International Economics

Theo Eicher, John H. Mutti, Michelle H. Turnovsky

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781135979669
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Thought-provoking and clearly explained, the new edition provides students of international economics and international business with a rigorous explanation of global economic theory and policy, both current trends and historic developments. It explores key models through case studies and review questions, enabling students to challenge the reporting of economic events by press and government alike.

Split into 2 parts – International Trade and International Finance – the text explains conceptual building blocks before applying them to current events and controversies. Key issues discussed include:

• 
  
  

• the influence of transportation costs
• economies of scale and the new economic geography
• the evaluation of preferential trade agreements
• european Economic and Monetary Union
• the integration of international financial markets
• international financial crises, China and other emerging economies.

Fully illustrated with tables and figures to allow students to visualise the issues discussed, the lively prose gives this book a refreshing approach. An accompanying website also provides context and coverage of the international financial crisis of October 2008, including the so-called 'credit crunch' and the collapse of some banking institutions.

Chapter 1
Introduction

Life in an International Economy

Why study international economics? For one, it is difficult to read a newspaper today without references to “globalization,” and its effects on firm profits and employment. What are the fundamental catalysts of globalization and how does international economics help us understand these drivers? Often a mental picture is worth a thousand words, and, in this general introduction to our textbook, we take the concrete example of the Apple iPod to highlight the many facets of the international economy. We will use this ultra popular portable media player to trace its production and sales patterns and introduce the forces of globalization and how they relate to the principles of international economics.

Apple Inc., a master of marketing, has used a global advertising campaign with its dark silhouetted characters dancing against bright-colored backgrounds to sell the iPod successfully worldwide. Introduced in 2001, iPod sales reached 100 million by 2007, and the product diversified quickly from music to videos, podcasting, and most recently to the ubiquitous iPhone. Some (lucky) students even receive free iPods from their universities to complete their assignments!

While iPods are closely associated with Apple Inc. – the American company that brought you the iMac – the product is actually not “Made in the USA.” Turn over your iPod, and you find that it carries the text “Designed in California, Made in China.” Strictly speaking, this statement is far from true! A recent study of iPod components shows the final product contains major intermediate inputs that are sourced from at least 5 countries, as shown in Table 1.1, and the share accounted for by China is a small part of the total.

Clearly, Apple does not produce each iPod in the country where it is sold, so it must be traded internationally. Table 1.1also shows that companies from all over the world are responsible for the various components used in an iPod; but the company whose name is stamped on a component may not generate all of its innovative ideas in the country where it is headquartered and it may well produce the component in some third country. For example, Toshiba, based in Japan, has a fabled research laboratory in Cambridge, U.K., that has been involved in many of the company’s creative innovations, but it produces the crucial iPod hard drive in the Philippines or China.

Different companies seem to make different choices about the best location for production. This textbook explains why. While iPod production may involve a handful of countries, its distribution is truly global – this is why Apple Inc. has been able to generate a staggering iPod revenue stream of $20 billion (so far!). Obviously the iPod trade is a far cry from the good old days when a commodity was produced and sold exclusively in one country. But then again, we live in a world where countries have long leveraged the gains from trade to improve national welfare.

TABLE 1.1 A Geographic Breakdown of the Value of the Fifth Generation iPod, 2005 The Most Expensive Parts

What Determines Where a Product is Produced?

The first chapters of this book consider alternative theories that economists have developed over time to explain patterns of production and trade. The most fundamental reasons to engage in international trade are differences in climates, natural resources, or know-how. These factors contribute to the substantial differences in production costs observed across countries. Note that these theories do not necessarily focus on one firm (aka Apple Inc.), but on a country. Trade theory is based on the welfare of an entire nation, and a central tenet is the possibility for mutual gains of trade for each country. Not everyone within a country may gain from trade, however, so we must also understand how the gains to some potentially offset the losses to others.

In the early twentieth century, two Swedish economists, Eli Heckscher and Bertil Ohlin, proposed a trade theory that focused on the availability of factors of production within a country (unskilled/ skilled labor or capital) and differences in factor requirements in the production of goods. Their framework, the Heckscher–Ohlin model, still serves today as a powerful tool to develop intuition about why countries engage in trade. The fact that some iPod components are produced in so called “high-wage countries” contradicts assertions in the popular press that firms thrive by ruthlessly exploiting low-wage workers. Rather, the production of many commodities requires a good amount of skilled labor. Trade theory suggests how the mix of factor inputs required at each stage of a production process, together with the comparative costs of those inputs, influences the production location decision. When the supply chain is as fragmented as in the case of the iPod, inputs are sourced from many different countries, and we examine when outsourcing of production becomes an attractive option for firms and countries.

