INTERNATIONAL ECONOMICS

INTERNATIONAL ECONOMICS
Eastwood's ECO 486 Notes INTERNATIONAL ECONOMICS Print the following information on the 3” x 5” card Your name, home country Other countries in which you have lived Other countries you have visited Economics courses you have completed Other Economics courses this semester Other international courses or experience (This information is for my use only) Introduction & Patterns of Trade

Learning Objectives Review the Syllabus & Calendar
Eastwood's ECO 486 Notes Learning Objectives Review the Syllabus & Calendar Explain aggregate characteristics of national economies Describe the trends and patterns in international trade Introduction & Patterns of Trade

Prerequisites Principles of Microeconomics, ECO 284,
Eastwood's ECO 486 Notes Prerequisites Principles of Microeconomics, ECO 284, Principles of Macroeconomics, ECO 285, and Junior Standing Or an approved waiver If you lack the prerequisite, contact me as soon as possible! Introduction & Patterns of Trade

Branches of International Economics
Trade (international microeconomics) Why do nations engage in international trade? What goods and services do nations trade? How does international trade affect national income, welfare, and jobs? How do trade barriers affect national welfare? How are countries affected by international movements of labor and capital? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Branches of International Economics (cont.)
Finance (international macroeconomics) What is the balance of payments? What is an exchange rate and what factors determine the exchange rate? What is the relationship between exchange rates, prices, and interest rates? How are countries affected by foreign direct investment and lending? How effective are domestic policies given the global economy? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Characteristics of National Economies
Eastwood's ECO 486 Notes Characteristics of National Economies Gross National Product (GNP) & Gross Domestic Product (GDP) GNP -- the value of final goods and services produced by domestically-owned resources. GDP -- the value of final goods and services produced within a country’s borders. Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Characteristics of National Economies Imports are the goods and services we buy from other countries. Exports are the goods and services we sell to people in other countries. Introduction & Patterns of Trade

Trade is growing faster than income
Exports and Imports as a Percentage of U.S. National Income

Eastwood's ECO 486 Notes Characteristics of National Economies Index of Openness measures importance of trade When trade is balanced, most use = 100( Exports/GDP) Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Characteristics of National Economies Purchasing Power Parity (PPP) GNP estimates adjusted to provide a better comparison across countries Shows how many US$ needed to buy here what the average citizen could buy in a foreign country Introduction & Patterns of Trade

Discussion Where are the poorest countries located?
…the richest countries? Which countries are the most open?...least? Which country exported most in 2004? …imported?

Patterns and Trends in International Trade
Eastwood's ECO 486 Notes Patterns and Trends in International Trade Trade has grown rapidly -- compare Index of openness for 1980 and 2004 See Figure 1-1, page 11 World GDP has grown 1950 base year (index value = 100) 2004 index value ~ 750 World exports have grown much faster 2004 index value ~ 2750 Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade The Direction of Trade for Six Regions See Figure 1.2 Which regions account for the bulk of world exports? Which regions have declining shares? What changes or consistencies can you find between the two periods? For example, countries trade most often with ___________ Due to lower transaction costs (including transportation & information) Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade US was the world’s largest importer & 2nd largest exporter in 2004 Which countries were our largest trading partners in 2004? See Table 1.2 Which category represented the largest share of world trade in 2003? See Table 1.3 Which category represented the largest share of US exports in 2003? …Egypt? See Table 1.4 Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade Trends in the Volume of Trade In 1960, the U.S. exported less than 5% of total output and imported 4.5% of the goods and services consumed domestically. Since, 1960 the composition of imports have changed dramatically food and raw material imports have fallen machinery comprise close to 50% of total imports Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade Balance of Trade and International Borrowing The merchandise balance of trade is the value of merchandise exports minus the value of merchandise imports In the latest 12 months, the U.S. had a $806.4 billion deficit The Economist, January 12, 2008, page 90. Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade Top Ten Trading Partners See Table 1.2, page 16 In 2004, ______% of all of US merchandise exports went to Canada. Similar to 1995, when 21.63% of all of US merchandise exports went to Canada. Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade What goods do countries trade? See Table 1.3, pages 19 & 20 It ranks goods by their share of the value of ‘03 trade Industries are identified by Standard International Trade Classification (SITC) Code Divides industries into ten broad categories (0-9) Example: 7 is machines and transport equipment 78 is road vehicles 781 is passenger motorcars rank #1 for rank #2 for ‘96, at 4.8%; 2003 rank? Surpassed by office machines, computers & parts Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade What goods do countries trade? Countries typically import agricultural commodities, raw materials, capital goods, or semi-manufactured goods A large share of imports do not compete directly for purchase by the final consumer notable exceptions (cars, clothing, computers, toys) Introduction & Patterns of Trade

Eastwood's ECO 486 Notes Patterns and Trends in International Trade What goods do countries trade? Commodity composition of trade Table 1.4, p exports of selected countries Table 1.5, p23 -- imports of selected countries Introduction & Patterns of Trade

World Trade in Services
Value of $2.1 trillion in 2004 (about 20% of international trade) U.S. is largest exporter and importer of services Most traded services: transportation, travel, other services (banking, medicine, consulting, insurance & education) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Eastwood's ECO 486 Notes Patterns and Trends in International Trade Conclusions Real-world trade is complex Abstract economic models aid understanding Introduction & Patterns of Trade

Homework Read Preface, Chapter 1, and Chapter 2
Eastwood's ECO 486 Notes Homework Read Preface, Chapter 1, and Chapter 2 Answer Chapter 1 exercises 1, 2, 5, 6 & 9 (typed or neatly written). See link to questions on my web calendar of assignments. Introduction & Patterns of Trade

Chapter 2 -- Tools INTERNATIONAL ECONOMICS, ECO 486
Eastwood's ECO 486 Notes Chapter 2 -- Tools INTERNATIONAL ECONOMICS, ECO 486 Display your name card Tools of Analysis

Learning Objectives Understand purpose of our model
Eastwood's ECO 486 Notes Learning Objectives Understand purpose of our model Familiarize ourselves with the seven assumptions of the Basic Model Solve the Basic Model Calculate a measure of national welfare Derive National Supply & Demand Tools of Analysis

Introduction Economists build models Answer important questions
Eastwood's ECO 486 Notes Introduction Economists build models Answer important questions Why does international (int’l) trade occur? What goods will a country import (export)? How much will be traded and at what price? Will trade affect wages, or other factor payments? Tools of Analysis

Eastwood's ECO 486 Notes Introduction Chapter 2 builds a model of a country that lives in isolation, a.k.a. autarky predict prices and outputs in autarky Basis of two trade models Classical (Ricardian) Model HO Model (Heckscher-Ohlin) Tools of Analysis

Methodology Models are abstract, yield predictions simplify reality
Eastwood's ECO 486 Notes Methodology Models are abstract, yield predictions simplify reality verbal mathematical geometric algebraic Tools of Analysis

Methodology Our model is geometric general equilibrium
Eastwood's ECO 486 Notes Methodology Our model is geometric general equilibrium Tools of Analysis

Assumption #1 All economic agents exhibit rational behavior
Eastwood's ECO 486 Notes Assumption #1 All economic agents exhibit rational behavior firms maximize profits consumers maximize utility Tools of Analysis

Assumption #2 There are two countries: America, A, and Britain, B
Eastwood's ECO 486 Notes Assumption #2 There are two countries: America, A, and Britain, B and two goods: Soybeans, S, and Textiles, T Each good is homogeneous. Some of each good is consumed in each country. Tools of Analysis

Assumption #3 There is no money illusion
Eastwood's ECO 486 Notes Assumption #3 There is no money illusion Economic decisions are based on relative price Let PS = price of S, PT = price of T. Assume the units are bushels of S and yards of T. Relative price of S equals PS / PT Graphs as the Terms-of-Trade (TOT) line Tools of Analysis

Terms of Trade 10 8 6 a’ 4 2 a 2 4 6 8 TEXTILES, T (yards per year)
Eastwood's ECO 486 Notes Terms of Trade 10 A farmer produces 8 bushels (bu.) S per year If 1 yard (yd.) T costs 2 bu. S, she may buy up to _____ yd. T |slope| = ______________ 8 6 Terms-of -trade line a’ 4 TEXTILES, T (yards per year) 2 a SOYBEANS, S (bushels per year) Tools of Analysis

Terms of Trade 10 8 6 a’ 4 2 a 2 4 6 8 TEXTILES, T (yards per year)
Eastwood's ECO 486 Notes Terms of Trade 10 A farmer produces 8 bushels (bu.) S per year If 1 yard (yd.) T costs 2 bu. S, she may buy up to 4 yd. T |slope| = 0.5 yd./bu. 8 6 Terms-of -trade line a’ 4 TEXTILES, T (yards per year) 2 a SOYBEANS, S (bushels per year) Tools of Analysis

Why are relative prices more important than nominal prices?
Eastwood's ECO 486 Notes Why are relative prices more important than nominal prices? See exercise 10, page 52. Tools of Analysis

Assumption #4 Production Possibilities Frontier, PPF
Eastwood's ECO 486 Notes Assumption #4 Factor endowments are fixed Technology is constant Production Possibilities Frontier, PPF Tools of Analysis

Constant Opportunity Cost
Eastwood's ECO 486 Notes Constant Opportunity Cost 5 A’s opportunity cost: 4 4 3 TEXTILES, T (millions of yards per year) 2 a 1 1 America’s PPF a' SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. 4 4 3 TEXTILES, T (millions of yards per year) 2 a 1 1 America’s PPF a' SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. B’s opportunity cost: 4 4 b 3 Britain’s PPF TEXTILES, T (millions of yards per year) 2 a b’ 1 1 America’s PPF a' SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Constant Opportunity Cost 5 A’s opportunity cost: 2 bushels S costs 1 yard T, |slope| = 0.5 yd./bu. B’s opportunity cost: 1 bushel S costs 3 yards T, |slope| = 3 yd./bu. 4 4 b 3 Britain’s PPF TEXTILES, T (millions of yards per year) 2 a b’ 1 1 America’s PPF a' SOYBEANS, S (millions of bushels per year) Tools of Analysis

