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MIE 781 Study Notes (International)
MIE 781 Study Notes (International)
MIE 781 Study Notes (International)
Here we dont specifically assume trade is proportional to GDPs and inversely 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 large incomes 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 limits international trade?
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 trade o 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 trade
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 spending o 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 final goods 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
o o o
Nontradable jobs: must occur close to customers Tradable jobs occur more in service-related sectors than manufacturing ones Thus, the dominance of manufacturing may only be temporary
The same amount of roses are produced, but more computers are produced in the world the world as a whole is producing more possible to raise everyones welfare (theory) Why the increase? Each country specialises in producing the good in which it has a comparative advantage 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
Trade b/tw 1 countries can benefit both countries if each country exports the goods in which it has a comparative advantage About possibilities not actualities Int production & trade are determined in the marketplace (demand/supply interaction) The Ricardian Model Labour is the only factor of production and is perfectly mobile no possibility of individuals being hurt by trade trade does not affect the distribution of income (not in reality)
A one-factor economy
One economy: HOME Two goods produced: cheese & wine
Home economys technology: labour productivity in each industry express i.t.o unit labour requirement number of hrs needed of labour required to produce one unit of cheese or wine o Cheese: 1hr o Wine: 2hrs Unit labour requirements are defined as the inverse of productivity the more units that can be produced in an hour, the lower the unit labour requirement o : unit labour req for wine o : unit labour req for cheese o : total labour supply
Production possibilities
Economies have limited resources, therefore there are trade-offs as to what they can produce; to produce more of one good, they must sacrifice the production of another.
The PPF shows the maximum amount of wine that can be produced once the decision has been made to produce any given amount of cheese, and vice versa The PPF is straight if there is only one factor of production (labour) : production of wine : labour used in producing wine : production of cheese : labour used in producing cheese PPF is determined by the limited resources:
Any mix of wine and cheese that lies on the straight line can be produced
Because the PPF is a straight line, the opportunity cost of a unit of cheese in terms of wine is constant.
Opportunity cost is defined as the number of units of wine the economy would have to give up in order to produce an extra unit of cheese To produce another unit of cheese would require person-hours Each of these person-hours could in turn have been used to produce Therefore, the opportunity cost of cheese in terms of wine is The opportunity cost is equal to the absolute value of the slope of the PPF
Cheese Wine
Therefore, the economy will specialise in cheese and produce only cheese, as it has the higher relative price : Price of cheese : Price of wine Hourly wage in the cheese sector: Hourly wage in the wine sector: Wages in the cheese sector will be higher if: Wages in the wine sector will be higher if:
Labour will want to work in the sector that offers the higher wage, thus the economy will specialise in the production of cheese if: If both goods will be produced ?
The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost in terms of wine; it will specialise in the production of wine if the relative price of cheese is less than its opportunity cost in terms of wine. If there is no int trade, Home has to produce both goods, but it will produce both only if the relative price of cheese is just equal to its opportunity cost. Because the opportunity cost equals the ratio of unit labour requirements in cheese and wine, we summarise: In the absence of international trade, the relative prices of goods are equal to their relative unit labour requirements.
We assume: Or
We assume the ratio of labour required to produce a unit of cheese to that required to produce a unit of wine is lower in Home than in Foreign Homes relative productivity is higher than it is in wine
The ratio of unit labour requirements is equal to the opportunity cost of cheese in terms of wine, and we defined a comparative advantage i.t.o. of opportunity cost Thus, the above equations say that Home has a comparative advantage in cheese The condition under which Home has a comparative advantage involves all four labour requirements. If we only compare the 2 countries unit labour requirements in cheese production, we determine absolute advantage:
The slope of the PPF equals the opportunity cost of cheese i.t.o. wine Foreigns PPF is steeper than Homes
In the absence of trade, the relative prices of cheese and wine in each country would be determined by the relative labour requirements In Home the relative price of cheese would be and in Foreign
Once there is international trade, prices will no longer be determined purely by domestic considerations. If the relative price of cheese is higher in Foreign that in Home, it will be profitable to ship cheese from Home to Foreign and to ship wine from Foreign to Home. This doesnt go on indefinitely. Eventually Home will export enough cheese to Foreign and Foreign enough wine to equalise the relative price.
