Fisherman John has an AA in fishing. International Trade I. Absolute Advantage (AA)*** Caught in a day: 80 lbs. Caught in a day: 20 lbs. Fisherman Ken Fisherman John Fisherman John has an AA in fishing.

Fisherman John also has an AA in lobstering. International Trade I. Absolute Advantage (AA)*** Caught in a day: 20 lbs. John and Ken also spend days catching lobsters… Caught in a day: 10 lbs. Fisherman Ken Fisherman John Fisherman John also has an AA in lobstering.

Pounds caught per fisherman per day Fisherman John Fisherman Ken Fish Fish 80 20 Lobster Lobster 20 10

trade with Fisherman Ken? Should Fisherman John trade with Fisherman Ken? To answer this correctly, we need to consider…

International Trade I. Absolute Advantage (AA)*** II. Comparative Advantage (CA) The person (or country) that can produce an item at a smaller opportunity cost has the CA.

Who has an absolute advantage in fish? In lobsters? Pounds caught in a day Fish Lobster John 80 20 Ken 10

1F = ¼L What is John’s opportunity cost of 1 pound of fish? Who has an absolute advantage in fish? In lobsters? Pounds caught in a day Fish Lobster John 80 20 Ken 10 We know that 80 pounds of fish will cost John 20 pounds of lobster. So… After simplifying… 80F = 20L = 80 80 But I want to know what 1 pound of fish will cost, not 80. So… 1F = ¼L And I can’t divide one side by 80 without dividing the other. So…

1F = ¼L 1L = ? 4F What is John’s opportunity cost of 1 pound of fish? What is John’s opportunity cost of 1 pound of lobster? Pounds caught in a day Fish Lobster John 80 20 Ken 10 It’s the reciprocal of the cost of fish… 1F = ¼L 1L = ? 4F

1F = ¼L 1F = ½L ? 1L = 4F 1L = 2F ? Pounds caught in a day Fish Lobster John 80 20 Ken 10 F = L 20 20 John’s opportunity costs Ken’s opportunity costs 1F = ¼L 1F = ½L ? 1L = 4F 1L = 2F ?

1F = ¼L 1F = ½L 1L = ? 4F 1L = 2F ? Pounds caught in a day Fish Lobster John 80 20 Ken 10 F = L 10 10 John’s opportunity costs Ken’s opportunity costs 1F = ¼L 1F = ½L 1L = ? 4F 1L = 2F ?

So, who has a comparative advantage in what? Pounds caught in a day Fish Lobster John 80 20 Ken 10 F = L 10 10 John’s opportunity costs Ken’s opportunity costs 1F = ¼L John has a lower OC and thus a CA in fish. 1F = ½L Compare opportunity costs… 1L = ? 4F 1L = 2F

So, who has a comparative advantage in what? Now, let’s take a closer look at John’s production possibilities… Pounds caught in a day Fish Lobster John 80 20 Ken 10 John’s opportunity costs Ken’s opportunity costs 1F = ¼L Ken has a lower OC and thus a CA in lobsters. John has a lower OC and thus a CA in fish. 1F = ½L 1L = 4F 1L = 2F

Now, let’s take a closer look at John’s production possibilities… Fisherman John 80 20 Fish Lobster John’s PPC shows constant opportunity costs, so we can easily break down his numbers… Since 1L = 4F, 4L = 16F Fish 80 64 48 32 16 Lobster 4 8 12 20

Taking a closer look at Ken’s PPC yields the following chart… Now, let’s take a closer look at John’s production possibilities… Fisherman Ken 20 10 Fish Lobster Fish 20 16 12 8 4 Lobster 2 6 10

Given their possibilities, John and Ken make the following production decisions… Fisherman John Fisherman Ken F 80 64 48 32 16 L 4 8 12 20 F 20 16 12 8 4 L 2 6 10 In this case, total pounds caught of fish and lobster are… Fish: 64 + 12 = 76 Lobster: 4 + 4 = 8 But what if John and Ken specialize based on comparative advantage?

