Econ 4310 Final

Surveys indicate that the U.S. public believes the United States spends how much of its budget on aid?

20 percent

According to Table 18-1, which of the following is a fair international price of tractors which is acceptable to both the US and Mexico?

5.5 tons of tomatoes

Grow rates declined from the early to late green revolution in all regions except Africa - a late comer in green revolution. MV stands for modern crop varities.

A disturbing trend: The growth rate of yields om the world's major cereal crops has trended strongly downward since the 1980s.

Primary products continue to dominate merchandise trade in

Africa

________ prices are domestic prices without trade.

Autarky

________ acts like a tax on economic activity and encourages rent-seeking behavior rather than productive investment.

Corruption

Which of the following is WRONG about the conditionality of foreign aids?

Countries have already agreed on a set of conditions that are appropriate for development.

Panel (b): gain from specialization

Facing the opportunities trade provides, a nation will also reallocate its resources as it pursues its comparative advantage. Mexico will not remain producing at point A when the US is willing to pay more for its tomatoes and sell farm equipment for less. The change from point A to B maximizes producers' profits and results in an additional improvement in welfare depicted in the change in consumption from point E to C, and the movement from IC2 to IC3: a gain from specialization.

Government may encourage the production of beans (protein-rich) by raising the relative price of beans to the red line position, so the slope of the iso-revenue curve is steeper. The resulting equilibrium point (W) will correspond to a higher level of beans and lower level of corns.

For example, Afghanistan can discourage poppy production by raising the price of wheat, which is the primary alternative.

Isoquant would be a straight line if labor and capital are perfect substitute at a certain fixed ratio.

Here, the isoquant is convex (bowed toward origin; not a straight line) because labor and capital are not perfect substitutes. When an economy moves along the isoquant curve, the conversion rate between labor and capital keeps changing. From D to E, ΔK substitutes for ΔL; from E to P, however, the economy needs 3*ΔK to substitute for another ΔL. •Example: a firm is trying to automate its production. Initially, a small amount of investment in computers &machinery can replace 100 workers. If it continues its efforts to make its production fully automatic, it would need to buy very expensive robotsand machinery to replace another 100 workers.

Figure 20-3 illustrates the case of negative externality. Which of the following price and quantity are determined at the private market equilibrium?

P1 and Q1

In Figure 19-1, t0 is the tariff rate. What is the domestic price consumers need to pay under Autarky?

Pd' (where supply meets demand curve)

TERMS OF TRADE FOR PRIMARY PRODUCTS

Slope = Pa/Pm •Figure 18-9 reproduces Figure 18-6a and adds a decline in the terms of trade - a worsening of the terms of trade for Mexico: Mexico will need to export more tomatoes in order to buy a certain number of tractors. •The slope of the price line = Pa/Pm, where Pa and Pm are the prices for agricultural (tomatoes) and manufactured products (tractors) respectively. •The counterclockwise rotation in the world price line indicates that the relative price of the exported good (tomatoes) for Mexico has fallen relative to the price of the imported good (tractors). •Mexico now will produce at point B' and consume at point C' after trade. •The new level of utility is represented by the indifference curve IC', which is worse than IC3, but still better than IC1 under autarky. •The opposite will happen to the US with an improving terms of trade.

The adoption of modern varieties was widespread but unevenly distributed over time and space.

Stark disparities in input intensity across regions.

This diagram is for the lagging sector (L)

To meet the higher demand for products in booming tradable and nontradables sectors, workers migrate from the lagging tradable - left shift of the supply curve of lagging tradables. If the world price is PL, this country's imports will increase by ΔML This is called a "resource movement effect."

Panel (a) The slope of the price line = price of the product on the horizontal axis (tomato) / price of the product on the vertical axis (tractor) A country can move freely along a price line by trading the two products, so this line is also a budget constraint. A steeper line means a smaller amount of tomatoes can buy a larger amount of tractors. In other words, tomatoes are relatively more expensive.

Under autarky relative price (1 tractor = 6 tons of tomatoes), the slope of the price line is 1/6. The equilibrium point is A is where the indifference curve (IC1) is tangent to the price line (A refers to Autarky). Under autarky, both production and consumption is at point A in Mexico. IC1 is the highest utility Mexico can obtain under this price. Under a fair international price (between 1/6 and 1/5), Mexico will trade with the US. Mexico now will produce at point B, but consume at point C, which offers a higher utility level (IC3). Triangle BCD is called the trade triangle: BD is export CD is import

Panel (b): gain from exchange

We can hypothetically apply the international relative price to autarky production bundle at point A. This depicts the opportunities a nation faces by trading with other nations even when it does not change production. Even under this scenario, Mexico still gains from trade benefiting from the higher prices the US is willing to pay for tomatoes and lower price Mexico pays for its imports of farm equipment. The highest utilityMexico can get is IC2 at point E, by exporting AF amount of tomatoes and importing EF amount of farm equipment. IC2 >IC1 •Note: EF/AF = world relative price of tomatoes This is the gain solely from exchange because it is due only to the difference between autarky and world prices.

Critical triangle of development goals

sustainability, poverty alleviation, growth

Which of the following country can most likely benefit from erecting a tariff on imports?

a large country

Which of the following points related to the production possibility frontier (PPF) are productively efficient?

all points on the PPF curve

The incremental cost of achieving a lower target in the amount of change in global temperature is a form of:

climate insurance.

A nation will have a(n) ________ of a good when its production of that good is relatively more productive than that of another nation.

comparative advantage

Which of the following is NOT a solution to negative externality?

corrective subsidies

In Figure 19-1, t0 is the tariff rate. Which area(s) represent the consumption efficiency loss from the tariff?

d

Figure 19-3 illustrates the determination of the exchange rate of peso in Mexico. The import substitution strategy (tariff) can

decreases the demand for foreign exchange and leads to an appreciation of peso

Which of the following is NOT a consequence of having an overvalued currency

it tends to lower import quantity

Which of the following CANNOT explain why aids may not lead to dollar-for-dollar investment in recipient country?

most of the aids are not intended to promote investment.

Economists Jeffrey Sachs and Andrew Warner found strong evidence that, on average and holding constant the other determinants of growth, countries with substantial primary product exports have grown

much more slowly than resource-poor countries.

Which of the following is the price at which anyone holding foreign exchange can convert it into local currency?

nominal exchange rate

Based on Mosher framework, the above figure illustrate the case of

non-binding technical constraint but binding economic constraint, possibly due to unsupportive policies or institutions.

Aid has helped in all of the following areas except:

stimulating tax revenue.

In the case of foreign aid, the "Dutch Disease" refers to

the case of how foreign aids may hurt local economy development as a result of a sudden aid capital inflow.

According to Table 18-1, the US has a comparative advantage in

tractors

Based on Mosher framework, the above figure illustrate the case of

very efficient and productive environment, but additional progress may be achieved by raising further the technical and economic ceilings.

HOW DOES DUTCH DISEASE HAPPEN?

•(Continued from the last slide) Peso appreciation renders other (non-oil) exports less competitive. •Producers of tradables, both nonprimary (non-oil) product exports and import competitors, face rising costs in their purchases of nontrdables goods and services such as rents of office spaces and the wages of Mexican workers. But they cannot charge higher prices because they compete with foreign producers, either as exporters or import competitors. Hence they face a profit squeeze, factory closure and job losses. •Overall, the boom in primary (oil) exports and nontradablesis partly offset by a contraction in other tradable industries. •If the contracting industries have more long-run potential for productivity growth, the short-run benefits of the commodity price boom will have negative long-term growth consequences. •If factors can move easily across industries, a commodity boom poses no major problem. Otherwise, the short-run boom may lead to a major disruption to growth. Box 18-1 illustrates the sectoral shifts common to Dutch disease.

BUILDING EXPORT PLATFORMS

•A common policy of the export-led strategy is to establish specialized export platforms that enables exporters to trade at close to world prices, even in the presence of more widespread distortions. •Export processing zones (EPZs): duty-free imports of inputs for further processing and eventual exporting of final goods. •Bonded warehouses: allow a firm to post a bond as a guarantee against any duties that might be applicable to imports diverted to the domestic market (duty-free on imported inputs if final goods are eventually exported; if they sell output locally instead of export it, they are liable to pay the import duties). •Duty exemption programs: duty-exemption on some imported inputs. •Science and technology parks •These policies help countries to liberalize their market step by step, starting from these policy zones and then expand to larger areas. •Few countries had the capacity to implement economy-wide reforms quickly. •These zones also serve as experiments before a reform is introduced to larger areas. •But not all incentive zones are successful, as in the case of Egypt.

AID MEASURES •Aids must be designed to promote economic development and welfare as its main objective. •Thus this excludes military and other non-developmental purposes. •Foreign aid flow mostly to low income countries. •Private capital flows mostly to upper-middle income countries.

•Aid measures: •total aid •aid per capita •aid as a percentage of gross national income (GNI)

AID, SAVING, AND TAX REVENUE

•Aids may not lead to dollar-for-dollar investment because •Not all aid is provided as investment goods or even aimed at increasing investment and growth (e.g., to buy consumer goods). •Even where aid is aimed directly at investment, the impact could be partially offset by a reduction in either private saving (increased funding after aid - reduced interest rate due to diminishing returns) or government savings. This is called the crowded out effect.

BOX 14-5: HOW FOOD AIDS UNDERMINED LOCAL FOOD PRODUCTION

•Donation of foods can sometimeshurt local farmers by undermining their incentives to produce locally. •Figure 14-6: food aid shifts supply curve rightward by the amount of aid. Local producers may or may not be hurt by food aids depending on if food aid change food price. •Panel (a): without imports, price dropsand local production drops from Q0 to Q1. Aid = Q2-Q1. •Panel (b): with imports, this country produces Q3 and imports (Q4-Q3) at Pwbefore aid. Aid lowers the domestic price but it is still higher than the world price Pw, so this country continue to imports at Pw but the aid reduces imports from (Q4-Q3) to (Q4-Q5). Because the price remains at Pw, the aid doesn't affect local production Q3.

COMPARATIVE ADVANTAGE

•Although Mexico has no absolute advantage in producing either good. It gains a comparative advantage in producing tomatoes. Relative to tractor in which Mexico is doing a lot worse than the US, Mexico is doing relatively or comparably better in tomatoes (in other words, not too bad). •Although the US has absolute advantage in producing both goods. It loses advantage to produce tomatoes, not because the US is doing absolutely worse than Mexico in producing tomatoes, but because US is doing so well in producing tractors: the opportunity cost for the US to produce tomatoes is high because the US producers would have to give up a lot of tractors in order to produce tomatoes.In other words, a country may lose advantage in producing a good just because it is so productive in producing another goods.This is why opportunity cost is important. •Of course, comparative advantage and absolute advantage can be the same, for example, in the simple case where the US is better in producing airplanes and Japan is better in producing cameras.

FIGURE 17-2

•Area A: a low productivity environment with a tight technical constraint, possibly due to lack of good land or seeds. •Area B: non-binding technical constraint but binding economic constraint, possibly due to unsupportive policies or institutions. •Area C: neither technical nor economic ceilings are binding for most farmers, but the achievement distribution (curve a) indicates that only a few farmers may be benefiting from the best available technologies and policies. So agricultural extension services may help the disadvantaged farmers. •Area D: very efficient and productive environment. Additional progress may be achieved by raising further the technical and economic ceilings.

