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Library of Congress Cataloging in Publication Data:

Salvatore, Dominick. International economics [electronic resource] / Dominick Salvatore. – 11th ed. 1 online resource. Includes index. Description based on print version record and CIP data provided by publisher; resource not viewed. ISBN 978-1-118-17793-8 (cloth)

1. International economic relations. I. Title. HF1411 337–dc 2012044493

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

To Lucille

Preface

This is the eleventh edition of a text that has enjoyed a flattering market success, having been adopted by more than 600 colleges and universities throughout the United States, Canada, and other English-speaking countries and more than 1,000 in other countries around the world. The text has been translated into Chinese, French, Greek, Indonesian, Italian, Korean, Polish, Portuguese (Brazilian), Spanish, Russian, and other languages. All the features that have made the previous editions of this text one of the leading texts of International Economics in the United States and around the world have been retained in the eleventh edition. However, the content has been thoroughly updated and expanded to include many new significant topics and important recent developments.

Significant International Developments

The main objective of the eleventh edition of International Ecconomics is to present a comprehensive, up-to-date, and clear exposition of the theory and principles of international economics that are essential for understanding, evaluating, and suggesting solutions to the important international economic problems and issues facing the United States and the rest of the world today, and that countries are likely to face in the coming years. These are:

1. Slow growth and high unemployment in advanced economies after the “Great Recession”—the deepest financial and economic crisis since the Great Depression of 1929. 2. Rising protectionism in the United States and in other advanced countries in the context of a rapidly globalizing world reduces the level of specialization and trade, and it raises the specter of trade wars that would be very detrimental to the welfare of all nations. 3. Excessive volatility and large and persistent misalignments of exchange rates discourage the international flow of trade and investments and could lead to international financial and monetary crises. 4. Deep structural imbalances in the United States, slow growth in Europe and Japan, and insufficient restructuring in the transition economies of Central and Eastern Europe reduce the volume of international trade and could cause the collapse of the dollar and/or the euro.

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5. The deep poverty in many developing countries and the widening international inequal- ities pose serious moral, political, and developmental problems for the United States and other advanced countries. 6. Resource scarcity, environmental degradation, and climate change put at risk contin- ued growth in the United States and other advanced countries, as well as sustainable development in emerging markets.

These events significantly affect the well-being of the United States and the rest of the world but are, to a large extent, beyond U.S. control.

New to the Eleventh Edition Chapter 1 has been thoroughly revised and updated to reflect the dramatic economic and financial changes that have taken place in the world economy since the last edition of this text. Section 1.6 has been thoroughly revised to identify the major international economic (trade and financial) problems facing the United States and the world today, and so has the discussion in Chapter 21 (Section 21.6), which examines how they can be resolved. The rapid globalization of the world economy is providing major benefits to most coun- tries, but it is also presenting many challenges to poor countries that are unable to take advantage of globalization, as well as to the United States and other advanced countries that face increasing competition from some emerging markets, especially China. These topics are discussed in several new sections and case studies in the trade and finance part of the text. The dollar–euro exchange rate is as much in the news these days as the huge and unsustainable trade deficits of the United States and sovereign debts in the Eurozone. The relationship between U.S trade deficits, trade protectionism and misaligned exchange rates, as well as the crisis in the Euro Area are examined, both theoretically and empirically, and in all of their ramifications, in several trade and finance sections and case studies in this new edition of the text. Besides their effect on international trade and international competitiveness, the contin- uing globalization of the world economy and liberalization of international capital markets have further eroded governments’ control over national economic and financial matters. Exchange rates exhibit great volatility and large misalignments, both of which interfere with the flow of international trade and investments and distort the comparative advan- tage of nations. At the same time, international macroeconomic policy coordination has not progressed sufficiently to deal adequately with the potential problems and challenges that increased interdependence in world financial markets create. The eleventh edition of this book also presents an in-depth analysis of the dangerous structural imbalances in the world economy and provides an evolution of the policy options available to deal with them. The major imbalances in the world economy today are the huge trade and budget (twin) deficits of the United States, the slow growth and high unemployment in Europe, the decade-long stagnation in Japan, the serious competitive challenge for both advanced and developing countries provided by the competition from China, the danger of financial and economic crises in emerging market economies, world poverty, resource scarcity, and environmental degradation. All of these topics are addressed in this edition of the text. There are 122 case studies in the text. Many are new, and the others have been thoroughly revised.

