ECON 314 Midterm 2

Heckscher-Ohlin Model

-prices determined by preferences and scarcity -A.k.a "neoclassical model" -created to incorporate factor endowments as basis of comparative advantage

Trade Share

-shows the share of that regions exports as a percentage of total world exports -Increasing trade share means it has faster export growth that rest of world -East asia has highest share and south asia and sub-saharan africa least

CPE Complexity and coordination

-supply and demand was often balanced by using previously achieved levels, which made accommodation of structural shifts difficult -Sectoral ministries made adjustments to help balance supply and demand, though this often involved compromises to productivity -Parallel activities regulated in gray markets helped mitigate shortages. -Continuous downward quality adjustments helped meet quotas. -Initially, growth in many CPEs was high and the above strategies helped to preserve the system -Shortages, inferior quality, and stagnant living standards eventually led to the collapse of Communist-bloc economic regimes.

Factor endowments

-the amount of land, labor, and capital a country has available for production -MEDCs will specialize in capital goods b/c that's where they have comparative advantage in (vice versa for LEDCs)

Consumer surplus

-the difference between what consumers are willing to pay (demand curve) and what the actually pay (market price) -Imposing the tariff creates a loss of consumer surplus b/c of increased market price

Collective action failure

-when individuals don't take an action that is in their interest b/c they can free-ride if this action is taken by others -The cost to any single consumer who tries to organize other consumers is much larger than the individual gain from free trade. If other consumers organize a lobbying effort, then an individual consumer can benefit from those efforts without contributing any effort. Individual consumers therefore have no incentive to incur lobbying costs and remain disorganized -Because there is less collective action failure amongst import and export sectors--politicians only react to lobbying from both sectors when making decisions about trade liberalization

Ratchet effect

-when you produce at under capacity to rig plan for the next period -Arises when there is repetitive interaction, asymmetric info, and a lack of commitment to the pre-established scheme

Why import/export sectors are less likely to face collective action failure

1) larger benefits to each sector from lobbying (2) easier to organize themselves b/c they are fewer in numbers than consumers

Three General Forms of Market Failure

1. The market cannot function properly or no market exists 2. The market exists but implies inefficient resource allocation 3. More expansively: the market produces undesirable results as measured by social objectives other than the allocation of resources ◦ Often items such as more equal income distribution, and "merit goods"such as health, are treated as separate rationales for policy, outside of economic efficiency

GATT

-Before WTO -ended 1995 (thats when it switched to WTO) -153 member countries

Why are LEDCs more prone to export price risks than MEDCs?

(1) Primary commodities are more likely to experience price fluctuations (2) LEDCs tend to have less diversified exports ■ Richer countries produce & export more diverse goods than poorer ones ■ More diversified export portfolio ⇒ less export price risks ● Diversification allows to have a "safety net" to fall back on

Two explanations for comparative advantage (Models)

(1) Ricardo model (2) Heckscher-Ohlin model

3 types of perverse incentives:

(1) Success indicator problem (2) Ratchet effect (3) Soft-budget constraints

Pros of multilateral trade

(1) avoids trade diversion (2) politically easier to achieve

Why should the government intervene with market failure?

(1) deal with inefficiencies (2) equity reasons

What are the roles of development planning?

(1) to address market failures -Prices that do not reflect the scarcity of goods; sending wrong signal (2) resource mobilization and allocation -Not enough people doing education now that will be able to serve the needs of firms/sectors in a few years -Do investment now so future economy will work better (intertemporal investment) (3) Attitudinal or psychological impact -Encouragement of where country is going; guidance from govt (4) Requirement to receive foreign aid -A lot of LEDCs will receive foreign aid, so it's important they have a plan and know what to do with it -Planning allows them to spend money in ways that will achieve growth

Welfare loss

(1) triangle ACE: loss from entry of inefficient firms (2) triangle DBF: loss in consumer surplus

