In The Name of God, the Merciful, the Magnificent
King Fahd University of Petroleum & Minerals
College of Industrial Management
Department of Finance & Economics
Class Notes of
ECON. 410
Husted & Melvin, International Economics
9th
Ed., 2012
Part I –International Trade
www.aw-bc.com/husted_melvin
Dr. Usamah Ahmed Uthman
Associate Professor of Economics
http://faculty.kfupm.edu.sa/finec/osama/
E- mail: osama@kfupm.edu.sa
Students may visit www.sama.gov.sa for information on trade of Saudi Arabia,
and other information on the Saudi economy in general.
KING FAHD UNIVERSITY OF PETROLEUM & MINERALS
College of Industrial Management
Department of Finance & Economics
Course Syllabus
:
International Economics
:
Dr. Usamah Ahmad Uthman
:
2:30 – 3:15 Sun., Tues. (or by appointment)
:
Husted, Steven and Michael Melvin: International Economics
9th Ed., Addison-Wesley, New York, 2012 (For Part I & II of the course)
Krugman, Paul & Maurice Obstfeld: International Economics, Theory & Policy 9th
Addison- Wesley, New York, 2009 (For part II of the course)
Econ 410
Instructor
Office Hours
Text Book
Web Site
Chapter
Chapter
Chapter
Chapter
Chapter
Chapter
Chapter
:
1
2
3
4
5
6
7
Chapter
37
Chapter
12
Chapter
14
Chapter
15
Chapter
17
Chapter
18
Chapter
19
Chapter
21
Important Note:
http://faculty.kfupm.edu.sa/finec/osama/
Course Outline – Part I: International Trade
: An Introduction to International Trade
: Tools of Analysis for International Trade Models
: The Classical Theory of International Trade
: The Heckscher-Ohlin Theory of International Trade
: Tests of Trade Models (strongly recommended)
: Tariffs
:Non-Tariff Barriers and Arguments for Protection
Course Outline – Part II: International Finance
from Lipsey, et al on “Exchange Rates & the Balance of Payments”
: The Balance of Payments: Emphasis on the "Twin Deficits"
: Prices and Exchange Rates: Purchasing Power Parity Theory
: Exchange Rates, Interest Rates, and Interest Parity
: Basic Theories of the Balance Payments
: Exchange Rate Theories
: Alternative International Monetary Standards
: Open -Economy Macroeconomic Policy & Adjustment (strongly recommended)
Handouts given by the Professor are part of the course requirements.
First Exam
Second Exam
Quizzes and assignments
Final Exam (Second Part only)
Total
25%
25%
10%
40%
100%
NOTE: Professor reserves the right to change the contents and
weights of course requirements.
FIRST MAJOR EXAM, Wednesday, 8 Jumada I, 1437 (17 February, 2016, 6:30- 8:15 PM
SECOND MAJOR EXAM, Wednesday, 27 Jumada II, 1437 (5 April, 2016), 7:00- 8:45 PM
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Welcome to Economics
Dear Students of ECONOMICS
Assalam Alikum WA Rahmat ALLAH wa Barakatuh
It is my pleasure to teach economics to another patch of KFUPM students. Economic issues and
events are with us all the time, at the personal, family, business, government, and international levels.
There is almost no issue, problem or, event in the world that does not have an economic dimension
either in terms of cause, consequences, or both. Economics Science tries to explain past and
present events and tries to predict future ones. It tries to help us draw policies at every level of
society. For these reasons the study of economics should be both necessary and enjoyable by
everyone.
How to Study Economics?
You should try to understand the concepts much more than memorizing statements. This is how you
can grasp and retain what you learn in your courses. Try to read ahead of class if you can, but
definitely after class, and may be more than once, with a pencil in your hand. Some
memorization is definitely required in the study of any science. To make sure you have retained
in your mind what you read, it is strongly advisable that you re-write what you have
read more than once.
Our main material for the course of will be my Class Notes that you can
find by clicking on the link below:
http://faculty.kfupm.edu.sa/finec/osama/
After that, click on Teaching to find the Notes relevant to your course. Please download and print
the Notes immediately and bring them with you to every class period. All information you need about
the course policies are explained at the beginning of the Class Notes.
For students of ECON.101 and ECON.102,upon reading a chapter at least twice, please try to solve
Study Guide, which you can find in any copying center on or around
Campus. Try to solve and understand the answers, and not memorize
them. Most of my quizzes come from the Study Guide.
some problems from the
For students of ECON.410, I will provide you with end –of-chapter
problems.
Attendance, and coming to class on time are musts.
Good luck and have an enjoyable semester.
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Chapter One
An Introduction to International Trade
International economics is tow broad branches:
I) International trade: The approach is microeconomics
II) International finance: The approach is macroeconomics
Questions of international Trade:
1. Why do countries trade?
2. What goods & services do countries trade?
3. How does trade affect the amount & distribution of incomes and jobs?
4. How does govt. policy (in terms of tariffs, quotas, subsidies, & other barriers) affect
trade?
5. How are countries affected by the international flow of labor & capital?
Questions of International Finance:
1) Theories of the balance of payments
2) Theories of the exchange rates ( ER)
3) The relationship between ER, prices & interest rates.
4) International banking , debt & risk
5) The interaction of macroeconomic policies among nations
6) The world's international monetary system & the role of international
organizations, such as the International Monetary Fund (IMF) & the World Bank.
Characteristics of national Economies:
GDP: the total value of all final goods and services produced at home.
GDP = C + I +G +(x-m)
GNP: GDP + net foreign income.
Index of openness: A measure of the importance of international trade to the economy=
X/GDP * 100
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Observations on Table 1.1:
1) Market ER tends to give much smaller measure of GDP, especially for less
developed countries. Thus the Purchasing Power Parity (PPP) ER is used to measure
GDP for all countries.
What is a PPP ER? It is an equilibrium rate that makes the purchasing power of a
currency abroad, the same as its purchasing power at home. To be discussed in the
second part of the course.
2) Physical size: Except for China & India, physical size (land area) and population
appear to have little role in explaining income per capita.
3) How do the poor survive (column 3 of the table)? Many of the low- & middle income countries are desperately poor. GNP per capita for some of these countries is
less than $500. How do they survive?
* Low productivities  low incomes  low prices.
*Government policies, especially subsidies, and foreign debt and foreign aid.
* Use of market ER tends to underestimate GDP  Use PPP ER in measuring GDP
instead.
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4) Why some countries have negative economic growth?

Wars.

Misguided Govt. Policies.

Declining prices of primary goods (oil, coffee, cocoa , copper, sugar, iron ..etc.) in the
1980’s 1990’s, on which these economies are dependent upon.

Stagnant economies combined with high population growth.
5) Why Some Countries have positive economic growth?
* The main engine of growth is the accumulation of knowledge & skills
* Investment in plant & equipment
* Endowments of factors of production
6) Why small countries tend to be more open than larger ones? Because small countries
produce less of what they need, they tend to trade more. The most open of all countries is
Singapore with an index of openness of 215 (i.e., exports were more than double its GDP.)
7) Increased openness since 1980: Between 1980-2004, most countries became more open.
The average value of the index of openness increased from 29 to 33. As with economic
growth however, changes in openness differed considerably among income groups.
The index for Japan & USA was 12 & 7 respectively, in spite of their enormous size of exports
which ranked second & forth in the value of exports in 2004(see column 8).
What Has caused the explosion of trade? Fig. 1.1 below
The growth rate of world trade has much out paced the growth of world GDP. This is
because:

Technological improvements & reduction in costs of transportation & communication.
EX: Container ships, supertankers, & satellite communication.

Multilateral & regional agreements among nations to reduce barriers to trade such as
tariffs, quotas, and subsidies. See Figure 1.1 below.
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The Direction of International Trade: Fig.1.2 compares the geographical pattern of
trade for the years 1965 & 2004.
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The following observations can be made:
1) Industrial countries still dominate international trade in both exports & imports. In 1965
the US, Canada the EU, New Zealand, Australia & Japan comprised 70 percent of World
exports. In 2004 the exports of these countries comprised 61 percent. These countries are
also the largest importers.
