What Happens When a Country Has an Absolute Advantage in All Goods
Intra-industry Trade between Similar Economies
The Benefits of Reducing Barriers to International Trade
Measuring Trade Balances
Trade Balances in Historical and International Context
Trade Balances and Flows of Financial Capital
The National Saving and Investment Identity
The Pros and Cons of Trade Deficits and Surpluses
The Difference between Level of Trade and the Trade Balance
6.1 Introduction
We live in a global marketplace. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery, airplanes, cars, scientific instruments, or many other technology-related industries, the odds are good that a hearty proportion of the sales of your employer—and hence the money that pays your salary—comes from export sales. We are all linked by international trade, and the volume of that trade has grown dramatically in the last few decades.
The first wave of globalization started in the nineteenth century and lasted up to the beginning of World War I. Over that time, global exports as a share of global GDP rose from less than 1% of GDP in 1820 to 9% of GDP in 1913. As the Nobel Prize-winning economist Paul Krugman of Princeton University wrote in 1995:
It is a late-twentieth-century conceit that we invented the global economy just yesterday. In fact, world markets achieved an impressive degree of integration during the second half of the nineteenth century. Indeed, if one wants a specific date for the beginning of a truly global economy, one might well choose 1869, the year in which both the Suez Canal and the Union Pacific railroad were completed. By the eve of the First World War steamships and railroads had created markets for standardized commodities, like wheat and wool, that were fully global in their reach. Even the global flow of information was better than modern observers, focused on electronic technology, tend to realize: the first submarine telegraph cable was laid under the Atlantic in 1858, and by 1900 all of the world’s major economic regions could effectively communicate instantaneously.
This first wave of globalization crashed to a halt early in the twentieth century. World War I severed many economic connections. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others. World War II further hindered international trade. Global flows of goods and financial capital were rebuilt only slowly after World War II. It was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I.
Figure 6.1: While the iPhone is readily recognized as an Apple product, 26% of the component costs in it come from components made by rival phone-maker, Samsung. In international trade, there are often “conflicts” like this as each country or company focuses on what it does best. (Credit: modification of work by Yutaka Tsutano Creative Commons)
Note
JUST WHOSE IPHONE IS IT?
The iPhone is a global product. Apple does not manufacture the iPhone components, nor does it assemble them. The assembly is done by Foxconn Corporation, a Taiwanese company, at its factory in Sengzhen, China. But, Samsung, the electronics firm and competitor to Apple, actually supplies many of the parts that make up an iPhone—representing about 26% of the costs of production. That means, that Samsung is both the biggest supplier and biggest competitor for Apple.
Why do these two firms work together to produce the iPhone? To understand the economic logic behind international trade, you have to accept, as these firms do, that trade is about mutually beneficial exchange. Samsung is one of the world’s largest electronics parts suppliers. Apple lets Samsung focus on making the best parts, which allows Apple to concentrate on its strength—designing elegant products that are easy to use. If each company (and by extension each country) focuses on what it does best, there will be gains for all through trade.
6.2 Absolute and Comparative Advantage
Section Learning Objectives
Define absolute advantage, comparative advantage, and opportunity costs
Explain the gains of trade created when a country specializes
The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever ruined by trade.” Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decades—for example, Japan, South Korea, China, and India—have done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.
In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.
A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a country’s natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of “drilling a hole.” Producing oil in other countries can require considerable exploration and costly technologies for drilling and extraction—if they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world’s richest copper mines. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage.
Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: “What do we give up to produce this good?” It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity. For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land and financial resources to produce other goods such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simplify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantage in greater detail and relates them to trade.
6.2.1 A Numerical Example of Absolute and Comparative Advantage
Video - Comparative Advantage
Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 17.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.
Table 6.1: How Many Hours It Takes to Produce Oil and Corn
Country
Oil (hours per barrel)
Corn (hours per bushel)
Saudi Arabia
1
4
United States
2
1
In Table 17.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing corn.
To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 6.2). Figure 6.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.
Table 6.2: Production Possibilities before Trade
Country
Oil Prod. using 100 worker hours (barrels)
Corn Prod. using 100 worker hours (bushels)
Saudi Arabia
100 or
25
United States
50 or
100
Figure 6.2: Production Possibilities Frontiers. Panel (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.
These graphs illustrate the production possibilities frontier before trade for both Saudi Arabia and the United States using the data in the table titled “Production Possibilities before Trade”. The x-axis plots corn production, measured by bushels, and the y-axis plots oil, in terms of barrels. All points above the frontier are impossible to produce given the current level of resources and technology.
(a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table.
(b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.
Arguably Saudi and U.S. consumers desire both oil and corn to live. Let’s say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table shows. Given the information in Table, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn.
Table 6.3: Production before Trade
Country
Oil Production (barrels)
Corn Production (bushels)
Saudi Arabia (C)
60
10
United States (C')
20
60
Total World Production
80
70
The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn.
The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 6.4 summarizes these calculations.
Table 6.4: Opportunity Cost and Comparative Advantage
Country
Opportunity cost of one unit: Oil
| (in terms of corn)
Opportunity cost of one unit: Corn
| (in terms of oil)
Saudi Arabia
\(\frac{1}{4}\)
4
United States
2
\(\frac{1}{2}\)
Again recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, (\(\frac{1}{4} < 2\) in Table 6.4) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.
In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 6.3), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 6.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.
Note
CAN A PRODUCTION POSSIBILITY FRONTIER BE STRAIGHT?
When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same.
In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.
6.2.2 Gains from Trade
Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded in Table 6.5. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receives in exchange an amount of oil greater than 20 barrels, it will gain from trade.
With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the chapter Welcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table illustrates the range of trades that would benefit both sides.
Table 6.5: The Range of Trades That Benefit Both the United States and Saudi Arabia
The U.S. economy, after specialization,
| will benefit if it: ,
The Saudi Arabian economy,
after specialization will benefit
| if it:
Exports no more than 60 bushels of corn
Imports at least 10 bushels of corn
Imports at least 20 barrels of oil
Exports less than 60 barrels of oil
The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.
Note
WHAT ARE THE OPPORTUNITY COSTS AND GAINS FROM TRADE?
The range of trades that will benefit each country is based on the country’s opportunity cost of producing each good. The United States can produce 100 bushels of corn or 50 barrels of oil. For the United States, the opportunity cost of producing one barrel of oil is two bushels of corn. If we divide the numbers above by 50, we get the same ratio: one barrel of oil is equivalent to two bushels of corn, or (100/50 = 2 and 50/50 = 1).
In a trade with Saudi Arabia, if the United States is going to give up 100 bushels of corn in exports, it must import at least 50 barrels of oil to be just as well off. Clearly, to gain from trade it needs to be able to gain more than a half barrel of oil for its bushel of corn—or why trade at all?
Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 6.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 6.2 to that in Table 6.6.)
Table 6.6: How Specialization Expands Output
Country
Quantity produced after 100%
| specialization — Oil (barrels)
Quantity produced after 100%
| specialization — Corn (bushels)
Saudi Arabia
100
0
United States
0
100
World Production
100
100
What if we did not have complete specialization, as in Table 6.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 6.3 shows. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.
Figure 6.3: Production Possibilities Frontier in Saudi Arabia. Trade allows a country to go beyond its domestic production-possibility frontier
On this graph, Corn is on the x-axis with a maximum production of 25 bushels and oil is on the y-axis with a maximum production of 100 barrels. Saudi Arabia begins producing and consuming at point C (coordinates 10, 60). If the “trade price” is 20 barrels of oil for 20 bushels of corn, the Saudis end up at D (coordinates 30, 40).
Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade.
Key Concepts and Summary
A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product.
A country has a comparative advantage when it can produce a good at a lower cost in terms of other goods.
Countries that specialize based on comparative advantage gain from trade.
Self-Check Questions
True or False: The source of comparative advantage must be natural elements like climate and mineral deposits. Explain.
Brazil can produce 100 pounds of beef or 10 autos. In contrast the United States can produce 40 pounds of beef or 30 autos. Which country has the absolute advantage in beef? Which country has the absolute advantage in producing autos? What is the opportunity cost of producing one pound of beef in Brazil? What is the opportunity cost of producing one pound of beef in the United States?
In France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Who has the absolute advantage in production of sweaters? Who has the absolute advantage in the production of wine? How can you tell?
What is absolute advantage? What is comparative advantage?
Under what conditions does comparative advantage lead to gains from trade?
What factors does Paul Krugman identify that supported expanding international trade in the 1800s?
Are differences in geography behind the differences in absolute advantages?
Why does the United States not have an absolute advantage in coffee?
Look at Exercise. Compute the opportunity costs of producing sweaters and wine in both France and Tunisia. Who has the lowest opportunity cost of producing sweaters and who has the lowest opportunity cost of producing wine? Explain what it means to have a lower opportunity cost.
6.3 What Happens When a Country Has an Absolute Advantage in All Goods
Chapter Learning Objectives
Show the relationship between production costs and comparative advantage
Identify situations of mutually beneficial trade
Identify trade benefits by considering opportunity costs
What happens to the possibilities for trade if one country has an absolute advantage in everything? This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Good students of Ricardo understand that trade is about mutually beneficial exchange. Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one’s comparative advantage.
