*CHAPTER 1 (Core Chapter) INTRODUCTION OUTLINE 1.1 Importance of Intemational Economics Case Study 1-1: The Dell PC IS All But American Case Study 1-2: What Is an "American" Car? 1.2 International Trade and The Nation's Standard of Living Case Study 1-3: Rising Importance of Intemational Trade to the United States 1.3 The Subject Matter of International Economics 1.4 Purpose of International Economic Theories and Policies 1.5 Current International Economic Problems 1.6 Organization and Methodology of the Book 1.6a. Organization of the Text 1.6b: Methodology of the Text Appendix: Al.1 Basic Intemational Trade Data 1.2 Sources of Additional International Data and Information Key Terms Interdependence Adjustment in the balance of payments Pure theory of trade Microeconomics ‘Theory of commercial policy Macroeconomics New protectionism Open economy macroeconomics Foreign exchange markets Intemational finance Balance of payments Lecture Gui 1. As the first chapter of the book, the general aim here is simply to define the field of study of international economics and its importance in today's interdependent world. 2. The material in this chapter can be covered in two classes. I would utilize one class to cover Sections 1 to 4 and the second class to cover Sections 5 and 6. I would spend most of the second class on Section 5 to identify the major current international economic problems facing the United States and the world today and to show how international economics can suggest ways to solve them. This should greatly enhance students’ motivation. 3Answer to Problems 1. a. Intemational economic problems reported in our daily newspapers are likely to include: (1) trade controversies between the United States, Europe, and Japan; (2) great volatility of exchange rates; ) financial crises in emerging market economies; (4) structural unemployment and slow growth in Europe, and stagnation in Japan; (3) job insecurity and stagnant wages in the United States; (©) restructuring problems of transition economies; (7) deep poverty in many developing nations in the world. b. (1) Can result in trade restrictions or even a trade war, which reduce the volume and the gains from trade; (2) discourage foreign trade and investments, and thus reduce the benefits from trade; ) financial crises in emerging market economies could spread to the United States; (4) reduces European and Japanese imports and the volume and the benefits from trade; (8) can lead to demands for trade protection; (6) can lead to political instability, which will adversely affect the United States; (7) can lead to political instability in these countries - which also adversely affect the United States. ¢. (1) Trade controversies can lead higher prices for imported products; (2) lead to great fluctuations in the price of imported products and cost of foreign travel; () can reduce the value of your investments (such as a stocks) in the United States; (4) reduces European and Japanese imports and increases the chances that you will have to change jobs; (3) can lead you to support demands for trade protection in the United States; (©) can lead your paying higher taxes for the United States to respond to these threats; (7) can result in your paying higher taxes to help these nations. 2. a. Five industrial nations not mentioned are: Italy, France, Canada, Austria, and Ireland. b. See Table 1A. ¢. Smaller nations, such as Ireland and Austria, are more interdependent than the larger ones Note that interdependence was measured by the percentage of the value of imports and exports (line 98c and 90c, respectively in IFS) to GDP (line 99b)..Table 1A Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2001 Imports Exports asapercent Asa percent Nation of GDP. of GDP. Italy 26.7 283 France 21.0 282 Canada 403 435 Austria 526 522 805 954 International Financial Statistics (Washington, D.C., IMF, August 2002), 3. a. Five developing nations not mentioned in the text are: Brazil, Pakistan, Colombia, Nepal, and Tunisia. b. See Table 1B. c. In general, the smaller the nation, the greater is its economic interdependence. Note that interdependence was measured by the percentage of the value of imports and exports (line 98c and 90c, respectively in IFS) to GDP (line 99b). Table 1B Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2001 Imports Exports asapercent Asa percent of GDP of GDP 144 133 194 174 21.0 189 317 29 516 476 Souree: Intemational Financial Statistics (Washington, D.C., IMF, August 2002). 4, a. One popular principle text, McConnell and Brue's Economics (15h ed., 2002) includes the following microeconomics topics: (1) supply and demand: elasticities and govemmment-se prices; (2) consumer behavior and utility maximization; (3) the costs of production; (4) pure competition;(5) pure monopoly; (6) monopolistic competition and oligopoly; (7) technology, R&D, and efficiency; (8) the demand for resources; (9) wage determination; (10) rent, interest, and profits. 9. Just as the microeconomics parts of your principles text deal with individual consumers and firms, and with the price of individual commodities and factors of production, so do Parts, One and Two of this text deal with production and consumption of individual nations with nations with and without trade, and with the relative price of individual commodities and factors of production. . McConnell and Brue'’s text includes the following macroeconomics topics: (1) measuring domestic output, national income, and the price level; (2) introduction to macroeconomic growth and instability; (3) building the aggregate expenditures model; (4) aggregate expenditures: the multiplier, net exports, and government; (5) aggregate demand and aggregate supply; (6) fiscal policy; (7) money and banking; (8) how banks and thrifts create money; (9) monetary policy; (10) extending the analysis of aggregate supply; (11) economic growth and the new economy; (12) deficits, surpluses, and the public debt; (13) disputes in macro theory and policy. 9. Just as the macroeconomics parts of your principles text deal with the aggregate level of savings, consumption, investment, and national income, the general price level, and monetary and fiscal policies, so do Parts Three and Four of this text deal with the aggregate amount of imports, exports, the total international flow of resources, and the policies to affect these broad aggregates, Consumer demand theory predicts than when the price of a commodity rises (cet. par.), the quantity demanded of the commodity declines. 9. When the price of imports rises to domestic consumers, the quantity demanded of exports can be expected to decline (if everything else remains constant),10. uM. a. A government can reduce a budget deficit by reducing govemment expenditures and/or increasing taxes. b. A nation can reduce or eliminate a balance of payments deficit by taxing imports and/or subsidizing exports, by borrowing more abroad or lending less to other nations, as well as by reducing the level of its national income. a. Nations usually impose restrictions on the free intemational flow of goods, services and factors. Differences in language, customs and laws also hamper these international flows. In addition, intemational flows may involve receipts and payments in different currencies, which may change in value in relation to one another through time. This is to be contrasted with the interregional flow of goods, services and factors which face no such restrictions as tariffs and are conducted in terms of the same currency, usually in the same language, and under basically the same set of customs and laws. b. Both intemational and interregional economic relations involve the overcoming of space or distance. Indeed, they both arise from the problems created by distance. This distinguishes them from the rest of economies, which abstracts from space and treats the economy as a single point in space, in which production, exchange, and consumption take place. We can deduce that nations benefit from voluntarily engaging in international trade because if they did not gain or if they lost they could avoid those losses by simply refusing to trade. Disagreement usually arises regarding the relative distribution of the gains from specialization in production and trade, but this does not mean that each nation does not gain from trade. International trade results in lower prices for consumers but harms domestic producers of products which compete with imports. Often those domestic producers that stand to lose a great deal from imports band together to pressure the government to restrict imports. Since consumers are many and unorganized and each individually stands to lose only very little from the import restrictions, governments ofien give in to the demands of producers and impose some import restrictions. These topics are discussed in detail in Chapter 9. A nation can subsidize exports of the commodity to other nations until it drives the competing nation's industry out of business, after which it can raise its price and benefit from its newly acquired monopoly power. Some economists and politicians in the United States have accused Japan of doing just that ( of engaging in strategic trade and industrial policy at the expense of U.S. industries), but this is a very complex and controversial aspect of trade policy and will be examined in detail in Chapter 9 712. a. When the value of the U.S. dollar falls in relation to the currencies of other nations, imports become more expensive for Americans and so they would purchase a smaller quantity of imports. b. When the value of the U.S. dollar falls in relation to the currencies of other nations, U.S. exports become chapter for foreigners and so they would purchase a greater quantity of U.S. exports. Multiple-Choice Questions 1. Which of the following products are not produced at all in the United States? *a. Coffee, tea, cocoa b. steel, copper, aluminum ¢. petroleum, coal, natural gas 4. typewriters, computers, airplanes 2. International trade is most important to the standard of living of: a. the United States *b, Switzerland ¢. Germany d. England 3. Over time, the economic interdependence of nations has: *a. grown b. diminished c. remained unchanged 4. cannot say 4. A rough measure of the degree of economic interdependence of a nation is given by: a._ the size of the nations’ population . the percentage of its population to its GDP *c. the percentage of a nation’s imports and exports to its GDP 4. all of the above10. Economic interdependence is greater for: *a, small nations b. large nations ¢. developed nations 4. developing nations 9. International economics deals with: a. the flow of goods, services and payments among nations b. policies directed at regulating the flow of goods, services and payments c._ the effects of policies on the welfare of the nation +d. all of the above International trade theory refers to: a, the microeconomic aspects of intemational trade b. the macroeconomic aspects of international trade €. open economy macroeconomics or intemational finance d. all of the above Which of the following is not the subject matter of international finance? a. foreign exchange markets b. the balance of payments *c, the basis and the gains from trade 4. policies to adjust balance of payments disequilibria Economic theory: a. seeks to explain economic events . seeks to predict economic events cc. abstracts from the many detail that surrounds an economic event *d_ all of the above Which of the following is not an assumption generally made in the study of intemational economies? a. two nations b. two commodities *c. perfect international mobility of factors 4. two factors of production11. In the study of international economics: a. international trade policies are examined before the bases for trade b. adjustment policies are discussed before the balance of payments cc. the case of many nations is discussed before the two-nations case ‘*d. none of the above 12. International trade is similar to interregional trade in that both must overcome: a, distance and space b. trade restrictions ¢. differences in currencies d. differences in monetary systems 13. The opening or expansion of international trade usually affects all members of society: a. positively ‘b. negatively *c, most positively but some negatively d. most negatively but some positively 14, An increase in the dollar price of a foreign currency usually: a. benefit U.S. importers *b. benefits U.S. exporters ¢. benefit both U.S. importers and U.S. exporters 4. harms both U.S. importers and U.S. exporters 15. Which of the following statements with regard to international economics is true? a. Itisa relatively new field *. ¢. most of its contributors were not economists dd. none of the above*CHAPTER 2 (Core Chapter) THE LAW OF COMPARATIVE ADVANTAGE OUTLINE 2.1 Introduction 2.2 The Mercantilists' Views on Trade Case Study 2-1: Munn's Mercantilistic Views on Trade Case Study 2-2: Mercantilism Is Alive and Well in the Twenty-first Century 2.3 Trade Based on Absolute Advantage: Adam Smith 2.3a Absolute Advantage 2.3b Ilustration of Absolute Advantage 2.4 Trade Based on Comparative Advantage: David Ricardo 24a The Law of Comparative Advantage 2.4 The Gains from Trade 2.de Exception to the Law of Comparative Advantage 2.4d Comparative Advantage with Money Case Study 2-3: The Petition of the Candlemaker 2.5 Comparative Advantage with Opportunity Costs 2.5a Comparative Advantage and the Labor Theory of Value 2.5b The Opportunity Cost Theory 2.5e The Production Possibility Frontier Under Constant Costs 2.5d Opportunity Costs and Relative Commodity Prices 2.6 The Basis and the Gains from Trade Under Constant Costs 2.6a Illustration of the Gains from Trade 2.6b Relative Commodity Prices with Trade 2.7 Empirical Tests of the Ricardian Model Case Study 2-4: Relative Unit Labor Costs and Relative Exports — United States and Japan Appendix: A2.1 Comparative Advantage with More than Two Commodities ‘2.2 Comparative Advantage with More than Two Nations “llKey Terms Basis for trade Labor theory of value Gains from trade Opportunity cost theory Pattern of trade Production possibility frontier Mercantilism Constant opportunity cost Absolute advantage Relative commodity prices Laissez-faire Complete specialization Law of comparative advantage Small country case Lecture Guide 1. This is a long and crucial core chapter and may require four classes to cover adequately. In the first lecture, I would present Sections 1, 2, and 3. These are short sections and set the stage for the crucial law of comparative advantage, 2. In the second lecture of Chapter 2, I would concentrate on Section 4 and carefully explain the Jaw of comparative advantage using simple numerical examples as in the text. The crucial parts here are 4b (which explains the law) and 4d (which establishes the link between trade theory and international finance). I find that the numerical explanations before the graphical analysis really helps the student to truly understand the law. The simple lawyer-secretary example should also render the law more immediately relevant to the student. I would also assign Problems 1-6. 3. In the third lecture, I would cover Sections 2.5 and 2.6a. | would pay particular attention to Sections 2.5c, 2.5d, and 2.6, which are the heart of the chapter. 4. In the fourth lecture, I would cover the remainder of the chapter. The crucial section here is 2.6b and the most difficult concept to explain is the shape of the combined supply curve for wheat and cloth. The appendixes could be made optional for the more enterprising students in the class. I would also assign Problems 7-13. Answer to Problems 1. Incase A, the United States has an absolute advantage in wheat and the United Kingdom in cloth. In case B, the United States has an absolute advantage (so that the United Kingdom has an absolute disadvantage) in both commodities. “12.In case C, the United States has an absolute advantage in wheat but has neither an absolute advantage nor disadvantage in cloth. In case D, the United States has an absolute advantage over the United Kingdom in both commodities. . In case A, the United States has a comparative advantage in wheat and the United Kingdom in cloth. In case B, the United States has a comparative advantage in wheat and the United Kingdom in cloth. In case C, the United States has a comparative advantage in wheat and the United Kingdom in cloth. In case D, the United States and the United Kingdom have a comparative advantage in neither commodities. . In case A, trade is possible based on absolute advantage. In case B, trade is possible based on comparative advantage. In case C, trade is possible based on comparative advantage. In case D, no trade is possible because the absolute advantage that the United States has over the United Kingdom is the same in both commodities. . a. The United States gains 1C. b. The United Kingdom gains 4C. ce. 3C<4W<8C. d. The United States would gain 3C while the United Kingdom would gain 2C. . a. The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 in the United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United States and 1/2 in the United Kingdom. b. Inthe United States, Pw=$1.50 and Pe=$2.00. c. Inthe United Kingdom, Pw=£1.00 and Pe=£0.50. -13-6. a. With the exchange rate of £1=$2, Pw=2.00 and Pc=$1.00 in the United Kingdom, so that the United States would be able to export wheat to the United Kingdom and the United Kingdom would be able to export cloth to the United States. b. With the exchange rate of £1=$4, Pw=$4.00 and Pc=$2.00 in the United Kingdom, so that the United States would be able to export wheat to the United Kingdom, but the United Kingdom would be unable to export any cloth to the United States. c. With £1=$1, Pw=$1.00 and Pc=$0.50 in the United Kingdom, so that the United Kingdom would be able to export both commodities to the United States, 4. $1.50 <£1.00<$4.00. 7. a See Figure 1 b. Inthe United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2, ©. Inthe United States Pc/Pw=4/3, while in the United Kingdom Pe/Pw=1/2. 8. See Figure 2. ‘The autarky points are A and A' in the United States and the United Kingdom, respectively. The points of production with trade are B and Bi in the United States and the United Kingdom, respectively. The points of consumption are E and E’ in the United States and the United Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E'> A’ for the UK. 9. a. If Dwus-ux) shifted up in Figure 2.3, the equilibrium relative commodity price of wheat would also rise by 1/3 to Pw/Pc=4/3. Since the higher Dwussux) would still intersect the vertical portion of the Swruseux) Curve, the United States would continue to specialize completely in the production of wheat and produce 180W, while the United kingdom would continue to specialize completely in the production of cloth and produce 120C. b. Since the equilibrium relative commodity price of cloth is the inverse of the relative commodity price of wheat, if the latter rises to 4/3, then the former falls to 3/4. This means that Deux-us) shifts down by 1/3 in the right panel of Figure 2.3, “14us, Fue ch ‘ us 4 ¢ 2 1 E ' a ° 2 rr rr v Fue? fat us, € e ge « Se go 2. ° ° o 10 Wheat Fue ux. + 2 © ux. & + 2 W UK. e ' 1 " 00 Whoat10. If Diyuseux) intersected Swiussuxy at Pw/Pc=2/3 and 120W in the left panel of Figure 2.3, this ‘would mean that the United States would not be specializing completely in the production of wheat. ‘The United Kingdom, on the other hand, would be specializing completely in the production of cloth and exchanging 20C for 30W with the United States. Since the United Kingdom trades at US. the pre-trade relative commodity price of Pw/Pc=2/3 in the United States, the United Kingdom receives all of the gains from trade. 