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Bob Carbaugh
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Ellensburg, Washington 98926
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Discussion 1 Need response According to Janssen, Wimmer & Del.docx
- 1. Discussion 1: Need response According to Janssen, Wimmer & Deljoo, (2015), policy making is a complex procedure which involves many stakeholders and which is subdivided into different stages which are identifying the problem, agenda setting, formulating the policy, policy adoption and implementation of the policy and finally evaluating the policy. Through every stage, the roles of the stakeholders are different. Stakeholders are important in this process as they give their opinions on what they want from the policy and they usually contribute to the acceptance of the policies by the community. This is because their involvement leads to an improved rate to which the residents get to comprehend the aspects of the policy. Their engagement also gives room for the airing out of many and varied alternatives for the policy. In the policy making, different stakeholders who may present contrasting opinions are involved and this provides room for solving their disputes. Thus, both the knowledgeable and those lacking participate. In the first stage, there is identification of the problem which requires the formation of a policy to address it. In this first stage, there is identification of the stakeholders who are to be involved in the policy making. There is identifying those who will be involved and then taking time to properly know them well, then there is estimating the resources that will be spent so that they are included in this process. This stage is important as it determines the ways through which they will be involved in the policy making. In the subsequent stages for instance the policy formulation stage, the stakeholders are fully involved in the process (Sterling, Betley, Sigouin, Gomez, Toomey, Cullman, Malone, Pekor, Arengo, Blair, Filardi, Landrigan & Porzecanski, (2017)). This is because they offer their opinions. In this stage, stakeholders who may be skilled in that particular area are consulted so that the policy is well
- 2. informed. In evaluation of the policy, the residents who use the policy are involved in which they are asked to air their opinions on the impact of the policy. Discussion 2: Need Response Problem Identification is the first step in the process of solving our project. We need to start by knowing exactly what the problem is, how the product should be designed, and what is its purpose. Problem Identification is the ability to recognize which problems are likely to be encountered in a particular task. Problem Identification should be taught from the first grade, at least. By the time they are in second grade, they should be able to recognize some of the problems they will face when solving the problems, they have learned but will probably find challenging in their careers. Moreover, the time they are in the third grade, we should be able to recognize some of the problems we will face when solving the problems, we have learned, but will probably find challenging in our careers. By the time they are in the fourth grade, we should have a high enough rate of success with the Problem Identification to be able to see what will be challenging to us, and what will not be challenging at all (Harland, 2019). Problem Identification is one of the objectives of a stakeholder’s engagement with the stakeholder group. A stakeholder is a person who is not a direct employee of the organization and who is actively involved in a particular issue. Stakeholders may be a group, organization, r individual. The primary holder to determine the views of stakeholders and to gain the views of all stakeholders, in order to provide information and suggestions to the organization about how to address the issue. The focus is on identifying the priorities and priorities of stakeholder groups, and on the impact, these priorities will have on policy-making. A policy-making group is
- 3. usually made up of representatives of a variety of stakeholders, each of whom is responsible for their own group's positions. A government agency usually convenes a policy-making group and views of the agency regarding potential policy changes. The group must consider the interests of all stakeholder groups and not just those who are directly affected by the proposed policy change. The agency then considers the best policy changes to make and, if applicable, to implement (Cubilla‐Montilla, 2019). Discussion 3: need response AGENDA SETTING: Agenda setting is an important aspect of the public policy process. Sudden, rare, and harmful events, known as focusing events, can be important influences on the policy process. Such events can reveal current and potential future harms, mobilize people and groups to address the policy failures that may be revealed by such events, and open the “window of opportunity” for intensive policy discussion and potential policy change. Although the idea of focusing events is firmly rooted in Kingdon’s “streams approach” to the policy process, focusing events are an important element of most theories of the policy process. Stakeholders having different interests, compete against each other to earn their issues a place on the agenda and keep others' issues off the agenda. Competition arises because the agenda is finite in scope and the political system possesses limited means and resources, whereby a finite number of issues can be addressed, among all possible issues perceived by the political community as requiring public intervention.
- 4. POLICY FORMULATION: Policy formulation is the second stage of the policy process and involves the proposal of solutions to agenda issues. Congress, the executive branch, the courts, and interest groups may be involved. Contradictory proposals are often made. The president may have one approach to immigration reform, and the opposition-party members of Congress may have another. Policy formulation has a tangible outcome: A bill goes before Congress or a regulatory agency drafts proposed rules. The process continues with adoption. A policy is adopted when Congress passes legislation, the regulations become final, or the Supreme Court renders a decision in a case. Some solutions might be something like: more highways were built in the 1950s, safer cars were required in the 1960s, and jailing drunk drivers was the solution in the 1980s and 1990s. Stakeholder analysis approach is used in the policy making environment. A stakeholder analysis is a tool to analyze the various actors and interests in an issue of public policy. It examines the interest of stakeholders in relation to the policy and understand which stakeholders will be most influential. This analysis is useful in prioritizing their interactions with the major interest groups, especially those directly affected. 0306090120150 ANTA CUBA COLOMBIA
- 7. ECUADOR U.S. ARGENTINA PORTUGAL VENEZUELA GHANA Greenland (DENMARK) ' S O U T H A T L A N T I C O C E A N N O R T H A T L A N T I C O C E A N N O R T H P A C I F I C O C E A N S O U T H P A C I F I C O C E A N BELIZE GUATEMALA HONDURAS
- 8. NICARAGUAEL SALVADOR COSTA RICA PANAMA GUYANA SURINAME CÔTE D'IVOIRESIERRA LEONE REP. OF THE CO TOGO BENIN BURKINA FASO T GUINEA-BISSAU French Guiana (FRANCE) NETH. SLOVAKIA HUNGARY WESTERN SAHARA A R C T I C
- 9. O C E A N A R C T I C O C E A N Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30 60 90 120 150 180 ARCTICA PAPUA NEW GUINEA RUSSIA CHINA SWAZILAND LESOTHO ZIMBABWE ZAMBIA ANGOLA
- 10. TANZANIA SOUTH AFRICA KENYA UGANDA YEMEN ER CAMEROON ON RWAY 30 60 90 120 150 180 0 30 60 30 60 SWEDEN FINLAND LAOS JAPAN
- 13. AZERBAIJAN KYRGYZSTAN TAJIKISTAN SAUDI ARABIA SOUTH KOREA GREECE MADAGASCAR CHAD SUDAN MOZAMBIQUE ETHIOPIA SOMALIA DEMOCRATIC REPUBLIC OF THE CONGO KAZAKHSTAN ' N O R T H P A C I F I C O C E A N
- 14. I N D I A N O C E A N S O U T H P A C I F I C O C E A N ROMANIA BULGARIATALY AUSTRIA SINGAPORE MARSHALL ISLANDS FEDERATED STATES OF MICRONESIA UNITED ARAB EMIRATES KUWAIT QATAR CZECH REP. BELARUS LAT. LITH.
- 15. EST. NGO TUNISIA CENTRAL AFRICAN REPUBLIC ISRAEL LEB. DJIBOUTI ERITREA MALAWI BRUNEI A R C T I C O C E A N MALDIVES RWANDA BURUNDI Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 16. time if subsequent rights restrictions require it. International Economics Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. International Economics FIFTEENTH EDITION R O B E R T J . C A R B A U G H Professor of Economics, Central Washington University
- 17. Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage
- 18. Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. International Economics, Fifteenth Edition Robert J. Carbaugh Vice President, General Manager, Social Science & Qualitative Business: Erin Joyner Product Director: Michael Worls Product Manager: Steven Scoble Content Developer: Jeffrey Hahn Product Assistant: Mary Umbarger Marketing Manager: Katie Jergens Media Developer: Leah Wuchnick Manufacturing Planner: Kevin Kluck Art and Cover Direction, Production Management, and Composition: Integra Software Services Pvt. Ltd. Cover Image: Ian McKinnell/ Photographer’s Choice/Getty Images Intellectual Property Analyst: Jennifer Nonenmacher
- 19. Project Manager: Sarah Shainwald © 2015, 2013 Cengage Learning ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored, or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher. For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 For permission to use material from this text or product, submit all requests online at www.cengage.com/permissions Further permissions questions can be e-mailed to [email protected] Library of Congress Control Number: 2014940617 ISBN: 978-1-285-85435-9 Cengage Learning 20 Channel Center Street Boston, MA 02210
- 20. USA Cengage Learning is a leading provider of customized learning solutions with office locations around the globe, including Singapore, the United Kingdom, Australia, Mexico, Brazil, and Japan. Locate your local office at: www.cengage.com/global Cengage Learning products are represented in Canada by Nelson Education, Ltd. To learn more about Cengage Learning Solution s, visit www.cengage.com. Purchase any of our products at your local college store or at our preferred online store www.cengagebrain.com Printed in the U nited States of America Print N umber: 01 Print Year: 2014 WCN: 02-200-203
- 21. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Brief Contents PREFACE ............................................................................................... ........... xv CHAPTER 1 The International Economy and Globalization .............................. 1 PART 1 International Trade Relations 27 CHAPTER 2 Foundations of Modern Trade Theory: Comparative
- 22. Advantage ........................................................................................ 29 CHAPTER 3 Sources of Comparative Advantage ............................................ 69 CHAPTER 4 Tariffs ............................................................................................. 107 CHAPTER 5 Nontariff Trade Barriers ............................................................... 149 CHAPTER 6 Trade Regulations and Industrial Policies ................................. 181 CHAPTER 7 Trade Policies for the Developing Nations ................................ 227 CHAPTER 8 Regional Trading Arrangements ................................................ 267 CHAPTER 9 International Factor Movements and Multinational Enterprises ..................................................................................... 295
- 23. PART 2 International Monetary Relations 327 CHAPTER 10 The Balance-of-Payments ............................................................ 329 CHAPTER 11 Foreign Exchange ......................................................................... 357 CHAPTER 12 Exchange Rate Determination .................................................... 393 CHAPTER 13 Mechanisms of International Adjustment ................................. 419 CHAPTER 14 Exchange Rate Adjustments and the Balance-of-Payments .................................................................... 427 CHAPTER 15 Exchange Rate Systems and Currency Crises .......................... 445 CHAPTER 16 Macroeconomic Policy in an Open Economy ........................... 479
- 24. CHAPTER 17 International Banking: Reserves, Debt, and Risk ...................... 495 GLOSSARY ............................................................................................... .............. 513 INDEX ............................................................................................... ..................... 527 v Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Contents
- 25. Preface ............................................................................................... ....................xv CHAPTER 1 The International Economy and Globalization ....................................... 1 Globalization of Economic Activity ............................................ 2 Waves of Globalization .................................................................. 3 Federal Reserve Policy Incites Global Backlash. . . . . . . . . . . . . . . . . . . . . . . . 4 First Wave of Globalization: 1870–1914 ............................. 4 Second Wave of Globalization: 1945–1980 ......................... 5 Latest Wave of Globalization ............................................... 5 Diesel Engines and Gas Turbines as Movers of Globalization . . . . . . . . . . . . . . . . 8 The United States as an Open Economy................................... 9
- 26. Trade Patterns......................................................................... 9 Labor and Capital ................................................................ 11 Why is Globalization Important? .............................................. 12 Globalization and Competition .................................................. 15 Kodak Reinvents Itself under Chapter 11 Bankruptcy .... 15 Bicycle Imports Force Schwinn to Downshift ................... 16 Element Electronics Survives by Moving TV Production to America ............................................ 17 Common Fallacies of International Trade .............................. 18 Is the United States Losing Its Innovation Edge?. . . . . . . . . . . . . . . . . . . . . . 19 Does Free Trade Apply to Cigarettes? ..................................... 19 Is International Trade an Opportunity or a Threat
- 27. to Workers?............................................................................... 20 Backlash against Globalization ................................................... 22 The Plan of This Text .................................................................. 24 Summary................................................................................. ......... 24 Key Concepts and Terms ............................................................ 25 Study Questions ............................................................................. 25 PART 1 International Trade Relations 27 CHAPTER 2 Foundations of Modern Trade Theory: Comparative Advantage ...... 29 Historical Development of Modern Trade Theory ............... 29 The Mercantilists .................................................................. 29
- 28. Why Nations Trade: Absolute Advantage ........................ 30 Why Nations Trade: Comparative Advantage ................. 31 David Ricardo. . . . . . . . . . . . . . . . . . . . . . . . . 32 Production Possibilities Schedules............................................. 35 Trading under Constant-Cost Conditions............................... 36 Basis for Trade and Direction of Trade ............................ 36 Production Gains from Specialization ............................... 37 Consumption Gains from Trade ........................................ 38 Babe Ruth and the Principle of Comparative Advantage. . . . . . . . . . . . . . . 39 Distributing the Gains from Trade .................................... 40 Equilibrium Terms of Trade ............................................... 41 Terms of Trade Estimates.................................................... 42 Dynamic Gains from Trade ........................................................ 43 How Global Competition Led to Productivity Gains for U.S. Iron Ore Workers ................................. 44
- 29. Changing Comparative Advantage............................................ 45 Trading under Increasing-Cost Conditions ............................ 46 Natural Gas Boom Fuels Debate . . . . . . . 47 Increasing-Cost Trading Case ............................................. 48 Partial Specialization ........................................................... 50 The Impact of Trade on Jobs ..................................................... 51 v i Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 30. Wooster, Ohio Bears the Brunt of Globalization .................. 52 Comparative Advantage Extended to Many Products and Countries ........................................................................... 53 More Than Two Products ................................................... 53 More Than Two Countries ................................................. 54 Exit Barriers .................................................................................... 55 Empirical Evidence on Comparative Advantage ................... 56 Comparative Advantage and Global Supply Chains............. 57 Advantages and Disadvantages of Outsourcing ............... 59 Outsourcing and the U.S. Automobile Industry............... 60 The iPhone Economy and Global Supply Chains............................................................................... 60 Outsourcing Backfires for Boeing 787 Dreamliner .......... 61 Reshoring Production to the United States ....................... 63 Summary................................................................................. ......... 64
- 31. Key Concepts and Terms ............................................................ 65 Study Questions ............................................................................. 65 Exploring Further .......................................................................... 67 CHAPTER 3 Sources of Comparative Advantage ...................................................... 69 Factor Endowments as a Source of Comparative Advantage .................................................................................. 69 The Factor-Endowments Theory ........................................ 70 Visualizing the Factor-Endowment Theory ...................... 72 Applying the Factor-Endowment Theory to U.S.–China Trade ........................................................... 73 Chinese Manufacturers Beset By Rising Wages and a Rising Yuan ..................................................................... 74 Globalization Drives Changes for U.S.
- 32. Automakers. . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Factor-Price Equalization .................................................... 76 Who Gains and Loses from Trade? The Stolper–Samuelson Theorem ................................. 78 Is International Trade a Substitute for Migration?.................................................................. 79 Specific Factors: Trade and the Distribution of Income in the Short Run ............................................... 81 Does Trade Make the Poor Even Poorer? ......................... 81 Is the Factor-Endowment Theory a Good Predictor of Trade Patterns? ................................................................... 83 Skill as a Source of Comparative Advantage .......................... 84 Economies of Scale and Comparative Advantage ................. 85 Internal Economies of Scale ................................................ 86 External Economies of Scale................................................ 87
- 33. Overlapping Demands as a Basis for Trade ........................... 88 Does a “Flat World” Make Ricardo Wrong?. . . . . . . . . . . . . . . . . . . . . . . 89 Intra-industry Trade ..................................................................... 90 Technology as a Source of Comparative Advantage: The Product Cycle Theory .................................................... 92 Radios, Pocket Calculators, and the International Product Cycle................................................................... 94 Japan Fades in the Electronics Industry............................ 95 Dynamic Comparative Advantage: Industrial Policy............ 96 WTO Rules that Illegal Government Subsidies Support Boeing and Airbus................................................................... 97 Do Labor Unions Stifle Competitiveness? . . . . . . . . . . . . . . . . . . . . . 99
- 34. Government Regulatory Policies and Comparative Advantage ................................................ 99 Transportation Costs and Comparative Advantage ............101 Trade Effects ........................................................................ 101 Falling Transportation Costs Foster Trade ..................... 103 Summary................................................................................. ....... 104 Key Concepts and Terms .......................................................... 105 Study Questions ........................................................................... 105 Exploring Further ........................................................................ 106 CHAPTER 4 Tariffs.................................................................................... .................... 107 The Tariff
- 35. Concept...................................................................... 108 Types Of Tariffs ........................................................................... 109 Specific Tariff....................................................................... 109 Ad Valorem Tariff .............................................................. 110 Compound Tariff ................................................................ 111 Effective Rate of Protection....................................................... 111 Trade Protectionism Intensifies As Global Economy Falls Into the Great Recession. . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Tariff Escalation ........................................................................... 114 Outsourcing and Offshore Assembly Provision...................115 Dodging Import Tariffs: Tariff Avoidance and Tariff Evasion ................................................................. 116
- 36. Ford Strips Its Wagons to Avoid High Tariff ............................................................................... 117 Smuggled Steel Evades U.S. Tariffs .................................. 117 Gains from Eliminating Import Tariffs . . . . . . . . . . . . . . . . . . . . . . . . 118 Contents vii Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Postponing Import Tariffs......................................................... 119 Bonded Warehouse.............................................................
- 37. 119 Foreign–Trade Zone ........................................................... 119 FTZ’s Benefit Motor Vehicle Importers ........................... 120 Tariff Effects: An Overview....................................................... 121 Tariff Welfare Effects: Consumer Surplus and Producer Surplus ........................................................... 122 Tariff Welfare Effects: Small Nation Model..........................123 Tariff Welfare Effects: Large Nation Model..............................126 The Optimum Tariff and Retaliation .............................. 128 Examples of U.S. Tariffs ............................................................ 130 Obama’s Tariffs on Chinese Tires .................................... 130 Should Footwear Tariffs Be Given the Boot?......................................................................... 131
- 38. Could a Higher Tariff Put a Dent in the Federal Debt?. . . . . . . . . . . . . . . . . . 132 How a Tariff Burdens Exporters .............................................132 Tariffs and the Poor.................................................................... 134 Arguments for Trade Restrictions ...........................................135 Job Protection ...................................................................... 136 Protection against Cheap Foreign Labor......................... 136 Fairness in Trade: A Level Playing Field ........................ 139 Maintenance of the Domestic Standard of Living ......... 139 Equalization of Production Costs ..................................... 140 Infant-Industry Argument ................................................. 140 Noneconomic Arguments ................................................... 140 Petition of the Candle Makers. . . . . . . . . 142 The Political Economy of Protectionism ...............................142
- 39. A Supply and Demand View of Protectionism .............. 144 Summary................................................................................. ....... 145 Key Concepts and Terms .......................................................... 146 Study Questions ........................................................................... 146 Exploring Further ........................................................................ 148 CHAPTER 5 Nontariff Trade Barriers ......................................................................... 149 Absolute Import Quota .............................................................. 149 Trade and Welfare Effects ................................................. 150 Allocating Quota Licenses ................................................. 152 Quotas versus Tariffs ......................................................... 153
- 40. Tariff–Rate Quota: A Two–Tier Tariff...................................154 Tariff–Rate Quota Bittersweet for Sugar Consumers ................................................................. 156 Export Quotas .............................................................................. 156 Japanese Auto Restraints Put Brakes on U.S. Motorists ................................................................ 157 Domestic Content Requirements .............................................158 How “Foreign” is Your Car? . . . . . . . . . . 160 Subsidies................................................................................. ........ 161 Domestic Production Subsidy............................................ 161 Export Subsidy .................................................................... 162 Dumping ........................................................................................ 163
- 41. Forms of Dumping ............................................................. 163 International Price Discrimination .................................. 164 Antidumping Regulations .......................................................... 166 Swimming Upstream: The Case of Vietnamese Catfish. . . . . . . . . . . . . . . . . . . 167 Whirlpool Agitates for Antidumping Tariffs on Clothes Washers ...................................................... 168 Canadians Press Washington Apple Producers for Level Playing Field.................................................. 169 Is Antidumping Law Unfair?.................................................... 169 Should Average Variable Cost Be the Yardstick for Defining Dumping?................................................. 170 Should Antidumping Law Reflect Currency Fluctuations?.................................................................. 171 Are Antidumping Duties Overused? ................................ 171
- 42. Other Nontariff Trade Barriers ................................................ 172 Government Procurement Policies.................................... 172 U.S. Fiscal Stimulus and Buy American Legislation. . . . . . . . . . . . . . . . . 173 Social Regulations ............................................................... 174 CAFÉ Standards ................................................................. 174 Europe Has a Cow over Hormone-Treated U.S. Beef ......................................................................... 174 Sea Transport and Freight Regulations ........................... 175 Summary................................................................................. ....... 176 Key Concepts and Terms .......................................................... 177 Study Questions ........................................................................... 177
- 43. CHAPTER 6 Trade Regulations and Industrial Policies ........................................... 181 U.S. Tariff Policies Before 1930 ...............................................181 Smoot–Hawley Act...................................................................... 183 Reciprocal Trade Agreements Act...........................................184 General Agreement on Tariffs and Trade .............................185 Trade without Discrimination .......................................... 185 Promoting Freer Trade ...................................................... 186 viii Contents Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage
- 44. Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Predictability: Through Binding and Transparency ................................................................. 187 Multilateral Trade Negotiations ....................................... 187 World Trade Organization........................................................ 189 Avoiding Trade Barriers during the Great Recession. . . . . . . . . . . . . . . . . . 190 Settling Trade Disputes ...................................................... 191 Does the WTO Reduce National Sovereignty?................ 192 Should Retaliatory Tariffs Be Used for WTO Enforcement? ...................................................... 193 Does the WTO Harm the Environment? ........................ 194 Harming the Environment ................................................ 194 Improving the Environment .............................................. 195 WTO Rules against China’s Hoarding
- 45. of Rare Earth Metals .................................................... 195 Future of the World Trade Organization ....................... 197 Trade Promotion Authority (Fast Track Authority) ..........198 Safeguards (The Escape Clause): Emergency Protection from Imports...................................................... 199 U.S. Safeguards Limit Surging Imports of Textiles from China ...................................................... 200 Countervailing Duties: Protection against Foreign Export Subsidies ..................................................... 201 Lumber Duties Hammer Home Buyers ........................... 202 Antidumping Duties: Protection against Foreign Dumping................................................................................. . 202 Would a Carbon Tariff Help Solve the Climate Problem? . . . . . . . . . . . . . . . . 203 Remedies against Dumped and Subsidized
- 46. Imports ................................................................................... 204 U.S. Steel Companies Lose an Unfair Trade Case and Still Win ................................................................. 206 Section 301: Protection against Unfair Trading Practices ................................................................... 207 Protection of Intellectual Property Rights .............................208 The Globalization of Ideas and Intellectual Property Rights. . . . . . . . . . . 210 Microsoft Scorns China’s Piracy of Software ..................................................................... 210 Trade Adjustment Assistance ................................................... 212 Industrial Policies of the United States ..................................212 U.S. Airlines and Boeing Spar over Export–Import Bank Credit.................................................................... 214
- 47. U.S. Solar Industry Dims as China’s Industrial Policy Lights Up ............................................................ 215 Industrial Policies of Japan ....................................................... 216 Strategic Trade Policy ................................................................. 217 Economic Sanctions .................................................................... 219 Factors Influencing the Success of Sanctions .................. 220 Economic Sanctions and Weapons of Mass Destruction: North Korea and Iran ........................... 221 Summary................................................................................. ....... 223 Key Concepts and Terms .......................................................... 224 Study Questions ........................................................................... 224 Exploring Further ........................................................................ 225 CHAPTER 7
- 48. Trade Policies for the Developing Nations ......................................... 227 Developing-Nation Trade Characteristics..............................227 Tensions between Developing Nations and Advanced Nations ......................................................... 229 Trade Problems of the Developing Nations .........................229 Unstable Export Markets ................................................... 230 Falling Commodity Prices Threaten Growth of Exporting Nations .................................................... 232 Worsening Terms of Trade ............................................... 232 Limited Market Access ....................................................... 233 Agricultural Export Subsidies of Advanced Nations ........................................................................... 235 Bangladesh’s Sweatshop Reputation................................. 235 Stabilizing Primary-Product Prices .........................................237
- 49. Production and Export Controls ...................................... 237 Buffer Stocks ........................................................................ 237 Multilateral Contracts ........................................................ 239 Does the Fair Trade Movement Help Poor Coffee Farmers? ............................................................. 239 The OPEC Oil Cartel ................................................................. 240 Maximizing Cartel Profits ................................................. 240 OPEC as a Cartel ............................................................... 242 Does Foreign Direct Investment Hinder or Help Economic Development?. . . . . . . . . . . . . . . . . . . . . . . . 244 Aiding the Developing Nations................................................ 244 The World Bank ................................................................. 245 International Monetary Fund........................................... 246 Generalized System of Preferences.................................... 247
- 50. Does Aid Promote Growth of Developing Nations?.......................................................................... 248 How to Bring Developing Nations in from the Cold.................................................................................. 248 Economic Growth Strategies: Import Substitution versus Export Led Growth .................................................. 250 Import Substitution ............................................................ 250 Import Substitution Laws Backfire on Brazil ................. 251 Export Led Growth ............................................................. 252 Is Economic Growth Good for the Poor? ........................ 253 Contents ix Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 51. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Can All Developing Nations Achieve Export Led Growth? .................................................................. 253 East Asian Economies ................................................................ 254 Flying Geese Pattern of Growth........................................ 255 Is State Capitalism Winning? . . . . . . . . . 256 China’s Great Leap Forward..................................................... 257 Challenges for China’s Economy ...................................... 258 China’s Export Boom Comes at a Cost: How to Make Factories Play Fair............................................. 260 India: Breaking Out of the Third World...............................261
- 52. Brazil Takes off ............................................................................ 263 Summary................................................................................. ....... 264 Key Concepts and Terms .......................................................... 265 Study Questions ........................................................................... 265 CHAPTER 8 Regional Trading Arrangements .......................................................... 267 Regional Integration versus Multilateralism .........................267 Types of Regional Trading Arrangements ............................268 Impetus for Regionalism............................................................ 270 Effects of a Regional Trading Arrangement .........................270 Static Effects................................................................... ...... 270
- 53. Dynamic Effects................................................................... 273 Is the U.S.–South Korea Free-Trade Agreement Good for Americans? . . . . . 274 The European Union .................................................................. 274 Pursuing Economic Integration ........................................ 275 Agricultural Policy .............................................................. 276 Is the European Union Really a Common Market? ......................................................... 278 Economic Costs and Benefits of a Common Currency: The European Monetary Union ........................................280 Optimum Currency Area................................................... 280 Eurozone’s Problems and Challenges ............................... 281 European Monetary “Disunion”. . . . . . . 282 Will the Eurozone Survive? ............................................... 283 North American Free Trade Agreement................................284
- 54. NAFTA’s Benefits and Costs for Mexico and Canada ............................................................ 285 NAFTA’s Benefits and Costs for the United States.................................................................. 286 U.S.–Mexico Trucking Dispute ......................................... 288 U.S.–Mexico Tomato Dispute ........................................... 289 Is NAFTA an Optimum Currency Area? ........................ 290 Summary..................................................................... ............ ....... 291 Key Concepts and Terms .......................................................... 292 Study Questions ........................................................................... 292 Exploring Further ........................................................................ 293 CHAPTER 9 International Factor Movements and Multinational Enterprises..... 295
- 55. The Multinational Enterprise ...................................................295 Motives for Foreign Direct Investment..................................297 Demand Factors.................................................................. 298 Cost Factors ......................................................................... 298 Supplying Products to Foreign Buyers: Whether to Produce Domestically or Abroad .................................299 Direct Exporting versus Foreign Direct Investment/Licensing .................................................... 300 Foreign Direct Investment versus Licensing .................... 301 Country Risk Analysis ................................................................ 302 Do U.S. Multinationals Exploit Foreign Workers? . . . . . . . . . . . . . . . . . . . . 303 International Trade Theory and Multinational Enterprise...............................................................................
- 56. .. 305 Japanese Transplants in the U.S. Automobile Industry .....305 International Joint Ventures ..................................................... 307 Welfare Effects..................................................................... 308 Multinational Enterprises as a Source of Conflict...............310 Employment ......................................................................... 310 Caterpillar Bulldozes Canadian Locomotive Workers ........ 311 Technology Transfer ........................................................... 312 National Sovereignty .......................................................... 314 Balance-of-Payments .......................................................... 315 Transfer Pricing .................................................................. 316 International Labor Mobility: Migration ...............................316
- 57. Apple Uses Tax Loopholes to Dodge Taxes . . . . . . . . . . . . . . . . . . . . . . 317 The Effects of Migration .................................................... 318 Immigration as an Issue .................................................... 320 Does Canada’s Immigration Policy Provide a Model for the United States? ................................... 322 Does U.S. Immigration Policy Harm Domestic Workers?. . . . . . . . . . . . . . . . . . . 323 Summary................................................................................. ....... 324 Key Concepts and Terms .......................................................... 324 Study Questions ........................................................................... 324 x Contents Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 58. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. PART 2 International Monetary Relations 327 CHAPTER 10 The Balance-of-Payments ...................................................................... 329 Double Entry Accounting.......................................................... 329 Balance-of-Payments Structure ................................................ 331 Current Account ................................................................. 331 Capital and Financial Account......................................... 332 International Payments Process. . . . . . . 333 Official Settlements Transactions ..................................... 334
- 59. Special Drawing Rights ...................................................... 335 Statistical Discrepancy: Errors and Omissions ............... 336 U.S. Balance-of- Payments.......................................................... 337 What Does a Current Account Deficit (Surplus) Mean? ........ 339 Net Foreign Investment and the Current Account Balance............................................................ 340 Impact of Capital Flows on the Current Account ......... 340 Is a Current Account Deficit a Problem? ........................ 341 The iPhone’s Complex Supply Chain Depicts Limitations of Trade Statistics . . . . . . . . . . . . . . . . . . . . . . 342 Business Cycles, Economic Growth, and the Current Account........................................................................ ... 343 How the United States Has Borrowed at Very Low Cost ............................................................... 344
- 60. Do Current Account Deficits Cost Americans Jobs? ............................................................ 345 Can the United States Continue to Run Current Account Deficits Indefinitely? ...................................... 346 Balance of International Indebtedness ...................................348 United States as a Debtor Nation .................................... 349 Global Imbalances. . . . . . . . . . . . . . . . . . . . 350 The Dollar as the World’s Reserve Currency.......................351 Benefits to the United States ............................................. 351 A New Reserve Currency?.................................................. 352 Summary................................................................................. ....... 353 Key Concepts and Terms .......................................................... 354 Study Questions ........................................................................... 354
- 61. CHAPTER 11 Foreign Exchange ................................................................................... 357 Foreign Exchange Market.......................................................... 357 Types of Foreign Exchange Transactions ..............................359 Interbank Trading ....................................................................... 361 Reading Foreign Exchange Quotations ..................................363 Yen Depreciation Drives Toyota Profits Upward. . . . . . . . . . . . . . . . . . . . . . . 366 Forward and Futures Markets .................................................. 366 Foreign Currency Options......................................................... 368 Exchange Rate Determination .................................................. 369 Demand for Foreign Exchange ......................................... 369 Supply of Foreign Exchange ..............................................
- 62. 369 Equilibrium Rate of Exchange .......................................... 370 Indexes of the Foreign-Exchange Value of the Dollar: Nominal and Real Exchange Rates ...................................371 Arbitrage ........................................................................................ 373 The Forward Market................................................................... 374 The Forward Rate............................................................... 375 Relation between the Forward Rate and Spot Rate....................................................... 376 Managing Your Foreign Exchange Risk: Forward Foreign Exchange Contract ......................... 377 Case 1 ................................................................................. .. 378 Case 2 ................................................................................... 378 How Markel, Volkswagen, and Nintendo
- 63. Manage Foreign Exchange Risk .................................. 379 Does Foreign Currency Hedging Pay Off?....................... 380 Currency Risk and the Hazards of Investing Abroad. . . . . . . . . . . . . . . . . . . . . 381 Interest Arbitrage, Currency Risk, and Hedging .................382 Uncovered Interest Arbitrage ............................................ 382 Covered Interest Arbitrage (Reducing Currency Risk) ......383 Foreign Exchange Market Speculation ...................................384 Long and Short Positions .................................................. 385 Andy Krieger Shorts the New Zealand Dollar................ 385 George Soros Shorts the Yen ............................................. 385 People’s Bank of China Widens Trading Band to Punish Currency Speculators .................................. 386 Stabilizing and Destabilizing Speculation ....................... 386 Foreign Exchange Trading as a Career ..................................387 Foreign Exchange Traders Hired by Commercial
- 64. Banks, Companies, and Central Banks ..................... 387 How to Play the Falling (Rising) Dollar. . . 388 Currency Markets Draw Day Traders............................. 389 Summary................................................................................. ....... 390 Key Concepts and Terms .......................................................... 390 Study Questions ........................................................................... 390 Exploring Further ........................................................................ 392 Contents xi Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 65. CHAPTER 12 Exchange Rate Determination .............................................................. 393 What Determines Exchange Rates?.........................................393 Determining Long Run Exchange Rates ................................395 Relative Price Levels ........................................................... 396 Relative Productivity Levels ............................................... 396 Preferences for Domestic or Foreign Goods .................... 396 Trade Barriers ..................................................................... 398 Inflation Rates, Purchasing-Power-Parity, and Long Run Exchange Rates ..........................................398 Law of One Price ................................................................ 398 Burgeromics: The “Big Mac” Index and the
- 66. Law of One Price .......................................................... 399 Purchasing-Power-Parity ................................................... 400 Inflation Differentials and the Exchange Rate. . . . . . . . . . . . . . . . . . . . . . . 401 Determining Short Run Exchange Rates: The Asset Market Approach...............................................404 Relative Levels of Interest Rates........................................ 405 Expected Change in the Exchange Rate .......................... 407 Diversification, Safe Havens, and Investment Flows .................................................. 408 International Comparisons of GDP: Purchasing-Power-Parity. . . . . . . . . . . . . . 409 Exchange Rate Overshooting .................................................... 410 Forecasting Foreign Exchange Rates.......................................411 Judgmental Forecasts.......................................................... 412
- 67. Technical Forecasts ............................................................. 413 Fundamental Analysis........................................................ 414 Commercial Mexicana Gets Burned by Speculation . . . . . . . . . . . . . . . 415 Summary................................................................................. ....... 416 Key Concepts and Terms .......................................................... 416 Study Questions ........................................................................... 416 Exploring Further ........................................................................ 418 CHAPTER 13 Mechanisms of International Adjustment........................................... 419 Price Adjustments........................................................................ 420
- 68. Gold Standard ..................................................................... 420 Quantity Theory of Money ............................................... 420 Current Account Adjustment ............................................ 421 Financial Flows and Interest Rate Differentials ...................422 Income Adjustments ................................................................... 423 Disadvantages of Automatic Adjustment Mechanisms .........424 Monetary Adjustments ............................................................... 425 Summary................................................................................. ....... 425 Key Concepts and Terms .......................................................... 426 Study Questions ........................................................................... 426 Exploring Further ........................................................................ 426
- 69. CHAPTER 14 Exchange Rate Adjustments and the Balance-of-Payments ............ 427 Effects of Exchange Rate Changes on Costs and Prices .............................................................. 427 Case 1: No Foreign Sourcing—All Costs Are Denominated in Dollars............................................... 428 Case 2: Foreign Sourcing—Some Costs Denominated in Dollars and Some Costs Denominated in Francs ........................................................................ 428 Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation .................................430 Appreciation of the Yen: Japanese Manufacturers ............................................................... 430 Japanese Firms Send Work Abroad as Rising Yen Makes Their Products Less Competitive . . . . . . . . . . . . . . . . . . . . . . . . . 432
- 70. Appreciation of the Dollar: U.S. Manufacturers....................................................... 432 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach...........................433 J–Curve Effect: Time Path of Depreciation ..........................436 Exchange Rate Pass-Through ................................................... 438 Partial Exchange Rate Pass-Through............................... 438 Does Currency Depreciation Give Weak Countries a Way out of Crisis?. . . . . . . . 441 The Absorption Approach to Currency Depreciation............................................................................ 441 The Monetary Approach to Currency Depreciation ..........442 Summary................................................................................. ....... 443
- 71. Key Concepts and Terms .......................................................... 444 Study Questions ........................................................................... 444 Exploring Further ........................................................................ 444 xii Contents Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 15 Exchange Rate Systems and Currency Crises.................................... 445
- 72. Exchange Rate Practices............................................................. 445 Choosing an Exchange Rate System: Constraints Imposed by Free Capital Flows.......................................... 447 Fixed Exchange Rate System .................................................... 448 Use of Fixed Exchange Rates ............................................ 448 Par Value and Official Exchange Rate............................ 450 Exchange Rate Stabilization.............................................. 450 Devaluation and Revaluation ........................................... 452 Bretton Woods System of Fixed Exchange Rates ........... 452 Floating Exchange Rates ............................................................ 453 Achieving Market Equilibrium ......................................... 454 Trade Restrictions, Jobs, and Floating Exchange Rates.............................................................. 455 Arguments for and against Floating Rates ..................... 455 Managed Floating Rates ............................................................. 456 Managed Floating Rates in the Short
- 73. Run and Long Run....................................................... 457 Exchange Rate Stabilization and Monetary Policy........ 459 Is Exchange Rate Stabilization Effective? ........................ 461 The Crawling Peg ........................................................................ 462 Currency Manipulation and Currency Wars........................462 Is China a Currency Manipulator?.................................. 464 Currency Crises............................................................................ 465 The Global Financial Crisis of 2007–2009. . . . . . . . . . . . . . . . . . . . . . . . . 466 Sources of Currency Crises ................................................ 468 Speculators Attack East Asian Currencies....................... 469 Capital Controls ........................................................................... 470 Should Foreign Exchange Transactions be Taxed? ........ 471 Increasing the Credibility of Fixed Exchange Rates ...........472
- 74. Currency Board................................................................... 472 For Argentina, No Panacea in a Currency Board......... 474 Dollarization........................................................................ 475 Summary................................................................................. ....... 477 Key Concepts and Terms .......................................................... 478 Study Questions ........................................................................... 478 CHAPTER 16 Macroeconomic Policy in an Open Economy ..................................... 479 Economic Objectives of Nations..............................................479 Policy Instruments....................................................................... 480 Aggregate Demand and Aggregate Supply: a Brief
- 75. Review......................................................................... 480 Monetary and Fiscal Policy in a Closed Economy .............481 Monetary and Fiscal Policy in an Open Economy .............483 Effect of Fiscal and Monetary Policy under Fixed Exchange Rates ................................................... 484 Effect of Fiscal and Monetary Policy under Floating Exchange Rates .............................................. 486 Macroeconomic Stability and the Current Account: Policy Agreement versus Policy Conflict.........................486 Monetary and Fiscal Policy Respond to Financial Turmoil in the Economy. . . . . 487 Inflation with Unemployment.................................................. 488 International Economic Policy Coordination .......................488 Policy Coordination in Theory ......................................... 489 Does Policy Coordination Work? ..................................... 491 Does Crowding Occur in an Open Economy?. . . . . . . . . . . . . . . . . . . . . . 492
- 76. Summary................................................................................. ....... 493 Key Concepts and Terms .......................................................... 493 Study Questions ........................................................................... 494 CHAPTER 17 International Banking: Reserves, Debt, and Risk ............................... 495 Nature of International Reserves ............................................. 495 Demand for International Reserves ........................................496 Exchange Rate Flexibility................................................... 496 Other Determinants............................................................ 498 Supply of International Reserves ............................................. 499 Foreign Currencies
- 77. ...................................................................... 499 Gold ............................................................................................... . 500 International Gold Standard............................................. 501 Gold Exchange Standard ................................................... 501 Demonetization of Gold..................................................... 502 Should the United States Return to the Gold Standard?.............................................................. 503 Special Drawing Rights .............................................................. 503 Facilities for Borrowing Reserves.............................................504 IMF Drawings ..................................................................... 504 General Arrangements to Borrow .................................... 504 Swap Arrangements............................................................ 505 International Lending Risk........................................................ 505
- 78. Contents xiii Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. The Problem of International Debt ........................................506 Dealing with Debt Servicing Difficulties .......................... 507 Reducing Bank Exposure to Developing Nation Debt ............................................................................ 508 Debt Reduction and Debt Forgiveness...................................509
- 79. The Eurodollar Market............................................................... 510 Summary................................................................................. ....... 511 Key Concepts and Terms .......................................................... 511 Study Questions ........................................................................... 511 Glossary ............................................................................................... ................513 Index ............................................................................................... .....................527 xiv Contents Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 80. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface I believe the best way to motivate students to learn a subject is to demonstrate how it is used in practice. The first fourteen editions of International Economics reflected this belief and were written to provide a serious presentation of international economic the- ory with an emphasis on current applications. Adopters of these editions strongly sup- ported the integration of economic theory with current events. The fifteenth edition has been revised with an eye toward improving this presentation and updating the applications as well as including the latest theoretical developments.
- 81. Like its predecessors, this edition is intended for use in a one- quarter or one-semester course for students having no more background than principles of economics. This book’s strengths are its clarity, organization, and applications that demonstrate the use- fulness of theory to students. The revised and updated material in this edition empha- sizes current applications of economic theory and incorporates recent theoretical and policy developments in international trade and finance. INTERNATIONAL ECONOMICS THEMES This edition highlights five current themes that are at the forefront of international economics: GLOBALIZATION OF ECONOMIC ACTIVITY • Wooster, Ohio bears brunt of globalization—Ch. 2 • Japan fades in the global electronics industry—Ch. 3 • Comparative advantage and global supply chains—Ch. 2 • Caterpillar bulldozes Canadian locomotive workers—Ch. 9 • Apple uses tax loopholes to dodge taxes—Ch. 9 • Diesel engines and gas turbines as engines of growth—Ch. 1 • Waves of globalization—Ch. 1
- 82. • Has globalization gone too far?—Ch. 1 • Putting the H-P Pavilion together—Ch. 1 • Is the United States losing its innovation edge?—Ch. 1 • Rising transportation costs hinder globalization—Ch. 3 • iPhone’s complex supply chain highlights limitations of trade statistics—Ch. 10 • Constraints imposed by capital flows on the choice of an exchange rate system— Ch. 15 FREE TRADE AND PROTECTIONISM • Whirlpool wins dumping case—Ch. 5 • Wage increases and China’s trade—Ch. 3 • Should shoe tariffs be stomped out?—Ch. 4 • Natural gas boom fuels trade debate—Ch.2 • Element Electronics brings TV manufacturing back to the United States—Ch. 1 • Carbon tariffs—Ch. 6 • Averting trade barriers during the Great Recession—Ch. 6 • Bangladesh’s sweatshop reputation—Ch. 7 x v Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 83. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. • Does the principle of comparative advantage apply in the face of job outsourcing?—Ch. 2 • Boeing outsources work, but protects its secrets—Ch. 2 • Does trade make the poor even poorer?—Ch. 3 • WTO rules against subsidies to Boeing and Airbus—Ch. 3 • Does wage insurance make free trade more acceptable to workers?—Ch. 6 • China’s hoarding of rare earth metals declared illegal by WTO—Ch. 6 • The environment and free trade—Ch. 6 TRADE CONFLICTS BETWEEN DEVELOPING NATIONS AND INDUSTRIAL NATIONS
- 84. • U.S.-Mexico tomato dispute—Ch. 8 • Is state capitalism winning?—Ch. 7 • Canada’s immigration policy—Ch. 9 • Is international trade a substitute for migration?—Ch. 3 • Economic growth strategies–import substitution versus export led growth—Ch. 7 • Does foreign aid promote the growth of developing countries?—Ch. 7 • The globalization of intellectual property rights—Ch. 7 • How to bring in developing countries from the cold—Ch. 7 • Microsoft scorns China’s piracy of software—Ch. 6 • The Doha Round of multilateral trade negotiations—Ch. 6 • Wage increases work against China’s competitiveness—Ch. 7 • China’s export boom comes at a cost: How to make factories play fair—Ch. 7 • Will emerging economies soon outstrip the rich ones?—Ch. 7 • Do U.S. multinationals exploit foreign workers?—Ch. 9 LIBERALIZING TRADE: THE WTO VERSUS REGIONAL TRADING ARRANGEMENTS • Does the WTO reduce national sovereignty?—Ch. 6 • Regional integration versus multilateralism—Ch. 8
- 85. • Is Europe really a common market?—Ch. 8 • The U.S.-South Korea Free Trade Agreement—Ch. 8 • NAFTA and the U.S.-Mexico trucking dispute—Ch. 8 • Will the euro survive?—Ch. 8 TURBULENCE IN THE GLOBAL FINANCIAL SYSTEM • Yen’s depreciation drives Toyota’s profits upward—Ch. 11 • People’s Bank of China punishes speculators—Ch. 11 • Can the euro survive?—Ch. 8 • Does currency depreciation give weak countries a way out of crisis?—Ch. 14 • Currency manipulation and currency wars—Ch. 15 • Paradox of foreign debt: how the United states borrows at low cost—Ch. 10 • Mistranslation of news story roils currency markets—Ch. 12 • Why a dollar depreciation may not close the U.S. trade deficit—Ch. 14 • Japanese firms send work abroad as yen makes its products less competitive—Ch.14 • Preventing currency crises: Currency boards versus dollarization—Ch. 15 • Should Special Drawing Rights replace the dollar as the world’s reserve
- 86. currency?—Ch. 17 • Should the United States return to the gold standard?—Ch. 17 xvi Preface Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Besides emphasizing current economic themes, the fifteenth edition of this text con- tains many new topics such as outsourcing and the U.S. auto industry, U.S. safeguards limiting imports of textiles from China, why Italian shoemakers strive to give the euro the boot, bike imports that forced Schwinn to downshift, and
- 87. how currency markets draw day traders. Faculty and students will appreciate how this edition provides a con- temporary approach to international economics. ORGANIZATIONAL FRAMEWORK: EXPLORING FURTHER SECTIONS Although instructors generally agree on the basic content of the international economics course, opinions vary widely about what arrangement of material is appropriate. This book is structured to provide considerable organizational flexibility. The topic of international trade relations is presented before international monetary relations, but the order can be reversed by instructors choosing to start with monetary theory. Instructors can begin with Chapters 10–17 and conclude with Chapters 2–9. Those who do not wish to cover all the material in the book can easily omit all or parts of Chapters 6– 9, and Chapters 15–17 without loss of continuity. The fifteenth edition streamlines its presentation of theory to provide greater flexibil-
- 88. ity for instructors. This edition uses online Exploring Further sections to discuss more advanced topics. By locating the Exploring Further sections online rather than in the textbook, as occurred in previous editions, more textbook coverage can be devoted to contemporary applications of theory. The Exploring Further sections consist of the following: Comparative advantage in money terms—Ch. 2 Indifference curves and trade—Ch. 2 Offer curves and the equilibrium terms of trade—Ch. 2 The specific-factors theory—Ch. 3 Offer curves and tariffs—Ch. 4 Tariff-rate quota welfare effects—Ch. 5 Export quota welfare effects—Ch. 5 Welfare effects of strategic trade policy—Ch. 6 Government procurement policy and the European Union—Ch. 8 Economies of scale and NAFTA—Ch. 8 Techniques of foreign-exchange market speculation—Ch. 11 A primer on foreign-exchange trading—Ch. 11 Fundamental forecasting–regression analysis—Ch. 12 Income adjustment mechanism—Ch. 13 Exchange-rate pass-through—Ch. 14
- 89. To access the Exploring Further sections, go to www.cengagebrain.com. SUPPLEMENTARY MATERIALS For Students International Economics CourseMate (www.cengagebrain.com) In this age of technology, no text package would be complete without Web-based resources. An international economics CourseMate product is offered with the fifteenth edition. Preface xvii Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 90. Within the online study tool CourseMate, students will find a vast amount of resources for self-study including access to the eBook, glossary, online quizzes, videos, graphing workshop games, EconApps, and flashcards. Students can purchase Course- Mate at www.cengagebrain.com. Study Guide To accompany the fifteenth edition of the International Economics text, Jim Hanson (Professor Emeritus at Willlamette University) has prepared an online Study Guide for students. This guide reinforces key concepts by providing a review of the text’s main topics and offering practice problems, true–false, multiple choice, and short–answer questions. The Study Guide is available online only and students can purchase it at www.cengagebrain.com. For Instructors
- 91. International Economics CourseMate (www.cengagebrain.com) Through CourseMate, instructors have access to Engagement Tracker that is designed to assess that students have read the material or viewed the resources that you’ve assigned. Engagement Tracker assesses student preparation and engagement. Using the tracking tools enables you to see progress for the class as a whole or for individual students, iden- tify students at risk early in the course, and uncover which concepts are most difficult for your class. Aplia Aplia is another feature of the fifteenth edition. With Aplia, international economics students use interactive chapter assignments and tutorials to make economics relevant and engaging. Students complete online assignments to improve their proficiency in understanding economic theory and they receive immediate, detailed explanations for every answer. Math and graphing tutorials help students overcome deficiencies in these
- 92. crucial areas. PowerPoint Slides The fifteenth edition also includes PowerPoint slides created by Syed H. Jafri of Tarleton State University. These slides can be easily downloaded from the Carbaugh Website available for instructors-only at http://login.cengage.com. Slides may be edited to meet individual needs. They also serve as a study tool for students. Instructor’s Manual To assist instructors in the teaching of international economics, there is an Instructor’s Manual with Test Bank that accompanies the fifteenth edition. The manual contains: (1) brief answers to end-of-chapter study questions; (2) multiple choice; and (3) true– false questions for each chapter. The Instructor’s Manual with Test Bank is available for download for qualified instructors from the Carbaugh Website for instructors-only at www.cengagebrain.com. Study Guide
- 93. To accompany the fifteenth edition of the International Economics, Jim Hanson (Profes- sor Emeritus at Willlamette University) has prepared an online Study Guide for students. This guide reinforces key concepts by providing a review of the text’s main topics and offering practice problems, true–false, multiple choice and short–answer questions. The xviii Preface Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Study Guide is only available online and students can purchase it at www.cengagebrain.
