TEACHING INTERNATIONAL TRADE AND FINANCE USING COMPUTER SPREADSHEETS.

Gregorowicz, Philip ; Hegji, Charles E.

Philip Gregorowicz [*]

Charles E. Hegji [*]

The possibility of the use of computer spreadsheet models as an aid to teaching economics is clearly established. The work of Smith and Smith (1988), Smith and Ellis (1990), Clark and Hegji (1997) and others clearly demonstrates that computer spreadsheets can be used to model standard micro economic concepts such as marginal revenue, marginal cost, and value of marginal product. Hegji (1998) has shown that managerial economics topics such as determining the firm's optimal level of advertising can be readily modeled with computer spreadsheets. The present paper builds on this approach by developing examples in which computer spreadsheets can be used to enhance the teaching of international economics and finance.

The importance of using computer spreadsheets to teach international economics comes from two sources. First, there has been a growing interest in international economics by the teaching profession. This is suggested by the increased international coverage in most principles of economics texts written since 1990. Second, the authors believe that topics covered in international trade and finance are difficult for most students. The idea of modeling international economics topics with computer spreadsheets is that this approach allows students to learn through experimentation. We are convinced that a hands-on approach is an effective way to teach such material.

With this in mind, the present paper develops several examples of how computer spreadsheets can be used as an aid in teaching international economics. The choice has been made based on the authors' experiences.

Using Supply and Demand Curves to Determine Exports and Imports in a Two Country Model

The following example was adapted from Managerial Economics: Theory, Applications, and Cases by Edwin Mansfield. A two-country model is assumed, with supply and demand curves for a single product specified for each country. The object of the exercise is to determine imports and exports for both countries.

Suppose that the supply (s) and demand (d) curves for a product manufactured and purchased in both the United States (u) and Germany (g) are given by

[[Q.sup.u].sub.s] = 5 + 2.6[P.sub.u],

[[Q.sup.u].sub.d] = 100 - 2[P.sub.u],

[[Q.sup.g].sub.s] = 2 + 2[P.sub.g],

[[Q.sup.g].sub.d] = 120 - 4[P.sub.g]. (1)

Prices in the United States are measured in $, while prices in Germany are in DDM.

Solution to above problem requires an exogenous exchange rate. Given this exchange rate, prices can be converted to a single currency. Given this conversion, the "law of one price" is invoked by equating worldwide supply and demand, and solving for the worldwide equilibrium price and quantity. Substituting this price into (1) obtains the quantities supplied and demanded in the two countries. These quantities can, in turn, be used to determine if a country is a net exporter or importer of the good.

Suppose that the exchange rate is e = 1.6 DM/$. This implies that [P.sub.g] = l.6[P.sub.u]. Substituting into (1), and letting

[[Q.sup.u].sub.s] + [[Q.sup.g].sub.s] = [[Q.sup.u].sub.d] + [[Q.sup.g].sub.d], (2)

results in an equilibrium price [P.sub.u], = $15 = 24 DM = [P.sub.g]. With these prices, the US demands 70 units of the above good and supplies 44 units. Germany demands 24 units and supplies 50 units. Therefore, the US imports 26 units and Germany exports 26 units.

An important concept for students to grasp is how these net export and import positions change with the exchange rate. The spreadsheet in Example 1 is set up to do this.

The exchange rate in DM/$ is entered into one cell in Column A of the spreadsheet. This exchange rate is used in the formulas in the remainder of the spreadsheet. The $ price of the good is entered in Col B, with US demand and supply expressed as a function of this price in Cols C and D. Demand equation (1) is used for this computation. The DM equivalent of this price is computed in Col B, using the exchange rate in A. German demand and supply for the good are computed using this price. World demand is computed as the sum of US demand and German demand, while world supply is computed as the sum of the two countries' supplies. Excess supply in the world market is computed in Col J, while US and German exports are computed in Cols K and L as the difference between supply and demand in the two countries respectively.

For a given exchange rate, equilibrium in the world market is approximated by the smallest absolute value of world excess supply. This is 1.5 in Example 1. Reading across this row obtains supply and demand in the two countries, the equilibrium prices in the two currencies, and US and German net exports of the good.

