New Perspectives on the World Economy

AN INTRODUCTION TO INTERNATIONAL ECONOMICS New Perspectives on the World Economy This book is designed for a one-semester or two-semester course in international economics, primarily targeting non-economics majors and programs in business, international relations, public policy, and development studies. It has been written to make international economics accessible to wide student and professional audiences. The book assumes a minimal background in microeconomics and mathematics and goes beyond the usual trade–finance dichotomy to give equal treatment to four “windows” on the world economy: international trade, international production, international finance, and international development. It takes a practitioner point of view rather than a standard academic view, introducing students to the material they need to become effective analysts in international economic policy. The website for the text is found at http://iie.gmu.edu. Kenneth A. Reinert is Professor of Public Policy in the School of Public Policy at George Mason University, where he won a Distinguished Teaching Award. He held past positions at Kalamazoo College, Wellesley College, and the U.S. International Trade Commission. He has published more than 60 articles and book chapters in the areas of trade, development, and environmental policy. In addition to the first release of this book, Windows on the World Economy: An Introduction to International Economics, his books include The Princeton Encyclopedia of the World Economy (co-edited with Ramkishen Rajan, 2009), Globalization for Development (co-authored with Ian Goldin, 2006; revised edition, 2007), and Applied Methods for Trade Policy Analysis (co-edited with Joseph Francois; Cambridge University Press, 1998). AN INTRODUCTION TO INTERNATIONAL ECONOMICS New Perspectives on the World Economy KENNETH A. REINERT School of Public Policy George Mason University cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Tokyo, Mexico City Cambridge University Press 32 Avenue of the Americas, New York, NY 10013-2473, USA www.cambridge.org Information on this title: www.cambridge.org/9780521177108 C Kenneth A. Reinert 2012 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2012 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication data Reinert, Kenneth A. An introduction to international economics : new perspectives on the world economy / Kenneth A. Reinert. – 2nd ed. p. cm. Rev. ed. of: Windows on the world economy / Kenneth A. Reinert. 2005. Includes bibliographical references and index. ISBN 978-1-107-00357-6 (hardback) – ISBN 978-0-521-17710-8 (paperback) 1. International economic relations. 2. International trade. 3. International finance. I. Reinert, Kenneth A. Windows on the world economy. II. Title. HF1411.R4198 2012 337–dc22 2011015937 ISBN 978-1-107-00357-6 Hardback ISBN 978-0-521-17710-8 Paperback Additional resources for this publication at http://iie.gmu.edu Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet websites referred to in this publication and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. To Gelaye, Oda, and Ayantu Summary Contents Preface page xvii Acknowledgments xix Acronyms xxi Symbols xxvii 1 Windows on the World Economy 1 part i. international trade 2 Absolute Advantage 19 3 Comparative Advantage 33 4 Intra-Industry Trade 45 5 The Political Economy of Trade 57 6 Trade Policy Analysis 75 7 The World Trade Organization 93 8 Preferential Trade Agreements 117 part ii. international production 9 Foreign Market Entry and International Production 141 10 Foreign Direct Investment and Intra-Firm Trade 159 11 Managing International Production 173 12 Migration 189 part iii. international finance 13 Accounting Frameworks 207 14 Exchange Rates and Purchasing Power Parity 227 15 Flexible Exchange Rates 245 16 Fixed Exchange Rates 265 vii viii SUMMARY CONTENTS 17 The International Monetary Fund 283 18 Crises and Responses 307 19 Monetary Unions 331 part iv. international development 20 Development Concepts 353 21 Growth and Development 371 22 International Production and Development 391 23 The World Bank 413 24 Structural Change and Adjustment 435 Glossary Index 455 467 Detailed Contents Preface page xvii Acknowledgments xix Acronyms xxi Symbols xxvii 1 Windows on the World Economy International Trade International Production International Finance International Development Connecting Windows Analytical Elements Conclusion Review Exercises Further Reading and Web Resources References 1 3 4 6 8 9 12 13 13 14 14 part i. international trade 2 Absolute Advantage Supply and Demand in a Domestic Market Absolute Advantage International Trade Gains from Trade Limitations Conclusion Review Exercises Further Reading and Web Resources Appendix: Consumer and Producer Surplus References 3 Comparative Advantage Autarky and Comparative Advantage International Trade Gains from Trade 19 20 21 23 26 28 29 29 29 30 30 33 34 37 39 ix x DETAILED CONTENTS Conclusion Review Exercises Further Reading and Web Resources Appendix: The Production Possibilities Frontier References 4 Intra-Industry Trade Intra-Industry and Inter-Industry Trade Global Patterns of Intra-Industry Trade An Explanation of Intra-Industry Trade Conclusion Review Exercises Further Reading and Web Resources Appendix: The Grubel-Lloyd Index References 5 The Political Economy of Trade Approaches to the Political Economy of Trade Comparative Advantage Revisited Trade and Factors of Production North-South Trade and Wages The Role of Specific Factors Conclusion Review Exercises Further Reading and Web Resources Appendix: Endogenous Protection References 6 Trade Policy Analysis Absolute Advantage Revisited Trade Policy Measures A Tariff Terms-of-Trade Effects A Quota Comparative Advantage Models Conclusion Review Exercises Further Reading and Web Resources Appendix A: The Imperfect Substitutes Model Appendix B: A Tariff Rate Quota References 7 The World Trade Organization The General Agreement on Tariffs and Trade The World Trade Organization Trade in Goods Trade in Services 41 41 41 42 44 45 46 48 51 53 53 54 54 55 57 59 60 61 64 67 69 69 70 70 72 75 76 77 81 82 83 85 86 87 87 87 89 91 93 94 97 99 100 DETAILED CONTENTS Intellectual Property Dispute Settlement The Environment Doha Round Conclusion Review Exercises Further Reading and Web Resources Appendix: WTO Membership and Multilateral Trade Negotiations References 8 Preferential Trade Agreements Preferential Trade Agreements The Economic Effects of Preferential Trade Agreements The European Union The North American Free Trade Agreement Mercosur and the FTAA ASEAN and AFTA Regionalism and Multilateralism Conclusion Review Exercises Further Reading and Web Resources Appendix: Rules of Thumb in Evaluating PTAs References xi 102 106 108 109 111 111 112 112 114 117 119 122 124 127 129 130 131 133 133 134 134 135 part ii. international production 9 Foreign Market Entry and International Production Foreign Market Entry Motivations for International Production Entry Mode Choice The Rise of Multinational Enterprises and International Production Conclusion Review Exercises Further Reading and Web Resources Appendix: FDI and Comparative Advantage References 141 142 146 148 150 153 154 155 155 156 10 Foreign Direct Investment and Intra-Firm Trade 159 Value Chains and Global Production Networks Firm-Specific Assets and Internalization Intra-Firm Trade A Cost View of Internalization Tying Things Together: The OLI Framework Conclusion Review Exercises Further Reading and Web Resources Appendix: The Gravity Model References 160 162 165 167 168 169 170 170 170 171 xii DETAILED CONTENTS 11 Managing International Production 173 Organizing the MNE Joint Ventures The Home Base Spatial Clusters Research and Development Conclusion Review Exercises Further Reading and Web Resources References 174 178 179 181 183 186 186 187 187 12 Migration Types of Migration The Migration Decision High-Skilled Migration Low-Skilled Migration Remittances Migration Policy Conclusion Review Exercises Further Reading and Web Resources Appendix: Migration and Comparative Advantage References 189 190 191 194 195 198 199 200 201 201 201 203 part iii. international finance 13 Accounting Frameworks 207 Open-Economy Accounts Balance of Payments Accounts Analyzing the Balance of Payments Accounts Global Imbalances Conclusion Review Exercises Further Reading and Web Resources Appendix A: Accounting Matrices Appendix B: An Open-Economy Model References 208 213 217 218 220 221 221 221 223 224 14 Exchange Rates and Purchasing Power Parity 227 The Nominal Exchange Rate The Real Exchange Rate Purchasing Power Parity Exchange Rates and Trade Flows Hedging and Foreign Exchange Derivatives Conclusion Review Exercises Further Reading and Web Resources 228 231 233 236 237 239 240 240 DETAILED CONTENTS Appendix A: Price Levels and the PPP Appendix B: The Monetary Approach to Exchange Rate Determination References 15 Flexible Exchange Rates A Trade-Based Model An Assets-Based Model Interest Rates, Expectations, and Exchange Rates Conclusion Review Exercises Further Reading and Web Resources Appendix: Monetary Policies and the Nominal Exchange Rate References 16 Fixed Exchange Rates xiii 240 241 242 245 246 250 253 256 256 257 257 262 265 Alternative Exchange Rate Regimes A Model of Fixed Exchange Rates Interest Rates and Exchange Rates The Role of Credibility The Impossible Trinity Currency Boards Conclusion Review Exercises Further Reading and Web Resources Appendix: Monetary Policies References 266 268 271 273 274 276 277 277 278 278 280 17 The International Monetary Fund 283 Some Monetary History The Operation of the IMF A History of IMF Operations The Political Economy of IMF Lending An Assessment Conclusion Review Exercises Further Reading and Web Resources References 18 Crises and Responses Types of Crises Contagion and Systemic Risk Analyzing Balance of Payments and Currency Crises The Asian Crisis The IMF Response The Sub-Prime Crisis of 2007–2009 Basel Standards Capital Controls Conclusion 284 289 294 301 303 304 304 305 305 307 308 313 314 316 319 320 322 323 324 xiv DETAILED CONTENTS Review Exercises Further Reading and Web Resources Appendix: Exchange Rate Target Zones References 19 Monetary Unions The European Monetary Union at a Glance Planning the European Monetary Union Implementing the European Monetary Union Optimal Currency Areas and Adjustment in the EMU Recent Crises in the EMU Monetary Unions in Africa Conclusion Review Exercises Further Reading and Web Resources References 325 325 326 327 331 332 333 338 341 344 345 347 347 348 348 part iv. international development 20 Development Concepts What Is Development? Growth Human Development Structural Change Conclusion Review Exercises Further Reading and Web Resources Appendix A: Gross Domestic Product and Gross National Income Appendix B: The Lorenz Curve and Gini Coefficient References 21 Growth and Development 353 354 355 359 365 366 366 367 367 368 369 371 Old Growth Theory New Growth Theory and Human Capital Trade and Growth Institutions and Growth Conclusion Review Exercises Further Reading and Web Resources Appendix: Growth Theory Algebra References 372 376 379 382 385 385 386 386 387 22 International Production and Development 391 Attracting International Production Benefits and Costs Policy Stances Promoting Linkages Transfer Pricing 392 394 400 402 404 DETAILED CONTENTS Governing International Production Conclusion Review Exercises Further Reading and Web Resources Appendix: OECD Guidelines for MNEs References 23 The World Bank Early History and Administrative Structure Policy-Based Lending Challenges and Responses Engaging with Ghana Recent Shifts Conclusion Review Exercises Further Reading and Web Resources References 24 Structural Change and Adjustment Structural Change Traded and Nontraded Goods Internal and External Balance Traded Goods and Growth The Order of Economic Liberalization Conclusion Review Exercises Further Reading and Web Resources Appendix: The Rybczynski Theorem References Glossary Index xv 405 407 407 407 408 408 413 414 421 425 428 430 431 431 431 432 435 436 438 439 445 446 449 450 450 451 452 455 467 Preface I have written An Introduction to International