International Economics

Study Questions

n 1. Why is international economics significant?

n 2. What is meant by a trade deficit or surplus?

n 3. Why do we organize, both domestically and internationally, based on comparative advantage and specialization?

n 4. Who wins and who loses in free international trade?

n 5. What are the two typical ways trade is “protected”?

n 6. Who wins and who loses in protected international trade?

n 7. How does free international trade affect jobs and the standard of living in the trading countries?

n 8. What is outsourcing?

n 9. How does a floating exchange rate system work?

Why is Trade Important?

n We cannot produce some things we want at all (or in inadequate quantities).

n We get benefits from specialization.

n We get more choices.

Imports and Exports

n Imports: goods we buy that are produced in another country.

n Exports: goods we produce that we sell to people in another country.

Trade Deficits and Surpluses

n Deficit: imports exceed exports

n Surplus: exports exceed imports

n With few exceptions, the US has had a trade deficit every year for the past 30 years.

How Free International Trade Begins

n Assume, as first, no international trade.

¨ The American market for a good is made up of US consumers and US producers only.

n Also, assume many US producers are high-cost producers compared to, say, European producers.

¨ They can sell at a lower price than US producers.

Figure 6-1. The American Market Before Imports

How Free International Trade Begins

n Now, let the European firm enter the American market and compete with US producers.

¨ Supply curve shifts right.

¨ Price falls to the world price.

Figure 6-2. The American Market After Imports

How Free International Trade Begins

n US customers buy more at lower prices.

n US customers can choose between US and European goods.

n Some high-cost US producers can’t compete profitably and stop producing.

n Instead of all US goods, US customers buy some US goods and some imported goods.

Figure 6-3. The American Market After Imports

Winners and Losers in Free International Trade

n US consumers win: more choice, lower prices, more wants and needs satisfied, have money left over to buy other goods.

n European low-cost importers win: increase sales, increase production, create jobs.

n US high-cost producers lose: lose sales, decrease production, lay off workers.

n International transport industry wins: More trade, create jobs.

What about US exports?

n The story is the same.

n Low-cost US firms penetrate the European market.

n Increase sales of US products, create US jobs.

n High-cost European producers lose sales, decrease production, lay off workers.

More Winners and Losers

n European customers win (just like US consumers)

n European high-cost producers lose (just like US high-cost producers)

n US low-cost producers win (just like European low-cost producers)

n International transport wins.

Results of Free International Trade (Both Countries)

n Consumers: More goods and services at lower prices.

n Standard of living increases.

n Low-cost, internationally competitive industries expand and create jobs.

n High-cost, internationally uncompetitive industries decrease production and lay off workers.

n International transportation grows and creates jobs.

Comparative Advantage

n This applies to an individual, to a firm, or to a nation:

¨ If you can produce a good at a lower opportunity cost than someone else, you have a comparative advantage over them.

n You should specialize in that good; they should rely on you to make it for them.

¨ They become your customers.

So What’s the Problem?

n High-cost producers do not like to:

¨ see their markets invaded by foreign competitors.

¨ lose sales.

¨ cut back production or quit the industry.

¨ lay off workers.

So What’s the Problem?

n High-cost producers appeal to their Congresspersons to “protect” them from competition by foreign importers.

¨ To restrict trade.

¨ To make the imported good less “desirable” to the consumer.

Methods of Protection

n Tariffs.

¨ Add a tax on imported goods to bring its price above the domestic good.

n Quotas.

¨ Restrict the amount imported.

¨ This shifts supply to the left, raising price above the domestic good.

n Bureaucratic red tape.

¨ Make it harder to import the good.

Excuses for Protection

n Military self-sufficiency.

n Increase domestic employment.

n Infant industry.

n Dumping.

n Cheap foreign labor.

Winners and Losers in Protected International Trade

n All winners in free international trade lose in protected international trade.

n All losers in free international trade win in protected international trade.

¨ Consumers lose: Prices are higher; choice is smaller.

¨ Standard of living is lower.

¨ There is a net job decrease in both countries.

¨ High-cost producers win; low-cost producers lose.

Outsourcing

n A firm hires an outside specialist to take over a particular function of a business.

n Families outsource many functions.

n Businesses outsource many functions.

n This became significant when US firms began to outsource functions to offshore specialists.

Outsourcing and Insourcing

n In fact, this is an international event.

n More functions are insourced from other countries into the US than outsourced from the US to other countries.

Foreign Exchange Markets

n International trade requires the use of two currencies.

¨ US buyers pay in dollars for imported European goods.

¨ European producer pays his bills in Euros.

¨ European buyers pay in Euros for imported US goods.

¨ US producer pays his bills in dollars.

Foreign Exchange Markets

n Who has a demand for Euros?

¨ US firms importing goods from Europe.

¨ American tourists in Europe

n Who has a supply of Euros?

¨ US firms exporting goods to Europe.

¨ European tourists in the US

The foreign exchange market

n The Euro market:

n S: supply of euros

n D: demand for euros

n P1: the price of one euro in terms of dollars

n Q1: the total number of euros that will be bought and sold

The foreign exchange market

n The Euro market:

n An increase in demand for the euro increases its price in dollars

n The euro appreciates and the dollar depreciates

The foreign exchange market

n The Euro market:

n An decrease in demand for the euro decreases its price in dollars

n The dollar appreciates and the euro depreciates

Floating Exchange Rates

n Any of the following will cause the exchange rate to change:

¨ A change in demand for Euros by Americans.

¨ A change in supply for Euros by Americans.

¨ A change in demand for dollars by Europeans.

¨ A change in supply for dollars by Europeans.

Floating Exchange Rates

n If the dollar appreciates against the Euro:

¨ the Euro depreciates against the dollar.

¨ the dollar can buy more Euros.

¨ the Euro can buy fewer dollars.

n If the dollar depreciates against the Euro:

¨ the Euro appreciates against the dollar.

¨ the dollar can buy fewer Euros.

¨ the Euro can buy more dollars.

Foreign Exchange Market

n Floating exchange rates:

¨ the free market prevails.

¨ Changes in the supply of and demand for currencies change the exchange rate.

n Fixed exchange rates:

¨ a government sets a rate that will not change.

¨ To work, the government must intervene to keep demand for and supply of the currency balanced.

¨ If the government cannot do this, the currency will be devalued.

Balance of Payments

n Current account: In addition to international trade, the following are included in the current account:

¨ income from investments

¨ unilateral transfers

¨ foreign aid

Balance of Payments

n There is a capital account that includes investments made by Americans in other countries and foreigners investments made in the US.

n There is also a reserve account run by the central bank, used to reduce volatility in exchange rates.

Balance of Payments

n The following must add up to zero:

¨ Current account

¨ Capital account

¨ Reserve Account

n The trade deficit makes the current account negative (dollar outflow).

n Thus the capital account must be positive (dollar inflow).

Figure 6-4. Exchanges between the United States and Euroland.

Is A Trade Deficit “Bad”?

n There is an interesting relationship between the size of the trade deficit and the business cycle.

¨ Peak? High trade deficit.

¨ Recession? Trade deficit decreases.

¨ Trough? Low (near zero) trade deficit.

¨ Recovery/prosperity? Trade deficit increases.