International Economics

Question 1

What is the difference between absolute advantage and comparative advantage?

Answer 1

A country has an absolute advantage if it is more efficient than other countries at producing some particular good

A country has a comparative advantage if it is more efficient at producing some particular good than producing some other good

Question 2

What is another way of stating the notion of comparative advantage?

Answer 2

A country has a comparative advantage in producing a good if, when compared to another country, the opportunity cost of producing it is less than the opportunity cost of producing other goods

Question 3

How is comparative advantage significant for international trade?

Answer 3

There will be greater total productivity and wealth if countries produce according to their comparative advantage and trade with other countries, even if they do not have an absolute advantage in anything

Question 4

What is an example of a country having a comparative advantage in producing some good?

Answer 4

Japan can produce 50 TVs with 5 units of input and 40 bushels of rice with 8 units of input

• China can produce 64 TVs with 8 units of input and 60 bushels of rice with 10 units of input
• Therefore, Japan can produce 10 TVs per input and 5 bushels of rice per input; China can produce 8 TVs per input and 6 bushels of rice per input

Opportunity cost of producing rice:
Japan – 2 TVs (10/5) per bushel of rice
China – 4/3 TVs (8/6) per bushel of rice

Opportunity cost of producing TVs:
Japan – 1/2 bushel of rice (5/10) per TV
China – 3/4 bushel of rice (6/8) per TV

Japan has lower opportunity cost of producing TVs, while China has lower opportunity cost of producing rice, so Japan should entirely produce TVs and China should entirely produce rice in order to maximize total productivity

Question 5

What is the Heckscher-Ohlin theory?

Answer 5

Seeks to explain why different countries or regions have different levels of efficiency in producing various goods – attributes these differences to the endowment of the factors of production

Question 6

What are some classifications of the factors of production?

Answer 6

(1) geographical conditions (land)
(2) climatic conditions (weather)
(3) human capacities (labor)
(4) capital accumulation
(5) proportions of resources
(6) political and social environment
(7) technology

Question 7

What are some assumptions of the Heckscher-Ohlin theory?

Answer 7

(1) a given product always requires the same input
(2) technology, if available anywhere, is globally available
(3) costs of transportation are minimal
(4) differences in consumer taste are minimal

Question 8

What is generally postulated by the Heckscher-Ohlin theory?

Answer 8

Countries tend to import what they have comparative disadvantages in and export what they have comparative advantages in – thus countries with significant capital will export more capital-intensive goods and import more land- and labor-intensive goods

Question 9

What is the Leontief paradox?

Answer 9

An empirical finding by Wassily Leontief that contradicted the Heckscher-Ohlin theory of international trade – it found that countries with a high capital accumulation actually tend to import more capital-intensive goods than they export

Question 10

What are some examples of capital-intensive, labor-intensive, and land-intensive goods?

Answer 10

Capital-intensive = oil production

Labor-intensive = service industries, like hotels

Land-intensive = farming

Question 11

What is the first mover theory?

Answer 11

Holds that the first firm to enter a given market has the best chance for immediately growing (economies of scale) and establishing itself, making it much more difficult for later competitors

Question 12

What is the Linder theory of overlapping demand?

Answer 12

Explains international trade as not only due to factor endowment (for raw materials) but also due to similar preferences/demand between countries (for manufactured goods)

Moreover, since consumer taste depends on income, a country’s per-capita income influences its demand, though not necessarily the direction of trade – so countries with similar per-capita income will be more willing to trade with each other, having similar preferences

Question 13

What do trade barriers generally accomplish?

Answer 13

They keep resources in domestic industries (which the barriers are designed to protect from competition) but thereby keep those resources from being used more efficiently elsewhere

GATT (General Agreement on Tariffs and Trade) is an example of an international agreement to reduce trade barriers

Question 14

What is one difficulty in evidences supporting free trade over against trade barriers?

Answer 14

The costs are more obvious and concentrated (e.g. factories closing down), while the benefits tend to be smaller and more scattered

Question 15

How might other countries’ economic conditions provide reasons for trade barriers?

Answer 15

Some countries exporting goods might have unsafe or unconscionable economic conditions (e.g. no health care or safety standards) that potential importing-countries would not want to abet – or the unsafe conditions might make a product unsafe for the importing country

Question 16

What are reasons related to self-sufficiency in favor of trade barriers?

Answer 16

(1) There may be economic risks (possible strikes) or political risks (gov’t upheaval) in other countries such that other countries would not want to be dependent on that country for trade
(2) The very fact of self-sufficiency can be a point of pride for a nation, not needing to lean on others for support
(3) Increased transportation costs and risks for international transportation (e.g. hurricanes) can favor domestic production

Question 17

How might infant industries provide reasons for trade barriers?

Answer 17

A domestic industry might have a comparative advantage in the long run but not the short run, and thus need extra protection early on to overcome the initial hardships of its infancy

Question 18

How might cheap foreign labor provide reasons for trade barriers?

