1. Lecture 4 July 19th 2010 Saksarun (Jay) Mativachranon

2. Announcement No class next week (July 26th, 2010)! Midterm exam is on August 2nd, 2010 8.45 – 10.15 No quiz today Lecture available at http://www.slideshare.net/saark/ibe303-internationa-lecture-4

3. Response from regulations

4. Response from regulations Creative Response Firms subject to regulation may attempt to avoid the regulation or minimize the costs by conform to the letter, but not the intent Feedback Effect Consumers’ behavior change as a result of regulations; undermining the original intent of the regulation

5. Terms of Trade

6. Opportunity Cost USA 1 computer = 0.5 wine Italy 1 computer = 4 wines Should USA trade 1 computer for 4 wines from Italy? Or Should Italy trade 1 wine for 2 computers from USA?

7. Assumptions of the Ricardian Model A 2-country, 2-commodity world Perfect competition No transportation costs Factors mobile internally, immobile internationally Constant costs of production Fixed technology for each country All resources are fully employed The “labor theory of value” holds

8. Notation Let: ax = labor time to produce 1 X in country A ay = labor time to produce 1 Y in country A bx = labor time to produce 1 X in country B by = labor time to produce 1 Y in country B

9. Comparative Advantage Defined Country A has a comparative advantage in good X if: If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y. or if or if

10. Comparative Advantage: An Example

11. Comparative Advantage Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), the U.S. must have a comparative advantage in corn. Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), Mexico must have a comparative advantage in blankets.

12. Comparative Advantage and the Total Gains from Trade Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different. How do we know that this is true?

13. Comparative Advantage and the Total Gains from Trade The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources. Suppose in our example the U.S. has 1,000 hours of labor available and Mexico has 1,800.

14. U.S. Production Possibilities Corn 1000 Slope: rise/run = -1000/200 = -5 A 500 100 200 Blankets

15. Slope of the PPF for this example, -5 Notice: the slope (in absolute value) is the APR of the good on the horizontal axis. Therefore, the slope is the opportunity cost of the good on the horizontal axis. The slope is also the marginal rate of transformation.

16. Mexico’s Production Possibilities Corn 600 Slope = -2, or the opportunity cost of blankets Blankets 300

17. Classical Model: The Gains from Trade Suppose that in autarky the U.S. is at point A Producing 500 corn Consuming 100 blankets Mexico is at point B Producing 300 corn Consuming 150 blankets

18. U.S. Production Possibilities Corn 1000 A 500 100 200 Blankets

19. Mexico’s Production Possibilities Corn 600 B 300 Blankets 150 300

20. Classical Model: The Gains from Trade Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of 1B = 3.33C or 1C = .3B If the U.S. specializes in corn, how many units of corn could it produce? 1000 If Mexico specializes in blanket manufacture, how many blankets could be made? 300

21. The Gains from Trade: U.S. If the U.S. wants to continue to consume 500C They will now have 500C to trade for blankets They produce 1,000C and 0B If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C? 150 Therefore, the U.S. can consume outside its PPF (to point C) by trading!

22. U.S. Production Possibilities Corn 1000 C A 500 100 150 200 Blankets

23. The Gains from Trade: Mexico If Mexico wants to continue to consume 150B They will now have 150B to trade for corn. They produce 300B and 0C If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B? 500 Therefore, Mexico can also move outside its PPF (to point D) by trading!

24. Mexico’s Production Possibilities Corn 600 D 500 B 300 Blankets 150 300

25. The Gains from Trade Note: In general The Ricardian model results in complete specialization. However, in trade between a small and a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.

26. The Consumption Possibilities Frontier (CPF) The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.

27. U.S. Consumption Possibilities Corn 1000 C A 500 CPF 200 100 150 300 Blankets

28. The Consumption Possibilities Frontier (CPF) The CPF’s slope is the same as the terms of trade. The CPF pivots around the production point. If trade is to the benefit of a country, the CPF lies outside the PPF.

29. Mexico’s Consumption Possibilities 1000 Corn CPF 600 D 500 300 B Blankets 150 300

30. The Limits to Mutually Advantageous Trade “Exchange rate” must be at least as great as Mexico’s APR. “Exchange rate” must be no greater than the U.S.’s APR. Bottom line: we still don’t know how the terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial.

31. The CPF and “Small” Countries The nearer are the terms of trade to a country’s APR, the less that country will gain from trade. The farther away the terms of trade are from a country’s APR, the more that country will gain from trade. Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.

