Absolute Advantage-make more.  Opportunity cost.  Inside PPF-under civilization.   Opportunity cost is constant if it is a straight line.  Slope of trade line=price they chose to trade at Gains from trade=outside PPF.  Comparative Advantage-opportunity cost, who can do it cheaper.  Producing on PPF, consuming outside.  Not a zero-sum.  Person max. Their material well-being when they use their resources where they.  Trade doesn’t imply their living standards or income are equal.  Income increases for people with increased absolute advantage without trade.

GATT: General Agreement on Tariffs and Trade.  Agreement, not an institution.  Signed in 1947 by 23 nations.  Very successful in lowering trade barriers.  Initially mention all ignored agriculture, textiles, approached services.  Replaced by WTO in 1986The Uruguay Round 1986-1993Most ambitious round that reformed tariffs and subsidies on agricultural textiles, sensitive areas.  Birth to WTO.  Extended trading system into intellectual property rights and services


World Trade Organization: The purpose of this organization was to help trade flow freely.  Deals with rules of trade between nations at global near global level.  A negotiating forum.  A set of rules.  A place to settle disputes.  Trade without discrimination.  Most favored nation-give you have to equal treatment to everyone.  National Treatment-once something is in the country, you may have to treat it just like your own stuff.  Freer trade gradually through negotiation.  Predictability through binding and transparently.  Lowers risks.  Confident that barriers aren’t going to change.  Promoting fair competition.  Encourage development and economic reform.  Extending transition time to developing.Current Members of WTO

International Monetary Fund (IMF): Monitors world’s economies, lends to members in economic difficulty, and provides technical assistance.  It is made up of 186 member countries.  The money comes from membership fee (quota) the larger a country’s output and trade, the larger its quota.  US largest quota.  257 has to be a major currency, 757 can be a small currency.  Power depends on your country’s economy and the big guys have a lot of power.  Only helps countries by invitation.  Charges interest.  Conditionality-we’ll give you $, but you have to make changes.  New since 1980’s World Bank: Consists of 187 country membership.  There is a membership quota with a source of financial and technical assistance to developing countries around the world.  Not a bank in the common sense, but a Helper with low interest loans, international free credits, and grants to developing countries.

5 Types of Regional Trade Agreements:

  1. Partial Trade Agreement: 2 or more countries liberalize trade in a selected group of product categories such as steel or autos.
  2. Free Trade Area (FTA)-Trade with specific region (NAFTA).
  3. Customs Union (CU):  An FTA plus a common external tariff (CET).  European Union in 1970’s and 1980’s.  MERCOSUR (South America).
  4. Common Market: A CU plus free mobility of factors of production.  EU in 1990’s.  ESA (Eastern and Southern Africa).
  5. Economic Union: A common market with coordination of macroeconomic policies including common currency, harmonization of standards and regulations.  Includes US, Canada, and EU.

RTA v. the WTO

An RTA is clearly a violation of most favored nation treatment.  So why would WTO allow an RTA?  Simple.  If it creates more trade than it diverts, the WTO isn’t going to care about it.  RTA’s-building blocks vs. stumbling blocks can create easier to reach agreement, Less domestic disruption, Experiment with new ideas, Credible threats.  Yet it undermines multilateral agreements, Polarize countries-piss people off, Sap energy, Discriminate against less-developed countries.  These International Instituions help to create order, Reduce uncertainty, Overcome free-rider program, Effectiveness ultimately depends on individual commitment.  Its cons are National sovereignty, Transparency, Ideology, and Symmetric implementation and adjustment cases.

Gains from trade: Adam Smith observed that increasing specialization in production was responsible for increased output. David Richards would in turn say trade is good for both parties, Theory of free trade and demonstrated the gains, From trade: one of the longest-standing and most agreed upon results in economies.  The Basic Assumptions would then be made to set the stage.  Only 2 nations, Only 2 goods, Only one input-labor, Technology is constant, No learning effects of production, Labor is perfectly mobile and can move back and forth between the industries, but not between countries.  If labor and capitalization become concentrated in that activity alone.  Difficult to develop a diversified and highly educated force.  National Income can fluctuate quality if commodity.  Price abruptly-leads to secure macroeconomic activity.  Can be a significant source of potential instability and corruption.  To avoid curse Strong institutions to guard against corruption.  Can be a significant source of potential instability and corruption.  Commitment to education and skills to develop human capital and diversify.