Before specialization: After specialization: Fisherman John Fisherman Ken F 80 64 48 32 16 L 4 8 12 20 F 20 16 12 8 4 L 2 6 10 Production gains: Fish: +4 Lobster: +2 Before specialization: Fish: 64 + 12 = 76 Lobster: 4 + 4 = 8 After specialization: Fish: 80 + 0 = 80 Lobster: 0 + 10 = 10

They come to an agreement: And now for the terms of trade… Fisherman Ken Fisherman John For John, 1L = 4F He expects to pay fewer fish for a lobster from Ken. For Ken, 1L = 2F He expects to get more fish for each lobster from John. They come to an agreement: 3F = 1L

3F = 1L So, 15 lbs. of fish is traded for 5 lbs. of lobster. 3 lb 1 lb Fisherman Ken Fisherman John 3 lb 1 lb They come to an agreement: 3F = 1L

3F = 1L 65 lbs. fish 5 lbs. lobster 15 lbs. fish 5 lbs. lobster So, 15 lbs. of fish is traded for 5 lbs. of lobster. Fisherman Ken Fisherman John Original consumption: 64 lbs. fish 4 lbs. lobster Original consumption: 12 lbs. fish 4 lbs. lobster After spec. and trade: 65 lbs. fish 5 lbs. lobster After spec. and trade: 15 lbs. fish 5 lbs. lobster They come to an agreement: 3F = 1L

Comparative advantage applied to trade Fisherman Ken Fisherman John Comparative advantage applied to trade If countries specialize in the production of goods for which they have CAs: Total production rises Through trade, higher production can make everyone better off

Fun with… Comparative Advantage 1. Quantity produced in an hour Hats Sunglasses Jake 9 3 Elwood 4 2 Jake: 1 H = ⅓ S 1 S = 3 H Comparative advantage in hats? In sunglasses? Elwood: 1 H = ½ S 1 S = 2 H Terms of trade? 1 S = 2½ H

Fun with… Comparative Advantage 2. Quantity produced in a day Lava Lamps Disco Balls Ike 30 Tina 40 25 Ike: 1 LL = 1 DB 1 DB = 1 LL Comparative advantage in lava lamps? In disco balls? Tina: 1 LL = 5/8 DB 1 DB = 8/5 LL

Fun with… Comparative Advantage 3. Quantity produced in a day Golden Snitches Horcruxes Harry 6 4 Voldemort 5 1 Harry: 1 GS =  H 1 H =  GS Comparative advantage in snitches? In horcruxes? Voldemort: 1 GS =  H 1 H = 5 GS

Fun with… Comparative Advantage Minutes it takes to assemble a parasol or stitch up some denim shorts Parasol Denim Shorts Edward 60 40 Jacob 75 100 Edward: 1 P =  DS 1 DS =  P Comparative advantage in mowing? In trimming? Note: this one is calculated differently than the three other examples. The others are based on total output of each item in a certain amount of time. This one is based on how much time (input) it takes to produce 1 unit of each item. Jacob: 1 P =  DS 1 DS =  P

IV. Trade Barriers A. Tariffs*** Revenue tariff Purpose is to generate revenue Placed on goods not produced domestically Protective tariff Designed to shield domestic producers Effects of tariffs…

P Widgets Sdomestic Sdomestic plus world Ddomestic Q a c e $12 $4 Foreign products are imported Sdomestic plus world $12 Imports drop the price $4 Ddomestic Q a c e Total domestic production falls Domestic production and consumption… No imports! Total production and consumption rise Imports

Total domestic production rises Total production and consumption fall Widgets Sdomestic $12 $6 +$2 tariff Tariff Revenue $4 Ddomestic Q a b c d e Total domestic production rises Total production and consumption fall Imports after tariff

IV. Trade Barriers A. Tariffs*** Revenue tariff Purpose is to generate revenue Placed on goods not produced domestically Protective tariff Designed to shield domestic producers Effects of tariffs… Domestic consumption  Domestic production  Imports  Gov. revenue  (paid by consumers) Foreign income  → Our exports  Domestic resources move to inefficient markets

P Sdomestic Sdomestic and quota Sdomestic plus world Ddomestic Q B. Import quotas Limit the amount that can be imported Effects are the same as a tariff, but extra revenue goes to foreign firms, not the government. P Sdomestic Sdomestic and quota Sdomestic plus world Ddomestic Q

+ – V. The Balance of Payments A. Sum of all transactions between countries B. Two main parts: 1. Current Account Measures trade in goods and services Exports are credits They earn foreign currency in U.S. banks Imports are debits They reduce foreign currency in U.S. banks Also includes investment income and transfer payments We have for years run a current account deficit. + –

Where did we get the money to pay for all of it? $295.5 Billion 2011 U.S. Trade Deficit: $558 Billion ? Where did we get the money to pay for all of it?

