CHAPTER OVERVIEW - Crawford's World



chapter EIGHTEEN

International Trade

ANSWERS TO END-OF-CHAPTER QUESTIONS

18-1 Quantitatively, how important is international trade to the United States relative to other nations? What country is the United States’ most important trading partner, quantitatively? With what country does the United States have the largest current trade deficit?

U.S. exports of goods and services are large in absolute terms (second only to Germany in 2003), but only about 10 percent of GDP, which is small relative to the proportion in many other industrialized nations. For example, the percentage is 62 percent in the Netherlands, 25 percent in United Kingdom, 29 percent in New Zealand, and 38 percent in Canada.

Canada is the United States’ most important trading partner (In 2004, 24 percent of U.S. exports, 18 percent of U.S. imports).

The largest trade deficit is with China, $162 billion in 2004.

18-2 Below are the hypothetical production possibilities tables for New Zealand and Spain. Each country can produce apples and plus. Referring to the tables, answer the following:

(a) What is each country’s cost ratio of producing plums and apples.

(b) Which nation should specialize in which product?

(c) Suppose the optimal product mixes before specialization and trade are alternative B in New Zealand and alternative S in Spain, and the actual terms of trade are 1 plum for 2 apples. What would be gains from specialization and trade?

| |

|New Zealand’s production possibilities table (millions of bushels) |

| | | | |

| | | | |

|Product |Production alternatives | | |

| |A |B |C |D |

|Apples |0 | |20 | |40 | |60 | |

|Plums |15 | |10 | |5 | |0 | |

| | | | | |

|Spain’s production possibilities table (millions of bushels) |

| | | | |

| | | | |

|Product |Production alternatives | | |

| |R |S |T |U |

|Apples |0 | |20 | |40 | |60 | |

|Plums |60 | |40 | |20 | |0 | |

| | | | | |

a) New Zealand’s cost ratio is 1 plum = 4 apples (or 1 apple = 1/4 plum). Spain’s cost ratio is 1 plum = 1 apple (or 1 apple = 1 plum).

b) New Zealand should specialize in apples, Spain in plums.

(c) Total production before specialization and trade: 40 apples (20 + 20) and 50 plums (10 + 40). After specialization and trade: 60 applies and 60 plums. Gain = 20 applies and 10 plums.

18-3 The following are production possibilities tables for South Korea and the United States. Assume that before specialization and trade the optimal product-mix for South Korea is alternative B and for the United States alternative U.

| | |

|Product |South Korea’s production possibilities |

| | | | | | | |

| |A |B |C |D |E |F |

|LCD displays (in 1000s) |30 |24 |18 |12 |6 |0 |

|chemicals (in tons) |0 |6 |12 |18 |24 |30 |

|Product |U.S. production possibilities |

| | | | | | | |

| |R |S |T |U |V |W |

|LCD displays (in 1000s) |10 |8 |6 |4 |2 |0 |

|chemicals (in tons) |0 |4 |8 |12 |16 |20 |

a. Are comparative cost conditions such that the two areas should specialize? If so, what product should each produce?

b. What is the total gain in LCD displays and chemical output that would result from such specialization?

c. What are the limits of the terms of trade? Suppose actual terms of trade are 1 unit of LCD displays for 1-1/2 units of chemicals and that 4 units of LCD displays are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation?

d. Explain why this illustration allows you to conclude that specialization according to comparative advantage results in more efficient use of world resources.

(a) Yes, because the opportunity cost of LCD displays is less (1L = 1C) in South Korea than in the United States (1L = 2C). South Korea should produce LCD displays and the United States should produce chemicals.

(b) If they specialize, the United States can produce 20 tons of chemicals and South Korea can produce 30,000 LCD displays. Before specialization South Korea produced alternative B and the United States alternative U for a total of 28,000 LCD displays (24,000 + 4,000) and 18 tons of chemicals (6 tons + 12 tons). The gain is 2,000 LCD displays and 2 tons of chemicals.

(c) The limits of the terms of trade are determined by the comparative cost conditions in each country before trade: 1L = 1C in South Korea and 1L = 2C in the United States. The terms of trade must be somewhere between these two ratios for trade to occur.

