Class 16 March 22 Last class: Result of Quiz 4 3. International trade theory Today: 3. International trade theory Next class: 3. International trade theory 4. Trade policies of importing nations Quiz 5 (Chapter 3) Reading: 3. International trade, comparative advantage …

Class 16 March 22 Important dates: Problem set 2 due today Midterm exam (chapters 1 – 3) Thursday (March 29) or Tuesday (April 3)?

3. International trade theory 3.1. Simple examples: two-person cases 3.2. Absolute and comparative advantages 3.3. Trade between two countries 3.4. The sources of comparative advantage 3.5. Other explanations for international trade 3.6. Measurement of the gains from trade 3.7. Exchange rate and its determination

3.3. Trade between two countries Wheat and cotton production in Australia and New Zealand (Table 16.2 on p. 3-4) New ZealandAustralia Wheat 6 bu./acre 2 bu./acre Cotton 2 bales/acre6 bales/acre Absolute advantage Australia: Cotton production New Zealand: Wheat production Production with no trade (Table 16.3 on p. 3-4) -- How to interpret Figure 16.1 on p. 3-5? -- Production possibility frontier (PPF)

3.3. Trade between two countries Gains from specialization and trade ( Table 16.4 ) When both countries have absolute advantages, specialization and trade can benefit both nations A strong assumption here: 1 bushel of wheat can be exchanged for 1 bale of cotton How to interpret Figure 16.2 on page 3.6?

3.3. Trade between two countries Suppose the wheat and cotton productivity in Australia and New Zealand has changed to: New ZealandAustralia Wheat 6 bu./acre 1 bu./acre Cotton 6 bales/acre3 bales/acre New Zealand has the absolute advantage in both wheat and cotton production (Australia does not have any absolute advantage) but Australia has the comparative advantage in cotton production (what comparative advantage does New Zealand have?) Production with no trade (Table 16.6)

3.3. Trade between two countries Gains from specialization and trade ( Table 16.7 ) Although Australia does not any absolute advantage, specialization and trade can benefit both nations because both nations have comparative advantages Data on production costs: Country ACountry B Wheat $3/bu.$2/bu. Cotton $6/bale$8/bale

Take-home exercise (Tuesday, March 20) Data on production costs: Country C Country D Wheat $3/bu.$2/bu. Cotton $6/bale$5/bale Which country has the absolute advantage in wheat production? Which country has the absolute advantage in cotton production? Which country has the comparative advantage in wheat production? Which country has the comparative advantage in cotton production? Can specialization and trade benefit both countries? If yes, which country is likely to export wheat?

3.4. The sources of comparative advantage What is comparative advantage? Explanation of the benefit from trade in terms of “opportunity costs” New ZealandAustralia Wheat 6 bu./acre 1 bu./acre Cotton 6 bales/acre3 bales/acre Opportunity cost of wheat Opportunity cost of cotton New Zealand: 1 bale of cotton1 bu. wheat Australia: 3 bales of cotton0.33 bu. wheat

3.4. The sources of comparative advantage Sources of comparative advantage Differences in natural resource endowments Differences in human resource endowment Differences in technology Differences in economic & development policies ….

3.5. Other reasons for international trade Economies of scale -- Returns to scale -- Increasing -- Constant -- Decreasing -- Economies of scale -- Economy of scale: Average cost (AC) decreases when output (Q) increases -- No economy of scale: AC is constant -- Diseconomy of scale: AC increases when Q increases Political and other factors

3.6. Measurement of the gains from trade A graphical analysis (see section 2.7 handout) no trade free trade change Exporting country CS PS Total (CS+PS) Importing country CS PS Total (CS+PS)

3.6. Measurement of the gains from trade A mathematical analysis U.S. (exporter)Japan market (importer) Demand:Qd = PQd = P Supply: Qs = PQs = P no trade free trade change Exporting country CS PS Total (CS+PS) Importing country CS PS Total (CS+PS)

3.7. Exchange rate and its determination Exchange rate: the ratio at which two currencies are traded (the price of one currency in terms of another) e.g., 1 US dollar = 1.56 Canadian dollars 1 US dollar = 7.90 Chinese yuans Importance of exchange rate in trade History of money (currency)

A barter economy

3.7. Exchange rate and its determination How is an exchange rate determined? -- In terms of a valuable product (e.g., gold) -- There is a range of exchange rates that make both countries to gain from trade Example (page 3-9 to page 3-11) U.S.Brazil Timber $13 reals Rolled steel$24 reals If $1=1R, Brazil wants to import both but US does not want to import ==> no trade If $1=4R or 1R=$0.25, US wants to import both but Brazil does not want import any If $1=2R or 1R=$0.5 ==>Brazil wants to import timber and US may import steel If $1=2.1R or 1R=$0.476 ==> US will import steel and Brazil will import timber See Table 16.9 for more alternative exchange rates.

3.7. Exchange rate and its determination How is an exchange rate determined? -- There is a range of change rates that make both countries to gain from trade Example (page 3-9 to page 3-11) U.S.Brazil Timber $13 reals Rolled steel$24 reals When the exchange rate is between $1=2R and $1=3R, both countries will trade and benefit from the trade. The exact exchange rate is determined by many factors such asdomestic demand and supply, balance of payments, negotiation, etc. The exact exchange rate will also determine the gains of each country (e.g., one country will gain more than the other).

3.7. Exchange rate and its determination Impacts of transportation and other costs? U.S.Brazil Timber $13 reals Rolled steel$24 reals If the transportation cost is $0.1 per unit for timber and $0.2 per unit for steel, what will happen? $1=2R $1=2.5R $1=3R Official exchange rate vs. black market rate Impacts of a change in exchange rate

Take home exercise (Thursday, March 22) Suppose we have the following cost information U.S.China Wheat $4/bu36 y/bu Shrimp$5/lb40 y/lb Answer the following 3 questions under each of the alternative exchange rates: (1) What dose the U.S. want to trade? (2) What does China want to trade? (3) If trade can benefit both countries, what will each country export and import? Alternative exchange rate: (a) $1 = 7y with no transportation cost (b) $1 = 8.3y with no transportation cost (c) $1 = 9y with no transportation cost (d) $1 = 8y with the transportation cost of $0.2/bu.for wheat and $0.3/lb. for shrimp