11. See Figure 3 on page 15 and the discussion in the last paragraph of Section 2.6b in the text. 12, a, The Ricardian model was tested empirically by showing the positive correlation between relative productivities and the ratio of U.S. to UK. exports to third countries and by the negative correlation between relative unit labor costs and relative exports b. The Ricardian trade model was confirmed by the positive relationship found between the relative labor productivity and the ratio of U.S. to U.K. exports to third countries, as well as. by the negative relationship between relative unit labor costs and relative exports. ¢. Even though the Ricardian model was more or less empirically confirmed we still need other models because the former assumes rather than explains comparative advantage (i.e, it does not explain the reason for the different labor productivities in different nations) and cannot say much regarding the effect of international trade on the earnings of factors of production. 13. The United States has a comparative disadvantage in the production of textiles. Restricting textile imports would keep U.S. workers from eventually moving into industries in which the United States has a comparative advantage and in which wages are higher. Answer to Problem in Appendix 2 ‘The numbers in the following table refer to the cost or price of commodities X, Y, and Z in nations A, B, and C in terms of the same currency. Thus, nation A exports commodity X to nations B and C; nation B exports commodity Y to nations A and C; nation C exports commodity Z to nations A and B. ‘Commodity X. 1203 ‘Commodity ¥ Oe ise 2) ‘Commodity Z eae 2) -16-Multiple-Choice Questions 1. The Mercantilists did not advocate: Ya, free trade b. stimulating the nation's exports, ¢. restricting the nations’ imports the accumulation of gold by the nation 2. According to Adam Smith, international trade was based on: a, absolute advantage b. comparative advantage ¢. both absolute and comparative advantage 4. neither absolute nor comparative advantage 3. What proportion of international trade is based on absolute advantage? a All b. most *c. some d. none 4, The commodity in which the nation has the smallest absolute disadvantage is the commodity of its: a. absolute disadvantage b. absolute advantage ©. comparative disadvantage *d. comparative advantage 5. If in a two-nation (A and B), two-commodity (X and Y) world, it is established that nation A has a comparative advantage in commodity X, then nation B must have: an absolute advantage in commodity Y an absolute disadvantage in commodity Y . acomparative disadvantage in commodity Y tae comparative advantage in commodity Y ese -17-6. If with one hour of labor time nation A can produce either 3X or 3Y while nation B can produce either 1X or 3Y (and labor is the only input): a. nation A has a comparative disadvantage in commodity X . nation B has a comparative disadvantage in commodity Y *c. nation A has a comparative advantage in commodity X 4. nation A has a comparative advantage in neither commodity 7. With reference to the statement in Question 6: a. Px/Py=1 in nation A b. PxPy=3 in nation B c. Py/Px=1/3 in nation B *d_all of the above 8. With reference to the statement in Question 6, if 3X is exchanged for 3Y: a. nation A gains 2X *b, nation B gains 6Y ¢. nation A gains 3Y d. nation B gains 3Y 9. With reference to the statement of Question 6, the range of mutually beneficial trade between nation A and B is: a 3Y<3X<5Y b. SY<3X<9Y ce. BY <3X<9Y a. 1Y<3X<3¥ 10. If domestically 3X=3Y in nation A, while 1X=1Y domestically in nation B: a. there will be no trade between the two nations b. the relative price of X is the same in both nations c._ the relative price of Y is the same in both nations *d_ all of the above 11. Ricardo explained the law of comparative advantage on the basis of: *a. the labor theory of value the opportunity cost theory the law of diminishing retums all of the above Bes -18-12. Which of the following statements is true? a. The combined demand for each commodity by the two nations is negatively sloped b. the combined supply for each commodity by the two nations is rising stepwise ¢. the equilibrium relative commodity price for each commodity with trade is given by the intersection of the demand and supply of each commodity by the two nations +4. all of the above 13. A difference in relative commodity prices between two nations can be based upon a difference in: a. factor endowments b. technology c. tastes d. all of the above 14. In the trade between a small and a large nation: athe large nation is likely to receive all of the gains from trade *b. the small nation is likely to receive all of the gains from trade . the gains from trade are likely to be equally shared dd. we cannot say 15. The Ricardian trade model has been empirically a, verified b. rejected c. not tested d._ tested but the results were inconclusive -19-*CHAPTER 3 (Core Chapter) THE STANDARD THEORY OF INTERNATIONAL TRADE OUTLINE 3.1 Introduction 3.2 The Production Frontier with Increasing Costs 3.2a Illustration of Increasing Costs 3.2b The Marginal Rate of Transformation 3.2c Reason for Increasing Opportunity Costs and Different Production Frontiers 3.3 Community Indifference Curves 3.3a Illustration of Community Indifference Curves 3.3b The Marginal Rate of Substitution 3.3¢ Some Difficulties with Community Indifference Curves 3.4. Equilibrium in Isolation 3.4a Ilustration of Equilibrium in Isolation 3.4b Equilibrium Relative Commodity Prices and Comparative Advantage Case Study 3-1: Revealed Comparative Advantage of the United Stat 3.5. The Basis for and the Gains from Trade with Increasing Costs 3.Sa Illustration of the Basis for and the Gains from Trade with Increasing Costs 3.5b Equilibrium Relative Commodity Prices with Trade 3.5 Incomplete Specialization Case Study 3-2: Specialization and Export Concentration in Selected Countries 3.5d Small Country Case with Increasing Costs 3.5e The Gains from Exchange and from Specialization Case Study 3-3: Job Losses in High U.S. Import-Competing Industrie Case Study 3-4: Intemational Trade and Deindustrialization in the United States, the European Union, and Japan 3.6 Trade Based on Differences in Tastes APPENDIX: A3.1 Production Functions, Isoquants, Isocosts and Equilibrium A3.2 Production Theory with Two Nations, Two Commodities and Two Factors A3.3 Derivation of the Edgeworth Box Diagram and Production Frontiers A3.4 Some Important Conclusions -20-Key Terms Increasing opportunity costs Revealed comparative advantage Marginal rate of transformation (MRT) Equilibrium relative commodity price with trade Community indifference curves Incomplete specialization Marginal rate of substitution (MRS) Gains from exchange Autarky Gains from specialization Equilibrium relative commodity price in isolation _ Deindustrialization Lecture Guide i In the first lecture of Chapter 3, 1 would cover Sections 1, 2, and 3. Section 2 can be covered quickly, except for 2b, which requires careful explanation because of its subsequent importance. Careful explanation is also required for 3b. I would assign Problems 1 and 2. In the second lecture, I would cover Sections 4, 5a, and Sb. This is the basic trade model and it is essential for the student to master it completely. To this end, I would assign and grade Problems 3 and 4. In the third lecture, I would cover the remainder of the chapter. The topics here represent elaborations of the basic trade model. 1 would assign problems 5, 6, and 7 and go over problem 7 in class even though its answer is also in the back of the book. | would make the Appendices optional for those students in the class who have had intermediate micro theory. Answer to Problems 1 a. See Figure 1. b. The slope of the transformation curve increases as the nation produces more of X and decreases as the nation produces more of Y. These reflect increasing opportunity costs as the nation produces more of X or Y. a. See Figure 2. ‘We have drawn community indifference curves as downward or negatively sloped because as the community consumes more of X it will have to give up some of Y to remain on the same indifference curve. b. The slope measures how much of Y the nation can give up by consuming one more unit of X and still remain at the same level of satisfaction; the slope declines because the more of X and the less of Y the nation is left with, the less satisfaction it receives from additional units of X and the more satisfaction it receives from each retained unit of Y. 2c. IM1> Il to the right of the intersection, while II > Il} to the left. This is inconsistent because an indifference curve should show a given level of satisfaction. Thus, indifference curves cannot cross. . a. See Figure 3 on page 22. b. Nation 1 has a comparative advantage in X and Nation 2 in Y. ¢. If the relative commodity price line has equal stope in both nations. . a. See Figure 4. b. Nation 1 gains by the amount by which point E is to the right and above point A and Nation 2 by the excess of E’ over A’. Nation 1 gains more from trade because the relative price of X with trade differs more from its pretrade price than for Nation 2. . a. See Figure 5. In Figure 5, $ refers to Nation 1's supply curve of exports of commodity X, while D refers to Nation 2's demand curve for Nation 1's exports of commodity X. D and S intersect at point E, determining the equilibrium Py=Px/Py=I and the equilibrium quantity of exports of 60X. b. At PwPy=1 1/2 there is an excess supply of exports of R'R=30X and Px/Py falls toward equilibrium Px/Py=1. c. At Px/Py=1/2, there is an excess demand of exports of HH'=80X and Px/Py rises toward Py/Py=1. .. The Figure in Problem 5 is consistent with Figure 3-4 in the text. From the left panel of Figure 3-4, we sce that Nation 1 supplies no exports of commodity X at Px/Py=1/4 (point A). This corresponds with the vertical or price intercept of Nation I's supply curve of exports of commodity X (point A). The left panel of Figure 3-4 also shows that at Px/Py=1, Nation 1 is willing to export 60X (point E). The same is shown by Nation 1's supply curve of exports of commodity X. The other points on Nation 1's supply curve of exports in the figure of Problem 5 can also be derived from the left pane! of Figure 3-4, but this is shown in Chapter 4 with offer curves. -23-> 0 © DO 10 Expos ol Corodiy X Faues Fue 24Nation 2's demand curve for Nation 1's exports of commodity X could be derived from the right panel of Figure 3-4, as shown in Chapter 4. What is important is that we can use the D and S figure in Problem 5 to explain why the equilibrium relative commodity price with trade is Px/Py=1 and why the equilibrium quantity traded of commodity X is 60 units in Figure 3-4. 7. See Figure 6 on page 24. The small nation will move from A to B in production, exports X in exchange for Y so as to reach point E> A. 8. a. The small nation specializes in the production of commodity X only until its opportunity cost and relative price of X equals Pw. This usually occurs before the small nation has become completely specialized in production. b. Under constant costs, specialization is always complete for the small nation. 9. a. See Figure 7. b. See Figure 8. 10. If the two community indifference curves had also been identical in Problem 9 the relative ‘commodity prices would also have been the same in both nations in the absence of trade and no mutually beneficial trade would be possible (see Figure 9), 11. If production frontiers are identical and the community indifference curves different in the ‘two nations, but we have constant opportunity costs, there would be no mutually beneficial trade possible between the two nations (see Figure 10 on page 27). 12, See Figure 11 (on page 27). 13. It is true that Mexico's wages are much lower than U.S. wages (about one fifth), but labor productivity is much higher in the United States and so labor costs are not necessarily higher than in Mexico. In any event, trade can still be based on comparative advantage. App. 1. See Figure 12 (on page 27). Commodity X is the L-intensive commodity in Nation 2 (as in Nation 1) because the production contract curve bulges toward the L-axis or is everywhere to the left of the diagonal. App. 2. Since L and K are released from the production of X in a higher ratio than are absorbed in the production of Y, wages fall in Nation 2. This leads to the substitution of L for K in the production of X and Y, so that the K/L ratio falls in the production of both commodities. 25-Y amion y NATION? Fowe7 yh a= Pa ae Furs y aT A ' a ° x Fue 26aTiON amion2 Fie 10 NaTION2 a aoe oe oen ex Fue 1s NaTion2Multiple-Choice Questions 1. A production frontier that is concave from the origin indicates that the nation incurs increasing ‘opportunity costs in the production of: a. commodity X only b. commodity Y only *c, both commodities . neither commodity 2. The marginal rate of transformation (MRT) of X for Y refers to: a, the amount of Y that a nation must give up to produce each additional unit of X the opportunity cost of X the absolute slope of the production frontier at the point of production *4, all of the above 3. Which of the following is not a reason for increasing opportunity costs: a. technology differs among nations b. factors of production are not homogeneous c. factors of production are not used in the same fixed proportion in the production of all commodities . for the nation to produce more of a commodity, it must use resources that are less and less suited in the production of the commodity 4, Community indifference curves: ‘a. are negatively sloped b. are convex to the origin ¢. should not cross 4. all of the above 5. The marginal rate of substitution (MRS) of X for Y in consumption refers to the: a. amount of X that a nation must give up for one extra unit of Y and still remain on the same indifference curve *b. amount of Y that a nation must give up for one extra unit of X and still remain on the same indifference curve ¢. amount of X that a nation must give up for one extra unit of Y to reach a higher indifference curve 4, amount of ¥ that a nation must give up for one extra unit of X to reach a higher indifference curve 28.10. u ‘Which of the following statements is true with respect to the MRS of X for Y? a._Itis given by the absolute slope of the indifference curve declines as the nation moves down an indifference curve . rises as the nation moves up an indifference curve *4_ all of the above Which of the following statements about community indifference curves is true? a. They are entirely unrelated to individuals’ community indifference curves they cross, they cannot be used in the analysis *c, the problems arising from intersecting community indifference curves can be overcome by the application of the compensation principle 4. all of the above. Which of the following is not true for a nation that is in equilibrium in isolation? +a, It consumes inside its production frontier . it reaches the highest indifference curve possible with its production frontier c. the indifference curve is tangent to the nation’s production frontier d. MRT of X for Y equals MRS of X for Y, and they are equal to Px/Py . If the intemal Px/Py is lower in nation 1 than in nation 2 without trade: a. nation 1 has a comparative advantage in commodity Y . nation 2 has a comparative advantage in commodity X “c, nation 2 has a comparative advantage in commodity Y 4d. none of the above ‘Nation I's share of the gains from trade will be greater: the greater is nation 1's demand for nation 2's exports *b. the closer Px/Py with trade settles to nation 2's pretrade Px/Py the weaker is nation 2's demand for nation 1's exports d._ the closer Px/Py with trade settles to nation I's pretrade Px/Py - If Px/Py exceeds the equilibrium relative Px/Py with trade a. the nation exporting commodity X will want to export more of X than at equilibrium. b. the nation importing commodity X will want to import less of X than at equilibrium cc. Px/Py will fall toward the equilibrium Px/Py *d_ all of the above12. With free trade under increasing costs: a. neither nation will specialize completely in production b. at least one nation will consume above its production frontier c. asmall nation will always gain from trade 4, all of the above 13. Which of the following statements is false? a. The gains from trade can be broken down into the gains from exchange and the gains from specialization , gains from exchange result even without specialization *c, gains from specialization result even without exchange 4. none of the above 14, The gains from exchange with respect to the gains from specialization are always: a. greater b. smaller . equal 4. we cannot say without additional information 15. Mutually beneficial trade cannot occur if production frontiers are: equal but tastes are not b. different but tastes are the same c. different and tastes are also different ‘*d. the same and tastes are also the same. -30-CHAPTER 4 DEMAND AND SUPPLY, OFFER CURVES, AND THE TERMS OF TRADE OUTLINE *4.1 Introduction *4.2 The Equilibrium Relative Commodity Price with Trade - Partial Equilibrium Analysis Case Study 4-1: Demand, Supply, and the International Price of Petroleum Case Study 4-2: The Index of Export to Import Prices for the United States 4.3 Offer Curves 43a Origin and Definition of Offer Curves 4.3b Derivation and Shape of the Offer Curve of Nation 1 4.3c Derivation and Shape of the Offer Curve of Nation 2 4.4 The Equilibrium Relative Commodity Price with Trade - General Equilibrium Analysis 4.5 Relationship Between General and Partial Equilibrium Analyses 4.6 The Terms of Trade 4.6a Definition and Measurement of the Terms of Trade 4.6b Illustration of the Terms of Trade 4.6c Usefulness of the Model Case Study 4-3: The Terms of Trade of the G-7 Countries Case Study 4-4: The Terms of Trade of Developing and Developed Countries Appendix: 4.1 Derivation of a Trade Indifference Curve for Nation 1 ‘A4.2 Derivation of Nation's | Trade Indifference Map A4.3 Formal Derivation of Nation's 1 Offer Curve ‘A4.4 Outline of the Formal Derivation of Nation 2's Offer Curve A4.5 General Equilibrium of Production, Consumption, and Trade A4.6 Multiple and Unstable Equilibria Key Terms Offer Curves ‘Commodity or net barter terms of trade Reciprocal demand curve General equilibrium model Terms of trade *Core Section 31Lecture Guide 1. Some Instructors may wish to cover only Sections 1 and 2 of this chapter and skip offer curves. I would then cover in one lecture Sections 1 and 2. 2. Otherwise, I would cover Sections 1-3 in the first lecture and Sections 4-6 in the second lecture, paying special attention to the shape of offer curves and to the relationship between general and partial equilibrium analyses. Answer to Problems 1. See Figure 1. The equilibrium Py/Px=P')=1/P3. 