1. Preparing for the Exam: Summarizing the Essentials

2. 2 Exam Final: 27.10.2008 at 8 - 10 ECO, lecture room Retake: 24.11.2008 at 8 - 10 ECO, lecture room Requirements: (a) Lectures, (b) Krugman (1993): What Do Undergrads Need to Know About Trade? American Economic Review 83(2): 23–26 (available from JSTOR) Three questions (answer all) You may answer in English or Finnish. Dictionaries are not allowed.

3. 3 Previous results (final exam)

4. 4 The most important things to learn Why trade is mutually beneficial? Comparative advantage, economies of scale Where do the world prices come from? Terms-of-trade analysis What does trade and international factor mobility do to distribution of income? Factor-price-equalization theorem What trade policy instruments do? Implications of subsidies, tariffs, quotas Arguments for activist trade policy Please note that these are just the most important things. To pass the exam you will need to know a bit more…

5. 5 Gains from Trade: Ricardian Model ClothWine 9,0000 4,5001,800 03,600 England Suppose that the international price turns out to be 2,5 yard per barrel and England produces only cloth Cloth Wine 3,000 9,000 3,600 Slope of the CPF = the amount of consumption of one good that must be given up to obtain one additional unit of the other good

6. 6 Gains from Trade: The Neoclassical/HO Model Good X XAXA YAYA Good Y XPXP XCXC YPYP YCYC Imports Exports (P X /P Y ) FT (P X /P Y ) A Equilibrium: MRT = (P X /P Y ) FT = MRS

7. 7 Gains from Trade: Krugman Model Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases i.e. a larger variety of products is available for smaller price everybody are better off even if the countries are identical Price Number of firms AC A P nAnA pApA n FT p FT AC FT

8. 8 Prices: Deriving the Offer Curve Good X Good Y XPXP XCXC YPYP YCYC (P X /P Y ) 1 Good X Good Y XPXP XCXC YPYP YCYC ( P X /P Y ) 2 Exports 1 Exports 2 Imports 1 Imports 2 Exports of good X Imports of good Y Exports 2 Exports 1 Imports 1 Imports 2 ( P X /P Y ) 2 = TOT 2 (P X /P Y ) 1 = TOT 1 Offer Curve Potential price lines: P X *Q X =P Y *Q Y  Q Y =(P X /P Y )*Q X i.e. given the prices, the value of exports equals the value of imports

9. 9 Prices: Putting the Offer Curves to One Graph Exports of good X Imports of good Y ( P X /P Y ) 2 (P X /P Y ) 1 Offer Curve Exports of good Y Imports of good X ( P X /P Y ) 2 (P X /P Y ) 1 Offer Curve Country 1 Country 2 Imports of good X Exports of good Y Offer Curve

10. 10 Prices: Trading Equilibrium Good X: Exports from country 1 Imports to country 2 Good Y: Imports to country 1 exports from country 2 (P X /P Y ) E = TOT E ( P X /P Y )’ Country 1’s offer curve Country 2’s offer curve

11. 11 Distribution of Income: Factor Price Equalization Autarky → Free trade o relative prices of final goods become identical relative price of paper increases (=relative price of clothes decrease) in Finland → Finland produces more paper, China more clothes Since producing paper is more capital intensive, demand for capital increases and demand for labour decreases in Finland → w ↓ r ↑ Similarly in China, demand for labour increases and demand for capital decreases → r ↓ w ↑ In equilibrium all prices (including factor prices) are identical

12. 12 Distribution of Income: the Stolper-Samuelson Theorem Trade affects both the prices of goods and the prices of factors of production: What then is the impact of trade on distribution of real income? o wages decrease in Finland, but also the price of clothes decreases (i.e. you need less money to buy the same amount of clothes). Which effect dominates? Stolper-Samuelson Theorem: real income of the owners of abundant factor increases and the real income of owners of scarce factor decreases o Think about the labour abundant country (e.g. China): Free trade → r ↓ w ↑ → capital/labour ratio ↑ → labour productivity ↑ → real wages ↑ W. Stolper & P. Samuelson (1941): International Factor-Price Equalisation Once Again. Economic Journal 59, no. 234.

13. 13 Distribution of Income: Impact of Migration Total world labour force wA1wA1 Country 1’s initial employment Country 2’s employment wA2wA2 Country 2: (receiving immigrants) wages decrease → transfer of income from labour to capital owners total output increases more than what is paid to the immigrants → immigration surplus However, there is a decrease in per capita output (given diminishing marginal productivity) Country 1: wages increase → transfer of income from capital to labour total output decreases more than the wage sum of those who left → immigration deficit But, there is a increase in per capita output (given diminishing marginal productivity) Country 1: MPP L, w Country 2: MPP L, w w*w* w*w* Country 1’s eq’m employment Country 2’s eq’m employment transfer from capital to labour in country transfer from labour to capital in country 1 gain for the immigrants immigration surplus

14. 14 imports after tariff Trade Policy: Import Tariff, Small-Country, Partial Equilibrium D Q SDSD P int (1+τ)P int imports in free trade increase of producer surplus tariff to the government deadweight loss deadweight loss imports after tariff P D Q SDSD P int (1+τ)P int imports in free trade Loss of consumer surplus P Increase of producer surplus and government income

15. 15 Trade Policy: Import Quota Small-Country, Partial Equilibrium For every quota there is an equivalent tariff (and for every tariff there is an equivalent quota) The changes in consumer and produce surplus are equivalent to that of a tariff However, the increase of government revenue may be lost (at least partially) quota P D Q SDSD P int imports in free trade PQPQ

16. 16 imports after the subsidy Trade Policy: Subsidy, Small-Country, Partial Equilibrium D Q SDSD P imports in free trade Cost to the government imports in free trade P imports after the subsidy P D Q SDSD P increase of producer surplus efficiency loss

17. 17 Trade Policy: Single Market, Two Countries, Free Trade QQ Country A Country B DADA SASA SBSB DBDB P P

18. 18 Trade Policy: Single Market, Two Countries, Free Trade QQ Country A Country B DADA SASA SBSB DBDB P P Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

19. 19 Trade Policy: Single Market, Two Countries, Tariff QQ Country A Country B tariff DADA SASA SBSB DBDB P P Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

20. 20 Trade Policy: Single Market, Two Countries, Tariff QQ Country A Country B tariff P FT PAPA PBPB DADA SASA SBSB DBDB P P ab C price decrease in country B De Country A: Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).

21. 21 General Equilibrium Effects of a Tariff for a Small Country Import tariff on good Y changes the price ratio Producers adjust from point P FT to P t Since the tariff doesn’t change world prices, country’s real income changes to (P X /P Y ) t Consumers maximize given domestic prices and real income and move to a lower utility level Note that real income is determined by the world prices Good XPtPt PtPt Good Y P FT C FT P FT C FT (P X /P Y ) FT P X /(1+τ)P Y CtCt CtCt (P X /P Y ) t

22. 22 General Equilibrium Effects of a Subsidy for a Small Country Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff The real income of the country remains the same Consumers face world prices and are able to consume at a higher utility level Good XPSPS PSPS Good Y P FT C FT P FT C FT (P X /P Y ) FT P X /(1+τ)P Y CSCS CSCS