RD and RD show that the demand for cheese relative to wine is a decreasing function of the price of cheese relative to that of wine RS shows that the supply of cheese relative to wine is an increasing function of the same relative price RS is a step o There would be no supply of cheese if the world price dropped below o If If 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 production of cheese at all
, there would be no
indifferent b/tw producing the two o If : Home specialises in cheese Foreign continues to specialise in wine
o o
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 ( )( ) If : Foreign is indifferent b/tw producing cheese and wine, and will produce both If : both Foreign and Home will specialise in cheese and no wine will be produced Cheese Wine Opportunity cost of
Home 1hr 2hrs Foreign 6hrs 3hrs - 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 of RS & 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 cost cheese in terms of wine in Home - Home produces both cheese and wine, however the relative supply of cheese is less than it would be if they specialised in cheese - Foreign still specialises in the production of wine Under 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 unit labour requirement - The rise in relative price of cheese in Home will lead Home to specialise in cheese (point F below) - The fall in the relative price of cheese in Foreign will lead Foreign to specialise in wine (point F*) below
Home could produce units of wine or units of cheese Home could trade cheese for wine, with each unit trading for units of wine Therefore, the original hour of labour yields ( )( ) units of wine This is more wine that an hour could have produced directly as long as ( )( ) or In international equilibrium, if neither country produces both goods, we must have Home can produce wine more efficiently
by making some cheese and trading it Examine how trade affects each countrys possibilities for consumption o Absence of trade: consume along PF or P*F* o Presence of trade: consume along TF or T*F* o Enlarged range of choice residents better off Once countries have specialised, Home workers earn the equivalent of one unit of cheese and Foreign workers earn the equivalent of 1/3 units of wine per hour If both sell for $12, Home workers earn $12 and Foreign workers $4 The relative wage of a countrys workers is the amount they are paid per hour, compared with the amount workers in another country are paid The relative wage of Home workers is it doesnt matter what price of a unit of cheese is, as long as a unit of wine sells for the same price As long as the relative price of cheese is 1, the wage of Home workers is 3 times that of Foreign workers The wage rate lies b/tw ratios of the 2 countries productivities in the 2 industries o Home is 6X as productive as Foreign in cheese, but only 3/2 times as productive in wine o Homes wage rate is 3 times that of Foreigns o Because the relative wage is b/tw the ratio of the productivities, each country ends up with a cost advantage in 1 good o Because Foreign has a lower wage rate, it has a cost advantage in wine, even though it has a lower productivity o Home has a cost advantage in cheese, despite its higher wage rate, because the higher wage rate is more than offset by its higher productivity
Foreign competition in unfair and hurts other countries when it is based on low wages Labour unions use to seek protection for industries Home is more productive in both and Foreigns lower wage rate is entirely due to lower wage rate Foreigns lower wage rate is irrelevant to whether Home gains from trade In Home, it is cheaper in terms of its own labour to produce cheese and trade it for wine than to produce it itself
3. Exploitation
Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations What is the alternative? Workers in poorer countries would be worse off if they didnt specialise and export something than if they did so based on lower wages Real wages would be even lower: the purchasing power of a workers hourly wage would fall from 1/3 to 1/6 unit of cheese
Production possibilities
How does the economys mix of output change as labour is shifted from one sector to the other?