6.3.1 Production Possibilities and Comparative Advantage
Consider the example of trade between the United States and Mexico described in Table 6.7. In this example, it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.
Table 6.7: Resources Needed to Produce Shoes and Refrigerators
Country
Number of Workers needed
| to produce 1,000 units — Shoes
Number of Workers needed
| to produce 1,000 units — Refrigerators
United States
4 workers
1 worker
Mexico
5 workers
4 workers
Absolute advantage simply compares the productivity of a worker between countries. It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, “How much am I giving up to produce this good in this country?” Another way of looking at this is that comparative advantage identifies the good for which the producer’s absolute advantage is relatively larger, or where the producer’s absolute productivity disadvantage is relatively smaller.
The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico’s comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes.
6.3.2 Benefits from Specialization (The Ricardian Trade Model)
When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibility frontier is a useful tool to visualize this benefit. This theory was developed by British Economist David Ricardo (1772--1823).
Consider a situation where the United States and Mexico each have 40 workers. For example, as Table 6.8 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced.
Table 6.8: Production Possibilities before Trade with Complete Specialization
Country
Shoe Production — using 40 workers
Refrigerator Production — using 40 workers
U.S.
10,000 shoes or
40,000 refrigerators
Mexico
8,000 shoes or
10,000 refrigerators
As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the former (see Figure 6.4).
Figure 6.4: Production Possibility Frontiers (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.
The graphs show two production possibility frontiers (PPFs) for the United States (graph a) and Mexico (graph b). The PPFs are linear. The x-axis plots refrigerators and the y-axis plots shoes. (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. Point B is where they end up after trade.
Let’s say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 6.9 shows the output of each good for each country and the total output for the two countries.
Table 6.9: Total Production at Point A before Trade
Country
Current Shoe Production
Current Refrigerator Production
U.S.
5,000
20,000
Mexico
4,000
5,000
Total
9,000
25,000
Continuing with this scenario, suppose that each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.S. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 × 1,000). Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but production of shoes increases by 2,000 pairs (10/5 × 1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 6.10.
The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States.
Table 6.10: Shifting Production Toward Comparative Advantage Raises Total Output
Country
Shoe Production
Refrigerator Production
U.S.
3,500
26,000
Mexico
6,000
2,500
Total
9,500
28,500
This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and in return import shoes.
6.3.3 How Opportunity Cost Sets the Boundaries of Trade
This example shows that both parties can benefit from specializing in their comparative advantages and trading. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.
Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators (see Figure and Table). Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico will be unambiguously better off. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off.
The range of trades that can benefit both nations is shown in Table 6.11. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade.
The Range of Trades That Benefit Both the United States and Mexico
Table 6.11: The Range of Trades That Benefit Both the United States and Mexico
The U.S. economy, after specialization will benefit if it:
================================ Exports fewer than 6,000 refrigerators
The Mexican economy, after specialization will benefit if it:
================================ Imports at least 2,500 refrigerators
Imports at least 1,500 pairs of shoes
Exports no more than 2,000 pairs of shoes
Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico.
The theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. The following Work It Out feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production.
Note
CALCULATING ABSOLUTE AND COMPARATIVE ADVANTAGE
In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber.
Table 6.12: 2 Country Example
Country
Oil (barrels)
Lumber (tons)
Canada
20 or
40
Venezuela
60 or
30
Who has the absolute advantage in the production of oil or lumber? How can you tell?
Which country has a comparative advantage in the production of oil?
Which country has a comparative advantage in producing lumber?
In this example, is absolute advantage the same as comparative advantage, or not?
In what product should Canada specialize? In what product should Venezuela specialize?
To calculate absolute advantage, look at the larger of the numbers for each product. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20.
Step 3.
To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. 1 oil = 2 lumber. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Calculate the same way for Venezuela: 60 oil = 30 lumber. Divide both sides of the equation by 60. One oil in Venezuela has an opportunity cost of 1/2 lumber. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil.
Step 4.
Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by 40. The opportunity cost of one lumber is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by 30. One lumber has an opportunity cost of two oil. Canada has the lower opportunity cost in producing lumber.
Step 5.
In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil.
Step 6.
Canada should specialize in the commodity for which it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.
6.3.4 Terms of Trade and Consumption Possibilities Curve
The terms of trade (TOT) is the rate at which units of one product can be exchanged for units of another product. It is typically expressed as the price of the export good over the price of the import good:
The consumption possibilities curve shows the combinations of two goods that a nation can consume when it specializes in producing one good and trades with another nation.
6.3.5 Comparative Advantage Goes Camping
To build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work?
Of course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like all mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage—that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain.
Key Concepts and Summary
Even when a country has high levels of productivity in all goods, it can still benefit from trade.
Gains from trade come about as a result of comparative advantage.
By specializing in a good that it gives up the least to produce, a country can produce more and offer that additional output for sale.
If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries.
Self-Check Questions
Is it possible to have a comparative advantage in the production of a good but not to have an absolute advantage? Explain.
How does comparative advantage lead to gains from trade?
You just overheard your friend say the following: “Poor countries like Malawi have no absolute advantages. They have poor soil, low investments in formal education and hence low-skill workers, no capital, and no natural resources to speak of. Because they have no advantage, they cannot benefit from trade.” How would you respond?
You just got a job in Washington, D.C. You move into an apartment with some acquaintances. All your roommates, however, are slackers and do not clean up after themselves. You, on the other hand, can clean faster than each of them. You determine that you are 70% faster at dishes and 10% faster with vacuuming. All of these tasks have to be done daily. Which jobs should you assign to your roommates to get the most free time overall? Assume you have the same number of hours to devote to cleaning. Now, since you are faster, you seem to get done quicker than your roommate. What sorts of problems may this create? Can you imagine a trade-related analogy to this problem?
6.4 Intra-industry Trade between Similar Economies
Chapter Learning Objectives
Identify at least two advantages of intra-industry trading
Explain the relationship between economies of scale and intra-industry trade
Absolute and comparative advantages explain a great deal about global trading patterns. For example, they help to explain the patterns that we noted at the start of this chapter, like why you may be eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin America are able to sell a substantial proportion of their exports to higher productivity regions like the European Union and North America. Comparative advantage, however, at least at first glance, does not seem especially well-suited to explain other common patterns of international trade.
6.4.1 The Prevalence of Intra-industry Trade between Similar Economies
The theory of comparative advantage suggests that trade should happen between economies with large differences in opportunity costs of production. Roughly half of all world trade involves shipping goods between the fairly similar high-income economies of the United States, Canada, the European Union, Japan, Mexico, and China (see Table 6.13).
Moreover, the theory of comparative advantage suggests that each economy should specialize to a degree in certain products, and then exchange those products. A high proportion of trade, however, is intra-industry trade—that is, trade of goods within the same industry from one country to another. For example, the United States produces and exports autos and imports autos.
Table 6.14 shows some of the largest categories of U.S. exports and imports. In all of these categories, the United States is both a substantial exporter and a substantial importer of goods from the same industry. In 2014, according to the Bureau of Economic Analysis, the United States exported $146 billion worth of autos, and imported $327 billion worth of autos. About 60% of U.S. trade and 60% of European trade is intra-industry trade.
Why do similar high-income economies engage in intra-industry trade? What can be the economic benefit of having workers of fairly similar skills making cars, computers, machinery and other products which are then shipped across the oceans to and from the United States, the European Union, and Japan? There are two reasons: (1) The division of labor leads to learning, innovation, and unique skills; and (2) economies of scale.
6.4.2 Gains from Specialization and Learning
Consider the category of machinery, where the U.S. economy has considerable intra-industry trade. Machinery comes in many varieties, so the United States may be exporting machinery for manufacturing with wood, but importing machinery for photographic processing. The underlying reason why a country like the United States, Japan, or Germany produces one kind of machinery rather than another is usually not related to U.S., German, or Japanese firms and workers having generally higher or lower skills. It is just that, in working on very specific and particular products, firms in certain countries develop unique and different skills.
Specialization in the world economy can be very finely split. In fact, recent years have seen a trend in international trade, which economists call splitting up the value chain. The value chain describes how a good is produced in stages. As indicated in the beginning of the chapter, producing the iPhone involves designing and engineering the phone in the United States, supplying parts from Korea, assembling the parts in China, and advertising and marketing in the United States. Thanks in large part to improvements in communication technology, sharing information, and transportation, it has become easier to split up the value chain. Instead of production in a single large factory, different firms operating in various places and even different countries can divide the value chain. Because firms split up the value chain, international trade often does not involve nations trading whole finished products like automobiles or refrigerators. Instead, it involves shipping more specialized goods like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade between similar countries produces economic gains because it allows workers and firms to learn and innovate on particular products—and often to focus on very particular parts of the value chain.
6.4.3 Economies of Scale, Competition, Variety
A second broad reason that intra-industry trade between similar nations produces economic gains involves economies of scale. The concept of economies of scale, as we introduced in Production, Costs and Industry Structure, means that as the scale of output goes up, average costs of production decline—at least up to a point.
