1. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition 1A Appendix Chapter 1 Gains From Trade: The Theory of Comparative Advantage

2. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-1 Definition: a comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Theory of Comparative Advantage

3. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-2 The Geometry of Comparative Advantage Consider the example given in appendix 1A. There are two countries, A and B, who can each produce only food and textiles. Initially they do not trade with each other. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-3 The Geometry of Comparative Advantage 300 Food Textiles 180 A production possibilities curve shows the various amounts of food or textiles that each country can make. The production possibilities of country A are such that if they concentrated 100% of their resources into the production of textiles, they could produce 180 million yards of textiles. If country A chose to concentrate 100% of their resources into the production of food, they could produce as much as 300 million pounds of food. Country A can produce any combination of food and textiles between these two points.

5. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-4 The Geometry of Comparative Advantage 300 Food Textiles 180 60 200 As a practical matter, the citizens of country A must choose a point along their production possibilities curve; initially they choose 200 million pounds of food, and 60 million yards of textiles.

6. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-5 The Geometry of Comparative Advantage 1,200300 Food Textiles 180 900 240 60 200 The production possibilities of country B are such that if they concentrated 100% of their resources into the production of textiles, they could produce 240 million yards of textiles. If country B chose to concentrate 100% of their resources into the production of food, they could produce as much as 900 million pounds of food.

7. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-6 The Geometry of Comparative Advantage 1,200300 Food Textiles 180 900 240 60 200 600 As a practical matter, the citizens of country B must choose a point along their production possibilities curve; initially they choose 600 million pounds of food, and 80 million yards of textiles. 80

8. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-7 The Geometry of Comparative Advantage 300 Food Textiles 180 900 240 60 200600 80 Country A enjoys a comparative advantage in textiles because they have to give up food at a lower rate than B when making textiles. Put another way, country B enjoys a comparative advantage in food because they have to give up textiles at a lower rate than A when making more food. Geometrically, a comparative advantage exists because the slopes of the production possibilities differ.

9. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-8 The Geometry of Comparative Advantage 300 Food Textiles 180 900 240 60 200600 80 If the countries specialize according to their comparative advantage, then country A should make textiles and trade for food, while country B should grow food and trade for textiles.

10. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-9 The Geometry of Comparative Advantage 1,200 300 Food Textiles 420 180 900 240 60 200600 80 Before trade, if both countries made only textiles, the combined production would be 420 million yards of textiles = 240 + 180. Before trade, if both countries made only food, the combined production would be 1,200 million pounds of food = 900 + 300.

11. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-10 The Geometry of Comparative Advantage 1,200300 Food Textiles 420 180 900 240 60 200600 80 The combined production possibilities curve of country A and B without trade are shown in the green line.

12. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-11 The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 180 900 240 60 200600 80 Before trade, the combined production is 800 million lbs of food and 140 million yards of textiles. 140

13. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-12 The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 900 240 60 200600 80 County B can produce food at a lower opportunity cost, so let B produce the first 900 million pounds of food. Country A can produce textiles at a lower opportunity cost, so let them produce the first 180 million yards of textiles. 180

14. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-13 The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 180 900 240 60 200600 80 The combined production possibilities curve with trade is composed of the original curves joined as shown.

15. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-14 The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 180 900 240 60 200600 80 The gains from trade are shown by the increase in consumption available—an extra 100 million pounds of food and 40 million yards of textiles are now available in excess of the pre-trade consumption.

16. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-15 Benefits Wealth increases in both countries Cheaper products

17. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-16 Job Loss or Gain “……45,734 Ohio jobs lost between 1995 and October 2003 can be directly traced to international trade” PolicyMattersOhio “in 2003 the United States exported $47 billion in civilian aircraft, parts, and engines, while importing only $24 billion, for a trade surplus of $23 billion in that category” Ben S. Bernanke, March 30, 2004, at Duke Univ.

18. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-17 Solution “…, we appear, nonetheless, to be graduating too few skilled workers to address the apparent imbalance between the supply of such workers and the burgeoning demand for them” Alan Greenspan, Testimony Before the House, Mar 11,2004,

19. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-18 Trade Policy Tariff Regulations Quota

20. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 1A-19 End Appendix One Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.