MIE 781 Study Notes (International).docx

7/27/2019 MIE 781 Study Notes (International).docx

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Chapter 2: World Trade An Overview

Who trades with whom?

South Africas main trading partners are:

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

Size matters: the Gravity Model

- Strong empirical relationship b/tw the size of a countrys economy & volume ofimports/exports

o Larger GDP = larger volume of trade-

Gravity model: the value of trade b/tw any two countries is proportional, other things equal,to the productof the two countries GDPs, and diminishes with the distance between the

two countries

o A more general form:

Here we dont specifically assume trade is proportional to GDPs andinversely proportional to distance

The exponents are chosen to fit the actual data as closely as possible- Why does the gravity model work?

o Large economies tend to spend large amounts on imports because they have largeincomes

o They tend to export a lot because they produce a wide range of products- What things arent equal?

o In practice, countries spend a lot of their income at home what limitsinternational trade?

Using the gravity model: looking for anomalies

- Anomalies: the Netherlands, Belgium & Irelando Ireland: cultural affinity: many Americans have Irish ancestors & shared language;

Ireland has many American multinational corporations

o Belgium & the Netherlands: geography & transport costs: both located near mouthof the Rhine NB points of entry

Impediments to trade: distance, barriers & borders

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


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- Gravity model shows a strong negative effect of distance: for a 1% increase in distance decrease of 0.7% - 1% of trade

o Reflects increasing transport costs- Close personal contact increases trade travel of company reps- Trade agreements: NAFTA no tariffs/other barriers to int trade b/tw US, Mexico & Canada

o Effective agreement significantly more trading among partners (theory)o Dont make national borders irrelevant still more intra-country tradeo Intra-Canadian trade decreases steadily with distance, but still greater than trade

with an American state the same distance away

- Existence of separate national currencies a possible impediment to tradeThe changing pattern of world trade

Has the world gotten smaller?

- Modern transportation & communications have abolished distance internet, jet transport- Gravity models still show a strong negative relationship b/tw distance & int trade have

the effects grown weaker over time? YES

- Political forces can outweigh modern advancementso Global economy w/ strong economic linkages is not new 2 waves

Railroads, steamships & telegraphs Internet & jets

o Keynes says that ages of globalisation come to an end WWI, WWII, GreatDepression & widespread protectionism depresses world trade

o Since 1970 world trade as a share of GDP has increased dramatically verticaldisintegration products go through many production stages in many countries

What do we trade?

- Manufactured goods: traded for the most part- Mineral products: increasing volume of trade- Agricultural products: key, but small piece- Services: increasing share

o Incl. Traditional transportation fees, insurance fees & foreign tourists spendingo Overseas telecommunications (still relatively small, but growing) outsourcing

- Mining products: mostly oil & other fuels- For developed countries: manufactured products are now more important that primary

products

- For developing countries: export mostly primary goods & import manufactured and finalgoods rise of export of manufactured goods

Service Offshoring

- Modern technology makes to possible to perform some economic functions at long range leads to dramatic increase in new forms of int trade call centres

- Producers must decide:o Set up foreign subsidiary to provide services (operate as multinational firm)o Outsource to another firm

- May occur w/in the same country long-distance services in the US


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

Do old rules still apply?

- Fundamental principles discovered by economists at the dawn of a global economy stillapply

- World trade is harder to characterise in simple terms in the past it was largely shaped byclimate & natural resources; disputes over trade were easy to explain political battles

over free trade versus protectionism

o Modern: human resources & human-created resources more NBo Trade disagreements involve workers whose skills are made less valuable by imports


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- RD and RDshow that the demand for cheese relative to wine is a decreasing function of theprice of cheese relative to that of wine

- RS shows that the supply of cheese relative to wine is an increasing function of the samerelative price

- RS is a stepo There would be no supply of cheese if the world price dropped below

Because Home will specialise in the production of wine if

Foreign will specialise in the production of wine if We assumed Therefore, at relative prices of cheese below , there would be no

production of cheese at all

o If both cheese and wine will be produced in Home Home isindifferent b/tw producing the two

o If

: Home specialises in cheese

If Foreign continues to specialise in wine When Home specialises in cheese, it produces units When Foreign specialises in wine, it produces units Therefore, for any relative price of cheese b/tw and , the

relative supply of cheese is

o If : Foreign is indifferent b/tw producing cheese and wine, and

will produce both

o If : both Foreign and Home will specialise in cheese and no winewill be produced

