Lecture1 Eng

why are we here?
module outline the origins of international economics absolute advanta
International Economics
Lecture 1
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why are we here? module outline the origins of international economics absolute advanta
Outline
why are we here?
module outline
the origins of international economics
absolute advantage vs comparative advantage

gains from trade
labour productivity and comparative advantage
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why are we here?
• national economies are now more open than ever

• what is openness? international movements of
• goods and services (nal and intermediate)
• factors of production (capital and labour)
• globalisation as the slow and progressive removal of barriers to

above
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why are we here?
• real side
1. international exchange of goods and services
2. international movements of production factors
2.1 capital: international investment (direct and indirect), bonds,

assets
2.2 labour: international migration of workers
• monetary side
• above gives origin to monetary ows recorded in the balance
of payments
→ exchange rates, international interest rates
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a quick tour of the world

according to national borders
Worldmapper ©
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where do we come from?
"World Map of Y-DNA Haplogroups" by Chakazul - Own work based on:Numerous academic
publications on the current distribution, origin and migration of each haplogroupen:Y-chromosome
haplogroups by populationsEupediaHaplogroup maps by Maulucioni (World, C3, E, F, G, H, I, J, R, Q,
N, O, M, S); Robertius (Europe). Licensed under CC BY-SA 3.0 via Commons - 6 / 60

population
Worldmapper ©
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GDP/wealth in 1500
Worldmapper ©
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GDP/wealth now
Worldmapper ©
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absolute poverty
Worldmapper ©
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infant mortality
Worldmapper ©
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child diarrea
Worldmapper ©
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yellow fever
Worldmapper ©
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primary education
Worldmapper ©
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secondary education
Worldmapper ©
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tertiary education
Worldmapper ©
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gender empowerment
Worldmapper ©
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HIV incidence
Worldmapper ©
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HIV deaths
Worldmapper ©
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health: public expenditure
Worldmapper ©
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health: private expenditure
Worldmapper ©
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health: service quality
Worldmapper ©
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urban slums
Worldmapper ©
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internet users
Worldmapper ©
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electricity access
Worldmapper ©
25 / 60

greenhouse gas emissions
Worldmapper ©
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carbon emissions increase (1980-2000)
Worldmapper ©
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increase in development
Worldmapper ©
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exports of cereals
Worldmapper ©
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exports of dairies
Worldmapper ©
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exports of clothing
Worldmapper ©
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exports of fruits
Worldmapper ©
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exports of vegetables
Worldmapper ©
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primary exports
Worldmapper ©
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secondary exports
Worldmapper ©
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exports of toys
Worldmapper ©
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exports of nance and insurance services
Worldmapper ©
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exports of high-tech
Worldmapper ©
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course outline
International trade
- Classical & Neoclassical Trade

- Trade Policy
- New Trade Theories
- New Interactions (New Economic Geography)
- Models with Heterogeneous Firms
39 / 60
course outline
International money & nance
- Foreign Exchange (FOREX) Functioning and Key Concepts

- International Parity Conditions
- Open Economy Macroeconomics
- Exchange rate determination
- International monetary system
- Currency crises & contagion
40 / 60
the origins...
Mercantilists vs. liberists
• MERCANTILIST SYSTEM:
• imports [M] = outflows of metal
• exports [X] = inflows of metal
• government should reduce M and encourage X
• trade balance was heavily regulated
• monopolies were encouraged
• side effects:
• colonialism
• black market
• international controversies (after all, Xi j = M ji)
41 / 60
the emergence of liberism

• Mercantilism survived even after increase in gold supply
in gold in 1500s
Corn Laws were set to stabilise the price of corn:
tari˙s/restrictions reduced (increased) when domestic price
increased (declined) excessively
• From the 1700s, it was evident that corn laws limited growth
of the country and industry in particular:
• side effect 1: greater instability: anticipation of tariff
changes by corn producers further increased price
fluctuations;
• side effect 2: class conflict: the laws favoured corn
producers (aristocracy) and disadvantaged entrepreneurs
(middle class);
• The interests of the middle class were represented by the
liberist movement
42 / 60
classical liberism
Adam Smith (1723-1790): An in inquiry into the Nature and Causes of the Wealth of
Nations (1776)
It is the maxim of every prudent master of a family
never to attempt to make at home what it will cost him
more to make than to buy. The taylor does not attempt to

