Unit 2.3.1 Costs of Production: Team Presentation Activity

Learning Objectives:

• Distinguish between fixed and variable costs of production
• Understand how the law of diminishing returns affects the shape of a firm’s short-run total costs and short-run average costs.
• Understand the relationships between marginal cost and the average costs faced by a firm
• Distinguish between the short-run and the long-run and understand how economies of scale determines the shape of a firm’s long-run ATC curve.
• Evaluate the importance to a business firm of understanding its short-run and long-run costs of production.

Process: Work with a partner in the class to prepare a presentation on the theories behind and the relationships between a firm’s short-run and long-run costs of production. Pairs will create a shared Google Presentation (which should also be shared with Mr. Welker) and collaborate on creating a presentation demonstrating your understanding of the topics outlined below. The presentations that are created will be shared among group members, and edited in class and over the weekend.

The assignment: Each team is to make one Google Presentation on an assigned topic based on what they learn using the web-resources provided by Mr. Welker below. Presentations will be shared with Mr. Welker and presented during our first meeting next week.

Guidelines for presentation:

1. Presentations must be at least 10 slides long, but no more than 15.
   
2. Presentations must include definition, explanations, illustrations and examples (when possible) for the key concepts identified below
3. Presentations must include graphs from the resources provided to illustrate concepts where necessary
4. Presentation must use each group’s own words. Copying and pasting text from the resources provided is not permitted.

Shor-run – Key Concepts

• Short-run
• Total, average and marginal product
• Law of diminishing returns
• Short-run total costs
• Short-run marginal and average costs

Resources on Short-run Costs of Production:

• Course Companion pages 73-79
• Unit 2.3.1 Study Guide
• Wiki page – Economic Costs
• Calculating total costs – BizEd
• Wiki page – Short-run Production Relationships
• Wiki page – Short-run Production Costs
• WW Blog – Diminishing Returns and graphing short-run costs (Read and respond to the discussion questions as a table group)
• Biz-Ed PowerPoint on short-run costs (slides 1-28)

Long-run: Key Concepts

• Long-run
• Long-run Average Total Cost
• Economies of scale/Increasing returns to scale
• Minimum efficient scale
• Constant returns to scale
• Diseconomies of scale/Decreasing returns to scale

Resources on Long-run Costs of Production:

• Course Companion pages 79-83
• Unit 2.3.1 Study Guide
• Wiki page – Economic Costs
• Wiki page – Long-run Production Costs
• Biz-Ed PowerPoint on long-run costs (slides 29-57):
• WW Blog – Economies of scale and the long-run ATC (Read and respond to the discussion questions as a table group)
• Biz-Ed – Economies of scale in farming
• Biz-Ed – Economies of scale in fishing

Grading Presentation: Total – 40 marks

FT.com / Asia-Pacific – Renminbi at heart of trade imbalances.

“The Americans get the toys, the Chinese get the Treasuries and we get screwed.” Thus a European Union official once characterised the pattern of Beijing accumulating US assets by selling renminbis for dollars, while nothing stood in the way of a rapid and destabilising appreciation of the euro.

In a world of freely floating exchange rates trade imbalances between countries would ultimately be reduced and eliminated. At least, that’s the belief of those advocating a floating exchange rate between East Asian currencies and the United States.

Here’s how it is supposed to work:

• Cheap labor and cheap imports from China following China’s joining the world economy 30 years ago led to a rapid increase in demand for Chinese manufactured goods in the US, creating growth, jobs, and rising national income for China.
• A trade imbalance emerges between the US and China as US spending on imports increases more rapidly than America’s  sale of exports. If the Chinese currency were allowed to float freely on foreign exchange markets, however, this imbalance would be temporary, because…
• The US current account deficit means, literally, that Americans are supplying more of their dollars in the foreign exchange market, while demanding more Chinese RMB. The forces of supply and demand would naturally lead to an appreciation of the RMB and a depreciation of the dollar.
• The weaker dollar resulting from the trade deficit with China would eventually make Chinese goods less attractive to Americans. Despite their lower costs of production, the weak dollar makes imported Chinese goods more expensive and less appealing to the American consumer.
• The strong RMB, on the other hand, makes American produced goods and services cheaper to Chinese consumers, who begin to import more from the US at the same time that Americans demand fewer of China’s products.
• Through free-floating exchange rates, a current account imbalance is eventually reduced and eliminated as exchange rates adjust to the flows of goods and services between trading partners.

