Economics
Chapter 8
International trade
International trade
Trade:
 Exchange of goods and services
International trade:
 Exchange of goods and services between countries
or regions.
 Example
1. USA and China
 USA sells computer to China
 China sells garment to USA
2. HK and other regions
 exports electronics goods
 Imports rice and cars
International trade
Terms of trade:
 International price
 The quantity of imported goods that can be
exchanged for one unit of exported goods.


Terms of trade =
𝐸𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒
𝐼𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒
Terms of trade index =
𝐸𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥
𝐼𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥
𝑥 100
International trade
Terms of trade:
 Given that:



Country A exports rice ($10 per unit) to Country B.
Country A imports garments ($5 per unit) from Country B.
Terms of trade =
𝐸𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒
𝐼𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒
=
$10
$5
=2

Meaning that for Country A, sales of 1 unit of rice can be
used to buy 2 units of garments

Note that form Country B, terms of trade is the reciprocal of
1
that fro Country A, i.e.
2
International trade
Assume trading among 2 countries only, calculate
terms of trade in the following cases
1.
A exports watches ($180 each) to B
B exports T-shirts ($60 each) to A (i.e. A imports)
Terms of trade for A =
2.
=3
C exports seafood ($135 each) to D
D exports camera ($1080 each) to C
Terms of trade for C =
3.
$180
$60
$135
$1080
=
1
=
8
0.125
E exports TV ($1500 each) to F
F exports furniture ($1500 each) to E
Terms of trade for E =
$1500
$1500
=1
Mutual benefits
Why trading?
If exports /
imports
HK
USA
Trade?
Loss
Loss

Loss
Gain

Gain
Loss

Gain
Gain


Mutual benefits

Free trade benefits both buyers and sellers.

Exporting country will gain from Px > Production cost, PX > PL

Importing country will gain from PM < Production cost, PM < PL
Absolute advantage
Definition



Adam Smith
If a country can produce more Good X than other countries
by using the same amount of resources, then this country
has an absolute advantage in producing Good X.
Given the same input of resources:
Production of
Good X
China
USA
1,000 units
300 units

 China has an absolute advantage in producing Good X

Conversely, USA has an absolute disadvantage.
Absolute advantage

Comparison of same goods among countries.

Determined by productivity.

Technologically advanced
 higher productivity in all good
 absolute advantage

Conversely, low level technology
 low productivity
 absolute disadvantage
Absolute advantage
Each unit of resources can produce:
Good X (units)
Good Y (units)
Country A
85
or
25
Country B
120
or
40
Yes

a. Country B must have more resources.
b. Country B is more technologically advanced.


c. Country B must have a higher total output than Country A.
d.
Country B has an absolute advantage in the production of
both goods.
e.
Country B has an absolute advantage in producing Good X
since each unit of resources can produce more X than Y.
No

∵ Compare the same goods among countries

Case study: Absolute advantage
Suppose Japan and USA both have 2,000 units
of resources.
They use half of their resource (1,000 units) to produce food
and clothes on their own.
Total
resources
(units)
Total production
of food (units)
USA
2,000
5,000
and
6,000
Japan
2,000
4,000
and
8,000
Total output
-
9,000
and
14,000
Total production
of clothes (units)
Case study: Absolute advantage
Each unit of resources can produce:
Food (units)
Clothes (units)
USA
5
or
6
Japan
4
or
8
For each unit of resources

USA produce more food than Japan
 USA has absolute advantage on food
 Japan has absolute disadvantage on food