WINNERS AND LOSERS IN THE HECKSCHER-OHLIN (HO) MODEL

•As a general rule, abundant factors benefit from trade while scarce factors lose from free trade. •Before trade under autarky, abundance factors receive lower factor prices due to more abundant supply. They benefit from having the opportunity to export products using intensively the abundant factors. Foreign demand will drive up the abundant factors' prices. •On the contrary, before trade under autarky, scarce factors receive high factor prices due to its scarcity. They lose from the imports of the products using intensively these factors. Foreign supply will drive down the scarce factors' prices. •Based on the previous example, Mexican workers (owners of labor) will gain, but American workers lose. On the contrary, Mexican capital owners will lose, but American capitalists gain from trade. •This is a distributional effect of trade. In other words, trade create winners and losers.

FIGURE 14-3 •In nominal terms, global ODA has increased steadily, with a decline in 1990s, but the trend reversed in 2000s due to increased aid to Iraq and Afghanistan. •In real terms, it follows a similar trend.

•As a share of national income, global ODA fell throughout most of 1980s and especially in 1990s. The trend reversed in 2000s. •Much of the recent increase in foreign aid has come from private sources.

COMPARATIVE ADVANTAGE

•Associated with David Ricardo in his Principles of Political Economy and Taxation(1817) •Main messages: •Any country can engage in and benefit from international trade, including the world's highest-cost and lowest-cost producers of any good. •Ricardianmodel (proposed originally by Ricardo): a country gains advantage in producing a good because of its higher productivity. •Heckscher-Ohlin model (or H-O model proposed by the European economists Heckscherand Ohlin): a country gains advantage in producing a good because of the abundance in the resourcesused intensively in producing this good. A country often gains most by exporting commodities that it producers using its abundant factors of production most intensively, while importing goods whose production requires relatively more of scarcer factors of production. •Both productivity and resource endowment affect the cost of production. •Ricardian model: Higher productivity - lower cost - advantage H-O model: More resources - lower factor prices - lower cost - advantage

SECURE INDIVIDUAL PROPERTY RIGHTS

•Benefits: •Improved incentives to conserve and invest in the land itself •The ability to transfer land ownership, possibly to those able to make the best use of the land (for instance by taking advantage of economies of scale) •The ability to use land as collateral, providing farmers access to credit markets (and the potential to adopt modern varieties and inputs) •Drawbacks: •the administrative costs of actually defining land boundaries and enforcing land rights •the risk that the poorest farmers, who often depend on access to common property resources (such as open/public pastures for gazing their livestock), could be deprived of their sources of livestock

BOXED EXAMPLES

•Box 19-1: Effective Rates of Protection (ERP) •Box 19-2: The Effect of Tariff in a Two-Country Model (not required in this class) •Box 19-3: Is China's Exchange-Rate Policy Unfair? •Box 19-4: Labor Activists and Labor Outcomes in Indonesia

BOXED EXAMPLES

•Box 20- 1: The Malthusian Effect of Population Growth on Adjusted Net Savings in Ghana •It examines through Malthusian lenses how comprehensive wealth grew in Ghana, but fell, per capita. The rate of ANS did not keep up with the population. •Box 20-2: Taxing Water Pollution in Colombia •The second box study discusses how a new regulation in Colombia charged a tax to facilities causing pollution. There were many barriers to this policy, but wastewater discharges have been significantly reduced. •Box 20- 3: Policy Failures and Deforestation in Indonesia •How government intervention in Indonesia restricted the export of raw material, causing overcapacity. Deforestation continued to occur, primarily to make room for other industries.

FOOD PRICES AND OIL PRICES

•Chemical fertilizers are largely petroleum-based products. •Most farm machinery runs on gasoline or diesel fuel. •Higher oil prices also increased the cost of transporting agricultural output domestically or internationally. •Very importantly, biofuels production because more profitable when oil prices are high. •By 2007, ethanol consumed 25% of the US corn crop. •It was estimated that 60-70% of the increase in corn prices was explained by the diversion of corn for biofuels production. •The increased demand for corn is thought to have explained up to 40% of the increase in soybean prices. •Resource constraint: only so much land and water to go around, so when more lands are used for corn, fewer lands left for other crops -price of other crops will go up as well. •In addition, to the extent that consumers substitute between staple grains, increased corn prices have contributed to increased demand for wheat and rice, adding to price increases for wheat and rice.

BOX 19-3: CHINA'S EXCHANGE RATE POLICY

•Chinese Yuan has been undervalued, as shown by its huge trade surplus. •Figure 19-3: trade surplus is consistent to an undervalued currency (eu) •For instance, if Chinese firms earned 10 billion dollars from exports but only spent 5 billion dollars to import foreign goods, the other 5 billion dollars will become reserves - a purchasing power to buy foreign goods or assets. •Trade surplus usually go hand in hand with capital outflow because China wants to invest the reserves back to foreign market (e.g., buy US government bonds) to gain returns. •Because the tight capital controls in China prevent people and firms from investing freely in foreign markets, capital outflow has been limited so China has been holding a large amount of reserves. •Benefits of having an undervalued currency: •Export promotion, employment, poverty reduction. •Large foreign reserve help stabilize the economy and reduce the chance of crisis. •It is costly to maintain an undervalued currency. •More costly for consumers or firms to buy from other countries. •The returns on investing in US government bonds has been low in recent years, especially when US dollar depreciates in value. •Trading partners may retaliate.

MARKET FAILURE: TRAGEDY OF COMMONS

•Common resources have two main characteristics: •Non-excludability: a person cannot be excluded from using the resource (it basically means that it is free to use) •Rival in consumption: due to its limited quantity, a person's use of the resource will diminish others' use or enjoyment. The congestion or crowdedness is also a type of negative externality, so the previous discussion on externalities also applies to common resources. •The tragedy of commons: Common resources can be overused or devastated easily.

CONDITIONALITY

•Conditionality: Donors like the World Bank and the IMF often demand aid-receiving countries to adopt certain reforms before providing the aids. •This is controversial: •Sometimes too many and much stricter than necessary. •Sometimes not enough conditions. •This is a part of the principal-agent problem: donor and recipient may have different objectives. •Shortcomings: •Not always clear what conditions are the most appropriate ones. •donors do not follow through on the conditions.

MEASURING SUSTAINABLE DEVELOPMENT

•Definition from the Brundtland Commission, 1987: •Sustainable development is the development that meets the needs of the present without compromising the ability of future generations to meet their own needs. But it fails to define "needs." •Most agree that the "needs" should imply no decline in the well-being of future generations, which requires that the growth rate of wealth should be no less than the growth rate of population. •But how to define capital or wealth? Comprehensive wealth = Produced capital + Natural capital + Intangible capital •Challenges to measure wealth: •Prices are unknown for many types of wealth •Wealth differs from GDP: •For example, the depletion of a country's resource counts toward each nation's GDP, but growth based on the depletion of natural resources is not sustainable.

ACCESS TO THE MARKETS IN DEVELOPED COUNTRIES

•Developed countries advocate for free trade but still maintain trade barriers in some sectors such as textiles and agriculture, which are precisely where the developing countries have comparative advantage. •For decades, textiles and clothing imports by the quad (US, EU, Canada, and Japan) were restricted via a complex system of quotas and tariffs under the Multi-Fiber Agreement (MFA), which was amended later as the Agreement on Textiles and Clothing (ATC). •The quad countries provide substantial protection to their farmers through tariffs, non-tariff barriers and direct farm subsidies. (see Table 19-1) •Tariffs and quotas hurt domestic consumers (e.g., sugar). •Farm subsidies make agricultural products even more competitive and hurt foreign farmers. They also lead to over-production and depress world market, and hurt foreign producers. They are also heavy burdens to the government and tax payers in developed countries. It is hard to remove them because farmers especially large agribusinesses are politically very strong. •In 2009, for example, the average US tariff on French products is under 1%, but over 15% on the products from Bangladesh. •Tariff escalation: low import duties on raw materials and higher duties on the finished goods that use these raw materials. •Makes it harder for developing countries to compete in the market for finished goods.

FIGURE 20-1: EKC

•Different possible paths: •Conventional EKC: discussed on the previous slide •Race to the bottom: pollution control comes with a cost, so countries have incentives to relax pollution controls so their firms pay less pollution levies and hence gain a cost advantage in international competition. If all countries compete to lower their environmental standards, we will enter a race to the bottom, which implies no or delayed decline in pollution even at higher income level. •New toxics: if economic growth and industrialization create new pollutants, we may see rising pollution even at higher income level. •Revised EKC: this happens when growth becomes less and less polluting (e.g., electric cars, solar power). •Overall it is still an empirical questions subject to debate. It is likely that different pollutants may follow different paths.

PRODUCTION SUBSIDIES

•Direct subsidies are an alternative to tariffs or quotas as a means of protecting domestic manufacturers. •The effect of subsidies is similar to tariffs in some ways: a 20% of subsidies on output and a 20% protective tariff on imports have identical effects on producer surplus. But the effects on consumers and the government budget can be quite different. •Figure 19-2: world price is Pw •A subsidy of s0 (equal to the earlier tariff t0) effectively moves the supply curve downward from S to S'. Recall: the height of the supply curve measures the cost of production. A subsidy is equivalent to a reduction in production cost. •Domestic firms compete against foreign firms at the world price Pw. After the subsidy, domestic supply increases from Q2 to Q4. Producers are equally happy with a subsidy or an equivalent tariff, by gaining area a. It is easier to see this from the perspective of an equivalent tariff t0 (recall Figure 19-1). •Consumers still buy Q1 at Pw, so no loss in consumer surplus (unlike the tariff case). •The total cost of subsidy = a +b (applied only to domestic production) •The transfer through a subsidy from government to producers is again inefficient, with a deadweight loss b, which is smaller than the deadweight loss from an equivalent tariff or quota (b+d).

DIFFERENCES IN OPINIONS

•For some of the more controversial topics, it is important to delineate the differences between the stances of the developed countries and less-developed countries, even among developing countries (e.g., between Brazil and India in the areas of agriculture) or among developed countries (e.g., EU and the US on Hi-tech and agricultural subsidies). •Students should be able to develop informed opinions on these core differences in the trade talks.

BILATERAL/REGIONAL TRADE AGREEMENTS

•Due to the slow progress under the GATT/WTO, some countries moved on with bilateral or plurilateral trade talks among close neighbors or allies. •The European Community (EC) or the European Union (EU) •The North America Free Trade Agreement (NAFTA): the US, Mexico and Canada •Replaced by the US-Mexico-Canada Agreement (USMCA) in 2018 •Many others such as US-Chile, US-Singapore, US-Korea, ASEAN. •Today, there are more than 200 regional trade agreements in the world. •Regional trade agreements can be stepping stones to multilateral liberalization if they complement the WTO by dealing with deeper issues such as competition, property rights, trade in services, etc. •Regional trade agreements can also be stumbling blocs of multilateral liberalization by diverting trade to less efficient producers. •For example, if Mexico is less efficient in producing tires than Asia, but remains competitive against Asia in exporting tires to the US because of the preferential lower or zero tariffs on Mexican tires under the NAFTA or the new USMCA agreement. In this case, the agreement diverts trade from more efficient Asian producers to less efficient Mexican producers - an efficiency loss to the world economy.

ENVIRONMENTAL KUZNETS CURVE (EKC)

•Economist Simon Kuznets showed an inverted-U relationship between inequality and income level, which is illustrated by the Kuznets curve (introduced in Chapter 6). •Later, pollutions were found to have followed a similar relationship with a country's income level. We use an environmental Kuznets curve to illustrate this in Figure 20-1. •In the very beginning of the primitive or agricultural societies, pollution was low. Along with the industrialization process, human activities generated more and more pollutions. After a country reaches a certain income level (let's say $8000 per capita), citizens will start to worry more about pollution and less about material life and will take action to protect environment, so would see a decline in pollution in richer countries. •Both income inequality and pollution are "bads" (which we want to pay to get rid of), compared to "goods" (which we want to pay to have).

