Chapter 9, Instruments of Trade Policy This chapter provides an updated discussion of the effects of trade restrictions on United States businesses. The chapter presents the macroeconomic antecedents and consequences of the 2007-2009 global financial crisis.
Asset Market Approach to Exchange Rate Determination
At the same time, we have ensured that the two halves of the book are completely independent. Both the real trade part of the book (Chapters 2 to 12) and the monetary part (Chapters 13 to 22) are divided into a core of chapters focusing on theory, followed by chapters that apply the theory to important policy issues, past and present.
Increasing Returns and Market Structure
This book covers the most important recent developments in international economics without lacking the enduring theoretical and historical insights that have traditionally formed the core of the subject. Here we highlight some newer topics that previous authors have failed to address systematically.
Firms in International Trade
We have made it a point to highlight links between trade and the monetary area as they arise. However, if you use the book for a year course covering both subjects, you'll find a treatment that doesn't leave students wondering why the principles underlying their trade theory work have been brushed aside over winter break.
Politics and Theory of Trade Policy
International Macroeconomic Policy Coordination
The World Capital Market and Developing Countries
Case Studies
Special Boxes
Captioned Diagrams
Learning Goals
Summary and Key Terms
Problems
Further Readings
Students and MyEconLab
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Additional Supplementary Resources
Shouldn't Americans be buying American goods whenever possible to help create jobs in the United States. We discuss the rationale for this system in Chapter 9 and examine whether the current rules of the game for international trade in the global economy can or should survive.
Size Matters: The Gravity Model
Taken together, these 15 countries accounted for 69 percent of the value of the U.S. Why did the United States trade so much with these countries. Looking at world trade as a whole, economists have found that an equation of the following form predicts the volume of trade between any two countries quite accurately.
Using the Gravity Model: Looking for Anomalies
The United States and the European Union each account for about 25 percent of the world's GDP, but each attracts only about 2 percent of the other's spending. The United States trades significantly more with its neighbors than with European economies of the same size.
Impediments to Trade: Distance, Barriers, and Borders
S. State at Similar Distance
The direction and composition of world trade today is quite different from what it was a generation ago, and even more different than it was a century ago.
Has the World Gotten Smaller?
In fact, two subsequent world wars, the Great Depression of the 1930s, and widespread protectionism did much to suppress world trade. World trade grew rapidly between 1870 and 1913, but suffered a sharp setback in the following decades, only recovering to pre-World War I levels around 1970.
What Do We Trade?
In the early 20th century, although Britain mostly exported industrial goods (manufactures), it mainly imported primary products. For example, more than 90 percent of the exports of China, the largest developing economy and a fast-growing force in world trade, are manufactured products.
Service Offshoring
In the long run, trade in electronically delivered services may become the most important component of world trade. We begin our discussion of the causes of world trade in Chapter 3 with an analysis of a model originally put forward in 1819 by the British economist David Ricardo.
SUMMARY
This suggests that the current dominance of commodities in world trade, shown in Figure 2-5, may be only temporary. Given all the changes in world trade since Ricardo's time, can old ideas still be relevant?
PROBLEMS
FURTHER READINGS
KEY TERMS
In this example, Colombia has a comparative advantage in winter roses and the United States has a comparative advantage in computers. Will the United States and Colombia eventually produce the goods in which each has a comparative advantage.
Production Possibilities
When the production possibility frontier is a straight line, the opportunity cost of a pound of cheese in the form of wine is constant. As we saw in the previous section, this opportunity cost is defined as the number of gallons of wine that the economy has to give up in order to produce an additional pound of cheese.
Relative Prices and Supply
Since the slope of the production possibility frontier is equal to the opportunity cost of cheese in terms of wine, the external frontier is steeper than the domestic one. In the absence of trade, the relative prices of cheese and wine in each country would be determined by the relative labor requirements per unit.
Determining the Relative Price After Trade
So in Home the relative price of cheese would be; abroad it would be. So for any relative price of cheese between and is the relative supply of cheese.
