Topic 1 The richardian model

Absolute advantage: best technology for produce good

Comparative advantage: compare to another good (opportunity cost)
Main idae:
-benefit from trade by specializing in the production of those goods they do relatively best
-trade them for other goods in the international market
Ricardian model:
Difference: labor productivity, labor number.
Labor can move between industries, not countries
first lesson: pattern of trade is determined by comparative advantage
second lesson: gains from trade for both countries
Home country
MPLC=2. MPLW=4

Foreign country
MPLC=1. MPLW=1

Advantage advantage
Competitive advantage in wheat (opportunity cost
MPLC=2. MPLW=4
Relative price P
Before trade

Competitive advantage in cloth

Production possibility frontier (PPF): budget constraint, straight line, assume the MPL
are constant constant slope
PPF slope = -

MPL(C )
MPL(W ) =-1/2 (OPPORTUNITITY COST OF WHEAT, PRICE)

Before trade

Real wage (wheat)= MPLW=1

Real wage (cloth)= MPLC=1

Indifference curve: preference

no-trade (autarky) equilibrium: point A
perfect competition: relative price of cloth = opportunity cost of cloth
Change in price
Opportunity cost of wheat: home country 1/2 , foreign country 1.
Home country exports wheat, Q in home country falls, P increases
Foreign country import wheat, Q in foreign country increases, P decreases
Price between 1/2 and 1, assume 2/3.
`
Price of international market for wheat 2/3
Supply of wheat

the terms of trade: price of export/price of import

higher, the better off
Change in wage
wage: W=P*MPL
PW*MPLW=PC*
Real wage (wheat)= W/PW=(PW*MPLW)/PW=MPLW=4 wheat
Real wage (cloth)= W/Pc=(Pc*MPLc)/Pc=(PW*MPLW)/Pc = MPLc=2 cloth
After trade
real wage (wheat)= W/PW=(PW*MPLW)/PW=MPLW=4
real wage (cloth)= W/Pc=(PW*MPLW)/Pc=2/3*4=8/3 (increase)

After trade
real wage (wheat)= W/PW=(Pc*MPLc)/PW=3/2 wheat
real wage (cloth)= W/Pc=(Pc*MPLc)/Pc=MPLC=1 cloth
lower productivity - lower wage - sell competitive price
although low than home country, still higher than before
other ways to increase wages:
-technology and productivity increase
e.g. China and India per capital income increase
higher productivity, higher wages

relative price of wheat increases, can buy more cloth. iu

wage in home country is 2-4 times higher
Change in production

2
4
P(W ) MPL(W )
3
=
>1
P(C ) MPL(C)
2
wage in wheat> wage in cloth, fully specialized in wheat
change in consumption
relative price of wheat =2/3 (1/2 before) -- opportunity cost of wheat 2/3 1 unit of
wheat exchange to 2/3 unit of cloth more than before

consumption possibility

Trade equilibrium
Relative price of each good is the same
Amount of each good countries want to trade is equal
gains from trade:
-higher consumption possibilities
-higher indifference curve
Patterns of trade

homes export and imports are equal when valued in the same unit

Lecture 2 SR model: The specific-factors model: gains and losses from trade
Ricardian model:
gains from trade for a country as a whole
only one factor of production (productivity)
patterns of trade
cross-country wage differentials and the evolution of wages
fails to:
distributional effects of trade within a country
determine winners and losers
specific-factors model (land is specific to agriculture, capital is specific to manufacturers):
explain who gains and who loses from trade (since relative price changes).
Overall gain: benefits exceed the losses
-true in SR, but not LR;
-Richard is LR
Model assumption:
Manufacture: workers+ capital
Agriculture: workers + land
Earnings of Specific factor (fixed): e.g. land, capital. More sensitive since stuck in the SR
Earnings of mobile factor: offset losses by seeking employment in other industries

PPF (concave): slope=

MPL( A)
P( A)
MPL( M ) = P (M )

(opportunity cost of manufacturing = relative price of manufacturing)

From A to B: more in manufactures, MPL(A) increases, MPL(M) decreases, steeper slope

W=MPLM*PM= MPLA*PA
Home country
Capital intensive
Before trade: lower relative price to manufacture goods
After trade: higher manufacture price in home, lower than foreign

Foreign country
Labor intensive
Before trade: lower relative price to manufacture goods
After trade: higher manufacture price in home, lower than foreign

