CHAPTER OVERVIEW

This chapter introduces the basic principles underlying the global economy; a more advanced discussion of international economics follows in Part Eight. The growth of world trade, and the United States ’ role in it, is examined first. The concept of comparative advantage is introduced as the basis for world trade followed by a discussion of foreign currencies and international exchange rates. Restrictive trade practices are examined, and this leads to a discussion of multilateral trade agreements and free-trade regions of the globe. The chapter concludes with an update of how well U.S. firms are competing in an increasingly competitive global economy.

LECTURE NOTES

I. Introduction

A. Even on a wilderness backpacking trip, Americans are not leaving the world behind. Much of backpacking equipment may be imported, not to mention the vehicle they used to arrive at the trail, the coffee they sip, etc.

B. Many “American” products are made with components from abroad or are manufactured there. For example, the Chevrolet Lumina is made in Canada ; the Gerber baby food company is owned by a Swiss company; Burger King is owned by a British corporation. The component parts of many “American” products are manufactured abroad.

II. Linkages

A. Several economic flows link the U.S. economy with the economies of other nations.

B. These linkages are:

1. Goods and services flows;

2. Capital and labor (resource) flows;

3. Information and technology flows;

4. Financial flows.

III. U.S. and World Trade

A. Volume and Pattern:

1. Table 6.1 gives an index of the importance of world trade to several countries.

2. Figure 6.2 reveals the growth in U.S. imports and exports over past decades. Currently, exports and imports are 12 percent and 17 percent of GDP, which is more than double their importance of twenty-five years ago.

3. The U.S. is world’s leading trading nation, although its share has diminished from post- World War II level of one-third of total trade to one-eighth today.

B. Dependence:

1. U.S. depends on imports for many food items (bananas, coffee, tea, spices); raw silk, diamonds, natural rubber, much petroleum.

2. On the export side, agriculture relies on foreign markets for one-fourth to one-half of sales; chemical, aircraft, auto, machine tool, coal, and computer industries also sell major portions of output in international markets (see Table 6-2).

C. Trade pattern:

1. The U.S. has a trade deficit in goods. In 1999 U.S. imports exceeded exports of goods by $346 billion.

2. While we have a deficit in goods trade, U.S. export of services exceeds the import of services by $81 billion.

3. The U.S. imports some of the same categories it exports. Specifically, automobiles, computers, chemicals, and semiconductors. (See Table 6‑2)

4. Most U.S. trade is with industrially advanced countries. (See Table 6‑3)

5. Canada is the United States ’ most important trade partner quantitatively. Twenty‑four percent of U.S. exports sold went to Canadians, who in turn provided 20 percent of U.S. imports. (See Table 6‑3)

6. The U.S. has sizable trade deficits with Japan and China . In 1999, the U.S. trade deficit with Japan was $75 billion. There was also a sizable trade deficit with China . (See Table 6‑3)

7. In 1999 the U.S. imported $24 billion of goods (mainly oil) from OPEC nations, while exporting $12 billion to those countries.

D. Financial Linkages: (International trade implies complex financial linkages among nations.) Trade deficits must be financed by borrowing or earning foreign exchange, which is accomplished by selling U.S. assets through foreign investment in the U.S. The U.S. borrows from citizens of other nations; the U.S. is the world’s largest debtor nation.

E. Facilitating factors that explain the growth of trade:

1. Transportation technology has improved over the years.

2. Communications technology allows traders to make deals in trade and global finance very easily.

3. Trade barriers declined dramatically since 1940, and the trend toward free trade continues.

F. Participants in international trade:

1. Global Perspective 6-1 shows the major participants in world trade.

2. New participants have become important, especially the Asian countries of Hong Kong , Singapore , South Korea , and Taiwan . China is also emerging as important in global trade. Collapse of communism has led to the emergence of former Soviet republics and Eastern bloc countries as world trade participants.

IV. Specialization and Comparative Advantage

A. The U.S. is referred to as an “open economy” when it is placed in the global economy.

B. Adam Smith observed in 1776 that specialization and trade increase the productivity of a nation’s resources. His observation related to the principle of absolute advantage whereby a country should buy a good from other countries if they can supply it cheaper than we can.

C. Basic principle of comparative advantage was first observed and explained in early 1800s by David Ricardo. This principle says that it pays for a person or a country to specialize and exchange even if that person or nation is more productive than potential trading partners in all economic activities. Specialization should take place if there are relative cost differences in production of different items.

D. Example: A CPA can paint her house faster and better than a painter. She earns $50 per hour as accountant and can hire a painter for $15 per hour. The CPA can do the painting job in 30 hours; it takes the painter 40 hours. Should she hire the painter? On economic grounds, the opportunity cost is greater for the accountant to paint her house. She is better off to specialize in accounting rather than sacrifice 30 x $50, or $1500, to paint her house, when she can hire the painter for 40 x $15, or $600. The accountant will gain, and the painter will also gain because he is very inefficient in accounting. It may take him 10 hours to prepare his tax return which would mean 10 x $15, hours or $150, in opportunity cost, whereas the accountant could probably complete the forms in 2 hours for a cost of $100. This example shows that even if a person (the accountant) has an absolute advantage in production of two products (painting and accounting), it is still advantageous to specialize and trade. The same is true for nations.

E. Comparative advantage and terms of trade: Tables 6-4 and 6-5 illustrate the principle of comparative advantage for two countries, U.S. and Mexico , with a simplified example. In Mexico , the opportunity cost of 1 ton of soybeans is giving up 4 tons of avocados. In the U.S. , the opportunity cost of 1 ton of soybeans is 3 tons of avocados. In other words, the comparative cost of soybeans is less in U.S. than in Mexico when the alternative is producing avocados. Thus the U.S. should specialize in soybeans, and Mexico should specialize in avocados.

1. If the two nations specialize according to comparative advantage, then to get the other product they must trade. A nation has a comparative advantage in some product when it can produce that product at a lower domestic opportunity cost than can a potential trading partner.

2. Table 6-6 summarizes which nation has a comparative advantage in each product.

3. The rate of exchange of these two products will be determined through negotiation; the outcome is called the terms of trade.

4. The terms of trade will be limited by the relative costs of production within each country. The U.S. will not forgo more than 1 ton of soybeans to get 3 tons of avocados and Mexico will not give up more than 4 tons of avocados for 1 ton of soybeans.

5. Somewhere between these limits, trade is possible. In the text example, the terms of trade are assumed to be 3.5 tons of avocados for each ton of soybeans. Americans would specialize in soybeans only if they could obtain more than 3 tons of avocados for 1 ton of soybeans by trading with Mexico .

F. Gains from specialization and trade:

1. Table 6-7, column 1, shows the optimal outputs for Mexico and U.S. in soybeans and avocados before specialization and trade.

2. Column 2 of Table 6-7 shows the amount each country produces when it specializes.

3. Column 3 of Table 6-7 shows quantities in each country after trade takes place at the rate of 1S = 3.5Av.

4. Mexico will give up 35 tons of avocados for 10 tons of U.S. soybeans.

5. Now each country will have more than they had originally: Mexico now has 25 tons of avocados left plus 10 tons of soybeans. U.S. now has 35 tons of avocados and keeps 20 tons of soybeans. Mexico has gained 1 ton of each; U.S. has gained 2 tons of avocados and 1 ton of soybeans, and these gains have occurred using the same resources as before specialization.

6. This example illustrates that specialization and trade can improve overall output even when one country ( U.S. ) can produce more of both items compared to the other without trade. Specialization and trade have the same effect as an increase in resources or technological progress. (Key Question 4)