Principles of Comparative Advantage and International Economics by Geoffrey T Andron (revised 3-9-05) ©2005 Geoffrey Teetor Andron

Principles of Comparative Advantage and

International Economics

byGeoffrey T Andron

(revised 3-9-05)

©2005 Geoffrey Teetor Andron

Overview Principles—Slide 1 of 2


The general patterns of specialization (and therefore

trade) --between people, regions or nations-- are determined by:

Incentives created by Principles of Comparative Advantage as

described in the theory of international economics

Overview Principles—Slide 2 of 2


But: The principles of “Comparative Advantage”

are identical to the principles of:

“response to differences in opportunity cost/benefit”

Elaboration of Overview Principles:

You cannot determine specialization without at the same time determining the basic patterns of trade between entities. Differences in opportunity cost (versus

benefits) determine specialization. Therefore:

Differences in opportunity cost also determine patterns of trade.

Therefore, “comparative advantage” must be the same idea as “differences in opportunity cost (versus benefits)”.


Next slides:Two examples illustrating comparative advantage in

action

Remember: These examples also illustrate the

impact of “differences in opportunity cost versus benefits”, since that is the

same thing.


Comparative advantage in actionExample 1—Two people (one of whom is more productive--better--at everything); two goods.

Person 1 32 4 Person 2 10 2

Person Fish/wk Rabbits/wk

Max. Production Possibility (per week)


Note 1: Even if Person 1 is so productive he has leisure time, and Person 2 is almost starving, BOTH can gain from trade! Note 2: Challenge: Can you remember Note 1 even when Person 2 is a high school dropout and Person 1 is Bill Gates?

A fundamental concept: People can use exchange rate differences to make money!(Use one exchange rate to convert currency 1 into currency 2, use another exchange rate to convert back.) Example:


Way 1 Way 2

Pesos 10 p 20 pDollars $ 1 $ 1

Convert p into $ this way

Convert $ into p this way

Comparative advantage in actionExample 2. Two countries, each with

different currency, three goods (one not tradable) and no information about which country is more productive.

Country I (Pink) 4 6 30Country II (Blue) 1 3 10

Country (currency unit) Food Clothing Shelter

Pre-trade prices of two goods

Trade-currency conversion ratios (Pink/Blue)

4 2 ?3 3

3.3 6.61.1 2.2


Based on these two examples, here are the key

ideas so far By the “law of one price”, each good will have just one price

within each country. If you want to know who will do what,

…differences in absolute costs are of no significance. …who is absolutely more productive or competitive is of no

significance. Differences in opportunity costs can temporarily exist between

countries due to the time and expense of trade, but. Differences in opportunity costs, also called “comparative

advantage”, generate specialization and also trade, but: Differences in opportunity costs will tend to be reduced or

even eliminated as trade builds. Between: people within a family or group; between two groups; between two regions; between two or more nations of people.


Next slides:How does comparative

advantage work in a more realistic world with many

goods?

Example 3: Six goods instead of just two.


Example 3. Six goods, two countries (people or areas).

Country I (Yahoo) 10 20 2 15 16 24Country II (Zulu) 2 10 2 5 4 3

Cntry (curr unit) Gd1 Gd2 Gd3 Gd4 Gd5 Gd6

Pre-trade prices of six goods

Trade-currency conversion

ratios (Yahoos/Zulu)

5 2 1 3 4 8

2.7? 2.7? 2.7? 2.7? 2.7? 2.7?

? = possible final values?


Supply and Demand curve analysis can be used to

understand the price changes as international

trade expands

--See the next few slides


Supply and Demand for “exportable goods” in the country of origin (the exporting

country)


S

p0

q0

D1

Added demand from

foreign nations--Exports

Do

p1

q1 q2

Demand from citizens of your own country

p2

D2

Supply and Demand for “importable goods” in the country of destination (the importing

country)


D

p0

q0

S1

Added supply from foreign

nations—Imports

So

p1

q1

Supply from producers in

your own country

Note: The typical internationally traded good is both an exportable (one

country) and an importable (other country).

Therefore:Every good requires two

diagrams-- one for origin and one for destination.

Example:The “exportables market” for wheat (in the U.S.) and the

“importables market for wheat (in Europe).


Next slides:

Surprising facts and models for the

“foreign exchange market”


Surprise! International trade does not require a foreign exchange

market!

So why does the foreign exchange market exist? To facilitate specialization and the

division of labor in international trade.


What will the exchange rate be?Let’s use Example 3, but after trade has built up:

Country I (Yahoo)Country II (Zulu)

Cntry (curr unit) Gd1 Gd2 Gd3 Gd4 Gd5 Gd6 F-exch Market

Direction of trade of the six goods



2.7 2.7 2.7 2.7 2.7 2.7


No3.4?

Convert Y into Z this way

Convert Z into Y this way

What will the exchange rate be?Let’s use Example 3, but after trade has built up:

Country I (Yahoo)Country II (Zulu)

Cntry (curr unit) Gd1 Gd2 Gd3 Gd4 Gd5 Gd6 F-exch Market

Direction of trade of the six goods



2.7 2.7 2.7 2.7 2.7 2.7


2.2?

