INTERNATIONAL ECONOMICS: TRADE THEORY

Transcription

1 INTERNATIONAL ECONOMICS: TRADE THEORY AND POLICY EXAM QUESTIONS CHAPTER 1: QUESTIONS Question 1: (i) Formulate the basic gravity equation in logs. Which variable is on the left hand side and which ones are the explanatory variables. Give an intuitive economic explanation of the impact of these explanatory variables. (ii) Give a concise interpretation of the parameters of this model that are usually econometrically estimated. (iii) Discuss some main empirical findings from this model. (i) log T ij = log A + alogy i + blogy j clogd ij + ℇ ij The log of bilateral trade flow is explained through the log of a constant and the log of both country s GDPs reduced by the log of the distance between the countries (plus the error term) The GDPs have a high positive impact The D has an important negative impact T ij = the value of trade between country i and country j bilateral trade flow A = a constant Y i = GDP of country i (exporter) Y j = GDP of country j (importer) D ij = distance between both countries (bilateral trade friction) impact of distance increased over time (modern transportation over time and communication hard to find data: Distance puzzle) (ii) Size (GDP): of an economy is directly related to the volume of imports and exports (not quantity); larger economies produce and export more => more income => more money for imports Distance: influences transportation costs and therefore costs of imports and exports; can also influence personal contact and communication; Cultural affinity: cultural ties make economic ties more likely; language is an important barrier of trade; Geography: ocean harbours and a lack of mountain barriers make the transport easier; Multinational corporations: corporations spread across nations shift their goods between their divisions; Borders: crossing borders involves formalities and take time and perhaps tariffs

2 (iii) Findings Distance should have decreased over time due to globalisation. Normally, there should be a death of distance. Distance is used as a proxy for transportation costs which declined. Nevertheless, the coefficient distance is increasing over time => Distance Puzzle Question 2: (i) Describe the basic form of the gravity model that is used to analyse the determinants of bilateral trade flows. (ii) Give a detailed interpretation of the parameters of the gravity model (that are econometrically estimated). (iii) Discuss the most important determinants of bilateral trade flows that are found in the literature. (i) Τ ij = A Y j a Y j b /D ij c D increases => T decreases Y increases => T increases (ii) Parameters T ij = the value of trade between country i and country j bilateral trade flow A = a constant Y i = GDP of country i (exporter) Y j = GDP of country j (importer) D ij = distance between both countries (bilateral trade friction) impact of distance increased over time (modern transportation over time and communication hard to find data: Distance puzzle) (iii) Size (GDP): of an economy is directly related to the volume of imports and exports (not quantity); larger economies produce and export more => more income => more money for imports Distance: influences transportation costs and therefore costs of imports and exports; can also influence personal contact and communication; Cultural affinity: cultural ties make economic ties more likely; language is an important barrier of trade; Geography: ocean harbours and a lack of mountain barriers make the transport easier; Multinational corporations: corporations spread across nations shift their goods between their divisions; Borders: crossing borders involves formalities and take time and perhaps tariffs

3 CHAPTER 3 CLASSICAL TRADE: TECHNOLOGY July 2014 The oldest explanation of trade between countries by David Ricardo is based on specialization in production arising from on differences in labour productivity. (i) How are the labour intensity and the labour productivity defined in this model? Derive the marginal cost of a typical firm in the Ricardo model. Discuss shortly the assumptions about the labour intensities in the Ricardo model. Labour intensity is defined as one factor of productivity and labour productivity is defined as technology, which differs between countries. Furthermore labour is mobile between sectors, but not between countries. The assumptions in the Ricardo model are: - Two countries, two final goods & one factor of production (Labour) - Constant returns to scale production functions (if the amount of inputs in an industry is doubled, the output level will also double) - Perfect competition (each firm wants to maximize profits, given the price levels in output and input markets) - Constant returns to scale + perfect competition if a good is produced in equilibrium the price level in the output market must be equal to the unit cost of production (P=MC) - Labour is mobile between sectors, but not between countries. - Costless trade in final goods (no impediments to trade) - Technology as reflected by labour productivity differs between countries (ii) Use the two-country, two-sector, one-factor Ricardo model and explain the concept of opportunity costs and comparative advantage. The concept of opportunity costs: The opportunity cost of product A in terms of product B is the number of B that could have been produced with the resources used to produce a given number of product A. The concept of comparative advantage: A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in hat country than it is in other countries. (iii) Define the production possibility frontier (PPF). Which factors determine the PPF and why? The PPF gives us all possible combinations of efficient production points of final goods. It determines the available factors of production and the state of technology, because we have to specify the available factors of production in each country. It suffices to specify the number of workers available as labour is the only factor of production. As an example the available labourers in the EU are 200, so they could produce 200/2 = 100 units of food. (iv) Give a formal derivation of the opportunity costs of a product based on the PPF and provide a short interpretation of your result.

