International Trade

Terms
Absolute Advantage - When a producer can create a given amount of output with the smallest amount of inputs. Budget Deficit - When the government spends more money than it receives. Capital - Money, machinery, and education put toward a business to increase its productivity. Comparative Advantage - When a producer has a lower opportunity cost of production for an item than another producer's. Consumption - Goods and services purchased by consumers. Cost of living - The relative amount of money needed to maintain a given lifestyle. Exchange Rates - Numbers that tell how much foreign product can be purchased with similar domestic product. Exports - Goods sent to another country for sale. Free Trade - Trade with which the government does not interfere. Goods - Products that consumers, manufacturers, and governments exchange. Imports - Goods produced in a foreign country and consumed in a domestic country. Income - Money that enters a country or household. Investment - Money spent to improve a company's growth and productivity. Net Exports - The difference between exports and imports. Net Foreign Investment - The total amount of investment in a country that results from trade deficits. Net foreign investment always equals net exports. Nominal Exchange Rates - The amount of foreign currency that exchangeable for domestic currency. Nominal Output - The amount of output valued in currency dollars. Opportunity Cost - What is given up in pursuing one option over another. Output - Goods and services produced. Protectionist Policies - Governmental policies that serve to help developing domestic industries. Quota - When a government limits the amount of a given good that can be imported. Imposing quotas is a protectionist policy. Real Exchange Rates - Numbers that describe the relative real value of foreign and domestic goods. Subsidy - Grants paid by the government to producers to help them develop. Subsidizing is a protectionist policy. Tariff - Fees charged by the government on imported goods to help raise the price and decrease the quantity sold. Use of tariffs is a protectionist policy. Trade - When goods from one producer are exchanged for goods from another producer. In this case, goods can be very broadly interpreted. Trade Balance - Exports minus imports. Trade Deficit - A trade deficit occurs when a country imports more than it exports. Trade Surplus - A trade surplus occurs when a country exports more than it imports.

Formulae

Output = income Y = C + I + G + Y = C + I + G + NX NX Net Exports Real Exchange Rate Nominal Exchange Rate Net Exports = exports - imports Real exchange rate = ((nominal exchange rate)(domestic price)) /(foreign price) Nominal exchange rate = (price of foreign currency) / (price of domestic currency)

Trade Basics

Why Trade?
Why should countries trade? Simply put, if a country can produce a good for less than another country, then the opportunity for advantageous trade exists. Of course, the opportunity for advantageous trade also exists 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. Let's use an example to explain. Say Jim lives on an island with a coconut tree. Sally lives on another island with a banana tree. Jim tires of eating coconuts and desires something new to eat. Surprisingly enough, Sally is tired of bananas and would love some nice sweet coconut. In this example, 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 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 Trade
A country may have two advantages over another country (or countries) regarding trade. Absolute advantage 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 happens when a producer has a lower opportunity cost of production than another producer. Comparative advantage may also apply to many countries, but in this SparkNote it will be restricted to cases of two countries and two goods. Each of these two cases will be discussed in detail in the following paragraphs. Farmer John has a pistachio farm. It takes him five hours worth of work to harvest one pound of nuts. Farmer Rick also has a pistachio farm. It takes him four hours worth of work to harvest one pound of nuts. Farmer Erica owns a third pistachio farm. She can

harvest one pound of nuts in three hours. In this example, Farmer Erica is said to have the absolute advantage in pistachio production since she is able to produce the largest amount of output in the smallest amount of time. 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. For instance, in the above example, it was far more productive for Farmer Erica to spend time harvesting pistachios than it was for Farmer Rick or Farmer John to do the same. Farmer Erica 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. In a more complex model though, producers can produce many different goods. Often times, if a producer chooses to produce one good, he or she must give up the opportunity to produce another good. This is called the opportunity cost of producing a good. The opportunity cost describes what is sacrificed or relinquished when one choice is taken over another. Let's use another example. Revisiting the farms belonging to Farmer Erica and Farmer Rick, we discover that they are both able to produce pistachios and soybeans. Farmer Erica can harvest 1 pound of pistachios in 2 hours and she can harvest 5 pounds of soybeans in 2 hours. Farmer Rick, on the other hand, can harvest 1 pound of pistachios in 10 hours and 50 pounds of soybeans in 2 hours. Looking at this information in terms of the total amount of time each farmer takes to harvest a pound of each product is the next step to understanding comparative advantage. Farmer Erica can harvest 1 pound of pistachios in an hour while it takes Farmer Rick 10 hours to harvest 1 pound of pistachios. On the other hand, Farmer Rick can harvest 1 pound of soybeans in about 2.5 minutes, but it takes Farmer Erica about 24 minutes to harvest a pound of soybeans. Since each of these farmers only has a fixed number of hours to spend harvesting, each hour spent harvesting pistachios cannot be spent harvesting soybeans, and similarly, each hour spent harvesting soybeans cannot be spent harvesting pistachios. For every hour Farmer Erica spends picking soybeans, she gives up 0.5 pounds of pistachios; and for every hour that Farmer Erica spends picking pistachios, she gives up 0.1 pounds of soybeans. Farmer Rick gives up 25 pounds of soybeans for every hour that he spends harvesting pistachios, and for every hour that Farmer Rick spends harvesting soybeans, he gives up 0.1 pounds of pistachios. We can reexamine this example in terms of opportunity costs. Farmer Erica has an opportunity cost of 0.1 pounds of soybeans for every 0.5 pounds of pistachios harvested, or similarly, 5 pounds of pistachios for every 1 pound of soybeans harvested. Farmer Rick has an opportunity cost of 0.1 pounds of pistachios for every 25 pounds of soybeans harvested, or 250 pounds of soybeans for every pound of pistachios harvested.