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a nation’s balance of payments, foreign exchange markets, and exchange rate determination. Part Four (Chapters 16–21) examines open-economy macroeconomics or the macro rela- tionships between the domestic economy and the rest of the world, as well as the operation of the present international monetary system. In the typical one-semester undergraduate course in international economics, instructors may wish to cover the 11 core chapters (1, 2–3, 5, 9, 13–17, 21) as well as the few other asterisked sections in other chapters, and exclude the appendices. Undergraduate courses in international trade could cover Chapters 1 to 12 and 21, whereas undergraduate courses in international finance could cover Chapters 1 and 13 to 21. The many examples and real-world case studies presented also make the text very suitable for international economics courses in business programs. In first-year graduate courses in international economics and business, instructors may want to cover the appendices also and assign readings from the extensive annotated bibliography at the end of each chapter.

For the Student

• The same example is utilized in all the chapters dealing with the same basic concept. This feature is unique to this text. For example, the same graphical and numerical model is used in every chapter, from Chapters 2 through 11 (the chapters that deal with trade theory and policy). This greatly reduces the burden on the student, who does not have to start fresh with a new example each time. It also shows more clearly the relationship among the different topics examined.
• Actual numbers are used in the examples and the graphs are presented on scales. This makes the various concepts and theories presented more concrete, accessible, and per- tinent to the student, and the graphs easier to read and understand.
• There are 122 c ase studies (from 4 to 9 per chapter). These real-world case studies are generally short and to the point and serve to reinforce understanding and highlight the most important topics presented in the chapter.
• The sections of each chapter are numbered for easy reference. Longer sections are broken into two or more numbered subsections. All of the graphs and diagrams are carefully explained in the text and then summarized briefly in the captions.
• The judicious use of color and shading enhances the readability of the text and aids student understanding.
• Each chapter ends with the following teaching aids :
  • Summary —A paragraph reviews each section of the text.
  • A Look Ahead —Describes what follows in the subsequent chapter.
  • Key Terms —Lists the important terms introduced in bold face type in the chapter. A glossary of all these terms is provided at the end of the book.
  • Questions for Review —Fourteen review questions are presented (two or more for each section in the chapter).
  • Problems —Fourteen to fifteen problems are provided for each chapter. These ask the student to calculate a specific measure or explain a particular event.

Preface ix

Brief answers to selected problems (those marked by an asterisk) are provided at www.wiley.com/college/salvatore for feedback.

• Appendices —These develop in a more rigorous but careful and clear fashion certain material that is presented on an intuitive level in the chapter.
• Selected Bibliography —The most important references are included, along with specific notes indicating the topic they cover. A separate Author Index is included at the end of the book.
• Internet —A section at the end of each chapter provides relevant Internet site addresses or links to data sources, information, and analyses to show the student how to access and use the wealth of information available on the Internet.
• Accompanying the text, there are also :
• A Web Site —Each chapter presents additional examples, cases, and theoretical points and questions as well as problems that can be answered or solved using the Internet. The web site is continuously updated to reflect important new developments in the international economy as they unfold.
• An Online Study Guide prepared by Professor Arthur Raymond of Muhlenberg College is available for students. This provides extensive review of key concepts, numerous additional illustrative examples, and practice problems and exercise sets.
• A Schaum Outline on the Theory and Problems of International Economics (4th edition, 1996), prepared by the author, can be purchased at a very low price in most bookstores. This provides a problem-solving approach to the topics presented in the traditional way in this and other international economics texts.

For the Instructor

• An Instructor’s Manual prepared by the author is available. It includes chapter objec- tives and lecture suggestions, answers to the end-of-chapter problems, a set of 15 to 20 multiple-choice questions, with answers, and additional problems and essays for each chapter.
• PowerPoint Presentations , prepared by Professor Leonie L. Stone of the State Univer- sity of New York at Geneseo, provide brief outline notes of the chapter and also contain all the figures and tables in the text. These are available on the Instructor Companion Site.
• A Test Bank , also prepared by Professor Stone, contains at least 25 multiple-choice questions per chapter and is available on the Instructor Companion Site. A computerized version for easy test preparation is also available.

Acknowledgments

This text grew out of the undergraduate and graduate courses in international economics that I have been teaching at Fordham University during the past 30 years. I was very fortunate to have had many excellent students who, with their questions and comments, contributed much to the clarity of exposition of this text.

