Economics concepts and applications

¶ … nature of U.S.-Mexican trade relations, it is difficult indeed not to think of the statement of Mexican President Porfirio Diaz at the turn of the last century, "Poor Mexico, so far from God, and so close to the United States." For Mexico does continue to seem to occupy a benighted position vis-a-vis its richer and more powerful neighbor to the north, a position that is in no small measure defined and continually recreated by the nature and mechanisms of international trade between the two nations. This paper examines the nature of the trade relations between the United States and Mexico in the light of several classical economics theories and models as well as in respect to recent developments in the wake of the 1992 signing of the NAFTA accord and the last decade's worth of increasing globalization.

Economic Theories and Models

We begin by discussing and summarizing some of the useful models and theories from the realm of classical economics, including two models developed by David Ricardo, the 18th and 19th century economist who was especially concerned with understanding the ways in which wages and value are determined in a society.

Ricardo believed in what he termed the "iron law of wages," which is to say that he believed that wages tend to settle at the subsistence level and while they may rise temporarily above that level, any such rise will be temporary because of the effects of competition among workers. This is an important point for the topic in question because a more open trade relationship between the United States and Mexico (as has existed since NAFTA went into effect in 1994, for example) tends to produce a de facto larger workforce (since workers from both countries are now competing directly with each other in ways that they were not before) than is the case when workers in each individual country are relatively more isolated from each other because of various forms of economic protectionism.

Any rise in wage rates above subsistence will cause the working population to increase to the point that heightened competition among the glut of laborers will merely cause their wages to fall back to the subsistence level (www.encyclopedia.com).

Ricardo was also determined to understand the ways in which the value of goods (both products and services) was established. He came to believe that value was a direct and relatively function of the labor needed to produce the good in question. This is important in regards to the nature of trade relations between the United States and Mexico precisely because the value of labor in the two countries is not the same, and so more labor is available (on, for example, an hourly basis) from Mexican workers.

According to his labor theory of value, a clock costing $100 required 10 times as much labor for its production as did a pair of shoes costing $10 (www.encyclopedia.com).

Finally, and perhaps most relevant of all of these three concepts to the topic at hand, Ricardo also developed an economic model to help explain the dynamics of international trade. His most important work in this are is the theory of comparative advantage.

In a now classic illustration, Ricardo explained how it was advantageous for England to produce cloth and Portugal to produce wine, as long as both countries traded freely with each other, even though Portugal might have produced both wine and cloth at a lower cost than England did (www.encyclopedia.com).

The following table further explains Ricardo's theory of why it is so very often economically advantageous for a nation to specialize in certain products (or certain goods) and then to trade in those products that it has specialized in rather than trying to compete in terms of trade in all of the commodities that it can or even does produce.

Table 1

Country

Wheat

Wine

Cost Per Unit In Man Hours

Cost Per Unit In Man Hours

England

15

30

Portugal

10

15

In Table 1, a unit of wine in England costs the same amount to produce as 2 units of wheat. Production of an extra unit of wine means foregoing production of 2 units of wheat (ie the opportunity cost of a unit of wine is 2 units of wheat). In Portugal, a unit of wine costs 1.5 units of wheat to produce (ie the opportunity cost of a unit of wine is 1.5 units of wheat in Portugal). Because relative or comparative costs differ, it will still be mutually advantageous for both countries to trade even though Portugal has an absolute advantage in both commodities (http://www.systemics.com/docs/ricardo/david.html).

It can be seen in this example that Portugal is relatively better at producing wine than wheat. Ricardo saw this as Portugal's comparative advantage in producing wine just as England can be seen to be relatively better at producing wheat than wine giving Britain a comparative advantage in the production of wheat.

[The table below] shows how trade might be advantageous. Costs of production are as set out in Table 1. England is assumed to have 270 man hours available for production. Before trade takes place it produces and consumes 8 units of wheat and 5 units of wine. Portugal has fewer labour resources with 180 man hours of labour available for production. Before trade takes place it produces and consumes 9 units of wheat and 6 units of wine. Total production between the two economies is 17 units of wheat and 11 units of wine.

Country

Production

Production

BeforeTrade

After Trade

Wheat

Wine

Wheat

Wine

E n g l a n d

8

5

18

0

P o r t u g a l

9

6

0

12

T o t a l

17

11

18

12

If both countries now specialise, Portugal producing only wine and England producing only wheat, total production is 18 units of wheat and 12 units of wine. Specialisation has enabled the world economy to increase production by 1 unit of wheat and 1 unit of wine (http://www.systemics.com/docs/ricardo/david.html).

It should be noted that while Ricardo's model of comparative advantage is still widely accepted by many important economists working today, it does make (as is typical of classical economic theories) a number of assumptions that do not in fact obtain in the real world of trade relations between the United States and Mexico or in any other on-the-ground situation. Among the important assumptions that this model makes that are contrary to fact are the following: there are no transportation costs involved in shipping goods, there are no economies of scale, there are no trade barriers, and there exists a state of perfect knowledge on the part of the economic agents involved so that all buyers and all sellers at all times know where the cheapest example of any given product may be found (http://www.systemics.com/docs/ricardo/david.html).

