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Published by tinareilly, 2018-11-15 10:10:38

GLOBAL ECONOMICS

GLOBAL ECONOMICS

150 120 90 60 30 0

A RCTIC Greenland A RCTIC
OCEAN (DENMARK) OCEAN

NO

U.S. ICELAND
60
CANADA UNITED DENMAR
NORTH KINGDOM
PACIFIC NETH.
OCEAN BELGIUM IRELAND GERMAN
SLOVAKIA
SOUTH FRANCE SWIT
PACIFIC HUNGARY
OCEAN
UNITED STATES NORTH PORTUGAL SPAIN
ATLANTIC
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T

30 MOROCCO
0
ALGERIA
30
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SAHARA

BELIZE MAURITANIA NIG
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EL SALVADOR NICARAGUA
SENEGAL BURKINA

COSTA RICA VENEZUELA GUINEA-BISSAUGUINEACÔTEFASO NIGE
BENIN
SIERRA LEONE D'IVOIRE TOGO
PANAMA SURINAME
LIBERIA
COLOMBIA GUYANA French Guiana GHANA

(FRANCE) EQUATORIAL
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PERU BRAZIL SOUTH
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PARAGUAY

CHILE

URUGUAY
ARGENTINA

60

150 120 90 60 30 ANTA
0

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30 60 90 120 150 A R C T I C180
OCEAN

RWAY

SWEDEN FINLAND RUSSIA

EST. 60
RK LITH. LAT.

POLAND BELARUS

NY CZECH REP. UKRAINE KAZAKHSTAN
Z. AUSTRIA
AZERBAIJAN UZBEKISTAN MONGOLIA
ROMANIA

TALY BULGARIA GEORGIA KYRGYZSTAN NORTH KOREA
TAJIKISTAN
GREECE TURKEY TURKMENISTAN NORTH
ARMENIA PACIFIC
JAPAN OCEAN
SYRIA CHINA SOUTH
TUNISIA ISRALEEBLJ. ORDIRAANQ IRAN AFGHANISTAN KOREA
LIBYA KUWAIT
PAKISTAN NEPAL 30

EGYPT SAUDI UNITED ARAB BHUTAN
ARABIA EMIRATES BANGLADESH
INDIA
BURMA LAOS
OMAN
THAILAND VIETNAM
ER SUDAN ERITREA YEMEN QATAR CAMBODIA PHILIPPINES FEDERATED STATES
CHAD DJIBOUTI OF MICRONESIA
MARSHALL
RIA ISLANDS

CENTRAL ETHIOPIA SRI BRUNEI
AFRICAN REPUBLIC SOMALIA LANKA MALAYSIA

CAM' EROON UGANDA MALDIVES SINGAPORE

ON DEMOCRATIC KENYA RWANDA INDONESIA 0

NGO REPUBLIC BURUNDI PAPUA
NEW GUINEA
OF THE CONGO TANZANIA SOLOMON
ISLANDS

ANGOLA MALAWI INDIAN
ZAMBIA MOZAMBIQUE OCEAN

FIJI

NAMIBIA ZIMBABWE MADAGASCAR
BOTSWANA

AUSTRALIA

SOUTH SWAZILAND 30
AFRICA LESOTHO

NEW
ZEALAND

SOUTH
PACIFIC
OCEAN

60

ARCTICA
30 60 90 120 150 180

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International Economics

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International Economics

FIFTEENTH EDITION
ROBERT J. CARBAUGH

Professor of Economics, Central Washington University

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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International Economics, Fifteenth Edition © 2015, 2013 Cengage Learning
WCN: 02-200-203
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Brief Contents

PREFACE .......................................................................................................... xv
CHAPTER 1 The International Economy and Globalization .............................. 1

PART 1 International Trade Relations 27
CHAPTER 2 Foundations of Modern Trade Theory: Comparative

Advantage ........................................................................................ 29
CHAPTER 3 Sources of Comparative Advantage ............................................ 69
CHAPTER 4 Tariffs ............................................................................................. 107
CHAPTER 5 Nontariff Trade Barriers ............................................................... 149
CHAPTER 6 Trade Regulations and Industrial Policies ................................. 181
CHAPTER 7 Trade Policies for the Developing Nations ................................ 227
CHAPTER 8 Regional Trading Arrangements ................................................ 267
CHAPTER 9 International Factor Movements and Multinational

Enterprises ..................................................................................... 295

PART 2 International Monetary Relations 327
CHAPTER 10 The Balance-of-Payments ............................................................ 329
CHAPTER 11 Foreign Exchange ......................................................................... 357
CHAPTER 12 Exchange Rate Determination .................................................... 393
CHAPTER 13 Mechanisms of International Adjustment ................................. 419
CHAPTER 14 Exchange Rate Adjustments and the

Balance-of-Payments .................................................................... 427
CHAPTER 15 Exchange Rate Systems and Currency Crises .......................... 445
CHAPTER 16 Macroeconomic Policy in an Open Economy ........................... 479
CHAPTER 17 International Banking: Reserves, Debt, and Risk ...................... 495

GLOSSARY ............................................................................................................. 513

INDEX .................................................................................................................... 527

v

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Contents

Preface ...................................................................................................................xv

CHAPTER 1

The International Economy and Globalization ....................................... 1

Globalization of Economic Activity ............................................ 2 Bicycle Imports Force Schwinn to Downshift ................... 16
Element Electronics Survives by Moving
Waves of Globalization .................................................................. 3
TV Production to America............................................ 17
Federal Reserve Policy Incites Common Fallacies of International Trade ..............................18
Global Backlash. . . . . . . . . . . . . . . . . . . . . . . . 4
Is the United States Losing Its
First Wave of Globalization: 1870–1914............................. 4 Innovation Edge?. . . . . . . . . . . . . . . . . . . . . . 19
Second Wave of Globalization: 1945–1980......................... 5
Latest Wave of Globalization ............................................... 5 Does Free Trade Apply to Cigarettes? .....................................19
Is International Trade an Opportunity or a Threat
Diesel Engines and Gas Turbines as
Movers of Globalization . . . . . . . . . . . . . . . . 8 to Workers?............................................................................... 20
Backlash against Globalization ................................................... 22
The United States as an Open Economy................................... 9 The Plan of This Text .................................................................. 24
Trade Patterns......................................................................... 9 Summary.......................................................................................... 24
Labor and Capital ................................................................ 11 Key Concepts and Terms ............................................................ 25
Study Questions ............................................................................. 25
Why is Globalization Important? .............................................. 12

Globalization and Competition.................................................. 15
Kodak Reinvents Itself under Chapter 11 Bankruptcy .... 15

PART 1 International Trade Relations 27

CHAPTER 2

Foundations of Modern Trade Theory: Comparative Advantage ...... 29

Historical Development of Modern Trade Theory ...............29 Distributing the Gains from Trade .................................... 40
The Mercantilists .................................................................. 29 Equilibrium Terms of Trade ............................................... 41
Why Nations Trade: Absolute Advantage ........................ 30 Terms of Trade Estimates.................................................... 42
Why Nations Trade: Comparative Advantage ................. 31 Dynamic Gains from Trade........................................................ 43
How Global Competition Led to Productivity
David Ricardo. . . . . . . . . . . . . . . . . . . . . . . . . 32
Gains for U.S. Iron Ore Workers ................................. 44
Production Possibilities Schedules............................................. 35 Changing Comparative Advantage............................................ 45
Trading under Constant-Cost Conditions...............................36
Trading under Increasing-Cost Conditions ............................46
Basis for Trade and Direction of Trade ............................ 36
Production Gains from Specialization ............................... 37 Natural Gas Boom Fuels Debate . . . . . . . 47
Consumption Gains from Trade ........................................ 38
Increasing-Cost Trading Case ............................................. 48
Babe Ruth and the Principle of Partial Specialization ........................................................... 50
Comparative Advantage. . . . . . . . . . . . . . . 39
The Impact of Trade on Jobs ..................................................... 51

vi

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Contents vii

Wooster, Ohio Bears the Brunt of Globalization ..................52 Outsourcing and the U.S. Automobile Industry............... 60
The iPhone Economy and Global Supply
Comparative Advantage Extended to Many Products
and Countries ........................................................................... 53 Chains............................................................................... 60
More Than Two Products ................................................... 53 Outsourcing Backfires for Boeing 787 Dreamliner .......... 61
More Than Two Countries ................................................. 54 Reshoring Production to the United States....................... 63

Exit Barriers .................................................................................... 55 Summary.......................................................................................... 64

Empirical Evidence on Comparative Advantage ...................56 Key Concepts and Terms ............................................................ 65

Comparative Advantage and Global Supply Chains.............57 Study Questions ............................................................................. 65
Advantages and Disadvantages of Outsourcing ............... 59
Exploring Further .......................................................................... 67

CHAPTER 3

Sources of Comparative Advantage ...................................................... 69

Factor Endowments as a Source of Comparative Does a “Flat World” Make
Advantage.................................................................................. 69 Ricardo Wrong?. . . . . . . . . . . . . . . . . . . . . . . 89
The Factor-Endowments Theory ........................................ 70
Visualizing the Factor-Endowment Theory ...................... 72 Intra-industry Trade ..................................................................... 90
Applying the Factor-Endowment Theory to
U.S.–China Trade ........................................................... 73 Technology as a Source of Comparative Advantage:
Chinese Manufacturers Beset By Rising Wages and a The Product Cycle Theory.................................................... 92
Rising Yuan ..................................................................... 74 Radios, Pocket Calculators, and the International
Product Cycle................................................................... 94
Globalization Drives Changes for U.S. Japan Fades in the Electronics Industry............................ 95
Automakers. . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Dynamic Comparative Advantage: Industrial Policy............96
Factor-Price Equalization .................................................... 76 WTO Rules that Illegal Government Subsidies Support
Who Gains and Loses from Trade?
Boeing and Airbus................................................................... 97
The Stolper–Samuelson Theorem ................................. 78
Is International Trade a Substitute Do Labor Unions Stifle
Competitiveness? . . . . . . . . . . . . . . . . . . . . . 99
for Migration?.................................................................. 79
Specific Factors: Trade and the Distribution of Government Regulatory Policies
and Comparative Advantage ................................................ 99
Income in the Short Run ............................................... 81
Does Trade Make the Poor Even Poorer? ......................... 81 Transportation Costs and Comparative Advantage............101
Trade Effects ........................................................................ 101
Is the Factor-Endowment Theory a Good Predictor Falling Transportation Costs Foster Trade ..................... 103
of Trade Patterns? ................................................................... 83
Summary ........................................................................................ 104
Skill as a Source of Comparative Advantage..........................84
Key Concepts and Terms ..........................................................105
Economies of Scale and Comparative Advantage .................85
Internal Economies of Scale ................................................ 86 Study Questions ...........................................................................105
External Economies of Scale................................................ 87 Exploring Further ........................................................................106

Overlapping Demands as a Basis for Trade ...........................88

CHAPTER 4

Tariffs........................................................................................................ 107

The Tariff Concept......................................................................108 Tariff Escalation ...........................................................................114
Outsourcing and Offshore Assembly Provision...................115
Types Of Tariffs...........................................................................109 Dodging Import Tariffs: Tariff Avoidance
Specific Tariff....................................................................... 109
Ad Valorem Tariff.............................................................. 110 and Tariff Evasion.................................................................116
Compound Tariff ................................................................ 111 Ford Strips Its Wagons to Avoid High

Effective Rate of Protection.......................................................111 Tariff............................................................................... 117
Smuggled Steel Evades U.S. Tariffs .................................. 117
Trade Protectionism Intensifies As
Global Economy Falls Into the Great Gains from Eliminating
Recession. . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Import Tariffs . . . . . . . . . . . . . . . . . . . . . . . . 118

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viii Contents

Postponing Import Tariffs.........................................................119 Tariffs and the Poor....................................................................134
Bonded Warehouse............................................................. 119 Arguments for Trade Restrictions ...........................................135
Foreign–Trade Zone ........................................................... 119
FTZ’s Benefit Motor Vehicle Importers ........................... 120 Job Protection ...................................................................... 136
Protection against Cheap Foreign Labor......................... 136
Tariff Effects: An Overview.......................................................121 Fairness in Trade: A Level Playing Field ........................ 139
Tariff Welfare Effects: Consumer Surplus Maintenance of the Domestic Standard of Living ......... 139
Equalization of Production Costs..................................... 140
and Producer Surplus ...........................................................122 Infant-Industry Argument ................................................. 140
Noneconomic Arguments................................................... 140
Tariff Welfare Effects: Small Nation Model..........................123
Petition of the Candle Makers. . . . . . . . . 142
Tariff Welfare Effects: Large Nation Model..............................126
The Optimum Tariff and Retaliation.............................. 128 The Political Economy of Protectionism...............................142

Examples of U.S. Tariffs ............................................................130 A Supply and Demand View of Protectionism .............. 144
Obama’s Tariffs on Chinese Tires .................................... 130
Should Footwear Tariffs Be Given Summary ........................................................................................ 145
the Boot?......................................................................... 131 Key Concepts and Terms ..........................................................146
Study Questions ...........................................................................146
Could a Higher Tariff Put a Dent Exploring Further ........................................................................148
in the Federal Debt?. . . . . . . . . . . . . . . . . . 132

How a Tariff Burdens Exporters .............................................132

CHAPTER 5

Nontariff Trade Barriers ......................................................................... 149

Absolute Import Quota..............................................................149 Whirlpool Agitates for Antidumping Tariffs
Trade and Welfare Effects................................................. 150 on Clothes Washers ...................................................... 168
Allocating Quota Licenses ................................................. 152
Quotas versus Tariffs ......................................................... 153 Canadians Press Washington Apple Producers
for Level Playing Field.................................................. 169
Tariff–Rate Quota: A Two–Tier Tariff...................................154
Tariff–Rate Quota Bittersweet for Is Antidumping Law Unfair?....................................................169
Sugar Consumers ................................................................. 156 Should Average Variable Cost Be the Yardstick
for Defining Dumping?................................................. 170
Export Quotas ..............................................................................156 Should Antidumping Law Reflect Currency
Japanese Auto Restraints Put Brakes on Fluctuations?.................................................................. 171
U.S. Motorists ................................................................ 157 Are Antidumping Duties Overused? ................................ 171

Domestic Content Requirements.............................................158 Other Nontariff Trade Barriers ................................................172
Government Procurement Policies.................................... 172
How “Foreign” is Your Car? . . . . . . . . . . 160
U.S. Fiscal Stimulus and Buy
Subsidies......................................................................................... 161 American Legislation. . . . . . . . . . . . . . . . . 173
Domestic Production Subsidy............................................ 161
Export Subsidy .................................................................... 162 Social Regulations ............................................................... 174
CAFÉ Standards ................................................................. 174
Dumping ........................................................................................ 163 Europe Has a Cow over Hormone-Treated
Forms of Dumping ............................................................. 163
International Price Discrimination .................................. 164 U.S. Beef ......................................................................... 174
Sea Transport and Freight Regulations ........................... 175
Antidumping Regulations..........................................................166
Summary ........................................................................................ 176
Swimming Upstream: The Case of
Vietnamese Catfish. . . . . . . . . . . . . . . . . . . 167 Key Concepts and Terms ..........................................................177

