Chapter 2: World Trade An Overview

Who trades with whom?

South Africas main trading partners are: The European Union (as a whole) China (largest single-country share) The United States (decreased in volume of trading) African countries (increasing share)

Size matters: the Gravity Model

Strong empirical relationship b/tw the size of a countrys economy & volume of imports/exports o Larger GDP = larger volume of trade Gravity model: the value of trade b/tw any two countries is proportional, other things equal, to the product of the two countries GDPs, and diminishes with the distance between the two countries

A more general form:

Here we dont specifically assume trade is proportional to GDPs and inversely proportional to distance The exponents are chosen to fit the actual data as closely as possible Why does the gravity model work? o Large economies tend to spend large amounts on imports because they have large incomes o They tend to export a lot because they produce a wide range of products What things arent equal? o In practice, countries spend a lot of their income at home what limits international trade?

Using the gravity model: looking for anomalies

Anomalies: the Netherlands, Belgium & Ireland o Ireland: cultural affinity: many Americans have Irish ancestors & shared language; Ireland has many American multinational corporations o Belgium & the Netherlands: geography & transport costs: both located near mouth of the Rhine NB points of entry

Impediments to trade: distance, barriers & borders

The closer two countries are, the larger the volume of their trade Mexico, Canada & the United States

Gravity model shows a strong negative effect of distance: for a 1% increase in distance decrease of 0.7% - 1% of trade o Reflects increasing transport costs Close personal contact increases trade travel of company reps Trade agreements: NAFTA no tariffs/other barriers to int trade b/tw US, Mexico & Canada o Effective agreement significantly more trading among partners (theory) o Dont make national borders irrelevant still more intra-country trade o Intra-Canadian trade decreases steadily with distance, but still greater than trade with an American state the same distance away Existence of separate national currencies a possible impediment to trade

The changing pattern of world trade

Has the world gotten smaller?
Modern transportation & communications have abolished distance internet, jet transport Gravity models still show a strong negative relationship b/tw distance & int trade have the effects grown weaker over time? YES Political forces can outweigh modern advancements o Global economy w/ strong economic linkages is not new 2 waves Railroads, steamships & telegraphs Internet & jets o Keynes says that ages of globalisation come to an end WWI, WWII, Great Depression & widespread protectionism depresses world trade o Since 1970 world trade as a share of GDP has increased dramatically vertical disintegration products go through many production stages in many countries

What do we trade?
Manufactured goods: traded for the most part Mineral products: increasing volume of trade Agricultural products: key, but small piece Services: increasing share o Incl. Traditional transportation fees, insurance fees & foreign tourists spending o Overseas telecommunications (still relatively small, but growing) outsourcing Mining products: mostly oil & other fuels For developed countries: manufactured products are now more important that primary products For developing countries: export mostly primary goods & import manufactured and final goods rise of export of manufactured goods

Service Offshoring
Modern technology makes to possible to perform some economic functions at long range leads to dramatic increase in new forms of int trade call centres Producers must decide: o Set up foreign subsidiary to provide services (operate as multinational firm) o Outsource to another firm May occur w/in the same country long-distance services in the US

o o o

Nontradable jobs: must occur close to customers Tradable jobs occur more in service-related sectors than manufacturing ones Thus, the dominance of manufacturing may only be temporary

Do old rules still apply?

Fundamental principles discovered by economists at the dawn of a global economy still apply World trade is harder to characterise in simple terms in the past it was largely shaped by climate & natural resources; disputes over trade were easy to explain political battles over free trade versus protectionism o Modern: human resources & human-created resources more NB o Trade disagreements involve workers whose skills are made less valuable by imports

Chapter 3: Labour productivity and comparative advantage the Ricardian Model

Countries engage in int trade for 2 basic reasons each contribute to gains from trade Countries trade because they are different from each other benefit from differences by reaching an agreement in which each does the things it does relatively well Achieve economies of scale in production if each country produces only a limited range of goods, it can produce each of these goods on a larger scale & hence more efficiently than if it tried to produce everything

The concept of comparative advantage

Resources used to produce something can be used to produce others trade-off Opportunity costs: the opportunity cost of one product 1 in terms of product 2 is the number of product 2 that could have been produced with the resources used to produce a given number of product 1 Differences in opportunity costs offer the possibility of a mutually beneficial rearrangement of world production o If the US produced only computers and Colombia produced only roses:

The same amount of roses are produced, but more computers are produced in the world the world as a whole is producing more possible to raise everyones welfare (theory) Why the increase? Each country specialises in producing the good in which it has a comparative advantage Comparative advantage: a country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries

Trade b/tw 1 countries can benefit both countries if each country exports the goods in which it has a comparative advantage About possibilities not actualities Int production & trade are determined in the marketplace (demand/supply interaction) The Ricardian Model Labour is the only factor of production and is perfectly mobile no possibility of individuals being hurt by trade trade does not affect the distribution of income (not in reality)

A one-factor economy
One economy: HOME Two goods produced: cheese & wine

Home economys technology: labour productivity in each industry express i.t.o unit labour requirement number of hrs needed of labour required to produce one unit of cheese or wine o Cheese: 1hr o Wine: 2hrs Unit labour requirements are defined as the inverse of productivity the more units that can be produced in an hour, the lower the unit labour requirement o : unit labour req for wine o : unit labour req for cheese o : total labour supply

Production possibilities
Economies have limited resources, therefore there are trade-offs as to what they can produce; to produce more of one good, they must sacrifice the production of another.

The PPF shows the maximum amount of wine that can be produced once the decision has been made to produce any given amount of cheese, and vice versa The PPF is straight if there is only one factor of production (labour) : production of wine : labour used in producing wine : production of cheese : labour used in producing cheese PPF is determined by the limited resources:

If only wine was produced: If only cheese was produced:

units of wine are produced units of cheese are produced

Any mix of wine and cheese that lies on the straight line can be produced

Because the PPF is a straight line, the opportunity cost of a unit of cheese in terms of wine is constant.

Opportunity cost is defined as the number of units of wine the economy would have to give up in order to produce an extra unit of cheese To produce another unit of cheese would require person-hours Each of these person-hours could in turn have been used to produce Therefore, the opportunity cost of cheese in terms of wine is The opportunity cost is equal to the absolute value of the slope of the PPF

Relative prices & supply

The PPF shows combos that Home can produce, but we need to look at prices to see what will actually be produced. What is the relative price of the economys 2 goods the price of one good i.t.o. of another? In a one-factor economy, the supply of cheese & wine will be determined by the movement of labour to whichever sector pays the higher wage One unit of cheese can be produced with one hour of labour and sells for $4 a unit One unit of wine can be produced with two hours of labour and sells for $7 a unit What will they produce? Earn per hour $4/hr $3.50/hr

Cheese Wine

Therefore, the economy will specialise in cheese and produce only cheese, as it has the higher relative price : Price of cheese : Price of wine Hourly wage in the cheese sector: Hourly wage in the wine sector: Wages in the cheese sector will be higher if: Wages in the wine sector will be higher if:

Labour will want to work in the sector that offers the higher wage, thus the economy will specialise in the production of cheese if: If both goods will be produced ?

What is the significance of

This is the opportunity cost of cheese i.t.o. wine

The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost in terms of wine; it will specialise in the production of wine if the relative price of cheese is less than its opportunity cost in terms of wine. If there is no int trade, Home has to produce both goods, but it will produce both only if the relative price of cheese is just equal to its opportunity cost. Because the opportunity cost equals the ratio of unit labour requirements in cheese and wine, we summarise: In the absence of international trade, the relative prices of goods are equal to their relative unit labour requirements.

