The Theory of Everything. Principles of Comparative Advantage and International Economics. Overview Principles Slide 1 of 2

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1 Principles of Comparative Advantage and International Economics The Theory of Everything Every activity is performed by the people for whom the opportunity cost is the lowest. Everyone else on the planet has a higher opportunity cost for that activity. (See how cool you are?) by Geoffrey T Andron (revised ) So draw a line around any group of people and pretend they are a country. Now see what that country exports, and imports Geoffrey Teetor Andron 4/25/ Geoffrey Teetor Andron 2 Overview Principles Slide 1 of 2 Overview Principles Slide 2 of 2 The general patterns of specialization (and therefore trade) --between people, regions or nations-- are determined by: But: The principles of Comparative Advantage are identical to the principles of: Incentives created by Principles of Comparative Advantage as described in the theory of international economics response to differences in opportunity cost/benefit 3 4 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. 5 6

2 Comparative advantage in action Example 1 Two people (one of whom is more productive--better--at everything); two goods. Person Max. Production Possibility (per week) Fish/wk Rabbits/wk Person Person 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? 2005 Geoffrey Teetor Andron 7 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: Convert p into $ this way Way 1 Way 2 Pesos 10 p 20 p Dollars $ 1 $ 1 Convert $ into p this way 2005 Geoffrey Teetor Andron Comparative advantage in action Example 2. Two countries, each with different currency, three goods (one not tradable) and no information about which country is more productive (since it doesn t matter!) Country (currency unit) Pre-trade prices of two goods Food Clothing Shelter Country I (Pink) Country II (Blue) Trade-currency (Pink/Blue) 4 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. 10 Next slides: How does comparative advantage work in a more realistic world with many goods? Example 3: Six goods instead of just two. 11 Example 3. Six goods, two countries (people or areas). Cntry (curr unit) Pre-trade prices of six goods Gd1 Gd2 Gd3 Gd4 Gd5 Gd6 Country I (Yahoo) Country II (Zulu) Trade-currency ? 2.7? 2.7? 2.7? 2.7? 2.7?? = possible final values? 12

3 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) p 2 p 1 p 0 D o S D 1 Added demand from foreign nations-- Exports D 2 Demand from citizens of your own country q 0 q 1 q Supply and Demand for importable goods in the country of destination (the importing country) p 0 p 1 q 0 q 1 D S o S 1 Supply from producers in your own country Added supply from foreign nations Imports 15 Note: The typical internationally traded good is both an exportable (one country) and an importable (other country). Therefore: Every go od 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). 16 Next slides: Models for the foreign exchange markets and Surprising facts 2006 Geoffrey Teetor Andron 17 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. 18

4 What will the exchange rate be? Let s use Example 3, but after trade has built up: Convert Y into Z this way Cntry (curr unit) Country I (Yahoo) Country II (Zulu) Trade-currency Direction of trade of the six goods Gd1 Gd2 Gd3 Gd4 Gd5 Gd6 F-exch Market Convert Z into Y this way 3.4? No What will the exchange rate be? Let s use Example 3, but after trade has built up: Cntry (curr unit) Country I (Yahoo) Country II (Zulu) Trade-currency Direction of trade of the six goods Gd1 Gd2 Gd3 Gd4 Gd5 Gd6 F-exch Market ? Yes 2.2? No 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. 21 A Brief Diversion: Models for Exchange Rate Determination in Presence of Inflation (this slide and next) General Principles of Monetary Theory (studied in macroeconomics) Money is a good. It has value. It has uses: Money is used as a temporary store of value and a medium of exchange (to make transactions). Transactions cannot occur unless the buyer has sufficient money, no matter how rich s/he is. Any person or firm attempts to have the correct amount of money on hand for their spending plans not too much and not too little. Money is not created or destroyed by its use. Instead, it merely passes from one person/group to anothe r. 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, citizens and firms attempt to get rid of it. The result: inflation. So: The general level of prices in any country is determined by the quantity of money in that country Geoffrey Teetor Andron 22 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. 23 Next slides: Models for the international flows of capital 24

5 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. 25 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, causing them to converge toward some common value. 26 Example 4. International flows of claims. Three goods in equilibrium; four claims at pre-trade prices. As claims are put into people s portfolios, the claims prices adjust. Example 4. International flows of claims. Three goods in equilibrium; four claims at pre-trade prices. As claims are put into people s portfolios, the claims prices adjust. Cntry(curr) Gd1 Gd2 Gd3 CL1CI CL2CII CL3CI CL4CII CI (Yahoo) CII (Zulu) Trade-curr Soon all trade currency are again equal, now including those for claims. 27 Cntry(curr) Gd1 Gd2 Gd3 CL1CI CL2CII CL3CI CL4CII CI (Yahoo) CII (Zulu) Trade-curr Soon all trade currency are again equal, now including those for claims. 28 Example 4. International flows of claims. Three goods and four claims, in equilibrium after all international adjustments. Cntry(curr) Gd1 Gd2 Gd3 CL1CI CL2CII CL3CI CL4CII CI (Yahoo) CII (Zulu) Trade-curr Trade currency now tend to be equal, including those for claims. 29 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). 30

6 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 p 1 p 0 a b q 0 q 1 D o S As international trade increases price, producer surplus increases by a + b, while consumer surplus decreases only by a D 1 Triangle b shows that producers gain more than the buyers lose Illustration of Pareto gains in the market for a country s importable goods p 0 p 1 a b q 0 q 1 D S o S 1 As international trade reduces price, consumer surplus increases by a + b, but producer surplus declines only by a. Triangle b shows that buyers gain more than producers lose. 33 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 34 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. 35 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 subaccount. 36

7 Summary and Conclusions The following 5 slides summarize key ideas and models from our study of the principles of international economics: 37 Key Principles of International Economics 1. Differences in opportunity cost create differences in trade-currency. These lead to international trade of goods, claims, foreign exchange (moneys). 2. As trade builds, differences in trade-currency, 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. 38 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. Key Principles of International Economics (continued) 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! 40 Key Principles of International Economics (continued) 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. 41 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. 42

8 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 Geoffrey Teetor Andron International topics for macroeconomics partial list 1. The foreign sector and economic growth and development. 2. Comparative advantage and the pattern of exports and imports 3. Determination of exchange rates 4. Balance of payments and international capital flows 5. 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 list 9. The foreign sector in the various macroeconomic models Classical model Keynesian model Synthesized model 10.The balance of payments. 11.Fixed versus flexible exchange rates. 12.Internal versus external balance.