Figure 6.5 illustrates economies of scale for a plant producing toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm or at a certain manufacturing plant. The vertical axis measures the average cost of production. Production plant S produces a small level of output at 30 units and has an average cost of production of $30 per toaster oven. Plant M produces at a medium level of output at 50 units, and has an average cost of production of $20 per toaster oven. Plant L produces 150 units of output with an average cost of production of only $10 per toaster oven. Although plant V can produce 200 units of output, it still has the same unit cost as Plant L.
In this example, a small or medium plant, like S or M, will not be able to compete in the market with a large or a very large plant like L or V, because the firm that operates L or V will be able to produce and sell its output at a lower price. In this example, economies of scale operate up to point L, but beyond point L to V, the additional scale of production does not continue to reduce average costs of production.
Figure 6.5: Economies of Scale. Production Plant S, has an average cost of production of $30 per toaster oven. Production plant M has an average cost of production of $20 per toaster oven. Production plant L has an average cost of production of only $10 per toaster oven. Production plant V still has an average cost of production of $10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce more cheaply on average than plant L.
The graph shows declining average costs. The x-axis plots the quantity of production or the scale of the plant and the y-axis plots the average costs. The average cost curve is a declining function, starting at (30, 30) with plant S, declining at a decreasing rate to (150, 10) with plant L, and (200, 10) with plant V, as explained in the text.
The concept of economies of scale becomes especially relevant to international trade when it enables one or two large producers to supply the entire country. For example, a single large automobile factory could probably supply all the cars consumers purchase in a smaller economy like the United Kingdom or Belgium in a given year. However, if a country has only one or two large factories producing cars, and no international trade, then consumers in that country would have relatively little choice between kinds of cars (other than the color of the paint and other nonessential options). Little or no competition will exist between different car manufacturers.
International trade provides a way to combine the lower average production costs that come from economies of scale and still have competition and variety for consumers. Large automobile factories in different countries can make and sell their products around the world. If General Motors, Ford, and Chrysler were the only players in the U.S. automobile market, the level of competition and consumer choice would be considerably lower than when U.S. carmakers must face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia, Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and responsiveness to what consumers want. America’s car producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure, especially from East Asian and European carmakers.
6.4.4 Dynamic Comparative Advantage
The sources of gains from intra-industry trade between similar economies—namely, the learning that comes from a high degree of specialization and splitting up the value chain and from economies of scale—do not contradict the earlier theory of comparative advantage. Instead, they help to broaden the concept.
In intra-industry trade, climate or geography do not determine the level of worker productivity. Even the general level of education or skill does not determine it. Instead, how firms engage in specific learning about specialized products, including taking advantage of economies of scale determine the level of worker productivity. In this vision, comparative advantage can be dynamic—that is, it can evolve and change over time as one develops new skills and as manufacturers split the value chain in new ways. This line of thinking also suggests that countries are not destined to have the same comparative advantage forever, but must instead be flexible in response to ongoing changes in comparative advantage.
Key Concepts and Summary
A large share of global trade happens between high-income economies that are quite similar in having well-educated workers and advanced technology.
These countries practice intra-industry trade, in which they import and export the same products at the same time, like cars, machinery, and computers.
In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in very particular tasks and from economies of scale.
Splitting up the value chain means that several stages of producing a good take place in different countries around the world.
Self-Check Questions
What is intra-industry trade?
What are the two main sources of economic gains from intra-industry trade?
What is splitting up the value chain?
Does intra-industry trade contradict the theory of comparative advantage?
Do consumers benefit from intra-industry trade?
Why might intra-industry trade seem surprising from the point of view of comparative advantage?
6.5 The Benefits of Reducing Barriers to International Trade
Chapter Learning Objectives
Explain tarrifs as barriers to trade
Identify at least two benefits of reducing barriers to international trade
Tariffs are taxes that governments place on imported goods for a variety of reasons. Some of these reasons include protecting sensitive industries, for humanitarian reasons, and protecting against dumping. Traditionally, tariffs were used simply as a political tool to protect certain vested economic, social, and cultural interests. The World Trade Organization (WTO) is committed to lowering barriers to trade. The world’s nations meet through the WTO to negotiate how they can reduce barriers to trade, such as tariffs. WTO negotiations happen in “rounds,” where all countries negotiate one agreement to encourage trade, take a year or two off, and then start negotiating a new agreement. The current round of negotiations is called the Doha Round because it was officially launched in Doha, the capital city of Qatar, in November 2001. In 2009, economists from the World Bank summarized recent research and found that the Doha round of negotiations would increase the size of the world economy by $160 billion to $385 billion per year, depending on the precise deal that ended up being negotiated.
In the context of a global economy that currently produces more than $30 trillion of goods and services each year, this amount is not huge: it is an increase of 1% or less. But before dismissing the gains from trade too quickly, it is worth remembering two points.
First, a gain of a few hundred billion dollars is enough money to deserve attention! Moreover, remember that this increase is not a one-time event; it would persist each year into the future.
Second, the estimate of gains may be on the low side because some of the gains from trade are not measured especially well in economic statistics. For example, it is difficult to measure the potential advantages to consumers of having a variety of products available and a greater degree of competition among producers. Perhaps the most important unmeasured factor is that trade between countries, especially when firms are splitting up the value chain of production, often involves a transfer of knowledge that can involve skills in production, technology, management, finance, and law.
Low-income countries benefit more from trade than high-income countries do. In some ways, the giant U.S. economy has less need for international trade, because it can already take advantage of internal trade within its economy. However, many smaller national economies around the world, in regions like Latin America, Africa, the Middle East, and Asia, have much more limited possibilities for trade inside their countries or their immediate regions. Without international trade, they may have little ability to benefit from comparative advantage, slicing up the value chain, or economies of scale. Moreover, smaller economies often have fewer competitive firms making goods within their economy, and thus firms have less pressure from other firms to provide the goods and prices that consumers want.
The economic gains from expanding international trade are measured in hundreds of billions of dollars, and the gains from international trade as a whole probably reach well into the trillions of dollars. The potential for gains from trade may be especially high among the smaller and lower-income countries of the world.
6.5.1 From Interpersonal to International Trade
Most people find it easy to believe that they, personally, would not be better off if they tried to grow and process all of their own food, to make all of their own clothes, to build their own cars and houses from scratch, and so on. Instead, we all benefit from living in economies where people and firms can specialize and trade with each other.
The benefits of trade do not stop at national boundaries, either. Earlier we explained that the division of labor could increase output for three reasons: (1) workers with different characteristics can specialize in the types of production where they have a comparative advantage; (2) firms and workers who specialize in a certain product become more productive with learning and practice; and (3) economies of scale. These three reasons apply from the individual and community level right up to the international level. If it makes sense to you that interpersonal, intercommunity, and interstate trade offer economic gains, it should make sense that international trade offers gains, too.
International trade currently involves about $20 trillion worth of goods and services moving around the globe. Any economic force of that size, even if it confers overall benefits, is certain to cause disruption and controversy. This chapter has only made the case that trade brings economic benefits. Other chapters discuss, in detail, the public policy arguments over whether to restrict international trade.
Note
IT’S APPLE’S (GLOBAL) IPHONE
Apple Corporation uses a global platform to produce the iPhone. Now that you understand the concept of comparative advantage, you can see why the engineering and design of the iPhone is done in the United States. The United States has built up a comparative advantage over the years in designing and marketing products, and sacrifices fewer resources to design high-tech devices relative to other countries.
China has a comparative advantage in assembling the phone due to its large skilled labor force. Korea has a comparative advantage in producing components. Korea focuses its production by increasing its scale, learning better ways to produce screens and computer chips, and uses innovation to lower average costs of production. Apple, in turn, benefits because it can purchase these quality products at lower prices. Put the global assembly line together and you have the device with which we are all so familiar.
Key Concepts and Summary
Tariffs are placed on imported goods as a way of protecting sensitive industries, for humanitarian reasons, and for protection against dumping.
Traditionally, tariffs were used as a political tool to protect certain vested economic, social, and cultural interests.
The WTO has been, and continues to be, a way for nations to meet and negotiate in order to reduce barriers to trade.
The gains of international trade are very large, especially for smaller countries, but are beneficial to all.
Self-Check Questions
If the removal of trade barriers is so beneficial to international economic growth, why would a nation continue to restrict trade on some imported or exported products?
Are the gains from international trade more likely to be relatively more important to large or small countries?
In World Trade Organization meetings, what do you think low-income countries lobby for?
Why might a low-income country put up barriers to trade, such as tariffs on imports?
Can a nation’s comparative advantage change over time? What factors would make it change?
6.6 Measuring Trade Balances
Chapter Learning Objectives
Measuring Trade Balances
Trade Balances in Historical and International Context
Trade Balances and Flows of Financial Capital
The National Saving and Investment Identity
The Pros and Cons of Trade Deficits and Surpluses
The Difference between Level of Trade and the Trade Balance
Explain merchandise trade balance, current account balance, and unilateral transfers
Identify components of the U.S. current account balance
Calculate the merchandise trade balance and current account balance using import and export data for a country
The balance of trade (or trade balance) is any gap between a nation’s dollar value of its exports, or what its producers sell abroad, and a nation’s dollar value of imports, or the foreign-made products and services that households and businesses purchase. Recall from The Macroeconomic Perspective that if exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports and imports are equal, then trade is balanced, but what happens when trade is out of balance and large trade surpluses or deficits exist?