Another important well-established economic model to understand in considering the status and nature of trade relations between the United States and Mexico is the factor proportions theory, which is a model that predicts that the United States and Mexico, like all other countries, will over time be net exporters of those products that make intensive use of the country's relatively abundant factors. Thus if we want to understand why a Canada is a primary exporter of newsprint to the rest of the world, we must understand that "newsprint makes intensive use of two factors "forest land" and "capital" that are relatively abundant in Canada" (http://pacific.commerce.ubc.ca/keith/Lectures/fpt.html).

The Heckscher-Ohlin may be seen to be related to the factor productions theory if not to be actually derived from it. It should be clear from the above explanation of the factor productions theory (and in fact this should be fairly clear simply from an examination of economic factors by common sense) that any nation that has abundant natural resources has in most cases a comparative advantage in producing goods that use those same resources over nations that do not have an abundance of the particular raw materials needed to produce those same goods. is obvious and straightforward. The Heckscher-Ohlin model is more complex and more subtle and thus not so obvious to a commonsensical examination of the issue, but it should be clear that the same basic concepts are involved.

The Heckscher-Ohlin theorem states that a country which is capital-abundant will export the capital-intensive good. Likewise, the country which is labor-abundant will export the labor-intensive good. Each country exports that good which it produces relatively better than the other country. In this model a country's advantage in production arises solely from its relative factor abundance (http://internationalecon.com/v1.0/ch60/60c110.html).

It may be seen from the above description that the Heckscher-Ohlin theory is primarily concerned with what must be considered to be two most significant elements involved in the production of goods: labor and capital. Some countries, like the United States, have relatively high rates of capitalization. This means that the average worker has an abundance of machinery and technology available to him or her. This high degree of capitalization is associated with relatively higher wages. This means in turn that goods that require a great deal of labor (such as the production of clothing) will be relatively more expensive to produce in countries with high levels of capitalization. Thus clothing produced entirely within the United States is very expensive vis-a-vis clothing produced in nations in which there is a relatively low rate of capitalization and low wages for the average worker -- such as Mexico.

However, it should be noted that this model correctly notes that not everything is cheaper to produce where labor is to be had cheaply. (This too accords with a common-sense assessment of the situation, for if everything were cheaper to produce in the Third World we should quickly have no First World production at all.) Goods that require high capitalization and relatively little labor (such as modern production of cars) can be accomplished more cheaply in a nation like the United States (http://www.econ.iastate.edu/classes/econ355/choi/ho.htm).

An understanding of these basic economic principles is helpful in understanding the trade relationship between the United States and Mexico. The relationship can in general be summarized as following classical economic models: Each country trades what it can produce cheaply for what the other nation can produce and export cheaply.

Economic Background and Research Assumptions

While economics provides us with essential tools for understanding the trade relationship, it is impossible to understand the trade relationship between the two countries without a consideration of the political relationship as well. While there are a number of aspects of the political relationship between the one (and of course the relationship between the two is dynamic and ever-changing), is the nature of the trade agreements. Although the best-known of these (in part because it is the most recent) is NAFTA, this is not the only trade agreement that defines the relationship between the two.

In order to understand the underpinnings of NAFTA one must look back actually to the end of World War II. One of the lessons that many of the world's leaders learned from the war was that they and their countries needed to reduce the harmful influence and effects of the protectionist monetary and trade policies that grown steadily in the years since 1871 and especially the protectionists trade restrictions that had been developed and enforced by a number of countries in the years after 1918. This realization began what was in many ways (only certainly not entirely purely) a series of fundamentally anti-protectionist and multilateral trade agreements that were wedded to a variety of other forms of cooperation along the international economic front.

This trend toward establishing and maintaining open borders for the trade of products (and services) as well as international monetary policies that encourage the free flow of capital across international lines have in the past two decades grown in strength at least in large measure because of the importance and growing strength and influence of transnational corporations -- despite the growing and legitimate concerns of many in the labor and environmental movements about the costs to the worker and to the earth of unrestrained trade.

The immediate post-World War II concerns about economic protectionism resulted in the General Agreement on Tariffs and Trade -- usually called GATT. In 1947, 23 countries were signatories of GATT: Among them they accounted for four-fifths of world trade (Zeiler, 1999, p. 18). GATT, like NAFTA and other such agreements, is a multilateral trade agreement that as its major goal sets forth the principles that each country must abide by.

Each signatory country (both those that first signed and those that became members at a later date), must consider a basis of "reciprocity and mutual advantage," to negotiate "a substantial reduction in customs tariffs and other impediments to trade, and the elimination of discriminatory practices in international trade" (www.gatt.org).

Also much in the news lately has been another of the most important free-trade organizations that grew out of the political situation of the post-World War II era: the World Trade Organization. The WTO, as it is invariably called, is an international organization that has as its stated goal the mission both toe provide supervision over international trade and the liberalization of world trade, which is to say the reduction of tariffs and other taxes as well as other regulatory barriers to the free trade of products and services across international borders (www.gatt.org).

