International Trade
October 13, 2001
Class Notes
Chapter 1
A. Importance of Trade
1. Great surge of world trade following WWII (1945)
2. Different levels of importance to different countries
3. Importance to Oman due to oil; desire of Sultan to develop non-oil sources of trade revenue
B. The Topics of International Economics
1. International Trade and International Finance
a. International economics is about trades of goods
b. International finance is about how trade is financed (i.e., paid for)
c. The two intersect in discussions of foreign exchange markets, since foreign exchange must be acquired in order to import goods. Thus, although the two are separate as courses at SQU, we will have to discuss some international finance in this international trade course.
d. International finance also deals with the use of credit and, therefore, with capital flows.
2. Topics in International Trade
a. Gains from international trade
(1) Gains are greater than most people think
(2) Trade includes international migration and international borrowing (part of international finance) - can diversify income
(3) Gains from specialization and large scale production
(4) International trade always harms some people while benefitting others - i.e., it has distributional effects
(a) losses to firms and industries that compete with imports
(b) gains to exporting firms and importing firms
(c) redistribution among capital and labor owners
b. The Pattern of Trade
(1) Why countries import and export what they do.
c. Protectionism
(1) Governments have typically tried to
(a) protect some firms and industries from harm due to competition from exports
(b) help some firms and industries compete with foreign companies in international markets
(2) The concept of trade policy
(3) Trade policy is determined more by conflicts of interest within nations (i.e., among the different political and economic groups) than conflicts of interest between nations.
d. Balance of Payments
(1) Definition: the record of a country's transactions with the rest of the world
(2) Trade deficit: more money paid out than paid in
(3) Trade surplus: more money paid in than paid out
a. Exchange Rate Determination
(1) Exchange rate: rate of exchange of one country's currency for the currency of another country.
(2) Why this is a relatively new subject
(a) Before WWI (1913), countries fixed their currencies by agreeing to exchange a given amount for a fixed amount of gold: the gold standard.
(b) After WWII (1945), countries fixed their currencies by agreeing to exchange a given amount for a given amount of U.S. dollars: the dollar standard.
(c) Today: there is no accepted standard, although the dollar is more widely used in international exchange today than previously
1.) Previous importance of the British pound sterling
2.) Increasing importance of the German mark and the Japanese yen in regional trade
3.) The European Union and the new euro
b. International Policy Coordination
(1) Trade: General Agreement on Tariff and Trade (GATT) for the last 45 years. GATT has grown into the World Trade Organization (WTO); European Union (EU); North American Free Trade Association (NAFTA); Asia-Pacific Economic Council (APEC); Gulf Coast Countries (GCC); Indian Ocean Rim Countries
(2) Macroeconomic Policy: European Union (EU); the internationalization of capital markets have caused macroeconomic policies to increasingly affect international investment
c. International Capital Market
(1) Definition: market in which individuals or institutions in one country exchange foreign exchange for promises to pay foreign exchange (e.g., loans of US dollars for promises to repay US dollars in the future).
(2) Volatility: debts may not be repaid and, as a result, the exchange rate may change. This appears to be a common characteristics of such markets.
(3) Practically all countries have special regulations on foreign exchange in order to control the international money flowing in and out of a country. We call these controls, or regulations, on international capital movements.
(4) Recent evasion of international controls of capital. Banking on a boat through the internet.
Chapter 2
A. Two Reasons for Trade
1. Opportunity costs of production may differ - comparative advantage may be present
2. Economies of Scale - a country may be too small to take advantage of these
3. Because international trade is a complex subject, this chapter considers the first reason, isolated from the second
B. Comparative Advantage in Theory
1. Theory: trade between two countries can benefit both if each exports the good in which it has a comparative advantage -- i.e., in which its opportunity costs are lower.
C. Comparative Advantage in Practice: Why Trade Occurs if Each Country has a Market Economy
1. The Ricardian model of a One-Factor (Labor) Economy
a. The opportunity cost of producing a unit of good A in this model refers to the amount of some other good that could be produced with the labor needed to produce the unit of A.
b. Homogeneity vs. heterogeneity of resources
c. Total (homogeneous) labor resources = L
d. Unit labor requirements- amount of labor required to produce a unit of a good. In a two good model (wine and cheese), we can define aLW as the unit labor requirements of wine and aLC as the unit labor requirements of cheese.
e. Constant returns to scale - the unit labor requirements stay the same regardless of the quantity produced. We assume constant returns to scale.
f. Production possibilities
(1) Possibilities of producing gallons (liters) of wine
(2) Possibilities of producing pounds (kilos) of cheese
(3) Writing an equation and drawing a graph to represent the production possibilities: p. 16.
(4) How the slope of the curve represents the opportunity cost
g. Each country uses the same kind of money. Ricardo assumed that the countries used gold.
2. Relative prices of goods in the absence of international trade
a. Competition among workers for jobs and among firms for profit will cause the relative price in this model to be the same as the ratio of their unit labor requirements. If the home country can produce a pound of cheese in one hour and a gallon of wine in 2 hours, then the price of cheese will be one half the price of wine. To prove this, assume that the price of cheese is either higher or lower and then put yourself in the shoes of competing firms and workers.
3. Relative price in the presence of international trade
a. We cannot know exactly what the relative price will be in this case. But we can show two things:
(1) It must lie between the absence-of-trade relative prices in the two countries
(2) it must be the same in both countries so long as there are no transactions costs or transportation costs
4. Why the presence-of-trade relative price must be between the absence-of-trade prices
a. How trade expands production possibilities: see graph and discussion on p. 22.
b. Referring to these graphs, note that Home will trade its cheese for wine only if the price of wine is lower in Foreign, which it is. Foreign will trade its wine for cheese only if the price of cheese is lower in Home, which it is. In the example the opportunity cost and absence-of-trade price of cheese is ½ a gallon of wine. In Foreign it is 2 gallons of wine. Thus the presence-of-trade relative price of cheese must be between ½ and 2 gallons of wine. Home will accept no less than ½ gallon for its exports of cheese and Foreign will pay no more than 2 gallons for its imports of cheese.
5. Relative wages: wages in one country relative to those in another country
a. The gains from trade will occur even though the workers in one country receive lower wages than those in a second country. Note that workers in both countries gain in their roles as consumers because international trade reduces the price of the imported good. Thus the Foreign workers can buy Home-produced cheese at a lower price.
D. Three Misconceptions About Comparative Advantage
1. Productivity and Competitiveness
a. Argument: Free trade is beneficial only if a country can produce goods more efficiently without causing its labor costs to be lower than another country's labor costs. In other words, it is only beneficial if a country's labor resources are more productive and its non-labor resources are more competitive than those of other countries.
b. Reply: Free trade can be beneficial if a one country's wages are lower than another, so long as there is comparative advantage - a difference in opportunity costs -- in this case the real wage will rise.
2. Pauper (i.e., poor) Labor
a. Arguments: (1) Foreign competition hurts other countries when it is based on low wages; (2) Foreign competition is unfair when it is based on low wages;
b. Reply: (1) Foreign competition is the same as international trade. It does not hurt workers in other countries because workers gain in their role as consumers due to the fact that international trade reduces the price of the imported good. (2) It may be unfair that foreign workers receive lower wages but this unfairness is not due to foreign competition. Indeed allowing this competition -- i.e., allowing international trade - benefits foreign workers in their role as consumers.