A graphical version of this story is told here:

This, of course, is precisely what has NOT happened, thanks to China’s strict management of the value of the RMB. In order to keep its currency weak, Beijing directly intervenes in foreign exchange markets, “by selling renmenbi for dollars” to accumulate American assets. As seen in the next graph, such interference has the effect of keeping the dollar strong against the RMB.

As any IB student knows, the Balance  of Payments between two countries includes not only the trade in goods and services, but also the flow of real and financial assets, such as government securities, stocks, real estate, factories, and so on, between the countries. China has actively promoted a policy of acquiring such American assets, which keeps demand for dollars strong in China, and supply of RMB high in America, without creating any jobs in manufacturing or services for Americans. China has financed America’s current account deficit by assuring it maintains a capital account surplus!

Put more simply, China has exported goods and services to America, while America has exported ownership of its real and financial assets to China. This is a major area of concern for US policy makers, who would like to see a more balanced current account between the two countries, since it is the export of goods and services that creates jobs for American workers, not the sale of bonds, stocks and real estate.

Discussion Questions:

1. Why does Europe care about China’s fixed exchange rate with the US dollar?
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
4. How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?

Look closely at the two cost curves below:

The curve on the left is a firm’s short-run average total cost curve. The one on the right represents a firm’s long-run average total cost curve. See the difference?

I didn’t think so. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms.

The Short-Run: In microeconomics, we define the short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size. Likewise, when demand falls for a firm’s products, it can cut back on work hours, fire workers, but cannot downsize its plants or factories.

The Long-Run: The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The graph below will illustrate this concept for you.

When we examine the long-run ATC more closely, it becomes apparent that there are in fact lots of little short-run ATC curves along the length of the long-run curve. Each of the gray lines in the graph above represent a short-run period in which this firm opened a new factories. There are three distinct phases of this firm’s long-run ATC:

• Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. My favorite illustration of the concept of economies of scale is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.
• Constant Returns to Scale: For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).
• Diseconomies of scale: Why did the Mongol, the British and the Soviet empires collapse? Some historians argue it was because they became too big for their own good. When an organization (whether it’s a country or a firm) becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980′s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.

Diminishing Returns versus Economies of Scale: A common area of confusion for economics students is the difference between these two seemingly similar concepts. The difference lies in the two curves above, the short-run ATC and the long-run ATC.

• The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.
• The shape of long run ATC is determined by economies of scale (and diseconomies of scale). All resources are variable in the long-run, but lower costs cannot be guaranteed the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point it becomes “too big for its own good” and costs start to rise as productivity of resources (land, labor and capital) is inhibited due to the firm’s massive size.

Discussion Questions:

1. What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
2. Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
3. Why don’t more companies make jumbo jets?

Mr. Welker’s note: The following post was submitted by a former student of mine at Shanghai American School. Marco graduated in 2008, completing the higher level IB Economics program. He now studies Economics and Political Science at McGill University in Canada. The following was written as an assignment for a McGill course, Econ 302: Money, Banking and Government Policy.

When Mr. Welker supervised my Extended Essay in 2008, the US Congress had already started putting pressure on the Chinese to allow their currency to appreciate. The economics of the US trade deficit seemed quite simple: the US bought more Chinese goods than the other way around, resulting in a current account deficit and causing the Yuan to appreciate. In return, the Chinese were in the habit of buying US government bonds, resulting in an American capital account surplus and depreciating the Yuan in relation to the Dollar. In other words, America has a Chinese credit card and the bill is quite large.

For obvious reasons, Congress is not thrilled with the debt. They have long claimed that the Chinese purposefully buy all this debt in order to boost their exports, but that it unfairly drags the US into further debt. The old protectionist tendencies flared and Congress tossed around accusations that Chinese companies maintain sub-American product quality, evidenced by the lead that was found in some toys, among other things. The threat of lead poisoning was a nifty pretense under which more stringent safety regulations could have rid the US market of Chinese goods without explicitly saying that they were doing so. In the end, Congress stuck to labeling China a ‘currency manipulator,’ which Chairman of the Fed Ben Bernanke upheld just a few days ago.

The game changer was the financial crisis. It turned out that the US wasn’t just indebted to China but also to themselves. For example, the price of housing in America had divorced itself from reality and people were purchasing houses that they couldn’t afford, on the assumption that they could sell it later at a higher price. When the housing bubble popped, the bookies came to collect the debt and people had a problem.

