Comparative and Absolute Advantage:

The distinction between comparative and absolute advantage is key in International Trade
Theory. Indeed, this was the big breakthrough of David Ricardo's theory with respect to Adam
Smith's theory of trade.

Answer and Explanation:

The theory of trade proposed by Adam Smith in "Wealth of Nations" (1776) developed the
concept of "absolute advantage" by stating that a country has an absolute advantage when it can
produce a certain good with more efficiency (using less units of capital and labor) than another
country. The problem with Smith's theory was that, if a country was more efficient producing all
the goods in the market, then it would be never willing to commerce, since it would not
experience any gains from trading.

David Ricardo (1817) knew than even when having absolute advantages in all the goods, the
empirical evidence showed that countries still traded. How could this be possible? Well, the
concept of "comparative advantage" came along to solve this problem. Comparative advantage is
not about comparing two countries efficiency to produce different goods and see which is
superior to which. Comparative advantage is related to the concept of opportunity cost. Indeed,
even when a country has no absolute advantage in the production of any good, it would still be
relative more efficient producing one good or another. In other words, the absolute advantage
would be more or less superior in the production of a certain good. Thus, Ricardo proved that
countries can still experience gains from commerce by specializing in the production of the good
in which they have the comparative advantage.

Let's consider the following table (extracted from Ricardo's book) in which we have the amount
of units of work Portugal and England require to producing a unit of textile and wine.
In this example, according to Smith's theory there would not be space for trade, since Portugal is
more efficient in the production of both textiles and wine. However, just by performing a simple
example we will see that everybody would be better of by trading. Indeed, we see that Portugal
has a comparative advantage in the production of wine while England has it in the production of
textiles. Then Portugal will produce wine and England textiles. Why? Let's see...

First, let's assume that we want to produce 2 units of textiles and 2 of wine. If each country
produce one of each we will need:

England = 100 + 120 (1 unit of textile + 1 unit of wine) = 220

Portugal = 90 + 80 (1 unit of textile + 1 unit of wine) = 170

Total= 390 units of labor.

On the other hand, if they specialize we will have that:

England: 200 (2 units of textile)

Portugal: 160 (2 units of wine=

Total = 360 units of labor.

In consequence, we see that trading, even when there's no absolute advantage, generates an
increase of the efficiency of the system.

In the public debate over ratification of the North American Free Trade Agreement, Ross Perot
said he heard a “giant sucking sound” of U.S. jobs headed south because of low wage rates in
Mexico. Using the theory of comparative advantage, discuss whether Perot’s fears are valid.

- The theory of comparative advantage suggests that a country will export those goods and
services for which it is relatively more productive than other nations and import those
goods and services in which other nations are relatively more productive. Thus, even
though the U.S. might be better at producing two goods, it should focus its efforts on the
one in which it is more productive. Since wage rates are lower in Mexico than in the
U.S., Perot felt that American companies would choose to build plants in Mexico to take
advantage of the cheaper Mexican labor force. While certainly one would expect some
 companies to make such a move, because of the low skill levels in the Mexican labor
force, other companies will not. In addition, one must consider whether the companies
that do make such a move actually save jobs in the U.S. that would have disappeared if
the companies had gone out of business

Hyundai decided to build a new automobile assembly plant in Alabama.

a. What factors do you think Hyundai considered in selecting Alabama as the site for the
factory?
- Proximity to the U.S. market, avoidance of tariff barriers in the auto industry, local
infrastructure, available workforce, workforce skills, as well as incentives provided by
the state of Alabama
b. Who benefits and who losses from the new plant in Alabama?
- Hyundai and Alabama both belive they benefit. Alabama gets jobs and tax revenue,
Hyundai gets benefits negotiated with the state and easier access to the U.S. market.
Assembly jobs may be lost in South Korea or other countries where Hyundai might have
built the plant.
c. Is the firm’s decision to build the new plant consistent with Dunning’s eclectic theory?
- Dunning’s eclectic paradigm suggests that FDI ill occur when a foreign location is
superior to a domestic location, when the firm enjoys an ownership advantage that can be
utilized to generate monopolistic profits in foreign markets, and when the firm finds it
cheaper to produce the product itself rather than hire some foreign firm to produce it.
Hyundai’s decision to build a plant in Alabama is consistent with Dunning’s theory.

