International Economics Flashcards
Why do firms trade?
CiRRES
- Cost factors: cheaper/better inputs, internal economics of scale so lower cost by concentrating production on few production sites
- increase revenues through new customers
- risk diversification
- ethical considerations (e.g. pharma offering medecines to developing countries)
- specialising in core competencies (so outsource less profitable steps in the value chain)
What did the Mercantilists argue?
Wealth = stock of precious metals possessed by a country.
Value of exports must exceed imports for a country to become wealthy.
Counter example: Dutch disease (they found gas)
What is the Dutch disease?
Dutch disease (the Dutch found gas) = detrimental effect of a resource-led export boom on other sectors of that exporting country:
- Appreciation effect: Export (oil) revenues materialise in dollars. When you convert these back into your currency, demand for your currency increases and your domestic currency appreciates. This deteriorates the international competitiveness of other exporting sectors.
- Inflation effect: Higher income from oil revenue raises income and wages, including in the non-exporting industries (mainly services). This lead to higher prices (inflation), which even more impairs the non-oil exporting sectors.
What did Adam Smith argue?
- Trade is based on absolute cost-advantages
- Free trade increases the wealth of nations; both exports and imports are important
What does the theory of absolute advantages say?
A country has an absolute advantage when its labour productivity in producing one item is higher than another country’s.
Each country should specialize in the good that it can produce more efficiently to increase worldwide wealth
Labour productivity = output/input (work hours)
Output calculation: 1000 hours, 1 car per 10 hours work
Output = 1000h x 1car/10h = 100 cars
What did David Ricardo argue?
Comparative advantage:
Trade is even positive for a country which has a lower labor productivity (absolute disadvantages) wrt every good if these absolute advantages differ between goods, thereby creating comparative advantages
What are the assumptions in the Ricardian Model (comparative advantages)?
- 2 countries (domestic (D) and foreign (F))
- 2 goods (cars and toys)
- Labour is the only resource used for production
- Labour supply in each country is the same and constant
- Labour productivity varies between countries (usually due to differences in technology), but is constant over time
- Perfect competition, so hourly wages of employees in toy production = market value of toys produced in an hour. Same goes for the car industry.
- As workers will work in the industry paying a higher wage, competition leads to equal wages in both industries within a country (people are mobile between different industries)
- Constant economies of scale (no higher marginal proft if you produce more)
How to calculate a comparative advantage?
A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in that country than in other countries:
aX/aY < aX/aY –> domestic comparative advantage
–> Produce the good for which your opportunity cost is lower (and so have comparative advantage)
Labour input coefficients
= hours needed to make the product
= input (hours) / output = 1/productivity
= a (domestic) or a* (foreign country)
Domestic opportunity cost of good X = aX/aY
= hours to produce X/hours to produce Y
= quantity of good Y that is given up to produce one more X
Foreign opportunity cost of good X = aX/aY
What is the production possibility frontier (PPF) of an economy?
The production possibility frontier (PPF) of an economy shows the maximum amount of each good that can be produced for a fixed amount of resources:
L = aX x QX + aY x QY
aX = hours of labour needed to produce product X
aY = hours of labourneeded to produce produc Y
QX = quantity of good X
QY = quantity of good Y
L = total amount of labour resources
How do you graph the production possibility frontier (PPF) of an economy? What it tell us?
x-axis: quantity of good X (QX)
y axis: quantity of good Y (QY)
L = aX x QX + aY x QY
Draw for domestic (PPF) and foreign country (PPF*)
CN = consumption possibilities (non-trade)
Ctrade = consumption possibilities with trade
Outer curve has absolute advantage
Steeper slope means higher opportunity cost for Good X (so no competitive advantage for producing Good X)
When the economy uses all its resources: opportunity cost of good X = absolute value (positive) of the slope of the PPF L = aX x QX + aY x QY aY x QY = L - aX x QX QY = L/aY - (aX/aY) x QX absolute value of the slope = aX/aY = opportunity cost of producing good X
What are the terms of trade?
Terms of trade = the relation between the price of country’s exports and the price of a country’s imports.
Domestic terms of trade
= Price of exported good X / Price of imported good Y
= PX/PY
Foreign terms of trade = Price of exported good Y / Price of imported good X
What is the relative price?
Relative price
= the relation between the world price for good X and the world price for good Y
= PX/PY
There is only one single relative world price WITH trade.