2. See Figure 2. 3. See Figure 3. 4, See Figure 4 on page 34. 5. a. Anation’s offer curve is similar to a demand curve because it shows the nation's demand for imports. b. A nation’s offer curve is similar to a supply curve because it shows the nation’s supply for exports. ¢. An offer curve shows how much of its import commodity a nation demands in order to supply various amounts of its export commodity. The usual demand and supply curves ‘measure the quantity demanded and supplied, respectively. 6. a. See Figure 5. b. The quantity of imports demanded by Nation 1 at Pr exceeds the quantity of exports of Y supplied by Nation 2. Therefore, Px/Py declines (Py/Px rises) until the quantity demanded of imports of Y by Nation 1 equals the quantity of exports of Y supplied by Nation 2 at Ps=Py. c. The backward bending (i.e., negatively sloped) segment of Nation 1's offer curve indicate that nation 1 is willing to give up less of X for larger amounts of Y. 32.NATION 7S MARKET FOR Y INTERNATIONAL TRADE NY NATION "8 MARKET FOR Y 8 Fegee2 Fores 33Fagus Furs Yh Pe Fue 347. a. See Figure 6 on page 34. b. The nation with the offer curve with the greater curvature gains more from trade. The nation with the offer curve with the greater curvature gains more from trade because the greater curvature of the offer curve reflects the nation's weaker or less intense demand for the other nation's export commodity. 8. See Figure 7. From the left panel of Figure 4.4, we see that Nation 2 does not export any amount of commodity Y at Px/Py=4, or Py/Px=1/4. This gives point A on Nation 2's supply curve of the exports of commodity Y (S). From the left panel of Figure 4.4, we also see that at Px/Py=2 or Py/Px=1/2, Nation 2 exports 40Y. This gives point H on S. Other point on S could similarly be derived. Note that S in Figure 7 is identical to S in Figure 4.6 in the text showing Nation 1's exports of commodity X. From the left panel of Figure 4.3, we see that Nation 1 demands 60Y of Nation 2's exports at Px/Py=Py/Px=1. This gives point E on Nation I's demand curve of Nation 2's exports of commodity Y (D). From the left panel of Figure 4.3, we can estimate that Nation 1 demands 40Y at Py/Px=3/2 (point H on D in Figure 7) and 120Y at Py/Px=2 (point H' on D). The equilibrium relative commodity price of commodity Y is Py/Px=1. This is determined at the intersection of D and $ in Figure 7. At Py/Px=3/2, there is an excess supply of R'R=30Y and Py/Px falls to Py/Px=1. On the other hand, at Py/Px=1/2, there is an excess demand of HH'=80Y and Py/Px rises to Py/Px=1. Note also that Figure 7 is symmetrical with Figure 4.6 in the text. 9. a. The analysis in the answer to Problem 8 refers to partial equilibrium analysis because it makes use of the traditional demand and supply curves. These refer to the market for commodity Y and abstract from all the interconnections that exist between the market for commodity Y and the market for all the other commodities in the economy. As such, it provides only an approximation to the answer sought. b. The analysis of Figure 4.5 relies on offer curves. These incorporate demand and supply information in both nations and for both commodities (in our two-nation, two-commodity world). As such, they allow us to trace a change in demand or supply, for either commodity, in either nation, on the demand and supply of the other commodity and in the other nation, as well as the repercussions from the original change on the demand and supply for both commodities in both nations. Thus, Figure 4-5 refers to general equilibrium analysis. This is admittedly more difficult than partial equilibrium analysis, but it also provides a complete and explicit answer to the problem. -35-Fons Noten 1 Nation 2 Faun 36¢. The partial equilibrium analysis shown in Figure 7 here and in Figure 4.6 in the text and the general equilibrium analysis provided by Figure 4.5 are related because both are derived from the same basic information (the production frontier and the indifference map of each nation). Partial equilibrium analysis, however, utilizes only part, not all, of the information provided by the production frontier and the indifference maps, as general equilibrium analysis does. 10. See Figure 8 on page 36. In Figure 8, Nation 2 is the small nation and we magnified the portion of the offer curve of Nation 1 (the large nation) near the origin (where Nation 1's offer curve coincides with Px=1/4, Nation 1's pretrade relative commodity price with trade). This means that Nation 2 can import a sufficiently small quantity of commodity X without perceptibly affecting Px/Py in Nation 1. ‘Thus, Nation 2 is a price taker and captures all of the benefits from its trade with Nation 1. The same would be true even if Nation 2 were not a small nation, as long as Nation 1 faced constant opportunity costs and did not specialize completely in the production of commodity X with trade. 11. See Figure 9 on page 36. Figure 9 shows that in the unlikely event that both nations faced constant costs, the offer curves of both would be straight lines until both nations became completely specialized in production. Afterwards, offer curves would assume their normal shape and determine the equilibrium Px/Py=P; at their intersection at point E. 12.a. If the terms of trade of a nation improved from 100 to 110 over a given period of time, the terms of trade of the trade partner would deteriorate by about 9 percent over the same period of time. b. A deterioration in the terms of trade of the trade partner can be said to be unfavorable because the trade partner must pay a higher price for its imports in terms of its exports. This does not necessarily mean that the welfare of the trade partner has decreased because the deterioration in its terms of trade may have resulted from an increase in productivity that is shared with the other nation. 13. Under the conditions of tight supply that prevailed during the 1970s, OPEC was given credit for the sharp increase in petroleum prices; but when excess supplies arose from the second half of the 1980s to most of the 1990s, OPEC was unable to prevent almost equally sharp price declines. Thus, OPEC does not seem able to set petroleum prices. App. 3. See Figures 10 and 11. App. 4. See Figure 12. App. 5. See Figure 13. At P', Nation 1 wants to import and export more than Nation 2 is willing to trade. As P' falls, Nation 1 will want to trade less and Nation 2 more, until Pc, where the amounts traded are in equilibrium. The opposite is true at P*. -37-Fopeo 10 Fue Figae 2 Foo 13 38Multiple Choice ns 1. Which of the following statements is correct? a. The demand for imports is given by the excess demand for the commodity . the supply of exports is given by the excess supply of the commodity . the supply curve of exports is flatter than the total supply curve of the commodity *d_ all of the above 2. Atarelative commodity price above equilibrium ‘a. the excess demand for a commodity exceeds the excess supply of the commodity b. the quantity demanded of imports exceeds the quantity supplied of exports *c, the commodity price will fall d._allof the above 3. The offer curve of a nation shows: a. the supply of a nation’s imports the demand for a nation’s exports c. the trade partner's demand for imports and supply of exports “d. the nation's demand for imports and supply of exports 4. The offer curve of a nation bulges toward the axis measuring the nation's a. import commodity *b. export commodity ¢. export or import commodity d._ nontraded commodity 5. Export prices must rise for a nation to increase its exports because the nation: incurs increasing opportunity costs in export production . faces decreasing opportunity costs in producing import substitutes c. faces decreasing marginal rate of substitution in consumption 4, all of the above 6. Which of the following statements regarding partial equilibrium analysis is false? a. Itrelies on traditional demand and supply curves ’. itisolates for study one market *c. it can be used to determine the equilibrium relative commodity price but not the equilibrium quantity with trade 4. none of the above -39-7. Which of the following statements regarding partial equilibrium analysis is true? a The demand and supply curve are derived from the nation’s production frontier and indifference map b. It shows the same basic information as offer curves c._ Itshows the same equilibrium relative commodity prices as with offer curves #4. all of the above 8. In what way does partial equilibrium analysis differ from general equilibrium analysis? a. The former but not the latter can be used to determine the equilibrium price with trade . the former but not the latter can be used to determine the equilibrium quantity with trade ¢. the former but not the latter takes into consideration the interaction among all markets in the ‘economy ‘+d, the former gives only an approximation to the answer sought. 9. Ifthe terms of trade of a nation are 1.5 in a two-nation world, those of the trade partner are: a 3/4 23 c. 3/2 a. 43 10. If the terms of trade increase in a two-nation world, those of the trade partner: +a, deteriorate b. improve . remain unchanged d. any of the above 11. Ifa nation does not affect world prices by its trading, its offer curve: a. isa straight line b. bulges toward the axis measuring the import commodity **c, intersects the straight-line segment of the world's offer curve 4. intersects the positively-sloped portion of the world’s offer curve 12. If the nation's tastes for its import commodity increases: a. the nation's offer curve rotates toward the axis measuring its import commodity b. the partner’ offer curve rotates toward the axis measuring its import commodity cc. the partner's offer curve rotates toward the axis measuring its export commodity "*d. the nation’s offer curve rotates toward the axis measuring its export commodity -40-13. If the nation's tastes for its import commodity increases: a. the nation's terms of trade remain unchanged +b. the nation’s terms of trade deteriorate ¢. the partner's terms of trade deteriorate 4. any of the above 14, If the tastes for a nation import commodity increases, trade volume: a, increases b. declines ¢. remains unchanged 4. any of the above 15. A deterioration of a nation's terms of trade causes the nation's welfare to: 4. any of the above Ale*CHAPTER 5 (Core Chapter) FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN THEORY OUTLINE 5.1 Introduction 5.2 Assumptions of the Theory 5.2a The Assumptions 5.2 Meaning of the Assumptions 5.3 Factor Intensity, Factor Abundance, and the Shape of the Production Frontier 5.3a Factor Intensity 5.3b Factor Abundance 5.3¢ Factor Abundance and the Shape of the Production Frontier Case Study 5-1: Relative Resource Endowments of Various Countries and Regions Case Study 5-2: Capital-Labor Ratios of Selected Countries 5.4 Factor Endowments and the Heckscher-Ohlin Theory 5.4a The Heckscher-Ohlin Theorem 5.4b General Equilibrium Framework of the Heckscher-Ohlin Theory 5.4c Illustration of the Heckscher-Ohlin Theory Case Study 5-3: Patterns of Comparative Advantage of Various Countries and Regions 5.5 Factor-Price Equalization and Income Distribution 5.5 The Factor-Price Equalization Theorem 5.5b Relative and Absolute Factor-Price Equalization 5.5 Effect of Trade on the Distribution of Income 5.5. The Specific-Factors Mode! Case Study 5-4: Has International Trade Increased U.S. Wage Inequalities? 5.5e Empirical Relevance Case Study 5-5: Convergence of Real Wages Among Industrial Countries 5.6 Empirical Tests of the Heckscher-Ohlin Model 5.6a Empirical Results - The Leontief Paradox 5.6b Explanations of the Leontief Paradox 5.6¢ Factor-Intensity Reversal Case Study 5-6: Capital and Labor Requirements in U.S. Trade Case Study 5-7: The H-O Model With Skills and Land Appendix: AS.1. The Edgeworth Box Diagram for Nation I and Nation 2 AS2 Relative Factor-Price Equalization AS.3 Absolute Factor-Price Equalization 42.AS.4 Effect of Trade on the Short-Run Distribution of Income: ‘The Specific-Factors Model A5.5 Illustration of Factor-Intensity Reversal A5.6 The Elasticity of Substitution and Factor Intensity Reversal AS.7 Empirical Tests of the Factor-Intensity Reversal Key Terms Same technology Heckscher-Ohlin (H-O) theory Labor-intensive commodity Heckscher-Ohlin (H-O) theorem Capital-intensive commodity Factor endowments Labor-capital ratio (L/K) Factor-proportions or factor-endowment theory Capital-labor ratio (K/L) Factor-price equalization (H-O-S) theorem Constant returns to scale Specific-factors model Perfect competition Input-output table Internal factor mobility Import substitutes International factor mobility Leontief paradox Factor abundance Human capital Relative factor prices Factor-intensity reversal Derived demand Elasticity of substitution Lecture Guide 1. This is one of the most important chapters in the book. It is also a long chapter and requires about four lectures to adequately cover. 2. In the first lecture, I would cover Sections 1-3. 3. In the second lecture, I would cover Section 4. This, of course, is one of the most important sections in the book. I would proceed slowly and carefully here and 1 would also assign problems 1-8 and grade problems 1-3, 5, 6 to make sure that students clearly understand the meaning of the theory (the answer to problems 4 and 7 appears at the end of the book). 4, Inthe third lecture, I would cover section 5 on the factor-price equalization theorem and income distribution. This is a difficult section. Case Study 5-3 adds a note of realism to the discussion. | ‘would also assign problems 9 and 10. 5. In the fourth lecture, I would cover section 6 on empirical tests of the Heckscher-Ohlin Model and assign problems 13, and 15. -43-Answer to Problems i a. See Figure 1. b. The slope of the lines measuring K/L of each commodity in Nation 2 fall if w/t rises in Nation 2 as a result of intemational trade. c. The slope of the lines measuring K/L of each commodity in Nation | rise if wir falls in Nation | as a result of intemational trade. 4. Given the results in parts (a) and (b), international trade reduces the difference in the K/L in the production of each commodity in the two nations as compared with the pretrade situation. a. See Figure 2. b. The comparative advantage of each nation is determined by differences in production conditions only since tastes are identical. ¢. The two nations consume different amounts of the two commodities in the absence of trade but the same amounts with trade because internal prices differ without trade but are identical with trade. See Figure 3. See Figure 4 on page 46. See Figure 5. a. Besides a difference in factor endowments, the production frontier of two nations could differ also because of a difference in technology. b. A difference in the production frontier of two nations due to a difference in the technology is prevented by assumption by the H-O model. ¢. Another possible cause (besides a difference in production frontiers) of a difference in relative commodity prices between two nations in the absence of trade is a difference in tastes. See Figure 6. People in developing countries consume very different goods and services than U.S. consumers not because tastes are very different from the tastes of U.S. consumers but because incomes are so different (much lower) than in the United States. 44.ay mix NaTION Kax NATION 2 Feu 459. 10. ve 12. a. If tastes change in favor of commodity Y (the commodity of its comparative disadvantage) in Figure 5-4 for Nation 1, Px/Py will be lower in Nation 1 because point A will move up and to the left. b. The effect of the change in tastes examined in part (a) for Nation 1 will cause r/w to rise in Nation 1. c. The effect of the changes examined in parts (a) and (b) will be to increase the volume of trade. These changes will improve the partner's terms of trade, ‘The statement was made by Gottftied Haberler in his Survey of Intemational Trade Theory, Special Papers in Intemational Economics, No.1 (Princeton, N.J.: Princeton University Press, Intemational Finance Section, July 1961), p. 18. ‘While the statement is true, it does not detract from Samuelson's great contribution in rigorously showing the conditions under which trade would bring about the complete equality in the returns to homogeneous factors among nations. Intematioal trade with developing economies, especially newly industrializing economies (NIEs), contributed in two ways to increased wage inequalities between skilled and unskilled ‘workers in the United States during the past two decades. Directly, by reducing the demand for unskilled workers as a result of increased U.S. imports of labor-intensive manufactures and, indirectly, by speeding up the introduction of labor-saving innovations, which further reduced the U.S. demand for unskilled workers. International trade, however, was only a small cause of increased wage inequalities in the United States. The most important cause was technological change. a. Leontief found that U.S. import substitutes were more K-intensive than U.S. exports even though the United States was the most K-rich nation. This implied factor-intensity reversal and rejection of the H-O trade model. b. Kravis found that wages in U.S. export industries were higher than in U.S. import- ‘competing industries, reflecting the greater productivity of labor in U.S. exports than in U.S. import substitutes. This was confirmed by Keesing who found that U.S. exports were more skill intensive than the exports of 9 other industrial nations. By adding human to physical capital, Kenen succeed in eliminating the paradox. Baldwin found that including human capital and excluding natural-resource industries eliminated the paradox. c. The paradox was seemingly resolved by Leamer, Stem and Maskus, and Salvatore and Barazesh by comparing the K/L ratio in U.S. production vs. U.S. consumption, rather than in exports vs. imports when natural-resource-based industries are excluded. Factor-intensity reversal seems to be rather rare in the real world. -47-13.4. See Figure 7 'b, Factor-intensity reversal could occur if the substitutability of K for L in the production of X ‘was much greater than for Y and t/w was lower in Nation 2 than in Nation 1. ¢. Minhas found factor-intensity reversal to be fairly frequent. However, by correcting an important source of bias in the Minhas study, Leontief showed that factor-intensity reversal ‘was much less frequent. Ball tested another aspect of Minhas’ conclusion and confirmed Leontief's results that factor-intensity reversal was rare in the real world, 14, With factor-intensity reversal, a commodity is L-intensive in one nation and K-intensive in the other. The H-O model would then predict that both nations would export the same commodity. Since this is impossible, both nations must export the commodity intensive in the same factor. If this is the K-intensive commodity, the demand for K will increase in both nations. If itis the L-intensive commodity, the demand for K will fall in both nations. Thus, the price of K will either rise or fall in both nations, and intemational