Summary midterm +list of important terms

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.


Chapter A: Economic globalization - What, how and when?

 

§A.1 ‘The global economy- Some general information’

There is no one standard answer to the question: “What is globalization?”. Globalization means different things to different people. Take farm leaders, trade unionists and human rights activists as an example ; they all see different pros and cons for globalization.

 

Based on this argumentation, there are five key issues to be considered:

  • Cultural globalization > Which is about the debate whether there is one big global culture or a set of universal cultural variables, and the degree  to which these universal cultural variables displace embedded national cultures and traditions.

An example that illustrates this debate: there are people afraid of ‘McDonaldization’ (hige multinationals are the carriers of culture globalization) and there are people seeing enough room for local traditions.

  • Economic globalization > Which is about the decline of national markets and the rise of global markets. Drivers for economic globalization are fundamental changes in technology which permit more efficient ways of internationally organizing production processes.
  • Geographical globalization > Which is about the result of ‘joint time and space’ due to reduced travel times and the rapid (electronic) exchange of information. Some neo-liberals named this development the ‘end of geography’ in which location no longer matters.
  • Institutional globalization > Which is about the spread of universal institutional regulations across the world, triggered by US President Reagan’s and UK Prime Minister Thatcher’s ‘revolution’ of neo-liberalism. These neo-liberal policies are represented by institutions such as the IMF (International Monetary Fund), the WB (World Bank) and the WTO (World Trade Organization). These universal institutional regulations are not only on macro-economic level, but also on the micro-economic level: multinationals adopt similar policies under the pressure of competition and regulation.
  • Political globalization > Which is about the relationship between the power of the market (multinational corporations) versus the nation-state, which continuously has to make changes and updates in reaction to economic and political forces. Popular anti-globalists stress that large multinationals become more and more powerful, out-powering the majority of nation-states.

 

In contradiction, others point out that real evidence for these fears is lacking, as the state has to provide security, a legal system, education and infrastructure, which are all of vital importance for economic activity and growth.

 

 

Keynes once said that the master economist should “examine the present in light of the past, for the purpose of the future”, by which the common opinion about economic globalization was that it was a totally new phenomenon with overwhelming power. Later research, however, showed that it is historically seen not a new phenomenon at all.

 

§A.2 ‘Globalization and welfare’

Before explaining the topic of this section, let’s first take a look at logarithmic graphs:

Note: This explanation of logarithmic graphs is based on Figure 1.7 in the book

A logarithmic scale is a scale that divides the vertical axis in steps of ten-fold increases: 1-10-100-1000-10000.

  • The important advantage of a logarithmic graph is that it can simultaneously show the developments in the level of a variable and its growth rate, where the slope (rise/run) of the line reflects the variable’s growth rate. In Figure 1.7, Variable A  grows constantly by 14,7% per year. Variable B has no constant growth rate (-5% for the first 30 years and then 8%). C, finally, does not grow at all: 0%, so a straight line.   
  • The important disadvantage of logarithmic graphs is that they can be misleading concerning the difference in levels for variables at the same point in time and for the same variable at different points in time. Let’s illustrate this;

In 1950, the difference between variables A and B is about twice that between the variables B and C, because the vertical difference is twice as large. However, this is a logarithmic graph, so these differences are multiplicative: the level of variable C is 100 times higher than the level of A

In 2000, if the variables all measure something positive, variable A obviously has fared better than variables B and C. But how much better? This is hard to tell from the figure

 

Now, back to the theory: globalization and welfare.

To describe the evolution of income over time, researcher Angus Maddison uses so-called ‘1990 international dollars’. Maddison collects data for virtually all countries in the world . The development of the world per capita income is illustrated in Figure 1.6, using a logarithmic scale. The logarithmic scale shows the level of income and the growth rate of the income. As you can see in the figure ; world income per capita only started to increase from the year 1000-1800 approximately.

Since 1800, per capita world income rose more than eleven-fold in a period of 188 years. Maddison made a note: not only per capita incomes are a measure of welfare, life expectation also is.

 

* ‘Leading and Lagging nations in terms of relative GDP/capita index’

The calculations of the deviation index of GDP per capita can be split in above the world average and below the world average. The calculations over 2000 years are available for 28 individual countries and 6 country groups, together covering the global economy. See Figure 1.8 + description: at the beginning of our calendar (year 0): the leading country was Italy, where many other countries were laggards. Later on, the Netherlands, the USA, Switzerland, Australia and the UK became leaders, where Africa, China, India and Iraq became laggards.

