International EconomicsExam notes and practice answers

LECTURE 1: INTRODUCTION 2

LECTURE 2: GAINS FROM TRADE 2

LECTURE 3: SPECIFIC FACTORS MODEL AND RYBCYZNSKI’S THEOREM 8

LECTURE 4: TRADE EQUILIBRIUM 13

LECTURE 5: TRADE POLICY 15

LECTURE 6: ENVIRONMENTAL ECONOMICS 20

LECTURE 9: IMMIGRATION 25

LECTURE 11: DEVELOPMENTAL ECONOMICS 27

Lecture 1: IntroductionIntroductory lecture not examined

Lecture 2: Gains from trade This topic will analyze 2 models

o Ricardo’s model (comparative advantage in labor productivity)o Specific Factors model (comparative advantage based on different

resource endowments) Definitions:

o Comparative advantage Being able to produce a good with the lowest opportunity

costo Opportunity cost

The value of the next-best alternative foregoneo Absolute advantage

The ability to produce with the least cost – in terms of resources used

Ricardo’s model – not in exam Basics of the model/assumptions

o Only two countrieso Only input is labouro The only difference between the countries is their relative

productivity in producing different goods This allows for an analysis of comparative advantage, via the opportunity

cost of production for each country.

The PPF and Indifference curves The ability to produce is described by the Production Possibility Frontier

(the PPF) (see Figure 1 Production Possibility Frontiers, below)o This shows how much of each product is able to be produced by a

countryo At production point “C”, on the graph, Y1 units of guns and X1 units

of butter are producibleo At production point “A” on the graph, Y2 units of guns and X2 units

of butter are producible.

Figure 1 Production Possibility Frontiers

The preference towards consumption are described by indifference curves, (see Figure 2 Indifference Curves, below)

o At any point on these curves, the consumers are equally happyo The further away from the origin the indifference curves, the

happier the consumers.o At consumption points A, B and C, consumers are equally happyo However, at curve 3, they are happier than at curve 1, since they

can consume more

Figure 2 Indifference Curves

Cobb-Douglas production function The Cobb-Douglas production function, simply, is as follows

o The marginal product of labour (MPL) is the increase in output from a one

unit increase in labour (with capital fixed)

o the marginal product of labour is the change in output

divided by the change in labour The marginal product of capital (MPK) is the increase in output from a

one unit increase in capital

o the marginal product of capital is the change in output

divided by the change in capital Graphing a Cobb-Douglas Production Function against Labour (see Figure

3 Cobb Douglas (y;L), below)o Production is increasing, but at a decreasing rateo i.e. there is a decreasing but positive marginal product of labour

Note, a Cobb Douglas function for capital looks identical

Figure 3 Cobb Douglas (y;L)

Constant returns to scaleo If you double inputs, outputs double o A Cobb Douglas function necessarily has constant returns to scale

Marginal products

o

o Thus, Marginal Product of Capital (MPK) is inversely related to the Capital Labour Ration (K/L)

o The Marginal Product of Labour (MPL) is directly related to (K/L)

The PPF, Indifference Curves, and Trade

Production Possibility Frontiers – Production Bias

Figure 4 Production Bias

On this PPF, Country A has a production bias towards food, and Country B has a production bias towards clothing

i.e. Country A has a lower opportunity cost for producing food

Consumption preference Just as production may be biased, consumption may be as well

Figure 5 Consumption Bias

In this diagram, Country A has a consumption bias towards Clothing (less units of clothing would satisfy the same as more units of food

Considering an economy with a Food production bias and a Clothing consumption bias

Without Trade Without trade, production and consumption must occur at the same point

– a “kissing point”

Figure 6 Kissing Point Equilibrium

With Trade Trade allows a separation of the PPF and the Indifference Curve: goods

produced can be sold, to purchase the goods to be consumed: a budget line is created

Figure 7 Trade Equilibrium

This allows greater consumption, with the production at point A, sold, and with the money, consumption bought at point B

Gains from trade

The distance between the two indifference curves represents the gains from trade

Summary Without trade, there is a lower, “kissing point equilibrium” Trade allows a different basket of goods to be consumed than produced

o Sell excess food at PfQf and buy clothing at PcQco Creates a budget line

Trade, if not required, won’t occur, thus, trade is an unrestricted optimum, whereas no trade restricts the optimum, necessarily less than or equal to the unrestricted one.

Lecture 3: Specific Factors Model and Rybcyznski’s Theorem

Creating the PPF via the Specific Factors Model

Figure 8 SFM1 - Labor is interchangeable

Labor is interchangeable between the two industries (Food and Manufactures) – i.e. one unit of labor leaves manufactures, one unit of labor enters food production.