differences in the price of K will decrease, increase or remain unchanged depending on the rate of change in the price of K in the two nations 15, a. By allowing for different technologies and factor prices across countries, nontraded goods transportation costs, and by using better and more disageregated data. . Factor endowments seem to explain comparative advantage and trade very well. c. Weretain the H-O model as the centerpiece of intemational trade theory. ‘App.2. See Figure 8, ‘App.4. The effect of the opening of trade on the real income of labor and capital in Nation 2 (the K- abundant nation) if L is mobile between the two industries in Nation 2 but K is not is to increase Py/Px and to cause more L to be used in the production of Y. ‘Wages then fall in terms of Y but rise in terms of X. On the other hand, the return on capital increases in the production of Y but falls in the production of X. App.5. See Figure 9. AtP) commodity Y is K-intensive (compare point C to point A). AtP2 commodity Y is still K-intensive (compare point D to point B). App.6. For the X isoquant e = (AK/L)/(K/L) = (3/3-2/4/(2/4) = 1 Aslope/slope (2-1/1 For the Y isoquant e = (4/2-2.5/3(2.5/3) = 1.4 (IV 48.amon 1 oy K nx Kh Kor Kinx Fue ‘NATION?Multiple-Choice Questions c ‘The H-O model extends the classical trade model by: a. explaining the basis for comparative advantage '. examining the effect of trade on factor prices *c. both aand b 4. neither a nor b Which is not an assumption of the H-O model? a. the same technology in both nations b. constant returns to scale *c. complete specialization 4. equal tastes in both nations ‘With equal technology nations will have equal K/L in production if: +a, factor prices are the same b. tastes are the same ¢. production functions are the same d. all of the above We say that commodity Y is K-intensive with respect to X when: a. more K is used in the production of ¥ than X . less L is used in the production of Y than X *c. a lower L/K ratio is used in the production of Y than X d. ahigher K/L is used in the production of X than Y ‘When wir falls, L/K a. falls in the production of both commodities *b. rises in the production of both commodities cc. can rise or fall d. isnot affected A nation is said to have a relative abundance of K if it has a: ‘greater absolute amount of K smaller absolute amount of L higher L/K ratio 'd. lower r/w pose -50-10. Me 12 A difference in relative commodity prices between nations can be based on a difference in: a. technology b. factor endowments ©. tastes *d. all of the above . In the H-O model, intemational trade is based mostly on a difference in: a. technology b. factor endowments ¢. economies of scale d._ tastes . According to the H-O model, trade reduces international differences in: a. relative but not absolute factor prices b. absolute but not relative factor prices *c. both relative and absolute factor prices 4. neither relative nor absolute factor prices According to the H-O model, international trade will: reduce international differences in per capita incomes increases international differences in per capita incomes ‘may increase or reduce international differences in per capita incomes lead to complete specialization ease The H-O model is a general equilibrium model because it deals with: a. production in both nations b. consumption in both nations ¢. trade between the two nations *d.all of the above ‘The H-O model is a simplification of the a truly general equilibrium model because it deals with: a. twonations b. two commodities ¢. two factors of production *d. all of the above “51.13, The Leontief paradox refers to the empirical finding that U.S. “a, import substitutes are more K-intensive than exports b. imports are more K-intensive than exports c. exports are more L-intensive than imports 4. exports are more K-intensive than import substitutes 14, From empirical studies, we conclude that the H-O theory: a. must be rejected b, must be accepted without reservations c, can be accepted while awaiting further testing 4. explains all intemational trade 15. For factor reversal to occur, two commodities must be produced with: “a, sufficiently different elasticity of substitution of factors ‘b. the same K/L ratio . technologically-fixed factor proportions 4d. equal elasticity of substitution of factors -52-CHAPTER 6 ECONOMIES OF SCALE, IMPERFECT COMPETITION, AND INTERNATIONAL TRADE OUTLINE 6.1 Introduction 6.2. The Heckscher-Ohlin Model and New Trade Theories 6.3 Economies of Scale and Intemational Trade Case Study 6-1: The New International economies of Scale 6.4 Imperfect Competition and International Trade 6.4a Trade Based on Product Differentiation Case Study 6-2: U.S. Intra-Industry Trade in Automotive Products 6.4b Measuring Intra-Industry Trade Case Study 6-3: Growth of Intra-Industry Trade 6.4e Formal Model of Intra-Industry Trade 6.4. Another Version of the Intra-Industry Trade Model 6.5 Trade Based on Dynamic Technological Differences and Synthesis of Trade Theories 6.5a The Technological Gap and Product Cycle Models 6.5b Illustration of the Product Cycle Model Case Study 6-4: The United States as the Most Competitive Economy in the World 6.6 Transportation Costs, Environmental Standards, and International Trade 6.6 Transportation Costs and Nontraded Commodities Case Study 6-5: Tranport Costs by Country Groups 6.66 Transportation Costs and the Location of Industry Case Study 6-6: The Maquiladoras: U.S. Plants Along the U.S.-Mexican Border 6.6c Environmental Standards, Industry Location, and International Trade Case Study 6-7: Environmental Sustainability Index Appendix: 6.1 External Economies and the Patten of Trade A6.2 Dynamic External Economies and Specialization Key Terms Increasing retums to scale Transport or logistics costs Monopoly ‘Nontraded goods and services Oligopoly General equilibrium analysis Intemational economies of scale Partial equilibrium analysis External economies Resource-oriented industries Differentiated products Market-oriented industries Intra-industry trade Footloose industries, -53-Intra-industry trade index Environmental standards Monopolistic competition Dynamic external economies ‘Technological gap model Learning curve Product cycle model Infant industry ‘Lecture Guide: 1 Although not a core chapter, Sections 6.1, 6.3 and 6.4 are important ones because they present some of the most recent developments in international trade theory. I would cover sections 1, 2, and 3 in lecture 1. The material is not difficult but very important. I would also assign problems 1-3. I would cover section 4 in lecture 2. This is the most important section in the chapter. I would pay very close attention to Figures 6-2 and 6-3. These require reviewing from principles of economics, the meaning of differentiated products, monopolistic competition, economies of scale, and the determination of profit maximization by the firm. I would also assign problems 4 through 9 and go over in class problems 6 through 9. In lecture 3, I would cover sections 5 and 6 and assign problems 10 through 14. Answer to Problems: i 2. See Figure 1. See Figure 2. See Figure 3. a T=1-/1000-1000/=1-_0_ 1000+1000 2000 b. T=1-/1000-750/= 1 - 250 =0. 1000+750 1750 c. T=] -/1000-500/= 1 - 500 = 0.67. 1000+500 1500 d. T=1-/1000-25 150. 1000#250 1250 e = 11000-0/ =1 - 1000=0. 1000+0 1000 “5dFauet- /10000-1000/ = 1 -_0_ 1000+1000 2000 - /750-1000/ = 1 - 250 750+1000 1750 86. c, T=1-/500-1000/ = 1 - 500 = 0.67. 500+1000 1500 4. T=1 -/250-1000/= 1 - 750 = 0.4, 250110001250 10-1000/ = 1 - 1000= 0, 0+1000 1000 ‘Note that the results are identical to those in Problem 4 because we take the absolute value of exports minus imports or imports minus exports, 6. See Figure 4, The AC and the MC curves in Figure 4 are the same as in Figure 6-2. However, D and the corresponding MR curve are higher on the assumption that other firms have not yet imitated this firm's product, reduced its market share, or competed this firm's profits away. In Figure 4, MR=MC at point E, so that the best level of output of the firm is 5 units and price is $4.50. Since at Q=5, AC=$3.00, the firm eams a profit of AB=$2,00 per unit and $10.00 in total. 7. a. Monopolistic competition resembles monopoly because under both forms of market organization the firm produces a product that is unique (i.e., no other firm produces an identical product). b. Monopolistic competition is different from monopoly because under monopolistic competition there are many other firms that produce a similar product. On the other hand, there is no close substitute for the product sold by a monopolist. Furthermore, under monopolistic competition, entry into the industry is easy, As a result, attracted by this firm's profits, more firms enter the industry to produce similar products. This reduces the monopolistically competitive firm's market share (ie., its demand and corresponding MR curves shift down) until we get to the situation depicted by Figure 6-2 in the text, where P=AC and our firm breaks even. On the other hand, under monopoly, entry into the industry is blocked, so that the monopolist can continue to eam profits in the long run, -56-Expo Sage! Sage Foes Sage ‘Segev omtetng¢. The difference between monopoly and monopolistic competition is important for consumer welfare because consumers get a greater variety of the commodity at a lower price with monopolistic competition than with monopoly. 8. A perfectly competitive firm faces an infinitely elastic or horizontal demand curve. This means that the firm is a price taker and can sell any quantity of the homogenous product at the price determined at the intersection of the market demand and supply curves for the commodity. Both the demand curves faced by the monopolistic competitive firm and the monopolist are downward sloping, indicating that each can sell more units of the commodity by lowering its price. However, the demand curve facing the monopolistically competitive firm generally has a smaller inclination (.e., it is more elastic) than the demand curve facing the monopolist because the former sells a commodity for which many good substitute are available, 9. If the C curve had shifted down only half as much as curve C’ in Figure 6-3, the new equilibrium point would be at P=AC=$2.50 and N=350, 10, See Figure 5 on the previous page. 11. The increased pirating or production and sale of counterfeit American goods without paying royalties by foreign producers shorten the U.S. product cycle or the time during which the U.S, firm can reap the benefits from the new product or technology it introduced and thus reduces the ability of U.S. firms to engage in research and development (R & D) new product cycles. 12. See Figure 6 on the previous page. With transportation costs specialization would proceed to point C in Nation 1 and point C° in Nation 2. Pe in nation 1 (the nation exporting commodity X) is smaller than Pc’ in Nation 2 (the country importing commodity X) by the relative cost of transporting each unit of commodity X from Nation 1 to Nation 2. Trade does not seem to be in equilibrium because transportation costs are expressed in terms of commodity X. 13, See Figure 7 on the next page. P2 exceeds PI by the relative cost of transporting one unit of commodity X from Nation 1 to ‘Nation 2. 14, See Figure 8. -58-Fawe? Fopnes 468)App.1. See Figure 9. The firm's AC=AF without and BC with external economies. Thus, ata given level of output of the firm, the firm's AC are lower (i.e., the firm's AC curve shifts down) as cumulative industry output expands. App.2. Parameter "a" refers to the starting AC (i.e., the AC when output or Q is zero). Parameter "b" refers to the rate of decline in AC as cumulative industry output increases. Thus, "b" should be negative. Furthermore, the larger the absolute value of b, the more rapid is the decline in AC as cumulative industry expands over time. Multiple-Choice Questions: 1. Relaxing the assumptions on which the Heckscher-Ohlin theory rests: leads to rejection of the theory . leaves the theory unaffected *c, requires complementary trade theories any of the above. 2. Which of the following assumptions of the Heckscher-Ohlin theory, when relaxed, leave the theory unaffected? a. Two nations, two commodities, and two factors ’. both nations use the same technology ¢. the same commodity is L-intensive in both nations 4. all of the above 3. Which of the following assumptions of the Heckscher-Ohlin theory, when relaxed, require new trade theories? +a, Economies of scale b. incomplete specialization ¢. similar tastes in both nations the existence of transportation costs 4, Intemational trade can be based on economies of scale even if both nations have identical: a. factor endowments b. tastes c._ technology **d_ all of the above -60-5. A great deal of international trade: e is intra-industry trade involves differentiated products is based on monopolistic competition 4, all of the above 6. The Heckscher-Ohlin and new trade theories explains most of the trade: ‘a. among industrial countries between developed and developing countries ¢. in industrial goods *d. all of the above 7. The theory that a nation exports those products for which a large domestic market exists was advanced by: a, Linder b. Vernon c. Leontief 4. Ohlin 8. Intra-industry trade takes place: because products are homogeneous *b. in order to take advantage of economies of scale ¢. because perfect competition is the prevalent form of market organization d. all of the above 9. Ifanation exports twice as much of a differentiated product that it import, its intra-industry (T) index is equal to: a 1.00 b. 0.75 *c. 0.50 a. 0.25 10. Trade based on technological gaps is closely related to: a. the H-O theory *b, the product-cycle theory ©. Linder’s theory all of the above ‘ole11. Which of the following statements is true with regard to the product-cycle theory? a. It depends on differences in technological changes over time among countries b. it depends on the opening and the closing of technological gaps among countries c. it postulates that industrial countries export more advanced products to less advanced countries **4_ all of the above 12. Transport costs: increase the price in the importing country . reduces the price in the exporting country *c, both of the above d. neither anor b. 13, Transport costs can be analyzed: a. with demand and supply curves b. production frontiers c. offer curves *4, all of the above 14. The share of transport costs will fall less heavily on the nation: a, with the more elastic demand and supply of the traded commodity '. with the less elastic demand and supply of the traded commodity ¢. exporting agricultural products, ._ with the largest domestic market 15. A footloose industry is one in which the product: a. gains weight in processing ’. loses weight in processing ¢. both of the above +4. neither a nor b. ~62-CHAPTER 7 ECONOMIC GROWTH AND INTERNATIONAL TRADE OUTLINE 7.1 Introduction 7.2 Growth of Factors of Production 7.2a Labor Growth and Capital Accumulation Over Time 7.2 The Rybezynski Theorem 73 Technical Progress 7.3a Neutral, Labor-Saving, and Capital-Saving Technical Progress 7.36 Technical Progress and the Nation's Production Frontier Case Study 7-1: Changes in Relative Resource Endowments of Various Countries and Regions Case Study 7-2: Change in Capital-Labor Rations in Selected Countries 7.4 Growth and Trade: The Small Country Case 74a The Effects of Growth on Trade 7.4b lustration of Factor Growth, Trade, and Welfare 7.4e Technical Progress, Trade, and Welfare Case Studv 7-3: Growth of Output per Worker from Capital Deepening, Technological Change, and Improvements in Efficiency 7.5 Growth and Trade: The Large-Country Case 7.5a Growth and the Nation's Terms of Trade and Welfare 7.5 Immiserizing Growth 7.5 Ilustration of Beneficial Growth and Trade 7.6 Growth, Change in Tastes, and Trade in Both Nations 7.6 Growth and Trade in Both Nations 7.6b Change in Tastes and Trade in Both Nations Case Study 7-4: Change in the Revealed Comparative Advantage of Various Countries or Regions Case Study 7-5: Growth, Trade, and Welfare in the Leading Industrial Nations Appendix: A7.1 Formal Proof of Rybezynski Theorem 7.2 Growth with Factor Immobility A73 Graphical Analysis of Hicksian Technical Progress Terms ‘Comparative statics Antitrade production and consumption Dynamic analysis ‘Neutral production and consumption Balanced growth Normal goods Rybezynski theorem Inferior goods Labor-saving technical progress Terms-of-trade effect Capital-saving technical progress Wealth effect Protrade production and consumption Immiserizing growth PeasLecture Guide 1. This is not a core chapter and it is one of the most challenging chapters in international trade theory. It is included for more advanced students and for completeness. 2. If I were to cover this chapter, I would present two sections in each of three lectures. Time permitting, I would, otherwise cover Sections 1 and 2, paying special attention to the Rybezynski theorem. Answer to Problems 1. a. See Figure 1. b. See Figure 2 c. See Figure 3. 2. See Figure 4. 3. a. See Figure 5. b. See Figure 6. ©. See Figure 7. 4. Compare Figure 5 to Figure 1. Compare Figure 6 to Figure 3, Note that the two production frontiers have the same vertical or Y intercept in Figure 6 but a different vertical or Y intercept in Figure 3. ‘Compare Figure 7 to Figure 2. Note that the two production frontiers have the same horizontal or X intercept in Figure 7 but a different horizontal or X intercept in Figure 2. ‘See Figure 8 on page 66. See Figure 9. See Figure 10. See Figure 11 ee NaH See Figure 12. 10. See Figure 13 on page 67. 11, See Figure 14. 12. See Figure 15. 13. The United States has become the most competitive economy in the world since the early 1990°s while the data in Table 7.3 refers to the 1965-1990 period. 64.y Y = » : y w . 8 ° ° - ° * wee «iF rom Fema Fos y ae oa 280 y © rn ° ° - 0 ® ar ar fom $ fees fem?FiresFue 1314. The data in Table 7.4 seem to indicate that China had a comparative advantage in capital- intensive commodities and a comparative disadvantage in unskilled-labor intensive commodities in 1973. This was very likely due to the many trade restrictions and subsidies which distorted the comparative advantage of China. Its true comparative advantage became evident by 1993 after China had started to liberalize its economy. App.l. a. See Figure 16. . For production and consumption to actually occur at the new equilibrium point after the doubling of K in Nation 2 we must assume either that commodity X is inferior the that Nation 2 is 00 small to affect the relative commodity prices at which it trades. c. Px/Py must rise (ie., Py/Px must fall) as a result of growth only. Px/Py will fall even more with trade. App.2. If the supply of capital increases in Nation 1 in the production of commodity Y only, the VMPLy curve shifis up, and w rises in both industries. Some labor shifts to the production of Y, the output of Y rises and the output of X falls, r falls, and Px/Py is likely to rise. App.3. Capital investments tend to increase real wages because they raise the K/L ratio and the productivity of labor. Technical progress tends to increase K/L and real wages if it is L- saving and to reduce K/L and real wages if it is K-saving. Mul 1e-Choice Questions 1. Dynamic factors in trade theory refer to changes in: a. factor endowments b. technology c.. tastes ‘+d. all of the above 2. Doubling the amount of L and K under constant retums to scale: a. doubles the output of the L-intensive commodity b. doubles the output of the K-intensive commodity . leaves the shape of the production frontier unchanged *d. all of the above. 