Name : Vinca Grace S

NIM : 2001101010060

SUMMARY OF INTERNATIONAL ECONOMIC

CHAPTER 1 :Labor Productivity and Comparative Advantage : The Ricardian Model

The Ricardian model shows the possibility that an industry in a developed country could compete against
an industry in a less-developed country (LDC) even though the LDC industry pays its workers much
lower wages.

The modern version of the Ricardian model assumes that there are two countries producing two goods
using one factor of production, usually labor. The model is a general equilibrium model in which all
markets (i.e., goods and factors) are perfectly competitive. The goods produced are assumed to be
homogeneous across countries and firms within an industry. Goods can be costlessly shipped between
countries (i.e., there are no transportation costs). Labor is homogeneous within a country but may have
different productivities across countries. This implies that the production technology is assumed to differ
across countries. Labor is costlessly mobile across industries within a country but is immobile across
countries. Full employment of labor is also assumed. Consumers (the laborers) are assumed to maximize
utility subject to an income constraint.

Below you will find a more complete description of each assumption along with a mathematical
formulation of the model.

Perfect Competition

Perfect competition in all markets means that the following conditions are assumed to hold.

1. Many firms produce output in each industry such that each firm is too small for its output
decisions to affect the market price. This implies that when choosing output to maximize profit,
each firm takes the price as given or exogenous.
2. Firms choose output to maximize profit. The rule used by perfectly competitive firms is to choose
the output level that equalizes the price (P) with the marginal cost (MC). That is, set P = MC.
3. Output is homogeneous across all firms. This means that goods are identical in all their
characteristics such that a consumer would find products from different firms indistinguishable.
We could also say that goods from different firms are perfect substitutes for all consumers.
4. There is free entry and exit of firms in response to profits. Positive profit sends a signal to the rest
of the economy and new firms enter the industry. Negative profit (losses) leads existing firms to
exit, one by one, out of the industry. As a result, in the long run economic profit is driven to zero
in the industry.
5. Information is perfect. For example, all firms have the necessary information to maximize profit
and to identify the positive profit and negative profit industries.
Two Countries

The case of two countries is used to simplify the model analysis. Let one country be the United States and
the other France. Note that anything related exclusively to France in the model will be marked with an
asterisk. The two countries are assumed to differ only with respect to the production technology.

Two Goods

Two goods are produced by both countries. We assume a barter economy. This means that no money is
used to make transactions. Instead, for trade to occur, goods must be traded for other goods. Thus we need
at least two goods in the model. Let the two produced goods be wine and cheese.

One Factor of Production

Labor is the one factor of production used to produce each of the goods. The factor is homogeneous and
can freely move between industries.

Utility Maximization and Demand

In David Ricardo’s original presentation of the model, he focused exclusively on the supply side. Only
later did John Stuart Mill introduce demand into the model. Since much can be learned with Ricardo’s
incomplete model, we proceed initially without formally specifying demand or utility functions. Later in
the chapter we will use the aggregate utility specification to depict an equilibrium in the model.

When needed, we will assume that aggregate utility can be represented by a function of the form U =
CCCW, where CC and CW are the aggregate quantities of cheese and wine consumed in the country,
respectively. This function is chosen because it has properties that make it easy to depict an equilibrium.
The most important feature is that the function is homothetic, which implies that the country consumes
wine and cheese in the same fixed proportion at given prices regardless of income. If two countries share
the same homothetic preferences, then when the countries share the same prices, as they will in free trade,
they will also consume wine and cheese in the same proportion.

