ECON 223: POLITICAL ECONOMY OF TRADE POLICY

GLOBAL IMBALANCES
2/9/2022

International economics is about how nations interact through trade of goods and services, through flows
of money and through investment.
- GDP (GROSS DOMESTIC PRODUCT): it measures the final value of all goods and services that are
produced within a country in a given time period
- GNP (GROSS NATIONAL PRODUCT): GDP + payments from foreign countries for factors of
production.
Will the US Current Account Explode soon?
- Record trading value in and out of the country.
- When an account is based on debt it will end up blowing up.
How US National Debt could blow up the Economy?
- Stock value (how much money you have at that time and how it would change when you take some)
/ Flow value: in and out.
Ex: if you have chocolate, if you take 2 and put 1 in, it will start decreasing and end up with none.
Debt is a stock value: because it means you’re expending more than you’re getting as income.
Nex debt, big returns?
- Each year US receives positive return. It means when they owe people money they have to pay
interest, but when they have assets, their returns are bigger than the interests they have to pay.

BASIC STRUCTURE
1. Current account: it’s a flow value for each year it is a certain amount).
a. Goods and services: when you sell to the rest of the world, money will come in to the country
b. Income (also include returns)
Liabilities: you have to pay interests
Assets: you will get paid interests
c. Net unilateral transfers (not as important): country gifts something
- Is current account deficit the same as trade deficit? Sometimes they go together but in other
countries.
2. Capital Account
- Balance of payment always = 0.
3. Financial Account: We always have the balance of payments by the end of the year. The balance of
payments ALWAYS equals to zero (if not, something is not right).

1
Current Account Deficit means the money in net value that its leaving the country (in toal there is more
money leaving the country)

CURRENT ACCOUNT
- Trade balance: is the difference between the value of a country’s exports- value of a country’s
imports. The current account deficit is bigger than any trade balance.
1. Balance on goods
2. Services balance
The Us managed to balance their trade during de 1960s, but after that, it was no longer balanced,
and they had huge deficit.
- Income balance
1. Net investment income
2. Net international compensation to employees
- Net unilateral Transfers
1. Private remittances
2. Government transfers

Why is current account important for a country?

- When CA > 0, this country’s net external credits increase.
Case of China that’s been running current account surplus for 30 years. There’re questions proposing
that maybe they’re that successful because their trade laws are not has hard as in other countries.
- When CA < 0, this country’s net external debt increases.

Global current account (of course of the countries that trade because those that don’t trade have a current
account of 0)
Theoretically we should see that they equal to 0, because when someone is running a deficit, others are
running a surplus.

According to IMF:
- Transportation lags could generate a positive current account if the exports of a country are
recorded in one year and imports are recorded in the following year.
- Especially in emerging economies, the underreporting of imports for tax evasion purposes.

2
 6/9/2022

Trade balance and Current Account always move together?

In the United States yes because the trade balance is the main component of the Current Account.
Here we can see in the USA it goes together, but in the other cases they are different.
Yes, because the three ballots and main components. For the USA this is true (in a particular case), even
though the two variables do not always necessarily move together (their trade deficits is a huge number
compared to the other component). Philippines’ case for example the trade balance is a deficit, meanwhile
the current account is deficit (the income has to be bigger than their trade deficit, ending up with a positive
CA; income is deficit).

Philippines: deficit for Trade Balance but surplus for Current Account. Philippines has hard working people
but not many working options, so they must go abroad to work at other countries.
Ireland: they have surplus in Trade Balance because they are big producers, almost 12% of their GDP, but
their Current Account is negative, they have debt, so their income is not enough and they have to pay huge
interests for other countries investments (they don’t risk not getting paid back).
- Even if they have a big production on place, their money is leaving the country at a pace they can’t
sustain.

A country is in debt or deep debt to the rest of the world, like a person (spending more than his income).
This accumulates.
If we look into a country, we need to take a look to the money, coming in and leaving this country. If we
want to analyze this, we do not only have to look into the trade policy, but also into the trade balance (it can
be really big, or income).

NET INTERNATIONAL INVESTMENT POSITION (NIIP)

It measures a country’s net foreign wealth.
NIIP= the value of foreign assets owned by the country’s residents – the value of the country’s assets owned
by the foreigners.
It is a stock while the current account is a flow.
The change in the NIIP is not only determined by current account but also by valuation changes.

3
 - If a currency appreciates or depreciates. (A currency appreciates/depreciates against another
currency)
Ex: USD appreciates→ if you are from Spain, you must spend more euros to buy dollars.
If a currency depreciates→ the assets become cheaper.
- It depends on which country dominates your assets/liability.

NIIP CHANGES FOR TWO REASONS:

- CA: current account
- Valuation changes: changes in the market value of the country’s foreign assets and liability positions
(due to currency appreciations or depreciations, change in stock prices…).
THE PARADOX: As a net debtor (NIIP<0) America has received more income on its foreign investments than it
has paid out to the foreign investors.

THE DARK MATTER

The Dark Matter hypothesis maintains that in reality the U.S net international investment position is
positive, but that the Bureau of Economic Analysis fails to account for all of it.
Mercantilism: it is a national economic policy that is designed to maximize the exports of a nation
- Mercantilism includes a national economic policy aimed at accumulating monetary reserves through
a positive balance of trade, especially of finished goods
- Historically, such policies frequently led to war and also motivated colonial expansion.

4
 MODELS OF INTERNATIONAL TRADE
9/9
WHY DO NATIONS TRADE
- When countries are different (1)
- When countries are similar
Trade is nothing new, it has been here for thousands of years→ the silk road. So there must be a reason to
trade.
Theories of why trade occurs:
1. Because of differences across countries in labor, labor skills, physical capital, natural resources,
technology, and preferences.
Because of economies of scale→ larger scale of production is more efficient.
- The Ricardian model examines differences in the productivity of labor (due to differences in
technology) between countries*

Gains from trade: the fact that there’re gains from trade is probably one of the most important insights in
international trade.
- Countries trading is always mutual beneficial.
- How could a country that us the most efficient producer of everything gain from trade? Because of
opportunity cost.
- Trade is predicted to benefit countries as a whole but it might harm particular groups within a
country.
It could harm the owners of resources that are relatively intensively in industries that compete with
imports→ the number of people that get harmed by trade outgrows the people that benefit by it.
Trade might affect the distribution of income within a country.

WHO TRADES WITH WHOM?

The pattern of trade describes who sells what to whom.
- Resources and climate explain why each country trades different things.
WHAT THEY TRADE
WHO GAINS FROM TRADE
- Winners / Losers
WHY PROTECT AND HOW

5
 IMPORTANT CONCEPTS:
- Absolute advantage: if a country can produce a product more efficiently
(cheaply) than other countries
- Comparative advantage: if it can produce a product at a lower opportunity cost
(if scarce factors of production are used to produce two goods, producing more
of one good always requires producing less of the other) than other countries.
- Pattern of Trade:
- Gains from Trade:

Can trade be mutual benefit between two countries one of which is more productive in every possible
area than the other? How?
- Opportunity Cost: if scarce factors of production are used to produce two goods, producing more of
one good always requires producing less of the other good.
EXAMPLE OF ROSES VS. COMPUTERS: for example, a limited number of workers could produce either roses
or computers.
- The opportunity cost of producing computers is the number of roses not produced
- The opportunity cost of producing roses is the amount of computers not produced

EX: Suppose that in the US, 10M roses could be produced with the same resources as 100,000 computers
In Colombia, 10M roses could be produced with the same resources as 30,000 computers
Who has a CA of producing roses? Colombia has a lower opportunity cost of producing roses: has to stop
producing fewer computers.

Who has a comparative advantage of producing roses?

