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# ECN102 World Economy

Dr Rachel Male

Lecture 8:

Law of comparative advantage: all countries can benefit from trade by specialising in the production of their comparative advantage good. Heckscher-Ohlin Model: a country will have a comparative advantage in the production of goods that are relatively intensive in the factor of production with which the country is relatively well endowed.

All countries will benefit from international trade, but not by the same amount.

The Heckscher-Ohlin Model yields three theorems which explain the impact of trade on the distribution of income and the effect of economic growth on trade. The Rybczynski Theorem at constant world prices, growth in the supply of one factor will lead to a country producing more of the good that is intensive in that factor and less of the other good. The Stolper-Samuelson Theorem free trade benefits the abundant factor within a country and harms the scarce factor The Factor Price Equalisation Theorem free trade will lead to the equalisation of factor prices across countries

Stolper-Samuelson Theorem
Stolper-Samuelson theorem suggests that free trade will harm the scarce factor and benefit the abundant factor Why? Country A: K abundant Country B: L abundant
With trade: A specialises in K intensive good (X) and B specialises in L intensive good (Y). Country A: demand for K and L Country B: demand for L and K

## Factor Price Equalisation Theorem

PXA = aLXwA + aKXrA = MCXA PXB = bLXwB + bKXrB = MCXB PYA = aLYwA + aKYrA = MCYA PYB = bLYwB + bKYrB = MCYB

Under the assumptions of the H-O model, both countries have the same technology. both countries require the same units of L and K to produce one unit of each good. Differences in price result from differences in factor prices (w,r). With trade: PXA = PXB and PYA = PYB Therefore: wA = wB = w and rA = rB = r Factor price equalisation

## Factor Price Equalisation Theorem

Why havent factor prices equalised?

Factor price equalisation only holds if all H-O model assumptions are satisfied.

## Trade Policy in Developing Economies

The main trade policies for economic development are:
1. Primary-Export-Led Development Strategy

## 1. Primary-Export-Led Development Strategy

Exploit natural comparative advantage increase production of goods closely related to countrys resource base. Use these goods as basis for international trade. Standards of living will increase due to the gains from trade. Successful country examples?

## 2. Import-Substitution Development Strategy

Promote industrialization by temporarily erecting high barriers to trade to encourage local production.

Infant Industry Argument: Developing countries have a potential comparative advantage in manufacturing. But cannot initially compete with well-established manufacturing in developed countries. To allow these new industries to develop, governments should temporarily support them until they are strong enough to compete internationally.
Successful country examples?

## 3. Outward-Looking Development Strategy

Government support for manufacturing sectors in which a country has a potential comparative advantage If a country is well endowed with low-skilled labour, then the government would encourage the development of labour-intensive industries in the hope of promoting exports of this type.

Essentially a strategy of
Successful country examples?

## TRADE POLICY TARIFFS, QUOTAS AND SUBSIDIES

Despite the potential gains from trade, most countries have not pursued a policy of completely free trade.

Why dont countries engage in completely free trade? What policy tools do countries use to restrict trade?

1. Tariffs A government imposed tax on imports or exports. 2. Quotas A limit on either the quantity or value of trade in a product.

3. Subsidies A government payment to an industry based upon the amount it engages in international trade.
4. Non-Tariff Barriers A wide range of policies (other than tariffs) designed to affect the volume or composition of a countrys international trade.

## TRADE POLICY TARIFFS, QUOTAS AND SUBSIDIES

1. TARIFFS

Tariffs can be either Specific, Ad Valorem or Compound. An is levied as a fraction of the value of the value of the imported goods (e.g. 10% of the value of imported cars). A is levied as a fixed charge for each unit of an imported good (e.g. \$3 per barrel of oil). A is levied as both a fixed charge for each unit of an imported good and as a fraction of the value of the value of the imported goods (e.g. 5.7 per kilo of mushrooms plus 8% of the value of imported mushrooms)

Tariffs have two main effects: 1. A effect generate government revenue 2. A effect domestic producers are able to expand their output because they are protected from foreign competition