Diminishing returns:
w/out
Lower right quadrant: production function for cloth o Movement downward along vertical axis increase labour input in cloth sector o Movement right along horizontal axis increase cloth output Upper left quadrant: production function for food o Movement left along horizontal axis increase labour input in food sector o Movement upward along vertical axis increase in food output
Lower left quadrant: economys allocation of labour o Downward movement along vertical axis increase labour employed in cloth o Leftward movement along horizontal axis increase labour employed in food o Downward-sloping 45 degree line with a slope of -1 - Upper right quadrant: economys PPF o Changing the labour allocation b/tw food & cloth sectors results in different mixes of goods being produced by joining the points in this quadrant, we get the PPF Adding more FOPs to the economy changes the shape of the PPF - Curvature reflects diminishing returns to labour in each sector When tracing the PPF, we shift from food to cloth production - Shift one person-hour of labour from food to cloth extra input will increase output in that sector by the marginal product of labour in cloth To increase cloth output by one unit increase labour input by hours By shifting each unit of labour from food to cloth food output by To increase production of cloth by one unit, food production must be decreased by
As we produce more cloth than food, & o As (and vice versa) This is the opportunity cost
Thus
- Left-hand side: slope of PPF - Right-hand side: negative relative price of cloth Therefore. At the production point, the PPF must be tangent to a line whose slope is minus the price of cloth divided by that of food
What happens to the allocation of labour and the dist of income when prices of food & cloth change. Equal proportional change in prices (change in overall price level):
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 Real wage rates (ratios of wage rate to prices of goods) dont change With 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 the same position as before. - Changes in overall price level have no real effects dont change physical quantities of the economy - Only changes in relative prices affect welfare or allocation of resources Change in relative prices (change in price of only 1 good)
The increase in shifts demand up by same proportion (7%) w rises, but by less than 7% L shifts from food to cloth output of cloth rises and output of food falls o The rise in the price of cloth is shown in the PPF:
- Food output falls & cloth output increases Since higher relative prices of cloth lead to a higher output of cloth relative to that of food, we can draw a relative supply curve showing as a function of
The final result is ambiguous depends on relative importance of cloth & food in workers consumption (determined by preferences)
Owners of capital: - Better off therefore profits i.t.o. of what they produce income of capital owners more than proportionately with income rises i.t.o. both goods Landowners: - Worse off - Real wage i.t.o. food income - purchasing power of any given income Summary: - Factor specific to sector whose relative price increases is definitely better off - Factor specific to sector whose relative price decreases is definitely worse off - Change in welfare for mobile factor is ambiguous
Why is different from ? - Different technologies or resources Relative price when open to trade: ( ) If no trade: lower relative price - ( )
Increase in relative price induces economy to produce relatively more cloth (shown in movement along PPF) - Consumers respond to higher relative price of cloth by demanding relatively more food export cloth & import food If opening trade had been associated w/ a decrease in the relative price of cloth changes in relative supply & demand would be reversed export cloth & import food Therefore, an economy exports the good whose relative price has increased and imports the good whose relative price has decreased
- 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 new export 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 exports o Shows the amount the economy can afford to import is limited by the amount it exports budget constraint
o o
Consuming one less unit of cloth saves the economy extra units of food One unit of cloth can be exchanged on world markets for
- Budget constraint is tangent to PPF at chosen production point - The economy can always afford to consume what it produces Potential gains from trade: 1. Absence of trade: economy consumes what it produces a. Consumption is a point on the PPF (point 2) 2. It is possible for a trading economy to consume more of both goods than it would in the absence of trade a. BC represents all poss combos that a country could consume given the world relative price of cloth b. Part of the BC (coloured region) situations in which the economy consumes more of both than in the absence of trade c. Only if pre-trade production point is at point 1 (trade has no impact) there is always a part of the BC that allows the consumption of more of both goods 3. The economy as a whole consumes more of both goods it is possible in principle to give each individual more of both goods everyone is better off as a result of trade Trade potentially benefits a country because it expands the economys choices it is always poss to redistribute income in such a way that everyone gains from trade everyone could gain, but doesnt mean they actually do
