Egb Notes 1 [Trade]

5/28/2018 Egb Notes 1 [Trade]

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Adam Smiths Theory of Absolute AdvantageA country has an absolute advantageover another country in the production of a good when it requires fewer labor hours toproduce that good than the other country.

David Ricardos Theory of Comparative AdvantageA country has a comparative

advantage over another country in the production of certain goods when the ratio ofproducing Good A and Good B is more favorable to Good A, and vice versa (Good B >Good A) for the second country. This is regardless of which country has absoluteadvantage.

- Arguments of Increasing Marginal Cost: Ricardian Economic Theory assumesthat marginal cost remains constant regardless of however many units of agood is produced.

o However, more realistically is theargument of increasing marginal costs,that as one industry expands at theexpense of another, the opportunity cost

in expanding that industry increases.That is, as one industry expands,increasing amounts of units of the otherindustrys products must be given up toget each extra unit of the expandingindustrys product.

o Assumption of increasing marginalcosts results in a bowed productionprobability curve.


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Community Indifference Curves- Without trade, an economy will tend to default to autarky equilibrium, where

the ratio between two goods demanded/supplied by the domestic economymatches the relative price ratio between the two goods (price being a definedloosely as labor hours).

-

Under free trade between two countries, the equilibrium price ratio is thatwhich is tangential to the community PPCs of both countries. The preexisting,respective indifference curves of each country becomes tangential to this newequilibrium price ratio (rather than the autarky price ratio equilibrium),leading to a higher indifference curve and, thus, greater utility.


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Winners and Losers in Trade (Pugel Chpt 5)Heckscher-Ohlin Theory

- A theory that postulates that a country will export products that use itsrelatively abundant factors intensively and import products that use its

relatively scarce factors intensively.

Stopler-Samuelson Theorem

- An event that changes relative product prices (e.g. an autarky opening up tofree trade):

o Increases the real returns to the factor used intensively in the rising-price industry (in the example of opening to free trade, this can be theexport-oriented sector or the industry for whom factors of productionsare relatively abundant in their country)

o Decreases the real returns to the factor used intensively in the falling-price industry (in the example of opening to free trade, this can be the

import-oriented sector or the industry for whom factors of productionare relatively scarce in their country)- This occurs regardless of domestic consumption habits.

o For example, a large proportion of a households income is spent onbuying clothing.o Because price of a good is a function of the quantity and cost to

factors i.e.

Pricewheat= MCwheat = wages*(laborwheat) + rent*(landwheat)

And;

Pricecloth= MCcloth = wages*(laborcloth) + rent*(landcloth)

(Under competition, price of a unit of good must equal MC.)

If the price of wheat goes up 10% and the price of clothremains the same in response to the country opening up totrade, rent will likely go up 10% as well (as wheat is land-intensive).

This means that for the price of cloth to remain the sameafter an increase in rent, wages must have decreased.

Furthermore, if the price of wheat had increased by 10%while wagessimultaneously decreased, rent must haveincreased by more than 10%.

o This means that opening up to trade in the above situation means thatbetween households of landowners and laborers, one factor(landowners as rents are up) can buy more of both goods while theother (laborers as wages are down) must buy less.


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The Specialized-Factor Pattern

- The more a factor is specialized in the production of a product, the more theystand to gain if the price of the product increases or lose if the price of theproduct decreases.

- Holds true over both short- and long-runThe Factor-Price Equalization Theorem

- Free trade causes the prices of both products and factors between twocountries to equalize more than if there were no free trade at all.

- Occurs even if factors are not mobile as trade allows factors that cannotmigrate to be implicitly shipped between countries.

o E.g. land cannot be exchanged between nations, but if the US exportswheat, the US land prices increase and the wheat-importing countrysland decreases until they equalize.

In the short-run, when factors are not mobile, the industry one is in determines the

winners and the losers. Those who work in an export-oriented industry gain while thosein import-competing industries lose. However, in the long-run, the those who make aliving off a countrys relatively abundant factor gains while those who make a livingfrom the countrys relatively scarce factor loses.

