13001IBA Lecture Notes 5Week 5 Topic 3.2 Economic Integr.docx

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3001IBA Lecture Notes 5/Week 5
Topic 3.2 Economic Integration/Regionalism/
The WTO
Text: Carbaugh R J (2013), International Economics, 14th
Edition
Regional Trading Arrangements
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© 2011 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password‐protected website for
classroom use
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Learning Objectives
Discuss Economic Integration – the types of regional
agreements
Discuss and analyse the Static economic effects of economic
integration:
Trade creation and welfare
Trade diversion and welfare
3. Discuss the Dynamic economic effects of regional
integration
Give a Brief overall assessment of the effects of economic
integration
Provide a Case Study of the European Union
Briefly discuss the WTO

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Types of Regional Trading Arrangements
Economic integration
Process of eliminating restrictions on international trade,
payments, and factor mobility
Results in the uniting of two or more national economies in a
regional trading arrangement
Motivations for regional trading arrangements
Prospect of enhanced economic growth
Economies of large-scale production & attract foreign
investment
Foster a variety of noneconomic objectives
Managing immigration flows
Promoting regional security
Enhance & solidify domestic economic reforms
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Free-trade area
Association of trading nations
Members agree to remove all tariff and nontariff barriers among
themselves
Each member maintains its own set of trade restrictions against
outsiders
North American Free Trade Agreement (NAFTA)
Canada, Mexico, and the United States
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Free-trade area (continued)
Association of trading nations
Agreement among members to remove trade barriers among
members while retaining independence in forming trade policies
with nonmembers.
Examples: multilateral - N(orth) A(merican) F(ree) T(rade)
A(greement) Canada, Mexico, and the United States; bilateral –
recent Australia-US FTA.

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Customs union
Agreement among two or more trading partners
To remove all tariff and nontariff trade barriers between
themselves
Each member nation imposes identical trade restrictions against
nonparticipants
Example:
Benelux
Belgium, the Netherlands, and Luxembourg – formed 1947;
absorbed into ECM 1958
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Common market
Group of trading nations
Customs union plus agreement that permits (1) free trade
among members; (2) common external trade restrictions; and (3)
free movement of factors of production
Example: E(uropean) C(ommon) M(arket) before it
evolved to the next type of arrangement
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Economic union
Common market agreement plus:
unification of main economic institutions and coordination
of economic policy between members.
Early example: Belgium and Luxembourg 1920s
National, social, taxation, and fiscal policies are harmonized
and administered by a supranational institution
Requires an agreement to transfer economic sovereignty to a
supranational authority

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Monetary union
Ultimate degree of economic union
So is economic union plus:
Unification of national monetary policies
Acceptance of a common currency administered by a
supranational monetary authority
Examples: United States, E(uropean) U(nion)
So all of above Types include trade liberalization for 2 or more
countries.
Question: What is APEC, & which above type does it
represent? (www.apec.org)
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Effects of a Regional Trading Arrangement
Static effects of economic integration
On productive efficiency
And consumer welfare
Trade creation takes place when there is a shift in product
origin from a higher-resource-cost domestic producer to a
lower-resource-cost member country producer. The shift
represents movement towards the free trade allocation.
Trade diversion takes place when there is a shift in product
origin from a lower-resource-cost nonmember producer to a
higher-resource-cost member country producer. The shift
represents movement away from the free trade allocation.
Dynamic effects of economic integration
Relate to long-term rates of growth
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Static effects
Trade-creation effect
Welfare gain
Some domestic production of one customs-union member
Replaced by another member’s lower-cost imports
Consumption effect

Production effect
Trade-diversion effect
Welfare loss
Imports from a low-cost supplier outside the union
Are replaced by purchases from a higher-cost supplier within
the union
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Trade creation and welfare
Consider a Customs Union (as defined previously), CU
Assume:
(1) Three countries L(uxembourg), US & G(ermany).
(2). No transportation costs
(3). Single good, produced in Countries US, G, and L.
SU.S. is the world price (faced by L, a price taker, (small
country). Under current trade arrangements (without a CU), L
imposes tariffs on imported grain – US is L’s lower cost
supplier at SU.S. + tariff, (since G’s supply price is SG + tariff)
Now L joins a CU with Country G, so it removes its tariff on
G’s grain exports (- which is now, at price SG, the lower-
resource-cost member). Since U.S. is a non-member of the CU,
the price of its grain exports to L is still SU.S. + tariff.

Welfare effects for trade creation (see diagram FIGURE 8.1)
There is Consumer surplus gain, a loss of producer surplus, and
a loss of tariff revenue
Adding all of these, the welfare gains = a + b which is positive
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Trade diversion and welfare
Again, Consider a Customs Union (as defined previously)
Assume same countries and product (grain) as previously.
Under current trade arrangements (without a CU), L
imposes a tariff only on imported grain from G – so US is L’s
lower cost supplier at SU.S. (the world free trade price), since
G’s supply price is SG + tariff.
Now L joins a CU with Country G, so it removes its tariff on
imported grain from G (- which is now, at price SG, the lower-
resource-cost member). Since U.S. is a non-member of the CU,
L imposes a tariff on imports of grain from the U.S. so the price
of its grain exports to L is now SU.S. + tariff.
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Welfare effects for trade diversion (see diagram FIGURE 8.1

