Economics 141: International Trade

Part I: The Pure Theory of International Trade

1. Introduction: The Hippasitic Oath: A teacher must never elicit assent by resort to authority but only by resort to logic and evidence. We subscribe to this oath in this course. (The great Pythagoras of the Pythagorean theorem and a student named Hippassus who was drowned by Pythagoras order for divulging the existence of irrational numbers; the ultimate building blocks of the world is numbers).

2. Purpose: To unlock the secrets behind trade and capital flows: (i) trade flows: Exports X =what we sell abroad; imports M=what we buy from abroad; goods (airplanes, Swiss watches) or services (ex pat managers); may be finished goods (bottles of Bourdeux wines) or imported inputs (oil; computer wafers); (ii) capital flows: foreign debt/borrowing, foreign lending; direct foreign investment, portfolio flows; (iii) OFW remittance and export of labor services. (iv) BOP = the trade account (X M) + the current account (inflows of capital outflows of capital).

3. An Interesting Question: Since 2002, the Philippines has been a BOP surplus country meaning BOP > 0. Meaning we are accumulating foreign exchange every year since 2002. Our foreign exchange reserve also called the Gross International Reserves (GIR) stands at $85b. Since BOP deficit was the norm before 2002, how did this come about?

4. Tools: Model building, Microeconomic concepts, Some algebra; Some Calculus; Loads of Graphs; Logic and Evidence

[Understanding Current Events: Weak versus Strong Peso: There is a current debate about the correct value of the peso. The peso is and has been since 2010 appreciating against the US dollar. It now stands at P42/$ whereas it was P45/$ in 2010. The appreciation of the peso comes from increased supply of $ in the economy coming in turn from OFW remittance ($20b a year), exports ($52b a year). BPO revenues (10b a year), borrowing by govt and foreign aid. This causes the supply curve of $ to shift upwards and lowers the equilibrium ER [show the demand and supply graph with equilibrium ER given by intersection of the two curves]. Wrong mantra: Strong peso means a strong economy. Correct mantra: Weak peso means a growing economy. Weak peso good for all tradables (exports, BPO, tourism, manufacturing). Example: Japan after the Plaza Accord (1987) forced the appreciation of the yen almost 100% led to the Japanese Bubble Economy and afterwards two decades of economic stagnation. Peso appreciation is like a cocaine fix, euphoria today, depression tomorrow].

Section 1: Neo-Classical Trade Model: From Autarchy to Free Trade 5. Neo-Classical Trade Model: Economy with Production and Consumption: a. Models: the DNA of economic thinking; separate us from other discipline. Are representations of reality that have the property of

(i)parsimony, that is, they abstract from nonessentials and retain only the most fundamental features which still allow us to understand the behavior of a system and (ii)consistency: they should not contain logical flaws or fallacies (iii) explanatory power: makes us understand certain real world phenomena Examples: Inconsistency: A >B, B> C, C> A! However, in the social interactions this may not bind: Nadal beats Federer, Federer beats Djokovic; but Djokovic beats Nadal (not in the French Open 2013 though). Fallacy: Ali is a thief, Ali is a Kasakh, Thus All Kasakhs are thieves; Fallacy: More people die per square meter in hospitals than anywhere else, thus hospitals are the most dangerous places in the world! Fallacy (Confusing Necessity and Sufficiency : If A then B. Since B then A! Fallacy: (Post hoc ergo propter hoc): WWII (1939) came after Keynes General Theory (1936); thus Keynes General Theory caused WWII. Conundrum: Epaminondas the Cretan says that all Cretans are liars; Was he telling the truth? Models start out with assumptions and their relations. Occams Razor, the name of Parsimony in popular parlance: the rule that we use the minimum set (smallest body) of assumptions to understand and explain a given reality. b. Assumptions of the Standard Trade Model: two-goods x and y and two countries Home (H) and World (W) thus a 2x2 model; there is perfect competition in both H and W; both x and y are traded goods; no non-traded goods; there exists a social welfare function (Community Utility

Function): an aggregation of the utility functions of citizens to form a quasi-utility function for the whole country/economy: W = W({ui}), I = 1,2,.N, where N = the number of citizens. c. H under Autarky : No trade

Where: A is both the production point and consumption pt. representing the autarchic basket of goods (x A, yA). I or more properly CIC is the Community Indifference Curve. How is I is derived? From hereon we adopt the convention that y is the vertical axis and x the horizontal axis. Issues: The community of indifference curve I or CIC is derived from a Social Welfare Function (SWF), W, defined over the utility functions of all individuals, i.e. W = W (u1, u2, , uN), concave and increasing; where

ui = ui ({xij}) i = 1, 2, , N, is ith utility function (concave and increasing). xij= the amount of good j allocated to citizen i. Ex.: The Bergson-Samuelson SWF: Derivation of W o(x, y) Max W({ui}) s.t. xij = xj i = 1,, N ; j = 1,, J,