2) The rising importance of Asia; The value of world exports was 56 times higher in 2004
than it was in 1965, but exports from Asia in 2004 were 131 times greater in value terms
than in 1965. The share of Asian exports in total world trade rose from 12 % to 29. 5 % in 39
years
3) Latin America & Africa saw their positions erode.
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Observations: 1) The US is the major trading partner for many countries, reflecting the
sheer size of its economy.
2) Distance seems to play a great role in trade pattern. Canada & US are the largest
trading partners of each other.
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What Goods do Countries trade? See Table 1.3
• Top three most traded products in 2003:
 Office machines, computers, and parts
 Automobiles
 Crude petroleum
A common pattern is for countries to import raw materials or semiprocessed goods and then complete the manufacturing process
before marketing the product
Not included in table 1.3 is trade in services. In 2004 world trade in services (
transportation, travel, insurance, banking, medicine, consulting, education) totaled
$2.1trillion, accounting for almost 20% of international trade.
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Chapter Two
Tools of Analysis of International Models
A model is an abstraction of reality that employs assumptions about a phenomenon, in
order make explanations of the past and the present and predictions and
recommendations for the future. A model could be verbal, graphical, mathematical, or
statistical. Different assumptions may lead to different conclusions.
The Basic Model of Trade: The model we try to build is one of General
Equilibrium in which production, consumption, producers & consumers are included
in the analysis.
Assumptions of the Model:
Assmpt.1: All economic agents, firms & consumers exhibit rational behavior  firms
max. Profits & consumers max. utility.
Assmpt.2: There are only two countries (A &B) and only two goods (Soybean & Textile).
Assmpt.3: There is no money illusion.  Relative prices are important
EX; Income =SR100, P S =SR10, P T =SR5,
P S x Q S + P T x P T = SR 100
The consumer can buy a max of 10 units of S (& non of T), or a max 20 units of T( & non
of S), or any combination that would exhaust his budget. See Fig.2.1 below.
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Relative prices can be expressed as: Either the ratio of money prices, or the reciprocal of
the ratio of physical quantities. i.e.
( P S / PT)= (10/5)= (Q T / Q S )= (20/10)=2/1 This is the slop of the budget line , which at
the same time measures the opp. Cost of one good in terms of the other. The meaning
of this is: The opportunity Cost of getting one more unit of S is to sacrifice 2
units of T. This ratio may also be called the terms of trade between the two
goods.
Assmpt.4: In each country, factor endowments are fixed & the set of technologies
available to each country is constant → No technology transfers across countries, and
factors of production do not emigrate from one country to another. It also means that no
economic growth is possible in the absence of trade.
If these supply conditions hold we can illustrate them by a production possibility
frontier (PPF) as indicated in Fig. 2.2 below. Fig.2.2-a assumes increasing opp. Cost,
while Fig. 2.2-b assumes constant opp. Cost , just like Fig2.1. In Part a , the opp. cost is
measured as the slop of PPF at any point. You notice that as we move along the PPF the
slop becomes steeper, which implies a higher opp. Cost.
What could cause opp. Cost to increase? One possibility is that the two industries S & T
use factors of production in different proportions.
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A constant opp. Cost ( Fig2.2-b) implies both industries use inputs in identical fixed
proportions.
Assmpt.5: Perfect competition prevails in both industries in both countries. In addition,
there are no externalities in production. Perfect comp. → P=MC →price line is the same
as & coincides with the opp. Cost line. = the slop of PPF. See fig 2.3
No externalities → Market price = private MC= social (opp.) MC. Externalities result
from the divergence between private and social costs (in case of negative externality)or
benefits( in case of positive externality).
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Assmp.6: Factors of production are perfectly mobile between the two industries, within
each country, but not across countries. → each factors of production earns the same factor
payment in both industries within a country.
Assumptions 4-6 describe the supply side of the economy.
Assmpt.7: (The demand side): D =f(Y, P, taste): Community preferences in
consumption can be represented by a consistent set of community
indifference curves (CICs)
Characteristics of CIC's: downward sloping, convex to the origin, do not
intersect, and a higher CIC indicates higher preferences. See Fig.2.4 below.
The slop of any CIC at any point is called the marginal rate of substitution (
MRS) It measures the rate at which consumers are welling to substitute
(trade) one good for the other. Equilib. is where the budget line is tangent
to highest CIC. → The Mkt. price (opp. Cost), measured by the slop of the
PPF, = MRS S ,T .
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THE BASIC MODEL: SOLUTIONS: The solution we shall obtain is under the
situation of Autarky (self sufficiency) i.e the country does not participate in
trade, yet. Fig 2.5 below illustrates a solution under constant opp. Cost.
In figure 2.5: why point y is not a point of equilibrium? If there is no equilibrium then
either there is excess demand or excess supply. At point y the slop of the CIC (the MRS,
or the psychological marginal benefit) is less steep than the slop of PPF, meaning that
the consumer is willing to pay a price less than the mkt. price, resulting in excess supply
of S. A surplus in S means a shortage in T. The production of S will drop and the
production of T will increase, leading to Z.
Note that: A straight – line PPF → a constant opp. Cost → a perfectly elastic (horizontal)
Supply curve. In this case demand plays no role in determining prices. Price is said to be
supply- determined. The position of the D- curve determines the equilibrium Q.
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Fig. 2.6 illustrates increasing opp. Cost:
At Pt. U : Q.S of S < Q.D. Why? Because MRS S ,T . The price consumers are welling to pay
for S is greater than the opp. Cost (slop of PPF) →ED for S( ES of T) → P S  , prod. Of S  ,
P T  & prod. Of T  .. The economy moves towards pt. X.
At pt. Y , the opposite is true.
MEASURING NATIONAL WELFARE.
GDP = Ps*S + P T *T
Divide both sides by P T ,
GDP/ P T = ( Ps/ P T ) *S + T
Note that Ps/ P T = T/ S
Thus GDP/ P T = (T/S)* S + T = T+T i.e GDP is measured in terms of units of T
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The parallel price lines in Fig. 2.7 below means that relative prices are constant, but
GDP is rising.
NATIONAL SUPPLY AND DEMAND: See Fig. 2.8 below. The lower part of the
figure shows the derivation of the national supply & demand curves from
the upper part. Fig 2. 9 shows the Autarky (no trade) equilibrium in a
country.
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Chapter 3: The Classical Model of International Trade
Definition: International division of labor: Specialization by nations in the production of
only a few goods.
Definition: Mercantilism: A system of policies & institutions aimed at increasing exports
& reducing imports.
Adam smith: the Theory of Absolute Advantage. A country has an absolute
advantage in the production of a good if it can produce it cheaper than any
other place in the world. According to Adam smith a country should specialize in
producing & export and the good that it has absolute advantage in. it should import the
good that it has an absolute disadvantage in.
Assmpt. 8: factors of production cannot move across countries.  Even after trade
wages in country A do not equal wages in country B. Also, the shapes of PPF’s don’t
change neither in location nor slope.
Assmpt. 9: There are no barriers to trade in goods.  After trade Pta= Ptb and Psa =
Psb.
The price of T shall be same in both countries after trade. The same is true for S.
Assmpt. 10: exports must pay for imports. This implies that there is no excess demand,
nor excess supply in either good world wide.  Trade must be balanced for both
countries.
Assmpt. 11: labor is the only relevant factor of production in terms of productivity
analysis or costs of production.  Identical labor/ capital ratio in both industries
within each country. However ratios are different across countries  Countries use
different technologies.
The Classical economists believed in a labor theory of value where prices are
determined by the amount of labor used to produce a good
Assmpt. 12: Constant return to scale in production. If we increase factors of production
by some proportion, output will increase by the same proportion.
Table 3.1: Absolute Advantage as a basis for Trade: The ability of a country to
produce a good, using fewer resources than is possible anywhere in the world.
S
T
A
3 hrs
6 hrs
B
12hrs
4 hrs
Country A will specialize in Soybean since it has the lowest labor cost, country B will
specialize in Textiles since it has the lowest labor cost.
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Table 3.2: Gains in production as a result of specialization:
S
In A
+2
In B
-1
In World +1
T
-1
+3
+2
The remarkable result is that specialization increases total world output
without using any extra resources.
Why the number of hours reflect cost?
