Eco 344



Lecture  Notes


The Trade Theory

The Neoclassical Model

Trade and Factor Prices (PPT)

Trade and Scale Economies

Tariffs and Quotas

Economic Integration

International economics as a field of study in economics; one may ask these questions:

What is so special about international economics?

What makes economic relations among nation states different from economic relations within a nation state?

Possible answers:
==Each country identifies itself by a geographical area over which it claims sovereignty.

==Each country has its own government and its own sets of rules and regulations. The political systems of most nation states are different.

==Activities or transactions leading to movements of people, factors of production (i.e., labor, capital and raw materials), manufactured goods and services across a county's borders are often controlled and in some cases prohibited.
( Economic integrations in some regions of the world are partially removing the borders, e.g., EU)

==Most nation states have their own monies (currencies) and banking systems.

==Despite the basic commonalties among all human beings, people of different countries tend to have different cultures, speak different languages, and have different tastes and habits.

===>All of the above have restricting effects on economic
         interactions among nation states.
International Economic Relations
Unilateral transfers of goods and services and factors of production
Official transactions

==>In this course we concentrate on trade.

First let us have a quick look at the dynamics of the world trade .

Trade In the World

Leading exporters and importers in world merchandise trade (excluding intra-EU trade), 1998
(Billion dollars and percentage)
                                                             Annual                                                                        Annual
                                                             percentage                                                               percentage
Rank      Exporters     Value     Share     change          Rank      Importers     Value     Share     change

1    Extra-EU
      exports                813.2      20.1          0                1        United States  944.4     22.3           5
2    United States       682.5     16.8          -1                2        Extra-EU       800.7      18.9          5
3    Japan                   387.9      9.6          -8                3        Japan             280.5        6.6       -17
4    Canada                214.3      5.3            0               4        Canada          206.2        4.9          3
5    China                  183.8       4.5           1                5        Hong Kong,  186.8        4.4        -12
6    Hong Kong,        174.9       4.3           -7                    retained imports(a)36.5        0.9       -30
  domestic exports     24.6         0.6         -10               6       China              140.2        3.3        -2
      re-exports         150.3         3.7         -7                 7      Mexico            129.0        3.0        14
7    Korea, Rep. of   132.3        3.3         -3                 8      Taipei, Chinese104.2        2.5         -9
8    Mexico              117.5        2.9         6                  9      Singapore        101.6        2.4        -23
9    Singapore          109.9        2.7        -12                        retained imports(a)55.1      1.3       -31
      domestic exports 63.4        1.6        -12               10    Korea, Rep. of     93.3        2.2       -35
      re-exports           46.5        1.1        -12
10    Taipei, Chinese109.9       2.7         -9

World's Service Trade
 Growth in the value of world trade in commercial services by selected region, 1998
 (Billion dollars and percentage)
           Exports                                                       Imports

 Value      Annual percentage change                 Value              Annual percentage change

 1998    1990-98   199719981998  1990-9819971998

 1320         7           4         0           World        1305                6                  3          1
 270           8           8         2   North America*  201                 6                 10          6
 53             8           8         5    Latin America     69                  9                 17         4
 636          5           2          6  Western Europe 593                  5                  0           7
 564          5          1          6    European Union  547                6                  0           7
 27            5          1         -3     Africa                  38                4                  4          0
 255         9          5         -15     Asia                 320                8                  2        -11
 62           5          3          -9      Japan               111                3                 -5         -9
 24           20      19          -2     China                  29               28                34        -4
 117          8        3          -26  Six East Asian     112               6                 -16      -14

 *  Excluding Mexico throughout this report.
 Note:  It should be mentioned at the outset that there are numerous breaks in the continuity of the figures at the country and regional levels due to frequent revisions to the trade in services data. See the Technical Notes.

US and International Trade
Growth in US Exports and Imports (Selected Years)
% of GDP
% of GDP

In real terms, between 1960 and 1997, the US imports have increased by 1028 percent (11 folds). The US imports have increased at almost the rate.

US Financial Link to the Rest of the World

 International Capital Flow
Selected    US invest.   Foreign        US GDP    % of GDP    % of GDP
Years        Abroad      Invst. in US                   US Inv Ab    F Inv In US
1960          4,099         2,294           526,600     0.78             0.44
1970          9,337         6,359        1,035,600      0.90             0.61
1980        86,967       62,612        2,784,200      3.12             2.25
1990        74,011       74,160        5,743,800      1.29             1.29
1997       478,502     477,666        8,111,000     5.90             5.89

The United States and the World

From the production possibilities curve analysis we have learned that an economy's output cannot grow beyond its production possibilities unless there is a an increase in its economic resources or/and there is an improvement in its technology.

Trading with other countries allows a country's consumers to consume outside its production possibility area; that means the country can achieve a consumption level not achievable without trade.

Since the end of the Second World War the world's international trade has been growing steadily.

Better and less expensive transportation, lower trade barriers, the establishment of international institutions and organizations including trade organizations, reduced levels of international tension,  regional economic agreements, and international trade agreements have all contributed to the growth in the in international trade.

The U.S. and International Trade

The United States has the largest amount of international trade in the world. In recent years the U.S. has exported about 12 percent of its GDP annually.

Since 1980, the value of the U.S. annual imports has (consistently) been greater than the value of its annual exports resulting in balance of trade deficits.

