Economics and Development International trade

Economics and Development International trade
Giorgia Giovannetti Professor of Economics, University of Firenze 07/11/2017 1

Proposal of change International Trade, September 16th- December 8th 1
1 16/9 Introduction: The main issues 2 19/9 Introduction, 2 detailed presentation of the course 3 23/9 Introduction, 3; Measuring globalization 4 26/9 Measuring Globalization, (VA) and overview of models 5 30/9 Overview trade models (Bernard et al 2007; 2011) 6 3/10 Gravity model 7 7/10 Gravity, Melitz intro 8 10/10 Melitz 9 14/10 Trade models: Ricardo 10 17/10 Trade models: Ricardo and H-O 11 21/10 Trade models: H-O,2, Leontieff 12 24/10 H-O, end, Trade and Imperfect competition, 1 13 28/10 Trade and imperfect competition, end 14 31/10 Mid term Hysteresis, Heterogeneous firms 15 4/11 Brexit UK, G, I , F1 Hysteresis, Heterogeneous firms 16 7/11 Brexit F2, S, S2, P The Melitz model 17 11/11 Networks of tradeFDI/migrants/ MIDTERM 18 14/11 INAUGURAL LECTURE/OTTAVIANO 19 18/11 GVC 1-3 FDI and Multinationals Offshoring/trade in tasks 20 21/11 Trade and w. 2 Prod 2 Trade policy 21 25/11 Trade policy- trade wars/ FDI and Multinationals: OLI theory 22 28/11 China and India/ new th. FDI Offshoring/trade in tasks, 23 2/12 New new theory Granularity and aggregate shocks 24 5/12 Final test Proposal of change

3 Erasmus 6 Erasmus 2 Erasmus 3 Brexit UK
S. Geyerhofer (Bachelor) ,M. Möllnitz (Master), R. Stofanakova (Bachelor), F. Canjels (Bachelor) 30 4 Erasmus 4/11 Germany Nina Kunzmann , Victoria Pörings, Caro Preuß 20 3 Erasmus Italy Jose Carlos Cuenca Serrano, David Lopez Laguardia, María Jimenez Nieto and Mara van Nuland Azuaga. Spain Andrea Simón Díaz, Beatriz Ramón Cienfuegos-Jovellanos, Laura Porto Vergara y Catalina Manea Surubaru. France Fien Yskout, L, Scheldewaert, J. Puelings, M. Dobblelaere PLUS C. Veneau A. Bouchonnier. 6 Erasmus 7/11 Netherland Martijn van Rijnsoever, Thijs Kamp, Sander Liesting and Youri Buskens 20 3 Erasmus 7/11 Ireland Frederique Bosveld, Anastasia Weiz, Gina Kuhlmann and Isabelle Schrage Poland Anna Tereshchenko ( Erasmus, Master degree), Viktoriia Kovryha ( Erasmus, Master ) 2 Erasmus Portugal J. Rujas, I. Romero, Pedro Ardiaca, Sergio Ledesma 18/11 GVCs 1 Kevin Mahekpreet Cheema, Moritz Pfeffer, Sebastian Munoz and Keno-Leon Hartman GVC 2 Szczepan Czernatowicz, MSC, Franziska Fasel, MSC, Alea Burkard, BSC,Anna Gschwind, GVC 3 Leonardo Rosini, Michele Fontani e Sharon di Cocco 3 Productivity Jan Hauer Clara Barroso Raya, Victor Martin Ortega, Juan Alberto Alonso Perez 4 21/11 Mara Chlechowitz; Alfredo Conde 2 Trade and wages Salazar E. Vania, Mejia, Isaza V., Maach Fatima Zohra S Carlo Poggi, -Iacopo Maria Taddei ,Andrea Cioli New Trade Th. C.Moretti, Francesca Ciapini, Francesco Vadalà, Giovanni Cappellini 4 ECO 2/12 Network Niccolò Toccafondi, Dario Gori e Simone Senesi 3 ECO 2/12 Migration and FDI Elisa del Sordo, Selma Sbai e Matteo Zorzenon

