International Trade Theory and Practice

Lecture Notes

Note: text in italics is just for you, not for the exam

International Economy – Introduction

Subject Content
International Economy – Introduction
Traditional Theories of International Trade
New Theories of International Trade and Investment
Trade Policy Instruments
Tekst
International Trade Policy

Economics is a social science that:

● analyzes the processes of production, distribution and consumption.
● focuses on the behavior of economic agents and whole economies.
● studies how societies allocate scarce resources and goods to satisfy their unlimited wants.

Economic Decisions
Both a household and a whole economy face many decisions, e.g.:
● Who will work?
● What goods and how many of them should be produced?
● What resources should be used in production?
● At what price should the goods be sold?

10 Principles of Economics (Mankiw)

1. When individuals make decisions, they face tradeoffs among alternative goals.
2. The cost of any action is measured in terms of foregone opportunities (opportunity
cost).
3. Rational people make decisions by comparing marginal costs and marginal benefits (e.g. MC
= MR).
4. People change their behavior in response to the incentives they face.
5. Trade can be mutually beneficial.
6. Markets are usually a good way of coordinating trade among people.
7. Government can potentially improve market outcomes if there is some market failure
or if the market outcome is inequitable.
8. Productivity is the ultimate source of living standards.
9. Money growth is the ultimate source of inflation.
10. Society faces a short-run tradeoff between inflation and unemployment.

Positive economics analyzes and explains economic phenomena („what is?”, „why?”).
It focuses on facts and cause-and-effect relationships. Positive economic statements are
testable by facts and explain the world as it is without making value judgments.
Normative economics reflects value judgments („what ought to be?”). For example, it
expresses goals of public policy.

Microeconomics analyzes the behavior of individual agents and individual markets.

Mesoeconomics analyzes structural changes in whole branches and sectors of an economy.
Macroeconomics analyzes the problems of an economy as a whole (economic growth,
unemployment, inflation, monetary and fiscal policy) and operates with aggregate values.
International Economics analyzes economic interactions among countries, characterized
by different levels of factors mobility and different currencies.

Short run is a time period in which at least one factor of production is constant (or not all economic
variables can adjust to the state of the economy).
Long run is a time period where there are no fixed factors of production (or all economic variables
can fully adjust to the state of the economy).

Why study International Economics?

Today, it is difficult to discuss any aspect of economic theory or policy without considering
international markets.
The uncertainty surrounding international trade and financial markets has brought about increasing
interest in the subject (especially after the global financial crisis and the outbreak of COVID-19
pandemic).
We are all consumers of foreign-produced goods.
Understanding mechanisms underlying the international economy may be helpful to make good
decisions.
It is also important to recognize the axiological aspects of international activity (e.g. is it ethical to buy
clothes produced by small children or to speculate against the euro?)

Some Statistics
World Gross Domestic Product (IMF)
World Trade (UNCTAD)
Foreign Exchange Turnover (BIS)
World Uncertainty Index

Lecture 1: Traditional Theories of International Trade. Part I

Introduction
Countries engage in international trade for two basic reasons:
● They are different from each other in terms of climate, land, capital, labor, and
technology (reflected e.g. in the productivity of labor).
● They try to achieve the economies of scale in production.

Theories of International Trade and Investment

Historical Developments
● Mercantilism (1500-1800) – positive trade balance
Absolute advantage – Adam Smith (1723-1790)
● Countries benefit from exporting what they make cheaper than anyone else
Comparative advantage – David Ricardo (1772-1823)
● Nations can gain from specialization, even if they lack an absolute advantage

Trade in a One-Factor World

If countries specialize according to their comparative advantage, they all gain from this
specialization and trade.
● Firstly, trade is a new way of producing goods and services (a new technology).
● Secondly, trade enlarges the consumption possibility for each of the two countries.
Because of technological differences, trade in goods does not make the wages equal across
the two countries.
A country with absolute advantage in both goods will enjoy a higher wage after trade.
Assumptions:
● There are two countries in the world (Home and Foreign).
● Each of the two countries produces two goods.
● Labor is the only factor of production.
● The supply of labor is fixed in each country.
● The productivity of labor in each good is fixed.
● Labor is not mobile across the two countries.
● Perfect competition prevails in all markets.

Absolute Advantage
A country has an absolute advantage in the production of a good, if it has a lower unit labor
requirement than the foreign country in this good.
 Output per labor hour
Nation Wine Cloth
United States 5 bottles 20 yards
United Kingdom 15 bottles 8 yards

In other words, a country has an absolute advantage in the production of a good, if it has a
lower unit labor requirement than the foreign country in this good.

Comparative Advantage
Even if one country has an absolute advantage in both goods, beneficial trade is possible
when each country exports the goods in which it has a comparative advantage (lower
opportunity costs).

Output per labor hour

Nation Wine Cloth
United States 40 bottles 40 yards 1W = 1C
United Kingdom 20 bottles 10 yards 1W = 1/2C

Even if one country has an absolute advantage in both goods, beneficial trade is possible
when each country exports the goods in which it has a comparative advantage (lower
opportunity costs).

Production Possibilities Frontier

Production possibilities frontier (transformation schedule) shows combinations of products
that can be made if all factors are used efficiently.
It generalizes the theory to include all factors (not only labor).
Its slope, or marginal rate of transformation, shows the opportunity cost of making more of
one good (how much of one good must be given up to make more of another).

Constant opportunity costs

Production gains from specialization
Consumption gains from trade

Equilibrium Terms-of-Trade Limits

Case of Many Goods

Transport Costs and Nontraded Goods
There are three main reasons why specialization in the real international economy is not
extreme:
● It is costly to transport goods and services.
● There exists more than one factor of production.
● Countries sometimes protect industries from foreign competition.
The result of introducing transport costs makes some goods nontraded.
In some cases, transportation is virtually impossible (e.g. services such as haircuts and auto
repair).