The relative size of a country's international trade as well as the types of goods it exports and imports determine the degree of its economic dependence on other countries.

The U.S. exports 12 percent of its GDP; its exports primarily consist of manufactured products such as aircraft, machinery, cars, and chemicals as well as significant amounts of agricultural products.

The U.S. imports oil, some minerals, agricultural products, consumer (manufactured) goods such as garments, footwear and cars, and some intermediate manufactured products.

Japan exports about 10 percent of its GDP; it exports mostly manufactured finished and intermediate products including many consumer goods.

Japan imports, oil, agricultural products, raw materials, and some manufactured intermediate products.

The Netherlands exports over 55 percent of its GDP, mostly manufactured products.

WASHINGTON10 (Reuters) - Following are key events in China's bid to join the
  World Trade Organization, its negotiations with the United States and the battle in
  Congress over permanent normal trade relations:

  Nationalist China is one of the 23 founding members of the WTO's precursor, the
  General Agreement on Tariffs and Trade (GATT).

  China pulls out of GATT, one year after the 1949 communist takeover, denouncing it as
  a capitalist club.

  China applies to join GATT, seven years after Beijing dumped Marxist economics in
  favor of markets and sparked a dramatic export-based economic resurgence.

  China's bloody June 4 suppression of pro-democracy demonstrators in Beijing's
  Tiananmen Square, along with a reversal of its economic liberalization program, derails
  the negotiations.

  Beijing accelerates its drive to join GATT but sees its dream of being present at the
  WTO's Jan. 1 birth dashed by free-trade advocates on grounds that China's opaque and
  highly protectionist trade system makes it ineligible.

  Jan. 1 - WTO replaces GATT.
  November - China unveils its biggest trade liberalization package in 16 years aimed at
  winning U.S. backing to enter the WTO. Beijing says it plans to slash import tariffs by
  30 percent and allow joint venture companies be set up.

  October - China slashes import duties to 17 percent from 23 percent, but maintains
  so-called "peak tariffs" on other goods including as automobiles.

  February - China promises a detailed program of tariff cuts, but the United States and
  other nations insist China open its doors wider to foreign products and services.

  March 4 - U.S. Trade Representative Charlene Barshefsky holds talks with Chinese
  officials, and leaves saying "significant gaps" remain on farm trade and services.

  April 6 - China and the United States reach a breakthrough on agricultural issues that
  removes major obstacles to China's bid.

  April 8 - U.S. President Bill Clinton and Chinese Premier Zhu Rongji sign a joint
  statement in Washington welcoming substantial progress and committing them to
  completion of a WTO deal by the end of the year.

  May 7 - NATO bombs Chinese Embassy in Belgrade, prompting Beijing to freeze
  WTO negotiations.

  Nov. 8 - Clinton sends top trade negotiator and a key White House aide to China to try
  to hammer out an agreement.

  Nov. 15 - U.S., China announce WTO agreement.

  January - Clinton kicks off U.S. congressional battle for permanent normal trade
  relations (PNTR) with China, declaring it a top legislative priority.

  April 19 - House Minority Leader Dick Gephardt announces opposition to PNTR.

  May 3 - Clinton administration officials announce unprecedented trade monitoring plan
  to ensure Chinese compliance with pact and endorse setting up a watchdog commission
  to monitor human rights, hoping to boost support for PNTR in a bitterly divided House
  of Representatives.

  May 19 - After months of negotiations, European Union signs market-opening pact to
  allow China entry to the WTO.

  May 19 - U.S. lawmakers forge agreement on commission to monitor Beijing's human
  rights record, a key side deal clearing the way for House passage.

  May 24 - House approves trade bill by vote of 237-197, sending it to the Senate.

  June - PNTR gets bogged down in the Senate as Republicans and Democrats spar over
  spending priorities.

  July 15 - Clinton's point-man in the PNTR fight -- Commerce Secretary William Daley
  -- leaves post to become chairman of Al Gore's presidential campaign.

  July 27 - Senate agrees to proceed to PNTR; final debate set for September.

  Sept 5 - Senate opens debate on trade bill after months of delay.

  Sept 7 - PNTR clears key procedural hurdle, putting trade bill on track for expected
  final passage by Sept 15.
Balance of Trade Deficits

The difference between the value of a country's exports and its imports over a given period of time (normally a year) constitutes its balance of trade surplus or deficit.

How is a balance of trade financed?

A country can finance its balance of payment by borrowing, by selling its assets and/or by getting (unilateral) financial help from other countries.

 Specialization, Trade and Comparative Advantage

"It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy."  Adam Smith

The opportunity to trade what one has (or can produce) for what he/she does not have (or cannot produce easily) makes it rational for each person to specialize in the production in of what she can produce most efficiently (least costly.)

Specialization and trade among regions and countries are based upon the same principle as among individuals.

Absolute Advantage in Production

A nation (or country) has an absolute advantage in the production of a good if, compared to another good, it uses less resources to produce.

An Example: Assume the U.S. and Mexico each has 240 units of labor, and labor is the only input used in the production of corn and tomatoes.

                                 Resources used in      Quantity of output             Total
                                 the production of         produced over                 world's
                                 one unit a good           one production period      output

                                  Mexico     U.S.             Mexico    U.S.