Selected US Import Tariffs
Crude Oil
General rate: 5.25 per barrel No tariff : Australia, Canada, Bahrain, Chile, Israel, Jordan, Mexico, Singapore and least-developed beneficiary developing countries Tariff reduced to 3.4/bbl for imports from Morocco General rate: 2.5% No special rates General rate: 15.3% No tariff : Canada, Israel, Jordan, Mexico and least-developed beneficiary developing countries Tariff reduced to 9.3% for imports from Singapore General rate: 6.9 per kilogram + 4.5% No tariff : Canada, Israel Mexico and least-developed beneficiary developing countries Tariff of 11.9% for imports from Jordan

Motor Cars
Pears

Processed Cherries

Selected US Import Tariffs (continued)
Pianos (Upright and Grand)
General rate: 4.7% No tariff : Australia, Bahrain, Canada, Chile, the Dominican Republic, Israel, Jordan, Morocco, Mexico and Singapore

Aircraft
General rate: No Tariff No special rates

Vacuum Cleaners
General rate: No Tariff No special rates

Skis
General rate: No Tariff (Cross-Country Skis) 2.6% (All other Skis) No tariff : Australia, Bahrain, Canada, Chile, the Dominican Republic, Israel, Jordan, Morocco, Mexico and Singapore

Examine in context of the market for a single product The good is partly produced at home and partly imported.

Assumptions:
Country is too small to affect world prices (it is a price taker) World supply to the country is perfectly elastic.

P SDomestic

PW DDomestic Q1

SWorld

Q2

P

.. Surplus difference between amount consumers are willing to pay to purchase a given quantity of goods and the amount they actually have to pay.

SDomestic

. Surplus difference between market price and minimum price required by firms to produce and market that good. PW DDomestic Q1

SWorld

Q2

P

SDomestic

PW + t PW

SWorld
DDomestic

Q1

Q3 Imports

(with TARIFF)

Q4

Q2

P

SDomestic

. PW + t PW

SWorld
DDomestic

Q1

Q3 Imports

(with TARIFF)

Q4

Q2

P

SDomestic

SWorld
DDomestic

Q1

Q3 Imports

(with TARIFF)

Q4

Q2

P SDomestic

PW + t PW

D DDomestic

SWorld

Q1

## Q3 Imports Q4 (with TARIFF)

Q2

Change in: Consumer Surplus Producer Surplus Government Revenue Net Welfare Change

## Trade Policy Import Tariff Example

P

SDomestic

20 10

SWorld
DDomestic Q

Tariff = ? With free trade, quantity of imports = ? With tariff, quantity of imports = ? Government Revenue = ? Deadweight Cost = ? Producer Gain = ? Consumer Loss = ?

100

200

300

400

Role of Tariffs Used to protect domestic industries from foreign competition. For example, tariffs can be used to protect old inefficient industries from foreign competition This may help to prevent unemployment in these parts of the economy. However, the consumer will suffer from higher prices.

In general, tariffs lower the standard of living in a country relative to free trade because they hurt consumer more than they help producers.

## TRADE POLICY TARIFFS, QUOTAS AND SUBSIDIES

2. QUOTAS

A limit on either the quantity or value of trade in a product A . Quota limits imports of product to no more than a fixed quantity in a given period (e.g. no more than 1.25 million tons of sugar per year) A . Quota limit imports of a product to no more than a fixed value in a given period (e.g. no more than \$25 million of cotton blouses)

An . is a quota that completely eliminates trade in a particular product. These are mostly used for political reasons For example, since 1962 the US has an embargo on the imports (and exports) of most goods from Cuba

P SDomestic

PW DDomestic Q1

SWorld

Q2

P

SDomestic

PW + t PW

SWorld
DDomestic

Q1

Q3 QUOTA

Q4

Q2

P Consumer Surplus Producer Surplus

SDomestic

PW + t PW

SWorld
DDomestic

Q1

Q3 QUOTA

Q4

Q2

P

SDomestic
. profits that accrue to whoever has the rights to bring imports into the country and sell these goods in the protected market. PW + t PW
A
B

SWorld
DDomestic

Q1

Q3 QUOTA

Q4

Q2

Quotas restrict the quantity of goods traded. They generate higher prices, raise domestic profits and increase the deadweight cost to society. The economic effects of quotas depend on the way in which they are administered.