Economics: New Perspectives on the World Economy for one- and two-semester courses in international economics, primarily targeting non-economics majors and programs in business, international relations, public policy, and development studies. The book assumes a minimal background in microeconomics, namely, familiarity with the supply and demand diagram and the production possibilities frontier diagram, along with basic algebra. It goes beyond the usual trade–finance dichotomy to give equal treatment to four “windows” on the world economy: international trade, international production, international finance, and international development. It also takes a practitioner point of view rather than a standard academic view. In one semester, there won’t be time to cover all the book’s chapters. In this case, the instructor can use the following table as a rough guide to choosing among chapters. I have written the book to make international economics accessible to a wider student and professional audience than has been served by many international economics texts. I hope I have at least partially succeeded in this effort. The book has an informal website to which I will be posting occasional updates as events and new research inevitably move forward. I would invite the reader to visit this website periodically: http://iie.gmu.edu. xvii xviii PREFACE SUGGESTED CHAPTER USE BY PROGRAM Chapter Economics Business International Studies Development Studies 1 Windows on the World Economy X X X X Part I International Trade 2 Absolute Advantage 3 Comparative Advantage 4 Intra-Industry Trade 5 The Political Economy of Trade 6 Trade Policy Analysis 7 The World Trade Organization 8 Preferential Trade Agreements X X X X X X X X X X X X X X X X X X X X X X X X X X Part II International Production 9 Foreign Market Entry and International Production 10 Foreign Direct Investment and Intra-Firm Trade 11 Managing International Production 12 Migration Part III International Finance 13 Accounting Frameworks 14 Exchange Rates and Purchasing Power Parity 15 Flexible Exchange Rates 16 Fixed Exchange Rates 17 The International Monetary Fund 18 Crises and Responses 19 Monetary Unions Part IV International Development 20 Development Concepts 21 Growth and Development 22 International Production and Development 23 The World Bank 24 Structural Change and Adjustment X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X Acknowledgments I would like to express my sincere appreciation to Scott Parris for his suggestion that I publish the second edition of this book with Cambridge University Press and for his assistance in the revision process. I would like to thank the following individuals who have supported An Introduction to International Economics as a critical user or as a reviewer over the years: Sisay Asefa, Richard Blackhurst, Robert Blecker, Iva Bozovic, Barbara Craig, Desmond Dinan, Gerald Epstein, Diane Flaherty, Sasidaran Gopalan, Joe Joyce, Leo Kahane, Tony Lima, Jon Nadenichek, Carl Pasurka, Willard Posko, Ramkishen Rajan, Chris Rodrigo, Farhad Sabetan, Ralph Sonenshine, Wendy Takacs, Dominique van der Mensbrugghe, the late Tony Wallace, and Jonathan Wight. Apologies to anyone I have missed here. I would also like to thank a few international economists who have directly influenced my thinking over the years: Christopher Clague, Joseph Francois, Ian Goldin, Arvind Panagariya, Ramkishen Rajan, David Roland-Holst, and Clinton Shiells. I would finally like to thank Gelaye, Oda, and Ayantu for their patience and support during the revision process. This book is dedicated to them! xix Acronyms AANZFTA ACP AD AFTA AGE AIDS ALBA AMC AMS ASEAN ATC BAW BIS BIT CAMA CAP CBD CDF CEC CEPT CET CFA CIG CINDE CIP CITES CMA CMO CO CPIA CRTA CTE CTH ASEAN-Australia-New Zealand Free Trade Area African, Caribbean, and Pacific Antidumping ASEAN Free Trade Area Applied general equilibrium Acquired immune deficiency syndrome Bolivarian Alternative for the Americas American Motor Corporation Aggregate measure of support Association of Southeast Asian Nations Agreement on Textiles and Clothing Beijing Auto Works Bank for International Settlements Bilateral investment treaty Central African Monetary Area Common Agricultural Policy Convention of Biological Diversity Comprehensive Development Framework Commission on Environmental Cooperation Common effective preferential tariff Common external tariff Communauté Financière Africaine Capital-intensive goods Coalición Costarricense de Initiativas para el Desarrollo/Costa Rican Investment Board Covered interest rate parity Convention on International Trade in Endangered Species of Wild Fauna and Flora Common Monetary Area of Southern Africa Contract manufacturing organization Certificate of origin Country Policy and Institutional Assessment Committee on Regional Trade Agreements Committee on Trade and the Environment Change in tariff heading xxi xxii ACRONYMS CU CVD DD DPL DSB DSU EC ECB ECF ECOFIN ECSC ECU EEC EFF EFSF EKC EMI EMIT EMS EMU EPZ ESCB EU FAO FCL FDI FEER FOGS FTA FTAA GAB GATS GATT GDI GDP GEM GNI GNP GPN GTAP GTC HDI HDR HICP HIPC HIV HPI Customs union Countervailing duties Demand diagonal Development policy lending Dispute Settlement Body Dispute Settlement Understanding European Community European Central Bank Extended Credit Facility European Council of Ministers of Economics and Finance European Coal and Steel Community European currency unit European Economic Community Extended Fund Facility European Financial Stability Facility Environmental Kuznets curve European Monetary Institute Working Group on Environmental Measures and International Trade European Monetary System European Monetary Union Export processing zone European System of Central Banks European Union United Nations Food and Agriculture Organization Flexible credit line Foreign direct investment Fundamental equilibrium exchange rate Functioning of the GATT system Free trade agreement Free Trade Agreement of the Americas General Agreement to Borrow General Agreement on Trade in Services General Agreement on Tariffs and Trade Gender-related development index Gross domestic product Gender empowerment measure Gross national income Gross national product Global production network Global Trade Analysis Project General trading company Human development index Human Development Report Harmonized index of consumer prices Highly indebted poor country Human immunodeficiency virus Human poverty index xxiii ACRONYMS HSM IBRD ICSID ICT ICU IDA IDA IDM IFC IFIAC IFSC IIA ILO IMF IOM IP ISF ITO JV LIG LOLR LSM M&A MAI MAL MBS MDG MEA MFN MIGA MNE MPI MTN NAAEC NAALC NAB NAFTA NATO NGBT NIC NT NTB NTM OECD OLI OTDS PC High-skilled migration International Bank for Reconstruction and Development International Center for Settlement of Investment Disputes Information and communication technology International Clearing Union International Development Agency (World Bank) Industrial Development Authority (Ireland) Integrated device manufacturer International Finance Corporation International Financial Institutions Advisory Commission International Financial Services Center (Ireland) International investment agreement International Labor Office International Monetary Fund International Organization for Migration Intellectual property International Stabilization Fund International Trade Organization Joint venture Labor-intensive goods Lender of last resort Low-skilled migration Mergers and acquisitions Multilateral Agreement on Investment Minimum access level Mortgage-backed security Millennium Development Goals Multilateral environment agreements Most favored nation Multilateral Investment Guarantee Agency Multinational enterprise Multidimensional poverty index Multilateral trade negotiation North American Agreement on Environmental Cooperation North American Agreement on Labor Cooperation New Agreement to Borrow North American Free Trade Agreement North Atlantic Treaty Organization Negotiating group on basic telecommunications Newly industrializing country National treatment Nontariff barrier Nontariff measure Organization for Economic Cooperation and Development Ownership, location, and internalization Overall trade distortion support Personal computer xxiv ACRONYMS PIIGS PNDC PPF PPP PRGF PRS PTA QPC R&D RCF REER REEs RIT ROO RORE RTA RVC SAB SACU SAL SBA SCF SDR SITC SLIG SOE SPS SRF STR TBT TEU TNI TRIMS TRIPS TRQ TSMC UIP ULIG UN UNCTAD UNDP UNESCO UNICEF URR U.S. USITC VDR Portugal, Italy, Ireland, Greece, and Spain Provisional National Defense Council (Ghana) Production possibilities frontier Purchasing power parity Poverty Reduction and Growth Facility Poverty Reduction Strategy Preferential trade agreement Quantitative performance criteria Research and development Rapid Credit Facility Real effective exchange rate Rare earth elements Regional investment treaty Rule of origin Rate of return to education Regional trade agreement Regional value content South African Breweries Southern African Customs Union Structural adjustment lending Standby Arrangement Stand-By Credit Facility Special drawing rights Standard international trade classification Skilled labor–intensive goods State-owned enterprise Sanitary and phyto-sanitary Supplemental Reserve Facility Standards and technical regulations Technical barriers to trade Treaty on European Union (Maastricht Treaty) Transnationality index Trade-related investment measures Agreement on Trade-Related Aspects of Intellectual Property Rights Tariff rate quota Taiwan Semiconductor Manufacturing Company Uncovered interest rate parity Unskilled labor–intensive goods United Nations United Nations Conference on Trade and Development United Nations Development Program United Nations Educational, Scientific and Cultural Organization United Nations Children’s Fund Unremunerated reserve requirement United States United States International Trade Commission Variable deposit requirement xxv ACRONYMS VEAM VER VNM WAMU WEO WTO Vietnam Engine and Agricultural Machinery Corporation Voluntary export restraint Value of nonoriginating materials West African Monetary Union World Environmental Organization World Trade Organization Symbols A B BI C D DD e E ES F G h H I ID k K L M n P Q r R re rw S SF SG SH t T θ Technology factor Grubel-Lloyd index Belassa index of revealed comparative advantage Household consumption or conditions Demand or distance Demand diagonal Change in Nominal exchange rate or exports as a percent of GDP Exports or emigration Emigration supply Fixed costs or flow of trade/foreign direct investment Government expenditures Ratio of total human capital to total labor (human capital-labor ratio) Total human capital Investment Immigration demand Ratio of total physical capital to total labor (capital-labor ratio) Physical capital Labor, liquidity, or loans Money Natural rate of population growth Price or price level Quantity Interest rate or crude birth/death rate Total return on asset Real exchange rate Relative wage Supply Foreign savings Government savings Household savings Ad valorem tariff Specific tariff or taxes Constant xxvii xxviii SYMBOLS V w y Y Z Variable costs Wage Real gross domestic product Nominal gross domestic production or gross national income Imports 1 Windows on the World Economy 2 WINDOWS ON THE WORLD ECONOMY In the late 1990s, I met an anthropology student who had just returned from a year in Senegal. As soon as she learned that I was an international economist, she asked, “Can you tell me about the CFA franc devaluation? Why was it necessary? It has made life very difficult in Senegal.” Some years later, I met a religion student who had just returned from a semester of working in a health clinic in Haiti. As soon as he learned that I was an international economist, he asked, “Can you tell me about structural adjustment programs? I’m concerned about how they are being applied to Haiti.” More recently, my son’s school bus driver quizzed me about the Doha Round of multilateral trade negotiations. These are not rare incidents. I receive such inquiries on a routine basis from all sorts of people. Increasingly, it seems, more and more of us – religion students, bus drivers, as well as economics and business students – need to know something about