iep~session 2

7/27/2019 IEP~Session 2

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Amity Business School

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MBA 2013, 3rd Semester

INTERNATIONAL ECONOMICS AND POLICY

Amanpreet Kang


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What will we learn in the subject?

Concerned with answering what, how and whom?

Depends on ownership of resources and their allocation

Market, command and mixed International economics external influence, economic

relationship and interdependence

Nations

Categories basis of income, developed and developingstatus, newly industrialized economies, transitioneconomies

Regional integration, economic gap, NIE

Recap


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International Economic Theory


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Mercantilism

Theory of Absolute Advantage

Theory of Relative/ Comparative Advantage

Competitive Advantage of Nations

International Trade Theories


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Economic ideas, concept, theory/theoretical framework

Examples of economic ideas tribals

In India, elsewhere

All theoretical frameworks are related to stages ofeconomic development

Meaning/ relevance of an idea related to the stage ofeconomic development

What happens in the economy gets reflected in theeconomic thought

Basics


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We are discussing 14th to 18th Century

Merchants as a class emerged Problems, perceptions and activities

Needed some changes in the society for their own benefit

Acquired capital through trade and margin

Wars not in their interest

Supported formation of STRONG nations Defend and attack

Should have surplus

To support unproductive labour

Needed wealth gold

Make thy neighbour beggar

Raw materials (Im vs Ex) and Finished Goods (Im vs. Ex)

Basics


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Felt that state should intervene

Cameralism increase wealth

Ideas did not work

Promoted trade but ignored agriculture France and Germany suffered

Physiocrats/ Physiocracy near nature

William Petty circulation of wealth in the society Productive, proprietary, sterile class

Only productive activity?

Nature works with human beings

State should be third party and not intervene

Basics


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Mercantilism was the economic philosophy underlying earlyEuropean colonial policy. The object of mercantilism was to increasethe wealth of the Mother Country (England) in gold and silver. Toaccomplish that goal, a favorable balance of trade was desired. Thatmeans that a nation would sell more than it would purchase, thuscreating a surplus in the treasury. The name of the philosophy pointsout the importance of merchants in this policy. Merchants would sellproducts to foreign nations and purchased items to be sold within thenation. Theorists using this model tended to view the market as a piethat was up for grabs. Wealth was always gained at the expense of

other nations. For some, the ideal was to become self-sufficient. Thenation would produce everything its people needed and buy nothingfrom foreign nations -- thus the idea of the trade deficit. Since theideal could not be accomplished in the real world of economics, theobject of mercantilism was to minimize imports that cost money and

maximize exports and the trade that brought money in to the nation.

Basics


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Nascent stage of development of economic ideas.

Group of ideas and policies.

15th to 18th Century (approximately)

Mercantilism is closely associated with trade and commercialactivities of an economy.

Economic counterpart of political nationalism and prevalentduring the days when nation states were formed.

Colbertism in France

Cameralism in Germany

Mercantilism aimed at state power; primary agent forunification; interested in the wealth of nations; expression ofcapital needs of the rising merchant class needed a strong

state to protect them and needed capital for trade.

Mercantilism


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Only a wealthy country could have and maintain strong armedforces and nations unity is a prerequisite for states power.

Mercantilists wanted an enhancement of state power througheconomic means.

Later theorists differed from mercantilists in not the objective ofstrengthening the state but the means applied to achieve thisobjective.

To mercantilists - state power was the military power which in

turn needed wealth (money and treasure) and to others statepower would emerge from the wealth and productive power ofnations.

2 additional forces lure for gold and discovery of new traderoutes to expand foreign trade, add new colonies, etc.

Mercantilism


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Devices and mechanisms for achieving mercantilistobjectives:

1. Balance of trade and specie flow

Bullionism

Mercantilism Proper

2. Quantity of Money and Rate of Interest inflationaryeffect, decrease in interest rates and increase financeresource

3. Other regulations

Payment of wages

Regulation of trade by the nation state additional

income sources like insurance and freight charges

Mercantilism


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Criticisms:

Not all nations could have a positive/ surplus balance oftrade

Gain of one state at the loss of the others

Mercantilism


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Theory of Absolute Advantage

Adam Smith (1723-1790)


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Competition perfect???

2 countries

2 products

Only one factor of production Labor mobile between sectors and not countries

Constant returns to scale

Technology is constant

No transport costs

Basics


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Analytical Tools

Ch l M ijk


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Thus, the production possibility curve represents efficient

output combinations.

final output (including non-optimal combinations)

All possible combinations of

is called the production possibility set

Charles van Marrewijk

Good X

Good Y

0


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17Good X

Good Y

0

Opportunity Cost

Marginal Rate of Transformation (MRT)

PPF/ PPC under Increasing Costs

A

C

C1

C2

W1 W2 W


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18Good X

Good Y

0

Opportunity Cost

Marginal Rate of Transformation (MRT)

PPF/ PPC & Optimum Combination of Output

A

C1

W2

F

PP1

P2


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19Good X

Good Y

0

P

Community Consumption Indifference Curve

An individual consumption indifference curveshows various combinations of commodities whichyield the same level of satisfaction to an individual.

