IBDP International Trade

INTERNATIONAL
ECONOMICS
ABHISHEK MAITY
2013

Abhishek Maity, KIS, 2013
1

 Chapter 1:
 Chapter 2:
 Chapter 3:
 Chapter 4:
 Chapter 5:
 Chapter 6:

International Trade
Protectionism
Exchange Rates
Balance of Payments
Economic Integration
Terms of Trade

2

INTERNATIONAL
TRADE
ABHISHEK MAITY
SEMESTER 2, 2013

3

 GAME:
 OBJECTIVE: To build a castle
 To construct a castle you need to gather:
 4 Rock (pebble)
 1 Food (candy)
 1 Gold (coin)
 2 Wood (pencils)
 You are allowed to communicate and talk to other teams
 WINNER: Team with most GOLD left over
 TIME LIMIT: 15 minutes
4

 VOLUNTARY TRADE IS MUTUALLY BENEFICIAL
 Lower Prices
 China!
 Taking advantage of different factors of endowments
 Economies of scale
 Increased variety and choice
 Acquisition of needed resources
 Competition can improve efficiency
 Political benefits
 Efficiency and exports = growth and development
5

 Objectives:
 Explain the theory of Absolute Advantage (AA).
 Explain, using a diagram, the gains from trade arising from
a country’s AA in the production of a good.
 Explain the theory of Comparative Advantage (CA).
 Describe the sources of CA.
 Draw diagrams to show CA.
 Calculate opportunity costs from a given set of data and
illustrate it on a graph.

6

 Adam Smith
(left)

 Ricardo
(right)

7

Absolute Advantage
Country

Guns per unit of time

Roses per unit of time

USA

30

5

Costa Rica

3

15

• USA should specialize in Guns and Costa Rica in Roses

8

“Absolute advantage is the situation that occurs
when one country can produce more of a given
product with the same or less resources than
another country.”
 The country with absolute advantage in one good should
specialize and trade.

9

Absolute Advantage

Country

Guns per
Roses
Opportunity Cost of
Opportunity Cost
unit of
per unit
1 Gun
of 1 Rose
time
of time

USA

30

5/30 units of roses

5

6 units of guns

Costa Rica

3

5 units of roses

15

1/5 units of guns

 Absolute Advantage PPC [DIAGRAM]
 Calculate the opportunity cost.
 Are they better of trading? What is a feasible new terms
of trade?
 Show new PPC after trading.
10

Some countries might be better at making
everything than others, should these countries
bother to trade?

11

Comparative Advantage

Country

Output of Opportunity
Output of
Opportunity Cost
TVs
Cost of 1 TV Smartphones of 1 Smartphone

USA

10

5

Costa Rica

20

15

“Comparative Advantage is when a country
produces a good at a lower opportunity cost than
another country.”
12

 Even in the case of one country having absolute advantage
in both products, you still benefit from trade.
 How?
 Terms of Trade
 Absolute and comparative advantage with PPC [DIAGRAM]

13

 Occurs when the opportunity costs of the two trading
partners are identical… then there is no room for trade.
 [DIAGRAM]
Comparative Advantage Matrix

Country

Input time for
1 unit of Iron
(hours)

Opportunity
Cost of
producing 1
unit of iron

Input time
Opportunity Cost
for 1 unit of
of producing 1
butter
unit of butter
(hours)

USA

20

0.5 butter

10

2 irons

Costa Rica

10

0.5 butter

5

2 irons

14

 Fill in the table and draw the PPC for the scenario below
before and after trade.
Opportunity
Cost of
producing 1
unit of iron

Input time
Opportunity Cost
for 1 unit of
of producing 1
butter
unit of butter
(hours)

Country

Input time for
1 unit of Iron
(hours)

USA

25

15

Costa Rica

10

5

15

 Assume the table below. On a PPC show how both
countries gain through trade in a general setting.