Germany, for example, has had substantial trade surpluses in recent decades, in which exports have greatly exceeded imports. According to the Central Intelligence Agency’s The World Factbook, in 2016, Germany ran a trade surplus of $295 billion. In contrast, the U.S. economy in recent decades has experienced large trade deficits, in which imports have considerably exceeded exports. In 2016, for example, U.S. imports exceeded exports by $502 billion.
A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. These crises begin with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their money to other countries. The economy then drops into deep recession, with real GDP often falling up to 10% or more in a single year. This happened to Mexico in 1995 when their GDP fell 8.1%. A number of countries in East Asia—Thailand, South Korea, Malaysia, and Indonesia—succumbed to the same economic illness in 1997–1998 (called the Asian Financial Crisis). In the late 1990s and into the early 2000s, Russia and Argentina had the identical experience. What are the connections between imbalances of trade in goods and services and the flows of international financial capital that set off these economic avalanches?
We will start by examining the balance of trade in more detail, by looking at some patterns of trade balances in the United States and around the world. Then we will examine the intimate connection between international flows of goods and services and international flows of financial capital, which to economists are really just two sides of the same coin. People often assume that trade surpluses like those in Germany must be a positive sign for an economy, while trade deficits like those in the United States must be harmful. As it turns out, both trade surpluses and deficits can be either good or bad. We will see why in this chapter.
Figure 6.6: We are all part of the global financial system, which includes many different currencies. (Credit: modification of work by epSos.de/Flickr Creative Commons)
Note
MORE THAN MEETS THE EYE IN THE CONGO
How much do you interact with the global financial system? Do you think not much? Think again. Suppose you take out a student loan, or you deposit money into your bank account. You just affected domestic savings and borrowing. Now say you are at the mall and buy two T-shirts “made in China,” and later contribute to a charity that helps refugees. What is the impact? You affected how much money flows into and out of the United States. If you open an IRA savings account and put money in an international mutual fund, you are involved in the flow of money overseas. While your involvement may not seem as influential as that of someone like the president, who can increase or decrease foreign aid and, thereby, have a huge impact on money flows in and out of the country, you do interact with the global financial system on a daily basis.
The balance of payments—a term you will meet soon—seems like a huge topic, but once you learn the specific components of trade and money, it all makes sense. Along the way, you may have to give up some common misunderstandings about trade and answer some questions: If a country is running a trade deficit, is that bad? Is a trade surplus good? For example, look at the Democratic Republic of the Congo (often referred to as “Congo”), a large country in Central Africa. In 2013, it ran a trade surplus of $1 billion, so it must be doing well, right? In contrast, the trade deficit in the United States was $508 billion in 2013. Do these figures suggest that the United States economy is performing worse than the Congolese economy? Not necessarily. The U.S. trade deficit tends to worsen as the economy strengthens. In contrast, high poverty rates in the Congo persist, and these rates are not going down even with the positive trade balance. Clearly, it is more complicated than simply asserting that running a trade deficit is bad for the economy. You will learn more about these issues and others in this chapter.
A few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported between countries as a way of measuring the balance of trade. Economists call this measurement is called the merchandise trade balance. In most high-income economies, including the United States, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers that have made it possible to export or import customer services, finance, law, advertising, management consulting, software, construction engineering, and product design. Most global trade still takes the form of goods rather than services, and the government announces and the media prominently report the merchandise trade balance. Old habits are hard to break. Economists, however, typically rely on broader measures such as the balance of trade or the current account balance which includes other international flows of income and foreign aid.
6.6.1 Components of the U.S. Current Account Balance
Table 6.15 breaks down the four main components of the U.S. current account balance for the last quarter of 2015 (seasonally adjusted). The first line shows the merchandise trade balance; that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. We can explain how the government collects this trade information in the following Clear It Up feature.
Table 6.15: Components of the U.S. Current Account Balance for 2015 (in billions)
Value of Exports (money
| flowing into U.S.)
Value of Imports (money
| flowing out of U.S.)
Ba lance
Goods
$410.0
$595.5
–$ 185.3
Services
$180.4
$122.3
$58.1
Income receipts
and payments
$203.0
$152.4
$50.6
Unilateral
transfers
$27.3
$64.4
–
$37.1
Current account
balance
$820.7
$934.4
–$ 113.7
Note
HOW DOES THE U.S. GOVERNMENT COLLECT TRADE STATISTICS?
Do not confuse the balance of trade (which tracks imports and exports), with the current account balance, which includes not just exports and imports, but also income from investment and transfers.
The Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce compiles statistics on the balance of trade using a variety of different sources. Merchandise importers and exporters must file monthly documents with the Census Bureau, which provides the basic data for tracking trade. To measure international trade in services—which can happen over a telephone line or computer network without shipping any physical goods—the BEA carries out a set of surveys. Another set of BEA surveys tracks investment flows, and there are even specific surveys to collect travel information from U.S. residents visiting Canada and Mexico. For measuring unilateral transfers, the BEA has access to official U.S. government spending on aid, and then also carries out a survey of charitable organizations that make foreign donations.
The BEA then cross-checks this information on international flows of goods and capital against other available data. For example, the Census Bureau also collects data from the shipping industry, which it can use to check the data on trade in goods. All companies involved in international flows of capital—including banks and companies making financial investments like stocks—must file reports, which the U.S. Department of the Treasury ultimately checks. The BEA also can cross check information on foreign trade by looking at data collected by other countries on their foreign trade with the United States, and also at the data collected by various international organizations. Take these data sources, stir carefully, and you have the U.S. balance of trade statistics. Much of the statistics that we cite in this chapter come from these sources.
The second row of Table 6.15 provides data on trade in services. Here, the U.S. economy is running a surplus. Although the level of trade in services is still relatively small compared to trade in goods, the importance of services has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-half of U.S. exports of goods in 2015, compared to one-fifth in 1980.
The third component of the current account balance, labeled “income payments,” refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States). The reason for including this money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is happening in the financial capital market.
The final category of the current account balance is unilateral transfers, which are payments that government, private charities, or individuals make in which they send money abroad without receiving any direct good or service. Economic or military assistance from the U.S. government to other countries fits into this category, as does spending abroad by charities to address poverty or social inequalities. When an individual in the United States sends money overseas, as is the case with some immigrants, it is also counted in this category. The current account balance treats these unilateral payments like imports, because they also involve a stream of payments leaving the country. For the U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991, for example, when the United States led an international coalition against Saddam Hussein’s Iraq in the Gulf War, many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.
The following Work It Out feature steps you through the process of using the values for goods, services, and income payments to calculate the merchandise balance and the current account balance.
Note
CALCULATING THE MERCHANDISE BALANCE AND THE CURRENT ACCOUNT BALANCE
Table 6.16: Calculating Merchandise Balance and Current Account Balance
Item
Exports (in $ billions)
Imports (in $ billions)
Balance
Goods Services Income payments Unilateral transfers Current account balance
Use the information given below to fill in Table 6.16, and then calculate:
The merchandise balance
The current account balance
Known information:
Unilateral transfers: $130
Exports in goods: $1,046
Exports in services: $509
Imports in goods: $1,562
Imports in services: $371
Income received by U.S. investors on foreign stocks and bonds: $561
Income received by foreign investors on U.S. assets: $472
Step 1.
Focus on goods and services first. Enter the dollar amount of exports of both goods and services under the Export column.
Step 2.
Enter imports of goods and services under the Import column.
Step 3.
Under the Export column and in the row for Income payments, enter the financial flows of money coming back to the United States. U.S. investors are earning this income from abroad.
Step 4.
Under the Import column and in the row for Income payments, enter the financial flows of money going out of the United States to foreign investors. Foreign investors are earning this money on U.S. assets, like stocks.
Step 5.
Unilateral transfers are money flowing out of the United States in the form of, for example, military aid, foreign aid, and global charities. Because the money leaves the country, enter it under Imports and in the final column as well, as a negative.
Step 6.
Calculate the trade balance by subtracting imports from exports in both goods and services. Enter this in the final Balance column. This can be positive or negative.
Step 7.
Subtract the income payments flowing out of the country (under Imports) from the money coming back to the United States (under Exports) and enter this amount under the Balance column.
Step 8.
Enter unilateral transfers as a negative amount under the Balance column.
Step 9.
The merchandise trade balance is the difference between exports of goods and imports of goods—the first number under Balance.
Step 10.
Now sum up your columns for Exports, Imports, and Balance. The final balance number is the current account balance.
The merchandise balance of trade is the difference between exports and imports. In this case, it is equal to $1,046 – $1,562, a trade deficit of –$516 billion. The current account balance is –$419 billion. See the completed Table 6.17.
Table 6.17: Completed Merchandise Balance and Current Account Balance
Value of Exports (money flowing into U.S.)
Value of Imports (money flowing out of U.S.)
