CHAPTER 1 INTRODUCTION
Chapter Organization
What is International Economics About?
The Gains from Trade
The Pattern of Trade Protectionism
The Balance of Payments Exchange-Rate Determination International Policy Coordination The International Capital Market International Economics: Trade and Money
CHAPTER OVERVIEW
The intent of this chapter is to provide both an overview of the subject matter of international economics and to provide a guide to the organization of the text. It is relatively easy for an instructor to motivate the study of international trade and finance. The front pages of newspapers, the covers of magazines, and the lead reports of television news broadcasts herald the interdependence of the U.S. economy with the rest of the world. This interdependence may also be recognized by students through their purchases of imports of all sorts of goods, their personal observations of the effects of dislocations due to international competition, and their experience through travel abroad.
The study of the theory of international economics generates an understanding of many key events that shape our domestic and international environment. In recent history, these events include the causes and consequences of the large current account deficits of the United States; the dramatic appreciation of the dollar during the first half of the 1980s followed by its rapid depreciation in the second half of the 1980s; the Latin American debt crisis of the 1980s and the Mexico crisis in late 1994; and the increased pressures for industry protection against foreign competition broadly voiced
in the late 1980s and more vocally espoused in the first half of the 1990s. Most recently, the financial crisis that began in East Asia in 1997 and spread to many countries around the globe and the Economic and Monetary Union in Europe have highlighted the way in which various national economies are linked and how important it is for us to understand these connections. At the same time, protests at global economic meetings have highlighted opposition to globalization. The text material will enable students to understand the economic context in which such events occur.
Chapter 1 of the text presents data demonstrating the growth in trade and increasing importance of international economics. This chapter also highlights and briefly discusses seven themes which arise throughout the book. These themes include: 1) the gains from trade; 2) the pattern of trade; 3) protectionism; 4), the balance of payments; 5) exchange rate determination; 6) international policy coordination; and 7) the international capital market. Students will recognize that many of the central policy debates occurring today come under the rubric of one of these themes. Indeed, it is often a fruitful heuristic to use current events to illustrate the force of the key themes and arguments which are presented throughout the text.
CHAPTER 2
LABOR PRODUCTIVITY AND COMPARATIVE ADVANTAGE: THE RICARDIAN MODEL
Chapter Organization
The Concept of Comparative Advantage A One-Factor Economy
Production Possibilities
Relative Prices and Supply
Trade in a One-Factor World
Box: Comparative Advantage in Practice: The Case of Babe Ruth Determining the Relative Price After Trade The Gains from Trade A Numerical Example
Box: The Losses from Non-Trade Relative Wages
Misconceptions About Comparative Advantage
Productivity and Competitiveness The Pauper Labor Argument Exploitation
Box: Do Wages Reflect Productivity? Comparative Advantage with Many Goods
Setting Up the Model
Relative Wages and Specialization
Determining the Relative Wage with a Multigood Model Adding Transport Costs and Non-Traded Goods Empirical Evidence on the Ricardian Model Summary
CHAPTER OVERVIEW
The Ricardian model provides an introduction to international trade theory. This most basic model of trade involves two countries, two goods, and one factor of production, labor. Differences in relative labor productivity across countries give rise to international trade. This Ricardian model, simple as it is, generates important insights concerning comparative advantage and the gains from trade. These insights are necessary foundations for the more complex models presented in later chapters.
The text exposition begins with the examination of the production possibility frontier and the relative prices of goods for one country. The production possibility frontier is linear because of the assumption of constant returns to scale for labor, the sole factor of production. The opportunity cost of one good in terms of the other equals the price ratio since prices equal costs, costs equal unit labor requirements times wages, and wages are equal in each industry.
After defining these concepts for a single country, a second country is introduced which has different relative unit labor requirements. General equilibrium relative supply and demand curves are developed. This analysis demonstrates that at least one country will specialize in production. The gains from trade are then demonstrated with a graph and a numerical example. The intuition of indirect production, that is \good by producing the good for which a country enjoys a comparative advantage and then trading for the other good, is an appealing concept to emphasize when presenting the gains from trade argument. Students are able to apply the Ricardian theory of comparative advantage to analyze three misconceptions about the advantages of free trade. Each of the three \represents a common argument against free trade and the flaws of each can be demonstrated in the context of examples already developed in the chapter.
While the initial intuitions are developed in the context of a two good model, it is straightforward to extend the model to describe trade patterns when there are N goods. This analysis can be used to explain why a small country specializes in the production of a few goods while a large country specializes in the production of many goods. The chapter ends by discussing the role that transport costs play in making some goods non-traded.
The appendix presents a Ricardian model with a continuum of goods. The effect of productivity growth in a foreign country on home country welfare can be investigated
with this model. The common argument that foreign productivity advances worsen the welfare of the domestic economy is shown to be fallacious in the context of this model.
ANSWERS TO TEXTBOOK PROBLEMS
1. a. The production possibility curve is a straight line that intercepts the apple axis at 400 (1200/3) and the banana axis at 600 (1200/2).
b. The opportunity cost of apples in terms of bananas is 3/2. It takes three units of labor to harvest an apple but only two units of labor to harvest a banana. If one foregoes harvesting an apple, this frees up three units of labor. These 3 units of labor could then be used to harvest 1.5 bananas.
c. Labor mobility ensures a common wage in each sector and competition ensures the price of goods equals their cost of production. Thus, the relative price equals the relative costs, which equals the wage times the unit labor requirement for apples divided by the wage times the unit labor requirement for bananas. Since wages are equal across sectors, the price ratio equals the ratio of the unit labor requirement, which is 3 apples per 2 bananas.
2. a. The production possibility curve is linear, with the intercept on the apple axis
equal to 160 (800/5) and the intercept on the banana axis equal to 800 (800/1). b. The world relative supply curve is constructed by determining the supply of
apples relative to the supply of bananas at each relative price. The lowest
relative price at which apples are harvested is 3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum number of apples supplied at the price of 3/2 is 400 supplied by Home while, at this price, Foreign harvests 800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This relative supply holds for any price between 3/2 and 5. At the price of 5, both countries would harvest apples. The relative supply curve is again flat at 5. Thus, the relative supply curve is step shaped, flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity 1/2 rising from 3/2 to 5, and then flat again from 1/2 to infinity.
3. a. The relative demand curve includes the points (1/5, 5), (1/2, 2), (1,1), (2,1/2).
b. The equilibrium relative price of apples is found at the intersection of the relative demand and relative supply curves. This is the point (1/2, 2), where the