the world economy. Why is this? Put simply, the world economy impacts us all in increasingly significant ways. It has become very difficult to take shelter in our academic majors and professions without being knowledgeable about the fundamentals of international economics. Increasingly, trade flows, exchange rates, and multinational enterprises matter to us all, even if we would prefer that they did not. The global financial crisis that began in 2007 made this apparent in the most dramatic way. As a consequence of these changes, students and professionals, and, more broadly, citizens now have significant concerns about “globalization.” Shortly before the failed Seattle Ministerial Meeting of the World Trade Organization (WTO) in December 1999, for example, I received a phone call from a former student. She was about to travel to Seattle to join in the protests against the WTO. She knew that I had spent a brief amount of time at the WTO and, before she set off, she wanted to raise her concerns about globalization and the impact it was having on rural economies in the United States with me. The Seattle Ministerial was a failure, in part because of the efforts of my former student and her fellow protesters. The same was true of the Cancún Ministerial Meeting of 2003. Were my student’s concerns well placed? Is globalization the evil that some contend it to be? Or, is it the unmitigated good that others contend it is? Most likely, the actualities of globalization are more variegated than the good–evil dichotomy that is often invoked. For example, in an analysis of the effects of various globalization processes on the developing world, Goldin and Reinert (2007) stated that, “The relationship between globalization and poverty is not well understood. . . . By examining both the processes through which globalization takes place and the effects that each of these processes has on global poverty alleviation, current discussions can be better informed” (p. 1). Better informing students and professionals about globalization is an important component of this book; exploring key aspects of globalization is one of the tasks we take up here. We will try to explore the world economy and globalization in as balanced a manner as possible. This will help us develop informed views and opinions, whatever they might be. Developing informed views and opinions requires a serious study of international economics. This field of study is typically divided into two parts: international trade and international finance. Indeed, these two parts often constitute the only two courses in a standard “core-course” series. In this book, however, we approach things differently. Acknowledging the diverse interests of students and professionals, as well as the diverse aspects of the world economy, we explore four different windows on the modern world economy. These are international trade, international production, 3 INTERNATIONAL TRADE 600 500 400 300 200 100 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 0 Exports of goods and services GDP Figure 1.1. Gross Domestic Product and Exports in the World Economy, 1980 to 2009 (1980 = 100). Source: World Bank, World Development Indicators and author calculations international finance, and international development. Let us briefly consider each of these in turn. INTERNATIONAL TRADE Our first window on the world economy is international trade.1 International trade refers to the exchange of goods and services among the countries of the world. In the previous sentence, the “and” between “goods” and “services” is important. We typically picture international trade as involving only goods, such as steel, automobiles, wine, or bananas. However, this view is incomplete. It is important to acknowledge that a significant portion of world trade is composed of trade in services. Financial services, architectural services, and engineering services are all traded internationally. In fact, trade in services is about one-fourth the volume of trade in goods.2 International trade in goods and services is playing an increasing role in the world economy. Consider the data presented in Figure 1.1. This figure plots two series of data for the years 1980 to 2009. The first series, represented by a dashed line, is inflationadjusted world gross domestic product (GDP), a measure of world output. It has been normalized so that the value in 1980 is 100, and the values for each subsequent year are 1 Every time you encounter a term in bold face in this book, you can find its definition in the glossary. 2 It is sometimes said that the word “goods” refers to things you can drop on your toe. Therefore, “services” refers to things you cannot drop on your toe! More formally, goods are tangible and storable, whereas services are intangible and non-storable. On trade in services, see Francois and Hoekman (2010). 4 WINDOWS ON THE WORLD ECONOMY measured relative to 1980. The second series, represented by a solid line, is inflationadjusted world exports.3 This series has been normalized in the same way as the GDP series. As you can see in this figure, over the decades considered, trade activity increased faster than production activity in the world economy. This is one of the main features of globalization, namely the expansion of exchange of goods and services among the countries of the world. You can also see that trade decreased more quickly in 2009 than did production in response to the global recession of that year. There are many reasons for the expansion of world trade, as shown in Figure 1.1. During the 1970s, a revolution in global goods shipping began with the use of containers; ships built to carry thousands of increasingly standardized, 20-foot containers; and ports redesigned to handle these ships and containers efficiently. This was followed by a revolution in information and communications technology (ICT) that greatly enhanced the ability of firms to coordinate both international trade logistics and, more generally, international production systems. Advances in ICT also greatly facilitated some types of services trade via electronic commerce. ICT subsequently enhanced the development of container shipping to such an extent that, to paraphrase Levinson (2006, p. 267), the container, combined with the computer, opened the way to globalization. Furthermore, an era of trade liberalization began with the lowering of tariff barriers both unilaterally and through regional and multilateral initiatives. All these factors helped to contribute to a world economy in which international trade relations grew increasingly important. You will begin to understand the major factors underlying international trade in Part I of this book. We will apply standard microeconomic thinking in analyzing both trade and trade policies. You will also be introduced to a set of key policy issues surrounding the management of international trade, including issues pertaining to the WTO and to preferential trade agreements such as the North American Free Trade Agreement (NAFTA) and the Association of Southeast Asian Nations (ASEAN). A full understanding of the factors underlying international trade, however, also requires an understanding of international production, which is discussed in Part II of this book. INTERNATIONAL PRODUCTION Our second window on the world economy is international production. Production patterns in the modern world economy can be relatively complex. For example, when my children were toddlers, one of their favorite books was Bear’s Busy Family, published by Barefoot Books. Featured in Inc. Magazine in 2006, Barefoot Books was founded in 1993 by Tessa Strickland and Nancy Traversy. It was initially run from their homes in the United Kingdom (where burgeoning inventory broke a table), but subsequently expanded with a flagship store in Cambridge, Massachusetts, in the United States. In the case of Bear’s Busy Family, the color separation was done in Italy and the actual printing in Malaysia. So the book my children held with such interest in their hands was a result of a production process that took place in four countries. Production of a product in multiple countries is what we mean by international production. 3 Note that world imports track world exports very closely, so we can use the level of exports as a proxy for the overall level of world trade. 5 INTERNATIONAL PRODUCTION 2500 2000 US$ billions 1500 1000 500 Low Income Middle Income 20 09 20 08 20 07 20 06 20 05 20 04 20 02 20 03 20 00 20 01 19 99 19 97 19 98 19 96 19 94 19 95 19 93 19 91 19 92 19 90 19 88 19 89 19 86 19 87 19 85 19 84 0 High Income Figure 1.2. Nominal FDI Inflows to Low, Middle, and High Income Countries, 1984 to 2009. Source: World Bank, World Development Indicators At the broadest level, international production can take place through two modes: contracts (international licensing and franchising) and foreign direct investment (FDI) undertaken by multinational enterprises (MNEs). Contracting is an arm’s length relationship across national boundaries that can be described as a low-commitment– low-control option. FDI involves firms based in one country, owning at least 10 percent of a firm producing in another country and thereby exerting management influence. It can be described as a high-commitment–high-control option. MNEs are now a major component of the world economy. To see this, consider the following facts: 1. 2. 3. 4. 5. MNEs account for approximately one-fourth of world GDP. The sales of foreign affiliates of MNEs now exceed the volume of world trade. MNEs are involved in approximately three-fourths of all world trade. Approximately one-third of world trade takes place within MNEs. MNEs account for approximately three-fourths of worldwide civilian research and development. A series of data on global FDI inflows from 1984 to 2009 is provided in Figure 1.2. The inflows are broken down among low-income, middle-income, and high-income countries that host the FDI. It is clear that the 1990s experienced a large surge of FDI flows, mostly into high-income countries and partly reflecting an upturn in mergers and acquisitions activity. What is also clear, however, is that the middle-income countries of the world are hosting a growing amount of FDI. FDI inflows into low-income countries are both very low and stagnant, with these members of the global economic community 6 WINDOWS ON THE WORLD ECONOMY largely excluded from this important part of economic globalization. Finally, as a result of the financial crisis and global recession, FDI flows decreased substantially in 2008 and 2009. What has accounted for the long-term increase in FDI activity in middle- and high-income countries? Two relevant factors mentioned earlier in our discussion of international trade include improvements in transportation and ICT. Add to these factors an expansion of global mergers and acquisition activity, particularly in the services sector (finance, transport, and communications). Indeed, services began to account for approximately half of FDI flows in the 1990s. Furthermore, many countries in the developing world began to shift from a policy posture of antipathy toward FDI inflows to one of relative friendliness. For example, this accompanied the well-known rise of FDI flows into China. As the preceding facts and data indicate, the operation of MNEs is another main feature of globalization. In Part II of this book, you will gain an understanding of MNEs and their role in international production. This includes an appreciation of the relatively complex decisions facing global firms, the function of global production networks (GPNs), and the management issues that arise when firms are spread across international borders. You will also gain an appreciation of the role of migration in international production. INTERNATIONAL FINANCE Our third window on the world economy is international finance. Whereas international trade refers to the exchange of goods and services among the countries of the world, international finance refers to the exchange of assets among these countries. Assets are financial objects characterized by a monetary value that can change over time. They make up the wealth portfolios of individuals, firms, and