4 The whole answer will be based on the following table: Labour units required to produce one unit of output Food Chemicals Total available EU Kenya labour An extra unit of Chemicals needs 8 units of labour in the EU. This labour could have made 8/2 = 4 units of Food; the opportunity cost of Chemicals production in the EU is 4 Food. An extra unit of Chemicals in Kenya needs 24 labours. This labour could have made 24/4 = 6 units of Food; the opportunity cost of Chemicals production in Kenya is 6 Food. The EU has a comparative advantage in Chemicals, Kenya in Food February 2014 The oldest explanation of trade between countries by David Ricardo is based on specialization in production based on differences in labour productivity. (i) Describe the concept of labour intensity and labour productivity as defined in the Ricardo model. Discuss shortly the assumptions about the labour intensities in this model and derive the marginal cost of a typical firm in the Ricardo model. (ii) Define the production possibility frontier (PPF) of a country. Which factors determine the PPF and why? (iii) Use the two-country, two-sector, one-factor Ricardo model and explain the concept of opportunity costs and comparative advantage. Give also a formal derivation of the opportunity costs of a product based on the PPF and provide a short interpretation of your result. => ANTWORTEN VON JULI 2014 KLAUSUR (iv) Explain why in this model a firm in a country can be competitive on the world market if this country exhibits lower labour productivity than its trading partner in all two sectors. Based on a theory of absolute cost advantages, Kenya would no be able to trade with the EU, because the EU is more efficient. But because of the theory of comparative cost advantage Kenya is able to trade with the EU. This theory argues that only relative, or comparative, costs are important for determining a nation s production advantage. Lets take the example of (iii) Kenya is twice as inefficient as the EU in producing food but three times as inefficient as the EU in producing chemicals. It should therefore specialize in the production of food and export this to the EU in exchange for chemicals. The oldest explanation of trade between countries is based on specialization in production as formulated in the Ricardo model. (i) Use the production possibility frontier and explain in detail the effects of trade liberalization (the move from autarky to free trade) on the production and trade patterns for the two-country Ricardo model. (ii) Give an intuitive explanation why both countries gain

5 from trade in the Ricardo model. (iii) Illustrate how relative wages are determined under free trade and give a short interpretation. (i) Autarky: - One country no trade - Demand = Supply Consumption = Production - both goods have to be produce (no trade) good basket - MRT is profit maximization = MRS utility max = price ratio - pc/pf = slope PPF Free Trade: In free trade agree upon a price of 4,8 food for 1 chemical. At that price Kenya will produce only food (30 units) and will purchase abroad the required amount of chemicals (maximum 30/4,8 = 6,25 units). Similarly, the EU will produce only chemicals (25 units) and will purchase the amount of food it wants (to a maximum of 25*4,8=120 units). Relative to autarky trade increases the relative price of chemicals (pc/pf) in the EU (exporter) and decreases it in Kenya (importer). Due to comparative advantages EU and Kenya start engaging in trade. (ii) Gain from Trade: Because of the comparative advantage Kenya and the EU gain from trade, since every country is able to specialize in the production of the good for which they have the comparative advantage. This leads to extended consumption, meaning that trade increases national income and welfare compared to autarky. (iii) Determination of relative wages: EU PC w a K P w a F EU c K F w w EU K P P C F 1 a 1 a EU c K F

6 Preis = Lohn*Arbeitsstunden Wages have to adjust according to productivity in each country (raising national income due to trade). Due to lower productivity/national income, wages are lower in Kenya. Food producers of Kenya are therefore competitive on the world market.

7 CHAPTER 4 PRODUCTION STRUCTURE December 2013 The (2 factor, 2 goods, 2 countries) Heckscher-Ohlin model is based on neoclassical production functions. (i) Describe the main assumptions and characteristics of these production functions. The neoclassical model focuses on differences in relative factor endowments (=Faktoren-ausstattung) as a cause for international trade flows. Characteristics: - Two inputs: capital (K) and labour (L) - Substitutability (Ersetzbarkeit): a given output level can be produced using different combinations of inputs, i.e. the use of one input can be substituted for the use of another input - Positive marginal product (Grenzprodukt): if more capital/labour is used - output increases - Diminishing marginal product: given the use of capital, an increase in the use of labour leads to ever smaller increases in output (similarly for capital) - Constant returns to scale: an increase in the use of both inputs by z% also leads to an increase in output of z% Main assumptions of the neoclassical model: - Two countries, two final goods and two factors of production (Capital and Labour) - Constant returns to scale production functions - Perfect competition in all markets - Capital and Labour is mobile between sectors, but not between countries - Costless trade in final goods (no impediments to trade) - Identical production technology in the two countries - No factor-intensity reversal - Identical homothetic tastes in the two countries (homothetic preferences: petal of consumption/ proportion of two goods does not change when income changes) - Countries differ in their (relative) factor endowments (ii) Illustrate cost minimization under the assumptions of the Heckscher-Ohlin model in one of its sectors. Illustrate the impact of changing factor prices on factor demand and give a short description of the characteristics of the resulting cost functions. The cost-minimization input combination depends on the capital-intensity parameter (α) and the wage-rental ratio (w/r). As an example we suppose that we want to produce M=1 at minimum cost taking wage rate w and rental rate r as given. => Total cost = wl m + rk m ; Minimum costs are achieved at a point of tangency between the isocost line, which gives us all combinations of input, which cost the same total amount and the isoquant. In the graph the cost minimum for the production is in point A using K capital and L labour.

