Flashcards in International Economics Deck (56):
What is the difference between absolute advantage and comparative advantage?
A country has an absolute advantage if it is more efficient than other countries at producing some particular good
A country has a comparative advantage if it is more efficient at producing some particular good than producing some other good
What is another way of stating the notion of comparative advantage?
A country has a comparative advantage in producing a good if, when compared to another country, the opportunity cost of producing it is less than the opportunity cost of producing other goods
How is comparative advantage significant for international trade?
There will be greater total productivity and wealth if countries produce according to their comparative advantage and trade with other countries, even if they do not have an absolute advantage in anything
What is an example of a country having a comparative advantage in producing some good?
Japan can produce 50 TVs with 5 units of input and 40 bushels of rice with 8 units of input
-China can produce 64 TVs with 8 units of input and 60 bushels of rice with 10 units of input
-Therefore, Japan can produce 10 TVs per input and 5 bushels of rice per input; China can produce 8 TVs per input and 6 bushels of rice per input
Opportunity cost of producing rice:
Japan -- 2 TVs (10/5) per bushel of rice
China -- 4/3 TVs (8/6) per bushel of rice
Opportunity cost of producing TVs:
Japan -- 1/2 bushel of rice (5/10) per TV
China -- 3/4 bushel of rice (6/8) per TV
Japan has lower opportunity cost of producing TVs, while China has lower opportunity cost of producing rice, so Japan should entirely produce TVs and China should entirely produce rice in order to maximize total productivity
What is the Heckscher-Ohlin theory?
Seeks to explain why different countries or regions have different levels of efficiency in producing various goods -- attributes these differences to the endowment of the factors of production
What are some classifications of the factors of production?
(1) geographical conditions (land)
(2) climatic conditions (weather)
(3) human capacities (labor)
(4) capital accumulation
(5) proportions of resources
(6) political and social environment
What are some assumptions of the Heckscher-Ohlin theory?
(1) a given product always requires the same input
(2) technology, if available anywhere, is globally available
(3) costs of transportation are minimal
(4) differences in consumer taste are minimal
What is generally postulated by the Heckscher-Ohlin theory?
Countries tend to import what they have comparative disadvantages in and export what they have comparative advantages in -- thus countries with significant capital will export more capital-intensive goods and import more land- and labor-intensive goods
What is the Leontief paradox?
An empirical finding by Wassily Leontief that contradicted the Heckscher-Ohlin theory of international trade -- it found that countries with a high capital accumulation actually tend to import more capital-intensive goods than they export
What are some examples of capital-intensive, labor-intensive, and land-intensive goods?
Capital-intensive = oil production
Labor-intensive = service industries, like hotels
Land-intensive = farming
What is the first mover theory?
Holds that the first firm to enter a given market has the best chance for immediately growing (economies of scale) and establishing itself, making it much more difficult for later competitors
What is the Linder theory of overlapping demand?
Explains international trade as not only due to factor endowment (for raw materials) but also due to similar preferences/demand between countries (for manufactured goods)
Moreover, since consumer taste depends on income, a country's per-capita income influences its demand, though not necessarily the direction of trade -- so countries with similar per-capita income will be more willing to trade with each other, having similar preferences
What do trade barriers generally accomplish?
They keep resources in domestic industries (which the barriers are designed to protect from competition) but thereby keep those resources from being used more efficiently elsewhere
GATT (General Agreement on Tariffs and Trade) is an example of an international agreement to reduce trade barriers
What is one difficulty in evidences supporting free trade over against trade barriers?
The costs are more obvious and concentrated (e.g. factories closing down), while the benefits tend to be smaller and more scattered
How might other countries' economic conditions provide reasons for trade barriers?
Some countries exporting goods might have unsafe or unconscionable economic conditions (e.g. no health care or safety standards) that potential importing-countries would not want to abet -- or the unsafe conditions might make a product unsafe for the importing country
What are reasons related to self-sufficiency in favor of trade barriers?
(1) There may be economic risks (possible strikes) or political risks (gov't upheaval) in other countries such that other countries would not want to be dependent on that country for trade
(2) The very fact of self-sufficiency can be a point of pride for a nation, not needing to lean on others for support
(3) Increased transportation costs and risks for international transportation (e.g. hurricanes) can favor domestic production
How might infant industries provide reasons for trade barriers?
A domestic industry might have a comparative advantage in the long run but not the short run, and thus need extra protection early on to overcome the initial hardships of its infancy
How might cheap foreign labor provide reasons for trade barriers?