make his own shoe. All of them nd it for their interest to
employ their whole industry in a way in which they have some
advantage over their neighbours and to purchase with a part
of its produce whatever else they have occasion for. What is
prudence in the conduct of every private family, can
scarce be folly in that of a great kingdom. Would it be a

reasonable law to prohibit the importation of all foreign wines,
merely to encourage the making of claret and burgundy in
Scotland?
43 / 60
wealth of nations: fundamental principles
• the wealth of a nation depends on its ability to produce

• the ability to produce requires no public intervention (e.g.
corn laws)
• free trade benefits all nations
Absolute advantage: The ability to produce a good with

smaller unit labour requirement.
NOTE: The value of goods is given by amount of labour
needed to produce them
⇒Compare producers in terms of their productivity
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absolute advantage example

Output per labour unit Italy France
Wine 5 litres 20 litres
Cheese 10 Kg 6 Kg
• Compare autarchy and equilibrium (use PPF)
45 / 60
absolute advantage example

Output per labour unit Italy France
Wine 5 litres 20 litres
Cheese 10 Kg 6 Kg
• Compare autarchy and equilibrium (use PPF)
46 / 60
why do countries trade?

• Adam Smith's Absolute Advantage: countries should trade in those
goods they have an absolute advantage in;
• Ricardo overcomes this theory:
• countries trade because they are different
• countries trade to achieve economies of scale in production
• even countries with absolute advantage in all goods can
benefit from trade
• to understand this, we need two key concepts:
Opportunity cost
trade-off in terms of missed opportunities: what you have to give
away to obtain something else
Comparative advantage
a country has a comparative advantage in the good it produces
with the lower opportunity cost
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some numbers...
• Adam Smith: trade beneficial Argentina USA
only if both countries have an
absolute advantage Unit Labour Requirement
Meat 4 > 2
• David Ricardo: trade always
beneficial, even if one country Microchips 24 > 8
has absolute advantage in the
Total Output
production of all goods
Total labour 120 200
Meat 30 < 100
Microchips 5 < 25
Opportunity Cost
Meat 0.16 > 0.25
Microchips 6 < 4
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gains from trade 1
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gains from trade 1
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gains from trade 1

Trade and the Consumption Possibilities Frontier (CPF)
• In autarchy, CPF = PPF
• With trade, CPF 6= PPF
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labour productivity & comparative advantage

a simple 2x2x1 model
• 2 countries (home [H] & foreign [F])

• 2 goods (2 industries): wine [W] & cheese [C])
• 1 factor of production (labour: L)
• technology defined by labour productivity in W & C
Definition of Unit Labour Requirement

the amount of labour required to produce a unit
(e.g., 1Lt of W or 1 Kg of C).
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labour productivity & comparative advantage
• L Total resources (in terms of Labour) ∴ total labour supply
• aLC unit labour requirements to produce cheese
• aLW unit labour requirements to produce wine
• L = QW · aLW + QC · aLC Total labour supply is also
Production Possibilities Frontier (PPF)
L aLC
QW = − QC ; slope = opportunity cost of cheese
aLW aLW | {z }
|{z} |{z} units of W to sacrifice to obtain C
intercept slope
when the PPF is a straight line, aLW is

aLC
constant
introducing prices
• PPF tells us what the economy CAN produce. To know what
the economy WILL produce, we need relative prices
• in perfectly competitive economies (i.e., zero profits),
hourly wages = value of worker's hourly production:
PC PW
Wc = , Ww =
aLC aLW
Wc T Ww if and only if (i from now on) PC
aLC T PW
aLW , that is:
PC aLC
PW T aLW
• everybody wants to work in the sector with higher wages, so

P aLC
C
 PW >
 aLW , specialise in cheese
PC aLC
P < aLW , specialise in wine
 PWC
 aLC
PW = aLW , produce both
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relative prices and supply

