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30.1: The International Sector: An Introduction

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  • Learning Objectives

    1. Discuss the main arguments economists make in support of free trade.
    2. Explain the determinants of net exports and tell how each affects aggregate demand.

    How important is international trade?

    Take a look at the labels on some of your clothing. You are likely to find that the clothes in your closet came from all over the globe. Look around any parking lot. You may find cars from Japan, Korea, Sweden, Britain, Germany, France, and Italy—and even the United States! Do you use a computer? Even if it is an American computer, its components are likely to have been assembled in Indonesia or in some other country. Visit the grocery store. Much of the produce may come from Latin America and Asia.

    The international market is important not just in terms of the goods and services it provides to a country, but as a market for that country’s goods and services. Because foreign demand for U.S. exports is almost as large as investment and government purchases as a component of aggregate demand, it can be very important in terms of growth. The increase in exports from 2000 to 2007, for example, accounted for almost 20% of the gain in U.S. real GDP during that period. For the period 2004 to 2007, the increase in exports accounted for about 30% of the gain.

    The Case for Trade

    International trade increases the quantity of goods and services available to the world’s consumers. By allocating resources according to the principle of comparative advantage, trade allows nations to consume combinations of goods and services they would be unable to produce on their own, combinations that lie outside each country’s production possibilities curve.

    A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than can other countries. If each country specializes in the production of goods in which it has a comparative advantage and trades those goods for things in which other countries have a comparative advantage, global production of all goods and services will be increased. The result can be higher levels of consumption for all.

    If international trade allows expanded world production of goods and services, it follows that restrictions on trade will reduce world production. That, in a nutshell, is the economic case for free trade. It suggests that restrictions on trade, such as a tariff, a tax imposed on imported goods and services, or a quota, a ceiling on the quantity of specific goods and services that can be imported, reduce world living standards.

    The conceptual argument for free trade is a compelling one; virtually all economists support policies that reduce barriers to trade. Economists were among the most outspoken advocates for the 1993 ratification of the North American Free Trade Agreement (NAFTA), which virtually eliminated trade restrictions between Mexico, the United States, and Canada, and the 2004 Central American Free Trade Agreement (CAFTA), which did the same for trade between the United States, Central America, and the Dominican Republic. Most economists have also been strong supporters of worldwide reductions in trade barriers, including the 1994 ratification of the General Agreement on Tariffs and Trade (GATT), a pact slashing tariffs and easing quotas among 117 nations, including the United States, and the Doha round of World Trade Organization negotiations, named after the site of the first meeting in Doha, Qatar, in 2001 and still continuing. In Europe, member nations of the European Union (EU) have virtually eliminated trade barriers among themselves, and 15 EU nations now have a common currency, the euro, and a single central bank, the European Central Bank, established in 1999. Trade barriers have also been slashed among the economies of Latin America and of Southeast Asia. A treaty has been signed that calls for elimination of trade barriers among the developed nations of the Pacific Rim (including the United States and Japan) by 2010 and among all Pacific rim nations by 2020.

    The global embrace of the idea of free trade demonstrates the triumph of economic ideas over powerful forces that oppose free trade. One source of opposition to free trade comes from the owners of factors of production used in industries in which a nation lacks a comparative advantage.

    A related argument against free trade is that it not only reduces employment in some sectors but also reduces employment in the economy as a whole. In the long run, this argument is clearly wrong. The economy’s natural level of employment is determined by forces unrelated to trade policy, and employment moves to its natural level in the long run.

    Further, trade has no effect on real wage levels for the economy as a whole. The equilibrium real wage depends on the economy’s demand for and supply curve of labor. Trade affects neither.

    In the short run, trade does affect aggregate demand. Net exports are one component of aggregate demand; a change in net exports shifts the aggregate demand curve and affects real GDP in the short run. All other things unchanged, a reduction in net exports reduces aggregate demand, and an increase in net exports increases it.

    Protectionist sentiment always rises during recessions. The recession that began in the United States in 2007 is no exception. The stimulus bill contained a provision ordering U.S. government agencies and contractors to purchase goods and services produced in the United States in preference to goods and services from other countries. Our trading partners have already begun threatening a trade war as a result of this provision. The stimulus bill does say that the “buy America first” provision should be “consistent with international obligations.” As yet, it is not clear how significant this provision would become.

    The Rising Importance of International Trade

    International trade is important, and its importance is increasing. From 1965 to 2007, world output rose by about 300%. But the gains in total exports were even more spectacular; they soared by over 1,000%!

    While international trade was rising around the world, it was playing a more significant role in the United States as well. In 1960, exports represented just 3.5% of real GDP; by 2010, exports accounted for 12.6% of real GDP. Figure 30.1 “U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2010” shows the growth in exports and imports as a percentage of real GDP in the United States from 1960 to 2010.

    Why has world trade risen so spectacularly? Two factors have been important. First, advances in transportation and communication have dramatically reduced the costs of moving goods around the globe. The development of shipping containerization that allows cargo to be moved seamlessly from trucks or trains to ships, which began in 1956, drastically reduced the cost of moving goods around the world, by as much as 90%. As a result, the numbers of container ships and their capacities have markedly increased1. Second, we have already seen that trade barriers between countries have fallen and are likely to continue to fall.

    Figure 30.1 U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2010


    The chart shows exports and imports as a percentage of real GDP from 1960 through the third quarter of 2010.

    Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (Revised November 23, 2010). Data are through the third quarter of 2010.