Shares of World Trade and Regional Trading Blocs
The United States is both the second largest exporter and the largest importer in the world’s economy. Thus, the United States generates the largest share of the $32.5 trillion in bilateral world trade (10.6 percent), comprising 8 percent of all exports and 13 percent of all imports. The next nine countries with the largest shares of world trade in 2008 were Germany (8.2 percent), China (7.9 percent), Japan (5 percent), France (4 percent), the Netherlands (4 percent), Italy (3 percent), United Kingdom (3 percent), Belgium (3 per- cent), and Canada (2.7 percent). Although these largest trading nations are predominantly
overcome the brand name barriers to entry in the U.S. market. International arbi- trage in goods and full attainment of PPP is partially prevented by the customer- switching costs imposed by these brand names. Most branded products compete in at least partially segmented domestic markets.
Second, even in the absence of branded products, PPP may fail to hold in the generic dish soap market because dirty dishes are immobile. Although the chemical ingredients, lemon scents, and hand softeners in Scala S.p.A.’s Patti Scala are virtu- ally identical to those in Harris Teeter Dish Soap, and despite the availability of surplus Patti Scala at 1,900 lire in Italy, the immobile dirty dish complements in consumption are located in the United States. One must therefore incorporate a transportation cost into these price comparisons. A delivered price of Patti Scala in the United States would be 1,900/2,284 lire = $0.84, plus perhaps 30 percent shipping cost—that is, $1.09. Transportation costs explain a substantial portion of the observed price differential between identical products priced in different currencies.
Still, one should ask, why do the prices of generic dish soap products shipped into another currency’s domestic market in the summer of 2001 differ by as much as $1.09 to $1.80? The answer lies in recognizing that purchasing power parity is a hypothesis about long-term price dynamics. Exchange rates often overshoot/under- shoot their equilibrium levels, and consequently the ratio of retail prices in one economy to the exchange rate-adjusted retail prices in another economy should be computed over several years. For example, two years earlier the Italian lira was much stronger than in the summer 2001; specifically, in June 1999, the U.S. dollar exchanged for just 1,665 lire, versus 2,248 lire in June 2001. With the suggested retail prices of Patti Scala and Dixan the same in 1999 as in 2001, Patti Scala at (1,900/1,665 lire = ) $1.14 + 30 percent transportation cost = $1.47 for 750 ml (i.e., $0.0020 per ml). This unit price in Italy is closely aligned with Harris Teeter’s unit price of $0.0022-per-ml for 828 ml of generic dish soap at $1.80. Furthermore, Dixan at (2,600/1,665 lire =) $1.56 + 30 percent transportation cost = $2.03 for 750 ml is nearly identical to Joy’s $1.99 price for 740 ml of branded dish soap.
In conclusion, successful brand name campaigns, the immobility of comple- ments, and temporary exchange rate overshooting/undershooting may create sig- nificant gaps between the final product prices of like products sold in different currencies. Nevertheless, a judicious use of PPP calculations can be very revealing.
Western-developed economies, the next six largest trading nations are predominantly rap- idly developing Asian economies: South Korea (2.6 percent), Hong Kong (2.3 percent), Russia (2.3 percent), Spain (2 percent), Singapore (2 percent), Mexico (1.9 percent), Tai- wan (1.5 percent), and India (1.4 percent). Altogether, the World Trade Organization (WTO) includes 149 nations who have agreed to share trade statistics, coordinate the lib- eralization of trade policy (i.e., the opening of markets), and cooperatively resolve their trade disputes in accordance with WTO rules and procedures.
Figure 6.9 shows that over the past two decades the import and export trade flows to and from the United States have grown to equal fully 31 percent of GDP; American exports are 13 percent of GDP or about $1.8 trillion worth of goods and services, of which 53 per- cent now goes to emerging markets. Some nations are much more export driven. In 2009, Germany and China both exported nearly $1.5 trillion but that represents a whopping 42 percent of German and 28 percent of Chinese GDP. British exports are 27 percent, Mex- ican exports are 35 percent, Canadian exports are 43 percent, South Korean exports are 53 percent, Malaysian exports are 93 percent, and Belgian exports are 177 percent of GDP!
