CHAPTER

Comparative Advantage,
Exchange Rates, and
Globalization
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 Chapter Goals
• Introduction
• Why do countries trade?
• Turkey’s international trade over the years
• Explain the principle of comparative advantage.
• Explain why economists’ and laypeople’s views of trade differ.
• Summarize the possible sources of comparative advantage of a
country
• Discuss how exchange rates are determined and what their role is in
equalizing trade flow.

© 2020 McGraw-Hill Education. 2

 Why do countries trade?
• Economies, regardless of their size, depend to some extent to
other economies and are affected by events outside their
borders.
• Why do countries engage in international trade?
• The reason that countries trade is the same reason why people
trade with each other: Trade can make both sides better off.

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 Turkey’s international trade
• Before we go any deeper into the issue of why countries trade with
each other, let’s examine our country’s position in terms of
international trade:
• Up until the 1980’s Turkey was virtually a “closed economy”: Very
low import and export volumes, even if there were any imports and
exports, they would balance each other out with almost zero trade
balance
• The share of exports and imports in GDP did not exceed 5 percent
(international trade volume at about 10 percent of GDP, indicating
a virtually closed economy)
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 Turkey’s international trade
• After the 1980’s, with a new opening up policy, Turkey started to
experience increases in both exports and imports: As of 2019, value
of imports in goods and services reached 227 bill. USD and exports
in goods and services reached 249 bill. USD with a 21 bill. USD trade
surplus;
• However since the 1980’s, Turkish economy has run a trade deficit
(imports value higher than export value) for most of the years.
• Over the years, what Turkey has exported and what she imported
has changed following the changing structure of the economy.

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 Exports and Imports, Turkey (bill. USD)
$300,00

$250,00

$200,00

$150,00

$100,00

$50,00

$0,00

Exports of goods and services Imports of goods and services

29.01.2022 Source: World Bank 6

 Trade balance=Exports-Imports, Turkey (bill. USD)
$30,00

$20,00 Trade surplus: Exports>Imports

$10,00

$0,00

-$10,00

-$20,00

-$30,00

-$40,00
Trade deficit: Imports>Exports
-$50,00

-$60,00

-$70,00

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 Exports and Imports as a share in GDP, %, Turkey
35

30

25

20

15

10

Exports/GDP Imports/GDP

Source: TÜİK
29.01.2022 8
 Proportion of imports covered by exports (%), Turkey
200,0

180,0

160,0

140,0

120,0

100,0

80,0

60,0

40,0

20,0

0,0

Source: TÜİK

29.01.2022 9
 Export components (% shares)
70

60

50

40

30

20

10

0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Capital goods Consumption goods Intermediate goods

Source: TÜİK
29.01.2022 10
 Import components (% shares)
90

80

70

60

50

40

30

20

10

0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Capital goods Consumption goods Intermediate goods

29.01.2022 Source: TÜİK 11

 The Principle of Comparative Advantage

Opportunity cost is what must be given up in one good in order to

get another good.
The principle of comparative advantage is that as long as the
relative opportunity costs of producing goods differ among
countries, then there are potential gains from trade

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 Comparative Advantage vs. Absolute Advantage

The theory of comparative advantage: trade enables countries to

specialize in what they produce the best – Ricardo

Absolute advantage: a country enjoys absolute advantage over another

country in the production of a product if it uses fewer resources to produce
that product than the other country does.

Comparative advantage: the advantage in the production of a product

enjoyed by one country over another when that product can be produced
at a lower cost in terms of other goods – lower opportunity cost – than it
could be in the other country.

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 Who Has Comparative Advantage in
Production of Oil? Food?
United States Saudi Arabia
% of resources Oil Food % of resources Oil Food
devoted to oil produced produced devoted to oil produced produced
(barrels) (tons) (barrels) (tons)
100 100 0 100 1,000 0
80 80 200 80 800 20
60 60 400 60 600 40
40 40 600 40 400 60
20 20 800 20 200 80
0 0 1,000 0 0 100

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 Application: Comparative Advantage
PPF : United States PPF: Saudi Arabia

Oil The U.S. has comparative
advantage in food because
it has a lower opportunity
cost (in terms of oil) to
produce food.
The U.S. should produce
100 1,000 tons of food.
80
Oil Saudi Arabia has comparative
advantage in oil because it
1,000 has a lower opportunity cost
(in terms of food) to produce
800 oil.
Saudi Arabia should produce
1,000 barrels of oil.
600

60 400

40 200
20
200 400 600 800 1,000 Food 20 40 60 80 100 Food

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 Application: The Gains from Trade
Production Consumption

U.S. Saudi Arabia U.S. Saudi Arabia I.T.