Trade in a one-factor world

There are now 2 countries, Home and Foreign. Each has one factor of production (labour) and produce 2 goods, cheese and wine. Home: Labour force: Unit labour requirements: o Cheese: o Wine:

Foreign: Labour force: Unit labour requirements: o Cheese: o Wine:

We assume: Or

We assume the ratio of labour required to produce a unit of cheese to that required to produce a unit of wine is lower in Home than in Foreign Homes relative productivity is higher than it is in wine

The ratio of unit labour requirements is equal to the opportunity cost of cheese in terms of wine, and we defined a comparative advantage i.t.o. of opportunity cost Thus, the above equations say that Home has a comparative advantage in cheese The condition under which Home has a comparative advantage involves all four labour requirements. If we only compare the 2 countries unit labour requirements in cheese production, we determine absolute advantage:

We cannot determine the pattern of trade from absolute advantage alone

The slope of the PPF equals the opportunity cost of cheese i.t.o. wine Foreigns PPF is steeper than Homes

In the absence of trade, the relative prices of cheese and wine in each country would be determined by the relative labour requirements In Home the relative price of cheese would be and in Foreign

Once there is international trade, prices will no longer be determined purely by domestic considerations. If the relative price of cheese is higher in Foreign that in Home, it will be profitable to ship cheese from Home to Foreign and to ship wine from Foreign to Home. This doesnt go on indefinitely. Eventually Home will export enough cheese to Foreign and Foreign enough wine to equalise the relative price.

Determining the relative price after trade

Prices of internationally traded goods are determined by supply & demand. General equilibrium analysis is used to analyse the trade, because it takes into account linkages b/tw the 2 markets. We focus on actual quantities of cheese and wine traded, but also relative supply & demand the number of units of cheese supplied/demanded divided by the number of units of wine supplied/demanded

RD and RD show that the demand for cheese relative to wine is a decreasing function of the price of cheese relative to that of wine RS shows that the supply of cheese relative to wine is an increasing function of the same relative price RS is a step o There would be no supply of cheese if the world price dropped below o If If Because Home will specialise in the production of wine if Foreign will specialise in the production of wine if We assumed Therefore, at relative prices of cheese below production of cheese at all

, there would be no

both cheese and wine will be produced in Home Home is

indifferent b/tw producing the two o If : Home specialises in cheese Foreign continues to specialise in wine

o o

When Home specialises in cheese, it produces units When Foreign specialises in wine, it produces units Therefore, for any relative price of cheese b/tw and , the relative supply of cheese is ( )( ) If : Foreign is indifferent b/tw producing cheese and wine, and will produce both If : both Foreign and Home will specialise in cheese and no wine will be produced Cheese Wine Opportunity cost of

Home 1hr 2hrs Foreign 6hrs 3hrs - Lower flat section = - Upper flat section = 2 Downward slope of RD reflects substitution effects as the relative price of cheese rises, consumers will tend to purchase less cheese and more wine, so the relative demand for cheese fall Equilibrium price: determined by intersection of RS & RD: - Is b/tw pre-trade relative prices of cheese (e.g. 1) - Each country specialises in what they have a comparative advantage in If the RD intersected RS: - The world relative price of cheese is , which is the same as the opportunity cost cheese in terms of wine in Home - Home produces both cheese and wine, however the relative supply of cheese is less than it would be if they specialised in cheese - Foreign still specialises in the production of wine Under trade, there is a convergence in world relative prices. - Each country specialises in the production of that good in which it has a relatively lower unit labour requirement - The rise in relative price of cheese in Home will lead Home to specialise in cheese (point F below) - The fall in the relative price of cheese in Foreign will lead Foreign to specialise in wine (point F*) below

cheese i.t.o. wine 2

The gains from trade

Countries with different relative labour productivities specialise in production of different goods and derive gains from trade Benefits shown in 2 ways: - Indirect method of production: produce cheese directly and trade it with Foreign for wine, which they produce indirectly more efficient method of production o Two alternative ways of using an hour of labour:

Home could produce units of wine or units of cheese Home could trade cheese for wine, with each unit trading for units of wine Therefore, the original hour of labour yields ( )( ) units of wine This is more wine that an hour could have produced directly as long as ( )( ) or In international equilibrium, if neither country produces both goods, we must have Home can produce wine more efficiently

by making some cheese and trading it Examine how trade affects each countrys possibilities for consumption o Absence of trade: consume along PF or P*F* o Presence of trade: consume along TF or T*F* o Enlarged range of choice residents better off Once countries have specialised, Home workers earn the equivalent of one unit of cheese and Foreign workers earn the equivalent of 1/3 units of wine per hour If both sell for $12, Home workers earn $12 and Foreign workers $4 The relative wage of a countrys workers is the amount they are paid per hour, compared with the amount workers in another country are paid The relative wage of Home workers is it doesnt matter what price of a unit of cheese is, as long as a unit of wine sells for the same price As long as the relative price of cheese is 1, the wage of Home workers is 3 times that of Foreign workers The wage rate lies b/tw ratios of the 2 countries productivities in the 2 industries o Home is 6X as productive as Foreign in cheese, but only 3/2 times as productive in wine o Homes wage rate is 3 times that of Foreigns o Because the relative wage is b/tw the ratio of the productivities, each country ends up with a cost advantage in 1 good o Because Foreign has a lower wage rate, it has a cost advantage in wine, even though it has a lower productivity o Home has a cost advantage in cheese, despite its higher wage rate, because the higher wage rate is more than offset by its higher productivity

A note on relative wages

-

Misconceptions about comparative advantage

1. Productivity & competitiveness
Free trade is beneficial only if your country is strong enough to stand up to foreign competition. Myth is based on absolute & not comparative advantage Absolute productivity advantage is neither necessary nor sufficient to have a comparative advantage The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign wage rate Foreign is less productive in wine, but is at an even greater relative productivity disadvantage in cheese overall lower productivity pays lower wages lower costs in wine production

2. The pauper labour argument

Foreign competition in unfair and hurts other countries when it is based on low wages Labour unions use to seek protection for industries Home is more productive in both and Foreigns lower wage rate is entirely due to lower wage rate Foreigns lower wage rate is irrelevant to whether Home gains from trade In Home, it is cheaper in terms of its own labour to produce cheese and trade it for wine than to produce it itself

3. Exploitation
Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations What is the alternative? Workers in poorer countries would be worse off if they didnt specialise and export something than if they did so based on lower wages Real wages would be even lower: the purchasing power of a workers hourly wage would fall from 1/3 to 1/6 unit of cheese

Chapter 4: Specific factors & income distribution

2 reasons that trade has strong effect on dist of income: - Short-run consequence: resources cannot move immediately or without cost from one industry to another - Long-run consequence: Industries differ in what FOPs they demand shifting what is produced raises the demand for some FOPs and reduces it for others The specific factors model is about the short-run consequences of trade on income dist when factors cannot move without cost b/tw sectors We assume that sector-switching cost for some factors is high enough that such a switch is impossible in the short run factors are specific to a particular sector

The specific factors model

The model assumes an economy produces 2 goods and can allocate labour supply b/tw 2 sectors - Labour is mobile - Specific factors can only be used in certain sectors

Assumptions of the model

2 goods produced: o Cloth: labour & capital o Food: labour & land - 3 FOPs: o Labour (L): mobile o Capital (K): specific o Land (T): specific Production functions: Cloth: ( Food: ( Labour supply: ) ) -

Production possibilities
How does the economys mix of output change as labour is shifted from one sector to the other?

