THE PEARSON SERIES IN ECONOMICS

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2 THE PEARSON SERIES IN ECONOMICS Abel/Bernanke/Croushore Macroeconomics* Acemoglu/Laibson/List Bade/Parkin Foundations of Berck/Helfand The Economics of the Environment Bierman/Fernandez Game Theory with Economic Applications Blanchard Macroeconomics* Boyer Principles of Transportation Economics Branson Macroeconomic Theory and Policy Bruce Public Finance and the American Economy Carlton/Perloff Modern Industrial Organization Case/Fair/Oster Principles of Chapman Environmental Economics: Theory, Application, and Policy Daniels/VanHoose International Monetary & Financial Economics Downs An Economic Theory of Democracy Farnham Economics for Managers Froyen Macroeconomics: Theories and Policies Fusfeld The Age of the Economist Gerber International Gordon Macroeconomics* Greene Econometric Analysis Gregory/Stuart Russian and Soviet Economic Performance and Structure Hartwick/Olewiler The Economics of Natural Resource Use Heilbroner/Milberg The Making of the Economic Society Heyne/Boettke/Prychitko The Economic Way of Thinking Hubbard/O Brien InEcon Money, Banking, and the Financial System* Hubbard/O Brien/Rafferty Macroeconomics* Hughes/Cain American Economic History Husted/Melvin International Economics Jehle/Reny Advanced Microeconomic Theory Keat/Young/Erfle Managerial Economics Klein Mathematical Methods for Economics Krugman/Obstfeld/Melitz International Economics: Theory & Policy* Laidler The Demand for Money Lynn Economic Development: Theory and Practice for a Divided World Miller Economics Today* Miller/Benjamin The Economics of Macro Issues Miller/Benjamin/North The Economics of Public Issues Mishkin The Economics of Money, Banking, and Financial Markets* The Economics of Money, Banking, and Financial Markets, Business School Edition* Macroeconomics: Policy and Practice* Murray Econometrics: A Modern Introduction O Sullivan/Sheffrin/Perez Economics: Principles, Applications and Tools* Parkin Perloff Microeconomics* Microeconomics: Theory and Applications with Calculus* Perloff/Brander Managerial Economics and Strategy* Pindyck/Rubinfeld Microeconomics* Riddell/Shackelford/Stamos/ Schneider Economics: A Tool for Critically Understanding Society Roberts The Choice: A Fable of Free Trade and Protection Scherer Industry Structure, Strategy, and Public Policy Schiller The Economics of Poverty and Discrimination Sherman Market Regulation Stock/Watson Introduction to Econometrics Studenmund A Practical Guide to Using Econometrics Todaro/Smith Economic Development Walters/Walters/Appel/ Callahan/Centanni/Maex/ O Neill Econversations: Today s Students Discuss Today s Issues Williamson Macroeconomics *denotes availability of titles with Pearson MyLab Economics denotes availability of Global Edition titles Log onto to learn more.

3 240 PART ONE International Trade Theory FURTHER READINGS 8. If there are internal economies of scale, why would it ever make sense for a firm to produce the same good in more than one production facility? 9. Most firms in the apparel and footwear industries choose to outsource production to countries where labor is abundant (primarily, Southeast Asia and the Caribbean) but those firms do not integrate with their suppliers there. On the other hand, firms in many capital-intensive industries choose to integrate with their suppliers. What could be some differences between the labor-intensive apparel and footwear industries on the one hand and capital-intensive industries on the other hand that would explain these choices? 10. Consider the example of industries in problem 9. What would those choices imply for the extent of intra-firm trade across industries? That is, in what industries would a greater proportion of trade occur within firms? Pol Antràs. Global Production: Firms, Contracts, and Trade Structure. Princeton, NJ: Princeton University Press, An excellent reference book on the theory and empirics of offshoring, outsourcing, and global value chains. Andrew B. Bernard, J. Bradford Jensen, Stephen J. Redding, and Peter K. Schott. Firms in International Trade. Journal of Economic Perspectives 21 (Summer 2007), pp A nontechnical description of empirical patterns of trade at the firm level that focuses on U.S. firms. Andrew B. Bernard, J. Bradford Jensen, and Peter K. Schott. Importers, Exporters, and Multinationals: A Portrait of Firms in the US that Trade Goods, in T. Dunne, J. B. Jensen, and M. J. Roberts, eds. Producer Dynamics: New Evidence from Micro Data. Chicago: University of Chicago Press, A nontechnical description of empirical patterns of trade at the firm level that focuses on U.S. firms and multinationals operating in the United States. Robert Feenstra. Integration of Trade and Disintegration of Production in the Global Economy. Journal of Economic Perspectives 12 (Fall 1998), pp A description of how the supply chain has been broken up into many processes that are then performed in different locations. Gordon Hanson, Raymond Mataloni, and Matthew Slaughter. Vertical Production Networks in Multinational Firms. Review of Economics and Statistics 87 (March 2005), pp An empirical description of vertical FDI patterns based on multinationals operating in the United States. Keith Head. Elements of Multinational Strategy. New York: Springer, A recent textbook focused on multinationals. Elhanan Helpman. Trade, FDI, and the Organization of Firms. Journal of Economic Literature 44 (September 2006), pp A technical survey of recent research on models that incorporate firm performance differences and on multinationals and outsourcing. Elhanan Helpman. Understanding Global Trade. Cambridge, MA: Harvard University Press, forthcoming. A nontechnical book that covers both comparative advantage theories of trade and more recent theories of trade based on the firm. Elhanan Helpman and Paul R. Krugman. Market Structure and Foreign Trade. Cambridge: MIT Press, A technical presentation of monopolistic competition and other models of trade with economies of scale. J. Bradford Jensen. Global Trade in Services: Fear, Facts, and Offshoring. Washington, DC: Peterson Institute for International Economics, A nontechnical book focusing on the effects of increased trade in services for the U.S. economy. James Markusen. The Boundaries of Multinational Enterprises and the Theory of International Trade. Journal of Economic Perspectives 9 (Spring 1995), pp A nontechnical survey of models of trade and multinationals.