Oil (barrels) 0 1,000 120 500 380

Food (tons) 1,000 0 500 120 380

A trader, I.T., arranges for Saudi Arabia to trade 500 barrels of oil to the U.S. for
120 tons of food.
The U.S. will trade 500 tons of food to Saudi Arabia for 120 barrels of oil.
I.T. keeps 380 barrels of oil and 380 tons of food.

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 Application: The Gains from Trade
PPF: United States PPF: Saudi Arabia

Oil Oil
After trade, the U.S. can consume 1,000 After trade, Saudi Arabia can
beyond its PPF. consume beyond its PPF.
800
120
100
600
80

60 400

40 200
20
200 400 600 800 1,000 Food 20 40 60 80 100 120 Food

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 The Gains from Trade
• Trade enables both countries to move beyond their previous
resource and productivity constraints;
• When countries specialize in producing goods in which they
have a comparative advantage, they maximize their combined
output and allocate their resources more efficiently

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 Dividing Up the Gains from Trade
Terms of trade: The ratio at which a country can trade
domestic products for imported products
Three determinants of the terms of trade are:
1. The more competition that exists among traders, the less
likely it is that the trader gets big gains of trade
2. Smaller countries tend to get a larger percentage of the
gains of trade than do larger countries
3. Gains from trade go to the countries producing goods that
exhibit economies of scale
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Why Economists and Laypeople Differ in Their Views of Trade
If trade is good, why do so many people oppose it?
• The gains of trade (lower prices) are harder to see than the cost (lost
jobs).
• The public believes that lower wages in other countries give them the
comparative advantage in everything, so we will lose all jobs.
• Laypeople often think of trade as trade only in manufactured goods.
• Laypeople are extremely concerned about the impact of trade on the
distribution of income.

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 Sources of Comparative Advantage
1. What determines whether a country has a comparative
advantage in heavy manufacturing or in agriculture?
2. What explains the actual trade flows observed around the
world?

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 Sources of Comparative Advantage
1. Factor endowments (the quantity and quality of natural resources
available);
2. Demographics;
3. Rates of capital investment including infrastructure investment;
4. Increasing returns to scale and the division of labor;
5. Investment in research & development which can drive innovation and
invention;
6. Non-price competitiveness of producers - covering factors such as the
standard of product design and innovation, product reliability, quality of
after-sales support;
7. Institutions

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Some Concerns about the Future: Inherent and Transferable
Comparative Advantage
Transferable comparative advantages are based on factors that can
change relatively easily, such as capital, technology, and types of labor.
Inherent comparative advantages are based on factors that are relatively
unchangeable, such as resources and climate.
Whether a country can maintain a much higher standard of living in the
long run depends in part on whether its comparative advantage is
inherent or transferable.

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Some Concerns about the Future: The Law of One Price
If factor prices aren’t equal, firms can reduce costs by redirecting
production to countries with lower factor prices.

The law of one price means that in a competitive market, there will
be pressure for equal factors to be priced equally.

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Some Concerns about the Future: Methods of Equalizing Trade
Balances
Wages rise in the surplus countries, making their goods more expensive.

Adjustments eventually occur to make surplus countries less competitive

and deficit countries more competitive.

The exchange rate of the deficit country falls and makes its goods less
expensive.

© 2020 McGraw-Hill Education. 25

 Determination of Exchange Rates and Trade:
Supply and Demand in Currency Markets
• The exchange rate is the rate at which one country’s currency can be
traded for another’s.
• People exchange currencies to buy goods or assets in other countries.
• To demand one currency, you must supply another.
• The supply curve of euros (or any other currency) is upward-sloping.
• The demand curve for euros (or any other currency) is downward-
sloping.
• The market for euros (or any other currency) is in equilibrium when
quantity supplied equals quantity demanded.

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 Exchange rates
• Nominal exchange rate (E): Price of the foreign currency in terms of
domestic currency
• For example,
– E=1.18 at the beginning of 2008 means that
1 USD=1.18 TL at the beginning of 2008; or similarly
1 TL= 1/E = 1/1.18 USD =0.85 USD
– E’=8.5 now in June 2021 means that
1 USD=8.5 TL in June 2021 or similarly
1 TL= 1/E’= 1/7.5 USD = 0.12 USD
• What does this mean? The price of USD in terms of TL has increased, or,
the price of TL in terms of USD has decreased: TL has lost value or
depreciated against USD (or, USD has appreciated/gained value against TL)

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 Depreciation vs. appreciation
• Depreciation of domestic currency: a decrease in the price of
domestic currency in terms of foreign currency (or an increase
in the price of foreign currency in terms of domestic currency,
an increase in E)
• Appreciation of domestic currency: an increase in the price of
domestic currency in terms of foreign currency (or a decrease
in the price of foreign currency in terms of domestic currency,
a decrease in E)

