1 International Economic Activity

2 Basic look at interaction with the rest of the world. When we talk about interactions with the rest of the world in economics we typically use the phrases open economy and international trade. US of A R est O f W orld Give up Get With all trade

3 Perhaps the most well know interaction with other nations is the flow of goods and services – often called the trade flow. Exports are goods and services made in the country and sold to folks from other countries. Imports are goods and services made elsewhere and sold to folks in the country. The % of US goods and services being exported has grown over time and is about 11% of all goods and services made (What we call the gross domestic product) in the US. Imports have also grown as a % of total product over time. In fact, imports have tended to be larger than exports for the last several decades.

4 Exports minus imports will result in a number we might in general call the trade pattern. If exports - imports > 0 we have a trade surplus, and if exports – imports < 0 we have a trade deficit, and if exports – imports = 0 we have a miracle! (or zero trade balance). Again, overall the US has had a deficit for many years. Our main trade partners in the US are Canada, Mexico and the European Union.

5 Comparative Advantage and the Open Economy This section is a theory about trade among nations

6 In the graph the amount of Good X is measured on the horizontal axis  Good Y is measured vertically.

7 Production Possibilities in country A Notice in the table on the previous slide that country A can only produce 1 combination of goods during a period (one column here) from the 5 possibilities because once it commits resource amounts to each product this is what happens. Each column, or combination, has a different amount of resources devoted to it. Plus, at most it can only make 18 units of X (with 0 Y) or 18 units of Y (with 0 X) in a certain time period because it is only so good at production. The graph is just a different way to present the same information as contained in the table. For example, for Country A combination “a” in the table is really the upper left most point in the graph – sometimes called the Y intercept. Combination “e’” is at the bottom right of the graph – sometimes called the X Intercept.

8 You may recall the slope of a line is the rise over the run. This means between any two points you take the change in the Y amount and divide by the change in the X amount. For Country A let’s look between the two points a and c. We have (18 – 11)/(0 – 7) = 7/(-7) = -1/1. So, here the slope has economic meaning! The minus sign means X and Y move in opposite directions on the line. The 1/1 means that each time X changes by 1 (the denominator), Y changes by 1 (in the opposite direction, remember?). The slope is really the opportunity cost of good X! In economics a special math is used where instead of looking at the slope we look at the difference in values between 2 points where we ignore the minus sign in the slope (that is what makes it special) and between any two columns just take the change in X and Y between the two columns – let’s take columns a and c. X goes up by 7 and Y goes down by 7. The special math would have us write 7X = 7Y and this means to change by 7 X we had to change Y by 7. Let’s use all this information in a bit.

9 Production Possibilities in country B Notice here that country B can only produce 1 combination of goods (one column here) from the 5 possibilities f through j. Plus, at most it can only make 60 units of X (with 0 Y) or 30 units of Y (with 0 X) in a certain time period. Let’s look at the f and h. The slope is (30 – 19)/(0 – 22) = 11/-22 = -0.5/1. Remember the minus sign means X and Y move in opposite directions on the line. The 0.5/1 means that each time X changes by 1 (the denominator), Y changes by 0.5 (in the opposite direction, remember?). The special math here (taking the change in X and Y between the two columns) between columns f and h gives 22X = 11Y. Let’s use all this information in a bit.

10 Absolute Advantage Country B has an absolute advantage in the production of both items because it can produce more of either item relative to country A. You can see this by comparing columns a and f, or e and j. Even though country B has an absolute advantage in both goods it may still want to trade with country A.

11 Comparative advantage If there is no trade among nations then countries can only consume what they first produce. Then A and B would have the same consumption possibilities as their production possibilities. (Then, of course, it would have to use some method to determine which option to make – maybe it would use a market system to decide.) But, if countries specialize in the item in which they have a comparative advantage and then trade for the other item then it is possible for the countries to have consumption possibilities greater than their production possibilities.

