Ch 1 The International Economy

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Ch 1 The International Economy

• Its simple economics, son.
• I dont understand it at all.
• Kyles Dad, Southpark

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Ch 1 The International Economy

• In every country it always is and must be the
  interest of the great body of the people to buy
  whatever they want of those who sell it cheapest.
  The proposition is so very manifest that it
  seems ridiculous to take any pains to prove it
  nor could it ever have been called in question,
  had not the interested sophistry of merchants and
  manufacturers confounded the common sense of
  mankind.

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Ch 1 The International Economy

• Their interest is, in this respect, directly
  opposite to that of the great body of the
  people.
• Adam Smith, Wealth of Nations

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Ch 1 International Economy

• Economic Interdependence
• Economies of scale, specialization
• European Community in 1950s
• Multinationals, 1960s
• Market power of OPEC, 1970s
• Globalization
• Technology
• Increased productivity
• Lower transport costs
• Liberalization of Trade and Investment

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Ch 1 International Economy
Measure of US as Open Economy - of GDP
Traded 1930 12 1950 10 1990
20 2004 25 2008 31
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Ch 1 International Economy

• Common Fallacies
• Trade is a zero-sum game.
• Imports reduce employment, exports promote
  employment.
• Tariffs and quotas save jobs and promote
  employment.

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Ch 1 International Economy

• Productivity Competitiveness
• Productivity (output per worker) is key indicator
  of competitiveness
• Intl trade increases productivity due to
  economies of scale, specialization.
• Resources move from low productivity uses to high
  productivity uses.
• Global competitiveness puts upward pressure on
  productivity.

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Ch 2 Foundations of Modern Trade Theory

• I shall therefore venture to acknowledge that
  not only as a man, but as a British subject, I
  pray for the flourishing commerce of Germany,
  Spain, Italy, and even France itself.
• David Hume

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Ch 2 Foundations of Modern Trade Theory

• Mercantilists (1500 1800)
• Wealth Nations supply of gold
• Need exports gt imports to be wealthy
• Advocated trade barriers
• Believed trade to be zero sum game
• David Hume
• Price-Specie-Flow Doctrine
• Favorable trade balance is short run
  possibility

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Ch 2 Foundations of Modern Trade Theory

• Why Nations Trade
• Absolute Advantage
• Adam Smith (1723-1790)
• Based on labor theory of value
• Labor is only factor of production
• Price of a good based on amount of labor required
  to produce it
• Nations should trade if one nation has an
  absolute cost advantage in production of one
  good, and the other nation has a cost advantage
  in production of the other good.

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Ch 2 Foundations of Modern Trade Theory

• Assume 2 nation, 2 product world

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Ch 2 Foundations of Modern Trade Theory

• Assume 2 nation, 2 product world

U.S. has absolute advantage in cloth. U.K. has
absolute advantage in wine.
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Ch 2 Foundations of Modern Trade Theory

• Why Nations Trade
• Comparative Advantage
• David Ricardo (1772-1823)
• Even when nation has absolute disadvantage in
  both goods, there is still basis for trade.
• Nation has comparative advantage when it can
  produce a good at a lower opportunity (relative)
  cost.

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Ch 2 Foundations of Modern Trade Theory

• Ricardos Assumptions
• Two nations, two goods.
• Labor is the only input, in fixed supply, fully
  employed, homogeneous.
• Labor moves freely between industries, but not
  between nations.
• Technology and costs are fixed.
• Perfectly competitive markets.
• Free trade (no barriers).
• Zero transportation costs.
• Firms maximize profits, consumers maximize
  utility.
• No money illusion.