1. If quota licences are ........................ by the government, the welfare effects of the quota are similar to those of a tariff. The government receives payment for the licence equivalent to the government revenue accrued from a tariff. Cost to society = B + D 2. If quota licences are .. to foreign countries through ..............................................., then quotas produce even larger deadweight losses. The foreign industries are able to raise their prices, thus earning quota rents on top of their normal profits. Cost to society = B + C + D

P
SDomestic

PW + t

PW

D
DDomestic

SWorld

Q1

Q3 QUOTA

Q4

Q2

Competitively Auctioned Quota: Consumer Surplus -A -B Producer Surplus +A Government Revenue Net Welfare Change

-C

-D

Voluntary Export Restraint (VER): Consumer Surplus -A -B -C Producer Surplus +A Government Revenue Net Welfare Change

-D

## Trade Policy Import Quota Example

P

SDomestic

20 10

SWorld
DDomestic Q

100

200

300

400

Quota = ? Quota restricts trade by the same amount as a tariff = ? Quota Rent = ? Deadweight Cost = ? Under a VER Agreement, welfare costs to the importing country = ?

In general, quotas lower the standard of living in a country relative to free trade because they hurt the consumer more than they help producers.

## TRADE POLICY TARIFFS, QUOTAS AND SUBSIDIES

3. SUBSIDIES

A government payment to an industry based upon the amount it engages in international trade. The payment of a subsidy enables domestic industries to charge a . price than would otherwise be charged. With .. prices, exporters are then able to gain a share of the world markets. Export subsidies on .. are outlawed by the WTO. However, export subsidies on . are permitted. The EU and US subsidise at least some of their agricultural products

P SDomestic

PW DDomestic Q1

SWorld

Q2

## Trade Policy Domestic Production Subsidy

P SDomestic SIDomestic
(with subsidy)

Subsidy = t

PW + t PW

SWorld DDomestic

Q1

Q3

Q2

## Trade Policy Domestic Production Subsidy

P SDomestic SIDomestic
(with subsidy)

Subsidy = t

Consumer Surplus with the subsidy and free trade, goods sell at PW so there is no reduction in consumer surplus.

PW + t PW

SWorld DDomestic

Q1

Q3

Q2

## Trade Policy Domestic Production Subsidy

P SDomestic SIDomestic
(with subsidy)

PW + t PW

D DDomestic

SWorld

Q1

Q3

## Imports (with SUBSIDY)

Q2

Change in: Consumer Surplus Producer Surplus Government Revenue Net Welfare Change

+A

## Trade Policy Domestic Production Subsidy

Because subsidies do not change the price paid by consumers, the loss of consumer surplus is smaller than with either Tariffs or Quotas.

Cost to society: Tariff = B + D Subsidy = B If the aim of the government is to increase output and employment the use of a subsidy is, in general, preferable to the use of a tariff.

## Trade Policy Europes Common Agricultural Policy (CAP)

To protect local farmers, EU operates system of target prices combined with import barriers and export subsidies.

Began as an effort to guarantee high prices to EU farmers. When prices fell below specified levels (the support price), the EU would buy the agricultural products. With Free Trade, the EU should be a net importer of most agricultural products. EU support price so high, EU farmers producing more than most consumers were willing to buy. Result EU was obliged to buy and store huge quantities of food.
To prevent unlimited growth of these stock piles, the EU had to turn to an Export Subsidy Program.

## Trade Policy Europes Common Agricultural Policy (CAP)

EU support price is fixed above both the World Market Price and the EU market clearing price. To export the resulting surplus, an Export Subsidy is paid that offset the difference between EU and world prices. The subsidised exports further depress the world price and increase the required subsidy. Combined cost to EU consumers and taxpayers exceeds the benefits to EU producers. Government subsidies to European farmers are equivalent to 36% of the total value of EU agricultural output. In 2006, CAP cost EU taxpayers \$60 billion.