No2.7? Yes

What are the “real forces” which determine “exchange

rates”?Foreign-exchange markets are never the only way to convert currencies.Exist only to facilitate specialization and the division of labor in international trade. In the long run, the exchange rate must roughly equal the trade currency conversion ratios of the traded goods. However, trade-currency conversion via goods takes much longer than conversion via the foreign exchange market, so the exchange rate can wander.


A Brief Diversion: Inflation, the Price Level and

Exchange Rates …(this slide and next)

Money is a good. It has value. It has uses: Money is used as a temporary store of value and to make transactions, and transactions cannot occur unless the buyer has sufficient money, no matter how rich s/he is. Any person wants to have the correct amount of money for their personal plans—not too much and not too little.Money is not created or destroyed as it is used. Instead, it merely passes from one person/group to another.Money is created by governments and by the banking systems of the various countries. Governments can control the quantity. If a government creates more money than citizens are willing to hold, they attempt to get rid of it. The result is inflation. So: The general level of prices in a country is determined by the quantity of money in that country.©2004 Geoffrey Teetor Andron

Inflation can change currency exchange rates, by the following

model: Suppose the quantity of money rises too fast in one country compared to the other country so prices rise farther in that country.

1. This will change all the trade-currency conversion rates.2. The immediate consequence will be: ALL goods and

claims can profitably flow in the same direction (using the foreign exchange market to convert back).

3. This leads to an imbalance of supply and demand for currencies in the foreign exchange markets—excess supply or demand. Result: the exchange rate changes.

Summary, if prices rise x% faster in one country than the other, in the long run the exchange rate will change by roughly x% to compensate.


Next slides:

Models for the international flows of

“capital”


Two types of capital can move between countries--“real assets” and

“claims”“Real assets” are goods which last longer than a year. Nothing more need be said, since we have already modeled the international trade of goods.“Claims” are “evidence of ownership”. (Usually, claims are paper with writing on them.) Like goods, claims can flow internationally. Each “claim” has a value (hence price) to the citizen of any country. Hence, like tradable goods, each claim has a trade-currency conversion ratio.But to really understand international capital flows, we must understand the theory of capital, so a very brief summary is given on the next slide.


Portfolio Theory:A model for the values of

“claims”People hold their wealth in portfolios of “claims”—holdings of stocks, bonds, coins, real estate, etc.Basics of portfolio theory: the “optimum portfolio” for each person or firm depends on each claim’s risk, return, and contribution to portfolio diversification.As claims move from one (group of) holders to another, values rise at the origin and fall at the destination. This is similar to the effect in goods markets as trade builds.In the international context, therefore, international claims movements reduce or eliminate differences in trade-currency conversion ratios, causing them to converge toward some common value.


CI (Yahoo) 9 27 12 800 800 40 100 CII (Zulu) 3 9 4 400 200 40 20

Example 4.International flows of “claims”.

Cntry(curr) Gd1 Gd2 Gd3 CL1CI CL2CII CL3CI CL4CII

Three goods in equilibrium; four claims at pre-trade prices. As claims are put into people’s portfolios, the

claims prices adjust.

Trade-curr. conversion ratios (Yahoos/Zulu)

3 3 3 2 4 1 5


Soon all trade currency conversion ratios are again equal, now including those for claims.

CI (Yahoo) 9 27 12 800 800 40 100 CII (Zulu) 3 9 4 400 200 40 20

CI (Yahoo) 900 750 60 90CII (Zulu) 300 250 20 30



Three goods in equilibrium; four claims at pre-trade prices. As claims are put into people’s portfolios, the

claims prices adjust.


3 3 3 2 4 1 5


Soon all trade currency conversion ratios are again equal, now including those for claims.

3 3 3 3

CI (Yahoo) 900 750 60 90CII (Zulu) 300 250 20 30



Three goods and four claims, in equilibrium after all international adjustments.


3 3 3


Trade currency conversion ratios now tend to be equal, including those for claims.

3 3 3 3

Notice: International flows of claims do not require a foreign exchange

market any more than the international trade of goods!

International capital flows do not change the following fact:

Foreign exchange markets only exist to facilitate specialization

and the division of labor in international trade-- of goods

and/or claims (capital). ©2004 Geoffrey Teetor Andron

New Topic: Who gains, and who loses, from international

trade?1. Those involved in production of exportables or

purchase of importables tend to gain, while those involved in production of importables or purchase of exportables tend to lose.

2. In most real world situations there are “pareto gains” from international trade. This means: “In theory”, the gainers could gain even if they compensated the losses of the losers.

3. Small countries tend to gain more than large countries.

4. Traders with monopoly power (example, colonialism?) tend to gain at the expense of others.


Illustration of “Pareto gains” in the market for a country’s “exportable goods”


S

p0

q0

D1

As international trade increases price, producer

surplus increases by “a”+”b”, while

consumer surplus decreases only by

“a”

Do

p1

q1

Triangle “b” shows that

producers gain more than the buyers lose.

a b

Illustration of “Pareto gains” in the market for a country’s “importable goods”


D

p0

q0

S1

Triangle “b” shows that

buyers gain more than producers

lose.