Study Questions ...........................................................................177

CHAPTER 6

Trade Regulations and Industrial Policies........................................... 181

U.S. Tariff Policies Before 1930 ...............................................181 General Agreement on Tariffs and Trade .............................185
Smoot–Hawley Act......................................................................183 Trade without Discrimination .......................................... 185
Reciprocal Trade Agreements Act...........................................184 Promoting Freer Trade ...................................................... 186

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Contents ix

Predictability: Through Binding and Remedies against Dumped and Subsidized
Transparency ................................................................. 187 Imports ................................................................................... 204

Multilateral Trade Negotiations ....................................... 187 U.S. Steel Companies Lose an Unfair Trade Case
and Still Win................................................................. 206
World Trade Organization........................................................189
Section 301: Protection against Unfair
Avoiding Trade Barriers during Trading Practices ...................................................................207
the Great Recession. . . . . . . . . . . . . . . . . . 190
Protection of Intellectual Property Rights .............................208
Settling Trade Disputes ...................................................... 191
Does the WTO Reduce National Sovereignty?................ 192 The Globalization of Ideas and
Should Retaliatory Tariffs Be Used for Intellectual Property Rights. . . . . . . . . . . 210

WTO Enforcement? ...................................................... 193 Microsoft Scorns China’s Piracy
Does the WTO Harm the Environment? ........................ 194 of Software ..................................................................... 210
Harming the Environment ................................................ 194
Improving the Environment .............................................. 195 Trade Adjustment Assistance ...................................................212
WTO Rules against China’s Hoarding
Industrial Policies of the United States..................................212
of Rare Earth Metals.................................................... 195 U.S. Airlines and Boeing Spar over Export–Import
Future of the World Trade Organization ....................... 197 Bank Credit.................................................................... 214
U.S. Solar Industry Dims as China’s Industrial
Trade Promotion Authority (Fast Track Authority) ..........198 Policy Lights Up ............................................................ 215

Safeguards (The Escape Clause): Emergency Industrial Policies of Japan .......................................................216
Protection from Imports......................................................199
U.S. Safeguards Limit Surging Imports of Strategic Trade Policy.................................................................217
Textiles from China...................................................... 200
Economic Sanctions ....................................................................219
Countervailing Duties: Protection against Factors Influencing the Success of Sanctions .................. 220
Foreign Export Subsidies .....................................................201 Economic Sanctions and Weapons of Mass
Lumber Duties Hammer Home Buyers........................... 202 Destruction: North Korea and Iran ........................... 221

Antidumping Duties: Protection against Foreign Summary ........................................................................................ 223
Dumping .................................................................................. 202
Key Concepts and Terms ..........................................................224
Would a Carbon Tariff Help Solve
the Climate Problem? . . . . . . . . . . . . . . . . 203 Study Questions ...........................................................................224

Exploring Further ........................................................................225

CHAPTER 7

Trade Policies for the Developing Nations ......................................... 227

Developing-Nation Trade Characteristics..............................227 Maximizing Cartel Profits ................................................. 240
OPEC as a Cartel ............................................................... 242
Tensions between Developing Nations
and Advanced Nations.........................................................229 Does Foreign Direct Investment
Hinder or Help Economic
Trade Problems of the Developing Nations .........................229 Development?. . . . . . . . . . . . . . . . . . . . . . . . 244
Unstable Export Markets................................................... 230
Falling Commodity Prices Threaten Growth Aiding the Developing Nations................................................244
of Exporting Nations .................................................... 232 The World Bank ................................................................. 245
Worsening Terms of Trade ............................................... 232 International Monetary Fund........................................... 246
Limited Market Access....................................................... 233 Generalized System of Preferences.................................... 247
Agricultural Export Subsidies of Advanced Does Aid Promote Growth of Developing
Nations ........................................................................... 235 Nations?.......................................................................... 248
Bangladesh’s Sweatshop Reputation................................. 235 How to Bring Developing Nations in from
the Cold.................................................................................. 248
Stabilizing Primary-Product Prices .........................................237
Production and Export Controls ...................................... 237 Economic Growth Strategies: Import Substitution
Buffer Stocks ........................................................................ 237 versus Export Led Growth ..................................................250
Multilateral Contracts........................................................ 239 Import Substitution ............................................................ 250
Does the Fair Trade Movement Help Poor Import Substitution Laws Backfire on Brazil ................. 251
Coffee Farmers? ............................................................. 239 Export Led Growth............................................................. 252
Is Economic Growth Good for the Poor? ........................ 253
The OPEC Oil Cartel .................................................................240

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x Contents

Can All Developing Nations Achieve Export China’s Export Boom Comes at a Cost: How to
Led Growth? .................................................................. 253 Make Factories Play Fair............................................. 260

East Asian Economies ................................................................254 India: Breaking Out of the Third World...............................261
Flying Geese Pattern of Growth........................................ 255 Brazil Takes off ............................................................................263

Is State Capitalism Winning? . . . . . . . . . 256 Summary ........................................................................................ 264
Key Concepts and Terms ..........................................................265
China’s Great Leap Forward.....................................................257
Challenges for China’s Economy ...................................... 258 Study Questions ...........................................................................265

CHAPTER 8

Regional Trading Arrangements .......................................................... 267

Regional Integration versus Multilateralism .........................267 Optimum Currency Area................................................... 280
Types of Regional Trading Arrangements ............................268 Eurozone’s Problems and Challenges............................... 281
Impetus for Regionalism............................................................270
Effects of a Regional Trading Arrangement .........................270 European Monetary “Disunion”. . . . . . . 282

Static Effects......................................................................... 270 Will the Eurozone Survive? ............................................... 283
Dynamic Effects................................................................... 273 North American Free Trade Agreement................................284

Is the U.S.–South Korea Free-Trade NAFTA’s Benefits and Costs for
Agreement Good for Americans? . . . . . 274 Mexico and Canada............................................................ 285

The European Union..................................................................274 NAFTA’s Benefits and Costs for the
Pursuing Economic Integration ........................................ 275 United States.................................................................. 286
Agricultural Policy .............................................................. 276
Is the European Union Really a U.S.–Mexico Trucking Dispute ......................................... 288
Common Market? ......................................................... 278 U.S.–Mexico Tomato Dispute ........................................... 289
Is NAFTA an Optimum Currency Area?........................ 290
Economic Costs and Benefits of a Common Currency:
The European Monetary Union ........................................280 Summary ........................................................................................ 291

Key Concepts and Terms ..........................................................292
Study Questions ...........................................................................292
Exploring Further ........................................................................293

CHAPTER 9

International Factor Movements and Multinational Enterprises..... 295

The Multinational Enterprise ...................................................295 Employment......................................................................... 310
Motives for Foreign Direct Investment..................................297 Caterpillar Bulldozes Canadian Locomotive Workers ........ 311
Technology Transfer ........................................................... 312
Demand Factors.................................................................. 298 National Sovereignty .......................................................... 314
Cost Factors ......................................................................... 298 Balance-of-Payments .......................................................... 315
Transfer Pricing .................................................................. 316
Supplying Products to Foreign Buyers: Whether International Labor Mobility: Migration ...............................316
to Produce Domestically or Abroad .................................299
Direct Exporting versus Foreign Direct Apple Uses Tax Loopholes
Investment/Licensing .................................................... 300 to Dodge Taxes . . . . . . . . . . . . . . . . . . . . . . 317
Foreign Direct Investment versus Licensing.................... 301
The Effects of Migration .................................................... 318
Country Risk Analysis................................................................302 Immigration as an Issue.................................................... 320
Does Canada’s Immigration Policy Provide
Do U.S. Multinationals Exploit
Foreign Workers? . . . . . . . . . . . . . . . . . . . . 303 a Model for the United States? ................................... 322

International Trade Theory and Multinational Does U.S. Immigration Policy Harm
Enterprise................................................................................. 305 Domestic Workers?. . . . . . . . . . . . . . . . . . . 323

Japanese Transplants in the U.S. Automobile Industry.....305 Summary ........................................................................................ 324
International Joint Ventures .....................................................307 Key Concepts and Terms ..........................................................324
Study Questions ...........................................................................324
Welfare Effects..................................................................... 308

Multinational Enterprises as a Source of Conflict...............310

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Contents xi

PART 2 International Monetary Relations 327

CHAPTER 10

The Balance-of-Payments ...................................................................... 329

Double Entry Accounting..........................................................329 Business Cycles, Economic Growth, and the Current
Balance-of-Payments Structure ................................................331 Account........................................................................... 343

Current Account ................................................................. 331 How the United States Has Borrowed at
Capital and Financial Account......................................... 332 Very Low Cost............................................................... 344

International Payments Process. . . . . . . 333 Do Current Account Deficits Cost
Americans Jobs? ............................................................ 345
Official Settlements Transactions ..................................... 334
Special Drawing Rights ...................................................... 335 Can the United States Continue to Run Current
Statistical Discrepancy: Errors and Omissions ............... 336 Account Deficits Indefinitely?...................................... 346
U.S. Balance-of-Payments..........................................................337
What Does a Current Account Deficit (Surplus) Mean?........ 339 Balance of International Indebtedness ...................................348
Net Foreign Investment and the Current
United States as a Debtor Nation .................................... 349
Account Balance............................................................ 340
Impact of Capital Flows on the Current Account ......... 340 Global Imbalances. . . . . . . . . . . . . . . . . . . . 350
Is a Current Account Deficit a Problem?........................ 341
The Dollar as the World’s Reserve Currency.......................351
The iPhone’s Complex Supply Benefits to the United States ............................................. 351
Chain Depicts Limitations of A New Reserve Currency?.................................................. 352
Trade Statistics . . . . . . . . . . . . . . . . . . . . . . 342
Summary ........................................................................................ 353

Key Concepts and Terms ..........................................................354
Study Questions ...........................................................................354

CHAPTER 11

Foreign Exchange ................................................................................... 357

Foreign Exchange Market..........................................................357 How Markel, Volkswagen, and Nintendo
Types of Foreign Exchange Transactions..............................359 Manage Foreign Exchange Risk.................................. 379
Interbank Trading .......................................................................361
Reading Foreign Exchange Quotations ..................................363 Does Foreign Currency Hedging Pay Off?....................... 380

Yen Depreciation Drives Toyota Currency Risk and the Hazards of
Profits Upward. . . . . . . . . . . . . . . . . . . . . . . 366 Investing Abroad. . . . . . . . . . . . . . . . . . . . . 381

Forward and Futures Markets ..................................................366 Interest Arbitrage, Currency Risk, and Hedging .................382
Foreign Currency Options.........................................................368 Uncovered Interest Arbitrage ............................................ 382
Exchange Rate Determination ..................................................369 Covered Interest Arbitrage (Reducing Currency Risk) ......383

Demand for Foreign Exchange ......................................... 369 Foreign Exchange Market Speculation ...................................384
Supply of Foreign Exchange .............................................. 369 Long and Short Positions .................................................. 385
Equilibrium Rate of Exchange .......................................... 370 Andy Krieger Shorts the New Zealand Dollar................ 385
Indexes of the Foreign-Exchange Value of the Dollar: George Soros Shorts the Yen ............................................. 385
Nominal and Real Exchange Rates ...................................371 People’s Bank of China Widens Trading Band
Arbitrage ........................................................................................373 to Punish Currency Speculators.................................. 386
The Forward Market...................................................................374 Stabilizing and Destabilizing Speculation ....................... 386
The Forward Rate............................................................... 375
Relation between the Forward Foreign Exchange Trading as a Career ..................................387
Foreign Exchange Traders Hired by Commercial
Rate and Spot Rate....................................................... 376 Banks, Companies, and Central Banks ..................... 387
Managing Your Foreign Exchange Risk:
How to Play the Falling (Rising) Dollar. . . 388
Forward Foreign Exchange Contract ......................... 377
Case 1................................................................................... 378 Currency Markets Draw Day Traders............................. 389
Case 2................................................................................... 378 Summary ........................................................................................ 390

Key Concepts and Terms ..........................................................390
Study Questions ...........................................................................390

Exploring Further ........................................................................392

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xii Contents

CHAPTER 12

Exchange Rate Determination .............................................................. 393

What Determines Exchange Rates?.........................................393 Expected Change in the Exchange Rate .......................... 407
Determining Long Run Exchange Rates................................395 Diversification, Safe Havens,

Relative Price Levels ........................................................... 396 and Investment Flows .................................................. 408

Relative Productivity Levels............................................... 396 International Comparisons of GDP:
Purchasing-Power-Parity. . . . . . . . . . . . . . 409
Preferences for Domestic or Foreign Goods .................... 396
Exchange Rate Overshooting....................................................410
Trade Barriers ..................................................................... 398 Forecasting Foreign Exchange Rates.......................................411

Inflation Rates, Purchasing-Power-Parity, Judgmental Forecasts.......................................................... 412
and Long Run Exchange Rates ..........................................398 Technical Forecasts ............................................................. 413
Law of One Price................................................................ 398 Fundamental Analysis........................................................ 414

Burgeromics: The “Big Mac” Index and the Commercial Mexicana Gets
Law of One Price .......................................................... 399 Burned by Speculation . . . . . . . . . . . . . . . 415

Purchasing-Power-Parity ................................................... 400 Summary ........................................................................................ 416

Inflation Differentials and the Key Concepts and Terms ..........................................................416
Exchange Rate. . . . . . . . . . . . . . . . . . . . . . . 401
Study Questions ...........................................................................416
Determining Short Run Exchange Rates: Exploring Further ........................................................................418
The Asset Market Approach...............................................404
Relative Levels of Interest Rates........................................ 405

CHAPTER 13

Mechanisms of International Adjustment........................................... 419

Price Adjustments........................................................................420 Disadvantages of Automatic Adjustment Mechanisms.........424
Gold Standard ..................................................................... 420
Quantity Theory of Money ............................................... 420 Monetary Adjustments...............................................................425
Current Account Adjustment............................................ 421 Summary ........................................................................................ 425

Financial Flows and Interest Rate Differentials ...................422 Key Concepts and Terms ..........................................................426
Income Adjustments...................................................................423 Study Questions ...........................................................................426
Exploring Further ........................................................................426

