Congratulations! You have arrived at the last topic for this course, International Trade. It is divided into three sections: The Theory of International Trade, Protectionism, and Exchange Rates.

The basis for trade between nations is comparative advantage. The concept is that each country should specialize in what it produces most efficiently and engage in trade for goods and services it produces relatively less efficiently. Consider the following table:

First, we note that Gamma has an absolute advantage over Omega in the production of these two agricultural products: 45 to 40 in corn and 37 to 18 in soybeans. However, absolute advantage is not the key. If it were, then the amount of trade between countries would be severely curtailed. Instead, focus on comparative advantage. If we assume that farmers in both countries use the same amount of labor and capital in the production of these items and that they could plant either corn or soybeans on the same land, then we can determine which country has the comparative advantage in each product by first calculating the internal opportunity costs or tradeoffs for each country and then comparing the two:

Which country has the comparative advantage in corn production? Another way to ask that question is: Which country gives up less in the production of corn? The answer is Omega gives up less (.45 soybeans), whereas Gamma has to give up .82 soybeans in order to produce one bushel of corn. Therefore, Omega has the comparative advantage in corn production.

Which country has the comparative advantage in soybean production? That is, which country gives up less in the production of soybeans? The answer is Gamma. It only gives up 1.22 bushels of corn in order to produce one bushel of soybeans while Omega must forgo 2.22 bushels of corn to produce one bushel of soybeans. Since Gamma gives up less, it has the comparative advantage in soybean production.

You could probably draw the correct comparative advantage conclusions by a quick scan of the original table, but you should be able to do the arithmetical calculations also.

Now let's take another look at a table for these two countries. This one will have more detail:

For Gamma, what is the tradeoff between corn and soybeans? 2 corn = 5 soybeans. Starting at the top of the table, Gamma must give up five bushels of soybeans every time it wants to increase corn output by two bushels. If 2 corn = 5 soybeans, then 1 corn = 2.5 soybeans.

For Omega, what is the tradeoff? 10 corn = 2 soybeans. Starting at the top, Omega must give up two bushels of soybeans every time it wishes to increase corn output by ten bushels. If 10 corn = 2 soybeans, then 1 corn = .2 soybeans.

Based on these calculations, Omega has the comparative advantage in corn production because it only gives up .2 bushels of soybeans to produce one bushel of corn, whereas Gamma must give up 2.5 bushels of soybeans to produce one bushel of corn. Since Omega gives up less to produce corn, it has the comparative advantage in corn production.

You should be able to make the equivalent calculations to show that Gamma has the comparative advantage in soybeans. If you are unable to do this, then go back and reread the explanation.

A consequence of applying the principle of comparative advantage is that after each country specializes in producing the goods and services that it can make efficiently, the total combined production of both trading partners should increase. The above table is shown again here:

Assume that before trade Gamma produces 4 corn and 20 soybeans. Omega produces 20 corn and 12 soybeans. Then Gamma specializes more in producing soybeans and Omega specializes more in growing corn. Gamma would move up in the table while Omega would move down.

After trade, the new production choices might be:

After trade begins total corn production equals 32, whereas before trade it was 24. After trade, the total soybean production is 35. Before trade it was 32.

Alternatively, the new production choices could be:

Verify for yourself that once again the total combined production is greater after trade than before.

The principle of comparative advantage is applicable to interstate commerce as well as international trade. Interstate commerce is simpler in that the same currency, the U.S. Dollar, is used. In addition, under the Commerce Clause of the U.S. Constitution, states are not free to erect significant barriers to interstate commerce. The State of Oklahoma would not be allowed to pass legislation setting a tariff of $5 per bushel on any wheat produced in Kansas and sold in Oklahoma. Such legislation would clearly be in violation of the Commerce Clause.

Getting back to comparative advantage, it makes sense that Kansas (and Oklahoma) would specialize in wheat and that Louisiana would not. Kansas has vast plains suitable for wheat farming while Louisiana does not. It would be inefficient for Louisiana to emphasize wheat production.