If the terms of trade are 1L = 1-1/2C, South Korea would end up with 26,000 LCD displays (= 30,000 - 4,000) and 6 tons of chemicals. The United States would have 4,000 LCD displays and 14 tons of chemicals (= 20 - 6). South Korea has gained 2,000 LCD displays. The United States has gained 2 tons of chemicals.

(d) By specializing in the production of goods according to who can produce a good the cheapest (in comparative terms), total world output is maximized. Consistent with the concept of productive efficiency, the world economy is getting more (and in this case maximum) output out of a fixed set of resources.

18-4 What effect do rising costs (rather than constant costs) have on the extent of specialization and trade? Explain.

Rising costs will result in incomplete specialization and less trade than with constant costs. The basis for trade is the cost advantage one nation has over another; if costs rise as a nation produces more (i.e. specializes), eventually that cost advantage will disappear, as will the motive for further specialization. This explains why nations produce goods that they also import – some units of the good they can produce more cheaply than their trading partners.

18-5 What is offshoring of white-collar service jobs and how does it relate to international trade? Why has it recently increased? Why do you think more than half of all offshored jobs have gone to India? Give an example (other than that in the textbook) of how offshoring can eliminate some U.S. jobs while creating other U.S. jobs.

Offshoring refers to the process of shifting work previously done by domestic workers to workers in foreign countries. It relates to international trade in that it represents a change in comparative advantage – job relocation suggests that comparative costs have changed. It also means that services once provided domestically, and possibly exported, are now imported, changing the balance of trade.

Offshoring has increased recently because of trade agreements and new information and communication technologies.

Many of the jobs have gone to India because wages are lower, in part because of the large population. Greater familiarity with the English language (compared to some of the other large population nations) is also an asset that reduces training costs for labor.

Examples: As operations for call centers (customer service, etc.) expand, so does the demand for computers and telecommunications equipment from the United States. Outsourcing of computer equipment manufacturing has lowered prices, encouraging firms to invest more heavily in computer technology and increasing the number of domestic support jobs in information technology.

18-6 Explain why the U.S. demand for Mexican pesos is downward-sloping and the supply of pesos to Americans is upward-sloping. Indicate whether each of the following would cause the Mexican peso to appreciate or depreciate:

a. The United States unilaterally reduces tariffs on Mexican products.

b. Mexico encounters severe inflation.

c. Deteriorating political relations reduce American tourism in Mexico.

d. The United States’ economy moves into a severe recession.

e. The U.S. engages in a high interest rate monetary policy.

f. Mexican products become more fashionable to U.S. consumers.

g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.

The U.S. demand for pesos is downward-sloping: When the peso depreciates in value (relative to the dollar) the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping: As the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos.

The peso appreciates in (a), (f), (g), and depreciates in (b), (c), (d), and (e).

18-7 Explain why you agree or disagree with the following statements:

a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.

b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate.

c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.

(a) This statement is true. If high rates of economic growth mean that the real incomes of a country’s citizens are rising more rapidly than in other countries, its imports will rise more than its exports. The demand for foreign currency by its citizens will increase more than the supply of foreign currency, causing the value of the domestic currency to decline.

(b) This statement is true. If domestic real interest rates are increasing more quickly than those in other countries, foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency and therefore an appreciation of the country’s currency.

(c) This statement is true. If a country’s inflation rate is lower than rates in other countries, the foreign prices of its products will decline relative to foreign-made products, increasing exports and the supply of foreign currency. At the same time, the domestic prices of foreign imports will increase relative to domestically made goods, decreasing the demand for foreign currency. Both factors will cause the country’s currency to appreciate.

18-8 If the European euro were to depreciate relative to the U.S. dollar in the foreign exchange market, would it be easier or harder for the French to sell their wine in the United States? Suppose you were planning a trip to Paris. How would the depreciation of the euro change the dollar price of this trip?

If the European euro declines in value, it means that Americans can receive more euros for each dollar. Therefore, they do not need as many dollars to pay the euro price of a bottle of French wine, so the quantity demanded would rise and it should be easier to sell French wine in the U.S. Likewise, the euro depreciation would make it less costly for Americans to travel in France, since the dollar would now buy more euros (assuming that prices inside France have not risen to entirely offset the depreciation of the euro).