The US Federal Reserve responded to the crisis by pumping US$800 billion into the American economy. It has followed up by announcing second cash injection of US$600 billion just a few weeks ago. This is part of a policy called Quantitative Easing (QE), in which the central bank maintains a low interest rate and purchases bonds from the government, financial institutions, insurance companies and pension funds with the objective of creating more credit in the economy.

This is where politics and economics really start to interact. Bernanke has showed the Chinese that is not afraid to create more money. That is, he is not afraid to create more US Dollars. China owns a substantial amount of US Dollars. If the value of the US Dollar falls, then the value of Chinese assets fall, since nearly $2 trillion US dollars and dollar denominated assets are held by the Chinese central bank. The Fed’s increase in the money supply could ultimately cause inflation and a depreciation of the dollar, eroding the value of China’s US$ assets. The Chinese will surely not allow Bernanke to simply inflate away the value of Chinese owned American debt.

In response, the Chinese have been slowly moving out of US Dollars, which is smart. Chinese companies and the government (the distinction is blurred) are showing strong demand for raw materials and commodities. China is buying big in copper, buying big in Africa, buying lots of aluminum, tin, zinc, canola and soybeans, as well. According to J.P. Morgan, China’s iron ore imports were 33 percent higher in April than a year earlier. Crude oil imports were up nearly 14 percent, aluminum oxide imports climbed 16 percent and refined copper imports jumped 148 percent.

The future looks very bright for China, indeed. By recycling its US debt into commodity ownership, China is creating a very nice situation for itself. Commodities are goods of real value and only likely rise in value over time, whereas US debt exists on paper and is subject entirely to the value of the US Dollar. Purchasing abroad reduces the current account surplus, stops the yuan from rising and keeps China’s exports competitive. But, most importantly, having large commodity reserves will safeguard its industrial policy in the future, when the West may find itself in a supply crisis. China may have internal discontents, but it is exceptionally well placed in the international economy.

The law of diminishing returns is a basic microeconomic concept that explains how a firm’s costs of production change in the short-run as it varies the amount of labor employed. As workers are added to a fixed amount of capital, the productivity of additional workers decreases beyond a certain point due to the lack of available capital.

To test the law of diminishing returns, it is possible to create a factory floor right in your own classroom. Follow the instructions below to determine whether the law applies to your own imaginary firm.

Introduction: Your classroom is about to turn into a factory that manufactures paper chains (to hold paper anchors for paper boats, of course!). A paper chain is made by taking two long, narrow strips of paper, folding one into a ring and stapling the ends together, then folding the other into a ring and connecting it to the first ring to make a chain. Two loops of paper stapled together make a chain. The longer your chain, the more productive your factory and its workers are. The goal of your paper chain factory, of course, is to make the longest chain possible in a fixed amount of time using a fixed amount of land and capital, with labor as your only variable resource. This is therefore an experiment to test the short-run law of diminishing marginal returns.

Resource:

• Land resources: You will need one table or a couple of desks pushed together. This is your factory floor. Additionally, you will need a box of paper, preferably recycled or used paper. These are your land resources.
• Capital resources: Every factory needs tools. The tools you’ll have for this activity are two pairs of scissors and two staplers. Since this is a short-run simulation, the amount of land and capital cannot be varied, therefore you may NOT use more scissors and staplers as more workers join the production process.
• Labor resources: These will consist of the members of your class. The simulation will start with just one worker, and in each successive round one additonal worker will be added until at least eight members of your class have joined the factory floor.

TIME: The time for each round of production is limited to one minute. Your teacher or a member of your class should be designated as time keeper.

Data Collection: Each student in the class should recored the following down in a data table. If you have access to laptops, the data can be collected in Microsoft Excel or in Google Spreadsheets. This way you can create graphs of the data to assist with your analysis later on. Each student should record the following data during the simulation.

# of Workers (QL) Total Product (TP): Marginal Product (=change in TP): Average Product (TP/QL)

Conducting the simulation: When your land and capital resources are ready and your recorder and time keeper have been designated, you may begin the simulation.

