IE2016Q4 Flashcards
What is the naïve gravity model?
What is the full gravity model? (Theoretically derived)
Remoteness:
- If distance (d) is high, the denominator will be low and GDPL/Dij0 will be high
- If China grow, (GDPl), Rj will be lower and thus trade between the two countries, ij will decrease.
Has the world gotten smaller and what influenced the two globalization wawes?
First wave:
- Steamships
- Telegraph
- Railrods
Second wave:
- Jets
- The rise of the Internet
- Telecommunication
World trade dropped in 1914 (WW1) and didn’t recover to the same level before 1970.
What is a comparative advantage?
A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.
Ricardian model
What does a straight-lined PPF tell us?
That the opportunity cost of one good in terms of another good is constant.
When does a country have an absolute advantage?
When one country can produce a unit of a good with less labor than another country, we say that the first country has an absolute advantage in producing that good.
What is autarchy?
The state where no countries trade with each other.
Discussion: is FREE trade good for Denmark? (yes and no)
Yes:
- Will increase the size of the total pie
- Variety of goods increases
- Prices for consumers decreases
- Decreases risk of conflicts and wars due to increased cooperation between countries
- No countries will ever be worse off but some will benefit more than others.
No:
- The poorest part of the society will often lose their jobs through offshoring and their wages permanently drops.
- The environment will be worse off due to transportation¨
- You typically want to protect some industries such as defense and agriculture
What is the slope of the PPF line in the Ricardian model?
- ac / aq
The nominator is taken from the horizontal axis.
How do you draw the Ricardian model? Visualize and explain the model
On the vertical part of the RS-line, both countries will specialize their production.
On the horizontal parts of the RS-line, one of the countries will produce both goods while the other will specialize in only one good.
What is the conclusion of the Ricardian model?
- Single-resource; Labor
- No income distribution.
- Countries gain from trade (never worse off).
- Countries produce what they are relatively good at, where they have a comparative advantage.
How does the world supply curve and demand curve look when we have multiple countries and how do you interpret the intersections?
What are the reasons behind free trades strong effects on distribution of income?
- Resources cannot move immediately or without cost from one industry to another.
- A shift in the mix of goods that a country produces will ordinarily reduce the demand for some factors of production, while raising the demand for others
What is difference in the specific factor model compared to the Ricardian model?
- It takes multiple factors and factor mixes are different.
- Technology is the same for all countries in the specific factor model (no comparative advantage from technology).
How do you draw the RS and RD curves of the two-specific factor model for autarchy and what happens when we open up to trade?
What is the slope of the production possibilities curve in the specific factor model and what does the PPF curve look like?
- MPLC / MPLF
In other words, the x-axis production factor variable in the denominator.
What happens if prices for goods increase proportionately and what happens if only one of the good’s prices increase?
- Proportionately: wages increase with the same amount as prices and the share of labor between the two industries stay intact
- Single good price increase: wages increase but less than prices increase in that industry. Why? Because labor will shift to the price-increasing industry and thus output in the other industry will decrease and dampen the increasing wage-effect (see picture) >>> the relative wage to cloth has decreased while the relative wage to food has increased. The relative price of clothes has increased and owners’ profits have increased.
What are the three main reasons to why economists do not generally stress the income distribution effects of trade?
- Income distribution effects are not specific to international trade. Every change in a nation’s economy, including technological progress, shifting consumer preferences, exhaustion of old resources and discovery of new ones, and so on, affects income distribution too.
- It is always better to allow trade and compensate those who are hurt by it than to prohibit the trade.
- Those who stand to lose from increased trade are typically better organized than those who stand to gain (because the former are more concentrated within regions and industries).
What is the general rule of thumb in regards to the specific factor model in an open economy?
- Factors specific to export sectors in each country gain from trade, while factors specific to import-competing sectors lose.
- Mobile factors that can work in either sector may either gain or lose.
What is autarchy wage + understand and explain the autarchy wage graph.
The value of a worker’s product.
We have to produce both goods so: W = Pc * MPLc = Pf * MPLf
w = Pc*MPLc = Pf*MPLf
Profit = Pc*Q(L, ?) - wL - r?