To get xij*({xj}) i = 1,,I ; j = 1,, J So Ui = Ui ({xij* (x1,, xj)}) = Uio(x1,,xj) So Wo = Wo(x1, x2, xj) for all i = 1,, I To be able to do this, we assume the composite function W({xij}) is well-behaved. This depends on the wellbehavedness of uis (see: Fabella, 1992, Quasi-concave (Composition) Function with Non-concave Argument Functions, International Economic Review, 1992). In a two good economy where the goods are x and y, we have Wo = Wo(x, y). From this is derived the community Indifference curve CIC the slope of which at every point is the Marginal Rate of Substitution (MRSxy) between x and y.

6. Domestic Terms of Trade: rate at which one good exchanges for another (say one x for one y or 3 xs for 2 ys. Note: MRS ixy= MRTDxy at A MRTDxy = Marginal Rate of Transformation between x and y which is the slope of the Production Possibility Curve

equals the marginal rate of substitution MRS xy between x and y, the slope of the Community Indifference Curve.

7. Deriving the PPF of H Ex.: Two Goods, x and y, One factor of production labor, L

(i)

Production Functions: Let x = aLx a>0 y = b(Ly ) b > 0 , 0 < < 1.

(ii)

Full Employment: Lx is the amount of labor used in x and Ly labor used in y production. The full employment assumption: Lx + Ly = L. (iii) The PPF equation gives one good y in terms of another x: y = f(x). Solving for y = f(x): y = b(Ly ) = b(L- Lx) = b(L- (x/a) ) = f(x) y = f(x) is the production possibility function; the standard PPF dy/dx = -(b/a)(L - x/a)
-1

<0

d2y/dx2 = -(a/b)(-1)(-1) < 0 MRTyx = (dy/dx) = the slope of the PPF

(Exercise: Let x = a(Lx)1/2 , y = b(Ly)1/2, Lx + Ly = L. Derive the production possibility function. Show the MRT. How does the PPF respond to a rise in L? to a? to b?

Ricardian PPF: If = 1, the production function for x is linear; so is that for y. Then y = b(L- (x/a) ) which is a linear relation between x and y. Thus, the PPF is just a straight line (draw). This is called a Ricardian PPF. It has only one slope throughout. By contrast the standard PPF has a different slope everywhere. Which slope will be chosen? The slope on the tangency between the PPF and the CIC at point A is also called the Terms of Trade between y and x at A. More properly, the slope at A is the home terms of trade or domestic terms of trade in H under Autarchy. We use the label HTOT. A is the production point and also the consumption point in H under Autarchy. Under autarchy, consumption cannot be outside the PPF. Free Trade between H and W: a) Small Country Assumption holds for H; b) W is a virtual large country. W may be viewed as a very large aggregation of small countries each of which are price takers. Aggregated W has its own PPF and Indifference map which generate its own terms of trade, WTOT.

A is consumption and production point before trade C consumption point after trade B production point after trade I and II are CICs MRTwyx = marginal rate of transformation of the world = slope of WTOT line MRTDyx = marginal rate of transformation of domestic = slope of DTOT line MRSyx = slope of the indifference curve at C. At C MRSiyx = MRTDyx = MRTwyx = Px/Py This is the Pareto Efficient Consumption Point. E is exports of x to pay for M imports y at the World TOT (why the domestic TOT becomes the world TOT?) [Current events, 6/26/2013: Two events: (i) the drop in the stock market index; PSE now in bear market territory , selling stocks dominate versus bull market territory: buying dominates), (ii) the weakening of the peso:

peso/dollar exchange rate rose to P43.7/$. What connects these events: the sudden outflow of portfolio investment. Why outflow? Ben Bernanke signaling the tapering off of quantitative easing (QE): the FRB buys corporate bonds to the tune of $85b a month as a stimulus to the weak economy. This expansionary monetary policy keeps interest rate very low in the US given the weak US economy, US investors try to find better returns in emerging markets like the Philippines. This inflow into the Philippines in 2012 caused the stock market bubble and the strengthening of the peso. The tapering of QE will raise interest rate in the US and cause capital flow to move back to USA. The current outflow took the wind out of the stock market sails and caused the peso to depreciate. The currency depreciation however is common for most Asian countries so does not improve our competitiveness vis--vis these countries. It gives our exporters and dollar earners like our OFW families some extra income. Should we not infer from this that the correct value of the peso is P43/$ without the pressure from the portfolio investment?] At autarchy, H produces and consumes at A with HTOT given as slope of tangency point A. When trade is opened for H, the WTOT differs from the HTOT. Good x is cheaper at H (say two x for one y) than at W (say one x for two y) as shown by the WTOT line moving clockwise to HTOT. (explain further). Possibility of Trade: If the WTOT line and the HTOT line have equal slopes, then HTOT WTOT and there is no trade! Suppose the HTOT is one y for one x and the WTOT is one y for one x. If H is opened to trade, there is no on incentive for H households to buy from W and viceversa. So no trade!

