The Big Picture

I. Introduction

We’ve covered all the issues concerning individual decisions by companies and consumers. We’ve discussed supply and demand. We’ve addressed marginal revenue and marginal cost.

This class we will explain the big picture of trade. We will also review several important concepts that we have already covered.

II. Trade

What is trade? It is an exchange of goods or services or money by one person for goods or services or money from another. When I give you an Alex (A-Rod) Rodriguez baseball card in exchange for your giving me a Derek Jeter card in return, this is called a trade. We would not make the exchange unless each of us felt we would be better off as a result. Maybe I have two A-Rod cards and the second one doesn’t mean as much to me as it would to you, for example.

When Pokeman cards were the big fad for children, they quickly learned to trade cards to improve their collections. Note that both sides must perceive a benefit for a trade to occur.

Dutch traders supposedly bought the island of Manhattan from Indians for only $24 in beads and trinkets over 300 years ago. At the time, Manhattan did not appear to be worth much. Land was plentiful, and it was difficult to get to Manhattan from the New Jersey side. If the story is true, then both sides felt they were better off from the trade. In the 1970s, New York City nearly went bankrupt and it was not worth a great deal then either. Would the Indians have taken it back?

Trade benefits both sides to the deal. It appears win-win for both parties, or one would not do it (assuming there is not any trickery involved). Generally, economists favor free trade, which means trade without government interference.

Now move to the big picture. Consider the massive amounts of trade that occurs between companies and people located in different countries. Exports are the goods that companies in one country make to be sold in another country. Those goods exit the country of origin and are purchased by foreigners. Imports are the opposite: they are goods that are made in a foreign country but purchased here.

Whenever you hear new economic concepts, try to think of examples yourself. What are some imports that you buy? Look at where your clothes are made. Labels disclose this information when you buy the clothes. Clothes are usually imports, often made in Mexico or China (if inexpensive) or Italy (if expensive). What are some cars that are imported?   Examples are Toyota (made in Japan), Hyundai (made in Korea), BMW (made in Germany), and Jaguar (made in England).

More difficult is to imagine goods that we export. You do not purchase any of those. Those are goods made in the United States for sale in a foreign country. Can you think of any examples? Music and movies are examples, as people around the world like to buy what Hollywood produces. Computer software is an other example, as the Microsoft monopoly is exported to the rest of the world.

Here is something we export that is controversial: we export jobs. Called outsourcing, this consists of a company firing an employee in the United States and then hiring a replacement at much lower wages in a foreign country, such as India. The foreign employee can be hired free of many government regulations that make jobs costly here, such as social security taxes, health benefits, taxes, risk of lawsuits, pensions, and so on. An employee hired at a wage of $30,000 in the United States may cost the employer $60,000 when all the regulatory costs are added. Not so if the company can hire a similar employee in a foreign country.

Do we ever import jobs from foreign countries? Not many. The Japanese car company Toyota did build some car manufacturing facilities here in response to complaints that it was hurting our automobile industry. Generally, however, it is more expensive for foreign countries to hire workers here than it would be to hire them elsewhere in the world.

China is the fastest growing exporter of goods in the world, and India is second. In 1980, China exported $18.2 billion in goods to other countries. By 2000, China exported $249.3 billion in goods. Why? Because China has very cheap labor. But it is also a Communist country. Some of those profits go into building up its military, and menacing its democratic neighbors. It points nuclear missiles at our western cities, like Los Angeles.

You can export or import cash itself. We export dollars to pay for imported goods. More generally, exports are what we sell in exchange for imports.

Sometimes you will hear on the news mention of the balance of payments or trade deficits. These terms apply to the difference between how much we import versus how much we export. Because goods are made more cheaply in foreign countries, we typically import far more than we export. That means the United States has a large trade deficit (amount that total exports exceed total imports).

The balance of payment account consists of two accounts that keep track of the goods and services entering and leaving a country: the capital account and the current account. The capital account monitors physical and financial assets; the current account monitors goods and services. Familiarity with these terms suffices, and do not worry if you do not fully understand them.

III. Free Trade versus Protectionism

One of the oldest political issues is the debate between free trade and protectionism. This has been an issue in American politics for over 200 years. It was a big issue in the Democratic presidential primaries this year, and will be a factor in the November elections. What is the controversy?

Supporters of free trade oppose government interference in trade between foreign countries. They feel that we should be able to import as many goods as possible from China, and export as many jobs as desired to China. They argue that trade makes both sides better off, so it should be allowed.

But what about the jobs that are lost in the United States due to the shift to foreign producers of goods and the outsourcing of the work? Advocates of free trade point out that the people who buy the imports are better off, and they save money by obtaining goods at a lower price. They do not need to make as much money from jobs because their expenses are decreasing.

The free trade advocates also argue that our economy becomes stronger due to the imports, and new jobs will be created for those who lost their prior jobs. When jobs were lost in the steel industry due to cheaper imports, new jobs were created in the services industry. The dot-com boom created many new jobs in the 1990s. There are temporary dislocations, but these are like growing pains until better jobs arise. That’s the argument in favor of free trade.

