COMPARATIVE ADVANTAGE AND GAINS FROM TRADE

The first chapter of this book introduces, albeit from the microeconomic perspective the concept of production possibility frontiers (PPFs). Comparative advantage and specialization at the microeconomic level explains why brain surgeons do not fly 747’s and pilots do not analyze CAT scans. At the macroeconomic level, the Law of Comparative Advantage says that nations can mutually benefit from trade so long as the relative production costs differ.

Comparative and Absolute Advantage

Our discussion of production possibilities illustrated the Law of Increasing Costs. The more an economy produces of anyone good, the more costly it becomes to produce. Rising costs of production leads to a search for less costly ways to produce and consume those goods. In many cases, this search leads to a potential trading partner who has comparative advantage in the production of a good. If Nation ABC can produce a good at lower opportunity cost than can Nation XYZ, it is said that Nation ABC had comparative advantage. An example can illustrate how this works between two states but the same principle works between two nations.

Example:

Climate and topography has blessed Indiana with land extremely suitable for the cultivation of soybeans, but with very little harvestable timber. Oregon’s timber production is unmatched, but farmers find it difficult to produce a self-sustaining soybean crop. The table below summarizes the production possibilities of these two isolated economics. Because Oregon can produce more timber than Indiana, Oregon is said to have an absolute advantage over Oregon in timber production. Indiana has an absolute advantage over Oregon in soybean production. Trade does not rely on absolute advantages, but on comparative advantage.

In isolation, both states can produce soybeans and timber along their production possibility frontiers, which are constrained by available technology and resources. Suppose that without trade, they enjoy consuming at the midpoint of the frontier. But if there are differences in production costs, they can each gain from specialization and trade. The opportunity costs of each good can be found from the table and can be illustrated in a production possibility frontier for each state.

Oregon:

Opportunity cost of timber is one soybean.

Opportunity cost of soybeans is one timber.

Indiana:

Opportunity cost of timber is 3 soybeans.

Opportunity cost of soybeans is 1/3 timber.

Since Indiana can produce soybeans at a cost that is lower than Oregon’s cost of soybeans, Indiana has a comparative advantage in soybeans. Oregon can produce timber at a lower cost than Indiana’s cost of timber, so Oregon has a comparative advantage in timber production. With these differences in cost, Indiana should specialize in soybean production (zero timber) while Oregon should specialize in timber production (zero soybeans), then trade.

Gains from Trade

After each state specializes, suppose that each decides to keep half of their production and send the other half to the other state.

Oregon:

Produce 10 timbers and send 5 to Indiana in exchange for 9 soybeans. Cost of a soybean before trade was 1 timber. Now I’m getting 9 soybeans, but only giving up 5.The cost now is 5/9, which is less than 1 timber. Great deal!

Indiana:

Produce 18 soybeans, and send 9 to Oregon in exchange for 5 timbers. Cost of a timber before trade was 3 soybeans. Now I’m getting 5 timbers and only giving up 9 soybeans. The cost now is 9/5, which is less than 3 soybeans. Great deal!

Another look at the production possibility frontiers after the trade shows that each state has actually moved beyond the constraints of their technology and resources.

Consumption Frontier

There are many such trade possibilities. Figure 13.3 overlaps the two production possibility frontiers. The line that connects Indiana’s specialization of soybeans to Oregon’s specialization of timber is called the consumption possibility frontier because with trade, each state can consume along this line; without trade, these points are impossible to attain.

Exports, Imports, and the World Price

In the market for a commodity like soybeans, many nations are both producers of soybeans and traders of soybeans. Whether or not a nation is a net exporter or a net Importer of soybeans depends upon the difference between the world price with trade, and the domestic price without trade.

Domestic Market Without Trade

The chart below illustrates the competitive U.S. market for soybeans without trade. The competitive price of $1 0 per bushel is found at the intersection of domestic demand and supply. At this point six million bushels are produced.

World Market With Trade

If the United States begins to trade soybeans with other nations, the world price may rise above, or fall below, $6 per bushel. If the world price falls below $6, there exists a shortage of soybeans in the U.S. market. Domestic producers supply only four million bushels, but domestic consumers demand eight million bushels. The United States must then import the difference of four million bushels. If the world price rises to $8, there exists a four million bushel surplus in the U.S. market and the U.S. exports this surplus.

The world price of a good is above the domestic price, the nation becomes an exporter of that good.

If the world price of a good is below the domestic price, the nation becomes an importer of that good.

BALANCE OF PAYMENTS

If Japanese citizens wish to purchase U.S. soybeans, the Japanese must pay in dollars. If U.S. citizens wish to buy Spanish olives, the Americans must pay in euros. Before goods can be exchanged between foreign trading partners, the currency of the importing nation must first be converted to the currency of the exporting nation.