Because under perfect competition
P = MC
P = wages * NO. of hrs
In country A
P S = W A X hrs SA = W A X 3
P T = W A X hrs TA = W A X 6
Relative price in A = P S / P T = (W A X 3)/ (W A X 6)= 3/6= 1/2
Likewise, in B: P S / P T = 12/4= 3
These calculations tell that in autarky one unit of S costs 1/2 unit of T in A, but 3 units of
T in B. If trade is allowed Consumers in A would want to buy T from B, while consumers
in B would want to buy S from A.
Ricardo’s Theory of Comparative Advantage.
Ricardo asked: if a country has absolute disadvantage in both goods, can it still
participate in trade? He showed that the answer is:
Yes if the county has a comparative advantage in at least one good.
Def. A country has a comparative advantage if it can produce a good relatively cheaper
than other countries. i.e if it has a lower pre-trade relative price.
Table3.3: Comparative Advantage as a basis of trade
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Country
A
B
S 3hrs 12hrs
T 6hrs 8hrs
Country A has an absolute advantage in both goods as it can produce both with fewer
hours than country B.
Relative Efficiencies:
Country A is 4 times (12/3) more efficient in producing S than country B.
Country A is 1.3 times (8/6) more efficient in producing T than country B.
Relative Prices:
Looking at relative prices of in each country: In country A
(P S / P T ) A = 3/6 = (½)/1 = (Q T /Q S ) A 
To produce one more unit of S in A, half a unit of T, have to be given up.
In country B:
(P S / P T ) B = 12/8 = (1.5)/1 = (Q T /Q S ) B  = 1.5/1. To produce one unit of S in B 1½
units of T have to be given up.
Comparing relative prices in the two countries, Country A has a compt. advantage in S
and B has a compt. Advantage in T.
Table 3.4: Gains in World production from specialization:
S
A
+2
B
-1
Net Change In world Production +1
T
-1
+1.5
+0.5
Once again the remarkable result here is that with specialization world production can
increase without using extra resources. Furthermore, even though country A has absolute
advantage in both goods, country B can still participate in trade if the principle of
comparative advantage is invoked.
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THE GENERAL EQUILIBRIUM SOLUTION OF THE CLASSICAL MODEL
Example:
Country A has 12000 hrs of labor.
Production of S requires 3hrs/unit.
Production of T requires 6hrs/unit.
Under Autarky
Relative prices  Ps/Pt = 3/6 = (1/2)/1= Qt/Qs  to produce one unit of S you have to
give up half unit of T. To produce one unit of T we have to give up two units of S.
Country B has 9600 hrs of labor
Production of S requires 12hrs/unit.
Production of T requires 8hrs/unit.
Relative prices  (Ps/Pt) = (12/8) = (1.5)/1= (Qt/Qs)
1) Country A produces and consumes at point K.
2) Country B produces and consumes at point L.
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Figure 3.3 after trade.
3) Constant opportunity cost implies complete specialization for both countries.
4) Production & trade follow comparative advantages. Country A specializes
completely in production of S (at point J) & exports S. Country B specializes in the
prod. Of T at point M & exports T. Prod. Of S rises in A, & prod. of T decreases. The
opposite is true for B.
5) TOT (terms of trade): the relative prices at which trade occurs between countries.
The TOT line is also the consumption possibilities frontier for both countries. After
trade opens up, the world relative prices, (or terms of trade) are:
½ < TOT :(Ps/PT)w < 1 ½
6) As a result of specialization in production & opening for trade, both countries
wind up on a higher CIC (higher standard of living).
Country A, consumes OH, exports HJ of S, and imports IH of T. Country B Consumes
OR of T, exports RM of T, & imports RN of S
7) The two trade triangles IHJ and NRM are identical and congruent  no trade
surplus or deficit for either country.
8). Absolute advantage of Adam smith is not necessary for trade to take place.
Walras Law of General Equilibrium:
If there are N markets and n-1 markets are in equilibrium, then the Nth market must
be in equilibrium.
Reciprocal demand: interaction of supply and demand to produce general
equilibrium in trade. There is demand from country B for S from country A. Also,
there is the opposite for T from A to B.
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THE GAINS FROM INTERNATIONAL TRADE:
Consider Fig.3.4 below
Under Autarky: The country produces & consumes at Pt. K
After Specialization & trade: the country produces at Pt. J (Complete
specialization in S) & consumes at Point I, on a higher CIC, consuming more of both
goods. Actually they can be at any point on TOT. People are better off. To see this,
Shift the Autarky PPF of Country A parallel to itself (which means measuring new
consumption at pre- trade prices) so that the dashed line passes through point I (the
after trade consumption level). We get GDP1/Pt0. As if the PPF of A has shifted
upwards. This means that the value of consumption at I > the value of consumption
at K.
What are the sources of gain from trade? 1) Consumption gain: purchasing
goods more cheaply. 2) Production gain: greater output results in higher GDP.
Which country stands to gain from trade? The further the TOT from a
country's autarky prices, the greater its gain.
The importance of being unimportant: when small & big countries trade, most of the
gains are likely to go to the small ones. This is because demand from big countries is
bigger than demand from small ones. Prices of small countries rise more than prices
of big ones.
This of course assumes that big countries play a fair game & do not try to exploit the
small ones.
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THE RELATIONSHIP BETWEEN TRADE & WAGES:
Under perfect competition: Firms produce where P = Mc
Before trade:
P SA = W A * hrs SA = W A * 3 hrs.
P TA = W A *hrs TA = W A * 6 hrs.
P SB = W B * hrs SB = W B *12 hrs
(3.1)
P TB = W B * hrs TB = W B * 8 hrs
Since A has comparative advantage in S and disadvantage in T 
P SA < E * P SB
(where E is the exchange rate)
P TA > E *P TB
(3.2)
From (3.1) & (3.2)
P SA = (W A * 3 hrs.) < (E * W B *12 hrs) = P SB
P TA = (W A * 6 hrs.) > (E * W B * 8 hrs) = P TB
(3.3)
Divide both inequalities of (3.3) by (E* W B )
W A / (E* W B ) < 4.
W A / (E* W B ) > 4/3
(3.4)
Or after combining terms:
4/3 < W A / (E* W B ) < 4
(3.5)
For both countries to export and import, wages in A should be no more
than 4 times & no less than 4/3 times as wages in B.
What if rates of wages get out of range of this inequality?
Ex. Wages in A become 5 times as wages in B? In this case:
WA = 5 * E * WB.
Consequently, Pre- trade prices in the two countries will be:
PSA = WA * 3= 5 *E * WB * 3 = E* WB * 15
PTA = WA * 6 = 5* E * WB * 6 = E * WB * 30
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Compare these prices to the prices of S and T in country B, in equation set (3.1)
above. Clearly, the pre- trade prices of both goods in A are higher than prices in B.
This happened because the wage differential between the two countries exceeded
the maximum productivity differential.
Thus, Country A loses comparative advantage in both goods. Country B
produces and exports both good to A.
Lessons:
1) High wages don’t preclude countries from participating in trade, if labor is highly
productive. So wags follow productivity.
2) If wages get out of line, one thing or another should happen:
Either wages adjust & go down, to reduce cost, or the exchange rate changes. That is
if wages go up, currency depreciation is inevitable. This is a short term solution
3) For the long run, productivity of labor must improve.
AN EVALUATION OF THE CLASSICAL MODEL:
Criticisms:
1) It explains comparative advantage and trade on the basis of labor productivity.
But it doesn’t explain the source of productivity.
2) It predicts complete specialization by countries. However realities of the world
show that countries export & import similar products.
3). It assumes very dissimilar technologies. However most trade takes place among
industrialized countries, & some technologies can be transferred.
The Usefulness of the model: Question: Why study the classical theory of trade?
It continues to explain some real world phenomena of trade between developed and
developing countries. It explains the relationship between wages, productivity and
trade. It shows clearly the benefits of specialization in production.
1). It explains trade between developing and developed countries. How? Labor
productivities are vastly different and thus wages are.
2). It explains why high - wage countries can still participate in trade. This is due to
their high productivities.
