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UNIT I
Introduction to the Global Economy
CHAPTER ONE
Understanding the Global Economy
I. Fundamental Issues
1.
2.
3.
4.
5.
6.
Why study global economic issues and policies?
How important is the global market for goods and services?
How important are the international monetary and financial markets?
What are market supply and market demand?
What are consumer surplus and producer surplus?
How are market prices determined?
II. Chapter Outline
1. Global Economic Policy and Issues
a. The Most Globalized Nations
b. Policy Notebook: Should the United States Expand Trade with Africa?
c. Important Issues Advanced in This Text
2. The Global Market for Goods and Services
a. The Real Sector
b. Online Globalization: Smokestack Industries Turn to the Web to Promote Global Business
c. The Importance of Global Trade
d. Management Notebook: Anoplophora Glabripennis—Unwanted Imports
3. The International Monetary and Financial Markets
a. The Foreign Exchange Markets
b. Foreign Direct Investment
c. Capital Flows to Emerging Economies
4. Understanding Global Markets: Supply and Demand
a. Demand and Supply
b. Changes in Demand and Supply
c. Visualizing Global Economic Issues: The Demand and Supply Curves
d. Market Demand and Supply
5. Consumer Surplus and Producer Surplus
a. Consumer Surplus
b. Producer Surplus
c. Visualizing Global Economic Issues: Measuring Consumer and Producer Surplus
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6. How Market Prices Are Determined
a. Excess Quantity Supplied and Excess Quantity Demanded
b. The Equilibrium Price
c. Visualizing Global Economic Issues: The Equilibrium Market Price
d. The Global Market
e. Consumer and Producer Surplus and the Global Market
f. Visualizing Global Economic Issues: Global Coffee Market
7. Questions and Problems
III. Chapter in Perspective
This chapter has two main purposes. First, the chapter introduces the reader to recent changes in global
markets, including growth in global trade in goods and services, growth in foreign exchange trading, and
growth in monetary and financial markets. Second, the chapter conveys the fundamentals of supply and
demand, including determination of equilibrium prices and consumer and producer surplus.
IV. Teaching Notes
1. Global Economic Policy and Issues
Defining globalization is not necessarily an easy task and many definitions are possible. In general,
globalization refers to the increasing interconnectedness of people and societies and the
interdependence of economies, governments, and environments. The key factor underlying
globalization is the extent to which relationships are becoming increasingly interconnected and
integrated. Clearly, globalization is increasing, but the rate and extent of change varies dramatically
for different countries. Access to modern technology, health issues and corruption keep many
countries from progressing in globalization.
a. The Most Globalized Nations
Large economies with well-developed domestic markets often rank surprisingly low on measures
of globalization. According to a survey by Foreign Policy magazine, the United States ranks
twelfth in globalization. This places the U.S. behind many smaller economies, in spite of the fact
that the U.S. is one of the most important markets for most countries in the world and its
interconnections are numerous and vital for many nations. The rankings are also used to
illustrate that more globalized economies tend to fare better in terms of political rights,
corruption, civil liberties and economic standard of living, although not necessarily income
distribution. Nevertheless, globalization remains a contentious topic due to common
misunderstandings about it, particularly within certain special interest groups such as labor
unions.
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b. Policy Notebook: Should the United States Expand Trade with Africa?
For Critical Analysis: Why might U.S. business promote higher labor and environmental
standards (than local firms)? How would this affect their ability to compete in the region
relative to firms already located there?
It is typical for foreign firms to work hard to be good corporate citizens in the host country. For
instance, Japanese firms operating in the U.S. typically pay higher wages and have higher
charitable donations than similar domestic U.S. firms. Foreign firms must overcome the negative
image of being an “interloper” in order to be able to compete with local businesses already there.
Hence, it is no surprise that the presence of U.S. firms operating in Africa is generally considered
positive.
c. Important Issues Advance in This Text
The level of economic integration is the extent and strength of real-sector and financial-sector
linkages among national economies. This is usually measured by volume of transactions in the
various sectors. International trade and capital flows are perhaps best thought of as methods of
improving the efficiency with which we allocate scarce global resources. Overall global growth
is assuredly improved by globalization, but certain sectors of local economies can be
detrimentally affected by globalization, leaving governments and institutions to address
distribution of wealth and sovereignty issues. Probably one of the major challenges of the next
century will be to reform existing international institutions or to design new institutional
structures needed to deal with the issues raised by globalization.
