Photo by Scott

Copyright by Carole E. Scott 1997-2001

Nobody suggests that even a city as large as New York City would be better off if all trade between it and the State of New York and the other states of the Union was forbidden. Nobody argues that the standard of living in  Japan, where no oil has been found, would be higher if it imported no oil. Nobody, too, seems to have suggested that Monaco or Jamaica would be better off  if they forbid foreign trade. Communist Cuba complains bitterly of the reduction in their standard of living caused by the United States' embargo on trade with Cuba.

Fear of Job Loss

It is not unusual, however, for Americans to argue that the United States government should reduce or eliminate the importation of various products because imports cause Americans to lose their jobs or be paid less. Yet, despite the fact that, because wage rates are high in alternative forms of employment in Alaska, people would have to be paid high wages to grow bananas there, nobody suggests Alaska grow bananas in greenhouses, rather than importing them from Central America. Many, however, in the Northern states have long complained that lower wage rates in the South is a threat to Northern jobs and wage rates, and it is the case that many businesses have moved to the South.

To prevent Northern employers from importing low wage black labor from the South, a bill was passed in Congress and signed many years ago requiring contractors working for the government to pay their employees the prevailing wage in the area where they were working. Congress' stated objective in passing a minimum wage law was to assure that the lowest paid people could afford a decent standard of living. Unions whose members earn more than the minimum wage support this law. Some say that this is because the minimum wage law can prevent employers from replacing a high skilled and highly paid worker with several low skilled and less well paid workers.

Domestic jobs are protected by either a tariff (a tax) on imports of things produced by foreigners or limit how much of it can be imported by imposing a quota. Having to pay a tariff causes foreign firms exporting to the United States to have to charge more for their products just as would a requirement by foreign governments that their workers be paid more. This increase in the price of imports will reduce how much foreigners can sell in the United States just as will a quota. In addition to preserving the jobs of Americans by preventing foreign firms from taking business away from domestic business, restrictions on imports. also deters American firms from producing products abroad where labor is cheaper and exporting them to the United States. Because tariffs and quotas protect American entrepreneurs from competition, they as well as their employees support their imposition.

The fact of the matter is that as consumers people want the things they buy to be cheap. For them to be cheap, either workers who produce the things they buy must be paid low wages, or they must be very productive. To be competitive with workers paid much lower wages, workers must be very productive.

On the other hand, as workers, people want high pay and easy jobs.

As employers, people want cheap, highly productive labor.

Clearly, there is conflict between what people want depending on whether they are viewing themselves as producers or as consumers and whether they are workers or employers. Because it makes imports more costly and prevents the forcing down of the prices charged by American firms, tariffs harm American consumers. By limiting the quantity of less expensive foreign-made products, quotas, too, harm consumers. 

Everybody is a consumer, and organizing this large a group of  people costs too much to justify anybody doing it. Because it is often not apparent that tariffs and quotas have boosted the price level, consumers may be apathetic. The gain to the far fewer entrepreneurs and workers producing a product whose sales and/or price would be reduced if subject to foreign competition is substantial and quite obvious to them, so they do organize to support tariffs and quotas. Therefore, it is not surprising that trade in many products is not free, that is, not subject to either tariffs or quotas.

The Argument for Free Trade

Classical economist Adam Smith discussed trade in terms of absolute advantage. If Smith, claimed, England can produce wool more cheaply than Portugal, while Portugal can produce wine more cheaply than can England, both countries will benefit if England produces wool, but no wine, and Portugal produces wine, but no wool, and England gets wine by trading wool for it with Portugal.

Mercantilists argued that if England was a lower cost producer of a wide range of commodities as compared to Portugal, free trade would enable England to exploit Portugal by exporting these commodities to Portugal. David Ricardo was the first economist to successfully challenge this idea. He argued that even if England is more efficient in producing a great many things than is its trading partners, both England and its trade partners will benefit from free trade.

He based his argument on opportunity cost. The opportunity cost of any product a country produces is how much of some other product it gives up in order to produce it. For example, say a given manufacturing facility can produce either product A, B, C, D, or E. If it produces, say, product C, it cannot produce either A, B, D, or E. Note I said "either." In order to do one thing, you don't give up doing everything else. You can only do one thing. So the doing of one thing causes you to give up doing one other thing.