Global economy near structural recession: The article below explains that the major economies
of the world, China, Japan, USA, and Europe in recession due to structural changes in their
economies. Of particular interest is China that is losing its comparative advantage in low- end
products due to rising labor wages. It is becoming less competitive in these products in
comparison to countries such as Vietnam and Bangladesh. What should China do?
http://www.businessinsider.com/global-economy-near-structural-recession-2015-9
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Chapter 4: The Heckscher-Ohlin Model (the Neo- Classical
Model) of Trade
The Classical theory explains trade on the basis of differences in relative labor
productivities. The H-O theory explains trade on the basis of relative factor
endowments.
Drop assumptions 11 and 12 of the classical model.
Asst.13). 2 factors of production:


Labor: receives wages.
Capital: receives rent.
Asst. 14) the set of technologies available to each country are identical.
This assumption is the most important departure from the CL. The CL
explains trade on the basis of different labor productivities, which implies different
tech. available to each country. The H-O theory explains trade on the basis of
different relative factor endowments, but similar tech. are available to all  the
choice of tech. is a function of factor prices which in turn are a function of relative
factor endowments. If factor prices in both countries are the same, technology used
will be the same.
Asst.15) In both countries textile is relatively labor intensive and soybeans is
relatively capital intensive.
 (L/K)t > (L/K)s
 (K/L)s > (K/L)t
Asst16). Country A is relatively capital abundant. County B is relatively labor
abundant.
 (K/L)a > (K/L)b
(L/K)a < (L/K)b
Asst.15&16 imply increasing opportunity cost in production concave PPF. As a
result, specialization of countries will be incomplete.
The PPF’s of both counties are non- linear, but they will not have the same shape.
Asst.17). Countries have identical taste  CICA = CICB  Direction of trade is
determined by supply conditions.
THE H-O Theorem: A country will have a comparative advantage in, and will
export the good that is relatively intensive in the factor of production that the
country is relatively endowed with.
- 34 -
See http://nobelprize.org/nobel_prizes/economics/laureates/
See figure 4.2 below.
Country A has a comparative advantage in product S  (PS/PT)A < (PS/PT)B. This is
shown by the fact that the tangent to the PPF in A is flatter than tangent to PPF in B.
 A exports S, B exports T.
EQUILIBRIUM IN THE H-O MODEL:
1) Under autarky (before trade) country produces and consumes at X0 = (C0).
- 35 -
2) If trade opens up A exports S  (Ps/Pt) rises to (Ps/Pt)1. Production moves to X1
and consumption to C1. It produces more of S & less of T. The country moves to a
higher CIC. It consumes more of both goods. It exports V1X1, imports V1C1. C1V1X1
is the trade triangle. If (Ps/Pt) rises to (Ps/Pt)2, the trade triangle is C2V2X2.
The trade triangles of the two countries are congruent and identical. The same
relative price (Ps/Pt) would prevail in both countries. This is the same equilibrium
condition
as before.
- 36 -
Figure 4.6: Explains the importance of both countries having identical tastes. If not
a strong taste for S in A will increase demand for S in county A and will lead to
increase in price of S.  Country A loses comparative advantage in S.
SOME NEW (EXTENTIONS) OF THE H-O THEOREM
THE RYBCZYNSKI THEOREM (Economica,1955): At constant world prices if a
country experiences an increases in the supply of one factor it will produce more of
the product intensive in that factor an less of the other good.
Country A is relatively capital abundant, good S is relatively capital intensive. Supply
of capital in A increases  production of S increases but production of T decreases.
The intuition of the theorem is that the way a country grows, has an impact on the
mixes of its production & trade. Countries with high savings and investment rates
will tend to produce and trade more capital- intensive goods.
An implication of the Rybz. Theorem is that the distribution of income in society will
change in favor of the owners of the expanding factor of production and the industry
intensive in its use.
THE FACTOR - PRICE EQUALIZATION THEOREM (Paul Samuelson,
Economic journal, 1948): This is perhaps the most controversial theory of
the H-O model.
Given all the assumptions of H-O theorem, free international trade will lead to the
international equalization of individual factor incomes.
- 37 -
Rational: Country A is labor scarce but capital abundant. Initially wages in A are
high, while rents are low. In country B the situation is the opposite.  Before trade
Wa> Wb & R a < Rb. A has a comp. advt. in S & B in T
If trade opens up, A will produce more S and less T. T releases less capital but more
labor than what is needed by S. The opposite happens in B.
Consequently, in A, Wa decreases, and R a increases. In B, Wb increases and Rb
decreases until Wa = Wb and R a = Rb.
Another way to put the rational, using H-O assumptions:
1) Tech. in A = Tech. in B.
2) No trade barriers.
3). Perfect competition in both countries prevails, before & after trade. If trade opens
up  Psa = Psb=MCs & Pta= Ptb= MC t
 Wa=Wb & Ra=Rb
Note the theory predicts this will happen even though factors of production do not
migrate across countries.
Empirical Support: Dan Ben-David found out that trade liberalization among
European countries led to less disparity in incomes.
The STOLPER - SAMUELSON Theorem:
Free international trade benefits the abundant factor and harms the scarce factor.
This theory explains why some people are against free international trade. It is the
most important theory of trade.
Rational: 1) labor is scarce in A, abundant in B. Capital is the opposite  As trade
opens up, the labor- intensive industry in B competes with the labor- intensive
industry in A. However, since labor is more abundant in B, B's labor intensive good
will be cheaper. Thus the labor- intensive good will be produced less in A  Wa
decreases. Also, as the capital- intensive good in A is produced more, Ra increases.
The opposite is true in B. Consequently, in each country, the abundant factor benefits
from trade & the scarce factor is harmed. In other words, as trade opens up, the
demand for abundant factor increases and thus increases its income. The opposite
happens for the scarce factor. Thus trade benefits the abundant factor and harms the
scarce one.
When a country exports a product, it exports the ingredients of that product, and
when it imports a product, it imports the ingredients of that product
- 38 -
Trade makes the scarce factor less scarce through imports. It also makes
the abundant factor less abundant through exports.
Saudi Arabia exported wheat for many years  we were exporting water .AS a result
of accessing the WTO, wheat exports are now banned & wheat production is being
decreased over time. Eventually wheat production in Saudi Arabia will be zero, &
domestic consumption will be met via imports. The owners of the scarce factor in
Saudi Arabia (agricultural land) are harmed due to free trade.
The Stolper – Samuelson theorem explains why some people are against trade, & why
some governments impose trade barriers. One way to compensate the losers from
trade is through taxes & subsidies
- 39 -
Contrasts and Comparisons between Ricardo’s Theory of International
Trade and Heckcher-Ohlin-Samuelson-Stolper(H-O-S-S) Theory (V.V.
Imp.)
1. The Classical Theory explains trade on the basis of relative labor
Productivities, which implies different technologies in different countries.
While the H-O Theory explains trade on the basis of relative factor
endowments, and assumes identical technologies.
2. The Classical Theory assumes constant opportunity cost in substituting one
product for another, and hence trade leads to complete specialization in
production. The H-O, Theory, assumes increasing opportunity cost and hence
an incomplete specialization in production.
3. Because of constant opportunity cost and complete specialization in the
Classical Theory, equilibrium quantities of exports and imports are
determined solely by the position of the demand curve. In the H-O, Theory
equilibrium is determined by both the supply and the demand curves. See
Fig.4.5 below.
FIGURE 4.5 Reciprocal demand in the classical
and HO models.
4.
The Classical Model places no restriction on the assumption about tastes
The H-O. Model assumes identical tastes.
5. The Classical Theory assumes that trade benefits everyone. The H-O-S-S
Theory explains that trade benefits the abundant factor and harms the
- 40 scarce one.
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Economics
image: http://www.projectsyndicate.org/default/library/7691d8cd294a1dedd477ec1efd227667.square.png
Anas Alhajji
Anas Alhajji is Chief Economist at NGP Energy Capital Management.
MAR 6, 2015
Living the Saudi Dream
IRVING, TEXAS – Saudi Arabia wants it all: to salvage OPEC, achieve income
diversification and industrialization, and preserve its market share in crude oil,
petroleum products, petrochemicals, and natural gas liquids (NGLs). Whether the
Saudis succeed will be determined largely by the shale-energy industry in the United
States.
