3.1.2 Raising Financial Capital in Business
3.1.3 Business Cycle
3.1.4 What is Trade
3.1.5 Measuring Trade between Nations
3.1.6 Barriers to Trade
Financial Markets and Trade
Overview
Functions of Money
Learning Objectives
10a Understand the functions of money.
What is Money?
Finance is about money. So, our first question is: What is money? If you happen to have one on you, take a look at a $5 bill. What you’ll see is a piece of paper with a picture of Abraham Lincoln on one side and the Lincoln Memorial on the other. Though this piece of paper—indeed, money itself—has no intrinsic value, it’s certainly in demand. Why? Because money serves three basic functions.
Money is a:
- medium of exchange;
- measure of value;
- and store of value.
To get a better idea of the role of money in a modern economy, let’s imagine a system in which there is no money. In this system, goods and services are bartered—traded directly for one another. Now, if you’re living and trading under such a system, for each barter exchange that you make, you’ll have to have something that another trader wants. For example, say you’re a farmer who needs help clearing his fields. Because you have plenty of food, you might enter into a barter transaction with a laborer who has time to clear fields but not enough food: he’ll clear your fields in return for three square meals a day. This system will work as long as two people have exchangeable assets.
However, the barter system can be inefficient. For instance, the person providing the labor for the field-clearing should ethically be paid more than what amounts to maybe $20 a day through the cost of meals. In fact, such labor—under currently emerging minimum wage guidelines—should ethically be no less than $120 per day. Money improves the exchange for all the parties involved in an offering exchange.
Medium of Exchange
Money serves as a medium of exchange because people will accept it in exchange for goods and services. Because people can use money to buy the goods and services that they want, everyone’s willing to trade something for money. The laborer will take money for clearing your fields because he can use it to buy food. You’ll take money as payment for his food because you can use it not only to pay him, but also to buy something else you need (perhaps seeds for planting crops).
For money to be used as a medium of exchange, it must possess a few crucial properties:
- It must be divisible—easily divided into usable quantities or fractions. (A $5 bill, for example, is equal to five $1 bills.)
- It must be portable—easy to carry; it can’t be too heavy or bulky.
- It must be durable—strong enough to resist tearing and the print can’t wash off if it winds up in the washing machine.
- It must be difficult to counterfeit. (It won’t have much value if people can make their own.)
Measure of Value
Money simplifies exchanges because it serves as a measure of value. We state the price of a good or service in monetary units so that potential exchange partners know exactly how much value we want in return for it. This practice is a lot better than bartering because it’s much more precise than an ad hoc agreement that a day’s work in the field has the same value as three meals.
Store of Value
Money serves as a store of value. Because people are confident that money keeps its value over time, they’re willing to save it for future exchanges. Under a bartering arrangement, the laborer earned three meals a day in exchange for his work. But what if, on a given day, he skipped a meal? Could he “save” that meal for another day? Maybe, but if he were paid in money, he could decide whether to spend it on food each day or save some of it for the future. If he wanted to collect on his “unpaid” meal two or three days later, the farmer might not be able to “pay” it; unlike money, food could go bad.
The Money Supply
Now that we know what money does, let’s tackle another question: How much money is there? How would you go about “counting” all the money held by individuals, businesses, and government agencies in this country? You could start by counting the money that’s held to pay for things on a daily basis. This category includes cash (paper bills and coins) and funds held in demand deposits—checking accounts, which pay given sums to “payees” when they demand them. Then, you might count the money that’s being “saved” for future use. This category includes interest-bearing accounts, time deposits (such as certificates of deposit, which pay interest after a designated period of time), and money market mutual funds, which pay interest to investors who pool funds to make short-term loans to businesses and the government.
M-1 and M-2
Counting all this money would be a daunting task (in fact, it would be impossible). Fortunately, there’s an easier way—namely, by examining two measures that the government compiles for the purpose of tracking the money supply: M-1 and M-2.
The narrowest measure, M-1, includes the most liquid forms of money—the forms, such as cash and checking-accounts funds, that are spent immediately.
M-2 includes everything in M-1 plus near-cash items invested for the short term—savings accounts, time deposits below $100,000, and money market mutual funds.
So, what’s the bottom line? How much money is out there? To find the answer, you can go to the Federal Reserve Board Web site. The Federal Reserve reports that in December 2008, M-1 was about $1.6 trillion dollars and M-2 was $8.2 trillion.