Ba lance
Goods
$1,510.3
$2,272.9
–$ 762.6
Services
$750.9
$488.7
$ 262.2
Income receipts
and payments
$782.9
$600.5
$ 182.4
Unilateral
transfers
$128.6
$273.6
–$ 145.0
Current account
balance
$3,172.7
$3,635.7
–$ 463.0
Key Concepts and Summary
The trade balance measures the gap between a country’s exports and its imports.
In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half.
The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services.
The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers.
Self-Check Questions
If foreign investors buy more U.S. stocks and bonds, how would that show up in the current account balance?
If the trade deficit of the United States increases, how is the current account balance affected?
State whether each of the following events involves a financial flow to the Mexican economy or a financial flow out of the Mexican economy:
: a. Mexico imports services from Japan b. Mexico exports goods to Canada c. U.S. investors receive a return from past financial investments in Mexico
If imports exceed exports, is it a trade deficit or a trade surplus? What about if exports exceed imports?
What is included in the current account balance?
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Explain why such a statement is economically impossible.
A government official announces a new policy. The country wishes to eliminate its trade deficit, but will strongly encourage financial investment from foreign firms. Explain why such a statement is contradictory.
6.7 Trade Balances in Historical and International Context
Chapter Learning Objectives
Analyze graphs of the current account balance and the merchandise trade balance
Identify patterns in U.S. trade surpluses and deficits
Compare the U.S. trade surpluses and deficits to other countries' trade surpluses and deficits
Code
import osimport numpy as npimport pandas as pdimport matplotlib.pyplot as pltimport seaborn as snstitleSize =16sns.set_style("whitegrid", {'grid.linestyle': ':'})max_year =2026# max year in time series graphs# -----------------------------------------------------------------------------## Load datadf_a = pd.read_csv('Graphs/Annual_FRED.csv', header=0, index_col=0, parse_dates=True)df_q = pd.read_csv('Graphs/Quarterly_FRED.csv', header=0, index_col=0, parse_dates=True)df_m = pd.read_csv('Graphs/Monthly_FRED.csv', header=0, index_col=0, parse_dates=True)# -----------------------------------------------------------------------------df_q['ExportsTrill'] = df_q['Exports']/1000df_q['ImportsTrill'] = df_q['Imports']/1000df_q['GDPTrill'] = df_q['GDP']/1000df_q['GNPTrill'] = df_q['GNP']/1000df_q['realGDPTrill'] = df_q['rGDP']/1000df_q['ExportsGDP'] = df_q['Exports']/df_q['GDP']*100df_q['ImportsGDP'] = df_q['Imports']/df_q['GDP']*100df_q['TradeBalance'] = (df_q['Exports']-df_q['Imports'])/df_q['GDP']*100
Code
df_q[['Exports', 'Imports']].plot(style = ['-', '--'], linewidth=2)plt.title('U.S. Exports and Imports', fontsize=titleSize)plt.ylabel('Billion Current US$')plt.show()
Figure 6.7: US exports and imports in billion USD
Code
df_q[['ExportsGDP', 'ImportsGDP']].plot(style = ['-', '--'], linewidth=2)plt.title('U.S. Exports and Imports Shares of GDP', fontsize=titleSize)plt.ylabel('%')plt.show()
Figure 6.8: US exports and imports as percent of GDP
Figure 6.9: US trade balance is Exports minus Imports as share of GDP
Code
df_q['CurrentAccountBill'] = df_q['CurrentAccount']/1000(df_q[['CA-old', 'CurrentAccountBill']]).plot(style = ['-','--'], linewidth=2)plt.title('U.S. Current Account Balance', fontsize=titleSize)plt.axhline(y=0, xmin=0, xmax = max_year, linewidth=2, linestyle='--', color='black')plt.ylabel('Billion Current US$')plt.show()
Figure 6.10: Current account balance
In Figure 6.7 we show the time series plots of US exports and imports in billions of current US dollars.
In Figure 6.8 we show exports and imports as fraction of GDP. In Figure 6.9 we show the trade balance as percent of GDP. The trade balance is the difference between exports and imports. Finally, in Figure 6.10 we show the current account balance in billions of USD.
We present the history of the U.S. current account balance in recent decades in several different ways. Figure 6.11 (a) shows the current account balance and the merchandise trade balance in dollar terms. Figure 6.11 (b) shows the current account balance and merchandise account balance yet again, this time as a share of the GDP for that year. By dividing the trade deficit in each year by GDP in that year, Figure 6.11 (b) factors out both inflation and growth in the real economy.
Figure 6.11: Panel (a) The current account balance and the merchandise trade balance in billions of dollars from 1960 to 2015. If the lines are above zero dollars, the United States was running a positive trade balance and current account balance. If the lines fall below zero dollars, the United States is running a trade deficit and a deficit in its current account balance. (b) This shows the same items—trade balance and current account balance—in relationship to the size of the U.S. economy, or GDP, from 1960 to 2015.
By either measure, the U.S. balance of trade pattern is clear. From the 1960s into the 1970s, the U.S. economy had mostly small trade surpluses—that is, the graphs in Figure show positive numbers. However, starting in the 1980s, the trade deficit increased rapidly, and after a tiny surplus in 1991, the current account trade deficit became even larger in the late 1990s and into the mid-2000s. However, the trade deficit declined in 2009 after the recession had taken hold, then rebounded partially in 2010 and has remained stable up through 2016.
Table 6.18 shows the U.S. trade picture in 2013 compared with some other economies from around the world. While the U.S. economy has consistently run trade deficits in recent years, Japan and many European nations, among them France and Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa; and China, India, and Korea.
The first column offers one measure of an economy's globalization: exports of goods and services as a percentage of GDP. The second column shows the trade balance. Usually, most countries have trade surpluses or deficits that are less than 5% of GDP. As you can see, the U.S. current account balance is –2.6% of GDP, while Germany's is 8.4% of GDP.
The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and then had even larger trade deficits in the late 1990s and early 2000s.
As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad, while a trade surplus necessarily means a net outflow of financial capital from an economy to other countries.
Self-Check Questions
In what way does comparing a country’s exports to GDP reflect its degree of globalization?
At one point Canada’s GDP was $1,800 billion and its exports were $542 billion. What was Canada’s export ratio at this time?
The GDP for the United States is $18,036 billion and its current account balance is –$484 billion. What percent of GDP is the current account balance?
Why does the trade balance and the current account balance track so closely together over time?
In recent decades, has the U.S. trade balance usually been in deficit, surplus, or balanced?
If a country is a big exporter, is it more exposed to global financial crises?
If countries reduced trade barriers, would the international flows of money increase?
6.8 Trade Balances and Flows of Financial Capital
Chapter Learning Objectives
Explain the connection between trade balances and financial capital flows
Calculate comparative advantage
Explain balanced trade in terms of investment and capital flows
As economists see it, trade surpluses can be either good or bad, depending on circumstances, and trade deficits can be good or bad, too. The challenge is to understand how the international flows of goods and services are connected with international flows of financial capital. In this module we will illustrate the intimate connection between trade balances and flows of financial capital in two ways: a parable of trade between Robinson Crusoe and Friday, and a circular flow diagram representing flows of trade and payme
6.8.1 A Two-Person Economy: Robinson Crusoe and Friday
To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Crusoe, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.
Robinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts, or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a trade surplus.
However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.
This parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in economic terms. The first issue that this story of Robinson and Friday raises is this: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.
The parable raises a second issue: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether Robinson repays that loan as planned, in full and on time. Perhaps Robinson spends several months loafing and never builds the irrigation system, or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which turns out not to be very productive. Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as he previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Why the repayment failed is likely to shape Friday’s attitude toward these renegotiations. If Robinson worked very hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If Robinson loafed or if he just refuses to pay, Friday may become irritated.
A third issue that the parable raises is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. To economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital. This last insight is worth exploring in greater detail, which we will do in the following section.
The story of Robinson and Friday also provides a good opportunity to consider the law of comparative advantage, which you learn more about in the International Trade chapter. The following Work It Out feature steps you through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain in the 1800s.
Note
CALCULATING COMPARATIVE ADVANTAGE
In the 1800s, the United States and Britain traded wheat and cloth. Table 6.19 shows the varying hours of labor per unit of output.
Table 6.19: U.S. and Britain
Country
Wheat (in bushels)
Cloth (in yards)
Relative labor cost of wheat \(\frac{P_w}{P_c}\)
Relative labor cost of cloth \(\frac{P_c}{P_w}\)
U.S.
8
9
8/9
9/8
Britain
4
3
4/3
3/4
Step 1.
Observe from Table that, in the United States, it takes eight hours to supply a bushel of wheat and nine hours to supply a yard of cloth. In contrast, it takes four hours to supply a bushel of wheat and three hours to supply a yard of cloth in Britain.
Step 2.
Recognize the difference between absolute advantage and comparative advantage. Britain has an absolute advantage (lowest cost) in each good, since it takes a lower amount of labor to make each good in Britain. Britain also has a comparative advantage in the production of cloth (lower opportunity cost in cloth (3/4 versus 9/8)). The United States has a comparative advantage in wheat production (lower opportunity cost of 8/9 versus 4/3).
Step 3.
