Frank Bernanke rd edition 2007 3 Ch

Frank & Bernanke rd edition, 2007 3 Ch. 9: International Trade 1

Comparative Advantage l The principle of comparative advantage tells us that we can all enjoy more goods and services when each country produces according to its comparative advantage, and then trades with other countries. 2

Production Possibilities Curve for a Many-Worker Economy A Coffee (pounds/year) 100, 000 40, 000 Observations • The OC of producing an additional unit = the slope of the line that touches the point • OC will increase as output of on good increases C D B 1, 000 2, 000 Computers (number/year) 3

Production and Consumption Possibilities and the Benefits of Trade l In a closed economy: l Society’s production possibilities = consumption possibilities. l If a country is self-sufficient, it is called autarky. l In an open economy: l The society’s consumption possibilities are typically greater than its production possibilities. 4

Buying and Selling in World Markets 150, 000 Coffee (pounds/year) 120, 000 A C Assume: • Producing at D • Closed economy • World price of coffee = $10/lb and computer = $500 100, 000 D 50, 000 B 1, 000 2, 400 Computers/year 3, 000 5

Buying and Selling in World Markets 150, 000 Coffee (pounds/year) 120, 000 E Consumption possibilities A C 100, 000 Observation: • Sell 2, 000 computers @ $500 • Take the $1 million and buy 100, 000 pounds of coffee • Consumption possibilities of 150, 000 is greater than PPC without trade D 50, 000 Production possibilities B 1, 000 2, 400 Computers/year F 3, 000 6

Buying and Selling in World Markets 150, 000 Coffee (pounds/year) 120, 000 E Consumption possibilities A C Observation: • Start at D • Sell 50, 000 lbs of coffee • Buy 1, 000 computers with the $500, 000 • Pt F is possible with trade but not on the PPC 100, 000 D 50, 000 Production possibilities B 1, 000 2, 400 Computers/year F 3, 000 7

Optimal Production Mix for an Open Economy 160, 000 150, 000 L E Coffee (pounds/year) 120, 000 100, 000 Consumption possibilities • 50 lbs of coffee trades for 1 computer • LM = consumption possibilities • G is the optimal combination for Costa Rica • Costa Rica can use trade to locate anywhere along LM A C 50, 000 G D Production possibilities B 1, 000 2, 400 Computers/year F M 3, 000 3, 200 8

Optimal Production Mix for an Open Economy 160, 000 150, 000 L E Coffee (pounds/year) 120, 000 100, 000 Consumption possibilities Why produce at G? • Slope of the PPC = LM • Domestic and international opportunity costs of acquiring an extra computer (in terms of forgone coffee) are equal A C 50, 000 G D Production possibilities B 1, 000 2, 400 Computers/year F M 3, 000 3, 200 9

A Straight-Line PPC Coffee (pounds/year) 800 600 A B Observation • The tradeoff between coffee and tea is constant at any point on the PPC C 200 D 200 600 Tea (pounds/year 800 10

Two Consumption Possibilities Curves Consumption possibilities curve when the world price of coffee is twice the world price of tea Coffee (pounds/year) 800 600 A • Islandia produces at A • Islandia can use the money earned from selling 800 lbs of coffee to choose any combination on AD’ B C 200 D 200 600 800 Tea (pounds/year D’ 1, 600 11

Two Consumption Possibilities Curves Coffee (pounds/year) 1, 600 A’ Consumption possibilities curve when the world price of tea is twice the world price of coffee 800 600 200 A • Islandia produces at D • Islandia can choose any combination on A’D B C D 200 600 800 Tea (pounds/year 12

Consumption Possibilities With and Without International Trade l With a bow-shaped PPC consumption possibilities is typically maximized by producing where the PPC is tangent to the consumption possibilities line. l With a straight-line PPC production is completely specialized. 13

Does “cheap” foreign labor pose a danger to high-wage economies? l Scenario l U. S. and Fredonia produce software and beef. l Real wages in Fredonia are lower than in the U. S. l Fredonia is half as productive as the U. S. in beef production. l Fredonia is one-tenth as productive in software production. 14

Does “cheap” foreign labor pose a danger to high-wage economies? l Outcome l Fredonia has a comparative advantage in beef. l U. S. has a comparative advantage in software. l The U. S. will trade software for beef and increase its consumption of both. l Employment in the software industry in the U. S. increases and employment in the beef industry will decrease. 15

The Market for Computers in Costa Rica Consumer surplus without trade = $1 mil/yr 2, 400 Domestic supply Consumer surplus with trade = $1. 96 mil/yr 2, 400 E Producer surplus with trade = $360 K/yr E 1, 400 Producer surplus without trade = $1 mil/yr Domestic supply F 1, 000 World price Computer Imports 400 Domestic demand 2, 000 Computer per year Without Trade 4, 800 400 Domestic demand 1, 200 2, 000 2, 800 Computer per year With Trade 4, 800 16