The US shale revolution divided OPEC according to the quality of its members' crude
oil. Exporters of light sweet crude – such as Algeria, Angola, and Nigeria – lost nearly
all of their market share in the US, while exporters of sour or heavier crude, including
Saudi Arabia and Kuwait, have lost little. Because almost all crude oil produced by
the Gulf States is sour, and most of the global surplus is sweet, any production cut by
Saudi Arabia and its neighbors would not drive prices back up and rebalance the oil
market. The only way to do that – and prevent an OPEC breakup – would be to reduce
the production of light sweet crude, including by US producers, which would thus lose
market share. If this occurred, oil prices could be expected to rise again relatively
quickly.
- 41 -
If, however, Saudi Arabia remains more committed to its strategic development
objectives, low oil prices could persist. Since the 1970s, several OPEC members, led
by Saudi Arabia, have worked to diversify their industrial base by promoting sectors
with a comparative advantage, such as petrochemicals, and building mega-refineries
to enable the export of value-added products. At the same time, to boost revenues,
they expanded exports of NGLs, which are not counted in OPEC quotas.
But just when these countries were beginning to achieve success, the US shale
revolution emerged, threatening all three of their main strategic objectives. The key to
the competitiveness of Saudi Arabia's petrochemical industry was its use of natural
gas and ethane, which was far less expensive than the oil product naphtha on which its
global competitors depended. Now that the US is producing massive amounts of lowprice natural gas and ethane, Saudi Arabia's competitive advantage – and market share
– is beginning to deteriorate.
The same goes for refining. Since the US does not allow exports of crude oil, the shale
revolution pushed down the US benchmark price, the West Texas Intermediate,
relative to international crude prices, sometimes with differentials as wide as $20. US
refiners took advantage of lower prices to increase their exports of petroleum products
– so much so, that they are now threatening the market share of Saudi refineries in
Asia and elsewhere. Likewise, US companies have increased NGL production
considerably, enabling the country to slash its liquefied petroleum gas (LPG) imports
and expand its NGL exports significantly. As a result, Saudi Arabia has lost market
share to US producers in Central and South America.
But the recent collapse in oil prices could change this dynamic. In refusing to cut its
own production, Saudi Arabia seems to be hoping that low oil prices will drive down
investment in US shale energy, undermining production growth there. Low prices may
already have contributed to delays in America's decision to begin exporting crude oil,
as well as to the political viability of US President Barack Obama's veto of the
Keystone XL pipeline, intended to transport oil from the Canadian tar sands to the
Gulf of Mexico for export. Add to that the delay in the opening of the Mexican energy
sector, and it seems that low oil prices could amount to a net gain for the Kingdom.
- 42 -
Though Saudi Arabia's motivation in not cutting production was probably almost
entirely economic, low oil prices could also offer distinct political advantages. Most
notably, the decline in prices is creating serious challenges for Iran, the Kingdom's
main rival in the region, as well as for the unstable, oil-dependent economies of
Russia and Venezuela. None of these countries has adequate savings to cushion the
blow of reduced revenues.
Under these circumstances, it seems likely that Saudi Arabia will continue to refuse to
cut oil production, leaving prices low until market forces trigger a rebound. And even
then, the price increase could be limited. After all, game theory dictates that, once the
surplus is eliminated, the dominant producer must prevent oil prices from rising high
enough to cause it to lose market share again. That means that Saudi Arabia will try to
compel non-OPEC countries, mainly in North America, to keep oil-production
increases commensurate with growth in global demand.
In short, it is in Saudi Arabia's interest for oil prices to rise high enough to sustain its
own economy, but not so high that they can sustain significant increases in non-OPEC
supply. In order to keep prices in this ideal range, Saudi Arabia may even increase
production again. This strategy is not without risk. In the short run, excessively low
prices could trigger political instability in some oil-producing countries, driving up
prices. Similarly, delays in upstream investment, especially megaprojects, could push
prices above the ideal level in the medium and long term.
But perhaps the biggest risk lies with the US shale-oil industry. Over the next few
years, US producers are likely to retrench, focus on sweet spots, improve technology,
reduce costs, and increase production once again. At that point, Saudi Arabia's current
strategy may no longer be adequate to sustain its market dominance.
https://www.project-syndicate.org/commentary/saudi-arabia-oil-market-dominanceby-a--f--alhajji-2015-03
© 1995-2015 Project Syndicate
- 43 -
A Reading: The Specialization Myth
http://www.project-syndicate.org/commentary/ricardo-hausmann-warns-that-advisingcities--states--and-countries-to-focus-on-their-economies--comparative-advantage-isboth-wrong-and-dangerous
Read more at http://www.project-syndicate.org/commentary/ricardo-hausmann-warnsthat-advising-cities--states--and-countries-to-focus-on-their-economies-comparative-advantage-is-both-wrong-and-dangerous#aCAljgpXsLEe8w3S.99
Question: What might be wrong with the author’s argument? What
might be right? See the answer below
- 44 -
Problem Solving : Chapters 2,3 &4
1. Constant
opportunity cost
Changing
Opportunity
Cost
A three good
economy  there is
production  there is
economy has more flexibility than a two good
more flexibility in employment of factors of
less opportunity cost in production.
4) Ps/Pt = 1.5 = Qt/Qs = 1.5
Suppose Ps/Pt > 1.5  the country has a comparative advantage in S  produce all S and
no T. conversely if Ps/Pt < 1.5  the country produces all T and no S.
Since there is a constant opportunity cost  Q is supply- determined.
- 45 -
Chapter 3
#1 case 1:
Good
Country
A
Country B
Soybean
6 hrs
15hrs
Textile
2hrs
12hs
A). (Ps/Pt)A = 6/3 = 2, (Ps/Pt)B = 15/12 = 5/4,
B). B has a comparative advantage in S.
A has a comparative advantage in T.
After Trade TOT:
5/4 < (Ps/Pt)World < 3
C). Limits to relative wages:

Method 1: Pi = MCi ;
1. PTA = WA * 2 < E *WB *12
2. PSA = WA * 6 > E * WB * 15
3. FROM 1 WA / E*WB < 12/2
4. FROM 2 WA/ E*WB > 15/6
5. FROM 3&4 5/2 < WA/E*WB < 6
2/5 > E*WB/WA > 1/6
 Wages in A should be no more than 6 times wages in B and no less than 5/2 times as
wages in B.

Method 2: A is 15/6 times as efficient as B in the production of S
Also A is 12/6 times as efficient as B in the production of T.
 A has comparative advantage in T and B has comparative advantage in S.
5/2 < WA/E*WB < 6.
It is important to note that we take the relative wages according to Ricardo.
9. Relative prices are equal  no room for trade.
- 46 -
_________________________________________________________________________________________________________
3.
A
B
Labor
45
20
Capital
15
10
Chapter 4
Both counties have more labor than capital, Also A has more of both inputs than B.
(L/K)A = 45/15 = 3 , (L/K)B = 20/10 = 2.
 A is relatively more labor abundant. B is relatively more capital abundant.
Since S is relatively more capital intensive  B has a comparative advantage in S
A has a comparative advantage in T.
Answer to The Myth of Specialization
The author makes the observation about greater diversification of economies instead
of specialization, but he does not explain it! A clinic in a small village does not
enjoy the same quantity and quality of resources as a hospital in a large city.
Cameroon, Chile, and the Netherlands have equally- sized populations, but the
quality of labor is definitely not the same, not to mention the quantity and quality
of land and capital. The theories of comparative advantage of David Ricardo and
later Hecsher-Ohlin are among the most important discoveries in economic science.
They still dominate the theory of international trade. The author is correct
however, about the role of government policy in improving the quality of resources
and thus enhancing the possibilities of productivity growth and further
diversification.
Usamah
- 47 -
Chapter 6: Tariffs
Commercial Policy: is a govt. policy to influence the quantity and composition of
imports and exports.
Types of commercial policy:

Tariffs

Quotas

Subsidies
 Other Nontariff barriers, such as health & safety standards, products
specifications, govt. procurement policy, tax rebates….etc.
