1. Topic 8: International Trade Comparative Advantage Exchange Rates

2. Absolute Advantage Someone has an absolute advantage in producing something when they can do so more efficiently (using fewer factors of production, e.g., less labor) than someone else. The person or group that is “better” at producing a good has the absolute advantage in doing so.

3. Comparative Advantage Someone has comparative advantage in producing something when their opportunity costs of doing so are lower than someone else. Compared to someone else, everyone has a comparative advantage in the production of something. Comparative advantage does not imply absolute advantage.

4. Things I could do: Writing Papers and Teaching Farm Where is my absolute advantage? Where is my comparative advantage compared to others?

5. Things I could do: Writing Papers and Teaching Landscaping and yard maintenance Remodel my kitchen Clean my bathroom Where is my absolute advantage? Where is my comparative advantage compared to others?

6. Examples The French and Irish can make both wine and beer Who has the absolute advantage in each product? Who has the comparative advantage in wine? Ireland must give up 10 Beer for each wine France must give up 1/2 beer for each wine France has lower opportunity cost, thus it has comparative advantage. BeerWine France5001000 Ireland1000100

7. Examples The French and Irish can make both wine and beer Who has the comparative advantage in beer? Ireland must give up 1/10 Wine for each Beer France must give up 2 Wine for each Beer Ireland has lower opportunity cost, thus it has comparative advantage. BeerWine France5001000 Ireland1000100

8. Examples The Scottish and Irish can make both sweaters and beer Who has the absolute advantage in each product? Who has the comparative advantage in sweaters? Ireland must give up 10/13 Beer for each sweater Scotland must give up 9/10 Beer for each sweater 10/13<9/10, so Ireland has lower opportunity cost, thus it has comparative advantage. SweatersBeer Scotland1000900 Ireland13001000

9. Examples The Scottish and Irish can make both sweaters and beer Who has the comparative advantage in Beer? Ireland must give up 13/10 Sweater for each Beer Scotland must give up 10/9 Sweater for each Beer 10/9<13/10, so Scotland has lower opportunity cost, thus it has comparative advantage. SweatersBeer Scotland1000900 Ireland13001000

10. Examples In Class Exercise

11. Examples Abby, Bruce and Carlos can make cheese and bread As always with comparative advantage problems in this class, assume linear PPFs for each producer. Who has the absolute advantage in each product Carlos has it in Cheese Bruce has it in Bread CheeseBread Abby500600 Bruce200700 Carlos600300

12. Examples Abby, Bruce and Carlos can make cheese and bread Who has the comparative advantage in Cheese? Abby v. Bruce?  Abby Abby v. Carlos?  Bruce Bruce v. Carlos?  Carlos Carlos > Abby > Bruce CheeseBread Abby500600 Bruce200700 Carlos600300

13. Examples Abby, Bruce and Carlos can make cheese and bread Who has the comparative advantage in Bread? Graph the PPF for the economy with trade. CheeseBread Abby500600 Bruce200700 Carlos600300

14. Comparative Advantage Summary Use the concept of comparative advantage to argue in favor of companies moving production from US to China or India. Who gains? On average, US citizens are better off. Are all US citizens better off? Consider the exchange of “goods” and “services”. Which does the US have comparative advantage in compared to most other countries?

15. Effects of Foreign Trade on Fiscal Policy Benefits of expansionary policy are no longer concentrated in domestic boarders. Might need more aggressive policy to see same effects at home. That is, the effective multiplier might be smaller. If the MPC is 0.8, an increase in G of 1000 might increase domestic Y by less than 1000 / (1- 0.8) = 5000. This is because some of the Y increase takes place in other countries.

16. Effects of Foreign Trade on Monetary Policy For this, we need to consider the foreign exchange market. Consider a world with only two countries: USA and UK Alternatively, think of UK as “rest of the world”

17. Demand for Pounds (£) by holders of $ 1. Import UK produced goods and services 2. Travel to UK 3. Buy UK financial assets (e.g., stocks, bonds, currency) 4. Buy UK “direct” investments (e.g., property, capital goods, firms) 5. Speculation in currency markets (i.e., expect price of £/$ to increase)

18. Supply of Pounds (£) in exchange for $ 1. Import USA produced goods and services to UK 2. Travel to USA 3. Buy USA financial assets (e.g., stocks, bonds, currency) 4. Buy USA “direct” investments (e.g., property, capital goods, firms) 5. Speculation in currency markets (i.e., expect price of £/$ to decrease)

19. Graphing Demand for £ The Price of £ is given in terms of US $, or P=$/£ Graph Demand for £ to Import UK Goods and Services for tourism to UK by currency speculators for investment or financial assets in UK

20. Graphing Demand for £ Demand for £ for investment or financial assets So, return is the same independent of exchange rate… But, what if we expect the exchange rate to decrease or increase during the course of our investment? Exchange Rate Investment in $ Investment in £ Return % Return in £ Return converted to $ $5/£1$100,000£20,00010%$2,000$10,000 $2/£1$100,000£50,00010%$5,000$10,000 $1/£1$100,000£100,00010%$10,000 $0.50/£1$100,000£200,00010%$20,000$10,000

21. Graphing Demand for £ If buy $100,000 investment at $5/£1 exchange rate, and expect to cash in on the investment after exchange rate falls to $2/£1. If buy $100,000 investment at $1/£1 exchange rate, and expect to cash in on the investment after exchange rate increases to $2/£1. Investment in $ Investment in £ bought at $5/£1 Return %Return in £ Return converted to $ at $2/£1 $100,000£20,00010%$2,000$4,000 Investment in $ Investment in £ bought at $1/£1 Return %Return in £ Return converted to $ at $2/£1 $100,000£100,00010%$10,000$20,000

22. Foreign Exchange Market Graph supply and demand together What is the equilibrium exchange rate?

23. Changing interest rate What happens if interest rate in USA decreases, but remains unchanged in UK? Buying US financial assets becomes relatively unattractive, so demand for £ increases, and supply of £ decreases. (Graph it) Price of £ increases. US exports increase, UK exports decrease. Therefore: Expansionary monetary policy (to decrease i at home) can be even more effective with trade, since it not only increases domestic investment but it also increases exports.

24. Some questions: Why do investors care about foreign exchange markets? Speculation Changes in currency prices effects the expected return on investment in different locations. How could the Federal Reserve increase the “strength” of the dollar (make the price of dollars go up)? Are you personally made better off when the dollar is stronger? If you are from abroad and must convert currency to $ to pay tuition? If you live in the US and like to travel abroad? If you own a consulting company that typically does 75% of its business in other countries?