Most nations continue to protect with tariffs and other trade barriers some infant or politically sensitive industries. France, for example, remains a largely agricultural polity and therefore lowers its agricultural subsidies only after great hand-wringing and ex- tended periods of tough negotiations with its European neighbors. The WTO’s Doha round of tariff-reduction negotiations was suspended in mid-2006 primarily because the EU refused to give up its€47 billion common agricultural policy (CAP). France receives
€10.6 billion of these CAP subsidies, 80 percent of which go not to rustic French family farms but rather to large French landholders for intensive industrial farming. The United States is hardly blameless as agricultural subsidies increased from 19 percent to 22 per- cent of total agricultural value, while the EU reduced agricultural subsidies from 47 per- cent to 35 percent over the period 1993–2003. Ethanol, sugar, and corn price support programs for small family farmers are embedded in American populist politics.
Today, the United States, the European Union (EU), and Canada have some of the lowest tariffs equivalent to 3 percent to 4 percent on imports. Mexico and India have FIGURE 6.8 The Growth of the Export Sector in the U.S. Economy
1997 98
Growth of export sector in U.S. economy
Export contribution Real GDP growth 20
16 12 6 4
1968 72 76 80 84 88 92 96 00 04 06 08 99 00 4
3 2 1 0
Panel (b)
Percent
Percent
Percent of GDP, 1968–2009 Panel (a)
03 04
01 02 05 06 07 08 09
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
some of the highest, equivalent to 12 percent to 15 percent. Fortunately, regional trading blocs like the EU and the North American Free Trade Agreement (NAFTA) have been highly successful in removing trade barriers, negotiating multilateral reductions in tariffs, and promoting free trade as a mechanism of peaceful competition between nations.
Across the world economy, six such regional trading blocs have emerged (see Figure 6.10). In South America, Argentina, Brazil, Paraguay, and Uruguay have formed one trading block (MERCOSUR) whose import-export merchandise trade doubled from 1996 to 2006 and is now approaching $600 billion, 80 percent of which is between the member countries (see Figure 6.11). The Andean group (Peru, Colombia, Bolivia, and Ecuador) has formed another trading bloc; both are attempts to mirror the NAFTA free trade area of Canada, the United States, and Mexico.27The Brazilian ($1.6 trillion), Canadian ($1.4 trillion) and Mexican ($1.2 trillion) economies are comparable in size, about one-tenth the size of the U.S. economy. Brazil, Mexico, and Argentina have large industrial bases protected by 14–16 percent import tariffs, whereas Paraguay, Bolivia, and Guatemala are commodity-based economies employing 6–8 percent import tariffs. The United States and Canada have 3.5 percent average import tariffs.
Trade disputes between Brazil and the United States have arisen over Brazilian steel, sugar, frozen orange juice, and ethanol exports to the United States. In 2009, Brazil FIGURE 6.9 U.S. Imports and Exports as a Percentage of GDP
Percent of world trade (%)
25
U.S. imports + exports as a percentage of GDP
1985 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 28
31
22
20
18
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
27Seven Southeast Asian (ASEAN) and 16 trans-Pacific economies including Japan and Mexico (APEC) have also formed trading blocs.