 

§A.3Globalization’s manifestation on international trade and business’

The most significant manifestation of the idea of a global economy is the rise in international trade and capital flows. Capital flows are not a completely new phenomenon, in the ancient cultures of Egypt and Greece for example such flows have always been central in economic interactions. According to Maddison, capital flows have been the most important for the economic rise of Western Europe the past millennium (Recap: Figure 1.8)

 

* Historical overview of the developments in the world economy

Venice: key figure in the economic rise of Western Europe (1000-1500):

  • Based on improved techniques of shipbuilding and navigation (the compass), Venice opened up trade routes within Europe, the Mediterranean and to China via the caravan routes, bringing in products and new technology (relevant for that time)
  • By establishing a system of public finance, Venice became the lead economy of the period

 

Portugal: more ambitious interactions between Europe and the rest of the world (second half of the 15th century)

  • By opening up trade and settlement in the Atlantic islands
  • By developing trade routes around Africa, to China, Japan and India
  • Portugal’s geographic location enabled its fishermen to gather knowledge of Atlantic winds, weather and tides
  • Portugal soon became the dominant player in the intercontinental trade due to the gained knowledge, maritime experience and the inventions Venice already did (improved techniques of shipbuilding and navigation)

 

The Netherlands: most dynamic economy (1400-mid 17th century)

  • By creating large canal networks
  • By developing shipping, shipbuilding and commercial services > Figure 1.9 shows how the carrying capacity of Dutch merchant shipping was about the same as the combined fleets of Britain, France and Germany.
  • By providing property rights, education and religious tolerance
  • Only 40% of the labour force in agriculture > a financial and entrepreneurial elite from Flanders and Brabant emigrated to Holland on a large scale > Holland became the centre for banking, finance and international commerce

 

Britain: leading economy (18th century)

  • By improving its financial, banking, fiscal and agricultural institutions along the lines pioneered by the Dutch
  • By accelerating technical progress and investing in physical capital, education and skills
  • By reformations in commercial trade policies: reducing protective duties on agricultural imports and eventually removing all trade and tariff restrictions

 

Europe (18th century-current) > Figure 1.10:

  • Massive outflow of capital for overseas investment (end 19th – beginning 20th centuries)
  • Collapse of trade, capital and migration flows and slow economic growth due to the two world wars and the Great Depression (mid-20th century)
  • The world economy starts growing again, and becomes more closely connected than ever before (end 20th century)

 

* International trade and MNEs

After the before provided historical overview of the world economy, it is clear that there are two waves of globalization: the end of the 19th century until the beginning of the 20th century and after the Second World War.

 

Globalization is not only due to macro-economic forces, but also to effects of micro-level enterprises. 

 

§A.4The global economy- a detailed analysis’

Economic globalization = ‘The increased interdependence of national economies and the trend towards greater integration of flows of goods, labour and capital markets’.

Only focusing on the volume of these flows gives a biased view of the degree of globalization. Two examples to illustrate this: the price wedge and fragmentation.

 

* The price wedge

Basic economic picture: a downward-sloping demand curve (people buy less if a product becomes more expensive) and an upward-sloping supply curve (firms produce more if the price rises). Take Figure 1.11, international trade flows can also be depicted in this most basic framework, with two twists:

  • Home’s demand curve for imports is the home’s demand for the good not provided by the home’s domestic suppliers. Similarly, this applies for the Foreign’s export supply curve

There may be a number of reasons for a deviation between Home’s and Foreign’s price > The price wedge = for example, because foreign firms have to overcome certain transport costs, tariffs, trade impediments, cultural differences, et cetera.
Point A: price wedge = paH – paF > 0, resulting in volume qa. From point A, rises in international trade flows can occur for two basic reasons:

  • A shift to the right in either demand or supply at a constant price wedge will result in increasing trade flows. In Figure , demand shifts to the right > international economy moves to point B, trade flows move from qa to qb (constant price wedge: paH – paF = pbH – pbF). Generally: increased globalization if the rise in trade flows is larger than the rise in production
  • Price wedge diminishes, resulting from for example lower tariffs or lower transportation costs. If the price wedge completely disappears, the international economy would move to point C

 

* The price wedge in history

Trade ;

According to O’Rourke and Williamson, early growth of international trade was of the first kind: a shift to the right in either demand or supply, as the importing countries themselves could not produce the goods then exported (spices, coffee, tea and sugar). Usually, these were expensive luxury items and their buyers could afford to pay the price wedge.

The two waves of globalization (Figure 1.10) explain the second kind of growth in international trade: decreasing transport costs, technology improvements, falling trade restrictions, international cooperation, the removal of trade restrictions and improved communication possibilities all led to a decreasing price wedge.

 

Capital ;

The development of the price wedge in between the two waves of globalization (decrease in the first wave, increase during the World Wars and a decrease in the second wave) is also visible on the capital market. As you compare Figure 1.10 with Figure 1.13, there are two waves of globalization in the capital market as well.

 

Migration ;

Generally, real wage differences between countries explain the direction of migration flows to a very large extent.

 

* Fragmentation
Fragmentation = Technological and communication advances have enabled many production processes to be subdivided into various phases which are physically separable > Figure 1.15. The fragmentation process is facilitated by service links such as transportation, telecommunications, insurance, quality control and management control. Fragmentation helps to clarify why some phases of the production will be internally organized and why some phases will be outsourced.

 

Chapter B: International Trade - Drivers and constraints

 

 

§B.1 Comparative advantage- another approach 

Around the 1930s, neo-classical economists became unhappy with the notion that trade was explained by differences in productivity and technology alone. They started to realize that if technology itself might not be too different between countries, other factors could also be responsible for productivity differences.

Differences in factor endowments = Other factors than technology that determine the level of trade and which country is more productive than another. The France climate, for example, is better for growing grapes than the Dutch climate. Here not technology is determinant for export, but climate.

