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International Economics
International Economics (University of South Australia)
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International Economics
Week 1: Comparative Advantage & Ricardian Model
Gains from Trade
Several ideas underline gains from trade
1. When a buyer and a seller engage in a voluntary transaction, both can be made
better off.
 Icelandic consumers import bananas that they have a hard time producing
 Producer of bananas receives income that it can use to buy other
goods/services that it desires
2. What if a country is the most (least) efficient producer of everything? Can it still gain
from trade?
 Countries use resources to produce what they’re most productive at
(compared to other production choices), then trade those products for goods
and services that they want to consume
o Focus on what they are best at producing relative to other goods
and trade these goods for others that other countries are relatively
efficient at producing
 Countries can specialise in production, while consuming goods and services
through trade
3. Trade benefits countries by allowing them to export goods made with relatively
abundant resources and import goods made with relatively scarce resources
4. When countries specialise, they may be more efficient due to larger-scale production
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Trade predicted to increase the welfare of a country and overall global welfare
Can hurt certain groups within countries
o Owners of resources that are used relatively intensively in industries that
compete with imports
Implies that trade has important distributional effects. This is non-trivial
Patterns of Trade
 Differences in climate and resources can explain why countries export certain goods
ie Brazil exporting coffee and Australia exporting Iron Ore
 Why does France export Peugeots to Germany while Germany exports VWs to
France?
o Differences between countries
o Economies of scale
 Determinants of ‘differences’ is complex. They can stem from differences in:
o Labor productivity
o Relative supplies of capital, labor and land and their use in the production of
different goods and services
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Models of Trade
1. Ricardian Model: how well a country produces is key
 Could be based in technology used in production of a certain good. Based on one
factor of production. Model predicts everyone gains
2. Specific factors model
 While countries and the global economy may gain from trade, sectors within an
economy will not share equally
 Specific factors model allows us to examine this
3. Heckscher Ohlin Model
 What about factor endowments? Surely these matter? If not, why is oil exported
from the middle-east? Why did Australia export gold in the 1850s?
4. None of these explain why France exports Peugeots and imports VWs
 Examine economies of scale in trade
For these models we will also examine effects on labour and capital movements between
countries
Effects of Government Polices on Trade
 Policy makers affect the amount of trade through
o Tariffs: tax on imports or exports
o Quotas: quantity restriction on imports or exports
o Export subsidies: payment to producers that export
o Through other regulations (product specifications) that exclude foreign
products from the market, but still allow domestic products
 What are the costs and benefits of these polices? How are they set?
o If governments restrict trade, which policy should it use and how much
should it restrict trade?
o If governments restrict trade, what are the costs if foreign governments
respond likewise?
o Trade policies are often chosen to cater to special interest groups, rather than
maximise national welfare
o Governments tend to adopt tariffs, then negotiate them down in exchange
for reduction in trade barriers of other countries
Globalisation
 When did the world start to become globalised?
o Most media discuss this as a very recent phenomenon
 True – but recent goes back to early 1800’s
o Transport costs start to fall dramatically
o Price differentials on goods and factors begin to drop
o Mass migrations in late 19th century part of this
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Shipping freight costs and index (courtesy of Jeff Williamson)
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Australia
 Colonial Australia was heavily reliant on trade
o Agricultural exports (sheep, cows, wheat)
 Land abundance
o Resource booms
 Copper (SA) & Gold (Vic) – 1840s/50s
 More copper & gold (WA)
o Imported manufactures
o One of the most open economies
 Outlier – Victoria – Protectionist post gold rush
 Average tariffs = 22% in 1890 on manufactures
Globalization backlash
 Post WW1
o Immigration restrictions
o Tariffs
 Why?
o Inequality, depression, growth
 Fall in protection from 70’s through today
Ricardian Model
 Focus on technological differences across countries
 Explains how a countries level of technology affects wages and prices, in turn,
explains how technology affects its trade pattern
Absolute and Comparative Advantage
 When a country has the best technology for producing a good, it has an absolute
advantage in the production of that good.
o Absolute advantage is not a good explanation for trade patterns. Instead,
comparative advantage is the primary explanation for trade among countries.
 A country has comparative advantage in producing those goods that it produces best
compared with how well it produces other goods.
o Comparative advantage in is therefore based on opportunity cost of
production.
 The opportunity cost of producing something measures the cost of foregone
production of other goods.
 For example, imagine a country that can produce only two goods - either roses or
computers.
o The opportunity cost of producing computers is the amount of roses not
produced.
o The opportunity cost of producing roses is the amount of computers not
produced.
 A country faces a trade off: how many computers or roses should it
produce with the limited resources that it has?
Example
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2 countries that can only produce computers or roses ie US and Ecuador
US:
o If all resources are devoted to roses, it can produce 10 million roses
o If all resources are devoted to computers, it can produce 100,000 computers
Ecuador:
o If all resources are devoted to roses, it can produce 10 million roses
o If all resources are devoted to computers, it can produce 30,000 computers
Graphical:
o
o USA has absolute advantage of both products
Ecuador has lower opportunity cost of producing roses
o Produce 10m roses, gives up 30,000 computers whereas:
o USA produces 10m roses, gives up 100,000 computers
Computers:
o Ecuador – produces 30k computers, gives up 10m roses
o US would only give up only 3.3m roses for this number of computers
o Competitive advantage in computers
Comparative advantage occurs where the opportunity cost of production is lower
than in another country
o Implies producing the good more efficient than the other country
Might make both countries better off
Intuition behind benefits of trade
 Each country can produce anywhere on its PPF
o Assume for a minute Ecuador produces 30k computers and US 10m roses.
o Could world consumpition rise with trade and specialisation?
 ALLOW EACH TO SPECIALISE ACCORDING TO CA:
o 10m roses still produced (by Ecuador)
o 70k more (=100k) computers produced by US.
 With trade, each country can do better than they would if they produced both goods
o This yields a net gain from trade
 This is what the Ricardian Model predicts..
Ricardian Model – formal
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Assumptions:
o Two countries: home and foreign
o Two goods: wheat and cloth
o Perfect competition, no diminishing returns
o One factor – labour – mobile (ignore land and capital)
 Marginal Product of Labour (MPL): extra output obtained from an
additional unit of labour – assume constant
Assume for home MPLw = 4, and MPLc = 2
o Implies one addiotnal worker can produce 4 units of wheat or 2 units of cloth
o 25 units on home country (L=25)
 All workers produce wheat = MPLw = 4x25 = 100
 All workers produce cloth = MPLc = 2x25 = 50
o For any given supply of labour, we can use MPL to derive each countries PPF
Slope of the PPF is the opportunity cost of producing wheat, expressed as the
amount of cloth that must be given up to obtain one more unit of wheat
Ricardian Model – Home
 L = 25. If all is employed, home can produce either 25x4=100 unites (bushels) of
wheat, or 50 units (yards) of cloth. PPF connects these points linearly
 The slope of the PPF equals the negative of the opportunity cost of wheat, which is
equal to the ratio of the marginal products of labor for the two goods.
o OCwH = 0.5c
o so therefore, OCcH = 2.0w
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Ricardian Model – Home, 2
 PPF is our supply side of our small economy.
 For the demand side, we use indifference curves to show preferences of Home’s
consumers towards wheat and cloth.
 Together, we have equilibrium at Home before international trade.
 Points A and B lie on the same indifference curve and give the Home consumers the
level of utility U1.
 The highest level of Home utility on the PPF is obtained at point A, which is the notrade equilibrium.
 Point D is also on the PPF but would give lower utility.
 Point C represents a higher utility level but is off of the PPF, so it is not attainable in
the absence of international trade.
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Opportunity cost and prices
 At point A, Home will produce wheat and cloth at the point where the PPF touches
the IC.
 The PPF, represents the opportunity costs of producing wheat. From basic
microeconomic principles, we know that optimal production will be where prices
reflect OC (p=OC). Must be that the slope of the PPF is also equal to the RELATIVE
PRICE. More formally:
o In perfect competition, p = w/MPL > w = pMPL
o Labour is perfectly mobile, wages equal in each sector, hence:
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Ricardian Model, Foreign
 Assume foreign (*) worker can produce one bushel of wheat or one yard of cloth
 MPL*w = 1, MPL*c = 1
 Assume 100 workers (L*) available in foreign
 All workers employed in wheat, they can produce 100 bushels
 All workers employed in cloth, they can produce 100 yards
 The Foreign PPF is a straight line between 100 yards of cloth and 100 bushels of
wheat.
 The slope of the PPF equals the negative of the opportunity cost of wheat, that is,
the amount of cloth that must be given up (1 yard) to obtain 1 more bushel of wheat.
o OCwF = 1c
o so therefore, OCcF = 1w
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Foreign Equilibrium with No Trade The highest level of Foreign utility on the PPF is
obtained at point A*, which is the no-trade equilibrium.
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Who has comparative advantage
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A country has a comparative advantage in a good when it has a lower opportunity
cost of producing it than another country.
By looking at the chart we can see that Foreign has a comparative advantage in
producing cloth.
Home has a comparative advantage in producing wheat.
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Competitve Advantage and Trade
 Can Home and Foreign Trade?
 We will see the country’s no-trade relative price determines which product it will
export and which it will import. The no-trade relative price equals its opportunity
cost of production. The pattern of exports and imports will be determined by the
opportunity costs of production (comp adv) in each country.
 The relative price of cloth in Foreign is PC/PW = 1 (in Home =2)
o Therefore Foreign would want to export their cloth to Home—they can make
it for P=1 (bushel wheat) and export it for more than P=1.
o The relative price of wheat at home is 0.5 yard of cloth. The price in foreign is
1 yard of cloth. Home would produce wheat for 0.5 and export it for a greater
price
o Home will export wheat and Foreign will export cloth, reflecting their
comparative advantage.
 As Home exports wheat, quantity of wheat sold at Home falls.
o This bids up the price of wheat at home (S at home)
o Bids down the price of wheat in foreign (S foreign)
 Note – though the Home price increases, it is still less than the pre-trade price in
Foreign.
 As Foreign exports cloth, the quantity sold in Foreign falls
o This bids up the price of cloth in foreign (S in foreign)
o Bids down the price of cloth in home (S home)
 International Trade Equilibrium occurs when the relative prices of wheat (and cloth)
in both countries converge.
New Relative Price
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To fully understand the international trade equilibrium, we are interested in two
issues:
o Determining the relative price of wheat (or cloth) in the trade equilibrium
o Seeing how the shift from the no-trade equilibrium to the trade equilibrium
affects production and consumption in both Home and Foreign.
The relative price of wheat in the trade equilibrium will be between the no-trade
price in the two countries.
For now we will assume the free-trade price of PC/PW is 2/3. This is between the price
of ½ in Home and 1 in Foreign and represents a relative ↑price of Wheat at Home
and a ↑ in Price of Cloth in Foreign.
We can now take this price and see how trade changes production and consumption
in each country.
The world price line shows the range of consumption possibilities that a country can
achieve by specializing in one good and engaging in international trade.
Home Equalibrium with Trade
 Remember that ABS(Pw/Pc) is the relative price of wheat. If the PPF is steeper, then
this number is larger, meaning that wheat is (relatively) more expensive.
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No trade eq’m is at point A.
With a world relative price of wheat of 2/3, Home production will occur at point B.
Through international trade, Home is able to export each bushel of wheat it produces
in exchange for 2/3 yard of cloth (previously ½).
As wheat is exported, Home moves up the world price line BC. Home consumption
occurs at point C, at the tangent intersection with indifference curve U2, since this is
the highest possible utility curve on the world price line.
Home’s consumption of wheat decreases (as it is more expensive than its pre-trade
price) but its consumption of cloth increases (as it is cheaper than the price offered
before trade).
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Given these levels of production and consumption, we can see that total exports are
60 bushels of wheat in exchange for imports of 40 yards of cloth and also that Home
consumes 10 fewer bushels of wheat and 15 more yards of cloth relative to its pretrade levels.
Foreign Equilibrium
 Remember that ABS(Pw/Pc) is the relative price of wheat. If the PPF is shallower,
then this number is smaller, meaning that wheat is (relatively) cheaper.
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With a world relative price of wheat of 2/3, Foreign production will occur at point B*.
Through international trade, Foreign is able to export 2/3 yard of cloth in exchange for
1 bushel of wheat, moving down the world price line.
Foreign consumption occurs at point C*, and total exports are 40 yards of cloth in
exchange for imports of 60 bushels of wheat. Relative to its pre-trade wheat and
cloth consumption (point A*), Foreign consumes 10 more bushels of wheat and 10
more yards of cloth.
Comparative advantage and Trade under the Ricardian model
 Each country is exporting the good for which it has the comparative advantage.
o This confirms that the pattern of trade is determined by comparative
advantage.
o This is the first lesson of the Ricardian model.
 There are gains from trade for both countries.
o This is the second lesson of the Ricardian model
Do wages converge with Trade?
 If we use the world price of wheat/cloth, Pw/Pc = 2/3, to calculate the real wage of
workers in Home and Foreign:
 Home:
o Recall, real wage = p  MPL , where p is the relative price
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o Home only produces wheat
o Hence:
o
Wage Convergence
 Note that wages have not converged – they are higher at home. Why?
 Intuition follows from the relative marginal products of workers in home and foreign.
 Foreign workers are less productive (MPLf=1; MPLh=4) and hence earn a lower wage
 Note that real wages will be higher (lower) when MPL is high (low) or the world price
of the good produced is high (low)
Labour Productivty and Wages
 Value-added (payments to labour and capital) per hour of work, and wages paid in
manufacturing
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Solving for international Prices
 Rather than assuming the world price, let’s determine it (for wheat):
 Home exports wheat, so we will derive a Home export supply curve, which shows
the amount it wants to export at various relative prices.
 Foreign imports wheat, so we will derive a Foreign import demand curve, which
shows the amount of wheat that it will import at various relative prices.
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Export Supply (by home)
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Below pw/pc = 0.5, supply = 0 because price is below Opp Cost.
When pw/pc = MPLc/MPLw, then Home workers are indifferent between producing
wheat or cloth, so supply can vary from 0 to up to where it specialises.
When pw/pc > opp cost, firms will specialise and export more wheat to Foreign
(point C).
Import Demand
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When pw/pc is above the Foreign MPLc/MPLw (or the Foreign pre-trade price of
wheat), no imports.
At pw/pc = MPLc/MPLw (foreign), then foreign could either consume all of the wheat
and cloth it produces, or it could specialize in cloth and export it to home.
At pw/pc < foreign pre-trade price, wheat is cheaper than it is able to produce itself,
and therefore imports.
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Equilibrium
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World Market for Wheat Putting together the Home export supply curve and the
Foreign import demand curve for wheat,
the world equilibrium is established at point C, where the relative price of wheat is
2
/3.
Terms of Trade
 The Terms of Trade The price of a country’s exports divided by the price of its imports
is called the terms of trade.
 Because Home exports wheat, (PW /PC) is its terms of trade.
 Foreign exports cloth, so (Pc /Pw) is its terms of trade.
 In this case, having a higher price for cloth (Foreign’s export) or a lower price for
wheat (Foreign’s import) would make the Foreign country better off. A rise in a
country’s terms of trade makes it better off because it is exporting at higher prices or
importing at lower prices.
Summary:
 Comp advantage in a good is determined by the lower Opportunity cost of
producing that good.
 Having competitive advantage means that a country should produce that good at a
(relatively) lower price
 Once trade is allowed, the price of the CA good will rise (as foreign country demands
more), price increases
 Country will export more of the CA good at a higher price and import the non CA
good at a lower relative price.
o Note that we get full specialisation: each country produces only the good that
it has a CA in.
 Under the model, welfare increases for both countries.
 In short
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o Trade pattern is determined by comparative advantage
o Both countries increase their welfare
Week 2 – Specific Factors and Trade
Home Equilibrium with Trade
 Remember that ABS(Pw/Pc) is the relative price of wheat. If the PPF is steeper, then
this number is larger, meaning that wheat is (relatively) more expensive.
Foreign Equilibrium
 Remember that
ABS(Pw/Pc) is the
relative price of
wheat. If the PPF
is shallower,
then this number
is smaller,
meaning that
wheat is
(relatively)
cheaper.
Ricardian Model – Wages
 Wages are determined by absolute advantage not comparative advantage
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o In last week’s example foreign wporkers earned less than at home based on
home having better technology in both goods. However, trade determined by
CA
o Complimentary results: the only way a country with inferior technology can
get another country to purchase their good is by having low wages. However
real wages have increased through trade (see page 47)
o Future technological improvements will yield higher real wages
Specific Factors Model
 The SFM allows us to start to examine how owners of land, labour and capital are
effected by trade.
o Last week we had only one factor, labour
 The outcome depends on the real earnings of each when trade opens
 In this model we assume that some factors are stuck in a particular sector while
labour is mobile
 We will relax this assumption next week
SMF Assumptions
 Two countries, Home and foreign
 Two goods – an agricultural good and a manufacturing good (or ‘industries’).
 In the short run, FOPs are fixed and specific to particular industries
o Land is specific to agriculture
o Capital to manufacturing
 Labour is used in both, not specific to either one and is perfectly mobile.
 Labour exhibits diminishing returns:
o dQ/dL > 0, d2Q/dL2 < 0, see fig 3.1. This is an important assumption, as we will
see...
Model 3 (Home)
 Firms hire labour up to the point where the marginal cost of labour (the wage (w)) =
the value of one more hour of labour in production (the Marginal Revenue Product
of Labour, MRPL).
 –Note that MRPL = Demand for L. Since L exhibits diminishing returns, as L↑, then
MPL will ↓ → Demand for L is downward sloping.
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Labour assumed perfectly mobile
Implies wages equal between sectors. Thus,
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This is the slope of the PPF
Intuition: The relative price of manufacturing (PM / PA) is determined by the OC of
manufacturing (MPLA / MPLM)
Model 2 (Home)
 Because each economy has two fixed FOPs, the PPF is concave and is subject to the
law of increasing opportunity costs. OCM is low when QM is low and rises as QM is
larger. Resources are not equally suited of producing M or A. As QM increases, the
OCM increases as factors that are more suited to producing A are being used for M.
 As in the Ricardian model, the slope of the PPF equals the opportunity cost or
relative price of the good on the horizontal axis: here it is manufacturing, PM/PA.
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What happens when International Trade Occurs?
 If we forgo the analysis of the foreign country for now, and
 World Pm lies between home and foreign Pm:
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Home has comparative advantage in the manufacturing good relative to Foreign
Trade will increase the relative price of manufactures leading to Home exporting
more of the good it has a comparative advantage in.
FOR HOME:
o Pre trade equilibrium at A
o When trade opened, world price: (PM/PA)W>(PM/PA)H
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o Hence – price line facing home steeper
o Domestic production of M increases (QM↑) (but not full specialisation – still
produces some A)
o Exports M and imports A
Consumption at C: WELFARE IMPROVEMENT
In the absence of international trade, the economy produces and consumes at point
A.
The relative price of manufactures, PM/PA, is the slope of the line tangent to the PPF
and indifference curve U1, at point A.
With international trade, the economy is able to produce at point B and consume at
point C.
The world relative price of manufactures, (PM/PA)W, is the slope of the line BC.
The rise in utility from U1 to U2 is a measure of the gains from trade for the economy.
Overall gains from trade
 The good whose relative price goes up (manufacturing, for Home) is exported and
the good whose relative price goes down (agriculture, for Home) is imported.
 By exporting manufactured goods at a higher price and importing food at a lower
price, Home is better off than it was in the absence of trade.
Impact of trade on earnings
 How does the change in relative prices affect earnings of workers, landowners and
capital owners?
 Just because there are gains from trade, is everybody better off?
 Start with workers
Impact of trade on wages
 In order to determine the impact of international trade on wages, we need to
evaluate the impact the effect of an increase in (PM/PA) for home (capital specific,
Comp Adv in manufacturing)
 Lets use the MPL diagrams for both M and A and place them on the same graph.
 Eqm is at point A. Note L is fixed at L-bar.
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Labor market equilibrium is at point A for both industries – this reflects our
assumption that L is mobile and that W will adjust to clear L market in both
industries. At the equilibrium wage of W, manufacturing uses 0ML units of labor
and agriculture uses 0AL units
Increase in Pm/Pa
 With an increase in the price of the manufactured good, the curve PM • MPLM shifts
up to PM’ • MPLM and the equilibrium shifts from point A to point B.
 The amount of labour used in manufacturing rises from 0ML to 0ML*, and the amount
of labor used in agriculture falls from 0AL to 0AL*.
 The money wage increases from W to W*, but this increase is less than the upward
shift ΔPM • MPLM.
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Impact on Real Wages
 Assumption that PA has not changed
 Hence – W has increased, so real wage in terms of food has risen (increase W/PA)
 For manufacturing
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Intuition: percentage increase wage is less than the percentage increase in PM. REAL
WAGE IN TERMS OF MANUFACTURED GOOD LOWER
Impact on wages and employment
 Overall result: effect on real wage in SFM ambiguous. For each individual depends on
their consumption bundle.
 Although ambiguous, this conclusion is important.
 In the Ricardian model, real wages increase for both countries (though they are not
equalised)
 SFM warns us that one cannot make unqualified statements about the effects of
trade on workers.
 The effect of trade on real wages can be complex.
 Note – model in determining wages in previous slides assumes full employment – not
necessarily the case. See the application section in the text.
Impact of trade on earnings of capital and land
 We now examine the effect of ↑PM on the rental rate of capital and land – our
specific factors.
 Particularly: which of the two factors gain in the event of international trade?
Earnings of capital and land
 If QM (QA) is the output in the manufactured (agriculture) good, the the returns to
capital and to land are the difference between revenue and labour costs:
o Payments to capital =
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o Payments to land =
Define RK is the rental on capital and RT the rental on land :
o
Or, by analogy with wages (W = Pi x MPLi),
o RK = PM x MPKM
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o RT = PA x MPTA
 Increase LM : marginal product of capital will rise
 because each machine has more labour to work it.
 In addition, as labour leaves agriculture, the marginal product of land will fall
because each acre of land has fewer labourers to work it.
 GENERAL RESULT: Increasing (decreasing) L in a sector will raise (lower) the MP of
the specific factor used in that industry
 In our example, L leaves agriculture towards manufacturing
Manufacturing
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Land
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o
As MPKM has risen, so too must RK/PM
PA has not changed: RK/PA also rises
UNAMBIGUOUS INCREASE IN REAL RETURNS TO CAPITAL
o
Workers leave land and MPTA falls. Hence nominal RT falls.
PA unchanged, hence RT/PA falls.
PM increased, hence RT/ PM falls.
Thus, landowners are clearly worse off from the rise in the price of the
manufactured good because they can afford to buy less of both goods.
The general conclusion is that an increase in the relative price of an industry’s output
will increase the real rental earned by the factor specific to that industry but will
decrease the real rental of factors specific to other industries. The effect on labour
will be unclear – real wages rise in terms of one good but fall in terms of the other
This conclusion means that:
the specific factors used in export industries will generally gain as trade is opened.
the relative price of exports rises.
the specific factors used in import industries will generally lose as trade is opened
and the relative price of imports falls.
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Summary
 For an increase in PM:
o real rental on land falls
o real rental on capital increases
o Change in real wage ambiguous
 For a decrease in PM:
o real rental on land increases
o real rental on capital falls
o Change in real wage ambiguous
 For an increase (decrease) in PA:
o real rental on land increases (falls)
o real rental on capital falls (increases)
o Change in real wage ambiguous
 The Model:
o How realistic is the assumption of specific factors?
o Assumption of short term is important here. Model may be good at picking
up some SR distributional effects of relative price changes.
 Gains still exist overall. But it is the owners of the factor specific to the export good
that gains as the price of the export good rises. Owners of the import competing
good lose.
 Policy implications. What is the optimal outcome? Protect import competing
industry? Will consumers want higher prices?
Week 3: Trade, Resources and the Heckscher-Ohlin Model
Specific Factors Model Summary
 Short run model, FOPs are fixed and specific to particular industries
 Labour is used in both, not specific to either one.
 Opening to trade:
o WINNERS: the specific factors used in export industries as the relative price of
exports rises.
o LOSERS: the specific factors used in import competing industries as the
relative price of imports falls.
Heckscher Ohlin Model – Ch4
 Countries have a relative abundance of FOPs
 H-O model uses these relative factor intensities as an underlying foundation of the
model
 So factor proportions become important
Assumptions:
 Two goods, shoes and computers
 Two factors of production, labor and capital, can move freely between the industries.
 Shoe production is labor-intensive; that is, it requires more labor per unit of capital
to produce shoes than computers, so that LS /KS > LC /KC. See fig 4.1 in text
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o This implies computer production is capital intensive
Foreign is L-abundant. Home is K-abundant. These are relative and are measured by
the labor–capital ratio. So L /K (F) > L /K (H) (and K/L (F) < K/L (H)
The final outputs, shoes and computers, can be traded freely (i.e., without any
restrictions) between nations, but not labor and capital.
The technologies used to produce the two goods are identical across the countries.
Pre-trade Equilibruim
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Free-trade Equilibrium (Home)
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H has CA in computers, so exports C. We can show how an increase in (PC/PS) from
trade to (PC/PS)W can lead to a general welfare gain. We can also show how the
export supply curve (for computers) is derived.
At the free-trade world relative price of computers, (PC /PS)W, Home produces at
point B in panel (a) and consumes at point C, exporting computers and importing
shoes.
The “trade triangle” has a base equal to the Home exports of computers (the
difference between the amount produced and the amount consumed with trade,
(QC2 − QC3) and the height of this triangle is the Home imports of shoes (the
difference between the amount consumed of shoes and the amount produced with
trade, QS3 − QS2).
In panel (b), we show Home exports of computers equal to zero at the no-trade
relative price, (PC /PS)A, and equal to (QC2 − QC3) at the free-trade relative price,
(PC/PS)W.
Free Trade Equilibrium (Foreign)
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
We can show how a change in (PC/PS) from trade [to (PC/PS)W] can lead to a general
welfare gain for Foreign. We can also show how the import demand curve (for
computers) is derived.
At the free-trade world relative price of computers, (PC /PS)W, Foreign produces at
point B* in panel (a) and consumes at point C*, importing computers and exporting
shoes.
The “trade triangle” has a base equal to Foreign imports of computers (the difference
between the consumption of computers and the amount produced with trade, (Q*C3
− Q*C2). The height of this triangle is Foreign exports of shoes (the difference
between the production of shoes and the amount consumed with trade, Q*S2 –
Q*S3).
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
In panel (b), we show Foreign imports of computers equal to zero at the no-trade
relative price, (P*C /P*S)A*, and equal to (Q*C3 − Q*C2) at the free-trade relative price,
(PC /PS)W.
Free Trade Equilibruim
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

