International Economics
Exam notes and practice answers
LECTURE 1: INTRODUCTION
2
LECTURE 2: GAINS FROM TRADE
2
LECTURE 3: SPECIFIC FACTORS MODEL AND RYBCYZNSKI’S THEOREM
8
LECTURE 4: TRADE EQUILIBRIUM
13
LECTURE 5: TRADE POLICY
16
LECTURE 6: ENVIRONMENTAL ECONOMICS
20
LECTURE 9: IMMIGRATION
25
LECTURE 11: DEVELOPMENTAL ECONOMICS
27
Lecture 1: Introduction
Introductory lecture not examined
Lecture 2: Gains from trade


This topic will analyze 2 models
o Ricardo’s model (comparative advantage in labor productivity)
o Specific Factors model (comparative advantage based on different
resource endowments)
Definitions:
o Comparative advantage
 Being able to produce a good with the lowest opportunity
cost
o Opportunity cost
 The value of the next-best alternative foregone
o Absolute advantage
 The ability to produce with the least cost – in terms of
resources used
Ricardo’s model – not in exam


Basics of the model/assumptions
o Only two countries
o Only input is labour
o The only difference between the countries is their relative
productivity in producing different goods
This allows for an analysis of comparative advantage, via the opportunity
cost of production for each country.
The PPF and Indifference curves

The ability to produce is described by the Production Possibility Frontier
(the PPF) (see Figure 1 Production Possibility Frontiers, below)
o This shows how much of each product is able to be produced by a
country
o At production point “C”, on the graph, Y1 units of guns and X1 units
of butter are producible
o At production point “A” on the graph, Y2 units of guns and X2 units
of butter are producible.
Figure 1 Production Possibility Frontiers

The preference towards consumption are described by indifference
curves, (see Figure 2 Indifference Curves, below)
o At any point on these curves, the consumers are equally happy
o The further away from the origin the indifference curves, the
happier the consumers.
o At consumption points A, B and C, consumers are equally happy
o However, at curve 3, they are happier than at curve 1, since they
can consume more
Figure 2 Indifference Curves
Cobb-Douglas production function

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The Cobb-Douglas production function, simply, is as follows
output = capital a ·labour (1-a )
o
y = K a L(1-a )
The marginal product of labour (MPL) is the increase in output from a one
unit increase in labour (with capital fixed)
¶y
o MPL =
¶L
 the marginal product of labour is the change in output
divided by the change in labour
The marginal product of capital (MPK) is the increase in output from a
one unit increase in capital
¶y
o MPK =
¶K
 the marginal product of capital is the change in output
divided by the change in capital
Graphing a Cobb-Douglas Production Function against Labour (see Figure
3 Cobb Douglas (y;L), below)
o Production is increasing, but at a decreasing rate
o i.e. there is a decreasing but positive marginal product of labour
Note, a Cobb Douglas function for capital looks identical
Figure 3 Cobb Douglas (y;L)


Constant returns to scale
o If you double inputs, outputs double
o A Cobb Douglas function necessarily has constant returns to scale
Marginal products
¶y a (1-a )
¶y a (1-a )
MPK =
K L
MPL =
K L
¶K
¶L
o MPK = a K (a -1) L(1-a ) MPL = (1- a )L-a K a
1-a
a
æLö
æK ö
MPK = a ç ÷ > 0 MPL = (1- a ) ç ÷ > 0
èK ø
èLø
o Thus, Marginal Product of Capital (MPK) is inversely related to the
Capital Labour Ration (K/L)
o The Marginal Product of Labour (MPL) is directly related to (K/L)
The PPF, Indifference Curves, and Trade
Production Possibility Frontiers – Production Bias
Figure 4 Production Bias


On this PPF, Country A has a production bias towards food, and Country B
has a production bias towards clothing
i.e. Country A has a lower opportunity cost for producing food
Consumption preference
 Just as production may be biased, consumption may be as well
Figure 5 Consumption Bias