Increasing Opportunity Cost
Eastwood's ECO 486 Notes Increasing Opportunity Cost 6 million yards of T Opportunity cost of 1 bushel of S is 1 yard T, |slope| = 1 yd./bu. 20 a' 18 14 TEXTILES, T (millions of yards per year) 12 6 million bushels S 6 America’s PPF 2 4 8 12 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Increasing Opportunity Cost 36 30 Opportunity cost of 1 bushel of S is 24 TEXTILES, T (millions of yards per year) 15 a Britain’s PPF 6 4 7 8 9 12 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Increasing Opportunity Cost 36 30 Opportunity cost of 1 bushel of S is 9 yards of T, |slope| = 9 yd./bu. 24 18million yards of T TEXTILES, T (millions of yards per year) 15 a Britain’s PPF 6 2 million bushels of S 4 7 8 9 12 SOYBEANS, S (millions of bushels per year) Tools of Analysis

PPF with three goods See exercise 1, page 51. Eastwood's ECO 486 Notes
Tools of Analysis

Assumption #5 Perfect competition No externalities P = MC MSB = MSC
Eastwood's ECO 486 Notes Assumption #5 Perfect competition P = MC No externalities MSB = MSC Tools of Analysis

Assumption #6 Perfectly mobile factors within each country
Eastwood's ECO 486 Notes Assumption #6 Perfectly mobile factors within each country Assumptions describe supply side. Assumption 7 describes demand. A lecture on indifference curves Tools of Analysis

Learning Objectives Calculate and graph a household’s budget line
Eastwood's ECO 486 Notes Learning Objectives Calculate and graph a household’s budget line Work out how the budget line changes when prices or income changes Make a map of preferences by using indifference curves Explain the choices that households make Tools of Analysis

Consumption Possibilities
Eastwood's ECO 486 Notes Consumption Possibilities Consumption choices are limited by income and prices. A budget line describes the limits to a household’s consumption choices. Tools of Analysis

Consumption Possibilities
Eastwood's ECO 486 Notes Consumption Possibilities Divisible and Indivisible Goods Divisible goods can be bought in any quantity desired ex.—gasoline Indivisible goods cannot be bought in all quantities ex. —movies Tools of Analysis

The Budget Line Consumption Movies ($6) Soda ($3)
Eastwood's ECO 486 Notes The Budget Line Consumption Movies ($6) Soda ($3) possibility (per month) (six-packs per month) a b c d e f Instructor Notes: 1) The rows of the table list Lisa’s affordable combinations of movies and soda when her income is $30, the price of soda is $3 a six-pack, and the price of a movie is $6. 2) For example, row a tells us that Lisa exhausts her $30 income when she buys 10 six-packs and sees no movies. Lisa’s Income is $30 Tools of Analysis

Eastwood's ECO 486 Notes The Budget Line 10 Soda (six-packs per month) 8 6 4 2 Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes The Budget Line a 10 b Soda (six-packs per month) 8 c 6 d 4 Instructor Points: 1) The points above will be used to develop Lisa’s budget line. 2) Points a through f on the graph represent the rows of the table. e 2 f Movies (per month) Tools of Analysis

The Budget Line a 10 b 8 c 6 d 4 e 2 Budget Line f
Eastwood's ECO 486 Notes The Budget Line Income $30 Movies $6 Soda $3 a 10 b Soda (six-packs per month) 8 c 6 d 4 Instructor Points: 1) For divisible goods, the budget line is the continuous line af. 2) To calculate the equation for Lisa’ budget line, start with expenditure equal to income: $3Qs + $6Qm = $30 Divide by $3 to obtain Qs + 2Qm= 10 Subtract 2Qm from both sides to obtain Qs = Qm e 2 Budget Line f Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes The Budget Line Income $30 Movies $6 Soda $3 a 10 b Soda (six-packs per month) 8 c Unaffordable 6 d 4 Instructor Notes: Lisa’s budget line shows the boundary between what she can and cannot afford. Affordable e 2 f Movies (per month) Tools of Analysis

The Budget Equation The budget equation is based upon:
Eastwood's ECO 486 Notes The Budget Equation The budget equation is based upon: Expenditure = Income $3Qs + $6Qm = $30 Qs = 10 – 2Qm The quantity of soda can be found by first setting the quantity of movies. Instructor Points: 1) For divisible goods, the budget line is the continuous line af. 2) To calculate the equation for Lisa’ budget line, start with expenditure equal to income: $3Qs + $6Qm = $30 Divide by $3 to obtain Qs + 2Qm= 10 Subtract 2Qm from both sides to obtain Qs = Qm Tools of Analysis

Eastwood's ECO 486 Notes The Budget Equation Real Income is the maximum quantity of a good that a household can afford to buy. Lisa’s Real Income (in terms of soda) is: Income/Price of soda = y/Ps Tools of Analysis

The Budget Equation Lisa’s real income in terms of soda is:
Eastwood's ECO 486 Notes The Budget Equation Lisa’s real income in terms of soda is: $30/$3 = 10 six packs Tools of Analysis

The Budget Equation Relative Price
Eastwood's ECO 486 Notes The Budget Equation Relative Price A relative price is the price of one good divided by the price of another good. Lisa’s relative price of a movie in terms of soda: Tools of Analysis

The Budget Equation Relative Price
Eastwood's ECO 486 Notes The Budget Equation Relative Price A relative price is the price of one good divided by the price of another good. Lisa’s relative price of a movie in terms of soda: $6/$3 = 2 six-packs per movie In other words, to see one more movie, Lisa must give up 2 six-packs (i.e. opportunity cost) Tools of Analysis

Changes in Prices a 10 8 6 A Change in Price 4 2 f
Eastwood's ECO 486 Notes Changes in Prices Price of a movie is... a 10 Soda (six-packs per month) 8 6 A Change in Price 4 Instructor Notes: 1) The budget line drawn assumes the price of a movie is $6. 2) If the price of a movie changes, the combinations of movies and soda changes. 3) This would change the budget line. 2 …$6 f Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Changes in Prices Price of a movie is... a 10 Soda (six-packs per month) 8 6 A Change in Price 4 Instructor Notes: 1) A fall in the price from $6 to $3 rotates the budget line outward and makes it flatter. 2) A rise in the price from $6 to $12 rotates the budget line inward and makes it steeper. 2 …$12 …$6 f Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Changes in Prices Price of a movie is... a 10 Soda (six-packs per month) 8 6 A Change in Price 4 2 …$12 …$6 …$3 f Movies (per month) Tools of Analysis

Changes in Income a 10 A Change 8 in Income 6 4 2 f
Eastwood's ECO 486 Notes Changes in Income a 10 A Change in Income Soda (six-packs per month) 8 6 4 Instructor Notes: 1) A change in income shifts the budget line. 2) Suppose Lisa’s income falls from $30 to $15. 2 Income $30 f Movies (per month) Tools of Analysis

Changes in Income a 10 A Change 8 in Income 6 4 2 f
Eastwood's ECO 486 Notes Changes in Income a 10 A Change in Income Soda (six-packs per month) 8 6 4 Instructor Notes: 1) Lisa’s income falls from $30 to $15 while the prices of movies and soda remain constant. 2) The budget line shifts leftward, but its slope does not change. 2 Income $15 Income $30 f Movies (per month) Tools of Analysis

Preferences and Indifference Curves
Eastwood's ECO 486 Notes Preferences and Indifference Curves An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Tools of Analysis

A Preference Map 10 8 An indifference curve c 6 4 2 g 0 2 4 6 8 10
Eastwood's ECO 486 Notes A Preference Map 10 Soda (six-packs per month) 8 An indifference curve c 6 4 Instructor Notes: 1) If Lisa drinks 6 six-packs of soda and sees 2 movies a month, she consumes at point c. 2) Lisa can compare all other possible combinations of soda and movies to point c and rank them on the scale preferred to point c, not preferred to point c, or indifferent. 3) The boundary between points that she prefers to point c and those that she does not prefer to point c is an indifference curve. 4) Lisa is indifferent between points such as g and c on the indifference curve. 5) She prefers any point above the indifference curve (yellow area) to any point on it, and she prefers any point on the indifference curve to any point below it (gray area). 2 g Movies (per month) Tools of Analysis

A Preference Map 10 8 An indifference curve c 6 4 2 g 0 2 4 6 8 10
Eastwood's ECO 486 Notes A Preference Map 10 Soda (six-packs per month) 8 An indifference curve c Preferred 6 4 Instructor Notes: 1) If Lisa drinks 6 six-packs of soda and sees 2 movies a month, she consumes at point c. 2) Lisa can compare all other possible combinations of soda and movies to point c and rank them on the scale preferred to point c, not preferred to point c, or indifferent. 3) The boundary between points that she prefers to point c and those that she does not prefer to point c is an indifference curve. 4) Lisa is indifferent between points such as g and c on the indifference curve. 5) She prefers any point above the indifference curve (yellow area) to any point on it, and she prefers any point on the indifference curve to any point below it (gray area). Not Preferred 2 g Movies (per month) Tools of Analysis

A Preference Map A preference map is a series of indifference curves.
Eastwood's ECO 486 Notes A Preference Map A preference map is a series of indifference curves. A preference map consists of an infinite number of indifference curves; each one slopes downward, and none of them intersects. Tools of Analysis