32. Adding Money to the Classical Model Suppose a money economy instead of a barter economy. A wage rate for each country, stated in that country’s currency (e.g., in U.S. $2 per hr., in the U.K., £1 per hr.). An exchange rate that relates the countries’ currencies (e.g., $1 = £1).

33. An Example

34. An Example

35. Adding Money to the Classical Model: An Example The U.S. will export wheat, since it can produce wheat for a lower price $4, as compared with $6 The U.K. will export cloth, since it can produce cloth for a lower price $4, as compared with $6

36. The Export Condition Country 1 should export good “j” when: where a1j and a2j are the labor requirements/hr to produce good “j” in countries 1 and 2 W1 and W2 are the wage rates/hr in countries 1 and 2 e is country 1’s exchange rate (# of country 2’s currency units per 1 of country 1’s).

37. The Export Condition Country 1 should export good j when: That is when country 1’s good j price is lower than 2’s, stated in a common currency. Therefore, the pattern of trade is determined by Relative labor efficiency, Relative wage rates, and The exchange rate.

38. The Export Condition Country A should export good j when: Let’s re-write this as follows: Country A should export good j when:

39. Wage Rate Limits As Country 1’s wage rate goes up relative to Country 2’s, Country 1 finds it harder to sell its exports to Country 2. As Country 1’s wage rate goes down relative to Country 2’s, Country 1 is less interested in importing from Country 2.

40. Wage Rate Limits: An Example

41. Wage Rate Limits: An Example

42. Wage Rate Limits: An Example Should the U.S. (Country 1) export wheat? It should if Since 2/6 < 1/(3*0.5) The U.S. should export wheat U.S. wheat price is $6 U.K. wheat price is £6 = $12 after exchange rate It’s easy to show that the U.K. should export cloth.

43. Wage Rate Limits: An Example What if the U.S. wage rate rose to $6?

44. Wage Rate Limits: An Example

45. Wage Rate Limits: An Example Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency. Exchange rate: £1 = $2 Therefore, If the wage rate in the U.S. should rise above $6, the U.K. will no longer buy U.S. wheat (trade will cease).

46. Wage Rate Limits: An Example What if instead the U.S. wage rate fell to $2.67?

47. Wage Rate Limits: An Example

48. Wage Rate Limits: An Example What if the U.S. wage rate fell to $2.67? Now the U.S. cloth price is the same as the U.K.’s, if we state them in a common currency ($8). Therefore, if the wage rate in the U.S. should fall below $2.67, the U.S. will no longer buy U.K. cloth (trade will cease).

49. Calculating Wage Rate Limits Using the Export Condition Solve the export condition for W1, for good X. Solve the export condition for W1, for good Y. These will give you Country A’s wage rate limits. For wheat(X): 2/6 = 1/(W1*0.5) -> W1= 6 For cloth(Y): 3/4 = 1/(W1*0.5) -> W1= 2.67

50. Country 2’s Wage Rate Limits Changes in Country 2’s wage rates also can affect the pattern of trade. If 2’s wage rises too much, they will not be able to export any more. If 2’s wage falls too much, 2 will no longer wish to import.

51. Exchange Rate Limits If Country 1’s currency appreciates Imports will seem cheaper and exports more expensive. If 1’s currency appreciates enough A will no longer be able to export. If 1’s currency depreciates enough A will no longer wish to import.

52. More Than Two Goods Having more than two goods has no effect on the basic Classical model. The export condition can still be used.

53. More Than Two Goods: An Example

54. More Than Two Goods: An Example Suppose the exchange rate is still $1 = £0.5 (that is, e = 0.5). Then Use this as a “pointer”: Country 1 should export everything to the left of the pointer

55. More Than Two Goods: An Example W2/(W1*e) = 0.67

56. More Than Two Goods: An Example If the U.S. wage rate were to fall The pointer would move to the right U.S. would start exporting goods it presently imports. If the U.S. wage were to rise The pointer would move left. Changes in the U.K.’s wage, or the exchange rate, would also move the pointer and thus affect the pattern of trade.

57. Adding Transportation Costs Assume: All transportation costs are paid by the importer. Transportation costs are measured in terms of their labor content. Country 1’s export condition: Suppose in previous example t-costs are 1 labor hour.

58. Transportation Costs: An Example W2/(W1*e) = 0.67

59. Transportation Costs: An Example Notice that although the U.K. has a comparative advantage in cloth, it will no longer export this product, since In the real world, some products with high t-costs (e.g., bulky ones) are not traded.

60. More Than Two Countries Having more than two countries also has no effect on the basic Classical model.

61. More Than Two Countries: An Example

62. More Than Two Countries: An Example U.K. has the CA in cloth, since its autarky cloth price is the lowest. U.S. has the CA in wheat, since its autarky wheat price is the lowest.