, Text 14th edition)
There is Consumer surplus gain, a loss of producer surplus, and
a loss of tariff revenue from G’s imports, as well as a further
loss from the tariff now imposed on U.S. grain imports.
Adding all of these, the welfare gain/loss = a + b - c which may
be positive or negative – if negative it is trade diversion.
The closer is the CU partner (Country G) price SG to the low-
cost world (Country U.S.) price SU.S., (i.e. the smaller is c,)
the more likely that the impact of integration is positive for
Country L.
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The formation of a customs union leads to a welfare-increasing
trade creation effect and a welfare-decreasing trade diversion
effect. The overall effect of the customs union on the welfare of
its members, as well as on the world as a whole, depends on the
relative strength of these two opposing forces.
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Static welfare effects of a customs union
FIGURE 8.1

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Dynamic effects
Greater competition – increased number of producers makes
collusion less likely and forces firms to become more efficient
Economies of scale – access to a larger market allows producers
to become more efficient through greater specialization, better
equipment, and usage of by-products
Stimulus of investment – because of increased rate of return and
ability to spread R&D costs trade makes greater levels of
investment more likely
Dynamic benefits from increased factor mobility among the
members – both labour and capital can move more freely from
areas of surplus to areas of scarcity – higher factor incomes and
increased economic efficiency.
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Brief Overall Assessment of Regional Integration
Likely positive net effects:
The higher pre-customs union tariffs and the lower the common
external tariff
The more elastic supply and demand are in member countries
The greater the numbers of participating members and the larger
the group size
The greater the ease in shifting from a higher cost domestic

source to a lower cost member source, and the more preunion
per-unit cost differences between sources (and the greater the
scope for economies of scale and higher foreign investment and
technology – dynamic effects).
The lower are the transport costs between members –
geographic proximity.
Possible negatives:
The distribution of benefits among member countries is
unknown.
Product suitability and choice for the integration arrangements.
Historical trade connections are often lacking for small
potential member countries.
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Brief Overall Assessment of Regional Integration
Possible negatives cont.:
Increasing emphasis on regional integration (-e.g. appears to be
deepening in the Asia-Pacific area – APEC -) may provide
stumbling blocks to a multilateral trading system and trade
liberalisation as embodied in the W(orld) T(rade)
O(rganisation), given the discrimination from within the
regional groups:
In particular:
trade barriers may be reduced for a relatively small group of
member countries; the regional group may further raise trade
barriers to outside non-members:
economies of scale may not be obtained – relatively small
markets;
the group members may concentrate on regional trade

negotiations instead of participating globally:
domestic economic policies can be more difficult due to loss of
control, and lessened sovereignty and independence, for the
members.
Question: Any example(s) of difficulties, failed
economic integration?
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European Union: 1960 - 1985
Treaty of Rome – 1957 – established European Community –
precursor to EU
EU members removed tariffs in 1968 leading to fivefold
increase in trade
EU adopted common external tariffs in 1970 making it a
customs union
trade creation: machinery, transportation equipment, chemicals
& raw materials
trade diversion: agricultural commodities and raw materials
trade creation exceeded trade diversion
EU saw increases in economies of scale, competition,
investment
1985 EU eliminated nontariff barriers resulting in creation of
European common market
European Union & Maastricht
1991 Maastricht Treaty established monetary union and euro as
common currency by 2002

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European Monetary Union
A common currency also implied the need for a single European
Central Bank responsible for all monetary and exchange rate
policies of the EMU.
advantages:
eliminated exchange rate risk
reduced currency conversion costs
insulation from monetary disturbance & speculation
disadvantages:
loss of individual monetary authority
transition to common currency could lead to speculative attacks
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World Trade Organization
Does WTO Reduce National Sovereignty?
Yes – because of WTO disputes settlement
No – because findings of a WTO dispute-settlement panel
cannot force the United States to change its laws
Retaliatory tariffs for WTO enforcement?

Small country impose retaliatory tariffs
Relatively more costly to initiate
No favorable movements in its terms of trade
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TRADE CONFLICTS
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World Trade Organization
Trade liberalization - harms the environment?
“Race to the bottom” in environmental standards
Social preferences
Trade liberalization - improves the environment?
Trade stimulates economic growth
Key factors in societies’ demand for a cleaner environment
Tougher environmental laws
Trade and growth
Development and dissemination of environmentally friendly
production techniques
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TRADE CONFLICTS
The WTO
January 1, 1995, GATT transformed into WTO
WTO
153 nations, 97% of world trade
International organization, headquartered in Geneva,
Switzerland
Multilateral trading system
Trade in services, intellectual property, and investment
Administers a unified package of agreements to which all
members are committed
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TRADE CONFLICTS
The WTO (cont.)
WTO
Reverses policies of protection in certain “sensitive” areas
Settling trade disputes
Is not a government
Individual nations - free to set their own appropriate levels of
environment, labor, health, and safety protections
Various councils and committees

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TRADE CONFLICTS
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3001BA
Lecture Notes 4 Week 4
Topic: Trade Policy and Competition
Tariffs & Nontariff Trade Barriers
Edition
Chapters 4 & 5 and 6 (pp. 188-191)
Copyright © 2009 South-Western, a division of Cengage
Learning. All rights reserved.
Learning Objectives
Define the instruments of Trade Policy
Discuss in detail tariffs with examples
Explain the basic concepts of Consumer & Producer Surplus
Analyse the economic or trade welfare effects of tariffs
Discuss traditional arguments for trade restrictions
Analyse the economic welfare effects of non-tariffs – quotas &
subsidies
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Restricted Trade and Instruments
Strategic Trade Policy
Is a set of government policies which interfere with free trade
flows, in order to protect or promote certain industries. (Why
choose? – “winners”
Strategic trade policy theories suggest how individual countries
can benefit over time from the active use of trade policy
instruments
The major trade Policy instruments are tariffs and non-tariffs –
examples of the latter being import and export quotas and
production subsidies
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The Tariff
Tariff
Definition A tax (duty) levied on a product when it crosses
national boundaries
Import tariff – much more common
Tax levied on an imported product
Export tariff –less common mainly used as an additional
revenue source
Tax imposed on an exported product
Often used by developing nations
Raise revenue, increase the world price
Purposes
Protective tariff – designed to reduce the amount of imports
entering a country; increases sales for domestic producers