Scale Economies, Imperfect Competition (Pugel Chpt 6)

Internal Scale Economies- Economies of scale within a firm; easier to produce more of good for cheaper

when firm is larger.External Scale Economies (aka agglomeration economies)

-

Average cost of firm producing a product in an area declines as the output ofthe industry itself increases in the same area; infrastructure and other servicesconcentrate in these areas to make it easier to produce a particular product(e.g. finance in New York).

- Agglomeration shifts supply to the right, from S1 to S2.- Free trade causes production to be concentrated in a few locations.


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Scale economies can affect the type of market seen in an industry:- Perfect competition- Monopolistic competition

o Three attributes: Firms products are differentiated from each other

There is some internal scale economies There is easy entry and exit of firms in the long run

- Oligopolyo Occur as a result of substantial scale economieso Implicit collusion to maintain profitable prices for products.

But there is always incentive to cut prices to increase marketshare.

- MonopolyIntra-industry Trade(IIT)

- When two countries trade products that are the same or similar.o

More prevalent when trade barriers and transport costs between twocountries are low.- May reflect several things between countries such as:

o Seasonal comparative advantages (e.g. US exports cherries in July butimports cherries in January)

o More often, it is due to product differentiation, as consumers maydemand an imported brand from another country over similar domesticproducts (e.g. clothing, appliances, cosmetics, cars)

Calculating IIT:

IIT = 1 - |XM|X + M


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With free trade, the world transforms from several individual markets in many countriesinto one large market.In the above diagram:

- The US only has access to 10 models of cars offered at $19,000.- With free trade, competition brings down the price of the car for US

consumers from $19,000 to $17,000 and increases the number of modelsoffered from 10 to 18.

Product differentiation is part of the reason why the Heckscher-Ohlin Theorem doesnt

always hold true.- Exporting can be driven by foreign demand for a specific, unique brand of a

product- Importing can be driven by domestic demand for the same.- This can lead to IIT between countries being quite large.

Gains from IIT:- Greater variety of products- Lower prices of domestic varieties


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Tariffs (Pugel Chpt 8)Specific Tariff

- Stipulated money amount per unit of import.Ad Valorem Tariff

- A percentage of the estimated market value of the import.

Before Tariff- World price is at P = 300, allowing for domestic consumption of S 0 = 600,000

bicycles and importing the difference between D0and S0(1.60.6 =1,000,000 bicycles).

- P = $210 represents the most efficient domestic firm producing the firstbicycle at $210, while the intersect between the supply curve and P = $300 isthe least efficient domestic producer producing the last bike at exactly $300.

- P = $540 represents the consumers willing to pay up to $540 for a bicycle.After Tariff

- The price-taking country imposes a $30 tariff on bicycle imports, representedby P increasing from $300 to $330.

- This causes the domestic supply of bicycles to increase from S0(600,000bicycles) to S1(800,00 bicycles) as domestic firms increase prices and/oroutput.

- Imports decrease from D0S0= 1,000,000 bicycles to D1S1= 600,000bicycles.

- Consumer surplus, represented by the area under the demand curve and aboveprice, is reduced by a + b + c + d= $45,000,000

- Producer surplus, represented by the triangle above the supply curve andbelow price, increase by a = $21,000,000

- Government revenue from the tariff is c = $18,000,000- There is a deadweight loss represented by b + d = $6,000,000- b is production loss, the loss of having inefficient domestic firms supplying

200,000 bicycles that foreign firms could supply more efficiently- dis consumption loss, the decrease in consumption due to the rise in prices.


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- Note that the loss to consumers exceeds the gain to producers. This is largelybecause producers gain only from the supply of domestic goods whileconsumers lose on the price increase to both domestic and imported goods.

When a large, price-making country imposes a tariff, it has the potential to affect world

prices.

- Above, a large country imposes a $6 tariff on bicycles.- A decrease in domestic demand in a very large country can cause world price

to drop as well as this large country may hold monopsony power.- This means that foreign exporters who have had to lower prices are now

paying part of the tariff, represented as a gain to the country of e=$2,880,000.

o This gain from monopsony power has its limits, however. If the tariffwere too high and importers couldnt make a profit, they could chooseto not sell to the large country at all, saddling the country with all thelosses involved with tariff imposition.