The WTO may be seen at least in key ways as the successor to GATT. The GATT was actually intended as a temporary organization by many of its founders, who hoped that it would be quickly replaced by a specialized agency of the United Nations that would be titled the International Trade Organization. The ITO never came about, in part because of the often glacial pace at which innovations are instituted at the United Nations but perhaps even more importantly because GATT itself had proved to be so successful at freeing the world's trade in such a short period of time. However, by the mid-1990s there were calls from a number of countries for a stronger multilateral organization to monitor that trade and resolve disputes (Danaher & Burbach, 2000, chapter one).

The WTO came into being Jan. 1, 1995. The 104 countries that composed its initial membership pledged that they would help enforce each of the member countries' upholding of all of the prior GATT agreements. GATT itself went out of existence in 1994, with the stated intention of ceding the stage of liberalizing world trade to the WTO, which then became responsible both for the negotiation of and the implementation of new trade agreements (Danaher & Burbach, 2000, p. 39).

Before leaving the topic of the WTO, a brief statement should be made about the issue of transnationalism, or globalization. Globalization, or transnationalism, in general refers to the current flows of capital, people, information and images and culture across national borders. Such flows of money, products and ideas across the previously far more impermeable national borders of the world has been brought about in large measure through two important and related processes (www.latimes.com).

It should perhaps be noted in passing yet one more of the important post-war economic organizations: the International Monetary Fund (called the IMF) along with the World Bank (which actually originated during the war years). Both institutions were part of a plan by the world's wealthier nations as well as some of its poorer ones to help lay the groundwork for a post-World War II world that would be marked by economic cooperation and economic stability. The United States was the primary shaper and mover behind both the World Bank and the IMF, institutions that have had an important influence on the Mexican economy (Low 1994).

The primary reason that the World Bank came into existence was to help in the economic (and political) reconstruction as well as the economic and social and political development of its member countries by making it as easy as possible to allow capital investment for productive purposes. The World Bank also made loans itself and recruited private parties to make loans as well to try to encourage a sufficiently high level of capitalization of projects in developing nations to give them a substantially higher chance of succeeding (Zeiler, 1999, p. 187). The mission of the IMF was, while related, a distinct one in that it was charged with stabilizing international monetary rates while at the same time encouraging cooperation in the exchange of foreign currencies and exchange rates. It has at many points been unable to do so -- especially during the 1970s when the rising oil prices that resulted after the international show of force by OPEC helped to undermine and in many cases severely destabilize the economies of Mexico along with other Third World countries. Its inability to stabilize the currencies of developing nations has caused those nations to hold it in suspicion. Perhaps even more damning in the eyes of the Third World has been the fact that IMF policies have not simply failed Third World nations but have dramatically benefited First World nations like the United States. The resulting tensions that have been felt between many poor and rich countries are most certainly felt between Mexico and the United States, and in a somewhat reduced way between Mexico and Canada. (Clearly both sides in the situation have argued for the point-of-view that will directly benefit them, and while this is in some sense perfectly understandable, it has behooved the industrialized nations with their greater wealth and their greater power to be more flexible.) (Esty, 1994, p. 154).

We come finally to NAFTA, the trade pact signed in 1992 (it actually went into effect Jan. 1, 1994) that had as its primary goals the intention of eliminating most tariffs and other barriers to the "free" trade of both products and services amongst the three largest nations of North America, Canada, the United States and Mexico. The major economic impetus for the establishment of such a free-trade zone (or relatively free-trade zone) was the rather dramatic success that the European Union members had had in eliminating tariffs to increase trade among its member nations.

It should be noted at this point that a tariff is simply one type of tax (and in fact is often called a customs tax) that is levied on a product (or, less frequently, a service) that is traded across an international border, or is traded across the borders of a group of countries that have a trade agreement to nations that are not a member of this union. Tariffs both protect the jobs of domestic workers and serve as rewards to political allies and are an ancient practice.

The general inspiration for NAFTA was thus both the European Union as well as the general and long-established practice of the establishment of taxes on the international trading of goods. The particular basis for the agreement was actually a free-trade agreement between the United States and Canada that was finalized in 1988. NAFTA was in some sense simply an extension of these originally binational agreement into a trinational one, with the important distinction that while the United States is a wealthier country than is Canada, the two are both undeniably wealthy, stable First World nations. By bringing Mexico (which is more a Third World nation in its political and economic structure than a First World one) in as an equal partner, the nature of the agreement was altered in important ways, with important consequences for all of the partners, including the United States.

The major intent of NAFTA (as with similar agreements) was the reduction of tariffs as well as all other barriers to trade amongst the three countries, some of these barriers being struck down immediately and others still to come. Not only have products thus been able to pass with greater ease across the borders of the three countries involved, but companies in the three countries have had greater access to banking and other financial services as well as communications technologies in the other nations (www.latimes.com).