1. 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.

2. 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.

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

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

5. 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.

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

7. 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…

8. 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

9. 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 ?

10. 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 ?

11. 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

12. 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

13. 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

14. 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

15. 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: = 76
Lobster: = 8
But what if John and Ken specialize based on comparative advantage?

16. 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: = 76
Lobster: = 8
After specialization:
Fish: = 80
Lobster: = 10

17. 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

18. 3F = 1L So, 15 lbs. of fish is traded for 5 lbs. of lobster. 3 lb 1 lb
Fisherman Ken
Fisherman John lb
1 lb
They come to an agreement:
3F = 1L

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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…

26. 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

27. 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

28. 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

29. 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

30. + – 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. + –

31. 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?

32. I O U

34. + – 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 + –

35. 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.

36. 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

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

38. 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
yen!
People in U.S. who want yen (to trade with Japan) D¥ q* Q¥

39. 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…

40. 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…

41. Market for Yen Our demand for Japanese goods increases… P¥ S¥ p2 p1q1 q2 Q¥

42. Market for Yen Our demand for Japanese goods increases… P¥ S¥ p2 p1q1 q2 Q¥
Yen appreciates

43. 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

44. 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

45. 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…

46. Market for Yen Our price level rises while Japan’s does not… P¥ S¥2 p2q1 Q¥

47. 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 $

48. 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?***

49. 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***

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

51. 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)