CHAPTER 5: The Foreign Sector

Characterised by…  expansion of trade between countries  capital markets sprung up in developing and former centrally planned economies  tourism has increased  new technologies have linked the farthest corners of the world Globalisation

 Read Box 5-1 on pages 102, 103 HOMEWORK

Self-sufficiency (or autarky) used to be popular among politicians and citizens who wanted to be independent. Countries gain if every country specialises and exports surplus not consumed domestically and import goods which not produced domestically. Why countries trade

“It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy... What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.” Extract from Adam Smith’s ‘Wealth of Nations’ (1776)

SA has… but no… More reasons to trade…

But what if both countries produce both wool and rubber? Will trade still be desirable or possible under such conditions? Assumptions…  only two countries  each of which producing two goods  goods are exchanged directly for goods (ignore exchange rates) Trade between countries

Absolute and Comparative Advantage Example You’re given the following info. about a newlywed couple and the time it takes each of them to do different chores: vacuuming a room or washing a load of dishes.

The person, firm, or nation with a higher level of productivity compared to that of another. Absolute Advantage: The person, firm, or nation with a higher level of productivity compared to that of another.  Who has the absolute advantage in vacuuming?  Debbie  Who has the absolute advantage in washing dishes?  Neither Absolute Advantage

Q: What is Mike’s opportunity cost of vacuuming in terms of washing dishes? A: Washing 1 1/3 loads of dishes. Q; What is Mike’s opportunity cost of washing dishes in terms of vacuuming? A: Vacuuming ¾ of a room. Q:What is Debbie’s opportunity cost of vacuuming in terms of washing dishes? A: Washing 2/3 of dishes. Q: What is Debbie’s opportunity cost of washing dishes in terms of vacuuming? Vacuuming 1½ room. OC of vacuuming= Time spent vacuuming a room Time spent washing dishes

the person, firm, or nation with the lower opportunity cost vs. that of another. Comparative Advantage: the person, firm, or nation with the lower opportunity cost vs. that of another.  Who has the comparative advantage in vacuuming?  Debbie  Who has the comparative advantage in washing dishes?  Mike Comparative Advantage

Zimbabwe has an absolute advantage in the production of _______ South Africa has an absolute advantage in the production of _______ Absolute advantage between countries Shirts (per worker/week) Cellphones (per worker/week) South Africa 5010 Zimbabwe1005 TOTAL15015

What would happen if both countries specialised ? Gains from specialisation and trade Shirts (per worker/week) Cellphones (per worker/week) South Africa 020 Zimbabwe2000 TOTAL (prev. total) 200 (150) 20 (15)

All that is required for both countries to benefit from trade is that the opportunity costs of production differ between the two countries. David Ricardo David Ricardo (1772–1823) Comparative (relative) advantage

 Germany has an absolute advantage over South Africa in the production of __________. Comparative Advantage Example Cars (per day) Barrels of wine (per day) South Africa 16 Germany28

 Has Germany got anything to gain from trading with South Africa???  Lets look at the OC of production… Gains from trade OC of producing 1 Car OC of producing 1 Barrel of wine South Africa 61/6 Germany41/4 Cars (per day) Barrels of wine (per day) South Africa 16 Germany28  Germany has a relative or comparative advantage in the production of _______  South Africa has a relative or comparative advantage in the production of _______

South Africa will shift resources into wine production if it can exchange fewer than 6 barrels of wine for a car from Germany. Germany will shift resources into car production if it can obtain more than 4 barrels of wine for every car it sends to South Africa. Beneficial if 1 car is exchanged for more than 4 but fewer than 6 barrels of wine. Terms of trade OC of producing 1 Car OC of producing 1 Barrel of wine South Africa 61/6 Germany41/4

Suppose 1 car exchanges for 5 barrels of wine: Germany receives 5 barrels of wine for each car sent to SA. Beneficial for Germany to shift resources from wine to car production and trade the excess cars. Without trade: Without trade: 4 barrels of wine for each car sacrificed. After trade: After trade: 5 barrels of wine for each car given up. Gains From Trade

Suppose 1 car exchanges for 5 barrels of wine: South Africa receives 1 car for 5 barrels of wine it sends to Germany. Beneficial for South Africa to shift resources from car to wine production and trade the excess. Without trade: Without trade: 1 car for 6 barrels of wine sacrificed. After trade: After trade: 1 car for 5 barrels of wine given up. Gains From Trade

International imports can hurt local firms. Gov. policies to protect domestic firms include…  Import tariffs: duties or taxes imposed on products imported into a country.  Import quotas: control number of imports  Subsidies: lowers the cots of domestic producers. Trade policy

Non-tariff barriers  discriminatory administrative practices, for example…  Deliberately awarding government contracts to domestic firms  insisting on technical standards difficult for foreign firms to meet  special licensing requirements  unnecessary red tape.  Exchange rate policy: movements in exchange rates may have significant effects on exports and imports

Exchange rates SA importers pay in foreign currencies for goods/services and exchange SA rand for foreign currencies. SA importers demand foreign currencies. Other countries, pay in rand for SA exports and exchange foreign currencies for rand SA exports lead to a supply of foreign currency. Rate at which currencies are exchanged = rate of exchange or exchange rate.

Exchange rates simply represents the price of one currency in terms of another. Increase in the value of one currency in terms of another (appreciation) implies a decrease (depreciation) in the value of the other currency.

$ per £ Quantity on ForEx Markets D£ S£ 1.85 Q1 Assume an initial exchange rate of £1 = $1.85. There are rumours that the UK is going to increase interest rates Investing in the UK would now be more attractive and demand for £ would rise D£ 1 Q2 Shortage 1.90 Q3 The rise in demand creates a shortage in£ and price of £1(exchange rate) would increase