4. GAME:
OBJECTIVE: To build a castle
To construct a castle you need to gather:
4 Rock (pebble)
1 Food (candy)
1 Gold (coin)
2 Wood (pencils)
You are allowed to communicate and talk to other teams
WINNER: Team with most GOLD left over
TIME LIMIT: 15 minutes
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5. VOLUNTARY TRADE IS MUTUALLY BENEFICIAL
Lower Prices
China!
Taking advantage of different factors of endowments
Economies of scale
Increased variety and choice
Acquisition of needed resources
Competition can improve efficiency
Political benefits
Efficiency and exports = growth and development
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6. Objectives:
Explain the theory of Absolute Advantage (AA).
Explain, using a diagram, the gains from trade arising from
a country’s AA in the production of a good.
Explain the theory of Comparative Advantage (CA).
Describe the sources of CA.
Draw diagrams to show CA.
Calculate opportunity costs from a given set of data and
illustrate it on a graph.
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8. Absolute Advantage
Country
Guns per unit of time
Roses per unit of time
USA
30
5
Costa Rica
3
15
• USA should specialize in Guns and Costa Rica in Roses
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9. “Absolute advantage is the situation that occurs
when one country can produce more of a given
product with the same or less resources than
another country.”
The country with absolute advantage in one good should
specialize and trade.
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10. Absolute Advantage
Country
Guns per
Roses
Opportunity Cost of
Opportunity Cost
unit of
per unit
1 Gun
of 1 Rose
time
of time
USA
30
5/30 units of roses
5
6 units of guns
Costa Rica
3
5 units of roses
15
1/5 units of guns
Absolute Advantage PPC [DIAGRAM]
Calculate the opportunity cost.
Are they better of trading? What is a feasible new terms
of trade?
Show new PPC after trading.
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11. Some countries might be better at making
everything than others, should these countries
bother to trade?
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12. Comparative Advantage
Country
Output of Opportunity
Output of
Opportunity Cost
TVs
Cost of 1 TV Smartphones of 1 Smartphone
USA
10
5
Costa Rica
20
15
“Comparative Advantage is when a country
produces a good at a lower opportunity cost than
another country.”
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13. Even in the case of one country having absolute advantage
in both products, you still benefit from trade.
How?
Terms of Trade
Absolute and comparative advantage with PPC [DIAGRAM]
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14. Occurs when the opportunity costs of the two trading
partners are identical… then there is no room for trade.
[DIAGRAM]
Comparative Advantage Matrix
Country
Input time for
1 unit of Iron
(hours)
Opportunity
Cost of
producing 1
unit of iron
Input time
Opportunity Cost
for 1 unit of
of producing 1
butter
unit of butter
(hours)
USA
20
0.5 butter
10
2 irons
Costa Rica
10
0.5 butter
5
2 irons
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15. Fill in the table and draw the PPC for the scenario below
before and after trade.
Comparative Advantage Matrix
Opportunity
Cost of
producing 1
unit of iron
Input time
Opportunity Cost
for 1 unit of
of producing 1
butter
unit of butter
(hours)
Country
Input time for
1 unit of Iron
(hours)
USA
25
15
Costa Rica
10
5
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16. Assume the table below. On a PPC show how both
countries gain through trade in a general setting.
Comparative Advantage Matrix
Country
Opportunity
Opportunity Cost
Production of
Cost of
Production
of producing 1
wheat (1 kg) producing 1 kg of oil (1 liter)
liter of oil
of wheat
USA
15
20
Costa Rica
5
10
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17. Supply and demand diagram of domestic equilibrium and
world price… Autarky vs. Free Trade argument.
[DIAGRAM]
Assumptions:
Perfectly competitive market
Homogenous product
Small country – i.e. world price not affected by the
country’s demand
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18. Factors of “endowment”
Example: Arable land agricultural advantage
Well educated public financial services
Abundant unskilled labor cheap manufacturing goods
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19. Perils of extreme specialization
Unrealistic Assumptions
Perfect knowledge
No transport costs
Very basic theory assuming a two country world
We assume linear PPC, constant returns to scale
Identical products across countries
Factors of production remain in the country
Free trade
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20. “Perils of extreme specialization”
Unrealistic Assumptions
Perfect knowledge
No transport costs
Very basic theory assuming a two country world
We assume linear PPC, constant returns to scale
Identical products across countries
Factors of production remain in the country
Free trade
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21. Your task for next class – Research about the WTO and be
ready to discuss it in class. This will contribute towards
your classroom participation grade.
