Summary: Main Points on

International Trade, Arbitrage, and Speculation

A Basic Diagram

Whenever there is trade between two places, such as Japan and Mexico, or Philadelphia and Los Angeles (or two time periods, such as Winter 1999-2000 and Summer 2000), we can graph the equilibrium by finding the price at which excess supply in one place equals excess demand in the other place. What would have been "excess supply" in the first place (without trade between two places) becomes exports from that place, and what would have been "excess demand" in the second place (without trade between two places) becomes imports into that place. See Figure 1 on page 155 of the textbook.

In this equilibrium, the quantity demanded in each place shows consumption in that place, and the quantity supplied in each place shows production (output of the good) in that place.

In equilibrium, the price is the same in both places.

The place that would have had the lower price without trade between two places exports the good.
The place that would have had the higher price without trade between two places imports the good.

Winners and Losers from Trade between 2 Places

WINNERS:      (1) Sellers in the exporting place    they sell at a higher price
                         (1) Buyers in the importing place       they buy at a lower price
LOSERS:        (1) Sellers in the importing place       they sell at a lower price
                         (1) Buyers in the exporting place       they buy at a higher price

International Trade

The "two places" are two countries. There is a single world equilibrium price.

In this equilibrium, quantity demanded in each country shows consumption in that country, and quantity supplied in each country shows production in that country. The country that would have excess supply without international trade produces more than it consumes -- the difference is exports. The country that would have excess supply without international trade produces more than it consumes -- the difference is exports.

Changes in Underlying Conditions

Suppose the countries are the USA and China. An increase in demand in China:

raises the world equilibrium price
raises Chinese consumption of the good
lowers American consumption of the good
raises production of the good in both countries

(See Figure 2 on page 158 of the text.)

An increase in supply of the good in China:

lowers the world equilibrium price
raises Chinese production of the good
lowers American production of the good
raises consumption of the good in both countries

(See Figure 3 on page 159 of the text.)

Arbitrage

The "two places" are two cities, or states, or two markets within a city, etc. There is a single equilibrium price in both places.

The analysis of arbitrage is exactly like the analysis of international trade.

Adding Costs of Arbitrage or International Trade

Arbitrage costs refers to costs of getting information about prices in various places, comunication or transportation costs (including time costs) of buying the goods in one place, costs of transporting goods to another place, costs of reselling the goods in the second place (marketing costs, time costs, and so on).

Here we consider the case of constant per-unit arbitrage costs -- for example, arbitrage costs are 10 cents per unit bought and resold.

Costs of trade between two places -- international trade or arbitrage -- introduce a price differential between those places, as in Figure 7 on page 168 of the textbook. There is no longer a single price in both places. Instead, in equilibrium,

the price in one place exceeds the price in the other place by the per-unit cost of arbitrage.

Other than this, all the analysis remains the same.

Speculation

For speculation: instead of "two places," think of two "time periods."

The analysis of speculation is almost the same as analysis of international trade or arbitrage. "Exports" become "put into storage." "Imports" become "take out of storage."

Without costs of speculation, equilibrium occurs as in Figure 5 on page 163 of the text and the current price equals the expected future price.

With costs of speculation, equilibrium occurs as in Figure 8 on page 169 of the text, and the current price exceeds the expected future price by the per-unit costs of speculation.

In equilibrium, quantity demanded at each time period shows consumption at that time, and quantity supplied in each time period shows production at that time. The current time period would have excess supply without speculation. With speculation, people produce more than they consume today, and the extra goods go into storage . A future time period would (be expected to) have excess demand without speculation. With speculation, people expect to produce more than they consume at that future time, and the extra consumption comes from goods taken out of storage .

Who puts the goods into storage and takes them out later? Anyone could --

A speculator could buy them, store them, and resell them later.
Producers could hold them off the market and store them to sell later. In this case, producers become speculators.
Consumers could buy them and store them to consume (use) later, In this case, consumers become speculators.

Analysis of speculation is "almost" the same as international trade -- because [BACK]

Goods must be put into storage before they can be taken out of storage. We can export goods from "this year" and import them "next year." We cannot export goods from "next year" and import them "this year."
Speculation only works for goods that are storable, such as art work, furniture, shares of stock, and books. It does not work for goods such as fresh fish, honest life styles, or live musical performances.
The future is uncertain, so analysis of a future time period refers to what people currently expect to happen at that future time.

Changes in Underlying Conditions

An increase in expected future demand for a storable good:

raises the expected future price
increases the amount of goods put into storage now to sell in the future
increases the current price
increases expected future consumption of the good
decreases current consumption of the good
increases current production and expected future production of the good

(See Figure 6 on page 166 of the text.)

Note that changes in expected future economic conditions (in this case, future demand for a good) affects current economic conditions.

An increase in the current supply of a storable good :

increases current production and lowers the current price
increases the amount of goods put into storage now to sell in the future
decreases the expected future price
increases expected future consumption of the good
increases current consumption of the good
decreases expected future production of the good

Applications

(1) International Borrowing and Lending

International trade in LOANS works like international trade in any other good. The supply of loans represents lending; the demand for loans represents borrowing. Use the analysis of international trade, with "lending" instead of "production" and "borrowing" instead of "consumption." See Figure 9 on page 171 of the text.

(2) Increase in Government Budget Deficit Increases Borrowing from other countries

An increase in the U.S. government budget deficit raises the demand for loans. With international trade in loans, this increase in demand:

raises the world interest rate (price of loans)
raises total U.S. borrowing
lowers total foreign borrowing
raises lending in the U.S. and in other countries
raises U.S. imports of loans -- that is, the U.S. borrows more from other countries

(See Figure 10 on page 171 of the text.)

(3) Futures Markets

When storage costs of a good are negligible (and with some other conditions involving risk, that you can ignore for now), in equilibrium, the futures price equals the spot price.

Logic -- the same as the logic of speculation. See pages 172-3 of the textbook.

(4) Stock Markets

Storage costs for shares of stock are near zero. The logic of speculation implies:

In equilibrium, a stock price roughly equals its expected future price. In other words, stock prices (roughly) follow a random walk . Getting rich by investing in the stock market is not easy! (Ask an investment advisor, "If you're so smart, why aren't you rich and retired, instead of working as an investment advisor?)

See pages 173-4 of the textbook.

© 1999 Alan C. Stockman, except:
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