 

* The Heckscher-Ohlin model

The H-O model, or the factor abundance model, explains international trade only through differences in endowments between countries. Six assumptions:

  • There are two countries, each producing two homogeneous products (Cloth (C) and Steel (S), using two production factors (capital (K) and labour (L)). Country 1 is said to be relatively well endowed with labour, compared to country 2
  • The production functions are identical for the two countries, but they have different factor intensities. We assume that steel is more capital-intensive than cloth
  • The supply of capital and labour differs between the two countries. Perfectly mobile within sectors within the country, perfectly immobile between countries > Factor prices are the same in the two sectors within a country
  • Production is perfectly competitive, constant returns to scale
  • Consumer preferences are the same in the two countries > the same price of cloth relative to steel, the consumption ratio of cloth relative to steel is the same
  • No barriers of trade

 

Factor price = the sale price set for a finished good or service is affected by the expense involved in the creation and manufacture of that product. The general idea is that the factor price is arrived at by taking into consideration all the factors of production.

 

Box 3.3

One of the most important assumptions of the H-O model is that countries use the same technology in each sector. Coe an Helpman did research on this and they found that if a country has trading partners with a large stock of R&D, the country benefits form that foreign R&D base through trade.

So, technological knowledge tends to converge between countries. In a continued study, they found that developing countries benefited from developed countries’ R&D investments > For results, see figure 3.3.

Horizontal axis: education-weighted ratio of a country’s foreign knowledge stock

Vertical axis: ratio of factor productivity (efficiency of the production process)

Take Niger as an example: the change in foreign knowledge stock is 2.02, but only 4% of the population completed secondary education > the population cannot effectively use the foreign technology

 

§B.2 Perfect competition and optimal production

Recap: micro economics ; price equals cost. In the long run, profits in perfectly competitive markets become zero, due to other suppliers constantly entering the market

Keep this theory in mind in this paragraph!!

 

The cost of production = labour needed to produce good X and the amount of capital needed to produce good X ; pX = costs = Labour for X * Wage + Capital for X * Rental rate

In short: pX = cost = Lx*w+Kx*r under the H-O model assumptions

 

Rewriting the formula > Kx = (costs/r) – (w/r) * Lx

This formula provides all combinations of labour and capital inputs with the same costs of production (w and r). Figure 3.5 shows these combinations as isocost lines. The slope of the lines is equal for every line > -w/r. The total costs are determined by the y-intercepts; more labour and capital means higher total cost and a higher y-intercept.

Now, if you want different combinations of labour and capital to yield the same level of total cost, you can use an isoquant. An example of an isoquant is illustrated in Figure 3.4.

 

Applying this theory

  • The lowest possible cost of production is determined by the intersection of the isoquant with one of the isocost lines ; Point A0 in Figure 3.5
  • If the slope changes (one cost of production becomes relatively more expansive than the other), the lowest possible cost of production also changes ; Point A1 in Figure 3.5

 

Unit-value isoquants = represent the production of each good that is worth one dollar of revenue when selling it. See Figure 1.6a, where the price of steel is pS and the price of cloth is pC0 and the isoquants for steel and cloth are 1/pS and 1/pC0.

  • If the price for steel is pS, we only have to produce 1/pS to get one dollar of revenue (pS*1/pS=1) ; so the unit value isoquant is inversely related to the price
  • The minimum cost combinations of capital and labour for both unit value isoquants must be points where both isoquants intersect a isocost line (steel0 and cloth0)
  • Price changes ; if the price for cloth increases from point pc0 to pC1, we have to produce less cloth to get one dollar of revenue, so its isoquant shifts more towards the origin (1/pC1). The minimum-cost output is now at cloth1,steel1 ; the slope of the isocost line has increased (w>r)

 

§B.3 Appliance of the Heckscher-Ohlin model

What happens in a trading equilibrium? When taking a look at Figure 3.5 and point A0 and A1, it is clear that country one is relatively more labour-abundant and country 2 is more capital-abundant. See Figure 3.7 (Figure 3.6b is copied in Figure 3.7) > as country 1 is more labour-abundant, (w/r)1 < (w/r)2. We can infer that in this case the price of labour-intensive cloth is lower in country one than in country 2: (pC/pS)1 < (pC/pS)2. This relative price difference is the basis for international trade.

Once international trade is possible:

  • Individual consumers exploiting arbitrage opportunities between the two countries will ensure that the price of cloth and steel will get the same in both countries
  • The trade equilibrium price will be anywhere between the two autarky prices (pC/pS)tr in Figure 3.7
  • (pC/pS)tr is above the trade equilibrium price for cloth in country one (excess supply) and below trade equilibrium for cloth in country two (excess demand) > Country one starts exporting cloth
  • (pC/pS)tr is above the trade equilibrium price for steel in country two (excess supply) and below trade equilibrium for steel in country one (excess demand) > Country two starts exporting steel

Conclusions : The above described is the Heckscher-Ohlin theorem > “A country will export the good that intensively uses its relatively abundant factor of production, and it will import the commodity that intensively uses its relatively scarce factor of production”

 

From the points of intersection of the unit value cost line and the isoquant with the axes we can determine the wage rate and the rental rate (must be the same in both countries)

 

Factor price equalization = an effect observed in models of international trade  that the prices of inputs to (factors of) production in different countries, like wages, are driven towards equality in the absence of trade barriers (open economies) 

Wrap up: The difference between the Ricardian model and the Heckscher-Ohlin model is that the Ricardian model assumes that technology differences, resulting in wage differences between countries, cause international trade. The H-O model assumes that differences in factor endowments trigger international trade. In both models the prices of final goods will be equalized, but in the H-O model, also factor prices will be the same in equilibrium.