Financial Convertibility

-Capital account convertibility -a.k.a. capital account convertibility -Flows of capital in and out of a country are unrestricted -Anybody can buy/sell the domestic currencies against foreign ones without any restrictions -If gov't doesn't allow capital to be mobile there can be financial repression -full financial convertibility can lead to bank runs

WTO & non-discrimination

-Cannot have different trade rules for different exporting countries (MFN: most favored nation clause) -Same treatment of all products in the domestic market (national treatment clause) i. If a country grants a favor to another country in terms of trade, it must extend that favor to all other countries ii. This is called the Most favored nation clause iii. Also, once imported good is in domestic market it must be treated like domestic products-- this is called National Treatment Clause-- this helps account for non-tariff barriers -Prevents reductions in tariffs remaining only bilateral

Terms of Trade

-A country's terms of trade measure the evolution of the prices of its exports relative to the prices of its imports. When terms of trade are volatile, it is a sign that countries face significant export price risk in world markets. A high export price risk means volatile export revenues and thus a high export revenue risk. -The percentage ratio of the export price index to the corresponding import price index is measured relative to the base year.

Voluntary export restraints

-A gov't may decide to limit exports to a certain country out of fear of being hit by import quotas from that country to which its goods are exported -WTO has limited us of voluntary export restraints

Sectoral ministry

-A ministry is a governmental organization, headed by a minister, that is meant to manage a specific sector of public administration.

Lange

-Argued that mathematical economics and programming could signal scarcity -

Hayek

-Argues that the modern economy is too complex to obtain enough info to plan it clearly -In a market economy, there is no need to obtain info, you just need to look at prices to get all the information you need -No need for central information

Patterns of Trade

-Comparative advantage explains patterns of intl trade -LEDCs specializing in primary commodities reflects their comparative advantage -Labor is the main input in production, agriculture is labor-intensive -Examples: coffee in Brazil, rice in Vietnam, gold in South Africa, labor-intensive manufacturing in China -Meanwhile, MEDCs move towards capital-intensive production -Mechanization and robotization of production -Examples: car industry, pharmaceuticals, baking industry (ATMs, not clerks) -successful exporters start with labor and/or resource intensive products and manufacturers, but as capital accumulates they diversify into more sophisticated manufactured products.

in hierarchies

-Cooperation is coordinated by a "planner." -Through most of the 20th century, economies planned through hierarchies were thought by some to be effective solutions to the coordination problem (Centrally Planned Economies orCPE).

Fixed Exchange Regime

-Currency Board

Theory of Comparative Advantage

-David Ricardo (1772-1823) -explains how economies benefit from trade through specialization and, therefore, greater efficiency. -Free trade leads to specialization and greater efficiency ⇒ increases welfare for all countries involved -Exchange is beneficial to all parties in the exchange -It provides one of the best explanation for which patterns of trade will emerge between diff countries

Relative factor endowments

-Determines was a country should specialize in -Are the capacities of a country in terms of its main production factors: capital and labor -More capital in rich countries -More labor in poor countries

Exchange-rate policies in developing countries

-Different countries have different currencies ⇒ trade requires exchange rates -Exchange rate b/w currencies of two countries can affect trade b/w them -Exchange rates can be manipulated to fix balance of payment issues -In general, a "lower" or "weaker" exchange rate tends to encourage exports and discourage imports, and a "higher" or "stronger" currency hurts exports and promotes imports.

Nature of development planning

-Economic policy to control private economic activity according to social objectives formulated by government -Needs mobilization of public investment -Must control private economic activity for a social objective -This is decided by the govt

Floating Exchange Rate

-Exchange rate set by supply and demand -Floating ER varies daily -ER will adjust on its own -Value of a currency rises (appreciates) when there is more demand for it -A bit more complicated IRL b/c forex market has more than two currencies

Winners and losers in international trade

-Export sectors that exploit a countrys comparative advantage are clear winners -Sectors that must compete with imports are hurt -Those working in export sector support trade liberalization but those working in import sector, like banking, oppose it

Currency Board

-Extreme example of fixed exchange rate -Allows a countrys central bank to print the local currency only in proportion to the amount of foreign reserves that come in

Types of Convertibility

-Financial -Trade

ER Volatility

-Large, sudden depreciation or appreciation in exchange rates is harmful to exporters and it complicates price and output management.