Why are clusters established, and why are they important in international trade? Illustrate your
answer with examples.

- Industrial clusters are geographic concentrations of interconnected businesses, suppliers,

and often other institutions in a particular sector. Clusters generally increase the
productivity and the competitiveness of the individual companies. They are well-
established in many countries, such as Germany and Italy, and generally span over many
sectors. Good examples are the Italian clusters of leather goods, and industrial tools in
the northern part of the country.

What are the advantages and disadvantages of an industry policy?

 - When a government adopts an industry policy, it formulates policies based upon the
needs of the national economy that will promote the competitiveness of key products and
industries with high growth prospects in international markets. If the policy works as it is
designed, companies should successfully capture large shares of important, growing
markets. However, the main difficulty with industry policy is correctly identifying which
industries should receive favorable treatment. It has been suggested that companies that
are selected for preferential treatment may be selected on the basis of their political clout
rather than on their foreign market potential. Firms and employees in industries that are
being threatened by low-priced imports may find themselves without any kind of
protection if the government determines that their companies are not the companies of the
future

Because of japan’s success in competing in international markets, it has been the target of
numerous complaints that its restricts foreign access to its local markets. As Japan reduces its
barriers to imported goods, who is likely to gain from lowered barriers? Who is likely to lose
from them?

- There are at least two constituents that are likely to gain from Japan’s lower barriers to
imported goods. First, Japanese consumers will probably benefit from the lower prices
and increased choice that occurs when competition becomes stronger. Second, foreign
firms that have been denied access to the Japanese consumers will benefit from its more
open marketplace. However, Japanese firms that have been protected to a large extent
from foreign competition in their domestic marketplace, such as food and beverages,
metals, machinery, chemicals,textiles, and apparel, will probably find that lowered
barriers will have a negative effect on their profits. In addition, some Japanese workers
may find themselves unemployed as their companies respond to increased competition
with layoffs

Refer to the text. What would happen if Japan offered Toshiba a subsidy of $15 billion after
learning that France granted Areva a subsidy of $2 billion?

- With the subsidy Areva is going to develop the technology. Using the figure, it shows
that if Toshiba were to get the subsidy and it chooses to develop the technology, Areva
would make nothing if it does not develop and $ 1 billion if it does not develop and $12
Billion if it does develop.
- Thus, Areva will always choose to develop. But if Toshiba knows that Areva will always
choose to develop, then the best strategy for Toshiba is not to develop.
Canada places a non-tariff barrier (NTB) on Emirates Airline flights by limiting the landing
rights of this foreign carrier within Canadian airports. If the Canadian government removes this
NTB what would be the implications of this decision on Canadian firms and the Canadian
economy?

- By removing the NTV on Emirates Airline flights into Canada, the Canadian government
could help promoting the interests of Canadian firms in the United Arab Emirates (UAE).
In effect, the UAE is the largest trade partner for Canada in the Middle East and North
Africa region. In addition, more Emirates flights coming into and departing from
Canadian airports could result in more UAE tourists coming into Canada and can
generate new jobs for Canadian citizens. Moreover, additional flights from Emirates
Airline into Canada will offer more options to the Canadian consumer.
- On the other hand, removing the NTB on Emirates Airline flights into Canada could
result in fierce competition for Air Canada. If such competition is going to eat up from
Air Canada’s market share, It might have a negative impact on the Canadian carrier and
could result in flights reduction and job losses. However, it could be argued here, that
more competition could help Air Canada by encouraging the airline to improve the
quality of its services.

7. Fixed exchange rate and flexible exchange rate are two exchange rate systems, differ in the
sense that when the exchange rate of the country is attached to the another currency or gold
prices, is called fixed exchange rate, whereas if it depends on the supply and demand of money
in the market is called flexible exchange rate.

The depreciation of Indian Rupee against US dollar is the common headline of almost all news
dailies, since past few years. Not only India but the primary concern of the monetary policy of all
the countries focus on stabilising the exchange rate. However, still, a major section of society is
unaware about currency fluctuations in the international market, as they do not have sufficient
knowledge.
First of all, you need to know what exchange rate is? As its name suggests, it is a rate at which
the currency of one country can be exchanged (converted) for another. Exchange rate regime or
system refers to a set of international rules that manages the setting of exchange rates and the
foreign exchange market. Take a read of this article, to know the important differences between
fixed and flexible exchange rates.