63. More Than Two Countries: An Example If the Terms of Trade (ToT) are 1C = 1.8W (or: 1W = .55C) Then the U.S. will export wheat (because the international wheat price is greater than the U.S. domestic price). France and the U.K. will export cloth (because the international cloth price is greater than their domestic prices).

64. More Than Two Countries: An Example ToT: 1C = 1.8W (or: 1W = .55C)

65. More Than Two Countries: An Example If the terms of trade are 1C = 1.6W (or: 1W = .625C), then The U.S. and France will export wheat (because the international wheat price is greater than their domestic prices). The U.K. will export cloth.

66. More Than Two Countries: An Example ToT: 1C = 1.6W (or: 1W = .625C)

67. Evaluating the Classical Model Empirical studies generally show that the classical model is consistent with observed trading patterns. However, the complexity of today’s world means the Classical model cannot supply a complete understanding of international trade.

68. Consumer Behavior Theory How do consumers decide how much of each good to consume?

69. Consumer Indifference (CI) Curves Y Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI. There are many, many CIs each representing higher or lower levels of consumer satisfaction. A B X

70. Consumer Indifference Curves Y Utility on S3 > Utility on S2 > Utility on S1 S3 S2 S1 X

71. Consumer Indifference Curves Are downward sloping because the goods are substitutes. Slope is Marginal Rate of Substitution (MRS): Are convex because of the principle of diminishing MRS. Represent the welfare of an entire country, NOT an individual.

72. Consumer Budget Constraint Y Budget constraint shows combinations of X and Y that can be purchased with a given level of income at fixed prices. The slope of the budget constraint is –Px/Py X

73. Consumer Equilibrium Given relative prices (PX/PY) and income, consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve. Consumer equilibrium occurs where

74. Consumer Equilibrium Y Budget constraint E S3 S2 S1 X

75. Production Possibilities Frontier Most PPFs are bowed out, not straight lines. This is because resources are not equally suited to all kinds of production. Slope of a tangent line at any point along the PPF is: the marginal rate of transformation, or the opportunity cost of the horizontal axis good, or MCX/MCY.

76. The PPF with Increasing Opportunity Costs Y PPF X

77. Problems With Classical Theory Labor theory of value is unrealistic. Assumption of constant opportunity costs is too restrictive. Demand is largely ignored.

78. Autarky Equilibrium In the absence of trade producers will seek to maximize profits. consumers will seek to maximize utility.

79. Production Equilibrium In Autarky Producers will choose to produce where the relative cost of producing one more unit of X is just equal to the relative price at which the producer can sell a unit of X. That is, equilibrium occurs where

80. Producer Equilibrium in Autarky Y At point E, MCX/MCY= PX/PY. E Autarky Price Line PPF X

81. Consumer Equilibrium in Autarky Given relative prices (PX/PY) and income, consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve. Consumer equilibrium occurs where

82. Consumer Equilibrium Y Budget constraint CI4 E CI3 CI2 CI1 X

83. Autarky Equilibrium In equilibrium, supply and demand jointly determine PX/PY, and therefore how much X and Y is produced (and consumed).

84. Autarky Equilibrium Y Community indifference curve E Y1 Price line PPF X X1

85. The Introduction of International Trade Trade will cause relative prices to change. Producers will respond to this by altering relative production of goods X and Y. Consumers will respond to this by altering relative consumption of goods X and Y.

86. Production in Trade Let’s suppose that Country A has a comparative advantage in good X. What will happen to the relative price of good X as Country A moves to trade? It will rise (otherwise, Country A would not wish to produce more of good X in order to export it).

87. Production in Trade Y Steeper int’l price line means PX/PY has increased. E Y1 Autarky Price Line E' Y2 Int’l Price Line X X1 X2

88. Trade Equilibrium Country A Exports X3X2 (the distance FE’) Imports Y3Y2 (the distance FC’) Y C' Y3 imports F E' Y2 exports X X2 X3

89. Movement From Autarky to Trade Movement to trade causes relative price of good X to rise. Higher relative price means more X will be produced, less Y . Higher relative price of X lowers consumption of X, raises consumption of Y. Extra X is exported, shortfall in Y is met by imports.

90. Production and Consumption Gains from Trade There are two distinct sources of trade gains Consumption gain: Even if producers don’t change production levels, welfare is enhanced. Production gain: Specialization in the comparative advantage product leads to higher welfare.