Answer 18

If other countries have laborers willing to work for very, very little – due to no minimum wage laws and/or lower standards of living – products from those countries could be artificially cheaper than products produced domestically with more expensive labor

Then, since a country ought to favor its own laborers over others’, trade barriers might be put in place to encourage the purchase of products produced through domestic labor

Question 19

What are some unintended negative consequences of trade barriers?

Answer 19

They can cause

• reduced overall domestic imports
• countervailing tariffs by the foreign country
• smuggling

Question 20

What is the difference between an import quota and a tariff?

Answer 20

Both are trade barriers, but:

• import quotas reduce only the amount of imports
• tariffs do not affect the amount of imports, but charge a tax that effectively increases their price in the importing country

Question 21

What are different ways a government can incentivize exports?

Answer 21

Directly, gov’ts can give subsidies to companies that produce goods for exporting, e.g. giving subsidies directly to the company

Indirectly, gov’ts can give subsidies or tax breaks, e.g. having lower taxes on export-related income

Question 22

What are two ways to reduce reliance on imported goods?

Answer 22

(1) substitution = developing products domestically that accomplish the same function as imported goods (e.g. hydraulic energy rather than oil)
(2) domestic content quotas = encouraging (indirectly) or requiring (directly) the production of a various number of goods that would otherwise be imported

Question 23

What is the European Union (EU)?

Answer 23

A federal of European nations with the objectives:

(1) to establish Europe-wide citizenship
(2) to ensure justice, security, and freedom
(3) to foster progress socially and economically
(4) to establish a role for Europe within the world

Question 24

What is the European Monetary Union (EMU)?

Answer 24

The part of the EU which all uses the euro as its currency

Question 25

What is the North American Free Trade Agreement (NAFTA)?

Answer 25

An agreement from 1994 among the U.S., Canada, and Mexico to gradually reduce trade barriers

Its goal of integration is not as ambitious as the EU

Question 26

What is the Central American-Dominican Republic Free Trade Agreement (CAFTA-DR)?

Answer 26

Reduces trade barriers between the U.S. and El Salvador, Guatemala, Honduras, Costa Rica, Nicaragua, and the Dominican Republic

Originally it was just with central America (and just called CAFTA), but the Dominican Republic entered the agreement in 2004

Question 27

What is an exchange rate?

Answer 27

The rate at which one currency can be purchased with another currency

This rate is needed if trade within a given area is not done with one common currency

Question 28

What is the difference between a floating exchange rate and a fixed exchange rate?

Answer 28

Floating = determined by the supply and demand of the free market for the currency

Fixed = the gov’t sets the exchange rate

Question 29

What occurs if the gov’t fixes an exchange rate above or below what the rate would naturally float to (i.e. the market/equilibrium price of the currency)?

Answer 29

It would have the same effect as price floors or price ceilings for other goods – a rate that is fixed higher than the equilibrium rate would yield a surplus, while a rate fixed lower than it would yield a shortage

Question 30

What is a managed float?

Answer 30

A mix of floating and fixed exchange rates – the rate mostly floats, but the gov’t fixes it sometimes to provide stability

Question 31

What is the difference between the spot rate and the forward rate?

Answer 31

(1) spot = the rate to purchase currency in the present (“on the spot”)
(2) forward = the rate to agree to purchase currency at some point in the future

If forward rate > spot rate, the difference is a premium; otherwise it is a discount

Question 32

What causes discounts or premiums for forward rates?

Answer 32

They are based on the (real) interest rates paid by domestic and foreign banks, which are themselves based on the expected inflation occurring between the countries

Thus, discounts and premiums (predictably) are based on the future purchasing power of the currencies – whether they will increase or decrease

Question 33

How and why do the interest rates paid by domestic and foreign banks relate to discounts or premiums on forward rates?

Answer 33

How: if domestic banks pay a higher interest rate, the forward rate will sell at a premium; otherwise it sells at a discount

Why: If the market is behaving properly, the investor would have to get the same overall amount whether (a) he gains interest on domestic currency and has a forward contract to convert it to foreign currency later or (b) he converts to foreign currency now and then gains interest on that foreign currency

Question 34

How do you calculate the effect of inflation on an exchange rate?

Answer 34

The difference in inflation between the currencies, added to or subtracted from 1, is the percentage by which the exchange rate is changed

Question 35

What is an example of inflation altering the exchange rate?

Answer 35

At Jan. 1, the euro trades for 1.5 USD. The euro experiences 8% inflation and the USD experiences 6% inflation over the year.

Difference in inflation = 2%
Year-end exchange rate = (1 - .02) x 1.5 USD per euro = 1.47 USD per euro

The euro inflated more and so became weaker in relation to the USD; it now purchases less USD than before

Question 36

What are different ways to avoid foreign currency risk?

Answer 36

(1) having fewer receivables or liabilities in foreign currency – but this may limit foreign trade itself
(2) balancing foreign receivables and liabilities – though this requires a large foreign presence
(3) bartering, i.e. contracting without currency, just with goods themselves
(4) foreign currency hedges

Question 37

How do foreign currency hedges guard against foreign currency risk?