Country

Opportunity
Opportunity Cost
Production of
Cost of
Production
of producing 1
wheat (1 kg) producing 1 kg of oil (1 liter)
liter of oil
of wheat

USA

15

20

Costa Rica

5

10

16

 Supply and demand diagram of domestic equilibrium and
world price… Autarky vs. Free Trade argument.
[DIAGRAM]
 Assumptions:
 Perfectly competitive market
 Homogenous product
 Small country – i.e. world price not affected by the
country’s demand

17

 Factors of “endowment”
 Example: Arable land  agricultural advantage
 Well educated public  financial services
 Abundant unskilled labor  cheap manufacturing goods

18

 Perils of extreme specialization
 Unrealistic Assumptions
 Perfect knowledge
 No transport costs
 Very basic theory assuming a two country world
 We assume linear PPC, constant returns to scale
 Identical products across countries
 Factors of production remain in the country
 Free trade

19

 “Perils of extreme specialization”
 Unrealistic Assumptions
 Perfect knowledge
 No transport costs
 Very basic theory assuming a two country world
 We assume linear PPC, constant returns to scale
 Identical products across countries
 Factors of production remain in the country
 Free trade

20

 Your task for next class – Research about the WTO and be
ready to discuss it in class. This will contribute towards
your classroom participation grade.
 History
 Aims and objectives
 Success
 Milestones
 Pros and cons
 Failures
 Alternative ideas
21

 Born out of the General Agreement on Tariffs and Trade
(GATT) in 1948 at the Bretton-Woods Conference.
 Created in 1993.
 “deals with the global rules of trade between nations…”
 Trade without discriminations
 Free trade
 Predictability and transparency
 Fair competitive practices
 Encourage development
22

 Functions:
 Provide a forum for trade negotiation
 Execute WTO agreements
 Evaluate and rule on trade complaints by member
countries
 Provide technical assistance to developing countries on
issues of trade
 Track changes in member states’ trade policies

23

 For Argument:
 WTO promotes peace through trade.

24

 Against Argument:
 WTO favors the rich.

25

Are there moral as well as economic reasons in
favor of free trade?
Do economies that are open to trade grow
faster?
Are rich countries more protectionist than poor
ones?
Does agricultural protectionism in the rich world
worsen global poverty?
26

PROTECTIONISM
ABHISHEK MAITY
SEMESTER 2, 2013

27

To protect domestic employment.
To protect infant industries
To counteract domestic tax difference
Prevent dumping
Diversify production base
Enforce product standard
To raise government revenue
Protect against unfairly low labor costs
Protect strategic industries
Overcome BOP deficits
Improve Terms of Trade
28


Misallocation of resources
Escalation to a trade war
Protectionism as a corruption magnet
Domestic complacency causes higher prices and
costs
Higher import costs
Reduced export competitiveness
29

World price and import levels [DIAGRAM]

30

Tariffs – tax imposed on imports
[DIAGRAM]
Affect on domestic producers
Affect on foreign producers
Affect on the government
Affect on the consumers
Welfare loss
31

Subsidy – subsidy to the domestic market
[DIAGRAM]
Welfare loss
32

Quota – quota for imports
[DIAGRAM]
Welfare loss
33

Tariffs or Duty – taxes on imports
Subsidy to domestic industry
Quota on imports
Nationalistic advertising campaigns
Price floor on imports
“Red Tape”
Health, safety, and environmental standards
Embargoes
34

 Using a diagram, explain the likely effects of a quota on
imported shoes on the shoe market.
 [See DIAGRAM] – Pg. 279
 World price is $1/liter of oil
 What happens after free trade
 A subsidy of 40 cents/liter is given – show on graph.
 Calculate the following changes from the subsidy:
 Consumer spending, Revenue of foreign producers, cost
to the government.
 Explain the impact to any two stakeholders in the oil
market.
35

EXCHANGE RATES
ABHISHEK MAITY
SEMESTER 2, 2013

36

The value of one currency expressed in terms of
another.
Sometimes against a basket of currencies –
Exchange Rate Index – like the CPI
Determined by several factors including the
FOREX market
London, New York, Frankfurt, Tokyo, and Zurich

37

Australia uses something known as a “trade
weighted index” (TWI)
 Why is it called a TWI?
 What are the current weightings?
 What are the current values compared to a year ago?
 Which currencies have contributed the most to the
change?