The Gains from Trade
In the absence of trade, consumption possibilities are the same as production possibilities (the solid lines PF and in Figure 3-4). Home's consumption possibilities are indicated by the colored line T in Figure 3-4a, while Foreign's consumption possibilities are indicated by in Figure 3-4b.
A Note on Relative Wages
Our discussion of the benefits of trade took the form of a "thought experiment" in which we compared two situations: one in which countries do not trade at all and another in which they have free trade. Although a lot of guesswork is involved, Irwin suggests that real incomes in the United States may have fallen by about 8 percent as a result of the embargo.
Productivity and Competitiveness
The Pauper Labor Argument
In the example, Home is more productive than Foreign in both industries, and Foreign's lower cost of wine production is due solely to its much lower wage rate. The answer is that in the real world, national wage rates actually reflect differences in productivity.
Exploitation
But denying them the opportunity to export and trade may well condemn them to even deeper poverty. To get closer to reality, however, it is necessary to understand how comparative advantage works in a model with a larger number of goods.
Setting Up the Model
The columnist who pointed out the income gap between the director of The Gap and the workers who make the clothes was angry about the poverty of Central American workers. This simplified analysis allows us to capture many essential points about comparative advantage and trade and, as we saw in the previous section, gives us a surprising amount of mileage as a resource for discussing policy issues.
Relative Wages and Specialization
If, for example, the home wage rate is five times that of foreigners (a ratio of domestic wages to foreign wages of five to one), apples and bananas will be produced at home and caviar, dates and enchiladas in foreign. If the home wage rate is three times the foreign wage (in other words, the foreign wage rate is one-third the home wage), Home will import dates and enchiladas.
Determining the Relative Wage in the Multigood Model
The result depends on the relative size of countries (which determines the position of RS) and the relative demand for goods (which determines the shape and position of RD). The distribution of trade gains depends on the relative prices of the goods that countries produce.
Assumptions of the Model
Diminishing returns are reflected in the form of the production function: flattens out as we move to the right, indicating that the marginal product of labor decreases as more labor is used.2. In this figure we directly plot the marginal product of labor as a function of the labor employed.
Prices, Wages, and Labor Allocation
First, although the wage rate increases, it increases by less than the increase in the price of clothes. The wage rate increases in the same ratio, from to , but the distribution of labor between the two sectors does not change.
Relative Prices and the Distribution of Income
Food production falls and cloth production rises due to the increase in the relative price of cloth. Opening to trade causes an increase in the relative price from (PC/PF)1 to (PC/PF)2.
Income Distribution and Trade Politics
In the modern world, restrictions on the flow of labor are legion – virtually all countries impose immigration restrictions. Show how the increase in the supply of capital to Home affects its production possibilities frontier.
Marginal and Total Product
The real wage in terms of cloth falls, leading to an increase in the income of the owners of capital. In the food sector, the real wage rises from , and landowners receive less real income in terms of food.
Prices and Production
The important feature of this frontier of production possibilities is that the opportunity cost of producing an additional meter of fabric in terms of food is not constant. Producing two less units of food frees up six machine hours that can be used to produce three meters of fabric: the opportunity cost of fabric is 2/3.
Choosing the Mix of Inputs
Note that the definition of intensity depends on the ratio of labor to capital used in production, not on the ratio of labor or capital to output. Factor Prices and Input Choices In each sector, the ratio of labor to capital used in production depends on the cost of labor relative to the cost of capital.
Factor Prices and Goods Prices
This ratio then implies that the ratios of labor to capital employed in the production of cloth and food must be and respectively (right panel of Figure 5-7). This wage-rent ratio then implies that the ratios of labor to capital employed in the production of cloth and food must be and.
Resources and Output
When it rises, the labor-to-capital ratio falls in both clothing and food production. An increase in labor supply shifts the economy's production possibility frontier outward to , but does so disproportionately in the direction of clothing production.
Relative Prices and the Pattern of Trade
In Chapter 4, we discussed how an economy responds to this trade opening based on the direction of the change in the relative price of the goods: The economy exports the good whose relative price rises. Thus, Home will export clothing (the relative price of clothing increases in Home), while Foreign will export food. The relative price of clothing falls in Foreign, which means that the relative price of food rises there).