The fact that the iPod spawned a whole industry of subsequent products (such as the iPod Nano or the Microsoft Zune) suggests that our study of international trade must also account for the introduction of new products. Innovations require upfront costs of research and development (R&D). This implies that a company like Apple must have some market power to recover its R&D outlays. To do so, it must be able to charge a price that exceeds the unit cost of production. Subsequent chapters examine how trade is affected when markets are not competitive and firms have ownership or location advantages that allow them to differentiate their product, segment the market, and charge a price that exceeds marginal costs.

Multinational Corporations and Trade

Even if there were no differences in wages and interest rates across countries, Apple would be unlikely to locate a production plant in every single country where it sold iPods. Rather, firms seek to achieve economies of scale by concentrating production in just a few locations in order to spread the fixed costs of production over more units of output. Then the product is shipped internationally.

Yet, why does Apple outsource iPod production in the first place? Even if the company realizes that there are gains from trade and that it is advantageous to produce inputs in different countries, why doesn’t Apple produce all the inputs itself? Is its most profitable strategy just to design and market products, not to produce them? When Apple assembles iPods in China, it does not do so in a factory owned by Apple. Rather, it contracts with a third party to produce according to the specifications it provides.

Actually, much of international trade does take place among affiliates and/or subsidiaries across the globe. No one pattern describes the production decision of all companies. When does a multinational seek to keep its production processes secret, and when can it risk outsourcing production? We devote a chapter to addressing such questions concerning the movement of companies across borders, and we additionally consider related incentives for the migration of labor and the flow of capital and technology.

How do Governments Influence International Trade?

Imagine the European Union imposed a 10 percent tariff on Japanese cars (well, actually it has) or that Canada imposed a $75 tax on iPods (as it attempted in January 2008, but the Canadian high court ruled the tariff was unconstitutional). One might jump to the conclusion that this action would simply add 10 percent to the price of Japanese cars in Europe, but things are more complicated than that. Prices are determined by the interaction between supply and demand, and the tariff may have induced Japanese companies to locate production plants within the European Union. The price of an iPod in Canada undoubtedly would have risen if the tax had been imposed, and Canadians would have lived with less music in their lives, unless they drove across the border to buy their iPods in the United States.

Starting in Chapter 6, we examine how government trade policies affect national welfare. Generally, the consequences for economic efficiency are negative. This immediately raises the question why governments choose to intervene in international trade in the first place. This question cannot be answered satisfactorily without formulating political economy models that consider not only the action of firms (such as Apple), but also the incentives of the owners of factors (such as workers) and the interests of politicians who serve specific interest groups or try to maximize their prospects of staying in office.

A further dimension of trade policy becomes apparent when we notice that all of Apple’s suppliers are members of the World Trade Organization (WTO). Is this an accident? It turns out that multilateral tariff reductions via the WTO (or its predecessor the General Agreement on Tariffs and Trade, GATT) have been accompanied by enormous expansions of international trade. Why do countries join multilateral tariff reduction agreements, and how do these agreements contribute to the more intricate supply chains and marketing decisions of multinationals like Apple Inc.? Not all agreements are made within the halls of the WTO in Geneva, however. Some countries reduce their trade restrictions on a preferential basis for just some countries, as is done for fellow members of the European Union or the North American Free Trade Agreement. In those situations, does such trade liberalization help the members, but hurt those that are not members? We address these questions about alternative forms of government trade policy intervention in the chapters that follow our initial treatment of unilateral trade policy choices made by a single country.

Assembly of the iPod and other consumer electronics in China typically takes place in special enterprise zones where taxes on imports are waived as long as the final goods are exported. What makes that arrangement attractive to Chinese policy makers and to Apple? Debate over the appropriate trade policy for developing countries remains contentious. Even the claim that exports have been critical to the amazing growth of several Asian economies is disputed by some economists. You will be asked to assess those claims in the chapters ahead.

International Finance – Exchange Rates

Table 1.1 shows that at least seven companies in five countries are involved in iPod production. Each of these countries has its own national currency. How does Apple pay its trading partners in foreign countries? Where and how does it obtain foreign currency and at what price? Do foreign companies perhaps accept U.S. dollars, or do they seek payments in currencies that they can in turn use to purchase their own inputs? These are some of the questions we address in the second part of this textbook when we explicitly examine macroeconomic aspects of the international economy.

One building block that economists use to keep track of the sources of demand and supply of a currency internationally is a balance of payments sheet. The nature of Apple’s iPod production and distribution should warn us that focusing on a balance of imports and exports with a single country, such as the U.S. trade balance with China, can be highly misleading, because only a small share of the value of an iPod is actually produced in China. Apple also has an incentive to declare its profits in locales where it can minimize its tax burden, which is likely to further influence the price it assigns to the assembled products it brings into the United States. In spite of these complications, which make it more difficult to interpret balance of payments entries than in previous eras, we still will find that they provide useful insights about what fundamental factors influence the market for a country’s currency.

