Brian Butler: TBird int'l economics class 05

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Series of lectures from Brian Butler, given during fall 2008 session at Thunderbird Global MBA, Miami campus:

This lecture 05: continue learning the basics of trade economics, starting with absolute advantage, comparative advantage, and looking at the economics of free trade

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Brian Butler: TBird int'l economics class 05

  1. 1. <ul><li>Brian David Butler </li></ul><ul><li>Miami Campus Facilitator </li></ul><ul><li>International Economics & Trade (Prof. Grosse) </li></ul><ul><li>Email: [email_address] </li></ul><ul><li>home: 305-396-6116 </li></ul><ul><li>Connect: </li></ul><ul><li>Facebook </li></ul><ul><li>Linkedin </li></ul><ul><li>GloboTrends blog </li></ul>Session #5
  2. 2. Why study trade? <ul><li>Class outline </li></ul><ul><li>Today Future class </li></ul><ul><li>Trade theory trade barriers </li></ul><ul><li>Why trade? Economics of tariffs </li></ul><ul><li>Comparative advantage </li></ul><ul><li>Compare this class vs. finance class? </li></ul>
  3. 3. Perspectives: <ul><li>Whats the difference: </li></ul><ul><li>How economist sees trade? </li></ul><ul><li>How marketing sees trade? </li></ul><ul><li>- Goals / objectives </li></ul>
  4. 4. For initial discussion… <ul><li>“ free trade is mutually beneficial for both countries” i.e. both countries are better off </li></ul><ul><li>“ the freer the trade, the more both countries benefit” </li></ul><ul><ul><li>Agree? disagree? Limitations? </li></ul></ul><ul><ul><li>what are the benefits of free trade? </li></ul></ul><ul><ul><li>Negatives? </li></ul></ul>
  5. 5. benefits? <ul><li>Greater diversity of products </li></ul><ul><li>Economies of scale (from specialization ) </li></ul><ul><ul><li>bigger market, drives costs down) </li></ul></ul><ul><ul><li>Greater efficiency in large plants (autos, example) </li></ul></ul><ul><ul><li>Advantage to specialize in fewer products, and trade </li></ul></ul><ul><ul><li>Don’t need factory in each country…less cost… </li></ul></ul><ul><li>3. Competition = innovation </li></ul><ul><ul><li>Kills off lazy & stupid </li></ul></ul><ul><li>4. Avoid inefficient costs of protectionism </li></ul><ul><ul><li>Tariffs, quotas, export su bsidies, etc… </li></ul></ul>
  6. 6. why controversial? <ul><li>Local industry harmed? </li></ul><ul><ul><li>Unfair competition /imperfect competition </li></ul></ul><ul><ul><li>Dumping </li></ul></ul><ul><ul><li>State enterprise vs. private enterprise </li></ul></ul><ul><li>2. Unfair Income distribution </li></ul><ul><ul><li>Convergence of relative prices…leads to effects on relative earnings of land & labor…leads to … </li></ul></ul><ul><ul><li>Trade tend to make low skilled workers in the US worse off, while making high-skilled workers better off. </li></ul></ul>
  7. 7. why controversial? <ul><ul><li>Special interests </li></ul></ul><ul><ul><ul><li>Pain is localized, benefit is generalized </li></ul></ul></ul><ul><ul><ul><li>Motivation of few vs. many </li></ul></ul></ul><ul><ul><ul><li>Protect income of certain interest groups </li></ul></ul></ul><ul><ul><li>Political process </li></ul></ul><ul><ul><ul><li>Buy votes with protectionism </li></ul></ul></ul>
  8. 8. <ul><li>History: </li></ul><ul><ul><li>Adam Smith (1776) – Absolute cost advantage Theory </li></ul></ul><ul><ul><li>England absolute = Machinery </li></ul></ul><ul><ul><li>France absolute = Wine </li></ul></ul><ul><ul><li>Should each specialize + Trade …obvious! </li></ul></ul>Trade: Absolute Advantage:
  9. 9. <ul><li>History: </li></ul><ul><ul><li>David Ricardo (1817) – Relative cost advantage </li></ul></ul><ul><ul><li>But, this time… Portugal is Absolute in BOTH </li></ul></ul><ul><ul><li>Trade … not obvious! </li></ul></ul>Trade: Comparative Advantage:
  10. 10. <ul><li>Portugal has 120/80 = 1.5x advantage in wine </li></ul><ul><li>Portugal has 100/90 = 1.1x advantage in cloth </li></ul><ul><ul><ul><li>… .so, they have a comparative better advantage in wine </li></ul></ul></ul><ul><ul><ul><li>Trade recommendation: specialize + trade for cloth </li></ul></ul></ul>Comparative Advantage cont’d:
  11. 11. Gains from Trade <ul><li>Gains from free trade – depend on </li></ul><ul><li>“ Specialization ” </li></ul><ul><ul><li>More production if you specialize, and everyone can be better off </li></ul></ul>
  12. 12. <ul><li>Insight: </li></ul><ul><ul><li>“ Trade between two countries can benefit BOTH countries if each country exports the goods in which it has a comparative advantage” </li></ul></ul><ul><ul><li>If you learn one economic principle in this class, it should be this one! </li></ul></ul>Trade: Comparative Advantage:
  13. 13. example: <ul><li>Airplanes apples </li></ul><ul><li>France 18 241 </li></ul><ul><li>USA 12 198 </li></ul><ul><li>The numbers in the table refer to the number of airplanes, and millions of bushels with complete specialization. </li></ul><ul><li>Which country has: </li></ul><ul><ul><li>Absolute advantage? </li></ul></ul><ul><ul><li>Comparative advantage? </li></ul></ul>
  14. 14. example: <ul><li>Airplanes apples </li></ul><ul><li>France 18 241 </li></ul><ul><li>USA 12 198 </li></ul><ul><ul><ul><li>Comparative: =18/12 = 241/198 </li></ul></ul></ul><ul><ul><ul><li>= 1.5 = 1.22 </li></ul></ul></ul><ul><li>Absolute advantage? France in both </li></ul><ul><li>Comparative? France has comparative advantage in Airplanes, USA in apples </li></ul>
  15. 15. <ul><li>What exchange rates will produce 2way trade, assuming these prices: </li></ul>Airplanes apples France* price € 100m €7.47 USA* price $90 m $5.4 Note: if you are given Airplane prices, you should be able to derive apple prices!
  16. 16. <ul><li>Airplanes apples </li></ul><ul><li>France* price € 100m €7.47 </li></ul><ul><li>USA* price $90 m $5.4 </li></ul><ul><li>USD / Euro = $90 / 100 =7.47/5.45 </li></ul><ul><li>Trade range= US$ 0.90 < x < US$0.73 </li></ul><ul><li>If USD weaken to $1 / euro…it would limit French airplane exports to USA. </li></ul><ul><li>If USD strengthens to $0.5 /euro…it would limit US exports of apples </li></ul>
  17. 17. Comp. Adv. Assumptions <ul><li>Products are identical </li></ul><ul><ul><li>Quality / characteristics </li></ul></ul><ul><li>Frictionless trade (negligible transport, etc.) </li></ul><ul><li>No gov’t interference </li></ul><ul><ul><li>Tariff </li></ul></ul><ul><ul><li>Subsidy </li></ul></ul><ul><ul><li>Etc..  </li></ul></ul><ul><li>Assume prices relate to costs…. </li></ul><ul><ul><li>(marketing guys will disagree!!!) </li></ul></ul>
  18. 18. Barriers to gains? <ul><li>Limitations on comparative advantage: </li></ul><ul><ul><li>Trade barriers (tariffs, quotas, etc) </li></ul></ul><ul><ul><li>Limits on labor mobility, </li></ul></ul><ul><ul><li>Limits on ability to shift production from one industry to other… </li></ul></ul>
  19. 19. Comparative Advantage Example: <ul><li>A ppliances B ananas </li></ul><ul><li>USA 200* 100 </li></ul><ul><li>Honduras 60 80 </li></ul><ul><li>*Max # units per year: </li></ul><ul><li>Note: US absolute better at both </li></ul>
