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# IBE303 International Economic Lecture 4

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### IBE303 International Economic Lecture 4

1. 1. Lecture 4<br />July 19th 2010<br />Saksarun (Jay) Mativachranon<br />
2. 2. Announcement<br />No class next week (July 26th, 2010)!<br />Midterm exam is on August 2nd, 2010<br />No quiz today<br />
3. 3. Response from regulations<br />
4. 4. Response from regulations<br />Creative Response<br />Firms subject to regulation may attempt to avoid the regulation or minimize the costs by conform to the letter, but not the intent<br />Feedback Effect<br />Consumers’ behavior change as a result of regulations; undermining the original intent of the regulation<br />
5. 5. Terms of Trade<br />
6. 6. Opportunity Cost<br />USA<br />1 computer = 0.5 wine<br />Italy<br />1 computer = 4 wines<br />Should USA trade 1 computer for 4 wines from Italy?<br />Or<br />Should Italy trade 1 wine for 2 computers from USA?<br />
7. 7. Assumptions of the Ricardian Model<br />A 2-country, 2-commodity world<br />Perfect competition<br />No transportation costs<br />Factors mobile internally, immobile internationally<br />Constant costs of production<br />Fixed technology for each country<br />All resources are fully employed<br />The “labor theory of value” holds<br />
8. 8. Notation<br />Let:<br />ax = labor time to produce 1 X in country A<br />ay = labor time to produce 1 Y in country A<br />bx = labor time to produce 1 X in country B<br />by = labor time to produce 1 Y in country B<br />
9. 9. Comparative Advantage Defined<br />Country A has a comparative advantage in good X if:<br />If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.<br />or if<br />or if<br />
10. 10. Comparative Advantage: An Example<br />
11. 11. Comparative Advantage<br />Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), <br />the U.S. must have a comparative advantage in corn.<br />Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), <br />Mexico must have a comparative advantage in blankets.<br />
12. 12. Comparative Advantage and the Total Gains from Trade<br />Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different.<br />How do we know that this is true?<br />
13. 13. Comparative Advantage and the Total Gains from Trade<br />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.<br />Suppose in our example <br />the U.S. has 1,000 hours of labor available and Mexico has 1,800.<br />
14. 14. U.S. Production Possibilities<br />Corn<br />1000<br />Slope: rise/run = -1000/200 = -5<br />A<br />500<br />100<br />200<br />Blankets<br />
15. 15. Slope of the PPF<br />for this example, -5<br />Notice: the slope (in absolute value) is the APR of the good on the horizontal axis.<br />Therefore, the slope is the opportunity cost of the good on the horizontal axis.<br />The slope is also the marginal rate of transformation.<br />
16. 16. Mexico’s Production Possibilities<br />Corn<br />600<br />Slope = -2, <br />or the opportunity cost of blankets <br />Blankets<br />300<br />
17. 17. Classical Model: The Gains from Trade<br />Suppose that in autarky<br />the U.S. is at point A<br />Producing 500 corn <br />Consuming 100 blankets<br />Mexico is at point B<br />Producing 300 corn <br />Consuming 150 blankets<br />
18. 18. U.S. Production Possibilities<br />Corn<br />1000<br />A<br />500<br />100<br />200<br />Blankets<br />
19. 19. Mexico’s Production Possibilities<br />Corn<br />600<br />B<br />300<br />Blankets<br />150<br />300<br />
20. 20. Classical Model: The Gains from Trade<br />Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of <br />1B = 3.33C or 1C = .3B<br />If the U.S. specializes in corn, how many units of corn could it produce? <br />1000<br />If Mexico specializes in blanket manufacture, how many blankets could be made? <br />300<br />
21. 21. The Gains from Trade: U.S.<br />If the U.S. wants to continue to consume 500C<br />They will now have 500C to trade for blankets<br />They produce 1,000C and 0B<br />If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C?<br />150<br />Therefore, the U.S. can consume outside its PPF (to point C) by trading!<br />