- 94. com. Instructors can view the online Study Guide through http://login.cengage.com. Compose Compose is the home of Cengage Learning’s online digital content. Compose provides the fastest, easiest way for you to create your own learning materials. South–Western’s Economic Issues and Activities content database includes a wide variety of high- interest, current event/policy applications as well as classroom activities designed specifi- cally to enhance economics courses. Choose just one reading or many—even add your own material—to create an accompaniment to the textbook that is perfectly customized to your course. Contact your South–Western/Cengage Learning sales representative for more information. ACKNOWLEDGMENTS I am pleased to acknowledge those who aided me in preparing the current and past edi- tions of this textbook. Helpful suggestions and often detailed reviews were provided by:
- 95. Sofyan Azaizeh, University of New Haven J. Bang, St. Ambrose University Burton Abrams, University of Delaware Abdullah Khan, Kennesaw State University Richard Adkisson, New Mexico State University Richard Anderson, Texas A&M Brad Andrew, Juniata College Richard Ault, Auburn University Mohsen Bahmani-Oskooee, University of Wisconsin— Milwaukee Kevin Balsam, Hunter College Kelvin Bentley, Baker College Online Robert Blecker, Stanford University Scott Brunger, Maryville College Jeff W. Bruns, Bacone College Roman Cech, Longwood University John Charalambakis, Asbury College Mitch Charkiewicz, Central Connecticut State University Xiujian Chen, California State University, Fullerton Miao Chi, University of Wisconsin—Milwaukee Howard Cochran, Jr., Belmont University Charles Chittle, Bowling Green University Christopher Cornell, Fordham University Elanor Craig, University of Delaware
- 96. Manjira Datta, Arizona State University Ann Davis, Marist College Earl Davis, Nicholls State University Juan De La Cruz, Fashion Institute of Technology Firat Demir, University of Oklahoma Gopal Dorai, William Paterson College Veda Doss, Wingate University Seymour Douglas, Emory University Carolyn Fabian Stumph, Indiana University—Purdue University Fort Wayne Preface xix Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 97. Farideh Farazmand, Lynn University Daniel Falkowski, Canisius College Patrice Franko, Colby College Emanuel Frenkel, University of California—Davis Norman Gharrity, Ohio Wesleyan University Sucharita Ghosh, University of Akron Jean-Ellen Giblin, Fashion Institute of Technology (SUNY) Leka Gjolaj, Baker College Thomas Grennes, North Carolina State University Darrin Gulla, University of Kentucky Li Guoqiang, University of Macau (China) William Hallagan, Washington State University Jim Hanson, Willamette University Bassam Harik, Western Michigan University Clifford Harris, Northwood University John Harter, Eastern Kentucky University Seid Hassan, Murray State University Phyllis Herdendorf, Empire State College (SUNY) Pershing Hill, University of Alaska—Anchorage David Hudgins, University of Oklahoma Ralph Husby, University of Illinois—Urbana/Champaign Robert Jerome, James Madison University Mohamad Khalil, Fairmont State College Wahhab Khandker, University of Wisconsin—La Crosse Robin Klay, Hope College
- 98. William Kleiner, Western Illinois University Anthony Koo, Michigan State University Faik Koray, Louisiana State University Peter Karl Kresl, Bucknell University Fyodor Kushnirsky, Temple University Daniel Lee, Shippensburg University Edhut Lehrer, Northwestern University Jim Levinsohn, University of Michigan Martin Lozano, University of Manchester, UK Benjamin Liebman, St. Joseph’s University Susan Linz, Michigan State University Andy Liu, Youngstown State University Alyson Ma, University of San Diego Mike Marks, Georgia College School of Business Michael McCully, High Point University Neil Meredith, West Texas A&M University John Muth, Regis University Al Maury, Texas A&I University Tony Mutsune, Iowa Wesleyan College Jose Mendez, Arizona State University Roger Morefield, University of St. Thomas Mary Norris, Southern Illinois University John Olienyk, Colorado State University Shawn Osell, Minnesota State University—Mankato Terutomo Ozawa, Colorado State University
- 99. Peter Petrick, University of Texas at Dallas xx Preface Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Gary Pickersgill, California State University, Fullerton William Phillips, University of South Carolina John Polimeni, Albany College of Pharmacy and Health Sciences Rahim Quazi, Prairie View A&M University Chuck Rambeck, St. John’s University Elizabeth Rankin, Centenary College of Louisiana Teresita Ramirez, College of Mount Saint Vincent Surekha Rao, Indiana University Northwest
- 100. James Richard, Regis University Suryadipta Roy, High Point University Daniel Ryan, Temple University Manabu Saeki, Jacksonville State University Nindy Sandhu, California State University, Fullerton Jeff Sarbaum, University of North Carolina, Greensboro Anthony Scaperlanda, Northern Illinois University Juha Seppälä, University of Illinois Ben Slay, Middlebury College (now at PlanEcon) Gordon Smith, Anderson University Sylwia Starnawska, Empire State College (SUNY) Steve Steib, University of Tulsa Robert Stern, University of Michigan Paul Stock, University of Mary Hardin—Baylor Laurie Strangman, University of Wisconsin—La Crosse Hamid Tabesh, University of Wisconsin–River Falls Manjuri Talukdar, Northern Illinois University Nalitra Thaiprasert, Ball State University William Urban, University of South Florida Jorge Vidal, The University of Texas Pan American Adis M. Vila, Esq., Winter Park Institute Rollins College Grace Wang, Marquette University Jonathan Warshay, Baker College Darwin Wassink, University of Wisconsin—Eau Claire Peter Wilamoski, Seattle University
- 101. Harold Williams, Kent State University Chong Xiang, Purdue University Elisa Quennan, Taft College Afia Yamoah, Hope College Hamid Zangeneh, Widener University I would like to thank my colleagues at Central Washington University—Tim Dittmer, David Hedrick, Koushik Ghosh, Roy Savoian, Peter Saunders, Toni Sipic, and Chad Wassell—for their advice and help while I was preparing the manuscript. I am also indebted to Shirley Hood who provided advice in the manuscript’s preparation. It has been a pleasure to work with the staff of Cengage Learning, especially Steven Scoble, who provided many valuable suggestions and assistance in seeing this edition to its completion. Thanks also to Jeffrey Hahn who orchestrated the development of this book in conjunction with Tintu Thomas, project manager at Integra Software Services. I also appreciate the meticulous efforts that Hyde Park Publishing Services did in the
- 102. copyediting of this textbook. Finally, I am grateful to my students, as well as faculty and students at other universities, who provided helpful comments on the material con- tained in this new edition. Preface xxi Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. I would appreciate any comments, corrections, or suggestions that faculty or students wish to make so I can continue to improve this text in the years ahead. Please contact me! Thank you for permitting this text to evolve to the fifteenth
- 103. edition. Bob Carbaugh Department of Economics Central Washington University Ellensburg, Washington 98926 Phone: (509) 963-3443 Fax: (509) 963-1992 E-mail: [email protected] xxii Preface Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. C H A P T E R
- 104. 1 The International Economy and Globalization In today’s world, no nation exists in economic isolation. All aspects of a nation’seconomy—its industries, service sectors, levels of income and employment, and living standard—are linked to the economies of its trading partners. This linkage takes the form of international movements of goods and services, labor, business enterprise, investment funds, and technology. Indeed, national economic policies cannot be formulated without evaluating their probable impacts on the economies of other countries. The high degree of economic interdependence among today’s economies reflects the historical evolution of the world’s economic and political order. At the end of World War II, the United States was economically and politically the most powerful nation in the world, a situation expressed in the saying, “When the United
- 105. States sneezes, the economies of other nations catch a cold.” But with the passage of time, the U.S. economy has become increasingly integrated into the economic activities of foreign countries. The formation in the 1950s of the European Community (now known as the European Union), the rising importance in the 1960s of multinational corporations, the market power in the 1970s enjoyed by the Organization of Petroleum Exporting Countries (OPEC), the creation of the euro at the turn of the twenty-first century, and the rise of China as an economic power in the early 2000s have all resulted in the evolution of the world community into a complicated system based on a growing interdependence among nations. The global recession of 2007–2009 provides an example of economic interdependence. The immediate cause of the recession was a collapse of the U.S. housing market and the resulting surge in mortgage loan defaults. Hundreds of billions of dollars in losses on these
- 106. mortgages undermined the financial institutions that originated and invested in them. Credit markets froze, banks would not lend to each other, and businesses and households could not get loans needed to finance day-to-day operations. This shoved the economy into recession. Soon the crisis spread to Europe. European banks were drawn into the financial crisis in part because of their exposure to defaulted mortgages in the United States. As these banks had to write off losses, fear and uncertainty spread regarding whether banks had enough capital to pay off their debt obligations. The financial crisis also spread to emerging economies such as Iceland and Russia that generally lacked the 1 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage
- 107. Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. resources to restore confidence in their economic systems. It is no wonder that “when the United States sneezed, other economies caught a cold.” Recognizing that world economic interdependence is complex and its effects uneven, the economic community has taken steps toward international cooperation. Conferences devoted to global economic issues have explored the avenues that cooperation could be fostered between industrial and developing nations. The efforts of developing nations to reap larger gains from international trade and to participate more fully in international institutions have been hastened by the impact of the global recession, industrial inflation, and the burdens of high priced energy. Over the past 50 years, the world’s market economies have become increasingly
- 108. interdependent. Exports and imports as a share of national output have risen for most industrial nations, while foreign investment and international lending have expanded. This closer linkage of economies can be mutually advantageous for trading nations. This link permits producers in each nation to take advantage of the specialization and efficiencies of large scale production. A nation can consume a wider variety of products at a cost less than what could be achieved in the absence of trade. Despite these advantages, demands have grown for protection against imports. Protectionist pressures have been strongest during periods of rising unemployment caused by economic recession. Moreover, developing nations often maintain that the so called liberalized trading system called for by industrial nations serves to keep the developing nations in poverty. Economic interdependence also has direct consequences for a student taking an introductory course in international economics. As consumers, we can be affected by changes in the international values of currencies. Should the
- 109. Japanese yen or British pound appreciate against the U.S. dollar, it would cost us more to purchase Japanese television sets or British automobiles. As investors, we might prefer to purchase Swiss securities if Swiss interest rates rise above U.S. levels. As members of the labor force, we might want to know whether the president plans to protect U.S. steelworkers and autoworkers from foreign competition. In short, economic interdependence has become a complex issue in recent times, often resulting in strong and uneven impacts among nations and among sectors within a given nation. Business, labor, investors, and consumers all feel the repercussions of changing economic conditions and trade policies in other nations. Today’s global economy requires cooperation on an international level to cope with the myriad issues and problems. GLOBALIZATION OF ECONOMIC ACTIVITY When listening to the news, we often hear about globalization.
- 110. What does this term mean? Globalization is the process of greater interdependence among countries and their citizens. It consists of the increased interaction of product and resource markets across nations via trade, immigration, and foreign investment— that is, via international flows of goods and services, people, and investments in equipment, factories, stocks, and bonds. It also includes noneconomic elements such as culture and the environment. Simply put, globalization is political, technological, and cultural, as well as economic. In terms of people’s daily lives, globalization means that the residents of one country are more likely now than they were 50 years ago to consume the products of another country, invest in another country, earn income from other countries, talk by telephone to people in other countries, visit other countries, know that they are being affected by economic developments in other countries, and know about developments in other countries.
- 111. 2 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. What forces are driving globalization?1 The first and perhaps most profound influ- ence is technological change. Since the industrial revolution of the late 1700s, technical innovations have led to an explosion in productivity and slashed transportation costs. The steam engine preceded the arrival of railways and the mechanization of a growing number of activities hitherto reliant on muscle power. Later discoveries and inventions
- 112. such as electricity, telephone, automobile, container ships, and pipelines altered production, communication, and transportation in ways unimagined by earlier generations. More recently, rapid developments in computer information and communications technology have further shrunk the influence of time and geography on the capacity of individuals and enterprises to interact and transact around the world. For services, the rise of the Internet has been a major factor in falling communication costs and increased trade. As technical progress has extended the scope of what can be produced and where it can be produced, and advances in transport technology have continued to bring people and enterprises closer together, the boundary of tradable goods and services has been greatly extended. Also, continuing liberalization of trade and investment has resulted from multilateral trade negotiations. For example, tariffs in industrial countries have come down from high double digits in the 1940s to about 4 percent by 2014. At the same time, most quo-
- 113. tas on trade, except for those imposed for health, safety, or other public policy reasons, have been removed. Globalization has also been promoted through the widespread liber- alization of investment transactions and the development of international financial mar- kets. These factors have facilitated international trade through the greater availability and affordability of financing. Lower trade barriers and financial liberalization have allowed more companies to glob- alize production structures through investment abroad that in turn has provided a further stimulus to trade. On the technology side, increased information flows and the greater tradability of goods and services have profoundly influenced production location decisions. Businesses are increasingly able to locate different components of their production pro- cesses in various countries and regions and still maintain a single corporate identity. As firms subcontract part of their production processes to their affiliates or other enterprises abroad, they transfer jobs, technologies, capital, and skills
- 114. around the globe. How significant is production sharing in world trade? Researchers have estimated production sharing levels by calculating the share of components and parts in world trade. They have concluded that global production sharing accounts for about 30 percent of the world trade in manufactured goods. Moreover, the trade in components and parts is growing significantly faster than the trade in finished products, highlighting the increasing interdependence of countries through production and trade.2 WAVES OF GLOBALIZATION In the past two decades, there has been pronounced global economic interdependence. Economic interdependence occurs through trade, labor migration, and capital (invest- ment) flows such as corporation stocks and government securities. Let us consider the major waves of globalization that have occurred in recent history.3
- 115. 1World Trade Organization, Annual Report, 1998, pp. 33–36. 2A. Yeats, Just How Big Is Global Production Sharing? World Bank, Policy Research Working Paper No. 1871, 1998, Washington, DC. 3This section draws from World Bank, Globalization, Growth and Poverty: Building an Inclusive World Economy, 2001. Chapter 1: The International Economy and Globalization 3 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. First Wave of Globalization: 1870–1914 The first wave of global interdependence occurred from 1870 to
- 116. 1914. The interdepen- dence was sparked by decreases in tariff barriers and new technologies that resulted in declining transportation costs, such as the shift from sail to steamships and the advent of railways. The main agent that drove the process of globalization was how much mus- cle, horsepower, wind power, or later on, steam power a country had and how creatively it could deploy that power. This wave of globalization was largely driven by European and American businesses and individuals. Therefore, exports as a share of world income nearly doubled to about 8 percent while per capita incomes, which had risen by 0.5 percent per year in the previous 50 years, rose by an annual average of 1.3 percent. The countries that actively participated in globalization, such as the United States, became the richest countries in the world. However, the first wave of globalization was brought to an end by World War I. Also, during the Great Depression of the 1930s, governments responded by practicing protec-
- 117. tionism: a futile attempt to enact tariffs on imports to shift demand into their domestic markets, thus promoting sales for domestic companies and jobs for domestic workers. T R A D E C O N F L I C T S F E D E R A L R E S E R V E P O L I C Y I N C I T E S G L O B A L B A C K L A S H Economic interdependence is part of our daily lives. When domestic economic policies have spillover effects on the economies of other countries, policymakers must take these into account. This why major countries frequently meet to discuss the impacts of their policies on the world eco- nomy. Consider the effects of the Federal Reserve’s policies on other economies as discussed below. For decades, the Federal Reserve (Fed) has attempted to fulfill its mandate to promote full employ- ment, price stability, and economic growth for the U.S. economy. Pursuing these objectives can impose adverse spillover effects on economies of other nations, as seen in the following example.
- 118. Facing a sluggish economy in 2010, the Fed enacted a controversial decision to pursue economic growth by purchasing $600 billion of U.S. Treasury bonds. The idea was to pump additional money into the economy that would cause long-term interest rates to fall. This would encourage Americans to spend more on invest- ment and big ticket consumption items, thus stimulat- ing the economy. However, critics doubted that the program would work and maintained that it might cause an increase in inflationary expectations that could destabilize the economy. Also, the Fed’s program was criticized by U.S. trad- ing partners such as Germany and Brazil, as an attempt to improve American competitiveness at their expense. They noted that printing more dollars, or cutting U.S. interest tends to cause depreciation in the dollar’s exchange value, that will be explained in Chapter 11 of this text. If the value of the dollar decreases, other countries’ exports become more expensive for Ameri- can consumers, thus reducing the amount of goods the United States imports from the rest of the world. The accompanying rise in the exchange value of other
- 119. countries’ currencies makes American goods cheaper for foreign consumers to purchase that should increase the amount of exports leaving the United States. This would benefit U.S. producers who would likely increase hiring to meet the increased production requirements of the increased global demand for their exports. What’s more, the rest of the world’s producers would see their exports fall, resulting in job losses for their workers. Producers in the United States would gain at the expense of producers abroad. However, Federal Reserve officials challenged this argument by stating that the purpose of their program was not to push down the dollar in order to disadvantage America’s trading partners. Instead, it was an attempt to grow the economy that is not just good for the United States, but for the world as a whole. A depreciation of the dollar was only a side effect of a growth oriented policy, not the purpose of the policy. This argument did not dampen the fears of foreigners regarding the Fed’s monetary policy, and their criticism continued. iS to ck
- 120. ph ot o. co m /p ho to so up 4 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 121. time if subsequent rights restrictions require it. For the world economy, increasing protectionism caused exports as a share of national income to fall to about 5 percent, thereby undoing 80 years of technological progress in transportation. Second Wave of Globalization: 1945–1980 The horrors of the retreat into nationalism provided renewed incentive for international- ism following World War II. The result was a second wave of globalization that took place from 1945 to 1980. Falling transportation costs continued to foster increased trade. Nations persuaded governments to cooperate to decrease previously established trade barriers. However, trade liberalization discriminated both in terms of which countries partici- pated and which products were included. By 1980, trade between developed countries in
- 122. manufactured goods had been largely freed of barriers. Barriers facing developing coun- tries had been eliminated for only those agricultural products that did not compete with agriculture in developed countries. For manufactured goods, developing countries faced sizable barriers. For developed countries, the slashing of trade barriers between them greatly increased the exchange of manufactured goods, thus helping to raise the incomes of developed countries relative to the rest. The second wave of globalization introduced a new kind of trade: rich country specialization in manufacturing niches that gained productivity through agglomeration economies. Increasingly, firms clustered together, some clusters produced the same product and others were connected by vertical linkages. Japanese auto companies, for example, became famous for insisting that their parts manufacturers locate within a short distance of the main assembly plant. For companies such as Toyota and Honda, this decision decreased the costs of transport, coordination,
- 123. monitoring, and contracting. Although agglomeration economies benefit those in the clusters, they are bad news for those who are left out. A region can be uncompetitive simply because not enough firms have chosen to locate there. Thus, a divided world can emerge, in which a network of manufacturing firms is clustered in some high wage region, while wages in the remaining regions stay low. Firms will not shift to a new location until the discrepancy in produc- tion costs becomes sufficiently large to compensate for the loss of agglomeration economies. During the second wave of globalization, most developing countries did not partici- pate in the growth of global trade in manufacturing and services. The combination of continuing trade barriers in developed countries and unfavorable investment climates and antitrade policies in developing countries confined them to dependence on agricul- tural and natural resource products.
- 124. Although the second globalization wave succeeded in increasing per capita incomes within the developed countries, developing countries as a group were being left behind. World inequality fueled the developing countries’ distrust of the existing international trading system that seemed to favor developed countries. Therefore, developing countries became increasingly vocal in their desire to be granted better access to developed country markets for manufactured goods and services, thus fostering additional jobs and rising incomes for their people. Latest Wave of Globalization The latest wave of globalization that began in about 1980 is distinctive. First, a large number of developing countries, such as China, India, and Brazil, broke into the world markets for manufacturers. Second, other developing countries became increasingly marginalized in the world economy and realized decreasing incomes and increasing Chapter 1: The International Economy and Globalization 5
- 125. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. poverty. Third, international capital movements, which were modest during the second wave of globalization, again became significant. Of major significance for this wave of globalization is that some developing countries succeeded for the first time in harnessing their labor abundance to provide them with a competitive advantage in labor intensive manufacturing. Examples of developing coun- tries that have shifted into manufacturing trade include Bangladesh, Malaysia, Turkey,
- 126. Mexico, Hungary, Indonesia, Sri Lanka, Thailand, and the Philippines. This shift is partly because of tariff cuts that developed countries have made on imports of manufactured goods. Also, many developing countries liberalized barriers to foreign investment that encouraged firms such as Ford Motor Company to locate assembly plants within their borders. Moreover, technological progress in transportation and communications permitted developing countries to participate in international production networks. However, the dramatic increase in manufactured exports from developing countries has contributed to protectionist policies in developed countries. With so many developing countries emerging as important trading countries, reaching further agreements on multilateral trade liberalization has become more complicated. Although the world has become more globalized in terms of international trade and capital flows compared to 100 years ago, there is less globalization in the world when it comes to labor flows. The United States had a very liberal
- 127. immigration policy in the late 1800s and early 1900s and large numbers of people flowed into the country, primarily from Europe. As a large country with abundant room to absorb newcomers, the United States also attracted foreign investment throughout much of this period, which meant that high levels of migration went hand in hand with high and rising wages. However, since World War I, immigration has been a disputed topic in the United States, and restrictions on immigration have tightened. In contrast to the largely European immigra- tion in the 1870–1914 globalization waves, contemporary immigration into the United States comes largely from Asia and Latin America. Another aspect of the most recent wave of globalization is foreign outsourcing, when certain aspects of a product’s manufacture are performed in more than one country. As travel and communication became easier in the 1970s and 1980s, manufacturing increas- ingly moved to wherever costs were the lowest. U.S. companies shifted the assembly of
- 128. autos and the production of shoes, electronics, and toys to low wage developing coun- tries. This shift resulted in job losses for blue collar workers producing these goods and cries for the passage of laws to restrict outsourcing. When an American customer places an order online for a Hewlett-Packard (HP) laptop, the order is transmitted to Quanta Computer Inc. in Taiwan. To reduce labor costs, the company farms out production to workers in Shanghai, China. They combine parts from all over the world to assemble the laptop that is flown as freight to the United States, and then sent to the customer. About 95 percent of the HP laptop is outsourced to other countries. The outsourcing ratio is close to 100 percent for other U.S. computer producers including Dell, Apple, and Gateway. Table 1.1 shows how the HP laptop is put together by workers in many different countries. By the 2000s, the Information Age resulted in the foreign outsourcing of white collar work. Today, many companies’ locations hardly matter. Work is
- 129. connected through digitization, the Internet, and high speed data networks around the world. Companies can now send office work anywhere, and that means places like India, Ireland, and the Philippines where workers are paid much less than American workers. A new round of globalization is sending upscale jobs offshore, including accounting, chip design, engineering, basic research, and financial analysis as shown in Table 1.2. Analysts estimate that foreign outsourcing can allow companies to reduce costs of a given service from 30 to 50 percent. 6 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 130. time if subsequent rights restrictions require it. Boeing uses aeronautics specialists in Russia to design luggage bins and wing parts for its jetliners. Having a master’s degree or doctorate in math or aeronautics, these specialists are paid $700 per month in contrast to a monthly salary of $7,000 for an American counterpart. Similarly, engineers in China and India, earning $1,100 a month, develop chips for Texas Instruments and Intel; their American counterparts are paid $8,000 a month. However, companies are likely to keep crucial research and development and the bulk of office operations close to home. Many jobs cannot go anywhere because they require face-to- face contact with customers. Economists note that the vast majority of jobs in the United States consist of services such as retail, restaurants and hotels, personal care services, and the like. These services are necessarily produced and consumed
- 131. locally, and cannot be sent offshore. Besides saving money, foreign outsourcing can enable companies to do things they simply couldn’t do before. A consumer products company in the United States found it impractical to chase down tardy customers buying less than $1,000 worth of goods. When this service was run in India, however, the cost dropped so much the company could profitably follow up on bills as low as $100. TABLE 1.1 Manufacturing an HP Pavilion, ZD8000 Laptop Computer Component Major Manufacturing Country Hard disk drives Singapore, China, Japan, United States Power supplies China Magnesium casings China Memory chips Germany, Taiwan, South Korea, Taiwan, United
- 132. States Liquid-crystal display Japan, Taiwan, South Korea, China Microprocessors United States Graphics processors Designed in United States and Canada; produced in Taiwan Source: From “The Laptop Trail,” The Wall Street Journal, June 9, 2005, pp.B1 and B8. TABLE 1.2 Globalization Goes White Collar U.S. Company Country Type of Work Moving Accenture Philippines Accounting, software, office work Conseco India Insurance claim processing Delta Air Lines India, Philippines Airline reservations, customer service Fluor Philippines Architectural blueprints
- 133. General Electric India Finance, information technology Intel India Chip design, tech support Microsoft China, India Software design Philips China Consumer electronics, R&D Procter & Gamble Philippines, China Accounting, tech support Source: From “Is Your Job Next?” Business Week, February 3, 2003, pp. 50–60. Chapter 1: The International Economy and Globalization 7 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 134. Although the Internet makes it easier for U.S. companies to remain competitive in an increasingly brutal global marketplace, is foreign outsourcing good for white collar workers? A case can be made that Americans benefit from this process. In the last two decades, U.S. companies have imported hundreds of thou- sands of immigrants to ease engineering shortages. Now, by sending routine service and engineering tasks to nations with a surplus of educated workers, U.S. labor and capital can be shifted to higher value industries and cutting- edge research and development. However, a question remains: What happens if displaced white collar workers cannot find greener pastures? The truth is that the rise of the global knowledge industry is so recent that most economists have not begun to figure out the implica-
- 135. tions. People in developing nations like India see foreign outsourcing as a bonus because it helps spread wealth from rich nations to poor nations. Among its many other virtues, the Internet might turn out to be a great equalizer. Outsourcing will be discussed at the end of Chapter 2. T R A D E C O N F L I C T S D I E S E L E N G I N E S A N D G A S T U R B I N E S A S M O V E R S O F G L O B A L I Z A T I O N When you consider internal combus- tion engines, you probably think about the one under the hood of your car or truck—the gasoline powered engine. Although this engine is good for moving you around, it is not adequate for moving large quantities of goods and people long distances; global transportation requires more mas- sive engines. What makes it possible for us to transport billions of tons of raw materials and manufactured goods from country to country? Why are we able to fly almost any-
- 136. where in the world in a Boeing or Airbus jetliner within twenty-four hours? Two notable technical innovations that have driven globalization are diesel engines, which power cargo ships, locomotives, and large trucks, and natural gas-fired turbines that power planes and other means of transportation. The diesel engine was first developed to the point of commercial success by Rudolf Diesel in the 1890s. After graduating from Munich Polytechnic in Germany, Diesel became a refrigerator engineer, but his true love lay in engine design. He developed an engine that converted the chemical energy available in die- sel fuel into mechanical energy that could power trucks, cargo ships, and so on. Today, more than 90 percent of global trade in manufactured goods and raw materials is transported with the use of diesel engines. The natural gas-fired turbine is another driver of globalization. A gas turbine is a rotary engine that extracts energy from a flow of combustion gas. This energy produces a power thrust that sends an airplane into the sky. It also turns a shaft or a pro- peller that moves locomotives and ships. The gas
- 137. turbine was invented by Frank Whittle, a British engineer, in the early 1900s. Although Wilbur and Orville Wright are the first fathers of flight, Whittle’s influence on global air travel should not be underestimated. These two engines, diesels and turbines, have become important movers of goods and people throughout the world. They have reduced transporta- tion costs to such an extent that distance to the mar- ket is a much smaller factor affecting the location of manufacturers or the selection of the origin of imported raw materials. Indeed, neither international trade nor intercontinental flights would have realized such levels of speed, reliability, and affordability as have been achieved because of diesel engines and gas turbines. Although diesels and turbines have caused environmental problems, such as air and water pollution, these machines will likely not disap- pear soon. Source: Vaclav Smil, Prime Movers of Globalization, MIT Press, Cambridge, Massachusetts, 2010 and Nick Schulz, “Engines of Commerce,” The Wall Street Journal, December 1, 2010. iS
- 138. to ck ph ot o. co m /p ho to so up 8 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 139. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. THE UNITED STATES AS AN OPEN ECONOMY It is generally agreed that the U.S. economy has become increasingly integrated into the world economy (become an open economy) in recent decades. Such integration involves a number of dimensions that include the trade of goods and services, financial markets, the labor force, ownership of production facilities, and the dependence on imported materials. Trade Patterns To appreciate the globalization of the U.S. economy, go to a local supermarket. Almost any supermarket doubles as an international food bazaar. Alongside potatoes from Idaho and beef from Texas, stores display melons from Mexico, olive oil
- 140. from Italy, coffee from Colom- bia, cinnamon from Sri Lanka, wine and cheese from France, and bananas from Costa Rica. Table 1.3 shows a global fruit basket that is available for American consumers. The grocery store isn’t the only place Americans indulge their taste for foreign made products. We buy cameras and cars from Japan, shirts from Bangladesh, DVD players from South Korea, paper products from Canada, and fresh flowers from Ecuador. We get oil from Kuwait, steel from China, computer programs from India, and semiconduc- tors from Taiwan. Most Americans are well aware of our desire to import, but they may not realize that the United States ranks as the world’s greatest exporter by selling personal computers, bulldozers, jetliners, financial services, movies, and thousands of other products to just about all parts of the globe. International trade and investment are facts of everyday life. As a rough measure of the importance of international trade in a
- 141. nation’s economy, we can look at that nation’s exports and imports as a percentage of its gross domestic product (GDP). This ratio is known as openness. Openness Exports Imports GDP Table 1.4 shows measures of openness for selected nations as of 2013. In that year, the United States exported 14 percent of its GDP while imports were 18 percent of GDP; the TABLE 1.3 The Fruits of Free Trade: A Global Fruit Basket On a trip to the grocery store, consumers can find goods from all over the globe. Fruit Country Fruit Country Apples New Zealand Limes El Salvador
- 142. Apricots China Oranges Australia Bananas Ecuador Pears South Korea Blackberries Canada Pineapples Costa Rica Blueberries Chile Plums Guatemala Coconuts Philippines Raspberries Mexico Grapefruit Bahamas Strawberries Poland Grapes Peru Tangerines South Africa Kiwifruit Italy Watermelons Honduras Lemons Argentina Source: From “The Fruits of Free Trade,” Annual Report, Federal Reserve Bank of Dallas, 2002, p. 3. Chapter 1: The International Economy and Globalization 9 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 143. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. openness of the U.S. economy to trade equaled 32 percent. Although the U.S. economy is significantly tied to international trade, this tendency is even more striking for many smaller nations, as shown in the table. Large countries tend to be less reliant on interna- tional trade because many of their companies can attain an optimal production size without having to export to foreign nations. Therefore, small countries tend to have higher measures of openness than do large ones. Figure 1.1 shows the openness of the U.S. economy from 1890 to 2013. One signifi- cant trend is that the United States became less open to
- 144. international trade between 1890 and 1950. Openness was relatively high in the late 1800s because of the rise in world trade resulting from technological improvements in transportation (steamships) and communications (trans-Atlantic telegraph cable). However, two world wars and the Great Depression of the 1930s caused the United States to reduce its dependence on trade, partly for national security reasons and partly to protect its home industries from import competition. Following World War II, the United States and other countries negotiated reductions in trade barriers that contributed to rising world trade. Technological improvements in shipping and communications also bolstered trade and the increasing openness of the U.S. economy. The relative importance of international trade for the United States has significantly increased during the past century, as shown in Figure 1.1. But a fact is hidden by these data. In 1890, most U.S. trade was in raw materials and agricultural products, today,
- 145. manufactured goods and services dominate U.S. trade flows. Therefore, American producers of manufactured products are more affected by foreign competition than they were a hundred years ago. The significance of international trade for the U.S. economy is even more noticeable when specific products are considered. We would have fewer personal computers without imported components, no aluminum if we did not import bauxite, no tin cans without imported tin, and no chrome bumpers if we did not import chromium. Students taking a 9 a.m. course in international economics might sleep through the class (do you really believe this?) if we did not import coffee or tea. Moreover, many of the products we buy from foreigners would be more costly if we were dependent on our domestic production. With which nations does the United States conduct trade? Canada, China, Mexico, and Japan head the list, as shown in Table 1.5.
- 146. TABLE 1.4 Exports and Imports of Goods and Services as a Percentage of Gross Domestic Product GDP), 2013 Country Exports as a Percentage of GDP Imports as a Percentage of GDP Exports Plus Imports as a Percentage of GDP Netherlands 87 79 166 South Korea 56 54 110 Germany 52 46 98 Norway 41 27 68
- 147. United Kingdom 32 34 66 Canada 30 32 62 France 27 30 57 United States 14 18 32 Japan 15 16 31 Source: From The World Bank Group, Country Profiles, 2014, available at http://www.worldbank.org. 10 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 148. Labor and Capital Besides the trade of goods and services, movements in factors of production are a measure of economic interdependence. As nations become more interdependent, labor and capital should move more freely across nations. However, during the past 100 years, labor mobility has not risen for the United States. In 1900, about 14 percent of the U.S. population was foreign born. But from the 1920s to the 1960s, the United States sharply curtailed immigration. This curtailment resulted FIGURE 1.1 Openness of the U.S. Economy, 1890–2013 10 5 E
- 151. o f G D P 0 1890 19901970195019301910 2013 30 32 25 20 15 2010 The figure shows that for the United States the importance of international trade has significantly increased from 1890 to 2013.
- 152. Source: Data from U.S. Census Bureau, Foreign Trade Division, U.S. Trade in Goods and Services, at http://www.census.gov/foreign-trade/ statistics and Economic Report of the President, various issues. TABLE 1.5 Top Ten Countries with Whom the U.S. Trades, 2012 Country Value of U.S. Exports of Goods (in billions of dollars) Value of U.S. Imports of Goods (in billions of dollars) Total Value of Trade (in billions of dollars) Canada 292.5 323.9 616.4
- 153. China 110.5 425.6 536.1 Mexico 215.9 277.6 493.5 Japan 70.0 146.4 216.4 Germany 48.8 108.7 157.5 United Kingdom 54.9 55.0 109.9 South Korea 42.3 58.9 101.2 France 30.1 41.7 71.8 Brazil 43.8 32.1 75.9 Taiwan 24.4 38.9 63.3 Source: From U.S. Department of Commerce, U.S. Census Bureau, Foreign Trade: U.S. Trade in Goods By Country, 2013. Chapter 1: The International Economy and Globalization 11 Copyright 2015 Cengage Learning. All Rights Reserved. May
- 154. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. in the foreign born U.S. population declining to 6 percent of the total population. During the 1960s, the United States liberalized restrictions and the flow of immigrants increased. By 2014, about 12 percent of the U.S. population was foreign born while foreigners made up about 14 percent of the labor force. People from Latin America accounted for about half of this figure while Asians accounted for another quarter. These immigrants contrib- uted to economic growth in the United States by taking jobs in labor scarce regions and filling the types of jobs native workers often shun.
- 155. Although labor mobility has not risen for the United States in recent decades, the country has become increasingly tied to the rest of the world through capital (invest- ment) flows. Foreign ownership of U.S. financial assets has risen since the 1960s. During the 1970s, OPEC recycled many of their oil dollars by making investments in U.S. finan- cial markets. The 1980s also witnessed major flows of investment funds to the United States as Japan and other nations, with dollars accumulated from trade surpluses with the United States, acquired U.S. financial assets, businesses, and real estate. By the late 1980s, the United States was consuming more than it produced and became a net borrower from the rest of the world to pay for the difference. Increasing concerns were raised about the interest cost of this debt to the U.S. economy and the impact of this debt burden on the living standards of future U.S. generations. This concern remains at the writing of this book in 2014. Globalization has also increased in international banking. The
- 156. average daily volume of trading (turnover) in today’s foreign exchange market (where currencies are bought and sold) is estimated at about $4 trillion, compared to $205 billion in 1986. The global trading day begins in Tokyo and Sydney and, in a virtually unbroken 24-hour cycle, moves around the world through Singapore and Hong Kong to Europe and finally across the United States before being picked up again in Japan and Australia. London remains the largest center for foreign exchange trading, followed by the United States; significant volumes of currencies are also traded in Asia, Germany, France, Scandinavia, Canada, and elsewhere. In commercial banking, U.S. banks have developed worldwide branch networks for loans, payments, and foreign exchange trading. Foreign banks have also increased their presence in the United States, reflecting the multinational population base of the United States, the size and importance of U.S. markets, and the role of the U.S. dollar as an
- 157. international medium of exchange and reserve currency. Today, more than 250 foreign banks operate in the United States; in particular, Japanese banks have been the dominant group of foreign banks operating in the United States. Like commercial banks, securities firms have also globalized their operations. By the 1980s, U.S. government securities were traded on virtually a 24-hour basis. Foreign investors purchased U.S. treasury bills, notes, and bonds, and many desired to trade during their own working hours rather than those of the United States. Primary dealers of U.S. government securities opened offices in such locations as Tokyo and London. Stock markets became increasingly internationalized with companies listing their stocks on different exchanges throughout the world. Financial futures markets also spread throughout the world. WHY IS GLOBALIZATION IMPORTANT? Because of trade, individuals, firms, regions, and nations can
- 158. specialize in the production of things they do well and use the earnings from these activities to purchase from others those items for which they are high-cost producers. Therefore, trading partners can 12 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. produce a larger joint output and achieve a higher standard of living than would other- wise be possible. Economists refer to this as the law of comparative advantage that will be further discussed in Chapter 2.
- 159. According to the law of comparative advantage, the citizens of each nation can gain by spending more of their time and resources doing those things where they have a rela- tive advantage. If a good or service can be obtained more economically through trade, it makes sense to trade for it instead of producing it domestically. It is a mistake to focus on whether a good is going to be produced domestically or abroad. The central issue is how the available resources can be used to obtain each good at the lowest possible cost. When trading partners use more of their time and resources producing things they do best, they are able to produce a larger joint output that provides the source for mutual gain. International trade also results in gains from the competitive process. Competition is essential to both innovation and efficient production. International competition helps keep domestic producers on their toes and provides them with a strong incentive to
- 160. improve the quality of their products. Also, international trade usually weakens monop- olies. As countries open their markets, their monopoly producers face competition from foreign firms. With globalization and import competition, U.S. prices have decreased for many pro- ducts like TV sets, toys, dishes, clothing, and so on. However, prices increased for many products untouched by globalization, such as cable TV, hospital services, sports tickets, rent, car repair and others. The gains from global markets are not restricted to goods traded internationally. They extend to such non-traded goods as houses that contain carpeting, wiring, and other inputs now facing greater international competition. During the 1950s, General Motors (GM) was responsible for about 60 percent of all passenger cars produced in the United States. Although GM officials praised the firm’s immense size for providing economies of scale in individual plant operations, skeptics
- 161. were concerned about the monopoly power resulting from GM’s dominance of the auto market. Some argued that GM should be divided into several independent companies to inject more competition into the market. Today, stiff foreign competition has resulted in GM’s current share of the market to stand at less than 24 percent. Not only do open economies have more competition, but they also have more firm turnover. Being exposed to competition around the globe can result in high-cost domes- tic producers exiting the market. If these firms are less productive than the remaining firms, then their exit represents productivity improvements for the industry. The increase in exits is only part of the adjustment. The other part is new firms entering the market unless there are significant barriers. With these new firms comes more labor market churning as workers formerly employed by obsolete firms must now find jobs in emerging ones. Inadequate education and training can make some workers unemploy-
- 162. able for emerging firms creating new jobs that we often cannot yet imagine. This is probably the key reason why workers find globalization to be controversial. The higher turnover of firms is an important source of the dynamic benefits of globalization. In general, dying firms have falling productivity, and new firms tend to increase their productivity over time. Economists have generally found that economic growth rates have a close relation to openness to trade, education, and communications infrastructure. Countries that open their economies to international trade tend to benefit from new technologies and other sources of economic growth. As Figure 1.2 shows, there appears to be some evidence of an inverse relation between the level of trade barriers and the economic growth of nations. Nations that maintain high barriers to trade tend to realize a low level of economic growth. Chapter 1: The International Economy and Globalization 13
- 163. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. International trade can also provide stability for producers, as seen in the case of Invacare Corporation, an Ohio based manufacturer of wheelchairs and other health care equipment. For the wheelchairs it sells in Germany, the electronic controllers come from the firm’s New Zealand factories; the design is largely American; and the final assembly is done in Germany with parts shipped from the United States, France, and the United Kingdom. By purchasing parts and components worldwide, Invacare can
- 164. resist suppliers’ efforts to increase prices for aluminum, steel, rubber, and other materi- als. By selling its products in 80 nations, Invacare can maintain a more stable workforce in Ohio than if it was completely dependent on the U.S. market. If sales decline anytime in the United States, Invacare has an ace up its sleeve—exports. On the other hand, rapid growth in countries like China and India has helped to increase the demand for commodities like crude oil, copper, and steel. Thus, American consumers and companies pay higher prices for items like gasoline. Rising gasoline prices, in turn, have spurred governmental and private sector initiatives to increase the supply of gasoline substitutes like biodiesel or ethanol. Increased demand for these alter- native forms of energy has helped to increase the price of soybeans and corn that are key inputs in the production of chicken, pork, beef, and other foodstuffs. Moreover, globalization can make the domestic economy vulnerable to disturbances
- 165. initiated overseas, as seen in the case of India. In response to India’s agricultural crisis, some 1,200 Indian cotton farmers committed suicide during 2005–2007 to escape debts to money lenders. The farmers borrowed money at exorbitant rates, so they could sink wells and purchase expensive biotech cotton seeds. But the seeds proved inadequate for small plots resulting in crop failures. Farmers suffered from the low world price of their cotton crop that fell by more than a third from 1994 to 2007. Prices were low partly because cotton was heavily subsidized by wealthy countries, mainly the United States. FIGURE 1.2 Tariff Barriers versus Economic Growth –10 0 4
- 167. a te ( % ) 16 20 Central African Republic Russia China 24 –5 0 5 Per-Capita Growth Rate (%) in GDP
- 168. 10 15 20 The figure shows the weighted average tariff rate and per capita growth rate in GDP for 23 nations in 2002. According to the figure, there is evidence of an inverse relationship between the level of tariff barriers and the economic growth of nations. Source: Data taken from The World Bank Group, World Development Indicators, available at http://www .worldbank.org/data/. 14 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 169. According to the World Bank, cotton prices would have risen about 13 percent if the subsidies had been eliminated. Although India’s government could impose a tariff on imported cotton to offset the foreign subsidy, its textile manufacturers, who desired to keep production costs low, welcomed cheap fibers. India’s cotton tariff was only 10 percent, much lower than its tariffs on most other commodities. The simple solution to the problem of India’s farmers would be to move them from growing cotton to weaving it in factories. India’s restrictive labor laws discouraged indus- trial employment and the lack of a safety net resulted in farmers clinging to their marginal plots of land. There is great irony in the plight of India’s cotton farmers. The British developed India’s long-fiber cotton in the1800s to supply British cotton
- 170. mills. As their inexpensive cloth drove India’s weavers out of business, the weavers were forced to work the soil. By the early 2000s, India’s textile makers were enjoying a revival but its farmers could not leave the soil to work in factories.4 GLOBALIZATION AND COMPETITION Although economists recognize that globalization and free trade can provide benefits to many firms, workers, and consumers, they can inflict burdens on others. Consider the cases of Eastman Kodak Company, the Schwinn Bicycle Company and Element Electronics Inc. Kodak Reinvents Itself under Chapter 11 Bankruptcy Vladimir Lenin, a Russian politician, once said, “A capitalist will sell you the rope to hang him.” That quote may contain an element of truth. Capitalists often invest in the technology that ruins their business, as seen in the case of Eastman Kodak Company.