Introduction to Factor Endowment Theory

Although in the real world, international trade is often explained by differences in labor
productivity, it also reflects differences in countries’ resources.
The Heckscher-Ohlin theory asserts that comparative advantage can be explained entirely
by different national supply conditions, especially resource endowments. It shows that
comparative advantage is influenced by:
● relative factor abundance (refers to countries)
● relative factor intensity (refers to goods)

Factor Endowment Theory (Heckscher-Ohlin Model)

Nations export products that use inputs which are relatively abundant (cheap) at
home, and import products which need inputs which are relatively scarce (expensive)
at home.

Assumptions:
There are two countries that have:
● same preferences
● same technology
● same production structure
● different resources (e.g. one country can have a higher ratio of labor to land than the
other).
Factor Intensity
Assume a world of two goods (autos and wheat) and two factors (labor, L, and land, T).
Wheat production is land-intensive, if at any given wage-rental ratio the land-labor ratio used
in the production of wheat is greater than that used in the production of autos:
TW/LW > TA/LA
Example:
Wheat production uses 80 workers and 200 acres, while auto production uses 20 workers
and 20 acres? Is wheat production land- or labor-intensive?
Wheat production is land-intensive and production of automobiles is labor-intensive.

Stolper-Samuelson Theorem
If the relative price of a good increases, holding factor supplies constant, then the nominal
and real return (in terms of both goods) to the factor used intensively in the production of that
good increases, while the nominal and real return (in terms of both goods) to the other factor
decreases.
The reverse is also true.
A comment
• An increase in the price of automobiles relative to that of wheat will:
– raise the income of workers relative to that of landowners,
– raise the ratio of land to labor in both automobile and wheat production and thus
raise the marginal product of labor in terms of both goods,
– raise the purchasing power of workers and lower the purchasing power of
landowners, by raising real wages and lowering real rents in terms of both goods.

Rybczynski Theorem
If a supply 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 for any given
commodity prices.
The reverse is also true.
An increase in the supply of land (labor) leads to a biased expansion of production
possibilities toward wheat (automobile) production.
An economy will tend to be relatively effective at producing goods that are intensive in the
factors with which the country is relatively well-endowed.

Lecture 2: Traditional Theories of International Trade. Part II

2. Increasing Opportunity Costs

International Equilibrium
• The final pattern of trade depends not only on supply, but also on demand – which is
determined by individual tastes (preferences).
• Preferences can be shown graphically with indifference curves, which show various
combinations of two goods that give a consumer the same total level of satisfaction (utility).

A Consumer’s Indifference Map

Indifference Curves
• Indifference curves have a negative slope, because keeping satisfaction constant
means giving up some of one good for more of another.
• Typically, indifference curves are convex, because as the consumer gets more of one
good, he is less willing to give up what is left of the other. The rate of substituting one good
for another (the marginal rate of substitution) is shown by the slope of the curve.
• Individual preferences cannot be added up into a “community indifference curve”, but
it is useful to imagine that they can for the purposes of trade theory.

Indifference Curves and International Trade

 closed economy

trade allows us to go beyond home

production (black line)

Effects of International Trade Between Two-Factor Economies

• Heckscher-Ohlin Theorem: A country will export
that commodity which uses intensively its abundant factor and import that commodity which
uses intensively its scarce factor.
• Trade produces a convergence of relative prices.
• Changes in relative prices have strong effects on the relative earnings of labor and
land in both countries – owners of a country’s abundant factors gain from trade, but owners
of a country’s scarce factors lose.
• Factor-Price Equalization Theorem: International trade leads to complete
equalization in the relative and absolute returns to homogeneous factors across countries. It
implies that international trade is a substitute for the international mobility of factors.
Immiserizing Growth

Immiserizing growth occurs when:

• nation’s economic growth is biased toward its export sector
• country is large enough to influence world prices (i.e. export prices fall when
domestic output expands)
• foreign demand for the nation’s exports is highly price-inelastic
• country is significantly engaged in international trade (negative effects related with
terms of trade deterioration outweigh positive effects of increased production)

• Immiserizing Growth: A Case Study

• According to the concept of immiserizing growth, specialization in production of
goods for exports can make the exporting nation worse off, because the more of a good is
being exported, the lower its price on world markets, and potentially the lower the revenues
from exports.
• This situation refers mostly to some developing countries that rely heavily on exports
of a single commodity such as coffee, cocoa, tea, tobacco, cotton or sugar.
• One of the most often given examples is Brazil which is the biggest coffee producer
and exporter in the world.
• Coffee arrived in Brazil in 1727.
• Owing to favorable natural conditions and cheap labor force the country became the
dominant coffee producer in the world in the 1840s.
• In the 1920s the country was responsible for production of 80% of the world’s coffee,
but this share has declined due to increased production in other countries and presently it
does not exceed one third of world production.
Arguments against immiserizing growth in Brazil:
• Currently the average share of coffee exports in total export earnings for Brazil is
about 2% (economic growth in this country no longer depends solely on the exports of coffee
and changes of its prices on the market).
• Between 1990 and 2012 there was a weak, but positive correlation between Brazilian
exports of coffee and average prices paid to coffee growers (while according to the concept
of immiserizing growth greater exports should lead to lower prices).
Nevertheless, there was an episode that can be referred to as immiserizing growth:
• Deregulation of coffee market (after the expiration of the International Coffee
Agreement in 1989 which had been imposing export quotas to stabilize prices) and huge
production increases in Brazil lead to the so-called coffee crisis of 1999-2004.
• The bumper crop made coffee prices plummet to a 30-year low in 2002 which had
devastating socio-economic consequences also for other countries exporting coffee,
because falling export earnings trapped many coffee growers in poverty. In Brazil the
situation was further aggravated by extensive income inequalities.
• Immiserizing Growth: A Case Study
• Besides, is coffee trade based on equal rules?
• Four large coffee traders (ECOM, Louis Dreyfus, Neumann, and VOLCAFE) control
around 40% of global trade, while five biggest transnational roasters (Nestlé, Kraft Foods,
Procter & Gamble, Sara Lee, and Tchibo) buy about a half of world’s coffee beans and reap
most of the profits from the coffee business.
• The situation of coffee farmers is very different. Although in the 1970s producers
retained about 20% of the retail price of coffee, during the coffee crisis they received just
1-3% of the price.
• Their situation has not changed significantly…