38

Fixed Exchange Rate
 The exchange rate is pegged or fixed to another currency,
a basket of currencies or a commodity
 Revaluation – increase in the value of the currency
 Devaluation – decrease in the value of the currency
 Maintained by government intervention in the FOREX
market
 [DIAGRAM] – Buy back
 [DIAGRAM] – Sell
 Make it illegal to trade at any other rate…
 Relatively ineffective – black markets
39

Floating Exchange Rate
 Equivalent of a free market for currency – determined
purely by supply and demand.
 [DIAGRAM]
 Appreciation – increasing value
 Depreciation – decreasing value
 Impacts?
 Purchasing power

40

Floating Exchange Rate (Quick Calc)
The US dollar is currently trading against the
Euro at a rate of USD 1 = 0.8E. What is the rate
for 1E?
With the above rate, what is the cost of a good
selling for USD 75 in Euros?
If the rate changes to USD 1 = 0.9E, explain what
would happen to the Euro price of a US
manufactured shirt that was being exported
from the USA at the cost of USD 150.
41

Managed Exchange Rate
A midway between a free-market (Floating) and
centrally-planned (Fixed) exchange rate regimes.
The government or central bank keeps an upper
and lower bound on the rates
The rates are usually kept secret

42

Floating Exchange Rate (Why do rates change?)
US dollars are demanded when:
Buy exports and travel to that country
Invest in that country (FDI or portfolio)
Savings in that country’s banks
Make money speculating on the future value of
the currency.
43

Increase in demand for US goods and services:
US inflation rates are lower than EU rates. So US
goods will be relatively less expensive.
An increase in the income level in the EU
A change in taste favoring US goods
US investment prospects
US interest rates increase
Speculators think the US dollar will appreciate in
value.
[DIAGRAM]


44

Will cause an increase in the supply of USD:
Increase in demand for EU goods and services:
US inflation rates are higher
Increase in US income levels
A change in taste for European goods.
EU investment prospects improve
EU interest rates increase
Speculators think that the US dollar will fall.
[DIAGRAM]
45

Downward pressure on inflation
More imports can be bought
Forces domestic producers to become more
efficient

46

Damage to exporting industries
Damage to domestic industries

47

Greater employment in exporting industries
Greater employment in domestic industries

48

Inflationary pressure
Fewer imports can be bought
Domestic firms may become lax

49

High currency value  lower inflation (?) 
unemployment (?)
Low currency value  low unemployment (?) 
inflationary pressures (?)

50

Using a suitable diagram, explain why a high value
of a currency may worsen unemployment in a
country.
With the help of a diagram, explain why a low
value of a currency may create inflationary
pressure in a country.
[Page 289 – Student Workpoint 23.6]

51

Why might the government want to meddle in the
FOREX Market?
Lower exchange rate
Raise the exchange rate to fight inflation
Maintain a fixed exchange rate
Avoid large fluctuations in floating rates
Stability – good for business confidence
Improve the current account defecit
52

Using their foreign exchange reserves to buy, or
sell, foreign currencies
By using Monetary Policy
Changing interest rates to attract foreign savings
Caveat – difference between attracting
investments and savings.

53

No uncertainty or speculation.
 Not always the case.

Forces sensible government policies on inflation

54

Maintain high levels of foreign exchange reserves
if balancing the rate by FOREX market trades
Deflationary or inflationary effects on the
economy if manipulating by use of interest rates
Judgment error in determining what the rate
should be!
International disagreements

55

Page 290, Student Workpoint 23.7

56

Interest rates can be used for domestic policy
alone.
In theory, the exchange rate should always
“correct” itself.
Opportunity cost of keeping large foreign
exchange reserves.