3. Exploitation
a. Argument: International trade exploits the workers of a low-wage country, making them worse off.
b. Reply: Without international trade, the workers would be worse off. The alternative is worse.
E. Comparative Advantage with Many-Goods (substitute this for the textbook discussion.)
1. Assume that each country produces the same N goods. Assume that there is some absence-of-trade wage rate in both countries. Note that we cannot determine the relative wage rate (i.e., the wage rate of one good in terms of another for each country) as we did before because there are many goods. We need to assume some relative wage rate.
2. Now arrange the potentially traded goods in order according to the ratios of the amount of labor requirements for the two countries: read p. 27 - the section on "setting up the model."
3. Those goods with low ratios of foreign to home labor requirements will tend to be imported and those with high ratios will tend to be exported. An example for five goods is given in table 2-3 on p. 28.
4. Note that the goods traded depend on what the relative wage rate in the two countries actually is.
5. Recognize that once trade begins, the wage rates of the two countries may change, since there are many good.
6. Usefulness of the model: it helps us see how the principles of the two-good Ricardian model also apply to a model with many goods. In other words, both countries gain, although the pattern of trade is more complex and depends on the magnitude of the differences in relative wages.
F. Reasons Why Specialization in the Real World is Less Extreme Than We Might Expect on the Basis of the Ricardian Model
1. More than one factor of production
2. Countries sometimes protect industries
3. There are transportation costs - consider the cement industry.
G. Empirical Evidence
1. Do countries import goods for which the ration of home labor requirements to foreign labor requirements are highest?
2. Factors that may lead to a different result in reality
a. Non-traded goods due to transportation or transactions costs
b. Model assumes no effects on the distribution of income - to be discussed in chapter 3
c. Countries have many different resources
d. The model assumes constant opportunity costs and thus neglects economies of scale.
e. Countries may restrict trade by using tariffs, quotas, or regulations
3. Old evidence: Interpret the scatterplot on p. 33.
4. Recent evidence: because countries are already involved in international trade, they do not produce goods for which their labor requirements are relatively high. So we do not get to observe the labor requirements for these goods.
5. Other evidence: the export of low wage goods by countries with low productivity and the export of high wage goods by countries with high productivity.
6.
Chapter 3
A. Limitations of the Ricardian Model of Chapter Two
1. Resources cannot move costlessly; they are not perfectly mobile
2. There are many factors of production and the factors used to produce different goods differ.
B. The Specific Factors Model
1. Assumptions
a. Two homogeneous goods and, therefore, two industries
b. Three homogeneous factors
(1) Land, capital are specific - land only used to produce food; capital only used to produce manufactures
(2) Labor is general - when combined with land, it can be used to produce food; when combined with capital, it can be used to produce manufactures.
(3) Fixed amounts of factors
(4) Production functions (equations 3-1 and 3-2 on p. 40-41)
(5) Labor constraint: equation 3-3.
2. Deriving the Bowed-Outward (Concave) Production Possibilities Frontier
a. The production function for each good (figure 3-1)
b. The marginal product of labor (figure 3-2)
c. How to derive the production possibilities frontier from the two production functions and the labor constraint (figure 3-3)
d. Why is the production possibilities frontier is bowed outward? Because we assume diminishing marginal products of labor in each industry. That is, because we assume that when additional units of labor are added to a fixed amount of capital (manufactures) or land (food), the units yield less and less additional product. In other words there is diminishing returns to labor.
e. The slope of the production possibilities curve: -MPLF/MPLM. Explain why by reading the paragraph the begins at the bottom of p. 44.
3. Prices, Wages and Labor Allocation
a. Determining the Wage Rate and the Quantity of Labor Used in Both Industries
(1) Definition: Value of the Marginal Product of Labor is the additional revenue that a firm can earn by hiring one more unit of labor. The additional unit of labor adds something to output and when that output is sold it adds to the revenue.
(2) Profit maximization condition: a firm should hire additional labor so long as the value of the marginal product is greater than or equal to the wage rate.
(3) Value of marginal product curve: it is the MPL curve times the price of the product. Show why. Note that the curve slopes downward just as the MPL curve does.
(4) Demand for labor curve: it is the value of the marginal product curve because this curve tells the quantity of labor that will be hired at each wage rate.
(1) Because the wage rate must be the same in the food and manufacturing industries, if we know the production possibilities frontier and the prices of the two products, we can find the equilibrium wage rate. It is the point at which the VMPLF = VMPLM. This is shown at w1 in figure 3-4. Note that the VMPLF starts from the right hand axis. Note that LM is not necessary equal to LF. Indeed, they are likely to be different.
b. Showing the Relative Price of the Goods on the Production Possibilities Frontier (figure 3-5)
c. Showing the Effects on Wages and Amount of Labor Employed in the Two Industries that Results from a Change in the Relative Price
(1) Effects of an Equal Proportional Change in Prices (figure 3-6)
(a) Wages rise; amounts of labor employed in the industries stay the same. Increase in prices causes a proportional increase in wages.
(2) Effects of an Increase in the Price of Manufactures (figure 3-7 and 3-8)
(a) Wages rise; amount of labor employed in manufactures rises; amount employed in food falls. Increase in prices causes less than proportional increase in wages.
2. Relative Prices and the Distribution of Income
a. Equilibrium in the market for a single good (figure 3-9)
(1) Why the relative supply curve slopes upward. We have seen that as the price of one of the goods rises, the quantity of it supplied rises also as more labor resources are shifted away from the production of the other good.
b. Distribution of Income
(1) Three types of people: owners of land, owners of capital, and owners of labor.
(2) How the distribution of income changes if there is an increase in the demand for manufactures relative to the demand for food.
(a) price effects of the change
1.) Price of manufactures rise
2.) Price of food falls
3.) Wages rise by less than the price of manufactures
4.) Rents (the book writes profit) on capital rise
5.) Rents on land fall
(b) Distribution effects
1.) Definition: change in real wage equals the change in money wage divided by the change in price
2.) Total effect on wages is ambiguous because
a.) Real wage in terms of manufactures falls
b.) Real wage in terms of food rises
3.) Rents (profits) on capital rise because real rents on capital in terms of manufacturing rise proportionately more.
4.) Rents on land fall because of the decrease demand for it.
1. Effect of an Increase in the Amount of a Resource
a. Increase in Capital (figure 3-10)
(1) Shifts MPLM to the right, raising the wage rate and increasing the quantity of labor used in manufacturing and reducing the quantity used in food. This raises manufacturing output and reduces food output.
(2) Reduces the relative price of manufactures.
b. Increase in labor
(1) increases employment of output in both industries
(2) effect on relative price is ambiguous
B. International Trade
1. Effect of Trade on Relative Prices (figure 3-11)
(1) Note that a similar graph could be used to describe the effects of trade in the world market for food.
2. Budget Constraint and Trading Equilibrium
a. Definition: The amount of imports that can be bought cannot exceed the amount of exports that are sold and (b) the imports must be bought and the exports must be sold at the final equilibrium world price.
b. Figure 3-12 shows a budget constraint and a production possibilities frontier.