• Introduction to Specific Factor Theory

• Trade has substantial effects on the income distribution within each trading nation.
• There are two main reasons why international trade has strong effects on the
distribution of income:
– Resources cannot move immediately or costlessly from one industry to another.
– Industries differ in the factors of production they demand.
• The specific factor model allows trade to affect income distribution.
• Specific Factor Theory
• Specific factor theory looks at the income distribution effects of trade in the short run,
when some factor inputs are not mobile among sectors.
• It predicts that owners of factors used in export industries gain from trade, while
owners of factors used in import-competing industries will lose from trade.
• Prices, Wages, and Labor Allocation
• In each sector, profit-maximizing employers will demand labor up to the point where
the value produced by an additional person-hour equals the cost of employing that hour.
• The wage rate must be the same in both sectors, because of the assumption that
labor is freely mobile between sectors.
• Suppose that the price of automobiles increases by 10%. Then, we would expect the
wage to rise by less than 10%, say by 5%.
• We cannot say whether workers are better or worse off; this depends on the relative
importance of automobiles and wheat in workers’ consumption.
• Owners of capital are definitely better off.
• Landowners are definitely worse off.
• Case Study: Leontief Paradox
• For many years the United States has been abundant in capital relative to the rest of
the world.
• Therefore, from the Heckscher-Ohlin theorem, one can expect that the United States
have exported capital-intensive goods and imported labor-intensive goods over these years.
• However, Wassily Leontief found empirically that in 1947 U.S. exports were less
capital-intensive than U.S. imports (in other words, capital-labor ratio was higher for U.S.
imports than for exports).
• Explanations
• In contrast to the assumptions of Heckscher-Ohlin theory, U.S. and foreign
technologies were not the same (also preferences could have differed) and the U.S. was not
engaged in completely free trade.
• Leontief focused only on labor and capital, thereby ignoring land abundance in the
United States.
• Leontief did not make any distinction between skilled and unskilled labor (U.S.
exports might have been as intensive in skilled labor in 1947 as it is nowadays).
• 1947 was not a typical year due to the postwar disorganization in many countries.
• In 1947 the U.S. observed a trade surplus which means that it might have exported
not only the capital-intensive goods, but also the labor-intensive goods.
• If the United States have been relatively capital abundant and labor scarce, the
scarce factor may have lobbied for import protection.
• The U.S. may have had high trade barriers to labor-intensive imports, while some of
its trading partners may have had restrictions on capital-intensive imports.
• In 1951 Leontief found that U.S. imports was still more capital-intensive than U.S.
exports.
• He suggested that U.S. workers may be more efficient than foreign.
• Leontief attributed the efficiency of U.S. workers to superior economic organization,
because he assumed that countries have had identical technologies and hence identical
capital-labor ratios.
• Assuming that the U.S. was abundant in effective factor (labor), there is no paradox,
because it can be explained in terms of differences in labor productivity across countries.

Summary
• The gains from trade can be shown in either of two ways:
– trade can be treated as an indirect method of production.
– trade enlarges a country’s consumption possibilities.
• The distribution of these gains depends on the relative prices of the goods countries
produce.
• The Heckscher-Ohlin theorem predicts the following pattern of trade: a country will
export that commodity which uses intensively its abundant factor and import that commodity
which uses intensively its scarce factor.
• The owners of a country’s abundant factors gain from trade, but the owners of scarce
factors lose.
• In reality, complete factor price equalization is not observed because of wide
differences in resources, barriers to trade, and international differences in technology.
• To assess the effects of trade on particular groups, the key point is that international
trade shifts the relative price of goods.
• Trade benefits the factor that is specific to the export sector of each country, but hurts
the factor that is specific to the import-competing sectors.
• Trade has ambiguous effects on mobile factors.

Lecture 4-5: New Theories of International Trade and Investment

Introduction
• Some patterns of trade are fairly easy to explain.
• It is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports
coffee.
• But why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?

Product Life Cycle Theory

• The product life-cycle theory was proposed by Raymond Vernon in the 1960.
• Accordingly, as products mature both the location of sales and the optimal production
location will change affecting the flow and direction of trade.
• Initially, the product would be produced and sold in the United States, because the
size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new
products.
• As demand grew in other developed countries, U.S. firms would begin to export.
• Later, producers based in advanced countries where labor costs were lower than the
United States might be able to export to the United States.
• If cost pressures were intense, developing countries would acquire a production
advantage over advanced countries.
• In general, production became concentrated in lower-cost foreign locations, and the
U.S. became an importer of the product.
• The product life cycle theory accurately explains what has happened for products like
photocopiers and a number of other high technology products developed in the United
States in the 1960s and 1970s.
• However, globalization and has made this theory less valid today:
– the theory is ethnocentric
– production today is dispersed globally
– products today are introduced in multiple markets simultaneously

• Introduction to New Trade Theory

• Traditional theories of international trade cannot explain trade between similar
countries that exchange similar but differentiated goods.
• New theory of international trade emphasizes market imperfections.
• New trade theory suggests that the ability of firms to gain economies of scale (unit
cost reductions associated with a large scale of output) can have important implications for
international trade.
• Countries specialize in the production and exports of particular products, because in
certain industries, the world market can only support a limited number of firms.
• New trade theory emerged in the 1980s.
• Paul Krugman won the Nobel prize for his work in 2008.

