Transcript Chapter 2

GSIAS – North American Economy
Intra- National Trade and
International Trade in North America
How and Why
Lesson Overview
• Current Trade Statistics
• Basics of why people / countries trade

Opportunity Cost and Comparative Advantage

Intl. Trade through Comparative Advantage
• Basic Trade Models

Gravity Model

Heckschire-Ohlin Model

Economies of Scale
• Barriers to Trade
• Developing Country Model (Mexico)
• Pros / Cons to Free Trade
• Application to N.American Economy
2-2
Trade in North America
USA
Canada
Mexico
GDP
$48,000
$40,200
$14,400
Current
Acct. Bal.
-$568.8 billion
$12.82 billion
-$13.45 billion
Export $
$1.377 trillion
$461.8 billion
$294 billion
Export
Products
capital goods 49.0%,
indust supplies 26.8%
consumer goods 15.0%
motor vehicles/parts, industrial
machinery, aircraft, tele equip.;
chemicals, plastics, fertilizers;
wood pulp, timber, crude
petroleum, natural gas, alum.
manufactured goods, oil
and oil products, silver,
fruits, vegetables, coffee,
cotton
Export
Partners
Can. 21.4%, Mex 11.7%
China 5.6%, Japan 5.4%
US 78.9%, UK 2.8%,
China 2.1%
US 82.2%, Canada 2.4%,
Germany 1.5%
Import $
$2.19 trillion
$436.7 billion
$305.9 billion
Import
Products
Indust supplies 32.9%
(crude oil 8.2%),
capital goods 30.4%,
consumer goods 31.8%
machinery and equipment,
motor vehicles and parts,
crude oil, chemicals,
electricity, durable consumer
goods
metalworking machines, steel mill
products, agricultural machinery,
electrical equipment, car parts for
assembly, repair parts for motor
vehicles, aircraft, and aircraft parts
Import
Partners
China 16.9%,
Can.15.7%,
Mexico 10.6%
US 54.1%, China 9.4%,
Mexico 4.2%
US 49.6%, China 10.5%,
Japan 5.8%,
South Korea 4.5%
Current Acct Balance: records a country's net trade in goods and services, plus net earnings from rents,
interest, profits, and dividends, and net transfer payments (such as pension funds and worker remittances)
to and from the rest of the world during the period specified.
Trade Basics: A PARABLE FOR THE
MODERN ECONOMY
Imagine an economic system with only two
goods, potatoes and meat and only two people,
a potato farmer and a cattle rancher
 What
should each person
produce?
 Why
should these people trade?
What can the Farmer and Rancher produce?
Reference:
1 ounce = 28.35 grams
Production Possibilities
• Suppose the farmer and rancher decide not to
engage in trade:

Each consumes only what he or she can produce
alone.

The production possibilities frontier is also the
consumption possibilities frontier.

Without trade, economic gains are diminished.
• Suppose instead the farmer and the rancher decide to
specialize and trade…

Both would be better off if they specialize in
producing the product they are more suited to
produce, and then trade with each other.
Figure 2 How Trade Expands the Set
of Consumption Opportunities
(a) The Farmer ’s Production and Consumption
Meat (ounces)
8
Farmer's
consumption
with trade
A*
5
4
Farmer's
production and
consumption
without trade
A
Farmer's
production
with trade
0
32
16
Potatoes (ounces)
17
Copyright©2003 Southwestern/Thomson Learning
Figure 2 How Trade Expands the Set
of Consumption Opportunities
(b) The Rancher ’s Production and Consumption
Meat (ounces)
Rancher's
production
with trade
24
Rancher's
consumption
with trade
18
13
B*
B
12
0
12
24 27
Rancher's
production and
consumption
without trade
48
Potatoes (ounces)
Copyright © 2004 South-Western
COMPARATIVE ADVANTAGE
• Differences in the costs of production determine the
following:

Who should produce what?

How much should be traded for each product?
• Two ways to measure differences in costs of
production:

The number of hours required to produce a unit of
output (for example, one pound of potatoes).

