CHAPTER 2: ABSOLUTE ADVANTAGE

Absolute advantage is the possibility that, due to differences in supply conditions, one country can
produce a product at a lower price than another country.

Autarky Price
Since no trade is involved between Vietnam and Japan
These two prices are known in international economics as autarky prices
Autarky is a situation in which a country has no economic relationships with other countries
Vietnam has an absolute advantage in the production of rice vis-à-vis Japan
Absolute advantage implies a potential pattern of trade
If the two countries forgo autarky and begin to trade
World price of rice will lie somewhere between the two autarky prices, or
PV < PW < PJ

CHAPTER 3: COMPARATIVE ADVANTAGE

Production Posibility Frontier(PPF) depict the combinations of output of two goods (rice and
motorcycles) that the economy (Vietnam or Japan) can produce given its available resources and
technology.

A diagram that illustrates the constraints on production in general equilibrium imposed by scarce
resources and technology.
It shows all the combinations of two goods that a country can produce given its resources and
technology

Comparative Advantage

Opportunity cost
An opportunity cost refers to a benefit that a person could have received, but gave up, to take another
course of action
Ex: a farmer is able to pick 5 apples from an apple tree or 5 oranges from an orange tree but he cannot
pick both → decides to pick apples
Farmer’s opportunity cost is the five oranges he cannot pick
Opportunity costs are used to measure the differences in returns between a chosen investment and one
that is forgone
Ex: a person invests in a stock that returns a paltry 2% over the year; gives up the opportunity to invest
in risk-free government bond yielding 6%
The opportunity cost is 4%, or 6% - 2%
Production Possibilities Frontier
 In a system of freely operating markets and full employment of production factors,
opportunity costs are fully reflected in relative prices
 The slope of a PPF where demand diagonal crosses it is the relative price of rice, or
 This is shown in Figure 3.3 by drawing the tangent lines to the PPFs at the point where
the demand lines cross them, points A
 Points A in the two PPFs in Figures 3.3 represent two countries under autarky.
Relative Prices in Vietnam and Japan under Autarky

Autarky and Comparative Advantage

 The tangency line giving relative prices is flatter in Vietnam than in Japan
 The opportunity cost of rice is lower in Vietnam than in Japan
 In other words, under autarky,
 Or, the relative price of rice is lower in Vietnam than in Japan
 What we have here is an expression of the pattern of comparative advantage
 Differences in economy-wide supply conditions cause differences in relative autarky
prices and hence a pattern of comparative advantage
 Note that comparative advantage involves four prices rather than two prices as in absolute
advantage
 Consequently, a country can have comparative advantage in a good in which it has an
absolute disadvantage

CHAPTER 4: INTRA-INDUSTRY TRADE

Inter-industry - Either imports or exports in a given sector of the economy. The source of Inter-industry
is Comparative advantage.
Horizontal intra-industry - Both imports and exports in a given sector of the economy at the same stage
of processing. The source of Horizontal intra-industry is Product differention.
Vertical intra-industry - Both imports and exports in a given sector of the economy at different stages of
processing. The source of Vertical intra-industry is Fragmentation.
Global Patterns of Intra-Industry Trade
Fragmentation is the use of different suppliers and component manufacturers in the production of a
good.
Approximately one third of world trade takes place as intra-industry trade
Especially prominent in manufactured goods among the developed or high-income countries of the
world
Probably accounts for up to 70% of trade
Globally, intra-industry trade is becoming more important over time, particularly in Asia.
The increasing extent of intra-industry trade in world trading system has some important implications
for the adjustment of economies to increasing trade
Increases in inter-industry trade based on absolute or comparative advantage involve import sectors
contracting and export sectors expanding
Requires that productive resources, most notably workers, shift from contracting to expanding sectors
in order to avoid unemployment → workers in Vietnam should shift from motorcycle to rice; workers in
Japan should shift from rice to motorcycle industry
The adjustment process in the case of intra-industry trade is very different
A given sector experiences increases in imports and exports simultaneously
Horizontal intra-industry trade - workers in the U.S. cheese sector can adjust to the expansion of
imports of cheese by expanding exports of a different cheese variety
Vertical intra-industry trade - workers in a computer sector might need to shift from producing both
computer components and final, assembled computers to just producing certain components