Outline Mid term: definitions, multiple choice, exercises
Mid term on November 11 No registration, Example of questions/exercises today Extending H-O Imperfect competition start

Part 1, Definition Absolute advantage: When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. Comparative Advantage: A country has a comparative advantage in producing those goods that it produces best compared with how well it produces other goods. Opportunity cost of good x: MPLy /MPLx Denotes the units of a good that I can renounce in order to have an additional unit of the other good Relative price of good x: Px/Py Denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up

Short summary of key concepts
Determination of wages In competitive markets, labor can move freely between industries. Labor will move to the higher paid industry. This will continue until there is equalization of wages between industries. Wages are equal to Wx =Px ⋅ MPLx = Py ⋅ MPLy = Wy The equalization of wages will give us the following: Px/Py = MPLy/MPLx

exercise You are given the information shown in the table about the production relationship between Wonderland and the rest of the world and use the standard Ricardian assumptions: Wonderland has 40 million labor hours in total and the rest of the world has 30 million labor hours in total per year. Labor Hours per Bottle of Wine Labor Hours per Pound of Cheese Wonderland 10 5 Rest of the World 6 2

Short summary of key concepts
Marginal Cost = Wage ⋅ Hours of Labor Marginal Cost = Price (In perfect competition) Relative price of good x: Px/Py Wages are equal to Px ⋅ MPLx = Py ⋅ MPLy then Px/Py = MPLy/MPLx Where MPLy /MPLx is the opportunity cost of good x

exercise: Which country has comparative advantage in wine? In cheese?
Labor Hours per Bottle of Wine Labor Hours per Pound of Cheese Wonderland 2 (Because Pw/Pc= 10/5= 2) 2 pounds of cheese per 1 bottle of wine 1/2 (Because Pc/Pw= 5/10= 1/2) Rest of the World 3 (Because Pw/Pc= 6/2= 3) 1/3 (Because Pc/Pw= 2/6= 1/3) Comparative advantage means lower opportunity costs. Therefore, wonderland has comparative advantage in producing wine and ROW has comparative advantage in producing cheese.

exercise: C: Graph each country’s PPF. Use indifference curve to show the no-trade equilibrium (label as point A) for each country. (Suppose Wonderland consumes 4 million pounds of cheese and the rest of the world consumes 6 pounds of cheese). We know from the exercise that Wonderland has 40 million labor hours in total and the rest of the world has 30 million labor hours in total per year.

exercise: 1) We need to identify the quantities of wine and cheese
Wonderland: 10QW + 5QC = 40 QC=40 (total hours)/5 (hours for one unit of cheese) = 8 pounds of cheese QW=40 (total hours)/10 (hours for one unit of wine) = 4 battles of wine ROW: 6 Q*W + 2Q*C = 30 Q*W =30/6 = 5 battles of wine Q*C=30/2 = 15 pounds of cheese

exercise: 2) Then, we can draw the graph
From the exercise we know that Wonderland consumes 4 million pounds of cheese and the rest of the world consumes 6 pounds of cheese. So, since we know the slope of the PPF and the intercept we can calculate the quantity of wine! y= a+ bx For Wonderland: 4= 8-2x x=2 For RoW: 6= 15–3x x=3 15

exercise: When trade is opened between Wonderland and the rest of the world, what is the pattern of trade? If the world price ratio is 0.4 bottle of wine per pound of cheese (Be careful this is not Pw/Pc but Pc/Pw), what happens to production in each country? (Label the new production point in each country as point P) PC/PW = 0.4 and therefore, PW/PC = 2.5

exercise: Now countries open to trade
In the Ricardo model, when countries open to trade: each country exports the good for which it has a CA. Wonderland exports wine and RoW exports Cheese

exercise: Therefore, when countries open to trade:
Two countries are in a trade equilibrium when: the relative price of each good is the same in the two countries the amount of each good that the countries want to trade is equal Wonderland Rest of the World Quantity of wine Price of wine Quantity of cheese Price of cheese

Back to exercise: Label the new production point in each country as point P 15 New price line (pink line) showing the world price. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and trading.