CHAPTER 14

Exchange Rate Adjustments and the Balance-of-Payments ............ 427

Effects of Exchange Rate Changes Will Currency Depreciation Reduce a
on Costs and Prices ..............................................................427 Trade Deficit? The Elasticity Approach...........................433
Case 1: No Foreign Sourcing—All Costs Are
Denominated in Dollars............................................... 428 J–Curve Effect: Time Path of Depreciation ..........................436
Case 2: Foreign Sourcing—Some Costs Denominated Exchange Rate Pass-Through ...................................................438
in Dollars and Some Costs Denominated
in Francs ........................................................................ 428 Partial Exchange Rate Pass-Through............................... 438

Cost Cutting Strategies of Manufacturers in Does Currency Depreciation Give Weak
Response to Currency Appreciation .................................430 Countries a Way out of Crisis?. . . . . . . . 441
Appreciation of the Yen: Japanese
Manufacturers ............................................................... 430 The Absorption Approach to Currency
Depreciation ............................................................................ 441
Japanese Firms Send Work Abroad as
Rising Yen Makes Their Products Less The Monetary Approach to Currency Depreciation ..........442
Competitive . . . . . . . . . . . . . . . . . . . . . . . . . 432 Summary ........................................................................................ 443

Appreciation of the Dollar: Key Concepts and Terms ..........................................................444
U.S. Manufacturers....................................................... 432 Study Questions ...........................................................................444
Exploring Further ........................................................................444

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Contents xiii

CHAPTER 15

Exchange Rate Systems and Currency Crises.................................... 445

Exchange Rate Practices.............................................................445 The Crawling Peg ........................................................................462

Choosing an Exchange Rate System: Constraints Currency Manipulation and Currency Wars........................462
Imposed by Free Capital Flows..........................................447 Is China a Currency Manipulator?.................................. 464

Fixed Exchange Rate System ....................................................448 Currency Crises............................................................................465
Use of Fixed Exchange Rates ............................................ 448
Par Value and Official Exchange Rate............................ 450 The Global Financial Crisis
Exchange Rate Stabilization.............................................. 450 of 2007–2009. . . . . . . . . . . . . . . . . . . . . . . . . 466
Devaluation and Revaluation ........................................... 452
Bretton Woods System of Fixed Exchange Rates ........... 452 Sources of Currency Crises ................................................ 468
Speculators Attack East Asian Currencies....................... 469
Floating Exchange Rates ............................................................453 Capital Controls ...........................................................................470
Achieving Market Equilibrium ......................................... 454
Trade Restrictions, Jobs, and Floating Should Foreign Exchange Transactions be Taxed? ........ 471
Exchange Rates.............................................................. 455
Arguments for and against Floating Rates ..................... 455 Increasing the Credibility of Fixed Exchange Rates ...........472
Currency Board................................................................... 472
Managed Floating Rates.............................................................456 For Argentina, No Panacea in a Currency Board......... 474
Managed Floating Rates in the Short Dollarization........................................................................ 475
Run and Long Run....................................................... 457
Exchange Rate Stabilization and Monetary Policy........ 459 Summary ........................................................................................ 477
Is Exchange Rate Stabilization Effective? ........................ 461 Key Concepts and Terms ..........................................................478

Study Questions ...........................................................................478

CHAPTER 16

Macroeconomic Policy in an Open Economy ..................................... 479

Economic Objectives of Nations..............................................479 Monetary and Fiscal Policy Respond to
Financial Turmoil in the Economy. . . . . 487
Policy Instruments.......................................................................480
Inflation with Unemployment..................................................488
Aggregate Demand and Aggregate Supply:
a Brief Review.........................................................................480 International Economic Policy Coordination.......................488
Policy Coordination in Theory ......................................... 489
Monetary and Fiscal Policy in a Closed Economy .............481 Does Policy Coordination Work? ..................................... 491

Monetary and Fiscal Policy in an Open Economy .............483 Does Crowding Occur in an
Effect of Fiscal and Monetary Policy under Open Economy?. . . . . . . . . . . . . . . . . . . . . . 492
Fixed Exchange Rates................................................... 484
Effect of Fiscal and Monetary Policy under Summary ........................................................................................ 493
Floating Exchange Rates .............................................. 486 Key Concepts and Terms ..........................................................493
Study Questions ...........................................................................494
Macroeconomic Stability and the Current Account:
Policy Agreement versus Policy Conflict.........................486

CHAPTER 17

International Banking: Reserves, Debt, and Risk ............................... 495

Nature of International Reserves .............................................495 Demonetization of Gold..................................................... 502
Should the United States Return to the
Demand for International Reserves ........................................496
Exchange Rate Flexibility................................................... 496 Gold Standard?.............................................................. 503
Other Determinants............................................................ 498
Special Drawing Rights ..............................................................503
Supply of International Reserves .............................................499
Foreign Currencies ......................................................................499 Facilities for Borrowing Reserves.............................................504
Gold ................................................................................................ 500 IMF Drawings ..................................................................... 504
General Arrangements to Borrow .................................... 504
International Gold Standard............................................. 501 Swap Arrangements............................................................ 505
Gold Exchange Standard ................................................... 501
International Lending Risk........................................................505

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xiv Contents

The Problem of International Debt ........................................506 The Eurodollar Market...............................................................510
Dealing with Debt Servicing Difficulties.......................... 507 Summary ........................................................................................ 511
Key Concepts and Terms ..........................................................511
Reducing Bank Exposure to Developing Study Questions ...........................................................................511
Nation Debt ............................................................................508

Debt Reduction and Debt Forgiveness...................................509

Glossary ...............................................................................................................513

Index ....................................................................................................................527

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Preface

I believe the best way to motivate students to learn a subject is to demonstrate how it is
used in practice. The first fourteen editions of International Economics reflected this
belief and were written to provide a serious presentation of international economic the-
ory with an emphasis on current applications. Adopters of these editions strongly sup-
ported the integration of economic theory with current events.

The fifteenth edition has been revised with an eye toward improving this presentation
and updating the applications as well as including the latest theoretical developments.
Like its predecessors, this edition is intended for use in a one-quarter or one-semester
course for students having no more background than principles of economics. This
book’s strengths are its clarity, organization, and applications that demonstrate the use-
fulness of theory to students. The revised and updated material in this edition empha-
sizes current applications of economic theory and incorporates recent theoretical and
policy developments in international trade and finance.

INTERNATIONAL ECONOMICS THEMES

This edition highlights five current themes that are at the forefront of international
economics:

GLOBALIZATION OF ECONOMIC ACTIVITY
• Wooster, Ohio bears brunt of globalization—Ch. 2
• Japan fades in the global electronics industry—Ch. 3
• Comparative advantage and global supply chains—Ch. 2
• Caterpillar bulldozes Canadian locomotive workers—Ch. 9
• Apple uses tax loopholes to dodge taxes—Ch. 9
• Diesel engines and gas turbines as engines of growth—Ch. 1
• Waves of globalization—Ch. 1
• Has globalization gone too far?—Ch. 1
• Putting the H-P Pavilion together—Ch. 1
• Is the United States losing its innovation edge?—Ch. 1
• Rising transportation costs hinder globalization—Ch. 3
• iPhone’s complex supply chain highlights limitations of trade statistics—Ch. 10
• Constraints imposed by capital flows on the choice of an exchange rate system—

Ch. 15
FREE TRADE AND PROTECTIONISM
• Whirlpool wins dumping case—Ch. 5
• Wage increases and China’s trade—Ch. 3
• Should shoe tariffs be stomped out?—Ch. 4
• Natural gas boom fuels trade debate—Ch.2
• Element Electronics brings TV manufacturing back to the United States—Ch. 1
• Carbon tariffs—Ch. 6
• Averting trade barriers during the Great Recession—Ch. 6
• Bangladesh’s sweatshop reputation—Ch. 7

xv

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xvi Preface

• Does the principle of comparative advantage apply in the face of job
outsourcing?—Ch. 2

• Boeing outsources work, but protects its secrets—Ch. 2
• Does trade make the poor even poorer?—Ch. 3
• WTO rules against subsidies to Boeing and Airbus—Ch. 3
• Does wage insurance make free trade more acceptable to workers?—Ch. 6
• China’s hoarding of rare earth metals declared illegal by WTO—Ch. 6
• The environment and free trade—Ch. 6

TRADE CONFLICTS BETWEEN DEVELOPING NATIONS
AND INDUSTRIAL NATIONS
• U.S.-Mexico tomato dispute—Ch. 8
• Is state capitalism winning?—Ch. 7
• Canada’s immigration policy—Ch. 9
• Is international trade a substitute for migration?—Ch. 3
• Economic growth strategies–import substitution versus export led growth—Ch. 7
• Does foreign aid promote the growth of developing countries?—Ch. 7
• The globalization of intellectual property rights—Ch. 7
• How to bring in developing countries from the cold—Ch. 7
• Microsoft scorns China’s piracy of software—Ch. 6
• The Doha Round of multilateral trade negotiations—Ch. 6
• Wage increases work against China’s competitiveness—Ch. 7
• China’s export boom comes at a cost: How to make factories play fair—Ch. 7
• Will emerging economies soon outstrip the rich ones?—Ch. 7
• Do U.S. multinationals exploit foreign workers?—Ch. 9
LIBERALIZING TRADE: THE WTO VERSUS REGIONAL TRADING
ARRANGEMENTS
• Does the WTO reduce national sovereignty?—Ch. 6
• Regional integration versus multilateralism—Ch. 8
• Is Europe really a common market?—Ch. 8
• The U.S.-South Korea Free Trade Agreement—Ch. 8
• NAFTA and the U.S.-Mexico trucking dispute—Ch. 8
• Will the euro survive?—Ch. 8
TURBULENCE IN THE GLOBAL FINANCIAL SYSTEM
• Yen’s depreciation drives Toyota’s profits upward—Ch. 11
• People’s Bank of China punishes speculators—Ch. 11
• Can the euro survive?—Ch. 8
• Does currency depreciation give weak countries a way out of crisis?—Ch. 14
• Currency manipulation and currency wars—Ch. 15
• Paradox of foreign debt: how the United states borrows at low cost—Ch. 10
• Mistranslation of news story roils currency markets—Ch. 12
• Why a dollar depreciation may not close the U.S. trade deficit—Ch. 14
• Japanese firms send work abroad as yen makes its products less
competitive—Ch.14
• Preventing currency crises: Currency boards versus dollarization—Ch. 15
• Should Special Drawing Rights replace the dollar as the world’s reserve
currency?—Ch. 17
• Should the United States return to the gold standard?—Ch. 17

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Preface xvii

Besides emphasizing current economic themes, the fifteenth edition of this text con-
tains many new topics such as outsourcing and the U.S. auto industry, U.S. safeguards
limiting imports of textiles from China, why Italian shoemakers strive to give the euro
the boot, bike imports that forced Schwinn to downshift, and how currency markets
draw day traders. Faculty and students will appreciate how this edition provides a con-
temporary approach to international economics.

ORGANIZATIONAL FRAMEWORK: EXPLORING
FURTHER SECTIONS

Although instructors generally agree on the basic content of the international economics
course, opinions vary widely about what arrangement of material is appropriate. This book
is structured to provide considerable organizational flexibility. The topic of international
trade relations is presented before international monetary relations, but the order can be
reversed by instructors choosing to start with monetary theory. Instructors can begin with
Chapters 10–17 and conclude with Chapters 2–9. Those who do not wish to cover all the
material in the book can easily omit all or parts of Chapters 6–9, and Chapters 15–17
without loss of continuity.

The fifteenth edition streamlines its presentation of theory to provide greater flexibil-
ity for instructors. This edition uses online Exploring Further sections to discuss more
advanced topics. By locating the Exploring Further sections online rather than in the
textbook, as occurred in previous editions, more textbook coverage can be devoted to
contemporary applications of theory. The Exploring Further sections consist of the
following:

Comparative advantage in money terms—Ch. 2
Indifference curves and trade—Ch. 2
Offer curves and the equilibrium terms of trade—Ch. 2
The specific-factors theory—Ch. 3
Offer curves and tariffs—Ch. 4
Tariff-rate quota welfare effects—Ch. 5
Export quota welfare effects—Ch. 5
Welfare effects of strategic trade policy—Ch. 6
Government procurement policy and the European Union—Ch. 8
Economies of scale and NAFTA—Ch. 8
Techniques of foreign-exchange market speculation—Ch. 11
A primer on foreign-exchange trading—Ch. 11
Fundamental forecasting–regression analysis—Ch. 12
Income adjustment mechanism—Ch. 13
Exchange-rate pass-through—Ch. 14
To access the Exploring Further sections, go to www.cengagebrain.com.

SUPPLEMENTARY MATERIALS

For Students
International Economics CourseMate (www.cengagebrain.com)
In this age of technology, no text package would be complete without Web-based
resources. An international economics CourseMate product is offered with the fifteenth
edition.

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xviii Preface

Within the online study tool CourseMate, students will find a vast amount of
resources for self-study including access to the eBook, glossary, online quizzes, videos,
graphing workshop games, EconApps, and flashcards. Students can purchase Course-
Mate at www.cengagebrain.com.

Study Guide
To accompany the fifteenth edition of the International Economics text, Jim Hanson
(Professor Emeritus at Willlamette University) has prepared an online Study Guide for
students. This guide reinforces key concepts by providing a review of the text’s main
topics and offering practice problems, true–false, multiple choice, and short–answer
questions. The Study Guide is available online only and students can purchase it at
www.cengagebrain.com.

For Instructors
International Economics CourseMate (www.cengagebrain.com)
Through CourseMate, instructors have access to Engagement Tracker that is designed to
assess that students have read the material or viewed the resources that you’ve assigned.
Engagement Tracker assesses student preparation and engagement. Using the tracking
tools enables you to see progress for the class as a whole or for individual students, iden-
tify students at risk early in the course, and uncover which concepts are most difficult for
your class.

Aplia
Aplia is another feature of the fifteenth edition. With Aplia, international economics
students use interactive chapter assignments and tutorials to make economics relevant
and engaging. Students complete online assignments to improve their proficiency in
understanding economic theory and they receive immediate, detailed explanations for
every answer. Math and graphing tutorials help students overcome deficiencies in these
crucial areas.

PowerPoint Slides
The fifteenth edition also includes PowerPoint slides created by Syed H. Jafri of Tarleton
State University. These slides can be easily downloaded from the Carbaugh Website
available for instructors-only at http://login.cengage.com. Slides may be edited to meet
individual needs. They also serve as a study tool for students.

Instructor’s Manual
To assist instructors in the teaching of international economics, there is an Instructor’s
Manual with Test Bank that accompanies the fifteenth edition. The manual contains:
(1) brief answers to end-of-chapter study questions; (2) multiple choice; and (3) true–
false questions for each chapter. The Instructor’s Manual with Test Bank is available for
download for qualified instructors from the Carbaugh Website for instructors-only at
www.cengagebrain.com.