- US: 10 million roses could be produced with the same resources as 100,000 computers.
- Colombia: 10 million roses could be produced with the same resources as 30,000 computers
Colombia has a comparative advantage because their opportunity cost is lower.
Because they’re only losing the chance of making 30.000 computers instead of 100,000.
Ricardian’s model is teaching us that a poor country can have an advantage towards a richer country→ he
doesn’t measure money, but how much you can produce.
The solution would be for Colombia to produce roses and stop producing computers and trade with the US,
that would stop producing roses and only produce computers.
- The US has a comparative advantage in computer production.
- Colombia has a comparative advantage producing roses.

6
COMPARATIVE ADVANTAGE AND OPPORTUNITY COST (cont.)
A country has a comparative advantage in producing a good if the opportunity cost of producing that good is
lower in the country than in the other countries.
- The US has a comparative advantage in computer production
- Colombia has a comparative advantage in rose production
Suppose initially that Colombia produces computers and the US produces roses, and that both countries
want to consume computers and roses. Can both countries be made better off?

COMPARATIVE ADVANTAGE AND TRADE

When countries specialize in production in which they have a comparative advantage, more goods and
services can be produced.
- Have the US stop growing roses and use those resources to make 100,000 computers
instead. Have Colombia stop making 30,000 computers and grow roses instead.
- If produce goods in which have a comparative advantage (the US produces computers and
Colombia roses), they could still consume the same 10M, but could consume 100,000-
30,000=70,000 more computers.

RICARDIAN MODEL
Examines differences in the productivity of labor, due to differences in technology, between countries.
He’s not identifying winner’s vs losers.
David Ricardo (1772-1823)
- He thinks trade is mutual benefit between countries differing in the productivity of labor→ he’s
trying to explain that trading is important because it can be mutually beneficial.
Important concepts:
Absolute advantage: a country has AA if it can produce more efficiently (cheaper) than the other country→
lower money spent→ DON’T USE RICARDIANS MODEL TO STUDY ABSOLUTE VALUE
Comparative advantage: a country has CA if it can produce a product at a lower opportunity cost than other
countries→ lower opportunity cost→ USE RICARDIAN MODEL TO STUDY IT

7
 Opportunity cost: if scare factors of production are used to produce two goods, producing more of
one good always requires producing less of the other product→ when you produce one product,
you’re losing the opportunity to produce an other product.
When countries specialize in production in which they have a comparative advantage, more goods and
services can be produced and consumed.
Understanding comparative advantage: Nations trade for the same reason people do,

For the Ricardian model to work, the countries only have one factor of production: Labor.
It also assumes that all markets are perfect competitive markets, so their profits= 0.

How to compute opportunity cost?

- Labor productivities: unit labor requirement= the amount of labor required to produce one unit of
output.
- Unit labor requirements is constant→ productivity and technology are constant, there’s no
improvements.
Example:
- alA: is defined as the number of workers required
to produce one bushel of apple in the home
country
- alB: is defined as the number of workers required
to produce one bushel of banana in the home
country

The national labor markets

- The number of workers in a country is fixed.
- In a country, workers can move freely between industries.
- Wages are endogenously determined.
- Full employment

Common misconceptions
- Trade is beneficial only if your country us strong enough to stand up to foreign competition.
- Trade can’t be beneficial if it leads to losses in some industries→ not everyone is going to win in
international trade because some countries lose industries but it’s beneficial still. You’re closing
some industries, but workers can move to other industries.

8
 - Trade with countries that pay low wages hurts high wage countries and is unfair→ it might hurt
workers but help consumers.

Production possibility frontier (PPF)

The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be
produced for a fixed amount of resources (labor).
- Frontier: you will not be able to produce more than this frontier because of the resources you have
available

WAGES
Because zero profits imply that revenues (PRICE X QUANTITY) equal the wage bill, wages of apple makers are
equal to the market value of the apple produced: PA/aLA
Similarly, wages of banana producers are equal to the market value of the banana produced: PB /aLB.
Autarky: Equilibrium prices and wages
- In a closed economy, prices of both goods must adjust so that wages are equal in both farms so that
both apple and banana are produced.

A country has a comparative advantage in producing a good if the opportunity cost of producing that good
is lower in the country than it is in other countries.
Example:
HOME: has a comparative advantage in Apple production:
it uses its resources more efficiently in producing A
compared to producing B
FOREIGN: has a comparative advantage in Banana
production: it uses its resources more efficiently in
producing B compared to producing A
Which means:
- Free trade between H and F:
- For example, H specializes in producing apple and F in producing banana
- Who will gain from this type of free trade?
- Perfect Competition Market:
- Pa be the price of one bushel of Apple. Pa=60$
- Pb be the price of one bushel of Banana. Pb= 30$

9
Autarchic Equilibrium
The relative price: the price of one good in terms of the other.
In the autarchic equilibrium, the relative price of apple equals the opportunity cost of apple.
This is because relative price must adjust so that wages are equal in the two industries so that both apple
and banana are produced.
Autarchic: they don’t trade yet.

When we open to trade prices must be equalized under free trade to rule out of arbitrage opportunities
PA /PB = P*A /P*B

GENERAL EQUILIBRIUM ANALYSIS

It focus on the linkages between two markets.
- Relative prices and relative quantity
- Relative demand and relative supply

THE RELATIVE QUANTITIES WIT TRADE

To calculate relative prices with trade, we first calculate relative quantities of world production=
(QA + Q* A )/(QB + Q* B)
RELATIVE SUPPLY AND RELATIVE DEMAND
Next, we consider relative supply of Apple→ the quantity of apple supplied by all countries relative to the
quantity of banana supplied by all countries at each relative price of apple=
PA /PB.

There is no supply of apple if the relative price of apple falls below aLA /aLB .

10
 - Why? because the domestic country will specialize in banana production whenever PA /PB < aLA
/aLB
- And we assumed that aLA /aLB < a * LA /a* LB so foreign workers won’t find it desirable to produce
apple either.
When PA /PB = aLA /aLB, domestic workers will be indifferent between producing apple or banana, but
foreign workers will still produce only banana.
Relative demand of apple is the quantity of apple demanded in all countries relative to the quantity of
banana demanded in all countries at each relative price of apple, PA /PB.
As the relative price of apple rises, consumers in all countries will tend to purchase less apple and more
banana so that the relative quantity of apple demanded falls.

Notice that the free trade relative price lies between both countries’ autarky relative prices.
Home specializes fully in apple production and Foreign specializes fully in banana production.

The comparative advantage is what determines the pattern of trade and not the absolute advantage.

PPF
- The slope of the PPF= opportunity cost of the product in the horizontal axe.

11
 SIR JAMES GOLDSMITH
IDEAS
There are all these countries out there that pay wages that are much lower than those in the West world.
Free trade with these countries cannot be mutually beneficial. Therefore, Ricardian model is invalid in the
modern world.

