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Sem 5 Prep
← Intl TradeComparative advantage with money and exchange rates

Formulas for this chapter

Money price of a good

Price per unit = wage rate per hour / output per hour

Whenever a question gives a wage and a productivity and asks for a price. It follows from the labour theory of value, where labour is the only cost.

Wage rate
Money paid per labour hour, in that country's currency
Output per hour
That country's productivity in that good

Currency conversion

Price in dollars = price in pounds x dollars per pound

To bring both countries' prices into one currency before comparing them. Multiply by the dollars-per-pound rate; dividing is the standard error and comes from reading the rate the wrong way round.

Dollars per pound
The exchange rate e; in the class example e = 2

Unit cost ratio

Unit cost ratio = wage ratio / productivity ratio

To answer the cheap-foreign-labour question, or to show why the less productive country can still undersell. A ratio below 1 means the foreign country is the cheaper producer.

Wage ratio
Foreign wage / home wage, in one currency
Productivity ratio
Foreign output per hour / home output per hour, same good

Exchange rate limit for one good

foreign price in foreign currency x e = home price in home currency

To find where a trade flow switches off. Solve for e. Doing this for both goods gives the range over which the pattern of trade survives: $1 < e < $3 in the class example.

e
Exchange rate, home currency units per foreign currency unit
Prices
Each computed as wage over productivity in its own country
Step 4 of 23
The real wordsTheory

The same formula in pounds

United Kingdom, from the class table (1 wheat, 2 cloth per hour), at a wage of £1 an hour:

  • Wheat: £1 / 1 = £1.00 a bushel
  • Cloth: £1 / 2 = £0.50 a yard

Two prices in dollars, two in pounds. They cannot be compared until one currency is converted into the other. That is what the exchange rate is for.

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