Derivative of profit = Pc*MPLc - w = 0
What is TTIP?
A bilateral trade agreement between Europe and America to reduce indirect trade barriers.
What happens if prices increase proportionately in the specific factors model regarding distribution of income?
There will be no labor allocation change and no one will therefore be hurt.
The new lines (P2f and P2c) are steeper.
Returns to factors:
W = Pc * MPLc = Pf * MPLf
Profit = Pc * Qc (K, Lc) – Rk*K – w*Lc
Derivative of profit with respect to k = Pc* MPK – Rk = 0
Rk = Pc* MPK
Rt = Pf * MPT
What happens if relative prices change in the specific factors model regarding distribution of income?
When relative prices change, the allocation of labor will change too.
In this case, prices of cloth relative to food increases by 7 %, which makes wages increase but with less than 7 %. Less than proportional increase in wage due to falling MPL
Workers can afford more food but fewer clothes. Therefore, the welfare effect on workers is indeterminate.
| Clothing | Food________|
Labor | w/Pc = MPLc | w/Pf = MPLf______|
Capital | Rk/Pc = MPK | Rk/Pf = MPK*(Pc/Pf)_|
Land | Rt/Pc = MPT*(Pf/Pc) | Rt/Pf = MPT_______|
MPK increases as L increases, while in this case MPT decreases as L decreases (assumption).
What are the 5 primary conclusions from the specific factor model?
- Shows how factor prices can differ in equilibrium, even if technology is the same
- Shows how trade can hurt some within a country
- Everyone can still gain from trade, with the right redistribution
- Factors specific to export gain from trade while factors specific to import lose.
- In the short run and factors are fixed to the sectors they are in.
Why do countries trade in the specific factors model?
The abundance of factors; factor endowments.
True or false: a country is abundant of a factor if it has more of that factor than the other one.
False.
Being abundant in a factor is like a comparative advantage.
Thus Home is abundant in K if:
K/T > K*/T*
What are the main differences between the 2-good specific factor model and Ricardian model?
Technology is fixed in 2-good specific factor model whereas it is flexible in the Ricardian model.
The Ricardian model is only focusing on one factor; labor, whereas the 2-good factor model is taking multiple production factors into account.
Home is capital-abundant. Do Home capital owners gain from opening up to trade?
Yes.
Factors specific to export gain from trade while factors specific to import lose.
In 3-factor model, does labor gain from trade?
Their purchasing power is going to change, so it actually depends on their utility and choice criteria between goods.
Thus, it is indeterminate.
What is the main focus of the Heckscher-Ohlin model?
Resources; that countries have different resources to produce with.
Countries with relatively more of a resource will export goods for which that resource is more useful in production.
What does the Heckscher-Ohlin theorem say?
A country exports goods that are intensive in the factor they are abundant in, so Western Europe exports highskilled-labor intensive goods to Eastern Europe.
What does Rybczynski theorem say?
If country gets more of a resource, then the output of the good that uses that resource intensively will rise while the output of the other good will fall.
Ex: if Denmark got more labor, it would increase its production of textiles OR if unskilled Iraqis come to Denmark, Denmark will be more abundant in unskilled-labor intensive goods and produce more of that.
What does Stolper-Samuelson theorem say?
A rise in the price of a final good for which a particular resource is more useful in production will increase the payments to that resource
Ex: if the price of textiles goes up, Chinese workers get higher wages
When opening up to trade, owners of factors in which the country exports will gain from trade, so unskilled labor will benefit when China opens up to trade.
SS = Stolper Samuelson
What does factor-price equalization say?
Trade should cause resource prices to converge
Ex: Danish and Chinese workers should be paid the same real wages.
(This is not the case in the real world though)
What is an isovalue line and what does it show?
The isovalue line is a line showing the relative prices of two goods and thus has a slope of: -Pc/Pf (for cloth and food – the horizontal value as numerator).
The isovalue line helps us find the optimal production point.
What does labor-intensive or capital-intensive mean and how do we show this graphically?
