Hubbard Obrien MacroEconomics 2nd edition chapter 18

Chapter 18

Comparative Advantage,International Trade, andExchange RatesIs Using Trade Policy to Help U.S. Industries a Good Idea?

Trade is, simply, the act of buying orselling. Is there a difference betweentrade that takes place within a countryand international trade? Within theUnited States, domestic trade makes itpossible for consumers in Ohio to eatsalmon caught in Alaska or for con-sumers in Montana to drive cars builtin Michigan or Kentucky. Similarly,international trade makes it possible forconsumers in the United States to drinkwine from France or use HD-DVDplayers from Japan. But one significantdifference between domestic trade andinternational trade is that internationaltrade is more controversial. At onetime, nearly all the televisions, shoes,clothing, and toys consumed in theUnited States were also produced in theUnited States. Today, these goods areproduced mainly by firms in othercountries. This shift has benefited U.S.consumers because foreign-madegoods have lower prices than the U.S.-made goods they have replaced. But atthe same time, many U.S. firms thatproduced these goods have gone out ofbusiness, and their workers have had tofind other jobs. Not surprisingly, opin-ion polls show that many Americansfavor reducing international tradebecause they believe doing so wouldpreserve jobs in the United States.

But do restrictions on tradeactually preserve jobs? In fact, restric-tions on trade may preserve jobs in

particular industries, but only at thecost of reducing jobs in other indus-tries. Consider, for example, U.S. pol-icy on imports of sugar and imports ofsugar-based ethanol. Ethanol is madefrom corn or sugar and can be used asa substitute for gasoline as a fuel inautomobiles. Sugar is a better base forethanol than corn because it fermentsmore quickly and is therefore cheaperto produce. In Brazil, ethanol is madefrom sugar, but in the United States,ethanol is made from corn. As a result,Brazilian ethanol costs just 80 cents agallon, about half the cost of ethanolproduced in the United States usingcorn. The Brazilian makers of ethanolwould like to ship this cheap fuel tothe United States, but the U.S. govern-ment has imposed a 54-cent-per-gallon tariff on imported ethanol. Thetariff, combined with the cost of trans-porting the ethanol to the UnitedStates, effectively prices Brazilianethanol out of the market.

The tariff helps U.S. firms thatproduce corn-based ethanol and U.S.farmers who grown corn, but it effec-tively increases fuel costs for manyU.S. firms. The higher fuel costs makethe products these firms producemore expensive, reducing sales andemployment in the industries affected.

In addition to the tariff on sugar-based ethanol, Congress has alsoenacted a sugar quota, which limits thequantity of raw sugar allowed into theUnited States. Several countriesaround the world can produce sugar atlower costs than can U.S. sugar pro-ducers. As a result, the world price ofsugar, which is the price at which sugar

can be bought on the world market, istoo low for U.S. sugar companies tocover their costs. The sugar quotaallows U.S. companies to sell sugardomestically for a price that is aboutthree times as high as the world price.Without the sugar quota, competitionfrom foreign sugar producers woulddrive many U.S. producers out ofbusiness. But the United States alsohas a large candy industry, which usesmany tons of sugar. The high price ofsugar has led many U.S. candy firmsto relocate their operations to othercountries where the price of sugar ismuch lower. Life Savers, Star Britemints, and Cherry Balls are a few ofthe candies no longer manufacturedin the United States.

Should the United States have atariff on imports of sugar-basedethanol and a quota on imports ofraw sugar? The tariff and the quotacreate winners—U.S. producers ofcorn-based ethanol, U.S. sugar com-panies, and U.S. corn farmers—andlosers—U.S. companies that usesugar, their employees, and U.S. con-sumers who must pay higher pricesfor goods that contain sugar and whoare not able to buy low-priced sugar-based ethanol as an alternative togasoline. In this chapter, we willexplore who wins and who loses frominternational trade and review thepolitical debate over whether interna-tional trade should be restricted. ANINSIDE LOOK AT POLICY on pageXXX discusses a recent trade agree-ment between the United States andSouth Korea.

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LEARNING ObjectivesAfter studying this chapter, youshould be able to:

18.1 Discuss the role of internationaltrade in the U.S. economy,page XXX.

18.2 Understand the differencebetween comparativeadvantage and absoluteadvantage in international trade,page XXX.

18.3 Explain how countries gain frominternational trade, page XXX.

18.4 Analyze the economic effects ofgovernment policies that restrictinternational trade, page XXX.

18.5 Evaluate the arguments overtrade policy and globalization,page XXX.

18.6 Explain how exchange ratesare determined and howchanges in exchange rates affect the prices of importsand exports, page xxx.

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Economics in YOUR Life!

Why Haven’t You Heard of the Sugar Quota?Politicians often support restrictions on trade to convince people to vote for them. The workers inthe industries protected by tariffs and quotas are likely to vote for these politicians because theworkers think trade restrictions will protect their jobs. But most people are not workers in industriesprotected from foreign competition by trade restrictions. We have seen that the sugar quota pro-tects U.S. sugar companies and the people who work for them, but this amounts to only a few thou-sand people. Millions of consumers, though, have to pay higher prices for soft drinks, bakery goods,and candy because of the sugar quota. How, then, have sugar companies convinced Congress toenact the sugar quota and why have very few people even heard of the quota? As you read thechapter, see if can answer this question. You can check your answers against those we provide at theend of the chapter. >> Continued on page XXX


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18.1 LEARNING OBJECTIVE

600 PA R T 8 | The International Economy

Tariff A tax imposed by agovernment on imports.

Imports Goods and services boughtdomestically but produced in othercountries.

Exports Goods and servicesproduced domestically but sold toother countries.

Markets for internationally traded goods and services can be analyzed using

the tools of demand and supply that we developed in Chapter 3. We saw in

Chapter 2 that trade in general—whether within a country or between

countries—is based on the principle of comparative advantage. In this chap-

ter, we look more closely at the role of comparative advantage in international trade. We also

use the concepts of consumer surplus, producer surplus, and deadweight loss from Chapter

4 to analyze government policies, such as the sugar quota, that interfere with trade. With this

background, we can return to the political debate over whether the United States benefits

from international trade. In this chapter we also analyze what determines the exchange rate

between the U.S. dollar and other currencies. We begin by looking at how large a role inter-

national trade plays in the U.S. economy.

18.1 | Discuss the role of international trade in the U.S. economy.

The United States in the InternationalEconomyInternational trade has grown tremendously over the past 50 years. The increase in tradeis the result of the falling costs of shipping products around the world, the spread ofinexpensive and reliable communications, and changes in government policies. Firmscan use large container ships to send their products across the oceans at low cost.Businesspeople today can travel to Europe or Asia using fast, inexpensive, and reliable airtransportation. The Internet allows managers to communicate instantaneously and at avery low cost with customers and suppliers around the world. These and other improve-ments in transportation and communication have created a global marketplace that ear-lier generations of businesspeople could only dream of.

In addition, over the past 50 years, many governments have changed policies to facil-itate international trade. For example, tariff rates have fallen. A tariff is a tax imposed bya government on imports of a good into a country. Imports are goods and servicesbought domestically but produced in other countries. In the 1930s, the United Statescharged an average tariff rate above 50 percent. Today, the rate is less than 2 percent. InNorth America, most tariffs between Canada, Mexico, and the United States were elimi-nated following the passage of the North American Free Trade Agreement (NAFTA) in1994. Twenty-seven countries in Europe have formed the European Union, which haseliminated all tariffs among member countries, greatly increasing both imports andexports, which are goods and services produced domestically but sold to other countries.

The Importance of Trade to the U.S. EconomyU.S. consumers buy increasing quantities of goods and services produced in other coun-tries. At the same time, U.S. businesses sell increasing quantities of goods and services toconsumers in other countries. Figure 18-1 shows that since 1950, both exports andimports have been steadily increasing as a fraction of U.S. gross domestic product(GDP). In 1950, exports and imports were both about 4 percent of GDP. In 2007,exports were about 12 percent of GDP, and imports were about 17 percent.

Not all sectors of the U.S. economy are affected equally by international trade. Forexample, although it’s difficult to import or export some services, such as haircuts orappendectomies, a large percentage of U.S. agricultural production is exported. Eachyear, the United States exports about 50 percent of the wheat crop, 40 percent of the ricecrop, and 20 percent of the corn crop.

Many U.S. manufacturing industries also depend on trade. About 20 percent of U.S.manufacturing jobs depend directly or indirectly on exports. In some industries, such ascomputers, the products these workers make are directly exported. In other industries,such as steel, the products are used to make other products, such as bulldozers or


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C H A P T E R 1 8 | Comparative Advantage, International Trade, and Exchange Rates 601

Figure 18-1International Trade Is of Increasing Importance to the United States

Exports and imports of goods and services asa percentage of total production—measuredby GDP—show the importance of interna-tional trade to an economy. Since 1950, bothimports and exports have been steadily risingas a fraction of the U.S. GDP.Source: U.S. Department of Commerce,Bureau of Economic Analysis.

Figure 18-2The Eight Leading ExportingCountries

The United States is the leading exportingcountry, accounting for about 10 percent oftotal world exports. The values are the sharesof total world exports of merchandise andcommercial services.Source: World Trade Organization, Interna-tional Trade Statistics , 2007.

machine tools, that are then exported. In all, about two-thirds of U.S. manufacturingindustries depend on exports for at least 10 percent of jobs.

U.S. International Trade in a World ContextThe United States is the largest exporter in the world, as Figure 18-2 illustrates. Six of theother seven leading exporting countries are also high-income countries. AlthoughChina is still a relatively low-income country, the rapid growth of the Chinese economyover the past 20 years has resulted in its becoming the third largest exporter.

International trade remains less important to the United States than it is to mostother countries. Figure 18-3 shows that imports and exports remain smaller fractions ofGDP in the United States than in other countries. In some smaller countries, likeBelgium, imports and exports make up more than half of GDP. Japan is the only high-income country that is less dependent on international trade than is the United States.


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How Expanding International TradeHas Helped BoeingThe Boeing 747 jumbo jet was a wonder of modern technologywhen it was introduced in 1970. With a much wider body than

existing passenger planes, the 747 had two aisles, with as many as 10 seats per row, andcould carry more than 500 passengers. Many early models had a second level with a pas-senger lounge, complete with a piano. Its range of more than 5,000 miles made it a trulyintercontinental plane.

By the late 1990s, however, Boeing, which is based in Chicago and assembles the747 outside of Seattle, Washington, was experiencing declining sales for the plane.Planes with newer technology were being introduced, and rising prices for jet fuel ledsome airlines to conclude that jumbo jets were too costly to operate. The decline in pas-senger travel after September 11, 2001, appeared to be the last nail in the 747’s coffin. An

executive for Airbus, a European firm that is Boeing’s main com-petitor, boasted, “The 747 is on its last legs. It doesn’t have any legsto stand on. Boeing is trying to breathe life into a 1960s-era design.There is only so much you can do with a plane.” But in the past fewyears, the 747 has gone through an unexpected revival, spurredlargely by recent growth in international trade. In the 1960s,Boeing’s managers made the important decision that the 747 bedesigned to serve as both a cargo plane and a passenger plane. Forexample, the nose cone was designed to open to make loadingcargo easier.

As international trade has grown rapidly in the past fewyears, so has the demand for the 747 because the plane has largercargo capacity than other planes. Most low-value goods beingshipped long distances—for instance, from China to Europe—arestill sent by sea on container ships. However, high-value goods—such as computers, televisions, and some food products—areincreasingly likely to be sent by plane, which is a much faster andsafer method of shipping. Air freight shipments have been grow-

ing at the rapid rate of 6 percent per year. Because of its large carrying capacity, cur-rently about 60 percent of all air freight worldwide is carried on 747s. The latestmodel, the 747-400, has new, technologically advanced engines and redesigned wings.It has a maximum speed of 675 miles per hour and has a range of more than 7,500miles—enough to fly nonstop from Los Angeles to Melbourne, Australia. Theincreased fuel efficiency of the new engines has reduced operating costs. In 2006,

|Making the

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Figure 18-3International Trade as aPercentage of GDP

International trade is still less important to theUnited States than to most other countries,with the exception of Japan.Source: Organization for Economic Coopera-tion and Development.

Rapid growth of international trade has spurred demand forthe 747 because it has a larger cargo capacity than other planes.


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Comparative advantage The abilityof an individual, a firm, or a countryto produce a good or service at alower opportunity cost thancompetitors.

Opportunity Cost The highest-valued alternative that must be givenup to engage in an activity.

Boeing received orders for 67 airplanes worth $16.75 billion. That’s good news forBoeing’s 120,000 employees in the United States.

Sources: Leslie Wayne, “Boeing Not Afraid to Say ‘Sold Out,”’ New York Times, November 28, 2006; Leslie Wayne, “Far fromExtinct,” New York Times, December 7, 2006; and Leslie Wayne, “Still Flying High,” New York Times, December 25, 2006.

YOUR TURN: Test your understanding by doing related problem 1.4 on page XXX at the end

of this chapter.

18.2 | Understand the difference between comparative advantage and absoluteadvantage in international trade.

Comparative Advantage in International TradeWhy have businesses around the world increasingly looked for markets in other coun-tries? Why have consumers increasingly purchased goods and services made in othercountries? People trade for one reason: Trade makes them better off. Whenever a buyerand seller agree to a sale, they must both believe they are better off; otherwise, therewould be no sale. This outcome must hold whether the buyer and seller live in the samecity or in different countries. As we will see, governments are more likely to interferewith international trade than they are with domestic trade, but the reasons for the inter-ference are more political than economic.

A Brief Review of Comparative AdvantageIn Chapter 2, we discussed the key economic concept of comparative advantage.Comparative advantage is the ability of an individual, a firm, or a country to produce agood or service at a lower opportunity cost than competitors. Recall that opportunitycost is the highest-valued alternative that must be given up to engage in an activity.People, firms, and countries specialize in economic activities in which they have a com-parative advantage. In trading, we benefit from the comparative advantage of other peo-ple (or firms or countries), and others benefit from our comparative advantage.