Oklahoma could try to specialize in producing oranges, but that would be inefficient. The climate and soil conditions needed to grow oranges are more prevalent in Florida than Oklahoma. On the other hand, it wouldn’t make sense for Florida to specialize in natural gas production because Florida does not have large reserves of gas and the finding costs would be too high. Oklahoma does have large natural gas resources, so Oklahoma has a comparative advantage over Florida in the production of natural gas.

For just a moment, forget about the principle of comparative advantage and assume that country X makes only one product, ham sandwiches, and that country Y also produces only one product, cherry limeade drinks. Presumably each country would be better off if some of the ham sandwiches were swapped for some of the cherry limeades. The utility, benefit, and satisfaction of each country would increase even if there were no change in the overall production amount.

From time to time, countries choose to interfere with the free flow of trade between nations. Many in government and business point out that there is a difference between free trade and fair trade. They support the idea of free trade, but only if it is fair. The access to sell in foreign markets must work in both directions.

The traditional devices used for protectionism are tariffs, quotas, and voluntary restraint agreements. Each of these will ge examined.

A tariff is a tax placed on item produced in another country and sold in the United States or vice versa. The good must cross the border and enter the U.S. in order to be subject to a U.S. tariff. Suppose there is a tariff of 2.5% on passenger cars (not trucks, as they are subject to different rules) made in other countries that are to be sold in America. If Honda assembles an Accord in Japan, it is subject to the tariff when it crosses into the United States. But if Honda assembled the vehicle in Ohio it is not subject to the tariff.

The effect of a tariff is to raise the price of the foreign-made product. When the price goes up, then under the law of demand, the sales level declines. The lower sales level for foreign-produced cars should translate into a higher sales level for U.S. made vehicles as consumers now have a price incentive to purchase the domestic good. We note that the higher price on foreign products means the consumer will pay for the protectionism. These higher prices may also provide an opportunity for domestic manufacturers to raise their prices.

It is true that in the example of a 2.5% tariff, there is not much interference with foreign trade. This relatively low tariff would be classified as a revenue tariff. This just means that it is part of the tax base and therefore the government obtains some revenue from it. This type of tariff is not a major interference with international trade.

Suppose the tariff under consideration was a 36% tax on all dinner plates produced in other countries and sold in the United States. This would be a significant impediment to trade and would be classified as a protective tariff. This high a tariff would have the effect of protecting the domestic dinner plate industry from foreign competition. Business firms in other countries that wanted to participate in the U.S. market might have to raise their prices so much that they would be effectively shut out of this market. At least temporarily, the effect of such a tariff is to protect American jobs and the financial health of U.S. companies in this business. However, the "victim" of such a protective tariff might retaliate with a protective tariff of its own. The consequence might be that ultimately both countries would lose some of the gains that result from applying the principle of comparative advantage.

When a tariff is put in place, a foreign competitor could decide not to raise prices immediately. Instead, it could try to cut costs or to simply accept less profit. But eventually, particularly if it is a protective tariff, prices will have to be raised.

Certain agreements, such as the North American Free Trade Agreement (NAFTA) between the U.S., Mexico, and Canada, are intended to reduce tariffs. Similar arrangements are in effect for other regional trading partners around the world. The consensus of most economists is that NAFTA has had both positive and negative results for the U.S. economy. In terms of job creation and job destruction, most economists assign a net result of about zero. The treaty has created some jobs and destroyed others.

Another protectionist device is the quota. This is a more aggressive action and is not as frequently used as the tariff. A quota is simply a numerical limit on how many items may be produced in one country and sold in another. If the U.S. Congress established a quota of 1.5 million Japanese cars that could be sold here, then once the limit is reached, there can be no more international trade. The effect of establishing such a quota is to shift the supply curve back to the left, thereby causing the price to rise. You should know how to illustrate this with a generic supply and demand sketch. Go ahead and do this now.