If a good is labor-intensive as cloth in the graph below (CC), production of cloth will always use more labor relative to capital than will production of food (FF).
We can graph the relative factor demand curves (wages/rental cost of capital) and see which one if most labor-intensive.
What would happen in a case where cloth and food is produced, and suddenly the labor supply increases a lot?
The labor-intensive industry, in this case the clothing industry, will be able to produce much more, while the food industry (capital-intensive) only will be able to produce a little more.
Thus we have a new PPF and a new tangent line with a slope of: -Pc/Pf so that we produce less food and now much more clothing è An economy produces what it is good at (comparative advantage) AND has the resources to produce (Hecksher-Ohlin).
What does it mean to be labor-abundant or capital-abundant?
That a country has a lot of that resource; they have lot of labor, they are labor-abundant.
REMEMBER: this is a ratio number and is relative to another country. Not absolute quantities.
What does the Heckscher-Ohlin theorem predict?
The country that is abundant in a factor exports the good whose production is intensive in that factor.
What does the Heckscher-Ohlin theory predict about distribution of income?
Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.
In theory, however, there are still gains from trade, in the limited sense that the winners could compensate the losers, and everyone would be better off.
What is the Leontief paradox?
The fact that after the 25 years following WW2, USA imported more capital-intensive goods than it exported despite having the highest Capital per person ratio in the world.
In other words, the Leontief paradox (based on data) is contradicting the Heckscher-Ohlin theory.
What is the conclusion on the Heckscher-Ohlin theory:
- Countries tend to export goods that are intensive in resources they are relatively abundant in.
- The owner of abundant factors gain from trade, while the owner of scarce resources lose from trade.
How is Heckscher-Ohlin different from the specific factor model?
Heckscher-Ohlin is working in the long run where factors can move across sectors.
Which PPF are squared, straight-lined and which are curved?
- Straight-line: Ricardian
- Square: 2-specific factor model,
- Curve: 3-specific factor model, HO, Standard
- Downward sloping: producing less of one good, can produce more of the other goods
- Curved: due to marginal product. A little less cloth gives you a lot more food in the beginning and the end you will have that to produce more food you will need to produce a lot less cloth.
How do you show an income effect and a substitution effect graphically in the standard model?
Doesn’t matter - it won’t be in the exam ;)
What is the difference between HO and Specific factors model? (Office hours with Jinkins)
- Specific model; 3 factor-model: Qc(L,K) and Qf(L,T)
- HO: Qc(L,K) and Qf(L,K)
What is the slope of an isovalue line?
-Pc/Pf (Pc because Qc is on the horizontal axis. IF this was Qf it would be –Pf/Pc)
Will we produce more or less cloth if the price of cloth increases and how can this be shown graphically?
Higher price of cloth = higher relative price (Pc/Pf) and more producers of cloth ➔ production of cloth increases and production of food decreases as more labor now work in the clothing industry.
The PPF curve has a slope of: - MPLf/MPLc
The isovalue lines (VV1 and VV2) have slopes of –Pc/Pf
How can indifference curves help show how much a country import and export of a good?
Value of production = price x Q of good 1 + price x Q of good 2 = consumption of good 1 + consumption of good 2
What is an income effect and what is a substitution effect?
- Income effect: increase/decrease in welfare after a given change in the economy such as the relative price level
- Substitution effect: change in consumption of goods after a given chance in the economy such as the relative price level.
What are the conclusion of the standard model in regards to price changes and welfare?
Terms of trade; the price of the exported good divided by the price of the imported goods.
P Export Good / P Import Good
- Welfare increases if terms of trade rise (improve)
- Welfare decreases if terms of trade fall (worsen)
- A worsening of the terms of trade can NEVER make welfare fall below autarchy level.
- BUT as worsening your terms of trade more and more, you will end up having export and import of the two goods opposite of your initial autarchy situation
- When your terms of trade keeps worsen, you will end up back in autarchy consuming what you are producing
What is biased growth and what are its drivers?
When the production possibility frontier shifts out more in one direction than in the other.
PPF will shift out due to technological progress for that product or increased resources for the production of a given product.
