International Economics
PRACTICAL INFORMATION
◼ Course: builds on courses of micro- and macro-economics
◼ Prerequisites: micro and macro economics
◼ Guidance/questions:
 Discussion board on TOLEDO, no e-mail
 Regular Q&A sessions
◼ Structure:
 Kaltura recordings combined with interactive Q&A sessions
◼ Handbook:
 International Trade: Theory and Policy (2018), Paul Krugman, Maurice Obstfeld, Marc
Mélitz
◼ Combination of asynchronous (recordings) and synchronous, on-campus teaching (Q&A
sessions)
◼ Class recordings and slides: Toledo (Course documents and Collaborate)
◼ Exam:
 Written
 Closed book
 Questions testing both knowledge and understanding
 Question bundle with 30 multiple choice questions – this also serves as scrap paper.
 Pre-printed answer sheet: make sure to be in the correct examination room!!
 Fill in the answer sheet at the end of the exam, using a pen (no pencil).
 No calculator
 No correction for guessing
◼ Exam feedback session
 Advantages and purpose
 Registration only possible on the day of the announcement of the exam results
◼ If guest lectures: information and study material on Toledo
◼ Contents of the course: cfr. end of this chapter
1
Structure of the course
Part 1: International trade theory
Chapter 1: Introduction
Chapter 2: World Trade
Chapter 3: Labour Productivity and Comparative Advantages: the Ricardian Model
Chapter 4: Specific Factors and Income Distribution
Chapter 5: Production Factors and Trade: the Heckscher-Ohlin model
Chapter 7: External Scale Effects and International Location of Production
Chapter 8: Firms in the Global Economy: Export Decisions, Outsourcing and Multinational
Firms
Part 2: International trade policy
Chapter 9: Instruments of Trade Policy
Chapter 10: Political Economy of Trade Policy
Chapter 11: Trade Policy in Developing Countries
Chapter 12: Controversies in Trade Policy
Planning of the course
2
Chapter 1: What is international economics?
What is international economics?
◼ Real economics (= this course)
 Increase in trade flows
 Benefits of trade
 Trade pattern
 Impact of government policy on trade
◼ Monetary economics (macro- and monetary courses)
◼ International economics studies the economic interactions between countries and the
problems that can prevail
 The study of international economics has never been as important as today: at the
beginning of the 21st century, nations are more closely linked through trade in goods
and services, through flows of money, and through investment in each others’
economies than ever before – although the benefits of globalization are ever more
questioned.
Increase in trade flows
3
4
Average of imports and exports as % of GDP is the trade openness of an economy
We notice that trade flows increased a lot
Why?
▪
Decrease in trade barriers such as tariffs and quota but also decrease of transport
costs in general
▪
Free trade areas/agreements (EU, NAFTA/USMCA, …)
5
Benefits of trade
Free trade offers benefits and costs
The most important benefits are:
1. Even if a country is the most/least efficient in producing all goods it still gains by
trading: it focuses on producing the good in which it is relatively best and imports the
rest (Ch3)
2. Trade will be beneficial for a country when it exports (imports) goods that intensively
use the abundant (scarse) factors of production (Ch4 and 5)
3. If countries specialise they can produce more efficiently because of a larger scale of
production (Ch7 and 8)
We will illustrate that trade is beneficial for individual countries but can be detrimental for
certain groups of economic agents within countries (division of benefits can differ –
Ch4/5/11)
▪
Trade can have a negative impact on factors of production that are used in import
competing sectors
▪
Trade can thus lead to different income effects within countries
▪
Trade can also lead to different income effects between countries (developed versus
developing)
Trade pattern
Trade pattern can be explained by:
▪
Differences in climate (inter-industrial trade)
▪
Differences in labour productivity (inter-industrial trade) – Ch3
▪
Differences in availability and use of factors of production (inter-industrial trade) –
Ch4 and 5
▪
Scale effects (intra-industrial trade) – Ch7 and 8
6
Impact of government policy on trade
The government can influence trade in a number of ways
What are the costs and benefits of such a policy? (Ch9-Ch12)
▪
If a government restricts trade, which instrument(s) does she use best?
▪
If a government restricts trade, to which degree does she do it best?
▪
If a government restricts trade, what are the costs of the policy ánd of the possible
counter measures undertaken by trade partners?
Example to illustrate the benefits of trade agreements/free trade.
Trump: produce cars in US or pay 35% tariff on imported cars from Mexico
7
Chapter 2: World Trade
Gravity model explains trade:
▪ Countries trade more when they are larger
▪ Countries trade more when they are closer to one another
Changing pattern of world trade
▪ Has the world become smaller?
▪ Which goods are traded?
▪ Outsourcing/offshoring
Gravity model explains trade
What explains/influences trade?
1. Size of countries
▪
Larger economies produce more goods and services, so they have more to sell in the
export market.
▪
Larger economies generate more income from the goods and services sold, so
people are able to buy more imports.
2. Distance between countries (influences transport costs + personal contacts)
3. Cultural affinity
4. Geography (harbors, mountains)
5. Multinational corporations
6. Borders (time and money cost; diff in language and currency)
8
In its basic form, the gravity model assumes that only size (+) and distance (-) are important for
trade in the following way:
Tij =
AxYi xY j
Dij
where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country j
◼ In a slightly more general form, the gravity model that is commonly estimated is
Tij =
AxY a i xY b j
D c ij
◼ Perhaps surprisingly, the gravity model works fairly well in predicting actual trade flows
◼ Estimates of the effect of distance from the gravity model predict that a 1% increase in the
distance between countries is associated with a decrease in the volume of trade of 0.7% to
1%
◼ The gravity model can assess the effect of trade agreements on trade:
➔ does a trade agreement lead to significantly more trade among its
partners than one would otherwise predict given their GDPs and distances
from one another?
9
◼ E.g. because of NAFTA/USMCA and because Mexico and Canada are close to the US, the
amount of trade between the US and its northern and southern neighbors as a fraction of
GDP is larger than between the US and European countries.
◼ Even with a free trade agreement between the US and Canada, which use a common
language, the border between these countries still seems to be associated with a reduction
in trade.
◼ The negative effect of distance on trade according to the gravity models is significant, but it
has grown smaller over time due to modern transportation and communication.
10
Changing pattern of world trade: Has the world become smaller?
There were different waves of globalization.
▪
1840–1914: economies relied on steam power, railroads, telegraph, telephones.
Globalization was interrupted and reversed by wars and depression.
▪
1945–present: economies rely on telephones, airplanes, computers, internet, fiber
optics,…
▪
From 1945 onwards: recovery of world trade
▪
From 1970 onwards: world trade as a fraction of GDP has increased substantially
▪
Today: recovery of the crisis + increased questioning regarding the benefits of
globalization
11
Changing pattern of world trade: Which goods are traded?
Today
▪
Most of the volume of trade is in manufactured products (55%) such as cars, computers,
clothing, machinery
▪
Importance of trade in services increases (25% of trade is in services)
▪
Mineral products and agricultural products constitute respectively 13% and 7% of trade
Before
▪
A large fraction of the volume of trade came from agricultural and mineral products.
12
Changing pattern of world trade: Outsourcing/offshoring
▪
Before 1945 there were hardly any multinationals; now they are everywhere
▪
‘Outsourcing’ and ‘offshoring’ = what?
When a firm that produces goods/services, moves its activities (or part of its activities)
abroad
▪
The activities are undertaken by an independent company in another country.
or
▪
The activities are undertaken by subsidiaries in another country.
Chapter 3: Labor productivity and comparative advantage: the
Ricardian model
▪
▪
▪
▪
▪
▪
Introduction
Concept of comparative advantage
Comparative advantage with 2 goods
▪ Relative production and relative prices without trade
▪ Relative production and relative prices with trade
▪ Benefits of trade
▪ Relative wages
▪ Misconceptions about comparative advantage
Comparative advantage with more goods
▪ Relative production with trade
▪ Benefits of trade
Transport costs and nontraded goods
Empirical evidence of the Ricardian model
13
Introduction
◼ Countries engage in international trade for two basic reasons:
 They are different from each other in terms of climate, land, capital, labor, and
technology – Ch3, 4 and 5
 They try to achieve scale economies in production – Ch7 and 8
◼ The Ricardian model is based on technological differences across countries.