- 171. Kodak is a multinational imaging and photographic equipment company headquar- tered in Rochester, New York. Its history goes back to 1889 when it was founded by George Eastman. During much of the 1900s, Kodak held a dominant position in the photographic equipment market. In 1976 it had a 90 percent market share of film sales and an 85 percent share of camera sales in the United States. Kodak’s slogan was “You press the button and we do the rest.” However, Kodak’s near monopoly position resulted in a culture of complacency for its management who resisted changing their strategy as global competition and new technologies would emerge. In the 1980s, Japanese competitor Fuji Photo Film Co. entered the U.S. market with lower priced film and supplies. However, Kodak refused to believe that American consu- mers would ever desert its popular brand. Kodak passed on the opportunity to become the official film of the 1984 Los Angeles Olympics. Fuji won these sponsorship rights
- 172. that provided it a permanent foothold in the American market. Fuji opened up a film manufacturing plant in the United States and its aggressive marketing and price cutting began capturing market share from Kodak. By the mid-1990s, Fuji held a 17 percent share of the U.S. market for photo film while Kodak’s market share plunged to 75 percent. Meanwhile, Kodak made little headway in Japan, the second largest market for its photo film and paper after the United States. Clearly, Kodak underestimated the competitiveness of its Japanese rival. 4“Cotton Suicides: The Great Unraveling,” The Economist, January 20, 2007, p. 34. Chapter 1: The International Economy and Globalization 15 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does
- 173. not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Another factor that contributed to Kodak’s decline was the development of digital cameras and smart phones that operate as cameras. Strange as it may seem, Kodak built one of the first digital cameras in 1975 but Kodak was slow in launching the production of digital cameras. Because Kodak’s competitors did not have this technology at that time, Kodak faced no pressure to change its strategy of selling cheap cameras to customers who would buy lots of its expensive film. All of this changed in the 1990s with the development of digital cameras by companies like Sony. With its lucrative film sales dropping, Kodak launched the production of digital cameras. By 2005, Kodak ranked at the top of the digital camera market in the United States. Despite high growth, Kodak failed to anticipate how fast these digital cameras became
- 174. commodities with low profit margins, as more companies entered the market. Kodak’s digital camera sales were quickly undercut by Asian competitors who could produce their cameras more cheaply. Also, smart phones were developed to replace cameras. Kodak also failed to understand emerging markets correctly. Kodak hoped the new Chinese middle class would purchase lots of film. They did for a short while, but then decided that digital cameras were preferable. Kodak provides a striking example of an industrial giant that faltered in the face of global competition and advancing technology. By 2012 Kodak was running short of cash. As a result, Kodak filed for Chapter 11 bankruptcy under which it would undergo reorganization under the supervision of a bankruptcy court judge. Following its filing, Kodak sold off many of its businesses and patents while shutting down the camera unit that first made it famous. Many of Kodak’s former employees lost retirement and health
- 175. care benefits as a result of the bankruptcy. In 2013, Kodak received court approval for its plan to emerge from bankruptcy as a much smaller digital imaging company. It remains to be seen how Kodak will perform in the years ahead. Bicycle Imports Force Schwinn to Downshift The Schwinn Bicycle Company illustrates the notion of globalization and how producers react to foreign competitive pressure. Founded in Chicago in 1895, Schwinn grew to pro- duce bicycles that became the standard of the industry. Although the Great Depression drove most bicycle companies out of business, Schwinn survived by producing durable and stylish bikes sold by dealerships that were run by people who understood bicycles and were anxious to promote the brand. Schwinn emphasized continuous innovation that resulted in features such as built-in kickstands, balloon tires, chrome fenders, head and taillights, and more. By the 1960s, the Schwinn Sting Ray became the bicycle that virtually every child wanted. Celebrities such as Captain Kangaroo and Ronald Reagan
- 176. pitched ads claiming that “Schwinn bikes are the best.” Although Schwinn dominated the U.S. bicycle industry; the nature of the bicycle mar- ket was changing. Cyclists wanted features other than heavy, durable bicycles that had been the mainstay of Schwinn for decades. Competitors emerged such as Trek, which built mountain bikes and Mongoose which produced bikes for BMX racing. Falling tariffs on imported bicycles encouraged Americans to import from companies in Japan, South Korea, Taiwan, and eventually China. These companies supplied Amer- icans with everything ranging from parts and entire bicycles under U.S. brand names, or their own brands. Using production techniques initially developed by Schwinn, foreign companies hired low wage workers to manufacture competitive bicycles at a fraction of Schwinn’s cost. As foreign competition intensified, Schwinn moved production to a plant in Green-
- 177. ville, Mississippi in 1981. The location was strategic. Like other U.S. manufacturers, Schwinn relocated production to the South in order to hire nonunion workers at lower 16 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. wages. Schwinn also obtained parts produced by low wage workers in foreign countries. The Greenville plant suffered from uneven quality and low efficiency and it produced bicycles no better than the ones imported from the Far East. As losses mounted for
- 178. Schwinn, the firm declared bankruptcy in 1993. Eventually Schwinn was purchased by the Pacific Cycle Company that farmed the production of Schwinn bicycles out to low wage workers in China. Most Schwinn bicycles today are built in Chinese factories and are sold by Walmart and other discount merchants. Cyclists do pay less for a new Schwinn under Pacific’s ownership. It may not be the industry standard that was the old Schwinn, but it sells at Walmart for approximately $180, about a third of the original price in today’s dollars. Although cyclists may lament that a Schwinn is no longer the bike it used to be, Pacific Cycle officials note that it is not as expensive as in the past either.5 Element Electronics Survives by Moving TV Production to America Few American industries have faltered as much as television manufacturing. During the 1950s–1960s, there were about 150 domestic producers and employment stood at about 100,000 workers. Imports began arriving, first from Japan and
- 179. later from China, South Korea, and other Asian countries. The introduction of flat panel televisions tipped the scales further in favor of Asia, because their lighter weight and sleek styling made shipping costs cheaper than the heavier and more bulky tube televisions that formerly dominated sales. By the early 2000s, American television manufacturing was virtually nonexistent. Costs in China have recently been going up as workers’ wages and other expenses, such as transportation, have increased. Meanwhile, sluggish wage increases in the United States and rapid productivity gains have reshaped many U.S. factories into more robust competitors. Once such competitor is Element Electronics Inc. headquartered in Eden Prairie, Minnesota. In 2012, Element Electronics became the only company assembling televi- sions in the United States. All of the parts of its televisions are imported. On an assembly line located in Detroit, Michigan, the firm produces a variety of
- 180. flat screen models that are sold by Walmart, Target, and other retailers. Element Electronics made the decision to manufacture products in America to shorten its supply chain and related lead times, thus becoming more responsive to American consumers. This would allow the firm to get the right products, at the right price, to the right place at the right time as well as reduce waste and increase the quality of the consumer’s out-of- box experience. Element Electronics’ locating a factory in Detroit provided advantages in terms of a qualified labor pool and distribution efficiencies based on population across the United States. Also, the firm said that by producing in Detroit rather than in Asia, it could avoid a 5 percent tariff on imported televisions and the higher cost of shipping televisions to American retailers. In 2013, the firm estimated that the average savings on tariffs was $27 for a 46-inch television, enough to account for the higher cost workers of Detroit. Moreover, the firm automated the assembly of its televisions to
- 181. reduce the amount of labor required to build a television. Officials of Element Electronics said that locating production in the United States was an emotional decision. Rather than being a contributor to jobs leaving America for other coun- tries, they wanted to pioneer a resurgence of creating quality manufacturing jobs in the United States. Element Electronics televisions are shipped in boxes painted with a colorful 5Judith Crown and Glenn Coleman, No Hands: The Rise and Fall of the Schwinn Bicycle Company, an American Institution. (New York, Henry Holt and Co., 1996) and Jay Pridmore, Schwinn Bicycles. (Osceola, WI: Motorbooks International, 2002). See also Griff Wittee, “A Rough Ride for Schwinn Bicy- cle,” The Washington Post, December 3, 2004. Chapter 1: The International Economy and Globalization 17 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 182. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. red, white, and blue flag on the side to portray a “Made in America” image. The boxes also display American workers assembling televisions at the Detroit factory.6 COMMON FALLACIES OF INTERNATIONAL TRADE Although gains from international trade are apparent, misconceptions prevail.7 One misconception is that trade results in a zero-sum game—if one trading partner benefits, the other must suffer. It turns out that both partners can benefit from trade. Consider the example of trade between Colombia and Canada. These countries can
- 183. produce more combined output when Canadians supply natural gas and Colombians supply bananas. The larger output allows Colombians to benefit by using revenues from their banana exports to buy Canadian natural gas. Canadians benefit by using revenues from their natural gas exports to buy Colombian bananas. Therefore, the larger combined production yields mutual benefits for both countries. According to the principle of com- parative advantage, if countries specialize in what they are relatively best at producing, they will import products that their trading partners are most efficient at producing, yield- ing benefits for both countries. Another misconception is that imports result in unemployment and burden the econ- omy, while exports enhance economic growth and jobs for workers. The source of this misconception is a failure to consider the connections between imports and exports. American imports of German machinery will result in losses of sales, output, and jobs in the U.S. machinery industry. However, as Germany’s machinery
- 184. sales to the United States increase, Germans will have more purchasing power to buy American computer software. Output and employment will thus increase in the U.S. computer software industry. The drag on the U.S. economy caused by rising imports of machinery tends to be offset by the stimulus on the economy caused by rising exports of computer software. People sometimes feel tariffs, quotas, and other import restrictions result in more jobs for domestic workers. However, they fail to understand that a decrease in imports does not take place in isolation. When we impose import barriers that reduce the ability of foreigners to export to us, we are also reducing their ability to obtain the dollars required to import from us. Trade restrictions that decrease the volume of imports will also decrease exports. As a result, jobs promoted by import barriers tend to be offset by jobs lost due to falling exports. If tariffs and quotas were that beneficial, why don’t we use
- 185. them to impede trade throughout the United States? Consider the jobs that are lost when, for example, Wisconsin purchases grapefruit from Florida, cotton from Alabama, tomatoes from Texas, and grapes from California. All of these goods could be produced in Wisconsin, although at a higher cost. Thus, Wisconsin residents find it less expensive to “import” these products. Wisconsin benefits by using its resources to produce and “export” milk, beer, electronics, and other products it can produce efficiently. Indeed, most people feel that free trade throughout America is an important contributor of prosperity for each of the states. The conclusions are the same for trade among nations. Free trade throughout America fosters prosperity; so, too, does free trade among nations. 6Ashok Bindra, “Element Electronics Brings TV Manufacturing Back to the United States,” TMCNet, January 11, 2012; “Element Electronics: USA Made TV is Bringing Jobs Back Home,” American Made Insider, February 17, 2013; Timothy Aeppel, “Detroit’s Wages
- 186. Take on China’s,” The Wall Street Jour- nal, May 23, 2012; Matt Roush, “Element Electronics: America Matters,” CBS Detroit, January 11, 2012. 7This section is drawn from James Gwartney and James Carter, Twelve Myths of International Trade, U.S. Senate, Joint Economic Committee, June 2000, pp. 4–11. 18 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. DOES FREE TRADE APPLY TO CIGARETTES? When President George W. Bush pressured South Korea in 2001 to stop imposing a
- 187. 40 percent tariff on foreign cigarettes, administration officials said the case had nothing to do with public health. Instead, it was a case against protecting the domestic industry T R A D E C O N F L I C T S I S T H E U N I T E D S T A T E S L O S I N G I T S I N N O V A T I O N E D G E ? The next time that you are at an elec- tronics store, pick up an iPhone. Open the box and you will find that the device was designed by Apple Inc. in California. Next look at the back of the iPhone and you will see that it was assembled in China. In the past, the United States has seen numerous industries disappear from its shores and locate in other countries. Industries ranging from smart phones to wind turbines, from solar panel technology to highly advanced computer circuitry born in the United States, now exist elsewhere. Moreover, when abandoning an industry, the United States may also lose technologies that would foster the development of future industries.
- 188. Consider the case of the Amazon Kindle. In 2007 in a Silicon Valley research facility, Amazon engineers and designers developed the Kindle electronic reader, a device that enables users to download and read news- papers, magazines, textbooks, and other digital media on a portable computer screen. Amazon first released the Kindle in November, 2007, for $399 and was sold out in five and one half hours; the device remained out of stock for five months, until late April 2008. By 2011, the Kindle sold for less than $140 as competition from other manufacturers intensified. To produce the electronic ink for the Kindle, Amazon initially partnered with E-Ink Co., a U.S. based firm. Because E-Ink did not have the technology to produce the computer screen for the Kindle, Amazon had to look for another partner. The search initially began in the United States, but it was not successful since American firms lacked the expertise and capabil- ity to produce the Kindle screen. Eventually, Amazon turned to Prime View, a Taiwanese manufacturer, to pro- duce the screen. Soon thereafter, Prime View purchased E-Ink and moved its production operations from the United States to Taiwan. Even though the Kindle’s key innovation, its electronic ink was invented in the United
- 189. States, most of the value added in producing the Kindle wound up being captured by the Taiwanese. Some economists maintain that the United States has been losing its innovation edge as American man- ufacturers locate abroad. They note that manufacturing is a key driver of research and development that gen- erates inventions that fuel economic growth. The United States cannot sustain the level of economic growth it needs without a strong manufacturing sector. According to these economists, to promote a stronger manufacturing sector, the United States needs invest- ment friendly public policies. Other economists disagree. They contend that from the perspective of America’s competitiveness, all of the key technologies and high-value added activities are still captured on American soil and that the United States leads the world in scientific and technological development. They also note that trade and compara- tive advantage foster an evolution in a country’s indus- tries over time. In the television market, the manufacturing of televisions initially began in the United States. As technologies became standardized,
- 190. television production moved offshore to countries with much lower wages and manufacturing costs and prices continued to fall, to the benefit of consumers. The global economy is dynamic and the firms that have survived have been the ones able to transform their business models to match their competitors. U.S. firms will continue to face strong competition as other countries master next generation production techniques and accrue expertise in innovation. In Chapter 2, we will learn more about the outsourcing of production and jobs to other countries. Source: Andrew Liveris, Make It In America: The Case for Re-Inventing the Economy, John Wiley & Sons, Inc., Hoboken, New Jersey, 2011 and James Hagerty, “U.S. Manufacturers Gain Ground,” The Wall Street Journal, August 18, 2013. iS to ck ph ot o.
- 191. co m /p ho to so up Chapter 1: The International Economy and Globalization 19 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 192. from foreign competition. However, critics maintained that nothing is that simple with tobacco. They recognized that free trade, as a rule, increases competition, lowers prices, and makes better products available to consumers, leading to higher consumption. Usually, that’s a good thing. However, with cigarettes, the result can be more smoking, disease, and death. Globally, about four million people die each year from lung cancer, emphysema, and other smoking related diseases, making cigarettes the largest single cause of preventable death. By 2030, the annual number of fatalities could hit 10 million according to the World Health Organization. That has antismoking activists and even some economists arguing that cigarettes are not normal goods but are, in fact, “bads” that require their own set of regulations. They contend that the benefits of free trade do not apply to cigarettes and that they should be treated as an exception to trade rules.
- 193. This view is finding favor with some governments, as well. In recent talks of the World Health Organization, dealing with a global tobacco control treaty, a range of nations expressed support for provisions to emphasize antismoking measures over free trade rules. The United States opposed such measures. In fact, the United States, that has sued tobacco companies for falsifying cigarettes’ health risks, has promoted freer trade in cigarettes. President Bill Clinton demanded a sharp reduction in Chinese tariffs, including those on tobacco, in return for U.S. support of China’s entry into the World Trade Organization. Those moves, combined with free trade pacts that have decreased tariffs and other barriers to trade, have helped stimulate the international sales of cigarettes. The United States, first under President Clinton and then President Bush, has only challenged rules imposed to aid local cigarette makers, not nondiscriminatory measures to protect public health. The United States opposed South
- 194. Korea’s decision to impose a 40 percent tariff on imported cigarettes because it was discriminatory and aimed at pro- tecting domestic producers and not at protecting the health and safety of the Korean people, according to U.S. trade officials. However, antismoking activists maintain that this is a false distinction and anything that makes cigarettes more widely available at a lower price is harmful to public health. Cigarette makers oppose limiting trade in tobacco. They maintain that there is no basis for creating new regulations that weaken the principle of open trade protected by the World Trade Organization. Current trade rules permit countries to enact measures to protect the health and safety of their citizens as long as all goods are treated equally, tobacco companies argue. A trade dispute panel notified Thailand that, although it could not prohibit foreign cigarettes, it could ban advertisements for both domestic and foreign made smokes. But tobacco control activists worry that the rules could
- 195. be used to stop governments from imposing antismoking measures. They contend that special pro- ducts need special rules, pointing to hazardous chemicals and weapons as goods already exempt from regular trade policies. Cigarettes kill more people every year than AIDS. Anti-tobacco activists think it’s time for health concerns to be of primary importance in the case of smoking, too. IS INTERNATIONAL TRADE AN OPPORTUNITY OR A THREAT TO WORKERS? • Tom lives in Chippewa Falls, Wisconsin. His former job as a bookkeeper for a shoe company that employed him for many years was insecure. Although he earned $100 a day, promises of promotion never panned out and the company eventually went bankrupt because cheap imports from Mexico forced shoe prices down. Tom then 20 Chapter 1: The International Economy and Globalization
- 196. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. went to a local university, earned a degree in management information systems, and was hired by a new machine tool firm that exports to Mexico. He now enjoys a more comfortable living even after making the monthly payments on his govern- ment subsidized student loan. • Rosa and her family recently moved from a farm in southern Mexico to the coun- try’s northern border where she works for a U.S. owned electronics firm that exports to the United States. Her husband, Jose, operates a janitorial
- 197. service and sometimes crosses the border to work illegally in California. Rosa and Jose and their daughter have improved their standard of living since moving out of subsistence agriculture. Rosa’s wage has not increased in the past year; she still earns about $3 per hour with no future gains in sight. Workers around the globe are living increasingly intertwined lives. Most of the world’s population now lives in countries that either are integrated into world markets for goods and finance or are rapidly becoming so. Are workers better off as a result of these globalizing trends? Stories about losers from international trade are often featured in newspapers: how Tom lost his job because of competition from poor Mexicans. But Tom currently has a better job and the U.S. economy benefits from his company’s exports to Mexico. Producing goods for export has led to an improvement in Rosa’s living standard and her daughter can hope for a better future. Jose is looking forward
- 198. to the day when he will no longer have to travel illegally to California. International trade benefits many workers. Trade enables them to shop for the cheapest consumption goods and permits employers to purchase the technologies and equipment that best complement their workers’ skills. Trade also allows workers to become more productive as the goods they produce increase in value. Producing goods for export generates jobs and income for domestic workers. Workers in exporting indus- tries appreciate the benefits of an open trading system. Not all workers gain from international trade. The world trading system, for example, has come under attack by some in industrial countries where rising unemployment and wage inequality have made people feel apprehensive about the future. Cheap exports produced by lower cost foreign workers threaten to eliminate jobs for some workers in industrial countries. Others worry that firms are relocating abroad in search of low wages
- 199. and lax environmental standards or fear that masses of poor immigrants will be at their company’s door, offering to work for lower wages. Trade with low wage developing countries is particularly threatening to unskilled workers in the import-competing sectors of industrial countries. As an economy opens up to international trade, domestic prices become more aligned with international prices; wages tend to increase for workers whose skills are more scarce internationally than at home and to decrease for workers who face increased competition from foreign workers. As the economies of foreign nations open up to trade, the relative scarcity of various skills in the world marketplace changes still further, harming those countries with an abundance of workers who have the skills that are becoming less scarce. Increased competition also suggests that unless countries match the productivity gains of their competitors, the wages of their workers will deteriorate. It is no wonder that workers in import-competing industries often lobby for
- 200. restrictions on the importa- tion of goods so as to neutralize the threat of foreign competition. Slogans such as “Buy American” and “American goods create American jobs” have become rallying cries among many U.S. workers. Keep in mind that what is true for the part is not necessarily true for the whole. It is certainly true that imports of steel or automobiles can eliminate American jobs. It is not true that imports decrease the total number of jobs in a nation. A large increase in Chapter 1: The International Economy and Globalization 21 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 201. U.S. imports will inevitably lead to a rise in U.S. exports or foreign investment in the United States. In other words, if Americans suddenly wanted more European autos, eventually American exports would have to increase to pay for these pro- ducts. The jobs lost in one industry are replaced by jobs gained in another industry. The long run effect of trade barriers is not to increase total domestic employment, but to reallocate workers away from export industries and toward less efficient, import-competing industries. This reallocation leads to a less efficient utilization of resources. International trade is just another kind of technology. Think of it as a machine that adds value to its inputs. In the United States, trade is the machine that turns computer software that the United States makes very well, into CD players, baseballs, and other
- 202. things that it also wants but does not make quite so well. International trade does this at a net gain to the economy as a whole. If somebody invented a device that could do this, it would be considered a miracle. Fortunately, international trade has been developed. If international trade is squeezing the wages of the less skilled, so are other kinds of advancing technology, only more so. “Yes,” you might say, “but to tax technological progress or put restrictions on labor saving investment would be idiotic: that would only make everybody worse off.” Indeed it would, and exactly the same goes for inter- national trade—whether this superior technology is taxed (through tariffs) or overregu- lated (in the form of international efforts to harmonize labor standards). This is not an easy thing to explain to American textile workers who compete with low wage workers in China, Malaysia, etc. Free-trade agreements will be more easily
- 203. reached if those who might lose by new trade are helped by all of the rest of us who gain. BACKLASH AGAINST GLOBALIZATION Proponents of free trade and globalization note how it has helped the United States and other countries prosper. Open borders permit new ideas and technology to flow freely around the world, fueling productivity growth and increasing living standards. Moreover, increased trade helps restrain consumer prices, so inflation becomes less likely to disrupt economic growth. Without trade, coffee drinkers in the United States would pay much higher prices because the nation’s supply would depend solely on Hawaiian or Puerto Rican sources. Critics maintain that U.S. trade policies primarily benefit large corporations rather than average citizens—of the United States or any other country. Environmentalists argue that elitist trade organizations, such as the World Trade
- 204. Organization, make undemocratic decisions that undermine national sovereignty on environmental regulation. Unions maintain that unfettered trade permits unfair competition from countries that lack labor standards. Human rights activists contend that the World Bank and International Monetary Fund support governments that allow sweatshops and pursue policies that bail out governmental officials at the expense of local economies. A gnawing sense of unfairness and frustration has emerged about trade policies that ignore the concerns of the environment, American workers, and interna- tional labor standards. The noneconomic aspects of globalization are at least as important in shaping the international debate as are the economic aspects. Many of those who object to globaliza- tion resent the political and military dominance of the United States. They also resent 22 Chapter 1: The International Economy and Globalization
- 205. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. the influence of foreign (mainly American) culture, as they see it, at the expense of national and local cultures. Public opinion surveys note that many Americans are aware of both the benefits and costs of interdependence with the world economy, but they consider the costs to be more than the benefits. In particular, less skilled workers are more likely to oppose freer trade and immigration than their more skilled counterparts
- 206. who have more job mobility. While concerns about the effect of globalization on the environment, human rights, and other issues are an important part of the politics of globalization, it is the tie between policy liberalization and worker inter- ests that forms the foundation for the backlash against liberalization in the United States. Some critics point to the terrorist attack on the United States on September 11, 2001, as what can occur when globalization ignores the poor people of the world. The terrorist attack resulted in the tragic loss of life for thousands of innocent Americans. It also jolted America’s golden age of prosperity and the promise it held for global growth that existed throughout the 1990s. Because of the threat of terrorism, Americans have become increasingly concerned about their safety and their livelihoods. Table 1.6 summarizes some of the pros and cons of globalization. The way to ease the fear of globalization is to help people move
- 207. to different jobs as comparative advantage shifts rapidly from one activity to the next. This process implies a more flexible labor market and a regulatory system that fosters investment. It implies an education system that provides people with the skills that make them mobile. It also implies removing health care and pensions from employment, so that when you move to a new job, you are not risking losing everything. For those who lose their jobs, it implies strengthening training policies to help them find work. These activ- ities are expensive, and they may take years to work. But an economy that finds its national income increasing because of globalization can more easily find the money to pay for it. TABLE 1.6 Advantages and Disadvantages of Globalization Advantages Disadvantages Productivity increases faster when countries produce
- 208. goods and services in which they have a comparative advantage. Living standards can increase more rapidly. Millions of Americans have lost jobs because of imports or shifts in production abroad. Most find new jobs that pay less. Global competition and cheap imports keep a constraint on prices, so inflation is less likely to disrupt economic growth. Millions of other Americans fear getting laid off, espe- cially at those firms operating in import-competing industries. An open economy promotes technological development and innovation, with fresh ideas from abroad. Workers face demands of wage concessions from their employers, which often threaten to export jobs abroad if wage concessions are not accepted. Jobs in export industries tend to pay about 15 percent more than jobs in import-competing industries.
- 209. Besides blue collar jobs, service and white collar jobs are increasingly vulnerable to operations being sent overseas. Unfettered capital movements provide the United States access to foreign investment and maintain low interest rates. American employees can lose their competitiveness when companies build state-of-the-art factories in low wage countries, making them as productive as those in the United States. Source: “Backlash Behind the Anxiety over Globalization,” Business Week, April 24, 2000, p. 41. Chapter 1: The International Economy and Globalization 23 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage
- 210. Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. THE PLAN OF THIS TEXT This text is an examination of the functioning of the international economy. Although the emphasis is on the theoretical principles that govern international trade, there also is considerable coverage of the empirical evidence of world trade patterns and trade policies of the industrial and developing nations. The book is divided into two parts. Part One deals with international trade and commercial policy; Part Two stresses the balance-of-payments and the adjustment in the balance-of- payments. Chapters 2 and 3 deal with the theory of comparative advantage, as well as theoretical extensions and empirical tests of this model. This topic is followed by Chapters 4 through 6, a treatment of tariffs, nontariff trade barriers, and
- 211. contemporary trade policies of the United States. Discussions of trade policies for the developing nations, regional trading arrangements, and international factor movements in Chapters 7 through 9 com- plete the first part of the text. The treatment of international financial relations begins with an overview of the balance-of-payments, the foreign exchange market, and the exchange rate determina- tion in Chapters 10 through 12. The balance-of-payments adjustment under alternate exchange rate regimes is discussed in Chapters 13 through 15. Chapter 16 considers macroeconomic policy in an open economy, and Chapter 17 analyzes the international banking system. SUMMARY 1. Throughout the post-World War II era, the world’s economies have become increasingly interdependent in terms of the movement of goods and services, business enterprise, capital, and technology.
- 212. 2. The United States has seen growing interdepen- dence with the rest of the world in its trade sector, financial markets, ownership of production facili- ties, and labor force. 3. Largely owing to the vastness and wide diversity of its economy, the United States remains among the countries that exports constitute a small fraction of national output. 4. Proponents of an open trading system contend that international trade results in higher levels of consumption and investment, lower prices of commodities, and a wider range of product choices for consumers. Arguments against free trade tend to be voiced during periods of excess production capacity and high unemployment. 5. International competitiveness can be analyzed in terms of a firm, an industry, and a nation. Key to the concept of competitiveness is productivity, or output per worker hour. 6. Researchers have shown that exposure to compe-
- 213. tition with the world leader in an industry improves a firm’s performance in that industry. Global competitiveness is a bit like sports: You get better by playing against folks who are better than you. 7. Although international trade helps workers in export industries, workers in import-competing industries feel the threat of foreign competition. They often see their jobs and wage levels under- mined by cheap foreign labor. 8. Among the challenges that the international trading system faces are dealing with fair labor standards and concerns about the environment. 24 Chapter 1: The International Economy and Globalization Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does
- 214. not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. KEY CONCEPTS AND TERMS Agglomeration economies (p. 5) Economic interdependence (p. 1) Globalization (p. 2) Law of comparative advantage (p. 13) Openness (p. 9) STUDY QUESTIONS 1. What factors explain why the world’s trading nations have become increasingly interdependent, from an economic and political viewpoint, during the post-World War II era? 2. What are some of the major arguments for and against an open trading system?
- 215. 3. What significance does growing economic inter- dependence have for a country like the United States? 4. What factors influence the rate of growth in the volume of world trade? 5. Identify the major fallacies of international trade. 6. What is meant by international competitiveness? How does this concept apply to a firm, an indus- try, and a nation? 7. What do researchers have to say about the relation between a firm’s productivity and exposure to global competition? 8. When is international trade an opportunity for workers? When is it a threat to workers? 9. Identify some of the major challenges confronting the international trading system. 10. What problems does terrorism pose for
- 216. globalization? Chapter 1: The International Economy and Globalization 25 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 217. PART 1 International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 218. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. C H A P T E R 2 Foundations of Modern Trade Theory: Comparative Advantage The previous chapter discussed the importance of international trade. This chapteranswers the following questions: (1) What constitutes the basis for trade—that is, why do nations export and import certain products? (2) At what terms of trade are products exchanged in the world market? (3) What are the gains from international trade in terms of production and consumption? This chapter addresses these questions, first by summarizing the historical development of modern trade theory and next by
- 219. presenting the contemporary theoretical principles used in analyzing the effects of international trade. HISTORICAL DEVELOPMENT OF MODERN TRADE THEORY Modern trade theory is the product of an evolution of ideas in economic thought. In particular, the writings of the mercantilists, and later those of the classical economists— Adam Smith, David Ricardo, and John Stuart Mill—have been instrumental in providing the framework of modern trade theory. The Mercantilists During the period 1500–1800, a group of writers appeared in Europe who were con- cerned with the process of nation building. According to the mercantilists, the central question was how a nation could regulate its domestic and international affairs to pro- mote its own interests. The solution lay in a strong foreign trade sector. If a country could achieve a favorable trade balance (a surplus of exports
- 220. over imports) it would real- ize net payments received from the rest of the world in the form of gold and silver. Such revenues would contribute to increased spending and a rise in domestic output and employment. To promote a favorable trade balance, the mercantilists advocated govern- ment regulation of trade. Tariffs, quotas, and other commercial policies were proposed by the mercantilists to minimize imports in order to protect a nation’s trade position.1 1See E. A. J. Johnson, Predecessors of Adam Smith (New York: Prentice-Hall, 1937). 2 9 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 221. By the eighteenth century, the economic policies of the mercantilists were under strong attack. According to David Hume’s price-specie-flow doctrine, a favorable trade balance is possible only in the short run for over time it would automatically be elimi- nated. To illustrate, suppose England achieves a trade surplus that results in an inflow of gold and silver. Because these precious metals constitute part of England’s money supply, their inflow increases the amount of money in circulation. This leads to a rise in England’s price level relative to that of its trading partners. English residents would therefore be encouraged to purchase foreign-produced goods, while England’s exports would decline. As a result, the country’s trade surplus would eventually be eliminated. The price-specie-flow mechanism thus shows that mercantilist policies could provide at best only short-term economic advantages.2
- 222. The mercantilists were also attacked for their static view of the world economy. To the mercantilists, the world’s wealth was fixed. This view meant that one nation’s gains from trade came at the expense of its trading partners; not all nations could simultaneously enjoy the benefits of international trade. This view was challenged with the publication in 1776 of Adam Smith’s The Wealth of Nations. According to Smith (1723–1790) the world’s wealth is not a fixed quantity. International trade permits nations to take advantage of spe- cialization and the division of labor that increase the general level of productivity within a country and thus increase world output (wealth). Smith’s dynamic view of trade suggested that both trading partners could simultaneously enjoy higher levels of production and con- sumption with trade. Smith’s trade theory is further explained in the next section. Although the foundations of mercantilism have been refuted, mercantilism is alive today. However, it now emphasizes employment rather than holdings of gold and silver.
- 223. Neo-mercantilists contend exports are beneficial because they result in jobs for domestic workers, while imports are bad because they take jobs away from domestic workers and transfer them to foreign workers. Trade is considered a zero- sum activity in which one country must lose for the other to win. There is no acknowledgment that trade can provide benefits to all countries, including mutual benefits in employment as prosperity increases throughout the world. Why Nations Trade: Absolute Advantage Adam Smith, a classical economist, was a leading advocate of free trade (open markets) on the grounds that it promoted the international division of labor. With free trade, nations could concentrate their production on the goods that they could make the most cheaply, with all the consequent benefits from this the division of labor. Accepting the idea that cost differences govern the international movement of goods, Smith sought to explain why costs differ among nations. Smith
- 224. maintained that produc- tivities of factor inputs represent the major determinant of production cost. Such pro- ductivities are based on natural and acquired advantages. The former include factors relating to climate, soil, and mineral wealth, whereas the latter include special skills and techniques. Given a natural or acquired advantage in the production of a good, Smith reasoned that a nation would produce that good at a lower cost and become more com- petitive than its trading partner. Smith viewed the determination of competitiveness from the supply side of the market.3 Smith founded his concept of cost on the labor theory of value that assumes within each nation, labor is the only factor of production and is homogeneous (of one quality) and the cost or price of a good depends exclusively on the amount of labor required to 2David Hume, “Of Money,” Essays, Vol. 1, (London: Green and Co., 1912), p. 319. Hume’s writings are also available in Eugene Rotwein, The Economic Writings of
- 225. David Hume (Edinburgh: Nelson, 1955). 3Adam Smith, The Wealth of Nations (New York: Modern Library, 1937), pp. 424–426. 30 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. produce it. For example, if the United States uses less labor to manufacture a yard of cloth than the United Kingdom, the U.S. production cost will be lower. Smith’s trading principle was the principle of absolute advantage: in a two-nation, two-
- 226. product world, international specialization and trade will be beneficial when one nation has an absolute cost advantage (uses less labor to produce a unit of output) in one good and the other nation has an absolute cost advantage in the other good. For the world to benefit from specialization, each nation must have a good that is absolutely more efficient in producing than its trading partner. A nation will import goods in which it has an absolute cost disad- vantage and export those goods in which it has an absolute cost advantage. An arithmetic example helps illustrate the principle of absolute advantage. Referring to Table 2.1, suppose workers in the United States can produce five bottles of wine or 20 yards of cloth in an hour’s time, while workers in the United Kingdom can produce 15 bottles of wine or ten yards of cloth in an hour. Clearly, the United States has an absolute advantage in cloth production; its cloth workers’ productivity (output per worker hour) is higher than that of the United Kingdom, and leads to lower costs (less
- 227. labor required to produce a yard of cloth). In like manner, the United Kingdom has an absolute advantage in wine production. According to Smith, each nation benefits by specializing in the production of the good that it produces at a lower cost than the other nation, while importing the good that it produces at a higher cost. Because the world uses its resources more efficiently as the result of specializing, an increase in world output occurs that is distributed to the two nations through trade. All nations can benefit from trade, according to Smith. The writings of Smith established the case for free trade that is still influential today. According to Smith, free trade would increase competition in the home market and reduce the market power of domestic companies by lessening their ability to take advantage of consumers by charging high prices and providing poor service. Also, the country would benefit by exporting goods that are desired on the world market for imports that are
- 228. cheap on the world market. Smith maintained that the wealth of a nation depends on this division of labor that is limited by the extent of the market. Smaller and more isolated economies cannot support the degree of specialization needed to significantly increase pro- ductivity and reduce cost, and thus tend to be relatively poor. Free trade allows countries, especially smaller countries, to more fully take advantage of the division of labor, thus attaining higher levels of productivity and real income. Why Nations Trade: Comparative Advantage In 1800, a wealthy London businessman named David Ricardo (1772–1823) came across The Wealth of Nations while on vacation and was intrigued. Although Ricardo appre- ciated the persuasive flair of Smith’s argument for free trade, he thought that some of TABLE 2.1 A Case of Absolute Advantage when Each Nation is More Efficient in the Production of One Good
- 229. World output possibilities in the absence of specialization OUTPUT PER LABOR HOUR Nation Wine Cloth United States 5 bottles 20 yards United Kingdom 15 bottles 10 yards © C en ga ge Le ar ni ng ®
- 230. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 31 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Smith’s analysis needed improvement. According to Smith, mutually beneficial trade requires each nation to be the least-cost producer of at least one good it can export to its trading partner. But what if a nation is more efficient than its trading partner in the production of all goods? Dissatisfied with this looseness in Smith’s theory, Ricardo devel- oped a principle to show that mutually beneficial trade can
- 231. occur whether countries have an absolute advantage. Ricardo’s theory became known as the principle of comparative advantage.4 Like Smith, Ricardo emphasized the supply side of the market. The immediate basis for trade stemmed from the cost differences between nations that their natural and acquired advantages supported. Unlike Smith, who emphasized the importance of abso- lute cost differences among nations, Ricardo emphasized comparative (relative) cost dif- ferences. Indeed, countries often develop comparative advantages, as shown in Table 2.2. T R A D E C O N F L I C T S D A V I D R I C A R D O David Ricardo (1772–1823) was the lead- ing British economist of the early 1800s. He helped develop the theories of classical economics that emphasize economic freedom through free trade and competition. Ricardo was a successful business- man, financier and speculator, and he accumulated a
- 232. sizable fortune. Being the third of 17 children, Ricardo was born into a wealthy Jewish family. His father was a merchant banker. They initially lived in the Netherlands and then moved to London. Having little formal education and never attending college, Ricardo went to work for his father at the age of 14. When he was 21, Ricardo married a Quaker despite his parents’ preferences. After his family disinherited him for marrying outside the Jewish faith, Ricardo became a stockbroker and a loan broker. He was highly successful in business and was able to retire at 42, accumulating an estate that was worth more than $100 million in today’s dollars. Upon retirement, Ricardo bought a country estate and established himself as a country gentleman. In 1819, Ricardo purchased a seat in the British Parliament and held the post until the year of his death in 1823. As a member of Parliament, Ricardo advocated the repeal of the Corn Laws that established trade barriers to protect British landowners from foreign competition. However, he was unable to get Parliament to abolish the law that lasted until its repeal in 1846. Ricardo’s interest in economics was inspired by a
- 233. chance reading of Adam Smith’s The Wealth of Nations when he was in his late twenties. Upon the urging of his friends, Ricardo began writing newspaper articles on economic questions. In 1817 Ricardo pub- lished his groundbreaking The Principles of Political Economy and Taxation that laid out the theory of com- parative advantage as discussed in this chapter. Like Adam Smith, Ricardo was an advocate of free trade and an opponent of protectionism. He believed that protectionism led countries toward economic stag- nation. However, Ricardo was less confident than Smith about the ability of a market economy’s poten- tial to benefit society. Instead, Ricardo felt that the economy tends to move toward a standstill. Yet Ricardo contended that if government meddled with the economy, the result would be only further eco- nomic stagnation. Ricardo’s ideas have greatly affected other econo- mists. His theory of comparative advantage has been a cornerstone of international trade theory for almost 200 years and has influenced generations of economists in the belief that protectionism is bad for an economy.
- 234. Source: Mark Blaug, Ricardian Economics. (New Haven, CT: Yale University Press, 1958), Samuel Hollander, The Economics of David Ricardo, (Cambridge: Cambridge University Press, 1993), and Robert Heilbronner, The Worldly Philosophers, (New York: Simon and Schuster, 1961). 4David Ricardo, The Principles of Political Economy and Taxation (London: Cambridge University Press, 1966), Chapter 7. Originally published in 1817. iS to ck ph ot o. co m
- 235. /p ho to so up 32 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. According to the principle of comparative advantage, even if a nation has an absolute cost disadvantage in the production of both goods, a basis for
- 236. mutually beneficial trade may still exist. The less efficient nation should specialize in and export the good in which it is relatively less inefficient (where its absolute disadvantage is least). The more efficient nation should specialize in and export that good in which it is relatively more efficient (where its absolute advantage is greatest). To demonstrate the principle of comparative advantage, Ricardo formulated a simpli- fied model based on the following assumptions: 1. The world consists of two nations, each using a single input to produce two commodities. 2. In each nation, labor is the only input (the labor theory of value). Each nation has a fixed endowment of labor and labor is fully employed and homogeneous. 3. Labor can move freely among industries within a nation but is incapable of moving between nations.
- 237. 4. The level of technology is fixed for both nations. Different nations may use different technologies, but all firms within each nation utilize a common production method for each commodity. 5. Costs do not vary with the level of production and are proportional to the amount of labor used. 6. Perfect competition prevails in all markets. Because no single producer or consumer is large enough to influence the market, all are price takers. Product quality does not vary among nations, implying that all units of each product are identical. There is free entry to and exit from an industry, and the price of each product equals the product’s marginal cost of production. 7. Free trade occurs between nations; that is, no government barriers to trade exist.
- 238. 8. Transportation costs are zero. Consumers will thus be indifferent between domesti- cally produced and imported versions of a product if the domestic prices of the two products are identical. 9. Firms make production decisions in an attempt to maximize profits, whereas consu- mers maximize satisfaction through their consumption decisions. TABLE 2.2 Examples of Comparative Advantages in International Trade Country Product Canada Lumber Israel Citrus fruit Italy Wine Jamaica Aluminum ore Mexico Tomatoes
- 239. Saudi Arabia Oil China Textiles Japan Automobiles South Korea Steel, ships Switzerland Watches United Kingdom Financial services © C en ga ge Le ar ni
- 240. ng ® Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 33 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 10. There is no money illusion; when consumers make their consumption choices and firms make their production decisions, they take into account the behavior of all prices. 11. Trade is balanced (exports must pay for imports), thus ruling out flows of money
- 241. between nations. Table 2.3 illustrates Ricardo’s principle of comparative advantage when one nation has an absolute advantage in the production of both goods. Assume that in one hour’s time, U.S. workers can produce 40 bottles of wine or 40 yards of cloth, while U.K. workers can produce 20 bottles of wine or ten yards of cloth. According to Smith’s principle of absolute advantage, there is no basis for mutually beneficial specialization and trade because the U.S. workers are more efficient in the production of both goods. However, the principle of comparative advantage recognizes that U.S. workers are four times as efficient in cloth production 40 10 4 but only twice as efficient in wine production 40 20 2 . The United States thus has a greater absolute advantage in cloth than in wine, while the United Kingdom has a smaller absolute disadvantage in wine than in cloth. Each nation specializes in and exports that good in which it has a
- 242. comparative advantage—the United States in cloth, the United Kingdom in wine. There- fore, through the process of trade, the two nations receive the output gains from special- ization. Like Smith, Ricardo asserted that both nations can gain from trade. Simply put, Ricardo’s principle of comparative advantage maintains that international trade is solely due to international differences in the productivity of labor. The basic pre- diction of Ricardo’s principle is that countries tend to export those goods in which their labor productivity is relatively high. In recent years, the United States has realized large trade deficits (imports exceed exports) with countries such as China and Japan. Some of those who have witnessed the flood of imports coming into the United States seem to suggest that the United States does not have a comparative advantage in anything. It is possible for a nation not to have an absolute advantage in anything; but it is not possible for one nation to have a
- 243. comparative advantage in everything and the other nation to have a comparative advan- tage in nothing. That’s because comparative advantage depends on relative costs. As we have seen, a nation having an absolute disadvantage in all goods would find it advanta- geous to specialize in the production of the good in which its absolute disadvantage is least. There is no reason for the United States to surrender and let China produce all of everything. The United States would lose and so would China, because world output would be reduced if U.S. resources were left idle. The idea that a nation has nothing to offer confuses absolute advantage and comparative advantage. Although the principle of comparative advantage is used to explain international trade patterns, people are not generally concerned with which nation has a comparative advan- tage when they purchase something. A person in a candy store does not look at Swiss TABLE 2.3
- 244. A Case of Comparative Advantage when the United States Has an Absolute Advantage in the Production of Both Goods World output possibilities in the absence of specialization OUTPUT PER LABOR HOUR Nation Wine Cloth United States 40 bottles 40 yards United Kingdom 20 bottles 10 yards © C en ga ge Le ar ni
- 245. ng ® 34 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chocolate and U.S. chocolate and ask, “I wonder which nation has the comparative advantage in chocolate production?” The buyer relies on price, after allowing for quality differences, to tell which nation has the comparative advantage. It is helpful, then, to illustrate how the principle of comparative advantage works in
- 246. terms of money prices, as seen in Exploring Further 2.1 that can be found at www.cengage.com/economics/ Carbaugh. PRODUCTION POSSIBILITIES SCHEDULES Ricardo’s law of comparative advantage suggested that specialization and trade can lead to gains for both nations. His theory, however, depended on the restrictive assumption of the labor theory of value, in which labor was assumed to be the only factor input. In practice, labor is only one of several factor inputs. Recognizing the shortcomings of the labor theory of value, modern trade theory pro- vides a more generalized theory of comparative advantage. It explains the theory using a production possibilities schedule, also called a transformation schedule. This schedule shows various alternative combinations of two goods that a nation can produce when all of its factor inputs (land, labor, capital, entrepreneurship) are used in their most effi-
- 247. cient manner. The production possibilities schedule thus illustrates the maximum output possibilities of a nation. Note that we are no longer assuming labor to be the only factor input, as Ricardo did. Figure 2.1 illustrates hypothetical production possibilities schedules for the United States and Canada. By fully using all available inputs with the best available technology FIGURE 2.1 Trading Under Constant Opportunity Costs 120 100 80 60 40
- 248. 20 0 20 40 60 80 100 120 140 160 Autos W h e a t B F C E tt Trading Possibilities Line (Terms of Trade = 1:1) D
- 249. A (a) United States MRT = 0.5 160 140 120 100 80 60 40 20 0 20 40 60 80 100 120 140 160
- 250. Autos W h e a t Trading Possibilities Line (Terms of Trade = 1:1) tt D ′ B ′ C ′ A′
- 251. (b) Canada MR T = 2.0 With constant opportunity costs, a nation will specialize in the product of its comparative advantage. The principle of comparative advantage implies that with specialization and free trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle denotes its exports, imports, and terms of trade. In a two-nation, two-product world, the trade triangle of one nation equals that of the other nation; one nation’s exports equal the other nation’s imports, and there is one equilibrium terms of trade. © C en ga ge Le ar
- 252. ni ng ® Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 35 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. during a given time period, the United States can produce either 60 bushels of wheat or 120 autos or certain combinations of the two products. Similarly, Canada can produce either 160 bushels of wheat or 80 autos or certain combinations
- 253. of the two products. Just how does a production possibilities schedule illustrate the concept of comparative cost? The answer lies in the slope of the production possibilities schedule, which is referred to as the marginal rate of transformation (MRT). The MRT shows the amount of one product a nation must sacrifice to get one additional unit of the other product: MRT ΔWheat ΔAutos This rate of sacrifice is sometimes called the opportunity cost of a product. Because this formula also refers to the slope of the production possibilities schedule, the MRT equals the absolute value of the production possibilities schedule’s slope. In Figure 2.1, the MRT of wheat into autos gives the amount of wheat that must be sacrificed for each additional auto produced. Concerning the
- 254. United States, movement from the top endpoint on its production possibilities schedule to the bottom endpoint shows that the relative cost of producing 120 additional autos is the sacrifice of 60 bush- els of wheat. This sacrifice means that the relative cost of each auto produced is 0.5 bushel of wheat sacrificed 60 120 0 5 ; the MRT 0 5. Similarly, Canada’s rela- tive cost of each auto produced is two bushels of wheat; that is, Canada’s MRT 2 0. TRADING UNDER CONSTANT-COST CONDITIONS This section illustrates the principle of comparative advantage under constant opportunity costs. Although the constant-cost case may be of limited relevance to the real world, it serves as a useful pedagogical tool for analyzing international trade. The discussion focuses on two questions. First, what are the basis for trade and the direction of trade? Second, what are the potential gains from trade, for a single nation and for the world as a whole?
- 255. Referring to Figure 2.1, notice that the production possibilities schedules for the United States and Canada are drawn as straight lines. The fact that these schedules are linear indicates that the relative costs of the two products do not change as the economy shifts its production from all wheat to all autos or anywhere in between. For the United States, the relative cost of an auto is 0.5 bushels of wheat as output expands or contracts; for Canada, the relative cost of an auto is 2 bushels of wheat as output expands or contracts. There are two reasons for constant-costs. First, the factors of production are perfect substitutes for each other. Second, all units of a given factor are of the same quality. As a country transfers resources from the production of wheat into the production of autos, or vice versa, the country will not have to resort to resources that are inadequate for the production of the good. Therefore, the country must sacrifice exactly the same amount of wheat for each additional auto produced, regardless of how
- 256. many autos it is already producing. Basis for Trade and Direction of Trade Let us examine trade under constant-cost conditions. Referring to Figure 2.1, assume that in autarky (the absence of trade) the United States prefers to produce and consume at point A on its production possibilities schedule, with 40 autos and 40 bushels of wheat. Assume also that Canada produces and consumes at point A on its production possibilities schedule, with 40 autos and 80 bushels of wheat. 36 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 257. The slopes of the two countries’ production possibilities schedules give the relative cost of one product in terms of the other. The relative cost of producing an additional auto is only 0.5 bushels of wheat for the United States but it is 2 bushels of wheat for Canada. According to the principle of comparative advantage, this situation provides a basis for mutually favorable specialization and trade owing to the differences in the countries’ relative costs. As for the direction of trade, we find the United States specializing in and exporting autos and Canada specializing in and exporting wheat. Production Gains from Specialization The law of comparative advantage asserts that with trade, each country will find it favor- able to specialize in the production of the good of its comparative advantage and will trade part of this for the good of its comparative disadvantage. In Figure 2.1, the United
- 258. States moves from production point A to production point B, totally specializing in auto production. Canada specializes in wheat production by moving from production point A to production point B in the figure. Taking advantage of specialization can result in production gains for both countries. We find that prior to specialization, the United States produces 40 autos and 40 bush- els of wheat. But with complete specialization, the United States produces 120 autos and no wheat. As for Canada, its production point in the absence of specialization is at 40 autos and 80 bushels of wheat, whereas its production point under complete specializa- tion is at 160 bushels of wheat and no autos. Combining these results, we find that both nations together have experienced a net production gain of 40 autos and 40 bushels of wheat under conditions of complete specialization. Table 2.4(a) summarizes these pro- duction gains. Because these production gains arise from the reallocation of existing resources, they are also called the static gains from
- 259. specialization: through specialization, a country can use its current supply of resources more efficiently and thus achieve a higher level of output than it could without specialization. Japan’s opening to the global economy is an example of the static gains from compar- ative advantage. Responding to pressure from the United States, in 1859 Japan opened its ports to international trade after more than two hundred years of self-imposed economic isolation. In autarky, Japan found that it had a comparative advantage in some products TABLE 2.4 Gains from Specialization and Trade: Constant Opportunity Costs (a) Production Gains from Specialization BEFORE SPECIALIZATION AFTER SPECIALIZATION NET GAIN (LOSS) Autos Wheat Autos Wheat Autos Wheat
- 260. United States 40 40 120 0 80 −40 Canada 40 80 0 160 −40 80 World 80 120 120 160 40 40 (b) Consumption Gains from Trade BEFORE TRADE AFTER TRADE NET GAIN (LOSS) Autos Wheat Autos Wheat Autos Wheat United States 40 40 60 60 20 20 Canada 40 80 60 100 20 20 World 80 120 120 160 40 40 © C en ga
- 261. ge Le ar ni ng ® Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 37 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. and a comparative disadvantage in others. For example, the
- 262. price of tea and silk was much higher on world markets than in Japan prior to the opening of trade, while the price of woolen goods and cotton was much lower on world markets. Japan responded according to the principle of comparative advantage: it exported tea and silk in exchange for imports of clothing. By using its resources more efficiently and trading with the rest of the world, Japan was able to realize static gains from specialization that equaled eight to nine percent of its gross domestic product at that time. Of course the long-run gains to Japan of improving its productivity and acquiring better technology were several times this figure.5 However, when a country initially opens to trade and then trade is eliminated, it suf- fers static losses, as seen in the case of the United States. In the early 1800s, Britain and France were at war. As part of the conflict, the countries attempted to prevent the shipping of goods to each other by neutral countries, notably the United States. This
- 263. policy resulted in the British and French navies confiscating American ships and cargo. To discourage this harassment, in 1807 President Thomas Jefferson ordered the closure of America’s ports to international trade: American ships were prevented from taking goods to foreign ports and foreign ships were prevented from taking on any cargo in the United States. The intent of the embargo was to inflict hardship on the British and French, and discourage them from meddling in America’s affairs. Although the embargo did not completely eliminate trade, the United States was as close to autarky as it had ever been in its history. Therefore, Americans shifted production away from previously exported agricultural goods (the goods of comparative advantage) and increased pro- duction of import-replacement manufactured goods (the goods of comparative disad- vantage). The result was a less efficient utilization of America’s resources. Overall, the embargo cost about eight percent of America’s gross national product in 1807. It is no surprise that the embargo was highly unpopular among
- 264. Americans and, therefore, terminated in 1809.6 Consumption Gains from Trade In the absence of trade, the consumption alternatives of the United States and Canada are limited to points along their domestic production possibilities schedules. The exact consumption point for each nation will be determined by the tastes and preferences in each country. But with specialization and trade, the two nations can achieve post-trade consumption points outside their domestic production possibilities schedules; that is, they can consume more wheat and more autos than they could consume in the absence of trade. Thus, trade can result in consumption gains for both countries. The set of post-trade consumption points that a nation can achieve is determined by the rate at which its export product is traded for the other country’s export product. This rate is known as the terms of trade. The terms of trade defines the relative prices at
- 265. which two products are traded in the marketplace. Under constant-cost conditions, the slope of the production possibilities schedule defines the domestic rate of transformation (domestic terms of trade) that represents the relative prices that two commodities can be exchanged at home. For a country to consume at some point outside its production possibilities schedule, it must be able to exchange its export good internationally at terms of trade more favorable than the domestic terms of trade. 5D. Bernhofen and J. Brown, “An Empirical Assessment of the Comparative Advantage Gains from Trade: Evidence from Japan,” The American Economic Review, March 2005, pp. 208–225. 6D. Irwin, The Welfare Cost of Autarky: Evidence from the Jeffersonian Trade Embargo, 1807–1809 (Cambridge, MA) Working Paper No. W8692, December 2001. 38 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May
- 266. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Assume that the United States and Canada achieve a terms of trade ratio that permits both trading partners to consume at some point outside their respective production pos- sibilities schedules (Figure 2.1). Suppose that the terms of trade agreed on is a 1:1 ratio, whereby 1 auto is exchanged for 1 bushel of wheat. Based on these conditions, let line tt represent the international terms of trade for both countries. This line is referred to as the trading possibilities line (note that it is drawn with a slope having an absolute value of one).