Slope = marginal product of labour

Diminishing returns:

w/out

increasing at a decreasing rate

Lower right quadrant: production function for cloth o Movement downward along vertical axis increase labour input in cloth sector o Movement right along horizontal axis increase cloth output Upper left quadrant: production function for food o Movement left along horizontal axis increase labour input in food sector o Movement upward along vertical axis increase in food output

Lower left quadrant: economys allocation of labour o Downward movement along vertical axis increase labour employed in cloth o Leftward movement along horizontal axis increase labour employed in food o Downward-sloping 45 degree line with a slope of -1 - Upper right quadrant: economys PPF o Changing the labour allocation b/tw food & cloth sectors results in different mixes of goods being produced by joining the points in this quadrant, we get the PPF Adding more FOPs to the economy changes the shape of the PPF - Curvature reflects diminishing returns to labour in each sector When tracing the PPF, we shift from food to cloth production - Shift one person-hour of labour from food to cloth extra input will increase output in that sector by the marginal product of labour in cloth To increase cloth output by one unit increase labour input by hours By shifting each unit of labour from food to cloth food output by To increase production of cloth by one unit, food production must be decreased by

Therefore, the slope of the PPF is:

As we produce more cloth than food, & o As (and vice versa) This is the opportunity cost

Prices, wages & labour allocation

The demand for labour in each sector depends on the price of output & wage rate wage rate depends on combined demand for labour by food & cloth procedures Employers hire labour in cloth up to the point where Value produced by an additional person-hour equals the cost of employing that hour Downward-sloping due to diminishing returns If the wage rate falls, other things equal, employers in the cloth sector will want to hire more workers Similarly, employers hire labour in food up to the point where The wage rate is the same in both sectors labour is freely mobile moves from low-wage sector to high-wage sector until wages are equalised The wage rate is, in turn, determined by the requirement that total labour demand equals total labour supply -

Thus

Wage rate & L in each sector determined by given prices of goods

- Left-hand side: slope of PPF - Right-hand side: negative relative price of cloth Therefore. At the production point, the PPF must be tangent to a line whose slope is minus the price of cloth divided by that of food

What happens to the allocation of labour and the dist of income when prices of food & cloth change. Equal proportional change in prices (change in overall price level):

Both labour demand curves shift upward by an amount proportional to the increase in prices (e.g. 10%) - Wage rate increases by 10% - Allocation of labour b/tw sectors & outputs of food & cloth dont change - No REAL changes occur: o Real wage rates (ratios of wage rate to prices of goods) dont change With the same amount of labour employed in each sector, receiving the same real wage rate, the real incomes of capital owners and landowners also remain the same. So everyone is in exactly the same position as before. - Changes in overall price level have no real effects dont change physical quantities of the economy - Only changes in relative prices affect welfare or allocation of resources Change in relative prices (change in price of only 1 good)

The increase in shifts demand up by same proportion (7%) w rises, but by less than 7% L shifts from food to cloth output of cloth rises and output of food falls o The rise in the price of cloth is shown in the PPF:

- Food output falls & cloth output increases Since higher relative prices of cloth lead to a higher output of cloth relative to that of food, we can draw a relative supply curve showing as a function of

The equilibrium relative price in the absence of trade is ( )

Relative prices & the distribution of income

What is the impact of a rise in the relative price of cloth? Workers: - Wage rate has risen (but by less than 7%) Real wage rate i.t.o. cloth Real wage rate i.t.o food

The final result is ambiguous depends on relative importance of cloth & food in workers consumption (determined by preferences)

Owners of capital: - Better off therefore profits i.t.o. of what they produce income of capital owners more than proportionately with income rises i.t.o. both goods Landowners: - Worse off - Real wage i.t.o. food income - purchasing power of any given income Summary: - Factor specific to sector whose relative price increases is definitely better off - Factor specific to sector whose relative price decreases is definitely worse off - Change in welfare for mobile factor is ambiguous

International trade in the specific factors model

For trade to occur, a country must face a world relative price that is different from the relative price that would prevail in the absence of trade

Why is different from ? - Different technologies or resources Relative price when open to trade: ( ) If no trade: lower relative price - ( )

Increase in relative price induces economy to produce relatively more cloth (shown in movement along PPF) - Consumers respond to higher relative price of cloth by demanding relatively more food export cloth & import food If opening trade had been associated w/ a decrease in the relative price of cloth changes in relative supply & demand would be reversed export cloth & import food Therefore, an economy exports the good whose relative price has increased and imports the good whose relative price has decreased

Income distribution and the gains from trade

What weve seen:

- Production poss are determined by resources & technology - What we choose to produce us determined by the relative price of cloth - How changes in relative price of cloth affect real incomes of diff FOPs - How trade affects both relative P & economys response to those P changes Who gains & loses from int trade - Trade shifts relative price of goods that are traded relative P of the good in the new export sector - The specific factor in the sector whose relative P increases will gain - Welfare changes for labour are ambiguous Trade benefits the factor that is specific to the export sector of each country but hurts the factor specific to the import-competing sectors, with ambiguous effects on mobile factors Do gains outweigh losses? - Subjective concept - Ask if those who gain from trade compensate those who lose & still be better off themselves trade is potentially a source of gain to everyone If a country doesnt trade, output = consumption

Int trade makes it poss for the mix of cloth & food consumed to differ from the mix produced. The value of consumption must be equal to the value of production: ( ( ) ( ) ( )

: food imports by how much consumption exceeds production ): cloth exports by how much production exceeds consumption Therefore, imports is equal to the relative price of cloth times exports o Shows the amount the economy can afford to import is limited by the amount it exports budget constraint

Slope of the budget constraint:

o o

Consuming one less unit of cloth saves the economy extra units of food One unit of cloth can be exchanged on world markets for

enough to purchase units of food

- Budget constraint is tangent to PPF at chosen production point - The economy can always afford to consume what it produces Potential gains from trade: 1. Absence of trade: economy consumes what it produces a. Consumption is a point on the PPF (point 2) 2. It is possible for a trading economy to consume more of both goods than it would in the absence of trade a. BC represents all poss combos that a country could consume given the world relative price of cloth b. Part of the BC (coloured region) situations in which the economy consumes more of both than in the absence of trade c. Only if pre-trade production point is at point 1 (trade has no impact) there is always a part of the BC that allows the consumption of more of both goods 3. The economy as a whole consumes more of both goods it is possible in principle to give each individual more of both goods everyone is better off as a result of trade Trade potentially benefits a country because it expands the economys choices it is always poss to redistribute income in such a way that everyone gains from trade everyone could gain, but doesnt mean they actually do

Chapter 5: Resources and trade the Heckscher-Ohlin Model

Trade is partly explained by differences in labour productivity and reflects differences in countries resources In this model, differences in resources are the only source of trade Comparative advantage is influenced by the interaction b/tw nations resources (relative abundance of FOPs) and technology of production (influences relative intensity w/ which different FOPs are used in the production of goods) Look at long-run consequences when all FOPs are mobile across sectors Heckscher-Ohlin theory emphasises the interplay b/tw proportions in which different FOPs are available in diff countries and proportions in which they are used in producing diff goods factorproportions theory

Model of a two-factor economy

2 X 2 X 2 model: - 2 countries o Home o Foreign - 2 goods o Cloth o Food - 2 FOPs (both mobile) equalise returns in both sectors in the long run o Labour (wage) o Capital (rental rate)

Prices & production

Production functions: ( ) ( ) Overall, the economy has a fixed supply of K and L that is divided b/tw employment in the 2 sectors Define the following expressions that are related to the 2 production technologies:

These are the quantities of capital or labour used to produce a given amount of cloth or food, rather than the quantity required to produce that amount - Some room for choice in the use of inputs Choices depend on factor prices for L & K If there is no possibility of substituting labour for capital:

Producing 1 unit of cloth: 2L & 2K Producing 1 unit of food: 1L & 3K Economy must produce s.t. both constraints