MARKET FAILURE: EXTERNALITIES

•Externalities are the uncompensated side effect of an action or transaction on third parties. It can be negative or positive. •Pollution is a good example for negative externalities. •In the case of negative externalities, social marginal cost (SMC) = private marginal cost (PMC) + external cost •Because supply curves measure the marginal costs, a negative externality will shift the supply curve upward from PMC to SMC. The difference between PMC and SMC is the external cost on environment or society. •Figure 10-3 illustrates the case of negative externality •Market equilibrium: Q1 and P1 •Socially optimal equilibrium: Q2 and P2 •Private market tends to overproduce dirty goods (Q1 > Q2) •In the case ofpositiveexternalities such as flu shot, social marginal benefit (SMB) = private marginal benefit (PMB) + external benefit of flu shot on others around the person who takes flu shot •Because demand curves measure the benefits or values, a positive externality will shift the demand curve upward by the amount of external benefit, and the resulting market equilibrium quantity is less than the socially optimal quantity.

RESOURCES AND DEVELOPMENT

•Few developing countries have been able to convert resource wealth into rapid economic growth. Too often, resources are degraded or depleted without producing sustainable development. •The inefficiencies stem partly from market failures. For example, open access to a common resource leads to excessive depletion. •Sources of market failure: public goods, externalities, monopoly, lack of information, etc. •More broadly, the exploitation of natural resources creates external diseconomies, including congestion, erosion, and pollution. With such externalities, competitive markets exploit the resources beyond the point that maximizes net benefits to society.

AID, SAVING, AND TAX REVENUE

•Figure 14-7: •PPF curve shows all combinations of consumption goods (today's consumption) and investment goods (or savings for future consumptions). It represents a resource constraint, so an aid of AB shifts the PPF outward from P to P'. •Indifference curves: reviewed on the next slide. •Initial equilibrium at A: investment = I1 and consumption=C1 •New equilibrium at D (after aid of amount AB): new investment < (I1+AB). Not all of the aid (AB) is invested; part of the aid (BE) is consumed probably because people anticipate higher level of consumption after aid so they respond by saving less and consuming more. •Fungible aids: aids effectively finance activities for which it was not originally intended. •On the contrary, some aids may crowd in government spending. This is called the "Flypaper effect" because aid money sticks where it hits, just like a fly to flypaper.

BOX 17-2: FERTILIZER SUBSIDIES IN MALAWI

•Figure 17-10 shows that the relative price of fertilizer affect the optimal level use of fertilizer and rice production. •During 2005-2006, Malawi distributed a large amount of heavily subsidized fertilizer and this contributed to the harvest of maize. •On the following diagram based on Figure 17-10 (next slide), this can be described by a flatter redrelative fertilizer price line, so both the resulting optimal use of fertilizer and rice production increase. •However, the programs is costly, unsustainable, and economically inefficient. In the backdrop of recovering from a severe economic crisis, this didn't help to restore donors' confidence. The program benefited more state-owned companies and threatened the nascent private fertilizer sector.

FARMERS' SUPPLY RESPONSE TO PRICE CHANGE

•Figure 17-11 derives the supply curve based on total cost and total revenue curves. Most of these should have been covered by principles of microeconomics. •Total cost (TC) is convex due to the law of increasing cost. •In general, TC increases with quantity slowly (concave) in the beginning due to cost sharing and then starts to increase with quantity quickly (convex) due to the law of increasing cost. •Total revenue (TR) is linear with slope = price of rice (P0): TR=P0*R, where R is the quantity of rice. We assume away fixed costs for simplicity, so the TR curve starts from origin. •Profit (=TR-TC) is maximized when the difference between TR and TC is the largest at quantity C. This is also where the slope of the TC = P0. •In Figure 17-11(b), marginal cost (MC) is derived from total cost (TC). •It is shown as a convex curve, although in general it is U-shaped. We are not interested in the first declining portion of the MC because no producer stops producing when MC keeps declining. This is why we show only the increasing portion of the MC. •A farmer produces quantity C at price P0 based on the profit maximization rule: MC=MR. Here, marginal revenue (MR) is simply the price of rice. •So the MC curve is basically the supply curve. If price increases to P1, the supply to be C'.

FOOD CRISIS OF 2005-2008

•Figure 17-12 shows the price hikes for several major crops. •It was caused by both demand and supply shocks. •Some of the potential causes are common to all commodities (such as higher oil prices and depreciation of the US dollars) •Others are commodity-specific (e.g., supply shocks & demand for biofuels) •Specific causes of the crisis: •Growth in demand from China and India •Speculations on financial markets •Hoarding and export restrictions •Weather shocks •Decreased productivity •Low interest rates •A depreciation of the US dollar (àhigher prices denominated in US dollars) •Rising oil prices •Declining food stockpiles Demand for biofuels

WHAT TO PRODUCE? THE PRODUCT-PRODUCT DECISION

•Figure 17-8 describes a farmer's production problem. •We assume two agricultural goods: bean and corn •The production possibility frontier (PPF) shows all of the combinations of beans and corns this farmer can possibly produce, using all of the available resources and technology. •The iso-revenue shows all of the combinations of beans and corns that give the same level of revenue (R=PBB+PCC) •Its slope is the priceratio = - PB/PC •The equilibrium point K: A amount of bean and H amount of corn. •All points on the PPF are productively efficient. But only the production bundle at point K is economically efficient (i.e., profit maximization) because this iso-revenue curve JKF is the highest possible revenue curve this farmer can reach, given his/her current PPF. •The slope of the iso-revenue curve (PB/Pc= the slope of the PPF at point K) measures the marginal rate of technical substitution (MRTS) between bean and corn (showing the tradeoff between bean and corn at point K).

TRADE OVER THE PAST 50 YEARS

•Figure 18-1 shows the level of exports in current US dollars, by regions, over time. •Trends of world trade show dramatic expansion over the past 50 years. •High- income economies, which make up nearly 80 percent of the world GDP, continue to dominate global exchange, but low- and middle-income economies have shown significant growth in international trade. •East Asia experienced the highest rate of growth in GDP per capita over the past 30 years. Most of the countries in this region followed a model in which trade served as the engine of economic growth. •The types of products traded tend to change as economies grow and the share of trade increases. •Many factors, such as population size, geographic location, and political agendas, determine the extent to which a country trades with the rest of the world. •Some facts: •Largest exporters in goods: China, Germany, the US ... •Canada is US's largest trading partner

COMPOSITION OF THE WORLD TRADE

•Figure 18-3 shows how the composition of merchandise exports (= primary + manufacture) has changed by region. •Over the past three decades, manufactures has replaced primary products as the main exports for three regions: East Asia, Latin America, and South Asia. •Primary products continue to dominate merchandise trade in Africa.

WHO TRADES?

•Figure 18-4: smaller countries have higher level of trade openness because •Small countries may not have the resources to produce some goods •Smaller countries need to enter the global markets to gain economies of scale. •Trade patterns are also influenced by a country's geographical characteristics, including its access to shipping routes, landlock status, and its location relative to major markets. •Figure 18-5 identifies 44 nations that do not have a coastline. Their trade to GDP ratio is only 25% as compared to 75% for all other economies. •Exceptions: •Austria, Luxemburg, and Switzerland are located in the midst of major markets, and are connected by high-quality road networks, and have had good relationships with neighboring states. •Botswana has been very successful, as its diamonds bring in plenty of revenue to overcome higher shipping costs. However, Uganda's coffee, the nation's primary export, does not enjoy the same advantage because the margins between production costs and world prices of coffee is small, unlike diamonds.

PROTECTIVE TARIFFS

•Figure 19-1: Welfare analysis of tariff compared to free trade •Domestic consumers lose areas = -(a+b+c+d) •Domestic producers gain area = +a •Government revenue = +c •Total deadweight loss = -(b+d) •The loss of area bis a production efficiency loss due to protecting inefficient domestic firms: for the increased domestic supply (Q4-Q2) after tariff, the domestic production cost represented by the height of the domestic supply curve is higher than the international cost represented by the world supply curve at Pw. This amount should have been produced by foreign firms, but now are produced by less efficient domestic firms under the protection of tariff. •The loss of area cis a consumption efficiency loss due to the fact domestic consumers buy less under the higher price after tariff. The amount of good between Q1 and Q3 can bring a higher benefit to domestic consumers (represented by the height of the segment of demand curve) than their production cost (represented by the world supply curve). The quantity Q1-Q3 should have been produced by foreign firms and then imported and consumed by domestic consumers, but this benefit is lost due to the higher price after tariff.

REMOVING THE BIAS AGAINST EXPORTS

•Figure 19-4 shows a declining trend in tariffs over time across regions. •The basic steps toward full-fledged liberalization aimed at removing the bias against exports include: •Remove quotas and tariffs and other forms of protection, especially on capital and intermediate goods. •Allow the currency to float with a market-determined exchange rate, and ensure macroeconomic stability through prudent monetary and fiscal policies. •Reduce unnecessary regulatory burdens, bureaucratic costs, and red tape that add to business costs. •Keep factor markets flexible, especially for labor and credit, with market determined wage and interest rates. •These policies are often seen as synonymous with broader market-based policies. This approach may not be aimed at exports per se, but export growth is likely to follow because the distortions that inhibited exports and favored other activities are removed.

SOLUTIONS TO ADDRESS EXTERNALITIES

•Figure 20-3: determination of optimal pollution •Marginal external cost (MEC) increases with pollution level •Marginal abatement cost (MAC) decreases with pollution level: when pollution activities decrease, it will become increasingly harder to reduce an additional unit of pollution. •The optimal pollution level is Q* (may not be zero): •At Q*, total cost is minimized: total cost = total external cost (area E) + total abatement cost (area A) •At Q2 > Q*, the abatement cost is lower than external damage of pollution, so we should continue to reduce pollution. •At Q1 < Q*, the abatement cost exceeds external damage of pollution, so it is no longer worth it to continue to reduce pollution. •Implication: society is better off with some pollution than none.

HOW DOES DUTCH DISEASE HAPPEN?

•From the perspective of a developing country, what may happen after an oil discovery in Mexico (local currency: peso). •The Dutch disease is a wolf in sheep's clothing because it typically starts with what looks like a good thing: A boom in a country's raw material exports. •The boom in exports can cause a sharp currency appreciation: •First, the influx of foreign exchange (e.g., US dollars) from higher export earnings creates a surplus of foreign currency which usually needs to be converted into a local currency (e.g., pesos) - higher demand for pesos - domestic currency appreciates relative to foreign exchange. •Second, higher income from booming primary exports increases the demand for all goods and services - higher prices for nontradables (prices of tradables may not change if a country is small as a price-taker in the world economy) - domestic prices increases relative to foreign prices - cheaper for Mexican to imports and less profitable to exports-- equivalent to an appreciation of peso. •Mexican central bank usually raises nominal interest rate when inflation rate is high to cool down the economy and to avoid negative real interest rate - higher demand for pesos (e.g., an investor can convert dollars into pesos to enjoy the higher interest rate and then convert back into dollars later to get better returns) - peso appreciation.