- 267. Suppose now that the United States decides to export 60 autos to Canada. Starting at post-specialization production point B in the figure, the United States will slide along its trading possibilities line until point C is reached. At point C, 60 autos will have been exchanged for 60 bushels of wheat, at the terms of trade ratio of 1:1. Point C then T R A D E C O N F L I C T S B A B E R U T H A N D T H E P R I N C I P L E O F C O M P A R A T I V E A D V A N T A G E Babe Ruth was the first great home run hitter in baseball history. His batting tal- ent and vivacious personality attracted huge crowds wherever he played. He made baseball more exciting by establishing home runs as a common part of the game. Ruth set many major league records, including 2,056 career walks and 72 games in which he hit two or more home runs. He had a .342 lifetime batting aver- age and 714 career home runs. George Herman Ruth (1895–1948) was born in Balti-
- 268. more. After playing baseball in the minor leagues, Ruth started his major league career as a left-handed pitcher with the Boston Red Sox in 1914. In 158 games for Boston, he compiled a pitching record of 89 wins and 46 losses, including two 20-win seasons—23 victories in 1916 and 24 victories in 1917. On January 2, 1920, a little more than a year after Babe Ruth had pitched two victories in the Red Sox World Series victory over Chicago, he became violently ill. Most suspected that Ruth, known for his partying excesses, simply had a major league hangover from his New Year’s celebrations. The truth was, Ruth had ingested several bad frankfurters while entertaining youngsters the day before, and his symptoms were misdiagnosed as being life-threatening. The Red Sox management, already strapped for cash, thus sold its ailing player to the Yankees the next day for $125,000 and a $300,000 loan to the owner of the Red Sox. Ruth eventually added five more wins as a hurler for the New York Yankees and ended his pitching career with a 2.28 earned run average. Ruth also had three wins against no losses in World Series competition, including one stretch of 29 2/3 consecutive scoreless
- 269. innings. At the time, Ruth was one of the best left- handed pitchers in the American league. Although Ruth had an absolute advantage in pitch- ing, he had even greater talent at the plate. Simply put, Ruth’s comparative advantage was in hitting. As a pitcher, Ruth had to rest his arm between appearances and thus could not bat in every game. To ensure his daily presence in the lineup, Ruth gave up pitching to play exclusively in the outfield. In his 15 years with the Yankees, Ruth dominated professional baseball. He teamed with Lou Gehrig to form what became the greatest one-two hitting punch in baseball. Ruth was the heart of the 1927 Yankees, a team regarded by some baseball experts as the best in baseball history. That year, Ruth set a record of 60 home runs. At that time, a season had 154 games com- pared to 162 games today. He attracted so many fans that Yankee Stadium that opened in 1923,was nick- named “The House that Ruth Built.” The Yankees released Ruth after the 1934 season and he ended his playing career in 1935 with the Boston Braves. In Ruth’s final game, he hit three home runs.
- 270. The advantages to having Ruth switch from pitching to batting were enormous. Not only did the Yankees win four World Series during Ruth’s tenure, but they also became baseball’s most renowned franchise. Ruth was elected to the Baseball Hall of Fame in Cooperstown, New York, in 1936. Source: Edward Scahill, “Did Babe Ruth Have a Comparative Advantage as a Pitcher?” Journal of Economic Education, Vol. 21, 1990. See also, Paul Rosenthal, “America at Bat: Baseball Stuff and Stories,” National Geographic, 2002, Geoffrey Ward and Ken Burns, Baseball: An Illustrated History, (Knopf, 1994), and Keith Brandt, Babe Ruth: Home Run Hero, (Troll, 1986). iS to ck ph
- 271. ot o. co m /p ho to so up Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 39 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 272. time if subsequent rights restrictions require it. represents the U.S. post-trade consumption point. Compared with consumption point A, point C results in a consumption gain for the United States of 20 autos and 20 bushels of wheat. The triangle BCD that shows the U.S. exports (along the horizontal axis), imports (along the vertical axis), and terms of trade (the slope) is referred to as the trade triangle. Does this trading situation provide favorable results for Canada? Starting at post- specialization production point B in the figure, Canada can import 60 autos from the United States by giving up 60 bushels of wheat. Canada would slide along its trading possibilities line until it reaches point C . Clearly, this is a more favorable consumption point than point A . With trade, Canada experiences a consumption gain of 20 autos and 20 bushels of wheat. Canada’s trade triangle is denoted by B C D . In our two-country
- 273. model, the trade triangles of the United States and Canada are identical; one country’s exports equal the other country’s imports that exchange at the equilibrium terms of trade. Table 2.4(b) on page 37 summarizes the consumption gains from trade for each country and the world as a whole. One implication of the foregoing trading example is that the United States produced only autos, whereas Canada produced only wheat—that is, complete specialization occurs. As the United States increases and Canada decreases the production of autos, both countries’ unit production costs remain constant. Because the relative costs never become equal, the United States does not lose its comparative advantage, nor does Canada lose its comparative disadvantage. The United States therefore produces only autos. Similarly, as Canada produces more wheat and the United States reduces its wheat production, both nations’ production costs remain the same. Canada produces only wheat without losing its advantage to the United States.
- 274. The only exception to complete specialization would occur if one of the countries, say Canada, is too small to supply the United States with all of its need for wheat. Canada would be completely specialized in its export product, wheat, while the United States (large country) would produce both goods; however, the United States would still export autos and import wheat. Distributing the Gains from Trade Our trading example assumes that the terms of trade agreed to by the United States and Canada will result in both benefiting from trade. But where will the terms of trade actu- ally lie? A shortcoming of Ricardo’s principle of comparative advantage is its inability to determine the actual terms of trade. The best description that Ricardo could provide was only the outer limits within which the terms of trade would fall. This is because the Ricardian theory relied solely on domestic cost ratios (supply
- 275. conditions) in explaining trade patterns; it ignored the role of demand. To visualize Ricardo’s analysis of the terms of trade, recall our trading example of Figure 2.1. We assumed that for the United States the relative cost of producing an addi- tional auto was 0.5 bushels of wheat whereas for Canada the relative cost of producing an additional auto was 2 bushels of wheat. Thus, the United States has a comparative advantage in autos, whereas Canada has a comparative advantage in wheat. Figure 2.2 illustrates these domestic cost conditions for the two countries. However, for each coun- try, we have translated the domestic cost ratio, given by the negatively sloped production possibilities schedule, into a positively sloped cost-ratio line. According to Ricardo, the domestic cost ratios set the outer limits for the equilibrium terms of trade. If the United States is to export autos, it should not accept any terms of trade less than a ratio of 0.5:1, indicated by its domestic cost- ratio line. Otherwise, the U.S.
- 276. post-trade consumption point would lie inside its production possibilities schedule. The United States would clearly be better off without trade than with trade. The U.S. 40 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. domestic cost-ratio line therefore becomes its no-trade boundary. Similarly, Canada would require a minimum of 1 auto for every 2 bushels of wheat exported, as indicated by its domestic cost-ratio line; any terms of trade less than this rate would be unacceptable to
- 277. Canada. Thus, its domestic cost-ratio line defines the no-trade boundary line for Canada. For gainful international trade to exist, a nation must achieve a post-trade consump- tion location at least equivalent to its point along its domestic production possibilities schedule. Any acceptable international terms of trade has to be more favorable than or equal to the rate defined by the domestic price line. Thus, the region of mutually bene- ficial trade is bounded by the cost ratios of the two countries. Equilibrium Terms of Trade As noted, Ricardo did not explain how the actual terms of trade would be determined in international trade. This gap was filled by another classical economist, John Stuart Mill (1806–1873). By bringing into the picture the intensity of the trading partners’ demands, Mill could determine the actual terms of trade for Figure 2.2. Mill’s theory is known as the theory of reciprocal demand.7 This theory asserts that within the outer limits of the terms of trade, the actual terms of trade is determined by the
- 278. relative strength of each country’s demand for the other country’s product. Simply put, production costs deter- mine the outer limits of the terms of trade, while reciprocal demand determines what the actual terms of trade will be within those limits. Referring to Figure 2.2, if Canadians are more eager for U.S. autos than Americans are for Canadian wheat, the terms of trade would end up close to the Canadian cost FIGURE 2.2 Equilibrium Terms of Trade Limits W h e a t Autos Improving Canadian
- 279. Terms of Trade U.S. Cost Ratio (0.5:1) Canada Cost Ratio (2:1) Improving U.S. Terms of Trade Region of Mutually Beneficial Trade The supply-side analysis of Ricardo describes the outer limits within which the equi- librium terms of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade. Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between the two nations’ domestic cost ratios. Accord- ing to the theory of reciprocal demand, the actual exchange
- 280. ratio at which trade occurs depends on the trading partners’ interacting demands. © C en ga ge Le ar ni ng ® 7John Stuart Mill, Principles of Political Economy (New York: Longmans, Green, 1921), pp. 584–585. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 41 Copyright 2015 Cengage Learning. All Rights Reserved. May
- 281. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. ratio of 2:1 Thus, the terms of trade would improve for the United States. However, if Americans are more eager for Canadian wheat than Canadians are for U.S. autos, the terms of trade would fall close to the U.S. cost ratio of 0.5:1 and the terms of trade would improve for Canadians. The reciprocal-demand theory best applies when both nations are of equal economic size, so that the demand of each nation has a noticeable effect on market price. However, if two nations are of unequal economic size, it is possible that the relative demand
- 282. strength of the smaller nation will be dwarfed by that of the larger nation. In this case, the domestic exchange ratio of the larger nation will prevail. Assuming the absence of monopoly elements working in the markets, the small nation can export as much of the commodity as it desires, enjoying large gains from trade. Consider trade in crude oil and autos between Venezuela and the United States before the rise of the Organization of Petroleum Exporting Countries (OPEC). Venezuela, as a small nation, accounted for only a very small share of the U.S.– Venezuelan market, whereas the U.S. market share was overwhelmingly large. Because Venezuelan consumers and producers had no influence on market price levels, they were in effect price takers. In trading with the United States, no matter what the Venezuelan demand was for crude oil and autos, it was not strong enough to affect U.S. price levels. As a result, Venezuela traded according to the U.S. domestic price ratio, buying and selling autos and crude oil at the price levels that existed in the United States.
- 283. The example just given implies the following generalization: If two nations of approx- imately the same size and with similar taste patterns participate in international trade, the gains from trade will be shared about equally between them. However, if one nation is significantly larger than the other, the larger nation attains fewer gains from trade while the smaller nation attains most of the gains from trade. This situation is character- ized as the importance of being unimportant. What’s more, when nations are very dis- similar in size, there is a strong possibility that the larger nation will continue to produce its comparative-disadvantage good because the smaller nation is unable to supply all of the world’s demand for this product. Terms of Trade Estimates As we have seen, the terms of trade affect a country’s gains from trade. How are the terms of trade actually measured? The commodity terms of trade (also referred to as the barter
- 284. terms of trade) is a frequently used measure of the international exchange ratio. It measures the relation between the prices a nation gets for its exports and the prices it pays for its imports. This is calculated by dividing a nation’s export price index by its import price index, multiplied by 100 to express the terms of trade in percentages: Terms of Trade Export Price Index Import Price Index 100 An improvement in a nation’s terms of trade requires that the prices of its exports rise relative to the prices of its imports over the given time period. A smaller quantity of export goods sold abroad is required to obtain a given quantity of imports. Conversely, deterioration in a nation’s terms of trade is due to a rise in its import prices relative to its export prices over a time period. The purchase of a given quantity of imports would
- 285. require the sacrifice of a greater quantity of exports. Table 2.5 gives the commodity terms of trade for selected countries. With 2005 as the base year (equal to 100), the table shows that by 2013 the U.S. index of export prices rose to 124, an increase of 24 percent. During the same period, the index of U.S. import prices rose by 27 percent, to a level of 127. Using the terms of trade formula, we find 42 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 286. that the U.S. terms of trade worsened by 2 percent 124 127 100 98 over the period 2005–2013. This means that to purchase a given quantity of imports, the United States had to sacrifice 2 percent more exports; conversely, for a given number of exports, the United States could obtain 2 percent fewer imports. Although changes in the commodity terms of trade indicate the direction of movement of the gains from trade, their implications must be interpreted with caution. Suppose there is an increase in the foreign demand for U.S. exports, leading to higher prices and revenues for U.S. exporters. In this case, an improving terms of trade implies that the U.S. gains from trade have increased. However, suppose that the cause of the rise in export prices and terms of trade is the falling productivity of U.S. workers. If these result in reduced export sales and less revenue earned from exports, we could hardly say that U.S. welfare has improved. Despite its limitations, however, the commod- ity terms of trade is a useful concept. Over a long period, it
- 287. illustrates how a country’s share of the world gains from trade changes and gives a rough measure of the fortunes of a nation in the world market. DYNAMIC GAINS FROM TRADE The previous analysis of the gains from international trade stressed specialization and reallocation of existing resources—the so called static gains from specialization. However, these gains can be dwarfed by the effect of trade on the country’s growth rate and the volume of additional resources made available to, or utilized by, the trading country. These are known as the dynamic gains from international trade as opposed to the static effects of reallocating a fixed quantity of resources. We have learned that international trade tends to bring about a more efficient use of an economy’s resources that leads to higher output and income. Over time, increased income tends to result in more saving and, thus, more investment in equipment and
- 288. manufacturing plants. This additional investment generally results in a higher rate of economic growth. Moreover, opening an economy to trade can lead to imported invest- ment goods such as machinery that fosters higher productivity and economic growth. In a roundabout manner, gains from international trade grow larger over time. Empirical TABLE 2.5 Commodity Terms of Trade, 2013 (2005 = 100) Country Export price index Import price index Terms of trade Australia 194 143 136 Argentina 166 153 108 Canada 132 125 106 Switzerland 148 142 104 United States 124 127 98 China 127 130 98
- 289. Brazil 156 184 85 Japan 108 145 74 Source: From International Monetary Fund, IMF Financial Statistics, Washington, DC, December 2013. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 43 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. evidence shows that countries that are more open to international trade tend to grow
- 290. faster than closed economies.8 Free trade also increases the possibility that a firm importing a capital good will be able to locate a supplier who will provide a good that more closely meets its specifica- tions. The better the match, the larger the increase in the firm’s productivity, which pro- motes economic growth. Economies of large-scale production represent another dynamic gain from trade. International trade allows small and moderately sized countries to establish and operate many plants of efficient size that would be impossible if production were limited to the domestic market. For example, the free access that Mexican and Canadian firms have to the U.S. market, under the North American Free Trade Agreement (NAFTA), allows them to expand their production and employ more specialized labor and equipment. These improvements have led to increased efficiency and lower unit costs for these firms.
- 291. Also, increased competition can be a source of dynamic gains in trade. For example, when Chile opened its economy to global competition in the 1970s, its exiting producers with comparative disadvantage were about eight percent less efficient than producers that continued to operate. The efficiency of plants competing against imports increased three to ten percent more than in the domestic economy where goods were not subject to foreign competition. A closed economy shields companies from international compe- tition and permits them to pull down overall efficiency within an industry. Open trade forces inefficient firms to exit the industry and allows more productive firms to grow. Therefore, trade results in adjustments that raise average industry efficiency in both exporting and import-competing industries.9 Simply put, besides providing static gains rising from the reallocation of existing pro- ductive resources, trade can also generate dynamic gains by stimulating economic
- 292. growth. Proponents of free trade note the many success stories of growth through trade. However, the effect of trade on growth is not the same for all countries. In general, the gains tend to be less for a large country such as the United States than for a small country such as Belgium. How Global Competition Led to Productivity Gains for U.S. Iron Ore Workers The dynamic gains from international trade can be seen in the U.S. iron ore industry, located in the Midwest. Because iron ore is heavy and costly to transport, U.S. producers supply ore only to U.S. steel producers located in the Great Lakes region. During the early 1980s, depressed economic conditions in most of the industrial world resulted in a decline in the demand for steel and thus falling demand for iron ore. Ore producers throughout the world scrambled to find new customers. Despite the huge distances and the transportation costs involved, mines in Brazil began shipping iron ore to steel produ- cers in the Chicago area.
- 293. The appearance of foreign competition led to increased competitive pressure on U.S. iron ore producers. To help keep domestic iron mines operating, American workers agreed to changes in work rules that increased labor productivity. In most cases, these changes involved an expansion in the set of tasks a worker was required to perform. 8D. Dollar and A. Kraay, “Trade, Growth, and Poverty,” Finance and Development, September 2001, pp. 16–19 and S. Edwards, “Openness, Trade Liberalization, and Growth in Developing Countries,” Journal of Economic Literature, September 1993, pp. 1358– 1393. 9Nina Pavcnik, “Trade Liberalization, Exit, and Productivity Improvements: Evidence from Chilean Plants,” Review of Economic Studies, Vol. 69, January 2002, pp. 245–276. 44 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 294. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. For example, the changes required equipment handlers to perform routine maintenance on their equipment. Before, this maintenance was the responsibility of repairmen. Also, new work rules resulted in a flexible assignment of work that required a worker to occa- sionally do tasks assigned to another worker. In both cases, the new work rules led to the better use of a worker’s time. Prior to the advent of foreign competition, labor productivity in the U.S. iron ore industry was stagnant. Because of the rise of foreign competition, labor productivity began to increase rapidly in the early 1980s; by the late 1980s,
- 295. the productivity of U.S. iron ore producers had doubled. Simply put, the increase in foreign competitive pressure resulted in American workers adopting new work rules that enhanced their productivity.10 CHANGING COMPARATIVE ADVANTAGE Although international trade can promote dynamic gains in terms of increased produc- tivity, patterns of comparative advantage can and do change over time. In the early 1800s, the United Kingdom had a comparative advantage in textile manufacturing. Then that advantage shifted to the New England states of the United States. Then the comparative advantage shifted once again to North Carolina and South Carolina. Now the comparative advantage resides in China and other low-wage countries. Let us see how changing comparative advantage relates to our trade model. Figure 2.3 illustrates the production possibilities schedules for computers and
- 296. automobiles, of the United States and Japan under conditions of constant opportunity cost. Note that the MRT of automobiles into computers initially equals 1.0 for the United States and 2.0 for Japan. The United States thus has a comparative advantage in the production of computers and a comparative disadvantage in auto production. FIGURE 2.3 Changing Comparative Advantage A u to s Computers 100 0 100 150
- 297. United States MR T = 0.67 MR T = 1.0 80 A u to s 40 Computers 160 MR T = 0.5MR T = 2.0 Japan If productivity in the Japanese computer industry grows faster
- 298. than it does in the U.S. computer industry, the opportunity cost of each computer produced in the United States increases relative to the opportunity cost of the Japanese. For the United States, comparative advantage shifts from computers to autos. © C en ga ge Le ar ni ng ® 10Satuajit Chatterjee, “Ores and Scores: Two Cases of How Competition Led to Productivity Miracles,” Business Review, Federal Reserve Bank of Philadelphia, Quarter 1, 2005, pp. 7–15.
- 299. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 45 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Suppose both nations experience productivity increases in manufacturing computers but no productivity change in manufacturing automobiles. Assume that the United States increases its computer manufacturing productivity by 50 percent (from 100 to 150 computers) but that Japan increases its computer manufacturing productivity by 300 percent (from 40 to 160 computers).
- 300. Because of these productivity gains, the production possibilities schedule of each country rotates outward and becomes flatter. More output can now be produced in each country with the same amount of resources. Referring to the new production possi- bilities schedules, the MRT of automobiles into computers equals 0.67 for the United States and 0.5 for Japan. The comparative cost of a computer in Japan has thus fallen below that in the United States. For the United States, the consequence of lagging pro- ductivity growth is that it loses its comparative advantage in computer production. But even after Japan achieves comparative advantage in computers, the United States still has a comparative advantage in autos; the change in manufacturing productivity thus results in a change in the direction of trade. The lesson of this example is that producers who fall behind in research and development, technology, and equipment tend to find their competitiveness dwindling.
- 301. It should be noted, however, that all countries realize a comparative advantage in some product or service. For the United States, the growth of international competition in industries such as steel may make it easy to forget that the United States continues to be a major exporter of aircraft, paper, instruments, plastics, and chemicals. To cope with changing comparative advantages, producers are under constant pres- sure to reinvent themselves. Consider how the U.S. semiconductor industry responded to competition from Japan in the late 1980s. Japanese companies quickly became domi- nant in sectors such as memory chips. This dominance forced the big U.S. chip makers to reinvent themselves. Firms such as Intel, Motorola, and Texas Instruments abandoned the dynamic-random-access-memory (DRAM) business and invested more heavily in manufacturing microprocessors and logic products, the next wave of growth in semicon- ductors. Intel became an even more dominant player in microprocessors, while Texas
- 302. Instruments developed a strong position in digital signal processors, the “brain” in mobile telephones. Motorola gained strength in microcontrollers and automotive semi- conductors. A fact of economic life is that no producer can remain the world’s low-cost producer forever. As comparative advantages change, producers need to hone their skills to compete in more profitable areas. TRADING UNDER INCREASING-COST CONDITIONS The preceding section illustrated the comparative-advantage principle under constant- cost conditions. In the real world, a good’s opportunity cost may increase as more of it is produced. Based on studies of many industries, economists think the opportunity costs of production increase with output rather than remain constant for most goods. The principle of comparative advantage must be illustrated in a modified form. Increasing opportunity costs give rise to a production possibilities schedule that
- 303. appears bowed outward from the diagram’s origin. In Figure 2.4, with movement along the production possibilities schedule from A to B, the opportunity cost of producing autos becomes larger in terms of wheat sacrificed. Increasing costs mean that the MRT of wheat into autos rises as more autos are produced. Remember that the MRT is mea- sured by the absolute slope of the production possibilities schedule at a given point. With movement from production point A to production point B, the respective tangent lines 46 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 304. T R A D E C O N F L I C T S N A T U R A L G A S B O O M F U E L S D E B A T E Natural gas provides an example of comparative advantage, as discussed below. Natural gas is nothing new. Its origins date back to about 1000 B.C. when a goat herdsman in Greece came across a flame rising from a fissure in rock on Mount Parnassus. The Greeks, believing it was divine origin or supernatural, built a temple on the flame. It wasn’t until about 500 B.C. that the Chinese discovered that the source of the flame was natural gas seeping to the earth’s surface. The Chinese made crude pipelines out of bamboo shoots to transport the gas, where it was used to boil sea water, separating the salt and making the water drinkable. Around 1785 Britain became the first country to commercialize the use of natural gas that was produced from coal and could be used to light houses and streetlights. In the United States, the natural gas industry has existed for over 100 years. The United States has
- 305. exported some natural gas during this period of time, but has generally imported more than it has exported, mostly from Canada. However, this trend began to change around 2010 when new sources of natural gas were found in the United States, particularly from shale gas. Technologies were developed (hydraulic fractur- ing and horizontal drilling) that allowed water, sand, and chemicals to create fissures in shale, allowing trapped natural gas to be cost-effectively extracted. Suddenly the United States increased its ability to pro- duce natural gas. The natural gas bonanza helped lower U.S. energy prices and resulted in U.S. producers being poised to ship vast quantities of gas overseas. How- ever, federal law requires the U.S. Department of Energy to determine that natural gas projects are in the public interest before granting export permits to countries that do not have free-trade agreements with the United States. As producers such as Exxon Mobil sought federal permits for export projects, a debate ensued over whether they should be allowed to expand their exports. Industry proponents argue that natural gas exports
- 306. provide a much needed source of energy to American trading partners and foster economic growth and jobs in the United States. They are eager to take advantage of large price differentials between the United States and foreign markets. For example, U.S. prices are about $3 per million metric British thermal units (MMBtus), while prices in Europe are $11 to $13 per MMBtu and as high as $18 per MMBtu in Southeast Asia. Industry experts acknowledge that although many countries are endowed with large shale reserves, most countries are several years behind the United States in extraction and exploration. Moreover, propo- nents maintain that expanded exports of natural gas are a boost to key U.S. allies, especially Japan, as it transitions away from nuclear power. However, environmentalists contend that natural gas still leaves a significant carbon footprint: A global interest in U.S. natural gas means an extended reliance on fossil fuels and the delay of the shift to clean-tech energy such as solar power or wind power. They also are concerned about the environmental damage from drilling techniques used in the extraction of natural gas from shale that can harm drinking water.
- 307. What effect exporting natural gas will have on U.S. prices is another vital question in the debate over whether to export. A significant increase in U.S. natural gas exports would likely impose upward pressure on domestic prices, but the extent of any rise is unclear. There are a variety of factors that affect prices, such as economic growth rates, differences in local markets, and government regulations. Producers contend that increased exports will not increases prices significantly because there is ample supply to meet domestic demand, and there will be the extra benefits of increased revenues, trade, and jobs. Consumers of nat- ural gas who are helped by low prices, fear prices will rise if natural gas is exported. At the writing of this text, it remains to be seen how the effects of increased natural gas exports will play out. Source: Michael Ratner, and others, U.S. Natural Gas Exports: New Opportunities, Uncertain Outcomes, Congressional Research Service, Washington, DC, April 8, 2013; Gary Hufbauer, Allie Bagnall,
- 308. and Julia Muir, Liquified Natural Gas Exports: An Opportunity for America, Peterson Institute for International Economics, February 2013; and Robert Pirog and Michael Ratner, Natural Gas in the U.S. Economy: Opportunities for Growth, Congressional Research Service, Washington, DC, November 6, 2012. iS to ck ph ot o. co m /p ho to
- 309. so up Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 47 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. become steeper—their slopes increase in absolute value. The MRT of wheat into autos rises, indicating that each additional auto produced requires the sacrifice of increasing amounts of wheat.
- 310. Increasing costs represent the typical case in the real world. In the overall economy, increasing costs result when inputs are imperfect substitutes for each other. As auto pro- duction rises and wheat production falls in Figure 2.4, inputs that are less adaptable to autos are introduced into that line of production. To produce more autos requires more of such resources and thus an increasingly greater sacrifice of wheat. For a particular product, such as autos, increasing cost is explained by the principle of diminishing mar- ginal productivity. The addition of successive units of labor (variable input) to capital (fixed input) beyond some point results in decreases in the marginal production of autos that is attributable to each additional unit of labor. Unit production costs thus rise as more autos are produced. Under increasing costs, the slope of the production possibilities schedule varies as a nation locates at different points on the schedule. Because the MRT equals the produc- tion possibilities schedule’s slope, it will also be different for
- 311. each point on the schedule. In addition to considering the supply factors underlying the production possibilities sche- dule’s slope, we must also take into account the demand factors (tastes and preferences) for they will determine the point along the production possibilities schedule at which a country chooses to consume. Increasing-Cost Trading Case Figure 2.5 shows the production possibilities schedules of the United States and Canada under conditions of increasing costs. In Figure 2.5(a), assume that in the absence of FIGURE 2.4 Production Possibilities Schedule under Increasing-Cost Conditions 160 120 80
- 312. 40 0 20 40 60 80 Autos W h e a t A Slope: 1A = 1W B Slope: 1A = 4W Increasing opportunity costs lead to a production possibilities schedule that is bowed outward, viewed from the diagram’s origin. The MRT equals the (absolute) slope of the
- 313. production possibilities schedule at a particular point along the schedule. © C en ga ge Le ar ni ng ® 48 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 314. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. trade the United States is located at point A along its production possibilities schedule; it produces and consumes 5 autos and 18 bushels of wheat. In Figure 2.5(b), assume that in the absence of trade Canada is located at point A along its production possibilities schedule, producing and consuming 17 autos and 6 bushels of wheat. For the United States, the relative cost of wheat into autos is indicated by the slope of line tU S tangent to the production possibilities schedule at point A 1 auto 0 33 bushels of wheat . In like manner, Canada’s relative cost of wheat into autos is indicated by the slope of line tC 1 auto 3 bushels of wheat . Because line tU S is flatter than line tC , autos are rela- tively cheaper in the United States and wheat is relatively cheaper in Canada. According
- 315. to the law of comparative advantage, the United States will export autos and Canada will export wheat. As the United States specializes in auto production it slides downward along its production possibilities schedule from point A toward point B. The relative cost of autos (in terms of wheat) rises, as implied by the increase in the (absolute) slope of the production possibilities schedule. At the same time, Canada specializes in wheat. As Canada moves upward along its production possibilities schedule from point A toward point B , the relative cost of autos (in terms of wheat) decreases, as evidenced by the decrease in the (absolute) slope of its production possibilities schedule. The process of specialization continues in both nations until the relative cost of autos is identical in both nations and U.S. exports of autos are precisely equal to Canada’s imports of autos, and conversely for wheat. Assume that this situation occurs when the
- 316. domestic rates of transformation (domestic terms of trade) of both nations converge at the rate given by line tt. At this point of convergence, the United States produces at point B, while Canada produces at point B . Line tt becomes the international terms of trade line for the United States and Canada; this point coincides with each nation’s domestic terms of trade. The international terms of trade are favorable to both nations because tt is steeper than tU S and flatter than tC . FIGURE 2.5 Trading Under Increasing Opportunity Costs 0 14 18 21 W
- 317. h e a t 5 12 Autos C A D B (a) United States tU.S.(1A = 0.33W) tt(1A = 1W) Trading Possibilities Line 201713
- 318. Autos 0 6 13W h e a t tt(1A = 1W) C ′ B ′ D ′ A′ (b) Canada tC(1A = 3W)
- 319. Trading Possibilities Line With increasing opportunity costs, comparative product prices in each country are determined by both supply and demand factors. A country tends to partially specialize in the product of its comparative advantage under increasing-cost conditions. © C en ga ge Le ar ni ng ®
- 320. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 49 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. What are the production gains from specialization for the United States and Canada? Comparing the amount of autos and wheat produced by the two nations at their points prior to specialization with the amount produced at their post- specialization production points we see that there are gains of 3 autos and 3 bushels of wheat. The production gains from specialization are shown in Table 2.6(a).
- 321. What are the consumption gains from trade for the two nations? With trade, the United States can choose a consumption point along international terms of trade line tt. Assume that the United States prefers to consume the same number of autos as it did in the absence of trade. It will export 7 autos for 7 bushels of wheat, achieving a post-trade consumption point at C. The U.S. consumption gains from trade are 3 bushels of wheat, as shown in Figure 2.5(a) and also in Table 2.6(b). The U.S. trade triangle, showing its exports, imports, and terms of trade, is denoted by triangle BCD. In like manner, Canada can choose to consume at some point along international terms of trade line tt. Assuming Canada holds constant its consumption of wheat, it will export 7 bushels of wheat for 7 autos and wind up at post- trade consumption point C . Its consumption gain of 3 autos is also shown in Table 2.6(b). Canada’s trade triangle is depicted in Figure 2.5(b) by triangle B C D . Note that Canada’s trade triangle
- 322. is identical to that of the United States. In this chapter, we discussed the autarky points and post-trade consumption points for the United States and Canada by assuming “given” tastes and preferences (demand conditions) of the consumers in both countries. In Exploring Further 2.2 and 2.3, located at ww.cengage.com/economics/Carbaugh, we introduce indifference curves to show the role of each country’s tastes and preferences in determining the autarky points and how gains from trade are distributed. Partial Specialization One feature of the increasing cost model analyzed here is that trade generally leads each country to specialize only partially in the production of the good in which it has a com- parative advantage. The reason for partial specialization is that increasing costs consti- tute a mechanism that forces costs in two trading nations to converge. When cost differentials are eliminated, the basis for further specialization ceases to exist.
- 323. TABLE 2.6 Gains from Specialization and Trade: Increasing Opportunity Costs (a) Production Gains from Specialization BEFORE SPECIALIZATION AFTER SPECIALIZATION NET GAIN (LOSS) Autos Wheat Autos Wheat Autos Wheat United States 5 18 12 14 7 −4 Canada 17 6 13 13 −4 7 World 22 24 25 27 3 3 (b) Consumption Gains from Trade BEFORE TRADE AFTER TRADE NET GAIN (LOSS) Autos Wheat Autos Wheat Autos Wheat
- 324. United States 5 18 5 21 0 3 Canada 17 6 20 6 3 0 World 22 24 25 27 3 3 © C en ga ge Le ar ni ng ® 50 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 325. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Figure 2.5 assumes that prior to specialization the United States has a comparative cost advantage in producing autos, whereas Canada is relatively more efficient at produc- ing wheat. With specialization, each country produces more of the commodity of its comparative advantage and less of the commodity of its comparative disadvantage. Given increasing-cost conditions, unit costs rise as both nations produce more of their export commodities. Eventually, the cost differentials are eliminated, at which point the basis for further specialization ceases to exist. When the basis for specialization is eliminated, there exists a
- 326. strong probability that both nations will produce some of each good. This is because costs often rise so rapidly, that a country loses its comparative advantage vis-à-vis the other country before it reaches the endpoint of its production possibilities schedule. In the real world of increasing-cost conditions, partial specialization is a likely result of trade. Another reason for partial specialization is that not all goods and services are traded internationally. For example, even if Germany has a comparative advantage in medical services, it would be hard for Germany to completely specialize in medical services and export them. It would be very difficult for American patients who require back surgeries to receive them from surgeons in Germany. Differing tastes for products also result in partial specialization. Most products are differentiated. Compact disc players, digital music players, automobiles, and other pro- ducts provide a variety of features. When purchasing
- 327. automobiles, some people desire capacity to transport seven passengers while others desire good gas mileage and attrac- tive styling. Thus, some buyers prefer Ford Expeditions and others prefer Honda CRVs. Simply put, the United States and Japan have comparative advantages in manufacturing different types of automobiles. THE IMPACT OF TRADE ON JOBS As Americans watch the evening news on television and see Chinese workers producing goods that they used to produce; the viewers might conclude that international trade results in an overall loss of jobs for Americans. Is this true? Standard trade theory suggests that the extent to which an economy is open influences the mix of jobs within an economy and can cause dislocation in certain areas or industries, but has little effect on the overall level of employment. The main determinants of total employment are factors such as the available work-
- 328. force, total spending in the economy, and the regulations that govern the labor market. According to the principle of comparative advantage, trade tends to lead a country to specialize in producing goods and services at which it excels. Trade influences the mix of jobs because workers and capital are expected to shift away from industries in which they are less productive relative to foreign producers and toward industries having a comparative advantage. The conclusion that international trade has little impact on the overall number of jobs is supported by data on the U.S. economy. If trade is a major determinant on the nation’s ability to maintain full employment, measures of the amount of trade and unemployment would move in unison, but in fact, they generally do not. As seen in Figure 2.6, the increase in U.S. imports as a percentage of GDP over the past several decades has not led to any significant trend in the overall
- 329. unemployment rate for Americans. Indeed, the United States has been able to achieve relatively low unemployment while imports have grown considerably. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 51 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Simply put, increased trade has neither inhibited overall job creation nor contrib- uted to an increase in the overall rate of unemployment. This topic will be further examined in Chapter 10 in the essay entitled “Do Current
- 330. Account Deficits Cost Americans Jobs?” WOOSTER, OHIO BEARS THE BRUNT OF GLOBALIZATION According to the principle of comparative advantage, although free trade tends to move resources from low productivity to high productivity, some people can be left behind. Consider the case of Rubbermaid’s exit from Wooster, Ohio. Rubbermaid is an American producer of household items such as food storage con- tainers, trash cans, laundry baskets, and the like. The company was founded in 1933 in Wooster when James Caldwell received a patent for his red rubber dustpan. Soon the company was producing a variety of rubber and plastic kitchen products under the name Rubbermaid. A solid corporate citizen, Rubbermaid donated to the arts, initiated a downtown revitalization by opening a retail store and led a drive to
- 331. convert an old movie theater into a cultural center. Also, it was designated as one of America’s most admired com- panies. Although workers on Rubbermaid’s factory floors were not getting wealthy, work was plentiful and it was common to find three generations of a family on the payroll. FIGURE 2.6 The Impact of Trade on Jobs 0 2 4 6 8 10
- 332. 12 14 16 18 20 1960 1970 1980 1990 2000 2010 0 2 4 6 8 10 12
- 333. Imports of goods as % of GDP (left scale) Unemployment rate (right scale) Im p o rt s o f G o o d s a s %
- 335. ( % ) Increased international trade tends to neither inhibit overall job creation nor contribute to an increase in the overall rate of unemployment. As seen in the figure, the increase in U.S. imports of goods as a percentage of GDP over the past several decades has not led to any significant trend in the overall unemployment for Americans. © C en ga ge Le ar ni
- 336. ng ® 52 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. However, trouble began for Rubbermaid in 1995 when the firm was dealing with sky- rocketing prices for resin, a key ingredient in plastic products. In that year, the firm lost $250 million, mainly because of resin price hikes. When Rubbermaid tried to pass a higher price for its plastic products onto Walmart, which accounted for about 20 percent
- 337. of its business, Walmart warned that if prices rose it would pull Rubbermaid’s products from its shelves. When negotiations failed, Walmart terminated the relationship and turned to other suppliers; generally foreign companies with lower labor costs. This resulted in Rubbermaid’s profits plunging by 30 percent in 1995, the closing of 9 of its manufacturing plants, and laying off 10 percent of its workers, the first major downsizing in its history. In 1999, Rubbermaid was purchased for $6 billion by Newell Corporation, a multina- tional consumer product corporation known for cost cutting; the newly merged firm was called Newell Rubbermaid Inc. Newell Rubbermaid transferred manufacturing work from Wooster’s rubber division to Mexico to take advantage of lower labor costs. Rubbermaid had established manufacturing plants in Poland, South Korea, and Mexico, but most of its production remained in America. Also, the corporate staff was transferred to Atlanta, Georgia, the headquarters of Newell Rubbermaid. As a result,
- 338. the work force in Wooster was cut by 1,000, while remaining workers toiled at a distribution center for Newell Rubbermaid products. As former Rubbermaid workers depleted their modest severance packages, they tried to find new employment. Some succeeded in landing jobs, often tem- porary and without benefits that paid 30–40 percent less than they were earning. The middle class workers of Wooster believed in the American dream that if you work hard and adhere to the rules you will prosper in America and your children would enjoy a better life than yours. However, they were shaken by the loss of their major employer in a globalized economy.11 COMPARATIVE ADVANTAGE EXTENDED TO MANY PRODUCTS AND COUNTRIES In our discussion so far, we have used trading models in which only two goods are pro- duced and consumed and trade is confined to two countries. This simplified approach has
- 339. permitted us to analyze many essential points about comparative advantage and trade. The real world of international trade involves more than two products and two countries; each country produces thousands of products and trades with many countries. To move in the direction of reality, it is necessary to understand how comparative advantage functions in a world of many products and many countries. As we will see, the conclusions of compara- tive advantage hold when more realistic situations are encountered. More Than Two Products When two countries produce a large number of goods, the operation of comparative advantage requires that the goods be ranked by the degree of comparative cost. Each coun- try exports the product(s) in which it has the greatest comparative advantage. Conversely, each country imports the product(s) in which it has the greatest comparative disadvantage. Figure 2.7 illustrates the hypothetical arrangement of six products—chemicals, jet
- 340. planes, computers, autos, steel, and semiconductors—in rank order of the comparative 11Donald Barlett and James Steel, The Betrayal of the American Dream, Public Affairs–Perseus Books Group, New York, 2012; Huang Qingy, et. al., “Wal-Mart’s Impact on Supplier Profits,” Journal of Marketing Research, Vol. 49, No. 2, 2012; Richard Freeman and Arthur Ticknor, “Wal-Mart Is Not a Business: It’s An Economic Disease,” Executive Intelligence Review, November 14, 2003. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 53 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 341. advantage of the United States and Japan. The arrangement implies that chemical costs are lowest in the United States relative to Japan, whereas the U.S. cost advantage in jet planes is somewhat less. Conversely, Japan enjoys its greatest comparative advantage in semiconductors. This product arrangement clearly indicates that with trade, the United States will pro- duce and export chemicals and that Japan will produce and export semiconductors. Where will the cutoff point lie between what is exported and what will be imported? Between computers and autos? Or will Japan produce computers and the United States produce only chemicals and jet planes? Will the cutoff point fall along one of the pro- ducts rather than between them—so that computers, for example, might be produced in both Japan and the United States? The cutoff point between what is exported and what is imported
- 342. depends on the - relative strength of international demand for the various products. One can visualize the products as beads arranged along a string according to comparative advantage. The strength of demand and supply will determine the cutoff point between U.S. and Japanese production. A rise in the demand for steel and semiconductors, for example, leads to price increases that move in favor of Japan. These increases lead to rising production in the Japanese steel and semiconductor industries. More Than Two Countries When a trading example includes many countries, the United States will find it advanta- geous to enter into multilateral trading relations. Figure 2.8 illustrates the process of multilateral trade for the United States, Japan, and OPEC. The arrows in the figure denote the directions of exports. The United States exports jet planes to OPEC, Japan imports oil from OPEC, and Japan exports semiconductors to the United States. The real world of international trade involves trading relations even
- 343. more complex than this triangular example. This example casts doubt upon the idea that bilateral balance should pertain to any two trading partners. The predictable result is that a nation will realize a trade surplus (exports of goods exceed imports of goods) with trading partners that buy a lot of the things that it supplies at low cost. Also, a nation will realize a trade deficit (imports of goods exceed exports of goods) with trading partners that are low-cost suppliers of goods that it imports intensely. FIGURE 2.7 Hypothetical Spectrum of Comparative Advantages for the United States and Japan U.S. Comparative Advantage
- 346. d u ct o rs When a large number of goods is produced by two countries, operation of the comparative-advantage principle requires the goods to be ranked by the degree of comparative cost. Each country exports the product(s) in which its comparative advantage is strongest. Each country imports the product(s) in which its comparative advantage is weakest. © C en ga ge Le
- 347. ar ni ng ® 54 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Consider the trade “deficits” and “surpluses” of a dentist who likes to snow ski. The dentist can be expected to run a trade deficit with ski resorts, sporting goods stores, and
- 348. favorite suppliers of services like garbage collection and medical care. Why? The dentist is highly likely to buy these items from others. On the other hand, the dentist can be expected to run trade surpluses with his patients and medical insurers. These trading partners are major purchasers of the services provided by the dentist. Moreover, if the dentist has a high rate of saving, the surpluses will substantially exceed the deficits. The same principles are at work across nations. A country can expect to run sizable surpluses with trading partners that buy a lot of the things the country exports, while trade deficits will be present with trading partners that are low- cost suppliers of the items imported. What would be the effect if all countries entered into bilateral trade agreements that balanced exports and imports between each pair of countries? The volume of trade and specialization would be greatly reduced and resources would be hindered from moving
- 349. to their highest productivity. Although exports would be brought into balance with imports, the gains from trade would be lessened. EXIT BARRIERS According to the principle of comparative advantage, an open trading system results in a channeling of resources from uses of low productivity to those of high productivity. Competition forces high-cost plants to exit, leaving the low-cost plants to operate in the long run. In practice, the restructuring of inefficient companies can take a long time because they often cling to capacity by nursing along antiquated plants. Why do compa- nies delay plant closing when profits are subnormal and overcapacity exists? Part of the answer lies in the existence of exit barriers, various cost conditions that make a lengthy exit a rational response by companies. FIGURE 2.8 Multilateral Trade Among the United States, Japan, and OPEC
- 350. OPEC Oil Japan United States Jet P lanes S em ic on du ct or s When many countries are involved in international trade, the home country will likely
- 351. find it advantageous to enter into multilateral trading relationships with a number of countries. This figure illustrates the process of multilateral trade for the United States, Japan, and OPEC. © C en ga ge Le ar ni ng ® Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 55 Copyright 2015 Cengage Learning. All Rights Reserved. May
- 352. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Consider the case of the U.S. steel industry in which overcapacity has often been a key problem. Overcapacity has been caused by factors such as imports, reduced demand for steel, and installation of modern technology that allows greater productivity and increases output of steel with fewer inputs of capital and labor. Traditional economic theory envisions hourly labor as a variable cost of production. However, the U.S. steel companies’ contracts with United Steelworkers of America, the labor union, make hourly labor a fixed cost instead of a variable cost, at least in part.
- 353. The contracts call for many employee benefits such as health and life insurance, pen- sions, and severance pay when a plant is shut down, as well as unemployment benefits. Besides employee benefits, other exit costs tend to delay the closing of antiquated steel plants. These costs include penalties for terminating contracts to supply raw materials and expenses associated with the writing off of undepreciated plant assets. Steel companies also face environmental costs when they close plants. Owners are potentially liable for environ- mental costs at their abandoned facilities for treatment, storage, and disposal costs that can easily amount to hundreds of millions of dollars. Furthermore, steel companies cannot realize much income by selling their plants’ assets. The equipment is unique to the steel industry and is of little value for any purpose other than producing steel. What’s more, the equipment in a closed plant is generally in need of major renovation because the for- mer owner allowed the plant to become antiquated prior to closing. Exit barriers hinder
- 354. the market adjustments that occur according to the principle of comparative advantage. EMPIRICAL EVIDENCE ON COMPARATIVE ADVANTAGE We have learned that Ricardo’s theory of comparative advantage implies that each coun- try will export goods for which its labor is relatively productive compared with that of its trading partners. Does his theory accurately predict trade patterns? A number of econo- mists have put Ricardo’s theory to empirical tests. The first test of the Ricardian model was made by the British economist G.D.A. MacDougall in 1951. Comparing the export patterns of 25 separate industries for the United States and the United Kingdom for the year 1937, MacDougall tested the Ricar- dian prediction that nations tend to export goods in which their labor productivity is relatively high. Of the 25 industries studied, 20 fit the predicted pattern. The MacDougall investigation thus supported the Ricardian theory of
- 355. comparative advantage. Using dif- ferent sets of data, subsequent studies by Balassa and Stern also supported Ricardo’s conclusions.12 A more recent test of the Ricardian model comes from Stephen Golub who examined the relation between relative unit labor costs (the ratio of wages to productivity) and trade for the United States vis-à-vis the United Kingdom, Japan, Germany, Canada, and Australia. He found that relative unit labor cost helps to explain trade patterns for these nations. The U.S. and Japanese results lend particularly strong support for the Ricardian model, as shown in Figure 2.9. The figure displays a scatter plot of U.S.–Japan trade data showing a clear negative correlation between relative exports and relative unit labor costs for the 33 industries investigated. 12G.D.A. MacDougall, “British and American Exports: A Study Suggested by the Theory of Comparative Costs,” Economic Journal, 61 (1951). See also B. Balassa, “An Empirical Demonstration of Classical
- 356. Comparative Cost Theory,” Review of Economics and Statistics, August 1963, pp. 231–238 and R. Stern, “British and American Productivity and Comparative Costs in International Trade,” Oxford Economic Papers, October 1962. 56 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Although there is empirical support for the Ricardian model, it is not without limitations. Labor is not the only input factor. Allowance should be made where appropriate for produc- tion and distribution costs other than direct labor. Differences
- 357. in product quality also explain trade patterns in industries such as automobiles and footwear. We should therefore proceed with caution in explaining a nation’s competitiveness solely on the basis of labor productivity and wage levels. The next chapter will discuss this topic in more detail. COMPARATIVE ADVANTAGE AND GLOBAL SUPPLY CHAINS For decades, most economists have insisted that countries generally gain from free trade. Their optimism is founded on the theory of comparative advantage developed by David Ricardo. The theory states that if each country produces what it does best and allows FIGURE 2.9 Relative Exports and Relative Unit Labor Costs: U.S./Japan, 1990 – 0.8 – 0.6 – 0.4 – 0.2 0.20 0.4 0.6 0.8 1
- 358. 2 1.5 1 0.5 0 –0.5 –1 U.S./Japanese Unit Labor Costs U .S ./ Ja p a n
- 359. e se E xp o rt s The figure displays a scatter plot of U.S./Japan export data for 33 industries. It shows a clear negative correlation between relative exports and relative unit labor costs. A rightward movement along the figure’s horizontal axis indicates a rise in U.S. unit labor costs relative to Japanese unit labor costs; this correlates with a decline in U.S. exports relative to Japanese exports, a downward movement along the figure’s vertical axis. Source: Stephen Golub, Comparative and Absolute Advantage in the Asia-Pacific Region, Center for Pacific
- 360. Basin Monetary and Economic Studies, Economic Research Department, Federal Reserve Bank of San Francisco, October 1995, p. 46. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 57 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. trade, all will realize lower prices and higher levels of output, income and consumption than could be achieved in isolation. When Ricardo formulated his theory, major factors of production could not move to other nations. Yet in today’s world, important
- 361. resources—labor, technology, capital, and ideas—often shift around the globe. From electronics and automobiles to clothing or software development, many goods today are provided by global supply chains. Rather than carrying out everything from research and development to delivery and retail sales within a particular country, many industries have separated this process into stages or tasks that are undertaken in many countries. The international production networks that allow firms to move goods and services efficiently across national borders are known as global supply chains. Global supply chains employ the practice of outsourcing (off shoring) which refers to the subcontracting of work to another firm or the purchase of components for a product rather than manufacturing them in order to save on production costs. The location of production near customers is another motivation of outsourcing. Over time, several factors have contributed to the development
- 362. of global supply chains—technological changes that allow production processes to be fragmented, falling trade barriers, lower transportation costs, improved telecommunications, more secure intellectual property rights, and improved contract enforcement. As countries have become more integrated into these chains, they become more specialized in specific tasks based on comparative advantage. Concerning comparative advantage, global supply chains foster new patterns of trade, as firms in a country specialize in a particular stage or task. In electronics, for example, intermediate goods are often produced in South Korea, Japan, Taiwan, and Hong Kong, while final assembly activities are contracted to Chinese companies. Apple’s iPhone, iPod and iPad are familiar examples of goods produced via a global supply chain.13 The ability to separate the production process into tasks that can be done in different loca- tions has implications for the pattern of world trade. First, it
- 363. means a change in the nature of specialization. Traditionally, a country’s exports were concentrated in final goods or services in which it had a comparative advantage. However, with global supply chains, specialization is more narrowly defined, with countries specializing in tasks or stages within products, based on comparative advantage. Also, the nature of trade flows are affected by global supply chains. As supply chains expand, trade between industrial and developing countries tends to increase, since the location of tasks depends on differences in comparative advantage. More- over, the pattern of trade becomes more dominated by trade in intermediate goods and services—such as parts, components, and computer services—as supply chains expand. The semiconductor industry provides an example of these effects. In the past, the United States would have exported finished semiconductors to China. Now, the United States performs research and development and also the design and front-end fabrication of a semiconductor. It then exports the semi-finished
- 364. semiconductor to a Southeast Asian country, such as Malaysia, that performs the back-end testing, assembly, and pack- aging of that semiconductor. Malaysia then exports the packaged semiconductor to China where it is incorporated into various electronic products, such as television sets, and then exported to consumers throughout the world. Therefore, global supply chains enhance a country’s gains from trade because they allow a good to be produced more efficiently than if the entire process had to take place in a single location. 13U.S. International Trade Commission, “Global Supply Chains.” In The Economic Effects of Significant U.S. Import Restraints, August 2011; Judith Dean and Mary Lovely, “Trade Growth, Production Frag- mentation and China’s Environment.” In China’s Growing Role in World Trade, edited by R. Feenstra and S. Wei, National Bureau of Economic Research and University of Chicago Press, 2010; Premachandra Athukorala and Nobuaki Yamashita, “Production Fragmentation and Trade Integration: East Asia in a Global Context,” North American Journal of Economics and
- 365. Finance, Vol. 17, 2006. 58 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Global supply chains may also provide gains for developing countries because of opportunities to participate in one or more stages in the production of technology, or skill-intensive goods, rather than having to attain mastery over the total production pro- cess. Firms initially performing the least-skilled tasks may learn through interaction with more advanced firms in the chain and thus can move to higher-
- 366. value production activities. India provides an example of this process. During the 1990s, India’s software firms tended to be in the lower to middle end of the software development chain, specializing in contract programming, coding, and testing. By the early 2000s, its firms engaged in business and tech- nology consulting, systems integration, product engineering, and other more skill-intensive activities as the firms learned through interaction with more skilled firms. Although global supply chains yield economic efficiencies, they can be subject to global shocks. For example, if a country undergoes an economic downturn, or experi- ences internal conflict or natural disasters, other countries in the supply chain be adversely affected. During the Great Recession of 2007–2009, the U.S. demand for Chinese electronics declined, thus causing a decrease in the Chinese demand for electronics parts and components from other Asian suppliers.
