Overview of the Field of International Economics International Trade –gains from trade –comparative advantage –trade barriers example: quotas International Finance –exchange rates –trade deficits or surpluses –a macroeconomic topic taken up in later lectures

Globalization of the Economy Recent high growth of international trade –reduced transportation costs –lower barriers to trade Look around you for many examples –todays news –this computer

Four ways to gain from trade voluntary exchange (already discussed) competition (already discussed) economies of scale (next lecture) comparative advantage (this lecture)

Definitions Absolute advantage: a country can produce a good relatively more efficiently than another country (example: U.S. better at oranges than Canada) Comparative Advantage: a country can produce a good relatively more efficiently than another good in comparison with another country Applies to people as well as to countries

Numerical example: Output per day of work

Find who has a comparative advantage in what US has an absolute advantage over K in both vaccine and TV sets –for Vaccine 6>1, for TV sets 3>2 US has a comparative advantage in vaccines –6/1 is greater than 3/2 K has a comparative advantage in TV sets –2/3 is greater than 1/6

Can define comparative advantage in terms of opportunity costs Definition: If country A has a lower opportunity cost of producing a good, then it has a comparative advantage in that good compared to country B Example. Opportunity cost of producing a TV in US is 2 vials while it is only 1/2 vial in Korea –Hence, Korea has the comparative advantage in TVs

To get a gut-feeling for the idea of comparative advantage, lets imagine 2 people with 2 skills: lawyer economist

Like two people, two countries can gain from trade based on comparative advantage. To see this, assume that the price with trade is 1 unit of vaccine for 1 TV set How can the US gain from trade? –reduce TV production by 3 –increase vaccine production by 6 –trade with K for 6 TV sets –come out ahead by 3 TV sets

Korea can also gain from trade –increase TV production by 6 –reduce vaccine production by 3, –trade with US for 6 vials of vaccine –come out ahead by 3 vials of vaccine

Determining the price ratio before trade United States –in the US, 6 vials cost the same to produce as 3 TVs –Thus, TVs should cost twice as much as vials –ratio of P TV to P v = 2 Korea –in Korea, 2 TVs cost the same to produce as 1 vial –Thus TVs should cost half as much as vials –ratio of P TV to P v = 1/2

Determining the price ratio after trade Price ratio must come together somewhere between 2 and 1/2 We cannot tell exactly what the price ratio will be; –it depends on demand For ease of multiplication, we therefore assume that the price ratio is 1 –that is, the ratio of P TV to P v = 1

Showing Comparative Advantage with Production Possibilities Curves (10,000 workers in US and 30,000 in K)

Do you think you could sketch that diagram by hand?