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Chapter 8 - Comparative advantage, exchange rates, and globalization. After reading this chapter, you should be able to: Explain the principle of comparative advantage, explain why economists'' and laypeople''s views of trade differ, summarize the sources of U.S. comparative advantage and discuss some concerns about the future in the U.S. economy, discuss how exchange rates are determined and what their role is in equalizing trade flows.
Introduction: Thinking Like an Economist CHAPTER 8 Comparative Advantage, Exchange Rates, and Globalization One of the purest fallacies is that trade follows the flag. Trade follows the lowest price current. If a dealer in any colony wished to buy Union Jacks, he would order them from Britain’s worst foe if he could save a sixpence — Andrew Carnegie McGrawHill/Irwin Copyright © 2013 by The McGrawHill Companies, Inc. All rights reserved 18 Comparative Advantage, Exchange Rates, and Globalization Chapter Goals Ø Ø Ø Ø Explain the principle of comparative advantage Explain why economists’ and laypeople’s views of trade differ Summarize the sources of U.S comparative advantage and discuss some concerns about the future in the U.S economy Discuss how exchange rates are determined and what their role is in equalizing trade flow 82 18 Comparative Advantage, Exchange Rates, and Globalization The Principle of Comparative Advantage Ø Ø The principle of comparative advantage is that as long as the relative opportunity costs of producing goods differ among countries, then there are potential gains from trade Opportunity cost is what must be given up in one good in order to get another good 83 18 Comparative Advantage, Exchange Rates, and Globalization Dividing Up the Gains from Trade Three determinants of the terms of trade are: The more competition, the less the trader gets Smaller countries get a larger proportion of the gain than larger countries Countries producing goods with economies of scale get a larger gain from trade 84 18 Comparative Advantage, Exchange Rates, and Globalization Why Economists and Laypeople Differ in Their Views of Trade If trade is good, why so many people oppose it? Ø Ø Ø Ø The gains of trade, lower prices, are harder to see than the cost, lost jobs The public believes that lower wages in other countries give them the comparative advantage in everything, so we will lose all jobs Laypeople often think of trade as trade only in manufactured goods Laypeople are extremely concerned about the impact of trade on the distribution of income 85 18 Comparative Advantage, Exchange Rates, and Globalization Sources of U.S Comparative Advantage Ø Ø Ø Ø U.S physical and technological infrastructure is the best in the world Wealth from past production and borrowing allows the U.S to be the world’s largest consumer U.S companies and individuals hold a large number of intellectual property rights The U.S has a relative open immigration policy 86 18 Comparative Advantage, Exchange Rates, and Globalization Some Concerns about the Future Inherent and transferable comparative advantage Ø Ø Ø Inherent comparative advantages are based on factors that are relatively unchangeable, such as resources and climate Transferable comparative advantages are based on factors that can change relatively easily, such as capital, technology, and types of labor Whether a country can maintain a much higher standard of living in the long run depends in part on whether its comparative advantage is inherent or transferable 87 18 Comparative Advantage, Exchange Rates, and Globalization Some Concerns about the Future The law of one price Ø Ø Ø The law of one price means that in a competitive market, there will be pressure for equal factors to be priced equally If factor prices aren’t equal, firms can reduce costs by redirecting production to countries with lower factor prices The convergence hypothesis is the tendency of economic forces to eliminate transferable comparative advantage 88 18 Comparative Advantage, Exchange Rates, and Globalization Some Concerns about the Future Methods of equalizing trade balances Ø Ø Ø Adjustments eventually occur to make surplus countries less competitive and deficit countries more competitive Wages rise in the surplus countries, making their goods more expensive The exchange rate of the deficit country falls and makes its goods less expensive 89 18 Comparative Advantage, Exchange Rates, and Globalization Determination of Exchange Rates and Trade Supply and Demand in Currency Markets Ø Ø The exchange rate is the rate at which one country’s currency can be traded for another’s People exchange currencies to buy goods or assets in other countries Ø To demand one currency, you must supply another Ø The supply curve of euros is upward-sloping Ø The demand curve for euros is downward-sloping Ø The market for euros is in equilibrium when quantity supplied equals quantity demanded 810 18 Comparative Advantage, Exchange Rates, and Globalization Determination of Exchange Rates and Trade Exchange Rates and Trade Ø Ø Ø Ø Trade for an economy that faces global competition needs to take into account world supply The exchange rate plays an important role in the demand for a country’s domestic goods As the quantity supplied of tradable goods rises, suppliers have to charge higher prices Exchange rate adjustments can bring comparative advantages into alignment, eliminating trade imbalances 811 18 Comparative Advantage, Exchange Rates, and Globalization Determination of Exchange Rates and Trade Some Complications in Exchange Rates Ø Trade imbalances arise due to: • • The fact that demand for a country’s currency also reflects a demand for its assets The presence of the resource curse: the paradox that countries with an abundance of resources tend to have lower economic growth and more unemployment than countries with fewer natural resources 812 18 Comparative Advantage, Exchange Rates, and Globalization Chapter Summary Ø Ø Ø Ø According to the principle of comparative advantage, as long as the relative opportunity costs of producing goods differ among countries, there are potential gains from trade The more competition exists in international trade, the less the trader gets and the more the involved countries get Once competition prevails, smaller countries tend to get a larger percentage of the gains from trade than larger countries Gains from trade go to countries that produce goods that exhibit economies of scale 813 18 Comparative Advantage, Exchange Rates, and Globalization Chapter Summary Ø Ø Ø Ø Ø Economists and laypeople differ in their views on trade The gains from trade are not easily recognized, while the costs in jobs lost tend to be readily identifiable The U.S has comparative advantages based on its skilled workforce, its institutions, and its language, among other things The prices of currencies—foreign exchange rates— can be analyzed with the supply and demand model The resource curse leads to trade imbalances 814 ... curve of euros is upward-sloping Ø The demand curve for euros is downward-sloping Ø The market for euros is in equilibrium when quantity supplied equals quantity demanded 8 10 18 Comparative Advantage, Exchange ... hypothesis is the tendency of economic forces to eliminate transferable comparative advantage 8 8 18 Comparative Advantage, Exchange Rates, and Globalization Some Concerns about the Future Methods... more unemployment than countries with fewer natural resources 8 12 18 Comparative Advantage, Exchange Rates, and Globalization Chapter Summary Ø Ø Ø Ø According to the principle of comparative