Topic 8: International Trade

Comparative AdvantageExchange Rates

Absolute AdvantageSomeone has an absolute advantage in

producing something when they can do so more efficiently (using fewer factors of production, e.g., less labor) than someone else.

The person or group that is “better” at producing a good has the absolute advantage in doing so.

Comparative AdvantageSomeone has comparative advantage in

producing something when their opportunity costs of doing so are lower than someone else.

Compared to someone else, everyone has a comparative advantage in the production of something.

Comparative advantage does not imply absolute advantage.

Things I could do:Writing Papers and Teaching Farm

Where is my absolute advantage? Where is my comparative advantage

compared to others?

Things I could do:Writing Papers and Teaching Landscaping and yard maintenanceRemodel my kitchenClean my bathroom

Where is my absolute advantage? Where is my comparative advantage

compared to others?

ExamplesThe French and Irish can make both wine and

beer

Who has the absolute advantage in each product?

Who has the comparative advantage in wine?Ireland must give up 10 Beer for each wineFrance must give up 1/2 beer for each wineFrance has lower opportunity cost, thus it has

comparative advantage.

Beer Wine

France 500 1000

Ireland 1000 100

ExamplesThe French and Irish can make both wine

and beer

Who has the comparative advantage in beer?Ireland must give up 1/10 Wine for each BeerFrance must give up 2 Wine for each BeerIreland has lower opportunity cost, thus it has

comparative advantage.

Beer Wine

France 500 1000

Ireland 1000 100

ExamplesThe Scottish and Irish can make both sweaters and

beer

Who has the absolute advantage in each product?Who has the comparative advantage in sweaters?

Ireland must give up 10/13 Beer for each sweaterScotland must give up 9/10 Beer for each sweater10/13<9/10, so Ireland has lower opportunity cost,

thus it has comparative advantage.

Sweaters Beer

Scotland 1000 900

Ireland 1300 1000

ExamplesThe Scottish and Irish can make both sweaters

and beer

Who has the comparative advantage in Beer?Ireland must give up 13/10 Sweater for each BeerScotland must give up 10/9 Sweater for each

Beer10/9<13/10, so Scotland has lower opportunity

cost, thus it has comparative advantage.

Sweaters Beer

Scotland 1000 900

Ireland 1300 1000

ExamplesIn Class Exercise

ExamplesAbby, Bruce and Carlos can make cheese and

bread

As always with comparative advantage problems in this class, assume linear PPFs for each producer.

Who has the absolute advantage in each productCarlos has it in CheeseBruce has it in Bread

Cheese Bread

Abby 500 600

Bruce 200 700

Carlos 600 300

ExamplesAbby, Bruce and Carlos can make cheese and

bread

Who has the comparative advantage in Cheese?Abby v. Bruce? AbbyAbby v. Carlos? BruceBruce v. Carlos? CarlosCarlos > Abby > Bruce

Cheese Bread

Abby 500 600

Bruce 200 700

Carlos 600 300

ExamplesAbby, Bruce and Carlos can make cheese

and bread

Who has the comparative advantage in Bread?

Graph the PPF for the economy with trade.

Cheese Bread

Abby 500 600

Bruce 200 700

Carlos 600 300

Comparative Advantage SummaryUse the concept of comparative advantage to

argue in favor of companies moving production from US to China or India.

Who gains?On average, US citizens are better off.Are all US citizens better off?

Consider the exchange of “goods” and “services”. Which does the US have comparative advantage in compared to most other countries?

Effects of Foreign Trade on Fiscal PolicyBenefits of expansionary policy are no longer

concentrated in domestic boarders.

Might need more aggressive policy to see same effects at home.

That is, the effective multiplier might be smaller. If the MPC is 0.8, an increase in G of 1000 might increase domestic Y by less than 1000 / (1- 0.8) = 5000. This is because some of the Y increase takes place in other countries.

Effects of Foreign Trade on Monetary PolicyFor this, we need to consider the foreign

exchange market.Consider a world with only two countries:

USA and UKAlternatively, think of UK as “rest of the

world”

Demand for Pounds (£) by holders of $1. Import UK produced goods and services2. Travel to UK3. Buy UK financial assets (e.g., stocks,

bonds, currency)4. Buy UK “direct” investments (e.g.,

property, capital goods, firms)5. Speculation in currency markets (i.e.,

expect price of £/$ to increase)

Supply of Pounds (£) in exchange for $1. Import USA produced goods and services

to UK2. Travel to USA3. Buy USA financial assets (e.g., stocks,

bonds, currency)4. Buy USA “direct” investments (e.g.,

property, capital goods, firms)5. Speculation in currency markets (i.e.,

expect price of £/$ to decrease)

Graphing Demand for £The Price of £ is given in terms of US $, or

P=$/£Graph Demand for £

to Import UK Goods and Servicesfor tourism to UKby currency speculators for investment or financial assets in UK

Graphing Demand for £Demand for £ for investment or financial assets

So, return is the same independent of exchange rate… But, what if we expect the exchange rate to decrease or increase during the course of our investment?

Exchange Rate

Investment in $

Investment in £

Return %

Return in £

Return converted to $

$5/£1 $100,000 £20,000 10% $2,000 $10,000

$2/£1 $100,000 £50,000 10% $5,000 $10,000

$1/£1 $100,000 £100,000 10% $10,000

$10,000

$0.50/£1

$100,000 £200,000 10% $20,000

$10,000

Graphing Demand for £If buy $100,000 investment at $5/£1

exchange rate, and expect to cash in on the investment after exchange rate falls to $2/£1.

If buy $100,000 investment at $1/£1 exchange rate, and expect to cash in on the investment after exchange rate increases to $2/£1.

Investment in $

Investment in £ bought at $5/£1

Return %

Return in £

Return converted to $ at $2/£1

$100,000 £20,000 10% $2,000 $4,000

Investment in $

Investment in £ bought at $1/£1

Return %

Return in £

Return converted to $ at $2/£1

$100,000 £100,000 10% $10,000

$20,000

Foreign Exchange MarketGraph supply and demand togetherWhat is the equilibrium exchange rate?

Changing interest rateWhat happens if interest rate in USA

decreases, but remains unchanged in UK?Buying US financial assets becomes relatively

unattractive, so demand for £ increases, and supply of £ decreases. (Graph it)

Price of £ increases.US exports increase, UK exports decrease.

Therefore: Expansionary monetary policy (to decrease i at home) can be even more effective with trade, since it not only increases domestic investment but it also increases exports.

Some questions:Why do investors care about foreign exchange

markets?SpeculationChanges in currency prices effects the expected return on

investment in different locations.How could the Federal Reserve increase the “strength”

of the dollar (make the price of dollars go up)?Are you personally made better off when the dollar is

stronger? If you are from abroad and must convert currency to $ to

pay tuition?If you live in the US and like to travel abroad?If you own a consulting company that typically does 75%

of its business in other countries?