What does the Ricardian model (theory of comparative advantage) tell us about the terms of trade?
Trade occurs when:
- equilibrium relative price of good X (=PX/PY) is higher than one country’s opportunity costs (=aX/aY) –> country has incentive to sell
- equilibrium relative price of good X (= PX/PY) is lower than the other country’s opportunity costs (=aX/aY) –> other country has incentive to buy
Therefore:
- production (opportunity) costs determine the limits of the relative price range
- reciprocal demand determines what the actual exchange ratio will be within these limits.
Is an increase in a country’s terms of trade good or bad? Why?
An increase in a country’s terms of trade is typically good…because it indicates that fewer export goods are needed to purchase the same number of import goods.
Terms of trade = the relation between the price of country’s exports and the price of a country’s imports.
What does the Ricardian model tell us about the scope and distribution of the benefits of trade?
The further apart the domestic opportunity cost ratios (aX/aY) are:
- the more room for mutually advantageous trade
- the larger the benefits that can be derived from global trade
The distribution of the benefits between the two countries depends on where the Terms of Trade (ToT) settle:
- If near the foreign country’s opportunity cost ratio, the home country derives most of the gains from trade.
- If neasr the home country’s opportunity cost ratio, the foreign country reapsmost of the benefits.
What are relative wages? What determines them?
Wages of domestic country/wages of foreign country.
NB: although the Ricardian model predicts that relative prices equalise across countries after trade, it will not predict that relative wages will do the same.
Productivity (technological) differences and relative prices determine wage differences in the Ricardian model
Work out the hourly wages in the home and foreign country where:
- 1 (domestic) car sells for $30,000 (takes 100 hours to produce)
- 1 (foreign) toy sells for $1,000 (takes 5 hours to produce)
What is the relative wage for the domestic country?
Hourly wage = product price / hours to produce product
Home country wages:
$30,000/100 = $300 per hour to produce cars (x)
Foreign country wages:
$1,000/5 = $200 per hour to produce toys (Y)
Relative wage = 300/200 = 3/2
= Px/ax / PY/aY = Px/PY times aY/ax
1/ax = productivity
Relative wage = relative price x a*Y/ax
What determines the wage and the wage differences between both countries? Who enjoys the higher wage? What impact does trade have on wages? When will a good be produced with cost advantages?
- Terms of trade (relative prices) and labour productivity (output/input = 1/aX) determine wages
- Terms of trade and absolute productivity advantage (aX/a*X) determines the wage differences across both countries
Relative wage = wx/wY = Px/PY x a*Y/ax
If the relative productivity of a country is higher than the relative wages, the good will be produced with cost advantages
ax/ax > w/w domestic country exports
NB: A country with absolute advantage in producing a good (so more productive) will enjoy a higher wage in that industry after trade, as the relative price of the good exported increases and the relative price of the imported good decreases.
What is the absolute cost of production for one good X?
a (hours to produce good X) x w
NB: highest wage in a country is the one to use!
What are the prerequesites for a good to be exported according to absolute cost advantage?
a/a > w/w –> export
hours to produce X abroad/hours to produce X domestically > domestic wages/foreign wages
OR a* x w* > a x w –> export
If a/a < w/w –> import
- The cost of high wages at home can be offset by high productivity. The cost of low productivity in the foreign country can be offset by low wages.
–> if the relative productivity of the home country in producting a good (1/a / 1/a* = a/a) is higher than the relative wage (w/w), then the good will be produced with cost advantages in that country. If it is lower it will be imported.
What is the impact of trade on wages according to the Ricardian model?
Workers earn a higher wage after trade liberlization, because the relative price of exported goods increases and the relative price of imported goods decreases.
Why might countries oppose specialisation as suggested by the Ricardian model of comparative advantage?
- Sectoral change: It results in job losses in some sectors (so need to assist them), but job gains in others; which sectors depends on the nation’s comparative advantage
- Recent years points to comparative advantage of industrialised nations residing in services, so you expect a move from manufacturing to the service sector.
What empirical evidence supports the Ricardian model?
- Empirical evidence shows low wages are associated with low productivity (cf wage and productivity of US Japan and Germany with China and India)
- Other evidence show wages rise as productivity rises.
- Ratio of US to British exports in 1951 cf ratio of labour productivity in 26 manufcturing industries suggests relationship between comparative advantage and exports; US had absolute advantage in all, but the ratio of exports was low in the least productive sectors of the US
What are the limitations of the Ricardian model (comparative advantage)?