Figure 9 SFM2 - Production function for food

Create a production function for food (labor (food); food production) with diminishing returns to labor (as per a Cobb-Douglas production function)

Figure 10 SFM3 - Production function for manufactures

And the same for manufactures Allows us to construct a production possibility frontier (A PPF – in Blue)

by creating a 4 segment graph and plotting relevant points)

Figure 11 SFM4 - The PPF

Two countries with different factor endowments Taking the example of England (blue) and France (red)

o They have the same labor forceo France has double the land (therefore, a higher returns to land

(land/labor ration))

Figure 12 SFM5 - Trade

That France has more land gives it a PPF in which it has a comparative advantage over England in the production of food (less manufactures are wasted in the production of food)

o Thus, it is more efficient, between the two economies if England solely produces manufactures and France solely produces food

Rybcyznski’s Theorem At constant product prices, when you add to a specific factor, you increase

the production of the good that relies on that factor, and decrease production of the other good in the SFM

This is because of the good which is more produced (i.e. the good with the increased factor) will provide more profit per unit of labor (because of an increased factor-labor ratio), therefore, the wages in that area will increase (to PfMPLf)

Labor then shifts away from the other factor to the increased factor Increasing production of the increased factor at the expense of the other

factor

Figure 13 Rybcynzki's Theorem

An increase in food technology increases the MPL of food shifting the PfMPLf curve upwards.

Wages increase for labor in food production, Labor shifts (diff between two dotted lines) from Manufactures to Food

Thus, the production of food increases because of increased labor and capital input, and the production of manufactures decreases because of equal capital and decreased labor

Proof

Figure 14 Proof of Rybcyznski's theorem

The SFM model shows the proof: for a fixed price level (shown as the diagonal dashed lines) an increase in food tech (purple arrow) leads to a change in the PPF’s (it gets pushed out, blue to red), a decrease in manufactures and an increase in food production.

Lecture 4: Trade Equilibrium

Step 1 Define PPF’sIn this example, a mini US and Australia (same manufacturing output, US has higher food output)

Figure 15 PPF's

Step 2: Autarky pricesDetermine the autarky prices for the smaller economy

Figure 16 Autarky (AUS)

Determine the autarky price for the other economy

Figure 17 Autarky (US)

Step 2: determine trade price [check]For trade, the prices must be the same (with the same “trade trianges”).You export what you are relatively better at producing (what is relatively cheaper in autarky (Stolper Samuelson)

Thus, the price lines must be parallel

Figure 18 Trade

Thus, Australia produces at A and consumes at BThe Uroduces at D and consumes at C

The US sells food to buy manufacturesAustralia sells manufactures to buy food

Relationships – The Hecksher Ohlin TheoremYou sell what you can produce relatively cheaply, buying what is relatively more expensive

The Stolper Samuelson TheoremAn increase in the relative price of a good increases the real return to its specific factor and reduces the return to the other specific factor via marginal products and wages, as per Rybcyznski’s

Welfare analysisWho receives more money and who has to pay more? (Oz rel prices of manufactures increases, food prices decrease: capitalists get more, poor pay more)

Lecture 5: Trade Policy Basic trade policy instruments:

o Tariffo Subsidyo Quotao Voluntary export restraints

Trade

Figure 19 without trade, supply and demand equilibrate domestically

Figure 20 where the world price is lower than domestic price, goods are imported

Figure 21 when the world price is above the domestic equilibrium, excess production is exported

TariffsTariffs are a government “fee” on imported items, which serves to raise the “world price” in the above diagram

Figure 22 A tariff

“a” is the cost of tariff (i.e. the increase in price) “d” is government revenue (calculated by “cost of the tariff” multiplied by

the amount of goods imported) “b+c+d+e” is the consumer loss “c+e” is the deadweight loss “b” is the producer gain

QuotasQuotas have the same effect as tariffs, but instead of increasing the price, they restrict the quantity of imports (“d”). But the government doesn’t make any money.

Optimal Tariff Where a nation is a huge market, a tariff may dent a market so much (by

reducing demand) that the world price decreases Terms of Trade are the ratio of export prices to import prices (an measure

of, relatively, how many exports are required to fund imports) An increase in the terms of trade is an increase in welfare for the country,

since they are able to purchase more imports for the same amount of exports

An optimum tariff works by reducing the world prices enough that the terms of trade benefit outweighs the deadweight loss of the tariff

This works by creating a tariff where the world price falls as a result, and government revenue increases

This is irrelevant to Australia which does not have the market share to influence the world markets to such an extent

sExport subsidiesThese work to increase the competitiveness of domestic goods, so that they may be exported.

