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六、 Investment Tools: Economics: Global Economic Analysis

1.A: Gaining from International Trade

a: State the conditions under which a nation can gain from international trade.

Comparative advantage is the ability to produce a good at a lower opportunity cost than others can produce it. Relative cost determines comparative advantage. When trading partners specialize in producing products for which they have comparative advantage, costs are minimized, output is greater, and both trading partners benefit.

Absolute advantage is a situation in which a nation, as the result of its previous experience or natural endowments, can produce more output with the same resources than another nation.

Note the difference: Absolute advantage refers to using the fewest resources to produce a product. Comparative advantage refers to the lowest opportunity cost to produce a product.

According to the law of comparative advantage, trading partners are both better off if they specialize in the production of goods for which they are the low-opportunity cost producer and trade for those goods for which they are the high-opportunity cost producer.

How trade expands consumption possibilities: A country gains from international trade when it exports those goods for which it has a comparative advantage and imports those goods for which it does not. To see this more clearly, suppose that we can produce wheat at $2 per bushel. If the production cost is $3 in all other nations, it is to our advantage to produce more wheat and sell it on the world market.

Additional considerations on international trade:

It allows firms to realize economies of scale.

It benefits domestic consumers by allowing them to purchase from large scale producers abroad.

It promotes competition and allows consumers to purchase a wider variety of goods.

b: Discuss the effects of international trade on domestic supply and demand.

Assume the U.S. has a comparative advantage in the production of Product L. The following graph indicates that when the world price is allowed to prevail in the domestic market, the price and quantity supplied of Product L are both higher. As a result, domestic consumers are losers because of the higher price they must pay, and domestic producers are winners because of the higher price they receive and higher quantity they sell. However there is a secondary effect. To buy Product L from the U.S., foreign consumers must generate U.S. dollars. To do this, foreigners will export goods to the U.S. for which they have a competitive advantage. These goods are cheaper for U.S. consumers, which benefits the U.S. consumers at the expense of U.S. producers of those products. The net result is a benefit to the U.S. and world economies.

c: Explain why nations adopt trade restrictions.

Some reasons given for trade restrictions have some or partial validity:

National defense argument: Some industries are highly sensitive to national security and should therefore remain in the country.

Infant industries argument: These industries should be protected for a time while they develop and reduce costs. One problem with this is that it is often hard to remove these tariffs.

Anti-dumping argument: Tariffs are used to prohibit foreign firms from selling products in the country at below cost in an attempt to gain market share.

Other reasons for trade restrictions are of more questionable validity:

Do trade barriers protect jobs? Part of the popularity of trade restrictions stems from their ability to protect easily identifiable jobs and the high wage levels in these jobs. But, in the long run, however, trade restrictions cannot protect the net number of jobs in the country.

Do trade restrictions create jobs? In the short run maybe, but in the long run, No! Trade restrictions prevent your trading partners from developing the purchasing power needed to buy import goods from you, thus depressing your own export industry.

Does trade with low-wage countries depress wage rates in high-wage countries? No! The belief that trading with low-wage countries depresses wages is based on a misunderstanding of the law of comparative advantage. A high hourly wage does not necessarily mean high per unit labor costs.

d: Explain who derives benefits and losses from the imposition of a tariff.

Tariffs benefit domestic producers of products because the level of imports will be reduced due to an effective increase in the price of the good. For example, if the world price of semiconductors is $40, and domestic producers can only profitably sell semiconductors at $45, foreign producers have a comparative advantage. Hence, domestic producers will not be able to compete in their own domestic semiconductor market. However, if the government places a $5 tariff on imported semiconductors, local producers will become competitive with foreign producers in the local market and local semiconductor production will rise. Tariffs will also benefit the government. They will collect the $5 tax on all foreign semiconductors sold in the domestic market.

Even though the government collects tariffs and supposedly uses these funds to increase the welfare of its citizens, consumers in the country still lose. Because the demand curve is downward sloping, the loss in consumer surplus cannot be fully recovered by tax revenue.

e: Discuss the validity of the arguments for trade restrictions.

Some reasons given for trade restrictions have some or partial validity:

National defense argument: Some industries are highly sensitive to national security and should therefore remain in the country.

Infant industries argument: These industries should be protected for a time while they develop and reduce costs. One problem with this is that it is often hard to remove these tariffs.

Anti-dumping argument: Tariffs are used to prohibit foreign firms from selling products in the country at below cost in an attempt to gain market share.

Other reasons for trade restrictions are of more questionable validity:

Do trade barriers protect jobs? Part of the popularity of trade restrictions stems from their ability to protect easily identifiable jobs and the high wage levels in these jobs. But, in the long run, however, trade restrictions cannot protect the net number of jobs in the country.

Do trade restrictions create jobs? In the short run maybe, but in the long run, No! Trade restriction prevent your trading partners from developing the purchasing power needed to buy import goods from you, thus depressing your own export industry.

Does trade with low-wage countries depress wage rates in high-wage countries? No! The belief that trading with low-wage countries depresses wages is based on a misunderstanding of the law of comparative advantage. A high hourly wage does not necessarily mean high per unit labor costs.