Why do countries trade in Heckscher-Ohlin model?
Because some countries are abundant in some factors, and tend to produce those products that are intensive in those factors.
Why is the Heckscher-Ohlin model called a long-run model?
Because you can use both factors to produce both goods, and in specific you can only use one factor to produce one good. You can also train labor to work in another sector.
How many factors are there in the standard HO model?
2 factors.
What is allowed to move between countries in the standard HO model?
Final goods (output).
How many theorems are there in HO?
4 theorems.
Name the theorems of HO
- HO-theorem
- Rybczynski theorem
- Stolper-Samuelson theorem
- Factor price equalization
Suppose we have a standard trade model, and home exports clothes.
- Suppose home’s terms of trade worsen. What does that mean in terms of relative prices?
Pc/Pf will fall
Suppose we have a standard trade model, and home exports clothes.
2. Using home’s PPF, show that worsening terms of trade reduce achievable welfare at home.
When terms of trade worsen, we move from isovalue line 1 to isovalue line 2 (which is flatter), indifference curve 1 can no longer be attained, so we fall to indifference curve 2 (which is lower).
Suppose we have a standard trade model, and home exports clothes.
3. Using home’s PPF, show what happens to quantities exported and imported after terms of trade worsen.
Suppose we have a standard trade model, and home exports clothes.
4. What will eventually happen if home’s terms of trade worsen enough?
Home will go to autarchy
What is export-biased and import-biased growth?
- Export-biased: growth that disproportionately expands a country’s production possibilities in the direction of the good it exports
- Import-biased: growth biased toward the good a country imports
What is the conclusion regarding import- and export-biased growth?
- Export-biased growth tends to worsen a growing country’s terms of trade, to the benefit of the rest of the world
- Import-biased growth tends to improve a growing country’s terms of trade at the rest of the world’s expense.
Why? Price of the good you export /price of the good you import ➔ export-biased will increase the relative price whereas import-biased will decrease the relative price
What are terms of trade (TOT)?
Price of the good you export / price of the good you import
Debate: Denmark should admit more immigrants
For:
- Dk needs young labor (growing elderly people)
- Multicultural is good (this is definitely not proven though)
- Increase trade through immigrants (shorter psychic distance; gravity model)
Against:
- High unemployment rate of immigrants (eating the pie instead of growing it)
- High crime rates
- Cultural differences + building double societies instead of integrating
What is immiserizing growth?
Immiserizing growth is a theoretical situation first proposed by Jagdish Bhagwati, in 1958, where economic growth could result in a country being worse off than before the growth. If growth is heavily export biased it might lead to a fall in the terms of trade of the exporting country. In rare circumstances this fall in the terms of trade may be so large as to outweigh the gains from growth.
Strongly export-biased growth must be combined with very steep RS and RD curve so that the change in the terms of trade is large enough to offset the direct favorable effects of an increase in country’s productive capacity.
When there are increasing returns, large firms may have an advantage over small ones, so that markets tend to be dominated by one or few firms.
- Technology depends upon scale and experience
- Best to concentrate production
- Drives countries to specialize even if ex-ante identical
- Large countries have lower cost
- Knowledge spillover
- Specialized labor market
- Specialized suppliers
- Room for helpful government policy
- Historical accident: industries can end up in the “wrong” = less efficient country
- There can be equilibrium losses from trade
- “Infant” industries may need early protection from competition
Are there constant, increasing or decreasing returns to scale in the Ricardian model?
Constant returns to scale
Name one reason why decreasing returns to scale might be reasonable in a multifactor model
Disproportionate amounts of one factor relative to another is ineffective.
Example: if producing 1 Irish coffee needs one unit of capital and one unit of labor, it is not beneficial to double our input/factor of labor if we don’t get more capital.
Name three possible reasons why increasing returns to scale might be reasonable
- Specialized suppliers (expensive to be away from the specialized suppliers)
- Labor market pooling (cheaper to recruit where the specialized labor is located)
- Knowledge spillover (“coffee break conversations”)
(Lower AC as fixed costs are split out)
What is the difference between external and internal economies of scale?