For simplicity, let's assume that the cost of producing each product is the same, and each will sell for the same price. Therefore, when you give up producing a unit of any one of them, you forgo the same profit.

The opportunity cost of producing 5 units of product E is 20 units of product C. For each unit of E you produce, you give up 4 units of product C. Therefore, given the simplifying assumption about costs and revenues, you will make less money producing E than C. The opportunity cost of producing 20 units of product C is 15 units of product D, the next best choice. Product C covers its opportunity cost. Product D, A, B, and E do not.

The opportunity cost of any choice you make about using your time and resources is the benefit you forgo by not choosing, instead, the best alternative use of your time and resources.

Ricardo argued that England should specialize in wool cloth production and trade it for wine from Portugal because it could produce wool cloth at a lower opportunity cost in terms of wine than could Portugal.

He claimed that even if England had an absolute advantage in both products, that is, it was a more efficient producer of both products than Portugal, but its advantage was greater in the case of wool, England would be better off to specialize in producing wool and trading it for wine from Portugal, ant that Portugal would be better off if it specialized in producing wine and traded it for wool from England.

For Smith and Ricardo trade is an engine of economic growth because it enables a country to take advantage of specialization and division of labor. Specialization allows for the division of labor. The division of labor increases productivity. Another reason for engaging in international free trade is that by enlarging the market for a product, foreign trade makes possible to obtain economies of scale which cannot otherwise be obtained.

In a world of perfect competition, the operation of free markets would lead countries to specialize in producing those things in which they have a comparative advantage because this increases profits. Here's an example of how countries come to specialize in producing certain items: An entrepreneur observing that shoes are enough cheaper in country A than in country B to more than cover the cost of transporting them to country B, will buy them in A and ship them to B, taking sales away from country B's shoemakers. An entrepreneur observing that electric motors are enough cheaper in country B to more than cover the cost of transporting them to country A, will buy them in B and ship them to A, taking sales away from country A's electric motor manufacturers. The resources no longer needed in shoe manufacturing in B can be shifted to producing electric motors. The resources no longer needed to manufacture electric motors in A can be shifted to producing shoes.

According to modern refinements of the theory of comparative advantage, countries differ in terms of their endowments of labor, capital, land, natural resources, and entrepreneur ship. They gain by specializing in the production of commodities and the manufacturing of products that intensively use their abundant factors of production, and then trading for other things with countries with different endowments.

According to the theory of comparative advantage, every country can gain from trade so long as the relative cost of goods in international markets are different from those that would exist in the domestic market in the absence of trade. A developing country with a rapidly growing labor force should, according to this theory, specialize in the production of  labor intensive products because labor is in that country is relatively abundant. In a Developed Country labor is not so relatively abundant.

The smaller a country is, the greater is the advantage of free trade. Small countries cannot be self sufficient in as many things as a large country can. Its domestic market is too small to obtain economies of scale in some industries. It is obvious that countries must engage in foreign trade to obtain raw materials that it does not have.

Although to preserve jobs or to be self sufficient in things needed to wage war, countries may product things that they are very inefficient producers, they do not go so far as to do something like supplying their citizens with bananas that would have to be grown in greenhouses.

The Infant Infantry

The purposeful reduction of competition in international trade has been justified in a variety of ways. Perhaps the most common way this is justified is called the infant industry argument. Suppose an industry was established long ago in a country which has a large domestic market for this industry's output. Because it was established long ago, it is way out on its learning curve. The learning curve refers to the fact that as you gain experience in producing a product, you become more proficient in producing it. You learn by doing. Skills are honed, and via experience and trial and error the best methods and tools of production are discovered. If the domestic market is large enough, maximum economies of scale can be obtained.

Economies of scale refers to the fact that as the scale of plant is expanded, up to some point, average cost per unit of output can be lowered. If, for example, the market is large enough to absorb, say, 50,000 units a day, a capital intensive, that is highly automated factory is justified.