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Ch 2 Foundations of Modern Trade Theory
U.S. has absolute advantage in both cloth AND
wine. Adam Smith would say no basis for
trade. Ricardo would say basis for trade exists
U.S. has GREATER advantage in cloth. 40/20 lt
40/10
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Ch 2 Foundations of Modern Trade Theory
Opportunity cost of 1 bottle of wine in U.S. 1
yd of cloth 40/40 Opportunity cost of 1 bottle
of wine in U.K. ½ yd of cloth 10/20 Wine costs
more in U.S. (in terms of cloth) than in U.K., so
U.K. has comparative advantage in wine production.
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Ch 2 Foundations of Modern Trade Theory
Opportunity cost of 1 yd of cloth in U.S. 1
bottle of wine 40/40 Opportunity cost of 1 yd of
cloth in U.K. 2 bottles of wine 20/10 Cloth
costs more in U.K. (in terms of wine) than in
U.S., so U.S. has comparative advantage in cloth
production.
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Ch 2 Foundations of Modern Trade Theory
Who has absolute advantage in wheat?
Textiles? Who has comparative advantage in
wheat? Textiles?
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Ch 2 Foundations of Modern Trade Theory
Who has absolute advantage in wheat?
Textiles? US has absolute advantage in both Who
has comparative advantage in wheat? Textiles? US
in wheat UK in textiles
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Ch 2 Foundations of Modern Trade Theory
Opportunity cost of 1 bushel of wheat in U.S.
1/4 yards 3/12 Opportunity cost of 1 bushel of
wheat in U.K. 1/2 yard 1/2 Wheat costs more in
U.K. (in terms of textiles) than in U.S., so U.S.
has comparative advantage in wheat production.
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Ch 2 Foundations of Modern Trade Theory

• Constant Costs
• Before Trade
• Country can only consume on PPC
• Slope of curve represents domestic terms of trade
• After Trade
• Complete specialization
• Country can consume outside PPC
• Country will only trade if international terms of
  trade are better than domestic

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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
60
120
CARS
CARS
80
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
PPC (domestic terms of trade)
60
120
CARS
CARS
80
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
PPC (domestic terms of trade)
A
60
A
120
CARS
CARS
80
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
A, A consumption w/o trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
B
160
PPC (domestic terms of trade)
A
60
A
B
120
CARS
CARS
80
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
B, B production with trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
120
International terms of trade
11
C
100
A
C
60
A
160
120
60
CARS
CARS
80
60
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
C, C consumption with trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
Exports
160
120
International terms of trade
C
100
A
C
60
Imports
A
160
120
60
CARS
CARS
80
60
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
C, C consumption with trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
120
Imports
C
100
A
C
60
A
Exports
160
120
60
CARS
CARS
80
60
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
C, C consumption with trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
Terms of Trade
120
C
100
A
C
60
A
T of T
160
120
60
CARS
CARS
80
60
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
C, C consumption with trade
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Ch 2 Foundations of Modern Trade Theory
U.S.
Canada
WHEAT
WHEAT
160
120
Trade Triangle
C
100
A
C
60
A
160
120
60
CARS
CARS
80
60
1 wh 2 cars 1 car ½ wh
1 wh ½ car 1 car 2 wh
C, C consumption with trade
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Ch 2 Foundations of Modern Trade Theory

• Increasing Costs
• Before Trade
• Country can only consume on PPC
• Country can still benefit from trade if
  international price is better than domestic.
• After Trade
• Partial specialization
• Increasing costs force costs in both countries to
  converge, eliminating basis for trade.
• Country can consume outside of PPC

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Ch 2 Foundations of Modern Trade Theory

• Increasing Costs

Wheat
A
w/o trade
Domestic Terms of Trade
Cars
w/o trade
A Production and consumption w/o trade
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Ch 2 Foundations of Modern Trade Theory

• Increasing Costs

Wheat
A
w/o trade
Domestic Terms of Trade
B
Prod w/ trade
Intl Terms of Trade
Cars
Prod w/ trade
w/o trade
B Production with trade
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Ch 2 Foundations of Modern Trade Theory

• Increasing Costs

Wheat
C
Cons w/ trade
A
w/o trade
Domestic Terms of Trade
B
Prod w/ trade
Intl Terms of Trade
Cars
Cons w/ trade
Prod w/ trade
w/o trade
C Consumption with trade
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Ch 2 Foundations of Modern Trade Theory

• Increasing Costs

Wheat
Trade Triangle
C
Cons w/ trade
A
w/o trade
Imports
Domestic Terms of Trade
B
Prod w/ trade
Exports
Intl Terms of Trade
Cars
Cons w/ trade
Prod w/ trade
w/o trade