 

§B.4 Conclusions

Section 2.2 elaborated on the differences between comparative advantage and competitive advantage for the Ricardian model. To a large extent, the same discussion goes for the H-O model, where firms producing the same commodity compete with each other in the international market. In equilibrium, they cannot be more expensive than their competitors in order to maintain market share. Once factor prices are equal, so will production cost be, but until factor prices are equalized, cost differences will determine the competitive position of firms.

Chapter C: Other insights on international trade

 

§ C.1 From monopoly to duopoly

In perfect competition, the market price cannot be affected by the behaviour of any of the firms. In a monopoly, knowing the behaviour of competitors is not important for the home monopolist as there is no competition in the home country. However, in oligopolistic markets, competitor’s behaviour is crucial.

See Figure 4.3 in the book:

  • In autarky (no trade), the Home firm as a monopolist chooses the maximum profit point (point H where MR=MC) and a price of point I. Its profit, then, equals IJKL.
  • A foreign firm can now sell its good in home market: international trade. We assume that the foreign firm assumes that the home firm will continue the same quantity as before (at maximum profit)
    • The residual demand curve for the foreign curve is from point I downwards, as home already produces J-I
    • The MR-foreign curve shows the marginal revenue curve of residual demand
    • The foreign firm maximises profit at point A at a price of point B, where its total profit is CBFG
    • Home and foreign produce a homogeneous product > point B is the market-clearing price in the home market. At that price DB is the total production, DC produced in home country, CB imported from foreign country. For the foreign firm DC is produced and CB is exported to the home country

Conclusions: Profitability for the home country has decreased, as price has fallen from J to D. The change in total profits as a result of introducing international trade flows is the net result of four different effects ;

  • Area I (KDCL), part of the initial monopoly profits that is not affected by the foreign firm entering the market
  • Area II (EKLF), increase in the initial monopoly profits resulting from larger sales reducing average costs
  • Area III (FCBG), increase in profits resulting for sales to the export market for the foreign firm
  • Area IIII (DJIC), decrease in the initial monopoly profits due to increased competition

 

The net welfare effect under these circumstances is positive, as the increase in consumer’s surplus > decrease in producer’s surplus

 

In the final equilibrium, home market sales are higher and the price is lower. Also, both firms have the incentive to enter each other’s market as they both think they can consolidate profits in the home market and gain some extra profit in the foreign market. The result is not only increased competition, but also increased trade in similar final goods.

 

§ C.2 Monopolistic competition

The framework of monopolistic competition does not rely on the assumption of identical goods. The central idea is illustrated in figure 4.5 in the book. Country A and country B each produce many varieties of a single product (take beer or cars for example).

 

Love-of-variety effect = Once one of the countries produces a new variety within the single product, there is always a market for this new product as it adapts to the needs of a specific group of clienteles.

 

Each car manufacturer has a monopoly power in its own market due to the variety of products. However, it does face competition from other manufacturers that produce similar, but slightly different products

 

The behaviour of a typical firm in this kind of market is illustrated in Figure 4.6 in the book for the monopolistic competition equilibrium, which is based on three assumptions:

  • The number of sellers is such that each firm takes the behaviour of another firm as a given
  • Products are heterogeneous
  • There is free entry and exit for firms

 

The demand curve in monopolistic competition is downward-sloping > by decreasing price you can increase market power

 

See figure 4.6. Each firm assumes that its competitors do not react if it lowers its price 

  • The demand curve location of a producer depends on the pricing behaviour of all other producers. If they decide to reduce prices ; the demand curve shifts downwards
  • New firms entering the market makes the demand curve shift downwards
  • Firms exiting the market makes the demand curve shift upwards
  • Profits are maximised at point B and a price of point C and a quantity of point A, where price equals average cost > Caused by the competitive pressure of other firms freely entering and exiting the market

 

Chamberlin’s tangency solution = There is a difference between average cost (C) and minimum average cost (F). This implies that there are unexploited economies of scale.

 

§ C.3 Trade with monopolistic competition

What happens in the previous monopolistic competition model if it becomes possible for two countries to engage in international trade?

 

As for the effects on consumers, the most important thing to remember is the love-of-variety effect > If consumers from country A can choose between varieties produced at home and abroad, their welfare will increase.

 

For the producers, however, each producer will lose half of its domestic sales to competitors. At the same time, each producer will gain half of its sales by entering the foreign market and selling to foreign customers.

 

Generally:

  • The increase in the variety attracts new customers
  • The entry of new firms increases competition
    • Individual suppliers face more elastic demand curves because they face closer substitutes to the products they supply
    • The intersection with the y axis becomes smaller

 

See Figure 4.7

  • In the pre-trade situation profits are maximised at point B and a price of point C and a quantity of point A, where price equals average cost > Caused by the competitive pressure of other firms freely entering and exiting the market
  • In the post-trade situation profits are maximised at point B’ and a price of point C’ and a quantity of point A’, where price equals average cost. Those new points are determined by the more elastic demand curve and thus a changed marginal revenue curve. The following then happens:
    • With changing demand and MR and other things remaining equal, the firm leads a loss
    • The loss makes other firms exiting the market > increases demand for remaining firms > continues until profits are zero
    • In trade equilibrium, consumers benefit from lower prices and more variety
    • In trade equilibrium, the two countries engage in two-way trade in similar products

* How do the models in this chapter differ from the models in chapter B?

