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it, one thing is clear: The United States is thoroughly integrated into a broader world econ-
omy. What happens in the United States influences other countries, and events abroad re-
verberate back here. Trillions of dollars™ worth of goods and services”American software,
Chinese toys, Japanese cars”are traded across international borders each year. A vastly
larger dollar volume of financial transactions”trade in stocks, bonds, and bank deposits,
for example”takes place in the global economy at lightning speed.
We have mentioned these subjects before, but Part 4 brings international factors from
the wings to center stage. Chapter 17 studies the factors that underlie international trade,
and Chapter 18 takes up the determination of exchange rates”the prices at which the
world™s currencies are bought and sold. Then Chapter 19 integrates these international in-
fluences into our model of the macroeconomy.
If you want to understand why so many Americans are worried about international
trade, why many thoughtful observers think we need to overhaul the international mone-
tary system, or why there was so much economic turmoil in Southeast Asia, Russia, and
Latin America during the last 15 years or so, read these three chapters with care.



CHAPTERS

17 | International Trade and 19 | Exchange Rates and the
Comparative Advantage Macroeconomy
18 | The International Monetary
System: Order or Disorder?




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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




International Trade and
Comparative Advantage
No nation was ever ruined by trade.
B E N J A M IN F R A N K L IN



E conomists emphasize international trade as the source of many of the benefits of
“globalization””a loosely defined term that indicates a closer knitting together of
the world™s national economies. Of course, countries have always been linked in vari-
ous ways. The Vikings, after all, landed in North America”not to mention Christopher
Columbus. In recent decades, however, dramatic improvements in transportation,
telecommunications, and international relations have drawn the nations of the world
ever closer together economically. This process of globalization is often portrayed as
something new. But in fact, it is not, as the box “Is Globalization Something New?” on
the next page points out. Still, it is changing the way the peoples of the world live.
Economic events in other countries affect the United States for both macroeconomic
and microeconomic reasons. For example, we learned in Parts 2 and 3 that the level of
net exports is an important determinant of a nation™s output and employment. But we
did not delve very deeply into the factors that determine a nation™s exports and im-
ports. Chapters 18 and 19 will take up these macroeconomic linkages in greater detail.
First, however, this chapter studies some of the microeconomic linkages among nations:
How are patterns and prices of world trade determined? How and why do govern-
ments often interfere with foreign trade? The central idea of this chapter is one we have
encountered before (in Chapters 1 and 3): the principle of comparative advantage.




CONTENTS
The Graphics of Comparative Advantage The Infant-Industry Argument
ISSUE: HOW CAN AMERICANS COMPETE WITH
“CHEAP FOREIGN LABOR”? Must Specialization Be Complete? Strategic Trade Policy
ISSUE RESOLVED: COMPARATIVE ADVANTAGE
WHY TRADE? CAN CHEAP IMPORTS HURT A COUNTRY?
EXPOSES THE “CHEAP FOREIGN LABOR” FALLACY
Mutual Gains from Trade ISSUE: A LAST LOOK AT THE “CHEAP FOREIGN
TARIFFS, QUOTAS, AND OTHER LABOR” ARGUMENT
INTERNATIONAL VERSUS
INTERFERENCES WITH TRADE
INTRANATIONAL TRADE | APPENDIX | Supply, Demand, and Pricing in
Tariffs versus Quotas
Political Factors in International Trade World Trade
The Many Currencies Involved WHY INHIBIT TRADE? How Tariffs and Quotas Work
in International Trade Gaining a Price Advantage for Domestic Firms
Impediments to Mobility of Labor and Capital Protecting Particular Industries
THE LAW OF COMPARATIVE ADVANTAGE National Defense and Other Noneconomic
Considerations
The Arithmetic of Comparative Advantage




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Licensed to:
Part 4
340 The United States in the World Economy




Is Globalization Something New?
Few people realize that the industrialized world was, in fact, highly between a Canadian province and an American state is 20
globalized prior to World War I, before the ravages of two world times smaller than domestic trade between two Canadian
wars and the Great Depression severed many international link- provinces, after adjusting for distance and income levels.
ages. Furthermore, as the British magazine The Economist pointed The financial markets are not yet truly integrated either. De-
out more than a decade ago, globalization has not gone nearly as spite the newfound popularity of international investing, capital
far as many people imagine. markets were by some measures more integrated at the start of
this century than they are now. . . . [And] labour is less mobile
Despite much loose talk about the “new” global economy,
than it was in the second half of the 19th century, when some
today™s international economic integration is not unprecedented.
60m people left Europe for the New World.
The 50 years before the first world war saw large cross-border
flows of goods, capital and people. That period of globalisation,
like the present one, was driven by reductions in trade barriers
and by sharp falls in transport costs, thanks to the develop-
ment of railways and steamships. The present surge of globali-
sation is in a way a resumption of that previous trend. . . .
Two forces have been driving [globalization]. The first is
technology. With the costs of communication and computing
falling rapidly, the natural barriers of time and space that sepa-
rate national markets have been falling too. The cost of a three-
minute telephone call between New York and London has
fallen from $300 (in 1996 dollars) in 1930 to $1 today . . .
The second driving force has been liberalisation. . . . Almost




SOURCE: © AP Images
all countries have lowered barriers to trade. . . . [T]he ratio of
trade to output . . . has increased sharply in most countries
since 1950. But by this measure Britain and France are only
slightly more open to trade today than they were in 1913. . . .
Product markets are still nowhere near as integrated across
borders as they are within nations. Consider the example of
SOURCE: “Schools Brief: One World?” from The Economist, October 18, 1997. Copy-
trade between the United States and Canada, one of the least right © 1997 The Economist Newspaper Ltd. All rights reserved. Reprinted with
restricted trading borders in the world. On average, trade permission. Further reproduction prohibited. http://www.economist.com.