governments. For example, individuals and firms around the world conduct international transactions in currencies, equities, government bonds, corporate bonds (commercial paper), and even real estate as part of their management of portfolios. The way in which the prices of these assets change in response to these international transactions affects the countries of the world in important ways. Additionally, as we will see, these transactions can provide a source of savings to countries over and above the domestic savings of their households and firms. International finance plays an increasingly important role in the world economy. We can see this by considering foreign exchange transactions. Foreign exchange transactions are much larger than trade transactions. For example, Figure 1.3 plots two variables for 3-year intervals between 1989 and 2010. The first variable, plotted as the vertical bars in reference to the lefthand scale (lhs), is daily foreign exchange turnover as measured by the Bank for International Settlements (BIS) in its triennial April surveys. Despite a downturn in 2001, the total foreign exchange turnover increased substantially over time. Observers were amazed when it broke US$1 trillion in 1995, but in 2010 it reached US$4 trillion! The second variable plots the annualized foreign exchange turnover (assuming constant turnover each day) as a multiple of total world exports in reference to the righthand scale (rhs), but only up to 2007. As you can see, foreign exchange turnover is 60 to 70 times the value of exports. This makes it strikingly clear that, on an annual basis, US$ billions 4,500 90.0 4,000 80.0 3,500 70.0 3,000 60.0 2,500 50.0 2,000 40.0 1,500 30.0 1,000 20.0 500 10.0 0 Multiple 7 INTERNATIONAL FINANCE 0.0 1989 1992 1995 1998 Turnover 2001 2004 2007 2010 Multiple of Exports Figure 1.3. Daily Foreign Exchange Market Turnover and Annualized Multiple of Exports (billions of U.S. dollars on lhs and multiple of exports on rhs). Sources: Bank for International Settlements Triennial Central Bank Surveys and World Bank, World Development Indicators. Note: The multiple of exports assumes a constant foreign exchange turnover each day of the year. global transactions in foreign exchange dwarf global trade transactions. International finance matters. Another important feature of international finance has emerged in recent years. A typical expectation in the field of international finance is that developing countries will naturally receive net inflows of capital and invest them at relatively high rates of return, with this capital being supplied by developed countries with relatively low rates of return. Since 2000, however, this pattern has been reversed. Largely as a result of deficits in the United States (U.S. citizens spending in excess of national savings), the developing world is now a significant exporter of financial capital rather than an importer. As of 2008, the capital exports of the developing world exceeded US$500 billion. This is a major new development in international finance. The importance of international finance, seen in Figure 1.3, became very evident in the later part of the 1990s. During this time, investors quickly sold assets in Mexico, Thailand, Indonesia, the Philippines, Russia, and Brazil, causing balance of payments and financial crises. This was a process known as capital flight. Capital flight involves investors selling a country’s assets and reallocating their portfolios into other countries’ assets. Beginning in mid-2008, the power of international finance again became evident in the form of a global crisis with roots in the United States housing market. Losses in housing mortgages were transmitted around the globe via a pyramid of financial instruments related to this sector. This was the result of banks taking loans that would have traditionally remained on their books, repackaging them in the form of asset-based securities, and trading these securities internationally. This provided a mechanism for a crisis involving new financial products that originated in one country to take on a global 8 WINDOWS ON THE WORLD ECONOMY Table 1.1. Measures of living standards (2008, except where indicated) Country PPP GDP per capita (U.S. dollars) Life expectancy (years) Adult literacy (percent) Human development index (0 to 1) Ethiopia India China Costa Rica South Korea United States 869 3,032 6,195 11,250 26,875 47,210 55 64 73 79 80 79 36 (2004) 63 (2006) 91 (2000) 95 (2000) .. .. 0.414 0.612 0.772 0.854 0.937 0.956 Source: World Bank, World Development Indicators and United Nations Development Program profile that has yet to be resolved at the time of this writing. As noted in the Financial Times in 2008, “The global system has shifted from financing anything, however crazy, to refusing to finance anything, however sensible.” This crisis did not just affect the United States. Its most severe effects have been felt in Europe – first in the United Kingdom, and then in Portugal, Italy, Ireland, Greece, and Spain. The crises in Greece and Ireland have been particularly acute, and the European Union has struggled to contain the damage to its political and economic integration. Watching the United States and the European Union succumb to financial instability has given many experts and policymakers pause. As we can see, international finance is a realm of increasing importance in the modern world economy. You will enter into this realm in Part III of this book. You will learn about open-economy accounting, exchange rate determination, the international monetary system, and financial crises. Throughout Part III, the asset considerations that set international finance apart from international trade will be paramount. INTERNATIONAL DEVELOPMENT The fourth and final window on the world economy is international development. The processes of international trade, international production, and international finance reflect the many goals of their participants. From a public policy perspective, however, it is hoped that these three processes will contribute to improved levels of welfare and standards of living throughout the countries of the world. Two major issues are involved here. The first is how we conceptualize levels of welfare or standards of living. The second is how the processes of international trade, production, and finance support or undermine international development. One inclusive, although not uncontroversial, measure of these differences in living standards is the human development index (HDI) measured by the United Nations Development Program (UNDP). For our purposes here, suffice it to say that the HDI reflects per capita income (adjusted for cost of living), average life expectancy, and average levels of education. Some data on these measures for the year 2005, as well as on the HDI itself, are presented for a small sample of countries in Table 1.1. As we can see from the data presented in Table 1.1, there is a wide range in measures of well-being among the countries of the world. GDP per capita ranges from less than US$1,000 in Ethiopia to approximately US$47,000 in the United States, a factor of CONNECTING WINDOWS 9 50 in this standard measure of economic development.4 Life expectancies range from 55 years in Ethiopia to 80 in South Korea (and even 83 in Japan). Low life expectancies often reflect high mortality among infants and children – sadly, nearly 10 million of whom perish each year. Literacy rates range from less than 40 percent of the population in Ethiopia to near-universal literacy in other countries. When combined into the single measure of the HDI, we see a wide variance as well, with a variation of approximately 0.41 to 0.96. However we view development (income, health, or education), its level varies widely among the countries of the world. The variation in development indicators reflects the fact that economies around the world differ in their productive capacities. For example, Florida (2005) constructed a world map that proxies productive capacities with nighttime light emissions in which higher emission levels appear as raised surfaces above the earth. Florida described the result as follows: “U.S. regions appear almost Himalayan on this map. From their summits one might look out on a smaller mountain range stretching across Europe, some isolated peaks in Asia, and a few scattered hills throughout the rest of the world” (p. 49). Florida refered to this pattern of development as “spiky globalization,” a pattern that confronts the world with a significant and persistent development challenge to raise productive capacities. You will begin to understand how the activities of international trade, production, and finance affect international development in Part IV of this book. In Part IV, we consider alternative concepts of development, the way trade can contribute to economic growth, the process of hosting MNEs, and the role of the World Bank and structural adjustment in developing countries. These intersections of our windows on the world economy are critical for improving the well-being of (literally) billions of individuals worldwide. CONNECTING WINDOWS Each of our four windows on the world economy – trade, production, finance, and development – offers a view, but each has a frame. That is, each window offers some insight into the world economy, an insight that needs to be supplemented by one or more of the other windows. Let me give you an example. In 1991, I was working for the U.S. International Trade Commission (USITC) in Washington, DC. At that time, most of my efforts were dedicated to analyzing the trade effects of the North American Free Trade Agreement (NAFTA). Based on the narrow trade window, I was excited about Mexico’s prospects. One day, the USITC received a delegation from Mexico, and I had an hour-long appointment with a Mexican economist accompanying the delegation. As it turned out, he was as worried about Mexico’s prospects, even as I was excited. During our conversation, he said, “I am very worried about the future. All of the excitement over NAFTA is causing an inflow of portfolio investment. It is very short term, and it is financing a large trade deficit. It could turn around in a day! And then where will we be?” As it turned out, this Mexican economist was right. The portfolio investment did turn around and cause a crisis in late 1994 and early 1995. My window on the Mexican 4 The GDP per capita measures are purchasing power parity measures, which adjust for differences in costs of living among countries (see Chapter 20). 