A good way to think of comparative advantage is to recall the example in Chapter 2of you and your neighbor picking fruit. Your neighbor is better at picking both applesand cherries than you are. Why, then, doesn’t your neighbor pick both types of fruit?Because the opportunity cost to your neighbor of picking her own apples is very high:She is a particularly skilled cherry picker, and every hour spent picking apples is an hourtaken away from picking cherries. You can pick apples at a much lower opportunity costthan your neighbor, so you have a comparative advantage in picking apples. Your neigh-bor can pick cherries at a much lower opportunity cost than you can, so she has a com-parative advantage in picking cherries. Your neighbor is better off specializing in pickingcherries, and you are better off specializing in picking apples. You can then trade some ofyour apples for some of your neighbor’s cherries, and both of you will end up with moreof each fruit.

Comparative Advantage in International TradeThe principle of comparative advantage can explain why people pursue different occu-pations. It can also explain why countries produce different goods and services.International trade involves many countries importing and exporting many differentgoods and services. Countries are better off if they specialize in producing the goods forwhich they have a comparative advantage. They can then trade for the goods for whichother countries have a comparative advantage.

We can illustrate why specializing on the basis of comparative advantage makescountries better off with a simple example involving just two countries and two products.


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Absolute advantage The ability toproduce more of a good or servicethan competitors when using thesame amount of resources.

TABLE 18-1An Example of JapaneseWorkers Being More ProductiveThan American Workers

OUTPUT PER HOUR OF WORK

CELL PHONES DIGITAL MUSIC PLAYERS

JAPAN 12 6

UNITED STATES 2 4

Suppose the United States and Japan produce only cell phones and digital music players,like Apple’s iPod. Assume that each country uses only labor to produce each good, andthat Japanese and U.S. cell phones and digital music players are exactly the same. Table18-1 shows how much each country can produce of each good with one hour of labor.

Notice that Japanese workers are more productive than U.S. workers in making bothgoods. In one hour of work, Japanese workers can make six times as many cell phonesand one and one-half times as many digital music players as U.S. workers. Japan has anabsolute advantage over the United States in producing both goods. Absolute advantageis the ability to produce more of a good or service than competitors when using thesame amount of resources. In this case, Japan can produce more of both goods using thesame amount of labor as the United States.

It might seem at first that Japan has nothing to gain from trading with the UnitedStates because it has an absolute advantage in producing both goods. However, Japanshould specialize and produce only cell phones and obtain the digital music players it needsby exporting cell phones to the United States in exchange for digital music players. The rea-son that Japan benefits from trade is that although it has an absolute advantage in the pro-duction of both goods, it has a comparative advantage only in the production of cell phones.The United States has a comparative advantage in the production of digital music players.

If it seems contrary to common sense that Japan should import digital music play-ers from the United States even though Japan can produce more players per hour ofwork, think about the opportunity cost to each country of producing each good. IfJapan wants to produce more digital music players, it has to switch labor away from cellphone production. Every hour of labor switched from producing cell phones to produc-ing digital music players increases digital music player production by 6 and reduces cellphone production by 12. Japan has to give up 12 cell phones for every 6 digital musicplayers it produces. Therefore, the opportunity cost to Japan of producing one moredigital music player is 12/6, or 2 cell phones.

If the United States switches one hour of labor from cell phones to digital musicplayers, production of cell phones falls by 2, and production of digital music playersrises by 4. Therefore, the opportunity cost to the United States of producing one moredigital music player is 2/4, or 0.5 cell phone. The United States has a lower opportunitycost of producing digital music players and, therefore, has a comparative advantage inmaking this product. By similar reasoning, we can see that Japan has a comparativeadvantage in producing cell phones. Table 18-2 summarizes the opportunity each coun-try faces in producing these goods.

TABLE 18-2 | The Opportunity Costs of Producing Cell Phones and Digital Music Players

The table shows the opportunity cost each country faces in producing cell phones and digital music players.For example,the entryin the first row and second column shows that Japan must give up 2 cell phones for every digital music player it produces.

OPPORTUNITY COSTS


JAPAN 0.5 digital music player 2 cell phones

UNITED STATES 2 digital music players 0.5 cell phone


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Autarky A situation in which acountry does not trade with othercountries.

Terms of trade The ratio at which acountry can trade its exports forimports from other countries.

TABLE 18-3Production without Trade

PRODUCTION AND CONSUMPTION


JAPAN 9,000 1,500

UNITED STATES 1,500 1,000

18.3 | Explain how countries gain from international trade.

How Countries Gain from InternationalTradeCan Japan really gain from producing only cell phones and trading with the UnitedStates for digital music players? To see that it can, assume at first that Japan and theUnited States do not trade with each other. A situation in which a country does not tradewith other countries is called autarky. Assume that in autarky each country has 1,000hours of labor available to produce the two goods, and each country produces the quan-tities of the two goods shown in Table 18-3. Because there is no trade, these quantitiesalso represent consumption of the two goods in each country.

Increasing Consumption through TradeSuppose now that Japan and the United States begin to trade with each other. The termsof trade is the ratio at which a country can trade its exports for imports from othercountries. For simplicity, let’s assume that the terms of trade end up with Japan and theUnited States being willing to trade one cell phone for one digital music player.

Once trade has begun, the United States and Japan can exchange digital music play-ers for cell phones or cell phones for digital music players. For example, if Japan special-izes by using all 1,000 available hours of labor to produce cell phones, it will be able toproduce 12,000. It then could export 1,500 cell phones to the United States in exchangefor 1,500 digital music players. (Remember: We are assuming that the terms of trade areone cell phone for one digital music player.) Japan ends up with 10,500 cell phones and1,500 digital music players. Compared with the situation before trade, Japan has thesame number of digital music players but 1,500 more cell phones. If the United Statesspecializes in producing digital music players, it will be able to produce 4,000. It couldthen export 1,500 digital music players to Japan in exchange for 1,500 cell phones. TheUnited States ends up with 2,500 digital music players and 1,500 cell phones. Comparedwith the situation before trade, the United States has the same number of cell phonesbut 1,500 more digital music players. Trade has allowed both countries to increase thequantities of goods consumed. Table 18-4 summarizes the gains from trade for theUnited States and Japan.

By trading, Japan and the United States are able to consume more than they couldwithout trade. This outcome is possible because world production of both goodsincreases after trade. (Remember that, in this example, our “world” consists of just theUnited States and Japan.)

Why does total production of cell phones and digital music players increase when theUnited States specializes in producing digital music players and Japan specializes in produc-ing cell phones? A domestic analogy helps to answer this question: If a company shifts pro-duction from an old factory to a more efficient modern factory, its output will increase. Ineffect, the same thing happens in our example. Producing digital music players in Japan andcell phones in the United States is inefficient. Shifting production to the more efficientcountry—the one with the comparative advantage—increases total production. The keypoint is this: Countries gain from specializing in producing goods in which they have a compar-ative advantage and trading for goods in which other countries have a comparative advantage.


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TABLE 18-4The Gains from Trade for Japanand the United States


With trade, the United States andJapan specialize in the good theyhave a comparative advantage inproducing . . .

WITHOUT TRADE

WITH TRADE

Production and ConsumptionCELL MP3PHONES PLAYERS

CELL MP3PHONES PLAYERS



12,000 0

0 4,000

1,500 1,500

1,500 1,500

Export Import

Import Export

10,500 1,500

1,500 2,500

9,000 1,500

1,500 1,000

1,500 Cell Phones

1,500 MP3 Players

Japan

Japan

Japan

United States

United States

United States

Increased Consumption

Production with Trade Trade Consumption with Trade

GAINS FROM TRADE

. . . and export some of that good inexchange for the good the othercountry has a comparativeadvantage in producing.

The increased consumption made possibleby trade represents the gains from trade.

Why Don’t We See Complete Specialization?In our example of two countries producing only two products, each country specializesin producing one of the goods. In the real world, many goods and services are producedin more than one country. For example, the United States and Japan both produce auto-mobiles. We do not see complete specialization in the real world for three main reasons:

• Not all goods and services are traded internationally. Even if, for example, Japanhad a comparative advantage in the production of medical services, it would be dif-ficult for Japan to specialize in producing medical services and then export them.There is no easy way for U.S. patients who need appendectomies to receive themfrom surgeons in Japan.

• Production of most goods involves increasing opportunity costs. Recall from Chapter2 that production of most goods involves increasing opportunity costs. As a result,when the United States devotes more workers to producing digital music players, theopportunity cost of producing more digital music players will increase. At some point,the opportunity cost of producing digital music players in the United States may riseto the level of the opportunity cost of producing digital music players in Japan. Whenthat happens, international trade will no longer push the United States further towardcomplete specialization. The same will be true of Japan: Increasing opportunity costwill cause Japan to stop short of complete specialization in producing cell phones.

• Tastes for products differ. Most products are differentiated. Cell phones, digitalmusic players, cars, and televisions—to name just a few products—come with awide variety of features. When buying automobiles, some people look for reliabilityand good gasoline mileage, others look for room to carry seven passengers, and stillothers want styling and high performance. So, some car buyers prefer Toyota Priushybrids, some prefer Chevy Suburbans, and others prefer BMWs. As a result, Japan,the United States, and Germany may each have a comparative advantage in produc-ing different types of automobiles.


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Does Anyone Lose as a Result of International Trade?In our cell phone and digital music player example, consumption increases in both theUnited States and Japan as a result of trade. Everyone gains, and no one loses. Or dothey? In our example, we referred repeatedly to “Japan” or the “United States” producingcell phones or digital music players. But countries do not produce goods—firms do. In aworld without trade, there would be cell phone and digital music player firms in bothJapan and the United States. In a world with trade, there would only be Japanese cellphone firms and U.S. digital music player firms. Japanese digital music player firms andU.S. cell phone firms would close. Overall, total employment will not change and pro-duction will increase as a result of trade. Nevertheless, the owners of Japanese digitalmusic player firms, the owners of U.S. cell phone firms, and the people who work forthem are worse off as a result of trade. The losers from trade are likely to do their best toconvince the Japanese and U.S. governments to interfere with trade by barring importsof the competing products from the other country or by imposing high tariffs on them.

Where Does Comparative Advantage Come From?Among the main sources of comparative advantage are the following:

• Climate and natural resources. This source of comparative advantage is the mostobvious. Because of geology, Saudi Arabia has a comparative advantage in the pro-duction of oil. Because of climate and soil conditions, Costa Rica has a comparativeadvantage in the production of bananas, and the United States has a comparativeadvantage in the production of wheat.

• Relative abundance of labor and capital. Some countries, such as the United States,have many highly skilled workers and a great deal of machinery. Other countries,such as China, have many unskilled workers and relatively little machinery. As aresult, the United States has a comparative advantage in the production of goodsthat require highly skilled workers or sophisticated machinery to manufacture, suchas aircraft, semiconductors, and computer software. China has a comparativeadvantage in the production of goods that require unskilled workers and smallamounts of simple machinery, such as children’s toys.

• Technology. Broadly defined, technology is the process firms use to turn inputs intogoods and services. At any given time, firms in different countries do not all have accessto the same technologies. In part, this difference is the result of past investments

Don’t Let This Happen to YOU!Remember That Trade Creates BothWinners and Losers

The following statement is from a Federal Reserve publica-tion: “Trade is a win–win situation for all countries thatparticipate.” Statements like this are sometimes taken tomean that there are no losers from international trade. Butnotice that the statement refers to countries, not individu-als. When countries participate in trade, they make theirconsumers better off by increasing the quantity of goodsand services available to them. As we have seen, however,expanding trade eliminates the jobs of workers employedat companies that are less efficient than foreign companies.Trade also creates new jobs at companies that export to for-eign markets. It may be difficult, though, for workers who

lose their jobs because of trade to easily find others. That iswhy in the United States, the federal government uses theTrade Adjustment Assistance program to provide funds forworkers who have lost their jobs due to international trade.These funds can be used for retraining, for searching fornew jobs, or for relocating to areas where new jobs areavailable. This program—and similar programs in othercountries—recognizes that there are losers from interna-tional trade as well as winners.

Source: Quote from Federal Reserve Bank of Dallas Web site, International Trade andthe Economy, www.dallasfed.org/educate/everyday/ev7.html.

YOUR TURN: Test your understanding by doing related

problem 3.12 on page XXX at the end of this chapter.


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Why Is Dalton, Georgia, the Carpet-Making Capital of the World?Factories within a 65-mile radius of Dalton, Georgiaaccount for 80 percent of U.S. carpet production and more

than half of world carpet production. Carpet production is highly automated andrelies primarily on synthetic fibers. Dalton, a small city located in rural northwestGeorgia, would not seem to have any advantages in carpet production. In fact, thelocation of the carpet industry in Dalton was a historical accident.

In the early 1900s, Catherine Evans Whitener started making bedspreads using amethod called “tufting,” in which she sewed cotton yarn through the fabric and then cutthe ends of the yarn so it would fluff up. These bedspreads became very popular. By the1930s, the process was mechanized and was then applied to carpets. In the early years,the industry used cotton grown in Georgia, but today synthetic fibers, such as nylon andolefin, have largely replaced cotton and wool in carpet manufacturing.

More than 170 carpet factories are now located in the Dalton area. Supportingthe carpet industry are local yarn manufacturers, machinery suppliers, and mainte-nance firms. Dye plants have opened solely to supply the carpet industry. Printingshops have opened, solely to print tags and labels for carpets. Box factories haveopened to produce cartons designed specifically for shipping carpets. The local work-

force has developed highlyspecialized skills for run-ning and maintaining thecarpet-making machinery.

A company establishinga carpet factory outside theDalton area is unable to usethe suppliers or the skilledworkers available to facto-ries in Dalton. As a result,carpet factories located out-side Dalton may have highercosts than factories locatedin Dalton. Although there isno particular reason why thecarpet industry should haveoriginally located in Dalton,

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countries have made in supporting higher education or in providing support forresearch and development. Some countries are strong in product technologies, whichinvolve the ability to develop new products. For example, firms in the United Stateshave pioneered the development of such products as televisions, digital computers,airliners, and many prescription drugs. Other countries are strong in process tech-nologies, which involve the ability to improve the processes used to make existingproducts. For example, firms in Japan, such as Toyota and Nissan, have succeeded bygreatly improving the processes for designing and manufacturing automobiles.

• External economies. It is difficult to explain the location of some industries on thebasis of climate, natural resources, the relative abundance of labor and capital, or tech-nology. For example, why does Southern California have a comparative advantage inmaking movies or Switzerland in making watches or New York in providing financialservices? The answer is that once an industry becomes established in an area, firmsthat locate in that area gain advantages over firms located elsewhere. The advantagesinclude the availability of skilled workers, the opportunity to interact with other firmsin the same industry, and being close to suppliers. These advantages result in lowercosts to firms located in the area. Because these lower costs result from increases in thesize of the industry in an area, economists refer to them as external economies.External economies Reductions in a

firm’s costs that result from anincrease in the size of an industry.