Export Diversification

-Makes specialization less risky -hard to sustain so mostly only Rich countries can afford to diversify their trade

How do countries coordinate economic activity?

-Markets -Hierarchies -All economies have elements of both (mixed economies), but different systems tend to emphasize one or the other.

Central Planning Debate

-Marx insisted central planning of economic activity would insure that the fruits of labor would go to workers and prevent depressions. Lenin thought central coordination would be more efficient. -Central planning of economic activity would allow the benefits of labor actually go to the laborers (workers) -This would prevent depression -Very popular idea in the 20th century

Trade Convertibility

-Means that importers and exporters are free from restrictions on exchanging the proceeds of trade from one currency into another -Current Account Convertibility -Profits from trading can be converted into different currencies -No trade convertibility ⇒ no trade benefits -Value of imports must equal value of exports -Communist countries had no trade convertibility -Economists say trade convertibility is necessary but not necessarily financial convertibility for developing countries

Import Tariffs

-Most common form of protectionism -taxes on imports -Encourage inefficient domestic production and discourage demand for cheaper foreign goods -i.e. China imposes a tariff on Japanese DVD players -Price of imported DVD players = their cost + cost of tariff

WTO Two Basic Principles

-Non Discrimination -Reciprocity

PPF

-Production Possibility Frontier -The maximum you can produce of one good for a given quantity of another good -flatter ppf = higher opportunity cost -two dimensional-graph in terms of output production -in autarky, the PPF is the budget constraint -a country maximizes its utility subject to a the budget constraint.

Import Quotas

-Quotas limit the total volume of imports to a country at a given moment in time -Gov't can implement them through the allocation of the licenses required to import goods from abroad -Keeps price of imported goods high, which protects domestic industries

Work Behavior (central planning)

-Shortages were also common in the labor market, especially at the end of the production cycle. This gave excess bargaining power to workers. -Hard to change workers' behavior b/c they have job protection (occurs with constraints) -in a seller's market for workers firms had to offer incentives to attract workers and were hesitant to fire poor performers. -Minimal worker discipline - high absenteeism and poor service -Centralized wages were crucial for central planning. When wage autonomy was given to firms, however, scarce labor generated wage inflation.

Ricardo Model

-prices dependent on the total labor costs -based on difference in labor costs in diff sectors -prices are only a function of the total labor costs of a product

Pegging

-The fixed exchange rate a developing country chooses is linked a particular currency -If a country pegs its currency to the dollar, and dollar falls relative to the euro and the yen, the currency of that country will also depreciate relative to those currencies -IMF used to tell LEDCs that they should keep a fixed ER -Done by pegging their currency to another major one, like the USD -Fixing currency of LEDCs to a strong currency -Currency will move in the same way as the one it is pegged to -Pegging creates stable price extentations

Fixed exchange rates

-The price of a country's currency remains fixed in terms of other currency(/ies) -When the supply of a currency is not equal to demand, the central bank intervenes by selling or buying reserves of foreign currencies as needed to keep exchange rates fixed. -Lose control over money supply

Regulatory barriers

-This is a form of protectionism that has been used more frequently over time and it can be difficult to detect -Govts issue domestic regulations that have the effect of limiting imports -Like specifications for product standards -Not easy to detects -US FDA rules leads to decline of food imports from Asia -U.S subsidies on cotton farms hurts international cotton trade

"give and take"

-Trade liberalization as a series of "give and take" interactions b/w lobbying groups -i.e US will allow more manufacturing exports from China if China allows the US banking industry enter into its local economy -Politicians view trade lib as give and take between lobbying groups -Not always most efficient -Unilateral trade liberalization does not take place for political reasons even when it has the potential to increase overall economic welfare in a country

Trade Specialization and Export Price Risk

-Trade specialization is sometimes risky. Columbia's dominance in coffee leaves it vulnerable to price fluctuations.Steep price falls are especially dangerous. -Developing economies are more prone to such risk: Primary commodity prices are especially volatile, but export diversification in small developing economies is usually low.