The world relative price of computers in the free-trade equilibrium is determined at
the intersection of the Home export supply and Foreign import demand, at point D.
At this relative price, the quantity of computers that Home wants to export, (QC2 −
QC3), just equals the quantity of computers that Foreign wants to import, (Q*C3 −
Q*C2).
Pattern of Trade
 Home exports computers, the good that uses intensively the factor of production
(capital) found in relative abundance at Home.
 Foreign exports shoes, the good that uses intensively the factor of production (labor)
found in relative abundance there.
 This important result is called the Heckscher-Ohlin theorem.
o A country will have CA in producing the good that uses its relatively
abundant factor intensively and imports the good that uses the relatively
scarce factor intensively.
o So H is K-abundant and C is K-intensive  H exports C
Testing HO
 To help understand the nuances in attempting to see how/whether the HO model
holds using data, read the section on the Leontieff paradox.
 Leontieff (1953)
o Tested for H-O predictions using 1947 data
o Expected US being K abundant would X K intensive goods and M L intensive
goods
o found that the US K/L ratio for export industries = $14,010 pa, and $18,180
for import industries.
o Paradox because contradicts H-O predictions.
Leontief Paradox
 What can explain this paradox? It comes down to assumptions
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
o focus only on labour and capital – what about land? There was relative land
abundance in the US also
o Identical technology? NO! US was a leader
o Allow for L-productivity differences? USA then has CA in skilled L.
o Data from 1947 – LR adjustments post WW2 still occuring
o Was there actually free trade? NO!
Later studies allowing for these issues suggest no paradox at all
Effect of Trade on factor prices in a HO World
 As with the other models, we will examine the effect of an increase in the relative
price of the good for which H has CA – focusing mainly on the effects at H.
 Begin by specifying an economy wide relative demand for Labour, RDL. The relative
demand is a weighted average of the Labour-capital ratio in each industry.