Because Catherine Evans Whitener started makingbedspreads by hand in Dalton, Georgia, 100 years ago, amultibillion-dollar carpet industry is now located there.


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external economies gave the area a comparative advantage in carpet making once itbegan to grow there.


of this chapter.

Comparative Advantage Over Time: The Rise and Fall—and Rise—of the U.S.Consumer Electronics IndustryA country may develop a comparative advantage in the production of a good, and then,as time passes and circumstances change, the country may lose its comparative advantagein producing that good and develop a comparative advantage in producing other goods.For several decades, the United States had a comparative advantage in the production ofconsumer electronic goods, such as televisions, radios, and stereos. The comparativeadvantage of the United States in these products was based on having developed most ofthe underlying technology, having the most modern factories, and having a skilled andexperienced workforce. Gradually, however, other countries, particularly Japan, gainedaccess to the technology, built modern factories, and developed skilled workforces. Asmentioned earlier, Japanese firms have excelled in process technologies, which involve theability to improve the processes used to make existing products. By the 1970s and 1980s,Japanese firms were able to produce many consumer electronic goods more cheaply andwith higher quality than could U.S. firms. Japanese firms Sony, Panasonic, and Pioneerreplaced U.S. firms Magnavox, Zenith, and RCA as world leaders in consumer electronics.

By 2008, however, as the technology underlying consumer electronics evolved, compar-ative advantage had shifted again, and several U.S. firms surged ahead of their Japanese com-petitors. For example, Apple Computer had developed the iPod and iPhone; Linksys, a divi-sion of Cisco Systems, took the lead in home wireless networking technology; and Kodakdeveloped digital cameras with EasyShare software that made it easy to organize, enhance,and share digital pictures. As pictures and music converted to digital data, process technolo-gies became less important than the ability to design and develop new products. These newconsumer electronics products required skills similar to those in computer design and soft-ware writing, where the United States had long maintained a comparative advantage.

Once a country has lost its comparative advantage in producing a good, its income willbe higher and its economy will be more efficient if it switches from producing the good toimporting it, as the United States did when it switched from producing televisions toimporting them. As we will see in the next section, however, there is often political pressureon governments to attempt to preserve industries that have lost their comparative advantage.

18.4 | Analyze the economic effects of government policies that restrictinternational trade.

Government Policies That RestrictInternational TradeFree trade, or trade between countries that is without government restrictions, makesconsumers better off. We can expand on this idea by using the concepts of consumersurplus and producer surplus from Chapter 4. Figure 18-4 shows the market for the bio-fuel ethanol in the United States, assuming autarky, where the United States does nottrade with other countries. The equilibrium price of ethanol is $2.00 per gallon, and theequilibrium quantity is 6.0 billion gallons per year. The blue area represents consumersurplus, and the red area represents producer surplus.

Now suppose that the United States begins importing ethanol from Brazil and othercountries that produce lower-priced sugar-based ethanol and that ethanol is selling in


Free trade Trade between countriesthat is without governmentrestrictions.


MARKED SET


those countries for $1.00 per gallon. Because the world market for ethanol is large, wewill assume that the United States can buy as much ethanol as it wants without causingthe world price of $1.00 per gallon to rise. Therefore, once imports of ethanol are permit-ted into the United States, U.S. firms will not be able to sell ethanol at prices higher thanthe world price of $1.00, and the U.S. price will become equal to the world price.

Figure 18-5 shows the result of allowing imports of ethanol into the United States.With the price lowered from $2.00 to $1.00, U.S. consumers increase their purchases

0

Price(dollars

per gallon)

Quantity(billions of gallons)

U.S. demand

U.S. supply

$2.00

6.0

Consumersurplus

Producersurplus

Figure 18-4The U.S. Market for Ethanolunder Autarky

This figure shows the market for ethanol in theUnited States, assuming autarky, where theUnited States does not trade with other coun-tries. The equilibrium price of ethanol is $2.00per gallon, and the equilibrium quantity is 6.0billion gallons per year. The blue area repre-sents consumer surplus, and the red area rep-resents producer surplus.

1.00

0

Price(dollars

per gallon)


3.0

U.S. demand

World price

U.S. supply

A

G

F

B

E

$2.00

Imports

Consumer Surplus

Producer Surplus

Economic Surplus

Under Autarky

A

B + E

A + B + E

With Imports

A + B + C + D

E

A + B + C + D + E

C D

9.06.0

Figure 18-5The Effect of Imports on the U.S. Ethanol Market

When imports are allowed into the UnitedStates, the price of ethanol falls from $2.00 to$1.00. U.S. consumers increase their purchasesfrom 6.0 billion gallons to 9.0 billion gallons.Equilibrium moves from point F to point G.U.S. producers reduce the quantity of ethanolthey supply from 6.0 billion gallons to 3.0 bil-lion gallons. Imports equal 6.0 billion gallons,which is the difference between U.S. consump-tion and U.S. production. Consumer surplusequals the areas A, B, C, and D. Producer sur-plus equals the area E.


MARKED SET


from 6.0 billion gallons to 9.0 billion gallons. Equilibrium moves from point F to pointG. In the new equilibrium, U.S. producers have reduced the quantity of ethanol theysupply from 6.0 billion gallons to 3.0 billion gallons. Imports will equal 6.0 billion gal-lons, which is the difference between U.S. consumption and U.S. production.

Under autarky, consumer surplus would be area A in Figure 18-5. With imports, thereduction in price increases consumer surplus, so it is now equal to the sum of areas A, B, C,and D. Although the lower price increases consumer surplus, it reduces producer surplus.Under autarky, producer surplus was equal to the sum of the areas B and E. With imports,producer surplus is equal to only area E. Recall that economic surplus equals the sum of con-sumer surplus and producer surplus. Moving from autarky to allowing imports increaseseconomic surplus in the United States by an amount equal to the sum of areas C and D.

We can conclude that international trade helps consumers but hurts firms that areless efficient than foreign competitors. As a result, these firms and their workers areoften strong supporters of government policies that restrict trade. These policies usuallytake one of two forms:

• Tariffs

• Quotas and voluntary export restraints

TariffsThe most common interferences with trade are tariffs, which are taxes imposed by a gov-ernment on goods imported into a country. Like any other tax, a tariff increases the cost ofselling a good. Figure 18-6 shows the impact of a tariff of $0.50 per gallon on ethanolimports into the United States. The $0.50 tariff raises the price of ethanol in the UnitedStates from the world price of $1.00 per gallon to $1.50 per gallon. At this higher price, U.S.ethanol producers increase the quantity they supply from 3.0 billion gallons to 4.5 billiongallons. U.S. consumers, though, cut back their purchases of ethanol from 9.0 billion gal-lons to 7.5 billion gallons. Imports decline from 6.0 billion gallons (9 billion − 6 billion) to3.0 billion (7.5 billion − 4.5 billion). Equilibrium moves from point G to point H.

By raising the price of ethanol from $1.00 to $1.50, the tariff reduces consumer sur-plus by the sum of areas A, T, C, and D. Area A is the increase in producer surplus from the

1.00

0

Price(dollars

per gallon)


3.0

U.S. demand

U.S. supply

World price

U.S. price = worldprice + tariffH

GTC

AD

$1.50

Loss of ConsumerSurplus

Increase inProducer Surplus

= GovernmentTariff Revenue

+ DeadweightLoss

A + C + T + D A T C + D

+

U.S. ethanolconsumption

Quantity suppliedby U.S. firms

4.5 7.5 9.0

Figure 18-6The Effects of a Tariff on Ethanol

Without a tariff on ethanol, U.S. producers willsell 3.0 billion gallons of ethanol, U.S. con-sumers will purchase 9.0 billion gallons, andimports will be 6.0 billion gallons. The U.S.price will equal the world price of $1.00 pergallon. The $0.50-per-gallon tariff raises theprice of ethanol in the United States to $1.50per gallon, and U.S. producers increase thequantity they supply to 4.5 billion gallons. U.S.consumers reduce their purchases to 7.5 bil-lion gallons. Equilibrium moves from point Gto point H. The ethanol tariff causes a loss ofconsumer surplus equal to the area A + C + T + D. The area A is the increase in producersurplus due to the higher price. The area T isthe government’s tariff revenue. The areas Cand D represent deadweight loss.


MARKED SET


higher price. The government collects tariff revenue equal to the tariff of $0.50 per gallonmultiplied by the 3.0 billion gallons imported. Area T represents the government’s tariffrevenue. Areas C and D represent losses to U.S. consumers that are not captured by any-one. They are deadweight loss and represent the decline in economic efficiency resultingfrom the ethanol tariff. Area C shows the effect on U.S. consumers of being forced to buyfrom U.S. producers who are less efficient than foreign producers, and area D shows theeffect of U.S. consumers buying less ethanol than they would have at the world price. As aresult of the tariff, economic surplus has been reduced by the sum of areas C and D. Recallfrom Chapter 4 that deadweight loss represents a loss of economic efficiency.

We can conclude that the tariff succeeds in helping U.S. ethanol producers but hurtsU.S. consumers and the efficiency of the U.S. economy.

Quotas and Voluntary Export RestraintsA quota is a numeric limit on the quantity of a good that can be imported, and it has aneffect similar to a tariff. A quota is imposed by the government of the importing coun-try. A voluntary export restraint (VER) is an agreement negotiated between two coun-tries that places a numeric limit on the quantity of a good that can be imported by onecountry from the other country. In the early 1980s, the United States and Japan negoti-ated a VER that limited the quantity of automobiles the United States would importfrom Japan. The Japanese government agreed to the VER primarily because it was afraidthat if it did not, the United States would impose a tariff or quota on imports ofJapanese automobiles. Quotas and VERs have similar economic effects.

The main purpose of most tariffs and quotas is to reduce the foreign competitionthat domestic firms face. We saw an example of this at the beginning of this chapter whenwe discussed the sugar quota, which Congress imposed to protect U.S. sugar producers.Figure 18-7 shows the actual statistics for the U.S. sugar market in 2006. The effect of a

Quota A numeric limit imposed by agovernment on the quantity of a goodthat can be imported into the country.

Voluntary export restraint (VER)An agreement negotiated betweentwo countries that places a numericlimit on the quantity of a good thatcan be imported by one country fromthe other country.

Loss ofConsumer

Surplus

A + C + B + D

$2.24 billion

Gain byU.S. SugarProducers

A

$1.20 billion

Gain toForeignSugar

Producers

B

$0.35 billion

DeadweightLoss

C + D

$0.69 billion

=

=

+

+

+

+

$0.12World price

of sugar

$0.22U.S. price

of sugar

0

Price(dollars

perpound)

Quantityof sugar

(billions ofpounds)

23.15.9

U.S. demand

F

A

CD

B

E

U.S. supply

21.518.0

U.S. sugarconsumption

Quantity suppliedby U.S. firms

Sugar quotaof 3.5 billionpounds

Figure 18-7The Economic Effect of the U.S. Sugar Quota

Without a sugar quota, U.S. sugar producerswould have sold 5.9 billion pounds of sugar,U.S. consumers would have purchased 23.1billion pounds of sugar, and imports wouldhave been 17.2 billion pounds. The U.S. pricewould have equaled the world price of $0.12per pound. Because the sugar quota limitsimports to 3.5 billion pounds (the bracket inthe graph), the price of sugar in the UnitedStates rises to $0.22 per pound, and U.S. pro-ducers increase the quantity of sugar they sup-ply to 18.0 billion pounds. U.S. consumersreduce their sugar purchases to 21.5 billionpounds. Equilibrium moves from point E topoint F. The sugar quota causes a loss of con-sumer surplus equal to the area A + B + C + D.The area A is the gain to U.S. sugar producers.The area B is the gain to foreign sugar produc-ers. The areas C and D represent deadweightloss. The total loss to U.S. consumers in 2006was $2.24 billion.


MARKED SET


quota is very similar to the effect of a tariff. By limiting imports, a quota forces thedomestic price of a good above the world price. In this case, the sugar quota limits sugarimports to 3.5 billion pounds (shown by the bracket in Figure 18-7), forcing the U.S.price of sugar up to $0.22 per pound, or $0.10 higher than the world price. The U.S. priceis above the world price because the quota keeps foreign sugar producers from selling theadditional sugar in the United States that would drive the price down to the world price.At a price of $0.22 cents per pound, U.S. producers increased the quantity of sugar theysupply from 5.9 billion pounds to 18.0 billion pounds, and U.S. consumers cut back theirpurchases of sugar from 23.1 billion pounds to 21.5 billion pounds. Equilibrium movesfrom point E to point F.

Measuring the Economic Effect of the Sugar QuotaOnce again, we can use the concepts of consumer surplus, producer surplus, and dead-weight loss to measure the economic impact of the sugar quota. Without a sugar quota,the world price of $0.12 per pound would also be the U.S. price. In Figure 18-7, con-sumer surplus equals the area above the $0.12 price line and below the demand curve.The sugar quota causes the U.S. price to rise to $0.22 cents and reduces consumer sur-plus by the area A + B + C + D. Without a sugar quota, producer surplus received by U.S.sugar producers would be equal to the area below the $0.12 price line and above the sup-ply curve. The higher U.S. price resulting from the sugar quota increases the producersurplus of U.S. sugar producers by an amount equal to area A.

A foreign producer must have a license from the U.S. government to import sugarunder the quota system. Therefore, a foreign sugar producer that is lucky enough to have animport license also benefits from the quota because it is able to sell sugar on the U.S. marketat $0.22 per pound instead of $0.12 per pound. The gain to foreign sugar producers is areaB. Areas A and B represent transfers from U.S. consumers of sugar to U.S. and foreign pro-ducers of sugar. Areas C and D represent losses to U.S. consumers that are not captured byanyone. They are deadweight losses and represent the decline in economic efficiency result-ing from the sugar quota. Area C shows the effect of U.S. consumers being forced to buyfrom U.S. producers that are less efficient than foreign producers, and area D shows theeffect of U.S. consumers buying less sugar than they would have at the world price.

