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A Lecture Presentation in PowerPoint to accompany Essentials of Economics by Robert L. Sexton Copyright © 2003 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333 Copyright © 2003 by Thomson Learning, Inc. Chapter 19 International Trade Copyright © 2003 by Thomson Learning, Inc. 19.1 The Growth in World Trade In a typical year, about 15 percent of the world's output is traded in international markets. While the importance of the international sector varies enormously from place to place, the volume of international trade has increased substantially. Copyright © 2003 by Thomson Learning, Inc. Major U.S. Trading Partners Top Five Trading Partners Exports of Goods in 2000 Rank 1 2 3 4 5 Country Percent of Total Canada Mexico Japan United Kingdom Germany SOURCE: CIA, The World Factbook 2001. Copyright © 2003 by Thomson Learning, Inc. 23 14 8 5 4 Top Five Trading Partners Imports of Goods in 2000 Rank 1 2 3 4 5 Country Canada Japan Mexico China Germany SOURCE: CIA, The World Factbook 2001. Percent of Total 19 11 11 8 5 19.2 Comparative Advantage and Gains from Trade The very existence of trade suggests that trade is economically beneficial. Because almost all trade is voluntary, it would seem that trade occurs because the participants feel that they are better off because of the trade. Both participants of an exchange of goods and services anticipate an improvement in their economic welfare. Copyright © 2003 by Thomson Learning, Inc. 19.2 Comparative Advantage and Gains from Trade The classical economist David Ricardo's theory that explains how trade can be beneficial to both parties centers on the concept of comparative advantage. A person, a region, or a country can gain from trade if it produces a good or service at a lower opportunity cost than others. An area should specialize in producing and selling those items in which it has a comparative advantage. Copyright © 2003 by Thomson Learning, Inc. 19.2 Comparative Advantage and Gains from Trade What is important for mutually beneficial specialization and trade is comparative advantage, not absolute advantage. Copyright © 2003 by Thomson Learning, Inc. 19.2 Comparative Advantage and Gains from Trade The gains from comparative advantage—specialization in what one is a lower opportunity cost producer of—can be illustrated with a production possibility curve. The differences in opportunity costs provide an incentive to gain from specialization and trade. Copyright © 2003 by Thomson Learning, Inc. Specialization and Trade B Food (pounds) 30 Total production with specialization Wendy’s PPC C 15 10 7.5 Calvin’s PPC A 7.5 10 15 Cloth (yards) Copyright © 2003 by Thomson Learning, Inc. 30 19.3 Supply and Demand in International Trade Consumer surplus difference between the most a consumer would be willing and able to pay for a quantity of a good and what a consumer actually has to pay Producer surplus difference between the least a supplier is willing and able to supply a quantity of a good or service for and the revenues a supplier actually receives for selling it Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade With the tools of consumer and producer surplus, we can better analyze the impact of trade. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade The demand curve represents a collection of maximum prices that consumers are willing and able to pay for different quantities of a good or service while the supply curve represents a collection of minimum prices that suppliers require to be willing to supply different quantities of that good or service. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade Trading at the market equilibrium price generates both consumer surplus and producer surplus. Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial opportunities from trade between suppliers and demanders will have taken place; the sum of consumer surplus and producer surplus is maximized. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade The total gains to the economy from trade is the sum of consumer and producer surplus. That is, consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus. Copyright © 2003 by Thomson Learning, Inc. Consumer and Producer Surplus $8 S 7 Price 6 5 CS CS CS 4 3 2 PS PS PS D 1 1 2 3 Quantity Copyright © 2003 by Thomson Learning, Inc. 4 19.3 Supply and Demand in International Trade When the domestic economy has a comparative advantage in a good because it can produce it at a lower relative price than the rest of the world, international trade raises the domestic market price to the world price, benefiting domestic producers but harming domestic consumers. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade While this redistributes income from consumers to producers, there are net benefits from allowing free trade because producer surplus increases more than consumer surplus decreases. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade While domestic consumers lose from the free trade, those negative effects are more than offset by the positive gains captured by producers. In net, export trade increases domestic wealth. Copyright © 2003 by Thomson Learning, Inc. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade When a country does not produce a good relatively as well as other countries, international trade will lower the domestic price to the world price, with the difference between what is domestically supplied and what is domestically demanded supplied by imports. Domestic consumers benefit from paying a lower price for the good, increasing their consumer surplus. Copyright © 2003 by Thomson Learning, Inc. 19.3 Supply and Demand in International Trade But domestic producers lose because they are now selling at the lower world price. While this redistributes income from producers to consumers, there is a net increase in domestic wealth from free trade and imports because the consumer surplus increases more than producer surplus decreases. Copyright © 2003 by Thomson Learning, Inc. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Tariffs a tax on imported goods usually relatively small revenue producers that retard the expansion of trade bring about higher prices and revenues to domestic producers, lower sales and revenues to foreign producers, and higher prices to domestic consumers The gains to producers are more than offset by the losses to consumers. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies With import tariffs, the domestic price of goods is greater than the world price. At the new price, the domestic quantity demanded is lower and the quantity supplied domestically is greater, reducing the quantity of imported goods. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies While domestic producers do gain more sales and producer surplus at the expense of foreign producers, and the government gains from tariff revenue, consumers lose more in consumer surplus than producers and the government gain from the tariff. Copyright © 2003 by Thomson Learning, Inc. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies One argument for tariffs is that tariff protection is necessary temporarily to allow a new industry to more quickly reach a scale of operation at which economies of scale and production efficiencies can be realized. This argument has many problems. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies How do you identify "infant industries" that genuinely have potential economies of scale and will become quickly efficient with protection? Would it not be wise to make massive loans to the industry in such a case, allowing it to instantly begin large-scale production rather than slowly and at the expense of consumers with a protective tariff? Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies The history of infant industry tariffs suggests that the tariffs often linger long after the industry is mature and no longer in “need” of protection. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Tariffs can lead to increased output and employment and reduced unemployment in domestic industries where tariffs were imposed. Yet the overall employment effects of a tariff imposition are not likely to be positive. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Not only might the imposition of a tariff lead to retaliatory tariffs by other countries, but domestic employment would likely suffer outside the industry gaining the tariff protection. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies If new tariffs lead to restrictions on imports, fewer dollars will be flowing overseas in payment for imports, which means that foreigners will have fewer dollars available to buy our exports. Other things equal, this will tend to reduce our exports, thus creating unemployment in the export industries. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Sometimes it is argued that tariffs are a means of preventing a nation from becoming too dependent on foreign suppliers of goods vital to national security, but the national security argument is usually not valid. If a nation's own resources are depletable, tariff-imposed reliance on domestic supplies will hasten depletion of domestic reserves. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies From a defense standpoint, it makes more sense to use foreign supplies in peacetime and perhaps stockpile “insurance” supplies so that large domestic supplies would be available during wars. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies An import quota gives producers from another country a maximum number of units of the good in question that can be imported within any given time span. The case for quotas is probably even weaker than the case for tariffs. Like tariffs, quotas directly restrict imports, leading to reductions in trade and thus preventing nations from fully realizing their comparative advantage. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Tariffs at least use the price system as the basis of restricting trade, while quotas do not. Unlike with a tariff, the U.S. government does not collect any revenue as a result of the import quota. Copyright © 2003 by Thomson Learning, Inc. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Nations have also devised still other, more subtle means to restrict international trade. Product standards ostensibly designed to protect consumers against inferior, unsafe, dangerous or polluting merchandise, which, in effect, are sometimes a means to restrict foreign competition. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Except in rather unusual circumstances, the arguments for tariffs and import quotas are rather suspect. They exist because of producers’ lobbying efforts to gain profits from government protection, called rent seeking. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Because these resources could have produced something instead of being spent on lobbying efforts, the measured deadweight loss from tariffs and quotas will likely understate the true deadweight loss to society. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies Working in the opposite direction, governments sometimes try to encourage exports by subsidizing producers. With a subsidy, revenue is given to producers for each exported unit of output, stimulating exports. While not a barrier to trade like tariffs and quotas, subsidies can also distort trade patterns, leading to ones that are inefficient. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies With subsidies, producers export goods not because their costs are lower than that of a foreign competitor, but because their costs have been artificially reduced by government action transferring income from taxpayers to the exporter. The actual costs of production are not reduced by the subsidy—society has the same opportunity costs as before. Copyright © 2003 by Thomson Learning, Inc. 19.4 Tariffs, Import Quotas, and Subsidies A nation's taxpayers end up subsidizing the output of producers who, relative to producers in other countries, are inefficient. The nation, then, exports products in which it does not have a comparative advantage. Gains from trade in terms of world output are eliminated or reduced by such subsidies. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments The record of all of the international financial transactions of a nation over a year is called the balance of payments. It records all the exchanges those in a nation engaged in that required an outflow of funds to other nations or an inflow of funds from other nations, and provides information about a nation’s world trade position. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments The balance of payments is divided into three main sections: the current account, the capital account, and official reserve assets. The current account is a record of a country’s imports and exports of goods and services, net investment income , and net transfers. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments Because the U.S. gains claims over foreign buyers by obtaining foreign currency in exchange for the dollars needed to buy U.S. exports, all exports of U.S. goods abroad are considered a credit or plus item in the U.S. balance of payments. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments When a U.S. consumer buys an imported item, the reverse is true. U.S. imports are considered a debit item in the balance of payment because the dollars sold to buy the necessary foreign currency add to foreign claims against U.S. buyers. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments Our imports provide the means by which foreigners can buy our exports. Nations import and export services, such as tourism, as well as the largest component of the balance of payments, merchandise (goods). Private and government grants and gifts to foreigners also count as a debit item in a country’s balance of payments, and grants and gifts from foreigners count as a credit item. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments The balance on current account is the net amount of debits or credits after adding up all transactions of goods, services, and fund transfers. If the sum of credits exceeds the sum of debits, a nation is said to have a balance of payments surplus on current account. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments If debits exceed credits, it is running a balance of payments deficit on current account. The merchandise import/export relationship is often called the balance of trade, which is different from the balance on current account. Copyright © 2003 by Thomson Learning, Inc. U.S. Balance of Payments (Billions of $) Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments A deficit on current account is settled by movements of financial, or capital, assets. Therefore, a current account deficit would be financed by a capital account surplus, and a current account surplus would be financed by a capital account deficit. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments Capital account transactions include income from U.S. financial investments in other countries and other foreign income from investments in the U.S., which can be viewed as compensation for the use of capital services. Income from U.S. investments overseas are a credit item in the U.S. balance of payments, and income from foreign investments in the U.S. are a debit item. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments Due to the reciprocal aspect of trade, the balance of payments must balance so that credits and debits are equal. However, errors and omissions mean the official measures do not come out equal. The statistical discrepancy is included so that the official balance of payments do balance. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments A useful analogy from personal financial transactions can be made to the balance of payments. People earn income by exporting their labor services, or receiving investment income, and they import consumption goods. Copyright © 2003 by Thomson Learning, Inc. 19.5 The Balance of Payments Both loans and fund transfers are sometimes made. Any deficit must be financed by borrowing or selling assets; surpluses allow new investment or additions to reserves. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates U.S. consumers must first exchange U.S. dollars for the seller’s currency in order to pay for imported goods. Similarly, foreigners buying U.S. goods must sell their currencies to obtain U.S. dollars in order to pay for exported goods. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates The price of one unit of a country’s currency in terms of another country’s currency is called the exchange rate. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates Prices of goods in their own currencies combine with exchange rates to determine the domestic price of foreign goods. For instance, an increase in the eurodollar exchange rate from $1 per euro to $2 per euro would increase the U.S. price of German goods, reducing the number of German goods that would be demanded in the United States. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates The demand for foreign currencies is a derived demand because it derives directly from the demand for foreign goods and services or for foreign capital. The more foreign goods demanded, the more of that foreign currency that will be needed to pay for those goods. Such an increased demand for the currency will push up the exchange value of that currency relative to other currencies. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates Similarly, the supply of foreign currency is provide by foreigners who want to buy the exports of a particular nation. The more foreigners demand U.S. products, the more of their currencies they will supply in exchange for U.S. dollars, which they use to buy our products. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates Just as in the product market, the supply of and demand for a foreign currency determine the equilibrium price (exchange rate) of that currency. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates The demand for a foreign currency is downward sloping because, as the price of the euro falls relative to the dollar, European products become relatively more inexpensive to U.S. consumers, who therefore buy more European goods. To do so, the quantity of euros demanded by U.S. consumers will increase to buy more European goods as the price of the euro falls. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates The supply curve of a foreign currency is upward sloping because, as the price, or value, of the euro increases relative to the dollar, American products become relatively more inexpensive to European buyers and the quantity of dollars they will demand will increase. Europeans will, therefore, increase the quantity of euros supplied to the U.S. by buying more U.S. products (assuming the European demand for U.S. products is price elastic). Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates Equilibrium in the foreign exchange market is reached where the demand and supply curves for a given currency intersect. If the dollar price of euros is higher than the equilibrium price, there will be an excess quantity of euros supplied at that price (a surplus of euros), and competition among euro sellers will push the price of euros down toward equilibrium. Copyright © 2003 by Thomson Learning, Inc. 19.6 Exchange Rates If the dollar price of euros is lower than the equilibrium price, there will be an excess quantity of euros demanded at that price (a shortage of euros), and competition among euro buyers will push the price of euros up toward equilibrium. Copyright © 2003 by Thomson Learning, Inc. Dollar Price of Euros Equilibrium in the Foreign Exchange Market Excess supply for euros $1.40 Supply for euros (U.S. sales of goods and services to Europeans) $1.20 $1.00 Excess demand for euros 0 Copyright © 2003 by Thomson Learning, Inc. Demand for euros (U.S. purchase of European goods and services) Quantity of Euros 19.7 Equilibrium Changes in the Foreign Exchange Market Any force that shifts either the demand for or supply of a currency will shift the equilibrium in the foreign exchange market, leading to a new exchange rate. An increased demand for euros will result in a higher equilibrium price (exchange value) for euros, while a decreased demand for euros will result in a lower equilibrium price (exchange value) for euros. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market Changes in a currency’s exchange rate can be caused by changes in tastes for goods, changes in income, changes in relative real interest rates, changes in relative inflation rates, and speculation. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market Demand for foreign currencies is derived from demand for foreign goods so shifts in the foreign goods demand curve will shift the foreign currency demand curve in the same direction. U.S. taste for European goods increases, the demand for euros increases, increasing the equilibrium price of euros U.S. taste for European goods decreases, the demand for euros decreases, decreasing the equilibrium price of euros. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market An increase in U.S. incomes would increase the amount of European imports purchased by Americans, which would increase the demand for euros, resulting in a higher exchange rate for euros. A decrease in U.S. incomes would decrease the amount of European imports purchased by Americans, which would decrease the demand for euros, resulting in a lower exchange rate for euros. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market A decrease in U.S. tariffs on European goods would tend to have the same effect as an increase in U.S. incomes, by making imports more affordable, increasing the U.S. demand for European goods and increasing the exchange rate for euros. Copyright © 2003 by Thomson Learning, Inc. Dollar Price of Euros Impact of U.S. Taste or Income Increase, of Tariff Decrease, in the Foreign Exchange Market E1 $1.50 $1.00 E0 D1 D0 0 Quantity of Euros Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market If European incomes rose, European tariffs on U.S. goods increased, or their tastes for American goods increased, Europeans would demand more U.S. goods, leading them to increase their supply of euros to obtain the added dollars necessary to make those purchases, leading to a new lower exchange rate for euros. Copyright © 2003 by Thomson Learning, Inc. Impact of European Taste of Income, or Tariff Decrease, on the Foreign Exchange Market Dollar Price of Euros S0 S1 E0 $1.50 $1.00 E1 D 0 Quantity of Euros Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market If U.S. interest rates were to increase relative to European interest rates, other things equal, the rate of return on U.S. investments would increase relative to that on European investments, increasing European’s demand for U.S. investments. It would increase the supply of euros to obtain the added dollars to buy added U.S. investments. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market At the same time, U.S. investors would also shift their investments away from Europe, decreasing their demand for euros. The combination of the increased supply of euros and the decreased demand for euros will lead to a new lower exchange rate for euros. Copyright © 2003 by Thomson Learning, Inc. Impact of U.S. Interest Rate Increase on the Foreign Exchange Market Dollar Price of Euros S0 S1 $1.90 E0 $1.50 E1 D0 D1 0 Quantity of Euros Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market If Europe experienced a higher inflation rate than the United States, European products would become more expensive to U.S. consumers, decreasing the quantity of European goods demanded by Americans, and decreasing the demand for euros. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market U.S. products would become less expensive to European consumers, increasing the quantity of U.S. goods demanded by Europeans, and, therefore, increasing the supply of Euros. The combination of the increased supply of euros and the decreased demand for euros will lead to a new lower exchange rate for euros. Copyright © 2003 by Thomson Learning, Inc. 19.7 Equilibrium Changes in the Foreign Exchange Market If currency speculators believe that the United States was going to experience more rapid inflation in the future than Japan, they will believe that the value of the dollar will soon be falling as a result. That will increase the demand for yen, so the yen will appreciate relative to the dollar. The opposite will occur if speculators expect less rapid inflation in the United States. Copyright © 2003 by Thomson Learning, Inc. The Impact of European Inflation Rate Increase on the Foreign Exchange Market Dollar Price of Euros S0 S1 $1.90 E0 $1.00 E1 D0 D1 0 Quantity of Euros Copyright © 2003 by Thomson Learning, Inc.