Back to exercise: Answer: The production point is point P. When the world price ratio is .4 bottle wine per pound of cheese, PC/PW = .4 and therefore, PW/PC = 2.5. In this case, the world price ratio is between these two country’s opportunity costs, therefore, Wonderland will specialize in producing wine (4m bottles of wine) and ROW will specialize in producing cheese (15m pounds of cheese). 15 New price line (pink line) showing the world price. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and trading.

exercise: Suppose that 2 million bottles of wine and 5 million pounds of cheese are traded. Show the consumption of each good in each country graphically using indifference curve (label the consumption point C)? Wonderland exports wine and RoW exports cheese. The quantity of cheese imported by Wonderland is the same of the quantity of cheese exported by RoW (5m pounds), and the quantity of wine exported by Wonderland is the same of the quantity of wine imported by RoW (2m bottles).

Excercise: 5 million pound of cheese imported by Wonderland and exported by RoW (Wonderland produces 0 of cheese). Thus, RoW still produces 15 of cheese but consumes 10 and export 5. 2 million of bottle of wine imported by RoW and Exported by Wonderland (RoW produces 0 of wine). Thus, Wonderland still produces 4 millions bottles of wine but consumes 2 and exports 2. 15

Excercise: 5 million pound of cheese imported by Wonderland and exported by RoW (Wonderland produces 0 of cheese). Thus, RoW still produces 15 of cheese but consumes 10 and export 5. 2 million of bottle of wine imported by RoW and exported by Wonderland (RoW produces 0 of wine). Thus, Wonderland still produces 4 millions bottles of wine but consumes 2 and exports 2. 15 X M X M

exercise 2: Labor productivity coefficients for the US and Mexico are given in the following table: Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 2 : Who has the absolute advantage in corn? in melons?
Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 2 : Who has the absolute advantage in corn? in melons?
Answer: Absolute advantage goes to the more productive country. The US therefore has an absolute advantage in both corn and melons. Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 2 : Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 2 : Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. Country Corn Melons Labor Endowment United States 2/5 5/2 1000 Mexico 1

exercise 2 : Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. The US is therefore the low opportunity cost producer of corn (2/5 < 1) and Mexico the low opportunity cost producer of melons (1 < 5/2) Country Corn Melons Labor Endowment United States 2/5 melon 5/2 1000 Mexico 1

exercise 2 : What are the limits on relative price before trade opens between the two countries?

exercise 2 : What are the limits on relative price before trade opens between the two countries? The Mexican price ratio would be Pc/Pm = 1. The US price ratio is Pc/Pm = 2/5. Prices reflect opportunity costs in both the US and Mexico. The price ratio after trade must therefore lie between 2/5 and 1.

exercise 2 : PPF?

exercise 2 : The PPF is given by 𝑄 𝑚 𝑈𝑆 = 1000 ⋅ 2 = 2000
𝑄 𝑚 𝑈𝑆 = 1000 ⋅ 2 = 2000 𝑄 𝑐 𝑈𝑆 = 1000 ⋅ 5 = 5000 𝑄 𝑚 𝑚𝑒𝑥 = 1000 ⋅ 1= 1000 𝑄 𝑐 𝑚𝑒𝑥 = 1000 ⋅ 1= 1000 𝑄 𝑚 𝑈𝑆 2000 𝑄 𝑐 𝑈𝑆 𝑄 𝑚 𝑚𝑒𝑥 1000 1000 𝑄 𝑐 𝑚𝑒𝑥

exercise 3 Assume that Home and Foreign produce two goods, televisions and cars, and use the following information to answer the questions.