3. Doubling only the amount of L available under constant returns to scale: a. less than doubles the output of the L-intensive commodity *b, more than doubles the output of the L-intensive commodity ¢. doubles the output of the K-intensive commodity leaves the output of the K-intensive commodity unchanged -68-Fun 16 69|. The Rybezynski theorem postulates that doubling L at constant relative commodity prices: a. doubles the output of the L-intensive commodity b, reduces the output of the K-intensive commodity cc. increases the output of both commodities 4. any of the above Doubling L is likely to: a. increases the relative price of the L-intensive commodity . reduces the relative price of the K-intensive commodity *c, reduces the relative price of the L-intensive commodity dd. any of the above . Technical progress that increases the productivity of L proportionately more than the productivity of K is called: *a, capital saving b. labor saving ¢. neutral d._ any of the above . A 50 percent productivity increase in the production of commodity Y: a. increases the output of commodity Y by 50 percent b. does not affect the output of X ¢._ shifts the production frontier in the Y direction only 4, any of the above 3. Doubling L with trade in a small L-abundant nation: *a, reduces the nation's social welfare b. reduces the nation’s terms of trade ¢. reduces the volume of trade d._all of the above ). Doubling L with trade in a large L-abundant nation: a._reduces the nation’s social welfare b. reduces the nation's terms of trade c. reduces the volume of trade *d. all of the above10. If, at unchanged terms of trade, a nation wants to trade more after growth, then the nation’s terms of trade can be expected to: +a, deteriorate improve remain unchanged any of the above aos 11. A proportionately greater increase in the nation's supply of labor than of capital is likely to result ina deterioration in the nation’s terms of trade if the nation exports: a. the K-intensive commodity *b, the L-intensive commodity c. either commodity 4. both commodities 12, Technical progress in the nation’s export commodity: a. may reduce the nation’s welfare will reduce the nation's welfare ¢. will increase the nation's welfare d._ leaves the nation’s welfare unchanged 13. Doubling K with trade in a large L-abundant nation: increases the nation’s welfare improves the nation's terms of trade c. reduces the volume of trade *4_ all of the above 14. An increase in tastes for the import commodity in both nations: a. reduces the volume of trade *b, increases the volume of trade ¢. leaves the volume of trade unchanged d._any of the above 15. An increase in tastes of the import commodity of Nation A and export in B: *a. will reduce the terms of trade of Nation A. . will increase the terms of trade of Nation A. ¢._ will reduce the terms of trade of Nation B d._ any of the above nlADDITIONAL ESSAYS AND PROBLEMS FOR PART ONE 1. Assume that both the United States and Germany produce beef and computer chips with the following costs: United States Germany (dollars) (marks) Unit cost of beef (B) 2 8 Unit cost of computer chips (C) 1 2 (@) What is the opportunity cost of beef (B) and computer chips (C) in each country? (b) In which commodity does the United States have a comparative cost advantage? What about Germany? (©) What is the range for mutually beneficial trade between the United States and Germany for each computer chip traded? (@ How much would the United States and Germany gain if | unit of beef is exchanged for 3 chips? ‘Ans. (a) Inthe United States: the opportunity cost of one unit of beef is 2 chips; the opportunity cost of one chip is 1/2 unit of beef. In Germany: the opportunity cost of one unit of beef is 4 chips; the opportunity cost of one chip is 1/4 unit of beef. (b) The United States has a comparative cost advantage in beef with respect to Germany, while Germany has a comparative cost advantage in computer chips. (c) The range for mutually beneficial trade between the United States and Germany for each unit of beef that the United States exports is 2C<1B<4C (d) Both the United States and Germany would gain 1 chip for each unit of beef traded.2. Given: (1) two nations (1 and 2) which have the same technology but different factor ‘endowments and tastes, (2) two commodities (X and Y) produced under increasing costs conditions, and (3) no transportation costs, tariffs, or other obstructions to trade, Prove geometrically that mutually advantageous trade between the two nations is possible. Note: Your answer should show the autarky (no-trade) and free-trade points of production and consumption for each nation, the gains from trade of each nation, and express the equilibrium condition that should prevail when trade stops expanding.) ‘Ans. See Figure 1 on page 74. Nations 1 and 2 have different production possibilities curves and different community indifference maps. With these, they will usually end up with different relative commodity prices in autarky, thus making mutually beneficial trade possible. In the figure, Nation 1 produces and consumes at point A and Px/Py=P, in autarky, while Nation 2 produces and consumes at point A’ and Px/Py=Py. Since Px A since it involves more of both X and Y and lies on a higher community indifference curve. Nation 2 starts at A’ in production and consumption in autarky, moves to point B' in production, and by exchanging B'C' of Y for CE’ of X reaches point E'in consumption (which exceeds A’). At Px/Py=Pp=Pa, Nation 1 wants to export BC of X for CE of Y, while Nation 2 wants to export BC’ (=CE) of Y for CE’ (=BC) of X. Thus, Pp=Pp is the equilibrium relative commodity price because it clears both (the X and Y) markets. 3. Draw a figure showing: (1) in Panel A a nation's demand and supply curve for a traded commodity and the nation's excess supply of the commodity, (2) in Panel C the trade partner's demand and supply curve for the same traded commodity and its excess demand for the commodity, and (3) in Panel B the supply and demand for the quantity traded of the commodity, its equilibrium price, and why a price above or below the equilibrium price will not persist. At any other price, QD # QS, and P will change to P>. Ans, See Figure 2 on page 74, The equilibrium relative commodity price for commodity X (the traded commodity exported by Nation 1 and imported by Nation 2) is P2 and the equilibrium quantity of commodity X traded is Qh. “TBPhy PANEL A Phy PANEL Py PANEL 144, (a) Identify the conditions that may give rise to trade between two nations. (b) What are some of the assumptions on which the Heckscher-Ohlin theory is based? (©) What does this theory say about the pattern of trade and effect of trade on factor prices? Ans. (a) Trade can be based on a difference in factor endowments, technology, of tastes between two nations. A difference either in factor endowments or technology results in a different production possibilities frontier for each nation, which, unless neutralized by a difference in tastes, leads to a difference in relative commodity price and mutually beneficial trade. If two nations face increasing costs and have identical production Possibilities frontiers but different tastes, there will also be a difference in relative commodity prices and the basis for mutually beneficial trade between the two nations. The difference in relative commodity prices is then translated into a difference in absolute commodity prices between the two nations, which is the immediate cause of wade. (b) The Heckscher-Ohlin theory (sometimes referred to as the modem theory — as opposed to the classical theory - of intemational trade) assumes that nations have the same tastes, use the same technology, face constant retums to scale (i.e, a given percentage increase in all inputs increases output by the same percentage) but differ widely in factor endowments. It also says that in the face of identical tastes or demand conditions, this difference in factor endowments will result in a difference in relative factor prices between nations, which in tum leads to a difference in relative commodity prices and trade. Thus, in the Heckscher-Ohlin theory, the intemational difference in supply conditions alone determines the pattern of trade. To be noted is that the two nations need not be identical in other respects in order for international trade to be based primarily on the difference in their factor endowments. (©) The Heckscher-Ohlin theorem postulates that each nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factor. As an important corollary, it adds that under highly restrictive assumptions, trade will completely eliminate the pretrade relative and absolute differences in the price of homogeneous factors among nations. Under less restrictive and more usual conditions, however, trade will reduce, but not eliminate, the pretrade differences in relative and absolute factor prices among nations. In any event, the Heckscher-Ohlin theory does say something very useful on how trade affects factor Prices and the distribution of income in each nation. Classical economists were practically silent on this point. ETS5. Suppose that tastes change in Nation 1 (the L-abundant and L-cheap nation) so that consumers demand more of commodity X (the L-intensive commodity) and less of commodity Y (the K- intensive commodity). Suppose that Nation 1 is India, commodity X is textiles, and commodity Y is food. Starting from the no-trade equilibrium position and using the Heckscher-Ohlin model, trace the effect of this change in tastes on India's (a) relative commodity prices and demand for food and textiles, (b) production of both commodities and factor prices, and (c) comparative advantage and volume of trade. (d) Do you expect international trade to lead to the complete equalization of relative commodity and factor prices between India and the United States? Why? Ans. (a) The change in tastes can be visualized by a shift toward the textile axis in India's indifference map in such a way that an indifference curve is tangent to the steeper segment of India's production frontier (because of increasing opportunity costs) after the increase in demand for textiles. This will cause the pretrade relative commodity price of textiles to rise in India, (b) The increase in the relative price of textiles will lead domestic producers in India to shift labor and capital from the production of food to the production of textiles. Since textiles are L-intensive in relation to food, the demand for labor and therefore the wage rate will rise in India. At the same time, as the demand for food falls, the demand for and thus the price of capital will fall. With labor becoming relative more expensive, producers in India will substitute capital for labor in the production of both textiles and food. (©) Even with the rise in relative wages and in the relative price of textiles, India still remains the L-abundant and low-wage nation with respect to a nation such as the United States. However, the pretrade difference in the relative price of textiles between India and the United States is now somewhat smaller than before the change in tastes in India. Asa result the volume of trade required to equalize relative commodity prices and hence factor prices is smaller than before. That is, India need now export a smaller quantity of textiles and import less food than before for the relative price of textiles in India and the United States to be equalized. Similarly, the gap between real wages and between India and the United States is now smaller and can be more quickly and easily closed (i.., with a smaller volume of trade). (@) Since many of the assumptions required for the complete equalization of relative commodity and factor prices do not hold in the real world, great differences can be expected and do in fact remain between real wages in India and the United States. Nevertheless, trade would tend to reduce these differences, and the H-O model does identify the forces that must be considered to analyze the effect of trade on the differences in the relative and absolute commodity and factor prices between India and the United States. -16-6. (a) Explain why the Heckscher-Ohlin trade model needs to be extended. (b) Indicate in what important ways the Heckscher-Ohlin trade model can be extended. (©) Explain what is meant by differentiated products and intra-industry trade. Ans. (a) The Heckscher-Ohlin trade model needs to be extended because, while generally correct, it fails to explain a significant portion of international trade, particularly the ‘ade in manufactured products among industrial nations. (b) The international trade left unexplained by the basic Heckscher-Ohlin trade model can be explained by (1) economies of scale, (2) intra-industry trade, and (3) trade based on imitation gaps and product differentiation. (©) Differentiated products refer to similar, but not identical, products (such as cars, typewriters, cigarettes, soaps, and so on) produced by the same industry or broad product group. Intra-industry trade refers to the international trade in differentiated products. -17-CHAPTER 8 TRADE RESTRICTIONS: TARIFFS OUTLINE *8.1 Introduction *8.2 Partial Equilibrium Analysis of a Tariff Case Study 8-1: Average Tariff on Industrial Products in Major Developed Countries Case Study 8-2: Average Tariff on Industrial Products in Some Major Developing Countries 8.2a Partial Equilibrium Effects of a Tariff 8.2b Effects of a Tariff on Producer and Consumer Surplus 8.2c Costs and Benefits of a Tariff Case Study 8-3: The Welfare Effects of Liberalizing Trade in Some U.S. Products Case Study 8-4: The Welfare Effects of Liberalizing Trade in Some EU Products *8.3 The Theory of Tariff Structure 8.3a The Rate of Effective Protection 8.3b Generalization and Evaluation of the Theory of Effective Protection Case Study 8-5: Rising Tariff Rates with Degree of Domestic Processing Case Study 8-6: Structure of Tariffs on Industrial Products in U.S., EU, Japan and Canada 8.4 General Equilibrium Analysis of a Tariff in a Small Country 8.4a General Equilibrium Effects of a Tariff in a Small Country 8.4b Illustration of the Effects of a Tariff in a Small Country 8.4 The Stolper-Samuelson Theorem 8.5 General Equilibrium Analysis of a Tariff in a Large Country 8.5a General Equilibrium Effects of a Tariff in a Large Country 8.5b Illustration of the Effects of a Tariff in a Large Country 8.6 The Optimum Tariff 8.6a The Meaning of the Concept and Retaliation 8.6b Illustration of the Optimum Tariff and Retaliation. Appendix: 8.1. Partial Equilibrium Effects of a Tariff in a Large Nation ‘A8.2 Derivation of the Formula for the Rate of Effective Protection A8.3. The Stolper-Samuelson Theorem Graphically 8.4. Exception to the Stolper-Samuelson Theorem - The Metzler Paradox A8.5Short-run Effect of a Tariff on Factors’ Income A8.6 Measurement of the Optimum Tariff -78-Key Terms Trade or commercial policies Consumer surplus Import tariff Rent or producer surplus Export tariff Protection cost or deadweight loss of a tariff ‘Ad valorem tariff Nominal tariff Specific tariff Rate of effective protection Compound tariff Domestic value added Consumption effect of a tariff Prohibitive tariff Production effect of a tariff Stolper-Samuelson theorem Trade effect of a tariff Metzler paradox Revenue effect of a tariff Optimum tariff Lect juide 1. Iwould cover sections 1 and 2 and assign problems 1-2 in the first lecture. The most difficult part of section 2 is the meaning and measurement of consumer and producer surplus. Since a clear understanding of the meaning and measurement of consumer and producer surplus is crucial in evaluating the effect of tariffs, I would explain these concepts very carefully. 2. I would then cover section 3 and assign problems 3-6 in the second lecture. The theory of tariff structure is also very difficult and important, and so I would also explain this concept very carefully. I found that the best way to explain it is by using the simple example used in the text of the suit with and without imported inputs. 3. The rest of the chapter can be skipped without loss of continuity by those Instructors who do not wish to cover the general equilibrium effects of tariffs. 4. For those Instructors who wish to cover the rest of the chapter, I would take up another two lectures to do so. I would also assign and grade problems 8-14 to make sure that students understand the material. 5. In covering section 8.4, I would pay special attention to the explanation of Figure 8-5 and to the Stolper-Samuelson theorem. 6. In covering Section 8.6, please note that the optimum tariff can only be discussed intuitively without trade indifference curves (examined in Appendix A8.6). -19-Answer to Problems 1. a. Consumption is 70Y, production is 10Y and imports are 60Y (see Figure 1 on the next page). b. Consumption is 60Y, production is 20Y and imports are 40Y (see Figure 1). ¢. The consumption effect is -10Y, the production effect is +10Y, the trade effect is -20Y and the revenue effect is $40 (see Figure 1). 2. a. The consumer surplus is $245 without and $180 with the tariff (see Figure 1). b. Of the increase in the revenue of producers with the tariff (as compared with their revenues under free trade), $15 represents the increase in production costs and another $15 represents the increase in rent or producer surplus (see Figure 1). ¢. The dollar value or the protection cost of the tariff is $10 (see Figure 1). 3. This will increase the rate of effective protection in the nation. 4. g=0.4- (0.50.4) = 0.4 -0.2=0.2= 40% 1.0-0.5 05 (05 260% 880% 0 8=20% pose 6. a. g=70% b. See the first paragraph of section 8.36. 7. See Figure 2. 8. When Nation 1 (assumed to be a small nation) imposes an import tariff on commodity Y, the real income of labor falls and that of capital rises. 9, Py/Px rises for domestic producers and consumers. As production of Y (the K-intensive commodity) rises and that of X falls, the demand and income of K rises and that of L falls. Therefore, r rises and w falls. 10. If Nation 1 were instead a large nation, then Nation 1's terms of trade rise and the real income of L may also rise. -80-> h 8111. India is more likely to restrict imports of K-intensive commodities in which India has a comparative disadvantage and this is likely to increase the return to capital and reduce the retum to labor according to the Stolper-Samuelson theorem. 