ECON102 Study Guide

Unit 7: International Trade

7a. Compare and contrast and discuss absolute advantage and comparative advantage

  • Define absolute advantage and comparative advantage.
  • Why is trade based comparative rather than absolute advantage?
  • In a simple model of two countries and two goods, does one country always have comparative advantage in one good, while the other has comparative advantage in the other good?
  • Name some goods and services U.S. businesses specializes in and export?
  • Name some goods and services Americans import?

International trade is based on the principle of comparative advantage. Countries specialize in the production of goods and services in which they have a comparative advantage. They export these goods and services to other countries and import the goods and services the other countries produce. The international marketplace has become increasingly robust, as it has become easier and more cost-effective to transport goods and services across great distances.

7b. Explain how the foreign exchange market works, how it reflects changes in the demand for or the supply of a country's currency, and how it relates to a country's net exports

  • How do changes in exports and imports affect net exports?
  • Define the relationship among net exports and aggregate demand.
  • How does international trade affect the equilibrium levels of real GDP and the price level?
  • Define exchange rate.
  • What changes in the foreign exchange market will bring about currency appreciation?
  • What about changes that depreciate the currency?
  • How does a change in the value of a currency affect the country's exports and imports, and therefore, its net exports?

Innovations in communications technologies and transportation have generated increased levels of international trade and globalization. Exports and imports across the globe have increased. Additional factors that have contributed to increased trade include income levels, relative prices, the exchange rate, trade policies, consumer preferences, and technology innovation.

Net Exports = Exports – Imports

Businesses and consumers who want to import goods and services from a foreign country need to purchase a sufficient amount of foreign currency to buy the goods or services they want to import. For example, a Japanese consumer who wants to buy certain American toys and games needs to buy enough U.S. dollars to cover the costs of the purchase.

Businesses, investors, banks, and consumers buy currencies on the foreign exchange market. Like other types of markets, the foreign exchange market is subject to the laws of supply and demand. When Japanese consumers exhibit a strong demand to buy American products and services, the price of the U.S. dollar increases.

The Market for Dollars

The Market for Dollars

A shift of demand and/or supply of dollars will affect the value of the U.S. dollar. For example, a shift of the demand for dollars to the right raises the equilibrium value of the dollar (the dollar will appreciate) and vice versa.

7c. Identify tariffs and quotas in international trade and how they relate to net exports

  • Define tariffs and quotas and explain how they restrict free trade?
  • How do trade restrictions affect each trade partner (importer and exporter), in terms of the price level for the goods subject to the tariff or quota, job availability, and the value of its currency?
  • How do trade restrictions affect final goods and services, when intermediate goods and services are subject to a tariff or quota?
  • How do trade restrictions affect market efficiency?

Free trade generally increases the well-being of both trade-partners since it allows countries to specialize in producing the goods and services in which they have comparative advantage. Nevertheless, policymakers frequently argue against free trade policies and impose trade restrictions, such as tariffs and quotas.

Consumers usually suffer when governments impose tariffs and quotas because foreign businesses pass along any additional fees they must pay for the tariff by increasing prices. Businesses may feel less pressure to make needed improvements to gain a competitive advantage in the global marketplace – since they no longer face competition from foreign companies.

To review how trade barriers such as tariffs and quotas affect international trade, see Net Exports and International FinanceTrade Barriers, and Free Trade.


7d. Explain how comparative advantage relates to the gains from international trade

International trade that operates in a free market benefits all trading partners. Exporting countries are able to sell additional goods and services, increase their economic activity, and promote employment in industries where they enjoy a comparative advantage. Consumers in importing countries have the opportunity to buy a greater variety of goods and services, that cost less than what is available in their own country. International trade allows trading partners to buy and sell goods in a marketplace beyond their own limited borders.

Figure 2.9 Production Possibilities Curves and Trade

Production Possibilities Curves and Trade

Suppose the world consists of two continents: South America and Europe. Both produce two goods: food and computers. We assume each continent has a linear production possibilities curve (panels a and b). South America has a comparative advantage in food production. Europe has a comparative advantage in computer production.

Free trade allows the continents to operate on the bowed-out curve GHI (panel c). If the continents refuse to trade, the world operates inside its respective production possibilities curve.

For example, if each continent produces at the midpoint of its production possibilities curve, the world produces 300 food units and 300 computers at point Q during each period. However, if the world adopts a policy of free trade, so each continent can specialize in the good where it has a comparative advantage, world production can increase to point H. The world produces more food and more computers.

To review the gains from trade, see Applications of the Production Possibilities Model.


7e. Describe the role of international trade in the exchange of currencies

Review the role of international trade in the exchange of currencies in learning outcome 7b above.


Unit 7 Vocabulary

  • Absolute advantage
  • Comparative advantage
  • Currency appreciation
  • Currency depreciation
  • Export
  • Foreign exchange market
  • Free trade
  • Gains from trade
  • International trade
  • Import
  • Net export
  • Net import
  • Opportunity cost
  • Production possibilities curve
  • Quota
  • Tariff
  • Trade restrictions