18-9 What measures do governments use to promote exports and restrict imports? Who benefits and who loses from protectionist policies? What is the net outcome for society?

Governments promote exports by providing subsidies to export producers, which effectively lowers their costs and enables them to sell their products at lower prices on world markets. Subsidies enable export firms or industries to compete against other nations, but the fact the subsidy was necessary for this competition means that the most efficient use of resources is not taking place.

Restriction of imports can be accomplished by tariffs, by import quotas, and by non-tariff barriers such as licensing requirements, unreasonable quality standards, and unnecessary import procedures.

The benefits of protectionist policies are to the industry that has to compete on world markets either with its exports or against imports. Even this may be a short-run benefit, because industries that are protected may become so inefficient and outmoded that they are unable to stay afloat even with the protection in the long run. There may also be some political benefits as those protected groups have a strong self interest in this protection and are vocal opponents of free trade for their industries, whereas the benefits of free trade are more diffuse and the benefits to any single group of voters is less noticeable.

The costs of protectionist policies are more widespread. The costs of protectionist policies arise because resources are not being used as efficiently as they might be under free trade. This raises the cost of production and raises prices, and means the total quantity of world output produced and consumed is not as great as it could be without such barriers. Consumers lose since they must pay higher prices, but worldwide producers also lose because productivity is not as high as it could be.

The net outcome to society is negative. Costs outweigh the benefits for the reasons stated above.

18-10 Speculate as to why some U.S. firms strongly support trade liberalization while other U.S. firms favor protectionism. Speculate as to why some U.S. labor unions strongly support trade liberalization while other U.S. labor unions strongly oppose it.

When trade barriers are eliminated, some U.S. firms will be hurt by the increased competition from foreign companies. On the other hand, if trade barriers against U.S. products are eliminated, the U.S. companies producing those products will be able to sell more of their products outside the U.S. Likewise, the union workers working for the firm that face increased international competition may lose their jobs, whereas union workers working for companies that are expanding due to international trade will experience an increase in job opportunities.

18-11 Explain: “Free-trade zones such as the EU and NAFTA lead a double life. They can promote free trade among members, but pose serious trade obstacles for nonmembers.” Do you think the net effects of these trade blocs are good or bad for world trade? Why? How do the efforts of the WTO relate to these trade blocs?

Free-trade zones increase the efficient use of resources within the zones by eliminating trade barriers and allowing for the freer movement of resources across international borders among the member nations. On the other hand, if trade barriers are retained against imports from nations outside the zone, this results in a less efficient allocation of resources in the larger global economy.

The evidence seems to point to the net effect of trade blocs as being good for world trade. They seem to be a first step in breaking down trade barriers as can be seen from the expansion of the original European Economic Community to today’s 25-member European Union, and the expansion of the U.S.-Canada free trade agreement to NAFTA. Also, the attraction of the large consumer markets within each trade zone makes other trade blocs more likely to conclude agreements between blocs that would further lower trade barriers.

Some might argue that such blocs are bad for world trade because the unity and self-sufficiency gained inside the trade zone may inhibit further overtures for trade expansion outside the bloc, but so far this does not seem to have been the case.

The WTO provides a forum for the trade blocs to meet and negotiate further reductions in trade barriers among the trade blocs.

18-12 What is the WTO, and how does it relate to international trade? How many nations belong to the WTO? (Update the number given in this book at .) Is the Doha round still in progress or has it been concluded with an agreement (again use the website shown)? If the former, when and where was the latest ministerial meeting. If the latter, what are the main features of the agreement?

The WTO is the World Trade Organization with 148 member nations (mid 2005). The organization promotes reduction in trade barriers and helps to enforce the agreement signed by its nation members.

The current round of WTO negotiations (2005) is named the Doha Round, after the city of Doha, Qatar, where the first formal negotiations of the round occurred in late 2001. [As of August 2005, the latest ministerial meeting was scheduled for Hong Kong in December 2005.]

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