The PPF is kinked (RED LINE) - Specialise in food (point 1) produce 1000 food o Spare labour capacity (only 1000 out of 2000 employed) - Specialise in cloth (point 2) produce 1000 cloth o Spare capital capacity (only 2000 out of 3000 employed) - At point 3: all labour and capital employed 1500 K & 1500 L in cloth; 1500 K & 500 L in food Opportunity cost of producing an extra unit of cloth i.t.o. food is not constant - Produce mostly food (left of point 3) spare labour capacity opportunity cost is 2/3 - Produce mostly cloth (right of point 3) spare capital capacity opportunity cost is 2 - Opportunity cost of cloth is higher when more units of cloth are being produced If there is the possibility of substituting capital for labour (and vice versa) in production: - Substitution removes kink

Opportunity cost in terms of food of producing one more unit of cloth rises as the economy produces more cloth and less food The economy chooses where to produce on the PPF depending on prices specifically at the point that maximises the value of production

The value of the economys production is: Isovalue line: value of output is constant along this line slope = Economy produces at point Q: point on PPF that touches highest poss isovalue line at this point the slope of the PPF is Opportunity cost i.t.o. food of producing another unit of cloth is equal to the relative price of cloth

Choosing the mix of inputs

Producers will face not fixed input req but trade-offs in each sector

- Shows alternative input combos that can be used to produce one more unit of food What will actually be produced depends on the relative costs of capital and labour - If capital rental rates are high and wages low, producers will choose to produce using relatively little capital and more labour - Input choice will depend on the ratio of the factor prices

The relationship b/tw factor prices and the ratio of labour to capital used in production of food is curve FF:

There is a corresponding relationship b/tw

and the labour-capital ratio in cloth production

curve CC - CC is shifted out relative to FF: at any given factor prices, production of cloth will always use more labour relative to capital than will production of food - Production of cloth is labour-intensive - Production of food is capital-intensive Definition of intensity depends on the ratio of labour to capital used in production, not the ratio of labour or capital to output goods cannot be both labour- and capital-intensive CC and FF are relative factor demand curves - Downward slope characterises substitution effects in producers factor demand - As w relative to r producers substitute capital for labour in their production decisions

Factor prices and goods prices

Assume an economy produces both food and cloth Competition among producers in each sector ensures the price of each good equals its cost of production Cost of producing a good depends on factor prices: if wages rise price of any good whose production uses labour will also rise Importance of a particular factors price to the cost of producing a good depends on how much of that factor the goods production involves One-to-one relationship b/tw SS curve to

Cloth production is labour-intensive and food production is capital-intensive one-to-one relationship - The higher the relative cost of labour, the higher must be the relative price of the labourintensive good Combining the 2 graphs:

Shows the linkage of

and

At ( ) : produce both goods ( ) ( ) &( ) If the relative price of cloth rises to ( ) : ( ) ( ) ( ) &( ) ( ) &( )

Increase of price of cloth relative to that of food will raise the income of workers relative to that of capital owners Such a change in relative prices will unambiguously raise the purchasing power of workers and lower the purchasing power of capital owners by raising real wages and lowering real rents i.t.o. both goods When the ratio of labour to capital falls in producing either good, the marginal product of labour i.t.o. that good increases workers find their real wage higher i.t.o. both goods Marginal product of capital falls in both industries capital owners real incomes lower i.t.o. both goods Changes in relative prices have strong effects on income distribution always changes it so much that owners of one factor of production gain while owners of the other are worse off

Resources and output

How do changes in resources (total FOP supply) affect the allocation of factors across sectors & associated changes in output produced

( ) ( ) ( ) &( ) If the labour force grows: At ( ) in both sectors remain constant

How does the economy accommodate the increase in aggregate relative supply of labour if relative labour demanded remains constant? How does the economy employ the additional labour hours? - The labour-capital ratio in cloth sector is higher than in the food sector the economy can increase the employment of labour to capital to production of cloth (holding the labourcapital ratio fixed in each sector) by allocating more labour and capital to the production of cloth (labour-intensive) - As labour & capital move from food to cloth economy produces more cloth and less food

: PPF before labour supply increase : PPF after increase in labour supply - PPF shifts out - More of both can be produced - Shifts out more relative to cloth biased expansion of production possibilities Expansion is strongly biased towards cloth production that at unchanged relative prices, production moves from 1 2 - Actual fall in food production & increase in cloth production Biased effect of increases is important to understanding how differences in resources give rise to international trade - labour supply expands production possibilities disproportionately in direction of cloth - An economy with a high relative supply of labour to capital will be relatively better at producing cloth than an economy with a low relative supply of labour to capital Generally, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well endowed

Effects of international trade between two-factor economies

Home & Foreign have identical tastes identical demand curves Same technology

Only difference: Home has a higher than Foreign does

Relative prices and the pattern of trade

Home: higher labour-abundant Foreign: lower capital-abundant Abundance is relative no country is abundant in everything Cloth is labour-intensive Homes PPF relative to Foreigns is shifted out more in direction of cloth - Home produces a higher ratio of cloth to food - Home has a higher relative supply of cloth relative supply curve is to the right of Foreigns Trade leads to convergence of relative prices the relative price of cloth to food will be equal

: Home relative supply o Absence of trade: equilibrium @ point 1 Relative price of cloth lower in Home : Foreign relative supply o Absence of trade: equilibrium @ point 3 - Trade: relative prices converge o Home: o Foreign: o New equilibrium @ point 2 b/tw pre-trade relative prices o Economy exports the good whose relative price increases Home exports cloth and Foreign food Home becomes an exporter of cloth because it is labour-abundant (relative to Foreign) & production of cloth is labour-intensive (relative to food production) Heckscher-Ohlin Theorem: The country that is abundant in a factor exports the good whose production is intensive in that factor Correlation b/tw abundance in a factor and its exports of goods that use the factor intensively: Countries tend to export goods whose production is intensive in factors with which the countries are abundantly endowed

Trade and the distribution of income

Trade induces a convergence of relative prices Changes in relative prices have strong effects on the relative earnings of labour & capital

Rise in cloth price raises purchasing power of labour i.t.o. both goods & lowers purchasing power of capital i.t.o. both goods - Rise in price of food has reverse effect International trade can have a powerful effect on income dist - Home: relative price of cloth rises o Labour workers/owners gain from trade o Capital workers/owners worse off - Foreign: relative price of cloth falls o Labour workers/owners lose from trade o Capital workers/owners gain The resource of which a country has a relatively large supply is the abundant factor in that country, and the resource of which it has a relatively small supply is the scarce factor Owners of a countrys abundant factors gain from trade, but owners of a countrys scarce factors lose FOPs used intensively by the import-competing industry are hurt by the opening of trade Opening trade expands an economys consumption possibilities can make everyone better off The specificity of factors to particular industries is often a temporary problem - Cannot migrate overnight shift over time to different sectors - Income distribution effects arise because labour & other factors of production are immobile represent a temporary, transitional problem - Effects of trade on income dist among land, labour & capital are more or less permanent

Factor-price equalisation
No trade: labour earns less in Home than in Foreign (capital, more) o Labour-abundant Home: lower relative price of cloth than capital-abundant Foreign o Difference in relative prices of goods implies an even larger diff in relative prices of factors - With trade: relative prices of goods converge causes convergence of relative price of factors In the model, there is complete equalisation of factor prices During trade, countries are indirectly trading FOPs: - Home lets Foreign have some abundant labour by trading goods w/ high ratio of labour to capital more labour is embodied in Homes exports than imports In reality, factor prices are not equalised may reflect differences in quality of labour (partially) - Assumptions: o Both countries produce both goods Factor-price equalisation occurs only if the countries involved are sufficiently similar in their relative factor endowments Might not equalise if countries have radically diff ratios of K to L or of skilled to unskilled labour o Technologies are the same If a country has a superior technology, it might have higher w & r o Trade actually equalises the prices of goods in 2 countries Prices of goods are not fully equalised by international trade in reality Lack of convergence is due to both natural barriers & barriers to trade -

Chapter 6: The standard trade model

The standard trade model is the general model, of which the Ricardian, specific factors and Heckscher-Ohlin models are specific cases