57

Uncertainty
Affected by various non market factors
Floating exchange rates can make inflation rates
worse…

58

BALANCE OF
PAYMENTS
ABHISHEK MAITY
SEMESTER 2, 2013

59

Current Account
Capital Account
Credit/Asset
Debit/Liability

60

Balance of trade in goods (tangible)
Balance of trade in services (intangible)
Net income from abroad
Current transfers – remittances, aid

61

Current Account Balance = Balance of trade in
goods + Balance of trade in services + Net income
flow + Net transfers

62

Usually a small component of Balance of
Payments
Capital Transfers
 Debt forgiveness, sale of fixed assets, transfer of goods
and financial assets from migration, gift tax, inheritance
tax, death duties et al

Transactions in non-produced, non-financial
assets
 Rights, patents, copyrights, brand names
63

Net change in foreign ownership of domestic
financial assets.
Direct Investment
 Purchase of long-term assets (FDI)
 IMF ruling – at least 10% ownership

Portfolio Investment
 Short-term investment in stocks and bonds and savings

Reserve Assets
 Gold and foreign currencies
64

Current Account = Capital Account + Financial
Account + Error (Statistical Discrepancy)

65

Excel Sheet

66

A simplified scenario

67

Why is a current account deficit a bad thing?
How does a government deal with deficits?
Can this happen indefinitely?
Deficit  Downward pressure on exchange rate
Surplus  Upward pressure on exchange rate
A bigger problem in fixed exchange rates
Short run v. Long run

68

If current account is in deficit, then the
capital/financial account must be in surplus.
Current Account Deficit:
Use of Forex reserves
Threat to economic sovereignty
Borrowing – currency crisis

69

If current account is in surplus, then the
capital/financial account must be in deficit.
Current Account Surplus:
May lead to protectionism
Impact on imports and exports

70

How big is a “big” current account deficit or
surplus.
Always calculate as a percent of GDP to be
comparable.
Please do not confuse current account deficit with
national debt.

71

Encouraging a switch from Imports to Domestic
goods
Government depreciates or devalues their
currency
Protectionist measures
Might violate WTO agreements

72

Contractionary Policy
Reduce overall expenditures
imports
Deflationary fiscal policy
Deflationary monetary policy

including

on

73

PEDExports + PEDImports > 1
Elasticity increases in the long run.

74

Suppose India and US have an exchange rate of
Rs. 50 = $1. Initially, the US exports 1000 units of
Widgets @ Rs. 100 per unit to India and India
exports 500 units of Golas @ Rs. 100 per unit to
the US. Now, India depreciates their currency by
10%. Calculate how this depreciation affects the
current account balance between India and the
US if:
PEDexports = 0.5 and PEDimports = 0.4
PEDexports = 0.5 and PEDimports = 0.8
75

According to the Marshall-Lerner condition, as the
currency depreciates, initially, the Current
Account deficit will actually become worse before
it becomes better.
[DIAGRAM]

76

Explain the possible effect on consumers and
producers when a specific tax is imposed on
cigarettes. [10 marks] – Pg 75 of Blink and Dorton

77

ECONOMIC
INTEGRATION
ABHISHEK MAITY
SEMESTER 3, 2013

78

Free trade is based on the principal of
comparative advantage and an ideal that would
promote maximum allocative efficiency.
But alas! That is not to be.
… but we are trying.

79

Preferential trade agreements (PTA)
Bilateral v. Multilateral (WTO)
PTA gives preferential access to certain goods,
from certain countries, by reducing or eliminating
tariffs or other arrangements.
 South Asian Preferential Trade Arrangement (SAPTA)
2007
 Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri
Lanka
 Goods Only!