Study Guide
To accompany the fifteenth edition of the International Economics, Jim Hanson (Profes-
sor Emeritus at Willlamette University) has prepared an online Study Guide for students.
This guide reinforces key concepts by providing a review of the text’s main topics and
offering practice problems, true–false, multiple choice and short–answer questions. The

Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Preface xix

Study Guide is only available online and students can purchase it at www.cengagebrain.
com. Instructors can view the online Study Guide through http://login.cengage.com.
Compose
Compose is the home of Cengage Learning’s online digital content. Compose provides
the fastest, easiest way for you to create your own learning materials. South–Western’s
Economic Issues and Activities content database includes a wide variety of high-
interest, current event/policy applications as well as classroom activities designed specifi-
cally to enhance economics courses. Choose just one reading or many—even add your
own material—to create an accompaniment to the textbook that is perfectly customized
to your course. Contact your South–Western/Cengage Learning sales representative for
more information.

ACKNOWLEDGMENTS

I am pleased to acknowledge those who aided me in preparing the current and past edi-
tions of this textbook. Helpful suggestions and often detailed reviews were provided by:

Sofyan Azaizeh, University of New Haven
J. Bang, St. Ambrose University
Burton Abrams, University of Delaware
Abdullah Khan, Kennesaw State University
Richard Adkisson, New Mexico State University
Richard Anderson, Texas A&M
Brad Andrew, Juniata College
Richard Ault, Auburn University
Mohsen Bahmani-Oskooee, University of Wisconsin—Milwaukee
Kevin Balsam, Hunter College
Kelvin Bentley, Baker College Online
Robert Blecker, Stanford University
Scott Brunger, Maryville College
Jeff W. Bruns, Bacone College
Roman Cech, Longwood University
John Charalambakis, Asbury College
Mitch Charkiewicz, Central Connecticut State University
Xiujian Chen, California State University, Fullerton
Miao Chi, University of Wisconsin—Milwaukee
Howard Cochran, Jr., Belmont University
Charles Chittle, Bowling Green University
Christopher Cornell, Fordham University
Elanor Craig, University of Delaware
Manjira Datta, Arizona State University
Ann Davis, Marist College
Earl Davis, Nicholls State University
Juan De La Cruz, Fashion Institute of Technology
Firat Demir, University of Oklahoma
Gopal Dorai, William Paterson College
Veda Doss, Wingate University
Seymour Douglas, Emory University
Carolyn Fabian Stumph, Indiana University—Purdue University Fort Wayne

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xx Preface

Farideh Farazmand, Lynn University
Daniel Falkowski, Canisius College
Patrice Franko, Colby College
Emanuel Frenkel, University of California—Davis
Norman Gharrity, Ohio Wesleyan University
Sucharita Ghosh, University of Akron
Jean-Ellen Giblin, Fashion Institute of Technology (SUNY)
Leka Gjolaj, Baker College
Thomas Grennes, North Carolina State University
Darrin Gulla, University of Kentucky
Li Guoqiang, University of Macau (China)
William Hallagan, Washington State University
Jim Hanson, Willamette University
Bassam Harik, Western Michigan University
Clifford Harris, Northwood University
John Harter, Eastern Kentucky University
Seid Hassan, Murray State University
Phyllis Herdendorf, Empire State College (SUNY)
Pershing Hill, University of Alaska—Anchorage
David Hudgins, University of Oklahoma
Ralph Husby, University of Illinois—Urbana/Champaign
Robert Jerome, James Madison University
Mohamad Khalil, Fairmont State College
Wahhab Khandker, University of Wisconsin—La Crosse
Robin Klay, Hope College
William Kleiner, Western Illinois University
Anthony Koo, Michigan State University
Faik Koray, Louisiana State University
Peter Karl Kresl, Bucknell University
Fyodor Kushnirsky, Temple University
Daniel Lee, Shippensburg University
Edhut Lehrer, Northwestern University
Jim Levinsohn, University of Michigan
Martin Lozano, University of Manchester, UK
Benjamin Liebman, St. Joseph’s University
Susan Linz, Michigan State University
Andy Liu, Youngstown State University
Alyson Ma, University of San Diego
Mike Marks, Georgia College School of Business
Michael McCully, High Point University
Neil Meredith, West Texas A&M University
John Muth, Regis University
Al Maury, Texas A&I University
Tony Mutsune, Iowa Wesleyan College
Jose Mendez, Arizona State University
Roger Morefield, University of St. Thomas
Mary Norris, Southern Illinois University
John Olienyk, Colorado State University
Shawn Osell, Minnesota State University—Mankato
Terutomo Ozawa, Colorado State University
Peter Petrick, University of Texas at Dallas

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Preface xxi

Gary Pickersgill, California State University, Fullerton
William Phillips, University of South Carolina
John Polimeni, Albany College of Pharmacy and Health Sciences
Rahim Quazi, Prairie View A&M University
Chuck Rambeck, St. John’s University
Elizabeth Rankin, Centenary College of Louisiana
Teresita Ramirez, College of Mount Saint Vincent
Surekha Rao, Indiana University Northwest
James Richard, Regis University
Suryadipta Roy, High Point University
Daniel Ryan, Temple University
Manabu Saeki, Jacksonville State University
Nindy Sandhu, California State University, Fullerton
Jeff Sarbaum, University of North Carolina, Greensboro
Anthony Scaperlanda, Northern Illinois University
Juha Seppälä, University of Illinois
Ben Slay, Middlebury College (now at PlanEcon)
Gordon Smith, Anderson University
Sylwia Starnawska, Empire State College (SUNY)
Steve Steib, University of Tulsa
Robert Stern, University of Michigan
Paul Stock, University of Mary Hardin—Baylor
Laurie Strangman, University of Wisconsin—La Crosse
Hamid Tabesh, University of Wisconsin–River Falls
Manjuri Talukdar, Northern Illinois University
Nalitra Thaiprasert, Ball State University
William Urban, University of South Florida
Jorge Vidal, The University of Texas Pan American
Adis M. Vila, Esq., Winter Park Institute Rollins College
Grace Wang, Marquette University
Jonathan Warshay, Baker College
Darwin Wassink, University of Wisconsin—Eau Claire
Peter Wilamoski, Seattle University
Harold Williams, Kent State University
Chong Xiang, Purdue University
Elisa Quennan, Taft College
Afia Yamoah, Hope College
Hamid Zangeneh, Widener University
I would like to thank my colleagues at Central Washington University—Tim Dittmer,
David Hedrick, Koushik Ghosh, Roy Savoian, Peter Saunders, Toni Sipic, and Chad
Wassell—for their advice and help while I was preparing the manuscript. I am also
indebted to Shirley Hood who provided advice in the manuscript’s preparation.
It has been a pleasure to work with the staff of Cengage Learning, especially Steven
Scoble, who provided many valuable suggestions and assistance in seeing this edition to
its completion. Thanks also to Jeffrey Hahn who orchestrated the development of this
book in conjunction with Tintu Thomas, project manager at Integra Software Services.
I also appreciate the meticulous efforts that Hyde Park Publishing Services did in the
copyediting of this textbook. Finally, I am grateful to my students, as well as faculty
and students at other universities, who provided helpful comments on the material con-
tained in this new edition.

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xxii Preface

I would appreciate any comments, corrections, or suggestions that faculty or students
wish to make so I can continue to improve this text in the years ahead. Please contact
me! Thank you for permitting this text to evolve to the fifteenth edition.
Bob Carbaugh
Department of Economics
Central Washington University
Ellensburg, Washington 98926
Phone: (509) 963-3443
Fax: (509) 963-1992
E-mail: [email protected]

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The International 1C H A P T E R
Economy and
Globalization

In today’s world, no nation exists in economic isolation. All aspects of a nation’s
economy—its industries, service sectors, levels of income and employment, and living
standard—are linked to the economies of its trading partners. This linkage takes the
form of international movements of goods and services, labor, business enterprise,
investment funds, and technology. Indeed, national economic policies cannot be
formulated without evaluating their probable impacts on the economies of other
countries.

The high degree of economic interdependence among today’s economies reflects the
historical evolution of the world’s economic and political order. At the end of World War II,
the United States was economically and politically the most powerful nation in the
world, a situation expressed in the saying, “When the United States sneezes, the
economies of other nations catch a cold.” But with the passage of time, the U.S.
economy has become increasingly integrated into the economic activities of foreign
countries. The formation in the 1950s of the European Community (now known as the
European Union), the rising importance in the 1960s of multinational corporations, the
market power in the 1970s enjoyed by the Organization of Petroleum Exporting
Countries (OPEC), the creation of the euro at the turn of the twenty-first century, and
the rise of China as an economic power in the early 2000s have all resulted in the
evolution of the world community into a complicated system based on a growing
interdependence among nations.

The global recession of 2007–2009 provides an example of economic interdependence.
The immediate cause of the recession was a collapse of the U.S. housing market and the
resulting surge in mortgage loan defaults. Hundreds of billions of dollars in losses on these
mortgages undermined the financial institutions that originated and invested in them.
Credit markets froze, banks would not lend to each other, and businesses and households
could not get loans needed to finance day-to-day operations. This shoved the economy
into recession. Soon the crisis spread to Europe. European banks were drawn into the
financial crisis in part because of their exposure to defaulted mortgages in the United
States. As these banks had to write off losses, fear and uncertainty spread regarding
whether banks had enough capital to pay off their debt obligations. The financial crisis
also spread to emerging economies such as Iceland and Russia that generally lacked the

1

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2 Chapter 1: The International Economy and Globalization

resources to restore confidence in their economic systems. It is no wonder that “when the
United States sneezed, other economies caught a cold.”

Recognizing that world economic interdependence is complex and its effects uneven,
the economic community has taken steps toward international cooperation. Conferences
devoted to global economic issues have explored the avenues that cooperation could be
fostered between industrial and developing nations. The efforts of developing nations to
reap larger gains from international trade and to participate more fully in international
institutions have been hastened by the impact of the global recession, industrial inflation,
and the burdens of high priced energy.

Over the past 50 years, the world’s market economies have become increasingly
interdependent. Exports and imports as a share of national output have risen for most
industrial nations, while foreign investment and international lending have expanded. This
closer linkage of economies can be mutually advantageous for trading nations. This link
permits producers in each nation to take advantage of the specialization and efficiencies of
large scale production. A nation can consume a wider variety of products at a cost less than
what could be achieved in the absence of trade. Despite these advantages, demands have
grown for protection against imports. Protectionist pressures have been strongest during
periods of rising unemployment caused by economic recession. Moreover, developing
nations often maintain that the so called liberalized trading system called for by industrial
nations serves to keep the developing nations in poverty.

Economic interdependence also has direct consequences for a student taking an
introductory course in international economics. As consumers, we can be affected by
changes in the international values of currencies. Should the Japanese yen or British
pound appreciate against the U.S. dollar, it would cost us more to purchase Japanese
television sets or British automobiles. As investors, we might prefer to purchase Swiss
securities if Swiss interest rates rise above U.S. levels. As members of the labor force, we
might want to know whether the president plans to protect U.S. steelworkers and
autoworkers from foreign competition.

In short, economic interdependence has become a complex issue in recent times, often
resulting in strong and uneven impacts among nations and among sectors within a given
nation. Business, labor, investors, and consumers all feel the repercussions of changing
economic conditions and trade policies in other nations. Today’s global economy requires
cooperation on an international level to cope with the myriad issues and problems.

GLOBALIZATION OF ECONOMIC ACTIVITY

When listening to the news, we often hear about globalization. What does this term
mean? Globalization is the process of greater interdependence among countries and
their citizens. It consists of the increased interaction of product and resource markets
across nations via trade, immigration, and foreign investment—that is, via international
flows of goods and services, people, and investments in equipment, factories, stocks, and
bonds. It also includes noneconomic elements such as culture and the environment.
Simply put, globalization is political, technological, and cultural, as well as economic.

In terms of people’s daily lives, globalization means that the residents of one country
are more likely now than they were 50 years ago to consume the products of another
country, invest in another country, earn income from other countries, talk by telephone
to people in other countries, visit other countries, know that they are being affected by
economic developments in other countries, and know about developments in other
countries.

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Chapter 1: The International Economy and Globalization 3

What forces are driving globalization?1 The first and perhaps most profound influ-
ence is technological change. Since the industrial revolution of the late 1700s, technical
innovations have led to an explosion in productivity and slashed transportation costs.
The steam engine preceded the arrival of railways and the mechanization of a growing
number of activities hitherto reliant on muscle power. Later discoveries and inventions
such as electricity, telephone, automobile, container ships, and pipelines altered production,
communication, and transportation in ways unimagined by earlier generations. More
recently, rapid developments in computer information and communications technology
have further shrunk the influence of time and geography on the capacity of individuals and
enterprises to interact and transact around the world. For services, the rise of the Internet
has been a major factor in falling communication costs and increased trade. As technical
progress has extended the scope of what can be produced and where it can be produced,
and advances in transport technology have continued to bring people and enterprises closer
together, the boundary of tradable goods and services has been greatly extended.

Also, continuing liberalization of trade and investment has resulted from multilateral
trade negotiations. For example, tariffs in industrial countries have come down from
high double digits in the 1940s to about 4 percent by 2014. At the same time, most quo-
tas on trade, except for those imposed for health, safety, or other public policy reasons,
have been removed. Globalization has also been promoted through the widespread liber-
alization of investment transactions and the development of international financial mar-
kets. These factors have facilitated international trade through the greater availability and
affordability of financing.

Lower trade barriers and financial liberalization have allowed more companies to glob-
alize production structures through investment abroad that in turn has provided a further
stimulus to trade. On the technology side, increased information flows and the greater
tradability of goods and services have profoundly influenced production location decisions.
Businesses are increasingly able to locate different components of their production pro-
cesses in various countries and regions and still maintain a single corporate identity. As
firms subcontract part of their production processes to their affiliates or other enterprises
abroad, they transfer jobs, technologies, capital, and skills around the globe.

How significant is production sharing in world trade? Researchers have estimated
production sharing levels by calculating the share of components and parts in world
trade. They have concluded that global production sharing accounts for about 30 percent
of the world trade in manufactured goods. Moreover, the trade in components and parts
is growing significantly faster than the trade in finished products, highlighting the
increasing interdependence of countries through production and trade.2

WAVES OF GLOBALIZATION

In the past two decades, there has been pronounced global economic interdependence.
Economic interdependence occurs through trade, labor migration, and capital (invest-
ment) flows such as corporation stocks and government securities. Let us consider the
major waves of globalization that have occurred in recent history.3

1World Trade Organization, Annual Report, 1998, pp. 33–36.
2A. Yeats, Just How Big Is Global Production Sharing? World Bank, Policy Research Working Paper No.
1871, 1998, Washington, DC.
3This section draws from World Bank, Globalization, Growth and Poverty: Building an Inclusive World
Economy, 2001.