Before trade:
Production constraint
No trade: Production =consumption =A

After trade:

low price of manufacture, export manufacturer, import agriculture, relative price of manufacture
increases. Slope is steeper.
Overall gain from trade: U2-U1
production: B
consumption: C
Effect on the wage: assume price of manufactures increases, price of agriculture doesnt
change. Wage increase. The same result assume price of agriculture decreases.
Effect on real wage:

L(M)+L(A)= total workers, no unemployment

Nominal wage increase

Labor demand: More workers, MPL decreases, lower wage, downward sloping
Equal wage interception equilibrium wage + allocation of workers.
Wage is higher for both industry.
More workers in M, less workers in A
Nominal wage: PA <W<PM
Real wage:
W/P(A): increase
W/P(M): W<P*MPLM, real wage decreases in terms of manufacture.
ambiguous effect
Depends on consumption pattern:
spends most money on manufacture worse off
spend on agriculture better off
Unemployment: trade adjustment assistance (TAA), no unemployment
unemployment is the macro phenomena affected by business cycle (temporary)
find new jobs in export industry (depend on labour market, labour skills)
Real life: trade leads to unemployment for import industry
Earnings of capital and land
manufacture price increase,
wage in manufacture increases,
labor shift from agriculture to manufacture,
MPK(m) increases, MPK(a) decreases
Rental calculation:
1.

2. R(capital)=P(m)*MPK(m), P(m) increases, and more workers in manufacturing, MPK(m)

increases, Rental increases.
For P(m), real rental = R(capital)/P(m)=MPK(m)
For P(a), RK increased while PA fixed. Thus, RK/PA .

Earning of land:
R(land)=P(a)*MPK(a), As MPTA and PA remains unchanged, RT and the real land rental,
RT/PA falls.
for P(a), real rental on land in terms of agricultural products has decreasedlandowners cannot
buy as much agricultural products (for ex. food)
for P(m) As PM has increased, landowners cannot buy as much of the manufactured good
either.
General equation:
e.g. Pm increases by 10%, Pa unchanged
nominal wage increase 5%
capital rental incease 17.5%
land rental decrease 5%

General result:
International trade
increase in the relative price of an industrys output
specific factors in export industries gain, increase the real rental earned by the factor specific to that industry
specific factors in importing industries lose: decrease the real rental of factors specific to other industries.
Mobile factors (such as labor) : offset losses from changes in relative prices by seeking employment in other sectors and so changes in wages are less extreme.

Why price in countries are different without trade:

1. productivity
2. resources

Topic 3 Heckscher-Ohlin Theorem

Specific factors model:
+ effects of trade on the distribution of income within a country
- cant help predict patterns of trade
ricardian model:
+ predictions about patterns of trade (export high productivity goods)
- high predict of productive specialization across countries
H-O model:
Factor endowments patterns of trade
Distribution effects of trade
Main idea:
export goods use intensively the factors in which the country is relatively abundant
import goods use intensively the factors in which the country is relatively scarce
Model
2 goods: computer (capital intensive KC/LC>KS/LS) and shoes (labor intensive KC/LC<KS/LS). only proportion.
2 factors: capital and labor

shoe industry is labor intensive: for same rental, shoes hire more workers, larger demand

10

Assumptions:
Only want to see factor difference influence on trade
factors move freely between industries, wage and rental are the same between industries
full employment/capital condition
same consumers
in reality: reversal of factor intensities( factor intensive is different from countries)

Home country
abundant in capital (more capital per unit of labor)
Before trade

Foreign country
abundant in labor (more labor per unit of capital)

home country: capital intensive --low opportunity cost of computers -- low relative
price of computers flat slope
home country, bias to production of computers

foreign country: labor intensive high opportunity cost of computers high relative
price of computers steep slope
home produce more computers and fewer shoes export computers

After trade:

After trade:

11

consumption line
consume at consumption C, produce at point B
trade triangle: triangle connects points B and C

trade triangle:
same dimension as home country (same height and width)