If other countries have laborers willing to work for very, very little -- due to no minimum wage laws and/or lower standards of living -- products from those countries could be artificially cheaper than products produced domestically with more expensive labor
Then, since a country ought to favor its own laborers over others', trade barriers might be put in place to encourage the purchase of products produced through domestic labor
What are some unintended negative consequences of trade barriers?
They can cause
-reduced overall domestic imports
-countervailing tariffs by the foreign country
What is the difference between an import quota and a tariff?
Both are trade barriers, but:
-import quotas reduce only the amount of imports
-tariffs do not affect the amount of imports, but charge a tax that effectively increases their price in the importing country
What are different ways a government can incentivize exports?
Directly, gov'ts can give subsidies to companies that produce goods for exporting, e.g. giving subsidies directly to the company
Indirectly, gov'ts can give subsidies or tax breaks, e.g. having lower taxes on export-related income
What are two ways to reduce reliance on imported goods?
(1) substitution = developing products domestically that accomplish the same function as imported goods (e.g. hydraulic energy rather than oil)
(2) domestic content quotas = encouraging (indirectly) or requiring (directly) the production of a various number of goods that would otherwise be imported
What is the European Union (EU)?
A federal of European nations with the objectives:
(1) to establish Europe-wide citizenship
(2) to ensure justice, security, and freedom
(3) to foster progress socially and economically
(4) to establish a role for Europe within the world
What is the European Monetary Union (EMU)?
The part of the EU which all uses the euro as its currency
What is the North American Free Trade Agreement (NAFTA)?
An agreement from 1994 among the U.S., Canada, and Mexico to gradually reduce trade barriers
Its goal of integration is not as ambitious as the EU
What is the Central American-Dominican Republic Free Trade Agreement (CAFTA-DR)?
Reduces trade barriers between the U.S. and El Salvador, Guatemala, Honduras, Costa Rica, Nicaragua, and the Dominican Republic
Originally it was just with central America (and just called CAFTA), but the Dominican Republic entered the agreement in 2004
What is an exchange rate?
The rate at which one currency can be purchased with another currency
This rate is needed if trade within a given area is not done with one common currency
What is the difference between a floating exchange rate and a fixed exchange rate?
Floating = determined by the supply and demand of the free market for the currency
Fixed = the gov't sets the exchange rate
What occurs if the gov't fixes an exchange rate above or below what the rate would naturally float to (i.e. the market/equilibrium price of the currency)?
It would have the same effect as price floors or price ceilings for other goods -- a rate that is fixed higher than the equilibrium rate would yield a surplus, while a rate fixed lower than it would yield a shortage
What is a managed float?
A mix of floating and fixed exchange rates -- the rate mostly floats, but the gov't fixes it sometimes to provide stability
What is the difference between the spot rate and the forward rate?
(1) spot = the rate to purchase currency in the present ("on the spot")
(2) forward = the rate to agree to purchase currency at some point in the future
If forward rate > spot rate, the difference is a premium; otherwise it is a discount
What causes discounts or premiums for forward rates?
They are based on the (real) interest rates paid by domestic and foreign banks, which are themselves based on the expected inflation occurring between the countries
Thus, discounts and premiums (predictably) are based on the future purchasing power of the currencies -- whether they will increase or decrease
How and why do the interest rates paid by domestic and foreign banks relate to discounts or premiums on forward rates?
How: if domestic banks pay a higher interest rate, the forward rate will sell at a premium; otherwise it sells at a discount
Why: If the market is behaving properly, the investor would have to get the same overall amount whether (a) he gains interest on domestic currency and has a forward contract to convert it to foreign currency later or (b) he converts to foreign currency now and then gains interest on that foreign currency
How do you calculate the effect of inflation on an exchange rate?
The difference in inflation between the currencies, added to or subtracted from 1, is the percentage by which the exchange rate is changed
What is an example of inflation altering the exchange rate?
At Jan. 1, the euro trades for 1.5 USD. The euro experiences 8% inflation and the USD experiences 6% inflation over the year.
Difference in inflation = 2%
Year-end exchange rate = (1 - .02) x 1.5 USD per euro = 1.47 USD per euro
The euro inflated more and so became weaker in relation to the USD; it now purchases less USD than before
What are different ways to avoid foreign currency risk?
(1) having fewer receivables or liabilities in foreign currency -- but this may limit foreign trade itself
(2) balancing foreign receivables and liabilities -- though this requires a large foreign presence
(3) bartering, i.e. contracting without currency, just with goods themselves
(4) foreign currency hedges
How do foreign currency hedges guard against foreign currency risk?