If you’re thinking that the numbers in Figure 3.1.1a are too big to make much sense, you’re not alone. One way to bring them into perspective is to figure out how much money you’d get if all the money in the United States were redistributed equally. According to the U.S. Census Population Clock, there are 305,726,680 people in the United States. Your share of M-1, therefore, would be about $5,200 and your share of M-2 would be about $27,000.
What is “Plastic Money”?
Are credit cards a form of money? If not, why do we call them plastic money? Actually, when you buy something with a credit card, you’re not spending money. The principle of the credit card is buy-now-pay-later. In other words, when you use plastic, you’re taking out a loan that you intend to pay off when you get your bill. And the loan itself is not money. Why not? Basically, because the credit card company can’t use the asset to buy anything. The loan is merely a promise of repayment. The asset doesn’t become money until the bill is paid (with interest). That’s why credit cards aren’t included in the calculation of M-1 and M-2.
Attributions
Title Image: Image of Farmer's Market (Credit: PhotoMix-Company, https://pixabay.com/photos/the-market-fresh-grocery-store-food-3147758/, CC0 Content)
Description: Image of rows of fruits and vegetables on display at a farmer's market.
"An Introduction to Business v.1.0" by Anonymous , 2012 Book Archive is licensed under CC BY-NC-SA 3.0
Raising Financial Capital in Business
Learning Objectives
10b Develop basic understanding of financial markets: stocks, commodities, securities.
Raising Financial Capital
Firms often make decisions that involve spending money in the present and expecting to earn profits in the future. Examples include when a firm buys a machine that will last 10 years, or builds a new plant that will last for 30 years, or starts a research and development project.
Firms can raise the financial capital they need to pay for such projects in four main ways: (1) from early-stage investors; (2) by reinvesting profits; (3) by borrowing through banks or bonds; and (4) by selling stock. When business owners choose financial capital sources, they also choose how to pay for them.
Early-Stage Financial Capital
Firms that are just beginning often have an idea or a prototype for a product or service to sell, but, at the beginning stage they have few customers—or even no customers at all—and thus are not earning profits. Such firms face a difficult problem when it comes to raising financial capital. Think of it this way: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors?
For many small businesses, the original source of money is the business owner. Someone who decides to start a restaurant or a gas station, for instance, might cover the startup costs by dipping into their own bank account, or by borrowing money (perhaps using a home as collateral). Alternatively, many cities have a network of well-to-do individuals, known as “angel investors,” who will put their own money into small new companies at an early development stage, in exchange for owning some portion of the firm.
Venture capital firms make financial investments in new companies that are still relatively small in size, but those new companies have to show the potential to grow substantially. These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small startups. They also provide advice on potential products, customers, and key employees. Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns, according to how the fund as a whole performs.
The amount of money invested in venture capital fluctuates substantially from year to year: as one example, venture capital firms invested more than $48.3 billion in 2014, according to the National Venture Capital Association.
All early-stage investors realize that the majority of small startup businesses will never hit it big; many of them will go out of business within a few months or years. They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon can make up for multiple failures. Therefore, early-stage investors are willing to take large risks in order to position themselves to gain substantial returns on their investment.
Profits as a Source of Financial Capital
If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable financial capital source—so that it can continue making real investments in tough times, the firm may not survive until better times arrive. Firms often need to find financial capital sources other than profits.
Borrowing: Banks and Bonds
When a firm has a record of at least earning significant revenues—and better still of earning profits, the firm can make a credible promise to pay interest; in this way, it becomes possible for the firm to borrow money. Firms have two main borrowing methods: bank loans and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.
A bond is a financial contract: a borrower agrees to repay the amount that it borrowed and also an interest rate over a period of time in the future. A bond specifies an amount that one will borrow, the interest rate that one will pay, and the time until repayment. A corporate bond is issued by firms. But bonds are also issued by various levels of government; for example, a municipal bond is issued by cities, a state bond by U.S. states, and a Treasury bond by the federal government through the U.S. Department of the Treasury.
A large company, for example, might issue bonds for $10 million. The firm promises to make interest payments at an annual rate of 8%, or $800,000 per year; after 10 years, the company will repay the $10 million it originally borrowed. When a firm issues bonds, it may choose to issue many bonds in smaller amounts that together reach the total amount it wishes to raise. A firm that seeks to borrow $50 million by issuing bonds, might actually issue 10,000 bonds of $5,000 each. In this way, an individual investor could, in effect, loan the firm $5,000, or any multiple of that amount.