Determine the relative price of one good in terms of the other good. The price of wheat, in this example, is the amount of cloth you have to give up. To find this price, convert the hours per unit of wheat and cloth into units per hour. To do so, observe that in the United States it takes eight hours to make a bushel of wheat, so workers can process 1/8 of a bushel of wheat in an hour. It takes nine hours to make a yard of cloth in the United States, so workers can produce 1/9 of a yard of cloth in an hour. If you divide the amount of cloth (1/9 of a yard) by the amount of wheat you give up (1/8 of a bushel) in an hour, you find the price (8/9) of one good (wheat) in terms of the other (cloth).
6.8.2 The Balance of Trade as the Balance of Payments
The connection between trade balances and international flows of financial capital is so close that economists sometimes describe the balance of trade as the balance of payments. Each category of the current account balance involves a corresponding flow of payments between a given country and the rest of the world economy.
Figure 6.12 shows the flow of goods and services and payments between one country—the United States in this example—and the rest of the world. The top line shows U.S. exports of goods and services, while the second line shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the rest of the world. Flow of goods and services (lines one and three) show up in the current account, while we find flow of funds (lines two and four) in the financial account.
The bottom four lines in Figure 6.12 show the flows of investment income. In the first of the bottom lines, we see investments made abroad with funds flowing from the home country to the rest of the world. Investment income stemming from an investment abroad then runs in the other direction from the rest of the world to the home country. Similarly, we see on the bottom third line, an investment from the rest of the world into the home country and investment income (bottom fourth line) flowing from the home country to the rest of the world. We find the investment income (bottom lines two and four) in the current account, while investment to the rest of the world or into the home country (lines one and three) is in the financial account. This figure does not show unilateral transfers, the fourth item in the current account.
Figure 6.12: Flow of Investment Goods and Capital. Each element of the current account balance involves a flow of financial payments between countries. The top line shows exports of goods and services leaving the home country; the second line shows the money that the home country receives for those exports. The third line shows imports that the home country receives; the fourth line shows the payments that the home country sent abroad in exchange for these imports.
The illustration shows relationships and transactions between a home country (box on the left) and the rest of the world (box on the right). The home country will provide exports, payment for imports, foreign investment, and investment income paid to the rest of the world. The rest of the world will provide payment for exports, imports, investment income received, and investment from abroad to the home country.
A current account deficit means that, the country is a net borrower from abroad. Conversely, a positive current account balance means a country is a net lender to the rest of the world. Just like the parable of Robinson and Friday, the lesson is that a trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad, while a deficit in the current account balance is exactly equal to the overall or net inflow of foreign investment capital from abroad.
It is important to recognize that an inflow and outflow of foreign capital does not necessarily refer to a debt that governments owe to other governments, although government debt may be part of the picture. Instead, these international flows of financial capital refer to all of the ways in which private investors in one country may invest in another country—by buying real estate, companies, and financial investments like stocks and bonds.
Key Concepts and Summary
International flows of goods and services are closely connected to the international flows of financial capital.
A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world.
A current account surplus is the opposite and means the country is a net lender to the rest of the world.
Self-Check Questions
State whether each of the following events involves a financial flow to the U.S. economy or away from the U.S. economy:
: a. Export sales to Germany
b. Returns paid on past U.S. financial investments in Brazil
c. Foreign aid from the U.S. government to Egypt
d. Imported oil from the Russian Federation
e. Japanese investors buying U.S. real estate
How does the bottom portion of Figure, showing the international flow of investments and capital, differ from the upper portion?
Explain the relationship between a current account deficit or surplus and the flow of funds.
Does a trade surplus mean an overall inflow of financial capital to an economy, or an overall outflow of financial capital? What about a trade deficit?
Is it better for your country to be an international lender or borrower?
6.9 The National Saving and Investment Identity
Chapter Learning Objectives
Explain the determinants of trade and current account balance
Identify and calculate supply and demand for financial capital
Explain how a nation's own level of domestic saving and investment determines a nation's balance of trade
Predict the rising and falling of trade deficits based on a nation's saving and investment identity
The close connection between trade balances and international flows of savings and investments leads to a macroeconomic analysis. This approach views trade balances—and their associated flows of financial capital—in the context of the overall levels of savings and financial investment in the economy.
6.9.1 Understanding the Determinants of the Trade and Current Account Balance
The national saving and investment identity provides a useful way to understand the determinants of the trade and current account balance. In a nation’s financial capital market, the quantity of financial capital supplied at any given time must equal the quantity of financial capital demanded for purposes of making investments. What is on the supply and demand sides of financial capital? See the following Clear It Up feature for the answer to this question.
Note
WHAT COMPRISES THE SUPPLY AND DEMAND OF FINANCIAL CAPITAL?
A country’s national savings is the total of its domestic savings by household and companies (private savings) as well as the government (public savings). If a country is running a trade deficit, it means money from abroad is entering the country and the government considers it part of the supply of financial capital.
The demand for financial capital (money) represents groups that are borrowing the money. Businesses need to borrow to finance their investments in factories, materials, and personnel. When the federal government runs a budget deficit, it is also borrowing money from investors by selling Treasury bonds. Therefore, both business investment and the federal government can demand (or borrow) the supply of savings.
There are two main sources for the supply of financial capital in the U.S. economy: saving by individuals and firms, called S, and the inflow of financial capital from foreign investors, which is equal to the trade deficit (M – X), or imports minus exports. There are also two main sources of demand for financial capital in the U.S. economy: private sector investment, I, and government borrowing, where the government needs to borrow when government spending, G, is higher than the taxes collected, T. We can express this national savings and investment identity in algebraic terms:
\[\text{Supply of financial capital} = \text{Demand for financial capital}\]
\[S + (M – X) = I + (G – T)\]
Again, in this equation, S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment. This relationship is true as a matter of definition because, for the macro economy, the quantity supplied of financial capital must be equal to the quantity demanded.
However, certain components of the national savings and investment identity can switch between the supply side and the demand side. Some countries, like the United States in most years since the 1970s, have budget deficits, which mean the government is spending more than it collects in taxes, and so the government needs to borrow funds. In this case, the government term would be G – T > 0, showing that spending is larger than taxes, and the government would be a demander of financial capital on the left-hand side of the equation (that is, a borrower), not a supplier of financial capital on the right-hand side. However, if the government runs a budget surplus so that the taxes exceed spending, as the U.S. government did from 1998 to 2001, then the government in that year was contributing to the supply of financial capital (T – G > 0), and would appear on the left (saving) side of the national savings and investment identity.
Similarly, if a national economy runs a trade surplus, the trade sector will involve an outflow of financial capital to other countries. A trade surplus means that the domestic financial capital is in surplus within a country and can be invested in other countries.
The fundamental notion that total quantity of financial capital demanded equals total quantity of financial capital supplied must always remain true. Domestic savings will always appear as part of the supply of financial capital and domestic investment will always appear as part of the demand for financial capital. However, the government and trade balance elements of the equation can move back and forth as either suppliers or demanders of financial capital, depending on whether government budgets and the trade balance are in surplus or deficit.
6.9.2 Domestic Saving and Investment Determine the Trade Balance
One insight from the national saving and investment identity is that a nation's own levels of domestic saving and investment determine a nation’s balance of trade. To understand this point, rearrange the identity to put the balance of trade all by itself on one side of the equation. Consider first the situation with a trade deficit, and then the situation with a trade surplus.
In the case of a trade deficit, the national saving and investment identity can be rewritten as:
In this case, domestic investment is higher than domestic saving, including both private and government saving. The only way that domestic investment can exceed domestic saving is if capital is flowing into a country from abroad. After all, that extra financial capital for investment has to come from someplace.
Now consider a trade surplus from the standpoint of the national saving and investment identity:
In this case, domestic savings (both private and public) is higher than domestic investment. That extra financial capital will be invested abroad.
This connection of domestic saving and investment to the trade balance explains why economists view the balance of trade as a fundamentally macroeconomic phenomenon. As the national saving and investment identity shows, the performance of certain sectors of an economy, like cars or steel, do not determine the trade balance. Further, whether the nation’s trade laws and regulations encourage free trade or protectionism also does not determine the trade balance (see Globalization and Protectionism).
6.9.3 Exploring Trade Balances One Factor at a Time
The national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall. Begin with the version of the identity that has domestic savings and investment on the left and the trade deficit on the right:
Now, consider the factors on the left-hand side of the equation one at a time, while holding the other factors constant.
As a first example, assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged. Table 6.20 shows the result in the first row under the equation. Since the equality of the national savings and investment identity must continue to hold—it is, after all, an identity that must be true by definition—the rise in domestic investment will mean a higher trade deficit. This situation occurred in the U.S. economy in the late 1990s. Because of the surge of new information and communications technologies that became available, business investment increased substantially. A fall in private saving during this time and a rise in government saving more or less offset each other. As a result, the financial capital to fund that business investment came from abroad, which is one reason for the very high U.S. trade deficits of the late 1990s and early 2000s.
As a second scenario, assume that the level of domestic savings rises, while the level of domestic investment and public savings remain unchanged. In this case, the trade deficit would decline. As domestic savings rises, there would be less need for foreign financial capital to meet investment needs. For this reason, a policy proposal often made for reducing the U.S. trade deficit is to increase private saving—although exactly how to increase the overall rate of saving has proven controversial.