The effect of a quota is to raise the price of the foreign-made good, which in turn should lead to an increased sales level for domestic-produced products. Sales, profits and jobs are protected, at least for a while. Disadvantages include the fact that the government receives no revenue from a quota and, as mentioned above, it is a more aggressive action than a tariff and could well induce retaliation.

Instead of using a quota, there is a less formal method available to set a numerical limit, namely a voluntary restraint agreement (VRA). Here, the two governments and industries involved sit down and negotiate what they believe is an acceptable, reasonable number of items to be sold in the country seeking protection. Suppose China knows that we are concerned about their market share in the U.S. shoe industry. They prefer negotiating a limit bilaterally rather than having the U.S. set a unilateral quota. They realize that under the circumstances they have to do something and it’s better to participate in the negotiation process and have some control over the final result. In situations where a country did not enter into a VRA and the other trading partner clearly believed that protection was needed, the alternative might be a protective tariff or a quota, both of which are less desirable than a VRA.

VRAs are widely used by the U.S. and other countries. Both the VRA and the tariff are preferred over the quota.

Protectionism is sometimes used to protect domestic industries from cheap foreign labor, although there are four factors of production, not one. It is noteworthy that back in the 1950s there was cheap foreign labor in many, many countries, yet the U.S. ran a small surplus in its foreign trade balance each year. Why? Because we were able to produce very efficiently with our combination of labor, capital, and land while other countries, even though they had cheap labor, did not have the tools, equipment, and machinery we had, and therefore were not as productive. So it is not surprising that wealthy nations have expensive labor. Their labor is expensive because it is highly productive due to the extensive availability of capital. Less developed, poorer nations do not have nearly the stock of capital goods possessed by richer countries and cannot be as productive. Since they are not as productive, they are paid less.

Countries also use protectionism to keep money and jobs at home. This sounds appealing as a rationale for protectionism, but we need to be aware of the consequences. Suppose we decided not to purchase any goods not produced in the State of Oklahoma. Take this one step further. We won’t buy anything not produced in the City of Tulsa. What would happen? Well, some goods might not be available at all and others might be considerably more expensive. Once again, we would start losing some of the benefits that come from applying the principle of comparative advantage.

Most consumers want to maximize their utility from their limited budgets. They don’t make their buying decisions based on whether the item is domestic or foreign. They just want to obtain the most for their money. If two products are equal in quality and price and the consumer is aware that one is domestic and the other foreign, then the buyer might choose to keep the money at home.

In some circumstances protectionism may be used for national security reasons. There are certain countries with which the U.S. does not trade because we believe their governments have misbehaved in an egregious manner. Cuba, Iraq, and Yugoslavia are examples. The U.S. would be especially concerned about selling them certain computer products and weapons systems for fear that they would be used against the U.S. or its allies. In such cases there may even be an embargo, that is, an outright ban on doing business with such countries.

In the international economy today, perhaps the most common rationale for protectionism is to counter dumping. Dumping is defined as selling a good in a foreign market at a price below the cost of producing it. The U.S. and many other countries consider this an objectionable, unfair trade practice. Alternatively, dumping is also defined as selling a product in a foreign market at a price below the "home" market price. For instance, if Honda sold an Accord in the U.S. at a price below the price they were sold for in Tokyo, then this could constitute improper dumping.

To prove a dumping case with the U.S. Commerce Department, a company or industry must show that money damages resulted from the dumping. If the dumping was predatory in nature, that is, if it was persistent and was intended to drive domestic competitors out of business, then there would be money damages. On the other hand, if the dumping was only occasional and was used to dispose of inventory that was no longer wanted, then even though the goods were sold below cost or below the home market price, there may be no money damages. If there are no provable money damages, the dumping case will be ineffective.

The money damage requirement is similar to a breach of contract lawsuit in that it is not enough to prove a breach. There must also be money damages. If a vendor fails to deliver proper, conforming goods to a buyer but the buyer is able to purchase substitute goods from another seller at a lower price, then there are no money damages and the breach of contract lawsuit will be ineffective.