 These technological differences are reflected in differences in the productivity of
labor.
Concept of comparative advantage
◼ Opportunity Cost
 The opportunity cost of roses in terms of computers is the number of computers that
could be produced with the same resources as a given number of roses.
◼ Comparative Advantage
 A country has a comparative advantage in producing a good if the opportunity cost
of producing that good in terms of other goods is lower in that country than it is in
other countries.
Numerical example:
◼ Suppose that in the U.S. 10 million roses can be produced with the same resources as
100,000 computers.
◼ Suppose also that in S-America 10 million roses can be produced with the same resources
as 30,000 computers.
◼ This example assumes that S-American workers are less productive than U.S. workers.
◼ If each country specializes in the production of the good with lower opportunity costs,
trade can be beneficial for both countries.
◼ Roses have lower opportunity costs in S-America.
◼ Computers have lower opportunity costs in the US,
◼ The benefits from trade can be seen by considering the changes in production of roses
and computers in both countries.
The world as a whole produces more (the same amount of roses but more computers) – it is
therefore possible to increase everyone’s life standard
14
The example illustrates the principle of comparative advantage:
◼ If each country exports the goods in which it has comparative advantage (lower
opportunity cost), then all countries can in principle gain from trade.
What determines comparative advantage? How do country differences determine the pattern of
trade?
Second intuitive example to illustrate the difference between absolute and comparative
advantage:
◼ 2 people: CEO and management assistant
◼ 2 tasks: lead company and writing up reports
◼ Given the following information:
 CEO is better than the management assistant in leading the company and faster
in writing up reports
 CEO is mainly better in leading the company (5 times more efficient than the
management assistant), rather than faster in writing up reports (2 times more
efficient than the management assistant)
◼ Questions:
 Is it profit maximizing for the CEO to fire the management assistant?
 Who has an absolute/comparative advantage in performing which task?
Comparative advantage with 2 goods
Relative production and relative prices without trade
Assume that we are dealing with an economy (which we call Home). In this economy:
 Labor is the only factor of production.
 Only two goods (say wine and cheese) are produced.
 The supply of labor is fixed in each country.
 The productivity of labor in each good is fixed.
 Perfect competition prevails in all markets.
◼ The unit labor requirement is the number of hours of labor required to produce one unit
of output.
 aLW : amount (hours) of labor needed to produce 1 gallon of wine.
 aLC : amount (hours) of labor needed to produce 1 pound of cheese
◼ The total labor supply in a country is defined by L
15
◼ 1/aLC is the marginal production
◼ Production Possibilities
 The production possibility frontier (PPF) of an economy shows the
maximum amount of wine that can be produced for any given amount of
cheese, and vice versa (the trade-off between two goods).
 The PPF of our economy is given by the following equation:
aLCQC + aLWQW = L
or
aLWQW = L - aLCQC
or
QW = L /aLW – aLC /aLW x QC
◼ In an economy with one production factor, the PPF is a straight line
◼ If the PPF is a straight line, the opportunity cost of a pound of cheese in terms of wine is
constant: aLC /aLW
 The production of one pound of cheese requires aLC man-hours
 Every man-hour could also be used for the production of 1/ aLW gallons of wine
◼ The opportunity cost is the slope of the PPF curve
◼ Example calculation opportunity cost
Opportunity cost is aLC / aLW
▪
aLC is number of hours one works in cheese industry = 1 hour
▪
1/ aLW is wine production per hour = ½ gallon per hour
▪
The opportunity cost of cheese in terms of wine = how much wine one could
produce if one does not opt for the production of cheese: take 1 hour from
the cheese production and use it for wine production => 1/2 gallons of wine
16
◼ PPF reveals what a country CAN produce
◼ What a country WILL produce depends on the relative price
◼ Relative Prices and Supply
 The particular amounts of each good produced are determined by prices
 The relative price of cheese in terms of wine is the amount of wine that can be
exchanged for one unit of cheese
◼ The supply is determined by the maximization decision of employees. They maximize
their income by working in the sector that offers the highest wage.
 PW (PC): price of wine (cheese)
 wW (wC): wage in the wine (cheese) industry
◼ Hourly wage = value of what a worker can produce in 1 hour
 wW = PW / aLW
 wC = PC / aLC
 Therefore, wC / wW = (PC / PW) / (aLC / aLW)
◼ The relation between relative prices and opportunity cost determines the specialization.
 If PC / PW > aLC / aLW → wC > wW → specialization in C
 If PC / PW < aLC / aLW → wC < wW → specialization in W
 If PC / PW = aLC / aLW → wC = wW → production of both goods
◼ The above relations imply that if the relative price of cheese (PC / PW ) exceeds its
opportunity cost (aLC / aLW), then the economy will specialize in the production of cheese.
◼ In the absence of trade, both goods are produced, and therefore PC / PW = aLC /aLW.
17
Comparative advantage with 2 goods: Relative production and relative prices with trade
◼ Assumptions of the model:
 There are two countries in the world (Home and Foreign).
 Each of the two countries produces wine and cheese.
 Labor is the only factor of production.
 The supply of labor is fixed in each country.
 The productivity of labor in each good is fixed.
 Labor is not mobile across the two countries.
 Perfect competition prevails in all markets.
 * refers to the Foreign country.
◼ Absolute advantage versus comparative advantage
 A country has an absolute advantage in the production of a good if it has a lower
unit labor requirement than the foreign country in this good: aLC < a*LC and aLW <
a*LW
2 labor inputs are required to determine absolute advantage (labour input
in cheese at Home and abroad or labour input in wine at Home and abroad)
 A country has a comparative advantage in the production of a good (cheese)
when: aLC /aLW < a*LC /a*LW
4 labor inputs are required to determine comparative advantage (labour
input in cheese and wine at Home and labour input in cheese and wine
in Foreign)
◼ The pattern of trade will be determined by the concept of comparative advantage
◼ Comparative Advantage
 Assume that aLC /aLW < a*LC /a*LW
o
This assumption implies that the opportunity cost of cheese in terms of
wine is lower in Home than it is in Foreign.
o
In other words, in the absence of trade, the relative price of cheese at
Home is lower than the relative price of cheese in Foreign.
◼ Home has a comparative advantage in cheese and will export it to Foreign in exchange
for wine.
◼ To determine the benefits of trade, we need to know the relative price if there would be
trade
18
Note:
PPF for F is steeper than
for H;
The opp cost for cheese
in terms of wine is
therefore larger in F
◼ In studying comparative advantages, we do not use a ‘partial equilibrium analysis’
(studying 1 particular market, e.g. the market of cheese),
◼ But we use a so-called ‘general equilibrium analysis’, where the linkages between the
two different markets – in this case cheese and wine – are studied
--> hence the relative demand/supply cheese wrt wine
◼ If no trade : PC / PW = aLC / aLW
◼ What determines the relative price (PC / PW) after trade?
 To answer this question we have to define the relative supply and relative
demand for cheese in the world as a whole.
 The relative supply of cheese equals the total quantity of cheese supplied by
both countries at each given relative price divided by the total quantity of wine
supplied, (QC + Q*C )/(QW + Q*W).
 The relative demand of cheese in the world is a similar concept.
19
20
21
22
◼ PC / PW < aLC / aLW : H and F produce wine, no cheese production
◼ PC / PW = aLC / aLW : H produces wine and cheese
◼ aLC / aLW < PC / PW < a*LC / a*LW : H produces cheese, F produces wine (full
specialization)
◼ PC / PW = a*LC / a*LW : F produces wine and cheese
◼ PC / PW > a*LC / a*LW : H and F produce cheese, no wine production
◼ In point 1 each country specializes fully
◼ In point 2, country 1 still specializes in the production of cheese but also produces wine
(relative production of cheese is smaller than with full specialization)
◼ Note that the relative price after trade is most of the time in between the opportunity
costs in both countries
Comparative advantage with 2 goods: Benefits of trade
◼ The Gains from Trade
 If countries specialize according to their comparative advantage, they all gain from
this specialization and trade.