exercise 3: a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home?

exercise 3: a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home? In general, wages are equal to Wtv = Ptv ⋅ MPLtv = Pc ⋅ MPLc = Wc then Px/Py = MPLy/MPLx

exercise 3: Wtv = Ptv ⋅ MPLtv 12= Ptv ⋅2 Ptv= 6 Wc = Pc ⋅ MPLc
Relative price of good x: Px/Py PTV/ P C = 3/2 = MPL C / MPLTV

exercise 3: a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home? Answer: MPLC =3, MPLTV =2, and PTV/ P C = MPL C / MPLTV =3/2

exercise 3: b. What is the marginal product of labor for televisions and cars in Foreign? What is the no-trade relative price of televisions in Foreign?

exercise 3: 𝑊 𝑡𝑣 ∗ = MPL*TV ⋅ P*TV 6 = MPL*TV ⋅ 3 MPL*TV = 2
𝑊 𝐶 ∗ =MPL∗C ⋅ P*C 6 = 1 ⋅ P* C P*C =6 P*TV/ P* C = MPL* C / MPL*TV =1/2

exercise 3: b. What is the marginal product of labor for televisions and cars in Foreign? What is the no-trade relative price of televisions in Foreign? Answer: MPL*C =3, MPL*TV =2, and P*TV/ P* C = MPL* C / MPL*TV =1/2

exercise 3 Now we have all the information 𝑊 𝑡𝑣 = 12 𝑊 𝐶 =12
HOME FOREIGN 𝑊 𝑡𝑣 = 12 𝑊 𝐶 =12 𝑊 𝑡𝑣 ∗ = 6 𝑊 𝐶 ∗ =6 MPLTV = 2 MPLC = 3 MPL*TV = 2 MPL∗C = 1 PTV = 6 PC = 4 P*TV = 3 P*C = 6

exercise 3: c. Suppose the world relative price of televisions in the trade equilibrium is PTV/ PC =1. Which good will each country export? Briefly explain why.

(Because Ptv/Pc= MPLc/MPLtv= 3/2)
exercise 3: We need to identify the comparative advantage TV Cars Home 3/2 (Because Ptv/Pc= MPLc/MPLtv= 3/2) 2/3 Foreign 1/2 2

(Because Pw/Pc= MPLc/MPLtv= 3/2)
exercise 3: We need to identify the comparative advantage Answer: Home will export cars and Foreign will export televisions because Home has a comparative advantage in cars whereas Foreign has a comparative advantage in televisions. TV Cars Home 3/2 (Because Pw/Pc= MPLc/MPLtv= 3/2) 2/3 Foreign 1/2 2

exercise 3: d. In the trade equilibrium, what is the real wage at Home in terms of cars and in terms of televisions? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? We need to calculate the Real Wages relying on the new international price! Remember: F produces and exports TV, while H produces and export Cars. We know from the exercise that the world relative price of televisions in the trade equilibrium is PTV/ PC =1

exercise 3: Therefore, we can calculate the real wages of workers at Home in terms of cars because Home exports cars. Home (exports cars) is better off with trade because its real wage in terms of televisions has increased.

Extending the Heckscher-Ohlin Model
The HO model can be made more realistic by allowing for more than two goods, factors, and countries. This is the first modification to the model. As the second modification, we will allow the technologies used to produce each good to differ across countries.

Extending the H-O Model
Many Goods, Factors, and Countries The predictions of the HO model depend on knowing what factor a country has in abundance, and which good uses that factor intensively. When there are more than two goods, it is more complicated to evaluate factor intensity and factor abundance. Measuring the Factor Content of Trade How do we measure the factor intensity of exports and imports when there are thousands of products traded between countries? How can we use this to test the HO model?