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The economy-wide relative demand for labor, RD, is an average of the LC /KC and
LS /KS curves and lies between these curves.
The relative supply, L/K, is shown by a vertical line because the total amount of
resources in Home is fixed.
The equilibrium point A, at which relative demand RD intersects relative supply L/K,
determines the wage relative to the rental, W/R.
Deriving a relative demand for labour
 Recall there are two inputs: K & L
 Q labour demanded in each sector depends on relative price of labour to that of
capital (w/r)
 Now want to derive an economy wide relative demand to compare with economy
wide relative supply of labour
 Quantities of K and L in the economy are fixed, so relative supply is fixed
 Relative demand is a weighted average of L/K in each sector weighted by share of k in
each industry
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
Effect of opening up for trade
 Free trade brings a relatively higher price for computers (PC / PS)A<(PC / PS)W
 This induces an increase (decrease) in domestic output of computers (shoes)
 K and L move from shoes to computers
 Relative supply fixed
 Share of capital in computers increases and falls in shoes (Kc/K) and (Ks/K)

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An increase in the relative price of computers shifts the economy-wide relative
demand for labor, RD1, toward the relative demand for labor in the computer
industry, LC /KC.
The new relative demand curve, RD2, intersects the relative supply curve for labor at
a lower relative wage, (W/R)2.
The lower relative wage causes both industries to increase their labor–capital ratios,
as illustrated by the increase in both LC /KC and LS /KS at the new relative wage.
Recap:
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
Increase in price of computers generates more home production of computers
o Resources move toward computer production which is k intensive
æ
ö
æ
ö
L LC + LS LC ç K C ÷ LS ç K S ÷
=
=
+
ç
÷
÷
ç
K
K
K
K
 ##  # #$
% C è % ø %K S è %K ø


No change
 # # #  #  # # $


No change
So:
o Computer output increases and shoe output decreases
o Relative supply of labour unchanged so relative demand overall is unchanged
also
o However, weights are changed: Ks/K falls, Kc/K rises
o Hence other terms change to ‘keep demand balanced’. These are L/K ratios in
each sector.
o Intuition: contraction (expansion) of labour (capital) intensive sector 
release of labour from labour intensive sector  more l/K released from shoes
than required in computers (K intensive)  nominal price (w/r) falls and L/K
rises
Effect on real rental rate
 Change in the Real Rental
 R = PC • MPKC and R = PS • MPKS
 Because the L/K ratio has increased, the MPK increases (more people to work with each unit K)
o MPKC = R/PC ↑ and MPKS = R/PS ↑
o Intuition: Since L/K ↑ in BOTH industries, the MPK ↑ in BOTH. Same logic as
in Specific Factors model – more labour makes existing stock of capital more
productive. Both industries are affected b/c in the LR, K is mobile and can
move freely across industries.
Real wage
 Change in the Real Wage
 W = PC • MPLC and W = PS • MPLS
 MPLC = W/PC ↓ and MPLS = W/PS ↓
 Intuition: As L/K rises in both sectors, MPL falls (diminishing returns).
Effect on wages and rental rate
 Stolper-Samuelson Theorem:
 In the long run, when all factors are mobile, an increase in the relative price of a
good will increase the real earnings of the factor used intensively in the production of
that good and decrease the real earnings of the other factor.
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
For our example, the Stolper-Samuelson theorem predicts that when Home opens to
trade and faces a higher relative price of computers, the real rental on capital in
Home rises and the real wage in Home falls. In Foreign, the changes in real factor
prices are just the reverse.
We have a theory that explains the distribution of wealth when relative prices
change due to trade
Long-run results of a change in factor prices


The equations relating the changes in product prices to changes in factor prices are
sometimes called the “magnification effect” because they show how changes in the
prices of goods have magnified effects on the earnings of factors:

Contrasting SFM and HO Models
 In SFM, real wage effects were ambiguous. Specific factors in X sector gain, SF in
import sector lose
o If we extend model to assume labour gets some propn of rental on FOP in
their sector, predict workers in X sector support free trade and workers in M
sector oppose it
o Industry of employment determines attitude to free trade.
 In HO, industry of employment irrelevant. If labour (capital) is relatively less (more)
abundant, wages (rental rates) fall (rise) in both sectors
 In reality (abstracting from assumptions in our model), skill levels matter. High skilled
workers tend to be used more in K intensive export sector and these can gain from
trade at the expense of low skilled workers
Week 4 – Movements of Capital and Labor – SR and LR
Labour and Capital Flows
 Migration is not a new phenomenon
o Have had periods of ‘mass’ migration (eg gold rushes in California and
Australia)
o For example, population of Victoria increased from 77,000 in 1851 to
540,000 in 1861 (increase of 602%).
o Immigration may be slower, but proceed over the long run (eg 18th century
US, 19th C Australia)
 What are the effects of an inflow of labour (or an outflow)
 We can use our trade models to examine SR and LR effects
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
Treat as a movement of L from foreign to home
Similarly, capital is now very mobile. What are the effects of these flows?
Note on Immigration:
 In 50 years prior to WW1, 60m Europeans left to the new world (eg Australia, US,
Canada, NZ)
o Williamson (1998), Hatton and Williamson (1998)
 Causes:
o Early industrialisation in UK (Europe)
o Resource discovery in New World
o Sharply falling transport costs
 These shocks actually delivered divergence in real wages before 1848
 Immigration generated a convergence in factor prices after that time
 Hatton and Williamson (1998) suggest 70% of this convergence caused
through migration
Increase of L & K in the short run
 We use the specific factors model to show what happens to W, RK and RT when there
is an inflow of labour and of capital (FDI) into Home.
 From the specific factors model:
o Capital and land are fixed and specific to manufacturing and agriculture, resp.
o Labour is mobile between industries.
o Labour L is fixed = LM + LA.
Migration (Inflow of Labour)


The Home wage is determined at point A, the intersection of the marginal product of
labor curves PM • MPLM and PA • MPLA in manufacturing and agriculture, respectively.
The amount of labor used in manufacturing is measured from left to right, starting at
the origin 0M, and the amount of labor used in agriculture is measured from right to
left, starting at the origin 0A. At point A, 0ML units of labor are used in manufacturing
and 0AL units of labor are used in agriculture.
SR Effect of Immigration on W at Home
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When the amount of labor at Home increases by the amount ΔL, the origin for
agriculture shifts to the right by that amount, from 0A to 0A’.
MPLA curve drawn relative to origin OA. Hence it shifts right by ΔL
Equilibrium in the Home labor market is now at point B: wages have fallen and the
amount of labor has increased in manufacturing (to 0ML’) and in agriculture (to 0A’L’).
The ↑L is shared b/w manufacturing and agriculture.
Both industries have more L, but have fixed K and T, so MPL in both will ↓ and W↓.
The SF model predicts that in the SR an inflow of L will lower wages in the recipent
nation.
Other effects of immigration at home under specific factors
 The rate of return of K and T
o If L is added to fixed K and T, MPK and MPT
o the returns on these factors rise
 Not surprising that capitalists and landowners generally do not oppose foreign
workers, whereas workers do.
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
With the increase in labor at Home from immigration, the production possibilities
frontier shifts outward and the output of both industries increases, from point A to
point B.
Output in both industries increases because of the short-run nature of the specificfactors model; in the short run, land and capital do not move between the
industries, and the extra labor in the economy is shared between both industries so
Q↑. P’s do not chg in SR.