achieved oil independence through an extensive sugar cane-based ethanol industry pro- ducing over 5 billion gallons a year. Despite being the largest ethanol producer in the world with 6.5 billion gallons produced, the United States has effectively barred competi- tion by imposing a protective (“infant industry”) tariff on Brazilian ethanol. Other pro- ducers of ethanol are the EU with 570 million, China with 486 million, and Canada with 211 million gallons produced annually.28
Comparative Advantage and Free Trade
Within a regional trading bloc like EU, NAFTA, MERCOSUR, or APEC, each member can improve its economic growth by specializing in accordance with comparative advan- tage and then engaging in free trade. Intuitively, low-wage countries like Spain, Mexico, Puerto Rico, China, and Thailand enjoy a cost advantage in the manufacture of labor- intensive goods such as clothes and the provision of labor-intensive services like sewing or coupon claims processing. Suppose one of these economies also enjoys a cost advan- tage in more capital-intensive manufacturing like auto assembly. One of the powerful in- sights of international microeconomics is that in such circumstances, the low-cost economy should not produce both goods, but rather it should specialize in that produc- tion for which it has the lower relative cost, while buying the other product from its higher-cost trading partner. Let’s see how thislaw of comparative advantagein bilateral trade reaches such an apparently odd conclusion.
FIGURE 6.10 Regional Trading Zones (Percentage of World Trade, 2008)
Australia Brunei Canada Chile China Hong Kong Indonesia Japan Malaysia
1.2 0.1 2.7 0.4 7.9 2.3 0.8 4.8 1.1
Mexico New Zealand P.N.G.
Philippines Singapore South Korea Taiwan Thailand U.S.
1.9 0.3 0.0 0.4 2.0 2.6 1.5 1.1 10.6 APEC
Brunei Indonesia Malaysia Philippines Singapore Thailand Vietnam
0.1 0.8 1.1 0.4 2.0 1.1 0.2 ASEAN Argentina
Brazil Paraguay Uruguay Bolivia Chile
0.4 1.2 0.1 0.1 0.3 0.3 MERCOSUR
Austria Belgium/Lux.
Britain Denmark Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden
1.1 2.9 3.4 0.7 0.6 4.0 8.2 0.3 0.8 3.4 3.7 0.5 2.1 1.1 EU Canada
Mexico U.S.
2.7 1.9 10.6 NAFTA
Source: World Trade Organization;“Special Report on America’s Economy,”The Economist, April 3, 2010.
28“ADM Makes Ethanol Push into Brazil with Venture,”Wall Street Journal(November 5, 2008), p. B1.
law of comparative advantageA principle defending free trade and specialization in accordance with lower relative cost.
Consider the bilateral trade between the United States and Japan in automobile car- buretors and computer memory chips. Suppose the cost of production of carburetors in Japan is ¥10,000 compared to $120 in the United States. At an exchange rate of ¥100/$, the Japanese cost-covering price of $100 is lower than the U.S. cost-covering price of
$120. Suppose, in addition, that memory chips cost ¥8,000 in Japan compared to $300 in the United States. Again, the price of the Japanese product (i.e., $80) is lower than the price of the U.S. product. Japan is said to enjoy anabsolute cost advantage in the manufacture of both products. However, Japan is 83 percent (i.e., $100/$120) as expen- sive in producing carburetors as the United States while being only 27 percent (i.e., $80/
$300) as expensive in producing memory chips. Japan is said to have a comparative ad- vantage in memory chips and should specialize in the manufacture of that product.
The gains from specialization in accordance with comparative advantage and subse- quent trade are best demonstrated using the real terms of trade. Real terms of trade identify what amounts of labor effort, material, and other resources are required to pro- duce a product in one economy relative to another. In Japan, the manufacture of mem- ory chips requires the sacrifice of resources capable of manufacturing 0.8 carburetors (see Table 6.3), whereas in the United States the manufacture of a memory chip requires the sacrifice of 2.5 carburetors. That is, Japan’s relative cost of memory chips (in terms of FIGURE 6.11 Gross Domestic Product, Exports as a Percentage of GDP, and Average Import Tariffs for
MERCOSUR Countries
Bolivia
Chile
Uruguay
$92 bn, 58%, 12.3%
Argentina
$328 bn, 45%, 13.5%
Paraguay
$16 bn, 111%, 8%
Brazil
$1.61 trn, 26%, 14.3%
French Guiana Surinam
Guyana Venezuela Colombia Ecuador
Peru
absolute cost advantageA
comparison of nominal costs in two locations, companies, or economies.
real terms of trade Comparison of relative costs of production across economies.
carburetor production that must be forgone) is less than a third as great as the relative cost of memory chips in the United States. On the other hand, U.S. carburetor produc- tion requires the resources associated with only 0.4 U.S. memory chips, while Japanese carburetor production requires the sacrifice of 1.25 Japanese memory chips. The U.S. rel- ative cost of carburetors is much lower than that of the Japanese. Said another way, the Japanese are particularly productive in using resources to manufacture memory chips, and the United States is particularly productive in using similar resources to produce carburetors. Each country has a comparative advantage: the Japanese in producing mem- ory chips and the United States in producing carburetors.
