Fundamentals of Economics

LEARNING OUTCOMES

At the end of this chapter, you should be able to:

 Describe international trade.

 Differentiate between absolute and comparative advantages.

 Discuss the advantages and disadvantages from trade.

 Discuss concepts of absolute advantage and comparative
advantage.

 Describe the reason for protectionism and elaborate tools of
protectionism.

 Calculate balance of payment (BOP), and discuss the structure
of the BOP as well as the effects and measures to reduce BOP
deficit.

 Discuss and differentiate between fixed and flexible exchange
rate systems.

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INTERNATIONAL TRADE

 Theoretically, international trade refers to government
and individual activities on the exchange of capital,
goods and services across international borders or
territories.

 The exchange of goods and services between one
country and another.

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INTERNATIONAL TRADE (cont.)

Theory of
International Trade

Classical Theory

Absolute Advantage Comparative
Advantage
Adam Smith
David Ricardo
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INTERNATIONAL TRADE (cont.)

Absolute Advantage Comparative Advantage

 Introduced by Adam  Introduced by David
Smith. Ricardo.

 A country is said to have  Comparative advantage
an absolute advantage in is measured in terms of
the production of a good opportunity cost; it refers
when it can produce to a country’s ability to
more of that good than produce a particular
another country by using good with a lower
the same amount of opportunity cost than
resources. another country.

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INTERNATIONAL TRADE (cont.)

 According to Adam Smith, countries would gain
simultaneously if they practised free trade and specialized in
goods which have absolute advantage.

Only two countries in the world that Only two goods are

are involved in international trade produced by two countries

Free trade exists between these Production is under
two countries constant cost.

No transportation costs
are incurred

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INTERNATIONAL TRADE (cont.)

Absolute Advantage
 A country is said to have an absolute advantage in the

production of a good when it can produce more of that
good than another country, using the same amount of
resources.

*Both countries allocate 50% of their
resources to produce wheat and cloth.

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INTERNATIONAL TRADE (cont.)

AB – Happy Land’s PPC
CD – Young Land’s PPC

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INTERNATIONAL TRADE (cont.)

Conclusion:

(1) Young Land have absolute advantage in producing cloth.

(2) Happy Land have an absolute advantage in producing
wheat.

 Since both countries have a mutual absolute advantage
in the production of wheat and cloth, specialization can
take place.

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INTERNATIONAL TRADE (cont.)

(1) Young Land can fully utilize their resources to
produce 4,000 metres of cloth.

(2) Happy Land can use all their resources to produce
1,500 kg of wheat.

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INTERNATIONAL TRADE (cont.)

(1) With specialization, both countries are able to trade with
each other in order to consume both products.

(2) Assuming that the term of trade is 1 kg of wheat to 1 metre
of cloth.

(3) Young Land need to give 500 metres of cloth if need 500 kg
of wheat.

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INTERNATIONAL TRADE (cont.)

(1) What if a country has an absolute advantage over both
goods?

(2) Will international trade then be necessary?
(3) How can the countries specialize?

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INTERNATIONAL TRADE (cont.)

Comparative Advantage

 Comparative advantage is measured in terms of
opportunity cost; it refers to a country’s ability to
produce a particular good with a lower opportunity cost
than another country.

 “A country should specialize in the production of goods
or services in which it has greater comparative
advantage or the lower opportunity cost by exporting
these goods; and import commodities where the
opportunity cost is higher or less comparative
advantage” – David Ricardo

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INTERNATIONAL TRADE (cont.)

 According to David Ricardo, when there are two countries, a country
should:

(i) Specialize (export) in the production of goods and services in
which the country has a greater comparative advantage or lower
opportunity cost, and

(ii) Import the commodity where the opportunity cost is higher or
comparative advantage is less.

 Who should specialize in wheat and who should specialize in
cloth?

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INTERNATIONAL TRADE (cont.)

STEP 1: To determine who should produce wheat and cloth, the
must be calculated.

Country Wheat (kg) Cloth (metres)
Young Land
Happy Land 1,000 W = 4,000 C 4,000 C = 1,000 W
1W=4C 1 C = 0.25 W

750 W = 1,800 C 1,800 C = 750 W
1 W = 2.4 C 1 C = 0.42 W

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INTERNATIONAL TRADE (cont.)

*Compare
which has
the lowest
opportunity

cost

Conclusion:

 Young Land has the lowest opportunity cost in producing
of wheat*

 Happy Land has the lowest opportunity cost in producing
of rice*

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INTERNATIONAL TRADE (cont.)

Advantages of International Trade
 Increase in world output
 Enjoy varieties of goods
 Increase in efficiency
 Enjoy economies of scale
 Higher income and higher rate of economic growth
 Earn foreign exchange
 Benefits to political, economy, social and technology links

Disadvantages of International Trade All Rights Reserved
 Depletions in country’s reserves
 Economics and political dependence 1–18
 Transportation costs

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PROTECTIONISM

 Barriers to free flow of goods and services imposed
by a country so as to protect its domestic industries.

Arguments for Protectionism All Rights Reserved
 Reduce deficit in the balance of payments
 Increase in government revenue 1–19
 Protect infant industries
 Prevent dumping
 Diversify the economy
 Create more job opportunities

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PROTECTIONISM (cont.)

