3. From Textbook: Why Do Nations
Trade
In your notes:
I. Why do nations trade?
1. Lower Prices
2. Greater Choice
3. Differences in Resources
4. Economies of Scale
5. Increased Competition
6. More Efficient Allocation of Resources
7. Sources of Foreign Exchange
4. Comparing Nations
Country A Country B
Description
Products they can make
Absolute Advantages
Comparative Advantages
Description
Products they can make
Absolute Advantages
Comparative Advantages
5. Imagine the following situation:
Country A is an
industrialized nation. It
has advanced technologies
and factories. It can
efficiently make lots of
different products
Country B is a developing
nation. It has no advanced
technologies and mostly
relies on subsistence
farming for its income.
6. Imagine the following situation:
Country A is an
industrialized nation. It
has advanced technologies
and factories. It can
efficiently make lots of
different products
Country B is a developing
nation. It has no advanced
technologies and mostly
relies on subsistence
farming for its income.
What products is
Country A is able to
make.
List What products
Country B is able to
make
7. Absolute Advantage
When one economy can produce a good or service
more efficiently than another country.
When one economy can produce more goods than
another country.
8. Imagine the following situation:
Country A is an
industrialized nation. It
has advanced technologies
and factories. It can
efficiently make lots of
different products
Country B is a developing
nation. It has no advanced
technologies and mostly
relies on subsistence
farming for its income.
Despite Country A’s
absolute advantage, the
two countries still trade.
A.Why do you think
they do this?
B.What do you think
would be traded?
9. Comparative Advantage
“Implies that one country is able to produce a good at a
lower opportunity cost than another.”
Example:
America can produce more of almost any good if it
wanted to.
Compared to Portugal, America has an absolute
advantage in the production of wine, for example.
10. (cont.)
Yet, because America can make more things, there are
more things that it is giving up when it diverts
resources to wine production
In other words, the resources diverted to wine
production could be better spent making automobiles.
Portugal does not have this opportunity cost because it
does not have the capacity to make cars on the scale
that America can.
11. (cont.)
These differences in opportunity mean that even the
poorest of nations have an advantage in production of
certain goods.
This is called comparative advantage.
“Implies that one country is able to produce a good at a
lower opportunity cost than another.”
12. Imports and Exports
Imports=Goods and services coming in to a country
from a foreign source.
Exports=Goods and services that are sold to a foreign
country.
14. Effect of World Supply on Domestic
Markets (graph)
To be an import, it must have a supply level below the
domestic price level.
Imports lower prices and increase quantity sold. They
also force domestic suppliers to sell below domestic
equilibrium
(Sd and Sw)
18. International Trade Diagrams
1. Market with no international trade
2. Market with international trade
3. Market with Tariff
4. Market with higher tariff
5. Market with lower tariff
19. Effect of Tariff on Market(graph)
Raises price level and decreases quantity sold.
Allows domestic producers to come closer to domestic
equilibrium
22. Non-Tariff Barriers
1. Quotas (set amount of imports allowed)
2. Subsidies (government helps suppliers pay for
production, thus increasing the supply curve by
lowering cost)
23. Non-Tariff Barriers (Cont)
3. Administrative Obstacles
A. “Red Tape” (forms, bureaucracy, etc. )
B. Health, Safety, and Environmental standards
C. Embargoes
4. Nationalism (people buy products made in their country as a
type of national pride.)
27. 1. Protecting Domestic
Employment
Trade barriers can be used to soften the blow of rapidly
changing economic conditions that may cause
unemployment.
Heavily criticized argument by economists, because the
money wasted on trade barriers could be spent on long-
term reform.
28. 2. Infant Industry Argument
Protect a growing industry from international
competitors so that the nation will benefit in the long-
run
Often used to legitimate trade barriers for less
developed countries
Note: US, Japan, Germany, and China all had
enormous trade barriers when their economies were
industrializing
29. 3. Diversification (avoid Over-
specialization)
Many poorer nations exploit their comparative advantages
fully. Unfortunately, this means that their economies
become one-dimensional.
If a seasonal change destroys a country’s cash crop, for
example, its economy would be devastated
Trade barriers allow an economy to diversify and not just
stick to its comparative advantage.
30. 4. Security Reasons
If a country depends on a potentially aggressive nation
for important trading goods, than that nation would
be at risk for economic collapse during a war.