22. 22. U.S. Production Possibilities<br />Corn<br />1000<br />C<br />A<br />500<br />100<br />150<br />200<br />Blankets<br />
23. 23. The Gains from Trade: Mexico<br />If Mexico wants to continue to consume 150B<br />They will now have 150B to trade for corn.<br />They produce 300B and 0C<br />If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B?<br />500<br />Therefore, Mexico can also move outside its PPF (to point D) by trading!<br />
24. 24. Mexico’s Production Possibilities<br />Corn<br />600<br />D<br />500<br />B<br />300<br />Blankets<br />150<br />300<br />
25. 25. The Gains from Trade<br />Note: In general<br />The Ricardian model results in complete specialization.<br />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.<br />
26. 26. The Consumption Possibilities Frontier (CPF)<br />The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.<br />
27. 27. U.S. Consumption Possibilities<br />Corn<br />1000<br />C<br />A<br />500<br />CPF<br />200<br />100<br />150<br />300<br />Blankets<br />
28. 28. The Consumption Possibilities Frontier (CPF)<br />The CPF’s slope is the same as the terms of trade.<br />The CPF pivots around the production point.<br />If trade is to the benefit of a country, the CPF lies outside the PPF.<br />
29. 29. Mexico’s Consumption Possibilities<br />1000<br />Corn<br />CPF<br />600<br />D<br />500<br />300<br />B<br />Blankets<br />150<br />300<br />
30. 30. The Limits to Mutually Advantageous Trade<br />“Exchange rate” must be at least as great as Mexico’s APR.<br />“Exchange rate” must be no greater than the U.S.’s APR.<br />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.<br />
31. 31. The CPF and “Small” Countries<br />The nearer are the terms of trade to a country’s APR, the less that country will gain from trade.<br />The farther away the terms of trade are from a country’s APR, the more that country will gain from trade.<br />Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.<br />
32. 32. Adding Money to the Classical Model<br />Suppose a money economy instead of a barter economy.<br />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.).<br />An exchange rate that relates the countries’ currencies (e.g., \$1 = £1).<br />
33. 33. An Example<br />
34. 34. An Example<br />
35. 35. Adding Money to the Classical Model: An Example<br />The U.S. will export wheat, since it can produce wheat for a lower price <br />\$4, as compared with \$6<br />The U.K. will export cloth, since it can produce cloth for a lower price <br />\$4, as compared with \$6<br />
36. 36. The Export Condition<br />Country 1 should export good “j” when: <br />where<br />a1j and a2j are the labor requirements/hr to produce good “j” in countries 1 and 2<br />W1 and W2 are the wage rates/hr in countries 1 and 2<br />e is country 1’s exchange rate (# of country 2’s currency units per 1 of country 1’s).<br />
37. 37. The Export Condition<br />Country 1 should export good j when: <br />That is<br />when country 1’s good j price is lower than 2’s, stated in a common currency.<br />Therefore, the pattern of trade is determined by<br />Relative labor efficiency,<br />Relative wage rates, and<br />The exchange rate.<br />
38. 38. The Export Condition<br />Country A should export good j when: <br />Let’s re-write this as follows:<br />Country A should export good j when: <br />
39. 39. Wage Rate Limits<br />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.<br />As Country 1’s wage rate goes down relative to Country 2’s, Country 1 is less interested in importing from Country 2.<br />
40. 40. Wage Rate Limits: An Example<br />
41. 41. Wage Rate Limits: An Example<br />
42. 42. Wage Rate Limits: An Example<br />Should the U.S. (Country 1) export wheat? <br />It should if<br />Since <br />2/6 < 1/(3*0.5)<br />The U.S. should export wheat <br />U.S. wheat price is \$6<br />U.K. wheat price is £6 = \$12 after exchange rate<br />It’s easy to show that the U.K. should export cloth.<br />
