THE INTERNATIONAL ECONOMY AND GLOBALIZATION

Chapter 1

THE INTERNATIONAL ECONOMY AND GLOBALIZATION

CHAPTER OVERVIEW

This chapter introduces students to the international economy and to globalization. The first part of the chapter emphasizes the high degree of economic interdependence that characterizes today’s economies.Economic interdependence includes international trade and international finance.The chapter also focuses on the United States as an open economy and discusses globalization as a process of greater interdependence among countries and their citizens. Data provided shows U.S. exports as a percent of gross domestic product and the value of U.S. trade with its major trading partners. The chapter notes that many U.S. firms source a portion of the production of their goods in foreign countries, and that goods from all over the world are available in our local stores.The chapter discusses the nature of international competitiveness—for firms, industries, and nations. It is noted that exposure to global competition tends to improve the efficiency of firms.A breakout section discusses whether the United States is losing its innovation edge. This is in direct response to industrial leaders, such as Apple, that developed technology in the United States and now produce their high-tech products elsewhere. Some economists maintain that the manufacturing process (now done abroad) drives innovation, thus when the U.S. loses its manufacturing, its technological edge will follow.Other economists disagree and cite trade and international competition as key drivers for America’s technological prowess.This chapter discusses the potential effects that international trade has on workers, and concludes with a look at the backlash against globalization that has emerged in recent years. The advantages and disadvantages of globalization are summarized.

After completing the chapter, students should be able to:

•Define economic interdependence.•Discuss the importance of international trade for the U.S. economy.•Examine the factors that make a company American.•Discuss the nature of competitiveness and how it applies to firms, industries, and nations.•Identify the advantages and disadvantages of globalization to workers and others.(International Economics, 17e Robert Carbaugh) (Instructor Manual all Chapters) 1 / 4

BRIEF ANSWERS TO STUDY QUESTIONS

1.Interdependence among today's economies reflects the historical evolution of the world's economic and political order. Since World War II, Europe and Japan have reindustrialized. What is more, the formation of the European Community and the Organization of Petroleum Exporting Countries, as well as the rise of multinational corporations, has contributed to closer economic and political linkages.

2.Proponents of an open trading system maintain that free trade leads to lower prices, the development of more efficient production methods, and a greater range of consumption choices. Free trade permits resources to move from their lowest productivity to their highest productivity. Critics of an open trading system maintain that import competition may displace domestic firms and workers. It is also argued that during periods of national emergency, it is in the best interests of a nation to protect strategic industries.

3.For the United States, growing economic interdependence has resulted in exports and imports increasing as a share of national output. Profits of domestic firms and wages of domestic workers are increasingly being affected by foreign competition.

4.The volume of international trade is governed by factors including the level of domestic economic activity (e.g., prosperity versus recession) and restrictions imposed by countries on their imports.

5.The chapter describes three fallacies of international trade:

• Trade is a zero sum activity
• Imports reduce employment and burden the economy.
• Tariffs and quotas will save jobs and promote a higher level of employment.

6.International competitiveness refers to the extent to which the goods of a firm or industry can compete in the marketplace; this competitiveness depends on the relative prices and qualities of products. No nation can be competitive in, and thus be a net exporter of, everything. Because a nation’s stock of resources is limited, the ideal is for these resources to be used in their most productive manner.Nations will benefit from specialization and trade by exporting products having a comparative advantage.

7.Researchers have found that global competitiveness is a bit like sports. You get better by playing against folks who are better than you. This means companies that are exposed to intense global competition tend to be more productive than those who aren’t.

8.International trade benefits most workers, especially those in exporting industries. In addition to providing them with jobs and income, it allows them to shop for consumption goods that are the cheapest and of the highest quality. However, workers in import-competing industries often feel threatened from competition of cheap foreign labor.

9.Among the challenges confronting the international trading system are maintaining fair standards for labor and promoting environmental quality. 2 / 4