4 CHAPTER 8 Firms in the Global Economy: Export Decisions, Outsourcing 241 Thierry Mayer and Gianmarco I. P. Ottaviano. The Happy Few: The Internationalisation of European Firms: New Facts Based on Firm-Level Evidence. Intereconomics 43 (May/June 2008), pp Marc J. Melitz and Daniel Trefler. Gains from Trade When Firms Matter. Journal of Economic Perspectives 26 (2012), pp A nontechnical survey that develops the monopolistic competition model with performance differences across firms in greater detail than in this chapter. The paper also contains a detailed description of the associated evidence for Canadian firms following implementation of the Canada U.S. Free Trade Agreement. Pearson MyLab Economics Can Help You Get a Better Grade Pearson MyLab Economics If your exam were tomorrow, would you be ready? For each chapter, Pearson MyLab Economics Practice Tests and Study Plans pinpoint sections you have mastered and those you need to study. That way, you are more efficient with your study time, and you are better prepared for your exams. To see how it works, turn to page 37 and then go to

5 APPENDIX TO CHAPTER 8 Determining Marginal Revenue In our exposition of monopoly and monopolistic competition, we found it useful to have an algebraic statement of the marginal revenue faced by a firm given the demand curve it faced. Specifically, we asserted that if a firm faces the demand curve its marginal revenue is Q = A - B * P, MR = P - (1>B) * Q. (8A-1) (8A-2) In this appendix, we demonstrate why this is true. Notice first that the demand curve can be rearranged to state the price as a function of the firm s sales rather than the other way around. By rearranging (8A-1), we get P = (A>B) - (1>B) * Q. (8A-3) The revenue of a firm is simply the price it receives per unit multiplied by the number of units it sells. Letting R denote the firm s revenue, we have R = P * Q = [(A>B) - (1>B) * Q] * Q. (8A-4) Let us next ask how the revenue of a firm changes if it changes its sales. Suppose the firm decides to increase its sales by a small amount, dx, so that the new level of sales is Q = Q + dq. Then the firm s revenue after the increase in sales, R, will be R = P * Q = [(A>B) - (1>B) * (Q + dq)] * (Q + dq) = [(A>B) - (1>B) * Q] * Q + [(A>B) - (1>B) * Q] * dq - (1>B) * Q * dq - (1>B) * (dq) 2. (8A-5) Equation (8A-5) can be simplified by substituting in from (8A-1) and (8A-4) to get R = R + P * dq - (1>B) * Q * dq - (1>B) * (dq) 2. (8A-6) When the change in sales dq is small, however, its square (dq) 2 is very small (e.g., the square of 1 is 1, but the square of 1>10 is 1>100). So for a small change in Q, the last term in (8A-6) can be ignored. This gives us the result that the change in revenue from a small change in sales is R = R = [P - (1>B) * Q] * dq. (8A-7) So the increase in revenue per unit of additional sales which is the definition of marginal revenue is MR = (R - R)>dQ = P - (1>B) * Q, which is just what we asserted in equation (8A-2). 242

