Posted: June 21st, 2015

Comparative Advantage and the Open Economy and Exchange Rates and the Balance of Payments

Comparative Advantage and the Open Economy and Exchange Rates and the Balance of Payments

The production of linen requires twice as much land and labor as the production of an equivalent amount of cotton. Nevertheless, linen is a staple material utilized in designer clothing, such as women’s blazers and dresses with prices exceeding $2,000, men’s trench coats that sell for more than $1,500, and wedding gowns priced above $5,500.

Two-thirds of the world’s linen is derived from a fiber called flax that is harvested within a narrow belt of farmland stretching from northern France into the Netherlands. The European coastal climate provides alternating sunshine and rain that contribute to development of a fungus that grows on the flax stems. The fungus breaks down the stems so that the linen fibers can be more readily separated from the plants. Thus, farmers residing this area are able to produce flax at a lower opportunity cost, in terms of forgone production of other goods, than almost anywhere else on the planet. This fact explains why this region of Europe has a comparative advantage in growing flax and specializes in the production of linen.

Why do you think that linen production generates gains from trade for European producers of flax and linen, even though cotton-based fabrics can be produced at lower absolute cost in many other parts of the world?

2. The U.S. Export-Import (Exim) Bank regularly extends about $100 billion in subsidized loans to foreign buyers of U.S.-manufactured products, including aircraft, hair-care products, and construction equipment. The Exim Bank’s extensions of taxpayer-subsidized credit to companies in other nations gives these foreign firms incentives to buy U.S. exports.

Airlines based in the United States are not enthused about aircraft-loan subsidies to competitors based in other nations, however. The U.S. airlines argue that the Exim Bank’s low-interest loans to foreign carriers provide a cost advantage that enables the foreign airlines to compete at lower expense in the international air transportation market. Thus, from the U.S. airlines’ point of view, U.S. taxpayers are subsidizing their foreign competitors.

Why do you suppose that some U.S. makers of hair-care products and certain U.S. construction contractors that bid for work in other nations have lodged complaints similar to those of the U.S. airlines?

3. Among the imported items for which the 1991 legislation sharply reduced U.S. tariff rates were Colombian cut flowers. The Colombian climate is superior to that of the western United States for growing most flowers, and Colombian farm labor costs are much lower. Thus, within a few years after the reduction in tariffs, Colombian flower growers had established a network for selling cut flowers in California.

Furthermore, in 2010, the Colombian firms opened a large distribution center in Los Angeles to increase the flow of cut-flower imports into the United States. As Figure 32-7 on page 721 of your textbook indicates, Colombian flower growers’ efforts led to a substantial increase in U.S. flower imports from that nation during the 2000s. By 2010, U.S. imports of Colombian cut flowers were nearly 400 percent greater than the 2002 level. As Colombian flower imports into California bloomed, the sales of cut flowers by California growers shriveled. When Congress passed the Andean Trade Promotion Act, there were 450 Californian flower farms. By 2010, there were 250.

In response to the upsurge in competition from Colombia, the California Cut Flower Commission, a trade association, successfully lobbied to delay congressional approval of a renewal of the Andean regional trade pact. The consequence was a re-imposition in 2011 of tariffs on Colombian flower growers, whose tariff payments increased sharply. As shown in Figure 32-7 on page 721, this significant tariff increase resulted in a considerable reduction in cut-flower imports from Colombia. As a consequence, the foreign supply of cut flowers in California decreased, and the demand for Californian cut flowers increased, which pushed up U.S. prices of cut flowers. Even as California flower growers’ earnings flourished, they began lobbying for U.S. government subsidies to enable them to establish their own cut-flower distribution center to compete with Colombia’s.

a. Which region appears to have a comparative advantage in producing cut flowers: Colombia or California? Explain.