12, See Figure 3 on the previous page 13, See Figure 4, 14. The volume of trade may shrink to zero (the origin of offer curves). App.. App.2. App.3. App.4. App.s. App.6 The more elastic Sy and Sr are, the lower is the free trade price of the commodity and the lower is the increase in the domestic price of the commodity as a result of the tariff. a. The supply curve of the nation for the commodity shifts up and to the left (as with the imposition of any tax); this does not affect the consumption of the commodity with free trade, but it reduces domestic production and increases imports of the commodity; it also increases the revenue effect and reduces producers’ surplus. b. The imposition of a tariff on imported inputs going into the domestic production of the commodity will have no effect on the size of the protection cost or deadweight loss. See Figure 5 (on the next page). |. See Figure 6. Real w will fall in terms of Y and rise in terms of X. On the other hand, real r will rise in terms of Y and fall in terms of X. This can be seen by drawing a figure similar to Figure 8-10, but with the VMPLy curve shifting upward. a, See Figure 7. b. After Nation 1 has imposed an optimum tariff and Nation 2 has retaliated with an optimum tariff of its own, the approximate terms of trade for Nation 1 is 0.8, while the approximate terms of trade of Nation 2 is 1.25. c. Nation I's welfare declines from the reduction in the volume and in the terms of trade. Although nation 2's terms of trade are higher than under free trade, the volume of trade has shrunk so much that nation 2's welfare is also likely to be lower than under free trade. -82-Fu FoesMultiple-choice Questions 1. Which of the following statements is incorrect? a. Anad valorem tariff is expressed as a percentage of the value of the traded commodity. b. aspecific tariff is expressed as a fixed sum of the value of the traded commodity. ¢. export tariffs are prohibited by the U.S. Constitution *d. The U.S. uses exclusively the specific tariff 2. A small nation is one: a. which does not affect world price by its trading b. which faces an infinitely elastic world supply curve for its import commodity €. whose consumers will pay a price that exceeds the world price by the amount of the tariff *d. all of the above 3. Ifa small nation increases the tariff on its import commodity, a. consumption of the commodity increases b. production of the commodity decreases ¢._ imports of the commodity increase 4, none of the above 4. The increase in producer surplus when a small nation imposes a tariff is measured by the area: *a. to the left of the supply curve between the commodity price with and without the tariff b. under the supply curve between the quantity produced with and without the tariff . under the demand curve between the commodity price with and without the tariff d. none of the above. 5. Ifa small nation increases the tariff on its import commodity: *a. the rent of domestic producers of the commodity increases b. the protection cost of the tariff decreases c. the deadweight loss decreases d. all of the above10. Which of the following statements ii incorrect with respect to the rate of effective protection? a. for given values of ai and ti, g is larger the greater is t b. fora given value of t and ti, g is larger the greater is a, ¢. gexceeds, is equal to or is smaller than t, ast; is smaller than, is equal to or is larger than t *d. when att exceeds t, the rate of effective protection is po: With a=: 10%, t=0, and t=20%, g is: a. 40% b. 20% c. 80% do . The imposition of an import tariff by a small nation: “a, increases the relative price of the import commodity for domestic producers and consumers b. reduces the relative price of the import commodity for domestic producers and consumers . increases the relative price of the import commodity for the nation as a whole d._ any of the above is possible The imposition of an import tariff by a small nation: a. increases the nation's welfare *b. reduces the nation's welfare c. leaves the nation's welfare unchanged d. any of the above is possible According to the Stolper-Samuelson theorem, the imposition of a tariff by a nation: ‘a. increases the real return of the nation's abundant factor **b. increases the real return of the nation's scarce factor c. reduces the real return of the nation's scarce factor d._any of the above is possible . The imposition of an import tariff by a nation results in: a. an increase in relative price of the nation’s import commodity b. an increase in the nation's production of its importable commodity c. reduces the real return of the nation's abundant factor *d. _alllof the above -85-12, The imposition of an import tariff by a nation can be represented by a rotation of the: ‘a. nation's offer curve away from the axis measuring the commodity of its comparative advantage b. the nation's offer curve toward the axis measuring the commodity of its comparative advantage ¢. the other nation’s offer curve toward the axis measuring the commodity of its comparative advantage 4. the other nation's offer curve away from the axis measuring the commodity of its comparative advantage 13. The imposition of an import tariff by a large nation: a. increases the nation’s terms of trade b. reduces the volume of trade c. may increase or reduce the nation's welfare *d_ all of the above 14, The imposition of an optimum tariff by a large nation: a, improves its terms of trade b. reduces the volume of trade c._ increases the nation's welfare *d,all of the above 15, The optimum tariff for a small nation is: a. 100% b. 50% *c.0 d. depends on elasticities*CHAPTER 9 (Core Chapter) NONTARIFF TRADE BARRIERS AND THE NEW PROTECTIONISM OUTLINE 9.1 Introduction 9.2 Import Quotas 9.2a Effects of an Import Quota 9.2b Comparison of an Import Quota to an Import Tariff 9.3 Other Nontariff Barriers and the New Protectionism 9.3a Voluntary Export Restraints Case Study 9-1: Voluntary Export Restraints on Japanese Autos to the United States 9.3b Technical, Administrative, and Other Regulations 9.3c International Cartels 93d Dumping Case Study 9-2: Antidumping Measures in Force in 2001 9.3e Export Subsidies Case Study 9-3: Agricultural Subsidies in Developed Nations Case Study 9-4: Countervailing Measures in Force in 2001 Case Study 9-5: The Pervasiveness of Nontariff Barriers 9.4 The Political Economy of Protectionism 9.4a Fallacious and Questionable Arguments for Protection 9.4b Infant-Industry and Other Qualified Arguments for Protection 9.4c Who Gets Protected? 9.5 Strategic Trade and Industrial Policies 9.5 Strategic Trade Policy Case Study 9-6: Welfare Effects on the U.S. Economy of Removing All Import Restraints 9.5 Strategic Trade and Industrial Policies with Game Theory 9.5¢ The U.S. Response to Foreign Industrial Targeting and Strategic Trade Policy 9.6 History of U.S. Commercial Policy 9.6a The Trade Agreements Act of 1934 9.6b The General Agreements on Tariffs and Trade (GATT) 9.6c The 1962 Trade Agreements Act and the Kennedy Round 9.6d The Trade Reform Act of 1974 and the Tokyo Round 9.6e The 1984 and 1988 Trade Acts 9.7 ‘The Uruguay Round and Outstanding Trade Problems 9.7a The Uruguay Round -87-Case Study 9-7: Gains from the Uruguay Round Case Study 9-8: The Multilateral Rounds of Trade Negotiations 9.7 Outstanding Trade Problems Case Study 9-9: International trade and the Anti-Globalization Movement ‘Appendix: A9.1 Centralized Cartels 9.2 International Price Discrimination A9.3 Tariffs, Subsidies and Domestic Goals Key Terms Quota ‘Smoot-Hawley Tariff Act of 1930 Nontariff trade barrier (NTBs) Trade Agreements Act of 1934 ‘New protectionism Most-favored-nation principle Voluntary export restraints (VERs) Bilateral Trade Technical, administrative, and General Agreement on Tariff and other regulations Trade (GATT) International cartel Multilateral Trade Negotiations Dumping International Trade Organization (ITO) Persistent dumping Peril-point provisions Predatory dumping Escape clause Sporadic dumping ‘National security clause Trigger-price mechanism ‘Trade Expansion Act of 1962 Export subsidies Trade Adjustment Assistance (AA) Export-Import bank Kennedy Round Foreign Sales Corporations ‘Trade Reform Act of 1974 Countervailing duties (CVDs) Tokyo Round Scientific tariff Trade and Tariff Act of 1984 Infant-industry argument Omnibus Trade and Competitiveness Act of 1988 Strategic trade policy ‘Uruguay Round Industrial Policy World Trade Organization (WTO) Game theory Globalization Anti-Globalization Movement Lecture Guide: 1. This is an important core chapter examining some of the most recent developments in international trade policy. 2. I would cover sections 1 and 2 in lecture 1. I would pay particular attention to Figure 9-1, which examines the partial equilibrium effects of an import quota. 3. I would cover section 3 in lecture 2. Here I would clearly explain the difference between a regular import quota and a voluntary export restraint. I would also clearly explain dumping and Figure 9-2 (which deals with export subsidies). The five case studies serve to highlight the theory and show the relevance of the theory in today’s world. -88-4. I would cover section 4 in lecture 3. Here I would give special attention to the fallacious arguments for protection since they are often heard in common discussions of trade matters. | would also clearly explain the importance of strategic trade and industrial policy and the political economy of who gets protected. 5. I would cover section 5 in lecture 4, which examines strategic trade and industrial policies with game theory. This is not difficult and the students will find it very interesting. 6. Sections 6 and 7 can be covered in lecture 5, Here I would stress the Uruguay Round and the outstanding intemational trade problems. Answer to Problems: 1. Nations restrict trade either in response to lobbying by the producers of a commodity in which the nation has a comparative disadvantage or to gain a strategic advantage in relation to other nations. The first leads to a welfare loss for the nation as a whole. The second is very difficult to achieve. 2. The partial equilibrium effects of the import quota are: P,=$1.50; consumption is 45X, of which 5X are produced domestically; by auctioning off import licenses, the revenue effect would be $15. 3. The partial equilibrium effects of the import quota are: .50; consumption is 40X, of which 10X are produced domestically; the revenue effect is $45, 4. The partial equilibrium effects of the quota are: P,=$2; domestic production and consumption are 50X; The revenue is zero. 5. The partial equilibrium effects of the quota are: P,=S1; consumption is 70X, production is 30X, and revenue is zero, 6. The partial equilibrium effects of a negotiated export quota of 30X are: P.=$4; domestic production is 40X, of which 10X are consumed at home. 7. An export tariff or quota, as an import tariff or quota, affects the price of the commodity and domestic consumption and production. But the effects are the opposite. 8. See Figure 1. The equilibrium price of the commodity is P,=OC and the equilibrium quantity is Q.OB in Figure 1. -89-gg Figue2 Fons9. Ifthe supply curve of the commodity in Figure 1 referred to a cartel of exporters acting as a monopolist, P,=OF and Q.=OA (see Figure 1). 10. Py is higher and Q, smaller when exporters behave as a monopolist. la. ‘The monopolist should charge P=! Appendix A9.2. 4 in the domestic market and P2=$3 in Figure 9-5 in This represents the best, or optimal distribution of sales between the two markets because any other distribution of sales in the two markets gives less revenue. 12. See Figure 2. To the left of point A, the domestic firm faces higher long-run average costs of production (LACp) than the foreign firm (LAC;). To the right of point A the opposite is the case. a. 14, App.1 App.2. App.3. If the entries in the top left-hand corner of Table 9-5 were changed to +10, +10, then both Boeing and Airbus would produce the aircraft without any subsidy, and so no strategic trade and industrial policy would be needed in the U.S. or Europe. If the entries in the top left-hand comer of Table 9-5 were changed to +5, +0, then both Boeing and Airbus would produce the aircraft without any subsidy, and so no strategic trade and industrial policy would be needed in the U.S. or Europe. ‘Note that even though Airbus only breaks even, in economics we include a normal retum ‘on investment as part of costs. Thus, Airbus would remain in business because it would eam a normal retum on investment. If the entries in the top lefi-hand corner of Table 9-5 were changed to +5, -10, then both Boeing produces and Airbus does not produce without any subsidy. With a subsidy of at least $10 million per year, however, Airbus would enter the market and lead to a loss of $100 million for Boeing unless the U.S. government would provide a subsidy of at least $5 million per year to Boeing. ‘The answers to parts (a) and (b) are presented in Appendix A9.3. . See Figure 3 on page 90. In order to maximize to maximize total profits the domestic monopolist practicing international price discrimination should sell at the price of Py=$20 in the domestic market and at the price of Pj=$15 in the foreign market, By imposing a 100% tax on the production of commodity X and giving it as a subsidy to producers of commodity Y. 91.Multiple-choice Questions: 1. An import quota: increases the domestic price of the imported commodity reduces domestic consumption increases domestic production 'd. all of the above pose 2. An increase in the demand of the imported commodity subject to a given import quota: a. reduces the domestic quantity demanded of the commodity *b. increases the domestic production of the commodity ¢. reduces the domestic price of the commodity 4. reduces the producers’ surplus 3. Adjustment to any shift in the domestic demand or supply of an importable commodity ocet a. in domestic price with an import quota b. in the quantity of imports with a tariff ¢. through the market mechanism with an import tariff but not with an import quota *d.all of the above 4, An international cartel refers to: a. dumping *b. an organization of exporters ¢. an international commodity agreement . voluntary export restraints 5. The temporary sale of a commodity at below cost or at a lower price abroad in order to drive foreign producers out of business is called: *a, predatory dumping b. sporadic dumping ©. continuous dumping 4. voluntary export restraints -92-6. The type of dumping which would justify antidumping measures by the country subject to the dumping is: *a, predatory dumping b. sporadic dumping €. continuous dumping 4. all of the above 7. A fallacious argument for protection is: a. the infant industry argument b. protection for national defense *c, the scientific tariff 4. to correct domestic distortions 8, Which of the following is true with respect to the infant-industry argument for protection? a. it refers to temporary protection to establish a domestic industry . to be valid, the return to the grown-up industry must be sufficiently high also to repay for the higher prices paid by domestic consumers of the commodity during the infancy period ¢._ is inferior to an equivalent production subsidy to the infant industry 4. all of the above 9. Which of the following is false with respect to strategic trade policy? a. it postulates that a nation can gain by an activist trade policy *b. it is practiced to some extent by most industrial nations ¢. ittcan easily be carried out d._all of the above 10. Industrial policy refers to: a. an activist policy by the government of an industrial country to stimulate the development ofan industry b. the granting of a subsidy to a domestic industry to stimulate the development of an industry c. the granting of a subsidy to a domestic industry to counter a foreign subsidy *4. all of the above 11. Game theory refers to: ‘ta, a method of choosing the optimal strategy in conflict situations b. the granting of a subsidy to correct a domestic distortion ¢. the theory of tariff protection d._ none of the above -93-12, Trade protection in the United States is usually provided to: a. low-wage workers b. well-organized industries with large employment c. industries producing consumer products 4. all of the above 13, The most-favored-nation principle refers to: a, extension to all trade partners of any reciprocal tariff reduction negotiated by the U.S. with any of its trade partners b, multilateral trade negotiation ¢. the General Agreement on Tariffs and Trade 4. the International Trade Organization 14, On which of the following principles does GATT rest? a. nondiscrimination b. elimination of nontariff barriers . consultation among nations in solving trade disputes “4, all of the above 15. Which of the following was not negotiated under the Uruguay Round? a. reduction of tariffs on industrial goods . replacement of quotas with tariffs ¢. reduction of subsidies on industrial products and on agricultural exports 4, liberalization in trade in most services -94-CHAPTER 10 ECONOMIC INTEGRATION: CUSTOMS UNIONS AND FREE TRADE AREAS OUTLINE 10.1. Introduction 10.2 Trade-Creating Customs Unions 10.2a Trade Creation 10.2b Illustration of a Trade-Creating Customs Union 10.3 Trade-Diverting Customs Unions 10.3a Trade Diversion 10.3b Illustration of a Trade-Diverting Customs Union 10.4 The Theory of the Second Best and Other Static Welfare Effects 10.4a The Theory of the Second Best 10.46 Conditions More Likely to Lead to Increased Welfare 10.4¢ Other Static Welfare Effects of Customs Unions 10.5 Dynamic Benefits of Customs Unions *10.6 History of Attempts at Economic Integration 10.6a The European Union Case Study 10-1: Economic Profile of the EU, NAFTA, and Japan Case Study 10-2: Gains from the Single EU Market 10.66 The European Free Trade Association 10.6c U.S. Free Trade Agreements and North American Free Trade Agreement Case Study 10-3: Macroeconomic Estimates of Mexico's Gains from NAFTA, 10.6d_Attempts at Economic Integration Among Developing Nations Case Study 10-4: Economic Profile of Mercosur ‘Case Study 10-5: Changes in Trade Patterns with Economic Integration 3444 10.6e Economic Integration in Central, Eastern Europe & Former Soviet Republics Case Study 10-6: Per Capita Income of Transition Economies Appendix: A10.1 General Equilibrium Analysis of Static Effects of a Trade-Diverting Customs Union ‘A10.2 Postwar Chronology of Regionalism * Core Section Key Terms Economic integration Variable import levies Preferential trade arrangements European Free Trade Association (EFTA) Free-trade area Trade deflection Customs union North American Free Trade Agreement (NAFTA) ‘Common market Southemn Common Market (Mercosur) Economic union Council of Mutual Economic Assistance (CMEA) Duty-free zones State trading companies Trade creation Bilateral agreements Trade diversion Bulk purchasing Trade-diverting customs union Central and Eastern European Countries (CEEC) Theory of the second best New Independent States (NIS) Tariff factories Commonwealth of Independent States (CIS) European Union (EU) Central European Free Trade Association (CEFTA) Baltic States Free Trade Area (BAFTA) -95-Lecture Guide: 1. This is not a core chapter and I would skip it except for section 6. Section 6 is an important section and can be regarded as an extension of Chapter 9, which is a core chapter. Section 6 deals with a very important set of current events. 2. Section 6 is a long section and may require two classes to be adequately presented. I would cover subsections a-d in one class and subsection ¢ as well as both case studies in the second class. Case Studies 10-1 to 10-6 can be used for a very stimulating class discussion. 