The opportunity cost of sacrificing one good for
another.
Opportunity Cost and Comparative
Advantage
• Compares producers of a good according to their
opportunity cost, that is, what must be given up to
obtain some item
• The producer who has the smaller opportunity cost of
producing a good is said to have a comparative
advantage in producing that good.
Who has the comparative advantage in the production of
each good?
?
?
Comparative Advantage and Trade
• Potato costs…

The Rancher’s opportunity cost of an ounce of
potatoes is ½ an ounce of meat.

The Farmer’s opportunity cost of an ounce of
potatoes is ¼ an ounce of meat.
• Meat costs…

The Rancher’s opportunity cost of a pound of meat
is only 2 ounces of potatoes.

The Farmer’s opportunity cost of an ounce of meat
is only 4 ounces of potatoes...
Comparative Advantage and Trade
…so, the Rancher has a comparative
advantage in the production of meat
but the Farmer has a comparative
advantage in the production of
potatoes.
APPLICATIONS OF COMPARATIVE
ADVANTAGE
• Should Tiger Woods Mow His Own Lawn?
?
?
?
?
Intl. Trade through Comparative Adv.
Basic Trade Model
•Countries will trade based on their particular comparative
advantage. Below, no trade equilibrium point.
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
The World Price and Comparative Advantage
• The effects of free trade can be shown by comparing
the domestic price of a good without trade and the
world price of the good. The world price refers to the
price that prevails in the world market for that good.
• If a country has a comparative advantage, then

the domestic price will be below the world price,
and

the country will be an exporter of the good.
• If the country does not have a comparative
advantage, then

the domestic price will be higher than the world
price, and

the country will be an importer of the good.
International Trade in an Exporting Country
Price
of Steel
Price
after
trade
Consumer surplus
surplus
Consumer
after trade
before
trade
Exports
A
BB
Price
before
trade
World
price
D
CC
Producer surplus
after
before
trade
trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
THE WINNERS AND LOSERS FROM
TRADE
• The analysis of an exporting country yields
two conclusions:

Domestic producers of the good are better
off, and domestic consumers of the good are
worse off.
 Trade
raises the economic well-being of the
nation as a whole.
The Gains and Losses of an
Importing Country
• International Trade in an Importing
Country
 If
the world price of steel is lower than the
domestic price,
• the country will be an importer of steel when
trade is permitted.
• domestic consumers will want to buy steel at
the lower world price.
• domestic producers of steel will have to lower
their output because the domestic price moves
to the world price.
International Trade in an Importing Country
Price
of Steel
Consumer surplus
before trade
Domestic
supply
A
Price
before trade
Price
after trade
B
C
D
Imports
Producer surplus
before trade
0
World
price
Domestic
demand
Quantity
of Steel
Figure 3 International Trade in an
Importing
Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
BB
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
The Gains and Losses of an
Importing Country
• How Free Trade Affects Welfare in an
Importing Country
 The
analysis of an importing country yields
two conclusions:
• Domestic producers of the good are worse off,
and domestic consumers of the good are better
off.
• Trade raises the economic well-being of the
nation as a whole because the gains of
consumers exceed the losses of producers.
Basic Trade Models
• There are a variety of models today that describe why
regions and countries trade. We will take a look at a
few of the primary ones.

Gravity Model

Heckschire-Ohlin Model

Economies of Scale
• One note regarding these trade models: These
models can be applicable whether we are talking
about intra-national or international trade.
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2-22
Size Matters: The Gravity Model
• Which countries do the US, Mexico and
Canada primarily trade with? Why?
• The Gravity Model can help explain.
Newton‘s law of gravity states that the gravitational attraction
between any two objects is proportional to the product of their
masses and diminishes with distance.
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2-23
Size Matters: The Gravity Model (cont.)
The Gravity Model
Determinants of Trade:
1. Size of the potential trading partners economy.

The more money a country has, the more they can spend
on your products!
2. Distance between markets influences transportation
costs and therefore the cost of imports and exports.