In SR, an inflow of L will result in:
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 W decrease
o RT and RK increase
o Higher output in aggregate
Effects of immigration in the long run
 Use the long run model , based on HO.
 Two factors – labour and capital.
 Two goods – shoes and computers
 Shoe production is labour intensive, so the L/K ratio is higher for shoe production
than computer production. (LS/KS > LC/KC)
 PPF given by fig 5.6
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The top and bottom axes of the box diagram measure the amount of labor, L, in the
economy, and the side axes measure the amount of capital, K.
At point A, 0SL units of labor and 0SK units of capital are used in shoe production, and
0CL units of labor and 0CK units of capital are used in computers.
The K/L ratios in the two industries are measured by the slopes of 0SA and 0CA,
respectively.
0SA is flatter than 0CA, we use less K(/S) for S than for C
Effect of immigration in LR an increase in L
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With an increase in Home labor from L to L + ΔL, the origin for the shoe industry
shifts from 0S to 0S’.
At point B, 0’SL’ units of labor and 0’SK’ units of capital are used in shoes, while 0CL’
units of labor and 0CK’ units of capital are used in computers.
In the long run, industry outputs adjust so that the K/L ratios in each industry at
point B (the slopes of 0S’B and 0CB) are unchanged from the initial equilibrium at
point A (the slopes of 0SA and 0CA).
To achieve this outcome, all new labor resulting from immigration is allocated to the
shoe industry, and capital and additional labor are transferred from computers to
shoes, keeping the capital-labor ratio in both industries unchanged.
In the LR, the economy must adjust so that the K/L ratio in each sector is unchanged
With an inflow of L, this can only be achieved via an expansion of the labour
intensive sector
Overall L has increased relative to capital, so this occurs through a contraction of the
k intensive sector
Intuition: an inflow of labour skews the economy towards the production of the
labour intensive good
o Rybczynski theorem
Real Wages & Rental
 To determine the wage and rental in the economy, we use the marginal products of
labor and capital, which are in turn determined by the capital-labor ratio in either
industry.
 We know that MPK and MPL change as the L/K ratio changes
o L/K  MPK r
L/K  MPL w
o L/K  MPK 
rL/K  MPL w
 Each amount of labor and capital used in the previous slide along line 0SA
corresponds to a particular capital-labor ratio for shoe manufacture and therefore a
particular real wage and real rental.
 While the total amount of labor and capital used in each industry changes, the
capital-labor ratios are unaffected by immigration, which means that the immigrants
can be absorbed with no change at all in the real wage and real rental.
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Effect on output in the LR model
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With an increase in the amount of labor at Home, the PPF shifts outward.
The output of shoes increases while the output of computers declines as the
equilibrium moves from point A to B.
The prices of goods have not changed, so the slopes of the PPFs at points A and B
(i.e., the relative price of computers) are equal.
Summary
 The Rybczynski theorem states that, in the Heckscher-Ohlin model with two goods
and two factors, an increase in the amount of a factor found in an economy will
increase the output of the industry using that factor intensively and decrease the
output of the other industry.
 We have shown the Rybczynski theorem for the case of immigration, where labor in
the economy grows.
 Factor prices do not need to change as a result of immigration as K/L ratios have not
changed
 The reason that factor prices do not need to change is that the economy can absorb
the extra amount of a factor by increasing the output of the industry using that
factor intensively and reducing the output of the other industry.
 The finding that factor prices do not change is sometimes called the factor price
insensitivity result.
Effect of FDI Flows
 We turn now to look at how capital can move from one country to another through
foreign direct investment (FDI), which occurs when a firm from one country owns a
company in another country.
 Our focus in this section will be on Greenfield investment, that is, the building of new
plants abroad.
 We model FDI as a movement of capital between countries, just as we modeled the
movement of labor between countries.
 The key question we ask is: How does the movement of capital into a country affect
the earnings of labor and capital there?
 This question is similar to the one we asked for immigration, so the earlier graphs
that we developed can be modified to address FDI.
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FDI in Specific Factors
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In panel (a), an inflow of capital into the manufacturing sector shifts out the
marginal product of labor curve in that sector as workers become more productive
with more capital.
The equilibrium in the labor market moves from point A to B, and the wage increases
from W to W’. Labor used in the manufacturing industry increases from 0ML to 0ML’.
These workers are pulled out of agriculture, so the labor used there shrinks from 0AL
to 0AL’.
In panel (b), with the inflow of capital into manufacturing, and the extra labor used in
that sector, the output of manufacturing increases.
Because labor has been drawn out of agriculture, the output of that sector falls.
These changes in outputs are shown by the outward shift of the PPF (due to the
increase in capital) and the movement from point A to point B. In SR, no P chg.
Effect on the rentals
 With regard to the rental on land, we know that with an inflow of FDI, fewer workers
are employed in agriculture, and each acre of land cannot be used as intensively.
 The value of marginal product of land falls. If MPTA falls and PA remains unchanged,
then land rental RT = PA • MPTA must fall.
 One way to measure the impact of FDI on the rental of capital is by the value of the
marginal product of capital, or RK = PM • MPKM. However, using this method is difficult
to determine how the rental on capital changes because MPKM falls due to
diminishing returns and MPKM rises due to ↑LM. But we know that W↑, so RK will
fall on balance.
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
To see how the inflow of FDI affects the rental on capital. In Figure 5-12, we begin at
point A and then assume the capital stock expands due to FDI. Suppose we hold the
wage constant, and let the labor used in manufacturing expand up to point C.
Because the wage is the same at points A and C, the marginal product of labor in
manufacturing must also be the same (since the wage is W = PM • MPLM).
 The only way that the marginal product of labor can remain constant is for each
worker to have the same amount of capital to work with as he or she had before the
capital inflow. In other words, the capital–labor ratio in manufacturing LM/KM must
be the same at points A and C: the expansion of capital in manufacturing is just
matched by a proportional expansion of labor into manufacturing.
 But if the capital–labor ratio in manufacturing is identical at points A and C, then the
marginal product of capital must also be equal at these two points (because each
machine has the same number of people working on it). Therefore, the rental on
capital, RK = PM • MPKM, is also equal at points A and C.
In Summary:
 W increases
 Rk and Rt both decrease
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FDI In the Long Run
 To analyze the impact of FDI in the long run, we continue with the same assumptions
as before – based on the HO model.
o There are two industries, computers and shoes, with two factors, labor and
capital.
o Computers are capital intensive and shoes are labor intensive.
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In panel (a) the top and bottom axes of the box diagram measure the amount of
labor in the economy, and the right and left axes measure the amount of capital. The
initial equilibrium is at point A.
In panel (b), with the increase in the amount of capital at Home from increased FDI,
the PPF shifts outward.
Capital increases due to FDI.
As the Rybczynski Theorem states, the increase in capital through FDI has increased
the output of the capital-intensive industry and reduced the output of the laborintensive industry.
This change in output is achieved with no change in the capital labor ratios in either
industry. In figure 5-13, OC’B and OSB have same slopes as OCA and OSA.
Because capital-labor ratios are unchanged, the wage and the rental on capital are
also unchanged.
In the long run model, an inflow of either factor of production will leave factor prices
unchanged.
Summary
 The effect of capital and labour inflows are non-trivial
o In the short run they effect factor returns
o In the long run they effect the output mix of the economy
 These views can tell us something about who may be likely to be against free
movement of capital and labour on economic grounds
 Note however that the productive capacity of a country will rise
 We also say nothing here about aspects such as the bringing of new skills, new
sectors, different cultural perspectives, etc. These are potentially real gains but
outside the models we view here
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Week 5: Scale Economies and Imperfect Competition
Previous Models
 Assume that CA determines trade flows
 Do not predict that a country will import and export the same good
o But this is often what happens….
 Japan, Germany, France (for example) all produce cars for domestic consumption and
export, but also import cars
 How can we explain this?






we see that China sells the most clubs to the United States, providing $254 million
worth of golf clubs at an average price of $18 each
Next is Thailand, selling $14 million of clubs at an average wholesale price of $102
Vietnam comes next, exporting $7 million of clubs at an average price of $14,
followed by Japan, selling $6 million of clubs with an average price of $125
The higher average prices of Thai and Japanese clubs compared with Chinese and
Vietnamese clubs most likely indicate that the clubs Thailand and Japan sell are of
much higher quality.
In total, the United States imported $284 million of golf clubs in 2009.

