IEP Session 2

Amity Business School

MBA 2013, 3rd Semester
INTERNATIONAL ECONOMICS AND POLICY
Amanpreet Kang
Recap
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 developing status, newly industrialized economies, transition economies Regional integration, economic gap, NIE
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International Economic Theory
International Trade Theories

Mercantilism Theory of Absolute Advantage Theory of Relative/ Comparative Advantage Competitive Advantage of Nations
Basics
Economic ideas, concept, theory/theoretical framework Examples of economic ideas tribals In India, elsewhere All theoretical frameworks are related to stages of economic development Meaning/ relevance of an idea related to the stage of economic development What happens in the economy gets reflected in the economic thought
Basics
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
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
Mercantilism was the economic philosophy underlying early European colonial policy. The object of mercantilism was to increase the wealth of the Mother Country (England) in gold and silver. To accomplish that goal, a favorable balance of trade was desired. That means that a nation would sell more than it would purchase, thus creating a surplus in the treasury. The name of the philosophy points out the importance of merchants in this policy. Merchants would sell products to foreign nations and purchased items to be sold within the nation. Theorists using this model tended to view the market as a pie that was up for grabs. Wealth was always gained at the expense of other nations. For some, the ideal was to become self-sufficient. The nation would produce everything its people needed and buy nothing from foreign nations -- thus the idea of the trade deficit. Since the ideal could not be accomplished in the real world of economics, the object of mercantilism was to minimize imports that cost money and maximize exports and the trade that brought money in to the nation.
Mercantilism
Nascent stage of development of economic ideas. Group of ideas and policies. 15th to 18th Century (approximately) Mercantilism is closely associated with trade and commercial activities of an economy. Economic counterpart of political nationalism and prevalent during the days when nation states were formed. Colbertism in France Cameralism in Germany Mercantilism aimed at state power; primary agent for unification; interested in the wealth of nations; expression of capital needs of the rising merchant class needed a strong state to protect them and needed capital for trade.
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Mercantilism
Only a wealthy country could have and maintain strong armed forces and nations unity is a prerequisite for states power. Mercantilists wanted an enhancement of state power through economic means. Later theorists differed from mercantilists in not the objective of strengthening the state but the means applied to achieve this objective. To mercantilists - state power was the military power which in turn needed wealth (money and treasure) and to others state power would emerge from the wealth and productive power of nations. 2 additional forces lure for gold and discovery of new trade routes to expand foreign trade, add new colonies, etc.
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Mercantilism
Devices and mechanisms for achieving mercantilist objectives: 1. Balance of trade and specie flow Bullionism Mercantilism Proper 2. Quantity of Money and Rate of Interest inflationary effect, decrease in interest rates and increase finance resource Other regulations Payment of wages Regulation of trade by the nation state additional income sources like insurance and freight charges
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3.
Mercantilism
Criticisms: Not all nations could have a positive/ surplus balance of trade Gain of one state at the loss of the others
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Theory of Absolute Advantage
Adam Smith (1723-1790)
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Basics
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
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Analytical Tools
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Charles van Marrewijk
Thus, the production possibility curve represents efficient Good Y output combinations. All possible combinations of
final output (including non-optimal combinations) is called the production possibility set
Good X
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PPF/ PPC under Increasing Costs

Good Y
A C
Opportunity Cost Marginal Rate of Transformation (MRT)
C1
C2
W1
W2
Good X
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PPF/ PPC & Optimum Combination of Output

Good Y
P A
Opportunity Cost Marginal Rate of Transformation (MRT)

P1
C1
P2
W2
Good X
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Community Consumption Indifference Curve

Good Y
An individual consumption indifference curve shows various combinations of commodities which yield the same level of satisfaction to an individual. Community indifference curve shows various combinations of 2 commodities which yield equal satisfaction to community or a nation.
P Q R
Good X
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Equilibrium Under Autarchy

Good Y
Good X
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Equilibrium Under Trade

Good Y
A2 E A A1
B B2 B1
Good X
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Smith's argument for free trade

You do not make your own clothes or shoes but buy them from your tailor or shoemaker to enjoy the benefits of increased specialization. You concentrate on producing what you do best. International trade, similarly, allows countries to concentrate on producing what they do best.
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Analysis of absolute cost advantage

