International Economics

Comparative versus Absolute Advantage

0Some people are better at producing things than others. This is an undisputable fact. Some people are more efficient, have better equipment,… there are many reasons!

0We say that anyone who can produce more of a good than someone else when they have the same amount of resources has the absolute advantage in production of that good or service.

0So if you can produce more of something than someone else, why would you bother to trade?

0OPPORTUNITY COSTS! Remember we all face opportunity costs of producing something. You will trade with someone if they have lower opportunity costs than you do in producing goods.

0We say someone who has a lower opportunity cost in producing a good or service has the comparative advantage in production.

Example:0 Debbie and Mark can both wash a load of dishes and

vacuum a room. Their times for doing this are as follows:

Wash 1 load of Dishes Vacuum 1 Room

Debbie 45 minutes 45 minutesMark 30 minutes 1 Hour

0 Given these figures does anyone have absolute advantage in doing anything?

0 How about comparative advantage?

0Once we know who has the comparative advantage in something, we offer to trade with them.

0We will provide what we have the lowest opportunity cost in and they provide what they have the lowest opportunity cost in.

0By doing this, we will engage in specialization in our good or service.

Remember specialization is where we focus on one good or service rather than others.

Now realistically, we know that in the U.S. we do not specialize in only one good or service.

We make lots of them! However, we still focus on those we have a lower opportunity cost in. The fact is that there are countries that provide greater numbers of cheap labor than we can. Because of that we trade their labor intensive goods for our more technologically advanced goods.

What kind of example of this can you think of?

Because of our increased global economy and economic interdependence, economic conditions and policies in one nation increasingly affect economic conditions and policies in other nations.

Exchange Rates0When you buy goods from other

countries what currency do you pay in?

0Typically you pay in their currency, even if you are buying the good from a catalog or off the internet. You do this because of exchange rates.

0When a foreign company makes a good, and demand and supply create a price for that good, that price is originally set in the currency of the foreign nation.

0To find out what the price might be in dollars, we have to examine the exchange rate.

This is the price of one nation’s currency in terms of another nation’s currency.

0These prices are determined like all goods – by the supply and demand of the currency.

0 Changes in the exchange rates can influence the prices of goods and services traded among countries. Someone will gain and someone else will lose.

0 Exchange rates can be expressed in two ways. You can say that:

1 U.S. dollar = .568214 British Pounds or

1 British Pound = 1.7599 U.S. Dollars

0 If you know how many pounds $1 will exchange for, you can figure out how many dollars £1 will exchange for.

0 You use the formula 1/.568214 = 1.7599. You simply divide by the number of pounds you know you will get for $1.

Now you try this example:

0You want to exchange dollars for Mexican pesos.

0The bank gives you 10.79 Pesos for 1 Dollar.

1. State the exchange rate in two ways. 2. Also how many dollars will 1 peso get you?

Two types of Exchange Rates0 There are actually two types of exchange rates:

fixed and floating

0 In countries with fixed exchange rates, the amount of money that may be exchanged is set. That means that $1 can only be exchanged for a specific amount of the foreign currency.

0 The opposite of that is floating exchange rates. These are rates that change based on the supply and demand of the currency.

0 The dollar is on a floating exchange rate and the value of it relative to other countries’ currencies can change daily.

0 We prefer floating rates because it influences the prices of goods we import. Of course it also influences the prices of our own goods. When we exchange dollars for other currency, we say that the dollar is “Strong” or “Weak” depending upon whether it is worth more than the foreign currency or less.

0 In the British pound example, the dollar is weak because it take more dollars to equal one pound. In the Mexico example, the dollar is strong because it takes less than $1 to equal 1 Peso.

0 Not everyone wants a strong dollar!

0 Americans who import goods do because it means that it takes fewer dollars to buy a foreign good.

0 Also tourists like stronger dollars because it means when they travel, their dollars will go further!

0 However, American producers don’t like stronger dollars!

0 Typically, because it means American goods are now more expensive relative to foreign goods. This means it is cheaper for a foreign nation to purchase their own goods or another countries goods rather than purchasing American goods.

0 If demand falls, production falls – who else is hurt then by the stronger dollar?

Balance of Payments0 Balance of trade refers to how much we import

versus how much we export. Imports are the foreign goods we buy and exports are the American goods we sell to other countries.

0 Typically we import much more than we export. Why do you think we do this?

0 When we import more than we export, we suffer a balance of trade deficit.

What is FREE TRADE?0Free Trade is trade among nations without

barriers.0Some common trade barriers include:

0Import Quotas – limits on the amount of a good that can be imported

0Tariffs – taxes on imported goods0Regulations – health and safety product

requirements

Imposing barriers to trade is a form of PROTECTIONISM.

Tariffs and Free Trade0 A tariff is a tax placed upon foreign goods (imports)

by the U.S. Government that will be brought into the U.S. to be sold here.

Why would the government do this?

What effect would a tariff have on the supply and demand for a good?

NAFTA0 The North American Free Trade Agreement0 An international agreement among:

0 The United States0 Canada0 Mexicoto reduce or remove trade barriers.

What are some potential concerns?