2. The Global Market for Goods and Services
a. The Real Sector
The real sector refers to the portion of the economy engaged in the production and sale of goods
and services. The financial sector refers to the portion of the economy in which people trade
financial instruments. Since 1970, growth in global trade of good and services has been negative
only in three years: 1976, 1983 and 2001. The average annual growth rate of real sector trade has
been six percent.
Teaching Tip:
Growth in global trade results in greater choices for consumers and lower prices. Protectionism
strategies generally benefit producers, not consumers.
b. Online Globalization: E-commerce and Online Globalization: Steel Industry
For Critical Analysis: Would it be better for e-commerce sites to be independent of the steel
firms, thereby promoting price competition, or to be partly owned by the firms to guarantee
the availability of materials?
There is no definitive answer to this question. U.S. Steel recently invested in e-Steel, a businessto-business web firm that helps both buyers and sellers of steel negotiate deals online. The
advantage of U.S. Steel backing the website is that steel buyers can have a greater confidence in
large buy orders actually being delivered on time. The downside is that if U.S. Steel dominates
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the online market, there is little chance for other steel firms to capture orders and price and
quality competition may be diminished. It is likely that unless other websites such as MetalSite
are driven out of business, the ability of other firms to offer similar services will limit U.S. Steel’s
ability to extract monopoly profits.
c. The Importance of Global Trade
The global market for goods and services has grown dramatically for most countries. (See, for
instance, Text Figure 1-2.) The value of world exports has grown by over 400% since 1979. The
measure: (Exports + Imports) / Total Domestic Output, provides a simple estimate of the
importance of exports and imports relative to total market size for an economy. This figure has
generally grown significantly over time for most major economies.
d. Management Notebook: Anoplophora Glabripennis—Unwanted Imports
For Critical Analysis: How would the restrictions imposed by the U.S. Secretary of
Agriculture affect the competitiveness of Chinese manufacturers relative to other Asian
manufacturers?
The U.S. requires all solid wood packing materials from China to be either heat or chemically
treated to kill the beetles that may infest the wood. Imposing this restriction on just one country
hurts the competitiveness of Chinese imports to the U.S. by adding an additional cost to these
imports that firms in other countries do not face.
3. The International Monetary and Financial Markets
Although the last few decades have seen dramatic growth in global trade of goods and services,
growth in global financial transactions has been phenomenal.
a. The Foreign Exchange Markets
The foreign exchange markets (FX) have grown tremendously rapidly over the last several
decades, although the advent of the Euro slowed FX trading in 2001. Nevertheless, daily
turnover is now averaging over $1 trillion. Hence, annual FX trading is thus equivalent to several
times of annual U.S. GDP many times over.
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Teaching Tip:
Since FX growth has vastly outpaced growth in world exports, this indicates that FX trading
serves many other purposes other than financing global trade. Other activities include
speculation, arbitrage and facilitation of cross-border capital flows.
b. Foreign Direct Investment (FDI)
FDI grew throughout the 1990s and remained positive in 2000. FDI is the acquisition of assets
that represent a controlling interest of 10% or greater in an enterprise located in another country.
FDI flows have also grown more rapidly than world exports since 1985.
c. Capital Flows to Emerging Economies
Capital flows to foreign countries are composed of FDI, portfolio investment and bank loans.
Capital flows have averaged $150 billion per year since 1990, although capital flows fell after the
1997 Asian and Russian financial problems.
4. Understanding Global Markets: Supply and Demand
a. Demand and Supply
Demand measures how many units of a good a consumer wishes to buy at a given price over a
certain time period, ceteris paribus. The law of demand states that there is an inverse
relationship between quantity demanded and price. The demand schedule depicts the various
quantities demanded at different prices.
Supply measures how many units of a good a producer wishes to sell at a given price over a
certain time period, ceteris paribus. The law of supply states that there is a direct relationship
between quantity supplied and price. The supply schedule depicts the various quantities supplied
at different prices.
b. Changes in Demand and Supply
Non-price shift factors for demand curves include:
1. Changes in consumer taste and preferences (usually the most important factor).
2. Changes in income: For normal goods higher income leads to greater demand, for inferior
goods higher income leads to lower demand.
3. Changes in the price of substitute goods: As the price of a substitute rises (falls), the demand
for the related good rises (falls).
4. Changes in the price of complementary goods: As the price of a complementary good rises
(falls), the demand for the related good falls (rises).
5. Changes in the number of consumers: As more consumers attempt to consume a product,
overall market demand rises.
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Non-price shift factors for supply curves include:
1. Changes in cost and availability of inputs (usually the most important factor).
2. Advances in technology and productivity growth: Technological advances have been
important sources of growth throughout the 1990s. Large economies of scale and scope have
also generated additional productivity growth leading to supply increases for many products.
