Why Do Nations Trade . . .?

Economics is based on. . .

• Supply and Demand

And

• Incentives

Market-Oriented Economic System

Market-Oriented Economic System includes . . .

Basic Competitive Model:• Consumers making rational choices• Profit Maximizing Firms• Highly competitive markets

Market-Oriented Economic System also needs

• Incentives• Price System• Property Rights – to use it and sell it• Inequality i.e., acceptance of. . . .• (almost) free markets . .• Belief in the benefits of efficiency• An understanding of cost benefit analysis

Market-Oriented Economic (Price) System vs . . .

• Rationing system• Pure free market/libertarianism • Strong government regulatory system

Market-Oriented Economic (Price) System vs . . .

• Command economy• State owned enterprises• Communist• Socialism• national socialism

• Mixed market economies

Market-Oriented Economic (Price) System vs . . .

- The International economy (trade and finance, etc.) is based on a mix of economic systems, but primarily a market-based, free trade system

- Every economic system must deal with it on those terms

- The global economy – international trade, finance, investment – is more free-market than most domestic economies

Capitalism vs Everything Else

- What are the alternatives?- Is capitalism the worst possible system? . . . . except for all the rest?- Should economic results be even, with

little opportunities for change?- Should foreign trade be

- Free?- Fair?

Bilateral vs Multilateral Trade

• Virtually all trade is multilateral• No country can just have bilateral trade• Too much emphasis on bilateral balances• Need not be a zero sum game, but gains are not equal• Exposes trading nations to external factors and makes them interdependent• Cannot survive without trade

Current Issues

• China has slowly allowed its currency to appreciate

• Japan has struggled to depreciate its currency's position

• Germany has resisted EU bailouts• Perimeter of EU barely hanging on to EuroRisks include:• Debt crisis worsening in EU and in US• Lack of consumer and business

confidence

Chinese YuanSource: St Louis Fed

Japanese YenSource: St Louis Fed

EuroSource: St Louis Fed

Trade Weighted Value of US$Source: St Louis Fed

Daily Foreign Exchange TradingSource: BIS via WSJ

Opportunity Costs

Everything has an opportunity cost

Resources (time, capital, labor) are finite

• Going to the movies• Going to college • Public infrastructure investments • Private financial investments

Sunk Costs

• An Economic Cost – that can be discounted.

• Should take them into account before deciding, but ....

• Example: Mortgage Loan Application Fees

Marginal Costs vsMarginal Benefits

To do something or not to do something – trade offs are critical to most decisions

• Related to opportunity costs Examples• Reducing carbon emissions

- Tire pressure rules in California???• Auto safety standards

Opportunity Set

• Group of available options• Involve Trade-offs, i.e. what is possible• Involve Budget Constraints• Time Constraints• Consumption Curve

Opportunity Set A group of available options

Budget constraints for individuals

DVDS

12

6

savings?

Borrowing?

$120 available

CDs

Production Possibility Curve and Diminishing Returns . . . for

societiesGuns

Butter

Note: Curved line vs. straight line

Diminishing Returns

Efficiency and productivity decline the more inputs are used

Trade Between Countries

• Countries trade to increase economic well-being. Trade will affect three main internal markets:

• Product• Labor• Capital

Comparative vs Absolute Advantage

Labor Cost of Producing Computers & Wheat

US Japan

Labor for one computer (# hrs) 100 120

Labor for one ton of wheat (# hrs) 5 8

Cost of one computer 20 tons of wheat 15 tons of wheat

Cost of 100 tons of wheat 5 computers 6.66 computers

PROBLEM #9Resources Needed

England Portugal

One bbl of wine

One bale of wool

One bbl of wine

One bale of wool

120 workers 100 workers 80 workers 90 workers

PROBLEM #9Resources Needed

England Portugal

One bbl of wine

One bale of wool

One bbl of wine

One bale of wool

1.2 balesof wool

0.833 bblsof wine

0.88 balesof wool

1.125 bblsof wine

Different Production Costs

Assumption:Single Product Production with 72,000

workers in each country

England Portugal

Bbls of wine Bales of wool Bbls of wine Bales of wool

600 0 900 0

0 720 0 800

OPPORTUNITY SETSWool

Wine

800 Portugal Production Possibilities

England Production Possibilities

720

900600

Assumption:Single Product Production with 72,000

workers in each country

England Portugal

Bbls of wine Bales of wool Bbls of wine Bales of wool

600 0 900 0

0 720 0 800

England Portugal

Wine Wool Wine Wool

300 bbls 360 bales 450 bbls 400 bales

Total Production/consumption: Wine: 750, wool: 760

Production/consumption with 36,000 workers in each sector; no trading

Why would Portugal Trade?

PROBLEM #9, cont.After trade: consumption outcome

England Portugal

Wine Wool Wine Wool

0 720 bales 855 bbls 40 bales

0 72,000 workers

68,400 workers 3,600 workers

Total Production: Wine: 855 (+105), wool: 760 (no change)

US China

Airplanes Garments Airplanes Garments

Initial Production Point 200 10,000 200 10,000

Revised Production Point 300 9,000 100 20,000

Net Change in Joint Production

No net change in aircraft production

9,000 net additional garments (in China)

Trade Possibilities

US Exports 100 aircraft, imports 4,500 garments

China imports 100 aircraft, exports 4,500 garments

Additional Consumption +3,500 garments (net) +4,500 garments (net)

Comparative Advantage vs. Absolute Advantage (see Stiglitz pp 42-43)

Comparative Costs for Airplanes and Garments

Production US China

100 airplanes 1,000 garments 10,000 garments

10,000 garments 1,000 airplanes 100 airplanes

PRODUCTION POSSIBILITIES(Stiglitz, p. 42-43)Garments

Airplanes Produced

20,000

China’s Production Possibilities

US Production Possibilities.

10,000

300

E’

E’’E

100 200

9,000

Marginal Rate of Transformation

PROBLEM #11Initial Situation with Total 240,000 worker hours, no trade and

labor equally divided among industries within countries

European Union United States

Car Truck Car Truck

Cost - Labor 100 600 80 400

0.166 trucks 6 cars 0.2 trucks 5 cars

Output # 1200 200 1500 300

Total Production: 2700 cars, 500 trucks

OPPORTUNITY SETSTrucks

Cars

600 U.S. Production Possibilities

EU Production Possibilities.

400

30002,400

PROBLEM #11Problem: Increase car production by 10 units, leave

Truck production unchanged

Private Consumption Consumption with Trade

EU US EU US

Cars Trucks Cars Trucks Cars Trucks Cars Trucks

1200 200 1500 300 1205 200 1505 300

Total cars: 2700 Total trucks: 500 Total cars: 2710 Total trucks: 500

PROBLEM #11Problem: Increase car production by 10 units, leave

Truck production unchanged

1. US produces 50 fewer cars and adds ten additional Trucks2. EU drops 10 Trucks, increases car production by 60 units3. US exchanges 10 Trucks with Europe for 55 cars