• Economies of Scale
• Models of trade based on comparative advantage used the assumptions of constant
returns to scale and perfect competition.
• Increasing the amount of all inputs used in the production of any commodity will
increase output of that commodity in the same proportion.
• In practice, many industries are characterized by economies of scale (also referred to
as increasing returns).
• Production is most efficient, the larger the scale at which it takes place.
• Economies of Scale as Basis for Trade

• A large country can benefit from economies of scale without giving up varieties.
• A small country has to choose between giving up some varieties or to produce them
with lower costs (decreasing the scale).
• Economies of Scale and Specialization
• Economies of scale provide incentives for specialization, because per unit costs go
down as production increases.
• Trade provides a larger potential market for products, making higher production
levels possible.
• There are two models of international trade in which economies of scale and
imperfect competition play a crucial role:
– Monopolistic competition model
– Dumping model
• Imperfect Competition
• Under imperfect competition firms are aware that they can influence the price of their
product.
• They know that they can sell more only by reducing their price.
• Each firm views itself as a price setter, choosing the price of its product, rather than a
price taker.
• The simplest imperfectly competitive market structure is that of a pure monopoly, a
market in which a firm faces no competition.

[Pure Monopoly]
[Monopolistic Competition]

• Imperfect Competition
• In a monopolistic competition model, trade is constituted by two parts:
• Inter‐industry:
• It is based on comparative advantage.
• The volume and the direction of trade is predictable.
• Intra‐industry:
• It is not based on comparative advantage.
• The volume of trade is predictable, but the direction is not.

• Imperfect Competition
• Under imperfect competition a company:
• sells more the larger the total demand for its industry’s product and the higher the
prices charged by its rivals,
• sells less the greater the number of firms in the industry and the higher its own price:
• Q = S x [1/n – b x (P – P*)]
where:
• Q is the firm’s sales
• S is the total sales of the industry
• n is the number of firms in the industry
• b is a constant term representing the responsiveness of a firm’s sales to its price
• P is the price charged by the firm itself
• P* is the average price charged by its competitors

• Imperfect Competition
• The equilibrium number of firms is given by the intersection of:
– the downward-sloping curve PP showing that the more firms, the lower the price
each firm will charge (the more firms, the more competition each firm faces),
– the upward-sloping curve CC depicting that the more firms there are, the higher the
average cost of each firm (if the number of firms increases, each firm will sell less, so firms
will not be able to move as far down their average cost curve).

• Inter-industry and Intra-industry Trade

• Inter-industry trade reflects comparative advantage, whereas intra-industry trade
does not.
• The pattern of intra-industry trade itself is unpredictable.
• The relative importance of intra-industry and inter-industry trade depends on how
similar countries are.
• About one half of world trade consists of intra-industry trade.
• Trade between countries that converge in income and technology can keep on
increasing.
• Nothing ensures that the concentration of an industry in a country is the most efficient
choice.
• Intra-industry trade plays a particularly large role in the trade in manufactured goods
among advanced industrial nations, which accounts for most of world trade.
• Intra-industry trade allows countries to benefit from larger markets.
• Gains from intra-industry trade will be large when economies of scale are strong and
products are highly differentiated.

• IIT: The Krugman Interpretation (trade in final goods)

• IIT: The Ethier Interpretation (trade in intermediate goods)

• Dumping
• Dumping is the most common form of price discrimination (the practice of charging
different customers different prices) in international trade.
• Dumping is a pricing practice in which a firm charges a lower price for an exported
good than it does for the same good sold domestically.
• It is a controversial issue in trade policy and is widely regarded as an unfair practice
in international trade.
• Dumping can occur only if two conditions are met:
– Imperfectly competitive industry
– Segmented markets

• Implications Of Trade Theory For Managers

• First mover implications: First movers can gain a scale-based cost advantage that
later entrants find difficult to match.
• Location implications / Foreign investment decisions: A firm should disperse its
various productive activities to those countries where they can be performed most efficiently.
• Government policy implications: Firms should work to encourage governmental
policies that support free trade.

• From the New Trade Theory to the New New Trade Theory
New theories of international trade focus on increasing returns to scale and consumer love
of variety as the basis for international trade. These theories explain intra-industry trade.
• Helpman & Krugman (1985) combine this theory with the concept of comparative
advantage and provide a relatively successful explanation for patterns of trade across
countries and industries.
• A key simplification in this theoretical literature was the assumption of a
representative firm within each industry.
• Increased availability of microdata on firms and plants revealed that there was vast
heterogeneity across producers within industries, in terms of size, productivity, capital and
skill-intensity, and wages.
• Firm Heterogeneity
• Typically a minority of plants in the industry export their products abroad.
• There is a considerable variation in export market participation rates across
industries.
• Exporters are systematically different from non-exporters: they are larger, more skill
intensive, more capital intensive, and more productive.
• These findings are consistent with classical trade theory of comparative advantage.
• High productivity induces firms to self-select into export markets (and/or learning by
exporting).
• New New Trade Theory
• Melitz (2003) introduces firm heterogeneity into Krugman's (1980) model of
intra-industry trade: produces a tractable and flexible framework that has become a standard
for analyzing international trade.
• One reason why international trade is so concentrated is that larger exporters not
only export more of a given product to a given destination than smaller exporters, but also
export more products to more destinations.
• Melitz model predicts a reallocation of resources across firms within industries.
• Low productivity firms will exit the market, while surviving companies characterized
by intermediate productivity will face a contraction of both revenues and sales.
• At the same time, high productivity firms enter the export markets and expand their
market shares.
• In this setup, a single firm does not change its productivity level, but it is the overall
distribution that changes due to the self-selection of the most productive firms and the
reallocation effects within industries.