23
◼ We will demonstrate these gains from trade in two ways.
 A first way to see the gains from trade is to consider how trade affects the
consumption in each of the two countries.
 The consumption possibility frontier (CPF) states the maximum amount of
consumption of a good a country can obtain for any given amount of the other
commodity.
 In the absence of trade, the consumption possibility curve is the same as the
production possibility curve.
 Trade enlarges the consumption possibility for each of the two countries.
 Secondly, we can think of trade as a new way of producing goods and services
(indirect production).
Doel:
•
Aantonen dat beide landen winnen bij handel
•
Absoluut voordeel is niet van belang, wel comparatief voordeel
24
◼ The previous numerical example implies that:
aLC / aLW = 1/2 < a*LC / a*LW = 2
In world equilibrium, the relative price of cheese must lie between these values.
Assume that PC / PW = 1 gallon of wine per pound of cheese.
◼ Both countries will specialize and gain from this specialization (H:C – F:W)
◼ Home:
 Home can use one hour of labor to produce 1/aLW = 1/2 gallon of wine if it does not
trade.
 Alternatively, it can use one hour of labor to produce 1/aLC = 1 pound of cheese, sell
this amount to Foreign, and obtain 1 gallon of wine.
 1 gallon > ½ gallon
◼ Foreign:
 Foreign can use one hour of labor to produce 1/a*LC = 1/6 pound of cheese if it does
not trade.
 Alternatively, it can use one hour of labor to produce 1/a*LW = 1/3 gallon of wine, sell
this amount to Home, and obtain 1/3 pound of cheese.
 1/3 pound > 1/6 pound
Comparative advantage with 2 goods: Relative wages
◼ Relative Wages
 Because there are technological differences between the two countries, trade in
goods does not make the wages equal across the two countries.
 A country with absolute advantage in both goods will enjoy a higher wage after
trade.
◼ This can be illustrated with the help of a numerical example:
 Assume that PC = $12 and that PW = $12. Therefore, we have PC / PW = 1 as in our
previous example.
 Since Home specializes in cheese after trade, its wage will be (1/aLC)PC = ( 1/1)$12 =
$12.
 Since Foreign specializes in wine after trade, its wage will be (1/a*LW) PW = (1/3)$12 =
$4.
 Therefore the relative wage of Home will be $12/$4 = 3.
 Thus, the country with the higher absolute advantage will enjoy a higher wage after
trade.
25
◼ The relative wage is between the productivity ratios of both goods:
 H is 6 time more productive in cheese production and 1,5 times more productive in
wine production than F
 The wage in H is 3 time higher than the wage in F
◼ These relationships imply cost advantages for both countries:
 In H, higher wages are compensated for by a higher productivity
 In F, lower productivity is compensated for by a lower wage
◼ In the Ricardian model, relative wage differences reflect relative productivity differences
Is this true in reality? Yes
Comparative advantage with 2 goods: Misconceptions about comparative advantage
◼ Productivity and Competitiveness
 Myth 1: Free trade is beneficial only if a country is strong enough to withstand
foreign competition.
 This argument fails to recognize that trade is based on comparative not
absolute advantage.
◼ The Pauper Labor Argument
 Myth 2: Foreign competition is unfair and hurts other countries when it is based
on low wages.
 Lower wages in Foreign simply reflect a lower productivity – Home still
benefits from trade.
◼ Exploitation
 Myth 3: Trade makes the workers worse off in countries with lower wages.
 In the absence of trade these workers would be worse off.
 Denying the opportunity to export is to condemn poor people to
continue to be poor.
26
Comparative advantage with MORE goods: Relative production with trade
◼ The Model:
 Both countries consume and are able to produce a large number, N, of different
goods.
◼ Relative Wages and Specialization
 The pattern of trade will depend on the ratio of Home to Foreign wages (w/w*)
 Goods will always be produced where it is cheapest to make them.
◼ H will produce and export good i if:
waLi < w*a*Li (or if a*Li /aLi > w/w*)
◼ How determine ratio of domestic and foreign wages (w/w*)?
o Easy in 2-goods model:
▪ If H has a comparative advantage in cheese: determine w in terms of
cheese and w* in terms of wine
▪ Then use relative price to calculate relative wage
→ this was only possible because we already knew the specialization
o
Less easy in more goods model:
→ we don’t know the specialisation yet – we need the relative wage to
determine the specialisation
How proceed? Look at relative demand and relative supply of labour –
relative demand for labour is deducted from relative demand for goods
◼ Which country produces which goods?
 A country has a cost advantage in any good for which its relative productivity is
higher than its relative wage.
◼ If, for example, w/w* = 3, Home will produce apples, bananas, and caviar,
while Foreign will produce only dates and enchiladas.
◼ Both countries will gain from this specialization (direct versus indirect
production).
27
◼ Determining the Relative Wage in the Multigood Model
 To determine relative wages in a multigood economy we must look behind the
relative demand for goods (i.e., the relative derived demand)
 The relative demand for Home labor depends negatively on the ratio of Home to
Foreign wages
Comparative advantage with more goods: Benefits of trade
◼ Illustrate benefits of trade: direct versus indirect production; e.g. H imports dates
 If import (indirect): 1 date ‘costs’ 12 units of labour in F
 If own production (direct): 1 date ‘costs’ 6 units of labour in H
◼ NOTE: these two units of labour cannot be compared
why not?
Because they are expressed in different units: wages in H are three times higher than
wages in F
 If import: 1 date ‘costs’ 12 units of labour in F = 4 units of labour in H
 If own production: 1 date ‘costs’ 6 units of labour in H
 4 units of labour in H < 6 units of labour in H so importing dates is beneficial for H
Transport costs and nontraded goods
◼ There are three main reasons why specialization in the real world is not extreme:
 The existence of more than one factor of production.
 Countries sometimes protect industries from foreign competition.
 It is costly to transport goods and services.
28
◼ The result of introducing transport costs makes some goods nontraded.
◼ In some cases transportation is virtually impossible.
◼ Example of non-tradable goods because of transport costs
 Caviar: exported from H to F
NO TRANPORT COSTS
◼ H: caviar ‘costs’ 3 units of labour in H = 9 units of labour in F
◼ F: caviar ‘costs’ 12 units of labour in F
=> Beneficial for F to import
TRANSPORT COSTS of 100 %
◼ H: caviar ‘costs’ 9*2 = 18 units of labour in F
◼ F: caviar ‘costs’ 12 units of labour in F
=> No longer beneficial for F to import
Empirical evidence of the Ricardian model
◼ The Ricardian model has several shortcomings:
 There is never full specialization in the real world
 One does not take income differences within countries into account
 There is no role for differences in available production factors
 The role of economies of scale is ignored
◼ We still see that the basic prediction of the model gets confirmed by several studies
◼ Balassa (1963): compare production and export in the UK and US after the second world
war:
 US has an absolute advantage in everything
 We however see that UK exports too (even twice as much as US); UK must
therefore also have comparative advantages.
29
Chapter 4: Specific factors and income distribution
▪
▪
▪
▪
▪
Introduction
Specific factors model
▪ Assumptions
▪ Production possibilities
▪ Prices, wages and labour allocation
International trade in the specific factors model
Income distribution and benefits of trade
Trade policy: preview
Introduction
▪
If trade is beneficial for an economy, why do we observe so much inhibitions to trade (e.g.
subisdies, quotas...)?
▪
In the model of Ricardo (chapter 3):
▪
▪
Trade leads to international specialisation, where in each country workers are moved
from the relative inefficient industry to the relative efficient industry
▪
Labour is assumed to be the only factor of production and it is mobile between
industries
In reality trade can lead to huge income distributions within a country
Two possible reasons:
▪
▪
Production factors cannot be transferred immediately and/or at zero costs
between industries.
▪
Industries differ with respect to the factors of production they need.