If the HTOT is one y for two x while the WTOT is two y for one x, then we say that x is cheaper at H than at W or same thing y is dearer at H than at W: H producers will want to sell their x in W (where their one x fetches two ys, double it can get in H) and consumers will want to buy their y from W (where their one x gets two ys). Thus H will export x to and import y from W. There will be trade! The existence of trade arises because of the difference in the TOTs. The fundamental condition of trade: HTOT WTOT! Trade Balance: At C, H is importing M of y and exporting E of x. The value of M is equal to the value of E at WTOT, that is Px E = Py M. Since trade balance is defined as T = Px E - Py M. This means that at C, T = 0 or trade is balanced. At T = 0, Px E - Py M = 0 so Px /Py = M/E = TOT. = the amount of y imported in payment for x exported at T = 0. We will assume trade balance in this trade model. Transcending the PPF: With trade, H is able to consume at C outside Hs PPF! In other words, trade allows domestic consumption to transcend Hs PPF. C is also on a higher social indifference curve. Thus higher welfare for H. This is accomplished via imports M of y paid for by exports E of x. This is the magic of trade (an example of the magic of the market: If every household produced everything it needed (clothes, food, shelter, shoes, etc), it will be very poor indeed. If it concentrated only on one good, say, food, and bought the rest from other households, it can produce more food and it can get more of each good; Adam Smiths pin factory with specialization narrative). Gains from Trade: the distance between the CIC at C and the CIC at A is called gains from trade. We can decompose this gain into two: gain from pure exchange

(from A to C) and gain from expansion of production (from C to C). First Complication: Both Large Countries Trade Between Large Countries: What if both countries H and W are large: Then the WTOT now responds to moves by H and W! Offer Curves: (i) The schedule of points each representing the amount of desired level of exports E of x and imports M of y at each TOT. (ii) The axes of the Offer curve space are traded goods volumes EH = xT of x and MW = yT of y, specifically desired exports and imports for both countries. (iii) Imports are considered additional to the consumption bundle so is viewed as positive; exports are considered deduction from consumption so is considered negative; (iv) the indifference curve on the (yT,xT)-space where export volume E is a bad (notionally) is upwardsloping; likewise the TOT on the same space is upward-sloping since one needs to be compensated with higher amount of the good (imports) to accept a higher level of bad (export). Compare with indifference curves on the (y,x) space when both commodities are goods. Equilibrium WTOT: the TOT at which the desired export of x of H = the desired imports of x of W and the desired export of y of W = the desired import of y of H. Operationally, it is the line that connects the origin and the intersection of the offer curves of H and W. Let MHy = the desired imports of y by H, EWy = desired exports of y by W, MWx = desired imports of x by W, EHx = desired exports of x by H, then equilibrium is characterized by: MWx = EHx and MHy = EWy.

Excess Demand: Let Excess Demand for x be EDx = MWx EHx and Excess Demand for y be EDy = MHy - EWy. Then at equilibrium WTOT, EDx = 0 and EDy = 0. Stability of WTOT: When the two offer curves form a lens, it is stable, that is, any deviation from the equilibrium WTOT will create excess demand and supply that will return the WTOT to equilibrium. Suppose the WTOT is thrown rightwards of the stable WTOT (x has become cheaper). Then EDx = MWx - EHx > 0 while EDy = MHy - EWy < 0. We say there is excess demand for x and an excess supply of y. The excess demand for x will cause the price of x to rise and the excess supply of y will cause the price of y to fall. The WTOT will return to equilibrium WTOT. (Graph) Instability: When the two offer curves together forms a heart at equilibrium TOT, the equilibrium WTOT is unstable: any deviations due to some shock will create excess demand and supply which will push it further and further from equilibrium. (Graph the heart shaped configuration). A shock that kicks the WTOT clockwise (price of x falls, price of y rises). Then we have EDx = MWx - EHx < 0 and EDy = MHy - EWy > 0; So that the price of x falls further and price of y rises further. The WTOT moves clockwise further away from equilibrium and the process continues. The WTOT does not return to equilibrium! Growth and Equilibrium WTOT: Assume H and W are both large; growth occurs in H when the PPF of H shifts outwards. It can be a neutral shift (outward shift equal everywhere) or biased (shift favors one good) (show PPF