Revenue tariff – designed to generate additional funds for
domestic governments
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Types of Tariffs
specific tariff (T) – fixed monetary amount per unit of the
imported good; P = Pw + T where P is price and Pw is the world
price
ad valorem tariff (t) – fixed percentage of the value of the
imported good; P = Pw.(1 + t)
customs valuation – process of determining the value of an
imported good
free-on-board (FOB) valuation – tariff applied as product leaves
country
cost-insurance-freight (CIF)valuation – tariff applied as
product enters country
compound tariff – combines the elements of both specific and
ad valorem tariffs

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Tariff revenues as a percentage of government revenues, 2007:
selected countries
TABLE 4.1Developing CountriesPercentageIndustrial Countries
PercentageThe Bahamas
Guinea
Ethiopia
Ghana
Sierra Leone
Madagascar
Dominican Republic
Jordan
51.2
47.9
33.5
28.5
27.6
26.9
20.9
11.3New Zealand
Australia
Japan
Canada
Switzerland
United States
United Kingdom
Iceland
2.6
2.5
1.2
1.2
1.2
1.1
1.0

1.0
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Examples of tariffs, selected countries (in %)
TABLE 4.3
Effective Rate of Protection
Nominal tariff rate
Published in the country’s tariff schedule
Applies to the value of a finished product that is imported into a
country
Effective tariff rate
Takes into account the nominal tariff rate
On a finished product
And any tariff rate applied to imported inputs
Used in producing the finished product
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Effective Rate of Protection
Effective tariff rate, e

e = The effective rate of protection
n = the nominal tariff rate on the final product
a = the ratio of the value of the imported input to the value of
the finished product
b = the nominal tariff rate on the imported input
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Effective Tariff Rate – Example
TABLE 4.4 p. 116 of Carbaugh
e = = = 0.5 = 50%
(n-ab)
(1-a)
0.1-0.8(0)
1-0.8
for this example:
n = $50/($100 + $400) = 0.1 = 10%
a = $400/($100 + $400) = 0.8
b = $0/($400) = 0
So in this case, e is much larger than n
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Tariff Escalation
tariff escalation – higher tariffs on intermediate and finished
goods and lower tariffs on raw materials examples – cases at
right from the TABLE:
incentive for developing nations to expand production
of raw materials
disincentive for developing nations to compete in market for
finished goods
Tariffs often rise significantly with the level of processing
(tariff escalation) in many industrial countries. This is
especially true for agricultural products. Tariff escalation in
industrial countries has the potential of reducing demand for
processed imports from developing countries, hampering
diversification into higher-value added exports.
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Tariff escalation on industrial countries’ imports from
developing countries
FIGURE 4.1
Outsourcing and Offshore-Assembly Provision
Outsourcing
Certain aspects of a product’s manufacture are performed in
more than one country
Low costs labor intensive produc

OAP - tariffs applied only to portion of production occurring in
another country
reduces effective tariff rate for domestic consumers
incentive for foreign producers to use home country components
in production
detrimental to home country workers who also produce the same
finished goods
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Postponing Import Tariffs
Bonded warehouse
Dutiable imports can be brought into the U.S. and temporarily
left in a bonded warehouse, duty-free
Imported goods - stored, repacked, or further processed - for up
to five years
No customs duties are owed until the goods are withdrawn for
domestic consumption
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Foreign-trade zone (FTZ)
An area within the U.S.

Business can operate without the responsibility of paying
customs duties on imported products or materials
For as long as they remain within this area
And do not enter the U.S. marketplace
Customs duties are due when goods are transferred from the
FTZ for U.S. consumption
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Foreign-trade zone (FTZ)
No time limit on how long goods can be stored
General-purpose zones
Public facilities
Used by more than one firm
Subzones
A single firm’s site
Used for more extensive manufacturing or assembly
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Tariff welfare effects. Basic Concepts - Consumer & Producer
Surplus

1) consumer surplus – additional benefit obtained by the buyer
of a good
difference between the maximum that the buyer is willing to pay
and the actual price
area below demand and above price
2) producer surplus – additional benefit obtained by the seller
of a good
difference between the minimum that the seller is willing to
accept and the actual price
area above supply and below price
Consumer surplus is the difference between the maximum
amount buyers are willing to pay for a given quantity of a good
and the amount actually paid. Graphically, consumer surplus is
represented by the area under the demand curve and above the
good’s market price. Producer surplus is the revenue producers
receive over and above the minimum necessary for production.
Graphically, producer surplus is the area above the supply curve
and below the good’s market price.
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Consumer surplus and producer surplus
FIGURE 4.2
Tariff Welfare Effects: Small-Nation Model
Small nation
Its imports - a very small portion of the world market supply
Price taker