Tomatoes:                 10 hrs       15 hrs           12             8                      20

Corn:                           8 hrs       4 hrs            15            30                      45

Now suppose each country specializes in the production of the good in which it has an absolute advantage.

                           Mexico       U.S.       Total
        Tomatoes    24                0              24
        Corn             0                60            60

Gains from trade: As a result of specialization and trade the world's output of tomatoes increases by 4 units and the output of corn by 15. These increases are referred to as gains from trade. The distribution of these gains between the two countries will be determined by the terms of trade negotiated between them. The terms of trade for each country would be the number of units of the imported good the country would receive for each unit of its export. For example, for the U.S. the terms of trade in this case would be the number of bushels of tomatoes it would receive for one bushel of its corn.

The U.S. would be happy to sell its corn at any price above .266 bushel of tomatoes. Mexico, on the other hand, would be glad to buy corn at any price below .8 bushel of tomatoes. That means the terms of trade would settle some where between these two prices; for example at .5 bushels of tomatoes per one bushel of corn.

Comparative Advantage

Now consider an alternative case:

                                Resources used in            Quantity of output              Total
                                the production of              produced over                   world's
                                one unit a good                 one production period       output

                               Mexico         U.S.            Mexico       U.S.

Rugs                        10 hrs           8 hrs                12             15                    27

Computers              40 hrs          10 hrs                3             12                     15

Now suppose each country specializes in the production
of the good in which it has a  comparative advantage.

                          Mexico   U.S.     Total
Rugs                    24          0          24
Computers           0          24          24

Gains from trade: -3 rugs + 9 computers.
Note that to both countries 9 computers is worth more than 3 rugs.

In this example the U.S. has an absolute advantage in rugs as well as in computers, but it has a
comparative advantage in the production of computers; the U.S. is comparatively more efficient in
computer production than it is in rug production.  Mexico, on the other hand, has a comparative
advantage in rug production; Mexico is comparatively less inefficient in the production of rugs than it is in
the production of computers.

A country has a comparative advantage in the production of a good compared to another county, if its
opportunity cost of producing that good (in terms of another good) is lower than the other country's
opportunity cost (of producing the same good.)

In the above example the opportunity cost of a computer in Mexico is 4 rugs, whereas in the U.S. it is
1.25 rugs. The opportunity cost of a rug in Mexico is .25 computer while in the U.S. it is .8 computer.
That is, rugs are cheap in Mexico while computers are cheap in the U.S.

Here Mexico would be happy to trade its rugs for computers at any price above .25 computer per rug and the U.S. will be glad to trade its computers for rugs at any price less than .8 computer per rug. The terms of trade will be settled at a price somewhere between these two relative prices.

The gains from trade for each country are measured in terms of the increases in the relative value of the goods available to it as a result of trade.

International trade allows a country to consume at a level beyond its own PPC. In essence, international trade has the same effect on a country's level of consumption, as does an increase in the amount of its resources or an improvement in its technology.

An Internet Visitation: To familiarize yourself with some trade issues visit this site.

Comparative Advantage: The Neoclassical Model

Before we introduce the tools that we need to know for this discussion let us make sure we understand that when a country has comparative (or absolute advantage) in production a good (relative to another good), compared to another country, the relative prices in the two countries will be different. It is this difference in the pre-trade relative prices that would lead to specialization and trade. In our graphical analysis the relative price was represented by the slope of the production possibilities curve.

The relative price of good X in terms of good Y is =  (Price of good X)/ (Price of good Y)

or  = ( Number of units of input needed to produce one X)/(Number of units of input needed to produce one Y)

or = the opportunity cost of producing one X in terms of the number of units of Y that would have be given up ( from a production perspective)

Recall that at equilibrium this relative price would be equal to consumers' MRS (marginal rate of substitution), making the relative price to consumers and producers the same.

Neoclassical Production Function
A production function may be:

New tools of analysis:

A production function:
Qx  =  fx  ( K ,  L )
       MPk(x)  =  Change in Qx / Change in  K
       MPL(x)  =  Change in Qx / Change in  L
Qy  = fy ( K ,  L )

The principle of diminishing return :

Keeping one factor of production constant (say, capital), as more of the other factor (say, labor) is added, beyond a certain point, each additional unit of labor will produce less output than the unit before it.

Why do relative prices vary?

A production function is a mathematical equation reflecting the relationship between inputs and output; it shows the maximum amount of the output that can be produced from any given amounts of inputs, given the state of the (available) technology.

Graphical Representation of a Production Function: Isoquants

An isoquant is a line representing all the combinations of two inputs from which a certain amount of output can efficiently be produced.

Slope of an isoquant = Marginal rate of (technical) substitution (MRTS)
                                                                                        Note: Be sure not to get MRTS confused with MRS which was related to indifference curves.

Isocosts: A line representing different combinations of two inputs that cost the same, given input prices.

The slope of an isocost = the ratio between the two input prices


Having studied and understood the basic model of trade in the context of a two-good-two-country model now we are ready to bring money into our analysis.

To keep things manageable, first let us continue to work with the same two-good-two-country model.

Here the idea is to work with money prices instead of relative prices.

Like before, we assume the price of a good is determined by the amount of labor used in the production of that good. For example, if a bushel of corn takes 4 units of labor to produce, the price of a bushel of corn will be equal to cost of 4 units of labor. What determine the cost of labor are the price of one unit of labor, or wage, and the quantity of labor.