- External: when cost per unit depends on the size of the industry but not necessarily on the size of any one firm
- Internal: when the cost per unit depends on the size of an individual firm but not necessarily on that of the industry.
What characterizes industries with external economies of scale?
No advantages to large firms since the differences are on industry level. Thus the market will typically be many small firms and be perfectly competitive.
External economies of scale also increase chances of clusters making the industry even more competitive through specialized suppliers, labor market pooling and knowledge spillover.
What characterizes industries with internal economies of scale?
Large firms have a cost advantage over small firms and lead to an imperfectly competitive market structure (monopoly or oligopoly)
What are the three main advantages of clustering?
- Specialized suppliers
- Labor market pooling
- Knowledge spillover
How are prices affected by increasing demand in an industry with external economies of scale?
As demand (Q) increases, the average cost of production falls and therefore we have a forward-falling supply curve; the larger the industry’s output, the lower the price at which firms are willing to sell.
Higher demand, lower AC, lower price.
How is the economies of scale model different from that of the specific factor model in regards to pricing when opening up to trade?
- Specific factor model: prices converge to somewhere between that of the two countries
- Economies of scale (WITH increasing returns); prices decreases to somewhere even lower than that of the country with the lowest price before trade because production is at the same place so we have lower AC.
What explains why industry clusters sometimes end up the place that is not economically most beneficial and how do you explain that graphically?
History coincidences.
First-mover advantages.
What will happen in an industry with decreasing marginal costs and where will the equilibrium be?
We will have one gigantic firm ⇒ A monopoly.
Why? Producing more equals lower marginal costs.
(Decreasing AC)
The equilibrium will be at the intersection between the demand curve, D and the AC-curve (which is equal to your MC since the firms only produce one unit as they are so small).
How can countries be worse off by trading when there are economies of scale?
The average cost per unit when starting producing a good might be higher than the world price.
The start-up cost is larger than the current equilibrium cost.
However, if not trading and just supplying its domestic market, Thai-producers of watches would be able to supply the domestic demand with a lower price.
Thus, Thailand in this example is worse off by trading.
What does dynamic increasing returns refer to?
When costs fall with cumulative production over time rather than with the current rate of production.
What is the infant industry argument?
That temporarily protecting an industry to enable them to gain experience is favorable since it will help decrease AC and improve competitiveness.
What is the poverty trap?
The idea is, that to work effectively you need to eat food but to get food you need food but how will you get food, when you are not full and can work effectively?
Classic poverty trap.
What does internal economies of scale imply?
That a firm’s average cost of production decreases the more output it produces.
What does imperfect competition imply on prices?
If a firm in imperfect competition sells much more, the prices of its products (the prices of the industry) will decrease.
When will imperfect competition occur? (2 situations)
Derivative: P’(Q) Q + P(Q) - c’(Q) (MR - MC)
Why does a monopoly’s marginal revenue curve always lie below the demand curve and how do you find the profit of a monopoly?
Because to sell an additional unit, the firm must lower the price of ALL units (not just the marginal one).
What affects the MR line?
Marginal revenue = MR = P – Q/B
The gap between price and MR depends on sales, Q, and the slope parameter, B.
If Q is higher, MR is lower, because the decrease in price required to sell a greater quantity costs the firm more.
The greater is B, the more sales fall for any given increase in price and the closer the MR is to the price of the good.
What are the two assumptions of monopolistic competition?
- Each firm has differentiated products so that consumers don’t shift their preferences due to small price changes
- Each firm behaves as if it were a monopolist and ignores the impact of its own price on the prices of other firms
Explain the following equation:
Q = Quantity demanded for a firm in monopolistic competition.
S = Total output of the industry
N = number of firms
B = constant term representing the responsiveness of a firm’s sales to its price
P = the firm’s price
P= The average price charged by its competitors
This implies that if all firms charge the same price, each will have a market share of 1/n.
We assume S is unaffected by the average price.
AC = F/Q + c = (n * F/S) + c (Explain the latter part)
AC depends on the number of firms in an industry and that industry’s size.