Assess what happens to the total goods produced if each economy specializes in pro- duction in accordance with comparative advantage and then trades to diversify its con- sumption. Assume that the United States and Japan produced one unit of each product initially, that labor is immobile, that no scale economies are present, and that the quality of both carburetors and both memory chips is identical. If the Japanese cease production of carburetors and specialize in the production of memory chips, they increase memory chip production to 2.25 chips (see Table 6.3). Similarly, if the United States ceases pro- duction of memory chips and specializes in the production of carburetors, it increases carburetor production to 3.5 carburetors. In these circumstances, the United States could offer Japan 1.5 carburetors for a memory chip, and both parties would end up unambig- uously better off. The United States would enjoy a residual domestic production after trade of 2.0 carburetors plus the import of one memory chip. And the Japanese would enjoy a residual domestic production after trade of 1.25 memory chips plus the import of 1.5 carburetors. As demonstrated in Table 6.3, each economy would have replaced all the products they initially produced, plus each would enjoy additional amounts of both goods—that is, unambiguous gains from trade.
Import Controls and Protective Tariffs
Some nations reject free-trade policies and instead attempt to restrain the purchase of foreign imports in order to expand the production of their domestic industries by
TABLE 6.3 R E A L T E R M S O F T R A D E A N D C O M P A R A T I V E A D V A N T A G E
A B S O L U T E C O S T , U . S . A B S O L U T E C O S T , J A P A N
Automobile carburetors $120 ¥10,000
Computer memory chips $300 ¥8,000
R E L A T I V E C O S T , U . S . R E L A T I V E C O S T , J A P A N
Automobile carburetors $120/$300 = 0.4 Chips ¥10K/¥8K = 1.25 Chips
Computer memory chips $300/$120 = 2.5 Carbs ¥8K/¥10K = 0.8 Carbs
G A I N S F R O M T R A D E , U . S . G A I N S F R O M T R A D E , J A P A N
Initial goods 1.0 Carb + 1.0 Chip 1.0 Carb + 1.0 Chip
After specialization:
Carburetors produced (1.0 + 2.5) Carbs 0
Memory chips produced 0 (1.0 + 1.25) Chips
Trade +1.0 Chip +1.5 Carb
−1.5 Carb −1.0 Chip
Net goods 2.0 Carbs + 1.0 Chip 1.5 Carbs + 1.25 Chips
artificially raising the price of substitute foreign products using protective tariffs. Figure 6.12 shows that Hong Kong, the United States, and Australia have some of the lowest protective tariffs while Mexico and India have some of the highest. To further bar im- ports, some nations also imposedirect import controls like a maximum allowable quota of a specific type of foreign import. Once in the 1990s, to preserve American manufacturing jobs, the U.S. Congress imposed so-called voluntary import restraints (VIRs) on Japanese autos. In response, Toyota and Honda built assembly plants all over the United States, and laid-offGM, Ford, and Chrysler workers went to work build- ing Camrys and Accords. The same U.S. policy has now been proposed against Chinese- manufactured textiles.