Figure %: Opportunity costs of production Figure 1 depicts the situation described above. Notice that for Farmer Erica, the opportunity cost of harvesting pistachios is lower than the opportunity cost of harvesting soybeans. Similarly, for Farmer Rick, the opportunity cost of harvesting soybeans is lower than the opportunity cost of harvesting pistachios. 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. Figure 1 makes finding the comparative advantage easy. Simply 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 competition. He therefore must produce another product with a greater amount of inputs than the competitor, hence the designation of comparative advantage. When either an absolute advantage or a comparative advantage exists, benefits from trade are guaranteed.

The Means of Trade

Flows of Capital and Goods

We learned the identity Y = C + I + G + NX to describe the output of an economy. In this equation, Y is the nominal output, C is money spent on consumption, It is money spent on investment, G is money spent by the government, and NX is net exports or exports less imports. The sum of these costs is the total amount of both income and output in a country. To understand how capital and goods flow 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, negative if a country imports more than it exports, and zero if exports and imports are equal. Let's work through each of these examples in turn. First we'll examine the simplest case, in which exports and imports are equal. In this example, there are two countries, Country A and Country 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. When countries import less than they export or import more than they export, the situation becomes significantly more complicated. Now let's examine the case when a country imports more than it exports. 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, however, 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 fairly 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 Understanding the identity NX = NFI and the means by which capital and goods flow between countries helps to clarify the workings of international trade.

Exchange Rates

Nominal Exchange Rates versus Real Exchange Rates

As we begin discussing exchange rates, we must make the same distinction that we made when discussing GDP. Namely, how do nominal exchange rates and real exchange rates differ? The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of domestic currency. The real exchange rate is a bit more complicated than the nominal exchange rate. While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation: real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Let's say that we want to determine the real exchange rate for wine between the US and Italy. We know that the nominal exchange rate between these countries is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember that we are attempting to compare equivalent types of wine in this example. In this case, we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine. By using both the nominal exchange rate and the real exchange rate, we can deduce important information about the relative cost of living in two countries. While a high nominal exchange rate may create the false impression that a unit of domestic currency will be able to purchase many foreign goods, in reality, only a high real exchange rate justifies this assumption.

Net Exports and the Real Exchange Rate

An important relationship exists between net exports and the real exchange rate within a country. When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise. This relationship helps to show the effects of changes in the real exchange rate.

Trade and the Country

Barriers to Trade
It may seem odd, but governments often step in to restrict trade. Why might a government want to restrict trade? If domestic industries cannot compete against foreign industries, the government will restrict trade to help the domestic industries develop. Governments may also restrict trade to foster business at home rather than encouraging business to move out of the country. These protectionist policies encourage prices to stay high and help domestic industries to develop.

Trade Interferences
Governments three primary means to restrict trade: quota systems; tariffs; and subsidies. A quota system imposes restrictions on the specific number of goods imported into a country. Quota systems allow governments to control the quantity of imports to help protect domestic industries. Tariffs are fees paid on imported goods. Tariffs increase the price that consumers pay for the good, thus reducing the quantity of the good demanded and making the price more in line with the price charged by domestic producers. Tariff profits may go to the government or to developing industries. Subsidies are grants given to domestic industries to help them develop and compete with foreign producers. Through subsidies, domestic producers can charge less for their goods without losing money due to outside grants. Through judicious use of quotas, tariffs, and subsidies, governments are able to improve the domestic economy. This may increase the price that domestic consumers pay for goods, though this small annoyance is usually outweighed by significantly bolstered overall economic levels and long-term economic growth.

Trade Deficit
In the section on net exports we learned that net exports equal exports minus imports. The difference between exports and imports is referred to as the trade deficit or the trade surplus. When exports exceed imports, a trade surplus exists. When imports exceed exports, a trade deficit exists. There often talk about the effects of the trade deficit on the economy. What is the actual effect of the trade deficit though? Remember that when there is a trade deficit, net foreign investment fills the gap between exports and imports, as NX = NFI. Thus, if a large trade deficit exists, foreign investment must be high. This is slightly problematic as domestic companies often enjoy domestic ownership--a large trade deficit threatens this condition. A trade deficit is often matched with a large governmental budget deficit. Though the

specific effects of a trade deficit are nebulous, in general a large trade deficit is thought to stunt long-term economic growth slightly. How can the trade deficit be resolved? First, exports can be increased to make annual net exports positive. When employed, this method will cause a trade deficit decrease over time. Second, funds can be used to pay off foreign investors, reducing balance due from trade and causing a lower trade deficit.