Midterm Review Econ 335

Large Nation Model

- A tariff may increase national welfare when imposed by an importing nation large enough so that changes in its quantity of imports influence world price - This large nation status applies to U.S., a large importer of autos, steel, oil & consumer electronics as well as to Japan, and the European Union

A small nation - tariff effects on nation's WELFARE

- Consumer surplus falls Additional tax revenues Benefits domestic producers Wastes resources - Revenue effect Government's collections of duty Redistributive effect Transfer of consumer surplus to domestic producers - Protective effect Loss to domestic economy from wasted resources used to produce autos at increasing unit costs - Consumption effect Decrease in consumption resulting from tariff artificially increasing price - Deadweight loss Protective effect and consumption effect combine to create deadweight loss of tariff

If tariff on finished product is LESS If tariff on finished product EXCEEDS

- If tariff on finished product is less than tariff on imported input Effective rate of protection is less than nominal tariff (may even be negative) Tariff protects domestic suppliers of raw materials more than domestic manufacturers - If tariff on finished product exceeds tariff on imported input Effective tariff exceeds nominal tariff

Principle of Comparative Advantage Simplified model; assumptions:

1. World consists of 2 nations and 2 goods. 2. Labor, fully employed & homogenous, is sole input. 3. Labor can move freely only within nation. 4. Technology fixed for both nations; all firms within nation utilize common production methods. 5. Costs proportional to amount of labor used and do not vary with level of production. 6. Perfect competition prevails in all markets; firms are price takers; products are identical. 7. Free trade occurs between nations; no barriers. 8. Transportation costs zero, so consumers don't care whether domestically produced or imported. 9. Firms make production decisions attempting to maximize profits; consumers maximize satisfaction. 10. No money illusion; consumers and firms take account of all prices in their decisions. 11. Trade is balanced (exports pay for imports), implying no money flows between nations.

Tariff

A tax (duty) levied on a product when it crosses national boundaries Import tariff Tax levied on an imported product Most common; called a customs duty Export tariff Tax imposed on an exported product Less common; illegal under U.S. Constitution Commonly used by developing nations

Trading Under Constant-Cost Conditions: A. Trade triangle for a country B. Trade Triangle

A. Exports - along horizontal axis Imports - along vertical axis Terms of trade equal to slope B. Denotes country's exports, imports, and terms of trade Same for both countries

Autarky

Absence of trade Specialization and trade result in production gains

International Trade: Opportunity or Threat to Workers International trade

Aligns domestic prices with international prices Wages increase for workers whose skills are scarce Wages decrease for workers who face increased competition Jobs lost in one industry replaced by jobs gained in other industries

Specific-factors theory

Analyzes the income distribution effects of trade in the short term, when resources are immobile among industries Resources specific to import-competing industries lose as a result of trade Resources specific to export industries gain as a result of trade

Why Nations Trade? Absolute Advantage

Assumption: Production costs differ among nations due to different productivities of factor inputs Absolute Cost Advantage Countries that use less labor to produce one unit of output Labor theory of value - assumes that within a nation, labor is the only factor of production

International Trade: Opportunity or Threat to Workers? International trade benefits many but not all workers

Cheaper consumer goods Employers - better technologies/equipment Workers - more productive Exports - jobs and income for domestic workers Cheap imports - rising unemployment Hurts unskilled workers in import-competing industries

Principle of Absolute Advantage

Consider two-nation, two-product world Each nation produces a good absolutely more efficiently than its trading partner With trade and specialization Countries export goods - if have absolute cost advantage Countries import goods - if have absolute cost disadvantage

Criticisms of Mercantilism

David Hume's price-specie-flow doctrine A favorable trade balance is possible only in short run Adam Smith, The Wealth of Nations (1776) World's wealth is not a fixed quantity International trade increases general level of productivity within a country as well as increases world output

Factor-endowment theory: Capital/Labor Ratio

Determines comparative advantage A country exports a good that uses a large amount of its relatively abundant resource A country imports a good that uses a large amount of its relatively scarce resource

Effect of resource endowments on comparative advantage

Difference in relative resource endowments -> difference in relative resource prices -> difference in relative product prices -> Pattern of Competitive Advantage

International Trade: Opportunity or Threat to Workers? The long-run effect of trade barriers

Does not increase total domestic employment Reallocates workers Away from export industries Toward less efficient, import-competing industries Leads to less efficient utilization of resources

Dynamic gains from international trade

Effect of trade on country's growth rate and volume of additional resources made available to, or utilized by, trading country Dwarf static gains from trade

Principle of Comparative Advantage

Emphasizes relative cost differences based on opportunity costs; the basis for trade Trade is possible even if a nation has an absolute cost disadvantage in production of both goods The more efficient nation Specializes and exports goods in which it is relatively more efficient or where its absolute advantage is greatest The less efficient nation Specializes and exports the good in which it is relatively less inefficient or where its absolute disadvantage is least

Trade is a zero-sum activity

False; both partners gain from trade

Fallacies: "Tariffs, quotas, and other import restrictions will save jobs and promote a higher level of employment"

False; fails to recognize that a reduction in imports does not occur in isolation

Fallacies: "Imports reduce employment and burden the economy, while exports promote growth and employment"