A complicating factor for international trade is that the various countries use different currencies. This means that conversions from one currency to another must be made to carry out these transactions. The specific exchange rate applicable to the U.S. dollar and the Japanese Yen can have a big impact on the pricing of goods in a foreign market as well on the bilateral trade balance between two countries.

In the international economy today floating exchange rates are used. This means that conversion rates are constantly changing in response to the underlying forces of supply and demand, much like the stock, bond, and commodities markets. The dollar might exchange for 125 yen today and 127 yen tomorrow. In that case, we would say that the dollar appreciated because it now fetches 127 yen instead of the previous 125 yen. Conversely, from the Japanese point of view, the yen depreciated because they now must pay 127 yen to obtain a dollar instead of 125 yen. If the dollar becomes stronger, then the yen is weaker. Both currencies cannot appreciate (or depreciate) against one another at the same time.

Assume the dollar starts again at 125 yen but the next day the exchange rate changes to one dollar = 123 yen. Now the dollar has depreciated or become weaker. It doesn't exchange for as many yen as before. From the Japanese point of view, the yen has appreciated or become stronger since fewer yen must be given up in order to obtain each dollar. If the dollar depreciates against the yen, then that means the yen appreciated.

Floating exchange rates replaced the earlier system of fixed exchange rates in 1971. Floating rates have been volatile between 1971 and the present and these movements have consequences for trade between nations. Suppose the dollar fell from 125 yen to 85 yen. We would predict that Japanese firms selling goods in the U.S. would raise their prices in an effort to make up for the fact that each dollar of profit to be sent back to Japan would convert into only 85 yen.

If the dollar started at 125 yen and then changed to 150 yen, we would predict that American purchases of Japanese products would increase tremendously as a result of the increase in buying power. Because of the strong dollar, Japanese firms could even lower their prices in the U.S. to try to increase their market share.

As mentioned earlier, exchange rates float based on a number of underlying forces of supply and demand. We will consider a number of these factors now.

Suppose all Japanese adults decided to buy American produced automobiles and trucks starting tomorrow. To carry out these transactions, U.S. dollars are needed. That is, U.S. auto companies will have to be paid in dollars. The demand for the dollar will increase and the dollar will appreciate. If the dollar appreciates, then the yen depreciates.

If we reverse this and say that all American adults will buy vehicles produced in Japan tomorrow, then more yen will be needed to carry out these transactions. The demand for yen will rise and the yen will appreciate. If the yen appreciates, that means the dollar depreciates.

Assume that Japanese investors believe that the New York Stock Exchange and the NASDAQ Stock Exchange are desirable places to invest money and they decide to double their investments in these U.S. markets. These deals will be done in dollars and so the demand for the dollar will increase. The dollar will appreciate and the yen will depreciate.

Alternatively, suppose American investors decide the U.S. stock market is about to decline and that the Nikkei (Tokyo) Exchange is the place to do stock market investing. As American investors shift toward the Japanese exchange, the demand for yen will increase, making the yen appreciate. The dollar will depreciate.

What if a Japanese company such as Honda decided to build a multi-million dollar assembly plant in the U.S.? The construction process would have to be paid for in dollars and demand for the U.S. dollar would increase. The dollar would appreciate and the yen would depreciate. A similar result would occur if a Japanese investor group entered into a contract to purchase General Motors Corporation. The purchase price would have to be paid in dollars, making the dollar go up and the yen go down.

Suppose the U.S. and Germany both start in the middle of the business cycle. Then the U.S. economy goes toward the peak of the business cycle while Germany's economy stays the same. As we approach the peak, our aggregate demand increases. This rise in total demand is applicable to both domestic products as well as foreign-made goods. Two consequences that follow are: (1) The U.S. bilateral trade balance with Germany will head in a negative direction because we will purchase more goods from them, but their purchases of U.S. products will stay the same. In other words, exports from the U.S. don't change but imports from Germany increase. Since the trade balance consists of exports minus imports, our trade balance will move toward deficit or, if we already have a deficit, toward a larger deficit. (2) The increase in U.S. demand for German products will result in the Euro appreciating or getting stronger while the dollar will depreciate.