CHAPTER 2

FOUNDATIONS OF MODERN TRADE THEORY: COMPARATIVE ADVANTAGE

CHAPTER OVERVIEW

This chapter introduces students to the foundations of modern trade theory, which seeks to answer three questions: (1) What constitutes the basis for trade? (2) At what terms of trade are products exchanged in the world market? (3) What are the gains from trade in terms of production and consumption?The chapter first examines the historical development of modern trade theory by introducing the ideas of the mercantilists Adam Smith and David Ricardo. Next, the deficiencies of mercantilism, including David Hume’s price-specie-flow doctrine and Adam Smith’s principle of absolute advantage, are noted.The discussion continues with an explanation of the principle of comparative advantage in terms of a production possibilities table and also in terms of money. Trading under conditions of constant opportunity cost and increasing opportunity cost are then discussed in detail. Attention then shifts to the determination of the equilibrium terms of trade. The chapter emphasizes the theory of reciprocal demand and offer curves in the determination of the equilibrium terms of trade. The effect of economic growth on the terms of trade is also examined, as is empirical data regarding the terms of trade. This chapter also discusses the role of demand in the trading model. The inclusion of demand allows us to determine the autarky point on each nation’s production possibilities frontier, the equilibrium value of the international terms of trade, and the equilibrium consumption point of each nation under free trade. Trading under a hypothetical constant-cost condition helps us to determine the basis for international trade and the direction of that trade as well as the potential gains from that trade for the nations involved and the world at large. Another philosopher, John Stuart Mill, asserts that the actual terms of trade are determined by the relative strength of each country’s demand for the other country’s product (Theory of Reciprocal Demand).Although the analysis concludes that international trade can provide economic gains for all trading nations, the chapter discusses the impact of trade on jobs, and recounts the case of Wooster, Ohio, which bore the brunt of globalization. The chapter then extends the principle of comparative advantage to more than two products and two countries, and notes the importance of being unimportant. A discussion of factor mobility and exit barriers follows. Next, the chapter examines the empirical evidence regarding comparative advantage, and discusses comparative advantage and global supply chains. Examples of firms for whom outsourcing was successful include the U.S. auto industry, and Apple, Inc. But the experience of Boeing demonstrates the potential for damage when a firm gives up control of its production process.The chapter concludes with a recounting of the number of firms (e.g. Caterpillar, Ford Motor Company, Google, Apple, and General Electric) who have reshored at least of some of their production facilities to the U.S., for reasons ranging from a narrowing wage gap to the proximity of suppliers.

After completing the chapter, students should be able to:

• Identify the trading ideas of the mercantilists Adam Smith and David Ricardo.• Compare and contrast the principle of absolute advantage and the principle of comparative advantage.• Identify the effects of comparative advantage under conditions of constant opportunity costs and increasing opportunity costs.• Explain how exit barriers modify the conclusions of the principle of comparative advantage.• Summarize the empirical evidence regarding comparative advantage.• Explain how changing supply and demand conditions influence the equilibrium terms of trade.• Identify the factors leading to the decision by some U.S. firms to reshore some production facilities. 3 / 4

BRIEF ANSWERS TO STUDY QUESTIONS

1.Modern trade theory addresses the following questions: (1) What constitutes the basis for trade? (2) At what terms of trade do nations export and import certain products? (3) What are the gains from trade in terms of production and consumption?

2.The mercantilists maintained that government should stimulate exports and restrict imports so as to increase a nation's holdings of gold. A nation could only gain at the expense of other nations because not all nations could simultaneously have a trade surplus. Smith maintained that with free trade, international specialization of resources in production leads to an increase in world output, which can be shared by both trading partners. All nations simultaneously can enjoy gains from trade in terms of production and consumption.

3.Assume that by devoting all of its resources to the production of steel, France can produce 40 tons. By devoting all of its resources to televisions, France can produce 60 televisions. Comparable figures for Japan are 20 tons of steel and 10 televisions. In this example, France has an absolute advantage in the production of steel and televisions. France has a comparative advantage in televisions.

4.Ignoring the role of demand's impact on market prices, Smith and Ricardo maintained that a country's competitive position is underlaid by supply conditions. Smith's trade theory is based on absolute costs, while comparative costs underlie Ricardo's trade theory.

5.The principle of comparative advantage can be explained in opportunity cost, which indicates the amount of one product that must be sacrificed in order to release enough resources to be able to produce one more unit of another product. The slope of the production possibilities curve (i.e., the marginal rate of transformation) indicates this rate of sacrifice. A nation facing a straight-line production possibilities curve produces under conditions of constant costs, while production under increasing costs refers to a bowed-out (i.e., concave) production possibilities curve.

6.Constant opportunity costs refer to a situation where the cost of each additional unit of one product in terms of another product remains the same. Constant costs occur when resources are completely adaptable to alternative uses. Under increasing cost conditions, a nation must sacrifice more and more of one product to produce each additional unit of another product. Increasing costs occur when resources are not completely adaptable to alternative uses.

7.Where a nation produces along its production possibilities curve in autarky affects the nation's comparative costs under increasing cost conditions. This is because the slope of a bowed-out production possibilities curve, which indicates the marginal rate of transformation, varies at each point along the curve. Under conditions of constant costs, the production possibilities curve is a straight line.The marginal rate of transformation does not change in response to movements along the production possibilities curve.

8.Under constant opportunity cost conditions, specialization is complete. A country can devote all of its resources to the production of a good without losing its comparative advantage. Under increasing cost conditions, specialization tends to be partial. As production costs rise with expanded production, the home country eventually loses its comparative advantage.

9.Production gains from trade refer to the increased output of goods and services made possible by the international division of labor and specialization. Consumption gains from trade refer to the increased amount of goods made available to consumers as the result of international trade.

10.The trade triangle includes a nation's exports, its imports, and international terms of trade.

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