Wednesday 9 September
A friend of yours had a summer job as crew on a boat that went back and forth between a French island and a Dutch island in the Caribbean. He tells you that the pay was lousy, but he still made a lot of money.
As crew, he did not have to go through customs either end of the trip, and he was allowed to take a duffle bag with him each way. He had an hour off in port each end of the trip. He got to know waitresses in cafes in both ports, who would buy or sell wine and/or schnapps [as a favor, from/to the cafe’s stock at the cafe’s regular prices, probably without the owner’s knowledge] at the following prices:
Wine 10 francs a bottle 8 guilders a bottle
Schnapps 40 francs a bottle 16 guilders a bottle
He made money by buying wine at Pierre’s, taking it over to Anton’s and selling it, then buying schnapps from Anton’s, and taking it to Pierre’s and selling it.
2) If he starts off with 20 francs, how much profit can he make after one round trip [in francs]?
20 francs buys 2 bottles of wine from Pierre’s, which he can sell for 16 guilders at Anton’s; with 16 guilders he can buy a bottle of schnapps, which he takes to Pierre’s and can sell for 40 francs. He has made 20 francs profit on the one round trip.
3) Do you need to know the value of a franc in guilders, or guilders in francs [the "exchange rates"], to answer questions 1 and 2? Why or why not? What creates the potential for profitable trade/exchange?
No, you do NOT need to know the exchange rate; absolute prices don’t matter, just as absolute advantage does not matter. The potential for profitable trade exists whenever relative prices differ, i.e. the price (or opportunity cost) of one good in terms of another. At Pierre’s, the opportunity cost of a bottle of schnapps is four bottles of wine; at Anton’s, only two bottles of wine. Buy low, sell high: at Anton’s, schnapps is relatively cheap (in terms of wine), so buy it there and sell it at Pierre’s, where (in terms of wine) it is worth more (has a higher opportunity cost). Vice versa, wine is cheap (in terms of schnapps) at Pierre’s, so buy it there and sell it at Anton’s (where, in terms of schnapps, it is worth more). Potentially profitable exchange (trade) is possible whenever relative prices differ [in jargon, this is called arbitrage]. If there are no barriers to the trade (like transport and transaction costs, customs tariffs or taxes) that process will tend to bring the relative prices together. If the initial price differences reflect different production costs, then the different underlying opportunity costs reflect "comparative advantage" – the basis for the profitable trade.