8 (iii) Based on your conclusions form (ii) what are the determinants of factor demand that this model predicts. Give a short explanation of your conclusion. April 2014 The (2 factor, 2 goods, 2 countries) Heckscher-Ohlin model is based on neoclassical production functions. (i) Describe the main assumptions and characteristics of these production functions. (ii) Illustrate cost minimization under the assumptions of the Heckscher-Ohlin model in one of its sectors. Illustrate the impact of changing factor prices on factor demand and give a short description of the characteristics of the resulting cost functions. => ANTWORTEN VON DEZEMBER 2013 KLAUSUR (iii) Discuss the necessary conditions for profit maximization in this model. The profit maximization is a two-step procedure. The first step is to minimize production costs and the second to determine optimal output level. The profit of the producer is revenue minus production costs => therefore the profit is maximized when the two steps are clearly respected!

9 CHAPTER 5 & 6 Use the (2 factor, 2 goods, 2 countries) Heckscher-Ohlin model and (i) show how the allocation of resources and the production structure of an economy change if the economy gets more capital (Rybczynski theorem). (ii) Summarize the main assumptions underlying the Rybczynski theorem (iii) Use this theorem to demonstrate that a country relatively better endowed with capital will produce more of the capital intensive good than its trading partner that is well endowed with labor (for this use the Rybczynksi line and the production possibility frontier). (i) Using the Edgeworth-Box was introduced to analyze connections between the available factors of production and the quantity of output produced. Supposing that both the capital and the labor market must be in equilibrium, all available inputs must be used to reach an economic equilibrium. Every point in the Edgeworth-Box represents an allocation of resources. 1. K0 (capital) and L (labor) determine the size of the Edgeworth Box. 2. Pm (price for manufactures) and Pf (price for food) determine w/r (wage/rental rate ratio). 3. w/r determines capital labor ratios Km/Lm and Kf/Lf slopes of expansion paths (red & blue lines). 4. Expansion and contraction of production for food and manufactures does not affect the optimal capital labor ratio (straight lines). 5. The distribution of capital and labor is determined by the full employment conditions (all capital and labor should be used), that is the point of intersection of the expansion paths (A) 6. Full employment implies that K=Km+Kf and L=Lm+Lf. 7. Good M is relatively capital intensive in production, therefore: Km/Lm > Kf/Lf. K/L is the capital-labor ratio. All changes in the capital-labor ratio are adjusted through changes in λm=lm/l, because:

10 When capital increases from K0 to K1: 1. The size of the box enlarges and shifts the food origin up to Of1. 2. The new full employment condition is reached in point B. 3. For given prices of the final goods the wage-rental ratio does not change (FPE result). 4. Given the wage-rental ratio, cost-minimization determines the optimal capital-labor ratio for production of food and manufactures. 5. The costs for producing the capital-intensive good fall causing production to rise. 6. This expansion is only possible by drawing labor out of the labor-intensive sector. This causes food production to fall. 7. In the Edgeworth-Box we notice that OmB>OmA output of M increases; Of1B<Of0A output of F decreases. This means that if capital increases, the output and therefore also export of capital-intensive goods increases, while the output of the labor-intensive sector falls. According to Heckscher Ohlin theory, if the country is capital intensive it exports M and imports F, so that the growth of capital causes the country to trade more at each price. (ii) The Rybczynski theorem discusses the effect of economic growth on a nation s trade. Rybczynski s proposition is: (include here all assumptions of HO) An increase in the supply of one of the factors of production results in: - increased production of the final good that uses this factor of production relatively intensively, and - reduced production of the other final good Thus, if the production of manufactures is capital intensive and the capital stock increases this leads to an increased production of manufactures and a reduced production of food (iii)

11 PPF: All max output possibilities for two or more goods given a set of inputs = transformation curve; depends on the technology and available factors. If capital increases, the PPF shifts out, skewed heavily to the capital-intensive goods side. This causes production in manufactures to rise, while production of food will decrease. So if input increases the PPF shifts outward in direction of the good that intensively uses this input. National income rises, prices, however, remain the same. Given homothetic preferences you are going to consume same proportion of M/F than before the income rise. This means that the country will further increase the exports of capital-intensive goods. Use the (2 factor, 2 goods, 2 countries) Heckscher-Ohlin model and (i) Formulate the Stolper- Samuelson theorem. (ii) Discuss why it is useful for analyzing the effects of trade liberalization. (iii) Use the Lerner diagram and sketch the proof of this theorem. (i) In a two-goods, two production factor economy, with CRS, perfect competition and factor substitutability the Stolper-Samuelson theorem leads to the conclusion: if the final goods price of manufactures rises (e.g. due to tariffs, expansion of trade) and manufactures are produced capitalintensively, the rental rate (reward to capital) rises and the wage rate (reward to labour) falls. Similarly, if the price of food rises (labor-intensive good), the wage rate rises and the rental rate falls. (ii) The Stolper Samuelson theorem allows useful insights into the developments of factor prices due to price variation on the market and therefore leaves assumptions for the factor endowment of the different sectors. (iii) The Lerner Diagram was introduced to analyze the links between the prices of final goods and the prices of factors of production in an economic equilibrium in which both goods are produced.

