1 Welcome to EC 382: International Economics By: Dr. Jacqueline Khorassani Week Two

2 Week Two: Class One Tuesday, September 11 14:00-14:50 AC 202 Tuesday, September 11 14:00-14:50 AC 202 The library does not have the book The library does not have the book –You will need to purchase it

3 Last class we defined absolute advantage If India can produce one yard of cloth using fewer resources than the US, then India has absolute advantage in production of cloth If India can produce one yard of cloth using fewer resources than the US, then India has absolute advantage in production of cloth Or Or If India uses all of its resources it can produce more cloth than the US, then India has absolute advantage in production of cloth If India uses all of its resources it can produce more cloth than the US, then India has absolute advantage in production of cloth According to the theory of absolute advantage: A country must export what they have absolute advantage in and import what they have absolute disadvantage in. According to the theory of absolute advantage: A country must export what they have absolute advantage in and import what they have absolute disadvantage in.

4 What is Production Possibilities Frontier (PPF) ? A curve that shows the different combinations of two goods that a nation can produce efficiently, with a given amount of resources and a given technology in a given period of time. A curve that shows the different combinations of two goods that a nation can produce efficiently, with a given amount of resources and a given technology in a given period of time.

5 PPFs in the US and India U.S.India Number of Machines Yards of Cloth Number of Machines Yards of Cloth

6 Let’ look at the table again: Who has absolute advantage in what? US has absolute advantage in production of machines US has absolute advantage in production of machines No one has absolute advantage in production of cloth No one has absolute advantage in production of cloth Based on the absolute advantage theory, US can export machines to India but India should not export anything to the US. Based on the absolute advantage theory, US can export machines to India but India should not export anything to the US. –In a barter economy, trade will not take place. India has nothing to offer US India has nothing to offer US U.S.India Number of Machines Yards of Cloth Number of Machines Yards of Cloth

7 Let’ look at the PPF table again What is the opportunity cost of producing one machine in each nation? What is the opportunity cost of producing one machine in each nation? –3 yards of cloth in US –5 yards of cloth in India U.S.India Number of Machines Yards of Cloth Number of Machines Yards of Cloth

8 B B’ U.S. Cloth Machines INDIA Cloth Machines A A’ Opp cost of 1 machine =MRT = -5 Opp cost of 1 machine=MRT= -3 Let’s draw the PPF for each country Production and consumption in before trade Since OPP cost is always the same = constant cost

9 The theory of comparative advantage David Ricardo (1772(Netherlands)- 1823) David Ricardo (1772(Netherlands)- 1823) A nation has comparative advantage in production of machines, if it can produce it at a lower opportunity cost. A nation has comparative advantage in production of machines, if it can produce it at a lower opportunity cost.

10 In our example: U.S.India Number of Machines Yards of Cloth Number of Machine s Yards of Cloth Who has comparative advantage in machines? Who has comparative advantage in machines? US with opp cost of 3 yards of cloth US with opp cost of 3 yards of cloth Who has comparative advantage in cloth? Who has comparative advantage in cloth? India with opp cost of 1/5 of machines India with opp cost of 1/5 of machines

11 You asked 1. Do we need to know absolute advantage to find comparative advantage? No No 2. How can a country have comparative advantage but not absolute advantage? Look at India Look at India

12 Trade based on comparative advantage A nation should specialize in production of the good in which it has comparative advantage and trade that good for a good that it has comparative disadvantage in. A nation should specialize in production of the good in which it has comparative advantage and trade that good for a good that it has comparative disadvantage in.

13 Assignment 1 Do it in teams of 2 or 3. Do it in teams of 2 or 3.

14 International Economics Week Two, Class 2 Week Two, Class 2 –11:10-12:00 –Tyndall

15 computers U.S. computers U.S. Beer Germany computers Germany Beer Asst 1 PPFs

16 The slope of US PPF = 0.5 = opp cost of 1 computer = MRT of beer for computer in the US The slope of German PPF = 1 = opp cost of 1 computer = MRT of beer to computer in Germany U.S. 0 beer computers Germany 0 beer computers PPFs

17 Which country has absolute advantage in production of what? Neither has absolute advantage in production of beer. US has absolute advantage in production of computers...

18 Based on the theory of absolute advantage who export what? No trade No trade –Because US can export computers but US does not want German beer.

