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Topic OUTLINE
Topic 12: 12.1 Absolute Advantage & Comparative
Advantage
INTERNATIONAL
12.2 Restriction to free trade
TRADE AND
12.3 Open economy: Export and import -
EXCHANGE RATE Balance of Payment (BOP)

12.4 Exchange Rate

12.1
Absolute Advantage & Comparative Advantage
Absolute advantage:
The advantage in the production of a product enjoyed
by one country over another when it:
(i) Use fewer resources to produce that product
than the other country does.
(ii) Produce more output with same resources
Comparative advantage:
The advantage in the production of a product enjoyed
by one country over another when that product can be
produced at lower cost in terms of other goods than it
could be in the other country (lower opportunity cost).
• To illustrate the theory of comparative advantage,
let us consider the case of two countries, Malaysia
and China, producing just two products cotton and
rice.
• Assume:
(i) production is under the law of constant costs.
(ii) free barriers to trade.
(iii) no transport or trading costs.
(iv) all factors are fully employed.
(v) the level of technology remain constant.

Example 1:
Comparative Advantage
Absolute vs. Comparative Advantage
Cotton (units) Rice (units)
Cotton (units) Rice (units)
Malaysia 20 60 Malaysia 60 10
China 40 20 China 20 10

Opportunity Cost???

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Comparative Advantage Comparative Advantage

Countries Cotton Rice Opportunity Countries Cotton Rice Opportunity Output After
(units) (units) Cost (units) (units) Cost Specialization
Cotton Rice
(units) (units) Cotton Rice Cotton Rice
(units) (units)

Malaysia 60 10 10/60 = 0.17 60/10 = 6

Malaysia 60 10 10/60 60/10 (10/0.17) + 0
China 20 10 10/20 = 0.5 20/10 = 2 = 0.17 =6 60
=118.8
China 20 10 10/20 20/10 0 (20/2)+
• Malaysia has lower opportunity cost in producing cotton (0.17 < 0.5). = 0.5 =2 10
Malaysia should specialize in producing cotton. = 20

• China has lower opportunity cost in producing rice (2 < 6). China • Malaysia has lower opportunity cost in producing cotton (0.17 < 0.5).
should specialize in producing rice. Malaysia should specialize in producing cotton.
• China has lower opportunity cost in producing rice (2 < 6). China
should specialize in producing rice.

Example 2:
Absolute vs. Comparative Advantage Absolute vs. Comparative Advantage
• Assume that only 2 countries in the world,
Yield Per Acre of Wheat & Cotton
New Zealand & Australia.
Country Wheat Cotton
• Each country produce wheat & cotton.
New Zealand 6 3
Yield per Acre of Wheat and Cotton Australia 3 6
Wheat Cotton
ØNew Zealand enjoys absolute advantage
New Zealand 6 bushels 3 bales
Australia 3 bushels 6 bales
in the production of ______.
ØAustralia enjoys absolute advantage in
the production of _______.
9 10

Absolute vs. Comparative Advantage Output After Specialization:

Yield Per Acre of Wheat & Opportunity Output After
Yield Per Acre of Wheat & Opportunity Specialization
Cotton cost
Cotton cost
Country Wheat Cotton Wheat Cotton Country Wheat Cotton Wheat Cotton Wheat Cotton
New Zealand 6 3 ? ?
Australia 3 6 ? ? New
6 3 0.5C 2W ? ?
Zealand
• New Zealand enjoys comparative advantage
Australia 3 6 2C 0.5W ? ?
in the production of _______. (lower opp.
cost)
• Australia enjoys comparative advantage in
the production of ______. (lower opp. cost)
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TRADE SURPLUSES &
DEFICITS
• All economies, regardless of their size, depend
to some e xte nt on o the r eco nomies & are
affected by events outside their borders.
• Trade surplus – the situation when a country
exports > imports.
• Trade deficit – the situation when a country
imports > exports.
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Tariffs
• A tax on imports that governments place
on internationally traded goods to
encouraging the consumption of domestic
goods.
• Tariffs will increase price and reduce
quantity.
• Under a tariff, the government collects the
tariff revenue.
Balance of Payment (BOP)
Three main components in the BOP:
1. Current Account
Four components: Balance of trade, Balance of
Services, Net investment income, Net current
transfers
2. Capital Account: Net assets & Errors and omissions
3. Official Reserves Account: Government foreign
currency reserves
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12.2 Restriction to Free Trade
• Protection = The practice of shielding (protecting) a
sector of the economy from foreign competition.
a) Tariff = A tax on imports that governments place on
internationally traded goods to encouraging the
consumption of domestic goods. Tariffs will increase
price and reduce quantity. Under a tariff, the
government collects the tariff revenue.
b) Export Subsidies = Government payments made to
domestic firms to encourage exports.
c) Quota = A limit on the quantity of imports.
12.3
Open economy: Export and import
- Balance of Payment (BOP)
• The record of a country’s transactions in
goods, services, and assets with the rest
of the world.
• The difference between the total value of
goods and services imported and
exported over a given period of time.
1. Current Account
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c. Net investment income d. Net current transfer:
The difference between investment income flows • The difference between current transfer flows
into and out of a country.
• Income – cover two type of transactions: • Current transfer:
(i) Income received on investment = The
investment by Malaysian in foreign countries.
(ii) Income payments on investment = The
investment by foreigner in Malaysia.
2. Capital Account
a. Net assets:
– A national account that shows the net change in
asset ownership for a nation.
– Two types of transaction namely private and
government.
– E.g. Records the payment flows on purchases of
foreign assets by Malaysians or Malaysian assets
by foreigners.
b. Error and omissions:
– There maybe some missing information.
– Uses error and omissions to balance the account.
THE BALANCE OF PAYMENTS
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into and out of a country.
– The transfers that involve a one-way payment.
– E.g. includes gifts, military aid and financial aid
by the government, private individuals and
organizations.
3. Official Reserve Account
• Consists of government foreign
currency reserves.
• If a country official reserves
increase, the official reserve account
balance is negative.
• The reason is that holding foreign
money is like investing abroad.
12.4 Exchange Rate
Three types of exchange rate system:
(i) Fixed exchange rate
(ii) Flexible (Floating) exchange rate
(iii) Managed floating system/ semi-
fixed exchange rate
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Fixed Exchange Rate Fixed Exchange Rate

• Government set a particular fixed rate at Advantage Disadvantage

which their currencies will exchange for
each other.
•Gr ea ter c er tai nt y for
exporters and importers -
– Example: Pegging (RM3.80 = USD1.00) less risky (encourage
investment).
•Wr o n g Va l u e - I f t h e
value of the exchange
ra t e i s t oo h ig h , t he n
exports will become
uncompetitive; this can
lead to lower demand
and lower growth.

Flexible (Floating) Exchange Rate Flexible (Floating) Exchange Rate

Advantages Disadvantage
• Exchange rates determined by the unregulated
force of supply and demand.
•Governments and central •Uncertainty - may lead to
banks do not participate in the wide fluctuations in currency
• The exchange rate movements have important foreign exchange market. values, discouraging foreign
impacts on imports, exports, and movement of trade and investment.
•A u t o m a t i c a d j u s t m e n t –
capital between countries. respond quickly to changing
supply and demand
conditions, clearing the
• Appropriate for medium and large industrialized market of shortages or
countries and some emerging market economies. surpluses of a given currency.

Managed Floating System Managed Floating System

• Th e gov ernmen t som etime s b uys or sel ls
currencies to influence the exchange rate, while Advantage Disadvantage
at other times letting private market forces
operate. •Can maintain stability •Lead to uncertainty.
and competiveness.
• Central bank may have to intervene to maintain
the value of the currency within the target.

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