In chapter 4 we analyse how trade can influence income distribution within a country,
assuming a more realistic world than Ricardo:
→ i.e. a world with more than 1 factor of production, where production
factors cannot be transferred immediately and/or at zero costs between
industries
Specific factors model: Assumptions
•
Assumptions of the model:
▪
Two goods: clothing (C) and food (F)
▪
Three factors of production: labour (L), capital (K) and land (T)
▪
Perfect competition in all markets
▪
Clothing is produced with capital and labour
30
▪
Food is produced with land and labour
▪
Labour is a mobile factor of production
▪
Land and capital are both specific factors of production that can only be used for the
production of 1 of both goods
Specific factors model: Production possibilities
▪
How much of each good will the economy produce?
▪
The production function for Clothing (Food) shows the quantity of Clothing (Food) that
can be produced for each given input of capital (land) and labour.
QC = QC (K, LC)
▪
(4-1)
en
QF = QF (T, LF)
(4-2)
The shape of the production function reflects the law of decreasing marginal revenues.
-
Moreover, each additional unit of labour adds less output than the previous
one (‘diminishing returns’).
31
▪
For the economy as a whole, the total amount of labour employed in the food and
clothing industry together has to equal the total supply of labour:
LC + LF = L
(4-3)
▪
We use a 4-quadrants diagram to construct the production possibility frontier (Figure
4.3).
▪
Why is the production possibility frontier bent?
▪
▪
Decreasing revenues for labour in each sector imply an increasing opportunity
cost when an economy increases its production.
▪
The opportunity cost of clothing in terms of food is the absolute value of the
slope of the production possibility frontier.
The opportunity cost to produce one extra unit of clothing:
MPLF / MPLC kilograms of food
(MPL= marginal product of labour)
Specific factors model: Prices, wages and labour allocation
▪
Demand for labour:
In each sector, producers will maximise their profits by demanding labour until the
point where the value produced by an additional hour of labour equals the marginal
costs of employing a worker during that hour.
32
▪
The demand curve for labour in the clothing sector:
MPLC x PC
▪
▪
(4-4)
The demand curve for labour in the food sector:
MPLF x PF
▪
= w
= w
(4-5)
Figure 4.4 illustrates the labour demand in two sectors.
▪
The two sectors need to pay the same wage because labour is free to move between
the sectors
▪
Where the two demand curves for labour intersect, we find the equilibrium wage
and the equilibrium divison of labour between the two sectors
There is a relation between output and relative prices:
In the production point:
MPLC x PC = MPLF x PF = w
-MPLF / MPLC
▪
= -PC / PF
(4-6)
“In the production point, the production possibility frontier (PPF) has to touch a line with a
slope equal to: minus the price of clothing divided by the price of food.”
33
▪
What happens if there is an equal, proportional change in prices (e.g, P C and PF increase by 10
%)?
➢ PC and PF increase by 10 %
➢ w also increases by 10 %
➢ The allocation of labour between the two sectors remains exactly the same
➢ The real income of capital owners and landowners remains exactly the same
34
▪
What happens if there is a change in relative price (e.g. PC increases by 7 %)
➢ When only PC increases, the relative price PC / PF changes
➢ The labour demand curve for the clothing industry shifts
➢ w does not increase as much as PC (since the employment in the clothing industry
increases, the marginal product of labour in the sector decreases)
➢ Labour is transferred from the food to the clothing sector
35
•
•
What is the economic effect of this price increase on the incomes of the following three
groups: employers, capital owners and landowners
o Employers ?
o Capital owners ?
o Land owners ?
The impact of a relative price change on the income distribution can be summarised as
follows:
o The production factor specific to the sector in which the relative price increases, is
better off
o The production factor specific to the sector in which the relative price decreases is
worse off
o The change in welfare for the mobile factor is ambiguous
36
International trade in the specific factors model
▪
Trade and relative prices
▪
The relative price of clothing without trade is determined by the intersection of the
relative supply and the relative demand of clothing in the country considered
▪
The relative price of clothing under free trade is determined by the intersection of
the relative world supply and relative world demand for clothing
▪
The relative supply for clothing for the world as a whole (RS world) will differ
from the one in the specific factors model in country 1 that we looked at
before
37
•
If there is free trade in the specific factors model, an economy will export that good whose
relative price has increased and import the good whose the relative price has decreased.
Income distribution and benefits of trade
▪
Who wins and who loses from trade?
▪
How does trade influence the welfare of different groups?
▪
Summarising:
“Trade is beneficial for the factor of production specific to the export sector
and harmful for the production factor specific for import competing sectors.
Trade has an ambiguous effect on mobile factors of production.”
▪
There are winners and losers from trade … but are the gains larger than the losses? In other
words, is trade globally speaking better than protection?
▪
▪
Can those who win from trade compensate the losers and still be better off
themselves? If yes, trade is possibly beneficial to all
Value of consumption has to equal value of production (note that D represents consumption
and Q production):
PCDC + PFDF = PCQC + PFQF
▪
(4-7)
This is a budget line with a slope of – (PC /PF):
(QF – DF) = – (PC /PF)(QC – DC)
38
(4-8)
Trade policy: preview
▪
Often losers are the ‘weaker ones’, i.e. the employers in the import competing sectors that
already have a relatively low wage
▪
Is this a reason to limit free trade?
No, because of 3 reasons:
1) Income effects are not specific to technological progress, there are for
instance also income effects if there is technological progress. Should
technological progress as a consequence be limited?
2) It is better to reap the global benefits of trade and compensate the losers
3) The losers of free trade are often better organised than the winners =
political argument (cfr. sugar industry US)
Chapter 5: Heckscher-Ohlin model
▪
▪
▪
▪
▪
▪
Introduction
Model of a two-factor economy
▪ Production possibilities
▪ Relationship factor prices and input choices
▪ Relationship factor prices and goods prices
▪ Relationship goods prices and input choices
▪ Relationship input choices and output
International trade between two-factor economies
Benefits of trade
Factor-price equalization
Empirical evidence
39
Introduction
◼ In the real world, while trade is partly explained by differences in labor productivity (Ch3), it
also reflects differences in countries’ resources (Ch4 and 5).
◼ The Heckscher-Ohlin theory:
 Emphasizes resource differences as the only source of trade
 Shows that comparative advantage is influenced by:
◼ Relative factor abundance (refers to countries)
◼ Relative factor intensity (refers to goods)
 Is also referred to as the factor-proportions theory
◼ Difference specific factors (Ch4) and Heckscher-Ohlin (Ch5)
 Ch4: ‘short’ term, i.e. certain factors of production are specific and therefore
immobile between the sectors
 Ch5: ‘long’ term, where all factors of production are mobile between the sectors
-> Basic idea is the same: differences in available factors of production determine the
trade pattern
Model of a two-factor economy: Production possibilities
•
Assumptions of the Model
▪
Two countries: H and F
▪
Two goods, cloth (C) and food (F)
▪
Two production factors: capital (K) and labour (L)
▪
The supply of labour and capital is constant within a country but differs between
countries
▪
In the long run, both labour and capital can be transferred from one sector to the
other one
▪
Both cloth and food are produced by both capital and labour
▪
Two production functions:
▪
QC = QC (KC,LC )
▪
QF = QF (KF,LF )
▪
Perfect competition prevails in all markets
▪
Production of food is capital-intensive and production of cloth is labor-intensive in
both countries.
LC /KC > LF /KF or aLC /aKC > aLF/aKF or aLC /aLF > aKC /aKF
40
▪
If more than one factor of production: PPF is no longer a straight line
▪
PPF is influenced by both capital- and labour-requirements (no subsititution inputs possible):
aKFQF + aKCQC ≤ K
aLFQF + aLCQC ≤ L
▪
Recall that: LC /KC > LF /KF ; this assumption influences the slope of the PPF
•
The opportunity cost of producing cloth in terms of food is not constant in this model:
•
o
it’s low when the economy produces a low amount of cloth and a high amount of
food
o
it’s high when the economy produces a high amount of cloth and a low amount of
food
If we allow substitution of inputs, then the PPF becomes curved.