(1) Notes:
(a) Because the slope of the budget constraint is the relative prices of the goods in the after-trade equilibrium, it cannot be the pre-trade equilibrium for the nation. In other words, a different relative price, such as that shown at point 2 in figure 3-14, must be the nation's pre-trade equilibrium.
(b) A nation faces a budget constraint only if it cannot borrow or if other individuals in other nations are not investing. Thus, this model assumes no movements of money capital between nations.
c. Trading equilibrium: figure 3-13.
(1) Notes: note that the two budget constraints are identical. This is because
(a) the slope equals the after-trade equilibrium relative price
(b) the maximum amounts of food and manufactures that each nation could acquire are the same. The equal the combined production possibilities of the two nations.
d. Gains from Trade and Changes in Income Distribution
(1) Gains from Trade to a Nation: figure 3-14
(a) Note that gains from trade are defined in terms of increased potential. This is because, as we show next, some people gain and others lose income. As economists, we don't want to compare satisfactions. The gainers might be rich while the losers are poor, for example.
(b) Note that point 2 is the pre-trade equilibrium. Point 1 is simply the point where the after-trade price line is tangent to the nation's production possibility frontier.
(2) Income Distribution
(a) On the basis of our assumptions, trade benefits the owners of the factors that are specific to the export sector of each nation but hurts the owners of the factors specific to the import-competing sectors, with ambiguous effects on mobile factors.
C. Political Economy of Trade
1. Optimal Trade Policy
a. Easy Case: each person has the same wants and owns an equal share of all three factors. "In this homogeneous economy, free international trade would clearly serve the government's objective."(p. 58)
b. Hard Case: losers are poor
c. Arguments against protectionism (restricting trade) in order to avoid harming the poor.
(1) In the real world, it is not easy for the government to know the exact effects. As a result, the costs to the government of examining every case may exceed the benefits. Krugman and Obstfeld discuss red tape, which means indecision by government bureaucrats.
(2) When prospective losers know that a government will protect them, they tend to demand protection. Even if they are not poor, the claim that they are. Their cries tend to not be offset by the gainers because there are typically many of them (consumers) and it is more costly for them to organize an opposition.
(3) There are other means of avoiding the harmful effects to the poor, such as compensation.
2. Trade Politics
a. Firms usually gain from protectionism; consumers usually lose
b. The number of firms is small and the amount each one gains is large
c. The number of consumers is large and the amount each gains is small
d. Even though there are potential gains from trade, the firms may win the political game
(1) In a democracy, the firms will persuade elected politicians by contributing to their political campaigns
(2) In an autocracy, the firms will often bribe public officials; or they will invest in building family and social ties
Chapter 4
A. Introduction
1. What is the Heckscher-Ohlin (H-O) model?: a model in which resource differences are the only reason why opportunity costs and relative prices of goods differ between nations and therefore the basic reason why the nations trade.
2. Factor proportions: the theory emphasizes the proportions of factors used in different industries. Example: the proportion of labor to land is high in densely populated countries. The theory is sometimes called the factor proportions theory.
3. Concepts
a. Relative abundance of a particular factor (factor abundance) in a country refers to the factor that it has a greater proportion of, relative to other countries. China and India are factor abundant in unskilled labor.
b. Factor intensity: the proportion of a factor, relative to other factors, used to produce a particular product. Agriculture, is factor intensive in land.
4. Implication of the model: Even if factors of production are immobile across country borders, the owners of the factors in the different countries will earn the same returns on their factors. Thus, a common laborer, the owner of a Caterpiller tractor, the owner of an acre of fertile farmland, and the brain surgeon in one country will earn the same relative wage as their counterparts in other countries.
B. The Model of a Single Two-Factor Economy that is Land Intense in Producing Food.
1. Choice of input combinations
a. In the H-O model, firms can choose their input (factor) combinations. The same good can be produced with different factor proportions. Figure 4-1 is a model with two factors.
b. Which choice will a firm make? It depends on the ratio of the factor prices. If the price of a particular factor is relatively low, the firm will choose to use relative more of that factor in its production.
2. Amounts of a factor used in different industries. Industry A is intensive in a particular factor if it uses proportionately more of that factor than other factors at a given price than other industries. Figure 4-2 shows a case where food is more land-intensive than cloth. Note: figure 4-2 shows the land labor ratio that would exist in both industries at every possible wage-rent ratio.
3. Prices of goods and ratio of factor prices. A rise in the price of a good that is relatively more intensive in factor A will cause the relative price of factor A to rise. Therefore, in this model, there is a direct relationship between relative good prices and relative factor prices. (See figure 4-3)
4. A country will tend to produce a larger proportion of goods that are intensive in the factors with which it is relatively well endowed.(see statement at top of p. 76.) The goal of figures 4-4 to 4-7 and the discussion beginning on p. 71-72 and ending on p. 76 is to show why this is so. It does this by asking what would happen if a country became more intensive in a particular factor. The starting point is to show the amounts of two goods that a country would produce assuming that it has a given endowment of two factors, land and labor. Figure 4-5 shows the amount of labor and capital that would be used for a given relative price of goods. The first (lower) production possibilities curve in figure 4-7 shows the quantities of food and cloth that would be produced.
a. Deriving the amount of land and capital that would be used at a given relative price of goods.
(1) Figure 4-4 combines figures 4-2 and 4-3. It allows us to find the land-labor ratio in the two industries at each relative price of cloth.
(2) Figure 4-4 (left) is the same as figure 4-3 turned on its side. For each relative price, we can find the wage-rent ratio. Competition requires that if there is an increase in the relative price of a good that there also be an increase in the price of the factor for which the production of that good is intensive. Figure 4-4 (right) is the same as figure 4-2. It shows the land labor ratio that corresponds to each wage rent ratio.
(3) What we know from figure 4-4: that for any given relative price of cloth, there will be a corresponding land labor ratio. The ratio will be higher for food than for cloth.
(4) Determining the amount of land and labor used in producing cloth and food respectively.
(a) First we represent the total amount of labor and land by a box (figure 4-5)
(b) Note that the height of the box is determined by the amount of land, while the base is determined by the amount of labor. Every point inside corresponds to an amount of labor and land used to produce either cloth or food. If there is more land, the box would be taller; if there is more labor; the box would be wider.
(c) The only point in the box at which the land-labor ratios correspond to those of figure 4-4 (right) is point 1. We find this by finding the intersection of the ratios. Line C represents all of the combinations of land and labor that have the land-labor ratio TC/LC1 in figure 4-4 (starting from the left, bottom). Line F represents all of the combinations of land and labor that have the land-labor ratio of TF/LF2 in figure 4-4 (starting from the right, top).
b. Showing how the amount of land and labor used to produce the different goods changes as the result of a change in the amount of land (figure 4-6). An increase in the amount of land is represented by making the box taller. Since the land-labor ratios stay the same, there are new equilibrium quantities of land and labor used in cloth and food production. The equilibrium changes from position "1" to position "2." Note that less labor and less land is used in cloth production. This means that less cloth is produced.
c. Showing these effects using production possibilities curves. The curves must be drawn such that an increase in land causes less cloth to be produced. (figure 4-7) Error: figure 4-7 contains an error. It shows a lower relative price of cloth at the new equilibrium ("2") than at the old equilibrium. The slopes of relative price lines for 1 and 2 should be the same. Thus QC2 should be to the right of where it is drawn. Drawn correctly, it would lie somewhere between QC2 and QC1.
d. Biased expansion of the production possibilities frontier: this is represented by the fact that the blue production possibilities curve has a different slope than the black one. Why? Because an increase in land greatly increases the possibility of producing food but only slightly increases by a small amount the possibility o f producing cloth. Note that if there was no bias or if there was a bias in the opposite direction, the new point QC2 would lie to the right of QC1.