History
Aims and objectives
Success
Milestones
Pros and cons
Failures
Alternative ideas
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22. Born out of the General Agreement on Tariffs and Trade
(GATT) in 1948 at the Bretton-Woods Conference.
Created in 1993.
“deals with the global rules of trade between nations…”
Trade without discriminations
Free trade
Predictability and transparency
Fair competitive practices
Encourage development
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23. Functions:
Provide a forum for trade negotiation
Execute WTO agreements
Evaluate and rule on trade complaints by member
countries
Provide technical assistance to developing countries on
issues of trade
Track changes in member states’ trade policies
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24. For Argument:
WTO promotes peace through trade.
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26. Are there moral as well as economic reasons in
favor of free trade?
Do economies that are open to trade grow
faster?
Are rich countries more protectionist than poor
ones?
Does agricultural protectionism in the rich world
worsen global poverty?
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28. To protect domestic employment.
To protect infant industries
To counteract domestic tax difference
Prevent dumping
Diversify production base
Enforce product standard
To raise government revenue
Protect against unfairly low labor costs
Protect strategic industries
Overcome BOP deficits
Improve Terms of Trade
28
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Escalation to a trade war
Protectionism as a corruption magnet
Domestic complacency causes higher prices and
costs
Higher import costs
Reduced export competitiveness
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31. Tariffs – tax imposed on imports
[DIAGRAM]
Affect on domestic producers
Affect on foreign producers
Affect on the government
Affect on the consumers
Welfare loss
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32. Subsidy – subsidy to the domestic market
[DIAGRAM]
Affect on domestic producers
Affect on foreign producers
Affect on the government
Affect on the consumers
Welfare loss
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33. Quota – quota for imports
[DIAGRAM]
Affect on domestic producers
Affect on foreign producers
Affect on the government
Affect on the consumers
Welfare loss
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34. Tariffs or Duty – taxes on imports
Subsidy to domestic industry
Quota on imports
Nationalistic advertising campaigns
Price floor on imports
“Red Tape”
Health, safety, and environmental standards
Embargoes
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35. Using a diagram, explain the likely effects of a quota on
imported shoes on the shoe market.
[See DIAGRAM] – Pg. 279
World price is $1/liter of oil
What happens after free trade
A subsidy of 40 cents/liter is given – show on graph.
Calculate the following changes from the subsidy:
Consumer spending, Revenue of foreign producers, cost
to the government.
Explain the impact to any two stakeholders in the oil
market.
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37. The value of one currency expressed in terms of
another.
Sometimes against a basket of currencies –
Exchange Rate Index – like the CPI
Determined by several factors including the
FOREX market
London, New York, Frankfurt, Tokyo, and Zurich
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38. Australia uses something known as a “trade
weighted index” (TWI)
Why is it called a TWI?
What are the current weightings?
What are the current values compared to a year ago?
Which currencies have contributed the most to the
change?
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39. Fixed Exchange Rate
The exchange rate is pegged or fixed to another currency,
a basket of currencies or a commodity
Revaluation – increase in the value of the currency
Devaluation – decrease in the value of the currency
Maintained by government intervention in the FOREX
market
[DIAGRAM] – Buy back
[DIAGRAM] – Sell
Make it illegal to trade at any other rate…
Relatively ineffective – black markets
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40. Floating Exchange Rate
Equivalent of a free market for currency – determined
purely by supply and demand.
[DIAGRAM]
Appreciation – increasing value
Depreciation – decreasing value
Impacts?
Purchasing power
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41. Floating Exchange Rate (Quick Calc)
The US dollar is currently trading against the
Euro at a rate of USD 1 = 0.8E. What is the rate
for 1E?
With the above rate, what is the cost of a good
selling for USD 75 in Euros?
If the rate changes to USD 1 = 0.9E, explain what
would happen to the Euro price of a US
manufactured shirt that was being exported
from the USA at the cost of USD 150.
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42. Managed Exchange Rate
A midway between a free-market (Floating) and
centrally-planned (Fixed) exchange rate regimes.
The government or central bank keeps an upper
and lower bound on the rates
The rates are usually kept secret
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43. Floating Exchange Rate (Why do rates change?)