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The top destination for U.S. clubs is Canada, followed by Japan and the United
Kingdom (with its world-famous golf courses in Scotland)
Notice that these three countries are also among the top 12 countries selling golf
clubs to the United States.
The average price for U.S. exports varies between $75 and $104 per club, higher than
the price of all the imported clubs except those from Thailand, Japan, and Malaysia,
which suggests that the United States is exporting high-quality clubs.
Other Problematic Assumptions
 When defining comparative advantage, the Ricardian model and the Heckscher-Ohlin
model both assume constant returns to scale:
o If all factors of production are doubled then output will
also double.
 But a firm or industry may have increasing returns to scale or economies of scale:
o If all factors of production are doubled, then output will more than double.
o Larger is more efficient: the cost per unit of output falls as a firm or industry
increases output. This is key to our understanding of how trade is influenced
by economies of scale.
 The Ricardian and HO models also rely on competition to predict that all income
from production is paid to owners of factors of production: no “excess” or monopoly
profits exist.
 But when economies of scale exist, large firms may be more efficient than small
firms, and the industry may consist of a monopoly or a few large firms.
o Production may be imperfectly competitive in the sense that excess or
monopoly profits are captured by large firms and it is the existence of
monopoly profits that determine the flow of firms in/out of a particular
industry.
 Further, Most goods are differentiated goods, that is, they are not identical.
Consequences
 Intraindustry trade – trade within industries.
 Trade involving (possibly) differentiated products
 Increasing returns to scale – countries can trade with one another despite having
almost identical technologies and factor endowments
 Idea of Gravity model to predict trade flows
Economies of Scale
 Increasing returns to scale
o Idea that large scale can be more efficient
o As firm size increases, lower AC of production
o Intuitively this provides an incentive to expand into world markets.
o We focus on this today – trade can increase welfare in this context
o Note, this may imply trade in same goods (see page 168 re golf clubs)
 US both an importer and exporter
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Trade under Monopolistic Competition – Assumptions
 Similar but slightly differentiated goods between firms. Downward sloping demand
therefore some market power .
 There are many firms in the industry.
o Let number firms = N; Share of demand is D/N
o When only one firm lowers its price, however, it will face a flatter demand
curve d.
o This is due to the differentiation of goods. It implies some substitutability
between goods, but not following a price fall will not lose all your customers!
 Firms produce using a technology with increasing returns to scale. See Fig 6.3 p173.
 Because firms can enter and exit the industry freely, monopoly profits are zero in the
long run.
 Identical countries
Without Trade – Short Run
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The short-run equilibrium under monopolistic competition is the same as a
monopoly equilibrium.
The firm chooses to produce the quantity Q0 at which the firm’s marginal revenue,
mr0, equals its marginal cost, MC.
The price charged is P0.
Because price exceeds average cost, the firm makes monopoly profits.
Without Trade – Long Run
 Drawn by the possibility of making profits in the short-run equilibrium, new firms
enter the industry and the firm’s demand curve, d0, shifts to the left and becomes
more elastic (i.e., flatter), shown by d1.
 Firms will enter until the marginal revenue curve, mr1 (associated with demand curve
d1), equals marginal cost. This is the long-run equilibrium under monopolistic
competition and occurs at the quantity Q1
 At that quantity, the no-trade price, PA, equals average costs at point A.
 In the long-run equilibrium, firms earn zero monopoly profits and there is no entry or
exit.
 The quantity produced by each firm is less than in short-run equilibrium (Figure 6-4).
Q1 is less than Q0 because new firms have entered the industry.
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D1 shows P&Q combinations for change P assuming all other firms do not change Ps
D/NA is share of demand for each firm with price matching.
o Note if only one firm reduces price, it faces demand d1. If others match price
decrease, demand D/NA applies. The former is more elastic.
Equilibrium – No Trade
 In the long run, the firm’s demand curve is flatter b/c new firms have entered the
market and b/c there are new product varieties (even though products are
differentiated, they are close substitutes and consumers are still price sensitive)
 Number of firms ↑ until P=AC and π=0.
 Note: d1 is derived on the basis that the firm will ↓P but its competitors don’t. D/N A
is the demand if all firms ↓P – then QD doesn’t ↑ by as much as for d1. ie it is less
elastic…
Equilibrium with Trade
 Assume Home and Foreign are exactly the same.
 Same number of consumers
 Same technology and cost curves
 Same number of firms in the no-trade equilibrium
 Given the above conditions, if there were no economies of scale, there would be no
reason for trade.
o Under the Ricardian model, countries with identical technologies would not
trade.
o Under the Heckscher-Ohlin model, countries with identical factor
endowments would not trade.
 However, under monopolistic competition, two identical countries will still engage in
trade.
Equilibrium with Trade – shortrun
 The number of firms in the no-trade equilibrium in each country is NA.
 Starting point is the in long-run equilibrium without trade for both countries
 When trade opens, the number of customers available to each firm doubles.
 Since there are twice as many consumers, but also twice as many firms, the ratio
stays the same (2D/2NA = D/NA).
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The product varieties also double.
o With the greater number of varieties available, the demand for each
individual variety will be more elastic.
When trade is opened, the larger market makes the firm’s demand curve more
elastic, as shown by d2 (with corresponding marginal revenue curve, mr2).
o individual firm chooses to produce the quantity Q2 and charge P2
o the firm will make profits because price is greater than AC.
BUT: All firms face the same incentive to lower prices to P2 capture some of these
monopoly profits
Now all firms face demand = D/NA. At P2 they sell Q′2.
All firms are making a loss (P2<AC)
Some exit will occur….
Equilibrium with Trade – Long Run
 Since firms are making losses, some of them will exit the industry.
 Firm exit will increase demand for the remaining firms’ products.
 We now have NT<NA firms.
 The new demand D/NT lies to the right of D/NA.
o ie. 2NT>NA
 The long-run equilibrium with trade occurs at point C.
 At this point, profits are maximized for each firm producing Q3 (which satisfies mr3 =
MC) and charging price PW (which equals AC). Since monopoly profits are zero when
price equals average cost, no firms enter or exit the industry.
 Compared with the long-run equilibrium without trade (Figure 6-5), d3 (along with
mr3) has shifted out as domestic firms exited the industry and has become more
elastic due to the greater total number of varieties with trade, 2NT > NA.
 Compared with the long-run equilibrium without trade at point A, the trade
equilibrium at point C has a lower price and higher sales by all surviving firms.
 Since in the SR, P < AC, firms will leave. So D/NT > D/NA as the fewer remaining firms
have a greater share of the market.
 Price is lower and Q is higher than for LR without trade.
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Gains from trade
 The long-run equilibrium at point C has two sources of gains from trade for
consumers:
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A drop in price.
o The lower price is a result of increased productivity of the surviving firms
coming from increasing returns to scale.
Gains from trade to consumers.
o Although there are fewer product varieties made within each country (by
fewer firms), consumers have more product variety because they can choose
products of the firms from both countries after trade.
Adjustment costs from Trade
 There are adjustment costs associated with monopolistic competition, as some firms
shut down or exit the industry.
 Workers in those firms experience a spell of unemployment.
 Over the long run, however, we could expect those workers to find new jobs, so
these costs are temporary.
Application – interindustry trade
 The model predicts that there is more intraindustry trade than for the H-O model
 Grubel and Lloyd, 1975 found that half of trade among high Y countries was within
rather than between industries.
 Gains from inter-industry trade reflect CA
 Gains from intra-industry trade reflect lower costs (scale econs) and wider consumer
choices.
 The model might be better able to explain trade b/w similar countries.
Measuring intra-industry trade (US 2012)
 The index of intra-industry trade tells us what proportion of trade in each product
involves both imports and exports:
o a high index (up to 100%) indicates that an equal amount of the good is
imported and exported, whereas a low index (0%) indicates that the good is
either imported or exported but not both.
o
o
Application – Gravity
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Gravity model has important implications for the monopolistic model with trade, as it
suggests that larger countries export more b/c they produce more varieties and
import more because their demand is higher. So trade is greater for bigger countries.
In physics, objects with a larger mass, or those that are close together, have greater
gravitational pull between them.
In economics, the gravity equation for trade states that countries with larger GDPs, or
that are close to each other, will have more trade between them.
Basic Model
 Trade is directly proportional to size and inversely proportional to distance
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o
There are many other determinants of trade, some of which we have covered (factor
endowments, labour prod…) but also variables such as:
o sharing a common border
o Common language and cultural variables
o shared colonial history
o trade agreements and investment accords
o institutional quality
o These are captured by the parameter A
Empirical evidence supporting the gravity model is for the most part very persuasive.
Conclusion
 When firms have differentiated products and increasing returns to scale, there is a
potential for gains from trade that did not exist in earlier models.
 The model of monopolistic competition shows that trade will occur between
countries even if these countries are identical.
 There is trade within the same industries across countries because there is a
potential to sell in a larger market.
 This will induce firms to lower their prices below those charged in the absence of
trade.
 As firms exit, remaining firms increase their output and average cost falls. Lower
costs results in lower prices for consumers in the importing country.
 Lower prices and higher product variety are the gains from trade under monopolistic
competition.
 However, since some firms exit the market, there are short-run adjustment costs due
to worker displacement.
 For a real-life example of these gains and costs, we examined the short-run
adjustment costs of NAFTA as well as the long-run gains for the three countries
involved.
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In the case of intra-industry trade across countries, the question of which countries
have a greater tendency to trade with each other turns specially relevant. For this
purpose, we examined the gravity equation.
The gravity equation predicts that the larger two countries are, or the closer they are,
the greater the amount of trade.
Week 6 – Tariffs and Quotas
Context & History
 Severe incr in protectionism post WW1. Followed by depression 1929 which
generated even greater protection!
 In 1947 the General Agreement on Tariffs and Trade (GATT) was established to
attempt to reduce barriers to international trade between nations. GATT’s main
provisions:
o A nation must extend the same tariffs to all trading partners that are
GATT/WTO members – most favoured nation.
o Tariffs may be imposed in response to unfair trade practices such as dumping.
o Countries should not limit the quantity of goods and services that they import
– no quotas.
o Countries should declare export subsidies provided to particular firms,
sectors, or industries.
o Countries can temporarily raise tariffs for certain products. when domestic
producers are suffering due to import competition (infant industry?).
o Regional trade agreements are permitted under Article XXIV of the GATT.
Recognising the ability of blocs of countries to form two types of regional
trade agreements: free-trade areas and customs unions
Consumer & Producer Surplus
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In panel (a), the consumer surplus from purchasing quantity D1 at price P1 is the
area below the demand curve and above that price.
The consumer who purchases D2 is willing to pay price P2 but has to pay only P1.
The shaded area shows the aggregate surplus of all consumers who would pay more
than the equilibrium
o This is a basic measure of consumer welfare
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In panel (b), the producer surplus from supplying the quantity S1 at the price P1 is
the area above the supply curve and below that price.
The supplier who supplies unit S0 has marginal costs of P0 but sells it for P1. The
difference is the producer surplus and represents the return to fixed factors of
production in the industry.
o Again, this is a basic measure of producer well-being
Small country gains from trade
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With Home demand of D and supply of S, the no-trade equilibrium is at point A, at
the price PA producing Q0.
With trade, the world price is PW, so quantity demanded increases to D1 and
quantity supplied falls to S1. Home imports D1 – S1.
Consumer surplus increases by the area (b + d), and producer surplus falls by area b.
The gains from trade are measured by area d.
Note: since PW < PA, Foreign ctry will have CA in this good.
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Home Import Demand
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The effect of a tariff can be seen in both Home and Import markets.
The no-trade equilibrium is at point A, with the price PA and import quantity Q0.
Import demand at this price is zero, as shown by the point A' in panel (b).
At a lower world price of PW, import demand is M1 = D1 – S1, as shown by point B.
As such, we obtain a downward sloping import demand curve, M.
Imposition of a tariff for a small country
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Applying a tariff of t dollars will increase the import price from PW to PW + t.
The domestic price of that good also rises to PW + t. This price rise leads to an
increase in Home supply from S1 to S2, and a decrease in Home demand from D1 to
D2, in panel (a). Imports fall due to the tariff, from M1 to M2 in panel (b).
As a result, the equilibrium shifts from point B to C.
Export supply X* shows the price at which foreign firms sell to H. It is horizontal b/c
H is small and its consumption can’t influence world prices.
Welfare effect of the tariff
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The triangle (b + d) is a deadweight loss, or a loss that is not offset by a gain
elsewhere in the economy
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Effect of tariff on welfare
 The tariff increases the price from PW to PW + t.
 As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area
a, and government revenue increases by the area c.
 Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is
measured by the two triangles b and d in panel (a) or the single (combined)
triangle b + d in panel (b).
Why and How are tariffs applied
 If a small country suffers a loss when it imposes a tariff, why do so many have tariffs
as part of their trade policies?
 One answer is that a developing country does not have any other source of
government revenue. Import tariffs are “easy to collect.”
 A second reason is politics.
o Benefits of protection centralized
o Costs diffuse.
Tariffs for a large country – Deriving Export Supply
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Large (Home) country implies that it possesses some influence over foreign exporters
prices due to the volume of consumption. As such X* is upward sloping. Note that
PW > PA*  F has CA
Export Supply
 In panel (a), with Foreign demand of D* and Foreign supply of S*, the no-trade
equilibrium in Foreign is at point A*, with the price of PA*.
 At this price, the Foreign market is in equilibrium and Foreign exports are zero—point
A* in panel (a) and point A* in panel (b), respectively.
 When the world price, PW, is higher than Foreign’s no-trade price, the quantity
supplied by Foreign, S*1, exceeds the quantity demanded by Foreign, D*1, and
Foreign exports X*1 = S*1 – D*1.
 In panel (b), joining up points A* and B*, we obtain the upward-sloping export
supply curve X*.
 With the Home import demand of M, the world equilibrium is at point B*, with the
price PW
Effect of the tariff – Large Country
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Area e is a measure of the terms-of-trade gain for the importer. f is an efficiency loss
due to the drop is export price and export flow for F.
The tariff is represented by a shifting up of the export supply curve from X* to X*+ t.
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As a result, the Home price increases from PW to P* + t, and the Foreign price falls
from PW to P*. Because H is large, the Price ↑ at H and the resultant fall in foreign
exports induces a decrease in the price offered by foreign exporter, P*. As such,
foreign firms incur some of the effect of the tariff, H consumers the other.
The deadweight loss at Home is the area of the triangle (b + d), and Home also has a
terms-of-trade gain of area e.
Foreign loses the area (e + f), so the net loss in world welfare is the triangle (b + d +
f).
Optimal Tariff
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Tariffs and Welfare for a Large Country
For a large importing country, a tariff initially increases the importer’s welfare
because the terms-of-trade gain exceeds the deadweight loss (e>b+d). So the
importer’s welfare rises from point B.
Welfare continues to rise until the tariff is at its optimal level (point C).
After that, welfare falls.
If the tariff is too large (greater than at B), then welfare will fall below the free-trade
level.
For a prohibitive tariff, with no imports at all, the importer’s welfare will be at the notrade level, at point A.
Optimal Tariff Formula The formula depends on the elasticity of Foreign export
supply, which we call E*X.
o
Import Quota
 Another form of trade protection is an import quota
 Under a quota, the quantity of imports is restricted
 Analysis of welfare effects identical to a tariff, however there is no government
revenue explicitly earned.
 Concept of quota rents. Allocation of rights to import important
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For every level of the import quota, there is an equivalent import tariff that would
lead to the same Home price and quantity of imports. Note the vertical export
supply curve with a quota.
Import Quota for a small country
 Under free trade, the Foreign export supply curve is horizontal at the world price PW,
and the free-trade equilibrium is at point B with imports of M1.
o Applying an import quota of M2 < M1 leads to the vertical export supply curve,
XẊ, with the equilibrium at point C.
o The quota increases the import price from PW to P2. There would be the same
impact on price and quantities if instead of the quota, a tariff of t = P2 – PW
had been used.
o Major difference between tariff and quota is area c
 With tariff c=government revenue for importing country
 Under the quota, area c is defined as a ‘quota rent’
 There are differing ways that the home government can deal with this
Allocating Quota Rents
 Four Possible Ways
1. Giving the Quota to Home Firms Quota licenses (i.e., permits to import the quantity
allowed under the quota system) can be given to Home firms
• These firms import at Pw and sell at P2
• Quota rents captured by firms at home
•
Rent Seeking
• How would the govt decide which firms they issue quota licences to?
 Often based on prior output. This may lead to firms over-producing
just to obtain quota licence for the next period
 Firms may also engage in bribery or lobbying
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Rent seeking
Rent seeking activities may be as large as the quota rents
themselves, in chich case net effect on home welfare = - (b + c
+ d)
2. Auctioning the Quota A third possibility for allocating the rents that come from the
quota is for the government of the importing country to auction off the quota
licenses.
• In a well-organized, competitive auction, the revenue collected should exactly
equal the value of the rents, so that area c would be earned by the Home
government. Using the auction method to allocate quota rents, the net loss in
domestic welfare due to the quota becomes
3. “Voluntary” Export Restraint The final possibility for allocating quota rents is for the
government of the importing country to give authority for implementing the quota to
the government of the exporting country.
• Because the exporting country allocates the quota among its own producers,
this is sometimes called a “voluntary” export restraint (VER), or a
“voluntary” restraint agreement (VRA). In the 1980s the United States used
this type of arrangement to restrict Japanese automobile imports.
• In this case, the quota rents are earned by foreign producers, so the loss in
Home welfare equals
•
Summary
 Gov’t has some ability to implement trade policies in the form of tariffs, quotas etc
 Most gov’ts however are members of WTO which provide rules governing trade
policies b/w countries
 For a SOE, the price faced will rise by the full amount under the tariff.
 For a large country, the prices rises but by not the full amount of the tariff. There is a
TOT effect. Because of this, the optimal tariff for a large econ is +ve.
 Quotas restrict Q  incr dom prices and dom Q. Work in a similar way to tariffs
except for c.
 Quotas generate ‘quota rents’ and there are various ways these can be dealt with
Week 7 – Trade, Labour and the Environment
Intro
 Early 20th C – idea that protection led to growth
o Empirical reality was that it stifled growth
o M substitution was usually inefficient
o Other sectors stifled (eg K importing sectors)
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Move towards greater integration and less protection
o WTO major part of this as are regional agreements
Backlash
 More recently there have been open protests against free trade and the WTO.
o Not the first (post WW1, post 1890s depression)
 Particularly in terms of environmental and labour rights activists
Large Country Tariff
 When a large country imposes a tariff on imports, it yields a terms of trade (ToT) gain
o This may improve its welfare
 As we noted however, this could spark retaliation
o Foreign may impose their own tariffs
o This is the case of a ‘trade war’
 ToT gains may be eliminated
International Trade Agreements
 The Logic of Multilateral Trade Agreements
 Tariffs for a Large Country
o
Payoffs
 Assume two identical countries
 If one country only sets tariff, its payoff = e – (b+d).
o For simplicity, assume e sufficiently large that e-(b+d)>0
o Foreign loses e+f
 If both countries set a tariff each loses b+d (domestic DWL) + f (loss incurred by
foreign tariff)
 If neither sets a tariff, zero payoff
 Each country moves simultaneously: prisoner’s dilemma type problem
Prisoner’s Dilemma The pattern of payoffs in Figure 11-2 has a special structure called the
prisoner’s dilemma. Each country acting on its own has an incentive to apply a tariff, but if
they both apply tariffs, they will both be worse off.
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Nash Equilibrium: The only Nash equilibrium in Figure 11-2 is for both countries to
apply a tariff (lower-right quadrant). The Nash equilibrium in this case leads to an
outcome that is undesirable for both countries even though it is the best outcome for
each country given that the other country is imposing a tariff.
Unique Nash equil where each sets a tariff
This however lowers world welfare
o Can be avoided possibly by repeated interaction or by some form of
agreement between nations
This is the basis for trade agreements between nations
How to avoid these losses
 PD type game is a Nash equil (no collusion)
 Clearly both countries better off is they set zero tariffs but the game demonstrates
that acting independently there would be no incentive to do so
 Moreover a non-binding agreement might invoke cheating
International Agreements
 Legally binding international agreements are a tool to escape protection and increase
welfare
 The WTO is a multilateral agreement, involving many countries, with agreement to
lower tariffs between all the members.
 There are also smaller regional trade agreements, involving several countries, often
located near each other.
 When countries seek to reduce trade barriers between themselves, they enter into a
trade agreement—a pact to reduce or eliminate trade restrictions.
 Under the most favored nation principle of the WTO, the lower tariffs agreed to in
multilateral negotiations must be extended equally to all WTO members.
 The WTO is an example of a multilateral trade agreement, which we analyze first in
this section.
Multilateral agreements
 Negotiations by countries to reduce protection against all trading partners
 For example, in WTO negotiated agreements we have the most favored nation
principle
o the lower tariffs agreed to in multilateral negotiations must be extended
equally to all WTO members.
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Regional Trade Agreement
 Countries make an agreement to reduce trade barriers among themselves, but
maintain protection for other nations
o Preferential trade agreements
o Free trade areas
o Customs union (agree to set of tariffs as a whole against foreign firms not in
union)
o Rules of origin become important where cutoms union not established
 Example - NAFTA
Trade Agreements
 Will trade agreements increase or decrease welfare?
o This may depend on the pre-existing conditions, which countries are
excluded, which goods and services we are looking at
o Changes to the composition of trade may be pivotal.
Trade Creation and Trade Diverson
 One possibility is that a member country imports a product from another member
country that it formerly produced for itself.
o Trade creation
 a member country may also begin to import a product from another member
country in lieu of other countries outside the new trade region that it formerly
imported from
o Trade diversion
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This table shows the cost to the United States of purchasing an automobile part from
various source countries, with and without tariffs. If there is a 20% tariff on all
countries, then it would be cheapest for the United States to buy the auto part from
itself (for $22). But when the tariff is eliminated on Mexico after NAFTA, then the U.S.
would instead buy from that country (for $20), which illustrates the idea of trade
creation. If instead we start with a 10% tariff on all countries, then it would be
cheapest for the U.S. to buy from Asia (for $20.90). When the tariff on Mexico is
eliminated under NAFTA, then the U.S. would instead buy there (for $20), illustrating
the idea of trade diversion.
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With Mexico and Asia facing the same tariff of t for sales into the United States, the
equilibrium is at A with the quantity Q2 exported by Mexico and the remainder
exported by Asia at a price of PAsia + t.
U.S. tariff revenue is the area (a + b + c + d).
Eliminating the tariff with Mexico under NAFTA leads to an expansion of Mexican
exports to Q3.
The United States loses the tariff revenue (a + b + c), which is the U.S. loss as a result
of trade diversion from Asia to Mexico.
Not All Trade Diversion Creates a Loss
Suppose that after joining NAFTA, Mexico has considerable investment in the auto
parts industry, and its supply curve shifts to SMex rather than SMex.
Then equilibrium imports to the United States will occur at point D, at the price PAsia,
and Mexico will fully replace Asia as a supplier of auto parts.