Price =  Wage x Number of units of labor

Because each country has its own currency, different countries measure prices and wages in different currencies.

For example, Mexico in peso, US in dollars and UK in pounds

In order to be able to compare price in one country to prices in another country we need to adjust them according to the exchange rate between their currencies.

What is an exchange rate? An exchange rate is the price of one currency in terms of another currency: the rate at which two currencies are traded.

Example: The exchange rate between the British pound is $1.45 per one pound. That is, the price of one pound in US dollar is $1.45.  We can also quote this exchange rate in terms of British pound; that would be .6896 pound per dollar.

Another Example: The rate of exchange between US dollar and Mexican peso is 9.5 peso per one dollar. Or, it is $.1052 per one peso.

Note : --------- = .1052

 An exchange rate could be quoted either way. Be careful when using it.

Now let us go back to our US/Mexico example.

Suppose both US and Mexico can produce tomatoes and corn. The table below shows the number of units of labor needed to produce these goods in each country.

            Production Labor Requirement
                    Corn           Tomatoes
US                   1                      2
Mexico            4                      4

According to the table, for example, in the US we use one unit of labor to produce one bushel of corn, where in Mexico it take 4 units of labor to produce one bushel of corn.

Let us suppose the wage is US is $6 per unit of labor (say, an hour) and in Mexico it is 8 pesos.

Now we can determine the money prices of these goods in each country.

Recall:  Price = Wage x Number of units of Labor
P = a.W    ;     P = Price ;   a = Number of units of labor ;        W = Wage

                 Price of Corn         Price of Tomatoes
US                    $6                                $12
Mexico*           p8                                   p8

*("p" represents peso)

Because prices in US and Mexico are quoted in different currencies we cannot compare them. In order to be able to compare them we need to convert either dollar prices into peso or peso prices into dollar.

For simplicity let us suppose that the exchange rate between US dollar and Mexican peso is 1.
(We'll relax this assumption later.)

That means $1 is equal to 1 peso. Or, 4 pesos is worth $4.

$price x Exchange rate = US price in peso

Now we can reconstruct our price table, quoting all prices in the same currency; say, peso.

            Price of Corn         Price of Tomatoes
US                    p6                        p12
Mexico             p8                         p8

Notice that the US has absolute advantage in both goods; both corn and tomatoes are cheaper in the US.

But Mexico has comparative advantage in tomatoes while the US has comparative advantage in corn.

Relative price of tomatoes in the US is 2/1; that is 2 units of corn for one unit of tomatoes.
Relative price of tomatoes in Mexico is 1; that is 1 unit of corn for one unit of tomatoes.

As a result of (free) trade the US will specialize in corn and Mexico in Tomatoes.

To determine the terms of trade between the two countries simply divide the price of tomatoes (in Mexico) by the price of corn (in US); that would be 8/6 or 1.33. That is 1.33 corn per one unit of tomatoes.

Now let us see if we can make the same analysis using money more directly.  Because we are using money prices we can consider each good separately.

What we are trying to do is in fact compare the price of a good in one country with the price of the same good in another country, having in mind the exchange rate.

Let us consider corn. In the US the price of corn can be obtained by multiplying wage (W) and the number of units of labor(a). But to compare this with the Mexican of corn we have to convert it to peso. We can do that simply by multiplying the dollar price by the exchange rate, e (quoted as the price of a dollar in peso).

(Note if the exchange rate is quoted as the price of a peso in dollar,  then we divide.)

Price of corn in the US (in peso) =  a1j .W1.e

Price of corn in Mexico (in peso) = a2j .W2

Where 1 represents US, 2 is Mexico, and j stands for corn.

Now, if  a1j .W1.e < a2j .W2.e , indicating corn is cheaper in the US than in Mexico,  then US will export corn to Mexico.

Note: In our example the left had side would be 6 and the right hand side would be 8.

This inequality can be rearranged and written as follows:

    a1j         W2
---------   <    -------------
   a2j                W1.e

                                                                     1                      2
Using the information in our example:     -----------   <      ---------
                                                                     4                       6(1)

Because the left hand side is smaller than the right hand side,  US will be able to export corn to Mexico.

The exchange rate limit: The exchange rate at which export (trade) would cease. (Keeping other things unchanged)
The Wage limit: The wage at which export (trade) would cease.

Thinking Exercise

Think about the a1/a2 ratio. What does it reflect?
Start with an inequality position and then think about changes in any one of the variables (one at a time) and consider the implications.

Repeat the above analysis for tomatoes.
Using our US/Mexico example, determine at what exchange rate the export of corn from US to Mexico would stop.
Using our US/Mexico example, determine the US wage rate at which the export of corn from US to Mexico would stop.
Using our US/Mexico example, determine at what exchange rate the export of tomatoes from Mexico to US would stop.
Using our US/Mexico example, determine the Mexican wage rate at which the export of tomatoes from Mexico to US would stop.

A Multiple-Good Model
Note: Before we move into a multiple good model, let me call your attention to the assumption of having only two countries. This assumption is not as unrealistic as it sounds. When we study international trade from the perspective of a given single country we can treat the rest of the world as another (or the second) country, and, in most cases, our two-country model serves us quite well. The only thing that we need to have in mind is that when our single country is a large country there might be certain feedback effects that should be incorporated in our model.

