Ch6. International Trade and Exchange Rates — Comparative Advantage, Free Trade, and Exchange Rate Determination

The Basics of International Trade

Why does trade occur between nations? The answer lies in comparative advantage — one of the most powerful insights in economics, introduced by David Ricardo in 1817.

The Theory of Comparative Advantage

Absolute Advantage vs. Comparative Advantage

Absolute Advantage: The ability to produce more output with the same resources

Comparative Advantage: The ability to produce a good at a relatively lower opportunity cost

Core insight: Even if one country has an absolute advantage in every good, both countries can still gain from trade if they specialize in the goods where they hold a comparative advantage.

Classic example:

Country	1 computer (days of work)	1 bottle of wine (days of work)
England	10 days	5 days
Portugal	20 days	8 days

England has the absolute advantage in both. But:

England’s opportunity cost of 1 computer = 2 bottles of wine
Portugal’s opportunity cost of 1 computer = 2.5 bottles of wine

→ England has comparative advantage in computers (lower opportunity cost) → Portugal has comparative advantage in wine (lower opportunity cost)

Therefore, England specializes in computers, Portugal in wine, and both gain from trade.

Benefits and Limits of Free Trade

Benefits of Free Trade

Specialization according to comparative advantage → production efficiency gains
Market competition → lower prices, increased consumer surplus
Economies of scale — producing for a larger global market
Technology transfer and innovation

Limits of Free Trade

Income distribution inequality: Workers in import-competing industries are harmed
Strategic industries need protection: Defense, food security, energy
Infant industry argument: Early-stage industries may need temporary protection

Protectionist Tools

Tariffs

Taxes levied on imported goods. Protect domestic producers and generate government revenue.

Economic effects of tariffs:

Import prices rise → imports fall
Domestic production rises, domestic consumption falls
Deadweight loss (DWL) is created

Non-Tariff Barriers

Import quotas: Direct limits on import volumes
Subsidies: Artificially boost domestic producers’ competitiveness
Technical barriers: Technical or safety standards that restrict imports
Voluntary Export Restraints (VER): A foreign country limits its own exports

Exchange Rates

An exchange rate is the rate at which one currency is exchanged for another.

Example: USD/EUR rate of 1.10 means 1 euro = $1.10

Exchange rate notation:

Direct quote: units of domestic currency per unit of foreign currency (e.g., $1.10/€1)
Indirect quote: units of foreign currency per unit of domestic currency

Exchange Rate Theories

Purchasing Power Parity (PPP)

Long-run exchange rate theory: Exchange rates adjust so that the same good costs the same in both countries.

The Big Mac Index: The Economist magazine’s informal gauge of exchange rate valuation, based on McDonald’s Big Mac prices worldwide.

US Big Mac price: $5.69; UK Big Mac price: £4.49 → PPP-implied rate: 5.69/4.49 ≈$ 1.27/£1 → If the actual market rate is $1.27/£1, sterling is fairly valued under PPP

Limitation: PPP often fails in the short run due to transaction costs and non-traded goods.

Interest Rate Parity

Short-run exchange rate theory: Exchange rates adjust so that expected returns on investments in both countries are equalized.

Example: US interest rates > UK interest rates → capital flows into US dollar assets → dollar demand rises → dollar appreciates

Economic Effects of Exchange Rate Changes

When the Dollar Weakens (Exchange Rate Rises vs. Foreign Currencies)

Item	Effect
Exports	Dollar-denominated receipts increase → improved price competitiveness → exports rise
Imports	Import prices rise → imports fall
Trade balance	Short-run deterioration (J-curve effect); long-run improvement
Inflation	Import prices rise → upward pressure on inflation
Foreign debt	Dollar-denominated debt burden increases in domestic terms

The J-Curve Effect

When a currency depreciates, the trade balance may actually worsen in the short run before improving.

Reason: Existing import and export contracts are already locked in, so trade volumes do not respond immediately — but prices change right away. As time passes, trade volumes adjust, and the trade balance improves.

The pattern traces a J-shape on a graph, hence the name.

Balance of Payments

The balance of payments systematically records all economic transactions between a country and the rest of the world over a given period.

Account	Content
Current Account	Trade in goods and services, income, transfers
Capital Account	Capital transfers, non-produced non-financial assets
Financial Account	FDI, portfolio investment, reserve assets

Current account surplus: Exports > Imports → accumulation of foreign assets Current account deficit: Imports > Exports → accumulation of foreign liabilities

The United States has run a persistent current account deficit, largely due to high consumer demand for imported goods and the dollar’s reserve currency status.

Learning Checklist

Explain the difference between absolute and comparative advantage using a numerical example
Explain why trade arises from comparative advantage
Analyze the economic effects of a tariff from consumer, producer, government, and social perspectives
Explain the difference between PPP and Interest Rate Parity
Explain how a weaker domestic currency affects exports, imports, and prices
Explain why the J-curve effect occurs

Key Concept Cards

Causes of Market Failure ★★★★★ : ① Public goods (non-rival, non-excludable) ② Externalities (positive/negative) ③ Information asymmetry (adverse selection, moral hazard) ④ Monopoly/oligopoly ⑤ Income inequality.

Negative Externalities and Pigouvian Tax ★★★★★ : Negative externality (e.g., pollution): private cost < social cost → overproduction. Pigouvian tax: levy equal to the external cost → social optimum achieved. Coase Theorem: if property rights are clear and transaction costs are zero, parties can negotiate to a socially optimal outcome.

Properties of Public Goods ★★★★★ : Non-rival: one person’s consumption does not reduce availability for others. Non-excludable: cannot prevent non-payers from consuming → free-rider problem → under-provision. Memory tip: Public good = non-rival + non-excludable / Club good = excludable + non-rival / Common resource = rival + non-excludable

Information Asymmetry: Adverse Selection and Moral Hazard ★★★★★ : Adverse selection: pre-contract information asymmetry (e.g., used car “lemons” market, life insurance). Solutions: signaling, screening. Moral hazard: post-contract behavior change (e.g., driving carelessly after getting insurance). Solutions: monitoring, cost-sharing.

Practice Quiz

Q. What is the core claim of the Coase Theorem?

If property rights are clearly defined and transaction costs are zero, the parties affected by an externality can negotiate to reach the socially optimal outcome without government intervention.

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