Is this ethical?
80

Four major types:
Free trade areas
Customs unions
Common markets
Economic (and Monetary) unions

81

Two or more countries can form a free trade area:
Tariffs and non-tariff barriers are abolished or
phased out
Maintain individual tariff with non-members
NAFTA (USA, Mexico, Canada)
EFTA
(Iceland,
Norway,
Liechtenstein,
Switzerland)

82

Two or more countries can form a customs union:
FTA with the following clause:
Maintain common tariff and trade policy with
non-members
MERCOSUR – 1991 – Argentina, Brazil, Paraguay,
Uruguay, Venezuela
EU and Turkey 1996
East African Customs Union

83

If in addition to a Customs Union, a Common
Market has:
Unrestricted factor of production flow
Free cross-border movement of labor and capital
Free flow of goods, services, labor and capital
SAPTA became SAFTA in 2004 (to be enacted by
2016)
Belarus, Kazakhstan, Ukraine, Russia (2003)
84

A Common Market become an Economic Union
when:
When the member states agree on certain
macroeconomic and regulatory policies.
If they adopt a common currency they become a
Monetary Union
The EU is the only such example.

85

Dismantling of trade-barriers leads to greater
competition among firms of the member
countries.
NOTE: PTAs are discriminatory while WTO
multilateral trade agreements are nondiscriminatory

86

Trading Blocs
Monetary Union

87

Pg. 316 (Blink and Dorton) – End of Chapter
Review Questions, Q#3
Evaluate the consequences of membership of a
monetary union. Be sure to use a real world
example.

88

TERMS OF TRADE
ABHISHEK MAITY
SEMESTER 3, 2013

89

Terms of Trade is the ratio of export prices to
import prices
TOT = Index of average export prices / Index of
average import prices x 100
Lower  deterioration
Better  improvement
NOTE: Do not confuse price with total value of
imports and exports!
90

Year
1
2
3
4
5
6

Index of average Index of average Calculation of Terms of Improvement or
export prices
import prices Terms of Trade Trade
deterioration?
100
100
109
116
120
120

100
105
105
112
110
125

Index year

91

What can we conclude about the “Buying Power”
of a country using ToT?
Is a “deterioration” of ToT a bad thing?

92

Can language be used to confuse or exclude
access to knowledge?
 Consider language that economists use that
could be misleading or difficult for noneconomists.

93

Changes in conditions of demand and supply
 Change in demand  change in price of exports
 Competitive price of exports
 Income in importing country
 Change in consumer tastes
 Change in supply  change in price of exports
 Good weather for agriculture?
 New technology?

94

Changes in relative inflation rate
 Higher inflation  price of exports increase
 Might lead to a short run improvement in ToT
 Eventually exports become less competitive

Changes in exchange rates
 Relative exchange rate will change the relative price of
exports to imports

95

Changes in Income
Improvement in Productivity and Technology

96

Improvement in TOT through increase in demand
[DIAGRAM]
Through inflation and elasticity
Commodities are usually inelastic
Most other goods are elastic
Inelastic  Elastic

97

Country
Primary Commodities (%) Manufacturing (%) Services (%)
Benin
93.8
6.2
Burkina Faso
93.5
6.5
Ethiopia
91.0
9.0
Mali
93.6
6.4
Angola
99.3
0.7
Yemen
95.1
4.9
Bangladesh
12.4
87.6
Nepal
28.0
72.0
Maldives
32.5
67.5

98

Not all LDCs have the same problems.
Commodities v. Oil v. Manufacturing v. Service
The non-oil commodities problem.
[DIAGRAM]

99

Changes in supply
Technology
Dumping
Changes in demand
Synthetic goods
Inelastic and developed
Miniaturization
Average Commodity Prices have been falling since
the 1950s
100

More exports needed for imports  leads to
production of more commodities  leads to
further fall in commodity prices.
Increase in debt levels
Negative externalities  unsustainable
CURSE OF NATURAL RESOURCES!

101

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