“changing policy environment and international business” prepared by vassily k. dermanov some...
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“Changing Policy Environment and
International Business”
Prepared by Vassily K. Dermanov
Some theory of international trade
2
International Trade• Buying and selling goods and services from
other countries
• The purchase of goods and services from abroad
that leads to an outflow of currency from the UK
– Imports (M)
• The sale of goods and services to buyers from
other countries leading to an inflow of currency
to the UK – Exports (X)
3
Labour productivity and comparative advantage: the
Ricardian model
4
Why countries are engaged in international trade?
First, countries trade because they are different from each other.
Second, countries trade to achieve economies of scale in production.
5
The concept
of comparative
advantage
6
The concept of comparative advantage
Is it possible to grow roses in Saint Petersburg?
It is a lot easier to grow roses in the South America.
A given amount of resources used in generator production yields fewer generators in South America than in Russia.
7
Opportunity cost and trade-off: the opportunity cost of roses in terms of electric generators is the number of
generators that could have been produced with the resources used to produce a
given number of roses.
The trade-off in South America might be something like 10 million roses for 100
generators, and 10 million roses for 500 generators in Russia.
8
Roses,millions
ElectricGenerators,
units
Russia 10 -
South America 10 -
Maximum 20 -
National Production
9
Roses,millions
ElectricGenerators,
units
Russia - 500
South America - 100
Maximum - 600
National Production
10
Roses,millions
ElectricGenerators,
units
Russia (50:50) 5 250
South America (50:50)
5 50
Total (50:50) 10 300
National Production
11
• Let Russia stop growing roses and devote the resources to produce generators.
• Let South America grow those roses instead.
• Look what has happened: Russia concentrating on generators and South America concentrating on roses, increases the size of the world's economic pie.
12
Roses,millions
ElectricGenerators,
units
Russia - 500
South America 10 -
World total 10 500
Hypothetical Changes in Production
13
•International trade increases world output because it allows each country to specialise in producing the good in which it has 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.
14
Specialisation and Trade
• Different factor endowments mean some countries can
produce goods and services more efficiently than others
– specialisation is therefore possible:
• Absolute Advantage:
– Where one country can produce goods with fewer resources
than another
• Comparative Advantage:
– Where one country can produce goods at a lower opportunity
cost – it sacrifices less resources in production
15
• South America has a comparative advantage in roses and Russia has a comparative advantage in generators.
• The standard of living can be increased in both places if South America produces roses for Russia, while the Russia produces generators for the South America.
So, trade between two countries can benefit both countries if each country exports the
goods in which it has a comparative advantage.
16
The Terms of Trade
• The Terms of Trade looks at the relationship between the price received for exports and the amount of imports we are able to buy with that money.
Average Price of Exports
Terms of Trade = ---------------------------------
Average Price of Imports
17
This approach, in which international trade is solely
based on international differences in the
productivity of labour, is known as the Ricardian
model.
18
A One-Factor
Economy
19
A One-Factor Economy
An economy (Home) has only one factor of production - labour.
Only two goods - wine and cheese - are produced.
The technology of Home's economy can be summarised by labour productivity in each industry, expressed in terms of the unit labour requirement.
20
A One-Factor Economy It might require: - 1 hour of labour to produce a kg of cheese, - 2 hours to produce a litre of wine. For future reference, we define:
alw as the unit labour requirements in wine production,
alc as the unit labour requirements in cheese production, respectively.
The economy's total resources are defined as L, the total labour supply.
21
Home wine production, Qw, in litres
Home cheese production, Qw, in kg
PPF
L/alw
L/alc
Absolute value of slope equals
opportunity cost of cheese in
terms of wine
22
L*/a*lw
L*/a*lc
Because Foreign's relative unit labour requirement in
cheese is higher than Home's (it needs to give up many
more units of wine to produce one more unit of
cheese), its production possibility frontier is steeper.
Foreign wine production, Qw, in litres
Foreign cheese production, Qw, in kg
PPF
23
RELATIVE PRICES
AND SUPPLY
24
RELATIVE PRICES AND SUPPLY
Let PС and PW be the prices of cheese and
wine, respectively.
Costs:
It takes aLC person-hours to produce a kg of cheese.
It takes aLW person-hours to produce a litre
of wine.
25
The economy will specialise in the cheese
production if PC /PW > aLC / aLW ;
it will specialise in the production of wine if
PC /PW < aLC / aLW .
Only when PC /PW is equal aLC / aLW , will
both goods be produced.
RELATIVE PRICES AND SUPPLY
26
The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost.
It will specialise in the production of wine if the relative price of cheese is less than its opportunity cost.
27
• In the absence of international trade, Home would have to produce both goods for itself. But it will produce both goods only if the relative price of cheese is just equal to its opportunity cost.
• In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements.
28
Trade in a
One-Factor World
29
Suppose that there are two countries: Home and Foreign.
