EAP MBA50 Vol.1 PDF

Economics for Managers
G.M. AGIOMIRGIANAKIS VOLUME 1

M. VLASSIS
International
Economic Environment
To the children of the World
(…including ours)
(by Minas Vlassis and George M. Agiomirgianakis)
also
to
my mother Eleftheria and
my sisters Marika and Marina
(by George M. Agiomirgianakis)
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ECONOMICS FOR MANAGERS
International Economic Environment
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International Economic Environment
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SCHOOL OF SOCIAL SCIENCES
PROGRAM OF STUDIES
Masters in Business Administration
(MBA)
MODULE
Economics for Managers
VOLUME 1
INTERNATIONAL ECONOMIC ENVIRONMENT
PATRAS 2005
CONTENTS
Preface 15
Introduction 16
CHAPTER 1
G.M. Agiomirgianakis
Markets in the global economy 19
The Scope of the Chapter...................................................................................................19
Learning Objectives............................................................................................................19
Key Words ...........................................................................................................................19
Introductory Comments.....................................................................................................19
1.1 Markets and market clearing in the global economy...............................................20
1.1.1 Consumers ............................................................................................................20
1.1.2 Producers ..............................................................................................................21
1.1.3 Market clearing and market intervention...........................................................22
1.1.4 Markets are international ....................................................................................23
1.1.5 Imports: An excess demand.................................................................................24
1.1.6 Exports: An excess supply....................................................................................25
1.1.7 Determining the international equilibrium of traded good T:
Excess supply vs excess demand ..........................................................................26
1.2 Balance of trade, the pattern of production and trade ............................................28
1.2.1 Balance of trade....................................................................................................28
1.2.2 The pattern of production and trade ..................................................................28
Synopsis - Conclusions......................................................................................................32
Appendix .............................................................................................................................33
7
Bibliography ........................................................................................................................34
Recommended Reading.....................................................................................................34
CHAPTER 2
International trade with constant cost 35
Key Words ...........................................................................................................................35
2.1 The production possibility frontier under constant cost.........................................36
2.2 The pattern of production and trade .........................................................................41
2.2.1 Gains acquired via international trade ...............................................................41
2.3 Labor productivity, wages and real exchange rate in the global economy ............44
2.3.1 Labor productivity and international trade........................................................44
2.3.2 Exchange rate and international trade ...............................................................45
Appendix .............................................................................................................................48
Bibliography ........................................................................................................................50
CHAPTER 3
M. Vlassis
International trade and trade policy 51
Key Words ...........................................................................................................................51
3.1 The production possibilities frontier.........................................................................52
3.1.1 Increasing marginal opportunity costs................................................................53
3.1.2 Autarky equilibrium and real income.................................................................53
8
3.2 Specialization with international trade.....................................................................56
3.2.1 Response to international prices.........................................................................56
3.2.2 Economic development .......................................................................................58
3.3 Trade policies ...............................................................................................................61
Appendix .............................................................................................................................64
Bibliography ........................................................................................................................65
CHAPTER 4
M. Vlassis
Protectionism 67
Key Words ...........................................................................................................................67
4.1 Tariffs ............................................................................................................................68
4.2 Non-tariff barriers.......................................................................................................70
4.2.1 Quotas ...................................................................................................................70
4.2.2 Voluntary export restraints and legal trade restrictions....................................72
4.3 Production distortions ................................................................................................73
4.4 Political economy considerations...............................................................................75
Appendix .............................................................................................................................79
Bibliography ........................................................................................................................80
CHAPTER 5
M. Vlassis
International prices and the terms of trade 81
9
Key Words ...........................................................................................................................81
5.1 Terms of trade, offer curves and international equilibrium...................................83
5.1.1 Terms of trade and offer curves ..........................................................................83
5.1.2 International equilibrium ....................................................................................85
5.1.3 Shifting offer curves and adjustments in the international equilibrium...........86
5.2 Improving the terms of trade with tariffs..................................................................90
5.2.1 Optimal tariffs and tariff wars .............................................................................90
5.2.2 Tariff games and equilibrium tariffs ...................................................................92
5.3 Trade of resources in limited stock............................................................................95
Appendix .............................................................................................................................98
Bibliography ........................................................................................................................99
CHAPTER 6
M. Vlassis
Production, international trade and income distribution 101
The Scope of the Chapter.................................................................................................101
Learning Objectives..........................................................................................................101
Key Words .........................................................................................................................101
Introductory Comments...................................................................................................101
6.1 The specific factors model.........................................................................................103
6.1.1 The market for shared labor..............................................................................103
6.1.2 International trade and the distribution of income in the SFM .....................105
6.2 The factor proportions model...................................................................................107
6.3 The fundamental theorems of international trade ................................................110
Synopsis - Conclusions....................................................................................................113
Appendix ...........................................................................................................................114
Bibliography ......................................................................................................................115
Recommended Reading...................................................................................................115
10
CHAPTER 7
M. Vlassis
Industrial structure and international trade 117
Key Words .........................................................................................................................117
7.1 Firms with market power and international markets ...........................................119
7.1.1 International monopolies ..................................................................................119
7.1.2 International price discrimination ....................................................................122
7.1.3 A dominant exporter and many fringe domestic firms....................................124
7.1.4 Product differentiation, quality variation and monopolistic
competition ........................................................................................................125
7.2 Oligopoly and international trade ...........................................................................128
7.2.1 The nature of oligopoly......................................................................................128
7.2.2 Price and output stability in oligopolistic industries........................................128
7.2.3 Competition versus collusion in international oligopolies..............................129
7.3 Technology and income in international trade ......................................................131
Appendix ...........................................................................................................................134
Bibliography ......................................................................................................................136
CHAPTER 8
International mobility of labor and capital 137
Key Words .........................................................................................................................137
8.1 International migration ............................................................................................138
8.1.1 Types of international migration.......................................................................138
11
8.1.2 Modeling international migration.....................................................................141
8.1.3 International trade and migration ....................................................................143
8.2 International capital mobility ..................................................................................145
8.2.1 Foreign direct investment and foreign portfolio investment ..........................145
8.2.2 Factors friends, factors enemies and distribution of income ..........................146
8.2.3 Specific factors model and migration of a factor .............................................147
Appendix ...........................................................................................................................150
Bibliography ......................................................................................................................152
CHAPTER 9
M. Vlassis
Multinational enterprises
and international economic integration 153
Key Words .........................................................................................................................153
9.1 The economics of multinational enterprises ..........................................................155
9.1.1 International marketing and multinational firms ............................................155
9.1.2 Gains and losses with multinational enterprises..............................................156
9.1.3 Multinational horizontal integration ................................................................156
9.1.4 Multinational vertical integration .....................................................................157
9.2 International externalities and policy coordination..............................................159
9.2.1 Externalities and public goods ..........................................................................159
9.2.2 International externalities and need for policy coordination .........................160
9.3 International economic integration.........................................................................161
Appendix ...........................................................................................................................163
Bibliography ......................................................................................................................164
12
CHAPTER 10
The balance of payments 165
Key Words .........................................................................................................................165
10.1 Balance of payments ................................................................................................166
10.1.1 Current account................................................................................................166
10.1.2 Capital account.................................................................................................170
10.2 Twin deficits and macroeconomic policies............................................................173
10.2.1 Twin deficits and the role of fiscal policy........................................................173
10.2.2 Current account deficit and monetary policy.................................................174
Appendix ...........................................................................................................................176
Bibliography ......................................................................................................................177
CHAPTER 11
The foreign exchange market 179
Key Words .........................................................................................................................179
11.1 Exchange rate determination .................................................................................180
11.1.1 Foreign exchange market ................................................................................180
11.1.2 Exchange rate changes and trade balance......................................................182
11.1.3 Fixed exchange rate regime .............................................................................183
11.1.4 Other definitions of exchange rate..................................................................185
11.2 Expectations, stability and trading in the forex market......................................187
11.2.1 Expectations in the forex market ....................................................................187
13
11.2.2 Speculation and stability in the forex market.................................................188
11.2.3 Demand and supply in the forex market and stability ...................................188
11.2.4 Arbitrage ...........................................................................................................189
11.2.5 Expected inflation, value of a currency and nominal versus real
interest rates .....................................................................................................190
Appendix ...........................................................................................................................194
Bibliography ......................................................................................................................196
CHAPTER 12
International finance 197
Key Words .........................................................................................................................197
12.1 Financial system ......................................................................................................198
12.1.1 Lenders, borrowers and financial institutions................................................198
12.1.2 Cost-benefit analysis and project selection ....................................................199
12.1.3 The market for loanable funds (credit market) .............................................201
12.1.4 International interest rate and exchange rate ................................................203
12.2 International money ................................................................................................205
12.2.1 The role of money ............................................................................................205
12.2.2 Money market...................................................................................................207
12.2.3 Purchasing power parity ..................................................................................209
Synopsis - Conclusions ...................................................................................................211
Appendix ...........................................................................................................................212
Bibliography ......................................................................................................................214
14
PREFACE
International Economic Environment has been specially written to meet the
needs of the module on International Economic Environment, which is part of the
thematic unit on Economics for Managers offered by the Hellenic Open University’s
MBA course. The aims of the course module are twofold: firstly to provide students
with the necessary tools to understand the global economy, and secondly to equip
them with the means of analyzing the ever changing international economic
environment that surrounds modern businesses. National markets for goods, services
and inputs are interrelated and interdependent. Modern economies mirror these
characteristics. Consequently, changes that originate in a national market or
economy are transmitted to international markets, thus affecting worldwide prices
of goods, raw materials and rewards to factors of production. This is especially true
for globalized financial markets where changes in a national market or economy are
transmitted instantaneously on a global scale. In today’s fast changing international
economic environment, managers need to have a sound knowledge of international
economics. A good understanding of international economics will facilitate
managers in making the right business decisions to protect their businesses, e.g.,
from exchange rate fluctuations, and will also allow them to compete successfully in
the international arena by improving their business competitiveness.
The purpose of this textbook is to help students:
ñ Effectively and systematically study the issues analyzed in each chapter of the
book.
ñ Assess their degree of understanding of each chapter by providing self-assessment
activities at the end of each section.
ñ By equipping them with the means to analyze international conditions and take
business decisions.
ñ Deepen their knowledge by providing recommended reading.
We hope that MBA students will find this textbook useful in follow-up case
courses as well as after graduation, when they will be called upon to apply this
material in real-life situations.
We welcome recommendations or comments about this textbook. We would
like to thank the Hellenic Open University (HOU) for giving us the opportunity to
produce this work. We would also like to thank the reviewers, Nicholas Apergis,
Henry Thompson, Nicholas Konidaris, Athanasios Mihiotis and Alexia Tzortzaki,
for providing helpful comments and suggestions that have significantly improved
the quality of the content.
George M. Agiomirgianakis and Minas Vlassis
15
INTRODUCTION
Markets today are open to international competition; thus modern managers
of small, medium and large enterprises are obliged to work daily in a complicated
international economic environment. Indeed, raw materials, semi-final goods,
final goods and services, capital and even labor move on a large and increasing
scale internationally. Due to this high and ever increasing mobility of goods,
services and factors of production, changes that originate in a national economy
are transmitted to the rest of the world. Clearly, this interdependence of modern
economies complicates the decision-making process within the modern business,
creating a multiplicity of factors that need to be taken into account. Consider, for
example, the case of a technological improvement adopted in the production
process of a particular good in some country X. If enterprises in country Y do not
adopt the same or a better technology, their competitiveness on that good will be
relatively lower compared to enterprises in country X, thus, resulting in a fall in
their exports. Moreover, when there is recession and unemployment abroad, no
matter what an economy produces and what its quality may be, exports of this
economy will deteriorate, thus transmitting recession and unemployment into
this economy. International economics argues that agents in an economy should
think globally and act both locally and internationally. That is, these agents should
not only be aware of the trends and changes that shape the global economy, but
should also be capable of constantly improving the competitiveness of their own
enterprises through adopting better technology, better management, better
marketing and so on.
This textbook provides a solid, easy-to-read review of International Economics. It
is intended to provide students with methods and tools used in modern International
Economics and it aims to further develop the ability of students to think critically on
issues relating to the international economic environment. The book is organized
into 12 chapters. Chapters 1, 2, 8, 10, 11 and 12 were written by George
Agiomirgianakis, while Chapters 3, 4, 5, 6, 7 and 9 were written by Minas Vlassis.
In Chapter 1 we explain the role of international trade in affecting domestic
markets worldwide. Since markets are open to international competition, countries
have to adjust constantly to the ever-changing international conditions. The
pattern of production and international trade depends on the international
competitiveness of a country, which, in turn, depends on the principle of
comparative advantage that ensures efficient use of resources globally and a higher
world output available for consumption.
In Chapter 2 we further explain comparative advantage by introducing the
concept of the Production Possibility Frontier (PPF) or Transformation Curve. We
examine cases such as an improvement in technology and economic growth and
calculate the real gains from trade. We analyze the relation between the
international prices of goods and wages. We show that an improvement in home
wages can be brought about by either an increase in the terms of trade or by an
improvement in home labor productivity.
16
In Chapter 3 we explain how and why overall gains can be enjoyed from (free)
international trade, and we provide basic training in the analysis of international
trade in relation to protectionism and trade policy.
In Chapter 4 we explain why protectionism restricts the beneficial effects of
exploiting comparative advantage, specialization, and free trade. We show that
protectionism restricts international trade, lowering national income and making its
distribution more uneven. Yet, it is likely for those who benefit from protectionist
policies to be organized and spend resources to lobby and influence political
decisions.
In Chapter 5 we explain how the conditions prevailing within large trading
countries can affect international prices as well as the volume of international trade.
By means of offer curves we illustrate the interplay between large trading partners,
and we thus study the international impact of protectionism. Protectionism is also
studied by means of reaction functions, as large countries are expected to engage in
tariff games.
In Chapter 6 we explain how the structure of production, as well as the structure
of consumption, underlies international trade and income distribution. This is
carried out by means of a general equilibrium framework that permits the study of
markets in an interconnected network. Thus, while in previous chapters the
equilibrium evolving from this network was summarized by means of the PPF and
offer curve schedules, Chapter 6 discusses what goes on behind these curves (when,
for instance, a tariff is imposed on a traded good).
In Chapter 7 we depart from the assumption of an ideal industrial structure
(e.g., perfect competition with price-taking firms) and we, thus, add more depth
and comprehension to the explanation of international trade whenever monopoly
power and/or competition among few firms with (some) market power characterize
international markets.
In Chapter 8 we present and analyze the case of international factor mobility in
a globalized world. Factors of production move internationally in search of better
rewards. This mobility of huge amounts of capital and large flows of labor affects
both the country of origin, as well as the receiving country. Factor mobility entails
gains for some countries, as well as losses for others; it may also change the pattern
of production and trade of a country.
In Chapter 9 we explain the causes of multinational enterprises, their operation
practices, and their effects regarding their source/host countries. Further, and
since national borders (including independent national policies) represent barriers
that (in principle) decrease global economic efficiency, the process of international
economic integration involves whatever may lower these barriers. Therefore, in
Chapter 9 we also address the implications of international externalities regarding
cross-country policy cooperation and international law, as well as the steps to
international economic integration.
In Chapter 10 we analyze the Balance of Payments (BOP) and its components. The
balance of payments is a record of all international transactions of a country with the
rest of the world. Deficits or surpluses in the balance of payments show the direction of
17
future changes in the exchange rate, in the pattern of domestic production and
employment, as well as the government policy required to reduce imbalances.
In Chapter 11 we focus our analysis on the Foreign Exchange (forex) market
and explain exchange rate determination. We also explain the different exchange
rate regimes, i.e., the free-floating exchange rate and the fixed exchange rate.
Moreover, we analyze foreign exchange trading and examine the role of
expectations in the forex market.
In Chapter 12 the international financial markets and their operations are
explained. We analyze the loanable funds market (credit market) and explain the
determination of the interest rate, both domestically as well as internationally. We
also explain the role of forward forex markets which economic agents may enter in
order to avoid the risk associated with changes in the spot exchange rates. Finally,
we analyze the law of one price and the purchasing power parity.
At the beginning of each chapter, there is an introductory text presenting the
main issues in the chapter. Each chapter has the following structure:
Chapter (Title)
ñ The Scope of the Chapter
ñ Learning Objectives
ñ Key Words
ñ Introductory Comments
ñ Self-Assessment Activities in each section of a chapter
ñ Synopsis – Conclusions
ñ Bibliography and Recommended Reading
At the end of each chapter there is an Appendix with the suggested answers to
the activities in each section.
Students may study the material in this textbook more efficiently by following
the steps below:
1. Read the introductory material at the beginning of each chapter, thus you will
have an overview of the issues to be discussed in the chapter.
2. Do the self-assessment activities at the end of each section and try to answer
them; then check the recommended answers in the appendix.
3. To gain even more understanding and deepen your knowledge of the issues
presented, read the material proposed in the recommended reading section of
each chapter.
4. Remember that effective and efficient reading means that you keep in close
touch with the issues studied, devoting a relatively little amount of reading time
each day rather than a huge amount of time in a relatively few days.
18
CHAPTER 1
MARKETS
IN THE GLOBAL ECONOMY
The scope of Chapter 1 is to introduce the basic analytical concepts and tools of The Scope
international economics. The topics covered include domestic and international of the Chapter
markets, excess demand, excess supply, market clearing in the global market, the balance
of trade, absolute advantage and comparative advantage.
Having completed the study of Chapter 1, the reader will be: Learning
ñ familiar with the basic analytical concepts and tools of international economics Objectives
ñ able to understand what determines the pattern of production and international
trade.
ñ Domestic and international markets Key Words

ñ Excess demand and excess supply
ñ Market clearing in the global market
ñ Balance of trade
ñ Opportunity cost
ñ Absolute advantage and comparative advantage
Chapter 1 explains the role of international trade in affecting domestic markets Introductory
and, hence, producers and consumers worldwide. Modern markets are operating Comments
within a globalized economy, that is, intermediate goods, final goods and services, as
well as factors of production such as capital and labor, move from one country to
another. This movement of goods, services and factors of production is always
associated with flows of currencies that are exchanged for each other. The balance of
trade (BOT) is the record of the international transactions with respect to goods that a
country has with the rest of the world. Since markets are open to international
competition, countries have to adjust constantly to changing international conditions.
The pattern of production and international trade depends on the international
competitiveness of a country, which, in turn, depends on the principle of comparative
advantage that ensures efficient use of resources globally and higher world output
available for consumption.
19
1.1 MARKETS AND MARKET CLEARING
1.1.1 Consumers
Consumer preferences are expressed by the demand curve. The demand curve
relates the quantity and the price of a good from the consumer’s point of view. A
consumer will prefer to buy a larger quantity of a good, Textiles (T) for instance,
the lower its price is. Thus, in terms of Figure 1, the price (È/T, on the vertical axis,
i.e., the euro price of a unit of T) and quantity demanded (T, on the horizontal axis)
of T are negatively related; this is illustrated by a downward-sloping demand curve
D. At the price of È20, consumers are willing to buy 200 units of T. If the price of T
could be lower, say È10, then 400 units of T would be demanded.
È/T
20
15
Dã
10
D
200 300 400 T
Figure 1: Demand Curve for Textiles (T): The Consumer’s Point of View
The negative relation between the quantity demanded of a good and its price is
called the law of demand. The demand curve results from observing consumer
behavior when the price of the good changes. A change in the price of a good
creates two distinct effects that may work either in the same direction or in
opposing directions. The first effect of a price change is called the substitution effect
and states that an increase in the price of T will induce the consumer to spend less
on this good and more on the substitutes for T. The second effect is called the
income effect and states that an increase in the price of T will result in a lower real
income for the consumer, inducing him/her to reduce consumption of T. The
demand curve is the end result of the above two effects.
20
CHAPTER 1
Demand curves differ from country to country. Indeed, there are several factors
that may affect the position of the demand curve. These factors include consumer
income, consumer price expectations, prices of related goods, and tastes of consumers.
Changes in these factors may cause a shift in the demand curve either to the right
(increases) or to the left (decreases). For example, if consumers expect the price of
good T to increase next year, they will buy a greater quantity of it today. In terms of a
graphical presentation, for any given price today, the quantity demanded will be
higher and this is illustrated by the shift of the demand curve to the right, i.e., to Dã.
1.1.2 Producers
The supply curve relates the quantity and the price of a good from the producer’s
point of view; thus, it shows the quantity of good T that producers are willing to supply
at various prices. A producer would like to sell a greater quantity of good T, the higher
its price is. Thus, in terms of Figure 2, the price (È/T, on the vertical axis) and quantity
supplied (T, on the horizontal axis) of T are positively related; this is illustrated by an
upward-sloping supply curve S. At the price of È10, producers are willing to sell 200
units of T. If the price of T were higher, say È20, then 400 units of T would be supplied.
Sã
È/T S
20
15
10
200 300 400 T
Figure 2: Supply Curve for Textiles (T): The Producer’s Point of View
The supply curve is positively sloped since an additional unit of good T can be
produced at a higher cost. This is due to two reasons: (a) the marginal productivity
of an input is diminishing as more and more of this input is used in the production
of good X, and (b) higher use of an input results in a higher price of this input.
Supply curves differ from country to country. Indeed, there are several factors
that may affect the position of the supply curve. These factors include:
ñ The prices of inputs
ñ The expectations that producers may have for future prices
ñ The level of technology used in the production
ñ The number of producers
21
Changes in these factors may cause a shift in the supply curve either to the right
(increases) or to the left (decreases). For example, if the price of oil increased by a
large percentage today (as happened, indeed, in 1973 and 1979), the production cost
of T would increase and soon the producers would have to increase the price of T. In
terms of a graphical presentation, this is represented by a shift of the supply curve to
the left, i.e. to Sã.
1.1.3 Market clearing and market intervention

Market clearing in the domestic market of good T occurs when the demand for
T matches exactly the supply of T and thus leaving neither shortages nor surpluses.
We may see this process with the help of Figure 3.
S
È/T
20
15
10
D
200 300 400 T
Figure 3: Market Clearing for Good T
The demand curve and supply curve intersect at the price of È15 and thus
consumers are willing to buy 300 units of good T, exactly as many units as producers
want to produce at that price.
Imagine, for a moment, that the price was different, say È20. Then producers
would like to supply 400 units of T while consumers would prefer to buy only 200 units
of T. Clearly, there would be an excess supply, i.e., quantity supplied minus quantity
demanded, of 200 units. If there was no intervention from outside, such as government
intervention, the price level would be pressed downwards until the excess supply were
eliminated, which would occur at the price of È15. If, however, there was government
intervention that fixed the price at È20 per unit of T, say because the government
wanted to guarantee a certain level of income for producers of T, then the market
would not clear and the excess supply of 200 units of T would remain. This is the case
often observed in the markets for agriculture goods that are protected by national
governments in many countries. Often, these governments buy the excess supply. If,
on the other hand, the price is lower than È15, say È10, consumers will be willing to
buy 400 units of good T, while producers will produce only 200 units of T. Clearly, in
this case we have an excess demand (quantity demanded minus quantity supplied, at
22
CHAPTER 1
any given price level). If the market is left without external intervention, the price will
rise till it reaches È15, where excess demand is eliminated and the market clears.
However, if the government intervened and kept the price of T low, attempting to
guarantee a certain level of consumption for consumers, the market would not clear
and excess demand would remain. This is often the case when governments intervene
in the market for medicines or in the housing market in order to protect their citizens.
The problem then is that there is a lack of production at the artificially low price.
1.1.4 Markets are international

The previous analysis assumes that national markets are not connected (i.e.
markets are segmented) and hence prices prevailing in one cannot affect the other.
However, modern markets, as we have already mentioned above, are international
which implies that goods may move from one country to another. This mobility of
goods, as we shall see shortly, sets a new price worldwide (international price) that
is different from the national prices that prevailed in the pre-trade world of
segmented markets. To examine the case of international trade we assume, for
simplicity, a world consisting of only two countries, say Greece (that we call the
home country) and Bulgaria (that we call the foreign country). We illustrate the
above in Figure 4, where the equilibrium price for good T in Greece is 15 euro,
while the same good has an equilibrium price of 10 leva in Bulgaria.
Let us, now, assume that these two countries are facing the possibility of opening
up their markets to international trade and let’s further define the exchange rate (e)
between the two currencies as the price of the foreign currency (Bulgarian leva) in
units of the domestic currency (È). Thus, we assume that a Bulgarian leva can buy
È0.50, and the current exchange rate is e = (È/Leva) = 0.5.1 International trade can
take place when goods in one country are cheaper than the other country.
È/T Leva/T
S
20
15
D*
20
10
D
10
S*
200 300 400 T 200 300 400 T
Greece Bulgaria
Figure 4: International Trade of Good T
1
A depreciation of the euro means a fall in the value of the euro, or that a leva can buy more euros (the
value of the leva is higher). That is, the exchange rate, e = (È/leva), rises.
23
A lower Bulgarian price of T will induce traders to import this good into Greece
and make profits. As traders do so, i.e., import good T from Bulgaria to Greece, the
new international price of T will change within the interval È15 to È5 (since 10 leva
= È5). This is so since Bulgarian producers now have to produce, not only for the
Bulgarian market, but also for the Greek market and this is possible at a price
higher than the pre-trade price of 10 leva (or È5). On the other hand, consumers in
Greece will be willing to buy more of T only if the price is lower than È15 per unit
of T. Although national markets do not clear now, the international market for T
will clear at that international price where the excess demand (imports) of one
country is equal to the excess supply (exports) of the other country. In terms of
Figure 4, this happens at the price of È10 where 300 units of T are exported from
Bulgaria into Greece. We should note, however, that the opening up to trade
creates winners, as well as losers. To explain this, let us examine the Greek market
first: consumers are paying less now (È10) compared to the pre-trade price (È15)
while producers are worse off since they are getting a lower price (È10) than what
they had in the pre-trade period (È15). The reverse is true for Bulgaria, where
producers are getting a higher price (20 leva compared to the pre-trade price of 10
leva), while consumers are paying a higher price now.
1.1.5 Imports: An excess demand

The above analysis can be facilitated in terms of excess demand and supply. As we
have already mentioned, we define excess demand as the difference between quantity
demanded and supplied, at any given price. It shows the imports that a country wants
at any given price. In contrast, excess supply is the difference between quantity
supplied and demanded and shows the exports that a country wants at any given price.
We start our analysis with the case of excess demand in the Greek market for T. Using
Figure 3, one can see that at the price of È15, the difference between quantity
demanded and supplied is zero, thus the excess demand curve passes through point
(0,15) in Figure 5. At the price of È10, excess demand is 200 (400-200), thus point
(10,200) is a point on the excess demand curve. We illustrate the above points in
Figure 5 where XD depicts the excess demand (imports) in the Greek market for T.
È/T
15
10 XDãã
XD
-200 0 200 XDã T
Figure 5: Greek Market for T and the Excess Demand Curve
24
CHAPTER 1
The excess demand curve in Greece may shift if factors affecting demand and
supply of T change. To analyze this, assume, for example, a decrease in consumer
income that results in a decrease in the demand for T which, in turn, results in a
reduction in the excess demand for T, i.e., fewer imports into Greece. Similarly, an
increase in Greek productivity, say due to the adoption of better technology, would
increase the supply of T, resulting in a reduction in the excess demand for T. Both
cases are illustrated by the shift of XD to XDã. If, on the other hand, consumer
income in Greece increased, the resulting higher demand for T would create a
higher excess demand illustrated by the shift of XD to XDãã.
1.1.6 Exports: An excess supply

We turn our analysis next to the case of excess supply in the Bulgarian market
for T. Using Figure 4, one can see that at the price 10 leva the difference between
quantity supplied and demanded is zero, thus, the excess supply curve in Figure 6
passes through point (0, 10). At the price of 20 leva, excess supply is 200 (400-200),
and thus point (20,200) is a point on the excess supply curve. We illustrate the
above points in Figure 6 where XS depicts the excess supply (exports) of Bulgaria
into Greece.
Leva/T
XSã
XS
20
10
-200 -100 0 200 T
Figure 6: Bulgarian Market for T and the Excess Supply Curve
The excess supply curve may shift if factors affecting demand and supply of T in
Bulgaria change. For example, an increase in the production cost due, say, to
higher Bulgarian wages or higher oil prices, will result in a fall in the supply of T
and thus the excess supply curve XS will shift to the left, say to XSã, reflecting a fall
in the Bulgarian exports. Consider next the case of euro depreciation. Bulgarian
excess supply (exports) will be more expensive for Greek consumers and this is
reflected by a shift of the excess supply curve to XSã.
25
1.1.7 Determining the international equilibrium
of traded good T:
Excess supply vs excess demand
In a world of only two countries and without barriers to free trade between the
countries, excess demand in one country should be equal to the excess supply of the
other country. This is illustrated with the help of Figure 7, where both excess demand
and excess supply curves intersect each other at point (10, 200).
XSã
È/T XS
11.25
10 A
XD
-200 -100 0 150 200 T
Figure 7: Determining the International Equilibrium of Traded Good T
The price of È10 is the international equilibrium price of good T where excess
demand in Greece equals excess supply in Bulgaria.
Consider next the case of a euro depreciation that, as we have already seen, will
shift the XS curve to the left, to XSã. Bulgarian exports become more expensive for
Greek consumers who will reduce their imports, resulting in a lower volume of
international trade, say from 200 to 150 units of T, due to the euro depreciation and
a new international price of 11.25.2
In sum, Section 1.1 analyzes domestic markets in a pre-trade situation and then
considers the case of opening markets up to the possibility of international trade. The
new international price for the traded good is between the two pre-trade domestic
prices. We should note, however, that the opening up to trade scenario might create
gains as well as losses for the consumers and producers involved. An exchange-rate
depreciation in the home country will reduce the volume of international trade as
imports will be more expensive in that country.
2
The equation of the excess demand curve is È = 15-0.025T.
26
CHAPTER 1
Activity 1/Chapter 1
Using excess demand and supply diagrams, examine the effects of an appreciation of the
euro and an increase in productivity in the home country.
The answer can be found in the Appendix at the end of this chapter.
27
1.2 BALANCE OF TRADE, THE PATTERN
OF PRODUCTION AND TRADE
1.2.1 Balance of trade

The international flow of goods and services involves financial transactions from
one currency to another. These financial transactions are facilitated by the banking
system that makes provision of foreign currency to traders in the exchange of
domestic currency. While traders keep their records of transactions with the help of
the banking system, a country needs its own record of international transactions.
The balance of trade (BOT) is the record of the international transactions of goods
that a country has with the rest of the world. We define the BOT as the difference
between the value of exports X and the value of imports M, that is:
BOT ≡ X-M = (Pexp á Qexp) - (Pimp á Qimp)
where X ≡ (Pexp á Qexp) and M ≡ (Pimp á Qimp); Pexp is the price of exports ; Qexp is
the quantity of exported good(s); Pimp ≡ P* e, where Pimp is the price of imports in
domestic currency, P* is the foreign currency price of imports and e is the exchange
rate (price of the foreign currency in units of the domestic currency); and Qimp the
quantity of imported good(s).
The BOT may be negative in case of a trade deficit or positive in case of a trade
surplus. In terms of Figure 7, at point A of the intersection between XS and XD, the
trade for the home country is balanced; above point A there is a trade surplus and
below point A there is a trade deficit. A depreciation of the home currency will
increase e and hence Pimp resulting in a deterioration of the trade balance (assuming
that Qimp remains unchanged, at least in the short run).
1.2.2 The pattern of production and trade

International trade takes place when national prices are different. Differences
in national prices are due to differences in: (a) the quantity and the quality of the
factor endowments such as labor, capital equipment, raw materials that a country
has available, and (b) the efficient use of the factor endowments that can make one
country more efficient compared to others in producing certain goods. Both lead to
specialization of a country in the production of certain goods. Like people or
regions within a country, countries also tend to specialize in what they do best or
more efficiently.
28
CHAPTER 1
We will proceed with our analysis in two steps: first, we will analyze absolute
advantage and then we will examine the role of comparative advantage in international
trade.
According to absolute advantage, countries that can produce a good with less
resources compared to others, should specialize in the production of that good. To
show this we assume a 2x2 world, i.e., two countries and two goods. Let’s say
Greece and Bulgaria produce goods X and Y. We also assume that by devoting one
factor unit to each good, we could have the quantities of goods illustrated in the
table below.
Greece Bulgaria World Production

X 10 1 11
Y 2 15 17
That is, one factor unit in Greece can produce 10 units of X or 2 units of Y, while
one factor unit in Bulgaria can produce 1 unit of X or 15 units of Y. Hence, each
country is more efficient than the other at producing one of the goods. Before
trade both countries produce both goods, devoting one factor unit to each good,3
thus the world output consists of 11 units of X and 17 units of Y.
Consider, next, the case where countries open up to trade. Each country
specializes in what it does best, and puts all its resources into making that good.
Assuming constant returns to scale, for simplicity, the result yields:

X 20 - 20
Y - 30 30
Thus, Greece will be specialized and export X while Bulgaria will be specialized
and export Y. World production has increased by nine units of X and by thirteen
units of Y. Both countries, by trading, are better off since they can consume more of
both goods.
Absolute advantage was the argument adopted by Adam Smith in 1776,4 to
support specialization and free trade. This outcome is intuitively obvious and it can
explain part of international trade but not the main bulk of it. What is less obvious is
the case when one country is more efficient at making both goods. This involves the
principle of comparative advantage proposed by David Ricardo in 1817.5 Consider
the following numerical example which is a bit different from the previous one in
that Bulgaria is now more efficient than Greece in making both goods.6
3
In other words, each country is endowed with two factor units.
4
See The Wealth of Nations.
5
See The Principles of Political Economy and Taxation.
6
In the previous numerical example, Bulgaria was more efficient only in making Y.
29
X 10 12 22
Y 2 15 17
That is, an hour of labor in Bulgaria can produce 12 units of X or 15 units of Y

compared with only 10 units of X and 2 units of Y in Greece. However,
specialization and trade can still be beneficial to both countries. The principle is
that Bulgaria, although better at making both goods than Greece, should
concentrate on the good in which it has the greatest advantage, i.e., Y. On the other
hand, Greece – though less efficient in producing both goods – should concentrate
on the good that can be produced less disadvantageously, i.e., X. When this is done,
Bulgaria will produce 30 units of Y and Greece will produce 20 units of X, which is
two X less than the world production before trade. However, Bulgaria can
compensate for this “loss” of two X by making the pre-trade amount of Y (17 units)
and by devoting 1.133 of a factor unit to it,7 while it can use the remaining 0.866 of a
factor unit8 to make 10.4 additional units of X.9 Thus, world production will be 30.4
units of X and 17 units of Y, giving a gain of 8.4 units of X compared to the pre-
trade situation.
It is obvious from the above that a gain can be made from specialization and
trade if the efficiency ratios are different, even if one country is more efficient in
making both goods.
We will analyze further the case of comparative advantage when production of a
unit of the two goods is given by hours of labor required, rather than by units of
goods produced per unit of input. Consider the following example where Greece
and Bulgaria can produce two goods X and Y with the use of only one factor of
production, say labor, and under constant returns to scale. The cost of production
in each country and for each good is summarized in the first three columns of the
following table.
Greece Bulgaria OCGreece OCBulgaria

X 60 120 6Y 10 Y
Y 10 12 1/6X 1/10 X
Thus production of one unit of X requires 60 hours of labor and production of

one unit of Y requires 10 hours in Greece. On the other hand, labor in Bulgaria is
less productive in both goods, as production of X takes 120 hours and production of
Y 12 hours.
To analyze this case we need to analyze the notion of the opportunity cost. Let us
define the opportunity cost of a good X as the units of good Y sacrificed in order to
7
If one factor unit produces 15 Y, then it requires about 1.133 factor units to get 17 units of Y.
8
That is, 2 – 1.133 = 0.866.
9
If one factor unit produces 12 units of X in Bulgaria, then 0.866 factor units will produce 10.4 units of X.
30
CHAPTER 1
get an additional unit of good X. The principle of comparative advantage says that
countries will be specialized in the production of the good for which they have
lower relative cost, i.e., lower opportunity cost. We can now compare opportunity
cost in the above example. The opportunity cost of producing an extra unit of X in
Greece is (60/10) = 6, that is, Greece has to forgo 6 units of Y in order to get one
unit of X. In Bulgaria the opportunity cost of producing an extra unit of X is
(120/12) = 10 units of Y. Similarly, the opportunity cost for Y is 1/6 of X in Greece
and 1/10 of X in Bulgaria. We illustrate the opportunity costs for each country in
the last two columns of the above table. Clearly, by comparing opportunity costs for
the two countries for each good, one may see that Greece has a lower opportunity
cost (6 compared to 10) in producing X and Bulgaria has a lower opportunity cost
(1/10 compared to 1/6) in producing Y. Thus, Greece should be specialized in
producing X and Bulgaria in producing Y.
Specialization of a country occurs due to international competition that forces
markets and countries to produce the goods for which they have the lower relative
cost (lower opportunity cost). The principle of comparative advantage, by
determining the pattern of production and international trade, guarantees efficient
use of resources globally and a higher world output.
In sum, Section 1.2 presented the balance of trade and examined the role of an
exchange rate change. With the help of numerical examples, we also presented and
analyzed the principle of absolute advantage that may explain some part of international
trade. In addition we presented and analyzed the principle of comparative advantage,
which determines the pattern of production and the main bulk of international
trade.
Look at the following three cases indicating units of output produced per unit of input,
illustrated in the table below.
Case 1 Case 2 Case 3