Let us suppose that the US produces a number of goods: A, B, C, D, E, F, and G.  We also assume that Mexico produces all these goods.
To determine which of these good could be exported (to Mexico) by the US, we test each good by the simple (inequality) formula that we constructed earlier. Namely,

aus,j       Wmx
---------   <   ------------  ,         where j = A, B, C, D, E, F, G
amx,j       Wus.e

Labor requirements in the US and Mexico
                        A      B       C     D      E      F        G
US:   aus:         2        3       6     6        2     4          1
Mexico amx:   10     12     40     20      5     6          2

aus                A       B        C      D      E      F      G
-------    =     .2      .25     .15    .3     .4     .66     .5

Let us know rank them:

aus                      C      A      B      D      E      G      F
------- =            .15      .2     .25    .3      .4     .5     .66

Now that we have the left-hand side of our inequality for each good, let us determine the write-hand side.

We need wages in the US and in Mexico:  The US wage is $6 per unit (say, an hour)
The Mexican wage is 20 pesos per unit.

We also need the exchange rate between the dollar and the peso. Let us say it is 10 pesos per dollar.

                    Wmx                      20
Now we are ready to calculate    -----------       =   ----------- =    .33
                    Wus.                  6 x 10

Note that  .15,  .2,  .25,  .3 are all less than .33. That means the US could export C, A, B, and D.
Consequently, the US would probably want to import E, G, and F.

A Simple Exercise:
Raise the US wage to $7 per hour and examine the effect.
Without changing other things (US wage =$6), devaluate the peso to 12 peso per dollar and examine the implications.
Think about and compare the two cases.

The Dornbusch-Fischer-Samuelson Model
Let us first rewrite our inequality condition for export:

aus,j       Wmx
---------   <   ------------  ,        where j = A, B, C, D, E, F, G ,………….
amx,j       Wus.e

This inequality can also be written as:

amx,j       Wus.e
---------   >   ------------  ,         where j = A, B, C, D, E, F, G, ………….
aus,j       Wmx

Note that the direction of the inequality changes, but the message remains the same.

What this inequality simply says is that for the US to be able to export good j to Mexico, the relative labor requirement of Mexico for good j (amx,j/ aus,j) must be greater than the relative wage ratio of the US (Wus.e/Wmx).

Now, using the labor requirement information in our US-Mexico example we can calculate the (amx,j/aus,j) ratio:

amx,j                C        A          B         D           E            G             F
---------- =     6.6        5          4        3.3          2.5          2           1.5

We now summarize the relationship between (amx,j/aus,j) ratios and different (Wus.e/Wmx) ratios in a table. Assuming a give exchange rate, if the (Wus.e/Wmx) ratio is equal to 1, as you can see in the table above, the j (amx,j/ aus,j) ratios for all seven goods will be greater. Therefore all seven goods could be offered for export. If it is equal to 2, then all but good F could be exported. Likewise, if the (Wus.e/Wmx) ratio is equal to 3, 4 goods (D,B,A,C)  would be offered for export.

                                      Number of Goods
(Wus.e/Wmx)        Offered for Export
    1                                         7
    2                                         6             (all the goods to the left of G)
    3                                         4             (all the goods to the left of E)
    4                                         3             (all the goods to the left of B)
    5                                         2             (C and possibly A)
    6                                         1             (Only C)
    7                                         0

This simple analysis is the basis of The Dornbusch-Fischer-Samuelson Model. If we plot the above table with the (Wus.e/Wmx)  ratio on the vertical axis and the number goods offered for export (z) on the horizontal axis, we'll have a downward (negatively) sloping line which would represent the country's (US's) supply of export. (Note that unlike a typical supply curve this supply curve is negatively sloped.)

To complete this picture, we need to consider the demand (for US's exports) side too. Assuming Mexico and the US maintain balanced trade positions, the more of US's goods are demanded by Mexico (or as z goes up), and a greater cumulative fraction of income is spent on the US goods, wages in the US (Wus) tend to go up and wages in Mexico (Wmx) tend to go down, raising  the Wus.e/Wmx ratio. This relationship will give us a positively sloped line that could be viewed as demand for US's exports.

A simple exercise: Discuss the effect of a devaluation of the peso on the DFS model.

Comparative Advantage
The Neoclassical Model
Neoclassical Production Function
• Increasing-cost production function
• Constant-cost production function
• Fixed-Proportions production function
New tools of analysis:
•   Isoquants
•   Isocosts
A production function:
• Qx  =  fx  ( K ,  L )
       MPk(x)  =  Change in Qx / Change in  K
       MPL(x)  =  Change in Qx / Change in  L
• Qy  = fy ( K ,  L )

• The principle of diminishing return

The Equilibrium
Capital/Labor Ratios in Different Industries
Production Possibilities Frontier
Production in Autarky

Why do relative prices vary?