C. International Trade Between Two Economies that Have Different Factor Intensities in Different Industries
1. Why figure 4-8 can be used
a. We have assumed that tastes, and therefore relative demands, are the same for both countries. Therefore RD represents the relative demand of each country separately.
b. We assume that Home is labor abundant and that the cloth industry is labor intensive. Therefore its relative supply of cloth is greater. It is RS, while Foreign's is RS*.
c. Since relative demand must stay the same but the new relative price of cloth must fall between the relative prices in the two countries, the new equilibrium point must lie between points "1" and "3" on each country's relative demand curve. At this point Home will export cloth and import food.
2. Effects of International Trade on the Distribution of Income
a. Trade of the type shown in figure 4-8 benefits laborers in the home country but harms landowners.
b. Principle: owners of a country's abundant factors gain from trade but owners of a country's scarce factors lose from trade. But
(1) Short run vs. long run
(a) in the short run, skilled labor is stuck in its current specialized employment; so laborers in those employments will lose if a country begins to import the goods they are specialized in producing.
(b) in the long run, skilled labor can learn new skills. It can shift from import industries to export industries. So the losses are less in the long run
(c) the book assumes that unskilled labor has no opportunity to shift to non-labor intensive industries.
D. Factor Price Equalization
1. Factor price equalization theorem: International competition will bring about equalization in the relative and absolute returns to homogeneous factors across nations.
2. Why factor prices tend to equalize. Do a thought experiment to understand why this is so in the model.(bottom of p. 78 to top of p. 79.) Also refer back to figure 4-3.
3. Why international trade has not resulted in factor price equalization
a. Countries may have radically different capital to labor ratios or skilled to unskilled labor ratios leading to a case where a country does not produce all of the goods that another country produces.
b. Countries may have different technologies.
c. Transportation costs and barriers to trade
E. Case Study: North-South Trade and Income Inequality
1. Definition: North-South Trade is trade between advanced industrial nations and less-developed economies
2. Definition: NIE - newly industrialized economies
3. Two trends from the viewpoint of the advanced industrialized countries
a. Before 1970: South exported raw materials and agricultural goods; North exported manufactured goods
b. After 1970: NIEs increasingly exported manufactured goods to the advanced industrial nations.
c. The goods exported from NIEs were relatively intensive in unskilled labor while the goods imported by them were relatively intensive in skilled labor.
4. Data in the U.S.: real wages (money wages divided by the price level) fell for lowest wage earners.
5. Question was the fall in U.S. real wages to low wage workers an example of factor price equalization?
6. Krugman and Obstfeld answer: Factor price equalization might have been a factor but it was probably a minor factor because there are other explanations. These are:
a. Because the wages share of total income received in the U.S. had stayed approximately constant, the data may reflect a change in the distribution from unskilled to skilled workers.
b. If the factor price equalization model was correct, there should have been a rise in price of products that are skilled-labor intensive and a fall in price of the products that are unskilled-labor intensive. There is no evidence of this.
c. If the factor price equalization model was correct, there should be increases in the wages of unskilled labor relative to skilled labor in the NIEs. There is no evidence of this.
d. Since trade is such a small per cent of total spending in the advanced nations, factor price equalization would be only a minor effect anyway.
F. Tests of Hechscher Ohlin
1. Contrary evidence: The Leontief Paradox: U.S. exports were less capital intensive than its imports even though the capital-labor ratio in the U.S. is very high. Confirmed in other countries as well.
2. Confirming evidence: in manufactures (see table 4-5)
3. Explanation of confirming evidence: Perhaps the U.S. exports high-tech goods and technology which used in other countries to produce manufactured goods.
Chapter 5
A. From the Production Possibilities Curves to Relative Demand and Relative Supply
1. Introduction
a. Purpose: to show how each country in the world responds to changes in world price.
b. Effects divided into two parts: demand and supply
2. Showing effects of world price on supply
a. Use a production possibilities curve for two goods to show how a change in world price affects the quantity of each good supplied - figure 5-2.
b. A nation's relative supply curve of a good.
c. From the relative supply curve of a single nation to the world relative supply curve. One must add the supply curves of the different countries horizontally.
3. Showing effects of world price on demand.
a. The concept of indifference curves
(1) Definition of indifference curve: a curve that traces the set of two goods that yield the same level of satisfaction to an individual
(2) Definition of indifference map: a set of indifference curves, each higher one showing a higher level of satisfaction than the one below it.
(3) The three properties of indifference curves (p. 97)
(4) From individual indifference curves to a social (country's) indifference curve
b. How a country involved in world trade chooses the combination of consumer goods that allows it to reach the highest possible indifference curve: figure 5-3.
c. Effects of a change in world price on the quantity demanded of a good for a country: figure 5-4.
(1) Does a decrease in world price of food cause an increase in the quantity that a country demands?
(a) Answer depends on the shape of the indifference curves
(b) The substitution effect: the country tends to substitute the lower- priced good for the higher-priced one in the budget. So it buys more of the lower priced good and less of the higher priced good.
(c) The income effect: the country buys more of a normal good but less of aninferior good. (Inferior good: a good for which the quantity demanded varies inversely with income; the lower the income, the higher the quantity demanded)
(d) The income effect may outweigh the substitution effect. This means that if the good whose price falls is an inferior good, the country may buy less of it
(e) If the good whose price falls is an inferior good and the income effect outweighs the substitution effect, the country's demand curve for the inferior good may not be negatively sloped.
(2) The world demand curve. Krugman and Obstfeld assume that it is sloped downward because they assume either (1) that the good is not an inferior good for all countries or (2) that even if the good is an inferior good the substitution effect outweighs the income effect.
A. Welfare Effects of a Change in the Terms of Trade
1. Terms of trade: the world price of a good (s) that a country initially exports divided by the price of the good (s) that a country initially imports
2. Using figure 5-4 to show the welfare effects of a change in the terms of trade
a. If the world relative price of food falls from W1 to W2, the country can move to a higher level of social indifference. It is better off.
b. If the world relative price of food rises from W2 to W1, the country moves to a lower level of social indifference. It is worse off.
c. Note that a rise in the world relative price of food in the figure is the same thing as a fall in the world relative price of cloth.
B. Welfare Effects of Economic Growth
1. Representing economic growth: for a country, it is an outward shift of its production possibilities curve.
2. Normal growth vs. biased growth: figure 5-6 shows biased growth in cloth (left) and biased growth in food (right)
3. Strong vs. weak bias: the bias in figure 5-6 (left) is said to be strong because the amount of food produced falls at a given price even though there is economic growth in both industries.