6 CHAPTER 9 The Instruments of Trade Policy Previous chapters have answered the question, Why do nations trade? by describing the causes and effects of international trade and the functioning of a trading world economy. While this question is interesting in itself, its answer is even more interesting if it also helps answer the question, What should a nation s trade policy be? For example, the grittiest part of the Brexit, Britain s withdrawal from the European Union (EU) negotiations is over trade. Its tariff, quota, and subsidy rules are fixed by its EU membership. Thus, the EU, Britain, and certain third countries are faced with a dilemma of possibilities of trade. Outside the customs union of the EU, Britain would face tariffs and non-tariff barriers, which could add between 2 and 15 percent to the cost of exports, depending on the product? This chapter examines the policies that governments adopt toward international trade, policies that involve a number of different actions. These actions include taxes on some international transactions, subsidies for other transactions, legal limits on the value or volume of particular imports, and many other measures. The chapter thus provides a framework for understanding the effects of the most important instruments of trade policy. PART TWO International Trade Policy LEARNING GOALS Basic Tariff Analysis After reading this chapter, you will be able to: Evaluate the costs and benefits of tariffs, their welfare effects, and winners and losers of tariff policies. Discuss what export subsidies and agricultural subsidies are, and explain how they affect trade in agriculture in the United States and the European Union. Recognize the effect of voluntary export restraints (VERs) on both importing and exporting countries, and describe how the welfare effects of these VERs compare with tariff and quota policies. A tariff, the simplest of trade policies, is a tax levied when a good is imported. Specific tariffs are levied as a fixed charge for each unit of goods imported (for example, $3 per barrel of oil). Ad valorem tariffs are taxes that are levied as a fraction of the value of the imported goods (for example, a 25 percent U.S. tariff on imported trucks see the box on page 253). In either case, the effect of the tariff is to raise the cost of shipping goods to a country. 243

7 244 PART TWO International Trade Policy Tariffs are the oldest form of trade policy and have traditionally been used as a source of government income. Until the introduction of the income tax, for instance, the U.S. government raised most of its revenue from tariffs. Their true purpose, however, has usually been twofold: to provide revenue and to protect particular domestic sectors. In the early 19th century, for example, the United Kingdom used tariffs (the famous Corn Laws) to protect its agriculture from import competition. In the late 19th century, both Germany and the United States protected their new industrial sectors by imposing tariffs on imports of manufactured goods. In the late 19th century, protection was a trade policy instrument used in Europe s development. In Europe tariffs had a positive impact on a country s growth, specifically on infant industry grounds. For example, Sweden, Italy, and France adopted rather severe agricultural protection policies. Germany adopted protectionist policies in both agriculture and manufacturing and experiencing strong growth of its infant industries with set higher tariffs. Also countries of the New World, such as Canada, Australia, and the United States also chose to protect its manufacturing and infant industries from European competition. The importance of tariffs has declined in modern times because modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such as import quotas (limitations on the quantity of imports) and export restraints (limitations on the quantity of exports usually imposed by the exporting country at the importing country s request). Nonetheless, an understanding of the effects of a tariff remains vital for understanding other trade policies. In developing the theory of trade in Chapters 3 through 8, we adopted a general equilibrium perspective. That is, we were keenly aware that events in one part of the economy have repercussions elsewhere. However, in many (though not all) cases, trade policies toward one sector can be reasonably well understood without going into detail about those policies repercussions on the rest of the economy. For the most part, then, trade policy can be examined in a partial equilibrium framework. When the effects on the economy as a whole become crucial, we will refer back to general equilibrium analysis. Supply, Demand, and Trade in a Single Industry Let s suppose there are two countries, Home and Foreign, both of which consume and produce wheat, which can be costlessly transported between the countries. In each country, wheat is a simple competitive industry in which the supply and demand curves are functions of the market price. Normally, Home supply and demand will depend on the price in terms of Home currency, and Foreign supply and demand will depend on the price in terms of Foreign currency. However, we assume the exchange rate between the currencies is not affected by whatever trade policy is undertaken in this market. Thus, we quote prices in both markets in terms of Home currency. Trade will arise in such a market if prices are different in the absence of trade. Suppose that in the absence of trade, the price of wheat is higher in Home than it is in Foreign. Now let s allow foreign trade. Since the price of wheat in Home exceeds the price in Foreign, shippers begin to move wheat from Foreign to Home. The export of wheat raises its price in Foreign and lowers its price in Home until the difference in prices has been eliminated. To determine the world price and the quantity traded, it is helpful to define two new curves: the Home import demand curve and the Foreign export supply curve, which are derived from the underlying domestic supply and demand curves. Home import demand is the excess of what Home consumers demand over what Home producers supply; Foreign export supply is the excess of what Foreign producers supply over what Foreign consumers demand. Figure 9-1 shows how the Home import demand curve is derived. At the price P 1, Home consumers demand D 1, while Home producers supply only S 1. As a result, Home import demand is D 1 - S 1. If we raise the price to P 2, Home consumers demand only D 2, while Home producers raise the amount they supply to S 2, so import demand falls to D 2 - S 2. These price-quantity combinations are plotted as