Anyone who owns a bond and receives the interest payments is called a bondholder. If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee the firm will have sufficient assets to pay off the bonds. The bondholders may recoup only a portion of what they loaned the firm.
Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms. The bank can get to know the firm extremely well—often because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals. Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, or to raise capital to pay off old bonds, or to buy other firms. However, the idea that firms or individuals use banks for relatively smaller loans and bonds for larger loans is not an ironclad rule: sometimes groups of banks make large loans, and sometimes relatively small and lesser-known firms issue bonds
Corporate Stock and Public Firms
A corporation is a business that “incorporates”—that is owned by shareholders that have limited liability for the company's debt but share in its profits (and losses). Corporations may be private or public, and they may or may not have publicly traded stock. They may raise funds to finance their operations or new investments by raising capital through selling stock or issuing bonds.
Those who buy the stock become the firm's owners, or shareholders. Stock represents firm ownership. A person who owns 100% of a company’s stock, by definition, owns the entire company.
The company's stock is divided into shares. Corporate giants like IBM, AT&T, Ford, General Electric, and Exxon all have millions of stock shares. In most large and well-known firms, no individual owns a majority of the stock shares. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the firm's overall ownership.
When a large number of shareholders own a company, there are three questions to ask:
How and when does the company obtain money from its sale of stock?
A firm receives money from the stock sale only when the company sells its own stock to the public (the public includes individuals, mutual funds, insurance companies, and pension funds). We call a firm’s first stock sale to the public an initial public offering (IPO). The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock (shares that a company keeps in their own treasury) or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. A venture capital firm may have a 40% ownership in the firm. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for substantially expanding its operations.
However, most of the time when one buys and sells corporate stock the firm receives no financial return at all. If you buy General Motors stock, you almost certainly buy it from the current share owner, and General Motors does not receive any of your money. This pattern should not seem particularly odd. After all, if you buy a house, the current owner receives your money, not the original house builder. Similarly, when you buy stock shares, you are buying a small slice of the firm's ownership from the existing owner—and the firm that originally issued the stock is not a part of this transaction.
What rate of return does the company promise to pay when it sells stock?
When a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. Alternatively, a financial investor might buy a share of stock in Wal-Mart for $45 and then later sell it to someone else for $60, for $15 gain. We call the increase in the stock value (or of any asset) between when one buys and sells it a capital gain.
Who makes decisions in a company owned by a large number of shareholders? Who makes the decisions about when a firm will issue stock, or pay dividends, or re-invest profits?
To understand the answers to these questions, it is useful to separate firms into two groups: private and public. A private company is frequently owned by the people who generally run it on a day-to-day basis. Individuals can run a private company. We call this a sole proprietorship. If a group runs it, we call it a partnership. A private company can also be a corporation, but with no publicly issued stock. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship. Partners may jointly own a larger law firm. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm.
When a firm decides to sell stock, which financial investors can buy and sell, we call it a public company. Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis. The more stock a shareholder owns, the more votes that shareholder is entitled to cast for the company’s board of directors.
In theory, the board of directors helps to ensure that the firm runs in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will serve on their board of directors. After all, few shareholders are knowledgeable enough or have enough personal incentive to spend energy and money nominating alternative board members.
How Firms Choose between Financial Capital Sources
There are clear patterns in how businesses raise financial capital. We can explain these patterns in terms of imperfect information, which is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.
Any young startup firm is a risk. Some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information than anyone else about how hard they are willing to work, and whether the firm is likely to succeed. When the founders invested their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers and their business plan personally and by giving them advice.
Accurate information is sometimes not available because corporate governance, the name economists give to the institutions that are supposed to watch over top executives, fails, as the Lehman Brothers example shows.
In 2008, Lehman Brothers was the fourth largest U.S. investment bank, with 25,000 employees. The firm had been in business for 164 years. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. There are many causes of the Lehman Brothers failure. One area of apparent failure was the lack of oversight by the Board of Directors to keep managers from undertaking excessive risk. We can attribute part of the oversight failure, according to Tim Geithner’s April 10, 2010, testimony to Congress, to the Executive Compensation Committee’s emphasis on short-term gains without enough consideration of the risks. In addition, according to the court examiner’s report, the Lehman Brother’s Board of Directors paid too little attention to the details of the operations of Lehman Brothers and also had limited financial service experience.