In this diagram, Country A has a consumption bias towards Clothing (less
units of clothing would satisfy the same as more units of food
Considering an economy with a Food production bias and a Clothing consumption
bias
Without Trade
 Without trade, production and consumption must occur at the same point
– a “kissing point”
Figure 6 Kissing Point Equilibrium
With Trade
 Trade allows a separation of the PPF and the Indifference Curve: goods
produced can be sold, to purchase the goods to be consumed: a budget
line is created
Figure 7 Trade Equilibrium
This allows greater consumption, with the production at point A, sold, and with
the money, consumption bought at point B
Gains from trade
The distance between the two indifference curves represents the gains from
trade
Summary
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Without trade, there is a lower, “kissing point equilibrium”
Trade allows a different basket of goods to be consumed than produced
o Sell excess food at PfQf and buy clothing at PcQc
o Creates a budget line
Trade, if not required, won’t occur, thus, trade is an unrestricted
optimum, whereas no trade restricts the optimum, necessarily less than
or equal to the unrestricted one.
Lecture 3: Specific Factors Model and Rybcyznski’s Theorem
Creating the PPF via the Specific Factors Model
Figure 8 SFM1 - Labor is interchangeable

Labor is interchangeable between the two industries (Food and
Manufactures) – i.e. one unit of labor leaves manufactures, one unit of
labor enters food production.
Figure 9 SFM2 - Production function for food

Create a production function for food (labor (food); food production) with
diminishing returns to labor (as per a Cobb-Douglas production function)
Figure 10 SFM3 - Production function for manufactures


And the same for manufactures
Allows us to construct a production possibility frontier (A PPF – in Blue)
by creating a 4 segment graph and plotting relevant points)
Manufactures
Labour (Manufactures)
Labour (Food)
Figure 11 SFM4 - The PPF
Food
Two countries with different factor endowments

Taking the example of England (blue) and France (red)
o They have the same labor force
o France has double the land (therefore, a higher returns to land
(land/labor ration))
Figure 12 SFM5 - Trade

That France has more land gives it a PPF in which it has a comparative
advantage over England in the production of food (less manufactures are
wasted in the production of food)
o Thus, it is more efficient, between the two economies if England
solely produces manufactures and France solely produces food
Rybcyznski’s Theorem

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
At constant product prices, when you add to a specific factor, you increase
the production of the good that relies on that factor, and decrease
production of the other good in the SFM
This is because of the good which is more produced (i.e. the good with the
increased factor) will provide more profit per unit of labor (because of an
increased factor-labor ratio), therefore, the wages in that area will
increase (to PfMPLf)
Labor then shifts away from the other factor to the increased factor
Increasing production of the increased factor at the expense of the other
factor
Figure 13 Rybcynzki's Theorem



An increase in food technology increases the MPL of food shifting the
PfMPLf curve upwards.
Wages increase for labor in food production, Labor shifts (diff between
two dotted lines) from Manufactures to Food
Thus, the production of food increases because of increased labor and
capital input, and the production of manufactures decreases because of
equal capital and decreased labor
Proof
Figure 14 Proof of Rybcyznski's theorem
The SFM model shows the proof: for a fixed price level (shown as the diagonal
dashed lines) an increase in food tech (purple arrow) leads to a change in the
PPF’s (it gets pushed out, blue to red), a decrease in manufactures and an
increase in food production.
Lecture 4: Trade Equilibrium
Step 1 Define PPF’s
In this example, a mini US and Australia (same manufacturing output, US has
higher food output)
Figure 15 PPF's
Step 2: Autarky prices
Determine the autarky prices for the smaller economy
Figure 16 Autarky (AUS)
Determine the autarky price for the other economy
Figure 17 Autarky (US)
Step 2: determine trade price [check]
For trade, the prices must be the same (with the same “trade trianges”).
You export what you are relatively better at producing (what is relatively
cheaper in autarky (Stolper Samuelson)
Thus, the price lines must be parallel
Figure 18 Trade
Thus, Australia produces at A and consumes at B
The Uroduces at D and consumes at C
The US sells food to buy manufactures
Australia sells manufactures to buy food
Relationships – The Hecksher Ohlin Theorem
You sell what you can produce relatively cheaply, buying what is relatively more
expensive
The Stolper Samuelson Theorem
An increase in the relative price of a good increases the real return to its specific
factor and reduces the return to the other specific factor via marginal products
and wages, as per Rybcyznski’s
Welfare analysis
Who receives more money and who has to pay more? (Oz rel prices of
manufactures increases, food prices decrease: capitalists get more, poor pay
more)
Lecture 5: Trade Policy