The wages in Ricardian Model:

- Wage for apple producers at home country (Wa= Pa/La= 60$/2= 30$)
- Wage for foreign apple producers (W*a= P*a/L*a=60$/60= 1$)
Relative price of apple:
a. The dollar price of apple (Pa), is 60$ per bushel
b. The dollar price of banana (Pb), is 30$ per bushel
c. The relative price of apple is 2 bushel of banana per bushel of apple: Pa/Pb

TRADE AND INCOME DISTRIBUTION:

While there will still be overall gains from trade, there will now be individual winners and losers from trade.
- Why trade? Countries trade because they are different from one another in terms of technology,
endowments, or preferences.
- What are the patterns of trade? It is the comparative advantage and not absolute advantage
determines the pattern of trade (RICARDIAN MODEL)
- Gains from trade? According to the Ricardian Model, free trade is mutually beneficial
- Can Ricardian model tells all? The Ricardian model emphasized technological differences but
abstracted from endowment differences.
Technology: technological advantage may be eroded over time by:
o Technology transfer to other countries
o Multinational companies
o Technical progress
- Sources of comparative advantage: What determines comprataive advantage?
o Technological differences
o Such as factor endowments of countries together with factor intensities of industries
o For example: US exports orange juice to Canada; not because its orange farmers are more
productive but because it is endowed with good weather in Florida.
- Factor endowment:
o Labor

12
 o Capital
o Land
o Skilled worker (human capital)
o Resources
- Factor intensities:
o Agriculture uses lots of land
o Texitles and apparel use lots of unskilled workers
o Autos use lots of capital

13
 THE HECKSCHER-OHLIN THEOREM
Countries have comparative advantage in, and therefore export goods that use relatively intensively their
relatively abundant factors
- Intuition: abundant factors are cheap (in autarky). Cheap factors produce cheap goods, hence
comparative advantage
- The model:
- Setup of the model
- Autarky equilibrium
- Free trade equilibrium
- Gains from trade

INTRODUCTION
In addition to differences in labor productivity, trade occurs due to differences in resources across countries
The Heckscher-Ohnlin theory argues that trade occurs due to differences in labor, labor skills, physical
capital, capital or other factors of production across countries
- Countries have different relative abundance of factors of production
- Production processes use factors pf production with the different relative intensity.

THE MODEL
- So called the “2x2x2” Model:
- Two countries: H and F
- Two goods: cloth and food
- Two factors of production: labor and land
- The H-O vs the Ricardian:
- In the H-O model, the per capita productivity is the same in both countries
- Two countries share the same technology
- Production Possibilities:

14
Two- factor Heckscher-Ohlin Model:
In threefin their factor endowments
Home is labor abundant relative to foreign
- In the sense that Home is endowed with relatively more labor: L/K>L*/K*
Cloth production is labor intensive relative to food production:
- In the sense that cloth production uses relatively more labor for all factor prices: aLC/aKC> aLF/aKF
Setup:
- If the production of one good is labor intensive relative to the production of another good in one
country we also assume the same to be the case in the other country.
- However, this assumption does not always hold in practice. For example, shoe production is capital
intensive relative to call center service production in the U.S. while the opposite is true in India.
- Technology features constant returns to scale.
- All markets are perfectly competitive.
- As one consequence, food and cloth producers take prices and wages as given.
- As another consequence workers are paid a competitive wage and land-owners are paid a competitive
rent.
Production possibilities:
- With more than one factor of production, the opportunity cost in production is no longer constant
and the PPF is no longer a straight line. Why?
- Numerical example: (total numbers of indument for the HOME COUNTRY)
o K = 3000, total amount of capital available for production
o L = 2000, total amount of labor available for production
o Suppose use a fixed mix of capital and labor in each sector.
aKC = 2, capital used to produce one yard of cloth
aLC = 2, labor used to produce one yard of cloth
aKF = 3, capital used to produce one calorie of foo
aLF = 1, labor used to produce one calorie of food
These numbers are not constant, but
variables. We should fix them first. In
difference form the Ricardian Model, these
are constant umbers.
Production possibilities are influenced by
both capital and labor:

15
 - Constraint on capital that capital used cannot exceed supply: 2QC + 3QF< 3000
- Constraint on labor that labor used cannot exceed labor supply: 2QC + QF < 2000
- Economy must produce subject to both constraints – i.e., it must have enough capital and labor.
- Without factor substitution, the production possibilities frontier is the interior of the two factor
constraints.
- Max food production 1000 (point 1) fully uses capital, with excess labor.
- Max cloth 1000 (point 2) fully uses labor, with excess capital.
- Intersection of labor and capital constraints occurs at 500 calories of food and 750 yards of cloth (point
3).

The Production Possibility Frontier without

Factor Substitution it is going to be the red line,
at point 3.It shows the shape.

The opportunity cost of producing one more yard of cloth, in terms of food, is not constant:
- Low (2/3 in example) when the economy produces a low amount of cloth and a high amount of food
- High (2 in example) when the economy produces a high amount of cloth and a low amount of food
Why? Because when the economy devotes more resources towards production of one good, the marginal
productivity1 of those resources tends to be low so that the opportunity cost is high. (We have 2 goods now,
the economy is just not firms, but in this economy is devoting more resources to one good, producing cloth,
and the marginal productivity of those resources decreases, and opp. cost will increase in this particular good)
The above PPF equations do not allow substitution of capital for labor in production.
- Unit factor requirements are constant along each line segment of the PPF.
If producers can substitute one input for another in the production process, then the PPF is curved (bowed).
- Opportunity cost of cloth increases as producers make more cloth.

1 Marginal productivity: is the extra unit of productivity. the net addition made to the total production by
producing an additional output unit. It analyzes the effect of increasing inputs on the prices of the factors of
production. It is also known as marginal physical productivity or pricing theory (EX: CHOCOLATE; repeated
times and values the pleasure, and drops eventually- marginal)

16
 We can switch it sometimes. This economy has 2
industries. In the Ricardian Model, it would be a
vertical line because the unit neighboring required is
constant. Here, because of the substation effect
between the productions these two factors, it is a
curve. The slope of this graphic is the opportunity cost
of cloth (always from the one lying in the horizontal
line)
- More in the beginning in food, less on cloth
- OPP COST OF PRODUCING CLOTH IS SMALL
- Moving to the right, the opp cost changes (the slope is steeper and steeper)

What does the country produce?

The economy produces at the point that maximizes the value of production, V.
An isovalue line (in a perfectly competitive market, we are price takers. Prices are constant because when
given any relative price level, we will be able to figure out how much to produce for QC and Qf in such a way
to make a value constant) is a line representing a constant value of production, V: V = PC QC + PF QF (“V” is a
constant number ; ex: 1000). We can draw the line with PPFF, with autarky equilibrium for the HOME
COUNTRY to find the optimal solution). It is just the combination of QC and QF.
- where PC and PF are the prices of cloth and food.
- slope of isovalue line is – (PC /PF)

In this graph, Q is the tangent point, the

equilibrium of autarky. We have the PPF
and if we stay within its frontiers, is
possible but not optimal. The tangency
here gives us the optimal solution. Each
lines gives us a value, and the further we
move from the original point, the higher it
will get.

Given the relative price of cloth, the economy produces at the point Q that touches the highest possible
isovalue line.

17
At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of
producing cloth.
- The trade-off in production equals the trade-off according to market prices.
Choosing the Mix of Inputs: producers may choose different amounts of
factors of production used to make cloth or food.
Factor prices: wage and rent
- The choice of factors of production depends on the wage, (w),
paid to labor and the rental rate, r, paid when renting capital.
- As the wage w increases relative to the rental rate (r), producers
use less labor and more capital in the production of both food
and cloth.

RESOURCES AND TRADE: HECKSCHER-OHLIN MODEL

The reason is not technology but the country’s abundancy→ that’s the reason to trade.
In this model, the per-capita productivity is the same in both countries.
F(capital, labor) = quantity
Trade and income distribution: While there will still be overall gains from trade, there will now be individual
winners and losers from trade!

Consumer theory: we look at two goods

What does the country produce?

- The economy produces at the point that maximizes the value of production, V.
- An isovalue line is a line representing a constant value of production
V: V = PC QC + PF QF
The price is constant through the graph

18
Slope of the PPF: the opportunity cost of producing the good in the horizontal line and it should be = to
the relative price of this good→ autarchy equilibrium.
- Tangency

Given the relative price of cloth, the economy produces at the point Q that touches the highest possible
isovalue line.
At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of
producing cloth.
- The trade-off in production equals the trade-off according to market prices.
Producers may choose different amounts of factors of production used to make cloth or food→ you can
choose different ones for the same input because they are complementary and can give you the same
result→ more labor or machines? UNDERSTAND THE RELATIVE WAGE (if it’s really high or increases more
than the rental rage for machines)
- The choice of factors of production depends on the wage, w, paid to labor and the rental rate, r, paid
when renting capital.
- As the wage w increases relative to the rental rate r, producers use less labor and more capital in the
production of both food and cloth.

