, 300 computers are as valuable as 15 cars, since either is achieved in the same production time (30 days) • The opportunity cost of producing 300 computers is the 15 cars that must be sacrificed • Each computer Guilder produces will cost the nation 0.05 of a car • Based on opportunity costs, Guilder has a comparative advantage in the production of computers • Fewer cars are being sacrificed • Both nations would benefit from specialization and trade if each nation uses its comparative advantage

Comparative Advantage • As a result of specialization, total production in the two nations has improved • There are just as many computers as before (300 units produced each month), but 10 additional cars are now produced each month • Using the principle of comparative advantage, the productive capacity of the two nations has been expanded by introducing greater efficiency Table 12.6: Output of cars and computers per 30 day production cycle, with specialization. Each nation uses its absolute advantage.

Comparative Advantage • If Guilder were to trade 200 computers for 15 cars, it would have an extra 5 cars available per month • Concrete proof that specialization and trade with Floren continue to provide economic benefits • Floren, with 45 cars now available per month, would be able to show an identical benefit of 5 extra cars • Using the principle of comparative advantage, both nations continue to benefit from specialization and trade Table 12.7: Output of cars and computers per 30 day production cycle, after specialization and trade.

Comparative Advantage • Comparative advantage originates from local, regional, and national variations that exist in the distribution of productive resources • Referred to as relative factor endowment • Represents what a community, province, or nation is naturally given to work with • Comparative advantage also results from the efficiency, effectiveness and scale of operations • Referred to as relative factor intensity • Represents how a particular resource endowment is put to use • Variations in factor endowment and factor intensity create local, regional, and national conditions of comparative advantage that promote cooperation and trade

Terms of Trade • The rate at which a country’s exports are exchanged for its imports is known as the terms of trade • Establish an international price for one product in terms of another product • This price depends partly on the domestic opportunity costs experience in both trading nations prior to trade • Traders must, at the very least, recover the opportunity costs that apply in domestic transactions in order to make international trade worthwhile

Terms of Trade • Let’s return to our example of Floren and Guilder • Before trade… • The opportunity cost of producing each car in Floren is 10 computers • The opportunity cost of producing each car in Guilder is 20 computers • If Guilder can acquire a car from Floren for less than 20 computers, it would make economic sense to do so • If Floren can acquire 200 computers from Guilder for less than the 20 cars it would be forced to sacrifice in order to produce its own computers, again, it would make economic sense to do so

Terms of Trade • If Guilder attempts to sell 200 computers to Floren for 20 cars, all the benefits of the trade would be assumed by Guilder • These terms of trade would not be acceptable to Floren • Fair negotiations should allow both trading partners to share the economic gains realized through specialization and trade

Terms of Trade • Over a period of time, market prices in the two nations would also be affected by a trade agreement between Floren and Guilder • In Guilder, given the opportunity cist, the price of a car should be 20X the cost of a computer • Since cars are available from Floren at the cost of 13.3 computers per unit, the price of cars relative to computers (in Guilder) will be reduced over time • In Floren, given the increase in the monthly supply of cars, the price of cars should also fall over time • Imports should help keep car prices competitive in both nations

The Case for Trade Restrictions • The gains from trade normally benefit both trading partners • However, historically, arguments have been made for the restriction of trade • Arguments usually focus on: • The protection of domestic industries from foreign competition • The protection of the domestic economy from foreign influence and control • The following arguments are used to support national policies that restrict international trade

Economic Arguments Protection of domestic employment • Importing goods, without increasing exports, results in the exporting of jobs • As imports flow into a nation, money must flow out to pay for them • The demand for domestic products is reduced and production levels decrease • Lower demand and production can slow down economic growth and create unemployment • On the other hand, a reduction in imports can stimulate economic activity in a nation and provide more jobs for domestic workers, at the expense of foreign workers

Economic Arguments • Imports produced by… • Low-cost labour in less developed economies • Government-subsidized production in other industrialized nations • …must be restricted from entering an industrialized nation in order to protect the jobs of domestic workers • Ex: In 2001, US President George W. Bush imposed ~30% taxes on softwood lumber imports from Canada, in order to protect jobs in the US softwood industry • Critics are quick to point out that jobs in inefficient industries may be protected at the expense of consumer prices, aggregate productivity, and ultimately, living standards