Intra-Industry Trade under Monopolistic Competition

Imperfect competition – Monopolistic competition
How can a monopoly be competitive?
The model borrows one feature from monopoly and another from perfect competition
Monopolistically competitive firm faces a downward-sloping demand curve
The monopolistically competitive firm produces a differentiated good → the good is differentiated in
the sense that it is slightly different from those of other firms in the industry/sector
All firms have the same, relatively low degree of market power; they are all price makers
The competition feature is that there is free entry and exit of firms from the sector in the long run →
there can be no long-run economic profits; but
Characterizes an industry in which many firms offer products or services that are similar, but not perfect
substitutes
For ex: restaurants, hair salons, clothing and consumer electronics
Because the products all serve the same purpose, there are relatively few options for sellers to
differentiate their offerings from other firms‘ → there might be "discount" varieties
Economies of scale:
Under economies of scale, average costs fall as a firm’s output increases

AC – average cost; MC – marginal cost; q – quantity of output

The marginal cost of production is the change in total cost that comes from making or producing one
additional item
If an average is falling, the marginal must be below it
For simplicity we assume that MC curve is constant
Centerpiece of the revenue side is the firms demand curve (d)
Due to the range of similar offerings, demand is highly elastic in monopolistic competition
Demand is very responsive to price changes → If your favorite multipurpose surface cleaner suddenly
costs 20% more, you probably won't hesitate to switch to an alternative
Marginal Revenue (MR) curve is steeper because whenever the firm increases its output, the price (P)
falls
In the short run, firms can make excess economic profits
Because barriers to entry are low, other firms have an incentive to enter the market, increasing the
competition, until overall economic profit is zero

Long-run equilibrium in the monopolistically competitive sector/industry

Firms must be maximizing profits → they choose output where marginal revenue equals marginal cost
(MR = MC)
Long run entry and exit of firms ensures that economic profits are zero or that price equals average
costs (P = AC)
The main effect of the international trade is to expand the market in which our firm is competing
Our particular firm is competing with a larger set of differentiated products → demand curve becomes
flatter
Flatter demand curve that trade brings carries along with it a flatter MR curve
The individual firm’s profit-maximizing output increase from qA to qT
Higher profit-maximizing level of output also involves a fall in the price PA to PT
All remaining firms have lowered their price is the result of increased competitive pressure
This increased competitive pressure involves some firms exiting from the sector
The number of firms in the sector is lower as a result of trade, but the number of available varieties is
higher as a result of trade, with more varieties being available from abroad
Gains from trade:
Prices are lower, quantities are higher
Households have access to a larger variety of goods, which has value in and of itself

Economies of Scale and Economy of Scope

Economies of scale is the cost advantage that arises with increased output of a product. Economies of
scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs;
i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs
are spread out over a larger number of goods.
Economies of scope is an economic theory stating that the average total cost of production decreases as
a result of increasing the number of different goods produced. For example, McDonald's can produce
both hamburgers and French fries at a lower average expense than what it would cost two separate
firms to produce each of the goods separately. This is because McDonald's hamburgers and French fries
are able to share the use of food storage, preparation facilities and so forth during production.

CHAPTER 5: THE POLITICAL ECONOMY OF TRADE

The Market for Protection

The market for protection approach emphasizes the supply-side and demand-side factors affecting
actual protection levels.
The supply of protection is provided by national governments.
The demand for protection can take place through a variety of mechanisms suggested in Table 5.1.

Focus Name Insight

Country-based Realism There are security externalities associated with

international trade.

Country-based Institutionalism Institutional structures within country governments

affect trade policies.

Factor-based Heckscher-Ohlin model Under factor mobility within a country, different

Stolper Samuelson theorem factors can win or lose from trade.

Sector-based Specific factors model With sector-specific factors, winning/losing depends

on export/import factor specificity.