shifts in graph). The PPF shift outwards can come from either improvements in technology (a rise in a or b of the production functions for x and y) or a rise in factor endowments (L in our derivation of PPF). This means a rise in imports and exports of H at same TOT (Graph). The offer curve of H shifts outward for each TOT. There is a new equilibrium point. The equilibrium TOT should shift clockwise in the traded goods space (counterclockwise in the goods space) which means lower price for exports of H. The WTOT moves against H. The adverse WTOT effect tempers the benefits from growth (Graphs). Compare with the impact of growth on a small economy H: no terms of trade deterioration; always good for H. Immiserizing Growth (Bhagwati): When the deterioration of the WTOT due to growth in H is severe (counterclockwise movement of the WTOT in the (x,y)space), the subsequent consumption point may be on a lower CIC than before growth occurred! This will be the case if the increased exports of x causes the price of x in the world market to collapse (extremely elastic demand for x). Farmers may experience this event: a bumper crop causes the price of the crop to fall so much that their total revenue decreases. In the past farmers would rather burn their standing crop or pour their milk in the river rather than see the prices collapse. (show in a graph) Price Elasticity of Demand: If total revenue is R = px, the first derivative or R with respect to x or marginal revenue MR is dR/dx = p + x(dp/dx) = p( [1+ (x/p)(dp/dx)] = (1 + epx ) > (<) 0 if /epx / < (>) 1. The term epx < 0 the elasticity of p with respect to x. It is the reciprocal of e xp = the price elasticity of demand for x with respect to its price. - e px < 1 -exp < 1 and vice-versa.

So revenue R will fall with a rise in output x if absolute value of the (negative) elasticity of price with respect to x exceeds one. Small increases in x causes a large fall in its price p. It will not happen if the demand for x is elastic. Tariff Protection: Preliminaries Tariff on Imports: The government of H may feel that H produces too little y, say rice, at free trade. It would like a higher output of y. One way to do this is to impose a tariff t per unit of import of y. How does this affect the Home TOT? The free trade TOT at H is (Px/Py)H = (Px/Py)W . With free trade the TOT in H becomes the TOT in W (why?). After the tariff t imposition the price of y in H becomes Py(1+t). The HTOT now becomes (Px/Py(1+t))H < (Px/Py)W. Good y has become dearer in H. It is more profitable to produce y rather than x and firms will shift to producing more y and less of x (Why? Related to full employment of factors. You can only produce more y by reducing x) . This goes on until a new equilibrium is reached at B. Welfare loss from a tariff: Effect of a tariff in general equilibrium when H is small: fall in imports and exports for same TOT; (ii) Since H is small, WTOT is unchanged; (iii) welfare loss from tariff; (iii) decomposition of the welfare loss. (Graphs) Tariff protection and Equilibrium WTOT: When both H and W are large A tariff leads to a fall in imports and exports of H for same TOT; H offer curve shifts inwards; (v) Equilibrium WTOT shift counter-clockwise (exports of H increase in price). (v) possible welfare gain from tariff; (vi) Indifference map when exports of one good (exports of x) is a bad and imports of the other good is a good: In this case exports of x is considered a loss to H consumers (negative: what

you export you cant consume!) (vii) TOT: positively sloped when one good is a bad; you accept more bad if given more good. (Graph) (vii) Possible gains from a tariff by H when the WTOT shifts in favor of H. The Community Indifference Curve and Optimal Tariff : H imposes a tariff t up to that point where the CIC of H and Ws Offer curve are tangent to each other (show in a Graph). That is the best that H can aspire for. For as long as W does not respond (W being dumb!), this tariff imposition improves Hs welfare. There is a temptation to gain at the others expense (Ws welfare suffers). If W is not dumb, W will retaliate with its own tariff which shifts its offer curve downwards; and we have a trade tit-for-tat (war). Trade War: H imposes a tariff on imports of y reducing demand for y causing the TOT to turn against y; W sees this and cries foul! W retaliates by imposing a tariff on its imports of x; Offer curve of W shifts inwards and equilibrium WTOT moves clockwise. H imposes further tariff etc. Both will end up at lower welfare level! (Graph, refer to Deardorffs Glossary). Trade War Game: Let the countries be H and W and their policy action set be (FT, T) = (Free Trade, Tariff). The payoffs are given below:

Table: Payoffs of the Tariff Trade War Game

Action
FT H T

FT
100, 100 120, 20

T 20, 120 40, 40

Note that the action profile (FT, FT) gives (100, 100) to each country, (T, T) give (40, 40) to each country so (FT, FT) is superior. But (FT, FT) is unstable: Starting from (FT, FT), W can get 120 > 100 if it deviates to T, H can also gain the same. If W deviates, H will be penalized (gets 20 instead of 100) so will also deviate to T. Both choosing T means each will get 40, a bad deal! From (T, T), there Is no incentive to deviate: if W deviates to FT, it get 20 < 40. Same with H. Therefore (T, T) is a bad equilibrium but it is stable: It is the Nash equilibrium of the trade war game! (meet John Nash at wiki). From a bad Nash equilibrium, the two countries cannot get out unless there is some new force applied. For the trading world, that force is from the WTO, formerly known as GATT (General Agreement of Trade and Tariff: see wiki for WTO). World Trade Organization (WTO): Mediating trade conflicts through negotiation and rules. In the past, trade conflict led to shooting wars. The WTO was conceived to peacefully mediate trade conflicts. As well as promote global trade and openness. When a WTO member is found guilty of unfair trade practice, WTO can impose sanctions on erring country. (see BBC News Report, 2009, on Europe and Banana trade; steel dispute US versus EU; distilled spirits Phil versus US/EU; WTO Stalemate). Another Complication: Monopoly The pedagogical tack we take is to start from the simplest possible case, perfect competition everywhere, and to radiate from there to greater complexity. The first complexity was if H is also a large country. Here we tackle market power in the form of a monopoly.

Monopoly in the Goods Market: Suppose of the two goods x and y, y is produced by a single firm while the x market is perfectly competitive (pc for short). Both firms are price takers in the factor markets (for L and K) The Microeconomics of a Monopolist: The profit function of the x monopolist is = R(y) C(y) = p(y)y cy where p(y) is the demand function, with slope p(y) < 0. Maximum profit for a monopolist is at (d/dy) =MR MC = 0. But MR = p + y(dp/dy) = p(1 + (y/p)(dp/dy)) = p(1 + (1/e)) where e = (dy/dp)(p/y) < 0 is the price elasticity of demand for y; the marginal cost is MC = c. So the monopoly profit max condition is: p(1+ (1/e)) = c. Note that as e this last condition becomes p = c, the condition for a pc firm. (Graph showing the monopoly equilibrium). Compare with the perfectly competitive firms profit max condition p = MC or p = c. Note that (1+ (1/e)) increases as e increases (decreases as e decreases). The smaller is e (less elastic demand as for basic commodity rice or oil), the larger should p be for p(1+ (1/e)) to equal same c. Thus the monopolist price is higher than the pc price. The more inelastic is the demand (the smaller is e) the higher is the price p of a monopolist. Thus the price of a monopolist is always higher than the price of a competitive firm for the same marginal cost c.

(Show the graph: equilibrium of a monopolist versus the competitive firm). No Distortion in factors market : Suppose the factor markets (for labor and capital) are perfectly competitive (no labor unions, no minimum wage law, free labor mobility). So there is no unemployment in the factors market. This means that the equilibrium domestic product mix is still on the PPF (not inside the PPF). The monopolist market equilibrium is given by MRTm = px/[py(1 + 1/e)], where MRTm is the marginal rate of transformation with a monopoly in y, perfect competition in x. The corresponding competitive market equilibrium is given by MRTc = px/py. Clearly, MRTm < MRTc. So more y and less x is produced if y is a monopoly than when x and y are both pc. This means a slide up along the PPF (y being the vertical axis). Not the Tangency: The autarchic equilibrium in a market with monopoly for y is not the tangency of the PPF and the Community Indifference curve! The slope of the community indifference is greater than the slope of the PPF thus the production point is at a lower indifference curve and lower welfare. The MRS MRT with monopoly production. (Graph showing autarky equilibrium under competition and under monopoly). Gains from Demonopolization: When trade with the world W, assumed large and pc, is opened, suddenly the monopoly power of the firm producing y is undermined by imports. It can no longer price x above world price. The equilibrium with trade is at consumption point C, given by MRTH = MRTW= MRSH. This is the same as the equilibrium

when starting from a pc in autarchy. The gains from openning trade starting from a monopoly autarchy is larger that if the initial autarchy is pc in H. It is augmented by gains from demonopolization! (Graph showing gains from trade with emphasis on gain from demonopolization).