QUESTIONS. 1. Is trade a zero-sum game or a positive-sum game?

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1 QUESTIONS 1. Is trade a zero-sum game or a positive-sum game? Trade is not a zero-sum game in the sense that one player (trading partner) can win only at the expense of another. Instead it is a positive-sum game because, for trade to take place, both nations must anticipate gain from it. 2. Explain: (a) the principle of absolute advantage and (b) the principle of relative advantage. According to the principle of absolute advantage, a country should export a commodity that can be produced at a lower cost than can other nations. Conversely, it should import a commodity that can be only produced at a higher cost than can other nations. The principle of relative advantage states that, although a country may be more efficient than another country in producing many products, it still should concentrate on either a product with the greatest comparative advantage or a product with the least comparative disadvantage. Conversely, it should import either a product for which it has the greatest comparative disadvantage or one for which it has the least comparative advantage. 3. Should there be trade if: (a) a country has an absolute advantage for all products over its trading partner and (b) the domestic exchange ratio of one country is identical to that of another country? Trade still should take place even when a country has an absolute advantage for all products over its trading partner as long as the degree of efficiency is not uniform across all products. As explained by the principle of relative advantage, absolute costs are irrelevant, and relative production costs instead should be used to determine whether trade will take place. A country should concentrate on either a product with the greatest comparative advantage or a product with the least comparative disadvantage. Trade is unlikely when the domestic exchange ratio of one country is identical to that of another country. There is simply no incentive or gain from trading for either party. Also when transaction costs and transportation costs are considered, it becomes too expensive to export a product from one country to another. 4. What is the theory of factor endowment? The theory of factor endowment holds that the inequality of relative prices is a function of regional factor endowments and that comparative advantage is determined in part by the relative abundance of such endowments. Since countries have different factor endowments, a country would have a relative advantage in a commodity that embodies in some degree that country's comparatively abundant factors. A country should thus export that commodity which is relatively plentiful (i.e., in comparison to other commodities) within the relatively abundant factor (i.e., in comparison to other countries). 1

2 5. Explain the Leontief Paradox. The Leontief Paradox casts some doubt on the validity of classical trade theories. Some empirical studies have shown that the United States' export and import patterns are not consistent with the trade patterns as predicted by the theory of factor endowment. According to these studies, the United States actually exports labor-intensive goods and imports capital- intensive products (when the opposite results were expected). 6. Discuss the validity and limitations of trade theories. Based on the empirical evidence and world trade patterns, the validity of trade theories is questionable and debatable as shown by the paradoxical findings. Apparently, other variables in addition to factor endowment affect trade practices. Trade theories fail to consider the demand side, marketing activities, and trade barriers. All of these can significantly alter trade patterns. The value of the trade theories is limited by their assumptions: immobility and constancy of factors of production, homogeneous quality of factors of production, and fixed proportions of factor inputs for a product. In all fairness, certain simplifying assumptions are necessary, at least, in the early part of the investigation. 7. Distinguish among: (a) free trade area, (b) customs union, (c) common market, (d) economic and monetary union, and (e) political union. Free trade area: The countries involved eliminate duties among themselves, while maintaining separately their own tariffs against outsiders. Customs union: Member countries must also agree on a common schedule of identical tariff rates against outsiders. Common market: Countries remove all customs and other restrictions on the movement of the factors of production among the members of the common market. Monetary union: Countries unify their currencies by either adopting a single currency or having convertible currencies with irrevocably fixed exchange rates. Economic union: Countries harmonize their national economic policies so as to create a single market. Political union: It involves both economic and political ties, and a treaty of integration between nations requires common economic and political policies. 8. Does economic cooperation improve or impede trade? Economic cooperation may either improve or impede international trade, depending on how the result of the cooperation is viewed. The tendency is for a member of an economic group 2