Japan produce more clothes than USA
 Japan has absolute advantage on clothes
 USA has absolute disadvantage on clothes
Case study: Absolute advantage
Suppose Japan and USA specialize on producing goods
with absolute advantages, i.e.
USA uses all the resources to produce food.
Japan uses all the resources to produce clothes.
Total
resources
(units)
Total production
of food (units)
USA
2,000
10,000
and
0
Japan
2,000
0
and
16,000
Total output
-
10,000
and
16,000
Total output of food and clothes 
Total production
of clothes (units)
Case study: Absolute advantage
Suppose USA exchanges 4,500 units of food for
7,000 units of clothes with Japan.
After international trade:
Total resources
(units)
Total production
of food (units)
Total production of
clothes (units)
USA
2,000
5,500
and
7,000
Japan
2,000
4,500
and
9,000
Total output
-
10,000
and
16,000
Compare with the output before trade:
Total resources
(units)
Total production
of food (units)
Total production of
clothes (units)
USA
2,000
5,000
and
6,000
Japan
2,000
4,000
and
8,000
Total output
-
9,000
and
14,000
Case study: Absolute advantage
Assume that
 Free trade
 No transaction cost
Through international trade

USA gains

500 units of food

1,000 units of clothes

Total output


Japan gains
 500 units of food
 1,000 units of clothes
 1,000 units of food
 2,000 units of clothes
Conclusion
 Specialize in production of goods with absolute advantage
 Through international trade
 Mutual benefits
Comparative advantage
Definition

David Ricardo

A country can produce Good X at a lower opportunity cost
than other countries.
Limitation of the principle of absolute advantage

A technologically advanced country
 Absolute advantage in all goods  Why import???

E.g.

Japan has high level of technology

Absolute advantage in all goods, but still imports from other countries
Comparative advantage
Each unit of resources can produce:
Good X (units)
Good Y (units)
Country A
50
or
25
Country B
10
or
2
Country A has absolute advantage in both Good X and Y.
Comparative advantage
With same unit of resources
Looking at the opportunity cost in Country A:

To produce 50 units of Good X
 give up producing 25 units of Good Y

25
Opportunity cost of producing 1X =
Y = 0.5Y
50

To produce 25 units of Good Y
 give up producing 50 units of Good X

50
Opportunity cost of producing 1Y =
X = 2X
25
Comparative advantage
Convert the table to show the opportunity cost:
Good X (units)
Good Y (units)
Country A
50
or
25
Country B
10
or
2
Good X
Good Y
Country A
25
50
Y = 0.5Y
or
50
25
X = 2X
Country B
2
10
Y = 0.2Y
or
10
2
X = 5X
Table 8.2: Unit costs of producing Good X and Y in Country A and B.
Comparative advantage
Good X
Good Y
Country A
0.5Y
or
2X
Country B
0.2Y
or
5X
Table 8.2: Unit costs of producing Good X and Y in Country A and B.

Country A has a lower opportunity cost in producing Good Y.
Country A has comparative advantage in Good Y.

Country B has lower opportunity cost in producing Good X.
Country B has comparative advantage in Good X.

No country can have a comparative advantage in all goods.

Low opportunity cost in Good X  High opportunity cost in Good Y
Comparative advantage
Textbook p.36
Each unit of resources can produce:
Good X (units)
Good Y (units)
Country A
6,000
or
7,200
Country B
4,000
or
6,000
Good X
Good Y
Country A
7200
6000
Y = 1.2Y
or
6000
7200
X = 0.83X
Country B
6000
4000
Y = 1.5Y
or
4000
6000
X = 0.67X
Table 8.2: Unit costs of producing Good X and Y in Country A and B.
Comparative advantage
Each unit of resources can produce:
Good X (units)
Good Y (units)
Country A
6,000
or
7,200
Country B
4,000
or
6,000
Yes
No

a. Country A has more resources.
b. Country A has an absolute advantage in producing Good X.

c. Country A has a comparative advantage in producing Good X.

d. Country A has a comparative disadvantage in producing Good X.

Country A has a comparative advantage in producing Good X
e. since the opportunity cost of producing Good X is lower than that
of Good Y.

