Download Terms of Trade

Trade Between Alpha and Omega

What would happen if Alpha and Omega
started to trade?

Under what circumstances will these two
countries trade bread for milk?


Determine the limits within which the terms of
trade must fall for the two countries to trade
Show what trade will do for each country
Terms of Trade

Alpha would not import milk if its cost per 1 gallon exceeds 0.5 loaves
of bread

Omega would not engage in trade if terms of trade exceed 2 loaves of
bread per 1 gallon of milk (or equivalently 0.5 gallon of milk per 1 loaf
of bread)

Both would trade if the terms of trade are one gallon of milk per one
loaf of bread

The result of trade is:



Unchanged production possibilities frontiers
Upward shift of consumption possibilities frontiers
Trade allows for more consumption with the same production
resources
Specialization in Trade and
Production


If Alpha produces only milk
and trades milk for bread, it
can consume more bread for
each amount of milk
consumption compared to
no-trade situation
If Omega produces only
bread and trades bread for
milk, it can consume more
milk for each amount of
bread consumption
compared to no-trade
situation

Alpha will concentrate on the
production of milk

Omega will concentrate on
the production of bread
Comparative Advantage

Comparative advantage: the ability of a country to produce a good at a
lower opportunity cost of producing the good than any other country


We’re not talking about the absolute costs here
In terms of labor, Alpha may use three times as much labor and capital for
the production of one gallon of milk compared to Omega, yet it would still
have comparative advantage in the production of milk

Comparative disadvantage: the inability of a country to produce a good
except at a higher opportunity cost of producing the good than another
country

A country typically has comparative advantage in some goods and
comparative disadvantage in some other goods

Different resource endowments and states of technology account for a
great deal of differences in comparative advantages and in
comparative disadvantages
Financing the International Trade

Exchange rate is the price of one currency in
terms of the monetary units of another
country

Exchange rates (in the absence of the
government intervention) are determined in
exchange markets that arise from millions of
import-export transactions between the
countries
World Exchange Rates
Sources of Foreign Currency
Tariffs

A tax placed on internationally
traded goods, usually imports

Tariffs are an important source of
(federal) government revenue

Tariffs are used mainly to protect
domestic jobs and production

Infant industry protection argument

Tariff burden normally gets shared
between producers and consumers,
but rarely in equal proportion

Tariffs increase demand for
domestically produced products
making domestically produced
goods more expensive
Quotas

Quota is a regulation that limits by law the
quantity of specific foreign goods or
services that may be imported during a
period of time

Quotas are used less often than tariffs

The new supply curve is vertical since
only that much of Brazilian sugar can be
sold in the US

Price the US consumers pay for Brazilian
sugar exceeds the price received by
Brazilian sugar producers

This difference in consumer and producer
prices is the profit of import license
holders

Quotas also increase prices of
domestically produced goods
Voluntary Export Restrictions and
Embargoes



Voluntary restraint agreement
is an international treaty
whereby one nation
“volunteers” to restrict its
exports of a product that it
sells to another nation
A voluntary restraint
agreement is in essence a
quota without the effect of
law
Voluntary but not really
voluntary

Embargo is a government
action aimed at eliminating
international trade between
the two countries



Can be thought of as import
and export quotas set to
zero
Most embargoes result from
political disputes (OPEC in
the 1970s, N. Korea these
days, Cuba)
Embargoes impose costs
not only on the foreign
nation, but on the domestic
economy as well
Foreign Trade Controversy

Protection from cheap foreign goods




A country’s population will lose from import restrictions
Foreign goods cannot possibly displaced all domestic production
since imports have to be paid for with foreign currency which can
only be obtained as a result of exports
Free trade may indeed injure segments of national economy (e.g.
less demand for domestically produced goods, more
unemployment)
Effects of the early 1980s “voluntary” exports restrictions for
Japanese cars in the US



Jobs in domestic car production saved
Jobs lost in the exporting sector
A job paying $30000-$40000 imposed a cost of $160000 as a
result of increased domestic prices