INTERNATIONAL ECONOMICS

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INTERNATIONAL ECONOMICS

• CLASS 4
• Production possibility curve and increasing
  costs, indifference curves and H-O-S theory

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Increasing marginal costs

• More than one factor of production (neoclassical
  theory)
• Increasing marginal costs Different products use
  factor inputs in different proportions therefore
  the proportion in which resources are released
  from one industry is different from the
  prevailing factor proportion in the other
  industry to which released resources are shifted
  (similar to the law of diminishing returns) ?
  increasing opportunity costs (OCX-?Y/?X)? as
  one industry expands, increasing amounts of the
  other good must be given up to produce extra unit
  of expanding output.
• Increasing opportunity costs constant returns
  to scale ? concave PPC ?incomplete specialization
  in production

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Community indifference curves

• Adding the demand conditions
• Preferences of consumers are presented by
  community indifference curve shows the various
  consumption combinations of good X and Y that
  yield equivalent satisfaction for the community
  or country.
• Different preferences (tastes) among countries ?
  different indifference curve
• Adding the indifference curves allows us to
  determine
• Autarky equilibrium in production and consumption
  and autarky eq. Price
• Consumption point in free trade
• World price (TOT)
• usual assumptions for preferences of an
  individual (more is preferred to less,
  transitivity of preferences) community indif.
  Curve must not intersect (income redistribution
  effect).

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Slope of the indifference curve marginal rate
of substitution

• community indiff. curves are downward-sloping if
  consumers reduce the level of consumption of one
  good they have to increase consumption of the
  other good to maintain the same satisfaction
  level
• The slope (in absolute value) reflects marginal
  rate of substitution MRSYX - ?Y/?X MUX/MUY
  amount of good Y the consumers are willing to
  give up for consumption of additional unit of X
  (unchanged utility)
• MRSYX is diminishing as we move toward
  consumption of a greater number of units of good
  X along any given indifference curve ? law of
  diminishing marginal utility ? Indifference
  curves are convex to the origin.

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Production and consumption together free trade
equilibrium
Figure General equilibrium in free trade for
country 1 (increasing costs and given
indifference curves) assume that P2 line
represents the autarky equilibrium relative price
for country 2

• NO TRADE (AUTARKY)
• PRODUCTION EQ. POINT CONSUMPTION EQ. POINT D
• MRTYX (PX/PY)1 MRSYX
• FREE TRADE
• assume (PX/PY)1 gt (PX/PY)2
• country 1 CA in Y and disadvantage in X
• specialisation QX? QY?
• trade IMX in EXY
• World relative price
• (PX/PY)1 gt (PX/PY)W gt(PX/PY)2
• PRODUCTION EQ. POINT B
• MRTYX (PX/PY)W
• Incomplete specialisation
• CONSUMPTION EQ. POINT C
• MRSYX (PX/PY)W
• Higher indifference curve ? GAINS from trade

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Example 1

• 1. Graphically show the general equilibrium in
  free trade for a small country, which is at given
  world relative price ratio (Px/Py)W an importer
  of good Y and exporter of good X. Define
• the production and consumption eq. point in free
  trade,
• the equilibrium quantities of exports and imports
  and
• gains from free trade.
• Country faces increasing MC and constant returns
  to scale!

Y
X
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Basis for trade

• Basis for trade Difference in autarky relative
  prices (determined by demand and supply
  conditions)
• Difference in factor endowments
• Difference in production technology
• Difference in tastes
• Classical and neoclassical trade theory
• Classical theory (Smith, Ricardo) difference in
  (relative) productivity as a basis for trade
• Neoclassical theory (H-O-S) difference in
  relative factor endowments among countries

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HOS theory - assumptions

• MODEL 2 countries, 2 homogeneous goods, and 2
  homogeneous factors of production
• perfect competition, free trade, factors are
  perfectly mobile within each country and not
  mobile between countries, no transportation
  costs
• technology is identical in both countries
  characterized by constant returns to scale for
  both commodities two commodities have different
  factor intensities, and the respective commodity
  factor intensities are the same for all factor
  price ratios.
• Tastes and preferences are homothetic and the
  same in both countries.
• The difference in autarky relative prices among
  countries are solely due to diff. in relative
  factor abundance

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H-O-S THEORY basic definitions

• FACTOR ABUNDANCE
• absolute one nation has more L or K on its
  disposal than the other nation
• relative
• Physical definition Country A would be the
  relatively labour-abundant country if its ratio
  of L to K exceeded the ration of L to K for
  county B (L/K)A gt (L/K)B? B is capital-abundant
  country
• Price definition Country A would be the
  relatively labour-abundant country if (w/r)A lt
  (w/r)B
• Due to the assumption of identical technologies
  and tastes in both countries (L/K)A gt (L/K)B ?
  (w/r)A lt (w/r)B