Current Account

The current account shows current import and export payments of both goods and services. It also reflects investment income sent to foreign investors and investment income received by U.S. citizens who invest abroad. For example, if a Canadian is receiving dividends from an American corporation or interest from a U.S. Treasury bill, these dollars would be sent out of the country. After accounting for all of the payments sent to foreign countries and payments received from foreign countries, the balance on the current account in 2005 was -$26. A deficit balance such as this tells us that the United States sent more American dollars abroad than foreign currency received in current transactions.

Capital Account

When a nation buys a foreign firm, or real estate or financial assets of another nation, it appears in the capital account. For example, if a Swedish firm buys a manufacturing facility in Idaho, or if a Mexican citizen buys a U.S. Treasury bond, it is recorded as an inflow of foreign capital assets into the United States. If an American firm buys a ship building company in Turkey, it would be an outflow of assets to foreign nations. A. surplus balance of $11 tells us that there was more foreign capital investment in the United States than there was U.S. investment abroad.

Official Reserves Account

The Federal Reserve holds quantities of foreign currency called official reserves. When adding the current account and the capital account, if the United States has sent more dollars out than foreign currency has come in, as in the hypothetical example above, there exists a balance of payments deficit. In this case the Fed credits the account so that it balances. This is similar to taking money from your savings account to make up for an overdrafted checking account. If the current and capital account balances are positive, more foreign currency was coming into the United States than American dollars flowed abroad.

With this balance of payments surplus, the Fed transfers the surplus currency back into official reserves.

U.S. imports require a demand for foreign currency and a supply of U.S. dollars.

U.S. exports require a supply of foreign currency and a demand for U.S. dollars.

Current account balance + capital account balance < 0, there is a balance of payments deficit.

If current account balance + capital account balance > 0, there is a balance of payments surplus.

FOREIGN EXCHANGE RATES

Currency Markets

When nations trade goods and services, they are implicitly trading currency. The rate of exchange between two currencies is determined in the foreign currency market. Some nations fix their exchange rates while others are allowed to “float” with the forces of demand and supply. For example, in the flexible exchange market for euros pictured in the graphs below, the equilibrium $2 dollar price of a euro is at the intersection of the supply of euros and the demand. Likewise, in the market for dollars, the equilibrium euro price of one dollar is .50 euros. This floating exchange rate has an impact on the balance of payments of both the United States and the European Union.

The exchange rate between two currencies tells you how much of one currency you must give up to get one unit of the second currency.

For example, if $2 = 1 euro, $1 = .5 euro.

Or example, if $1 = 10 pesos, $.10 = 1 peso.

Appreciating and Depreciating Currency

If the U.S. economy is strong, Americans increase their demand for European goods a

services. As American consumers increase their demand for the euro, they increase the supply of dollars in the foreign exchange market; the dollar price of a euro rises, and the euro price of a dollar falls. The euro as an asset is appreciating in value and the dollar as an asset is depreciating in value. The changing value of euros and dollars is seen in Figures 13.6 and 13.7.

Then the price of a currency is rising, it is said to be appreciating. More dollars are needed to buy a euro.

When the price of a currency is falling, it is said to be depreciating. Fewer euros are needed to buy a dollar.

Changes in Exchange Rates

The above example illustrates that market forces and changing macroeconomic variables have an impact in the rate of exchange between the dollar and the euro. There are several determinants that affect currency appreciation and depreciation.

Consumer Tastes

When domestic consumers build a stronger preference for foreign produced goods and services, the demand for those currencies increases and the dollar depreciates. On the other hand, if foreign consumers increase their demand for U.S. made goods, the dollar appreciates.

Relative Incomes

When one nation’s macroeconomy is strong and incomes are rising, all else equal, they increase their demand for all goods, including those produced abroad. So if Europeans are enjoying economic growth and the United States is in a recession, the relative buying power of European citizens is growing. They increase their consumption of both domestic and U.S.-made goods, increasing demand for the dollar and appreciating its value.

Relative Inflation

If one nation’s price level is rising faster than another nation, consumers seek the goods that are relatively less expensive. If European inflation is higher than inflation in the United States, American-made goods are a relative bargain to German consumers and the dollar appreciates. This is another good reason for the Fed to keep inflationary pressure low.

Speculation

Because foreign currencies can be traded as assets, there are investors who leek to profit from buying currency at a low rate and selling it at a higher rate. For example, if it appears that future interest rates will fall in the United States relative to interest rates in Japan, the yen is looking like a good investment. Speculators would then increase their demand for Japanese assets, thus appreciating the yen and depreciating the dollars

Connection to Monetary Policy

A final variable that affects the price of one currency relative to another is a difference in relative interest rates between nations. When the Fed increases the money supply, the interest rates on American financial assets begin to fall. If the interest rate is relatively lower in the United States, people around the world see U.S. financial assets as less attractive places to put their money. Demand for the dollar falls, and the dollar depreciates relatives to other foreign currencies. A depreciating dollar makes goods in the United States less expensive to foreign consumers, so American net exports increase, which shifts AD to the right.

