Baumol & Blinder MACROECONOMICS (11th ed)

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PART

THE UNITED STATES IN THE

WORLD ECONOMY

“G lobalization” became a buzzword in the 1990s—and it remains one today. Some people extol its virtues and view it as something to be encouraged. Others deplore

its (real or imagined) costs and seek to stop globalization in its tracks. For example, globalization is often viewed as a threat to the livelihoods of American workers.

We will examine several aspects of the globalization debate in Part 4. But love it or hate it, one thing is clear: The United States is thoroughly integrated into a broader world economy. What happens in the United States influences other countries, and events abroad re-

verberate back here. Trillions of dollars’ worth of goods and services—American software, Chinese toys, Japanese cars—are traded across international borders each year. A vastly larger dollar volume of financial transactions—trade in stocks, bonds, and bank deposits, for example—takes place in the global economy at lightning speed.

We have mentioned these subjects before, but Part 4 brings international factors from

the wings to center stage. Chapter 17 studies the factors that underlie international trade, and Chapter 18 takes up the determination of exchange rates—the prices at which the world’s currencies are bought and sold. Then Chapter 19 integrates these international influences into our model of the macroeconomy.

If you want to understand why so many Americans are worried about international

trade, why many thoughtful observers think we need to overhaul the international monetary system, or why there was so much economic turmoil in Southeast Asia, Russia, and Latin America during the last 15 years or so, read these three chapters with care.

C H A P T E R S

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INTERNATIONAL TRADE AND

COMPARATIVE ADVANTAGE

No nation was ever ruined by trade.

BENJAMIN FRANKLIN

E conomists emphasize international trade as the source of many of the benefits of “globalization”—a loosely defined term that indicates a closer knitting together of the world’s national economies. Of course, countries have always been linked in vari-

ous ways. The Vikings, after all, landed in North America—not to mention Christopher Columbus. In recent decades, however, dramatic improvements in transportation, telecommunications, and international relations have drawn the nations of the world ever closer together economically. This process of globalization is often portrayed as something new. But in fact, it is not, as the box “Is Globalization Something New?” on the next page points out. Still, it is changing the way the peoples of the world live.

Economic events in other countries affect the United States for both macroeconomic and microeconomic reasons. For example, we learned in Parts 2 and 3 that the level of net exports is an important determinant of a nation’s output and employment. But we did not delve very deeply into the factors that determine a nation’s exports and imports. Chapters 18 and 19 will take up these macroeconomic linkages in greater detail. First, however, this chapter studies some of the microeconomic linkages among nations: How are patterns and prices of world trade determined? How and why do governments often interfere with foreign trade? The central idea of this chapter is one we have encountered before (in Chapters 1 and 3): the principle of comparative advantage.

C O N T E N T S

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Is Globalization Something New?

Americans (and the citizens of many other nations) often want their government to limit or prevent import competition. Why? One major reason is the common belief that imports take bread out of American workers’ mouths. According to this view, “cheap foreign labor” steals jobs from Americans and pressures U.S. businesses to lower wages. For many years, attention focused on the phenomenon of manufacturing jobs moving abroad. Lately, there has

been a great deal of concern over the “offshoring” of a wide variety of service jobs— ranging from call center operators to lawyers. Such worries were prominently voiced in the 2008 presidential campaign. For example, during the Democratic primaries, Senators Hillary Clinton and Barack Obama competed over who could be more disparaging toward the North American Free Trade Agreement (NAFTA), arguing that competition from cheap Mexican labor had destroyed many good American jobs.

Oddly enough, the facts appear to be grossly inconsistent with the theory that trade kills jobs. For one thing, wages in most countries that export to the United States have risen dramatically in recent decades—much faster than wages here. Table 1 shows hourly compensation rates in eight countries on three continents, each expressed as a percentage of hourly compensation in the United States, in 1975 and 2005. Only workers in Mexico lost ground to American workers over this 30-year period. Labor in

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1 China would be an even more extreme example, but we lack Chinese data dating back to 1975.

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INTERNATIONAL VERSUS INTRANATIONAL TRADE

The 50 states of the United States may be the most eloquent testimonial to the large gains that can be realized from specialization and free trade. Florida specializes in growing oranges, Michigan builds cars, California makes software and computers, and New York specializes in finance. All of these states trade freely with one another and, as a result, enjoy great prosperity. Try to imagine how much lower your standard of living would be if you consumed only items produced in your own state.

