Preparing for the Exam Summarizing the Essentials Exam

Preparing for the Exam: Summarizing the Essentials

Exam • Final: 27. 10. 2008 at 8 - 10 ECO, lecture room • Retake: 24. 11. 2008 at 8 - 10 ECO, lecture room • Requirements: (a) Lectures, (b) Krugman (1993): What Do Undergrads Need to Know About Trade? American Economic Review 83(2): 23– 26 (available from JSTOR) • Three questions (answer all) • You may answer in English or Finnish. Dictionaries are not allowed. 2

Previous results (final exam) 3

The most important things to learn • Why trade is mutually beneficial? n Comparative advantage, economies of scale • Where do the world prices come from? n Terms-of-trade analysis • What does trade and international factor mobility do to distribution of income? n Factor-price-equalization theorem • What trade policy instruments do? n n Implications of subsidies, tariffs, quotas Arguments for activist trade policy Please note that these are just the most important things. To pass the exam you will need to know a bit more… 4

Gains from Trade: Ricardian Model Suppose that the international price turns out to be 2, 5 yard per barrel and England produces only cloth Cloth 9, 000 Slope of the CPF = the amount of consumption of one good that must be given up to obtain one additional unit of the other good England Cloth Wine 9, 000 0 4, 500 1, 800 0 3, 600 3, 000 3, 600 Wine 5

Gains from Trade: The Neoclassical/HO Model (PX/PY)FT Good Y Equilibrium: MRT = (PX/PY)FT = MRS Imports YC YA YP (PX/PY)A XC XA XP Exports Good X 6

Gains from Trade: Krugman Model • Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases • i. e. a larger variety of products is available for smaller price • everybody are better off even if the countries are identical Price ACA ACFT p. A p. FT P n. A n. FT Number of firms 7

Good Y Prices: Deriving the Offer Curve YC Imports of good Y (PX/PY)1 Good Y Good X Exports 1 Imports 2 XP YC YP (PX/PY)2 XC XP Exports 2 Good X (PX/PY)2 = TOT 2 Potential price lines: PX*QX=PY*QY QY=(PX/PY)*QX i. e. given the prices, the value of exports equals the value of imports Imports 2 Imports 1 YP XC (PX/PY)1 = TOT 1 Exports of good X Exports 2 Exports 1 8

Prices: Putting the Offer Curves to One Graph Country 2 (PX/PY)1 Offer Curve Exports of good Y Imports of good Y Offer Curve Imports of good X Country 1 (PX/PY)2 Exports of good X Exports of good Y Imports of good X 9

Prices: Trading Equilibrium Good Y: Imports to country 1 exports from country 2 (PX/PY)E = TOTE (PX/PY)’ Country 2’s offer curve Country 1’s offer curve Good X: Exports from country 1 Imports to country 2 10

Distribution of Income: Factor Price Equalization • Autarky → Free trade o relative prices of final goods become identical n relative price of paper increases (=relative price of clothes decrease) in Finland → Finland produces more paper, China more clothes • Since producing paper is more capital intensive, demand for capital increases and demand for labour decreases in Finland → w↓r↑ • Similarly in China, demand for labour increases and demand for capital decreases → r ↓ w ↑ • In equilibrium all prices (including factor prices) are identical 11

Distribution of Income: the Stolper-Samuelson Theorem • Trade affects both the prices of goods and the prices of factors of production: What then is the impact of trade on distribution of real income? o wages decrease in Finland, but also the price of clothes decreases (i. e. you need less money to buy the same amount of clothes). Which effect dominates? • Stolper-Samuelson Theorem: real income of the owners of abundant factor increases and the real income of owners of scarce factor decreases o Think about the labour abundant country (e. g. China): Free trade → r ↓ w ↑ → capital/labour ratio ↑ → labour productivity ↑ → real wages ↑ 12 W. Stolper & P. Samuelson (1941): International Factor-Price Equalisation Once Again. Economic Journal 59, no. 234.

Distribution of Income: Impact of Migration Country 1’s eq’m employment Country 2: Country 2’s MPPL, w eq’m employment w. A 2 w* im m su igr rp ati lu on s Country 2: (receiving immigrants) • wages decrease → transfer of income from labour to capital owners • total output increases more than what is paid to the immigrants → immigration surplus • However, there is a decrease in per capita output (given diminishing marginal productivity) Country 1: • wages increase → transfer of income from capital to labour • total output decreases more than the wage sum of those who left → immigration deficit • But, there is a increase in per capita output (given diminishing marginal productivity) Country 1: MPPL, w transfer from capital to labour in country transfer from labour to capital in country 1 w* gain for the immigrants w. A 1 Country 1’s initial employment Country 2’s employment Total world labour force 13

Trade Policy: Import Tariff, Small-Country, Partial Equilibrium Increase of producer surplus and government income Loss of consumer surplus P SD P (1+τ)Pint increase of t gh producer i we s d surplus a s Loss of consumer surplus Pint de lo tariff to the government SD de ad w lo eig ss h t DD imports after tariff imports in free trade Q 14

Trade Policy: Import Quota Small-Country, Partial Equilibrium • For every quota there is an equivalent tariff (and for every tariff there is an equivalent quota) SD P • The changes in consumer and produce surplus are equivalent to that of a tariff • However, the increase of government revenue may be lost (at least partially) PQ Pint DD quota imports in free trade Q 15

Trade Policy: Subsidy, Small-Country, Partial Equilibrium SD P increase of cy n e producer i fic oss f e l surplus Cost to the government P P DD DD imports after the subsidy imports in free trade Q imports after the subsidy Q imports in free trade 16

Trade Policy: Single Market, Two Countries, Free Trade P Country A Country B P SA SB DB DA Q Q 17

Trade Policy: Single Market, Two Countries, Free Trade P Country A Country B P SA SB DB DA Q Q Countries A and B have different supply curves (cost of production) and demand curves 18 (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

Trade Policy: Single Market, Two Countries, Tariff P Country A Country B P SA SB DB tariff DA Q Q Price in Country A = Price in country B + tariff. If the price in country B would remain constant 19 after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

Trade Policy: Single Market, Two Countries, Tariff Country A P DA Country B P SA DB SB PA PFT e a D b tariff C PB Q price decrease in country B Q Country A: Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports 20 before tariff).

General Equilibrium Effects of a Tariff for a Small Country • • Good Y CFT Ct Pt PX/(1+τ)PY PFT )t /P Y (P X • Import tariff on good Y changes the price ratio Producers adjust from point PFT to Pt Since the tariff doesn’t change world prices, country’s real income changes to (PX/PY)t Consumers maximize given domestic prices and real income and move to a lower utility level Note that real income is determined by the world prices (PX/PY)FT Ct Pt CFT PFT Good X 21

General Equilibrium Effects of a Subsidy for a Small Country • • • Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff The real income of the country remains the same Consumers face world prices and are able to consume at a higher utility level Good Y CFT CS PS PX/(1+τ)PY PFT (PX/PY)FT CS PS CFT PFT Good X 22