General Equilibrium

The Ricardian model is a general equilibrium model. This means that it describes a complete circular flow
of money in exchange for goods and services. Thus the sale of goods and services generates revenue to
the firms that in turn is used to pay for the factor services (wages to workers in this case) used in
production. The factor income (wages) is used, in turn, to buy the goods and services produced by the
firms. This generates revenue to the firms and the cycle repeats again. A “general equilibrium” arises
when prices of goods, services, and factors are such as to equalize supply and demand in all
markets simultaneously.
CHAPTER 2 : Spesific Factors and Income Distribution

The specific factor (SF) model was originally discussed by Jacob Viner, and it is a variant of the
Ricardian model. Hence the model is sometimes referred to as the Ricardo-Viner model. The model was
later developed and formalized mathematically by Ronald Jones (1971)See R. W. Jones, “A Three-Factor
Model in Theory, Trade and History,” in Trade, Balance of Payments and Growth, ed. J. N. Bhagwati, R.
W. Jones, R. A. Mundell, and J. Vanek (Amsterdam: North-Holland Publishing Co., 1971). and Michael
Mussa (1974)Michael Mussa, “Tariffs and the Distribution of Income: The Importance of Factor
Specificity, Substitutability, and Intensity in the Short and Long-Run,” Journal of Political Economy, 82,
no. 6 (1974): 1191–1203.. Jones referred to it as the two-good, three-factor model. Mussa developed a
simple graphical depiction of the equilibrium that can be used to portray some of the model’s results. It is
this view that is presented in most textbooks.

The model’s name refers to its distinguishing feature—that one factor of production is assumed to be
“specific” to a particular industry. A specific factor is one that is stuck in an industry or is immobile
between industries in response to changes in market conditions. A factor may be immobile between
industries for a number of reasons. Some factors may be specifically designed (in the case of capital) or
specifically trained (in the case of labor) for use in a particular production process. In these cases, it may
be impossible, or at least difficult or costly, to move these factors across industries.

The SF model is designed to demonstrate the effects of trade in an economy in which one factor of
production is specific to an industry. The most interesting results pertain to the changes in the distribution
of income that would arise as a country moves to free trade.

Specific Factor Model Results

The SF model is used to demonstrate the effects of economic changes on labor allocation, output levels,
and factor returns. Many types of economic changes can be considered, including a movement to free
trade, the implementation of a tariff or quota, growth of the labor or capital endowment, or technological
changes. This section will focus on effects that result from a change in prices. In an international trade
context, prices might change when a country liberalizes trade or when it puts into place additional barriers
to trade.

When the model is placed into an international trade context, differences of some sort between countries
are needed to induce trade. The standard approach is to assume that countries differ in the amounts of the
specific factors used in each industry relative to the total amount of labor. This would be sufficient to
cause the PPFs in the two countries to differ and could potentially generate trade. Under this assumption,
the SF model is a simple variant of the H-O model. However, the results of the model are not sensitive to
this assumption. Trade may arise due to differences in endowments, differences in technology, differences
in demands, or some combination. The results derive as long as there is a price change, for whatever
reason.

So suppose, in a two-good SF model, that the price of one good rises. If the price change is the result of
trade liberalization, then the industry whose price rises is in the export sector. The price increase would
set off the following series of adjustments. First, higher export prices would initially raise profits in the
export sector since wages and rents may take time to adjust. The value of the marginal product in exports
would rise above the current wage, and that would induce the firms to hire more workers and expand
output. However, to induce the movement of labor, the export firms would have to raise the wage that
they pay. Since all labor is alike (the model assumes labor is homogeneous), the import-competing sector
would have to raise its wages in step so as not to lose all of its workers. The higher wages would induce
the expansion of output in the export sector (the sector whose price rises) and a reduction in output in the
import-competing sector. The adjustment would continue until the wage rises to a level that equalizes the
value of the marginal product in both industries.

The return to capital in response to the price change would vary across industries. In the import-
competing industry, lower revenues and higher wages would combine to reduce the return to capital in
that sector. However, in the export sector, greater output and higher prices would combine to raise the
return to capital in that sector.