Eastwood's ECO 486 Notes A Preference Map 10 Soda (six-packs per month) 8 c 6 j 4 Instructor Notes: 1) A preference map consists of an infinite number of indifference curves. 2) This graph shows just three that are part of Lisa’s preference map. 3) Each indifference curve shows points among which Lisa is indifferent. For example, she is indifferent between point c and point g on indifference curve I1. 4. But, she prefers any point on a higher indifference curve to any point on a lower indifference curve. For example, Lisa prefers point j to point c or g, so she prefers any point on indifference curve I2 to any point on indifference curve I1. 2 g Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes A Preference Map 10 Soda (six-packs per month) 8 c 6 j 4 Instructor Notes: 1) A preference map consists of an infinite number of indifference curves. 2) This graph shows just three that are part of Lisa’s preference map. 3) Each indifference curve shows points among which Lisa is indifferent. For example, she is indifferent between point c and point g on indifference curve I1. 4. But, she prefers any point on a higher indifference curve to any point on a lower indifference curve. For example, Lisa prefers point j to point c or g, so she prefers any point on indifference curve I2 to any point on indifference curve I1. I2 2 g I1 I0 Movies (per month) Tools of Analysis

Marginal Rate of Substitution
Eastwood's ECO 486 Notes Marginal Rate of Substitution The marginal rate of substitution (MRS) is the rate at which a person will give up one good in order to get more of another good and at the same time remain indifferent. Tools of Analysis

Eastwood's ECO 486 Notes Marginal Rate of Substitution The marginal rate of substitution (MRS) is measured by the slope of an indifference curve. Steep indifference curves have a high MRS. Flat indifference curves have a low MRS. Tools of Analysis

Eastwood's ECO 486 Notes Marginal Rate of Substitution 10 Soda (six-packs per month) 8 6 c 4 Instructor Notes: The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). 2 g I1 Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Marginal Rate of Substitution 10 Soda (six-packs per month) 8 MRS = 2 6 c 4 Instructor Notes: 1) The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). 2) The red line at point c tells us that Lisa is willing to give up 10 six-packs to see 5 movies. 3) Her marginal rate of substitution at point c is 10 divided by 5, which equals 2. 2 g I1 Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Marginal Rate of Substitution 10 Soda (six-packs per month) 8 MRS = 2 6 c 4 Instructor Notes: 1) The red line at point g tells us that Lisa is willing to give up 4.5 six-packs to see 9 movies. 2) Her marginal rate of substitution at point g is 4.5 divided by 9, which equals 1/2. 3) As Lisa consumes more movies and her consumption of soda decreases, her marginal rate of substitution diminishes. MRS = 1/2 2 g I1 Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Marginal Rate of Substitution Notice: As the consumption of movies increases, the MRS decreases. This is referred to as the diminishing marginal rate of substitution. Tools of Analysis

The Degree of Substitutability
Eastwood's ECO 486 Notes The Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. Tools of Analysis

Degree of Substitutability
Eastwood's ECO 486 Notes Degree of Substitutability Soda (cans) 10 Ordinary Goods 8 6 4 Instructor Notes: 1) This graph shows the indifference curves for two ordinary goods: movies and soda. 2) To consume less soda and remain indifferent, one must see more movies. 3) The number of movies that compensates for a reduction in soda increases as less soda is consumed. 2 Movies Tools of Analysis

Eastwood's ECO 486 Notes Degree of Substitutability 10 Perfect substitutes 8 Marker pens at the local supermarket 6 4 Instructor Notes: 1) This graph shows the indifference curves for two perfect substitutes. 2) For the consumer to remain indifferent, one fewer marker pen from the local supermarket must be replaced by one extra marker from the campus bookstore. 2 Marker pens at the campus bookstore Tools of Analysis

Eastwood's ECO 486 Notes Degree of Substitutability 5 Left running shoes Perfect complements 4 3 2 Instructor Notes: 1) This graph shows the indifference curves for two perfect complements--two goods that cannot be substituted for each other at all. 2) Having two left running shoes with one right running shoe is no better than having one of each. 3) But having two of each is preferred to having one of each. 1 Right running shoes Tools of Analysis

Predicting Consumer Behavior
Eastwood's ECO 486 Notes Predicting Consumer Behavior Individuals maximize their utility given their income budget line when they: Tools of Analysis

Predicting Consumer Behavior
Eastwood's ECO 486 Notes Predicting Consumer Behavior Individuals maximize their utility given their income budget line when they: Are on their their highest attainable indifference curve Have a marginal rate of substitution between the two goods equal to their relative price. Tools of Analysis

The Best Affordable Point
Eastwood's ECO 486 Notes The Best Affordable Point 10 Soda (six-packs per month) 8 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. 2 Movies (per month) Tools of Analysis

The Best Affordable Point
Eastwood's ECO 486 Notes The Best Affordable Point 10 f Best affordable point Soda (six-packs per month) 8 c 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. i I2 h 2 I1 I0 Movies (per month) Tools of Analysis

Eastwood's ECO 486 Notes Assumption #7 Community preferences in consumption can be represented by a consistent set of community indifference curves. Holds under restrictive conditions: Tools of Analysis

Eastwood's ECO 486 Notes Assumption #7 Community preferences in consumption can be represented by a consistent set of community indifference curves. Holds under restrictive conditions: One-person community Monarchy or dictatorship All citizens have identical tastes and incomes Why doesn’t it hold in general? Tools of Analysis

Eastwood's ECO 486 Notes General Equilibrium Solution given constant opportunity cost shown in Figure 2.5, page 41. Solution given increasing opportunity cost shown in Figure 2.6, page 42. Tools of Analysis

Solution -- constant opportunity cost
Eastwood's ECO 486 Notes Solution -- constant opportunity cost 10 H 8 G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. L 2 PPF SOYBEANS, S (millions of bushels per year) Tools of Analysis

Solution -- constant opportunity cost
Eastwood's ECO 486 Notes Solution -- constant opportunity cost 10 H Autarky General Equilibrium |slope PPF| = PS/PT 8 G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. CIC2 L 2 CIC1 PPF CIC0 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Solution -- increasing opp.cost
Eastwood's ECO 486 Notes Solution -- increasing opp.cost 10 8 G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. 2 PPF SOYBEANS, S (millions of bushels per year) Tools of Analysis

Solution -- increasing opp.cost
Eastwood's ECO 486 Notes Solution -- increasing opp.cost 10 Autarky General Equilibrium |slope of price line| = PS/PT = slope of PPF and CIC at point G 8 H G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. L CIC2 2 CIC1 PPF CIC0 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Measuring national welfare
Eastwood's ECO 486 Notes Measuring national welfare Tools of Analysis

Measuring national welfare
Eastwood's ECO 486 Notes Measuring national welfare Divide both sides by PT Figure 2.7, page 46, shows lines of equal real GNP. Tools of Analysis

Eastwood's ECO 486 Notes Measuring real GDP 10 8 G General Equilibrium TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. 2 PPF SOYBEANS, S (millions of bushels per year) Tools of Analysis

Measuring real GDP 10 8 G 6 4 2 0 2 4 6 8 10 GDP2/PT=
Eastwood's ECO 486 Notes Measuring real GDP GDP2/PT= 10 8 GDP1/PT= G General Equilibrium TEXTILES, T (millions of yards per year) GDP0/PT= 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. 2 PPF SOYBEANS, S (millions of bushels per year) Tools of Analysis

Calculate nominal and real GNP
Eastwood's ECO 486 Notes Calculate nominal and real GNP See exercise 2, page 51. Interpretation: see exercise 3 Tools of Analysis

National supply and demand
Eastwood's ECO 486 Notes National supply and demand Figure 2.8 derives national supply (NS) and (ND) when opportunity costs are increasing. Figure 2.9 (page 49) plots NS & ND together to determine autarky equilibrium Figure 2.10 (page 50) plots NS & ND for two countries, A & B Tools of Analysis

Quantity of Soybeans Supplied
Eastwood's ECO 486 Notes Quantity of Soybeans Supplied H 10 Autarky General Equilibrium |slope PPF| = PS/PT = 2 yd.T/bu.S 8 G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. 2 PPF L SOYBEANS, S (millions of bushels per year) Tools of Analysis

Quantity of Soybeans Supplied
Eastwood's ECO 486 Notes Quantity of Soybeans Supplied PS/PT = 1 yd.T/bu.S H 10 Autarky General Equilibrium |slope PPF| = PS/PT = 2 yd.T/bu.S 8 G TEXTILES, T (millions of yards per year) 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. PS/PT = 3 yd.T/bu.S 2 PPF L SOYBEANS, S (millions of bushels per year) Tools of Analysis

National Supply of S Constant Opportunity Cost
Eastwood's ECO 486 Notes National Supply of S Constant Opportunity Cost Relative Price (yards of T per bushel of S) 3 2 1 1 5 Quantity (millions of bushels per year) Tools of Analysis

National Supply of S Constant Opportunity Cost
Eastwood's ECO 486 Notes National Supply of S Constant Opportunity Cost Capacity, see PPF Relative Price (yards of T per bushel of S) A’s National Supply of Soybeans 3 2 1 1 5 Quantity (millions of bushels per year) Tools of Analysis

Quantity of Soybeans Demanded
Eastwood's ECO 486 Notes Quantity of Soybeans Demanded 10 H 8 G TEXTILES, T (millions of yards per year) 6 L 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. CIC2 2 CIC1 CIC0 PPF 1.8 4.7 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Quantity of Soybeans Demanded PS/PT = 2.5 yd.T/bu.S 10 H 8 General Equilibrium |slope PPF| = PS/PT = 2 yd.T/bu.S G TEXTILES, T (millions of yards per year) 6 L 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. CIC2 2 CIC1 CIC0 PPF 1.8 4.7 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes Quantity of Soybeans Demanded PS/PT = 2.5 yd.T/bu.S 10 H 8 General Equilibrium |slope PPF| = PS/PT = 2 yd.T/bu.S G TEXTILES, T (millions of yards per year) 6 L PS/PT = 1 yd.T/bu.S 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. CIC2 2 CIC1 CIC0 PPF 1.8 4.7 SOYBEANS, S (millions of bushels per year) Tools of Analysis

Eastwood's ECO 486 Notes National Demand for S Relative Price (yards of T per bushel of S) 2.5 2 1 1.8 1 2 3 4.7 5 Quantity (millions of bushels per year) Tools of Analysis

