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Lecture 7: The foreign market Rationale With the increasing trend towards the globalisation of the world economy, an individual nation can no longer be domestic in its outlook. Increasingly, it must pay heed to the global issues that have the potential to affect the performance of its economy. Concepts to be studied · International trade · Protectionism · The Balance of Payments · Exchange rates __________________________________________________________________________________ International trade Free trade refers to trade between nations that is not restricted by government protection of domestic industries. Free trade between nations is said to: - Increase world output; - Reduce the cost of goods; - Increase the nation’s standard of living. To be effective, free trade must be based on comparative advantage and specialisation. A nation has a comparative advantage over another nation in the production of a good if it has a lower opportunity cost in the production of that good than the other nation. For example, assume a world in which there are only: - Two nations (Australia and the USA); - Two products (wheat and iron ore); - Constant costs (straight production possibility curves); - Different resource and technological capabilities between the nations. Assume that, using all its resources efficiently, the USA can produce wheat and/or iron ore in the following combinations (see Table 7.1 and Figure 7.1). Figure 7.1 suggests that the domestic opportunity cost within the USA is 1 wheat = 1 iron ore. That is, for every one unit of wheat it produces, the USA has to forego one unit of iron ore production. Conversely, for every one unit of iron ore it produces, the USA has to forego one unit of wheat production. A B C D E F G H I Wheat(tonnes) 80 70 60 50 40 30 20 10 0 Iron ore(tonnes) 0 10 20 30 40 50 60 70 80 Table 7.1: The USA’s production possibility schedule Wheat (tonnes) 80 A 70 B 60 C 50 D The USA’s domestic Production Possibility Curve (domestic opportunity cost 1 wheat = 1 iron ore) 40 E 30 F 20 G 10 H I 0 10 20 30 40 50 60 70 80 Iron ore (tonnes) Figure 7.1 The USA’s production possibility curve Assume that, using all its resources efficiently, Australia can produce wheat and iron ore in the following combinations (see Table 7.2 and Figure 7.2). Figure 7.2 suggests that the domestic opportunity cost within Australia is 1 wheat = 2 iron ore. That is, for every one unit of wheat it produces, Australia has to forego two units of iron ore production. Conversely, for every one unit of iron ore it produces, Australia has to forego half of one unit of wheat production. A B C D Wheat(tonnes) 30 20 10 0 Iron ore(tonnes) 0 20 40 60 Table 7.2: Australia’s production possibility schedule Wheat (tonnes) 30 A 20 B Australia’s domestic Production Possibility Curve (domestic opportunity cost 1 wheat = 2 iron ore) 10 C D 0 10 20 30 40 50 60 Iron ore (tonnes) Figure 7.2: Australia’s production possibility curve Given the above data, Australia would have a comparative advantage over the USA in the production of iron ore because it can produce iron ore comparatively more efficiently (has a lower opportunity cost) than the USA. To produce one unit of iron ore, Australia foregoes 1/2 unit of wheat whereas the USA foregoes 1 unit of wheat. By the same token, the USA has a comparative advantage over Australia in the production of wheat because it can produce wheat comparatively more efficiently (has a lower opportunity cost) than Australia. To produce one unit of wheat, Australia foregoes 2 units of iron ore whereas the USA foregoes 1 unit of iron ore. Given the above data, according to the law of comparative advantage, Australia should specialise in the production of iron ore and the USA should specialise in the production of wheat. The two nations should then trade Australian iron ore for US wheat. The actual trade between Australia and the USA (exchange of iron ore for wheat) is based on the Terms of Trade (the ratio of export prices to import prices). In the above example, the terms of trade lie between 1 wheat for 1 iron ore (USA) and 1 wheat for 2 iron ore (Australia). That is, for every unit of wheat traded by the USA to Australia, the USA will want at least 1 unit of iron ore (the USA’s opportunity cost) in return from Australia, while the maximum Australia would be prepared to give the USA would be 2 units of iron ore (Australia’s opportunity cost). Assume that without trade, the USA produces 50 wheat and 30 iron ore for its own domestic market and that Australia produces 20 wheat and 20 iron ore for its own domestic market. This gives a combined domestic output of 70 units of wheat and 50 units of iron ore. Now assume that each nation specialises in the product in which it has the relatively lower opportunity cost. Australia specialises in iron ore (because it has the lower opportunity cost in iron ore) and the USA specialises in wheat (because it has the lower opportunity cost in wheat). Australia would produce only iron ore (60 units) and the USA would produce only wheat (80 units). As Table 7.3 shows, specialisation has resulted in greater output (10 more units of iron ore and 10 more units of more wheat). Nation Output beforespecialisation Output afterSpecialisation Gains from specialisation The USA 50 wheat30 iron ore 80 wheat0 iron ore Australia 20 wheat20 iron ore 0 wheat60 iron ore Total 70 wheat50 iron ore 80 wheat60 iron ore 10 wheat10 iron ore Table 7.3: Output before and after specialisation Assume now that Australia and the USA agree to exchange iron ore for wheat at the terms of trade of 1 unit of wheat for 1½ units of iron ore (the USA trades 24 units of wheat to Australia in exchange for 36 units of iron ore from Australia).
Approximate Word count = 3752
Approximate Pages = 15
(250 words per page double spaced)
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