- Complete specialisation in production does not occur because:
- labour is not the only production factor
- protectionism
- transportation costs reduce or prevent trade in some goods - Limiting the analysis to “labour”:
- assumes away important effects of international trade on the distribution of income within countries
- allows no role for differences among resources between countries as a reason for trade - It neglects the possible role of economies of scale as a cause of trade, whch is important to explain intraindustry trade.
- Trade due to comparative advantages explains why countries export and import dissimilar goods (“interindustry trade”) but not “intraindustry trade” of similar (but not identical) goods that can even arise if both technology and factor endowments are identical between countries.
What conclusions does the Ricardian model provide?
- Comparative advantage if opportunity cost is lower than in other countries
- After specialisation, the relative price of the produced good rises, income for those workers rise and imported goods are less expensive for consumers.
- Trade benefits both high and low productivity countries, although it may change the distribution of income within countries.
- Cost advantage can result from high productivity OR low wages
What model explains intraindustry trade? How?
Helpman and Krugman model, using economies of scale.
Assumes:
- Firms are homogenous (same size, productivity, each captures same share of total exports) (same assumptation as Ricardo)
- Goods are heterogenous (differentiated), not homogeneous as assumed by Ricardo (e.g. VW v Peugeot)
- Increasing economies of scale make it advantageous to specialize in production of a limited range of goods and services, explaining some intraindustry trade.
- increasing economies of scale leads to monopolies or oligopolies. Therefore, excess profits are captured by large firms (unlike Ricardian perfect competition with workers receiving all profit)
What types of economies of scale are there? What are these industries characterised by?
- Internal economies of scale: where average cost per unit of output decreases with the increase of the size of the firm (characterised by monopolies, oligopolies, monopolistic competition)
- External economies of scale: where average cost per unit of output decreases with the increases of the size of the industry (characterised by many small firms)
Is either internal or exteral economies of scale consistent with perfect competition?
Internal economies of scale - NO
External economies of scale - YES
Why might external economies of scale exist?
If a larger industry is organised in industrial clusters, this can allow for :
- more efficient provision of services/equipment to firms in the industry, due to nearness of supplies and availability of consultancies
- higher availability of workers, transparency of a local labour market and labour pooling
- higher availability of implicit information and accumulation of knowledge (driven by learning curve effects = dynamic increasing returns)
- cluster effects: collaboration, joint R and D, exchange of info, infrastructure
What happens if the number of firms in a market with monopolistic competition increases?
- Smaller market shares, so:
- Higher average cost (each firm sells less)
- Lower prices due to competition
- Equilibrium price and number of firms where price = average cost
How does international trade affect markets with monopolistic competition?
- Bigger market size
- More production, lower average costs
- More firms than in purely national market
- Higher competition so consumers benefit from lower prices and increased product variety
What does the presence of monpolistic competition predict wrt trade and income distribution?
- More intraindustry trade
- No change in income distribution within a country
Represent the effects of trade on an industry with internal economies of scale on a graph. Explain what it is saying.
x-axis: number of firms, n
y-axis: Cost, C and Price, P
Downwards sloping price function: prices decrease with increasing number of firms (does not depend on market size)
Upwards sloping cust curve (CC): costs increase with increasing number of firms in a given market due to internal economies of scale
Shift CC down (slightly flatter) due to trade liberalisation: Trade liberalisation increases market size, increases market share, decreases unit costs due to internal economies of scale (some firms that can’t compete at new, lower equilibrium price drop out)
New equilibrium: Consumers get more variety for a lower price.
Trade therefore offers an opportunity for mutual gains from trade, even if countries do not differ in their reources or technology. NB: total output and employment can be maintained in all countries, given that the country can respecialise and export more intermediary or other products.
What is the Grubel-Lloyd Index?
The Grubel-Lloyd Index measures the extent of intra-industry trade.
100 = pure intra-industry trade
0 = pure inter-industry trade
What determines the relative importance of intraindustry trade?
How similar the countries are:
- Similar comparative advantages –> intraindustry trade
- Different comparative advantages –> interindustry trade
e.g. General Electric refrigerators
- US consumers prefer refrigeraters with 2 doors –> produced in USA
- Mexican consumers prefer 1 door –> produced in Mexico
Trade to satisfy preferences in both goods
What might determine the pattern of trade if external economies of scale exist?