Nationally Optimal Tariff- The tariff that creates the greatest net gain for the country imposing it.- A nationally optimal tariff is still unambiguously bad on an international

scale:o The price-making countrys gain is, dollar-for-dollar, at the expense of

foreign exporters. Foreign exporters also lose the additional surplus onexports discouraged by the tariff, resulting in a net loss for the world.

o This is not including the possibility of retaliatory tariffs levied byforeign governments.


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Nontariff Barriers to Imports

Import Quota- Quantitative limit on imports- May be preferred to a tariff as it puts a quantitative limit on imports.

oWith a tariff, quantity can still increase if importers lower costs ordomestic demand increases.

o Can be used as a political tool as it gives officials more administrativeauthority over who can import.

The division of this import license can be determined through: Fixed favoritism (government discretion) Auction held amongst firms Resource-using procedures

o E.g. awarding licenses based on productioncapacity (although this encourages wastingresources)

o Domestic monopolies also prefer quotas as a quantitative limit onimports means once this limit is reached, these firms can increaseprices without losing demand to imports.

- With free trade, quantity of bikes supplied (domestic and importers combined)is 1,000,000 at the world price $300.

- A quota (represented by the supply curve shifting to the left) brings quantityof bikes imported to 600,000 at the world price. The excess of demand inresponse to the reduction of supply causes domestic price to increase to $330.

o The domestic quantity supplied is 800,000 at $330.o Domestic quantity demanded is 1,400,000.

- Domestic producers gain a- Domestic consumer lose a + b + c + d- bis a deadweight loss (production effect), representing the bicycles produced

by domestic firms (200,000 bicycles) that could be produced more efficientlyby foreign firms.


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- d is a deadweight loss (consumption effect), representing the loss of domesticdemand (by 200,000 bicycles) as a result of the increase in price.

- c represents the markup gained by importers from bicycles imported at theworld price and sold in the country at the higher price (caused by the quota).

o c is received by whoever holds the import quota license (rent).o

Some of cis a loss to the nation as firms waste productive resource inrent-seeking activities

- When a large country imposes a quota, the reduction in demand for foreignimports causes world price to drop from $300 to $285 as foreign firmscompete for import licenses, absorbing some of the price gain.

- Domestic price for bicycles is pushed up to $315.- erepresents gains to the nation as the world price decreases due to the quota

causing a reduction in demand.

-Voluntary Export Restraint- Quantitative limit on exports (based on threat of foreign trade sanctions)- Effects on price similar to quota, except no one receives the gains from c,

making the deadweight loss b + c + d.o This represents a greater loss to the nation if VERs are implemented.

- Export producers have less incentive to compete as the exporting countrysgovernment usually distributes licenses to export specified quantities to itsproducers.

o Instead tend to act like a cartel to limit sales and divide marketamongst themselves, charging at the highest price the market will bear.

Tariff-quota

- Allows imports to enter at low/no tariff at a specified quantity, imports afterthat quantity have a higher tariff imposed.

Government procurement- When the government purchases local products

Local content and mixing requirements

- Require local labor and materials


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- Do not generate revenue for government; markup captured by local producers.o Local Content:

Government can create barriers to foreign products Can also limit the import of foreign materials otherwise used in

domestic production (e.g. Malaysia forces domestic

automakers to use local components)o Mixing Requirement:

Government can require domestic retailers to buy a percentageof their supply domestically.

Technical and product standards- Enforcing standards that favor local products, but force costly modifications

to foreign products.o E.g. EU banning beef from cows given growth hormones, specifically

protecting European beef producers from imports from Americanproducers.

Advance deposit

-

Requires some of the value of intended imports to be deposited withgovernment at low/no interestImport licensing

- Requires importers to apply for the right to importTrue Costs of Barriers to Trade

- We can calculate Net National Loss (deadweight loss b + d) due to the tariffas a percentage of GDP by using the following formula:

- However, there are other costs to erecting barriers to trade:o Foreign retaliation

Other governments can respond to barriers by erecting theirown and hindering trade.

o Enforcement costs Enforcing protectionism can become costly.

o Rent-seeking costs Firms may waste resources seeking protection (e.g. lobbying).

oRent to foreign producers

VERs encourage foreign exporters to raise export prices.o Innovation

Less competitive pressure can remove incentive to innovate.