41
•
•
The production possibility frontier describes what an economy can produce, but to
determine what the economy does produce, we must determine the prices of goods.
In general, the economy should produce at the point that maximizes the value of production,
V:
V = PCQC + PFQF
where PC is the price of cloth and PF is the price of food
•
•
Define an isovalue line as a line representing a constant value of production.
o
V = PCQC + PFQF
o
PFQF = V – PCQC
o
QF = V/PF – (PC /PF)QC
o
The slope of an isovalue line is – (PC /PF)
At that point, the slope of the PPF equals – (PC /PF), so the opportunity cost of cloth equals
the relative price of cloth.
42
Model of a two-factor economy: Relationship factor prices and input choices
▪
Producers can use different quantities of factors of production to produce clothing and food
•
Their choice of input combinations depends on the wage rate, w, and the rental rate r, more
in particular the ratio of these two factor prices: w/r
•
As the wage rate increases relative to the rental rate, producers are willing to use more
capital and less labor in the production of food and cloth (relationship factor prices and
factors of production).
•
Recall that cloth production is labour-intensive, if at any given wage-rental ratio the labourcapital ratio used in the production of cloth is greater than that used in the production of
food:
LC/KC > LF/ KF
•
The production of cloth is relatively labour intensive, while the production of food is relative
capital intensive
43
Model of a two-factor economy: Relationship factor prices and goods prices
•
Stolper-Samuelson Theorem (effect):
If the relative price of a good increases, holding factor supplies constant,
then the nominal and real return (in terms of both goods) to the factor used
intensively in the production of that good increases,
while the nominal and real return (in terms of both goods) to the other factor
decreases.
Model of a two-factor economy: Relationship goods prices and input choices
•
An increase in PC/PF will:
o
Raise the income of workers relative to that of capital owners, w/r
o
Raise the ratio of capital to labor, K/L, in both cloth and food production and thus
raise (lower) the marginal productivity of labor (capital) in terms of both goods
44
o
Raise the purchasing power of workers and lower the purchasing power of capital
owners, by raising real wages and lowering real rents in terms of both goods
w = MPL*p and r = MPK*p for both goods so
w/p = MPL and r/p = MPK
Model of a two-factor economy: Relationship input choices and output
▪
To what degree do the production levels change when the factors of production of an
economy change?
▪
Rybczynski theorem:
“If a factor of production (K or L) increases, then the supply of the
good that
uses this factor intensively increases and the supply of the other good decreases for
any given commodity prices”
▪
We assumed that:
▪
Clothing is labour intensive
▪
Food is capital intensive
•
Assume the supply of labour increases; i.o.w. the ratio (L/K) increases
•
An increase in the supply of capital (labor) leads to a biased expansion of production
possibilities towards food (cloth) production.
•
o
The biased effect of increases (decreases) in resources on production possibilities is
the key to understanding how differences in resources give rise to international
trade.
o
Why?
An economy will tend to be relatively effective at producing goods that are intensive in the
factors with which the country is relatively well-endowed.
45
International trade between two-factor economies
•
What if trade happens?
o
o
The two countries have similarities:
▪
Same tastes (so same relative demand)
▪
Same technology
▪
Same production structure
The two countries differ:
▪
Different resources:
Home is labour abundant and Foreign is capital abundant
▪
Since cloth is labour intensive, for every given relative price of cloth to food,
Home will produce a higher ratio of cloth to food than Foreign
•
If H and F trade, their relative prices converge: relative price of cloth increases in H (from 1 to
2) and decreases in F (from 3 to 2) and we end up in a point between the two pre-trade
prices (point 2)
•
Implications of trade pattern?
•
o
In Home, the rise in the relative price of cloth leads to a rise in the production of
cloth and a decline in relative consumption, so Home becomes an exporter of cloth
and an importer of food.
o
Conversely, the decline in the relative price of cloth in Foreign leads it to become an
importer of cloth and an exporter of food
Heckscher-Ohlin theorem:
o
A country will export that commodity which uses intensively its abundant factor and
import that commodity which uses intensively its scarce factor.
46
Benefits of trade
•
Trade and the Distribution of Income
o Long run
▪
Trade produces a convergence of relative prices.
▪
Changes in relative prices have strong effects on the relative earnings of
labor and capital in both countries:
▪
o
In Home, where the relative price of cloth rises, workers are made
better off and capital owners are made worse off.
•
In Foreign, where the relative price of cloth falls, the opposite
happens, workers are made worse off and capital owners are made
better off.
Owners of a country’s abundant factors gain from trade, but owners of a
country’s scarce factors lose.
Short run
▪
•
•
Production factors that are ‘stuck’ in a particular industry – temporarily or
for a longer time period – are called ‘specific factors’ (cfr. Chapter 4)
Can those who benefit from trade compensate the losers and still be better off? Yes, cfr.
Figure 4.11 Chapter 4
Factor-price equalization
•
•
•
In the absence of trade: workers would earn less in Home than in Foreign, and capital owners
would earn more.
The HO model predicts that factors prices will be equalized if countries trade
→ Free trade equalizes relative goods prices
→ As a consequence of the link between goods and factor prices factor prices will also
be equalized. How far will this go? According to the model we will get a full
equalization of factor prices (wages and rents)
Factor-Price Equalization Theorem:
o
International trade leads to a complete equalization of factor prices. If both goods
are produced in both countries, the factor prices will the the same in both countries.
This implies that international trade is a substitute for the international mobility of
factors of production.
•
BUT … In the real world factor prices are not equalized between countries
o
Has international trade equalized the returns to homogeneous factors in different
countries in the real world?
▪
Even casual observation clearly indicates that it has not.
47
▪
Under these circumstances, it is more realistic to say that international trade
has reduced, rather than completely eliminated, the international difference
in the returns to homogeneous factors.
•
Four assumptions crucial to the prediction of factor price equalization are in reality untrue:
o Both countries produce both goods
o Both countries have the same technologies in production
o Both countries have the same prices of goods due to trade (often not so because of
limitations to free trade)
o The remuneration of production factors is the same irrespectively of their industry of
employment
•
The model predicts the outcome in the long run, but when an economy decides to
participate in free trade it is possible that production factors cannot immediately be
transferred to industries that intensively use abundant factors of production
Empirical evidence
▪
Tests on US data
o
▪
Leontief paradox: Leontief found that US exports were less capital-intensive than US
imports, even though the US is the most capital-abundant country in the world
Tests on global data
o
A study by Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model using
data for a large number of countries and confirms the Leontief paradox on a broader
level.
𝑒𝑛𝑑𝑜𝑤𝑚𝑒𝑛𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑖𝑛𝑐𝑜𝑚𝑒 𝑖𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑦
>
𝑒𝑛𝑑𝑜𝑤𝑚𝑒𝑛𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛 𝑤𝑜𝑟𝑙𝑑
𝑖𝑛𝑐𝑜𝑚𝑒 𝑖𝑛 𝑤𝑜𝑟𝑙𝑑
⇒ country exports capital intensive goods
48
▪
The case of missing trade
▪
A study by Trefler in 1995 showed that technological differences across a sample of
countries are very large
▪
Since factor prices are never fully equalised between countries, the predicted trade is
mostly a lot larger than the effective trade
→ This phenomenon is known as the phenomenon of ‘missing trade’
▪
North-South trade
▪
North-South trade in manufactures seems to fit the Heckscher-Ohlin theory much
better than the overall pattern of international trade
49
▪
Changes through time according to the HO model:
▪
▪
When Japan and the four Asian ‘miracle’-countries (South Korea, Taiwan, Hong Kong
and Singapore) became more ‘skill-abundant’ between 1960 and 1998, the US
imports from these countries has shifted from ‘less skill intensive industries’ to ‘more
skill intensive industries’ – cfr. Fig 5.13
Implications of the tests of the HO model
▪
The HO model has been less successful at explaining the actual pattern of
international trade.
▪
It has been useful as a way to analyze the effects of trade on income distribution.
