Is international trade really as good for a nation’s standard of living as economists say? And, what the heck is comparative advantage anyway? And what about the foreign currency market and those confusing supply & demand curves? Yes, the quest to understand the economic benefits of international trade is enough to make any citizen or first-year economic student vomit, tremble, get a headache, or at least curse.

Having been an AP Economics’ teacher for 8 years now, I must candidly admit that it took me a few years of study and research to try to reduce international trade to pure simplicity and understanding. Let me give it a shot below. I love simplicity.

The average “Joe Citizen” in almost any country in the world is suspicious of trade, and rightfully so, since he reads or observes factories being closed, jobs lost, and the feeling that somehow his country is going down the toilet as his own home fills up with foreign-made products. Unfortunately, what Joe Citizen does not understand is that the money his own nation is spending for those foreign products (imports) is spent right back into the pockets of his own country, increasing employment and income.

Let’s take a single, real-world, international trade example being careful to accurately explain the whole economic story:

Let’s say that the United States (we’ll say Wal-Mart) decides to buy several shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from a shirt manufacturer in Elon, North Carolina (USA). As a US AP Economics’ teacher I am one of about only 47 Americans in Fairfax County Virginia, which not coincidentally ties to the number of AP Students I taught this year, that quickly understand that the decision to purchase the shirts from China, in lieu of the US manufacturer in North Carolina, is actually BETTER for America and will make my home country better off in the long run! What? Mr. Latter, are you Benedict Arnold, the American traitor, reincarnated?

Let me explain how the US benefits (and China too!) in simple terms ignoring foreign currency transactions, which will just confuse the discussion and cause the student to lose sight of what is really happening:

The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China!

The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has actually traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly for the shirts!

Yes, the “punch line” is that all home-currency spending by the domestic nation on foreign products (imports), in turn, are spent right back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is shown in a nation’s balance of payments schedule which always nets to zero, but, yuk, who cares about that right now with summer coming!)

And, yes, let’s not forget that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Our nation loves competition (ready for the Olympics?) and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity), and hopefully get the next shirt contract from Wal-Mart or some other firm! If not, well, that North Carolina firm may just have to close down.

If you are still reading this post at this point, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400”. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received back into America in lieu of buying US products. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really no problem at all! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for the war in Iraq, the war against terrorism, and several other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and buy that GPS system or build more plants to employ more Americans!

Now one last thing. Promise! Let’s get back to why trade is really so economically advantageous to any nation that pursues it. And by advantageous, I mean how it increases our incomes and standards of living. In one word, the answer is “productivity”. If we go back to the original example of the US buying shirts from China and China taking the US dollars to buy the GPS, we remember that the shirt manufacturer from North Carolina was “left out in the cold” because Wal-Mart did not buy the shirts from them. We can logically conclude that perhaps some Chinese manufacturer of GPS systems was “left out in the cold” because some Chinese business elected to buy from FleetMatics in the USA, and not the Chinese GPS manufacturer. Wow, I love global competition! What a great way to incent businesses in both the USA and China to compete against each other and increase their productivity and conserve our nations’ scarce resources, increase our choice, and lower our costs!

Discussion Questions:

1. Which basic economic principles underly the emergence of international trade as a global economic force.
2. Who are the winners and losers of trade between the US and China as explained above?
3. Why do you think free trade is such a controversial topic among certain groups of Americans an other Western nations’ people?

FT.com / World / Americas - US economy threatens Dominican Republic

Trade based on comparative advantage… the theory originally articulated by Adam Smith, later fine-tuned by David Ricardo, the theory that suggests that if each nation specializes its economic activity on the products for which it faces the lowest opportunity cost, then trades with its neighbors, total world output and efficiency can be maximized: today this theory represents the philosophical underpinning of all free trade agreements signed between and among the nations of the world.

Through trade, countries can exchange their extra output with other nations for the goods specialized in by others, enabling all nations to enjoy a level of consumption beyond what they’d be able to achieve if they tried to produce all goods domestically.

For many developing countries, with their abundance of either land or labor, comparative advantages tend to lie in either agricultural goods or low-skilled manufactured goods. Since global prices for food are highly unstable and dependency on healthy harvests, good weather, and stable rainfall are all highly risky endeavors for a poor country, developing nations prefer to foster the growth of manufacturing sectors in their path towards economic development.