Pattern of Export Specialization for Developing countries

-Traditionally developing countries specialized in primary good but the trend is that they're beginning to produce more manufactured goods (especially in Asia)

Russian Revolution in 1917

-Was an agricultural economy, attempted to evolve its economy and starting in the 20s starts to shut itself off from the world. In the rest of the world you had the Great Depression. Russia was able to change their economy from agriculture to industrialized within a very short period of time (about 30 years). During WW2 they had a number of machines in which they used to fight. This quick change impressed many

Labor-discipline campaigns

-Were generally ineffective. Because of the necessity of plan fulfillment, employers had little incentive for reporting indiscipline.

WTO

-World Trade Organization -Main role is for multilateral negotiations, but also helps implement agreements (rules), settle trade disputes, and enforce compliance. -Practices discrimination -Reciprocity

Markets

-agents conduct transactions at at "arms length" -Market forces are the pillar of the capitalist system.

Centralized wages

-are important for a planned economy -Not a lot of ways to discipline workers ⇒ ineffective labor-discipline campaigns

Primary goal of central planning

-economic development -Managers were given various commands for procurement and production, which often generated strong perverse incentives

Soft-budget constraints

-fulfill production quotas but give up financial integrity -Govt will not close firms regardless of losses it incurs -too big to fail, sunk costs in construction, defense contracting, etc.)

Neoclassical model (look at graph)

-has a PPF -without international trade (autarky), production in each country is determined at the tangency point (point A) between the PPF and an indifference curve (determined by domestic demand preferences). -with trade at the world relative price ratio, domestic production is at point B and consumption is at point C, a higher level of utility in each country. -Trade is indicated by trade triangles: for each country exports are given by line BD and imports by BC.

regional trade agreements

-held between a subset of countries -promotes wasteful trade diversion

Multilateral Trade Negotiations

-held between multiple countries -Multiple rounds held beginning in 1947 when GATT was created -GATT was replaced by WTO -enlarges the set of possible exchanges

Bank runs

-i.e East Asian crisis -A situation in which a bank's customers make massive withdrawals of their deposits, usually causing the bank to close because it cannot satisfy these demands for deposit withdrawal

Argument against WTO

-it promotes agendas of rich countries

Trade Openness

-measured as the share of exports to GDP -An increasing share of exports over GDP is interpreted as increasing openness because it means that exports grow faster than GDP -Openness has increased since rise of globalization--more so in developing countries and developed

Plan-fulfillment bonus system

-meet production targets by lowering the quality -manger's pay flat below 100% of plan fulfillment. By fulfilling a plan, the manager receive a large lump sum bonus with linear increases to that bonus for fulfilment above 100% - Manager receives more money (lump sm) with increases of production above 100% -Incentive to produce more steel -An indicator can be very tricky when fulfilling an incentive -i.e. production is measured in weight, but to meet the production weight, producers may make steel heavier (different quality of steel) rather than making more steel -Another example: producing larger sheets of glass (but making them thinner)

Non-tariff barriers

-often more insidious than tariffs because they are less visible but just as harmful. 1. Import quotas 2. Voluntary export restraints 3. Regulatory barriers

The Planning Mystique

-people do not like any aspect of a planned economy -This is false, some aspects of planning are important, especially to achieve economic growth -A comprehensive development policy framework can play an important role in accelerating growth and reducing poverty

The evolution of world trade (basic trends)

1. The share of exports in GDP has trended up for developed countries but even more so for developing countries 2. This trend hides a large heterogeneity among developing countries; while exports of east asian countries have gone up spectacularly, exports form Africa and Middle east have grown more slowly than the rest of the world 3. The pattern of export specialization by developing countries is changing over time

Two main points of Comparative Advantage

1. exchange is beneficial to all 2. there are advantages to specialization

Volatility in the terms of trade

Good measure of export price risk.