We denote Home's labor force by L and Home's unit labor
requirements in wine and cheese production by aLW and aLC,
respectively.
We denote Foreign's labor force L*; Foreign's unit labor requirements in wine and cheese will be denoted by a*LW
and a*LC , respectively.
• Let as assume that:
aLC /aLW < a*LC / a*LW
• or, equivalently, that
aLC / a*LC < aLW / a*LW .
30
Wine production, Qw, in litres
Cheese production,
Qc, in kg
L/alw
PF
L/alc
HomeWine production,
QW*, in litres
Cheese production,
Qc, in kg
PF*
L*/a*lc
L*/a*lw
Foreign
31
• Home's relative productivity in cheese is higher than it is in wine.
Home has a comparative advantage in cheese.
• Foreign's relative productivity in wine is higher than it is in cheese.
• Foreign has a comparative advantage in wine.
32
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.
One of the most important sources of
error in discussing international
trade is to confuse comparative
advantage with absolute advantage.
33
In the absence of foreign trade the
relative prices in each country would
be determined by the relative unit labor
requirements.
In case of international trade prices
will no longer be determined purely by
domestic considerations.
34
The World
Relative Supply
and Demand
35
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
36
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
There will be no world cheese production and no world supply of cheese if the world price drops below аLC /аLW.
Home and Foreign will produce wine only whenever Pc/Pw < аLC /аLW .
37
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
When the relative price of cheese, Pc/Pw, is exactly аLC /аLW, workers in Home can earn exactly the same amount making either cheese or wine. So Home will be willing to supply any relative amount of the two goods, producing a flat section to the supply curve.
Foreign will produce wine whenever Pc/Pw < а*LC /а*LW .
38
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
If Pc/Pw is above аLC /аLW Home will specialize in the production of cheese. As long as Pc/Pw < а*LC /а*LW , however.
Foreign will continue to specialize in producing wine.
39
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
At Pc Pw = а*LC /а*LW, Foreign workers are indifferent between producing cheese and wine. Thus here we again have a flat section of the supply curve.
40
World Relative Supply and Demand
Pc/Рw
aLC / aLW
a*LC / a*LW
RS
RD
L / аLC
L* / а*LW
Relative quantity of cheese
Qc + Qc*
Qw + Qw*
Relative prices of cheese
Finally, for Pc/Pw > а*LC /а*LW, both Home and Foreign will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will become infinite.
41
Russia and Germany: mutual trade
OilOil f
rom Russia
Cars from Germany
Map courtesy of http://www.theodora.com
case
42
Russia and Germany: Relative Supply and Demand in oil and cars
Pc/Рoil
aruLC / aru
Loil
agerLC / ager
Loil
RS
RD
Lru / аruLC
Lger / аgerLoil
Relative quantity of cars
Qruc + Qcger
Qruoil + Qoilger
Relative prices of cars
43
The Gains From Trade
44
THE GAINS FROM TRADE
Trade as an indirect method of production
Home could produce wine directly, but trade with Foreign allows it to "produceproduce" wine by producing cheeseby producing cheese and then trading the cheese for wine.
This indirect method of "producing" wine is a more efficient method than direct production.
45
Trade affects each country's possibilities for consumption.
In the absence of trade, consumption possibilities are the same as production possibilities.
Once trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces.
Trade makes residents of each country better off.
Resources and Trade: The
Heckscher-Ohlin Model
47
Introduction• Comparative advantage could arise because of
international:
– differences in labor productivity;
– differences in countries' resources.
• Canada exports forest products to the United
States because Canada has more forested land
per capita than the United States.
48
• Labor is important, but what about of other factors of production (such as land,
capital, and mineral resources)?
• We will examine a model in which resource differences are the only source of trade.
• This model shows that comparative advantage is influenced by the interaction between nations' resources and the technology of production.
What does it mean
efficiency?
49
• Developed by two Swedish economists, Eli Heckscher and Bertil Ohlin (Nobel Prize in economics in 1977), the theory is often referred to as the Heckscher-Ohlin theory (H-O theory).
• H-O theory emphasises the interplay between the proportions in which different factors of production are available in different countries and the proportions in which they are used in producing different goods. Due to it is also referred to as the factor-proportions theory.
50
A Model of a Two-factor Economy
• The model is in many ways very similar to the specific factors model.
• It is assumed that each economy is able to produce two goods and that production of each good requires the use of two factors of production.
• The same two factors are used in both sectors. (It is a more difficult model, but with some new insights.
51
Assumptions of the Model• The economy we are analyzing can produce two goods:
cloth and food.• Production of these goods requires two inputs that are in
limited supply: labor and land. Let us define the following expressions:
• aTC = acres of land used to produce one m2 of cloth
• aLC = hours of labor used to produce one m2 of cloth
• aTF = acres of land used to produce one calorie of food
• aLF = hours of labor used to produce one calorie of food
• L = economy's supply of labor • Т = economy's supply of land
52
• Notice that we speak in these definitions of the quantity of land or labor used to produce a given amount of food or cloth, rather than the amount required to produce that amount.