Likewise, if the Fed decreases the money supply, American interest rates begin to rise and the dollar appreciates relative to foreign currencies. An appreciating dollar makes American goods more expensive to foreign consumers, decreasing Americans net exports, shifting AD the left.

Be careful! When interest rates rise, we see a decrease in capital investments (machinery and other equipment) because it becomes more costly to borrow for those projects. But, when interest rates rise, we see an increase in financial investments (bonds) because income earned on those bonds is rising.

If the Fed increases the MS, Decrease i%, Decrease D$, Depreciates the $, Increase U.S. Net Exports, Increase AD.

If the Fed decreases the MS, Increase i%, Increase D$, Appreciates the $, Decreases U.S Net Exports, Decrease AD.

Pay attention to the relationship between relative interest rates and exchange rates because it has made an appearance on several recent AP Macroeconomics exams.

All else equal, demand for the U.S. dollar increases and the dollar appreciates relative to the euro if:

European taste for American-made goods is stronger.

European relative incomes are rising, increasing demand for U.S. good.

The U.S. relative price level is falling, making U.S. goods relatively less expensive. Speculators are betting on the dollar to rise in value.

The U.S. relative interest rate is higher, making the United

States a relatively more

attractive place for financial investments (i.e., bonds).

3.4 TRADE BARRIERS

The issue of free trade is hotly politicized. Proponents

usually argue that free trade raises the standard of living in

both nations, and most economists agree. Detractors argue

that free trade, especially with nations that pay lower wages

than those paid to domestic workers, costs domestic jobs in

higher-wage nations. The evidence shows that industries,

job losses have certainly occurred as free trade has become

more prevalent. To protect domestic jobs, nations can

impose trade barriers. Tariffs and quotas are

among the common of barriers.

Tariffs

In general, there are two types of tariffs. A revenue tariff is an excise tax levied on goods that are not produced in the domestic market. For example, the United States does not produce bananas, If a revenue tariff were levied on bananas, it would not be a serious impediment to trade, and it would raise a little revenue for the government. A protective tariff is an excise tax levied on a good that is produced in the domestic market. Though this tariff also raises revenue, the purpose of this tariff, as the name suggests, is to protect the domestic industry from global competition by increasing the price of foreign

products.

Example:

The domestic supply and demand for steel is pictured in

below. The domestic price is $100 per ton and the

equilibrium quantity of domestic steel is 10 million tons.

Maybe other nations can produce steel at lower cost. As a

result, in the competitive world market, the price is $80 per

ton. At that price, the Unites States would demand 12 million

tons, but only produce eight million tons and so four million

tons are imported. It is important to see that in the

competitive (free-trade) world market, consumer surplus is

maximized and no dead weight loss exists. You can see the

consumer surplus as the triangle below the demand curve

and above the $80 world price.

If the steel industry is successful in getting a protective tariff

passed through Congress, the world price rises by $10,

increasing the quantity of domestic steel supplied, reducing

the amount of steel imported from four million to two million

tons. A higher price and lower consumption reduces the area

of consumer surplus and creates dead weight loss.

Economic Effects of the Tariff

Consumers pay higher prices and consume less steel. If you

are building airplanes or door hinges, you have seen an

increase in your costs.

Consumer surplus has been lost.

Domestic producers increase output

Domestic steel firms are not subject to the tariff, so they can

sell more steel at the price of $90 than they could at $80.

Declining imports.

Fewer tons of imported steel arrive in the United States.

Tariff revenue

The government collects $10*2 million = $20 million in tariff

revenue as seen in the shaded box in Figure 13.10. This is a

transfer from consumers of steel to the government, not an

increase in the total well being of the nation.

Inefficiency

There was a reason the world price was lower than the

domestic price. It was more efficient to produce steel abroad

and export it to the United States. By taxing this

efficiency, the United States promotes the inefficient

domestic industry and stunts the efficient foreign sector. As a result, resources are diverted from the efficiency to the inefficient sector.

Dead weight loss now exists.

Quotas

Quotas work in much the same way as a tariff. An import

quota is a maximum amount of a good that can be imported

into the domestic market. With a quota, the government only

allows two million tons to be imported. Figure 13.11 looks

much like Figure 13.10, only without revenue collected by

government. So the impact of the quota, with the exception

of the revenue, is the same: higher consumer prices and inefficient resource allocation.

Tariffs and quotas share many of the same economic effects.

Both hurt consumers with artificially high prices and lower consumer surplus.

Both protect inefficient domestic producers at the expense of efficient foreign firms, creating dead weight loss.

Both reallocate economic resources toward inefficient producers.

Tariffs collect revenue for the government, while quotas do not.