4. Note that in figure 5-6 (right), the amount of cloth does not fall at a given price. It stays the same. We must assume, contrary to the text, that this does not represent a case of a strong bias.
5. Export-biased growth: an increase in production possibilities that is biased toward the good that a country exports.
6. Import-biased growth: an increase in production possibilities that is biased toward the good that a country imports.
7. Effects of economic growth on the terms of trade
a. Small country vs. large country: small country has small effect on the terms of trade
b. If there is no bias, the country's terms of trade are not effected in any important way. However if there is bias, the situation is different for a large country.
c. Export-bias means that a country sells more abroad, thereby reducing the relative price (the terms of trade)
d. Import-bias means that a country sells less abroad, thereby increasing the relative price of its exported good (its terms of trade).
8. Effects of economic growth in the rest of the world on a country's welfare.
a. If there is no bias, the country will not be affected in any important way. However if there is bias, the situation is different.
b. If there is a bias in the growth of possibilities of producing the good that the country exports, the price of that exported good will fall; the terms of trade for the export good will fall; and the country will be worse off - the case of immizerising growth.
c. If there is a bias in the growth of possibilities of producing the good that the country imports, the price of that imported good will fall; the terms of trade for the export good will rise; and the country will be better off
Skip rest of chapter.
Chapter 6
A. Economies of Scale and Trade
1. Definition: a doubling of inputs more than doubles output.
2. Incentive to trade based on economies of scale
a. Assume two identical countries that produce two products at opportunity costs that are the same for each country.
b. Assume that there is no incentive to trade based on comparative advantage; in other words, each country faces the same opportunity costs.
c. Assume that there are economies of scale in each industry.
d. If each country specializes in one of the products, its cost of production will fall and it will gain a comparative advantage in that good. The other country will gain a comparative advantage in the other good. As the other country specializes, it will experience lower per unit costs. Thus, when both countries specialize, each will develop a comparative advantage that it did not possess at first.
3. Types of economies of scale
a. External: as the number of firms in the industry increases, the costs faced by each firm decreases.
(1) This kind of industry is likely to be competitive
b. Internal: an increase in the size of a firm reduces its costs.
(1) This kind of industry is likely to be monopolized - the natural monopoly.
B. Natural Monopoly
1. Pricing in the natural (decreasing cost) monopoly firm (figure 6-1).
a. Note that MR is less than price and that the firm earns profit, unlike the perfectly competitive firm. (We learned this in Intermediate Microeconomics: refer to those notes.)
C. Monopolistic Competition (Skip the textbook discussion from p. 127 to p. 137; refer to these notes instead)
1. Definition: two parts
a. many firms that produce a differentiated product (e.g., different versions, or brands, of the same product - breakfast cereals, soft drinks)
b. firms do not believe that they can influence the prices of their competitors
2. Model:
a. each firm is like a little monopoly because it has "loyal" customers who will not switch to other versions of the product if there is an increase in price. This means that the demand curve faced by the firm is not perfectly elastic. It is not a horizontal line, as in the case of a perfectly competitive firm (recall this from microeconomics). It is like the demand curve faced by a monopolist. Yet if the firm raises price too high, all the customers will shift to other versions.
b. The concept of brand loyalty - for example, loyalty to the Toyota or the Ford.
c. each firm may charge a different price from its competitors who produce somewhat different products.
D. International Trade in a Monopolistically Competitive Industry with Internal Economies of Scale
1. The model
a. Assume two countries, two goods, and factor intensity. Home is capital abundant and, therefore, has a comparative advantage in manufactures, as in chapter 4. Foreign is labor abundant and has a comparative advantage in food production. Before trade, both countries produce both manufactures and food.
b. The manufactures industry is monopolistically competitive in both countries and there are internal economies of scale in the industry.
c. Recall the case of perfectly competitive industries with no economies of scale. Home exports manufactures and Foreign exports food.(figure 6-6)
2. Characteristics of the model: Home is still a net exporter of manufactures and a net importer of food. In other words, it still exports more manufactures than it imports and imports more food than it exports. However, it does import some manufactures. These manufactures are cheaper when they are produced abroad than when they are produce at home.(figure 6-7)
a. Reasons for this outcome: monopolistic competition and internal economies of scale
(1) Some of the manufacturing firms in Foreign can sell their versions (brands) of manufactures because Home consumers prefer them over the Home versions (brands). For example, Foreign may export a manufactured product to which Home consumers become loyal (e.g., cars). This is a consequence of the assumption that the industry is monopolistically competitive
(2) A foreign producer of manufactures may expand his output because he can now sell units in both countries. If he does, he will be able to produce the output at a lower per unit cost. This is a consequence of the assumption that each firm faces internal economies of scale.
3. Interindustry and intraindustry trade
a. Interindustry trade: Home exports goods from one industry; it imports goods from the other.
b. Intraindustry trade: Home exports one version (brand) of the good in an industry; it imports another version (brand) of good in the same industry.
c. The example above referred to intraindustry trade.
d. Gains to Home from intraindustry trade
(1) Wider range of choice: Home consumers can now buy Foreign versions (brands).
(2) Possible lower prices on Foreign versions (brands).
(3) Possible higher profits to producers of Home brands due to cost savings; may be offset by competition from Foreign brands.
a. If there is a different capital-labor ratio and similar technologies, the type of trade will tend to be interindustry. If the capital-labor ratios are similar (and if there is monopolistic competition and especially if there are economies of scale), the pattern of trade will be intraindustry. The text says that intraindustry trade this is characteristic of manufactured goods and particularly of in EEC countries. The presence of intra-industry trade explains why trade in the EEC grew at twice the rate of world trade during the 1960s.
b. Example of intraindustry trade: U.S. and Canada in Automobiles, beginning in 1964 (Case study: p. 141)
B. Dumping
1. Economic definition: Dumping means that a firm charges a lower price for foreigners than for the home country. It is a form of price discrimination. From the viewpoint of Home firms, a Foreign firm that charges a lower price in Home than in Foreign appears to be engaging in "unfair competition."
2. A simple model of the profitability of dumping (figure 6-8)
a. Firm must be a price maker (monopolist) in its domestic market.
b. Firm can sell all it wants on the world market at the world market price (this implies that it is in a small country)
c. The world price is the firm's marginal opportunity cost of selling at home.
d. Firm maximizes profit by producing for the home market the quantity at which its marginal opportunity cost (world price) = home marginal revenue. This is point 2 in the graph.
e. Point 3 in the graph tells the price it should charge at home.
f. The remaining quantity is sold in the world market up to the point where the world price(Pfor) - marginal cost. This is point 1.
g. Note that the domestic price (Pdom) is higher than the world price (Pfor).
3. )Legal definition: selling at a price that is below the costs of production - an "unfair price" (case study - Antidumping as Protectionism)
a. Why a firm might sell at a loss:
(1) to break into a new market - i.e., to achieve brand recognition.
Skip Reciprocal Dumping: p. 146.
A. Theory of External Economies
1. Definition: see above
2. Reasons for external economies
a. Specialized suppliers of resources
b. Labor market pooling
c. Knowledge spillovers
3. Specialized suppliers: a large market makes it profitable for specialized suppliers to emerge
a. Examples: infrastructure firms (banking, international finance, specialists in export and import, advertising and marketing specialists); spinoff firms (research and development firms; producers or importers of specialized materials and equipment started by former employees who believe they can produce at a lower cost if they form a separate firm)
4. Labor market pooling: different firms use the same labor pool
a. Reasoning: because some firms want to be laying off workers while other firms want to be hiring, a large labor pool benefits both producers and workers.