ISSUE: HOW CAN AMERICANS COMPETE WITH “CHEAP FOREIGN LABOR”?
Americans (and the citizens of many other nations) often want their govern-
ment to limit or prevent import competition. Why? One major reason is the
common belief that imports take bread out of American workers™ mouths. Ac-
cording to this view, “cheap foreign labor” steals jobs from Americans and
pressures U.S. businesses to lower wages. For many years, attention focused
on the phenomenon of manufacturing jobs moving abroad. Lately, there has
been a great deal of concern over the “offshoring” of a wide variety of service jobs”
ranging from call center operators to lawyers. Such worries were prominently voiced
in the 2008 presidential campaign. For example, during the Democratic primaries,
Senators Hillary Clinton and Barack Obama competed over who could be more
disparaging toward the North American Free Trade Agreement (NAFTA), arguing that
competition from cheap Mexican labor had destroyed many good American jobs.
Oddly enough, the facts appear to be grossly inconsistent with the theory that trade
kills jobs. For one thing, wages in most countries that export to the United States have
risen dramatically in recent decades”much faster than wages here. Table 1 shows
hourly compensation rates in eight countries on three continents, each expressed as a
percentage of hourly compensation in the United States, in 1975 and 2005. Only work-
ers in Mexico lost ground to American workers over this 30-year period. Labor in



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Licensed to:

Chapter 17 341
International Trade and Comparative Advantage



Europe gained substantially on their U.S. counterparts”rising in Britain, TA BL E 1
for example, from just above half the U.S. standard to above-U.S. lev- Labor Costs in Industrialized Countries
els. And the wage gains in Asia were nothing short of spectacular. as a Percentage of U.S. Labor Costs
Labor compensation in South Korea, for example, soared from just
1975 2005
5 percent of U.S. levels to more than half.1 Yet, while all this was going




SOURCE: U.S. Bureau of Labor Statistics.
France 73% 104%
on, American imports of automobiles from Japan, electronics from
United Kingdom 54 109
Taiwan, and textiles from Korea expanded rapidly.
Spain 41 75
Ironically, then, the United States™ dominant position in the interna- Japan 48 92
tional marketplace deteriorated just as wage levels in Europe and Asia South Korea 5 57
were rising closer to our own. Clearly, something other than exploiting Taiwan 6 27
Mexico 24 11
cheap foreign labor must be driving international trade”in contrast to
Canada 99 101
what the “common sense” view of the matter suggests. In this chapter,
we will see precisely what is wrong with this commonsense view. NOTE: Data are compensation estimates per hour,
converted at exchange rates, and relate to production
workers in the manufacturing sector.




WHY TRADE?
The earth™s resources are distributed unequally across the planet. Although the United
States produces its own coal and wheat, it depends almost entirely on the rest of the world
for such basic items as rubber and coffee. Similarly, the Persian Gulf states have little land
that is suitable for farming but sit atop huge pools of oil”something we are constantly re-
minded of by geopolitical events. Because of the seemingly whimsical distribution of the
earth™s resources, every nation must trade with others to acquire what it lacks.
Even if countries had all the resources they needed, other differences in natural endow-
ments such as climate, terrain, and so on would lead them to engage in trade. Americans could
grow their own bananas and coffee in hothouses, albeit with great difficulty. But these crops
are grown much more efficiently in Honduras and Brazil, where the climates are appropriate.
The skills of a nation™s labor force also play a role. If New Zealand has a large group of
efficient farmers and few workers with industrial experience, while the opposite is true in
Japan, it makes sense for New Zealand to specialize in agriculture and let Japan concen-
trate on manufacturing.
Finally, a small country that tried to produce every product its citizens want to con-
sume would end up with many industries that are simply too small to utilize modern
mass-production techniques or to take advantage of other economies of large-scale opera-
tions. For example, some countries operate their own international airlines for reasons
that can only be described as political, not economic.
To summarize, the main reason why nations trade with one another is to exploit the
many advantages of specialization, some of which were discussed in Chapter 3. Interna- Specialization means
that a country devotes its
tional trade greatly enhances living standards for all parties involved because:
energies and resources to
1. Every country lacks some vital resources that it can get only by trading with others. only a small proportion of
the world™s productive
2. Each country™s climate, labor force, and other endowments make it a relatively effi-
activities.
cient producer of some goods and a relatively inefficient producer of others.
3. Specialization permits larger outputs via the advantages of large-scale production.


Mutual Gains from Trade
Many people have long believed that one nation gains from trade only at the expense of
another. After all, nothing new is produced by the mere act of trading. So if one country
gains from a swap, it has been argued for centuries, the other country must necessarily
lose. One consequence of this mistaken belief was and continues to be attitudes that call
for each country to try to take advantage of its trading partners on the (fallacious) grounds
that one nation™s gain must be another™s loss.


China would be an even more extreme example, but we lack Chinese data dating back to 1975.
1




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Part 4
342 The United States in the World Economy



Yet, as Adam Smith emphasized, and as we learned in Chapter 3, both parties must
expect to gain something from any voluntary exchange. Otherwise, why would they agree
to trade?
But how can mere exchange of goods leave both parties better off? The answer is that
although trade does not increase the total output of goods, it does allow each party to ac-
quire items better suited to its tastes. Suppose Levi has four cookies and nothing to drink,
while Malcolm has two glasses of milk and nothing to eat. A trade of two of Levi™s cookies
for one of Malcolm™s glasses of milk will not increase the total supply of either milk or
cookies, but it almost certainly will make both boys better off.
By exactly the same logic, both the United States and Mexico must reap gains when
Mexicans voluntarily ship their tomatoes to the United States in return for American

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