Cheese Wine Opportunity cost of


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cheese i.t.o. wine

Home 1hr 2hrs

Foreign 6hrs 3hrs 2

- Lower flat section = - Upper flat section = 2

Downward slope of RD reflects substitution effects as the relative price of cheese rises,

consumers will tend to purchase less cheese and more wine, so the relative demand for cheese fall

Equilibrium price: determined by intersection ofRS & RD:

- Is b/tw pre-trade relative prices of cheese (e.g. 1)- Each country specialises in what they have a comparative advantage in

If the RD intersected RS:

- The world relative price of cheese is , which is the same as the opportunity costcheese in terms of wine in Home

- Home produces both cheese and wine, however the relative supply of cheese is less than itwould be if they specialised in cheese

- Foreign still specialises in the production of wineUnder trade, there is a convergence in world relative prices.

- Each country specialises in the production of that good in which it has a relatively lower unitlabour requirement

- The rise in relative price of cheese in Home will lead Home to specialise in cheese (point Fbelow)

- The fall in the relative price of cheese in Foreign will lead Foreign to specialise in wine (pointF*) below

The gains from trade

Countries with different relative labour productivities specialise in production of different goods and

derive gains from trade

Benefits shown in 2 ways:

- Indirect method of production: produce cheese directly and trade it with Foreign for wine,which they produce indirectly more efficient method of productiono Two alternative ways of using an hour of labour:


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Chapter 4: Specific factors & income distribution

2 reasons that trade has strong effect on dist of income:

- Short-run consequence: resources cannot move immediately or without cost from oneindustry to another

- Long-run consequence: Industries differ in what FOPs they demand shifting what isproduced raises the demand for some FOPs and reduces it for others

The specific factors model is about the short-run consequences of trade on income dist when factors

cannot move without cost b/tw sectors

We assume that sector-switching cost for some factors is high enough that such a switch is

impossible in the short run factors are specific to a particular sector

The specific factors model

The model assumes an economy produces 2 goods and can allocate labour supply b/tw 2 sectors

- Labour is mobile- Specific factors can only be used in certain sectors

Assumptions of the model

- 2 goods produced:o Cloth: labour & capitalo Food: labour & land

- 3 FOPs:o Labour (L): mobileo Capital (K): specifico Land (T): specific

Production functions:

Cloth: Food:

Labour supply:

Production possibilities

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

- - Slope = marginal product of labour


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- Both labour demand curves shift upward by an amount proportional to the increase in prices

(e.g. 10%)

- Wage rate increases by 10%- Allocation of labour b/tw sectors & outputs of food & cloth dont change- No REAL changes occur:

o Realwage rates (ratios of wage rate to prices of goods) dont changeWith the same amount of labour employed in each sector, receiving the same real wage rate, the

real incomes of capital owners and landowners also remain the same. So everyone is in exactly thesame position as before.

- Changes in overall price level have no real effects dont change physical quantities of theeconomy

- Only changes in relative prices affect welfare or allocation of resourcesChange in relative prices (change in price of only 1 good)


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- Production poss are determined by resources & technology- What we choose to produce us determined by the relative price of cloth- How changes in relative price of cloth affect real incomes of diff FOPs- How trade affects both relative P & economys response to those P changes

Who gains & loses from int trade

- Trade shifts relative price of goods that are traded relative P of the good in the newexport sector

- The specific factor in the sector whose relative P increases will gain- Welfare changes for labour are ambiguous

Trade benefits the factor that is specific to the export sector of each country but hurts the factor

specific to the import-competing sectors, with ambiguous effects on mobile factors

Do gains outweigh losses?

- Subjective concept- Ask if those who gain from trade compensate those who lose & still be better off themselves

trade is potentially a source of gain to everyone

If a country doesnt trade, output = consumption

Int trade makes it poss for the mix of cloth & food consumed to differ from the mix produced. The

value of consumption must be equal to the value of production:

()

- : food imports by how much consumption exceeds production-

: cloth exports by how much production exceeds consumption

- Therefore, imports is equal to the relative price of cloth times exportso Shows the amount the economy can afford to import is limited by the amount it

exports budget constraint

- Slope of the budget constraint:


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The PPF is kinked (RED LINE)- Specialise in food (point 1) produce 1000 food

o Spare labour capacity (only 1000 out of 2000 employed)- Specialise in cloth (point 2) produce 1000 cloth

o Spare capital capacity (only 2000 out of 3000 employed)- At point 3: all labour and capital employed 1500 K & 1500 L in cloth; 1500 K & 500 L in

food

Opportunity cost of producing an extra unit of cloth i.t.o. food is not constant

- Produce mostly food (left of point 3) spare labour capacity opportunity cost is 2/3- Produce mostly cloth (right of point 3) spare capital capacity opportunity cost is 2- Opportunity cost of cloth is higher when more units of cloth are being produced

If there is the possibility of substituting capital for labour (and vice versa) in production:

- Substitution removes kink

- Opportunity cost in terms of food of producing one more unit of cloth rises as the economyproduces more cloth and less food

The economy chooses where to produce on the PPF depending on prices specifically at the point

that maximises the value of production


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Effects of biased growth on relative supply

- TT1 TT2: biased growth towards C- TT1 TT3: biased growth towards F

Why biased?

1. Ricardian model:a. Technological progress in 1 sector expands production poss more in the direction of

that sectors output than the other

2. Heckscher-Ohlin model:a. Increase in FOP biased expansion of production poss

Biased growth above is strong

- Economy can produce more of BOTH- At an unchanged relative P of C output of F falls in (a) & output of C falls in (b)

Even mild bias results in more of one output produced relative to the other R shifts right

Panel (c):

- RS1 RS2: growth biased toward C- RS1 RS3: growth biased toward F

World relative supply and the terms of trade

If Home has growth biased toward C (export) panel (a)

- Output of C & output of F- Output of C relative to F rises @ any given P for the world as a whole RSWORLD shifts right

Growth & world relative supply

- RS1 RS2o PC/PF:

o Homes TOTo Foreigns TOT

- Doesnt matter which economy grows, but which sector experiences growth (direction ofbias)

- If Foreign had cloth-biased growth: same effect on TOT


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External economies before trade

Open up for trade:

Trade & prices

- Chinese button industry expands & American one contracts- China has the lower initial average cost- Chinas AC as output - Eventually all button production will be in China- Because Chinas initial AC is forward-falling, increased production as a result of trade leads

to a world price that is lower than the original price lower than in either country before

trade

- No convergence only decrease due to stronger external economiesExternal economies & the pattern of trade

What leads to the initial advantage of a lower cost?

- Comparative advantage (partial explanation)- Historical contingency: something gives initial advantage gets locked in by external

economies even if circumstances that gave initial advantage no longer there New York &

Londono Sheer accident

- Consequence of history: not always located in the right place


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o Gap depends on initial sales Q and slope parameter Bo Higher Q lower MRo Larger Bmore sales fall for any given increase in P closer MR is to P

Average & marginal costs

- Larger output lower AC- Constant MC economies of scale come from fixed production costs difference

becomes smaller and smaller as fixed cost if spread over more output

- Total cost:

- Average cost: (

)

o AC > MC always

Average versus marginal cost

Profit-maximising output of monopolist: MR = MC

- Here P > AC economic profitMonopolistic competition

- Make economic profit attract competitors pure monopoly rare in practice oligopolymore likely

- Oligopolies interdependent: consider consumers & competitors expected responses tochanges in Pmonopolistic competition

- Assumptions in monopolistic competition to get around interdependence:o Differentiated productso Assume firm takes prices charged by rivals as given

- Each firm is a monopolist in the sense that it is the only firm producing its particular good,but the demand for its good depends on the number of other similar products available and

on the prices of other firms products in the industry

Assumptions of the model:

[ ]o

Q: quantity demandedo S: total output of the industryo n: number of firmso b: constant rep responsiveness of firms sales to price


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o P: price charged by THIS firmo : average price charged by competitors

- All charge same P market share = o Charge more = smaller share

- S is unaffected by firms only gain customers at the expense of otherso o

- All firms have the same costs (are symmetric) and have the same demand curve & costfunction

[ ]

Market equilibrium

1. The number of firms and average costAll firms are symmetric all charge same P in equi

Each firms output is a 1/n share of total industry sales S

Average costs depends inversely on firms output AC depends on size of the market &

number of firms:

( )

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

Equilibrium in a monopolistically competitive market

More firms lower output of each firm higher each firms AC

2. The number of firms and the priceP charged by a typical firm also depends on number of firms in the industry more firms =

more intense competition lower PShow each firm faces a straight-line demand curve & use to determine P