Welfare Gains from trade: Fig 6.1
static gains: include consumption and production gains. In Fig. 6.1:
1) It is assumed that the country has a comparative advantage in S. under Autarky (before
trade), the country is at Point A in terms of both production and consumption. After
opening for trade, the price of S is higher. The Country has a comparative advantage in S 
production of S rises  The country's production moves from A to X. Also
consumption moves from A to C. this is the total gain.
2) To decompose gains into consumption and production gains: a). Assume resources
initially don’t move, shift the price line back so as to pass through point A.  production
remains at point A. However, because the price of S increases  the country moves to a
higher CIC (from A to B) this is the consumption gain. b). Let resources move 
production changes from A to x  shift the price line back to original position. The
economy moves from B to C. This is production gain. i.e. .as the economy becomes more
specialized in production, it can enjoy a further, higher consumption level on CIC2.
- 48 -
Dynamic gains from trade
1) Trade in capital goods  increases the production capacity of the capital- importing
country  economic growth & PPF shifts upwards. Trade enhances economic growth
through imports of capital goods.
2) Trade enhances international diffusion of technology.
3) Trade is pro-competition. It enhances competition  more efficiency.
4) Trade expands market size  greater specialization economies of scale  more
efficiency.
5) Pooling of international savings necessary for investment spending.  Higher
incomes & savings.
TARIFFS: AN INTRODUCTION
Some definitions:
Most Favored Nation (MFN) Treatment: a country agrees not to charge
tariffs on another country's goods that are any higher than those it imposes on
the goods of any other country.
Types of Tariffs:
-Ad Valorem Tariff: a trade tax equal to a given percentage of the sale price.
-Specific Tariff: a trade tax equal to a fixed amount of money per unit sold.
-Compounded Tariff: A trade tax that has both the specific and ad valorem
components.
Revenue Effect: Amount of revenue accruing to the government from a tariff.
Protective Effect: the amount by which domestic producers are able to
expand their output because of the tariff.
Generalized System of Preferences: A system in which industrialized
countries charge preferential, lower tariff rates on goods from certain
developing countries.
Consumer's & Producer's Surpluses: Two important concepts to
understand the economics of tariffs.
- 49 -
Consumer's Surplus: the difference between the amount of money a
consumer is welling to pay & what he actually pays. Graphically, it is the area
below the D- curve & above the price line. See Fig. 6.2 below.
Producer's Surplus: The difference between the price paid in the market & the
minimum price required to cover costs. Graphically, it is the area below the
price line & above the S- curve. See Fig.6.3 below.
- 50 -
THE GAINS FROM TRADE : ONE MORE TIME
Assumption 1: A small country  it is a price taker in the world markets 
It cannot influence world prices.
Assumption 2: The value of 1 Riyal of consumer surplus = the value of 1 Riyal
of producer surplus
- Trade >>> decreases prices >>> the price moves from (Pa) to (Pw)
>>>Imports = Q2-Q1.
- Consumer Gain = a +b + c
- Producer losses = -a
- Welfare Gain = b + c
- 51 -
Figure 6.5 Exports causes price at home to go up
Consumers loss = -e –f
Producers gain = e +f +g
Net welfare gain from exports = +g.
Exports = Q4 – Q3.
- 52 -
THE WELFARE COST OF TARIFFS
Assumptions:
1), a small country  It is a price taker in the world markets.  It can not influence
world prices.
2). one riyal value to those who gain from trade = one riyal value to those who lose.
Loss in consumer surplus = - a – b – c – d
Gain in producer surplus =
Govt. Rev. from tariffs =
+a
+c
DWL -Dead weight loss (or Welfare cost) = - b – d
The size of areas b& d depends upon elasticities of S & D curves. Areas b &
d are considered dead weight because they represent losses to one party that is not
gained by any other. Area a is lost by consumers, but gained by producers. Area c is
gained by government.
Note: because this is a small, price – taker country, its consumers pay for
the full amount of the tariff revenue collected by the govt.
- 53 -
Area b is producers' welfare loss (due to increased production at higher cost than
world price), and area d is consumers' welfare loss (due to decreased consumption,
due to a higher price) .
a = a1+a2.
a1: is additional producers' surplus on output before tariff.
a2: is additional producers' surplus on additional output (q1-q3) after tariff.
Note: that Q3-Q1 could have been purchased at world prices (pw) and
would have cost area e. However when produced at home it costs area
(e+b)  b is an additional cost due to tariff.
Measuring the size of DWL
Assuming straight -line S &D curves:
DWL = -(b+d) = - (½)(t) (change in imports)
= -(1/2)(t)((q3-q1)+ (q2-q4)).
Once again: the size of areas b& d depends upon elasticities of S & D curves
and the height of the tariff. So, the more elastic S& D curves the greater the
DWL.
- 54 -
The Optimal Tariff: A tariff imposed by a large country to force the other country
to lower its prices and thus lower the DWL to the citizens of the imposing country.
The tariff leads to a welfare improvement for the imposing country relative to free
trade.
See Figure 6.8 below:
Under autarky (no trade) PB< PA  country B has comparative advantage in producing
and exporting the product. After opening for trade PB<PW< PA & (Q2-Q1) is XB = MA.
- 55 -
Welfare Analysis: In figure 6.9, assuming that country A is an economically large
country, it imposes a tariff on imports from B. Because A is a large importer, part of the
tariff is absorbed by produces of country B in order to stabilize their sales. Thus t=
p'' – p', where p'' is price paid by consumers of A and p' is received by producers of B.
Note that price in A will rise by less than the full tariff & the price received by exporters of
B is less than the free trade price (p'= < PFT.)
Consumers' loss in country A = - a – b – c - d
Produces' gain in A =
+a
Govt. rev in A =
Net Welfare change
+c
-b
+e
-d
+e
While area c of govt. revenue is paid for by consumers of A, area e is paid for by
producers of country B.
Net welfare change = e – (b+d)
Once again, the size of areas e, b, and d depends on the relative elasticities of S & D
curves and on the size of the tariff imposed by country A . The optimal tariff is the one that
tries to maximize this sum.
The market power of a country is determined by its size relative to total world market of
the good in question. It is either a large buyer (a monopsonist), or a large producer (a
monopolist). It is also determined by the relative elasticities of S & D. Optimal tariffs are rare
because of fear of retaliatory measures by other countries. It is outlawed by WTO.
Question: Which country stands to bear a greater burden of the tariff?
- 56 -
The effective rate of protection: is the actual protection provided by a
tariff for the value added by home producers.
The value added = value of sales – value of inputs purchased from outside the firm
(or the country) = profits + interest + taxes+ wages+ value of any input provided by
the firm- Subsidies.
Example 1: tariffs on finished Suits imported but not on textiles. Assume each suit uses
5 yards of textile. Textiles are available at home and are imported at constant world price
of $20/yard. Let the free trade world price of a finished suit, PFT = $150.
Domestic value added before tariff (V) = $150-$100=$50
Tariff (on a finished imported suite) = 20% = (0.2)(150) = $30
Sales price after tariff= Pw +t = $150 +$ 30 = $180.
The value added after tariff (V') = sales price - cost of inputs =$ 180 -$100 = $80
The nominal rate of protection (NRP)= t/p = $30/$150 = 1/5 = 20%
The effective rate of protection (ERP) = (v’ – v)/v
V’ = value added after tariff
V = value added before tariff
ERP = (v’ – v )/v =($80-$50)/$50 = 30/50 = 3/5 = 60%
The higher the ERP is, the greater the diversion of resources from other industries
to the protected industry.
Example 2: 20% tariff on imported finished suits and 10% tariff on imported textiles.
Cost of imported textiles = (5yards x $20/yard)(1.1) =$110
The value added after tariff on imported raw materials= $180 – $110 = $70
NRP = t/p = $30/$150 = 20% (same as before)
ERP = (v’ – v)/v = ($70- $ 50)/ $50 = 20/50 = 40%.
Tariff on imported inputs lowers home added value and thus the ERP. The higher the
tariff on imported inputs, the lower is ERP. See table 6.7 below
- 57 -
1) Even if NRP may be positive for the final product, ERP can be negative! If the tariff on
imported inputs is sufficiently high, it could outweigh the value added at home, & thus
making the ERP negative.