Figure 18-7 provides enough information to calculate the dollar value of each ofthe four areas. The results of these calculations are shown in the table in the figure. Thetotal loss to consumers from the sugar quota was $2.24 billion in 2006. About 53 per-cent of the loss to consumers, or $1.20 billion, was gained by U.S. sugar producers asincreased producer surplus. About 16 percent, or $0.35 billion, was gained by foreignsugar producers as increased producer surplus, and about 31 percent, or $0.69 billion,was a deadweight loss to the U.S. economy. The U.S. International Trade Commissionestimates that eliminating the sugar quota would result in the loss of about 3,000 jobs inthe U.S. sugar industry. The cost to U.S. consumers of saving these jobs is equal to $2.24billion/3,000, or about $750,000 per job. In fact, this cost is an underestimate becauseeliminating the sugar quota would result in new jobs being created, particularly in thecandy industry. As we saw at the beginning of this chapter, U.S. candy companies havebeen moving factories to other countries to escape the impact of the sugar quota.

Solved Problem|18-4Measuring the Economic Effect of a Quota

Suppose that the United States currently both produces andimports apples. The U.S. government then decides torestrict international trade in apples by imposing a quota

that allows imports of only 4 million boxes of apples intothe United States each year. The figure shows the results ofimposing the quota.


MARKED SET


10

$12

0

Price(dollars

per box)

Quantity(millions of

boxes)

166

U.S. demand

B

A

C

G

H I

D E

J K

F

U.S. supply

1410

Fill in the following table, using the prices, quantities, and letters in the figure:

WITHOUT QUOTA WITH QUOTA

World price of apples __________ __________

U.S. price of apples __________ __________

Quantity supplied by U.S. firms __________ __________

Quantity demanded by U.S. consumers __________ __________

Quantity imported __________ __________

Area of consumer surplus __________ __________

Area of producer surplus __________ __________

Area of deadweight loss __________ __________

>> End Solved Problem 18-4

SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem is about measuring the economic

effects of a quota, so you may want to review the section “Quotas andVoluntary Export Restraints,” which begins on page XXX, and “Measuring theEconomic Effect of the Sugar Quota,” which begins on page XXX.

Step 2: Fill in the table. After studying Figure 18-7, you should be able to fill in thetable. Remember that consumer surplus is the area below the demand curveand above the market price.


World price of apples $10 $10

U.S. price of apples $10 $12

Quantity supplied by U.S. firms 6 million boxes 10 million boxes

Quantity demanded by U.S. consumers 16 million boxes 14 million boxes

Quantity imported 10 millions boxes 4 million boxes

Area of consumer surplus A + B + C + D + E + F A + B

Area of domestic producer surplus G G + C

Area of deadweight loss No deadweight loss D + F

YOUR TURN: For more practice, do related problem 4.14 on page XXX at the end of this chapter.


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18.5 | Evaluate the arguments over trade policy and globalization.

The Argument over Trade Policies and GlobalizationThe argument over whether the U.S. government should regulate international tradedates back to the early days of the country. One particularly controversial attempt torestrict trade took place during the Great Depression of the 1930s. At that time, theUnited States and other countries attempted to help domestic firms by raising tariffs onforeign imports. The United States started the process by passing the Smoot-HawleyTariff in 1930, which raised average tariff rates to more than 50 percent. As other coun-tries retaliated by raising their tariffs, international trade collapsed.

By the end of World War II in 1945, government officials in the United States andEurope were looking for a way to reduce tariffs and revive international trade. To helpachieve this goal, they set up the General Agreement on Tariffs and Trade (GATT) in1948. Countries that joined GATT agreed not to impose new tariffs or import quotas. Inaddition, a series of multilateral negotiations, called trade rounds, took place, in whichcountries agreed to reduce tariffs from the very high levels of the 1930s.

In the 1940s, most international trade was in goods, and the GATT agreementcovered only goods. In the following decades, trade in services and in products incor-porating intellectual property, such as software programs and movies, grew in impor-tance. Many GATT members pressed for a new agreement that would cover servicesand intellectual property, as well as goods. A new agreement was negotiated, and inJanuary 1995, GATT was replaced by the World Trade Organization (WTO), head-quartered in Geneva, Switzerland. More than 130 countries are currently members ofthe WTO.

Why Do Some People Oppose the World Trade Organization?During the years immediately after World War II, many low-income, or developing,countries erected high tariffs and restricted investment by foreign companies. Whenthese policies failed to produce much economic growth, many of these countriesdecided during the 1980s to become more open to foreign trade and investment. Thisprocess became known as globalization. Most developing countries joined the WTOand began to follow its policies.

During the 1990s, opposition to globalization began to increase. In 1999, this oppo-sition took a violent turn at a meeting of the WTO in Seattle, Washington. The purposeof the meeting was to plan a new round of negotiations aimed at further reductions intrade barriers. A large number of protestors assembled in Seattle to meet the WTO dele-gates. Protests started peacefully but quickly became violent. Protesters looted stores andburned cars, and many delegates were unable to leave their hotel rooms.

Why would attempts to reduce trade barriers with the objective of increasingincome around the world cause such a furious reaction? The opposition to the WTOcomes from three sources. First, some opponents are specifically against the globaliza-tion process that began in the 1980s and became widespread in the 1990s. Second, otheropponents have the same motivation as the supporters of tariffs in the 1930s—to erecttrade barriers to protect domestic firms from foreign competition. Third, some critics ofthe WTO support globalization in principle but believe that the WTO favors the inter-ests of the high-income countries at the expense of the low-income countries. Let’s lookmore closely at the sources of opposition to the WTO.

Anti-Globalization Many of the protestors in Seattle distrust globalization. Somebelieve that free trade and foreign investment destroy the distinctive cultures of manycountries. As developing countries began to open their economies to imports from the



World Trade Organization (WTO)An international organization thatoversees international tradeagreements.

Globalization The process ofcountries becoming more open toforeign trade and investment.


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The Unintended Consequences of Banning Goods Made with Child LaborIn many developing countries, such as Indonesia, Thailand,

and Peru, children as young as seven or eight work 10 or more hours a day. Reports ofvery young workers laboring long hours, producing goods for export, have upset manypeople in high-income countries. In the United States, boycotts have been organizedagainst stores that stock goods made in developing countries with child labor. Manypeople assume that if child workers in developing countries weren’t working in factoriesmaking clothing, toys, and other products, they would be in school, as are children inhigh-income countries.

In fact, children in developing countries usually have few good alternatives to work.Schooling is frequently available for only a few months each year, and even children whoattend school rarely do so for more than a few years. Poor families are often unable to

afford even the small costs ofsending their children toschool. Families may evenrely on the earnings of veryyoung children to survive, aspoor families once did in theUnited States, Europe, andJapan. There is substantialevidence that as incomesbegin to rise in poor coun-tries, families rely less onchild labor. The United Stateseventually outlawed childlabor, but not until 1938. Indeveloping countries where


United States and other high-income countries, these imports of food, clothing, movies,and other goods began to replace the equivalent local products. So, a teenager inThailand might be sitting in a McDonald’s restaurant, wearing Levi’s jeans and a RalphLauren shirt, listening to a recording by U2 on his iPod, before going to the local movietheater to watch Spider-Man 3. Globalization has increased the variety of products avail-able to consumers in developing countries, but some people argue that this is too high aprice to pay for what they see as damage to local cultures.

Globalization has also allowed multinational corporations to relocate factories fromhigh-income countries to low-income countries. These new factories in Indonesia,Malaysia, Pakistan, and other countries pay much lower wages than are paid in theUnited States, Europe, and Japan and often do not meet the environmental or safety reg-ulations that are imposed in high-income countries. Some factories use child labor,which is illegal in high-income countries. Some people have argued that firms with fac-tories in developing countries should pay workers wages as high as those paid in thehigh-income countries. They also believe these firms should follow the health, safety,and environmental regulations that exist in the high-income countries.

The governments of most developing countries have resisted these proposals. Theyargue that when the currently rich countries were poor, they also lacked environmentalor safety standards, and their workers were paid low wages. They argue that it is easierfor rich countries to afford high wages and environmental and safety regulations than itis for poor countries. They also point out that many jobs that seem very poorly paid byhigh-income country standards are often better than the alternatives available to work-ers in low-income countries.

|Making the

Connection

Would eliminating child labor in developing countries be agood thing?


MARKED SET


child labor is common today, jobs producing export goods are usually better paying andless hazardous than the alternatives.

As preparations began in France for the 1998 World Cup, there were protests thatBaden Sports—the main supplier of soccer balls—was purchasing the balls from suppli-ers in Pakistan that used child workers. France decided to ban all use of soccer balls madeby child workers. Bowing to this pressure, Baden Sports moved production fromPakistan, where the balls were hand-stitched by child workers, to China, where the ballswere machine-stitched by adult workers in factories. There was some criticism of theboycott of hand-stitched soccer balls at the time. In a broad study of child labor, threeeconomists argued:

Of the array of possible employment in which impoverished childrenmight engage, soccer ball stitching is probably one of the most benign. . . . [InPakistan] children generally work alongside other family members in thehome or in small workshops. . . . Nor are the children exposed to toxic chem-icals, hazardous tools or brutal working conditions. Rather, the only seriouscriticism concerns the length of the typical child stitcher’s work-day and theimpact on formal education.

In fact, the alternatives to soccer ball stitching for child workers in Pakistan turnedout to be extremely grim. According to Keith Maskus, an economist at the University ofColorado and the World Bank, a “large proportion” of the children who lost their jobsstitching soccer balls ended up begging or in prostitution.

Sources: Drusilla K. Brown, Alan V. Deardorff, and Robert M. Stern, “U.S. Trade and Other Policy Options to Deter ForeignExploitation of Child Labor,” in Magnus Blomstrom and Linda S. Goldberg, eds., Topics in Empirical InternationalEconomics: A Festschrift in Honor of Bob Lipsey, Chicago: University of Chicago Press, 2001; Tomas Larsson, The Race to theTop: The Real Story of Globalization, Washington, DC: Cato Institute, 2001, p. 48; and Eric V. Edmonds and Nina Pavcnik,“Child Labor in the Global Economy,” Journal of Economic Perspectives, Vol. 19, No. 1, Winter 2005, pp. 199–220.


of this chapter.

“Old-Fashioned” Protectionism The anti-globalization argument against free tradeand the WTO is relatively new. Another argument against free trade, called protec-tionism, has been around for centuries. Protectionism is the use of trade barriers toshield domestic firms from foreign competition. For as long as international trade hasexisted, governments have attempted to restrict it to protect domestic firms. As we sawwith the analysis of the sugar quota, protectionism causes losses to consumers and elim-inates jobs in the domestic industries that use the protected product. In addition, byreducing the ability of countries to produce according to comparative advantage, pro-tectionism reduces incomes.

Why, then, does protectionism attract support? Protectionism is usually justified onthe basis of one of the following arguments:

• Saving jobs. Supporters of protectionism argue that free trade reduces employ-ment by driving domestic firms out of business. It is true that when more-efficient foreign firms drive less-efficient domestic firms out of business, jobs arelost, but jobs are also lost when more-efficient domestic firms drive less-efficientdomestic firms out of business. These job losses are rarely permanent. In theU.S. economy, jobs are lost and new jobs are created continually. No economicstudy has ever found a long-term connection between the total number of jobsavailable and the level of tariff protection for domestic industries. In addition,trade restrictions destroy jobs in some industries at the same time that they pre-serve jobs in others. The U.S. sugar quota may have saved jobs in the U.S. sugarindustry, but, as we saw at the beginning of this chapter, it also has destroyedjobs in the U.S. candy industry.

• Protecting high wages. Some people worry that firms in high-income countries willhave to start paying much lower wages to compete with firms in developing countries.

Protectionism The use of tradebarriers to shield domestic firms fromforeign competition.


MARKED SET

Has NAFTA Helped or Hurt the U.S. Economy?The North American Free Trade Agreement (NAFTA) wasvery controversial when it was being negotiated in the early

1990s. During the 1992 presidential campaign, independent candidate Ross Perotclaimed to hear a “giant sucking sound” as jobs were pulled out of the United Statesand into Mexico. NAFTA, which went into effect in 1994, eliminated most tariffs onproducts shipped between the United States, Canada, and Mexico. This policychange made it possible for each of these countries to better pursue its comparativeadvantage. For example, before NAFTA, the Mexican government had used tariffs toprotect its domestic automobile industry, but that industry was much less efficientthan the U.S. automobile industry. When tariffs were removed, Mexican consumerscould take advantage of the efficiency of the U.S. industry, and U.S. exports of motorvehicles to Mexico soared. Similarly, Canadian consumers could take advantage oflower-priced U.S. beef, and U.S. consumers could take advantage of lower-pricedCanadian lumber. As we would expect, expanding trade increased consumption inall three countries. In the United States, consumption increased about $400 per yearfor a family of four as a result of NAFTA.

Contrary to Ross Perot’s prediction, NAFTA did not lead to a loss of jobs in theUnited States. Between 1994, when NAFTA went into effect, and 2007, the number of

|Making the

Connection


This fear is misplaced, however, because free trade actually raises living standards byincreasing economic efficiency. When a country practices protectionism and producesgoods and services it could obtain more inexpensively from other countries, it reducesits standard of living. The United States could ban imports of coffee and begin grow-ing it domestically. But this would entail a very high opportunity cost because coffeecould only be grown in the continental United States in greenhouses and would requirelarge amounts of labor and equipment. The coffee would have to sell for a very highprice to cover these costs. Suppose the United States did ban coffee imports: Eliminatingthe ban at some future time would eliminate the jobs of U.S. coffee workers, but thestandard of living in the United States would rise as coffee prices declined and labor,machinery, and other resources moved out of coffee production and into production ofgoods and services for which the United States has a comparative advantage.

• Protecting infant industries. It is possible that firms in a country may have a compar-ative advantage in producing a good, but because the country begins production of thegood later than other countries, its firms initially have higher costs. In producing somegoods and services, substantial “learning by doing” occurs. As workers and firms pro-duce more of the good or service, they gain experience and become more productive.Over time, costs and prices will fall. As the firms in the “infant industry” gain experi-ence, their costs will fall, and they will be able to compete successfully with foreign pro-ducers. Under free trade, however, they may not get the chance. The established foreignproducers can sell the product at a lower price and drive domestic producers out ofbusiness before they gain enough experience to compete. To economists, this is themost persuasive of the protectionist arguments. It has a significant drawback, however.Tariffs used to protect an infant industry eliminate the need for the firms in the indus-try to become productive enough to compete with foreign firms. After World War II,the governments of many developing countries used the “infant industry” argumentto justify high tariff rates. Unfortunately, most of their infant industries never grew up,and they continued for years as inefficient drains on their economies.