- 367. Another example is the 2011 earthquake and tsunami that hit Japan and disrupted supply chains of Toyota and Honda who manufactured autos at factories in the United States. Advantages and Disadvantages of Outsourcing Proponents of outsourcing maintain that it can create a win-win situation for the global economy. Obviously, outsourcing benefits a recipient country such as India. For exam- ple, some of India’s people work for a subsidiary of Southwestern Airlines of the United States and make telephone reservations for Southwestern’s travelers. Moreover, incomes increase for Indian vendors supplying goods and services to the subsidiary, and the Indian government receives additional tax revenue. The United States also benefits from outsourcing in several ways: • Reduced costs and increased competitiveness for Southwestern, which hires low-wage workers in India to make airline reservations. In the United States, many offshore jobs are viewed as relatively undesirable or of low prestige;
- 368. whereas in India, they are often considered attractive. Thus, Indian workers may have higher motivation and out-produce their U.S. counterparts. The higher productivity of Indian workers leads to falling unit costs for Southwestern. • New exports. As business expands, Southwestern’s Indian subsidiary may purchase additional goods from the United States, such as computers and telecommunications equipment. These purchases result in increased earnings for U.S. companies such as AT&T and additional jobs for American workers. • Repatriated earnings. Southwestern’s Indian subsidiary returns its earnings to the parent company; these earnings are plowed back into the U.S. economy. Many offshore providers are, in fact, U.S. companies that repatriate earnings. Simply put, proponents of outsourcing contend that if U.S. companies cannot locate work abroad they will become less competitive in the global
- 369. economy as their competi- tors reduce costs by outsourcing. This process will weaken the U.S. economy and threaten more American jobs. Proponents also note that job losses tend to be temporary and that the creation of new industries and new products in the United States will result in more lucrative jobs for Americans. As long as the U.S. workforce retains its high level of skills and remains flexible as companies position themselves to improve their produc- tivity, high-value jobs will not disappear in the United States. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 59 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 370. Of course, what is good for the economy as a whole may not be good for a particular individual. The benefits of outsourcing to the United States do not eliminate the burden on Americans who lose their jobs or find lower-wage jobs because of foreign outsour- cing. American labor unions often lobby Congress to prevent outsourcing, and several U.S. states have considered legislation to severely restrict their governments from contracting with companies that move jobs to low-wage developing countries.14 Outsourcing and the U.S. Automobile Industry Developments in the U.S. automobile industry over the past century illustrate the under- lying forces behind outsourcing. In the early 1900s, it took only 700 parts for workers at Ford Motor Company to produce a Model T. With this relatively small number of parts, Ford blended the gains of large-scale mass production with the gains of a high degree of
- 371. specialization within a single plant. Workers were highly specialized and usually per- formed one single task along an automated assembly line, while the plant was vertically integrated and manufactured the vehicle starting from raw materials. As consumers became wealthier and insisted on more luxurious vehicles, competitors to Ford emerged. Ford was forced to develop a family of models, each fitted with com- fortable seats, radios, and numerous devices to improve safety and performance. As cars became more sophisticated, Ford could no longer produce them efficiently within a sin- gle plant. As the number of tasks outgrew the number of operations that could be effi- ciently conducted within a plant, Ford began to outsource production. The firm has attempted to keep strategically important tasks and production in-house while noncore tasks are purchased from external suppliers. As time has passed, increasing numbers of parts and services have come to be considered noncore, and Ford has farmed out pro-
- 372. duction to a growing number of external suppliers, many of which are outside the United States. Today, about 70 percent of a typical Ford vehicle comes from parts, com- ponents and services purchased from external suppliers. Clearly, without the develop- ment toward increased specialization and outsourcing, today’s cars would be either closer to Model T technology in quality or they would be beyond the budgets of ordinary people. By the 2000s, service industries, such as information technology and bill proces- sing, were undergoing similar developments as the automobile industry had in the past.15 The iPhone Economy and Global Supply Chains Apple Inc. is a multinational company that produces consumer electronics, computer software, and commercial servers. Headquartered in Cupertino, CA, the company was founded by Steve Jobs and Steve Wozniak in 1976. Although Apple used to produce its goods in America, today most are produced abroad. Virtually all iPhones, iPads, iMacs and other Apple products are made in Asia, Europe, and
- 373. elsewhere. Apple employs 40,000 workers in the United States but has 700,000 workers in China; Apple licenses the produc- tion of its devices to Foxconn Technology Group that is headquartered in Taiwan and is the world’s largest maker of consumer electronics products. What would it take to make iPhones in the United States? In its early days, Apple usually did not look outside the United States for manufacturing sites. For example, for several years after Apple began producing the Macintosh in 1983, the company boasted that the Mac was a computer “Made in America.” However, this began to change at the turn of the century when Apple switched to foreign manufacturing. 14Jagdish Bhagwati, et. al., “The Muddles Over Outsourcing,” Journal of Economic Perspectives, Fall 2004, pp. 93–114. See also McKinsey Global Institute, Offshoring: Is It a Win-Win Game? (Washington, DC: McKinsey Global Institute, 2003). 15World Trade Organization, World Trade Report 2005 (Geneva, Switzerland), pp. 268–274.
- 374. 60 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Asia’s attractiveness was partly due to its less expensive, semiskilled workers. That was not the main motivation for Apple because the cost of labor is negligible compared with the expense of purchasing parts and running supply chains that combine components and ser- vices from hundreds of companies. Apple maintains that the vast scale of overseas factories as well as the flexibility, perseverance, and skills of foreign workers have become so super-
- 375. ior to their American counterparts that manufacturing in the United States is no longer a realistic option for most Apple products. For example, Apple used a Chinese factory to revamp the production of the iPhone just weeks before it was introduced to the market. Apple had redesigned the iPhone’s screen at the last minute, necessitating an assembly line overhaul. New screens began arriving at the plant around midnight. To implement a speedy changeover, the plant foreman woke up the workers sleeping in the company’s crowded dormitories and the overhaul began. Within four days, the plant overhaul was complete and began producing 10,000 iPhones a day with a new, unscratchable glass screen. Workers at this plant toil up to 12 hours a day, six days a week. Apple’s executives noted that the plant’s speed and flexibility are superb and there is no American plant that can rival it. However, critics maintain that in China, human costs are built into the iPhone and other Apple products. They note that Apple’s desire to increase product quality and
- 376. decrease production costs has resulted in the firm and its suppliers often ignoring safety conditions for workers, disposal of hazardous waste, employment of underage workers, excessive overtime, and the like. Bleak working conditions have also been documented at Chinese factories manufacturing products for Hewlett-Packard, Dell, IBM, Sony, and others. Yet some aspects of the iPhone are American. The product’s software, for example, and its innovative marketing characteristics were mostly developed in the United States. Also, Apple has built a data center in North Carolina and key semiconductors inside the iPhone are made in Austin, Texas factory by Samsung, of South Korea. However, those facilities do not provide many jobs for Americans. Apple’s North Carolina data center employs only 100 full-time workers and the Samsung plant employs about 2,400 work- ers. Simply put, if you expand production from one million phones to 25 million phones, you don’t need many additional programmers.
- 377. In defending its strategy of production outsourcing, Apple notes that there are not enough American workers with the skills the company needs or U.S. factories with suffi- cient speed and flexibility. According to Apple, a crucial challenge in setting up plants in the United States is finding a technical work force. In particular, Apple and other tech- nology companies say they need engineers with more than high school training, but not necessarily a bachelor’s degree. Americans at that skill level are hard to find. Simply put, Apple’s outsourcing is not merely motivated by low wages in China.16 Outsourcing Backfires for Boeing 787 Dreamliner Although outsourcing may have contributed to greater efficiencies in auto production, it created problems for Boeing in the production of jetliners. In 2007, the first wings for Boeing’s new $150 million jetliner, the 787 Dreamliner, landed in Seattle, Washington, ready-made in Japan. Three Japanese firms were awarded 35 percent of the design and
- 378. manufacturing work for the 787, with Boeing performing final assembly in only three- day’s time. Other nations, such as Italy, China, and Australia, were also involved in 16Charles Duhigg and Keith Bradsher, “How the U.S. Lost Out on iPhone Work,” The New York Times, January 21, 2012; “In China, Human Costs Are Built Into an iPad,” The New York Times, January 25, 2012 at http://www.nytimes.com.; Rich Karlgaard, “In Defense of Apple’s China Plants,” The Wall Street Journal, February 2, 2012, p. A-13; Greg Linden, Kenneth Kraemer, and Jason Dedrick, “Innovation and Job Creation in a Global Economy: The Case of Apple’s iPod,” Journal of International Commerce and Economics, 2011. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 61 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 379. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. supplying sections of the 787, as seen in Table 2.7. Boeing maintained that by having contractors across the world build large sections of its airplanes, the firm could decrease the time required to build its jets by more than 50 percent and reduce the plane’s development cost from $10 billion to $6 billion. Simply put, Boeing has manufactured just 35 percent of the plane before assembling the final aircraft at its plant outside Seattle; 65 percent of the plane’s manufacturing comes from abroad. To decrease costs, Boeing required foreign suppliers to absorb some of the costs of developing the plane. In return for receiving contracts to make sections of the 787, for- eign suppliers invested billions of dollars, drawing from whatever subsidies were avail-
- 380. able. For example, Japan’s government provided loans of up to $2 billion to the three Japanese suppliers of Boeing, and Italy provided regional infrastructure for its supplier company. This spreading of risk allowed Boeing to decrease its developmental costs and thus be a more effective competitor against Airbus. The need to find engineering talent and technical capacity was another motive behind Boeing’s globalization strategy. According to Boeing executives, the complexity of design- ing and producing the 787 requires that people’s talents and capabilities are brought together from all over the world. Also, sharing work with foreigners helps Boeing main- tain close relationships with its customers. For example, Japan has spent more money buying Boeing jetliners than any other country: Boeing shares its work with the Japanese, and the firm in turn secures a virtual monopoly in jetliner sales to Japan. But the strategy backfired when Boeing’s suppliers fell behind in getting their jobs done,
- 381. which resulted in the 787’s production being more than four years behind schedule. The suppliers’ problems ranged from language barriers to snarls that erupted when some con- tractors themselves outsourced chunks of work. Boeing was forced to turn to its own union workforce to piece together the first few airplanes after their sections arrived at the firm’s factory in Seattle, with thousands of missing parts. That action resulted in anger and anxiety among union workers who maintained that if Boeing had let them build the 787 in the first place, they would have achieved the production goal. Boeing workers also feared that the firm would eventually attempt to allow foreign contractors to go one step further and install their components directly in the 787. Although Boeing officials insisted that they had no intentions to do this, they refused to give union workers assurances in writing. By giving up control of its supply chain, Boeing had lost the ability to oversee each step of production. Problems often were not discovered until parts came together at Boe-
- 382. ing’s Seattle plant. Fixes were not easy and cultures among suppliers often clashed. TABLE 2.7 Producing the Boeing 787: Examples of How Boeing Outsources Its Work Country Part/Activity Japan Wing, mid-fuselage section, fixed trailing edge, wing box China Rudder, vertical fin, fairing panels South Korea Wing tip, tail cone Australia Inboard flap, movable trailing edge Canada Engine pylon fairing, main landing gear door Italy Horizontal stabilizer United Kingdom Main landing gear, nose landing gear Source: “Boeing 787: Parts From Around the World Will Be Swiftly Integrated,” The Seattle Times, September 11,
- 383. 2005, “Boeing Shares Work, But Guards Its Secrets,” The Seattle Times, May 15, 2007, and “Outsourcing at Crux of Boeing Strike,” The Wall Street Journal, September 8, 2008. 62 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Boeing officials lamented that it seemed like the Italians only worked three days a week (they were always on vacation) while the Japanese worked six days a week. Also, there were apprehensions among Boeing workers that they were giving up their trade secrets to the Japanese and Chinese and that they would soon be their
- 384. competition. Outsourcing was intended to save money, but in Boeing’s case it backfired. The 787 came in at several billion dollars over budget and over three years behind schedule before it made first flight in late 2011. The plane’s Lithium-ion batteries overheated that caused additional downtime to correct. Boeing officials admitted that they outsourced work to people who were not up to the task, the result being poorly made components, problems with electrical systems and environmental controls, and missed deadlines that disrupted the production schedule for the entire plane. Simply put, Boeing spent a lot more money in trying to recover than it would have spent if it kept many of the key technologies closer to Boeing.17 Reshoring Production to the United States For several decades, many American firms with high labor costs found that they could realize huge savings by sending work to countries where wages were much lower. However, by 2013 producers were increasingly rethinking their
- 385. offshoring strategies. Prominent firms such as Caterpillar, Ford Motor Company, Google, Apple, and General Electric were bringing some of their production back to the United States. Why? The most important reason was that wages in China and India were increasing by 10–20 percent a year while manufacturing pay in the United States and Europe remained sluggish. Therefore, the wage gap was narrowing. True, other countries such as Vietnam and Bangladesh are competing to replace China as low-wage havens. However, they lack China’s scale, efficiency, and supply chains. America’s companies were also realizing the downside of distance. The cost of ship- ping goods around the world by ocean freight was increasing sharply, and goods often spent weeks in transit. Rising shipping, rail, and road costs are especially harmful for companies that produce goods with relatively low value, such as consumer goods and appliances. Also, locating production far away from customers
- 386. in large, new markets makes it difficult to customize products and respond quickly to changing local demand. Companies are increasingly factoring in the risk that natural disasters or geopolitical shocks could disrupt supply chains. Therefore, Emerson, an electrical equipment maker, has moved factories from Asia to the United States to be closer to its customers. Lenovo, a Chinese technology company, has started making personal computers in North Carolina in order to customize them for American customers. IKEA, a Swedish firm that makes furniture and other products for the home, has opened a factory in the United States in order to reduce delivery costs. Desa, a power tools firm, has returned production from China to the United States because savings on transport and raw materials offset higher labor costs. Also, consider the following examples of reshoring.18 • In 2014, Whirlpool Corp. moved part of its washing machine production from its
- 387. plant in Monterrey, Mexico, to a plant in Clyde, Ohio; the company’s largest wash- ing machine factory. Although wages for production workers in Clyde averaged $18 to $19 an hour, about five times higher than in Monterrey, the firm maintained that the shift would decrease costs overall. Why? The Clyde plant is more automated and 17Steve Denning, “What Went Wrong At Boeing?”, Forbes, January 21, 2013. 18“Here, There and Everywhere: Outsourcing and Offshoring,” The Economist, January 19, 2013; James Hagerty, “Whirlpool Jobs Return to U.S.” The Wall Street Journal, December 20, 2013, p. B-4.; James Hagerty, “America’s Toilet Turnaround,” The Wall Street Journal, September 25, 2013, pp. B-1 and B-8. Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 63 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 388. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. electricity costs are much lower than in Monterrey. Also, Whirlpool could save on transportation because the washing machines would not have to be shipped across a border before going into the company’s American distribution network. Whirlpool also announced that it would increase production of washing machines for Mexico’s market at the Monterrey plant and would not need to reduce its Mexican workforce. Similar to other companies, Whirlpool is trying to produce goods closer to where it sells them, thus decreasing the time required to respond to changes in demand. • After decades of moving production overseas, by 2014 American producers of toilets
- 389. were ramping up production in the United States. Among these companies were Kohler Co., American Standard Brands, and Mansfield Plumbing Co. The reasons for reshoring included the desire to get products to American customers faster, reduce shipping costs, respond quickly to changes in consumer preferences, and offer a “Made in U.S.A.” label that the companies believe is increasingly popular. However, the magnitude of the reshoring movement should not be overstated. Most of the companies involved have been bringing back only some of their production des- tined for the American market. Much of the production that they offshored during the past few decades remains overseas. At the writing of this text, the extent that reshoring will continue for the United States was unclear. SUMMARY 1. To the mercantilists, stocks of precious metals represented the wealth of a nation. The mercanti-
- 390. lists contended that the government should adopt trade controls to limit imports and promote exports. One nation could gain from trade only at the expense of its trading partners because the stock of world wealth was fixed at a given moment in time and because not all nations could simulta- neously have a favorable trade balance. 2. Smith challenged the mercantilist views on trade by arguing that, with free trade, international specializa- tion of factor inputs could increase world output, which could be shared by trading nations. All nations could simultaneously enjoy gains from trade. Smith maintained that each nation would find it advanta- geous to specialize in the production of those goods in which it had an absolute advantage. 3. Ricardo argued that mutually gainful trade is possible even if one nation has an absolute disadvantage in the production of both commodities compared with the other nation. The less productive nation should specialize in the production and export of the com- modity in which it has a comparative advantage. 4. Comparative costs can be illustrated with the pro-
- 391. duction possibilities schedule. This schedule indi- cates the maximum amount of any two products an economy can produce, assuming that all resources are used in their most efficient manner. The slope of the production possibilities schedule measures the MRT that indicates the amount of one product that must be sacrificed per unit increase of another product. 5. Under constant-cost conditions, the production possibilities schedule is a straight line. Domestic relative prices are determined exclusively by a nation’s supply conditions. Complete specialization of a country in the production of a single commod- ity may occur in the case of constant-costs. 6. Because Ricardian trade theory relied solely on supply analysis, it was not able to determine actual terms of trade. This limitation was addressed by Mill in his theory of reciprocal demand. This theory asserts that within the limits to the terms of trade, the actual terms of trade are determined by the intensity of each coun- try’s demand for the other country’s product.
- 392. 7. The comparative advantage accruing to manufac- turers of a particular product in a particular coun- try can vanish over time when productivity growth falls behind that of foreign competitors. Lost com- parative advantages in foreign markets reduce the sales and profits of domestic companies as well as the jobs and wages of domestic workers. 64 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 8. In the real world, nations tend to experience increasing-cost conditions. Thus, production possi- bilities schedules are drawn bowed outward. Rela-
- 393. tive product prices in each country are determined by both supply and demand factors. Complete spe- cialization in production is improbable in the case of increasing costs. 9. According to the comparative-advantage principle, competition forces high-cost producers to exit from the industry. In practice, the restructuring of an industry can take a long time because high-cost producers often cling to capacity by nursing along antiquated plants. Exit barriers refer to various cost conditions that make lengthy exit a rational response for high-cost producers. 10. The first empirical test of Ricardo’s theory of com- parative advantage was made by MacDougall. Comparing the export patterns of the United States and the United Kingdom, MacDougall found that wage rates and labor productivity were important determinants of international trade patterns. A more recent test of the Ricardian model conducted by Golub, also supports Ricardo. KEY CONCEPTS AND TERMS
- 394. Autarky (p. 36) Basis for trade (p. 29) Commodity terms of trade (p. 42) Complete specialization (p. 40) Constant opportunity costs (p. 36) Consumption gains (p. 38) Dynamic gains from international trade (p. 43) Exit barriers (p. 55) Free trade (p. 30) Gains from international trade (p. 29) Importance of being unimportant (p. 42) Increasing opportunity costs (p. 46) Labor theory of value (p. 30) Marginal rate of transformation
- 395. (MRT) (p. 36) Mercantilists (p. 29) No-trade boundary (p. 41) Outer limits for the equilibrium terms of trade (p. 40) Outsourcing (p. 58) Partial specialization (p. 50) Price-specie-flow doctrine (p. 30) Principle of absolute advantage (p. 31) Principle of comparative advantage (p. 32) Production gains (p. 37) Production possibilities schedule (p. 35) Region of mutually beneficial trade (p. 41) Terms of trade (p. 38) Theory of reciprocal demand (p. 41)
- 396. Trade triangle (p. 40) Trading possibilities line (p. 39) STUDY QUESTIONS 1. Identify the basic questions with which modern trade theory is concerned. 2. How did Smith’s views on international trade dif- fer from those of the mercantilists? 3. Develop an arithmetic example that illustrates how a nation could have an absolute disadvantage in the production of two goods and still have a compara- tive advantage in the production of one of them. 4. Both Smith and Ricardo contended that the pat- tern of world trade is determined solely by supply conditions. Explain. 5. How does the comparative-cost concept relate to a nation’s production possibilities schedule? Illustrate how differently shaped production possibilities schedules give rise to different opportunity costs.
- 397. 6. What is meant by constant opportunity costs and increasing opportunity costs? Under what condi- tions will a country experience constant or increasing costs? 7. Why is it that the pre-trade production points have a bearing on comparative costs under increasing-cost conditions but not under condi- tions of constant-costs? 8. What factors underlie whether specialization in production will be partial or complete on an international basis? 9. The gains from specialization and trade are dis- cussed in terms of production gains and consump- tion gains. What do these terms mean? 10. What is meant by the term trade triangle? Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 65 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 398. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 11. With a given level of world resources, international trade may bring about an increase in total world output. Explain. 12. The maximum amount of steel or aluminum that Canada and France can produce if they use all the factors of production at their disposal with the best technology available to them is shown (hypotheti- cally) in Table 2.8. Assume that production occurs under constant- cost conditions. On graph paper, draw the pro- duction possibilities schedules for Canada and France; locate aluminum on the horizontal axis and steel on the vertical axis of each country’s
- 399. graph. In the absence of trade, assume that Canada produces and consumes 600 tons of aluminum and 300 tons of steel and that France produces and consumes 400 tons of aluminum and 600 tons of steel. Denote these autarky points on each nation’s production possibilities schedule. a. Determine the MRT of steel into aluminum for each nation. According to the principle of comparative advantage, should the two nations specialize? If so, which product should each country produce? Will the extent of specialization be complete or partial? Denote each nation’s specialization point on its production possibilities schedule. Compared to the output of steel and alumi- num that occurs in the absence of trade, does specialization yield increases in output? If so, by how much? b. Within what limits will the terms of trade lie if specialization and trade occur? Suppose Canada and France agree to a terms of trade ratio of 1:1 1 ton of steel 1 ton of aluminum . Draw the terms of trade line in the diagram of
- 400. each nation. Assuming 500 tons of steel are traded for 500 tons of aluminum, are Canadian consumers better off as the result of trade? If so, by how much? How about French consumers? c. Describe the trade triangles for Canada and France. 13. The hypothetical figures in Table 2.9 give five alternate combinations of steel and autos that Japan and South Korea can produce if they fully use all factors of production at their disposal with the best technology available to them. On graph paper, sketch the production possibilities schedules of Japan and South Korea. Locate steel on the vertical axis and autos on the horizontal axis of each nation’s graph. a. The production possibilities schedules of the two countries appear bowed out, from the ori- gin. Why? b. In autarky, Japan’s production and consumption points along its production possibilities schedule
- 401. are assumed to be 500 tons of steel and 600 autos. Draw a line tangent to Japan’s autarky point and from it calculate Japan’s MRT of steel into autos. In autarky, South Korea’s production and con- sumption points along its production possibilities schedule are assumed to be 200 tons of steel and 800 autos. Draw a line tangent to South Korea’s autarky point and from it calculate South Korea’s MRT of steel into autos. c. Based on the MRT of each nation, should the two nations specialize according to the princi- ple of comparative advantage? If so, in which product should each nation specialize? d. The process of specialization in the production of steel and autos continues in Japan and South Korea until their relative product prices, or MRTs, become equal. With specialization, sup- pose the MRTs of the two nations converge at MRT 1. Starting at Japan’s autarky point, slide along its production possibilities schedule until the slope of the tangent line equals 1. This becomes Japan’s production point under partial specialization. How many tons of steel and how
- 402. many autos will Japan produce at this point? In TABLE 2.8 Steel and Aluminum Production Canada France Steel (tons) 500 1200 Aluminum (tons) 1500 800 © C en ga ge Le ar ni ng ® TABLE 2.9
- 403. Steel and Auto Production JAPAN SOUTH KOREA Steel (tons) Autos Steel (tons) Autos 520 0 1200 0 500 600 900 400 350 1100 600 650 200 1300 200 800 0 1430 0 810 © C en ga ge Le
- 404. ar ni ng ® 66 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. like manner, determine South Korea’s produc- tion point under partial specialization. How many tons of steel and how many autos will South Korea produce? For the two countries, do their combined production of steel and autos
- 405. with partial specialization exceed their output in the absence of specialization? If so, by how much? e. With the relative product prices in each nation now in equilibrium at 1 ton of steel equal to 1 auto MRT 1 , suppose 500 autos are exchanged at this terms of trade. (1) Determine the point along the terms of trade line at which Japan will locate after trade occurs. What are Japan’s consumption gains from trade? (2) Determine the point along the terms of trade line at which South Korea will locate after trade occurs. What are South Korea’s consumption gains from trade? 14. Table 2.10 gives hypothetical export price indexes and import price indexes 1990 100 for Japan, Canada, and Ireland. Compute the commodity terms of trade for each country for the period 1990– 2006. Which country’s terms of trade improved, worsened, or showed no change?
- 406. 15. Why is it that the gains from trade could not be determined precisely under the Ricardian trade model? 16. What is meant by the theory of reciprocal demand? How does it provide a meaningful explanation of the international terms of trade? 17. How does the commodity terms of trade concept attempt to measure the direction of trade gains? E X P L O R I N G F U R T H E R For a presentation of Comparative Advantage in Money Terms, go to Exploring Further 2.1 that can be found at www.cengage.com/economics/Carbaugh. For a presentation of indifference curves that show the role of each country’s tastes and preferences in determining the autarky points and how gains from trade are distributed, go to Exploring Further 2.2 that can be found at www.cengage.com/economics/Carbaugh. For a presentation of Offer Curves and the Equilibrium Terms of Trade, go to Exploring Further 2.3 that can be found at www.cengage.com/economics/Carbaugh. TABLE 2.10
- 407. Export Price and Import Price Indexes EXPORT PRICE INDEX IMPORT PRICE INDEX Country 1990 2006 1990 2006 Japan 100 150 100 140 Canada 100 175 100 175 Ireland 100 167 100 190 © C en ga ge Le
- 408. ar ni ng ® Chapter 2: Foundations of Modern Trade Theory: Comparative Advantage 67 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 409. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. C H A P T E R 3 Sources of Comparative Advantage In Chapter 2, we learned how the principle of comparative advantage applies to thetrade patterns of countries. The United States, for example, has a comparative advantage in, and exports considerable amounts of chemicals, semiconductors, computers, generating equipment, jet aircraft, agricultural products, and the like. It has comparative disadvantages in, and depends on other countries for cocoa, coffee, tea, raw
- 410. silk, spices, tin, and natural rubber. Imported products also compete with U.S. products in many domestic markets: Japanese automobiles and televisions, Swiss cheese, and Austrian snow skis are some examples. Even the American pastime of baseball relies greatly on imported baseballs and gloves. What determines a country’s comparative advantage? There is no single answer to this question. Sometimes comparative advantage is determined by natural resources or climate, abundance of cheap labor, accumulated skills and capital, and government assistance granted to a particular industry. Some sources of comparative advantage are long lasting, such as huge oil deposits in Saudi Arabia; others can evolve over time like worker skills, education, and technology. In this chapter, we consider the major sources of comparative advantage: differences in technology, resource endowments, and consumer demand, and the existence of government policies, economies of scale in production, and
- 411. external economies. We will also consider the impact of transportation costs on trade patterns. FACTOR ENDOWMENTS AS A SOURCE OF COMPARATIVE ADVANTAGE When Ricardo formulated the principle of comparative advantage he did not explain what ultimately determines comparative advantage. He simply took it for granted that relative labor productivity, labor costs and product prices differed in the two countries before trade. Moreover, Ricardo’s assumption of labor as the only factor of production ruled out an explanation of how trade affects the distribution of income among various factors of pro- duction within a nation and why certain groups favor free trade while other groups oppose it. As we will see, trade theory suggests that some people will suffer losses from free trade. 6 9 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 412. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. In the 1920s and 1930s, Swedish economists Eli Heckscher and Bertil Ohlin for- mulated a theory addressing two questions left largely unexplained by Ricardo: What determines comparative advantage and what effect does international trade have on the earnings of various factors of production in trading nations? Because Heckscher and Ohlin maintained that factor (resource) endowments determine a nation’s comparative advantage, their theory became known as the factor-endowment theory. It is also known as the Heckscher–Ohlin theory.1 Ohlin was awarded the 1977 Nobel prize in economics for his contribution to the theory
- 413. of international trade. The Factor-Endowments Theory The factor-endowment theory asserts that the immediate basis for trade is the differ- ence between pre-trade relative product prices of trading nations. These prices depend on the production possibilities curves and tastes and preferences (demand conditions) in the trading countries. Because production possibilities curves depend on technology and resource endowments, the ultimate determinants of comparative advantage are technology, resource endowments, and demand. The factor- endowment theory assumes that technology and demand are approximately the same between countries; it emphasizes the role of relative differences in resource endowments as the ultimate determinant of comparative advantage.2 Note that it is the resource–endowment ratio, rather than the absolute amount of each resource available, that determines compara- tive advantage.
- 414. According to the factor-endowment theory, a nation will export the product that uses a large amount of the relatively abundant resource, and it will import the product that in production uses the relatively scarce resource. Therefore, the factor-endowment theory predicts that India, with its relative abundance of labor, will export shoes and shirts while the United States, with its relative abundance of capital, will export machines and chemicals. What does it mean to be relatively abundant in a resource? Table 3.1 illustrates hypothetical resource endowments in the United States and China that are used in the production of aircraft and textiles. The U.S. capital/labor ratio equals 0 5 100 machines 200 workers 0 5 that means there is 0.5 machines per worker. In China, the capital/labor ratio is 0 02 20 machines 1,000 workers 0 02 that means there is 0.02 machines per worker. Since the U.S. capital/labor ratio exceeds
- 415. China’s capital/labor ratio, we call the United States the relatively capital abundant country and China the relatively capital-scarce country. Conversely, China is called the relatively labor abundant country and the United States the relatively labor scarce country. 1Eli Heckscher’s explanation of the factor-endowment theory is outlined in his article “The Effects of Foreign Trade on the Distribution of Income,” Economisk Tidskrift, 21 (1919), pp. 497–512. Bertil Ohlin’s account is summarized in his Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). See also Edward Leamer, The Heckscher–Ohlin Model in Theory and Practice, Princeton Studies in International Finance, No. 77, February 1995. 2The factor-endowment theory also assumes that the production of goods is conducted under perfect competition, suggesting that individual firms exert no significant control over product price; that each product is produced under identical production conditions in the two countries; that if a producer increases the use of both resources by a given proportion,
- 416. output will increase by the same proportion; that resources are free to move within a country, so that the price of each resource is the same in the two industries within each country; that resources are not free to move between countries, so that pre- trade payments to each resource can differ internationally; and that there are no transportation costs nor barriers to trade. 70 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. How does the relative abundance of a resource determine comparative advantage
- 417. according to the factor-endowment theory? When a resource is relatively abundant, its relative cost is less than in countries where it is relatively scarce. Therefore, before the two countries trade, their comparative advantages are that capital is relatively cheap in the United States and labor is relatively cheap in China. So, the United States has a lower relative price in aircraft, that use more capital and less labor. China’s relative price is lower in textiles that use more labor and less capital. The effect of resource endowments on comparative advantage can be summarized as follows: The predictions of the factor-endowment theory can be applied to the data in Table 3.2 that illustrates capital/labor ratios for selected countries in 2011. To permit useful international comparisons, total capital stocks per worker are shown in 2005 U.S. dollar prices to reflect the actual purchasing power of the dollar in each country. We see that the United States had less capital per worker than
- 418. some other industrial countries, but more capital per worker than the developing countries. According to the factor-endowment theory, we can conclude that the United States has a comparative advantage in capital-intensive products in relation to developing countries, but not with all industrial countries. TABLE 3.1 Producing Aircraft and Textiles: Factor Endowments in the United States and China Resource United States China Capital 100 machines 20 machines Labor 200 workers 1,000 workers TABLE 3.2 Total Capital Stock per Worker of Selected Countries in 2011* Industrial Country Developing Country
- 419. Japan $297,565 South Korea $233,959 United States 292,658 Mexico 85,597 Germany 251,468 Colombia 67,292 Australia 250,949 Brazil 64,082 Canada 198,930 China 57,703 Sweden 190,793 Philippines 34,913 Russia 107,182 Vietnam 24,721 *In 2005 U.S. dollar prices. Source: From Robert Feenstra, Robert Inklaar, and Marcel Timmer, University of Groningen, Groningen Growth and Development Centre, Penn World Table, Version 8.0, 2013, available at www.rug.nl/research/ggdc/data/penn-world-table. © C en
- 420. ga ge Le ar ni ng ® Differences in relative resource endowments Differences in relative resource prices Differences in relative product prices Pattern of
- 421. comparative advantage Chapter 3: Sources of Comparative Advantage 71 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Visualizing the Factor-Endowment Theory Figure 3.1 provides a graphical illustration of the factor- endowment theory. Figure 3.1 shows the production possibilities curves of the United States, assumed to be the rela- tively capital abundant country, and China, assumed to be the relatively labor abundant country. The figure also assumes that aircraft are relatively
- 422. capital intensive in their production process and textiles are relatively labor intensive in their production process. Because the United States is the relatively capital abundant country and aircraft are the relatively capital-intensive good, the United States has a greater capability in produc- ing aircraft than China. Thus, the production possibilities curve of the United States is skewed (biased) toward aircraft, as shown in Figure 3.1. Similarly, because China is the relatively labor abundant country and textiles are a relatively labor intensive good, China has a greater capability in producing textiles than does the United States. China’s pro- duction possibilities curve is skewed toward textiles. Suppose that in autarky, both countries have the same demand for textiles and aircraft that results in both countries producing and consuming at point A in Figure 3.1(a).3 At this point, the absolute slope of the line tangent to the U.S. production possibilities curve
- 423. is smaller U S MRT 0 33 than that of the absolute slope of the line tangent to China’s production possibilities curve China’s MRT 4 0 . Thus, the United States has a lower relative price for aircraft than China. This finding means that the United States has a comparative advantage in aircraft while China has a comparative advantage in textiles. FIGURE 3.1 The Factor-Endowment Theory Textiles (labor intensive) China’s Production Possibilities Curve U.S. Production Possibilities Curve China’s MRT = 4.0 U.S. MRT = 0.33
- 424. (a) Autarky Equilibrium Aircraft (capital intensive) A6 0 7 Textiles (labor intensive) (b) Post-trade Equilibrium Aircraft (capital intensive) A B C B 13
- 425. 7 6 1 0 3 7 9 15 China’s Production Possibilities Curve U.S. Production Possibilities Curve Terms of Trade (1:1) A country exports the good whose production is intensive in its relatively abundant factor. It imports the good whose production is intensive in its relatively scarce factor. © C en ga
- 426. ge Le ar ni ng ® 3Note that the factor-endowment theory does not require that tastes and preferences be identical for the United States and China. It only requires that they be approximately the same. This approximation means that community indifference curves have about the same shape and position in all countries, as discussed in Exploring Further 2.2 in Chapter 2. For simplicity, Figure 3.1 assumes exact equality of tastes and preferences. 72 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 427. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Although Figure 3.1(a) helps us visualize the pattern of comparative advantage, it does not identify the ultimate cause of comparative advantage. In our trading example, capital is relatively cheap in the relatively capital abundant country (the United States) and labor is relatively cheap in the relatively labor abundant country (China). It is because of this difference in relative resource prices that the United States has a comparative advantage in the relatively capital-intensive good (aircraft) and China has a comparative advantage in the relatively labor intensive good (textiles). The factor endowment theory asserts that the difference in relative resource abundance is the cause of the pre-trade differences in the
- 428. relative product prices between the two countries. Most of the analysis of the gains from trade in Chapter 2 applies to the factor- endowment model seen in Figure 3.1(b). With trade, each country continues to specialize in the production of the product of its comparative advantage until its product price equalizes with that of the other country. Specialization continues until the United States reaches point B and China reaches point B, the points where each country’s production possibilities curve is tangent to the common relative price line that is assumed to have an absolute slope of 1.0. This relative price line becomes the equilibrium terms of trade. Let’s assume that with trade both nations prefer a post-trade consumption combination of aircraft and textiles given by point C. To achieve this point, the United States exports six aircraft for six units of textiles and China exports six units of textiles for six aircraft. Because point C is beyond the autarky consumption point A, each country realizes gains from trade.
- 429. The factor-endowment model explains well why labor abundant countries such as China would export labor intensive products such as textiles and toys and capital abundant countries such as the United States would export aircraft and machinery. How- ever, it does not adequately explain two-way trade that widely exists: many countries export steel and automobiles, but they also import them. Also, the factor-endowment theory does not satisfactorily explain why wealthy countries such as the United States and Europe that have similar endowments of labor and capital, trade more intensively with those with dissimilar endowments. You will learn about additional trade theories as you read this chapter. Applying the Factor-Endowment Theory to U.S.–China Trade The essence of the factor-endowment theory is seen in trade between the United States and China. In the United States, human capital (skills), scientific talent, and engineering talent are relatively abundant, but unskilled labor is relatively
- 430. scarce. Conversely, China is relatively rich in unskilled labor while relatively scarce in scientific and engineering talent. Thus, the factor-endowment theory predicts that the United States will export to China goods embodying relatively large amounts of skilled labor and technology, such as aircraft, software, pharmaceuticals, and high-tech components of electrical machinery and equipment; China will export to the United States goods for which a relatively large amount of unskilled labor is used, such as apparel, footwear, toys, and the final assembly of electronic machinery and equipment. Table 3.3 lists the top U.S. merchandise exports to China and the top Chinese merchandise exports to the United States in 2012. The pattern of U.S.–China trade appears to fit quite well to the predictions of the factor- endowment theory. Most of the U.S. exports to China were concentrated in higher skilled industries such as computers, chemicals, and transportation equipment including aircraft. Conversely, Chinese exports
- 431. to the United States tended to fall into the lower skilled industries such as electronics, toys, sporting equipment, and apparel. These trade data provide only a rough overview of U.S.–Chinese trade patterns and do not prove the validity of the factor-endowment theory. Chapter 3: Sources of Comparative Advantage 73 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chinese Manufacturers Beset By Rising Wages and a Rising Yuan For several decades, a vast pool of inexpensive labor fostered
- 432. China’s manufacturing boom. China’s workers have toiled for a small fraction of the cost of their American or European competitors. However, as China’s economy has expanded, its workers have become harder to find and keep, especially on the coasts where China’s exporting factories are clustered. China’s one-child policy has resulted in the number of young adults shrinking, resulting in labor scarcity. Moreover, although the country’s inland villages contain millions of potential workers for its coastal factories, China’s land policies and household registration system discourage migration to the cities. Villagers risk losing family plots if they do not tend them. They cannot enroll their children in city schools or benefit from other government services until they have been officially declared as permanent urban residents that can take years. The supply of factory workers is not infinite, even in China. With fewer workers heading to China’s manufacturing zones, the result is upward pres- sure on wages. Unrest has increased in China as workers have
- 433. demonstrated for higher wages: strikes, stoppages, and suicides have afflicted companies such as Honda that have fac- tories on China’s coast. Higher wages at home and low wage competition from countries such as Vietnam are making it more difficult for China to maintain rapid export growth. Many economists maintain that the high growth phase will soon run out. Increasingly, China will have to rely on technology, infrastructure, and education as sources of growth. Although higher wages will improve the lives of urban workers, they will make it more difficult for Chinese exporters of low end merchandise like toys and apparel to continue to compete on price. Exporters will have to increase productivity to make up for higher wages and begin producing higher end products that are less sensitive to price increases. If wages increase in China, its workers would have more money to spend, some that will be spent on imported goods. This spending will result in increasing pressure on trade, a main drive of China’s economic growth.
- 434. Consider Lever Style Inc., a Chinese manufacturer of blouses and shirts. In 2013, the firm began moving apparel production to Vietnam where wages were less than half those in China; the firm expected that Vietnam would be producing about 40 percent of its clothes within a few years. Lever Style’s management considered the relocation as a matter of survival. After a decade of almost 20 percent annual wage increases in China, Lever Style said that it was increasingly difficult to make money in China. As production shifts to Vietnam, Lever Style said it could offer its customers discounts up to 10 percent per garment. That is attractive to American retailers, whose profit margins tend to TABLE 3.3 U.S.–China Merchandise Trade: 2012 (billions of dollars) U.S. EXPORTS TO CHINA U.S. IMPORTS FROM CHINA Product Value Percent Product Value Percent
- 435. Agricultural products 20.7 18.7 Electronics 158.4 37.2 Computers and electronics 13.9 12.6 Toys, sporting equipment 36.6 8.6 Transportation equipment 15.7 14.2 Apparel 32.1 7.5 Chemicals 12.9 11.7 Electrical equipment 30.5 7.2 Machinery 9.9 8.9 Leather products 24.6 5.8 All others 37.4 33.9 All others 143.4 33.7 Total 110.5 100.0 Total 425.6 100.0 Source: From U.S. Department of Commerce, International Trade Administration, available at http://www.ita.doc.gov. Scroll down to TradeStats Express (http://tse.export.gov/) and to National Trade Data. See also Foreign Trade Division, U.S. Census Bureau. 74 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May
- 436. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. average one percent to two percent. Although the move is intended to allow Lever Style’s prices to be held in check, competition for labor in places like Vietnam and Cambodia is pushing up wages in those countries as well.4 Another factor contributing to China’s export woes is the strengthening (appreciating) yuan. As discussed in Chapter 15, the United States has long maintained that the yuan has been kept artificially low to boost China’s exports, and that the yuan is undervalued. However, from 2011 to 2014 (at the writing of this textbook), the yuan’s exchange value
- 437. was appreciating against the dollar that made China’s goods more expensive overseas and decreased profits in local currency terms. Therefore, some low end manufacturers were abandoning China for cheaper locations abroad. Higher wages and a stronger yuan alone are not sufficient to cause firms to leave China. The country has the world’s best supply chains of parts and components for industries and its infrastructure works well. Moreover, China has become a huge market in its own right. Therefore, China will likely remain an attractive site for many manufacturers. T R A D E C O N F L I C T S G L O B A L I Z A T I O N D R I V E S C H A N G E S F O R U . S . A U T O M A K E R S The history of the U.S. automobile industry can be divided into distinct eras: the emergence of Ford Motor Company as a dom- inant producer in the early 1900s; the shift of domi- nance to General Motors in the 1920s; and the rise of
- 438. foreign competition since the 1970s. Foreign producers have become effective rivals of the Big Three (GM, Ford, and Chrysler) which used to be insulated from competitive pressures on their costs and product quality. The result has been a steady decrease in the Big Three’s share of the U.S. automo- bile market from more than 70 percent in 1999 to about 45 percent in 2011. For decades, the competitive threat of foreign companies was greatest in the small car seg- ment of the U.S. market. Now, the Big Three also face stiff competition on the lucrative turf of pickup trucks, minivans, and sport utility vehicles. Several factors detracted from the cost competitive- ness of the Big Three during the first decade of the 2000s. First, the Big Three were saddled with large pen- sion obligations and health care costs for their, negoti- ated by the United Auto Workers (UAW) and the Big Three when times were better for these firms. These benefit costs were much higher than for American workers of nonunionized Toyota and Honda, with their younger workforces and fewer retirees. Relatively high wages represented another cost disadvantage of the Big Three. In 2008, for example, wages for Big
- 439. Three production workers averaged about 33 percent more than for American production workers at Toyota and Honda. Industry analysts estimate that labor cost accounts for about 10 percent of the cost of manufacturing an automobile. Moreover, Toyota and Honda have been widely viewed as the most efficient producers of automobiles in the world. As global competition intensified and the U.S. econ- omy fell into the Great Recession of 2007–2009, the Big Three’s sales, market share, and profitability deterio- rated. In 2009, GM and Chrysler declared bankruptcy. Therefore, the UAW agreed to a series of concessions to preserve the jobs of their members. They accepted higher premiums and copayments for health care and they set up a second tier wage for entry level workers at about half the wage for current workers. UAW work- ers also agreed to suspend bonuses and cost of living increases. These adjustments brought the pay of Big Three production workers closer to that of their Japa- nese competitors. However, auto workers in the United States are paid much higher wages and benefits than auto workers in China, India, and South America.
- 440. As competition in the U.S. auto market has become truly international, it is highly unlikely that the Big Three will ever regain the dominance that on allowed them to dictate which vehicles Americans bought and at what prices. Toyota and Honda will likely remain as major threats to their financial stability. 4Deborah Kan, China Inc. Moves Offshore, Reuters Video Gallery, July 20, 2011, at www.reuters.com/ video/; Kathy Chu, “China Manufacturers Survive by Moving to Asian Neighbors,” The Wall Street Journal, May 1, 2013 and “China Grapples With Labor Shortage as Workers Shun Factories,” The Wall Street Journal, May 1, 2013. iS to ck ph ot o. co
- 441. m /p ho to so up Chapter 3: Sources of Comparative Advantage 75 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Factor-Price Equalization
- 442. In Chapter 2, we learned that international trade tends to equalize product prices among trading partners. Can the same be said for resource prices?5 To answer this question, consider Figure 3.2. The figure continues our example of comparative advantage in aircraft and textiles by illustrating the process of factor-price equalization. Recall that the Chinese demand for inexpensive American aircraft results FIGURE 3.2 The Factor-Price Equalization Theory (a) Trade Alters the Mix of Factors (resources) Used in Production (b) Trade Promotes Factor Prices Moving into Equality across Countries United States Textiles (labor intensive)
- 443. Aircraft (capital intensive) More capital Less labor A 6 1 0 7 15 B´ China Textiles (labor intensive) Aircraft (capital intensive) More
- 444. labor Less capital A B 6 13 0 73 Price of Capital Pretrade, China Equalization of the price of capital Pretrade, United States
- 445. Price of Labor Pretrade, United States Equalization of the price of labor Pretrade, China By forcing product prices into equality, international trade also tends to force factor prices into equality across countries. © C en ga ge Le
- 446. ar ni ng ® 5See Paul A. Samuelson, “International Trade and Equalization of Factor Prices,” Economic Journal, June 1948, pp. 163–184, and “International Factor-Price Equalization Once Again,” Economic Journal, June 1949, pp. 181–197. 76 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 447. in an increased American demand for its abundant resource, capital; the price of capi- tal thus rises in the United States. As China produces fewer aircraft, its demand for capital decreases, and the price of capital falls. The effect of trade is to equalize the price of capital in the two nations. Similarly, the American demand for cheap Chinese textiles leads to an increased demand for labor in China, its abundant resource; the price of labor rises in China. With the United States producing fewer textiles, its demand for labor decreases and the price of labor falls. With trade, the price of labor tends to equalize in the two trading partners. We conclude that by redirecting demand away from the scarce resource and toward the abundant resource in each nation, trade leads to factor-price equalization. In each nation, the cheap resource becomes relatively more expensive, and the expensive resource becomes relatively less expensive until price equalization occurs.