Basic trade policy instruments:
o Tariff
o Subsidy
o Quota
o Voluntary export restraints
Trade
Figure 19 without trade, supply and demand equilibrate domestically
pl
y
Quantity
p
Su
World price
D
Dom estic
Production
em
an
d
Im ports
Price
Figure 20 where the world price is lower than domestic price, goods are imported
p
Su
pl
y
Quantity
World price
Dom estic
Consum ption
Ex ports
D
em
an
d
Price
Figure 21 when the world price is above the domestic equilibrium, excess production is exported
Tariffs
Quantity
Tariffs are a government “fee” on imported items, which serves to raise the
“world price” in the above diagram
Su
l
pp
y
Tariff Price
a
b
c
d
e
World Price
D
em
an
d
Price
Figure 22 A tariff





“a” is the cost of tariff (i.e. the increase in price)
“d” is government revenue (calculated by “cost of the tariff” multiplied by
the amount of goods imported)
“b+c+d+e” is the consumer loss
“c+e” is the deadweight loss
“b” is the producer gain
Quotas
Quotas have the same effect as tariffs, but instead of increasing the price, they
restrict the quantity of imports (“d”). But the government doesn’t make any
money.
Optimal Tariff
 Where a nation is a huge market, a tariff may dent a market so much (by
reducing demand) that the world price decreases
 Terms of Trade are the ratio of export prices to import prices (an
measure of, relatively, how many exports are required to fund imports)
 An increase in the terms of trade is an increase in welfare for the country,
since they are able to purchase more imports for the same amount of
exports
 An optimum tariff works by reducing the world prices enough that the
terms of trade benefit outweighs the deadweight loss of the tariff
 This works by creating a tariff where the world price falls as a result, and
government revenue increases
 This is irrelevant to Australia which does not have the market share to
influence the world markets to such an extent
sExport subsidies
These work to increase the competitiveness of domestic goods, so that they may
be exported.
Supply
Subsidy price
Quantity
a
b
d
c
World price
Dom estic
Consum ption
Ex ports
Price
Figure 23 An export subsidy
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“c+d+e” is the government cost of the subsidy
“b+c+d” is the producer surplus
Consumer loss is “b+c”
“c+e” is deadweight loss
Voluntary export restraint

f
e
like a quota, limits exports
D
em
an
d
Lecture 6: Environmental economics
Concerns of environmentalists


Pollution, environmental degradation, global warming etc. caused by:
o Population growth and industrialization
o Market failure via externalities
There is an argument as to whether pareto (economic) efficiency should
take precedence over sustainability
o Internalizing externalities
Global population

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Increasing wages have increased the opportunity cost of child bearing,
reducing fertility (from 6 children per woman in 1800 to 2.5 in 2000) and
causing a global aging population
This is enforced by a doubling of life expectancy in the past 200 years
In 1950 there was a population explosion, but population growth is said
to decrease by 2050
Population growth is said to plateau
Global warming