50
Chapter 7: External scale effects and the international location of
production
▪
▪
▪
▪
▪
▪
▪
Introduction
Economic scale effects and international trade
Scale effects and market structure
Theory of external scale effects
External scale effects and international trade
Dynamic increasing scale effects
International trade and economic geography
Introduction
▪
Countries engage in international trade for two basic reasons:
 Countries trade because they differ either in their resources or in technology
(comparative advantages). (Chapters 3-5)
 Countries trade in order to achieve scale economies or increasing returns in
production. (Chapters 7-8)
▪
Implications for trade?:
 Chapters 3-5: markets are perfectly competitive. All monopoly gains are competed
away.
 With scale effects, large firms have an advantage over small firms, such that markets
are often dominated by 1 firm (monopoly) or a limited number of firms (oligopoly).
▪
There are external scale effects (level of the industry) and internal scale effects (level of the
individual firm).
 External scale effects = chapter 7
 Internal scale effects = chapter 8
Economic scale effects and international trade
◼ Models of trade based on comparative advantage used the assumptions of constant returns
to scale and perfect competition:
 Increasing the amount of all inputs used in the production of any commodity will
increase output of that commodity in the same proportion.
 Ricardo and HO model assume all incomes of production are transferred to the
factors of production; there are no ‘monopoly’gains
51
◼ In practice, many industries are characterized by economies of scale (also referred to as
increasing returns).
 Production is most efficient, the larger the scale at which it takes place.
 Output grows proportionately more than the increase in all inputs.
 Average costs (costs per unit) decline with the size of the market.
Scale effects and market structure
◼ External scale effects (chapter 7)
 The cost per unit depends on the size of the industry but not necessarily on the size
of any one firm
 An industry will typically consist of many small firms and be perfectly competitive
◼ Internal scale effects (chapter 8 )
 The cost per unit depends on the size of an individual firm but not necessarily on that
of the industry
 The market structure will be imperfectly competitive with large firms having a cost
advantage over small
◼ Both types of scale economies are important causes of international trade
52
Theory of external scale effects
There are three main reasons why a cluster of firms may be more efficient than an individual firm in
isolation:
1. Specialized suppliers
2. Labor market pooling
3. Knowledge spillovers
1. Specialized Suppliers
 In many industries, the production of goods and services and the development of
new products requires the use of specialized equipment or support services.
 An individual company does not provide a large enough market for these services to
keep the suppliers in business.
◼ A localized industrial cluster can solve this problem by bringing together
many firms that provide a large enough market to support specialized
suppliers.
◼ Eg. Silicon Valley has a large concentration of silicon chip firms that need
particular machines to make these chips
2. Labor Market Pooling
 A cluster of firms can create a pooled market for workers with highly specialized
skills.
 It is an advantage for:
◼ Producers
 They are less likely to suffer from labor shortages.
◼ Workers
 They are less likely to become unemployed.
3. Knowledge Spillovers
 Knowledge is one of the important input factors in highly innovative industries.
 The specialized knowledge that is crucial to success in innovative industries comes
from:
◼ Research and development efforts
◼ Informal exchange of information and ideas
53
External scale effects and international trade
▪
A country that has large production in some industry will tend to have low costs of
producing that good.
▪
Trade with external scale effets happens often, both within and between countries:
▪
▪
What are the implications of this type of trade?
▪
▪
▪
Eg. New York (Manhattan) exports financial services to the rest of the US and
the world.
External scale effects can make countries stuck in an unwanted pattern of
specialisation and can even result in losses from international trade.
With external economis of scale, the pattern of trade is often determined by
historical coincidence.
▪
Countries that start out as large producers in certain industries (eg. because
of historical reasons) tend to remain large producers even if some other
country could potentially produce the goods more cheaply.
▪
Eg. Location of financial centers in London and New York is determined by
historical events (cfr. book).
▪
A consequence of the role of ‘history’ in determining the location of an
industry is the fact that industries are not always localised in the best
location.
Graphically: external scale effects imply lower costs and therefore lower prices with
an increasing output
➔ ‘forward-falling’ supply curve
▪
Example: button industry in China and the US
▪
No trade: equilibrium price and output for each country is where demand
and supply curve intersect
Suppose: price in China is initially lower
▪
▪
Trade: equilibrium price and output for the two countries together (‘world’)
is where total demand and supply curve of the cheapest producer intersect
Intitially lower price in 1 country can be because of:
▪
Better technology
▪
Lower labour costs
▪
Historical events
▪
…
54
▪
What happens to production and prices if there is trade?
▪
Production?
China expand production, production US shrinks
➔ costs in China decrease and costs in US increase until finally all production
takes place in China
▪
Prices?
Trade leads to lower prices for both China and the US!!
DIFFERENCE comparative advantages:
➢ Comparative advantages: trade converges prices, ie increase in 1
country, decrease in the other country
➢ External scale effects: trade decreases prices in both countries
55
▪
Impact on welfare if external scale effects?
▪
Trade based on external economies has more ambiguous effects on national welfare
than either trade based on comparative advantage or trade based on economies of
scale at the level of the firm.
With external scale effects, a country can be worse off because of
▪
trade
Suppose: Vietnam and China are 2 button producers and Vietnam is cheaper
▪
This does not imply that Vietnam will produce for the whole world – if China
has a beginners advantage – for whatever reason - China will serve the world
market (because Vietnam does not produce enough to benefit from a lower
production cost)
→ It can be better for a country to produce the goods itself rather than to
import; iow trade can be negative for an individual country
→ Trade is and remains beneficial because one can use external scale
effects
→ Total welfare impact = ambiguous
▪
Example of negative welfare impact for 1 country
▪
Watch-industry: Thailand versus Switzerland
56
Dynamic increasing scale effects
Until now: costs depend on current output
Now: costs depend on accumulated output
= Dynamic increasing returns
▪
Costs decrease with cumulative production over time rather than with
current production
= Learning curve
▪
It relates unit cost to cumulative output
▪
It is downward sloping because of the effect of the experience gained though
production on costs
Dynamic scale effects justify protectionism
▪
Temporary (!!) protection of industries enables them to gain experience
(infant industry argument).
▪
Is this a good argument for trade protection?
International trade and economic geography
•
External scale effects explain trade patterns and therefore also the location of industries
= economic geography
•
Trade and location cannot simply be explained by comparative advantages but also by
accident and historical events
▪
Silicon Valley – Hewlett and Packard
▪
LA – movies
57
Chapter 8: Internal scale effects
▪
▪
▪
Introduction
Theory of imperfect competition
Monopolistic competition and trade
Introduction
▪
We focus on internal econonomies of scale that are typical for imperfect competition.
▪
Now large firms have a cost advantage over small firms, rendering the industry not
competitive.
▪
The industry is therefore monopolistic or oligopolistic.
Theory of imperfect competition
•
With imperfect competition, firms are aware that they can influence the price of their
product
▪
They know that they can sell more only by reducing their price.
▪
Each firm considers itself to be a price setter, choosing the price of its product, rather than a
price taker
▪
Some examples of imperfectly competitive market structure are those of monopoly,
oligopoly and monopolistic competition
▪
Oligopoly
▪
What is an oligopolististic market structure?
There are several firms, each of which is large enough to affect prices, but none
with an uncontested monopoly.
▪
Strategic interactions between oligopolists
Each firm decides its own actions, taking into account how its decision might
influence its rival’s actions -> problems of interdependence
▪
Cooperation among oligopolists
Monopolistic competition and trade
•
Monopolististic competition = a special case of oligopoly
o Two key assumptions are made to get around the problem of interdependence:
▪ Each firm is assumed to be able to differentiate its product from its rivals
▪ Each firm is assumed to take the prices charged by its rivals as given (there is
competition but each firm acts as a monopolist)
58
o
•
Are there any monopolistically competitive industries in the real world?
▪ Some industries may be reasonable approximations (e.g., the automobile
industry in Europe)
▪ The main appeal of the monopolistic competition model is not its realism,
but its simplicity and the fact that it can illustrate how all countries can gain
from trade
Market equilibrium:
o
All firms in the industry are symmetric
▪
o
3 steps to determine the average price (P) and the number of firms (n):
▪
▪
▪
•
The demand and cost function is the same for all firms
We derive a relationship between the number of firms and the average cost
of a typical firm.