• Protecting national security. As already discussed, a country should not rely onother countries for goods that are critical to its military defense. For example, theUnited States would probably not want to import all its jet fighter engines fromChina. The definition of which goods are critical to military defense is a slipperyone, however. In fact, it is rare for an industry to ask for protection without raisingthe issue of national security, even if its products have mainly nonmilitary uses.

Despite resistance to NAFTA,time proved that the U.S. economygained jobs.


MARKED SET


Dumping Selling a product for aprice below its cost of production.

jobs in the United States increased by more than 21 million. Some commentators arguedthat jobs in the United States could be preserved with NAFTA, but only if wages for U.S.workers declined to the much lower levels being paid Mexican workers. In fact, a study byGordon Hanson of the University of California, San Diego, showed that the oppositeoccurred: Wages for both U.S. and Mexican workers increased following NAFTA. Inaddition, the gap between U.S. wages and Mexican wages did not close.

There were, of course, people in all three countries who were made worse off byNAFTA. Some firms in each country were no longer competitive after tariffs were low-ered. In the United States, government assistance helped workers who lost their jobs toretrain or relocate. Overall, most economists have concluded that NAFTA helped the U.S.economy become more efficient, thereby expanding the consumption of U.S. households.

Source: Gordon H. Hanson, “What Has Happened to Wages in Mexico Since NAFTA? Implications for Hemispheric FreeTrade,” in Toni Estevadeordal, Dani Rodrick, Alan Taylor, and Andres Velasco, eds., FTAA and Beyond: Prospects forIntegration in the Americas, Cambridge, MA: Harvard University Press, 2004.


of this chapter.

DumpingIn recent years, the United States has extended protection to some domestic industriesby using a provision in the WTO agreement that allows governments to impose tariffs inthe case of dumping. Dumping is selling a product for a price below its cost of produc-tion. Although allowable under the WTO agreement, using tariffs to offset the effects ofdumping is very controversial.

In practice, it is difficult to determine whether foreign companies are dumpinggoods because the true production costs of a good are not easy for foreign governmentsto calculate. As a result, the WTO allows countries to determine that dumping hasoccurred if a product is exported for a lower price than it sells for on the home market.There is a problem with this approach, however. Often there are good business reasonsfor a firm to sell a product for different prices to different consumers. For example, theairlines charge business travelers higher ticket prices than leisure travelers. Firms alsouse “loss leaders”—products that are sold below cost, or even given away free—whenintroducing a new product or, in the case of retailing, to attract customers who will alsobuy full-price products. For example, when Sun Microsystems attempted to establishStarOffice as a competitor to Microsoft Office, Sun gave the software away free on itsWeb site. During the Christmas season, Wal-Mart sometimes offers toys at prices belowwhat they pay to buy them from manufacturers. It’s unclear why these normal businesspractices should be unacceptable when used in international trade.

Positive versus Normative Analysis (Once Again)Economists emphasize the burden on the economy imposed by tariffs, quotas, and othergovernment restrictions on free trade. Does it follow that these interferences are bad?Remember from Chapter 1 the distinction between positive analysis and normativeanalysis. Positive analysis concerns what is. Normative analysis concerns what ought tobe. Measuring the impact of the sugar quota on the U.S. economy is an example of pos-itive analysis. Asserting that the sugar quota is bad public policy and should be elimi-nated is normative analysis. The sugar quota—like all other interferences with trade—makes some people better off and some people worse off, and it reduces total incomeand consumption. Whether increasing the profits of U.S. sugar companies and the num-ber of workers they employ justifies the costs imposed on consumers and the reductionin economic efficiency is a normative question.

Most economists do not support interferences with trade, such as the sugar quota.Few people become economists if they don’t believe that markets should usually be asfree as possible. But the opposite view is certainly intellectually respectable. It is possiblefor someone to understand the costs of tariffs and quotas but still believe that tariffs and


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quotas are a good idea, perhaps because they believe unrestricted free trade would causetoo much disruption to the economy.

The success of industries in getting the government to erect barriers to foreign com-petition depends partly on some members of the public knowing full well the costs oftrade barriers but supporting them anyway. However, two other factors are also at work:

1 The costs tariffs and quotas impose on consumers are large in total but relativelysmall per person. For example, the sugar quota imposes a total burden of about$2.24 billion per year on consumers. Spread across 300 million Americans, the bur-den is only about $7.50 per person: too little for most people to worry about, even ifthey know the burden exists.

2 The jobs lost to foreign competition are easy to identify, but the jobs created by for-eign trade are less easy to identify.

In other words, the industries that benefit from tariffs and quotas benefit a lot—thesugar quota increases the profits of U.S. sugar producers by more than $1 billion—whereas each consumer loses relatively little. This concentration of benefits and widelyspread burdens makes it easy to understand why members of Congress receive strongpressure from some industries to enact tariffs and quotas and relatively little pressurefrom the general public to reduce them.

18.6 | Explain how exchange rates are determined and how changes in exchangerates affect the prices of imports and exports.

The Foreign Exchange Market and Exchange RatesA firm that operates entirely within the United States will price its products in dollars andwill use dollars to pay suppliers, workers, interest to bondholders, and dividends to share-holders. A multinational corporation, in contrast, may sell its product in many differentcountries and receive payment in many different currencies. Its suppliers and workers mayalso be spread around the world and may have to be paid in local currencies. Corporationsmay also use the international financial system to borrow in a foreign currency. During the1990s, for example, many large firms located in East Asian countries, such as Thailand andSouth Korea, received dollar loans from foreign banks. When firms make extensive use offoreign currencies, they must deal with fluctuations in the exchange rate.

The nominal exchange rate is the value of one country’s currency in terms ofanother country’s currency. Economists also calculate the real exchange rate, which cor-rects the nominal exchange rate for changes in prices of goods and services. We discussthe real exchange rate later in this chapter. The nominal exchange rate determines howmany units of a foreign currency you can purchase with $1. For example, the exchangerate between the U.S. dollar and the Japanese yen can be expressed as ¥100 = $1. (Thisexchange rate can also be expressed as how many U.S. dollars are required to buy 1Japanese yen: $0.01 = ¥1.) The market for foreign exchange is very active. Every day, theequivalent of more than $1 trillion worth of currency is traded in the foreign exchangemarket. The exchange rates that result from this trading are reported each day in thebusiness or financial sections of most newspapers.

Banks and other financial institutions around the world employ currency traders, whoare linked together by computer. Rather than exchange large amounts of paper currency,they buy and sell deposits in banks. A bank buying or selling dollars will actually be buyingor selling dollar bank deposits. Dollar bank deposits exist not just in banks in the UnitedStates but also in banks around the world. Suppose that the Credit Lyonnais bank in Francewishes to sell U.S. dollars and buy Japanese yen. It may exchange U.S. dollar deposits that itowns for Japanese yen deposits owned by the Deutsche Bank in Germany. Businesses andindividuals usually obtain foreign currency from banks in their own country.


Nominal exchange rate The value of one country’s currency in terms of another country’s currency.


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The market exchange rate is determined by the interaction of demand and supply,just as other prices are. Let’s consider the demand for U.S. dollars in exchange forJapanese yen. There are three sources of foreign currency demand for the U.S. dollar:

1 Foreign firms and households who want to buy goods and services produced in theUnited States.

2 Foreign firms and households who want to invest in the United States eitherthrough foreign direct investment—buying or building factories or other facilitiesin the United States—or through foreign portfolio investment—buying stocks andbonds issued in the United States.

3 Currency traders who believe that the value of the dollar in the future will be greaterthan its value today.

Equilibrium in the Market for Foreign ExchangeFigure 18-8 shows the demand and supply of U.S. dollars for Japanese yen. Notice that aswe move up the vertical axis in Figure 18-8, the value of the dollar increases relative tothe value of the yen. When the exchange rate is ¥150 = $1, the dollar is worth 1.5 timesas much relative to the yen as when the exchange rate is ¥100 = $1. Consider, first, thedemand curve for dollars in exchange for yen. The demand curve has the normaldownward slope. When the value of the dollar is high, the quantity of dollarsdemanded will be low. A Japanese investor will be more likely to buy a $1,000 bondissued by the U.S. Treasury when the exchange rate is ¥100 = $1 and the investor paysonly ¥100,000 to buy $1,000 than when the exchange rate is ¥150 = $1 and the investormust pay ¥150,000. Similarly, a Japanese firm is more likely to buy $150 million worth ofmicrochips from Intel Corporation when the exchange rate is ¥100 = $1 and themicrochips can be purchased for ¥15 billion than when the exchange rate is ¥150 = $1and the microchips cost ¥22.5 billion.

Consider, now, the supply curve of dollars in exchange for yen. The supply curve hasthe normal upward slope. When the value of the dollar is high, the quantity of dollarssupplied in exchange for yen will be high. A U.S. investor will be more likely to buy a¥200,000 bond issued by the Japanese government when the exchange rate is ¥200 = $1and he needs to pay only $1,000 to buy ¥200,000 than when the exchange rate is ¥100 =$1 and he must pay $2,000. The owner of a U.S. electronics store is more likely to buy¥20 million worth of television sets from the Sony Corporation when the exchange rateis ¥200 = $1 and she only needs to pay $100,000 to purchase the televisions than whenthe exchange rate is ¥100 = $1 and she must pay $200,000.

0

Exchangerate (¥/$)

Quantity of dollars traded

120

Supply

Surplus of dollars

Shortage of dollars

Demand

¥150

100

Supply of dollarsin exchange foryen

Demand for dollarsin exchange foryen

Figure 18-8Equilibrium in the ForeignExchange Market

When the exchange rate is ¥150 to the dollar, itis above its equilibrium level, and there will bea surplus of dollars. When the exchange rate is¥100 to the dollar, it is below its equilibriumlevel, and there will be a shortage of dollars. Atan exchange rate of ¥120 to the dollar, the for-eign exchange market is in equilibrium.


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As in any other market, equilibrium occurs in the foreign exchange market wherethe quantity supplied equals the quantity demanded. In Figure 18-8, ¥120 = $1 is theequilibrium exchange rate. At exchange rates above ¥120 = $1, there will be a surplus ofdollars and downward pressure on the exchange rate. The surplus and the downwardpressure will not be eliminated until the exchange rate falls to ¥120 = $1. If the exchangerate is below ¥120 = $1, there will be a shortage of dollars and upward pressure on theexchange rate. The shortage and the upward pressure will not be eliminated until theexchange rate rises to ¥120 = $1. Surpluses and shortages in the foreign exchange marketare eliminated very quickly because the volume of trading in major currencies such asthe dollar and the yen is very large, and currency traders are linked together by computer.

Currency appreciation occurs when the market value of a country’s currencyincreases relative to the value of another country’s currency. Currency depreciationoccurs when the market value of a country’s currency decreases relative to the value ofanother country’s currency.

How Do Shifts in Demand and Supply Affect the Exchange Rate?Shifts in the demand and supply curves cause the equilibrium exchange rate to change.Three main factors cause the demand and supply curves in the foreign exchange marketto shift:

1 Changes in the demand for U.S.-produced goods and services and changes in thedemand for foreign-produced goods and services

2 Changes in the desire to invest in the United States and changes in the desire toinvest in foreign countries

3 Changes in the expectations of currency traders about the likely future value of thedollar and the likely future value of foreign currencies

Shifts in the Demand for Foreign Exchange Consider how the three factors listedabove will affect the demand for U.S. dollars in exchange for Japanese yen. During aneconomic expansion in Japan, the incomes of Japanese households will rise, and thedemand by Japanese consumers and firms for U.S. goods will increase. At any givenexchange rate, the demand for U.S. dollars will increase, and the demand curve will shift


Don’t Let This Happen to YOU!Don't Confuse What Happens When aCurrency Appreciates with WhatHappens When It Depreciates.

One of the more confusing aspects of exchange rates is thatthey can be expressed in two ways. We can express theexchange rate between the dollar and the yen either as howmany yen can be purchased with $1 or as how many dollarscan be purchased with ¥1. That is, we can express the exchangerate as ¥100 = $1 or as $0.01 = ¥1. When a currency appreci-ates, it increases in value relative to another currency. When itdepreciates, it decreases in value relative to another currency.

If the exchange rate changes from ¥100 = $1 to ¥120 =$1, the dollar has appreciated and the yen has depreci-ated because it now takes more yen to buy $1. If theexchange rate changes from $0.01 = ¥1 to $0.015 = ¥1,

however, the dollar has depreciated and the yen hasappreciated because it now takes more dollars to buy ¥1.This situation can appear somewhat confusing becausethe exchange rate seems to have “increased” in bothcases. To determine which currency has appreciated andwhich has depreciated, it is important to remember thatan appreciation of the domestic currency means that itnow takes more units of the foreign currency to buy oneunit of the domestic currency. A depreciation of thedomestic currency means it takes fewer units of the for-eign currency to buy one unit of the domestic currency.This observation holds no matter which way we expressthe exchange rate.

YOUR TURN: Test your understanding by doing related

problem 6.4 on page XXXX at the end of the chapter.

Currency appreciation An increasein the market value of one currencyrelative to another currency.

Currency depreciation A decrease inthe market value of one currencyrelative to another currency.


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to the right. Similarly, if interest rates in the United States rise, the desirability of invest-ing in U.S. financial assets will increase, and the demand curve for dollars will also shiftto the right. Some buyers and sellers in the foreign exchange market are speculators.Speculators buy and sell foreign exchange in an attempt to profit from changes inexchange rates. If a speculator becomes convinced that the value of the dollar is goingto rise relative to the value of the yen, the speculator will sell yen and buy dollars. Ifthe current exchange rate is ¥120 = $1, and the speculator is convinced that it willsoon rise to ¥140 = $1, the speculator could sell ¥600,000,000 and receive $5,000,000(= ¥600,000,000/¥120) in return. If the speculator is correct and the value of the dollarrises against the yen to ¥140 = $1, the speculator will be able to exchange $5,000,000 for¥700,000,000 (= $5,000,000 × ¥140), leaving a profit of ¥100,000,000.