2) It is common for countries to impose low tariffs on imported raw materials, but higher
tariffs on finished products. Resources will be driven from industries with low ERP to those
of high ERP.
3) ERP's are useful to politicians & trade negotiators because they tell them how a
change in tariff structures will affect incomes received by domestic factors of
production.
How did the trade war contributed to the World Great Depression(1929-1939): See
item 6.2 on Fig. 6.10 below.
- 58 -
Chapter 7: Non – Tariff Barriers (NTB's) & arguments for and
against protection.
NTB's: such as quotas, subsidies, govt. procurement policies, specifications and
standards…..etc.
Quotas: are govt.-imposed restrictions on the no. of physical units or on the value of
goods imported.
Rent: Payment in excess of normal pay necessary to supply a product or factor of
production.
Quota Rents: are profits that come about because a quota has artificially raised the
price of imported products.
Tariff –quotas: a quota is imposed for a certain no. of imports at zero, or very low
tariff. A tariff is imposed on imports above that quota.
The welfare effects of a quota depend on how govt. handles the quota and on market
conditions. A quota has at least the same welfare effects of a tariff, sometimes worse.
Under free trade: PFT= $1000, and imports = 50000- 10000
Under a quota of 20000,  price increases from $1000 to $1500
Welfare effects: case1). Govt. auctions the quota licenses & collects the quota rent.
Consumer loss =
-a –b –c –d
Producers gain =
+a
Rev. to govt. (Quota Rents) =
Net welfare effect
+c
= -b – d
In this case a quota is as just bad as a tariff.
- 59 -
Case2). Govt. leaves the quota rents (area c) to local producers
Consumers loss = -a –b –c –d
Producers gain = + a
Net welfare effect =
+c
- b –d.
Again, welfare effect is the same as tariff.
Case3). Voluntary Export Restraint (VER): The two governments agree that exporters
restrain their exports to some agreed -upon limits. As a result exporters can raise price
and collect the quota rents (area C)
Welfare affect = - b - d –c.
VER implies a quota is worse than a tariff.
Two Regional Cases:
Some governments impose a quota on exports. For example the Egyptian govt.
declares a different quota of rice exports every year, and issues licenses to Egyptian
farmers to export rice, and then a tariff of 1000 Egyptian pounds is imposed on every
exported ton of rice.
Also in Saudi Arabia, the government used to force domestic producers of cement to
satisfy their local customers first, selling cement at SR10/bag (SR 200= $54 / ton),
before they are allowed to export. A license that indicates the amount to be exported,
and valid for three months, is required before any exports are made. Furthermore,
producers are required to maintain a 10% reserve of the firm's output. The purpose
of this reserve is to meet any unexpected rise in domestic demand. However, if
producers do not wish to export, they can sell domestically at whatever price they
choose. Only three, out of eight producers chose to export at the time.
_________________________________________________________________________________________________________
The Equivalence or Nonequivalence of tariffs & Quotas: Quotas are also
worse than tariffs under the following situations:
1) Effects of a Quota under Monopoly Conditions: if a tariff is imposed, a domestic
monopolist cannot charge more than (Pw +t) because he faces competition from
other foreign suppliers. However if a quota is imposed instead, the monopolist
knowing of limited world supply, he can exercise his monopoly power on the
remaining part of the domestic market. He raises his price & reduces his output, thus
making consumers' loss larger & making a quota worse than a tariff.
2) Change in market Forces: A shift in demand: in case of a tariff an increase in
demand can be met by increasing imports, thus reducing, if not eliminating price
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increases. However, under a quota, prices most probably will rise, increasing
consumers' loss.
3) Administrative Difficulties: How to allocate quotas?
4) Corruption: if quota licenses are sold, it may generate corruption.
Other Non- Tariff Barriers:
1). Export Subsidies: They are outlawed by WTO, except for some primary products.
Forms of subsidies are direct tax rebate, low-interest loans to foreign purchasers,
insurance guarantees, direct grants, govt. funding of research and development, and
reduced- cost industry feed (ex: petro-chemicals in Saudi Arabia). The economic effect is
similar to tariffs. Resources are drawn from sector to another.
Some importing countries impose countervailing duty to reduce impact of subsidies.
2). Govt. procurement policy: Giving preference to local producers in govt. contracts.
Local producers may raise price above world price, transferring income in the process from
taxpayers to domestic producers. This is outlawed by WTO for countries that signed the
special code on this, which requires that countries give equal access to each other in govt.
contracts.
3) Health and safety standards: Example: the dispute between Europe and the US over
beef for hormones used in US to grow cattle. Also, The EC imposed some restrictions in the
past on Saudi shrimp exports to Europe.
4) Failure to protect property rights: Things like copyrights, patents, trademarks are
all protected under WTO. Protection of such rights is necessary to encourage
investments in intellectual works. Saudi Arabia has two laws to protect copyrights,
patents, and trademarks. The USA has long been accusing China of violating property
rights, especially computer software. Pharmaceuticals are a hot area of debate between
developing & developed countries. Developing countries want to manufacture some drugs,
such as HIV/ AIDS drugs without paying for intellectual rights. The argument is these
countries are so poor to pay for the medicine, let alone property rights. Pharmaceuticals
companies argue that investments in such areas are very risky, & thus protection is
needed to encourage the development of new drugs. There are merits in each side's
argument. The solution is for direct govt. research grants on the one hand, and for
companies to charge different prices in different markets, provided that resale from
developing to developed markets is not possible.
Another problem is trade in counterfeit goods. Such goods are sold with fake trade marks.
The Uruguay Round of trade talks (ended with the WTO agreement) included a sub –
agreement known as Trade Related Intellectual Property Rights (TRIPs), covering
patents, trademarks, copyrights, industrial designs.
HOW IMPORTANT ARE NONTARIFF BARRIER?
There are many other forms of NTBs such as: Conditional import authorization,
whereby quota licenses are granted conditional upon the importer taking commitments in
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other areas, such as re- export; taxes, known as variable levies, that adjust so that the
import price equalizes to a decreed internal price, price floors on foreign products;
domestic content laws; deliberate undervaluation of currencies, and special treatment to
local products. Table 7.3 below summarizes research on NTBs in some industrial countries.
The numbers in the table are known as frequency ratios. They are calculated as the
number of product categories subject to NTBs as a percentage of the total number of
possible product categories. The higher the value of the frequency ratio, the more
pervasive are NTBs as a means of restricting trade. Nonetheless, the numbers should be
viewed with caution. First, national reporting of NTBs is uneven; there is no simple way of
comparing national regulations across countries. Second, these statistics represent policies
as goods cross borders. They do not include internal government measures, such health &
safety standards. Finally, these ratios do not provide information on the economic impact
that NTBs may have on prices, production, consumption, and international trade.
ARGUMENTS FOR PROTECTION: NOTE: the discussion in the textbook may be
more applicable to developed countries.
Invalid Arguments
1) Patriotism: Nationalism. Be a Saudi and buy a Saudi product. If the quality is good
enough and prices are competitive, it may be justified.
2) Employment: The basis for this argument is the claim that because output
expands in the protected industry, employment must grow in other industries.
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However, resources may have to come from other industries (the full employment
assumption). The text claims, without any discussion, that even if resources may be
unemployed, the decrease in imports may lead to a decrease in exports. The
argument here is unclear, citing Keynes saying, "Imports are receipts. Exports are
payments". Keynes is correct. However, see the ' "Infant – Industry Argument" in the
next section of the chapter.
3) Fallacy of Composition: The protected industry purchases inputs from other
industries. However, they may be cheaper abroad. Protecting the Sugar industry in
Saudi Arabia raised cost for sugar- using industries, such as candy manufacturers.
The poultry producers in Saudi Arabia tried to get government protection against
alleged dumping from French & Brazilian exporters, but they failed!
4) Fair Play for Domestic Industry: Foreign workers sometimes earn lower wages.
Foreign firms might not be subject to the same laws regarding pollution control &
workers safety, and the like. However, this is no justification for barriers to trade.
The enforcement of quality standards & environmental protection, plus free trade
raises the standard of living.
Valid Arguments
1) Government Revenue: tariffs are popular as a source of govt. revenue for two
reasons: a) there is the possibility that foreigners may actually pay for the tariff.