3. Changes in the price of substitute goods: As the price of a substitute good used in production
rises (falls), the supply of the related good falls (rises). For instance, nuts and bolts may be
substituted for lag screws in many applications. If the price of nuts and bolts rises, a
hardware supplier will be more willing to supply nuts and bolts and less willing to supply lag
screws.
4. Changes in the price of complementary goods: As the price of a complementary good used in
production rises (falls), the supply of the related good rises (falls).
5. Changes in the number of producers: As more suppliers are added to the market, overall
market supply rises.
6. Taxes and subsidies: Producer taxes reduce supply and subsidies increase supply.
Teaching Tip:
Many students will have trouble determining whether a given effect is a supply or demand effect
and will have difficulty in distinguishing between shifts in the curves and movements along the
curves. You might give them a simple exercise similar to the following:
Event
Crop failure
Technological improvement reduces costs to producer
New cell phones with built-in games are a big hit
Successful advertising campaign boosts product sales
New, low-price imported goods hit market
Supply effect
Shift left
Shift right
Move along
Move along
Shift right
Demand effect
Move along
Move along
Shift right
Shift right
Move along
c. Visualizing Global Economic Issues: The Demand and Supply Curves for Gasoline
For Critical Analysis: What might cause a change in the demand for gasoline? What might
cause a change in the supply of gasoline? Can you think of a single event that might shift
both the demand and supply curve?
The demand for gasoline should be reduced by the introduction of the new fuel-efficient cars that
should be coming into production within a year or two. Environmental concerns could also
reduce the demand for gasoline, as could changes in demographics including age, habits such as
commuting and availability of public transportation. Changes in supply could occur due to new
oil finds, technological advancements in oil extraction or transportation such as pipelines. A war
in the Middle East could both disrupt supply and influence demand from U.S. customers not
wishing to be dependent on non-U.S. oil sources.
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d. Market Demand and Supply
Market demand is a curve that illustrates the prices that consumers are willing and able to pay
for various quantities of a good or service for a given time period, all other things constant.
Market supply is a curve that illustrates the prices that producers are willing and able to accept
for various quantities of a good or service they supply to the market for a given time period, all
other things constant.
5. Consumer Surplus and Producer Surplus
Consumer and producer surplus are conceptual tools that can be used to analyze the effects of
domestic and global events and policies on various constituents’ welfare.
a. Consumer Surplus
Consumer surplus is the benefit that consumers receive from the existence of a market price. It
is measured as the difference between what consumers are willing and able to pay for a good or
service and the market price. Visually, it is the area below the demand curve and above the
market price.
b. Producer Surplus
Producer surplus is the benefit that producers receive from the existence of a market price. It is
measured as the difference between what producers are willing to accept to supply a particular
quantity of a good or service and the market price. Visually, it is the area above the supply curve
and below the market price.
6. How Market Prices Are Determined
a. Excess Quantity Supplied and Excess Quantity Demanded
Excess quantity demanded is the amount by which quantity demanded exceeds quantity
supplied at a given price. Excess quantity demanded leads to rising prices. Excess quantity
supplied is the amount by which quantity supplied exceeds quantity demanded at a given price.
Excess quantity supplied leads to falling prices.
b. Visualizing Global Economic Issues: Measuring Consumer and Producer Surplus — OPEC
For Critical Analysis: OPEC, the Organization of Petroleum Exporting Countries, seeks to
protect the interests of its members. Explain, using the concepts of consumer and producer
surplus, how OPEC might achieve this objective.
By restricting the supply of oil, a necessary commodity in production, OPEC can boost the price
of oil thereby increasing producer surplus and reducing consumer surplus (see f. below). A
second strategy (at least in theory) would be for OPEC to engage in price discrimination, selling
barrels of oil at auction to the highest bidders.
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c. The Equilibrium Price
The market clearing or equilibrium price is the price at which quantity supplied equals quantity
demanded.
d. Visualizing Global Economic Issues: The Equilibrium Market Price
For Critical Analysis: Suppose that, as the supply of gasoline falls, customers turn to more
fuel-efficient automobiles. How would these two events together affect the equilibrium
price of gasoline and the quantity transacted in the market?