Trade and the Distribution of Income
So what is responsible for the widening gap between skilled and unskilled workers in the United States. An increase in the relative cost of skilled workers induces producers in both sectors to reduce the employment of skilled workers relative to unskilled workers.
Factor-Price Equalization
To derive the wage and rent rates from the prices of clothing and food in Figure 5-6, we assumed that the country produced both goods. Finally, the proposition of full factor-price equalization depends on full convergence of commodity prices.
Trade in Goods as a Substitute for Trade in Factors
The essence of the Heckscher-Ohlin model is that trade is driven by differences in the abundance of factors between countries. We will see how the pattern of trade between developed and developing countries matches the predictions of the Heckscher-Ohlin model quite well.
Patterns of Exports Between Developed and Developing Countries
If one makes the working assumption that technological differences between countries take a simple multiplicative form—that is, that a given set of inputs produces only times as much in China as it does in the United States, where some number is less than 1— it is possible to use data on factor trade to estimate the relative efficiency of production in different countries. We can see that the experience of these Asian economies fits these predictions very well: As the supply of skilled labor increased, they increasingly specialized in the production of skill-intensive goods.
Implications of the Tests
However, the pattern of trade in goods between developed and developing countries agrees quite well with the model's predictions. A recent, state-of-the-art demonstration that a modified version of the Heckscher-Ohlin model has great explanatory power.
Choice of Technique
The first was the claim, shown in Figure 5-5, that the ratio of labor to capital employed in any industry depends on the wage-rent ratio. Second, there was the claim, shown in Figure 5-6, that there is a one-to-one relationship between relative prices of goods and the wage-rent ratio.
Goods Prices and Factor Prices
Finally, now consider the effects of an increase in the price of goods on the wage-rent ratio. If the price of a commodity rises, fewer yards of the commodity must be produced to have a dollar's value.
More on Resources and Output
Now consider the effects of an increase in the economy's labor supply Let a given relative price of clothing: increases while and both remain constant. An increase in the price of clothing If the price of clothing increases, a smaller production is now worth a dollar.
Production Possibilities and Relative Supply
This chapter highlights those insights from international trade theory that do not depend strongly on the details of the supply side of the economy. This relationship between relative prices and relative output is reflected in the economy's relative supply curve shown in Figure 6-2b.
Relative Prices and Demand
The relative supply of clothing will therefore increase when the relative price of clothing increases. In panel (a), the slope of the isovalue lines is equal to minus the relative price of fabric.
The Welfare Effect of Changes in the Terms of Trade
If the income effect of the price change were large enough, then consumption levels of both goods could rise (and both did); but the substitution effect of demand dictates that the relative consumption of cloth decreases. If the economy cannot trade, then it consumes and produces at point 3 (related to relative price.
Determining Relative Prices
Note, however, that changes in a country's terms of trade can never reduce the country's welfare below its level of welfare in the absence of trade (represented by consumption in
Economic Growth: A Shift of the RS Curve
The equilibrium relative price is determined by the intersection of the world relative supply and demand curves. At the equilibrium relative price, Home's exports of cloth are equal to Foreign's imports of cloth; and Home's imports of food are equal to Foreign's exports of food.
Growth and the Production Possibility Frontier
We can find similar ambiguities when looking at the effects of home growth. The standard model of trade developed in the last section provides a framework that can bridge these apparent contradictions and clarify the effects of economic growth in a trading world.
World Relative Supply and the Terms of Trade
In case (a), growth is biased toward cloth (shift from to ), while in case (b), growth is biased toward food (shift from to. The accompanying shifts in the relative supply curve are shown in panel (c): shift it to the right (from to ) when the growth is biased towards the fabric and shift it to the left (from RS1 to RS3) when the growth is biased towards the feed.
International Effects of Growth
The magnitude of fluctuations in the terms of trade for the United States is small, with no clear trend from decade to decade. Import tariffs (taxes imposed on imports) and export subsidies (payments given to domestic producers who sell a good abroad) are usually not imposed to affect a country's terms of trade.