Strategies for economic growth available to developing nations include export-oriented and inward-oriented growth. A country like the Dominican Republic, the largest economy in the Caribbean, has pursued a predominantly export-oriented growth strategy, promoting through “free zones” the growth of a textile industry aimed at producing goods for consumers in developed countries, primarily the US.

To the Domincans, producing textiles for export to America has successfully given the people of this poor nation a grip on a rung of the ladder towards economic development. The import of capital has taken previously unproductive workers out of agriculture and put them into an industry where productivity, thus income, has risen, leading to improvements in living standards. Export-led growth, however, runs some serious risks of its own, as is being realized by the people of the Dominican Republic today.

It had been clear for some time that Luis Caraballo’s textile factory, in one of the Dominican Republic’s largest “free zones”, was struggling.

Finally, last December, he closed the factory gates for the last time: cut-throat competition from China and Vietnam, a weakening US dollar and unsustainable costs had become too much.

Once a hot destination for American companies looking for a cheap place to “off-shore” production of labor intensive textiles, the Dominican Republic today faces new competition, and is finding its comparative advantage slip slowly away from textiles…

The Dominican Republic depends heavily on the US, which is the destination of more than 85 per cent of exports. But textile exports – these days accounting for less than a third of total exports – fell by 32 per cent over 2007.

Although other countries in the Caribbean are also suffering from Asian competition – with Chinese textile exports to the US tripling between 2000 and 2005, while Vietnam’s multiplied almost 117 times – the Dominican Republic has been worst hit.

Here’s the thing: a nation’s comparative advantage may shift over time (from land to labor to capital intensive goods) as the structure of the global economy evolves. Once an economy like the Dominican Republic’s has undergone a period of structural adjustment, away from agriculture and towards industry, the flow of low wage workers from farm to factory begins to slow to a trickle, leading to rising wages and increased competition from countries with more abundant supplies of cheap labor.

The challenge for policy makers is to manage the structural changes as they come, minimizing the deleterious impact such global shifts of productive resources has on the citizens of a country like the D.R. Clearly, it is in the country’s interest to prepare its citizens for a “new economy”, one in which skilled labor will play a larger role. The problem is, this requires a solid education system, which the D.R., it turns out, does not yet have:

There is widespread acceptance of the need to develop a better-educated workforce, but so far education spending has been inadequate.

“The government simply doesn’t have enough resources,” said Mr Montás. About 40 per cent of its budget goes on debt obligations and another 15 per cent is dished out through subsidies. Just 1.5 per cent goes towards education.

It also turns out that this is a balance of payments story:

Mr Montás calculated that for every percentage point the US economy contracted, the Dominican Republic’s GDP would shrink by 0.4 per cent.

Not only will exporters be hit, but also the huge tourism sector and remittance flows…

One possible result of the decline in exports and flows of remittances from the US will be a depreciation of the D.R. peso, as demand for pesos by Americans falls. A weaker peso might make the country’s exports attractive once again, assuming the exchange rate is allowed to adjust on foreign exchange markets. A weaker peso should help slow the decline in the D.R.’s exports to the US, at least until new competition emerges, perhaps elsewhere in Asia, maybe even from Africa or other Latin American countries.

In all likelihood, given the increased competition from Asian textile manufacturers, continued economic growth in the Dominican Republic will depend on the country’s ability to educate and train its workforce to adapt to a more capital, technology and information-based economy, which, if successful, will eventually lead to rising incomes and higher standards of living for the people of the this rising Caribbean nation.

Comparative advantages evolve with the emergence of new competition among developing and developed countries. The negative impacts this evolution has on a particular economy can be managed if wise policy actions are taken to assure a country’s workforce is educated and trained to participate in tomorrow’s economy, rather than yesterday’s or today’s.

How do Chinese granite quarries and a decline in the US death threaten a family business in rural Vermont?

Listen and find out…

 

 Chinese headstones [4:09m]: Play Now | Play in Popup | Download

Source: NPR Economy Podcast, 2/29/2008 

Pepsi Tests ‘Naturally Sourced’ Beverage - Advertising Age - News

Pepsi is just about to launch its first new beverage since 1992.  The drink, called “RAW” will present consumers with a healthier alternative to the artificially flavored soft drinks that dominate the oligopolistic market.

Apple extract, sparkling water, grapes, coffee leaf, raw cane sugar. The list of ingredients sounds like it belongs to a health drink, but those are the components of Pepsi’s newest variant.

Pepsi Raw, being launched in U.K. test markets, is meant to be a more healthful alternative to the traditional cola. A type of Pepsi made from only “naturally sourced” ingredients, it taps into demand for premium, less-processed products.