Greece Bulgaria Greece Bulgaria Greece Bulgaria
X 8 4 8 4 10 5
Y 3 2 1 1 4 2
In each case explain which country has absolute and comparative advantage, and the
goods that each country will produce.
31
Synopsis – Conclusions
In Chapter 1 we introduced the basic analytical concepts and tools of
international economics. We examined first a pre-trade situation where countries
produce all the goods they consume. Next we opened up countries to international
trade and examined market clearing in the global market. The new international
price is between the two pre-trade prices. International trade may create gains,
as well as losses for the consumers and producers in the individual countries. An
exchange rate depreciation in the home country will reduce the volume of
international trade as imports will be more expensive in that country. We also
presented the balance of trade and examined the role of an exchange rate change.
Finally, with the help of numerical examples, we presented and analyzed the
principle of absolute advantage and the principle of comparative advantage that
determines the pattern of production and international trade.
32
CHAPTER 1
APPENDIX
Answers to Activities
Activity 1
We can use Figure 7 to illustrate the shifts in the two curves. Consider first the effects of an
appreciation of the euro. An exchange rate appreciation will increase the value of the euro,
and thus the purchasing power of consumers in Greece, inducing them to increase their
demand for T. As a result of this, the excess demand curve will shift to the right, i.e., XDã.
Next, consider the case of an increase in Greek productivity, say due to the adoption of
better technology. This will increase the supply of T in Greece, thus resulting in a reduction
in the excess demand for T, i.e., XDãã. Point K (the intersection of XDããwith XS) depends
upon the relative size of the two shifts.
È/T XS
K
10
A
XDã
XDãã
XD
-200 -100 0 150 200 T
Activity 2
Case 1 Case 2 Case 3

Greece Bulgaria Greece Bulgaria Greece Bulgaria
X 8 4 8 4 10 5
Y 3 2 1 1 4 2
In case 1, Greece has an absolute advantage over Bulgaria in producing both goods.
However, the advantage is higher in good X (8:4) compared to Y (3:2), therefore Greece will
be specialized in producing and exporting good X and Bulgaria will be specialized in
producing and exporting good Y.
In case 2, Greece has an absolute advantage over Bulgaria in producing X but both
countries are equally good in producing Y. Since the advantage is higher in good X (8:4)
compared to Y (1:1), Greece will be specialized in producing and exporting good X and
Bulgaria will be specialized in producing and exporting good Y.
In case 3, Greece has an absolute advantage over Bulgaria in producing both goods. However,
in this case we cannot find a comparative advantage as now the advantage is the same in both
goods (10:5) in X and (4:2) in Y. Therefore, in this case there will be no international trade
between the two countries.
33
BIBLIOGRAPHY
Thompson H., International Economics: Global Markets and International Competition,
World Scientific, Singapore 2001, pp. 1-37.
RECOMMENDED READING
Asheghian P., International Economics, West Publishing Company, Minneapolis/St.
Paul, MN 1995, pp. 11-30.
Carbaugh R., International Economics, Seventh Edition, South Western College
Publishing, Cincinnati, Ohio 2000, pp. 20-30.
Salvatore D., International Economics, Seventh Edition, John Wiley & Sons, New
York 2001, pp. 27-40.
34
CHAPTER 2
INTERNATIONAL TRADE
WITH CONSTANT COST
The scope of Chapter 2 is to look more closely into the production process and The Scope
its role in international trade. To this aim we introduce more analytical concepts of the Chapter
and tools of international trade, in order to examine cases such as an improvement
in technology and economic growth. We also analyze the real gains from trade, the
relation of domestic wages to the terms of trade, as well as the limits imposed on the
exchange rate by free trade. The topics covered include the production possibility
frontier, marginal rate of substitution, terms of trade, real gains from international trade
and the role of exchange rate and wages in international trade.
ñ familiar with the role of comparative advantage in international trade Objectives
ñ able to understand the gains obtained from international trade, the role of
advances in technology, as well as the role of exchange rate and wages.
ñ Production possibilities frontier Key Words

ñ Marginal rate of substitution
ñ Improvement in technology
ñ Comparative advantage and terms of trade
ñ Real gains from trade
ñ International wages and exchange rate
Chapter 2 further explains comparative advantage by introducing the concept of Introductory

production possibility frontier (PPF) or transformation curve. The production Comments
possibility frontier is a curve that shows all possible combinations of two goods that
a country can produce with full employment of all factors of production and using
the best possible technology. With the use of the PPF in two countries, we examine
cases such as an improvement in technology and economic growth and calculate the
real gains from trade. Next, we analyze the relation between the international prices
of the two goods and the wages in the two countries and the labor productivity. We
show that an improvement in home wages can be brought about by either an
increase in the terms of trade or by an improvement in home labor productivity.
Finally, we analyze the role of the exchange rate and we find the limits of it in order
to have mutually beneficial trade between the two countries.
35
2.1 THE PRODUCTION POSSIBILITY
FRONTIER UNDER CONSTANT COST
We consider, first, the production possibilities in the home country (Greece)
and we make the following assumptions:
a. There is only one factor of production, labor,1 producing two goods, X and Y.
b. Labor is fully employed in producing X and Y.
c. Each unit of labor is homogeneous to all other units of it.
d. There is a fixed quantity of labor available to a country, denoted by the letter L.
e. The amount of labor required in the making of each additional unit of output,
say X, does not change2 as output increases.
Clearly, with a fixed quantity of labor, full employment and fixed factor
proportions, an increase in the quantity of X can be achieved only at the expense of
the quantity of Y produced, i.e., as the quantity of X increases, the quantity of Y has
to decrease.
We may illustrate the above with the help of a numerical example. Let’s
assume that that the quantity of labor required to produce a unit of good X is 5
workers and that production of a unit of Y requires 6 workers. We may denote
these requirements per unit of good as ·LX = 5 and ·LY = 6, that is, 5 workers are
required per unit of X and 6 workers are required per unit of Y. Thus, (·LXX) is
the number of workers employed in the production of X and (·LYY) is the number
of workers employed in the production of Y. Assuming also that labor endowment
of the home country is fixed and equal to 120, i.e., L = 120, we may then write the
production possibilities as
L = 120 = ·LXX + ·LY Y = 5X + 6Y. (1)
We solve (1) for Y and we get
Y = (L /·LY) - (·LX /LY) X = 20 – (5/6) X. (2)
Equation (2) gives the equation of the production possibility frontier (PPF) that
we illustrate in Figure 1.
1
Assuming more than one factor of production does not change our analysis, however it complicates it.
The assumption that labor produces all goods reflects the labor theory of value, i.e., the price of a good
depends upon the quantity of labor used in its production.
2
That is, the assumption of fixed factor proportions, i.e., that the factors of production are used in fixed
proportions in the production of X and Y.
36
CHAPTER 2
Y
20
15 K
14.167 M
13.334 N
PPF
Slope = MRT = – (·LX /·LY) = – (5/6) = –0.833
6 7 8 24 X
Figure 1: The Production Possibility Frontier under Constant Cost
The production possibility frontier shows the maximum production possibilities

with full employment of labor, given the best available technology. At point K on
the PPF, production of X is 6 units and Y is 15 units. An additional unit of X can be
produced at the expense of a lower Y, that is point M with X = 7 and Y = 14.167. If
a further increase in X is required, say again by one unit, then point N is attained
with X = 8 and Y = 13.334. Thus, any additional unit of X will reduce Y by the same
amount of (5/6) = 0.833 = (·LX / ·LY) that is, the opportunity cost of producing an
additional unit of X is constant throughout the PPF. The slope3 of the PPF is the
relative price of X, also called the marginal rate of transformation (MRT), and shows
how many units of Y should be sacrificed in order to get an additional unit of X.
An Improvement in the Technology of Producing X

Assume now that technology in the production of good X is improving and as a
result, the production of good X requires a lower labor requirement per unit of
good X, say that ·LX = 4. Thus the PPF is now given by:
L = 120 = ·LXX + ·LY Y = 4X + 6Y (3)

or
Y = 20 – (4/6) X. (4)
The slope of the PPF (4/6 = 0.666) is lower, thus, the opportunity cost of producing
X is lower now and the PPF rotates from point (0,24) to the left, intersecting the
horizontal axis at point (120/4) = 30, as illustrated by the shaded arrow in Figure 2.
The new PPF shows that higher quantities of both goods X and Y can be produced.4
3
Slope of PPF = MRT = – ·LX / ·LY = –5/6 = – 0.833.
4
The new PPF is to the right and above the initial PPF. However, to show this, consider that Y = 15 with PPFã.
Now 7.5 units of X can be produced compared to 6 before the improvement in technology; i.e., point Kã with
the improvement in the technology of X. Similarly, if X = 6 with the PPFã, now 16 units of Y can be produced
compared to 15 before the improvement in technology, i.e., Kãã with the improvement in the technology of X.
37
Y
20
Kãã
16
15 Kã
K
PPF PPFã
MRT = –0.666
6 7.5 24 30 X
Figure 2: The Production Possibility Frontier and an Improvement in the
Technology of X
Economic Growth
Consider, next, the case where the labor endowment in the economy increases
to Lã= 180,5 say due to immigration or to population growth in Greece. The PPF will
shift parallel to the right, increasing the production and consumption possibilities of
both goods X and Y, as illustrated in Figure 3. The MRT does not change, i.e., the
opportunity cost of X remains the same.
Y
30
20
PPF PPFã
MRT = –0.833
24 36 X
Figure 3: The Production Possibility Frontier and Economic Growth
As in the previous case, the new PPFãshows that higher quantities of both
goods X and Y can be produced and consumed.
5
That is, 180 = 5X + 6Y and MRT = – (5/6) = –0.833.
38
CHAPTER 2
The Foreign Production Possibility Frontier

Consider next the case of a foreign country (Bulgaria) that also produces goods
X and Y under different unit labor requirements and labor endowment. Let’s
assume that ·*LX = 6, ·*LY = 7 and L* = 150.6 We illustrate the above in Figure 4.
Clearly, the home country has an absolute advantage in producing both goods,7 as
unit labor requirements are lower at home than abroad. However, as we already
know, the pattern of production and trade is determined by comparative advantage.
Greece has a comparative advantage in producing good X since its opportunity cost
is lower in Greece8,9 as MRTGreece = (5/6) = 0.833 < MRTBulgaria = (6/7) = 0.857.
Thus it could be more profitable for both countries if Greece were specialized in the
production of X and Bulgaria in the production of Y.
25
PPFBulgaria
20
MRTGreece = (5/6) = 0.833 < MRTBulgaria = (6/7) = 0.857
PPFGreece
21.4 24 X
Figure 4: The Production Possibility Frontiers in Two Countries in a Pre-trade

Case
In sum, in Section 2.1 we presented and analyzed the production possibilities

frontier (PPF), which shows the maximum output that a country can produce under
full employment of its resources and the best available technology. We made the
assumption of constant unit labor costs in the production of both goods.10 The slope
of the PPF is the marginal rate of transformation and shows the opportunity cost of
producing X, that is, how many units of Y should be sacrificed in order to get an
6
That is, 150 = 6X* + 7Y* and MRT* = –(6/7) = –0.857, where we denote foreign variables with an
asterisk.
7
We assume for the home country the example of Figure 1, i.e., Y = 20 – (5/6)X.
8
We compare MRTs in absolute terms.
9
Bulgaria also has a comparative advantage in producing good Y.
10
That is the assumption of fixed factor proportions; however here we have assumed that labor is the only
input.
39
additional unit of X. Advances in technology or increases in the population of a
country increase the production possibilities of this country. Next we illustrated and
compared the production possibility frontiers of two countries with the one country
having an absolute advantage in both goods. Countries, by having free trade, could
improve their production and consumption possibilities, as we will show in the next
section.
Using the numerical examples of Figures 1, 2 and 3 and assuming that consumers always
spend an equal share of their income on each good, compare whether consumers are
better off with an increase in the labor endowment or with an improvement in the
technology of X.
40
CHAPTER 2
2.2 THE PATTERN OF PRODUCTION

AND TRADE
2.2.1 Gains acquired via international trade

As we already mentioned in Chapter 1, international trade takes place when
national prices are different. These differences are based on the efficient use of the
factor endowments that can make one country more efficient compared to others
in producing certain goods. Let’s now assume that the two countries open their
borders up to international trade and consider their production possibilities frontiers
depicted in Figure 5.
150
PPFBulgaria
MRTGreece = 0.333 and

MRTBulgaria = 3
50
PPFGreece
50 150 X
Figure 5: The Production Possibility Frontiers and International Trade
According to comparative advantage, countries will be specialized where they

have a lower opportunity cost. That is, Greece will be fully specialized in
producing X and Bulgaria will be fully specialized in producing Y. The next
question that countries will have to ask is what could be the terms of trade, so that
international trade would be mutually beneficial. If the price of X is valued more
abroad than in Greece (3 > 0.33), then any price above 0.33 is beneficial for
Greece. In Bulgaria X is valued quite high, so any price below 3 will be beneficial
for Bulgaria. Therefore, the terms of trade, denoted by tt, should be between 0.33
and 3, i.e., 0.33 < tt < 3.
Let us now focus only on the case of the home country, Greece, and assume
41
that the terms of trade are equal to one, that is tt = 1.11 We illustrate this in Figure 6.
The value of X in Greece is 0.333, while the international price of X is 1. As X is
valued much more abroad, Greece will gain by being fully specialized in producing X.
Thus, Greece, by exporting all its production of X and trading it at the international
price 1, will get 150 units of imported Y, that is, 100 units more than what it could get
domestically, by devoting all its resources to producing Y.
Y
150
tt = 1
100


75  K
 Real gains from trade

 Pre–trade price of X
50  PPFGreece
P
25
MRTGreece = 0.333
Z N X
75 150
Figure 6: Specialization and the Triangle of Trade
Let’s assume now that although Greece is fully specialized in the production of
X, only some of it is consumed at home and the rest of X is exported abroad. Let’s
assume that consumers in Greece prefer to consume 75 units of X and export the
remaining 75 units in exchange for 75 units of Y. The triangle of trade is KZN,
where the arrow from N to Z shows exports of X and the arrow from Z to K shows
imports of Y. Let’s compare now the pre-trade consumption bundle at point P with
the consumption bundle after-trade at point K. In the pre-trade case, consumers
restricted at point P were consuming 75 units of X and 25 units of Y, while
consumption after-trade at point K has the same quantity of X but a much higher
quantity of Y, indeed now the consumption is 75 units of Y which is 50 units more
than before. Therefore, consumers are better off with international trade.
We may measure the real gains of international trade in terms of only one good
and by using the pre-trade prices. To show this, we evaluate the consumption
11
The terms of trade are tt = (PX /PY) = (Y/X), that is, the relative price of X internationally, which in our
example means that one unit of X is priced internationally equal to one unit of Y.
42
CHAPTER 2
bundle at point K in terms of good Y, i.e. 75 Y + (0.333 x 75 Y) = 100 Y, that is

illustrated by the intersection point of the dotted line, indicating the pre-trade
prices of X, that passes through point K with the vertical axis at point 100. Since
maximum production and consumption of Y in pre-trade was 50, the real gains
from trade are 100 - 50 = 50 units of Y.12 Thus, the percentage increase in terms of
real income 13 due to international trade is 100%. 14 These gains depend on the
international demand for good X, which determines the international terms of
trade tt. The higher tt is compared to the opportunity cost of producing good X at
home,15 the larger will be the gains obtained through international trade.
In sum, in Section 2.2, we used the production possibility frontier to show the
real gains that countries can obtain by being involved in international trade. These
gains depend on the international demand for good X and will be larger the higher
the terms of trade are.
Using the numerical examples in Figure 6, calculate the real gains to trade in terms of good
X for the home country.
12
In terms of Figure 6, these 100 units of Y are exactly the distance on the vertical axis between the
PPFGreece and the line that passes through point K and shows the pre-trade price of X.
13
That is, when real income is measured in terms of good Y. One can also find the real gains in terms of
good X.
14
Similarly, one can find the real gains for the foreign country.
15
That is, the MRT.
43
2.3 LABOR PRODUCTIVITY, WAGES
AND REAL EXCHANGE RATE
2.3.1 Labor productivity and international trade

We turn our analysis now to home wages and their relation to foreign wages, as
well as to analyzing the role of international trade in affecting labor income. We
assume that goods X and Y are produced under conditions of perfect competition
both at home and abroad. As we know, in perfect competition, prices are equal to
the average cost of production, that is P = AC. We also assume that due to
international trade, Greece is fully specialized in the production of X and Bulgaria
in the production of Y and that unit labor requirements in X and Y are ·LX = 4 and
·*LY = 6. Therefore, we may write
PX = ACX = ·LXW = 4W. (5)
That is, the price charged for home produced good X is equal to the unit labor
requirement times the domestic wage. In terms of our example, the price of a unit
of X equals four times the home wage, as four units of labor are required.
Similarly, for Bulgaria we may write
PY = ACY = ·*LYW* e = 6 (W* e) (6)
where e is the exchange rate, as we have defined it in Chapter 1, i.e., e is the price of
the foreign currency (Bulgarian leva) in units of the domestic currency (È), and
thus e = (È/Leva). Hence, multiplying W* by e converts the foreign wage W* into
home currency units, i.e., into È.
Next, recall that the terms of trade are
tt = (PX /PY) = (Y/X). (7)
Substituting (5) and (6) into (7) we get
tt = (PX /PY) = (Y/X) = (·LX/·*LY) (W/eW*) = (2/3) (W/eW*). (8)
Equation (8) relates the terms of trade to labor productivity in both goods and
wages in both countries. Solving (8) for W yields
W = (PX /PY) (·*LY /·LX) (W* e). (9)
44
CHAPTER 2
Equation (9) says that domestic wages depend on three factors:

1. The terms of trade.
2. The ratio of foreign productivity in producing Y to home productivity in
producing X.
3. The domestic value of foreign wages.
Therefore, an increase in the home wage could be possible via one of the
following three ways: an increase in the terms of trade; or an increase in the Greek
labor productivity, that is a reduction in ·LX, relative to Bulgarian productivity
·*LY; or finally via an increase in the exchange rate, that is by an exchange rate
depreciation. An increase in labor productivity can be brought about by investment
in capital (both physical and human capital). An increase in the terms of trade
depends upon international demand conditions and it is denoted by a shift of the tt
schedule to the right, showing that the relative price of the home produced good is
higher resulting in a higher wage for the home country.
2.3.2 Exchange rate and international trade

We turn now to examining the limits of the exchange rate by analyzing how
exchange rate and wages are related. In order for good X to be exported, it has to
be cheaper in Greece than in Bulgaria,16 i.e. PX < PX*, which implies, using (8), that
e > (·LX /·*LX) (W/W*). (10)
Similarly, for good Y to be exported from Bulgaria into Greece, it has to be

cheaper than the Greek price,17 PY > PY*, which implies
e < (·LY /·*LY) (W/W*). (11)
Thus combining (10) and (11), we have the interval for the exchange rate
(·LX /·*LX) (W/W*) < e < (·LY /·*LY) (W/W*). (12)
That is, the exchange rate is within the interval determined by the ratio of home
and foreign productivities in goods X and Y and the ratio of home and foreign
wages.18 Values of e less than the lower limit make good X too expensive in Bulgaria,
while values of e above the upper limit will make Greek imports too expensive. Only
if e is within this interval will international trade be mutually beneficial for the two
countries, according to the principle of comparative advantage.
In sum, in Section 2.3 we analyze the relation between the international prices of
the two goods and the wages and labor productivity in the two countries. We show
16
Where PX*= (·*LX) (e W*).
17
Where PY*= (·*LY) (e W*).
18
Or (Px /Px*) < e < PY/PY*.
45
that an improvement in home wages can be brought about by either an increase in
the terms of trade or by an improvement in home labor productivity. Finally, we
analyze the role of exchange rate and we find its limits in order to have mutually
beneficial trade between the two countries.
If ·LX = 5 ; ·LY = 6 and ·*LX = 6; ·*LY = 7 then what should be the interval for the Greek
wage, so that, according to the comparative advantage principle, Greece would export
good X and import good Y from Bulgaria?
46
CHAPTER 2
In Chapter 2, we presented and analyzed the production possibilities frontier
(PPF), which shows the maximum output a country can produce under full
employment of its resources and the best available technology. We made the
assumption of constant unit labor costs in the production of both goods19 and we
used the production possibility frontier to show the real gains that countries can
obtain by being involved in international trade. These gains depend on the
international demand for good X and will be larger the higher the terms of trade
are. We also analyzed the relation between the international prices of the two
goods and the wages and labor productivity in the two countries. We showed that
an improvement in home wages can be brought about by either an increase in the
terms of trade or by an improvement in home labor productivity. Finally, we
analyzed the role of exchange rate and we found its limits, in order to have
mutually beneficial trade between the two countries.
19
That is the assumption of fixed factor proportions; however here we have assumed that labor is the only
input.
47
APPENDIX
Activity 1
The PPF in the numerical example in Figure 1 is given by

120 = 5X + 6Y or Y = 20 – (5/6) X.
The relative price of X, which is given by the MRT, is

MRT = (5/6) = 20/24 = 0.83333.
Consumers spend an equal share of their income on each good when 5/6 as much Y is
consumed as X, or 120 = 5X + 6 (5/6X) = 10X. That is, X = 12 and Y = 10. We may confirm
that 5x12 = 6x10 = 60 = 120(1/2).
When the PPF is changed due to improved technology in X, the new PPF is given by 120 =
4X + 6Y or Y = 20 - (4/6) X and MRT = (4/6) = 20/30 = 0.666. Consumers spend an equal
share of their income on each good when 4/6 as much Y is consumed as X, that is 120 = 4X
+ 6 (4/6X) = 10X, so that X = 15 and Y = 10.
Finally, when the PPF changes due to a higher population, we have

180 = 5X + 6Y or Y = 30 - (5/6)X and MRT = (5/6) = 30/36 = 0.83333.
Consumers spend an equal share of their income on each good when 5/6 as much Y is
consumed as X. That is, 180 = 5X + 6 (5/6X) = 10X so that X = 18 and Y = 15.
Clearly, comparing the three consumption bundles of X and Y and assuming that more of a
good is better,20 consumers are better off with the higher consumption resulting from the
higher population.
Activity 2
To show this, we evaluate the consumption bundle at point K in terms of good X, that is 75 X
+ (3 á 75 X) = 300 Y, that could be illustrated by the intersection point of the dotted line,
indicating the pre-trade prices of X, that passes through point K with the horizontal axis at
point 300. Since maximum production and consumption of X in pre-trade was 150, the real
gains from trade are 300 - 150 = 150 units of X.21 Thus, the percentage increase in terms of
real income22 due to international trade is 100%.
20
That is, there is no satiation for the consumer.
21
In terms of Figure 6, these 150 units of Y are exactly the distance on the horizontal axis between the
PPFGreece and the line that passes through point K and shows pre-trade price of X.
22
This is when real income is measured in terms of good X.
48
CHAPTER 2
Activity 3
If ·LX = 5 ; ·LY = 6 and ·*LX = 6; ·*LY = 7, then using (12) we have

(5/6) (W/W*) < e < ( 6/7) (W/W*)
which implies that

(7/6) (ew*) < W < (6/5) (ew*)
or that
1.166(ew*) < W < 1.20(ew*).
That is, home wages have to be between 1.166 and 1.20 higher than the foreign wages in
order for trade to be mutually beneficial for the two countries, as suggested by the
comparative advantage principle.
49
BIBLIOGRAPHY
RECOMMENDED READING
Paul, MN 1995, pp. 31-35.
Salvatore D., International Economics, Seventh Edition, John Wiley & Sons, New
York 2001, pp. 42-57.
50
CHAPTER 3
INTERNATIONAL TRADE
AND TRADE POLICY
M. Vlassis
The scope of Chapter 3 is to address the basic arguments for free international The Scope
trade and lay out the tools for analyzing issues in trade policy. The topics covered of the Chapter
include the production possibilities frontier, measures of the gains from trade, economic
development and international trade, and trade policy.
ñ familiar with the basic tools used to address and analyze issues in international Objectives
trade and trade policy
ñ able to evaluate the effects of international trade and trade policy on the creation
and (re)distribution of income.
ñ Gains from trade Key Words

ñ Diminishing marginal returns
ñ Increasing opportunity costs
ñ Marginal rate of substitution
ñ Marginal rate of transformation
ñ Nominal prices
ñ Relative prices
ñ Terms of trade
ñ Import substitution
ñ Export promotion
ñ Subsidies
ñ Immiserizing growth
Chapter 3 explains how and why overall gains can be enjoyed from free international Introductory
trade. Yet nations often hinder international trade with tariffs, quotas, foreign Comments
exchange controls, export subsidies and other methods of trade policy. In any of
these instances, effects on income creation and redistribution emerge. This chapter
(along with the chapter that follows) provides basic training in the analysis of
international trade in relation to protectionism and trade policy.
51
3.1 THE PRODUCTION POSSIBILITIES
FRONTIER
Economies as well as firms and industries are constrained in their production
possibilities because labor, capital and other inputs/factors of production are
limited, at least for a certain time period. By this token, and given the status of
technology, the Production Possibilities Frontier (PPF) summarizes an economy’s
potential to produce. Effectively, it depicts the influence of relative prices on the
economy’s pattern of production and implies the potential gains from trading with
other economies.
As an illustration, consider an economy producing two types of output: Textiles
(T) and computer software (S). Prices and volumes of both outputs are determined
in separate markets. The prices of the factors of production used to produce either
type of output are determined in the relevant factor markets. In a closed as well as in
an open economy setting, economic activity can then be summarized by the circular
flow diagram shown in Figure 1.
Domestic Foreign
Firms Firms
Domestic Foreign
Consumers Consumers
Domestic Foreign
Government Government
National
Boundary
Figure 1: Economic Activity within/across National Borders
To interpret Figure 1, note that the solid arrows represent flows of goods and
services, the dotted arrows represent factor flows, while payments flow in the opposite
direction(s). Foreign firms enter the picture by (buying) selling their (intermediate
inputs) outputs to (from) domestic firms, consumers, and government; while
domestic factor owners can supply labor, as well as capital and other resources, to
foreign firms (or the foreign government).
52
CHAPTER 3
3.1.1 Increasing marginal opportunity costs

As said, the PPF (shown in Figure 2) summarizes the entire domestic economy’s
production possibilities. Its curvature depicts the fact that the marginal opportunity
costs of production of either T or S are increasing.
C
300 B
275
A
200
125 P
100
Q
50 100 150 300 S
125
Figure 2: Increasing Marginal Opportunity Costs
At any point, the slope of the PPF is an estimate of the marginal opportunity cost
of S in terms of ∆, i.e., it shows how much (forgone) ∆ production an extra unit of S
would cost. Note that this slope, hereafter called the marginal rate of transformation
(MRT), increases as more units of S are produced. Hence, the more units of S that
are produced, the more units of ∆ that have to be sacrificed per extra unit of S;
with increasing opportunity costs, the PPF is concave to the origin. This is
effectively due to the fact that, given the status of technology and the deployment
of all other factors of production (inputs), the marginal productivity of each input
is diminishing, i.e., as more units of that input are used in production, the extra
output gained (per extra unit of input) decreases. Hence, the more, say, labor is
used in the production of S, the more labor needs to shift away from ∆ in order to
produce an extra unit of S.
3.1.2 Autarky equilibrium and real income

In autarky, consumers choose the point along the PPF they want, according to
their demand for T and S, while producers’ choice is represented by the PPF.
Effectively, the latter’s slope (e.g. the MRT) at any point measures the price of S
relative to T which producers are willing to accept in order to cover S’s relative
opportunity cost (in terms of forgone T). In the background, factor markets determine
payments to factor owners. This in turn determines consumers’ incomes and,
hence, influences their demand for T and S. All markets are linked together and
interact to determine the general equilibrium.
53
The choice made by consumers can be pictured with indifference curves. As
shown in Figure 3, consumers will choose the (T, S)-bundle on the highest possible
indifference curve. That is, given the PPF, in autarky, consumers will choose bundle
A, where their utility is higher relative to the also possible bundles B and P. In
consequence, the autarky equilibrium will be at A.
300
B
200 A
III
100 P
II
I
MRS=MRT
100 150 S
Figure 3: Consumer Choice in Autarky
To explain the equilibrium, first note that the slope of an indifference curve,
called the marginal rate of substitution (MRS), at any point measures the consumers’
evaluation of S relative to ∆. That is, MRS measures how many units of ∆ consumers
are willing to give up, in order to get an extra unit of S and still stay on the same
indifference curve. In other words, MRS measures the price of S relative to ∆ which
consumers are willing to pay. Then, at A, and only there, MRS equals MRT, i.e.,
consumers value the last unit of S as much as its opportunity cost (in terms of
forgone ∆) and, hence, the relative price of S will be in equilibrium. In contrast, at B
(P) consumers value the last unit of S more (less) than its opportunity cost and,
hence, the relative price of S will increase (decrease) in a market economy. As a
direct consequence, the tangent line to the PPF, at the autarky equilibrium point A,
indicates the value of the national output expressed in units of either good (∆ or S).
In sum, Section 3.1 suggests that the domestic price line (its absolute slope
measuring the relative price of S) provides a consistent measure (in terms of S or ∆)
of the economy’s real income in autarky. Then, a straightforward way to measure
the gains from international trade is to check whether trade increases real national
income valued at domestic prices, or equivalently, to check whether international
trade leads consumers to end up with a bundle of goods valued higher at domestic
prices (i.e., moves them to a higher indifference curve relative to autarky).
54
CHAPTER 3
Figure 4 below depicts the economy’s equilibrium bundle in autarky (point A). Assuming
that the price of ∆ is $5, find and analytically reason the value of the economy’s national
(nominal) income at A.
T
500
T/S=2
400
300
A
200
100 150 200 250 S

Figure 4
55
3.2 SPECIALIZATION
WITH INTERNATIONAL TRADE
3.2.1 Response to international prices

There are two ways for an economy to end up with higher consumption, utility
and national income: first, by expanding its resource base and/or improving
technology, i.e., by shifting outward its PPF in autarky; or second, through
international specialization and trade. As an illustration, consider first the situation
depicted in Figure 5.
T
625
T/S=tt=4
400
300
200
A
125
100 P
100 125 1561/4 S
Figure 5: Specialization as a Response to International Prices
In autarky, the economy produces and consumes at point A, with a (domestic)

relative price of S, T/S=2. Yet, the international ∆/S price, measured by the absolute
value of the slope of tt, equals 4 (e.g., in the international market each unit of S can
be exchanged for four units of ∆). In addition, the economy is small relative to the
international market and, hence, whether the economy trades or not, the
international price will not be affected. Then, it is easy to guess which market
domestic firms producing S will choose. If, at home, the nominal price of a unit of ∆
is $2, the nominal price of S is $4 at home and $8 in the international market. Hence,
the higher international price of S provides the incentive to export. Effectively, the
economy will specialize in the S sector, moving from the autarky production point A
56
CHAPTER 3
to production point P. As next depicted in Figure 6, real gains from trade evolve for
the specialized economy.
T/S=tt=4
300
205 Z
A
III
125 P
105 125 S
Figure 6: Gains from Specialization and Trade
The specialized economy produces 125 units of S (25 more relative to autarky)
and 125 units of ∆ (75 less relative to autarky), trading 20 units of S for 80 units of
∆, at the international price indicated by the absolute value of the slope of the
terms-of-trade line, tt = 80/20 = 4. Therefore, with specialization and free trade,
domestic consumers end up with consumption at bundle ∑, where the MRS along
indifference curve III equals the relative price of S in the international market. As
can be checked by comparing III with II (the indifference curve at the autarky
consumption bundle A), consumers will thus move to a higher utility level. The
same is shown by the trade triangle: with free trade consumers enjoy more of both
goods relative to autarky. Then, the real gains from trade are easily found by
valuing consumption (with trade) at domestic autarky prices. In terms of S, the
specialized economy gains 7.5S relative to autarky. At this point, two important
notes should be further addressed:
ñ First, there can be overall gains from free trade even if less of some particular
good is then consumed, relative to autarky. The reason is that trade allows
domestic consumers to enjoy bundles of goods beyond their economy’s PPF,
and this does not necessarily imply that their most preferred bundle will contain
larger quantities of any good.
ñ Second, since foreign firms similarly have a cost advantage in producing the
goods which the economy under consideration imports, some domestic firms
will go out of business as the economy adjusts from A to P. Or, the same firms
may switch some of their activity from production to importing; as cheap T is
bought from abroad, the domestic T industry is forced to adopt the lower price
and, hence, lower its output. As shown in Figure 7, this costly adjustment places,
temporarily, the economy below its PPF.
57
T
Figure 7: Short-Run Costs from Specialization
The economy’s adjustment to international trade follows the path with arrows.
Since resources originally devoted to the ∆ sector (e.g. specialized labor and/or
textiles, capital machinery and equipment) are not suitable for S production, costs
of retraining, retooling and relocating must be paid out of scarce economic resources
(that is, adjustment frictions). Hence, the economy temporarily produces less than it
would in the absence of such frictions, and as adjustments are made, eventually
moves to P.
In the example depicted in Figure 6, calculate the gains from trade in terms of national
(nominal) income.
3.2.2 Economic development

As said, economies may develop by expanding and/or improving their resource
base, as well as by improving technology (e.g., the techniques used in combining
the various inputs – especially capital and labor – to produce the output). This
process can be pictured by an outward shift of the PPF; as the economy develops,
it produces more of every good, while it may also establish new industries (sectors
of production). To this end, international trade may bring export led growth: with
specialization and exports an economy becomes more attractive to foreign
investment, while as the economy opens, workers get more training in order to
compete effectively in international markets. For these reasons government
policy aiming at the economy’s international specialization is called export
promotion.
Yet, the governments of many least developed countries (LDCs) have tried
import substitution, i.e., to replace imports with domestically-produced goods. The
58
CHAPTER 3
motivation for that typically is the belief that “the economy should be able to provide
for itself.” Figure 8 depicts how losses emerge from import substitution.
T
tt
ttã
Z
Zã
A
IS
Figure 8: Losses from Trade Contraction
Originally, with free trade the economy produces at point P, specializing in S and
trading it for ∆ at the international terms-of-trade line tt. An import substitution policy
induces the economy to move up its PPF, toward the autarky point A, and to produce
at point IS. Then the economy effectively trades at the line ttã consumers are “forced”
to a lower level of utility, and real income falls from point Z to point Zã Nevertheless,
there is often the sentiment that LDCs should not be “exploited” by the developed
countries (DCs); when a large multinational firm invests domestically and produces
goods for exports, protests against “labor exploitation” are raised. Domestic firms that
would benefit through avoiding international import competition promote this
sentiment. The workers in those firms also favor the import substitution policy, since
they thus expect more jobs.
In contrast, countries that specialize and trade are expected to have higher income
and grow faster. Figure 9 depicts a situation of export led growth, where the PPF
expands outward and this expansion favors the (export) good T.
Pã
Zã
P Z
Figure 9: Specialization and Long-Run Expansion
59
Originally, the economy produces at point P and trades to point ∑, according to
the international terms of trade. Then note that the terms-of-trade line determines
the exact production point at which the optimal development pattern must be
realized. Regarding the latter it is obvious that, as the economy develops, its potential
to produce ∆ grows faster than its potential to produce S. This bias in growth can be
due to foreign investment, improved labor skills, adoption of new technology, in M.
Hence, so long as the terms of trade do not change, with (∆-) export led growth the
economy produces at Pã and consumes at Zã. After development consumers enjoy a
higher level of utility and higher real income (compare trade triangles also).
However, export led growth can lead to a fall in the terms of trade (enough to
make the exporter worse off after growth), if the economy under consideration is a
major supplier of the exported good and world demand is sufficiently inelastic. Figure
10 depicts this case, which could be characterized as an instance of immizerising
growth.
T
ttã
tt
Pã
P
C
Cã
Figure 10: Growth and Deterioration in the Terms of Trade
Note that before growth the terms-of-trade line (tt) led to consumption at point
C. With growth, the terms of trade fall to ttã. Hence, after growth consumption
ended at Cã below original consumption C, denoting a lower level of utility and
lower real income. Yet, nations do not generally affect their terms of trade when
expanding their exports.
In sum, Section 3.2 suggests that, especially for a small LDC, the threat of
immizerizing growth should not be used as an argument in favor of protection and
import substitution. On the contrary, the potential to specialize in order to export
generates incentives for investing in export-oriented sectors, leading to greater
production possibilities and ultimately higher income. In this process, multinational
firms may provide LDCs with both physical and human capital, in the forms of
equipment, skilled labor, and management. Thus, policies promoting foreign
investment also encourage capital accumulation. Therefore, despite some
reluctance to “sell out” to foreign interests, the gains from specialization, trade and
growth are too great to be pushed aside.
60
CHAPTER 3
3.3 TRADE POLICIES