A standard model of a trading economy

Built on 4 key relationships: 1. Relationship b/tw PPF & relative supply curve 2. Relationship b/tw relative P & relative D 3. Determination of world equi by world relative S&D 4. Effect of terms of trade on nations welfare Terms of trade:

Production possibilities and relative supply

P2F goods: food & cloth - Each countrys PPF:

Point where production actually takes place depends on price of cloth relative to food At given market prices, a market economy chooses production levels that maximise value of outpu t Isovalue lines: ( o o )

Higher V farther away isoline is from the origin Slope:

If

: Graph (a): isolines become steeper Produce more cloth and less food Relative supply of cloth rises when the relative price of cloth rises shown in relative supply curve in graph (b)

Relative prices and demand

Value of consumption = value of production: - Production & consumption lie on the same isovalue line Choice of a point on the isovalue line depends on tastes of consumers represented by an indifference curve 3 properties of the IC: 1. Downward-sloping 2. Further to the upper right corner higher levels of welfare 3. Gets flatter as we move to the right diminishing marginal utility Choose to consume @ point in isovalue line where there is the highest poss welfare where isovalue line is tangent to the highest reachable IC (point D) - Point D: economy exports cloth & imports food What if ?

Produce C & F Consumption choice shifts: o Reflects 2 effects of o o Change

: advantage

Moved to higher IC better off Export C &

shift along IC toward F & away from C

C now relatively more expensive welfare: income effect Tends to increase consumption of both goods Shift in consumption at any given level of welfare: subs effect Tends to make economy consume less C and more F

Panel (b): relative production of cloth (1 2) & relative consumption of cloth (1 2) Change in relative consumption captures subs effect of P change If income effect was large enough consumption levels of both goods could rise (DC & DF ), but subs effect of demand dictates that the relative consumption of cloth If the economy cannot trade: equi @ point 3 worse off D2 D1)

The welfare effect of changes in the terms of trade

: cloth exporter initially better off (if If initially food exporter instead of cloth direction of effect is reversed: - Relative P of food Define terms of trade (TOT): price of the good initially exported divided by price of a good initially imported TOT welfare

Changing TOT can never decrease welfare to below the level of welfare in the absence of trade (D3) RS RS*

Determining relative prices

Home: TOT measured by Foreign: TOT measured by

Assume trade patterns induced by diff in Home & Foreigns production capabilities diff RS

Equilibrium relative price with trade & associated trade flows Home produces and Foreign produces

World relative supply obtained by summing production levels for C & F and taking ratios: ( ) ( ) - Lies b/tw Home & Foreigns RS World relative demand: ( ) ( )

Same preferences same relative demand curves world relative demand curve is the same Equi relative P: point 1 - Determines how many units of Homes cloth are traded for how many units of Foreigns food - Homes exports = Foreigns imports: Homes imports = Foreigns exports:

Economic growth: a shift of the RS curve

- The effects of economic growth at home and in the rest of the world Abroad: - Good: larger market for exports & lower import prices - Bad: increased competition for exports & domestic producers Home: - Good: production capacity more valuable (sell more) - Bad: lower prices for exports

Growth and the production possibility frontier

Outward shift of PPF due to resources or efficiency Growth typically biased shift PPF out more in one direction than the other

Effects of biased growth on relative supply - TT TT : biased growth towards C - TT1 TT3: biased growth towards F Why biased? 1. Ricardian model: a. Technological progress in 1 sector expands production poss more in the direction of that sectors output than the other 2. Heckscher-Ohlin model: a. Increase in FOP biased expansion of production poss Biased growth above is strong - Economy can produce more of BOTH - At an unchanged relative P of C output of F falls in (a) & output of C falls in (b) Even mild bias results in more of one output produced relative to the other R shifts right Panel (c): - RS1 RS2: growth biased toward C - RS1 RS3: growth biased toward F
1 2

World relative supply and the terms of trade

If Home has growth biased toward C (export) panel (a) - Output of C & output of F - Output of C relative to F rises @ any given P for the world as a whole RSWORLD shifts right

Growth & world relative supply RS RS o

1 2

PC/PF: ( ) ( )

o Homes TOT o Foreigns TOT Doesnt matter which economy grows, but which sector experiences growth (direction of bias) If Foreign had cloth-biased growth: same effect on TOT

Food-biased growth: o Leftward shift of RS: RS1 RS3 o PC/PF: ( ) ( )

o Homes TOT o Foreigns TOT Export-biased growth: growth that disproportionately expands a countrys production poss in direction of export Import-biased growth: growth that disproportionately expands a countrys production poss in direction of import Export-biased growth tends to worsen a growing countrys TOT, to the benefit of the RO W; import-biased growth tends to improve a growing countrys TOT, at ROWs expense

International effects of growth

Whether growth at home or abroad is good or bad depends on the bias of the growth Type of growth Effect on TOT Export-biased: Home Export-biased: Foreign Import-biased: Home Import-biased: Foreign Historical view: growth in the industrialised world would be import-biased, while that in the lessdeveloped world would be export-biased - Growth in poorer nations could be self-defeating export-biased growth TOT to the point of getting smaller immiserizing growth o Must have strong export-biased growth combined w/ very steep RS & RD curves change in TOT enough offset direct favourable effects of an increase in a countrys productive capacity o Theoretical concept Growth at home usually raises our own welfare even under trade, not true of growth abroad import-biased growth is likely when the rest of the world achieves this home TOT Most countries experience fluctuations in TOT - Some developing countries: exports concentrated in mineral & agri sectors very volatile world prices larger TOT swings substantial changes in welfare can attribute fluctuations in GDP to fluctuations in TOT

Chapter 7: External economies of scale and the international location of production

Assumed perfect competition so far If there are economies of scale, there are increasing returns to scale larger companies may take advantage of smaller ones and dominate the market (monopoly/oligopoly) imperfect competition

Economies of scale and international trade: an overview

Economies of scale: production is more efficient the larger the scale at which it takes place double inputs more than double outputs

Widgets produced using only labour amount of labour req depends on number of widgets produced - Double labour input more than double output - Average labour input decreases the more is produced - Incentive for trade: by concentrating production in one country world economy uses same amount of hrs to produce more output - Transfer labour from some sectors to others in order to increase/decrease production - To gain economies of scale: focus on producing a few things on a larger scale world economy can produce more of each good Role in trade: makes it poss for each country to produce a restricted range of goods and to take advantage of economies of scale w/out sacrificing variety in consumption typically leads to increased variety

Economies of scale & market structure

External economies of scale: when cost per unit depends on the size of the industry, but not necessarily on the size of one firm - Increase the number of firms, holding each firms output constant overall output increases - Cost of each firm decreases Internal economies of scale: when cost per unit depends on the size of an individual firm, but not necessarily on the size of the industry - Decrease number of firms and hold overall output constant each firm produces more Different implications: - Purely external: many small firms & perfect competition - Internal: large firms have cost advantage & imperfect competition

The theory of external economies

Examples: Silicon Valley; Hollywood; New York (finance) Reasons for external economies of scale: 1. Specialised suppliers

Bringing together many firms to collectively provide a large enough market to support a wide range of specialised suppliers Increased tendency towards industrial localisation Advantages: key inputs cheaper & more easily available (& better quality) 2. Labour market pooling Cluster of firms creates pooled market for specialised labour Fewer labour shortages & lower unemployment Labour can move easily b/tw firms depending on demand for their skills results in lower unemployment in one area than over two distant areas 3. Knowledge spillovers Companies learn from competitors nearby study & reverse-engineer products Informal exchange of info/ideas social gatherings bars

External economies & market equilibrium

Strength of economies of scale depends on industry size bigger industry = stronger external economies o Larger industry = lower costs