The essence of models in this chapter is that trade arises in similar or identical commodities between similar or identical countries, so no differences in productivity or endowment in the production processes between firms. In the models of chapter 3, the lack of these differences implies that there is no reason for trade. Also, increasing returns to scale imply imperfect competition, which makes positive profit and thus entering the market possible. With constant returns to scale (perfect competition), the assumption of identical firms and identical countries do not give rise to an underlying reason to engage in international trade.

 

§ C.4 Other views on intra-industry trade

A lot of research is done to investigate drives for intra-industry trade.

One expects that intra-industry trade between two countries will be high if:

  • Incomes per capita are high
  • Differences in level of development are low
  • The average of the countries’ GDP is high

 

Here, it is assumed that if incomes per capita are high and basic needs are thus fulfilled, a relatively large share of income will be spent on luxury goods. Furthermore, if countries differ in development, it is expected that consumers have different tastes.

In addition, intra-industry trade will also be high if:

  • Barriers to trade are low
  • Pairs of countries share a common border on language
  • Countries are part of some type of a preferential trade agreement

 

All these variables stimulate trade flows between countries.

Finally, intra-industry trade will be high if:

  • The level of product differentiation within sectors is high
  • Economies of scale are present
  • Transaction costs are low

 

Leamer and Levinsohn discussed problems to the measure of intra-industry trade

1. It is often unclear which of the above variables to include and which to exclude

2. It is often difficult to find proxies for variables that are important in theory

Chapter D: Trade impediments

 

§D.1 ‘Introduction’

Despite the obvious advantages of free trade flows and a gradual reduction of trade barriers since the 1980s, there are still many governmental restrictions to trade, such as tariffs, quotas and minimum standards. The same goes for capital. The main question we address in this chapter is why trade restrictions even exist if theory often says they should not.

 

§D.2 ‘Tariffs and trade restrictions- general information’

See Figure 5.1 in the book.

Trade restrictions have been falling on a global scale for a long time. To a large extent this can be attributed to the WTO, the World Trade Organization. In a long series of negotiations, the average tariff rate (all goods) has fallen from 8.71% in 1988 to 2.69% in 2010.

 

The reasons for the introductions and reductions of tariffs can be varied for individual countries, where Figure 5.2 illustrates the US. The tariffs, on average, have been declining, but there were also periods where the tariffs were raised:

  • At the beginning of the nineteenth century, the tariff revenue was very high (more than 50% of total imports around 1830) > tariff of Abominations, southern congressmen included high tariffs on raw materials in the hope that their northern colleagues would reject it (northern manufacturers used those raw materials), but they didn’t
  • 1833: comprise law, tariffs started to decline
  • 1861: stop of the decline, the Morrill rate was passed and the rates on iron and steel raised. This continued until 1864 and the raises were also done to finance the Civil War
  • At the beginning of the twentieth century, tariff rates came down when Wilson put many items on the so called free list
  • First recession (after World War I): free list was reversed and in 1922 the Fordney-McCumby tariff was passed, intended to help the farmers. This tariff was followed by the Hawley Smoot tariff in 1930. Kenen said it was “once called the Holy-Smoke Tariff”.
  • After World War II: a series of GATT negotiations resulted in the current low average tariff rate of around 1.8%

 

There are not only differences between countries in tariffs (Figure 5.3), but also within countries between commodities. Think of tobacco.

Non-tariff measures (NTM) = All non-price and non-quantity restrictions on trade in goods, services and investments, at federal and state level. This includes border measures (customs procedures), as well as domestic laws, regulations and practices.

Two examples:
1. Differences in testing requirements for new cars in different countries that have the purpose of creating safety for passengers ; may lead to extra costs for multinationals, which are in turn passed on to the customers via the price of the car

2. Differences in rules regarding animal testing in the cosmetics industry

 

§D.3 ‘Effects of tariffs’

Figure 5.4 in the book illustrates the most important effects of trade restrictions by analysing the economic consequences of imposing a tariff on imported goods

> The figure shows a perfectly competitive market

  • With free trade, the world market price equals p0, which is way lower than the equilibrium autarky price p2
  • This way lower price means an excess demand, so import is represented by q0-q4
  • Imposing an ad valorem on imports (t) means there origins a price wedge between the price foreign producers receive (p1) and the price on the domestic market ((1+t)p1)

 

The consequences of the above described phenomenon on four different economic agents:

1. Domestic consumers are confronted with higher prices ((1+t)p1) instead of p0; which reduces their demand by q4-q3. The welfare loss (the loss in consumer’s surplus) is represented by D+E+F1+G

2. Domestic producers perceive less competition from abroad, so they are able to increase their price to ((1+t)p1) instead of p0. Quantity supplied increases with q1-q0. The increase in producer’s surplus is represented by D

3. The domestic government receives the tariff. The total revenue is the difference between import price p1 and the domestic price (1+t)p1 multiplied by the amount of imports, q3-q1 in this case. The total government revenue is F1+F2

4. The rest of the world faces a reduction in demand: from q0-q4 to q1-q3. If this reduction in demand is substantial enough on a global scale (the economy imposing the tariff is large), the world price for the good falls from p0 to p1 (area F2 of government revenue is paid for by the rest of the world), which means the rest of the world now receives less for its exports. Note that, if the economy imposing the tariff is small, no changes in world price level will occur

 

Terms-of-trade gain = a positive welfare contribution due to a drop in price. In Figure 5.4 equal to F2.