Trade policies aim to manage the composition and direction of trade. In practice
this means that governments try to help selected domestic industries to expand
through international trade. These favorable policies typically include export
subsidies, free trade zones, and free enterprise zones, while at the same time
governments protect domestic industries competing with imports. Thus, in the
background, trade policies can often be carried out under pressure from industries
seeking favors, in exchange for political support and financial contributions that
help keep politicians in office. On the other hand, however, promoting an export
industry seems more desirable than currency devaluation. The latter would
increase the price of imported intermediate goods/inputs and, hence, would
increase production costs and the price of consumer goods. These, in turn, might
also discourage inward foreign investment.
The simplest type of export subsidy is a direct payment per unit of the good
exported. Other subsidies come in the form of reduced taxes on profits, wage
subsidies, or waivers on tariffs of imported intermediate goods/inputs. In addition, the
government may sponsor research and development (R&D) in the export industry.
All these devices reduce costs and thus enable exporting firms to sell at a lower
price in the international market. On the other hand, since the revenues needed to
finance the subsidy are typically raised from taxes levied on domestic taxpayers, an
export subsidy effectively taxes domestic consumers. As an illustration, consider
the case depicted in Figure 11.
$/export
S
Sã
12
10
5
D
50 100 120 Qexport
Figure 11: A Subsidy Taxes Domestic Consumers
Prior to an export subsidy, and given the international price ($10) for the particular
good, the domestic supply (S) and demand (D) schedules led to 50 units exported.
With a $2 per unit export subsidy, domestic supply increases from S to Sã 20 more
61
units are exported and, thus, export revenues increase by $200. In consequence, some
firms that would not have produced without the subsidy may now enter the industry,
and inefficient production is encouraged. In addition a $240 tax burden is created, to
finance export promotion. Hence, even if national income increases with a subsidy,
income is redistributed by the subsidy and the tax: firms, stockholders and workers in
the export industry will benefit at the expense of taxpayers. Yet a subsidy can lead to
long-run gains if it successfully biases growth toward an industry with rising prices in
the international market. This is rather unlikely however; economic growth is a
complicated process and governments cannot manage this process any better than
markets.
As mentioned, trade policy is often served through free trade zones (FTZ) and free
enterprise zones (FEZ). The former denote an area inside a country exempt from
tariffs on intermediate goods/inputs and capital goods, while taxes on foreign
investment can also be lower therein. Effectively, FTZs increase international trade
and investment, by relaxing protectionism at least inside the FTZ. Protectionism
can also be partially relaxed by means of a FEZ, a designated area wherein goods
and services are traded free of tariffs, quotas and administrative hassle. In terms
of efficiency, neoclassical economic theory favors both FTZs and FEZs; if the
entire economy were an FEZ, there would be free trade and more gains could be
exploited.
In sum, Section 3.3 suggests that, as regards export promotion, taxpayers would
be unwilling to lend support to industrial trade policy if they realized that they
would thus subsidize selected industries and foreign consumers, with unforeseen
long-run growth effects. Hence, since any proposed policy must pass the economic
test of weighing its costs versus its benefits, so far both theory and evidence seem to
favor free trade over the use of subsidies or any other industrial trade policy.
62
CHAPTER 3
The shape and position of an economy’s production possibilities frontier
illustrates two facts:
ñ First, the economy’s production resources are limited.
ñ Second, the (marginal) opportunity costs of production are increasing.
Then, given the domestic consumers’ preferences, relative prices determine
the economy’s best output bundle in autarky. Therefore the fundamental source
of the gains of trade effectively is that specialization and trade allow an economy
to consume a more highly-valued output bundle which is beyond the economy’s
potential. In other words, specialization and trade allow consumers to enjoy a
level of welfare beyond what their economy’s production possibilities frontier
allows in autarky. By the same token, export-led growth increases welfare.
Economic development, leading to an expanding production possibilities
frontier, may thus be driven by specialization with an exports perspective.
Yet inefficient export promotion and/or import substitution policies are used
in many countries, pursued by industrialists and politicians, whilst there are
other means of industrial trade policy, like free trade/enterprise zones, which are
efficiency-enhancing, since they promote specialization and exchange).
63
APPENDIX
Activity 1
At A the economy’s national income can be alternatively valued in terms of 400 units of T or
of 200 units of S. Since, in equilibrium, MRT = T/S = 2 (that is one unit of S is exchanged for
2 units of T), at A the economy produces 200T + 100S (= 200T) = 400T, or, 100S + 200T
(= 100S) = 200S. In terms of T the value of national income, therefore, is $(5/T)á400T =
$2000. Equivalently, since the nominal price of S must be twice the nominal price of T (as
T/S = 2), in terms of S the value of national income is $(10/S)á200S = $2000.
Activity 2
In terms of S, since the economy gains 7.5S from free trade, and the (domestic) nominal
price of S is $4, the economy gains $30 in terms of national income. On the other hand, in
terms of T the economy gains 15T (= 5T + 5S (= 10T)) from free trade. Hence, since the
nominal price of T is $2, the economy’s gain in terms of national income is equivalent to
$30.
64
CHAPTER 3
BIBLIOGRAPHY
RECOMMENDED READING
Krugman P., “Myths and Realities of US Competitiveness,” Science, November,
1991.
65
CHAPTER 4
PROTECTIONISM
M. Vlassis
The scope of Chapter 4 is to study protectionism, that is, to address and analyze The Scope
policies which alter the pattern of production and trade in order to “protect” domestic of the Chapter
industry from foreign competition. The topics covered include tariffs on imports,
quotas and other non-tariff barriers to trade, the distortion on production caused by
protection, and the political economy of protection.
After completing the study of Chapter 4, the reader will be: Learning
ñ familiar with the basic international trade theory that examines the causes, tools, Objectives
and effects of trade restrictions
ñ able to understand and evaluate the arguments against protectionism as well as
why the latter evolves, and still continues, in many economies.
ñ Tariffs Key Words

ñ Quotas
ñ Non-tariff barriers
ñ Voluntary export restraints
ñ Legal trade restrictions
ñ Dumping
ñ Effective protection
ñ Deadweight loss
ñ Production distortion
ñ Smuggling
ñ Rent seeking
ñ Logrolling
Chapter 4 develops a partial equilibrium framework of market supply and demand Introductory
necessary to understand and evaluate the effects of protectionism. It also uses the Comments
production possibilities frontier tool of analysis in order to develop a picture of
adjustment to protectionist policies across the economy. It is clearly shown that
protectionism restricts the beneficial effects of exploiting comparative advantage,
specialization, and free trade: protectionism restricts international trade, lowering
national income and making its distribution more uneven. Yet those who benefit
from protectionist policies are more likely (than those harmed) to be organized
and to spend resources to lobby and influence political decisions.
67
4.1 TARIFFS
A tariff is essentially a tax levied on an imported good. Therefore, the domestic
consumer ends up paying a higher price. Yet, as regards the government levying
that tax, tariffs have the two-fold advantage of being inconspicuous and easy to
collect; tariffs have historically been a popular way for governments to raise
revenue, and many governments have raised most of their revenue with tariffs.
Tariffs can be levied on finished products or they can be hidden in intermediate
goods to be used as (imported) inputs for domestic output. Thus, the effective rates
of protection include protection on inputs, and effective protection is defined as the
% of domestic value added that is shielded by tariffs, where domestic value added,
say V, refers to the share of the price of a final product accounted for by domestic
inputs. Therefore, protection is valued relative to V: if P*(p*) is the international
price of the finished (intermediate) good and T (t) respectively is the tariff rate, the
effective rate of protection (ERP) is defined as ERP=(TP*-tp*)/V. As an example,
assume that for a finished product in the textiles industry, P* = $20, T = $2, and
the domestic producer imports textiles worth $12 per unit of the finished product.
Hence, V = $8. Then, if t = 0, T (= $2) protects domestic value added by $2/$8 =
25%. If, however, t = 0.05 is levied on imported textiles as well, it will reduce the
ERP to ($2 – $0.60)/$8 = 17.5%.
Note that if t = x, so that xá$12≥$2, then the ERP≤0. The domestic producer
may even operate at a net disadvantage because of the tariffs. Yet, as shown in the
following illustration, domestic consumers will typically pay a higher price and end
up consuming less with a tariff.
The effects of a tariff on the domestic market are depicted in Figure 1.
$/T
15
10
F
C G B
6 D A
5
E
D
100 120 270 300 T
Figure 1: The Deadweight Loss of a Tariff
68
CHAPTER 4
The international price of good ∆ is $5. With free trade, and since the economy is
a price-taker in the international market, at that price, 300 units of ∆ are consumed
(along D), while 100 units of T are domestically produced (along S). Hence, 200
units of ∆ are imported. Suppose that a 20% tariff is levied per unit of ∆ imported.
Then, the domestic price of ∆ rises to ($5 + 0.2$5) = $6, and as domestic producers
and consumers respond to the higher price, adjusting domestic supply and demand
for ∆ along S and D, the following market results are easily predicted: (i) domestic
production increases by 20 units; (ii) domestic consumption decreases by 30 units;
and (iii) imports decrease by 50 units (e.g., by 25%). Does the economy gain from
the tariff? To find out note that:
ñ Consumers lose the consumer surplus area (A + B + C + D) = $285.
ñ Producers gain the producer surplus area D = $110.
ñ The government raises tariff revenue equal to the area A = $150.
Therefore, as tariff revenues are redistributed back into the economy in the
form of government spending (presuming that the government is benevolent),
triangles B and C represent a $25 deadweight loss from the tariff, essentially a loss in
consumer surplus which is not offset by the government revenue or the producer
surplus.
Domestic consumers of good ∆ are thus hurt by the tariff. However, domestic
firms that compete with imports are helped. The workers of those firms also gain
(in terms of more jobs and possibly higher wages), as do the owners of the capital
employed in the ∆ industry (yet, the latter groups must also pay a higher price for
∆). Hence, since the net gains to “winners” can be sizeable, they may find it
worthwhile to spend money lobbying politicians for protection. Politicians (for
instance, Parliament representatives) may in turn find it worthwhile to accept the
money. Political support and/or contributions can then explain the bias toward
protectionism, despite the social loss it brings about.
In sum, Section 4.1 suggests that the inefficient organization of production,
resulting from tariffs, creates losses. Firms that cannot effectively compete are
encouraged to continue operation, while valuable productive inputs are spent
making products available at cheaper prices on international markets. Essentially,
tariffs drive the domestic economy to produce substitutes for the products it should
be importing instead of concentrating on profitable export production. Losses are
moreover incurred through the lobbying efforts of the industry and the labor groups.
Use Figure 1 to explain the effects on economic efficiency and income redistribution, of a
tariff high enough to seize imports.
69
4.2 NON-TARIFF BARRIERS
4.2.1 Quotas
A quota is a quantitative restriction on the level of imports, i.e., the level of
imports cannot exceed the quota even if the imported good is priceless. In general,
quotas provide more protection than tariffs for domestic import-competing
industries and cost the economy more. The reason for that essentially is that quotas
force all adjustment onto price. In effect, in markets with growing demand or
declining supply, prices will rise more with a quota than with a tariff. Other non-
tariff barriers have similar effects.
As an illustration, in Figure 2 consider the case of a quota instead of a tariff issued
on T-imports.
$/T
15 S
10
C B
6 D A
p*=5
D
100 120 270 300 T
Figure 2: The Deadweight Loss of a Quota
A quota of 150 units on the imported good ∆, drives the domestic price to the
level where imports (= quantity demanded – quantity domestically supplied) =
150. Thus, technically, the case depicted in Figure 2 is similar to the one depicted in
Figure 1, that is, a quota of 150 on ∆-imports brings the same effects on the market
as a 20% tariff per unit of ∆ imported. Yet, the quota creates no tariff revenue.
Hence, it is easy to see that more inefficiency is now created. The deadweight loss
from the quota amounts to the area (A + B + C) in Figure 2. Therefore, if this
import market switched to an equivalent tariff, domestic consumers and firms
would be indifferent, while the government would gain the (tariff revenue) rectangle
A. On the other hand, since with the quota (as with a 20% tariff) foreign firms will
70
CHAPTER 4
sell at a price of $6, their export revenues increase to $900 (from $750 with the tariff).
Thus, rectangle A = $150 is now a transfer of consumer surplus, from domestic
consumers to foreign firms (instead of to the government). In effect, this quota
costs the economy $150 more, compared to the tariff (while the tariff costs the
economy $25, compared with free trade). Governments can, nonetheless, raise
revenue by licensing quotas to firms. Thus buying at the international price of $5
and selling at the artificial domestic price of $6, a domestic importer or a foreign
exporter enjoys higher profit. In consequence, if importers were forced to bid for
the right to import, and the bid was competitive, the government could appropriate
almost all of the area A.
As mentioned above, a fundamental difference between quotas and tariffs is
that with a quota the market adjustment to any change in initial conditions is
entirely channeled onto the price. As an example, consider the instance of growing
domestic demand for ∆, depicted in Figure 3.
$/T
S
15
7
6
120 290 T
100 140 270 300
Figure 3: A Quota Raises the Domestic Price
With a tariff, market adjustment falls entirely on the quantity. Since the domestic
economy is small, the international and, hence, the domestic price (as well as
domestic production), remain unchanged. However, the quantity demanded rises to
320 and imports therefore increase to 200.
With a quota of 150, on the other hand, the increase in demand drives the price
up to $7. As a result, consumers are worse off with the quota than with the tariff, as
they consume 30 fewer units of good ∆. That is, at the price of $7, consumption is
290. Yet, (inefficient) domestic production increases to 140.
In general, protected industries prefer quotas to tariffs when the international
price is falling, domestic demand is rising, or domestic supply is falling. The reason is
that, under such circumstances, the domestic industry can maintain its output level
with a quota. On the contrary, domestic industries would be expected to lobby for
tariffs rather than quotas when the international price is expected to rise, domestic
demand is expected to fall, or domestic supply is expected to rise.
71
Use Figure 3 to explain why a tariff would be more effective than a quota, in offering
protection to domestic producers, when domestic demand is expected to fall.
4.2.2 Voluntary export restraints

and legal trade restrictions
Besides quotas, there exist other non-tariff barriers, such as voluntary export
restraints (VERs) and legal trade restrictions. The reason for that is that, in the
context of the GATT, WTO, NAFTA, EU and other free trade agreements, many
industrialized economies are committed to lower tariffs, while at the same time
their governments face the pressure of national industries for protection. As a
response, new methods are devised to circumvent free trade agreements.
For instance, in the USA, the auto industry exercises pressure on the government,
which in turn puts pressure on the Japanese government, in order for the latter to
induce VERs on the part of Japanese automakers. Then, inside the USA, such VERs
have the same basic effects as a quota except that they discriminate among trading
partners; European auto exporters to the USA benefit from the Japanese VERs. Yet,
those VERs implicitly render monopoly power to the Japanese auto industry. Since
the Japanese government acts as the coordinator of the various Japanese auto
makers, it effectively creates a cartel restricting competition in the USA market. As a
result, the profits for the Japanese auto industry, as well as of the other car exporters
to the USA, will rise; the Japanese VERs raise the price of imported cars in the USA,
thus creating spillovers that favor foreign car exporters at the cost of local households.
Legal trade restrictions are popular non-tariff barriers which favor domestic firms
by artificially restricting foreign competition. In most nations, the telecommunications
and electric utility industries are thus protected. By national legislation, lawyers,
doctors, and other specialists are restricted from practicing across national
borders, while national health laws are selectively and unfairly applied to foreign
goods. In principle, licensing of any sort of activity restricts competition. Thus
while benefits may occur from complying with certain product standards, these
benefits should be weighed against their efficiency costs. On the other hand,
monitoring is also needed to ensure the fair application of product standards.
In sum, Section 4.2 suggests that quotas and other non-tariff barriers are more
harmful than tariffs. Besides protecting the status quo of inefficient production,
they distort the overall pattern of trade, raise prices, and lower real income.
72
CHAPTER 4
4.3 PRODUCTION DISTORTIONS

Whilst it may lead the economy to lower bounds of production, protection
moreover results in efficiency losses by distorting the international pattern of
production. Here the focus turns to how much extra income the economy could
produce by giving up protection and specializing in what it does more efficiently.
To analyze this issue, consider the situation depicted in Figure 4.
600
tt=2
Zã
430 Z
400
A
Pã
200
P
435 550 600 S

400
Figure 4: A Tariff Distorts the Pattern of Production
Autarky production and consumption is at point A on the production possibilities

frontier (PPF): with no international trade, the economy’s representative consumer
maximizes his/her utility, given that there is full employment of the economy’s
resources and complete efficiency in production. If, however, the economy engages
in trade, and given the terms-of-trade line, tt=T/S=2, specialization (in S) will
move production to point P and consumption to point ∑. Since the economy can
trade at the world’s relative price of S, i.e., 2 units of imported ∆ per unit of exported
S, the consumer equilibrium will be at ∑ and, hence, more of both goods will be
consumed with specialization and free trade. Consumers are better off in that real
income and the level of utility are higher. The reason for this improvement
essentially is that the economy has a comparative advantage in S (e.g., it has a low
relative price of S in autarky). Thus, it gives up relatively few units of ∆ as it switches
to S production, while it gains relatively more units of (imported) ∆ per unit of S
(exported).
A tariff on ∆ imports will distort this efficient pattern of production and trade.
The relative price of ∆ inside the country effectively increases with a tariff and, hence,
production moves to point Pã. As a result, the economy specializes less in S with the
73
tariff. This production distortion essentially wastes resources on ∆ production, whose
output is low-priced in the world market. Note that, at point Pã, 2 units of ∆ are
still imported per unit of S exported, but consumption falls to point Zã; a tariff
reduces the domestic consumers’ potential to consume both goods. Thus, the
economy’s real income (measured in terms of either T or S at the autarky price)
decreases, while there are further adjustment costs as the country changes its pattern
of production (from P to Pã).
A tariff can nonetheless improve the terms of trade if the country under consideration
is a large consumer of the particular product in the world market. The reason is that
the decline in international demand (brought about by the tariff) will decrease the
product’s international price. As a result, so long as the terms of trade adequately
improve, the country imposing the tariff may benefit from it (e.g., the ttã line
rotates outward beyond point Z). Yet, this optimal tariff argument is not enough to
justify tariffs. Even if the appropriate conditions for an optimal tariff are found,
ceteris paribus, such a policy may lead to a tariff war among large countries. Then,
the conditions that ex ante led to a (unilaterally) optimal tariff may ex post prove to
be absent.
Explained as a rational response to protectionism, smuggling is illegal trade
aiming to bypass protection and prohibition. Today, the volume of smuggling is
estimated to be around 10% of the total volume of international trade. A smuggler,
like any rational economic agent, evaluates the benefits versus the costs of smuggling
(including the probability of being caught and penalized). Not surprisingly, smuggling
will then increase the degree of international specialization and trade, helping the
economy to move closer to an efficient allocation of resources. By the same token,
however, smuggling spends more resources (relative to free trade) since the goods
are more costly to distribute illegally.
In sum, Section 4.3 suggests that, from an international perspective, a tariff leads
to an inefficient pattern of production. Tariffs prevent an economy from specializing
according to its comparative advantage and thus reduce consumption possibilities
and real income.
74
CHAPTER 4
4.4 POLITICAL ECONOMY

CONSIDERATIONS
The basic economic arguments so far reviewed against protectionism seem to
be enough to persuade both businesspeople and politicians to opt for free trade.
Under protectionism, economies suffer from lower income, misallocation of
resources, and decline in competitiveness. At the same time, protectionism induces
illegal activity (smuggling) and reallocates income at the expense of consumers.
Then, the question naturally arises as to why protectionism has persisted for so
long in many economies. To answer this inquiry the analysis needs to incorporate
political economy considerations.
Rent Seeking and Lobbying

Since they will benefit from it, firms/industries are willing to spend resources in
order to buy protection. Then, the political process works as follows. The Parliament is
the institutional body that establishes trade legislation. The Parliament representatives
are typically elected from districts that have a single large firm or industry. So long
as these firms are seeking protection, they are willing to lobby representatives and,
for that reason, contribute to their political campaigns. Thus, political campaign
contributions are tied to the representative’s voting behavior in the Parliament.
This rent seeking activity is inefficient, since the resources spent for lobbying could be
used to produce goods and services. The representative, in turn, trade votes in the
Parliament (logrolling), in order to gain enough support from other representatives
for the particular legislation he/she favors, in exchange for his/her support for the
legislation which is in the latter representatives’ special interest. Typically, the
outcome of this process is the passage of laws which pool many individual tariffs and
quotas together, each of them being in the narrow interest of some representative(s).
Of course, a representative who does not protect local industry will then find it
difficult to be elected again. On the other hand, consumers may suffer with protection,
but they are typically disorganized and, thus, unable to influence this political process
(by lobbying as well).
Political Competition
An alternative political economy reasoning of protectionism can be illustrated
by means of Figure 5.
75
Thousands
of votes
MC
300
200
100
MB
5% 10% Tariff rate
Figure 5: The Optimal Tariff Maximizes Expected Votes
Political parties, competing for office, expect to gain the support of some
groups of voters by imposing tariffs. Typically, these groups include: the workers of
the protected industry, who are expected to support the political party that delivers
protection for their jobs; the stockholders of protected firms; and the
owners/workers of other local businesses. On the other hand, as already shown,
tariff protection creates distortions: importing firms are harmed, prices increase,
and real income falls. These distorting effects are expected to “translate” into less
political support for the tariff. In Figure 5, this fact is reflected in the upward-
sloping MC schedule, showing that as the tariff rate increases, its MC – in terms of
votes lost – increases. In contrast, the downward-sloping MB schedule depicts the
fact that as the tariff rate increases, the expected gain in political support decreases;
the most votes would be gained by the lowest tariff, and higher tariffs lead to fewer
votes gained. In consequence, the politically optimal tariff (10%: MB = MC) is the
one that maximizes the expected votes for the protectionist party and, hence, the
probability of (re) election to office.
Dumping Allegations
Firms opting for protection may base their claims upon allegations of unfair trade
competition on the part of foreign firms via dumping practices (i.e., temporarily
selling below cost). Effectively, subsidies by foreign governments to their export
industries are considered to be unfair by domestic firms, even though foreign
taxpayers are thus subsidizing domestic consumers. However, these dumping
allegations cannot be proven unless foreign cost data can be submitted. Hence, claims
against dumping are based on the politics of protection rather than on economic
evidence.
76
CHAPTER 4
Union Goals
Labor unions, which typically opt for protectionism, often pursue goals in trade
policy. In the USA, for instance, some of their most common recommendations
are to:
ñ Negotiate bilateral trade deficit reductions.
ñ Address unfair trade practices.
ñ Enact domestic content laws.
ñ Enact policy to process raw products before export.
ñ Extend VERs.
In sum, Section 4.4 suggests that even if consumers (who lose because of higher
prices and fewer goods) were completely aware of the costs of protectionism, they
would find it difficult to organize and lobby against it, while, on the other hand,
industries and labor unions are organized and thus able to influence the decisions
of politicians. Moreover, the attitude of consumers can be affected by local
protectionism: It is difficult to find people who would favor the opening up of a
local protected industry to foreign competition if relatives and friends would then
be threatened with the loss of their jobs.
77
ñ Protectionism introduces distortions in the pattern of international production.
It, thus, promotes inefficiency and waste of resources. Consumers lose in terms
of higher prices and fewer goods, while the economy suffers lower real income.
ñ The benefits of protectionism can be measured in jobs saved.
ñ ∆o date, the evidence suggests that the ratio of costs to benefits is much higher
than unity. Nonetheless, even if consumers were aware of this ratio, it is
difficult to organize and lobby against protectionism. On the other hand,
domestic firms open to international competition seek and lobby for
protectionism and typically find that the labor unions are their allies in that
quest.
ñ ∆he free trade versus protectionism debate will continue so long as the benefits
to protected industries and workers outweigh the costs associated with lobbying
to acquire protection. In addition, the possibility remains that the terms of
trade for a large economy may improve with protectionism (tariffs).
78
CHAPTER 4
APPENDIX
Activity 1
Prior to a tariff, the international price of good ∆ is $5. With free trade, and since the
economy is a price-taker in the international market, at that price, 300 units of T are
consumed, 100 units of T are domestically produced, and 200 units of T are imported. With
a 100% tariff levied per unit of ∆ imported, the domestic price of ∆ rises to $10, and thus
domestic producers adjust domestic supply (along S) so as to cover the entire domestic
demand (which decreases, along D, after the tariff). Imports are therefore seized. Then, it
can easily be seen that:
ñ In terms of consumer surplus, domestic consumers lose: (A + B + C + G) + (the area

that corresponds to producer surplus gained with the tariff).
ñ The government raises no tariff revenue.
Hence, since there is no tariff revenue, the area (A + B + C + G) represents a deadweight

(or efficiency) loss from the tariff. That is a loss in consumer surplus which is not offset by
government revenue or producer surplus. On the other hand, the area that corresponds to
producer surplus gained from the tariff is redistributed from consumers to producers.
Activity 2
To work out this activity, first suppose that the initial conditions in domestic demand were
the opposite of what is depicted in Figure 3 (i.e., the domestic demand for ∆ was initially
high). Then, with a tariff on ∆ imports, and since the domestic economy is small, the
international price and, hence, the domestic price ($7) and production (140) will remain the
same as domestic demand decreases. However, the total quantity demanded domestically
will fall, and thus imports will accordingly decrease. On the other hand, with a quota of 150
originally, the fall in domestic demand drives the price down to $6 (as the quota is no longer
binding). Hence, domestic production decreases to 120.
79
BIBLIOGRAPHY
RECOMMENDED READING
Jones R., Krueger A. (eds.), The Political Economy of International Trade, Blackwell,
London 1990.
80
CHAPTER 5
INTERNATIONAL PRICES
AND THE TERMS OF TRADE
M. Vlassis
The scope of Chapter 5 is to explain how the terms of trade, that is, the price of The Scope
imports relative to the price of exports, are determined along with the volume and of the Chapter
direction of trade. The topics covered include offer curves (explaining how the terms
of trade between two economies are determined), optimal tariffs (designed to
improve the terms of trade), tariff games (addressing strategic interaction among
countries regarding tariffs and protection), and the trade of resources in limited stock.
ñ familiar with the nature and the effects of the strategic interaction between Objectives
trading partners that are individually large enough to affect the international
price of a traded good
ñ able to understand the determination of the pattern of international specialization,
the effects of protectionism, and the gains from trade, when the international
prices and the terms of trade are not fixed but are rather determined by the
behavior of the trading partners.
ñ Offer curves Key Words

ñ International equilibrium
ñ Optimal tariff, tariff war
ñ Two-party game
ñ Zero-sum game
ñ Negative sum game
ñ Prisoner’s Dilemma
ñ Dominant strategy
ñ Nash equilibrium
ñ Reaction function
ñ Equilibrium tariffs
ñ Mixed strategy tariff game
So far the effects of trade and protection have been approached by simplifying Introductory
the analysis to assume that the international prices of the traded goods and, hence, Comments
the terms of trade, are fixed. In fact, if exports/imports at the country level are
small enough, this assumption is realistic. However, some countries are large
exporters of particular goods, whilst some countries have also market power in
81
buying particular imports. Therefore, the conditions prevailing in those countries
can affect international prices as well as the volume of international trade. As a
rule, a country’s terms of trade are variable if shifts in its own production or
preferences are large enough to affect international prices. Such a country is a
price searcher, rather than a price taker, in the international market. Chapter 5
illustrates the interplay between such trading partners. By means of offer curves,
one for each country, the international impact of protectionism between two large
economies can thus be predicted. Protectionism can be studied by means of
reaction functions, as large countries are expected to engage in tariff games.
82
CHAPTER 5
5.1 TERMS OF TRADE, OFFER CURVES

AND INTERNATIONAL EQUILIBRIUM
5.1.1 Terms of trade and offer curves

In a two-partner trading context, offer curves show how the terms of trade are
settled between (large) economies. In the background, the pattern of production
and consumption in each country, determined by the PPF and the representative
consumer’s indifference map, leads to the construction of an offer curve for each
country, as follows. First, consider the specialization case depicted in Figure 1. In
autarky (point A), T/S<2. Hence, given the international relative price of S (terms of
trade) tt=T/S=2, the economy is induced to specialize in S, moving production to
point P, trading 30S (exports) for 60T (imports) and consuming at point Z: in the
trading equilibrium, the representative consumer’s welfare increases from indifference
curve I to II.
tt=2
150
110 Z
100 A
II
50 P I
50 105 135 150 S

100
Figure 1: Specialization in S
Assume now that the terms of trade improve to tt=3. Then, as shown in Figure
2, the economy increases its specialization, by allocating more (less) resources to
S(∆) until its MRT increases to 3, and the level of trade increases, as pictured by the
larger trade triangle. In the new trading equilibrium (point Zã with the better
terms of trade, more is exported (35S) in exchange for more imports (105∆), and
the (representative) consumer is better off by consuming more of both goods. With
the better terms of trade, the consumer’s welfare increases to indifference curve
83
πππ, while the lower relative price of ∆ induces a switch of consumption toward a
higher ∆/S ratio.
150 tt=3
130 Zã
100
A III
25
50 110 145 150 S

100
Figure 2: Specialization in S Increases as the Terms of Trade Improve
By plotting imports (T) over exports (S), at different terms of trade, the information
contained in the two previous figures can be summarized in Figure 3.
Timports
tt=3
H
105
tt=2
60
20 30 35 Sexports
Figure 3: The Offer Curve for the S-Exporting Country
The depicted offer curve (H) for the country exporting S comprises of all (∆, S)
combinations, each for a different terms of trade (T/S) ratio, with the latter shown
by the slope of the line tt. Hence, each point along this schedule represents a
potential international equilibrium for that country: for any terms of trade, a
certain quantity of S exports will be offered per unit of ∆ imports. It is obvious that
as the terms of trade improve, the trade triangles expand, indicating that the volume
of trade increases and thus larger gains ensue for the country specializing in (and
exporting) S.
Analogously, Figure 4 illustrates the offer curve (F) for the country specializing
in (and exporting) ∆.
84
CHAPTER 5
Texports
tt=2
tt=1
80 F
60
30 80 Simports
Figure 4: The Offer Curve for the ∆-Exporting Country
For this country, assume that in autarky the relative price of ∆ is 1/3 (e.g.,
T/S=3). Then, obviously, only if tt=T/S<3, will the country engage in international
trade. If, for instance, the terms of trade (the slope of tt) equal 2, i.e., 0.5 units of ∆
can be exchanged per unit of S, this country will be induced to trade ∆ for S. As the
terms of trade further improve (for instance, the slope of tt becomes 1), as shown
from the trade triangles, the economy expands its willingness to trade, offering
more ∆ (in exchange for more S). Of course, the ∆-exporting country’s PPF and its
representative consumer’s indifference map are “hidden” behind the F curve: each
point on this curve represents a potential equilibrium with international trade for this
country, where the tt line is tangential to both the PPF and the highest indifference
curve. Note that the F offer curve bends toward the S (import) axis. Likewise, the H
offer curve bends toward the T axis (i.e., the import axis for the S-exporting country).
5.1.2 International equilibrium

The international equilibrium among two trading partners (countries) determines
the direction of trade, the volume of trade, and the terms of trade. For an international
equilibrium to exist, the terms of trade (tt) must fall between autarky relative prices
(M/S). If, in the previous example, tt=T/S=3, no quantity of T is offered by the T-
exporting country, whilst if tt=T/S=1, no quantity is offered by the S-exporting
country. If, nonetheless, 1<tt=T/S<3, an international equilibrium can be found
where home imports equal foreign exports and vice versa, i.e., at the equilibrium
terms of trade the quantities offered by each country match. By this token, in an
international equilibrium the terms of trade have been adjusted so that the
quantity each country is willing to export is equal to the quantity the other country
wants to import. Therefore, the international equilibrium, comprised of the terms
of trade as well as the volume of trade, is determined where the two offer curves
(one for each country) intersect. As shown in Figure 5, where the H and F curves
85
intersect (e.g., at tt=T/S=2, the volume of S (T) which the S-exporting country is
willing to export (import), and is exactly equal to the volume of S which the T-
exporting country wants to import (export).
T
tt=2
tt=1.5
H
F
75
60
30
20 30 50 S
Figure 5: Market Adjustment and International Equilibrium
Note that each trading country alone would prefer better terms of trade, along
its own offer curve, but it is not able to induce its trading partner in that direction.
To see this clearly, and grasp how the market forces adjust the terms of trade
toward the achievement of an international equilibrium, suppose that originally
T/S (e.g., the international relative price of S) was equal to 1.5. Of course, if
equilibrium could be found at those terms of trade, the ∆-exporting country would
be better off than it is with tt=2; its trade triangle would become larger. Yet, at
tt=1.5 there is a shortage (surplus) of S (T) in the international market: the volume
of S supplied (by the S-exporting country) falls 30 units short of the volume of S
demanded (by the ∆-exporting country), while the volume of ∆ supplied (by the ∆-
exporting country) exceeds, by 45 units, the volume of ∆ demanded (by the S-
exporting country). As a result, the relative price of S (e.g., T/S) increases, while the
relative price of T (e.g., S/T) decreases, toward the terms of trade where the
international equilibrium is found (i.e., T/S=2). In the background, the producers
of T realize that they produce more than they can sell, whilst buyers will bid up the
price of S. Note that, by the same token, any other terms of trade will also lead the
two trading partners to adjustments in their quantities supplied and demanded
until the international T/S price ratio equals 2. Hence, there is stability in the
international equilibrium depicted in Figure 5.
5.1.3 Shifting offer curves and adjustments

in the international equilibrium
Changes in technology and/or in the availability of resources, as well as changes
in consumer preferences or income, all result in shifts of the country’s offer curve.
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CHAPTER 5
For instance, assume that in the S-exporting country, the technology of producing
good T domestically deteriorates, say because of reduced investments in the country’s
T industry. Then, an inward shift of the country’s PPF occurs, indicating reduced
ability to produce T at any given quantity of S. Thus, since in terms of forgone S, T
becomes more expensive to produce domestically, the S-exporting country would be
willing to offer (export) more S per unit of T imported, and this can be depicted by an
outward shift of the S-exporting country’s offer curve, as shown in Figure 6.
H
Hã
50
25
20 30 S
Figure 6: Declining Technology for ∆ in the S-exporting Country
Figure 6 equivalently suggests that, as it becomes less efficient in producing the

good it imports, the S-exporting country becomes more open to international
trade; after the decline in technology in the production of good T, the S-exporting
country is willing to accept less T imported per unit of S exported.
Similarly, an outward shift in the S (T)-exporting country’s offer curve may result
from:
1. Shortage of resources suitable to produce T (S).
2. Increased domestic demand for T (S).
3. Decreased domestic demand for S (T).
4. Increased domestic supply of S (T).
In case (2), for instance, as the preferences of the S-exporting country’s representative
consumer change, so that the he/she places a higher value on the consumption of good
T, the S-exporting country is willing to sacrifice more S (through exports) in order to
obtain more imports of T. For any of the above cases, resulting in an outward shift of
the S-exporting country’s offer curve, the international equilibrium will subsequently
be adjusted as shown in Figure 7.
87
tt=2
Hã
T H tt=1.75
F
70
60
30
30 40 S
Figure 7: International Equilibrium with Deterioration in the Terms of Trade
In Figure 7 note that, as the S-exporting country’s offer curve (H) shifts to the
right, the international relative price of S (e.g., the slope of the terms-of-trade line)
declines. The reason is that, just after the expansion of the H offer curve, at the
“original” terms of trade (tt=T/S=2), a surplus of S (along with a shortage in T) is
created, suppressing the relative price of S. Obviously, the equilibrium will be
restored at tt=T/S=1.75, where the terms of trade have been worsened for the S-
exporting country, a higher volume of trade materializes in the international
market, and the trade triangle in each country expands. As regards the latter effect of
the falling terms of trade in the S-exporting country, note that while its consumers
will enjoy more of the (imported) good T, each unit of this good will cost more in
terms of units of the (exported) good S. Finally, note that increased capability to
produce the good S, say because of improved technology in the exports industry,
will bring the same effects as above, of an expanding offer curve of the S-exporting
country. Gains in efficiency in the exports industry would thus lead to strikingly
worse terms of trade. Nonetheless, because of the improvement in technology,
there would still be higher real income and utility for the S-exporting country, while
cases (1)-(3) would result in higher real income and utility for the trading partner
(e.g., the T-exporting country).
The opposite effects on the international equilibrium will be brought about by an
inward shift in the offer curve of either of the two trading partners. Such a contraction
of the offer curve (say again of the S-exporting country) is typically due to the
following reasons:
1. Decreased domestic demand for the imported (T) good.
2. Losses in efficiency in the production of the exported (S) good.
3. Increased domestic demand for the exported (S) good.
4. Increased supply of the imported (T) good.
As shown in Figure 8, all of the above result in a shrinking offer curve for the S-
exporting country, eventually leading to an improvement in the terms of trade.
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CHAPTER 5
tt=2.5
T
tt=2
Hã H
F
60
50
20 30 S
Figure 8: International Equilibrium with Improvement in the Terms of Trade
In Figure 8, note that while the terms of trade improve for the S-exporting
country, there is a reduction in the volume of trade; thus the trade triangle in each
country shrinks. As regards the S-exporting country, the reason behind the latter
effect is that, because of changes (1) – (4) that shift the country’s offer curve
inward, this country is willing to sacrifice less units of S per unit of T, while with the
improved terms of trade, it can obtain more units of T (imported) per unit of S
(exported).
In sum, Section 5.1 suggests the following:
ñ Given the terms of trade (e.g., the exported good’s relative price), a country’s
offer curve shows the volume of exports the country is willing to offer in exchange
for a volume of imports. Effectively, this curve summarizes the pattern of
production and consumption of the trading country.
ñ As the terms of trade improve, a country specializes more in its exported good
(in whose production the country is relatively more efficient) and increases the
volume of trade. Thus, consumers enjoy increased gains from trade.
ñ In the context of two trading countries, the terms of trade as well as the volume
of trade are jointly determined where the two offer curves intersect.
ñ As the country’s offer curve shifts outward (inward) the terms of trade decline
(improve) while the volume of trade increases (decreases).
(a) Following the discussion so far explain: (i) where the line tt=1 must be placed in
Figures 1 and 3; and (ii) where the line tt=3 must be placed in Figure 4.
(b) If in the S-exporting country a change in the tastes of the representative consumer in
favor of good S takes place, sketch out the sequence of changes that would occur: (i) in
the country’s autarky equilibrium; and (ii) in the international equilibrium.
The answers can be found in the Appendix at the end of this chapter.
89
5.2 IMPROVING THE TERMS
OF TRADE WITH TARIFFS
5.2.1 Optimal tariffs and tariff wars