FACTOR INTENSITY
It measures the input ratio of production factors in the production.
It is not the absolute amount of capital and labor used in the production, but the amount of labor per unit of
capital L/K
Example: clothes is more labor intensive; food is more capital (machine) intensive
- The labor in the food industry divided by the capital intensive is smaller than the capital intensity
- The capital in the clothes industry divided by the labor is smaller than the labor intensity.

CHOOSING THE MIX OF INPUTS

Assume that at any given factor prices, cloth production uses more labor relative to capital than food
production uses: aLC /aKC > aLF /aKF or LC /KC > LF /KF
- How will the relative price change→ have an impact in wages, the allocation of resources…
- Mutual beneficial doesn’t mean everybody wins, someone looses
Production of cloth is relatively labor intensive, while production of food is relatively land intensive. Relative
factor demand curve for cloth CC lies outside that for food FF.

19
FACTOR PRICES AND GOOD PRICES
In competitive markets, the price of a good should equal its cost of production, which depends on the factor
prices.
How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used.
- An increase in the rental rate of capital should affect the price of food more than the price of cloth
since food is the capital intensive industry.
- Changes in w/r are tied to changes in PC /PW.

STOLPER-SAMUELSON THEOREM
If the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the
production of that good increases, while the real wage or rental rate of the other factor decreases.
Any change in the relative price of goods alters the distribution of income.

An increase in the relative price of cloth (Pc/Pf) is predicted to:

- Raise income of workers relative to that of capital owners (w/r)
- Raise the ratio of capital to labor services (k/l), used in both industries
- Raise the real income (purchasing power) of workers and lower the real income of capital owners

RESOURCES AND OUTPUTS

How do levels of output change when the economy’s resources change?
The Rybbczynski theorem: if you hold output prices constant as the amount of a factor od production
increases, then the supply of the good that uses this factor intensively increases and the supply of the other
good decreases.

20
 - Assume an economy’s labor force grows, which implies
that its ratio of labor to capital L/K increases.
- Expansion of production possibilities is biased toward
cloth.
- At a given relative price of cloth, the ratio of labor to
capital used in both sectors remains constant.
- To employ the additional workers, the economy expands
production of the relatively labor-intensive good cloth
and contracts production of the relatively capital-
intensive good food.
- An economy with a high ratio of labor to capital produces a high output of cloth relative to food.
- Suppose that Home is relatively abundant in labor and Foreign in capital: L/K > L*/ K*
Likewise, Home is relatively scarce in capital and Foreign in labor.
- Home will be relatively efficient at producing cloth because cloth is relatively labor intensive.

TRADE IN HECKSCHER-OHLIN MODEL

The countries are assumed to have the same technology and the same tastes.
- With the same technology, each economy has a comparative advantage in producing the good that
relatively intensively uses the factors of production in which the country is relatively well endowed.
- With the same tastes, the two countries will consume cloth to food in the same ratio when faced with
the same relative price of cloth under free trade.
- Since cloth is relatively labor intensive, at each relative price of cloth to food, Home will produce a
higher ratio of cloth to food than Foreign.
Home will have a larger relative supply of cloth to food than Foreign.
Home’s relative supply curve lies to the right of Foreign’s.

21
Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices with trade.
With trade, the relative price of cloth rises in the relatively labor abundant (home) country and falls in the
relatively labor scarce (foreign) country.
Relative prices and the pattern of trade: In Home, the rise in the relative price of cloth leads to a rise in the
relative production of cloth and a fall in relative consumption of cloth.
- Home becomes an exporter of cloth and an importer of food
The decline in the relative price of cloth in foreign leads it to become and importer of cloth and an exporter of
food.
Heckscher-Ohlin theorem: The country that is abundant in a factor exports the good whose production is
intensive in that factor.
This result generalizes to a correlation:
- Countries tend to export goods whose production is intensive in factors with which the countries are
abundantly endowed.

TRADE AND DISTRIBUTION OF INCOME

Changes in relative prices can affect the earnings of labor and capital.
- A rise in the price of cloth raises the purchasing power of labor in terms of both goods while lowering
the purchasing power of capital in terms of both goods.
- A rise in the price of food has the reverse effect.
Thus, international trade can affect the distribution of income, even in the long run:
- Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.
- Factors of production that are used intensively by the import-competing industry are hurt by the
opening of trade, regardless of the industry in which they are employed.
Compared with the rest of the world, the United States is abundantly endowed with highly skilled labor while
low-skilled labor is correspondingly scarce.

22
 - International trade has the potential to make low-skilled workers in the United States worse off - not
just temporarily, but on a sustained basis.
Changes in income distribution occur with every economic change, not only international trade.
- Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of
new ones all affect income distribution.
- Economists put most of the blame on technological change and the resulting premium paid on
education as the major cause of increasing income inequality in the US.
It would be better to compensate the losers from trade (or any economic change) than prohibit trade.
- The economy as a whole does benefit from trade.
There is a political bias in trade politics: potential losers from trade are better politically organized than the
winners from trade.
- Losses are usually concentrated among a few, but gains are usually dispersed among many.
- Each of you pays about $8/year to restrict imports of sugar, and the total cost of this policy is about
$2 billion/year.
- The benefits of this program total about $1 billion, but this amount goes to relatively few sugar
producers.

NORTH-SOUTH TRADE AND INCOME INEQUALITY:

Over the last 40 years, countries like South Korea, Mexico, and China have exported to the U.S. goods intensive in
unskilled labor (ex., clothing, shoes, toys, assembled goods). At the same time, income inequality has increased in the
U.S., as wages of unskilled workers have grown slowly compared to those of skilled workers.

Did the former trend cause the latter trend?

The Heckscher-Ohlin model predicts that owners of relatively abundant factors will gain from trade and owners of
relatively scarce factors will lose from trade.
- Little evidence supporting this prediction exists.

1. According to the model, a change in the distribution of income occurs through changes in output prices, but
there is no evidence of a change in the prices of skill-intensive goods relative to prices of unskilled-intensive
goods.
2. According to the model, wages of unskilled workers should increase in unskilled labor abundant countries
relative to wages of skilled labor, but in some cases the reverse has occurred:
a. Wages of skilled labor have increased more rapidly in Mexico than wages of unskilled labor.
b. But compared to the U.S. and Canada, Mexico is supposed to be abundant in unskilled workers.
3. Even if the model were exactly correct, trade is a small fraction of the U.S. economy, so its effects on U.S.
prices and wages prices should be small.
a. The majority view of trade economists is that the villain is not trade but rather new production
technologies that put a greater emphasis on worker skills (such as the widespread introduction of
computers and other advanced technologies in the workplace).

