EXCHANGE RATIOS, TRADE, AND GAIN

Although an analysis of relative advantage can indi- cate what a country should export and import, that analysis cannot explain exactly how a country will gain from trading with a partner. In order to deter- mine the extent of trading gain, an examination of the domestic exchange ratio is required. Based on Case 2 of Table 2.1, Japan’s domestic exchange ratio between the two products in question is 1:2 (i.e., ten computers for every twenty automobiles). In other words, Japan must give up two automobiles to make one computer. But by exporting automo- biles to the USA, Japan has to give up only 1.5 auto- mobiles in order to get one computer.Thus, trading essentially enables Japan to get more computers than feasible without trading.

The US domestic exchange ratio is 1:1.5 (i.e., twenty computers for every thirty automobiles). The incentive for the USA to trade with Japan occurs in the form of a gain from specializing in computer manufacturing and exchanging comput- ers for automobiles from Japan. The extent of the gain is determined by comparing the domestic exchange ratios in the two countries. In the USA, one computer brings 1.5 automobiles in exchange, but this same computer will result in two automo- biles in Japan. Trading thus is the most profitable way for the USA to employ its resources.

Theoretically, trade should equalize the previ- ously unequal domestic exchange ratios and bring about a new ratio, known as the world market exchange ratio, or terms of trade. This ratio, which will replace the two different domestic exchange ratios, will lie between the limits estab- lished by the pre-trade domestic exchange ratios.

Such benefits derived from trade do not imply that trade must always take place and that all nations will always gain from trade.We will carry the hypo- thetical example a step further. In Case 3 of Table

2.1, the USA now makes forty automobiles (instead of ten as in Case 1 and thirty as in Case 2). Not only does the USA have absolute advantage for both products, but it also has the same domestic exchange ratio as that of Japan. This situation is

Units of computer

Units of automobile

graphically expressed by two parallel production possibility curves (Figure 2.2).

Under these circumstances, trade probably will not occur for two principal reasons. First, since the USA is 100 percent better than Japan for each product, the relative advantage for the USA is iden- tical for both products. Second, since both countries have the identical domestic exchange ratio, there is no incentive or gain from trading for either party. Whether in the USA or in Japan, one unit of com- puter will fetch two automobiles. When such other costs as paperwork and transportation are taken into account, it becomes too expensive to export a product from one country to another. Thus inter- national trade is a function of the varying domestic exchange ratios, and these ratios cause variations in comparative costs or prices.

Date: 2014-12-21; view: 1542