- 448. Indian computer engineers provide an example of factor-price equalization. Without immigration restrictions, the computer engineers could migrate to the United States where wage rates are much higher, thus increasing the relative supply of computer engi- neering skills and lessening the upward pressure on computer engineering wages in the United States. Although such migration has occurred it has been limited by immigration restrictions. What was the market’s response to the restrictions? Computer engineering skills that could no longer be supplied through migration now arrive through trade in services. Computer engineering services occur in India and are transmitted via the Inter- net to business clients in the United States and other countries. In this manner, trade serves as a substitute for immigration. The forces of globalization have begun to even things out between the United States and India. As more U.S. tech companies poured into India in the first decade of the 2000s, they soaked up the pool of high end computer
- 449. engineers who were mak- ing about 25 percent of what their counterparts earned in the United States. The result was increasing competition for the most skilled Indian computer engineers and a nar- rowing U.S.–India gap in their compensation. By 2007, India’s Software and Service Association estimated wage inflation in its industry at 10 to 15 percent a year, while some tech executives said it was closer to 50 percent. In the United States, wage inflation in the software sector was less than three percent. For experienced, top level Indian engineers, salaries increased to between $60,000 and $100,000 a year, pressing against salaries earned by computer engineers in the United States. Wage equalization was occurring between India and the United States. Taking into account the time difference with India, some Silicon Valley firms concluded that they were not saving any money by locating there anymore and began to bring jobs home to American workers.
- 450. Although the tendency toward the equalization of resource prices may sound plausi- ble, in the real world, we do not see full factor-price equalization. Table 3.4 shows 2011 indexes of hourly compensation for nine countries Wages differed by a factor of about ten from workers in the highest wage country (Norway) to workers in the lowest wage country (Mexico). There are several reasons why differences in resource prices exist. Most income inequality across countries results from uneven ownership of human capital. The factor-endowment model assumes that all labor is identical. However, labor across countries differs in terms of human capital that includes education, training, skill, and the like. We do not expect a computer engineer in the United States with a Ph.D. and 25 years’ experience to be paid the same wage as a college graduate taking his/her first job as a computer engineer in Peru. Also, the factor-endowment model assumes that all countries use the same technology
- 451. for producing a particular good. When a new and better technology is developed, it tends to replace older technologies. This process can take a long time, especially between Chapter 3: Sources of Comparative Advantage 77 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. advanced and developing countries. Returns paid to resource owners across countries will not equalize when two countries produce the same good using different technologies. Machinery workers using superior production technologies in Germany tend to be paid
- 452. more than workers using inferior production technologies in Algeria. Transportation costs and trade barriers can prevent product prices from equalizing. Such market imperfections reduce the volume of trade, limiting the extent that product prices and resource prices can become equal. Resource prices may not fully equalize across nations can be explained in part by the assumptions underlying the factor-endowment theory are not completely borne out in the real world. Who Gains and Loses from Trade? The Stolper–Samuelson Theorem Recall that in Ricardo’s theory, a country as a whole benefits from comparative advantage. Also, Ricardo’s assumption of labor as the only factor of production rules out an explanation of how trade affects the distribution of income among various factors of production within a nation, and why certain groups favor free trade whereas other
- 453. groups oppose it. In contrast, the factor-endowment theory provides a more comprehen- sive way to analyze the gains and losses from trade. The theory does this by providing predictions of how trade affects the income of groups representing different factors of production such as workers and owners of capital. The effects of trade on the distribution of income are summarized in the Stolper– Samuelson theorem, an extension of the theory of factor-price equalization.6 According to this theorem, the export of a product that embodies large amounts of a relatively cheap, abundant resource makes this resource more scarce in the domestic market. The increased demand for the abundant resource results in an increase in its price and an increase in its income. At the same time, the income of the resource used intensively in the import-competing product (the initially scarce resource) decreases as its demand falls. The increase in the income to each country’s abundant resource comes at the expense of the scarce resource’s income. The Stolper–
- 454. Samuelson theorem states that an TABLE 3.4 Indexes of Hourly Compensation for Manufacturing Workers in 2011 (U.S. = 100) Norway 181 Germany 133 Austria 121 Netherlands 119 Canada 103 Japan 101 South Korea 53 Brazil 33 Mexico 18
- 455. Source: From U.S. Department of Labor, Bureau of Labor Statistics, available at Web site http://www.bls.gov. Scroll to International Labor Comparisons and to Indexes of Hourly Compensation in U.S. Dollars (U.S. = 100). 6Stolper, W. F. and P. A. Samuelson, “Protection and Real Wages.” Review of Economic Studies, Vol. 9, pp. 58–73, 1941. 78 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. increase in the price of a product increases the income earned
- 456. by resources that are used intensively in its production. Conversely, a decrease in the price of a product reduces the income of the resources that it uses intensively. Note that the Stolper–Samuelson theorem does not state that all the resources used in the export industries are better off, or that all the resources used in the import- competing industries are harmed. Rather, the abundant resource that fosters comparative advantage realizes an increase in income and the scarce resource realizes a decrease in its income regardless of industry. Trade theory concludes that some people will suffer losses from free trade, even in the long-term. Although the Stolper–Samuelson theorem provides some insights regarding the income distribution effects of trade, it tells only part of the story. An extension of the Stolper–Samuelson theorem is the magnification effect that suggests the change in the price of a resource is greater than the change in the price of the good that uses the
- 457. resource intensively in its production process. Suppose that as the United States starts trading, the price of aircraft increases by six percent and the price of textiles decreases by three percent. According to the magnification effect, the price of capital must increase by more than six percent, and the price of labor must decrease by more than two per- cent. If the price of capital increases by eight percent, owners of capital are better off because their ability to consume aircraft and textiles (that is, their real income) is increased. However, workers, because their ability to consume the two goods is decreased (their real income falls), are worse off. In the United States, owners of capital gain from free trade while workers lose. The Stolper–Samuelson theorem has important policy implications. The theorem sug- gests that even though free trade may provide overall gains for a country, there are win- ners and losers. Given this conclusion, it is not surprising that owners of abundant resources tend to favor free trade, while owners of scarce
- 458. factors tend to favor trade restrictions. The U.S. economy has an abundance of skilled labor, so its comparative advantage is in producing skill-intensive goods. The factor- endowment model suggests that the United States will tend to export goods requiring relatively large amounts of skilled labor and import goods requiring large amounts of unskilled labor. International trade in effect increases the supply of unskilled labor to the U.S. economy, lowering the wages of unskilled American workers compared to those of skilled workers. Skilled workers—who are already at the upper end of the income distribution—find their incomes increasing as exports expand, while unskilled workers are forced into accepting even lower wages in order to compete with imports. According to the factor-endowment theory, then, international trade can aggravate income inequality, at least in a country such as the United States where skilled labor is abundant. This is a reason why unskilled workers in the United States often support trade restrictions.
- 459. Is International Trade a Substitute for Migration? Immigrants provide important contributions to the U.S. economy. They help the economy grow by increasing the size of the labor force, they assume jobs at the lower end of the skill distribution where few native born Americans are available to work, and they take jobs that contribute to the United States being a leader in tech- nological innovation. In spite of these advantages, critics maintain that immigrants take jobs away from Americans, suppress domestic wages, and consume sizable amounts of public services. They contend that legal barriers are needed to lessen the flow of immigrants into the United States. If the policy goal is to reduce immi- gration, could international trade be used to achieve this result rather than adopting legal barriers? The factor-endowment model of Heckscher and Ohlin addresses this question. Chapter 3: Sources of Comparative Advantage 79
- 460. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. According to the factor-endowment theory, international trade can provide a substi- tute for the movement of resources from one country to another in its effects on resource prices. The endowments of resources among the countries of the world are not equal. A possible market effect would be movements of capital and labor from countries where they are abundant and inexpensive to countries where they are scarce and more costly, thus decreasing the price differences. The factor-endowment theory also supports the idea that such
- 461. international move- ments in resources are not essential, because the international trade in products can achieve the same result. Countries that have abundant capital can specialize in capital- intensive products and export them to countries where capital is scarce. In a sense, capital is embodied in products and redistributed through international trade. The same conclusion pertains to land, labor, and other resources. A key effect of an international movement of a resource is to change the scarcity or abundance of that resource and alter its price; that is, to increase the price of the abun- dant resource by making it more scarce compared to other resources. When Polish workers migrate to France, wage rates tend to increase in Poland because labor becomes somewhat more scarce there; also, wage rates in France tend to decrease (or at least increase more slowly than they would otherwise) because the scarcity of labor declines. The same outcome occurs when the French purchase Polish products that are
- 462. manufactured by labor intensive methods: Polish export industries demand more workers, and Polish wages tend to increase. In this manner, international trade can serve as a substitute for international movements of resources through its effect on resource prices.7 An example of international trade as a substitute for labor migration is the North American Free Trade Agreement of 1995. Signed by Canada, Mexico, and the United States, the agreement eliminated trade restrictions among the three nations. At that time, former President Bill Clinton noted that NAFTA would result in an even more rapid closing of the gap between the wage rates of Mexico and the United States. As the benefits of economic growth spread in Mexico to working people, they will have more income to buy American products and there will be less illegal immigration because more Mexicans will be able to support their children by staying home. While NAFTA may have helped lessen the flow of
- 463. migrants from Mexico to the United States, other factors continued to encourage migration—high birth rates in Mexico, the collapse of the peso that resulted in recession, and the loss of jobs to other countries, especially China, where average wages are less than half of Mex- ico’s. Although international trade and economic growth would lessen the flow of Mexicans to the United States, achieving this result would take years, perhaps decades. International trade and labor migration are not necessarily substitutes: they may be complements, especially over the short and medium terms. As trade expands and an economy attempts to compete with imports, some of its workers may become unem- ployed. The uprooting of these workers may force some of them to seek employment abroad where job prospects are better. In this manner, increased trade can result in an increase in migration flows. During the first decade of the 2000s, Mexico lost thousands
- 464. of jobs to China, whose average wages were half of Mexico’s and whose exports to other countries were increasing. This loss provided additional incentive for Mexican workers to migrate to the United States to find jobs. The topic of immigration is further discussed in Chapter 9. 7Robert Mundell, “International Trade and Factor Mobility,” American Economic Review, June 1957. 80 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 465. Specific Factors: Trade and the Distribution of Income in the Short Run A key assumption of the factor-endowment model and its Stolper–Samuelson theorem is that resources such as labor and capital can move effortlessly among industries within a country while they are completely immobile among countries. For example, Japanese workers are assumed to be able to shift back and forth between automobile and rice production in Japan, although they cannot move to China to produce these products. Although such factor mobility among industries may occur in the long-term, many factors are immobile in the short-term. Physical capital (such as factories and machin- ery) is generally used for specific purposes; a machine designed for computer production cannot suddenly be used to manufacture jet aircraft. Similarly, workers often acquire certain skills suited to specific occupations and cannot immediately be assigned to other occupations. These types of factors are known in trade theory as specific factors. Specific
- 466. factors are those that cannot move easily from one industry to another. Thus, the specific-factors theory analyzes the income distribution effects of trade in the short- term when resources are immobile among industries. This is in contrast to the factor- endowment theory and its Stolper–Samuelson theorem that apply to the long-term mobility of resources in response to differences in returns. To understand the effects of specific factors and trade, consider steel production in the United States. Suppose that capital is specific to producing steel, labor is mobile between the steel industry and other industries, and capital is not a substitute for labor in producing steel. Also suppose that the United States has a comparative disadvantage in steel. With trade, output decreases in the import-competing steel industry. As the relative price of steel decreases, labor moves out of the steel industry to take employment in export industries having comparative advantage. This movement causes the fixed stock of capital to become less productive for U.S. steel
- 467. companies. As output per machine declines, the returns to capital invested in the steel industry decrease. At the same time, as output in export industries increases, labor moves to these industries and begins working. Hence, output per machine increases in the export industries, and the return to capital increases. The specific-factors theory concludes that resources specific to import-competing industries tend to lose as a result of trade, while resources specific to export industries tend to gain as a result of trade. This analysis helps explain why U.S. steel companies since the 1960s have lobbied for import restrictions to protect their specific factors that suffer from foreign competition. The specific-factors theory helps explain Japan’s rice policy. Japan permits only small quantities of rice to be imported, even though rice production in Japan is more costly than in other nations such as the United States. It is widely recognized that Japan’s over- all welfare would rise if free imports of rice were permitted. However, free trade would
- 468. harm Japanese farmers. Although rice farmers displaced by imports might find jobs in other sectors of Japan’s economy, they would find changing employment to be time con- suming and costly. Moreover, as rice prices decrease with free trade, so would the value of Japanese farming land. It is no surprise that Japanese farmers and landowners strongly object to free trade in rice; their unified political opposition has influenced the Japanese government more than the interests of Japanese consumers. Exploring Further 3.1 pro- vides a more detailed presentation of the specific-factors theory; it can be found at www.cengage.com/economics/Carbaugh. Does Trade Make the Poor Even Poorer? Before leaving the factor-endowment theory, consider this question: Is your income pulled down by workers in Mexico or China? That question has underlined many Chapter 3: Sources of Comparative Advantage 81 Copyright 2015 Cengage Learning. All Rights Reserved. May
- 469. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Americans’ fears about their economic future. They worry that the growth of trade with low wage developing nations could reduce the demand for low skilled workers in the United States and cause unemployment and wage decreases for U.S. workers. The wage gap between skilled and unskilled workers has widened in the United States during the past 40 years. Over the same period, imports increased as a percentage of gross domestic product. These facts raise two questions: Is trade harming unskilled workers? If it is, then is this an argument for an increase in
- 470. trade barriers? Economists agree that some combination of trade, technology, education, immigra- tion, and union weakness has held down wages for unskilled American workers; but apportioning the blame is tough, partly because income inequality is so pervasive. Economists have attempted to disentangle the relative contributions of trade and other influences on the wage discrepancy between skilled workers and unskilled workers. Their approaches share the analytical framework shown by Figure 3.3. This framework views the wages of skilled workers “relative” to those of unskilled workers as the outcome of the interaction between supply and demand in the labor market. The vertical axis of Figure 3.3 shows the wage ratio that equals the wage of skilled workers divided by the wage of unskilled workers. The figure’s horizontal axis shows the labor ratio, that equals the quantity of skilled workers available divided by the
- 471. quantity of unskilled workers. Initially we assume that the supply curve of skilled workers relative to unskilled workers is fixed and is denoted by S0. The demand curve for skilled workers relative to unskilled workers is denoted by D0. The equilibrium wage ratio is 2.0, found at the intersection of the supply and demand curves, and sug- gests that the wages of skilled workers are twice as much as the wages of unskilled workers. FIGURE 3.3 Inequality of Wages between Skilled and Unskilled Workers 1.5 2.0 2.5 Labor Ratio 2.5 2.0 1.5
- 472. 0 W a g e R a tio D0 D1 S1S0S2 By increasing the demand for skilled relative to unskilled workers, expanding trade or technological improve- ments result in greater inequality of wages between skilled and unskilled workers. Also, immigration of unskilled workers intensifies wage inequality by decreasing the supply of skilled workers relative to unskilled workers. However, expanding opportunities for college education results in an increase in the supply of skilled relative to
- 473. unskilled workers, thus reducing wage inequality. In the figure, the wage ration equals wage of skilled workers/ wage of unskilled workers. The labor ratio equals the quantity of skilled workers/quantity of unskilled workers. © C en ga ge Le ar ni ng ® 82 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 474. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. In the figure, a shift in either the supply curve or demand curve of skilled workers available relative to unskilled workers will induce a change in the equilibrium wage ratio. Let us consider resources that can affect wage inequality in the United States. • International trade and technological change. Trade liberalization and falling trans- portation and communication costs result in an increase in the demand curve of skilled workers relative to unskilled workers, say, to D1 in the figure. Assuming a constant supply curve, the equilibrium wage ratio rises to 2.5, suggesting that the wages of skilled workers are 2.5 times as much as the wages of
- 475. unskilled workers. Similarly, skill biased technological improvements lead to an increase in the demand for skilled workers relative to unskilled workers, thus promoting higher degrees of wage inequality. • Immigration. Immigration of unskilled workers results in a decrease in the supply of skilled workers relative to unskilled workers. Assuming that the demand curve is constant, as the supply curve shifts from S0 to S2, the equilibrium wage ratio rises to 2.5, thus intensifying wage inequality. • Education and training. As the availability of education and training increases, so does the ratio of skilled workers to unskilled workers, as seen by the increase in the supply curve from S0 to S1. If the demand curve remains constant, then the equilibrium wage ratio will fall from 2.0 to 1.5. Additional opportunities for education and training thus serve to reduce the wage inequality between skilled and unskilled workers.
- 476. We have seen how trade and immigration can promote wage inequality. However, economists have found that their effects on the wage distribution have been small. In fact, the vast majority of wage inequality is because of domestic sources, especially technology. One often cited study by William Cline, estimated that during the past three decades technological change has been about four times more powerful in widen- ing wage inequality in the United States than trade, and that trade accounted for only 7.0 percentage points of all the unequalizing forces at work during that period. His conclu- sions are reinforced by the research of Robert Lawrence that concludes rising wage inequality during the first decade of the 2000s more closely corresponds to asset-market performance and technological and institutional innovations than to international trade in goods and services. The minor importance of trade implies that any policy that focuses narrowly on trade to deal with wage inequality is likely to be ineffective8
- 477. Economists generally agree that trade has been relatively unimportant in widening wage inequality. Also, trade’s impact on wage inequality is overwhelmed not just by tech- nology but also by education and training. Indeed, the shifts in labor demand away from less educated workers are the most important factors behind the eroding wages of the less educated. Such shifts appear to be the result of economy wide technological and organizational changes in how work is performed. IS THE FACTOR-ENDOWMENT THEORY A GOOD PREDICTOR OF TRADE PATTERNS? Following the development of the factor-endowment theory, little empirical evidence was brought to bear about its validity. All that came forth were intuitive examples such as labor abundant India exporting textiles or shoes; capital abundant Germany exporting 8William Cline, Trade and Income Distribution, Institute for International Economics, Washington, DC,
- 478. 1997, p. 264 and Robert Lawrence, Blue Collar Blues: Is Trade to Blame for Rising U.S. Income Inequal- ity? Institute for International Economics, Washington DC, 2008, pp. 73–74. Chapter 3: Sources of Comparative Advantage 83 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. machinery and automobiles; or land abundant Australia exporting wheat and meat. However, some economists demanded stronger evidence concerning the validity of the factor-endowment theory.
- 479. The first attempt to investigate the factor-endowment theory empirically was under- taken by Wassily Leontief in 1954.9 It had been widely recognized that in the United States capital was relatively abundant and labor was relatively scarce. According to the factor-endowment theory, the United States will export capital- intensive goods and its import-competing goods will be labor intensive. Leontief tested this proposition by ana- lyzing the capital/labor ratios for some 200 export industries and import-competing industries in the United States, based on trade data for 1947. Leontief found that the capital/labor ratio for U.S. export industries was lower (about $14,000 per worker year) than that of its import-competing industries (about $18,000 per worker year). Leontief concluded that exports were less capital-intensive than import- competing goods. These findings that contradicted the predictions of the factor- endowment theory, became known as the Leontief paradox. To strengthen his conclusion, Leontief repeated his investigation in 1956 only to again find that U.S. import-
- 480. competing goods were more capital intensive than U.S. exports. Leontief’s discovery was that America’s comparative advantage was something other than capital-intensive goods. The doubt cast by Leontief on the factor-endowment theory sparked many empirical studies. These tests have been mixed. They conclude that the factor-endowment theory is relatively successful in explaining trade between industrialized and developing countries. The industrialized countries export capital-intensive (and temperate-climate land-inten- sive) products to developing countries, and import labor and tropical land-intensive goods from them. However, a large amount of international trade is not between indus- trialized and developing countries, but among industrialized countries with similar resource endowments. This suggests that the determinants of trade are more complex than those illustrated in the basic factor-endowment theory. Factors such as technology, economies of scale, demand conditions, imperfect competition, and a time dimension to
- 481. comparative advantage must also be considered. In the following sections, we will exam- ine these factors. SKILL AS A SOURCE OF COMPARATIVE ADVANTAGE One resolution of the Leontief paradox depends on the definition of capital. The exports of the United States are not intensive in capital such as tools and factories. Instead, they are skill-intensive, meaning that they are intensive in “human capital.” U.S. exporting industries use a significantly higher proportion of highly educated workers to other workers as compared to U.S. import-competing industries. Boeing represents one of America’s largest exporting companies. Boeing employs large numbers of mechanical and computer engineers having graduate degrees relative to the number of manual work- ers. Conversely, Americans import lots of shoes and textiles that are often manufactured by workers with little formal education. In general, countries endowed with highly-educated workers
- 482. have their exports concentrated in skill-intensive goods, while countries with less educated workers export goods that require little skilled labor. Figure 3.4 provides an example of this tendency. It compares the goods the United States imports from Germany, where the average adult 9Wassily W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Reexa- mined,” Proceedings of the American Philosophical Society 97, September 1953. 84 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 483. has in excess of ten years of formal education, with the goods the United States imports from Bangladesh, where the average adult has only 2.5 years of formal education. In each country, industries are ranked according to their skill intensity: increasing skill intensity is shown by a rightward movement along the horizontal axis of the figure. The figure shows that Germany captures large shares of U.S. imports of skill-intensive goods, and much smaller shares for goods that sparingly require skilled labor. This is seen by the schedule representing Germany (GG) to be upward sloping: as a German industry becomes more skill intensive, its share of exports to the United States increases. Con- versely, Bangladesh exhibits the opposite trade pattern with its exports to the United States concentrated in goods that require little skilled labor. Given the downward slope of Ban- gladesh’s schedule (BB), as a Bangladesh industry becomes less skill intensive, its share of exports to the United States increases. The figure concludes that
- 484. countries capture larger shares of the world trade of goods that more intensively use their abundant factors. ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE For some goods, economies of scale may be a source of comparative advantage. Economies of scale (increasing returns to scale) exist when expansion of the scale of production capacity of a firm or industry causes total production costs to increase less proportionately than output. Therefore, long-run average costs of production decrease. Economies of scale are classified as internal economies and external economies.10 FIGURE 3.4 Education, Skill Intensity, and U.S. Import Shares, 1998 S h a re
- 486. d e sh , b y in d u st ry Skill intensity of industry B G G B
- 489. 0.3 0.1 0.2 12% 10 8 6 4 2 0.050 0.10 0.15 0.20 0.25 0.30 0.35 0.40 The figure suggests that countries that are abundant in skilled labor capture larger shares of U.S. imports in industries that intensively use those factors. Conversely, countries that are abundant in unskilled labor capture
- 490. larger shares of U.S. imports in industries that intensively use those factors. Adapted from John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review, Vol. 94, No. 1, 2004, pp. 67–97. 10Paul Krugman, “New Theories of Trade Among Industrial Countries,” American Economic Review, 73, No. 2, May 1983, pp. 343–347, and Elhanan Helpman, “The Structure of Foreign Trade,” Journal of Eco- nomic Perspectives, 13, No. 2, Spring 1999, pp. 121–144. Chapter 3: Sources of Comparative Advantage 85 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 491. Internal Economies of Scale Internal economies of scale arise within a firm itself and are built into the shape of its long-run average cost curve. For an automobile producer, the first auto is expensive to produce, but each subsequent auto costs much less than the one before because the large setup costs can be spread across all units. Companies such as Toyota reduce unit costs because of labor specialization, managerial specialization, efficient capital, and other factors. As the firm expands its output by increasing the size of its plant, it slides downward along its long-run average cost curve because of internal economies of scale. Figure 3.5 illustrates the effect of economies of scale on trade. Assume that a U.S. auto firm and a Mexican auto firm are each able to sell 100,000 vehicles in their respective countries. Also assume that identical cost conditions result in the same long-run average
- 492. cost curve for the two firms, AC. Note that scale economies result in decreasing unit costs over the first 275,000 autos produced. Initially, there is no basis for trade, because each firm realizes a production cost of $10,000 per auto. Suppose that rising income in the United States results in demand for 200,000 autos, while the Mexican auto demand remains constant. The larger demand allows the U.S. firm to produce more output and take advantage of economies of scale. The firm’s cost curve slides downward until its cost equals $8,000 per auto. Compared to the Mexican firm, the U.S. firm can produce autos at a lower cost. With free trade, the United States will now export autos to Mexico. Internal economies of scale provide additional cost incentives for specialization in production. Instead of manufacturing only a few units of each product that domestic FIGURE 3.5
- 493. Economies of Scale as a Basis for Trade 0 7,500 8,000 10,000 P ri ce ( D o lla rs ) 100 200 275
- 494. Autos (Thousands) C B A AC Mexico, U. S . By adding to the size of the domestic market, international trade permits longer pro- duction runs by domestic firms, which can lead to greater efficiency and reductions in unit costs. © C en ga ge Le ar
- 495. ni ng ® 86 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. consumers desire to purchase, a country specializes in the manufacture of large amounts of a limited number of goods and trades for the remaining goods. Specialization in a few products allows a manufacturer to benefit from longer production runs that lead to
- 496. decreasing average costs. A key aspect of increasing–returns trade theory is the home market effect: countries will specialize in products that have a large domestic demand. Why? By locating close to its largest market, an industry can minimize the cost of shipping its products to its cus- tomers while still taking advantage of economies of scale. Auto companies will locate in Germany rather than France if it is clear that Germans are likely to buy more cars. That way the company can produce low-cost cars and not have to pay much to ship them to its largest market. But the home market effect also has a disturbing implication. If industries tend to locate near their largest markets, what happens to small market areas? Other things equal, they’re likely to become unindustrialized as factories and industries move to take advantage of scale economies and low transportation costs. Hence, trade could lead to small countries and rural areas becoming peripheral to
- 497. the economic core; the backwater suppliers of commodities. As Canadian critics have phrased it, “With free trade, Canadians would become hewers of wood and drawers of water.” However, other things are not strictly equal: comparative-advantage effects exist alongside the influence of increasing returns so the end result of open trade is not a foregone conclusion. External Economies of Scale The previous section considered how internal economies of scale that are within the control of a firm, can be a source of comparative advantage. Economies of scale can also rise outside a firm, but within an industry. For example, when an industry’s scope of operations expands because of the creation of a better transporta- tion system, the result is a decrease in cost for a company operating within that industry. External economies of scale exist when the firm’s average costs
- 498. decrease as the indus- try’s output increases. This cost reduction could be caused by a decrease in the prices of the resources employed by the firm or in the amount of resources per unit of output. This effect is shown by a downward shift of the firm’s long run average cost curve. External economies of scale can occur in a number of situations: • The rising concentration of an industry’s firms in a particular geographic area attracts larger pools of a specialized type of worker needed by the industry, thus reducing the cost of hiring for a firm. • New knowledge about production technology spreads among firms in the area through direct contacts among firms or as workers transfer from firm to firm. Rather than having to pay a consultant, a firm may be able to pick up useful technical knowledge from its workers mixing with workers of other firms.
- 499. • If a country has an expanding industry it will be a source of economic growth, and through this, the government can collect additional tax revenues. Recognizing this, the government can invest in better research and development facilities at local universities so that several businesses in that area can benefit. • Access to specialized inputs increases with the clustering of component suppliers close to the center of manufacturing. Many auto component suppliers locate in the Detroit–Windsor area where General Motors, Ford, and Chrysler produce automo- biles. With the increase in the number of suppliers come increased competition and a lower price of components for an auto company. Chapter 3: Sources of Comparative Advantage 87 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 500. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. External economies of scale help explain why New York has a comparative advan- tage in financial services, California’s Silicon Valley has a comparative advantage in semiconductors, and Hollywood has a comparative advantage in movies. External economies of scale have resulted in Dalton, Georgia becoming the carpet manufacturing capital of the world. The location of the carpet industry in Dalton can be traced back to a wedding gift given in 1895 by a teenage girl, Catherine Whitener, to her brother and his bride. The gift was an unusual tufted bedspread. Copying a quilt pattern, Catherine sewed thick cotton yarns with a running stitch into unbleached muslin, clipped the ends of the yarn so they would fluff out, and
- 501. washed the spread in hot water to hold the yarns by shrinking the fabric. Interest grew in Catherine’s bed- spreads, and in 1900, she made the first sale of a spread for $2.50. Demand became so great for the spreads that by the 1930s, local women had haulers take the stamped sheeting and yarns to front porch workers. Often entire families worked to hand tuft the spreads for $0.10 to $0.25 per spread. Nearly 10,000 local men, women, and chil- dren were involved in the industry. When mechanized carpet making was developed after World War II, Dalton became the center of the new industry because specialized tufting skills were required and the city had a ready pool of workers with those skills, thus reducing hiring costs. Dalton is now home to more than 170 carpet plants, 100 carpet outlet stores, and more than 30,000 people employed by these firms. Supporting the carpet industry are local yarn manufacturers, machinery suppliers, dye plants, printing shops, and
- 502. maintenance firms. The local workforce has acquired specialized skills for operating carpet making equipment. Because firms that are located outside of Dalton cannot use the suppliers or the skilled workers available to factories in Dalton, they tend to have higher production costs. Although there is no particular reason why Dalton became the carpet making capital of the world, external economies of scale provided the area with a comparative advantage in carpet making once firms established there. OVERLAPPING DEMANDS AS A BASIS FOR TRADE The home market effect has implications for another theory of trade, the theory of overlapping demands. This theory was formulated by Staffan Linder, a Swedish econo- mist in the 1960s.11 According to Linder, the factor-endowment theory has considerable explanatory power for trade in primary products (natural resources) and agricultural goods. It does not explain trade in manufactured goods because
- 503. the main force influenc- ing the manufactured-good trade is domestic demand conditions. Because much of international trade involves manufactured goods, demand conditions play an important role in explaining overall trade patterns. Linder states that firms within a country are generally motivated to manufacture goods for which there is a large domestic market. This market determines the set of goods that these firms will have to sell when they begin to export. The foreign markets with greatest export potential will be found in nations with consumer demand similar to those of domestic consumers. A nation’s exports are thus an extension of the production for the domestic market. Going further, Linder contends that consumer demand is conditioned strongly by their income levels. A country’s average or per capita income will yield a particular 11Staffan B. Linder, An Essay on Trade and Transformation
- 504. (New York: Wiley, 1961), Chapter 3. 88 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. pattern of demand. Nations with high per capita incomes will demand high quality man- ufactured goods (luxuries), while nations with low per capita incomes will demand lower quality goods (necessities). The Linder hypothesis explains which nations will most likely trade with each other. Nations with similar per capita incomes will have overlapping
- 505. demand structures and will likely consume similar types of manufactured goods. Wealthy (industrial) nations T R A D E C O N F L I C T S D O E S A “ F L A T W O R L D ” M A K E R I C A R D O W R O N G ? The possibility that the United States could lose from free trade is at the heart of some recent critiques of globalization. One cri- tique contends that the world has tended to become “flat” as comparative advantages have dwindled or dried up. Proponents of this view note that as countries such as China and India undergo economic develop- ment and become more similar to the United States, a level playing field emerges. The flattening of the world is largely due to countries becoming intercon- nected as the result of the Internet, wireless technol- ogy, search engines and other innovations. Consequently, capitalism has spread like wildfire to China, India, and other countries where factory work- ers, engineers and software programmers are paid a fraction of what their American counterparts are paid. As China and India develop and become more similar
- 506. to the United States, the United States could become worse off with trade. However, not all economists agree with this view. They see several problems with this critique. First, the general view of globalization is that it is a phenomenon marked by increased international economic interde- pendence. However, the above critique is of a situation in which development in China and India lead to less trade, not more. If China and the United States have differences that allow for gains from trade (for exam- ple, differences in technologies and productive capabil- ities), then removing those differences may decrease the amount of trade and thus decrease the gains from that trade. The worst case scenario in this situation would be a complete elimination of trade. This is the opposite of the typical concern that globalization involves an overly rapid pace of international economic interdependence. The second problem with the critique is that it ignores the ways in which modern trade differs from Ricardo’s simple model. The advanced nations of the world have substantially similar technology and factors
- 507. of production, and seemingly similar products such as automobiles and electronics are produced in many countries, with substantial trade back and forth. This is at odds with the simplest prediction of the Ricardian model, under which trade should disappear once each country is able to make similar products at comparable prices. Instead, the world has observed substantially increased trade since the end of World War II. This increase reflects the fact that there are gains to intra- industry trade, in which broadly similar products are traded in both directions between nations; for example, the United States both imports and exports computer components. Intra-industry trade reflects the advan- tages garnered by consumers and firms from the increased varieties of similar products made available by trade, as well as the increased competition and higher productivity spurred by trade. Given the histori- cal experience that trade flows have continued to increase between advanced economies even as pro- duction technologies have become more similar, one would expect the potential for mutually advantageous trade to remain even if China and India were to develop so rapidly as to have similar technologies and prices as the United States.
- 508. Finally, it is argued that the world is not flat at all. While India and China may have very large labor forces, only a small fraction of Indians are prepared to compete with Americans in industries like information technology, while China’s authoritarian regime is not compatible with the personal computer. The real prob- lem is that comparative advantage can change very rapidly in a dynamic economy. Boeing might win today, Airbus tomorrow, and then Boeing may be back in play again. Source: Thomas Friedman, The World Is Flat, Farrar, (New York: Straus and Girous, 2005), Jagdish Bhagwati, In Defense of Globali- zation, (New York: Oxford University Press, 2004, Martin Wolf, Why Globalization Works, (New Haven, CT: Yale University Press, 2004): and Economic Report of the President, 2005, pp. 174–175. iS to ck ph
- 509. ot o. co m /p ho to so up Chapter 3: Sources of Comparative Advantage 89 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 510. are more likely to trade with other wealthy nations, and poor (developing) nations are more likely to trade with other poor nations. Linder does not rule out all trade in manufactured goods between wealthy and poor nations. Because of unequal income distribution within nations, there will always be some overlapping of demand structures; some people in poor nations are wealthy, and some people in wealthy nations are poor. However, the potential for trade in manufac- tured goods is small when the extent of demand overlap is small. Linder’s theory is in rough accord with the facts. A high proportion of international trade in manufactured goods takes place among the relatively high income (industrial) nations: Japan, Canada, the United States, and the European nations. Much of this trade involves the exchange of similar products: each nation
- 511. exports products that are much like the products it imports. However, Linder’s theory is not borne out by devel- oping country trade. The bulk of lower income, developing countries tend to have more trade with high income countries than with other lower income countries. INTRA-INDUSTRY TRADE The trade models considered so far have dealt with inter- industry trade—the exchange between nations of products of different industries. Examples include computers and aircraft traded for textiles and shoes, or finished manufactured items traded for primary materials. Inter-industry trade involves the exchange of goods with different factor requirements. Nations having large supplies of skilled labor tend to export sophisticated manufactured products, while nations with large supplies of natural resources export resource–intensive goods. Much of inter-industry trade is between nations having vastly different resource endowments (such as developing countries
- 512. and industrial countries) and can be explained by the principle of comparative advantage (the Heckscher–Ohlin model). Inter-industry trade is based on inter-industry specialization: each nation specializes in a particular industry (say, steel) in which it enjoys a comparative advantage. As resources shift to the industry with a comparative advantage, certain other industries having comparative disadvantages (say, electronics) contract. Resources move geographi- cally to the industry where comparative costs are lowest. As a result of specialization, a nation experiences a growing dissimilarity between the products that it exports and the products it imports. Although some inter-industry specialization occurs, this generally has not been the type of specialization that industrialized nations have undertaken in the post-World War II era. Rather than emphasizing entire industries, industrial countries have adopted
- 513. a narrower form of specialization. They have practiced intra- industry specialization, focusing on the production of particular products or groups of products within a given industry (for example, subcompact autos rather than full size sedans). With intra- industry specialization, the opening up of trade does not generally result in the elimina- tion or wholesale contraction of entire industries within a nation; however, the range of products produced and sold by each nation changes. Advanced industrial nations have increasingly emphasized intra- industry trade—two-way trade in a similar commodity. Computers manufactured by IBM are sold abroad, while the United States imports computers produced by Hitachi of Japan. Table 3.5 provides examples of intra-industry trade for the United States. As the table indicates, the United States is involved in two-way trade in many goods such as airplanes and computers. 90 Part 1: International Trade Relations
- 514. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. The existence of intra-industry trade appears to be incompatible with the models of comparative advantage previously discussed. In the Ricardian and Heckscher–Ohlin models, a country does not simultaneously export and import the same product. Califor- nia is a major importer of French wines as well as a large exporter of its own wines; the Netherlands imports Lowenbrau beer while exporting Heineken. Intra-industry trade involves flows of goods with similar factor requirements. Nations that are net exporters
- 515. of manufactured goods embodying sophisticated technology also purchase such goods from other nations. Most of intra-industry trade is conducted among industrial coun- tries, especially those in Western Europe, whose resource endowments are similar. The firms that produce these goods tend to be oligopolies, with a few large firms constituting each industry. Intra-industry trade includes trade in homogeneous goods as well as in differentiated products. For homogeneous goods, the reasons for intra-industry trade are easy to grasp. A nation may export and import the same product because of transportation costs. Canada and the United States, for example, share a border whose length is several thou- sand miles. To minimize transportation costs (and thus total costs), a buyer in Albany, New York may import cement from a firm in Montreal, Quebec while a manufacturer in Seattle, Washington sells cement to a buyer in Vancouver, British Columbia. Such trade can be explained by the fact that it is less expensive to transport
- 516. cement from Montreal to Albany than to ship cement from Seattle to Albany. Another reason for intra-industry trade in homogeneous goods is seasonal. The sea- sons in the Southern Hemisphere are opposite those in the Northern Hemisphere. Brazil may export seasonal items (such as agricultural products) to the United States at one time of the year and import them from the United States at another time during the same year. Differentiation in time also affects electricity suppliers. Because of heavy fixed costs in electricity production, utilities attempt to keep plants operating close to full capacity, meaning that it may be less costly to export electricity at off-peak times when domestic demand is inadequate to ensure full-capacity utilization and import electricity at peak times. Although some intra-industry trade occurs in homogeneous products, available evidence suggests that most intra-industry trade occurs in differentiated products. Within
- 517. manufacturing, the levels of intra-industry trade appear to be especially high in machin- ery, chemicals, and transportation equipment. A significant share of the output of TABLE 3.5 Intra-Industry Trade Examples: Selected U.S. Exports and Imports, 2012 (in millions of dollars) Category Exports Imports Crude oil 2,504 312,799 Steel 19,787 19,458 Chemicals (inorganic) 35,537 24,763 Civilian aircraft 94,366 10,289 Toys, games, sporting goods 10,450 33,466 Televisions 5,054 33,466 Computers 16,942 65,759
- 518. Telecommunications equipment 38,551 52,796 Source: From U.S. Census Bureau, U.S. International Trade in Goods and Services: FT 900, 2013. See also U.S. Census Bureau, Statistical Abstract of the U.S. Chapter 3: Sources of Comparative Advantage 91 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. modern economies consists of differentiated products within the same broad product group. Within the automobile industry, a Ford is not identical to a Honda, a Toyota, or
- 519. a Chevrolet. Two-way trade flows can occur in differentiated products within the same broad product group. For industrial countries, intra-industry trade in differentiated manufactured goods often occurs when manufacturers in each country produce for the “majority” consumer demand within their country while ignoring “minority” consumer demand. This unmet need is fulfilled by imported products. Most Japanese consumers prefer Toyotas to General Motors vehicles; yet some Japanese consumers purchase vehicles from General Motors, while Toyotas are exported to the United States. Intra- industry trade increases the range of choices available to consumers in each country, as well as the degree of competition among manufacturers of the same class of product in each country. Intra-industry trade in differentiated products can also be explained by overlapping demand segments in trading nations. When U.S. manufacturers look overseas for mar-
- 520. kets in which to sell, they often find them in countries having market segments that are similar; for example, luxury automobiles sold to high-income buyers. Nations with similar income levels can be expected to have similar tastes, and thus sizable overlapping market segments as envisioned by Linder’s theory of overlapping demand; they are expected to engage heavily in intra-industry trade. Besides marketing factors, economies of scale associated with differentiated products also explain intra-industry trade. A nation may enjoy a cost advantage over its foreign competitor by specializing in a few varieties and styles of a product (for example, sub- compact autos with a standard transmission and optional equipment) while its foreign competitor enjoys a cost advantage by specializing in other variants of the same product (subcompact autos with automatic transmission, air conditioning, DVD player, and other optional equipment). Such specialization permits longer production runs, econo- mies of scale, and decreasing unit costs. Each nation exports its
- 521. particular type of auto to the other nation, resulting in two-way auto trade. In contrast to inter-industry trade that is explained by the principle of comparative advantage, intra-industry trade can be explained by product differentiation and economies of scale. With intra-industry specialization, fewer adjustment problems are likely to occur than with inter-industry specialization, because intra-industry specialization requires a shift of resources within an industry instead of between industries. Inter-industry specialization results in a transfer of resources from import-competing to export-expanding sectors of the economy. Adjustment difficulties can occur when resources, notably labor, are occupationally and geographically immobile in the short-term; massive structural unemployment may result. In contrast, intra-industry specialization often occurs without requiring workers to exit from a particular region or industry (as when workers are shifted from the production of large-size automobiles to subcompacts); the probability
- 522. of structural unemployment is lessened. TECHNOLOGY AS A SOURCE OF COMPARATIVE ADVANTAGE: THE PRODUCT CYCLE THEORY The explanations of international trade presented so far are similar in that they presuppose a given and unchanging state of technology that is the process firms use to turn inputs into goods and services. The basis for trade was ultimately attributed to such factors as differing labor productivities, factor endowments, and national demand struc- tures. In a dynamic world, technological changes occur in different nations at different rates of speed. Technological innovations commonly result in new methods of producing 92 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 523. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. existing commodities, production of new commodities, or commodity improvements. These factors can affect comparative advantage and the pattern of trade. Japanese automobile companies such as Toyota and Honda have succeeded by greatly improving the processes for designing and manufacturing automobiles. This improve- ment allowed Japan to become the world’s largest exporter of automobiles, selling large numbers to Americans and people in other countries. Japan’s comparative advantage in automobiles has been supported by the superior production techniques developed by that country’s manufacturers that allowed them to produce more vehicles with a given amount of capital and labor than their European or American
- 524. counterparts. Therefore, Japan’s comparative advantage in automobiles is caused by differences in technology; the techniques in production. Although differences in technology are an important source of comparative advantage at a particular point in time, technological advantage is often transitory. A country may lose its comparative advantage as its technological advantage disappears. Recognition of the importance of such dynamic changes has given rise to another explanation of inter- national trade: the product life cycle theory. This theory focuses on the role of techno- logical innovation as a key determinant of the trade patterns in manufactured products.12 According to this theory, many manufactured goods such as electronic products and office machinery undergo a predictable trade cycle. During this cycle, the home country initially is an exporter, then loses its competitive advantage to its trading partners and eventually may become an importer of the commodity. The
- 525. stages that many manu- factured goods go through comprise the following: 1. Manufactured good is introduced to home market. 2. Domestic industry shows export strength. 3. Foreign production begins. 4. Domestic industry loses competitive advantage. 5. Import competition begins. The introduction stage of the trade cycle begins when an innovator establishes a tech- nological breakthrough in the production of a manufactured good. At the start, the rela- tively small local market for the product and technological uncertainties imply that mass production is not feasible. The manufacturer will most likely operate close to the local market to gain quick feedback on the quality and overall appeal of the product. Produc- tion occurs on a small scale using high skilled workers. The high price of the new product will also offer high returns to the specialized capital stock needed to produce the new product.
- 526. During the trade cycle’s next stage, the domestic manufacturer begins to export its product to foreign markets having similar tastes and income levels. The local manufac- turer finds that during this stage of growth and expansion, its market becomes large enough to expand production operations and sort out inefficient production techniques. The home country manufacturer is therefore able to supply increasing amounts to the world markets. As the product matures and its price falls, the capability for standardized production results in the possibility that more efficient production can occur by using low-wage labor and mass production. At this stage in the product’s life, it is most likely that produc- tion will move toward economies that have resource endowments relatively plentiful in low-wage labor, such as China or Malaysia. The domestic industry enters its mature stage as innovating businesses establish branches abroad and the outsourcing of jobs occurs.
- 527. 12See Raymond Vernon, “International Investment and International Trade in the Product Life Cycle,” Quarterly Journal of Economics, 80, 1966, pp. 190–207. Chapter 3: Sources of Comparative Advantage 93 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Although an innovating nation’s monopoly position may be prolonged by legal patents, it will most likely break down over time because in the long-term, knowledge tends to be a free good. The benefits an innovating nation achieves from its technological gap are short lived, because import competition from foreign
- 528. producers begins. Once the innovative technology becomes fairly commonplace, foreign producers begin to imitate the production process. The innovating nation gradually loses its comparative advantage and its export cycle enters a declining phase. The trade cycle is complete when the production process becomes so standardized that it can be easily used by other nations. The technological breakthrough therefore no longer benefits only the innovating nation. In fact, the innovating nation may itself become a net importer of the product as its monopoly position is eliminated by foreign competition. The product life cycle theory has implications for innovating countries such as the United States. The gains from trade for the United States are significantly determined by the dynamic balance between its rate of technological innovation and the rate of its technological diffusion to other countries. Unless the United States can generate a pace
- 529. of innovation to match the pace of diffusion, its share of the gains from trade will decrease. Also, it can be argued that the advance of globalization has accelerated the rate of technological diffusion. What this advance suggests is that preserving or increas- ing the economy’s gains from trade in the face of globalization will require acceleration in the pace of innovation in goods and service–producing activities. The product life cycle theory also provides lessons for a firm desiring to maintain its competitiveness: to prevent rivals from catching up, it must continually innovate so as to become more efficient. Toyota Motor Corporation is generally regarded as the auto industry’s leader in production efficiency. To maintain this position, the firm has contin- ually overhauled its operations and work practices. In 2008, Toyota was working to decrease the number of components it uses in a typical vehicle by half and develop faster and more flexible plants to assemble these simplified cars. This simplification would
- 530. allow workers to churn out nearly a dozen different cars on the same production line at a speed of one every 50 seconds, compared to Toyota’s fastest plant that produces a vehicle every 56 seconds. The cut would increase the output per worker and reduce costs by about $1,000 per vehicle. By pushing out the efficiency target, Toyota was attempting to prevent the latter stages of the product cycle from occurring. Radios, Pocket Calculators, and the International Product Cycle The experience of U.S. and Japanese radio manufacturers illustrates the product life cycle model. Following World War II, the radio was a well- established product. U.S. manufacturers dominated the international market for radios because vacuum tubes were initially developed in the United States. As production technologies spread, Japan used cheaper labor and captured a large share of the world radio market. The transistor was then developed by U.S. companies. For a number of years, U.S. radio manufacturers were able to compete with the Japanese, who continued to use outdated
- 531. technologies. Again, the Japanese imitated the U.S. technologies and were able to sell radios at more competitive prices. Pocket calculators provide another illustration of a product that has moved through the stages of the international product cycle. This product was invented in 1961 by engineers at Sunlock Comptometer, Inc. and was marketed soon after at a price of approximately $1,000. Sunlock’s pocket calculator was more accurate than slide rules (widely used by high school and college students at that time) and more portable than large mechanical calculators and computers that performed many of the same functions. 94 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 532. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. By 1970, several U.S. and Japanese companies had entered the market with competing pocket calculators; these firms included Texas Instruments, Hewlett-Packard, and Casio (of Japan). The increased competition forced the price down to about $400. As the 1970s progressed, additional companies entered the market. Several began to assemble their pocket calculators in foreign countries, such as Singapore and Taiwan, to take advantage of lower labor costs. These calculators were then shipped to the United States. Steadily improving technologies resulted in product improvements and falling prices; by the mid-1970s, pocket calculators sold routinely for $10 to $20, sometimes even less. It appears that pocket calculators had reached the standardized product stage of the prod-
- 533. uct cycle by the late 1970s, with product technology available throughout the industry, price competition (and thus costs) of major significance, and product differentiation widely adopted. In a period of less than two decades, the international product cycle for pocket calculators was complete. Japan Fades in the Electronics Industry The essence of the product cycle theory can also be seen in the Japanese electronics industry.13 In the late 1980s, Japan seemed prepared to dominate the world’s electronics market. The Japanese had seemingly formulated a superior business model where active government intervention in export oriented industries, along with protection of Japanese firms from foreign competition, led to high growth rates and trade surpluses. Japan’s achievements in electronics were notable as Sharp, Panasonic, Sony, and other Japanese firms flooded the world market with their cameras, television sets, video cassette recor- ders (VCRs), and the like.