• The reason is that in a two-factor economy there may be some room for choice in the use of inputs.
53
Input Possibilities in Food Production
Unit land input aTF , in acres per calorie
Unit labor input, aLF , in hours per calorie
Input combinations thatproduce one calorie of food
I I
54
• What input choice will producers actually make? It depends on the relative cost of land and labor.
• If land rents are high and wages low, farmers will choose to produce using relatively little land and a lot of labor.
• If rents are low and wages high, they will save on labor and use a lot of land.
55
Factor Prices and Input Choice
Wage-rental
ratio, w/r
Land-labor
ratio, T/L
FF
In each sector, the ratio of land to labor used in production depends on the cost of labor relative to the cost of land, w/r. The curve FF shows the land-labor ratio choices in food production, the curve CC the corresponding choices in cloth production.
At any given wage-rental ratio, food production uses a higher land-labor ratio; so, food production is land-
intensive and that cloth production is labor-intensive.
w/r
СС
w - is the wage rate per hour of labor;r - the cost of one acre of land,
56
Factor Prices and Goods Prices
• Suppose that the economy produces both cloth and food.
• Then competition among producers in each sector will ensure that the price of each good equals its cost of production.
• The cost of producing a good depends on factor prices: If the rental rate on land is higher, then other things equal the price of any good whose production involves land input will also have to be higher.
57
Factor Prices and Goods PricesRelative price of cloth, PC/PF
Wage-rental ratio, w/r
SS
Because cloth production is labor-intensive there is a one-to-one relationship between the factor price ratio w/r and the relative price of cloth PC/PF .
The higher the relative cost of labor, the higher must be the relative price of the labor-intensive good.
58
Let us put previous figures together. In combined figure the SS curve will be turned on its side, while the right panel reproduces figure with “Factor prices and Input Choice”.
Relative price of cloth, PC/PF
Wage-rental ratio, w/r
SS
Wage-rental
ratio, w/r
Land-labor
ratio, T/L
FF
w/r
СС
59
From Goods Prices to Input Choices
Relativeprice of cloth, PC/PF
Land-labor
ratio, T/L
FF
СС
w/r1
w/r2
SS
PC/P 2F PC/P1
FTC/L1
C TC/L2C TF/L1
F TF/L2F
IncreasingIncreasing
By putting these diagrams together, we see a surprising linkage of the prices of goods to the ratio of land to labor used in the production of each good. Wage-rental
ratio, w/r
60
From Goods Prices to Input Choices
Relativeprice of cloth, PC/PF
Wage-rental
ratio, w/r
Land-labor
ratio, T/L
FF
СС
w/r1
w/r2
SS
PC/P 2F PC/P1
FTC/L1
C TC/L2C TF/L1
F TF/L2F
IncreasingIncreasing
61
Resources and Output
• Let us describe the relationship between goods prices, factor supplies, and output.
• Suppose that we take the relative price of cloth as given.
• Relative price of cloth determines the wage-rental ratio w/r, and thus the ratio of land to labor used in the production of both cloth and food.
62
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
63
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
The height of the box
represents total
supply of land.
64
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
gThe width of the box represents the
economy's total supply of labor.
65
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
OF
LF
LC
TFTC
OC
C
F
1
66
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
OF
LF
LC
TFTC
OC
C
F
1
Thus at point 1 OCLC is the labor used in cloth production and OCTC is the land used in cloth production.
We measure the use of labor and land in the cloth sector as the horizontal and vertical distances of such a point from OC .
Thus at point 1 OCLC is the labor used in cloth production and OCTC is the land used in cloth production.
67
The Allocation of Resources
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
OF
LF
LC
TFTC
OC
C
F
1
We measure inputs into the food sector starting from the opposite comer: OFLF is the labor, OFTF the land used in food production.
OF
68
The question is what happens when the
economy's supply of land is increased, holding both goods prices and the labor
supply fixed.
69
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
O1F
L1C
T1C
OC
C
F1
1
An Increase in the Supply of Land
O2F
F2
2T2C
L2C
70
Increasing
IncreasingL
and u
sed in food production
Labor used in cloth production
Labor used in food production
Lan
d u
sed
in c
loth
pro
duct
ion
Increasin
gIn
crea
sin
g
O1F
L1C
T1C
OC
C
F1
1
An Increase in the Supply of Land
O2F
F2
2T2C
L2C
Thus an increase in the economy's supply of land will, holding prices constant, lead to a fall in the output of the labor-intensive good.
71
Output of food, QF
Output of cloth, QC
Q2F
Q2C
2
TT1
Q1F
1
Q1C
An increase in the supply of land shifts the economy's production possibility frontier outward from TT1 to TT2, but does so disproportionately in the direction of food production. The result is that at an unchanged relative price of cloth (indicated by the slope -PС/PF), cloth production
actually declines from Q1C to
Q2C.