10 WINDOWS ON THE WORLD ECONOMY International Trade International Production Figure 1.4. Connecting Windows International Finance International Development economy was insufficient to allow me (and many other trade economists) to appreciate where Mexico was heading. The Mexican economist was more attuned to the realities of the Mexican economy because he was viewing it through more than one window. He was using the window of international finance as well. I want to suggest that you take the integrated view illustrated in Figure 1.4. In the figure, the four windows of our book are represented with four boxes. More important, there are six connections among the windows, represented by double-headed arrows. These are the connections among our four windows that we must keep in mind. NAFTA was an agreement for liberalizing trade and investment among the countries of North America, but its effects went beyond the trade and production windows to the finance window. The financial crises of the 1990s took place in the realm of international finance, but the effects were strongly transmitted to the realm of international development: standards of living fell. So as you proceed through the remainder of this book, it will be important for you to identify connections among the four windows. Figure 1.4 helps us to be cognizant of the connections among the four aspects of international economics that you will explore in this book; however, we must keep in mind that there are additional realms that affect the way in which the world economy evolves over time. These are technology, politics, culture, and the environment. At various points in the book, we discuss how these factors play important roles. It is fair to say that the boxes and arrows in Figure 1.4 should be thought of as being strongly influenced by technological, political, cultural, and environmental factors. The accompanying box takes up technology in the form of ICT. We must also say a few words about politics, culture, and the environment. ICT in the World Economy As a dynamic, driving force for global economic change, technology is central. Indeed, a large part of the globalization process can be attributed to revolutions in information and communication technologies (ICT). It is ICT that allows an employee of Philips, the Dutch consumer-electronics firm, to use the Internet in order to adjust a television assembly line process in the Flextronics factory in Guadalajara, Mexico. It is ICT that allows a fund manager in London to quickly buy or sell equities on the Johannesburg stock exchange. Most recently, new ICT technologies in the area of “telepresence” (e.g., Hewlett-Packard’s Halo system) allow teleconferencing to move into a new era in which it appears that participants half a world away are sitting across the table, greatly enhancing global coordination and reducing the need for international travel. In the realm of international production, ICT has had a somewhat unusual impact of moving production in two opposing directions: toward greater global integration and CONNECTING WINDOWS 11 toward selective disintegration of production systems. Communication and coordination costs of multinational production have long been a deterrent to FDI, requiring that MNEs possess offsetting advantages before engaging in successful foreign production. Advances in ICT have lowered these costs, contributing to increased integration of global production systems. Swissair, for example, has set up an accounting subsidiary in Mumbai, India. Because close of business in Switzerland corresponds to morning in Mumbai, this accounting work is done on an overnight basis from the Swiss standpoint. This is an example of services being globalized but remaining internal to the firm. At the same time, however, a second process has been at work. Improvements in ICT have resulted in firms contracting out on a global basis functions that they used to carry out in-house. This process has become known as “outsourcing.” For example, many U.S. firms now contract their software development to Indian firms, notably to Tata Consultancy Services and Tata Unysys Ltd. Also, a number of hospitals in the United States now contract with Indian firms for medical transcription services, making use of satellite technology. These are example of services being globalized while being external to the firm. Both of the preceding scenarios, FDI and outsourcing, are made possible by advances in ICT that are only a few decades old. These advances are causing a global reconfiguration of the way work is carried out. This is a process that has not yet reached its final destination point but has already had revolutionary impacts on the world economy. Sources: Dicken (2007) and The Economist (2000, 2007) In an ideal world, countries would interact with one another within the multilateral framework of international law, committed to dispute resolution procedures, conflict prevention, transparency, and respect for human rights. We do not live in this ideal world: country governments do not always respect international law, and armed, nonstate actors exert their own influence across national boundaries. Consequently, political events of all magnitudes continually impact the world economy. Civil and international conflicts dramatically affect the supply sides of national economies, bias government expenditures toward armaments, and promote the role of militaries in national governments. These national governments themselves are of varying degrees of strength and capability, from effective to outright failed. Political instability in struggling states affects all four windows on the world economy, but impinges on international development most strongly and negatively. Consequently, the best-intentioned developments in the world of international economic policy can come to naught in our less-than-ideal political world. Culture is as real as it is difficult to define, and we usually do not notice it until our own cultural norms have been seriously violated. It is popular to depict cultural clashes as inevitable and growing in strength in the form of a “clash of civilizations” and to further define this clash as one that is occurring between Islam and Christianity. Many of these claims do not stand up to close scrutiny. For example, Sen (2006) noted that India is considered to be central to the “Hindu world,” but has more Muslim citizens than most of the countries classified as part of the “Muslim world.” That said, it is nevertheless important to recognize that the extent to which cultural conflicts are managed (at the level of international politics or within a single MNE) matters a great deal to the evolution of the world economy. We should not discount the importance of culture. 12 WINDOWS ON THE WORLD ECONOMY The environmental issue as it relates to the world economy has developed along a number of tracks. There are global issues such as climate change, regional issues such as the environmental impacts of NAFTA, and local issues related to globalization such as toxic waste dumping. A common theme related to the politics of environmental issues is the importance of a multilateral approach to environmental problems, which is embodied in “multilateral environmental agreements,” or MEAs.5 MEAs include the Convention on International Trade in Endangered Species of Wild Fauna and Flora (CITES), the Montreal Protocol on Substances that Deplete the Ozone Layer (Montreal Protocol), the Convention on Biological Diversity (CBD), the Kyoto Protocol to the UN Framework Convention on Climate Change (Kyoto Protocol), and the Convention on Biological Diversity (CBD). The hope of many working in this realm is that MEAs will help the world economy avoid the dangers of serious and irreversible environmental harm. It is important for us to appreciate the extent to which the political, cultural, environmental, and economic can be deeply entwined. I once had the opportunity to talk at length with Dr. Owens Wiwa, the brother of Ken Saro-Wiwa, a member of the Ogani people of the Niger delta. Dr. Wiwa informed me of his brother’s campaign against the environmental damage resulting from oil exploration in the Niger delta for which he was eventually executed by the Nigerian government. One particular fact pressed upon me by Dr. Wiwa was that the gas flaring within the region takes place horizontally across the ground rather than vertically, as is typical practice. Despite being a handy way to dry laundry, this has had severe environmental and health impacts. Today, one can view these gas flares on Google Images, and the Niger delta is in a near civil war. Global production of petroleum has gravely affected the politics, culture, and environment of this particular region of the world economy. Other examples of the way political, cultural, and environmental issues interact are common around the globe. ANALYTICAL ELEMENTS As we begin to examine the four windows of the world economy, we will utilize a number of analytical elements to improve our understanding of many complex processes. These are simultaneously actual elements at work in the real world economy and conceptual elements of the various models used by researchers to understand the world economy. We will rely on seven such analytical elements: 1. Countries. These are the states of the world economy, their national governments, serving as “home” to both firms and residents. 2. Sectors. These are categories of production defined largely in terms of final goods. An example is the automotive sector. 3. Tasks. On occasion, we are going to need to recognize that production in a particular sector involves a number of steps or separate tasks. Automobile production moves from a chassis to engine mounting to body mounting, for example. 4. Firms. Production in any sector of a country is undertaken by firms, either purely local or MNEs. 5. Factors of production. Production in any sector of a country undertaken by a firm makes use of various factors of production. Automobile production uses labor and physical capital. 5 On MEAs, see Runge (2009). REVIEW EXERCISES 13 6. Currencies. Most (not all) countries in the world economy have a separate currency in which transactions with other countries take place through foreign exchanges. 7. Financial assets. Both countries and firms issue various types of financial assets, denominated in a particular currency, that can be bought to be part of wealth management portfolios by other countries, other firms, and residents of any country. These are the seven analytical elements that we will draw upon in various combinations as we move through the chapters of this book. In each chapter, I will let you know at the beginning what elements we are going to use. CONCLUSION It is becoming increasingly difficult for us to ignore the important realities of the world economy. Students and professionals of many types are finding that a basic understanding of international economics is necessary for them to operate successfully in the world. Perhaps you have the same experience. A thorough understanding of the world economy involves the study of four realms of international economics: international trade, international production, international finance, and international development. These are the four windows on the world economy that we explore in this book. International trade is increasing faster than global production. International production, meanwhile, is taking on more and more complex forms, involving both contractual arrangements and FDI. FDI is undertaken by multinational enterprises, and these organizations play a critical role in the world economy that cannot be ignored. However, as we have seen, viewing the world through trade and production windows is also incomplete. The realm of international finance is paramount, with foreign exchange transactions dwarfing trade transactions. It is hoped that international trade, international production, and international finance will contribute positively to international development, improving welfare and living standards. Understanding how this occurs (or does not occur) provides an important fourth window on the world economy.6 These four windows – trade, production, finance, and development – must be seen as connected. Furthermore, these four windows are strongly affected by the realms of technology, politics, culture, and the environment. The task of understanding how these four windows and the four larger realms (technology, politics, culture, and the environment) evolve over time in a system of globalization is not, to say the least, an easy one. Indeed, it takes us far beyond the scope of this book. However, with persistence and some patience, you will begin to build an intellectual foundation for understanding this system in the remaining chapters. REVIEW EXERCISES 1. Why are you interested in international economics? What is motivating you? How are your interests, major, or profession affected by the world economy? 2. What are the four windows on the world economy? 3. What is the difference between trade in goods and trade in services? 6 On this important issue, see Goldin and Reinert (2007). 14 WINDOWS ON THE WORLD ECONOMY 4. What is the difference between international trade and foreign direct investment? 5. What is the difference between international trade and international finance? 