 

The total welfare can now be calculated by adding the individual welfare effects;

D+F1+F2 – (D+E+F1+G) = F2 – (E+G)

The right hand of this equation is the terms-of-trade gain F2 minus the sum of the Harberger Triangles E+G

Harberger Triangle = The waste of protection ; les efficient domestic producers increase production at the expense of more efficient foreign competitors, which is paid for by domestic consumers

 

* Box 5.1

Various reasons have been put forward to explain why removing protectionist measures (liberalization) leads to small estimates of welfare gains based on the Harberger triangles

  • Those estimates are static, while there is not dealt with the dynamic effects of liberalization
  • Harberger triangles can be measured only if products are actually present in the economy and of a given quality. This can seriously underestimate the true cost of protection, as some products are not even imported and thus not measured and some products are of lower quality (less expensive) than would otherwise be the case
  • Estimates of the Harberger triangles assume that products are homogeneous. After reading chapter 4, we know that most intra-industry trade is with heterogeneous goods, so the Harberger triangles can only be estimated for a limited set of goods
  • All types od estimates underestimate the true cost of trade restrictions, as they ignore the transaction costs of protection

 

Note: One should bear in mind that moving from protection to liberalization also involves costs. The cost of adjustment for firms and workers dealing with the new situation without protection for example.

 

§D.4 ‘Imposing a trade restriction- the effect on the world’s welfare’

What is the effect of a tariff for the world as a whole? > See Figure 5.5

  • The supply curve shows the difference between quantity produced and consumed for different prices in the rest of the world ; the demand curve shows the difference between quantity demanded and supplied domestically for different domestic prices
  • Trade0 in Figure 5.5 equals q4-q0 in Figure 5.4 and trade 1 in Figure 5.5 equals q3-q1

 

Now, a country that is large enough imposes a tariff, which makes the price drop from p0 to p1

  • F1+F2 are still the tariff revenues for the government
  • E+G still represents the sum of the two Harberger triangles
  • E+F1+G represents the loss for domestic producers and consumers

 

The welfare effect for the rest of the world is equal to the area between p0 and p1 up to the foreign export supply curve > that is F2+H

Change in world welfare caused by the tariff = the sum of the welfare loss for domestic consumers and producers (F1+E+G), the welfare loss for foreign producers and consumers (F2+H) and the welfare gain for the domestic government (F1+F2).

Conclusions : The net welfare effect for the two countries combined is a welfare loss equal to E+G+H. So for the world as a whole, the welfare effects of tariffs are always negative.

 

§D.5 ‘Other protectionist effects’

So, for the world as a whole, protection reduces welfare. Usually, the same goes for individual countries. Then why do countries still impose trade restrictions?

One clear answer ; even if the net effect is negative, the impact of the tariff will benefit specific groups such as domestic producers or the government. There are, however, other reasons for protectionism;

  • Government finance ; some (developing) countries set trade restrictions as a matter of easily financing government expenditures.
  • Income distribution ; from figures 5.4 and 5.5 we know that trade restrictions influence income distribution > domestic producers gain at the expense of consumers and foreign producers. Moreover, changes in prices caused by tariffs also influences the income distribution.
  • Infant industry ; it is argued that some industries need protections in their early existence, until a certain scale of production has been reached and the firm can compete on the world market for example. Three problems with the infant industry argument:
    • It is not easy to identify infant industries
    • If it is possible to identify them, why would government support be necessary? The private sector could do the same as profit-seeking banks could give these firms a credit > consumers will not be confronted with higher prices
    • Firms in the protected industry will get addicted to the protection
  • Employment considerations ; protecting an industry raises production and thus employment in that industry. The question is, of course, if this is the best way to influence employment > the answer is no
  • Strategic behaviour ; the shift in profits from foreign firms to domestic firms due to trade restrictions such as tariffs and export subsidies. Drawbacks:
    • The optimal type of policy depends on the type of competition between two rivals (on prices or quantities)
    • The optimal type of policy also depends on knowledge regarding production costs and demand
    • The same as for the infant industry argument: Why can’t the private sector provide support?

 

§D.6 ‘Trade agreements’

The central aim of the WTO is to promote free trade. It tries to achieve this by organizing the so-called trade rounds (See box 5.3).

 

The Most Favoured Nation (MFN) principle = central in the WTO negotiations. Is about all countries to be treated alike. For example: if one country decides to reduce its tariff to another country, it must apply the sae to all WTO members.

 

Preferential Trade Agreements (PTAs) = important exception to the MFN principle. It means a group of countries may decide to lower their tariffs between group members, but still apply tariffs to imports from the rest of the world. This can take several forms (we name only two examples):

  • A group of countries can stop all tariffs internally, but maintain an own tariff for the rest of the world: Free Trade Area (FTA)
  • A group of countries can stop all tariffs internally and have identical tariffs against the rest of the world: a Customs Union

Some very well-known PTAs are the EU, the NAFTA and ASEAN.

