Transcript Lecture 3

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.
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Previous results (final exam)
Fall 2006
Spring 2006
14
16
12
14
10
12
10
8
8
6
6
4
4
2
2
0
0
5
4
3
2
1
F
5
4
3
2
1
F
3
The most important things to learn
• Why trade is mutually beneficial?
 Comparative advantage, economies of scale
• Where do the world prices come from?
 Terms-of-trade analysis
• What does trade and international factor mobility do to
distribution of income?

Factor-price-equalization theorem
• What trade policy instruments do?
 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
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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
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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
pA
pFT
P
nA
nFT
Number of firms
7
Good Y
Prices:
Deriving the Offer Curve
Offer Curve
(PX/PY)1
Good Y
Good X
Exports1
Imports1
Imports2
XP
YC
YP
(PX/PY)2
XC XP
Exports2
Good X
(PX/PY)2 =
TOT2
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
Imports2
Imports1
YP
XC
(PX/PY)1 = TOT1
Imports of good Y
YC
Exports of good X
Exports2
Exports1
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Prices:
Putting the Offer Curves to One Graph
Country 2
(PX/PY)1
Offer Curve
Offer Curve
Exports of good Y
Imports of good Y
Offer Curve
Imports of good X
Country 1
(PX/PY)1
(PX/PY)2
(PX/PY)2
Exports of good X
Exports of good Y
Imports of good X
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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
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Distribution of Income:
Factor Price Equalization
• Autarky → Free trade
o
relative prices of final goods become identical

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
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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 ↑
W. Stolper & P. Samuelson (1941): International Factor-Price Equalisation Once Again. Economic Journal 59, no. 234.
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Distribution of Income:
Impact of Migration
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
Country 1’s
eq’m employment
Country 2:
Country 2’s MPPL, w
eq’m employment
wA2
transfer from labour
to capital in country 1
w*
transfer from capital
to labour in country
w*
gain for the
immigrants
wA1
Country 1’s
initial employment
Country 2’s
employment
Total world labour force
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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
(1+τ)Pint
increase of
producer
surplus
Loss of consumer surplus
Pint
tariff to the
government
SD
Pint
DD
imports after tariff
Q
DD
imports after tariff
Q
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imports in free trade
imports in free trade
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
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Trade Policy:
Subsidy, Small-Country, Partial Equilibrium
SD
P
P
Cost to the
government
P
P
SD
increase of
producer
surplus
DD
DD
imports after the subsidy
imports in free trade
Q
imports after the subsidy
Q
imports in free trade
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Trade Policy:
Single Market, Two Countries, Free Trade
P
Country A
Country B
P
SA
SB
DB
DA
Q
Q
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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 the
(preferences). In free trade equilibrium the world price is such that country B is willing to export
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
after a tariff is set, country B would be willing to export more that country A would be willing 19to
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
price decrease
in country B
PB
Q
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
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before tariff).
General Equilibrium Effects of a
Tariff for a Small Country
•
•
•
•
•
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
Good Y
CFT
Ct
Pt
PX/(1+τ)PY
PFT
(PX/PY)FT
Ct Pt CFT
PFT
Good X
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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
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