US dollars are demanded when:
Buy exports and travel to that country
Invest in that country (FDI or portfolio)
Savings in that country’s banks
Make money speculating on the future value of
the currency.
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44. Floating Exchange Rate (Why do rates change?)
Increase in demand for US goods and services:
US inflation rates are lower than EU rates. So US
goods will be relatively less expensive.
An increase in the income level in the EU
A change in taste favoring US goods
US investment prospects
US interest rates increase
Speculators think the US dollar will appreciate in
value.
[DIAGRAM]
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45. Floating Exchange Rate (Why do rates change?)
Will cause an increase in the supply of USD:
Increase in demand for EU goods and services:
US inflation rates are higher
Increase in US income levels
A change in taste for European goods.
EU investment prospects improve
EU interest rates increase
Speculators think that the US dollar will fall.
[DIAGRAM]
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46. Downward pressure on inflation
More imports can be bought
Forces domestic producers to become more
efficient
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47. Damage to exporting industries
Damage to domestic industries
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48. Greater employment in exporting industries
Greater employment in domestic industries
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51. Using a suitable diagram, explain why a high value
of a currency may worsen unemployment in a
country.
With the help of a diagram, explain why a low
value of a currency may create inflationary
pressure in a country.
[Page 289 – Student Workpoint 23.6]
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52. Why might the government want to meddle in the
FOREX Market?
Lower exchange rate
Raise the exchange rate to fight inflation
Maintain a fixed exchange rate
Avoid large fluctuations in floating rates
Stability – good for business confidence
Improve the current account defecit
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53. Using their foreign exchange reserves to buy, or
sell, foreign currencies
By using Monetary Policy
Changing interest rates to attract foreign savings
Caveat – difference between attracting
investments and savings.
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54. No uncertainty or speculation.
Not always the case.
Forces sensible government policies on inflation
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55. Maintain high levels of foreign exchange reserves
if balancing the rate by FOREX market trades
Deflationary or inflationary effects on the
economy if manipulating by use of interest rates
Judgment error in determining what the rate
should be!
International disagreements
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57. Interest rates can be used for domestic policy
alone.
In theory, the exchange rate should always
“correct” itself.
Opportunity cost of keeping large foreign
exchange reserves.
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58. Uncertainty
Affected by various non market factors
Floating exchange rates can make inflation rates
worse…
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61. Balance of trade in goods (tangible)
Balance of trade in services (intangible)
Net income from abroad
Current transfers – remittances, aid
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62. Current Account Balance = Balance of trade in
goods + Balance of trade in services + Net income
flow + Net transfers
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63. Usually a small component of Balance of
Payments
Capital Transfers
Debt forgiveness, sale of fixed assets, transfer of goods
and financial assets from migration, gift tax, inheritance
tax, death duties et al
Transactions in non-produced, non-financial
assets
Rights, patents, copyrights, brand names
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64. Net change in foreign ownership of domestic
financial assets.
Direct Investment
Purchase of long-term assets (FDI)
IMF ruling – at least 10% ownership
Portfolio Investment
Short-term investment in stocks and bonds and savings
Reserve Assets
Gold and foreign currencies
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68. Why is a current account deficit a bad thing?
How does a government deal with deficits?
Can this happen indefinitely?
Deficit Downward pressure on exchange rate
Surplus Upward pressure on exchange rate
A bigger problem in fixed exchange rates
Short run v. Long run
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69. If current account is in deficit, then the
capital/financial account must be in surplus.
Current Account Deficit:
Use of Forex reserves
Threat to economic sovereignty
Borrowing – currency crisis
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70. If current account is in surplus, then the
capital/financial account must be in deficit.
Current Account Surplus:
May lead to protectionism
Impact on imports and exports
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71. How big is a “big” current account deficit or
surplus.
Always calculate as a percent of GDP to be
comparable.
Please do not confuse current account deficit with
national debt.
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72. Encouraging a switch from Imports to Domestic
goods
Government depreciates or devalues their
currency
Protectionist measures
Might violate WTO agreements
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73. Contractionary Policy
Reduce overall expenditures
imports
Deflationary fiscal policy
Deflationary monetary policy
including
on
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74. PEDExports + PEDImports > 1
Elasticity increases in the long run.