12 e.g. We assume a two-goods economy (M and F) where manufactures are capital-intensive in production. 1. The final goods prices of manufactures rises. 2. The unit value isoquant shifts inwards because M= 1/Pm. 3. Consequently to this shift, the prices of the factor rewards (wages and rental rate) have to adjust, which leads to a shift of the isocost line to 1/r and 1/w. 4. As illustrated, the rental rate rose (capital becomes more cost-intensive) while the wage rate fell (labor becomes cheaper). 5. The sectors adjust their factor use: M use of less capital, use of more labor L use of less capital, use of more labor Use the (2 factor, 2 goods, 2 countries) Heckscher-Ohlin model and (i) formulate the Stolper- Samuelson theorem. Discuss why it is useful for analyzing the effects of trade liberalization. For this assume that a small country abolishes its tariffs on labor intensive goods. What would the Stolper- Samuelson theorem predict? (ii) State the most important assumptions underlying this theorem and give the main arguments of its proof. (i) The Stolper-Samuelson Theorem is a basic theorem in Heckscher-Ohlin trade theory. It describes the relationship between relative prices of output and relative factor rewards. Under specific economic assumptions the theorem predicts a rise in the relative price of a good will lead to a rise in the return to that factor, which is used most intensively in the production of the good, and, conversely, to a fall in the return of the other factor. The Stolper Samuelson theorem allows useful insights into the developments of factor prices due to price variation on the market and therefore leaves assumptions for the factor endowment of the different sectors. In the underlying example, Stolper-Samuelson theorem leads to the conclusion: if the final goods price of e.g. food as a labor-intensive good decreases because of tariff abolishment, the wages fall (reward factor to labor) and the rental rates rise (reward factor to capital). (ii) Assumptions underlying the theorem are:

13 1. two countries 2. two final goods 3. two production factors (K and L) 4. constant returns to scale 5. perfect competition in all markets 6. K and L mobile between sectors 7. identical technology in the two countries 8. homothetic preferences (consumed proportion of the two goods does not change with income) 9. countries differ in their relative factor endowments 1. Due to the abolishment of the tariff the final goods price of F falls. 2. This leads to adjustment of the unit value isoquant for F (shifts outwards to F because 1/Pf). 3. Due to changed final goods prices, also factor rewards do adjust. 4. Wages fall (labor is getting cheaper), rental rate rises (capital is getting more expensive) shift of the isocost line.

14 CHAPTER 7 FACTOR ABUNDANCE Question 1: Give a short review of the empirical evidence on the Heckscher-Ohlin Model. (i) Define (in words) the factor content of trade. Discuss the Leontief Paradoxon and the related evidence. (ii) Discuss the phenomenon of missing trade as put forward by Trefler. (iii) Which type of trade flows is best described by the Heckscher-Ohlin Model and why? (i) The Heckscher-Ohlin theorem states that a country s exports use intensively the relatively abundant factors. In other words the differences in endowments motivate specialisation. A capital abundant country will produce and export manufacture and import a labour intensive good as food. As a result, through trade both countries can gain and increase welfare as well as efficiency. Producer focus on the abundant factor and export on world market price and the consumer can achieve a higher utility curve. Leontief Paradox: First and most famous empirical study of the neoclassical trade model by Wassily Leontief (1959). He compared the import and exports in the US and expected as the US is capital abundant that the exports would be a lot more capital intense than the imports according to the HOS theorem. But the capital-labour ration (dollars per worker) was 13000$ for the exports and 13700$ for the imports. So the US imported capital intense goods from abroad. This became the Leontief Paradox. Trade patterns can not only be explained through the differences in factor endowments. (ii) Daniel Trefler (1995) analysed trade flows between 33 countries who together account for 76% of the world exports and 79% of the GNP (Gross National Product). He distinguished 9 factors of production: capital, cropland (Ackerland), pasture (Grasland) and six labour categories. The empirical success of the model was modest (explained 71% percent). The important contribution was that Trefler analysed the deviations between empirical trade flows and predicted trade flows. It was shown that in particular the factor of service trade is much smaller than its factor endowments prediction => referred to as the case of missing trade. Trefler came up with two hypotheses: Technology differences and demand bias (consumer bias to domestically produced goods) Adapting the model with both hypotheses increased the explanation of the model to 93%. (iii) Which type of trade flows is best described by the Heckscher-Ohlin Model and why? In the 2 factor,-2 goods-2 countries is the bilateral trade flow the most efficient one. So each country can specialise on his abundant factor and produce cheaper which leads to a comparative advantage. For a capital abundant country this means to produce manufactures for example and a labour abundant country will produce food. These products can be sold with a profit and this money can be