  20. 20. Comparative Advantage Example: <ul><li>A B </li></ul><ul><li>USA 200 100 </li></ul><ul><li>Honduras 60 80 </li></ul><ul><li>Relative : 200/60 100/80 </li></ul><ul><li>advantage USA: = 3.33x = 1.25x </li></ul><ul><li>333% more efficient </li></ul><ul><li>Note: USA has BIGGER advantage in appliances </li></ul>
  21. 21. Question: <ul><li>Will both countries really be better off if each specializes in “comparative advantage” and if they engage in free trade? </li></ul><ul><li>If so, by how much? </li></ul>
  22. 22. With no trade:
  23. 23. Production if both countries specialize + trade <ul><li>A B </li></ul><ul><li>USA 200 0 </li></ul><ul><li>Honduras 0 80 </li></ul><ul><li>total = 200 + 80 = 280 </li></ul>Production / consumption with NO trade A B USA 120 40 Honduras 40 30 total = 160 + 70 = 230
  24. 24. How much SHOULD they trade? <ul><li>Need to trade enough to meet minimum consumption desires of both countries. </li></ul><ul><li>All extra = surplus </li></ul><ul><li>So, if the US makes 200 (A), and Honduras wants 40, then 40 = min export…can keep 160…which is more than could be kept without trade </li></ul><ul><li>Benefit from trade! (more goods overall) </li></ul>
  25. 25. What exchange rates make trade possible <ul><li>Assume: </li></ul><ul><ul><li>Price appliance US = $10 </li></ul></ul><ul><ul><li>Price appliances Hon = L200 </li></ul></ul><ul><li>Banana </li></ul><ul><ul><li>What does price in US have to be? 200 / 100 ratio….so 200 appliances have same value as 100 bananas </li></ul></ul><ul><ul><li>Price bananas US = $20 (must be able to calculate!) </li></ul></ul><ul><ul><li>Price bananas Hon = 60/80… 200 *60 / 80 = L150 </li></ul></ul>
  26. 26. What FX rates give trade? <ul><li>Appliances bananas </li></ul><ul><li>USA $10 $20 </li></ul><ul><li>Honduras L200 L150 </li></ul><ul><li>Lempira/ USD = L20 / 1 =L7.5/1 </li></ul><ul><li>Trade range= L 20/1 < x < L7.5/1 </li></ul><ul><li>If HON weaken to L100 / dollar…it would limit US appliance exports to HON. </li></ul><ul><li>If HON strengthens to L5 /dollar…it would limit HON bananas exports to USA </li></ul><ul><li>If FX = L20/1… which country has advantage? </li></ul>
  27. 27. Comparative vs. Absolute? <ul><ul><li>Heckscher-Ohlin Theory: </li></ul></ul><ul><ul><ul><li>Takes what Ricardo did </li></ul></ul></ul><ul><ul><ul><li>But adds….factor product proportions </li></ul></ul></ul><ul><ul><ul><ul><li>Land, resources, minerals, etc… </li></ul></ul></ul></ul>
  28. 28. Trade: definitions <ul><li>Import tariff : taxes levied on imports…raises the price of imported goods inside country vs price outside </li></ul><ul><li>Export subsidy : payments given to domestic producers who sell abroad…incentive to export…effect is to raise prices at home </li></ul><ul><li>Terms of trade : relative prices of a country's exports to imports </li></ul>
  29. 29. Trade: Comparative Advantage: <ul><ul><li>“ undeniably true yet not obvious to intelligent people” Samuelson </li></ul></ul><ul><ul><li>Opportunity costs= trade off </li></ul></ul><ul><ul><ul><li>Ex: opportunity cost of roses in terms of computers </li></ul></ul></ul><ul><ul><ul><li>Ex: 10 million roses (resources to grow) = 100,000 computers </li></ul></ul></ul><ul><ul><ul><li>So, opportunity cost of 10 mm roses = 100k computers </li></ul></ul></ul><ul><ul><ul><li>But, other country might have different ratio… </li></ul></ul></ul><ul><ul><ul><ul><li>10 mm roses = just 30 k computers </li></ul></ul></ul></ul><ul><ul><ul><ul><li>So, other country should grow roses! </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Each specialize, Import + increase world production! </li></ul></ul></ul></ul>

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