Measuring the Factor Content of Trade Using Leontief’s test, we can look at similar data. We can multiply his numbers shown in Table 4.2 by the actual value of U.S. exports and U.S. imports. This gives values for “total exports” and “total imports.” These values are called the factor content of exports and factor content of imports. They measure the amounts of labor and capital used to produce exports and imports. By taking the difference between the factor content of exports and factor content of imports.

Factor Content of Trade for the United States, 1947 This table extends Leontief’s test of the Heckscher-Ohlin model to measure the factor content of net exports. The first column for exports and for imports shows the amount of capital or labor needed per $1 million worth of exports from or imports into the United States, for The second column for each shows the amount of capital or labor needed for the total exports from or imports into the United States. The final column is the difference between the totals for exports and imports. Table 4.2 Factor Content of Trade for the United States, 1947 This table extends Leontief’s test of the Heckscher-Ohlin model to measure the factor content of net exports. The first column for exports and for imports shows the amount of capital or labor needed per $1 million worth of exports from or imports into the United States, for The second column for each shows the amount of capital or labor needed for the total exports from or imports into the United States. The final column is the difference between the totals for exports and imports. Source: Edward E. Leamer, 1980, “The Leontief Paradox, Reconsidered,” Journal of Political Economy, 88(3), 495–503. Reprinted in Edward E. Leamer, ed., 2001, International Economics, New York: Worth Publishers, pp. 142–149.

Measuring the Factor Content of Trade Since both these factor contents are positive, we see that the U.S. was running a trade surplus. The U.S. exported large amounts of goods to help countries of Europe rebuild after WWII. The fact that the factor content of net exports for both capital and labor are positive will be important as we move forward.

Measuring Factor Abundance How should we measure factor abundance when there are more than two factors and two countries? To determine whether a country is abundant in a certain factor, we compare the country’s share of that factor with its share of world GDP. If the share of a factor > share of world GDP. The country is abundant in that factor. If the share of factor < share of world GDP. The country is scarce in that factor.

Country Factor Endowments, 2000 Figure 4.9 Country Factor Endowments, 2000 Shown here are country shares of six factors of production in the year 2000, for eight selected countries and the rest of the world. In the first bar graph, we see that 24% of the world’s physical capital in 2000 was located in the United States, with 9% located in China, 13% located in Japan, and so on. In the final bar graph, we see that in 2000 the United States had 22% of world GDP, China had 11%, Japan had 8%, and so on. When a country’s factor share is larger than its share of GDP, then the country is abundant in that factor, and when a country’s factor share is less than its share of GDP, then the country is scarce in that factor. Notes: (1)The product of 1990 capital per worker (Penn World Table) and 2000 total labor force (World Bank, World Development Indicators). China figure based on Chow, Gregory, and Kui-Wai Li, 2002, “China’s Economic Growth: 1952–2010,” Economic Development and Cultural Change, vol. 51, pp. 247– countries included. (2)The product of R&D researcher intensity and total population (World Bank, World Development Indicators). 55 countries included. (3)Labor force with tertiary education (World Bank, World Development Indicators); when unavailable, population 25 and over with postsecondary education was used (R.J. Barro and J.W. Lee, 2000, “International Data on Educational Attainment: Updates and Implications,” Center for International Development at Harvard University, Working Paper No. 42). 123 countries included. (4)Labor force with primary and/or secondary education (World Bank, World Development Indicators); when unavailable, population 25 and over with primary and/or secondary education was used (R.J. Barro and J.W. Lee, 2000, “International Data on Educational Attainment: Updates and Implications,” Center for International Development at Harvard University, Working Paper No. 42). 123 countries included. (5)The product of one minus the adult literacy rate and the adult population in 2004 (World Bank, World Development Indicators). 136 countries included. (6)Hectares of arable land (World Bank, World Development Indicators). 196 countries included. (7)Gross domestic product converted to 2000 international dollars using purchasing power parity rates (World Bank, World Development Indicators). 169 countries included.