Mr. Welker’s students hard at work in the paper chain factory

1. In round one, only one student should come to the table. The timekeeper must start the clock and give the worker one minute to cut and staple as many links into one paper chain as he or she can. At the end of the minute the recorder must count the number of links in the chain, record it in the production table, and then take the chain and any links that were cut but not stapled aside in preparation for the next round.
2. In round two, a second worker should join the first and the two may work together for one minute to make as long a chain as they can. Again, the recorder will count the number of links in the chain at the end of one minute, record this under “total product”, then remove the chain and any unstapled links from the table.
3. In rounds three through eight, an additional worker is added in each round and the new production team is given exactly one minute to make as long a chain as they can. At the end of each round, the recorder must count the number of links and record this under “total product”.
4. At the end of the eighth round the factory must close its doors and the simulation is over. Now the class as a whole should look at the total product data and together help the recorder calculate the marginal product and average product for each of the eight rounds.

Data analysis: With your productivity data tables complete, you may now plot your data for total, marginal and average product on a graph similar to those earlier in this chapter, with the quantity of labor on the x-axis and the firm’s output on the y-axis. Using Microsoft Excel or Google Spreadsheets you can create a graph that should look something like the following (created using real data from Mr. Welker’s class recorded in a Google Spreadsheet):

• As a class, analyze the relationships between total and marginal product.
• Determine whether your paper chain factory ever experienced increasing returns and whether it ever experienced diminishing returns.
• Discuss the reasons for the changes in total product during each round of production.

• The graph above illustrates just marginal and average products. Discuss the meanings of marginal product and average product and determine how they changed as workers were added to your factory floor.
• What is the relationship between marginal product and average product?
• Decide whether the law of diminishing marginal returns applied to your factory. If so, why? If not, why not?

YouTube – Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns

Mr. Clifford, an AP Economics teacher from San Diego, demonstrates the law of diminishing returns by deriving a total product and marginal product curve using production data from a student’s lawn mowing business.

Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns The video above is most useful to Econ students because it enforces the Law of Diminishing Returns. The more important application of this basic economic concept, however, is the short-run per-unit cost curve, Marginal Cost, Average Variable Cost and Average Total Cost. Mr. Clifford offers his quick explanation of the relationships between a firm’s short-run costs in the following video.

Econ Concepts in 60 Seconds: Per Unit Costs Curves

Discussion Questions:

1. Mr. Clifford derives a Marginal Product Curve in the first video and a Marginal Cost Curve in the second video. What is the relationship between the marginal product of a firm’s variable resource and the firm’s marginal cost of production? How are the shapes of both these curves determined by the law of diminishing marginal returns?
2. Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?
3. What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?
4. What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

I was thinking about the great students that I teach and wondering what they should be doing today to increase their odds of not being one of the future unemployed in our country’s unemployment statistics. But before I give that advice, let’s first look at the composition of the unemployed using the official unemployment statistics as reported by the BLS for the most recent October 2010 monthly report:

The current 9.6% national unemployment rate consists of the following:

• 4.7% unemployment for those with a college degree or advanced degree
• 8.5% unemployment for those with some college, but not a bachelor degree
• 10.1% unemployment for those with a high school degree, but no college
• 15.3% unemployment for those with less than a high school degree

It is easy to see from the above trend that one should get as much education as you can! The jobs in today’s advanced economies are clearly biased towards those with advanced skills, advanced degrees in the form of a master’s degree or better, and education is the clearest path to get those 21st century skills!

Besides teaching Economics, I also teach Personal Finance. When learning about careers in Personal Finance, I suggest to my students that they should be concerned more about majoring in “LIFE”, rather than majoring in Marketing, History, Education, Economics, or Political Science. Moreover, they should even be more concerned about majoring in LIFE than in whether they should apply to Virginia Tech, William & Mary, Duke, or Georgetown. By majoring in LIFE they are more apt to have the best college experience and career possible, and increase their likelihood of never being structurally, or even cyclically, unemployed.

So, you might be asking, what exactly is this LIFE major?

I’m glad you asked!

LIFE is an acronym for what I, and many others, consider the 4 key skill sets to thrive in 21^st Century future careers, which will include a rate of technological, social, and global change never seen before. Those four employment key skill sets for the future are:

Leadership

Interpersonal skills

Flexibility

Emerging technology mastery

Leadership

Are you thinking about how you will learn to become more optimistic (not pessimistic and sarcastic) and a confident initiative taker? Having been a member of management for many years, the companies I worked for were always quicker to lay off (made unemployed) those that lacked initiative (“it’s not my job!”). Very often, we would somehow find a new job for the employee whose job was going away if they were strong in leadership and initiative. Often, “initiative” hurts, as it causes one to work harder with more stress, which is why so many workers do not have it!