• Summary
• Theories of international trade focused on countries, industries and then particular
firms.
• New theories of international trade concentrate on increasing returns to scale and
consumer love of variety as the basis for international trade. These theories explain
intra-industry trade.
• Imperfect competition makes it possible for firms to differentiate their products.
• New new theory emphasizes the role of firm heterogeneity.

International Factor Movements - Introduction

• Movement of goods and services is one form of international integration.
• Another form of integration is international movement of factors of production (factor
movements).
• Factor movements include:
– labor migration
– transfer of capital via international borrowing and lending
– international linkages involved in the formation of multinational corporations

• International Migration
• The redistribution of the world’s labor force:
– leads to a convergence of real wage rates
– increases the world’s output as a whole
– leaves some groups worse off (because of changes of distribution of income between
capital and labor)
• Other concerns:
– fiscal drain from immigration
– brain drain from developing countries
– status of temporary guest workers
– illegal migration

[statistics: International Organization for Migration]

• Foreign Direct Investment

• Foreign direct investment refers to international capital flows in which a company
from one country:
– buys a controlling interest in a firm in another country
– buys or builds new plants or equipment overseas
– shifts funds abroad to create or expand a subsidiary
– reinvests the earnings of a foreign subsidiary
• FDI involves not only a transfer of resources but also the acquisition of control.
• FDI leads to forming of multinational organizations (multinational companies) which
play an important part in world trade and investment.
• Reasons for Foreign Direct Investment
• Demand factors
– Serve different local markets
– Respond to market competition
• Cost factors
– Access to key raw materials
– Labor costs
– Transportation costs
– Government policies
• Theory of Multinational Enterprise

[Statistics: UNCTAD]

– OLI Paradigm (John Dunning)

• Ownership motive – firm specific advantage is usually intangible and can be
transferred at low cost (e.g. technology, brand name, benefits of economies of scale)
• Location motive – a good is produced in two or more different countries rather than
one because of:
– access to resources
– transport costs
– barriers of trade
• Internalization motive – a good is produced in different locations by the same firm
rather than by separate firms because it is more profitable due to:
– technology transfer
– vertical integration

• Theory of Multinational Enterprise

• The distinction between firm‐ and plant‐level scale economies is important:
• Firm‐level scale economies: firms will be large, and tend to have sales in many
countries.
• Plant‐level scale economies: firms will not want to split production into many
separate units.
• MNEs are more likely to appear when there are high firm‐level scale economies
combined with low plant‐scale economies (i.e: Coca‐Cola; Burger‐King).

• Controversies over Multinationals

• Employment
– host country may not gain many jobs, foreign managers often brought in; source
country worries about losing jobs
• Technology transfer
– MNEs are reluctant to share technology with host nations; source country worries
about giving away advantage
• National sovereignty
– host country worries about power of MNE to influence affairs; source country worries
about ability to regulate MNE activities elsewhere
• Controversies over Multinationals
• Balance of payments
– MNE investments and profits (internal transfers) have impacts on the payments
status of both source and host nations
• Taxation
– source countries may have difficulty taxing MNE income stemming from foreign
operations
• Transfer pricing
– both host and source governments worry that MNEs may illegally manipulate prices
paid between subsidiaries to avoid taxes
• Transfer Pricing

Lecture 6: Import Tariffs and Other Instruments of Trade Policy under Perfect Competition

• Classification of Trade Policy Instruments

• Defining Tariffs
• A tariff is a tax (duty) levied on products as they move between nations:
• import tariff is levied on imported goods
• export tariff is levied on exported goods
• protective tariff is designed to insulate domestic producers from competition
• revenue tariff is intended to raise funds for the government
• Types of Tariffs
• specific tariff – tax that is levied as a fixed charge for each unit of goods imported
• Example: A specific tariff of $10 on each imported bicycle with an international price
of $100 means that customs officials collect the fixed sum of $10.
• ad valorem tariff – tax that is levied as a fraction of the value of the imported goods
• Example: A 20% ad valorem tariff on bicycles generates a $20 payment on each
$100 imported bicycle.
• a compound duty (tariff) – a combination of an ad valorem and a specific tariff
• Supply, Demand and Trade in a Single Industry
• Suppose that there are two large countries.
• Both countries consume and produce wheat, which can be costlessly transported
between the countries.
• In each country, wheat is a competitive industry.
• Suppose that in the absence of trade the price of wheat at Home exceeds the
corresponding price at Foreign.
• This implies that shippers begin to move wheat from Foreign to Home.
• The export of wheat raises its price in Foreign and lowers its price in Home until the
initial difference in prices has been eliminated.
• Suppose Home imposes a tax of $2 on every bushel of wheat imported.
• Then shippers will be unwilling to move the wheat unless the price difference
between the two markets is at least $2.

• Effects of a Tariff
• In the absence of tariff, the world price of wheat (Pw) would be equalized in both
countries.
• With the tariff in place, the price of wheat rises to PT at Home and falls to P*T (= PT
– t) at Foreign until the price difference is $t.
• In Home: producers supply more and consumers demand less due to the higher
price, so that fewer imports are demanded.
• In Foreign: producers supply less and consumers demand more due to the lower
price, so that fewer exports are supplied.
• Thus, the volume of wheat traded declines due to the imposition of the tariff.
• The increase in the domestic Home price is less than the tariff, because a part of the
tariff is reflected in a decline in Foreign’s export price.
• If Home is a small country and imposes a tariff, the foreign export prices are
unaffected and the domestic price at Home (the importing country) rises by the full amount of
the tariff.

