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  1. 1. By
  2. 2. International Trade1. Why should countries trade?  Absolute advantage.  Comparative advantage.2. Who should produce goods when using trade advantages as criteria?  Opportunity cost.3. Flows of Capital and Goods.  Negative net exports.  Would you always expect a country that has few imports and many exports to have much foreign investment?
  3. 3. Gains From Trade1. if a country can produce a good for less than another country, then the opportunity for advantageous trade exists - and both countries could benefit.2. when a country can produce a good that another country is unable to produce.In each of these cases, both the consuming country andthe producing country will be better off with trade thanwithout it.
  4. 4. Absolute Advantage An absolute advantage occurs when one producer uses a smaller amount of inputs to produce a given amount of outputs than another producer.
  5. 5. ExampleX lives on an island with a coconut tree. Y lives on anotherisland with a banana tree. X tires of eating coconuts anddesires something new to eat. Surprisingly enough, Y is tiredof bananas and would love some nice sweet coconut. Tradewould benefit both parties.This example presents only one of the two cases in whichtrade is adventurous.In the other case, a country can produce both goods at anabsolutely or relatively lower price than another country.These conditions are called the absolute advantage andthe comparative advantage respectively.
  6. 6. Advantages in TradeA country may have two advantages over another country (or countries)regarding trade.Absolute advantageThis occurs when a producer can use the smallest amount of inputs toproduce a given amount of output compared to other producers. Absoluteadvantage may apply to many countries.Comparative advantageThis happens when a producer has a lower opportunity cost of productionthan another producer. Comparative advantage may also apply to manycountries, but it will be restricted to cases of two countries and two goods.
  7. 7. ExampleFarmer X has a vegetable farm. It takeshim five hours worth of work to harvest PRODUCTIVITYone pound of vegetables. FARMER ACTIVITY HOUR MONEYFarmer Y also has a vegetable farm. Ittakes him four hours worth of work toharvest one pound of vegetables. X 5 VEGETABLE ONE Y 4 FARMING POUNDFarmer Z owns a third vegetable farm. He Z 3can harvest one pound of vegetable inthree hours.In this example, Farmer Z is said to havethe absolute advantage in pistachioproduction since he is able to produce thelargest amount of output in the smallestamount of time.
  8. 8. In terms of trade, it is always most beneficial for theproducer with the absolute advantage in the productionof a good to specialize in the production of that good.In this case, it was far more productive for Farmer Z tospend time harvesting vegetables than it was for FarmerX or Farmer Y to do the same.Farmer Z therefore has a lower cost of production thaneither of the other two producers.Applying this idea to international trade leads us to theconclusion that goods should be produced for whichthe cost of production is lowest.
  9. 9. Comparative Advantage A comparative advantage occurs when a producer has a lower opportunity cost of production than other producers
  10. 10. ExampleRevisiting the farms belonging PRODUCTIVITYto Farmer Z and Farmer Y, we FARMER ACTIVITYdiscover that they are both able HOUR POUNDSto produce vegetables and VEGETABLEsoybeans. FARMING 2 1 Z SOYABEANS 2 5Farmer Z can harvest 1 pound ofvegetables in 2 hours and he can VEGETABLEharvest 5 pounds of soybeans in 10 1 Y FARMING2 hours. SOYABEANS 2 50Farmer Y, on the other hand, canharvest 1 pound of vegetables in10 hours and 50 pounds ofsoybeans in 2 hours.
  11. 11. PRODUCTIVITY PRODUCTIVITYFARMER ACTIVITY FARMER ACTIVITY HOUR MONEY HOUR POUNDS X 5 VEGETABLE 2 1 VEGETABLE ONE Z FARMING Y 4 FARMING POUND SOYABEANS 2 5 Z 3 VEGETABLE 10 1 Y FARMING SOYABEANS 2 50Farmer Z can harvest 1 pound of vegetables in 2 hour while ittakes Farmer Y 10 hours to harvest 1 pound of vegetables.Farmer Y can harvest 1 pound of soybeans in about 2.4 minutes,but it takes Farmer Z about 24 minutes to harvest a pound ofsoybeans.
  12. 12. Each of these farmers only has a fixed number of hours tospend harvesting, each hour spent harvesting vegetablescannot be spent harvesting soybeans, and similarly, eachhour spent harvesting soybeans cannot be spentharvesting vegetables.For every hour Farmer Z spends picking soybeans, hegives up 0.5 pounds of vegetables; and for every hourthat Farmer Z spends picking vegetables, he gives up 2.5pounds of soybeans.Farmer Y gives up 25 pounds of soybeans for every hourthat he spends harvesting vegetables, and for every hourthat Farmer Y spends harvesting soybeans, he gives up0.1 pounds of vegetables.