23
Skill-based Technological Change and Income Inequality:
- Even though skilled labor becomes relatively more expensive, in panel (b) producers in both sectors
respond to to the skill-biased technological change by increasing their employment of skilled workers
relative to unskilled workers.
o The trade explanation in panel (a) predicts an opposite response for employment in both
sectors.
- A widespread increase in the skilled labor ratios for most sectors in the U.S. economy points to the
skill-biased technological explanation.
- Trade likely has been an indirect contributor to increases in wage inequality, by accelerating the
process of technological change.
o Firms that begin to export may upgrade to more skill-intensive production technologies
o Trade liberalization can then generate widespread technological change by inducing a large
proportion of firms to make such technology-upgrade choices.
- Breaking up the production process across countries can increase the relative demand for skilled
workers in developed countries similar to skill-biased technological change

Factor Price Equalization:

- Unlike the Ricardian Model, the Heckerscher-Ohlin model predits that factor prices will be equalized
among countries that trade.
- Free trade equalizes relative output prices
- Due to the connection between output prices and factor prices, factor prices are also equalized
- Trade increases the demand of good produces by relatively abundant factors, indirectly increasing the
demand of these factors, raising the prices of the relatively abundant factors.
- In the real world, factor prices are not equal across countries

24
 - The model assumes that trading countries produce the same goods, but countries may produce
different goods if their factor ratios radically differ.
- The model also assumes that trading countries have the same technology, but different technologies
could affect the productivities of factors and therefore the wages/rates paid to these factors
- The model also ignores trade barriers and transportation costs, which may prevent output prices and
thus factor prices from equalizing.
- The model predicts outcomes for the long run, but after an economy liberalizes trade, factors of
production may not quickly move to the industries that intensively use abundant factors.
o In the short run, the productivity of factors will be determined by their use in their current
industry, so that their wage/rental rate may vary across countries.

Empirical Evidence on the Heckscher- Ohlin Model:

- Tests on US data
- Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is
the most capital-abundant country in the world: Leontief paradox.
- Tests on global data:
Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model on data from 27 countries and
confirmed the Leontief paradox on an international level.
- Because the Heckscher-Ohlin model predicts that factor prices will be equalized across trading
countries, it also predicts that factors of production will produce and export a certain quantity goods
until factor prices are equalized.
In other words, a predicted value of services from factors of production will be embodied in a
predicted volume of trade between countries.
- But because factor prices are not equalized across countries, the predicted volume of trade is much
larger than actually occurs.
A result of “missing trade” discovered by Daniel Trefler.
- The reason for this “missing trade” appears to be the assumption of identical technology among
countries.
Technology affects the productivity of workers and therefore the value of labor services.
A country with high technology and a high value of labor services would not necessarily import a lot
from a country with low technology and a low value of labor services
- An important study by Donald Davis and David Weinstein showed that if relax the assumption of
common technologies, along with assumptions underlying factor price equalization (countries
produce the same goods and costless trade equalizes prices of goods):

25
 Then the predictions for the direction and volume of the factor content of trade line-up well with
empirical evidence and ultimately generate a good fit.
- Difficulty finding support for the predictions of the “pure” Heckscher-Ohlin model can be blamed on
some of the assumptions made.
- Contrast the exports of labor-abundant, skill-scarce nations in the developing world with the exports
of skill-abundant, laborscarce (rich) nations.
The exports of the three developing countries to the United States are concentrated in sectors with
the lowest skill-intensity.
The exports of the three skill abundant countries to the United States are concentrated in sectors with
higher skill intensity.
- Or compare how exports change when a country such as China grows and becomes relatively more
skill-abundant.
The concentration of exports in high-skill sectors steadily increases over time.
In the most recent years, the greatest share of exports is transacted in the highest skillintensity
sectors, whereas exports were concentrated in the lowest skill-intensity sectors in the earlier years.

SUMMARY
Substitution of factors used in the production process generates a curved PPF.
- When an economy produces a low quantity of a good, the opportunity cost of producing that good is
low.
- When an economy produces a high quantity of a good, the opportunity cost of producing that good
is high.

When an economy produces the most value it can from its resources, the opportunity cost of producing a
good equals the relative price of that good in markets.
An increase in the relative price of a good causes the real wage or real rental rate of the factor used
intensively in the production of that good to increase,
- while the real wage and real rental rates of other factors of production decrease.

If output prices remain constant as the amount of a factor of production increases, then the supply of the
good that uses this factor intensively increases, and the supply of the other good decreases

An economy exports goods that are relatively intensive in its relatively abundant factors of production and
imports goods that are relatively intensive in its relatively scarce factors of production.

26
Owners of abundant factors gain, while owners of scarce factors lose with trade.

A country as a whole is predicted to be better off with trade, so winners could in theory compensate the
losers within each country.

The Heckscher-Ohlin model predicts that relative output prices and factor prices will equalize, neither of
which occurs in the real world.

Empirical support of the Heckscher-Ohlin model is weak except for cases involving trade between high-
income countries and low/middle- income countries or when technology differences are included

AFTER MIDTERM

27
HECKSCHER-OHLIN MODEL
Stolper- Samuelson Theorem
As soon as you open to trade you have to face world trade.
- Your relative price is going to change accordingly to what this
price is.
- When the relative price changes, we want to know how it will
change our factors relative price→ ratio between wage-
capital.
- As soon as the world price is higher, your factor relative prices
will go up.

Rybczynski theorem- Resources and output

How do levels of output change when the economy’s resources change?
- If you hold output prices constant as the amount of a factor of production increases, then
the supply of the good that uses this factor intensively increases and the supply of the other
good decreases.
Assume an economy’s labor force grows, which implies that its ratio of labor to capital L/K
increases.
Expansion of production possibilities is biased toward cloth.
At a given relative price of cloth, the ratio of labor to capital used in both sectors remains constant.
To employ the additional workers, the economy expands production of the relatively labor-
intensive good cloth and contracts production of the relatively capital-intensive good food.
An economy with a high ratio of labor to capital produces a high output of cloth relative to food.
Suppose that Home is relatively abundant in labor and Foreign in capital: L/K > L*/ K* – Likewise,
Home is relatively scarce in capital and Foreign in labor. • Home will be relatively efficient at
producing cloth because cloth is relatively labor intensive.

Trade in the Heckscher-Ohlin Model

The countries are assumed to have the same technology and the same tastes.
- With the same technology, each economy has a comparative advantage in producing the
good that relatively intensively uses the factors of production in which the country is
relatively well endowed.

28
- With the same tastes, the two countries will consume cloth to food in the same ratio when
faced with the same relative price of cloth under free trade.

29
 1/11

FREE TRADE AND JOBS

Free trade doesn’t benefit all→ mutually beneficial over all for those who open to trade but doesn’t
benefit everyone within the country.
- In the Ricardian Model we trade because of productivity
- In H-O model we trade because of abundance.
Three rules to free trade
- Trade must be voluntary:
- All trading parties must benefit.
- Trade moves products from people who value them less, to people who value them more.

Winners and losers from trade

- Trade raises the economic well-being of a nation
- Gains of the winners exceed the losses of the losers
- Trade CAN make everyone better off!

Paul Krugman
- Growing U.S. trade with third world countries reduces the real wages of many and perhaps
most workers in this country.
- We respond to the trouble with trade not by shutting trade down, but by doing things like
strengthening the social safety net.
- Highly educated workers benefit from high wages and expanded job opportunities…
- The highly educated workers who clearly benefit from growing trade with third-world
economies are a minority, greatly outnumbered by those who probably lose.

Are these two related?

- Trade deficits
- Losing jobs: imports account for a small share.
- Total jobs: import and employment growth are positively related.
If our economy is doing well, imports increase→ you have more money, so you spend more.

30
Decline in manufacturing share of employment is similar across advanced societies.

31
 11/11
THE INSTRUMENTS OF TRADE POLICY

TYPES OF TARIFFS
A tariff is a tax levied when a good is imported.
A specific tariff is levied as a fixed charge for each unit of imported goods.
- For example, $3 per barrel of oil.
An ad valorem tariff is levied as a fraction of the value of imported goods.
- For example, 25% tariff on the value of imported trucks.

SUPPLY, DEMAND, AND TRADE IN A SINGLE INDUSTRY

EXAMPLE: Consider how a tariff affects a single market, say that of wheat.
Suppose that in the absence of trade the price of wheat is higher in Home than it is in Foreign.
With trade, wheat will be shipped from Foreign to Home until the price difference is eliminated.
An import demand curve is the difference between the quantity that Home consumers demand
minus the quantity that Home producers supply, at each price.
The Home import demand curve (MD= D – S) intercepts the price axis at PA and is downward
sloping:
- As price increases, the quantity of imports demanded declines.
- As the price of the good increases, Home consumers demand less, while Home producers
supply more, so that the demand for imports declines.

