International Economics International Economics: Trade Theory and Policy WS 2013/14 Christen/Leiter/Pfaffermayr Lecture: Mo. 8:30-11:00, HS3 Proseminar: see Syllabus Page 1

International Economics Literature van Marrewijk, Ch. (2012), International Economics, Oxford University Press, 2 nd ed. Chapters from Parts I, II and III Additional material will be covered in the Proseminar Page 2

International Economics Includes all the material covered in the course (lecture plus proseminar). A positive grade in the PS is a necessity. Course grade is an ECTS-weighted average of exam and PS. An example of an exam plus some examples of exam questions are provided in OLAT. Three final exams per semester. Lecture: 70.0% Two short essays. You can choose from three topics. Proseminar: 30.0% Three short questions.. Exam and Grading Page 3

International Economics Determinants of trade and industry structure of an open economy in the long run. The welfare effects and distributional consequences (factor incomes) of worldwide globalization and trade liberalization. Labor market effects of trade and foreign direct investment. Trade Policy: Instruments and their welfare effects The impact and the welfare effects of regional trade agreements Questions addressed in trade theory and policy I Page 4

International Economics Structural change and trade liberalization: Should European countries protect e.g. their textile industries? ‘Are our wages set in Beijing?’: The impact of trade with low wage countries on low skilled workers’ wages in Europe. Why do trade volumes grow faster than GDP? What can we expect from the multilateral trade liberalization efforts of WTO? The impact of a bilateral Trade Agreements, e.g., between EU and US? Questions addressed in trade theory and policy II Page 5

International Economics Study Guide: Stephan Schueller and Daniel Ottens Oxford University Press Krugman, Paul R., Maurice Obstfeld and Marc J. Melitz: International Economics, Theory and Policy, Pearson, 9th ed., Feenstra Robert C. and Alan M. Taylor, International Economics: International Edition, Worth Publishers, 2nd ed., 2011 Further literature cited in these two books, especially papers in the academic journals Literature and Resources I Page 6

International Economics FIW: WIFO: WIIW: WTO: EU: WITS: CEPII: UNCTAD: GTAP: Feeenstra: Literature and Resources II Page 7

International Economics p. 4: „International economics is what international economists do,…, you will only know about intern- ational economics, once you have studied it your- self“. „…I think that an important distinguishing cha- racteristic is the general equilibrium nature of this approach.“ This forces us to be precise and complete in our explanations. Chapter 1: The World Economy – Some Stylized Facts Page 8

International Economics Figure 1.1 Angus Maddison ( ) * The portrait was painted by Carla Rodenburg in I am grateful to Angus Maddison for his permission to use this painting.  Angus Maddison Page 9

International Economics The economic size (power?) of a nation is best measured in terms of the total value of goods and services produced in a certain time period. Other measures of size such as land area and population are weakly correlated with economic size – look at Russia, China, India, Brazil on the one hand, and on the European Countries on the other hand. Chap. 1.2 and 1.3: Page 10

International Economics 1.Accurate data from the statistical offices in national currency (Maddison in our case). 2.Decide to look at GNP or GDP GDP + net receipts of factor income = GNP GDP…market value of goods and services produced by labor and property located in a country. GNP… market value of goods and services produced by labor and property of the nationals of a country. 3. Use the same currency ($): current US $ or PPP. A size comparison across open countries needs three steps: Page 11

International Economics The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of GDP. Fig 1.2: GDP and GNP, 2008 ($ billion) Page 12

International Economics Comparing income in current $ tends to overestimate the differences between high and low income countries ( i) Tradable goods are subject to international competition so that the prices of such tradable goods tend to be equal when measured in the same currency. (ii) Within a country producers of tradable and non-tradable goods compete for same resources (labor) so that the wage rate in each country reflects labor productivity. (iii) Across countries differences in productivity in the non-tradable sectors tend to be smaller than in the tradable sectors. In current $, the value of output tends to be under- estimated in low-income countries. Purchasing Power Parity (PPP) Page 13

International Economics Example: based on the current exchange rate Cost of hair cut in the US: 10$ Cost of hair cut in Tansania: 1$ So the same service is priced differently: the value of production in US is overestimated by a factor 10! United Nation income comparison project (ICP) collects price data on goods and services in all countries of the world and calculates PPP comparing prices in local currencies. P $ =P TZS E $/TZS => implied PPP: Purchasing Power Parity (PPP)-continued Page 14

International Economics Figure 1.3: Gross domestic product, 2008; top 15, ranked according to PPP Page 15