The more firms, the less each firm produces and thus AC will be higher due to less economies of scale.
What does this model show?
Answer is three-fold
- CC: the more firms, the higher costs (AC is higher since economies of scale is lower when more firms have to produce the same amount)
- PP: the more firms, the lower prices will be due to increased competition (P = c + 1/(b*n)) ➔ the more firms, the lower the markup over MC.
- In point E, the equilibrium number of firms in the industry is achieved. Here firms have profit maximized at the price P2 that is equal to their average cost, AC2 ➔ a long-run equilibrium.
What happens to the equilibrium price and quantities of firms if the size of the market increases?
AC = F/Q + c = (n * F/S) + c
The CC-curve changes as S increases.
- Lower equilibrium price
- More firms
- More varieties for consumers
The PP-curve Is not affected; (P = c + 1/(b*n))
What properties does economies of scale add to our arguments for international trade being beneficial?
- Product differentiation and international economies of scale lead to trade between similar countries with no comparative advantage differences between them (intra-industry trade)
- Consumers benefit from a greater variety of products at a lower price as firms can take advantage of economies of scale.
What is intra-industry trade?
Two-way exchanges of similar goods.
- 97 = nearly equal import and export
- 10 = unequal import/export (in this case import is much higher than export
A firm with a lower marginal cost will do what?
- Set a lower price
- At a higher markup over marginal cost
- Produce more output
- Earn higher profits
When does entry stop in a market with internal economies of scale?
When expected profits across all potential cost levels, Ci, are driven to zero.
In external; firms enter until profits for all firms are driven to zero
Make sure you can explain this
What is the difference between horizontal and vertical FDI?
- Horizontal: investment in affiliates who replicates the production process elsewhere in the world
- Vertical: break up their production chain and perform some parts of that chain in their foreign facilities.
- Outsourcing
- Offshoring
What is the proximity-concentration trade-off in regards to FDI?
That investing in production facilities closer to the customer is beneficial as transport cost are lower (+ trade barriers avoided) BUT at the same time doing so is bad economically as you don’t gain as much from economies of scale.
What is offshoring?
Instead of outsourcing completely, the corporation still owns the foreign-based subsidiary and thus makes trade within the corporation itself and keeps full control and has lower risk of doing business.
What is the strong assumption behind partial equilibrium models?
Neither incomes nor other prices change.
Welfare only affected by consumption or sale of the single good.
What is the difference between specific tariffs and ad valorem tariffs?
- Specific: fixed charge added for each unit imported: P = P* + t
- Ad valorem: fraction of the value added to each unit imported: P = P* (1 + t) ⇒ 0,25 % tariff on the value of imported cars: 0,25.
What are nontariff barriers?
- Import quotas
- Export restraints (usually imposed on the importing country’s request)
How is Home’s import demand curve derived?
Graph to the right: X-axis; the difference between the quantity that domestic consumers demand and the quantity domestic producers supply.
How is Foreigns’ export supply curve derived?
Graph to the right: X-axis; the difference between the quantity that foreign produce and the quantity foreign supply.
What does MD = XS say?
That we are in equilibrium in the world market meaning that:
Domestic demand - Domestic supply (Import demand) = Foreign supply - Foreign demand (Export supply) ⇒ D - S = S* - D
How does an import tariff affect the equilibrium in Home, Foreign and in the World market?
You can mark the world-market equilibrium with P-autarchy and P*-autarchy where the lines intersects the y-axis.
Who wins and who lose when imposing tariffs?
- Consumers lose in the importing country (price increases) while prices decrease in the exporting country. Thus, consumers in the importing country lose, and those in the exporting country win.
- Suppliers/producers in the importing country gain, while those in the exporting country lose (looking at how much the suppliers are paid for their products).
How do you calculate and find consumer surplus graphically?
Length x width x 0.5
How do you calculate and find producer surplus graphically?
Explain who gains and who loses from an export subsidy
Exporting country: producers gain, consumers are hurt and the government loses.
Export subsidies worsens the terms of trade because it lowers the price of the export in the foreign market from Pw to Ps* ⇒ The cost will always be bigger than its benefits.