15 used to import the other good from the other country. This leads to a gain and higher welfare for the consumers as well who can achieve a higher utility function. Question 2: Use the 2 factor,-2 goods-2 countries Heckscher-Ohlin model. (i) Describe the production possibility frontier (PPF) for that model. Illustrate, why this model implies that the opportunity costs of a good increase if the production of that good increases. What assumptions are behind this conclusion? (ii) Illustrate the autarky and the free trade equilibrium for a small country that is capital abundant. State the conditions that characterize the competitive equilibrium (both for the autarky and the free trade equilibrium) and give an interpretation of these conditions. (iii) Why does this country gain from trade? (i) PPF = all maximum output possibilities for two goods (food and manufactures) given a set of inputs = transformation curve; a capital and a labour intensive good; Assumption = input increases the PPF shifts outward in direction of the good that intensively uses this input; therefore we assume that the country will produce more of the abundant good cheaper than others due to the comparative advantage; Example: If capital increases => shifts out (more manufacture capital intense and less food production) BUT still same price! (ii) Autarky: Producer: maximise profit => MRT tangency to income B determines level of food and manufacture (and prices) Consumer: maximise utility => utility curve tangency to income A determines consumption of food and manufature Autarky Equilibrium: domestic production = domestic consumption (demand = supply) => prices adjust in autarky equilibrium so that A = B => Optimum if no trade (closed economies) Free trade Producer: produce more manufacture than demanded; manufacture production increases and food decreases Consumer: can trade along the income line; optimum = point of tangency;

16 Utility and Profit are different Prices might differ depending on world market Consumer higher utility curve => gain from trade => more welfare Country export foot and import manufacture Trade triangle by the rest of the world (RoW) = trading position; Equilibrium: world production = world demand (prices adjust) Independent of change of prices there is gain from trade relativ to autarky (iii) Gain through trade: Consumer can achieve a higher utility curve (tangency with income) than in an autarky => more welfare Producers can produce more and cheaper in their abundant factor. They can use this comparative advantage to make profit Trade helps the production to export food and import manufactures (trade triangle by the rest of the world - RoW) Question 3: Use in the standard trade model with two goods, cloth and food: (i) Describe the production possibility frontier (PPF) assumed in that model and explain why this model implies that the opportunity costs of a good increase if the production of that good increases. What assumptions are behind this conclusion? (ii) Illustrate the autarky and the free trade equilibrium for a country that has a comparative advantage in the production of cloth. State the conditions that characterize the competitive equilibrium (both for the autarky and the free trade equilibrium) and give an interpretation of these conditions. (iii) Why does this country gain from trade?

17 (i) See question 2 (ii) Comparative advantage in production of cloth: Autarky Producer: maximise profit => MRT tangency to income B determines level of food and manufacture (and prices) Consumer: maximise utility => utility curve tangency to income A determines consumption of food and manufature Autarky Equilibrium: domestic production = domestic consumption (demand = supply) => prices adjust in autarky equilibrium so that A = B => Optimum if no trade (closed economies) Equilibrium Producer: Capital abundant country => can produce cloths cheaper => manufacture increases and food production decreases Consumer: can trade along the income line; optimum = point of tangency; more food than in autarky Consumer higher utility curve => gain from trade => more welfare Country export cloths and import food Trade triangle by the rest of the world (RoW) = trading position; (iii) Gain through trade:

18 Consumer can achieve a higher utility curve (tangency with income) than in an autarky => more welfare Producers can produce more and cheaper in their abundant factor so in this case cloths. They can use this comparative advantage to make profit Trade helps the production to export cloths and import food (trade triangle by the rest of the world - RoW)

19 CHAPTER 8 TRADE POLICY April 2013 Many countries have import quotas on certain goods. Use a partial equilibrium model under perfect competition to illustrate the effects of an import quota for the case of a small country. Import quotas = restricted number of imports of a certain good Small country = price change has no effect on world price (i) How can the gains and losses in welfare induced by the quote be measured (explain in detail)? Changes in the producer welfare can be measured by changes in the producer surplus Changes in the consumer welfare can be measured by changes in the consumer surplus Changes in the government welfare can be measured by changes in the government surplus (ii) Which group is winning or losing from the quota regime and why are its welfare effects always negative for a small country? Welfare effects consumers: Consumers of the product in the importing country are worse off as a result of the quota. The increase in the domestic price of both imported goods and the domestic substitutes reduces consumer surplus in the market. Welfare effects producers: Producers in the importing country are better off as a result of the quota. The increase in the price of their product increases producer surplus in the industry. The price increase also induces an increase in the output of existing firms. Welfare effects on quota rents: Who receives the quota rents depends on how the government regulates the quota. o if the government auctions the quota rights for their full price, then the government receives the quota rents. In this case, the quota is equivalent to a tariff o If the government gives away the quota rights, then the quota rents accrue to whoever receives these rights. o If the government gives the quota rights away to foreigners, then people in the foreign country receive the quota rents. In this case, the rents would not be a part of the importing country effects. The welfare effect are always negative for a small country because the consumer loss cannot be absorbed by the surplus of producers/government Net welfare loss = Harberger Triangles (iii) Compare the impact of an import quota with that of a tariff Both lead to higher prices for consumers and less imports Tariffs are probably better for the government as the government receives the tariffs - with quotas it depends on how the government regulates it.