Distance may also influence personal contact and
communication, which may influence trade.
2. Cultural affinity: if two countries have cultural ties, it
is likely that they also have strong economic ties.
3. Geography: ocean harbors and a lack of mountain
barriers make transportation and trade easier.
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2-25
The Gravity Model (cont.)
4. Multinational corporations: corporations spread
across different nations import and export many
goods between their divisions.
5. Borders: crossing borders involves formalities that
take time and perhaps monetary costs like tariffs.

These implicit and explicit costs reduce trade.

The existence of borders may also indicate the existence of
different languages (see 2) or different currencies, either of
which may impede trade more.
6. Trade Pacts
Distance and Borders (cont.)
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2-27
Heckscher-Ohlin Trade Model
• While trade is partly explained by differences in labor
productivity (ie. Ricardo model), it also can be
explained by differences in resources across
countries.
• The Heckscher-Ohlin theory argues that international
differences in labor, labor skills, physical capital or
land (factors of production) create productive
differences that explain why trade occurs.


Countries have relative abundance (or scarcity) of factors of
production. ie. land to people.
Production processes use factors of production with
relative intensity. ie. Farming is land intensive. Making cloth
is labor intensive.
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4-28
Production and Prices (cont.)
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4-29
Trade in the Heckscher-Ohlin Model
• Suppose that the domestic country has an abundant
amount of labor relative to the amount of land.



The domestic country is abundant in labor and the foreign
country is abundant in land: L/T > L*/ T*
Likewise, the domestic country is scarce in land and the
foreign country is scarce in labor.
However, the countries are assumed to have the same
technology and same consumer tastes. Does this matter?
• Because the domestic country is abundant in labor, it
will be relatively efficient at producing cloth because
cloth is labor intensive.
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4-30
Trade in the Heckscher-Ohlin Model (cont.)
• Like the Ricardian model, the Heckscher-Ohlin model
predicts a convergence of relative prices with trade.
• With trade, the relative price of cloth will rise in the
domestic country and fall in the foreign country.

In the domestic country, the rise in the relative price of cloth
leads to a rise in the relative production of cloth and a fall in
relative consumption of cloth; the domestic country becomes
an exporter of cloth and an importer of food.

The decline in the relative price of cloth in the foreign country
leads it to become an importer of cloth and an exporter
of food.
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4-31
Economies of Scale
• The Heckscher-Ohlin model and many other models
assume constant returns to scale:

If all factors of production are doubled then output will
also double.
• But a firm or industry may have increasing returns
to scale or economies of scale:

If all factors of production are doubled, then output will more
than double.

Larger is more efficient: the cost per unit of output falls as a
firm or industry increases output.
• Also…when economies of scale exist, large firms may
be more efficient than small firms, and the industry
may consist of a monopoly or a few large firms.
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6-32
Types of Economies of Scale
• Economies of scale could mean either that
larger firms or that a larger industry (e.g., one
made of more firms) is more efficient.
• External economies of scale occur when
cost per unit of output depends on the size of
the industry. Ie. Hollywood example
• Internal economies of scale occur when the
cost per unit of output depends on the size of
a firm. Ie. Auto industry example
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6-33
Economies of Scale - Who
• Do economies of scale exist in N.Am.?
• Name some examples for each type of
economies of scale for this region.
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6-34
Barriers to Trade
• Tariffs
• Import quotas
• Export subsidies
• Voluntary export restraints
• Local content requirements
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8-35
The Effects of a Tariff
• A tariff is a tax on goods produced
abroad and sold domestically.
• Tariffs raise the price of imported goods
above the world price by the amount of
the tariff.
Figure 4 The Effects of a Tariff
Price
of Steel
Consumer surplus
Producer surplus
Domestic
supply
A
Deadweight Loss
B
Price
with tariff
Price
without tariff
0
C
D
E
G
Tariff
F
Imports
with tariff
Q
S
Q
S
Domestic
demand
Q
Imports
without tariff
D
Q
D
World
price
Quantity
of Steel
The Effects of a Tariff
• A tariff reduces the quantity of imports
and moves the domestic market closer
to its equilibrium without trade.
• With a tariff, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
Import Quotas: Another Way to Restrict Trade
• The Effects of an Import Quota

An import quota is a limit on the quantity of a good
that can be produced abroad and sold
domestically.

