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International Trade and Finance
|Page Number: 1|
|Globalization is a reality of modern life—and studies indicate the trend will continue. We conclude this course with a discussion about international trade and finance. Specifically, this lesson covers the actions that nation-states take to promote or discourage trade and examines the economic consequences of these and other actions.|
|Page Title: Menu Page|
|Page Number: 2|
|This lesson presents the following topics:|
· Markets and Trade
· Protectionist Policies
· How Exchange Rates Are Determined
· The Global Financial System Today
|Page Title: Markets and Trade|
|Page Number: 3|
|Let’s start with a discussion about the term “market.”|
Think of a local “farmers’ market” where you can buy fresh produce. A market is an arrangement that allows buyers and sellers to exchange things. I’ll give you cash if you give me a bunch of carrots.
A market system facilitates the exchange of money and products.
Markets exist because individuals are not self-sufficient, but instead consume many products produced by others. I don’t grow carrots in my garden; therefore, I need to buy them at the market.
|Page Title: Specialization and the Gains from Trade|
|Page Number: 4|
|Each of us specializes in producing just a few products and uses the market to exchange goods and services.|
Why do we specialize?
Answer: Because output for society as a whole will increase if the task of producing something is assigned to the country or person who can produce greater quantities of the product more efficiently.
We can use the Principle of Opportunity Cost to explain the benefits from specialization and trade.
According to the Principle of Opportunity Cost, the opportunity cost of something is what you sacrifice to get it – what you give up.
In the case of specialization, the opportunity cost is measured by what we do not produce because we are producing the good or service that we intend to sell or trade. For example, in the time it takes someone to perform routine maintenance on their car, they could instead mow their lawn and weed their garden. If that person specializes in performing car maintenance, he or she could probably make enough money working on one car to pay for lawn and garden care several times over.
|Page Title: Absolute Versus Comparative Advantage|
|Page Number: 5|
|One of the main theories to explain why one country specializes in one product but not another is the Theory of Comparative Advantage. Let’s explore the theory using an example.|
Consider the productivity table below. Who has the absolute advantage of producing more bread and items per hour?
| ||Bread per hour||Shirts per hour|
Of course it is Brenda.
|Page Title: Absolute Versus Comparative Advantage (Cont’d)|
|Page Number: 6|
|Although Brenda does have the absolute advantage [A country’s ability to produce a good at a lower absolute cost than another country] over Sam, the decision about who should specialize in the production of one good or the other is based on comparative advantage [A country’s ability to produce a good at an opportunity cost that is lower than the opportunity cost of another country], not on absolute advantage.|
Specialization is beneficial if there are differences in opportunity cost that generate a comparative advantage. With this in mind, let’s consider whether Brenda or Sam should specialize in the production of shirts.
|Page Title: Opportunity Cost and Comparative Advantage|
|Page Number: 7|
|Production per Hour and Opportunity Cost|
|Bread produced per hour||6||1|
|Shirts produced per hour||2||1|
|Opportunity cost of one loaf of bread||1 shirt|
|Opportunity cost of one shirt||3 loaves of bread||1 load of bread|
|Page Title: Opportunity Cost and Comparative Advantage (Cont’d)|
|Page Number: 8|
|According to this table:|
· Brenda sacrifices 3 loaves of bread for each shirt she produces.
· Sam sacrifices 1 loaf of bread for each shirt he produces.
With both of these factors in mind, who should specialize in the production of shirts? Brenda or Sam?
Answer: Sam should specialize in the production of shirts because he faces a lower opportunity cost in that activity.
|Page Title: Check Your Understanding|
|Page Number: 9|
|For each statement given below, select the most appropriate answer option.|
Statement 1: Comparative advantage is the ability of one person or nation to produce a good at an opportunity cost that is higher than the opportunity cost of another person or nation.
The correct answer is: False
|Page Title: Check Your Understanding (Cont’d)|
|Page Number: 10|
|Statement 2: Specialization is beneficial if there are differences in opportunity cost that generate a comparative advantage.|
The correct answer is: True
|Page Title: Markets and International Trade|
|Page Number: 11|
|Exports are goods produced in this country and sold elsewhere.|
Imports are goods produced elsewhere and sold in this country.
Trade among countries is based on the same principles of trade that function between individuals. Specialization based on comparative advantage results in gains for all participants. Smaller nations rely more on trade because they have fewer opportunities for specialization within their borders.
|Page Title: Protectionist Policies|
|Page Number: 12|
|We have learned that countries can maximize their welfare by specializing. However, this assumes that there is free trade so they can freely sell goods in which the country specializes. In reality, many countries restrict imports through protectionist measures.|
There are three common forms of protection that countries can institute when enacting a policy regarding international trade:
· A quota: A quota is a limit on the amount of a good that can be imported.