National income is typically reduced by such import barriers. One reason why is be- cause trading partners who experience export growth often purchase more American- manufactured imports. As the Japanese export-driven economy accelerated in the past decade, Japanese households increased import consumption of fashion merchandise from Seven for Mankind, Apple, Gap, and Prada by 40 percent. Similarly, in this decade the most popular upscale car for a burgeoning class of new business owners in Shanghai is a Buick LeSabre. In 2010, GM is planning to export the Cadillac CTS to China and brand it as a Buick. A second reason for higher national income when import barriers are avoided arises because import controls lead inevitably to a reduction in the demand of a nation’s currency in the foreign exchange market. For example, when some Ameri- can households are prohibited from completing import purchases of Japanese- manufactured Toyotas and Hondas they would otherwise have bought, those households fail to request the Japanese yen they would have needed to accomplish the import pur- chases. As we studied earlier in the chapter, this reduced demand for the Japanese yen FIGURE 6.12 Trade-Weighted Tariffs, 2008
Hong Kong 0 Percent
3 6 9 12 15
Turkey United States Australia Canada EU Japan China Russia South Korea Brazil Mexico India
Source: World Bank database, 2009.
results in a higher FX value of the USD against the JPY, which in turn retards the U.S.
export sector, worsening the trade balance (exports minus imports), thereby decreasing U.S. national income. Better to resist import controls, while pressing our newest big trad- ing partner China to replace their managedfloat with a market-determined flexible ex- change rate.
In short, free trade and open markets offer the prospect of higher national income.
The World Bank estimates that developing countries with open economies grow by 4.5 percent per year, whereas those with import controls and protective tariffs grow by only 0.7 percent per year. Rich country comparisons also favored free trade: 2.3 percent to, again, 0.7 percent. In the 1990s, this gap widened still further. Those developing coun- tries whose import plus export trade as a percentage of GDP ranked in the top 50 per- centiles of developing countries had GDP growth per person of 5 percent. Those in the bottom 50 percentiles saw GDP growth per person actually shrink by 1 percent.29 Clearly, globalization and trade enhance prosperity, even in the lesser developed countries.
Thereareseveral valid arguments for trade restrictions (import quotas or tariffs): (1) to protectinfant industriesuntil they reach minimum efficient scale, (2) to offset govern- ment subsidies provided to foreign competitors with one’s owncountervailing duties,and (3) to impose antidumping sanctions for foreign goods sold below their domestic cost.
Chilean salmon, Argentine honey, and Brazilian frozen orange juice concentrate and slab steel have all been subject to U.S. antidumping duties in recent years. The Brazilians, in particular, claim that their export prices simply reflect a countervailing price reduction relative to their domestic cost in order to offset the enormous $30 billion in farm subsi- dies that the United States makes available to its agricultural sector. The United States does spend $20,000 per full-time farmer to subsidize agricultural products (third behind Switzerland’s $27,000 and Japan’s $23,000).
In April 2004, The WTO’s court agreed that cotton subsidies in the United States and sugar subsidies in EU protectorate Caribbean nations violated international trade rules.
The WTO has undertaken as part of its Doha round of trade talks to begin sorting out these claims and counterclaims on agricultural subsidies and steel duties. Whether the United States will ultimately be sustained in imposing antidumping sanctions on $8 bil- lion of steel or whether Brazil will be sustained in their countervailing duties to offset the massive U.S. agricultural subsidies remains to be seen.
The Case for Strategic Trade Policy
Although the logic of free trade has dominated academic debate since 1750, and the twentieth century saw the repeal of many import controls and tariffs, a few exceptions are worth noting. The WTO has very effectively spearheaded the negotiation of mutual trade liberalization policies. However,unilateral reduction of tariffs when trading part- ners stubbornly refuse to relax import controls or open their domestic markets seldom makes sense. The United States has found it necessary to threaten tariffs on Japanese consumer electronics, for example, in order to negotiate successfully the opening of Jap- anese markets to U.S. cellular phones and computer chips. This threat bargaining and negotiated mutual reduction of trade barriers illustrates the concept of “strategic trade policy.”
In the spring of 1999, continued EU import controls on U.S.-based Dole and Chiquita bananas from Central America led the United States to impose WTO-sanctioned duties on $180 million of European products from Louis Vuitton plastic handbags and British
29“Globalization, Growth and Poverty,”World Bank Report(December 2001).