1. 1 International Economic Activity

2. 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. 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. 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. 5 Comparative Advantage and the Open Economy This section is a theory about trade among nations

6. 6 Production Possibilities in country A Production Combo’s ProductABCDE Good X020244060 Good Y1510950 Notice here that country A can only produce 1 combination of goods (one column here). Plus, at most it can only make 60 units of X or 15 units of Y in a certain time period. Let’s look at any two columns and take the change in X and Y between the two columns – take columns A and C. X goes up by 24 and Y goes down by 6. A special math would have us write 24X = 6Y and this means to change by 24 X we had to change Y by 6. Let’s use all this information in a bit.

7. 7 Production Combo’s ProductRSTUV Good X030336090 Good Y302019100 Production Possibilities in country B Notice here that country B can only produce 1 combination of goods (one column here). Plus, at most it can only make 90 units of X or 30 units of Y in a certain time period. Let’s look at any two columns and take the change in X and Y between the two columns – take columns R and T. X goes up by 33 and Y goes down by 11. A special math would have us write 33X = 11Y and this means to change by 33 X we had to change Y by 11. Let’s use all this information in a bit.

8. 8 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 R, or E and V. Even though country B has an absolute advantage in both goods it may still want to trade with country A.

9. 9 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 then it is possible for the countries to have consumption possibilities greater than their production possibilities.

10. 10 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.

11. 11 Comparative advantage - Y From our special math we had the following: In country A 24X = 6Y and in country B 33X = 11Y. Remember in this math 24X = 6Y, for example, means 24 more X can be made if 6 Y are given up, or 6 more Y can be made if 24 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 24X = 6Y, 4X = 1Y and this means the cost of an additional Y is giving up 4 units of X. In country B 3X = 1Y, so the cost of an additional Y is 3 units of X. Thus county B has a comparative advantage in the production of Y.

12. 12 Comparative Advantage Y Another way of saying this is that country B has a lower opportunity cost in making Y than does country A. Remember opportunity cost is what is given up when a course of action is taken. So, in country A making 1 Y means 4X are given up, and In country B making 1 Y means 3X are given up.

13. 13 Comparative advantage - X Again from our special math we had the following: In country A 24X = 6Y and in country B 33X = 11Y. Now, in country A 1X = (6/24)Y = (1/4)y and in country B 1X = (1/3)Y. So, country A has a comparative advantage in X because it only gives up (1/4)Y while country B gives up (1/3)Y. Summary: 1X requires Country A to give up (1/4)Y, and Country B to give up (1/3)Y. Thus, in X, country A has a comparative advantage. Summary: 1Y requires Country A to give up 4X, and Country B to give up 3X. Thus, in Y, country B has a comparative advantage.

14. 14 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 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 4X, and Country B to give up 3X. Thus, in Y, country B has a comparative advantage.

15. 15 Terms of trade If 1Y trades for between 3X and 4X (the opportunity costs in the two countries), then I claim trade can benefit both countries. Let’s say trade can happen at 1Y = 3.5X. (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.

16. 16 Gains from Trade – country A Say country A without trade would have chosen to make combination C – 24X and 9Y. 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 E – 60X and 0Y. Since trade can occur at 1Y = 3.5X if country A gives up 35X it will get back 10Y and it can then consume 25X and 10Y. If it goes it alone country A gets 24X and 9Y, but by specialization and trade it gets more of both, 25X and 10Y.

17. 17 Gains from Trade – country B Say country B without trade would have chosen to make combination T – 33X and 19Y. 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 R – 0X and 30Y. Since trade can occur at 1Y = 3.5X if country B gives up 10Y it will get back 35X and it can then consume 35X and 20Y. If it goes it alone country B gets 33X and 19Y, but by specialization and trade it gets more of both, 35X and 20Y. Hey, it is my hunch that you would prefer to specialize in something other than looking at this theory here. But, if you focus and practice a bit I know you will pick up on this! You can do it!