An export supply curve is the difference between the quantity that Foreign producers supply minus
the quantity that Foreign consumers demand, at each price.

32
The Foreign export supply curve (XS*= S*- D*) intersects the price axis at PA* and is upward
sloping:
- As price increases, the quantity of exports supplied rises.
- As the price of the good rises, Foreign producers supply more while Foreign consumers
demand less, so that the supply available for export rises.

In equilibrium:
- Import demand = export supply
- Home demand - home supply= foreign supply - foreign demand
- Home demand + foreign demand = home supply + foreign supply
- World demand = world supply

WORLD EQUILIBRIUM
The equilibrium world price is where Home import demand (MD curve) equals Foreign export
supply (XS curve).

33
EFFECTS OF A TARIF
A tariff acts like a transportation cost, making sellers unwilling to ship goods unless the home price
exceeds the Foreign price by the amount of the tariff: PT – t= PT*
- There’s a price difference now.
- A tariff makes the price rise in the Home market and fall in the Foreign market. The volume
traded thus declines

Because the price in the Foreign market falls from Pw under free trade to PT with the tariff:
- Home producers supply more and Home consumers demand less
- The quantity of imports falls from Qw under free trade to QT with the tariff.
Because the price in the Home market rises from Pw under free trade to PT* with the tariff:
- Foreign producers supply less, and Foreign consumers demand more
- The quantity of exports falls from Qw to . QT
The quantity of Home imports demanded equals the quantity of Foreign exports supplied when
PT – PT*= t
- The increase in the price in Home can be less than the amount of the tariff.
- Part of the effect of the tariff causes the Foreign export price to decline. – But this effect is
sometimes very small.

EFFECTS OF A TARIFF IN A SMALL COUNTRY

When a country is “small,” it has no effect on the foreign (world) price because its demand is an
insignificant part of world demand for the good.
- The foreign price does not fall, but remains at Pw
- The price in the home market rises by the full amount of the tariff, to PT = PW + t

34
It’s not a good idea for a small country to impose tariff if you can’t have any influence in the world
market because you won’t change anything, and it will only harm your own country.

MEASURING THE AMOUNT OF PROTECTION

The effective rate of protection measures how much protection a tariff (or other trade policy)
provides.
- It represents the change in value that firms in an industry add to the production process
when trade policy changes, which depends on the change in prices the trade policy causes.
Effective rates of protection often differ from tariff rates because tariffs affect sectors other than
the protected sector, causing indirect effects on the prices and value added for the protected
sector.
For example, suppose that automobiles sell in world markets for $8,000, and they are made from
factors of production worth $6,000.
- The value added of the production process is $8,000 $6,000.
Suppose that a country puts a 25% tariff on imported autos so that home auto assembly firms can
now charge up to $10,000 instead of $8,000.
The effective rate of protection for home auto assembly firms is the change in value added:

In this case, the effective rate of protection is greater than the tariff rate.

COSTS AND BENEFITS OF TARIFFS

A tariff raises the price of a good in the importing country, so it hurts consumers and benefits
producers there.
In addition, the government gains tariff revenue.
How to measure these costs and benefits? Use the concepts of consumer surplus and producer
surplus

35
CONSUMER AND PRODUCER SURPLUS
CONSUMER
Consumer surplus measures the amount that consumers gain from purchases by computing the
difference in the price actually paid from the maximum price they would be willing to pay for each
unit consumed.
- When price increases, the quantity demanded decreases as well as the consumer surplus.

Consumer surplus from the demand curve: Consumer surplus on

each unit sold is the difference between the actual price and
what consumers would have been willing to pay.
Example: if you’re willing to pay 1500 $ for a trip but the market
price is 700$, then you will get consumer surplus.

Price discrimination: if the market knows how much you’re willing to pay, they will ask you for that
and not less.

PRODUCER
Producer surplus measures the amount that producers gain from sales by computing the difference
in the price received from the minimum price at which they would be willing to sell.
- When price increases, the quantity supplied increases as well as the producer surplus.

- Producer surplus= area above the supply curve and below the price

36
MEASURING THE COSTS AND BENEFITS OF TARIFFS
A tariff raises the price in the importing country:
- Consumer surplus decreases (consumers worse off)
- Producer surplus increases (producers better off).
- The government collects tariff revenue equal to the tariff rate times the quantity of imports
with the tariff.
(Pt*= price tariff of the foreign country)
COSTS AND BENEFITS OF A TARIFF FOR THE IMPORTING COUNTRY
When we’re studying tariffs we look at A because they’re the ones importing their products, so they
set the tariffs to protect their producers.
Small economy, so they will not have influence in the world market, they will not change the world
price of the product they imposed a tariff on.

For a “large” country, whose imports and exports

affect world prices, the welfare effect of a tariff is
ambiguous→
- The triangles b and d represent the efficiency
loss.
The tariff distorts production and
consumption decisions: producers produce
too much and consumers consume too little.

37
 - The rectangle e represents the terms of trade gain.
- The tariff lowers the Foreign price, allowing Home to buy its imports cheaper.
Part of government revenue (rectangle e) represents the terms of trade gain, and part (rectangle c)
represents some of the loss in consumer surplus.
- The government gains at the expense of consumers and foreigners.
If the terms of trade gain exceed the efficiency loss, then national welfare will increase under a
tariff, at the expense of foreign countries.
- However, foreign countries are apt to retaliate.
Area e makes everything unstable: E= TERMS OF PRICE (rekative price)
- If it pushes the prices, then you will get more money from foreigners
Tariffs can lead trading partners to retaliate with their own tariffs, thus hurting exporters in the
country that first adopted the tariff.
Tariffs can be hard to remove and large tariffs may induce producers to engage in wasteful
activities to avoid paying tariffs.
- Ford and Subaru install (then later remove) seats in vans and pickups trucks to avoid U.S.
tariff on imports of light commercial trucks.

The difference is the tax revenue!

- In a small country is your own taxpayer who are paying for the tariff
- In a large country, is not only the insiders who pay but also the foreign people.
u can make the foreign countries push the prices down, you can benefit from the tariff.

Costs and benefits of Tariffs:

For a large country whose imports and exports can affect
foreign world prices, the welfare effect of a tariff is
ambiguous.
Triangles b + d= efficiency loss
- The tariff distorts production and consumption
decisions: producers produce too much and consumers
consume too little compared to the market outcome.
Rectangle e= terms of trade gain.
- This terms increase because the tariff lowers foreign export (domestic import) prices).

38
Tariffs can lead trading partners to retaliate with their own tariffs, thus hurting exporters in the
country that first adopted the tariff.
Tariffs can be hard to remove and large tariffs may induce producers to engage in wasteful
activities to avoid paying tariffs.
- Ford and Subaru install (then later remove) seats in vans and pickups trucks to avoid U.S.
tariff on imports of light commercial trucks.

EXPORT SUBSIDY
An export subsidy can also be specific or ad valorem:
- A specific subsidy is a payment per unit exported.
- An ad valorem subsidy is a payment as a proportion of the value exported.
An export subsidy raises the price in the exporting country, decreasing its consumer surplus
(consumers worse off) and increasing its producer surplus (producers better off).
An export subsidy damages national welfare.
The triangles b and d= the efficiency loss.
- The export subsidy distorts production and
consumption decisions: producers produce too
much and consumers consume too little
compared to the market outcome.
The area b + c + d + f + g= cost of the subsidy paid by
the government.
- The terms of trade decrease, because the price
of exports falls.