91. Consumption Gains Even if producers don’t change production levels in response to a change to (Px/Py)2, the new consumer equilibrium at C is on a higher indifference curve. Y C E (Px/Py)2 X

92. Production Gains Eventually producers adjust production levels to E’. This permits additional gains to C’. Y C' C E E' (Px/Py)2 X

93. Countries A and B Together Let’s continue to suppose that A has a comparative advantage in good X. Therefore, B must have a comparative advantage in good Y. It must also be true that

94. Exports, Imports in A and B Country B Country A Y Y e' Y5 C' Y3 Exp. E e Y1 Y4 c' Imp. Y6 E' Y2 Imp. Exp. X2 X1 X X X4 X5 X3 X6

95. Minimum Conditions for Trade Trade will be mutually advantageous as long as the two countries’ APRs differ. This can occur because of: differences on the supply side, or differences on demand side, or Both.

96. Identical Demand Conditions Suppose that the citizens of Country A have the exact same tastes and preferences as the citizens of Country B. Then their community indifference curves would be identical. Autarky prices will still differ between the countries as long as the countries differ on their supply sides.

97. Identical Demand Conditions (PX/PY)T Y CI1 Y5 f C’, c’ CI2 Y2 Y3 F (PX/PY)T X X3 X5 X2

98. Identical Demand Conditions Even if demand conditions are the same, differences in supply conditions would cause differences in APRs across countries, and so: Trade could still be mutually advantageous. Implicitly, this is what is going on in the Classical model.

99. Identical Supply Conditions What if two countries have identical technologies and resource endowments? Then their PPFs would be identical. The Classical model would predict no trade, but what does the Neoclassical model show?

100. Identical Supply Conditions Y PPF for both countries X 6-100

101. Identical Supply Conditions Y (CI1)A E Y1 (PX/PY)A e Y4 (PX/PY)B (CI1)B X X1 X4 6-101

102. Identical Supply Conditions Y E Y1 Y3 E’, e' (PX/PY)T e Y4 X X1 X4 X3 6-102

103. Identical Supply Conditions Y2 Y C' E Y1 Y3 E’, e' e Y4 c' Y5 X X1 X4 X3 X5 X2 6-103

104. Identical Supply Conditions Even if supply conditions are the same, differences in demand conditions would cause differences in APRs across countries, and so: Trade could still be mutually advantageous. This was not a possibility in the Classical model, because it assumed away demand.

105. Offer Curves comprise all combinations of a country’s desired exports and imports at different terms of trade. are also known as reciprocal demand curves (J.S. Mill). measure a country’s willingness to trade. can be derived from the PPF-indifference curve graph.

106. Y C P Y1 Y2 (PX/PY)1 X Y X2 X1 (PX/PY)1 Y5 X X5 7-106

107. Y Y3 (PX/PY)1 Y4 (PX/PY)2 X4 X3 X Y (PX/PY)2 (PX/PY)1 Y6 Y5 X X5 X6 7-107

108. Y Y3 (PX/PY)1 Y4 (PX/PY)2 X4 X3 X Y (PX/PY)2 OCA (PX/PY)1 Y6 Y5 X X5 X6 7-108

109. Offer Curves Offer curves represent willingness to trade at every possible terms of trade. As the relative price of good X rises, Country A becomes willing to export more and import more. Offer curves “bow” towards the import good axis.

110. Deriving Country B’s Offer Curve This will reflect Country B’s willingness to trade at different terms of trade. B’s offer curve bows towards the axis with B’s import good on it.

111. Y (PX/PY)1 p Y7 c Y8 X Y X7 X8 (PX/PY)1 Y9 X X9 7-111

112. Y (PX/PY)1 Y10 (PX/PY)2 Y11 X Y X10 X11 (PX/PY)1 (PX/PY)2 OCB Y12 Y9 X X9 X12 7-112

113. Terms of Trade Equilibrium The international terms of trade (that is, PX/PY) will be the slope of a line passing through the point where the offer curves cross. This equilibrium point takes into account demand and supply conditions in both countries.

114. Terms of Trade Equilibrium OCA (PX/PY)E Y OCB Y1 If these are the terms of trade, country A will desire to export X1 units, and country B will want to import X1 units. X1 X

115. Terms of Trade Equilibrium OCA (PX/PY)E Y OCB Y1 If these are the terms of trade, country A will desire to import Y1 units, and country B will want to export Y1 units. X1 X

116. How Do We Know It’s Equilibrium? Any terms of trade other than (PX/PY)E will result in excess demand for one good, and excess supply for the other. Therefore relative prices will adjust until (PX/PY)E is reached.