Community indifference curve shows variouscombinations of 2 commodities which yield equal

satisfaction to community or a nation.

Q

R


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20Good X

Good Y

0

E

Equilibrium Under Autarchy

T

R


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21Good X

Good Y

0

E

Equilibrium Under Trade

DA2

A

A1

B B1B2


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Smith's argument for free trade

You do not make your own clothes or shoes but buy them fromyour tailor or shoemaker to enjoy the benefits of increasedspecialization.

You concentrate on producing what you do best.

International trade, similarly, allows countries to concentrate onproducing what they do best.


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2 countries; USA and Japan

International trade based on differences in technology. The mainassumptions of the theory are;

No transport costs

2 goods; Food and Cars

1 factor of production; labor L

Constant returns to scale; CRS

Labor mobile between sectors, not between countries

Perfect competition

Analysis of absolute cost advantage


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Note that the USA is more efficient than Japan for the production of

Food (requires 2 < 3 labourers), while Japan is more efficient thanthe USA in the production of cars (requires 6 < 8 labourers).

In autarky (without international trade) both countries will produceboth goods if consumers demand both Food and Cars.


Productivity table; labor required to produce 1 unit of output

General specification Example

Food Cars Food Cars

USA US

F

a US

C

a USA 2 8

Japan JFa

JCa Japan 3 6


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According to Adam Smith, both countries can gain from international tradethrough specialization (USA producing more food and Japan producingmore cars):Suppose the USA produces 1 car less, this frees up 8 labourers.

These 8 labourers can now produce 8/2 = 4 units of foodTo keep the production level of cars constant, Japan should make 1 carmore. This requires 6 labourers.

These 6 labourers could have made 6/3 = 2 units of food.

Conclusion: USA Japan Change in world prodct.

production of cars: -1 +1 0

production of food: +4 -2 +2

The extra production represents gains from trade



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David Ricardo (1772-1823)

Relative/ Comparative Cost


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Classical economics and comparative advantage

According to Paul Samuelson (Nobel prize 1970) the theory ofcomparative advantage is one of the few ideas in economics that is

true without being obvious.

Technological differences between nations are the classical drivingforce behind international trade flows.

According to David Ricardo relative orcomparative differences are

important, not absolute differences.


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2 countries; EU and Kenya

International trade based on differences in technology. Assumptionsare:

No transport costs

2 goods; Food and Chemicals 1 factor of production; labor L

Constant returns to scale; CRS

Labor mobility between sectors, not between countries

Perfect competition

Analysis of comparative advantage


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Productivity table to summarize the state of technology

Note that the EU is more efficient than Kenya in the production of both

goods, requiring 2 < 4 laborers for Food and 8 < 24 laborers for Chemicals.Why would the EU trade with Kenya?

Note: EU is twice more productive in Food, and three times in Chem.

In autarky (without international trade) both countries will produce both

goods if consumers demand both Food and Chemicals.


Productivity table; labor required to produce 1 unit of output

General specification Example

Food Chemicals Food Chemicals

EU EUFa

EUCa EU 2 8

Kenya KFa

KCa Kenya 4 24


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According to David Ricardo both countries can gain from international tradethrough specialization (EU producing more chemicals and Kenya producingmore food):

Suppose Kenya produces 1 chemical less, this frees up 24 laborers.

These 24 labourers can now produce 24/4 = 6 units of food

To keep the production level of chemicals constant, the EU should make 1chemical more. This requires 8 labourers.

These 8 labourers could have made 8/2 = 4 units of food.

Conclusion: EU Kenya Change world prod.

production of chem. +1 -1 0

production of food -4 +6 +2

The extra production represents gains from trade



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Production possibility frontier and autarky

Production possibility frontier (ppf) = All possible combinations of efficientproduction points given the available factors of production and the state oftechnology. Note:

PPF depends on available factors of production

PPF depends on state of technology

PPF does not depend on type of market competition

Total labor available and maximum production levels

Total labor Maximum production

available Food Chemicals

EU 200 EU 100 25

Kenya 120 Kenya 30 5


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More countries and World PPFFood

Chemicals0

A

B

C

D

00 / fc ppslope

11 / fc ppslope

E0

E1

World ppf

Cmax

Fmax


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Elaborations and Refinements of the

Classical Theory

Introduction of Money and Comparative money costs

Goods are not exchanged against goods but are bought with money.