3. While section 6 can be presented without covering the material in sections 1-5, some terms discussed in sections 1-5 (such as trade creation and trade diversion) need to be defined. 4. In a one-year course in international economics, I would cover the entire chapter. I would then cover sections 10-1 to 10-3 in one class and sections 10-4 and 10-5 in the second class. In the first class, the most important aspect would be the presentation and clear explanation of Figures 10-1 and 10-2. Answers to Problems: 1. If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X from Nation B and Nation C, Nation A will produce commodity X domestically because the domestic price of commodity X is $10 as compared with the tariff-inclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C. 2. a, If Nation A forms a customs union with Nation B, Nation A will import commodity X from Nation B at the price of $8 instead of producing it itself at $10 or importing it from Nation C at the tariff-inclusive price of $12. . When Nation A forms a customs union with Nation B this would be a trade-creating customs union because it replaces domestic production of commodity X at Px=810 with tariff-free imports of commodity X from Nation B at Px=$8, 3. If Nation A imposes a 50 percent ad valorem tariff on imports of commodity X from Nation B and Nation C, Nation A will import commodity X from nation C at the tariff-inclusive price of $9 instead of producing commodity X itself or importing it from Nation B at the tariff-inclusive price of $12. 4. a. If Nation A forms a customs union with Nation B, Nation A will import commodity X from Nation B at the price of $8 instead of importing it from Nation C at the tariff- inclusive price of $9. -96-b. When Nation A forms a customs union with Nation B this would be a trade-diverting customs union because it replaces lower-price imports of commodity X of $6 (from the point of view of Nation A as a whole) with higher priced imports of commodity X from Nation B at $8, Specifically, Nation A's importers do not import commodity X from Nation C because the tariff-inclusive price of commodity X from Nation C is $9 as compared with the no- tariff price of $8 for imports of commodity X from Nation B. However, since the government of Nation A collects the $3 tariff per unit on imports of commodity X from Nation C, the net effective price for imports of commodity X_ from Nation C is really $6 for Nation A as a whole. 5. See Figure 10-1 in the text. Any figure similar to Figure 10-1 in the text would do. 6. The welfare gains that Nation 2 receives from joining Nation 1 to form a customs union is given by the sum of the areas of triangles CJM and BHN in Figure 10-1 in the text. Any similar figure and sum of corresponding triangles would, of course, be adequate. 7. See Figure 10-2 in the text. Any figure similar to Figure 10-2 in the text would do. 8. ‘The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union is given by CJJ+B'HH™- MNH'J=$11.25 in Figure 10-2 in the text. Any similar figure and sum of corresponding triangles minus the area of corresponding rectangle would, of course, be adequate. 9. See Figure | and compare it to Figure 10-2. 10. The net gain from the trade-diverting customs union shown in Figure 1 is given by CU4B'HH-MJH'N. As contrasted with the case in Figure 10-2, however, the sum of the areas of the two triangles (measuring gains) is greater than the arca the rectangle (measuring the loss). Thus, the nation would now gain from the formation of a custom union. Had we drawn the figure on graph paper, we would have been able to measure the net gain in ‘monetary terms also. 11. A trade-diverting customs union is more likely to lead to a welfare gain of a member nation (1) the smaller is the relative inefficiency of nation 3 with respect to nation 1, (2) the higher is the level of the tariff, and (3) the more elastic are Dx and Sx in nation 2. These can seen by comparing Figure 10-2 in the text with Figure 1 on the next page. 12. See Figure 2. The formation of the customs union has no effect. 13, NAFTA created much more controversy because the very low wages in Mexico led to great fears of large job losses in the U. 14, The possible cost to the U.S. from EU92 arose from the increased efficiency and competitiveness of the E.U. The benefit arose because a more rapid growth in the EU spills into a greater demand for American products, which benefits the U. S. App. Compare points B' and H' in Figure 10-3 with the corresponding points in Figure 3. 97+Fores 98le-choice 1. Which of the following statements is correct? *a. Ina customs union, member nations apply a uniform external tariff b. ina free-trade area, member nations harmonize their monetary and fiscal policies ¢. within a customs union there is unrestricted factor movement da customs union is a higher form of economic integration than a common market 2. A customs union that allows for the free movement of labor and capital among its member nations is called a: a. preferential trade arrangement b. free-trade area *c. common market 4. all of the above 3. A trade-creating customs union is one where: a. lower-cost imports from outside the customs union are replaced by higher-cost imports from a union member +b, some domestic production in a member nation is replaced by lower-cost imports from another member nation ¢. trade among members increases but trade with nonmembers decreases 4. trade among members decreases while trade with nonmembers increases 4, A trade-diverting customs union: a. increases trade among union members and with nonmember nations b. reduces trade among union members and with nonmember nations *c. increases trade among members but reduces trade with non-members d. reduces trade among union members but increases it with nonmembers 5. A trade-diverting customs union results in: a. trade diversion only . trade creation only +c, both trade creation and trade diversion d. we cannot say -99-6. The formation of a trade-creating customs union where all economic resources of member nations are fully employed before and after the formation of the customs union leads to an: a. increase in the welfare of member and nonmember nations . increase in the welfare of member nations only . increase in the welfare of nonmember nations only d._ increase or decrease in the welfare of member and nonmember nations 7. A trade-diverting customs union: a. increases the welfare of member and nonmember nations b. reduces the welfare of member and nonmember nations c. increases the welfare of member nations but reduces that of nonmembers *d, reduces the welfare of nonmembers and may increase or reduce that of members 8. A trade-diverting customs union is more likely to lead to trade creation: a. the lower are the pre-union trade barriers of the member countries *b. the lower are the customs union's barriers on trade with the rest of the world ¢. the smaller is the number of countries forming the customs union and the smaller their size d. the more complementary rather than competitive are the economies of the nations forming the customs union 9. The theory of customs union is a special case of the theory of: a. effective protection *b. the second best ¢. the product cycle d. comparative advantage 10. Which is not a dynamic benefit from the formation of a customs union? a. increased competition, b. economies of scale c. stimulus to investment 4, trade creation 11. The formation of the EU resulted in: a. trade creation in industrial and agricultural products b. trade diversion in industrial and agricultural products *c. trade creation in industrial products and trade diversion in agricultural products 4. trade diversion in industrial products and trade creation in agricultural products -100-12. 13. 14. 15, ‘The benefit that the United States is likely to receive from NAFTA: a. increasing competition in product and resource markets greater technical innovation ¢._ improvements in its terms of trade d. all of the above The benefit that Mexico is likely to receive from NAFTA: a. greater export-led growth b. encouraging the retum of flight capital ¢. more rapid structural change *d_ all of the above Which is a stumbling block to successful economic integration among groups of developing nations? a. benefits are not evenly distributed among nations b, many developing nations are not willing to relinquish part of their newly-acquired sovereignty to a supranational community body, as required for successful economic integration ¢. the complementary nature of their economies and competition for the same world markets for their agricultural exports 4. all of the above . The formation of a free trade area among the countries of Eastern Europe is advocated in order to: a. restore trade trading *b. retain the traditional trade links that can be justified on market principles ¢. reduce the need for structural change 4. none of the above -101-CHAPTER 11 INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT OUTLINE 11.1 Introduction 11.2 The Importance of Trade to Development 11.2a Trade Theory and Economic Development Case Study 11-1: The East Asian Miracle of Growth and Trade Case Study 11-2: The Crisis in High-Performance Asian Economies (HPAEs) 11.2b Trade as an Engine of Growth 11.2c. The Contributions of Trade to Development 11.24. International Trade and Endogenous Growth Theory 11.3. The Terms of Trade and Economic Development 11.3a The Various Terms of Trade Case Study 11-3: Change in Commodity Prices Over Time 11.3b Alleged Reasons for Deterioration in the Commodity Terms of Trade 11.3¢ Historical Movement in the Commodity and Income Terms of Trade 11.4 Export instability and Economic Development 11.4 Causes and Effects of Export Instability 11.4b Measurements of Export Instability and its Effect on Development 11.4c International Commodity Agreements 11.5. Import Substitution versus Export Orientation 11.5a Development Through Import Substitution Versus Exports 11.5b The Experience with Import Substitution 11.5c Recent Trade Liberalization and Growth in Developing Countries Case Study 11-4: The Growth of Rich Countries, Globalizers and Non-Globalizers 11.6 Current Problems Facing Developing Countries Case Study 11-5: Manufactures in Total Exports of Selected Developing Countries 11.6a Poverty in Developing Countries 11.6b The Foreign Debt Problem of Developing Countries Case Study 11-6: The Foreign Debt Burden of Developing Countries 11.6c Trade Problems of Developing Countries Case Study 11-7: Globalization and Poverty Appendix: Income Inequalities by Traditional and Purchasing-Power Parity (PPP) Measures -102-Terms Regions of recent settlement Engine of growth Vent for surplus Endogenous growth theory High-performance Asian economies (HPAEs) Commodity, or net barter, terms of trade Income terms of trade Single factoral terms of trade Double factoral terms of trade Export instability Marketing boards Intemational commodity agreements Lecture Guide: Buffer stocks Export controls Purchase contracts, Import substitution industrialization (ISI) Export-oriented industrialization Foreign debt Newly industrialized economies (NIEs) Export pessimism ‘New International Economic order (NIEO) United Nations Conference on Trade and Development (UNCTAD) 1. This is not a core chapter and I would skip it, except for section 6. 2. If covered this chapter, I would present two sections in each of three lectures. Answer to Problems: 1. International trade could retard development by: (1) keeping the nation in primary production; (2) leading the nation to adopt excessive capital-intensive production techniques; (3) increasing the propensity to consume, thus reducing the nation’s savings rate; (4) leading to foreign exploitation of natural resources; 2. Each of the criticisms that intemational trade can retard development given in the answer to problem I can by countered as follows: (1) As the availability of capital and technology increases, the nation can begin to export manufactured goods; (2) through appropriate taxes and subsidies the nation can avoid the use of excessive capital- intensive production techniques; (3) increased taxation can increase the rate of public savings; (4) taxation and regulation can reduce or eliminate foreign exploitation; 3. An improvement in the technology of primary production results in a shift in the nation’s transformation curve from YX; to YX in Figure 1 ‘An improvement in the technology of primary production is likely to lead to deterioration in the terms of trade as the developing nation exports more primary commodities. 5. A vent for surplus can be shown by a movement from point A inside the nation’s production frontier without trade to point A’ on the higher production frontier with growth and trade in Figure 2 on the previous page. -103-yh wy % % x Feet Yh % A A ° % mx Figue2 Pk10. i. 12. 13. 15. a. The nation's commodity terms of trade would be 91.7. b. The nation’s income terms of trade would be 119.2. ¢. The nation's single factoral terms of trade would be 128.4. The nation of problem 6 will be better off in 2000 as compared with 1980 because its income and single factoral terms of trade rose. Figure 7-6 in the text shows how deteriorating terms of trade resulting from growth can make a nation worse off after trade than before. This was called immiserizing growth in Chapter 7. Figure 3 on the previous page shows that when the supply of a commodity increases, its equilibrium price will fall by a greater amount, the more price inelastic is the demand curve for the commodity, Figure 4 on the next page shows that with a negatively inclined demand curve and a positively inclined supply curve, producers’ earnings fluctuate more with a shift in demand (Panel a) than with a shift in supply (Panel b). Figure 5 shows how a buffer stock could either lead to an unmanageable stock of the commodity or to the running out of the commodity. Specifically, if the buffer stock authority sets price above the long-run equilibrium price of the commodity, it will face an unmanageable stock of the commodity. On the other hand, if the buffer stock authority sets price below the long-run equilibrium level, then the buffer stock authority will run out of the commodity. A New Intemational Economic Order (NIEO) has not been established because industrial countries did not want to give up control over the present system and pay the economic costs of reforming it along the lines demanded by developing countries. The establishment of a NIEO is no longer a hotly debated topic because developed countries faced serious problems of their own during the 1980s and early 1990s in the form of slow growth and high unemployment. The NIEO was replaced by concerns about globalization in the 1990s, The Uruguay Round benefited developing countries by the reduction in trade protectionism on agricultural products and labor-intensive commodities. Although protectionism will be reduced, it will still remain relatively high in these products. Immiserizing growth does not seem to have occurred in most globalizing developing countries despite some deterioration in their terms of trade because the volume of trade and their income terms of trade have increased substantially over the past three decades. Rich nations should forgive all of the foreign debt of the poorest developing countries because it is impossible for them to repay it or even service it. This, however, might encourage the poorest nations to continue to borrow and even use borrowed funds unwisely knowing that eventually their foreign debt might be forgiven. -105-Figure 4 Panels) Fre (Pane) Figure 106According to traditional trade theory, a developing nation should export the commodity: a. ofits comparative advantage b. that it can produce relatively more efficiently c. intensive in the nation’s relatively abundant factor *d, all of the above Which of the following is false with respect to traditional trade theory? it can incorporate changes in factor endowments and technology . it leads to the best allocation of resources at any point in time it is a dynamic theory it is based on comparative advantage According to Nurkse, international trade was an engine of growth for: +a. the regions of recent settlements during the 19th century b. regions of recent settlements during the 20th century ¢. developed nations during the 19th century d. developed nations during the 20th century Trade cannot be an engine of growth for today's developing nations because: a. the income elasticity for many of their exports is less than 1 b. the development of synthetic substitutes technical advances reduced the raw-material content of many products *d. all of the above If the price of a nation’s exports and imports both rise, the nation's commodity terms of trade: a. improve b. deteriorate ¢. remain unchanged +d. any of the above The nation's commodity terms of trade times the productivity index in its export sector gives the nation's: a, income terms of trade b. double factoral terms of trade *c, single factoral terms of trade 4. barter terms of trade -107-10. i. ‘When a nation’s commodity terms of trade deteriorate and its single factoral terms of trade improve, the nation’s welfare: a. falls *b. rises ¢. remains unchanged 4. any of the above Developing nations often experience wildly fluctuating export prices for their primary products because of: a. inelastic and stable demand and supply b. elastic and unstable demand and supply *c. inelastic and unstable demand and supply 4. elastic and stable demand and supply . MacBean found that the export instability faced by developing nations was: *a. not very large and did not seriously interfere with development b. very large and seriously interfered with development c. very large but did not seriously interfere with development d. not very large but seriously interfered with development Supporting the price of a commodity by buying it when its price is low is: a. a buffer stock b. a purchase contract an export control dd. amarketing board ‘The policy of import substitution was most vigorously followed by: a. large developing nations during the 1970's *b. large developing nations during the 1960's ¢. small developing nations during the 1970's d. small developing nations during the 1960's -108-12, What is the advantage of a policy of import substitution? a. setting up an industry to replace imports minimizes risk of failure because the market for the product already exists in the nation as evidenced by the nation's imports of the commodity b. It is easier for developing nations to protect their domestic market against foreign competition than to force developed nations to lower their trade barriers against their ‘manufactured exports c. foreign firms are induced to establish tariff factories to overcome the tariff wall of developing nations +4. all of the above. 