Prof. Bryan Caplan

bcaplan@gmu.edu

http://www.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

Week 12: The International Economy

  1. The Iowa Car Crop Revisited
    1. Recall Landsburg's story of "the Iowa car crop."
    2. Key point: Trade can be viewed as any other technology for producing things. The fact that people in distant lands are involved makes no difference.
    3. Is there anything more to say about international trade? Yes: Trade is a special kind of technology, because it has to work! Why? The law of comparative advantage.
  2. Comparative Advantage
    1. It is important to make a distinction between absolute advantage and comparative advantage.
      1. Absolute advantage: I am a better computer programmer than you.
      2. Comparative advantage: Compared to you, I am relatively good at programming and relatively bad at baking.
    2. Note: EVERYONE has a comparative advantage in something, even though some people don't have an absolute advantage in anything!
    3. Key insight: Mutually beneficial trade arises due to comparative advantage, not absolute advantage. Since everyone has a comparative advantage in something, mutually beneficial trade is always possible!
  3. Comparative Advantage for Individuals
    1. Classic example: Dr. X is a great brain surgeon and the world's fastest typist. Should he hire a secretary? Yes! This frees up more time for brain surgery.
    2.  

      Dr. X

      Secretary

      Surgeries/Hour

      1

      0

      Words/Hour

      5000

      1000

    3. Mathematical truth: Dr. X has a comparative advantage in surgery implies the secretary has an comparative advantage in typing!
    4. Dr. X has a comparative advantage in surgery compared to his secretary so long as: (surgeries/hour)/(words/hour)surgeon>(surgeries/hour)/(words/hour)secretary; in this instance, as long as 1/5000>0/1000. And the secretary has a comparative advantage in typing as long as (words/hour)/(surgeries/hour)/surgeon<(words/hour)/(surgeries/hour)secretary; in this instance, as long as 5000/1<1000/0.
    5. Question: Will people always choose to specialize in their comparative advantage? They will so long as the good is worth producing at all. Example: Suppose the market price of 1 surgery is $100,000, and the market price of 1000 words typed is $10. Then the above table implies:
    6.  

      Dr. X

      Secretary

      Surgery Wage

      $100,000

      $0

      Typing Wage

      $50

      $10

    7. In contrast, if surgery's price is $0 (it kills people instead of saving them), and the market price of typing stays the same, the above table becomes:
    8.  

      Dr. X

      Secretary

      Surgery Wage

      $0

      $0

      Typing Wage

      $50

      $10

    9. Thus, both Dr. X and the secretary become typists!
  4. Comparative Advantage for Nations
    1. Critical insight: comparative advantage also works for nations! Ex: Germany and U.K. producing cotton and wheat:
    2.  

      Germany

      U.K.

      Cotton/man-hr.

      10

      20

      Wheat/man-hr.

      20

      10

    3. Germany has a comparative advantage in wheat compared to U.K. so long as: (wheat/hour)/(cotton/hour)Germany>(wheat/hour)/(cotton/hour)U.K.; in this instance, as long as 2/1>1/2. And the U.K. has a comparative advantage in cotton as long as (cotton/hour)/(wheat/hour)/Germany<(cotton/hour)/(wheat/hour)U.K.; in this instance, as long as 1/2/<2/1.
    4. Again, countries specialize in their comparative advantage IF the good is worth producing at all. If the price of wheat is $3 and the price of cotton is $4, we have:
    5.  

      Germany

      U.K.

      Cotton/wage

      $40

      $80

      Wheat/wage

      $60

      $30

    6. In contrast, if the price of wheat were $1 and the price of cotton were still $4, neither country produces wheat:
    7.  

      Germany

      U.K.

