1. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 INTERNATIONAL ECONOMICS 2004 / 2005 E-Commerce School Southwestern University of Finance & Economics Mr. Stephan Schoop

2. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 We Live in an Interdependent World Consider your typical day: –You wake up to an alarm clock made in Korea. –You pour yourself coffee from beans grown in Brazil. –You put on some clothes made of cotton grown in Cambodia and sewn in factories in Thailand. –You watch the morning news discussing the stock market in New York on your TV made in Mianyang. –You drive to class in a car made of parts manufactured in a half-dozen different countries. –You call your friend with your mobile phone from Finland. –You play with your translator made in Japan..

3. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005... and you haven’t been up for more than two hours yet!

4. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Why Should We Study Trade? A pervasive feature of today’s capitalism is that people trade with each other. Do you know anyone who makes all the things he or she consumes? [economic systems]economic systems To understand our world we need to understand why people trade so much. We need to understand whether trade is good for us or bad for us. Understanding this is important precisely because we trade a lot.

5. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Why Is Trade Good for Us? Trade enables each person to do only what he/she is better suited to do. Imagine what it would be like if you were required to produce everything that you used. The situation would be similarly awful for a country that either chose not to trade with other countries or was forced to end all trade with other countries. There are additional reasons why trade is good for us. Those reasons will be briefly discussed later.later

6. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 A Parable For The Modern Economy Imagine... –only two goods: potatoes and meat –only two people: a potato farmer and a cattle rancher What should each produce? Why should they trade?

7. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Table 1 The Production Opportunities of the Farmer and Rancher Figure 1 The Production Possibilities Curve

8. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Farmer’s Production Possibilities: Further Details Time Spent OnAmount Produced MeatPotatoesMeatPotatoes 08032 26224 44416 6268 8080 As the Farmer needs 60 minutes to make an ounce of meat and 15 minutes to make an ounce of potatoes, here’s what he/she can do in 8 hours:

9. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Production Possibilities If either person increases his production of meat, his production of potatoes must decrease. –This idea can be represented by the Technology Tables (Table 1) or the Production Possibilities Curve or PPC (Figure 1: Farmer, Rancher).Table 1FarmerRancher When there is no trade, each person must consume what he produces. Therefore, if either the Farmer or the Rancher increases his consumption of meat, his consumption of potatoes must decrease.

10. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Figure 1 The Production Possibilities Curve Potatoes (ounces) 4 16 8 32 A 0 Meat (ounces) (a) The Farmer ’ s Production Possibilities Frontier If there is no trade, the farmer chooses this production and consumption. table 1

11. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Figure 1 The Production Possibilities Curve Potatoes (ounces) 12 24 B 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier 48 24 If there is no trade, the rancher chooses this production and consumption.

12. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Figure 1a The Production Possibilities Curve Can Shift Potatoes (ounces) 4 16 8 32 0 Meat (ounces) (a) The Farmer’s Production Possibilities Frontier A B If more or better resources become available or if more advanced technology becomes available, the PPC will move outward. In that case it might be possible to produce more of both goods, as in the move from A to B.

13. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 More Meat and More Potatoes? It may be possible to increase one’s consumption of both meat and potatoes if… –More resources or better resources become available, or –Technology becomes more advanced, or –Farmer and Rancher begin to trade This chapter will show that trade can increase the overall production—and consumption—of both goods even if resources and technology remain unchanged. This is the miracle of trade.

14. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Absolute Advantage Although it sounds reasonable to say that everybody would benefit if each person sticks to what he or she is better at, what do we really mean by “better at”? One answer is that you are better at producing something if you have an absolute advantage in it. You have an absolute advantage in producing something if you can produce more of it (than others can) with the same amount of resources.

15. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Absolute Advantage The comparison among producers of a good according to their productivity— absolute advantage –Describes the productivity of one person, firm, or nation compared to that of another. –The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

16. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Rancher has an absolute advantage in the production of both meat and potatoes. Absolute Advantage The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes.

17. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Absolute Advantage—an Example In Table AA below (different numbers ! ) –the Farmer has an absolute advantage in the production of potatoes; he produces one ounce of potatoes in less time (or more ounces in a specified amount of time) than Rancher can. –Similarly, the Rancher has an absolute advantage in the production of meat. Table AAMinutes needed to produce one ounce MeatPotatoes Farmer6015 Rancher4020

18. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Theory of Absolute Advantage This theory says that if each person specializes in producing what he or she has an absolute advantage in, then total production of every good can increase and, as a result, trade can benefit everybody. Applied to Table AA, the theory says that if Farmer specializes in potatoes and Rancher specializes in meat, the total production of meat can be increased without requiring the total production of potatoes to decrease. As a result, if Rancher and Farmer then trade, they could both benefit.

19. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Theory of Absolute Advantage—II We will later show why the theory is indeed true for our example. But if we can take the theory to be correct, for now, we see that it is an explanation for the pervasiveness of trade in modern economies. We owe the Theory of Absolute Advantage to Adam Smith, the founder of modern economics.

20. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Theory of Absolute Advantage—III But what about Table 1? In that case Rancher has an absolute advantage in the production of meat and potatoes! Therefore, the Theory of Absolute Advantage cannot tell us who should specialize in what and whether trade is a good idea.Table 1 If Rancher is a more productive producer of meat and a more productive producer of potatoes, why should it buy anything from Farmer? Should we conclude that trade won’t help Farmer and Rancher in this case?

21. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Theory of Comparative Advantage No, we shouldn’t! There’s a better theory—the Theory of Comparative Advantage—that says that trade will benefit everybody even in the example in Table 1. According to this theory, everybody would benefit if each person sticks to what he or she is better at, where it is understood that one is “better at” producing a good if he or she has a comparative advantage in the production of that good.

22. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Cost We have seen that, for both the Farmer and the Rancher, any increase in the production of meat necessitates a decrease in the production of potatoes The change in the production of potatoes necessitated by a one unit change in the production of meat is called the opportunity cost of meat The opportunity cost of potatoes can be similarly defined

23. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Cost To make 1 ounce of meat Farmer needs 60 minutes. In that time he could have made 4 ounces of potatoes. Therefore, Farmer’s opportunity cost of 1 ounce of meat is 4 ounces of potatoes.

24. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Cost To make 1 ounce of potatoes Farmer needs 15 minutes. In that time he could have made 1/4 ounces of meat. Therefore, Farmer’s opportunity cost of 1 ounce of potatoes is 1/4 ounces of meat.

25. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Cost To make 1 ounce of meat Rancher needs 20 minutes. In that time he could have made 2 ounces of potatoes. Therefore, Rancher’s opportunity cost of 1 ounce of meat is 2 ounces of potatoes.

26. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Cost To make 1 ounce of potatoes Rancher needs 10 minutes. In that time he could have made 1/2 ounces of meat. Therefore, Rancher ’s opportunity cost of 1 ounce of potatoes is 1/2 ounces of meat.

27. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Opportunity Costs of Farmer and Rancher, Table 1 The opportunity costs, therefore, are: Table 3Opportunity Costs MeatPotatoes Farmer41/4 Rancher21/2

28. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Comparative Advantage and Opportunity Cost You have a comparative advantage in producing some good if the opportunity cost of producing that good is lower for you than it is for others. It follows that, Farmer has a comparative advantage in potatoes and Rancher has a comparative advantage in meat. Table 3Opportunity Costs MeatPotatoes Farmer41/4 Rancher21/2

29. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Theory of Comparative Advantage The Theory of Comparative Advantage says that if each person specializes in producing what he or she has a comparative advantage in, then total production of every good can increase and, as a result, trade can benefit everybody. Applied to Table 1, the theory says that if Farmer specializes in potatoes and Rancher specializes in meat, the total production of meat can be increased and the total production of potatoes can simultaneously be increased. As a result, if Rancher and Farmer then trade, they could both benefit. But why?

30. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Theory of Comparative Advantage—Proof Suppose Farmer increases his production of potatoes by 4 ounces. Then, according to Table 3, his production of meat must decrease by 1 ounce. Table 3Opportunity Costs MeatPotatoes Farmer41/4 Rancher21/2 Table 1dSuggested Change in Production MeatPotatoes Farmer+4

31. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Theory of Comparative Advantage—Proof Suppose Rancher increases his production of meat by 1.5 ounces. Then his production of potatoes must decrease by 3 ounces. Table 3Opportunity Costs MeatPotatoes Farmer41/4 Rancher21/2 Table 1dSuggested Change in Production MeatPotatoes Rancher+1.5-3

32. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Theory of Comparative Advantage—Proof Therefore, by making Farmer and Rancher specialize according to their comparative advantages, it is possible to increase the total output of meat by 0.5 ounces and of potatoes by 1 ounce. Table 1dPossible Changes in Production MeatPotatoes Farmer+4 Rancher+1.5-3 Total+0.5+1

33. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Wow! We have just witnessed a miracle—the miracle of trade. For an individual, it is impossible to make more of one good without making less of some other good. But for the world as a whole, it is possible to produce more of all goods simultaneously if we embrace trade. Table 1dChange in Production MeatPotatoes Farmer+4 Rancher+1.5-3 Total+0.5+1.0

34. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Proof—Further Details We have seen that specialization can increase total production of both goods, enabling both Farmer and Rancher to benefit. The tables below show more explicitly how the additional output can be shared by Farmer and Rancher through trade. TradesChange in Consumption MeatPotatoesMeatPotatoes FarmerImport 1.25 Export 3.5Farmer+0.25+0.5 RancherExport 1.25 Import 3.5Rancher+0.25+0.5 Total+0.5+1.0

35. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Generality of the Theory of Comparative Advantage Differences in opportunity costs form the basis for specialized production and trade. Whenever potential trading parties have different opportunity costs, they can all benefit from trade. We owe this theory to David Ricardo (1772- 1823) David Ricardo

36. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Applications Of Comparative Advantage Should Tiger Woods Mow His Own Lawn? Should the United States Trade with Other Countries?

37. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Absolute Advantage—One Last Time I had promised earlier to show that the Theory of Absolute Advantage—remember that?—was indeed true for the example in Table AA.earlier Table AA This is easy to do. Simply retrace the proof that I worked out for Table 1 but this time start with Table AA! The Theory of Absolute Advantage is true whenever every individual has an absolute advantage in the production of some good, as in Table AA.

38. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Generality of the Theory of Comparative Advantage The problem is that in some cases, there may exist people, such as Farmer in Table 1, who do not have absolute advantage in anything. In such cases Absolute Advantage is useless. Thankfully, Comparative Advantage comes to the rescue and shows that trade is good for Farmer and Rancher even when the Theory of Absolute Advantage is silent. We owe this theory to David Ricardo.

39. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 The Legacy of Adam Smith and David Ricardo Adam Smith – In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today. David Ricardo –In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.

40. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Differences Make Trade Useful Had the opportunity costs of Farmer and Rancher been equal in Table 3, the proof of the Theory of Comparative Advantage would not have worked. If we are similar to each other, it would not be possible to use the Theory of Comparative Advantage to explain why trade is so pervasive. But why then is Canada our main trade partner?

41. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Other Reasons Why Trade Is Good for Us Trade allows us to fully utilize the benefits of bulk production by allowing each country’s production to be sold everywhere. Trade intensifies competition and squeezes out inefficient production.

42. http://www.bized.ac.uk E-Commerce School Southwestern University of Finance & Economics INTERNATIONAL ECONOMICS 2005 Terms of Trade In showing how trade can make Farmer and Rancher better off, I worked out an example of how trade could occur. Specifically, I showed that if 1.25 ounces of meat are traded for 3.5 ounces of potatoes, both Farmer and Rancher would be better off. But the question is, if trade takes place, will it be like the trade envisioned in my example or will it look very different?