Interpersonal Skills

Tomorrow’s career “winners” will need to combine their leadership skills and be better at teaming with others more so than ever before. The rate of specialization is increasing at an increasing rate which necessitates the need to collaborate more effectively than ever to get any job done. Consider reading Thomas Friedman’s The World Is Flat to learn about how specialization and collaboration will continue to increase in any future career. Continue to work on your flexibility and your ability to team successfully with others in all that you do. Don’t be the person who has 5 reasons on why it won’t work, but rather, be the person that can explain to the team the 5 reasons why it will work!

Flexibility

Those that are not “lifetime learners” or those that do not embrace constant learning will soon be unemployed as the rate of constant change in our globalized world will leave them behind. Assess your own tolerance to setbacks and your personal reaction to the need to continuously change directions. If you get “bent out of shape” too easily when your plans go awry, or when you are faced with unforeseen obstacles, it is time to start now, while in high school to change your levels of patience, perserverence, and commitment to success. Flexibility and patience can be learned; it is not genetic and is not linked to toilet training.

Emerging Technology Mastery

Embrace, love, and continuously pursue and integrate the latest in technology into your daily life and education. Tomorrow’s employment and career winners will have “in their blood” the ability to be a technology step ahead from the average worker. Start immediately as it is delusional to avoid being an early adopter today and think you will become an early adopter in the future. Be sure to take a computer science course in your freshman year of college, consistently use your laptop in planning and course work, and be sure to be the one that other students go to for application and technology help.

Let me end this blog by letting you in on a “dirty little secret” known by managers and industry leaders across the globe: when it is time for a promotion or when it is time to reduce the work force due to a slowing business, managers get very creative and are biased towards promoting, or not laying off, those that have majored in LIFE…whether you went to Virginia Tech, Duke, William & Mary, or Georgetown makes little difference in career success in the long run, although it certainly opens more doors in the short run. So sure, aim for that bachelor’s degree or higher in a specialized major that you are passionate about, but don’t forget to double major in LIFE!

Discussion Questions:

1. Does the above breakdown of unemployment by educational category surprise you? What message, if any, do you take away from these statistics?
2. Is the LIFE acronoym pursuit valid, in your opinion, as an early focus to help avoid unemployment? Do you think the LIFE major is a necessary, intentional focus/practice along with your college major or do you think the development of these LIFE skills will just progress naturally?
3. Which area of the LIFE acronym are you strongest at? Weakest?
4. What percent, based on 100%, do you think becoming unemployed is just “bad luck” or deteriorating business conditions, versus you can help ensure your own employed destiny by continued employment through focus on the LIFE major? Did my “dirty little secret” referenced above make common sense?

In my last post, I outlined the consequences of a nation running a persistent deficit in its current account. In the post below, I will share some thoughts on how a nations can reduce its trade deficit by promoting increased competitiveness in the global economy through the use of expansionary supply-side policies. Earlier in the chapter from which this post is taken, I outlined other deficit reduction strategies, including the use of protectionism, currency devaluation and contractionary demand-side fiscal and monetary policies. In my opinion, each of these methods creates more harm than good for a nation, resulting in a misallocation of society’s scarce resources (in the case of protectionism) and negative effects on output and employment (in the case of contractionary demand-side policies)

Therefore, the following presents the “supply-side” strategies for reducing a deficit in a nation’s current account.

From Chapter 22 of my upcoming textbook: Pearson Baccalaureate Economics

Contractionary fiscal and monetary policies will surely reduce overall demand in an economy and thereby help reduce a current account deficit. But the costs of such policies most likely outweigh the benefits, as domestic employment, output and economic growth suffer due to reduced spending on the nation’s goods and services. A better option for governments worried about their trade deficit is to pursue supply-side policies that increase the competitiveness of domestic producers in the global economy.

In the long-run, the best way for a nation to reduce a current account deficit is to allocate its scarce resources towards the economic activities in which it can most effectively compete in the global economy. In an environment of increasingly free trade between nations, countries like the United States and those of Western Europe will inevitably continue to confront structural shifts in their economies that at first seem devastating, but upon closer inspection will prove to be inexorable.