Introduction of money does not invalidate the comparative cost theory. If wages rise or fall below certain limits, it will distort the trade pattern

Introduction of Transfer costs

Ricardian theory assumes that the transfer of goods betweencountries does not involve any costs.

Transfer costs affect whether the goods will or will not be tradedamong countries


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Classical Theory

More than two commodities

The same theory can be applied to cases in which not merely two buta number of goods are traded.

More than two countries

Variable costs of production

Production under conditions of increasing costs

Production under conditions of increasing costs


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Classical Theory

Non competing groups

The distinct categories of labour with rather well marked and enduringdifferences in wages are known as non-competing groups.

Existence of such groups will not affect the comparative trade theoryprovided that in each country the relative scale of wages was the same

Capital charges Low interest rate is advantageous

A high rate of interest is a handicap


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Factor Endowment Theory

The factor endowment theory was developed by Eli Heckscher andhis student Bertil Ohlin.

This theory consists of 2 important theorems:1. Heckscher Ohlin Theorem

Examines the reasons for comparative cost differences inproduction and states that a country has comparative advantage

in production of that commodity which uses more intensively thecountrys most abundant factor.

2. Factor price equalisation theorem


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The factor endowment theory was developed by Eli Heckscher andhis student Bertil Ohlin.

This theory consists of 2 important theorems:1. Heckshser Ohlin Theorem

2. Factor price equalisation theorem

Examines the effect of international trade on factor prices and statesthat free international trade equalises factor prices betweencountries, relatively and absolutely, and thus serves as asubstitute for international factor mobility.


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This theory supplements the explanation of theory of comparativeadvantage by explaining the reasons for the differences in thecomparative costs.

Heckscher Ohlin Theorem:

Explains the basis of international trade in terms of factor endowments

It attempts to explain why comparative cost differences existinternationally. The international cost differences can be attributed to:

Different prevailing endowments of the factors of production

The fact that production of various commodities requires that the

factors of production be used with different degrees of intensity.


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Heckscher Ohlin Theorem:

A country will specialize in the production and export of goods whoseproduction requires relatively large amount of the factor with which the

country is relatively well endowed.

Factors of production are considered scarce or abundant in relativeterms and not absolute terms.

In country A vs. B:

Supply of labour = 25 units vs. 12 units

Supply of capital = 20 units vs. 15 units

Relative ?

Absolute ?


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Heckscher Ohlin Theorem: explicit and implicit assumptions:

Both product and factor markets in both countries are characterisedby perfect competition

Factors of production are perfectly mobile within each country butimmobile between countries

Factors of production are of identical quality in both countries

Factor supplies in each country are fixed

Factors of production are fully employed in both the countries Factor endowments of one country vary from that of the other.

There is free trade between the countries

International trade is costless


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Heckscher Ohlin Theorem: explicit and implicit assumptions:

Techniques of producing the identical goods are the same in bothcountries

Factor intensity varies between goods. Production is subject to the law of constant returns.


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Factor Price Equalisation Theorem:

Free international trade equalises factor prices between countries,

relatively and absolutely, and this serves as a substitute forinternational factor mobility.

International trade increases demand for abundant factors leading to

increase in their prices and decrease in the demand for scarcefactors, leading to a fall in their prices, because when nationstrade, specializations take place on the basis of factorendowments.


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The effect of inter regional trade is to equalise commodity prices.There is also a tendency towards equalisation of the prices offactors of production, which means their better use and areduction of the disadvantages arising from the unsuitable

geographical distribution of the productive factors.


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Leontief Paradox

US has scarce labour, abundant capital

If factor proportions theory is correct, US should export, capital intensivegoods

Leontiefs test disapproved this hypothesis

Took 2 factors, labour and capital

Assumed US decreased production of exports and imports by $1mn.

When exports decreased, capital and labour are set free.

As imports have been decreased, more labour & capital needed tomanufacture the same quantity of imports.

As US exports are capital intensive and imports labour intensive, labourfreed, will not be sufficient to manufacture labour intensive imports.

Also, there will be extra capital available.


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Leontief Paradox

Leontiefs test however showed that ratio of capital to labour washigher in import substitution industries than export industries.

He hence concluded that America participated in international trade byspecialisation in labour intensive rather than capital intensive lines of

production.

Explanation:

1) Leontief suggested:

Though labour was scarce vis--vis capital, effective supply of labourwas greater because of higher productivity of American labour.

Exclusion from study certain factors, which would also determine thecountrys productive capacity.


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Leontief Paradox

2) Production functions i.e. ways of producing goods are not identicalbetween countries. Leontief should have studied whether goodsimported into US were capital or labour intensive.