3 to shift from the most efficient supplier in the world to the lowest-cost supplier within that particular economic region. As such, trade creation among the partners is offset by trade diversion from the rest of the world, and the net effect may be either positive or negative. DISCUSSION ASSIGNMENTS AND MINICASES 1. Name products or industries in which the United States has a comparative advantage as well as those in which it has a comparative disadvantage. The United States has relatively more land, capital, and technology than most other countries. As such, it can be expected that the United States will have a comparative advantage in products which extensively utilize these factors of production. In fact, the United States does have a relative advantage in such temperate-zone agricultural commodities as wheat, corn, and soybeans. Although these commodities are labor-intensive (at least in many countries), the United States is not at a disadvantage because the high labor cost can be minimized by substituting technology and capital (i.e., machinery) for the labor content. The strength of the United States in the high-tech area also makes it possible for the United States to have an edge in a number of high-tech manufactured goods (e.g., computers and capital goods). As expected, the United States has a relative disadvantage in products which are labor intensive. Textile products are a prime example. Furthermore, the United States seems to have lost its comparative edge in such low-tech manufactured goods as consumer electronics products. The United States also imports mineral fuels (e.g., oil) due to its high level of consumption coupled with other countries' better endowment of such fuels. According to the U.S. Department of Commerce (see Business America, May 1994, 25), Latin America and the Caribbean are attractive markets for traditional U.S. exports. Based on both dollar volume and expected growth, the best prospects for sale of U.S. products are: auto parts and service equipment; oil and gas field equipment; telecommunications; computers, peripherals and software, food products and packaging equipment; machine tools and metal working equipment; pollution control equipment; medical equipment; mining equipment; consumer goods; electrical power equipment; and aircraft and equipment. Apparently, these products are based on the relative strengths of the United States. 2. Why is it beneficial for the well-endowed, resource- rich United States to trade with other nations? Although relatively well endowed, the United States still greatly benefits from international trade. Many countries are better endowed than the United States in terms of labor. Even though the United States has an absolute advantage in most products, it still should concentrate on those that are most promising and should leave other countries to supply other products at lower costs to satisfy U.S. consumers' needs. Without trade, it is reasonable to expect that the prices of most products will be significantly higher and that the innovations will slow. The protectionist measures considered by Congress can thus do more harm than good. 3

4 3. For a country with high labor cost, how can it improve its export competitiveness? The United States, Japan, and Germany are the countries with high labor cost. The success of Japan and Germany in world trade, however, has clearly shown that the high labor cost and content can still be reasonably managed in a number of ways. A country can reduce the labor content by investing in automation. The idea is to change or adjust factors of production. For example, capital is substituted for labor. The quality of the factors of production is another consideration. Workers should be well trained in order to increase the productivity or efficiency with the emphasis on reducing the rate of defective products. Another strategy is to shift the production of certain components to labor-rich countries in order to gain those countries' comparative advantage. Moreover, high-cost countries should keep innovating in order to keep the comparative advantage in the area of high-tech products. Last but not least, the marketing aspect must be emphasized in order to shift the battle from the disadvantageous commodities to the area of value-added, branded products which the United States, Japan, and Germany seem to have psychological advantage as far as consumer perceptions are concerned. 4. Explain how the advanced economies should cope with the shift in comparative advantage. This assignment is highly related to the previous one. The United States needs to devise strategies to cope with the loss of comparative advantage in several products. First of all, it needs to consider automation while shifting workers from low- skilled production areas to jobs requiring greater skills. Research in technological improvement must continue so that the United States may choose to specialize on sophisticated products. Whenever possible, U.S. firms can minimize the relative disadvantage by switching to the assembly operation which uses parts made in countries with lower labor cost. Marketing is required to endow U.S. products with desirable psychological images so that the cut-throat competition common for undifferentiated commodities can be avoided. Finally some kind of systematic planning as discussed at the end of the chapter should be considered. 5. There has been a proliferation of regional trading arrangements in the 1990s. The European Union and the North American Free Trade Agreement in particular have commanded a great deal of world attention. There are numerous reasons for the formation of a regional trading arrangement. Some of the reasons are economic in nature, while others are political. As a policymaker for a medium-sized and developing country, list and explain the reasons that may motivate you to consider forming or joining a regional trade group. 4

5 The purpose of this assignment is to encourage students to think about both the pros and cons of a regional trading arrangement. It should be noted that a trend toward regional integration is continuing. A strong interest in regionalism has to do in part with nations frustration with the multilateral process. But there are also other political and economic motives. A country wanting to join a regional trade group faces several problems. For example, it must cede substantial sovereignty to the trade group. As a result, it may have to adopt restrictive policies. It should also be apparent that regional trade blocs endorse trade liberalization internally but that they achieve trade protection externally. According to an IMF study (see Uruguay Round Outcome Strengthens Framework for Trade Relations, IMF Survey, 14 November 1994, 353ff), several factors have contributed to the impetus toward regional arrangements, and they are as follows: a) growth-related incentives, particularly the opportunity to exploit economies of scale, regional specialization, and learning-by-doing, as well as to attract investment by expanding the regional market b) noneconomic objectives, such as enhancing regional political cohesion, managing immigration flows, and promoting regional security c) the slow progress under the Uruguay Round and the desire to strengthen negotiating positions d) the opportunity to preempt future restrictions on market access and create a more stable and predictable trading environment e) the ability to lock in domestic policy reforms f) the opportunity cost of remaining outside regional trading arrangements In spite of the advantages of regional trade arrangements, it must be concluded that the first-best policy should be global, instead of regional, free trade. 5