Unlike small countries, large countries may find optimal the imposition of tariffs.
As the demand for the imported good falls in the international market with the tariff,
the terms of trade will ceteris paribus improve for the large country. Hence, a large
country has the potential to increase its welfare (relative to free trade) by consuming
more goods with a tariff. This case is depicted in Figure 9.
T tt ttã
Zã
Z
A MRS
Pã
P
MRT
Figure 9: Domestic Welfare Increases with a Tariff
Prior to a tariff on the imported good T, and given the (tt=T/S) international price
for good S, the economy produces at P and consumes at Z. A tariff on T, besides
protecting the domestic T industry, reduces the world demand for textiles and, hence,
increases the international price of S (from to. As a result, a tariff on T brings two
effects: (1) inside the country, the economy changes its production pattern, from tt to
ttã; and (2) in the international market, the economy trades up along the new terms-
of-trade line ttã. Yet, due to the application of the tariff on good T, inside the country
the relative price of S becomes lower: MRT=MRS<tt<ttã.Effectively, after the
tariff the economy consumes more of both goods relative to free trade. As indicated
by the new consumption bundle Zã, the representative consumer’s welfare increases
in equilibrium, while, as expected, the national income evaluated at the domestic
autarky prices increases as well.
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CHAPTER 5
In consequence, when a large country imposes a tariff on imports, the value of its
exports rises in the international market, its offer curve shifts leftward and better
terms of trade result; small countries have no potential to thus gain from tariffs since
are unable to individually affect international prices. On the other hand, a tariff
creates efficiency losses due to decreased specialization. In principle, therefore, the
government of a large country can search for the optimal tariff, i.e., the tariff level
where the marginal benefits from improved terms of trade exactly outweigh the marginal
costs of lost efficiency. Taking the viewpoint of the (large country’s) representative
consumer, the search for the optimal tariff can however be reduced to finding the
tariff that maximizes home utility, subject to the constraint of the foreign offer curve. This
analysis can be made using the map of trade indifference curves for imports and
exports (see Figure 10).
T
VI
III II
I
1
2
Figure 10: Finding the Optimal Tariff
As viewed by the domestic representative consumer (say, in the S-exporting

country), exports are an economic good and imports are an economic “bad”; they
are produced domestically but consumed abroad. Hence, for that consumer to
preserve his/her utility level, more exports (S) have to be offset by more imports
(T), while as the level of exports rises it should be outweighed by increasing levels
of imports. Trade indifference curves thus slope upwards and they are convex to
the S axis, while higher indifference curves represent higher utility levels for the S-
exporting country’s representative consumer (note that indifference curve I
represents the autarky utility level). Then, assuming that the foreign (T-exporting)
country’s offer curve (F) is fixed and the S-exporting country’s offer curve originally
(i.e., with free trade) passes through point 1, the domestic consumer’s utility is
maximized at the point where the F curve is tangent to indifference curve III. This
equilibrium could be achieved by means of an (optimal) tariff that would shift the
home offer curve leftward so that it crosses the F curve at point 2.
Next, suppose that the S-exporting country does impose its optimal tariff,
improving its terms of trade at the expense of the T-exporting country in the
international equilibrium. Yet, this equilibrium is sustainable only if the latter
91
country does not retaliate with an optimal tariff of its own. If it does, the two trading
partners are engaged in a tariff war which is hazardous for both countries. The
various rounds of such a war, leading to diminishing levels of international trade,
are depicted in Figure 11.
T ttã
Hã tt
H ttãã
F
B A
Hãã
C
D Fãã
Fã
E
S
Figure 11: International Trade Declines with a Tariff War
Assume that, in the first round, the S-exporting country imposes an optimal
tariff of its own, shifting its offer curve from H to Hãand moving the international
equilibrium from A to B along the T-exporting country’s offer curve. The latter
country notices the deterioration in its terms of trade (from tt to ttã) and, in the
second round, retaliates by imposing an optimal tariff of its own, based on the S-
exporting country’s new offer curve Hã. The T-exporting country’s offer curve thus
is restricted to Fã and the international equilibrium is (temporarily) restored at C.
Obviously (see point E), after successive rounds, a tariff war will result in little
change in the terms of trade, while all trade may even cease when prohibitive tariffs
are reached.
5.2.2 Tariff games and equilibrium tariffs

Tariff choice can be considered as a game between countries and the outcome of
this game depends on the strategies chosen on the part of each individual opponent.
Consider the following two-party tariff game. Two countries, trading with each other,
have the potential to individually impose a tariff on imports. In principle, through
the improved terms of trade, each country may gain with a tariff (only) through the
other country’s loss. If that happens, and the individual gain is exactly offset by the
opponent’s loss, the game is called a zero-sum game. Yet, due to the decline in
global efficiency, such tariff games are negative sum games: overall losses outweigh
gains. To see this, suppose that each country/government chooses between free
trade (i.e., a 0% tariff) and a 12% tariff, while individual choices are simultaneously
made. Table 1 below summarizes the pay-offs to each country, in terms of national
income, realized under the four possible combinations of individual choices/
strategies.
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CHAPTER 5
Table 1: Prisoner’s Dilemma in a Tariff Game
Home tariff
0% 12%
0% ($90, $90) ($60, $110)

Foreign tariff
10% ($110, $60) ($70, $70)
The situation depicted in Table 1 is a typical case of what is called in game

theory the Prisoner’s Dilemma: The imposition of a 12% tariff on imports is the
dominant strategy for each country, since national income is higher under this choice
regardless of the opponent country’s choice. Hence, symmetric multilateral tariffs are
the Nash equilibrium in this game; though both countries could be better off by
multilaterally lifting tariffs, this is not possible unless each country is (somehow)
committed to lifting its own tariff. This may explain why international negotiations
under the auspices of the GATT and the WTO have proved helpful in moving
toward free trade. However, this simple example also shows that free trade is an
unstable equilibrium. In the context of a repeated game (e.g., Table 1 is repeated,
year after year), in order for free trade to persist each country must resist the
temptation of a temporary gain from a surprise tariff.
Turning to the search for equilibrium tariffs in the game theoretic framework so
far introduced, the analysis is helped by means of the tariff reaction functions (one
for each country) pictured in Figure 12.
Foreign
tariff H Hã
10%
12%
3% 8% 10% Home tariff
Figure 12: Each Tariff is the Best Response to the Other’s Tariff
Each reaction function shows each (large) country’s best response, in terms of
imposition of its own tariff, to any tariff imposed by its opponent country. To link
these schedules to the previous analysis, note that with no foreign tariff the optimal
tariff for the home country is, say, 3% (e.g., a tariff above 3%, through the decline
93
in the volume of trade, would outweigh the gains of the improved terms of trade).
Therefore, the home tariff reaction function (H) starts from the optimal tariff level
for this country. Correspondingly, (e.g., given that the home country imposes no
tariff of its own), the foreign tariff reaction function (F) starts from the foreign
optimal tariff level. Further, both reaction functions slope upwards since, in the
context of a tariff war, a higher opponent tariff deteriorates the terms of trade and
requires a higher own optimal tariff as the best response (recall the analysis embedded
in Figure 11).
It is then fairly evident that the tariff equilibrium is reached where the two
reaction functions intersect. There, since each country’s tariff is on the country’s
reaction function, each country materializes its best response (by means of an
optimal tariff), given the tariff strategy of the opponent country. As shown in
Figure 12, this equilibrium is reached where the home country imposes an 8% tariff
and the foreign country imposes a 10% tariff. Any other tariff combination is off at
least one of the trading country’s reaction functions and, hence, cannot correspond
to the (Nash) equilibrium.
Figure 12 also depicts a second possible tariff equilibrium, (10%, 12%), which has been
caused by changed conditions, namely by increased demand for imported goods in the
home country. Which changing conditions in the foreign country may in turn restore the
original 10% tariff that the foreign country imposes in equilibrium?
Note that, if one of the trading partners is a small country, the equilibrium is
realized where the small country imposes no tariff while the large country unilaterally
chooses its optimal tariff. If, for instance, the foreign country happened to be the
small country, its tariff reaction function would coincide with the horizontal axis (in
Figure 12), hence, the home country would impose a 3% tariff in equilibrium.
In sum, Section 5.2 suggests that large countries may opt to improve their terms
of trade through tariffs, because a tariff decreases home demand for the imported
good and, due to the country size, lowers its price in the international market. Yet,
the outcome of a tariff war (in principle depending on the strategies/options open
to the players/countries) is likely to result in an international equilibrium which is
hazardous for all, while free trade is a reasonable as well as a fair policy.
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CHAPTER 5
5.3 TRADE OF RESOURCES

IN LIMITED STOCK
The relative international prices of resources in limited stock (hereafter, LSR),
like oil and minerals, are typically subject to tariffs and other trade policies. The key
feature of such a resource is that once used today, it cannot be used in the future; the
opportunity cost of its present use is its use in the future. Hence, the economics of
LSR are different from those of renewable resources and this becomes visible in
international economics and political relations. Consider the case of oil: an agent
owning the right to sell oil is quite similar to an agent (stockholder) owning an asset
which produces a yearly return. Thus, a crucial issue in order for this agent to decide
how much oil to sell in any particular year is what is expected to happen to the oil
price in the future (e.g., the opportunity cost of selling now). Then, if the market for
oil is competitive, the path of oil prices will be defined by its perceived opportunity
cost, with oil owners depleting their asset at the rate that will increase its price at a
rate equal to the (real) return on other assets. For instance, with a 5% rate of return,
the (real) price of oil over a two-year period, starting from $30 will be $30, $31.50; the
optimal depletion rate will, in turn, involve selling just enough oil to create these
prices in the market. In consequence, if tariffs imposed by (large) oil importers lower
the price of oil, the depletion rate will increase as more oil will be sold to keep the
rate of return on oil assets competitive. On the other hand, oil producers may restrict
supply to raise the oil price (however, at a risk of decreasing the value of their asset as
they render R&D incentives to oil importing countries for finding substitutes). In
fact, OPEC was founded with the primary aim of improving the terms of trade for oil
producers. To get an insight into this interaction, Figure 13 illustrates a simple model
of trade between OPEC and Europe, where OPEC exports oil and imports the
“composite good” EurX (European Exports).
EurX ttã
OPEC tt
1 Europe
2
Cartel Oil
quota
Figure 13: Trade between OPEC and Europe
95
Originally, the terms of trade and the volume of trade between OPEC and
Europe (at point 1) are based on oil’s competitive market depletion. That is, in this
international equilibrium “oil in the ground” is worth the same as any other asset,
e.g., the expected return to owning oil is the same as the expected return to owning
other assets. Next, assume that OPEC, acting as a cartel, imposes a production
quota on its members. In consequence, the cartel’s offer curve becomes vertical at
the level of the quota, the terms of trade improve for OPEC (from tt to ttã), and the
volume of trade shrinks to point 2. Yet, OPEC, as well as other international
cartels, may find it difficult to agree on the quantities that individual members/oil
producers are allowed to sell under the cartel quota and keep the agreement. Note
that in Figure 13 a surplus of oil would occur at the artificially high price of ttã if the
quota is broken. The latter is quite likely to happen as individual oil producers have
an incentive to cheat and gain by selling more than the agreed upon limited quantity
when the price is high. In other words, a Prisoner’s Dilemma situation again
evolves.
In sum, Section 5.3 suggests that the international prices of LSR in principle
depend on how the owners of those resources discount the future. Nonetheless,
cartels and trade policies (like tariffs, subsidized R&D for LSR substitutes, auto
efficiency and pollution emission standards) all affect the international markets for
LSR and may lead to inefficient resource depletion.
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ñ A country’s offer curve summarizes the volume of exports the country is
willing to offer in exchange for a volume of imports for various terms of trade.
ñ For any country, better terms of trade in international markets improve
national income and increase consumer utility.
ñ The terms of trade between large countries are determined through a process
of specialization (reflected in each country’s offer curve) and trade
bargaining. In each of the trading countries, supply and demand play the
critical role in the determination of the relative prices of traded goods.
ñ Tariffs can improve the terms of trade for a large country since they decrease
the international demand for the imported goods and thus lower their prices
in international markets. Therefore, large countries may opt for optimal
tariffs designed so as to maximize their own income/utility.
ñ If all large trading partners opt for an optimal tariff, a tariff war ensues. The
outcome of such a war would be rather inefficient, with little influence on the
terms of trade and a dramatic decrease in the volume of trade.
ñ As regards the trade of resources which are in limited stock (like oil and
minerals), trade policies and international cartels result in inefficient
resource depletion.
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APPENDIX
Activity 1(a)
(i) The terms-of-trade line denotes that the international relative price of S (e.g.,) equals one
and, thus, there is no more incentive for the S-exporting country to specialize in and export
services (in exchange for textiles). In graphical terms, this is explicitly shown as follows.
1. In Figure 1, the line tt = 1 is tangent to the PPF at A (e.g., the autarky point), where MRS
= MRT, and the volume of trade is zero (e.g., the trade triangle no longer exists).
2. In Figure 3, the absence of trade whenever tt = T/S = 1 is reconfirmed since the line tt =
1 crosses the S-exporting country’s offer curve at the origin, where of course T = 0, S =
0. The line tt = 3 must be placed in Figure 4.
(ii) In Figure 4, the line tt = 3 crosses the T-exporting country’s offer curve at the origin
showing that, whenever tt = T/S = 3, the T-exporting country has no incentive to specialize
in and export textiles (in exchange for services).
Activity 1(b)
If in the S-exporting country a change in the tastes of the representative consumer in favor
of good S materializes, the following changes would occur:
(i) The country’s autarky equilibrium will shift rightward along the PPF, toward good S.
Effectively, this will be brought about by the increasing (decreasing) domestic demand
for S (T) that leads to an increase in the relative price of S in autarky.
(ii) As a result of the above, less exports (S) will be offered in exchange for imports (T),
hence, the S-exporting country’s offer curve will shift inward and (given the T-exporting
country’s offer curve) the S-exporting country’s terms of trade (tt = T/S) will improve in
the international equilibrium.
Activity 2
Note (in Figure 12) that, given the increased demand for imported goods in the home
country (which caused the rightward shift in the H reaction function), the original 10% tariff
for the foreign country can be restored in equilibrium by a (proper) rightward shift in the F
reaction function. This, in turn, can be brought about by the reduced demand for imported
goods in the foreign country. In such an event, the bargaining position of the foreign country
becomes stronger and, hence, it relaxes its tariff rate regardless of the tariff imposed by its
partner (e.g., the home country). Of course, in the new equilibrium, the tariff rate imposed by
the home country (along its Hã reaction function) would then be lower than 10%.
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CHAPTER 5
BIBLIOGRAPHY
RECOMMENDED READING
Hoekman B., Kostecki M., The Political Economy of the World Trading System:
From GATT to WTO, Oxford University Press, Oxford 1995.
99
CHAPTER 6
PRODUCTION,
INTERNATIONAL TRADE
AND INCOME DISTRIBUTION
M. Vlassis
The scope of Chapter 6 is to address the fundamental analysis of the relationship The Scope
between production and international trade and in that way provide understanding of the Chapter
of the distribution of income across factors of production. The topics covered include
the specific factors model, the factor proportions model and the four fundamental
theorems of international trade.
After having completed the study of Chapter 6, the reader will: Learning
ñ understand the links between the structure of production and international trade Objectives
ñ understand the links between international trade and the payments to the factors
of production
ñ have developed an overall picture of the causes and effects of international trade.
ñ General equilibrium Key Words

ñ Diminishing marginal product
ñ Marginal cost
ñ Cost minimization
ñ Marginal revenue
ñ Marginal revenue product
ñ Isoquant
ñ Isocost line
ñ Factor abundance
ñ Factor substitution
ñ Factor intensity
ñ Factor demand
ñ Price-taking firm
ñ Specific factors
ñ Factor price equalization
Chapter 6 explains how the structure of production, as well as the structure of Introductory
consumption, underlies international trade and income distribution. This is carried Comments
out by means of a general equilibrium framework that permits the study of markets
in an interconnected network, where:
ñ Firms/industries determine supply so as to maximize profits by minimizing the
cost of the employed factors of production.
101
ñ Consumers determine demand by choosing among goods so as to maximize
utility, given the prices of goods and their income.
ñ In markets for the factors of production, firms/industries demand factor inputs
in order to produce goods, while individuals supply their factor resources in
order to derive income.
In previous chapters, the equilibrium evolving from this network was summarized
by means of the PPF and offer curve schedules. This chapter describes what goes on
behind these curves when, for instance, a tariff is imposed on a traded good.
102
CHAPTER 6
6.1 THE SPECIFIC FACTORS MODEL
6.1.1 The market for shared labor

The specific factors model (SFM) is a general equilibrium model where each
industry/sector of the economy uses a specific type of capital input in its production,
and all industries share the (same) labor input. This model presumes that capital
does not move between industries, as it is always the case in the short run. Thus, any
adjustment across the economy, to tariffs, international migration and investment,
is explained in the market for shared labor. Figure 1 depicts how the demand for
labor, for instance, in the software (S) industry/sector (LS), responds to changes in
the wage rate that prevails in that sector (wS); an analogous picture summarizes labor
demand in the textiles (T) industry/sector.
Ws
Ds=MRPs
Ls
Figure 1: Demand for Labor
The downward slope of the labor demand schedule (that is, Ds = MRPs) reflects
the principle of the diminishing marginal product of labor (MPs), in the services
industry/sector. Since the capital input is fixed, as the labor input increases, say by
one unit, its contribution to the firm’s production (in terms of extra units of output
produced, that is MPs) becomes smaller. In consequence, since at the same time it
is presumed that the price of output (ps) is fixed for any individual (price-taking)
firm, the marginal revenue product of labor (MRPs=psáMPs) becomes smaller as
more labor is hired. In effect, given its current employment status, any individual
firm will have an incentive to hire an extra unit of labor only so long as the latter’s
cost (i.e., the wage rate) decreases so as to be equal to the (lower) MRPs. The same
103
is true for the entire industry, by simply aggregating over the many individual firms
like the above.
Combining the labor demand schedules of the economy’s two sectors (e.g.
services and textiles), Figure 2 subsequently explains how the economy’s total labor
endowment is distributed in each sector, as well as how the wage rate is determined,
in equilibrium.
WT WS
W* W*
DS DT
0T 0S
LT L* LS
Figure 2: Equilibrium in the Market for Labor
In Figure 2 note that the length of the horizontal axis measures the economy’s
limited amount of labor (total labor endowment) in the short-run. Then, given
each sector’s stock of specific capital, which determines the position of the sector’s
labor demand schedule, the equilibrium in the market for shared labor is realized
where the two demand schedules intersect. This equilibrium configures the
economy’s equilibrium wage rate (w*) and – as the two arrows indicate – the
allocation of the economy’s labor endowment into employment in the two sectors. It
is secured by means of appropriate labor shifts between the two sectors, whenever
the wage rate differs across sectors. If, say, wT>wS, then workers will move from
the services sector to the textiles sector. Hence, the increased supply in the latter
sector will lower wT (and will thus increase employment along the DT = MRPT
schedule), while the decreased supply in the services sector will raise wS (and thus
decrease employment along DS = MRPS ), until wT=wS=w* and labor enjoys the
same per unit return everywhere.
Moreover as regards the economy’s adjustment to changing conditions, the
following points are important:
ñ The demand for labor in any sector depends on the price of the sector’s output
and the marginal product of labor. The latter is in turn positively related to the
quality/amount of capital input.
ñ In the SFM the quality/amount of capital input which is employed in each sector is
fixed (vertical supply). Hence, the price per unit of capital (in any particular sector)
is solely determined by the demand for capital input (in that sector). Of course, the
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CHAPTER 6
latter in turn depends on the price of the sector’s output and the marginal product
of capital.
6.1.2 International trade and the distribution

of income in the SFM
The effects of protectionism on income distribution (across factors of production)
can now be easily examined in the context of the SFM. If, for instance, a tariff on
textiles is imposed, the T output will rise, while the S output will fall, along the
economy’s PPF. In the market for the shared labor input, since a tariff on T will raise
the price of T, it will shift DT rightward (and DS leftward) and will lead to a rise in the
wage rate (being equal in both sectors, in equilibrium). However, in the markets for
the specific factors of production, the price of T-specific capital will rise while the
price of the S-specific capital will fall. This explains why all agents (e.g., stockholders,
management, labor unions) in a particular industry opt for protectionism.
In the opposite case (i.e., when a country opens to free international trade), the
demand for the good in which the economy has a comparative advantage (disadvantage)
will rise (fall). Therefore, free trade arising from differences in the cost structure
across countries will typically lead to a more even distribution of income. To see
this, assume that a country is relatively capital abundant in the S sector, while it is
relatively capital scarce in the T sector, i.e., this country has a higher KS/KT ratio
than its potential trading partners. Moreover, assume (for simplicity) that demand
for services and textiles are identical across countries. Hence, the differences in the
country’s autarky prices of S (lower) and T (higher), relative to those of its potential
trading partners, are solely due to the differences in sector-specific capital supplies.
Then, if this country engages in free international trade, the increased demand for
S (from abroad) will lead to a rise in the price of S, while the decreased (domestic)
demand for T will lead to a fall in the price of T. In consequence, the increased
demand for labor in the S sector will cause a shift of the shared factor in that sector,
which in turn will lead to a rise in the country’s wage rate. At the same time,
nonetheless, the price of capital employed in the S sector will increase and the T-
specific capital payment will decrease.
In sum, the SFM suggests that opening the economy to free trade raises (decreases)
the price of the relatively abundant/cheap (scarce/expensive) factor of production
and, hence, creates a more even distribution of income across countries. For
instance, the least developed countries, which are typically characterized by
abundant and therefore cheap unskilled labor, will – according to this model – find it
beneficial to produce and export goods that intensively use this type of labor input.
Developed countries should in turn do better by lowering their protection on such
goods (rather than contributing in foreign aid programs) in order to stimulate growth
in those countries.
The reader can summarize what he/she has learned from Section 6.1 by undertaking
the following activity.
105
Assume that the price of textiles decreases, because the economy opens up to free trade
while the international (relative) price of services is high. Explain the following:
(a) The economy’s adjustment along its PPF.
(b) The adjustment in the market for shared labor.
(c) The adjustment in the (two) markets for sector-specific capital.
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6.2 THE FACTOR PROPORTIONS MODEL

The factor proportions model (FPM) depicts a trading economy with two
factors of production, labor (L) and capital (K), which are in combination used in
the production of two goods, say S and T. This model is frequently called the
Hechsher-Ohlin model. The basics of this model are as follows:
1. In any sector/industry, production is materialized by competitive price-taking

firms.
That is, each firm’s marginal revenue (MR), i.e., the extra revenue the firm gains
by selling an extra unit of (S or T) output, is simply equal to the output’s price (p).
On the other hand, an extra unit of output incurs an extra cost, MC, for the firm.
Hence, each firm will produce (and sell) the number of units of output which
maximizes its profits, e.g., it will produce at the output level where MR = MC.
Nonetheless, so long as the economic profit of any incumbent firm in an industry is
positive (negative), at least some new (incumbent) firms will enter (exit) the
industry. Thus, in the long run, total supply will increase (decrease) pushing
(pulling) the output’s price down (up), until all economic profits in the sector
become zero. In effect, in the long run, each firm will produce the level of output
where p (the firm’s average, or per unit, revenue) = AC (the firm’s average, or per
unit, cost). Hence, in the long-run equilibrium, p = MR = MC = AC.
2. In any sector, any firm can choose among different combinations of the K and L
factors of production (e.g., substitute one input for the other) in order to
produce a certain amount of output (q).
As shown in Figure 3, all (K, L) combinations that produce, say, 10 units of q, lie
on a production isoquant with a negative slope and convex curvature. That is, more
capital (labor) must be used to offset a certain decrease in the labor (capital) input.
Also, it takes increasing capital (labor) to substitute for labor (capital), as capital
(labor) increases and labor (capital) decreases. In standard terminology, the
marginal rate of technical substitution (MRTS), which is measured by the slope of
the isoquant, decreases as labor is substituted for capital along the isoquant. Of
course, each level of output is shown by a different isoquant; isoquants of more
(less) than 10 units of output should be placed higher (lower) than the one depicted
in Figure 3, as they are generated by input combinations comprised of more (less)
K and/or L.
107
K
0.6
q=10
0.5 1 L
Figure 3: Production Isoquant
3. Firms are also price takers in the markets for inputs. In effect, each firm minimizes
its cost of production by varying the optimal input mix according to the input
prices.
For instance, assume that all firms face a wage rate of w = $10 and a price per
unit of capital (rent) of r = $5. Then, for any firm, all input combinations with a
given total cost (TC) are summarized by the isocost line: TC=$10L+$5K. As in
turn the firm seeks to maximize its profits (given the output price), it will produce
any particular level of output by combining K and L so as to minimize the TC of
producing the optimal output level. Moreover, in the long run the optimal output
level must, as previously explained, satisfy the zero profit condition, p = AC
(hence, p = AC≡ TC/q). In consequence, if, say, p = $1, a firm can produce, say 10
units of output (hence, $10 in terms of output value), at minimum cost only if it
employs 1 unit of capital and 0.5 units of labor (e.g., producing with the optimal
input mix). As can be easily seen from Figure 4, if this firm produces with any other
input combination along the q = 10 isoquant, it will end up on a higher isocost line
and thus will have to incur higher total costs.
K
K/L=2
q=10
0.5 L
Figure 4: Optimal Input Mix
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CHAPTER 6
Note that at the optimal input mix (L = 0.5, K = 1), MRTS=w/r. In effect, given
the input prices, the K/L(=2) ratio which satisfies the MRTS=w/r condition defines
the firm’s cost minimizing expansion path: moving along this path the firm must
proportionally increase its inputs as output expands to higher isoquants. However,
whenever the price of any input changes, the firm must optimally adjust its K/L
ratio along a new expansion path.
In sum, Section 6.2 provides a coherent picture of an economy’s production
structure (see Figure 5), where:
ñ Products and processes across the economy are different; the opportunities to
substitute among (K and L) inputs are different across (T and S) sectors.
ñ As capital and labor move freely between sectors, the wage as well as the return
to capital are (in equilibrium) equal across sectors.
ñ Even when the price and quantity of each sector’s output is the same, production
is materialized at different input combinations (e.g., at different K/L ratios). As
depicted, for instance, in Figure 5, while both sectors produce the same level of
output (e.g., S = 10, T = 10), and both outputs are of the same value (say, $10 if
pS=pT=$1 the S sector is capital intensive and the T sector is labor intensive.
(K/L)S=2
1
(K/L)T=1/2
0.4 S=10
T=10
0.5 0.8 L
Figure 5: A Two-Sector, Two-Factor Economy
109
6.3 THE FUNDAMENTAL THEOREMS
OF INTERNATIONAL TRADE
There are four theorems of international trade which are based on the production
structure addressed in Section 6.2. These theorems provide a solid foundation of the
factor proportions trade theory, since they provide intuition for the effects of
protection, international migration and international capital movements, on income
distribution, the pattern of production and the pattern of trade.
The theorems are built on what has been learned so far, in the context of the FPM.
Figure 6 depicts an equilibrium in production (denoted by s and t) of an economy
possessing certain input endowments (K = 1000, L = 1100), and a production
technology where the T sector is labor intensive and the S sector is capital intensive.
K
S=2
FE=(1000,1100)
1000
s
600
T=1/2
400 t
300 800 1100 L
Figure 6: Equilibrium in Production of a Two-Sector, Two-Factor Economy
In Figure 6 note that the equilibrium outputs of sectors S and T are respectively
materialized at points s (where K S =600, L S =300, MRTS S =w/r) and t (where
KT=400, LT=800, MRTST=w/r,). Hence, these outputs are consistent with cost
minimization and full employment of resources.
Given the economy’s factor endowments (FE), this production structure is
achieved by:
(i) Free factor mobility between sectors, so that w and r are equalized across sectors.
(ii) Each sector adjusting its K/L ratio along its own expansion path, according to
the common w/r ratio.
Then, changing circumstances across sectors/economies give rise to the following
propositions:
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CHAPTER 6
1. The Endowment-Output (Rybczynski’s) Theorem

An increase in the economy’s capital (labor) endowment will lead the economy
to produce more of the capital- (labor-)intensive good S (T) and to produce less of
the labor- (capital-) intensive good T (S).
(In Figure 6, an increase in, say, the economy’s capital endowment, implies that
the parallelogram sFEt0 becomes taller and thinner. FE moves leftward (say, to
FE’), s moves outward (say, to s’) along the S expansion path, and t moves inward
(say, to t’), along the T expansion path.
A graphical proof of this proposition can be given by means of the PPF. As
shown in Figure 7, a relative increase in the given economy’s capital endowment will
shift the PPF outward with a bias toward the capital intensive good S. Then, so long
as the (international) relative price of S, shown by the slope of line p, remains the
same, this economy will move its production structure from P to P’, in equilibrium.
P
t
Pã
tã
p
p
s sã S
Figure 7: The Rybczynski Theorem
2. The Endowment-Exports (Hechsher-Ohlin) Theorem

Countries specialize in and export goods according to their relative factor
endowments; a country which is abundant in capital (labor) will export the good
which is capital- (labor-) intensive.
In Figure 6, this proposition implies that point FE (FE’) represents a labor-
(capital-) intensive country. Hence, in accordance with the previous proposition,
the former (latter) country will specialize in and export T (S).
3. The Factor Price Equalization Theorem
Free international trade between two countries that are each producing two goods
using two factors of production with the same production technology leads to equal
factor prices across countries.
A proof of this proposition is straightforwardly derived from the analysis embedded
111
in Figure 5. When two countries engage in free international trade, output prices are
eventually equalized between them (through arbitrage). This means that the values of
the isoquants depicted in Figure 5 are effectively the same in both countries. Since,
therefore, the depicted tangent isocost line describes both countries, wages and
capital rents should be the same across countries in equilibrium.
Note that this proposition entails the assumption that free trade has a similar
effect on factor prices as international factor movements (i.e., international
labor/capital migration). Seeking higher wages, workers often migrate from a labor
abundant country to a country with a labor shortage; this migration will in principle
continue until wages are equalized across countries. Likewise, with similar effects,
capital owners seek the highest return to their assets. Free trade thus substitutes
for international factor mobility.
4. The Tariff/Factor Price (Stolper-Samuelson) Theorem
A tariff raises the price of the factor which is intensively used in the protected
(import-competing) industry and lowers the price of the factor which is intensively
used in the export industry.
To explain why, consider a tariff raising the domestic price of imported textiles in
the S-exporting (capital-abundant country). Then, the domestic output of the
protected labor-intensive sector (T) increases and, hence, the demand for the labor
input (which is intensively used in that sector’s production) increases. In consequence,
the wage rises and the return to capital falls.
In equilibrium, as labor becomes relatively more expensive, both the T and S
sectors switch away from labor to capital and become capital intensive. Thus, the
economy deviates from its comparative advantage, changes it production pattern
and suffers efficiency losses. Thus income is redistributed, away from capital
owners, toward labor.
Once again, the reader is encouraged to review and check what he/she has
learned from Section 6.3 by undertaking the following activity.
Using (any of) the fundamental theorems of international trade, explain the key effects (e.g.,
on income distribution, the pattern of production and the pattern of trade) of:
(i) Abolishing a tariff.
(ii) International migration and international capital movements.
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CHAPTER 6
ñ A critical issue in international economics is the income distribution among the
factors of production due to tariffs and other trade policies. As the payments to
some factors rise with a tariff, whereas the payments to other factors fall, the
SFM and the FPM provide the tools to find out who wins and who loses with
protection.
ñ One important result, derived from the SFM, is that protection increases the
payments made to factors which are specific to the protected sectors, as well
as to factors which are shared by protected and non-protected sectors. At the
same time, protection hurts the income of factors which are specific to non-
protected sectors.
ñ In the SFM, the differences in the autarky prices across countries are (apart
from differences in the structure of demand) due to differences in the relative
scarcity of the sector-specific factors of production. International trade,
arising from thus defined comparative advantages, distributes (factor)
income more evenly across countries.
ñ The FPM plays a central role in the theory of international trade. Conceptually,
it captures how the structure of production across countries adjusts to changes
and, in that way, this model predicts the effects of changing conditions
(including a switch to protection/free trade) on the distribution of income
across the factors of production.
ñ An important feature of the FPM is that firms are competitive price takers in
output (as well as in input) markets. Yet, as we will see later on, the industrial
structure (beyond perfect competition) has significant implications for issues
in international trade.
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APPENDIX
Activity 1
Since with free trade, the (relative) price of T decreases, we may predict the following:
(a) The economy adjusts to the higher relative price of S by shifting resources (i.e., shared
labor) out of the T sector into the S sector. This entails a move along the PPF; the S
output increases while the T output decreases.
(b) As the higher relative price of S stimulates increased production in the S sector, in the
market for shared labor the demand for labor increases. Hence, given the wage rate
and the economy’s total labor endowment, there is excess demand for labor across the
economy. This in turn bids up the wage, inducing a labor shift out of the T sector into the
S sector until the wage rate becomes equal across sectors.
(c) As more (less) labor is allocated to the S (T) sector, the marginal product of capital
which is specific to that sector increases (decreases), since it is now cooperating with
more (less) labor. On the other hand, recall that with free trade and, hence, with higher
labor requirement, the price of output in the S (T) is higher (lower). Hence, as more
(less) labor is allocated to the S (T) sector, the marginal revenue product of the S (T)
specific capital input will definitely increase (decrease). In consequence, given that this
factor is fixed in supply, excess demand (supply) will be created in the market for S (T)
specific capital, driving up (down) its price in equilibrium.
Activity 2
(i) According to the Tariff/Factor Price (Stolper-Samuelson) Theorem, abolishing a tariff that
has been imposed on, say, the imported textiles, will decrease the price of labor (e.g.,
the factor which is intensively used in the production of T), while it will increase the price
of capital. In consequence, and since the reason for the tariff was to protect labor
income, this will restore the economy’s comparative advantage arising from abundant
(and thus relatively cheap) labor. That is, the country will specialize in and export T,
while both sectors will adjust to a lower w/r (and thus K/L ratio.
(ii) An implication of the Factor Price Equalization Theorem is that international factor
mobility is a substitute for free trade. As workers (capital owners) seeking higher wages
(rents) migrate (reallocate their investments) from a labor- (capital-) abundant country
to a country with labor (capital) shortage, this will eventually lead to a more even
distribution of factor income across countries. Nonetheless, recall that free trade brings
factor price equalization so long as the given countries possess the same production
technologies. Given that, international factor movements will (similarly to an opening to
free trade) restore an economy’s pattern of production and trade that have been
distorted by domestic labor/capital market restrictions.
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CHAPTER 6
BIBLIOGRAPHY
RECOMMENDED READING
Findlay R., Factor Proportions, Trade and Growth, MIT Press, Cambridge 1988.
115
CHAPTER 7
INDUSTRIAL STRUCTURE
AND INTERNATIONAL TRADE
M. Vlassis
The scope of Chapter 7 is to examine the influence of different industrial structures The Scope
(or types of industrial organization) on international trade. Industrial structure/ of the Chapter
industrial organization refers to the way in which the interaction among firms in an
industry/sector makes up (e.g., determines the outcomes of) the industry/sector.
There are four prevalent types of industrial organization: perfect competition,
monopoly, monopolistic competition, and oligopoly. Using this framework, the
topics covered in this chapter include firms with market power and international
markets (along with product differentiation, quality variation and international trade),
oligopoly and international trade. Moreover, Chapter 7 addresses other important
factors that cause international trade (technology, product cycles, increasing returns,
income).
After completing the study of Chapter 7, the reader will: Learning

ñ understand the links between firms’ interactions, industrial organization and Objectives
international trade
ñ have acquired insight into alternative (to comparative advantage/factor proportions)
theories of international trade
ñ have developed an understanding of the variety of activities that make up international
production and trade.
ñ Natural monopoly Key Words

ñ International monopoly
ñ Price discrimination
ñ Dumping
ñ Dominant firms
ñ Fringe firms
ñ Minimum efficiency scale
ñ Monopolistic competition
ñ International duopoly
ñ Oligopoly
ñ Collusion
ñ Kinked demand curve
ñ Product cycle
ñ Technology and trade
117
Introductory Departing from the assumption of the ideal industrial structure (e.g., perfect
Comments competition with price-taking firms), Chapter 7 adds more depth and comprehension
to the explanation of international trade in the context of the factor proportions
model. Monopoly power and/or competition among few firms with some market
power often characterize international markets (e.g., industries/sectors open to
international trade). To this end, the simplest type of industrial structure is
monopoly, where there is only one firm in the market. For instance, an international
monopoly occurs when a single firm is the only supplier in an international market.
Then, compared to a perfectly competitive structure, in this market the equilibrium
output will be less, it will be sold at a higher price, and the international monopolist
will enjoy positive economic profits even in the long run (so long as the monopoly
power is maintained). Further, often there are only a few firms in an international
market; thus there is an oligopoly. For instance, a firm in one country competes
with a few firms in other countries. Then, the decisions of any one of these firms
affect the decisions of the others, while the outcome of such an industrial structure
can be nearly as competitive as a market with many firms. Yet, a few (probably not
many) firms may collude, instead of competing, and thus share monopoly profits.
International cartels, such as OPEC, are made up in that manner. On the other
hand, in some international markets, there are many firms each selling its own
particular brand. This is a structure of monopolistic competition, where individual
firms possess some power to set their price, but they still enjoy zero economic
profits in the long run. All of these types of industrial organization contribute to the
study of international production and trade, as do the various alternative theories
and ideas (like the one suggesting that if two countries have different production
technologies, trade will benefit both).
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CHAPTER 7
7.1 FIRMS WITH MARKET POWER

