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
Trade
Investment
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
imports
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
China
6 Hong Kong,
174.9 4.3
-7
retained imports(a)36.5 0.9
-30
China
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
(15)
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
traders
* 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)
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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
$Million
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:
1948
Nationalist China is one of the 23 founding members
of the WTO's precursor, the
General Agreement on Tariffs and Trade (GATT).
1950
China pulls out of GATT, one year after the 1949
communist takeover, denouncing it as
a capitalist club.
1986
China applies to join GATT, seven years after
Beijing dumped Marxist economics in
favor of markets and sparked a dramatic export-based
economic resurgence.
1989
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.
1994
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.
1995
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.
1997
October - China slashes import duties to 17 percent
from 23 percent, but maintains
so-called "peak tariffs" on other goods including
as automobiles.
1998
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.
1999
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.
2000
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.
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.
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:
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?
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.
1
Note : --------- = .1052
9.5
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.
Practice
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
amx
Let us know rank them:
aus
C A B
D E G
F
------- =
.15 .2 .25
.3 .4 .5
.66
amx
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. e
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
aus,j
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
Isoquants
Isocosts
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
off.
Chapter Four
Trade, Distribution, and Welfare
Outline
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 goods 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 goods opportunity cost and relative price.
See Table 4.1 for trades 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 theorems 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 Dont 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 Dont 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 Dont 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 economys 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
Outline
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
Introduction
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 todays 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 worlds largest manufacturer of tvs
now its
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 models favor.
The Leontief Tests
Leontief used 1947 data for the united states in the first test of
Heckscher and Ohlins 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 worlds 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