Free traders cite the Law of Comparative Advantage: nations are better off by exporting goods it produces at a lower relative price than others, and importing goods that it cannot make as cheaply. If China makes trinkets more cheaply than we can, then let’s save money by buying them from China and let’s focus our work on what we do best.

Opportunity cost supports this view. You lower your opportunity cost by spending your time most efficiently working on what you do best. Ford Motor can make a car more efficiently than you can. But perhaps you can provide medical or legal services more efficiently than Ford Motor can. So spend your time making money as a doctor or lawyer, and buy your cars from Ford Motor. You’ll have extra money that way. If you spend all your time trying to build a car, then you’d go broke and incur enormous opportunity cost.

For the purposes of economics courses and the CLEP exam, free trade and the above arguments are the correct answers. There is much to be said in their favor. The free traders also think they are promoting peace. If goods cannot cross borders, then soldiers will is one of their favorite sayings.

However, there are many smart people who would be considered protectionists (though they would dislike the pejorative label). Can you think of reasons to oppose free trade?

The first argument is the simplest: money isn’t everything. Put another way, overall utility is about more than money. Even if free trade makes me better off, I may still not want to do it if it helps wrongdoing or promotes evil. Someone may choose not to buy lottery tickets even if he thinks he will win, if he is morally opposed to gambling. Many of us oppose how China persecutes Christians, requires abortion, and points nuclear weapons at our cities. Even if we benefit from trading with them, we don’t want them to benefit and continue the activities we oppose. But you won’t hear economists making this argument.

The second argument for protectionism questions whether the foreign trade is really free. China is a Communist country. What is free about trading with it? It does not have free enterprise. Neither does India. Why should we let these government-controlled economies take jobs away from ours? With great risk and many failures through trial and error, we developed successful industries. Why should we allow foreign governments to be copycats for our successes, at our expense in siphoning away jobs? Let them promote free enterprise in their countries first, and then we can copy them as much as they copy us. Through discipline and protectionist measures, perhaps we could induce these countries to embrace free enterprise more.

The third argument for protectionism is as follows. Workers facing loss of jobs due to the outsourcing to other countries ask this: why aren’t the executive jobs exported in addition to the jobs of the employees? Sure, workers are cheaper in China and India than American counterparts. But moving the highly paid executive jobs to those countries would save even more money (per worker)! The advocates of free trade appear to be selective about which jobs they support moving offshore. Why not start with moving their job to a foreign country first? They do not seem to be volunteering for that.

One of the reasons Ralph Nader is able to attract a few percentage votes in the presidential election is that he opposes free trade more vocally than anyone else. However, he may simply be exploiting anger by union employees who are losing their jobs. Ralph Nader’s own organizations (e.g, PIRG) are actually funded by millions of dollars in mandatory fees imposed by universities on students. If you go to a public university for college, you may find yourself supporting Ralph Nader’s groups without even realizing it. I have not investigated this, but it wouldn’t surprise me if our local community colleges charge student fees that fund Nader’s organizations or similar groups. For those interested in how student fees are used to fund liberal political activities, do an internet search on PIRG student fees.

IV. Tariffs

Tariffs are a tax on imports. They raise the price of imported goods, and the supplier must then reduce its received price to attain the same level where supply meets demand. This has the effect of reducing supply, which is exactly what the protectionists want. A tariff on Toyota cars, for example, would reduce the supply of Toyota cars in the market. Ford Motor and GM would jump for joy.

Ironically, our government uses quotas rather than a tariff to appease Ford and GM. Instead of imposing a tariff on Toyota’s imports, our government negotiated an agreement with it so that it would not sell more than a fixed quota of certain types of cars each year. This reduces supply also, but without any revenue to the government. Many criticize these import quotas by observing that the effect is the same as a tariff, but without the benefits of the revenue that government would receive from a tariff.

For most of our country’s history (until the Sixteenth Amendment legalized the income tax), our federal government’s major source of revenue was tariffs. The issue of the tariff was a recurrent controversy that divided the pro-tariff North from the anti-tariff South.

V. Possibilities of Production

Possibilities of production is an important concept. It means all the different combinations of goods a nation can produce. The United States can produce X cars and Y bundles of wheat, for example. Or it could produce more than X cars and fewer than Y trucks. We could graph the number of cars on the Y-axis and the number of trucks on the X-axis, and draw a production possibility curve through all the possible combinations. It would be downward sloping: more cars means less trucks, and vice-versa. The opportunity cost of producing more cars is the loss in production of trucks. In the production possibility curve for cars and boats shown in Figure A (attached), the opportunity cost of moving from point A to point B is 100 cars.

If the overall number of workers or investment capital increased, then you could produce more of everything. The entire production possibilities graph (or frontier) would shift upward and to the right. An improvement in technology would have the same effect. An increase in bureaucracy or administrative costs, however, would have the opposite effect, forcing a contraction in overall production.

Sometimes in politics this is described as guns versus butter. The more guns (e.g., military weapons) we make, the less butter (e.g., food and domestic services) we can produce. The idea is that there is a trade-off between spending money on our military and spending it on domestic goods and services.