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75. Suppose India and US have an exchange rate of
Rs. 50 = $1. Initially, the US exports 1000 units of
Widgets @ Rs. 100 per unit to India and India
exports 500 units of Golas @ Rs. 100 per unit to
the US. Now, India depreciates their currency by
10%. Calculate how this depreciation affects the
current account balance between India and the
US if:
PEDexports = 0.5 and PEDimports = 0.4
PEDexports = 0.5 and PEDimports = 0.8
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76. According to the Marshall-Lerner condition, as the
currency depreciates, initially, the Current
Account deficit will actually become worse before
it becomes better.
[DIAGRAM]
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77. Explain the possible effect on consumers and
producers when a specific tax is imposed on
cigarettes. [10 marks] – Pg 75 of Blink and Dorton
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79. Free trade is based on the principal of
comparative advantage and an ideal that would
promote maximum allocative efficiency.
But alas! That is not to be.
… but we are trying.
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80. Preferential trade agreements (PTA)
Bilateral v. Multilateral (WTO)
PTA gives preferential access to certain goods,
from certain countries, by reducing or eliminating
tariffs or other arrangements.
South Asian Preferential Trade Arrangement (SAPTA)
2007
Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri
Lanka
Goods Only!
Is this ethical?
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81. Four major types:
Free trade areas
Customs unions
Common markets
Economic (and Monetary) unions
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82. Two or more countries can form a free trade area:
Tariffs and non-tariff barriers are abolished or
phased out
Maintain individual tariff with non-members
NAFTA (USA, Mexico, Canada)
EFTA
(Iceland,
Norway,
Liechtenstein,
Switzerland)
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83. Two or more countries can form a customs union:
FTA with the following clause:
Maintain common tariff and trade policy with
non-members
MERCOSUR – 1991 – Argentina, Brazil, Paraguay,
Uruguay, Venezuela
EU and Turkey 1996
East African Customs Union
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84. If in addition to a Customs Union, a Common
Market has:
Unrestricted factor of production flow
Free cross-border movement of labor and capital
Free flow of goods, services, labor and capital
SAPTA became SAFTA in 2004 (to be enacted by
2016)
Belarus, Kazakhstan, Ukraine, Russia (2003)
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85. A Common Market become an Economic Union
when:
When the member states agree on certain
macroeconomic and regulatory policies.
If they adopt a common currency they become a
Monetary Union
The EU is the only such example.
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86. Dismantling of trade-barriers leads to greater
competition among firms of the member
countries.
NOTE: PTAs are discriminatory while WTO
multilateral trade agreements are nondiscriminatory
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88. Pg. 316 (Blink and Dorton) – End of Chapter
Review Questions, Q#3
Evaluate the consequences of membership of a
monetary union. Be sure to use a real world
example.
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90. Terms of Trade is the ratio of export prices to
import prices
TOT = Index of average export prices / Index of
average import prices x 100
Lower deterioration
Better improvement
NOTE: Do not confuse price with total value of
imports and exports!
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91. Year
1
2
3
4
5
6
Index of average Index of average Calculation of Terms of Improvement or
export prices
import prices Terms of Trade Trade
deterioration?
100
100
109
116
120
120
100
105
105
112
110
125
Index year
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92. What can we conclude about the “Buying Power”
of a country using ToT?
Is a “deterioration” of ToT a bad thing?
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93. Can language be used to confuse or exclude
access to knowledge?
Consider language that economists use that
could be misleading or difficult for noneconomists.
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94. Changes in conditions of demand and supply
Change in demand change in price of exports
Competitive price of exports
Income in importing country
Change in consumer tastes
Change in supply change in price of exports
Good weather for agriculture?
New technology?
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95. Changes in relative inflation rate
Higher inflation price of exports increase
Might lead to a short run improvement in ToT
Eventually exports become less competitive
Changes in exchange rates
Relative exchange rate will change the relative price of
exports to imports
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97. Improvement in TOT through increase in demand
[DIAGRAM]
Through inflation and elasticity
Commodities are usually inelastic
Most other goods are elastic
Inelastic Elastic
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99. Not all LDCs have the same problems.
Commodities v. Oil v. Manufacturing v. Service
The non-oil commodities problem.
[DIAGRAM]
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100. Changes in supply
Technology
Dumping
Changes in demand
Synthetic goods
Inelastic and developed
Miniaturization
Average Commodity Prices have been falling since
the 1950s
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101. More exports needed for imports leads to
production of more commodities leads to
further fall in commodity prices.
Increase in debt levels
Negative externalities unsustainable
CURSE OF NATURAL RESOURCES!
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