To summarize, the demand curve for dollars shifts to the right when incomes inJapan rise, when interest rates in the United States rise, or when speculators decide thatthe value of the dollar will rise relative to the value of the yen.

During a recession in Japan, Japanese incomes will fall, reducing the demand for U.S.-produced goods and services and shifting the demand curve for dollars to the left.Similarly, if interest rates in the United States fall, the desirability of investing in U.S. finan-cial assets will decrease, and the demand curve for dollars will shift to the left. Finally, ifspeculators become convinced that the future value of the dollar will be lower than its cur-rent value, the demand for dollars will fall, and the demand curve will shift to the left.

Shifts in the Supply of Foreign Exchange The factors that affect the supply curvefor dollars are similar to those that affect the demand curve for dollars. An economicexpansion in the United States increases the incomes of Americans and increases theirdemand for goods and services, including goods and services made in Japan. As U.S.consumers and firms increase their spending on Japanese products, they must supplydollars in exchange for yen, which causes the supply curve for dollars to shift to theright. Similarly, an increase in interest rates in Japan will make financial investments inJapan more attractive to U.S. investors. These higher Japanese interest rates will causethe supply of dollars to shift to the right, as U.S. investors exchange dollars for yen.Finally, if speculators become convinced that the future value of the yen will be higherrelative to the dollar than it is today, the supply curve of dollars will shift to the right astraders attempt to exchange dollars for yen.

A recession in the United States will decrease the demand for Japanese products andcause the supply curve for dollars to shift to the left. Similarly, a decrease in interest ratesin Japan will make financial investments in Japan less attractive and cause the supplycurve of dollars to shift to the left. If traders become convinced that the future value ofthe yen will be lower relative to the dollar, the supply curve will also shift to the left.

Adjustment to a New Equilibrium The factors that affect the demand and supplyfor currencies are constantly changing. Whether the exchange rate increases or decreasesdepends on the direction and size of the shifts in the demand curve and supply curve.For example, as Figure 18-9 shows, if the demand curve for dollars in exchange forJapanese yen shifts to the right by more than the supply curve does, the equilibriumexchange rate will increase.

Some Exchange Rates Are Not Determined by the MarketTo this point, we have assumed that exchange rates are determined in the market. Thisassumption is a good one for many currencies, including the U.S. dollar, the euro, theJapanese yen, and the British pound. Some currencies, however, have fixed exchangerates that do not change over long periods. For example, for more than 10 years, thevalue of the Chinese yuan was fixed against the U.S. dollar at a rate of 8.28 yuan to thedollar. As we will discuss in more detail in Chapter xx, a country’s central bank has tointervene in the foreign exchange market to buy and sell its currency to keep theexchange rate fixed.

Speculators Currency traders whobuy and sell foreign exchange in anattempt to profit from changes inexchange rates.


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How Movements in the Exchange Rate Affect Exportsand ImportsWhen the market value of the dollar increases, the foreign currency price of U.S.exports rises, and the dollar price of foreign imports falls. For example, suppose thatinitially the market exchange rate between the U.S. dollar and the euro is $1 = €1. Inthat case, an Apple iPod Nano that has a price of $200 in the United States will have aprice of €200 in France. A bottle of French wine that has a price of €50 in France willhave a price of $50 in the United States. Now suppose the market exchange ratebetween the U.S. dollar and the euro changes to $1.20 = €1. Because it now takes moredollars to buy a euro, the dollar has depreciated against the euro, and the euro hasappreciated against the dollar.

The depreciation of the dollar has decreased the euro price of the iPod from€200 to $200/(1.20 dollars/euro) = €167. The dollar price of the French wine hasrisen from $50 to €50 × 1.20 dollars/euro = $60. As a result, we would expect moreiPods to be sold in France and less French wine to be sold in the United States. Togeneralize, we can conclude that a depreciation in the domestic currency willincrease exports and decrease imports, thereby increasing net exports. As we saw inprevious chapters, net exports is a component of aggregate demand. If the economyis currently below potential GDP, then, holding all other factors constant, a depreci-ation in the domestic currency should increase net exports, aggregate demand, andreal GDP. An appreciation in the domestic currency should have the opposite effect:Exports should fall, and imports should rise, which will reduce net exports, aggregatedemand, and real GDP.


0

Exchangerate (¥/$)


¥130

D1

A

B

D2

S2

S1

120

1. The supply curveof dollars shifts tothe right . . .

2. . . . while the demandcurve for dollars shiftsfurther to the right . . .

3. . . . causing theequilibrium exchangerate to rise.

Figure 18-9Shifts in the Demand and SupplyCurve Resulting in a HigherExchange Rate

Holding other factors constant, an increase inthe supply of dollars will decrease the equilib-rium exchange rate.An increase in the demandfor dollars will increase the equilibriumexchange rate. In the case shown in this figure,the demand curve and the supply curve haveboth shifted to the right. Because the demandcurve has shifted to the right by more than thesupply curve, the equilibrium exchange rate hasincreased from ¥120 to $1 at point A to ¥130 to$1 at point B.

Solved Problem|18-6The Effect of Changing Exchange Rates on the Prices of Imports and Exports

In March 2001, the average price of goods imported into theUnited States from Canada fell 3.3 percent. This decline wasthe largest since the federal government began gatheringsuch statistics in 1992. Is it likely that the value of the U.S.

dollar appreciated or depreciated versus the Canadian dollarduring this period? Is it likely that the average price inCanadian dollars of goods exported from the United Statesto Canada during March 2001 rose or fell?


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SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem is about changes in the value of a

currency, so you may want to review the section “How Movements in theExchange Rate Affect Exports and Imports,” which appears on this page.

Step 2: Explain whether the value of the U.S. dollar appreciated or depreciated againstthe Canadian dollar. We know that if the U.S. dollar appreciates against theCanadian dollar, it will take more Canadian dollars to purchase one U.S. dollar,and, equivalently, fewer U.S. dollars will be required to purchase one Canadiandollar. A Canadian consumer or business will need to pay more Canadian dollarsto buy products imported from the United States: A good or service that hadbeen selling for 100 Canadian dollars will now sell for more than 100 Canadiandollars. A U.S. consumer or business will have to pay fewer U.S. dollars to buyproducts imported from Canada: A good or service that had been selling for 100U.S. dollars will now sell for fewer than 100 U.S. dollars. We can conclude that ifthe price of goods imported into the United States from Canada fell, the value ofthe U.S. dollar must have appreciated versus the Canadian dollar.

Step 3: Explain what happened to the average price in Canadian dollars of goodsexported from the United States to Canada. If the U.S. dollar appreciated rel-ative to the Canadian dollar, the average price in Canadian dollars of goodsexported from the United States to Canada will have risen.

YOUR TURN: For more practice, do related problem 6.9 on page XXXX at the end of this chapter. >> End Solved Problem 18-6

>> Continued from page XXX

Economics in YOUR Life!

At the beginning of the chapter, we asked you to consider how sugar companies haveconvinced Congress to enact the sugar quota and why relatively few people have heardof this quota. In the chapter, we saw that the sugar quota costs U.S. consumers more than$2 billion per year as a result of higher sugar prices and has led several U.S. candy makersto eliminate domestic jobs and move their facilities to other countries. This might seem toincrease the mystery of why Congress has enacted the sugar quota, especially because itsaves relatively few jobs in the U.S. sugar industry. We have also seen, though, that perperson, the burden of the sugar quota is small—only about $7.50 per person per year. Notmany people will take the trouble of writing a letter to their member of Congress or oth-erwise make their views known in the hope of saving $7.50 per year. In fact, few peoplewill even spend the time to become aware that the quota exists. So, if before you readthis chapter you had never heard of the sugar quota, you are certainly not alone.

ConclusionThere are few issues economists agree upon more than the economic benefits of freetrade. However, there are few political issues as controversial as government policytoward trade. Many people who would be reluctant to see the government interfere withdomestic trade are quite willing to see it interfere with international trade. The damagehigh tariffs inflicted on the world economy during the 1930s shows what can happenwhen governments around the world abandon free trade. Whether future episodes ofthat type can be avoided is by no means certain.

Read An Inside Look at Policy on the next page for a discussion of how eliminatingtariffs on cars and other goods benefits the United States and South Korea.


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The United Statesand South KoreaReach a Trade Deal

An Inside LOOK at Policy

626

NEW YORK TIMES, APRIL 3, 2007

a

U.S. and SouthKorea Agree to Sweeping Trade DealUnited States and South Korean nego-tiators struck the world’s largest bilat-eral free trade agreement on Monday,giving the United States a badlyneeded lift to its trade policy at homeand South Korea a chance to reinvigo-rate its export economy. . . .

If ratified, the trade deal wouldeliminate tariffs on more than 90 per-cent of the product categories tradedbetween the countries. South Koreaagreed to lift trade barriers to impor-tant American products like cars andbeef, while the United States agreed toallow Seoul to continue to subsidizeSouth Korean rice. . . .

As South Korean workers andfarmers protested in the streets—onSunday, one man even set himself onfire—negotiators haggled to the endearly Monday.

The breakthrough came whenboth sides compromised on the mostdelicate deal-breaking issues. Wash-ington dropped its demand that theSouth Korean government stop pro-tecting its politically powerful ricefarmers, and Seoul agreed to resumeimports of American beef, haltedthree years ago over fears of mad cowdisease, if, as expected, the WorldOrganization on Animal Healthdeclares United States meat safe in aruling next month.

b

South Korea also agreed to phaseout the 40 percent tariff on Americanbeef over 15 years. It will remove an 8percent duty on cars and revise adomestic vehicle tax system thatUnited States officials say discrimi-nates against American cars with big-ger engines.

The United States will eliminatethe 2.5 percent tariff on South Koreancars with engines smaller than 3,000cubic centimeters; phase out the 25percent duty on trucks over the courseof 10 years; and remove tariffs, whichaverage 8.9 percent, on 61 percent ofSouth Korean textiles. . . .

The deal is the biggest of its kindfor the United States since the NorthAmerican Free Trade Agreement in1994 with Canada and Mexico. It isWashington’s first bilateral trade pactwith a major Asian economy.

Studies have estimated that theaccord would add $20 billion to bilat-eral trade, estimated last year at $78billion. Potential gains to the UnitedStates economy range from $17 billionto $43 billion, according to Usha C. H.Haley, director of the Global BusinessCenter at the University of NewHaven. South Korea’s exports to theUnited States are expected to rise inthe first year by 12 percent.

Analysts doubt that the deal willprovide an immediate lift to Ameri-can car manufacturers. Only 5,000American cars were sold here lastyear, while South Korean automakerssold 800,000 vehicles in the UnitedStates. The gap accounted for 80 per-cent of the $13 billion United States

c

trade deficit with South Korea lastyear.

American officials hope that thedeal will placate American cattlefarmers, who are struggling to recap-ture global market share after an out-break of mad cow disease in late 2003.Before the import ban, South Koreawas the world’s third-largest con-sumer of American beef, importing$800 million a year.

Consumers in both countries arethe deal’s biggest winners. Hyundaicars and Samsung flat-panel TV sets,as well as Korean-made clothing, willbecome significantly cheaper in theUnited States.

American beef and oranges, aswell as Ford cars and Toyota vehiclesbuilt in the United States, will be moreaffordable in South Korea. SouthKorean TV networks will be able tobroadcast more American movies andTV series like “CSI,” which alreadycommand a huge following here, afterSeoul eases a cap on foreign content to80 percent of total airtime from 75percent.

The deal entails heavy politicalcosts for South Korea, which canexpect the loss of tens of thousands offarming jobs. Up to 2 trillion won($2.2 billion) in agricultural revenuewill be lost as cheap American corn,soybeans and processed foods comein, according to studies by SouthKorean economists. . . .

Source: Choe Sang-Hun, “U.S. and South KoreaAgree to Sweeping Trade Deal,” New York Times,April 3, 2007, p. C1. Copyright © 2007 The NewYork Times Co. Reprinted by permission.


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countries, such as the United States, gov-ernments receive most of their revenuefrom taxes on personal and corporateincome. For example, tariff revenue in theUnited States for 2006 amounted to onlyabout 1 percent of all revenue received bythe federal government, but governments inlow-income countries often have difficultycollecting income taxes, so they rely heavilyon tariffs for revenue. In these countries, thegovernment’s need for revenue can pose aserious barrier to expanding internationaltrade by reducing tariffs because govern-ments have difficulty replacing the revenueslost from tariff reductions. This was alsotrue in the United States early in its history.In 1800, tariffs brought in 90 percent of allfederal government revenue. As late as the1950s, tariffs accounted for 14 percent offederal revenues.

Trade benefits the entire economy butcan create losses for certain groups

in the economy. While South Korean con-sumers will gain from less expensive food,agricultural interests in South Korea will behurt. These interests are likely to lobbyagainst ratification of the agreement.

Thinking Critically

About Policy1. Tariffs on South Korean car and textile

imports save jobs for Americans workingin those industries. Do you support thesetariffs? Why or why not?

2. In which goods mentioned in the articledoes the United States have a compara-tive advantage? In which does SouthKorea have a comparative advantage?Explain your reasoning.

c

627

Key Points in the ArticleThe article discusses a recent trade agree-ment negotiated between the UnitedStates and South Korea that will reducerestrictions on trade between the twocountries. Agreements such as this one toexpand trade between two countries areknown as bilateral agreements. The tradeagreements worked out by the WorldTrade Organization are multilateral agree-ments. Neither Congress nor the SouthKorean National Assembly has yet ratifiedthe agreement. However, if the legislaturesdo ratify the agreement, a free-trade zonecovering the world’s largest and eleventh-largest economies would be created.

Analyzing the News

In this chapter, we have seen thatexpanding trade raises living stan-

dards by increasing consumption and eco-nomic efficiency. Reducing tariffs on tradebetween South Korea and the United Stateswill aid consumers in both countries. The

a

figure shows the U.S. market following theelimination of the tariff on South Koreancars. (For simplicity, we assume that thereare no remaining U.S. tariffs on cars.) Theprice of cars in the United States falls fromP1 to P2, and equilibrium in the U.S. carmarket moves from point E to point F. U.S.consumption of cars increases from Q3 toQ4, the quantity of cars supplied by U.S. carmakers declines from Q2 to Q1, and importsincrease from Q3 − Q2 to Q4 − Q1. Consumersurplus increases by the sum of areas A, B,C, and D. Area A represents a transfer fromproducer surplus under the tariff to con-sumer surplus. Areas C and D represent theconversion of deadweight loss to consumersurplus. Area B represents a conversion ofgovernment tariff revenue to consumer sur-plus. Eliminating the tariff reduces the costto South Korean car producers of sellingtheir product in the United States. U.S. con-sumers purchase a larger quantity of SouthKorean cars at a lower price.