As a third scenario, imagine that the government budget deficit increased dramatically, while domestic investment and private savings remained unchanged. This scenario occurred in the U.S. economy in the mid-1980s. The federal budget deficit increased from $79 billion in 1981 to $221 billion in 1986—an increase in the demand for financial capital of $142 billion. The current account balance collapsed from a surplus of $5 billion in 1981 to a deficit of $147 billion in 1986—an increase in the supply of financial capital from abroad of $152 billion. The connection at that time is clear: a sharp increase in government borrowing increased the U.S. economy’s demand for financial capital, and foreign investors through the trade deficit primarily supplied that increase. The following Work It Out feature walks you through a scenario in which private domestic savings has to rise by a certain amount to reduce a trade deficit.
Note
SOLVING PROBLEMS WITH THE SAVING AND INVESTMENT IDENTITY
Use the saving and investment identity to answer the following question: Country A has a trade deficit of $200 billion, private domestic savings of $500 billion, a government deficit of $200 billion, and private domestic investment of $500 billion. To reduce the $200 billion trade deficit by $100 billion, by how much does private domestic savings have to increase?
Step 1.
Write out the savings investment formula solving for the trade deficit or surplus on the left:
\[(X – M) = S + (T – G) – I\]
Step 2.
In the formula, put the amount for the trade deficit in as a negative number (X – M). The left side of your formula is now:
\[–200 = S + (T – G) – I\]
Step 3.
Enter the private domestic savings (S) of $500 in the formula:
\[–200 = 500 + (T – G) – I\]
Step 4.
Enter the private domestic investment (I) of $500 into the formula:
\[–200=500+ (T – G) – 500\]
Step 5.
The government budget surplus or balance is represented by (T – G). Enter a budget deficit amount for (T – G) of –200:
\[–200 = 500 + (–200) – 500\]
Step 6.
Your formula now is:
\[(X – M) = S + (T – G) – I\]
\[–200 = 500 + (–200) – 500\]
The question is: To reduce your trade deficit (X – M) of –200 to –100 (in billions of dollars), by how much will savings have to rise?
\[(X – M) = S + (T – G) – I\]
\[–100 = S + (–200) – 500\]
\[S = 600\]
Step 7.
Summarize the answer: Private domestic savings needs to rise by $100 billion, to a total of $600 billion, for the two sides of the equation to remain equal (–100 = –100).
6.9.4 Short-Term Movements in the Business Cycle and the Trade Balance
In the short run, whether an economy is in a recession or on the upswing can affect trade imbalances. A recession tends to make a trade deficit smaller, or a trade surplus larger, while a period of strong economic growth tends to make a trade deficit larger, or a trade surplus smaller.
As an example, note in [link] that the U.S. trade deficit declined by almost half from 2006 to 2009. One primary reason for this change is that during the recession, as the U.S. economy slowed down, it purchased fewer of all goods, including fewer imports from abroad. However, buying power abroad fell less, and so U.S. exports did not fall by as much.
Conversely, in the mid-2000s, when the U.S. trade deficit became very large, a contributing short-term reason is that the U.S. economy was growing. As a result, there was considerable aggressive buying in the U.S. economy, including the buying of imports. Thus, a trade deficit (or a much lower trade surplus) often accompanies a rapidly growing domestic economy, while a trade surplus (or a much lower trade deficit) accompanies a slowing or recessionary domestic economy.
When the trade deficit rises, it necessarily means a greater net inflow of foreign financial capital. The national saving and investment identity teaches that the rest of the economy can absorb this inflow of foreign financial capital in several different ways. For example, reduced private savings could offset the additional inflow of financial capital from abroad, leaving domestic investment and public saving unchanged. Alternatively, the inflow of foreign financial capital could result in higher domestic investment, leaving private and public saving unchanged. Yet another possibility is that greater government borrowing could absorb the inflow of foreign financial capital, leaving domestic saving and investment unchanged. The national saving and investment identity does not specify which of these scenarios, alone or in combination, will occur—only that one of them must occur.
Key Concepts and Summary
The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit:
\[\text{Supply of financial capital} = \text{Demand for financial capital}\]
\[S + (M – X)=I + (G – T)\]
A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).
Self-Check Questions
If a country is running a government budget surplus, why is (T – G) on the left side of the saving-investment identity?
What determines the size of a country’s trade deficit?
If domestic investment increases, and there is no change in the amount of private and public saving, what must happen to the size of the trade deficit?
Why does a recession cause a trade deficit to increase?
Both the United States and global economies are booming. Will U.S. imports and/or exports increase?
What are the two main sides of the national savings and investment identity?
What are the main components of the national savings and investment identity?
Many think that the size of a trade deficit is due to a lack of competitiveness of domestic sectors, such as autos. Explain why this is not true.
If you observed a country with a rapidly growing trade surplus over a period of a year or so, would you be more likely to believe that the country's economy was in a period of recession or of rapid growth? Explain.
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Is this possible?
6.10 The Pros and Cons of Trade Deficits and Surpluses
Chapter Learning Objectives
Identify three ways in which borrowing money or running a trade deficit can result in a healthy economy
Identify three ways in which borrowing money or running a trade deficit can result in a weaker economy
Because flows of trade always involve flows of financial payments, flows of international trade are actually the same as flows of international financial capital. The question of whether trade deficits or surpluses are good or bad for an economy is, in economic terms, exactly the same question as whether it is a good idea for an economy to rely on net inflows of financial capital from abroad or to make net investments of financial capital abroad. Conventional wisdom often holds that borrowing money is foolhardy, and that a prudent country, like a prudent person, should always rely on its own resources. While it is certainly possible to borrow too much—as anyone with an overloaded credit card can testify—borrowing at certain times can also make sound economic sense. For both individuals and countries, there is no economic merit in a policy of abstaining from participation in financial capital markets.
It makes economic sense to borrow when you are buying something with a long-run payoff; that is, when you are making an investment. For this reason, it can make economic sense to borrow for a college education, because the education will typically allow you to earn higher wages, and so to repay the loan and still come out ahead. It can also make sense for a business to borrow in order to purchase a machine that will last 10 years, as long as the machine will increase output and profits by more than enough to repay the loan. Similarly, it can make economic sense for a national economy to borrow from abroad, as long as it wisely invests the money in ways that will tend to raise the nation’s economic growth over time. Then, it will be possible for the national economy to repay the borrowed money over time and still end up better off than before.
One vivid example of a country that borrowed heavily from abroad, invested wisely, and did perfectly well is the United States during the nineteenth century. The United States ran a trade deficit in 40 of the 45 years from 1831 to 1875, which meant that it was importing capital from abroad over that time. However, that financial capital was mostly invested in projects like railroads that brought a substantial economic payoff. (See the following Clear It Up feature for more on this.)
A more recent example along these lines is the experience of South Korea, which had trade deficits during much of the 1970s—and so was an importer of capital over that time. However, South Korea also had high rates of investment in physical plant and equipment, and its economy grew rapidly. From the mid-1980s into the mid-1990s, South Korea often had trade surpluses—that is, it was repaying its past borrowing by sending capital abroad.
In contrast, some countries have run large trade deficits, borrowed heavily in global capital markets, and ended up in all kinds of trouble. Two specific sorts of trouble are worth examining. First, a borrower nation can find itself in a bind if it does not invest the incoming funds from abroad in a way that leads to increased productivity. Several of Latin America's large economies, including Mexico and Brazil, ran large trade deficits and borrowed heavily from abroad in the 1970s, but the inflow of financial capital did not boost productivity sufficiently, which meant that these countries faced enormous troubles repaying the money borrowed when economic conditions shifted during the 1980s. Similarly, it appears that a number of African nations that borrowed foreign funds in the 1970s and 1980s did not invest in productive economic assets. As a result, several of those countries later faced large interest payments, with no economic growth to show for the borrowed funds.
Note
ARE TRADE DEFICITS ALWAYS HARMFUL?
For most years of the nineteenth century, U.S. imports exceeded exports and the U.S. economy had a trade deficit. Yet the string of trade deficits did not hold back the economy at all. Instead, the trade deficits contributed to the strong economic growth that gave the U.S. economy the highest per capita GDP in the world by around 1900.
The U.S. trade deficits meant that the U.S. economy was receiving a net inflow of foreign capital from abroad. Much of that foreign capital flowed into two areas of investment—railroads and public infrastructure like roads, water systems, and schools—which were important to helping the U.S. economy grow.
We should not overstate the effect of foreign investment capital on U.S. economic growth. In most years the foreign financial capital represented no more than 6–10% of the funds that the government used for overall physical investment in the economy. Nonetheless, the trade deficit and the accompanying investment funds from abroad were clearly a help, not a hindrance, to the U.S. economy in the nineteenth century.
