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International Trade Concepts and Examples

Learn about comparative advantage, absolute advantage, and exchange rates in international trade with detailed examples. Understand the effects on fiscal and monetary policies.

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International Trade Concepts and Examples

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  1. Topic 8: International Trade Comparative Advantage Exchange Rates

  2. Absolute Advantage • Someone 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.

  3. Comparative Advantage • Someone 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.

  4. Things I could do: • Writing Papers and Teaching • Farm • Where is my absolute advantage? • Where is my comparative advantage compared to others?

  5. Things I could do: • Writing Papers and Teaching • Landscaping and yard maintenance • Remodel my kitchen • Clean my bathroom • Where is my absolute advantage? • Where is my comparative advantage compared to others?

  6. Examples • The 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 wine • France must give up 1/2 beer for each wine • France has lower opportunity cost, thus it has comparative advantage.

  7. Examples • The 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 Beer • France must give up 2 Wine for each Beer • Ireland has lower opportunity cost, thus it has comparative advantage.

  8. Examples • The 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 sweater • Scotland must give up 9/10 Beer for each sweater • 10/13<9/10, so Ireland has lower opportunity cost, thus it has comparative advantage.

  9. Examples • The 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 Beer • Scotland must give up 10/9 Sweater for each Beer • 10/9<13/10, so Scotland has lower opportunity cost, thus it has comparative advantage.

  10. Examples • In Class Exercise

  11. Examples • Abby, 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 product • Carlos has it in Cheese • Bruce has it in Bread

  12. Examples • Abby, Bruce and Carlos can make cheese and bread • Who has the comparative advantage in Cheese? • Abby v. Bruce?  Abby • Abby v. Carlos?  Bruce • Bruce v. Carlos?  Carlos • Carlos > Abby > Bruce

  13. Examples • Abby, Bruce and Carlos can make cheese and bread • Who has the comparative advantage in Bread? • Graph the PPF for the economy with trade.

  14. Comparative Advantage Summary • Use 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?

  15. Effects of Foreign Trade on Fiscal Policy • Benefits 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.

  16. Effects of Foreign Trade on Monetary Policy • For this, we need to consider the foreign exchange market. • Consider a world with only two countries: USA and UK • Alternatively, think of UK as “rest of the world”

  17. Demand for Pounds (£) by holders of $ • Import UK produced goods and services • Travel to UK • Buy UK financial assets (e.g., stocks, bonds, currency) • Buy UK “direct” investments (e.g., property, capital goods, firms) • Speculation in currency markets (i.e., expect price of £/$ to increase)

  18. Supply of Pounds (£) in exchange for $ • Import USA produced goods and services to UK • Travel to USA • Buy USA financial assets (e.g., stocks, bonds, currency) • Buy USA “direct” investments (e.g., property, capital goods, firms) • Speculation in currency markets (i.e., expect price of £/$ to decrease)

  19. Graphing Demand for £ • The Price of £ is given in terms of US $, or P=$/£ • Graph Demand for £ • to Import UK Goods and Services • for tourism to UK • by currency speculators • for investment or financial assets in UK

  20. 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?

  21. 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.

  22. Foreign Exchange Market • Graph supply and demand together • What is the equilibrium exchange rate?

  23. Changing interest rate • What 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.

  24. Some questions: • Why do investors care about foreign exchange markets? • Speculation • Changes 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?

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