External economies & market equilibrium If there are external economies AC is downward sloping (not upward-sloping) o Forward-falling supply curve: larger output = lower price, because of AC o AC as Q External economies drive a lot of trade w/in & b/tw countries

External economies & international trade

-

External economies, output & prices

Initially: no trade across borders - 2 countries - External economies of scale in production forward-falling supply curve in BOTH countries

External economies before trade Open up for trade:

Trade & prices Chinese button industry expands & American one contracts China has the lower initial average cost Chinas AC as output Eventually all button production will be in China Because Chinas initial AC is forward-falling, increased production as a result of trade leads to a world price that is lower than the original price lower than in either country before trade No convergence only decrease due to stronger external economies

External economies & the pattern of trade

What leads to the initial advantage of a lower cost? - Comparative advantage (partial explanation) - Historical contingency: something gives initial advantage gets locked in by external economies even if circumstances that gave initial advantage no longer there New York & London o Sheer accident - Consequence of history: not always located in the right place

Once est. advantage, may retain advantage even if another country could do it more cheaply

The importance of established advantage Due to external economies of scale many small firms competition drives AC down ACVIETNAM is below ACCHINA could manufacture buttons more cheaply (at point 2) China est. industry first historical advantage Vietnams initial AC is still higher than Chinas equi AC o If there is no initial production Q0 C0 > P1

Trade & welfare with external economies

Assume external economies gains from trade over and above those from comparative advantage - World more efficient & richer gains from both Trade based on external economies may leave a country worse off than in the absence of trade -

External economies and losses from trade Thailand could produce more cheaply, but Switzerland started producing watches first equi @ point 1 If there was no trade in watches & Thailand was forced to be self-sufficient equi @ point 2 o P2 < P1

Situation in which the price of a good that Thailand imports would actually be lower if there was no trade & the country forced to produce the good themselves trade leaves the country worse off than w/ no trade Incentive for Thailand to protect potential watch industry from foreign comp External economies of scale may disadvantage indiv countries, but world as a whole still benefits External economies arise from accumulation of knowledge Firm improves product through experience likely to be imitated & others benefit from knowledge spillover Spillover gives rise to situations in which production costs of indiv firms fall as industry as a whole accumulates experience Now industry costs depend on experience measured by cumulative output of industry to date

Dynamic increasing returns

-

The learning curve - Relates unit cost to cumulative output - Downward-sloping: effect on costs of experience gained through production Dynamic increasing returns: when costs fall with cumulative production over time rather than with current rate of production - Can lock in advantage: L has advantage - L* has lower input costs & less production experience - If L has a sufficiently large head start potentially lower costs of 2nd industry may not allow 2nd country to enter market - May justify protectionism o Country has low costs but no experience, therefore cannot export competitively can increase long-term welfare by subsidising production or protecting from foreign competition until industry is more mature infant industry argument

Chapter 8: Firms in the global economy export decisions, outsourcing & multinational enterprises
The theory of imperfect competition
Perfectly competitive market: - Many buyers & sellers - All a small part of the market - Price takers Imperfect competition: - Few firms produce a good - Can influence prices - Highly differentiated products - Price-setters - Pure monopoly - Oligopolies

Monopoly: a brief overview

Monopolistic pricing & production decisions Downward-sloping demand curve Corresponding marginal revenue curve (always below demand) o Always less than price to sell additional must lower P of all Marginal revenue & price - How much less is marginal revenue than P? Depends on: o How much output firm is already selling o Slope of demand curve How much monopolist must cut P to sell one more unit Very flat: small price cut Very steep: large price cut - Assume D is a straight line dependence of monopolists total sales on P charged: Marginal revenue:

o Gap depends on initial sales Q and slope parameter B o Higher Q lower MR o Larger B more sales fall for any given increase in P closer MR is to P Average & marginal costs - Larger output lower AC - Constant MC economies of scale come from fixed production costs difference becomes smaller and smaller as fixed cost if spread over more output - Total cost: Average cost: ( o AC > MC always )

Average versus marginal cost Profit-maximising output of monopolist: MR = MC - Here P > AC economic profit

Monopolistic competition
Make economic profit attract competitors pure monopoly rare in practice oligopoly more likely - Oligopolies interdependent: consider consumers & competitors expected responses to changes in P monopolistic competition - Assumptions in monopolistic competition to get around interdependence: o Differentiated products o Assume firm takes prices charged by rivals as given - Each firm is a monopolist in the sense that it is the only firm producing its particular good, but the demand for its good depends on the number of other similar products available and on the prices of other firms products in the industry Assumptions of the model: [ o o o o ( )] -

Q: quantity demanded S: total output of the industry n: number of firms b: constant rep responsiveness of firms sales to price

o o -

P: price charged by THIS firm : average price charged by competitors

All charge same P market share = o Charge more = smaller share S is unaffected by firms only gain customers at the expense of others o o All firms have the same costs (are symmetric) and have the same demand curve & cost function [ ( )]

Market equilibrium 1. The number of firms and average cost All firms are symmetric all charge same P in equi

Each firms output is a 1/n share of total industry sales S Average costs depends inversely on firms output AC depends on size of the market & number of firms: ( )

More firms in the market higher AC Upward-sloping relationship b/tw n & AC:

Equilibrium in a monopolistically competitive market More firms lower output of each firm higher each firms AC 2. The number of firms and the price P charged by a typical firm also depends on number of firms in the industry more firms = more intense competition lower P Show each firm faces a straight-line demand curve & use to determine P Assume firms take each others prices as given taken as given

Therefore demand: [( ) *( ) = Substitute into MR: + = A ]

Profit-maximising firms set MR=MC:

Rearrange to get P charged by each firm:

If all charge same P each sell Therefore, the relationship b/tw number of firms and P each charges:

More firms in market lower P charged Each firms mark-up over MC competing firms decreases w/ number of

Equilibrium in a monopolistically competitive market 3. Equilibrium number of firms Intersection of PP and CC PP: more firms = lower P face more comp CC: more firms = higher each AC each sells less Equi @ n2: zero-profit number of firms in the industry Long-run: n tends towards n2 E is the long-run equi Short-run: o At n1: firms making monopoly profits more firms enter profitable industry & drive profit down

o -

At n3: many firms making losses more firms exit market

Monopolistic competition & trade

Trade increases market size If there are economies of scale variety of goods & scale of production are constrained by market size - If countries trade w/ each other form integrated world market loosen constraints - Each specialises in narrower range trade increase variety available - Opportunity for mutual gain even when countries do not differ in resources or tech Use monopolistic model to show: - Trade improves trade-off b/tw scale & variety - Show larger market leads to lower AC & greater variety - Create world market larger than those comprising it

The effects of increased market size

The number of firms in a monopolistically competitive industry & P charged are affected by size of the market larger markets = both more firms & more sales per firm consumers offered lower P and greater variety Look at CC curve:

S AC for any n CC curve in larger market is below one in smaller market:

Effects of a larger market Look at PP curve:

Does not shift S doesnt affect PP

Chapter 9: The instruments of trade policy

Basic tariff analysis
Specific tariff: levied as fixed amount per unit imported Ad valorem tariff: levied as percentage of value per unit Effect if either: raise the cost of shipping goods to a country Traditionally NB source of govt income & protect domestic industries Other: nontariff barriers import quotas & export restraints Use a partial equilibrium framework to analyse

Supply, demand & trade in a single industry

Home D&S depend on price i.t.o. Home currency & Foreign D&S depend on price i.t.o Foreign currency assume exchange rate unaffected by trade policy enacted quote both i.t.o Home currency Trade arises because of diff P in absence of trade - No trade: P higher in Home than Foreign allow trade good goes from Foreign to Home price in Foreign increases and in Home decreases eliminate difference Derive HOME IMPORT DEMAND CURVE & FOREIGN EXPORT SUPPLY CURVE

