1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich

2 Lecture 15: March 5 Ch. 2, 3, 4, 5

3 Basis for Trade Gravity Model –T(i, j) =  Y(i)Y(j)/D(i, j) –T(i, j): value of trade between country i and j –Y: GDP –D(i, j): distance between country i and j 1% increase in distance between two countries is associated with % decrease in trade Transportation costs, similarities (familiarities) – language, tastes

Gravity Model: NAFTA (2010) % of Exports to NAFTA Countries % of Imports from NAFTA Countries Canada76%57% US4934 Mexico8451 4

5 Gravity Model: EU (2010) EU27 %of exports –EU27: 68% –Europe: 74% % of imports –EU27: 65% –Europe: 70%

US Exports, 2011: Top 10 Countries Exports (US$ B) GDP per Capita (US$) Canada28150,345 Mexico19810,047 China1045,445 Japan6645,903 UK5639,038 Germany4944,060 South Korea4322,424 Brazil4312,594 Netherlands4250,076 Hong Kong3635,156 6

US Imports, 2011: Top 10 Countries Imports (US$ B) GDP per Capita (US$) China3995,445 Canada31550,345 Mexico26310,047 Japan12945,903 Germany9944,060 South Korea5722,424 UK5139,038 Saudi Arabia4820,540 Venezuela4310,810 Taiwan41NA 7

8 Basis for Trade Differences in relative prices –[P1/P2] A  [P1/P2] B –Countries differ Resources Culture, tastes Demographics Rules Incentives/motivation Differences in availabilities of products (goods, services) –Companies create competitive advantages

9 General Equilibrium: Closed Economy Model Objective: maximize production subject to resource and technology constraints  production possibility frontier Assumptions: –Two factors of production: X1, X2 –Two goods: Y1, Y2 –Full employment –Given state of technology: T –No convexities – no economies of scale, no externalities –No public goods –Production functions: Y(i) = F i [X1, X2, T]

10 Optimization Solution: 1 Maximize production: –Max Y1, Y2 –S.t. production functions [F i, i = 1,2] Maximum availabilities of X1, X2 Production functions, isoquants

11 Optimization Solution: 1 Maximize production: –Max Y1 –S.t. Y1 = F 1 [X1, X2, T] Y2 = 0 Y2 X1  0 X1 X2  0 X2 Box diagram with isoquants Production possibility frontier [G(Y1, Y2)]

12 PPF Efficient production –knowledge of production functions –producing on frontier of production function –given state of technology –full employment PPF can also be derived by minimizing costs of producing various quantities of the two products –Min: C1X1 + C2X2 –S.t. Y1  F 1 [X1, X2, T] Y1  0 Y1 [isoquant and isocosts]

13 Optimization Solution: 2 Optimal level of production of two products: Y1, Y2 Maximize value of output –Max: P1Y1 + P2Y2 –S.t.: PPF [PPF and income lines] Max utility –Max: U(Y1, Y2) –S.t.: PPF Solution: GE model with perfect competition  P1, P2, C1, C2, Y1, Y2

14 Changes in Relative Prices Equilibrium P2/P1 will change if: –Change in shape of PPF – changes in relative supplies Change in relative availabilities of X1, X2 Change in production functions Change in state of technology –Changes in tastes – changes in relative demands

15 Basis for Trade Different relative prices –Different technologies – different p.f., different states of technology –Different relative quantities of factors of production, climate –Different tastes – different utility functions, income per capita, culture –Absence of perfect competition: monopolistic markets Different products –Different factors of production –Absence of perfect competition –Different tastes Low trade costs –Transportation costs (infrastructure, oil prices, containers, jet aircraft) –Trade barriers (carbon taxes) –Information –Other – hedging, insurance, etc. (piracy)

16 Basis for Trade Bottom Line: firms produce goods –Firms need info on products (characteristics, p.f.); technology –Agents need info on relative and absolute prices and access to distribution channels in foreign countries –Costs for information increase with distance – geographic, culture Value chain: production of final product entails various intermediate stages – examples: gasoline at retail; laptops; autos; cell phones; aircraft; drugs –Trade in intermediate products –Trade in intermediate services –Who is control?