## 3 components: Price Support: PEU > PEU*

Import Restrictions: ensures imports do not enter at price below PEU Export Subsidies: PEU subsidy = PWORLD surplus unloaded on world market PWORLD greater subsidy required

P SDomestic

PW DDomestic Q1

SWorld

Q2

## Trade Policy Europes Common Agricultural Policy (CAP)

P SEU
PEU (with subsidy)
PEU (no imports)

SWorld

## International Negotiations and Trade Policy

World Trade Organisation (WTO); 153 member countries Main roles: To administer existing WTO (and GATT) agreements To provide a forum for further trade negotiations To deal with trade disputes To monitor national trade policies To provide technical assistance and training to developing countries in trade related matters. Encourages Fair (not free) Trade member countries must give each other the lowest level of trade tariffs they offer.

## International Negotiations and Trade Policy

The GATT-WTO system prohibits the imposition of:
Export Subsidies (except for agricultural products) Import quotas (except when imports threaten market disruption) Tariffs (any new tariff or increase in a tariff must be offset by reductions in other tariffs to compensate the affected exporting countries)

A large group of countries get together to negotiate a set of tariff reductions and other measures to liberalize trade.

## International Negotiations and Trade Policy: A Brief History

First Round (1947 1948; 23 countries) Topics: Tariffs General Agreement on Tariffs and Trade (GATT) established. 45,000 tariff concessions affecting \$10 billion of trade
Second Round (1949; 13 countries) Topics: Tariffs Countries exchanged around 5000 tariff concessions Third Round (1950; 33 countries) Topics: Tariffs Countries exchanged around 8,700 tariff concessions, cutting the 1948 tariff levels by 25%

## International Negotiations and Trade Policy: A Brief History

Fourth Round (1955 1956; 26 countries ) Topics: Tariffs Tariff reductions worth \$2.5 billion agreed Dillon Round (1961 1962; 26 countries) Topics: Tariffs Tariff concession worth around \$4.9 billion of world trade agreed Began negotiations relating to the creation of the European Economic Community (Belgium, France, Germany, Italy, Luxembourg and the Netherlands) Kennedy Round (1964 1967; 62 countries) Topics: Tariffs, Anti-Dumping Introduced new anti-dumping agreement and a section on development Tariff concession worth around \$40 billion of world trade agreed

## International Negotiations and Trade Policy: A Brief History

Tokyo Round (1974 1979; 102 countries ) Topics: Tariffs, Non-Tariff Barriers (Quotas, Subsidies . . . ) Results Tariff concession worth more than \$300 billion of world trade agreed Average of 1/3rd cut in customs duty in worlds 9 major industrial markets (reduced average tariff on industrial products down to 4.7%) Talks on non-tariff barriers began and new codes for controlling the proliferation of nontariff barriers.
Uruguay Round (1986 1993; 123 countries) Topics: Extended to cover almost all types of trade, trade barriers and disputes World Trade Organisation (WTO) established. Rules for settling disputes revised (to speed up process) Compromise reached over agricultural subsidies. Further significant reductions in tariffs.

## International Negotiations and Trade Policy: A Brief History

Doha Round (2001 - ) All 153 WTO member countries participating Topics: Covers almost all types of trade, trade barriers and disputes; Emphasis on Development Doha Development Agenda want to achieve tariff-free, quota-free markets for goods from the least developed countries Agriculture further attempt to eliminate export subsidies

## Key Points from Todays Lecture

Main instruments of trade policy are: Tariffs, Quotas and Subsidies
In general, both quotas and tariffs lower the standard of living in a country relative to free trade because they hurt the consumer more than they help producers. If the aim of the government is to increase output and employment the use of a subsidy is, in general, preferable to the use of a tariff or quota.

## Key Points from Todays Lecture

The main trade policies for economic development are: 1. Primary-Export-Led Development Strategy Policies designed to exploit natural comparative advantage by increasing production of a few export goods most closely related to a countys resource base. 2. Import-Substitution Development Strategy Policies that seek to promote rapid industrialization by erecting high barriers to foreign goods to encourage local production.
3. Outward-Looking Development Strategy Government support for manufacturing sectors in which a country has a potential comparative advantage

## Next Two Lectures . . .

An Introduction to International Finance Balance of Payment Exchange Rates Open Economy Macroeconomic Policy and Adjustment Reading: Husted & Melvin (2010) Chapters 11 and 12 Sloman and Wride (2009) Chapter 25