• Costs and Benefits of a Tariff

• A tariff raises the price of a good in the importing country and lowers it in the
exporting country.
• As a result of these price changes:
• consumers lose in the importing country and gain in the exporting country
• producers gain in the importing country and lose in the exporting country
• government imposing the tariff gains revenue
• To measure and compare these costs and benefits, we need to define consumer and
producer surplus.
• Consumer surplus measures the amount a consumer gains from a purchase by the
difference between the price he actually pays and the price he would have been willing to
pay.
• It can be derived from the market demand curve.
• Graphically, it is equal to the area under the demand curve and above the price.
• Producer surplus measures the amount a producer gains from a sale by the
difference between the price he actually receives and the price at which he would have been
willing to sell.
• It can be derived from the market supply curve.
• Graphically, it is equal to the area above the supply curve and below the price.
• Producer Surplus

• Measuring the Cost and Benefits

• We can (algebraically) add consumer and producer surplus because any change in
price affects each individual in two ways:
– as a consumer
– as a worker
• We assume that at the margin a dollar’s worth of gain or loss to each group is of the
same social worth.

• Costs and Benefits of a Tariff for the Importing Country

TAKIE BEDZIEMY RYSOWAC NA
TESCIE

a- incise in surplus for suplayer

• The areas of the two triangles b and d measure the loss to the nation as a whole
(efficiency loss) and the area of the rectangle e measures an offsetting gain (terms of trade
gain).
• The efficiency loss arises because a tariff distorts incentives to consume and
produce.
• Producers and consumers act as if imports were more expensive than they actually
are.
• Triangle b is the production distortion loss and triangle d is the consumption distortion
loss.
• The terms of trade gain arises because a tariff lowers foreign export prices.
• If the terms of trade gain is greater than the efficiency loss, the tariff increases
welfare for the importing country.
• In the case of a small country, the tariff reduces welfare for the importing country.

• Some Data on Tariffs

• Go to: www.wto.org

• Who Pays for Import Restrictions?

• Overall net loss for the economy (deadweight loss).
• Domestic consumers face increased costs.
• Low-income consumers are especially hurt by tariffs on low-cost imports
• Export industries face higher costs for inputs.
• Cost of living increases.
• Other nations may retaliate, further restricting trade.
Import Quota
• Import quota is a direct restriction on the quantity of a good that is imported.
• The restriction is usually enforced by issuing licenses to some group of individuals or
firms.
• An import quota always raises the domestic price of the imported good. License
holders are able to buy imports and resell them at a higher price in the domestic market.
• The difference between a quota and a tariff is that with a quota the government
receives no revenue.
• Effects of an Import Quota

Export Subsidies
• Export subsidy is a payment made by the government to a firm or individual that
ships a good abroad.
• When the government offers an export subsidy, shippers will export the good up to
the point where the domestic price exceeds the foreign price by the amount of the subsidy.
• It can be either specific or ad valorem.
• Effects of an Export Subsidy
• An export subsidy raises prices in the exporting country while lowering them in the
importing country.
• In addition, and in contrast to a tariff, the export subsidy worsens the terms of trade.
• An export subsidy unambiguously leads to costs that exceed its benefits.

Voluntary Export Restraints

• Voluntary export restraint (VER) is an export quota administered by the exporting
country.
• VERs are imposed at the request of the importer and are agreed to by the exporter to
forestall other trade restrictions.
• VER is exactly like an import quota where the licenses are assigned to foreign
governments and is therefore very costly to the importing country.
• VER is always more costly to the importing country than a tariff that limits imports by
the same amount.

Local Content Requirements

• Local content requirement is a regulation that requires that some specified fraction of
a final good be produced domestically.
• Local content laws do not produce either government revenue or quota rents.
• Instead, the difference between the prices of imports and domestic goods gets
averaged in the final price and is passed on to consumers.
• Example:
• Suppose that auto assembly firms are required to use 50% domestic parts. The cost
of imported parts is $6000 and the cost of the same parts domestically is $10,000. Then the
average cost of parts is $8000 (0.5 x $6000 + 0.5 x $10,000).

• Other Instruments of Trade Policy

• Export credit subsidies – a form of a subsidized loan to the buyer of exports (they
have the same effect as regular export subsidies)
• National procurement – purchases by the government (or public firms) can be
directed towards domestic goods, even if they are more expensive than imports
• ”Red-tape barriers” – barriers based on health, safety and customs procedures

• Case study: Trump tariffs (cf. WTO, Brookings Institute)