Application
 The effect of NAFTA on Canadian manufacturing industries measured by the
difference between trade created and trade diverted:

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
Because this calculation is positive we conclude that trade creation exceeded trade
diversion. Therefore, Canada definitely gained from the free-trade agreement with
the United States
International Agreements on Labour Issues
 We use the term labor standards to refer to all issues that directly affect workers,
including occupational health and safety, child labor, minimum wages, and so on.
Labor standards were included in NAFTA to satisfy several groups.
o First, consumers and policy makers are often concerned with the working
conditions in factories abroad and want to avoid “sweat shop” conditions that
exploit workers.
o Second, unions in the industrial countries are also concerned with these
conditions, partly in solidarity with foreign workers and partly because poor
labor standards abroad will create more competition for U.S. workers.
 Labor Side Agreement Under NAFTA
o The labor side agreement negotiated under NAFTA does not change the
existing labor laws in these countries but is meant to improve the
enforcement of such laws.
 Other Labor Agreements
o Besides the labor side agreement in NAFTA, there are many other examples
of international agreements that monitor the conditions of workers in foreign
countries.
o Unions and other organizations are concerned with issues such as job safety,
the right of workers to unionize, workers’ entitlement to breaks and not being
forced to work overtime, and so on.




This table summarizes the responses from a survey conducted by the National
Bureau of Economic Research that asked individuals about attitudes toward an item
made under good working conditions and under poor working conditions.
Corporate Responsibility
o Because of the pressure from consumers and unions, corporations have
started to monitor and improve the conditions in their overseas plants and
the plants of their overseas subcontractors.
Country Responsibility
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o Several U.S. trade laws give the president the power to withhold trade
privileges from countries that do not give their workers basic rights, including
the right to organize.
 Living Wage
o Is it fair to expect foreign firms to pay a living wage to their workers, that is, a
wage above the norm in the developing country? Economists have a ready
answer: the wages should be as high as the market will allow, and not any
higher.
American tariffs, Bangladeshi Deaths
 The collapse of garment factories in Bangladesh in 2013 killed more than 1,000
workers.
o As a response, Sanchita Saxena of UC Berkeley proposed that the United
States should reduce the tariff on garment imports from Bangladesh and
other Asian countries.
o Why? High US tariffs  lower profits for exporters  lower wages, poorer
working conditions
 US responded by raising several tariffs against Bangladesh
International Agreements on the Environment
 Environmental Issues in the GATT and WTO
o The WTO does not directly address environmental issues; other international
agreements, called multilateral environmental agreements, deal specifically
with the environment.
o
o
Does trade help or harm the environment?
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Externalities
• An externality occurs when one person’s production or consumption of a good
affects another person.
• Externalities can be positive, such as when one firm’s discoveries from research and
development (R&D) are used by other firms, or negative, such as when the
production of a good leads to pollution.
• Closely related to the concept of externalities is the idea of market failure, which
means that the positive or negative effects of the externality on other people are not
paid for.
Externalities & Trade
•
•
•
•
•
Panel (a) illustrates a negative production externality, which means that the social
marginal cost curve, SMC, lies above the private marginal cost (supply) curve S. With
free trade, the price falls from PA to PW and Home supply falls from Q0 to S1. As a
result, the social cost of the externality is reduced by area c, which measures a social
gain that is additional to the private gains from trade, area b.
Panel (b) illustrates a negative consumption externality, meaning that the social
marginal benefits, SMB, lie below the private marginal benefit (demand) curve D. The
vertical distance between the SMB and D curve, times the quantity consumed,
reflects the social cost of the externality. With free trade Home demand increases
from Q0 to D1. As a result, the social cost of the externality increases by area d. That
area is a social cost that offsets the private gains from trade, area b.
Note that this suggest home welfare increases with trade for a negative production
externality
• Producers lose but < gain for consumers. Lower domestic production implies
lower external cost.
is ambiguous for a negative consumption externality
• Gain in CS and loss PS same, but now increased domestic consumption leads
to > external cost
Externalities and the environment
 It is however even more complicated:
o first result holds for a local externality. If problem is not site specific (eg CO2
emissions) then production externality just shifted offshore. Foreign
production may or may not be cleaner
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o In such cases world welfare may fall if foreign production generates a greater
externality
Positive Exteralities
 Positive externalities exist. For example spillover benefits from domestic production.
o See for example Nunn and Trefler (2003)
 In these circumstances the opposite results hold.
o If t applied for production externality, losses of tariff partially offset by
increased domestic prodn
o If t applied where there is a consumption externality, the costs of t are
exacerbated by decrease in domestic consumption
 Ethanol as a lower emission fuel:
o Can be produced from sugar or corn
o Quotas on US sugar imports induce ethanol producers towards corn. Corn
however generates greater env. costs (require more fertilizers (greater energy
costs to produce these), degrades soil more – negative production externality.
o However, this has been offset by elimination of tariffs on Brazilian ethanol
o Trade likely to decrease env damage.
Environment and Impact of Trade
US Automotive VER
 The “voluntary” export restraint (VER) on exports of Japanese cars to the United
States, which began in 1981, limited the number of cars that Japanese firms could
export each year, but not their value.
 As a result, there was an incentive for the Japanese firms to export larger and/or
more luxurious models.
 As the quality of the Japanese cars rose, so did the engine size and weight of the
vehicles; as a result, the average gas mileage of the imported cars fell.
 This figure uses data on Japanese imported cars from 1979 to 1982, before and after
the “voluntary” export restraint with Japan began. The horizontal axis shows the
change in the quantity sold (in percent) between these years, and the vertical axis
shows the gas mileage of each model. The models with the lowest mileage—such as
the Maxima, Cressida, and Mazda 626—had the greatest increase in sales between
these years.
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
Tragedy of the Commons
 Free trade can harm the environment when a resource is treated as common
property that anyone can harvest. The resource may be subject to overuse, a
phenomenon referred to as the tragedy of the commons.
Trade in Fish
 When a resource such as fish is treated as common property that anyone can
harvest, it will be subject to overfishing and its stocks will diminish rapidly over time
as each producer seeks to maximize its own share of the resource.
 According to one scientific study, 29% of fish and seafood species have collapsed;
that is, their catch declined by 90% or more between 1950 and 2003.
Trade in Buffalo
 Buffalo Hide Imports This figure shows estimates of the imports to the United
Kingdom and France of buffalo hides from the United States. The amount of imports
into these countries was small or negative before 1871 but then grew rapidly and
peaked in 1875. In that year, the United Kingdom and France combined imported
more than 1 million hides and over the entire period from 1871 to 1878 imported
some 3.5 million hides. Much of this trade volume can be attributed to an invention
in London in 1871 that allowed buffalo hides to be tanned for industrial use.

Trade in Solar Panels
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


When consumers install solar panels there is a positive consumption externality,
because this source of electricity does not rely on the burning of fossils fuels,
which contributes to climate change.
The extra social gains that come from free trade are even larger when one
country subsidizes the production of solar panels and exports more panels at
lower prices.
That is what the United States and the European Union believe that China has
done. But rather than accept the low-priced solar panels, with the positive
consumption externality, these countries have threatened to apply tariffs against
China.
International Agreements on Pollution
 Payoffs in an Environmental Game
 This payoff matrix shows the gains and losses for Home and Foreign countries,
depending on whether they adopt environmental regulations. If governments weight
producer surplus more than consumer surplus, then the structure of payoffs is
similar to the prisoner’s dilemma because the Nash equilibrium is to have both
countries not adopt regulations. That outcome can occur with “global” pollutants.


Mutual Agreements
o One example of an international agreement is the Montreal Protocol on
Substances that Deplete the Ozone Layer, which has successfully eliminated
the use of chlorofluorocarbons (CFCs).
Application
 The Kyoto Protocol built on the United Nations’ 1992 treaty on climate change,
established specific targets for reduction in greenhouse gas emissions: the industrial
countries should cut their emissions of greenhouse gases by a collective 5.2% less
than their 1990 levels.
 There are four reasons often given to explain why the United States did not join the
Kyoto Protocol:
o although the evidence toward global warming is strong, we still do not
understand all the consequences of policy actions;
o while the United States is the largest emitter of greenhouse gases, meeting
the Kyoto targets would negatively affect its economy;
o Kyoto failed to include the developing countries, especially China and India;
o there are other ways to pursue reductions in greenhouse gas emissions.
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



The Copenhagen Accord is a recognition that further increases in global average
temperature should be kept below 2 degrees centigrade.
Under this accord, an agreement was made that industrialized countries will submit
goals for greenhouse gas emissions reductions, while developing countries will
communicate their efforts in this regard.
There is also the establishment of a fund to finance the needs of developing
countries in fighting the effect of climate change.
In March 2010, China and India agreed to join the Copenhagen Accord, as has the
United States and more than 100 other countries.
Summary
 There are two primary types of free-trade agreements: multilateral and regional.
Multilateral agreements are negotiated among large groups of countries (such as all
countries in the WTO) to reduce trade barriers among them, whereas regional
agreements operate among a smaller group of countries, often in the same region.
 Under perfect competition, we can analyze the benefits of multilateral agreements
by considering the Nash equilibrium of a two-country game in which the countries
are deciding whether to apply a tariff. The unique Nash equilibrium for two large
countries is to apply tariffs against each other, which is an example of a “prisoner’s
dilemma.” By using an agreement to remove tariffs, both countries become better off
by eliminating the deadweight losses of the tariffs.
 Regional trade agreements are also known as “preferential trade agreements,”
because they give preferential treatment (i.e., free trade) to the countries included
within the agreement, but maintain tariffs against outside countries. There are two
types of regional trade agreements: free-trade areas (such as NAFTA) and customs
unions (such as the European Union).
 The welfare gains and losses that arise from regional trade agreements are more
complex than those that arise from multilateral trade agreements because only the
countries included within the agreement have zero tariffs, while tariffs are
maintained against the countries outside the agreement. Under a free-trade area,
the countries within the regional trade agreement each have their own tariffs against
outside countries; whereas under a customs union, the countries within the regional
trade agreement have the same tariffs against outside countries.
 Trade creation occurs when a country within a regional agreement imports a product
from another member country that formerly it produced for itself. In this case, there
is a welfare gain for both the buying and the selling country.
 Trade diversion occurs when a member country imports a product from another
member country that it formerly imported from a country outside of the new trade
region. Trade diversion leads to losses for the former exporting country and possibly
for the importing country and the new trading region as a whole.
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Week 8 – National and International Accounts
Introduction
 Evaluation of the macroeconomy, construction of policy, academic research
o All rely on the collection of macroeconomic data
o Today we focus on how a country’s transactions are measured (accounted for)
 Examination of international system of trade and payments
 Provide an exposition as to how international trade in G&S is complemented and
balanced by a parallel trade in assets
 Consider the implications for national income and wealth
 Recall concept of the circular flow from 1st year
o National income and product accounts
 In an open economy, measurements complicated by the need to account for cross
border transactions
 These are recorded in the Balance of Payments accounts
Preliminaries – Closed
 Gross National Expenditure (GNE)
 Expenditure on final goods and services by home entities in a given period
o GNE = C + I G
 GNE is an expenditure measure. Where do the payments go? Must be on goods and
services produced domestically (closed econ)
 value of goods and services produced is measured by GDP
o Note GDP is a product measure and is measured on value added terms (ie.
Final value of goods and services minus value of intermediate goods and
services)
o Note that intermediate sales = intermediate purchases so GNE=GDP
 GDP measures value of firm outputs minus cost of inputs. This latter flow represents
a return to factors. Sum of these factor payments = GNI (gross national income) =
Total income resources in a closed economy

Extending to an open economy
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Trade Balance
 Trade Balance (TB): difference between payments received for X and those made on
M.
o  net payments to domestic firms from int trade
o GNE + TB = total value of production at home

NFIA


Some home GDP is paid to foreigners (returns to factors (K,Land(T),L) owned
offshore): factor service imports
Some income is received from offshore by domestic entities owning (K,T,L): factor
service exports
o EXFS – IMFS = Net factor income from abroad (NFIA)

NUT


Nonmarket transactions such as foreign aid may be paid or received by the home
country (unilateral transfers)
Difference between what is received and paid = net unilateral transfers (NUT). These
need to be added to GNI to derive gross national disposable income (GNDI)  total
income resources available to a country

Current Account
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
The current account (CA) is a tally of all international transactions in goods, services,
and income (occurring through market transactions or transfers).