Shortcomings of the Riparian Model:

  1. It predicts an extreme degree of specialization that we do not observe in the real world
  2. Assumes away the effects of trade on distribution of income within countries
  3. Allows no role for diff. in resources among countries as a cause for trade
  4. Neglects the possible role of economies of scale as a cause for trade

Empirical evidence.  The basic prediction of the Ricardian Model-that countries should tend to export those goods in which their productivity is high-has been strongly confirmed by a number of studies over the year.  Higher productivity-export more.

New Theory of Trade

Ricardian Model-Smith and Ricardo believed productivity differences-and hence comparative advantage-war a result of each country’s new technology.  Ricardo considered a single homogeneous factor of production (labor) and would not have been able to produce comparative advantage with out technology difference in labor.  Activity using different technologies

Factor Endowments: Nations are endowed with different levels of factor inputs (land, labor, capital, and entrepreneurship)  What is the role of factor endowments motivating trade?  Hecksher-chain model of trade.  Founder of the modern theory of international trade.  Key difference: based on a country’s comparative advantage on its factor endowments, rather than differences in technology

H-O Theorem: Countries will export products that utilize their abundant and cheap factors of production and import products that utilize true countries factors.  Countries comparative advantage uses in the production of goods that intensively use relatively abundant factors.  For example, U.S. has a lot of land, true produce corn, etc. they have a comparative advantage in canola oil because of their endowments (not their labor).  Once this is determined, it should be possible to predict which goods they’ll export and import.  Relative abundance of a factor implies that in autarky its relative cost is less than in countries where it is relatively scarcer.  Relatively scarce resources are more expensive

Price Convergence: In autarky: Canada provides relatively more jeans because it has relatively more labor.  The relative price of jeans will be less.  The relative price of jeans will higher in the U.S.  As trade occurs, the world price of jeans will converge Graph.  The HO model provides a more sophisticated way to analyze gains and losses from trade because it drops unrealistic assumptions.  Labor can be divided into categories of different skill levels.  Other types of inputs can be included.  Industries can require different mixes of various inputs.  Advantages: Drops unrealistic assumptions.  Labor can be divided into different skill levels.  More than one input.  Varying input requirements for different goals resulting in different allocation of benefits among producers.  Displays systematic relationship between factor endowments in a country and winners/losers of trade.

Income Distribution effects of Trade

Trade produces a convergence of relative prices.  Change in relative prices have a strong effect on relative earnings of input factors.  In Canada, where $ of jeans rises, people will get their income from labor gain from trade, and those who get….

Stopler-Samuelsom Theorem

Owner’s of a country’s abundant factors gain from trade but owners of a country’s scarce factors lose.  Theorem: An increase in price of good raises the income earned by factors that are used intensively in its production.  Not every factor used in production, but the abundant factor.  Ultimate effects on income of an opening of trade depend on flexibility of affected factors

Specific Factors Model. ¬†Factors of production that are ‚Äústuck‚ÄĚ in an industry, at least temporarily, are referred to as specific factors. ¬†Ex: -commodities is bread and steal. ¬†Factors are land, labor, and capital. ¬†Bread requires land and labor. ¬†Steel requires capital and labor. ¬†Land and capital are specific factors in the short run are immobile. ¬†Labor is a variable factor and is mobile between industries. ¬†Suppose the introduction of trade leads to a drop in the price of steel (capital and labor). ¬†In the long run: landowners gain and capital owners lose. ¬†In the short run:¬†Since land is immobile, landowners whose land is used for steel production will be hurt. ¬†Since capital is immobile, capital owners whose capital is used for bread will gain

Policy Implications: Most economists don’t regard the effects of trade on income distribution as a good reason to limit trade.  In its distribution effects, trade is no different from many other forms of economic change, which are not normally regulated.  Economists would rather address the problem of Income Distribution directly; rather than by interfering with trade flows.  But is a highly contested issue.  Those who lose from trade are usually more informed, cohesive, and organized

Empirical Evidence

Tests on US Data: Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is the most capital-abundant country in the world Leontief Paradox.  He suggests that the U.S. comparative advantage is actually high in skilled labor, rather than the traditional idea of capital.  Tests on global data: Bowen, Leamer.  Implications:  While the HO model has been less successful at explaining the actual patterns of trade, it remains vital for understanding the effects of trade, especially its effects on the distribution of income

Why is Comparative Advantage not enough?  Trade models built exclusively on the idea of Comparative advantage have a mixed record of success in predicting trade patterns.  It’s very difficult to measure a country’s Comparative advantage.  Even if the Comparative advantage is known, the country may have several products to choose from which utilize the abundant factor.