These are the quantities of capital or labour used to produce a given amount of cloth or food, rather than the quantity required to produce that amount - Some room for choice in the use of inputs Choices depend on factor prices for L & K If there is no possibility of substituting labour for capital:
Producing 1 unit of cloth: 2L & 2K Producing 1 unit of food: 1L & 3K Economy must produce s.t. both constraints
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 economy produces 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
The value of the economys production is: Isovalue line: value of output is constant along this line slope = Economy produces at point Q: point on PPF that touches highest poss isovalue line at this point the slope of the PPF is Opportunity cost i.t.o. food of producing another unit of cloth is equal to the relative price of cloth
- Shows alternative input combos that can be used to produce one more unit of food What will actually be produced depends on the relative costs of capital and labour - If capital rental rates are high and wages low, producers will choose to produce using relatively little capital and more labour - Input choice will depend on the ratio of the factor prices
The relationship b/tw factor prices and the ratio of labour to capital used in production of food is curve FF:
curve CC - CC is shifted out relative to FF: at any given factor prices, production of cloth will always use more labour relative to capital than will production of food - Production of cloth is labour-intensive - Production of food is capital-intensive Definition of intensity depends on the ratio of labour to capital used in production, not the ratio of labour or capital to output goods cannot be both labour- and capital-intensive CC and FF are relative factor demand curves - Downward slope characterises substitution effects in producers factor demand - As w relative to r producers substitute capital for labour in their production decisions
Cloth production is labour-intensive and food production is capital-intensive one-to-one relationship - The higher the relative cost of labour, the higher must be the relative price of the labourintensive good Combining the 2 graphs:
and
At ( ) : produce both goods ( ) ( ) &( ) If the relative price of cloth rises to ( ) : ( ) ( ) ( ) &( ) ( ) &( )
Increase of price of cloth relative to that of food will raise the income of workers relative to that of capital owners Such a change in relative prices will unambiguously raise the purchasing power of workers and lower the purchasing power of capital owners by raising real wages and lowering real rents i.t.o. both goods When the ratio of labour to capital falls in producing either good, the marginal product of labour i.t.o. that good increases workers find their real wage higher i.t.o. both goods Marginal product of capital falls in both industries capital owners real incomes lower i.t.o. both goods Changes in relative prices have strong effects on income distribution always changes it so much that owners of one factor of production gain while owners of the other are worse off
How does the economy accommodate the increase in aggregate relative supply of labour if relative labour demanded remains constant? How does the economy employ the additional labour hours? - The labour-capital ratio in cloth sector is higher than in the food sector the economy can increase the employment of labour to capital to production of cloth (holding the labourcapital ratio fixed in each sector) by allocating more labour and capital to the production of cloth (labour-intensive) - As labour & capital move from food to cloth economy produces more cloth and less food
: PPF before labour supply increase : PPF after increase in labour supply - PPF shifts out - More of both can be produced - Shifts out more relative to cloth biased expansion of production possibilities Expansion is strongly biased towards cloth production that at unchanged relative prices, production moves from 1 2 - Actual fall in food production & increase in cloth production Biased effect of increases is important to understanding how differences in resources give rise to international trade - labour supply expands production possibilities disproportionately in direction of cloth - An economy with a high relative supply of labour to capital will be relatively better at producing cloth than an economy with a low relative supply of labour to capital Generally, 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
: Home relative supply o Absence of trade: equilibrium @ point 1 Relative price of cloth lower in Home : Foreign relative supply o Absence of trade: equilibrium @ point 3 - Trade: relative prices converge o Home: o Foreign: o New equilibrium @ point 2 b/tw pre-trade relative prices o Economy exports the good whose relative price increases Home exports cloth and Foreign food Home becomes an exporter of cloth because it is labour-abundant (relative to Foreign) & production of cloth is labour-intensive (relative to food production) Heckscher-Ohlin Theorem: The country that is abundant in a factor exports the good whose production is intensive in that factor Correlation b/tw abundance in a factor and its exports of goods that use the factor intensively: Countries tend to export goods whose production is intensive in factors with which the countries are abundantly endowed