3) Differences in demand patterns domestic demand not considered. A

country may consume goods that are produced using its abundantfactor.

4) Trade barriers

5) Human capital and R&D

7) Factor intensity reversal Depending on the use of a factors ofproduction in production process. Production process may vary betweencountries.


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Factor Intensity Reversal

Factor endowments

Factor intensities

Changes in relative factor endowments and factor intensities is possibleover time.

These changes may reverse the pattern of trade.

Factor intensity reversal refers to a situation where the factor intensitiesin the production of a product reverses between 2 cases.

It can also occur in the same country over time.

Growth in factor supplies may make a scarce factor abundant and viceversa.

This may then change the commodity composition of trade.

Production function may alter because of ????


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Complementary Trade Theories

Technological Gap Model

Suggested by Postner

Great deal of trade among industrialised countries based on introductionof new products and new production processes.

Technological innovation may form the basis of trade

Innovating firm may become a monopoly through patents, copyrights,etc.


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Product Cycle Model

New/ innovative product is first introduced in an advanced countrybecause of favourable factors such as large markets, ease of organising

production, etc.

Availability and Non Availability Theory

4 basis of availability factor natural resources, technological progress,

product differentiation, government policy.

Absence of free trade and competition, limits trade to goods that cannotbe produced by the importing country.

The most important restriction on international trade are those imposed

by governments and by cartels.


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A country achieves international success in a particular industry due to 4broad attributes of a country that shape the environment in which

nations compete and promote or impede the creation of competitiveadvantage. These factors include;

Factor conditions

Demand conditions

Related and supporting industries

Firm strategy, structure and rivalry


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1) Factor conditions:

Depends on how efficiently and effectively are the factors employed.

Advanced factors (R&D in sophisticated disciplines, highly educatedpersonnel, modern communication infrastructure, etc.)

Specialised factors (knowledge base in specific fields, narrowly skilledpersonnel, infrastructure with specialised properties, etc.)

Basic factors (natural resources, climate, location, unskilled and semi-skilled labour, etc.)

Generalised factors (highway system, supply of debt capital, etc.)


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1) Factor conditions:

Advanced and specialised factors are more critical in determiningcompetitive advantage than the basic factors and generalised factors.

Development of advanced and specialised factors demands concertedefforts and sustained investments in human and physical capital.

Countries will succeed in industries where they are good at factorcreation.

Selective disadvantages in basic factors force a company to innovateand upgrade.


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2) Demand conditions:

3 attributes of home demand which influence competitive advantage are:

Composition of home demand

Size and pattern of growth of home demand

Mechanism by which nations domestic demands are transmitted toforeign markets.

Home demand gives the companies a clear and early picture ofemerging buyer needs

Demanding buyers pressurize companies to innovate faster.


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2) Demand conditions:

Size and pattern of home demand reinforces the national advantage inan industry.

Large home market size can lead companies to achieve economies ofscale or learning.

It also helps in case the same products are demanded in other countriesalso.

Domestic demand internationalises and pull the products and servicesabroad.


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3) Related and supporting industries:

If related and supporting industries are internationally competitive, theycreate advantages in downstream industries in several ways such assupply of most cost efficient inputs in an efficient way.

Advantageous in innovating and upgrading based on close working

relationships.


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4) Firm Strategy, structure and rivalry:

Creation, organisation and management of companies

Domestic rivalry powerful stimulating effect on others.

Creates pressure to innovate and innovate in ways that upgrade the

competitive advantage of a nations firms.


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Role of government and chance:

Government influences each of the 4 determinants by industrial, fiscaland monetary policies, promotional and regulatory measures in respectof industry and trade

Chance effects competitive position because of major technological

breakthroughs and new inventions, political decisions by foreigngovernments, wars, shifts in financial markets, discontinuities in inputcosts, surges in world or regional demand


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Assignment

Cases Discussed

1) Case 1: Costa Rica: Using Foreign Trade to Trade up Economically

Questions given in class

2) Case 2: Factor Mobility Theory in Information Technology Industry

Questions at the end of the case

Reading material provided (mail sent)

3) International Investment and International Trade in the Product Cycle byRaymond Vernon

Discuss what will be the direction of trade as per Vernons IPLC

4) The Competitive Advantage of Nations by Michael E. Porter


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1. International Economics, Francis Cherunilam (5thEdition), Mc Graw Hill

2. International Economics, BO Sodersten and Geoffrey

Reed (3rd Edition), Macmillan

3. International Economics, Paul Krugman and MauriceObstfeld (6th Edition), Pearson Education

4. Economics, Samuelson & Nordhaus (18th Edition), TataMc Graw Hill

5 History of Economic Thought H L Bhatia

References

iep~session 2

Documents