National Demand for S H 2.5 G 2 L 1 1 2 3 5
Eastwood's ECO 486 Notes National Demand for S Relative Price (yards of T per bushel of S) H 2.5 G 2 L 1 A’s National Demand for Soybeans 1.8 1 2 3 4.7 5 Quantity (millions of bushels per year) Tools of Analysis

National Supply & Demand
Eastwood's ECO 486 Notes National Supply & Demand Relative Price (yards of T per bushel of S) A’s National Supply of Soybeans 3 2 1 1 2 3 5 Quantity (millions of bushels per year) Tools of Analysis

National Supply & Demand
Eastwood's ECO 486 Notes National Supply & Demand Relative Price (yards of T per bushel of S) A’s National Supply of Soybeans 3 2 1 A’s National Demand for Soybeans 1 2 3 5 Quantity (millions of bushels per year) Tools of Analysis

You Derive NS & ND See exercise 4, page 51. Eastwood's ECO 486 Notes
Tools of Analysis

Use NS & ND See exercise 5, page 52. Eastwood's ECO 486 Notes
Tools of Analysis

Review balance of homework
Eastwood's ECO 486 Notes Review balance of homework Tools of Analysis

Stevedores stow bags of maize in a cargo ship in Mozambique FAO, Mattioli

Chapter 3 -- Classical Model
Eastwood's ECO 486 Notes Chapter 3 -- Classical Model INTERNATIONAL ECONOMICS, ECO 486 Display your name card Classical Model

Learning Objectives Understand five more assumptions
Eastwood's ECO 486 Notes Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade Classical Model

Assumption #8 Factors of production cannot move between countries
Eastwood's ECO 486 Notes Assumption #8 Factors of production cannot move between countries Classical Model

Assumption #9 There are no barriers to trade in goods.
Eastwood's ECO 486 Notes Assumption #9 There are no barriers to trade in goods. Classical Model

Assumption #10 Exports must pay for imports
Eastwood's ECO 486 Notes Assumption #10 Exports must pay for imports Assumptions 8-10 apply to both the Classical and HO Models Assumptions 11 & 12 apply only to Classical Model Classical Model

Eastwood's ECO 486 Notes Assumption #11 Labor is the only relevant factor of production in terms of productivity analysis or costs of production. Classical Model

Eastwood's ECO 486 Notes Assumption #12 Production exhibits constant returns to scale, CRS, between labor and output. Classical Model

CRS Implies Linear PPF See Figure 3.1, page 68
Eastwood's ECO 486 Notes CRS Implies Linear PPF See Figure 3.1, page 68 Classical Model

Autarky See Figure 3.2, page 69 Given perfect competition,
Eastwood's ECO 486 Notes Autarky See Figure 3.2, page 69 Given perfect competition, Classical Model

Autarky See Figure 3.2, page 69 Given perfect competition, P = MC
Eastwood's ECO 486 Notes Autarky See Figure 3.2, page 69 Given perfect competition, P = MC Autarky price of S equals slope of PPF Resource payments correspond to their productivity Classical Model

Absolute Advantage Compare one good across countries.
Eastwood's ECO 486 Notes Absolute Advantage Compare one good across countries. Country with lower labor input has an absolute advantage in that good. Classical Model

Comparative Advantage
Eastwood's ECO 486 Notes Comparative Advantage Calculate opportunity costs. Compare one good across countries. Country with lower opportunity cost has a comparative advantage in that good. Classical Model

Which Advantage? Absolute advantage is a special case.
Eastwood's ECO 486 Notes Which Advantage? Absolute advantage is a special case. Comparative advantage is the general case. Classical Model

Terms of Trade Once trade begins, an international equilibrium results
Eastwood's ECO 486 Notes Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good Classical Model

Terms of Trade Once trade begins, an international equilibrium results
Eastwood's ECO 486 Notes Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good called the terms of trade between the two autarky prices determined by reciprocal demand Classical Model

International Trade Equilibrium
Eastwood's ECO 486 Notes International Trade Equilibrium See Figure 3.3, page 71 Complete specialization in Comparative Advantage good CIC & ToT tangent at consumption point Congruent trade triangles imply balanced trade Classical Model

Gains From Trade Higher CIC shows a gain
Eastwood's ECO 486 Notes Gains From Trade Higher CIC shows a gain Measure gains from trade using GDP Sources of gain: Classical Model

Gains From Trade Higher CIC shows a gain
Eastwood's ECO 486 Notes Gains From Trade Higher CIC shows a gain Measure gains from trade using GDP Sources of gain: production (gains from specialization) consumption (ToT price lower than autarky) Classical Model

Perfect Competition Review (Product & Resource Markets)
Eastwood's ECO 486 Notes Perfect Competition Review (Product & Resource Markets) PXC = MC for a good, X, in a country, C MC = w/MPPL (Labor, L, is only var. input) w=MRPL =(MR) MPPL=(P) MPPL=VMPL Classical Model

Perfect Competition Review (Product & Resource Markets)
Eastwood's ECO 486 Notes Perfect Competition Review (Product & Resource Markets) PXC = MC for a good, X, in a country, C MC = w/MPPL (Labor, L, is only var. input) w=MRPL =(MR) MPPL=(P) MPPL=VMPL MRPL = Marginal Revenue Product MR = Marginal Revenue; MPPL = Marginal Physical Product of L VMPL = Value Marginal Product of L Classical Model

Prices & Wages PXC = MC = w/MPPL
Eastwood's ECO 486 Notes Prices & Wages PXC = MC = w/MPPL MPPL is measured as units of X per hour hoursXC is stated as hours per unit of X PXC = wC (hoursXC) Classical Model

Exchange Rates State exchange rate, E, in US dollars per UK pound
Eastwood's ECO 486 Notes Exchange Rates State exchange rate, E, in US dollars per UK pound say $2/£ A good will be imported if its foreign pre- trade price (x E) is less than the domestic price PSA < E x PSB Classical Model

Buy Low . . . Trade requires PSA < E x PSB PTA > E x PTB
Eastwood's ECO 486 Notes Buy Low . . . Trade requires PSA < E x PSB PTA > E x PTB autarky prices A has comparative advantage in S B has comparative advantage in T Classical Model

Trade & Wages Substitute PXC = wC (hoursXC) To solve
Eastwood's ECO 486 Notes Trade & Wages Substitute PXC = wC (hoursXC) wA (hoursSA) < E x wB (hoursSB) wA (hoursTA) > E x wB (hoursTB) To solve divide both sides by (E x wB) divide both sides by (hoursXA) Classical Model

Eastwood's ECO 486 Notes Trade & Wages (Cont.) Classical Model

Eastwood's ECO 486 Notes Trade & Wages (Cont.) Trade will occur if the wage ratio does not exceed the productivity ratio Classical Model

Eastwood's ECO 486 Notes Trade & Wages (Cont.) Classical Model

Eastwood's ECO 486 Notes Trade & Wages (Cont.) If one country is technologically advanced, it must have a higher wage rate. Classical Model

Losing Comparative Advantage
Eastwood's ECO 486 Notes Losing Comparative Advantage If the wage ratio exceeds the productivity ratio, trade will not occur If a currency is overvalued (say $1/£ instead of $2/£), both goods may be cheaper in one country Classical Model

Eastwood's ECO 486 Notes Review Homework Classical Model

Q#8: Degree of Specialization
Eastwood's ECO 486 Notes Q#8: Degree of Specialization X = COMPLETE SPECIALIZATION, P = PARTIAL SPECIALIZATION X 10 Autarky Equilibrium 8 P C = COMPLETE SPECIALIZATION, ALLOWS GREATER CONSUMPTION G TEXTILES, T (millions of yards per year) 6 C D 4 Instructor Notes: Use this slide to answer question 8 in the homework. CIC2 2 CIC1 CIC0 PPF SOYBEANS, S (millions of bushels per year) Classical Model

Eastwood's ECO 486 Notes Quantity of Soybeans Demanded PS/PT = 2.5 yd.T/bu.S 10 H 8 Autarky General Equilibrium |slope PPF| = PS/PT = 2 yd.T/bu.S G TEXTILES, T (millions of yards per year) 6 L PS/PT = 1 yd.T/bu.S 4 CIC2 2 CIC1 CIC0 PPF 1.8 4.7 SOYBEANS, S (millions of bushels per year) Classical Model

Chapter 4 -- HO Model INTERNATIONAL ECONOMICS, ECO 486
Eastwood's ECO 486 Notes Chapter 4 -- HO Model INTERNATIONAL ECONOMICS, ECO 486 Display your name card HO Model

Learning Objectives Examine the need to build a new model
Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Classical Model Strengths Weaknesses Trade is mutually beneficial
Eastwood's ECO 486 Notes Classical Model Strengths Trade is mutually beneficial High & low wage countries may trade Explains some of the trade patterns we observe Weaknesses Why does so much trade occur among developed countries? Why does technology differ across countries? HO Model

Heckscher-Ohlin (HO) Model
Eastwood's ECO 486 Notes Heckscher-Ohlin (HO) Model Built upon observed differences among Factors that countries possess Factors required to produce various goods Insights Causes of trade Effects of trade on factor prices Effect of economic growth on trade patterns Political behavior HO Model

Assumptions for HO Model
Eastwood's ECO 486 Notes Assumptions for HO Model Keep assumptions 1 through 10 Drop assumptions 11 & 12 Add assumptions 13 through 17 HO Model

Eastwood's ECO 486 Notes Assumption #13 There are two factors of production, labor (L), and capital (K). Owners of capital are paid a rental payment (R) for the services of their assets, and labor receives a wage payment (W). HO Model

Eastwood's ECO 486 Notes Assumption #14 The technologies available to each country are identical. Any technology is available to any country Factor prices determine the technology chosen HO Model

A Model of a Two-Factor Economy
Eastwood's ECO 486 Notes A Model of a Two-Factor Economy Compare to Figure 4-1: Input Possibilities in Soybean Production Unit Capital input aTS , in machines per bushel Unit Labor input aLF , in hours per bushel // Input combinations that produce one bushel of Soybeans HO Model