Pattern of trade:
Move along PPF
Home country exports computers, the good that uses their abundant factor of
production intensively capital.
Effects of trade on factor prices
More larbors and capital in computer industry.
relative demand: weighted average of the labor-capital ratio in each industry

demand for labor: capital proportion * labour intensitive

if one industry has larger share, overall relative demand closer to that sector

12

overall relative demand to labour, lie in between

not in the middle
vertical line: relative supply.
Equilibrium wage to capital: point A.
After trade:
Relative price to computer increases produce more computers shift more
capital and labors to computer industry more capital proportion -- shift overall
relative labor demand to computer industry (red line) wage/rental decreases
-- labor is cheaper (shift to capital intensive, relatively more labor leave shoe
industry unemployment -- go to computer industry wage reduces
- lower wage, use more workers in computer industry, higher L/K
- lower wage, use more workers in shoe industry, higher L/K

13

Nominal rental decreases

Real rental
-L/K increases, MPK increases (MPK in both shoe and computer increases), real
rental increases
relative price of computer increases
Wage
nominal wage decreases
Real wage
Computer industry: L/K increases, MPLC decreases, W=MPLC*PC
Shoe industry: lose capital, lose more labours, L/K increase, MPL S decreases,
real W=MPLS*PS
Workers are worse off
e.g.
before trade:
computers: sale revenue = 100, earning of labor = 50
earning of capital = 50 (higher relative shares, capital intensive)
shoes: sale revenue = 100
earning of labor = 60, earning of capital = 40
after trade:
relative change in wage: decrease by 40%
relative change in rental: increase by 60%

an increase in PC:
and decrease in PC

magnification effect:
trade change relative price larger change in factors

The Stolper-Samuelson theorem:

In the longrun, increase in relative price of a good
increase real earnings of the factor
--decrease the real earnings of the other factor

14

application: opinions toward free trade

In the SR, industry related to answer. E.g. import or export industry
In the LR, industry is in not important. Factor of production can move. People can move to another industry.
Depend on skill of worker. E.g. education, wage.
Workers with lower education, against free trade (import)
Higher education, welcome free trade (export)
Testing
Testing the H-O theorem: Leontiefs paradox
Capital and labor to produce 1 million import and export
Input output tables (no information about input), only for US, since assume technologies are the same

the U.S. is labor abundant

exports is capital-intensive.
Reasons:
1. different technology
2. land abundance (other factors)
3.skilled and unskilled labors (adjust abor productivity)
4. data before world war
5. trade is not free
Extending the Heckscher- Ohlin Model
1. more than 2 goods, 2 factors and 2 countries
2. technologies are different--- different productivity
1. factor intensity: factor content of trade ( exports and imports)
factor content of net export = factor content of export- factor content of import

15

both the labor and capital contents of net exports were positive for US
trade surplus
net exporter in capital: capital intensive
Measure the factor abundance
compare countrys share of that factor with its share of the world GDP
share of a factor of countrys GDP > share of countrys GDP/world GDP, the country is abundant in that factor

labor
country GDP >

country GDP
world GDP

2. technologies are different--- different productivity

Adjust any factors of production
Effective factor of endowment: actual factor endowment * the factor productivity
e.g. effective labor force: no. of labors* productivity

laborproductivity
>
country GDP

country GDP
world GDP

if the country is abundant in one factor, the share of GDP is larger than share of country GDP
New version of H-O test: sign test
If a country is abundant in an effective factor, then the factors content in net export should be positive.

effective capital > its share of world GDP

16

capital in export sector> capital in import sector

pass the test: the US is capital abundant
labor < its share of world GDP (after adjustment, labor > share, use wage as productivity)
labor in export sector > capital in import sector
pass the test: the US is labor abundant
no paradox in US pattern of trade
HO is good model

Topic 4 International movement of labor and capital between countries

Movement of labour
SR equilibrium (specific factor model, fixed factor.)
2 industries: manufacturing and agriculture
manufacruging: K+L
agriculture: T+L

foreign equilibrium wage < home equilibrium wage

migrate

LR equilibrium (HO model, all factors can be adjusted)

2 industries: shoes (labor internsiive) and computers (capital intensive)
2 factors: labor and capital
can move between industries

determination of real wage and real rental:

slope: capital-labor ratio wage- rental ratio MPL/MPK ratio
computer line is steeper

After trade

17

more workers ariculture shift to rightnominal wage drops more workers

real wage: lower, assume price is the same
sending country: wage increases

Both labor and capital increase in shoe industry

Capital-labor ratio unchanged
Marginal products are unchanged
Wages and rentals are unchanged
In the LR, capital can move freely, immigration has no impact on the wage and rental
rates

- land and capital rentals

more workers in each industry -- MPK, MPT increases, both rental on capital
and land increase.