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4 Chapter 1: The International Economy and Globalization

TRADE CONFLICTS FEDERAL RESERVE POLICY INCITES
GLOBAL BACKLASH

Economic interdependence is part of our They noted that printing more dollars, or cutting U.S. iStockphoto.com/photosoup
daily lives. When domestic economic interest tends to cause depreciation in the dollar’s
policies have spillover effects on the economies of exchange value, that will be explained in Chapter 11
other countries, policymakers must take these into of this text. If the value of the dollar decreases, other
account. This why major countries frequently meet to countries’ exports become more expensive for Ameri-
discuss the impacts of their policies on the world eco- can consumers, thus reducing the amount of goods the
nomy. Consider the effects of the Federal Reserve’s United States imports from the rest of the world. The
policies on other economies as discussed below. accompanying rise in the exchange value of other
For decades, the Federal Reserve (Fed) has countries’ currencies makes American goods cheaper
attempted to fulfill its mandate to promote full employ- for foreign consumers to purchase that should increase
ment, price stability, and economic growth for the U.S. the amount of exports leaving the United States. This
economy. Pursuing these objectives can impose would benefit U.S. producers who would likely
adverse spillover effects on economies of other increase hiring to meet the increased production
nations, as seen in the following example. requirements of the increased global demand for their
Facing a sluggish economy in 2010, the Fed enacted exports. What’s more, the rest of the world’s producers
a controversial decision to pursue economic growth by would see their exports fall, resulting in job losses for
purchasing $600 billion of U.S. Treasury bonds. The their workers. Producers in the United States would
idea was to pump additional money into the economy gain at the expense of producers abroad.
that would cause long-term interest rates to fall. This
would encourage Americans to spend more on invest- However, Federal Reserve officials challenged this
ment and big ticket consumption items, thus stimulat- argument by stating that the purpose of their program
ing the economy. However, critics doubted that the was not to push down the dollar in order to disadvantage
program would work and maintained that it might America’s trading partners. Instead, it was an attempt to
cause an increase in inflationary expectations that grow the economy that is not just good for the United
could destabilize the economy. States, but for the world as a whole. A depreciation of
Also, the Fed’s program was criticized by U.S. trad- the dollar was only a side effect of a growth oriented
ing partners such as Germany and Brazil, as an attempt policy, not the purpose of the policy. This argument did
to improve American competitiveness at their expense. not dampen the fears of foreigners regarding the Fed’s
monetary policy, and their criticism continued.

First Wave of Globalization: 1870–1914
The first wave of global interdependence occurred from 1870 to 1914. The interdepen-
dence was sparked by decreases in tariff barriers and new technologies that resulted in
declining transportation costs, such as the shift from sail to steamships and the advent
of railways. The main agent that drove the process of globalization was how much mus-
cle, horsepower, wind power, or later on, steam power a country had and how creatively
it could deploy that power. This wave of globalization was largely driven by European
and American businesses and individuals. Therefore, exports as a share of world
income nearly doubled to about 8 percent while per capita incomes, which had risen by
0.5 percent per year in the previous 50 years, rose by an annual average of 1.3 percent.
The countries that actively participated in globalization, such as the United States,
became the richest countries in the world.

However, the first wave of globalization was brought to an end by World War I. Also,
during the Great Depression of the 1930s, governments responded by practicing protec-
tionism: a futile attempt to enact tariffs on imports to shift demand into their domestic
markets, thus promoting sales for domestic companies and jobs for domestic workers.

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Chapter 1: The International Economy and Globalization 5

For the world economy, increasing protectionism caused exports as a share of national
income to fall to about 5 percent, thereby undoing 80 years of technological progress in
transportation.

Second Wave of Globalization: 1945–1980
The horrors of the retreat into nationalism provided renewed incentive for international-
ism following World War II. The result was a second wave of globalization that took
place from 1945 to 1980. Falling transportation costs continued to foster increased
trade. Nations persuaded governments to cooperate to decrease previously established
trade barriers.

However, trade liberalization discriminated both in terms of which countries partici-
pated and which products were included. By 1980, trade between developed countries in
manufactured goods had been largely freed of barriers. Barriers facing developing coun-
tries had been eliminated for only those agricultural products that did not compete with
agriculture in developed countries. For manufactured goods, developing countries faced
sizable barriers. For developed countries, the slashing of trade barriers between them
greatly increased the exchange of manufactured goods, thus helping to raise the incomes
of developed countries relative to the rest.

The second wave of globalization introduced a new kind of trade: rich country
specialization in manufacturing niches that gained productivity through agglomeration
economies. Increasingly, firms clustered together, some clusters produced the same
product and others were connected by vertical linkages. Japanese auto companies, for
example, became famous for insisting that their parts manufacturers locate within a
short distance of the main assembly plant. For companies such as Toyota and Honda,
this decision decreased the costs of transport, coordination, monitoring, and contracting.
Although agglomeration economies benefit those in the clusters, they are bad news for
those who are left out. A region can be uncompetitive simply because not enough firms
have chosen to locate there. Thus, a divided world can emerge, in which a network of
manufacturing firms is clustered in some high wage region, while wages in the remaining
regions stay low. Firms will not shift to a new location until the discrepancy in produc-
tion costs becomes sufficiently large to compensate for the loss of agglomeration
economies.

During the second wave of globalization, most developing countries did not partici-
pate in the growth of global trade in manufacturing and services. The combination of
continuing trade barriers in developed countries and unfavorable investment climates
and antitrade policies in developing countries confined them to dependence on agricul-
tural and natural resource products.

Although the second globalization wave succeeded in increasing per capita incomes
within the developed countries, developing countries as a group were being left behind.
World inequality fueled the developing countries’ distrust of the existing international
trading system that seemed to favor developed countries. Therefore, developing countries
became increasingly vocal in their desire to be granted better access to developed country
markets for manufactured goods and services, thus fostering additional jobs and rising
incomes for their people.

Latest Wave of Globalization
The latest wave of globalization that began in about 1980 is distinctive. First, a large
number of developing countries, such as China, India, and Brazil, broke into the world
markets for manufacturers. Second, other developing countries became increasingly
marginalized in the world economy and realized decreasing incomes and increasing

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6 Chapter 1: The International Economy and Globalization

poverty. Third, international capital movements, which were modest during the second
wave of globalization, again became significant.

Of major significance for this wave of globalization is that some developing countries
succeeded for the first time in harnessing their labor abundance to provide them with a
competitive advantage in labor intensive manufacturing. Examples of developing coun-
tries that have shifted into manufacturing trade include Bangladesh, Malaysia, Turkey,
Mexico, Hungary, Indonesia, Sri Lanka, Thailand, and the Philippines. This shift is partly
because of tariff cuts that developed countries have made on imports of manufactured
goods. Also, many developing countries liberalized barriers to foreign investment that
encouraged firms such as Ford Motor Company to locate assembly plants within their
borders. Moreover, technological progress in transportation and communications
permitted developing countries to participate in international production networks.
However, the dramatic increase in manufactured exports from developing countries has
contributed to protectionist policies in developed countries. With so many developing
countries emerging as important trading countries, reaching further agreements on
multilateral trade liberalization has become more complicated.

Although the world has become more globalized in terms of international trade and
capital flows compared to 100 years ago, there is less globalization in the world when it
comes to labor flows. The United States had a very liberal immigration policy in the late
1800s and early 1900s and large numbers of people flowed into the country, primarily
from Europe. As a large country with abundant room to absorb newcomers, the United
States also attracted foreign investment throughout much of this period, which meant
that high levels of migration went hand in hand with high and rising wages. However,
since World War I, immigration has been a disputed topic in the United States, and
restrictions on immigration have tightened. In contrast to the largely European immigra-
tion in the 1870–1914 globalization waves, contemporary immigration into the United
States comes largely from Asia and Latin America.

Another aspect of the most recent wave of globalization is foreign outsourcing, when
certain aspects of a product’s manufacture are performed in more than one country. As
travel and communication became easier in the 1970s and 1980s, manufacturing increas-
ingly moved to wherever costs were the lowest. U.S. companies shifted the assembly of
autos and the production of shoes, electronics, and toys to low wage developing coun-
tries. This shift resulted in job losses for blue collar workers producing these goods and
cries for the passage of laws to restrict outsourcing.

When an American customer places an order online for a Hewlett-Packard (HP)
laptop, the order is transmitted to Quanta Computer Inc. in Taiwan. To reduce labor
costs, the company farms out production to workers in Shanghai, China. They combine
parts from all over the world to assemble the laptop that is flown as freight to the United
States, and then sent to the customer. About 95 percent of the HP laptop is outsourced
to other countries. The outsourcing ratio is close to 100 percent for other U.S. computer
producers including Dell, Apple, and Gateway. Table 1.1 shows how the HP laptop is put
together by workers in many different countries.

By the 2000s, the Information Age resulted in the foreign outsourcing of white collar
work. Today, many companies’ locations hardly matter. Work is connected through
digitization, the Internet, and high speed data networks around the world. Companies
can now send office work anywhere, and that means places like India, Ireland, and the
Philippines where workers are paid much less than American workers. A new round of
globalization is sending upscale jobs offshore, including accounting, chip design,
engineering, basic research, and financial analysis as shown in Table 1.2. Analysts estimate
that foreign outsourcing can allow companies to reduce costs of a given service from 30 to
50 percent.

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Chapter 1: The International Economy and Globalization 7

TABLE 1.1

Manufacturing an HP Pavilion, ZD8000 Laptop Computer

Component Major Manufacturing Country
Hard disk drives Singapore, China, Japan, United States
Power supplies China

Magnesium casings China

Memory chips Germany, Taiwan, South Korea, Taiwan, United States

Liquid-crystal display Japan, Taiwan, South Korea, China

Microprocessors United States

Graphics processors Designed in United States and Canada; produced in Taiwan

Source: From “The Laptop Trail,” The Wall Street Journal, June 9, 2005, pp.B1 and B8.

TABLE 1.2

Globalization Goes White Collar

U.S. Company Country Type of Work Moving
Accenture Philippines Accounting, software, office work
Insurance claim processing
Conseco India Airline reservations, customer service
Architectural blueprints
Delta Air Lines India, Philippines Finance, information technology
Chip design, tech support
Fluor Philippines Software design
Consumer electronics, R&D
General Electric India Accounting, tech support

Intel India

Microsoft China, India

Philips China

Procter & Gamble Philippines, China

Source: From “Is Your Job Next?” Business Week, February 3, 2003, pp. 50–60.

Boeing uses aeronautics specialists in Russia to design luggage bins and wing
parts for its jetliners. Having a master’s degree or doctorate in math or aeronautics,
these specialists are paid $700 per month in contrast to a monthly salary of $7,000
for an American counterpart. Similarly, engineers in China and India, earning
$1,100 a month, develop chips for Texas Instruments and Intel; their American
counterparts are paid $8,000 a month. However, companies are likely to keep
crucial research and development and the bulk of office operations close to home.
Many jobs cannot go anywhere because they require face-to-face contact with
customers. Economists note that the vast majority of jobs in the United States
consist of services such as retail, restaurants and hotels, personal care services, and
the like. These services are necessarily produced and consumed locally, and cannot
be sent offshore.

Besides saving money, foreign outsourcing can enable companies to do things they
simply couldn’t do before. A consumer products company in the United States found it
impractical to chase down tardy customers buying less than $1,000 worth of goods.
When this service was run in India, however, the cost dropped so much the company
could profitably follow up on bills as low as $100.

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8 Chapter 1: The International Economy and Globalization
Although the Internet makes it easier for U.S. companies to remain competitive

in an increasingly brutal global marketplace, is foreign outsourcing good for
white collar workers? A case can be made that Americans benefit from this
process. In the last two decades, U.S. companies have imported hundreds of thou-
sands of immigrants to ease engineering shortages. Now, by sending routine service
and engineering tasks to nations with a surplus of educated workers, U.S. labor and
capital can be shifted to higher value industries and cutting-edge research and
development.

However, a question remains: What happens if displaced white collar workers
cannot find greener pastures? The truth is that the rise of the global knowledge
industry is so recent that most economists have not begun to figure out the implica-
tions. People in developing nations like India see foreign outsourcing as a bonus because it
helps spread wealth from rich nations to poor nations. Among its many other virtues, the
Internet might turn out to be a great equalizer. Outsourcing will be discussed at the end of
Chapter 2.

TRADE CONFLICTS DIESEL ENGINES AND GAS TURBINES AS
MOVERS OF GLOBALIZATION

When you consider internal combus- The natural gas-fired turbine is another driver of iStockphoto.com/photosoup
tion engines, you probably think about globalization. A gas turbine is a rotary engine that
the one under the hood of your car or truck—the extracts energy from a flow of combustion gas.
gasoline powered engine. Although this engine is This energy produces a power thrust that sends an
good for moving you around, it is not adequate for airplane into the sky. It also turns a shaft or a pro-
moving large quantities of goods and people long peller that moves locomotives and ships. The gas
distances; global transportation requires more mas- turbine was invented by Frank Whittle, a British
sive engines. engineer, in the early 1900s. Although Wilbur and
What makes it possible for us to transport billions of Orville Wright are the first fathers of flight, Whittle’s
tons of raw materials and manufactured goods from influence on global air travel should not be
country to country? Why are we able to fly almost any- underestimated.
where in the world in a Boeing or Airbus jetliner within
twenty-four hours? Two notable technical innovations These two engines, diesels and turbines, have
that have driven globalization are diesel engines, which become important movers of goods and people
power cargo ships, locomotives, and large trucks, and throughout the world. They have reduced transporta-
natural gas-fired turbines that power planes and other tion costs to such an extent that distance to the mar-
means of transportation. ket is a much smaller factor affecting the location of
The diesel engine was first developed to the point manufacturers or the selection of the origin of
of commercial success by Rudolf Diesel in the 1890s. imported raw materials. Indeed, neither international
After graduating from Munich Polytechnic in Germany, trade nor intercontinental flights would have realized
Diesel became a refrigerator engineer, but his true such levels of speed, reliability, and affordability as
love lay in engine design. He developed an engine have been achieved because of diesel engines and
that converted the chemical energy available in die- gas turbines. Although diesels and turbines have
sel fuel into mechanical energy that could power caused environmental problems, such as air and
trucks, cargo ships, and so on. Today, more than 90 water pollution, these machines will likely not disap-
percent of global trade in manufactured goods and pear soon.
raw materials is transported with the use of diesel
engines. Source: Vaclav Smil, Prime Movers of Globalization, MIT Press,
Cambridge, Massachusetts, 2010 and Nick Schulz, “Engines of
Commerce,” The Wall Street Journal, December 1, 2010.

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Chapter 1: The International Economy and Globalization 9

THE UNITED STATES AS AN OPEN ECONOMY

It is generally agreed that the U.S. economy has become increasingly integrated into the
world economy (become an open economy) in recent decades. Such integration involves a
number of dimensions that include the trade of goods and services, financial markets, the
labor force, ownership of production facilities, and the dependence on imported materials.