The board of directors, elected by the shareholders, is supposed to be the first line of corporate governance and oversight for top executives. A second institution of corporate governance is the auditing firm the company hires to review the company's financial records and certify that everything looks reasonable. A third institution of corporate governance is outside investors, especially large shareholders like those who invest large mutual funds or pension funds. In the case of Lehman Brothers, corporate governance failed to provide investors with accurate financial information about the firm’s operations.
Borrowing Money for Financial Capital
As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important, because information has become more widely available regarding the company’s products, revenues, costs, and profits. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.
At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing money is that the firm maintains control of its operations and is not subject to shareholders. Issuing stock involves selling off company ownership to the public and becoming responsible to a board of directors and the shareholders.
The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about repaying this money. If the firm is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing and placing stock is expensive, requires the expertise of investment bankers and attorneys, and entails compliance with reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission (SEC).
Attributions
"Principles of Microeconomics 3e" by David Shapiro, Daniel MacDonald, Steven A. Greenlaw, OpenStax is licensed under CC BY 4.0
Business Cycle
More recent information can be researched through the following organizations and their websites: US Bureau of Economic Analysis and National Bureau of Economic Research.
Learning Objectives
10c Discuss the business cycle.
Business Cycle
Although the US economy has grown significantly over time, the growth has not occurred at a constant, consistent pace. At times, the economy has experienced faster-than-average growth, and occasionally the economy has experienced negative growth. For any quarter in which real GDP is growing, the percentage change will be positive. When the growth rate of real GDP is negative, the economy is shrinking. The percentage change in real GDP for each quarter is shown in Figure 3.1.3a—which is an illustration of the growth of GDP over time.
There has been a definitive long-term upward trend in GDP, but it has not been in a straight line. Instead, the economy has expanded much like the curve: periods of quick growth are followed by slower or even negative growth. These alternating growth periods are known as the business cycle.
Stages of the Business Cycle
The business cycle consists of a period of economic expansion followed by a period of economic contraction. During the period of economic expansion, the GDP rises. And employment expands as businesses produce more, while unemployment falls. Other measures of economic growth may include increased new business starts and new home construction. The economy is said to be “heating up.” Unfortunately, as the expansion continues, inflation often becomes a concern.
Fast-paced economic expansion is not sustainable. Eventually, growth slows and unemployment rises. The economy has moved from expansion to contraction when this occurs. Often, the contraction is referred to as a recession. The point at which the business cycle turns from expansion to contraction is known as the peak. The point at which the contraction ends and the economy begins to expand again is known as the trough. The length of one business cycle is measured by the time from one trough to the trough of the next cycle, as shown in Figure 3.1.3c.
A private think tank, the National Bureau of Economic Research (NBER), tracks the business cycle in the United States. The NBER is the entity that officially declares recessions in the United States. The National Bureau of Economic Research was founded in 1920 to create measures of economic activity that could be used in public policy discussions. It is a private, nonpartisan organization that conducts research that is followed by businesses and the public sector.
Historically, a recession was defined as two consecutive quarters of declining GDP. Today, the NBER defines a recession in a broader, less precise manner; it will declare a recession when there is a significant decline in economic activity that is spread across the economy and lasts for at least a few months. Measures of real income, employment, industrial production, and wholesale and retail sales are considered in addition to real GDP.
Historical Trends
The NBER has identified business cycle peaks and troughs in data going back to the mid-19th century. Figure 3.1.3d lists each of these cycles, denoting the months of peaks and troughs.
In Figure 3.1.3d. we see a repetition of the economic behavior—an expansion, a peak, a recession, and a trough, followed by yet another expansion, peak, recession, and trough. The cycles are events that repeatedly occur in the same order. However, the cycles are not identical; the lengths of the cycles vary greatly. On average, the contractions have lasted about 17 months and expansions have lasted about 41 months. The typical business cycle has been about 4.5 years long.
When this section was initially drafted (2021), the United States was in an economic recession. The previous trough was in June 2009. From the summer of 2009 through February 2020, the US economy was in the expansionary phase of the business cycle. This 128-month expansion is the longest expansion in US history. This expansion peaked in February 2020, when the economy fell into a contractionary period associated with the COVID-19 pandemic.