We derive a relationship between the number of firms and the price each
firm charges.
We derive the equilibrium number of firms and the average price that firms
charge.
(1) The number of firms and average cost
o
The upward sloping CC curve tells us that the more firms are present, the higher the
average cost of each firm will be
(if the number of firms increases, each firm will sell less so firms will not be able to
move down their average cost curve)
•
•
(2) The number of firms and the price
o
The downward-sloping PP curve shows that the more firms are present, the lower
the price of each firm will be
o
(the more firms, the more competition each firm faces)
(3) Equilibrium number of firms and price
59
•
•
The monopolistic competition model can be used to show how trade leads to:
o
A lower average price due to scale economies
o
The availability of a greater variety of goods due to product differentiation
o
Imports and exports within each industry (intra-industry trade)
Graphically: effects of an increase in market size (because of trade):
o
PP-curve does not change
o
CC-curve changes
60
•
•
•
Internal scale effects and comparative advantage combined: what is the trade pattern?
Assumptions:
▪
2 countries: Home (the capital-abundant country) and Foreign.
▪
2 industries: manufactures (the capital-intensive industry) and food.
▪
Neither country is able to produce the full range of manufactured products
by itself due to economies of scale.
Main differences between inter-industry and intra-industry trade:
▪
Inter-industry trade reflects comparative advantage, whereas intra-industry
reflects scale effects.
▪
The pattern of intra-industry trade itself is unpredictable, whereas that of
inter-industry trade is determined by underlying differences between
countries.
▪
The relative importance of intra-industry and inter-industry trade depends
on how similar countries are.
▪
No income effects if intra-industrial trade, as opposed to inter-industry trade
in the HO model
61
•
•
The Significance of Intraindustry Trade
▪
About one-fourth of world trade consists of intra-industry trade.
▪
Intra-industry trade plays a particularly large role in the trade in
manufactured goods among advanced industrial nations, which accounts for
most of world trade.
Why Intraindustry Trade Matters
▪
Intraindustry trade allows countries to benefit from larger markets (extra
benefits of trade apart from the effects of comparative advantage).
▪
Gains from intraindustry trade will be large when economies of scale are
strong and products are highly differentiated (little or no income effects).
Chapter 9: Instruments of trade policy
▪
▪
Instruments of trade policy
Costs and benefits of different instruments
▪ Tariff
▪ Export subsidy
▪ Other instruments
Instruments of trade policy
•
Tariff barriers
o
Tariffs are taxes levied on goods that cross borders:
▪
Specific tariffs
•
▪
Ad valorem tariffs
•
o
Taxes that are levied as a fixed charge for each unit of goods
imported
Taxes that are levied as a fraction of the value of the imported goods
Export subsidies are given by a government to an exporting firm; can also be specific
or ad valorem
62
•
Non-tariff barriers
o Import quotas: limit the quantity of imports
o ‘Voluntary’ Export restraints: limit the quantity of exports
Costs and benefits of different instruments: Tariff
•
Assumptions:
o
Two countries (Home and Foreign)
o
1 good
o
No transportation costs
o
Suppose that in the absence of trade the price of the good at H exceeds the
corresponding price at F
This implies that shippers begin to move the good from F to H such that the price
in F increases and in H decreases
•
To determine the world price (Pw) and the quantity of trade (Qw), two curves are defined:
o
Home import demand curve
▪
o
Shows the maximum quantity of imports the Home country would like to
consume at each price of the imported good.
• That is, the excess of what Home consumers demand over what
Home producers supply: MD = D(P) – S(P)
Foreign export supply curve
▪
Shows the maximum quantity of exports Foreign would like to provide the
rest of the world at each price.
• That is, the excess of what Foreign producers supply over what
foreign consumers demand: XS = S*(P*) – D*(P*)
63
•
Some useful definitions:
o
The terms of trade is the relative price of the exported good expressed in units of
the imported good (PEX/PIM )
o
A small country is a country that cannot affect its terms of trade no matter how
much it trades with the rest of the world
o
The tariff always equals the difference between domestic and foreign prices:
PT - PT* = t
the level of these prices depends on the fact whether the
tariff is small or rather large
64
country installing the
•
We assume the importing country to be a large country and there is a specific tariff of “t”
Euro
The price for importers in a large country becomes:
PT - PT* = t
(where PT* < PW)
•
•
•
•
•
•
In the absence of tariff, the world price of the good (Pw) would be equalized in both
countries.
With the tariff in place, the price of the good rises at Home and falls at Foreign.
o
In Home: producers supply more and consumers demand less due to the higher
price, so that fewer imports are demanded.
o
In Foreign: producers supply less and consumers demand more due to the lower
price, so that fewer exports are supplied.
o
Thus, the total volume traded declines due to the imposition of the tariff.
The increase in the domestic Home price is less than the tariff, because part of the tariff is
reflected in a decline in Foreign’s export price.
A tariff raises the price of a good in the importing country and lowers it in the exporting
country.
As a result of these price changes:
o
Consumers lose in the importing country and gain in the exporting country
o
Producers gain in the importing country and lose in the exporting country
o
Government imposing the tariff gains revenue
To measure and compare these costs and benefits, we need to define consumer and
producer surplus.
65
•
Measuring the Cost and Benefits
o
Is it possible to sum consumer and producer surplus?
▪
o
We can (algebraically) sum consumer and producer surplus because any
change in price affects each individual in two ways:
•
As a consumer
•
As a worker
We assume that at the margin a dollar’s worth of gain or loss to each group is of the
same social worth.
66
•
The net welfare effect of a tariff on national welfare in a large country:
Loss for consumers = - (a + b + c + d)
+ gain for producers = + a
+ gain for government = + c + e
-------------------------------------------------------= - (a + b + c + d) + a + c + e
= - (b + d) + e
Net effect: ambiguous because depends on (b+d) < e or (b+d) > e
•
The areas of the two triangles b and d measure the loss to the nation as a whole (efficiency
loss) and the area of the rectangle e measures an offsetting gain (terms of trade gain).
o The efficiency loss arises because a tariff distorts incentives to consume and
produce.
▪ Producers and consumers act as if imports were more expensive than they
actually are.
▪ Triangle b is the production distortion loss and triangle d is the consumption
distortion loss.
o The terms of trade gain arises because a tariff lowers foreign export prices (PEX/PIM )
o If the terms of trade gain is greater than the efficiency loss, the tariff increases
welfare for the importing country.
•
What if we assume a small country?
o The domestic price increases by less than the tariff because part of the tariff is
‘transferred’ to the foreign country
▪ If the home country is a small country, it cannot ‘transfer’ anything abroad
and the domestic price increase will equal the tariff
The price for importers in a small country is:
PT - PW = t
(where PT* = PW)
67
o
o
Note that a small country can never improve its terms of trade such that the welfare
impact of a tariff for a small country can never be positive
Make the graphical welfare analysis for a small country on your own
Costs and benefits of different instruments: Export subsidy
▪
A payment by the government to a firm or individual that ships a good abroad
▪
▪
▪
The firm exports to the point where the domestic price PS equals the foreign price PS*
plus the export subsidy (PS - PS* = s)
Analysis for a large country
▪
An export subsidy increases the price in the exporting country (from Pw to Ps) and
decreases the price (from Pw to Ps*) in the importing country
▪
Since the price in the importing country decreases from Pw to Ps*, the price increase
in the exporting country is smaller than the subsidy
▪
An export subsidy decreases the terms of trade (PEX /PIM)
▪
An export subsidy always implies larger costs than benefits
Make your own analysis for a small country
68
▪
The net effect of an export subsidy on the national welfare in a large country:
loss for consumers = - (a + b)
+ gain for producers = + a + b + c
+ loss for government = - (b + c + d + e + f + g)
------------------------------------------------------------------------------= - (b + c + d + e + f + g) + c
= - (b + d) – (e + f + g)
What effects does this equation represent?
