What You Will Learn in this Chapter

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  How comparative advantage leads to mutually beneficial international trade
• 
  The sources of international comparative advantage
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  Who gains and who loses from international trade, and why the gains exceed the losses
• 
  How tariffs and import quotas cause inefficiency and reduce total surplus
• 
  The meaning of the balance of payments accounts and the determinants of international capital flows
• 
  The role of the foreign exchange market and the exchange rate

Car Parts and Sucking Sounds

International trade improves the welfare of Mexican producers of auto parts as well as American car buyers and sellers.

Susana Gonzalez/Bloomberg via Getty Images
Scott Olson/Getty Images

STOP IN AN AUTO SHOWROOM, and odds are that the majority of cars on display were produced in the United States. Even if they’re Nissans, Hondas, or Volkswagens, most cars sold in this country were made here by the Big Three U.S. auto firms or by subsidiaries of foreign firms. The cars are assembled in “Auto Alley,” a north–south corridor roughly defined as the space between Interstate 65, which runs from Chicago to Mobile, and Interstate 75, which runs from Detroit to western Florida.

Although that car you’re looking at may have been made in America, a significant part of what’s inside was probably made elsewhere, very likely in Mexico. Since the 1980s, U.S. auto production has increasingly relied on factories in Mexico to produce labor-intensive auto parts, such as seat parts—products that use a relatively high amount of labor in their production.

Changes in economic policy over the years have contributed greatly to the emergence of large-scale U.S. imports of auto parts from Mexico. Until the 1980s, Mexico had a system of trade protection—taxes and regulations limiting imports—that both kept out U.S. manufactured goods and encouraged Mexican industry to focus on selling to Mexican consumers rather than to a wider market. In 1985, however, the Mexican government began dismantling much of its trade protection, boosting trade with the United States. A further boost came in 1993, when the United States, Mexico, and Canada signed the North American Free Trade Agreement (NAFTA), which eliminated most taxes on trade among the three nations and provided guarantees that business investments in Mexico would be protected from arbitrary changes in government policy.

NAFTA was deeply controversial when it went into effect: Mexican workers were paid only about 10% as much as their U.S. counterparts, and many expressed concern that U.S. jobs would be lost to low-wage competition. Most memorably, Ross Perot, a U.S. presidential candidate in 1992, warned that there would be a “giant sucking sound” as U.S. manufacturing moved south of the border. And although apocalyptic predictions about NAFTA’s impact haven’t come to pass, the agreement remains controversial even now.

Most economists disagreed with those who saw NAFTA as a threat to the U.S. economy. We saw in Chapter 2 how international trade can lead to mutual gains from trade. Economists, for the most part, believed that the same logic applied to NAFTA, that the treaty would make both the United States and Mexico richer. But making a nation as a whole richer isn’t the same thing as improving the welfare of everyone living in a country, and there were and are reasons to believe that NAFTA hurts some U.S. citizens.

Until now, we have analyzed the economy as if it were self-sufficient, as if the economy produces all the goods and services it consumes, and vice versa. This is, of course, true for the world economy as a whole. But it’s not true for any individual country. Assuming self-sufficiency would have been far more accurate 50 years ago, when the United States exported only a small fraction of what it produced and imported only a small fraction of what it consumed.

Since then, however, both U.S. imports and exports have grown much faster than the U.S. economy as a whole. Moreover, compared to the United States, other countries engage in far more foreign trade relative to the size of their economies. To have a full picture of how national economies work, we must understand international trade.

This chapter examines the interaction of national economies. We begin with a discussion of the economics of international trade. With that foundation established, we move on to discuss how trade and capital flows are part of the balance of payments accounts. Finally, we look at the various factors that influence exchange rates.