Sounds great, right? But would you be willing to pay more for a “natural” Pepsi than for the good old fashioned artificially flavored Pepsi and Cokes you grew up with? Pepsi is betting the drink will appeal to young hipsters, and is launching it primarily at clubs and bars in six UK cities to test out the market.

So when can Americans expect to  enjoy the natural goodness of Pepsi RAW? Unfortunately, Pepsi seems to think Americans are a bunch of fat tightwads:

 ”It makes sense to launch first in the U.K. because health concerns are a bigger issue there,” Ms. Dornblaser said, adding, “It might not fly as well in the U.S. because of the price.”

Oh, and if you’re too young to remember what Pepsi’s last attempted new product launch was, allow me to jog your memory:

Hey, I LOVED Crystal Pepsi! So, would you be willing to pay more for a healthier Pepsi?

Nokia Won’t Play iPhone’s Tune

As we know, oligopolistic markets are characterized by a few large firms which act interdependently based on the actions of one another. Examples of such interdependence may include pricing and output behavior, advertising behavior, sales and promotions, non-price competition, services offered to consumers, and so on. The “game” of oligopoly is played with one very important goal in mind: maintaining market share in the face of competition from rivals.

In a previous post I discussed some of the strategies Apple has used to break into the oligopolistic market for cellular phones, which it recently did by introducing the thus far wildly successful iPhone. A chart in that post showed that as of earlier this year, the dominant firm in the mobile phone market was Nokia, with a market share of 35.1%. Apple was not even a competitor in this market until July of this year, which saw the successful launch of the iPhone, causing some of the incumbent mobile phone makers to pay close attention to the newcomer’s behavior.

Nokia executives, however, appear to be in denial of the potential threat posed by the iPhone to its dominance in the cell phone industry:

Nokia managers would never admit to being influenced by the Apple iPhone, which mobile phone industry insiders regard as clever but technologically unimpressive. “We don’t determine strategy based on the competition,” insists Anssi Vanjoki, Nokia executive vice-president and general manager for multimedia. “The consumer is our compass.”

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Holiday weekend retail sees big crowds, but no splurging - Nov. 25, 2007

Black Friday; a most interesting phenomenon of American culture. A day when consumer demand in retail product markets is at its strongest, the day after Thanksgiving when, still lightheaded from excess tryptophan and mashed potato intakes and an NFL overdose from the previous day, millions of Americans stumble full-bellied from their beds and flock to the malls and big box retail outlets of suburban America to give thanks to the gods of consumerism: Wal-mart, Target, JCPenny, Nordstroms, Macey’s… all the holy temples of our sacred religion open their golden gates to the hoards of consumption-crazed pilgrims, all hoping to pay tribute to their beloved deities with their almighty dollars.

Although deep discounts brought out much bigger crowds of holiday bargain hunters, a major retail trade group said Sunday that shoppers actually spent less money this year over the crucial Thanksgiving weekend.

The National Retail Foundation’s (NRF’s) 2007 Black Friday Weekend Survey said more than 147 million shoppers hit the stores over the Black Friday weekend, up 4.8 percent from last year.

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China Mobile negotiating with Apple to carry iPhone

Try try as he might, Steve Jobs and Apple can barely launch their hottest new product, the iPhone, before the Chinese have copied it and put a knockoff on the market as quickly as you can say “can you hear me now?” But what is Apple doing making a cell phone anyway? Isn’t the mobile phone market pretty much dominated by a few big name companies already? How will apple ever survive in a market with such well established firms as Nokia, Samsung, and Motorola?

The answer is through product differentiation. The iPhone is truly an innovative little gadget. More than an MP3 player, more than a cell phone, the iPhone has features that differentiate it from most products available from the established firms in the mobile phone market. Like any firm, Apple advertises its iPod through commercials and other media in order to inform consumers about what makes its product special. What message does the following advertisement send about the iPhone?

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by Hansen Gu and Elaine Lung

Economics is not just for people living in the “real” world, you know! No it’s not. For some of us in high school, we actually prefer the fantasy life of the World of Warcraft. And yes, there is a real economy in our world too. And yes, it does exhibit characteristics of pure competition, and YES, workers do specialize their production based on their own comparative advantage!

Jeeze, why do I feel like I’m always having to defend myself here? Anyway, to learn more about the economy of our favorite fantasy world, watch this video!

Competitively Priced Electricity Costs More, Studies Show - New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry. A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized) Continue Reading »