Internal Economies of Scale (Ex: Electrical Utility)

Both of the previous models assumed constant returns to scale: When inputs doubled, outputs also doubled.  In practice, many industries are characterized by economies of scale: Production is more efficient the larger the scale at which it takes place.  Doubling inputs more than doubles output.  Decreasing costs over a relatively large range of output.  Economies of scale can be a source of comparative advantage.

Marginal Cost (MC)-how much more to produce 1 more

Average Cost (AC)-Total Costs/# of units


Outsourcing-another firm does part of the other company’s business.  Off shoring-same company, outside of the U.S.  Off shoring and Outsourcing-Different company outside of the U.S.  Off-shoring became a concern in the 1980’s.  Modern communications and transportation technology made it possible for firms to relocate production abroad.  The effects and extent of off-shoring are not well understood since most countries do not collect the necessary types of data motivation.  Trade in services should be no different from trade in goods.  Specialization and trade should provide the same or similar gains for services as they do for goods.  Conventional wisdom: firms relocate abroad in order to find low wages or escape environmental/labor regulations.

Concerns: Effect off-shoring has on home country, particularly on jobs. Possibilities: Job losses in the home country or at other times.  Evidence: Most firms locate production offshore in order to obtain access to a market and to produce specialized products that fit a particular market’s need contrary to conventional wisdom that says firms relocate abroad in order to find low wages or escape environmental/labor regulations.  Conventional wisdom in not wrong but describes only a small share of off shoring.  Vast majority of off-shoring by U.S. multinationals is in high-income, high-wage economies (67% overall and 80% manufacturing).  Additionally, most off shoring is…Graph.  Monopoly has no incentive to drop price.  Internal-8 per unit depends on size of firm.  External-size of industry but not on the size of any 1 firm:If America A concentrates production in Industry A, it will need more labor: That labor will have to come from a industry B.  Industry B will have to decrease or stop production.

Where does trade enter?  Consumers still want a variety of goods.  British can shift labor form its dominant industry A to industry B.  Each country must concentrate on producing only a limited number of goods.  International trade makes it possible for each country to produce a restricted range of goods and take edge econ of Q without sacrificing variety in consumption.  Graph  However….Economies of scale lead to a market structure other than that of perfect competition.  Internal economies of scale giver larger firs a cost.

Theory of Imperfect Competition: Firms are aware they can influence the prices of their price setters

Monopolistic competition: Assumptions: Each firm differentiates its products from rivals.  Gives each firm differentiates its products from rivals.  Insulates each firm somewhat from competition.  Takes rivals: price as given (they can’t influence it-changing their price doesn’t change rival’s price).  Ex, possibly automotive industry in Europe Ford, GM, VW, REANAULT, VELVO.  Limitation: few industries well described by MC

Equilibrium in MC

The more firms there are the more intensely they compete, and the lower industry price (PP).  Less each firm sells, higher their costs (CC)

MC and Trade

In industries with economies of scale, market size matters because market size constraints the variety of goods that a country can produce and scarce of its production.  Trade forms an integrated market bigger than any individual market and loosens constraints.  Trade=opportunity for gain even if countries don’t differ in technology (Ricardo) or resources.

Increased Market Size.  Number of firms in MC industry the prices they charge are affected by the size of the market.  Larger markets lead to: more firms, more sales to firms, move a variety of products, lower prices, but it is unclear it firms will locate in domestic country or foreign country.  Trade allows us to have a huge variety in our lives.  An increase in size of market allows each firm to produce more and have lower AC.  Downward shift of CC.  Leads to more firms, more variety, lower price.  Possibility to increase whole market.

EOS and Comparative Advantage

Results:Gains from inter industry trade reflect comparative advantage.  Gains from intra industry trade reflect economies of scale (lower costs) and wider consumer choices

The monopolistic competition model does not predict in which country firms locate, but a good comparative advantage in producing differentiated good will likely cause country to export more of that good than it imports

How important intra-industry trade is depends on similarities of: Countries with similar relative amounts of factors of production are predicted to have intra industry trade.  Different relative amounts of FDP interindustry unlike interdinustry trade on H-O model, income distribution effects are not predicted to occur with intra-industry trade.  25 % of world trade is intra-industry trade.  Some industries are=more than others.  Industries requiring skilled labor, technology, and physical capital-intra industry trade for US.