Net national lossfrom the tariff = * Tariff rate * % reduction in import quantity * Import value

GDP GDP


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Arguments For and Against Protectionism (Pugel Chpt 10)

Generic Arguments in Favor of Protectionism- If there is something extra good about local production of a product.- If there is something extra good in employing people or other resources in

producing a product.- If there is something extra bad about local consumption of a product.- If there is something extra good about the government collecting more

revenue.- If it is desirable to enhance the incomes of factors used in the import-

competing industry.

So long as gaps exist between what private individuals use to make decisions and the fulleffects of these actions on society, private actions will not lead to the best possibleoutcomes for society.

If some costs of producing or consuming a product are ignored by individuals, toomuch of the product is produced/consumed

If some benefits of the activity are ignored by individuals, too little of the activityoccurs.

Government Policies toward Externalities

Tax-or-Subsidy- The approach of spotting distortions in peoples/firms private

incentives and correct the incentives with taxes or subsidies.- E.g. if social marginal cost exceeds private cost, the government

should levy a tax so that this private marginal cost equals socialmarginal cost.o Conversely, if social marginal benefit does not equal private

marginal benefit, then subsidies so that they doequal.Assigning Property-Rights

- The approach of assigning property rights so that the existence ofprivate property creates private incentives to rectify negativeexternalities.

- E.g. A paper mill polluting a river. Either people downstream own theriver and charge the paper mill for any pollution, or the paper millowns the river and demands compensation for cleaning it up.

The Specificity Rule

- It is usually more efficient to use the government policy tool that acts asdirectly as possible on the source of economic distortion separating theassociation between private and social benefits or costs.


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Arguments for Protectionism

- Local production produces spillover benefits as other firms and industriesbenefit from it.

- Employment in this industry imparts new worker skills.- By producing now at a high cost, firms can find ways to lower their costs over

time.- There are extra costs to workers if they are forced to switch to anotherindustry.

- National pride in domestic production of a product.- Product is essential to national defense.- Employment in the industry is a way to redistribute income to the poor or

disadvantaged.

Effective Rate of Protection:New value addedOld value added

Old value added

Subsidy

- A tariff of $30 (like the one on the left) would result in the deadweight loss ofboth b (production loss) and d (consumption loss).

- However, a subsidy of $30 increases revenue per unit sold to $330 ($300 paidby consumers, $30 paid by the government).

- Both tariff and subsidy of $30 causes firms to raise annual domesticproduction from 600,000 to 800,000 bicycles.

o NOTE: Domestic consumption does not decrease from 1.6 millionunits due to the subsidy as it would with the tariff (down to 1.4million). This is due to the fact that consumers still pay the $300, justas before the subsidy was implemented.

- Assumption that there are no sources of net social loss from having thegovernment raise additional taxes or reduce other spending to pay the subsidy.


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Politics of Subsidies

- Subsidies generate smaller losses to the nation, but arent used as often astariffs.

o Due to the fact that industries tend to lobby for tariffs rather thansubsidies because subsidies are targets for price cuts. Tariffs and NTBs

are a more consistent shelter.

Infant Industries

- An argument that a temporary tariff is justified in cutting down imports whilethe infant domestic industry learns how to produce at low enough costs.

- Initially, the domestic industry is producing at a cost per unit far above theworld price

- The tariff allows the domestic industry to capture a small portion of themarket (represented by b).

- Eventually, the domestic industry will be able to push its costs low enoughthat its supply curve shifts from Sdn to Sdf, where its products are costcompetitive to the world price.

- Why this may be necessary:o Imperfections in the financial market: It might be difficult for young

industries to convince financial institutions to provide capital.o The first domestic entrant to the industry incurs costs in learning the

industry. However, subsequent follower firms can take advantage ofthe pathway forged by the first entrant. Protectionism can even out thisinitial disadvantage.

- Risks:o There is a potential that the infant industry is never able to bring its

costs down to a competitive level. There may be little incentive to doso if firms expect that they can ask for more time with protection.


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Dying Industries

- Rationale for:o Firms in an industry tend to concentrate geographically. If many

workers loser their jobs in such an industry in a short period of time,the labor market can become congested.

o- Problems:

o May encourage firms to enter import-vulnerable industries as theyexpect a safety net.