Tariff effects
Raises the home price of imports by the full amount of the duty
Higher domestic production
Lower domestic consumption
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Tariff Welfare Effects: Small-Nation Model
Small nation - Tariff effects on nation’s welfare
Consumer surplus falls
Welfare effects of a tariff
Revenue effect
Redistribution effect
Protective effect
Consumption effect
Additional tax revenue
Benefits domestic producers
Wastes resources
Harms the domestic consumer
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For a small nation, a tariff placed on an imported product is
shifted totally to the domestic consumer via a higher product

price. Consumer surplus falls as a result of the price increase.
The small nation’s welfare decreases by an amount equal to the
protective effect and consumption effect, the so-called
deadweight losses due to a tariff.
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Tariff trade and welfare effects: small nation model
FIGURE 4.3
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Tariff Welfare Effects – Small Nation
Have small countries and large countries – small countries are
defined as those too insignificant in a market to influence the
world price. (Large countries definition?) Also, partial
equilibrium effects – only 1 industry is considered, not the 2 or
more industries in the country’s whole economy
Before Trade:
Home country consumer surplus is area in red.
Home country producer surplus is area in green.
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With Free Trade:
CS increases by total area a+b+c+d+e+f
Producer surplus decreases by areas a+e
The overall increase in welfare is [a+b+c+d+e+f] –(a+e) i.e.
b+c+d+f.
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With Tariff:
CS decreases by a+b+c+d
c = revenue effect = now government revenue.
PS increases by a
= redistributive effect = shift from CS to PS
Total effect of tariff is
a+c –(a+b+c+d) = -(b+d)
a negative effect overall
b + d = deadweight loss = benefits lost to all parties
b = protective effect
d = consumption effect

Trade protectionism intensifies as global economy falls into
recession
Global economic downturns - catalyst for trade protectionism;
2007–2009,
Decrease in the demand for goods and services
Decline in international trade
Credit crunch - extra squeeze on trade
Shortfall of some $100 billion in trade finance – 90% of world
trade
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GLOBALIZATION
Trade protectionism intensifies as global economy falls into
recession
Indiscriminate decrease in trade
Exports declined by 30 %
China - targeted by the most governments for protectionist
measures
Russia
Increased tariffs on imported automobiles
India
Raised tariffs on steel imports
Argentina
New obstacles to imported auto parts and shoes

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GLOBALIZATION
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Creeping protectionism during global economic downturn of
2008–2009: number of protectionist measures initiated*
TABLE 4.6
Arguments for Trade Restrictions
Free-trade argument
If each nation produces what it does best and permits trade
In the long term
Lower prices
Higher levels of output, income, and consumption
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1) Job protection argument

preserve jobs in some industries but decrease employment in
others
increased cost to consumer greater than average salary for
worker whose job was saved
Job gains for only a few industries
Job losses spread across many industries
Each job saved
Ends up costing domestic consumers more than the worker’s
salary
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2) Protection against cheap foreign labor
productivity and cost relevant factors
relevant to labor intensive production only
Low wages by themselves do not guarantee low production
costs
3) Fairness in trade – level playing field
other nations lack of environmental regulations
response to trade barriers of other nations
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4) Maintenance of the domestic standard of living
One nation imposes a tariff that improves its income and
employment
restrictions only improve standard of living at the expense of
trading partners
5) equalized production costs
scientific tariff – tariff to offset cost differentials
subsidizes inefficient domestic production
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6) Infant-industry argument
Trading nations should temporarily shield their newly
developing industries from foreign competition
short run protection for new domestic industries against
developed foreign competition
7) Noneconomic arguments
National security argument, Cultural and sociological
considerations

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Supply of protectionism
By the domestic government
Depends on:
The costs to society
The political importance of import-competing producers
Adjustment costs
Public sympathy
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Import Quota
Import quota
Physical restriction on the quantity of goods that can be
imported during a specific time period
Require an import license
Specifies the total volume of imports allowed
On manufactured goods
Outlawed by the World Trade Organization
Global quota
Permits a specified number of goods to be imported each year
Does not specify from where the product is shipped or who is
permitted to import
Plagued by accusations of favoritism
Selective quota
Import quota allocated to specific countries
May lead to a domestic monopoly of production and higher

prices
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Examples of U.S. import quotas*
TABLE 5.1
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Import Quota Welfare Effects
With Import Quota:
a = redistributive effect = shift from CS to PS
b + d = deadweight loss
b = protective effect
d = consumption effect
c = revenue effect
“windfall profit”/
“quota rent”
portion to foreign exporters and portion to home country
importers

Total effect of quota is
c – (b+d)
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Import Licenses
With an import quota, the government must find method to
allocate limited supply of imports to domestic importers.
historical market share – bias against new importers
pro rata – each importer receives fraction of its demand
auction import licenses to highest bidder(s) – allows the
domestic government to capture the windfall profits (area c =
revenue effect)
If import quota = area c, effects are same as tariff except
government does not have tariff revenue. However, if the quota
is auctioned, the government gains area c and the welfare loss is
same as in the tariff case.
If the quota is not auctioned, the rent-seeking loss = area c
Quota vs. tariff:
Initially similar - however if demand increases, tariff leads to
more imports at the same price, whereas quota leads to a higher
price & more imports
Thus an import quota can be more restrictive.
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Tariff-Rate Quota
allows specified number of goods at one tariff rate – “within
quota rate”
additional imports are subject to higher tariff rate – “over quota
rate”
in principle - less restrictive than a quota
in practice - may be as restrictive if the over quota rate is
prohibitively high
license on demand allocation – importers apply for licenses on
first come-first served basis – if demand exceeds quota, volume
is reduced proportionally for all importers
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Export Quota
domestic government limiting the exports of a certain good to
another country
voluntary export restraint (VER) agreement or orderly
marketing agreement – administered by the exporting country.
economic impact identical to import quota, although area c (see
previous diagrams) may be lost to the foreign exporters)
common on television sets, steel, textiles, autos and ships
increases costs to consumers
translates to higher profits for foreign exporters
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Domestic Content Requirement
minimum percentage of product’s total value produced
domestically required to qualify for zero tariff rate