Although the cost of building a capital intensive manufacturing facility is high, the recovery of the high cost of the factory adds very little to the price of each unit because it is spread over so many units. In order to sell a  large amount of output the market it is sold in must be large. If, however, the market is quite small, and, therefore, output is well below what the factory is capable of producing, the high cost per unit of output of a capital intensive factory causes the average cost per unit to exceed what it would be with a less expensive, more labor intensive factory. (If you are going to assemble two automobiles a year, it is unreasonable to build an automated factory that costs several hundred million dollars to build them in, because to recover the cost of this plant even over many years would require charging vastly more for the automobiles built than anyone would be willing to pay. It would cost far less per automobile to have workers using relatively simple and cheap tools assemble them.)

The infant industry argument claims that  in an environment of free trade, an industry will never emerge in a country which does not have it if it has long existed in another country which, either by having a large domestic market or via a large market gained through international trade, has obtained maximum economies of scale.

The government of the country without the industry can, however, through either tariffs or quotas on the importation of this industry's product or a subsidy to domestic firms in this industry, enable this industry to come into being. Over time it can become competitive with foreign industry by moving out the learning curve and gaining a large enough market to obtain economies of scale. Then the tariff or subsidy can then be removed and free trade allowed so consumers can enjoy the benefits of competition (lower prices and better products).

Tariffs, of course, bring the government revenues. A subsidy is a cost. A quota is neither a revenue producer or a cost. For a poor country tariffs have an obvious attraction. (Collecting other forms of taxes is usually more costly. The government can also claim that tariffs on imports are paid by foreigners. They are, however, likely to at least in part be passed onto domestic consumers.)

It makes a difference whether a tariff or a quota or a subsidy is utilized. A tariff or a quota causes the price of the industry's product to be higher. A tariff raises the price of foreign goods. As a result, domestic producers can get away with charging the higher price foreign producers need to cover the higher costs they have as a result of having to pay the tariff. A quota on imports also raises the price of imported goods, as the fewer units a seller can offer, the higher will be the market price of the seller's product. Higher prices means the country's people will have to consume less.

Because a subsidy covers part of the domestic producer's costs, the domestic producer can sell at a lower price which is competitive with foreign producers'. Subsidies can be financed by taxation, borrowing, or printing money. All of these have consequences. Taxation reduces consumers' disposable income. So does domestic borrowing. Borrowing from foreigners means interest payments must be paid foreigners, rather than citizens. Domestic borrowing raises domestic interest rates, which will reduce how much is invested in other industries by private investors. Poor countries will find it relatively more expensive to offer subsidies than will rich countries because their opportunity costs are higher. (Very important alternative uses of funds must be forgone in a low income country because it can not afford to meet all the needs that a wealthy country can.) Printing money can cause inflation.

The chief problem with the infant industry theory in practice has been the failure of the protected industry to reduce its costs of production. That is, it remains dependent on the tariff, quota, or subsidy. This is sometimes due to the fact that the industry is government-owned and operated and its policies are determined on a political, rather than an economic basis. (Economic efficiency it not its prime goal.) It is also the case privately-owned firms prefer to use their political clout to maintain the tariff or subsidy to becoming more efficient. Seeking profits through political favors, rather than serving consumers needs,  is called rent seeking, that is, getting something for nothing.

Foreign Exchange

 Buying something from or selling something to a foreigner involves a risk not found in domestic transactions. Either the buyer or the seller must use another country's currency. Either the buyer must agree to pay in a foreign currency, or the seller must accept a foreign currency. Because the price (exchange rate) of one currency in terms of another fluctuates, an American buyer risks that by the time he or she has to pay for foreign goods the dollar cost of the foreign currency will have risen, while the American seller risks that by the time the foreign currency is received its dollar price will have declined. 

The use of money, rather than barter,  facilitates foreign as well as domestic trade. A complication is introduced, however, by the fact that different countries use different monies. So, either the buyer must acquire foreign money to pay the seller, or the seller must accept foreign money. If the buyer doesn't earn the  necessary foreign money, he or she must borrow or buy it. If the seller doesn't have any purchases to make with the foreign money, he or she must sell it

People need foreign currencies to purchase foreign goods and services, foreign securities, and foreign real estate. If a country's importers purchase more from foreigners than its exporters sells to them, because, as a result, the country is not earning enough foreign currency to pay for its imports, it will have to either borrow or buy foreign currencies. When a foreign currency is borrowed, an interest cost is incurred.