What are quota rents?
The profits received/earned by the holders of import licenses.
Explain who gains and losses from a tariff in terms of the importing country’s perspective
Explain who gains and losses from an import quota and what the difference is from a import tariff
Home market: Producers gain, consumers are hurt and the license holder will earn quota rents.
The difference from import tariffs is, that here the licensee will earn some money instead of the government. Money will go to the foreign producers instead of domestic government.
What is a VER?
A voluntary export restraint; a quota on trade imposed from the exporting country’s side (typically on request of the importer).
The effects are exactly the same as for an import quota.
What is a local content requirement?
A regulation that requires some specified fraction of a final good to be produced domestically.
Producers’ point of view: same protection as an import quota
Consumers/firms that must buy domestically: allows firms to import more, as long as they also buy more domestically.
When do suppliers sell domestically, and when do they sell in foreign?
- Sellers only sell abroad if the foreign price is greater than the domestic price plus the tariff.
- Sellers only sell domestically if the foreign price is less than than the domestic price plus the tariff
Depending on the size of two countries’ economies, who will have steep and who will have flat MD and XS curves?
- Flat for the big economy: The big economy’s supply or demand is affected a lot in quantities when prices change ⇒ Very elastic.
- Steep for the small economy: The small country’s economy is affected relatively little in quantities supplied and demanded when prices change ⇒ Inelastic.
How is government revenue gain calculated?
Government revenue gain = tariff * Q
In summary what are the effects of a tariff?
In summary what are the effects of an export subsidy?
In summary what are the effects of an import quota?
In summary what are the effects of a VER?
Why is imports quotas, VERs and export subsidies ALWAYS worse than import tariffs?
Simply because the government revenue gain is given out to a third-party making these trade policy tools more costly than import tariffs.
What are the arguments for free trade?
- Restrictions on trade causes net losses so from a cost-benefit point of view the benefits are simply outweighed by the costs.
- Other costs:
- Free trade will make the world benefit from economies of scale
- Access to bigger markets are more beneficial for entrepreneurs which will drive more innovations.
- Rent-seeking costs
On average, how much would countries gain from moving to completely free trade?
Only about 1 % since tariffs are usually really small and import quotas etc. rare. Protection level is generally low.
The real gains are bigger when taking economies of scale etc. into account but it is hard to estimate.
What are the arguments against free trade?
- In some cases, there is a terms of trade argument for tariffs (almost only for bigger countries that can affect world price). This also holds for export in some situations such as with Saudi Arabia’s oil export restrictions.
- Be aware that these gains will be on other countries expense who will very likely want a friendly talk.
- The argument of domestic market failure; consumer and producer surplus might not be the best way to measure the actual cost and benefits of free trade. A tariff might yield extra social benefits than those examined in the consumer and producer surplus
- Theory of the second best; this is not directly against free trade, but states the fact that restrictions can be beneficial if the markets do not act properly.
- Politically, the opportunity of protecting industries cause lobbyism by influential groups.
Arguments against free trade: What is the argument of domestic market failure?
Consumer and producer surplus might not be the best way to measure the actual cost and benefits of free trade.
A tariff might yield extra social benefits than those examined in the consumer and producer surplus.
Arguments against free trade: What is the theory of the second best?
This is not directly against free trade, but states the fact that restrictions can be beneficial if the markets do not act properly.
What are domestic market failures and how do you see the marginal social benefit graphically?
A market in the country is not doing its job right. This could be:
- The labor market is not clearing
- The capital market is not allocating resources efficiently
It is often a question of marginal social benefit from the learning curve. Protecting industries will keep the industry running and it might improve its productivity through technological innovations etc.
What is the theory of the second best?
The idea that a hands-off policy is desirable only if all markets are working properly. If they are not, a government intervention that appears to distort incentives in one market may actually increase welfare by offsetting the consequences of market failures elsewhere.
For example, if the labor market is malfunctioning and fails to deliver full employment, a policy of subsidizing labor-intensive industries, might turn out to be a good idea.