A Supply and Demand Perspective on Trade l If the price of a good or service in a closed economy is greater than the world price, and that economy opens itself to trade, the economy will tend to become a net importer of that good or service. 17

The Market for Coffee in Costa Rica Consumer surplus without trade = $250 K/yr Consumer surplus with trade = $40 K/yr Domestic supply 12 10 E F World price E 7 7 Producer surplus with trade = $600 K/yr Producer surplus without trade = $150 K/yr 4 4 Domestic demand 100, 000 Coffee (pounds/year) Without Trade 240, 000 Coffee exports Domestic demand 40, 000 100, 000 240, 000 Coffee (pounds/year) With Trade 18

A Supply and Demand Perspective on Trade l If the price of a good or service in a closed economy is lower than the world price, and that economy opens itself for trade, the economy will tend to become a net exporter of that good or service. 19

Mutually Beneficial Gains from Trade l l Countries will profit by exporting the goods and services for which they have a comparative advantage. The revenue from the exports are used to import goods and services for which they do not have a comparative advantage. The markets will ensure that goods will be produced where opportunity cost is lowest. The consumption possibilities will be maximized. 20

Price of computers ($/computer) Exercise Domestic supply 2, 400 Question • Given the graph shown, what impact would trade have on producer and consumer surplus? 2, 100 World price 1, 200 600 Domestic demand 200 500 800 Computers per year 1, 200 21

Winners and Losers from Trade l Winners l Consumers of imported goods l Producers of exported goods l Losers l Consumers of exported goods l Producers of imported goods 22

Protectionism l l Tariff l l A tax imposed on an imported good Quota l l The view that free trade is injurious and should be restricted A legal limit on the quantity of a good that may be imported Other l l Red-tape barriers Regulations 23

Price of computers ($/computer) Import Tariff on Computers Domestic supply 2, 400 E 1, 200 World price + tariff 1, 000 World price 400 Imports without tariff 1, 200 1, 600 2, 400 2, 800 Computers per year Domestic demand 4, 800 24

The Market for Computers after the Imposition of an Import Tariff Price of computers ($/computer) 2, 400 Consumer surplus with tariff = 1. 44 K/yr Domestic supply Tariff revenue = $160 K/yr E 1, 200 World price + tariff 1, 000 World price 400 Producer surplus with tariff = 640 K/yr Imports with tariff 1, 200 1, 600 2, 400 2, 800 Computers per year Domestic demand 4, 800 25

Exercise Domestic supply Price of computers ($/computer) 3, 600 Question • Given the graph shown, how will a tariff of $300 per computer affect total economic surplus? 2, 100 1, 500 World price 1, 200 600 Domestic demand 200 300 500 700 800 Computers per year 1, 200 26

Protectionist Policies l What do you think? l Why did President George W. Bush support the imposition of tariffs on steel imported into the United States? 27

Protectionist Policies l Quotas l Legal limit on the number or value of foreign goods that can be imported l Can be enforced by issuing permits 28

Imposition of an Import Quota Domestic supply Price of computers ($/computer) 2, 400 Domestic supply + quota E 1, 400 Imports with free trade = 1, 600 computers/yr F 1, 200 World price 1, 000 400 Domestic demand 1, 200 1, 600 2, 400 2, 000 2, 800 Computers per year 4, 800 29

The Market for Computers after the Imposition of an Import Quota Price of computers ($/computer) 2, 400 Domestic supply Consumer surplus with quota = $1, 440 K/yr Domestic supply + quota E 1, 400 Economic rent to holders of import licenses = $80 K/year F 1, 200 World price 1, 000 Imports = 800 computers/year 400 Producer surplus with quota = $640 K/yr Domestic demand 1, 200 1, 600 2, 400 2, 000 2, 800 Computers per year 4, 800 30

Quotas & Tariffs l Market effects are the same. l Tariffs generate tax revenue. l Quotas generate revenue for the firms that hold an import license. 31

Quotas l Who benefited from and who was hurt by voluntary export restraints on Japanese automobiles in the 1980 s? 32

The Inefficiency of Protectionism Trade barriers are inefficient and reduce the size of the economic pie. l Because trade barriers benefit certain groups, and these groups may be well organized, they may be successful in lobbying for trade barriers. l The gains from trade could be used to assist groups that have been hurt by trade. l 33

Outsourcing A term increasingly used to connote having services performed by low-wage workers overseas l Outsourcing of services to low-wage foreign workers is exactly analogous to the importation of goods manufactured by low-wage foreign workers. l 34

Outsourcing l Characteristics of Jobs that are Less Susceptible to Outsourcing l Less rules-based jobs l “Face-to-Face” complex communication jobs l Jobs that require the worker to be physically present 35

Outsourcing Responding to changing economic conditions requires the ability to adapt quickly to new circumstances. l Education provides the means to develop a comparative advantage that is not rules -based and does require complex face-to -face communication. l 36