The figure shows that eliminating thetariff on cars also eliminates the rev-

enue the U.S. government had been col-lecting from this tariff. In high-income

b

P1

0

Price(dollarsper car)

Quantity(cars per year)

Q4Q3Q1 Q2

U.S. demand

U.S. supply

World price

U.S. price

F

E

BAD

P2

Increase inConsumerSurplus

Decrease inProducer Surplus

=

Decrease inGovernment

Tariff Revenue+

Decrease inDeadweight

Loss

A + C + B + D A B C + D

+

C

The market for cars in the United States after the tariff on South Korean cars iseliminated.


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>> End Learning Objective 18.1


Key TermsAbsolute advantage, p. 604

Autarky, p. 605

Comparative advantage, p. 603

Currency appreciation, p. 622

Currency depreciation, p. 622

Dumping, p. 619

Exports, p. 600

External economies, p. 608

Free trade, p. 609

Globalization, p. 615

Imports, p. 600

Nominal exchange rate, p. 620

Opportunity cost, p. 603

Protectionism, p. 617

Quota, p. 612

Speculators, p. 623

Tariff, p. 600

Terms of trade, p. 605

Voluntary export restraint(VER), p. 612

World Trade Organization(WTO), p. 615

18.1 LEARNING OBJECTIVE 18.1 | Discuss the role of international trade in the U.S. economy, pages XXX–XXX.

The United States in the International Economy

Summary

International trade has been increasing in recent decades, inpart because of reductions in tariffs and other barriers totrade. A tariff is a tax imposed by a government on imports.The quantity of goods and services the United Statesimports and exports has been continually increasing.Imports are goods and services bought domestically butproduced in other countries. Exports are goods and servicesproduced domestically but sold to other countries. Today,the United States is the leading exporting country in theworld, and about 20 percent of U.S. manufacturing jobsdepend on exports.

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Review Questions

1.1 Briefly explain whether you agree or disagree withthe following statement: “International trade is moreimportant to the U.S. economy than to most othereconomies.”

Problems and Applications

1.2 If the United States were to stop trading goods andservices with other countries, which U.S. industrieswould be likely to see their sales decline the most?Briefly explain.

1.3 Briefly explain whether you agree with the followingstatement: “Japan has always been much more heav-ily involved in international trade than are mostother nations. In fact, today Japan exports a largerfraction of its GDP than do Germany, Great Britain,or the United States.”

1.4 [Related to the Making the Connection onpage XXX] Some politicians in the United Statesbelieve that European governments unfairly helpAirbus, Boeing’s main competitor, by subsidizing, ormaking payments, to Airbus. Suppose that the U.S.Congress passes legislation forbidding U.S. airlinesfrom buying planes from Airbus or any other non-U.S. aircraft firm. Would this legislation be likely toactually help Boeing? Briefly explain.

18.2 LEARNING OBJECTIVE 18.2 | Understand the difference between comparative advantage and absolute

advantage in international trade, pages XXX–XXX.

Comparative Advantage in International Trade

Summary

Comparative advantage is the ability of an individual, abusiness, or a country to produce a good or service at thelowest opportunity cost. Absolute advantage is the abilityto produce more of a good or service than competitorswhen using the same amount of resources. Countries tradeon the basis of comparative advantage, not on the basis ofabsolute advantage.


Review Questions

2.1 A World Trade Organization publication calls com-parative advantage “arguably the single most power-ful insight in economics.” What is comparativeadvantage? What makes it such a powerful insight?Source: World Trade Organization, Trading into the Future, April 1999.


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18.3 LEARNING OBJECTIVE 18.3 | Explain how countries gain from international trade, pages XXX–XXX.

How Countries Gain from International Trade

Summary

Autarky is a situation in which a country does not tradewith other countries. The terms of trade is the ratio atwhich a country can trade its exports for imports fromother countries. When a country specializes in producinggoods where it has a comparative advantage and trades forthe other goods it needs, the country will have a higher levelof income and consumption. We do not see complete spe-cialization in production for three reasons: Not all goodsand services are traded internationally, production of mostgoods involves increasing opportunity costs, and tastes forproducts differ across countries. Although the population ofa country as a whole benefits from trade, companies—andtheir workers—that are unable to compete with lower-costforeign producers lose. Among the main sources of compar-ative advantage are climate and natural resources, relativeabundance of labor and capital, technology, and externaleconomies. External economies are reductions in a firm’s

cost that result from an increase in the size of an industry. Acountry may develop a comparative advantage in the pro-duction of a good, and then as time passes and circum-stances change, the country may lose its comparative advan-tage in producing that good and develop a comparativeadvantage in producing other goods.


Review Questions

3.1 Briefly explain how international trade increases acountry’s consumption.

3.2 What is meant by a country specializing in the pro-duction of a good? Is it typical for countries to becompletely specialized? Briefly explain.

3.3 What are the main sources of comparative advantage?

2.2 What is the difference between absolute advantageand comparative advantage? Will a country always bean exporter of a good where it has an absolute advan-tage in production?


2.3 Why do the goods that countries import and exportchange over time? Use the concept of comparativeadvantage in your answer.

2.4 Briefly explain whether you agree with the followingargument: “Unfortunately, Bolivia does not have acomparative advantage with respect to the UnitedStates in the production of any good or service.”(Hint: You do not need any specific informationabout the economies of Bolivia or the United Statesto be able to answer this question.)

2.5 In 1987, an economic study showed that, on average,workers in the Japanese consumer electronics indus-try produced less output per hour than did U.S.workers producing the same goods. Despite this fact,Japan exported large quantities of consumer elec-tronics to the United States. Briefly explain how thisis possible.

Source: Study cited in Douglas A. Irwin, Free Trade under Fire, Princeton,NJ: Princeton University Press, 2002, p. 27.

2.6 Patrick J. Buchanan, a former presidential candidate,argues in his book on the global economy that thereis a flaw in David Ricardo’s theory of comparativeadvantage:

Classical free trade theory fails the test ofcommon sense. According to Ricardo’slaw of comparative advantage . . . ifAmerica makes better computers and tex-tiles than China does, but our advantagein computers is greater than our advan-tage in textiles, we should (1) focus oncomputers, (2) let China make textiles,and (3) trade U.S. computers for Chinesetextiles. . . .

The doctrine begs a question. IfAmericans are more efficient thanChinese in making clothes . . . why sur-render the more efficient Americanindustry? Why shift to a reliance on aChinese textile industry that will takeyears to catch up to where American fac-tories are today?

Do you agree with Buchanan’s argument? Brieflyexplain.

Source: Patrick J. Buchanan, The Great Betrayal: How American Sovereigntyand Social Justice Are Being Sacrificed to the Gods of the Global Economy,Boston: Little, Brown, 1998, p. 66.


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3.4 The following table shows the hourly output perworker in two industries in Chile and Argentina.

OUTPUT PER HOUR OF WORK

HATS BEER

CHILE 8 6

ARGENTINA 1 2

a. Explain which country has an absolute advan-tage in the production of hats and which coun-try has an absolute advantage in the productionof beer.

b. Explain which country has a comparative advan-tage in the production of hats and which countryhas a comparative advantage in the production ofbeer.

c. Suppose that Chile and Argentina currently do nottrade with each other. Each has 1,000 hours oflabor to use producing hats and beer, and thecountries are currently producing the amounts ofeach good shown in the following table.

HATS BEER

CHILE 7,200 600

ARGENTINA 600 800

Using this information, give a numeric example ofhow Chile and Argentina can both gain fromtrade. Assume that after trading begins, one hatcan be exchanged for one barrel of beer.

3.5 A political commentator makes the followingstatement:

The idea that international trade shouldbe based on the comparative advantage ofeach country is fine for rich countries likethe United States and Japan. Rich coun-tries have educated workers and largequantities of machinery and equipment.These advantages allow them to produceevery product more efficiently than poorcountries can. Poor countries like Kenyaand Bolivia have nothing to gain frominternational trade based on comparativeadvantage.

Do you agree with this argument? Briefly explain.3.6 Demonstrate how the opportunity costs of produc-

ing cell phones and digital music players in Japanand the United States were calculated in Table 18-2on page xxx.

3.7 Briefly explain whether you agree or disagree withthe following statement: “Most countries exhaust

their comparative advantage in producing a good orservice before they reach complete specialization.”

3.8 Is free trade likely to benefit a large, populous coun-try more than a small country with fewer people?Briefly explain.

3.9 A Federal Reserve publication offers the followingobservation: “Too many U.S. citizens associate freetrade with job losses rather than opportunities and ahigher standard of living.” Do you agree? Brieflyexplain.

Source: Surya Sen and Dan Wassmann, The Great Trade Debate: FromRhetoric to Reality, Federal Reserve Bank of Chicago, January 1999.

3.10 Hal Varian, an economist at the University ofCalifornia, Berkeley, has made two observationsabout international trade:

a. Trade allows a country “to produce more withless.”

b. There is little doubt who wins [from trade] inthe long run: consumers.

Briefly explain whether you agree with either or bothof these observations.

Source: Hal R. Varian, “The Mixed Bag of Productivity,” New York Times,October 23, 2003.

3.11 In a recent public opinion poll, 41 percent of peopleresponding believed that free trade hurts the U.S.economy, while only 28 percent believed that it helpsthe economy. (The remaining people were uncertainof the effects of free trade.) What is “free trade”? Doyou believe it helps or hurts the economy? (Be sure todefine what you mean by “helps” or “hurts.”) Why doyou think that more Americans appear to believe thatfree trade hurts the economy than believe that ithelps the economy?

Source: Matthew Benjamin, “Americans Souring on Free Trade AmidOptimism About Economy,” Bloomberg News, January 19, 2007.

3.12 [Related to the Don’t Let This Happen toYou! on page XXX] Briefly explain whether youagree or disagree with the following statement: “Ican’t believe that anyone opposes expanding interna-tional trade. After all, when international tradeexpands, everyone wins.”

3.13 [Related to the Making the Connection onpage XXX] Explain why there are advantages to amovie studio operating in southern California, ratherthan in, say, Florida.


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18.4 LEARNING OBJECTIVE 18.4 | Analyze the economic effects of government policies that restrict

international trade, pages XXX–XXX.

Government Policies That Restrict International Trade

Summary

Free trade is trade between countries without governmentrestrictions. Government policies that interfere with tradeusually take the form of: tariffs, quotas, or voluntary exportrestraints (VERs). A tariff is a tax imposed by a government onimports. A quota is a numeric limit imposed by a governmenton the quantity of a good that can be imported into the coun-try. A voluntary export restraint (VER) is an agreementnegotiated between two countries that places a numeric limiton the quantity of a good that can be imported by one countryfrom the other country. The federal government’s sugar quotacosts U.S. consumers $2.24 billion per year, or about $750,000per year for each job saved in the sugar industry. Saving jobs byusing tariffs and quotas is often very expensive.


Review Questions

4.1 What is a tariff? What is a quota? Give an example ofa non-tariff barrier to trade.

4.2 Who gains and who loses when a country imposes atariff or a quota on imports of a good?


4.3 An editorial in BusinessWeek argued the following:

[President] Bush needs to send a pureand clear signal that the U.S. supports freetrade on its merits. . . . That means resist-ing any further protectionist demands bylawmakers. It could even mean unilater-ally reducing tariffs or taking down tradebarriers rather than erecting new ones.Such moves would benefit U.S. con-sumers while giving a needed boost tostruggling economies overseas.

What does the editorial mean by “protectionistdemands”? How would the unilateral elimination ofU.S. trade barriers benefit both U.S. consumers andeconomies overseas?

Source:“The Threat of Protectionism,” BusinessWeek, June 3, 2002.

4.4 Political commentator B. Bruce-Biggs once wrote thefollowing in the Wall Street Journal: “This is not to saythat the case for international free trade is invalid; it isjust irrelevant. It is an ‘if only everybody . . .’ argu-

ment. . . . In the real world almost everybody seesbenefits in economic nationalism.”What do you thinkhe means by “economic nationalism”? Do you agreethat a country benefits from free trade only if everyother country also practices free trade? Briefly explain.

Source: B. Bruce-Biggs,“The Coming Overthrow of Free Trade,” Wall StreetJournal, February 24, 1983, p. 28.

4.5 Two U.S. senators make the following argumentagainst allowing free trade: “Fewer and fewerAmericans support our government’s trade policy.They see a shrinking middle class, lost jobs andexploding trade deficits. Yet supporters of free tradecontinue to push for more of the same—more job-killing trade agreements. . . . ” Do you agree withthese senators that reducing barriers to trade reducesthe number of jobs available to workers in the UnitedStates? Briefly explain.

Source: Byron Dorgan and Sherrod Brown, “How Free Trade Hurts,”Washington Post, December 23, 2006, p. A21.

4.6 The United States produces beef and also importsbeef from other countries.a. Draw a graph showing the supply and demand for

beef in the United States. Assume that the UnitedStates can import as much as it wants at the worldprice of beef without causing the world price ofbeef to increase. Be sure to indicate on the graphthe quantity of beef imported.

b. Now show on your graph the effect of the UnitedStates imposing a tariff on beef. Be sure to indicateon your graph the quantity of beef sold by U.S.producers before and after the tariff is imposed,the quantity of beef imported before and after thetariff, and the price of beef in the United Statesbefore and after the tariff.

c. Discuss who benefits and who loses when theUnited States imposes a tariff on beef.

4.7 [Related to the Chapter Opener on pageXXX] Which industries are affected unfavorably bythe sugar quota and by the tariff on imports of sugar-based ethanol? Are any industries (other than thesugar industry) affected favorably by the sugar quotaand the tariff on imports of sugar-based ethanol?(Hint: Think about what sugar is used for andwhether substitutes exist for these uses and what thesubstitutes are for sugar-based ethanol.)