• Resource endowment differentials
• The Heckscher-Ohlin model
• Technology differences
• Taste differences
• Or a combination of the above
Heckscher-Ohlin Model
   The theorem: Assuming taste and technology do not differ between countries, under free trade a country specializes and exports those goods that use (more intensively) the factor of production the country has a relatively abundant of while  importing those goods whose production requires more of the factor of production that is relatively scarce in that country.
What does factor abundance mean?
 Factor abundance is measured relatively.
   For example, by the ratio between the amount of capital amount of labor:
 Ka/La  vs.  Km/Lm     or    La/Ka    vs.  Lm/Km

Or, by the ratio between factor prices:

 Wa/ra    vs.   Wm/rm         or     ra/Wa  vs.   rm/Wm

Different Factor Abundance
Different Tastes
Offer curve
• An offer curve shows the amounts of export and import of a country at various terms of trade; it shows how much of its export good a county is willing to offer for a given amount of import at each relative price ratio or given terms of trade.
• Each point on an offer curve corresponds to a mix of export and import consistent with given terms of trade.
Deriving an Offer curve

Equilibrium Terms of Trade

Trade and Welfare
A more “General” Equilibrium Approach
Stolper-Samuelson Theorem
• The changes in output prices resulting from trade will lead to (more than proportional) changes in the relative input prices.

• Under the H-O assumptions, as a result of trade the price the abundant resource will increase while the price of the relatively scarce resource will fall.
Trade and Factor Prices
The Welfare Effect
Recall that under competition  P = MC
MC = the cost of producing one additional unit of output
=> Price = MC =  aL . W  + ak . r

When the price of the labor intensive good increases:
=>  Wage will go up  & rent will go down
=>  With the wage going up more than proportionally
       (relative to the price), the wage earner is better

Chapter Four
Trade, Distribution, and Welfare
• Introduction
• Partial and General Equilibrium Analysis
• Stolper-Samuelson Theorem
• Factor Price Equalization Theorem
• Specific Factors Model
• Trade and Welfare:  Gainers, Losers, and Compensation

• Time to examine some of the major contributions international trade theory has made to general-equilibrium analysis.
– We will look at the primary reason for the controversy between policies of free trade and policies of protectionism.
Partial and General Equilibrium Analysis
• General-equilibrium analysis
– Interrelationships among various markets in the economy.
• Extreme example would be a model of a world economy that includes every good, every input, and every country and in which everything depended on everything else.
• Partial-equilibrium analysis
– Focuses on events in one or two markets and assumes others remain unaffected.
• Simple example: analysis of effect of a Florida freeze on prices of orange juice.
Effect of Output Prices on Factor Prices
• Stolper-Samuelson Theorem
– Link between changes in output prices and changes in factor prices.
– Most general form: an increase in the relative price of a good increases the real return to the factor used intensively in that good’s production and decreases the real return to the other factor.
• Factor prices change proportionally more than output prices (magnification effect).
Effect of Output Prices on Factor Prices
• In Figure 4.1, as production of the labor-intensive good increases, opening trade generates a net increase in demand for labor.
– Net effect on demand for capital is negative, because production of the capital-intensive good falls.
– With fixed factor endowments, the reward paid to the abundant factor rises and that paid to the scarce factor falls.
• The wage-rental ratio under restricted trade exceeds the ratio under autarky.
Effect of Output Prices on Factor Prices
• When assumptions of Heckscher-Ohlin model are added, the Stolper-Samuelson theorem means that opening trade raises the real reward to the abundant factor and lowers the real reward to the scarce factor.
– Trade boosts production of the good of comparative advantage, increasing that good’s opportunity cost and relative price.
• See Table 4.1 for trade’s effects on production, output prices, and factor prices.
How Do Factor Prices Vary Across Countries?
•  The Factor Price Equalization Theorem
– According to Stolper-Samuelson theorem, moving from autarky to unrestricted trade raises the real reward of the abundant factor.
• Similarly, such a move lowers the real reward of the scarce factor.
• Same adjustment takes place in the second country, but with the roles of the two factors reversed.
– Trade raises the real reward of a factor in a country where that factor is abundant and lowers its price in the country where it is scarce.
How Do Factor Prices Vary Across Countries?
– Thus, even when factors are immobile between the two countries, unrestricted trade in goods tends to equalize the price of each factor across countries.
• With free trade in goods and no international factor mobility, wA = wB and rA = rB.
– This is idea behind Factor Price Equalization Theorem.
• Table 4.2 (page 111) summarizes the theorem’s implications, assuming country A is labor-abundant and good X is labor intensive.
How Do Factor Prices Vary Across Countries?
– To increase production of the labor-intensive good (X), firms in both industries must increase their capital-labor ratios.
• The rise in wage-rental ratio from (w/r)0 to (w/r)1 brings about this adjustment.
– Firms choose to use less labor and more capital as labor becomes more expensive relative to capital.