Deriving Homes import demand curve As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines

Deriving Foreigns export supply curve As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for export rises

World equilibrium The equilibrium world price is where Home import demand (MD) = Foreign export supply (XS)

Effects of a tariff

Effects of a tariff Absence of tariff: - Price equalises at PW in both countries point 1 Tariff: - Exporters not willing to move good from Foreign to Home unless Home price exceeds Foreign P by at least t - Nothing shipped: excess demand in Home & excess supply in Foreign P Home & P Foreign until P diff is t - Intro wedge b/tw P in 2 markets o P in Home PT o P in Foreign PT* = PT t - Home: demand for imports producers supply more and consumers demand less o 12 - Foreign: supply & demand export supply o 13

Volume traded: QW QT Home P: PW PT is less than amount of tariff part of tariff reflected in decline in Foreigns export P not passed on to Home consumers Effects of tariff on small country:

A tariff in a small country When a small country imposes a tariff its share of world market for good it imports is usually minor to begin with import reduction has very little impact on world (foreign export) price Tariff raises P of imported good in country imposing tariff by full amount : PW PW + t Production of imported goods : S1 S2 Consumption of imported goods : D1 D2 Imports fall in country imposing tariff

Measuring the amount of protection

2 problems with trying to measure: 1. If the small country is not a good approximation, part of the tariffs effect will be to lower foreign export prices 2. Tariffs may have very diff effects on goods at diff stages of production

Costs & benefits of a tariff

Deriving consumer surplus from the demand curve Consumer surplus on each unit sold is the diff b/tw the actual price and what consumers would have been willing to pay

Geometry of consumer surplus Consumer surplus is equal to the area under the demand curve and above the price

Geometry of producer surplus Producer surplus is equal to the area above the supply curve and below the price

Measuring the costs & benefits

Costs & benefits of a tariff for the importing country - Domestic price : PW PT - Foreign price : PW PT* - Consumer loss: a, b, c, d - Producer gain: a - Govt revenue: c + e - Deadweight loss: b + d Net effect on welfare = net cost of tariff: ( ) b + d = efficiency loss o b: production distortion loss ( )

o c: consumption distortion loss - e = TOT gain because tariff lowers foreign export P Small country cannot affect world price lose e welfare loss Tariffs distort incentives of producers & consumers induce to act as if imports are more expensive than they are - Consumers reduce consumption marginal unit yields welfare = tariff-inclusive domestic price - Domestic producers expand production marginal cost = tariff-inclusive price could have bought more cheaply abroad

Other instruments of trade policy

Export subsidies: theory
Definition: payment to firm that ships a good abroad - Specific/ad valorem - When govt offers subsidy shippers export up to the point at which domestic P > foreign P by the amount of the subsidy

Effects of an export subsidy PW PS: exporting country PW PS*: importing country P less than subsidy Exporting country: o Consumer loss: a + b o Producer gain: a + b + c o Govt subsidy: b + c + d + e + f + g o Deadweight loss: b + d + e + f + g b, d: consumption & production distortion losses Subsidy worsens TOT exporting P ) o Leads to additional TOT loss: e + f + g = (

Import quotas: theory

Definition: direct restriction on the quantity of some good that may be imported Always raises the domestic P of the imported good - Limit imports immediate result: D > (S + Z) P market clears

Long-run: raises domestic prices by the same amount as a tariff that limits imports to the same level Diff b/tw tariff & quota: govt receives no revenue - Quota rents to licence holders (not govt tax rev)

Effects of the U.S. import quota on sugar

Voluntary export restraints

Definition: quota on trade imposed from the exporting countrys side instead of the importers Imposed at request of the importer & agreed to by the exporter forestall other trade restrictions - Exactly like an import quota where the licences are assigned to foreign govt very costly to importing country - More costly than a tariff tax revenue becomes rents earned by foreigners under the VER VER clearly produces a loss for importing country - Bulk of cost: transfer of income rather than loss of efficiency

Local content requirements

Definition: regulation that req some specified fraction of a final good to be produced domestically - Physical units or value terms - Similar protection to import quota for domestic producers of parts - For firms that buy locally: effective price of inputs to firm is an average of the price of imported and domestically-produced inputs - No rent/revenues cost passed on to consumers @ final stage

Other trade policy instruments

1. Export credit subsidies: like export subsidy, but is a subsidised loan to buyer 2. National procurement: govt/strongly-regulated firms buying can be directed towards domestically produced goods even when more expensive than imports 3. Red-tape barriers: informal restrictions

Chapter 10: The political economy of trade policy

The case for free trade
Most countries have a degree of protectionism Even if free trade isnt perfect, it is a better alternative to any govt policy

Free trade & efficiency

The efficiency case for free trade Tariff causes welfare loss by distorting choices of consumers & producers leads to DWL Free trade eliminates the distortions Tariffs generally low & quotas rare total distortions generally small Cost-benefit analyses dont tell full story Small & developing countries gain have substantial gains from trade o Economies of scale protected markets limit gains & internal economies fragment production, reduce competition & raise profits, also lead too many firms to enter industry inefficiency o Offers more opportunities for learning & innovation for entrepreneurs o Makes whole economy more efficient more firms with higher productivity Hard to quantify When firms incur large costs to get import licences earn economic rents as holders Waste some of economys productive resources Reflects the fact that a political commitment to free trade may be a good idea in practice, even though there may be better in principle Trade policies are dominated by special-interest politics rather than considering national welfare some tariffs/subsidies may increase welfare o If govt agencies tried to pursue this captured by interest groups redistribute income politically influential sectors Barriers used to protect some interest groups sometimes for overall welfare Large country: able to affect prices of foreign exporters tariff lowers import P TOT benefit o Offset benefit against costs of tariff (distortions)

Additional gains from trade

Rent-seeking

Political argument for free trade

National welfare arguments against free trade

-

The terms of trade argument for a tariff

The optimum tariff At small tariff welfare > welfare w/ no tariff At a certain point, costs become greater than benefits and welfare decreases After tariff becomes prohibitive flattens out no effect on welfare For export sectors: optimal policy is a negative subsidy (tax) raise P of exports to foreigners o Optimum export tax always +ve but less than prohibitive tax Problem for large countries: akin to using national monopoly power to get gains at other countries expense o Retaliation from other countries

Domestic market failure argument against free trade

Producer/consumer surplus dont properly measure costs/benefits Domestic market failures o Labour might have otherwise been unemployed or underemployed o Defects in sectors prevent rapid transfer of resources o Tech spillovers from innovative industries - Marginal social benefits Panel (a): - Conventional cost-benefit analysis for tariff in small country Panel (b): - Marginal benefit of production not accounted for by producer surplus o If the tariff is small enough c must always exceed a + b welfare-maximising tariff Theory of second best: - Hands-off policy is desirable in any one market only if all other markets are working properly govt intervention that may distort incentives in 1 market may offset failures elsewhere -

How convincing is the market failure argument?