Historical accidents, often caused by political action in line with economic policy (industrial policy)
–> countries may remain large producers in certain industries, even if another country could potentially produce the goods more cheaply
e.g. car industry in Stuttgart, industrial banana, semiconductor industry in the Silicon Valley stayed in the USA and didn’t move to India
Do external economies of scale justify an infant industry argument?
Debatable.
Otherwise, countries with a head start with substantial learning effects may prevent other more efficient countries from entering the market.
What do the different models explain? What don’t they explain?
- Ricardian (inter-industrial trade and specialisation): comparative advantages drive specialization processes, raises relative price of produced goods, lowers relative prices of imported goods, raises wages, benefits both high and low productivity countries. Ignores role of resources, impact on distribution of income, doesn’t explain intraindustrial trade.
- Krugman (intra-industrial trade and product differentiation): Increasing returns and product differentiation drive intra-industry trade.
- Gravity Model: helps describe the main characteristics of the structure of today’s world’s aggregated trade flows
- Melitz and Helpman model (Domestic firms, exporting firms, and FDI firms: Only the most productive firms trade, the even more productive firms do FDI
What are the steps of international economic activities?
- Domestic firms deliver only the regional or national market - many firms!
- Exporters serve foreign markets too - few firms!
- Multinational firms produce in the target market - ver few firms
Describe the Melitz model
- Recognises firms are heterogeneous (diff size, productivity) - unlike Ricardian and Krugman models. E.g. in the 1980s only 18% French manufacturing firms were exporters
- Builds on monpolistic competition from Helpman-Krugman and extends it by a dynamic component
Describe the Melitz model assumptions as it pertains to domestic production.
Self-selection into domestic production:
- Potential entrants (sink irreversible investment) - to enter (e.g. market research, business plan…). Nb no knowledge of their productivity until they enter the market.
- Entrants (randomly draw productivities) - through lottery, where different random distributions can be assumed
3aa. High productivity entrants (positive profits) - so πD(Θ) > 0
- -> 3ab. Survivors
3ba. Low productivity entrants (negative profits) - so πD(Θ) < 0)
- -> 3bb. Exiters.
- Demand side: demand function
- Supply side: asymmetric firms with different productivity levels
- Productivity is denoted by Θ and Θ(j) for firm j.
- Fixed costs cfD of production, e.g. costs for getting market access, establishing sales channels, initial market research, establishing and supporting service activities
- Variable costs of production c/Θ(j) (per unit of output) where c is the same for all firms
- Firm j selects profit maximising price, leading to firm-specific profit πD(Θ), which depends on productivity level of the firm in a linear profit function
Represent the Melitz model on a graph, as it applies to the domestic market. Interpret it.
x-axis: Θ for productivity
y-axis: π for profits
πD (profits from domestic activity) straight line:
- intersecting y-axis below 0 at -cfD (fixed costs from domestic activity)
- intersecting x-axis at ΘD (where you start to be profitable)
Interpretation:
Firms between 0 and y-intercept ΘD are exiters. To the right of ΘD are the survivors who will stay (with profit)
What are the assumptions of the Melitz model for exporting?
- To serve a foreign market, a firm incurs greater fixed costs than for the domestic market cfx > cfD
- The fixed costs are specific to each country the exports go to, and arise for each new destination country –> fixed costs increase with the number of destination countries
- Further, variable costs of exporting are incurred, modeled as melting iceberg costs (T-1 units will melt during the journey)
Consequences:
- Each firm may achieve an aditional profit from taking part in international trade
- Additional profit follows the linear profit function πx(Θ), which again depends on the firm’s productivity
Represent the Melitz model on a graph, as it applies to the exporting. Interpret it.
x-axis: Θ for productivity
y-axis: π for profits
πD (profits from domestic activity) intersects y-axis at -cfD and x-axis at ΘD.
πx (additional profits from exporting):
- intersects y-axis at -cfx (below -cfD)
- intersects x-axis at Θx: the bigger the foreign market, the smaller is the cut-off point for Θx
- flatter slope than for πD, as marginal profits of exports are smaller due to the additional melting iceberg costs
Interpretation:
- Below ΘD: firm quits
- Between ΘD and Θx: firm produces for domestic market only
- Above Θx: firm realises additional profits from exporting
