CHAPTER CHAPTER 5: The 5: The

Foreign Foreign SectorSector

Characterised by…expansion of trade between countriescapital markets sprung up in developing and former centrally planned economiestourism has increased new technologies have linked the farthest corners of the world

Globalisation

Read Box 5-1 on pages 102, 103

HOMEWORKHOMEWORK

Self-sufficiency (or autarky) used to be popular among politicians and citizens who wanted to be independent.

Countries gain if every country specialises and exports surplus not consumed domestically and import goods which not produced domestically.

Why countries Why countries tradetrade

“It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy ... What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

Extract from Adam Smith’s ‘Wealth of Nations’ (1776)

SA has… but no…

More reasons to More reasons to trade…trade…

But what if both countries produce both wool and rubber? Will trade still be desirable or possible under such conditions?

Assumptions… only two countrieseach of which producing two goodsgoods are exchanged directly for goods (ignore exchange rates)

Trade between Trade between countriescountries

Absolute and Comparative Absolute and Comparative Advantage ExampleAdvantage Example

You’re given the following info. about a newlywed couple and the time it takes each of them to do different chores: vacuuming a room or washing a load of dishes.

Absolute Advantage: The person, firm, or nation The person, firm, or nation with a higher level of productivity compared to with a higher level of productivity compared to that of another.that of another.

Who has the absolute advantage in Who has the absolute advantage in vacuuming? vacuuming?

DebbieDebbieWho has the absolute advantage in washing Who has the absolute advantage in washing dishes? dishes?

NeitherNeither

Absolute AdvantageAbsolute Advantage

Q: What is Mike’s opportunity cost Q: What is Mike’s opportunity cost of of

vacuuming in terms of washing vacuuming in terms of washing dishes?dishes?

A: Washing A: Washing 11 1/3 loads of dishes. 1/3 loads of dishes.Q; What is Mike’s opportunity cost Q; What is Mike’s opportunity cost

of of washing dishes in terms of washing dishes in terms of

vacuuming?vacuuming?

A: Vacuuming ¾ of a room.A: Vacuuming ¾ of a room.

Q:What is Debbie’s opportunity Q:What is Debbie’s opportunity cost of cost of

vacuuming in terms of washing vacuuming in terms of washing dishes?dishes?

A: Washing 2/3 of dishes.A: Washing 2/3 of dishes.Q: What is Debbie’s opportunity Q: What is Debbie’s opportunity

cost of cost of washing dishes in terms of washing dishes in terms of

vacuuming?vacuuming?

Vacuuming 1½ room.Vacuuming 1½ room.

OC of vacuuming= OC of vacuuming= Time spent vacuuming a roomTime spent vacuuming a room

Time spent washing dishesTime spent washing dishes

Comparative Advantage: the person, firm, or nation the person, firm, or nation

with the lower opportunity cost vs. that of another.with the lower opportunity cost vs. that of another.

Who has the comparative advantage in vacuuming? Who has the comparative advantage in vacuuming?

DebbieDebbie

Who has the comparative advantage in washing Who has the comparative advantage in washing

dishes? dishes?

MikeMike

Comparative AdvantageComparative Advantage

Zimbabwe has an absolute advantage in the Zimbabwe has an absolute advantage in the production of _______production of _______

South Africa has an absolute advantage in the South Africa has an absolute advantage in the production of _______production of _______

Absolute advantage between Absolute advantage between countriescountries

Shirts (per

worker/week)

Cellphones (per

worker/week)

South AfricaSouth Africa 5050 1010

ZimbabweZimbabwe 100100 55

TOTAL 150150 1515

What would happen if both What would happen if both countries specialised ?countries specialised ?

Gains from specialisation Gains from specialisation and tradeand trade

Shirts (per

worker/week)

Cellphones (per

worker/week)

South AfricaSouth Africa 00 2020

ZimbabweZimbabwe 200200 00

TOTAL (prev. total)

200 (150)200 (150) 20 (15)20 (15)

All that is required for both countries to benefit from trade is that the opportunity costs of production differ between the two countries.