Eastwood's ECO 486 Notes Assumption #15 The production of T is labor intensive relative to the production of S That is, T requires more labor per machine Implies that production of S is capital intensive (relative to the production of T). That is, S requires more machines per worker HO Model

K per Worker for US Industries
Eastwood's ECO 486 Notes K per Worker for US Industries Thousands of 1972 dollars. Item 4.1, page 89, 5th edition, Husted & Melvin HO Model

Factor Prices and Input Choices
Eastwood's ECO 486 Notes Which line represents the Capital-intensive industry, 1 or 2? Wage-rental ratio, w/r Capital-labor ratio, K/L 1 2 Compare to Figure 4.2, page 70 HO Model

Factor Prices and Input Choices
Eastwood's ECO 486 Notes Factor Prices and Input Choices Soybean production is capital-intensive at any given wage/rental ratio Wage-rental ratio, w/r Capital-labor ratio, K/L TT SS HO Model

Combing Figures 4-2 and 4-3 Compare to Figure 4-4, page 71 Capital-
Eastwood's ECO 486 Notes Capital- labor Ratio, K/L Relative price of T, PT/PS Wage-rental ratio, w/r TT PW SS (w/r)2 (PT/PS)2 (KT/LT)2 (KS/LS)2 (w/r)1 (PT/PS)1 (KT/LT)1 (KS/LS)1 Increasing Increasing Compare to Figure 4-4, page 71 HO Model

Eastwood's ECO 486 Notes Assumption #16 Country A is relatively capital abundant, while B is labor abundant. HO Model

K per Worker: Selected Countries
Eastwood's ECO 486 Notes K per Worker: Selected Countries 1985 international prices. Item 4.2, page 91, 5th edition Husted & Melvin HO Model

Quantity definition of factor abundance
Eastwood's ECO 486 Notes Quantity definition of factor abundance Country A is relatively capital abundant, if the ratio of its capital stock to its labor force (K/L) is greater than that of the other country: HO Model

Price definition of factor abundance
Eastwood's ECO 486 Notes Price definition of factor abundance Country A is relatively capital abundant, if its wage-rental ratio (W/R) is higher than the other country’s wage-rental ratio: HO Model

Strong factor abundance assumption
Eastwood's ECO 486 Notes Strong factor abundance assumption If country A is relatively capital abundant, by the quantity definition, its wage-rental ratio (W/R) will be higher than the other country’s wage-rental ratio. That is, the price definition holds, too. HO Model

Increasing Opportunity Cost in A
Eastwood's ECO 486 Notes Increasing Opportunity Cost in A S is K-intensive A is K-abundant 20 18 14 America’s PPF TEXTILES, T (millions of yards per year) 12 6 2 4 8 10 12 16 SOYBEANS, S (millions of bushels per year) HO Model

Increasing Opportunity Cost in B
Eastwood's ECO 486 Notes Increasing Opportunity Cost in B T is L-intensive B is L-abundant 40 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 5 10 SOYBEANS, S (millions of bushels per year) HO Model

Assumption #17 Tastes in the two countries are identical.
Eastwood's ECO 486 Notes Assumption #17 Tastes in the two countries are identical. Given same GDP & prices, same choice Implies that supply conditions alone determine the direction of comparative advantage (CA). Different tastes would imply different demand Could reverse the direction of CA. HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and less of the other. See Figure 4.5 , page 73, and 4.6, page 74 Krugman & Obstfeld See Figure 4.7, page 102 5th edition Husted & Melvin Evidence: read item on “Dutch Disease, p. 292 HO Model

Which is the K-intensive industry?
Eastwood's ECO 486 Notes Which is the K-intensive industry? Labor used in _____________ production Increasing L__ K_ O_ O_ __ Capital used in ________ production Increasing __ 1 L_ K_ Increasing Capital used in _____ production Labor used in______production Increasing Compare to Figure 4-5, page 73 HO Model

S is K intensive, T is L intensive
Eastwood's ECO 486 Notes S is K intensive, T is L intensive Labor used in Soybean production Increasing LS KS OS OT S Increasing Capital used in Textile production T 1 Capital used in S production LT KT Increasing Labor used in Textile production Increasing HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem How do the outputs of the two goods change when the economy’s resources change? Increase the amount of one factor, say K, and observe the results HO Model

K increases. S (K int.) expands. S needs more labor. T must contract
Eastwood's ECO 486 Notes K increases. S (K int.) expands. S needs more labor. T must contract Increasing L used in S production O2S L2S L2T L1S L1T S2 O1S OT S1 Increasing K used in S production Increasing T 1 K used in T production K1S K1T K2S K2T 2 L used in T production Increasing HO Model

An increase in K in Country A.
Eastwood's ECO 486 Notes An increase in K in Country A. Output of T, QT S, QS Slope = -PS/PT 1 Q1T 2 Slope = -PS/PT Q2T PPF2 PPF1 Q1S Q2S HO Model

An increase in L in country B.
Eastwood's ECO 486 Notes An increase in L in country B. Output of T, QT S, QS 2 Q2T Q2S Slope = -PS/PT PPF2 Slope = -PS/PT 1 Q1T Q1S PPF1 Compare to Figure 4-7, page 75. Now try it yourself – solve problem 2 HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem Also helps us to understand that an economy will tend to be more productive in industries that use its abundant factor intensively. HO Model

Heckscher-Ohlin Theorem
Eastwood's ECO 486 Notes Heckscher-Ohlin Theorem A country will export the goods whose production is intensive in the factor with which that country is abundantly endowed. “Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed.” page 76 Krugman & Obstfeld A country will have comparative advantage in, and therefore will export, that good whose production is intensive in the factor with which that country is relatively well endowed. Page 94, (5th edition) Husted & Melvin HO Model

Eastwood's ECO 486 Notes Autarky in A 18 a 15 CIC0 TEXTILES, T (millions of yards per year) 12 10 13 16 SOYBEANS, S (millions of bushels per year) HO Model

Eastwood's ECO 486 Notes Autarky in A (PS/PT )A = |slope| = 1 yd./bu. 18 a 6 million yards of T 15 CIC0 TEXTILES, T (millions of yards per year) 12 6 million bushels S 10 13 16 SOYBEANS, S (millions of bushels per year) HO Model

Autarky in B 40 a 30 CIC0 20 Britain’s PPF 10 4 6.5 9
Eastwood's ECO 486 Notes Autarky in B 40 a 30 CIC0 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 10 4 6.5 9 SOYBEANS, S (millions of bushels per year) HO Model

Autarky in B 40 a 30 CIC0 20 Britain’s PPF 10 4 6.5 9
Eastwood's ECO 486 Notes Autarky in B (PS/PT )B = |slope| = 4 yd./bu. A has comp. adv. in S B has comp. adv. in T 40 a 30 20 mil. yards of T CIC0 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 10 5 million bushels of S 4 6.5 9 SOYBEANS, S (millions of bushels per year) HO Model

Trade Leads to a Convergence of Relative Prices
Eastwood's ECO 486 Notes Trade Leads to a Convergence of Relative Prices Relative price of S, ______ Relative quality of S, RD RSA RSB 1 2 3 Compare to Figure 4-8, page 77. HO Model

Trade Leads to a Convergence of Relative Prices
Eastwood's ECO 486 Notes Trade Leads to a Convergence of Relative Prices Relative price of S, PS/PT Relative quality of S, QS + Q*S QT + Q*T RSB RSA 3 2 1 As prices converge, B produces less S and more T. A produces more S and less T. RD HO Model

Eastwood's ECO 486 Notes With free trade, there will be one world relative price for S (PS/PT) and T (PT/PS). As PS/PT rises in Country A, their S industry expands while their T industry contracts. As PS/PT falls in Country B, their S industry contracts while their T industry expands. Tricky to draw the general equilibrium solution, so let’s try it together. Show/draw Figure 4.4, page 98, Husted & Melvin HO Model

International Trade Equilibrium
Eastwood's ECO 486 Notes International Trade Equilibrium Incomplete specialization in Comparative Advantage good. Community Indifference Curve (CIC) & Terms of Trade line (ToT) tangent at consumption point Congruent trade triangles imply balanced trade. HO Model

Stolper-Samuelson Theorem
Eastwood's ECO 486 Notes Stolper-Samuelson Theorem Free international trade benefits the abundant factor and harms the scarce factor. “Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.” page 77, Krugman & Obstfeld. Free international trade benefits the abundant factor and harms the scarce factor. Page 105, Husted & Melvin HO Model

As PS/PT rises in Country A, PT/PS and w/r fall.
Eastwood's ECO 486 Notes As PS/PT rises in Country A, PT/PS and w/r fall. Look back at Figure 4-4, or slide 15. A is K abundant (L scarce) As PS/PT falls in Country B, PT/PS and w/r rise. B is L abundant (K scarce) Show/draw Figure 4.4, page 98, Husted & Melvin HO Model

Factor-Price Equalization (FPE) Theorem
Eastwood's ECO 486 Notes Factor-Price Equalization (FPE) Theorem Given all the assumptions of the HO model, free trade will lead to the international equalization of individual factor prices. Look again at Figure 4-4, or slide 15. One relative price for T, PT/PS One wage-rental ratio, w/r HO Model

Factor-Price Equalization?
Eastwood's ECO 486 Notes Factor-Price Equalization? “There isn’t any.” Why not? Some goods are not produced in some countries. Productivity (technology) does differ between countries. Goods’ prices differ due to natural and artificial barriers to trade. HO Model

Eastwood's ECO 486 Notes Reciprocal Demand See Figure 4.5, page 100 5th edition Husted and Melvin HO Model

Eastwood's ECO 486 Notes Importance of Tastes See Figure 4.6, page 102 5th edition Husted and Melvin HO Model

Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem Introduce Specific-Factors Model HO Model