20 A quota does mean that there are less products available on the market and therefore the price rises Whenever a small country implements a quota, national welfare falls. The more restrictive the quota, the larger will be the loss in national welfare. The quota causes a redistribution of income. Producers and the recipients of the quota rents gain, while consumers lose. September 2013 Many countries subsidize some of their exporting industries. Use a partial equilibrium model under perfect competition to illustrate the effects of an export subsidy for a large country. Export subsidy has an effect on world price level! it will decrease (i) Give a detailed illustration of the welfare effects of an export subsidy. Export subsidy effects on consumers: Consumers of the product in the exporting country experience a decrease in well-being as a result of the export subsidy. The increase in their domestic price lowers the amount of consumer surplus in the market. Export subsidy effects on producers: Producers in the exporting country experience an increase in well-being as a result of the subsidy. The increase in the price of their product in their own market raises producer surplus in the industry. Export subsidy effects on government: The government must pay the subsidy to exporters. These payments must come out of the general government budget. Who loses as a result of the subsidy payments depends on how the revenue is collected. o If there is no change in total spending when the subsidy payments are made, then a reallocation of funds implies that funding to some other government program is reduced. o If the subsidy is funded by raising tax revenues, then the individuals responsible for o the higher taxes lose out. If the government borrows money to finance the subsidy payments, then the budget cut or the tax increase can be postponed until some future date. Regardless of how the subsidy is funded, however, someone in the domestic economy must ultimately pay for it. An export subsidy of any size will reduce world production and consumption efficiency and thus cause world welfare to fall. (ii) Which group is winning and which is losing from the subsidy? Consumers: loss in welfare Producers: gain in welfare Government: depends (see above) National welfare falls when a large country implements an export subsidy. (iii) Why are the welfare effects of an export subsidy always negative? The net welfare effect consists of three components: a negative terms of trade effect, a

21 negative consumption distortion and a negative production distortion reduction in national welfare for the exporting country. (some groups gain while others lose) Harberger Triangles! (iii) Give an example of an European industry which gets export subsidies Agrarpolitik der EU Exportsubventionen für Zucker Schiffbau Stahlindustrie Lebensmittelexporte (v.a. Fleisch) February 2014 Many countries still levy tariffs on certain goods. Use a partial equilibrium model under perfect competition to illustrate the effects of a tariff in the case of a large country. (i) Explain how a tariff affects the production and the imports in the tariff-protected industry. A tariff positively influences the domestic production and negatively influences the imports. Due to tariffs imported goods get more expensive (p+t). Therefore the domestic producers have an advantage (no T!) and can sell more goods. Moreover does a change of the domestic price influences the world price level. The level will fall. (ii) How can the welfare gains and losses induced by the tariff be measured? Give a detailed explanation. producer surplus rises (blue area) government revenue rises (green areas) consumer surplus falls (blue, brown, green lined)!the revenue of the government is not only paid by consumers but also by foreign producers (light green!) net welfare: positive if Harberger triangles are smaller than the light green area (iii) Which group is winning or losing from the tariff and why is that the case? Producers - Gain in welfare domestic producers can sell more goods than before. (less goods are imported) Government - gain in welfare they receive tariff revenues from consumers and foreign producers Consumers - loss in welfare

22 have to pay the higher price for the good (iv) Assess the overall welfare effects of the tariff. Give a detailed explanation. The net welfare effect can be positive and negative. Depending on which part is bigger. Are the Harberger triangles bigger than the part of the government that foreign producers have to pay than it s a welfare loss. Otherwise the welfare effect is positive. (v) How do your conclusions change, if you consider a tariff in a small country? A tariff in a small country also changes the price, but this change in price does not influence the world price level. This does mean that the whole surplus of the government is paid by the consumers and therefore the net welfare is always negative (at the size of the Harberger triangles)