Capital Abundance 24% of the world’s physical capital is located in the U.S., 8.7% is located in China, 13.3% in Japan, etc. The final bar in the graph shows each country’s % of world GDP. The U.S. had 21.6% of world GDP, China had 11.2%, Japan had 7.5%, etc. We can conclude that the U.S. was abundant in physical capital in Japan and Germany were also abundant in physical capital. The opposite holds for China and India—their shares of world capital are less than their share of GDP. They are scarce in capital.

Labor and Land Abundance We can use a similar comparison to determine whether each country is abundant or not in R&D scientists, in types of labor distinguished by skill, in arable land, or any other factor of production. For example: U.S. is abundant in R&D scientists: 26.1% of the world’s total as compared to 21.6% of the world’s GDP. The U.S. is also abundant in skilled labor but is scarce in less-skilled labor and illiterate labor. India is scarce in R&D scientists: 2.5% of world’s total as compared to 5.5% of the world’s GDP.

Labor and Land Abundance The U.S. is also scarce in arable land which is surprising since we think of the U.S. as a major exporter of agriculture. Another surprise is that China is abundant in R&D scientists. These findings seem to contradict HO model. It is likely that the productivity of R&D scientists and arable land are not the same in both countries. In this case, shares of GDP are not the whole story. We need to allow for differences in productivity.

Differing Productivities Across Countries Remember that Leontief found that the U.S. was exporting labor-intensive products even though it was capital-abundant at that time. One explanation is that labor is highly productive in the U.S. and less productive in the rest of the world. Then the effective labor force in the U.S. is much larger than if we just count people. Effective labor force is the labor force times its productivity. We can now look at differing productivities into the HO model.

Measuring Factor Abundance Once Again Effective Factor Endowment is the actual factor endowment times the factor productivity. The amount of effective labor in the world is found by adding up the effective factor endowments across all countries. To determine if a country is abundant in a certain factor, we compare the country’s share of that effective factor with share of world GDP. If share of an effective factor is less than its share of world GDP then that country is abundant in that effective factor. If share of an effective factor is less than its share of world GDP, then that country is scarce in that effective factor.

Effective R&D Scientists The effectiveness of an R&D Scientist depends on what they have to work with. On way to measure this is through a country’s R&D spending per scientist. If more spending, then scientist will be more productive. Take the total number of scientists and multiply that by the R&D spending per scientists Figure 4.10 shows these shares. With these productivity corrections, the U.S. is more abundant in effective R&D scientists and China is lower.

Effective Arable Land We also need to do a correction for arable land. Effective arable land is the actual amount of arable land times the productivity in agriculture. The U.S. has a very high productivity in agriculture where China has a lower productivity. We repeat the same calculations from figure of 2000 The 4th bar graph shows each country’s share of effective arable land, corrected for productivity differences The numbers before and after the correction are very close. The U.S. is neither abundant nor scarce in effective arable land.

“Effective” Factor Endowments, 2000 Figure 4.10 “Effective” Factor Endowments, 2000 Shown here are country shares of R&D scientists and land in 2000, using first the information from Figure 4.9, and then making an adjustment for the productivity of each factor across countries to obtain the “effective” shares. China was abundant in R&D scientists in 2000 (since it had 14% of the world’s R&D scientists as compared with 11% of the world’s GDP) but scarce in effective R&D scientists (since it had 7% of the world’s effective R&D scientists as compared with 11% of the world’s GDP). The United States was scarce in arable land when using the number of acres (since it had 13% of the world’s land as compared with 22% of the world’s GDP) but neither scarce nor abundant in effective land (since it had 21% of the world’s effective land, which nearly equaled its share of the world’s GDP). Notes: (1)The product of R&D researcher intensity and total population (World Bank, World Development Indicators). 55 countries included. (2)R&D expenditure in units of purchasing power parity (World Bank, World Development Indicators). 74 countries included. (3)Hectares of arable land (World Bank, World Development Indicators). 196 countries included. (4)Productivity adjustment based on agriculture TFP estimation (based on data from the Food and Agriculture Organization of the United Nations). 152 countries included. (5)Gross domestic product converted to 2000 international dollars using purchasing power parity rates (World Bank, World Development Indicators). 169 countries included.