Resources and Production Possibilities
TT2
Slope = - PM / PF
Slope = - PC / PF
72
Output of energy, QE
Output of machinery, QM
Q2E
Q2M
2
TT1
Q1E
1
Q1M
An increase in the supply of
energy shifts the economy's
production possibility
frontier outward from TT1
to TT2. The result is that at at
an unchanged relative price an unchanged relative price
of machineryof machinery (indicated by
the slope -PM /PE),
machinery production
actually declines from Q1M
to Q2M.
Russia: resources and Production Possibilities
TT2
Slope = - PM / PE
Slope = - PM / PE
case
73
• The biased effect of increases in resources on
production possibilities is the key to
understanding how differences in resources give
rise to international trade.
• An increase in the supply of land expands
production possibilities disproportionately in the
direction of food production, while an increase in
the supply of labor expands them
disproportionately in the direction of cloth
production.
74
Abundance and Intensity
The resource of which a country has a relatively large supply is the abundant factor in that country, and the resource of which it has a relatively small supply (land in Home, labor in Foreign) is the scarce factor.
75
Abundance and Intensity
Example:
If America has 80 million workers and 200 million acres (a labor-to-land ratio of 1: 2.5), while Britain has 20 million workers and 20 million acres (a labor-to-land ratio of 1:1) we consider Britain to be labor-abundant even though it has less total labor than America.
• Since Home has a higher ratio of labor to
land than Foreign, Home is labor-
abundant and Foreign is land-abundant.
76
Abundance and Intensity
• So, "abundance" is always defined in relative
terms, by comparing the ratio of labor to land in
the two countries.
• Thus, no country is abundant in everything.
• Since cloth is the labor-intensive good, Home's
production possibility frontier relative to
Foreign's is shifted out more in the direction of
cloth than in the direction of food.
77
Thus an economy with a high ratio of land
to labor will be relatively better at
producing food than an economy with a low
ratio of land to labor.
Generally, an economy will tend to be
relatively effective at producing goods
that are intensive in the factors with
which the country is relatively well-
endowed.
78
Effects Of International Trade Between Two-Factor Economies
• What happens when two such economies, Home and Foreign, trade.
• Home and Foreign are similar along many dimensions:– the same tastes,– identical relative demands for food and cloth,– the same technology: a given amount of land and labor
yields the same output of either cloth or food in the two countries.
79
Effects Of International Trade Between Two-Factor Economies
The only difference between the countries is in their resources: Home has a higher ratio of labor to land than
Foreign does.
80
• That means that Home will have a
larger relative supply of cloth.
• Home's relative supply curve, then,
lies to the right of Foreign's.
• The relative supply schedules of
Home (RS) and Foreign (RS*) are
illustrated in the next figure.
81
RS
RS*
RSWORLD
RDWORLD
(PC/PF)*
(PC/PF)
(PC/PF)W
Relative quantity of cloth,
Relative price of cloth, PC/PF
Trade Leads to a Convergence of Relative Prices
Qc + Qc*QF + QF*
1
2
3
In the absence of trade, Home's equilibrium would be at point 1, where domestic relative supply RS intersects the relative demand curve RD.
In the absence of trade, Foreign's equilibrium would be at point 3., where Foreign relative supply RS* intersects the relative demand curve RD.
Trade leads to a world relative price that lies between the pretrade prices, e.g., at point 2.
The standard
trade model
83
In spite of the differences in their details, our models share a number of
features.
1. The productive capacity of an economy can be
summarized by its production possibility frontier.
2. Production possibilities determine a country's
relative supply schedule.
3. World equilibrium is determined by world
relative demand and a world relative supply.
84
• The models may be viewed as special cases of a more general model of a trading world economy.
• So, let’s develop a standard model of a trading world economy to understand how a variety of changes in basic parameters affect the world economy.
85
A STANDARD MODEL OF A TRADING ECONOMY
The standard trade model is built on four key relationships:
• the relationship between the production possibility frontier and the relative supply curve;
• the relationship between relative prices and relative demand;
• the determination of world equilibrium by world relative supply and world relative demand,
• and the effect of the terms of trade on a nation's welfare.
86
PRODUCTION POSSIBILITIES AND RELATIVE SUPPLY
• Let’s assume that each country produces– two goods, food (F) and cloth (C),
– country's production possibility frontier is a smooth curve.
87
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
The point on PPF at which an economy actually produces depends on the price of cloth relative to food, PC/PF.
88
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
It is a basic proposition of microeconomics that a market
economy maximizes the value of output at given market prices,
PCQC + PFQF .
89
We can indicate the market value of output by drawing a number of isovalue lines — that is, lines along which the value of output is constant.
90
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
Q
Isovalue lines
TT
An economy whose production possibility frontier is TT will produce at Q, which is on the highest possible isovalue line.
91
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
Q
Isovalue lines
TT
Each of these lines is defined
by an equation of the form
PCQC + PFQF = V.