23 CHAPTER 9 IMPERFECT COMPETITION Assume a two goods economy. Furthermore, assume that there is a monopoly for one good, say salt, but all other markets including that for labour and capital are competitive. (2x) (i) Illustrate the price setting behaviour of the monopolist under autarky and explain its markup pricing behaviour. Give also a formal illustration. (ii) Use the production possibility frontier and illustrate why this economy is not producing at the social optimum. Illustrate the equilibrium conditions (also formally) and the distortion induced by the monopoly. (i) Consider a country producing two types of good in autarky: Food and Manufactures - There are many producers in the food sector; perfect competition ensures: p F = MC F - There is a single producer (monopolist) in the manufacturing sector; profit maximization ensures: p M (1-1/) = MC M - At the autarky equilibrium we know: domestic demand = domestic supply (consumption=production) MRT = MC M /MC F Utility maximization gives: MRS = p M /p F Profit maximization gives: p F = MC F & p M (1-1/) = MC M - Combining this info gives a wedge (Keil) between MRT and MRS: MRT = MC m = p m(1 1 ε m ) MC f p f < p m p f = MRS Monopoly in manufactures mon = autarky equilibrium: - consumption and production must be at mon - efficient production on ppf - consumption at mon gives price ratio (equal to MRS) - MRT at mon lower than price ratio because of mark-up pricing in monopoly sector (so MRT < MRS = price ratio) - To be consistent we need: MRT / MRS = (1-1/) (ii) The autarky equilibrium with a monopoly is not optimal; the equilibrium is distorted - A higher welfare level can be reached at point pc (= perfect competition, where MRS = MRT = price ratio) - The extent of the distortion (Verzerrung) depends on the ratio MRT / MRS = (1-1/) and thus on the mark-up of price over marginal cost in the monopoly sector (causing a too low production level of manufactures)

24 The wedge between MRT and MRS is produced by the mark-up of price from the monopoly. In perfect competition this wedge does not exist anymore (MRT=MRS) because there is no mark-up on price in perfect competition (p=mc). Illustrate the market equilibrium in a Cournot-setting with two firms that produce a homogenous good under a linear demand function that does not depend on income. (Thereby, assume marginal costs are constant and the same for all firms.) (2x) (i) In particular, describe the profit maximizing conditions for a firm and define its reaction function. A country with a monopoly sector does not produce at the social optimum. (ii) Illustrate the impact on prices, quantities and welfare when a foreign firm enters and the monopoly is changed to a duopoly (assume Cournot competition). (iii) Explain why there are pro-competitive gains from trade. (i) Oligopoly profit maximization - Demand-price combinations are a function of both outputs, so is each firm s profit - Firm A maximizes profits given the output level of firm B, say q B0 - Firm A then picks optimal output along line q B0 to max profit, say at point A 0 (the higher the quantity, the smaller the price) - To be optimal, firm A s iso-profit curve must be tangent at point A 0 - The curve connecting all firm A s optimal responses to changes in firm B s output level is called A s reaction curve - If firm B produces a higher level of output, say q B1, firm A will adjust its optimal output - In this case it will reduce output to point A 1 ; this point must again be tangent to A s iso-profit curve - Similarly for levels q B2, q B3 leading to points A 2 and A 3 - Obviously, firm A s profits are maximized if firm B produces nothing as firm A is then a monopolist - Maximum profits are thus reached at point q mon,a - Firm A s iso-profit curves therefore increase in the direction of the arrows towards point q mon,a (ii)?? More oligopoly firms in the market implies lower market share per firm, and thus lower markup than only one monopoly firm (iii) A country with a monopoly sector does not produce at the social optimum The effect of this distortion can be reduced by allowing for free trade Free trade implies more firms More firms implies more competition More competition implies lower market shares Lower market shares implies lower mark-up Lower mark-up implies lower distortion ( increases efficiency) These are the pro-competitive gains from trade

25 (i) Explain the reciprocal dumping model. State the main assumptions of this model. (ii) Explain why there is dumping in this model. (iii) State the conditions for gains from trade in this model. Explain the welfare effects implied by this model in detail. (i) Reciprocal dumping = firms sell goods in the other country at the same price as at home and do not recuperate the costs of transportation Dumping is the sale of export below the normal price (comparable price in the exporting country, comparable price in a third country or costs in the exporting country + reasonable mark-up) (ii) In the reciprocal dumping model is dumping because the importing firm sales it s exports below the normal price. The make the product cheaper than it actually is because they do not recuperate the cost of transportation. (iii) There is no monopoly anymore but a duopoly so there are pro-competitive gains form trade leading to lower prices and higher quantities and lower mark-ups over marginal costs. Welfare effects: trade reduces prices increase in consumer rent; Loss of profits in the domestic market only partially compensated by additional profits abroad;

26 CHAPTER 10 INTRA INDUSTRY TRADE International trade is often of the intra-industry type and occurs between countries, which do not differ much in productivity or factor endowments. Instead it is trade in goods which are produced under economies of scale (at the firm level) and which are differentiated. (2x) (i) Define the Grubel-Lloyd index that measures the extent of intra industry trade empirically and give a short interpretation. (ii) Give a short intuitive explanation how the monopolistic competition model works. (iii) Why do countries gain from intra industry trade? (iv) Based on such a model, what can one expect from deeper economic integration? (i) Intra industry trade is when country simultaneously imports and exports similar types of goods/services, that is trade within the same industry or sector The Grubel-Lloyd index measures the extent of intra industry trade: Gruble Lloyd sector i = 1 ( export sector i import sector i export sector i + import sector i ) The Grubel-Lloyd index varies from 0 (pure inter industry trade no intra industry trade) to 1 (pure intra industry trade). (ii) The Dixit-Stiglitz (DS) monopolistic competition model explains intra industry trade: Paul Krugman realized that the exported goods are usually similar, but not identical to, the imported goods consumers like to demand different varieties, Krugman builds on the Dixit-Stiglitz (DS) monopolistic competition model to explain intra industry trade Utility function: U = utility, i = variety index, c i = consumption of variety i, N = number of varieties, = parameter N α U = [ c i ] i=1 1 α ; 0 < α < 1 - The demand for variety i is characterized by constant price elasticity of demand - MR = MC mark-up positive operating profits - production requires fixed costs fw - If op > fw firms enter the market, otherwise they exit - If new firms enter the market, firm i s demand falls - output decreases to q but, does not affect the price p (constant mark-up) - Operating profits fall - Firms enter the market until op = fw - zero-profit condition determines the number of varieties N produced (proportional to the size of the market)