When a country's imports exceed its exports, it is running a trade deficit. If a country's exports exceed its imports, it is running a trade surplus, which means it is earning more foreign currencies than it needs to pay for imports; so its central bank must either hold them as foreign currency reserves or sell them. If the U.S. runs a trade surplus with Germany, Germany is running a trade deficit with the U.S. If the U.S. is running a trade deficit with Japan, Japan is running a trade surplus with the U.S. If exports from the U.S. to the United Kingdom equals its imports from the United Kingdom, its trade is in balance. Countries typically run trade deficits with some countries, and trade surpluses with other countries. Overall, a country's trade is either in deficit, surplus, or in balance.

The market in which foreign currencies are bought and sold is called the foreign exchange market. The price at which one currency exchanges (sells) for in terms of another is called the foreign exchange rate. If, for example, one U.S. dollar exchanges for 4 German marks, in the U.S. the exchange rate would be said to be one dollar is worth 4 German marks, while in Germany it would be said that one mark is worth 25 cents.

The buyer can buy foreign money from a bank that deals in foreign exchange, and the seller can sell it to a bank. The latter is how a bank gets the foreign money to sell to the buyer. Foreign currencies (foreign exchange) can also be acquired through foreign exchange brokers. Important foreign exchange markets are located in   Hong Kong, Singapore, Tokyo, Bahrain, Frankfurt, London, New York, Chicago, and San Francisco. Typically, over a trillion dollars changes hands daily.

Dollar-denominated deposits held by banks outside the U.S. are called Eurodollars even if they are located outside Europe. Foreign currency deposits collectively are called Eurocurrencies, even though some are located outside Europe. Dollar denominated bonds issued abroad are called Eurobonds.

If a country allows its currency to be freely bought and sold in foreign exchange markets, the value of  its currency in terms of other currencies--the foreign exchange rate--will fluctuate with shifts in supply and demand. Because exchange rates fluctuate, people who hold foreign currencies are exposed to exchange rate risk. That is, while a German mark may be worth 25 cents today when an American manufacturer agrees to sell a German a $2 million airplane, by the time the 8 million marks ($2 divided by $0.25) are received, the mark may be worth only 10 cents. The $800,000 they can be sold for may fall far short of the cost to the American firm to manufacture the airplane. (If the German agreed to pay dollars, he would be the one experiencing exchange rate risk. While the dollar might today cost 4 marks, when it came time to pay for the airplane, a dollar might cost, say, 6 marks..)

To avoid this risk, the American manufacturer can hedge by signing a futures or forward contract. A futures contract is a contract between a buyer and a seller for the seller to deliver goods or securities or currency to the buyer at a date in the future at a price set today. Someone who is to receive foreign currency in the future can hedge by signing a futures contract now in which she promises to deliver it to a buyer in the future when she receives it at a price set now. (Someone who will need foreign currency in the future can sign a futures contract in which she promises to buy it in the future at a dollar price set now.)

Suppose an American agrees to pay 4,000 pesos for goods you are importing from a foreign country. If this person purchased these pesos today for delivery today, suppose that they would cost him or her $2,000 because the exchange rate for immediate delivery is $1 = 2 pesos. This would be a spot market transaction. If this person got somebody to agree to sell him or her the pesos in the future when payment was due at a price set today, this would be a forward  market transaction. 

If you purchase the 4,000 pesos today for $2,000, it may be the case that in the future, when you receive the merchandise and it is time to pay for it, that the spot price of pesos has fallen. Maybe $1 now exchanges for 4 pesos. So, if you had waited to buy the pesos when you needed them, they would only have cost $1,000. On the other hand, it might be the case that buying the pesos in advance saved you money. Maybe when it comes time to pay the spot price of pesos has risen to $1 = 1 peso.

If you buy the pesos in the spot market to make payment, say, in six months, while you know what the merchandise is going to cost you in dollars, you will forgo earning interest for six months if you simply hold onto the pesos. Investing them for six months will expose you to whatever risk this investment involves. If you decide, instead, to wait and buy the pesos in the spot market when you need them, there's no telling how much you will have to pay for them. To avoid either of these situations, you can go into the forward exchange markets and sign a contract with someone who promises to deliver the foreign currency to you in the future when you need it.