Assume firms take each others prices as given taken as given


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Chapter 9: The instruments of trade policy

Basic tariff analysis

Specific tariff: levied as fixed amount per unit imported

Ad valorem tariff: levied as percentage of value per unit

Effect if either: raise the cost of shipping goods to a country

Traditionally NB source of govt income & protect domestic industriesOther: nontariff barriers import quotas & export restraints

Use a partial equilibrium framework to analyse

Supply, demand & trade in a single industry

Home D&S depend on price i.t.o. Home currency & Foreign D&S depend on price i.t.o Foreign

currency assume exchange rate unaffected by trade policy enacted quote both i.t.o Home

currency

Trade arises because of diff P in absence of trade

- No trade: P higher in Home than Foreign allow trade good goes from Foreign to Home price in Foreign increases and in Home decreases eliminate difference

Derive HOME IMPORT DEMAND CURVE & FOREIGN EXPORT SUPPLY CURVE

Deriving Homes import demand curve

- As the price of the good increases, Home consumers demand less, while Home producerssupply more, so that the demand for imports declines

Deriving Foreigns export supply curve

- As the price of the good rises, Foreign producers supply more while Foreign consumersdemand less, so that the supply available for export rises


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o c: consumption distortion loss- e = TOT gain because tariff lowers foreign export P

Small country cannot affect world price lose ewelfare loss

Tariffs distort incentives of producers & consumers induce to act as if imports are more expensive

than they are

- Consumers reduce consumption marginal unit yields welfare = tariff-inclusive domesticprice

- Domestic producers expand production marginal cost = tariff-inclusive price couldhave bought more cheaply abroad

Other instruments of trade policy

Export subsidies: theory

Definition: payment to firm that ships a good abroad

- Specific/ad valorem- When govt offers subsidy shippers export up to the point at which domestic P > foreign P

by the amount of the subsidy

Effects of an export subsidy

- PW PS: exporting country- PW PS*: importing country- P less than subsidy - Exporting country:

o Consumer loss: a + bo Producer gain: a + b + co Govt subsidy: b + c + d + e + f + go Deadweight loss: b + d + e + f + g

b, d: consumption & production distortion losses- Subsidy worsens TOTexporting P

o Leads to additional TOT loss: e + f + g = Import quotas: theory

Definition: direct restriction on the quantity of some good that may be imported

Always raises the domestic P of the imported good

- Limit imports immediate result: D > (S + Z) Pmarket clears


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Chapter 10: The political economy of trade policy

The case for free trade

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

Free trade & efficiency

The efficiency case for free trade

- Tariff causes welfare loss by distorting choices of consumers & producers leads to DWL- Free trade eliminates the distortions- Tariffs generally low & quotas rare total distortions generally small

Additional gains from trade

- Cost-benefit analyses dont tell full story- Small & developing countries gain have substantial gains from trade

o Economies of scale protected markets limit gains & internal economies fragmentproduction, reduce competition & raise profits, also lead too many firms to enter

industry inefficiency

o Offers more opportunities for learning & innovation for entrepreneurso Makes whole economy more efficientmore firms with higher productivity

- Hard to quantifyRent-seeking

- When firms incur large costs to get import licences earn economic rents as holders- Waste some of economys productive resources

Political argument for free trade

- Reflects the fact that a political commitment to free trade may be a good idea in practice,even though there may be better in principle

- Trade policies are dominated by special-interest politics rather than considering nationalwelfare some tariffs/subsidies may increase welfare

o If govt agencies tried to pursue this captured by interest groups redistributeincome politically influential sectors

National welfare arguments against free trade

- Barriers used to protect some interest groups sometimes for overall welfareThe terms of trade argument for a tariff

- Large country: able to affect prices of foreign exporters tariff lowers import P TOTbenefit

o Offset benefit against costs of tariff (distortions)


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- Have excess returns economic profits profits above what equally risky investmentelsewhere in the economy can international comp over who gets

- Govt can alter rules of the game shift excess returns from foreign to domestic firms subsidise domestic firms by deterring investment & production by foreign competitors

raise domestic profit by more than the subsidy subsidy raises national income at the

expense of other countries

- Brander-Spencer analysis: exampleo 2 firms compete from diff countrieso New product both capable of making

- Either firm alone could earn profits making the good, but if both firms try to produce, bothincur losses