Content: Fixed Exchange Rate Vs Flexible Exchange Rate

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart
Basis for
Fixed Exchange Rate Flexible Exchange Rate
Comparison

Fixed exchange rate refers to a rate which Flexible exchange rate is a rate
Meaning the government sets and maintains at the that variate according to the
same level. market forces.

Determined by Government or central bank Demand and Supply forces

Changes in
Devaluation and Revaluation Depreciation and Appreciation
currency price

Takes place when there is rumor about

Speculation Very common
change in government policy.

Self-adjusting Operates through variation in supply of Operates to remove external

mechanism money, domestic interest rate and price. instability by change in forex rate.
Definition of Fixed Exchange Rate

An exchange rate regime, also known as the pegged exchange rate, wherein the government and
central bank attempts to keep the value of the currency is fixed against the value of other
currencies, is called fixed exchange rate. Under this system, the flexibility of exchange rate (if
any) is permitted, under IMF (International Monetary Fund) arrangement, but up to a certain
extent.

In India, when the currency price is fixed, an official price of its currency in reserve currency is
issued by the apex bank, i.e. Reserve Bank of India. After the determination of the rate, the RBI
undertakes to buy and sell foreign exchange, and the private purchases and sales are postponed.
The central bank makes changes in the exchange rate (if necessary).

Definition of Flexible Exchange Rate

A monetary system, wherein the exchange rate is set according to the demand and supply forces,
is known as flexible or floating exchange rate. The economic position of the country determines
the market demand and supply for its currency.

In this system, the currency price is market determined, concerning other currencies, i.e. the
higher the demand for a particular currency, the higher is its exchange rate and the lower the
demand, the lesser is the value of currency compared to other currencies. Therefore, the
exchange rate is not under the control of the government or central bank.

Key Differences Between Fixed and Flexible Exchange Rates

The following points are noteworthy so far as the difference between fixed and flexible exchange
rates is concerned:

1. The exchange rate which the government sets and maintains at the same level is called
fixed exchange rate. The exchange rate that variates with the variation in market forces is
called flexible exchange rate.
2. The fixed exchange rate is determined by government or the central bank of the country.
On the other hand, the flexible exchange rate is fixed by demand and supply forces.
 3. In fixed exchange rate regime, a reduction in the par value of the currency is termed as
devaluation and a rise as the revaluation. On the other hand, in the flexible exchange rate
system, the decrease in currency price is regarded as depreciation and increase, as
appreciation.
4. Speculation is common in the flexible exchange rate. Conversely, in the case of fixed
exchange rate speculation takes place when there is a rumour about change in
government policy.
5. In fixed exchange rate, the self-adjusting mechanism operates through variation in the
supply of money, domestic interest rate and price. As opposed to the flexible exchange
rate that operates to remove external instability by the change in forex rate.

Conclusion

As both the exchange rate system have their positive and negative aspects. It is not possible for
economists to reach a particular conclusion, so the debate is indecisive, as counter arguments
keep coming from both regimes. While theoreticians are favours flexible exchange rate due to
their reliance on the free market system and price mechanism, policy makers, and central bankers
supported fixed exchange rate system.

Are there any circumstances under which a country might want to increase its currency’s value?
Countries may try to increase the value of their currencies in certain circumstances. For example,
major trading partners met at the Louvre Accord in an effort to halt the decline of the dollar, which
had plummeted almost 46 percent against the Deutsche mark and 41 percent against the yen in just
two years. Countries were worried that any further devaluation in the dollar would disrupt world
trade. However, for the most part, countries will be reluctant to revalue their currencies because a
stronger currency makes exports less competitive, and imports less expensive. The combination of
these effects creates a trade deficit.
Discuss the major types of arbitrage activities that affect the foreign-exchange

market.

The arbitrage of goods across national boundaries is represented by the theory of purchasing

power parity (ppp). The arbitrage of money has the greatest effect on the exchange rate. There

are three types of arbitrage of money: two-point arbitrage, three-point arbitrage, and covered-

interest arbitrage.