92
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
Q
Isovalue lines
TTThe higher V is, the farther out an isovalue line lies; thus isovalue lines farther from the origin correspond to higher values of
output.
93
Relative Prices Determine the Economy's Output
Food production, QF
Cloth production, QС
Q
Isovalue lines
TTThe economy will produce the highest value of output it can, which can be achieved by producing
at point Q.
94
How an Increase in the Relative Price of Cloth Affects Relative Supply
Food production, QF
Cloth production, QС
TT
Q1
Q2
V V1 (PC/PF)1
V V2 (PC/PF)2
The isovalue lines become
steeper when the relative
price of cloth rises from
(PC/PF)1 to (PC/PF)2
(shown by the rotation
from VV1 to VV2). As a
result, the economy
produces more cloth and
less food and the
equilibrium output shifts
from Q1 to Q2.
95
RELATIVE PRICES AND DEMAND
• The value of an economy's consumption equals the value of its production:
PCQC + PFQF = PCDC + PFDF = V
• Production and consumption must lie on the same isovalue line.
96
Food production, QF
Cloth production, QС
TT
D
Production, Consumption, and Trade in the Standard Model
Isovalue line
Indifference curves
Cloth exports
Food imports
The economy produces at point Q,.
The economy consumes at
point D.
Q
97
Food production, QF
Cloth production, QС
TT
D
Q
Production, Consumption, and Trade in the Standard Model
Isovalue line
Indifference curves
Cloth exports
Food imports
The economy produces
more cloth than it
consumes and therefore
exports cloth;
correspondingly, it
consumes more food
than it produces and
therefore imports food.
The economy produces
more cloth than it
consumes and therefore
exports cloth;
correspondingly, it
consumes more food
than it produces and
therefore imports food.
98
Food production, QF
Cloth production, QС
TT D1
Q1
When that relative
price rises all isovalue
lines become steeper.
The maximum-value line
rotates from VV1 to VV2.
Effects of a Rise in the Relative Price of Cloth
Q2
D2
V V1 (PC/PF)1
V V2 (PC/PF)2
99
Food production, QF
Cloth production, QС
TT D1
Effects of a Rise in the Relative Price of Cloth
V V1 (PC/PF)1
V V2 (PC/PF)2
The economy produces
more C and less F,
shifting production
shifts from Q1 to Q2
The economy's consumption choice shifts from D1 to D2
Q1
The economy's consumption choice shifts from D1 to D2D2
Q2
The economy produces
more C and less F,
shifting production
from Q1 to Q2
100
Food production, QF
Cloth production, QС
TT D1
The move from D1 to D2 reflects two effects of the rise in PC/PF
V V1 (PC/PF)1
V V2 (PC/PF)2
1) the economy has moved to a higher indifference curve: It is better off. The reason is that this economy is an exporter of cloth.
Q1
1) the economy has moved to a higher indifference curve: It is better off. The reason is that this economy is an exporter of cloth.
D2
Q2
101
Food production, QF
Cloth production, QС
TT D1
The move from D1 to D2 reflects two effects of the rise in PC/PF
V V1 (PC/PF)1
V V2 (PC/PF)2
2) the change in relative prices leads to a shift towards consumption of more food
Q1
2) the change in relative prices leads to a shift towards consumption of more food.
D2
Q2
102
Consumer goods production, QC
Oil production, QО
TT D1
Q1
Effects of a Rise in the Relative Price of Oil
Q2
D2
V V1 (PO/PC)1
V V2 (PO/PC)2
case
103
THE WELFARE EFFECT OF CHANGES IN THE TERMS OF TRADE
• When PC/PF increases, a country that initially
exports cloth is made better off, as illustrated
by the movement from D1 to D2.
• Conversely, if PC/PF were to decline, the
country would be made worse off; for
example, consumption might move back
from D2 to D1.
104
THE WELFARE EFFECT OF CHANGES IN THE TERMS OF TRADE
The general statement, then, is that a rise in the terms of trade
increases a country's welfare, while a decline in the terms of
trade reduces its welfare.
105
RS
RD
(PC/PF)1
Relative quantity of cloth,
Relative price of cloth, PC/PF
Qc + Qc*QF + QF*
1
World Relative Supply and Demand 1) An increase in PC/PF
leads both countries to
produce more cloth
and less food.
2) An increase in PC/PF leads both countries to shift their consumption mix away from cloth toward food.
106
Now we can use RS, RD
and the ToT to
understand a number of
important issues in
international economics.
107
ECONOMIC GROWTH: A SHIFT OF THE RS CURVE
• The effects of economic growth in a trading
world economy are a source of concern
around two questions:
– is economic growth in other countries good or
bad for our nation?
– is growth in a country more or less valuable
when that nation is part of a closely integrated
world economy?
108
The effects of growth
“+” “-”
at home on other
economies
in other countries on
home economy
109
The effects of growth at home
• On one hand, growth in an economy's production capacity should be more valuable when that country can sell some of its increased production to the world market.