Specific-Factors Model
Eastwood's ECO 486 Notes Specific-Factors Model Keep all HO assumptions except: one factor is immobile (say K) different rental rates for machines in S & T industries Labor still mobile, implying one wage, W W = VMPS = PS x MPLS Appendix 4.2, pages , Husted & Melvin. See Figures A4.5 and A4.6 HO Model

Specific-Factors Model
Eastwood's ECO 486 Notes Specific-Factors Model W = VMPS = PS x MPLS W = VMPT = PT x MPLT HO Model

Eastwood's ECO 486 Notes The End of Chapter 4 HO Model

Chapter 5 -- Tests of Trade Models
Eastwood's ECO486 Notes Chapter 5 -- Tests of Trade Models INTERNATIONAL ECONOMICS, ECO 486 Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Learning Objectives Understand the results of well-known tests of the Classical and HO Models. Become familiar with new theories concerning the source of comparative advantage Understand intra-industry trade, and calculate IIT. Tests of Trade Models; Sources of Comparative Advantage

Tests of the Classical Model
Eastwood's ECO486 Notes Tests of the Classical Model MacDougall compared US and British exports for 1937. Calculated APL Compared relative APL to relative wage America’s wages were twice those in Britain Classical model predicts that US would export a good if its labor is more than twice as productive. Tests of Trade Models; Sources of Comparative Advantage

Table 5.1, MacDougall’s Test
Eastwood's ECO486 Notes Table 5.1, MacDougall’s Test p. 123 Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Tests of the Classical Model Of 25 products tested, 20 fit this theory Supports a relationship between labor productivity and exports Does not rule out the HO Model Did not control for differences in other factors (e.g., transportation costs, resource intensity,…) Tests of Trade Models; Sources of Comparative Advantage

Leontief’s Test of the HO Model
Eastwood's ECO486 Notes Leontief’s Test of the HO Model Leontief, Wassily {lay-ohn’-tyef, vah-sil’ee} born 5 Aug 1906 St. Petersburg, Russia Leontief developed input-output (I-O) model Assumed that US was most K-abundant country in 1947 HO Model predicts US exports K-intensive Used I-O Model to Test HO Theory Tests of Trade Models; Sources of Comparative Advantage

Leotief’s Test of the HO Model
Eastwood's ECO486 Notes Leotief’s Test of the HO Model Test: Cut US exports by $1 million Raise US production of import-competing goods by $1 million Tests of Trade Models; Sources of Comparative Advantage

Leontief’s Test (continued)
Eastwood's ECO486 Notes Leontief’s Test (continued) Reducing production of exports released more labor than required to expand the production of import-competing goods. US imports were more capital intensive than US exports! This surprising result is known as the Leontief Paradox Tests of Trade Models; Sources of Comparative Advantage

Attempts to Resolve the Paradox
Eastwood's ECO486 Notes Attempts to Resolve the Paradox Leontief (’52) argued that US labor was more productive (see quote page 127) Vanek (’63) argued for the inclusion of a third factor of production, natural resources natural resource production is K-intensive Travis explained the paradox by the structure of US tariffs (high on L-int. goods)* *published in Leamer’s book (’84) Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Attempts to Resolve the Paradox Technology differs -- Leontief assumed that US technology was used to produce US imports High W/R  firms use K-intensive methods Tastes differ -- Table 5.2 shows that consumption patterns differ. But enough to reverse direction of CA??? Tests of Trade Models; Sources of Comparative Advantage

Table 5.2, Consumption Patterns
Eastwood's ECO486 Notes Table 5.2, Consumption Patterns p. 129 Tests of Trade Models; Sources of Comparative Advantage

Other Tests of the HO Model
Eastwood's ECO486 Notes Other Tests of the HO Model Leontief examined ‘51 data, found paradox Baldwin examined ‘62 data, found paradox Stern & Maskus examined ‘72 data, paradox gone (assuming US was still K abundant) Tests of Trade Models; Sources of Comparative Advantage

Caves, World Trade and Payments, p. 301
Eastwood's ECO486 Notes Test Results: Domestic Capital Required per Labor Year per Million Dollars of … Caves, World Trade and Payments, p. 301 Tests of Trade Models; Sources of Comparative Advantage

Tests: Other Countries
Data on trade among developing countries supports HO Results of tests on East Germany and former Soviet Union were consistent with HO theory. Other paradoxical results found in developed country trade Paradox was also found in tests of foreign countries (Japan, Canada, India).

Recent Tests of the HO Model
Eastwood's ECO486 Notes Recent Tests of the HO Model Leontief linked factor intensities and trade patterns Leamer linked factor endowments and trade patterns HO Model links all three Leamer showed that the relative abundance of a given factor of production helps explain the goods that a country exports Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Recent Tests of the HO Model Maskus Results contradict many HO predictions Used US I-O table to identify factor intensities of US exports and imports Bowen (et al) looked at more countries Mixed results Used US I-O table as well, but noted that other countries may use other technologies Tests of Trade Models; Sources of Comparative Advantage

More Recent Tests of HO Model
Since the 1980s, more tests have been conducted because: Earlier studies were incomplete since these did not link trade patterns with factor endowments Using a multifactor version of the HO model, Leamer (1980) showed that trade patterns and factor endowments were related to each other Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

More Recent Tests (cont.)
Two studies attempted to test the links between endowments and intensities to trade patterns: Maskus (1985) Bowen, Leamer, and Sveikauskas (1987) Both studies found contradictory results. Other studies which relaxed HO assumptions had better results. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Most Recent Tests Combine Models
Eastwood's ECO486 Notes Most Recent Tests Combine Models Trefler By allowing for differing technology, found support for Factor Price Equalization Technology and tastes included in model, resolved many of the discrepancies Harrigan Differing technology and factor endowments explain observed specialization in production Tests of Trade Models; Sources of Comparative Advantage

Sources of Comparative Advantage
Eastwood's ECO486 Notes Sources of Comparative Advantage Human Skills Theory Product Life-Cycle Theory Similarity of Preferences Theory Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Human Skills Theory Kravis found that the bulk of US exports are provided by high-wage industries In ’56, but still true Keesing (’65-6) argues that differing endowments of K & L are less important than differing endowments skilled and unskilled labor Tests of Trade Models; Sources of Comparative Advantage

Product Life-cycle Theory
Eastwood's ECO486 Notes Product Life-cycle Theory Vernon argues that some countries have CA in innovation. US has CA in developing new products, a labor-intensive activity As products “mature,” production becomes automated (K-intensive) and CA may shift Tests of Trade Models; Sources of Comparative Advantage

Product Life-cycle Theory (cont.)
Eastwood's ECO486 Notes Product Life-cycle Theory (cont.) Applies only to some goods Cannot predict when shift will occur Gagnon & Rose (’95) few shifts (‘62 v. ’88 data) Tests of Trade Models; Sources of Comparative Advantage

Similarity of Preferences
Eastwood's ECO486 Notes Similarity of Preferences Linder focused on demand and hypothesized that consumers prefer variety, which trade provides Countries with similar standards of living will produce (& trade) similar goods. Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Similarity of Preferences “In each country, industries produce goods designed to please the tastes of consumers in that country.” Some people prefer products that differ  trade Factor endowments influence standard of living Standard of living influences tastes Rich countries will trade with other rich countries Tests of Trade Models; Sources of Comparative Advantage

Similarity of Preferences (SP)
Eastwood's ECO486 Notes Similarity of Preferences (SP) Linder rejects HO for trade in manufactured goods No paradox SP explains intra-industry trade SP applies only to differentiated products Linder explains trade in other goods using HO Tests of Trade Models; Sources of Comparative Advantage

Conclusions The world is a very complicated place.
Developing direct tests of international trade models is difficult due to restrictive assumptions, data, and measurement problems. International economics is an evolutionary science. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

If a Country Has Comparative Advantage in a Good, Why Would the Country Import It?
Transportation costs Data aggregation and categorization problems Increasing returns to scale and imperfect competition Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Intra-industry Trade (IIT)
Eastwood's ECO486 Notes Intra-industry Trade (IIT) Occurs when countries both export and import the products of an industry Not predicted by Classical or HO Models Some IIT is consistent with the HO Model Transportation costs Data aggregation Linder’s hypothesis predicts IIT Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Intra-industry Trade (IIT) Grubel-Lloyd index (see p. 137 in Husted) Let ej = exports of j, ij = imports of j Tests of Trade Models; Sources of Comparative Advantage

Calculate IIT, example 1 Eastwood's ECO486 Notes
Tests of Trade Models; Sources of Comparative Advantage

Example 1 Eastwood's ECO486 Notes

Table 5.3 Intra-industry Trade, 1983
Eastwood's ECO486 Notes Table 5.3 Intra-industry Trade, 1983 See page 137, Husted & Melvin, 7th edition Tests of Trade Models; Sources of Comparative Advantage

The Long-run Average Cost Curve
Eastwood's ECO486 Notes The Long-run Average Cost Curve The long run average total cost curve is derived from the short-run average total cost curves. The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve. Tests of Trade Models; Sources of Comparative Advantage

Long-run Average Cost Curve
Eastwood's ECO486 Notes Long-run Average Cost Curve Instructor Notes: 1) In the long run, Swanky can vary both capital and labor inputs. 2) The long-run average cost curve, LRAC, traces the lowest attainable average total cost of production. 3) Swanky produces on its long-run average cost curve if it uses 1 machine to produce up to 10 sweaters a day, 2 machines to produce between 10 and 18 sweaters a day, 3 machines to produce between 18 and 24 sweaters a day, and 4 machines to produce more than 24 sweaters a day. 5) Within these ranges, Swanky varies its output by varying its labor input. Tests of Trade Models; Sources of Comparative Advantage

Short-run and Long-run Cost Curves
Eastwood's ECO486 Notes Short-run and Long-run Cost Curves If plant size can be varied by tiny amounts, LRAC curve is a smooth, U-shaped curve The SRAC curve for each plant just touches the LRAC curve at a single output level Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Short-run and Long-run Cost Curves SRAC touches LRAC LRAC shows economies and diseconomies of scale Tests of Trade Models; Sources of Comparative Advantage