29.01.2022 28
 The nominal exchange rate
• Let
1$ = 1,5TL; E = 1,5
1
1TL = $ = 0,66$
1,5
Depreciation Appreciation
New E ' = 1,55 New E ' ' = 1,4
1 1
1TL = $ = 0,64$ 1TL = $ = 0,71$
1,55 1,4

• If the exchange rate E increases from 1,5 to 1,55, the TL depreciates against the
US$
• If the exchange rate E decreases from 1,5 to 1,4, the TL appreciates against the
US$

29.01.2022 29
Nominal exchange rates
(yearly averages)
USD and EUR
2000-2020

Source: CBRT

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Nominal exchange rates
2021-Daily

Source: CBRT

31
 Determination of Exchange Rates and Trade:
Currency Depreciation and Appreciation
• If forces shift the supply and demand for a currency, the
exchange-rate price will change.
• A currency depreciation is a change in the exchange rate so
that one currency buys fewer units of a foreign currency.
• A currency appreciation is a change in the exchange rate so
that one currency buys more units of a foreign currency.

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 The Supply of and Demand for Euros

In this figure, the

supply of euros is
S0 S1
equivalent to the
demand for dollars,
Price of euros (in dollars)

and equilibrium occurs

$1.30
at a dollar price of
$1.30 for one euro.
1.10
D0 If the supply of euros
rises, and the demand
D1 for euros falls, the price
decreases to $1.10, the
0 QD new equilibrium.
Quantity of euros
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 Exchange Rates and Trade

• Depreciation of a domestic country’s currency will shift the world

supply curve up.
• An appreciation will shift the world supply curve down.
• Trade for an economy that faces global competition needs to take
into account world supply

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 Exchange Rates and Trade
• The exchange rate plays an important role in the demand for a country’s
domestic goods
• As the quantity supplied of tradable goods rises, suppliers have to
charge higher prices
• Exchange rate adjustments can bring comparative advantages into
alignment, eliminating trade imbalances

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 Exchange rates and trade
• What do appreciation and appreciation mean for trade flows?
– Depreciation of TL: makes TL relatively cheaper against other
currencies; Turkish goods are now relatively cheaper in other
countries, Turkish exports rise; foreign goods are now relatively more
expensive in Turkey, our imports fall; Trade deficit (X-M) is now
smaller;
– Appreciation of TL: makes TL relatively more expensive against other
currencies; Turkish goods are now relatively more expensive in other
countries, Turkish exports fall; foreign goods are now relatively
cheaper in Turkey, our imports increase; Trade deficit (X-M) is now
higher.
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 Exchange Rates and Trade
If the world price level is
P1, domestic producers
will sell Q1 and domestic
Domestic
supply
consumers will demand
Q2. The difference is
made up by imports
SW0
P0
shown by the difference
Price

P1 SW1
between Q2 and Q1. A
country will have a zero
trade balance when the
Domestic world price level equals
demand the domestic price level,
0 Q1 Q0 Q2 P0.
Imports
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 Some Complications in Exchange Rates
Trade imbalances arise due to:

The fact that demand for a country’s currency also reflects a demand
for its assets.

The presence of the resource curse: The paradox that countries with an
abundance of resources tend to have lower economic growth and more
unemployment than countries with fewer natural resources.

© 2020 McGraw-Hill Education. 38

 Chapter Summary (1 of 3)
According to the principle of comparative advantage, as
long as the relative opportunity costs of producing goods
differ among countries, there are potential gains from
trade.
The more competition exists in international trade, the less
the trader gets and the more the involved countries get.
Once competition prevails, smaller countries tend to get a
larger percentage of the gains from trade than do larger
countries.
Gains from trade go to countries that produce goods that
exhibit economies of scale.

© 2020 McGraw-Hill Education. 39

 Chapter Summary (2 of 3)
Economists and laypeople differ in their views on trade.
The gains from trade are not easily recognized, while the
costs in jobs lost tend to be readily identifiable.
The U.S. has comparative advantages based on its skilled
workforce, its institutions, and its language, among other
things.
The prices of currencies—foreign exchange rates—can be
analyzed with the supply and demand model.

© 2020 McGraw-Hill Education. 40

 Chapter Summary (3 of 3)
Inherent comparative advantages are based on factors
that are relatively unchangeable. They are not subject
to the law of one price.
Transferable comparative advantages are based on
factors that can change relatively easily. The law of one
price can eliminate these comparative advantages.
The resource curse leads to trade imbalances.

© 2020 McGraw-Hill Education. 41