Ex: Dependence on oil from the Middle East when we
seem to always be at war over there
31. 5. Anti-Dumping
Dumping is selling goods below market price.
The goal is to “predatory price”: eliminate a competitor
Anti-dumping trading restrictions only bring the good
back to market price.
32. 6. Protect Product Standards
A country might want to protect itself from harmful
goods or goods that do not meet certain health, safety,
or environmental standards.
34. Arguments Against Protectionism
(In Favor of Free Trade)
1. Costs are bigger than benefits
2. Less Choice
3. Domestic Industry becomes Weak
4. Inefficient Resource Allocation
5. Real National Security
35. 1. Costs are bigger than benefits
Protectionism helps some, free-trade helps more.
Lower prices for consumers
Lower input costs for Domestic producers that use
imported products.
36. 2. Less Choice
Not only does protectionism raise prices, it limits
choices for consumers.
37. 3. Domestic Industry Becomes
Weak
Domestic industries get spoiled by protectionism
Become more concerned with lobbying government
than competing
Historically, trade restrictions that are supposed to
help infant industries last too long.
38. 4. Inefficient Resource Allocation
Optimal use=using limited factors of production for
best outcome to society
Trade barriers allow inefficient use of resources
Does not take advantage of comparative advantage.
39. 5. Real National Security
“When goods can’t cross borders, armies will.”
Trade barriers lead to international tensions
Free-trade creates dependency.
If Country A depends on a good from Country B, they are less
likely to go to war with them.
The EU was originally conceived as a means to unite Europe
economically in order to prevent costly wars.
It has been effective in creating common interests among the
once warring people.
42. Bretton Woods
IMF (International Monetary Fund)
Goal is to stabilize exchange rates and foster
development
World Bank
Provides loans to developing nations
Used the dollar as a basis for all exchange rates
Dollar would be linked to the dollar
General Agreement on Tariffs and Trade (GATT)
Obligated everyone to commit to non-discrimination in
trade
Reduce/eliminate tariffs
43. GATTWTO
Between 1947 and 1979 there were a series of
negotiations that sought to reduce trade barriers
In that period, tariffs fell from an average of 40% to 4.7%
Between 1986 and 1993 (called the Uruguay Round)
expanded open trade laws for agriculture, investment,
and intellectual property
Name was officially changed to WTO in 1995
44. Details
Now, headquarter in Geneva
All “power” rests from multilateral
agreements, not force
Power is not through penalization,
but through allowing penalization
through tariffs
WTO members account for 95% of
the world’s trade
45. Objectives of the WTO
1. Non-discrimination in trade practices
Most Favored Nation clause (MFN)
2. Using negotiation to mediate trade conflicts
3. Creating stable trade environment
4. Fair Competition
If a nation is determined to be “dumping,” for example,
tariffs can be enacted.
5. Development
(in development)
46. Functions
1. Oversee agreements
2. Be a forum for negotiation
3. Handle trade disputes among members
4. Monitor trade policies of different nations
5. Provide technical assistance
47. Doha Round
In 2001, in response to protests like those in Seattle, the
WTO began to refocus its agenda.
More of a focus on Development
This period is referred to as the “Doha Round”
Negotiations collapsed in 2008.
Some negotiation restarted in 2013 over administrative
obstacles.
48. Successes (Economists Point of
View)
Economists generally view it as hugely successful
1. Representation
146 member states
2. Poverty
A stated goal of the WTO is to alleviate poverty.
While that goal has not been attained, it is probably responsible for
moving more people out of poverty than any other organization.
3. Dispute Settlement
Peaceful and effective
4. Lessening Trade Barriers
Its original purpose has largely been met.
49. Failures (economist’s point of view)
1. Allows Regional Exclusion Areas that give
preferential treatment to some
NAFTA, EU, etc.
Seen as a means to an end.
2. Subsidies to agriculture in developed nations have
remained
51. WTO Public Criticisms
1. Undemocratic
The “people” don’t get a voice
2. Encourages the race to the bottom
Pushes developing nations to have
less labor and environmental
standards
3. Dependency of poorer nations on
wealthier nations
52. Criticisms Continued
4. Lack of Environmental
Protections
5. Lack of Labor Standards
6. Lack of Public Health Standards
53. US-China Disputes
Wind Power
1. What is the US complaint against China?
2. Based on the information, which side do you think
the WTO will take? Why?