- Which actually gets profits? Depends on who gets there first- Boeing gets a head start Airbus finds no incentive to enter market- Situation can be reversed country commits itself to pay firm subsidy of 25 if it enters

changes payoffs profitable for Airbus to produce regardless of what Boeing does

- Implication:o Boeing is now deterred from entering at all they will lose regardless of what they

choose to do

o Govt subsidy removes advantage of head start from Boeing and conferred it onAirbus

o Subsidy raises profits by more than the amount of the subsidy itself deterrenteffect on foreign competition creates advantage for Airbus comparable w/

strategic advantage Airbus would have had if it was first

- Problems:o Req more info than is actually available

Cant fill in entries in table w/ any confidence Get it wrong subsidy could be costly misjudgement

Cant view industry in isolation

give strategic advantage in one industrymay cause strategic disadvantage in others


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o Risk foreign retaliation beggar-thy-neighbour policies increase our welfare atothers expense

Risk trade war that leaves everyone worse offGlobalisation & low-wage labour

Shift in manufactured exports from richer poorer countries depend e=heavily on these exports

-Lower GDP/capita & low wages

- Bad working conditionsSubject of activism anti-globalisation movement

Anti-globalisation movement

- Harm trade was doing to workers in developing countries- WTO riding roughshod over national independence & imposing free trade ideas that hurt

workers

- Failure of WTO meeting in Seattle 1999 nations failed to agree to agenda in advance &couldnt agree on direction of new trade round to get started

Trade & wages revisited

- Very low wages in developing countries not helping workers- Labour agreements hurt both poor & rich countries labour misconceptions about

comparative advantage

- Trade actually benefits both sets of workers- Standard economic analysis says that while workers in a capital-abundant nation like the US

might be hurt by trade with a labour-abundant country like Mexico, the workers in the

labour-abundant country should benefit from a shift in the distribution of income in their

favour

- Actually increases labour employment in the poorer country & working conditions are betterthan they would be otherwise

- Mobility of capital and immobility of labour argument against increased welfare in poorercountry

Labour standards & trade negotiations

- Whether & to what extent int trade agreements should also contain provisions aimed atimproving wages & working conditions in poor countries

o Monitor & make results of monitoring available to consumers version of marketfailure analysis consumers can choose to buy certified goods feel better about

purchases

o Wouldnt have a large impact only impact in export factories- Formal labour standards


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o Strongly opposed by developing countries protectionist tool used as basis forprivate lawsuits against foreign companies sim to antidumping legislation used by

pvt companies to harass foreign competitors

Environmental & cultural issues

- Globalisation is bad for the environmento Damage done in developing countries in order to produce goods for developed

markets

- Cases of environmental damage occurred in the name of inward -looking policies ofcountries reluctant to integrate w/ global economy

- Should trade agreements incl environmental standards?o Modest improvements benefit allo Shut down potential export industries in poor countries cannot afford to maintain

things by Western standards

- Effect of globalisation on local & national cultureso Growing integration of markets homogenisation of cultures around the world

also Americanisation something is lost due to thiso Market failure argument on behalf of policies that attempt to preserve national

cultural diff infringes upon rights

Globalisation & the environment

- Growing concern worldwide & has impacted domestic politics role in disputes over inttrade

o Growing int trade automatically harms the environmento WTO agreements act to block environmental action

Globalisation, growth & pollution

- Production & consumption by-product environmental damageo Pollution from factorieso Farmers fertilisers & pesticideso Consumers carso Economic growth environmental damage

- Not necessarily true: as a country becomes richer, they change production/consumptionmixes reduce environmental impact

- Growing wealth growing political demands for environmental quality stricterregulations

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


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- Trade promotes economic growth increases per capita income can better/worsenenvironment depending on where a country is on the curve

- Not necessarily an argument FOR globalisation can show the opposite FOR NOW Chinao Not a problem of globalisation a problem for China as a result of globalisation

The problem of pollution havens

- Pollution haven: because of int trade, an economic activity that is subject to strongenvironmental controls in some countries can take place in other countries with less strict

regulation

- Are they important?o Relatively small impact on int trade not much evidence that dirty industries move

to countries with lax environmental regulation lower wages are more of a lure

than environmental regulation

- Do they deserve to be the subject of int negotiation?o Do nations have a legit interest in others environmental policies?o Pollution = negative externality valid reason for govt interventiono Diff forms have diff geographical reach only if they cross borders is there

justification for int concern

o Things like carbon emissions are an int concern cause global problems in thefuture

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