ECONOMICS OF CLIMATE CHANGE

•Global warming: •Figure 20-8 shows the changes in global temperature •Driven primarily by the accumulation of greenhouse gas (GHGs) •Figure 20-9: area of each country's bar indicates total CO2 emission •As of 2006, China overtook the US as the world's largest CO2 emitter, but per capita emissions in the US are still approximately four times greater than those in China. •GHG emission is an example of negative externality •However, global warming is also subject to intensive debate •Concerted international efforts to mitigate climate change are urgent if future economic development is to be sustainable. •Response to the potential threats from global climate change requires simultaneous action on two fronts: mitigation and adaptation

DIFFERENCES BETWEEN TARIFFS & QUOTAS

•Government cannot collect a tariff revenue under a quota. Area c (tariff revenue in Figure 19-1) is called "quota rent" under a quota -- a benefit derived from beneficial government policies rather than profit-seeking efforts (e.g., innovation). Depending on how the rent is distributed, Home may or may notreceive area c. •If Home government auctionthe quota, area c will be received by Home government just like tariff revenue (as what New Zealand once did). •For example, if domestic price would increase by $5 under the quota, then a foreign firm that wants to sell to Home market need to pay $5 per product to Home government. •When the government administratively allocates (gives away) import licenses to domestic firms (importers), importers get the rent. •For example, if the US government allocate the clothing import license to Walmart, Walmart can import clothes at international price but sells them at higher prices (due to limited quantity), so Walmart receives the difference - quota rent. •If Home government simply gives away the licenses to foreign firms, then foreign firms (license holders) can earn a windfall profits equal the area c. •For example, if the US government allows a Mexican sugar producer to export only a certain amount of sugar, this privileged producer will be able to sell to the US for a higher price, and hence capture the quota rent.

TRADE POLICY INSTRUMENTS

•Governments have four basic policy instruments at their disposal to influence the industrialization process: •tariffs on imports: protective tariffs involve significant efficiency losses, particularly when effective rates of protection are quite high. •quantitative restrictions on trade: import quotas have similar effects, with the added disadvantage of bestowing monopoly power and scarcity rents on favored firms. •various forms of subsidy: subsidies and other market preferences can achieve similar ends, usually with a larger deadweight loss to the economy. •exchange-rate policy: •the first 3 instruments can be applied to very specific products or firms. Exchange rate policy, however, affects all producers of tradables in a more evenhanded fashion. •An overvalued real exchange rate renders exports less profitable and imports less expensive, while an undervalued real exchange rate has the opposite effects. •Ironically, efforts to shield domestic producers from import competition discriminate, through exchange-rate effects, against exports as well as against imports.

HOW MUCH TO PRODUCE? THE FACTOR-PRODUCT DECISION

•Having decided what to produce and how to produce it, a farmer still needs to decide how much to produce. •Figure 17-10: A production function is utilized •We assume only one input (let's say, fertilizer) is used to produce rice (output), holding all other inputs constant (e.g., land and seed strand). •The concaveproduction curve implies diminishing marginal returns to fertilizer: additional unit of fertilizer becomes less and less important when more and more fertilizer is applied. So production increases with fertilizer but with decreasing speed, and may eventually drop with fertilizer when too much fertilizer is applied. •The production is maximized when OI amount of fertilizer is applied, but this is not necessarily the profit maximization point. To know the profit maximization quantity, we also need to know the price of rice and fertilizer. •The slope of line ON = relative price of fertilizer = PF/PR •Profit is maximized when marginal revenue (MR=PRΔR) equals marginal cost (MC=PFΔF) •To produce additional rice (ΔR), it costs additional fertilizer (ΔF), so MR=PRΔR and MC=PFΔF •MR=MC, PRΔR =PFΔF, ΔR/ΔF (slope of production function) =PF/PR(slope of line ON) •At profit-maximizing point F, slope of production function for traditional variety=slope of line ON. •For modern variety of rice, the profit-maximization point is L, which may corresponds to different level of fertilizer.

THE HECKSCHER-OHLIN (HO) MODEL

•Heckscher-Ohlin (HO) model is a 2x2x2 model: two countries (Home & Foreign) produce two goods (let's say, Clothes and Computers) using two factors (let's say, capital and labor). Contributors: Swedish economists Eli Heckscherand BertilOhlin •Labor is assumed to be more abundant in one country (let's say Foreign or Mexico), while capital is assumed to be more abundant at Home (or the US). •Abundant factors are usually cheaper, so wage is lower in Foreign while capital rental rate (or interest rate) is lower at Home. •For example, •We can assume that labor is intensively used in producing Tomatoesand capital is intensively used in producing Farm equipment. •Because Mexico is abundant in labor (wage is low), Mexico can produce labor-intensive tomatoes with low cost and hence gains an advantage in exporting tomatoes. •Because the US is abundant in capital (interest rate is low), the US can produce capital-intensive computer with low cost and hence gains an advantage in exporting Computers.

COMPARATIVE ADVANTAGE OF RESOURCE RICH COUNTRIES

•Higher international prices of resources will induce resource rich countries to specialize in producing primary goods. •If a country has the capacity to produce more than it can sell on the domestic market (surplus capacity), trade provides a "vent for surplus" (coined by Adam Smith). •Additional factors of production, such as capital and labor (including domestic and foreign labor and investment), can be gained from the expansion of primary product exports. •Also, primary product exports present the possibility of stimulating other related sectors, which leads to the backward and forward linkages. •Backward linkages: the growth of one industry (such as textiles) stimulates domestic production of an upstream input (such as cotton). •Forward linkages: the availability of low-cost primary goods (cotton) can stimulate the production in downstream sectors (textiles). •However, developed nations often employ tariff escalation(imposing higher tariffs on imports of processed goods than on the raw materials), making it harder for developing countries to move up the value-added ladder.

REVIEW OF INDIFFERENCE CURVE

•Home Indifference Curve •PPF alone cannot determine how much of each good to be produced. •We need information about the country's preferences—we need an indifference curve. •All points on an indifference curve have the same level of utility (happiness). *A video on indifference curve:

DIFFERENT EXPORT-LED STRATEGIES ACROSS REGIONS

•Hong Kong and Singapore adopted relatively open policies with fewer government interventions and distortions. •Korea was much more interventionist (bias toward exports): stiff protective barriers against many imports especially consumer goods such as cars. Korean firms were offered favorable interest rates and cheap credits and were induced to meet ambitious export targets. Not all firms succeeded (e.g., heaving and chemical industries) •Indonesia, Malaysia, Taiwan, and Thailand used a more mixed approach: •heavily protected industries never became internationally competitive, •the industries without heavy protection were more successful. •China has been more interventionist adopting policies far from free trade: Undervalued currency to encourage exports and discourage imports - large trade surplus - international tensions in trade. •More detailed discussion of China's exchange rate policy on the next slide.

WHY DO COUNTRIES ERECT TRADE BARRIERS?

•If both tariffs and quotas lead to deadweight loss, why do most countries employ such measures? •Revenue purpose: tariffs are easier to collect than other (e.g., poor countries with low income cannot reply on income taxes). •This is more relevant to developing countries. It is not a major reason for rich countries because tariff rates are already low in rich countries. •Infant industry argument •Politics: "Size of pie" vs. "Distribution of pie" •Trade creates losers, even as it makes the country as a whole better off. •The losses are often highly concentrated among a small group of people, who feel them acutely and will more likely to take collective actions lobbying for protection. •The gains are often spread thinly over many consumers, who may not see how trade benefits them so are unlikely to take collective action. •The visible losers and invisible beneficiaries help to explain an anti-trade biasand protection policies in many countries (e.g., Beer protection in Thailand, rice protection in Japan, diary protection in the EU, and sugar protection in the US).

EXCHANGE RATE MANAGEMENT

•If domestic currency is undervalued (like eu in Figure 19-3): more effective •Undervaluation, not overvaluation, is more common today. •Undervalued domestic currency helps exports and reduce imports. This has been used by some East Asian countries, most notably China, and proved to be more effective

ANOTHER EXAMPLE TO HELP YOU GAIN INTUITION OF COMPARATIVE ADVANTAGE

•Image you are the founder & CEO of a company and needs to decide whether to hire a telephone receptionist. Both you and the telephone receptionist can perform two tasks: a simple task of handling routine telephone calls and a more strategic task (such as R&D and marketing). •You can be better in doing both but not equally better: You do only a little better than the telephone receptionist in handling telephone calls but a lot better in doing something more strategic at higher end. •You may decide to hire and pay this telephone receptionist even though you have absolute advantage in both because trade is based on comparative advantage which is in turn based on the comparison between opportunity costs. •You lose advantage in handling telephone calls because the opportunity cost for you to receive telephone calls is higher - you would have to give up the opportunity to perform higher end tasks. •The telephone receptionist gains comparative advantage in receiving telephone calls because he/she is not good at handling higher end tasks anyway - hence a lower opportunity cost. •In the Ricardianmodel, the party with lower opportunity cost gain comparative advantage in producing a product.

IMPORT QUOTAS

•Import quotas are quantitative restrictions on imports. •Quotas and tariffs are similar: •An import quota (M2), equivalent to the same amount of tariff as in Figure 19-1, can lead to the same changes in domestic production, consumption, and imports. •The welfare effects on domestic consumers, domestic producers, as well as deadweight loss are also the same as the tariff case. •But not the same for government: there is no tariff revenue under a quota. This will be discussed on the next slide.

TRADE STRATEGIES

•Import substitution strategy: •To encourage the production of domestic goods and services that replace (or substitute for) imports, a country protect its domestic industries by erecting trade barriers that limit imports of similar products. •Outward-looking strategy: •Shifts the focus to producing for exports for global markets by deploying export-friendly policies. •More discussions in Chapter 19.

IMPORT SUBSTITUTION

•Import substitution was nearly universal in the 1960s and remained widespread until quite recently. •This strategy entails identifying large domestic markets served by imports, assessing the technical feasibility of domestic production, and then erecting protective barriers (e.g., tariffs and quotas) to shield ostensible infant industries from import competition. •Trade barriers, by raising prices of imports and reducing the quantity of imports, allow domestic producers to charge higher prices to make profits despite their higher production costs. This policy comes at a cost to consumers and other firms, who pay the higher prices. •Products using simple technologies such as textiles, processed foods, beverages should be the first targets. Many countries, however, use this strategy to protect steel, machinery and other capital goods, and usually with little success. •After an initial burst of growth, import substitution generally bogs down because domestic markets are limited in size and infant industries remain too uncompetitive to penetrate export markets.

RAISING ECONOMIC CEILING

•In Mosher's framework, the economic ceiling was determined by a combination of economic incentives, infrastructure, access to markets, and institutions. •A central the dilemma of pricing: producers and consumers both have conflicting interests. •Consumers lose from higher prices •Producers benefit from higher equilibrium prices •Make sure that you understand the difference between a higher equilibrium prices and a higher price raised by a producer alone. •The former is possible only if supply or demand curve shifts (e.g., a technological advance shifts the supply curve rightward and leads to a permanent lower equilibrium price). •The latter is not going to lead to a permeant change in equilibrium price (for example, other things equal, if only one producer raises the price of a product in a competitive market, this can only cause a surplus and this producer will be eventually forced to lower the price to the original equilibrium price. •This was labeled by Timmer, Falcon & Pearson "the policy food dilemma"

HOW TO PRODUCE? THE FACTOR-FACTOR DECISION

•In addition to deciding what mix of crops to grow, farmers must also determine the least costly combination of inputs needed to produce a given quantity of output, as illustrated in Figure 17- 9. •We assume two types of inputs: labor (L) and capital (K) •Isoquantcurve: different combinations of labor and capital that farmers may use to produce a given quantity of output of a particular crop (e.g., 100 kg of rice in Figure 17-9). •Point D: a lot of labor using simple tools •Point P: a small amount of labor using machinery (a lot of capital) •Isocostcurve: total cost of production is the same (C = wL+ rK) at very point on the line. •w is the wage rate, and r is the interest rate (cost of using capital) •The slope of isocostcurve = - r/w •A correctionon Figure 17-9: C=wLr+Kshould be C=wL+rK •Equilibrium: a cost-minimizing producer will want to choose the least cost combination of capital and labor at point E to produce 100 kg or rice.