So

p1

q1

As international trade reduces price, consumer surplus

increases by “a”+”b”, but

producer surplus declines only by

“a”.

a b

“The balance of payments”“the current account

balance”“the merchandise trade

balance”“the capital account

balance”

Next 2 slides-- definitions and key ideas about

balances©2004 Geoffrey Teetor Andron

Definitions of balances


Definition: Balance of payments– The value of all exports (goods and claims) minus the value of all imports.

Definition: Current account balance— Total value of exports of goods and services (plus income from investments abroad) minus imports of goods and services (plus foreigner income from investments here).

Definition: Capital account balance– The total value of exports of claims (called capital inflows!) minus imports of claims (called capital outflows!). If more capital is flowing in than out (more claims out than in), this is called a capital account deficit because foreigners are increasing their claims on the home country compared to home claims on foreigners.

Definition: Merchandise trade balance– The total value of exports of goods minus imports of goods.

Definition: Services balance— Total value of exports of services minus imports of services.

Important facts about international balances


1. The “balance of payments” “always” balances to zero. (Exceptions are only possible if one country makes gifts to another or international trade is not yet in equilibrium.)

2. The other international balances usually do not equal zero.3. However: The current account balance and the

capital account balance are “always” equal and opposite to each other.Why? Because the entire balance of payments must “always” be zero and it is made up of these two sub-balances. Example: If a country exports $600 billion of goods and services and imports $800 billion, then it must be experiencing a capital account deficit of $200 billion, for example exporting $300 billion of claims and importing $100 billion.

4. A deficit in one sub-account of the balance of payments must be mirrored by a surplus in at least one other sub-account.

Summary and Conclusions

The following 5 slides summarize key ideas and models from our study of

the principles of international economics:


Key Principles of International Economics

1. Differences in opportunity cost create differences in trade-currency conversion ratios. These lead to international trade of goods, claims, foreign exchange (moneys).

2. As trade builds, differences in trade-currency conversion ratios, hence opportunity costs, are reduced.

3. Though both winners and losers are created in every nation, international trade creates “Pareto gains” in every nation.

4. International trade does not require a foreign exchange market.


Key Principles of International Economics (continued)

5. International capital (claims) flows are determined by the principles of portfolio theory set in the international context—basically by international differences in the opportunity costs of buying or holding assets.

6. International capital flows reduce or eliminate such differences.

7. International capital flows do not require a foreign exchange market.



8. There is no reason to hold non-interest earning money of a foreign country except in anticipation of expected or possible immediate purchases of foreign goods, therefore holdings of money tend to reflect current (i.e. short run) forces.

9. Foreign exchange markets exist to facilitate specialization and the division of labor in the conduct of international trade of goods and claims (“capital”), but are not necessary for international trade to occur!



10. The balance of payments “always” balances (unless one country makes gifts to another). But:

• Since total trade includes flows of both goods and claims, there can be imbalances of goods, mirrored by opposite imbalances of claims. More generally, an imbalance can occur in any sub-account if balanced by an opposite imbalance in some other sub-account or accounts.

• Example: If Country I exports $600 billion of goods and services and imports $800, it can at same time export $200 billion more claims per year than it imports.


Key Principles of Int’l. Economics (cont’d.)

11. What forces and variables determine the “foreign exchange rates” in the real world foreign exchange markets? Basically two types of forces —“monetary” and “real”.

“Monetary”: Exchange rates are determined by the general level of prices around the world.

“Monetary”: Changes in exchange rates are caused by differences in inflation rates around the world.

“Real”: In the long-run, exchange rates are determined by the trade-currency conversion potentialities of tradable goods and claims as determined by differences in opportunity cost (“comparative advantage”). These are the so-called the fundamental forces.

Short run versus long run: Since financial claims and foreign exchange can be moved between nations more quickly than most goods, foreign exchange markets seem more tightly linked to the claims markets than to the goods markets in the short run.


The End


Topics in microeconomics:candidates for inclusion

1. Comparative advantage.2. Integration of exports or imports into

markets.3. Determination of exchange rates.4. Who gains from trade?…from

specialization?5. U.S. economy in a global setting.6. Behavior of international businesses.7. Balance of payments and international

capital flows.8. Tariffs and other trade restrictions.9. Impact of trade on income inequality.


International topics for macroeconomics—partial

list1. The foreign sector and economic

growth and development.2. Comparative advantage and the

pattern of exports and imports3. Determination of exchange rates4. Balance of payments and

international capital flows5. Integration of foreign sector into

the circular flow model

International topics for macroeconomics—partial list

6. Foreign sector as a source of business cycle shocks.

7. National income accounting for exports and imports.

8. Impact of foreign sector on business cycles, especially:

Interest rates Inflation and the price level Employment

International topics for macroeconomics—partial list9. The foreign sector in the various

macroeconomic modelsClassical modelKeynesian modelSynthesized model

10.The balance of payments.11.Fixed versus flexible exchange

rates.12.Internal versus external balance.

Documents

Principles of Comparative Advantage and International Economics by Geoffrey T Andron (revised 3-9-05) ©2005 Geoffrey Teetor Andron