However, this would be true only for large countries. b) Tariffs are easy taxes to
collect. However, to calculate area C the needed information about the elasticities of
supply & demand of many products could be enormous. It is suggested that a better
alternative is a general income tax. In developing countries, where tax
administration is weak, this may not be a viable solution. Table 7.4 indicates that in
industrial countries tariffs represent a much smaller percentage of govt. revenue
than in less- developed countries. The typical tax in developed countries is an
income tax, or a value- added tax.
2) Income Redistribution: Trade policy can be used to redistribute income from one
sector in society to another. This may explain most of protection in both industrial
and developing countries. Protection benefits producers at the expense of
consumers. Recall the H- O –S –S theory that trade benefits the abundant factor
and harms the scarce factor. So according to the theory, it is the scarce factor, and
industries using the scarce factor that may seek protection. So labor & capital are
expected to take opposite sides on protection. However, a study on various American
sectors, by Stephen Magee showed that in many cases, labor and capital take the
same sides on protection. For instance, both the domestic steel producers and labor
unions support trade barriers on steel. This suggests that at least in the short run,
the incomes of both groups would fall if trade barriers were not imposed. Such a
situation could arise if capital and/ or labor were not mobile among various sectors.
Tariffs on luxuries are some times justified as taxing the rich to aid the poor. If (a big
if) prices of luxuries rise enough, it may encourage the production of luxuries, withdrawing
resources from more other sectors, at the expense of some necessities.
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Appeal of Commercial policy to redistribute income. This is because those who are
harmed may not be aware of it. This is unlike a sales tax, for example. Also, while benefits
of a commercial policy are concentrated among a few producers, costs are distributed
among a large number of consumers. An Income tax may be a much better way to
redistribute income. The DWL is reduced, and the distortions to resource allocation
are less.
3) Noneconomic Goals: Such as national defense. This argument does provide a valid
basis for protecting certain industries. The problem is that a) it may be overused, b)
national security needs may be better served by expanding imports during peace times and
store them for emergency times. However, this may not work if a country could be
under siege from some superpowers (The case of Iraq, for example in the
1990’s).
Direct Subsidies, coupled with free trade may be a better alternative to tariffs in
order to increase domestic production. See Fig.7.2
If the govt. paid a subsidy of SR t per unit to producers, the S- curve shifts downward
by the amount of the subsidy. Domestic output would increase from Q 0 to Q1 (same as
a tariff of t would do). Producers receive (but not gain): a+b = (t x Q1) = value of
subsidy. Their profits (gain)rise by area a. However, the remainder they receive goes
to pay for the additional cost of resources needed to pay for expanding production
from Q0 to Q1. But since govt. has to collect taxes to pay for the tariff, consumers lose
a+b. Thus, area b is DWL of govt. subsidy. This compares favorably with a DWL of a
tariff = - (b+d). Thus a tariff causes a production DWL (area b), but not a
consumption DWL (area d).
Furthermore, the cost of a subsidy to the economy is more visible than the cost of a
tariff.
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Question: What is the cost of the subsidy to the govt. budget?
4) Infant Industry Argument: Some industries require temporary protection from
foreign competition to grow. This may be because the initial costs of production tend
to be high.
Problems: a) The argument presupposes that protected industries are going to lower
costs. b) It presumes that the protected industry will grow up
and mature. c) It assumes that the government is capable of picking winners than the
private sector is.
The Validity of the argument is where the govt. is in a superior position to
support the development of certain industries, when the infant industry is one
whose growth could lead to an expansion of the infrastructure of the economy.
However, as shown above, in some cases subsidies may be a better alternative than
tariffs.
5) Domestic Distortions (Or the Theory of the 2nd Best): Economic theory states that
perfect competition is Pareto – optimal. That is if perfect competition is ever
reached, then no one in the economy can be made better off without making
someone worse off. However, perfect competition is rarely, if ever achieved.
•
According the theory of the 2nd best, if there are distortions that prevent the
economy from reaching perfect competition, then it may be best for the govt. to
add more distortions.
•
Example, an agricultural price support program to help farmers incomes (Refer
to Figure 7.3 below).Effects of price support:
 Guaranteed higher price (a price floor):First distortion
 Excess supply of the product. Govt. may have to buy the excess supply:
Second distortion.
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 If free trade is allowed: Importers buy the good at lower world price and
sell at the higher support price. Imports may actually make it very difficult
to maintain the price floor. Cost of the farm program increase: Third
distortion
 To reduce the effect of imports, protection, becomes necessary. A tariff =P1Pw may be required: Fourth distortion.
6) Protecting the Environment: The existence of negative externalities causes the social
cost of production to exceed the private cost of firms.  Production is more than
socially optimal. If production occurs in one country and pollution is transported across
borders, there may be a role for trade policy (e.g. tariffs, quota) by the country receiving
pollution to discourage the polluting industry. This policy may work only if the country
imposing the policy is a major customer of the polluting country. Some
environmentalists in the USA opposed NAFTA on the grounds that it would increase
global pollution. The passage of NAFTA would allow US firms to relocate in Mexico
where pollution standards are less.
Response: a) The argument assumes that the cost of pollution abatement is a major
cause of industrial location. Data on US manufacturing suggests that pollution
abatement costs average only 1.38 % of total value added.
b) All available studies suggests that Mexico has a comparative advantage in agriculture
and labor intensive industries, & a comparative disadvantage in capital (manufacturing) intensive industries. So, Free trade is expected to produce more
Mexican specialization in "clean" industries.
7) Strategic Trade Policies: The use of trade policy (e.g. tariffs & quota) to increase the
welfare of the imposing country at the expense of another trading partner.
EXAMPLE 1: Brazil & IBM( A foreign Monopolist): When increasing returns to scale are
present, domestic markets are no longer competitive. Under such conditions policies
such as tariffs and export subsidies may increase domestic welfare. In Figure 7.4 below,
assume Brazil imports computers from IBM in the USA, which is assumed a world
monopolist. In the figure, DB and MRB are demand and marginal revenue curves that IBM
faces in Brazil, respectively. The straight line C is IBM marginal cost curve. Under free
trade, IBM maximizes profits by producing at Q* and charging a price P* per computer. The
shaded area is IBM's profits.
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So long IBM does not raise price above P* it can keep all the market for itself. If the price
rises above that, Brazil can manufacture computers profitably. To do that, Brazil should
impose a tariff on imported computers. What would be the result of this tariff? So long
IBM wants to keep its market for itself; it would not raise the price. Since its price has
not changed, neither would its sales to Brazil. Thus consumers would not be hurt. The
only result would be that some of IBM profits will remain in Brazil in the form of govt.
revenue. Clearly, Brazil should impose a tariff until it captured all IBM profits (t= P* - C),
provided that IBM keeps its price at P*, to restrict competition. Note that this is a very
special situation. The Brazilian tariff imposes no DWL on either country, because
neither prices nor trade levels change.
Question: Does this mean that IBM no longer makes any profits? What price would IBM
charge and what quantity would it produce if it were to act competitively?
EXAMPLE 2: Strategic Game by Two Monopolies, Airbus & Boeing: This example is
provided by Paul Krugman (Noble Prize Laureate in Economics, 2008, See
www.nobelprize.org
Also,
See
http://nobelprize.org/nobel_prizes/economics/laureates .
In Table 7.5, P refers to produce, & N refers to not to produce. If each firm makes its
decision at the same time, then there is no unique solution to the game. However, if
Boeing has ahead start, then it will decide to produce the aircraft, and Airbus should
stay out of the market. In the absence of any govt. intervention, Boeing makes a profit of
$ 100.
Suppose, however that Europe decides to extend an export subsidy of $10 to Airbus,
regardless of whether Boeing produces, or not. The outcome is illustrated in the second
matrix. A subsidy of $10 million raises Airbus profits to $110 million. Of this $100
million is a transfer of profit & welfare from the USA to Europe.
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Note that if the firms compete by changing production levels, the best policy is an export
subsidy. If they compete by changing prices, the best policy is an export tariff!
In reality, Boeing buys some of its parts from Europe, and some parts of Airbus are
bought from the US. A strategic policy would in this case hurt one's self.
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