• recall that aLC
aLW is the opportunity cost
• PC
PW T : the economy will specialise in the production of
aLC
aLW
cheese (wine) if the relative price of cheese (wine) is greater
that its opportunity cost
• In the absence of international trade, Home [H] will have to
produce both goods
in this case PPWC = aaLW
LC
, i.e. the relative price of cheese equals its
opportunity cost, there is no trade
Without international trade, relative prices equal relative unit
labour requirements PPWC = aaLW
LC
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international trade in a one factor model

• denote Foreign units with asterisks (*)
a∗LC
• aLC
aLW T ⇔H cheese opportunity cost can be T than F
a∗LW
opportunity cost
∗
• if aaLC < aa∗LC , i.e. aa∗LC < aaLW
∗ : Home has a COMPARATIVE
LW LW LC LW
ADVANTAGE (lower opportunity cost) in cheese production
NOTE dierence between Absolute and Comparative
Advantage
ABSOLUTE ADVANTAGE only needs productivities, i.e.
aLC,LW > a∗LC,LW
COMPARATIVE ADVANTAGE relies on opportunity cost that
needs aLC , aLW , a∗LC , a∗LW
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world relative supply and demand

RD Relative Demand; RS Relative Supply (relative: cheese vs wine)
• for PC /PW < aLC /aLW , a∗LC /a∗LW , both Home and
foreign specialise in wine
since we are assuming aLC /aLW < a∗LC /a∗LW ⇒
supply of cheese = 0 when world price drops
below aLC /aLW
• for PC /PW = aLC /aLW , Home indierent between
producing W or C (at RS)
• for aLC /aLW < PC /PW < a∗LC /a∗LW , Home specialises
in Cheese (QC = L/aLC ) and Foreign in wine
(QW∗ = L∗ /a∗LW ) and relative supply of cheese =
L/aLC
L∗ /a∗LW
• for PC /PW = a∗LC /a∗LW , Foreign indierent between
producing W or C (at RS)
• for PC /PW > a∗LC /a∗LW , Home and foreign specialise
in cheese, wine production = 0 and Relative
Supply of cheese is innite
57 / 60
world relative supply and demand

RD Relative Demand; RS Relative Supply
• RD simply reects substitution eects

• if RD and RS cross in 1, Home and Foreign
specialise in good with comparative advantage
• if RD and RS cross in 2, Home
produces W & C,
Foreign still specialises in W Q < LL/a LC
∗ /a∗
LW
• if both specialise, the relative price falls between
the pre-trade levels in the two countries.
58 / 60
gains from trade 2

trade as an indirect method of production
• produce cheese and exchange it for wine: use 1 hour of labour

to produce
• 1/aLW litres of wine or
• 1/aLC Kg of cheese, that could be sold for PC /PW litres of
wine, i.e.
1
aLC · PPWC
• as long as · PPWC > aLW
1
aLC
1
, or PPWC > aaLW
LC
,
i.e. when neither country produces both goods, trade allows
Home to have more wine by producing cheese and exchanging
for wine
59 / 60
comparative advantage
empirical evidence (MacDougall, 1951)
60 / 60

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why are we here?

module outline the origins of international economics absolute advanta

why are we here?

the origins of international economics

absolute advantage vs comparative advantage

• national economies are now more open than ever

• globalisation as the slow and progressive removal of barriers to

2.1 capital: international investment (direct and indirect), bonds,

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

a quick tour of the world

- Classical & Neoclassical Trade

- Foreign Exchange (FOREX) Functioning and Key Concepts

the emergence of liberism

It is the maxim of every prudent master of a family

never to attempt to make at home what it will cost him

more to make than to buy. The taylor does not attempt to

scarce be folly in that of a great kingdom. Would it be a

wealth of nations: fundamental principles

• the wealth of a nation depends on its ability to produce

Absolute advantage: The ability to produce a good with

absolute advantage example

absolute advantage example

why do countries trade?

gains from trade 1

gains from trade 1

gains from trade 1

labour productivity & comparative advantage

• 2 countries (home [H] & foreign [F])

Definition of Unit Labour Requirement

when the PPF is a straight line, aLW is

• everybody wants to work in the sector with higher wages, so

• RD simply reects substitution eects