Often the spot price of a currency differs from its forward price. Here's why: If the spot price of pesos today is $1 = 2 pesos, and most people dealing in the foreign exchange markets think the spot price of pesos six months from now will be $1 = 1 peso, the forward price of pesos will not be $1 = 2 pesos. Here's the reason. If someone promises to sell you 2 pesos for $1 six months from now, and the spot price then is $1 = 1 peso, this person will be giving you 2 pesos for $1 which at that time can be sold for only 1 peso. So, people will not give you a forward price of $1 = 2 pesos, today's spot price, when they think the spot price in the future will be $1 = 1 peso.

By purchasing either in the spot or forward markets foreign currency you will need to make a payment in the future, you are eliminating exchange rate risk. You have locked in the dollar cost of foreign merchandise. If you are to receive a foreign currency in the future and sign a forward contract to sell it in the future, you have locked in the dollar value of a sale of merchandise to a foreigner. When you so avoid exchange rate risk, you are said to have engaged in hedging. 

The cost of foreign money (exchange rate) fluctuates for the same reasons other prices do: the supply of and demand for them changes. There is a dollar demand for, say, pesos because Americans need them to buy goods, services, real estate, and securities denominated in pesos. There may also be a speculative demand for them. If you expect the spot price of pesos in dollars to rise in the future, you may buy them today and hold them, planning to sell them in the future for more than you paid for them today. There is a supply of pesos because Americans who have earned pesos need to exchange them for dollars to pay their American workers and suppliers.

If the value of a currency declines in terms of another currency, it is said to have depreciated. The other country's currency is said to have appreciated. Running a trade deficit will, ceteris paribus, cause a currency to depreciate because of the resulting increase in its demand for foreign currency. (When exports fall short of imports, the amount of foreign currency earned is insufficient to pay for imports, so foreign currency must be bought with domestic currency.) Example: If the U.S. runs a trade deficit with Germany, the dollar demand for marks will rise; thereby increasing the dollar price of  the  mark. This means that the dollar has depreciated against the mark, and the mark has appreciated against the dollar. (The fact that transactions between the two countries sometimes are transacted in dollars and sometimes in marks does not alter the impact on the exchange rate between the two currencies.)

If a country runs a trade surplus, ceteris paribus, its currency will appreciate. This is because it will bid up the price of its currency by exchanging the unneeded foreign currencies for its own currency. Example: If Germany runs a trade surplus with the U.S., it will earn more dollars than it needs to pay for imports from the U.S. So, it will exchange dollars for marks, which will increase the mark price of the dollar. That is, the dollar demand for marks will increase, raising the dollar price of the mark.

The depreciation of the dollar resulting from the U.S. running a trade deficit with Germany will cause U.S. goods to become more attractive to Germans and German goods to become less attractive to Americans. Consider, for example, if the exchange rate is $1 = 4 marks, a U.S. good costing $1,000 will cost a German 4,000 marks. If the dollar depreciates so that $1 = 2 marks, the U.S. good costing $1,000 will only cost 2,000 marks. Because the depreciation of the dollar has halved the cost of   this good, Germans will buy more of it. On the other hand, while previously a German good costing 4,000 marks cost an American only $1,000, now it will cost $2,000; so Americans will buy less of it. Therefore, trade deficits are, ceteris paribus, self correcting. This is because, ceteris paribus, the currency of the country running a deficit will depreciate, while the country running a surplus will appreciate. The depreciation of  the currency of the country that ran a deficit will enable it to sell more in the future to the country that ran a surplus because its goods are now cheaper in terms of the other country's currency. The appreciation of the currency of the country that ran a surplus will cause it to be unable to export as much as before because its goods are now more expensive in terms of  the other country's currency.

Note what has just been said: If the U.S. runs a trade deficit with Germany, Americans will use dollars to demand (exchange for) marks, while Germans will also use dollars to demand (exchange for) marks. Americans will be buying (demanding) marks with dollars to pay for German goods that cannot be paid for with marks earned by exporting to Germany. Germans dispose of the excess of the dollars it earns over what they need to pay for imports from the U.S. by exchanging them for marks. Because dollars are "chasing" marks, the dollar price of  mark rises; so the dollar depreciates (is worth fewer marks), and the mark appreciates (is worth more marks).