• On the other hand, the benefits of growth may be passed on to foreigners in the form of lower prices for the country's exports rather than retained at home.
110
The effects of growth in other countries
• On one side, economic growth in the rest of the world may be good for our economy because it means larger markets for our exports.
• On the other side, growth in other countries may mean increased competition for our exporters.
111
The standard model of trade provides a
framework that can clarify the effects of
economic growth in a trading world.
112
GROWTH AND THE PRODUCTION POSSIBILITY FRONTIER
• This growth can result either from increases
in a country's resources or from
improvements in the efficiency with which
these resources are used.
• The international trade effects of growth
result from the fact that such growth growth
typically has a biastypically has a bias.
113
Food production, QF
Cloth production, QC
TT1 TT2
Biased GrowthFood production, QF
Cloth production, QC
TT1 TT2
b) growth biased toward fooda) growth biased toward cloth
Growth is biased when it shifts production possibilities out more
toward one good than toward another. In both cases the
production possibility frontier shifts out from
TT1 to TT2 .
114
Food production, QF
Cloth production, QC
TT1 TT2
Biased GrowthFood production, QF
Cloth production, QC
TT1 TT2
b) growth biased toward fooda) growth biased toward cloth
In case (a) this shift is biased toward cloth.
In case (b) this shift is biased toward food.
115
Food production, QF
Cloth production, QC
TT1 TT2
Biased GrowthFood production, QF
Cloth production, QC
TT1 TT2
b) growth biased toward fooda) growth biased toward cloth
In case (a) at an unchanged relative price of cloth the output of food actually
falls.
In case (b) at an unchanged relative price of cloth the output of cloth actually
falls.
116
Growth may be biased for two main reasons:
1. The Ricardian model shows that technological progress in one sector of the economy will expand the economy's production possibilities more in the direction of that sector's output than in the direction of the other sector's output.
117
Growth may be biased for two main reasons:
2. The H-O Model showed that an increase in a country's supply of a factor of production — say, an increase in the capital stock resulting from saving and investment — will produce biased expansion of production possibilities.
118
RS2
RD(PC/PF)2
(PC/PF)1
Relative price of cloth, PC/PF
1
2
RS1
Growth and Relative Supply
Relative quantity of cloth,
Qc + Qc*
QF + QF*
a) Cloth-biased growth
Suppose that Home experiences growth strongly biased toward cloth, so that its output of cloth rises at any given relative price of cloth, while its output of food declines.
119
RS2
RD(PC/PF)2
(PC/PF)1
Relative price of cloth, PC/PF
1
2
RS1
Growth and Relative Supply
a) Cloth-biased growth
Then for the world as a whole the output of cloth relative to food will rise at any given price and the world relative supply curve will shift to the right from RS1 to RS2.
Relative quantity of cloth,
Qc + Qc*
QF + QF*
120
RS2
RD(PC/PF)2
(PC/PF)1
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS1
Growth and Relative Supply
Qc + Qc*
QF + QF*
a) Cloth-biased growth
This shift results in a decrease in the relative price of cloth from (PС/PF)1 to
(PС/PF)2 , a worsening
of Home's terms of trade and an improvement in Foreign's terms of trade.
121
RS2
RD(PC/PF)2
(PC/PF)1
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS1
Growth and Relative Supply
Qc + Qc*
QF + QF*
RS1
RD(PC/PF)1
(PC/PF)2
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS2
Qc + Qc*
QF + QF*
b) Food-biased growth a) Cloth-biased growth
122
RS2
RD(PC/PF)2
(PC/PF)1
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS1
Growth and Relative Supply
Qc + Qc*
QF + QF*
RS1
RD(PC/PF)1
(PC/PF)2
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS2
Qc + Qc*
QF + QF*
b) Food-biased growth a) Cloth-biased growth
Notice that the important consideration
here is not which economy Grows but the bias
of the growth.
123
Growth and Relative Supply
RS1
RD(PC/PF)1
(PC/PF)2
Relative quantity of cloth,
Relative price of cloth, PC/PF
1
2
RS2
Qc + Qc*
QF + QF*
b) Food-biased growth
Either Home or Foreign
growth biased toward food
leads to a leftward shift of
the RS curve (RS1 to RS2)
and thus to a rise in the
relative price of cloth from
(PС/PF)1 to (PС/PF)2. This
increase is an
improvement in Home's
terms of trade, a
worsening of Foreign's.
124
• Growth that disproportionately expands a country's production possibilities in the direction of the good it exports (cloth in Home, food in Foreign) is export-biased growth.
• Similarly, growth biased toward the good a country imports is import-biased growth.
125
Our analysis leads to the following general principle:
• 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.
126
INTERNATIONAL EFFECTS OF GROWTH
• We are now able to resolve our questions about the international effects of growth.
• Is growth in the rest of the world good or bad for our country?
• Does the fact that our country is part of a trading world economy increase or decrease the benefits of growth?