Rise in cloth price raises purchasing power of labour i.t.o. both goods & lowers purchasing power of capital i.t.o. both goods - Rise in price of food has reverse effect International trade can have a powerful effect on income dist - Home: relative price of cloth rises o Labour workers/owners gain from trade o Capital workers/owners worse off - Foreign: relative price of cloth falls o Labour workers/owners lose from trade o Capital workers/owners gain The resource of which a country has a relatively large supply is the abundant factor in that country, and the resource of which it has a relatively small supply is the scarce factor Owners of a countrys abundant factors gain from trade, but owners of a countrys scarce factors lose FOPs used intensively by the import-competing industry are hurt by the opening of trade Opening trade expands an economys consumption possibilities can make everyone better off The specificity of factors to particular industries is often a temporary problem - Cannot migrate overnight shift over time to different sectors - Income distribution effects arise because labour & other factors of production are immobile represent a temporary, transitional problem - Effects of trade on income dist among land, labour & capital are more or less permanent
Factor-price equalisation
No trade: labour earns less in Home than in Foreign (capital, more) o Labour-abundant Home: lower relative price of cloth than capital-abundant Foreign o Difference in relative prices of goods implies an even larger diff in relative prices of factors - With trade: relative prices of goods converge causes convergence of relative price of factors In the model, there is complete equalisation of factor prices During trade, countries are indirectly trading FOPs: - Home lets Foreign have some abundant labour by trading goods w/ high ratio of labour to capital more labour is embodied in Homes exports than imports In reality, factor prices are not equalised may reflect differences in quality of labour (partially) - Assumptions: o Both countries produce both goods Factor-price equalisation occurs only if the countries involved are sufficiently similar in their relative factor endowments Might not equalise if countries have radically diff ratios of K to L or of skilled to unskilled labour o Technologies are the same If a country has a superior technology, it might have higher w & r o Trade actually equalises the prices of goods in 2 countries Prices of goods are not fully equalised by international trade in reality Lack of convergence is due to both natural barriers & barriers to trade -
Point where production actually takes place depends on price of cloth relative to food At given market prices, a market economy chooses production levels that maximise value of outpu t Isovalue lines: ( o o )
If
: Graph (a): isolines become steeper Produce more cloth and less food Relative supply of cloth rises when the relative price of cloth rises shown in relative supply curve in graph (b)
Value of consumption = value of production: - Production & consumption lie on the same isovalue line Choice of a point on the isovalue line depends on tastes of consumers represented by an indifference curve 3 properties of the IC: 1. Downward-sloping 2. Further to the upper right corner higher levels of welfare 3. Gets flatter as we move to the right diminishing marginal utility Choose to consume @ point in isovalue line where there is the highest poss welfare where isovalue line is tangent to the highest reachable IC (point D) - Point D: economy exports cloth & imports food What if ?
: advantage
C now relatively more expensive welfare: income effect Tends to increase consumption of both goods Shift in consumption at any given level of welfare: subs effect Tends to make economy consume less C and more F
Panel (b): relative production of cloth (1 2) & relative consumption of cloth (1 2) Change in relative consumption captures subs effect of P change If income effect was large enough consumption levels of both goods could rise (DC & DF ), but subs effect of demand dictates that the relative consumption of cloth If the economy cannot trade: equi @ point 3 worse off D2 D1)
Changing TOT can never decrease welfare to below the level of welfare in the absence of trade (D3) RS RS*
Assume trade patterns induced by diff in Home & Foreigns production capabilities diff RS
Equilibrium relative price with trade & associated trade flows Home produces and Foreign produces
World relative supply obtained by summing production levels for C & F and taking ratios: ( ) ( ) - Lies b/tw Home & Foreigns RS World relative demand: ( ) ( )
Same preferences same relative demand curves world relative demand curve is the same Equi relative P: point 1 - Determines how many units of Homes cloth are traded for how many units of Foreigns food - Homes exports = Foreigns imports: Homes imports = Foreigns exports:
Effects of biased growth on relative supply - TT TT : 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
1 2
PC/PF: ( ) ( )