• The term Trump tariffs refers to a series of tariffs imposed on various goods by the
U.S. President Donald Trump in 2018.
• The goal was to decrease persistent trade deficit and to stimulate increases in
production and employment in the United States.
• In response many countries (e.g. Canada, Mexico, European Union, China)
implemented retaliatory tariffs on hundreds of U.S. goods and opened WTO cases against
the United States.
• For instance, on January 23, tariffs were imposed on solar panels and washing
machines.
• On March 1, tariffs were imposed on steel (25%) and aluminum (10%).
• In general, the United States maintained that both steel and aluminum played a key
role in U.S. national defense. The tariffs were imposed under Section 232 of the U.S. Trade
Expansion Act as necessary measures for the protection of U.S. security interests.
• On March 22 it was announced that the tariffs would be suspended on the following
countries: Canada, Mexico, the European Union, Australia, South Korea, Brazil, and
Argentina until May 2018.
• In retaliation for the steel and aluminum tariffs China announced tariffs on $3 billion of
U.S. goods such as pork and wine. (…)
• How can we assess the impact of Trump tariffs before the onset of the COVID-19
pandemic?
• Trump tariffs did not help to reduce the U.S. trade deficit which in 2018 amounted to
$622.1 billion and was 12.6% higher than in 2017 when it was equal to $552.3 USD.
• As a matter of fact, it was the highest value since 2008.
• To some extent a greater trade deficit can be attributed to cyclical developments of
the U.S. economy, as real GDP growth rate in 2018 was equal to 2.9% compared to 2.2% in
2017, while the unemployment rate decreased from 4.4% in 2017 to 3.9% in 2018.
• A deeper analysis of the effects of Trump tariffs on the U.S. economy revealed that
imports from targeted countries declined 31.5%, while exports fell 11.0%.
• Apart from the costs associated with the tariffs, also the variety of imported goods
declined, as many foreign companies decided against exporting to the U.S. due to tariffs.
• Who pays for tariffs?
• The $79 billion could come from three different sources:
• the foreign companies exporting goods to the United States;
• the American companies importing goods from abroad, or using imported inputs in
their production processes;
• American households as final consumers.
• The Trump administration repeatedly argued that foreign companies are paying for
tariffs.
• But multiple studies suggest this is not the case: the cost of tariffs have been borne
almost entirely by American households and American firms, not foreign exporters.
• Economic analyses suggest the average American household has paid somewhere
from several hundred up to a thousand dollars or more per year thanks to higher consumer
prices attributable to the tariffs.
• Did tariffs benefit American workers?
• In general, then, Trump’s tariffs have helped some workers and hurt others.
• Nothing is particularly surprising about this; trade policy almost always has important
distributive effects, and any change in trade policy is a choice to benefit some groups at the
expense of others.
• Those jobs that have been created have come at great cost: studies suggest
American consumers paid about $817,000 in higher prices attributable to the tariffs for every
job created in the washing machine industry and $900,000 in the steel industry.

• Summary
• A tariff drives a wedge between foreign and domestic prices, raising the domestic
price but by less than the tariff rate (except in the “small” country case).
• The costs and benefits of a tariff or other trade policy instruments may be measured
using the concepts of consumer and producer surplus.
• The net welfare effect of a tariff can be separated into two parts: efficiency loss
(consumption and production) and terms of trade gain (which is zero in the case of a small
country).

Lecture 7: Trade Policy from an International Perspective. Concluding remarks

• Income Distribution and Trade Policy – Instead of an Introduction

• In practice, trade policy is dominated by income distribution considerations.
• The desires of individuals to get more are more or less imperfectly reflected in the
objectives of government (policies are determined by competition among political parties that
try to attract as many votes as possible).
• Trade policies that impose total large losses that are spread among many individual
firms or consumers may not face opposition.
• Industries that are well organized (or have a small number of firms) get protection.
• Protected are such sectors as agriculture or clothing.
• Developing Nations’ Concerns
• Developing countries often:
– question whether gains from trade with industrial countries have been fairly
distributed,
– face problems of unstable export market (they usually concentrate on one or a few
primary-product exports combined with inelastic supply and demand conditions),
– argue that they face worsening terms of trade as the relative value of primary
products has fallen compared to manufactured goods they import.

• Free Trade vs. Protectionism

Free Trade: No barriers
Protectionism: Tariffs
Neoprotectionism: Nontariff Barriers

• Free Trade – Pros

– efficiency – in the case of a small country, free trade is the best policy,
– economies of scale in production,
– political argument – a political commitment to free trade may be a good idea,
because trade policies in practice are dominated by special-interest politics rather than
consideration of national costs and benefits.
• Free Trade – Cons
– the terms of trade argument for a tariff – for a large country (a tariff lowers the price of
imports and generates a terms of trade benefit)
– the domestic market failure – producer and consumer surplus does not properly
measure social costs and benefits, because it ignores e.g. unemployment or
underemployment of labor, technological spillovers from industries that are new or
particularly innovative, environmental externalities…
• Domestic Market Failure
• The domestic market failure argument against free trade is a particular case of the
theory of the second best.
• The theory of the second best states that a hands-off policy is desirable in any one
market only if all other markets are working properly.
• If one market fails to work properly, a government intervention may actually increase
welfare.
• However, domestic distortions should be corrected with domestic (as opposed to
international trade) policies.
• Furthermore, market failures are hard to diagnose and measure.
• The Optimum Tariff

• Arguments for Trade Restrictions

• job protection
• protect against cheap foreign labor
• fairness in trade (level playing field)
• protect domestic standard of living
• infant-industry protection
• imperfect competition
• political and social reasons
• environmental standards
• cultural homogenization

• Infant Industry Argument

• The infant industry argument states that developing countries have a potential
comparative advantage in manufacturing and they can realize that potential through an initial
period of protection.
• However, it is not always good to try to move today into the industries that will have a
comparative advantage in the future. Protecting manufacturing does no good unless the
protection itself helps make industry competitive.

• The Problem of Trade Warfare

dominant strategy

• International Commodity Agreements

• International commodity agreements are inter-governmental arrangements
concerned with the production and trade of some primary commodities like: coffee, cocoa,
natural rubber, wheat, olive oil, nutmeg, sugar, cotton, timber, tin, nickel, copper or crude oil.
• International prices of these products are supported through such instruments as
export quotas.
• Theoretically, international commodity agreements include consumers in the
negotiation process.

• International Cartel Agreements

• A cartel is a group of firms making output and price decisions collectively to increase
their market power. Cartels behave like monopolists, because they produce less and charge
higher prices than in a perfectly competitive market. Cartels are unstable as each member is
tempted to produce more than agreed.
• International cartel agreements are arrangements between producers located in
different countries or between governments aimed to restrict competition.
• International cartel agreements began to receive more attention in early 1970s when
OPEC appeared to be an effective cartel in the global oil market.