From H-O to new trade theory
Standard theories of int. trade (AA- Smith, CA- Ricardo and Heckscher-Ohlin) focus on production-side differences as the basis for competitive advantage. The sources of differences are technologies, factor productivities, factor endowments, and differences across products in the use of productive factors in producing the products. The more different the countries are – regarding productivity, technology, or capital-to- labor ratio – the greater the economic gain from specialization and trade. We expect that (most) international trade will occur between countries that are different in these regards. In other words, we expect that developed countries (capital-abundant, high productivity, advanced technologies) will trade with developing countries (labor-abundant, low-productivity, outdated technology).

But….trade facts in search of better theory
Substantial trade among industrialized countries, much of which is intra-industry trade. The dominance of a few large firms in some world industries. Now, theories that focus not only on the supply side differences (technology, endowment, etc.) but also on the demand side differences as the source of trade. The Ricardian and Heckscher-Ohlin theories both assume that the technology for the production of a good is characterized by constant returns to scale In the 1970s, economists built formal theories of trade that instead assumed increasing returns to scale

Increasing returns to scale
Under increasing returns to scale, if quantities employed of all resources are, say, quadrupled, then the quantities produced will more than quadruple; When resource costs, say, quadruple, output will more than quadruple Therefore, cost per unit produced—also called average cost—decreases as output increases The technology for the production of a commodity is said to show increasing returns to scale if a doubling of the resources used in production causes production to more than double This implies that the per unit cost of production will be lower when 20 units are produced than when 10 units are produced In other words, increasing returns to scale means that bulk production is cheaper production

Fig. Average Versus Marginal Cost
When AC decreases as output increases, MC < AC at all levels of output. The cost per unit could be measured by the unit labor requirement. (That is, labor could be the numeraire, thereby setting wage = 1.)

Increasing returns to scale cannot coexist with perfect competition
Price Demand P = MC < AC implies that no firm can be profitable under perfect competition. Average cost Average cost Loss price Marginal cost Q Quantity

Monopolistic Competition
Increasing returns to scale cannot coexist with perfect competition We assume imperfect competition; Specifically, there is one differentiated good The industry has many firms each firm produces a unique variety of the differentiated good This industry is characterized by monopolistic competition, which is an important form of imperfect competition

Monopolistic Competition
Each firm in an industry can differentiate its product from the products of its competitors. Each firm sells a product that is somewhat unique Each firm faces a downward sloping demand curve Each firm ignores the impact that changes in its price will have on the prices that competitors set even though each firm faces competition it behaves as if it were a monopolist. A firm in a monopolistically competitive industry is expected: to sell more as total sales in the industry increase and as prices charged by rivals increase; to sell less as the number of firms in the industry decreases and as its price increases. Each firm’s demand curve becomes more elastic (flatter) as the number of competitors (firms in the same industry) increases

Typical firm’s production and pricing
This diagram proves that whenever a firm’s demand curve touches its average cost curve at more than one point, the firm will surely enjoy positive profits This will induce the entry of competitors, Which will reduce the firm’s demand 17 Profit per unit = 5 Just as average cost could be measured by the unit labor requirement when labor is the numeraire, the demand curve could be the willingness to pay in units of labor. 12 Average Cost Demand 20 Quantity

Typical firm’s production and pricing
The entry of competitors will continue to reduce the firm’s demand till demand is tangent to the average cost curve and positive profits are no longer possible The entry of competitors will also make demand flatter P = AC =14 When labor is the numeraire, the tangency condition determines (a) each firm’s output and (b) the unit labor requirement. Therefore, for given labor endowment, the number of firms (varieties) is also determined. Average Cost D2 D1 15 Quantity