27 (iii) Gains from trade in the Krugman setting derive from the ability to sustain a wider variety of goods and services in a larger market as a result of increasing returns to scale. A larger market enables an increase in the number N of varieties produced. This increase leads to higher utility levels through a love-of- variety effect. Ethier: Intra industry trade in intermediate goods enables producers to benefit from a rising extent of the market, because larger markets leads to an increase in the number of intermediate goods available to final goods producers, which increases their total output level (productivity gains) through a positive production externality. (iv) (Unter wirtschaftlicher Integration oder Marktintegration werden Prozesse verstanden, die mehrere Märkte (z. B. den deutschen und den französischen Stahlmarkt) zu einem größeren Markt (z. B. einem europäischen Stahlmarkt) zusammenführen) Deeper economic integration leads to more intra-industry trade?? International trade is often of the intra-industry type and occurs between countries, which do not differ much in productivity or factor endowments. Instead it is trade in goods which are produced under economies of scale (at the firm level) and which are differentiated. (i) Give a short intuition, why such countries gain from intra industry trade. (ii) Discuss the main assumptions and the main results of an economic model of intra industry trade. (iii) Based on such a model, what can one expect from deeper economic integration of these countries? (i) Gains from trade in the Krugman setting derive from the ability to sustain a wider variety of goods and services in a larger market as a result of increasing returns to scale. A larger market enables an increase in the number N of varieties produced. This increase leads to higher utility levels through a love-of- variety effect. Ethier: Intra industry trade in intermediate goods enables producers to benefit from a rising extent of the market, because larger markets leads to an increase in the number of intermediate goods available to final goods producers, which increases their total output level (productivity gains) through a positive production externality. (ii) The Dixit-Stiglitz (DS) monopolistic competition model explains intra industry trade: Paul Krugman realized that the exported goods are usually similar, but not identical to, the imported goods consumers like to demand different varieties, Krugman builds on the Dixit-Stiglitz (DS) monopolistic competition model to explain intra industry trade Utility function: U = utility, i = variety index, c i = consumption of variety i, N = number of varieties, = parameter

28 N α U = [ c i ] i=1 1 α ; 0 < α < 1 - The demand for variety i is characterized by constant price elasticity of demand - MR = MC mark-up positive operating profits - production requires fixed costs fw - If op > fw firms enter the market, otherwise they exit - If new firms enter the market, firm i s demand falls - output decreases to q but, does not affect the price p (constant mark-up) - Operating profits fall - Firms enter the market until op = fw - zero-profit condition determines the number of varieties N produced (proportional to the size of the market) (iii) (Unter wirtschaftlicher Integration oder Marktintegration werden Prozesse verstanden, die mehrere Märkte (z. B. den deutschen und den französischen Stahlmarkt) zu einem größeren Markt (z. B. einem europäischen Stahlmarkt) zusammenführen) Deeper economic integration leads to more intra-industry trade?? (i) Describe the demand function used in the monopolistic competition model. (ii) Illustrate why the underlying utility function implies a love for variety. (iii) Illustrate profit maximization of a firm that produces a variety under increasing returns and under monopolistic competition. Give also an interpretation of the first order conditions for profit maximization in that model. (i) c i = constant p i ε ; ε 1 (1 α) > 1 The constant in the demand function above depends on - The price p j charged by other firms - The number of competitors N - The general income level in the economy Firm i takes these as given (ii) Characteristic is the love-of-variety effect, e.g. if c i = c for all i: N α U = [ c i ] i=1 1 α = (Nc α ) 1 α = Nαc 1 = N (1 α ) 1 [ Nc ] love of variety claim on resources

29 Love-of-variety effect = an increase in the extent of the market, which increases the number of varieties N the consumer can choose from, more than proportionally increases utility. (iii) Profit maximization for the unique variety i - If there are N (= large ) different varieties of manufactures 1 i=1 ] N α - Utility function: U = [ c i α ; 0 < α < 1 - subject to the budget constraint: i=1 p i c i = 1 - Demand for a variety, say j, is: c j = p ε j [p ε 1 1 ε 1], where P = [ p j ] N i=1 N 1 ε, ε 1 (1 ρ) > 1