The auto industry in the United States has been forever changed due to competition from Japan. The textile industry in Europe has long passed its apex of production experienced decades past, and the UK consumer will never again buy a television or computer monitor made in the British Isles. The reality is, much of the world’s manufactured goods can be and should be made more cheaply and efficiently in Asia and Latin America than they could ever be produced in the US or Europe.

The question Europe and the United States should be asking, therefore, is not “how can we get back what we have lost and restore balance in our current account”, but, “what can we provide the world with that no one else can?” By focusing their resources towards providing the goods and services that no Asian or Latin American competitor is capable of providing, the deficit countries of the world should be able to reduce their current account deficits and at the same time stimulate aggregate demand at home, while increasing the productivity of the nation’s resources and promoting long-run economic growth.

Sure, you say, that all sounds great, but how can they achieve this? This is where supply-side policies come in. Smart supply-side policies mean more than tax cuts for corporations and subsidies to domestic producers. Smart supply-side policies that will promote more balanced global trade and long-run economic growth include:

• Investments in education and health care: Nothing makes a nation more competitive in the global economy than a highly educated and healthy work force. Exports from Europe and the US will lie ever increasingly in the high skilled service sector and less and less in the manufacturing sector; therefore, highly educated and skilled workers are needed for future economic growth and global competitiveness, particularly in scientific fields such as engineering, medicine, finance, economics and business.
• Public funding for scientific research and development: Exports from the US and Europe have increasingly depended on scientific innovation new technologies. Copyright and patent protection assure that scientific breakthroughs achieved in one country will allow for a period of time over which only that country will enjoy the sales of exports in the new field. Green energy, nano-technology, bio-medical research; these are the field that require sustained commitments from the government sector for dependable funding.
• Investments in modern transportation and communication infrastructure: To remain competitive in the global economy, the countries of Europe and North America must assure that domestic firms have at their disposal the most modern and efficient transportation and communication infrastructure available. High speed rail, well-maintained inter-state or international highways, modern port facilities, high-speed internet and telecommunications; these investments allow for lower costs of production and more productive capital and labor, making countries goods more competitive in the global marketplace.

Reducing a current account deficit will have many benefits for a nation like the United States, Spain, the UK or Australia. A stronger currency will assure price stability, low interest rates will allow for economic growth, and perhaps most importantly, less taxpayer money will have to be paid in interest to foreign creditors. Governments and central banks may go about reducing a current account deficit in many ways: exchange rate controls, protectionism, contractionary monetary and fiscal policies, or supply-side policies may all be implemented to restore balance in the current account. Only one of these options will promote long-run economic growth and increase the efficiency with which a nation employs its scarce factors of production.

Supply-side policies are clearly the most efficient and economically justifiable method for correcting a current account deficit. Unfortunately, they are also the least politically popular, since the benefits of such policies are not realized in the short-run, but take years, maybe decades, to accrue. For this reason, we see time and time again governments turning to protectionism in response to rising trade deficits.

The following is an excerpt from Chapter 22  - “Balance of Payments” of my soon to be published textbook “Pearson Baccalaureate Economics”

If the total spending by a nation’s residents on goods and services imported from the rest of the world exceeds the revenues earned by the nation’s producers from the sale of exports to the rest of the world, the nation is likely experiencing a current account deficit. The situation is not at all uncommon among many of the world’s trading nations. The map belowmap  represents nations by their cumulative current account balances over the years 1980-2008. The red countries all accumulated current account deficits over the three decades, with the largest by far being the United States with a cumulative deficit of $7.3 trillion. The green countries are ones which have had a cumulative surplus in their current accounts, the largest surplus belonging to Japan at $2.7 trillion, followed by China at $1.5 trillion.

source: http://en.wikipedia.org/wiki/File:Cumulative_Current_Account_Balance.png

The top ten current account deficit nations are represented below. It is obvious from this chart that the United States alone accounts for a larger current account deficit then the next nine countries combined. At $7.3 trillion dollars in deficits over 28 years, the US deficit surpasses Spain’s (at number 2) by 1,000 percent.

The consequences of a nation having a current account deficit are not immediately clear. It should be pointed out that it is debatable whether a trade deficit is necessarily a bad thing, in fact. Below we will examine some of the facts about current account deficits, and we will conclude by evaluating the pros and cons for countries that run deficits in the short-run and in the long-run.