Only two other expansions have lasted for over 100 months: the 120-month expansion that ran through the 1990s and the 106-month expansion that ran during the 1960s. The longest recessionary period on record is the 65-month recession that occurred during the 1870s. The recession that began in 1929 was the second-longest recession in US history. At 43 months long, this recession that ended in 1933 was so severe that it has been called the Great Depression.
Attributions
"Principles of Finance" by Julie Dahlquist, Rainford Knight, OpenStax is licensed under CC BY 4.0
Access for free at: https://openstax.org/books/principles-finance/pages/3-3-business-cycles-and-economic-activity
What is Trade?
Learning Objectives
10d Know about the balance of trade.
Globalization
The globalization of business is bound to affect you. Not only will you buy products manufactured overseas, but it’s highly likely that you’ll meet and work with individuals from various countries and cultures as customers, suppliers, colleagues, employees, or employers. The bottom line is that the globalization of world commerce has an impact on all of us. Therefore, it makes sense to learn more about how globalization works.
Never before has business spanned the globe the way it does today. And this leads to some important questions we should tackle in this section:
- Why is international business important?
- Why do companies and nations engage in international trade? What strategies do they employ in the global marketplace?
- What challenges do companies face when they do business overseas?
- How do governments and international agencies promote and regulate international trade?
- Is the globalization of business a good thing?
- What career opportunities are there for you in global business? How should you prepare yourself to take advantage of them?
Why Do Nations Trade?
No national economy produces all the goods and services that its people need. That is why the United States imports automobiles, steel, digital phones, and apparel from other countries. That is also why other countries buy wheat, chemicals, machinery, and consulting services from us. Importers buy goods and services from other countries; exporters sell products to other nations.
The monetary value of international trade is enormous. In 2010, the total value of worldwide trade in merchandise and commercial services was $18.5 trillion, according to the World Trade Organization press release entitled “Trade growth to ease in 2011 but despite 2010 record surge, crisis hangover persists.”
Absolute and Comparative Advantage
To understand why certain countries import or export certain products, you need to realize that every country (or region) can’t produce the same products. The cost of labor, the availability of natural resources, and the level of know-how vary greatly around the world. Most economists use the concepts of absolute advantage and comparative advantage to explain why countries import some products and export others.
Absolute Advantage
A nation has an absolute advantage if (1) it’s the only source of a particular product or (2) it can make more of a product using the same amount of or fewer resources than other countries. Because of climate and soil conditions, for example, France had an absolute advantage in wine making until its dominance of worldwide wine production was challenged by the growing wine industries in Italy, Spain, and the United States. Unless an absolute advantage is based on some limited natural resource, it seldom lasts. That’s why there are few, if any, examples of absolute advantage in the world today.
Comparative Advantage
Comparative advantage exists when a country can produce a product at a lower opportunity cost compared to another nation. Now we are referring back to a term you learned in the first chapter of this book: opportunity cost. Opportunity costs, in this scenario, are the products that a country must decline to make in order to produce something else. When a country decides to specialize in a particular product, it must sacrifice the production of another product.
Let’s simplify things by imagining a world with only two countries—the Republic of High Tech and the Kingdom of Low Tech. We’ll pretend that each country knows how to make two and only two products: wooden boats and telescopes. Each country spends half its resources (labor and capital) on each good. Figure 3.1.4a "Comparative Advantage in the Techs" shows the daily output for both countries: High Tech makes three boats and nine telescopes while Low Tech makes two boats and one telescope.
First, note that High Tech has an absolute advantage (relative to Low Tech) in both boats and telescopes: it can make more boats (three versus two) and more telescopes (nine versus one) than Low Tech can with the same resources. So, why doesn’t High Tech make all the boats and all the telescopes needed for both countries? Because it lacks sufficient resources to make all the boats and all the telescopes, High Tech must, therefore, decide how much of its resources to devote to each of the two goods.
Let’s assume that each country could devote 100 percent of its resources on either of the two goods. We’ll pick boats as a start. If both countries spend all their resources on boats (and make no telescopes), here’s what happens:
- When we assumed that High Tech spent half of its time on boats and half of its time on telescopes, it was able to make nine telescopes. If it gives up the opportunity to make the nine telescopes, it can use the time gained by not making the telescopes to make three more boats (the number of boats it can make with half of its time). Because High Tech could make three more boats by giving up the opportunity to make the nine telescopes, the opportunity cost of making each boat is three telescopes (9 telescopes ÷ 3 boats = 3 telescopes).