o Homes TOT o Foreigns TOT Doesnt matter which economy grows, but which sector experiences growth (direction of bias) If Foreign had cloth-biased growth: same effect on TOT
o Homes TOT o Foreigns TOT Export-biased growth: growth that disproportionately expands a countrys production poss in direction of export Import-biased growth: growth that disproportionately expands a countrys production poss in direction of import Export-biased growth tends to worsen a growing countrys TOT, to the benefit of the RO W; import-biased growth tends to improve a growing countrys TOT, at ROWs expense
Widgets produced using only labour amount of labour req depends on number of widgets produced - Double labour input more than double output - Average labour input decreases the more is produced - Incentive for trade: by concentrating production in one country world economy uses same amount of hrs to produce more output - Transfer labour from some sectors to others in order to increase/decrease production - To gain economies of scale: focus on producing a few things on a larger scale world economy can produce more of each good Role in trade: makes it poss for each country to produce a restricted range of goods and to take advantage of economies of scale w/out sacrificing variety in consumption typically leads to increased variety
Bringing together many firms to collectively provide a large enough market to support a wide range of specialised suppliers Increased tendency towards industrial localisation Advantages: key inputs cheaper & more easily available (& better quality) 2. Labour market pooling Cluster of firms creates pooled market for specialised labour Fewer labour shortages & lower unemployment Labour can move easily b/tw firms depending on demand for their skills results in lower unemployment in one area than over two distant areas 3. Knowledge spillovers Companies learn from competitors nearby study & reverse-engineer products Informal exchange of info/ideas social gatherings bars
External economies & market equilibrium If there are external economies AC is downward sloping (not upward-sloping) o Forward-falling supply curve: larger output = lower price, because of AC o AC as Q External economies drive a lot of trade w/in & b/tw countries
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 economies
Once est. advantage, may retain advantage even if another country could do it more cheaply
The importance of established advantage Due to external economies of scale many small firms competition drives AC down ACVIETNAM is below ACCHINA could manufacture buttons more cheaply (at point 2) China est. industry first historical advantage Vietnams initial AC is still higher than Chinas equi AC o If there is no initial production Q0 C0 > P1
External economies and losses from trade Thailand could produce more cheaply, but Switzerland started producing watches first equi @ point 1 If there was no trade in watches & Thailand was forced to be self-sufficient equi @ point 2 o P2 < P1
Situation in which the price of a good that Thailand imports would actually be lower if there was no trade & the country forced to produce the good themselves trade leaves the country worse off than w/ no trade Incentive for Thailand to protect potential watch industry from foreign comp External economies of scale may disadvantage indiv countries, but world as a whole still benefits External economies arise from accumulation of knowledge Firm improves product through experience likely to be imitated & others benefit from knowledge spillover Spillover gives rise to situations in which production costs of indiv firms fall as industry as a whole accumulates experience Now industry costs depend on experience measured by cumulative output of industry to date
The learning curve - Relates unit cost to cumulative output - Downward-sloping: effect on costs of experience gained through production Dynamic increasing returns: when costs fall with cumulative production over time rather than with current rate of production - Can lock in advantage: L has advantage - L* has lower input costs & less production experience - If L has a sufficiently large head start potentially lower costs of 2nd industry may not allow 2nd country to enter market - May justify protectionism o Country has low costs but no experience, therefore cannot export competitively can increase long-term welfare by subsidising production or protecting from foreign competition until industry is more mature infant industry argument
Chapter 8: Firms in the global economy export decisions, outsourcing & multinational enterprises
The theory of imperfect competition
Perfectly competitive market: - Many buyers & sellers - All a small part of the market - Price takers Imperfect competition: - Few firms produce a good - Can influence prices - Highly differentiated products - Price-setters - Pure monopoly - Oligopolies
Monopolistic pricing & production decisions Downward-sloping demand curve Corresponding marginal revenue curve (always below demand) o Always less than price to sell additional must lower P of all Marginal revenue & price - How much less is marginal revenue than P? Depends on: o How much output firm is already selling o Slope of demand curve How much monopolist must cut P to sell one more unit Very flat: small price cut Very steep: large price cut - Assume D is a straight line dependence of monopolists total sales on P charged: Marginal revenue:
o Gap depends on initial sales Q and slope parameter B o Higher Q lower MR o Larger B more 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 profit
Monopolistic competition
Make economic profit attract competitors pure monopoly rare in practice oligopoly more likely - Oligopolies interdependent: consider consumers & competitors expected responses to changes in P monopolistic competition - Assumptions in monopolistic competition to get around interdependence: o Differentiated products o 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 o o o ( )] -
Q: quantity demanded S: total output of the industry n: number of firms b: constant rep responsiveness of firms sales to price
o o -
All charge same P market share = o Charge more = smaller share S is unaffected by firms only gain customers at the expense of others o o All firms have the same costs (are symmetric) and have the same demand curve & cost function [ ( )]
Market equilibrium 1. The number of firms and average cost All 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 price P charged by a typical firm also depends on number of firms in the industry more firms = more intense competition lower P Show each firm faces a straight-line demand curve & use to determine P Assume firms take each others prices as given taken as given
If all charge same P each sell Therefore, the relationship b/tw number of firms and P each charges:
More firms in market lower P charged Each firms mark-up over MC competing firms decreases w/ number of
Equilibrium in a monopolistically competitive market 3. Equilibrium number of firms Intersection of PP and CC PP: more firms = lower P face more comp CC: more firms = higher each AC each sells less Equi @ n2: zero-profit number of firms in the industry Long-run: n tends towards n2 E is the long-run equi Short-run: o At n1: firms making monopoly profits more firms enter profitable industry & drive profit down
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Deriving Homes import demand curve As the price of the good increases, Home consumers demand less, while Home producers supply 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 consumers demand less, so that the supply available for export rises
World equilibrium The equilibrium world price is where Home import demand (MD) = Foreign export supply (XS)
Effects of a tariff
Effects of a tariff Absence of tariff: - Price equalises at PW in both countries point 1 Tariff: - Exporters not willing to move good from Foreign to Home unless Home price exceeds Foreign P by at least t - Nothing shipped: excess demand in Home & excess supply in Foreign P Home & P Foreign until P diff is t - Intro wedge b/tw P in 2 markets o P in Home PT o P in Foreign PT* = PT t - Home: demand for imports producers supply more and consumers demand less o 12 - Foreign: supply & demand export supply o 13
Volume traded: QW QT Home P: PW PT is less than amount of tariff part of tariff reflected in decline in Foreigns export P not passed on to Home consumers Effects of tariff on small country:
A tariff in a small country When a small country imposes a tariff its share of world market for good it imports is usually minor to begin with import reduction has very little impact on world (foreign export) price Tariff raises P of imported good in country imposing tariff by full amount : PW PW + t Production of imported goods : S1 S2 Consumption of imported goods : D1 D2 Imports fall in country imposing tariff
Deriving consumer surplus from the demand curve Consumer surplus on each unit sold is the diff b/tw the actual price and what consumers would have been willing to pay
Geometry of consumer surplus Consumer surplus is equal to the area under the demand curve and above the price
Geometry of producer surplus Producer surplus is equal to the area above the supply curve and below the price
Costs & benefits of a tariff for the importing country - Domestic price : PW PT - Foreign price : PW PT* - Consumer loss: a, b, c, d - Producer gain: a - Govt revenue: c + e - Deadweight loss: b + d Net effect on welfare = net cost of tariff: ( ) b + d = efficiency loss o b: production distortion loss ( )
o c: consumption distortion loss - e = TOT gain because tariff lowers foreign export P Small country cannot affect world price lose e welfare 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 domestic price - Domestic producers expand production marginal cost = tariff-inclusive price could have bought more cheaply abroad
Effects of an export subsidy PW PS: exporting country PW PS*: importing country P less than subsidy Exporting country: o Consumer loss: a + b o Producer gain: a + b + c o Govt subsidy: b + c + d + e + f + g o Deadweight loss: b + d + e + f + g b, d: consumption & production distortion losses Subsidy worsens TOT exporting P ) o Leads to additional TOT loss: e + f + g = (
Long-run: raises domestic prices by the same amount as a tariff that limits imports to the same level Diff b/tw tariff & quota: govt receives no revenue - Quota rents to licence holders (not govt tax rev)
