Preparing for the Exam: Summarizing the Essentials

2

Exam

• Final: 27.10.2008 at 8 - 10 ECO, lecture room

• Retake: 24.11.2008 at 8 - 10 ECO, lecture room

• Requirements: (a) Lectures, (b) Krugman (1993): What Do Undergrads Need to Know About Trade? American Economic Review 83(2): 23–26 (available from JSTOR)

• Three questions (answer all)• You may answer in English or Finnish.

Dictionaries are not allowed.

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Previous results (final exam)

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10

12

14

16

5 4 3 2 1 F

Spring 2006

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12

14

5 4 3 2 1 F

Fall 2006

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The most important things to learn• Why trade is mutually beneficial?

Comparative advantage, economies of scale

• Where do the world prices come from? Terms-of-trade analysis

• What does trade and international factor mobility do to distribution of income?

Factor-price-equalization theorem• What trade policy instruments do?

Implications of subsidies, tariffs, quotas Arguments for activist trade policy

Please note that these are just the most important things. To pass the exam you will need to know a bit more…

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Gains from Trade:Ricardian Model

Cloth Wine

9,000 0

4,500 1,800

0 3,600

England

Suppose that the international price turns out to be 2,5 yard per barrel and England produces only cloth

Cloth

Wine3,000

9,000

3,600

Slope of the CPF = the amount of consumption of one good that must be given up to obtain one additional unit of the other good

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Gains from Trade: The Neoclassical/HO Model

Good XXA

YA

Good Y

XPXC

YP

YC

Imp

ort

s

Exports

(PX/PY)FT

(PX/PY)A

Equilibrium: MRT = (PX/PY)FT = MRS

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Gains from Trade:Krugman Model

• Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases

• i.e. a larger variety of products is available for smaller price

• everybody are better off even if the countries are identical

Price

Number of firms

ACA

P

nA

pA

nFT

pFT

ACFT

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Prices:Deriving the Offer Curve

Good X

Good

Y

XPXC

YP

YC

(PX/PY)1

Good X

Good

Y

XPXC

YP

YC

(PX/PY)2

Exports1

Exports2

Imp

ort

s 1Im

port

s 2

Exports of good X

Imp

ort

s of

good

Y

Exports2

Exports1

Imp

ort

s 1

Imp

ort

s 2

(PX/PY)2 = TOT2

(PX/PY)1 = TOT1

Offer Curve

Potential price lines: PX*QX=PY*QY QY=(PX/PY)*QX

i.e. given the prices, the value of exports equals the value of imports

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Prices:Putting the Offer Curves to One Graph

Exports of good X

Imp

ort

s of

good

Y

(PX/PY)2

(PX/PY)1

Offer Curve

Exports of good Y

Imp

ort

s of

good

X

(PX/PY)2

(PX/PY)1

Offer Curve

Country 1 Country 2

Imports of good X

Exp

orts o

f good

Y

Offer Curve

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Prices:Trading Equilibrium

Good X: Exports from country 1

Imports to country 2

Go

od

Y:

Imp

ort

s to

co

un

try

1 ex

po

rts

fro

m c

ou

ntr

y 2

(PX/PY)E = TOTE (PX/PY)’

Country 1’s offer curve

Country 2’s offer curve

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Distribution of Income:Factor Price Equalization• Autarky → Free trade

o relative prices of final goods become identical relative price of paper increases (=relative price of clothes

decrease) in Finland

→ Finland produces more paper, China more clothes

• Since producing paper is more capital intensive, demand for capital increases and demand for labour decreases in Finland → w ↓ r ↑

• Similarly in China, demand for labour increases and demand for capital decreases → r ↓ w ↑

• In equilibrium all prices (including factor prices) are identical

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Distribution of Income:the Stolper-Samuelson Theorem• Trade affects both the prices of goods and the

prices of factors of production: What then is the impact of trade on distribution of real income?o wages decrease in Finland, but also the price of

clothes decreases (i.e. you need less money to buy the same amount of clothes). Which effect dominates?

• Stolper-Samuelson Theorem: real income of the owners of abundant factor increases and the real income of owners of scarce factor decreases o Think about the labour abundant country (e.g.

China): Free trade → r ↓ w ↑ → capital/labour ratio ↑ → labour productivity ↑ → real wages ↑

W. Stolper & P. Samuelson (1941): International Factor-Price Equalisation Once Again. Economic Journal 59, no. 234.

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Distribution of Income: Impact of Migration

Total world labour force

wA1

Country 1’s initial employment

Country 2’s employment

wA2

Country 2: (receiving immigrants)• wages decrease → transfer of income

from labour to capital owners• total output increases more than

what is paid to the immigrants → immigration surplus

• However, there is a decrease in per capita output (given diminishing marginal productivity)

Country 1:• wages increase → transfer of income

from capital to labour• total output decreases more than the

wage sum of those who left → immigration deficit

• But, there is a increase in per capita output (given diminishing marginal productivity)

Country 1:MPPL, w

Country 2:MPPL, w

w*w*

Country 1’s eq’m employment

Country 2’s eq’m employment

transfer from capitalto labour in country

transfer from labour to capital in country 1

gain for the immigrants

imm

igrat

ion

surp

lus

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imports after tariff

Trade Policy:Import Tariff, Small-Country, Partial Equilibrium

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

increase ofproducersurplus ta

riff t

o th

ego

vern

men

t

dead

weight

loss

deadweightloss

imports after tariff

P

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

Loss of consumer surplus

P

Loss of consumer surplusIncrease of producer surplus andgovernment income

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Trade Policy:Import Quota Small-Country, Partial Equilibrium

• For every quota there is an equivalent tariff (and for every tariff there is an equivalent quota)

• The changes in consumer and produce surplus are equivalent to that of a tariff

• However, the increase of government revenue may be lost (at least partially)

quota

P

DD

Q

SD

Pint

imports in free trade

PQ

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imports after the subsidy

Trade Policy:Subsidy, Small-Country, Partial Equilibrium

DD

Q

SD

P

imports in free trade

Cost to the government

imports in free trade

P

imports after the subsidy

P

DD

Q

SD

P

increase ofproducersurplus eff

icie

ncy

loss

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Trade Policy: Single Market, Two Countries, Free Trade

Q Q

Country A Country B

DA

SA

SB

DB

PP

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Trade Policy: Single Market, Two Countries, Free Trade

Q Q

Country A Country B

DA

SA

SB

DB

PP

Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

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Trade Policy: Single Market, Two Countries, Tariff

Q Q

Country A Country B

tariff

DA

SA

SB

DB

PP

Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

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Trade Policy: Single Market, Two Countries, Tariff

Q Q

Country A Country B

tariffPFT

PA

PB

DASA

SBDB

PP

a b

Cprice decrease in country B

De

Country A:Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).

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General Equilibrium Effects of a Tariff for a Small Country

• Import tariff on good Y changes the price ratio

• Producers adjust from point PFT to Pt

• Since the tariff doesn’t change world prices, country’s real income changes to (PX/PY)t

• Consumers maximize given domestic prices and real income and move to a lower utility level

• Note that real income is determined by the world prices Good XPt

Pt

Good Y

PFTCFT

PFT

CFT

(PX/PY)FT

PX/(1+τ)PY

Ct

Ct

(PX /P

Y ) t

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General Equilibrium Effects of a Subsidy for a Small Country

• Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff

• The real income of the country remains the same

• Consumers face world prices and are able to consume at a higher utility level

Good XPS

PS

Good Y

PFTCFT

PFT

CFT

(PX/PY)FT

PX/(1+τ)PY

CS

CS