Economic Arguments Retaliation • When a trading partner adopts a strategy of import reduction to combat domestic unemployment, it is effectively exporting some of its unemployment to the other nation’s economy • This other nation may try to recapture some of the lost jobs by imposing new import restrictions of its own • This generally leaves both partners worse off by reducing the benefits of specialization and trade • Domestic producers often argue that we should not let foreign goods into our country if our goods are excluded from their markets

Economic Arguments Protection against dumping • Sometimes foreign competitors attempt to dump production surpluses abroad to protect domestic prices • Dumping refers to the deliberate practice of selling a product abroad at a price lower than the domestic price • Ex: A shirt that sells for $100 in the country in which it was made might be sold to foreign buyers for $50 in order to unload large quantities of stock without affecting the $100 selling price at home • Dumping makes it very difficult for shirt producers in the second nation to compete • They may not be able to sell their shirts for $50 without incurring heavy losses • Trade restrictions can help reduce the frequency and limit the impact of dumping

Economic Arguments Diversification • Trade restrictions can help to diversify an economy whose prosperity is closely tied to the export of a few products or to a single nation • Extreme reliance on a few export products or on a single trading partner can leave an economy vulnerable to market fluctuations abroad • Trade restrictions allow for the development of new domestic industries and export markets • The more a national economy is diversified, the more self-sufficient it will be in times of conflict or crisis

Economic Arguments Protection of “vital” industries • Trade restrictions can also be used to protect national security and public health • For example, the uncontrolled export of military equipment, biotechnology, and nuclear technology can compromise national and global security if these resources fall into the wrong hands

Economic Arguments Protection of developing industries • Trade restrictions can be used to protect developing, or “infant”, industries from foreign competition • Because of their recent origin and small size, newer domestic industries may lack the efficiency and economies of scale needed to compete head to head with established foreign producers • The problem with this argument is the difficulty in determining the point at which a developing industry had had sufficient time to stand on its own against foreign competition • Critics argue that, under protection, there is no incentive to maximize efficiency, and, therefore, protected “infant” industries never mature

Economic Arguments Improvement of terms of trade • When a nation’s volume of trade is large enough to affect global markets, it can use trade restrictions to improve its terms of trade • For example, by restricting its exports of petroleum, the world’s largest oil-exporting nation could affect the global market price for crude oil by producing a supply shortage • By imposing restrictions on its imports, the world’s largest importer of newsprint could decrease the global demand for that product enough to lower the market price • On a smaller scale, trading partners can impose temporary trade restrictions to help negotiate more favorable terms of trade

Economic Arguments Protection of environmental and safety standards • In order to protect workers and the natural environment, many governments impose industrial standards • These standards vary greatly • When a nation imposes high standards, this results in increased production costs for domestic industries • These increased costs are generally passed on to the consumer in the form of higher prices • Nations with lower environmental and safety standards effectively reduce the operating expenses and product prices of domestic industries

Economic Arguments • If trade restrictions are not imposed on products coming from nations with lower standards… • Increased globalization will be accompanied by more incidents of environmental damage and worker injury • Firms will be able to profit from practices that fall well below the standard of good corporate citizenship • In a global economy, firms may choose to relocate to countries with lower standards in order to gain a competitive advantage and improve profits

Economic Arguments Protection from foreign influence and control • Trade restrictions can be used to protect key domestic industries from foreign control • Increased imports results in a net flow of money out of the country • Domestic currency in the hands of foreign investors can be used to purchase control of chief domestic industries rather than to purchase consumer goods • Governments may seek to control the flow of currency out of a country by setting restrictions on imports

Economic Arguments • Cultural industries can be protected from foreign domination • Two such industries are: • Broadcasting (protected by restricting the imported content of radio and tv programming) • Publishing (protected by restricting the use of foreign textbooks in schools)

Economic Arguments • There are many arguments in favour of restricting trade • Generally speaking, at the heart of most arguments is the trade-off between global economic efficiency and the political and economic pursuits of a nation • As the forces of globalization prevail, national agendas will continue to diminish in importance

Impediments to Trade • At the present time, the volume of international trade is restricted by the 7 impediments outlined in the handout provided

Canadian Trade Patterns • In order to understand the magnitude and scope of international transactions, we need to clarify further the terminology of trade • Goods that are grown, extracted, or manufactured in one country and sold to another form part of the global merchandise trade • Also referred to as visible trade because of the tangible nature of the goods • The exchange of service, tourism, investment incomes, and other transfers of funds is known as non-merchandise (or invisible) trade • Consists of money flows often without tangible products flowing in return • More difficult to document and measure statistically due to its intangible nature

Unit 4: The Global Economy: International Trade and Development