The spreadsheet can be used to aid the teaching of international economics in several ways. Three of these are:

* To demonstrate to the student how exports, imports, and prices are impacted by the exchange rate

* To demonstrate how tariffs and quotas alter the relationship between exchange rates, prices, and exports and imports

* To demonstrate how changes in costs and the resulting shifts in supplies in the two countries change exports, imports, and equilibrium prices, holding the exchange rate constant

Lectures, in-class exercises, and homework could be designed using Spreadsheet 1 to examine the above three points.

Determining Domestic and Foreign Production and Prices at the Firm Level

A topic not covered in standard treatments of international trade is how the firm determines output and prices in domestic and foreign markets. A related topic is how foreign production impacts the firm. The following example develops spreadsheets to study these topics.

Begin by assuming a firm produces a product at constant unit costs of $40. The firm is assumed to face two demand curves, one in the domestic (D) market, and one in the foreign (F) market. Domestic prices are measured in $, while foreign prices are denominated in foreign currency units #. The demand curves are, respectively,

[P.sub.D] = $200 - 2[Q.sub.D]

[P.sub.F] = #600 - 8[Q.sub.F] (2)

Assume that the exchange rate is denominated in dollars per foreign currency unit, e = $/#. The problem is to see how changes in e impact the firm's decisions. This can be answered by using the theory of price discrimination (pricing in two markets) assuming the firm maximizes total $ profits.

Theory suggests that a single product should be priced in two markets so that the marginal revenue from each market is the same. Expressing total domestic revenue as [TR.sub.D] = [P.sub.D][Q.sub.D] and total $ foreign revenue as [TR.sub.F] = [eP.sub.F][Q.sub.F], and substituting from (2) results in the marginal revenues

[MR.sub.D] = 200 - 4[Q.sub.D]

[MR.sub.F] = e(600 - 16[Q.sub.F]) (3)

Equating the marginal revenues in (3) obtains

[Q.sub.F] = 125(3 - 1/e) + [Q.sub.D]/4e. (4)

Equation (4) expresses foreign sales as a function of domestic sales and the exchange rate for the demand curves in (2). This relationship is used in spreadsheet Example 2.

Spreadsheet 2 starts by entering the exchange rate in $/# into one cell in Column A. This exchange rate is used in the formulas in the remainder of the spreadsheet. Domestic sales in units are entered into Column B, while the domestic price based on the demand curve in (2) is in entered into Column C. Column D of the spreadsheet contains foreign sales based on Column B and equation (4). The corresponding foreign prices are computed in Column E. Revenue from domestic sales is calculated from B and C, while dollar revenue from foreign sale is computed from D, E and the exchange rate. Total costs are computed in F by multiplying the assumed $40 unit cost by the sum of domestic and foreign output. Profits are displayed in Column G, and computed by subtracting total costs from the sum of domestic revenue and foreign revenue expressed in $.

For a given exchange rate the optimal policy is determined by maximum total profits. Example 2 shows that for the exchange rate of e = .7$/#, profits will be maximized at $9646. Reading across the row obtains domestic and foreign unit sales, domestic and foreign prices, domestic and foreign revenues, and total costs.

In Example 2 production is done entirely domestically at a cost of $40 per unit. A simple extension would be to assume that the good must be produced both in the US and in the foreign country. For instance, we could assume that $20 per unit value added comes from domestic operations and #40 per unit costs comes from foreign operations. Under these assumptions, unit costs in dollars would be AC = $20 + e#40. This unit cost would be used in calculating total costs in Column F of Example 2.

Spreadsheet 2 was constructed to help managerial economics students understand the impact that the recent devaluation of Southeast Asian currencies had on American firms with Asian exposure. The types of questions that can be investigated with the aid of these spreadsheets are:

* What is the impact on firm profits when the currency of a country in which a firm has revenue exposure is devalued?

* How are profits modified when some of the production of a product occurs in the country with the devalued currency?

Lectures, in-class exercises, and homework can be designed using Spreadsheet 2 to examine the above points.

Concluding Remarks

The authors believe that the use of computer spreadsheets is a good way of stimulating class participation and getting students to inquire into issues on their own, particularly in the difficult areas of international economics and finance. We have had some success with Examples 1 and 2 and plan on doing more work along these lines. We encourage others to follow.

(*.) Professors of Economics, Auburn University at Montgomery, Montgomery, AL 36117-3596.

References

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