Firm-based Firm-based Trade exposure of firms can influence their posture

to trade liberalization

Heckscher-Ohlin Model
A country exports the good whose production is intensive in its abundant factor. It imports the good
whose production is intensive in its scarce factor.
For instance, Vietnam’s comparative advantage in rice causes an increase in the output of rice at the
expense of motorcycles
Results in an increase in demand for land and a decrease in demand for physical capital
Vietnamese land owners gain from trade, while Vietnamese capital owners (capitalists) lose from trade
Japan’s comparative advantage in motorcycles causes an increase in the output of motorcycles at the
expense of rice
Results in an increase in demand for physical capital and a decrease in demand for land
Japanese capital owners gain from trade and Japanese land owners lose from trade
Would expect that land owners in Vietnam and capital owners in Japan would support trade
Political opposition to trade would come from capital owners in Vietnam and land owners in Japan
Thus, strong and persistent opposition to rice imports in Japan
Due in part to political clout of Japanese land owners
However, it is not “economic security and culture” that explains the opposition but income loss

The Heckscher Ohlin Model and the Stolper-Samuelson Theorem

When moving from autarky to trade, the country’s abundant factor of production (used intensively in
the export sector) gains, while the country’s scarce factor of production (used intensively in the
import sector) loses
The Stolper-Samuelson theorem cannot be applied blindly
Applies only to trade based on different endowments in factors of production (inter-industry trade)
Trade based on differences in technology can mitigate effects described by theorem
Technological considerations arise in the application of the theorem to the issue of North-South trade
and wages

Exercise(will be on exam)
Consider the trade between Germany and the Dominican Republic. Germany is a capital-abundant
country, and the Dominican Republic is a labor-abundant country.
There are two goods: a capital-intensive good – chemicals, and a labor intensive good – clothing
 1. Draw a comparative advantage diagram such as Figure 5.1 for trade between Germany and the
Dominican Republic, labeling the trade flows along the axes of your diagrams
2. Using the Stolper-Samuelson theorem, describe who will support and who will oppose trade in
these two countries. Use a flow chart diagram like that of Figure 5.2 to help you in your
description

Figure 5.1:

The Role of Specific Factors

Central assumption of Heckscher-Ohlin model and Stolper-Samuelson theorem
Resources or factors of production such as labor, physical capital, and land can move effortlessly among
different sectors of trading economies
For example, Japanese resources are assumed to be able to shift back and forth between rice and
motorcycle production
For some types of analysis (particularly that applying to the long run) assumption is reasonable
However, sometimes assumption can be contrary with reality
Factors of production can be sector specific or specific factors and not easily move from one sector to
another
Requires a modification of the Stolper-Samuelson theorem
For example—steel production in United States
United States is relatively abundant in physical capital
Theorem suggests capital owners in United States would gain as a result of increased trade
But in 2000 US-based Weirton Steel Corporation drew attention to what it called an “import crisis” and
pledged to fight the “import war”
Why would capitalists in a capital abundant country oppose increased trade in violation of Stolper-
Samuelson theorem?
Weirton Steel Corporation and other US steel firms own large amounts of specific factors (steel mills)
which are specific to steel production
Cannot move into the production of other products such as semiconductors → they are specific to the
production of steel
Need to modify the Stolper-Samuelson theorem to adjust for specific factors
Factors of production that are specific to import (export) sectors tend to lose (gain) as a result of trade
Weirton is in an import sector characterized by sector-specific physical capital (and perhaps even labor)
and stands to lose as a result of increased trade

 Keep the difference between specific and mobile factors in mind when assessing politics of
trade
 Mobile factors of production
 Stolper-Samuelson theorem applies
  Abundant factor of production (used intensively in the export sector)
gains
 Scarce factor of production (used intensively in the import sector) loses
 Specific factors of production
 Stolper-Samuelson theorem does not apply
 Factor of production specific to the export sector gains
 Factor of production specific to the import sector loses
 Fate of mobile factors is uncertain
Exercise
 In the early 1800s in England, a debate arose in Parliament over the Corn Laws, restriction on
imports of grain into the country. David Ricardo, the father of the comparative advantage
concept, favored the repeal of these import restrictions.
 Consider the two relevant political groups in England at that time: land owners and capital
owners. Who do you think agreed with Ricardo? Why?