If a firm fears the domestic currency might depreciate in value (e.g. if it has liabilities in a foreign currency), then it could buy forward contracts which benefit from an appreciation in the foreign currency to offset the risk
Likewise, if the fear is that the foreign currency might depreciate in value (e.g. if the firm has receivables in that currency), then it could sell forward contracts which benefit from a depreciation in the foreign currency
What are different risks in managing foreign operations rather than domestic operations?
Besides the currency/exchange risk, there is
(1) "sovereignty risk," where a foreign gov't could nationalize the foreign business, or establish a monopoly that illegalizes the foreign business, or place some other restriction
(2) the risk of double taxation from both the foreign and domestic gov't
(3) the risk that trade secrets or copyrights could be leaked or unprotected
What are different ways that companies can establish a foreign presence?
(1) contracting with an independent person to serve as a sales rep in the foreign country
(2) opening a branch of the company
(3) establishing a foreign subsidiary
What are the pros and cons of having an independent foreign representative?
It results in smaller risk, as only inventory, at most, is at risk, but also minimal control
What are the pros and cons of having a branch of the company (either sales or manufacturing) in a foreign country?
It involves greater control, but also greater responsibilities (e.g. dealing with foreign labor laws and income taxes) -- also may be difficult to manage from abroad due to cultural differences
What are the pros and cons of having a foreign subsidiary?
(i) since the sub would have its own production, sales, and (sometimes) financing, it would not involve imports
(ii) since it is more independent, there would be less need for constant management from abroad
(iii) yet the investment would be very expensive, possibly involving a duplication of the domestic company
(iv) also, the foreign country could place limitations on foreign ownership of subsidiaries in their country
What are the general pros and cons of multinational corporations (MNCs)?
Pros: MNCs claim...
(i) to support free trade
(ii) to improve the international monetary system
(iii) to advance cultural tolerance
(i) due to their enormity they can be difficult to manage
(ii) they have more power to cover up shady practices
What advantages and disadvantages do MNCs provide for the home country?
Advantages: MNC profits improve the balance of payments for the home country, and support local philanthropic causes much more than foreign ones
-MNCs may also be more adept at acquiring scarce resources
Disadvantages: MNCs can reduce domestic investment, including employment and tax revenues
What advantages and disadvantages do MNCs provide for the host/foreign country?
Advantages: MNCs can invest more in the host countries, giving them greater employment and technology, better living standards, and more tax revenue
Disadvantages: MNCs can avoid paying taxes to the host country through transfer pricing (transferring income to the company's other branches), and can defeat local competitors -- moreover, the MNCs may not have much of a concern for local interests, just profits
What is the name given to the economic phenomenon of MNCs overvaluing profit at the expense of foreign peoples?
The absentee landlord effect -- the MNC is profiting from the foreign country in an unethical way that would not be tolerated in the home country due to a better awareness of such practices, just as a landlord could derive rent from a property without caring about its upkeep
What is the balance of payments (BOP)?
The net of money coming into and going out of a country -- a positive amount (surplus) means that more money is coming in, while a negative amount (deficit) means that more money is exiting
What are the two accounts by which a country's BOP is measured?
Current account and capital account
The BOP is the sum of these two accounts
As regards the BOP, what is included in the current account?
The goods and services, interest, dividends, and unilateral transfers made into and out of the country
What is the balance of trade (BOT) and the balance of goods and services?
BOT = net of imported goods and exported goods for a country -- doesn't include services
Balance of goods and services = net of imported and exported goods and services
In the current account, what is included within unilateral transfers?
Payments to family outside the country, payments of foreign aid (by the gov't), and some pension payments
As regards the BOP, what is included in the capital account?
All fixed assets (e.g. equipment) and financial assets (e.g. stock)
What is the International Monetary Fund (IMF)?
An international organization created in 1945 designed to improve and stabilize the world's payment system after WWII
Includes a pool of currency which can be applied against member countries that have a negative BOP
Strongly related to the World Bank, which lends money to help finance underdeveloped countries
What is transfer pricing?
The pricing established between divisions of the same company (or other related parties) for whatever transactions they might do
Especially important for MNCs, since transfer payments with foreign subsidiaries can funnel income in specific jurisdictions to lessen their taxes
Besides tax minimization, how is transfer pricing significant?
It can help with managerial decision-making: properly valuing a segment of the company by having an accurately-valued transfer price
Thus, companies are allowed to have two different sets of transfer prices (for taxation and for financial reporting)