International trade based on differences in technology. The main assumptions of the theory are;
2 countries; USA and Japan 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
No transport costs
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Productivity table; labor required to produce 1 unit of output
General specification Food USA aUS F
J aF
Example Food USA 2 Cars 8
Cars
US aC J aC
Japan
Japan
Note that the USA is more efficient than Japan for the production of Food (requires 2 < 3 labourers), while Japan is more efficient than the USA in the production of cars (requires 6 < 8 labourers). In autarky (without international trade) both countries will produce both goods if consumers demand both Food and Cars.
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According to Adam Smith, both countries can gain from international trade through specialization (USA producing more food and Japan producing more cars): Suppose the USA produces 1 car less, this frees up 8 labourers. These 8 labourers can now produce 8/2 = 4 units of food To keep the production level of cars constant, Japan should make 1 car more. 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:
production of food:
-1
+4
+1
-2
0
+2
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The extra production represents gains from trade
Relative/ Comparative Cost
David Ricardo (1772-1823)

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Classical economics and comparative advantage

Technological differences between nations are the classical driving force behind international trade flows. According to David Ricardo relative or comparative differences are important, not absolute differences. According to Paul Samuelson (Nobel prize 1970) the theory of comparative advantage is one of the few ideas in economics that is true without being obvious.
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Analysis of comparative advantage

International trade based on differences in technology. Assumptions are: 2 countries; EU and Kenya 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 No transport costs
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Productivity table to summarize the state of technology Productivity table; labor required to produce 1 unit of output General specification Food Chemicals
EU aC K aC
Example Food Chemicals
EU
Kenya
EU aF K aF
EU
Kenya
2
4
8
24
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.
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According to David Ricardo both countries can gain from international trade through specialization (EU producing more chemicals and Kenya producing more 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 1 chemical more. This requires 8 labourers. These 8 labourers could have made 8/2 = 4 units of food.
Conclusion:
production of chem. production of food
EU
+1 -4
Kenya Change world prod.

-1 +6 0 +2
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The extra production represents gains from trade
Production possibility frontier and autarky

Production possibility frontier (ppf) = All possible combinations of efficient production points given the available factors of production and the state of technology. 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 available EU Kenya 200 120 EU Kenya Maximum production Food 100 30 Chemicals 25 5
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More countries and World PPF

Food Fmax A E0 B
slope pc 0 / p f 0
slope pc1 / p f 1
E1 World ppf D
Chemicals
Cmax
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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 between

countries does not involve any costs. Transfer costs affect whether the goods will or will not be traded among countries
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More than two commodities
The same theory can be applied to cases in which not merely two but
a 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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Non competing groups
The distinct categories of labour with rather well marked and enduring differences in wages are known as non-competing groups. Existence of such groups will not affect the comparative trade theory provided 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 and his student Bertil Ohlin.
This theory consists of 2 important theorems:
1. Heckscher Ohlin Theorem

Examines the reasons for comparative cost differences in production and states that a country has comparative advantage in production of that commodity which uses more intensively the countrys most abundant factor.
2. Factor price equalisation theorem

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The factor endowment theory was developed by Eli Heckscher and his 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 states that free international trade equalises factor prices between countries, relatively and absolutely, and thus serves as a substitute for international factor mobility.
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This theory supplements the explanation of theory of comparative advantage by explaining the reasons for the differences in the comparative costs.
Heckscher Ohlin Theorem:

Explains the basis of international trade in terms of factor endowments It attempts to explain why comparative cost differences exist internationally. 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 whose production requires relatively large amount of the factor with which the country is relatively well endowed.
Factors of production are considered scarce or abundant in relative terms 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 characterised by perfect competition
Factors of production are perfectly mobile within each country but immobile 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 both countries
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 for international factor mobility.
International trade increases demand for abundant factors leading to increase in their prices and decrease in the demand for scarce factors, leading to a fall in their prices, because when nations trade, specializations take place on the basis of factor endowments.
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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 of factors of production, which means their better use and a reduction 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 intensive goods 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 to manufacture the same quantity of imports. As US exports are capital intensive and imports labour intensive, labour freed, 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 was higher in import substitution industries than export industries. He hence concluded that America participated in international trade by specialisation in labour intensive rather than capital intensive lines of production.
Explanation: 1) Leontief suggested: Though labour was scarce vis--vis capital, effective supply of labour was greater because of higher productivity of American labour. Exclusion from study certain factors, which would also determine the countrys productive capacity.
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Leontief Paradox
2) Production functions i.e. ways of producing goods are not identical between countries. Leontief should have studied whether goods imported 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 abundant factor. 4) Trade barriers 5) Human capital and R&D 7) Factor intensity reversal Depending on the use of a factors of production in production process. Production process may vary between countries.
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Factor Intensity Reversal