6. Identify one way in which the activities of international trade, finance, and production could positively contribute to international development. Identify one way in which these activities could negatively contribute to international development. How could you demonstrate that the activities have either a positive or negative impact on development? FURTHER READING AND WEB RESOURCES Osterhammel and Petersson (2005) present a concise history of globalization accessible to a broad audience. Dicken (2007) and Dunning and Lundan (2008) look at foreign direct investment in recent decades, and Prahalad and Lieberthal (2008) provide a short, interesting assessment of FDI in developing countries. On international trade, see Hoekman and Kostecki (2009). Eichengreen (2008) gives an excellent history of international finance, and the Financial Times (2008) takes a brief look at its recent failure. Szirmai (2005) and Goldin and Reinert (2007) examine the relationship of a number of aspects of globalization to development and poverty alleviation, Sen (2006) effectively addresses cultural issues in a global perspective, and Speth and Haas (2006) address global environmental issues. Finally, Reinert et al. (2009) have edited a comprehensive encyclopedia of the world economy directly relevant to the four windows on the world economy examined here. The Peterson Institute for International Economics in Washington, DC, provides timely and readable analyses of many issues in international economics. Its website is www.iie.com. Two quality sources on international economic developments are The Economist and The Financial Times. Their websites are www.economist.com and www.ft.com. Important institutions of the world economy include the World Trade Organization (www.wto.org), the World Bank (www.worldbank.org), and the International Monetary Fund (www.imf.org). REFERENCES Dicken, P. (2007) Global Shift: Mapping the Changing Contours of the World Economy, Guilford. Dunning, J.H. and S.M. Lundan (2008) Multinational Enterprises and the Global Economy, Edward Elgar. The Economist (2000) “Have Factory, Will Travel,” February 12. The Economist (2007) “Behold, Telepresence,” August 24. Eichengreen, B. (2008) Globalizing Capital: A History of the International Monetary System, Princeton University Press. Financial Times (2008) “The Year the God of Finance Failed,” December 26. Florida, R. (2005), “The World Is Spiky,” Atlantic Monthly, October. Francois, J.F. and B. Hoekman (2010) “Services Trade and Policy,” Journal of Economic Literature, 48:3, 642–92. Goldin, I. and K.A. Reinert (2007) Globalization for Development: Trade, Finance, Aid, Migration and Policy, World Bank. Hoekman, B.M. and M. Kostecki (2009) The Political Economy of the World Trading System, Oxford University Press. REFERENCES 15 Levinson, M. (2006) The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger, Princeton University Press. Osterhammel, J. and N.P. Petersson (2005) Globalization: A Short History, Princeton University Press. Prahalad, C.K. and K. Lieberthal (2008) The End of Corporate Imperialism, Harvard Business Press. Reinert, K.A., R.S. Rajan, A.J. Glass, and L.S. Davis (eds.) (2009) The Princeton Encyclopedia of the World Economy, Princeton University Press. Runge, C.F. (2009) “Multilateral Environmental Agreements,” in K.A. Reinert, R.S. Rajan, A.J. Glass, and L.S. Davis (eds.), The Princeton Encyclopedia of the World Economy, Princeton University Press, 795–9. Sen, A. (2006) Identity and Violence: The Illusion of Destiny, Norton. Speth, J.G. and P. M. Haas (2006) Global Environmental Governance, Island Press. Szirmai, A. (2005) The Dynamics of Socio-Economic Development, Cambridge University Press. I INTERNATIONAL TRADE 2 Absolute Advantage 20 ABSOLUTE ADVANTAGE Throughout most of the 1980s, Vietnam imported rice. In 1989, however, Vietnam exported more than 1 million tons of rice. In the 1990s, its annual rice exports increased to more than 3 million tons. Despite a fall in rice exports in 2004, Vietnam was expected to export 6 million tons of rice in 2009. As discussed in Goldin and Reinert (2007, Chapter 3) and Heo and Doanh (2009), despite being the staple consumption crop in Vietnam, the expansion of rice exports helped to alleviate poverty in that country through increased employment and wage income. This beneficial increase in rice exports represents one important aspect of Vietnam’s entry into the world economy through the process of trade expansion we discussed in Chapter 1. Why does a country export or import a particular good? This chapter takes a first step in helping you answer this fundamental question by utilizing a framework that should be familiar to you from your introductory economics class: the supply and demand diagram. We will use this diagram to illustrate an important concept in international economics, that of absolute advantage. Absolute advantage refers to the possibility that, due to differences in supply conditions, one country can produce a product at a lower price than another country.1 In this chapter, we consider the product rice and the fact that Vietnam can produce rice more cheaply than Japan. This situation causees rice to be exported from Vietnam to Japan. It also involves what international economists call the gains from trade, which benefit both Vietnam and Japan. These gains are what motivate countries to take part in trading relationships. Analytical elements for this chapter: Countries, sectors, and factors of production. SUPPLY AND DEMAND IN A DOMESTIC MARKET Throughout the world, rice is exchanged in markets. Although these markets are international, let’s assume for a moment that we can analyze a single domestic market in isolation. This will help orient you to the supply and demand model. Figure 2.1 illustrates such a market. The diagram has two axes. The horizontal axis plots the quantity (Q ) of rice in tons per year. The vertical axis plots the price (P ) of rice per ton. There are two curves in the diagram identified by the symbols S and D. S is the supply curve and represents the behavior of domestic rice-producing firms. D is the demand curve and represents the behavior of domestic consumers of rice, both firms and households.2 There are a number of properties of the supply and demand curves in Figure 2.1 that are important to understand. Let’s consider the supply curve first. It is upward sloping, and this indicates that firms supply more rice to the market as the price increases. Consequently, changes in price are represented in the diagram by movements along the supply curve. These movements are known as changes in quantity supplied. There are two additional supply-side factors relevant to the supply curve. These are input or factor prices and technology. Reductions in input prices and improvements in technology shift the supply curve to the right. This means that producers supply more rice than before at every price. Increases in input prices and technology setbacks shift the supply curve 1 For an alternative approach, see Van Marrewijk (2009). 2 Firms consuming rice use it as an intermediate product to produce a final product such as rice flour or a restaurant meal. 21 ABSOLUTE ADVANTAGE P S PE Figure 2.1. A Domestic Rice Market D Q QE to the left. This means that producers supply less rice than before at every price. We can see that changes in input prices and technology are represented by shifts of the supply curve. These shifts are known as changes in supply. Now let’s take a look at the rice demand curve. It is downward sloping, and this indicates that consumers demand less rice from the market as the price increases. Consequently, changes in price are represented in the diagram by movements along the demand curve. These movements are known as changes in quantity demanded. There are a number of additional demand-side factors relevant to the demand curve. Two important ones are incomes and preferences.3 Increases in incomes and increased preference for rice consumption shift the demand curve to the right. This means that consumers demand more rice than before at every price. Decreases in incomes and decreased preference for rice consumption shift the demand curve to the left. This means that consumers demand less rice than before at every price. Consequently, changes in incomes and preferences are represented by shifts of the demand curve. These shifts are known as changes in demand. Finally, the intersection of the supply and demand curves in Figure 2.1 determines the equilibrium in the domestic rice market. In this diagram, the equilibrium price is P E , and the equilibrium quantity is Q E . Given what was just stated about the role of input prices, technology, incomes, and preferences in shifting the two curves in Figure 2.1, you can see that any such shifts will change the equilibrium price and quantity for rice by shifting the demand or supply curves. These sorts of changes are natural parts of market processes. As we stated above, rice markets are actually international. Therefore, we cannot analyze them effectively using Figure 2.1. We need to consider how to account for the international character of rice markets in the supply and demand framework, an important initial step in understanding international trade. ABSOLUTE ADVANTAGE Rice is produced in many countries, but to simplify, suppose we consider just Vietnam and Japan. To help us analyze the international rice market that arises between these 3 Other demand-side factors are prices of related products, wealth, and expectations. Changes in these factors shift the demand curve, as do changes in income and preferences. 22 ABSOLUTE ADVANTAGE Vietnam Japan P P D D Q Q Figure 2.2. Demand for Rice in Vietnam and Japan two countries, we will make a simplifying assumption about the demand side of the rice market in both Vietnam and Japan. More specifically, we assume that demand conditions are exactly the same in both countries. That is, there are no differences in preferences, incomes, or the way demand responds to price changes in Vietnam and Japan. This implies that the demand curves for rice in the two countries are exactly the same, as illustrated in Figure 2.2. The reason we make this simplifying demand-side assumption is that trade often arises due to differences in supply conditions rather than in demand conditions. Indeed, most of the field of trade theory is based on various explanations for these supply-side differences among countries. Therefore, we will allow supply conditions for rice to differ between Vietnam and Japan. In particular, we will assume that the supply curve for Vietnam is farther to the right than the supply curve for Japan, which means that at every price, Vietnam supplies more rice than Japan. Why might this be? One possibility is that Vietnam produces rice using technology superior to that of Japan so that labor productivity in rice production in Vietnam is higher than in Japan. This possibility, however, is not relevant to rice production in these two countries.4 Another possibility is that the prices for inputs used in rice production are lower in Vietnam than in Japan. This, in turn, could reflect the fact that Vietnam is more abundantly endowed with rice production factors (available land and agricultural labor) than Japan. It is this latter factor that is relevant in the current case. This situation is depicted in Figure 2.3. The upward sloping supply curves reflect the positive relationship between price and quantity supplied. The difference in supply conditions positions Vietnam’s supply curve farther to the right than Japan’s supply curve. The intersections of the supply and demand curves determine the equilibrium prices of rice in the two markets. The two prices are recorded as P V and P J in the figure. Because no trade is involved, these two prices are known in international economics as autarky prices. Autarky is a situation in which a country has no economic relationships with other countries. 4 For a case where technology is relevant, see the box on p. 25 on Japan’s advantage in industrial robots. 