Tyres
1. What is the Chinese complaint against the US?
2. Based on the information, which side do you think
the WTO will take? Why?
54. Doha Round
In 2001, in response to protests like those in Seattle, the
WTO began to refocus its agenda.
More of a focus on Development
Reducing agricultural subsidies in developed nations
Environmental Protections
Labor Protections
Intellectual Property—Patenting of Medicine
Transparency
Negotiations broke down in 2008, but restarted in 2011
56. Basic Assumptions of the Model
Trade is done rationally (people do not trade to get less value than
what they had before.)
People do not “sit on,” bury, or destroy money.
Exports, Imports, Inflows, and Outflows can be tracked and
tracked well.
Currencies used in one economy cannot be used in another
economy (more on this later).
Exports means money is coming in and goods/services are leaving.
imports means money is leaving and goods/services are coming in.
57. Balance of Payments
A record of the value of all the transactions between
the residents of one country and the residents of all
other countries.
It is not a budget, so don’t confuse it with national debt
or budget (fiscal) deficit
58. Two Types of Accounts
Goods and Services
Current Account
Flows of Payment
Capital Account
Financial Account
59. Current Account
Current Account: Shows flows of exports and imports
(X-M)
Balance of Trade in goods
Balance of trade in services
Current Transfers (foreign aid and grants)
60. How to calculate the Current
Account
X-M (exports minus imports)
Add up the value of all the goods and services being sold to
other countries.
Subtract all the goods and services being bought from
other countries
If + than “Trade surplus”
If – than “Trade Deficit”
61. Balances
In popular media, the term “trade balance” or “trade
imbalance” usually refers to the Current Account
We have a “trade deficit” when we buy more imports
than the exports we sell.
However, this “deficit” also creates a surplus in the
capital account and financial account.
62. Financial and Capital Account
Shows flows of capital (Inflows-Outflows).
Money coming into a country to invest in the stock market
(Portfolio investment), buy businesses (FDI), buy bonds,
etc.
Capital Account includes money transferred through
movement or buying “intangible assets” (like copyrights)
Financial Account includes investment.
63. How to calculate the Capital and
Financial Account
Investment coming in MINUS investment going out
Add up all the investment entering the United States
(inflows)
Subtract all the investment leaving the United States
(outflows)
Examples of investment: Buying debt bonds, buying land,
buying/building factories, buying currencies.
64. Note:
In U.S., the “Capital Account” includes both the capital
account and the financial account
65. Simple Equation, Confusing Idea
Current Account + Capital Account
+Financial Account= 0
Or: Capital Account + Financial
Account= -Current Account
Assuming no errors or omissions
66. Why?
Imagine that the U.S. buys 100 cars from Japan and
Japan buys nothing from America.
Japan would have a Current Account Surplus because
it has exported more than it has imported
BUT, America would pay for those cars with dollars.
Japan would then have to do something with those
dollars
This would create a Financial Account deficit for Japan
67. Quick Note on Exchange Rates
When Japan exchanges Dollars for Yen, it is effectively
buying dollars with Yen
This may help you understand why the capital account
must always balance out the current account.
73. Exchange Rates
The value of one currency expressed in terms of
another currency.
The “price” of a currency relative to other currencies
Example: 1 Euro=1.34 US Dollars
74. 4 Terms
Appreciation
When the value of a currency raises relative to others in the
marketplace
Revaluation
When a government re-pegs or adjusts their currency at a
higher value
Depreciation
When the value of a currency falls relative to others in the
marketplace
Devaluation
When a government re-pegs their currency at a lower value
75. Concluding Phrases: Trade Flows
If exports decrease, the exchange rate depreciates.
If exports increase, the exchange rates appreciates
If imports increase, the exchange rate depreciates
If imports decrease, the exchange rate appreciates.
77. Concluding Sentences: Speculation
If speculators think a currency will appreciate, it will
appreciate.
If speculators think a currency will depreciate, it will
depreciate.
78. Graphing Exchange Rates
1. Appreciation caused by increase in Demand
2. Appreciation caused by decrease in Supply
3. Depreciation caused by decrease in Demand
4. Depreciation caused by increase in supply
83. Effects of Exchange Rates on Trade
If a currency appreciates, it will increase the buying
power of consumers:
This will increase imports
If a currency appreciates, it will decrease the buying
power of consumers in other countries:
This will decrease exports.