12 Review some basic math 12 inches = 1 foot. How many feet are in 24 inches? Since the ratio of inches to feet is always 12 to 1 you can have 12 is to 1 as 24 is to x. Then you can convert to fractions 12 = 1 24 X, and then by cross multiplying you have12X = 24 or x = 2. How many inches are in 7 feet? 12 is to 1 as x is to 7, so x = 12 times 7 = 84 or 84 inches.

13 Comparative advantage - Y From our special math we had the following: In country A 7X = 7Y and in country B 22X = 11Y. Remember in this math 7X = 7Y, for example, means 7more X can be made if 7 Y are given up, or 7 more Y can be made if 7 X are given up. A country will have a comparative advantage in the production of a good if the amount it gives up of the other good is lower in its country compared to the trade-off in another country. So, in country A since 7X = 7Y, 1X = 1Y and this means the cost of an additional Y is giving up 1 unit of X. In country B 22X = 11Y, or 2X = 1Y, so the cost of an additional Y is 2 units of X. Thus county A has a comparative advantage in the production of Y.

14 Comparative Advantage Y Another way of saying this is that country A has a lower opportunity cost in making Y than does country B. Remember opportunity cost is what is given up when a course of action is taken. So, in country A making 1 Y means 1 X is given up, and In country B making 1 Y means 2 X are given up. So, country A, when making 1 Y gives up fewer X and thus we say country A has a comparative advantage in in Y.

15 Comparative advantage - X Again from our special math we had the following: In country A 7X = 7Y and in country B 22X = 11Y. Now, in country A 1X = 1Y and in country B 1X = 0.5Y. So, country B has a comparative advantage in X because it only gives up 0.5Y while country A gives up 1Y. Summary: 1X requires Country A to give up 1Y, and Country B to give up 0.5Y. Thus, in X, country B has a comparative advantage. Summary: 1Y requires Country A to give up 1X, and Country B to give up 2X. Thus, in Y, country A has a comparative advantage.

16 Terms of trade Usually we talk about trade in terms of money. But let’s think about an example. If a pop cost 50 cents and a hotdog costs a dollar, then a hotdog can be thought of as costing two pops. The same can be thought of in terms of X and Y between the countries A and B. How do you like fractions? Most students I know (and teachers too!) would prefer not to deal with then. So, from the previous slide I will reproduce the summary without fractions: Summary: 1Y requires Country A to give up 1X, and Country B to give up 2X. Thus, in Y, country A has a comparative advantage.

17 Terms of trade If 1Y trades for between 1X and 2X (the opportunity costs in the two countries), then I claim trade can benefit both countries. Let’s say trade can happen at 1Y = 1.5X. (maybe by supply and demand this is how it works out) Major point (this is all good stuff, though) For a country to benefit from trade it first has to specialize in the item in which it has a comparative advantage and then trade for the other good. Let’s see this next.

18 Gains from Trade – country A Say country A without trade – sometimes called the self-sufficient point or autarky point - would have chosen to make combination c – 7 X and 11 Y. Then this is the combination it would have to consume. Now if it specializes in the item in which it has a comparative advantage it would produce combination “a” (0X and 18Y). Since trade can occur at 1Y = 1.5X, if country A gives up 6Y it will get back 9X and it can then consume 9 X and 12 Y (the 12 = 18 – 6). If it goes it alone country A gets 7 X and 11 Y, but by specialization and trade it gets more of both, 9 X and 12 Y.

19 Gains from Trade – country B Say country B without trade would have chosen to make combination h – 22 X and 19 Y. Then this is the combination it would have to consume. Now if it specializes in the item in which it has a comparative advantage it would produce combination j (60X and 0Y). Since trade can occur at 1Y = 1.5X if country B gives up 36 X it will get back (36/1.5 = ) 24 Y and it can then consume 24 X and 24Y. If it goes it alone country B gets 22 X and 19Y, but by specialization and trade it gets more of both, 24 X and 24 Y. What you see on the next slide is that through trade each country can have a greater consumption pattern than what it could have made on its own if it was self-sufficient! Trade is beneficial to both.

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