EXPORT-ORIENTED STRATEGY

•In contrast, the export-led strategy of East Asia's "tigers" (Hong Kong, Korea, Singapore, and Taiwan) has been outstandingly successful. •Followed by the success in Chile, China, Indonesia, Malaysia, Mauritius, Poland, Thailand, Tunisia, and Vietnam. •Usually started with labor-intensive products using less sophisticated technologies, and shift to more sophisticated products later. •These countries have been interventionist and protectionist to varying degrees, but they shared four key characteristics: •a disciplined focus on policies to promote rapid economic development, •prudent management of macroeconomic policy and exchange-rate policy, •flexible factor markets, and •insulation of exports from domestic price distortions. •This strategy is not a panacea and need to be accompanied by many other policies and institutional reforms. •Failures: Bolivia, Zambia, and many republics from the breakup of the former USSR.

EXPORT PESSIMISM--ISSUES WITH SPECIALIZING IN PRIMARY COMMODITIES

•In the 1950s, Raul Prebisch, Hans Singer, and other economists generated the idea of export pessimism, referring to the decrease of primary commodity export prices relative to prices of manufactured goods over the long run. Here are a few supporting ideas: •Engel's law: the demand for staple foods grows more slowly than income. •In rich countries, the income elasticity of demand for foods is below 0.5, implying that demand for foods (including those imported from developing countries) tends to lag far behind income growth. On the contrary, this elasticity is greater than one for manufactured goods. Both could contribute to lower relative prices of primary products. •Technological changes in manufacturing •reduce the wastage so less raw materials are need to produce a certain amount of manufactured goods •allow for the substitution of synthetics for raw materials •Developed countries have market power, whereas primary producers in developing countries faced much greater competition. •The decline of prices of nonfuel commodities over the past 50 years and the fluctuation in commodity prices are two apparent trends .

TERMS OF TRADE FOR PRIMARY PRODUCTS

•In the previous two-country, two-good example, the prediction of changing terms of trade is straightforward. The empirical record in the real world with many countries and goods, however, is somewhat mixed. •Figure 18-10 shows the nonfuel commodity price trend during 1960-2009. •A general secular decline In the price over the past 50 years. •But the fluctuations in the prices is an even more pronounced trend. •Terms of trade (= export prices / import prices) reveal similar patterns. •We also consider overall terms of trade (not just commodity terms of trade). A commonly used measure of relative prices of traded goods is the net barter terms of trade = average price of a country's exports / average price of its imports, for either primary products or manufactures or both. •Figure 18-11 shows the trends of the net barter terms of trade: •For all nations including oil exporting countries, the terms of trade rise dramatically after 1972 (oil crisis) and remain high, despite the fall of oil prices during the 1980s and early 1990s. (OPEC has some monopoly power so it helps to keep oil price high) •For non-oil exporting developing countries only, the net barter terms of trade decline over the period by nearly 30%, which supports the view of export pessimism.

INSTITUTIONS FOR AGRICULTURAL DEVELOPMENT

•Institutions define the rules of the game by which individuals in society interact with each other. •In the context of agricultural development, institutions governing the ownership and transfer of land are of particular importance. •Table 17-2 shows the inequality level (GINI) of land ownership in selected countries. Chapter 6: GINI coefficient ranges from 0 to 1. •Great variations in the size of average land holdings and the quality of land ownership across regions and countries. •Land ownership is more equal in African •Land ownership is more unequal in Latin America. •Latifundia: large estates that dominate the distribution •Minifundia: small family farms on which peasant farmers struggle to feed their families

BOX 18-1: DUTCH DISEASE -- A GEOMETRIC PRESENTATION

•It discusses the implications of growth in an economy with •Three sectors: a booming tradable sector (B), a lagging tradable sector (L), and a nontradablesector (N). •In most developing countries, the leading example of the lagging sector from which employees are leaving is the agricultural sector. •All sectors use labor, and workers are assumed to move freely among sectors - wage will be equalized in equilibrium. •Each sector uses a specific factor (e.g., land in lagging agriculture sector). •When the booming tradablessector experiences a boom, it can lead directly to inflation and currency appreciation. •Booming tradableswill expand in the short-run, lagging tradableswill certainly shrink, while the effect on nontradablescan be ambiguous. •A stream of workers will leave the lagging tradablessector for the booming tradablesand nontradablessector, potentially never to return to the former sector once the boom ends. Some workers may move fromnontrablesto boomingtradables.

•Most of the technical contents are simply applications of the firm behavior theories you had learned from principles of microeconomics course (how firms maximize profits)?

•It explores what kind of agricultural policies governments should promote, what kind of investments are most effective, and what institutions and rules are the most critical for effectively implementing and maximizing the investments and policies pursued. •In particular, this chapter discusses the green revolution which led to a substantial increase in productivity beyond traditional agriculture. In developing countries, this green revolution have been concentrated in Asia and Latin America, with comparatively little impact on agricultural development in sub-Saharan Africa. •A policy dilemma on food prices: higher prices benefit producers but hurt consumers and may lead to problems of hunger and malnutrition that are endemic in many developing countries.

NOMINAL AND REAL EXCHANGE RATES

•Keys to understanding the paradox of Dutch disease are the nominal exchange rate, real exchange rate, and the prices of tradable and the prices of non tradable goods. •Tradables: goods and services that are internationallytradable such as cars and electronics. Their prices are determined by the world market. •Nontradables: the prices of internationally non tradable goods and services (such as land and haircuts) are determined by domestic supply and demand. •The concept of real exchange rate is a bit confusing. It is okay if you cannot understand it fully, as long as you understand the linkage between exchange rate and the Dutch disease on the following slides.

REVEALED PATTERNS FROM TABLE 20-1

•Low income countries rely substantially on natural capital compared to high-income countries, with most of the differences lying in the relative proportions of intangible capital. •Over time, the increase in wealth in the low-income countries is associated with a shift in composition of total wealth from natural capital to intangible capital. •But not all of the low-income countries can achieve growth. •The Hartwick Rule: a sustainable development path for countries that depend on nonrenewable resources requires the rents from those resources to be continually invested rather consumed. •Successes: Botswana, Mexico, Peru. Failures: Nigeria, Democratic Republics of the Congo, Zambia, Zimbabwe.

SUSTAINABLE DEVELOPMENT

•Many uncertainties remain concerning the long-term effects of pollution, but history consistently has disproved simple Malthusian views that the world is running out of resources (Thomas Malthus). •One reason is that technology has more than kept pace with population. •More to the point, neoclassical economics shows that markets respond to scarcity by inducing substitutions, conservation, exploration for new reserves, and development of alternative materials. •Hence, a sound strategy for sustainable development is to promote efficient markets, effective property rights, and a minimum of distortionary interventions. •Because poverty is a powerful impediment to conservation and prudent management of resources, economic development is itself part of the solution. •In this regard, the rich nations have a great stake in promoting development of the poor nations.

DIFFERENCES BETWEEN TARIFFS & QUOTAS

•Market dynamics that shift the domestic supply and demand curves or the world price have very different impacts with tariffs and quotas. Consider a fall in the world price Pw: •With a tariff, both Pw and Pd will fall, giving consumers the benefit of the lower price; domestic production falls and imports increase to fill the gap. They still react on the margin to market changes as they would in an open economy. •Under a quota, however, imports cannot rise. Domestic consumption an production remain at the same level. Domestic price remains at Pd. •This is why tariffs are preferred to quotas. Under the GATT/WTO, members are supposed to eliminate quotas or convert quotas into equivalent tariffs (called tariffication").

SOLUTIONS TO ADDRESS EXTERNALITIES

•Market-based solutions: •Corrective taxes or subsidies: internalization of externalities (correct market, not to regulate it) •A tax on pollution based on external cost can shifts the cost (supply curve) upward to the position of social marginal cost and hence makes market participants (buyers and sellers) accountable for the environmental damage. •A subsidy to flu shots based on the external benefit shifts the value (demand curve) upward to the position of social marginal benefit. This helps to compensate the market participants and encourage more people to take flu shot (at the socially optimal level of quantity). •Tradable pollution permits that entitle the holders to pollute or use the resource: reduces pollution at lower costthan regulation. •Firms with low cost of reducing pollution sell whatever permits they can. •Firms with high cost of reducing pollution buy permits. •More efficient because firms know better the costs and benefits. •The permit is a property right with a market value; use of the permit therefore entails an opportunity cost that internalizes the externality.

INFORMAL REGULATION

•Minimizing government intrusion is desirable because policy failures are another major cause of resource mismanagement. •Through protectionist trade measures, tax breaks, energy subsidies, and poorly appraised infrastructure investments, government interventions often accentuate the wasteful use of scarce resources. •See one section in chapter 20 on policy failures. •Informal regulation is an alternative to government regulation. •It often involves public disclosure of information pertaining to environmental records. This form of regulation is especially attractive to developing nations. •Public disclosure of information about a factory's environmental performance to local stake holders is an example of informal regulation. •It can be in the form of moral codes or social sanctions such as "No Smoking" sign in public areas. •With any form of intervention, including government regulation, adverse effects are a possibility. •It is difficult to find the right balance of how much intervention and which form of intervention are needed to reach optimal levels and avoid policy failures.

OVERALL ASSESSMENT OF TRADE STRATEGIES

•More sophisticated recent research indicates that open economies perform better than closed ones. •Still, some notable skeptics remain. •Where the instruments have been used to encourage open trade and outward-looking industrialization, the result generally has been rapid growth in income and productivity, although the direction of cause-and-effect remains uncertain. •In general, trade helps poverty reduction as well. Even though some suggest that outward orientation creates more sweatshops, evidence does not corroborate this suggestion.

•Aid may be provided bilaterally or multilaterally.

•Multilateralaids: •The largest multilateral aid donor is the World Bank, but its aids (usually to low-income countries) only account for a small part of its loans. Most of the World Bank loans are provided at market interest rates to middle-income countries, so are not characterized as foreign aid. •Likewise, the International Monetary Fund (IMF) provides limited amount of foreign aid. •Most aids are provided bilaterallybetween two countries (donor & recipient).

APPROACHES TO TRADE LIBERALIZATION

•Multilateralism: GATT/WTO •Nondiscrimination principle (or Most-favored Nation Clause): No discrimination against other members. If a member lowers its tariffs on the products from another member, the lower tariffs will be enjoyed by all WTO members (in other words, all members are treated as favored nations). •Regionalism: bilateral/regional trade agreements (discriminatory against outsiders) •Free trade areas: free trade within the trading area/block; each member set its own tariffs on products imported from countries outside the trading block (external tariffs). (example: NAFTA) •Customs unions: free trade area + commonexternal tariffs (example: EU) •Unilateral approach: •Some countries voluntarily lower tariffs without being pressed by or reciprocity from trading partners. •For example, many Latin American and South Asian countries lowered their tariffs after 1980s, seeing the failure of their import substitution strategy and the success of the East Asian's export-led strategy.