· A voluntary export restraint (VER): A voluntary restraint is where a nation voluntarily decreases its exports in an attempt to avoid more restrictive policies.
· A tariff: A tariff is a tax on imported goods.
Additionally, there are other ways a nation can limit imports without an official trade barrier:
· Strict enforcement of health and safety laws
· Allowing a customs system to be inefficient and sluggish
|Page Title: Effects of Trade Restrictions|
|Page Number: 13|
|We can illustrate the effects of trade restrictions with a simple supply and demand graph. Suppose that we plot shirts per day along the x axis and price per shirt (in dollars) along the y axis on the graph. Then we draw the curve for domestic demand for shirts. We also draw three different supply curves on the graph as follows:|
· The first supply curve depicts the total supply of shirts when there is free trade. Let’s assume that with free trade, the price of shirts is $12. This is the lowest supply curve on the graph.
· The second supply curve depicts the effects of trade barriers (an import quota, tariff, or voluntary export restraints). In this case, there is still some trade, and let’s say that the price of shirts is $20. This is the middle supply curve on the graph.
· The third supply curve represents a complete ban of imported shirts. With a total ban on imports, let’s say the price of shirts will be $23. This is the topmost supply curve on the graph.
Therefore, an import quota, a VER, or a tariff causes the total supply with free trade to shift to the left. The result is a lower quantity and higher price of the good in question to domestic consumers.
Domestic producers benefit from the trade restriction because they receive a higher price for their products.
|Page Title: Rationales for Protectionist Policies|
|Page Number: 14|
|There are arguments for and against protectionist policies. Three possible motivations for policies that restrict trade include:|
· To shield workers from foreign competition. For example, there are individuals in the United States who want to make it harder to move jobs abroad in order to protect American jobs. They are less motivated by the impact on the price of goods than on employment. Manufacturers counter that the effect would be higher prices on goods that would not be affordable by many.
· To nurture infant industries [A new industry that is protected from foreign competitors] until they mature. For example, a government may want to develop a car industry. For many years, it is likely that this new industry will make cars that are inferior to foreign alternatives as the company learns. Unless the company is protected, it will not be able to establish itself because customers will flock to the superior product. The counter to this argument is that consumers in the country are forced to fund development of the industry through the purchase of inferior products.
· To help domestic firms establish monopolies in world markets.
Arguments against protectionism include:
· In practice, protecting workers in industries that would be hurt by trade is difficult.
· Many displaced workers don’t have the skills to work in other sectors, and obtaining these skills takes time.
· Keeping tariffs in place to prevent temporary unemployment results in less efficient production, higher prices, and lower consumption.
|Page Title: Arguments Against Protectionism|
|Page Number: 15|
|Other arguments against protectionism include:|
· Protectionist policies are often defended on the grounds that they protect new or infant industries.
· In practice, infant industries rarely become competitive with their foreign rivals. In the 1950’s and 1960’s, Latin American countries used tariffs and other policies to protect their young industries, but the industries never became as efficient as foreign suppliers.
· Once an industry is given tariff protection, it is difficult to take that tariff protection away.
· If production of a particular good has very large economies of scale, the world market will support only a few firms.
· A nation might provide financial support to a firm to guarantee the firm will make a profit. A foreign firm would be reluctant to enter, so the domestic firm will capture the monopoly profit. But if two nations subsidize their domestic firms, both firms will enter the market and lose money.
· A nation may pick the wrong industry to subsidize.
|Page Title: Check Your Understanding|
|Page Number: 16|
|For each question given below, select the most appropriate answer option.|
Question 1: Exports are goods produced in this country and sold elsewhere. Imports are goods produced elsewhere and sold in this country. So under what principles does trade among countries function?
· Trade among countries is based on the same principles as trade between individuals.
· Trade among countries is based on the Export and Import Principles.
· Trade among countries is based on the Market Principle and the International Trade Policy.
· Trade among countries is prohibited.
The correct answer is: Trade among countries is based on the same principles as trade between individuals.
|Page Title: Check Your Understanding (Cont’d)|
|Page Number: 17|
|Question 2: What are the three possible motivations for policies that restrict trade?|
· To maintain a monopoly of the product, to penalize countries that do not adhere to domestic policies, and to restrict cash flow.
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