Assets
 Current account tells us about international transaction in goods, services or income
 These do not include financial assets (eg stocks, bonds, real estate) that are traded
 GNDI can be increased or decreased through net asset purchases with foreigners.
Difference between asset imports and asset exports is termed the Financial Account
(FA)
 A country may also give or receive financial assets. These are captured in the capital
account (KA)

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GNE to GDP (accounting for trade in G&S)
 Familiar from 1st year, GDP is the sum of GNE and the trade balance:


The trade balance (TB), also referred to as net exports, may be positive or negative.
o If TB > 0, exports are greater than imports and we say a country has a trade
surplus.
o If TB < 0, imports are greater than exports and we say a country has a trade
deficit.
GDP to GNI (accounting for trade factor services)
 GNI = GDP plus NFIA:

The Celtic Tiger
 GNI = GDP + NFIA
  NFIA = GNI - GDP
 Mid 70’s, Ireland one of the poorer European countries. Investment boom late 80s
and 90s  strong growth. Though 15% or so of gains flows to foreign investors

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GNI to GNDI – Accounting for transfers of income
 If a country receives transfers worth UTIN and gives transfers worth UTOUT, then its net
unilateral transfers (NUT), are
o NUT = UTIN − UTOUT .
 Adding net unilateral transfers to gross national income, gives a full measure of
national income in an open economy, known as gross national disposable income
(GNDI), henceforth Y:
Y = ( C + I + G ) + ( E X - I M ) + ( E X F S - I M F S ) + (U T I N - U T O U T )
 #  # $
 # #  # #$
 # #  # #$
 #  # $
GNDI
T ra d e
b a la n c e
(T B )
GNE
N e t fa c to r in c o m e
fro m a b ro a d
(N F IA )
 # # # # # # #  # # # # # # # $

GNI
N e t u n i l a te r a l
tra n s fe rs
(N U T )
What does all of this tell us
 On LHS is national income (GNDI)
 1st term RHS captures payments by domestic entities (GNE)
 Remaining RHS terms capture net payments to home from all tns in goods, services,
and income. Grouped into the CA.
Y = C # + I +# $ G + { ( E X - I M ) + ( E X F S - I M F S ) + (U T + - U T - ) }
 #  # $
 #  # $
 # #  # #$
GNDI
GNE
T rad e
b a la n c e
(T B )
N e t fa c to r in c o m e
fro m a b ro a d
(N F I A )
N e t u n ila te ra l
tra n s fe rs
(N U T )
 # # # # # # # #  # # # # # # # #$
o
C u rre n t a c c o u n t
(C A )
National Income Identity
 Y = C + I + G + CA
 This equation is the open-economy national income identity. It tells us that the
current account represents the difference between national income Y (or GNDI) and
gross national expenditure GNE (or C + I + G). Hence:
o GNDI is greater than GNE if and only if CA is positive, or in surplus.
o GNDI is less than GNE if and only if CA is negative, or in deficit.
Understanding data
 U.S. Economic Aggregates in 2012 The table shows the computation of GDP, GNI, and
GNDI in 2012 in billions of dollars using the components of gross national
expenditure, the trade balance, international income payments, and unilateral
transfers.
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
Current Account Balance and National Savings
 Let S  national savings (private plus public), where S = Y – C – G (eq 1)
 In a closed economy, Y = C + I + G  I = Y – C – G
 Hence, I=S
 In an open economy, Y = C + I + G + CA (2)
 Noting from (1) that S = Y – C – G, we can rewrite and rearrange (2) to yield:
o S = I + CA
 Note, we have not distinguished here between government saving (T-G) and private
savings (Y – T – C), Hence:
o If

o Then C A = t o t a l d o m e s t i c s a v i n g s - I
Implications
o Closed economy: I only if domestic savings
o Open economy can generate extra (SR) investment from O/S (i.e. raise I by
borrowing from O/S which raises CAD)  Open economy does not need to
NS to I
Pitchford Thesis
 Back in the 80s, much angst about rising current account deficits (CAD)
 John Pitchford (ANU) argued that if funding private investment then CAD not a
problem (in fact may be a good thing)
o Expect private investment to generate returns which repay borrowings from
abroad
o Even if defaults occur, then markets will deal by penalising future borrowers
(which will decr future CAD)
o Expect private investment to generate productive capacity for the economy
 Problem where CAD is generated via govt overspending however as govt may not be
subject to commercial/market discipline
o This is where CAD may fundamentally differ between nations
Ricardian Equivalence
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







Ricardian equivalence suggest that a decrease in T-G is offset by an increase in S.
Why?
Suppose govt lowers tax by $100 and borrows to finance deficit
o Citizens realise debt will need to be repaid, hence save in anticipation of extra
taxation later  government reduction in savings offset by increase in private
savings
Empirical support weak, hence reductions in govt saving (ie usually an increase in G)
without any change in S imply higher CAD.
Text cites research suggesting 1% T-G  0.2-0.4% CAD
o Example: US increased G (Iraq and Afghanistan conflicts) at the same time as
decrease in T. CAD increased from around 1% to 6% of GDP.
Note that for advanced countries that in general S<I with rising CAD
For developing countries, this is reversed (S>I)  CA surplus
These countries are net exporters of funds for investment.
Advanced countries are net importers of funds for I.

Assets – Financial Account – Asset Transactions
 The financial account (FA) records transactions between residents and nonresidents
that involve financial assets. This definition covers all types of assets:
o real assets such as land or structures,
o and financial assets such as debt (bonds, loans) or equity, issued by any
entity.
 Subtracting asset imports from asset exports yields the home country’s net overall
balance on asset transactions, which is known as the financial account, where FA =
EXA − IMA.
 The financial account therefore measures how the country accumulates or reduces
assets through international transactions.
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Assets – Capital Account – Asset Transactions
 The capital account (KA) covers two remaining areas of asset movement of minor
quantitative significance.
o the acquisition and disposal of nonfinancial, nonproduced assets (e.g.,
patents, copyrights, trademarks, etc.)
o capital transfers (i.e., gifts of assets), an example of which is the forgiveness
of debts
 We denote capital transfers received by the home country as KAIN and capital
transfers given by the home country as KAOUT. The capital account, KA = KAIN − KAOUT,
denotes net capital transfers received.
Balance of Payments
Macroeconomic
 Adding the last two expressions, we have the value of the total resources available to
the home country for expenditures. This total value is equal the total value of home
expenditure on final goods and services, GNE:


Cancelling GNE from both sides we obtain the result known as the balance of
payments identity or BOP identity:

Microeconomic
 We have to understand one simple principle: every market transaction (whether for
goods, services, factor services, or assets) has two parts.
 If party A engages in a transaction with a counterparty B, then A receives from B an
item of a given value, and in return B receives from A an item of equal value.
 The components of the BOP identity allow us to see the details behind why the
accounts must balance.
C A = (E X - IM ) + (E X FS - IM
FS
) + (U T I N - U T O U T )
K A = ( K A IN - K A O U T )



F A = ( E X AH - I M
H
A
) + ( E X AF - I M AF )
If an item has a plus sign, it is called a balance of payments credit or BOP credit.
If an item has a minus sign, it is called a balance of payments debit or BOP debit.
Double Entry Principle
 Suppose you live in US and purchase a printer from Japan for $1000. You use your
Visa to pay for this.
 The purchase registers as an import in the CA (negative sign). There must be a
corresponding credit to Balance the BoP.
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
Here it is the ‘sale of a foreign asset’. Through the Visa debit, the US has exported an
Asset (the Japanese producer now has a claim against Visa) This appears in the
financial account.
o
Understanding the Data for BOP
 A country that has a current account surplus is called a (net) lender. By the BOP
identity, it must have a deficit in its asset accounts.
 Any lender, on net, buys assets (acquiring IOUs from borrowers). For example, China
is a large net lender.
 A country that has a current account deficit is called a (net) borrower. By the BOP
identity, it must have a surplus in its asset accounts.
 Any borrower, on net, sells assets (issuing IOUs to lenders). Eg, the United States is a
large net borrower.
What the BOP tells us
 The balance of payments accounts consist of:
o the current account, which measures external imbalances in goods, services,
factor services, and unilateral transfers.
o the financial and capital accounts, which measure asset trades.
 Surpluses on the current account side must be offset by deficits on the asset side.
Deficits on the current account must be offset by surpluses on the asset side.
 The balance of payments makes the connection between a country’s income and
spending decisions and the evolution of that country’s wealth.
External Wealth
 Just as a household is better off with higher wealth, all else equal, so is a country.
 “Net worth” or external wealth with respect to the rest of the world (ROW) can be
calculated by adding up all of the home assets owned by ROW and then subtracting
all of the ROW assets owned by the home country.
 In 2012, the United States had an external wealth of about –$4,474 billion. This
made the United States the world’s biggest debtor in history at the time.
Level of External Wealth
 The level of a country’s external wealth (W) equals

o
A country’s level of external wealth is also called its net international investment
position or net foreign assets. It is a stock measure, not a flow measure.
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

If W > 0, home is a net creditor country: external assets exceed external liabilities.
If W < 0, home is a net debtor country: external liabilities exceed external assets.
Changes in External Wealth
 There are two reasons a country’s level of external wealth changes over time.
o Financial flows: As a result of asset trades, the country can increase or
decrease its external assets and liabilities.
Net exports of home assets cause an equal increase in the level of external
liabilities and hence a corresponding decrease in external wealth.
o Valuation effects: The value of existing external assets and liabilities may
change over time because of capital gains or losses. In the case of external
wealth, this change in value could be due to price effects or exchange rate
effects.
 Adding up these two contributions to the change in external wealth (ΔW), we find

o
Since −FA = CA + KA, substituting this identity into Equation (5-15), we obtain
é C h a n g e in ù é C u rre n t ù é C a p ita l ù é C a p ita l g a in s o n ù
ê e x te rn a l w e a lth ú = ê a c c o u n t ú + ê a c c o u n t ú + ê e x te rn a l w e a lth ú
ë # ##  # # #$ û ë #  # $ û ë #  # $ û ë # # #  # # #$ û
DW
CA
=
U n sp e n t
in c o m e
 #  #$

KA
=
N e t c a p ita l
tra n s fe rs re c e iv e d
 #  #$
V a lu a tio n e ffe c ts
=
C a p i ta l g a i n s
m in u s c a p ita l lo ss e s
o
This implies that an increase in stock wealth comes from:
o Domestic thrift (increase CAS)
o Charity from RoW
o Windfall gains
Week 9 – Exchange Rates
Introduction
 Exchange rates affect large flows of international trade by influencing the prices in
different currencies.
 Foreign exchange also facilitates massive flows of international investment, which
include direct investments as well as stock and bond trades.
 In the foreign exchange market, trillions of dollars are traded each day and the
economic implications of shifts in the market can be dramatic.
 FX Market. Topics include
o exchange rate basics,
o basic facts about exchange rate behavior,
o the foreign exchange market, and
o two key market mechanisms: arbitrage and expectations.
Exchange rate essentials
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

An exchange rate (E) is the price of some foreign currency expressed in terms of a
home (or domestic) currency.
Because an exchange rate is the relative price of two currencies, it may be quoted in
either of two ways:
o The number of home currency units that can be exchanged for one unit of
foreign currency.
o The number of foreign currency units that can be exchanged for one unit of
home currency.
Defining the exchange rate
 To avoid confusion, we must specify which country is the home country and which is
foreign.
 When we refer to a particular country’s exchange rate, we will quote it in terms of
units of home currency per units of foreign currency.
 For example, Denmark’s exchange rate with the Eurozone is quoted as Danish krone
per euro (or kr/€).
 Exchange Rate Quotations This table shows major exchange rates as they might
appear in the financial media. Columns (1) to (3) show rates on December 31, 2012.
For comparison, columns (4) to (6) show rates on December 31, 2011. For example,
column (1) shows that at the end of 2012, one U.S. dollar was worth 0.996 Canadian
dollars, 5.659 Danish krone, 0.759 euros, and so on. The euro-dollar rates appear in
bold type.