- 534. The Japanese electronics industry weakened during the first decade of the 2000s, with exports declining and losses increasing. Japanese executives blamed their problems on the appreciation of the yen’s exchange value that made their products more expensive and less attractive to foreign buyers. A strong yen could not assume all of the burden for Japan’s problems. According to analysts, the main source of the problem was Japa- nese firms’ ignorance of two basic principles. First, as countries mature, their sources of comparative advantage change. Although abundant skilled labor, inexpensive capital, and price may initially be critical determinants of competitiveness, as time passes, innovation in products and production processes becomes more significant. Second, competitiveness is not just about what products to offer to the market, but also about what products not to offer. Ignoring these principles, Japanese firms attempted to compete with upstart electron- ics firms like Samsung (South Korea) on the basis of
- 535. inexpensive capital and manufacturing efficiency rather than product innovation. The Japanese kept producing products that were formerly profitable, such as semiconductors and consumer audio- video products that eventually lost market share to newly invented products from abroad. Also, when Japanese firms failed, their solution was mergers. Their rationale was that combining several losing firms into one would turn them into a winner as the result of economies of large scale production. However, the merger of Japanese electron- ics firms could not keep pace with the rapidly changing world of digital electronics. Firms such as Intel and Texas Instruments abandoned standardized products, where price is key to competitiveness, and invented more sophisticated and profitable products, thus leapfrogging the Japanese. 13Richard Katz, “What’s Killing Japanese Electronics?” The Wall Street Journal, March 22, 2012, at http://online.wsj.com/; Michael Porter, “The Five Competitive Forces That Shape Strategy", Harvard
- 536. Business Review, January 2008, pp. 79–93; Ian King, “Micron Biggest Winner as Elpida Bankruptcy Side- lines Rival,” Bloomberg News, February 27, 2012 at http://www.bloomberg.com/. Chapter 3: Sources of Comparative Advantage 95 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Today almost four-fifths of Japan’s electronics output consists of parts and compo- nents that often go into other firm’s products, such as Apples’ iPad. However, most of the profit goes to Apple that invents new and popular products rather than the firms
- 537. that produce their parts. Whether its smartphones or personal computers, Japanese firms are no longer the market leaders. DYNAMIC COMPARATIVE ADVANTAGE: INDUSTRIAL POLICY David Ricardo’s theory of comparative advantage has influenced international trade theory and policy for almost 200 years. It implies that nations are better off by promoting free trade and allowing competitive markets to determine what should be produced and how. Ricardian theory emphasizes specialization and reallocation of existing resources found domestically. It is essentially a static theory that does not allow for a dynamic change in industries’ comparative advantage or disadvantage over the course of several decades. The theory overlooks the fact that additional resources can be made available to the trading nation because they can be created or imported. The remarkable postwar economic growth of the East Asian
- 538. countries appears to be based on a modification of the static concept of comparative advantage. The Japanese were among the first to recognize that comparative advantage in a particular industry can be created through the mobilization of skilled labor, technology, and capital. They also realized that, in addition to the business sector, government can establish policies to promote opportunities for change through time. Such a process is known as dynamic comparative advantage. When government is actively involved in creating comparative advantage, the term industrial policy applies. In its simplest form, industrial policy is a strategy to revitalize, improve, and develop an industry. Proponents maintain that government should enact policies that encourage the development of emerging, “sunrise” industries (such as high-technology). This strategy requires that resources be directed to industries in which productivity is highest, linkages to the rest of the economy are strong (as with semiconductors), and future competitiveness
- 539. is important. Presumably, the domestic economy will enjoy a higher average level of productivity and will be more competitive in world markets as a result of such policies. A variety of government policies can be used to foster the development and revitali- zation of industries; examples are antitrust immunity, tax incentives, R&D subsidies, loan guarantees, low-interest-rate loans, and trade protection. Creating comparative advantage requires government to identify the “winners” and encourage resources to move into industries with the highest growth prospects. To better understand the significance of dynamic comparative advantage, we might think of it in terms of the classic example of Ricardo’s theory of comparative advantage. His example showed that, in the eighteenth century, Portugal and England would each have gained by specializing respectively in the production of wine and cloth, even though Portugal might produce both cloth and wine more cheaply than England. According to
- 540. static comparative advantage theory, both nations would be better off by specializing in the product in which they had an existing comparative advantage. However, by adhering to this prescription, Portugal would sacrifice long-run growth for short-run gains. If Portugal adopted a dynamic theory of comparative advantage instead, it would specialize in the growth industry of that time (cloth). The Portuguese government (or Portuguese textile manufacturers) would initiate policies to foster the development of its cloth industry. This strategy would require Portugal to think in terms of acquiring or creating strength in a “sunrise” sector instead of simply accepting the existing supply of resources and using that endowment as productively as possible. 96 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 541. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Countries have used industrial policies to develop or revitalize basic industries, including steel, autos, chemicals, transportation, and other important manufactures. Each of these industrial policies differs in character and approach; common to all is an active role for government in the economy. Usually, industrial policy is a strategy developed collectively by government, business, and labor through some sort of tripartite consultation process. Advocates of industrial policy typically cite Japan as a nation that has been highly successful in penetrating foreign markets and achieving rapid economic growth. Follow-
- 542. ing World War II, the Japanese were the high-cost producers in many basic industries (such as steel). In this situation, a static notion of comparative advantage would require the Japanese to look to areas of lesser disadvantage that were more labor intensive (such as textiles). Such a strategy would have forced Japan into low- productivity industries that would eventually compete with other East Asian nations having abundant labor and modest living standards. Instead, the Japanese invested in basic industries (steel, autos, and later electronics, including computers) that required intensive employment of capital and labor. From a short-run, static perspective, Japan appeared to pick the wrong industries. From a long-run perspective, those were the industries in which technological progress was rapid, labor pro- ductivity rose quickly, and unit costs decreased with the expansion of output. They were also industries that one would expect rapid growth in demand as national income increased.
- 543. These industries combined the potential to expand rapidly, thus adding new capacity, with the opportunity to use the latest technology and promote a strategy of cost reduc- tion founded on increasing productivity. Japan, placed in a position similar to that of Portugal in Ricardo’s famous example, refused to specialize in “wine” and chose “cloth” instead. Within three decades, Japan became the world’s premier low-cost producer of many of the products that it initially started in a high-cost position. Critics of industrial policy contend that the causal factor in Japanese industrial success is unclear. They admit that some of the Japanese government’s targeted industries—such as semiconductors, steel, shipbuilding, and machine tools—are probably more competi- tive than they would have been in the absence of government assistance. They assert that Japan also targeted some losers, such as petrochemicals and aluminum, and that the returns on investment were disappointing and capacity had to be reduced. Moreover,
- 544. several successful Japanese industries did not receive government assistance—motorcycles, bicycles, paper, glass, and cement. Industrial-policy critics contend that if all trading nations took the route of using a combination of trade restrictions on imports and subsidies on exports, a “beggar- thy-neighbor” process of trade-inhibiting protectionism would result. They also point out that the implementation of industrial policies can result in pork barrel politics, in which politically powerful industries receive government assistance. It is argued that in a free market, profit maximizing businesses have the incentive to develop new resources and technologies that change a country’s comparative advantage. This incentive raises the question of whether the government does a better job than the private sector in cre- ating comparative advantage. WTO RULES THAT ILLEGAL GOVERNMENT SUBSIDIES SUPPORT BOEING AND AIRBUS
- 545. An example of industrial policy is the government subsidies that apply to the commer- cial jetliner industry as seen in Boeing and Airbus. The world’s manufacturers of commercial jetliners operate in an oligopolistic market that has been dominated by Chapter 3: Sources of Comparative Advantage 97 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Boeing of the United States and the Airbus Company of Europe, although competition is emerging from producers in Canada, Brazil, China, and other countries. During the
- 546. 1970s, Airbus sold less than 5.0 percent of the world’s jetliners; today, it accounts for about half of the world market. The United States has repeatedly complained that Airbus receives unfair subsidies from European governments. American officials argue that these subsidies place their company at a competitive disadvantage. Airbus allegedly receives loans for the develop- ment of new aircraft; these loans are made at below market interest rates and can amount to 70 to 90 percent of an aircraft’s development cost. Rather than repaying the loans according to a prescribed timetable as typically would occur in a competitive mar- ket, Airbus can repay them after it delivers an aircraft. Airbus can avoid repaying the loans in full if sales of its aircraft fall short. Although Airbus says that has never occurred, Boeing contends that Airbus has an advantage by lowering its commercial risk, making it easier to obtain financing. The United States maintains that these subsi- dies allow Airbus to set unrealistically low prices, offer
- 547. concessions and attractive financ- ing terms to airlines, and write off development costs. Airbus has defended its subsidies on the grounds that they prevent the United States from holding a worldwide monopoly in commercial jetliners. In the absence of Airbus, European airlines would have to rely exclusively on Boeing as a supplier. Fears of depen- dence and the loss of autonomy in an area on the cutting edge of technology motivate European governments to subsidize Airbus. Airbus also argues that Boeing benefits from government assistance. Rather than receiv- ing direct subsidies like Airbus, Boeing receives indirect subsidies. Governmental organiza- tions support aeronautics and propulsion research that is shared with Boeing. Support for commercial jetliner innovation also comes from military sponsored research and military procurement. Research financed by the armed services yields indirect but important techno- logical spillovers to the commercial jetliner industry, most notably in aircraft engines and
- 548. aircraft design. Boeing subcontracts part of the production of its jetliners to nations such as Japan and China whose producers receive substantial governmental subsidies. The state of Washington provides tax breaks to Boeing who has substantial production facilities in the state. According to Airbus, these subsidies enhance Boeing’s competitiveness. As a result of the subsidy conflict between Boeing and Airbus, the United States and Europe in 1992 negotiated an agreement to curb subsidies for the two manufacturers. The principal element of the accord was a 33 percent cap on the amount of government subsidies that these manufacturers could receive for product development. In addition, the indirect subsidies were limited to 4.0 percent of a firm’s commercial jetliner revenue. Although the subsidy agreement helped calm trade tensions between the United States and Europe, by the first decade of the 2000s the subsidy dispute was heating up again. The United States criticized the European Union for granting
- 549. subsidies to Airbus and called for the European Union to renegotiate the 1992 subsidy deal. In 2005, Boeing and Airbus filed suits at the World Trade Organization (WTO) that contended that each company was receiving illegal subsidies from the governments of Europe and the United States. During 2010–2011, the WTO ruled that both Boeing and Airbus received illegal subsi- dies from their governments. The WTO determined that Airbus received about $20 billion in illegal aid and that about $2.7 in illegal aid was granted to Boeing. In response to these rulings, Boeing stated that it was prepared to accept compliance and thus not receive illegal aid. However, Airbus resisted abandoning aid from the governments of Europe. At the writing of this text in 2014, the subsidy dispute continued. Both Boeing and Airbus accused each other of not complying with the WTO’s rulings concerning the illegality of their subsidies. It remains to be seen how compliance with the rulings
- 550. will be resolved. 98 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. GOVERNMENT REGULATORY POLICIES AND COMPARATIVE ADVANTAGE Besides providing subsidies to enhance competitiveness, governments impose regulations on business to pursue goals such as workplace safety, product safety, and a clean environment. In the United States, these regulations are imposed by the Occupational
- 551. Safety and Health Administration, the Consumer Product Safety Commission, and the Environmental Protection Agency. Although government regulations may improve the wellbeing of the public, they can result in higher costs for domestic firms. According to T R A D E C O N F L I C T S D O L A B O R U N I O N S S T I F L E C O M P E T I T I V E N E S S ? For more than a century, labor unions have attempted to improve wages, ben- efits, and working conditions for their members. In the United States, unions represented about one-third of all workers in the 1950s. By 2011, unions represented only about 12 percent of the American labor force–8 percent of the labor force in the private sector and 36 percent of public sector workers. Many private sector union members belong to industrial unions, such as the United Auto Workers (UAW), which represents workers at American auto firms, tractor and earth mov- ing equipment firms such as Caterpillar and John Deere, and Boeing in the aerospace industry.
- 552. During the 1950s and 1960s, organized labor in the United States was generally receptive to free trade, an era when U.S. producers were strong in international markets. However, labor union leaders began to express their concerns about free trade in the 1970s as their members encountered increased competition from producers in Japan and Western Europe. Since that time, American union leaders have generally opposed efforts to liberalize trade. Some analysts note that unions can have adverse effects on firms’ competitiveness when they set wages and benefits above those of a competitive market. Unions can also impose restrictive work rules that decrease productivity and stifle innovation. Also, union emphasis on seniority over merit in promotion and pay can hinder the incentive for worker effort. Moreover, strikes can lessen a firm’s ability to maintain market share. An influential study by Hirsch concluded that unions tend to result in compensation rising faster than pro- ductivity, diminishing profits while also lessening the ability of firms to remain price competitive. This has caused unionized companies to lose market share to
- 553. nonunionized firms in domestic and international markets: classic examples of this tendency include American auto and steel companies. Hirsch found that unions will typically raise labor costs to a firm by 15 to 20 percent, while delivering a negligible increase in productivity. Thus, the profits of unionized firms tend to be 10 to 20 percent lower than similar nonunion firms. Also, the typical unionized firm has 6 percent lower capital investment than an equivalent nonunion firm, and a 15 percent lower share of spending on research and development. However, Hirsch found that the evidence does not show a higher failure rate among unionized firms. However, other analysts contend that unions can increase the sense of worker loyalty to the firm and decrease worker turnover, thus increasing worker pro- ductivity and reducing costs to the firm for hiring and training. They also note that unions are a major force for greater social equality, and it is virtually impossible to have decent health care, pensions and other worker benefits without a strong labor movement. Moreover, they note that the United States, which has a far lower rate of unionization than many other advanced countries, has consistently maintained huge trade
- 554. deficits. If low rates of unionization determine trade competitiveness, shouldn’t the United States be close to the top? Source: Daniel Griswold, “Unions, Protectionism, and U.S. Competitiveness,” Cato Journal, Vol. 30, No. 1, Winter 2010, pp. 181–196. See also Barry Hirsch, “Sluggish Institutions in a Dynamic World: Can Unions and Industrial Competition Coexist?” Journal of Economic Perspectives, 2008, Vol. 22, No. 1 and Richard Freeman and James Medoff, What Do Unions Do? New York, Basic Books, 1984. iS to ck ph ot o. co m
- 555. /p ho to so up Chapter 3: Sources of Comparative Advantage 99 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. the American Iron and Steel Institute, U.S. steel producers today are technologically advanced, low-cost, environmentally responsible, and customer
- 556. focused. Yet they con- tinue to face regulatory burdens from the U.S. government that impair their competitive- ness and trade prospects. Strict government regulations applied to the production of goods and services tend to increase costs and erode an industry’s competitiveness. This is relevant for both export and import competing firms. Even if government regulations are justified on social wel- fare grounds, the adverse impact on trade competitiveness and the associated job loss have long been a cause for policy concern. Let us examine how governmental regulations on business can affect comparative advantage. Figure 3.6 illustrates the trade effects of pollution regulations imposed on the production process. Assume a world of two steel producers, South Korea and the United States. The supply and demand schedules of South Korea and those of the United States are indicated by SS K 0 and DS K 0, and by SU S 0 and DU S 0. In the absence of trade, South Korean produ-
- 557. cers sell 5 tons of steel at $400 per ton, while 12 tons of steel are sold in the United States at $600 per ton. South Korea thus enjoys a comparative advantage in steel production. With free trade, South Korea moves toward greater specialization in steel produc- tion, and the United States produces less steel. Under increasing-cost conditions, South Korea’s costs and prices rise, while prices and costs fall in the United States. The basis for further growth of trade is eliminated when prices in the two countries are equal at $500 per ton. At this price, South Korea produces 7 tons, consumes 3 tons, and exports 4 tons, and the United States produces 10 tons, consumes 14 tons, and imports 4 tons. Suppose that the production of steel results in discharges into U.S. waterways, leading the Environmental Protection Agency to impose pollution regulations on domestic steel producers. Meeting these regulations adds to production costs, resulting in the U.S.
- 558. supply schedule of steel shifting to SU S 1. The environmental regulations thus provide FIGURE 3.6 Trade Effects of Governmental Regulations 400 500 600 D o lla rs Steel (Tons) 0 E
- 560. Steel (Tons) 0 United States 4 10 12 14 C A B D DU.S .0 SU.S.0 SU.S.1 The imposition of government regulations (clean environment, workplace safety, product safety) on U.S. steel companies leads to higher costs and a decrease in market
- 561. supply. This imposition detracts from the competi- tiveness of U.S. steel companies and reduces their share of the U.S. steel market. © C en ga ge Le ar ni ng ® 100 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 562. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. an additional cost advantage for South Korean steel companies. As South Korean com- panies expand steel production, say, to 9 tons, higher production costs result in a rise in price to $600. At this price, South Korean consumers demand only 1 ton. The excess supply of 8 tons is earmarked for sale to the United States. As for the United States, 12 tons of steel are demanded at the price of $600, as determined by South Korea. Given supply schedule SU S 1, U.S. firms now produce only 4 tons of steel at the $600 price. The excess demand, 8 tons, is met by imports from South Korea. For U.S. steel companies, the costs imposed by pollution regulations lead to further comparative disad- vantage and a smaller share of the U.S. market.
- 563. Environmental regulation thus results in a policy trade-off for the United States. By adding to the costs of domestic steel companies, environmental regulations make the United States more dependent on foreign-produced steel. However, regulations provide American households with cleaner water and air, and thus a higher quality of life. Also, the competitiveness of other American industries, such as forestry products, may benefit from cleaner air and water. These effects must be considered when forming an optimal environmental regulatory policy. The same principle applies to the regulation of workplace safety by the Occupational Safety and Health Administration and the regulation of product safety by the Consumer Product Safety Commission. TRANSPORTATION COSTS AND COMPARATIVE ADVANTAGE Besides embodying production costs, the principle of
- 564. comparative advantage includes the costs of moving goods from one nation to another. Transportation costs refer to the costs of moving goods, including freight charges, packing and handling expenses, and insurance premiums. These costs are an obstacle to trade and impede the realization of gains from trade liberalization. Differences across countries in transport costs are a source of comparative advantage and affect the volume and composition of trade. Trade Effects The trade effects of transportation costs can be illustrated with a conventional supply and demand model based on increasing-cost conditions. Figure 3.7(a) illustrates the supply and demand curves of autos for the United States and Canada. Reflecting the assumption that the United States has the comparative advantage in auto production, the U.S. and Canadian equilibrium locations are at points E and F, respectively. In the absence of trade, the U.S. auto price, $4,000, is lower than that of Canada, $8,000.
- 565. When trade is allowed, the United States will move toward greater specialization in auto production, whereas Canada will produce fewer autos. Under increasing-cost condi- tions, the U.S. cost and price levels rise and Canada’s price falls. The basis for further growth of trade is eliminated when the two countries’ prices are equal, at $6,000. At this price, the United States produces 6 autos, consumes 2 autos, and exports 4 autos; Canada produces 2 autos, consumes 6 autos, and imports 4 autos. Therefore, $6,000 becomes the equilibrium price for both countries because the excess auto supply of the United States just matches the excess auto demand in Canada. The introduction of transportation costs into the analysis modifies the conclusions of this example. Suppose the per-unit cost of transporting an auto from the United States to Canada is $2,000, as shown in Figure 3.7(b). The United States would find it advanta- geous to produce autos and export them to Canada until its relative price advantage is
- 566. eliminated. But when transportation costs are included in the analysis, the U.S. export Chapter 3: Sources of Comparative Advantage 101 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. price reflects domestic production costs plus the cost of transporting autos to Canada. The basis for trade thus ceases to exist when the U.S. auto price plus the transportation cost rises to equal Canada’s auto price. This equalization occurs when the U.S. auto price rises to $5,000 and Canada’s auto price falls to $7,000, the difference between
- 567. them being the $2,000 per-unit transportation cost. Instead of a single price ruling in both countries, there will be two domestic auto prices, differing by the cost of transportation. Compared with free trade in the absence of transportation costs, when transportation costs are included the high-cost importing country will produce more, consume less, and import less. The low-cost exporting country will produce less, consume more, and export less. Transportation costs, therefore, tend to reduce the volume of trade, the degree of specialization in production among the nations concerned, and thus the gains from trade. The inclusion of transportation costs in the analysis modifies our trade model conclu- sions. A product will be traded internationally as long as the pre-trade price differential between the trading partners is greater than the cost of transporting the product between them. When trade is in equilibrium, the price of the traded
- 568. product in the exporting nation is less than the price in the importing country by the amount of the transporta- tion cost. Transportation costs also have implications for the factor-price equalization theory presented earlier in this chapter. Recall that this theory suggests that free trade tends to equalize product prices and factor prices so that all workers earn the same wage rate and all units of capital earn the same interest income in both nations. Free trade permits factor-price equalization to occur because factor inputs that cannot move to another FIGURE 3.7 Free Trade Under Increasing-Cost Conditions 2 4 6 Autos Exports Imports (a) No Transportation Costs
- 569. 2 046Autos Auto Price (Thousands of Dollars) 4 6 8 a b c d F D D E S SUnited States Canada
- 570. Exports Imports Autos 3 4 5 (b) With Transportation Costs of $2,000 per Auto 3 045 Auto Price (Thousands of Dollars) 4 5 7 8 D D E S
- 571. S F e f hg United States Canada Autos In the absence of transportation costs, free trade results in the equalization of prices of traded goods, as well as resource prices, in the trading nations. With the introduction of transportation costs, the low-cost exporting nation produces less, consumes more, and exports less; the high-cost importing nation produces more, con- sumes less, and imports less. The degree of specialization in production between the two nations decreases as do the gains from trade. © C en
- 572. ga ge Le ar ni ng ® 102 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 573. country are implicitly being shipped in the form of products. However, looking at the real world we see U.S. autoworkers earning more than South Korean autoworkers. One possible reason for this differential is transportation costs. By making low-cost South Korean autos more expensive for U.S. consumers, transportation costs reduce the volume of autos shipped from South Korea to the United States. This reduced trade volume stops the process of commodity- and factor-price equalization before it is complete. In other words, the prices of U.S. autos and the wages of U.S. autoworkers do not fall to the levels of those in South Korea. Transportation costs thus provide some relief to high-cost domestic workers who are producing goods subject to import competition. The cost of shipping a product from one point to another is determined by a number of factors, including distance, weight, size, value, and the volume of trade between the two points in question. Since the 1960s, the cost of international transportation has
- 574. decreased significantly relative to the value of U.S. imports. From 1965 to the first decade of the 2000s, transportation costs as a percentage of the value of all U.S. imports decreased from ten percent to less than four percent. This decline in the relative cost of international transportation has made imports more competitive in U.S. markets and contributed to a higher volume of trade for the United States. Falling transportation costs have been due largely to technological improvements, including the development of large dry-bulk containers, large-scale tankers, containerization, and wide-bodied jets. Moreover, technological advances in telecommunications have reduced the economic distances among nations.14 Falling Transportation Costs Foster Trade If merchants everywhere appear to be selling imports, there is a reason. International trade has been growing at a rapid pace. What underlies the expansion of international commerce? The worldwide decrease in trade barriers, such as tariffs and quotas, is
- 575. certainly one reason. The economic opening of nations that have traditionally been minor players, such as Mexico and China, is another. But one factor behind the trade boom has largely been unnoticed: the declining costs of getting goods to the market. Today, transportation costs are a less severe obstacle than they used to be. One reason is that the global economy has become much less transport intensive than it once was. In the early 1900s, for example, manufacturing and agriculture were the two most impor- tant industries in most nations. International trade thus emphasized raw materials, such as iron ore and wheat, or processed goods such as steel. These sorts of goods are heavy and bulky, resulting in a relatively high-cost of transporting them compared with the value of the goods themselves. As a result, transportation costs had much to do with the volume of trade. Over time, however, world output has shifted into goods whose value is unrelated to their size and weight. Finished manufactured goods, not raw
- 576. commodities, dominate the flow of trade. Therefore, less transportation is required for every dollar’s worth of exports or imports. Productivity improvements for transporting goods have also resulted in falling trans- portation costs. In the early 1900s, the physical process of importing or exporting was difficult. Imagine a British textile firm desiring to sell its product in the United States. First, at the firm’s loading dock, workers would have lifted bolts of fabric into the back of a truck. The truck would head to a port and unload its cargo, bolt by bolt, into a dockside 14Jean-Paul Rodrigue, Transportation, Globalization and International Trade, 2013, New York, Routledge; Alberto Behar and Anthony Venables, “Transportation Costs and International Trade,” Handbook of Transport Economics, Ed. Andre de Palma and others, Edward Elgar, Northampton MA, 2010; David Hummels, “Transportation Costs and International Trade in the Second Era of Globalization,” Journal of Economic Perspectives, Vol. 21, No. 3, Summer 2007, pp. 131– 154.
- 577. Chapter 3: Sources of Comparative Advantage 103 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. warehouse. As a vessel prepared to set sail, dockworkers would remove the bolts from the warehouse and hoist them into the hold, where other dockworkers would stow them in place. When the cargo reached the United States, the process would be reversed. Indeed, this sort of shipment was a complicated task, requiring much effort and expense. With the passage of time came technological improvements such as modern ocean liners, standard
- 578. containers for shipping goods, computerized loading ports, and freight companies such as United Parcel Service and Federal Express that specialize in using a combination of aircraft and trucks to deliver freight quickly. These and other factors have resulted in falling transportation costs and increased trade among nations. Recent decades have witnessed a growth in world trade that was supported by decreases in transportation costs and trade barriers. However, when oil prices surged in 2008 and 2011, rising transport costs became an increasing challenge to world trade. For example, economists estimated that transportation costs were the equivalent of a 10–11 percent tariff on goods coming into U.S. ports when the price of a barrel of oil rose to $145 per barrel in 2008. This is compared with the equivalent of only three percent when oil was selling for $20 a barrel in 2000. Rising shipping costs suggest that trade should be both dampened and diverted as markets look for shorter, and thus, less costly transportation
- 579. routes. As transportation cost rise, markets tend to substitute goods that are from closer locations rather than from locations half way around the world carrying hugely inflated shipping costs. For example, Emerson Electric Co., a St. Louis based manufacturer of appliance motors and other electrical equipment, shifted some of its production from Asia to Mexico and the United States in 2008, in part to offset increasing transportation costs by being closer to customers in North America. SUMMARY 1. The immediate basis for trade stems from relative product price differences among nations. Because relative prices are determined by supply and demand conditions, such factors as resource endow- ments, technology, and national income are ultimate determinants of the basis for trade. 2. The factor-endowment theory suggests that differ- ences in relative factor endowments among nations underlie the basis for trade. The theory asserts that a
- 580. nation will export that product in the production of which a relatively large amount of its abundant and cheap resource is used. Conversely, it will import com- modities in the production of which a relatively scarce and expensive resource is used. The theory also states that with trade, the relative differences in resource prices between nations tend to be eliminated. 3. According to the Stolper–Samuelson theorem, increases in income occur for the abundant resource that is used to determine comparative advantage. Conversely, the scarce factor realizes a decrease in income. 4. The specific-factors theory analyzes the income distribution effects of trade in the short run when resources are immobile among industries. It con- cludes that resources specific to export industries tend to gain as a result of trade. 5. Contrary to the predictions of the factor endow- ment model, the empirical tests of Wassily Leontief demonstrated that for the U.S. exports are labor intensive and import competing goods are capital
- 581. intensive. His findings became known as the Leon- tief paradox. 6. By widening the size of the domestic market, inter- national trade permits firms to take advantage of longer production runs and increasing efficiencies (such as mass production). Such economies of scale 104 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. can be translated into lower product prices, which improve a firm’s competitiveness.
- 582. 7. Staffan Linder offers two explanations for world trade patterns. Trade in primary products and agricultural goods conforms well to the factor- endowment theory. But trade in manufactured goods is best explained by overlapping demand structures among nations. For manufactured goods, the basis for trade is stronger when the structure of demand in the two nations is more similar—that is, when the nations’ per capita incomes are similar. 8. Besides inter-industry trade, the exchange of goods among nations includes intra-industry trade—two- way trade in a similar product. Intra-industry trade occurs in homogeneous goods as well as in differ- entiated products. 9. One dynamic theory of international trade is the product life cycle theory. This theory views a variety of manufactured goods as going through a trade cycle, during which a nation initially is an exporter, then loses its export markets, and finally becomes an importer of the product. Empirical studies have demonstrated that trade cycles do exist for manufactured goods at some
- 583. times. 10. Dynamic comparative advantage refers to the crea- tion of comparative advantage through the mobili- zation of skilled labor, technology, and capital; it can be initiated by either the private or public sec- tor. When government attempts to create compar- ative advantage, the term industrial policy applies. Industrial policy seeks to encourage the develop- ment of emerging, sunrise industries through such measures as tax incentives and R&D subsidies. 11. Business regulations can affect the competitive position of industries. These regulations often result in cost increasing compliance measures, such as the installation of pollution control equip- ment, which can detract from the competitiveness of domestic industries. 12. International trade includes the flow of services between countries as well as the exchange of man- ufactured goods. As with trade in manufactured goods, the principle of comparative advantage applies to trade in services.
- 584. 13. Transportation costs tend to reduce the volume of international trade by increasing the prices of traded goods. A product will be traded only if the cost of transporting it between nations is less than the pre-trade difference between their relative commodity prices. KEY CONCEPTS AND TERMS Capital/labor ratio (p. 70) Dynamic comparative advantage (p. 96) Economies of scale (p. 85) External economies of scale (p. 87) Factor-endowment theory (p. 70) Factor-price equalization (p. 76) Heckscher–Ohlin theory (p. 70) Home market effect (p. 87) Industrial policy (p. 96) internal economies of scale (p. 86) Inter-industry specialization (p. 90) Inter-industry trade (p. 90) Intra-industry specialization (p. 90)
- 585. Intra-industry trade (p. 90) Leontief paradox (p. 84) Magnification effect (p. 79) Product life cycle theory (p. 93) Specific-factors theory (p. 81) Stolper–Samuelson theorem (p. 78) Theory of overlapping demands (p. 88) Transportation costs (p. 101) STUDY QUESTIONS 1. What are the effects of transportation costs on international trade patterns? 2. Explain how the international movement of products and of factor inputs promotes an equalization of the factor prices among nations. 3. How does the factor-endowment theory differ from Ricardian theory in explaining international trade patterns?
- 586. 4. The factor-endowment theory demonstrates how trade affects the distribution of income within trading partners. Explain. Chapter 3: Sources of Comparative Advantage 105 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 5. How does the Leontief paradox challenge the overall applicability of the factor-endowment model? 6. According to Staffan Linder, there are two expla- nations for international trade patterns—one for manufactures and another for primary (agricul-
- 587. tural) goods. Explain. 7. Do recent world trade statistics support or refute the notion of a product life cycle for manufactured goods? 8. How can economies of scale affect world trade patterns? 9. Distinguish between intra-industry trade and inter-industry trade. What are some major determinants of intra-industry trade? 10. What is meant by the term industrial policy? How do governments attempt to create comparative advantage in sunrise sectors of the economy? What are some problems encountered when attempting to implement industrial policy? 11. How can governmental regulatory policies affect an industry’s international competitiveness? 12. International trade in services is determined by what factors?
- 588. 13. Table 3.6 illustrates the supply and demand schedules for calculators in Sweden and Norway. On graph paper, draw the supply and demand schedules of each country. a. In the absence of trade, what are the equilib- rium price and quantity of calculators produced in Sweden and Norway? Which country has the comparative advantage in calculators? b. Assume there are no transportation costs. With trade, what price brings about balance in exports and imports? How many calculators are traded at this price? How many calculators are produced and consumed in each country with trade? c. Suppose the cost of transporting each calculator from Sweden to Norway is $5. With trade, what is the impact of the transportation cost on the price of calculators in Sweden and Norway? How many calculators will each country pro- duce, consume, and trade? d. In general, what can be concluded about the impact of transportation costs on the price of
- 589. the traded product in each trading nation? The extent of specialization? The volume of trade? E X P L O R I N G F U R T H E R For a more detailed presentation of the specific-factors theory, go to Exploring Further 3.1 which can be found at www.cengage.com/economics/Carbaugh. TABLE 3.6 Supply and Demand Schedules for Calculators SWEDEN NORWAY Price Quantity supplied Quantity demanded Price Quantity supplied Quantity demanded $ 0 0 1200 $0 – 1800 5 200 1000 5 – 1600 10 400 800 10 – 1400 15 600 600 15 0 1200
- 590. 20 800 400 20 200 1000 25 1000 200 25 400 800 30 1200 0 30 600 600 35 1400 – 35 800 400 40 1600 – 40 1000 200 45 1800 – 45 1200 0 © C en ga ge Le ar ni
- 591. ng ® 106 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. C H A P T E R 4 Tariffs According to the free-trade argument, open markets based on comparative advantageand specialization result in the most efficient use of world resources. Not only do
- 592. free trade and specialization enhance world welfare, but they can also benefit each participating nation. Every nation can overcome the limitations of its own productive capacity to consume a combination of goods that exceeds the best it can produce in isolation. However, free-trade policies often meet resistance among those companies and workers who face losses in income and jobs because of import competition. Policymakers are thus torn between the appeal of greater global efficiency in the long run made possible by free trade and the needs of the voting public whose main desire is to preserve short run interests such as employment and income. The benefits of free trade may take years to achieve and are spread over wide segments of society, whereas the costs of free trade are immediate and fall on specific groups such as workers in an import-competing industry. When forming an international trade policy, a government must decide where to
- 593. locate along the following spectrum: As a government protects its producers from foreign competition, it encourages its economy to move closer to a state of isolationism, or autarky. Nations like Cuba and North Korea have traditionally been highly closed economies and therefore are closer to autarky. Conversely, if a government does not regulate the exchange of goods and services between nations, it moves to a free-trade policy. Countries such as Hong Kong (now part of the People’s Republic of China) and Singapore are largely free-trade countries. The remaining countries of the world lie somewhere between these extremes. Rather than considering which of these two extremes a government should pursue, policy discussions generally consider where along this spectrum a country should locate—that is, “how much” trade liberalization or protectionism to pursue. Protectionism Autarky
- 594. (closed market) ------------------------ Free Trade (open market)Trade liberalization 1 0 7 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. This chapter considers barriers to trade. In particular, it focuses on the role that tariffs play in the global trading system. THE TARIFF CONCEPT A tariff is simply a tax levied on a product when it crosses
- 595. national boundaries. The most widespread tariff is the import tariff that is a tax levied on an imported product. This tax is collected before the shipment can be unloaded at a domestic port; the collected money is called a customs duty. A less common tariff is an export tariff that is a tax imposed on an exported product. Export tariffs have often been used by develop- ing nations. Cocoa exports have been taxed by Ghana, and oil exports have been taxed by the Organization of Petroleum Exporting Countries (OPEC) in order to raise revenue or promote scarcity in global markets and hence increase the world price. Did you know that the United States cannot levy export tariffs? When the U.S. Constitution was written, southern cotton producing states feared that northern textile manufacturing states would pressure the federal government into levying export tariffs to depress the price of cotton. An export duty would lead to decreased exports and a fall in the price of cotton within the United States. As the result
- 596. of negotiations, the Con- stitution was worded to prevent export taxes: “No tax or duty shall be laid on articles exported from any state.” Tariffs may be imposed for protection or revenue purposes. A protective tariff is designed to reduce the amount of imports entering a country, thus insulating import- competing producers from foreign competition. This tariff allows an increase in the output of import-competing producers that would not have been possible without protection. A revenue tariff is imposed for the purpose of generating tax revenues and may be placed on either exports or imports. Over time, tariff revenues have decreased as a source of government revenue for advanced nations, including the United States. In 1900, tariff revenues constituted more than 41 percent of U.S. government receipts; in 2010, the figure stood at about 1.0 percent. However, many developing nations currently rely on tariffs as a sizable source of
- 597. government revenue. Table 4.1 shows the percentage of government revenue that several selected nations derive from tariffs. TABLE 4.1 Taxes on International Trade as a Percentage of Government Revenues, 2011: Selected Countries Developing Countries Percentage Advanced Countries Percentage Bahamas 43.3 New Zealand 2.8 Ethopia 29.7 Australia 1.8 Liberia 28.5 Japan 1.6 Bangladesh 26.5 United States 1.3 Grenada 25.6 Switzerland 1.0 Russian Federation 25.6 Norway 0.2 Philippines 19.5 Ireland 0.1
- 598. India 14.3 World average 3.9 Source: From World Bank Data at http://data.worldbank.org. See also International Monetary Fund, Government Finance Statistics, Yearbook, Washington, DC. 108 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Some tariffs vary according to the time of entry into the United States, as occurs with agricultural goods such as grapes, grapefruit, and cauliflower.
- 599. This tariff reflects the harvest season for these products. When these products are out of season in the United States, the tariff is low. Higher tariffs are imposed when U.S. production in these goods increases during harvest season. Not all goods that enter the United States are subject to tariffs. In 2013, only about 30 percent of U.S. imports were dutiable (subject to import duties) while 70 percent of imports were free of tariffs.1 That U.S. imports are duty free is mainly because of free- trade agreements that the United States reaches with other countries (North American Free Trade Agreement) and trade preferences that the United States gives to imports from developing countries (Generalized System of Preferences program). Also, a sizable portion of most favored nation (MFN) tariffs are duty free. These topics are discussed in Chapters 6, 7, and 8 of this textbook. TYPES OF TARIFFS
- 600. Tariffs can be specific, ad valorem, or compound. A specific tariff is expressed in terms of a fixed amount of money per physical unit of the imported product. A U.S. importer of a German computer may be required to pay a duty to the U.S. government of $100 per computer, regardless of the computer’s price. Therefore, if 100 computers are imported, the tariff revenue of the government equals $10,000 inequality. In the figure, the wage ration equals wage of skilled workers/wage of unskilled workers. The labor ration equals the quantity of skilled workers/quantity of unskilled workers. $100 100 $10,000 . An ad valorem (of value) tariff, much like a sales tax, is expressed as a fixed percent- age of the value of the imported product. Suppose that an ad valorem duty of 2.5 percent is levied on imported automobiles. If $100,000 worth of autos are imported, the govern- ment collects $2,500 in tariff revenue $100,000 2 5% $2,500 . This $2,500 is collected whether 5, $20,000 Toyotas are imported or 10
- 601. $10,000 Nissans. Most of the tariffs levied by the U.S. government are ad valorem tariffs. A compound tariff is a combination of specific and ad valorem tariffs. A U.S. importer of a television might be required to pay a duty of $20 plus 5 percent of the value of the television. Table 4.2 lists U.S. tariffs on certain items. What are the relative merits of specific, ad valorem, and compound tariffs? Specific Tariff As a fixed monetary duty per unit of the imported product, a specific tariff is relatively easy to apply and administer, particularly to standardized commodities and staple pro- ducts where the value of the dutiable goods cannot be easily observed. A main disadvan- tage of a specific tariff is that the degree of protection it affords domestic producers varies inversely with changes in import prices. A specific tariff of $1,000 on autos will discourage imports priced at $20,000 per auto to a greater
- 602. degree than those priced at $25,000. During times of rising import prices, a given specific tariff loses some of its protective effect. The result is to encourage domestic producers to produce less expensive goods, for which the degree of protection against imports is higher. On the other hand, a specific tariff has the advantage of providing domestic producers more protection during 1The effective tariff is a measure that applies to a single nation. In a world of floating exchange rates, if all nominal or effective tariff rates rose, the effect would be offset by a change in the exchange rate. Chapter 4: Tariffs 109 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 603. time if subsequent rights restrictions require it. a business recession, when cheaper products are purchased. Specific tariffs thus cushion domestic producers progressively against foreign competitors who cut their prices. Ad Valorem Tariff Ad valorem tariffs usually lend themselves more satisfactorily to manufactured goods because they can be applied to products with a wide range of grade variations. As a percentage applied to a product’s value, an ad valorem tariff can distinguish among small differentials in product quality to the extent that they are reflected in product price. Under a system of ad valorem tariffs, a person importing a $20,000 Honda would have to pay a higher duty than a person importing a $19,900 Toyota. Under a system of specific tariffs, the duty would be the same. Another advantage of an ad valorem tariff is that it tends to
- 604. maintain a constant degree of protection for domestic producers during periods of changing prices. If the tariff rate is a 20 percent ad valorem and the imported product price is $200, the duty is $40. If the product’s price increases to $300, the duty collected rises to $60; if the product price falls to $100, the duty drops to $20. An ad valorem tariff yields revenues proportionate to values, maintaining a constant degree of relative protection at all price levels. An ad valorem tariff is similar to a proportional tax in that the real proportional tax burden or protection does not change as the tax base changes. In recent decades, in response to global inflation and the rising importance of world trade in manufactured products, ad valorem duties have been used more often than specific duties. The determination of duties under the ad valorem principle at first appears to be simple, but in practice it has suffered from administrative complexities. The main prob- lem has been trying to determine the value of an imported
- 605. product, a process referred to as customs valuation. Import prices are estimated by customs appraisers who may dis- agree on product values. Moreover, import prices tend to fluctuate over time, making the valuation process rather difficult. Another customs-valuation problem stems from variations in the methods used to determine a commodity’s value. For example, the United States has traditionally used free-on-board (FOB) valuation, whereby the tariff is applied to a product’s value as it leaves the exporting country. But European countries have traditionally used a cost-insurance-freight (CIF) valuation, whereby ad valorem tariffs are levied as a TABLE 4.2 Selected U.S. Tariffs Product Duty Rate Brooms $0.32 each
- 606. Fishing reels $0.24 each Wrist watches (without jewels) $0.29 each Ball bearings 2.4% ad valorem Electrical motors 6.7% ad valorem Bicycles 5.5% ad valorem Wool blankets $0.18/kg + 6% ad valorem Electricity meters $0.16 each + 1.5% ad valorem Auto transmission shafts $0.25 each + 3.9% ad valorem Source: From U.S. International Trade Commission, Tariff Schedules of the United States, Washington, DC, Government Printing Office, 2013, available at http://www.usitc.gov/tata/index.htm. 110 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 607. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. percentage of the imported commodity’s total value as it arrives at its final destination. The CIF price thus includes transportation costs, such as insurance and freight. Compound Tariff Compound duties are often applied to manufactured products embodying raw materials that are subject to tariffs. In this case, the specific portion of the duty neutralizes the cost disadvantage of domestic manufactures that results from tariff protection granted to domestic suppliers of raw materials, and the ad valorem portion of the duty grants protection to the finished–goods industry. In the United States
- 608. there is a compound duty on woven fabrics ($0.485 cents per kilogram plus 38 percent). The specific portion of the duty ($0.485 cents) compensates U.S. fabric manufacturers for the tariff protection granted to U.S. cotton producers, while the ad valorem portion of the duty (38 percent) provides protection for their own woven fabrics. How high are import tariffs around the world? Table 4.3 provides examples of tariffs of selected advanced and developing countries. EFFECTIVE RATE OF PROTECTION In our previous discussion of tariffs, we assumed that a given product is produced entirely in one country. For example, a desktop computer produced by Dell (a U.S. firm) could be the output that results from using only American labor and components. However, this ignores the possibility that Dell imports some parts used in producing desktops, such as memory chips, hard-disk drives, and microprocessors.
- 609. When some inputs used in producing finished desktops are imported, the amount of protection given to Dell depends not only on the tariff rate applied to desktops, but also on whether there are tariffs on inputs used to produce them. The main point is that when Dell imports some of the inputs required to produce desktops, the tariff rate on desktops may not accurately indicate the protection being provided to Dell. TABLE 4.3 Average Import Tariff Rates* for Selected Countries, 2012 (in percentages) Advanced Country Average Tariff Rate Bahamas 18.9 South Korea 8.7 Brazil 7.9
- 610. China 4.1 United States 1.6 Japan 1.3 Germany 1.1 Canada 0.9 World average 3.0 *Tariff rate, applied simple mean, all products. Source: From World Bank Data at http://data.worldbank.org. Chapter 4: Tariffs 111 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does
- 611. not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. In analyzing tariffs, economists distinguish between the nominal tariff rate and the effective tariff rate. The nominal tariff rate is the rate that is published in the country’s tariff schedule. This rate applies to the value of a finished product that is imported into a country. The effective tariff rate takes into account not only the nominal tariff rate on a finished product, but also any tariff rate applied to imported inputs that are used in pro- ducing the finished product.1 If a finished desktop enters the United States at a zero tariff rate, while imported components used in desktop production are taxed, then Dell is taxed instead of protected. A nominal tariff on a desktop protects the production of Dell, while a tariff on imported components taxes Dell by increasing its costs. The
- 612. effective tariff rate recog- nizes these two effects. The effective tariff rate refers to the level of protection being provided to Dell by a nominal tariff on desktops and the tariff on inputs used in desktop production. Specif- ically, it measures the percentage increase in domestic production activities (value added) per unit of output made possible by tariffs on both the finished desktop and on imported inputs. A given tariff on a finished desktop will have a greater protective effect if it is combined with a low tariff on imported inputs than if the tariff on imported inputs is high. To illustrate this principle, assume Dell adds value by assembling computer compo- nents that are produced abroad. Suppose the imported components can enter the United States on a duty free basis (zero tariff). Suppose also that 20 percent of a desktop’s final value can be attributed to domestic assembly activities (value added). The remaining
- 613. 80 percent reflects the value of the imported components. Let the cost of the desktop’s T R A D E C O N F L I C T S T R A D E P R O T E C T I O N I S M I N T E N S I F I E S A S G L O B A L E C O N O M Y F A L L S I N T O T H E G R E A T R E C E S S I O N Global economic downturns can be a catalyst for trade protectionism. As economies shrink, nations have incentive to protect their struggling producers by establishing barriers against imported goods. Consider the Great Recession of 2007–2009. As the global economy fell into recession, there occurred a decrease in the demand for goods and ser- vices and thus a decline in international trade. Exports declined by 30 percent or more for countries as diverse as Indonesia, France, South Africa, and the Philippines. Increasingly, firms and workers worried about the harm that was inflicted on them by their foreign com- petitors who were seeking customers throughout the globe. China was the country targeted by the most
- 614. governments for protectionist measures. Although leaders of the Group of 20 large econo- mies unanimously pledged not to resort to protection- ism in 2008 and 2009, virtually all of them slipped at least a little bit. Russia increased tariffs on imported automobiles, India raised tariffs on steel imports, and Argentina established new obstacles to imported auto parts and shoes. Also, in 2009 the United States imposed tariffs of between 25 percent and 35 percent on imports of tires from China for the next three years. This policy essentially priced out of the market 17 per- cent of all tires sold in the United States and forced up the market price for consumers. During the Great Depression of the 1930s, countries raised import tariffs to protect producers damaged by foreign competition. The United States increased import tariffs on some 20,000 goods that provoked widespread retaliation from its trading partners. Such tariff increases contributed to the volume of world trade shrinking by a quarter. A lesson from this era is that once trade barriers are increased, they can severely damage global supply chains. It can take
- 615. years of negotiation to dismantle trade barriers and years before global supply chains can be restored. In spite of this lesson, governments have continued to adopt protectionist policies as their economies slide into recession. iS to ck ph ot o. co m /p ho to so up
- 616. 112 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. components be the same for both Dell and its foreign competitor, say, Sony Inc. of Japan. Assume that Sony can produce and sell a desktop for $500. Suppose the United States imposes a nominal tariff of ten percent on desktops, so that the domestic import price rises from $500 to $550 per unit, as seen in Table 4.4. Does this mean that Dell realizes an effective rate of protection equal
- 617. to 10 percent? Certainly not! The imported components enter the country duty free (at a nominal tariff rate less than that on the finished desktop), so the effective rate of protection is 50 percent. Com- pared with what would exist under free trade, Dell can incur 50 percent more production activities and still be competitive. Table 4.4 shows the figures in detail. Referring to Table 4.4(a), under free trade (zero tariff), a Sony desktop could be imported for $500. To meet this price, Dell would have to hold its assembly costs to $100. Referring to Table 4.4(b), under the protective umbrella of the tariff, Dell can incur up to $150 of assembly costs and still meet the $550 price of imported desktops. The result is that Dell’s assembly costs could rise to a level of 50 percent above what would exist under free- trade conditions: $150 $100 $100 0 5. In general, the effective tariff rate is given by the following formula:
- 618. e n ab 1 a where e = The effective rate of protection n = The nominal tariff rate on the final product a = The ratio of the value of the imported input to the value of the finished product b = The nominal tariff rate on the imported input When the values from the desktop example are plugged into this formula, we obtain the following: e 0 1 0 8 0 1 0 8 0 5 or 50 percent The nominal tariff rate of ten percent levied on the finished desktop thus allows a 50 percent increase in domestic production activities—five
- 619. times the nominal rate. TABLE 4.4 The Effective Rate of Protection (a) Free Trade: No Tariff on Imported Sony Desktops SONY’S DESKTOP COST DELL’S DESKTOP COST Component parts $400 Imported component parts 400 Assembly activity (value added) 100 Assembly activity (value added) 100 Import price $500 Domestic price $500 (b) 10 Percent Tariff on Imported Sony Desktops SONY’S DESKTOP COST DELL’S DESKTOP COST Component parts $400 Imported component parts $400 Assembly activity (value added) 100 Assembly activity (value added) 150
- 620. Nominal tariff 50 Domestic price $550 Import price $550 © C en ga ge Le ar ni ng ® Chapter 4: Tariffs 113 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 621. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. However, a tariff on imported desktop components reduces the level of effective protection for Dell. This reduction means that in the above formula, the higher the value of b, the lower the effective–protection rate for any given nominal tariff on the finished desktop. Suppose that imported desktop components are subject to a tariff rate of 5.0 percent. The effective rate of protection would equal 30 percent: e 0 1 0 8 0 05 1 0 8 0 3 or 30 percent
- 622. This is less than the 50 percent effective rate of protection that occurs when there is no tariff on imported components. From these examples we can draw several conclusions. When the tariff on the fin- ished product exceeds the tariff on the imported input, the effective rate of protection exceeds the nominal tariff. If the tariff on the finished product is less than the tariff on the imported input, the effective rate of protection is less than the nominal tariff and may even be negative. Such a situation might occur if the home government desired to protect domestic suppliers of raw materials more than domestic manufacturers.2 Because national governments generally admit raw materials and other inputs either duty free or at a lower rate than finished goods, effective tariff rates are usually higher than nominal rates. Table 4.5 provides examples of nominal and effective tariff rates for China in 2001.