 

The question now becomes: is a partial reduction of tariffs in a PTA also welfare-increasing?

The answer is quite complicated, as there are three or more countries involved instead of 2 as in sections D.3&D.4.

 

To answer the question, we take Australia (A), Brazil (B) and China (C) as an example. We assume that Australia once decides to form a trade agreement with Brazil; before the agreement Australia imposed tariff t in imports from both countries.

We also assume that Australia is not large enough to influence prices in other countries with their tariff t. For Brazil and China, import prices inclusive of the tariff are pBt and pCt in Figure 5.7, where the autarky equilibrium counts for Australia.

> Our welfare analysis has two possible situations (there are three countries): Brazil is the most efficient or China is the most efficient

 

Brazil- trade creation (Figure 5.7)

First, we assume that Australia forms a customs union with Brazil > tariffs disappear for Brazil, but not for China. Brazil is a more efficient supplier of the product : pB < pC    

Before the customs union, Australia imported q3-q1 from Brazil (at a domestic price of pB + t < pC + t). After the customs union, Australia imports q4-q1 from Brazil (at a domestic price pB). This increase in imports due to the formation of a PTA is called trade creation.

Actually, in this situation the reverse of what happened in section D3 happens: producer’s surplus decreases by area D because of increased competition. The consumer’s surplus increases by DEFG. Moreover, the government revenue is decreased by F

Conclusions: The net welfare effect is (DEFG) – D – F = E + G > 0, so a positive trade creation

 

China- trade diversion (Figure 5.8)

We again assume that Australia forms a customs union with Brazil, but now China is the most efficient supplier (pC < pB). Before customs union, Australia imports q3-q1 from China, the most efficient supplier. After the customs union, Australia imports q4-q1 from Brazil, not because it is more efficient, but because it receives PTA > trade creation effect.

Trade diversion effect = supplier switching effect. Where Australia first imported from China it now imports from Brazil.

 

The welfare effects are similar as before:

  • Producer’s surplus reduced by area D
  • Consumer’s surplus increased by are D E F1 G
  • Government revenue is decreased by F1 + F2, where the term F2 reflects a decrease in government revenue not compensated by an increase in consumer’s surplus, so the negative F2 term is caused by the trade-diversion effect, as imports no longer come from the most efficient supplier

 

Net welfare effect: (D + E + F1 + G) – D – (F1 + F2) = E + G – F2, so an increase in welfare only occurs if the trade creation effect surpasses the trade diversion effect.

 

Domino theory = The world may end up in one large trading bloc, so that PTAs eventually lead to free trade

 

§D.7 ‘The theory of games- Airbus and Boeing as an example’

All previous sections assumed perfect competition, which very often is not a very realistic assumption. Some markets are better characterized by imperfect competition.

 

Recap: Chapter 4 > Government support (a subsidy) led to a downward shifting supply curve. Production increased, the profit-maximising price decreased and the firm’s profits increased. In this situation, it became hard for a foreign firm to enter the home market and to compete with the home firm. A subsidy can thus be (mis)used to manipulate the market outcome.

 

The previous argumentation opens doors to lobbyists for government support for specific industries. > See Table in attachments

We take the following assumptions:

  • Each firm alone can make a profit in the market
  • If the firms both enter the market, they both make a loss
  • If the firms both do not enter the market, the situation remains the same and profits for both are zero

The EU now decides to offer Airbus a subsidy that is large enough to cover potential losses. This has two effects: positive profit for Airbus, no entry from Boeing.

 

Table 5.3 see attachments

This table shows that whatever Boeing does, it is optimal for Airbus to enter the market. This also ensures that Boeing won’t enter the market > Insures Airbus’ profits.

 

§D.8 ‘Conclusions’

The complete analysis of this chapter now allows us to draw some conclusions regarding protection. First, consumers are always worse off and producers are always better off. Particularly governments might be tempted to introduce protectionist measures, because of the terms-of-trade effect.

 

Chapter E: List of important terms:

 

Globalization = The process of integration across world-space. Has 5 dimensions.

 

Cultural globalization = The debate whether there is one big global culture or a set of universal cultural variables, and the degree  to which these universal cultural variables displace embedded national cultures and traditions.

 

Economic globalization = The decline of national markets and the rise of global markets.

 

Geographical globalization = The result of ‘joint time and space’ due to reduced travel times and the rapid (electronic) exchange of information.

 

Institutional globalization = The spread of universal institutional regulations across the world.

 

Political globalization = The relationship between the power of the market (multinational corporations) versus the nation-state, which continuously has to make changes and updates in reaction to economic and political forces.

 

GDP per capita GDP per capita = Gross domestic product divided by the population. The GDP is the sum of gross value added by all producers in the economy.

 

Price wedge = Deviation between home-and foreign’s price, due to for example foreign firms having to overcome certain transport costs, tariffs, trade impediments, cultural differences, et cetera.

 

Fragmentation = Technological and communication advances have enabled many production processes to be subdivided into various phases which are physically separable.