I O U

+ – 2. Financial Account (or Capital Account) Transfer of real assets… Such as an office building, an oil well, or real estate Or financial assets… Such as government bonds (debt), corporate bonds, or stocks “Exports” are credits “Imports” are debits We have for years run a financial account surplus + –

In effect, our country has been behaving like an extraordinarily rich family that possesses an immense farm… In order to consume 4 percent more than we produce -- that's the trade deficit -- we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.

Current Account + Financial Account = 0 The “balance” part Every unit of foreign exchange used (debits) must have a source (credits). The summed components of the BOP must equal zero… Current Account + Financial Account = 0 Debits Credits

Foreign Exchange Market I. Supply and Demand for currency Equilibrium prices are exchange rates

Market for Yen P¥ S¥ p* So, $1 will buy 99.265 yen! D¥ q* Q¥ Price of one yen in terms of dollars People in Japan who want dollars (to trade with U.S.) S¥ Current exchange rate: 1 yen costs $0.0101 p* Price is an “exchange rate” So, $1 will buy 99.265 yen! People in U.S. who want yen (to trade with Japan) D¥ q* Q¥

Foreign Exchange Market I. Supply and Demand for currency Equilibrium prices are exchange rates II. Exchange rate determination and effects… A. When the dollar price of foreign currency falls… the dollar appreciates the other currency depreciates B. Changes in tastes Suppose our demand for Japanese goods increases…

Foreign Exchange Market I. Supply and Demand for currency Equilibrium prices are exchange rates II. Exchange rate determination and effects… A. When the dollar price of foreign currency falls… the dollar appreciates the other currency depreciates B. Changes in tastes Suppose our demand for Japanese goods increases…

Market for Yen Our demand for Japanese goods increases… P¥ S¥ p2 p1 q1 q2 Q¥

Market for Yen Our demand for Japanese goods increases… P¥ S¥ p2 p1 q1 q2 Q¥ Yen appreciates

Market for Yen Market for Dollars Our demand for Japanese goods increases… Market for Yen Market for Dollars P¥ P$ S$1 S$ S¥ p2 S$2 p1 p1 D¥2 p2 D$ D¥ D¥1 q1 q2 Q¥ q1 q2 Q$ Yen appreciates Dollar depreciates

B. Changes in tastes Suppose our demand for Japanese goods increases. D for yen  → P of yen  → Yen appreciates S of dollars  → P of $  → $ depreciates Suppose our demand for Japanese goods falls Result?*** Suppose Japanese demand for our goods increases. S of yen  → P of yen  → Yen depreciates D for $  → P of $  → $ appreciates

C. Changes in relative income Suppose our national income (RGDP) grows more rapidly than Japan’s… D for yen  → P of yen  → Yen appreciates S of dollars  → P of $  → $ depreciates Why?*** Changes in relative price levels Suppose our domestic price level rises and Japan’s does not…

Market for Yen Our price level rises while Japan’s does not… P¥ S¥2 p2 q1 Q¥

Market for Yen Market for Dollars Our price level rises while Japan’s does not… Market for Yen Market for Dollars P¥ S¥2 P$ p2 S¥1 S$1 S$2 p1 p1 D¥2 p2 D$2 D¥ D¥1 D¥ D$1 q1 Q¥ q1 Q $

C. Changes in relative income Suppose our national income (RGDP) grows more rapidly than Japan’s… D for yen  → P of yen  → yen appreciates S of dollars  → P of $  → $ depreciates Why?*** Changes in relative price levels Suppose our domestic price level rises and Japan’s does not… D for yen  and S of yen  → Yen appreciates D for $  and S of $  → Dollar depreciates Why?***

E. Changes in real interest rates Suppose our real interest rate rises relative to Japan’s… D for yen  and S of yen  → Yen depreciates S of $  and D for $  → $ appreciates Why?*** F. Speculation***

? What's the dollar's current trend? Which is better? Appreciating? Depreciating?

G. When the $ appreciates… Foreign goods seem (cheaper / more expensive) Our imports (increase / decrease) Our goods seem (cheaper / more expensive) to foreigners Our exports (increase / decrease)