5. Knowledge spillover
a. The text writes about the informal exchange of ideas at certain key, popular places where people socialize.
Skip External Economies and International Trade: p. 150-155
Chapter 7
A. Introduction
1. Types of factor movements (mobility)
a. Labor migration
b. Transfer of capital by international borrowing
(1) distinction between physical capital and money capital
(2) money capital transferred enables the receiving country to import physical capital and human capital
c. Transfers by multinational corporations
2. Greater political problems raised by international factor movements than by trade (this means that governments typically interfere with factor mobility more than they do with trade; we discuss interference with trade in chapters 8 and 9.
a. All countries have immigration restrictions
b. Most countries have laws against transfers of money in and out of the country
c. Most countries either have restrictions against or threaten restrictions against multinational corporations
B. A Model of Labor Mobility (p. 160)
1. Forms of economic integration
a. International trade of goods
b. International trade of factors of production
c. Immigration (emigration)
d. International financing of business (movements of financial capital due to a difference in domestic and foreign appraisals of the factors of production)
2. A one good model of international labor mobility
a. Why assume only one good? Because it allows us to isolate the factor mobility form of economic integration
b. Why assume only two factors: land and labor? Since land, by definition, cannot move, this will enable us to isolate the mobility of a factor as a form of economic integration. Thus, it enables us to disregard the other forms in order to focus specifically on labor mobility.
3. Using the marginal product of labor curve to show the distribution of income that results from production (appendix to chapter 3)
a. Total output (and income) as the area under the MPL curve
b. How to determine the distribution of the total output in a three factor model: figures 3A-2, 3A-3, and 3A4.
c. A one-good, two factor model of factor movements
d. Distribution of income in a two factor model (figure 7-2)
(1) Note that the model assumes that the market structure of the labor market is perfect competition
e. Cause and effects of international labor mobility (figure 7-3)
(1) The initial equilibrium
(2) Initial difference between MPL and the real wage rate in the two countries represents the incentive to exchange
(3) How mobility reduces that difference
(4) The distributional effects of factor mobility
4. Factor movements vs. trade in goods: discussion on p. 163-164
a. Assume no trade in factors and no capital movements
b. Is trade in consumers' goods a perfect substitute for international labor mobility? No because
(1) of barriers to trade
(2) different technologies
(3) extreme differences in natural resources
c. Could international labor mobility eliminate all potential gains from trade in goods? No because of substantial immigration barriers.
(1) cost of changing location
(2) legal barriers
C. International Money Capital Mobility
1. Meaning of capital flows: flow of money not physical capital
2. Borrowing and Lending
a. Three methods by which home firms can obtain foreign money capital (Note that foreign governments and individuals may also acquire foreign money capital. However, we are concerned here only with sources of financing for firms.)
(1) Domestic firms may borrow from foreign banks or individuals
(2) A domestic subsidiary (or parent) of a multinational corporation may obtain investment funds from its parent (or subsidiary)
(3) Corporations may issue stock which is bought by foreigners
b. The real interest rate as representing the tradeoff in a country between current consumption and future consumption.
(1) Tradeoff for an individual between current consumption and future consumption. The notion of time preference.
(2) Tradeoff for an isolated nation: the intertemporal production possibility frontier: figure 7-4.
(a) Compare two countries
(b) Note that the shape of the frontier depends partly on the age structure of the population.
(3) The real interest rate as the relative price of future consumption
(a) Difference between the nominal and real interest rate
(4) Representing pre-trade time preference by the equilibrium real interest rate: the slope of the production possibilities frontier.
(a) Production possibilities frontier of a country that is rich in present consumption (e.g., an oil rich country)
(b) Production possibilities frontier of a country that is poor in present consumption but has potential for producing much future consumption.
(5) Intertemporal comparative advantage and trade (top of p. 168)
(a) Note that the discussion does not use indifference curves to determine the relative price
(b) Facts: see the discussion on p. 168 and table 22-2 (p. 198). Also see the graph on p. 169. Now the explanation
3. Direct Foreign Investment
a. Definition: international capital flows in which a firm in one country creates or expands a sister firm in another
b. Two views of such activity
(1) the multinational corporation is an alternative to borrowing and lending for a domestic firm.
(2) the multinational corporation is a means for domestic firms to gain control over operations in foreign countries
(3) The text prefers the second view by pointing out that money often flows in the opposite direction -- i.e., from foreign subsidiaries to the parent corporation
c. Why multinational enterprises form (i.e., the theory of multinational enterprises)
(1) Two elements in the explanation: location theory and internalization.
(2) Location theory: why is the same good produced in different countries?
(a) transport costs (we discussed these in Salvatore -- ch. 6)
(b) other barriers to trade
(3) Internalization
(a) Two apparent reasons for the existence of multinationals
1.) Output of one operation in one country may be an input for another in another country
2.) Desire to extend the use of a particular technology beyond a nation's boundaries
3.) However, a multinational firm is not necessary to achieve these goals: inputs could be sold by a firm in one country to a different firm in another country. And a corporation in one country could sell or lease its technology to a corporation in another country. We must explain the multinational corporation by looking more deeply into problems that may arise (i.e. transactions costs) in such exchanges.
(b) Under these conditions trade in consumers goods would not remove all incentive to gain from trade because trade is not a perfect substitute for international factor movement. There are four reasons: (1) countries are sometimes too different in their resources to remain unspecialized; (2) there are barriers to trade, both natural and artificial; (3) to differences in technology; (4) and differences in
1.) Upstream firm may have a monopoly. By producing its own inputs in a different country, a multinational corporation can avoid paying monopoly prices.
2.) A multinational corporation may be able to avoid serious coordination problems between the supply of outputs and demands for inputs in a world of unexpected increases in supply and demand (uncertainty). In other words, communication of changes in demands and supply may be cheaper and quicker within the firm than they are among different firms in a market. Firms in a market must use market prices to communicate.
3.) The larger, multinational corporation is in a better position to pool risk
4.) Note: make sure that you know the definition of vertical integration
(c) Three problems with using markets to transfer technology (Why can't technology sometimes be bought and sold efficiently?)
1.) Technology may be embodied in individuals whose cannot be bought and sold
2.) A buyer cannot judge how much technology is worth because, by definition, he does not know it
3.) Property rights in knowledge are hard to establish
d. Issues
(1) Multinationals are a significant part of all industrialized nations; however, Japan is the exception: cultural obstacles and perhaps red tape.
(2) Are multinationals villains? Two points
(a) Much of the objection to multinational firms is due to the fact that foreigners are involved in influencing the domestic economy. However, multinationals are a substitute for trade between the corporations of different nations and for international capital flows. Thus, if there were no multinationals, it is likely that a country would still be influenced by foreigners. The only difference is that the influence would be less visible to the people. Economic integration necessarily entails some amount of foreign control of the domestic economy. If a country wants to be part of the international trading network, it must tolerate this.