19 Which country has comparative advantage in what? Opp cost of 1 beer Opp cost of 1 computer US 2 computers 0.5 beer Germany 1 computer 1 beer

20 Notes: The opportunity cost of computer = slope of PPF The opportunity cost of computer = slope of PPF The opportunity cost of Beer = inverse of the slope of PPF The opportunity cost of Beer = inverse of the slope of PPF (This is always true.) (This is always true.)

21 Which country has comparative advantage in what? US has comparative advantage in production of computers Germany has comparative advantage in production of beer. This means that the US must trade computers for beer with Germany

B B U.S. 0 beer computers Germany 0 beer computers choose a combination of computers and beer from the PPF Label this point on your graph. As point “B”. PPFs Pre-trade consumpti on and production Pre-trade consumpti on & production

23 Pre-trade best points were picked arbitrarily Pre-trade best points were picked arbitrarily US best point represents 5 units of Computers and 2.5 bottles of Beer. US best point represents 5 units of Computers and 2.5 bottles of Beer. Germany’s best point represents 3 units of Computers and 2 bottles of Beer. Germany’s best point represents 3 units of Computers and 2 bottles of Beer.

24 Who should specialize in production of what? Since the US has comparative advantage in production of computers, it must specialize in production of computers. Since the US has comparative advantage in production of computers, it must specialize in production of computers. –Produce 10 Computers and 0 Beers Since Germany has comparative advantage in production of beer, it must specialize in production of beer. Since Germany has comparative advantage in production of beer, it must specialize in production of beer. – Produce 0 Computers and 5 Beers Note: partial specialization is also possible. Note: partial specialization is also possible.

B B U.S. 0 beer computers Germany 0 beer computers Production points after trade are points P & P Post-trade production P P

26 Determination of the range of the mutually beneficial terms of trade The terms of the trade must be acceptable to both countries. The terms of the trade must be acceptable to both countries. An acceptable term of trade is a price less than domestic opportunity cost. An acceptable term of trade is a price less than domestic opportunity cost. The opportunity cost of producing 1 beer in the US is 2 computers. The opportunity cost of producing 1 beer in the US is 2 computers. Or the opportunity cost of 2 computers is 1 beer. Or the opportunity cost of 2 computers is 1 beer. Therefore, US will only trade 2 computers for more than 1 beer. Therefore, US will only trade 2 computers for more than 1 beer. That is, the US would like the 2 computers to be more valuable than 1 beer. That is, the US would like the 2 computers to be more valuable than 1 beer. We can show this constraint this way: We can show this constraint this way: –2 computers > 1 beer)

27 Determination of the range of the mutually beneficial terms of trade The opportunity cost of producing 1 computer in Germany is 1 beer. The opportunity cost of producing 1 computer in Germany is 1 beer. Or the opportunity cost of 1 beer is 1 computer. Or the opportunity cost of 1 beer is 1 computer. Therefore, Germany will only trade 1 beer for more than 1 computer. Therefore, Germany will only trade 1 beer for more than 1 computer. That is, Germany would like 1 beer to be more valuable than 1 computer. That is, Germany would like 1 beer to be more valuable than 1 computer. We can show this constraint this way: We can show this constraint this way: –1 beer > 1 computer)

28 Determination of the range of the mutually beneficial terms of trade Putting US and Germany’s constraints together Putting US and Germany’s constraints together 2 computers > 1 beer > 1 computer 2 computers > 1 beer > 1 computer This is the range of the mutually beneficial terms of trade This is the range of the mutually beneficial terms of trade This means that 1 beer needs to be traded for more than 1 computer but less than 2 computers in order for both nations to benefit. This means that 1 beer needs to be traded for more than 1 computer but less than 2 computers in order for both nations to benefit. So the two nations can choose any terms that fall in this range. So the two nations can choose any terms that fall in this range. –1 beer for 1.5 computers –Or, 1 beer for 1.75 computers

29 Let’s say that they agree to trade 1 beer for 1.5 computers Which means that 3 beers will be trade for 4.5 computers. Which means that 3 beers will be trade for 4.5 computers. United States trades 4.5 units of computers to Germany for 3 bottles of beer United States trades 4.5 units of computers to Germany for 3 bottles of beer

30 After Trade US will produce 10 computers and no beer US will produce 10 computers and no beer –Gives 4.5 to Germany for 3 beers. –So it is left with Computers and Beer –So it is left with 5.5 Computers and 3 Beer Before trade it had 2.5 beer and 5 computers. Before trade it had 2.5 beer and 5 computers. After trade it has 0.5 more beer and 0.5 more computers than pre-trade. After trade it has 0.5 more beer and 0.5 more computers than pre-trade. US is better off by 0.5 computers and 0.5 beer US is better off by 0.5 computers and 0.5 beer