EXPORT SUBSIDY IN EUROPE

The European Union’s Common Agricultural Policy sets high process for agricultural products and
subsidizes exports to dispose of excess output.

TERMS OF TRADE
TOT: the price of a country’s exports divided by the price of it’s imports.
It can be interpreted as the amount of import goods a country can purchase per unit of export
goods.

39
IMPORT QUOTA
If you’re a small country and a big country imposes a tariff on you, doing nothing is never the best
strategy, because you’ll have to face that tariff for a long time. So, need to retaliate and impose
tariff on them, because thanks to trade, your tariffs make them suffer because they also depend on
your exports. (USA-CANADA)
An import quota is a restriction on the quantity of a good that may be imported.
- This restriction is usually enforced by issuing licenses to domestic firms that import, or in
some cases to foreign governments of exporting countries.
- A binding import quota will push up the price of the import because the quantity
demanded will exceed the quantity supplied by domestic producers and from imports.
When a quota instead of a tariff is used to restrict imports, the government receives no revenue.
- Instead, the revenue from selling imports at high prices goes to quota license holders:
either domestic firms or foreign governments.
- These extra revenues are called quota rents.

As a consumer, this quota hurts you.

VOLUNTARY EXPORT RESTRAIN

It’s not a good thing for you to do, but you do it voluntary because you know you need it.
A voluntary export restraint works like an import quota, except that the quota is imposed by the
exporting country rather than the importing country.
However, these restraints are usually requested by the importing country.
The profits or rents from this policy are earned by foreign governments or foreign producers.
- Foreigners sell a restricted quantity at an increased price.

40
LOCAL CONTENT REQUIREMENT
A local content requirement is a regulation that requires a specified fraction of a final good to be
produced domestically.
It may be specified in value terms, by requiring that some minimum share of the value of a good
represent domestic valued added, or in physical units→ to create some jobs.
From the viewpoint of domestic producers of inputs, a local content requirement provides
protection in the same way that an import quota would.
From the viewpoint of firms that must buy domestic inputs, however, the requirement does not
place a strict limit on imports, but allows firms to import more if they also use more domestic parts.
Local content requirement provides neither government revenue (as a tariff would) nor quota
rents.
Instead the difference between the prices of domestic goods and imports is averaged into the price
of the final good and is passed on to consumers.

EFFECTS OF TRADE POLICY

For each trade policy, the price rises in the Home country adopting the policy.
- Home producers supply more and gain.
- Home consumers demand less and lose.
The world price falls when Home is a “large” country that affects world prices.
Tariffs generate government revenue; export subsidies drain it; import quotas do not affect
government revenue.
All these trade policies create production and consumption distortions.

41
SUMMARY
A tariff decreases the world price of the imported good, increases the domestic price of the
imported good and reduces the quantity traded when a country is “large”.
A quota does the same.
An export subsidy decreases the world price of the exported good increases the domestic price of
the exported good and increases the quantity produced when a country is “large”.
The welfare effect of a tariff, quota and export subsidy can be measured by:
- Efficiency loss from consumption and production
- Terms of trade gain or loss
With import quotas, voluntary export restraints and local content requirements; the government of
the importing country receives no revenue.
With voluntary export restraints and occasionally import quotas, quota rents go to foreigners.

WHY PROTECT?
If you don’t protect your internal industry, you might never have the chance to compete or even
produce a product. You’ll have to depend on other countries.
- It’s a normal strategy for the economy.

42
 ECONOMIES OF SCALE
INCREASING RETURNS
In the Ricardian and Heckscher-Ohlin models, we assume that production processes have constant
returns to scale:
- When factors of production change at a certain rate, output increases at the same rate.
But a firm or industry may have increasing returns to scale or economies of scale:
- When factors of production change at a certain rate, output increases at a faster rate.
- A larger scale is more efficient: the cost per unit of output falls as a firm or industry
increases output

IMPERFECT COMPETITION
The Ricardian and Heckscher-Ohlin models also rely on competition to predict that all income from
production is paid to owners of factors of production: no “excess” or monopoly profits exist.
But when economies of scale exist, large firms may be more efficient than small firms, and the
industry may consist of a monopoly or a few large firms.

TYPES OF ECONOMIES OF SCALE

Economies of scale could mean either that larger firms or a larger industry is more efficient.
EXTERNAL ECONOMIES OF SCALE
Occur when cost per unit of output depends on the size of the industry→ if you make the size of an
industry large, you can enjoy the positives of an economy of scale.
- Transportation
- Research and experiment
- Banking facility
- Skilled workers
External economies of scale may result if a larger industry allows for more efficient provision of
services or equipment to firms in the industry.
- Many small firms that are competitive may comprise a large industry and benefit when
services or equipment can be efficiently provided to all firms in the industry.

43
INTERNAL ECONOMIES OF SCALE
Occur when the cost per unit of output depends on the size of a firm.
Internal economies of scale result when large firms have a cost advantage over small firms, causing
the industry to become uncompetitive

ECONOMIES OF SCALE
Economies of scale are another reason to trade because in some industries there’s likely to be only
a few profitable firms.
- Ricardian and H-O models don’t give us reasons on why to trade.
It does not contradict the theory of comparative advantage, but instead identifies another source
of comparative advantage. Reasons to trade:
- Comparative advantage
o Ricardian model: labor productivity + technology
o H-O: labor abundance.
- Economies of scale.

Firms with first mover advantages will develop economies of scale and create barriers to entry for
other firms.

Economies of scale typically, requires industries with high, fixed costs.

World demand will support few competitors.
Competitors may emerge because “they got there first”
- first-mover advantage.
Some argue that it generates government intervention and strategic trade policy (e.g. the need to
nurture and protect “first movers”)

REASONS FOR DUOPOLY

Barriers to Entry
Barriers to entry exist for a number of reasons, but the end result is that there is limited entry into a
market or industry because the hurdles that must be overcome are great, and therefore firms that
are already part of the industry or market have an advantage and are insulated from competition
from new entrants.

44
When an industry has a government backing it up, it’s hard for other firms to enter. These barriers
can be:
- Financing
- Engineering
- Technology
- Production
World Trade Organization
- Legal case that’s trying to eliminate trade barriers.
- Sets the legal ground-rules for international commerce.
These rules are transparent and predictable
- Used to settle trade disputes between nations
- The most favored nation rule: It requires that a WTO member must apply the same
conditions on all trade with other WTO members.

In a perfectly competitive market, firms are price takers.

With imperfect competition, firms are price setters→ majority of markets.
- The firms have market power, especially in the monopoly markets.

MONOPOLISTIC COMPETITION
Monopolistic competition is a model of an imperfectly competitive industry which assumes that
- Each firm can differentiate its product from the product of competitors (e.g., auto industry).
- Each firm ignores the impact that changes in its price will have on the prices that
competitors set: even though each firm faces competition it behaves as if it were a
monopolist.

A MODEL
We assume two things:
- The products are different: even though they’re alike, the consumers can tell the difference.
- You focus on your product and prices, you don’t acre how your changes will affect the other
firms.
Each firm produces a particular good.
All goods produced in this industry are similar and substitutes for one another.

45
The demand function each firm is facing:
- The total demand
- Its own price
- The prices charged by its rivals
- The total number of firms in the industry

Q= individual firm’s sales.

S= the total sales of the industry
N= the number of firms in the industry
B= constant term representing the responsiveness of a firm’s sales to its price→ determines you’re
share in the market.
- If the firm is a big one, B will be a small number (happens to apple)
P= price charged by the firm itself→ if you charge a high price, you lose market share→ but not always,
if you’re consumers are very loyal, you won’t lose your share.
P_= the average price charged by its competitors

ONE BIG ASSUMPTION FOR MONOPOLISTIC COMPETITION FIRMS

We assume that all firms face the same demand functions and have the same cost functions:
Thus, in equilibrium, all firms should charge the same price: P = P→ We know what will happened
to our share equally
In equilibrium:
- Q = S/n + 0
- AC = C/Q = F/Q + c = F(n/S) + c

MONOPOLISTIC COMPETITION
What will happened when the firms open to trade?
As the number of firms n in the industry increases, the average cost increases for each firm
because each produce less→ this is not good.
- The less firms you have in the monopolistic competition, the better, because you will
produce more and can use an economy of scale.
- As total sales S of the industry increase, the average cost decreases for each firm because
each produces more.