E$/€ = 1.318 = U.S. exchange rate (American terms)
E€/$ = 0.759 = Eurozone exchange rate (European terms)
E $ /€ =

1
E € /$
1 .3 1 8 =
1
0 .7 5 9
Appreciations and Depreciations
 If one currency buys more of another currency, we say it has experienced an
appreciation—its value has risen, appreciated, or strengthened.
o Eg in previous slide over two periods EE/$ moved from 0.77 in 2011 to 0.759 in
2012
o In other words to buy 1USD using Euro it costs less in 2012
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
If a currency buys less of another currency, we say it has experienced a depreciation
—its value has fallen, depreciated, or weakened.
o Flip of above. ESU/E moved from 1.298 to 1.318  more USD required to
purchase 1EUR.
 To determine the size of an appreciation or depreciation, we compute the
proportional change, as follows:
 In 2011, at time t, the dollar value of the euro was
o E$/€,t = $1.298.
 In 2012, at time t + 1, the dollar value of the euro was
o E$/€,t+1 = $1.318.
 The change in the dollar value of the euro was
o Δ E$/€,t = 1.318 − 1.298 = + $0.020.
 The percentage change was
o Δ E$/€,t/E$/€,t = +0.020/1.298 = +1.54%.
 Thus, the euro appreciated against the dollar by 1.54%.
Exchange Rate Regimes: Fixed Versus Floating
 There are two major types of exchange rate regimes— fixed and floating:
o Fixed (or pegged) exchange rates fluctuate in a narrow range (or not at all)
against some base currency over a sustained period. A country’s exchange
rate can remain rigidly fixed for long periods only if the government
intervenes in the foreign exchange market in one or both countries.
o Floating (or flexible) exchange rates fluctuate in a wider range, and the
government makes no attempt to fix it against any base currency.
Appreciations and depreciations may occur from year to year, each month, by
the day, or every minute.
 This figure shows exchange rates of three currencies against the euro, introduced in
1999. The pound and the yen float against the euro. The Danish krone provides an
example of a fixed exchange rate. There is only a tiny variation around this rate, no
more than plus or minus 2%. This type of fixed regime is known as a band.


Exchange rates in developing countries show a wide variety of experiences and
greater volatility. Pegging is common but is punctuated by periodic crises (you can
see the effects of these crises in graphs for Thailand, South Korea, and India).
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
Recent Exchange Rate Experiences
 Figure 2-4 shows an IMF classification of exchange rate regimes around the world,
which allows us to see the prevalence of different regime types across the whole
spectrum from fixed to floating.
 The classification covers 192 economies for the year 2008, and regimes are ordered
from the most rigidly fixed to the most freely floating.
 Seven countries use an ultrahard peg called a currency board, a type of fixed regime
that has special legal and procedural rules designed to make the peg “harder”—that
is, more durable.
Spectrum of Exchange Rate Regimes


This figure shows IMF classification of exchange rate regimes around the world for
covers 192 economies in 2010. Regimes are ordered from the most rigidly fixed to
the most freely floating. Seven countries use an ultrahard peg called a currency
board, while 35 others have a hard peg.
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

An additional 43 counties have bands, crawling pegs or bands, while 46 countries
have exchange rates that either float freely, are managed floats are allowed to float
within wide bands.
Market for Foreign Exchange
 Exchange rates the world over are set in the foreign exchange market (or forex or FX
market).
o In April 2010, the global forex market traded, $4 trillion per day in currency.
o The three major foreign exchange centers are located in the United Kingdom,
the United States, and Japan.
o Other important centers for forex trade include Hong Kong, Paris, Singapore,
Sydney, and Zurich.
Spot Contract
 The simplest forex transaction is a contract for the immediate exchange of one
currency for another between two parties. This is known as a spot contract.
 The exchange rate for this transaction is often called the spot exchange rate.
 The use of the term “exchange rate” always refers to the spot rate for our purposes.
 The spot contract is the most common type of trade and appears in almost 90% of all
forex transactions.
Derivatives
 In addition to the spot contracts other forex contracts include forwards, swaps,
futures, and options.
 Collectively, all these related forex contracts are termed derivatives.
 The spot and forward rates closely track each other.
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
Arbitrage and Spot Rates
 Arbitrage ensures that the trade of currencies in New York along the path AB occurs
at the same exchange rate as via London along path ACDB. At B the pounds received
must be the same, regardless of the route taken to get to B:
E £N/$.Y . = E £L/$o n d o n

Arbitrage with Three Currencies
 Now consider 3 currencies (can trade (say) from USD to GBP to EUR). Possibilities:
o The direct trade from dollars to pounds has a better rate: E£/$ > E£/€ E€/$
o The indirect trade has a better rate: E£/$ < E£/€ E€/$
o The two trades have the same rate and yield the same result: E£/$ = E£/€ E€/$.
Only in the last case are there no profit opportunities. This no-arbitrage
condition:

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
The right-hand expression, a ratio of two exchange rates, is called a cross rate.
An important question for investors is in which currency they should hold their liquid cash
balances.
• Would selling euro deposits and buying dollar deposits make a profit for a banker?
• These decisions drive demand for dollars versus euros and the exchange rate
between the two currencies.
Exchange Rate Risk
 A trader in New York cares about returns in U.S. dollars. A dollar deposit pays a
known return, in dollars. But a euro deposit pays a return in euros, and one year
from now we cannot know for sure what the dollar-euro exchange rate will be.
 Riskless arbitrage and risky arbitrage lead to two important implications, called
parity conditions.
Riskless Arbitrage: Covered Interest Parity
 Contracts to exchange euros for dollars in one year’s time carry an exchange rate of
F$/ € dollars per euro. This is known as the forward exchange rate.
o If you invest in a dollar deposit, your $1 placed in a U.S. bank account will be
worth (1 + i$) dollars in one year’s time. The dollar value of principal and
interest for the U.S. dollar bank deposit is called the dollar return.
o If you invest in a euro deposit, you first need to convert the dollar to euros.
Using the spot exchange rate, $1 buys 1/E $/€ euros today.
o These 1/E $/€ euros would be placed in a euro account earning i €, so in a year’s
time they would be worth (1 + i €)/E$/€ euros.
 To avoid that risk, you engage in a forward contract today to make the future
transaction at a forward rate F$/€.
o The (1 + i €)/E$/€ euros you will have in one year’s time can then be exchanged
for (1 + i €)F$/€/E$/€ dollars, or the dollar return on the euro bank deposit.
o
 This is called covered interest parity (CIP) because all exchange rate risk on the euro
side has been “covered” by use of the forward contract.
Evidence on Covered Rates Parity
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

Financial Liberalization and Covered Interest Parity: Arbitrage Between the United
Kingdom and Germany CIP holds where arbitrage is possible. Capital controls
restricts this mechanism. This shows the effect of financial liberalization in Geramy
and the UK during the period 1979-81.
Riskless Arbitrage: Uncovered Interest Parity
 Traders may also be prepared to take on risk and make a forecast of the future spot
e
rate. We refer to the forecast as E $ / € , which we call the expected exchange rate

Based on the forecast, you expect that the ( 1 + i € ) / E $ / € euros you will have in one

year’s time will be worth ( 1 + i € ) / E $ / € / E $ / € when converted into dollars; this is the
expected dollar return on euro deposits.
The expression for uncovered interest parity (UIP) is:
e
o


Under UIP, returns to holding dollar deposits accruing interest going along the path
AB must equal returns from investing in euros going along the risky path ACDB.
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Hence, at B, the expected payoff must be the same on both paths
E $e / €
(1 + i $ ) =
(1 + i € )
E $/€
What determines the spot rate
 Uncovered interest parity is a no-arbitrage condition that describes an equilibrium in
which investors are indifferent between the returns on unhedged interest-bearing
bank deposits in two currencies.
 We can rearrange the terms in the uncovered interest parity expression to solve for
the spot rate:
E $ / € = E $e / €

1 + i€
1 + i$
UIP and CIP
 CIP and UIP look similar; one uses a hedged forward rate, the other expectations
 If we divide UIP by CIP we see a relationship
U IP

C IP


( 1 + i $ ) = (1 + i $ )
1 + i $ ) E $e/ Î E $ / Î
(
1=
(1 + i $ ) E $ /Î F $ /Î
 E

( 1 + i $ ) = (1 + i $ )
e
E $e/ Î
E $ /Î
F $ /Î
E $ /Î
E $e/ Î
=
F $ /Î
=F
$ /Î
$ /Î
o
o Implies that if investors truly do not care about risk, then forward exchange
rate must equal the expected exchange rate
o INTUITION: If investors don’t care about risk  No reason to prefer to avoid
using F  XRs equivalent
If the forward rate equals the expected spot rate, the expected rate of depreciation
equals the forward premium (the proportional difference between the forward and
spot rates):
o
While the left-hand side is easily observed, the expectations on the right-hand side
are typically unobserved.
Prices, money and the exchange rate
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Intro



Just as arbitrage occurs in the international market for financial assets, it also occurs
in the international markets for goods.
The result of goods market arbitrage is that the prices of goods in different countries
expressed in a common currency tend to be equalized.
Applied to a single good, this idea is referred to as the law of one price; applied to an
entire basket of goods, it is called the theory of purchasing power parity.
Law of one price (LOOP)
 The law of one price (LOOP) states that in the absence of trade frictions (such as
transport costs and tariffs), and under conditions of free competition and price
flexibility (where no individual sellers or buyers have power to manipulate prices and
prices can freely adjust), identical goods sold in different locations must sell for the
same price when prices are expressed in a common currency.
o


q Ug S / E U R
  #
= ( E $ / € P EgU R ) /
 $  $#
P% UgS
R e la t iv e p r i c e o f g o o d g
in E u ro p e v e rs u s U .S .
E u ro p e a n p ric e
o f g o o d g in $
U .S . p ric e
o f g o o d g in $
(1 )
q Ug S / E U R
expresses the rate at which goods can be exchanged: it tells us how many
units of the U.S. good are needed to purchase one unit of the same good in Europe.
E $/€
expresses the rate at which currencies can be exchanged ($/€).
Example
 Suppose basket of goods cost EUR100 and E$/E=1.20 (1.2 dollars per Euro), Basket
must cost USD120 in US.
 LOOP implies
1
R e la tiv e p ric e o f g o o d g
i n E u r o p e v e r s u s U .S .


= (1
 .$2 # 1$ 0%0 ) / 1 2 0
E u ro p e a n p ric e
o f g o o d g in $
o
Note if LHS was > or < RHS, arbitrage occurs
Note if LOOP holds
1
R e la tiv e p ric e o f g o o d g
in E u ro p e v e rs u s U .S .
= ( E $ / € P EgU R ) /
 $ # $%
g
P U S
E u ro p e a n p ric e
o f g o o d g in $
U .S . p ric e
o f g o o d g in $
H ence
P UgS
= E $ /€
P EgU R
o
 LOOP implies the exchange rate must equal the ratio of good prices expressed in two
currencies
Purchasing Power Parity (PPP)
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

The principle of purchasing power parity (PPP) is the macroeconomic (aggregate)
counterpart to LOOP. To express PPP algebraically, we can compute the relative price
of the two baskets of goods in each location
o
There is no arbitrage when the basket is the same price in both locations qUS/EUR = 1.
PPP holds when price levels in two countries are equal when expressed in a common
currency. This statement about equality of price levels is also called absolute PPP.
qUS/EUR is also the real ER. It is the price of the European basket in terms of the U.S.
basket.
PPP and the ER
 The exchange rate that would be implied by absolute PPP:

o
Purchasing power parity implies that the exchange rate at which two currencies
trade equals the relative price levels of the two countries.
PPP and the real ER
 Purchasing power parity states that the real exchange rate is equal to 1.
 If the real exchange rate qUS/EUR is below 1 by x%, then Foreign goods are relatively
cheap, x% cheaper than Home goods.
o In this case, the Home currency (the dollar) is said to be strong, the euro is
weak, and we say the euro is undervalued by x%.
 If the real exchange rate qUS/EUR is above 1 by x%, then Foreign goods are relatively
expensive, x% more expensive than Home goods.
o In this case, the Home currency (the dollar) is said to be weak, the euro is
strong, and we say the euro is overvalued by x%.
Inflation and Relative PPP
 PPP has implications for understanding inflation.
 If Equation (14-1) (Ed/f=Pd/Pf) holds for levels of exchange rates and prices, then it
must also hold for rates of change in these variables. See p 381 for derivation

o
This way of expressing PPP is called relative PPP, and it implies that the rate of
depreciation of the nominal exchange rate equals the difference between the
inflation rates of two countries (the inflation differential).
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Evidence of PPP
 Relative price levels tend to change slowly and have a small range of movement;
exchange rates move more abruptly and experience large fluctuations. Therefore,
relative PPP does not hold in the short run but appears to hold well in the longer run.


Deviations from PPP
 Transaction costs. Include costs of transportation, tariffs, duties, shipping, legal, etc.
o On average, they are more than 20% of the price of goods traded
internationally.
 Nontraded goods. Some goods are inherently nontradable; they have infinitely high
transaction costs. Most goods and services fall somewhere between tradable and
nontradable.
 Imperfect competition and legal obstacles. Many goods are not simple
undifferentiated commodities, as LOOP and PPP assume, but are differentiated
products with brand names, copyrights, and legal protection. Such differentiated
goods create conditions of imperfect competition because firms have some power to
set the price of their good. With this kind of market power, firms can charge different
prices not just across brands but also across countries.
 Price stickiness. Prices do not or cannot adjust quickly and flexibly to changes in
market conditions.
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