Goods Prices and Factor Prices: The Distributional Consequences of International Trade Nothing is accomplished until someone sells something. (popular business saying)

The Goals of this Chapter for ECN 665 Use the general equilibrium model to understand how price changes lead to winners and losers. Use different models to identify these winners and losers. Introduce a two-country partial equilibrium model to see how shocks to supply and demand affect the terms of trade. Use the partial equilibrium model to illustrate how consumers and producers are affected by international trade.

Who Wins and Who Loses? Trade affects relative prices. Changes in domestic relative prices influence factor rewards (e.g. wages) as well as the prices of goods we buy. We can use different characterizations of the economy (i.e. models) to predict how real factor rewards respond to a price change.

Trade in a one-factor model The Ricardian model assumes there is only one factor, labor. Trade occurs because of differences in labor productivity. Trade raises real GDP. Because everyone is alike, everyone gains. Distribution is simple and unrealistic!

Trade based on factor proportions Opening a country to trade (or reducing tariffs or quotas) raises the relative price of the exportable relative to the importable. What happens to factor rewards depends on how this price change affects the demand and supply of each factor.

The Heckscher-Ohlin Model Two industries: labor-intensive and capital- intensive Two factors: labor and capital Both factors are assumed to be in fixed supply and perfectly mobile across sectors. THIS MOBILITY ASSUMPTION IS VERY IMPORTANT.

The Heckscher-Ohlin Model (2) Suppose freer trade raises the relative price of the labor-intensive good ( as it would in a labor-abundant country). The higher price for the labor-intensive good leads this industry to expand and the capital-intensive industry to contract. These production responses raise the wage and lower the rental on capital.

The Heckscher-Ohlin Model (3) We summarize this analysis with the Stolper-Samuelson Theorem: an increase in the relative price of the labor (capital) intensive good raises the real return to labor (capital) and lowers the real return to the other factor. Notice the REAL return is driven up or down.

What if factors are not mobile? Then the demand for factors is linked only to the sector in which the factor works. We summarize this insight in the specific factors model: specific factors gain in real terms when the price of the product they produce increases (and lose when it falls).

What if gains come because trade increases scale and/or variety? We need to introduce increasing returns to scale and differentiated products. It is possible for everyone to gain when trade is based on IRS industries. There is a danger only in a small subset of cases: when countries are large enough to produce IRS goods but not large enough to do so on a big scale.

Measuring the Welfare Gains from Exchange: Producer Surplus and Consumer Surplus Producer surplus: The net gains to producers of a product, equal to the total revenue minus the sum of marginal (variable) costs. Consumer surplus: The net gains for consumers of a product, equal to the sum of all marginal gains minus the market price paid for the products.

Equilibrium price = $6 Equilibrium quantity = 50

Equilibrium price = $613 Equilibrium quantity = 50 Producer surplus = $125 ($5x50 = $250/2 = $125)

Equilibrium price = $6 Equilibrium quantity = 50 Producer surplus = $125 ($5x50/2 = $250/2 = $125) Consumer surplus = $75 (3x50/2 = $150/2 = $75)

Equilibrium price = $6 Equilibrium quantity = 50 Producer surplus = ($5x50)/2 = $250/2 = $125 Consumer surplus = $75 ($3x50)/2 = $150/2 = $75 Total gains from exchange equals consumer surplus plus producer surplus Gains from exchange = ($8x50)/2 = $400/2 = $200

The Two-Country Partial equilibrium Model The textbook emphasizes two-country models in order to remind you that what happens in one country affects markets in other countries. Partial equilibrium models assume “all other things remain equal” in other markets, obviously an unrealistic assumption. But, a two-country partial equilibrium model can isolate how, all other things equal, a change in a market in one country affects the market for the same product in another country. Specifically, the two-country partial equilibrium model lets us estimate the changes in consumer and producer surplus in the two countries.

The Welfare Gains from Trade Heartland producers gain surplus. Heartland consumers lose surplus. Orient producers lose surplus. Orient consumers gain surplus. But remember that we do not trade in one good – these changes are only for one market.

Applying the Two-Country Partial Equilibrium Model Now that you understand the two-country partial equilibrium model and how to calculate the welfare gains from international exchange, you are ready to apply the model. One interesting case is to examine the welfare effects of an increase in foreign demand for a product. Specifically, suppose that in a certain market, demand increases in the foreign country that currently imports the good.

The Net Gains from Trade Increase in Both Countries after the Rise in Demand in Orient An increase in foreign demand raises the price of corn in both countries. Producers in Heartland gain welfare. Consumers in Orient gain welfare. The net gains from exchange increase in both countries.

Analyzing the Effect of Transport Costs on International Trade The partial equilibrium model can be used to analyze how transport costs affect international trade. Transport costs in effect drive a wedge in between the price received by an exporter and the price paid by a foreign importer. Transport costs increase the cost of products to the final user, and it should not be surprising that they reduce both the volume of trade and the gains from trade. The analysis of transport costs uses the concepts of consumer and producer surplus.

Consumer surplus is equal to the area A Producer surplus is equal to the area B The net gains from exchange are equal to the areas A + B

Transport costs of $40 raise the effective international supply curve from S to S T. Transport costs drive a “wedge” between what suppliers receive and consumers pay. The volume of trade falls from 40 to 20. Producer surplus is reduced to area b. Consumer surplus is reduced to area a.

Decreasing transport costs increase trade. The international supply curve shifts down to S T2. The equilibrium price falls to $60. The gains from trade rise from a + b to a + b + c + d.

Trade and Transport Costs An increase in transport costs reduces the gains from trade for both the importing and exporting countries. A decline in transport costs increases the gains from trade. Most of the increase in trade during the past two centuries is due to improvements in the efficiency of transportation.

The Effect of Trade on Price Competition The partial equilibrium model is also useful for analyzing the gains from trade under imperfect competition. International trade increases the number of potential suppliers, which tends to increase price competition. Increased price competition reduces monopoly profit and deadweight losses. The effect of increased competition can be visualized by comparing consumer and producer surplus under imperfect competition and under perfect competition.

Imperfectly competitive firms face a downward-sloping demand curve D. Profit-maximizing firms equate marginal revenue equal marginal cost. Prices exceed marginal cost. The quantity supplied, q, is less than the quantity, Q, that would be supplied under perfect competition. Total welfare is reduced by the “deadweight” loss, which is equals to area D.

When firms face the horizontal demand curve in a competitive global market, price declines from p to P. Consumption shifts from c to C. The competitive market eliminates the deadweight loss.