Market failures prevalent in poorer countries, but more subtle in advanced ones

Defending fee trade: o Should correct domestic market failures w/ domestics policies aimed directly at problem o Cannot diagnose market failure accurately enough to have certain policy Use subsidy instead of a tariff deal w/ as directly as poss unintended distortions elsewhere in the economy Always look at domestic policy aimed at correcting market failure before international trade policy probably worse

The domestic market failure argument for a tariff

Income distribution and trade policy

Distinguish b/tw whole nations welfare & the welfare of welfare of particular groups No such thing as national welfare only desires of indiv that get more/less imperfectly reflected in govt objectives Preferences of voters might be reflected in actual policies Model: o 2 competing parties, each willing to promise whatever to win policy is described along a single dimension o Voters differ in policies they prefer o What policy will 2 parties promise to follow middle ground converge on tariff preferred by median voter

Electoral competition
-

Political competition tM: median voters preferred rate If offer tA: considerably above tM other party offers tB program preferred by almost all voters It would always be in the political interest of a party to undercut any tariff proposal that is higher than what the median voter wants Politicians offer higher tariff if opponents offer one lower than median voters tariff both offer ones close to what the median voter wants Importance of party activists in getting out the vote the party might not be able to offer tariffs like this as activists are ideologically motivated Model does not work well w/ trade policy precisely wrong prediction choose policy that pleases most voters o Large loss for a few but smaller benefits for many (theory) o Large benefits for a few but smaller losses for many (actuality) Political activity on behalf of a group is a public good benefits of such activity accrue to all members of that group, not just the indiv that perform the activity Policies that impose large losses in total, but small losses on any indiv may not face effective opposition Problem with collective action: while it is in the interests of the group as a whole to press for favourable policies, it is not in any individuals interest to do so Overcome problem when group is small each indiv reaps significant share of benefits & well-organised mobilise members to act collectively This is beneficial to producers and not consumers

Collective action
-

Chapter 12: Controversies in trade policy

New controversies over int trade 1. 1980s sophisticated arguments for govt intervention in trade in advanced countries a. Focus on high-tech industries b. Strategic trade policy 2. 1990s effects of growing int trade on workers in developing countries a. Standards for wages/labour conditions 3. Environmental issues

Sophisticated arguments for activist trade policy

Activist govt policy needs a specific kind of justification must be offset by some preexisting domestic market failure Arguments for trade policy dont link to specific failures Potential market failure arising from difficulties of appropriating knowledge marginal social benefit of the knowledge other producers use same knowledge w/out having had to pay for it not reflected by incentives of firms Externalities shown to be NB case for subsidising industry Same for infant industries in developing countries and est. industries in developed countries o Edge in advanced countries: generation of knowledge can be a central role of the industry devote time & money to improving tech explicitly & implicitly o Activities take place in all industries no line b/tw high-tech & the rest o Clear diff in degree of knowledge Firms cannot fully get benefit of their investment in knowledge others can still copy & benefit under laissez-faire, high-tech firms do not receive as a strong an incentive to innovate as they should Case for govt support of high-tech industries: o Can the industries be targeted specifically & what should be the gains from targeting? o No reason to subsidise employment of capital or nontechnical workers in high-tech industries o Innovation & tech spillovers happen in industries that arent entirely innovative o Trade & industrial policy should be targeted specifically on activity in which market failure occurs subsidise generation of knowledge that firms cant appropriate not easy to identify Rise, fall & rise of high-tech worries o Deliberate policy of protecting high-tech industries & helping compete against foreign rivals o Unfounded in the past o Rise once again declining employment in ICT sector in the US o Innovators cant thrive unless innovators are close, physically and in business terms to people who turn innovations into goods Argument for industrial targeting: identifies market failure that justifies govt intervention as the lack of perfect competition Some markets only have a few firms in perfect comp small number of firms negate perfect comp assumptions

Technology & externalities

Imperfect competition & strategic trade policy

-

Have excess returns economic profits profits above what equally risky investment elsewhere in the economy can international comp over who gets Govt can alter rules of the game shift excess returns from foreign to domestic firms subsidise domestic firms by deterring investment & production by foreign competitors raise domestic profit by more than the subsidy subsidy raises national income at the expense of other countries Brander-Spencer analysis: example o 2 firms compete from diff countries o New product both capable of making

Either firm alone could earn profits making the good, but if both firms try to produce, both incur losses Which actually gets profits? Depends on who gets there first Boeing gets a head start Airbus finds no incentive to enter market Situation can be reversed country commits itself to pay firm subsidy of 25 if it enters changes payoffs profitable for Airbus to produce regardless of what Boeing does

Implication: o Boeing is now deterred from entering at all they will lose regardless of what they choose to do o Govt subsidy removes advantage of head start from Boeing and conferred it on Airbus o Subsidy raises profits by more than the amount of the subsidy itself deterrent effect on foreign competition creates advantage for Airbus comparable w/ strategic advantage Airbus would have had if it was first Problems: o Req more info than is actually available Cant fill in entries in table w/ any confidence Get it wrong subsidy could be costly misjudgement Cant view industry in isolation give strategic advantage in one industry may cause strategic disadvantage in others

Risk foreign retaliation beggar-thy-neighbour policies increase our welfare at others expense Risk trade war that leaves everyone worse off

Globalisation & low-wage labour

Shift in manufactured exports from richer poorer countries depend e=heavily on these exports - Lower GDP/capita & low wages - Bad working conditions Subject of activism anti-globalisation movement

Anti-globalisation movement
Harm trade was doing to workers in developing countries WTO riding roughshod over national independence & imposing free trade ideas that hurt workers Failure of WTO meeting in Seattle 1999 nations failed to agree to agenda in advance & couldnt agree on direction of new trade round to get started Very low wages in developing countries not helping workers Labour agreements hurt both poor & rich countries labour misconceptions about comparative advantage

Trade & wages revisited

-

Trade actually benefits both sets of workers Standard economic analysis says that while workers in a capital-abundant nation like the US might be hurt by trade with a labour-abundant country like Mexico, the workers in the labour-abundant country should benefit from a shift in the distribution of income in their favour Actually increases labour employment in the poorer country & working conditions are better than they would be otherwise Mobility of capital and immobility of labour argument against increased welfare in poorer country Whether & to what extent int trade agreements should also contain provisions aimed at improving wages & working conditions in poor countries o Monitor & make results of monitoring available to consumers version of market failure analysis consumers can choose to buy certified goods feel better about purchases o Wouldnt have a large impact only impact in export factories Formal labour standards

Labour standards & trade negotiations

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Strongly opposed by developing countries protectionist tool used as basis for private lawsuits against foreign companies sim to antidumping legislation used by pvt companies to harass foreign competitors

Environmental & cultural issues

Globalisation is bad for the environment o Damage done in developing countries in order to produce goods for developed markets Cases of environmental damage occurred in the name of inward-looking policies of countries reluctant to integrate w/ global economy Should trade agreements incl environmental standards? o Modest improvements benefit all o Shut down potential export industries in poor countries cannot afford to maintain things by Western standards Effect of globalisation on local & national cultures o Growing integration of markets homogenisation of cultures around the world also Americanisation something is lost due to this o Market failure argument on behalf of policies that attempt to preserve national cultural diff infringes upon rights Growing concern worldwide & has impacted domestic politics role in disputes over int trade o Growing int trade automatically harms the environment o WTO agreements act to block environmental action Production & consumption by-product environmental damage o Pollution from factories o Farmers fertilisers & pesticides o Consumers cars o Economic growth environmental damage Not necessarily true: as a country becomes richer, they change production/consumption mixes reduce environmental impact Growing wealth growing political demands for environmental quality stricter regulations

Globalisation & the environment

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Globalisation, growth & pollution

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The environmental Kuznets curve A B: growing per capita income growing damage to environment C D: as a country gets sufficiently rich take action to protect environment

Trade promotes economic growth increases per capita income can better/worsen environment depending on where a country is on the curve Not necessarily an argument FOR globalisation can show the opposite FOR NOW China o Not a problem of globalisation a problem for China as a result of globalisation Pollution haven: because of int trade, an economic activity that is subject to strong environmental controls in some countries can take place in other countries with less strict regulation Are they important? o Relatively small impact on int trade not much evidence that dirty industries move to countries with lax environmental regulation lower wages are more of a lure than environmental regulation Do they deserve to be the subject of int negotiation? o Do nations have a legit interest in others environmental policies? o Pollution = negative externality valid reason for govt intervention o Diff forms have diff geographical reach only if they cross borders is there justification for int concern o Things like carbon emissions are an int concern cause global problems in the future

The problem of pollution havens

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