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INTERNATIONAL TRADEBy

eNotesMBA

www.enotesmba.blogspot.com

http://www.enotesmba.blogspot.com/

International Trade1. Why should countries trade?

Absolute advantage.Comparative advantage.

2. Who should produce goods when using trade advantages as criteria?Opportunity cost.

3. Flows of Capital and Goods.Negative net exports.Would you always expect a country that has few

imports and many exports to have much foreign investment?


Gains From Trade1. if a country can produce a good for less than

another country, then the opportunity for advantageous trade exists - and both countries could benefit.

2. when a country can produce a good that another country is unable to produce.

In each of these cases, both the consuming country and the producing country will be better off with trade than without it.


Absolute AdvantageAn absolute advantage occurs when one

producer uses a smaller amount of inputs to produce a given amount of outputs than another producer.


Example

X lives on an island with a coconut tree. Y lives on another island with a banana tree. X tires of eating coconuts and desires something new to eat. Surprisingly enough, Y is tired of bananas and would love some nice sweet coconut. Trade would benefit both parties. This example presents only one of the two cases in which trade is adventurous.

In the other case, a country can produce both goods at an absolutely or relatively lower price than another country.

These conditions are called the absolute advantage and the comparative advantage respectively.


Advantages in TradeA country may have two advantages over another country (or countries) regarding trade.

Absolute advantage

This occurs when a producer can use the smallest amount of inputs to produce a given amount of output compared to other producers. Absolute advantage may apply to many countries.

Comparative advantage

This happens when a producer has a lower opportunity cost of production than another producer. Comparative advantage may also apply to many countries, but it will be restricted to cases of two countries and two goods.


Example

Farmer X has a vegetable farm. It takes him five hours worth of work to harvest one pound of vegetables.

Farmer Y also has a vegetable farm. It takes him four hours worth of work to harvest one pound of vegetables.

Farmer Z owns a third vegetable farm. He can harvest one pound of vegetable in three hours.

In this example, Farmer Z is said to have the absolute advantage in pistachio production since he is able to produce the largest amount of output in the smallest amount of time.

FARMER

ACTIVITY

PRODUCTIVITY

HOUR

MONEY

XVEGETAB

LEFARMING

5ONE

POUND

Y 4

Z 3


In terms of trade, it is always most beneficial for the producer with the absolute advantage in the production of a good to specialize in the production of that good.

In this case, it was far more productive for Farmer Z to spend time harvesting vegetables than it was for Farmer X or Farmer Y to do the same.

Farmer Z therefore has a lower cost of production than either of the other two producers.

Applying this idea to international trade leads us to the conclusion that goods should be produced for which the cost of production is lowest.


Comparative AdvantageA comparative advantage occurs when a

producer has a lower opportunity cost of production than other producers


Example

Revisiting the farms belonging to Farmer Z and Farmer Y, we discover that they are both able to produce vegetables and soybeans.

Farmer Z can harvest 1 pound of vegetables in 2 hours and he can harvest 5 pounds of soybeans in 2 hours.

Farmer Y, on the other hand, can harvest 1 pound of vegetables in 10 hours and 50 pounds of soybeans in 2 hours.

FARMER

ACTIVITYPRODUCTIVITY

HOUR POUNDS

Z

VEGETABLE

FARMING2 1

SOYABEANS 2 5

Y

VEGETABLE

FARMING10 1

SOYABEANS 2 50


FARMER


HOUR MONEY

XVEGETABL

EFARMING

5

ONE POUND

Y 4

Z 3

FARMER


HOUR

POUNDS

Z

VEGETABLE

FARMING2 1

SOYABEANS

2 5

Y

VEGETABLE

FARMING10 1

SOYABEANS

2 50Farmer Z can harvest 1 pound of vegetables in 2 hour while it takes Farmer Y 10 hours to harvest 1 pound of vegetables.

Farmer Y can harvest 1 pound of soybeans in about 2.4 minutes, but it takes Farmer Z about 24 minutes to harvest a pound of soybeans.


Each of these farmers only has a fixed number of hours to spend harvesting, each hour spent harvesting vegetables cannot be spent harvesting soybeans, and similarly, each hour spent harvesting soybeans cannot be spent harvesting vegetables.

For every hour Farmer Z spends picking soybeans, he gives up 0.5 pounds of vegetables; and for every hour that Farmer Z spends picking vegetables, he gives up 2.5 pounds of soybeans.