David Ricardo David Ricardo (1772–1823)

Comparative (relative) advantage

Germany has an absolute advantage over South Africa in the production of __________.

Comparative Advantage Comparative Advantage ExampleExample

Cars(per day)

Barrels of wine(per day)

South AfricaSouth Africa 11 66

GermanyGermany 22 88

Has Germany got anything to gain from trading with South Africa???

Lets look at the OC of production…

Gains from tradeGains from trade

OC of producing 1

Car

OC of producing 1

Barrel of wine

South AfricaSouth Africa 66 1/61/6

GermanyGermany 44 1/41/4

Cars(per day)

Barrels of wine(per day)

South AfricaSouth Africa 11 66

GermanyGermany 22 88

Germany has a relative or comparative advantage in the production of _______

South Africa has a relative or comparative advantage in the production of _______

South Africa will shift resources into wine South Africa will shift resources into wine production if it can exchange fewer than 6 production if it can exchange fewer than 6 barrels of wine for a car from Germany. barrels of wine for a car from Germany.

Germany will shift resources into car Germany will shift resources into car production if it can obtain more than 4 barrels production if it can obtain more than 4 barrels of wine for every car it sends to South Africa. of wine for every car it sends to South Africa.

Beneficial if 1 car is exchanged for more than Beneficial if 1 car is exchanged for more than 4 but fewer than 6 barrels of wine.4 but fewer than 6 barrels of wine.

Terms of tradeTerms of tradeOC of

producing 1 Car

OC of producing 1

Barrel of wine

South AfricaSouth Africa 66 1/61/6

GermanyGermany 44 1/41/4

Suppose 1 car exchanges for 5 barrels of wine:Germany receives 5 barrels of wine for each car sent to SA. Beneficial for Germany to shift resources from wine to car production and trade the excess cars.

Without trade: Without trade: 4 barrels of wine for each car sacrificed.

After trade: After trade: 5 barrels of wine for each car given up.

Gains From Gains From TradeTrade

Suppose 1 car exchanges for 5 barrels of wine:South Africa receives 1 car for 5 barrels of wine it sends to Germany. Beneficial for South Africa to shift resources from car to wine production and trade the excess.

Without trade: Without trade: 1 car for 6 barrels of wine sacrificed.

After trade: After trade: 1 car for 5 barrels of wine given up.

Gains From Gains From TradeTrade

International imports can hurt local firms.

Gov. policies to protect domestic firms include…Gov. policies to protect domestic firms include…Import tariffs: duties or taxes imposed on products imported into a country.

Import quotas: control number of imports

Subsidies: lowers the cots of domestic producers.

Trade policy

Non-tariff barriers discriminatory administrative practices, for example…

Deliberately awarding government contracts to domestic firms

insisting on technical standards difficult for foreign firms to meet

special licensing requirements unnecessary red tape.

Exchange rate policy: movements in exchange rates may have significant effects on exports and imports

Exchange ratesExchange ratesSA importers pay in foreign currencies for goods/services and exchange SA rand for foreign currencies.

SA importers demand foreign currencies.

Other countries, pay in rand for SA exports and exchange foreign currencies for rand

SA exports lead to a supply of foreign currency.

Rate at which currencies are exchanged = rate of exchange or exchange rate.

Exchange rates simply represents the price of one currency in terms of another.

Increase in the value of one currency in terms of another (appreciation) implies a decrease (depreciation) in the value of the other currency.

$ per £

Quantity onForEx Markets

D£

S£

1.85

Q1

Assume an initial exchange rate of £1 = $1.85. There are rumours that the UK is going to increase interest rates

Investing in the UK would now be more attractive and demand for £ would rise

D£1

Q2

Shortage

1.90

Q3

The rise in demand creates a shortage in£ and price of £1(exchange rate) would increase