Prelim 1 Flashcards
What is Adam Smith’s Second Insight?
given different national prices, it makes sense to specialize in production.
What is Adam Smith’s First Insight?
national price differentials, in and of themselves, provide incentives to trade between countries
Absolute Advantage
producing a product more (most) efficiently e.g. at lowest absolute cost − compared to other countries or producers.
Opportunity Cost
the number of units of one good you must sacrifice to get one additional unit of another good. (what you give up/what you get)
Comparative Advantage
producing a good with lower or the lowest opportunity costs of production.
Specialization
the use of resources to produce some, but not all, goods required by society.
Autarky
absence of trade; a no - trade equilibrium point
Terms of Trade
relative prices of a country’s exports and imports: Calculation (Index of export prices / Index of import prices) x 100
What happens when a country has an absolute advantage (e.g. lowest cost) in neither product or no product?
David Ricardo (early 19th century): even in this case, trade and specialization can occur due to the principle of comparative advantage
What was David Ricardo’s Insight?
the same incentives to specialize and trade exist, even though one country has an absolute advantage in both products
What is Globalization?
Begin with a basic economic perspective − the reduction and elimination of traditional barriers which separate international buyers and sellers:
- Decreasing transportation costs
- Decreasing transactions costs
- Trade policy barriers: tariffs, quotas, etc.
- Market determined exchange rates
Globalization levels the competitive playing field (“the world is flat”–T. Friedman)
But, there is still asymmetric information, imperfect markets, market power, and major institutional flaws (IMF) (Stiglitz)
Production Possibilities Frontier
curve showing all possible combinations of outputs of two products that a producer (or economy) can produce with resources fully employed and the best available technology
Marginal Rate of Transformation
the amount of one product that a producer (or economy) must sacrifice in order to produce one more unit of another commodity (also the slope of the production possibility frontier at the point of production) MRT = Slope of PPF
Marginal Cost of Production (MC)
cost of producing an incremental unit of a good or service (equivalent to MRT between 2 goods – e.g., what you give up of one good to get more of another)
what happens if marginal costs are constant – what does the Production Possibility Frontier look like?
Linear PPF
What happens when we allow trade and specialization with constant (for now) marginal costs?
Each country produces and consumes along a linear (constant marginal cost) Production Possibility Frontier
Decreasing marginal costs most likely to occur in industries with ______________ ?
significant economies of scale
In what industries are economies of scale most likely to occur and why?
Utilities industry (electricity, natural gas, water, etc.) – why? - Capital intensive, large initial fixed investment – - Low transactions costs for marginal nth consumer
What is more common, increasing marginal costs, or decreasing marginal costs?
Increasing Marginal Costs
Why do Increasing Marginal Costs occur?
At some point as production increases, marginal costs of production increase due to costs of:
- training and educating the workforce
- physical infrastructure to expand, reduce bottlenecks
- marketing
- higher pay to induce labor supply
Comparative Advantage Vs. Competitive Advantage
Comparative advantage: Based on production costs (e.g. opportunity costs) and factor endowments. ”Competitive advantage”: (Michael Porter) Based on: • Firm strategy and structure • Consumer demands • Supporting industries (agglomeration economies) • Specialized factor conditions
Indifference Curve
curve showing all possible points of consumption of two goods which yield an equal level of utility or satisfaction.
Marginal Rate of Substitution (MRS)
the amount of one product that a consumer (or nation) must sacrifice in order to consume one additional unit of a second product and leave total utility unchanged (also the slope of the indifference curve at the point of consumption)
Diminishing Marginal Utility
the substitution of one good for another in demand becomes progressively more expensive; that is, one must sacrifice less and less of one good to consume more and more of a second good (e.g., indifference curves are convex to the origin, with a declining slope as a consumer (nation) moves down the curve).
What is the slope of the indifference Curve?
Marginal Rate of Substitution
Describe the “Indifference Curve”
Convex: Represents diminishing marginal utility
What are the assumptions behind Free Trade Equilibrium?
- No trade barriers (e.g., no tariffs, quotas, or non-tariff barriers (NTB’s))
- Trade is free and costless (e.g., no transportation or transactions costs)
- One good only (no substitution effects)
- Both countries are “large” trading countries (e.g., either can affect international price determination)
- Trade is perfectly competitive (e.g., no monopoly or market power effects)
What is Consumer Surplus?
Difference between what consumers are willing to pay and what they actually pay for a good (Q*). Willing to Pay (area under demand curve before equilibrium) - Actually Pay (area from price to equilibrium)
What is Producer Surplus?
Difference between what producers are willing to accept and the price they actually receive at a given quantity supplied (Q*). Price received - price willing to accept.
**Producer surplus is noted in green in the diagram**
What is a determinant of Comparative Advantage?