Relative Demand and Supply Effects of a Tariff
The result is a shift in the terms of trade, both for the country imposing the policy change and for the rest of the world. The extent of this trade condition depends on how large the country imposing the tariff is relative to the rest of the world: if the country is only a small part of the world, it cannot have a large effect on the world's relative supply and demand. cannot therefore have a large effect on relative prices.
Effects of an Export Subsidy
If the United States, a very large country, were to impose a 20 percent tariff, some estimates suggest that the US. measure small.
Implications of Terms of Trade Effects
Who Gains and Who Loses?
If the US, a very large country, were to impose a 20 percent tariff, some estimates suggest that the US terms of trade could increase by 15 percent. At the same time, Home loses from the deterioration of the terms of trade and from the distorting effects of its policy.
Intertemporal Production Possibilities and Trade
The Real Interest Rate
Since the tradeoff is one unit of consumption in the present for units in the future, so is the relative price of future consumption. When this relative price of future consumption rises (that is, real interest rates fall), a country responds by investing more; this increases the supply of future consumption relative to current consumption (a movement to the left along the intertemporal frontier of production possibilities in Figure 6-10) and implies an upward-sloping relative supply curve for future consumption.
Intertemporal Comparative Advantage
In this case, is it still true that an increase in the terms of trade increases welfare. This appendix contains a more detailed examination of the two-period intertemporal trade model described in the chapter.
Specialized Suppliers
As we have already noted, not all economies of scale apply at the individual company level. When economies of scale apply at the industry level rather than the individual company level, they are called external economies.
Labor Market Pooling
For example, some Silicon Valley firms that specialize in providing highly sophisticated computer chips for specific customers have chosen to become "fables," that is, they have no factories in which to manufacture chips. You just drove in a different direction on Monday morning.”2 This flexibility makes Silicon Valley an attractive location both for highly skilled workers and for the companies that employ them.
Knowledge Spillovers
External Economies and Market Equilibrium
As we will see below, however, external economies of scale strongly influence our view of the causes and consequences of international trade. Similarly, Britain exports financial services to the rest of Europe, largely because these same external economies have led to the concentration of financial firms in London.
External Economies, Output, and Prices
When there are external economies of scale, the average cost of producing a product falls as the quantity produced rises. However, in the presence of external economies of scale, there is a forward-sloping supply curve: the larger the industry's output, the lower the price at which firms are willing to sell, because their average cost of production falls as industry output rises.
External Economies and the Pattern of Trade
London became the dominant financial center of Europe in the 19th century, when Britain was the leading economy in the world and the center of a global empire. One might hope that this would always imply that Vietnam will in fact supply the world market.
Trade and Welfare with External Economies
As we saw in Figure 7-4, the importance of a vested advantage means there is no guarantee that the right country will produce a good subject for external economies. In fact, trade based on external economies may actually leave a country worse off than it would have been without trade.
Dynamic Increasing Returns
Anyway, one of the largest exporters in the United States is the entertainment sector, especially movies. For each of the following examples, explain whether they are external or internal economies of scale:.
Monopoly: A Brief Review
We can be more specific about the relationship between price and marginal revenue if we assume that the demand curve facing the firm is a straight line. Equation (8-2) reveals that the gap between price and marginal revenue depends on the firm's initial sales, Q, and the slope parameter, B, of its demand curve.
Monopolistic Competition
We therefore conclude that the average costs depend on the size of the market and the number of companies in the industry:. The number of companies and the price. Meanwhile, the price charged by the typical company also depends on the number of companies in the industry.
The Effects of Increased Market Size
This means that it is the equilibrium number of firms in the industry and this is the equilibrium price.5. The result is a simultaneous increase in the number of firms (and thus in the variety of goods available) and a decrease in the price of each.
Gains from an Integrated Market: A Numerical Example
That is, in the absence of trade, the foreign market would support eight firms, each producing 200,000 automobiles, and selling them at a price of $8,750. The integrated market supports more firms, each producing on a larger scale and selling at a lower price than any national market on its own.
The Significance of Intra-Industry Trade