4.8 When Congress was considering a bill to imposequotas on imports of textiles, shoes, and otherproducts, Milton Friedman, a Nobel Prize–winningeconomist, made the following comment: “The con-sumer will be forced to spend several extra dollars to


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0.75

$1.00

0

Price(dollars

perpound)

Quantity(millions of

pounds)

13.04.0

U.S. demand

B

A

C

G

H I

D E

J K

F

U.S. supply

12.06.0

subsidize the producers [of these goods] by one dol-lar. A straight handout would be far cheaper.” Whywould a quota result in consumers paying much morethan domestic producers receive? Where do the otherdollars go? What does Friedman mean by a “straighthandout”? Why would this be cheaper than a quota?

Source: Milton Friedman,“Free Trade,”Newsweek, August 27, 1970.

4.9 The United States has about 9,000 rice farmers. In2006, these rice farmers received $780 million in sub-sidy payments from the U.S. government (or nearly$87,000 per farmer). These payments result in U.S.farmers producing much more rice than they other-wise would, a substantial amount of which is exported.According to an article in the Wall Street Journal,Kpalagim Mome, a farmer in the African country ofGhana, can no longer find buyers in Ghana for his rice:

“We can’t sell our rice anymore. It getsworse every year,” Mr. Mome says. . . .Years of economic hardship have driventhree of his brothers to walk and hitch-hike 2,000 miles across the Sahara toreach the Mediterranean and Europe. Hissister plans to leave next year. Mr. Mome’splight is repeated throughout farm com-munities in Africa and elsewhere in thedeveloping world.

Why would subsidies paid by the U.S. government toU.S. rice farmers reduce the incomes of rice farmersin Africa?

Source: Juliane von Reppert-Bismarck, “How Trade Barriers Keep AfricansAdrift,”Wall Street Journal, December 27, 2006.

4.10 An economic analysis of a proposal to impose aquota on steel imports into the United States indi-cated that the quota would save 3,700 jobs in thesteel industry but cost about 35,000 jobs in otherU.S. industries. Why would a quota on steel importscause employment to fall in other industries?Which other industries are likely to be mostaffected?

Source: Study cited in Douglas A. Irwin, Free Trade Under Fire, Princeton,NJ: Princeton University Press, 2002, p. 82.

4.11 A student makes the following argument:

Tariffs on imports of foreign goods into theUnited States will cause the foreign compa-nies to add the amount of the tariff to theprices they charge in the United States forthose goods. Instead of putting a tariff onimported goods, we should ban importingthem. Banning imported goods is betterthan putting tariffs on them because U.S.producers benefit from the reduced com-petition and U.S. consumers don’t have topay the higher prices caused by tariffs.

Briefly explain whether you agree with the student’sreasoning.

4.12 Suppose China decides to pay large subsidies to anyChinese company that exports goods or services tothe United States. As a result, these companies areable to sell products in the United States at farbelow their cost of production. In addition, Chinadecides to bar all imports from the United States.The dollars that the United States pays to importChinese goods are left in banks in China. Will thisstrategy raise or lower the standard of living inChina? Will it raise or lower the standard of livingin the United States? Briefly explain. Be sure to pro-vide a definition of “standard of living” in youranswer.

4.13 [Related to the Chapter Opener on pageXXX] According to an editorial in the New York Times,because of the sugar quota, “Sugar growers in thiscountry, long protected from global competition, havehad a great run at the expense of just about everyoneelse—refineries, candy manufacturers, other food com-panies, individual consumers and farmers in the devel-oping world.” Briefly explain how each group men-tioned in this editorial is affected by the sugar quota.

Source:“America’s Sugar Daddies,” New York Times, November 29, 2003.

4.14 [Related to Solved Problem 18-4 on pageXXX] Suppose that the United States currently bothproduces kumquats and imports them. The U.S. gov-ernment then decides to restrict international tradein kumquats by imposing a quota that allows importsof only six million pounds of kumquats into theUnited States each year. The figure shows the resultsof imposing the quota.

Fill in the table on the following page using theletters in the figure:


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World price of kumquats __________ __________

U.S. price of kumquats __________ __________

Quantity supplied by U.S. firms __________ __________

Quantity demanded __________ __________

Quantity imported __________ __________

Area of consumer surplus __________ __________

Area of domestic producer surplus __________ __________

Area of deadweight loss __________ __________

18.5 LEARNING OBJECTIVE 18.5 | Evaluate the arguments over trade policy and globalization, pages XXX–XXX.

The Argument over Trade Policies and Globalization

Summary

The World Trade Organization (WTO) is an internationalorganization that enforces international trade agreements.The WTO has promoted globalization, the process of coun-tries becoming more open to foreign trade and investment.Some critics of the WTO argue that globalization has dam-aged local cultures around the world. Other critics opposethe WTO because they believe in protectionism, which isthe use of trade barriers to shield domestic firms from for-eign competition. The WTO allows countries to use tariffsin cases of dumping, when an imported product is sold for aprice below its cost of production. Economists can point outthe burden imposed on the economy by tariffs, quotas, andother government interferences with free trade. But whetherthese policies should be used is a normative decision.


Review Questions

5.1 What events led to the General Agreement on Tariffsand Trade? Why did the World Trade Organizationeventually replace GATT?

5.2 What is globalization? Why are some people opposedto globalization?

5.3 What is protectionism? Who benefits and who losesfrom protectionist policies? What are the main argu-ments people use to justify protectionism?

5.4 What is dumping? Who benefits and who loses fromdumping? What problems arise when implementinganti-dumping laws?


5.5 [Related to the Making the Connection onpage XXX] The following excerpt is from a

newspaper story on President Bill Clinton’s proposalsfor changes in the World Trade Organization. Thestory was published just before the 1999 World TradeOrganization meeting in Seattle that ended in rioting:

[President Clinton] suggested that aworking group on labor be created withinthe WTO to develop core labor standardsthat would become “part of every tradeagreement. And ultimately I would favora system in which sanctions would comefor violating any provision of a tradeagreement. . . . ” But the new U.S. stand issure to meet massive resistance fromdeveloping countries, which make upmore than 100 of the 135 countries in theWTO. They are not interested in adoptingtougher U.S. labor standards.

What did President Clinton mean by “core laborstandards”? Why would developing countries resistadopting these standards?

5.6 Steven Landsburg, an economist at the University ofRochester, wrote the following in an article in theNew York Times:

Free trade is not only about the right ofAmerican consumers to buy at the cheap-est possible price; it’s also about the rightof foreign producers to earn a living.Steelworkers in West Virginia struggle hardto make ends meet. So do steelworkers inSouth Korea. To protect one at the expenseof the other, solely because of where theyhappened to be born, is a moral outrage.

How does the U.S. government protect steelworkersin West Virginia at the expense of steelworkers inSouth Korea? Is Landsburg making a positive or anormative statement? A few days later, Tom Redburnpublished an article disagreeing with Landsburg:

It is not some evil character flaw to caremore about the welfare of people nearby


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than about that of those far away—it’shuman nature. And it is morally—andeconomically—defensible. . . . A societythat ignores the consequences of eco-nomic disruption on those among its citi-zens who come out at the short end of thestick is not only heartless, it also under-mines its own cohesion and adaptability.

Which of the two arguments do you find mostconvincing?

Sources: Steven E. Landsburg, “Who Cares if the Playing Field IsLevel?” New York Times, June 13, 2001; and Tom Redburn, “EconomicView: Of Politics, Free Markets, and Tending to Society,” New YorkTimes, June 17, 2001.

5.7 [Related to the Making the Connection onpage XXX] An editorial in the New York Times con-tained the following observation:

Globalization is tough to sell to averagepeople. Economists can promote the very

real benefits of a robustly growing world:when they sell more overseas, Americanbusinesses can employ more people. Butwhat sticks in our minds is the televisionimage of the father of three laid off whenhis factory moves offshore.

Do you agree that the negative effects of internationaltrade are more visible than the positive effects? Brieflyexplain.Source:“Still Flying High,”New York Times, December 25, 2006.

5.8 The following appeared in an article in BusinessWeekthat argued against free trade:“The U.S. is currently in aprecarious position. In addition to geopolitical threats,we face a severe economic shock. We have already losttrillions of dollars and millions of jobs to foreigners.” Ifa country engages in free trade, is the total number ofjobs in the country likely to decline? Briefly explain.Source: Vladimir Masch, “A Radical Plan to Manage Globalization,”BusinessWeek, February 14, 2007.

Summary

The nominal exchange rate is the value of one country’scurrency in terms of another country’s currency. Theexchange rate is determined in the foreign exchange mar-ket by the demand and supply of a country’s currency.Changes in the exchange rate are caused by shifts indemand or supply. The three main sets of factors thatcause the supply and demand curves in the foreignexchange market to shift are changes in the demand forU.S.-produced goods and services and change in thedemand for foreign-produced goods and services; changesin the desire to invest in the United States and changes inthe desire to invest in foreign countries; and changesin the expectations of currency traders—particularlyspeculators —concerning the likely future values of thedollar and the likely future values of foreign currencies.Currency appreciation occurs when a currency’s marketvalue increases relative to another currency. Currencydepreciation occurs when a currency’s market valuedecreases relative to another currency. The real exchangerate is the price of domestic goods in terms of foreigngoods. The real exchange rate is calculated by multiply-ing the nominal exchange rate by the ratio of the domes-tic price level to the foreign price level.


Review Questions

6.1 If the exchange rate between the Japanese yen and theU.S. dollar expressed in terms of yen per dollar is¥110 = $1, what is the exchange rate when expressedin terms of dollars per yen?

6.2 Suppose that the current exchange rate between thedollar and the euro is 1.1 euros per dollar. If theexchange rate changes to 1.2 euros per dollar, hasthe euro appreciated or depreciated against the dollar?

6.3 What are the three main sets of factors that cause thesupply and demand curves in the foreign exchangemarket to shift?


6.4 [Related to the Don’t Let This Happen to You!on page xxx] If we know the exchange ratebetween Country A’s currency and Country B’s cur-rency and we know the exchange rate betweenCountry B’s currency and Country C’s currency, thenwe can compute the exchange rate between CountryA’s currency and Country C’s currency.a. Suppose the exchange rate between the Japanese

yen and the U.S. dollar is currently ¥120 = $1and the exchange rate between the British

18.6 LEARNING OBJECTIVE 18.6 | Explain how exchange rates are determined and how changes in exchange

rates affect the prices of imports and exports, pages XXXX–XXXX.

The Foreign Exchange Market and Exchange Rates


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i. Interest rates in the United States have declined.ii. Income rises in Japan.iii. Speculators begin to believe the value of the

dollar will be higher in the future.6.9 [Related to Solved Problem 18-2 on page

xxx] When a country’s currency appreciates, is thisgenerally good news or bad news for the country’sconsumers? Is it generally good news or bad news forthe country’s businesses? Explain your reasoning.

6.10 The following appeared in an article in the Wall StreetJournal: “. . . Japanese exporters got a lift from thesagging yen.”a. What does the reporter mean by a “sagging yen”?b. Why would the yen’s sagging help Japanese

exporters?

Source: Tim Annett, “Housing Still Hurting,” Wall Street Journal, February22, 2007.

6.11 Some U.S. firms have argued that the Chinese govern-ment has kept the value of yuan artificially low againstthe U.S. dollar, which gives Chinese firms an advantagewhen selling their products in the United States. Whywould a low value of the yuan in exchange for the dollarhelp Chinese firms exporting to the United States?

6.12 Phil Treadway is president and owner of Erie MoldedPlastics, Inc., which is located in Erie, Pennsylvania,and makes electrical connectors and plastic bottlecaps. Treadway was quoted as follows in the New YorkTimes: “Our customers have a market without borders,and we know that. We can compete against China’s lowlabor costs. . . . But we cannot compete with them ifthey have a 20 percent to 40 percent currency advan-tage.” What does Treadway mean by a “currencyadvantage”? How would a currency advantage make ithard for his firm to compete with Chinese firms?

Source: Elizabeth Becker and Edmund L. Andrews, “Currency ofChina Is Emerging as Tough Business Issue in U.S.,” New York Times,August 26, 2003.


pound and the U.S. dollar is £0.60 = $1. What isthe exchange rate between the yen and the pound?

b. Suppose the exchange rate between the yen anddollar changes to ¥130 = $1 and the exchangerate between the pound and dollar changes to£0.50 = $1. Has the dollar appreciated or depreci-ated against the yen? Has the dollar appreciatedor depreciated against the pound? Has the yenappreciated or depreciated against the pound?

6.5 Beginning January 1, 2002, 12 of the 15 membercountries of the European Union eliminated theirown individual currencies and began using a newcommon currency, the euro. For a three-year periodfrom January 1, 1999, through December 31, 2001,these 12 countries priced goods and services in termsof both their own currencies and the euro. During thisperiod, the value of their currencies was fixed againsteach other and against the euro. So during this time,the dollar had an exchange rate against each of thesecurrencies and against the euro. The information inthe following table shows the fixed exchange rates offour European currencies against the euro and theirexchange rates against the U.S. dollar on March 2,2001. Use the information on the next page to calcu-late the exchange rate between the dollar and the euro(in euros per dollar) on March 2, 2001.

UNITS PER EURO UNITS PER U.S. DOLLARCURRENCY (FIXED) (AS OF MARCH 2, 2001)

German mark 1.9558 2.0938

French franc 6.5596 7.0223

Italian lira 1,936.2700 2,072.8700

Portuguese escudo 200.4820 214.6300

6.6 Graph the demand and supply of U.S. dollars for euros and label each axis. Show graphically andexplain the effect of an increase in interest rates in Europe by the European Central Bank (ECB) onthe demand and supply of dollars and the resultingchange in the exchange rate of euros for U.S. dollars.

6.7 Graph the demand and supply of U.S. dollars foreuros and label each axis. Show graphically andexplain the effect of an increase in U.S. governmentbudget deficits that increase U.S. interest rates on thedemand and supply of dollars and the resultingchange in the exchange rate of euros for U.S. dollars.Why might the change in the exchange rate lead to acurrent account deficit?

6.8 Use the graph to answer the following questions.a. Briefly explain whether the dollar appreciated or

depreciated against the yen.b. Which of the following events could have caused

the shift in demand shown in the graph?


0

Exchangerate (¥/$)


¥130

D1

D2

S

120


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Hubbard Obrien MacroEconomics 2nd edition chapter 18

Economy & Finance

sugar quota

sugar companies

madefrom sugar

sugar atlower costs

imports ofraw sugar

frominternational trade

theunited states

lowpriced sugarbasedethanol