Grubel-lloYD Index

The broader the definition of an industry, the more trade appears to be intraindustry trade

GLi=1-! X-M! /X+M

Closer to 1:a lot of intra

Closer to 0: little number of intra

The are many benefits of intra-industry trade.  Export/import prices lower because firms can lower their costs by producing for a larger market.  In previous models, import prices decrease but export prices increase.  Also the number of firms increases, so employment increases.  Could be in either country, however.  Consumer choice increases.  Fewer income redistribution effects

Dumping is a¬†consequence of imperfect competition. ¬†It is beneficial to firms because of monopolistic competition. ¬†Why would you sell to foreign more? ¬†Because they can differentiate the price. ¬†An incentive means a higher marginal revenue. ¬†Because higher domestic market that foreign (typically) because international markets are imperfectly integrated due to both transportation costs and protectionist trade barriers. ¬†Means foreign sales are more affected by their pricing than domestic sales. ¬†Firms have less monetary power in foreign markets. ¬†Economies of scale to lead to increase of international trade, lead to imperfect competition. ¬†Imperfect competition has consequences for international trade. ¬†Most striking result: firms do not necessarily charge same price for goods that are exported and those that are sold to domestic buyers. ¬†Dumping is when a foreign country selling goods in another country for below cost. ¬†Example of price discrimination-different customers, different prices. ¬†Controversial issue in trade policy. ¬†Widely regarded as ‚Äúunfair‚ÄĚ. ¬†Subject to special rules and penalties

Price Discrimination and dumping may occur if Imperfect competition exists: firms must be able to set market prices rather than take them as given

International economics is divided into two broad subfields: international trade and international money.¬† Transactions that involve the physical movement of goods or a tangible commitment of resources are the domain of international trade analysis. ¬†In 2005, total world imports were estimated to be 20.5 % of world gross domestic product (GDP). ¬†The current process of increasing economic integration among national economies, better known as globalization, is actually the world‚Äôs second wave of such integration.¬† Examples in international factor movement: Direct foreign investment, labor migration, international borrowing and lending.¬† The measures economists examine to assess the degree of globalization and international economic integration: similarity of prices in separate markets, factor movements, and trade flows.¬† The U.S. economy today appears more integrated with the world economy as signified by its increased index of openness.¬† An indicator that today the U.S. Economy is less integrated with the world than it was a century ago is its reduced proportion of foreign-born citizens.¬† ‚ÄúOpenness‚ÄĚ is the relative importance of trade to a national economy; (Exports + Imports)/GDP.¬† Small countries tend to be more open than the larger countries.¬† Three kinds of evidence that economists use to support the assertion that open economies grow faster than economies that are close to the world economy:

1)   Evidence of statistical comparison of countries-statistical tests of the relationship between trade policy and economic growth yield results that consistently show that more open economies grow more rapidly

2)   Casual empirical evidence of historical experience-countries with the same background that were divided by the war indicate that those who closed their economies from the rest of the world suffered

3)   Economic logic and deductive reasoning-Open trade fosters competition, innovation, and learning by doing and brings international best practices to the attention of domestic producers, spurring greater efficiency, export expansion, and economic growth

4)   Current day trade different than earlier trade: the share of manufacturing trade has risen, while the share of agricultural trade has fallen and the fraction of current international trade is organized and conducted by multinational firms has grown since 1950

Industrial Policy is a government policy assigned to create/support an industry.  Many have come not to believe in this policy, but their are justifications for this reason.

Market Failure=when market fails to deliver an optimal quantity of goods and services

  • The value of a good to private consumers (private returns) and to society (social returns) fails to equal to its cost of production
  • Not all costs/benefits of an activity, some are externalized-outside area of concern of economic agents engaged in activity
  • Externalities-market failure that results from externalization of costs of benefits

Government needs to step in: all costs of regulation

When social returns > private returns, free-market economy produces less than optimal amount

  • Not all benefits are captured by the firm, so they are not included when making production decision

When social returns < private returns, a free-market economy produces more than optimal outputs

Ex: positive externality: live next door to orchestra

  • Either too much negative is produced or not enough positive is produced


Justification 2

Strategic Trade Policy

  • Selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms

Requires that: industry has economies of scale, firms in industry have market power

  • Tries to convince foreign firms to leave the market
  • Game theory:

The importance of Industrial Policy tools is one that has become ever present in today’s global economy.

The Uruguay round and WTO prohibit direct subsidies. ¬†However they can subsidize ‚Äúpre-competitive‚ÄĚ activities (like research).

Governments can use other policies.  Providing info about foreign markets to domestic firms.  Helping negotiate contracts.  Lobbying foreign governments to adept to home country standards.  Trying foreign aid to purchases from domestic firms.  Also seen: discounted foreign currency, low-interest plans, special tax treatment, government purchases.