127
• export-biased growth in the rest of the world is good for us, improving our terms of trade,
• while import-biased growth abroad worsens our terms of trade.
128
• Export-biased growth in our own country worsens our terms of trade, reducing the direct benefits of growth,
• while import-biased growth leads to an improvement of our terms of trade, a secondary benefit.
129
Economies of scale and
international trade
130
There are two reasons why countries specialize and trade:
1. countries differ either in their resources or in technology and specialize in the things they do relatively well;
2. economies of scale (or increasing returns) make it advantageous for each country to specialize in the production of only a limited range of goods and services.
132
International trade plays a crucial
role: It makes it possible for each
country to produce a restricted range of
goods and to take advantage of
economies of scale without sacrificing
variety in consumption.
133
• Mutually beneficial trade can arise as a result of economies of scale.
• Each country specializes in producing a limited range of products, which enables it to produce these goods more efficiently than if it tried to produce everything for itself.
• Specialized economies then trade with each other to be able to consume the full range of goods.
134
• External economies of scale occur when the cost per unit depends on the size of the industry but not necessarily on the size of any one firm.
• Internal economies of scale occur when the cost per unit depends on the size of an individual firm but not necessarily on that of the industry.
135
• External and internal economies of scale have
different implications for the structure of
industries.
– An industry where economies of scale are purely
external will typically be perfectly competitive.
– Internal economies of scale lead to an
imperfectly competitive market structure.
• Both external and internal economies of scale
are important causes of international trade.
136
THE EFFECTS OF INCREASED MARKET SIZE
• In our contemporary world – both the variety of goods that a
country can produce – and the scale of its production
are constrained by the size of the market.
• By trading with each other, and therefore forming an integrated world market, nations are able to loosen these constraints.
137
Effects of a Larger Market
CC1
CC2
Number of firms, n
Cost, C andPrice, P
PP
1
2
n1 n2
P1
P2
An increase in the size of the market allows each firm, other things equal, to produce more and thus have lower average cost.
The more firms there are in monopolistically industry the lower the output of each firm, and thus the higher its average cost per unit of output.
138
Equilibrium in the Automobile Market
38
36
34
32
30
24
22
20
18
16
14
12
10
8
6
4
CC
Number of firms, n
Price per auto in thousands USD
PP
(a) The Home market1 2 3 4 5 6 7 8 9 10 11 12
Figure shows the PP and CC curves for the Home auto industry. In the
absence of trade when the market is for 900 000 auto Home would have 6 automobile firms, selling at a price of
$10,000 each.
139
Equilibrium in the Automobile Market
38
36
34
32
30
24
22
20
18
16
14
12
10
8
6
4
CC
Number of firms, n
Price per auto in thousands USD
PP
(b) The Foreign market1 2 3 4 5 6 7 8 9 10 11 12
Figure shows the PP and CC curves for the Foreign auto industry. In the absence of trade when the market is for 1.6 million auto Foreign would
have 8 automobile firms, selling at a price of $ 8750 each.
140
Equilibrium in the Automobile Market
38
36
34
32
30
24
22
20
18
16
14
12
10
8
6
4
CC
Number of firms, n
Price per auto in thousands USD
PP
(c) Integrated1 2 3 4 5 6 7 8 9 10 11 12
Figure shows the PP and CC curves for combined market. Integrating the two markets creates a market for 2.5 million autos. This market supports 10 firms, and the price of an auto is
only $8000.
141
ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE
• How economies of scale interact with comparative advantage to determine the pattern of international trade.
• Let us imagine a world economy consisting, as usual, of our two countries Home and Foreign.
• Each of these countries has two factors of production, capital and labor.
142
Trade in a world without increasing return
Home (capital-abundant)
Foreign labor-abundant)
Manufactures Food
The length of the arrows indicates the value of trade in each direction; so Home would export manufactures equal in value to the food it imports.
143
Trade with increasing return and monopolistic competition
Home (capital-abundant)
Foreign labor-abundant)
Manufactures Food
Because of economies of scale, neither country is able to produce the full range of manufactured products by itself; thus they will be producing different things.
Interindustry
trade
Intraindustry
tradeHome will be a net exporter of
manufactures and an importer of food.
144
Trade with increasing return and monopolistic competition
Home (capital-abundant)
Foreign labor-abundant)
Manufactures Food
Because of economies of scale, neither country is able to produce the full range of manufactured products by itself; thus they will be producing different things.
Interindustry
trade
Intraindustry
trade
Home, although running a trade surplus in manufactures, will import as well as export within the manufacturing industry.
145
Trade with increasing return and monopolistic competition
Home (capital-abundant)
Foreign labor-abundant)
Manufactures Food
Because of economies of scale, neither country is able to produce the full range of manufactured products by itself; thus they will be producing different things.
Interindustry
trade
Intraindustry
trade
Foreign firms in the manufacturing sector will produce products different
from those that Home firms produce.