Farmer Y gives up 25 pounds of soybeans for every hour that he spends harvesting vegetables, and for every hour that Farmer Y spends harvesting soybeans, he gives up 0.1 pounds of vegetables.


An opportunity cost is a way of describing what is given up when one choice is taken over another.

OPPORTUNITY COST

Farmer Z Farmer Y

0.1 pounds of soybeans for every 0.5 pounds of vegetables harvested; or

0.1 pounds of vegetables for every 25 pounds of soybeans harvested; or

5 pounds of vegetables for every 1 pound of soybeans harvested.

250 pounds of soybeans for every 1 pound of vegetables harvested.


OPPORTUNITY COST OF

VEGETABLES OVER SOYABEANS SOYABEANS OVER VEGETABLES

FARMER Z 1/5 5

FARMER Y 250 1/250

Farmer ZThe opportunity cost of harvesting vegetables is lower than the opportunity cost of harvesting soybeans. For Farmer YThe opportunity cost of harvesting soybeans is lower than the opportunity cost of harvesting vegetables.

In both of these cases, this means that both farmers are better off spending their time harvesting the product that they can produce most efficiently.


The producer with the lower opportunity cost of production is said to have the comparative advantage. Notice that in a case with two producers and two products, each producer must have a comparative advantage in one, and not both, products.

We may represent the opportunity cost of one product in terms of the other product for both producers, and then compare these numbers. Whichever producer has the lower opportunity cost has the comparative advantage and should produce that product.


Absolute advantage and comparative advantage are theoretically straightforward.

When a producer has an absolute advantage, he can produce a given output by using fewer inputs than any competing producer.

When a producer has a competitive advantage, he can produce one product with a smaller amount of inputs than the competitor.

When either an absolute advantage or a comparative advantage exists, benefits from trade are guaranteed.


Flow of Trade

In the identity Y = C + I + G + NX describes the output of an economy. In this equation, Y is the nominal output, C is money spent on consumption, I is money spent on investment, G is money spent by the government, and NX is net exports (exports less imports).

The sum of these the total amount of both income and output in a country.


To understand flow of capital and goods in and out of countries, we should keep the Y = C + I + G + NX identity in mind.

• NX is of particular interest. NX is defined as the total amount of exports less the total amount of imports.

• NX is positive if a country exports more than it imports.

• NX is negative if a country imports more than it exports, and zero if exports and imports are equal.


Two Countries A & B

If Country A exports 1 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then the NX for both countries is equal to zero since exports equal imports.

In this case, goods are traded for goods and at the end of the term, the trade balance is equal.


If debt is is short-term

If Country A exports 0.5 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then Country A has a negative trade balance, called a trade deficit.

In this case, Country A owes Country B money for the imported bananas beyond the 0.5 million dollars worth of exported coconuts.

If this is a short-term debt, nothing of consequence would occur since Country A has the ability to export more coconuts quickly to make up for the difference.


If the debt is long term

Country A must somehow repay Country B for the imported bananas. The easiest way to think of this exchange is to imagine Country A giving Country B interest in the future coconuts produced by Country A.

To repay the debt that Country A owes to Country B, Country B becomes invested in Country A.


Any amount of exports that exceeds the total amount of imports results in foreign investment.

The opposite occurs when exports exceed imports as the exporting country becomes a foreign investor in the importing country.


This leads us to another important international trade identity

NX = NFI where NX is net exports or exports less imports and NFI is net foreign investment.

Simply put, the difference between what a country exports and imports is equal to the amount of foreign investment.

The trade balance can remain fair even if a country imports more than it exports - it must make up the difference through foreign investment.


If net exports remain equal to net foreign investment, a few tendencies arise: • countries with few imports and many exports will

tend to have significant foreign investment• countries with few exports and many imports will

also tend to have significant foreign investment• countries with exports equal to imports will tend

to have little investment in foreign countries and little foreign investment


The identity NX = NFI and the means by which capital and goods flow between countries help to clarify the workings of international trade.



What happens when net exports are negative?• When net exports are negative, net foreign

investments are positive as foreigners gain stock in domestic firms to pay for imports

Would you expect a country that has few imports and many exports to have much foreign investment?• A country with few imports would likely have a

significant amount of interest in other foreign countries, but little foreign investment in the country.

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