CHAPTER 9

Category Mode Characteristics

Domestic None Purely domestic firm supplying home market

Exporting Indirect Exporting Another firm acts as sales agent

Exporting Direct Exporting Firm completes export transaction itself

Contractual Licensing License to foreign firm to produce abroad (including

logos, trademarks, designs, and branding)

Contractual Franchising License with conditions to ensure consistency

Contractual Subcontracting Contract with materials and specifications

Investment Joint Venture Jointly owned separate firm

Investment Mergers and Acquisitions Purchase of part or whole of foreign firm

Investment Greenfield Brand-new production facility

Contractual
 Licensing
 The home-country firm licenses a foreign firm to allow it to use the home-country firm’s
production process (including logos, trademarks, designs, and branding)in the foreign
country. In return, the foreign firm would pay royalties to the home-country firm
 Franchising
 The home-country firm licenses a foreign firm to allow it to use the home-country firm’s
production process in the foreign country but exerts more control over production and
marketing to ensure consistency across foreign markets
 Subcontracting
 The home-country firm contracts with a foreign firm to produce a product to certain
specifications

Investment
 Joint venture (JV)
 The home-country firm establishes a separate firm in the foreign country that is jointly-
owned with a foreign-country firm
 Mergers and acquisitions (M&A)
 The home-country firm buys part (merger) or all (acquisition) of the shares of an
already-existing production facility in the foreign country. ¾ of FDI is of the M&A form.
 Greenfield investment
 The home-country firm establishes a brand-new production facility in the foreign
country that it fully owns

Motivation for International Production

 Resource seeking
 Gaining access to natural resources or human resources
 Market seeking
 Locating near expected market growth, to better adapt a product to local needs, and to
supply intermediate inputs to another firm
 Efficiency seeking
 Rationalize the established structure of international production for economies of scale
and scope
 Strategic asset seeking
 Part of a strategic game among global competitors in oligopolistic sectors

Entry Mode Choice

 Economic view
  A firm will chose the entry mode that will provide it with the greatest risk-adjusted or
expected return on the entry investment
 Entry mode choice factors include
 Degree of control
 Level of resource commitment
 Dissemination risk
 Dissemination risk
 the possibility of a foreign partner firm obtaining technology or other know-how from
the home-country firm and exploiting it for its own commercial advantage
Entry Mode Choice
 If a firm’s most important concern was
 Degree of control over the production and marketing process
 Lead the firm towards an investment mode of foreign market entry based on a
subsidiary obtained either through greenfield or acquisition investment
 Limiting resource commitment to low levels
 Consider either trade or contractual modes of foreign market entry
 Low degree of dissemination risk
 Either trade or investment via a subsidiary would be the preferred mode of
entry
 In most instances, firms have more than one primary concern

Acquisition of an Existing Business

Advantages:
Quick entry into an industry
Barriers to entry avoided
Access to complementary resources and capabilities
Disadvantages:
Cost of acquisition—whether to pay a premium for a successful firm or seek a bargain in struggling firm
Underestimating costs for integrating acquired firm
Overestimating the acquisition’s potential to deliver added shareholder value

Internal Development: Organic Growth

Advantages:
Avoids pitfalls and uncertain costs of acquisition.
Allows entry into a new or emerging industry where there are no available acquisition candidates.
Disadvantages:
Must overcome industry entry barriers.
Requires extensive investments in developing production capacities and competitive capabilities.
May fail due to internal organizational resistance to change and innovation.
International Strategies
Simple export – a concentration of activities (particularly manufacturing) in one country, typically the
country of the organization’s origin; Marketing of the exported goods is very loosely coordinated
overseas, perhaps handled by independent sales agents
This strategy is chosen by the companies with a strong locational advantage
Some companies have insufficient international marketing capabilities or when the coordinated
marketing add little value
Multidomestic – loosely coordinated internationally, but involves a dispersion overseas of various
activities
Instead of export, goods and services are produced locally in each national market
Each market is treated independently
This strategy is appropriate where there are few economies of scale and strong benefits to adapting
to local needs.
Complex export – involves the location of most activities in a single country, but builds on more
coordinated marketing
Economies of scale for manufacturing and R&D but branding and pricing strategies are more
systematically managed
Especially good for companies from emerging countries → retain some locational advantages but seek
to build a stronger brand and network overseas
Global strategy – describes the most mature international strategy, with highly coordinated activities
dispersed geographically around the world
Geographical location is chosen according to the specific locational advantages for each activity, but
costs of coordination increase