Trade Patterns
To appreciate the globalization of the U.S. economy, go to a local supermarket. Almost any
supermarket doubles as an international food bazaar. Alongside potatoes from Idaho and
beef from Texas, stores display melons from Mexico, olive oil from Italy, coffee from Colom-
bia, cinnamon from Sri Lanka, wine and cheese from France, and bananas from Costa Rica.
Table 1.3 shows a global fruit basket that is available for American consumers.

The grocery store isn’t the only place Americans indulge their taste for foreign made
products. We buy cameras and cars from Japan, shirts from Bangladesh, DVD players
from South Korea, paper products from Canada, and fresh flowers from Ecuador. We
get oil from Kuwait, steel from China, computer programs from India, and semiconduc-
tors from Taiwan. Most Americans are well aware of our desire to import, but they may
not realize that the United States ranks as the world’s greatest exporter by selling
personal computers, bulldozers, jetliners, financial services, movies, and thousands of
other products to just about all parts of the globe. International trade and investment
are facts of everyday life.

As a rough measure of the importance of international trade in a nation’s economy,
we can look at that nation’s exports and imports as a percentage of its gross domestic
product (GDP). This ratio is known as openness.

Openness Exports Imports
GDP

Table 1.4 shows measures of openness for selected nations as of 2013. In that year, the
United States exported 14 percent of its GDP while imports were 18 percent of GDP; the

TABLE 1.3

The Fruits of Free Trade: A Global Fruit Basket

On a trip to the grocery store, consumers can find goods from all over the globe.

Fruit Country Fruit Country
Apples New Zealand Limes El Salvador

Apricots China Oranges Australia

Bananas Ecuador Pears South Korea
Blackberries Canada Pineapples Costa Rica
Blueberries Chile Plums Guatemala
Coconuts Philippines Raspberries Mexico
Grapefruit Bahamas Strawberries Poland
Grapes Peru Tangerines South Africa
Kiwifruit Italy Watermelons Honduras

Lemons Argentina

Source: From “The Fruits of Free Trade,” Annual Report, Federal Reserve Bank of Dallas, 2002, p. 3.

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10 Chapter 1: The International Economy and Globalization

TABLE 1.4

Exports and Imports of Goods and Services as a Percentage of Gross
Domestic Product GDP), 2013

Country Exports as a Imports as a Exports Plus Imports
Netherlands Percentage of GDP Percentage of GDP as a Percentage of GDP
South Korea
Germany 87 79 166
Norway
56 54 110

52 46 98

41 27 68

United Kingdom 32 34 66

Canada 30 32 62

France 27 30 57

United States 14 18 32

Japan 15 16 31

Source: From The World Bank Group, Country Profiles, 2014, available at http://www.worldbank.org.

openness of the U.S. economy to trade equaled 32 percent. Although the U.S. economy is
significantly tied to international trade, this tendency is even more striking for many
smaller nations, as shown in the table. Large countries tend to be less reliant on interna-
tional trade because many of their companies can attain an optimal production size
without having to export to foreign nations. Therefore, small countries tend to have
higher measures of openness than do large ones.

Figure 1.1 shows the openness of the U.S. economy from 1890 to 2013. One signifi-
cant trend is that the United States became less open to international trade between 1890
and 1950. Openness was relatively high in the late 1800s because of the rise in world
trade resulting from technological improvements in transportation (steamships) and
communications (trans-Atlantic telegraph cable). However, two world wars and the
Great Depression of the 1930s caused the United States to reduce its dependence on
trade, partly for national security reasons and partly to protect its home industries from
import competition. Following World War II, the United States and other countries
negotiated reductions in trade barriers that contributed to rising world trade.
Technological improvements in shipping and communications also bolstered trade
and the increasing openness of the U.S. economy.

The relative importance of international trade for the United States has significantly
increased during the past century, as shown in Figure 1.1. But a fact is hidden by these
data. In 1890, most U.S. trade was in raw materials and agricultural products, today,
manufactured goods and services dominate U.S. trade flows. Therefore, American producers
of manufactured products are more affected by foreign competition than they were a
hundred years ago.

The significance of international trade for the U.S. economy is even more noticeable
when specific products are considered. We would have fewer personal computers without
imported components, no aluminum if we did not import bauxite, no tin cans without
imported tin, and no chrome bumpers if we did not import chromium. Students taking a
9 a.m. course in international economics might sleep through the class (do you really believe
this?) if we did not import coffee or tea. Moreover, many of the products we buy from
foreigners would be more costly if we were dependent on our domestic production.

With which nations does the United States conduct trade? Canada, China, Mexico,
and Japan head the list, as shown in Table 1.5.

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Chapter 1: The International Economy and Globalization 11

FIGURE 1.1
Openness of the U.S. Economy, 1890–2013

32

Exports + Imports of Goods and 30
Services as a Percent of GDP
25

20

15

10

5

0 1910 1930 1950 1970 1990 2010 2013
1890

The figure shows that for the United States the importance of international trade has significantly increased
from 1890 to 2013.

Source: Data from U.S. Census Bureau, Foreign Trade Division, U.S. Trade in Goods and Services, at http://www.census.gov/foreign-trade/
statistics and Economic Report of the President, various issues.

TABLE 1.5

Top Ten Countries with Whom the U.S. Trades, 2012

Country Value of U.S. Value of U.S. Total Value of Trade
Canada Exports of Goods Imports of Goods (in billions of dollars)
(in billions of dollars) (in billions of dollars)
616.4
292.5 323.9 536.1
493.5
China 110.5 425.6 216.4
157.5
Mexico 215.9 277.6 109.9
101.2
Japan 70.0 146.4
Germany 48.8 108.7 71.8
United Kingdom 54.9 75.9
South Korea 42.3 55.0 63.3
France 30.1 58.9
Brazil 43.8 41.7
Taiwan 24.4 32.1
38.9

Source: From U.S. Department of Commerce, U.S. Census Bureau, Foreign Trade: U.S. Trade in Goods By Country, 2013.

Labor and Capital
Besides the trade of goods and services, movements in factors of production are a
measure of economic interdependence. As nations become more interdependent, labor
and capital should move more freely across nations.

However, during the past 100 years, labor mobility has not risen for the United States.
In 1900, about 14 percent of the U.S. population was foreign born. But from the 1920s
to the 1960s, the United States sharply curtailed immigration. This curtailment resulted

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12 Chapter 1: The International Economy and Globalization

in the foreign born U.S. population declining to 6 percent of the total population. During
the 1960s, the United States liberalized restrictions and the flow of immigrants increased.
By 2014, about 12 percent of the U.S. population was foreign born while foreigners made
up about 14 percent of the labor force. People from Latin America accounted for about
half of this figure while Asians accounted for another quarter. These immigrants contrib-
uted to economic growth in the United States by taking jobs in labor scarce regions and
filling the types of jobs native workers often shun.

Although labor mobility has not risen for the United States in recent decades, the
country has become increasingly tied to the rest of the world through capital (invest-
ment) flows. Foreign ownership of U.S. financial assets has risen since the 1960s. During
the 1970s, OPEC recycled many of their oil dollars by making investments in U.S. finan-
cial markets. The 1980s also witnessed major flows of investment funds to the United
States as Japan and other nations, with dollars accumulated from trade surpluses with
the United States, acquired U.S. financial assets, businesses, and real estate. By the late
1980s, the United States was consuming more than it produced and became a net
borrower from the rest of the world to pay for the difference. Increasing concerns were
raised about the interest cost of this debt to the U.S. economy and the impact of this
debt burden on the living standards of future U.S. generations. This concern remains at
the writing of this book in 2014.

Globalization has also increased in international banking. The average daily volume
of trading (turnover) in today’s foreign exchange market (where currencies are bought
and sold) is estimated at about $4 trillion, compared to $205 billion in 1986. The global
trading day begins in Tokyo and Sydney and, in a virtually unbroken 24-hour cycle,
moves around the world through Singapore and Hong Kong to Europe and finally
across the United States before being picked up again in Japan and Australia. London
remains the largest center for foreign exchange trading, followed by the United States;
significant volumes of currencies are also traded in Asia, Germany, France, Scandinavia,
Canada, and elsewhere.

In commercial banking, U.S. banks have developed worldwide branch networks for
loans, payments, and foreign exchange trading. Foreign banks have also increased their
presence in the United States, reflecting the multinational population base of the United
States, the size and importance of U.S. markets, and the role of the U.S. dollar as an
international medium of exchange and reserve currency. Today, more than 250 foreign
banks operate in the United States; in particular, Japanese banks have been the dominant
group of foreign banks operating in the United States. Like commercial banks, securities
firms have also globalized their operations.

By the 1980s, U.S. government securities were traded on virtually a 24-hour basis.
Foreign investors purchased U.S. treasury bills, notes, and bonds, and many desired to
trade during their own working hours rather than those of the United States. Primary
dealers of U.S. government securities opened offices in such locations as Tokyo and
London. Stock markets became increasingly internationalized with companies listing
their stocks on different exchanges throughout the world. Financial futures markets also
spread throughout the world.

WHY IS GLOBALIZATION IMPORTANT?

Because of trade, individuals, firms, regions, and nations can specialize in the production
of things they do well and use the earnings from these activities to purchase from others
those items for which they are high-cost producers. Therefore, trading partners can

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Chapter 1: The International Economy and Globalization 13

produce a larger joint output and achieve a higher standard of living than would other-
wise be possible. Economists refer to this as the law of comparative advantage that will
be further discussed in Chapter 2.

According to the law of comparative advantage, the citizens of each nation can gain
by spending more of their time and resources doing those things where they have a rela-
tive advantage. If a good or service can be obtained more economically through trade, it
makes sense to trade for it instead of producing it domestically. It is a mistake to focus
on whether a good is going to be produced domestically or abroad. The central issue is
how the available resources can be used to obtain each good at the lowest possible cost.
When trading partners use more of their time and resources producing things they
do best, they are able to produce a larger joint output that provides the source for
mutual gain.

International trade also results in gains from the competitive process. Competition is
essential to both innovation and efficient production. International competition helps
keep domestic producers on their toes and provides them with a strong incentive to
improve the quality of their products. Also, international trade usually weakens monop-
olies. As countries open their markets, their monopoly producers face competition from
foreign firms.

With globalization and import competition, U.S. prices have decreased for many pro-
ducts like TV sets, toys, dishes, clothing, and so on. However, prices increased for many
products untouched by globalization, such as cable TV, hospital services, sports tickets,
rent, car repair and others. The gains from global markets are not restricted to goods
traded internationally. They extend to such non-traded goods as houses that contain
carpeting, wiring, and other inputs now facing greater international competition.

During the 1950s, General Motors (GM) was responsible for about 60 percent of all
passenger cars produced in the United States. Although GM officials praised the firm’s
immense size for providing economies of scale in individual plant operations, skeptics
were concerned about the monopoly power resulting from GM’s dominance of the auto
market. Some argued that GM should be divided into several independent companies to
inject more competition into the market. Today, stiff foreign competition has resulted in
GM’s current share of the market to stand at less than 24 percent.

Not only do open economies have more competition, but they also have more firm
turnover. Being exposed to competition around the globe can result in high-cost domes-
tic producers exiting the market. If these firms are less productive than the remaining
firms, then their exit represents productivity improvements for the industry. The
increase in exits is only part of the adjustment. The other part is new firms entering
the market unless there are significant barriers. With these new firms comes more labor
market churning as workers formerly employed by obsolete firms must now find jobs in
emerging ones. Inadequate education and training can make some workers unemploy-
able for emerging firms creating new jobs that we often cannot yet imagine. This is
probably the key reason why workers find globalization to be controversial. The higher
turnover of firms is an important source of the dynamic benefits of globalization. In
general, dying firms have falling productivity, and new firms tend to increase their
productivity over time.

Economists have generally found that economic growth rates have a close relation to
openness to trade, education, and communications infrastructure. Countries that open
their economies to international trade tend to benefit from new technologies and other
sources of economic growth. As Figure 1.2 shows, there appears to be some evidence of
an inverse relation between the level of trade barriers and the economic growth
of nations. Nations that maintain high barriers to trade tend to realize a low level of
economic growth.

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14 Chapter 1: The International Economy and Globalization

FIGURE 1.2
Tariff Barriers versus Economic Growth

24

Weighted Average Tariff Rate (%) 20 Central
African

16 Republic

12

8 Russia
China

4

0

–10 –5 0 5 10 15 20

Per-Capita Growth Rate (%) in GDP

The figure shows the weighted average tariff rate and per capita growth rate in
GDP for 23 nations in 2002. According to the figure, there is evidence of an inverse
relationship between the level of tariff barriers and the economic growth of nations.

Source: Data taken from The World Bank Group, World Development Indicators, available at http://www
.worldbank.org/data/.

International trade can also provide stability for producers, as seen in the case of
Invacare Corporation, an Ohio based manufacturer of wheelchairs and other health
care equipment. For the wheelchairs it sells in Germany, the electronic controllers come
from the firm’s New Zealand factories; the design is largely American; and the final
assembly is done in Germany with parts shipped from the United States, France, and
the United Kingdom. By purchasing parts and components worldwide, Invacare can
resist suppliers’ efforts to increase prices for aluminum, steel, rubber, and other materi-
als. By selling its products in 80 nations, Invacare can maintain a more stable workforce
in Ohio than if it was completely dependent on the U.S. market. If sales decline anytime
in the United States, Invacare has an ace up its sleeve—exports.

On the other hand, rapid growth in countries like China and India has helped to
increase the demand for commodities like crude oil, copper, and steel. Thus, American
consumers and companies pay higher prices for items like gasoline. Rising gasoline
prices, in turn, have spurred governmental and private sector initiatives to increase the
supply of gasoline substitutes like biodiesel or ethanol. Increased demand for these alter-
native forms of energy has helped to increase the price of soybeans and corn that are key
inputs in the production of chicken, pork, beef, and other foodstuffs.

Moreover, globalization can make the domestic economy vulnerable to disturbances
initiated overseas, as seen in the case of India. In response to India’s agricultural crisis,
some 1,200 Indian cotton farmers committed suicide during 2005–2007 to escape debts
to money lenders. The farmers borrowed money at exorbitant rates, so they could sink
wells and purchase expensive biotech cotton seeds. But the seeds proved inadequate for
small plots resulting in crop failures. Farmers suffered from the low world price of their
cotton crop that fell by more than a third from 1994 to 2007. Prices were low partly
because cotton was heavily subsidized by wealthy countries, mainly the United States.

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Chapter 1: The International Economy and Globalization 15

According to the World Bank, cotton prices would have risen about 13 percent if the
subsidies had been eliminated.

Although India’s government could impose a tariff on imported cotton to offset the
foreign subsidy, its textile manufacturers, who desired to keep production costs low,
welcomed cheap fibers. India’s cotton tariff was only 10 percent, much lower than its
tariffs on most other commodities.