∵ Compare the same goods among countries
Absolute advantage &
Comparative advantage


Absolute advantage:

A country with high productivity (usu.  technology)

Can be all types of goods
Comparative advantage

A country with lower costs in producing a certain kind of goods

Comparatively a certain kinds of goods only
Principle of comparative advantage

1.
If a country
specializes in and exports goods in which it has
a comparative advantage, and
2.
imports goods in which it has comparative disadvantage,
the world’s total output will increase and both countries will benefit.
Principle of comparative advantage

Assumptions

Only 2 countries, Country A and Country B

Only 2 types of goods, Goods X and Goods Y

Amount of goods produced by each unit of resources is fixed

Barter system (exchange of goods)

No transaction cost
Comparative advantage
Good X
Good Y
Country A
0.5Y
or
2X
Country B
0.2Y
or
5X
Table 8.2: Unit costs of producing Good X and Y in Country A and B.
Country A
vs.
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
Lower cost
A should produce Good Y
Lower cost
B should produce Good X
Principle of comparative advantage

Therefore, after specialization:
Country A
Country B
Specialize
production in
Good Y
Good X
Exports
Good Y
Good X
Imports
Good X
Good Y
Comparative advantage
Country A
vs.
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
After specialization (Good X)
Effect on Good X
Effect on Good Y
Country A produces
1 less unit of X
- 1X
+0.5Y
Country B produces
1 more unit of X
+1X
-0.2Y
Total output
Unchanged
+0.3Y
Comparative advantage
Country A
vs.
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
After specialization (Good Y)
Effect on Good X
Effect on Good Y
Country A produces
1 more unit of Y
- 2X
+1Y
Country B produces
1 less unit of Y
+5X
-1Y
Total output
+3X
Unchanged
Potential gain from trade
Potential gain (highest possible gain)

Gain before deducting the cost (transaction cost)
of trade, such as transportation costs

If transaction cost is involved,
Actual gain < Potential gain
Potential gain from trade
After specialization (Good X)
Effect on Good X
Effect on Good Y
Country A produces
1 less unit of X
- 1X
+0.5Y
Country B produces
1 more unit of X
+1X
-0.2Y
Total output
Unchanged
+0.3Y

Cost saved by Country A = 0.5Y

Cost paid by Country B = 0.2Y

World Total cost saving = 0.3Y

Total increase in output = World total cost saving = 0.3Y
Potential gain from trade
From the example:

Countries specialize in producing goods with lower opportunity cost

International trade is mutually beneficial to 2 countries

Potential gain form trade = Cost difference between 2 countries
= 0.3Y

Next questions:

Which country gains more?

Is the gain evenly distributed among 2 countries?
Terms of trade determine
the distribution of gains
Before trade:
Country A
vs.
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
Suppose the terms of trade: 1X = 0.4Y
Country A’s gain from importing 1X
Country B’s gain from exporting 1X
Domestic cost of 1X
0.5Y
Domestic cost of 1X
0.2Y
Import price
0.4Y
Export price
0.4Y
Cost saved
0.1Y
Gain
0.2Y
Trade. Total gain is shared by Country A (0.1Y) & B (0.2Y)
Terms of trade determine
the distribution of gains
Before trade:
Country A
vs.
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
Suppose the terms of trade: 1X = 0.3Y
Country A’s gain from importing 1X
Country B’s gain from exporting 1X
Domestic cost of 1X
0.5Y
Domestic cost of 1X
0.2Y
Import price
0.3Y
Export price
0.3Y
Cost saved
0.2Y
Gain
0.1Y
Trade. Total gain is shared by Country A (0.2Y) & B (0.1Y)
Terms of trade determine
the distribution of gains
Before trade:
Country A
Country B
vs.
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Table 8.3: Unit costs of Country A and B.
Suppose the terms of trade: 1X = 0.1Y
Country A’s gain from importing 1X
Country B’s gain from exporting 1X
Domestic cost of 1X
0.5Y
Domestic cost of 1X
0.2Y
Import price
0.1Y
Export price
0.1Y
Cost saved
0.4Y
Loss
0.1Y
No trade. Country B will lose if trading.
Case study (textbook p.39)
Given the domestic costs:
 Country A: 1Y = 2X and Country B: 1Y = 5X