43. 43. Wage Rate Limits: An Example<br />What if the U.S. wage rate rose to \$6?<br />
44. 44. Wage Rate Limits: An Example<br />
45. 45. Wage Rate Limits: An Example<br />Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency.<br />Exchange rate: £1 = \$2<br />Therefore, <br />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).<br />
46. 46. Wage Rate Limits: An Example<br />What if instead the U.S. wage rate fell to \$2.67?<br />
47. 47. Wage Rate Limits: An Example<br />
48. 48. Wage Rate Limits: An Example<br />What if the U.S. wage rate fell to \$2.67?<br />Now the U.S. cloth price is the same as the U.K.’s, if we state them in a common currency (\$8).<br />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).<br />
49. 49. Calculating Wage Rate Limits Using the Export Condition<br />Solve the export condition for W1, for good X.<br />Solve the export condition for W1, for good Y.<br />These will give you Country A’s wage rate limits.<br />For wheat(X):<br />2/6 = 1/(W1*0.5) -> W1= 6<br />For cloth(Y):<br />3/4 = 1/(W1*0.5) -> W1= 2.67<br />
50. 50. Country 2’s Wage Rate Limits<br />Changes in Country 2’s wage rates also can affect the pattern of trade.<br />If 2’s wage rises too much, they will not be able to export any more.<br />If 2’s wage falls too much, 2 will no longer wish to import.<br />
51. 51. Exchange Rate Limits<br />If Country 1’s currency appreciates<br />Imports will seem cheaper and exports more expensive.<br />If 1’s currency appreciates enough<br />A will no longer be able to export.<br />If 1’s currency depreciates enough<br />A will no longer wish to import.<br />
52. 52. More Than Two Goods<br />Having more than two goods has no effect on the basic Classical model.<br />The export condition can still be used.<br />
53. 53. More Than Two Goods: An Example<br />
54. 54. More Than Two Goods: An Example<br />Suppose the exchange rate is still \$1 = £0.5 (that is, e = 0.5).<br />Then <br />Use this as a “pointer”: <br />Country 1 should export everything to the left of the pointer<br />
55. 55. More Than Two Goods: An Example<br />W2/(W1*e) = 0.67<br />
56. 56. More Than Two Goods: An Example<br />If the U.S. wage rate were to fall<br />The pointer would move to the right<br />U.S. would start exporting goods it presently imports.<br />If the U.S. wage were to rise<br />The pointer would move left.<br />Changes in the U.K.’s wage, or the exchange rate, would also move the pointer and thus affect the pattern of trade.<br />
57. 57. Adding Transportation Costs<br />Assume:<br />All transportation costs are paid by the importer.<br />Transportation costs are measured in terms of their labor content.<br />Country 1’s export condition:<br />Suppose in previous example t-costs are 1 labor hour.<br />
58. 58. Transportation Costs: An Example<br />W2/(W1*e) = 0.67<br />
59. 59. Transportation Costs: An Example<br />Notice that although the U.K. has a comparative advantage in cloth, it will no longer export this product, since <br />In the real world, some products with high t-costs (e.g., bulky ones) are not traded.<br />
60. 60. More Than Two Countries<br />Having more than two countries also has no effect on the basic Classical model.<br />
61. 61. More Than Two Countries: An Example<br />
62. 62. More Than Two Countries: An Example<br />U.K. has the CA in cloth, since its autarky cloth price is the lowest.<br />U.S. has the CA in wheat, since its autarky wheat price is the lowest.<br />
63. 63. More Than Two Countries: An Example<br />If the Terms of Trade (ToT) are 1C = 1.8W (or: 1W = .55C)<br />Then the U.S. will export wheat (because the international wheat price is greater than the U.S. domestic price).<br />France and the U.K. will export cloth (because the international cloth price is greater than their domestic prices).<br />
64. 64. More Than Two Countries: An Example<br />ToT: 1C = 1.8W (or: 1W = .55C)<br />
65. 65. More Than Two Countries: An Example<br />If the terms of trade are 1C = 1.6W (or: 1W = .625C), then <br />The U.S. and France will export wheat (because the international wheat price is greater than their domestic prices).<br />The U.K. will export cloth.<br />