popular argument for organized labor
common in auto industry
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Subsidies
government funding to domestic producers
include: tax concession, low interest loans, insurance
arrangement & cash disbursements
allows producers to sell goods for a lesser price
domestic production subsidy – granted to producers of import
competing goods
export subsidy – granted to producers of goods that are to be
sold in other countries – will consider later, in Part II Topic 4.0
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Domestic Production Subsidy-Welfare Effects
With Domestic Production Subsidy
increases domestic supply but price does not change
PS increases due to greater sales; this increase was partially
redistributed consumer surplus
and partially protective effect/deadweight loss
Result: *Subsidies do not decrease welfare as much as tariffs or
quotas
Using areas from Tariff/Quota graphs:
PS increases by a+b
CS decreases by b
Govt. subsidy paid is a+b
Total effect is a+b –b – (a+b) = -b (*smaller loss than –(b+d))

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Product Dumping
charging foreign buyers a lower price than domestic buyers for
an identical product
also called international price discrimination – is a further type
of trade restriction
sporadic dumping – firm disposes of excess inventory on
foreign markets
predatory dumping – temporary reduction in price designed to
force foreign competitors out of business to gain monopoly
power
persistent dumping – indefinite reduction in foreign price in
order to maximize profits
Generally prohibited under WTO rules and under various
countries’ regulations
Is Antidumping Law Unfair?
Antidumping laws
Ensure a level playing field by offsetting artificial sources of
competitive advantage
Protected industries gain
Consumers of the protected good lose more
Whole economy lose more
Dumping
When a foreign producer sells goods in U.S. at less than fair

value
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Other Nontariff Trade Barriers
Government Procurement Policies: National and local
governments buy many goods but many have buy-national
policies giving preference to domestic over foreign goods.
Social Regulations: Governments attempt to correct health and
environmental side effects of trade; examples: fuel economy
standards and limits on hormone-treated meats
Sea Transport & Freight Regulations: Nations can use
restrictive practices on unloading cargo to serve as a barrier to
trade.
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3001IBA Lecture Notes Week 3
2.0 Economies of Scale, Geography & Trade
Edition
Sources of Comparative
Advantage
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Learning Objectives
Discuss the Heckscher-Ohlin (H-O) theory of international
trade, based on factor endowments
Briefly discuss applications & criticisms of H-O
Explain the Increasing Returns to Scale theory
Discuss the theory of Overlapping Demands
Explain the basis for Intra-industry Trade
Discuss the Product Life Cycle Theory of international trade
Factor Endowments
Factor-endowment theory
Economists Heckscher and Ohlin formulated this theory in the
1920s and 1930s.
Immediate basis for trade: difference between pre-trade relative
product prices of trading nations

Prices depend on the production possibilities curves and tastes
and preferences (demand conditions) in the trading countries
Production possibilities curves depend on technology and
resource endowments
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Factor Endowments
Ultimate determinants of comparative advantage
Technology
Resource endowments
Demand
Assumption: technology and demand are approximately the
same between countries
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Factor Endowments
Resource-endowment ratio
Determines comparative advantage
Export the product that uses a large amount of its relatively
abundant resource
Import the product which in production uses the relatively
scarce resource

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H-O Factor Endowments – Example
TABLE 3.1 p. 67 of Carbaugh
U.S.: capital/labor (K/L) ratio = 0.5 (100/200)
China: capital/labor (K/L) ratio = 0.02 (20/1,000)
Since the U.S. has relatively more abundant capital (i.e. higher
K/L ratio), the U.S. will produce capital-intensive goods, with
China producing goods that are more labor-intensive.
6
Factor Endowments
Effect of resource endowments on comparative advantage
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Capital stock per worker of selected countries, 1997*
TABLE 3.2
A country exports the good whose production is intensive in its
relatively abundant factor. It imports the good whose production
is intensive in its relatively scarce factor.
U.S. MRT = 0.33, China’s MRT = 4.0 - implication is that U.S.
has a lower relative price of aircraft
so U.S. has comparative advantage in aircraft & China has
comparative advantage in textiles
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The factor-endowment theory
FIGURE 3.1
Factor Endowments
Factor-endowment theory, U.S.-China trade
United States
Relatively abundant: human capital (skills), scientific talent,
and engineering talent are relatively abundant
Relatively scarce: unskilled labor is relatively scarce
China
Relatively rich: unskilled labor

Relatively scarce: scientific and engineering talent
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Factor Endowments
Factor-endowment theory, U.S.-China trade
United States exports to China
Goods embodying relatively large amounts of skilled labor and
technology
Aircraft, software, pharmaceuticals, and high-tech components
of electrical machinery and equipment
China exports to the United States
Goods for which a relatively large amount of unskilled labor is
used
Apparel, footwear, toys, and the final assembly of electronic
machinery and equipment
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U.S.-China trade: top ten products, 2007 (thousand of dollars)

TABLE 3.3
Skill as Source of Comparative Advantage
Leontief paradox
Capital/labor ratios, 200 export industries and import-competing
industries, 1947
Capital/labor ratio for U.S. export industries
Lower than that of its import-competing industries
Exports - less capital intensive than import-competing goods
Import-competing goods - more capital intensive than U.S.
exports
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Factor content of U.S. Trade: capital and labor requirements per
million dollars of U.S. Exports and import substitutes
TABLE 3.5
Economies of Scale