 

Horizontal multinational = Market seeking, a firm starts producing and selling products or services to clients in a host country (the value chain moves horizontally to a different location).

 

Vertical multinational = Efficiency seeking, a specific part of the production process can be done more efficiently in another country, so only a part of the value chain is moved to another country.

 

Differences in factor endowments = Other factors than technology that determine the level of trade and which country is more productive than another.

 

The Heckscher-Ohlin model = The factor abundance model, explains international trade only through differences in endowments between countries under six assumptions

 

Factor price = The sale price set for a finished good or service is affected by the expense involved in the creation and manufacture of that product. The general idea is that the factor price is arrived at by taking into consideration all the factors of production.

 

Perfectly competitive markets = No participants are large enough to have the market power to set the price of a homogeneous product.

 

The cost of production = Labour needed to produce good X and the amount of capital needed to produce good X ; pX = costs = Labour for X * Wage + Capital for X * Rental rate

In short: pX = cost = Lx*w+Kx*r under the H-O model assumptions.

 

Isocost lines = Represent different combination of factors of production with the same total cost, given the factor prices.

 

Isoquants = A graph depicting different combinations of factors of production yielding the same level of total cost.

 

Unit-value isoquants = Represent the production of each good that is worth one dollar of revenue when selling it.

 

Factor price equalization = An effect observed in models of international trade  that the prices of inputs to (factors of) production in different countries, like wages, are driven towards equality in the absence of trade barriers (open economies).

 

Residual demand curve = The market demand curve minus the quantity supplied by other firms.

 

Market-clearing price = The price of a good or service at which quantity supplied is equal to quantity demanded, also called the equilibrium price.

 

Love-of-variety effect = Once one of the countries produces a new variety within the single product, there is always a market for this new product as it adapts to the needs of a specific group of clienteles.

 

Chamberlin’s tangency solution = There is a difference between average cost (C) and minimum average cost (F). This implies that there are unexploited economies of scale.

 

Non-tariff measures (NTM) = All non-price and non-quantity restrictions on trade in goods, services and investments, at federal and state level. This includes border measures (customs procedures), as well as domestic laws, regulations and practices.

 

Terms-of-trade gain = a positive welfare contribution due to a drop in price. In Figure 5.4 equal to F2.

 

Harberger Triangle = The waste of protection ; les efficient domestic producers increase production at the expense of more efficient foreign competitors, which is paid for by domestic consumers.

 

The Most Favoured Nation (MFN) principle = central in the WTO negotiations. Is about all countries to be treated alike. For example: if one country decides to reduce its tariff to another country, it must apply the sae to all WTO members.

 

Preferential Trade Agreements (PTAs) = important exception to the MFN principle. It means a group of countries may decide to lower their tariffs between group members, but still apply tariffs to imports from the rest of the world.

 

Trade creation effect = Increase in imports due to the formation of a PTA.

 

Trade diversion effect = supplier switching effect. Where Australia first imported from China it now imports from Brazil for example.

 

Domino theory = The world may end up in one large trading bloc, so that PTAs eventually lead to free trade.

 

 

attachment_for_online_summary_midterm_international_economics_for_ebemidterm_2013-14.doc

Access: 
Public
Work for WorldSupporter

Image

JoHo can really use your help!  Check out the various student jobs here that match your studies, improve your competencies, strengthen your CV and contribute to a more tolerant world

Working for JoHo as a student in Leyden

Parttime werken voor JoHo

Image

Check how to use summaries on WorldSupporter.org


Online access to all summaries, study notes en practice exams

Using and finding summaries, study notes en practice exams on JoHo WorldSupporter

There are several ways to navigate the large amount of summaries, study notes en practice exams on JoHo WorldSupporter.

  1. Starting Pages: for some fields of study and some university curricula editors have created (start) magazines where customised selections of summaries are put together to smoothen navigation. When you have found a magazine of your likings, add that page to your favorites so you can easily go to that starting point directly from your profile during future visits. Below you will find some start magazines per field of study
  2. Use the menu above every page to go to one of the main starting pages
  3. Tags & Taxonomy: gives you insight in the amount of summaries that are tagged by authors on specific subjects. This type of navigation can help find summaries that you could have missed when just using the search tools. Tags are organised per field of study and per study institution. Note: not all content is tagged thoroughly, so when this approach doesn't give the results you were looking for, please check the search tool as back up
  4. Follow authors or (study) organizations: by following individual users, authors and your study organizations you are likely to discover more relevant study materials.
  5. Search tool : 'quick & dirty'- not very elegant but the fastest way to find a specific summary of a book or study assistance with a specific course or subject. The search tool is also available at the bottom of most pages

Do you want to share your summaries with JoHo WorldSupporter and its visitors?

Quicklinks to fields of study (main tags and taxonomy terms)

Field of study

Comments, Compliments & Kudos:

Add new contribution

CAPTCHA
This question is for testing whether or not you are a human visitor and to prevent automated spam submissions.
Image CAPTCHA
Enter the characters shown in the image.
Promotions
Image
The JoHo Insurances Foundation is specialized in insurances for travel, work, study, volunteer, internships an long stay abroad
Check the options on joho.org (international insurances) or go direct to JoHo's https://www.expatinsurances.org

 

Access level of this page
  • Public
  • WorldSupporters only
  • JoHo members
  • Private
Statistics
287