      Cotton/wage

      $40

      $80

      Wheat/wage

      $20

      $10

    8. How can this improve your strategic gaming?
    9. Conclusion: Trade is just another form of technology, as Landsburg emphasizes. But more amazingly, it is always a useful technology, since a country can't lack a comparative advantage.
  5. Exchange Rates
    1. International trade usually requires two transactions rather than one. First you have to change your currency for their currency, then you have to buy what you want using their currency.
    2. How are exchange rates determined? Supply and demand.
    3. Complication: There are always two ways to represent the market: "our" view and "their" view. Both are right, you just have to keep your axes straight.
    4. It's easiest to do it from "our" view. Then this is a standard S&D problem: pounds might as well be pizzas. Then on the y-axis, we should have the dollar price of e.g. 1 pound, just like we usually have the dollar price of 1 pizza. On the x-axis, we have the quantity of pounds exchanged.
    5. If the S of pounds increases, it takes fewer dollars to buy a pound. In international trade lingo, the pound "depreciates" and the dollar "appreciates."
    6. If the D for pounds increases, it takes more dollars to buy a pound. In jargon, the pound "appreciates" and the dollar "depreciates."
    7. What about "their" view. If you were a British economics student and you were buying a pizza, how would you label your S&D graphs?
    8. You do the same to show the British perspective on the foreign exchange market.
    9. Key insight: "our" S of pounds is "their" D for dollars; "our" D for pounds is "their" S of dollars.
    10. Note: Both perspectives give the same answer. If the S of pounds increases, the dollar-price of pounds falls, so the dollar appreciates; if the D for dollars increases, the pound-price of dollars rises, so the dollar appreciates.
  6. Purchasing Power Parity
    1. Can we say anything more about exchange rates? Yes: given some assumptions (no transportation costs, no taxes), the real price of goods will be the same all over the world. This is known as "purchasing power parity."
    2. What's the intuition? Suppose I:
      1. Buy $100 worth of gold in the U.S.
      2. Go to Paris and sell the gold for francs.
      3. Use the francs to buy cotton.
      4. Go back to the U.S. and sell the cotton for dollars.
    3. If I have more than $100 at the end, then with no transportation costs or taxes, I have an incentive to export gold and import cotton. This:
      1. Raises the U.S. price of gold.
      2. Lowers the U.S. price of cotton.
      3. Lowers the French price of gold.
      4. Raises the French price of cotton.
    4. In equilibrium, such opportunities for pure arbitrage thus disappear.
    5. Thus, if purchasing power parity holds, $100 will buy the same bundle of goods everywhere in the world.
    6. Due to transportation costs and taxes, purchasing power parity doesn't work perfectly, but it does work surprisingly well.
    7. The Big Mac index of purchasing power parity.
  7. Current and Capital Accounts
    1. What exactly is a "trade deficit"? It simply means that our current purchases from a country exceed their current purchases from us.
    2. How is this possible? We are selling assets (real estate, bonds, stocks, money...) to make up the difference.
    3. Value of Goods Bought=Value of Goods Sold -- by definition. We can talk about the trade deficit only by separating "goods" into the "currently-produced goods" (the Current Account) and "all other assets" (the Capital Account).
    4. What do one person's Current and Capital Accounts look like?
    5. Key insight: Trade deficits just reflect swaps of current output for assets. It is just as mutually beneficial as any other kind of trade.
    6. Implication: If one country has a higher savings rate than another, you should expect the country with the lower savings rate to have trade deficits with the country with the higher savings rate. E.g. Japan and U.S.! This merely reflects the fact that people in Japan want to trade their current output for U.S. assets, and people in the U.S. want to trade their assets Japan's current output.
    7. How to buy stuff for green pieces of paper: the case of Russian dollarization.
  8. Fallacies of International Trade
    1. There are probably more economic fallacies about international trade than any other topic in economics. In virtually all countries, people dislike and scapegoat "foreigners."
    2. Fallacy #1: "Exploitation." Foreigners are taking advantage of us by selling us things. Basic denial of the mutually advantageous nature of trade.
    3. Fallacy #2: "The trade deficit is bad." Aka "the balance of trade doctrine." Trade deficits do exist, but there is no reason to care about them. All a trade deficit means is that some people are selling assets to buy current output. Nothing more.
    4. Fallacy #3: "Unfair competition." If a country can produce something cheaply, that is a good thing, not a bad thing. Trade exists precisely because abilities differ both individually and internationally. "Equalizing the conditions of production" amounts to "Eliminating the motivation for trade." The Candlemakers' petition.