No change

effect on industry output

18

PPF: increase more in shoes output

Production: shoes production increase, computer decreases

S
S
S
S

PPF can be more in one good after trade

Relative price unchanged
In the SR, wage decreases
Capital and land owners benefit
Overall production increase
Rybczynski Theorem:
In HO model (two goods and two factors)
Increase in one factor
Increase the output of industry intensive in that factor
Decrease the output in another industry
Factor price intensitivity
In HO model (2 goods and 2 factors)
Increase in one factor
Absorb by changing outputs of industries
Without change in price
Further consideration:
Foreign and home workers are complements
e.g. high and low skilled labors
good in different aspects

Foreign direct investment (FDI)

19

Greenfield FDI: build a plant in foreign country

Reason:
-save on trade and transportation costs
-close to markets (export platform)
-low labor and manufacturing cost
SR equilibrium (specific factor model)

more capital, MPL increases

wage increases
more labor in manufacturer, less in agriculture
Effect on rentals
Agriculture: fewer workers, MPT decreases, rental decreases
Manufacturing: more capital and workers, MPK is not sure
Another way: price of manufacture goods no change MPL increases -wage increase -- to breakeven, have to pay less of another factor -- capital
rental decreases
Effect on outputs
Agriculture: land no change, labor decrease, output decrease
Manufacturing: labor and capital increase, output increase

LR equilibrium

effect on factor price:

increase in capital, absorb by capital-intensive industry
capital-labor ratio unchanged marginal product unchanged
wage and rentals unchanged

Increase the output of capital-intensive industry

Decrease labor-intensive industry

20

Gains from migration

skilled migration or brain drain: highly educated workers more allowed

Costs of the brain drain in foreign country:
the "fiscal loss" from the flight of high income earners (Bhagwati and Hamada 1974)
- loss in human capital (Wong and Yip 1999)
- loss of potential positive human capital externalities in productivity (Benhabib and Jovanovic 2007)
Benefits of the brain drain:
- the incentives for human capital formation (higher education) that migration generates (Stark 2004)
- the possibility of return of skilled workers (Kapur and McHale 2006)
- the creation of international networks to channel transfers of knowledge and to stimulate trade (Rauch and Trinidade 2002)

21

Topic 5: increasing returns to scale and imperfect competition

Intra-industry trade
Imperfect competition (monopolistic competition)
Differentiated goods
Economies of scale or increasing returns to scale specialization -- international
trade increases quantity, decreases AC

Inter-industry trade
Perfect competition
Homogeneous goods
Richardian model differences in technology
Heckscher-ohlin model: factor endowments

Monopolistic competition model

22

same products, price differential captures the whole market

differentiated products: price differential curve d (more elastic than D/2 only one firm lower price, increase demand by more than all firms lower price )
charge P2, sell at C, increase demand + take away demand from other firms
-capture more than other firms, but dont capture the whole market
Without trade

With trade
assume home and foreign are exactly the same:
-number of consumers
-technology and cost curves
-number of firms in the no-trade equilibrium

23

starting point A: long run no trade equilibrium

firm number: Na-2Na
customer number: D-2Da
individual demand curve without price differentiation doesnt change firms can keep
original equilibrium A, make zero profit
one firm price differentiation: more competitors more elastic consumers --price
differentiation -- d2 rotate with point A, equilibrium: B, make positive profit
all firm differentiate and charge at P2, new equilibrium: B, loss

24

Have trade

firms make loss in the SR exit N decreases --D/N shifts to the right still more
than non-trade case slope of d3 (flatter than d1, stepper than d3)
no trade: A
have trade: C
Comparison:
LR trade with/without trade comparison
- more firms: 2NT>NA (more variety)
-existing firms produce a higher quantity: Q3>Q1
-lower price: PW<PA (since AC decreases, pass to consumers)
-when all firms lower their prices, some firms exit the market, the remaining firms
expand their output, lowering their average costs through increasing returns to scale.
-gains from trade in the LR:
1. more variety (some local firms exist, but consumers can buy other countries
products)
2. lower price
loss in SR:
adjustment costs in the SR, since local firms are driven out, unemployment in SR

Index of intra-industry trade: how important of the trade

25

IIT=

min ( import , export)