- 623. TARIFF ESCALATION When analyzing the tariff structures of nations, we often see that processed goods face higher import tariffs than those levied on basic raw materials. Logs may be imported tariff-free while processed goods such as plywood, veneers, and furniture face higher import tariffs. The purpose of this tariff strategy is to protect, say, the domestic plywood industry by enabling it to import logs (used to produce plywood) tariff free or at low TABLE 4.5 China’s Nominal and Effective Tariff Rates in Forestry Products, 2001 Product Nominal Rate (%) Effective Rate (%) Mouldings 9.4 26.6 Furniture 11.0 21.8 Veneers 4.0 9.4
- 624. Plywood 8.4 11.7 Fiberboard 7.5 9.2 Particleboard 9.6 10.6 Source: From Manatu Aorere, Tariff Escalation in the Forestry Sector, New Zealand Ministry of Foreign Affairs and Trade, Wellington, New Zealand, August 2002. 2Besides depending on the tariff rates on finished desktops and components used to produce them, the effective rate of protection depends on the ratio of the value of the imported input to the value of the finished product. The degree of effective protection for Dell increases as the value added by Dell declines (the ratio of the value of the imported input to the value of the final product increases). That is, the higher the value of a in the formula, the greater the effective protection rate for any given nomi- nal tariff rate on desktops. 114 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May
- 625. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. rates while maintaining higher tariffs on imported plywood that competes against domestic plywood. This policy is referred to as tariff escalation: although raw materials are often imported at zero or low tariff rates, the nominal and effective protection increases at each stage of production. As seen in Table 4.6, tariffs often rise significantly with the level of processing in many countries. This is especially true for agricultural products. The tariff structures of the industrialized nations may indeed
- 626. discourage the growth of processing, hampering diversification into higher value–added exports for the less devel- oped nations. The industrialized nations’ low tariffs on primary commodities encourage the developing nations to expand operations in these sectors, while the high protective rates levied on manufactured goods pose a significant entry barrier for any developing nation wishing to compete in this area. From the point of view of less developed nations, it may be in their best interest to discourage disproportionate tariff reductions on raw materials. The effect of these tariff reductions is to magnify the discrepancy between the nominal and effective tariffs of the industrialized nations, worsening the potential compet- itive position of the less developed nations in the manufacturing and processing sectors. OUTSOURCING AND OFFSHORE ASSEMBLY PROVISION Outsourcing is a key aspect of the global economy. Electronic components made in the
- 627. United States are shipped to another country with low labor costs such as Singapore, for assembly into television sets. The assembled sets are then returned to the United States for further processing or packaging and distribution. This type of production sharing has evolved into an important competitive strategy for producers who locate each stage of production in the country where it can be at least cost. The Tariff Act of 1930 created an offshore assembly provision (OAP) that provides favorable treatment to products assembled abroad from U.S. made components. Under OAP, when U.S. made components are sent abroad and assembled there to become a finished good, the cost of the U.S. components is not included in the dutiable value of the imported assembled good into which it has been incorporated. American import duties thus apply only to the value added in the foreign assembly process, provided that the U.S. manufactured components are used in assembly operations. Manufactured
- 628. TABLE 4.6 Tariff Escalations in Advanced and Developing Countries, 2008 AGRICULTURE PRODUCTS INDUSTRIAL PRODUCTS Country Primary Products Processed Products Primary Products Processed Products Bangladesh 17.5 23.0 9.1 15.4 Uganda 17.5 20.3 4.2 11.7 Argentina 5.7 11.5 2.9 9.5 Brazil 6.5 12.1 4.2 10.7 Russia 6.9 9.2 5.3 9.5 United States 1.0 2.8 1.3 2.8 Japan 4.5 10.9 0.5 1.9 World 12.0 15.1 5.6 7.7
- 629. Source. From World Bank Data at http://data.worldbank.org. Chapter 4: Tariffs 115 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. goods entering the United States under OAP have included motor vehicles, office machines, television sets, aluminum cans, semiconductors, and the like. These products have represented about 8–10 percent of total U.S. imports in recent years. The OAP pertains to both American and foreign companies. A U.S. computer com-
- 630. pany could produce components in the United States, send them to Taiwan for assem- bly, and ship finished computers back to the United States under favorable OAP. Alternatively, a Japanese photocopier firm desiring to export to the United States could purchase U.S made components, assemble them in Japan and ship finished photocopiers to the United States under favorable OAP. One of the effects of OAP is to reduce the effective rate of protection of foreign assembly activity and shift demand from domestic to foreign assembly, as explained below. Suppose that ABC Electronics Co. is located in the United States and manufactures televisions sets worth $300 each. Included in a set are components worth $200 that are produced by the firm in the United States. To reduce labor costs, consider the firm sends these components to its subsidiary in South Korea where relatively low-wage Korean workers assemble the components, resulting in finished television sets. Assume that Korean assembly is valued at $100 per set. After being
- 631. assembled in South Korea, the finished sets are imported into the United States for sale to American consumers. What will the tariff duty be on these sets? In the absence of the OAP, the full value of each set, $300, is subject to the tariff. If the tariff rate on such televisions is 10 percent, a duty of $30 would be paid on each set entering the United States, and the price to the U.S. consumer would be $330.3 Under OAP, however, the 10 percent tariff rate is levied on the value of the imported set minus the value of the U.S. components used in manufacturing the set. When the set enters the United States, its dutiable value is thus $300 $200 $100, and the duty is 0 1 $100 $10. The price to the U.S. consumer after the tariff has been levied is $300 $10 $310. With the OAP system, the effective tariff rate is only 3.3 percent $10 $300 instead of the 10 percent shown in the tariff schedule. Therefore, the effect of the OAP is to reduce the effective rate of protection of the
- 632. South Korean assembly activity and to shift demand from American to Korean assem- blers. Opponents of the OAP emphasize that the OAP makes imported television sets more price competitive in the U.S. market. They also stress the associated displacement of American assembly workers and the accompanying negative effects on the U.S. balance of trade. However, this “tariff break” is available only if U.S. made components are used to manufacture television sets. This suggests a simultaneous shift of demand from foreign to American made components. Defenders of the OAP emphasize the asso- ciated positive effects on the production and exporting of American components. Indeed, the OAP has been a controversial provision in U.S. tariff policy. DODGING IMPORT TARIFFS: TARIFF AVOIDANCE AND TARIFF EVASION When a country imposes a tariff on imports, there are economic incentives to dodge it. One way of escaping a tariff is to engage in tariff avoidance, the legal utilization of the
- 633. tariff system to one’s own advantage in order to reduce the amount of tariff that is payable by means that are within the law. By contrast, tariff evasion occurs when indi- viduals or firms evade tariffs by illegal means such as smuggling imported goods into a country. Let us consider each of these methods. 3This example assumes that the United States is a “small” country, as discussed later in this chapter. 116 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 634. Ford Strips Its Wagons to Avoid High Tariff Several times a month, Ford Motor Company ships its Transit Connect five-passenger wagons from its factory in Turkey to Baltimore, Maryland. Once the passenger wagons arrive in Baltimore, the majority of them are driven to a warehouse where workers listening to rock music rip out the rear windows, seats, and seat belts. Why? Ford’s behavior is part of its efforts to cope with a lengthy trade conflict. In the 1960s, Europe imposed high tariffs on imported chickens, primarily intended to discourage American sales to West Germany. President Lyndon Johnson retaliated with a 25 percent tariff on imports of foreign made trucks and commercial vans (motor vehicles for the transport of goods). This tariff exists today and applies to trucks and commercial vans even if they are produced by an American company in a foreign country. However, the U.S. tariff on imports of vehicles in the category of “wagons” and “cars” (motor vehicles for the transport of persons) face a much lower 2.5 percent
- 635. tariff. Realizing that a 25 percent tariff would significantly add to the price of its cargo vans sold in the United States, and thus detract from their competitiveness, in 2009 Ford embarked on a program to avoid this tariff. Here’s how it works. Ford ships the Transit Connects wagons to the United States that face a 2.5 percent tariff. Once the wagons reach a processing facility in Baltimore, they are transformed into cargo vans. The rear windows are removed and replaced by a sheet of metal, and the rear seats and seat belts are removed and a new floorboard is screwed into place. Although the vehicles start as five-passenger wagons, Ford converts them into two-seat cargo vans. The fabric is shredded, the steel parts are broken down, and everything is sent along with the glass to be recycled. According to U.S. customs officials, this practice complies with the letter of the law. Transforming wagons into cargo vans costs Ford hundreds of
- 636. dollars per vehicle, but the process saves the company thousands in terms of tariff duties. On a $25,000 passenger wagon a 2.5 percent tariff would result in a duty of only $625 $25,000 0 025 $625 . This compares to a duty of $6,250 that would result from a 25 percent tariff imposed on a cargo van $25,000 0 25 $6,250 . The avoidance of the higher tariff on cargo vans would save Ford $5,625 on each vehicle $6,250 $625 $5,625 minus the cost of transforming the passenger wagon into a cargo van. Smart, huh? Ford’s transformation process is only one way to avoid tariffs. Other auto makers have avoided U.S. tariffs using different techniques. Toyota Motor Corp., Nissan Motor Co., and Honda Motor Co. took the straightforward route and built plants in the United States, instead of exporting vehicles from Japan to the United States that are subject to import tariffs.4 Smuggled Steel Evades U.S. Tariffs Each year, about 38 million tons of steel with a value of about
- 637. $12 billion are imported by the United States. About half of this steel is subject to tariffs that range from pennies to hundreds of dollars a ton. The amount of the tariff depends on the type of steel prod- uct (there are about 1,000) and on the country of origin (there are about 100). These tariffs are applied to the selling price of the steel in the United States. American customs inspectors scrutinize the shipments that enter the United States to make sure that tariffs are properly assessed. However, monitoring shipments is difficult given the limited staff of the customs service. Therefore, the risk of being caught for smuggling and the odds of penalties being levied are modest, while the potential for illegal profit is high. 4Drawn from “To Outfox the Chicken Tax, Ford Strips Its Own Vans,” The Wall Street Journal, September 23, 2009, p. A-1. Chapter 4: Tariffs 117 Copyright 2015 Cengage Learning. All Rights Reserved. May
- 638. not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Ivan Dubrinski smuggled 20,000 tons of steel into the United States in the first decade of the 2000s. It was easy. All he did was modify the shipping documents on a product called “reinforcing steel bar” to make it appear that it was part of a shipment of another type of steel called “flat-rolled.” This deception saved him about $38,000 in import duties. Multiply this tariff evasion episode many times over and you have avoided millions of dollars in duties. The smuggling of steel concerns the U.S. govern- ment that loses tariff revenue and also the U.S. steel industry, that maintains it cannot
- 639. afford to compete with products made cheaper by tariff evasion. Although larger U.S. importers of steel generally pay correct duties, it is the smaller, often fly-by-night importers that are more likely to try to slip illegal steel into the coun- try. These traders use one of three methods to evade tariffs. One method is to falsely reclassify steel that would be subject to a tariff as a duty free product. Another is to detach markings that the steel came from a country subject to tariffs and make it appear to have come from one that is exempt. A third method involves altering the chemical composition of a steel product enough so that it can be labeled duty free. T R A D E C O N F L I C T S G A I N S F R O M E L I M I N A T I N G I M P O R T T A R I F F S What would be the effects if the United States unilaterally removed tariffs and other restraints on imported products? On the positive side, tariff elimination lowers the price of the affected
- 640. imports and may lower the price of the competing U.S. good, resulting in economic gains to the U.S. con- sumer. Lower import prices also decrease the produc- tion costs of firms that buy less costly intermediate inputs, such as steel. On the negative side, the lower price to import-competing producers, as a result of eliminating the tariff, results in profit reductions; work- ers become displaced from the domestic industry that loses protection; and the U.S. government loses tax revenue as the result of eliminating the tariff. In 2011 the U.S. International Trade Commission estimated the annual economic welfare gains from eliminating significant import restraints from their existing levels. The result would have been equivalent to a welfare gain of about $2.6 billion to the U.S. economy. The largest welfare gain would come from liberalizing trade ethanol, textiles and apparel, and dairy products, as seen in Table 4.7. TABLE 4.7 Economic Welfare Gains from Liberalization of Significant Import Restraints*, 2015
- 641. (millions of dollars) Import-Competing Industry Annual change in Economic Welfare Ethanol 1,513 Textiles and apparel 514 Dairy 223 Footwear and leather products 215 Tobacco 63 Tuna 16 Costume jewelry 12 *Import tariffs, tariff-rate quotas, and import quotas. Source: From U.S. International Trade Commission, The Economic Effects of Significant U.S. Import Restraints, Washington, DC, Government Printing Office, 2011.
- 642. iS to ck ph ot o. co m /p ho to so up 118 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due
- 643. to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Although customs inspectors attempt to scrutinize imports, once the steel gets by them they can do little about it. They cannot confiscate the smuggled steel because it is often already sold and in use. Meanwhile, the people buying the steel get a nice price break and the American steel companies that compete against smuggled steel, find their sales and profits declining.5 POSTPONING IMPORT TARIFFS Besides allowing the avoidance of tariffs, U.S. tariff law allows the postponement of tariffs. Let us see how a bonded warehouse and a foreign-trade
- 644. zone can facilitate the postponing of tariffs. Bonded Warehouse According to U.S. tariff law, dutiable imports can be brought into the United States and temporarily left in a bonded warehouse, duty free. Importers can apply for authorization from the U.S. Customs Service to have a bonded warehouse on their own premises or they can use the services of a public warehouse that has received such authorization. Owners of storage facilities must be bonded to ensure that they will satisfy all customs duty obligations. This condition means that the bonding company guarantees payment of customs duties in the event that the importing company is unable to do so. Imported goods can be stored, repacked, or further processed in the bonded warehouse for up to five years. Domestically produced goods are not allowed to enter a bonded ware- house. If warehoused at the initial time of entry, no customs duties are owed. When the time
- 645. arrives to withdraw the imported goods from the warehouse, duties must be paid on the value of the goods at the time of withdrawal rather than at the time of entry into the bonded warehouse. If the goods are withdrawn for exportation, payment of duty is not required. While the goods are in the warehouse, the owner may subject them to various processes necessary to prepare them for sale in the market. Such processes might include the repacking and mixing of tea, the bottling of wines, and the roasting of coffee. However, imported components cannot be assembled into final products in a bonded warehouse, nor can the manufacturing of products take place. A main advantage of a bonded warehouse entry is that no duties are collected until the goods are withdrawn for domestic consumption. The importer has the luxury of con- trolling the money for the duty until it is paid upon withdrawal of the goods from the bonded warehouse. If the importer cannot find a domestic buyer for its goods or if the
- 646. goods cannot be sold at a good price domestically, the importer has the advantage of selling merchandise for exportation that cancels the obligation to pay duties. Also, paying duties when goods first arrive in the country can be expensive, and using a bonded ware- house allows importers time to access funds from the sale of the goods to pay the duties rather than having to pay duties in advance. Foreign-Trade Zone Similar to a bonded warehouse, a foreign-trade zone (FTZ) is an area within the United States where business can operate without the responsibility of paying customs duties on imported products or materials for as long as they remain within this area and do not enter the U.S. marketplace. Customs duties are due only when goods are transferred 5Drawn from “Steel Smugglers Pull Wool over the Eyes of Customs Agents to Enter U.S. Market,” The Wall Street Journal, November 1, 2001, pp. A-1 and A-14. Chapter 4: Tariffs 119
- 647. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. from the FTZ for U.S. consumption. If the goods never enter the U.S. marketplace, then no duties are paid on those items. What distinguishes an FTZ from a bonded warehouse? With an FTZ, once merchan- dise has moved in to it, you can do just about anything to the merchandise. You can re-package goods, repair or destroy damaged ones, assemble component parts into finished products, and export either the parts or finished products. The manufacturing
- 648. of goods is also allowed in FTZs. Therefore, importers who use FTZs can conduct a broader range of business activities than can occur in bonded warehouses that permit only the storage of imported goods and limited repackaging and processing activities. Many FTZs are situated at U.S. seaports, such as the Port of Seattle, but some are located at inland distribution points. There are currently more than 230 FTZs throughout the United States. Among the businesses that enjoy FTZ status are Exxon, Caterpillar, General Electric, and International Business Machines (IBM). The FTZ program encourages U.S. based business operations by removing certain disincentives associated with manufacturing in the United States. The duty on a product manufactured abroad and imported into the United States is paid at the rate of the fin- ished product rather than that of the individual parts, materials, or components of the product. A U.S. based company would find itself at a
- 649. disadvantage relative to its foreign competitor if it had to pay a higher rate on parts, materials, or components imported for use in the manufacturing process (this is known as “inverted tariffs”). The FTZ program corrects this imbalance by treating a product manufactured in a FTZ, for purposes of tariff assessment, as if it were produced abroad. Suppose an FTZ user imports a motor that carries a 5.0 percent duty rate, and uses it in the manufacture of a lawn mower that is free of duty. When the lawn mower leaves the FTZ and enters the U.S. marketplace, the duty rate on the motor drops from the 5.0 percent rate to the free lawn mower rate. By participating in the FTZ program, the lawn mower manufacturer has eliminated the duty on this component, and thus decreased the component cost by 5.0 percent. An FTZ can also help a firm eliminate import duties on product waste and scrap. Sup- pose a U.S. chemical company imports raw material that carries a 10 percent duty to pro-
- 650. duce a particular chemical that also carries a 10 percent duty. Part of the production process involves bringing the imported raw material to high temperatures. During this process, 20 percent of the raw material is lost as heat. If the chemical company imports $1 million of raw material per year, it will pay $100,000 ($1 million 0 1 $100,000 in duty as the raw material enters the United States. However, by participating in the FTZ program, it does not pay duty on the raw material until it leaves the zone and enters the U.S. marketplace. Because 20 percent of the raw material is lost as heat during the manufacturing process, the raw material is now worth only $800,000. Assuming that all the finished chemical is sold in the United States, the 10 percent customs duty totals only $80,000. This is a savings of $20,000. While it may appear that the FTZ program benefits only the U.S. chemical company, it is important to remember that its competitors who make the same product abroad already have the benefit of not having to pay on the waste loss in the production of their chemical.
- 651. FTZ’s Benefit Motor Vehicle Importers Toyota Motor Co. is an example of a company that benefits from the U.S. FTZ program. Toyota has vehicle processing centers located within FTZ sites in the United States. Before imported Toyotas are shipped to American dealers, the processing centers clean them, install accessories such as radios and CD players, and so on. A primary benefit of the processing center’s being located within a FTZ site is customs duty deferral—the postponement of the payment of duties until the vehicle has been processed and shipped to the dealer. 120 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 652. time if subsequent rights restrictions require it. For parts imported into the United States, Toyota also has parts distribution centers that are located within FTZ sites. Because of extended warranties, Toyota must maintain a large inventory of parts within the United States for a lengthy period of time that makes the FTZ program attractive from the perspective of duty deferral. Also, a large number of parts may become obsolete and have to be destroyed. By obtaining FTZ designation on its parts distribution center, Toyota can avoid the payment of customs duties on those parts that become obsolete and are destroyed. Another benefit to Toyota of a FTZ is the potential reduction in the dutiable value of the imported vehicle according to the inverted duty principle, as discussed above. Sup- pose that a CD player that is imported from Japan is installed at a Toyota processing center within a FTZ site. In 2011 the duty on the imported CD
- 653. player was 4.4 percent and the duty on a final Toyota automobile was 2.5 percent. Toyota has the ability to reduce the duty on the cost of the CD player by 1.9 percent 4 4% 2 5% 1 9% by having the CD player installed at its processing center within the FTZ site. TARIFF EFFECTS: AN OVERVIEW Before we make a detailed investigation of tariffs, let us consider an introductory over- view of their effects. Tariffs are taxes on imports. They make the item more expensive for consumers, thus reducing demand. Suppose there is a U.S. company and a foreign company supplying computers. The price of the U.S. made computer is $1,000 and the price of foreign- made computer is $750. The U.S. computer company is not able to stay competitive in this situation. Suppose that the United States imposes an import tariff of $300
- 654. per computer. The tariff increases the price of imported computers above the foreign price by the amount of the tariff; $300. American suppliers of computers who compete with suppliers of imported computers can now sell their computers for the foreign price plus the amount of the tariff, $1,050 $750 $300 $1,050 . As the price of computers increases, both imported and domestic consumption decreases. At the same time, the higher price has encouraged American suppliers to expand output. Imports are reduced as domestic con- sumption decreases and domestic production increases. Notice that a tariff need not push the price of the imported computer above the price of its domestic counterpart for the American computer industry to prosper. The tariff should be just high enough to reduce the price differential between the imported computer and the American made computer. If no tariff is imposed, as under free trade, Americans would have saved money by buying the cheaper foreign computer. The U.S. computer
- 655. industry would either have to become more efficient in order to compete with the less expensive imported product or face extinction. Although the tariff benefits producers in the U.S. computer industry, it imposes costs to the U.S. economy: • Computer buyers will have to pay more for their protected U.S. made computers than they would have for the imported computers under free trade. • Jobs will be lost at retail and shipping companies that import foreign made computers. • The extra cost of the computers gets passed on to whatever products and services that use these computers in the production process. These costs will have to be weighed against the number of jobs the tariff would save to get a true picture of the impact of the tariff.
- 656. Chapter 4: Tariffs 121 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Now that we have an overview of the effects of a tariff, let us consider tariffs in a more detailed manner. We will examine the effects of tariffs for a small importing coun- try and a large importing country. Let us begin by reviewing the concepts of consumer surplus and produce surplus as discussed in the next section of this text. TARIFF WELFARE EFFECTS: CONSUMER SURPLUS AND PRODUCER SURPLUS
- 657. To analyze the effect of trade policies on national welfare, it is useful to separate the effects on consumers from those on producers. For each group, a measure of welfare is needed; these measures are known as consumer surplus and producer surplus. Consumer surplus refers to the difference between the amount that buyers would be willing and able to pay for a good and the actual amount they do pay. To illustrate, assume that the price of a Pepsi is $0.50. Being especially thirsty, assume you would be willing to pay up to $0.75 for a Pepsi. Your consumer surplus on this purchase is $0.25 $0 75 $0 50 $0 25 . For all Pepsis bought, consumer surplus is merely the sum of the surplus for each unit. Consumer surplus can also be depicted graphically. Let us first remember that the height of the market demand curve indicates the maximum price
- 658. that buyers are willing and able to pay for each successive unit of the good, and in a competitive market, buyers pay a single price (the equilibrium price) for all units purchased. Referring now to Figure 4.1(a), consider the market price of gasoline is $2 per gallon. If buyers purchase four gallons at this price, they spend $8, represented by area ACED. For those four FIGURE 4.1 Consumer Surplus and Producer Surplus 4 B A 2 0 D Total Expenditure
- 659. (Actual Price) Demand (Maximum Price) Gasoline (Gallons) C E 84 Consumer Surplus P ri ce ( D o lla
- 660. rs ) (a) Consumer Surplus A C B D (Actual Price) Supply (Minimum Price) Total Variable Cost Producer Surplus Gasoline (Gallons)
- 661. P ri ce ( D o lla rs ) 2 4 (b) Producer Surplus Consumer surplus is the difference between the maximum amount buyers are willing to pay for a given quan- tity of a good and the amount actually paid. Graphically, consumer surplus is represented by the area under the demand curve and above the good’s market price. Producer
- 662. surplus is the revenue producers receive over and above the minimum necessary for production. Graphically, producer surplus is represented by the area above the supply curve and below the good’s market price. © C en ga ge Le ar ni ng ® 122 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed
- 663. from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. gallons, buyers would be willing and able to spend $12, as shown by area ABCED. The difference between what buyers actually spend and the amount they are willing and able to spend is consumer surplus; in this case, it equals $4 and is denoted by area ABC. The size of the consumer surplus is affected by the market price. A decrease in the market price will lead to an increase in the quantity purchased and a larger consumer surplus. Conversely, a higher market price will reduce the amount purchased and shrink the consumer surplus. Let us now consider the other side of the market; producers.
- 664. Producer surplus is the revenue producers receive over and above the minimum amount required to induce them to supply a good. This minimum amount has to cover the producer’s total variable costs. Recall that total variable cost equals the sum of the marginal cost of producing each successive unit of output. In Figure 4.1(b), the producer surplus is represented by the area above the supply curve of gasoline and below the good’s market price. Recall that the height of the market supply curve indicates the lowest price that producers are willing to supply gasoline; this minimum price increases with the level of output because of rising marginal costs. Sup- pose that the market price of gasoline is $2 per gallon, and four gallons are supplied. Producers receive revenues totaling $8, represented by area ACDB. The minimum revenue they must receive to produce four gallons equals the total variable cost that equals $4 and is depicted by area BCD. Producer surplus is the difference, $4 $8 $4 $4 ,
- 665. and is depicted by area ABC. If the market price of gasoline rises, more gasoline will be supplied and the producer surplus will rise. It is equally true that if the market price of gasoline falls, the producer surplus will fall. In the following sections, we will use the concepts of consumer surplus and producer surplus to analyze the effects of import tariffs on a nation’s welfare. TARIFF WELFARE EFFECTS: SMALL NATION MODEL To measure the effects of a tariff on a nation’s welfare, consider the case of a nation whose imports constitute a small portion of the world market supply. This small nation would be a price taker, facing a constant world price level for its import commodity. This is not a rare case; many nations are not important enough to influence the terms at which they trade. In Figure 4.2, a small nation before trade produces autos at market equilibrium point
- 666. E, as determined by the intersection of its domestic supply and demand schedules. At the equilibrium price of $9,500, the quantity supplied is 50 autos, and the quantity demanded is 50 autos. Now suppose that the economy is opened to foreign-trade and that the world auto price is $8,000. Because the world market will supply an unlimited number of autos at the price of $8,000, the world supply schedule would appear as a horizontal (perfectly elastic) line. Line Sd w shows the supply of autos available to small nation consumers from domestic and foreign sources combined. This overall supply schedule is the one that would prevail in free trade. Free-trade equilibrium is located at point F in the figure. Here the number of autos demanded is 80, whereas the number produced domestically is 20. The import of 60 autos fulfills the excess domestic auto demand. Compared with the situation before trade occurred, free trade results in a fall in the domestic auto price from $9,500 to $8,000. Consumers are better off because they can import more
- 667. autos at a lower price. However, domestic producers now sell fewer autos at a lower price than they did before trade. Chapter 4: Tariffs 123 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Under free trade, the domestic auto industry is being damaged by foreign competi- tion. Industry sales and revenues are falling and workers are losing their jobs. Suppose management and labor unites and convinces the government to levy a protective tariff
- 668. on auto imports. Assume the small nation imposes a tariff of $1,000 on auto imports. Because this small nation is not important enough to influence world market conditions, the world supply price of autos remains constant, unaffected by the tariff. This lack of price change means that the small nation’s terms of trade remains unchanged. The intro- duction of the tariff raises the home price of imports by the full amount of the duty, and the increase falls entirely on the domestic consumer. The overall supply shifts upward by the amount of the tariff, from Sd w to Sd w t. The protective tariff results in a new equilibrium quantity at point G, where the domestic auto price is $9,000. Domestic production increases by 20 units, whereas domestic consumption falls by 20 units. Imports decrease from their pre-tariff level of 60 units to 20 units. This reduction can be attributed to falling domestic consumption and rising domestic production. The effects of the tariff are to impede imports and pro- tect domestic producers. But what are the tariff’s effects on the
- 669. nation’s welfare? Figure 4.2 shows that before the tariff was levied, consumer surplus equaled areas a b c d e f g. With the tariff, consumer surplus falls to areas e f g, an FIGURE 4.2 Tariff Trade and Welfare Effects: Small-Nation Model 9,500 9,000 8,000 P ri ce ( D o
- 670. lla rs ) 20 40 50 60 80 Quantity of Autos F d G cb E f g e a
- 671. H Sd Sd+w+t Sd+w Dd For a small nation, a tariff placed on an imported product is shifted totally to the domestic consumer via a higher product price. Consumer surplus falls as a result of the price increase. The small nation’s welfare decreases by an amount equal to the protec- tive effect and consumption effect, the so-called deadweight losses due to a tariff. © C en ga
- 672. ge Le ar ni ng ® 124 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. overall loss in consumer surplus equal to areas a b c d. This
- 673. change affects the nation’s welfare in a number of ways. The welfare effects of a tariff include a revenue effect, redistribution effect, protective effect, and consumption effect. As might be expected, the tariff provides the government with additional tax revenue and benefits domestic auto pro- ducers; however, at the same time it wastes resources and harms the domestic consumer. The tariff’s revenue effect represents the government’s collections of duty. Found by multiplying the number of imports (20 autos) times the tariff ($1,000), government revenue equals area c, or $20,000. This revenue represents the portion of the loss in consumer surplus in monetary terms that is transferred to the government. For the nation as a whole, the revenue effect does not result in an overall welfare loss; the consumer surplus is merely shifted from the private to the public sector. The redistributive effect is the transfer of the consumer surplus in monetary terms,
- 674. to the domestic producers of the import-competing product. This is represented by area a, that equals $30,000. Under the tariff, domestic home consumers will buy from domes- tic firms 40 autos at a price of $9,000, for a total expenditure of $360,000. At the free trade price of $8,000, the same 40 autos would have yielded $320,000. The imposition of the tariff thus results in home producers’ receiving additional revenues totaling areas a b, or $40,000 (the difference between $360,000 and $320,000). However, as the tariff encourages domestic production to rise from 20 to 40 units, producers must pay part of the increased revenue as higher costs of producing the increased output, depicted by area b, or $10,000. The remaining revenue, $30,000, area a, is a net gain in producer income. The redistributive effect is a transfer of income from consumers to producers. Like the revenue effect, it does not result in an overall loss of welfare for the economy. Area b, totaling $10,000, is referred to as the protective effect of the tariff. This effect
- 675. illustrates the loss to the domestic economy resulting from wasted resources used to produce additional autos at increasing unit costs. As the tariff induced domestic output expands, resources that are less adaptable to auto production are eventually used, increasing unit production costs. This increase means that resources are used less efficiently than they would have been with free trade, in which case autos would have been purchased from low-cost foreign producers. A tariff’s protective effect thus arises because less efficient domestic production is substituted for more efficient foreign pro- duction. Referring to Figure 4.2, as domestic output increases from 20 to 40 units, the domestic cost of producing autos rises, as shown by supply schedule Sd. The same increase in autos could have been obtained at a unit cost of $8,000 before the tariff was levied. Area b, that depicts the protective effect, represents a loss to the economy equal to $10,000. Notice that the calculation of the protection effect simply involves the calcula- tion of the area of triangle b. Recall from geometry that the area
- 676. of a triangle equals base height 2. The height of triangle b equals the increase in price due to the tariff ($1,000); the triangle’s base (20 autos) equals the increase in domestic auto production due to the tariff. The protection effect is thus 20 $1,000 2 $10,000. Most of the consumer surplus lost because of the tariff has been accounted for: c went to the government as revenue; a was transferred to home producers as income; and b was lost by the economy because of inefficient domestic production. The consumption effect, represented by area d, that equals $10,000 is the residual not accounted for else- where. The residual arises from the decrease in consumption resulting from the tariff’s artificially increasing the price of autos from $8,000 to $9,000. A loss of welfare occurs because of the increased price and lower consumption. Notice that the calculation of the consumption effect involves the calculation of the area of triangle d. The height of the
- 677. triangle ($1,000) equals the price increase in autos because of the tariff; the base (20 autos) equals the reduction in domestic consumption based on the tariff. The con- sumption effect is thus 20 $1,000 2 $10,000. Chapter 4: Tariffs 125 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Like the protective effect, the consumption effect represents a real cost to society, not a transfer to other sectors of the economy. Together, these two effects equal the deadweight loss of the tariff (areas b d in the figure).
- 678. As long as it is assumed that a nation accounts for a negligible portion of interna- tional trade, its levying an import tariff necessarily lowers its national welfare. This is because there is no favorable welfare effect resulting from the tariff that would offset the deadweight loss of the consumer surplus. If a nation could impose a tariff that would improve its terms of trade to its trading partners, it would enjoy a larger share of the gains from trade. This would tend to increase its national welfare, offsetting the deadweight loss of consumer surplus. Because it is so insignificant relative to the world market, a small nation is unable to influence the terms of trade. Levying an import tariff reduces a small nation’s welfare. TARIFF WELFARE EFFECTS: LARGE NATION MODEL The support for free trade by economists may appear so pronounced that one might conclude that a tariff could never be beneficial. This is not necessarily true. A tariff
- 679. may increase national welfare when it is imposed by an importing nation that is large enough so that changes in the quantity of its imports, by means of tariff policy, influence the world price of the product. This large nation status applies to the United States that is a large importer of autos, steel, oil, and consumer electronics and to other economic giants such as Japan and the European Union. If the United States imposes a tariff on automobile imports, prices increase for American consumers. The result is a decrease in the quantity demanded, that may be significant enough to force Japanese firms to reduce the prices of their exports. Because Japanese firms can produce and export smaller amounts at a lower marginal cost, they are likely to prefer to reduce their price to the United States to limit the decrease in their sales. The tariff’s effect is thus shared between U.S. consumers who pay a higher price than under free trade for each auto imported, and Japanese firms who realize a lower price than under free trade for each auto exported. The
- 680. difference between these two prices is the tariff duty. The welfare of the United States rises when it can shift some of the tariff to Japanese firms via export price reductions. The terms of trade improves for the United States at the expense of Japan. What are the economic effects of an import tariff for a large country? Referring to Figure 4.3, line Sd represents the domestic supply schedule and line Dd depicts the home demand schedule. Autarky equilibrium occurs at point E. With free trade, the importing nation faces a total supply schedule of Sd w. This schedule shows the number of autos that both domestic and foreign producers together offer domestic consumers. The total supply schedule is upward sloping rather than horizontal because the foreign supply price is not a fixed constant. The price depends on the quantity purchased by an importing country who is a large buyer of the product. With free trade, our country achieves market equilibrium at point F. The price of autos falls to $8,000, domestic con-
- 681. sumption rises to 110 units, and domestic production falls to 30 units. Auto imports totaling 80 units satisfy the excess domestic demand. Suppose that the importing nation imposes a specific tariff of $1,000 on imported autos. By increasing the selling cost, the tariff results in a shift in the total supply sched- ule from Sd w to Sd w t. Market equilibrium shifts from point F to point G while the product price rises from $8,000 to $8,800. The tariff levying nation’s consumer surplus falls by an amount equal to areas a b c d. Area a, totaling $32,000, represents the 126 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any
- 682. time if subsequent rights restrictions require it. redistributive effect; this amount is transferred from domestic consumers to domestic producers. Areas d b depict the tariff’s deadweight loss, the deterioration in national welfare because of reduced consumption consumption effect $8,000 and an ineffi- cient use of resources protective effect $8,000 . As in the small nation example, a tariff’s revenue effect equals the import tariff multi- plied by the quantity of autos imported. This effect yields areas c e, or $40,000. Notice that the tariff revenue accruing to the government now comes from foreign producers as well as domestic consumers. This result differs from the small nation case in which the supply schedule is horizontal and the tariff’s burden falls entirely on domestic consumers. The tariff of $1,000 is added to the free trade import price of
- 683. $8,000. Although the price in the protected market will exceed the foreign supply price by the amount of the duty, it will not exceed the free trade foreign supply price by this amount. Compared with the free trade foreign supply price of $8,000, the domestic consumers pay only an additional $800 per imported auto. This is the portion of the tariff shifted to the con- sumer. At the same time, the foreign supply price of autos falls by $200. This means that foreign producers earn smaller revenues, $7,800, for each auto exported. Because FIGURE 4.3 Tariff Trade and Welfare Effects: Large-Nation Model 9,600 8,800 8,000 7,800
- 684. 0 P ri ce ( D o lla rs ) 30 50 Quantity of Autos 70 90 110 a c e
- 685. d F G E Dd Sd+w Sd+w+ t Sd b For a large nation, a tariff on an imported product may be partially shifted to the domestic consumer via a higher product price and partially absorbed by the foreign exporter via a lower export price. The extent by which a tariff is absorbed by the foreign exporter constitutes a welfare gain for the home country. This gain offsets some (all) of
- 686. the deadweight welfare losses due to the tariff’s consumption and protective effects. © C en ga ge Le ar ni ng ® Chapter 4: Tariffs 127 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
- 687. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. foreign production takes place under increasing-cost conditions, the reduction of imports from abroad triggers a decline in foreign production and unit costs decline. The reduc- tion in the foreign supply price of $200 represents that portion of the tariff borne by the foreign producer. The levying of the tariff raises the domestic price of the import by only part of the duty as foreign producers lower their prices in an attempt to maintain sales in the tariff levying nation. The importing nation finds that its terms of trade has improved if the price it pays for auto imports decreases while the price it charges for its exports remains the same. Thus, the revenue effect of an import tariff in the large nation includes two compo-
- 688. nents. The first is the amount of tariff revenue shifted from domestic consumers to the tariff levying government; in Figure 4.3, this amount equals the level of imports (40 units) multiplied by the portion of the import tariff borne by domestic consumers ($800). Area c depicts the domestic revenue effect, t equals $32,000. The second element is the tariff revenue extracted from foreign producers in the form of a lower supply price. Found by multiplying auto imports (40 units) by the portion of the tariff falling on foreign producers ($200), the terms-of-trade effect is shown as area e, that equals $8,000. Note that the terms-of-trade effect represents a redistribution of income from the foreign nation to the tariff levying nation because of the new terms of trade. The tariff’s revenue effect thus includes the domestic revenue effect and the terms-of- trade effect. A nation that is a major importer of a product is in a favorable trade situation. It can use its tariff policy to improve the terms at which it trades and
- 689. therefore its national welfare. But remember that the negative welfare effect of a tariff is the deadweight loss of the consumer surplus that results from the protection and consumption effects. Refer- ring to Figure 4.3, to decide if a tariff levying nation can improve its national welfare, we must compare the impact of the deadweight loss (areas b d) with the benefits of a more favorable terms of trade (area e). The conclusions regarding the welfare effects of a tariff are as follows: 1. If e is greater than b d national welfare is increased. 2. If e equals b d national welfare remains constant. 3. If e is less than b d national welfare is diminished. In the preceding example, the domestic economy’s welfare would decline by an amount equal to $8,000. This is because the deadweight welfare losses totaling $16,000 more than offset the $8,000 gain in welfare attributable to the terms-of- trade effect.
- 690. The Optimum Tariff and Retaliation We have seen that a large nation can improve its terms of trade by imposing a tariff on imports. However, a tariff causes the volume of imports to decrease, that lessens the nation’s welfare by reducing its consumption of low-cost imports. There is a gain because of improved terms of trade and a loss due to reduced import volume. Referring to Figure 4.4, a nation optimizes its economic welfare by imposing a tariff rate at which the positive difference between the gain of improving terms of trade (area e) and the loss in economic efficiency from the protective effect (area b) and the consumption effect (area d) is at a maximum. The optimum tariff refers to such a tariff rate. It makes sense that the lower the foreign elasticity of supply, the more the large country can get its trading partners to accept lower prices for the large country’s imports. A likely candidate for a nation imposing an optimum tariff
- 691. would be the United States; it is a large importer compared with world demand of autos, electronics, and other 128 Part 1: International Trade Relations Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. products. An optimum tariff is only beneficial to the importing nation. Because any benefit accruing to the importing nation through a lower import price implies a loss to the foreign exporting nation, imposing an optimum tariff is a beggar-thy- neighbor policy that could invite retaliation. After all, if the United States were to
- 692. impose an optimal tariff of 25 percent on its imports, why should Japan and the European Union not levy tariffs of 40 or 50 percent on their imports? When all countries impose optimal tariffs, it is likely that everyone’s economic welfare will decrease as the volume of trade declines. The possi- bility of foreign retaliation may be a sufficient deterrent for any nation considering whether to impose higher tariffs. A classic case of a tariff induced trade war was the implementation of the Smoot– Hawley Tariff Act by the U.S. government in 1930. This tariff was initially intended to provide relief to U.S. farmers. Senators and members of Congress from industrial states used the technique of vote trading to obtain increased tariffs on manufactured goods. The result was a policy that increased tariffs on more than a thousand products with an average nominal duty on protected goods of 53 percent! Viewing the Smoot–Hawley tariff as an attempt to force unemployment on its workers, 12 nations promptly
- 693. increased their duties against the United States. American farm exports fell to one- third of their former level, and between 1930 and 1933 total U.S. exports fell by almost 60 percent. Although the Great Depression accounted for much of that decline, the adverse psychological impact of the Smoot–Hawley tariff on business activity cannot be ignored. FIGURE 4.4 How an Import Tariff Burdens Domestic Exporters 112,500 110,000 105,000 100,000 900 100 Quantity of Tractors
- 694. A B MC1 = AC1 MC0 = AC0 Demand = Price MR $ Caterpillar, Inc. A tariff placed on imported steel increases the costs of a steel- using manufacturer. This increase leads to a higher price charged by the manufacturer and a loss of inter- national competitiveness. © C en
- 695. ga ge Le ar ni ng ® Chapter 4: Tariffs 129 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 696. EXAMPLES OF U.S. TARIFFS Let us now consider two examples of tariffs that have been imposed to protect American producers from foreign competition. Obama’s Tariffs on Chinese Tires President Barack Obama’s import tariffs on tires provide an example of protectionism intended to aid a domestic industry. As a condition for China’s entering the World Trade Organization in 2001, it agreed that other nations could clamp down on surges of imports from China without having to prove unfair trade practices. This special safeguard lasted until 2013. The surge became real when China increased its shipments of tires for automobiles and light trucks to the United States by almost 300 percent during 2004–2008 to $1.8 billion. Four American tire plants were closed and about 4,500 tire production jobs were lost during that period according to the United Steelworkers (USW) union. In response to a complaint by the USW, Obama imposed a tariff
- 697. in 2009 in addition to the existing tariff, for a three-year period on imports of tires from China. The tariff was applied to low price tires, roughly $50 to $60 apiece, that constitute the bulk of the tires China exports to the United States. The amount of the additional tariff was set at 35 per- cent in the first year, 30 percent in the second year, and 25 percent in the third year. The move would cut off about 17 percent of all tires sold in the United States. Obama justified his tariff policy by stating that he was simply enforcing the rule the Chinese had accepted. Critics maintained that Obama was pandering to blue collar workers and union leaders who were needed to support his legislative agenda regarding health care and other issues. The tariff signaled Obama’s desire to keep his word announced during his presidential campaign about protecting American jobs, many of which have moved to China and left employment holes in American manufacturing industries. The USW hailed the decision by declaring that it was the right thing to do for beleaguered
- 698. American tire workers. Officials of China’s government stated that Obama’s decision sent the wrong signal to the world: not only was it a grave act of trade protectionism, but it violated rules of the World Trade Organization and contradicted open market commitments that the U.S. government made at the G20 financial summit in 2009. According to the Obama administration, the tariffs would significantly reduce tire imports from China and boost U.S. industry sales and prices, resulting in increased profit- ability. This profitability would result in the preservation of jobs and the creation of new ones, as well as encourage investment. Also, the tariff would have little or no impact on the U.S. production of automobiles and light trucks because tires account for a very small share of the total cost of those products. Moreover, tires account for a relatively small share of the annual cost of owning and operating an automobile or light truck. Critics contended that the story was more complicated. They
- 699. noted that the USW petition for the tariff increase was not supported by American tire companies because they had already abandoned making low-cost tires in the United States: Tire company officials declared that it was not profitable to produce inexpensive tires in domestic plants in view of competition from foreign companies. Most American tire companies, such as Goodyear Tire and Rubber Co. and Cooper Tire and Rubber Co., manufacture low-cost tires in China that they sell in the United States. Any other American tire manufacturer that wanted to get involved in the low end business would have to revamp factory lines to produce such tires, a costly and complicated practice that would require considerable time. Critics also noted that if Chinese tire exports to the United States were blocked by the tariff, low wage manufacturers in other countries would replace them. However, it would take many months for producers in places like Brazil and 130 Part 1: International Trade Relations
- 700. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Indonesia to pick up the slack. In the meantime, shortages of low end tires would likely appear in the U.S. market resulting in prices increasing by an estimated 20 to 30 percent. Therefore, it was not clear that the Obama tariffs would actually lead to more jobs for the American tire worker or be good for the nation as a whole, according to the critics. The imposition of the tire tariffs provided mixed evidence of their effects. The biggest beneficiaries of the tariffs were probably tire producers in
- 701. Indonesia, South Korea, and Thailand, that replaced supply from China during the 3-year period of the tariffs. Should Footwear Tariffs Be Given the Boot? In 2013 shoppers were busy hunting for bargains at shoe departments of Target, Walmart and other discount stores. They encountered a wide assortment of shoes for children and adults. What they may have not realized was that most of the shoes sold at stores in the United States are produced abroad and are subject to substantial import tariffs. Why impose high tariffs on footwear? American footwear tariffs began in the 1930s. At that time, there was a large shoe industry in the United States that produced mostly rubber and canvas footwear. Tariffs protected these producers from less expensive imports. Although many U.S. tariffs have been greatly decreased or eliminated since the 1930s, footwear tariffs have remained mostly unchanged. Although the U.S. footwear has benefitted from tariff protection, it
- 702. is now virtually extinct; almost 99 percent of all footwear sold in America is currently imported. Nevertheless footwear tariff rates have continued and are high as 67.5 percent. Why does the U.S. government impose high tariffs on footwear when there is virtually no American industry to protect? Critics contend that footwear tariffs are a hidden tax on a household necessity, increasing costs for consumers Also, they note that discount store sneakers are subject to a 48 percent tariff, while leather dress shoes are taxed at only 8.5 percent. Therefore, a Wall Street execu- tive pays a lower tariff rate on his Italian leather loafers while low income households pay more than five times this tariff rate for their shoes. Footwear tariffs are regressive and thus burden people at the lower end of the income ladder more than the wealthy. In 2013 the Affordable Footwear Act was introduced to Congress. This legislation attempts to abolish the most severe of these footwear tariffs— the sizable tariffs on
- 703. lower to moderately priced footwear no longer produced in America. The passage of this legislation would result in the removal of tariffs on about one-third of all footwear imports. The goal is to ultimately reduce the price of shoes, a product that everyone buys, especially lower income households. The legislation ensures that protections con- tinue for the few remaining U.S. footwear producers. Critics of the Affordable Footwear Act consider high shoe tariffs as essential in shield- ing U.S. footwear producers from foreign competition. New Balance Inc. operates facto- ries employing about 1,400 people in the United States. The company maintains that a reduction in footwear tariffs could harm its workers. Yet proponents of the Affordable Footwear Act contend that U.S. footwear companies generally produce specialty and high value shoes, not the types of inexpensive shoes that are subject to the tariff cut pro- visions of the Affordable Footwear Act. At the writing of this text, it remains to be seen whether the Affordable Footwear Act will be passed by the U.S.
- 704. government.6 6H.R. 1708: Affordable Footwear Act of 2013, 113th Congress, 2013–2015; “Shoe Importers Push to Cut Long-Standing Tariff,” Los Angeles Times, July 1, 2012; Eric Martin, “New Balance Wants Its Tariffs, Nike Doesn’t,” Bloomberg Businessweek, May 3, 2012; “Footwear Business Hopes to Stomp Out Higher Outdoor Shoe Tariffs,” CBS/Denver, November 29, 2012; Edward Gresser and Bryan Riley, “Give Shoe Taxes the Boot,” Progressive Economy, The Heritage Foundation, April 24, 2012; “A Shoe Tariff with a Big Footprint,” The Wall Street Journal, November 22, 2012. Chapter 4: Tariffs 131 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
- 705. HOW A TARIFF BURDENS EXPORTERS The benefits and costs of protecting domestic producers from foreign competition as dis- cussed earlier in this chapter are based on the direct effects of an import tariff. Import- competing producers and workers can benefit from tariffs through increases in output, profits, jobs, and compensation. A tariff imposes costs on domestic consumers in the form of higher prices for protected products and reductions in the consumer surplus. There is also a net welfare loss for the economy because not all of the loss in the consumer surplus is transferred as gains to domestic producers and the government (the protective effect and consumption effects). A tariff carries additional burdens. In protecting import- competing producers, a tariff leads indirectly to a reduction in domestic exports. The net result of protectionism is to
- 706. move the economy toward greater self sufficiency, with lower imports and exports. For domestic workers, the protection of jobs in import-competing industries comes at the expense of jobs in other sectors of the economy, including exports. Although a tariff is intended to help domestic producers, the economy wide implications of a tariff are adverse for the export sector. The welfare losses because of restrictions in output and employment in the economy’s export industry may offset the welfare gains enjoyed by import-competing producers. Because a tariff is a tax on imports, the burden of a tariff falls initially on importers who must pay duties to the domestic government. However, importers generally try to T R A D E C O N F L I C T S C O U L D A H I G H E R T A R I F F P U T A D E N T I N T H E F E D E R A L D E B T ? The debt of the U.S. government is of much concern to policymakers and citi-
- 707. zens alike.