A country's currency may also depreciate because the yield on its securities is lower than in another country. If, for example, interest rates in Germany, which were formerly the same as those in the U.S. rise, rise above their level in the U.S., German's demand for dollars declines as they switch to buying their own securities. This reduced demand for dollars will lower the mark price of the dollar, that is, the dollar will depreciate; thus the mark has appreciated. American demand for marks will rise as Americans switch to investing in German securities. This higher dollar demand for marks will cause the dollar value of  the mark to rise, that is, the mark will appreciate; thus the dollar will depreciate.

If real estate prices in the U.S. rise, while German real estate prices stay the same or fall, because of the resulting higher American demand for marks to buy German real estate and the lower German demand for dollars resulting from Germans buying less American real estate, the dollar will depreciate, which means that the mark has appreciated.

Inflation can also causes a currency to depreciate. If the price level in the U.S. rises, while the price level in Germany stays the same or declines, the dollar will depreciate. This is because German goods will become more attractive to Americans either because their prices have not increased or have increased less than domestic prices have, and American goods will become less attractive to Germans. Therefore, American exports to Germany will decline, while its imports from Germany will rise. So Americans will be buying more marks, while Germans will be buying fewer dollars.

If the exchange rate between the dollar and the mark is $1 = 4 marks, a suit that costs $400 in the U.S. and 1,600 marks in Germany cost Americans and Germans the same thing whether they buy it in the U.S. or in Germany. The American can either spend $400 to buy the suit in the U.S., or he can buy 1,600 marks with $400 and buy the suit in Germany. If this is, on the average, true of everything that people have a choice as to where to buy it, the $1 = 4 marks is a purchasing power parity rate of exchange. Actual exchange rates seem to fluctuate around whatever is the purchasing power parity rate.

Assets whose prices fluctuate provide an opportunity to gamble. Buying something only because you think that you might be able to sell it for more in the future is called speculation. Speculation can also cause a currency to depreciate. If people think the mark price of the dollar is going to fall in the future (The dollar is going to depreciate, and the mark appreciate.), they will get sell dollars for marks because they expect to be able to switch back from marks to dollars at a profit in the future. That is, if the exchange rate today is $1 = 4 marks, and they expect it will be $1 = 2 marks in the future, they can exchange $1 for 4 marks today and exchange these 4 marks for $2 in the future. This is a self-fulfilling prophecy, as an increased dollar demand for marks resulting from people thinking the dollar will depreciate, will cause it to depreciate!

The opposite of what causes a currency to depreciate causes it to appreciate: trade surplus, higher interest rates, lower real estate prices, lower inflation, and expectation that the currency will appreciate.

Countries usually get worried about running a trade deficit. One way to eliminate it in the short run is for your central bank to intervene in the foreign exchange markets. If it does, the foreign exchange rate is no longer freely floating. Our central bank, the Federal Reserve System, can cause the dollar to depreciate by using dollars to buy (exchange for) other currencies. It can also cause it to appreciate by using foreign currencies to buy (exchange for) dollars. These foreign currencies may come either from foreign currency reserves (mentioned earlier) or foreign currency borrowings.

A lot of dollars are held abroad. Foreign central banks hold them. Foreign businesses hold them because firms in other foreign countries demand to be paid dollars. Individuals hold them either as an investment, assuming that they will appreciated relative to the domestic currency, or to use to conduct some in-country transactions.

Companies that both buy and sell abroad may be able to avoid exchange rate risk through obtaining a balance between the amount of foreign currency needed in the future and the amount to be earned in the future. That is, what will be needed equals what will be received.

Some LDCs peg their currencies to the currency of a DC that they trade a lot with. That is, by buying and selling the DC's currency, an LDC keeps the value of its currency close to a targeted exchange rate with the DC currency. By so tying its currency a DC currency, the exchange rate risk of dealing in the LDC's currency is about the same as dealing in the DC currency. It is, of course, advantageous to have people willing to accept your currency. A cost of this to the LDC is that they lose control over the size of their money supply. The supply of their money is determined by what is necessary to maintain the target exchange rate with the DC currency.

The picture at the top of this page was taken by Carole E. Scott  in Savannah, Georgia