The reduction in supply would increase the equilibrium price as the supply curve shifts left. The
switch to more fuel-efficient vehicles is a reduction in demand. The leftward, downward shift in
the demand curve would lower the equilibrium price. The net effect on price is thus
indeterminate.
e. The Global Market
In the global market, excess quantity supplied for the domestic market will equal exports. Excess
quantity demanded will equal imports. Applying the same pricing principles as before, in the
global market the equilibrium price is found where global quantity demanded equals global
quantity supplied, or at the price where both excess quantity demanded and excess quantity
supplied are zero. This is tantamount to saying that globally, the equilibrium price is the one
where the quantity of exports supplied equals the quantity of imports demanded.
f.
Consumer and Producer Surplus and the Global Market
Exposure to the global market can change consumer and producer surplus. Generally speaking,
changes in the global market that lead to domestic price increases will benefit producers at the
expense of consumers. The converse holds for price decreases.
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g. Visualizing Global Economic Issues: Global Coffee Market
For Critical Analysis: Suppose that a frost damages a major portion of Coffeeland’s crop.
Show what would happen to the global price of coffee and to the consumer and producer
surplus in both nations.
The supply of coffee available from Coffeeland is reduced (supply curve shifts left and up).
Creamerland will now have an excess quantity of coffee demanded and the price of coffee will
rise, reducing consumer surplus and increasing producer surplus in Creamerland. Consumer
surplus in Coffeeland is also reduced by the higher coffee price. The change in producer surplus
for Coffeeland appears to be indeterminate, because the price rise increases producer surplus, but
the leftward shift in the supply curve reduces producer surplus.
7. Answers to End of Chapter Questions
1. It could very well be that the nation is closed to capital flows. In addition, residents may be
exporting a large volume of goods, but trade barriers may prevent imports. Because of the large
volume of exports, this measure of openness may still be high.
2. It may be that a large number of Internet sites exist because of failures in other electronic
communication systems that prevent communication across national borders. Or, it may be that
the large number of Internet sites exist in an attempt to solicit information from abroad due to
government restrictions on other forms of foreign information. In either case, the nation may not
be very globalized.
3. The technological advance would cause an increase in the global supply of these agricultural
products. The increase in supply would result in a lower equilibrium price, an increase in the
quantity demanded, and a greater equilibrium quantity.
4. This fear of genetically modified agricultural products would cause a decrease in demand for
these products. The decrease in demand would lead to a lower equilibrium price, a reduction in
quantity supplied, and a lower equilibrium quantity.
5. Supply increases (rightward shift of the supply curve) and demand decreases (leftward shift of the
demand curve). The simultaneous shift of demand and supply results in an unambiguous
decrease in the equilibrium price, but the change in quantity is ambiguous.
6. Restricting imported beef would result in an increase in the price of beef in the United States.
The higher price would spur an increase in the quantity of beef supplied by U.S. farmers and the
surplus of these farmers would rise. Due to the higher price and lower quantity demanded, the
surplus of U.S. beef consumed would decrease.
7. Prior to trade, consumer surplus in each nation equals the area of the triangle formed by points A,
B, and C, while producer surplus is equal to the area of the triangle formed by points C, B, and D.
These areas cannot be calculated without knowing the vertical intercepts indicated by points A
and D.
8. After trade takes place between the two nations, consumer surplus in Coffeeland equals the area
of the triangle formed by points A, F, E, while consumer surplus in Creamerland equals the area
of the triangle formed by points A, G, and E. Producer surplus in Coffeeland equals the area of
the triangle formed by points E, G, and D, while producer surplus in Creamerland equals the area
of the triangle formed by points E, F, and D.
Consumer surplus in Coffeeland fell by the area formed by points E, F, B, and C. This area
equals [($0.30 * 10) + ($0.30 * 5) / 2] * 2,000 = $7,500. (Note that the price is per pound, and a
ton equals 2,000 pounds.) Consumer surplus in Creamerland rose by the area formed by points
C, B, G, and E. This area equals [($0.35 * 15) + ($0.35 * 5) / 2* 2,000 = $12,250.
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Producer surplus in Coffeeland rises by the area formed by points E, G, B, and C. This
area equals [($0.30 * 15) + ($0.30 * 5) / 2] * 2,000 = $10,500. Producer surplus in
Creamerland falls by the area formed by points C, B, F, and E. This area equals
[($0.35 * 10) + ($0.35 * 5) / 2)] * 2,000 = $8,750.
9. If the government of this coffee exporting nation were to burn some of the coffee fields, the
supply of coffee would decrease. The decrease in the supply of coffee would generate an
increase in the global equilibrium price of coffee and a lower equilibrium quantity would be
transacted.
10. The government would be motivated to do this if it benefits the nation’s coffee growers. The total
revenue of the nation’s farmers rises if the proportional change in equilibrium price (increase)
exceeds the proportional change in equilibrium quantity (decrease).