Because the quota raises the domestic price
above the world price, domestic buyers of the good
are worse off, and domestic sellers of the good are
better off.

License holders are better off because they make
a profit from buying at the world price and selling at
the higher domestic price.
The Effects of an Import Quota
Price
of Steel
Consumer surplus after quota
Surplus for firms
with licenses
Domestic
supply
Equilibrium
without trade
Domestic
supply
+
Import supply
Quota
A
Isolandian
price with
quota
Price
World
without =
price
quota
0
Producer surplus
after quota
B
C
E'
D
G
Equilibrium
with quota
F
E"
Imports
with quota
Q
S
Q
S
Domestic
demand
Q
Imports
without quota
D
Q
D
World
price
Quantity
of Steel
CASE STUDY: KORUS FTA
• Opening up the Korean Beef Market to
US
Imports (for approx. the same qty and quality meat)
• Korean Beef Price at Lotte Mart = 31,500/kilo
• Aust. Beef Price at Lotte Mart = 21,000/kilo
CASE STUDY: KORUS FTA
• Opening up the Korean Beef Market to USA Imports
(for approx. the same qty and quality meat)
• Safeway (US grocery store chain) retail price in
Seattle, WA (doesn’t account for shipping and
any added expenses) = 7,500/kilo
CASE STUDY: KORUS FTA
• 305,000 metric tons consumed (2006)
• Total Spending (only Korean Beef): 19.2 Quad.
• Total Spending (only Austr. Beef): 12.8 Quad.
• Total Spending (only US Beef):

4.58 Quad.
(Approx. spending assuming above assumptions
and US Beef xfer pricing similar to what is found in
USA)
• What is the Korean consumer surplus?
• What is Korean producer surplus?
Voluntary Export Restraint
• A voluntary export restraint works like an
import quota, except that the quota is imposed
by the exporting country rather than the
importing country.
• However, these restraints are usually
requested by the importing country.
• The profits or rents from this policy are earned
by foreign governments or foreign producers.

Foreigners sell a restricted quantity at an
increased price.
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8-44
Local Content Requirement
• A local content requirement is a regulation that
requires a specified fraction of a final good to be
produced domestically.
• It may be specified in value terms, by requiring that
some minimum share of the value of a good represent
domestic valued added, or in physical units.
• provides protection in the same way that an import
quota would.
• provides neither government revenue (as a tariff
would) nor quota rents.
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8-45
The Cases for and against Free Trade
• For

Efficient allocation of resources with no govt. involvement

economies of scale.

competition and opportunities for innovation.
• Against

Optimal Tariff

Jobs Argument

National-Security Argument

Infant-Industry Argument

Unfair-Competition Argument

Protection-as-a-Bargaining-Chip Argument
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9-46
Developing Country Models
• Import substituting industrialization
• Export oriented industrialization
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9-47
Import Substituting Industrialization
• Import substituting industrialization was a
trade policy adopted by many low and middle
income countries before the 1980s.
• The policy aimed to encourage domestic
industries by limiting competing imports.
• It was often accompanied with the belief that
poor countries would be exploited by rich
countries through international financial
markets and trade.
• Primary basis was on the infant industry
argument.
10-48
Export Oriented Industrialization
• Instead of import substituting industrialization,
several countries in East Asia adopted
trade policies that promoted exports in
targeted industries.

Japan, Hong Kong, Taiwan, South Korea,
Singapore, Malaysia, Thailand, Indonesia and
China are countries that have experienced rapid
growth in various export sectors and rapid
economic growth in general.

These economies or a subset of them are
sometimes called “high performance Asian
economies”.
• These days, Mexico is trying to orient their
economy towards this model.
10-49
Application to N.American Economy
• See handout.
10-50