The essential logic behind international trade is no different from that underlying trade among different states; the basic reasons for trade are equally applicable within a country or among countries. Why, then, do we study international trade as a special subject? There are at least three reasons.

Political Factors in International Trade

First, domestic trade takes place under a single national government, whereas foreign trade always involves at least two governments. But a nation’s government is normally much less concerned about the welfare of other countries’ citizens than it is about its own. So, for example, the U.S. Constitution prohibits tariffs on trade among states, but it does not prohibit the United States from imposing tariffs on imports from abroad. One major issue in the economic analysis of international trade is the use and misuse of political impediments to international trade.

The Many Currencies Involved in International Trade

Second, all trade within the borders of the United States is carried out in U.S. dollars, whereas trade across national borders almost always involves at least two currencies. Rates of exchange between different currencies can and do change. In 1985, it took about 250 Japanese yen to buy a dollar; now it takes fewer than half that many. Variability in exchange rates brings with it a host of complications and policy problems.

Impediments to Mobility of Labor and Capital

Third, it is much easier for labor and capital to move about within a country than to move from one nation to another. If jobs are plentiful in California but scarce in Ohio, workers can move freely to follow the job opportunities. Of course, personal costs such as the financial

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burden of moving and the psychological burden of leaving friends and familiar surroundings may discourage mobility. But such relocations are not inhibited by immigration quotas, by laws restricting the employment of foreigners, or by the need to learn a new language.

There are also greater impediments to the transfer of capital across national boundaries than to its movement within a country. For example, many countries have rules limiting foreign ownership. Even the United States limits foreign ownership of broadcast outlets and airlines and, recently, political furors arose when a Chinese company sought to purchase a U.S. oil company and when a Middle Eastern company offered to take over the management of several U.S. ports. Foreign investment is also subject to special political risks, such as the danger of outright expropriation or nationalization after a change in government.

But even if nothing as extreme as expropriation occurs, capital invested abroad faces significant risks from exchange rate variations. An investment valued at 250 million yen is worth $2.5 million to American investors when the dollar is worth 100 yen, but it is worth only $1 million when it takes 250 yen to buy a dollar.

2 To review, see page 49.

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The United States in the World Economy

input used to produce computers and television sets in the two countries and that the United States has an absolute advantage in manufacturing both goods. In this example, one year’s worth of labor can produce either 50 computers or 50 TV sets in the United States but only 10 computers or 40 televisions in Japan. So the United States is the more efficient producer of both goods. Nonetheless, as we will now show, it pays for the United States to specialize in producing computers and trade with Japan to get the TV sets it wants.

To demonstrate this point, we begin by noting that the United States has a comparative advantage in computers, whereas Japan has a comparative advantage in producing televisions. Specifically, the numbers in Table 2 show that the United States can produce 50 televisions with one year’s labor, whereas Japan can produce only 40, giving the United States a 25 percent efficient edge over Japan. However, the United States is five times as efficient as Japan in producing computers: It can produce 50 per year of labor rather than 10. Because America’s competitive edge is far greater in computers than in televisions, we say that the United States has a comparative advantage in computers.

From the Japanese perspective, these same numbers indicate that Japan is only slightly less efficient than the United States in TV production but drastically less efficient in computer production. So Japan’s comparative advantage is in producing televisions. According to Ricardo’s law of comparative advantage, then, the two countries can gain if the United States specializes in producing computers, Japan specializes in producing TVs, and the two countries trade.

Let’s verify that this conclusion is true. Suppose Japan transfers 1,000 years of labor out of the computer industry and into TV manufacturing. According to the figures in Table 2, its computer

U.S. Japan Total output will fall by 10,000 units, while its TV output will rise by 40,000 units. This information is recorded in the middle column of Table 3. Suppose, at the same time, the United States transfers 500 years of labor out of television manufacturing (thereby losing

25,000 TVs) and into computer making (thereby gaining 25,000 computers). Table 3 shows us that these transfers of resources between the two countries increase the world’s production of both outputs. Together, the two countries now have 15,000 additional TVs and 15,000 additional computers—a nice outcome.