- When we assumed that Low Tech spent half of its time on boats and half of its time on telescopes, it was able to make only one telescope. If it gives up the opportunity to make the telescope, it can use the time gained by not making the telescope to make two more boats. Because Low Tech could make two more boats by giving up the opportunity to make one telescope, the opportunity cost of making each boat is half a telescope (1 telescope ÷ 2 boats = 1/2 of a telescope).
- Low Tech, therefore, enjoys a lower opportunity cost: Because it must give up less to make the extra boats (1/2 telescope vs. 3 telescopes), it has a comparative advantage for boats. And because it’s better—that is, more efficient—at making boats than at making telescopes, it should specialize in boat making.
Now to telescopes. Here’s what happens if each country spends all its time making telescopes and makes no boats:
- When we assumed that High Tech spent half of its time on boats and half of its time on telescopes, it was able to make three boats. If it gives up the opportunity to make the three boats, it can use the time gained by not making the boats to make nine more telescopes. Because High Tech could make nine more telescopes by giving up the opportunity to make three boats, the opportunity cost of making each telescope is one-third of a boat (3 boats ÷ 9 telescopes = 1/3 of a boat).
- When Low Tech spent half of its time on boats and half of its time on telescopes, it was able to make two boats. If it gives up the opportunity to make the two boats, it can use the time to make one more telescope. Thus, if High Tech wants to make only telescopes, it could make one more telescope by giving up the opportunity to make two boats. Thus, the opportunity cost of making each telescope is two boats (2 boats ÷ 1 telescope = 2 boats).
- In this case, High Tech has the lower opportunity cost: Because it had to give up less to make the extra telescopes (1/3 of a boat vs. 2 boats), it enjoys a comparative advantage for telescopes. And because it’s better—more efficient—at making telescopes than at making boats, it should specialize in telescope making.
Each country will specialize in making the good for which it has a comparative advantage—that is, the good that it can make most efficiently, relative to the other country. High Tech will devote its resources to telescopes (which it is good at making), and Low Tech will put its resources into boat making (which it does well). High Tech will export its excess telescopes to Low Tech, which will pay for the telescopes with the money it earns by selling its excess boats to High Tech. Both countries will be better off.
Things are a lot more complex in the real world; however, generally speaking, nations trade to exploit their advantages. They benefit from specialization, focusing on what they do best, and trading the output to other countries for what they do best.
The United States, for instance, is increasingly an exporter of knowledge-based products, such as software, movies, music, and professional services (management consulting, financial services, and so forth). America’s colleges and universities, therefore, are a source of comparative advantage, and students from all over the world come to the United States for the world’s best higher-education system.
France and Italy are centers for fashion and luxury goods and are leading exporters of wine, perfume, and designer clothing. Japan’s engineering expertise has given it an edge in such fields as automobiles and consumer electronics. And with large numbers of highly skilled graduates in technology, India has become the world’s leader in low-cost, computer-software engineering.
Attributions
"An Introduction to Business v.2.0" by Anonymous , 2012 Book Archive is licensed under CC BY-NC-SA 3.0
Measuring Trade between Nations
Information in this section was largely secured from the following source:
“U.S. Trade in Goods and Services—Balance of Payments (BOP) Basis, 1960 thru 2010,” June 9, 2011, http://www.census.gov/foreign-trade/statistics/historical/gands.txt (accessed August 21, 2011).
To encourage research on up to date statistics you might have students go to the same site and find current data.
Learning Objectives
10d Know about the balance of trade.
Measuring Trade between Nations
To evaluate the nature and consequences of its international trade, a nation looks at two key indicators. We determine a country’s balance of trade by subtracting the value of its imports from the value of its exports. If a country sells more products than it buys, it has a favorable balance, called a trade surplus. If it buys more than it sells, it has an unfavorable balance, or a trade deficit.
For many years, the United States has had a trade deficit: we buy far more goods from the rest of the world than we sell overseas. This fact shouldn’t be surprising. With high income levels, we not only consume a sizable portion of our own domestically produced goods but also enthusiastically buy imported goods. Trade deficits are not necessarily a bad thing. They can be positive if a country’s economy is strong enough both to keep growing and to generate the jobs and incomes that permit its citizens to buy the best the world has to offer. That was certainly the case in the United States in the 1990s.
Other countries, such as China and Taiwan, which manufacture primarily for export, have large trade surpluses because they sell far more goods overseas than they buy, which certainly seems like a positive thing that would lead to more cash flow.