Market Entry Modes: Exporting

Market Entry Modes: Foreign direct investment

Market Entry Modes: Joint ventures and allies

Market Entry Modes: Licensing

CHAPTER 10: FOREIGN DIRECT INVESTMENT AND INTRA-FIRM TRADE
A value chain is a series of value-added processes involved in the production of any good or service
Consider a semiconductor value chain:
- Research, development and design leading up to details of the physical circuitry of the chip to be
placed on the silicon
- Fabrication (or just fab in semiconductor jargon) in an advanced manufacturing process in which
circuitry layouts are etched onto silicon wafers containing many die
- Assembly and testing in which the die are cut from wafers and mounted or packaged into a functioning
device with wire contacts and insulation
- Final incorporation in which the semiconductor is incorporated into the final piece of equipment such
as a personal computer or mobile phone

Primary Activities and Costs: Supply Chain Management -> Operations -> Distribution -> Sales and
Marketing -> Service -> Profit Margin

Support Activities and Costs:

1.Product R&D, Technology and Systems Development
2. Human Resource Management
3. General Administration
CHAPTER 14: EXCHANGE RATES AND PURCHASING POWER PARITY
The Nominal Exchange Rate
Relative price of two currencies
Often expressed as number of units of local or home currency required to buy a unit of foreign currency
We will usually view Mexico (peso) as our home country and United States (dollar) as our foreign
country
Nominal or currency exchange rate (e) is defined as
e = peso/dollar
Or
e = home currency/foreign currency

 If e increases the value of the peso (home currency) falls

 If e decreases the value of the peso (home currency) rises
 Since e and the value of the peso are inversely related, e is often graphed as its inverse which is
equal to the value of the peso
 It is important when looking at exchange rate data to be aware of which country is the home
country

The Effective Exchange Rate

In most cases, a country has significant economic relationships with more than one foreign country, so
more than one nominal exchange rate becomes relevant
This leads us to consider the effective exchange rate or trade-weighted nominal exchange rates
Consider Mexico with two trade partners: the United States and the European Union

e(eff) = a(US)*e(dollar) + a(EU)*e(euro)

Real Exchange Rate

Measures the rate at which two countries’ goods trade against each other
Makes use of the price levels in the two countries under consideration
P(M)—overall price level in Mexico (the home country)
P(US)—overall price level in the United States (the foreign country)

re = e x P(US)/P(M)
re = e x P(foreign)/P(home)
Change Intuition Effect in “re” equation

PUS increases US goods increase in price. Therefore, it Because it is in the numerator,

takes more Mexican goods to buy a unit of the increase in PUS increases
US goods. The real value of the peso has the value of re.
fallen.

PM increases Mexican goods increase in price. Because it is in the

Therefore, it takes fewer Mexican goods denominator, the increase in
to buy a unit of US goods. The real value of PM decreases the value of re.
the peso has risen.
e increases It takes more Mexican pesos to buy US The increase in increases the
dollars. The real value of the peso has value of re.
fallen.

Real Effective Exchange Rate

Just as there is an effective exchange rate for the nominal exchange rate, so is there a real effective
exchange rate (REER) for the real exchange rate

re(eff) = a(US)*re(dollar) + a(EU)*re(euro)

Purchasing Power Parity

Begins with the hypothesis that the nominal exchange rate will adjust so that the purchasing power of a
currency will be the same in every country
The purchasing power of a currency in a given country is inversely related to price level in that country
Therefore, the PPP hypothesis can be stated as

1/P(M) = 1/e * 1/P(US)

Hedging

 Foreign exchange derivates are financial instruments that have the effect of “locking in” a
forward exchange rate
 How can they play a role in hedging exchange rate exposure?
 Consider this using the forward rate
 If the forward rate of the euro (€/US$) is the same as the spot rate, the euro is said to
be “flat”
 If the forward rate of the euro is above the spot rate, the euro is said to be at a “forward
discount”
 Finally, if the forward rate of the euro is below the spot rate, the euro is said to be at a
“forward premium”
 Suppose that we begin with the exchange rate (€/US$) being 1.00 and that a US firm is
expecting euro revenues of €1.0 million in six month’s time
 Suppose that the euro is at a six-month forward discount of 1.11.
 The US firm could take out a forward contract and, at that future time, convert the euro
revenue into $900,900 of dollar revenue.
 Would this be a smart move?
 If the firm knew with certainty that the future spot rate were to be 1.25, it would be
 With the forward contract, the firm would earn $900,900 rather than $800,000.
 If the future spot rate were actually to be below 1.11, though, it would not be
 The firm could have earned more than $900,900 without the forward contract
 Thus hedging exchange rate exposure requires that firms have expectations or forecasts of
future spot rates