Implications of persistent current account deficits: When a country like like those above experience deficits in the current account for year after year, there are some predictable consequences that may have adverse effects on the nation’s macroeconomy. These include currency depreciation, foreign ownership of domestic assets, higher interest rates and foreign indebtedness.

The effect of a current account deficit on the exchange rate: In the previous chapter you learned about the determinants of the exchange rate of a nation’s currency relative to another currency. One of the primary determinants of a currency’s exchange rate is the demand for the nation’s exports relative to the demand for imports from other countries. With this in mind, we can examine the likely effects of a current account deficit on a nation’s currency’s exchange rate. Additionally, we will see that under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.

When households and firms in one nation demand more of other countries’ output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners’ currencies and downward pressure on the importing nation’s currency. In this way, a movement towards a current account deficit should cause the deficit country’s currency to weaken.

As an illustration, say that New Zealand’s imports from Japan begin to rise due to rising incomes in New Zealand and the corresponding increase in demand for imports. Assuming Japan’s demand for New Zealand’s output does not change, New Zealand will move towards a deficit in its current account and Japan towards a surplus. In the foreign exchange market, demand for Japanese yen will rise while the supply of NZ$ in Japan increases, as seen above, depreciating the NZ$.

The downward pressure on exchange rates resulting from an increase in a nation’s current account deficit should have a self-correcting effect on the trade imbalance. As the NZ$ weakens relative to its trading partners’ currencies, consumers in New Zealand will start to find imports more and more expensive, while consumers abroad will, over time, begin to find products from New Zealand cheaper. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account. The persistence of global trade imbalances illustrated in the map above is evidence that in reality, the ability of flexible exchange rates to maintain balance in nations’ current accounts is quite limited.

Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad ends up in the does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations’ central banks.

Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation’s currency.

The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained above, a current account deficit can put downward pressure on a nation’s exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country’s central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country’s government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.

Side note: While the interest rate effect of a large current account deficit should be negative (i.e. causing interest rates to rise in the deficit country), in recent years the country with the largest trade deficit, the United States, has actually experienced record low interest rates even while maintaining persistent current account deficits. This can be understood by examining by the macroeconomic conditions of the US and global economies, in which deflation posed a greater threat than inflation over the years 2008-2010. The fear of deflation combined with low confidence in the private sector among international investors has kept demand for US government bonds high even as the US trade deficit has grown, allowing the US government and central bank to keep interest rates low and continue to attract foreign investors.

Whereas under “normal” macroeconomic conditions a build up of US dollars among America’s trading partners would require the US to raise interest rates to create an incentive for foreign investors to re-invest that money into the US economy, in the environment of uncertainty and low confidence in the private sector that has prevailed over the last several years, America’s trading partners have been willing to finance its current account deficit at record low interest rates.

The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. For instance, as of August 2010, the Chinese central bank held $868 billion of United States Treasury Securities (government bonds) on its balance sheet. In total, the amount of US debt owned by foreign nations in 2010 was $4.2 trillion, or around 50% of the country’s total national debt and 30% of its GDP.source: http://www.ustreas.gov/tic/mfh.txt

On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country’s government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.

The opportunity cost of foreign owned national debt is the public goods and services that could have been provided with the money that instead is owed in interest to foreign creditors. If the US current account were more balanced, foreign countries like China would not have the massive reserves of US dollars to invest in government debt in the first place, and the taxpayer money going to pay interest on this debt could instead be invested in the domestic economy to promote economic growth and development.

Discussion Questions:

1. Why would a large current account deficit cause a nation’s currency to depreciate? How could a weaker currency automatically reduce a nation’s current account deficit?
2. Why should governments be concerned about a large trade deficit? What is one policy a government could implement to reduce a deficit in the current account?
3. Would a nation with a large trade deficit be better off without trade at all? Why or why not?
4. Discuss the validity of the following claim: “Americans buy tons of Chinese imports, but the Chinese don’t buy anything from America, this is why the US has such a huge trade deficit with China”. To what extent is this claim true or false?