Returns to Scale -- Internal to the Firm
Eastwood's ECO486 Notes Returns to Scale -- Internal to the Firm Describes changes in average cost as a firm expands (literally, when a one-plant firm builds a bigger plant) Holding factor prices constant A multi-plant firm may realize some economies as it adds additional plants A multi-product firm may realize some economies of scope as it adds products Tests of Trade Models; Sources of Comparative Advantage

Returns to Scale & Slope of LRAC
Eastwood's ECO486 Notes Returns to Scale & Slope of LRAC Increasing Returns to Scale, IRS (a.k.a. Economies of Scale) – LRAC negative slope Constant Returns to Scale, CRS Decreasing Returns to Scale, DRS (a.k.a. Diseconomies of Scale) Tests of Trade Models; Sources of Comparative Advantage

Increasing Returns -- Internal to the Firm
Eastwood's ECO486 Notes Increasing Returns -- Internal to the Firm Say we double all inputs and get more than twice the output q = f(K,L), but 2q < f(2K,2L) With factor prices constant, total cost (TC) doubles, while output (q) more than doubles Average cost ($/unit) falls (LRAC = TC/q) This is Increasing Returns to Scale, IRS (a.k.a. Economies of Scale) Tests of Trade Models; Sources of Comparative Advantage

Slope of Long-run Industry Supply
Eastwood's ECO486 Notes Slope of Long-run Industry Supply Increasing Cost Industry – positive slope Constant Cost Industry – zero slope Decreasing Cost Industry – negative slope Describes how factor prices change as an industry expands Tests of Trade Models; Sources of Comparative Advantage

Long-run Changes in Price and Quantity
Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Decreasing-cost industry Price Price Price S0 S0 S0 Ps Ps Ps Instructor Notes: When demand increases from D0 to D1, entry occurs and the industry supply curve shifts from S0 to S1. P0 P0 P0 D1 D1 D1 D0 D0 D0 Q0 Qs Q0 Qs Q0 Qs Quantity Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Price S0 Ps Instructor Notes: 1) In this graph the long-run supply curve, LSA, is horizontal. 2) The quantity increases from Q0 to Q1 , and the price remains constant at P0 . P0 D1 D0 Q0 Qs Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Price S0 S1 Ps Instructor Notes: 1) In this graph the long-run supply curve, LSA, is horizontal. 2) The quantity increases from Q0 to Q1 , and the price remains constant at P0 . P0 D1 D0 Q0 Qs Q1 Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Price S0 S1 Ps Instructor Notes: 1) In this graph the long-run supply curve, LSA, is horizontal. 2) The quantity increases from Q0 to Q1 , and the price remains constant at P0 . P0 LSA D1 D0 Q0 Qs Q1 Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Price Price S0 S1 S0 Ps Ps Instructor Notes: 1) In the second graph, the long-run supply curve is LSB; the price rises to P2, and the quantity increases to Q2. 2) This case occurs in industries with external diseconomies. P0 LSA P0 D1 D1 D0 D0 Q0 Qs Q1 Q0 Qs Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Price Price S0 S1 S0 S2 Ps Ps P2 Instructor Notes: 1) In the second graph, the long-run supply curve is LSB; the price rises to P2, and the quantity increases to Q2. 2) This case occurs in industries with external diseconomies. P0 LSA P0 D1 D1 D0 D0 Q0 Qs Q1 Q0 Qs Q2 Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Price Price S0 S1 S0 S2 Ps Ps LSB P2 Instructor Notes: 1) In the second graph, the long-run supply curve is LSB; the price rises to P2, and the quantity increases to Q2. 2) This case occurs in industries with external diseconomies. P0 LSA P0 D1 D1 D0 D0 Q0 Qs Q1 Q0 Qs Q2 Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Decreasing-cost industry Price Price Price S0 S1 S0 S2 S0 Ps Ps LSB Ps P2 Instructor Notes: 1) In the third graph, the long-run supply curve is LSC; the price falls to P3, and the quantity increases to Q3. 2) This case occurs in an industry with external economies. P0 LSA P0 P0 D1 D1 D1 D0 D0 D0 Q0 Qs Q1 Q0 Qs Q2 Q0 Qs Quantity Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Decreasing-cost industry Price Price Price S0 S1 S0 S2 S0 Ps Ps LSB Ps S3 P2 Instructor Notes: 1) In the third graph, the long-run supply curve is LSC; the price falls to P3, and the quantity increases to Q3. 2) This case occurs in an industry with external economies. P0 LSA P0 P0 D1 D1 D1 D0 D0 D0 Q0 Qs Q1 Q0 Qs Q2 Q0 Qs Quantity Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Long-run Changes in Price and Quantity Constant-cost industry Increasing-cost industry Decreasing-cost industry Price Price Price S0 S1 S0 S2 S0 Ps Ps LSB Ps S3 P2 Instructor Notes: 1) In the third graph, the long-run supply curve is LSC; the price falls to P3, and the quantity increases to Q3. 2) This case occurs in an industry with external economies. P0 LSA P0 P0 LSC P3 D1 D1 D1 D0 D0 D0 Q0 Qs Q1 Q0 Qs Q2 Q0 Qs Q3 Quantity Quantity Quantity Tests of Trade Models; Sources of Comparative Advantage

Decreasing Cost Industry
Eastwood's ECO486 Notes Decreasing Cost Industry The entry of new firms causes falling input prices. Falling input prices shift the cost curves downward, and the short-run industry supply curve shifts to the right. Long-run Industry Supply has a negative slope. This describes a Decreasing Cost Industry, a.k.a. External Economies. Tests of Trade Models; Sources of Comparative Advantage

Economies of Agglomeration
Eastwood's ECO486 Notes Economies of Agglomeration Plants in a single industry cluster Three types A Marshallian cluster A North Italian cluster A Chandlerian firm Alfred Marshall Alfred Chandler studied the growth of large firms Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Economies of Agglomeration Occur when a number of plants in a single industry cluster in the same area Organizational economists distinguish three types A Marshallian cluster is a group of firms with no formal connections sharing the same talent pool and supporting industries A North Italian cluster – small firms with formal agreements for sharing common facilities A Chandlerian firm – a large firm stimulates the growth of a cluster of supplying firms with much more formal ownership, joint holdings and formal alliances Alfred Marshall Alfred Chandler studied the growth of large firms Tests of Trade Models; Sources of Comparative Advantage

Advancing Technology Technological change
Eastwood's ECO486 Notes Advancing Technology Technological change New technology allows firms to produce at lower costs This causes their cost curves to shift downward Firms adopting the new technology make an economic profit More new technology firms enter Old technology firms disappear, the price falls, and the quantity produced increases Tests of Trade Models; Sources of Comparative Advantage

Learning by Doing People learn through on-the-job experience
Eastwood's ECO486 Notes Learning by Doing People learn through on-the-job experience Learning curve analysis explores this phenomenon Plot labor/unit against cumulative units produced Has been observed to fall by some regular percentage for each doubling of cumulative output Examples from WWII – hours per destroyer fell by 52.3% from with no increase in K or L. Tests of Trade Models; Sources of Comparative Advantage

Ladder of Comparative Advantage
Eastwood's ECO486 Notes Ladder of Comparative Advantage Industrial Countries Knowledge intensive Computers Created Comp. Adv. Newly Industrializing Countries K-intensive Machinery Skilled L-intensive Electronics Developing Countries Unskilled L-intensive Textiles HO Model Innate Comp. Adv. Resource intensive Commodities Ricardian Tests of Trade Models; Sources of Comparative Advantage

Increasing Returns to Scale End Pure Competition
Eastwood's ECO486 Notes Increasing Returns to Scale End Pure Competition Suppose that a firm in pure competition faces falling long-run marginal and average costs Increase its profit by expanding output Its advantage grows as it gets larger Suppose that a firm in pure competition faces falling long-run marginal and average costs. MC cuts the P = MR line from above. The firm can increase its profit by expanding output. (WHY?) Each firm will have an incentive to expand output, but if one firm is larger than the rest it will have lower average costs. Further, it will find its advantage growing as it gets larger. Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Increasing Returns to Scale End Pure Competition One or a few firms will supply a significant share of the industry's total output The industry becomes imperfectly competitive Studies have found IRS in many non-agricultural industries A decreasing-cost industry could be competitive (US agriculture) Under continuously increasing returns to scale, one or a few firms will expand their output to the point where they supply a significant share of the industry's total output. The industry then becomes imperfectly competitive. This phenomenon is not merely an academic curiosity. Many studies have found that a wide range of non-agricultural industries show declining average long-run costs. Given that economies of scale are common, we cannot be surprised at the extent of imperfect competition in the modern industrial economy. Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes IRS in both S & T (p. 140) With one-half of the resources in each industry, less than one-half of the potential output is produced. F F/2 TEXTILES, T (yards per year) G G H E/2 E SOYBEANS, S (bushels per year) Tests of Trade Models; Sources of Comparative Advantage

IRS as another source of gains from trade
Eastwood's ECO486 Notes IRS as another source of gains from trade F N M CIC1 TEXTILES, T (yards per year) CIC0 Britain’s PPF E SOYBEANS, S (bushels per year) Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes IRS as another source of gains from trade F Even with PS/PT unchanged, there are gains from trade. N also no change in W/R – less disruption M CIC1 TEXTILES, T (yards per year) CIC0 Britain’s PPF E SOYBEANS, S (bushels per year) Tests of Trade Models; Sources of Comparative Advantage

Increasing Returns and CA
Eastwood's ECO486 Notes Increasing Returns and CA Direction of CA is indeterminate and contingent Historical accident determines the direction Example: If B’s textile industry expands before A’s, then B gains CA in T. B will specialize in T With imperfect information, and differing endowments, they could specialize in the wrong goods Tests of Trade Models; Sources of Comparative Advantage

Countries may specialize in differentiated products within the same industry, and then trade, leading to IIT