On a personal level, it is usually impossible to do two things at once. Either you spend the next hour working on this course, or you spend it doing something else. You could graph a production possibility curve for how you spend 24 hours each day. It could be 10 hours sleeping, 2 hours playing sports, 3 hours cooking and eating, 4 hours studying, 1 hour relaxing, and 4 hours working at a job. If you take an hour away from one activity, then you can add it to another. Your production possibility curve would represent all the possibilities.

Economists observe that utilizing the Law of Comparative Advantage can improve the production possibilities. Suppose your job paid you $9 but you could hire a cook for $6. Then it might make sense for you to work one more hour and hire someone to save you one hour of cooking. In the absence of taxes, you would be $3 better off. Then you could work one-third of an hour less to make the same money (after expenses) as before. That extra one-third of an hour could be added to your sports or relaxation time. You have moved your production possibilities frontier (the curve of all possibilities) outward, for greater benefit.

VI. Review

There is only one more Lecture after today, and then there is the final exam. It is important to begin reviewing all the concepts in the course. The key to mastering economics is to learn to quiz yourself on the principles to make sure you understand it. The review list in Lecture #10 should be useful, and return to it again and again. Email me if you need another copy.

This is not a course where memorization is important. This is not history. Economics is about a handful of concepts that are used and applied over and over and over. Once you understand the concepts, you can answer dozens of problems correctly.

What is the most important concept of the course? Perhaps the obvious desire of companies to maximize their profits. Whether it is a monopoly or a perfectly competitive firm, they share this common goal: it wants to make more profits. You can answer 20% or more of the questions on any microeconomics exam simply by applying that basic rule. And at what point does any company maximize its profits? Where marginal revenue (MR) declines to the point where it equals marginal cost (MC). When marginal revenue declines further (or marginal cost increases more), then the company is losing profits. It won’t do that.

You need to understand the supply and demand curves thoroughly. Know what elasticity is, in all its forms. Appreciate what substitutes and complements are.

Know the difference between the short run and the long run. Many of you missed questions concerning this on the exam. In the short run, inefficient changes to inputs and outputs are made. For example, an employee is asked to work overtime at wages 1.5 times ordinary wages. But in the long run, inefficiencies are eliminated by better planning. Overtime is avoided.

Acquire a solid understanding of marginal cost (MC), average variable cost (AVC) and average total cost (ATC). See Figure B (attached). Notice how an increase in MC causes a delayed increase in AVC and ATC. MC moves quickly because it is just the additional cost for one additional unit of output. AVC moves more slowly because it is an average over all the output. If a star baseball player bats 1000 in a game by going 4-for-4, his batting average for the entire season is not going to jump to that level. Nor does AVC jump around with every variation in MC. Meanwhile, ATC is always higher than AVC, because ATC includes fixed costs.

Why is AVC and ATC so important? Because that helps determine your profit or loss. You’ll shut down your company if you lose money from making additional goods, which happens in the short run when AVC > P.

VII. Assignment

  1. The curve that illustrates how much a company or country can produce of multiple items is called the ________________________.
  1. A monopolistic competitive firm has the following characteristic that is lacking for a perfectly competitive firm:

(a) There are low barriers to entry

(b) MR = MC in the long run.

(c) P > MC

(d) There are many competitors.

Explain your answer

  1. A customer to our homeschool dinner expected to pay $40, but we only charged him $25. An economist would call the $15 difference the ___________. (Hint: see Lecture #10 review list)
  1. Look at Figure B (attached). If the price of sale falls below P1 then the firm in the short run will (a) increase Q, (b) increase labor, (c) increase price, or (d) shut down. How much profit is it making at a price of P2?
  1. Look again at Figure B (attached). Assume the firm is perfectly competitive. Explain what AFC is, and use the labels on the graph to describe its amount.
  1. Now turn to Figure A (attached). What is the opportunity cost of shifting production from B to C?
  1. Suppose that is your firm in Figure A (attached). What changes might enable you to move production to point D?
  1. The term normal profit means zero economic profits, which occurs when total revenue equals explicit costs (like cash expenditures) plus implicit costs (like opportunity costs of wasted time). In Figure B (attached), at point A, what kind of profits does the company have: (a) more than a normal profit, (b) equal to a normal profit or (c) less than a normal profit.? Explain.
  1. Do you support free trade or protectionism? Explain your view.

Extra credit (4 points for 10 and 11; 6 points for 12):

  1. Look at Figure C (attached). Assuming it represents the long run, describe what type of industry this is (e.g., monopoly, oligopoly, monopolistic competition, or perfect competition). Explain your answer.
  1. Economics is sometimes called the dismal science because economists predicted population to grow faster than the food supply, marginal returns to diminish, and profits to vanish. But, in fact, there is an abundance of food and profits have not vanished. Why is economics not so dismal after all?
  1. Look again at Figure C (attached). This question has three parts. (I) At what point is there allocatively efficient quantity? (II) At what point is revenue maximized? (III) At what point is profit maximized? Explain your answers.