Chapter 1: International Economics Is Different

Overview

The introduction to the subject of international economics has three major purposes:

1. Show that international economics addresses important and interesting current events and issues. 2. Show why international economics is special.
3. Provide a broad overview of the book.

We begin with four sets of events that show the importance of current issues addressed by international economics. The first is a set of trade policy conflicts. Here we introduce the rising importance of regional trade agreements (trade blocs) and the role of the World Trade Organization (WTO) as a global arbiter. One policy conflict is the fight over the European Union's banana import policy. The WTO ruling went against the European Union, and the WTO allowed the United States to retaliate with 100 percent tariffs on specific products. Another policy conflict is the European Union's refusal to import beef raised using growth hormones. Again, the WTO ruling went against the European Union.

The second is the set of financial crises that hit the world economy. We trace the beginning of the crisis in Thailand in 1997 and the subsequent contagion that spread to other Asian countries that year, as well as effects on countries outside Asia, including Russia in 1998. We summarize five diagnoses showing the range of opinion about what caused the crises and what can be done in response.

The third is European monetary union, in which 11 of the 15 European Union countries are in the process of replacing their national moneys with a single new currency, the euro. The monetary union has been controversial, because countries must yield powers over national monetary policy to the new unionwide European Central Bank.

The fourth is the set of controversies over policy toward immigration. Industrialized countries impose limits on legal immigration, and there are pressures to tighten the limits and to do more to stop illegal immigration. Addressing concerns about the fiscal effects of immigration, the U. S. government in 1996 passed a law to make even legal immigrants ineligible for some government benefits and services.

These four sets of events show that international economics addresses important current issues. They also can be used to show why international economics is special—why national boundaries matter in economics. The first reason that international economics is special is that national government policies matter—in fact, they matter in two ways. One way is that national governments adopt policies toward international transactions. This is seen clearly in the discussions of bananas, beef, and immigration, as well as in the diagnosis that capital controls can prevent or limit financial crises. The other way is that national governments adopt different macroeconomic policies. These national policies usually are designed to serve national interests, but they often have international effects. The tension between national interests and international effects is raised in the diagnoses of financial crises that focus on flawed financial systems and the need to tighten the government budget. Tension is also seen in the controversy over ceding national monetary authority to European monetary union.

The second reason that international economics is special is that some resources do not move freely between countries. Land is essentially immobile. There are substantial impediments to the movement of labor internationally, because the personal and economic costs to people of moving from one country to another can be substantial. As the discussion of immigration shows, government policies also often impede international movement of labor. Financial capital moves more freely, but, as the discussion of financial crises shows, international capital movements can sometimes be surprisingly disruptive.

Chapter 2: The Basic Theory of International Trade Demand and Supply

Overview

This chapter indicates why we study theories of international trade and presents the basic theory using supply and demand curves. Trade is important to individual consumers, to workers and other factor owners, to firms, and therefore to the whole economy. Trade is also controversial, with perpetual battles over government policies toward trade. To understand all of this, we need to develop theories of why people trade as they do.

It is useful to organize the analysis of international trade by contrasting a world of no trade with a world of free trade, leaving analysis of intermediate cases (e.g., non-prohibitive tariffs) for Part II. The analysis seeks to answer four key questions about international trade:

1. Why do countries trade? What determines the pattern of trade?
2. How does trade affect production and consumption in each country?
3. What are the gains (or losses) for a country as a whole from trading?
4. What are the effects of trade on different groups in a country? Are there groups that gain and other groups that lose?

Theories of international trade provide answers to these four questions.

Basic demand and supply analysis can be used to provide early answers to these four questions, as well as to introduce concepts that can be used in more elaborate theories. Using motorbikes as an example, the chapter first reviews the basic analysis of both demand (the demand curve, other influences on quantity demanded, movements along the demand curve and shifts in the demand curve, and the price elasticity of demand as a measure of responsiveness) and supply (the supply curve, the role of marginal cost, other influences on quantity supplied, movements along the supply curve and shifts in the supply curve, and the price elasticity of supply). It pays special attention to the meaning and measurement of consumer surplus and producer surplus. This section, which focuses on review and development of basic tools, ends with the picture of market equilibrium in a national market with no trade as the intersection of the domestic demand curve and the domestic supply curve.

The remainder of the chapter examines the use of supply and demand curves to analyze international trade. If there are two international markets and no trade, it is likely that the product's price will differ between the two markets. Someone should notice the difference and try to profit by arbitrage between the two markets. If governments permit free trade, then the export supply from the initially low-priced market (the rest of the world in the textbook example) can satisfy the import demand in the initially high-priced market (the United States in the textbook example), and the world shifts to a free-trade equilibrium. We can show this free trade equilibrium by deriving the supply-of-exports curve for the rest of the world and the demand-for-imports curve for the United States. The international market for the product clears at the intersection of the export-supply and import-demand curves, indicating the equilibrium international or world price and the quantity traded. This equilibrium world price also becomes the domestic price in each country with free trade.

The same set of three graphs (the two national markets and the international-trade market) is used to show the effects of the shift from no-trade to free-trade on different groups in each country and to show the net gains from trade for each nation. In the importing country consumers of the product gain consumer surplus and producers of the product lose producer surplus. Using the one-dollar, one-vote yardstick, the country as a whole gains, because the gain in consumer surplus is larger than the loss of producer surplus. In the exporting country producers of the product gain producer surplus and consumers of the product lose consumer surplus. Furthermore, the analysis shows that the country as a whole gains because the gain in producer surplus is larger than the loss of consumer surplus. The country that gains more from the shift to free trade is the country whose price changes more--the country with the less elastic trade curve (import demand or export supply).