Preface xi

Francis Colella (Simpson College), Evangelos Djinopolos (Fairleigh Dickinson University), Ali Ebrahimi (Pace University), Dawn Elliott (Texas Christian University), Holger Engberg (New York University), Marcel Fulop (Kean College), George Georgiou (Towson State Uni- versity), Reza Ghorashi (Stockton College), Fred Glahe (University of Colorado), Henry Golstein (University of Oregon), Michael Halloran (partner at Ernst & Young), Sunil Gulati (Columbia University), Francis J. Hilton (Loyola of Baltimore), Syed Hussain (University of Wisconsin), William Kaempfer (University of Colorado), Demetrius Karantelis (Assumption College), Samuel Katz (Georgetown University), James Kokoris (Northeastern Illinois Uni- versity), Kishore Kulkarni (Metropolitan State College in Denver), J. S. LaCascia (Marshall University), Leroy Laney (Federal Reserve Bank of Dallas), Mary Lesser (Iona College), Cho Kin Leung (William Patterson College), Richard Levich (New York University), Farhad Mirhady (San Francisco State University), Kee-Jim Ngiam (Carleton University), Shreekant Palekar (University of Mexico), Anthony Pavlick (University of Wisconsin), Ruppert Rhodd (Florida Atlantic University), T. S. Saini (Bloomburg University), Vedat Sayar (Brooklyn College), Gerald Scott (Florida Atlantic University), Jeffrey R. Shafer (Managing Director of Salomon Smith Barney), Lezcek Stachow (St. Anselm College), Stanislaw Wasowski (Georgetown University), Bernard Wolf (York University in Canada), Behzad Yaghmaian (Ramapo College of New Jersey), Darrel Young (University of Texas), Helen Youngelson (Portland State University), and Eden Yu (University of Oklahoma). Mary Burke, Fred Campano, Edward Dowling, Ralf Hepp, Baybars Karacaovali, Darryl McLeod, Subha Mani, Erick Rengifo, Henry Schwalbenberg, Booi Themeli, and Greg Winczewski, my colleagues at Fordham University, read through the entire manuscript and provided much useful advice. Joseph Mauro, Michael Mebane, and Shannon Pullaro my graduate assistants, provided much help with many aspects of the project. Finally, I express my gratitude to George Hoffman, vice president and executive publisher at Wiley; Joel Hollenbeck, executive editor; Jennifer Manias, content editor; Jesse Cruz, marketing manager; Erica Horowitz, editorial assistant; and the entire staff at Wiley for their kind and skillful assistance. And my thanks to Angela Bates and Josephine Cannariato (department secretaries) for their efficiency and cheerful disposition.

Dominick Salvatore Distinguished Professor of Economics Fordham University New York 10458 Tel. 718-817- Fax 718-817- e-mail: salvatore@fordham.edu