The real effects of the price change on wages and rents are somewhat more difficult to explain but are
decidedly more important. Remember that absolute increases in the wage, or the rental rate on capital,
does not guarantee that the recipient of that income is better off, since the price of one of the goods is also
rising. Thus the more relevant variables to consider are the real returns to capital (real rents) in each
industry and the real return to labor (real wages).

Ronald Jones (1971) derived a magnification effect for prices in the SF model that demonstrated the
effects on the real returns to capital and labor in response to changes in output prices. In the case of an
increase in the price of an export good and a decrease in the price of an import good, as when a country
moves to free trade, the magnification effect predicts the following impacts:

1. The real return to capital in the export industry will rise with respect to purchases of both exports
and imports.
2. The real return to capital in the import-competing industry will fall with respect to purchases of
both exports and imports.
3. The real wage to workers in both industries will rise with respect to purchases of the import good
and will fall with respect to purchases of the export good.

CHAPTER 3 : Resources and Trade : The Heckscher-Ohlin Model

The Heckscher-Ohlin (H-O; aka the factor proportions) model is one of the most important models of
international trade. It expands upon the Ricardian model largely by introducing a second factor of
production. In its two-by-two-by-two variant, meaning two goods, two factors, and two countries, it
represents one of the simplest general equilibrium models that allows for interactions across factor
markets, goods markets, and national markets simultaneously.

These interactions across markets are one of the important economics lessons displayed in the results of
this model. With the H-O model, we learn how changes in supply or demand in one market can feed their
way through the factor markets and, with trade, the national markets and influence both goods and factor
markets at home and abroad. In other words, all markets are everywhere interconnected.

he Main Results of the H-O Model

There are four main theorems in the H-O model: the Heckscher-Ohlin (H-O) theorem, the Stolper-
Samuelson theorem, the Rybczynski theorem, and the factor-price equalization theorem. The Stolper-
Samuelson and Rybczynski theorems describe relationships between variables in the model, while the H-
O and factor-price equalization theorems present some of the key results of the model. The application of
these theorems also allows us to derive some other important implications of the model. Let us begin with
the H-O theorem.

The Heckscher-Ohlin Theorem

The H-O theorem predicts the pattern of trade between countries based on the characteristics of the
countries. The H-O theorem says that a capital-abundant country will export the capital-intensive good,
while the labor-abundant country will export the labor-intensive good.

Here’s why. A country that is capital abundant is one that is well endowed with capital relative to the
other country. This gives the country a propensity for producing the good that uses relatively more capital
in the production process—that is, the capital-intensive good. As a result, if these two countries were not
trading initially—that is, they were in autarky—the price of the capital-intensive good in the capital-
abundant country would be bid down (due to its extra supply) relative to the price of the good in the other
country. Similarly, in the country that is labor abundant, the price of the labor-intensive good would be
bid down relative to the price of that good in the capital-abundant country.

Once trade is allowed, profit-seeking firms will move their products to the markets that temporarily have
the higher price. Thus the capital-abundant country will export the capital-intensive good since the price
will be temporarily higher in the other country. Likewise, the labor-abundant country will export the
labor-intensive good. Trade flows will rise until the prices of both goods are equalized in the two markets.

The H-O theorem demonstrates that differences in resource endowments as defined by national
abundancies are one reason that international trade may occur.

CHAPTER 4 : The Standard Model

1. The standard trade model derives a world relative supply curve from production possibilities and a
world relative demand curve from preferences. The price of exports relative to imports, a country’s terms
of trade, is determined by the intersection of the world relative supply and demand curves. Other things
equal, a rise in a country’s terms of trade increases its welfare. Conversely, a decline in a country’s terms
of trade will leave the country worse off.