Costs and benefits of different instruments: Other instruments
(1) Import quota
o An import quota is a direct restriction on the quantity of a good that is imported.
o The restriction is usually enforced by issuing licenses to some group of individuals or
firms.
o An import quota always raises the domestic price of the imported good.
o License holders are able to buy imports and resell them at a higher price in the
domestic market.
o Welfare analysis of import quotas versus of that of tariffs
▪ The difference between a quota and a tariff is that with a quota the
government receives no revenue.
▪ In assessing the costs and benefits of an import quota, it is crucial to
determine who gets the rents.
(2) Voluntary export restraint (VER)
o A voluntary export restraint (VER) is an export quota administered by the exporting
country.
o VERs are imposed at the request of the importer and are agreed to by the exporter
to forestall other trade restrictions.
o Welfare analysis? A VER is exactly like an import quota where the licenses are
assigned to foreign governments and is therefore very costly to the importing
country.
(3) Local Content Requirements
(4) Export credit subsidies
o A form of a subsidized loan to the buyer of exports
o Welfare analysis idem export subsidies
(5) National procurement
(6) Red-tape barriers
69
Chapter 10: Political economy of trade policy
•
•
Why do governments not always base their policy on economists’ cost-benefit calculations?
o Why opt for free trade?
o Why deviate from free trade?
International trade agreements
Why do governments not always base their policy on economists’ cost-benefit
calculations?: Why opt for free trade?
1) Free trade increases efficiency (certainly for a small country)
 Cfr. Chapter 9: analysis of tariff for a small country; free trade avoids efficiency losses
and thus increases welfare
 Note that since tariffs are already very low for most countries, extra free trade will
not increase welfare that much
70
2) Extra benefits of free trade (figures Table 10.1 may be an underestimation):
 Free trade allows countries to exploit scale economies
Cfr. Chapter 8: scale economies lead to lower prices and more varieties for
consumers
 Free trade stimulates learning and innovating
▪
Only the best and most efficient firms can survive
▪
Countries can learn from each other; especially important for developing
countries
3) More trade reduces rent-seeking
 Rent seeking = investing time and money to obtain quota rights (and the profits they
imply)
4)
Political argument for free trade
 Trade policies in practice are dominated by special-interest politics rather than
consideration of national costs and benefits.
Why do governments not always base their policy on economists’ cost-benefit
calculations?: Why deviate from free trade?
1) Infant industry argument (Chapter 8)
2) Terms of trade argument (Chapter 9)
 For a large country (that is, a country that can affect the world price through
trading), a tariff lowers the price of imports and generates a terms of trade benefit.
◼ This benefit must be compared to the costs of the tariff (production and
consumption distortions).
 It is possible that the terms of trade benefits of a tariff outweigh its costs.
◼ Therefore, free trade might not be the best policy for a large country.
71
 Optimal tariff:
◼
Zero for a small country
◼
Always less than the prohibitive tariff
3) Domestic market failure argument
 Producer and consumer surplus do not properly measure social costs and benefits.
◼ Consumer and producer surplus ignore domestic market failures such as:
 Unemployment or underemployment of labor
 Technological spillovers from industries that are new or particularly
innovative
 Environmental externalities
 A tariff may raise welfare if there is a marginal social benefit to production of a good
that is not captured by producer surplus measures.
72
 The domestic market failure argument against free trade is a particular case of the
theory of the second best.
◼ The theory of the second best states that a hands-off policy is desirable in
any one market only if all other markets are working properly.
 If one market fails to work properly, a government intervention may
actually increase welfare.
 How Convincing Is the Market Failure Argument?
◼ There are two basic arguments in defense of free trade in the presence of
domestic distortions:
 Domestic distortions should be corrected with domestic (as opposed
to international trade) policies
 Market failures are hard to diagnose and measure
International trade agreements
◼ Since 1930’s tariffs and nontariff barriers to trade were gradually removed
◼ How was the removal of tariffs politically possible?
 The postwar liberalization of trade was achieved through international negotiation.
 It is easier to lower tariffs as part of a mutual agreement than to do so as a unilateral
policy because:
◼ It helps mobilize exporters to support freer trade.
◼ It can help governments avoid getting caught in destructive trade wars.
 First bilateral negotiations (since 1930’s)
 The multilateral tariff reductions since World War II have taken place under the
General Agreement on Tariffs and Trade (GATT) – now called WTO
 The GATT-WTO system prohibits the imposition of:
◼ Export Subsidies (except for agricultural products)
◼ Import quotas (except when imports threaten “market disruption”)
◼ Tariffs (any new tariff or increase in a tariff must be offset by reductions in
other tariffs to compensate the affected exporting countries)
 WTO engages in Trade rounds where a large group of countries get together to
negotiate a set of tariff reductions and other measures to liberalize trade.
◼ Now also services + TRIPS
◼ Dispute settlement (decisions within 12 months; WTO can allow counter
measures)
73
◼ Doha round: why not a success?
•
Tariffs have already decreased a lot, politically sensitive sectors
remain
•
Estimated profits are small and even negative for some countries
 GATT/WTO assume a non-discriminatory decrease in tariffs
 The GATT-WTO, through the principle of non-discrimination called the “most favored
nation” (MFN) principle, prohibits such agreements.
◼ The formation of preferential trading agreements is allowed if they lead to
free trade between the agreeing countries.
◼ Preferential Trade Agreements (PTA’s) can lead to trade creation (+) and
trade diversion (-)
-> ‘Stumbling block’ or ‘stepping stone’ for free trade?
74
Chapter 12: Controversies in trade policy
▪
▪
Argument for trade protection: market failures
▪ Externalities
▪ Strategic trade policy with imperfect competition
Arguments concerning trade and people
▪ Trade and low wages
▪ Trade and environment
▪ Trade and culture
Argument for trade protection: market failures: Externalities
▪
First argument for trade protection
▪
Firms realize that if they invest in technology, they risk their knowledge to be copied
▪
Investments in technology create positive externalities for other firms
▪
The costs are for one party, the benefits for more parties
▪
The marginal social benefit of the investment cannot be measured by the producer
surplus
➔ Governments should subsidize these high tech firms in order to stimulate
them to innovate
▪
Possible problems of such a subsidy:
▪
Defining the ‘right’ industry
▪
Can be introduced in a simpler way through taxes (e.g. allowing firms to deduct
investments from taxes)
▪
Correct estimation of externalities
▪
Externalities also happen outside country borders
Argument for trade protection: market failures: Strategic trade policy with imperfect
competition
▪
▪
Second argument for trade protection
Because of trade protection, oligopoly profits can be transferred to the own country
o Brander-Spencer analysis:
▪ 2 airplane constructors: Airbus (EU) and Boeing (VS)
▪ Will they each build a new plane? This will depend on the decision of their
competitor (game theory)
▪ Suppose there are large fixed costs such that if they both decide to produce
the average costs remain very high (because of the limited production) such
that both producers suffer a loss
▪ Who will start up production first? The government can influence this game
by giving subsidies
75
▪
Trade policy can attract oligopoly profits to the country (e.g: Airbus realizes large profits
thanks to a relative small subsidy)
▪
Possible problems of such a policy:
o
One often does not have the correct information of all firms (e.g. correct costs and
benefits)
o
If all countries do this, we end up in a very expensive trade war
o
Strategic trade policy can be influenced by strong lobby groups
Arguments concerning trade and people: Trade and low wages
▪
Rich countries often import from poorer countries with lower wages and bad working
conditions
▪
Lower wages:
▪
▪
Ricardo and HO illustrate that without trade wages would be even lower
Bad working conditions
▪
Often working conditions in exporting firms within developing countries are
better than in domestic firms within developing countries
▪
How improve working conditions?
▪
International labour standards but this can be very expensive for
developing countries – hence their resistence
76
Arguments concerning trade and people: Trade and environment
▪
Does trade have a negative impact on the environment?
▪
▪
Depends on the level of development: Kuznets curve
Should international environmental standards be introduced?
▪
Cfr. International labour standards: developing countries are not in favour because of
higher costs
▪
Problem pollution havens
Arguments concerning trade and people: Trade and culture
▪
Does trade destroy culture?
77