Increasing Returns to Scale
Internal economies of scale
Largely based on Krugman’s work in the 1970s and 1980s
Nations with similar factor endowments
Negligible comparative-advantage differences
May find it beneficial to trade
Because they can take advantage of massive economies of scale
Produce that good in great quantity at low average unit costs
Trade those low-cost goods to other nations
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By adding to the size of the domestic market, international trade
permits longer production runs by domestic firms, which can
lead to greater efficiency and reductions in unit costs.
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Economies of scale as a basis for trade
FIGURE 3.5
External Economies of Scale
External economies of scale
The average cost of the typical firm decreases
As the output of the industry within this area increases
Concentration of an industry’s firms in a particular geographic

area
Larger pools of a specialized type of worker
New knowledge about production technology spreads among
firms in the area
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Overlapping Demands as a Basis for Trade
Theory of overlapping demands, Linder, 1960s
Factor-endowment theory - explains trade in primary products
and agricultural goods
Not trade in manufactured goods
Force influencing manufactured-good trade
Domestic demand conditions
Firms within a country – manufacture goods for which there is a
large domestic market
A nation’s exports - extension of the production for the
domestic market
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Consumer demand - conditioned strongly by income levels
A country’s average or per capita income will yield a particular
pattern of demand

Nations with high per capita incomes will demand high-quality
manufactured goods (luxuries)
Nations with low per capita incomes will demand lower-quality
goods (necessities)
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Nations with similar per capita incomes
Overlapping demand structures
Consume similar types of manufactured goods
Wealthy (industrial) nations
More likely to trade with other wealthy nations
Poor (developing) nations
More likely to trade with other poor nations
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Intra-industry Trade
Intra-industry specialization, trade
Trade models so far have dealt with inter-industry trade and CA
Production of particular products or groups of products within a
given industry
The opening up of trade does not generally result in the
elimination or wholesale contraction of entire industries within

a nation
The range of products produced and sold by each nation changes
Emphasized by advanced industrial nations
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Intra-industry Trade
Intra-industry specialization, trade
Involves flows of goods with similar factor requirements
Conducted mostly among industrial countries with similar
resource endowments
Firms – in oligopolies (markets with only a few firms)
Trade in homogeneous goods
Transportation costs may be lowered
Seasonal
Trade in differentiated products
Unmet need
Overlapping demand segments in trading nations
Economies of scale
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Intra-industry trade examples: selected U.S. exports and
imports, 2007 (in millions of dollars)
TABLE 3.6
Technology: The Product Cycle Theory
Technological innovations
Different nations, at different rates of speed
Result in:
New methods of producing existing commodities
Production of new commodities
Commodity improvements
Often transitory
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Technology: The Product Cycle Theory
Product life cycle theory
Predictable trade cycle:
Manufactured good is introduced to home market
Domestic industry shows export strength.
Foreign production begins
Domestic industry loses competitive advantage
Import competition begins
International product cycle
U.S. and Japanese radio manufacturers
U.S. and Japanese pocket calculators manufacturers

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FIGURE 2.3

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Edition
Foundations of
Modern Trade Theory:
Comparative Advantage
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Learning Objectives
History of Trade Theories:
Mercantilists (1500-1800)
Absolute Advantage – Adam Smith (1776)
Define principle of Comparative Advantage (CA)
Explain the basis for trade

Analyze the (comparative static) gains from trade with constant
& increasing opportunity costs
Discuss the dynamic gains from trade
Consider the limitations of CA
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Historical Development of Modern Trade Theory
Principle of comparative advantage
- Even if a nation has an absolute cost disadvantage in the
production of both goods
-- The less efficient nation
Specialize in and export the good in which it is relatively less
inefficient
Where its absolute disadvantage is least
--The more efficient nation
Specialize in and export that good in which it is relatively more
efficient
Where its absolute advantage is greatest
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Principle of comparative advantage, simplified model -
assumptions
1. The world consists of two nations
Each uses a single input, produces two commodities
2. In each nation, labor is the only input
Fixed endowment of labor
Labor is fully employed and homogeneous
3. Labor can move freely among industries
Within a nation, but is incapable of moving between nations
4. Technology - fixed for both nations
Different nations may use different technologies
All firms within each nation - a common production method for
each commodity
5. Costs do not vary with the level of production
Proportional to the amount of labor used
6. Perfect competition prevails in all markets
All are price takers
Identical products
Free entry to and exit from an industry
Price of each product = product’s marginal cost of production
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Principle of comparative advantage, simplified model -
assumptions
7. Free trade occurs between nations
No government barriers to trade
8. Transportation costs are zero
Consumers - indifferent between domestically produced and
imported versions of a product if the domestic prices of the two
products are identical
9. Firms make production decisions in an attempt to maximize
profits
Consumers maximize satisfaction through their consumption
decisions
10. There is no money illusion
When consumers make their consumption choices and firms
make their production decisions, they take into account the
behavior of all prices
11. Trade is balanced i.e. exports must pay for imports
This rules out flows of money between nations
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Comparative Advantage - Example
Assume 2 countries each producing 2 goods
The U.S. can produce twice as much wine as the U.K. but four
times as much cloth. Therefore the U.S. should specialize in
producing cloth while the U.K. specializes in producing wine.
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Production Possibilities Schedules
Modern trade theory
- More generalized theory of comparative advantage
- Use a production possibilities schedule PPS
-- Transformation schedule
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Production possibilities schedule shows
Various alternative combinations of two goods
a nation can produce
- When all of its factor inputs
-- Labour (L), capital (K), [generally assume these 2] and land,
entrepreneurship, (technology) are used in their most efficient
manner
- Maximum output possibilities of a nation
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Marginal rate of transformation, MRT
- The amount of one product a nation must sacrifice to get one
additional unit of the other product
-- Rate of sacrifice = opportunity cost of a product
- Absolute value of the slope of production possibilities
schedule
For Figure 2.1
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In graph (a) the MRT in the US equals 0.5 because wheat output
falls by 20 (e.g. from 60 to 40) when auto output rises by 40
(e.g. from 0 to 40). In graph (b) the MRT in Canada equals 2.0
because wheat output falls by 40 (from 80 to 40) when auto
output rises by 20 (from 40 to 60)
So 1 additional auto in the U.S. => loss of 0.5 bushel of wheat
Whereas 1 additional auto in Canada => loss of 2 bushels of
wheat
Since the U.S. has a lower opportunity cost of auto production,
it will be mutually beneficial for the U.S. to produce autos and
trade them to Canada for wheat.
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Trading under constant opportunity costs
FIGURE 2.1