Opportunity cost
Country A
Country B
Produce 1X
0.5Y
0.2Y
Produce 1Y
2X
5X
Country A exports Good Y, because opportunity cost is lower.
Conversely, Country B exports Good X.
Term of trade
Exports Y
A’s gain
B’gain
1Y = 1X
No trade
-
-
1Y = 2X
Country A
0
3X
1Y = 3X
Country A
1X
2X
1Y = 4X
Country A
2X
1X
1Y = 5X
Country A
3X
0
1Y = 6X
No trade
-
-
Mutual
benefits
Case study (textbook p.39)
Conclusion
 Mutual benefits
 Cost of importers > Terms of trade > Cost of exporters
 If term of trade = Cost of importer



If term of trade = Cost of exporter



Importer’s gain = max. (i.e. potential gain)
Exporter’s gain = 0
If term of trade > cost of importer or term of trade < cost of exporter


Importer’s gain = 0
Exporter’s gain = max. (i.e. potential gain)
No trade
Determination of term of trade
 Depends on the bargaining power of the countries
 E.g. Bilateral trade negotiations bet. USA and China
Conditions for mutually beneficial trade

Each party has a comparative advantage
 Different opportunity costs in producing different goods

Mutual beneficial terms of trade
 Terms of trade lies between domestic costs of both parties
 Cost of importer > Terms of trade > Cost of exporter

Reasonable cost of trade
 Low transaction cost



Transportation
Negotiation
Trade protection policies
Advantages of international trade
Social development


Exchange of products

Native products

E.g. teapots, art-crafts
Cultural interflow

Cultural exchange during communication and negotiation

E.g. Western businessmen learn Chinese culture
Advantages of international trade
Economical aspect
 Comparative advantage
 Lower cost
 Specialization
 More experience and knowledge
 Better use of technology
 Economies of scales
 Specialization allows increasing scale of production
 Thus, lower average cost
 Technological interflow
 Trade enhance technological interflow
 Higher productivity
 Enhancement of competition
 Higher quality of domestic products
 Lower cost to produce domestic products with advanced technology
The effects of exchange rate on
international trade
Think about this:
A Japanese car costs ¥1,500,000
Assume the exchange rate is HKD1 = JPY10
How much should a HK citizen pay for this car in terms of HKD?
 HK$ 1 can be converted into JP¥ 10
  The car costs HK$1,500,000 / 10 = HK$150,000
If HKD depreciates against JPY, what do you think about
the price of the car in terms of HKD?
 If the exchange rate is now HKD1=JPY9,
 The car costs HK$1,500,000 / 9 = HK$166,666.67
The same car, but the price .
 HK people suffer.
The effects of exchange rate on
international trade
Think about this:
Assume you have no special preference towards rice from different
countries. If
 HKD depreciates against AUD, and
 HKD appreciates against THB (Thai Baht).
Which one will you choose? Why?
Depreciation and exports
Suppose garments are exported to Europe.
Price of garment made in HK = HK$100
Exchange rate: HK$100 = €11
Export price = €11
P (€)
HKD depreciation:
Exchange rate: HK$100 = €10
Local price = HK$100
Export price = €10
Price   Qd
(Law of demand)
HK garments
11
10
0
Q1
Q2
That is, quantity demanded of HK garment export increases.
Export
volume
Appreciation and exports
Suppose garments are exported to Europe.
Price of garment made in HK = HK$100
Exchange rate: HK$100 = €11
Export price = €11
P (€)
HKD appreciation:
Exchange rate: HK$100 = €12
Local price = HK$100
Export price = $100 = €12
Price  Qd
(Law of demand)
HK garments
12
11
0
Q2
Q1
That is, quantity demanded of HK garment export decreases.
Export
volume
Depreciation and imports
Suppose watches are imported from Europe.
Price of European watch = €110
P ($)
Exchange rate: HK$100 = €11
Import price = HK$1000
HKD depreciation:
Exchange rate: HK$100 = €10
European watches
1100
1000
Import price = $110 x (100/10) = HK$1100
Price   Qd
(Law of demand)
0
Q2
Q1
Import
volume
That is, quantity demanded of European watches import decreases.
Appreciation and imports
Suppose watches are imported from Europe.
Price of European watch = €110
P ($)
Exchange rate: HK$100 = €11
Import price = HK$1000
European watches
1000
HKD appreciation:
Exchange rate: HK$100 = €12
916.7
Import price = $110 x (100/12) = HK$916.7
0
Price  Qd
(Law of demand)
Q1
Q2
Import
volume
That is, quantity demanded of European watches import increases.
The effects of exchange rate on
international trade
Summary
Exports
Imports
Price
Qd
Price
Qd
Depreciation