23 INTERNATIONAL TRADE Vietnam Japan P P SJ PJ SV PV D D Q Q Figure 2.3. Absolute Advantage in the Rice Market Figure 2.3 depicts a situation in which the autarky price of rice is lower in Vietnam than in Japan. That is: PV < PJ (2.1) In international trade theory, this situation is interpreted as Vietnam having an absolute advantage in the production of rice vis-à-vis Japan. This absolute advantage reflects the differences in supply conditions in the two countries. The presence of absolute advantage makes international trade a possibility. INTERNATIONAL TRADE The idea of absolute advantage was first stated in Adam Smith’s Wealth of Nations, published in 1776. Adam Smith (1937) stated the following: “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage” (p. 424). In other words, a pattern of absolute advantage implies a potential pattern of trade. How does this apply to our example? If the two countries move out of autarky and begin to trade, the world price of rice P W will be somewhere between the two autarky prices, as follows: PV < PW < PJ (2.2) This situation is depicted in Figure 2.4. In the movement from autarky to trade, Vietnam experiences an increase in the price of rice to the world level (from P V to P W ). Quantity supplied will increase, whereas quantity demanded will decrease. The amount by which quantity supplied exceeds quantity demanded in Vietnam at P W constitutes its exports of rice, E V . Japan experiences a decrease in the price of rice to the world level (from P J to P W ). Here, quantity supplied will decrease, whereas quantity demanded will increase. The amount by which quantity demanded exceeds quantity supplied in Japan at P W constitutes its imports of rice, Z J .5 The country that has an absolute advantage (Vietnam) expands its quantity supplied and exports the good in question, 5 We use a Z to denote imports throughout this book. Why Z ? As we will see, I is used in economics to denote investment, and M is used to denote money. Therefore, we cannot use either of the first two letters of the word “imports.” 24 ABSOLUTE ADVANTAGE Vietnam Japan P P SJ P J EV SV W P ZJ PV D D Q Q Figure 2.4. Trade in the Rice Market whereas the trading partner (Japan) contracts its quantity supplied and imports the good. The associations you should have in your mind from the preceding discussion are presented in Figure 2.5. The starting points are comparative levels of technological proficiency and endowments of factors used in the production of the sector’s product. The latter affects the relevant input prices for a sector in a country. Vietnam, for example, has lower domestic prices for rice-growing land and labor. Technological and factor characteristics determine a pattern of absolute advantage between two countries. This pattern of absolute advantage, in turn, can generate a pattern of trade. Vietnam tends to export rice, whereas Japan tends to import rice. Another example in which Japan’s technological proficiency in the production of industrial robots leads to exports is given in the accompanying box. Superior technology in a sector and/or Larger endowments of factors used in a sector (lower input prices) Inferior technology in a sector and/or Smaller endowments of factors used in a sector (higher input prices) Absolute advantage in a sector Tendency to export the sector’s product Absolute disadvantage in a sector Tendency to import the sector’s product Figure 2.5. A Schematic View of Absolute Advantage INTERNATIONAL TRADE 25 Japan’s Advantage in Industrial Robots The word robot first appeared in 1921 in a Czech play written by Karel Čapek, based on the Czech word “robota,” meaning drudgery. The world’s first industrial robot was built in the United States by the industrialist Joseph Engelberger, who founded the company Unimation in 1956 and installed the first industrial robot in 1961. Engelberger had a moment of fame in 1966 when one of his robots appeared on Johnny Carson’s Tonight Show, opening and pouring a can of beer. In 1967, Engelberger was invited to Japan and addressed 600 Japanese scientists and business executives. As a result, Japan imported its first industrial robots from the United States. In 1969, robot production began in Japan under a licensing agreement with Unimation. In 1972, the Japan Robot Association was founded. Thus began Japan’s involvement with what has been called “the most important manufacturing innovations of recent times” (Mansfield, 1989, p. 19). Japan’s first exports of industrial robots began in 1975. Thereafter, exports grew slowly but steadily. By the end of the 1980s, Japan became the leader in most areas of the robotics industry, such as numerical controllers, machine tools, motors, and optical sensors. It accounted for one-half of the world production of industrial robots. The technological nature of Japan’s advantage in robot production was captured by Porter (1990): “The pace of innovation and new product introduction among the Japanese firms was feverish. Product innovations were soon imitated or upstaged by other producers. For example, the American firm Adept Technology introduced the world’s first commercially successful direct-drive robot near the end of 1984. Less than a year later, seven Japanese firms, including Yamaha, Matsushita, and FANUC, introduced direct drive robots” (p. 235). Along with faster innovation times, Japanese firms benefited from lower innovation costs. There is some evidence that Japan’s faster innovation times and lower innovation costs were due to a greater emphasis on manufacturing over marketing in the innovation process in comparison with the United States. Accompanying and contributing to Japan’s technological lead in industrial robots was the degree of competition in the Japanese industrial robots industry. With fewer than 10 firms in 1968, the industry expanded to nearly 300 firms by 1987 and declined to approximately 150 firms in 2000. Another important factor has been intra-firm diffusion, where firms requiring the use of robots (e.g., the electronic equipment industry) begin producing robots for their own use. A final factor pushing the use of robots in Japan has been the presence of significant labor shortages in many areas; robots replaced humans where these shortages appeared. As of 1997, Japan used one robot for every 36 manufacturing employees, whereas the United States used only one robot for every 250 manufacturing employees. Currently, one-half of the world’s industrial robots are installed in Japan. Despite these long-term positive factors, the Japan Robot Association (2001) pointed to some weaknesses. The industry has had difficulty moving out of large industrial applications into biotech, medical, and consumer applications as well as leveraging venture capital. In contract to past models of technological innovation characterizing Japan, the Japan Robot Association called for a focus on small business and greater openness. This, it was hoped, would position the industry for a different set of robotic applications with promising future growth prospects. Sources: The Economist (1980), Horiuchi (1989), Mansfield (1989), Porter (1990), Tanzer and Simon (1990), and Japan Robot Association (2001) 26 ABSOLUTE ADVANTAGE It is important to stress here that Figure 2.5 is only a preliminary look at international trade. In the real world, international trade is actually determined by comparative advantage rather than absolute advantage. This is why we use the word tendency in the far right-hand boxes of the figure. Consequently, you will not have a full appreciation of how international trade is determined until you complete Chapter 3. Nevertheless, our discussion in this chapter is useful in order to understand how the traditional supply and demand framework must be modified to account for trading relations and to understand the gains from trade.6 A question that often arises in students’ minds is: What ensures that the amount exported by Vietnam is the same as the amount imported by Japan? The answer is that, if E V were smaller than Z J , there would be excess demand or a shortage in the world market for rice. As we know from introductory microeconomics, excess demand causes the price to rise. As P W rose, exports of Vietnam would increase and imports of Japan would decrease until the excess demand in the world market disappeared. Similarly, if E V were larger than Z J , P W would fall to bring the world market back into equilibrium. Before moving on to discuss the gains from trade, another key concept in international economics, let’s summarize what we have shown thus far in a box: Differences in supply conditions among the countries of the world can give rise to complementary patterns of absolute advantage. These patterns of absolute advantage, in turn, make possible complementary patterns of international trade. GAINS FROM TRADE Up to this point, we have seen that, given a pattern of absolute advantage, it is possible for a country to give up autarky in favor of importing or exporting. Japan can import rice, and Vietnam can export rice. But should a country actually do this? We can answer this question by examining Figure 2.4 from the standard economic point of view using consumer surplus and producer surplus.7 This is done in Figure 2.6. If you do not recall the consumer surplus and producer surplus concepts from your introductory microeconomics course, please consult the appendix to this chapter. Let us first consider Vietnam. In its movement from autarky to exporting in the rice market, producers experience both an increase in price and an increase in quantity supplied along the supply curve. This should be good for producers, and as you can see in Figure 2.6, there has been an increase in producer surplus of area A + B as a result of the movement from autarky to trade. Consumers, on the other hand, experience an increase in price and a decrease in quantity demanded along the demand curve. This should harm consumers, and you can see in Figure 2.6 that there has been a decrease in consumer surplus of area A. What do these effects mean for Vietnam? Producers have gained area A + B , whereas consumers have lost area A. The gain to producers exceeds the loss to consumers. 6 As we will see in Chapter 6, the supply and demand framework is also used to conduct trade policy analysis. 7 There are alternatives to the standard economic view of welfare. These are discussed in Chapter 20 and very briefly in the appendix to this chapter. 27 GAINS FROM TRADE Vietnam Japan P P SJ P J EV SV C W P A B D ZJ PV D D Q Q Figure 2.6. Gains from Trade in the Rice Market For the economy as a whole, then, there is a net welfare increase of area B . Vietnam gains from its entry into the world economy as an exporter.8 Next, consider Japan. In its movement from autarky to importing in the rice market, producers experience a decrease in price and a decrease in quantity supplied along the supply curve. This should harm these producers, and you can see in Figure 2.6 that there has been a decrease in producer surplus of area C. Consumers, on the other hand, experience a decrease in price and an increase in quantity demanded. These contribute to an increase in consumer surplus of area C + D. What do these effects mean for Japan? Consumers have gained C + D, whereas producers have lost area C. The gain to consumers exceeds the loss to producers. For the economy as a whole, then, there is a net welfare increase of area D. Japan gains from its entry into the world economy as an importer.9 You can see that moving from autarky to either importing or exporting involves a net increase in welfare for the country involved. This net increase in welfare is known as the gains from trade. Not only is it possible for a country to give up autarky in favor of importing or exporting, but it makes sense to do so in most instances from the standpoint of overall welfare. The notion of gains from trade is an important concept. To judge from the tone and content of many popular writings on the world economy, trade relationships are a win-lose proposition for the countries involved. To export is to win; to import is to lose. The gains from trade idea, however, tells us that trade can be mutually beneficial to the countries involved. For this reason, we need to be cautious in our assessment of some popular writing of the win-lose variety. Although there are specific instances in which trade can be a win-lose proposition, this is not the case for trade in general.10 For the peculiar case of international advantages in rare earth elements, see the accompanying box. 8 Area A can be viewed as a transfer from consumers to producers in Vietnam. 9 Area C can be viewed as a transfer from producers to consumers in Japan. 10 This point was emphasized some time ago by Krugman (1996). Krugman stated that “The conflict among nations that so many policy intellectuals imagine prevails is an illusion; but it is an illusion that can destroy the reality of mutual gains from trade” (p. 84). 