The simple solution to the problem of India’s farmers would be to move them from
growing cotton to weaving it in factories. India’s restrictive labor laws discouraged indus-
trial employment and the lack of a safety net resulted in farmers clinging to their
marginal plots of land.

There is great irony in the plight of India’s cotton farmers. The British developed
India’s long-fiber cotton in the1800s to supply British cotton mills. As their inexpensive
cloth drove India’s weavers out of business, the weavers were forced to work the soil. By
the early 2000s, India’s textile makers were enjoying a revival but its farmers could not
leave the soil to work in factories.4

GLOBALIZATION AND COMPETITION

Although economists recognize that globalization and free trade can provide benefits to
many firms, workers, and consumers, they can inflict burdens on others. Consider the
cases of Eastman Kodak Company, the Schwinn Bicycle Company and Element
Electronics Inc.
Kodak Reinvents Itself under Chapter 11 Bankruptcy
Vladimir Lenin, a Russian politician, once said, “A capitalist will sell you the rope to
hang him.” That quote may contain an element of truth. Capitalists often invest in
the technology that ruins their business, as seen in the case of Eastman Kodak
Company.

Kodak is a multinational imaging and photographic equipment company headquar-
tered in Rochester, New York. Its history goes back to 1889 when it was founded by
George Eastman. During much of the 1900s, Kodak held a dominant position in the
photographic equipment market. In 1976 it had a 90 percent market share of film sales
and an 85 percent share of camera sales in the United States. Kodak’s slogan was “You
press the button and we do the rest.” However, Kodak’s near monopoly position resulted
in a culture of complacency for its management who resisted changing their strategy as
global competition and new technologies would emerge.

In the 1980s, Japanese competitor Fuji Photo Film Co. entered the U.S. market with
lower priced film and supplies. However, Kodak refused to believe that American consu-
mers would ever desert its popular brand. Kodak passed on the opportunity to become
the official film of the 1984 Los Angeles Olympics. Fuji won these sponsorship rights
that provided it a permanent foothold in the American market. Fuji opened up a film
manufacturing plant in the United States and its aggressive marketing and price cutting
began capturing market share from Kodak. By the mid-1990s, Fuji held a 17 percent
share of the U.S. market for photo film while Kodak’s market share plunged to 75 percent.
Meanwhile, Kodak made little headway in Japan, the second largest market for its photo
film and paper after the United States. Clearly, Kodak underestimated the competitiveness
of its Japanese rival.

4“Cotton Suicides: The Great Unraveling,” The Economist, January 20, 2007, p. 34.

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16 Chapter 1: The International Economy and Globalization

Another factor that contributed to Kodak’s decline was the development of digital
cameras and smart phones that operate as cameras. Strange as it may seem, Kodak
built one of the first digital cameras in 1975 but Kodak was slow in launching the
production of digital cameras. Because Kodak’s competitors did not have this technology
at that time, Kodak faced no pressure to change its strategy of selling cheap cameras to
customers who would buy lots of its expensive film. All of this changed in the 1990s with
the development of digital cameras by companies like Sony. With its lucrative film sales
dropping, Kodak launched the production of digital cameras. By 2005, Kodak ranked at
the top of the digital camera market in the United States. Despite high growth, Kodak
failed to anticipate how fast these digital cameras became commodities with low profit
margins, as more companies entered the market. Kodak’s digital camera sales were
quickly undercut by Asian competitors who could produce their cameras more cheaply.
Also, smart phones were developed to replace cameras. Kodak also failed to understand
emerging markets correctly. Kodak hoped the new Chinese middle class would purchase
lots of film. They did for a short while, but then decided that digital cameras were
preferable.

Kodak provides a striking example of an industrial giant that faltered in the face of
global competition and advancing technology. By 2012 Kodak was running short of
cash. As a result, Kodak filed for Chapter 11 bankruptcy under which it would undergo
reorganization under the supervision of a bankruptcy court judge. Following its filing,
Kodak sold off many of its businesses and patents while shutting down the camera unit
that first made it famous. Many of Kodak’s former employees lost retirement and health
care benefits as a result of the bankruptcy. In 2013, Kodak received court approval for its
plan to emerge from bankruptcy as a much smaller digital imaging company. It remains
to be seen how Kodak will perform in the years ahead.

Bicycle Imports Force Schwinn to Downshift
The Schwinn Bicycle Company illustrates the notion of globalization and how producers
react to foreign competitive pressure. Founded in Chicago in 1895, Schwinn grew to pro-
duce bicycles that became the standard of the industry. Although the Great Depression
drove most bicycle companies out of business, Schwinn survived by producing durable
and stylish bikes sold by dealerships that were run by people who understood bicycles
and were anxious to promote the brand. Schwinn emphasized continuous innovation
that resulted in features such as built-in kickstands, balloon tires, chrome fenders, head
and taillights, and more. By the 1960s, the Schwinn Sting Ray became the bicycle that
virtually every child wanted. Celebrities such as Captain Kangaroo and Ronald Reagan
pitched ads claiming that “Schwinn bikes are the best.”

Although Schwinn dominated the U.S. bicycle industry; the nature of the bicycle mar-
ket was changing. Cyclists wanted features other than heavy, durable bicycles that had
been the mainstay of Schwinn for decades. Competitors emerged such as Trek, which
built mountain bikes and Mongoose which produced bikes for BMX racing.

Falling tariffs on imported bicycles encouraged Americans to import from companies
in Japan, South Korea, Taiwan, and eventually China. These companies supplied Amer-
icans with everything ranging from parts and entire bicycles under U.S. brand names, or
their own brands. Using production techniques initially developed by Schwinn, foreign
companies hired low wage workers to manufacture competitive bicycles at a fraction of
Schwinn’s cost.

As foreign competition intensified, Schwinn moved production to a plant in Green-
ville, Mississippi in 1981. The location was strategic. Like other U.S. manufacturers,
Schwinn relocated production to the South in order to hire nonunion workers at lower

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Chapter 1: The International Economy and Globalization 17

wages. Schwinn also obtained parts produced by low wage workers in foreign countries.
The Greenville plant suffered from uneven quality and low efficiency and it produced
bicycles no better than the ones imported from the Far East. As losses mounted for
Schwinn, the firm declared bankruptcy in 1993.

Eventually Schwinn was purchased by the Pacific Cycle Company that farmed the
production of Schwinn bicycles out to low wage workers in China. Most Schwinn
bicycles today are built in Chinese factories and are sold by Walmart and other discount
merchants. Cyclists do pay less for a new Schwinn under Pacific’s ownership. It may
not be the industry standard that was the old Schwinn, but it sells at Walmart for
approximately $180, about a third of the original price in today’s dollars. Although
cyclists may lament that a Schwinn is no longer the bike it used to be, Pacific Cycle
officials note that it is not as expensive as in the past either.5
Element Electronics Survives by Moving TV Production to America
Few American industries have faltered as much as television manufacturing. During the
1950s–1960s, there were about 150 domestic producers and employment stood at about
100,000 workers. Imports began arriving, first from Japan and later from China, South
Korea, and other Asian countries. The introduction of flat panel televisions tipped the scales
further in favor of Asia, because their lighter weight and sleek styling made shipping costs
cheaper than the heavier and more bulky tube televisions that formerly dominated sales. By
the early 2000s, American television manufacturing was virtually nonexistent.

Costs in China have recently been going up as workers’ wages and other expenses,
such as transportation, have increased. Meanwhile, sluggish wage increases in the United
States and rapid productivity gains have reshaped many U.S. factories into more robust
competitors.

Once such competitor is Element Electronics Inc. headquartered in Eden Prairie,
Minnesota. In 2012, Element Electronics became the only company assembling televi-
sions in the United States. All of the parts of its televisions are imported. On an assembly
line located in Detroit, Michigan, the firm produces a variety of flat screen models that
are sold by Walmart, Target, and other retailers. Element Electronics made the decision
to manufacture products in America to shorten its supply chain and related lead times,
thus becoming more responsive to American consumers. This would allow the firm to
get the right products, at the right price, to the right place at the right time as well as
reduce waste and increase the quality of the consumer’s out-of-box experience.

Element Electronics’ locating a factory in Detroit provided advantages in terms of a
qualified labor pool and distribution efficiencies based on population across the United
States. Also, the firm said that by producing in Detroit rather than in Asia, it could avoid
a 5 percent tariff on imported televisions and the higher cost of shipping televisions to
American retailers. In 2013, the firm estimated that the average savings on tariffs was
$27 for a 46-inch television, enough to account for the higher cost workers of Detroit.
Moreover, the firm automated the assembly of its televisions to reduce the amount of
labor required to build a television.

Officials of Element Electronics said that locating production in the United States was an
emotional decision. Rather than being a contributor to jobs leaving America for other coun-
tries, they wanted to pioneer a resurgence of creating quality manufacturing jobs in the
United States. Element Electronics televisions are shipped in boxes painted with a colorful

5Judith Crown and Glenn Coleman, No Hands: The Rise and Fall of the Schwinn Bicycle Company, an
American Institution. (New York, Henry Holt and Co., 1996) and Jay Pridmore, Schwinn Bicycles.
(Osceola, WI: Motorbooks International, 2002). See also Griff Wittee, “A Rough Ride for Schwinn Bicy-
cle,” The Washington Post, December 3, 2004.

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18 Chapter 1: The International Economy and Globalization

red, white, and blue flag on the side to portray a “Made in America” image. The boxes also
display American workers assembling televisions at the Detroit factory.6

COMMON FALLACIES OF INTERNATIONAL TRADE

Although gains from international trade are apparent, misconceptions prevail.7 One
misconception is that trade results in a zero-sum game—if one trading partner benefits,
the other must suffer. It turns out that both partners can benefit from trade.

Consider the example of trade between Colombia and Canada. These countries can
produce more combined output when Canadians supply natural gas and Colombians
supply bananas. The larger output allows Colombians to benefit by using revenues from
their banana exports to buy Canadian natural gas. Canadians benefit by using revenues
from their natural gas exports to buy Colombian bananas. Therefore, the larger combined
production yields mutual benefits for both countries. According to the principle of com-
parative advantage, if countries specialize in what they are relatively best at producing,
they will import products that their trading partners are most efficient at producing, yield-
ing benefits for both countries.

Another misconception is that imports result in unemployment and burden the econ-
omy, while exports enhance economic growth and jobs for workers. The source of this
misconception is a failure to consider the connections between imports and exports.
American imports of German machinery will result in losses of sales, output, and jobs in
the U.S. machinery industry. However, as Germany’s machinery sales to the United States
increase, Germans will have more purchasing power to buy American computer software.
Output and employment will thus increase in the U.S. computer software industry. The
drag on the U.S. economy caused by rising imports of machinery tends to be offset by
the stimulus on the economy caused by rising exports of computer software.

People sometimes feel tariffs, quotas, and other import restrictions result in more jobs
for domestic workers. However, they fail to understand that a decrease in imports does
not take place in isolation. When we impose import barriers that reduce the ability of
foreigners to export to us, we are also reducing their ability to obtain the dollars required
to import from us. Trade restrictions that decrease the volume of imports will also
decrease exports. As a result, jobs promoted by import barriers tend to be offset by jobs
lost due to falling exports.

If tariffs and quotas were that beneficial, why don’t we use them to impede trade
throughout the United States? Consider the jobs that are lost when, for example,
Wisconsin purchases grapefruit from Florida, cotton from Alabama, tomatoes from
Texas, and grapes from California. All of these goods could be produced in Wisconsin,
although at a higher cost. Thus, Wisconsin residents find it less expensive to “import”
these products. Wisconsin benefits by using its resources to produce and “export” milk,
beer, electronics, and other products it can produce efficiently. Indeed, most people feel
that free trade throughout America is an important contributor of prosperity for each of
the states. The conclusions are the same for trade among nations. Free trade throughout
America fosters prosperity; so, too, does free trade among nations.

6Ashok Bindra, “Element Electronics Brings TV Manufacturing Back to the United States,” TMCNet,
January 11, 2012; “Element Electronics: USA Made TV is Bringing Jobs Back Home,” American Made
Insider, February 17, 2013; Timothy Aeppel, “Detroit’s Wages Take on China’s,” The Wall Street Jour-
nal, May 23, 2012; Matt Roush, “Element Electronics: America Matters,” CBS Detroit, January 11, 2012.
7This section is drawn from James Gwartney and James Carter, Twelve Myths of International Trade,
U.S. Senate, Joint Economic Committee, June 2000, pp. 4–11.

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Chapter 1: The International Economy and Globalization 19

TRADE CONFLICTS IS THE UNITED STATES LOSING ITS
INNOVATION EDGE?

The next time that you are at an elec- States, most of the value added in producing the Kindle iStockphoto.com/photosoup
tronics store, pick up an iPhone. Open wound up being captured by the Taiwanese.
the box and you will find that the device was designed
by Apple Inc. in California. Next look at the back of the Some economists maintain that the United States
iPhone and you will see that it was assembled in China. has been losing its innovation edge as American man-
In the past, the United States has seen numerous ufacturers locate abroad. They note that manufacturing
industries disappear from its shores and locate in is a key driver of research and development that gen-
other countries. Industries ranging from smart phones erates inventions that fuel economic growth. The
to wind turbines, from solar panel technology to highly United States cannot sustain the level of economic
advanced computer circuitry born in the United States, growth it needs without a strong manufacturing sector.
now exist elsewhere. Moreover, when abandoning an According to these economists, to promote a stronger
industry, the United States may also lose technologies manufacturing sector, the United States needs invest-
that would foster the development of future industries. ment friendly public policies.
Consider the case of the Amazon Kindle. In 2007 in a
Silicon Valley research facility, Amazon engineers and Other economists disagree. They contend that from
designers developed the Kindle electronic reader, a the perspective of America’s competitiveness, all of the
device that enables users to download and read news- key technologies and high-value added activities are
papers, magazines, textbooks, and other digital media still captured on American soil and that the United
on a portable computer screen. Amazon first released States leads the world in scientific and technological
the Kindle in November, 2007, for $399 and was sold development. They also note that trade and compara-
out in five and one half hours; the device remained tive advantage foster an evolution in a country’s indus-
out of stock for five months, until late April 2008. By tries over time. In the television market, the
2011, the Kindle sold for less than $140 as competition manufacturing of televisions initially began in the
from other manufacturers intensified. United States. As technologies became standardized,
To produce the electronic ink for the Kindle, television production moved offshore to countries
Amazon initially partnered with E-Ink Co., a U.S. with much lower wages and manufacturing costs and
based firm. Because E-Ink did not have the technology prices continued to fall, to the benefit of consumers.
to produce the computer screen for the Kindle, Amazon
had to look for another partner. The search initially The global economy is dynamic and the firms that
began in the United States, but it was not successful have survived have been the ones able to transform
since American firms lacked the expertise and capabil- their business models to match their competitors.
ity to produce the Kindle screen. Eventually, Amazon U.S. firms will continue to face strong competition as
turned to Prime View, a Taiwanese manufacturer, to pro- other countries master next generation production
duce the screen. Soon thereafter, Prime View purchased techniques and accrue expertise in innovation. In
E-Ink and moved its production operations from the Chapter 2, we will learn more about the outsourcing
United States to Taiwan. Even though the Kindle’s key of production and jobs to other countries.
innovation, its electronic ink was invented in the United
Source: Andrew Liveris, Make It In America: The Case for
Re-Inventing the Economy, John Wiley & Sons, Inc., Hoboken,
New Jersey, 2011 and James Hagerty, “U.S. Manufacturers Gain
Ground,” The Wall Street Journal, August 18, 2013.