13. Which are is not an advantage of export-oriented industrialization? a. It overcomes the smaliness of the domestic market and allows developing nations to take advantage of economies of scale *b, domestic industries grow accustomed to protection and have an incentive to become more efficient ¢. production of manufactured goods for export requires and stimulates efficiency throughout the economy 4. the expansion of manufactured exports is not limited by the size of the domestic market 14. Those nations that liberalized trade during the past decade “a, grew faster than those that did not b. grew more slowly than those that did not , grew at about the same rate as those that did not, 4. any of the above 15, Which of the following is not part of the demand for a NIEO? a. the establishment of international commodity agreements +b, preferential access for the manufactured exports of developed nations c, removal of the agricultural trade barriers in developed nations d. increasing the yearly flow of foreign aid to developing nations -109-CHAPTER 12 INTERNATIONAL RESOURCE MOVEMENTS AND. MULTINATIONAL CORPORATIONS OUTLINE 12.1 Introduction 12.2 Some Data on Intemational Capital Flows Case Study 12-1: Fluctuation of Foreign Direct Investment Flows to the United States. 12.3 Motives for International Capital Flows 12.3a Motives for International Portfolio Investments 12.3b Motives for Direct Foreign Investments to the United States Case Study 12-2: The Stock of Foreign Direct Investments Around the World 12.4 Welfare Effects of International Capital Flows 12.4a Effects on the Investing and Host Countries 12.4b Other Effects on the Investing and Host Countries 12.5 Multinational Corporations 12.5a Reasons for the Existence of Multinational Corporations Case Study 12-3: The World's Largest Multinational Industrial Corporations 12.5b Problems Created by Multinational Corporations in the Home Country Case Study 12-4: Employment of U.S. MNCs Abroad 12.5 Problems Created by Multinational Corporations in the Host Country 12.6 Motives for and Welfare Effects of Intemational Labor Migration 12.6a Motives for International Labor Migration 12.6b Welfare Effects of International Labor Migration 12.6 Other Welfare Effects of International Labor Migration Case Study 12-5: British and Soviet Brain Drain Is U.S. Brain Gain Case Study 12-6: U.S. Immigration and Debate Over Immigration Policy Appendix: The Transfer Problem Terms Portfolio investments Vertical integration Direct investments Multinational corporations (MNCs) Portfolio theory Transfer pricing Risk diversification Brain drain Horizontal integration -110-Lecture Guide: ‘This is not a core chapter and I would skip it except for section 5 on multinational corporations and section 6 on immigration. Otherwise, I would present two sections in each of three classes. Answer to Problems: 1. See Figure 1. In Figure 1, the outflow of capital is shown by the leftward and upward shift of the Sx curve to x. This increases the return on capital until it is equal to that in the host or receiving country. 2, See Figure 2. In Figure 2, the outflow of capital is shown by the rightward and downward shift of the Sx curve to S'x. This reduces the return on capital until it is equal to that in the investing country. 3. The data to update Table 12-1 is found in the July issue of the most recent year of the Survey of Current Business. 4. The data to update Table 12-2 is found in the July issue of the most recent year of the Survey of Current Business. 5. The data to update Table 12-3 is found in the July issue of the most recent year of the Survey of Current Business. 6. The data to update Table 12-4 is found in the July issue of the most recent year of the ‘Survey of Current Business. 7. The Statement is true. The profitability of a portfolio is equal to the weighted average of the yield of the securities included in the portfolio. Therefore, the profitability of a portfolio of many securities can never exceed the yield of the highest-yield security in the portfolio. The second part of the statement is also true if the portfolio includes securities for which yields are inversely correlated over time. 8. See Figure 3 ‘The gain of the investing country is EGR. 9. See Figure 4, ‘The gain of the host or receiving country is ERM. 10. The general principle that can be deduced from the answers to the previous two problems and from Figure 12-1 is that the nation with the more rapidly declining VMPX curve gains more. With the VMPx curves declining at equal rates, both nations gain equal amounts. “lleey11. The rate of return on US. direct investment in developing nations often exceeds the rate of retum on investment on it investments in developed nations because of relative scarcity of capital and technology and lower wage rates in developing than in developed nations. 12. US. labor generally opposes U.S. investments abroad because they reduce the K/L ratio and the productivity and wages of labor in the United States, 13, An inflow of foreign capital leads to an increase in the K/L ratio and in the productivity and ‘wages of labor or employment in developing nations. 14, The data to update Table 12-6 are found in the World Investment Report published yearly by the United Nations for the most recent year. App. See Table 1. Table 1 (a) By ter a Year Petroleum Price OPEC Exports OPEC Imports US Petroleum Imports (U8 $/barrel) (bill. $) (bil. $) (bill. $) 1973 2.70 39.0 20.1 1.6 1974 9.76 119.3 32.1 26-1 1975 10.72 109.8 51.3 26.5 1976 11.51 133.0 62.2 34.1 1977 12.40 146.0 83.8 44.2 1978 12.70 341.9 94.9 41.6 1979 16.97 208-0 101.6 58.6 1980 28.67 294.2 133.2 76.9 Source: International Financial Statistics, 1981 Yearbook. Petroleum prices refer to Saudi Arabian prices -113-Multiple-choice Questions: 1. Portfolio investments refer primarily to: a. direct investments *b. bonds c. liquid assets d. short-term assets 2. Direct investments usually involve the transfer of: a. capital b. technology ©. management *d. all of the above 3. Which of the following is not true with regard to direct investments? a. US. direct investments abroad and foreign direct investments in the U.S. grew very rapidly from 1950 to 2001 b. the amount of U.S. direct investments abroad is similar to the amount of foreign direct investments in the U.S *c. USS. direct investments in Canada are higher than in Europe 4. US. private holdings of foreign long-term securities grew very rapidly from 1950 to 2001 4, Two-way international capital flows can be explained by the desire to: a. eam higher yields abroad b. avoid tarifis *c, diversify risks 4. all of the above 5. Portfolio theory tells us that by investing in securities with yields that are inversely related over time: a. a given yield can be obtained at a smaller risk b. a higher yield can be obtained for the same level of risk c. a two-way capital flow may be required to achieve a balanced portfolio 4. all of the above -14-10. Ml. ‘The reason the residents of a nation do not borrow from other nations and themselves undertake real investments in their own nation is that: *a. multinationals want to retain control over their own technology b. banks do not want to lend to foreigners ¢. vertical integration is not possible for foreigners 4. multinationals want to avoid horizontal integration Which is not a reason for private foreign direct investments? a. horizontal and vertical integration b. to maximize profits and diversify risks *c, to stimulate development to avoid tariffs Which of the following is not a beneficial effect of direct investments on the investing country? a. the transfer of technology higher profits ¢. risk diversification 4. avoids the possible loss of export markets Foreign direct investment benefits the host nation because it: increases the K/L ration . increases the productivity of labor c. increases per capita income *d. all of the above ULS. labor generally a. opposes U.S. investments abroad b. favors U.S. investments abroad c. is indifferent to U.S. investments abroad 4. we cannot say without additional information Labor in developing countries generally a. opposes an inflow of foreign direct investments from abroad *b. favors an inflow of foreign direct investments from abroad c. is indifferent to foreign direct investments from abroad d. we cannot say without additional information -115-12. Owners of capital in developing countries generally a. oppose an inflow of foreign direct investments from abroad favor an inflow of foreign direct investments from abroad are indifferent to foreign direct investments from abroad we cannot say without additional information pes 13. The basic reason for the existence of MNC is the: *a, competitive advantage of a global network of production and distribution. b. incentives provided by the investing nation ¢. incentives provided by the host nation 4. imperfections of international capital markets 14, Transfer pricing refers to: a. risk diversification b. the pricing of the technology transferred *c. the artificial overpricing of components shipped to an affiliate in a higher tax nation 4. portfolio theory 15, The brain drain refers to the transfer of: a, technology from developed to developing nations b._ skilled labor and professionals from developed to developing nations c. unskilled labor from developing to developed nations ‘*d. skilled labor and professionals from less advanced to more advanced nations -116-ADDITIONAL ESSAYS AND PROBLEMS FOR PART TWO 1. From the following figure, in which De and Sc refer, respectively to the domestic demand and supply curves of cloth, and S, and S,-, refer, respectively, to the world supply curve of cloth under free trade and with a 50% import tariff imposed by the nation on the importation of cloth, determine: 7 0 wm 0 Mw 0 1 110 1m 1m WC @) the consumption, production effect, and the trade effect of the tariff. (©) the reduction in consumer surplus, the increase in producer surplus or rent, the tariff Tevenue, and the protection cost or deadweight loss to the economy as a result of the tariff. Answ. (a) The consumption effect is equal to BR=-20c; the production effect is equal to GN=20C; therefore, the trade effect is equal to -(BR+GN)=-40c. (b) The reduction in consumer surplus is FIHB=$90; the increase in producer surplus is FIMG=$30; the revenue effect is NMHR=$40; the protection cost or deadweight loss to the economy is equal to the sum of the area of triangles GMN and BHR or $20, “1172. (a) Explain why and under what conditions the infant-industry argument for an import tariff is valid. (b) How must this argument be qualified? Answ. (a) The infant-industry argument for tariffs is generally valid, especially for less developed countries (LDCs). It holds that an LDC may have a potential comparative advantage in a particular commodity, say textiles, but that because its initial production costs are too high (due to lack of know-how and the initial small level of output), this industry cannot be established or grow in the LDC in the face of foreign competition. An import tariff is then justified to help the LDC establish the industry and protect it during its “infancy,” until the industry has grown in size and efficiency and is able to meet foreign competition. At that time, the tariff is to be removed. (b) In order for the infant-industry argument to be valid, not only must the tariff eventually be removed and the "grown up" industry be able to compete with foreign firms without protection, but the extra return in the industry (after the removal of the protection) must be high enough to justify the costs involved during the period of protection. These costs arise because the commodity is produced domestically rather than imported for less. It may also be difficult to determine which industry or potential industry qualifies for this treatment, and to eventually remove the tariff once it is imposed. Economists also agree that what a tariff can do here, a direct subsidy to the infant industry can do better. This is because a subsidy can be varied so as to provide the infant industry with the same degree of protection as an equivalent import tariff but without distorting relative prices and domestic consumption. However, a subsidy requires revenue, rather than generating it as the tariff does. 3. (@ How can strategic trade policy justify trade protection? (b) What difficulties arise in carrying out a strategic trade policy? Answ. (a) According to strategic trade policy, a nation can create a comparative advantage through temporary trade protection in such fields as semiconductors, computers, telecommunications, and other industries that are deemed crucial to future growth in the nation. These high-technology industries are subject to high risks, require large-scale production to achieve economies of scale and give rise to extensive external economies ‘when successful. Strategic trade policy suggests that by encouraging such industries, the nation can enhance its future growth prospects. This is similar to the infant-industry argument in developing nations, except that it is advanced for industrial nations to acquire a comparative advantage in crucial high-technology industries. Most nations do some of this. Indeed, some economists would go so far as to say that a great deal of the postwar industrial and technological success of Japan is due to its strategic industrial and trade policies. -118-(b) There are three serious difficulties in carrying out strategic trade policy. First, it is extremely difficult to pick winners (i.e., choose the industries that will provide large extemal economies in the future) and devise appropriate policies to successfully nurture them. Second, since most leading nations undertake strategic trade policies at the same time, their efforts are largely neutralized so that the potential benefits to each may be small. Third, when a country does achieve substantial success with strategic trade policy, this comes at the expense of other countries (ie., it is a beggar-thy- neighbor policy) and so other countries are likely to retaliate. Faced with all these practical difficulties, even supporters of strategic trade policy grudgingly acknowledge is still the best . 4. (a) Why do you think that the United States supported economic integration in Europe after World War II? (©) What direct or indirect evidence can you give to conclude that U.S. support for economic integration in Europe did in fact result in the hope-for outcome? (©) What are the major economic disputes between the United States and Europe about these days? What dangers do they create? Answ. (a) The United States supported economic integration in Europe to foster and strengthen democratic systems in Europe after World War Il, resist communism, and to promote peaceful coexistence among European countries, especially Germany and France, which were once bitter enemies. (©) Evidence that U.S. support for economic integration in Europe achieved its goals is provided by the fact that the members of the European Union have strong democratic governments and economies, communist regimes have collapsed in Easter Europe and the Soviet Union, and Germany and France are so closely integrated economically that a future armed conflict between them is practically nil. (©) The major economic disputes between the United States and Europe (the European Union) today are about trade protection in agriculture and some services as well as, subsidies that the European Union provides to some of its industries, such as Airbus Industrie. These disputes could degenerate into trade wars that would harm both the European Union and the United States. -119-5. (a) Why did large developing nations generally follow a policy of import substitution as a strategy for growth during the 1950s, 1960s, and 1970s? Why was this not generally possible for small developing nations? (>) Why was the policy of import substitution generally a failure? (©) Why did developing nations that switched from a policy of import substitution to a policy of export promotion generally grow faster during the past decade? Answ. (a) Large developing nations generally followed a policy of import substitution during the 1950s, 1960s, and 1960s because their large domestic market allowed them to reap many of the benefits economies of scale in production even without intemational trade. On the other hand, small developing nations generally did not have the choice of industrializing through import substitution because their small domestic market would have made production costs unacceptably high. (b) The policy of import substitution was generally a failure even in large developing nations because once protection was granted to a domestic industry in order to encourage it establishment and growth, it becomes practically impossible to remove the protection. This led to inefficiencies and higher costs in the developing country even for unprotected industries that use the output of protected industries as intermediate products or inputs in their production processes. (©) The developing countries that switched from a policy of import substitution to export promotion generally grew faster than those developing countries that did not make that switch because production for export and international competition stimulated efficiency throughout the economy and resulted in domestic prices more closely reflecting the true opportunity costs of commodities and inputs. -120-6. One of the most significant international economic developments of the postwar period is the proliferation of multinational corporations (MNCs). These are firms that own, control or ‘manage production facilities in several countries. With regard to MNCs, explain (@) the reason for their existence; (b) some of the alleged problems that they create for the home country; (c) some of the alleged problems that they create for the host country. ‘Answ. (a) The basic reason for the existence of MNCs is the competitive advantage that they have over other forms of economic organization based on economies of scale in production, financing, research and development (R&D), and in gathering market information, resulting from a global network of production and distribution. Today, MNCs account for about 25% of world output, and the trade between the parent firms and their foreign affiliates accounts for about one-third of world trade in manufactured goods. (b) The most controversial of the alleged harmful effects of MNCs on the home country is the loss of domestic jobs resulting from foreign direct investments. However, it must be pointed out that the home country may have lost some of these jobs anyway to foreign competitors. A related problem stems from the export of advanced technology. Countering this harmful effect, however, is the tendency of MNCs to concentrate their R&D in the home country. Finally, easy accessibility of MNCs to the international capital market reduces the effectiveness of domestic monetary policy. (©) Host countries have even more serious complaints against MNCs. First is the alleged domination by the MNC of the hosts’ economy. The largest MNCs have yearly sales greater than the GNP of all but a handful of nations. It is further alleged that MNCs absorb local savings and local entrepreneurial talent, use excessive K-intensive production techniques that are inappropriate for developing nations and do not train local labor. Most of these complaints are to some extent true especially for host LDCs and have led these nations to regulate foreign direct investments in order to mitigate the harmful effects and increase the possible benefits. -121-