ROADS TO INDUSTRIALIZATION

•Nearly all developing countries try to accelerate the pace and influence the pattern of industrialization. Two main trade strategies: •inward-looking import substitution encourages the production of goods and services that replace (or substitute for) imports by erecting trade barriers that make imported products more expensive or more difficult to purchase, with the aim that over time firms will become more efficient and competitive. •export-led outward-looking industrialization shifts the focus to producing for global markets by relying on market forces: strengthening key institutions; and in some cases, using subsidies, managed exchange rates, and other policy instruments. •The core premise of import substitution is that infant industriesneed protection to survive, while the premise of outward-looking industrialization is that domestic producers must become internationally competitive to gain access to new technologies, increase efficiency and enlarge the scope of their potential markets. •Infant industry argument: some new industries in developing countries are like infants, who need some temporary protection until they "grow up" to compete on international markets.

BOX 18-2: NIGERIA: A BAD CASE OF DUTCH DISEASE

•Nigeria was severely impacted by Dutch disease after the oil price boom of the late 1970s and early 1980s. •The Nigerian government reaped windfall profits during this period, but much of the profit was squandered on wasteful projects or disappeared into offshore bank accounts. •Because the government misdirected its funds, agricultural production not only remained archaic, but deteriorated even further—all in the face of a rapidly rising population to feed. •Even with the oil price recovery in the early 2000s, Nigeria experienced little economic growth while its poverty rate continued to soar. •The Dutch disease is nowhere close to being responsible for Nigeria's woes but does factor into the picture at times.

BOX 19-1: EFFECTIVE RATS OF PROTECTION

•Nominal rate of protection (NPR) and Figure 19-1 focus only on output market, without considering imported inputs needed to produce the good. •Domestic producers are protected by tariffs on a final good, but get hurt by the tariffs on inputs they have to import in order to produce the final good. Therefore, the correct measure of protection should take into account the counter veiling effect of tariffs on inputs. •Effectiverate of protection (ERP) measures the protection afforded by the entire structure of tariffs on inputs and outputs. It focuses attention on the impact of trade policies on value added, the difference between the selling price of the good and the unit cost of intermediate goods. •At domestic prices, value added = domestic price of the good (Pd) - domestic unit cost of intermediate goods (Cd). •At world prices, value added = world price of the good (PW) - unit cost of intermediate goods at world price (CW). •ERP= (Pd-Cd)/(PW-CW) - 1 = [PW(1+t0)-CW (1+ti)]/(PW-CW) - 1 1)ERP > NRP if tariff on final good t0> input tariff rate ti 2)ERP < NRP if tariff on final good t0< input tariff rate ti ERP = NRP if tariff on final good t0= input tariff rateti

TARIFF VS QUOTA VS SUBSIDY: THE VIEWS FROM ECONOMISTS VS POLITICIANS

•Note that subsidies here refer only to the subsidies to domestic import-competing firms. The effect of other types of subsidies (such as export subsidies) are different. •Among the trade policies to protect domestic import-competing firms, economistsgenerally prefer subsidies over tariffs (and tariffs over quotas) because consumers doesn't lose welfare. •However, government officialstend to prefer quotas or tariffs over subsidies because the costs of subsidies appear on the budget while the costs of tariffs/quotas are less visible. •All of them have something in common: •For example, it is always difficult to pick winners, i.e., those sectors with potentials to succeed in the future after temporary protection.

TRADE AND RACE TO THE BOTTOM IN LABOR AND ENVIRONMENTAL STANDARDS

•One concern in developed countries is that developing countries gain cost advantage in the world market simply because they have low labor and environmental standards (so firms pay low wages and pollution taxes). •In order to encourage exports and attract foreign businesses, countries may have incentives to compete by lowering their standards - the so called "race to the bottom." •There are not many supporting evidence because labor and environmental standards are mainly determined by domestic policies rather than trade. •Nevertheless, labor and environmental issues have caught people's attention and become an indispensable parts of some of the international trade agreements.

EMPIRICAL EVIDENCE ON PRIMARY EXPORT-LED GROWTH

•Since the 1950s, some economists and the leaders of many developing countries have argued that, despite the possible benefits, primary exports cannot effectively lead the way to economic development. •The markets for primary products grow too slowly to fuel growth; •The prices received for these commodities have been declining; •Earnings are too unstable; •Linkages do not work; •Fiscal windfall more often than not breeds corruption and civil strife rather than growth and development. •Figure 18-8: economists Jeffrey Sachs and Andrew Warner found strong evidence that, on average and holding constant the other determinants of growth, countries with substantial primary product exports have grown much more slowly than resource-poor countries.

Absolute advantage is based on the absolute costs (e.g., labor hours per unit): •US is assumed to have absoluteadvantage in producing bothgoods. • Comparative advantage is based on the comparison between opportunity costs: •Opportunity cost of tomato: 50/300 = 1/6 tractor in Mexico; 40/200=1/5 tractor in US •Mexico has lower opportunity cost of tomato (1/6 < 1/5) in terms of the amount of tractors a country needs to give up to produce a ton of tomatoes, so Mexico gainscomparative advantage in producing tomato.

•Opportunity cost of tractor: 300/50 = 6 tomatoes in Mexico; 200/40=5 tomatoes in US •The US has lower opportunity cost of tractor (5 < 6) in terms of the amount of tomatoes a country needs to give up to produce a tractor, so the US gains comparative advantage in producing tractors. •Another way to solve for the trade pattern: •For tractors, Mexico cost relative to the US = 300/200 = 150% •For tomatoes, Mexico cost relative to the US = 50/40 = 125% •The two ratios imply that the US is doing 50% better than Mexico in producing tractors, but only 25% better than Mexico in producing tomatoes. Hence the US should produce and export tractors, and import tomatoes from Mexico.

TRADE STRATEGY AND INDUSTRIAL POLICY

•Outward looking policies are not the same as free trade or laissez-faire. Policy neutrality regarding production for exports vs production for domestic market has been the exception rather than the rule. •Much of the debate revolves around industrial policy - a broad set of interventions to favor one set of economic activates over others, including but not limited to undervalued exchange rates, subsidies, and EPZs. •The economic justification for industrial policies is market failure, where government intervention may help to improve economic efficiency. •The main problem with industrial policies is that government may not be able to figure out what firms really need, and more often than not they breed corruption and waste resources. This is why there are successes but mostly failures. •Some economists such as Dani Rodrikrecommend a combination of private initiatives and government interventions. •They see the role of government as extending beyond the traditional areas of ensuring macro stability, providing public goods, and resolving externalities. •Government also has a coordinating role to play in facilitating structural change.

COMPARATIVE ADVANTAGE OF RESOURCE RICH COUNTRIES

•Overall, primary products (raw materials, food, fuels, minerals, ores, etc.) still represent about one third of the value of all traded goods. •Figure 18-7 identifies economies that are dependent on exports of primary products, that is, where more than 75% of their merchandized exports is in primary products. •13 low-income countries; 27 middle-income countries, and 9 high-income countries. •The rest of the chapter focuses on the trade of primary products as an engine for growth for many nations and its potential failures. •For most developing economies, international trade often began with primary products and subsequent thinking about the impact of trade on development has its roots in the exchange of primary products from the south (refers to developing countries) for manufactured goods from the north (refers to rich countries). •The growth performance of resource-rich economies often has been disappointing, referred to as the resource curse and seemingly the opposite of the predictions of comparative advantage. •Trade in manufactured goods is considered in Chapter 19.

DUTCH DISEASE

•Prebischand Singer worried about declining terms of trade. But improvements in a nation's terms of trade brought on by booming primary export prices may be even more perilous for an emerging economy. •Dutch disease is named after the experience of the Netherlands after 1960, when major reserves of natural gas were discovered. •The export boom of natural gas and trade surplus promised new prosperity. •However, during the 1970s, the Dutch economy suffered from rising inflation, declining export of manufactures, lower rates of income growth, and rising unemployment. •Oil-rich Mexico, Nigeria, and Saudi Arabia, and some coffee producing African states followed a similar path. •Because the influx of foreign exchange itself cause the Dutch disease, the syndrome also can result from large inflows of foreign capital in any form. •The import of gold and silver from the Americas, for example, may have helped retard Spain's growth in the 16thcentury. •Similarly, large foreign aid flows to developing countries can undermine exporting firms' international competitiveness, as discussed in Chapter 14.

THE PRINCIPAL-AGENT PROBLEM WITH AIDS

•Principal-agent problems: •Agents have their own goals and motivations, which may not be the same as the principals' goals. •Agents also have more information than the principals and can use the information in ways that run counter to the principals' interests. •Principals are faced with the problem of writing contracts and establishing rules that more closely align agents' interests with their own. •This problem is particularly challenging for foreign aid because •the principals (donors) and agents (local agencies) are only indirectly related: beneficiaries of aids and agents are usually different the principals and agents are located in different countries.

THE PRINCIPAL-AGENT PROBLEM WITH AIDS

•Principals in a private company (owners), club (members) or public administration (taxpayers) cannot make all decisions and carry out all tasks themselves, so they must delegate these responsibilities to agentsto work on their behalf: managers, employees, elected officials, and civil servants.

MARKET FAILURE: EXTERNALITIES

•Private solution: Coasetheorem •The previous example shows that the private solution based on the Coase theorem works regardless the initial allocation of the property right. It works as long as the right is clearly defined and one party has the right. It doesn't matter which party has the right. •Coasetheorem suggests minimal government control even in the case of market failure. •The only thing the government needs to provide is clearly defined property rights. •Limitations of Coasetheorem: the transaction cost must be low. The transaction costs include the costs of defining property right, the costs of signing, implementing and following a contract, etc.

ISSUES WITH EXPORT PESSIMISM

•Some of their findings on characteristics of the global economy that existed in the first half of the 20th century no longer hold. •The declining trend in relative prices hold for some primary products, but not for others such as diamonds, natural gas, oil, tropical woods, and other primary products that face either relatively income elastic demand, shrinking supply, or few synthetic substitutes. •Primary producers may climb the ladder by transitioning to manufactured goods. •The fierce global competition in manufactured goods that exists today has also brought down the prices of many manufactured goods such as electronics and computers. •The cartels (such as the OPEC) that influence the prices of some primary product markets help to keep their prices high, but are not as effective as before in recent years (lower oil price). Nevertheless, their attention tothe terms of traderemains an important issue.

MARKET FAILURE: EXTERNALITIES

•Private solution: proposed by economist Ronald Coase •The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own given clearly defined property rights. •Example: Imagine families live downstream have a dispute with a plant which pollutes the waters upstream. If no property right is defined, then both parties can defend their position and it will be hard for them to find a solution (plant needs to produce so workers can make a living; family living downstream have the right to use clean water). If government defines the property right, then both parties can bargain and make a deal more easily: •If the plant is critical to local economy and not many people living downstream, then local government will probably assign the production right to the plant, so people living downstream will face the following options: relocate to another place or help the plant to clean the water or buy environmentally more friendly equipment. •If the plant is small hiring only a small number of workers in a sunset industry, while many people are living downstream, then local government will probably assign the right to the people living downstream. The plant will face the following options: closes the plant, buys cleaner equipment, or compensates the people living downstream for the damage they cause through water pollution.

SOLUTIONS TO ADDRESS EXTERNALITIES

•Regulations or command & control policies: •For example, the EPA can ask firms to adopt certain cleaner technologies to avoid penalties or requires the firms to abate their pollutions to certain levels. •Main problem: government official doesn't know all of the cost and production information, so may cause inefficiency, corruption, and bureaucracy.