The Negatives of Trade Deficits and Trade Surpluses
The rapidly accelerating trade deficit of the United States causes concerns for experts. Investment guru Warren Buffet, for example, cautioned in 2006 that no country can continuously sustain large and burgeoning trade deficits, because creditor nations will eventually stop taking IOUs from debtor nations. And, of course, the debts do have to paid at some point. Some observers are worried about the U.S. dollar, which has undergone an accelerating pattern of unfavorable balances of payments since the 1970s. For one thing, carrying negative balances has forced the United States to cover its debt by borrowing from other countries.
By the same token, trade surpluses aren’t necessarily good for a nation’s consumers. Japan’s export-fueled economy produced high economic growth in the 1970s and 1980s. But most domestically made consumer goods were priced at artificially high levels inside Japan itself—so high, in fact, that many Japanese traveled overseas to buy the electronics and other high-quality goods on which Japanese trade was dependent. CD players and televisions were significantly cheaper in Honolulu or Los Angeles than in Tokyo. How did this situation come about? Though Japan manufactures a variety of goods, many of them are made for export. To secure shares in international markets, Japan prices its exported goods competitively. Inside Japan, because competition is limited, producers can put artificially high prices on Japanese-made goods. Due to a number of factors (high demand for a limited supply of imported goods, high shipping and distribution costs, and other costs incurred by importers in a nation that tends to protect its own industries), imported goods are also expensive.
Balance of Payments
A key measure of the effectiveness of international trade is balance of payments: the difference, over a period of time, between the total flow of money coming into a country and the total flow of money going out. As in its balance of trade, the biggest factor in a country’s balance of payments is the money that comes in and goes out as a result of imports and exports. But balance of payments includes other cash inflows and outflows, such as cash received from or paid for foreign investment, loans, tourism, military expenditures, and foreign aid. For example, if a U.S. company buys some real estate in a foreign country, that investment counts in the U.S. balance of payments, but not in its balance of trade, which measures only import and export transactions. In the long run, having an unfavorable balance of payments can negatively affect the stability of a country’s currency.
Attributions
"An Introduction to Business v.2.0" by Anonymous , 2012 Book Archive is licensed under CC BY-NC-SA 3.0
Barriers to Trade
Students might research the effects of the 2017 - 2018 steel and aluminum tarrifs.
Learning Objectives
10d Know about the balance of trade.
10e Understand common barriers to trade and how they affect producers and consumers.
Obstacles to Trade
International trade is carried out by both businesses and governments—as long as no one puts up trade barriers. In general, trade barriers keep firms from selling to one another in foreign markets. The major obstacles to international trade are natural barriers, tariff barriers, and nontariff barriers.
Natural Barriers
Natural barriers to trade can be either physical or cultural.
Distance is one of the natural barriers to international trade. For instance, even though raising beef in the relative warmth of Argentina may cost less than raising beef in the bitter cold of Siberia, the cost of shipping the beef from South America to Siberia might drive the price too high.
Language is another natural trade barrier. People who can’t communicate effectively may not be able to negotiate trade agreements or may ship the wrong goods.
Tariff Barriers
A tariff is a tax imposed by a nation on imported goods. It may be a charge per unit, such as per barrel of oil or per new car; it may be a percentage of the value of the goods, such as 5 percent of a $500,000 shipment of shoes; or it may be a combination. No matter how it is assessed, any tariff makes imported goods more costly, so they are less able to compete with domestic products.
Protective tariffs make imported products less attractive to buyers than domestic products. The United States, for instance, has protective tariffs on imported poultry, textiles, sugar, and some types of steel and clothing. In March of 2018 the Trump administration added tariffs on steel and aluminum from most countries.
On the other side of the world, Japan imposes a tariff on U.S. cigarettes that makes them cost 60 percent more than Japanese brands. U.S. tobacco firms believe they could get as much as a third of the Japanese market if there were no tariffs on cigarettes. With tariffs, they have under 2 percent of the market.
Arguments For and Against Tariffs
Congress has debated the issue of tariffs since 1789.
The main arguments for tariffs include the following:
- Tariffs protect infant industries. A tariff can give a struggling new domestic industry time to become an effective global competitor.
- Tariffs protect U.S. jobs. Unions and others say tariffs keep foreign labor from taking away U.S. jobs.