146
• World trade in a monopolistic competition model consists of two parts.
• There will be two-way trade within the manufacturing sector. This exchange of manufactures for manufactures is called intraindustry trade.
• The remainder of trade is an exchange of manufactures for food called interindustry trade.
147
• Interindustry (manufactures for food) trade reflects comparative advantage. The pattern of interindustry trade is that Home, the capital-abundant country, is a net exporter of capital-intensive manufactures and a net importer of labor-intensive food. So comparative advantage continues to be a major part of the trade story.
Four points about this pattern of trade:
148
• Intraindustry trade does not reflect comparative advantage. Even if the countries had the same overall capital-labor ratio, their firms would continue to produce differentiated products.
• Thus economies of scale can be an independent source of international trade.
Four points about this pattern of trade:
149
• The pattern of intraindustry trade itself is unpredictable. All we know is that the countries will produce different products. Since history and accident determine the details of the trade pattern, an unpredictable component of the trade pattern is an inevitable feature of a world where economies of scale are important.
Four points about this pattern of trade:
150
• The relative importance of intraindustry and interindustry trade depends on how similar countries are. If , for instance, Home and Foreign are similar in their capital-labor ratios, then there will be little interindustry trade, and intraindustry trade, based ultimately on economies of scale, will be dominant.
Four points about this pattern of trade:
151
THE SIGNIFICANCE OF INTRAINDUSTRY TRADE
• About 1/4 of world trade consists of intraindustry trade.
• The industrial countries have become increasingly similar in their levels of technology and in the availability of capital and skilled labor.
• There is often no clear comparative advantage within an industry, and much of international trade therefore takes the form of two-way exchanges within an industry.
152
Indexes of Intraindustry Trade for U.S. Industries
Inorganic chemicals 0.99
Power-generating machinery 0.97
Electrical machinery 0.96
Organic chemicals 0.91
Medical and pharmaceutical 0.86
Office machinery 0.81
Telecommunications equipment 0.69
Road vehicles 0.65
Iron and steel 0.43
Clothing and apparel 0.27
Footwear 0.20
intraindustry trade/total trade
153
The Theory of External Economies
• Economies of scale that occur at the level of the industry instead of the firm are called external economies.
• There are three main reasons why a cluster of firms may be more efficient than an individual firm in isolation:– Specialized suppliers– Labor market pooling– Knowledge spillovers
What does it mean cluster?
154
Clusters: Definitions from the Cluster Literature
• Porter (1998) “A cluster is a geographically proximate group of interconnected companies and associated institutions in a particular field, linked by commonalities and complementarities”.
• Crouch and Farrell, (2001) “The more general concept of ‘cluster’ suggests something looser: a tendency for firms in similar types of business to locate close together, though without having a particularly important presence in an area.”
• Rosenfeld (1997) “A cluster is very simply used to represent concentrations of firms that are able to produce synergy because of their geographical proximity and interdependence, even though their scale of employment may not be pronounced or prominent.”
155
Clusters: Definitions from the Cluster Literature
• Roelandt and den Hertag (1999) “Clusters can be characterised as networks of producers of strongly interdependent firms (including specialised suppliers) linked each other in a value-adding production chain.”
• Swann and Prevezer (1998) “A cluster means a large group of firms in related industries at a particular location”.
• Simmie and Sennett (1999) “We define an innovative cluster as a large number of interconnected industrial and/or service companies having a high degree of collaboration, typically through a supply chain, and operating under the same market conditions.”
156
• In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services.– An individual company does not provide a large
enough market for these services to keep the suppliers in business.
• A localized industrial cluster can solve this problem by bringing together many firms that provide a large enough market to support specialized suppliers.
– This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley.
Specialized Suppliers
157
• A cluster of firms can create a pooled market for workers with highly specialized skills.– It is an advantage for:
• Producers– They are less likely to suffer from labor
shortages.
• Workers– They are less likely to become unemployed.
Labor Market Pooling
158
• Knowledge is one of the important input factors in highly innovative industries.– The specialized knowledge that is crucial
to success in innovative industries comes from:• Research and development efforts
• Reverse engineering
• Informal exchange of information and ideas
Knowledge Spillovers
159
• External Economies and the Pattern of Trade– A country that has large production in some
industry will tend to have low costs of producing that good.
– Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply.
External Economies and International Trade
160
External Economies and Specialization
ACSWISS
Q1
P1
Price, cost (per watch)
Quantity of watchesproduced and demanded
ACTHAI
2
1
C0
D
Thailand could potentially supply the world market more cheaply than Switzerland. If the Swiss industry gets established first, however, it may be able to sell watches at the price P1, which is below the cost C0 that an individual Thai firm would face if it began production on its own.
161
• Trade based on external economies has more ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies of scale at the level of the firm.
Trade and Welfare with External Economies
162
Russia in a changing world
• What is a Russia’s role in current
international division of labour?
• What may be a Russia’s role in a future
international division of labour?