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II. FACTOR INTENSITY OF PRODUCTION

• Factor intensity is the characteristic of
  technology
• Commodity X is (relatively) labour-intensive
  compared to commodity Y if the production of X
  requires relatively more L than does the
  production of Y for all factor-price ratios
• (L/K)X gt (L/K)Y
• (K/L)Y gt (K/L) X
• X L-intensive commodity
• Y K-intensive commodity

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III. FACTOR SUBSTITUTION

• The same output can be produced with different
  combinations of K and L ? (partial) substitution
  of factors in production
• at given technology with constant returns to
  scale the choice of K to L ratio in production
  depends on relative factor prices
• w/r? L is getting relatively more expensive ?
  producers will want to substitute it for more K
  (K/L?) in production of both goods
• Assumption no factor-intensity reversal

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IV. FACTOR PRICES DETERMINE COMMODITY PRICES

• Factor prices determine production costs ?
  production costs determine commodity prices
• w/r? the price of L-intensive good increases
  more than does the price of K-intensive good ?
  PX? gt PY? ? (PX/PY)?
• In case of no factor-intensity reversal, a unique
  factor-price ratio corresponds to each
  commodity-price ratio, and vice-versa
• Due to the assumption of identical production
  technologies in both countries, the relationship
  between factor and commodity price ratios is the
  same for both countries

PX/PY
X L-intensive commodity Y K-intensive commodity
w1
w2
w W/R
0
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1. THEOREM H-O theorem
Each country will export the commodity that uses
relatively intensively its relatively abundant
factor of production, and it will import the good
that uses relatively intensively its relatively
scarce factor of production.

• Comparative advantage is determined by the
  relative factor abundance
• Specialisation and trade Country specialises and
  exports the commodity in which it has CA and
  imports commodity of comparative disadvantage

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2. THEOREM The factor price equalisation theorem
International trade will cause relative and
absolute factor prices to equalize between the 2
countries if both countries continue to produce
both goods (incomplete specialisation).

• Free trade works as a (perfect) substitute to
  international factor movements (certain
  conditions)

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3. THEOREM The Stolper-Samuelson theorem
If there are constant returns to scale and if
both goods continue to be produced, a relative
increase in the price of a commodity will
increase the real return to the factor used
intensively in that industry and reduce the real
return the other factor.

• Int. Trade reduces the real returns to owners of
  the relatively scarce factor and increases the
  real returns to owners of relatively abundant
  factor of production ? validity in the long run!
• ? lobbying of the owners of relatively scarce
  factor for barriers to trade barriers to trade
  ? ? rel. price of protected (imported) commodity
  ? ? of real return to the owners of scarce factor
  used intensively in protected industry (welfare ?)

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HOS THEORY EXAMPLE

• Consider the following 2X2X2 model
• The K to L ratio is greater in the production of
  cars compared to the production of shoes for all
  factor-price ratios (K/L)C gt (K/L)S C
  K-intensive good S L-intensive good
• The total quantities of L and K in GB and USA are
  given in the Table 1
• Standard H-O-S assumptions
• Identical preferences in both countries
• Identical technology (production functions) in
  both countries with increasing MC and constant
  returns to scale, etc.
• Demonstrate the basis and effects of free trade
  according to theorems!

Table 1
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Example 2

• Country A is capital abundant and B labor
  abundant, product X is capital intensive and Y
  labor intensive. Given that all the assumptions
  of the classical trade model are fulfilled,
  explain how trade ensures that the relative
  factor prices become similar (equal) between the
  two countries.

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• Autarky (Px/Py)A lt (Px/Py)B ? A CA in X, B CA
  in Y
• ? B (r/w)A lt (r/w)B
• A specializes in production of X (Ex X, Im Y)
• Supply of X? Y?
• X? DL?, DK? Y? SL?, SK?
• X K-intensive product ? ?DK gt ?SK (Y
  L-int.) r ?
• ?DL lt ?SL w ?
• B specializes in production of Y (Ex Y, Im X)
• Y? X?
• Y? DL?, DK? ? SL?, SK?
• Y L-intensive product ? ?DL gt ?SL w ?
• ?DK lt ?SK r ?
• International trade ?(r/w)zda in ?(r/w)vb ?
  smaller difference or equalization (under certain
  conditions) relative and absolute factor prices

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Example 3

• Assume that cars and bread are produced (where
  cars are capital intensive and bread is labor
  intensive). Draw the approximate PP curves and
  autarky equilibria for the two countries.Show a
  possible free trade equilibrium with the
  consumption and production points and determine
  the exported and imported quantities.