66. 66. More Than Two Countries: An Example<br />ToT: 1C = 1.6W (or: 1W = .625C)<br />
67. 67. Evaluating the Classical Model<br />Empirical studies generally show that the classical model is consistent with observed trading patterns.<br />However, the complexity of today’s world means the Classical model cannot supply a complete understanding of international trade.<br />
68. 68. Consumer Behavior Theory<br />How do consumers decide how much of each good to consume?<br />
69. 69. Consumer Indifference (CI) Curves<br />Y<br />Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI.<br />There are many, many CIs each representing higher or lower levels of consumer satisfaction.<br />A<br />B<br />X<br />
70. 70. Consumer Indifference Curves<br />Y<br />Utility on S3 > Utility on S2 > Utility on S1<br />S3<br />S2<br />S1<br />X<br />
71. 71. Consumer Indifference Curves<br />Are downward sloping because the goods are substitutes.<br />Slope is Marginal Rate of Substitution (MRS): <br />Are convex because of the principle of diminishing MRS.<br />Represent the welfare of an entire country, NOT an individual.<br />
72. 72. Consumer Budget Constraint<br />Y<br />Budget constraint shows combinations of X and Y that can be purchased with a given level of income at fixed prices. <br />The slope of the budget constraint is –Px/Py<br />X<br />
73. 73. Consumer Equilibrium<br />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.<br />Consumer equilibrium occurs where<br />
74. 74. Consumer Equilibrium<br />Y<br />Budget constraint<br />E<br />S3<br />S2<br />S1<br />X<br />
75. 75. Production Possibilities Frontier<br />Most PPFs are bowed out, not straight lines.<br />This is because resources are not equally suited to all kinds of production.<br />Slope of a tangent line at any point along the PPF is:<br />the marginal rate of transformation, or<br />the opportunity cost of the horizontal axis good, or<br />MCX/MCY.<br />
76. 76. The PPF with Increasing Opportunity Costs<br />Y<br />PPF<br />X<br />
77. 77. Problems With Classical Theory<br />Labor theory of value is unrealistic.<br />Assumption of constant opportunity costs is too restrictive.<br />Demand is largely ignored.<br />
78. 78. Autarky Equilibrium<br />In the absence of trade <br />producers will seek to maximize profits.<br />consumers will seek to maximize utility.<br />
79. 79. Production Equilibrium In Autarky<br />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.<br />That is, equilibrium occurs where <br />
80. 80. Producer Equilibrium in Autarky<br />Y<br />At point E, MCX/MCY= PX/PY.<br />E<br />Autarky Price Line<br />PPF<br />X<br />
81. 81. Consumer Equilibrium in Autarky<br />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.<br />Consumer equilibrium occurs where<br />
82. 82. Consumer Equilibrium<br />Y<br />Budget constraint<br />CI4<br />E<br />CI3<br />CI2<br />CI1<br />X<br />
83. 83. Autarky Equilibrium<br />In equilibrium, supply and demand jointly determine PX/PY, and therefore how much X and Y is produced (and consumed).<br />
84. 84. Autarky Equilibrium<br />Y<br />Community indifference<br />curve<br />E<br />Y1<br />Price line<br />PPF<br />X<br />X1<br />
85. 85. The Introduction of International Trade<br />Trade will cause relative prices to change.<br />Producers will respond to this by altering relative production of goods X and Y.<br />Consumers will respond to this by altering relative consumption of goods X and Y.<br />
86. 86. Production in Trade<br />Let’s suppose that Country A has a comparative advantage in good X.<br />What will happen to the relative price of good X as Country A moves to trade?<br />It will rise (otherwise, Country A would not wish to produce more of good X in order to export it).<br />
87. 87. Production in Trade<br />Y<br />Steeper int’l price line<br />means PX/PY has increased.<br />E<br />Y1<br />Autarky Price Line<br />E'<br />Y2<br />Int’l Price Line<br />X<br />X1<br />X2<br />