31 After Trade Germany will produce 5 beers and no computers Germany will produce 5 beers and no computers –Gives 3 beer to US for 4.5 computers –So it is left with 4 Computers and 2Beer –So it is left with 4.5 Computers and 2 Beer Before trade it had 2 beer and 3 computers. Before trade it had 2 beer and 3 computers. After trade it has 1.5 more computers than pre-trade. After trade it has 1.5 more computers than pre-trade. Germany is better off by 1.5 computers Germany is better off by 1.5 computers Note that before trade the world production of computers was 8 and now it is 10. Note that before trade the world production of computers was 8 and now it is 10. Note that before trade the world production of beer was 4.5 and now it is 5. Note that before trade the world production of beer was 4.5 and now it is 5. So the world production of both goods has increases. So the world production of both goods has increases.

32 World production ComputersBeer Pre-trade84.5 Post-trade105

33 The red lines are the trading possibility curves and consumption possibilities curves The slope of the trading possibility curves = the terms of trade = 3/4.5 = 1/1.5=0.67= international price of 1 computer B B C Imports Exports P C Imports 5 P U.S. 0 beer computers Germany 0 beer computers Let’s look at our PPFs again 5.5

34 International Economics Week Two: Class 3 Week Two: Class 3 –Wednesday, September 12 –15:10-16:00 –AC201

35 Remember that the range of mutually beneficial terms of trade was Remember that the range of mutually beneficial terms of trade was –2 computers >1 beer>1 computer What affects the exact position of the exchange rate within this range? What affects the exact position of the exchange rate within this range? –1 beer for 1.5 computers, or –1 beer for computers? In Assignment 1

36 The theory of reciprocal demand suggests that The stronger the US demand for German beer, the closer the rate to 1 beer for 2 computers The stronger the US demand for German beer, the closer the rate to 1 beer for 2 computers The stronger the German demand for US computer, the closer the rate to 1 beer for 1 computer The stronger the German demand for US computer, the closer the rate to 1 beer for 1 computer

37 Note: Under constant cost assumption (linear PPFs), the supply curve of a good in each country is horizontal. beer computers Price of Computer in terms of forgone beer computers Supply 5 10 US 0.5 The Price of computer in terms of the number of forgone beer is always constant

38 Supply Curves of a Good and the Production Possibilities Frontier Under Increasing Cost Conditions beer computers Price of computers 5A 4.5 B 1 C 2 D E 9 F 10 Supply The opportunity coat of first computer is 0.5 beer. The opportunity cost of 10 th computer is 2 beers.

39 Why is there increasing cost? beer computers 5A 4.5 B 1 C 2 D E 9 F 10 Resources are not homogenous Some labor is more productive in production of beer and some can produce computers better

40 Study Figure 2.8, Page 47 carefully Study Figure 2.8, Page 47 carefully –Notice that the only difference between this and constant cost case is At any given point on PPF the slope of the tangency line = opportunity cost of the good measured on horizontal axis. At any given point on PPF the slope of the tangency line = opportunity cost of the good measured on horizontal axis. The blue line (the line representing the exchange rate) is tangent to PPF at the production level after trade. The blue line (the line representing the exchange rate) is tangent to PPF at the production level after trade. Complete specialization is not possible under increasing cost assumption because if a nation wants to completely specialize in production of a good, its cost of producing that good will be extremely high. Complete specialization is not possible under increasing cost assumption because if a nation wants to completely specialize in production of a good, its cost of producing that good will be extremely high. Trade Under Increasing Opportunity Costs

41 Static Gains from trade Static Gains from trade –Gains in word output Dynamic gains from trade Dynamic gains from trade –Gains from trade over time Increased efficiency and productivity Increased efficiency and productivity Static/ Dynamic Gains From Trade

42 Chapter 3: Why does Germany have comparative advantage in production of beer? Why does Germany have comparative advantage in production of beer? How would trade change the distribution of income in each nation? How would trade change the distribution of income in each nation? Several theories try to answer the above questions. Several theories try to answer the above questions. Each theory is developed based on certain assumptions an draws some conclusions Each theory is developed based on certain assumptions an draws some conclusions