  13. 13. An opportunity cost is a way of describing what is given upwhen one choice is taken over another. OPPORTUNITY COST Farmer Z Farmer Y0.1 pounds of soybeans for every 0.5 0.1 pounds of vegetables for every 25pounds of vegetables harvested; or pounds of soybeans harvested; or5 pounds of vegetables for every 1 250 pounds of soybeans for every 1pound of soybeans harvested. pound of vegetables harvested.
  14. 14. OPPORTUNITY COST OF SOYABEANS OVER VEGETABLES OVER SOYABEANS VEGETABLESFARMER Z 1/5 5FARMER Y 250 1/250Farmer ZThe opportunity cost of harvesting vegetables is lower thanthe opportunity cost of harvesting soybeans.For Farmer YThe opportunity cost of harvesting soybeans is lower than theopportunity cost of harvesting vegetables.In both of these cases, this means that both farmers are betteroff spending their time harvesting the product that they canproduce most efficiently.
  15. 15. The producer with the lower opportunity cost ofproduction is said to have the comparative advantage.Notice that in a case with two producers and twoproducts, each producer must have a comparative advantagein one, and not both, products.We may represent the opportunity cost of one product interms of the other product for both producers, and thencompare these numbers. Whichever producer has the loweropportunity cost has the comparative advantage and shouldproduce that product.
  16. 16. Absolute advantage and comparative advantage aretheoretically straightforward.When a producer has an absolute advantage, he can producea given output by using fewer inputs than any competingproducer.When a producer has a competitive advantage, he canproduce one product with a smaller amount of inputs thanthe competitor.When either an absolute advantage or a comparativeadvantage exists, benefits from trade are guaranteed.
  17. 17. Flow of TradeIn the identity Y = C + I + G + NX describes the output of aneconomy. In this equation, Y is the nominal output, C ismoney spent on consumption, I is money spent oninvestment, G is money spent by the government, and NX isnet exports (exports less imports).The sum of these the total amount of both income andoutput in a country.
  18. 18. To understand flow of capital and goods in and out ofcountries, we should keep the Y = C + I + G + NX identity inmind.• NX is of particular interest. NX is defined as the total amount of exports less the total amount of imports.• NX is positive if a country exports more than it imports.• NX is negative if a country imports more than it exports, and zero if exports and imports are equal.
  19. 19. Two Countries A & BIf Country A exports 1 million dollars worth of coconuts toCountry B and imports 1 million dollars worth of bananasfrom Country B, then the NX for both countries is equal tozero since exports equal imports.In this case, goods are traded for goods and at the end of theterm, the trade balance is equal.
  20. 20. If debt is is short-termIf Country A exports 0.5 million dollars worth of coconuts toCountry B and imports 1 million dollars worth of bananasfrom Country B, then Country A has a negative trade balance,called a trade deficit.In this case, Country A owes Country B money for theimported bananas beyond the 0.5 million dollars worth ofexported coconuts.If this is a short-term debt, nothing of consequence wouldoccur since Country A has the ability to export more coconutsquickly to make up for the difference.
  21. 21. If the debt is long termCountry A must somehow repay Country B for the importedbananas. The easiest way to think of this exchange is toimagine Country A giving Country B interest in the futurecoconuts produced by Country A.To repay the debt that Country A owes to Country B, CountryB becomes invested in Country A.
  22. 22. Any amount of exports that exceeds the total amount ofimports results in foreign investment.The opposite occurs when exports exceed imports as theexporting country becomes a foreign investor in theimporting country.
  23. 23. This leads us to another important international tradeidentityNX = NFI where NX is net exports or exports less imports andNFI is net foreign investment.Simply put, the difference between what a country exportsand imports is equal to the amount of foreign investment.The trade balance can remain fair even if a country importsmore than it exports - it must make up the differencethrough foreign investment.
  24. 24. If net exports remain equal to net foreign investment, afew tendencies arise:• countries with few imports and many exports will tend to have significant foreign investment• countries with few exports and many imports will also tend to have significant foreign investment• countries with exports equal to imports will tend to have little investment in foreign countries and little foreign investment
  25. 25. The identity NX = NFI and the means by which capital andgoods flow between countries help to clarify the workings ofinternational trade.
  26. 26. What happens when net exports are negative?• When net exports are negative, net foreign investments are positive as foreigners gain stock in domestic firms to pay for importsWould you expect a country that has few imports andmany exports to have much foreign investment?• A country with few imports would likely have a significant amount of interest in other foreign countries, but little foreign investment in the country.
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