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Trading Under Constant-Cost Conditions
Basis for Trade
- Principle of comparative advantage
Direction of Trade
- Specialize and export the good with the lowest opportunity
cost
Production Gains from Specialization
- Production gains for both countries
-- Arise from the reallocation of existing resources
-- Static gains from specialization
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Gains from specialization & trade: constant opportunity costs

TABLE 2.4
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Consumption Gains from Trade
- Trade = consumption gains for both countries
- Consumption points
-- Outside domestic production possibilities schedules
-- Consume more of both goods
Terms of trade
Rate at which a country’s export product is traded for the other
country’s export product
Define the relative prices of the two products
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Trading possibilities line
International terms of trade for both countries
Trade triangle for a country
Exports – along the horizontal axis
Imports – along the vertical axis
Terms of trade – the slope
Complete specialization
Produce only one product
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Domestic cost ratio
Negatively sloped production possibilities schedule
Transform into a positively sloped cost-ratio line
Outer limits for the equilibrium terms of trade
Becomes no-trade boundary
Region of mutually beneficial trade
Bounded by the cost ratios of the two countries
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The supply-side analysis of Ricardo describes the outer limits
within which the equilibrium terms of trade must fall. The
domestic cost ratios set the outer limits for the equilibrium
terms of trade. Mutually beneficial trade for both nations occurs
if the equilibrium terms of trade lies between the two nations’
domestic cost ratios. According to the theory of reciprocal
demand, the actual exchange ratio at which trade occurs
depends on the trading partners’ interacting demands.
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Equilibrium terms-of-trade limits
FIGURE 2.2
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Equilibrium Terms of Trade, John Stuart Mill (1806–1873)

Add the intensity of the trading partners’ demands
Determine the actual terms of trade
The theory of reciprocal demand
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TRADE CONFLICTS
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Improvement in a nation’s terms of trade
Rise in its export prices
Relative to its import prices
A smaller quantity of export goods sold abroad
Required to obtain a given quantity of imports
Deterioration in a nation’s terms of trade
Rise in its import prices
Relative to its export prices
Purchase of a given quantity of imports
Sacrifice of a greater quantity of exports
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Commodity terms of trade, 2008 (2000 = 100)
TABLE 2.5

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Dynamic Gains From Trade
Dynamic gains from international trade
More efficient use of an economy’s resources
Higher output and income
More saving, More investment
Higher rate of economic growth
Higher productivity
Economies of large-scale production
Increased competition
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Changing Comparative Advantage
Patterns of comparative advantage change over time
Productivity increases
Production possibilities schedule changes
More output can be produced - with the same amount of
resources
Producers - need to hone their skills to compete in more

profitable areas
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If productivity in the Japanese computer industry grows faster
than it does in the U.S. computer industry, the opportunity cost
of each computer produced in the United States increases
relative to the opportunity cost of the Japanese. For the United
States, comparative advantage shifts from computers to autos.
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Changing comparative advantage
FIGURE 2.3
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Trading Under Increasing-Cost Conditions
Increasing opportunity costs
Concave production possibilities schedule
Bowed outward from the diagram’s origin
Inputs are imperfect substitutes for each other
MRT rises
Absolute slope of the production possibilities schedule
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Increasing opportunity costs lead to a production possibilities
schedule that is concave, viewed from the diagram’s origin.
The marginal rate of transformation equals the (absolute) slope
of the production possibilities schedule at a particular point
along the schedule.
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Production possibilities schedule; increasing-cost conditions
FIGURE 2.4

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Increasing-Cost Trading Case
One country specializes in producing one good
The other country specializes in producing the other good
Specialization continues in both nations until
Relative cost of one good is identical in both nations
One country’s exports of one good are precisely equal to the
other country’s imports of the good
Same domestic rates of transformation
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With increasing opportunity costs, comparative product prices
in each country are determined by both supply and demand
factors. A country tends to partially specialize in the product of
its comparative advantage under increasing cost conditions.