Answer 37

If a firm fears the domestic currency might depreciate in value (e.g. if it has liabilities in a foreign currency), then it could buy forward contracts which benefit from an appreciation in the foreign currency to offset the risk

Likewise, if the fear is that the foreign currency might depreciate in value (e.g. if the firm has receivables in that currency), then it could sell forward contracts which benefit from a depreciation in the foreign currency

Question 38

What are different risks in managing foreign operations rather than domestic operations?

Answer 38

Besides the currency/exchange risk, there is

(1) “sovereignty risk,” where a foreign gov’t could nationalize the foreign business, or establish a monopoly that illegalizes the foreign business, or place some other restriction
(2) the risk of double taxation from both the foreign and domestic gov’t
(3) the risk that trade secrets or copyrights could be leaked or unprotected

Question 39

What are different ways that companies can establish a foreign presence?

Answer 39

(1) contracting with an independent person to serve as a sales rep in the foreign country
(2) opening a branch of the company
(3) establishing a foreign subsidiary

Question 40

What are the pros and cons of having an independent foreign representative?

Answer 40

It results in smaller risk, as only inventory, at most, is at risk, but also minimal control

Question 41

What are the pros and cons of having a branch of the company (either sales or manufacturing) in a foreign country?

Answer 41

It involves greater control, but also greater responsibilities (e.g. dealing with foreign labor laws and income taxes) – also may be difficult to manage from abroad due to cultural differences

Question 42

What are the pros and cons of having a foreign subsidiary?

Answer 42

(i) since the sub would have its own production, sales, and (sometimes) financing, it would not involve imports
(ii) since it is more independent, there would be less need for constant management from abroad
(iii) yet the investment would be very expensive, possibly involving a duplication of the domestic company
(iv) also, the foreign country could place limitations on foreign ownership of subsidiaries in their country

Question 43

What are the general pros and cons of multinational corporations (MNCs)?

Answer 43

Pros: MNCs claim…

(i) to support free trade
(ii) to improve the international monetary system
(iii) to advance cultural tolerance

Cons:

(i) due to their enormity they can be difficult to manage
(ii) they have more power to cover up shady practices

Question 44

What advantages and disadvantages do MNCs provide for the home country?

Answer 44

Advantages: MNC profits improve the balance of payments for the home country, and support local philanthropic causes much more than foreign ones
-MNCs may also be more adept at acquiring scarce resources

Disadvantages: MNCs can reduce domestic investment, including employment and tax revenues

Question 45

What advantages and disadvantages do MNCs provide for the host/foreign country?

Answer 45

Advantages: MNCs can invest more in the host countries, giving them greater employment and technology, better living standards, and more tax revenue

Disadvantages: MNCs can avoid paying taxes to the host country through transfer pricing (transferring income to the company’s other branches), and can defeat local competitors – moreover, the MNCs may not have much of a concern for local interests, just profits

Question 46

What is the name given to the economic phenomenon of MNCs overvaluing profit at the expense of foreign peoples?

Answer 46

The absentee landlord effect – the MNC is profiting from the foreign country in an unethical way that would not be tolerated in the home country due to a better awareness of such practices, just as a landlord could derive rent from a property without caring about its upkeep

Question 47

What is the balance of payments (BOP)?

Answer 47

The net of money coming into and going out of a country – a positive amount (surplus) means that more money is coming in, while a negative amount (deficit) means that more money is exiting

Question 48

What are the two accounts by which a country’s BOP is measured?

Answer 48

Current account and capital account

The BOP is the sum of these two accounts

Question 49

As regards the BOP, what is included in the current account?

Answer 49

The goods and services, interest, dividends, and unilateral transfers made into and out of the country

Question 50

What is the balance of trade (BOT) and the balance of goods and services?

Answer 50

BOT = net of imported goods and exported goods for a country – doesn’t include services

Balance of goods and services = net of imported and exported goods and services

Question 51

In the current account, what is included within unilateral transfers?

Answer 51

Payments to family outside the country, payments of foreign aid (by the gov’t), and some pension payments

Question 52

As regards the BOP, what is included in the capital account?

Answer 52

All fixed assets (e.g. equipment) and financial assets (e.g. stock)

Question 53

What is the International Monetary Fund (IMF)?

Answer 53

An international organization created in 1945 designed to improve and stabilize the world’s payment system after WWII

Includes a pool of currency which can be applied against member countries that have a negative BOP

Strongly related to the World Bank, which lends money to help finance underdeveloped countries

Question 54

What is transfer pricing?

Answer 54

The pricing established between divisions of the same company (or other related parties) for whatever transactions they might do

Especially important for MNCs, since transfer payments with foreign subsidiaries can funnel income in specific jurisdictions to lessen their taxes

Question 55

Besides tax minimization, how is transfer pricing significant?

Answer 55

It can help with managerial decision-making: properly valuing a segment of the company by having an accurately-valued transfer price

Thus, companies are allowed to have two different sets of transfer prices (for taxation and for financial reporting)

Question 56

What are different ways that companies can set their transfer prices?

Answer 56

(1) market value
(2) variable cost
(3) full cost
(4) a price determined by negotiation between managers