(b) Much of the objection to multinational firms is due to the fact that some members of the society are visibly harmed by the operations of the firms. However, distributional effects within a country of a multinational corporation are similar to all distributional effects of international trade and international capital flows. Some gain and some lose. Thus, it is beside the point for particular groups to blame their losses on the multinationals. They should blame them on international trade and capital flows. But without international trade and capital flows (i.e., without economic integration, a country could not move beyond its own production possibilities boundary.
Chapter 8
A. The Theory of the Tariff
1. History of the tariff
a. Types of tariffs
(1) Specific tariff: fixed charge per unit of a good
(2) Ad valorem tariff: a percent of the value of the good
b. Purpose
(1) original purpose: to raise revenue
(2) new purpose: to protect particular domestic industries from international competition
c. Substitutes
(1) non-tariff barriers
(a) import quotas
(b) export restraints imposed by exporting country
2. Deriving the import demand curve and the export supply curve: Note: the model in chapter 4 in Salvatore assumed that you already knew how to do this. Figure 8-1, 8-2 and 8-3 (p. 188-90)
3. Effects of a tariff on price and quantity in two countries
a. How the tariff "drives a wedge" between the prices in the two markets.
b. Effects shown in figure 8-4 on p. 190-1.
c. How the magnitude of the effects depend on the elasticities of demand and supply.
d. The case of the perfectly elastic world supply; the text calls this the small country case (figure 8-5, p. 192
4. Measuring the amount of protection
a. Usual method: measuring the percent change in price.
b. Problems of measuring protection:
(1) One effect of a tariff may be to lower foreign export prices (the large country)
(2) If firms in a country must import factors of production, the effective rate of protection should be calculated on a percent of value-added basis, not a percent of price basis.(example on p. 192-193)
(3) The tariff may be on a factor of production, in which case it
(a) provides positive protection for the producers of the factors.
(b) provides negative protection for the producers of the final product.(example on p. 193)
5. Costs and benefits of the tariff
a. The concepts of consumer and producer surplus: figures 8-6, 8-7, 8-8)
b. Showing the gains and losses to consumers, producers, and government (figure 8-9): concepts
(1) efficiency loss = production distortion loss + consumption distortion loss
(2) terms of trade gain: only arises when the tariff reduces foreign export prices
(3) summary of effects: figure 8-10
B. Other Instruments of Trade Policy
1. Export subsidy
a. Effects on price and quantity
b. Production and consumption distortion loss, net welfare loss (figure 8-11)
2. Import quota
a. Note that the effects on price and quantity are the same as a tariff that raises the price to the same level.(show graphically, beginning with figure 8-10)
b. Difference: the tariff revenue is not received; instead quota rents go to the licensed firms.
3. Voluntary export restraints (VER): a quota imposed by the exporter, usually as a result of a trade agreement with the government of the importing country
a. Like an import quota, except that the quota rents are collected by either the foreign companies or by a foreign government that auctions off the licenses
b. VER's yield even a greater welfare loss than import quotas to the nation as a whole.
4. Local content requirements: requires some fraction of quantity or value of a good to be locally produced
a. Effects on producers of factors of production
b. Effects on producers of the product: effective price of inputs is an average of the prices of the lower-priced foreign-produced factor and the higher-priced domestically-produced factor
c. Does not produce either government revenue or quota rents
5. Others
a. Export credit subsidies: Export-Import Bank: the domestic government makes a low interest loan to a foreign buyer of a domestically-produced good.
b. National procurement: Government organizations or regulated firms are required to buy only from domestic firms. Example of government telecommunications
c. Red-tape barriers: use of health and safety standards or customs procedures to raise the costs to foreign suppliers
C. Case Studies
1. Europe's common agriculture policy
a. Two parts
(1) remove all tariffs in Europe
(2) massive export subsidy program
b. History of the program
(1) price support program (backed by tariffs to prevent imports)
(2) this changed to an export subsidy program (see figure 8 -12)
2. U.S. sugar import quota
a. price support program (backed by import quotas to prevent too many imports)
b. rights to sell sugar to U.S. importers are assigned to foreign governments
c. show the welfare effects (figure 8-13)
3. Voluntary export restraints of Japanese autos
a. Effects: as described above
b. Three complications:
(1) Japanese cars not perfect substitutes
(2) Japanese improved quality as a substitute for quantity
(3) Auto industry is not perfectly competitive
4. The Hungarian bus company case
Chapter 9
A. The Case for Free Trade: Three (or Four) Arguments in Favor of Free Trade
1. The efficiency case for free trade: figure 9-1.
2. Dynamic gains from free trade
a. Economies of scale. Because protected markets lead to production by many firms instead of just a few, the economies of scale are higher under free trade.
b. Greater incentive for learning and innovation. Under "managed trade" the government typically dictates the pattern of exports. Under free trade, entrepreneurs must find out for themselves which exports are most profitable.
3. Political Argument
a. The government trade managers who decide which exports will be protected or subsidized may be "captured" by interest groups. Instead of promoting exports that are likely to benefit the country in the long run (assuming that the government officials can identify them), the trade managers will respond to persuasion, bribes, or other pressures that have nothing to do with long run efficiency goals. The result will be inefficiency.
B. National Welfare Arguments Against Free Trade
1. The terms of trade argument for a tariff: refer to figure 9A-2 on p. 252
a. The concept of an optimum tariff. Note that this is only relevant for a large country. In this case, a large country refers to a country whose producers produce a large share of the total output of some commodity. Why? The large country can cause the world price to rise.
b. The optimum export subsidy. Note again that this is only relevant for a large country. Why? The large country can cause the world price to fall.
c. Problems
(1) A country may be geographically large but its firms may not have monopolistic or monopsonistic power
(2) Even if a large country has monopolistic or monopsonistic power, other "large countries" may retaliate, since the gains to the first country come at the expense of the people in the second country.
2. The domestic market failure argument against free trade
a. Market failures:
(1) monopoly
(2) externality
b. The gains from reducing the losses (the textbook calls these the marginal social benefit) due to a market failure exceed the losses due to trade intervention. Note that figure 9-3 is for the case of a "small country"
c. Problems (defense of free trade against the domestic market failure argument)
(1) Direct domestic policies to correct for the market failure may be superior to a trade intervention policy. The two types of policies should be compared.
(2) Market failures are hard to identify
(3) Political argument: the government trade managers may be "captured" by special interests. See above.
Skip p. 230-4 on "Income Distribution and Trade Policy
A. International Negotiations and Trade Policy
1. Why international negotiation is a means of moving a nation toward a free trade policy
a. International negotiations provide an incentive for domestic exporters to be a counter force to the special interests who benefit from restrictions on (barriers to) trade.
b. International negotiations can help avoid a trade war
(1) The prisoner's dilemma situation (table 9-2)
(2) Note that the payoffs in the table refer to the payoffs to the nation's trade managers and probably do not refer to the benefits to the nation as a whole
B. History of International Trade Agreements
1. Postwar (World War 2) agreements
2. GATT (General Agreement on Tariffs and Trade)
a. Main constraints place on members
(1) no export subsidies, except for agriculture
(2) no import quotas, except when imports threaten "market disruption"
(3) new tariff must be offset by compensating reductions in other tariffs
b. Results of the 1986-1994 Uruguay Round
(1) trade liberalization
(a) reduce tariffs on most goods
(b) reduce agricultural subsidies; replace all quotas with subsidies
(c) eliminate all quantitative restrictions (quotas) on textiles
(d) new rules opening government purchases to foreign competition.