AND INTERNATIONAL
MARKETS
7.1.1 International monopolies

A firm facing a downward sloping demand curve for its product is a firm that
possesses some market power. Typically, such firms opt to determine the price and
quantity of their output that maximize their own profits. In the extreme case of
monopoly, i.e., when there is only one firm in the given industry, the demand for
the firm’s output is the entire market demand. In principle, there are two types of
monopolies: natural monopolies and legal monopolies.
ñ A natural monopoly arises when, due to economies of scale, average costs

decline up to output levels able to satisfy the entire market demand. This
implies that a large firm can meet market demand facing lower per unit cost
than any one of the small firms, which altogether comprise the alternative
supply source. Naturally then, any small firm would eventually be driven out of
business and/or would not dare to enter the market in the first place.
ñ A legal monopoly, on the other hand, arises as it possesses property rights (e.g.,
patents, licensing, franchises, resource ownership) that prevent other firms
from entering the market, even if there is no situation of natural monopoly.
In any of the above instances, the monopolistic firm’s profit maximizing price and
quantity are those at which the MR (the additional revenue) and the MC (the
additional cost) of an extra unit of the firm’s output (produced and sold) are equal.
As an illustration (see Figure 1), consider the case of a legal monopoly in the
international market for diamonds; assume for example that the world’s diamond
deposits are located in a single country and this country has rendered to a single
firm the property rights to mine and sell diamonds in the international market.
119
P
MC
PM
PC
MR
QM QC Q
Figure 1: An International Monopoly of Diamonds
The profit maximizing price and quantity are found as follows:

The general algebraic representation of the (linear) inverse demand function D,
depicted in Figure 1, is P=a–bQ;a>0, b>0. Therefore, the expression for the total
revenue function is TR(≡ PáQ)=aQ–bQ2. It follows that MR(≡ dTR/DQ)=a–2b.
Hence, as depicted in Figure 1, the (linear) curve is downward sloping, with the
same D curve vertical intercept and twice its slope. On the other hand, because of
the diminishing marginal productivity of the variable input (labor), in the short run,
the MC(≡ dTR/dQ) curve is, as drawn in Figure 1, upward sloping. In consequence,
the monopolist’s profit-maximizing output QM occurs where the two curves (MR
and MC) intersect. There, and only there, does the firm’s extra revenue from the
last unit of output sold (MR) exactly compensate the extra cost of producing that
unit (MC).The intuition of this result is that, if Q<(>)Q M and as noted from
Figure 1, MR>(<)MC the firm must increase (decrease) the quantity of diamonds
it produces and sells in the international market, since its per unit extra revenue
will then be higher (lower) than its per unit extra cost.
Once the profit-maximizing quantity QM is derived as above, the monopolist’s
profit-maximizing price PM is simply the price that corresponds to that quantity along
the D curve; at this price, the quantity of diamonds supplied by the monopolistic firm
is equal to the quantity of diamonds demanded by consumers in the international
market.
To grasp the effects of monopoly in the international market for diamonds,
assume that, given the same demand conditions, the industry was instead made up
of a large number of competitive small firms. That is, suppose that no property
right to mine and sell diamonds has been exclusively rendered to any producer and
that there are no economies of scale (or other production asymmetries among
firms) leading to a situation of natural monopoly. Then, the MC curve drawn in
Figure 1 will depict the aggregate supply curve in the international market for
diamonds and, thus, the international equilibrium will occur at a higher quantity
of diamonds (QC), sold at a lower price (PC), relative to the case of international
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CHAPTER 7
monopoly. To understand why this will be so, first note that, given a large number
(say n) of symmetric firms, each firm will produce and sell the same quantity of
diamonds, qC=QC/n in equilibrium. The latter can in turn be explained with the
help of Figure 2.
MC
PC D=MR
qC q
Figure 2: A Competitive Seller of Diamonds
Figure 2 depicts the equilibrium for any one of the many (n) small firms that
make up the international diamond industry. Its essence is that this firm has no
market power, since it cannot alone affect the international price of diamonds. In
effect, this firm (just as any one of the other n – 1 firms) is always a price-taker in
the international market. Hence, its MR always coincides with the international
price of diamonds and, as previously explained, it will produce up to the point
where P=MR=MC. In consequence, the international aggregate (market) supply
of diamonds, drawn as the monopolist’s MC curve in Figure 1, is made up of the
horizontal summation of n MC curves like the one depicted in Figure 2. Thus, the
equilibrium in the competitive international market for diamonds occurs where:
ñ D=MC, i.e., market demand equals market supply (at Q=Q C ), and this
configuration delivers a price Q=QC to each competitive firm.
ñ D=P=PC=MR=MC, and each competitive firm produces q C =Q C /n.
Unlike international monopolies, perfect competition in the international
market leads to the elimination of economic profits in the long-run; whenever, in
the short-run, the competitive firms are making profits, other firms enter the
industry thereby increasing supply (and thus decreasing the price) until all
economic profits are exhausted in equilibrium. Hence, if a country imports from an
international monopolist, a tariff may prove politically popular. While domestic
consumers will then face a higher price (for less of the imported good), they can
enjoy part of the monopoly profits in the form of transfers which are financed by
the tariff revenue. Interestingly, therefore, the value of the tariff revenue (and thus
the transfers to consumers) can be even higher than the value of the consumer
surplus which is lost due to the tariff. This situation is depicted in Figure 3.
121
PM
PAT MC*
PBT AC*
MRã MR Dã D
QAT QBT QM
Figure 3: A Tariff on an International Monopolist
Prior to a tariff, the equilibrium (P BT,Q BT)occurs where MR=MC. A tariff

imposed per unit of the imported good (Q M )results in an inward shift of the
demand curve which the monopolist effectively faces after the tariff (e.g., from D to
Dã. In consequence, the international monopolist determines its after-tariff optimal
output (QAT>QBT) so as to satisfy the condition MRã=MC. At this (lower) level of
output the price charged to consumers (along the curve) is in turn PAT>PBT.
Hence, because of the tariff, domestic consumers suffer a loss (in terms of
consumer surplus) equal to: {(PAT –PBT)áQAT +[(PAT –PBT)á(QBT –QAT)]1/2}, in
equilibrium. Yet, on the other hand, this policy brings in tariff revenue equal to the
shaded area, in equilibrium, and the value of this tariff revenue is obviously larger
than the value of the lost consumer surplus.
7.1.2 International price discrimination

To increase its profits, an international monopoly can apply international price
discrimination, regarding the price of the (same) good it is exporting to different
countries. In principle, this pricing strategy arises because the demand schedules
derived from consumers living in different countries exhibit different price elasticities
of demand. Then, so long as international resale of the good charged at different
prices is impossible, the international monopolist will charge a higher (lower) price for
the good exported in countries with more inelastic (elastic) demand.
As an illustration (see Figure 4), assume that an international monopolist
exports its product to two countries whose individual demands for the product are
summarized by D (high elasticity) and Dã(low elasticity). Effectively, therefore, the
monopolist respectively faces two separate group of buyers (one located in each
country), each delivering a different marginal revenue schedule; Then, since the
monopolist’s cost to produce an extra unit of output (e.g., its MC here assumed to
be constant) is the same wherever it sells that unit, the profit-maximizing strategy
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for the international monopolist is to allocate its exports so that:

ñ The last unit sold in each separate market brings in the same extra revenue (e.g.,
ñ The last unit of output (wherever sold) brings in as much extra revenue as its
extra cost for the firm (e.g., MR=MR*).
PM
P*
P
MR*
MC
MR D* D
Q* Q QM
Figure 4: International Price Discrimination
As shown in Figure 4, the international monopolist will charge a higher price

(P*) and export a lower quantity (Q*) to the country with the (relatively) inelastic
demand schedule (D*). Note that a similar result emerges if the MC schedule (here
the marginal cost is assumed to be constant) slopes upward, or even downward. It
should be further noted that, in international economics, the term dumping
typically means that a foreign firm may temporarily sell its exports at a price lower
than its average cost, in order to run domestic competition out of business. This
must not be conceptually confused with the price discrimination strategy of an
(already established) international monopolist, as is the case here. Yet, if we
assume that the relatively inelastic demand country is the (monopolist’s) domestic
market, then charging a lower price abroad than at home looks similar to a dumping
strategy.
(a) Give the intuition behind the price discrimination rule; why shouldn’t the profit-
maximizing monopolist charge the same price across (the D,D*) countries?
(b) Assume that only the country with the low elasticity of demand imposes a tariff on the
imported good. Is it, then, possible that the monopolist will reverse its pricing strategy
(e.g., charge its exports to the D(D*) country at the higher (lower) price)? Should it,
then, export more or less in each country? Explain using Figure 4.
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7.1.3 A dominant exporter and many fringe
domestic firms
Some markets are characterized by the co-existence of a large foreign firm
that sets the price (i.e., a dominant exporter), and a large number of small (fringe)
domestic firms that behave as price-takers. The foreign exporter’s market power
typically arises from both its individual size (capacity) and lower cost relative to
domestic firms. The latter firms can do nothing more than producing and supplying
according to the price set by the foreign exporter. Such an instance is depicted in
Figure 5.
FS
Pmax
D
DF*
PD
Pmin
MC*
MR*
QF QD QR Q
Figure 5: A Dominant Exporter
In Figure 5, D represents total domestic demand for good Q, while FS is the

aggregate supply curve of all the (symmetric) domestic producers; it is made up of
the horizontal summation of the similar individual MC curves of the domestic
(fringe) firms. Then, the schedule DF* represents the (residual) domestic demand
which the foreign exporter effectively faces. This is so since:
ñ If the foreign exporter sets its price equal to and/or below Pmin, domestic aggregate
supply (FS) would be zero; hence, the entire domestic demand should be covered
by exports.
ñ If the foreign exporter sets its price equal to and/or above Pmax, domestic demand
would be entirely covered by domestic production (along the FS curve), hence,
exports would be zero.
ñ If the foreign exporter sets a price between Pmin and Pmax, exports would cover
the part of domestic demand which is left after subtracting (from total domestic
demand) what domestic producers would in sum offer at that price.
In consequence, the dominant foreign exporter will set its price so as to equalize
its (residual) marginal revenue MR* (derived from DF*) with its marginal cost
MC*. Hence, in equilibrium, the dominant firm will export the quantity QD and
charge the price PD. At this price, in turn, the domestic price-taking firms will in
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sum produce QF. Note that, since QF = (QR – QD), at the equilibrium price PD (as
at any other price satisfying Pmin<P<Pmax), the emerging output configuration
verifies the exporter’s residual demand function DF*.
The effects of a tariff, imposed on imports from the dominant foreign exporter,
can subsequently be considered:
ñ A tariff will reduce the dominant exporter’s market share/output on the domestic
market, to the benefit of domestic producers. Hence, due to a tariff, some of the
foreign firm’s market power and profit will be taken away.
ñ A tariff will create revenue for the government and increase domestic employment.
ñ A tariff will increase the price of the good (imported and domestically produced),
will decrease consumption, and thus lead to a loss in consumer surplus.
7.1.4 Product differentiation, quality variation

and monopolistic competition
In the framework of industrial organization, there is a self-evident conceptual
distinction between the terms product differentiation and different products. Yet,
given any practical (even arbitrary) classification of products, there will be some
product differentiation, due to quality variation, within each product category.
More importantly, cost differences in producing different qualities of the “same”
product can lead to international trade involving imports/exports of goods belonging
in the same product category.
Consider, for instance, a market for soccer balls. A consumer buying a ball is in fact
interested in the sporting service provided to him/her by that product. Effectively, the
market for soccer balls is a market for ball services, and higher quality implies
better ball services. On the other hand, a ball of better quality costs more to produce.
As an illustration, Figure 6 depicts the pricing/quantities strategy of an international
monopolist of soccer balls, distinguishing between two qualities of balls: high (h),
low (l).
MCh
Ph
MCl
Pl
D
MR
Qh Ql Q
Figure 6: Quality Variation and Price Differentiation
125
In Figure 6, note that the international monopolist faces two marginal cost
schedules: MCh, corresponding to the high quality ball, and MCl corresponding to
the low quality ball, and that MCh > MCl at any level of output Q. On the other
hand, the various points along the D schedule (e.g., the aggregate demand for
soccer balls) effectively represent heterogeneous consumers, with different
willingness to pay for “soccer ball quality;” consumers valuing quality more will be
willing to pay a higher price per ball. In equilibrium, therefore, the monopolist will
produce a lower (higher) quantity of the high (low) quality balls: Qh > Ql, and will
correspondingly charge a different price per ball, Ph > Pl, since with this price/output
configuration MR equals MC for each quality.
From this analysis, significant implications arise for international trade.
Suppose that somehow there exist only two firms producing soccer balls. One is
located in a capital abundant country (say, France), while the other is located in a
labor abundant country (say, Pakistan). Then if the production of high (low)
quality balls is capital (labor) intensive, the French (Pakistani) firm will effectively
become an international monopolist in high (low) quality balls. In effect, France
(Pakistan) will export high (low) quality balls and import low (high) quality balls,
i.e., both countries will import and export goods belonging to the same product
category.
Yet, in a different industrial context, firms selling differentiated products may have
some but not all of the market power, and the structure and effects of international
trade will then be different. In the previous example, moreover, assume that while
consumers have similar tastes for soccer balls across countries, entry is free to the
soccer ball industry. Then, as both French and Pakistani firms make positive
economic profits, there is a clear incentive for other firms to produce soccer balls
(of any quality) and sell their product in the international market. In consequence,
two major effects will ensue:
ñ As more firms (selling differentiated products) enter the industry, consumers have
more substitutes and thus the demand that each firm faces falls and becomes
more elastic.
ñ Entry may lead to competitive bidding in the factors markets, thus pushing up
each firm’s per unit cost (AC).
As a result, the soccer ball industry will eventually be organized in the type of
monopolistic competition. As shown in Figure 7 below, such an industrial structure
in turn means that, in the long-run, the typical firm of the soccer ball industry will
still possess some market power, and will thus face a downward-sloping D curve,
due to product differentiation. Yet, due to free entry and international competition,
such a firm will enjoy zero economic profits.
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MC
AC
P*
MR
q*=Q*/n q
Figure 7: Product Differentiation and Monopolistic Competition
The reader can summarize and check his/her understanding of the content of
Section 7.1, by undertaking the following activity.
(a) Assume that there are no cost differences to produce a high or low quality soccer ball.
Would there still be scope for price differentiation, P h > P l , for an international
monopolist of soccer balls? Explain, using Figure 6.
(b) Starting from the equilibrium depicted in Figure 1, and ending up at the equilibrium
depicted in Figure 7, explain (step by step) how and why unlimited entry into a
monopolistic industry (through international trade) will eventually lead to zero economic
profits. Note that, in Figure 7, q stands for the individual output level of the typical firm in
the industry, while Q stands for the industry’s aggregate output, and n stands for the
number of firms in the industry.
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7.2 OLIGOPOLY
AND INTERNATIONAL TRADE
7.2.1 The nature of oligopoly

An industry/sector populated with only a small number of firms, each of them
possessing some market power, is called an oligopoly (or, an oligopolistic industry/
sector). Oligopolies can be national or international. In the latter case, firms can be
located in different countries while they are competing in the international market.
In oligopolistic industries, three crucial elements characterize the nature of interaction
among firms:
ñ Due to large individual size, the firms’ decisions are strategically interrelated.
That is, each firm always considers their opponents’ reactions to any of its
decisions and thus designs its optimal strategy.
ñ Instead of competing, firms may find it optimal to collude and thus effectively
act as a monopoly. The latter option (cartel) means that, while the firms’ joint
profits thus increase, there is a problem of splitting those (monopoly) profits
among individual “partners”.
ñ Within national borders collusion can be made easier, nonetheless, national
antitrust laws may discourage cartel formation. On the other hand, collusion
across national borders is more difficult, but the absence of international legal
restrictions often gives rise to international cartels (like in oil, rubber, coffee,
tea, and bananas).
7.2.2 Price and output stability

in oligopolistic industries
The kinked demand model attempts to explain the price and output stability
which is often observed in (domestic and/or international) oligopolistic industries.
Assume that the running price for a certain product which is produced and traded
in an oligopolistic market is PS and, by charging this price, each of the n firms in the
industry enjoys a certain market share (q=Q/n) along the industry’s market demand
schedule D (see Figure 8).
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CHAPTER 7
PS MC
MCh
MCl D
MR
qS q=Q/n
Figure 8: Price and Output Stability in Oligopoly
Then, regarding its pricing policy, each firm in the industry faces the following
strategy options:
ñ To raise its price above P S. In that instance, no other firm in the industry is
expected to follow this policy and, hence, the given firm’s market share will fall.
The same is true for all P>PS, therefore, for that range of prices the demand
schedule which the given firm effectively faces becomes more elastic.
ñ To lower its price below PS. Then, all other firms would naturally be expected to
follow the same policy, in order to avoid a shift of their customers to the price
cutting firm. In effect, for any P<PS the given firm’s demand schedule coincides
with D.
In consequence, any oligopolistic firm in the industry faces a discontinuous MR
schedule (derived from the kinked demand curve), like the one shown in Figure 8.
More interestingly, this in turn implies that changing costs, leading to shifts of the
MC curve within the depicted (MCh , MCl) range, will not lead to price and output
changes away from the depicted equilibrium (PS ; q S ).
7.2.3 Competition versus collusion

in international oligopolies
As stated above, in international oligopolistic markets collusion, though “legal”,
is less likely to emerge than in domestic markets. To understand why, consider the
following international duopoly game. Two firms act simultaneously in deciding how
much each will produce and sell in a domestic/international market, and for
simplicity assume that each firm faces two options: either to produce a high quantity
(strategy H), or to produce a low quantity (strategy L). As the product price depends
on the total quantity produced and sold in the market, if both firms choose the H
strategy, and thus compete in quantities, their payoffs (e.g., profits) will be lower in
equilibrium than if they collude by simultaneously choosing L, and thus effectively
forming a cartel splitting the emerging (joint) monopoly profits between them.
129
Yet, a temptation arises for each firm to cheat, by unilaterally increasing its own
output and thus enjoying an even higher payoff than that obtained by complying
with the implicit cartel arrangement (where both firms choose L). Of course, if this
deviation materializes, the cartel breaks down and oligopolistic competition
instead of collusion emerges, which is beneficial for consumers. In fact, if this game
takes place once (say, a year), both firms will definitely choose the L strategy, and
oligopolistic competition will thus emerge in equilibrium.
Nonetheless, as the game is repeated year after year, assume that any one of the
firms unilaterally restricts its own output (e.g., “plays” L) in the first year, and all
years after so long as its rival also restricts its output the first year (and all years
after). Conversely, if a firm’s rival deviates, in any year, the firm will “pay back” its
rival by also “playing” H forever. Hence, collusion may emerge, as the other firm
realizes that the (split of the cartel) profits it enjoys by also restricting its output, over
the time span, will be higher than the (temporarily higher) profits from cheating. It
follows that, for a cartel to be established and sustained, all that is needed is
consistent restrictive behavior by all firms. Yet, for the latter to be guaranteed,
monitoring and detection – and thus “punishment” – of the deviants is required.
This, in turn, can be easier in (small) domestic industries than in (large) international,
oligopolistic industries.
In sum, the main suggestions of Section 7.2 are the following:
ñ In an oligopolistic industry, firms have an incentive to collude and, by forming a
cartel, each enjoys higher profits than with rivalry. Yet, game theory predicts
that international oligopolistic collusion, though legal, is more difficult to
emerge/sustain than in domestic oligopolies.
ñ The kinked demand model offers an explanation for the price and output stability
which is often present in domestic/international oligopolistic industries under
various cost circumstances.
ñ In general, the strategies available to firms, along with the structure of their
payoffs arising from each choice, determine the outcome of an international
oligopoly.
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7.3 TECHNOLOGY AND INCOME

IN INTERNATIONAL TRADE
The present section lays out, in summary form, four supplementary theories
about the possible causes of international trade. Three of them deal with technology
factors, while the other addresses income as an important determinant in international
trade.
Technology Factors
ñ The production of the various goods depends on technology, i.e., the production
function which, in each particular instance, describes the relationship between
inputs and outputs. Therefore, different countries may be endowed with and
employ the same amounts of factors of production and still get different outputs
for each product variety. In consequence, countries have an incentive to specialize
in, and export, the products in whose production they possess a relative
technological advantage.
ñ One proxy to measure technology is spending on research and technology (R&D).
The main issue here is that, as new products typically require substantial
investments in R&D, the developed countries (DC), which typically are relatively
abundant in scientists and engineers, have a comparative advantage in developing
and exporting new products. On the other hand, as goods produced with
established techniques require no R&D, the least developed countries (LDC)
have a comparative advantage in producing and thus exporting low-tech goods.
This pattern of production and trade is reviewed from time to time, as the LDCs
eventually copy new products and thus the DCs lose their monopoly power
delivered from past R&D. In consequence, as the product cycle model predicts,
so long as countries are putting resources into R&D, they are net exporters of
new products.
ñ Returns to scale refer to the percentage increase in the firm’s output as all of its
inputs increase by the same percentage. As the employment of all inputs is, say,
doubled, output could: increase by 100% (constant returns to scale (CRS));
increase by less than 100% (decreasing returns to scale (DRS)); or increase by
more than 100% (increasing returns to scale (IRS)). Thus, with IRS (DRS), and
given the input prices, a firm’s long-run AC decreases (increases), as the firm
increases its output by proportionally increasing all of its inputs. Typically, as a firm
increases its output level, it initially faces IRS, it eventually reaches an output level
where it achieves the lowest possible AC, which is the firm’s minimum efficiency
scale (MES), and then the firm faces DRS (e.g., increasing AC). Therefore, all
131
other things being equal, any firm producing at a level of output less than its
MES cannot compete with other firms in the same industry operating at their
MES. This point has significant implications for international trade: firms
considering entry into an industry should not enter unless they can reach their
MES. In effect, countries need to specialize in some industries, and increase
production through trade, in order to enjoy higher income.
Income
While the comparative advantage determines a country’s pattern of production,
income (among other demand parameters) contributes to the determination of a
country’s consumption pattern. Hence, the income determinant of demand may
help to predict the pattern of trade arising among a group of countries. To see why,
define the income elasticity of demand for a good Q as:
dQ/Q
eI = 
dI/I
That is e1, measures the percentage change in the quantity of the good demanded,
relative to the percentage change in income (I) that ceteris paribus causes the
former change. Most goods, in turn, exhibit a positive eI, and they are called normal
goods, while some goods for which eI< 0 are called inferior goods. Moreover, some
of the normal goods may exhibit an eI >1, and they are characterized as luxury
goods, while others which are called necessity goods have eI<1. More importantly,
higher income typically leads to less (more) consumption of inferior and necessity
(luxury) goods. Hence, it can be inferred that high income countries tend to import
relatively more luxury goods than necessity and inferior goods, while low income
countries tend to import relatively more necessity and inferior goods, and fewer
luxury goods. As a corollary, if the production pattern is similar across countries,
LDCs would be net importers of necessity/inferior goods, while DCs would be net
importers of luxury goods.
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ñ Firms with market power restrict output and raise prices, relative to competitive
firms. Hence, contrary to the case where the given industry/sector is
organized in the form of perfect competition, a tariff on imports from a
foreign monopolist can be welfare improving: so long as the tariff revenue is
somehow transferred to domestic consumers, the welfare gains can be higher
than the losses in terms of consumer surplus due to the tariff.
ñ Product differentiation and quality variation are sources of market power
and lead to international trade regarding similar product categories. Those
sectors/industries, in turn, are often structured in the form of monopolistic
competition. Under this market structure, the outcome is close to that of
perfect competition as regards long-run profits. Yet, the output is still
restricted (while the price is raised) and, thus, consumers are (implicitly)
“taxed” for enjoying product variety.
ñ In an international/domestic oligopoly, firms have an incentive to collude,
form a cartel and collectively enjoy monopoly profits. Yet, it is more difficult for
international oligopolies relative to domestic ones to emerge and be sustained,
endogenously. On the other hand, international antitrust legislation is still
non-existent and politically difficult to get established.
ñ There are supplemental explanations of the causes of trade among countries:
technological differences, need for investments in R&D and, thus, differential
ability to develop new products, increasing returns to scale, and differences in
national incomes. Yet, the factor proportions theory provides the fundamental
reasoning regarding international trade.
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APPENDIX
Activity 1
(a) To get the intuition behind the price discrimination rule, assume that the international
monopolist charges the same price, say PE, across the D,D* countries. For instance,
assume that PE is equal to the price charged to the D* country (e.g. P*) under the price
discrimination rule. Then, from Figure 4, it is evident that the quantities sold (when the
price is PE) in each country are QE,QE with QE < Q and QE* = Q*. At this output/sales
configuration, MR>MR*=MC. Therefore, regarding the D country, the price charged
per unit of output must decrease (below P*), so that the quantity sold there will increase
until MR=(MR*=)MC. The reason is that, unless the output sold in the D country is
exactly Q, each extra unit of output sold there will bring more revenue to the firm than its
costs of production. Hence, the monopolist’s profits can be further increased by
producing more output and allocating it as sales (only) in the D country. This is done by
configuring prices (as shown in Figure 4) so that the last unit of output, wherever sold,
will get as much extra revenue as its extra cost of production.
(b) As the country with the low elasticity of demand imposes a tariff on the imported good,
both the D* and MR* schedules effectively shift inward for the monopolist. The reason is
that the after-tariff price which the monopolist receives is, at any level of sales, lower
than the price paid by domestic consumers by a fixed amount, which is the tariff rate per
unit of imports. In consequence, the monopolist will export even less in the D* country,
and charge its exports there at an even higher price (along the original D* curve), than
prior to the tariff. On the other hand, since the D and MR schedules remain the same,
the monopolist will not change its pricing/sales policy regarding the D country.
Therefore, with the tariff, the monopolist will reinforce its price discrimination strategy
across the D*, D, countries.
Activity 2
(a) Since there are no cost differences to produce a high or low quality soccer ball, in Figure
6, the international monopolist faces the same MC schedule, say MC l , in order to
produce an extra ball of either quality. Hence, given the aggregate demand for soccer
balls (D), the total quantity of balls produced and sold in equilibrium would, as
previously, be Qh + Ql. However, if marginal cost was MCh, the monopolist would only
produce Qh (high quality balls). Yet, recall that the D schedule aggregates the demand
of heterogeneous consumers with different willingness to pay for “soccer ball quality.”
In equilibrium, therefore, the monopolist will still differentiate prices, i.e., will charge the
high (low) price to the group of consumers that values quality more (less). The reason is
that, with Ph > Pl, and given that consumers (living in different countries) have limited
ability to “buy low and sell high”, the international monopolist’s profits increase as it
extracts consumer surplus equal to (Ph – Pl)á Qh.
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(b) Figure 1 illustrates the short-run equilibrium of an international monopolist of diamonds.

Recall that the property rights to mine and sell diamonds are assumed to belong only to
the given firm. Therefore, in the long run, this firm will enjoy economic profits if entry into
the particular industry is still legally prohibited. Suppose, however, that entry is freed.
That is, the government of the given country renders the right to mine and sell diamonds
to any (domestic or foreign) firm. Then, as many firms (e.g., enter the diamonds
business, opting for some of the economic profits, and all charge the same price, the D
demand schedule of Figure 1 effectively depicts the fraction of aggregate demand (e.g.,
which corresponds to each firm at any (common) price. This, in turn, means that the D
demand schedule of Figure 7, which the typical firm of the industry individually faces,
cannot be compatible with positive economic profits for long, i.e., above the AC curve,
in equilibrium. So long as the incumbent firms enjoy some economic profits, more firms
will enter the industry, and price competition among them will drive the diamond price
down, until (as shown in Figure 7) all economic profits are exhausted.
135
BIBLIOGRAPHY
RECOMMENDED READING
Blair R., Kaserman D., Antitrust Economics, Irwin, Chicago 1985.
136
CHAPTER 8
INTERNATIONAL MOBILITY
OF LABOR AND CAPITAL
The scope of Chapter 8 is to examine international factor mobility, that is, the The Scope
international mobility of labor and capital. In a globalized economy, not only are of the Chapter
raw materials, semi-final and final goods as well as services, moving from one
country to another, but factors of production are also. This factor mobility may
change the production possibilities of all countries involved and thus it may change
the pattern of production and trade. This chapter analyzes the importance of factor
mobility in modern economies. The topics covered include international migration,
international capital mobility, international trade and factor mobility, and finally,
income redistribution resulting from factor mobility.
After having completed the study of Chapter 8, the reader will be: Learning
ñ familiar with the role of factor mobility in the globalized world Objectives
ñ able to understand the gains obtained and losses incurred for countries involved
in international factor mobility.
ñ Immigration and emigration Key Words

ñ Legal and illegal migration
ñ Economic migrants and asylum seekers
ñ Temporary or host workers migration
ñ Brain drain
ñ Replacement migration
ñ Foreign direct investment
ñ Foreign portfolio investment
ñ Factor mobility and trade
Chapter 8 presents and analyzes the case of international factor mobility in a Introductory
globalized world. Factors of production are moving internationally in search of Comments
better rewards. That is, capital is searching for better returns and labor is searching
for better income opportunities and/or better living standards. This mobility of
huge amounts of capital and large flows of labor affects both the country of origin,
as well as the receiving country. Factor mobility entails gains for some countries, as
well as losses for others; it may also change the pattern of production and trade of a
country. We first examine the case of international migration, and then we analyze
the case of international capital mobility; in each case we examine the role of
international trade and the income redistribution resulting from factor mobility.
137
8.1 INTERNATIONAL MIGRATION
International labor mobility is an issue of increasing interest and importance
worldwide for many reasons.
ñ First, international labor flows affect the size, the age structure and the skills of
the labor force in both the country of origin and the host country.
ñ Second, the magnitude of human flows across countries has become relatively
large in recent years: in 1999 some 130 million people (2.2% of the total world
population) were residing outside their nations of citizenship.
ñ Third, the scale of international labor flows might rise in the future as a result of
widening economic differentials, demographic pressures, differential labor-
force growth rates and the extension of transportation and communications.
Moreover, many governments of countries where labor is in abundance are
currently following policies which either explicitly or implicitly promote exports
of labor. Given the high level of unemployment in many western countries,
labor inflows generate concerns by both policymakers and the general public
about the possible adverse effects of immigration on the employment of native
workers.
ñ Fourth, migration flows are volatile and unpredictable, with political as well as
economic causes and consequences. Indeed, in the past decade, political and
economic changes in Europe have resulted in millions of international migrants
from Eastern European countries into EU countries. In Albania, for example,
the net emigration between 1991 and 1993 is estimated to have been between 6.2
and 9.2 % of the Albanian population. Also, traditional emigration countries,
such as Italy, Greece, Spain and Portugal, have not only become net immigration
countries but, along with Germany, are also the main destination countries in
Europe.
ñ Fifth, the financial flows associated with international labor movements are
substantial: official remittances were nearly US$ 70 billion in 1995, second in
value only to trade in crude oil, and larger than official development assistance.
8.1.1 Types of international migration

International migration flows are categorized either from the point of view of
the sending and receiving countries or upon the intentions and characteristics of
the migrants. In this section, we distinguish between immigration and emigration,
regular and irregular migration, economic migrants and asylum seekers, as well as
temporary and replacement migration; we also present the case of brain drain.
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CHAPTER 8
Immigration and Emigration

Immigration is the case of having migration flows into a country which is often
called the receiving or host country, while emigration is the case of having migration
outflows from a country which is often called the sending or home country.
Regular or Legal Migration and Irregular or Illegal Migration

By regular or legal migration we mean that migrants are authorized to enter the
receiving country and to engage in activities under the laws and regulations of the
receiving country. On the other hand, irregular or illegal migration is when workers
cross the borders into foreign countries without the required authorization, or they
initially enter legally but then abuse their residence permit or visa and become
“illegal immigrants.” From the economic point of view, there is not any basic
difference in the causes of legal versus illegal migration other than the higher costs
and uncertainty related to the illegal case. Illegal immigration has recently become
a topic of increasing interest word-wide. In the European Union there are currently
more than 3.0 million illegal migrants. Greece, for example, a traditional emigration
country, has become a net immigration country with illegal immigration from
Albania equivalent to 9% of the Greek labor force.1 Moreover, poor living standards
and political unrest in many parts of the world are expected to raise the scale of
migratory movements in the future. Governments try to control illegal migration
either by imposing fines on the firms that employ illegal migrants, and thus making
it difficult for illegal migrants to find a job, or by increasing patrolling of the
borders, imposing penalties on migrants and detaining illegal migrants.
Economic Migrants versus Asylum Seekers

Economic migrants are legal or illegal migrants that care about economic
conditions both in the country of origin and the destination country. On the other
hand, asylum seekers are people pushed out of their country due to political
persecution, civil wars or to violation of human rights. Thus, the main difference
between asylum seekers and economic migrants is that asylum seekers would not be
expected to care about economic conditions in the country of origin; however,
empirical evidence shows that they are sensitive to differences in economic conditions
between potential destination countries. The total number of asylum seekers in
Europe was about 158,000 in 1980; 170,000 in 1985; 695,000 in 1992 and 344,000 in
1998. Germany, the UK, the Netherlands, Switzerland, Belgium and France were
the countries which attracted most of the asylum seekers in the period 1980-1998.
The problem with the asylum migration is that it causes certain costs to the
receiving countries, such as administration, housing and maintenance expenses. In
France, the costs implied by asylum seekers was FF 52.9 million in 1988 and
increased to FF 142.9 million in 1990, while in Germany it went from DM 143.5 in
1
In the USA, the number of illegal workers is estimated to be between 3.5 and 4.0 million.
139
1992 to DM 486 million in 1993. With the numbers of asylum seekers and the
associated costs increasing rapidly, most governments have had to impose higher
restrictions. Due, however, to the asylum shopping behavior, 2 there is
interdependence between countries in changing legislation since softer asylum
laws in one country induce more asylum seekers to enter that country.
Temporary or Contract or Host Workers Migration

This type of migration includes low-skilled and low-paid workers. A typical
example of this type is the European guest worker program and the resulting large-
scale migration flows that took place from the 1950s till 1973. This migration
covered temporary gaps in the labor market of the western European countries,
such as Belgium, France and Germany, from the lesser-developed Mediterranean
countries. Temporary migrants have the intention of returning to their countries
after the period of invitation. Given the large income differences between EU-host
countries and non-EU sending countries, liberal EU policies have resulted in large
migration inflows that were self-perpetuated in the subsequent years due to
network migration.
Replacement Migration
According to the United Nations, replacement migration is the international
migration that a country would need in order to offset population decline and
population ageing resulting from low fertility and mortality rates. For example,
according to a United Nations population report, in the period 1995-2050 countries
like Italy will incur a reduction of between one-quarter and one-third of its 1995
population. This future reduction in population, and consequently in the workforce
of Italy, raises doubts about the viability of the social welfare system in this country. It
has been suggested, therefore, that countries facing a decline in their population
should allow replacement migration so as to be able to maintain their social welfare
system intact.
Brain Drain
Emigration is not only an attractive option to an unskilled labor force, but it is
even more attractive to highly skilled professionals such as medical doctors, IT
specialists, engineers, scientists and other professionals, who could expect much
higher returns abroad and at much lower risks than an unskilled worker could
expect. Indeed, as we have already seen, educated and skilled people have a much
higher probability of migrating abroad because they face lower information costs
and higher adaptability when abroad. This emigration of highly skilled individuals
from developing countries into advanced countries has been referred to as a brain
drain. Skilled labor immigration is encouraged by governments of the receiving
2
That is, when asylum seekers are turned down in one country, they reapply to another country.
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CHAPTER 8
countries simply because the host country can thus easily find the appropriate skills
and qualifications (human capital) required for the smooth functioning of its
economy, without undertaking the cost of creating these skills. A typical example
of this case is the summer 2000 invitation of the German government to 20,000 IT
specialists from India and the Central and Eastern European countries (The
Economist, 2000). On the other hand, this emigration of skilled and qualified labor
from the sending - and often poor - countries deprives these countries of human
capital that was created for the purpose of serving the needs of these countries. The
brain drain changes the composition of skills within the home country and has led
to suggestions of imposing a brain drain tax that would reimburse sending countries
for their costs in creating human capital.
8.1.2 Modeling international migration

According to the Neoclassical Model, the decision to migrate abroad is based on
the utility maximization of a potential migrant, subject to a budget constraint.
Migrants face two alternative “work regimes,” either to work at home or to work
abroad. Differences in the labor market conditions between the home country and
abroad result in a wage differential between them. For example, a large supply of
labor relative to capital in the foreign country (say, Bulgaria) will create a low
equilibrium wage in Bulgaria. On the other hand, a low supply of labor relative to
capital endowment at home (say, Greece) will result in a high home wage. As a result
of these different labor-market conditions between the home and foreign countries,
there will be a wage differential in favor of the home country that will induce workers
to immigrate and work in the home country rather than staying and working in the
foreign country. This approach can be traced back to Hicks (1932) who noted that
“...differences in net economic advances, chiefly differences in wages, are the main
causes of migration...” We may illustrate the above with the help of Figure 1.
W W*
(SGreece/SBulgaria)
DBulgaria
_30 K
Z
_20
M 20 Leva
DGreece
L 5 10 L*
Figure 1: Home and Foreign Labor Markets and Migration
141
In Figure 1, the Greek demand for labor is derived from the summation of all
industrial demands for labor in the home country. An industrial demand for labor
is, in turn, derived from the value of the marginal product of labor, that is:
VMP = P á MPL
where VMP stands for the value of marginal product of labor, P is the product level,
and MPL is the marginal product of labor. The demand for labor slopes downward
due to the diminishing marginal productivity of labor. The labor endowment of
Greece is assumed to be equal to 5 million workers so the Greek labor supply is
vertical3 at L = 5. Equilibrium in the Greek labor market occurs at the point of
intersection (point K) between demand and supply of labor showing an equilibrium
wage equal to È30. The Bulgarian labor market may also be illustrated in the same
figure. Assuming that the size of the horizontal axis (that is the world endowment)
is equal to 20 million workers, the Bulgarian labor endowment is equal to 15
million workers, i.e., the distance from the right to the left as indicated with the
arrow. Thus, Bulgaria’s labor supply is vertical at point L*=15 (or L = 5). The
Bulgarian labor demand is upward sloping 4 in Figure 1. Equilibrium in the
Bulgarian Labor market is at point M with an equilibrium wage equal to 20 leva or
È10.5 Obviously, Greek wages are three times higher and this wage differential in
favor of home wages will be the driving force in inducing emigration from Bulgaria
into Greece. The size of migration flows might be hindered by cultural and language
differences, as well as by the cost of moving. Also, there might be government
restrictions in the home country. However, in the absence of restrictions and with
zero migration costs, emigration into Greece will gradually shift labor supply to the
right and exactly to the middle of the horizontal axis so that each country will have a
workforce of 10 million workers. The new equilibrium point is Z where the wage will
be equal to È20. Clearly, Greece will be better off, as now there is a larger
workforce in the Greek labor market that increases the production possibilities of
Greece, while the reverse is true for Bulgaria. Of course, emigrants may repatriate
some of their earnings in which case the loss to Bulgaria is compensated to some
extent. Greek workers will be paid lower wages now and Bulgarian workers will
enjoy higher wages.
The neoclassical model assumes a market-clearing wage, which of course is in
sharp contrast to the high unemployment in several western countries and especially
in Europe. It could be argued, for example, that the migration decision should
not only depend on the wage differential, but also on the relative employment/
3
Labor supply can be considered to be positively sloped here, however, this would complicate the
presentation.
4
It is downward sloping when the foreign wage is on the vertical axis and labor on the horizontal, however
in Figure 1 the system of axis is rotated around the vertical axis.
5
That is, assuming that a Bulgarian leva can buy È0.50, that is e = (È/Leva) = 0.5.
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CHAPTER 8
unemployment rates, since the migrant could not be certain of finding a job
abroad. This has prompted an extension of the neoclassical model to the case of
unemployment by the Harris-Todaro model, hereafter called the HT model, where
the utility of the migrant depends on the expected wage differential rather than the
actual one. The expected wage differential depends on the probability of the
potential migrant finding a job at his/her destination, which, in turn, depends on
the unemployment rate in the destination country.
8.1.3 International trade and migration

As we saw in the previous section, international migration equalizes the wages
between home and abroad. However, equalization of wages can be brought about
through international trade as well. We illustrate this in Figure 2.
D ' Bulgaria
W W*
(SGreece/SBulgaria)
DBulgaria
K
_30
N
_20
M 20 Leva
D' Greece DGreece
L 5 10 L*
Figure 2: Labor Markets at Home and Abroad and International Trade
Assume now that migration is not allowed between two countries and that the
only option available is international trade. Since Bulgaria has the larger labor
endowment, it will export the labor-intensive good to Greece. As a result of these
exports, the price of the labor-intensive good will increase in Bulgaria which will in
turn increase the demand for labor;6 this is illustrated by the shift of DBulgaria to the
left. On the other hand, the production of the labor-intensive good will fall in
Greece and the price of the labor-intensive good will fall also, resulting in a fall in
the Greek demand for labor, which is illustrated by the shift of D to the left. Free
trade equilibrium is at point N where the equilibrium wage is È20. Thus, free trade
has resulted in an equalization of wages between the two countries by increasing
6
Recall that VMP = P á MPL , so if P increases the VMP increases, and hence the demand curve shifts to
the right.
143
the foreign wage and decreasing the home wage. This equalization was brought
about by shifts in the labor demand curves rather than by shifts in the labor supply
curves, as is the case with international migration.
However, if international trade brings about equalization of wages and we
assume that the wage differential is the driving force behind migration, then
clearly, international trade – by reducing wage differentials – reduces the incentive
to migrate. Thus, international trade is a substitute to international migration. This
is the reason why Mundell (1957) suggested that an increase in international trade
barriers induces migration flows while an increase in the restrictions to factor
movement stimulates international trade. However, Markusen (1983) showed that
Mundell’s conclusions are not valid if the reasons for international trade are
differences in technology or preferences. In that case, international trade and
migration could be complements.
In sum, in Section 8.1 we examined international labor migration. We first
presented the types of international migration and then the neoclassical modelling of
international migration. Next, we examined the effects of international human flows,
both in the sending country and in the host countries. In the absence of restrictions to
free mobility of labor, and also in the absence of moving costs, international migration
will bring about an equalization of wages worldwide. In addition we explained that
international trade can also lead to an equalization of wages worldwide. Thus, trade is
a substitute to international migration since it reduces the wage differentials and thus
the incentive of a worker to migrate abroad.
Is international trade preferable to international migration?