46
 Equilibrium of a Monopolistic market before trade:
As the number of firms n in the industry increases,
the price that each firm charges decreases because
of increased competition.

If the number of firms is greater than or less than the equilibrium number, then firms have an
incentive to exit or enter the industry.
- Firms have an incentive to enter the industry when revenues exceed all costs (price >
average cost)
- Firms have an incentive to exit the industry when revenues are less all costs (price <
average cost)

MONOPOLISTIC COMPETITION AND TRADE

Because trade increases market size, trade is predicted to decrease average cost in an industry
described by monopolistic competition.
- Industry sales increase with trade leading to decreased average costs: AC = F(n/S) + c
Because trade increases the variety of goods that consumers can buy under monopolistic
competition, it increases the welfare of consumers. And because average costs decrease,
consumers can also benefit from a decreased price.

Effects of a larger market.

As a result of trade, the number of firms in a
new international industry is predicted to
increase relative to each national market.
But it is unclear if firms will locate in the
domestic country or foreign countries.

47
GAINS FROM AN INTEGRATED MARKET
The integrated market supports more firms, each producing at a larger scale and selling at a lower
price than either national market does on its own.
Everyone is better off as a result of the larger market with integration:
- Consumers have a wider range of choices, and
- Each firm produces more and is therefore able to offer its product at a lower price.

INTER-INUSTRY TRADE
According to the Heckscher-Ohlin model or Ricardian model, countries specialize in production.
- Trade occurs only between industries: inter-industry trade.
In a Heckscher-Ohlin model suppose that:
- The capital abundant domestic economy specializes in the production of capital intensive
cloth, which is imported by the foreign economy.
- The labor abundant foreign economy specializes in the production of labor intensive food,
which is imported by the domestic economy

If a country decides to change its production= specialize, because of international trade→ they will
benefit from trade (there’s an incentive for them).

INTRA-INDUSTRY TRADE
Suppose now that the global cloth industry is described by the monopolistic competition model.
Because of product differentiation, suppose that each country produces different types of cloth.
The monopolistic model explains this.
- Because of economies of scale, large markets are desirable: the foreign country exports
some cloth and the domestic country exports some cloth.
- Trade occurs within the cloth industry: intra-industry trade

DUMPING
Dumping is charging different prices for the same product= price discrimination.
Dumping is the practice of charging a lower price for exported goods than for goods sold
domestically→ want to drive your company out of business and then they’ll charge you higher
prices.

48
It’s a business strategy for profit increase.
Dumping is an example of price discrimination: the practice of charging different customers
different prices.
Price discrimination and dumping may occur only if:
- imperfect competition exists: firms are able to influence market prices.
- markets are segmented so that goods are not easily bought in one market and resold in
another.
THE WTO ANTIDUMPING AGREEMENT
WTO is for multilateral agreements, not bilateral agreements.
WTO’s Anti-Dumping Agreement:
- It provides complex rules for determining when dumping has occurred and for resolving
dumping disputes.
- Every WTO member country is expected to see that its national anti dumping laws comply
with the WTO rules.
This agreement allows governments to act against dumping where there is genuine (“material”)
injury to the competing domestic industry.

Dumping may be a profit maximizing strategy because of differences in foreign and domestic
markets.
One difference is that domestic firms usually have a larger share of the domestic market than they
do of foreign markets.
- Because of less market dominance and more competition in foreign markets, foreign sales
are usually more responsive to price changes than domestic sales→ they’re price takers
- Domestic firms may be able to charge a high price in the domestic market but must charge a
low price on exports if foreign consumers are more responsive to price changes.
To maximize profits, the firm should sell a limited amount in the domestic market at a high price
Pdom but sell in foreign markets at a low price Foreign.
- Since more can always be sold at Foreign, the firm should sell its products at a high price in the
domestic market until marginal revenue there falls to PFOR.
- Thereafter, it should sell exports at PFOR until marginal costs exceed this price.
In this case, dumping is a profit-maximizing strategy.

49
 Monopolies produce at a point where Marginal
revenue (MC) = marginal cost (MC).
We have two markets: the domestic one and
the foreign one.
In the domestic one, they will be price makers,
because they have power over the price.
In the foreign markets they’ll be price takers,
because their actions don’t change the world
market price.
They charge at the point where the marginal cost/ marginal revenue intercepts with their demand.

DUMPING AND PROTECTIONISM

Dumping (as well as price discrimination in domestic markets) is widely regarded as unfair.
The Special Import Measures Act (SIMA) helps protect Canadian industry from injury caused by the
dumping and subsidizing of imported goods.
The Canada Border Services Agency (CBSA) and the Canadian International Trade Tribunal (CITT) are
jointly responsible of the investigative process.

CASE STUDY
On March 5 2002, Bush signed a proclamation imposing increased tariffs on imports of certain steel
products.
Bush’s action was taken pursuant to Section 201 of the Trade Act of 1974.

50
 THE CASES AGAINST FREE TRADE
Free trade and globalization is generally believed to cause a degradation in the world environment.
POLLUTION HAVEN
Because more developed countries usually have strict environmental regulations and less
developed countries do not, environmentally hazardous activities may be moved to less developed
countries.
- A pollution haven is a place where an economic activity that is subject to strict
environmental controls in some countries is moved to (sold to) other countries with less
strict regulation.
- Yet, there is evidence that pollution havens are insignificant relative to the pollution that
occurs without international trade.
TRADE AND CULTURE
Some activists believe that trade destroys culture in other countries.
- This belief neglects the principle that we should allow people to define their culture through
the choices that they make, not through standards set by others.
- Also, any economic change, not just trade, leads to changes in everyday life.

INTERNATIONAL NEGOCIATIONS OF TRADE POLICY

TRADE WAR
If you start imposing tariffs, the other country will also impose tariffs on you.
When a trade war begins, the best option is for countries to renegotiate and go back to free
trade→ win-win solution.
Multilateral negotiations also help avoid a trade war between countries, where each country enacts
trade restrictions.
A trade war could result if each country has an incentive to adopt protection, regardless of what
other countries do.
- All countries could enact trade restrictions, even if it is in the interest of all countries to have
free trade.
- Countries need an agreement that prevents a trade war or eliminates the protection from
one.

51
WORLD TRADE ORGANIZATION
WTO negotiations address trade restrictions in at least 3 ways:
- Reducing tariff rates through multilateral negotiations.
- Binding tariff rates: a tariff is “bound” by having the imposing country agree not to raise it
in the future.
- Eliminating nontariff barriers: quotas and export subsidies are changed to tariffs because
the costs of tariff protection are more apparent and easier to negotiate.
o Subsidies for agricultural exports are an exception.
o Exceptions are also allowed for “market disruptions” caused by a surge in imports.
The World Trade Organization is based on a number of agreements:
- General Agreement on Tariffs and Trade covers trade in goods. (GATT)
- General Agreement on Tariffs and Services covers trade in services (ex., insurance,
consulting, legal services, banking).
- Agreement on Trade-Related Aspects of Intellectual Property: covers international property
rights (ex., patents, and copyrights).

ANTI-GLOBALIZATION MOVEMENT
Negative-sum game describes situations in which the total of gains and losses is less than zero, and
the only way for one party to maintain the status quo is to take something from another party.

52