0.8 degree temperature rise since the 1800’s
large increase in co2 stock since industrial revolution
Sources of co2 emmissions:
o Land use
o Energy
o Agriculture
o Transport
In 2100, worst projection is 5 degrees higher, best is 1.5 degrees (we are
currently tracking worse than the worst projections
Environmental economics
Figure 24 the difference between MDS and MDF is the externality
Internalizing externalities
Figure 25 A tax increases the cost to the firm so that MDF=MDS at social optimum
Figure 26 A subsidy reduces the MC of Abatement so that the firm outputs at the socially optimum
level
Figure 27 A legal limit illegalizes output where pollution is greater than the legal limit
Policy issues
 Costs
 Difficulty of determining the social optimum
Multiple polluters
The social optimum creates a target, which is the allowable output for the two
firms in this model
Figure 28 with a "0" target, each firm produces nothing
With a current output of 20, and a target of 10 (a halving of pollution)
Figure 29 A legal limit would force each firm to output no more than 5 units
Figure 30 At this tax level, firm 1 outputs 1 unit, firm 2 outputs 4 units: the tax is too high
Figure 31 At this tax level, firm 1 outputs 4, and 2 outputs 6, ideal output with no knowledge of
internal costs
Tradable rights to pollute similarly equilibrate without knowledge of costs of
each firm
Through trade: price equilibrates at unit outputs required, easier than tax
Lecture 9: Immigration
Allocation of revenue to factors of production leaves 0 net income, therefore
wages are equal to the MPL at the point of labour employment multiplied by
W
wages divided by price, or
L
P
Initial allocation of labour
In d (
w/ p )
Oz
/
(w
p)
Em ploym ent (Ind)
Em ploym ent (Oz)
Total Em ploym ent (Oz + Ind)
Figure 32 An initial allocation of labour
Oz
/
(w
p)
In d (
w/ p )
Em ploym ent (Ind)
Em ploym ent (Oz)
Total Em ploym ent (Oz + Ind)
Figure 33 Equilibrium (with immigration)
Oz
/
(w
p)
Aus (Capitalists)
In d (
w/ p )
Aus (Labourers)
Em ploym ent (Ind)
Em ploym ent (Oz)
Total Em ploym ent (Oz + Ind)
Figure 34 Welfare analysis
Deadweight
loss
Initial allocation of labour
In d (
w/ p )
Oz
/
(w
p)
Em ploym ent (Ind)
Em ploym ent (Oz)
Total Em ploym ent (Oz + Ind)
Figure 35 Deadweight loss of no immigration
Lecture 11: developmental economics
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Aid is complex, sometimes political (e.g. eastern Europe and Israel)
Africa is still the hotspot of population on less than 1 dollar a day
As well as under 5 year old mortality rate
HIPC – highly indebted poor countries (centered on Africa)
Three scourges of the developing world
o Currency risk
o Commodity risk
o Debt trap
 Rose in the ‘70’s because of OPEC
Debt relief
o Increases value of debt via increasing chance of payback via
“effort”
o Super-incentives too
Reduce food subsidies
Though this might increase food prices
The Maths
Key
e = Effort, 0 < e < 2
L = "on _ paper"loan _ val
R = repayment _ val
l = cost _ of _ effort
Effort is the chance of repayment, L is the original loan value, R is the “asked for”
loan value
The Creditor’s perspective
 The valuation of a loan in this model takes into account the likeliness of
repayment, in the form of “e”
o Expected _ Payoff = R·e
 Thus, it is in the creditor’s interest to increase “e”
The creditor can only do this by changing “ R ”
 The creditor will end up halving “ R ” to maximize “ Expected _ Payoff ”
The debtor’s perspective
The debtor can only change “ e ”
There is, in this model, an assumption that the debtor nation is only able to
produce, at maximum effort e =1, an output equal to L.
Thus, the most the debtor nation is able to get is (L-R), multiplied by the “effort”,
that is e(L - R) .
Utility to the debtor = E(payoff _ debtor) - l[Cost _ of _ effort]
l e2
Udebtor =
2
E(U D ) = (L - R)e -
le2
2
The debtor seeks to maximize U D
dt(U D 0
Thus
= L - R - le = 0 (to maximize)
de
L-R
 This is called the debtor reaction function
e=


l
If R=L, e=0
L
If R-0, e =
l
Simultaneously equate
L-R
E(Payoff ) = R · e, e =
E(Payoff ) = R ·
d 1
(LR - R 2 )
dR l
max = 0 =
1
l
L-R
l
l
(L - 2R)
L
2
Thus, the optimum “R” in this model is “L/2”
R=