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8.2 INTERNATIONAL CAPITAL MOBILITY
8.2.1 Foreign direct investment

and foreign portfolio investment
Capital is highly mobile in the world economy and is moving from one country to
another in order to get the highest possible returns. The mobility of capital,
however, is much higher than the mobility of labor, because capital owners do not
move with their capital and also due to the electronic financial transfers provided by
the banking system. International capital movements can take the form of either
Foreign Direct Investment (FDI) or Foreign Portfolio Investment (FPI).
FDI is the capital flows resulting from the behavior of multinational companies
(MNCs). Therefore, factors that affect the behavior of MNCs will also affect the
magnitude and direction of FDI flows. As a definition, we could say that FDI is the
purchase of physical assets abroad, over which the parent company (MNC) retains
control. These physical assets can be real estate, factories or businesses run by other
firms or individuals. FDI can be either inward, when foreigners purchase assets in
the home economy, or outward, when home citizens purchase assets abroad. In the
first case, there are capital inflows into the home economy while in the second there
are capital outflows.
On the other hand, FPI is the acquisition of financial assets such as bonds, shares,
treasury bills, bank accounts and other securities. Investment in financial assets is
usually for a shorter-term period than an investment in physical assets. Moreover,
an acquisition of bonds and shares in some company does not lead to direct control
of this company,7 which is the case with FDI.
In this chapter we focus primarily on FDI. The reason for this is that FDI transfers
productive resources from one country into another for longer periods than FPI.
Thus, by its nature, FDI contributes to economic growth of the host country, facilitates
the diffusion of knowledge among countries and improves the general welfare of the
host country. This is why governments in the developing and developed countries
alike, try to attract FDI flows, by incorporating FDI-encouraging strategies into their
industrial and competition policies. More specifically, in the EU there has been an
active promotion of FDI in the last two decades, not only for intra-EU FDI flows, but
also for US and Japanese FDI inflows into member states. Figure 3 illustrates the
effects of capital movement.
7
However, if a company buys a large amount of shares in another company, it may take the form of
acquisition, thus allowing the first company to have direct control over the second one.
145
Greek rate of return r
Bulgarian rate of return r*

(S/S*)ã S/S*
B 15%
10% C
5% A
D* D
20 30
K Total world capital K*
Figure 3: Home and Foreign Capital Markets
The vertical axes of Figure 3 show the real returns on capital, that is the nominal
return minus expected capital depreciation and expected inflation rate. The home
capital market is illustrated on the left side of Figure 3. The home demand for
capital, denoted by D, is negatively sloped due to diminishing marginal productivity
of capital. The horizontal axis shows world endowment of capital which is equal to 40
units of capital. World capital is allocated between the two countries, as shown by the
relative supply line S/S* which is vertical at point 30. Thus, the home market has a
capital endowment of 30 units and the foreign market a capital endowment of 10
units. Clearly, with higher rates of return in Bulgaria, the foreign country, capital will
move out of Greece into Bulgaria seeking higher returns. As capital moves into
Bulgaria, the relative supply schedule S/S* moves to the left and, without restrictions
to free mobility, it will end up exactly in the middle of the horizontal axis at point 20,
with a rate of return equal to 10% in both countries. Thus, capital mobility equalizes
the returns of capital between home and abroad.
Illustrate and explain the equalization of capital returns achieved under free trade.
8.2.2 Factors friends, factors enemies

and distribution of income
We proceed now in our analysis to the examination of how income distribution
might be affected by factor mobility. We distinguish between two types of related
factors: (a) factor friends for which a higher supply of one leads to a higher payment
for the other, and (b) factor enemies for which a higher supply of one leads to a lower
payment for the other. Thus, the income redistribution associated with factor
mobility depends on the specific relation between the migrating factor and all other
factors at home and abroad. We illustrate the above using Figure 4.
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CHAPTER 8
Return of factor F
S
Migra
tion o
f fac tor F
Migra
tion o
f
facto other
rs
Factor F
Figure 4: Factors Friends, Factors Enemies and Distribution of Income
Figure 4 illustrates the demand for and supply of a factor F at home. Migration
of factor F alters its supply and thus results in a shift in its supply curve. Migration
of other factors of production affects the marginal productivity of F and therefore
shifts the demand for the factor. Assume now that there is an immigration of
unskilled workers and that factor F is a friend with unskilled workers, say F is skilled
labor. The demand for F will shift to the right as the marginal productivity of skilled
labor increases. Thus, the payment of F will rise. If, however, factor F itself
immigrates in the domestic economy, that is, there is more unskilled labor in the
domestic economy, the supply of F shifts to the right and thus the payment for F
will fall. Therefore, the income redistribution associated with the migration of a
factor depends upon the relation this factor has, friend or enemy, with all other
non-migrating factors.
8.2.3 Specific factors model and migration of a factor

More insights into the effects of immigration of a factor into a sector of the
domestic economy can be obtained by considering the specific factors model.
Consider the sector that produces good X in the domestic economy. We assume
that there is an inflow of capital in sector X resulting in an increase in the supply of
capital in sector X. This is illustrated in Figure 5.
return rx S Sã
r1
r2
Capital in Sector X (Kx)
Figure 5: Market for Capital in Sector X and Inflow of Capital
147
As a result of this inflow, the return to capital in sector X will fall along the
unchanged demand for capital, i.e., from r1 to r2. Consider next, in Figure 6, the
effects of this capital inflow on labor, which is the shared input.
S Sã
WX 2
WX 3
WX 1 WY
DY
DX DãX
LX LY
Figure 6: Market for Labor in Sectors X and Y and Inflow of Capital
Labor demand will increase in sector X since the productivity of labor is higher
now due to higher capital available. Thus, labor demand shifts to the right, as
indicated by the arrow, and therefore the wage in sector X will rise to Wx2. This
higher wage in sector X will result in an internal migration of workers from sector Y
to sector X. As labor is moving out of sector Y into sector X, labor supply shifts to
the right, reducing the wage to Wx2. In Sector Y, demand for capital falls as labor is
moving out and thus the return to capital in sector Y will fall. We may then conclude
that the inflow of capital has made workers in both sectors better off, but has reduced
the returns to capital in both sectors.
In sum, in Section 8.2 we examined international capital mobility. We first
explained that international capital movements may take the form of either Foreign
Direct Investment (FDI) or Foreign Portfolio Investment (FPI). Although both are
significant, we focused our analysis on FDI since it is longer-term capital that
contributes to the economic growth and welfare of a country. As in the case of
migration, in the absence of restrictions to free capital mobility, the rates of return to
capital will be equalized internationally. We next examined the income redistribution
resulting from capital mobility and we showed that it depends on the relation that
this factor may have with all other non-migrating factors. We also examined the case
of an inflow of capital into a two-sector economy and we analyzed its results, namely
that the inflow of capital makes workers in the country better off and capital owners
in both sectors worse off.
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CHAPTER 8
In Chapter 8 we analyzed the international mobility of production factors,
namely the case of international labor mobility and international capital
mobility. Factors of production move internationally, seeking higher returns.
Huge flows of capital and large flows of labor affect both the countries of origin
as well as the host countries. Thus, factor mobility may change the pattern of
production and trade of a country. Also, international trade may affect the size of
factor mobility, as it reduces the differential returns between the country of
origin and the host country. In Section 8.1 we examined international labor
migration by presenting the types of international migration and its effects. In
Section 8.2 we examined international capital mobility by explaining the main
forms it may take, i.e., FDI or FPI. As in the case of migration, in the absence of
restrictions to free capital mobility, the rates of return to capital will be equalized
internationally. We next examined the income redistribution resulting from
capital mobility and we showed that it depends on the relation that a factor may
have with all other non-migrating factors. We also examined the case of an
inflow of capital into a two-sector economy and we analyzed its results, namely
that the inflow of capital makes workers in the country better off and capital
owners in both sectors worse off.
149
APPENDIX
Activity 1
International trade creates specialization gains while international migration creates

efficiency gains. Free trade is politically preferred to migration. This is so since given the
high level of unemployment in many western countries, labor inflows generate concerns
among the general public about the possible adverse effects of immigration on the
employment of native workers. NAFTA was motivated by the idea that international trade
with Mexico would deter migration flows as wages would increase in Mexico exactly due to
international trade generated by NAFTA. This is based on the idea that international trade is
a substitute to international migration. However, Markusen (1983) showed that Mundell’s
conclusions are not valid, if the reasons for international trade are differences in technology
or preferences. In that case, international trade and migration are complements. Indeed,
several studies suggest that migration and international trade might be complements,
however, empirical evidence is not yet conclusive.
Activity 2
International Trade and Capital Mobility

Equalization of capital returns can be brought about through international trade. We
illustrate this in the figure below.
Greek rate of return r
Bulgarian rate of return r*

S/S*
15%
10%
5% Dã
D* D
Dã* 20 30
K Total world capital K*
Capital Markets and International Trade

Assume now that capital mobility is not allowed between two countries and that the only
option available is international trade. Since Greece has the larger capital endowment, it
will export the capital-intensive good to Bulgaria. As a result of these exports, the price of
the capital-intensive good will increase in Greece and this will in turn increase the demand
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CHAPTER 8
for capital,8 which is illustrated by the shift of D to the right, thus raising the Greek rate of
return from 5% to 10%. On the other hand, the production of the capital-intensive good will
fall in Bulgaria, and its price will also fall, resulting in a fall in the Bulgarian demand for
capital which is illustrated by the shift of D* to the right. Free trade equilibrium is with a net
return of 10%. Thus, free trade has resulted in an equalization of capital returns between the
two countries by decreasing the foreign return (where capital is scarce) and increasing the
home wage, thus shifting the demands for capital rather than by shifting capital supplies, as
international capital mobility does.
Once more the issue with international trade and factor mobility, in this case capital
mobility, reappears; that is, if international trade by reducing capital returns reduces the
incentive of capital mobility. Thus, international trade is a substitute for international capital
mobility.
8
Recall that VMP = P x MPK; thus if P increases, then VMP increases, and the demand curve shifts to the
right.
151
BIBLIOGRAPHY
“A Continent on the Move,” The Economist, May 4, 2000.
Hicks J., The Theory of Wages, Macmillan, London 1932.
Markusen J.R., “Factor Movements and Commodity Trade as Complements,”
Journal of International Economics, 14(3/4), 1983, pp. 351-356.
Mundell R., “International Trade and Factor Mobility,” American Economic Review,
June, 1957.
RECOMMENDED READING
Agiomirgianakis G.M., The Macroeconomics of Open Economies under Labour
Mobility, Ashgate, Aldershot, Hants, England 1999.
Agiomirgianakis G.M., Asteriou D., Papathoma R., “The Determinants of Foreign
Direct Investment: A Panel Data Study for the OECD Countries,” in Advances in
International Economics and Finance, by C. Tsoukis, G. Agiomirgianakis and T.
Biswas (eds.), Kluwer, USA 2004.
Agiomirgianakis G.M., Zervoyianni A., “Macroeconomic Equilibrium with Illegal
Immigration,” Journal of Economic Modelling, Vol. 18(2), April 2001, pp. 181-202.
Paul, MN 1995, pp. 437-446.
Zervoyanni A., Argiros G. and Agiomirgianakis G.M., European Integration,
Macmillan Publishing, London UK, forthcoming 2005.
152
CHAPTER 9
MULTINATIONAL ENTERPRISES
AND INTERNATIONAL
ECONOMIC INTEGRATION
M. Vlassis
The scope of Chapter 9 is to address the main issues involved in the process of The Scope
international economic integration. The topics covered include multinational of the Chapter
enterprises, international policy coordination, and steps towards economic integration.
After completing the study of Chapter 9, the reader will: Learning

ñ have obtained insight into the economics of multinational enterprises Objectives
ñ understand why international externalities create a reason for international
coordination, as regards policy and legislation
ñ understand how countries can promote free international trade and finance
through various steps of economic integration.
ñ Horizontal integration Key Words

ñ Vertical integration
ñ Joint venture
ñ Licensing agreement
ñ Branch plant
ñ Subsidiary
ñ Shadow price
ñ Transfer pricing
ñ Externalities
ñ Marginal social cost
ñ Public goods
ñ Free rider problem
ñ Customs union
ñ Common market
ñ Economic union
From the economist’s point of view, national borders (sometimes including Introductory
independent national policies) represent barriers that decrease global economic Comments
efficiency. Therefore, the process of international economic integration involves
whatever may lower these barriers. On the other hand, however, this process
raises difficult – international political economy – issues. In this context, Chapter
9 examines:
153
ñ The reasons why multinational enterprises exist, their operation practices, and
their effects on their source/host countries.
ñ The implications of international externalities (such as pollution to neighboring
countries), regarding cross-country policy cooperation and international law.
ñ The steps toward international economic integration.
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CHAPTER 9
9.1 THE ECONOMICS

OF MULTINATIONAL ENTERPRISES
9.1.1 International marketing

and multinational firms
A multinational (or transnational) enterprise (MNE) is a firm operating branch
plants in different countries. Today, roughly a quarter of total world trade takes
place between (branches of) MNEs. At the same time, foreign direct investment
(FDI), launched by MNE in order to carry out their international operations, is a
widespread form of foreign investments. To understand the reasons for MNE-FDI,
it must first be noted that a firm opting to sell its product to a foreign country can
do so by means of any of the following international marketing practices:
ñ Exports: A foreign importer buys and distributes the given exporting firm’s
product in the target market.
ñ Licensing Agreements: Agreements, allowing the foreign licensee firm to attach
the brand name of the given source firm, or, transfer the source firm’s know-
how to the licensee, are typically made.
ñ Joint Ventures: Agreements, to share management, production processes, market
information, sources of raw materials, and so on, are typically made between
the given firm and a firm already operating in the target market.
ñ Branch Plants: Via FDI, the given firm on its own sets up a branch plant (subsidiary)
in the target market and, thus, becomes an MNE.
While each of the above strategies to penetrate a foreign market has its own
advantages and disadvantages, they should be considered as four successive stages of
a long-run plan business plan. A firm does not become a multinational “overnight”.
Apart from exports, licensing is the easiest way for a firm to enter a foreign market,
and lets the firm expand its operation internationally when there is a high level of
protection. Moving down the list as familiarity with the foreign country increases, by
means of a joint venture the given firm can specialize, and thus lower its costs and
become able to carry on with a project that would not be feasible if it was operating
independently. However, if the given firm is threatened by probable imitation/copying
of its production and/or management know-how, it would do better to set up a foreign
subsidiary. With this strategy, those firm-specific assets will be maintained within the
firm. In principle, multinational subsidiaries are formed when international business
activity within a firm is more economical than between firms: being structured in the
form of an MNE, a firm internalizes intra-business transactions.
155
9.1.2 Gains and losses
with multinational enterprises
While no single model can predict under which circumstances a firm would
become multinational, the major effects (regarding who loses and who gains) of such
international business transformations are as follows:
ñ With increased MNE activity, entrepreneurs and managers will migrate (not
necessarily physically) from countries where they are abundant/cheap to countries
where they are scarce/expensive. As a result, the returns to domestic management
in the host country will be lowered, while at the same time other domestic factors
of production may be benefited; as these factors become more productive, their
demand is expected to increase, and domestic labor and capital returns are likely
to increase.
ñ Foreign entry, through MNE activity, will increase rivalry and, thus, is ceteris paribus
expected to lower the profits of domestic firms. Nonetheless, increased competition
may, on the other hand, force domestic firms to become more efficient.
In conclusion, viewing a host country as a whole, gains may outweigh losses with
inward MNE-FDI.
9.1.3 Multinational horizontal integration

When the same firm produces its output at different locations, it is said to be a
horizontally integrated firm. The main problem facing a horizontally integrated
MNE is deciding how to allocate its total production across its branch plants
(subsidiaries) which are located in different countries. As an illustration, consider
the case depicted in Figure 1.
PM
PE
D
MC
MRM=MC*=MC
MR
MC*
Q Q* (QE+QE*) QM
Figure 1: A Horizontally Integrated MNE
In Figure 1 note that: (i) the given firm is assumed to be a monopolist, selling its
product (Q M ) in a single (international/domestic) market, with demand and
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CHAPTER 9
marginal revenue respectively depicted by the schedules D and MR; and (ii) the
considered firm is an MNE, as it can allocate its total production in two different
branch plants (e.g., QM=Q+Q*, each facing a different marginal cost schedule:
MC(Q)>MC*(Q*). Hence, this MNE must simultaneously decide on: its optimal
total output (QE+QE*); its optimal price(PE); and the optimal allocation of its
total output across its two subsidiaries (QE,QE*). In fact, however, in resolving the
third, the first and second decisions are straightforwardly taken: the MNE must
produce total output, allocate production, and price the output, so that:
1. The last unit of output, wherever produced, incurs for the firm the same extra
cost (e.g., MC=MC*).
2. When sold at the price dictated by the D schedule, the extra cost of the last unit
is equal to the extra revenue it brings to the firm (e.g., MC=MC*=MR).
9.1.4 Multinational vertical integration

MNEs often produce intermediate products (IP) in foreign subsidiaries and
subsequently use them in their home plants to produce the final product (FP);
instead of buying raw materials and/or intermediate products from abroad and
shipping them home, processing may take place in the source country. In this way,
i.e., through vertical integration, an MNE internalizes the relevant market (of, say,
a required IP in order to produce the firm’s FP) within the firm. Figure 2 illustrates
such a case of a vertically integrated MNE.
PFP PIP
MCFP
MCIP
DFP
MRFP DIP=MRPIP
QFP QIP
Figure 2: A Vertically Integrated MNE
In Figure 2, three points must be made clear at the outset. First, the right panel
demand schedule for the firm’s intermediate product (DIP) is effectively derived
from the left panel demand schedule for the firm’s final product (D FP). If, for
example, DFP shifts to the left (due, say, to improved advertising/marketing), the
demand for the firm’s intermediate product will increase (e.g., the DIP will shift to
the right). Second, the IP price (paid to the subsidiary, through transfer pricing) is an
157
implicit “shadow price” determined by the MNE, since effectively there is no market
transaction for the IP. Third, because the IP represents an input for the MNE, the
DIP effectively coincides with the IP’s marginal revenue product schedule (e.g., Then,
as shown in Figure 2, by applying the MR = MC rule, the MNE simultaneously
determines the QIP and QFP levels, as well as their prices, so as to maximize its profits.
In addition, the MNE can use the declared IP’s price as a device to transfer profits to
the location where taxes are lower. If the corporate income tax is higher at home
(abroad), the IP’s price can be overstated (understated) in order to make the home
branch (foreign subsidiary) operation appear less profitable and, thus, for the MNE
to gain in terms of overall, after-tax profits.
The reader can check his/her understanding of the major points in Section 9.1,
by undertaking the following activities.
In Figure 1 note that, instead of operating the high-MC plant, the given MNE could have
shifted all of its production to the low-MC* plant (and, thus, shut down the operation of the
high-MC plant. In that case:
(i) The MNE would have to decrease its total production.
(ii) The profits of the MNE would decrease.
Dou you agree, or disagree, with the above statements? In each instance, explain why,
using Figure 1.
In the case of MNE vertical integration depicted in Figure 2, analytically explain:

(i) The meaning of the DIP=MRPIP schedule.
(ii) Why the IP’s “shadow price” must decrease, as the MCFP decreases.
(iii) Why the IP’s “shadow price” must increase, as the DFP increases.
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CHAPTER 9
9.2 INTERNATIONAL EXTERNALITIES

AND POLICY COORDINATION
9.2.1 Externalities and public goods

Externalities, negative or positive, occur whenever an economic agent’s decision
generates some costs or benefits to some other agent, who is not involved in
making that decision. In particular, a negative production externality occurs when
a firm does not entirely pay the costs which its productive activity creates. Here, a
typical instance is pollution; residents close to a polluting plant implicitly pay part
of the production costs, by breathing dirty air, needing to clean their houses and
cars, and so on. In consequence, as it does not consider those implicit costs, a
polluting firm would extend its production to socially-inefficient levels. Such a
case, and what economic theory suggests in order to bring about the (socially-)
optimal production/pollution levels, is depicted in Figure 3.
PS
PP MSC
MPC
MR
QS QP Q
Figure 3: A Pollution Tax Brings the Optimal Level of Pollution
In Figure 3 note that, at any level of output (Q), there is a difference between
the marginal private cost (MPC) and the marginal social cost (MSC). The latter is
higher than the former, as it includes the pollution costs (which the production of
Q implies). Therefore, from the society’s point of view, the optimal level of output
is QS, where MR = MSC. However, as the given firm ignores pollution costs (hence,
it extends production up to where MR = MPC), it produces the (inefficiently high)
level of output, QP. However, if a pollution tax (per unit of Q), equal to the difference
159
(MSC – MPC) is imposed on the firm so as to effectively raise its MPC up to the
MSC, it will cut output and, hence, pollution, back to their socially-optimal levels.
Public goods, on the other hand, can be viewed as goods creating positive
externalities to those who are not contributing to their production. Typical instances
of such goods are police, national defense, public health and education. The
production of public goods suffers from the so-called free rider problem. Since it is
impossible or inefficient to exclude someone from the public good’s consumption,
free-riders enjoy the product without paying for it. In consequence, as the involved
firms are not adequately compensated, free market operation fails to provide (at
least, the socially-efficient levels of) public goods. In principle, the solution in those
cases is analogous to that in cases generating negative externalities. To illustrate
this using Figure 3 above, simply substitute MPC for MSC, and QS for QP (and vice
versa); as the unit of the (public) good Q creates positive externalities, MSC is
lower than MPC and, hence, QS>QP. Then, it is fairly obvious that a firm can be
induced to produce the socially-optimal level of output (QS), by means of a negative
tax. That is, by means of a production subsidy, effectively bringing MPC down to
MSC, which is given to the firm per unit of Q produced up to QS.
9.2.2 International externalities and need

for policy coordination
Externalities also occur across national borders. Many externalities – pollution
externalities, for instance – already pose a difficult problem to solve inside a country,
because liability and property rights are often not clear. Nonetheless, resolutions to
international pollution externalities are even more puzzling, as different governments
have different standards and pollution policies. Moreover, and since liability across
borders is not recognized, a pollution tax to cure such externalities is impractical.
What remains, though difficult to achieve, is coordination among governments,
industries and citizen groups, across countries.
In sum, Section 9.2 suggests that the path to resolving international externalities
(and/or problems with public goods crossing national borders) is political, and must
eventually develop into a practice of international law. The key reasons for that are
as follows:
ñ The different sets of laws, customs, and national policies, across national
boundaries, increase the costs of finding (negotiated) international agreements.
ñ National politicians must be “coerced” to remove the temptation for them to set
up international policies which are favorable to certain domestic groups, while
they are unfavorable to their country as a whole.
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CHAPTER 9
9.3 INTERNATIONAL ECONOMIC

INTEGRATION
The previous sections clearly suggest that the international political process,
evolved in promoting free international trade/investment (and efficiently dealing
with international externalities/public goods), leads toward international economic
integration. That is, it encourages a settlement in which the countries involved have
common trade, and common legal, fiscal and monetary policies. Typically, such a
settlement may emerge by means of the four consecutive steps summarized below:
1. Free Trade Areas (FTA)
Though protectionism is costly, it is difficult for a national government to stop the
practice of protecting its favored industries. Yet, by forming a FTA, the countries
involved eliminate trade barriers against each other and, thus, enjoy overall gains
which are higher than the adjustment costs paid in some national sectors.
2. Custom Unions (CU)
The next step, beyond the FTA, is the formation of a CU. A CU establishes
common protection for the member countries with the rest of the world. This is a
much harder step (than the FTA) to accomplish, since the (likely asymmetric)
national industries joining an FTA may disagree on the common protection levels
with the rest of the world. However, a CU makes trade within an FTA easier, while
it is difficult to maintain an FTA without a CU.
3. Common Markets (CM)
The next step toward economic integration is the formation of a CM. A CM is a
CU with no restrictions on movements of capital and labor across the member
countries’ national borders. So long as the member countries of a CU converge in
their national policies regarding international factor movements with the rest of
the world, forming a CM is not considered to be a difficult step.
4. Monetary Unions (MU)
From a narrow viewpoint, the final step of international economic integration is
a monetary union, with the member countries sharing common fiscal and monetary
policies. Yet, a political union, with commonly accepted legislation and judicial
institutions, would be the ideal and, hence, would actually correspond to the final
stage of economic integration among a group of countries already forming a CM.
To that end, however, the formation of an MU is a necessary, and rather difficult,
step that a CM has first to accomplish. To do that, national governments must be
persuaded to abolish their monopoly power on money creation, which allows them
to chase voters by spending more than their tax revenues.
161
ñ Since free international trade and investment improve global economic
welfare, they are goals worth pursuing and they, thus, present reasons for
international political agreements.
ñ Multinational firms raise the levels of international trade and investment.
Yet, since their operations bring inflows of skilled labor and capital, they
lower the returns to the host countries’ skilled labor and capital owners and
raise domestic opposition.
ñ International externalities call for legal and policy coordination across
countries.
ñ Through various steps, contributing to the promotion of international trade
and finance, independent nations can eventually become economically
integrated.
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CHAPTER 9
APPENDIX
Activity 1
(i) If the MNE decides to shut down the operation of its high-MC plant (and produce by
using only its low-MC* plant) then, in equilibrium, the MNE’s total production would
indeed decrease. As can easily be seen in Figure 1, total production (say, QX) would in
this case occur where: MR=MC*, hence, QX<QE+QE*.
(ii) Whenever a production change occurs, a simple way to judge whether the (given) firm’s
profits, as a consequence, increase or decrease, is by comparing the area gained or
lost below its MR schedule (that sums up to the firm’s total revenues), to the area gained
or lost below its MC schedule (that sums up to the firm’s total costs). Then, if the positive
(negative) gains, in terms of higher (lower) total revenues, outweigh the negative
(positive) gains, in terms of higher (lower) total costs, the firm’s profit’s increase
(decrease). By that means, it can be easily checked (in Figure 1) that, as QE decreases
to zero, and QE* increases to QX, the MNE’s profits decrease.
Activity 2
(i) To explain the meaning of the DIP=MRPIP schedule, recall (from Section 6.1) that the
marginal revenue product of the labor input, (here the input is the MNE’s IP) used in the
production of the output s (here s is the MNE’s FP) is defined as: MRPS=pSáMPS, where
pS stands for the priced of the output (here the FP). Recall also that an input’s optimal
employment is found by equating the input’s price with its marginal revenue product.
Therefore, the DIP schedule, showing how many units of IP the MNE demands (e.g.,
requires from its subsidiary to produce), at various (IP) prices, must coincide with the
MRPIP.
(ii) From Figure 2 it can be easily seen that, as the MCFP decreases (e.g., the MCFP schedule
shifts to the left), the price of the MNE’s FP (e.g., P FP) decreases, in equilibrium. In
consequence, and since MRPIP=pFPáMPIP, the DIP(=MRPIP) schedule shifts to the left,
leading to a decrease in the IP’s “shadow price” (e.g., PIP) in equilibrium.
(iii) As the DFP (and, hence, the MRFP schedules shift to the right, the price of the MNE’s FP
(e.g. PFP) increases, in equilibrium (see Figure 2). Then, the DIP(=MRPIP) schedule
shifts to the right, leading to an increase in the PIP, in equilibrium.
163
BIBLIOGRAPHY
RECOMMENDED READING
Cassing J., Husted S. (eds.), Capital, Technology, and Labor in the Global Economy,
The AEI Press, Washington 1988.
164
CHAPTER 10
THE BALANCE OF PAYMENTS

The scope of Chapter 10 is to introduce and analyze the concept of the balance of The Scope
payments and its components, and also to make clear that the balance of payments of the Chapter
reflects, at any given moment, the international competitiveness of a country. The
topics covered include trade balance, current account, capital account and import
elasticity, and the relation of macro-policies to the current account.
After having completed the study of Chapter 10, the reader will be: Learning
ñ familiar with the concept and role of the balance of payments and its components Objectives
ñ able to understand how the balance of payments, by reflecting at any given
moment the international competitiveness of a country, shows the direction of
future changes in the exchange rate, domestic production, employment and
government policies.
ñ Trade balance Key Words

ñ Trade in services
ñ Balance on goods and services
ñ Import elasticity
ñ Current account
ñ Capital account
ñ Balance of payment
ñ Macroeconomic policies and current account
Chapter 10 presents the balance of payments (BOP) and its components. The Introductory
balance of payments is a record of all international transactions of a country with the Comments
rest of the world. It shows important information to policy makers and investors about
the international competitiveness of the country in producing and exchanging goods,
services and capital. Deficits or surpluses in the balance of payments show the
direction of future changes in the exchange rate, in the pattern of domestic production
and employment, as well as the government policy required to reduce imbalances.
165
10.1 BALANCE OF PAYMENTS
10.1.1 Current account

The balance of trade (BOT) is the record of the international transactions of
goods that a country has with the rest of the world. The trade balance1 is defined as
the difference between revenues from exports of goods and expenditure on
imports of goods. The revenues from exports are recorded as credits while the
payments for imports are recorded as debits. More formally we have
BOT ≡ XGoods – MGoods = (Pexp á Qexp) – (Pimp á Qimp) (1)
where XGoods ≡ (Pexp á Qexp) and MGoods ≡ (Pimp á Qimp); Pexp is the price of exports;
Qexp is the quantity of exported good(s); Pimp ≡ P* e, where Pimp is the price of imports
in domestic currency, P* is the foreign currency price of imports and e is the exchange
rate (price of the foreign currency in units of the domestic currency); Q imp the
quantity of imported good(s); XGoods stands for exports of goods; and MGoods stands
for imports of goods.
The trade balance can be in surplus (BOT > 0) or in deficit (BOT < 0). A surplus
in the trade balance means that a country’s revenues from exports are greater than
its expenditure on imports. On the other hand, a deficit is the result of a higher
expenditure on imports or lower receipts from exports. A trade deficit may result in a
reduction in domestic employment, not only because domestic jobs may be lost in
favor of foreign workers producing the home country imports, but also because a
reduction in exports may imply that domestic firms in the exporting sector should cut
their production and thus employment.
Next, we define trade in services (TS) as the difference in revenues from exports
of services and expenditure on imports of services such as tourism, transportation,
shipping, accounting, banking, insurance, telecommunications, and entertainment.
Thus, formally, we have
TS = XServices – MServices (2)
Next, we define the balance on goods and services (BGS) by putting together
the trade balance and trade in services, that is
1
It is also called the visible balance since goods can be seen visibly moving from one country to another.
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CHAPTER 10
BGS = BOT + TS (3)