2. Economic growth means an outward shift in a country’s production possibility frontier. Such growth is
usually biased; that is, the production possibility frontier shifts out more in the direction of some goods
than in the direction of others. The immediate effect of biased growth is to lead, other things equal, to an
increase in the world relative supply of the goods toward which the growth is biased. This shift in the
world relative supply curve in turn leads to a change in the growing country’s terms of trade, which can
go in either direction. If the growing country’s terms of trade improve, this improvement reinforces the
initial growth at home but hurts the growth in the rest of the world. If the growing country’s terms of
trade worsen, this decline offsets some of the favorable effects of growth at home but benefits the rest of
the world.
3. The direction of the terms of trade effects depends on the nature of the growth. Growth that is export-
biased (growth that expands the ability of an economy to produce the goods it was initially exporting
more than it expands the economy’s ability to produce goods that compete with imports) worsens the
terms of trade. Conversely, growth that is import-biased, disproportionately increasing the ability to
produce import-competing goods, improves a country’s terms of trade. It is possible for import-biased
growth abroad to hurt a country.

4. Import tariffs and export subsidies affect both relative supply and relative demand. A tariff raises
relative supply of a country’s import good while lowering relative demand. A tariff unambiguously
improves the country’s terms of trade at the rest of the world’s expense. An export subsidy has the reverse
effect, increasing the relative supply and reducing the relative demand for the country’s export good, and
thus worsening the terms of trade.

CHAPTER 5 : External Economies of Scale and The International Location of Production

External economies of scale occur outside of an individual company but within the same industry.
Remember that in economics, economies of scale mean that the more units a business produces, the less it
costs to produce each unit.

External economies of scale describe similar conditions, only for an entire industry instead of a company.
For example, if a city creates a better transportation network to service a particular industry, then all
companies in that industry will benefit from the new transportation network, and experience decreased
production costs.

• External economies of scale are business-enhancing factors that occur outside a company but
within the same industry.
• In addition to lower production and operating costs, external economies of scale may also
reduce a company's variable costs per unit because of operational efficiencies and synergies.
• On the downside, external economies of scale could dull the competitive edge of a company, as
it cannot exclude competitors from benefiting also.

The Basics of External Economies of Scale

Businesses in the same industry tend to cluster in together. For example, a film studio might determine
that California is a particularly good location for year-round film-making, so it moves to Hollywood. New
movie producers also move to Hollywood because there are more camera operators, actors, costume
designers, and screenwriters in the area. Then, more studios might decide to move to Hollywood to take
advantage of the specialized labor and infrastructure already in place, thanks to the success of the first
firm.

As more and more firms succeed in the same area, new industry entrants can take advantage of even more
localized benefits. It makes sense for industries to concentrate in areas where they are already strong.
CHAPTER 6 : Firms in the Global Economy : Export Decisions, Outsourcing, and Multinational
Enterprises

• Internal economies of scale imply that a firm’s average cost of production decreases the more
output it produces
• Imperfect competition
o Firms produce goods that are depreciated from one another
o Performance measures across vary widely across firms
• Perfectly competitive market is where there are many seller and buyers but none of them
represents a large part of the market so they are price takers
• In imperfect competition firms are aware that they can influence prices of their products and
they can sell more only by reducing their piece… price setters
• When there are only a few major producers of a particular good
o Each firm produces a differentiated good
• Monopoly = imperfect competition no competition

MONOPOLY

• Has negative sloping demand curve – indicating that firm can sell more units of output only if the
price of output falls
• Marginal revenue (MR) = demand curve = gain from selling an additional good
• In monopoly to sell one more unit firm must lower price MC is below demand curve
• Output should be chosen at MR=MC
• We know MR is less than Price but by how much?
o Depends on how much output the firm is already selling
o Depends on slope of demand curve
• if curve = flat then firm can sell additional unit at a small price cut MR will be close to the price
per unit
• Formula MR = P-Q/B
o Equation says gap between price and MR depends on initial sales Q and the slope B of the
demand curve
o If Q = higher MR is lower
o The higher the B the more sales fall for any given increase in price and the closer then MR is to
the price of good
• Average Cost = AC = total cost divided by its output
o ATC = F/Q + C
• This average cost = greater than MC and declines with output produced Q meaning ATC declines
as output rises
o Downward slope represents that there are economies of scale
• The larger the firm’s output the lower its cost per unit
• Marginal cost = MC = we assume its flat
o Economies of scale must then come from fixed cost (unrelated to production)
o This fixed cost pushes the AC above the constant MC
 o The gap between them is constantly decreasing as the fixed cost is spread over an increasing
number of output units