False; source of fallacy is failure to consider link between imports and exports

Wassily Leontief: 1st attempt to test factor-endowment theory empirically

Given: U.S. has relatively abundant capital, relatively scarce labor According to theory, U.S. will: Export capital-intensive goods Import-competing goods will be labor intensive Leontief tested capital/labor ratios for 200 export industries & import-competing industries in U.S. in 1947

Factor Endowments as a Source of Comparative Advantage: Heckscher & Ohlin

Heckscher & Ohlin formulated theory to answer these questions - the factor-endowment theory (Heckscher-Ohlin theory): Immediate basis for trade is difference between pre-trade relative product prices of trading nations. Pre-trade relative prices in turn depend on production possibilities curves and tastes and preferences (demand conditions) in trading countries

Large Nation Model If e > (b + d) If e = (b + d) If e < (b + d)

If e > (b + d) National welfare is increased If e = (b + d) National welfare remains constant If e < (b + d) National welfare is diminished

The factor-endowment theory:

Immediate basis for trade is difference between pre-trade relative product prices of trading nations. Assumption: technology and demand are approximately the same between countries Production possibilities curves depend on technology and resource endowments

Small Nation Model

Imports very small portion of world market supply; unable to impact market price Is a price taker, facing constant world prices for products it imports Tariff effects Raises home price of imported good by full amount of duty Results in higher domestic production & PS Lowers domestic consumption & decreases CS

Fallacies: Fallacies: Free trade

Increases competition, lowers prices Makes better products available to consumers Results in higher consumption

International Trade: Opportunity or Threat to Workers? International trade

Just another kind of technology Adds value to inputs

Leontief paradox

Leontief's findings: Capital/labor ratio for U.S. exports lower than that of it's import-competing industries Concluded that exports were less capital-intensive than import-competing goods Findings contradicted predictions of the factor-endowment theory: Leontief paradox

Protective effect (Area "b")

Loss to domestic economy Wasted resources used to produce additional goods at increasing unit costs Less efficient domestic production replaces more efficient foreign production Loss of welfare

Dynamic gains from international trade INCLUDE

More efficient use of an economy's resources Higher output and income More saving, more investment Higher rate of economic growth Higher productivity Economies of large-scale production Increased competition

Effective Rate of Protection

Nominal and Effective tariff rates

Why is Globalization Important?

Open economies More competition, which lowers prices More firm turnover Improvements for industry Economic growth rates - closely related to Openness to trade Education Communications infrastructure

Large Nation Model : U.S. imposes tariff on automobile imports

Prices increase for American consumers Quantity demanded decreases If significant enough - forces Japanese firms to reduce prices of their exports Effect shared between U.S. consumers, who pay higher price, and Japanese firms, which receive lower price than under free trade Difference between these prices is tariff duty Terms of trade improve for U.S. at expense of Japan

The Mercantilists, 1500-1800

Promoted a favorable trade balance by encouraging exports and discouraging imports Sought rise in domestic output and employment Advocated government regulation of trade (tariffs, quotas, other commercial policies) Held static view of world economy

Deadweight loss of tariff (Area "b+d")

Protective effect Consumption effect

Terms of Trade

Rate at which country's export product is traded for other country's export product Defines relative prices of the two products

Large Nation Model Letters/ Economic effects of an import tariff

Redistributive effect From domestic consumers to domestic producers Deadweight loss Consumption effect Protective effect Revenue effect Domestic revenue effect Terms-of-trade effect

Consumption effect (Area "d")

Residual not accounted for elsewhere Loss of welfare arises from Increased price Lower consumption

Constant opportunity costs

Straight line production possibilities schedules Factors of production perfect substitutes, and all units of a factor are of same quality

Revenue Effect (Area "c")

The government's collection of duties calculated as quantity of imports times tariff rate Loss of consumer surplus - transferred to government

What is most important fallacies of trade?

Trade is a zero-sum activity"

Arguments for Trade Restrictions: Infant-Industry Argument

Trading nations temporarily shield their newly developing industries from foreign competition However, once a protective tariff is imposed - very difficult to remove Special-interest groups - convince policy makers that further protection is justified Hard to determine which industries will realize comparative advantage potential in long-run Not valid for mature, industrialized nations Alternatives may include providing subsidy to domestic industry in place of tariffs

Redistributive Effect (Area "a")

Transfer of consumer surplus to domestic producers of import-competing product Transfer of income from consumers to producers

Specific-factors theory depends on

consumption product labor

Effective Rate of Protection: Effective tariff rate (e) calculated as:

e= (n-ab) / (1-a) e = effective rate of protection n = nominal tariff rate on final product a = ratio of value of the imported input to value of finished product b = nominal tariff rate on imported input

Specific factors:

factors that cannot move easily from one industry to another Workers acquire skills for specific occupations, not easily transferable to other industries

Effective Rate of Protection: Nominal tariff rate

rate published in country's tariff schedule Applies to value of finished product

Effective Rate of Protection: Effective tariff rate

takes into account not only nominal tariff on finished good but any tariff applied to imported inputs Ex: If Dell manufacturers desktops assembled elsewhere, and finished desktop enters U.S. at a zero tariff rate, but imported components used in desktop production are taxed, then Dell is taxed instead of protected

Factor-endowment theory does not explain..

two-way trade nor why wealthy countries with similar endowments trade more intensively than countries with different endowments