We can illustrate how changing prices in exports and imports may affect the BGS
using a demand and supply diagram for the exported good X and the imported
good Y in the home country. Consider, first, the case of exports of the home country
Greece, illustrated by the difference between the demand and supply of good X in
Figure 1.
_/X
25 400
20 200
D
100 200 400 500 Good X
Figure 1: Exports of Good X, Demand and Supply of X at Home
When the international price is È20, Greek exports are 200 units of good X; that
is 400 units of X are produced and only 200 units are consumed domestically.
Assume now that the international price increases to È25. Exports increase to 400
units of X, that is, 500 units of X are produced and only 100 are consumed
domestically. The increase in exports by 200 units of X, increases export revenues
by È6,000.2 Greek consumers pay now a higher price of È25 and consume less of
good X. They have an expenditure of È2,500 for 100 units of X compared to the
expenditure of È4,000 for 200 units when the price was È20. Domestic producers,
on the other hand, have revenues now of È12,500 compared to È8,000 when the
price was È20, that is, an increase of È4,500. We may also analyze the effects of a
price change on BGS by using a diagram of excess demand and supply as illustrated
in Figure 2.
2
That is, 400á25 = 10,000 and 200á20 = 4,000, so the difference is È6,000.
167
_/X
XS
25
20
10
XD*ã
X
-200 0 200 400 XD*
Figure 2: Exports of Good X, Excess Demand and Supply
An increase in the demand for good X abroad, indicated by the shift of the
excess demand curve to the right, causes a higher international price for good X
equal to È25, resulting in an increase in exports to 400 units of X. We may then
conclude that the higher price of the exported good raises revenues from exports
for the home country and thus improves the BGS, but at the same time, the higher
price of the exported good makes domestic consumers worse off.
Consider, next, the case of imports of good Y in the home country Greece as
illustrated in Figure 3.
_/X S
15 200
10 400
D
200 300 500 600 Good Y
Figure 3: Imports of Good X, Excess Demand and Supply
At the price of È10, domestic production provides 200 units of good Y and
consumers want 600 units, so the excess demand of 400 units is covered by imports.
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CHAPTER 10
Assume now an increase in the price of imports3 to È15. At the new price, domestic
production increases to 300 units of Y as more producers find it profitable to
produce good Y and at the same time consumers reduce their consumption to 500
units, thus imports fall to 200 units of Y. Greek consumers’ spending increases by
È1500, 4 while domestic producers’ revenues increase by È2,500. 5 For Greece,
expenditure on imports falls from È4,000 to È3,000 resulting in an improvement in
the BGS. Therefore, we may conclude that a higher import price has two effects:
(a) it helps domestic producers to compete with international competition, and (b)
it induces home consumers to reduce their consumption. Both effects contribute to
a fall in the home country’s expenditure on imports and thus to an improvement in
the BGS. However, home consumers have to pay higher prices and incur a higher
expenditure, after the price increase in imports.
To measure the effects of a price change on imports and thus on the import
expenditure, we use the import elasticity (ε imports) which we define as the absolute
value of the percentage change in quantity of imports (%¢Q imports) divided by the
percentage change in the price of imports (%¢P imports). That is,
∆Qimports
ε imports = ( %
% ∆Pimports
) (4)
the elasticity can be higher than one, i.e., (ε imports > 1), in which case we say that the
demand for imports is elastic; or it can be less than one, (ε imports < 1) in which case
we say that the demand for imports is inelastic. Finally it can be equal to one, ( ε
imports=1); we then say that the demand for imports is unit elastic. In case of elastic
demand for imports, an increase in the price of imports by 1% will result in a
reduction in the quantity of imports by more than 1%, so spending on imports will
be less. In case of inelastic demand for imports, however, an increase in the price of
imports by 1% will reduce imports by less than 1%, and thus spending on imports
will increase. Finally, imports expenditure will remain unchanged, following a price
change, if there is unit elasticity of imports. We can now measure the elasticity of
demand for the numerical example in Figure 3: the numerator in equation (3),
%¢Q imports, is equal to (200 – 400)/300 = – 0.666; and the denominator, %¢P imports, is
equal to (15 – 10)/12.5 = 0.4. Thus the resulting ε imports = 1,665 > 1. This confirms
our finding earlier that if the import elasticity is greater than one and the price of
imports increases, the expenditure on imports will decrease. Recall that Greek
expenditure on imports falls from È4,000 to È3,000, resulting in an improvement in
the BGS.
Import elasticity is affected by several factors that may result in higher values of
it. These factors are:
3
An example of this, often quoted in the literature, is oil prices and especially in 1973 and 1979 when they
increased sharply, up to three-fold.
4
That is, (15á500 =) 7,500 – 6,000 (= 10á600).
5
That is, (300á15) = 4,500 – 2000 (= 10á200).
169
ñ The number and closeness of substitute goods to imports. That is, if a given
imported good has many and close substitutes, it will be easier for consumers to
reduce their consumption of the given imported good.
ñ The share of income spent on the imported goods. That is, the larger the share of
income spent on imports, the more the consumers will have to reduce their
consumption of imported goods.
ñ The time period of adjustment. That is, the longer the period of time, the easier it
will be for consumers to adjust their consumption pattern.
ñ The elasticity of the domestic supply curve. That is, the more elastic the domestic
supply curve is, the more the domestic production will be, and thus the smaller
will be the expenditure on imports.
We may now continue with the definition of current account (CA), which is the
sum of the trade balance on goods and services and the net investment income (NII).
That is,
CA = BGS + NII, (5)
where NII includes net payments on financial and real assets6 that can take the form
of interests, rents, dividends, and profits from investment abroad. The current
account can be in surplus (CA > 0) or in deficit (CA < 0). A surplus in current
account means that the country is earning more than it spends abroad, in which case
the country accumulates assets over time; while a deficit means that the country
spends more than it earns abroad, in which case the country increases its liabilities
over time. Thus, large and persistent current account deficits mean that a country
borrows against its future income and that the country’s debt will increase. A higher
debt requires higher debt services every year, i.e., a higher share of the national
income for debt services, leaving domestic residents with a lower share for future
consumption and investment. The current account may also show the direction of
future changes in the exchange rate. If, for example, a country has a current account
deficit for several years, it means that domestic residents have a higher demand for
foreign goods than the foreigners have for domestic goods. Therefore, domestic
residents have a higher demand for foreign currency, in order to buy foreign goods,
resulting in a depreciation of the home currency.7
10.1.2 Capital account

The capital account (KA) records the transactions of a country related to the
movements of financial capital with the rest of the world. It is defined as the sum of
6
That can be bonds, loans, shares, buildings and so forth.
7
In other words, home currency outpayments exceed home currency inpayments and so the value of the
home currency will be less (depreciation).
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CHAPTER 10
foreign direct investment and foreign portfolio investment,8 which was analyzed in
detail earlier in Chapter 8. That is,
KA = FDI + NII. (6)
We may at this point distinguish between capital inflows and capital outflows.
Capital may move into a country when a country borrows from abroad or when the
country sells assets abroad or when foreigners invest in the country. These inflows
of capital are recorded as credit items in the capital account.9 Effectively, inflows of
capital either reduce the holdings of a country in foreign assets or increase the
liabilities to foreigners. On the other hand, capital may move out of a country when
domestic residents lend abroad or when they buy assets abroad or when they buy
domestic assets from foreigners. These capital outflows are recorded as debits in
the capital account.10
We may now put all the pieces together and define the balance of payments as
the record of all transactions a country has with the ROW (rest of the world). It is
the sum of the current account and the capital account, that is:
BOP = CA + KA. (7)
The BOP can be in deficit (BOP < 0) or in surplus (BOP > 0). A deficit is not
necessarily bad. Consider the case of a country that undertakes FDI abroad and
thus an outflow of capital results in a BOP deficit. In the future, however, domestic
residents will enjoy profits, dividends or interest receipts precisely because of that
large outflow of capital that will create surpluses in the BOP for the country. On
the other hand, a surplus in the BOP is not necessarily a good thing, as one could
argue exactly the reverse, i.e., long-term investment in the country undertaken by
foreigners may result in the future in a stream of profits, dividends and interest
payments that will create deficits in the BOP.
In sum, Section 10.1 presents the balance of payments and its components. We
first examined the trade balance and we saw that a trade deficit may result in a
reduction in domestic employment. We also presented the trade in services such as
tourism, transportation, and shipping. Next we analyzed the balance on goods and
services, and we concluded that a higher price of the exported good raises revenues
from exports for the home country, but at the same time it makes domestic
consumers worse off. Similarly, we saw that higher import prices may help domestic
producers to compete with international competition; domestic consumers will have
to pay higher prices while the home country expenditure on imports will be lower.
Then we presented the elasticity of import that shows the relation between changes
in the price of imports and expenditure on imports and we stated the factors that
8
Once more, we note here that the difference between FDI and FPI is that FPI does not lead to direct
control of a company, which is the case with FDI.
9
They are credits, since domestic residents sell foreigners an IOU (I Owe You) and get paid by foreigners.
10
They are debits, since domestic residents buy an IOU from foreigners and pay foreigners.
171
may influence it. We defined the current account and explained the meaning of
surpluses and deficits in it; we also presented the capital account and its components
by distinguishing between long-run and short-run capital. Then, we concluded
Section 10.1 with the definition of the balance of payments and some plausible
explanations for BOP deficits or surpluses.
Explain which of the following items is a debit and which is a credit in the BOP:
1. A Greek resident buys a share of a USA company.
2. A USA multinational company sells its subsidiary in Greece to a Greek corporation.
3. The Japanese Toyota establishes a green-field subsidiary in Greece.
4. Greek residents sell company shares of the German Mercedes.
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CHAPTER 10
10.2 TWIN DEFICITS AND

MACROECONOMIC POLICIES
10.2.1 Twin deficits and the role of fiscal policy

It is often said that fiscal policy affects the current account deficit, in other
words, that changes in the size of the government expenditure and the level of taxes
may affect the current account. Indeed, empirical evidence in the 1990s from
several western countries such as the USA, Germany, Sweden, the UK and the
Netherlands has shown that a deficit in the current account co-existed with a
budget deficit. We may see this by using the national accounts identity
(G – T) + (I – S) = –CA (8)
where G stands for government expenditure, T is government taxes, I is private
investment, S is private saving and (–CA) is the current account deficit.
Equation (8) shows that the sum of the net borrowing of the government (G –
T) and the private-sector net borrowing (I – S) is equal to the current account
deficit (–CA). As, we have already mentioned, a surplus in the current account
means a net financial inflow for the domestic residents. Thus, the home country has
funds available to potential debtors and it becomes a lender. On the other hand,
when the country has a current account deficit, it means that the country has
domestic spending larger than its national income, and thus the country should
borrow from abroad. According to (8), an increase in the government budget
deficit must be compensated either by a fall in private sector borrowings (less
private investment or more private saving) or by an increase in the current account
deficit. In other words, government borrowing should be financed either by the
private sector at home or from abroad. When the government borrows from the
home private sector, home private saving has to increase and private investment
has to decrease, so that the private sector will be able to buy government bonds,
issued in order to finance government debt. On the other hand, a budget deficit at
home requires either higher interest rates or cheap government bonds. Both will
attract foreign investors and create an exchange rate appreciation that, by making
home goods and services more expensive, will lead to a current account deficit.
Although this relation between budget deficits and current account deficits was
established in the 1990s for several countries, the empirical evidence is not yet
conclusive, as there are also other periods of time for the USA or other countries,
for example Italy, where this relationship is not established and, despite the
173
existence of large budget deficits, there were no current account deficits. As a
result of this, we should not consider fiscal policy as an effective tool against
current account deficits. What is a much better tool to combat current account
deficits is a well-targeted commercial trade policy that may take several forms, such
as tariffs, quotas or subsidies and non-tariff barriers.
10.2.2 Current account deficit and monetary policy

Monetary policy is either exercised by a central monetary authority, such as the
European Central Bank (ECB), via the manipulation of the money supply or by
fixing interest rates at home. Both affect the inflation rate and interest rates. An
expansionary monetary policy may create higher inflation or expectations of higher
inflation at home, resulting in a loss of home competitiveness and thus leading to a
budget deficit. A higher interest rate at home compared to the rest of the world, by
attracting short-run capital (foreign portfolio investment), may result in an
exchange rate appreciation that will worsen the current account. Again monetary
policy is not an appropriate tool to combat current account imbalances.
In sum, Section 10.2 presents the relations of government policy with the
current account. It has been established that budget deficits, and thus fiscal policy,
have a relationship with the current account. The same can be stated for monetary
policy, which may also affect the current account via the inflation rate and interest
rates. However, both policies are weak tools in dealing with current account
imbalances, and what is suggested is a well-targeted commercial policy that may
take several forms. Tariffs, quotas or subsidies and non-tariff barriers, free trade
zones, and foreign exchange controls are some of the measures that can change the
spending patterns of a country.
Explain why macroeconomic policies are not the best way to combat a current account
deficit, and state what other alternatives are available for a country facing current account
deficits.
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CHAPTER 10
In Chapter 10 we presented the balance of payments and its components. We
first examined the trade balance and then the trade in services such as tourism,
transportation, and shipping. We analyzed the balance on goods and services
and we concluded that a higher price of an exported good raises revenues from
exports for the home country, but at the same time it makes domestic consumers
worse off. On the other hand, higher import prices may help domestic producers
to compete with international competition; however, domestic consumers will
have to pay higher prices while the home country expenditure on imports will be
lower. We also presented the elasticity of imports that shows the relation
between changes in the price of imports and expenditure on imports and we
stated the factors that may influence it. We defined the current account and
explained the meaning of surpluses and deficits in it. We also presented the
capital account, distinguishing between long-run and short-run capital. Then,
we defined the balance of payments and gave some plausible explanations for its
deficits or surpluses. We also presented the relation of government policy
(monetary or fiscal policy) with the current account. It has been established that
budget deficits, and thus fiscal policy, have a relationship with the current
account. Also, monetary policy may affect the current account via the inflation
rate and interest rates. However, both policies are weak tools in dealing with
current account imbalances and what is suggested is a well-targeted commercial
policy that may take several forms. Tariffs, quotas or subsidies and non-tariff
barriers, free trade zones, and foreign exchange controls are some of the
measures that can change the spending patterns of a country.
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APPENDIX
Activity 1
1. A Greek resident buys a share of a USA company. This is an outflow of capital from
Greece (a payment to foreigners) and increases Greek assets abroad. Hence it is a
debit.
2. A USA multinational Company sells its subsidiary in Greece to a Greek corporation. This
is also an outflow of capital from Greece to the USA (a payment to foreigners) and is
recorded as a debit in the capital account.
3. The Japanese Toyota establishes a green-field subsidiary in Greece. This is the case of
an inflow of capital into Greece (a payment from foreigners). Hence it is a credit.
4. Greek residents sell company shares of the German Mercedes. Again it is an inflow of
capital to Greece (a payment from foreigners). Hence it is a credit.
Activity 2
Macroeconomic policies may affect the whole economy and not only the trade balance.
Fiscal as well as monetary policy may affect the current account by affecting interest rates and
inflation rates. Their effect is not a direct one, as it works indirectly via other macroeconomic
variables, to reduce current account imbalances. It is suggested that direct controls, either
trade controls or exchange controls, are more targeted and thus more successful. Trade
controls include tariffs, quotas or subsidies and non-tariff barriers, free trade zones, and
quantitative restrictions. For example, a tariff on imports, by increasing import prices, will
induce consumers to switch to import substitutes. Exports subsidies also make home
goods relatively cheaper to foreigners and thus contribute to a current account
improvement. Exchange controls include restrictions on capital mobility or multiple
exchange rates with higher exchange rates for luxury-imported goods and lower exchange
rates for essential inputs such as capital equipment.
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CHAPTER 10
BIBLIOGRAPHY
RECOMMENDED READING
Paul, MN 1995, pp. 218-229.
Pilbeam K., International Finance, Second Edition, Macmillan, Business Houndmills,
Basingstoke, Hampshire 1998, pp. 31-53.
Salvatore D., International Economics, Seventh Edition, John Wiley & Sons, New York
2001, pp. 431-439 and 652-654.
177
CHAPTER 11
THE FOREIGN
EXCHANGE MARKET
The scope of Chapter 11 is to examine the foreign exchange (forex) market. We The Scope
analyze the reasons why economic agents enter the forex market, and the of the Chapter
determination of the exchange rate in a floating exchange rate system, as well as the
setting of the exchange rate under a fixed exchange rate regime. We also analyze the
relation of the exchange rate to the balance of trade, as well as the role of expectations,
stability and arbitrage in the forex market. The topics covered include the foreign
exchange market, exchange rate determination, exchange rate systems, stability and
arbitrage.
ñ familiar with the concept and role of the foreign exchange market Objectives
ñ able to understand how the exchange rate is determined, the different systems
of exchange rates, and stability and arbitrage in the foreign exchange market.
ñ Foreign exchange market Key Words

ñ Nominal and real exchange rates
ñ Exchange rate determination
ñ Spot and forward exchange rates
ñ Exchange rate systems
ñ Stability
ñ Arbitrage
Chapter 11 presents the foreign exchange (forex) market and explains the Introductory
exchange rate determination. We also explain the different exchange rate regimes, Comments
i.e., the free-floating exchange rate and the fixed exchange rate. Moreover, we
analyze foreign exchange trading and examine the role of expectations in the forex
market.
179
11.1 EXCHANGE RATE DETERMINATION
11.1.1 Foreign exchange market

The market for foreign exchange (forex) is the international market where the
currency of one country is exchanged for the currency of another country. In our
example of two countries, Greece and Bulgaria, the participants in the domestic
(Greek) forex market offer euro in exchange of leva. The price at which the euro is
exchanged for the leva is the exchange rate, denoted by the letter (e). In general
there are two definitions for the exchange rate:
1. It can be defined as the price of foreign currency (Bulgarian leva) in units of the
domestic currency (È), i.e., assuming that a Bulgarian leva can buy È0.50, the
current exchange rate is e = (È/Leva) = 0.5.1
2. It can be defined as the price of domestic currency (È) in units of the foreign
currency (Bulgarian leva), i.e., in our example, e = (Leva /È) =2.2
In this book we follow the first definition, and thus an increase in e denotes an
exchange rate depreciation for È (or appreciation of leva, that is, a leva can buy
more È) while a decrease in e denotes an exchange rate appreciation of È
(depreciation for leva; that is, a leva can buy less È).
Let us consider the forex market in the home country of Greece. The demand
for leva is derived from the demand for Bulgarian goods3 by Greek citizens. The
demand for foreign exchange is illustrated by the curve D in Figure 1, which slopes
downwards since as the exchange rate gets lower (a movement from point A to
point B corresponding to the movement from e1 to e2 on the vertical axis), the euro
(È) appreciates (or equivalently, the leva depreciates). Thus Bulgarian goods
become cheaper in Greece and this, in turn, leads to a higher demand for
Bulgarian imports in Greece. The supply of leva is derived from the demand for
Greek goods by Bulgarian citizens. The supply of foreign exchange is illustrated by
the curve S in Figure 1. It is upward sloping because, as the exchange rate increases
(a movement from point B to point C or from point e2 to e3 on the vertical axis), the
euro depreciates (or the leva appreciates), and thus Greek goods become cheaper
1
A depreciation of the euro means a fall in the value of the euro or equivalently, a leva can buy more euros
(the value of the leva is higher). That is, the exchange rate e = (È/Leva) rises.
2
Clearly, with the second definition, a depreciation of the euro is associated with a fall in the exchange rate
e = (Leva/È).
3
The term “goods” here may denote not only physical products but also services and financial assets.
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CHAPTER 11
which, in turn, leads to higher imports of Greek goods into Bulgaria and thus to a
higher quantity of leva supplied by Bulgarian importers.
_/Leva S Bulgarian Importers

of Greek goods
e1 A
e2 C
B
e3
D Greek Importers
of Bulgarian goods
L1 L2 L3 Billion Leva
Figure 1: Exchange Rate Determination
The intersection of the demand and supply curves in the forex market determines
the equilibrium exchange rate e2 where the market clears in the absence of government
interventions.
Let us examine, next, how shifts in the demand and supply curve of foreign
exchange are associated with depreciation or appreciation of the exchange rate. An
increase in the demand for foreign goods will increase the demand for foreign
currency, thus shifting the demand curve D for foreign exchange to the right, as
illustrated in Figure 2, and hence leading to an exchange rate depreciation from e2
to e3. On the other hand, a decrease in the demand for foreign products, say due to
their bad quality, will lead to a lower demand for foreign currency and thus will
lead to an exchange rate appreciation (not illustrated).
S Bulgarian Importers
_/Leva
of Greek goods
Z
e3
B
e2
Dã
D Greek Importers
of Bulgarian goods
L2 L3 Billion Leva
Figure 2: Demand for Foreign Currency and Exchange Rate Depreciation
181
Consider next the case of an increase in the demand for domestic goods by
foreigners. The higher demand for domestic goods will result in a higher supply of
foreign currency, as illustrated by the shift of the supply curve S of foreign currency
to the right in Figure 3 and thus lead to an exchange rate appreciation from e2 to e4.
_/Leva
of Greek goods
Sã
B
e2
e4 M
D Greek Importers
of Bulgarian goods
L2 L4 Billion Leva
Figure 3: Supply of Foreign Currency and Exchange Rate Appreciation
When governments do not intervene in the forex market by buying and selling
their currency and allow the exchange rate to change due to changes in the demand
and supply forces in the forex market, we say that we have a floating exchange rate
regime. In contrast, when the exchange rate is set by a central monetary authority
(or the government), we have a fixed exchange rate regime.
11.1.2 Exchange rate changes and trade balance

We now consider the case of exchange rate depreciation on the trade balance.
Let us, first, assume that imports are elastic, both at home and abroad. As the
exchange rate depreciates, home imports become more expensive, thus expenditure
on home imports will fall, while home exports (that is imports for some other
countries) become cheaper abroad and thus revenues from home exports will
increase, resulting in an overall improvement in the trade balance. However,
exchange rate depreciation will improve4 the trade balance, even if imports are not
elastic at home or abroad, provided that the Marshall-Lerner condition holds. The
Marshall-Lerner condition states that if the sum of import and export elasticities is
greater than one, then an exchange rate depreciation will lead to an improvement
in the trade balance. Empirical evidence suggests that this relationship holds for
4
By improvement in the trade balance, we mean either a reduction in the trade deficit or an increase in the
trade surplus.
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the long run. However, in the short run we may even observe a worsening of the
trade balance following exchange rate depreciation. This is so, because in the short
run there are contracts for delivery of goods and thus quantities of imports and
exports are fixed, so with exchange rate depreciation at home, the value of imports
increases while the revenue from exports (in foreign currency) decreases.5 As a
result of these two effects we may observe a worsening of the trade balance: the so-
called J-curve effect.6 Over time, however, quantities adjust and the trade balance
improves, as illustrated in Figure 4.
BOT
0
Time
Figure 4: The Time Path (the J-Curve) of Adjustment in the Trade Balance due
to an Exchange Rate Appreciation
11.1.3 Fixed exchange rate regime

As we saw earlier, in a floating exchange rate system, the central monetary
authorities (or a government) do not intervene in the forex market and so exchange
rates may change as a result of changes in demand and supply in the forex market.
However, governments may intervene in the forex market in order to support their
currency. Central banks or governments often support their currency for a variety
of reasons:
ñ An overvalued currency reduces the monetary burden created by national debt
abroad.
ñ A high value of the home currency will deter imports and thus import expenditure,
helping to keep lower deficits in the balance of payments.
5
To show this we may use a numerical example: 100 units of a British-made good are exported to the EU.
The price of this good is í2 per unit in the UK, and the spot exchange rate is assumed initially to be È1 =
í0.69 (or í1 = È1.45) while at some later time the pound depreciates to È1 = í0.80 (or í1 = È1.25).
With fixed quantities of goods, due to existing contracts, the price of the British goods in euro is È2.90 (=
í2á1.45), while after depreciation it is È2.50(= í2á1.25). Thus, export revenues diminish from È290 to
È250, following the depreciation of pound.
6
It is called the J-curve due to the shape of the curve describing the path of adjustment in the trade balance.
183
ñ A high value of home currency may effectively support domestic firms competing
with foreign firms.
ñ Highly valued currencies are attractive for international investors as a store of
value for their funds.
To examine a fixed exchange rate regime, assume first that market forces
determine the equilibrium exchange rate between the euro and the leva at the
value e eq = 0.5. That is, a leva can buy half a euro, as illustrated in Figure 5.
Assume, next, that the Bulgarian central bank (or government) would like to fix
the value of the leva at a much higher price, say at eInterv= 0.6, so that a leva can buy
È0.60. At this fixed exchange rate, there is an excess supply equal to (L2-L1) billion
leva, which is equivalent to an excess demand of (L2-L1) * eInterv = 0.6 (L2-L1) for
euro. That is, the central bank of Bulgaria would have to sell 0.6(L2-L1) billion
euros out of its foreign exchange reserves, every day, in order to support the fixed
exchange rate eInterv = 0.6. Clearly, if a country wants to maintain, for a quite long
period, an exchange rate higher than the equilibrium one, then the country will
deplete its foreign exchange reserves. Thus, maintaining an overvalued currency is
not sustainable in the long run. However, fixing exchange rates may be attractive
when countries try to avoid temporary fluctuations over or under the equilibrium
exchange rate that may affect their economic transactions with the rest of the
world.
_/Leva
of Greek goods
eInterv
B
eeq
D Greek Importers
of Bulgarian goods
L1 Leq L2 Billion Leva
Figure 5: Fixing Exchange Rate
At this point it is worthwhile to distinguish between, on the one hand, the

concepts of appreciation and depreciation, and on the other hand, the concepts of
revaluation and devaluation. Revaluation of exchange rate refers to a reduction in
the exchange rate, imposed by a government in a fixed exchange rate system, while
appreciation is the decrease in the exchange rate according to market forces (no
government intervention) in the forex market operating under a floating exchange
rate regime. In both cases (revaluation of appreciation) the value of foreign currency
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decreases in terms of domestic currency. Similarly, devaluation is an increase in the

exchange rate in a fixed exchange rate system, while depreciation is a decrease in
the exchange rate in a floating exchange rate system.
11.1.4 Other definitions of exchange rate

The Concept of the Real Exchange Rate
So far, we have defined and used the nominal exchange rate, which relates units
of one currency to units of other currency, ignoring changes in the price levels
between trading countries. However, differential inflation rates between countries
may change the price level in one country more or may be less than those of its
trading partners, and consequently affect its international competitiveness. Assume,
for example, that a country’s nominal exchange rate is devalued by 5% and incurs a
5% inflation rate while its trading partners enjoy a zero inflation rate. Clearly, the
international competitiveness of the country is unaffected since in real terms the
exchange rate remains the same. If, however, the 5% devaluation was combined
with a 7% inflation rate in the home country, home “goods” would be 2% more
expensive abroad and thus international competitiveness of the country would be
worsened. Therefore, to assess the competitiveness of a country, we use the notion
of the real exchange rate, defined as:
Â ≡ e (P* / P)
where Â stands for the real exchange rate; e is the nominal exchange rate defined
earlier; P* is the price level abroad; and P is the home price level.
Spot versus Forward Exchange Rates

The spot exchange rate is the quotation between two currencies when a
transaction takes place immediately. That is, the spot exchange rate is the current
exchange rate between two currencies, although, the actual transaction of exchanging
currencies might take place some days after the agreement. However, it is also
possible for traders to agree today on future exchange of currencies. In this case,
when the exchange of currencies is agreed upon to take place in the future, we call
the rate of exchange the forward exchange rate. Economic agents may be involved in
such agreements in order to minimize the uncertainty and risk associated with the
volatility of exchange rates.
In sum, Section 11.1 presents the foreign exchange market and the determination
of the exchange rate. In a floating exchange rate system, the exchange rate is
determined by demand and supply forces in the forex market. Changes in the
exchange rate affect the trade balance. A depreciation of the exchange rate will
improve the BOT if the Marshal-Lerner condition is satisfied, although it might
cause a worsening of it in the short run, as described by the J-curve. In a fixed
exchange rate regime, the central monetary authorities or governments set the
exchange rate. If the exchange rate is set above its equilibrium value, the country will
185
incur a loss of foreign reserve in order to support its currency and will be forced, at
some point, to reset its exchange rate at a lower level. The nominal exchange rate
relates units of one currency with units of another currency, ignoring changes in the
price levels between trading countries, while real exchange rates take into account
the price levels between trading countries.
Explain what the effect of the following will be on the exchange rate:
1. An increased demand in Britain for imports of high quality US cars.
2. An increased number of Turkish tourists visit Bulgaria.
3. IBM produces a very fast computer.
4. The Turkish government issues new bonds with a high and secure yield.
5. Central banks worldwide announce a plan to sell euros in order to depreciate the euro.
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11.2 EXPECTATIONS, STABILITY

AND TRADING IN THE FOREX MARKET
11.2.1 Expectations in the forex market

Expectations about the future value of a currency may affect the spot exchange
rate today. Assume, for example, that traders have formed expectations that the
euro will appreciate within three months. If the euro is expected to appreciate in
the future, economic agents should act today by selling their holdings in other
currencies and buying euros. By doing so, economic agents would expect to make
some profits. Therefore, economic agents, based on their expectations about
future exchange rates, acting today will increase their demand for the euro, thus
pushing up the value of the euro today, i.e., resulting effectively in an appreciation
of the euro. This is the self-fulfilling mechanism of expectations about future
changes in the exchange rate.
If expectations about future exchange rates can affect spot exchange rates, then
one should ask how economic agents form their expectations. Expectations might
be adaptive, i.e., they are based on past information regarding how the exchange rate
has behaved, say, over the last five years or so. The shortcoming of this approach is
that adaptive expectations will allow only gradual adjustments of exchange rates,
which is not always the case. Indeed, since 1973 with the prevailing floating
exchange rates system, we have observed sharp charges in the exchange rates. On
the other hand, economic agents always make use of all information available to
them (past, present and average future information related to exchange rates). This
is the case of rational expectations (or efficient markets hypothesis) in the forex
market.
Economic agents try to predict exchange rate changes either by following either
fundamentalists or chartists. Fundamentalists examine the underlying theory and
variables that may affect the exchange rate. These variables may be money supply
growth, price level, budget deficits, or the balance of payments deficits across the
trading partners. On the other hand, Chartists “chart” the path of the exchange rate
and try to find certain patterns in its behavior by identifying “spikes,” “heads,”
“shoulders,” “cliffs,” “bubbles” and so on. Chartists claim that certain patterns of
exchange rate repeat themselves, and so by detecting these patterns, one should be
able to predict future exchange rate changes. Although most exchange rate traders
follow chartists, there is still no clear-cut winner in terms of which strategy is the
best in predicting exchange rates.
187
11.2.2 Speculation and stability in the forex market
Speculation on the foreign exchange market may have stabilizing or destabilizing
effects. Assume, for example, that at time 0 the forex market clears at the exchange
rate e0, as illustrated on the left hand side of Figure 6. At time 1, the supply curve of
leva (S 1) is less than the supply curve (S 0) at time 0, due, say, to a change in the
preferences of Bulgarian investors who prefer to invest in Bulgarian assets as illustrated
on the right hand side of Figure 6.
S1
_/Leva
_/Leva
e1
S0
e0 A e0
D0 D1
Billion Leva Billion Leva
Figure 6: Stabilization Effects of Speculation
If speculators at time 0 could have correctly anticipated that the leva would
appreciate in the future, they could have acted at time 0 and bought leva (selling
euro) with the aim of selling leva at time 1 when their price is much higher, at e1,
and thus making speculative profits. By buying leva at time 0, speculators would
have increased the demand curve (D 0) and thus pushed the exchange rate up,
while by selling leva at time 1, they would have increased (S 1) and lowered e 1.
Thus, each time, if speculation is profitable, it may reduce the exchange rate
variability. However, speculation may not always be profitable or it might create
bubbles, i.e., speculators will keep buying leva, on the expectations that the
appreciation of the leva will continue for a long time, thus pushing its value faster
and well above the value of the leva in the absence of speculation. Moreover, when
the bubble bursts, speculators rush to sell their holdings of leva, pushing it down
faster and further.
11.2.3 Demand and supply in the forex market

and stability
Stability in the forex market does not depend only on speculation, but has also to
do with the slopes of the demand and supply curves in the forex market. We illustrate
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demand curves and supply curves for foreign exchange in Figure 7. Although
demand is downward sloping, we note that the supply curve is also downwards
sloping, and with a lower slope than the demand curve.
_/Leva
e0
D
Billion Leva
Figure 7: Demand and Supply Curves in the Forex Market and Stability of
the Exchange Rate
The supply curve is downward sloping because foreign imports are assumed to
be inelastic, that is, as the euro appreciates, home goods become more expensive
abroad, foreign expenditure is higher and thus the quantity of foreign currency
supplied increases. This might be the case in the short run where contracts may
restrict trading partners to certain quantities of goods. In such a case, the point of
intersection is at e0, however, this is not a stable equilibrium since above point e0,
the quantity demanded is higher than the quantity supplied, and hence the exchange
rate is pushed up without limit. Also, below point e0, the quantity supplied is higher
than the quantity demanded, thus pushing the exchange rate further down without
any limit.
11.2.4 Arbitrage
Arbitrage is the case where economic agents are involved in two simultaneously
taken actions: (a) they purchase a currency in a market where it is cheaper, and (b)
they sell it in a market where it is more expensive, with the sole aim of making a profit
out of differences in the spot exchange rates. Thus arbitrage is a riskless activity that
exploits differentials in the spot exchange rates. We distinguish between two types of
arbitrage: (a) two-point arbitrage or financial center arbitrage, where only two
currencies are traded between financial centers, and (b) triangular or three-point
arbitrage, where three currencies are traded between three financial centers. Both
cases of arbitrage, by affecting demand and supply forces, bring equalization of
spot exchange rates across financial centers. Let us examine each case of arbitrage
separately.
189
Consider, first, the case of two-point arbitrage and assume, for example, that
the pound’s spot price is í1 = $2 in New York and í1 = $2.05 in London. An
arbitrager that buys pounds in New York (where the pound is cheaper at $2) and
immediately sells them in London (where the pound is more expensive at $2.05),
will make profits equal to five cents per pound. Moreover, buying pounds in New
York will push up the price of the pound, while selling pounds in London will
decrease the value of the pound. Thus, as a result of arbitrage, the dollar-pound
spot exchange rate in New York will be exactly the same as the spot exchange rate
quoted in London.
Consider next the case of triangular arbitrage and assume the following spot
exchange rates: í1 = $1.827 (or $1 = í0.54) and È1 = $1.26 (or $1 = È0.79).
Currency arbitrage implies that the exchange rate of the euro against the pound
will be í1 = È1.447 (or È1 = í0.69). If this were not the case, and the actual spot
exchange rate was í1 = È1.70, then a foreign exchange dealer could do much
better by first obtaining È1.70 then buying $2.143 and thus making profits of 0.443
cents of a dollar8 = 2.143 – 1.700. Once more the increased demand for the euro
will push it up against the pound to í1 = È1.44.
11.2.5 Expected inflation, value of a currency

and nominal versus real interest rates
As we saw earlier, capital moves between countries, seeking the highest possible
returns. International investors compare possible returns to their investments in
order to take investment decisions. However, currencies all over the world have
been inflated since World War II. Inflation erodes the purchasing power of any
currency over time. Moreover, different countries incur different inflation rates
and thus their currencies are affected differently. Hence, comparing nominal
returns to assets nominated in different currencies or real returns to investments
undertaken in different currencies, does not take into account differential inflation
rates. For this reason, we need the notion of real return that takes into account
both the nominal return and the inflation rate associated with a currency.
Consider, for example, the case of the nominal interest rate obtained from a
savings account. If the nominal rate of interest is 10%, and at the same time the
inflation rate is 8%, the owner of this savings account will obtain, at the end of the
investment period, a net return of 2% on his/her capital. This is the so-called Fisher
Equation, stating that the nominal interest rate is the sum of the real exchange rate
plus the expected inflation rate, i.e.
i = r + exp
7
This is so, since È1 = $1.26 (0.54) = í0.69 (or í1 = È1.44).
8
That is, È1.70 * 0.69 = í1.173 * 1.827 = $ 2.143.
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CHAPTER 11
where i is the nominal exchange rate; r is the real exchange rate; and exp is the
expected rate of inflation.
Let us now use the notion of real interest rates to compare returns in different
countries. Assume again a world with only two countries, say Greece and Bulgaria. In
Greece, nominal interest rates are, say, 4.5% and the expected inflation rate is 3%,
while in Bulgaria nominal interest rates are 23% and the expected inflation rate is
21.5%. Clearly, both countries have the same real exchange rates. Therefore,
someone investing in either country would get the same net return provided that
his/her expectations about inflation rates in the two countries exactly matched the
actual inflation rates at the end of the period. As expected inflation rates in the
two countries are not observable; economic agents have to guess their magnitudes
well in advance of their investment decisions. However, inflation results, not only
from the economic policy implemented in one country, but also often from
unexpected episodes such as an oil price increase, a war in the Middle East,
political events, social unrest, and so on, that are hard to foresee. Thus even the
most experienced investors may make wrong guesses about expected inflation and
real returns. We can see the above with the help of an example. Assume that the
spot exchange rate is 2 leva /È and the inflation rate at the end of the year turns
out to be 25% for leva and 3% for È. The leva has lost 25-3=22% of its value
relative to the euro. Thus the exchange rate should be 1.22á2 = 2.44 leva/È at the
end of the year. If an investor had made a “guess” of expected inflation rate of the
leva of only 21.5%, as we assumed in the previous example, his/her relative return
would be 3.5% less. This occurs since the investor would have expected only a
18.5% depreciation of the leva while, in fact, at the end of the period, there was a
22% depreciation of the leva.
Thus, comparing real interest rates involves the risk of miscalculating the non-
observable expected inflation. Economic agents in practice use the nominal returns
and consider differences in nominal returns as the market expectation of the discount
between inflation rates. Hence in the case of interest rates, the difference between
nominal interest rates of two countries is the market expectation of the discount
between inflation rates. So in our previous example, the leva has a 23%-4.5% =
18.5% discount against the euro, or conversely, the euro has an 18.5% premium
against the leva.
In sum, Section 11.2 explains the role of expectations, stability and trading in
the forex market. Expectations are important in the forex market, as expectations
about future values of exchange rates affect spot exchange rates today. Economic
agents try to predict exchange rate movements either by looking at the fundamentals,
i.e., by making use of the underlying theory of exchange rates, or by identifying
certain patterns on the time path of the exchange rate, as suggested by chartists.
Speculation may have both stabilizing and destabilizing effects on the exchange rate.
The stability of the forex market is not only dependent upon speculation, but also
upon the forces that determine demand and supply in the forex market. A two-point
or three-point arbitrage brings about equalization of the spot exchange rates
internationally.
191
Explain what the effect will be of exchange rate changes on businesses.