International trade involves the use of various currencies. A key question is to determine how we measure the price of foreign currency (i.e. the exchange rate), first when only one other country is involved and then when we account for the reality of a world with many trade partners and potential investors abroad. We should not be surprised that the price Apple Inc. has to pay for foreign currency directly influences its bottom line. The cost of a foreign component varies not only with the price quoted in a foreign currency, but also with the exchange rate. Indeed Apple’s quarterly report to the U.S. Securities and Exchange Commission on July 23, 2008 indicates that:

In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars.

How countries choose to intervene to influence their exchange rate is a basic national choice that impacts Apple’s dealings in various markets. When Apple trades with a Japanese company, for example, the exchange rate can change from day to day (second by second, in fact). In contrast, the Chinese central bank plays a much more direct role in determining its exchange rate. Until July 2005, its policy was to fix the price it charged to exchange Chinese currency for U.S. dollars. In that setting, Apple could confidently forecast the Chinese/U.S. exchange rate weeks in advance!

Why would a country fix its exchange rate and what are the actual mechanics involved in such a “fix”? This type of government intervention sounds like price controls that you may have encountered in your introductory economics class (for example in agricultural markets). The international macroeconomics section of this textbook discusses in detail how exchange rate fluctuations can have a profound and, at times, adverse impact on the domestic economy. Hence it might be in the interest of a country to manage exchange rate fluctuations. Once we have developed a basic framework to analyze the open economy, we can examine how fiscal and monetary policies affect the exchange rate and output in a global economy. Then we can assess the costs and benefits associated with the different ways a central bank may choose to manage the value of its currency.

Open Economy Models and Policy

We begin our analysis of open economies by formulating simple models where there are no international capital flows. That is a far cry from the world confronting Apple, but that background helps us sort out the additional implications that capital flows introduce. When we allow for such flows, the many new innovations in international financial markets with respect to futures, forwards, swaps, and options play a significant role, and we devote a chapter to explaining the economic significance of that specialized collection of international financial instruments.

For a sample of what these financial innovations mean for Apple, consider another passage from its July 2008 report, which states that the company:

may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its material foreign exchange exposures, typically for 3 to 6 months.

At this point, much of what Apple seems to be doing to insulate itself from foreign exchange risk may sound a bit like financial gibberish. We will demonstrate how those strategies help Apple limit the foreign exchange risks it faces and lock in future profits earned in different countries.

International financial flows have not only spawned financial innovations, but they also influence whether a government’s monetary and fiscal policy is successful in stabilizing its economic performance. So the models of the earlier chapters must be extended to take into account these international flows of capital. For example, U.S. policy makers may favor very low interest rates to encourage more demand for housing and to promote recovery of the construction industry. When international capital flows are possible, the lower interest rate is likely to result in a capital outflow and a weaker dollar. That may spur U.S. exports and have a more immediate effect on U.S. output than any recovery in the housing market. With respect to the prospects of a single company such as Apple, the weaker dollar also means that its euro earnings translate into more dollars and allows it to report a higher profit rate to its stockholders.

The progression of models we use also allows for the effects of rising prices. While developing countries in particular have been remarkably more successful in controlling inflation in this decade than in previous decades, the implications of rising prices can be ignored only with great peril. A company such as Apple has a particular stake in China successfully managing to keep its economy from overheating and generating higher inflation rates; whether China maintains its billing as the workshop of the world depends importantly upon that answer.

International Monetary Developments

Over the past century or so, the financial monetary system has seen great changes. We have now reached an era with near perfect capital mobility and a host of new international financial entities, practices, and instruments, e.g. offshore operations, derivatives. These activities cannot be regulated at the national level, and international agencies need to scrutinize and police them. Multinationals such as Apple strive to do business in countries with a minimal level of regulations to maximize their profit, but this must be balanced against the risk of an international financial meltdown that would have dire consequences on their business.

Any text in international macroeconomics must address the European monetary integration. A large group of important countries sharing a common currency and instituting common financial regulations will certainly facilitate business dealings for a multinational such as Apple. Foreign exchange risk and accounting costs are reduced. On the other hand, the increase in transparency means that it will be easier ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of Case Studies
• List of Boxes
• List of Figures
• List of Tables
• Preface
• 1 Introduction: Life in an International Economy
• PART I INTERNATIONAL TRADE AND TRADE POLICY
• PART II INTERNATIONAL FINANCE AND OPEN ECONOMY MACROECONOMICS
• Glossary