Part III International Economics International Trade and the

Part III. International Economics International Trade and the Theory of Comparative Advantage

Thinking of the Economy as Open or Closed In an economy open to trade, exports of goods and services add a fourth component to planned aggregate expenditure. Consumers and businesses in open economies have more choices—instead of spending exclusively on domestically produced products, they can turn to foreign producers for consumer goods, capital goods, and raw materials. Y=C+I+G+(X-M)

International vs. Domestic Trade What is the difference between international and domestic trade? 1. 2. 3. Expanded trading opportunities. Sovereign nations. Exchange rates.

Imports and Exports in Ukraine

The Logic of Free Trade: Theory of Comparative Advantage l Ricardo’s theory that from specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

How two people can gain from trade? Biff and Veronica, the only two people in the world, can engage in only two activities - producing food and/or producing clothing. How much can they produce per hour? See the information below: Biff would take 12 hours to produce 1 unit of food and/or 6 hours to produce 1 unit of clothing Veronica would take 1 hour to produce 1 unit of food and/or 3 hours to produce 1 unit of clothing Notice that Veronica is 12 times better at food production than Biff and she is 2 times better at clothing production than Biff. Common sense would tell us that there’s no way that Veronica can benefit by trading with Biff. Right?

Now let’s use two countries to illustrate theory of comparative advantage. The U. S. and China, the only two countries in a hypothetical world, can engage in only two activities - producing computers and/or producing dolls. How much can they produce per hour? See the information below: China would take 10 hours to produce 1 computer and/or 5 hours to produce 1 doll The U. S. would take 1 hour to produce 1 computer and/or 4 hours to produce 1 doll Notice that the U. S. is 10 times better at computer production than China and the U. S. is 1. 25 times better at doll production than China. Common sense would tell us that there’s no way that the U. S can benefit by trading with China. Right?

Absolute Advantage vs. Comparative Advantage l Absolute advantage: The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product that the other country does. l Comparative advantage: The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost than in the other country in terms of other goods.

#1 You are given the following information about production relationships in Lindertania and the rest of the world: Inputs per Bushel of Rice Output Inputs per Yard of Cloth Output Lindertania Rest of the world 75 50 100 50 You make several Ricardian assumptions: These are the only two commodities, there are constant ratios of input to output whatever the level of output of rice and cloth, and competition prevails in all markets. a. Does Lindertania have an absolute advantage in producing rice? Cloth? b. Does Lindertania have a comparative advantage in producing rice? Cloth? c. If no international trade is allowed, what price ratio would prevail between rice and cloth within Lindertania? d. If free international trade is opened up, what are the limits for the equilibrium international price ratio? What product will Lindertania export? Import?

#2 Consider another Ricardian example, using standard Ricardian assumptions: Vintland Moonited Republic Labor Hours per Bottle of Wine 15 10 Labor Hours per Kilogram of Cheese 10 4 Vintland has 30 million hours of labor in total per year. Moonited Republic has 20 million hours of labor per year. a. Which country has an absolute advantage in wine? In cheese? b. Which country has a comparative advantage in wine? In cheese? c. Graph each country's production-possibility curve. Using community indifference curves, show the no-trade equilibrium for each country (assuming that with no trade, Vintland consumes 1. 5 million kilos of cheese and Moonited Republic consumes 3 million kilos of cheese). d. When trade is opened, which country exports which good? If the equilibrium international price ratio is 1/2 bottle of wine per kilo of cheese, what happens to production in each country? e. In this free-trade equilibrium, 2 million kilos of cheese and 1 million bottles of wine are traded. What is the consumption point in each country with free trade? Show this graphically using community indifference curves. f. Does each country gain from trade? Explain, referring to your graphs as is appropriate.

The Theory of Comparative Advantage and Observed Trade Flows l l The Heckscher-Ohlin Theorem A theory explaining the existence of a comparative advantage by a country’s factor endowments: a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. Other explanations for trade (intra-industry trade; “acquired” comparative advantages and “natural” comparative advantage; economies of scale etc. )

Supply-and-Demand Analysis of Trade and Tariffs l Free trade vs. no trade Trade barriers Tariff A tax on imports Quota A limit on the quantity of imports. l

The Case for Protection l l l It saves jobs Cheap foreign labor makes competition unfair It protects the national security It encourages dependency It protects infant industries It provides protection during temporary currency overvaluation