Monopolistic Competitions

• Differentiated products allows firms to remain price setter for their own individual product
• Demand curve shifts when there is more demand
• Once competition reaches a certain level, additional entry would no longer be profitable long run
equilibrium is achieved

Assumptions of the Monopolistic Market Model

• Q = S X (1/n – b X (P – P*))
• we must look for n and P*
o derive relationship between number of firms and the AC
• this relationship is upward sloping bcuz more firms = lower output of each firms = higher firm’s
cost per unit of output
o relationship between number of firms and the price each firm charges which must equal P* in
equilibrium
• this relationship is downward sloping bcuz more firms = more competition = lower price they can
charge
• price > AC = entry
• price < AC = exit
• in the long run entry and exit processes drives profits SO P* should = AC
• Since firms charge one price we know that P = P*
• AC = F/Q + C where Q = S/n
• More firms in the industry = higher average cost

CC curve is the relationship between n and A

• P = C + Q/ (S X B) P = C + 1/ (b X n)
• The more firms the lower price each firm will charge
o Known as the downward sloping PP Curve

Monopolistic Competition and Trade

• Large markets = more sales per firm… CC curve with the larger market = below smaller market
curve
o Increase in S = CC curve flatter so shift to the left
o Decrease in S = CC curve steeper = shift right but not more than Autarky
• But PP curve does not shift since the size of market doesn’t effect
• Integration results in everyone being better off – integration means international trade
• product differentiation and internal economies of scale lead to trade between similar countries
with no comparative advantage differences between them
• intra-industry trade = two way exchanges of similar goods where a country both imports and
exports some products
• two channels of welfare benefits from trade
• we observe gains from trade in the form of greater product variety and consolidated
production at lower average cost
CHAPTER 7 : The Instruments of Trade Policy

Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints,
local content requirements, administrative policies and antidumping duties.

A tariff is a tax levied on imports or exports. They are divided in two categories:

1. Specific tariffs: are levied as a fixed charge for each unit of a good imported.

2. Ad valorem tariffs: are levied as a proportion of the value of the imported good

In most cases, tariffs are placed on imports to protect domestic producers; tariffs increases government
revenues.

A subsidy is a government payment to a domestic producer. They take many forms like, cash grants, low-
interest loans, tax breaks and government equity participation in domestic firms. Subsidies help domestic
producers in two ways: (1) competing against foreign imports and (2) gaining export markets.

An import quota is a direct restriction on the quantity of some good that maybe imported into a country.
The restriction is usually enforced by issuing import licenses to a group of individuals or firms

A voluntary export restraint is a quota on trade imposed by the exporting country, typically at the request
of the importing country’s government.

A local content requirement is a requirement that some specific fraction of a good needs to be produced
domestically.

Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a
country.

Antidumping duties. Dumping is a variously defined as selling goods in a foreign market at below their
costs of producing; dumping is viewed as a method by which firms unload excess production in foreign
markets. Antidumping policies are designed to punish foreign firms that engage in dumping. Their
objective is to protect domestic producers from unfair foreign competition.
CHAPTER 8 : The Political Economy of Trade Policy

Producers and consumers allocate resources most efficiently when governments do not distort
market prices through trade policy
-> National welfare of a small country is highest with free trade
-> with restricted trade, consumers pay higher prices & consume too little while firms produce
too much