How Do Factor Prices Vary Across Countries?
• The factor price changes predicted by the factor price equalization theorem provide the firm an incentive to undertake the necessary changes in production techniques.
– Profit-maximizing firms will choose to use more of the scarce factor as it becomes relatively cheaper and less of the abundant factor as it becomes relatively more expensive.
• This “economizing” on use of the abundant factor allows the country to specialize in producing the comparative advantage good.
An Alternate View of Factor Price Equalization
• Trade in outputs serves as a “substitute” for trade in factors of production.
– For example, when a labor-abundant country exports a unit of a labor-intensive good, it indirectly exports labor to a labor-scarce country.
• Unrestricted trade in either output or input markets can serve as a substitute for trade in the other markets.
Why Don’t We Observe Factor Price Equalization?
• Full factor price equalization is never observed.
– In Figure 4.3, it is shown that wages, before corrections for differences in labor productivity, differ widely across countries (by a factor of 20).
• Reason #1: Uneven ownership of human and nonhuman capital yields inequality of wealth.
• Reason #2:  Not all countries use identical technology in production…some are more advanced than others.
– Causes factor productivity to vary across countries.
Why Don’t We Observe Factor Price Equalization?
• Figure 4.4 shows that relative factor price differences across countries match relative productivity differences.
– Countries with high (low) labor productivity relative to that of the U.S. have high (low) wages relative to the U.S.
– Countries with high (low) capital productivity relative to the U.S. have high (low) rental rates.
Why Don’t We Observe Factor Price Equalization?
• Complete output price equalization may not occur due to transportation costs, barriers to trade, and existence of goods that are rarely traded.
– The factor price equalization theorem suggests an important policy alternative:
• Allow free trade in outputs, specialize in labor-intensive production, and export labor indirectly in the form of labor-intensive goods.
– Countries such as Ireland, the Philippines, India, Jamaica, and Singapore have begun using new technologies to do just that.
What if Factors Are Immobile in the Short-Run?
• Previous assumptions were that factors are completely mobile among industries within a country and completely immobile among countries.
– In the short-term, mobility of factors may
be imperfect.
• Short-run effects of opening trade may differ from long-run effects captured by Stolper-Samuelson and factor price equalization theorems.
Reasons for Short-Run Factor Immobility
• Physical capital: machines and factories
– Most equipment is specialized…it is suited only for the specific purpose for which it was designed.
– As physical capital wear out from use and age, firms set aside funds (depreciation allowances) to replace the equipment.
• Funds can be used to buy a different type of capital.
• Labor capital – same arguments apply.
– As older workers retire and new ones enter the labor force, the skill distribution slowly changes in favor of growing industries and away from shrinking ones.
Effects of Short-Run Factor Immobility
• Figure 4.5 illustrates that an increase in the price of shoes raises the wage rate in both the shoe and the computer industries, but by less than the rise in the price of shoes.
– The return to capital specific to the shoe industry rises more than proportionally with the price of shoes, and the return to capital specific to the computer industry falls.
Effect of a Rise in Shoe Prices on Factor Prices when Capital is Immobile
• Wage rates rise in both industries, but by less than the price of shoes.
– Effect on workers’ purchasing power depends on shares of shoes and computers in workers’ consumption.
• The return to shoe capital rises more than the price of shoes, so owners of shoe capital enjoy an increase in buying power regardless of their pattern of consumption.
• Return to computer capital falls, so those owners suffer a loss of purchasing power regardless of their pattern of consumption.
Trade with an Industry-Specific Factor
• Continue with a case in which labor is highly mobile among industries, but capital is immobile in the short-run.
– Country has a comparative disadvantage in labor-intensive shoe production and comparative advantage in capital-intensive computer production – it opens trade with another country.
• Shoe production falls and computer production rises.
• If both labor and capital were mobile between two industries, newly employed workers from shoe industry would flow into computer industry, and computer industry would buy unused capital from shoe industry.
Trade with an Industry-Specific Factor
• In our example, in the short-run, capital employed in the computer industry and workers who buy more shoes than computers gain from the opening of trade.
– And, capital employed in shoe industry and workers who buy more computers than shoes lose.
– In the long-run, owners of capital, the factor used intensively in computer production, gain from the opening of trade.
• And, workers, the factor used intensively in shoe production, lose.
Trade with an Industry-Specific Factor
• The existence of factors specific to single industries creates a short-run rigidity, or limitation on the economy’s ability to reallocate production among industries quickly and at a low cost.
– The more industry-specific the factors of production, the more costly will be any adjustment to relative price changes in terms of temporary unemployment or underutilization of capital.
Trade and Welfare: Gainers, Losers, and Compensation
• Opening trade increases the total quantity of goods available and makes it possible for everyone to gain.
– In order for everyone to gain, a portion of the gains enjoyed by some would have to be used to compensate others for their losses.
• If this were done, society as a whole would be made better off by trade.
– In general, however, no automatic mechanism to make this compensatory redistribution exists.
Potential versus Actual Utility
• Figure 4.6 shows that trade allows production of larger quantities of goods, making a higher indifference curve attainable (potentially to make every individual better off – if, for example, the additional goods were distributed among all individuals).
The Pareto Criterion
• If, the additional goods were distributed such that every person ended up with more of such a good
– Then you could say that this move increased actual welfare or utility according the the Pareto Criterion.
• States that any change that makes at least one person better off without making any individual worse off increases welfare.
Comparing Utility: The Compensation Criterion
• Opening trade harms some groups.
– How can gainers from a policy gain enough to allow them to compensate the losers for their losses and still enjoy a net gain?
• Opening international trade satisfies this Compensation Criterion for welfare improvement.
– Because the world economy produces more goods with trade, gainers can, in principle, compensate losers and still be better off.
• Such compensation, though possible, rarely occurs.
Trade Adjustment Assistance
• International trade is dynamic – industries are always making adjustments in order to maintain competitive advantages.
– These adjustments cause certain losses.
• Temporary unemployment
• Relocation
• Retraining
– U.S. government administers the Trade Adjustment Assistance (TAA) program.
• Provides variable compensation for workers displaced for trade-related reasons…see Table 4.5.
– Trend stems mainly from changes in technology rather than from international trade.
• Increased importance of knowledge-intensive skills has increased demand for workers who possess those skills.
Chapter Five
Beyond Comparative Advantage:
Empirical Evidence and New Trade Theories
• Introduction
• Questions to be answered
• How do we know if a theory about trade is correct?
• Testing the Hecksher-Ohlin model
• Intra-industry trade
• Trade with economies of scale
• Technology-based theories of trade:  The product cycle
• Overlapping demands as a basis for trade
• Transporting costs as a determinant of trade
• Location of industry