Appreciation




Case study in textbook p.46:
Change in revenue which is brought be depreciation or appreciation
depends on the price elasticity of demand.
Try yourself!!!
Trade in Hong Kong
Merchandise trade (Goods)
 Exports




Garments
Electronic products
Toys
Jewellery
(accounted for more than 60% of total domestic exports in 2008)
Trade in Hong Kong
Merchandise trade (Goods)
 Retained imports






Raw materials (e.g. gold, silver)
Semi-finished goods (e.g. LCD display, plastic button)
Capital goods (e.g. truck, machine)
Consumption goods (e.g. clothes, TV)
Fuel
Food
(accounted for more than 99% of total retained imports in 2008)
Trade in Hong Kong
Trade in services
 Exports of services (Exports have higher value than imports)






Financial consultation
Commerce
Accounting
Transportation
Entertainment
Imports of services (Imports have higher value than exports)


Tourism
Insurance
Trade in Hong Kong
Major trading partners
Value
of
goods
Total trade
volume
Import
suppliers
Export
markets
Re-exports
Sources
Destinations
High
The Mainland The Mainland
Low
USA
The Mainland The Mainland
USA
Japan
The Mainland
Japan
USA
Japan
Taiwan
Netherlands
Taiwan
Japan
Taiwan
Korea
UK
Korea
Germany
Trade in Hong Kong
Trade based on comparative advantage
 Low opportunity cost: Exports
 Goods (e.g. garments, electronic products)
 Services

Low opportunity cost: Re-exports

High opportunity cost: Imports
 Goods (e.g. capital goods)
 Services
Importance of trade to Hong Kong’s economy

Acquiring consumption goods and raw
materials
 HK is lack of resources
 Rely on imports
 Hugh demand of daily necessities (e.g. food)
and raw materials (e.g. coal)

Favourable to the development of high valueadded industries


HK has comparative advantage in specializing in
value-added industries
E.g. finance and commercial industrials
Importance of trade to Hong Kong’s economy

Trade generates huge income
 In 2010, GDP = $1,748.1billion

Exports



Value of exports of goods

Imports

Value of imports of goods
= $3,061.3 billion
= $3,395.1 billion
(175.1% of GDP)
(194.2% of GDP)
Value of exports of services

Value of imports of services
= $835.0 billion
= $396.6 billion
(47.8% of GDP)
(22.7% of GDP)
International trade is very important to HK economy
Pros and Cons of free trade

Pros

Consumers
 More choices
 Cheaper and higher quality imported goods

Workers



Businessmen


Open new markets  More profits
Owners of Trading firm


Products can be sold worldwide  More job opportunity
More profits  Higher wages
More business for the company
Service providers (e.g. banks, transportation firms)

More business More income
Pros and Cons of free trade

Cons

Workers
 Keen international competition
 Close down of factories  unemployment
or  less profits  Lower wages

Local famers
 Large quantity imported farm products
 Less sales
 Poor livelihood

Local consumers
 High quality products are for exports
 Buy only low quality products locally