(import+ export)/2

IIT higher, more important intra-industry trade (more difference between import and export more difference the products)
e.g. IIT=100%, an equal amount of the good is imported and exported, IIT is very important
IIT=0%, the good is either imported or exported, but not both
Gravity equation of trade:
Monopolistic competition model + IRS larger countries will tend to trade more
Trade =B

GDP 1GDP2
dist

Border effect (B): factors affect trade (much larger within a country)
-Tariffs
-Quotas
-Geographic: share the common land or not
-Cultural
-Other administrative rules and regulations

Topic 6: foreign outsourcing of goods and services

Trade in intermediate goods (parts of a good), rather than final goods
main idea: produced abroad more cheaply -- imports parts or components -- save production costs
outsourcing: contract out
offshoring/vertical multinationals: subsidy firms
assumption 1: foreign wages for both workers < home, especially cheaper unskilled
W* <W and W* <W W* /W* <W /W
L
L
S
S,
L
S
L
Assumption 2: other costs in foreign location: capital costs, transportation and trade costs.
Assume extra costs apply uniformly across all the activities in the value chain and across all sectors
Outsourcing model: two activities or intermediate inputs
R&D: skilled labor intensively
Components: unskilled labor intensively
Labors are mobile between activities

26

Without outsourcing

With outsourcing

new equilibrium of production: B (more R&D and less component production)

new equilibrium of consumption: C (exports R&D and imports components)
produce more output
gains from outsourcing within the firm
more productive: final goods produced increase: Y1-Y0
more competitive: cost of production decreases -- lower prices
Effect of outsourcing on relative wages
Sign free trade agreement cost of trade decreases (foreign reduces components price)--- easier to outsource shift more activities in the value chain to foreign

More skilled labor intensive in home country

more unskilled labor intensive in foreign country

27

application:
wage and number of skilled labor increase in US and UK, means the demand shift to right
-outsourcing lead to decrease in demand for unskilled labors
-skill-biased technological increase the demand for skilled labor
- increase in relative demand for skilled labor (absolute number will fall for both skilled and unskilled)
-increases the demand for skilled labor in foreign
-after outsourcing, relative wage of skilled increases in both countries
(not occur in HO model)
nonproduction workers = skilled workers
Fall in price of components
Foreign improves its productivity in components fall in price of components -- improve home country terms of trade better off

28

PPF: slope = relative price of components to R&D (marginal cost)

Fall in the price of R&D
Foreign firms engage in more R&D home R&D price decrease -- terms of trade worse home country worse off but still better off than no outsourcing

29

terms of trade (export good price/import goods price) export R&D terms of trade (R&D prices/component price)
R&D reduces -- terms of trade reduces -- selling its export less or pay more for its imports
Final good output Y3 is still higher than output without trade
Outsourcing in service
Skill intensive
Example: customer service of flight, mobile, taxi companies
Firms accounting
Technical assistance computer debugging
Assumption 2 is wrong:
-cost of skilled service activities < cost of outsourcing relatively unskilled manufacturing activities
-communication infrastructure > physical infrastructure
-India has competitive advantages in service activities

Topic 7: Tariffs and quotas under perfect competition

30

Trade policy: government action to influence the amount of international trade

WTO: wprld trade organization
GATT: general agreement on tariffs and trade
1.
2.
3.
4.
5.
6.

most favored nation clause: same tariffs to all trading partners

tariffs respond to dumping
cant limit amount imports, but for exceptional cases
should declare export subsidy
safeguard provision/escape provision: can temporarily raise tariffs if suffer from import competition. E.g. US steel tariff
regiongal trade agreements permitted if imply zero trade barriers. E.g. free teade barieers; customer unions

Tariff: tax on imports

Specific tariff: amount of money per unit imported
Ad-valorem tariff: % on the price of the imported good
Free trade of small country

Pw<PA, import, M1=D1-S1

Pw>Pa, export
Raise in consumer surplus: b+d
Fall in producer surplus: -b
Net effect: d
Import tafiffs for a small country
Before tariff:

Import tafiffs for a large country

Before tariff:

31

home import: M1=D1-S1

After tariff

foreign export: X1=S1-D1

After tariff

tariff export supply curve facing the home country shifts up by t supply is perfectly
elastic (foreign exporters still receive Pw) -- domestic consumers need to pay more
(Pw+t) import reduce from M1 to M2encourages increase domestic supply (S1 to
S2) MC of production increases from Pw to Pw+t domestic price is Pw+t domestic
price equals international price home domestic demand D2M2=D2-S2

less elastic foreign supply foreign suppliers share tariff-- price received by
foreign exporters: Pw reduced to P*-- international and home price: P*+t (increase
less than t) import decreases domestic demand decreases domestic supply
increases

32

fall in consumer surplus: -(a+b+c+d)

rise in producer surplus: +a
rise in government revenue: +c
net effect on home welfare: -(b+d)
b (production loss/efficiency loss): produce from S1 to S2 MC increases MC is more
than world price at Pw oversupply
d (consumption loss): higher price -- quantity consumed reduced from D1 to D2 drop
in consumer surplus
net effect on foreign welfare:0

fall in consumer surplus: -(a+b+c+d)

rise in producer surplus: +a
rise in government revenue: c+e
net effect on home welfare: e-(b+d)
e (Terms of trade gain): drop in import price (Pw-P*) times import tariff paid by
foreign exporters
Effect on foreign welfare: e (terms of trade loss)+f (supply decreases)
Net effect on world welfare: -(b+d)-f

net effect on world welfare: -(b+d)= *t*import

Optimal tariff:
e>b+d, home country better off
maximize increase in welfare for the importing country
Depend on elasticity of foreign export supply: Ex*
Optimal tariff: 1/Ex*
Large importing country: elasticity of foreign export supply decreases foreign
export supply curve is steeper (Ex reduces) higher optimal tariff
small importing country: perfectly elastic -- optimal tariff = 0
problems:
beggar thy neighbor policy --- potential for trade war
allow export country retaliate with tariffs
prevent importers from using optimal tariffs

33

dominant strategy: tariff

nash equilibrium: (tariff, tariff)
solution: multilateral trade agreement to eliminate tariff deal with prisoners
dilemma
Why tariff:
1. increase gov. revenue

2. politics reason
3. tariff can change the world price foreign exporters reduce price good price increases less than tariff tariff is ahred by foreign
exporters -- get welfare benefit for large import country
Import quotas: limit on the amount of goods a country can import
Maltifibre Arrangement (MFA): allow industrialized countries to restrict imports of textile and apparel products from developing countries.
Small importing country

34

Effect of the quota (M2<M1)

Increase in the home price
Reduction in home imports
Equivalent import tariff: t=P2-Pw

area C: quota rents

different ways allocate rents:

35

1. give the quotas to home firms: quota licenses

net effect on home welfare: -(b+d)
same loss as tariff (c captures by gov)
2. auctioning the quota licenses
revenue collected = value of rent
net effect on home welfare: -(b+d)
3. rent seeking
firms engage in inefficient activities
waste of resources (until c)
net effect on home welfare -(b+c+d)
4. voluntary export restraint (VER)
importing country gives authority for implementing the quota to the exporting government VER
net effect on home welfare: -(b+c+d)
foreign exporters get c avoid a tariff or quota war
effects of the VER:
home price increase (more market power)
increase in price due to VER
increase in price due to quality improves
dumpling

Topic 8: trade policy II: export subsidies in agriculture and high-tech industries
Different forms of aid received by farmers:
Export subsidies
Production subsidies
Other domestic farm support programs (loans, purchase of surpluses)
-keep world price low hurts farmers in developing countries
-keep domestic price high hurt domestic consumers
import countries can use countervailing tariffs (retaliatory tariffs): similar to anti-dumping duties
why use subsidy: protect local farmers
-Farmer is the important group
-agriculture is the low income group
Other forms of domestic support:
Tax incentives
Food aid programs
Production subsidies
export subsidy: payment to a firm for every unit exported

36

-specific subsidy: fixed amount

-ad-valorem subsidy: fraction of the sales price
Small exporting country

world market price: Pw, doesnt change

exporter receive price: Pw+s
domestic price: Pw+s
quantity supplied: S2
quantity demanded: D2
home export: X2=S2-D2
Deadweight Loss:

Large exporting country

world market price: P* < Pw

exporters receive the price: P*+s
domestic price: P*+s
quantity supplied: S2
quantity demanded: D2
home export: X2=S2-D2
foreign consumers pay a lower price for Home exports,
home terms of trade fall and foreign terms of trade rise (more export and less import)
Deadweight Loss:

37

DWL similar to effects of tariff

Reduce in demand surplus: a+b
Increase in producer surplus: a+b+c
Government loss: b+c+d
Oversupply MC increases -- Production efficiency loss/production distortion: d
Higher than efficiency price consumers demand less -- Consumption efficiently
loss/consumer distortion: b
Total DWL: b+d
No influence to foreign customers

consumer surplus loss: a+b

producer surplus increases: a+b+c
gov. subsidy cost: b+c+d+e
domestic DWL: b+d+e
(Terms of trade loss to home: -e)
Foreign gains:
Consumer surplus increae: e
Total domestic loss: b+d+e
Total foreign gain: e
Overall world DWL: b+d+f
(f : terms of trade loss in home is not completely offset by a term of trade gain in
foreign)
Inefficient way to transfer gains from trade among countries
Can help directly by giving cash
Does not change free-trade levels of production and consumption in either country
Avoid DWL

Who gains and who loses if eliminate subsidies:

-rise in world price
benefit potential exporters
benefit industrialized countries themselves (DWL and terms of trade loss before)
famers with subsidies before suffer, but can compensate them

38

food importing countries suffer

Agricultural Production subsidy
Small home country
Production subsidy: provide subsidy of s monetary units for every unit that a home firm
produces (not just units exported)
Guarantee minimum price to farmer
Provide subsidy to purchase increase demand price increases

Large home country

Downward sloping foreign import demand curve:

Increase in export under production subsidy is less
the increase in supply lower the world price.
But the drop in world price would be less than the drop for export subsidy

domestic price = world price = Pw

price home producer get: Pw+s
home quantity supplied: S1 to S2 export supply shifts to the right
domestic consumption: D1
exports: X2=S2-D1
new world equilibrium: X2
export subsidy: higher home price quantity demanded decreases greater home
export (export increase because both home demand decreases and supply increases)
shift down the home export supply curve by exactly amount s
production subsidy: same increase in supply constant home price quantity
demanded unchanged export increase less shift down the home supply curve by

39

amount less than s

Welfare effect

home welfare:
Increase in Producer surplus: +(a+b), real supply curve is still the blue
Consumer surplus is unaffected since quantity demanded is unaffected.
Government cost of the subsidy: -(a+b+c)
Net welfare effect on Home: -c
Production subsidy is better than export subsidy to help farmers
Cant use trade barriers to protect labors/unemployment. Better to create more jobs.
Targeting principle/first-best policy: Lower DWL
WTO considers eliminate production subsidies and other forms of domestic support for agriculture than about export subsidies

High tech export subsidies

-spillover benefits (positive externalities) to other areas of the economy
-strategic trade policy: imperfection competition large profits
e.g. subsidies to interest, direct money subsidies
rise price for aircraft
strategic interaction: game theory
No competitive advantage

US has competitive advantage

40

NE: (producing, not producing) or (not producing, producing)

Want to get first mover advantage
Subsidy 25m

NE: (producing, not producing)

Boeing stay in the market
Subsidy 25m

41

NE: (not producing, producing)

Subsidy persuade Boeing not to produce so that Airbus is the only producer
of the super-jumbo
European welfare:
Net gain = 125m-25m = 100m

NE: (procude, producce)

Does not makes Boeing exists as it did in the earlier no-cost-advanatge scenario
Net gain: 20-25 =-5

Topic 9: international trade agreement

Multilateral trade agreement
Most favored nation principle: extend equally to all WTO members

WTO to deal with prisoners dilemma

Regional trade agreement

Preferential trade agreement: eliminate tariffs among themselves, and keep tariffs
against other countries.
1. free trade areas: eliminate tariffs among themselves + keep former tariffs
against other countries.
e.g. NAFTA, ASEAN
2. customs unions: eliminate tariffs among themselves + keep same tariffs
schedule against other countries.
e.g. European Union, Mercosur
Effect on welfare: trade creation and trade division
Trade creation: made for itself before imports from another member country
For importing country: lower price -- gain in consumer surplus
For exporting country: increase sales gain in producer surplus
Trade diversion: export from non-member country export from member country
For importing country: from less efficient producer
Government loses tax revenue
Problems with free trade agreements:
Rule of origin:
-specifies what type of goods can be shipped duty-free within the free trade area
-north American content to qualify duty free access
-members of regional trade agreements might oppose to extending the agreement to
other countries and lose their preferential statues

42

43