Eastwood's ECO486 Notes IRS and Shape of PPF Increasing returns does not necessarily imply decreasing opportunity cost Assume two monopolistically competitive industries, Food & Clothing In autarky, each produces a wide variety of products Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes IRS and Shape of PPF With trade, the variety of products produced domestically drops, while consumers enjoy a wider selection in the world market Each firm produces its own good on a larger scale (with IRS), selling to world market Tests of Trade Models; Sources of Comparative Advantage

Specializing in Fewer Varieties. . .
Eastwood's ECO486 Notes Specializing in Fewer Varieties. . . F Clothing, C E H Food, F Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Specializing in Fewer Varieties. . . F . . .allows each industry to exploit IRS. More can be produced from any allocation of resources. PPF shifts out. Clothing, C E H Food, F Tests of Trade Models; Sources of Comparative Advantage

Conclusions Tests are inconclusive
Eastwood's ECO486 Notes Conclusions Tests are inconclusive Results (paradox) may due to data problems Or, assumptions of the (2x2x2) HO Model may be too unrealistic Direct tests of the HO Model are difficult Economic theory is still evolving Trefler found differing technology, factor endowments & preferences explain trade Tests of Trade Models; Sources of Comparative Advantage

The Theory of External Economies
Economies of scale that occur at the level of the industry instead of the firm are called external economies. There are three main reasons why a cluster of firms may be more efficient than an individual firm in isolation: Specialized suppliers Labor market pooling Knowledge spillovers

Specialized Suppliers In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services. An individual company does not provide a large enough market for these services to keep the suppliers in business. A localized industrial cluster can solve this problem by bringing together many firms that provide a large enough market to support specialized suppliers. This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley.

Labor Market Pooling A cluster of firms can create a pooled market for workers with highly specialized skills. It is an advantage for: Producers They are less likely to suffer from labor shortages. Workers They are less likely to become unemployed.

Knowledge Spillovers Knowledge is one of the important input factors in highly innovative industries. The specialized knowledge that is crucial to success in innovative industries comes from: Research and development efforts Reverse engineering Informal exchange of information and ideas

External Economies and Increasing Returns External economies can give rise to increasing returns to scale at the level of the national industry. Forward-falling supply curve The larger the industry’s output, the lower the price at which firms are willing to sell their output.

External Economies and Trade
External Economies and the Pattern of Trade A country that has large production in some industry will tend to have low costs of producing that good. Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply. Next figure illustrates a case where a pattern of specialization established by historical accident is persistent.

External Economies and Specialization Price, AC ($/watch) Quantity of watches produced and demanded The Swiss industry has lower AC because the industry is large, even though the individual firms are small. D AC0 ACTHAI 1 Q1 P1 ACSWISS 2

Trade and Welfare with External Economies Trade based on external economies has more ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies of scale at the level of the firm. An example of how a country can actually be worse off with trade than without is shown next.

External Economies and Losses from Trade Price, AC ($/watch) Quantity of watches produced and demanded If the Thai industry can be encouraged, it might have a lower AC. DWORLD ACSWISS AC0 1 P1 2 P2 ACTHAI DTHAI

Dynamic Increasing Returns Learning curve It relates unit cost to cumulative output. It is downward sloping because of the effect of the experience gained though production on costs. Dynamic increasing returns A case when costs fall with cumulative production over time, rather than with the current rate of production. Dynamic scale economies may justify protectionism. Temporary protection of industries enables them to gain experience (infant industry argument).

External Economies and International Trade
Dynamic Increasing Returns (continued) Learning-by-doing example: Liberty ships , US produced 2,500 Liberty cargo ships. 1941: 1.2 million person-hours to build a ship 1942: 0.6 million person-hours to build a ship 1943: 0.5 million person-hours to build a ship Physical capital used changed only slightly Much human capital was accumulated, more than doubling productivity.

The Learning Curve – Home’s experience gives it a cost advantage over Foreign, even though Foreign has, say, lower wages. AC ($/ship) Cumulative output L AC*0 L* AC1 QL

Monopolistic Competition and Trade
Eastwood's ECO486 Notes Monopolistic Competition and Trade The monopolistic competition model can be used to show how trade leads to: A lower average price due to scale economies The availability of a greater variety of goods due to product differentiation Imports and exports within each industry (intra-industry trade, IIT) Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Monopolistic Competition and Trade The Effects of Increased Market Size The number of firms in a monopolistically competitive industry and the prices they charge are affected by the size of the market. Tests of Trade Models; Sources of Comparative Advantage

Effects of a Larger Market Average Cost, AC, and Price, P Number of firms, n CC1: AC = n (F/S) + c PP: n1 P1 1 CC2 n2 P2 2 c P = c + 1 /(bn)

Eastwood's ECO486 Notes Monopolistic Competition and Trade If manufactures is a monopolistically competitive sector, world trade consists of two parts: Intraindustry trade The exchange of manufactures for manufactures Interindustry trade The exchange of manufactures for food Tests of Trade Models; Sources of Comparative Advantage

Trade with Increasing Returns and Monopolistic Competition Manufactures Food Home (capital abundant) Interindustry trade Intraindustry trade Foreign (labor abundant)

Main differences between interindustry and intraindustry trade: Interindustry trade reflects comparative advantage, whereas intraindustry trade does not. The pattern of intraindustry trade itself is unpredictable, whereas that of interindustry trade is determined by underlying differences between countries. The relative importance of intraindustry and interindustry trade depends on how similar countries are.

The Significance of Intraindustry Trade (IIT) About 1/4 of world trade consists of IIT IIT plays a particularly large role in the trade in manufactured goods among advanced industrial nations, which accounts for most of world trade.

Why Intraindustry Trade Matters Intraindustry trade allows countries to benefit from larger markets. The case study of the North American Auto Pact of 1964 indicates that the gains from creating an integrated industry in two countries can be substantial. Gains from intraindustry trade will be large when economies of scale are strong and products are highly differentiated. For example, sophisticated manufactured goods.

Why Intraindustry Trade Matters (continued) Consumers gain more variety at a lower prices than those that would prevail without trade. Production is more efficient. (Larger market allows full exploitation of economies of scale.) When similar countries trade, the resulting change in the income distribution (capital v. labor) will be small Thus, everyone may gain from trade.

Chapter 5 -- Tests of Trade Models
Eastwood's ECO486 Notes Chapter 5 -- Tests of Trade Models INTERNATIONAL ECONOMICS, ECO 486 Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Tests of the Classical Model MacDougall compared US and British exports for 1937. Calculated APL Compared relative APL to relative wage America’s wages were twice those in Britain Classical model predicts that US would export a good if its labor is more than twice as productive. Tests of Trade Models; Sources of Comparative Advantage

Table 5.1, MacDougall’s Test
Eastwood's ECO486 Notes Table 5.1, MacDougall’s Test p. 123 Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Tests of the Classical Model Of 25 products tested, 20 fit this theory Supports a relationship between labor productivity and exports Does not rule out the HO Model Did not control for differences in other factors (e.g., transportation costs, resource intensity,…) Tests of Trade Models; Sources of Comparative Advantage

Leontief’s Test of the HO Model
Eastwood's ECO486 Notes Leontief’s Test of the HO Model Leontief, Wassily {lay-ohn’-tyef, vah-sil’ee} born 5 Aug 1906 St. Petersburg, Russia Leontief developed input-output (I-O) model Assumed that US was most K-abundant country in 1947 HO Model predicts US exports K-intensive Used I-O Model to Test HO Theory Tests of Trade Models; Sources of Comparative Advantage

Leotief’s Test of the HO Model
Eastwood's ECO486 Notes Leotief’s Test of the HO Model Test: Cut US exports by $1 million Raise US production of import-competing goods by $1 million Tests of Trade Models; Sources of Comparative Advantage

Leontief’s Test (continued)
Eastwood's ECO486 Notes Leontief’s Test (continued) Reducing production of exports released more labor than required to expand the production of import-competing goods. US imports were more capital intensive than US exports! This surprising result is known as the Leontief Paradox Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Attempts to Resolve the Paradox Leontief (’52) argued that US labor was more productive (see quote page 127) Vanek (’63) argued for the inclusion of a third factor of production, natural resources natural resource production is K-intensive Travis explained the paradox by the structure of US tariffs (high on L-int. goods)* *published in Leamer’s book (’84) Tests of Trade Models; Sources of Comparative Advantage

Eastwood's ECO486 Notes Attempts to Resolve the Paradox Technology differs -- Leontief assumed that US technology was used to produce US imports High W/R  firms use K-intensive methods Tastes differ -- Table 5.2 shows that consumption patterns differ. But enough to reverse direction of CA??? Tests of Trade Models; Sources of Comparative Advantage

Table 5.2, Consumption Patterns
Eastwood's ECO486 Notes Table 5.2, Consumption Patterns p. 129 Tests of Trade Models; Sources of Comparative Advantage

Other Tests of the HO Model
Eastwood's ECO486 Notes Other Tests of the HO Model Leontief examined ‘51 data, found paradox Baldwin examined ‘62 data, found paradox Stern & Maskus examined ‘72 data, paradox gone (assuming US was still K abundant) Tests of Trade Models; Sources of Comparative Advantage

Caves, World Trade and Payments, p. 301
Eastwood's ECO486 Notes Test Results: Domestic Capital Required per Labor Year per Million Dollars of … Caves, World Trade and Payments, p. 301 Tests of Trade Models; Sources of Comparative Advantage

Tests: Other Countries
Data on trade among developing countries supports HO Results of tests on East Germany and former Soviet Union were consistent with HO theory. Other paradoxical results found in developed country trade Paradox was also found in tests of foreign countries (Japan, Canada, India).

Eastwood's ECO486 Notes Recent Tests of the HO Model Leontief linked factor intensities and trade patterns Leamer linked factor endowments and trade patterns HO Model links all three Leamer showed that the relative abundance of a given factor of production helps explain the goods that a country exports Tests of Trade Models; Sources of Comparative Advantage