The Monetary Approach to Exchange Rate Determination

  There is an approach to monetary theory known as monetarism
 This concerns the quantity theory of money based on the equation of exchange
MV = Py
 Here, M is the money stock, V is the velocity of money, P is the overall price level and y is real
GDP
 Monetarists add two assumptions to this equation
 V is stable (slowly changing)
 y is determined by the supply side (slowly changing)

CAPACITY PLANNING

Capacity is the amount of work that can be done in a specified time period
The capability of a worker, machine, work center, plant, or organization to produce output per time
period.
Capacity available is the capacity of a system or resource to produce a quantity of output in a given time
period
Capacity required is the capacity of a system or resource needed to produce a desired output in a given
time period

Formulas:
Available time = Number of equipments * Hours per day * Total Working Days
Rated Capacity = Available Time * Utilization * Efficiency
Efficiency = Actual rate of production/Standard rate of production * 100%
Utilization = hours actually worked/available hours * 100%

PRODUCTION PLANNING SYSTEM

3 basic strategies used in developing a production plan:

 Chase strategy
 Production levelling
 Subcontracting

Chase (demand matching) Strategy

 Varying production rates to meet changes in demand → inventory levels remain stable while
production varies to meet demand
 For ex: Farmers must produce in growing season, restaurants prepare meal when the customer
wants → these industries cannot stockpile or inventory their products
 They must capable of meeting demand as it occurs
 Company must have enough capacity to meet the peak demand
 Hiring and training people during the peak period and lay them off when the peak is past →
extra shifts and overtime. These changes add cost.
 Inventories can be kept to a minimum, goods are not stockpiled, costs for carrying inventories
are avoided
 Often used when resources are flexible and inexpensive to change

Production levelling
  Continually producing an amount equal to the average demand → calculating total demand
and on the average, producing enough to meet it
 Demand is low → inventory builds up
 Often used when resources difficult or very expensive to change

Advantages:
 smooth level of operation
 no cost of change
 no need for excess capacity to meet peak demand
 No need to hire and train workers and lay them off in slack periods → stable work force

Subcontracting
 Always producing at the level of minimum demand and meeting any additional demand through
subcontracting
 Major advantage is cost → costs associated with excess capacity are avoided, and there are no
change costs as the production is levelled.

 Disadvantage: cost of purchasing (item cost, purchasing, transportation, and inspection costs)
may be greater than if the item were made in the plant
 Firms manufacture → confidentiality, to maintain quality, and to maintain workforce
 Supplier can have special expertise in design and manufacture of a component

Level production plan

1. Total the forecast demand for the planning horizon
2. Determine the opening inventory and the desired ending inventory
3. Calculate the total production required as follows:
Total production=total forecast + back orders + ending inventory – opening inventory
4. Calculate the production required each period → total production divided by the number of
periods
5. Calculate the ending inventory for each period
Level production plan → Example
 Amalgamated Fish Sinkers want to develop production plan
 Expected opening inventory is 100 cases and they want to reduce it to 80 cases by the end of
the planning period
 Number of working days is the same for each period, no back orders
Ending inventories for each period:

c. Total cost of carrying inventory:

(106 + 102 + 88 + 84 + 80)x($5) = $2300
d. No stockouts and no changes in the level of production → $2300 is the total cost of the plan
 Opening inventory is 100, but the company wishes to bring this down to 80 cases.
 Assume the production before the period 1 was 100 cases
 The production in the first period would then be:
110 – (100 – 80) = 90 cases
  Cost of changing production level:
60 x $20 = $1200
 Cost of carrying inventory:
80 cases x 5 periods x $5 = $2000
 Total cost of the plan:
$1200 + $2000 = $3200