Was there some sleight of hand here? How did both the United States and Japan gain both computers and TVs? The explanation is that the process we have just described involves more than just a swap of a fixed bundle of commodities, as in our earlier cookies- and-milk example. It also involves a change in the production arrangements. Some of Japan’s inefficient computer production is taken over by more efficient American makers. And some of America’s TV production is taken over by Japanese television companies, which are less inefficient at making TVs than Japanese computer manufacturers are at making computers. In this way, world productivity is increased. The underlying principle is both simple and fundamental:

When every country does what it can do best, all countries can benefit because more of every commodity can be produced without increasing the amounts of labor and other resources used.

Where does the United States hold and lack comparative advantage? Among our big export powerhouses are the aerospace industry, agriculture, chemicals, high-tech services, financial services, entertainment, and higher education. We are, of course, huge importers of petroleum, television sets, automobiles, computers, clothing, toys, and much else.

The Graphics of Comparative Advantage

The gains from trade also can be illustrated graphically, and doing so helps us understand whether such gains are large or small.

The lines US and JN in Figure 1 are closely related to the production possibilities frontiers of the two countries, differing only in that they pretend that each country has the

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A country’s absolute advantage in production over another country is shown by its having a higher per-capita production possibilities frontier. The difference in the comparative advantages between the two countries is shown by the difference in the slopes of their frontiers.

Because opportunity costs differ in the two countries, gains are possible if the two countries specialize and trade with one another. Specifically, it is cheaper, in terms of real resources forgone, for either country to acquire its computers in the United States. By a similar line of reasoning, the opportunity cost of TVs is higher in the United States than in Japan, so it makes sense for both countries to acquire their televisions in Japan.4

Notice that if the slopes of the two production possibilities frontiers, JN and US, were equal, then opportunity costs would be the same in each country. In that case, no potential gains would arise from trade. Gains from trade arise from differences across countries, not from similarities. This is an important point about which people are often confused. It is often argued that two very different countries, such as the United States and Mexico, cannot gain much by trading with one another. The fact is just the opposite:

Two very similar countries may gain little from trade. Large gains from trade are most likely when countries are very different.

The pattern is apparent in U.S. trade statistics—with one big exception. Canada, a country very similar to the United States, is our biggest trading partner. But that is mainly because the two nations share a huge and very porous border. However, our next three biggest

3To review the concept of the production possibilities frontier, see Chapter 3.

4As an exercise, provide this line of reasoning.

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trading partners, in order, are China, Mexico, and Japan—three countries very different from the United States.

How nations divide the gains from trade depends on the prices that emerge from world trade—a complicated topic taken up in the appendix to this chapter. But we already know enough to see that world trade must, in our example, leave a computer costing more than one TV and less than four. Why? Because if a computer bought less than one TV (its opportunity cost in the United States) on the world market, the United States would produce its own TVs rather than buying them from Japan. And if a computer cost more than four TVs (its opportunity cost in Japan), Japan would prefer to produce its own computers rather than buy them from the United States. So we conclude that, if both countries are to trade, the rate of exchange between TVs and computers must end up somewhere between 4:1 and 1:1. Generalizing:

If two countries voluntarily trade two goods with one another, the rate of exchange between the goods must fall in between the price ratios that would prevail in the two countries in the absence of trade.

To illustrate the gains from trade in our concrete example, suppose the world price ratio settles at 2:1—meaning that one computer costs as much as two televisions. How much, precisely, do the United States and Japan gain from world trade in this case?

Figure 2 helps us visualize the answers. The blue production possibilities frontiers, US in Panel (b) and JN in Panel (a), are the same as in Figure 1. But the United States can do better than line US. Specifically, with a world price ratio of 2:1, the United States can buy two TVs for each computer it gives up, rather than just one (which is the opportunity cost of a computer in the United States). Hence, if the United States produces only computers— point S in Figure 2(b)—and buys its TVs from Japan, America’s consumption possibilities will be as indicated by the brick-colored line that begins at point S and has a slope of 2— that is, each computer sold brings the United States two television sets. (It ends at point A because 40 million TV sets is the most that Japan can produce.) Because trade allows the United States to choose a point on AS rather than on US, trade opens up consumption possibilities that were simply not available before (shaded gray in the diagram).

FIGURE 2

The Gains from Trade

NOTE: Quantities are in millions.

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