Typical firm’s production and pricing—autarky
Let the autarky outcome be as shown How will free trade be different? A, Country A’s Autarky 14 Average Cost Dautarky 15 Quantity

Free trade Under free trade, every firm, irrespective of which country it is located in, will have the same number of competitors Therefore, every firm’s demand will be just as flat as every other firm’s demand As each firm’s demand must be tangent to its average cost (AC) curve in equilibrium, and as all firms have the same AC curve, Under free trade, every firm, irrespective of which country it is located in, will be on the same point on its AC curve The question is, Which point will it be?

Typical firm’s production and pricing—free trade
Under free trade, the typical firm’s production and price could be At A, or At a point such as B, or At a point such as C. Recall that the demand curve must be tangent to the AC curve in equilibrium B A 14 C Average Cost DA 15 Quantity

Free trade increases market size—assumption
It is reasonable to assume that total industry output worldwide will be higher under free trade than under autarky in just one country Total industry output = typical firm’s output  number of firms in the industry Free trade converts two economies with small labor endowments into one integrated economy with a large labor endowment. This drives each firm down the AC curve to a point such as C and increases the number of varieties. Therefore, every individual is better off. However, it is not possible to say which firms will locate where.

Under free trade, the production and price for a typical firm could be At A, Country A’s autarky outcome, or At a point such as B, or At a point such as C. B A 14 C Average Cost Dautarky 15 Quantity

Could the typical firm’s production and price under free trade be at A? If so, the number of firms would have to increase because we have assumed that industry output is higher under free trade But in that case the typical firm’s demand would have to be flatter than in autarky Therefore, the demand curve could not be tangent to the AC curve at Country A’s autarky outcome, as is required for equilibrium In short, for the typical firm, the free trade and autarky outcomes could not possibly be identical B A, Autarky = Free Trade outcome? 14 C Average Cost Dautarky 15 Quantity

Could the typical firm’s production and price under free trade be point B? Again, the number of firms in the industry would have to increase because we have assumed that industry output is higher under free trade But in that case the typical firm’s demand would have to be flatter than in autarky Therefore, the demand curve could not be tangent to the AC curve at point B, as is required for equilibrium In short, for the typical firm, the free trade outcomes could not be a point such as B Therefore, the free trade outcome would have to be a point such as C. B = Free Trade outcome? A, Autarky The same argument shows that in autarky the more populous country will be at C with a lower autarky price. When autarky ends and trade begins, this country will face increasing export demand for its cheaper goods. Its firms will go down the AC curve. But with given labor endowment, this will force it to produce fewer varieties. The smaller country will begin producing the varieties abandoned by the larger country. This will continue till a new equilibrium is reached at which all firms are at the same point on their AC curves, with all firms producing more than under autarky. The output expansion will necessarily be more dramatic for the smaller country. 14 C Average Cost Dautarky 15 Quantity

The free trade outcome would have to be a point such as C. That is, free trade output is higher than autarky output for the typical firm as well as the industry And the price is lower in free trade B Autarky 14 C = Free Trade outcome Average Cost Dautarky 15 Quantity

Trade Leads to Specialization
IRS means that large-scale production is cheaper than small-scale production. Therefore, Trade under IRS generally has one country specializing in the production of one good and the other country specializing in the production of the other good.

Trade = Greater Variety
In autarky, a country would be able to produce only a few brands of, for instance, cars, because if many brands are produced in autarky, each brand would have to be produced in small-scale and that would usually be very expensive. Under free trade, on the other hand, each country can bulk produce just a few brands for customers all over the world and, in this way, more brands of cars would be available to consumers everywhere at prices they can afford

Economics and Development International trade

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Economics and Development International trade

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Presentation on theme: "Economics and Development International trade"— Presentation transcript:

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