If the U.S. and Germany both started in the middle of the business cycle and then the German economy slid toward a trough of the cycle while the U.S. economy stayed the same, then the results would be similar to those discussed above. Since we would be in a stronger position than Germany, we would buy relatively more from them than they would from us. Again, the Euro would go up and the dollar would go down.

What if both countries started in the middle again, but this time the German economy expanded rapidly while the U.S. economy remained in an intermediate position? Germany would now purchase relatively more from us than we would from them. The U.S. bilateral trade balance with Germany would move toward surplus. The dollar would appreciate and the Euro would go down.

If both countries started in the middle and the German economy stayed the same while the U.S. economy went into a downturn, then the results would be similar to those just discussed. The U.S. trade balance would move toward surplus and the dollar would appreciate. It is the relative position of the two countries on the business cycle that determines the trade balance and exchange rate consequences.

Here is a table that summarizes these business cycle effects:

Interest rate changes also affect currency exchange rates. Higher interest rates will attract foreign investors and lower interest rates will induce them to go elsewhere. If U.S. interest rates increase relative to Japanese interest rates, then dollar-denominated investments will become more attractive to foreign investors. The resulting increase in demand for such investments will make the dollar appreciate and the yen depreciate. On the other hand, if Japanese interest rates increase relative to U.S. interest rates, then yen-denominated investments will attract American investors. The increase in demand for Japanese investments will drive up the yen and take the dollar down.

Assume that the U.S. Treasury Bill (or T-Bill) is the interest rate under consideration. Assume also that Japan has an equivalent short term security that investors can buy. Keep in mind that mutual funds, pension funds and other investor groups are perfectly free to choose between U.S. and Japanese investment products. Here is a table that summarizes the effects of interest rate changes:

Inflation is another factor that has an impact on currency conversion rates. If the U.S. inflation rate is low and stays low while the inflation rate in Mexico jumps from a creeping inflation rate to a double-digit rate, then investors may perceive the Mexican economy as unstable and decide to avoid making investments in that country until the economy is stabilized. Demand for the Mexican peso would fall, making the peso depreciate. Consider the following table:

If the increase in the Mexican economy's inflation was quite mild, say from 2% to 3%, then an opposite effect would occur. Investors would anticipate a small but noticeable increase in Mexican interest rates as a consequence of the higher, but still well controlled, inflation. These higher interest rates would induce more investors to seek peso-denominated investments.

If you were a Japanese tourist visiting the Grand Canyon, then you would be displeased with the weak yen: You would have to give up too many yen to obtain each dollar and unless you were a wealthy person you would have to make do with less expensive meals, hotel rooms, etc.

An American company that buys parts from Japan would be happy with the strong dollar, as the effect is to reduce the price. But an American company that sells goods in Japan would be displeased because it would take 200 yen to convert back to the U.S. dollar.

If you were running a tourist business at the Grand Canyon that catered to visitors from Japan, you wouldn't much care for the dollar's appreciation to 200 yen as this might reduce your business. You would like it better if the dollar weakened to 100 yen. The stronger yen should have the effect of increasing your business.

Foreign business firms such as Toyota prefer the stronger dollar as this provides an incentive for American consumers and business firms to buy more products from them. Yet if Japan is running too large a bilateral trade surplus with the United States, then the U.S. Government might want a weaker dollar to help reduce the trade imbalance.

To summarize, many factors influence the floating exchange rates that are used today. It's clear that your preference for a strong or weak dollar depends on several factors and that it would be a gross oversimplification to say that all American consumers and business firms want a strong dollar and all Japanese consumers and business firms want a strong yen.

You are now ready to work on the Problems and Exercises for Unit Four, Assignment Two.