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CHAPTER 11
In Chapter 11 we present the forex market and the exchange rate determination.
In a floating exchange rate system, the exchange rate is determined by demand and
supply forces in the forex market, while in a fixed exchange rate system, the
exchange rate is determined exogenously by a central monetary authority or the
government. An exchange rate depreciation will improve the BOT if the Marshal-
Lerner condition is satisfied, however, it might cause a worsening of the BOT in
the short run, as described by the J-curve. Real exchange rate takes into account
the price levels between two trading countries. Expectations are important in the
forex market, as expectations about future values of the exchange rate affect spot
exchange rates today. Economic agents try to predict exchange rate movements
either by looking at the fundamentals, i.e. by making use of the underlying theory
of exchange rates, or as suggested by chartists, by making predictions based on
identifying certain patterns on the time path of the exchange rate. Speculation
may have both stabilizing and destabilizing effects on the exchange rate. The
stability of the forex market is not only dependent upon speculation, but also
upon the forces that determine demand and supply in the forex market. A two-
point or three-point arbitrage brings equalization of the spot exchange rates
internationally.
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APPENDIX
Activity 1
1) An increased demand for imports of high quality US cars in Britain will increase the
demand for foreign currency (dollars) in the UK and thus lead to depreciation of the
pound against the dollar.
2) An increased number of Turkish tourists visiting Bulgaria will result in a higher demand
for the leva in Turkey and will depreciate the Turkish lira.
3) IBM’s production of a very fast computer will cause many people and companies
abroad to be willing to buy this new computer, so the supply of foreign currency will
increase and the dollar will appreciate.
4) The Turkish government’s issuance of new bonds with a high and secure yield will
make them very attractive and foreign investors will be willing to buy them, thus pushing
up the demand for the Turkish lira (or equivalently increasing the supply of foreign
currency) and leading to an appreciation of it.
5) If central banks worldwide announce a plan to sell euros in order to depreciate the euro,
and if traders, dealers, investors and speculators are convinced that this plan will work,
then they will move out of euros and buy assets nominated in other currencies,
including the dollar. This will lead to an increased demand for other currencies and an
increased supply of euros, resulting in a depreciation of the euro.
Activity 2
The effect of exchange rate changes on businesses can be seen with the help of a
numerical example. Let us assume that 100 units of a British-made good are exported to
the EU. Assume that the cost of producing this good is í80, its price in the EU is È2 per unit
and the spot exchange rate is initially at È1= í0.69, while at some later moment it changes
to È1= í0.80. We now obtain the following picture of accounting concerning the particular
firm that produces this good.
È1= í0.69 È1= í0.80
Sales in EU market 100 @ È2 = È200 Sales in EU market 100 @ È2 = È200
EU sales converted into ís = í138 í160
Cost í80 Cost í80
Profits í58 Profits í80
This simple numerical example shows that a depreciation of the pound makes exports to
the EU market more profitable. Indeed, the exchange rate depreciation makes British
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products more attractive abroad, creating opportunities for expansion of the scale of
production.
In general, however, changes in the exchange rate will result in changes in the competitiveness
of this country, which may have positive or negative effects. In our example, the exchange rate
depreciation in the home country improves the international competitiveness of the host
country in the short run. However, this exchange rate depreciation may cause inflation in the
home country, thus reducing its international competitiveness in the long run. Moreover,
often changes in exchange rates, i.e., an extensive variability of exchange rates, create an
environment of increased uncertainty that does not favor international businesses as it
prevents firms from planning ahead.
195
BIBLIOGRAPHY
RECOMMENDED READING
Paul, MN 1995, pp. 240-269.
McAllese D., Economics for Business, Prentice Hall, Essex 2001, pp. 550-581.
196
CHAPTER 12
INTERNATIONAL FINANCE
The scope of Chapter 12 is to present international financial markets and their The Scope
operations. We explain the needs of lenders and borrowers and the role of a financial of the Chapter
system. We examine the loanable funds market (credit market) and explain real
interest rate determination. We present the role and the functions of money, as well
as the money market and the determination of the home price level. The relation of
the exchange rate to the price level at home and abroad is also analyzed. The topics
covered include credit market, forward exchange rates, international money and
purchasing power parity.
ñ familiar with the role of the credit market and the determination of real interest Objectives
rates in a globalized world
ñ able to understand the role of money in modern economies and the relation of
the exchange rate to the price levels at home and abroad.
ñ Physical capital and financial capital Key Words

ñ Lenders, borrowers and financial institutions
ñ Money market
ñ Forward exchange rate
ñ Covered interest parity
ñ Purchasing power parity
Chapter 12 presents and analyzes international financial markets and their Introductory
operations. We start our analysis with the motives of lenders and borrowers, then we Comments
proceed to the role of the financial system that exists in order to serve the needs of
lenders and borrowers. Next, we analyze the loanable funds market (credit market) and
explain the determination of interest rates, both domestically as well as internationally.
We analyze the role of the forward forex market which economic agents may enter in
order to avoid the risk associated with changes in the spot exchange rates. We then
proceed to the role of international money, explaining the equilibrium in the money
market. Finally, we analyze the law of one price and purchasing power parity.
197
12.1 FINANCIAL SYSTEM
12.1.1 Lenders, borrowers and financial institutions

We start our analysis by distinguishing between physical capital and financial
capital. The term physical capital is related to the definition of production factor or
input in microeconomics and includes real estate, factories, machinery, or equipment
that – combined with other production factors, such as labor and raw materials – will
produce a semi-final or a final good. The term financial capital is related to loans.
Loans are offered by economic agents whose spending is lower than their income,
thus they have money available for lending; they are called savers or lenders. On the
other hand, borrowers or investors are economic agents whose spending is higher than
their income. They borrow funds because they want to buy physical capital in order to
either set up their business or increase the size of their existing business. The
financial system, which comprises the financial intermediaries and financial markets,
exists because of savers and investors. Indeed, financial institutions, including banks,
investment trusts, insurance companies and discount houses, serve the needs of
lenders and borrowers, as we will analyze shortly. At this point, however, we should
note that savers and investors are not necessarily the same agents. Often, savers and
investors are different; for example, an investor could be a firm manager wishing to
expand the size of his firm, while savers could be individuals wishing to put some of
their income aside for retirement. However, even if savers and investors are the same
agents, the timing of their needs may be different: savings can precede investment or
follow afterwards as debts are gradually repaid. Moreover, saving and investment do
not necessarily occur in the same geographical place. This is true especially in
modern economies of globalized financial markets. Consider, for example, the case
of the 19th century British savings that financed the construction of the US railroads,
or the development of British North Sea oil that was financed by US saving; consider
also the case of oil rich countries that have financed investment in many western
economies.
Savers’ motivations could be one of the following:
ñ To save for short periods (e.g., for Christmas expenditures, or a holiday abroad).
ñ To save for longer periods, e.g., retirement.
ñ A desire on the part of firms to save for future investment or for future adverse
business conditions.
ñ Because the fiscal system (tax-system) may induce people to save more or less.
Investors’ needs, on the other hand, are for long-term capital since investment
is durable, i.e., lasts for long periods and generates a flow of earnings, which
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allows investors to recover the cost of their investment gradually. Also,

investment is specialized, implying that capital that has been used to buy specific
machines, buildings, equipment and raw materials is difficult to liquidate without
loss, if the firm needs liquidity urgently. Moreover, investment is a risky activity
occurring in an environment of uncertainty. Due to the above characteristics of
the investment, borrowers are looking for long-term liabilities and they would
also prefer part of their liabilities to take the form of equity capital (shares) rather
than having loans (bonds). They would also like to pay as little as possible for the
funds they obtain.
Financial intermediaries, as we mentioned earlier, exploit the differences
between savers and lenders. Indeed, they may perform the following functions:
ñ Mobilize savings and raise its level in the economy by offering to savers higher
security, safety and income, e.g., pension funds, life insurance institutions and
banks offering deposits.
ñ Facilitate or encourage investment, e.g., banks make loans and encourage clients
to go ahead with their plans for investment.
ñ Transform maturities 1 between savers and borrowers by pooling savings, as
savers prefer short maturities (deposits and short loans) while, on the other
hand, investors want long-term liabilities.
ñ Transform risk by channeling small savings of many individuals to large sums to
borrowers, e.g., many individual bank deposits are required to make up a single
mortgage or a large industrial project.
ñ Reduce information and transaction costs of funding. Individual agents or
companies do not have the information that financial institutions may have due
to their specialization in some markets, e.g., building societies are specialized in
the house market mortgages; banks in business and consumption loans, as well
as in mortgages; investment companies in the stock markets. All financial
institutions have a network of branches and agencies that allows them to have
economies of scale achieving lower costs of operation.2
12.1.2 Cost-benefit analysis and project selection

To be able to analyze the demand for loans in the next section, we need to
understand some elements of cost benefit analysis and explain, first, how
investment projects are selected. Assume that one wishes to undertake an
investment project that will incur costs today and have returns in the future.
Clearly, an investor should compare present costs (C) with future returns Y1, Y2…
Yn, in their equivalent values today. That is, the investor has to compare the cost of
1
Maturity is the time which elapses before a deposit or a loan is due to be repaid.
2
For example, they know better the legal procedure needed in their different types of operation than
individuals may know it.
199
investment incurred today with the discounted values of future project returns. The
future project returns Y1, Y2… Yn should be discounted by the factor (1 + i), where r
is the interest rate. To simplify matters, assume an investment project that gives a
return of È100 per year, for a period of two years. The potential investor will have
to discount the amount of È100 of the first year by the discount factor (1 + r), and
the second year’s amount of È100 by the discount factor (1 + r)2, as illustrated in
Figure 1.
(100)/(1+r)
0 1 2 Time
_100 _100
(100)/(1+r)2
Figure 1: PV of Future Returns
Thus, the present value (PV) of these two future returns is: (100)/(1 + r) +
(100)/(1 + r)2.
In general, if there is a stream of returns for n years, i.e., Y1, Y2… Yn, the present
value of these n returns is given by:
n
Yt Y1 Y2 Yn
PV = ∑ = + + .........
t =1 (1 + r ) t
(1 + r ) t
(1 + r ) t
(1 + r )t .
An investment project will be selected only if the cost of investment today (C) is
lower than the PV of its future returns, i.e., C < PV.
Investors often have to select an investment project from several projects.
Selecting the most profitable project among other projects is based on the criterion
of internal rate of return. Defining net present value (NPV) of a project as the
difference between the PV of future returns and the current cost C of the project,
i.e.:
n
Yt
NPV ≡ PV – C = ∑ –C,
t =1 (1 + r )t
the internal rate of return, i, is the rate that sets NPV equal to zero, i.e., NPV = 0.
Selecting an investment project from two mutually exclusive investment
projects requires the comparison of their internal rates of return. That is, project A
will be selected over project B if the internal rate of return of project A is higher
than that of project B, i.e., iA > iB.
Comparison of a project’s internal rate of return, i, with market interest rate, r,
shows whether that project will give a higher return than a savings deposit in a
bank. Clearly, higher interest rates will reduce investment, as a lower number of
investment projects will give internal rates of return higher than the market
interest rates.
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12.1.3 The market for loanable funds (credit market)

Having analyzed the process of project selection, we may now proceed to the
market for loans. Let us first define loanable funds as the quantity of funds changing
hands between lenders and borrowers and assume that both borrowers and lenders
take their decisions on borrowing and lending based on real interest rates.3 The real
interest rate is the cost of borrowing funds and the return for lending funds. The
demand for loanable funds is derived from the behavior of borrowers (investors) and
is related to the real interest rate. As we mentioned in the previous section, a
potential investor will decide on undertaking an investment project by comparing the
internal rate of return of the particular project with the market real interest rate.
Clearly, a higher interest rate will deter borrowers from undertaking some investment
projects, as a fewer number of projects will give internal rate of returns higher than
the market interest rate, thus, the quantity of loanable funds demanded will be less. In
other words, the demand curve should be downward sloping in Figure 2. The supply
curve of loanable funds, in Figure 2, is upward sloping since at higher market interest
rates, lenders are willing to lend more funds (higher return to their funds). The
market for loanable funds (credit market) clears at the point of intersection between
the demand and supply curves, determining the equilibrium real interest rate req and
the volume of funds Leq changing hands from lenders to borrowers.
Real interest rate r%
SLF
req
DLF
Leq Loanable funds _ billions
Figure 2: Home Market for Loanable Funds
Above the equilibrium real interest rate there is an excess supply of loanable
funds that pushes down real interest rates, while below r eq there is an excess
demand pushing it towards the equilibrium real interest rate, req.
Compare, next, the case of the domestic real interest rate with the international
real interest rate. If the home economy is a small open economy, it cannot affect
3
We have defined real interest rate in Chapter 11, i.e., the Fisher equation: i = r + exp, so, r = i - exp.
201
international interest rates, as its size in providing or asking funds is small compared
to the rest of the world (ROW). Therefore, a small open economy takes international
interest rates as given,4 that is, international interest rates will prevail in the home
economy. If the international real interest rate is higher than the autarky home real
interest rate, then the home economy will be a lender and the reverse, i.e., a borrower,
if the international real interest rate is lower than the autarky domestic one.
However, when the home economy is large and its size in demand and supply of
loanable funds can affect the global demand and supply of loanable funds, 5
international real interest rates are also affected. The determination of the real
interest rate in the case of large economies is analogous to the international excess
demand and supply of goods discussed in Chapter 1. We illustrate the global credit
market in Figure 3. The excess demand for loanable funds (XD) of the home country
starts from the point rhome eq of the autarky equilibrium real interest rate in the home
country and slopes downward, as for lower international interest rates, there will be a
higher demand for funds. Let us now turn into the excess supply that is derived from
the foreign credit market. The excess supply (XS*) of funds in the foreign country
starts from the point (rforeign eq) of the equilibrium real interest rate in the foreign
economy and slopes upward as for higher international interest rates there will be a
higher supply of funds in the foreign economy. The point of intersection of the two
curves determines the international real interest rate, which is between the two
autarky real interest rates. That is, rforeign eq < rinter < rhome eq, which implies an outflow
of funds from the foreign country into the home country. Clearly, borrowers at home
will be better off, as international interest rates are lower; however, home lenders will
be worse off. Similarly, lenders in the foreign economy will enjoy higher returns on
their funds, while borrowers will face a higher international interest rate.
Real interest rate r
r home eq XS*
r inter
r foreign eq XD
0 Linter LLF
Figure 3: Global Market for Loanable Funds
4
We say that a small open economy is a price taker in the global credit market, which means that it cannot
affect international interest rates.
5
As is the case with the USA, the EU and Japan.
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12.1.4 International interest rate and exchange rate

Covered Interest Arbitrage and Forward Exchange Rate
Financial markets today are globalized, as investors seek the best opportunities
for their funds internationally. Indeed, if interest rate returns are higher in some
market around the world, funds will move very fast into that market seeking to make
profits. The decision about moving funds from one country into another involves
the comparison of foreign with domestic interest rates, as well as the comparison of
spot exchange rates at the time of any transaction. Although interest rates in the two
countries are known from the beginning of the period, the spot exchange rate is
changing in response to changing conditions in the forex market and thus the future
spot exchange rate is not known to traders in advance. Thus, an investor who moves
funds into a foreign country and wants at some future time to repatriate these funds
along with their return, takes an open position.6 This open position involves the risk
that the spot exchange rate may change and thus investor’s funds and earnings
might be less. If, for example, foreign currency were to depreciate in the future,
investor’s funds and earnings would be worth less in terms of the domestic currency.
Consider, for example an investor with È1000 in the EU where interest rates are i =
6%. At the end of the year this investor could earn È1060. Assume, next that the US
interest rate is i* = 4% and that the spot exchange rate is e = È/$ = 0.79. The
amount of È1000 can be exchanged 7 into 1000/0.79 = È1265.82. This amount
invested in the US could yield 1265.82á1.04 = $1316.45, at the end of the year.
Assume, next, that the investor takes an open position and wishes to convert his/her
earnings and capital into dollars at the spot exchange rate at the end of the period. If
the exchange rate were to depreciate, clearly the investor would incur a loss in
his/her capital and earnings. The investor could avoid this risk of depreciation by
entering the forward exchange rate market. That is, the investor could sign a
forward contract in selling $1316.45 in exchange for euro. The forward exchange
rate is known at the beginning of the year and anyone can sign a contract for any
time period and any amount. In our example, the forward exchange rate has to be f
= È/$ = (1060/1316.45) = 0.805 for the simple reason that the amount of $1316.45
converted into euro should be exactly equal to È1000, otherwise traders could be
involved in risk free arbitrage eliminating immediately any discrepancy.
Let us next state explicitly the relation between the two interest rates (domestic
and foreign) and the two exchange rates (spot and forward) known as the covered
interest arbitrage (CIA), which states that when earnings in foreign currency are
converted into home currency, they should be exactly equal to the earnings in the
home currency. More formally,
CIA = (1 + i) = (1/e) (1 + i*)f.
6
An open position is a situation faced by a trader in some market involving risk if market prices fall or rise.
7
Dividing by e converts domestic currency units into foreign currency units.
203
To derive this relation, assume that an investor with È1 at home can earn (1 + i)
by investing in domestic assets (bonds, treasury bills and so on). Alternatively, the
investor can convert È1 into dollars (dividing È1 by the spot exchange rate, i.e, 1/e)
by buying a US asset and yielding a return (1 + i*). The investor can close his/her
position by converting his/her earning back into euros (multiply by f). Covered
interest arbitrage is ensured by the simultaneous operation of several markets: the
spot foreign exchange markets, the international credit markets and the forward
exchange rate markets.
In sum, Section 12.1 explains the motives of lenders and borrowers and the role
of a financial system that exists in order to serve the needs of lenders and borrowers.
Next, we analyze the loanable funds market or credit market and explain the
determination of interest rates, both domestically as well as internationally.
Economic agents may wish to avoid exposure to changes in spot exchange rates, and
for this reason, they may cover their position by entering the forward forex market.
Thus, we presented and derived the CIA, which states the relation between the two
interest rates (domestic and foreign) and the two exchange rates (spot and forward).
A Explain and analyze the importance of a financial system in a modern economy.
B. What does the Loanable Funds theory suggest for the determination of the interest
rate? Discuss critically.
C. Multiple choice questions

1. The financial system is primarily a means by which:
a. borrowers can use savers’ funds until the savers themselves need the funds
b. money is put into circulation
c. the government puts into operation its plans for the economy
d. business firms distribute their goods
2. Economists define risk as:

a. the difference between the interest rate borrowers pay and the interest rate
lenders receive
b. the degree of uncertainty of an asset’s return
c. the ease with which an asset can be exchanged for other assets or for goods and
services
3. Economists define liquidity as:

a. the difference between the return on the asset and the return on a long-term US
Treasury bond
b. the fraction which the asset makes up of an investor’s portfolio
c. the ease with which an asset can be exchanged for other assets or for goods and
services
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12.2 INTERNATIONAL MONEY
12.2.1 The role of money

In the early stages of society, there were self-sufficient individuals as everyone
used to produce all the goods he or she needed. However, as the economy became
more advanced, people realized that they could produce more goods and services
by being specialized in the production of certain goods, where they had a talent or
they had gradually developed a know-how advantage. Specialization brings about
economies of scale in production; that is, as people become specialized in
producing certain goods, the average variable cost of production 8 is declining.
Nevertheless, in primitive societies, money did not exist and people used to
exchange goods and services for other goods and services: this is the so-called
barter economy. Although with specialization people could produce more goods,
this additional quantity of goods made the need for money in a barter economy
stressed even more important. Indeed, in barter economies, every good had many
prices and thus producing more of certain goods would certainly create a greater
need to find other goods to be exchanged for this additional quantity. To illustrate
this, let us assume two cases: (a) that there are only three goods, and (b) that
there are only four goods in the economy. In Figure 4 the points A, B, C and D
represent goods, while the lines between them represent their prices. In the first
case, that we have only three goods, so there should be only three prices, i.e., PAB
= PBA, PBC = PCB, PCD = PDC. In the second case of four goods, there should be
six prices.9
A C A B
B D C
Figure 4: Barter Economy: Goods and Their Prices
8
That is total variable cost per unit of output, i.e., AVC = TVC/Q where AVC is the average variable cost,
TVC is the total variable cost and Q is the output level.
9
These six prices are PAB = PBA, PBC = PCB, PCD = PDC, PAD = PDA, PAC = PCA, PBD = PDB .
205
N × ( N − 1)
In general for N goods there are , so for 100 goods there should be
2
4,950 prices. Clearly, with so many prices around people should invest considerable
time in order to find out what these prices are and also to discover other people
that may want their products.10 The introduction of money into an economy has
facilitated the functioning of transactions and simplified life. Indeed, in a monetary
economy, the use of money has reduced the number of prices, as all goods are in
terms of money, i.e., 100 goods result in only 100 prices. The lower number of
prices has, in turn, reduced the search time needed by traders and has eliminated
the need for double coincidence of wants.
We should at this point define what money is. A general definition could be that
money is anything accepted by most traders as a means of payment for goods and
services. More formally, however, money is anything that can have the following
functions:
ñ Medium of exchange
ñ Unit of account
ñ Store of value
Money as a medium of exchange has to be acceptable by most traders. Also,
money is the unit of account, as prices of all other goods are expressed in terms of
it. Finally, as a store of value, money facilitates the transfer of resources from the
present into the future. What can serve as money? The answer is that money can be
any durable good of standardized quality and acceptable by most traders. Initially,
money was some durable good (commodity money) or a precious metal, i.e., gold or
silver. However, commodity money had the problems of purity or indivisibility11
and this created the need for fiat money, i.e., money issued by a central monetary
authority such as a central bank: in the US the Fed (Federal Reserve Bank) issues
dollar notes, in the EU the ECB (European Central Bank) issues euro notes and in
the UK the Bank of England issues sterling notes. Modern societies use not only
fiat money in daily transactions, but also checks, and the Electronic Funds Transfer
System (EFTS). Checks are not money; they are promises to pay money on demand
and are drawn on money deposited with a financial institution, while EFTS allows
payments to be made by using electronic telecommunication, e.g., debit cards,
where funds are deducted from the checking account of the owner in order to pay
for his/her purchases. The evolution over time of the payments system is illustrated
in Figure 5.
10
That is the case of double coincidence of wants, e.g., a boat maker that wants to have wine should find a
wine maker that should also want to exchange his wine for a boat.
11
Another problem with commodity money was that some goods were too heavy to be carried into the
market place.
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CHAPTER 12
Commodity Fiat Checks EFTS ... ... ...

Money Money
Figure 5: The Evolution of the Payments System
At this point we have to distinguish between wealth and money. Wealth is

anything that has a market value and can be exchanged for money, goods or assets.
Wealth includes money (domestic or foreign currency), bonds, shares or property
(land, houses, cars). Also, money is not equivalent to income as money is a stock,
i.e., a certain amount at any given point in time, while income is a flow of earnings in
a time period, e.g., 30,000 euro in a year/month/week.
The supply of money in an economy is controlled by its central bank that can
exercise monetary policy by controlling the monetary base or M1, both defined
below as:
M0 Cash in circulation (notes and coins outside banks) + cash reserves of the
commercial banks.
M1 Cash in circulation (notes + coins outside banks)
+ private sector sight deposits
The value of money depends on the demand and supply in the money market.
Money that does not maintain its value becomes less valued in domestic and
international transactions relative to other currencies.
12.2.2 Money market

We now turn our analysis to the money market and the determination of the
domestic price level. Let us first assume that the domestic price level P is the
average price of all goods and services produced in an economy in terms of the
home currency, i.e., P = È/good. The reverse of the price level, 1/P = good/È,
shows the purchasing power of money, i.e., the quantity of goods that a euro can
buy. An increase in the domestic price level makes goods more expensive, reducing
the purchasing power of money as fewer goods can be bought with a euro. Money is
not only the unit of account and medium of exchange in all transactions, but also, it
is used as a store of value. An increase in the domestic price level, P, by reducing
the purchasing power of the domestic currency, 1/P, will induce people to hold less
domestic money and more of other assets such as shares, bonds, gold, real estate
and foreign currency. Thus, the demand for money is downward sloping in Figure
6. Money supply is determined exogenously by the central monetary authorities of
the home country and thus is independent of the price level.
207
1/P
S Sã
(1/P)eq
(1/P)ãeq
D
M Mã _Trillion
Figure 6: The Home Money Market
The intersection of money demand with money supply M1 determines the home
price level. If, for example, M1 = È2 trillion and P = 1.17 in 2004 and the base year is
the year 2000 (P2000 = 1), the price level of 1.17 shows that prices were 17% higher
compared to the price level in the year 2000 and correspond to the purchasing power
of the euro, (1/P = 1/1.17) = 0.854. Assume next that money supply increases to M1
= È2.2 trillion, indicated in Figure 6 by the shift of the money supply to the right,
which reduces the real value of money, 1/P, to 1/1.22 = 0.819 and increases the
domestic price level, P, to 1.22 (i.e., a 22% increase compared to the price level in the
year 2000).
The money market illustrates the quantity theory of money or the equation of
exchange (Fisher 1911)
(MV) ≡ (PQ)
where M is the quantity of money; V is the velocity of money, i.e., the average
number of times that a euro is spent each year on a purchase of goods and services;
P is the average domestic price level; and Q is real output or GDP. Thus, MV is the
value of all transactions taking place in an economy during a year and PQ is the
value of domestic output. The equation of exchange is a tautology and thus it is
stated as an identity. However, assuming that velocity, V, is determined by
institutional factors and is reasonably constant in the short run, the real output, Q,
is also assumed constant in its long-run value. Hence Q/V is constant and we get:
 Q
M = P  .
V 
Therefore, if M increases by 10%, with Q/V being constant, P should also increase
by 10%. The quantity theory equation says that economies using expansionary
monetary policy often12 will experience more inflation than economies with a more
stable monetary policy.
12
That is, economies that often make increases in the money supply.
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CHAPTER 12
Changes in the demand for money may also affect the domestic price level.
Consider for example the case of foreigners who wish to increase their assets in
euros due, say, to their expectation of a euro appreciation. In this case, the demand
for euros will increase, pushing up the real value, 1/P, and reducing the price level,
P, while at the same time the euro is appreciating in the forex market as illustrated
in Figure 7.
1/P
S
(1/P)ã
(1/P)eq
Dã
D
M _ Trillion
Figure 7: Increases in the Money Demand and the Value of the Euro
Thus, expectations of future euro appreciation increase the real value of the euro,
pushing down the domestic price level and appreciating the euro in the forex market.
12.2.3 Purchasing power parity

Goods and services produced in one country can be either tradable or non-tradable
internationally. Technological advances in communications and transportation have
helped to make most goods tradable across countries. Due to international trade,
prices of goods and services in one country are related to prices and services of
goods in other countries. The theory of purchasing power parity (PPP) is attributed
to Gustav Cassell’s writings in the 1920s. PPP is based on the law of one price, which
states that in the absence of significant transportation costs and other restrictions to
international trade, competition in goods markets will lead to an equalization of
good prices internationally, if the price of goods can be measured in the same
currency. Thus, the theory of PPP says that the exchange rate between two currencies
should change in order to reflect changes in the price level of the two countries and
ensure that the law of one price holds. The PPP appears in two forms: the absolute
and the relative form.
Absolute Form of PPP

The absolute version says that if one could take a basket of identical goods in
two countries and convert, by the exchange rate, the price of one basket of goods
209
into the currency of the other country, then the prices of the two baskets should be
equal. Formally,
P
e=
P*
where e is the exchange rate; P is the domestic price (the price of the domestic
basket of goods expressed in domestic currency) level; and P* is the price of the
foreign basket of goods expressed in foreign currency. According to the absolute
PPP, increases in money supply at home will result in increases in the domestic
price level P and the exchange rate will have to depreciate, i.e., the home currency
has less real value relative to the foreign currency.
Relative Form of PPP

The absolute form of the PPP is unlikely to hold because of the existence of
barriers to international trade, such as tariffs, quotas, imperfect information and
significant transportation costs. However, a weaker form of PPP, known as relative
PPP, may hold even in the presence of the above restrictions to international trade.
The relative form of PPP says that the exchange rate should change by the inflation
differential between the two economies. That is,
% ¢e = % ¢P% - ¢P*
where % ¢e is the percentage change of the exchange rate; % ¢P is the domestic
inflation rate; and % ¢P* is the foreign inflation rate.
According to the relative PPP, if the home inflation rate is 6% and the foreign
inflation rate is 3%, then domestic currency should depreciate by 3%. Empirical
evidence shows that the relative form of PPP holds for the long run.
In sum, Section 12.2 explains the role of international money, the evolution of
the payments system and the determination of the price level in the money market.
The role of money supply on the price level and on the exchange rate is further
analyzed through the use of the quantity theory of money and purchasing power
parity.
State algebraically and show diagrammatically the long-run relationship between money
supplies in two countries and the exchange rate of their currencies. Provide an economic
explanation of this relation.
210
CHAPTER 12
In Chapter 12 we analyzed international financial markets. We presented the
credit market and explained the determination of interest rate, both domestically
and internationally. We also examined the case of the forward forex market that
economic agents may enter in order to avoid spot exchange rate fluctuations. The
relation between domestic and foreign interest rates with spot and forward
exchange rates was presented with the covered interest arbitrage. Moreover, we
explained the role of international money, the evolution of the payments system
and the determination of the price level in the money market. Monetary policy in
a country may affect its domestic price level and thus the exchange rate, as we
explained using the quantity theory of money and purchasing power parity.
211
APPENDIX
Activity 1
A. Mobilizing savings, facilitating-encouraging investment, transforming maturities,

transforming risk, reducing information cost. Financial markets could also be analyzed:
equity, bond, money, commodity, physical assets (real estates), forex market, derivative
markets.
B. The supply and demand for loanable funds framework provides a theory of how interest
rates are determined. It predicts that interest rates will change when there is a change in
the demand due to changes in income (or wealth), expected returns, risk and liquidity,
and also when there is a change in the supply of loanable funds due to changes in the
attractiveness of investment opportunities, the real cost of borrowing, or government
activities.
C. Multiple choice questions

1. a
2. b
3. c
Activity 2
P
According to the absolute version of PPP, we have e= . Also the quantity theory of
P*
 Q V 
money states that M = P   , or rewriting it we get P = M  , and similarly we obtain
V   Q
*
*V 
for the foreign country price level P = M   . Thus substituting the two price levels in
*
 Q
the PPP, we get the long-run exchange rate:
V 
M 
P  Q
e= == *
P* *V 
M  
 Q
which says that the long-run exchange rate depends on the relative money supply. This
relation is illustrated in Figure 8.
212
CHAPTER 12
e=P/P*
B
A
M/M*
Figure 8: Long-Run Exchange Rate and Money Supplies
An increase in money supply in the home country relative to the foreign country (that is, a
move from point A to point B), by increasing the domestic price level more than the foreign
price level, will depreciate the long-run exchange rate. On the other hand, economies with a
relatively tight monetary policy will experience low inflation and thus an appreciation of their
currency relative to more inflationary economies (that is, a move from point B to point A).
213
BIBLIOGRAPHY
Fisher I., The Purchasing Power of Money, Macmillan, New York 1911.
Thompson T., International Economics: Global Markets and International Competition,
RECOMMENDED READING
Paul, MN 1995, pp. 240-269.
McAllese D., Economics for Business, Prentice Hall, Essex 2001, pp. 319-349.
214
George M. Agiomirgianakis is currently Associate Professor at the Business School of the
Hellenic Open University and holds a Senior Research Fellowship at City University of
London. He is also the Secretary General of the European Economics and Finance
Society (EEFS). He has 20 years teaching experience in higher education, both in Greece
and in Britain. From 1997 to 2001 he taught at City University of London. His research
interests lie in the areas of International Economics, Macroeconomic Policy Games,
Labour Economics, Human Capital, Economic Growth, SMEs and Foreign Direct
Investment. He has served as guest editor for the following journals: Policy Modelling,
Applied Economics, International Journal of Economic Research, International
Journal of Financial Management Services, International Review of Economics and
Finance, International Journal of Finance and Economics and the Journal of
Economic Integration. He has published three books: a) The Macroeconomics of Open
Economies under Labour Mobility (1999), Ashgate Publishing UK, b) European
Integration (forthcoming 2005), with A. Zervoyianni and G. Argyros, Macmillan
(Palgrave),UK, and c) Aspects of Globalisation: Macroeconomic and Capital Market
Linkages in the Integrated World Economy (December 2003), with C. Tsoukis and T.
Biswas, Kluwer, USA.
Nicholas Apergis is currently Professor at the Department of International & European

Economic & Political Studies, University of Macedonia. He has taught at educational
institutions including Fordham University, Manhattan College and at the University of
Ioannina. He is also currently teaching at the Hellenic Open University and acting as
coordinator in the area of Money and Capital Markets. He is the Editor of the International
Journal of Economic Research and a Member of the Editorial Board of International
Advances of Economic Research issued by the Atlantic Economic Association. He has
acted as a referee for many journals, such as the Journal of Policy Modeling, European
Economic Review, Journal of Macroeconomics, Applied Economics, Atlantic Economic
Journal, International Advances of Economic Research, International Economic Review,
and International Economic Journal. He is currently serving as Chairman of the
Department of International & European Economic & Political Studies, University of
Macedonia. Finally, he is a member of the board of the Hellenic Stock Exchanges, S.A. He
studied Economics at the University of Athens and obtained a Master’s degree in
Economics at the Athens University of Economics and Business. His Ph.D. dissertation in
Macroeconomics was “The Role of Intervention Policies in the Foreign Exchange Market
in the Process of Business Cycles: The Case of the US” and it was presented at Fordham
University in New York.
Minas Vlassis is Assistant Professor at the Department of Economics of the University of

Ioannina, Teaching Fellow (SEP) in Module DEO34 (Economic Analysis and Policy)
of the Hellenic Open University, and Research Fellow of the Institute of Economic Policy
Studies (IMOP). Prior to his current post, he served over 20 years as a Scientific Associate,
and subsequently as a Lecturer, at the Department of Economics of the Athens University
of Economics and Business. His research interests are focused in the areas of Labour
Economics, Industrial Organization, the Economics of Trans-National Production, and
215
Political Economy. He has published a number of articles in international scientific
journals, such as Economic Theory, Labour Economics, Journal of Macroeconomics,
and Review of International Economics. He has served as a referee for a number of
journals as well; including the Journal of Public Economics, International Journal of
Industrial Organization, Bulletin of Economic Research, Manchester School,
Environmental and Resource Economics, and International Journal of Finance and
Economics.
216
ISBN 960-538-570-8

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Economics for Managers

G.M. AGIOMIRGIANAKIS VOLUME 1

International Economic Environment

PREPARATION OF THE TEACHING MATERIAL

International Economic Environment

Coordination of the development of the educational material

In accordance with Law 2121/1993,

Economics for Managers

George M. Agiomirgianakis and Minas Vlassis

ñ Domestic and international markets Key Words

200 300 400 T

200 300 400 T

1.1.3 Market clearing and market intervention

200 300 400 T

Figure 3: Market Clearing for Good T

1.1.4 Markets are international

Figure 4: International Trade of Good T

1.1.5 Imports: An excess demand

Figure 5: Greek Market for T and the Excess Demand Curve

1.1.6 Exports: An excess supply

-200 -100 0 200 T

Figure 6: Bulgarian Market for T and the Excess Supply Curve

-200 -100 0 150 200 T

Figure 7: Determining the International Equilibrium of Traded Good T

1.2.1 Balance of trade

1.2.2 The pattern of production and trade

Greece Bulgaria World Production

Greece Bulgaria World Production

That is, an hour of labor in Bulgaria can produce 12 units of X or 15 units of Y

Greece Bulgaria OCGreece OCBulgaria

Thus production of one unit of X requires 60 hours of labor and production of

Case 1 Case 2 Case 3

Case 1 Case 2 Case 3

ñ Production possibilities frontier Key Words

Chapter 2 further explains comparative advantage by introducing the concept of Introductory

The production possibility frontier shows the maximum production possibilities

An Improvement in the Technology of Producing X

L = 120 = ·LXX + ·LY Y = 4X + 6Y (3)

Figure 3: The Production Possibility Frontier and Economic Growth

The Foreign Production Possibility Frontier

MRTGreece = (5/6) = 0.833 < MRTBulgaria = (6/7) = 0.857

Figure 4: The Production Possibility Frontiers in Two Countries in a Pre-trade

In sum, in Section 2.1 we presented and analyzed the production possibilities

2.2 THE PATTERN OF PRODUCTION

2.2.1 Gains acquired via international trade

MRTGreece = 0.333 and

According to comparative advantage, countries will be specialized where they

Figure 6: Specialization and the Triangle of Trade

bundle at point K in terms of good Y, i.e. 75 Y + (0.333 x 75 Y) = 100 Y, that is

2.3.1 Labor productivity and international trade

PX = ACX = ·LXW = 4W. (5)

PY = ACY = ·*LYW* e = 6 (W* e) (6)

tt = (PX /PY) = (Y/X). (7)

Substituting (5) and (6) into (7) we get

tt = (PX /PY) = (Y/X) = (·LX/·*LY) (W/eW*) = (2/3) (W/eW*). (8)

W = (PX /PY) (·*LY /·LX) (W* e). (9)

Equation (9) says that domestic wages depend on three factors:

2.3.2 Exchange rate and international trade

e > (·LX /·*LX) (W/W*). (10)

Similarly, for good Y to be exported from Bulgaria into Greece, it has to be

e < (·LY /·*LY) (W/W*). (11)

(·LX /·*LX) (W/W*) < e < (·LY /·*LY) (W/W*). (12)

The PPF in the numerical example in Figure 1 is given by

PY = ACY = ·LYW e = 6 (W* e) (6)

tt = (PX /PY) = (Y/X) = (·LX/·LY) (W/eW) = (2/3) (W/eW*). (8)

W = (PX /PY) (·LY /·LX) (W e). (9)

e > (·LX /·LX) (W/W). (10)

e < (·LY /·LY) (W/W). (11)

(·LX /·LX) (W/W) < e < (·LY /·LY) (W/W). (12)

If ·LX = 5 ; ·LY = 6 and ·LX = 6; ·LY = 7, then using (12) we have