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 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 fragment production, reduce competition & raise profits, also lead too many firms to enter industry inefficiency o Offers more opportunities for learning & innovation for entrepreneurs o Makes whole economy more efficient more firms with higher productivity Hard to quantify When firms incur large costs to get import licences earn economic rents as holders Waste some of economys productive resources 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 national welfare some tariffs/subsidies may increase welfare o If govt agencies tried to pursue this captured by interest groups redistribute income politically influential sectors Barriers used to protect some interest groups sometimes for overall welfare Large country: able to affect prices of foreign exporters tariff lowers import P TOT benefit o Offset benefit against costs of tariff (distortions)
Rent-seeking
The optimum tariff At small tariff welfare > welfare w/ no tariff At a certain point, costs become greater than benefits and welfare decreases After tariff becomes prohibitive flattens out no effect on welfare For export sectors: optimal policy is a negative subsidy (tax) raise P of exports to foreigners o Optimum export tax always +ve but less than prohibitive tax Problem for large countries: akin to using national monopoly power to get gains at other countries expense o Retaliation from other countries
Defending fee trade: o Should correct domestic market failures w/ domestics policies aimed directly at problem o Cannot diagnose market failure accurately enough to have certain policy Use subsidy instead of a tariff deal w/ as directly as poss unintended distortions elsewhere in the economy Always look at domestic policy aimed at correcting market failure before international trade policy probably worse
Electoral competition
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Political competition tM: median voters preferred rate If offer tA: considerably above tM other party offers tB program preferred by almost all voters It would always be in the political interest of a party to undercut any tariff proposal that is higher than what the median voter wants Politicians offer higher tariff if opponents offer one lower than median voters tariff both offer ones close to what the median voter wants Importance of party activists in getting out the vote the party might not be able to offer tariffs like this as activists are ideologically motivated Model does not work well w/ trade policy precisely wrong prediction choose policy that pleases most voters o Large loss for a few but smaller benefits for many (theory) o Large benefits for a few but smaller losses for many (actuality) Political activity on behalf of a group is a public good benefits of such activity accrue to all members of that group, not just the indiv that perform the activity Policies that impose large losses in total, but small losses on any indiv may not face effective opposition Problem with collective action: while it is in the interests of the group as a whole to press for favourable policies, it is not in any individuals interest to do so Overcome problem when group is small each indiv reaps significant share of benefits & well-organised mobilise members to act collectively This is beneficial to producers and not consumers
Collective action
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Have excess returns economic profits profits above what equally risky investment elsewhere 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: example o 2 firms compete from diff countries o New product both capable of making
Either firm alone could earn profits making the good, but if both firms try to produce, both incur 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 on Airbus o Subsidy raises profits by more than the amount of the subsidy itself deterrent effect 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 industry may cause strategic disadvantage in others
Risk foreign retaliation beggar-thy-neighbour policies increase our welfare at others expense Risk trade war that leaves everyone worse off
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 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 better than they would be otherwise Mobility of capital and immobility of labour argument against increased welfare in poorer country Whether & to what extent int trade agreements should also contain provisions aimed at improving wages & working conditions in poor countries o Monitor & make results of monitoring available to consumers version of market failure 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
Strongly opposed by developing countries protectionist tool used as basis for private lawsuits against foreign companies sim to antidumping legislation used by pvt companies to harass foreign competitors
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
Trade promotes economic growth increases per capita income can better/worsen environment depending on where a country is on the curve Not necessarily an argument FOR globalisation can show the opposite FOR NOW China o Not a problem of globalisation a problem for China as a result of globalisation Pollution haven: because of int trade, an economic activity that is subject to strong environmental 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 intervention o 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 the future