Factor Endowments
Factor Endowment Theory is based on:
- Factor Intensities: The relative proportions of factors required to produce a unit of output.
- Factor Endowments: Relative amounts of factors of production countries possess.
Comparative Advantage: Path
- Differences in relative resource endowments
- Differences in relative resource prices
- Differences in relative product prices = Comparative Advantage
Heckscher-Ohlin Proposition
“A country will export that commodity whose production is relatively more intensive in its abundant factor of production, and will import that commodity which is relatively more intensive in its scarce factor of production.”
Leontief Paradox
Leontief’s paradox in economics is that the country with the world’s highest capital-per worker has a lower capital/labor ratio in exports than in imports. In 1954, Leontief found that the United States—the most capital-abundant country in the world—exported labor-intensive commodities and imported capital-intensive commodities. So despite the fact that the U.S is the most capital abundant country, people still want other capital intensive goods. Our thirst for materialistic goods must be quenched.
Rybczynski Theorem
In a two good world with constant prices, growth in the supply of one factor of production causes the output of the other good to decline.
“Dutch Disease” - If more of one good is produced with fixed factors, production of the other good must decline.
Examples: North Sea gas exploitation
Stolper Samuelson Theorem
In a two good, two factor world, where the production of one good is intensive in the use of one input and the production of the other good is intensive in the use of the other input, a (trade induced) rise in the relative price of one good will raise the real price of the intensively used factor and lower the real price of the other.
Implication: The more a factor is specialized in the production of exports, the more it will gain from trade. The more it is specialized in the production of imports, the more it will lose from trade.
Ex: NAFTA Debate
Factor Price Equalization Theorem
Factor Price Equalization says that when free trade across trading partners occurs, factor prices among them will tend to equalize.
Human Skills Theory
Differences in Human Capital and labor intensities explain trading patterns.
Product Life Cycle Theory
Comparative advantage shifts from the country which successfully invented or innovated to the lowest cost producer (once standardization occurs) Ex. Pocket Calculators
What is Intra-Industry Trade and why does it happen?
Countries both export and import the same products.
Why?
- Vertical specialization
- Transportation costs
- Product differentiation
- Seasonality
- Statistical factors: data aggregation
What are the assumptions behind Free Trade Equilibrium?
- No trade barriers (e.g. no tariffs, no quotas, no non-tariff barriers)
- Trade is free and costless (e.g. no transportation costs or transaction costs.
- One good only (no substitution effects)
- Both countries are “large” trading countries (e.g. either can affect international price determination).
- Trade is perfectly competitive (e.g. no monopoly or market power effects).
What is a Tariff?
A Tax on imports.
What are the purposes of a tariff?
- Raise government revenues
- Protect domestic producers
- Alter trading patterns
What types of tariffs are there?
- Specific Tariff
- Ad-valorem
- Compound Tariff
What is a Specific tariff?
Fixed amount per unit of product.
What is an Ad-Valorem tariff?
% of product value or price.
What is a Compound tariff?
It combines use of a specific tariff and an ad-valorem tariff. So it has a fixed amount per unit of product as well as a percentage of the product value or price charged to the exporter.
What happened in the Tariff Act of 1789?
The U.S Congress was given the right to impose tariffs.
Walker Tariff
Reduced tariffs from 45% in 1845 to about 25% in 1846.
Smoot Hawley Tariff 1932
Signed into law on June 17, 1930 and raised U.S. tariffs on over 20,000 imported goods to record levels. “Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression.”
Reciprocal Trade Agreements Act of 1934
Gave presidents the authority to negotiate tariff cuts. Reciprocal tariff cuts “Most favored nation” principle (lowest bilateral tariff among trading partners)
GATT: General Agreement on Tariffs and Trade 1947-1948
A multilateral agreement regulating international trade. According to its preamble, its purpose was the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis.”
Major Negotiating Rounds:
- Kennedy Round
- Tokyo Round
- Uruguay Round
When was the World Trade Organization created (WTO)?
January 1995 - An outcome of the Uruguay Round of GATT in 1986-1993
Optimal Tariff
A large trading country can optimize its social welfare, recognizing it has an affect on world price.
Effective Tariff
Total increase (in %) in domestic productive activity (in value-added terms) due to the entire tariff structure in the economy e = (n -nb)/1 -a
- e=effective tariff (e is an indicator of the real level of protection given to industries which compete with inputs)
- n =nominal tariff on output
- a = imported inputs (% of final product value)
- b =nominal tariff of imported inputs
What is the key difference between a “small country” and a “large country” in international trade?
Price-setting ability
The general trend in average U.S. tariffs since the Great Depression of the 1930s is
decreasing tariffs
What is generally associated with lower trade barriers and trade protection?
- Lower consumer prices
- Higher economic growth
- Broader selection of products for consumers
- A more flexible labor market