International Economics Trade flows can readily compared using exchange rates. We distinguish merchandise trade and trade in commercial services. Stylized facts 2008 (see for more recent evidence): China has been the largest merchandize trade exporter, followed by Germany and US. US share in world exports is just 8.5%. Many countries have a larger share in world exports than in world production (country size matters!). 1.5 International Trade Page 16

International Economics The difference between exports and imports (trade balance) is more pronounced than the difference between GDP and GNP, but relative to the size of imports and exports the difference is small. In 2008 China had the largest trade surplus in goods and services (349 bn $) followed by Germany (228 bn $). US has the largest trade deficit (696 bn $). In relative terms Brunei is the largest net exporter and Ethiopia the largest net-importer. Trade openness is defined as the ratio of exports +imports to production. For Singapore this ratio is more than 234%. Exports Relative to Imports Page 17

International Economics The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of exports. Figure 1.4: Exports and imports of goods and services, 2008 ($ billion) Page 18

International Economics Figure 1.5: Relative exports of goods and services, 2008 (% of GDP) Page 19

International Economics Figure 1.6: Taxes on international trade Page 20

International Economics Globalization defined by Neary (2002): The increased interdependence of national economies; trend towards greater integration of goods, labor and capital markets. Globalization and Income: Income statistics based on Maddison’s work (in 1990 international Dollars (corrected for PPP, ensure transitivity, base country invariance and additivity). Logarithmic scale (level and growth). Big increase in GDP per capita in 1820 (industrial revolution). Two waves of globalization: second half of 19 th century and after WW2. New institutional setting after WW2: income per capita +3% p.a., world income +5% p.a., world trade flows +8%.p.a. 1.6 Globalization Page 21

International Economics Figure 1.7: Development of world per capita income over the last 2000 years Page 22

International Economics Figure 1.8: Two waves of globalization in trade Page 23

International Economics Globalization and capital: Two similar waves of globalization in the capital markets. Sharp increase in capital mobility since the 1960thies. Globalization and migration: Two modern waves of migration: : 40 millions migrants mainly form Europe to US, Canada, South America and Australia, young and mainly low skilled workers. After WW2 (not yet ended): Since the 1990thies the source countries are now mainly Asian and Eastern European countries. Many countries have quotas to restrict inward migration. Labor markets are less globally integrated than goods and capital markets. 1.6 Globalization (continued) Page 24

International Economics Figure 1.9: Foreign capital stocks, assets / world GDP Page 25

International Economics Figure 1.10: Relative migration flows, Western Europe and Western Offshoots Page 26

International Economics 1.7: Some Stylized Facts for Austria Page 27

International Economics 1.7: Some Stylized Facts for Austria Page 28

International Economics Austria‘s most important trading partners (exports in 2009) 1.7: Some Stylized Facts for Austria Page 29

International Economics 1.7: Some Stylized Facts for Austria Austria‘s FDI Position Page 30

Chapter 3 Classical Trade: Technology International Economics Page 31

International Economics Page 32 Overview Ricardian (classical) model Technology differences between countries are the driving force behind international trade flows Relative (or comparative) differences are crucial, not absolute differences Absolute differences are important for determining a country’s wage rates and welfare level The production possibility frontier summarizes the state of technology and the available factors of production in final goods space Trade flows increase welfare (technology gains from trade)

International Economics Page 33 David Ricardo ( ) “When a country can either import a commodity or produce it at home, it compares the cost of producing at home with the cost of procuring from abroad; if the latter is less than the first, it imports.”

International Economics Page 34 Assumptions of the Ricardian technology model Two countries(EU and Kenya) Two final goods(Food and Chemicals) One factor of production(Labour) Constant returns to scale production functions Perfect competition Labour is mobile between sectors, but not between countries. Costless trade in final goods (no impediments to trade) Technology as reflected by labor productivity differs between countries General (example)

International Economics Page 35 Technology differences between countries Production technology is summarized in a productivity table: Labour units required to produce one unit of output FoodChemicals EU28 Kenya424 The EU technology is more productive for both goods The EU has an absolute advantage in Food production: it requires less labour (2 units instead of 4) The EU also has an absolute advantage in Chemicals production: it requires less labour (8 units instead of 24)

International Economics Page 36 Comparative advantage: productivity method Labour units required to produce one unit of output FoodChemicals EU28 Kenya424 The EU is twice as productive in the Food sector (4/2 = 2) The EU is three times as productive in the Chemicals sector (24/8 = 3), so The EU has a comparative advantage in Chemicals, and Kenya has a comparative advantage in Food