RESOURCES TRAPS

•Resource traps are explained in detail by Paul Collier in The Bottom Billion. •He identifies several traps that prevent nations from growing. Problems such as commodity price cycles and macroeconomic mismanagement are often caused by poor governance and corruption acts like a tax on economic activity. •Resources often lead to rent-seekingactivities. Unlike profit-seeking, rent-seeking is the action of market participants to seek benefit through unproductive activities (e.g., through building good relations with government officials). This can lead more corruption (which acts like a tax on the economy), conflicts, and even civil wars (conflict trap as illustrated by the phrase "blood diamonds"). •It is possible to escape these problems and overcome the resource curse, though. The use of sovereign wealth funds and adoption of international charters such as the Extractive Industries. •Sovereign wealth funds refer to the accumulation of foreign assets, usually financed by primary product export earnings. •Funds should be used countercyclicallyto provide a national nest egg when non-renewable commodities are depleted. •But they are not a substitute for good governance. Venezuela, for example, has borrowed heavily against its sovereign wealth fund minimizing its potential benefits. Transparency Initiative (EITI) are current approaches being used.

EXTENDING THE RICARDIANMODEL-- THE HECKSCHER-OHLIN (HO) MODEL

•Ricardianmodel assumes only one factor: labor. It predicts that both countries will gain from trade. However, in reality, trade create winners and losers. To explain the distributional effects of trade, we need to extend the model. One method is to allow for more than one factor. •One such extension is the Heckscher-Ohlin model. This model shows how trade is driven by different resource endowment among countries. The idea is simple, when a factor is abundant in a country, it will be cheaper; hence, products that use intensively this factor will be cheaper to produce and gain price advantage in trade. •Although this linkage is well understood, many people fail to realize the surprisingly large differences in factor endowment across countries and hence the tremendous room for further gains from trade. Hence, before getting into the model, I want to present first the significant differences in resource endowment across countries (please watch the video tilted "video presentation_differencesin resource endowment" in Chapter 18 module).

GAINS FROM TRADE

•Ricardianmodel shows that both countries gain from trade. •Figure 18-6 illustrates the gains from trade. It is convenient to take it as a case for Mexico (because we focus on developing countries in this class). Similar analysis can be done for the US. •Mexican PPF for two goods: agriculture goods and farm equipment •The straight lines are relative price lines: slope = Pa/Pm, where Pa and Pm are agriculture and manufacture prices respectively. •Relative price under autarky = 1/6 •Relative price under trade (international relative price) is between 1/6 and 1/5. •The relative price is called terms of trade= a country's export price / import price. •The convex curves are Mexican indifference curves (IC). •All points on an IC have the same utility level, so Mexico is indifferent among them. •The further away from the origin, an IC offers a higher level of utility. •Refer to the slides of Chapter 14 for a review of indifference curves. •A country can consume anywhere along a price line by trading with another country. For example, under international price, Mexico produces at point B, but can consume anywhere along the BC price line. Mexico will choose to consume at point C because this bundle offers the highest utility level (IC3)

COMPARATIVE ADVANTAGE & ECONOMIC DEVELOPMENT

•Ricardo's discussion of comparative advantage assumes static conditions that hold the factors of production in fixed supply and unusable to cross borders. •But economic growth is fundamentally a dynamic process. To explain growth and structural changes, we need to account for changes over time in the amount of capital, land, and labor available to producers as well as improvements in the quality or productivity of those factors. •To better understand how trade and development affect each other, we need to examine some of the alternative trade strategies nations have adopted, some of which are consistent with comparative advantage and others not.

AGRICULTURAL SYSTEMS

•Shifting cultivation: •Producers cultivate one area until its fertility is exhausted (soil erosion) and then migrate to another plot of land. •Pastoral nomadism: •Producers travel more or less continuously. •Settled agriculture: •Intensive annual crops such as staple cereal crops •Mixed farming: crops & livestock •Perennial crops: tree crops •Livestock systems

RICARDIAN MODEL

•Simple trade case: •Imagine US is better than Japan in producing airplanes, while Japan is better than the US in producer Cameras - US should export airplanes and import cameras. •Easy to see without taking an economies class. •But we focus on a less simple trade case: •US is better than Mexico in producing all goods (let's assume only two goods for simplicity: •an agricultural good (1 ton of tomatoes), and •a manufactural good such as farm equipment (1 tractor) •Table 18-1 lists the costs of production. •Should the US import anything from Mexico if the US is doing better in both sectors? •Should Mexico produce anything if Mexico is doing worse in both?

EXCHANGE RATE MANAGEMENT

•Sometimes, a country may intervene directly exchange rate. •If domestic currency is overvalued (like e0in Figure 19-3): ineffective •Many import substitution strategies overvalue domestic currency to make it cheaper to import capital goods, food and fuels, etc. Other nonessential imports are kept out of the domestic market via high tariffs and quotas. •However, the overvaluation of domestic currency has a uniformeffect on all imports. This will reduce the effectiveness of the strategy by making imports cheaper and hence harming domestic import-competing firms. See an example on p722-723 in the book. •Overvaluation of domestic currency also hurts exporters because they would have to ask higher prices in foreign currency and hence may lose competitiveness. •A possible vicious circle: tariff lead to overvaluation of domestic currency, which reduce the cost of imports and thus create a need for even higher tariffs rates to compensate. •In addition, Figure 19-3 shows that an overvaluation of domestic currency or cheaper US dollars (eo, where the subscript "o" refers to "overvalued") creates an excess demand for foreign exchange - ration foreign exchange is necessary - source of rent-seeking, corruption, and black market for foreign exchange. •Import substitution often results from lobbying and political connections.

EXCHANGE RATE MANAGEMENT

•Tariffs, quotas, and subsidies are used to support specific sectors, while exchange rate management has a uniform affect on the prices of all tradables. •Figure 19-3: market for foreign exchange (US dollars) from the perspective of Mexico •Exporters supply foreign exchange and importers demand foreign exchange •Vertical axis is the exchange rate (e.g., how many pesos can buy a US dollar) •Without any policy intervention, the equilibrium exchange rate: ee •An import substitution strategy using tariffs or quotas reduces the demand for foreign exchange - left shift of demand curve - Peso appreciates (lower ee' ) •Peso appreciation acts like a tax on Mexican exports because a US dollar's worth of exports now returns fewer pesos. •An important insight: anytime a government uses trade protection, it affects both imports and export. Many import substitution strategies were designed to foster industrial development but at the same time often hurt traditional exports, including agricultural goods.

MULTILATERAL TRADE NEGOTIATIONS & THE WTO

•The General Agreement of Tariffs and Trade (GATT) was signed in 1947 to liberalize world trade through many rounds of multilateral negotiations. •The Uruguay round (1986-1994) is the first around in which rich countries agreed to include discussions on agricultural subsidies. •Rich countries promised: •Significant reduction in tariffs on manufactured goods •The end of the MFA that had restricted trade in textiles and clothing •Reduction in agricultural protection with a commitment to even larger reduction in the future •Developing countries promised to reduce in their own tariffs, sign agreement on new rules on investment, trade in services, and trade-related intellectual property rights (TRIPs) and support of a new organization, the World Trade Organization (WTO), to replace GATT in 1995. •Enforcement: developing countries were largely disappointed because rich nations didn't reduce agricultural protection as promised and they now face higher royalty payment under the TRIPS. •Doha round of the WTO started in 2001: an ambitious round focusing on development issues but failed to reach an agreement to achieve its goals. •One reason for the slow progress under the WTO: consensus needed to sign anything.

CONSTRAINTS TO AGRICULTURAL DEVELOPMENT

•The Mosher framework compares the actual performance (yield) of agricultural producers with their potential performance. •It considers technical and economic constraints as ceilings on yields. •Figure 17-1: •Horizontal axis: distribution of land to a particular crop •Vertical axis: actual or potential yields, ordered from highest to lowest (would be flat if all farmers have the same yields). •Technical ceiling (curve t) is the maximum biologically possible yield given available technology. •Economic ceiling (curve e) describes the distribution of yields that are possible when all farmers maximize their profits in a given policy environment. •Achievement distribution (curve a) refers to actual yields across farms. •Curve t always lies above curve e, which always lies above curve a. •This figure also discusses how achievement distribution and technical/economic ceiling can be raised.

AVOID THE DUTCH DISEASE

•The best prevention is to avoid or reverse the initial appreciation of currency. •Devaluation of currency, and •Spending restraint to avoid inflation •Channel new investments into health, education, and infrastructure development that improve overall well-being, enhance productivity, and open up economic opportunities outside the primary goods sector. •Harness export windfalls to finance sound and long-term developments. •By delaying the new expenditures, the government acts counter-cyclically to stabilize the economy: spending less during the most inflationary period of the boom and more after the boom has faded. •A good example: Box 18-3

FOOD POLICY DILEMMA

•The challenge in practice is how to make farming profitable while at the same time protecting poor consumers from the threat of high food prices. •The prices received by farmers are lower than the prices paid by consumers. •The margin between the farm-gate price and the retail price is called the marketing margin. •To the extent that these marketing margins are increased by poor infrastructure or limited access to markets, the food policy dilemma is aggravated. •Box 17-3: Cell Phones and Agricultural Development •This case study looks at cell phones and the role they play— primarily in providing rural farmers with access to markets and marketing information. •Improved infrastructure provides a good comparison between poor farmers who are remote from their markets and those who are close to market centers— and do better.

DISCUSSION

•The controversy: William Easterly's White Man's Burden. Three viewpoints on aid and development.

TEMPORARY MIGRATION: ANOTHER DIMENSION OF TRADE

•The four modes of supply of services: •Mode 1: Cross-border trade in services •Morgan Staley provides financial services to a bank located in a foreign country. •Mode 2: Consumption abroad: •Tourists, foreign students studying in the US, or foreign patients in a US hospital •Mode 3: Commercial presence •A foreign branch of Bank of America in Mexico provides banking services to Mexican •Mode 4: Presence of natural persons (migration). •Trade in services is governed by the WTO's General Agreement on Trade in Services (GATS) •Controversy around migration: •Economist LantPritchett argues that immigration has the greatest potential to help developing countries. •Migration faces opposition from the rich countries due to the concerns of job loss, lower wage standard, etc.

DISCUSSIONS

•The gains from trade are as real today as before. But trade is not a panacea. As the discussion of primary product exports demonstrates, economic growth and development entails for more than just he pursuit of comparative advantage. •China would be a great topic to continue the discussion as it has followed this trade- focused model since the 1970s and had remarkable growth since then. •Recent history of the use of successful trade models will be excellent for conversation. •The trade relationship between Mexico and the United States is examined throughout much of the chapter, and this relationship is used to explain several concepts and terms.

LAND RIGHTS

•The most common forms of land ownership (in the agricultural sector). •Purely individual rights •Purely collective forms •Fixed rent tenancy: a family might rent land from a large landlord and pay a fixed cash rent. •Tenants are residual claimants to the output, and bear all risks. •Share cropping: the farm family rents a plot of land from the landlord, with whom the family shares a fixed portion of output. •Tenants and landlord share the risks. •popular in South Asia

COMPARATIVE ADVANTAGE

•The opportunity costs on the previous slides are the conversion ratio between two products in a country in the absence of trade(autarky). They are also the reservation prices people use to compare to the international prices when deciding whether to trade with another country. •A fair international price (acceptable to both countries) must lie in between the two domestic prices. •For example, the autarky prices of a tractor (or opportunity cost of a tractor) are 5 and 6 tons of tomatoes in the US and Mexico respectively. Hence, a fair international price of a tractor should be between 5 to 6 tons of tomatoes, let's say, 5.5 tons of tomatoes. •It costs Mexico 6 tons of tomatoes to produce a tractor, so Mexico is willing to pay 5.5 tons of tomatoes to import a tractor from the US. •At the international price (1 tractor = 5.5 tons of tomatoes), 1 ton of tomatoes is equivalent to 1/5.5 (about 0.18) tractor. The opportunity cost of producing a ton of tomatoes in the US is 1/5 = 0.2 tractor. So it is cheaper for the US to pay only 0.18 tractor to import a ton of tomatoes from Mexico.