High Performance Asian Economies (HPAE)

  • Economic growth in Japan took off in 1950‚Äôs
  • Shortly after growth in: 4 tigers-Hong Kong, Singapore, South Korea and Taiwan
  • Indonesia, Malaysia, and Thailand-classified as newly industrial countries

Asian Miracle:

World Bank: designated them high performance, as Econ (HPAE) newly industrializing haven’t quite caught up

Asia=variations in size, range in growth rates, different urbanization percentages

What characteristic is true to explain the growth?

HPAE Income convergence.  We still haven’t figured out why countries are growing.

4 reasons=common to all 8 economies

  1. Shared Growth-entire country benefited ‚Äúshare the wealth‚ÄĚ
  2. Rapid Accumulation of Physical and Human Capital
  3. Rapid Growth of manufactured exports
  4. Stable macroeconomic environments
  5. Open Economies

Latin American contrast: Far less impressive results.  High levels of inequality.  Periods of macroeconomic instability.  Inward orientation: closed economy

  1. Shared Growth.  Inequality of income and growth already low at start of period of high growth.  Kuznet’s curve=growth in developing countries=result first in falling and then if world grows.  Didn’t happen in HPAE.  Wealth sharing mechanism. Land Reform.  Free public education.  Free basic health care.  Significant investments in rural infrastructures (clean water, transportation, communication).  Could spread wealth to outlying areas.  Rural areas could start their own businesses and have better lives.
  1. Rapid Accumulation of Physical/Human Capital
  • High levels of investment=high savings rates

The level of savings in HPAE Birth rates/death rates decrease:

  • Less children
  • Higher % of population: working
  • High savings=Higher savings rate
  • Rapid rate of income growth
  • Low inflation
  • Public investment in education: primary and secondary levels
  • Social impact=much greater at this level than at university level
  • Literacy rates rose dramatically: skilled labor force
  • High skilled workforce capable of sophisticated forms of production
  1. Rapid Growth of Manufactured Exports
  • HPAE began development push with import substitution policies (domestic instead)
  • These policies quickly replaced with emphasis on export promotion
  • Between 1985 and 2000 the HPAE more than doubled their share of total world exports

8 countries=1/5 of world exports

  1. Stable Macroenvironment environment

A persistent problem of Latin America has been frequent reoccurrence of macroeconomic crises.  The HPAE are not completely crises free, but policy responses were usually give quick and appropriate.  Kept deficits and debts manageable.  High exports generated foreign assets.  Governments created rules that foster efficient outcome to ensure that individuals and business use their resources in most productive manner.

What makes Government policies credible?

-Property rights: It’s mine until I sell it.

-Competent bureaucracies: It’s easy to do business.  US when she worked in Russia.

-Freedom to make contracts that will be enforced: Enter into wage agreement that won’t break and widespread access to information.

Regulations everyone knows and understands

Clear and well-publicized regulations

Several of HPAE do no support political/civil liberties.  However, authoritarian HPAE did foster growth.

Fiscal Discipline

  • Maintenance of stable macroeconomic environment requires:

-Fiscal discipline, stable exchange rates

-Governments provided stable environments for good business platforms

Were the East Asian Economies Open?  HPAE placed high reliance on their export sectors through active promotion.  Were their trade policies open?: Considering tariff rates/quotas=not enough.

The Role of Industrial Policies

Targeting at specific industries

Directed credit-low international loans are common in HPAE.

Export Promotion

Specific Industries

  • An attempt to change comparative advantage by channeling resources to favored industries

They were strongest in: Japan (steel, airbus, textiles, shipbuilding) SATS, Korea (heavy and chemical industries), and Taiwan (research institutes, science parts, import subs).  Import restrictions, licensing, quotas, tariffs, export subsidies.  Many firms earned high profits domestically, compensating for losses in international markets.

Directed Credit: Signaled the private sector of a favored government industry.  It encouraged private lending to new and risky industries (Not handling over money).  Government placed macroeconomic stability above industrial policies-programs scaled back if fiscal problems arose.  Really had to perform-take government $, use it, become efficient producer, get stuff out the door and out the country.  If government starts running out of money, programs are cut off so countries don’t go into huge amount of debt.

Did the policies Work?  There was no consensus.  The World Bank says general industrial policies did not foster growth  They do agree that if industrial policies are going to be successful, countries must have:

  1. Clear performance criteria (live targets)
  2. Mechanism to monitor and enforce compliance
  3. Low costs so that non-targeted sectors do not suffer

Source for HPAE Growth can be seen in east Asia.  East Asia is remarkable for its growth in per capita income and labor productivity.  Growth comes from more capital, education, productive use of available resources.Growth Accounting:  Increase Real GDP/Capita Increase Aggregate Production Increase labor productivity Increase Capital Increase Human Capital Increase Technology.  Most of their growth coming from capital accumulation.


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