Counter argument:
- However, because tariffs are already low for most countries
-> estimated benefit of moving to free trade are only a small fraction of National Income for
most countries
-> for the world as a whole protection costs <1% of GDP
-> gains from free trade are somewhat smaller for advanced economies & somewhat larger for
poorer developing countries
Cases against Free Trade - Terms of trade
- For a large country, a tariff lowers the price of imports in world markets & generates terms of
trade gain
-> may exceed the losses caused by distortions in production and consumption
- small tariff will lead to increase in national welfare for a large country
-> but at some tariff rate, national welfare will begin to decrease as economic efficiency loss
exceeds terms of trade gain
- A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t0 may
exist that maximizes national welfare: an optimum tariff
- An export tax (a negative export subsidy) that completely prohibits exports leaves a country
worse off, but export tax rate may exist that maximizes national welfare through terms of trade
-> export subsidy lowers ToT for a large country (lowers price of exports for foreigners)
-> export tax raises terms of trade (raises price of exports)

Cases against free trade - Domestic market failures

- domestic market failures may exist that cause free trade to be suboptimal policy
-> consumer & producer surplus calculations assume that markets function well
-> types of market failures include:
=> persistently high under-employment of workers (because wages do not adjust)
=> persistently high underutilisation of structures, equipment and other forms of capital (because
capital prices do not adjust)
=> property rights not well defined/enforced
=> technological benefits for society discovered through private production, but from which
private firms cannot fully profit
=> environmental costs for society caused by private production but for which private firms do
not fully pay
=> sellers that are not well-informed about opportunity cost of production or buyers who are not
well-informed about value from consumption
- Economists calculate the marginal social benefit to represent additional benefit to society
from private production
-> with market failure, marginal social benefit not accurately measured by producer surplus of
private firms
-> possibly when tariff increases domestic production, benefits to domestic society will increase
due to market failure
- domestic market failure argument is example of theory of the second best: Free market policy
only desirable, if all other markets working properly
-> if not, government intervention that distorts market incentives in one market may increase
national welfare by offsetting consequences of market failure elsewhere
-> if the best policy (fixing the market failure) not feasible, then government intervention in
another market may be the "second-best" way of fixing the problem

A Model of Trade Policy

Funds to run campaigns may especially come from groups who do not have collective action
problem and are willing to advocate special interest policy
-> trade-off between reduction in welfare of constituents as a whole & increase in campaign
contributions from special interests
International Negotiations of Trade Policy
- General Agreements of Tariffs and Trade (1947)
-> replaced by World Trade Organisation (1995)
- multilateral (mehrere Staaten betreffend) negotiations mobilize exports to support free trade if
they believe exports market will expand
-> also help avoid trade war between countries, where each country enacts trade restrictions
(trade war could result if each country has incentive to adopt protection, regardless of what other
countries do
-> all countries could enact trade restrictions, even if it's in the interest of all countries to have
free trade)
What is the WTO and what is its trade agenda?
Formal organisation for implementing multilateral trade negotiations (and policing them)
It address trade restrictions in at least 3 ways:
1) Reducing tariff rates through multilateral negotiations
2) Binding tariff rates: having the imposing country agree not to raise tariffs in the future
3) Eliminating nontariff barriers: quotas and export subsidies changed to tariffs, because costs
of tariff protection are more apparent & easier to negotiate
- Free trade area: free trade among members, but each member can have own trade policy
towards non-member countries (example NAFTA).
- Customs union: free trade among members, requires common external trade policy towards
non-member countries (example EU).
How do protected markets interfer with free trade in case of economies of scale? (external and
internal)
They limit gains from external economies by inhibiting the concentration of industries: by not
increasing much market size (S), they do not allow for the industry to expand and lower AC for
each firm remaining (and therefore price), leading to missed profits.
In the case of internal scales, they fragment the production internationally by reducing
competition and raising profits, leading to too many firms entering the protected markets.
With so many firms entering the narrow domestic market, output per firm decreases, becoming
inefficient.