Factor endowments Factor intensities Changes in relative factor endowments and factor intensities is possible over time. These changes may reverse the pattern of trade. Factor intensity reversal refers to a situation where the factor intensities in 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 vice versa. 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 introduction of 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 country because 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 cannot be produced by the importing country. The most important restriction on international trade are those imposed 49 by governments and by cartels.

Competitive Advantage of Nations A country achieves international success in a particular industry due to 4 broad attributes of a country that shape the environment in which nations compete and promote or impede the creation of competitive advantage. These factors include; Factor conditions Demand conditions Related and supporting industries Firm strategy, structure and rivalry
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Competitive Advantage of Nations
1) Factor conditions: Depends on how efficiently and effectively are the factors employed. Advanced factors (R&D in sophisticated disciplines, highly educated personnel, modern communication infrastructure, etc.) Specialised factors (knowledge base in specific fields, narrowly skilled personnel, infrastructure with specialised properties, etc.) Basic factors (natural resources, climate, location, unskilled and semiskilled 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 determining competitive advantage than the basic factors and generalised factors. Development of advanced and specialised factors demands concerted efforts and sustained investments in human and physical capital. Countries will succeed in industries where they are good at factor creation. Selective disadvantages in basic factors force a company to innovate and 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 to foreign markets. Home demand gives the companies a clear and early picture of emerging 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 in an industry. Large home market size can lead companies to achieve economies of scale or learning. It also helps in case the same products are demanded in other countries also. Domestic demand internationalises and pull the products and services abroad.
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3) Related and supporting industries: If related and supporting industries are internationally competitive, they create advantages in downstream industries in several ways such as supply 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, fiscal and monetary policies, promotional and regulatory measures in respect of industry and trade Chance effects competitive position because of major technological breakthroughs and new inventions, political decisions by foreign governments, wars, shifts in financial markets, discontinuities in input costs, 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 by Raymond 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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References
1. International Economics, Francis Cherunilam (5th Edition), Mc Graw Hill 2. International Economics, BO Sodersten and Geoffrey Reed (3rd Edition), Macmillan 3. International Economics, Paul Krugman and Maurice Obstfeld (6th Edition), Pearson Education
4. Economics, Samuelson & Nordhaus (18th Edition), Tata Mc Graw Hill

5. History of Economic Thought, H L Bhatia
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IEP Session 2

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Amity Business School

Amity Business School

INTERNATIONAL ECONOMICS AND POLICY

Amity Business School

Amity Business School

International Economic Theory

Amity Business School

International Trade Theories

Amity Business School

Amity Business School

Wars not in their interest Supported formation of STRONG nations

Amity Business School

Amity Business School

Amity Business School

Amity Business School

Amity Business School

Amity Business School

Amity Business School

Theory of Absolute Advantage

Adam Smith (1723-1790)

Amity Business School

Amity Business School

Charles van Marrewijk

Amity Business School

Amity Business School

PPF/ PPC under Increasing Costs

Opportunity Cost Marginal Rate of Transformation (MRT)

Amity Business School

PPF/ PPC & Optimum Combination of Output

Opportunity Cost Marginal Rate of Transformation (MRT)

Amity Business School

Community Consumption Indifference Curve

Amity Business School

Equilibrium Under Autarchy

Amity Business School

Equilibrium Under Trade

Amity Business School

Smith's argument for free trade

Amity Business School

Analysis of absolute cost advantage

1 factor of production; labor L

Amity Business School

Analysis of absolute cost advantage

Example Food USA 2 Cars 8

Amity Business School

Analysis of absolute cost advantage

The extra production represents gains from trade

Amity Business School

Relative/ Comparative Cost

David Ricardo (1772-1823)

Amity Business School

Classical economics and comparative advantage

Amity Business School

Analysis of comparative advantage

Amity Business School

Analysis of comparative advantage

Example Food Chemicals

Amity Business School

Analysis of comparative advantage

Kenya Change world prod.

The extra production represents gains from trade

Amity Business School

Production possibility frontier and autarky