88. 88. Trade Equilibrium<br />Country A <br />Exports X3X2 (the distance FE’)<br />Imports Y3Y2 (the distance FC’)<br />Y<br />C'<br />Y3<br />imports<br />F<br />E'<br />Y2<br />exports<br />X<br />X2<br />X3<br />
89. 89. Movement From Autarky to Trade<br />Movement to trade causes relative price of good X to rise.<br />Higher relative price means more X will be produced, less Y .<br />Higher relative price of X lowers consumption of X, raises consumption of Y.<br />Extra X is exported, shortfall in Y is met by imports.<br />
90. 90. Production and Consumption Gains from Trade<br />There are two distinct sources of trade gains<br />Consumption gain: <br />Even if producers don’t change production levels, welfare is enhanced.<br />Production gain: <br />Specialization in the comparative advantage product leads to higher welfare.<br />
91. 91. Consumption Gains<br />Even if producers don’t change <br />production levels in response <br />to a change to (Px/Py)2, the new <br />consumer equilibrium at C is <br />on a higher indifference curve.<br />Y<br />C<br />E<br />(Px/Py)2<br />X<br />
92. 92. Production Gains<br />Eventually producers adjust <br />production levels to E’. This <br />permits additional gains to C’.<br />Y<br />C'<br />C<br />E<br />E'<br />(Px/Py)2<br />X<br />
93. 93. Countries A and B Together<br />Let’s continue to suppose that A has a comparative advantage in good X.<br />Therefore, B must have a comparative advantage in good Y.<br />It must also be true that<br />
94. 94. Exports, Imports in A and B<br />Country B<br />Country A<br />Y<br />Y<br />e'<br />Y5<br />C'<br />Y3<br />Exp.<br />E<br />e<br />Y1<br />Y4<br />c'<br />Imp.<br />Y6<br />E'<br />Y2<br />Imp.<br />Exp.<br />X2<br />X1<br />X<br />X<br />X4<br />X5<br />X3<br />X6<br />
95. 95. Minimum Conditions for Trade<br />Trade will be mutually advantageous as long as the two countries’ APRs differ.<br />This can occur because of:<br />differences on the supply side, or<br />differences on demand side, or<br />Both.<br />
96. 96. Identical Demand Conditions<br />Suppose that the citizens of Country A have the exact same tastes and preferences as the citizens of Country B.<br />Then their community indifference curves would be identical.<br />Autarky prices will still differ between the countries as long as the countries differ on their supply sides.<br />
97. 97. Identical Demand Conditions<br />(PX/PY)T<br />Y<br />CI1<br />Y5<br />f<br />C’, c’<br />CI2<br />Y2<br />Y3<br />F<br />(PX/PY)T<br />X<br />X3<br />X5<br />X2<br />
98. 98. Identical Demand Conditions<br />Even if demand conditions are the same, differences in supply conditions would cause differences in APRs across countries, and so:<br />Trade could still be mutually advantageous.<br />Implicitly, this is what is going on in the Classical model.<br />
99. 99. Identical Supply Conditions<br />What if two countries have identical technologies and resource endowments?<br />Then their PPFs would be identical.<br />The Classical model would predict no trade, but what does the Neoclassical model show?<br />
100. 100. Identical Supply Conditions<br />Y<br />PPF for both countries<br />X<br />6-100<br />
101. 101. Identical Supply Conditions<br />Y<br />(CI1)A<br />E<br />Y1<br />(PX/PY)A<br />e<br />Y4<br />(PX/PY)B<br />(CI1)B<br />X<br />X1<br />X4<br />6-101<br />
102. 102. Identical Supply Conditions<br />Y<br />E<br />Y1<br />Y3<br />E’, e'<br />(PX/PY)T<br />e<br />Y4<br />X<br />X1<br />X4<br />X3<br />6-102<br />
103. 103. Identical Supply Conditions<br />Y2<br />Y<br />C'<br />E<br />Y1<br />Y3<br />E’, e'<br />e<br />Y4<br />c'<br />Y5<br />X<br />X1<br />X4<br />X3<br />X5<br />X2<br />6-103<br />
104. 104. Identical Supply Conditions<br />Even if supply conditions are the same, differences in demand conditions would cause differences in APRs across countries, and so:<br />Trade could still be mutually advantageous.<br />This was not a possibility in the Classical model, because it assumed away demand.<br />
105. 105. Midterm Topics<br />
106. 106. Midterm Topics<br />Economic growth<br />Regulation and Antitrust Policy<br />Incentives and costs of Regulation<br />International Trade<br />