DOES FREE TRADE APPLY TO CIGARETTES?

When President George W. Bush pressured South Korea in 2001 to stop imposing a
40 percent tariff on foreign cigarettes, administration officials said the case had nothing
to do with public health. Instead, it was a case against protecting the domestic industry

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20 Chapter 1: The International Economy and Globalization

from foreign competition. However, critics maintained that nothing is that simple with
tobacco. They recognized that free trade, as a rule, increases competition, lowers prices,
and makes better products available to consumers, leading to higher consumption.
Usually, that’s a good thing. However, with cigarettes, the result can be more smoking,
disease, and death.

Globally, about four million people die each year from lung cancer, emphysema, and
other smoking related diseases, making cigarettes the largest single cause of preventable
death. By 2030, the annual number of fatalities could hit 10 million according to the
World Health Organization. That has antismoking activists and even some economists
arguing that cigarettes are not normal goods but are, in fact, “bads” that require their
own set of regulations. They contend that the benefits of free trade do not apply to
cigarettes and that they should be treated as an exception to trade rules.

This view is finding favor with some governments, as well. In recent talks of the
World Health Organization, dealing with a global tobacco control treaty, a range of
nations expressed support for provisions to emphasize antismoking measures over free
trade rules. The United States opposed such measures. In fact, the United States, that
has sued tobacco companies for falsifying cigarettes’ health risks, has promoted freer
trade in cigarettes. President Bill Clinton demanded a sharp reduction in Chinese
tariffs, including those on tobacco, in return for U.S. support of China’s entry into
the World Trade Organization. Those moves, combined with free trade pacts that
have decreased tariffs and other barriers to trade, have helped stimulate the international
sales of cigarettes.

The United States, first under President Clinton and then President Bush, has only
challenged rules imposed to aid local cigarette makers, not nondiscriminatory measures
to protect public health. The United States opposed South Korea’s decision to impose a
40 percent tariff on imported cigarettes because it was discriminatory and aimed at pro-
tecting domestic producers and not at protecting the health and safety of the Korean
people, according to U.S. trade officials. However, antismoking activists maintain that
this is a false distinction and anything that makes cigarettes more widely available at a
lower price is harmful to public health. Cigarette makers oppose limiting trade in
tobacco. They maintain that there is no basis for creating new regulations that weaken
the principle of open trade protected by the World Trade Organization.

Current trade rules permit countries to enact measures to protect the health and
safety of their citizens as long as all goods are treated equally, tobacco companies
argue. A trade dispute panel notified Thailand that, although it could not prohibit
foreign cigarettes, it could ban advertisements for both domestic and foreign made
smokes. But tobacco control activists worry that the rules could be used to stop
governments from imposing antismoking measures. They contend that special pro-
ducts need special rules, pointing to hazardous chemicals and weapons as goods
already exempt from regular trade policies. Cigarettes kill more people every year
than AIDS. Anti-tobacco activists think it’s time for health concerns to be of primary
importance in the case of smoking, too.

IS INTERNATIONAL TRADE AN OPPORTUNITY
OR A THREAT TO WORKERS?

• Tom lives in Chippewa Falls, Wisconsin. His former job as a bookkeeper for a shoe
company that employed him for many years was insecure. Although he earned $100
a day, promises of promotion never panned out and the company eventually went
bankrupt because cheap imports from Mexico forced shoe prices down. Tom then

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Chapter 1: The International Economy and Globalization 21

went to a local university, earned a degree in management information systems,
and was hired by a new machine tool firm that exports to Mexico. He now enjoys
a more comfortable living even after making the monthly payments on his govern-
ment subsidized student loan.
• Rosa and her family recently moved from a farm in southern Mexico to the coun-
try’s northern border where she works for a U.S. owned electronics firm that exports
to the United States. Her husband, Jose, operates a janitorial service and sometimes
crosses the border to work illegally in California. Rosa and Jose and their daughter
have improved their standard of living since moving out of subsistence agriculture.
Rosa’s wage has not increased in the past year; she still earns about $3 per hour with
no future gains in sight.
Workers around the globe are living increasingly intertwined lives. Most of the
world’s population now lives in countries that either are integrated into world markets
for goods and finance or are rapidly becoming so. Are workers better off as a result of
these globalizing trends? Stories about losers from international trade are often featured
in newspapers: how Tom lost his job because of competition from poor Mexicans. But
Tom currently has a better job and the U.S. economy benefits from his company’s
exports to Mexico. Producing goods for export has led to an improvement in Rosa’s
living standard and her daughter can hope for a better future. Jose is looking forward
to the day when he will no longer have to travel illegally to California.
International trade benefits many workers. Trade enables them to shop for the
cheapest consumption goods and permits employers to purchase the technologies and
equipment that best complement their workers’ skills. Trade also allows workers to
become more productive as the goods they produce increase in value. Producing goods
for export generates jobs and income for domestic workers. Workers in exporting indus-
tries appreciate the benefits of an open trading system.
Not all workers gain from international trade. The world trading system, for example,
has come under attack by some in industrial countries where rising unemployment and
wage inequality have made people feel apprehensive about the future. Cheap exports
produced by lower cost foreign workers threaten to eliminate jobs for some workers in
industrial countries. Others worry that firms are relocating abroad in search of low wages
and lax environmental standards or fear that masses of poor immigrants will be at their
company’s door, offering to work for lower wages. Trade with low wage developing
countries is particularly threatening to unskilled workers in the import-competing
sectors of industrial countries.
As an economy opens up to international trade, domestic prices become more aligned
with international prices; wages tend to increase for workers whose skills are more scarce
internationally than at home and to decrease for workers who face increased competition
from foreign workers. As the economies of foreign nations open up to trade, the relative
scarcity of various skills in the world marketplace changes still further, harming those
countries with an abundance of workers who have the skills that are becoming less
scarce. Increased competition also suggests that unless countries match the productivity
gains of their competitors, the wages of their workers will deteriorate. It is no wonder
that workers in import-competing industries often lobby for restrictions on the importa-
tion of goods so as to neutralize the threat of foreign competition. Slogans such as “Buy
American” and “American goods create American jobs” have become rallying cries
among many U.S. workers.
Keep in mind that what is true for the part is not necessarily true for the whole. It is
certainly true that imports of steel or automobiles can eliminate American jobs. It is
not true that imports decrease the total number of jobs in a nation. A large increase in

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22 Chapter 1: The International Economy and Globalization

U.S. imports will inevitably lead to a rise in U.S. exports or foreign investment in
the United States. In other words, if Americans suddenly wanted more European
autos, eventually American exports would have to increase to pay for these pro-
ducts. The jobs lost in one industry are replaced by jobs gained in another industry.
The long run effect of trade barriers is not to increase total domestic employment,
but to reallocate workers away from export industries and toward less efficient,
import-competing industries. This reallocation leads to a less efficient utilization of
resources.

International trade is just another kind of technology. Think of it as a machine that
adds value to its inputs. In the United States, trade is the machine that turns computer
software that the United States makes very well, into CD players, baseballs, and other
things that it also wants but does not make quite so well. International trade does this
at a net gain to the economy as a whole. If somebody invented a device that could do
this, it would be considered a miracle. Fortunately, international trade has been
developed.

If international trade is squeezing the wages of the less skilled, so are other kinds of
advancing technology, only more so. “Yes,” you might say, “but to tax technological
progress or put restrictions on labor saving investment would be idiotic: that would
only make everybody worse off.” Indeed it would, and exactly the same goes for inter-
national trade—whether this superior technology is taxed (through tariffs) or overregu-
lated (in the form of international efforts to harmonize labor standards).

This is not an easy thing to explain to American textile workers who compete with
low wage workers in China, Malaysia, etc. Free-trade agreements will be more easily
reached if those who might lose by new trade are helped by all of the rest of us who
gain.

BACKLASH AGAINST GLOBALIZATION

Proponents of free trade and globalization note how it has helped the United States and
other countries prosper. Open borders permit new ideas and technology to flow freely
around the world, fueling productivity growth and increasing living standards. Moreover,
increased trade helps restrain consumer prices, so inflation becomes less likely to disrupt
economic growth. Without trade, coffee drinkers in the United States would pay much
higher prices because the nation’s supply would depend solely on Hawaiian or Puerto
Rican sources.

Critics maintain that U.S. trade policies primarily benefit large corporations rather
than average citizens—of the United States or any other country. Environmentalists
argue that elitist trade organizations, such as the World Trade Organization, make
undemocratic decisions that undermine national sovereignty on environmental
regulation. Unions maintain that unfettered trade permits unfair competition from
countries that lack labor standards. Human rights activists contend that the World
Bank and International Monetary Fund support governments that allow sweatshops
and pursue policies that bail out governmental officials at the expense of local
economies. A gnawing sense of unfairness and frustration has emerged about trade
policies that ignore the concerns of the environment, American workers, and interna-
tional labor standards.

The noneconomic aspects of globalization are at least as important in shaping the
international debate as are the economic aspects. Many of those who object to globaliza-
tion resent the political and military dominance of the United States. They also resent

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Chapter 1: The International Economy and Globalization 23

the influence of foreign (mainly American) culture, as they see it, at the expense of
national and local cultures.

Public opinion surveys note that many Americans are aware of both the benefits
and costs of interdependence with the world economy, but they consider the costs
to be more than the benefits. In particular, less skilled workers are more likely
to oppose freer trade and immigration than their more skilled counterparts
who have more job mobility. While concerns about the effect of globalization
on the environment, human rights, and other issues are an important part of the
politics of globalization, it is the tie between policy liberalization and worker inter-
ests that forms the foundation for the backlash against liberalization in the United
States.

Some critics point to the terrorist attack on the United States on September 11, 2001,
as what can occur when globalization ignores the poor people of the world. The terrorist
attack resulted in the tragic loss of life for thousands of innocent Americans. It also
jolted America’s golden age of prosperity and the promise it held for global growth that
existed throughout the 1990s. Because of the threat of terrorism, Americans have become
increasingly concerned about their safety and their livelihoods. Table 1.6 summarizes
some of the pros and cons of globalization.

The way to ease the fear of globalization is to help people move to different jobs
as comparative advantage shifts rapidly from one activity to the next. This process
implies a more flexible labor market and a regulatory system that fosters investment.
It implies an education system that provides people with the skills that make them
mobile. It also implies removing health care and pensions from employment, so that
when you move to a new job, you are not risking losing everything. For those who lose
their jobs, it implies strengthening training policies to help them find work. These activ-
ities are expensive, and they may take years to work. But an economy that finds its
national income increasing because of globalization can more easily find the money to
pay for it.

TABLE 1.6 Disadvantages

Advantages and Disadvantages of Globalization Millions of Americans have lost jobs because of imports
or shifts in production abroad. Most find new jobs that
Advantages pay less.
Productivity increases faster when countries produce
goods and services in which they have a comparative Millions of other Americans fear getting laid off, espe-
advantage. Living standards can increase more rapidly. cially at those firms operating in import-competing
industries.
Global competition and cheap imports keep a constraint
on prices, so inflation is less likely to disrupt economic Workers face demands of wage concessions from their
growth. employers, which often threaten to export jobs abroad if
wage concessions are not accepted.
An open economy promotes technological development
and innovation, with fresh ideas from abroad. Besides blue collar jobs, service and white collar jobs are
increasingly vulnerable to operations being sent
Jobs in export industries tend to pay about 15 percent overseas.
more than jobs in import-competing industries.
American employees can lose their competitiveness
Unfettered capital movements provide the United States when companies build state-of-the-art factories in low
access to foreign investment and maintain low interest wage countries, making them as productive as those in
rates. the United States.

Source: “Backlash Behind the Anxiety over Globalization,” Business Week, April 24, 2000, p. 41.

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24 Chapter 1: The International Economy and Globalization

THE PLAN OF THIS TEXT

This text is an examination of the functioning of the international economy. Although
the emphasis is on the theoretical principles that govern international trade, there also
is considerable coverage of the empirical evidence of world trade patterns and trade
policies of the industrial and developing nations. The book is divided into two parts.
Part One deals with international trade and commercial policy; Part Two stresses the
balance-of-payments and the adjustment in the balance-of-payments.

Chapters 2 and 3 deal with the theory of comparative advantage, as well as theoretical
extensions and empirical tests of this model. This topic is followed by Chapters 4
through 6, a treatment of tariffs, nontariff trade barriers, and contemporary trade policies
of the United States. Discussions of trade policies for the developing nations, regional
trading arrangements, and international factor movements in Chapters 7 through 9 com-
plete the first part of the text.

The treatment of international financial relations begins with an overview of the
balance-of-payments, the foreign exchange market, and the exchange rate determina-
tion in Chapters 10 through 12. The balance-of-payments adjustment under alternate
exchange rate regimes is discussed in Chapters 13 through 15. Chapter 16 considers
macroeconomic policy in an open economy, and Chapter 17 analyzes the international
banking system.

SUMMARY

1. Throughout the post-World War II era, the world’s 5. International competitiveness can be analyzed in
economies have become increasingly interdependent terms of a firm, an industry, and a nation. Key to
in terms of the movement of goods and services, the concept of competitiveness is productivity, or
business enterprise, capital, and technology. output per worker hour.

2. The United States has seen growing interdepen- 6. Researchers have shown that exposure to compe-
dence with the rest of the world in its trade sector, tition with the world leader in an industry
financial markets, ownership of production facili- improves a firm’s performance in that industry.
ties, and labor force. Global competitiveness is a bit like sports: You
get better by playing against folks who are better
3. Largely owing to the vastness and wide diversity of than you.
its economy, the United States remains among the
countries that exports constitute a small fraction of 7. Although international trade helps workers in
national output. export industries, workers in import-competing
industries feel the threat of foreign competition.
4. Proponents of an open trading system contend that They often see their jobs and wage levels under-
international trade results in higher levels of mined by cheap foreign labor.
consumption and investment, lower prices of
commodities, and a wider range of product choices 8. Among the challenges that the international
for consumers. Arguments against free trade tend trading system faces are dealing with fair
to be voiced during periods of excess production labor standards and concerns about the
capacity and high unemployment. environment.

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