117. Disequilibrium OCA (PX/PY)1 Y OCB X

118. Disequilibrium OCA (PX/PY)1 Y Y1 OCB Y2 At (PX/PY)1, country A wishes to import Y1 units, but country B is only interested in exporting Y2 units. That is, there is an excess demand for good Y. X

119. Disequilibrium OCA (PX/PY)1 Y OCB At (PX/PY)1, country A wishes to export X1 units, but country B is only interested in importing X2 units. That is, there is an excess supply of good X. X2 X1 X

120. Disequilibrium Excess demand for Y causes PY to rise. Excess supply of X causes PX to fall. Thus, (PX/PY) falls. In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium.

121. Moving Towards Equilibrium OCA (PX/PY)1 Y OCB X

122. Disequilibrium Terms of trade lines that are flatter than (PX/PY)E, such as

123. Disequilibrium OCA (PX/PY)2 Y OCB X

124. Disequilibrium Terms of trade lines that are flatter than (PX/PY)E will results in an excess demand for good X, and an excess supply of good Y, and so (PX/PY) will rise. That is, the terms of trade line will get steeper until (PX/PY)E is reached.

125. Moving Towards Equilibrium OCA (PX/PY)2 Y OCB X

126. A Note on the Terms of Trade A country’s “terms of trade” are the price of its exports divided by the price of its imports, so a rising terms of trade is good news. In this example, (PX/PY) is country A’s terms of trade, since A exports good X and imports Y. (PY/PX) is country B’s terms of trade in this example.

127. A Note on the Terms of Trade, continued As A’s terms of trade (PX/PY) improve, B’s terms of trade (PY/PX) must be deteriorating and vice-versa.

128. Shifts of Offer Curves Anything that causes country A’s willingness to trade to change will shift A’s offer curve. increased willingness to trade: OCA shifts right decreased willingness to trade: OCA shifts left These can be caused by changes in demand conditions or changes in supply conditions.

129. Demand Changes in Country A OCA (PX/PY)E Y OCB Y1 X1 X

130. Demand Changes in Country A OCA' OCA (PX/PY)E Y OCB Increased demand for imports by Country A causes a rightward shift of A’s offer curve. X

131. Demand Changes in Country A OCA' OCA (PX/PY)E Y (PX/PY)E' OCB Y2 Volume of trade increases, but A’s terms of trade go down. B’s terms of trade improve. X2 X

132. Demand Changes in A Any change that might make A demand more imports leads to a rightward OC shift, and thus an increase in trade volume, and a decrease in A’s terms of trade.

133. Demand Changes in Country B OCA (PX/PY)E Y OCB Y1 X1 X

134. Demand Changes in Country B OCA (PX/PY)E Y OCB' OCB Increased demand for imports by Country B shifts B’s OC upward. X

135. Demand Changes in Country B OCA (PX/PY)E Y (PX/PY)E' OCB' OCB Y2 Volume of trade increases, but Country B’s terms of trade decrease (and A’s terms of trade improve). X2 X

136. Other Demand Changes Any decrease in a country’s willingness to trade will shift its OC leftward or downward. An example is when a country imposes an import tariff. Tariffs therefore lead to decreased trade volume, but improve the imposing country’s terms of trade.

137. Supply Changes Changes in supply conditions will also shift a country’s offer curves around. Examples include productivity changes, and discovery of new resources.

138. Offer Curve Elasticity Until now, we’ve been dealing with offer curves that are elastic. Offer curves can also be unit elastic or even inelastic. The shape of the offer curves depends on the elasticity of demand for imports:

139. Offer Curve Elasticity Y From origin to point A, offer curve is elastic. Between points A and B, offer curve is inelastic. At point A, offer curve is unit elastic. B Y1 A X1 X

140. Offer Curve Elasticity Over the elastic range, a 1% change in the relative price of imports will lead to a greater than 1% change in quantity of imports purchased. Over the inelastic range, a 1% change in the relative price of imports will lead to a less than 1% change in quantity of imports purchased.

141. Offer Curve Elasticity Recall that in general a country gives up its export good in order to purchase its import good. Over the elastic range, a relative decline in the import price induces a country to give up more of the export good in order to buy more of the import good.

142. Offer Curve Elasticity Over the inelastic range, when there is a relative decline in the import price, a country is willing to give up less of the export good in order to buy more of the import good. This would occur if the income effect of a price change outweighs the combined effects of substitution and production.

143. Other Concepts of the Terms of Trade We’ve focused on the commodity terms of trade so far, but there are others: Income Terms of Trade Single Factoral Terms of Trade Double Factoral Terms of Trade

144. Midterm Topics

145. Midterm Topics Economic growth Regulation and Antitrust Policy Incentives and costs of Regulation International Trade