Protectionism Tools
 Tariff
 Quota
 Subsidies on export
 Exchange controls
 Embargo

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BALANCE OF PAYMENTS

 Balance of payments is the national accounts of a
country.

 It measures all financial transactions, flow of currencies
into and out of the economy within a particular period,
usually a year.

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BALANCE OF PAYMENTS (cont.)

Structure of Current Account
BOP Capital & Financial Account
Official Financing Account

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BALANCE OF PAYMENTS (cont.)

Trade Balance Consists of export and import of
physical goods

Components Service Consists of the sale and purchase
in Current Balance of services
Account
Net Income (Income received from abroad) –
Balance (Income paid to residents abroad)

Current Gifts, military aid, donation and
Transfer financial aid by the government,
Balance
private organizations or
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BALANCE OF PAYMENTS (cont.)

Capital Account

Acquisition of Capital transfers
non-produced
non-financial All Rights Reserved

assets 1–24

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BALANCE OF PAYMENTS (cont.)

Errors and Omissions
 Use as a balancing item to bring the final balance of

payments account to zero.
Official Financing Account/Reserve Assets
 Shows the balance of monetary movements into and out of

a country.

A positive sign (+) shows a net
inflow of funds, or surplus.

A negative sign (−) shows a net
outflow of funds, or deficit.

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BALANCE OF PAYMENTS (cont.)

Basic Calculation of BOP
(1) Merchandise Trade Balance = Merchandise Export –

Merchandise Import
(2) Service Balance = Service Export – Service Import

(3) Balance in Current Account = Merchandise Trade Balance +
Service Balance + Net Income + Current Transfer

(4) Balance on Capital Account = Capital Account + Financial
Account

(5) Overall Balance = Balance in Current Account + Balance in
Capital Account + Errors and Omissions

(6) Reserve Assets = –(Overall Balance)

(7) Basic Balance = Balance in Current Account + Long-term
Capital Account

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EXCHANGE RATE

 Exchange rate is the price of one currency in terms of
another currency.

If RM4.00 = USD1,
meaning, the price of a ringgit, RM1.00 = USD0.25 cents

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EXCHANGE RATE (cont.)

Types of Fixed Exchange Rates
Exchange Rates
Floating Exchange Rates

Managed Floating
Exchange Rates

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EXCHANGE RATE (cont.)

A fixed exchange rate means the government fixes the
external value of its currency in relation to other currencies.

Types of Fixed Exchange Rates

The Gold Standard Bretton Woods System

Countries need to fix the prices of Countries need to peg
their domestic currencies in terms their currencies in terms of
of a specified amount of gold at the US dollar instead of gold.

fixed price. All Rights Reserved

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EXCHANGE RATE (cont.)

Gold Standard

 In this system, the trading countries need to fix the prices of
their domestic currencies in terms of a specified amount of
gold at the fixed price.

 For example, if the United States defines $25 in terms of one
ounce of gold and Britain defines ₤5 for one ounce of gold,
then the exchange rate between dollars and pounds will be
$5 to ₤1. Under this system, each nation must:

(a) Define its currency in terms of a quantity of gold.

(b) Maintain a fixed relationship between its stock of gold and
its money supply.

(c) Allow gold to be freely exported and imported.

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EXCHANGE RATE (cont.)

Fixed Exchange Rates—Advantages
 Ensures certainty and stability in the international

financial system and encourages the development of
international trade.
 Discourages speculation of a country’s currency as
speculation may cause fluctuations in the value of the
currency.

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EXCHANGE RATE (cont.)

Fixed Exchange Rates—Disadvantages

 An inappropriate parity may cause a currency to be
overvalued or undervalued which could harm the
economy.

 A deficit country will suffer severe deflationary costs of lost
output and unemployment whereas a surplus country will
‘import’ inflation.

 Resources which could be used more productively
elsewhere are tied up in official reserves, as in fixed
exchange rates.

 The government may have to sacrifice other domestic
policy objectives.

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EXCHANGE RATE (cont.)

Floating Exchange Rates
 A floating exchange rate is determined by the market

forces of demand and supply of the country’s
currency.

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EXCHANGE RATE (cont.)

Floating Exchange Rates—Advantages
 Respond and adjust to slow changes in demand and

comparative advantage.
 Governments can simply allow market forces to look

after the balance of payments while they concentrate on
domestic economic policy.
 Insulates the country from ‘importing inflation’ from the
rest of the world.
 Country’s monetary policy and fiscal policy are
independent of external conditions and influences.

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EXCHANGE RATE (cont.)

Floating Exchange Rates—Disadvantages
 Volatility and instability caused by floating exchange

rates reduce the volume of international trade.
 Exchange rates are vulnerable to speculative capital

or ‘hot money’ movements and fail to reflect correctly
the trading competitiveness of the country’s
industries.

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EXCHANGE RATE (cont.)

Managed Floating Exchange Rate
 Managed exchange rate regime occurs when the

country’s central bank actively intervenes in the
foreign exchange markets through buying or selling
reserves and its own currency to influence the
movement of the exchange rates in a particular
direction.

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