84. Effects of Exchange Rates on Trade
If a currency depreciates, it will decrease the buying
power of consumers:
This will decrease imports
If a currency depreciates, it will increase the buying
power of consumers in other countries:
This will increase exports
85. Exchange Rates Balance Trade
Decreases in the exchange rate cause the current account to
increase and vice versa
Easier to sell exports, harder to buy imports
Increases in the current account cause the exchange rate to
appreciate and vice versa
Less imports and more exports makes the currency more
valuable.
This means that exchange rates balance out trade in
the long-run.
86. Homeostasis
When your blood vessels swell and are more exposed,
you get colder.
When you get cold, your blood vessels retract into your
body.
A Negative Feedback Loop: Body responds to correct a
problem
87. Trade
When you import a lot, your currency depreciates.
When your currency depreciates, you can’t import as
much.
A negative feedback loop: Exchange rates respond to
correct a problem.
88. Balance
If there’s too many imports, exchange rates depreciate
and make it harder to import.
If there’s too many exports, exchange rates appreciate
and make it harder to export.
89. 1. Fixed Exchange Rate
Government sets the exchange rate.
This can be either done through proclamation or through
intervention in the market
Central Bank manipulates the “price” by buying and selling the
currency and adjusting the interest rate
In extreme cases, the central bank may make transfer of the currency
illegal (will create a black market)
China has been accused of having a fixed exchange rate. Most of the
world was under a fixed exchange rate system until 1971
90. 2. Floating Exchange Rate
Currency Value is entirely determined by the market
Supply and demand of the currency are allowed to
freely exist without government intervention.
As per WTO rules, participating nations are supposed
to have a floating exchange rate.
91. 3. Managed Exchange Rate
A managed system is a combination of a fixed and a
floating.
Supply and demand determine the exchange rate.
A price floor and price ceiling is secretly set.
If things get out of hand, the Central Bank will intervene.
Almost all countries in reality use a managed exchange
rate. (Though most claim it is floating until something bad
happens).
92. Managing Exchange Rates
1. Adjust Interest Rate
Higher interest rates will make more people want to
have the currency because they could see a higher rate
of return
Higher Interest Rate=Appreciation
Lower Interest Rate=Depreciation
93. 2. Buy/sell foreign currencies
A central bank can sell their currency to put more on
the market, thus devaluing it
It can also buy its own currency on the market, thus
revaluing it
If a bank runs out of foreign currency to buy its own
currency, it can borrow from the IMF (International
Monetary Fund)
The original purpose of the IMF
94. 3. New Peg
Governments can re-peg their exchange with
gold or other currencies if they cannot
maintain the exchange rate
4. Deflationary/Inflationary Policies
Government could print less of its own
currency or cut back on spending to revalue
Could also print more money or increase
spending to devalue
95. 5. Adjust trade policy
Protectionist measures would slow down the exit of
home currency, thus revaluing it
More free trade would speed up the exit of home
currency, thus devaluing it.
96. I. Economic Integration
“A process by which countries coordinate and link
their economic policies.”
An increase in economic integration means more
working together and sharing.
A decrease in economic integration means less
working together and sharing.
97. II. Trade Agreements
Bilateral Trade agreements are between two countries
Multilateral Trade agreements are between multiple
countries.
98. III. Trading Bloc Types
There are different ways and different degrees by
which countries integrate.
99. 1. Preferential Trading Area (PTA)
Giving preferential treatment to a country or group of
countries.
This could include special quotas or lower tariffs
Example: ACP (African-Caribbean and Pacific Group of
States).
100. 2. Free Trade Areas
Countries agree to trade or mostly trade freely between
each other, but maintain separate trade policies with
other countries.
Key examples: CAFTA, KORUS, and NAFTA
103. 3. Customs Unions
When there is free trade between groups of countries
and the countries also agree to common trade policies
with the outside world.
All of the following are types of customs unions:
A. Common Market
B. Monetary Union
C. Complete Economic Integration
106. A. Common Market
A customs union with common policies on regulation
and the movement of goods, services, capital, and
labor.
EEC: European Economic Community
108. B. Monetary Union
A common market with a common currency and a
common central bank.
Example: European Union with the ECB (European
Central Bank) and the Euro.
110. C. Complete Economic Integration
Common market with complete integration.
Individual countries would maintain some political
independence, but economically it is one country.