• International Trade Agreements – A Historical Perspective

• Internationally coordinated tariff reduction as a trade policy dates back to the 1930s.
• The multilateral tariff reductions since World War II have taken place under the
General Agreement on Tariffs and Trade (GATT), established in 1947 (WTO since 1995).
• The GATT-WTO system prohibits the imposition of:
– export subsidies (except for agricultural products)
– import quotas (except when imports threaten “market disruption”)
– tariffs (any new tariff or increase in a tariff must be offset by reductions in other tariffs
to compensate the affected exporting countries)
• The GATT was a provisional agreement, while the WTO is a full-fledged international
organization.
• The GATT applied only to trade in goods, while the WTO included rules on trade in
services (the General Agreement on Trade in Services) and on international application of
international property rights.
• The WTO has a new “dispute settlement” procedure which is designed to reach
judgments in a much shorter time.
• Selected Trade Rounds
• Kennedy Round (completed in 1967) involved a 50% reduction in tariffs by the major
industrial countries, except for specified industries whose tariffs were left unchanged.
Overall, the Kennedy Round reduced average tariffs by about 35%.
• Uruguay Round (completed in 1994) resulted in the decrease of average tariffs
imposed by advanced countries by almost 40%.
• Doha Round (launched in 2001) also addresses the problems of developing
countries.
• Nothing is agreed until everything is agreed.

• International Trade Agreements and Economic Integration

• Since World War II, advanced nations have significantly lowered their trade
restrictions. This trade liberalization has stemmed from two approaches:
– a reciprocal reduction of trade barriers on a nondiscriminatory basis (GATT/WTO
system: tariff reductions agreed on by any two nations would be extended to all other
members),
– a formation of regional trading arrangements (member nations agree to impose lower
barriers to trade within the group than to trade with nonmember nations) which are an
exception to the principle of nondiscrimination embodied in the WTO.
• Economic Integration
• Economic integration is a process of eliminating restrictions on international trade,
payments, and factor mobility.
• Economic integration thus results in the uniting of two or more national economies in
a regional trading arrangement.
• Stages of Economic Integration
– Preferential trade area
– Free trade area – free-trade among members, but with own trade policy towards
non-member countries
– Customs union – free trade among members and a common external trade policy
towards other countries
– Common market – customs union with free factor movements (especially labor)
among members
– Economic union – harmonization of national, social, tax, and fiscal policies
(administered by a supranational institution)
– Monetary union – unification of national monetary policies (and usually adoption of a
common currency administered by a supranational monetary authority)
– Political union
• Effects of Regional Trade Agreements
• Static effects:
– trade creation effect occurs when the formation of a PTA leads to the replacement of
high-cost domestic production by low-cost imports from other members
– trade diversion effect occurs when the formation of a PTA leads to the replacement of
low-cost imports from non-members with higher-cost imports from member nations
• Dynamic effects:
– economies of scale
– greater competition
– investment stimulus
• Summary
• One of the most notable events in the global economy over the past 20 years has
been the phenomenal growth in the number of international economic integration
agreements.
• Most of them tend to be regional or continental in scope.
• There are more than 300 agreements notified to the WTO.
• Furthermore, there has been a virtual explosion in the number of EIAs in the past
decade. This trend is called the New Regionalism (hence the prominent analogy to a
spaghetti bowl…).
Another direction of Economic Integration?
The concept of the European Digital Single Market goes back to 2015.
It is related to the free movement of goods, persons, services and capital in conditions of fair
competition, and a high level of consumer and personal data protection, irrespective of their
nationality or place of residence.

• International Economics I upside down

• Most of the textbooks claim that international trade and migration are substitutes, so
both can increase welfare.
• Why then countries that adopt the most restrictive migration laws are often the
loudest advocates of free trade?
• Maybe developed countries want to limit the supply of labor to maintain high real
wages?
• Assume that for a country as a whole labor costs are fixed costs.
• Then developed countries have high fixed costs and low variable costs. They
promote free trade to increase the size of the market of their products to exploit economies
of scale. This induces further division of labor, higher fixed costs, and lower variable costs.
• Less developed countries or latecomers (characterized by lower fixed costs and
higher variable costs) are less competitive.
• Economies of scale are not that important for this group of countries, so they prefer
protectionism over free trade.
• In 1817 David Ricardo wrote:
• Under a system of perfectly free commerce, each country naturally devotes its capital
and labor to such employments as are most beneficial to each. … by using most
efficaciously the peculiar powers bestowed by nature, it distributes labor most effectively and
most economically: while, by increasing the general mass of production, it diffuses general
benefit, and binds together, by one common tie of interest and intercourse, the universal
society of nations throughout the civilized world.
• It is in this principle which determines that wine shall be made in France and
Portugal, that corn shall be grown in America and Poland, and that hardware and other
goods shall be manufactured in England.
• If the USA followed this suggestion, today it would still be a corn growing country.
• US manufacturing industries were established due to the protectionist policy of the
US government.
• Trade policy shifted towards free trade after these industries became highly
competitive.
• There is a tendency for superpowers to advocate free trade, and for poor countries to
prefer protectionism.
• Therefore, many individuals conclude that free trade means prosperity, while
protection results in poverty.
• Historically, latecomers that turned into industrial powers (e.g. USA, Japan,
Germany) adopted protectionist policies in the period of takeoff.

• Instead of a Summary
• “The ideas of economists and political philosophers, both when they are right and
when they are wrong, are more powerful than is commonly understood. Indeed, the world is
ruled by little else. Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually slaves of some defunct economist.” [John Maynard
Keynes]
• “It is no crime to be ignorant of economics, which is, after all, a specialized discipline
and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible
to have a loud and vociferous opinion on economic subjects while remaining in this
state of ignorance.” [Murray N. Rothbard]