International Economics: Trade Explained

• International Economics involves the theory and practice of international trade and finance.
• It encompasses economic relations among nations.
• It recognizes the crucial interdependence of nations for economic well-being.

Why Nations Trade

• Trade happens if a desired product is not locally available
• Nations trade when a product is of better quality, fit, or cheaper abroad.
• Producers gain by making more sales than possible in their domestic market alone.
• Foreign exchange can be earned through trade.
• While trade generally benefits societies, not every individual or company benefits equally.
• If countries import products produced more efficiently and cheaply abroad, the world benefits.
• A firm buying cheaper Chinese-made wipers benefits, but domestic wiper producers selling more expensive wipers lose out.
• Buyers (firms) often gain more than domestic sellers lose
• Production costs that ignore social costs like pollution are an exception to the benefits of international trade.

Economic Relations Between Nations

• Economic relations between nations give rise to distinct problems.
• These problems require different analytical tools.
• International Economics warrants its own branch of applied economics.
• A US firm exporting machinery to Germany faces challenges like restrictions (tariffs), language barriers, and fluctuating currency values.
• These international trade issues differ from inter-regional trade concerns.

Subject Matter of International Economics

• Microeconomic aspects include pure theory of trade and commercial policy.
• Pure Theory of Trade studies the basis for and gains from trade.
• Theory of Commercial Policy studies the reasons for and results of trade obstructions
• Macroeconomic aspects involve balance of payments and adjustments in the balance of payments
• Balance of Payments examines a nation's total payments to and receipts from other countries, impacting currency exchange.
• Adjustments in the Balance of Payments deals with the adjustment mechanism for balance of payments disequilibria under different international monetary systems.

Evolution of International Economics: Mercantilism

• From the 16th to mid-18th century, Britain, Spain, France, and the Netherlands followed Mercantilism.
• The key belief was that Export > Import leads to a rich and powerful nation.
• Export - Import should result in an inflow of precious metals, mainly gold.
• Mercantilism advocated government stimulation of exports and import restrictions.
• The flaw in this was that all nations cannot simultaneously have an export surplus.
• Mercantilism presumes a fixed amount of gold, and a nation can only gain at the expense of others.

Evolution of International Economics: Adam Smith's Absolute Advantage

• Adam Smith's "The Wealth of Nations" (1776) attacked mercantilism.
• Smith advocated for free trade.
• With free trade, each nation specializes in producing commodities in which it has an absolute advantage.
• Absolute advantage means producing more output with the same resources, or needing fewer resources for the same output, resulting in lower costs than other economies.
• Export the commodity of absolute advantage.
• Import the commodity of absolute disadvantage.
• Free trade should result in increased world output.
• Nations need not gain at each other's expense; all can gain simultaneously.

Adam Smith's Absolute Advantage (Examples)

• In cloth production, England needs 60 labour hours while Portugal needs 120, giving England absolute advantage.
• In wine production, Portugal requires 70 labour hours while England needs 110, giving Portugal absolute advantage.
• Specialization leads to a fall in labor hours (cost) in both nations.
• Suppose US produces 5 cars while Brazil produces 2 cars in a year, giving the US absolute advantage
• Suppose Brazil produces 8 bananas while the US produces 1 banana in a year, giving Brazil absolute advantage
• If the US specializes in cars (producing 10 cars with 2 workers) and Brazil in bananas (16 units), the combined output would be greater than before specialization
• Both nations would share this increased output through voluntary exchange

Limitations of Absolute Advantage Theory

• Developing countries are behind technologically and cannot compete in the global market, so they can't benefit from free trade.
• The absolute advantage theory does not consider various factors of production such as land, labor, and capital
• In today’s world, countries exchange of one type of good with another type of good between two countries, such as cars etc, so the absolute advantage theory does not consider various types of goods.

Evolution of International Economics: David Ricardo's Comparative Advantage

• Mutually advantageous trade can still occur even if a nation (Brazil) has an absolute disadvantage in producing both commodities (cloth and airplanes) compared to another nation (US).
• The less efficient nation should specialize in producing and exporting the commodity in which its absolute disadvantage is less.
• The less efficient nation should import the commodity in which its absolute disadvantage is greater.
• Comparative advantage one of the most famous and still unchallenged laws of economics
• US has a greater absolute advantage in airplanes (12:1) vs. cloth (5:4).
• Brazil has a lower absolute disadvantage in cloth

Evaluation of Ricardo's Law of Comparative Advantage

• Ricardo's law assumes a labor theory of value, where a commodity's price equals the labor amount going into its production
• Ricardo said the value of labor and its exchange value in the market is a commodity cost based on labor time.
• Marx stated that a commodity's value is objectively measured by the average labor hours for its production, i.e., socially necessary labor.
• A critique is expending much labor time on a good can result in little or no value.
• Labor theory of value is rejected, so too is Ricardo's explanation of comparative advantage.
• The law of comparative advantage remains valid and is explained by opportunity costs.

Evolution of International Economics: Absolute vs Comparative Advantage

• Absolute advantage is concerned with producing at a lower cost.
• Comparative advantage is concerned with producing at a lower opportunity cost
• Opportunity Cost= Value of the next-highest-valued alternative use of a resource.
• Having absolute advantage doesn't necessarily mean an economy should produce that good or everything!!!
• If the US produces clothing, the opportunity cost is 12/5 = 2.4 airplanes foregone, if Brail produces clothing the opportunity cost is 1/4 = 0.25 airplanes foregone, therefore, the US should specialize in producing airplanes.
• After specialization, we assume countries are able to concentrate on doubling production because they produce only one good rather than two thus total output and economic welfare increases.