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By
eNotesMBA

www.enotesmba.blogspot.com

International Trade
1. 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 Trade
1. 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 Advantage
 An 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 Trade
A 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 PRODUCTIVITY
one pound of vegetables.
FARMER ACTIVITY
HOUR MONEY
Farmer Y also has a vegetable farm. It
takes him four hours worth of work to
harvest one pound of vegetables. X 5
VEGETABLE ONE
Y 4
FARMING POUND
Farmer Z owns a third vegetable farm. He
Z 3
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.


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 Advantage
 A comparative advantage occurs when a producer
has a lower opportunity cost of production than
other producers


Example

Revisiting the farms belonging PRODUCTIVITY
to Farmer Z and Farmer Y, we FARMER ACTIVITY
discover that they are both able HOUR POUNDS
to produce vegetables and VEGETABLE
soybeans. FARMING
2 1
Z
SOYABEANS 2 5
Farmer Z can harvest 1 pound of
vegetables in 2 hours and he can VEGETABLE
harvest 5 pounds of soybeans in 10 1
Y FARMING
2 hours.
SOYABEANS 2 50

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


PRODUCTIVITY PRODUCTIVITY
FARMER ACTIVITY FARMER ACTIVITY
HOUR MONEY HOUR POUNDS
X 5 VEGETABLE
2 1
VEGETABLE ONE Z FARMING
Y 4
FARMING POUND SOYABEANS 2 5
Z 3
VEGETABLE
10 1
Y FARMING

SOYABEANS 2 50

Farmer 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 0.1 pounds of vegetables for every 25
pounds of vegetables harvested; or pounds of soybeans harvested; or
5 pounds of vegetables for every 1 250 pounds of soybeans for every 1
pound of soybeans harvested. pound of vegetables harvested.


OPPORTUNITY COST OF
SOYABEANS OVER
VEGETABLES OVER SOYABEANS
VEGETABLES
FARMER Z 1/5 5

FARMER Y 250 1/250
Farmer Z
The opportunity cost of harvesting vegetables is lower than
the opportunity cost of harvesting soybeans.
For Farmer Y
The 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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