(2) administrative reforms
(a) replaced GATT (an agreement) with WTO (an organization)
(b) set up DSU (Dispute Settlement Understanding) to resolve disputes in a shorter period of time and gave countries the right to retaliate against countries who fail to follow the judgments in dispute settlements.
(c) set framework to liberalize services.
c. Preferential Trading Agreements
(1) definition: tariffs of countries applying to each others' products are lower than the tariffs imposed on the products of other countries.
(2) status: outlawed under GATT with one exception -- tariffs must be zero for the countries making the agreement.
(3) two cases
(a) free trade area: free trade between the countries within the area; tariffs on goods produced by countries outside the area are set independently by each member of the area. Example: North American Free Trade Agreement (NAFTA)
(b) customs union: free trade between the countries within the area; tariffs on goods produced by countries outside the area are set jointly and each member must impose the same tariff. Example: European Union (EU)
(c) note that a country can be worse off if it joins a customs union if the tariffs set by the union are higher than the tariffs that it would have otherwise set on other countries' products.
(4) trade creation: the new trade created when a joins a customs union.
(5) trade diversion: the trade that is diverted from outsiders to insiders when a country joins a custom union.
Chapter 10
A. Import-Substituting Industrialization
1. Initial ideas
a. Definition of import-substituting industrialization: In order to industrialize and develop, a less developed country must gradually substitute its own production of goods for the goods that it currently imports, particularly in manufacturing.
b. A related idea is the goal of self-sufficiency. This is the idea that a nation should attempt to produce all of the goods it wants within its own boundaries. This is just the opposite of trade based on comparative advantage. Self-sufficiency is sensible only if there is no comparative advantage. Thus, if a country is successful in achieving the goal of self-sufficiency, it will also wipe out all comparative advantages.
2. The infant industry argument for protecting certain firms or industries from international competition
a. The argument: Although firms in developing countries have the potential for removing a comparative disadvantage, they cannot at first compete successfully with well-established firms in other nations. Therefore tariffs, import quotas, and other protectionist measures should be used to temporarily protect the firms from foreign competition. (The textbook applies this argument to manufacturing.)
b. The metaphor: Note that the argument is a metaphor. We know that infants need protection to grow into adults. The argument assumes that a new firm in a less developed country is like an infant. However, the owners of firms are not infants. They may be smart local, or possibly even international, investors.
c. Textbook discussion of the infant industry argument
(1) Infants that are born dead. Instead of being treated as an "healthy, growing infant," a firm seeking help by claiming that it is an infant should be treated as an infant that was born dead. It should be buried rather than protected..
(2) Pseudo infants: Even if a protected firm seems to develop into a healthy adult firm, it may have done so without the protection. Thus, even though there appear to be some successes, these do not prove that the argument is correct
(3) False analogy: unlike infants, firms can be bought and sold by capitalists. If a firm has potential for profit, we would expect the following. If a current owner underestimates its growth potential, he will sell it to another capitalist who estimates its growth potential more correctly.
d. Market failure arguments for protecting infant industries.
(1) Imperfect capital markets
(a) People with capital, including foreigners, have no efficient way of finding out about a firm's profitability or no way of protecting their investment.
(b) First-best policy is to create a better capital market.
(2) Appropriability Argument (appropriability roughly means ownership)
(a) The infant firm causes other benefits for which it cannot charge a price.
(b) First-best policy is for the government to reward the firm directly for its non-appropriable benefits
3. Import substituting industrialization vs. export promotion
a. Why there is a tradeoff
b. Reasons why governments pursued import substitution policies
(1) The belief that every country should follow the same pattern. Whatever is produced in the industrialized countries ought to be produced at home.
(2) Benefits to interest groups who already produced the goods; no interest groups represented future export goods producers
(3) Belief that firms from developing countries would not be treated fairly
(a) governments from other nations would not give firms a fair chance to enter their markets
(b) existing foreign firms would try to drive them out of business
c. Positive results: many countries developed highly protected manufacturing firms and manufacturing as a per cent of GDP rose in most countries. Exports also remained only at moderate levels. However, this was achieved at the expense of continuing high import barriers.
d. Negative results: countries did not achieve significant development. The reasons are
(1) lack of skilled labor, entrepreneurship, and managerial competence, along with lack of social organization meant that infant industries could not succeed in the long run, even with help. Thus firms remained inefficient, although they were able to sell their products domestically because of the high trade barriers.
(2) the high cost of the protection
(a) countries have used complex and inefficient methods of protection instead of a simple tariff
(b) production has occurred on an inefficiently small scale
(c) protectionist growth encouraged labor unions, which (a) raised wages further and (b) put further pressure on governments to protect the companies from competition to protect union jobs. This created a dual economy.
2. Dual Economy
a. Definition: an economy in which a high-wage industrial sector exists alongside a low-wage farm sector. Note that this is not a precise definition
b. Relevance of dualism to international trade
(1) the presence of dualism probably means that markets are not working properly
(2) dualism might be caused by a nation's trade policy
c. Improperly working markets
(1) The wage differentials argument for encouraging growth in industrial at the expense of growth in farming
(a) argument: since industry pays high wages and farm pays low wages, a government-promoted shift of a worker from farm to industry will raise overall wages.
(b) counter arguments
1.) The first best policy is to remove the barriers to labor's movement from the farm to the industrial sector
2.) The Harris and Todaro argument that helping the industrial sector would cause greater unemployment as more workers moved from the farm to the cities in a gamble to get one of the few high paying industrial jobs.
3. Trade policy as a cause of the dual economy
a. Trade policy may help cause a dual economy if the policy also supports unionization of the industrial sectors.
b. Are the relatively high wages paid in the industrial sector due to unions or are they "efficiency wages?"
B. The East Asian Miracle
1. Facts of Asian Growth
a. Three sets of countries
(1) Japan
(2) Hong Kong, South Korea, Singapore, and Taiwan
(3) Thailand, Malaysian, Indonesia, China
b. Growth rates: 5-10% per year over several years
c. Openness to trade: relative to the export-substitution countries, they are very open to trade
2. Theories about the reasons for growth
a. Outward-oriented trade policy theory
(1) The theory: because these developing countries were more open to trade than others, they grew faster
(2) Question: correlation does not necessarily mean correlation. Perhaps they grew for other reasons. If freer trade policies played a role, perhaps the role was not so large
b. The industrial policy theory
(1) The theory: development was the payoff to sophisticated government industrial policies, which identified favored "strategic" industries and targeted them over other industries for special subsidies and other advantages
(2) Question: Although these countries did indeed employ industrial policies,
(a) the policies differed from country to country
(b) World Bank study found little evidence of causation
(c) There have been notable failures
c. Cultural theory (other factors)
(1) The theory: development was caused by high savings rates (which implies high rates of domestic investment) and high levels of public education. When governments established private property rights and gave the people security in their wealth, they became industrious. Each man set out to build his own dynasty or empire for his family.
(2) Question: the theory is controversial