 US balance of payments deficit hits another record – WSWS.org – 16 March 2006

As I was looking for news stories about the balance of payments, which we started studying in AP Economics today, I stumbled upon a story from over two years ago, published on the World Socialist Website, of all places. The reason I am blogging about it today, 25 months later, is that it contains some ominously prophetic messages about what the future (now the past) could hold for the US based on the economic data at the time. Read below to see what I mean:

The extent of the imbalances in the global economy and the fact that normal growth patterns will not correct them has been underlined by the latest US balance of payments deficit. The current account deficit reached $225 billion in the fourth quarter of 2005, up from $185.4 billion in the third. For the year 2005 the deficit was $805 billion, equivalent to 6.4 percent of gross domestic product.The latest figures show that rather than being closed, the payments gap is widening. This was the seventh year out of the last eight in which the deficit hit a new record.

“The bottom line is that a current account deficit of this unparalleled magnitude is unsustainable and there is no hope of it being painlessly resolved through higher exports alone,” Paul Ashworth, an analyst at Capital Economic told the Financial Times.

Total US exports would need to increase by 70 percent to eliminate the payments gap. “This is clearly not going to happen,” Ashworth continued. “Instead it will require a big dollar depreciation alongside much weaker domestic demand for imports.”

In other words,

 

the only way the deficit would start to fall is through a major recession in the US.“a big dollar depreciation” would almost certainly lead to a sharp interest rate rise, as international banks and financial institutions demanded bigger compensation for placing their funds in dollar assets. And a significant interest rate rise would bring a downturn in the economy.On the other hand, On the one hand,

 

“weaker domestic demand for imports” could be achieved only by a severe contraction of the US economy.This is because the very structure of the US economy, in which imports of goods and services are some 59 percent higher than exports, means that normal economic growth automatically increases the deficit.

 

So far almost everything the article has mentioned has actually happened, except for the increase in US interest rates. In fact, the Fed has lowered interest rates as the economy has approached recession, indicating that it considers a slowdown in growth a bigger threat than a weaker dollar and the accompanying inflation. In fact, expansionary monetary policy in the US (i.e. lower interest rates) has accelerated the dollar’s decline as foreign investors have pulled their money out of the US assets as interest rates in Europe and other markets have become more attractive.The article doesn’t hold out much hope for rising exports helping the US out of the predicted recession:

The only way the US could export its way out of the crisis would be if economic growth in the rest of the world proceeded at a significantly higher rate than the American economy. But here a vicious circle is in operation because economic growth in the rest of the world is itself highly dependent on an expanding US market. This is especially the case in Asia where economic growth is increasingly being fuelled by exports to China where goods are manufactured for the American market.

Today in class we introduced the determinants of exchange rates. One way Americans have been able to import so much more from China and other countries (remember, the US has trade deficits with 13 of its 15 largest trading partners!!) has been through foreign purchase of financial and real assets in the US, including government bonds:

In fact, the US is becoming increasingly dependent on foreign sources to support its current account and budget deficits. Foreign lenders have been financing 80 percent of the increase in the federal budget deficit, and foreign holdings of treasury securities increased by $108 billion in the last quarter of 2005.As Stephen Roach noted, with a foreign capital inflow of $3 billion every business day—up from $2 billion in 2003—the external dependency of the US “is simply without precedent in the annals of globalization and international finance”.

 

I found it interesting that most of what this article predicted would happen has already transpired, or is in the process of transpiring as we speak. The dollar has depreciated by 18% to the RMB, and even more to other major currencies, the US has entered a recession, raising questions as to the degree to which the economies of Europe and Asia have “de-coupled” from the US economy.Whether the US recession will lead to a significant slowdown in growth among its trading partners has yet to be seen. Uncertainty in global financial market has resulted in an international credit-crunch, meaning lenders have been less willing to extend loans to borrowers, leading to a decline investment and consumption everywhere; but with growth rates still predicted at 8-10% in China, and not too far behind elsewhere in the developing world, it seems plausible that a continued decline of the dollar combined with healthy growth and rising incomes abroad will shift America’s balance of payments away from worsening deficits in 2008.

Discussion Questions:

1. Define “US balance of payments deficit“. What accounts make up a country’s balance of payments?
2. In what ways would “a big dollar depreciation alongside much weaker domestic demand for imports” help achieve more balanced trade between the US and its trading partners?
3. Explain the statement: “weaker domestic demand for imports could be achieved only by a severe contraction of the US economy“
4. Which of the determinants of exchange rates that we learned in class (remember “SIPIT”) is referred to in the following claim: “The only way the US could export its way
   out of the crisis would be if economic growth in the rest of the world
   proceeded at a significantly higher rate than the American economy“.