Total cost of production

Hours of production, not cost

Benefits of Specialization

International trade says countries should specialize in those areas in which they have a comparative advantage relative to other nations

absolute advantage

Lower total cost of production in total

Protectionism

Occurs when a country puts in place barriers to international trade in order to protect its domestic industries. These barriers aim at reducing the volume of imports as a means to guarantee those industries large shares of domestic markets

Vertical Integration

Practice where a single entity controls the entire process of a product, from the raw materials to distribution

Comparative advantage

Producing a good with lower opportunity cost

Hoarding Demand

Rather than release particular workers when demand for its products falls, a firm may retain them so as to be in a position to expand production again quickly when demand picks up.

Force substitution

Substitute available inputs for those in shortage

ER Conclusion

a floating ER is better for MEDCs, fixed is better for LEDCs

Trade Diversion

inefficient trade flows that would not exist under full multilateral trade liberalization.

Three types of global trade negotiations

a) bilateral trade negotiations b) multilateral trade negotiations c) regional trade agreements

Von Mises

absence of a pricing system means scarcity cannot be identified

Specialization

doing a job using skills you excel at

Bilateral Trade Negotiations

held between two countries -often result of trade diversion

WTO Reciprocity

i. If a country reduces its trade barriers, other countries must reciprocate ii. Concessions from one country must be matched by concessions from others iii. This helps solve the incentive to raise tariffs in order to attract capital to a country

Autarky

no free trade

Political economy of trade liberalization

the conflicts b/w sectors and firms that become winners and losers due to trade liberalization

Opportunity Cost

the cost of production one good over another

Exchange rate (ER)

the price of a country's currency in terms of another currency

Globalization

things we use were produced abroad for domestic consumption ○ Not everyone benefits from globalization; there are some losers

Subsidies

used to resist imports or encourage exports. The U.S. subsidizes cotton industry exports.

Success indicator problem

when the measure of success is an inaccurate measure of performance

Central Planning and Shortage

• common problems in CPEs were the mismatch of supply and demand, inferior quality, and a limited assortment of products (often too much demand and not enough supply) • Shortage was cumulative but production was not -excess demand was more frequent than excess supply

Financial Repression

■ Govt making domestic returns to capital very low ■ Low returns on deposits means people will spend more -There will be underdevelopment of the financial sector because low returns on capital discourage its development

Decrease of volatility?

■ Reflects greater diversification due to stronger manufacturing exports ■ Reduced share of primary commodities in exports

Private sector in mixed economies include:

■ Subsistence sector ■ Small scale businesses ■ Medium size enterprise ■ Larger domestic firms ■ Large joint or foreign owned firms

Economic Behavior under shortage

○ Force substitution : substitute inputs that are in shortage with available ones ■ Maintain a direct "pusher" relationship w/ suppliers ○ Expectations of future shortages led to hoarding demand ■ This made the shortage worse in the short run -Barters and grey-market transactions were technically illegal but tolerated for the purpose of fulfilling plan goals -Black-market transactions were also illegal. They generated rival profit and harmed the fulfillment of plans. Black markets ware very prevalent in command economies -Ratchet effect, output volatility, and soft budgets led to firm-level investment biased toward increasing capacity rather than productivity

East Asian Financial Crisis

○ Large capital inflows into East Asian countries from 1970s to 1990s due to strong economic growth ○ Capital flight happened in 1997 when East Asian countries liberalized capital markets, leading to widespread decline in GPA ■ Made worse by huge Thai foreign debt and IMF prescribing countries to increase their IR ○ East Asian crisis didn't affect China b/c it never had financial mobility ■ Could not speculate against Chinese currency

Financial crises

○ Often triggered by macroeconomic mismanagement ⇒ capital mobility forces disciplines b/c bad management gets punished ○ Consequences of financial crises can be very bad ■ 2001 Argentinian bank run , when a lot of customers want to withdraw deposits from banks, but banks cannot satisfy these demands and so shut down ○ Countries keep foreign reserves to protect against speculative attacks