28 ABSOLUTE ADVANTAGE Rare Earth Elements Rare earth. No, not the rock band. Rather, 17 chemical elements collectively known as “rare earth elements,” or REEs. REEs are key components in some of the information and communication technology (ICT) discussed in Chapter 1 as drivers of globalization. These include liquid-crystal displays, fiber-optic cables, communication system magnets, wind turbines, solar panels, and rechargeable batteries used in hybrid cars. REEs are not actually rare, however. Some of them, for example, are much more common than gold. Despite this abundance, REEs are not usually concentrated enough for commercial mining, and there are consequently only a few sources. From 1965 to 1980, most REEs came from the Mountain Pass mine in the Mojave Desert in the United States. Beginning in 1985, advantage switched to the Inner Mongolia region of China. The Economist (2009) noted that Communist Party Leader Deng Xiaoping, “declaring rare earths to be the oil of China, encouraged the development of mines in the mid-1980s. Prices fell dramatically and existing mines in America were priced out of business.” Currently, China supplies 95 percent of the global market for REEs, and the Mountain Pass mine closed in 2002. As China’s own demand for REEs has grown, concern has arisen about the security of supplies. The Economist (2009) reported: “sales of (REEs) add up to less than $2 billion each year. But without them, industries worth trillions of dollars would grind to a halt.” In response to this situation, there has been even talk in the Chinese government about a ban of exports of some important REEs. Consequently, attention has turned to alternative supply possibilities with Western Australia, North America (Alaska and Quebec), and South Africa. In 2010, REEs became part of a dispute between Japan and China over the Senkaku (Japanese) or Diaoyu (Chinese) islands in the East China Sea, which are claimed by both countries. China barred exports of REEs to Japan as a result. Consequently, the U.S. Congress began discussions of reopening Mountain Pass mine. The matter was also taken up in the World Trade Organization (WTO) dispute settlement process (see Chapter 7), which ruled against China in 2011. Sources: Bradsher (2010), The Economist (2009), and U.S. Geological Survey (2002) LIMITATIONS The notion of absolute advantage, first suggested by Adam Smith in his Wealth of Nations, is useful to understanding international trade in the context of the familiar supply and demand framework. It is also useful to understanding that trade can improve overall welfare for the countries involved. The concept has its limits, however. In particular, it suggests the possibility that a country could not have an absolute advantage in anything, and therefore would have nothing to export at all. This, it turns out, is unlikely. To understand why, we must turn to a more sophisticated notion of trade, comparative advantage. We do this in the next chapter. The notion of the gains from trade also has its limits. It suggests that countries as a whole mutually gain from trade. It does not suggest, however, that everyone within a country will gain from trade. As you have already seen in the example of this chapter, producers of rice in Japan lose from trade, and consumers of rice in Vietnam lose from FURTHER READING AND WEB RESOURCES 29 trade. We will take up the subject of the winners and losers from trade in earnest in Chapter 5 on the political economy of trade. CONCLUSION Autarky refers to a situation in which a country does not engage in either imports or exports. It is a rare situation. More commonly, countries engage in both importing and exporting relationships with other countries of the world economy. In this chapter, you have begun to understand why. Absolute advantage reflects differences among countries in technology or factor conditions. A country with better technology and larger endowments of the factors necessary to produce an item is more likely to have absolute advantage in the production of that item. It is also more likely to export that item. Patterns of absolute advantage in the world economy also make possible mutual gains from trade in which the overall welfare of the countries involved increases. The notion of absolute advantage has its limits. First, it suggests that a country might not have anything to export at all. This, as we will see in the next chapter on comparative advantage, is an unlikely outcome. Second, it does not suggest that all persons in a country will gain from trade. Within any country, there can be both winners and losers from international trade. REVIEW EXERCISES 1. Use Figure 2.1 to consider the following changes: a fall in incomes due to a recession; an increased preference for rice consumption; an increase in input prices for rice production; and an improvement in rice production technology. Use diagrams to analyze the effects of these changes on equilibrium price and quantity. 2. Create an example of an absolute advantage model by choosing two countries and a single product. a. Draw a diagram describing autarky and a pattern of absolute advantage for your example. b. Show the transition from autarky to trade in your diagram, label the trade flows, and demonstrate the gains from trade. c. In a new diagram, and starting from a trading equilibrium, show what would happen to the world price if income increased by exactly the same, small amount in both countries. 3. Can you recall from introductory microeconomics the notions of the price elasticity of demand and price elasticity of supply? If so, can you say what would happen to the gains from trade as supply and demand in Vietnam and Japan become more and more inelastic? FURTHER READING AND WEB RESOURCES The idea of absolute advantage was first discussed in Chapter II, Book IV of Smith (1937). This book is available in the nonfiction section of www.bibliomania.com. A much more recent overview can be found in Van Marrewijk (2009). A blog about global rice trade can be found at rice-trade.blogspot.com. 30 ABSOLUTE ADVANTAGE P Consumer Surplus S Producer Surplus PE Figure 2.7. Consumer and Producer Surplus D Q QE . APPENDIX: CONSUMER AND PRODUCER SURPLUS Our discussion of the gains from trade in this chapter utilized the notions of consumer surplus and producer surplus. These concepts are illustrated in Figure 2.7. This figure considers equilibrium in a single market. The equilibrium price is P E , and the equilibrium quantity is Q E . The height of the demand curve shows consumers’ maximum willingness to pay for the good in question. For quantities between zero and Q E , however, the willingness to pay is greater than what consumers actually pay. That is, the height of the demand curve is greater than the market price. This gives the consumers a premium on each unit up to Q E , and the sum of the consumer premia is the upper triangle in the figure, consumer surplus. The height of the supply curve shows the producers’ minimum willingness to accept for the good in question. For quantities between zero and Q E , however, the willingness to accept is less than what the producers actually receive. That is, the height of the supply curve is less than the market price. Producers too, then, receive a premium on each unit up to Q E . The sum of the producer premia is the lower triangle in the figure, producer surplus. In demonstrating the gains from trade in Figure 2.6, we considered the changes in consumer and producer surplus that result from the price changes brought on by the move from autarky to trade. This analysis of the gains from trade is based on the standard view of economic welfare. As discussed in Reinert (2004) and in Chapter 20, this standard view does impose some limitations. It restricts our consideration of welfare to income per capita or, more formally, what economists term the utility of consumption. Alternative views, such as in the form of human capabilities as argued by Sen (1987), are advocated by some economists. REFERENCES Bradsher, K. (2010) “Amid Tension, China Blocks Crucial Exports to Japan,” New York Times, September 22. The Economist (1980) “Robots,” October 17. The Economist (2009) “The Hunt for Rare Earths,” October 8. Goldin, I. and K.A. Reinert (2007) Globalization for Development: Trade, Finance, Aid, Migration and Policy, World Bank. REFERENCES 31 Heo, Y. and N.K. Doanh (2009) “Trade Liberalization and Poverty Reduction in Vietnam,” World Economy, 32:6, 934–964. Horiuchi, T. (1989) “Development Process of Robot Industries in Japan,” Rivista Internazionale di Scienze Economiche e Commerciali, 36:12, 1089–1108. Japan Robot Association (2001) Summary Report on Technology Strategy for Creating a Robot Society in the 21st Century. Krugman, P. (1996) “The Illusion of Conflict in International Trade,” in Pop Internationalism, MIT Press, 69–84. Mansfield, E. (1989) “Technological Change in Robotics: Japan and the United States,” Managerial and Decision Economics, Special Issue, 19–25. Porter, M.E. (1990) The Competitive Advantage of Nations, The Free Press. Reinert, K.A. (2004) “Outcomes Assessment in Trade Policy Analysis: A Note on the Welfare Propositions of the ‘Gains from Trade,’” Journal of Economic Issues, 38:4, 1067–1073. Sen, A. (1987) The Standard of Living, Cambridge University Press. Smith, A. (1937) The Wealth of Nations, Modern Library (first published in 1776). Tanzer, A. and R. Simon (1990) “Why Japan Loves Robots and We Don’t,” Forbes, 145:8, April 16, 148–153. United States Geological Survey (2002) Rare Earth Elements: Critical Resources for High Technology, USGS Fact Sheet 087–02. Van Marrewijk, C. (2009) “Absolute Advantage,” in K.A. Reinert, R.S. Rajan, A.J. Glass, and L.S. Davis (eds.) The Princeton Encyclopedia of the World Economy, Princeton University Press, 1–3. 3 Comparative Advantage 34 COMPARATIVE ADVANTAGE In Chapter 2, we used the concept of absolute advantage to examine trade in rice between Vietnam and Japan. For Vietnam, rice is a significant component of the country’s total production and an important component of domestic consumption. As incomes have increased in Vietnam, however, there is another product that many Vietnamese think about buying. That product is a motorcycle. Indeed, motorcycles have been all the rage in Vietnam. Originally, the most desirable motorcycle was the aptly named Honda Dream, but subsequently, attention turned to the Honda Wave. These brands are so popular that copies of them are made in China and exported to Vietnam. Hundreds of new motorcycles are registered daily in the city of Hanoi alone, and tourists visiting this city report being overwhelmed by the chaos of motorcycle traffic. In this chapter, we place motorcycles alongside rice so that you can begin to understand the powerful concept of comparative advantage and its role in generating patterns of trade among the countries of the world. Vietnam Japan QM QM DD DD QR QR Figure 3.1. Demand Diagonals in Vietnam and Japan In order to understand comparative advantage, we will use the concept of a production possibilities frontier (PPF). The PPF should be familiar to you from an introductory microeconomics course. If it is not, please see the appendix to this chapter for a brief introduction. Analytical elements for this chapter: Countries, sectors and factors of production. AUTARKY AND COMPARATIVE ADVANTAGE Consider again our two countries, Vietnam and Japan. Both of these countries produce two goods, rice and motorcycles. To help us in our analysis of comparative advantage, we will assume that demand for rice and motorcycles in both Vietnam and Japan are such that these two goods are consumed in the same, fixed proportions.1 This assumption is depicted in Figure 3.1. In the diagrams for Vietnam and Japan, the quantity of rice 1 We use this assumption to simplify the presentation of comparative advantage for the introductory student. However, this assumption can be relaxed without changing any of the results of this chapter. Indeed, this is exactly what is done in more advanced texts in trade theory such as M…

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