Terms of Trade - International Economics - Lecture Slides, Slides of Economics

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• The terms of trade is the relative price of

the exportable good expressed in units of

the importable good.

The Terms of Trade

• In Assignment 1, remember that the range of mutually beneficial terms of trade was
• 2 computers >1beer>1 computer
• But what affects the actual exact exchange rate within this limit?
• The theory of reciprocal demand suggests that:

1. The stronger the German demand for US computer, the higher the price German’s will pay for US computer, the closer the actual exchange rate will be to 1 beer for 1 computer
2. The stronger the US demand for German beer, the higher the price US will pay for German beer, the closer the actual exchange rate will be to 1 beer for 2 computer

• So the actual exchange rate will depends on how strong the demand of one nation is for the other nation’s product.

The theory of reciprocal demand

• Increasing Costs and the Production Possibilities
  • The increasing amount of a good that a country must forego to release enough resources to produce each additional unit of another good.
  • A country may have increasing opportunity costs because: - Factors of production are specialized in the production of a particular product. - For example, highly skilled labor is used in the computer production while low skilled labor is used in the beer production. - Production of different goods use resources in different relative proportions. - For example, the computer industry may require large amounts of capital and the beer industry may require large amounts of labor.

Trade Under Increasing

Opportunity Costs

Supply Curves of a Good and the Production

Possibilities Frontier Under Increasing Cost

Conditions

beer

computers

Price of computers

computers

5 A 4.5 B

1

C 2 D E

9

F 10

Supply

1

10

2

• The opportunity coat of first computer is 0.5 beer.
• The opportunity cost of 10th^ computer is 2 beers.

• Static Gains from trade
  • Gains in word output that result from specialization and trade are the static gains from trade.
• Dynamic gains from trade
  • Gains from trade over time that occur because trade causes an increase in a country’s economic growth or induces greater efficiency in the use of existing resources.

Static/ Dynamic Gains From Trade

Chapter 3: The Factor-Proportions Theory (the theory attempts to

explain what determines comparative advantage.)

• Assumptions of the Factor Proportions Theory
  1. Two countries – U.S. and India producing two goods – machines and cloth
  2. Production and consumption conducted under perfect competition A. Firms are price takers. B. Prices of factors are determined by supply and demand in each market. C. In long run, prices of goods are equal to their respective costs of production.

The Factor-Proportions Theory

7. Technology for production same in both

countries and produced under constant returns to scale.

8. Capital and Labor can flow freely from one

industry to the other domestically

9. Labor and Capital cannot move freely

between countries.

The Factor-Proportions Theory

10. Production techniques available lead to

cloth being a labor-intensive good and

machines being a capital-intensive good

in both countries.

a) Machines use a lot of capital relative to labor

• high K/L ratio. b) Cloth uses a lot of labor relative to capital – low K/L ratio.

The Factor-Proportions Theory

Table 3.1: Production conditions in the U.S. and India

Input Requirements to Produce Country 1 Machine 10 Yards of Cloth U.S. 10 units of capital +4 days of labor^ 4 units of capital +8 days of labor

India 10 units of capital +4 days of labor^ 4 units of capital +8 days of labor

The Factor-Proportions Theory

• Factor Intensity: In a world of two

commodities (cloth and machine) and

two factors (labor and capital), we say

that machine is capital-intensive if the

capital-labor ratio (K/L) used in the

production of machine is greater than

K/L used in the production of cloth.

The Factor-Proportions Theory

• The Factor-Proportions Theorem
  • Assume that U.S. and India have the same tastes: When faced with the same relative price of the two goods, U.S. and India have identical relative demands for machines and cloth.
  • Assume that both countries have the same technology: A given amount of capital and labor yields the same output of either cloth or machines in the two countries.
  • The only difference between the countries is in their resources: U.S. has a higher ratio of capital to labor than India does.

The Factor-Proportions Theory

• Before trade
  • Capital less expensive in capital-abundant country – U.S.
  • Labor less expensive in labor-abundant country - India

The Factor-Proportions Theory

• Lower opportunity cost to produce goods

in the country abundant in the main factor

of production

• U.S. has lower opportunity cost in production of goods using more capital and less labor.
• India has lower opportunity cost in production of goods using more labor and less capital.

The Factor-Proportions Theory

• U.S. (capital abundant) has comparative

advantage in the production of machines

(capital intensive).

• India (labor abundant) has comparative

advantage in production of cloth (labor

intensive).