BOX 18-3: INDONESIA: FINDING A CURE

•The rising oil price was eventually handled by Indonesia. •The government first experienced inflation but then imposed, among other policies, stringent management of the money supply to protect foreign exchange rates. •Investment in agriculture had a high priority. •Devalue its currency. •Integrated the multitude of ethnic groups to avoid conflicts over fiscal resources. •Undertook a series of reforms that laid the basis for rapid growth: •Reduce import barriers •Opened banking sector to foreign competition •Created ab active stock market By the 1990s, Indonesia was considered an economic miracle.

TRADE, GROWTH AND POVERTY REDUCTION

•The theory of comparative advantage implies that all countries can benefit from trade. The HO model predicts that workers in developing countries (mostly labor-intensive) should benefit from trade. But the empirical evidence on trade and growth or poverty reduction is not as clear due to the following challenges: •Reverse causality: trade promotes growth or growth promotes trade? •Omitted variables: it is hard for researchers to control all relevant variables in their analysis, so trade and growth may be caused simultaneous by something else such as other type of institutional reforms that is not taken into account in the analyses. •Measurement errors: it is hard to come up with precise and internationally comparable measures of trade openness, growth and poverty data. •Frankel and Romerand myself, among others, have tried to take care of the above-mentioned issues. Overall, trade appears to contribute to economic growth, although the results are not always conclusive. •The mixed results are to be expected because many factors are behind economic growth. Trade polices alone may not be sufficient to deliver growth and poverty reduction. Other accompany policies are also important.

FOOD CRISIS AND TRADE POLICIES

•The tripling of world riceprices relates more to the combustible mixture of distortionary trade interventions and panic buying. •World rice markets are thin compared with those for other grains. •Only 5-7% of global rice production is traded internationally (compared with 20% of wheat) àworld rice price is relatively volatile. •Global rice exports are dominated by a small number of countries: •Thailand, India, Vietnam, and Pakistan account for 70% of global rice exports. •Price exploded after India reacted to rising rice prices by banning exports in 2007. •Importing countries, like Philippines in particular, accelerated their import orders, fearing further price increases. •In response, Vietnam, China, Cambodia, and Egypt also intervened to restrict rice exports. •Figure 17-13 placed these and related events on a chart.

TRADE STRATEGIES

•There exists a continuum of trade strategies a nation might pursue, from autarky to free trade at the opposite ends and many others in between. •The pendulum of which approach to follow has swung back and forth. •A relaxation of restraints on trade characterized the early 20th century only to be reserved after WWI and the Great Depression. •After WWII, many nations signed the 1947 General Agreements on Tariffs and Trade (GATT), resulting in a reduction in tariffs and other barriers and an expansion in international trade. Most of the developed countries had embraced free trade policies, with major exceptions in sectors such as agriculture & textiles. •Correction of a typo on page 711 in the book: In "GlobalAgreement on Tariffs and Trade (GATT)", "Global" should be "General". •Two types of popular trade strategies after WWII in developing world: •Latin America, South Asia and Africa adopted an inward-looking import substitution strategy by protecting domestic industries using tariffs and other barriers. But his strategy did not live up its promise and by the 1980s had generally been abandoned in favor of more outward-looking approaches. •East Asia has succeeded by embracing an outward-looking export-oriented policies.

•Trade provides low- and middle- income nations with significant opportunities to improve welfare and accelerate growth and development. •Open trade allows producers to have a larger market in which they can sell, and it allows consumers to have greater choices in purchases of goods and services.

•There is much debate about who benefits most from trade, and there are typically both winners and losers.

•Foreign aid is a controversial topic with detractors from the right and left.

•This chapter provides examples to highlight the nature of the debate.

CRITICAL TRIANGLES OF DEVELOPMENT GOALS

•Three primary goals for development: •economic growth, •poverty alleviation, and •environmental sustainability. •Fragile environments of the world are largely populated by the world's poor. •There may be conflicts in the short-run among them, but these goals are highly compatible in the long run.

HAS AID HELPED GROWTH AND DEVELOPMENT?

•Three viewpoints (Figures 14-4 & 14-5): •Aid on average has a positiveimpact on economic growth and development. •Aid helps health, education, and the environment; provides humanitarian relief; and supports economic and political stability. •Aid has actually underminedgrowth. •Absorptive capacity, crowding out tax revenue, and aid dependency. •Aid has a conditional relationship with growth, helping countries with good policies or institutions. •Supported by recent empirical research, but the evidence is far from clear-cut.

WHY CAN AIDS HURT LOCAL PRODUCERS? •If foreign aids come in the form of cash. Large aids flows can cause "Dutch disease": negative impact on an economy of anything that gives rise to a sharp inflow of foreign currency, such as the discovery of large oil reserves or foreign aids.

•To make local purchases using foreign aids, foreign exchanges need to be converted into local currencies. Usually, central banks take the foreign currencies as reserves and supply an equivalent local currency - increase in money supply - inflation - exporters need to ask for higher prices in foreign markets to match the higher prices at home - equivalent to an appreciation of local currency - hurt domestic exporters because they now need to ask for higher prices in foreign markets and lose competitiveness. •According to supply & demand, aids imply supply of more foreign currencies - appreciation of local currencies - hurt domestic exporters. •Next, we discuss aids in the form of in-kind transfer (not cash).

OTHER GAINS FROM TRADE

•Total gains = gains from exchange + gains from specialization •These are efficiency gains attributed to efficient spending or production. •Trade also confers other significant benefits: •First, trade exposes domestic firms to competition. •Second, trade often embodies new technologies that raise productivity. •Third, trade increases not only the quantity of goods available for consumption, but also the quality and variety of goods obtainable. •Fourth, trade brings people into contact with one another and share more common interests, so it will be harder for them to enter conflicts (economically, politically and militarily). •Peace is indeed the initial motive behind European integration.

TRADE OPENNESS

•Trade openness = (X+M)/GDP, where X is export & M is import •Figure 18-2: •East Asia has the steepest increase in trade openness •For developing countries as a whole, imports plus exports on goods and services combined is about 64% of their total output. •Sub-Sahara Africa is often thought to be marginalized from the global economy in terms of the share of their trade in total world trade. As a share of their own GDPs, however, their openness has been among the highest in the world (more than 50%). •This is partially because most of the African countries are small, so they are more dependent on global markets, as shown by Figure 18-4 later. •South Asia, where India's economy dominates, is the region where trade continues to play the smallest role, although this has been changing over time.

MARKET FAILURE: TRAGEDY OF COMMONS

•Tragedy arise because property rights are not established: •Nobody owns air, so no one can charge polluters. Result: too much pollution. •Nobody can charge people who benefit from basic research. Result: too little basic research funded by private firms/individuals. •Buffalowere extinct because they were owned by nobody, but cowsare not. •A general rule: the socially optimal outcome is achieved when the owner of property rights is a profit-maximizer and sells output in a competitive market. •Solution to solve the tragedy: •Regulateuse of the resource •Correctivetax/feeto internalize externality (more discussion later) •hunting & fishing licenses, entrance fees for congested national parks •Auctionoff permits allowing use of the resource •spectrum auctions by the U.S. Federal Communications Commission •Privatization to confer long-term transferable rights: convert public land to a private good by dividing & selling parcels to individuals

GREEN REVOLUTION

•Two ways to promote technology: •Technology diffusion •Technology progress •Most of the gains in agricultural productivity over the past 50 years have resulted from the green revolution, which refers broadly to the science-based innovations in crop breeding and farming practices, with roots dating from the 1940s, that transformed global agriculture during the second half of the last century. •Agronomist Norman Borlaug is often referred to as the Father of the Green Revolution for his early scientific work in Mexico on developing semidwarfdisease resistant wheat. •Many of similar projects were supported by the Rockefeller and the Ford Foundations. •As shown by the following several figures, East Asia has done well in adopting modern crop varieites(MVs) while sub-Saharan African lagged behind.

WELFARE IMPLICATION OF TARIFF

•When Home country is small with no negotiating power, domestic consumers will bear all of the burden of tariff (recall "tax incidence"). •If domestic consumers refused to bear the burden of tariff, foreign producers could simply choose not to sell to Home market (which is small so not very important) and sell to other markets instead. •The gains to domestic producers and government are transferred from domestic consumers. But this transfer is not efficient and part of it is lost (deadweight loss). •When government collects tariff and protects domestic producers, it also causes production and consumption inefficiency (deadweight loss) •Another example of inefficient transfer: holiday gifts •When you spend $100 dollar to buy a holiday gift for your friend, the true value of this gift to your friend is likely to be less than $100 for many reasons (maybe your friend is not long interested in this gift or already has one). •Economists estimated that holiday gift exchanges could generate huge deadweight loss. •Cash or gift cards are more efficient as your friends can use then to buy what they need.

WHY DO COUNTRIES ERECT TRADE BARRIERS?

•When a country is large: term of trade gain •This part is beyond our textbook, but will be covered by the quizzes and exams. I only explain the intuition without drawing new diagrams. •A small country cannot influence the world price, so all the gains to domestic producers and tariff revenue come from domestic consumers who pay higher prices. •When Home country is large, however, Home can press Foreign to lower the world price. So a large Home is not longer a price-taker, but a price-maker. •For example, the before tariff world price of a product is $10. When Home levies a $2 tariff, foreign firms will shift completely the $2 tariff onto Home consumers if Home is small. If Home is large, however, foreign firms may be willing to share some burden of the tariff, for example, by charging only $11 in Home market, in afraid of losing the large Home's market if they raised the price to $12. After turning in $2 to Home government as tariff, foreign firms only have $9 left, which is the new lower world price (< $10 world price before tariff). We call this a term of trade gain (because it is now cheaper to buy foreign goods at the lower world price). When the term of trade gain is bigger than the deadweight loss, Home may have a net welfare gain. •This is why a large country may have incentive to levy a tariff. •However, if both Home and Foreign are large and they both erect tariffs for terms of trade gains, then none of them will gain because the tariff wars will cancel out each other's gain. This is why countries sign trade agreements to prevent trade wars.

PROBLEMS WITH IMPORT-SUBSTITUTION

•Where these instruments have been geared to protect import-substitution industries, they typically impose heavy costs on consumers, discourage exports (limiting import capacity), induce excessively capital-intensive investments, discourage backward linkages, promote political rent-seeking activity in lieu of competitive market adjustments, and ultimately lead to arrested growth (or stoppage of economic growth). •To induce domestic entrepreneurs to commit capital to new industries, there may well be a need for some form of protection, but it should be used selectively to support infant industries that show clear promise of growing up and becoming competitive. •Not all developing countries, of course, have the capacity to intervene so judiciously. In any case, once competitive production is within reach, no further protection is justified.

HOW TO IMPROVE AID EFFECTIVENESS

•improving the selection of countries •Paul Collier & David Dollar: "poverty-efficient" allocation of aid in which funding would be provided to the poorest countries with relatively stronger policies and institutions to maximize the impact of aid on global poverty reduction. •having more recipient participation to partially alleviate the principal-agent problem •increasing coordination among all donors •basing aid on results

•By definition, foreign aid consists of grants or subsidized loans, falling into one of the following main categories:

•official development assistance (ODA) •concessional assistance: carry at least 25% below-market terms •private voluntary assistance (PVA), such as Bill & Melinda Gates Foundation

THE MOTIVATIONS FOR AID •Five distinct objectives:

•to support foreign policy and political alliances, •to raise income levels and reduce poverty •to impact country size •to strengthen commercial ties •to reward newly democratic countries