• After studying several theories to explain international trade patterns (Ricardian, neoclassical, and Heckscher-Ohlin models), must we adopt a single theory of trade, or might different theories best explain various aspects of trade?
– Should empirical testing be used to decide?
– Do we need to modify any of these theories to explain today’s economic patterns?
Questions To Be Answered
• Is one explanation from one of the economic theory models sufficient to explain why Colombia exports coffee, Taiwan color tvs, or Brazil steel?
• What part does intra-industry trade (trade in which each country both imports and exports products from the same industry) play?
• How do international trade patterns change over time?
• U.S. used to be the world’s largest manufacturer of tvs…now it’s Taiwan. Why?
How Do We Know If a Theory About Trade Is Correct?
• Economists turn to empirical testing of international trade theories in order to strengthen their arguments about the important influences on various types of trade.
– Both Adam Smith and David Ricardo used rudimentary empirical testing to support their claims.
– Certain difficulties exist with empirical testing:
• Empirical evidence can appear to support a theory, but it cannot prove it true (and vice versa).
• Most useful outcome of empirical test is refinement of both theory and test.
Testing the Heckscher-Ohlin Model
• Hurdles to empirical testing
– Heckscher-Ohlin model implies that exports as a group should be more intensive in use of the abundant factor than imports as a group.
• Virtually impossible to test for this.
– Simple observations do not necessarily comprise definitive evidence in the model’s favor.
The Leontief Tests
• Leontief used 1947 data for the united states in the first test of Heckscher and Ohlin’s key proposition (since U.S. was capital-abundant, it was expected that the U.S. Would export capital-intensive goods).
– Since data on the factor intensity of imports was not available, he used data on import substitutes (the U.S.-Produced versions of the import goods).
– Empirical results showed the opposite of what was expected.
• U.S. Exports were 30% more labor intensive than us import substitutes.
– Known as Leontief paradox.
The Leontief Tests
• Possible explanations of this paradox:
– In 1947 most of world’s economies were still in a highly disrupted state.
– Further tests in the early 1950s reduced the magnitude of the paradox.
• Fair to state that simplest version of Heckscher-Ohlin model does poor job of explaining trade patterns.
– Modifications and extensions have been made in the model.
Fine-Tuning the Heckscher-Ohlin Model
• Role of Tastes
– Heckscher-Ohlin model assumed tastes were identical across countries.
• This is not true.
– Large differences in tastes among countries can introduce a taste bias that can dominate the production bias.
• Should this occur, a country will have a comparative advantage in production of the good that uses its scarce factor intensively.
• Evidence does exist for a “home bias” in consumption (consumers in a given country tend to consume more domestically produced goods than we would expect).
Fine-Tuning the Heckscher-Ohlin Model
• Classification of Inputs
– Original theory used only two inputs: capital and labor.
• Inputs are now classified in several ways…most common:
– Arable farmland
– Raw materials or natural resources
– Human capital
– Man-made or nonhuman capital
– Unskilled labor
Fine-Tuning the Heckscher-Ohlin Model
• Technology, Productivity and Specialization
– The original theory assumed identical technologies across countries when it predicted countries would export goods that used their abundant factors intensively.
• We clearly observe different technologies across countries.
– The theory must be amended to take these production process differences into account.
What Is Intra-Industry Trade and How Big Is It?
• Defined as trade in which a single country both imports and exports products in the same industry.
– Comprises a significant share of world trade.
• The Intra-Industry Trade (IIT) index is used to estimate the extent of this trade within an industry or within a country trade as a whole.
– Table 5.1 (page 144) shows that IIT indexes tend to be higher for industrialized countries than for developing countries.
Intra-Industry Trade in Homogenous Goods
• Homogenous (non-differentiated) goods that are most likely to be involved in intra-industry trade include items that are heavy or for some other reason expensive to transport.
– In Figure 5.1, each country both exports and imports the product because of the greater proximity of consumers to the foreign than to the domestic producer.
Figure 5.1: Location Can Cause Intra-Industry Trade in Homogeneous Goods
Intra-Industry Trade in Differentiated Goods
• Product differentiation is the most obvious explanation for intra-industry trade.
– Consumers have a variety of tastes, some best served by domestically produced goods and others by imports.
Why Does It Matter?
• Intra-industry trade involves trade in goods in the same industry and produced using similar factor intensities.
– Therefore, changes in factor demands and relative factor prices from such trade tend to be smaller.
• Provides one explanation for global trade liberalization in last fifty years.
– Greatest success in lowering trade barriers has occurred in manufactured-goods industries in which the developed countries engage in large amounts of intra-industry trade.
Econmic Growth PP Notes

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