Pushing Exports (Pugel Chpt 11)DumpingSelling exports at a price that is lower than fair market value.

- Where fair market value is definedo As the price charged to comparable domestic buyers in the home

marketo

A price that is equal to/greater than the marginal cost of the product.Types of Dumping- Predatory Dumpingwhen a firm is trying to drive its foreign competitors

out of business, with the intention of using monopoly power to raise priceslater.

- Cyclical Dumping - when a recession occurs and the firm lowers prices tolimit the decline in quantity sold in response to reduced demand.

- Seasonal Dumpingwhen a firm tries to sell excess inventory of a product ata time in the year when the inventory is no longer in as high a demand.

- Persistent Dumpingwhen a firm with market power uses pricediscrimination between markets to increase its total profits, such as charging

lower prices in a foreign market where it has less monopoly power comparedto its home market, and home buyers cannot buy the good abroad and importit cheaply.

o The home buyers cannot buy cheaper imports often due to tariffs orNTBs.

o So long as these markets remain separate, persistent dumping ispossible.

Reactions to Dumping- In the case of persistent, seasonal, and introductory-price dumping, generally

the importing country should welcome it as they receive more favorable termsof trade.

oFurthermore a tariff for these types of dumping would have to beprohibitively high (due to possibly enormous price differencesbetween countries) and would wipe out both trade and a great deal ofdomestic consumer surplus for a relatively small amount of domesticproducer surplus.

- Predatory dumping is often viewed negatively as there is a tacit promise thatprices will increase once the firm achieves monopoly power.


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o Some believe that predatory dumping may not occur that oftenanyways.

Many firms fear the uncertainty of making a profit later inrelation to the certain losses of selling below fair market value.

There is no guarantee that new competitors may not spring uplater on once the firm increases prices.- In the case of cyclical dumping, it would be difficult to convince the

importing country that it is fair for them to bear the weight of the globalreduction in output.

o It is also viewed as unfair if the exporting country is facing a nationalrecession only as they would be exporting some of theirunemployment to the importing country.

- The WTO allows for retaliation against dumping by granting the ability forthe importing country to impose an antidumping duty.

o A tariff equal to the discrepancy between export price and fair marketvalue.

oProcess begins with a complaint from the US producers, examined bythe Department of Commerce and the US Intl Trade Commission.

The DOC and ITC often find dumping and injury(respectively) as they are naturally biased towards USproducers, even when no dumping or less dumping thanclaimed has occurred.

Eventually the duty may be lifted after a subsequent review bythe DOC.

o The simple threat of dumping complaints by import-competing firmscan prod exporters to raise the prices and restrain their competition.

o The WTO does not allow subsidies linked directly to exporting whilesubsidies not linked directly to exporting but still have an impact onexports are actionable.

- Safeguard policyis the use of temporary import protection when a suddenincrease in imports causes injury to domestic producers.

o Intended to give import-competing firms and their workers time toadjust to heightened competition.

o Could be used proactively, in place of antidumping policies.o As it is temporary, there is more pressure for domestic firms to adjust.

- The WTO


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Export subsidy- Expands exports and production of the subsidized product. Can switch

product from being imported to being exported.- Lowers price paid by foreign buyers relative to the price local customers pay

(assuming something prevents local buyers from importing the product at

lower foreign prices).- Export subsidy reduces net national well-being of the exporting country.Small country example

f is the consumption effect, h is the production effect.Big country example


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Turning an Import into an Export

Gains to domestic producers = ACEFLoss to domestic consumers = ABJE

Strategic Export Subsidies- In some industries, two firms in different countries may want to enter in direct

competition.- Both entering may wipe out profits for both sides.

- For example, in the case of Boeing and Airbus, if both were to enter the exactsame airplane market at the same time, they might both lose $8 billion.

- However, if Airbus was promised a subsidy of $10 billion if and only if itproduced, Airbus would have incentive to produce (as it would generateincome either way).

o This could be a good strategy for an exporting country. However, it isdependent on too many conditions to be reliable.


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For example, if both EU and US give Airbus and Boeing $10billion subsidies, both countries spend a great deal of moneyfor not much in the way of returns.

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Egb Notes 1 [Trade]