- Tariffs aid in military preparedness. Tariffs should protect industries and technology during peacetime that are vital to the military in the event of war.
The main arguments against tariffs include the following:
- Tariffs discourage free trade, and free trade lets the principle of competitive advantage work most efficiently.
- Tariffs raise prices, thereby decreasing consumers’ purchasing power. In 2017, the United States imposed tariffs of 63.86 percent to 190.71 percent on a wide variety of Chinese steel products. The idea was to give U.S. steel manufacturers a fair market after the Department of Commerce concluded their antidumping and anti-subsidy probes. It is still too early to determine what the effects of these tariffs will be, but higher steel prices are likely. Heavy users of steel, such as construction and automobile industries, will see big increases in their production costs. It is also likely that China may impose tariffs on certain U.S. products and services and that any negotiations on intellectual property and piracy will bog down.
Nontariff Barriers
Governments also use other tools besides tariffs to restrict trade. One type of nontariff barrier is the import quota—limits on the quantity of a certain good that can be imported. The goal of setting quotas is to limit imports to the specific amount of a given product. The United States protects its shrinking textile industry with quotas. A complete list of the commodities and products subject to import quotas is available online at the U.S. Customs and Border Protection Agency website.
A complete ban against importing or exporting a product is an embargo. Often embargoes are set up for defense purposes. For instance, the United States does not allow various high-tech products—such as supercomputers and lasers—to be exported to countries that are not allies. Although this embargo costs U.S. firms billions of dollars each year in lost sales, it keeps enemies from using the latest technology in their military hardware.
Government rules that give special privileges to domestic manufacturers and retailers are called buy-national regulations. One such regulation in the United States bans the use of foreign steel in constructing U.S. highways. Many state governments have buy-national rules for supplies and services.
In a more subtle move, a country may make it hard for foreign products to enter its markets by establishing customs regulations that are different from generally accepted international standards, such as requiring bottles to be quart size rather than liter size.
Exchange controls are laws that require a company earning foreign exchange (foreign currency) from its exports to sell the foreign exchange to a control agency, usually a central bank. For example, assume that Rolex—a Swiss company—sells 300 watches to Zales Jewelers—a U.S. chain—for US$600,000. If Switzerland had exchange controls, Rolex would have to sell its U.S. dollars to the Swiss central bank and would receive Swiss francs. If Rolex wants to buy goods (supplies to make watches) from abroad, it must go to the central bank and buy foreign exchange (currency). By controlling the amount of foreign exchange sold to companies, the government controls the number of products that can be imported. Limiting imports and encouraging exports helps a government to create a favorable balance of trade.
The Legal and Regulatory Environment
One of the more difficult aspects of doing business globally is dealing with vast differences in legal and regulatory environments. The United States, for example, has an established set of laws and regulations that provide direction to businesses operating within its borders. But because there is no global legal system, key areas of business law—for example, contract provisions and copyright protection—can be treated in different ways in different countries. Companies doing international business often face many inconsistent laws and regulations. To navigate this sea of confusion, American businesspeople must know and follow both U.S. laws and regulations and those of nations in which they operate.
Business history is filled with stories about American companies that have stumbled in trying to comply with foreign laws and regulations. Coca-Cola, for example, ran afoul of Italian law when it printed its ingredients list on the bottle cap rather than on the bottle itself. Italian courts ruled that the labeling was inadequate because most people throw the cap away. In another case, 3M applied to the Japanese government to create a joint venture with the Sumitomo Industrial Group to make and distribute magnetic tape products in Japan. 3M spent four years trying to satisfy Japan’s complex regulations, but by the time it got approval, domestic competitors, including Sony, had captured the market. By delaying 3M, Japanese regulators managed, in effect, to stifle foreign competition.
One approach to dealing with local laws and regulations is hiring lawyers from the host country who can provide advice on legal issues. Another is working with local businesspeople who have experience in complying with regulations and overcoming bureaucratic obstacles.
Attributions
"Introduction to Business" by Lawrence J. Gitman, Carl McDaniel, Amit Shah, Monique Reece, Linda Koffel, Bethann Talsma, James C. Hyatt, OpenStax is licensed under CC BY 4.0
Access for free at: https://openstax.org/books/introduction-business/pages/3-3-barriers-to-trade
"An Introduction to Business v.2.0" by Anonymous , 2012 Book Archive is licensed under CC BY-NC-SA 3.0