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Trading under increasing opportunity costs
FIGURE 2.5
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Production gains
More of each good is being produced
Consumption gains
Both countries consume more of at least one good
The trade triangle
Exports, imports, and terms of trade
Same for both countries
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Gains from specialization and trade: increasing opportunity
costs
TABLE 2.6
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The Impact of Trade on Jobs
Extent to which an economy is open
Influences the mix of jobs within an economy
Can cause dislocation in certain areas or industries
Little effect on the overall level of employment
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Increased international trade tends to neither inhibit overall job
creation nor contribute to an increase in the overall rate of
unemployment. As seen in the figure, the increase in U.S.
imports as a percentage of GDP over the past several decades
has not led to any significant trend in the overall unemployment
for Americans.
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The impact of trade on jobs
FIGURE 2.6
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Comparative Advantage Extended to Many Products and
Countries
More Than Two Products
Comparative advantage
Rank the goods by the degree of comparative cost
Each country exports the product(s)
Has the greatest comparative advantage
Each country imports the product(s)

Has greatest comparative disadvantage
Cutoff point between exports and imports
Relative strength of international demand
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When a large number of goods is produced by two countries,
operation of the comparative-advantage principle requires the
goods to be ranked by the degree of comparative cost. Each
country exports the product(s) in which its comparative
advantage is strongest. Each country imports the product(s) in
which its comparative advantage is weakest.
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Hypothetical spectrum of comparative advantages, U.S. and
Japan
FIGURE 2.7

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Comparative Advantage Extended to Many Products and
Countries
More Than Two Countries
Multilateral trading relations
Bilateral balance should not pertain to any two trading partners
Trade surplus
With trading partners that buy a lot of the things that it supplies
at low cost
Trade deficit
With trading partners that are low-cost suppliers of goods that it
imports intensely
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When many countries are involved in international trade, the
home country will likely find it advantageous to enter into
multilateral trading relations with a number of countries. This
figure illustrates the process of multilateral trade for the United
States, Japan, and OPEC.

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Multilateral trade: U.S., Japan, and OPEC
FIGURE 2.8
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Outsourcing: Pros & Cons
Pros
reduced costs and increased competitiveness for domestic
companies
increased exports to countries in which new jobs are created
higher level of repatriated earnings reinvested into domestic
economy
Cons
reduced employment in specific industries
lower wages, particularly for unskilled workers
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National Competitive Advantage: Porter’s Diamond
Existing theories of international trade can be argued to be too
narrow and inadequate. Porter’s theory focuses on explaining
the success of a particular industry of a country. Rather than
Comparative Advantage, the theories of Porter [Michael E.
Porter (1990), The Competitive Advantage of Nations, New
York: Free Press] and others focus on Competitive Advantage,
which refers to industries (groups of firms) producing goods
and services of greater value than their international
competitors, where value is determined by a range of attributes
in addition to lower relative costs of production/higher relative
factor abundance. Many countries with similar relative factor
endowments have competitive advantages in different industries
– e.g.s: Switzerland excels in precision instruments (such as
watches), Germany in chemical industry, and Japan in
household electronic products.
Four attributes promoting or impeding the creation of
competitive advantage:
Factor Endowments such as skilled labour or the infrastructure
(power for IT industry) necessary to compete in a given
industry
Demand Conditions—nature of home demand for the industry’s
products
Related and Supporting Industries—supplier industries and
related industries that are internationally competitive
Firm Strategy, Structure and Rivalry—conditions in the country
determining how firms are created, organized and managed and
the nature of domestic rivalry.

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Challenges of Globalization
Rapid increases in international economic activity,
including the communications revolution, has reduced the intra-
country significance of Porter’s Diamond – factors above still
important but globally, not just domestically. E.g.; Demand
conditions attribute – the nature of international demand for the
industry’s products is important also.

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Porter’s Diamond
Criticism on Porter's national diamond model resolves around a
number of assumptions that underlie it. As described by Davies
and Ellis:
"sustained prosperity may be achieved without a nation
becoming 'innovation-driven', strong 'diamonds' are not in place
in the home bases of many internationally successful industries
and inward foreign direct investment does not indicate a lack of
'competitiveness' or low national productivity".
Porter generalised from the American case; for developing
countries the model may be wrong.
Michael E. Porter (1990), The Competitive Advantage of
Nations, New York: Free Press
Wheat
MRT
Autos
D
=
D
100
Export Price Index
Terms of trade =
Import Price Index
´
Factor
Endowments
Firm Strategy,
Structure and
Rivalry

Demand
Conditions
Related
and
Supporting
Industries
Factor Endowments
Related and Supporting
Industries
Firm Strategy, Structure and Rivalry
Demand Conditions
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Edition
The International Economy
and Globalization
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LECTURE NOTES – INTRODUCTION - WEEK 1 CONTENTS
Discussion of course details from Course Profile including
aims, content, & assessment
The International Economy and Globalization
Global Financial Crisis and Recovery
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Course Content

Course examines how nations and companies promote and retain
competitiveness in a globalized world economy.
National level focus on international trade and national
competitiveness.
Company level focus on company operations, participating
strategies and competitiveness.
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Learning Objectives
Explain globalization
Discuss the importance of globalization
Discuss criticisms of globalization
Briefly describe the Global Financial Crisis and Recovery
Discuss history of international trade – Mercantilists, David
Hume, Adam Smith and Absolute Advantage
Define the principle of Comparative Advantage (CA)
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The International Economy
High degree of economic interdependence
Steps toward international cooperation
Mutually advantageous for trading nations

Specialization, efficiencies of large scale production
Wider variety of products at lower cost
Protectionist pressures
Financial flows and exchange rates
Developing nations
Liberalized trading system - serves to keep the developing
nations in poverty?
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Globalization of Economic Activity
Globalization
A (continuing) process of greater interdependence among
nations (countries and their citizens)
International flows
Goods and services
People
Investments in equipment, factories, etc.; financial investments
in stocks, bonds, etc.
Non-economic elements
Culture and the environment

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