Contents

• 1 Introduction - 1.1 The Globalization of the World Economy - 1.1A We Live in a Global Economy - United States Are Anything but American!  Case Study 1-1 The Dell PCs, iPhones, and iPads Sold in the -  Case Study 1-2 What Is an “American” Car? - 1.1B The Globalization Challenge -  Case Study 1-3 Is India’s Globalization Harming the United States? - 1.2 International Trade and the Nation’s Standard of Living - United States  Case Study 1-4 Rising Importance of International Trade to the - 1.3 The International Flow of Goods, Services, Labor, and Capital - 1.3A The International Flow of Goods and Services: The Gravity Model - 1.3B The International Flow of Labor and Capital -  Case Study 1-5 Major Net Exporters and Importers of Capital - 1.4 International Economic Theories and Policies - 1.4A Purpose of International Economic Theories and Policies - 1.4B The Subject Matter of International Economics - 1.5 Current International Economic Problems and Challenges - 1.6 Organization and Methodology of the Text - 1.6A Organization of the Text - 1.6B Methodology of the Text
  • Summary
  • A Look Ahead
  • Key Terms
  • Questions for Review
  • Problems
  • A1.1 Basic International Trade Data
  • A1.2 Sources of Additional International Data and Information
  • Selected Bibliography
  • INTERNet
• 2 The Law of Comparative Advantage Part 1 International Trade Theory - 2.1 Introduction - 2.2 The Mercantilists’ Views on Trade -  Case Study 2-1 Munn’s Mercantilistic Views on Trade - Twenty-first Century  Case Study 2-2 Mercantilism Is Alive and Well in the - 2.3 Trade Based on Absolute Advantage: Adam Smith - 2.3A Absolute Advantage - 2.3B Illustration of Absolute Advantage - 2.4 Trade Based on Comparative Advantage: David Ricardo - 2.4A The Law of Comparative Advantage - 2.4B The Gains from Trade - 2.4C The Case of No Comparative Advantage - 2.4D Comparative Advantage with Money -  Case Study 2-3 The Petition of the Candlemakers - 2.5 Comparative Advantage and Opportunity Costs - 2.5A Comparative Advantage and the Labor Theory of Value - 2.5B The Opportunity Cost Theory - 2.5C The Production Possibility Frontier under Constant Costs - 2.5D Opportunity Costs and Relative Commodity Prices - 2.6 The Basis for and the Gains from Trade under Constant Costs - 2.6A Illustration of the Gains from Trade - 2.6B Relative Commodity Prices with Trade - 2.7 Empirical Tests of the Ricardian Model - Exports—United States and Japan  Case Study 2-4 Relative Unit Labor Costs and Relative
  • Summary
  • A Look Ahead
  • Key Terms
  • Questions for Review
  • Problems
  • A2.1 Comparative Advantage with More Than Two Commodities
  • A2.2 Comparative Advantage with More Than Two Nations
  • Selected Bibliography
  • INTERNet
• 3 The Standard Theory of International Trade Contents xvii - 3.1 Introduction - 3.2 The Production Frontier with Increasing Costs - 3.2A Illustration of Increasing Costs - 3.2B The Marginal Rate of Transformation - Production Frontiers 3.2C Reasons for Increasing Opportunity Costs and Different - 3.3 Community Indifference Curves - 3.3A Illustration of Community Indifference Curves - 3.3B The Marginal Rate of Substitution - 3.3C Some Difficulties with Community Indifference Curves - 3.4 Equilibrium in Isolation - 3.4A Illustration of Equilibrium in Isolation - 3.4B Equilibrium-Relative Commodity Prices and Comparative Advantage - Emerging Economies  Case Study 3-1 Comparative Advantage of the Largest Advanced and - Increasing Costs 3.5 The Basis for and the Gains from Trade with - Increasing Costs 3.5A Illustrations of the Basis for and the Gains from Trade with - 3.5B Equilibrium-Relative Commodity Prices with Trade - 3.5C Incomplete Specialization - Selected Countries  Case Study 3-2 Specialization and Export Concentration in - 3.5D Small-Country Case with Increasing Costs - 3.5E The Gains from Exchange and from Specialization - Industries  Case Study 3-3 Job Losses in High U.S. Import-Competing - United States, the European Union, and Japan  Case Study 3-4 International Trade and Deindustrialization in the - 3.6 Trade Based on Differences in Tastes - 3.6A Illustration of Trade Based on Differences in Tastes
  • Summary
  • A Look Ahead
  • Key Terms
  • Questions for Review
  • Problems
  • A3.1 Production Functions, Isoquants, Isocosts, and Equilibrium - Two Factors A3.2 Production Theory with Two Nations, Two Commodities, and
  • A3.3 Derivation of the Edgeworth Box Diagram and Production Frontiers xviii Contents
  • A3.4 Some Important Conclusions
  • Selected Bibliography
  • INTERNet
• 4 Demand and Supply, Offer Curves, and the Terms of Trade - 4.1 Introduction - Equilibrium Analysis 4.2 The Equilibrium-Relative Commodity Price with Trade—Partial - Price of Petroleum  Case Study 4-1 Demand, Supply, and the International - United States  Case Study 4-2 The Index of Export to Import Prices for the - 4.3 Offer Curves - 4.3A Origin and Definition of Offer Curves - 4.3B Derivation and Shape of the Offer Curve of Nation - 4.3C Derivation and Shape of the Offer Curve of Nation - Equilibrium Analysis 4.4 The Equilibrium-Relative Commodity Price with Trade—General - 4.5 Relationship between General and Partial Equilibrium Analyses - 4.6 The Terms of Trade - 4.6A Definition and Measurement of the Terms of Trade - 4.6B Illustration of the Terms of Trade -  Case Study 4-3 The Terms of Trade of the G-7 Countries - Developing Countries  Case Study 4-4 The Terms of Trade of Advanced and - 4.6C Usefulness of the Model
  • Summary
  • A Look Ahead
  • Key Terms
  • Questions for Review
  • Problems
  • A4.1 Derivation of a Trade Indifference Curve for Nation
  • A4.2 Derivation of Nation 1’s Trade Indifference Map
  • A4.3 Formal Derivation of Nation 1’s Offer Curve
  • A4.4 Outline of the Formal Derivation of Nation 2’s Offer Curve
  • A4.5 General Equilibrium of Production, Consumption, and Trade
  • A4.6 Multiple and Unstable Equilibria
  • Selected Bibliography
  • INTERNet