Figure 23 An export subsidy

“c+d+e” is the government cost of the subsidy “b+c+d” is the producer surplus Consumer loss is “b+c” “c+e” is deadweight loss

Voluntary export restraint like a quota, limits exports

Lecture 6: Environmental economics

Concerns of environmentalists Pollution, environmental degradation, global warming etc. caused by:

o Population growth and industrialization o Market failure via externalities

There is an argument as to whether pareto (economic) efficiency should take precedence over sustainability

o Internalizing externalities

Global population Increasing wages have increased the opportunity cost of child bearing,

reducing fertility (from 6 children per woman in 1800 to 2.5 in 2000) and causing a global aging population

This is enforced by a doubling of life expectancy in the past 200 years In 1950 there was a population explosion, but population growth is said

to decrease by 2050 Population growth is said to plateau

Global warming 0.8 degree temperature rise since the 1800’s large increase in co2 stock since industrial revolution Sources of co2 emmissions:

o Land useo Energyo Agricultureo Transport

In 2100, worst projection is 5 degrees higher, best is 1.5 degrees (we are currently tracking worse than the worst projections

Environmental economics

Figure 24 the difference between MDS and MDF is the externality

Internalizing externalities

Figure 25 A tax increases the cost to the firm so that MDF=MDS at social optimum

Figure 26 A subsidy reduces the MC of Abatement so that the firm outputs at the socially optimum level

Figure 27 A legal limit illegalizes output where pollution is greater than the legal limit

Policy issues Costs Difficulty of determining the social optimum

Multiple pollutersThe social optimum creates a target, which is the allowable output for the two firms in this model

Figure 28 with a "0" target, each firm produces nothing

With a current output of 20, and a target of 10 (a halving of pollution)

Figure 29 A legal limit would force each firm to output no more than 5 units

Figure 30 At this tax level, firm 1 outputs 1 unit, firm 2 outputs 4 units: the tax is too high

Figure 31 At this tax level, firm 1 outputs 4, and 2 outputs 6, ideal output with no knowledge of internal costs

Tradable rights to pollute similarly equilibrate without knowledge of costs of each firmThrough trade: price equilibrates at unit outputs required, easier than tax

Lecture 9: ImmigrationAllocation of revenue to factors of production leaves 0 net income, therefore wages are equal to the MPL at the point of labour employment multiplied by

wages divided by price, or

WPL

Figure 32 An initial allocation of labour

Figure 33 Equilibrium (with immigration)

Figure 34 Welfare analysis

Figure 35 Deadweight loss of no immigration

Lecture 11: developmental economics Aid is complex, sometimes political (e.g. eastern Europe and Israel) Africa is still the hotspot of population on less than 1 dollar a day As well as under 5 year old mortality rate HIPC – highly indebted poor countries (centered on Africa) Three scourges of the developing world

o Currency risko Commodity risko Debt trap

Rose in the ‘70’s because of OPEC Debt relief

o Increases value of debt via increasing chance of payback via “effort”

o Super-incentives too Reduce food subsidies Though this might increase food prices

The Maths

Keye=Effort ,0<e<2L= ital on _ ital paper loanvalR=repayment valλ=cos t of effortEffort is the chance of repayment, L is the original loan value, R is the “asked for” loan value

The Creditor’s perspective The valuation of a loan in this model takes into account the likeliness of

repayment, in the form of “e”

o ExpectedPayoff=R⋅e Thus, it is in the creditor’s interest to increase “e”

The creditor can only do this by changing “R ”

The creditor will end up halving “R ” to maximize “ExpectedPayoff ”

The debtor’s perspectiveThe debtor can only change “e ”

There is, in this model, an assumption that the debtor nation is only able to produce, at maximum effort e=1 , an output equal to L.Thus, the most the debtor nation is able to get is (L-R), multiplied by the “effort”,

that is e (L−R ).

Utility to the debtor = E( payoff debtor )−λ [Cost of effort ]

Udebtor=λe2

2

E(U D )=(L−R )e− λe2

2The debtor seeks to maximize U D

Thus

δt (U D0δe

=L−R−λe=0 (to maximize)

e= L−Rλ This is called the debtor reaction function

If R=L, e=0

If R-0, e= L

λ

Simultaneously equate

E(Payoff )=R⋅e , e=L−Rλ

E(Payoff )=R⋅L−Rλ

δδR

1λ

(LR−R2 )

max=0=1λ(L−2R )

R=L2

Thus, the optimum “R” in this model is “L/2”