A second “trouble” is: What happens if the foreign money flows in, and then suddenly flows out again? We raised this scenario at the start of the chapter. In the mid-1990s, a number of countries in East Asia—Thailand, Indonesia, Malaysia, and South Korea—ran large trade deficits and imported capital from abroad. However, in 1997 and 1998 many foreign investors became concerned about the health of these economies, and quickly pulled their money out of stock and bond markets, real estate, and banks. The extremely rapid departure of that foreign capital staggered the banking systems and economies of these countries, plunging them into deep recession. We investigate and discuss the links between international capital flows, banks, and recession in The Impacts of Government Borrowing.
While a trade deficit is not always harmful, there is no guarantee that running a trade surplus will bring robust economic health. For example, Germany and Japan ran substantial trade surpluses for most of the last three decades. Regardless of their persistent trade surpluses, both countries have experienced occasional recessions and neither country has had especially robust annual growth in recent years. Read more about Japan’s trade surplus in the next Clear It Up feature.
The sheer size and persistence of the U.S. trade deficits and inflows of foreign capital since the 1980s are a legitimate cause for concern. The huge U.S. economy will not be destabilized by an outflow of international capital as easily as, say, the comparatively tiny economies of Thailand and Indonesia were in 1997–1998. Even an economy that is not knocked down, however, can still be shaken. American policymakers should certainly be paying attention to those cases where a pattern of extensive and sustained current account deficits and foreign borrowing has gone badly—if only as a cautionary tale.
Note
ARE TRADE SURPLUSES ALWAYS BENEFICIAL? CONSIDERING JAPAN SINCE THE 1990S.
Perhaps no economy around the world is better known for its trade surpluses than Japan. Since 1990, the size of these surpluses has often been near $100 billion per year. When Japan’s economy was growing vigorously in the 1960s and 1970s, many, especially non-economists, described its large trade surpluses either a cause or a result of its robust economic health. However, from a standpoint of economic growth, Japan’s economy has been teetering in and out of recession since 1990, with real GDP growth averaging only about 1% per year, and an unemployment rate that has been creeping higher. Clearly, a whopping trade surplus is no guarantee of economic good health.
Instead, Japan’s trade surplus reflects that Japan has a very high rate of domestic savings, more than the Japanese economy can invest domestically, and so it invests the extra funds abroad. In Japan’s slow economy, consumption of imports is relatively low, and the growth of consumption is relatively slow. Thus, Japan’s exports continually exceed its imports, leaving the trade surplus continually high. Recently, Japan’s trade surpluses began to deteriorate. In 2013, Japan ran a trade deficit due to the high cost of imported oil. By 2015, Japan again had a surplus.
Key Concepts and Summary
Trade surpluses are no guarantee of economic health, and trade deficits are no guarantee of economic weakness.
Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital.
Self-Check Questions
How did large trade deficits hurt the East Asian countries in the mid 1980s? (Recall that trade deficits are equivalent to inflows of financial capital from abroad.)
Describe a scenario in which a trade surplus benefits an economy and one in which a trade surplus is occurring in an economy that performs poorly. What key factor or factors are making the difference in the outcome that results from a trade surplus?
When is a trade deficit likely to work out well for an economy? When is it likely to work out poorly?
Does a trade surplus help to guarantee strong economic growth?
What is more important, a country’s current account balance or GDP growth? Why?
6.11 The Difference between Level of Trade and the Trade Balance
Chapter Learning Objectives
Identify three factors that influence a country's level of trade
Differentiate between balance of trade and level of trade
A nation’s level of trade may at first sound like much the same issue as the balance of trade, but these two are actually quite separate. It is perfectly possible for a country to have a very high level of trade—measured by its exports of goods and services as a share of its GDP—while it also has a near-balance between exports and imports. A high level of trade indicates that the nation exports a good portion of its production. It is also possible for a country’s trade to be a relatively low share of GDP, relative to global averages, but for the imbalance between its exports and its imports to be quite large. We emphasized this general theme earlier in Measuring Trade Balances, which offered some illustrative figures on trade levels and balances.
A country’s level of trade tells how much of its production it exports. We measure this by the percent of exports out of GDP. It indicates the degree of an economy's globalization. Some countries, such as Germany, have a high level of trade—they export almost 50% of their total production. The balance of trade tells us if the country is running a trade surplus or trade deficit. A country can have a low level of trade but a high trade deficit. (For example, the United States only exports 13% of GDP, but it has a trade deficit of over $500 billion.)
Three factors strongly influence a nation’s level of trade: the size of its economy, its geographic location, and its history of trade. Large economies like the United States can do much of their trading internally, while small economies like Sweden have less ability to provide what they want internally and tend to have higher ratios of exports and imports to GDP. Nations that are neighbors tend to trade more, since costs of transportation and communication are lower. Moreover, some nations have long and established patterns of international trade, while others do not.
Consequently, a relatively small economy like Sweden, with many nearby trading partners across Europe and a long history of foreign trade, has a high level of trade. Brazil and India, which are fairly large economies that have often sought to inhibit trade in recent decades, have lower levels of trade; whereas, the United States and Japan are extremely large economies that have comparatively few nearby trading partners. Both countries actually have quite low levels of trade by world standards. The ratio of exports to GDP in either the United States or in Japan is about half of the world average.
The balance of trade is a separate issue from the level of trade. The United States has a low level of trade, but had enormous trade deficits for most years from the mid-1980s into the 2000s. Japan has a low level of trade by world standards, but has typically shown large trade surpluses in recent decades. Nations like Germany and the United Kingdom have medium to high levels of trade by world standards, but Germany had a moderate trade surplus in 2015, while the United Kingdom had a moderate trade deficit. Their trade picture was roughly in balance in the late 1990s. Sweden had a high level of trade and a moderate trade surplus in 2015, while Mexico had a high level of trade and a moderate trade deficit that same year.
In short, it is quite possible for nations with a relatively low level of trade, expressed as a percentage of GDP, to have relatively large trade deficits. It is also quite possible for nations with a near balance between exports and imports to worry about the consequences of high levels of trade for the economy. It is not inconsistent to believe that a high level of trade is potentially beneficial to an economy, because of the way it allows nations to play to their comparative advantages, and to also be concerned about any macroeconomic instability caused by a long-term pattern of large trade deficits. The following Clear It Up feature discusses how this sort of dynamic played out in Colonial India.
Note
ARE TRADE SURPLUSES ALWAYS BENEFICIAL? CONSIDERING COLONIAL INDIA.
India was formally under British rule from 1858 to 1947. During that time, India consistently had trade surpluses with Great Britain. Anyone who believes that trade surpluses are a sign of economic strength and dominance while trade deficits are a sign of economic weakness must find this pattern odd, since it would mean that colonial India was successfully dominating and exploiting Great Britain for almost a century—which was not true.
Instead, India’s trade surpluses with Great Britain meant that each year there was an overall flow of financial capital from India to Great Britain. In India, many heavily criticized this financial capital flow as the “drain,” and they viewed eliminating the financial capital drain as one of the many reasons why India would benefit from achieving independence.
6.11.1 Final Thoughts about Trade Balances
Trade deficits can be a good or a bad sign for an economy, and trade surpluses can be a good or a bad sign. Even a trade balance of zero—which just means that a nation is neither a net borrower nor lender in the international economy—can be either a good or bad sign. The fundamental economic question is not whether a nation’s economy is borrowing or lending at all, but whether the particular borrowing or lending in the particular economic conditions of that country makes sense.
It is interesting to reflect on how public attitudes toward trade deficits and surpluses might change if we could somehow change the labels that people and the news media affix to them. If we called a trade deficit “attracting foreign financial capital”—which accurately describes what a trade deficit means—then trade deficits might look more attractive. Conversely, if we called a trade surplus “shipping financial capital abroad”—which accurately captures what a trade surplus does—then trade surpluses might look less attractive. Either way, the key to understanding trade balances is to understand the relationships between flows of trade and flows of international payments, and what these relationships imply about the causes, benefits, and risks of different kinds of trade balances. The first step along this journey of understanding is to move beyond knee-jerk reactions to terms like “trade surplus,” “trade balance,” and “trade deficit.”
Note
MORE THAN MEETS THE EYE IN THE CONGO
Now that you see the big picture, you undoubtedly realize that all of the economic choices you make, such as depositing savings or investing in an international mutual fund, do influence the flow of goods and services as well as the flows of money around the world.
You now know that a trade surplus does not necessarily tell us whether an economy is performing well or not. The Democratic Republic of the Congo ran a trade surplus in 2013, as we learned in the beginning of the chapter. Yet its current account balance was –$2.8 billion. However, the return of political stability and the rebuilding in the aftermath of the civil war there has meant a flow of investment and financial capital into the country. In this case, a negative current account balance means the country is being rebuilt—and that is a good thing.
Key Concepts and Summary
There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP, or the size of the economy. Small economies that have nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports.
Trade deficits and trade surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, if it invests that money in productivity-boosting investments it can lead to an improvement in long-term economic growth.
Self-Check Questions
What three factors will determine whether a nation has a higher or lower share of trade relative to its GDP?
What is the difference between trade deficits and balance of trade?
Will nations that are more involved in foreign trade tend to have higher trade imbalances, lower trade imbalances, or is the pattern unpredictable?
Some economists warn that the persistent trade deficits and a negative current account balance that the United States has run will be a problem in the long run. Do you agree or not? Explain your answer.