International Economics Page 37 An extra unit of Chemicals needs 8 units of labor in the EU This labor could have made 8/2 = 4 units of Food; the opportunity cost of Chemicals production in the EU is 4 Food. An extra unit of Chemicals in Kenya needs 24 labor This labor could have made 24/4 = 6 units of Food; the opportunity cost of Chemicals production in Kenya is 6 Food Comparative advantage: opportunity cost method Labour units required to produce one unit of output FoodChemicals EU28 Kenya424 The EU has a comparative advantage in Chemicals, Kenya in Food

International Economics Page 38 The ppf is a straight line in the Ricardian model Labour units required to produce one unit of output FoodChemicals EU28 Kenya424 Suppose the EU has 200 units of labour available and Kenya has 120 units available (remember: it is just an example) If all workers in the EU produce only Food, the EU can make 200/2 = 100 Food (and 0 Chemicals) If all workers in the EU produce only Chemicals, the EU can make 200/8 = 25 Chemicals (and 0 Food) Similarly, if all workers in Kenya produce Food total output is 120/4 = 30 Food (and 0 Chemicals); if they all produce Chemicals total output is 120/24 = 5 Chemicals (and 0 Food)

International Economics Page 39 Definition: all possible combinations of efficient production points of final goods, given the available factors of production and the state of technology; Note that: It is a technical specification: the ppf does not depend on the type of market competition The ppf depends on the available factors of production: if, e.g., more labour becomes available more goods can be produced The ppf depends on the state of technology: if new techniques become available, output increases with the same use of inputs Production possibility frontier (ppf)

International Economics Page 40 Production possibility frontiers The EU can produce (0 Chemicals, 100 Food) or (20 Chemicals, 0 Food), or any combination in between Kenya can produce (0 Chemicals, 30 Food) or (5 Chemicals, 0 Food), or any combination in between

International Economics Page 41 Production in the EU ; p C /p F = relative price of Chemicals Producer maximizing profits in this setting is equivalent to maximizing total revenue, given the final goods price ratio p C /p F Food Chemicals EU If p C /p F is low, this implies only production of Food Pr EU slope = - p C /p F

International Economics Page 42 Production in the EU ; p C /p F = relative price of Chemicals Producer maximizing profits in this setting is equivalent to maximizing total revenue, given the final goods price ratio p C /p F Food Chemicals EU If p C /p F is high, this implies only production of Chemicals Pr EU

International Economics Page 43 Production in the EU ; p C /p F = relative price of Chemicals Producer maximizing profits in this setting is equivalent to maximizing total revenue, given the final goods price ratio p C /p F Food Chemicals EU If p C /p F is equal to the slope of the ppf, production can be anywhere along the ppf (to be determined by other factors) Under Autarky it must hold that p C /p F is equal to the slope of the ppf.

International Economics Page 44 Gains form Trade Relative to autarky trade increases the rel. price of chemicals in the EU (exporter) and decrease it in Kenya (importer). Consumption can be extended in both trading partners (gains form trade).

International Economics Page 45 Value of consumption =Value of production, trade is balanced in each country. Product prices are determined at the World market equating world demand =world supply. Marginal rate of substitution of consumers = P C /P F. Wages have to adjust according to productivity in each country. Due to lower wages food producers of Kenya (holding the comparative advantage) are competitive on the world market. Equilibirum

International Economics Page 46 Some empirical evidence Figure 3.5 Kenya–EU exports and productivity, various sectors

International Economics Page 47 Some empirical evidence - continued The Balassa index Exports of 28 manufacturing sectors for the member of OECD countries Reference country is the group of all OECD countries Observe high values for countries with a smaller industrial base such as Italy and Finland. Observe the persistence of comparative advantages.

International Economics Page 48 Some empirical evidence - continued Figure 3.7 Highest Balassa index, selected countries

International Economics Page 49 Some empirical evidence - continued Figure 3.7 Highest Balassa index, selected countries

International Economics Page 50 Concluding remarks, Ricardian (classical) model Technological differences between countries are the classical driving force for international trade flows. Only comparative costs, not absolute costs, are important for determining the direction of trade flows. Absolute costs are important for determining a country’s welfare level. Allowing for more countries and more goods is easy, allowing for more than one factor of production is not (see neoclassical model).

International Economics Page 51 Production Structure Chapter 4

International Economics Page 52 Overview Production Structure The neoclassical model focuses on differences in relative factor endowments as a cause for international trade flows. The main contributors are Eli Heckscher, Bertil Ohlin, and Paul Samuelson: it is therefore referred to as the HOS model. This chapter reviews the production structure of the model. Neoclassical production functions with two inputs and constant returns to scale. Optimizing economic agents, taking prices as given. The impact of technology differences is analyzed in Chapter 3, we therefore assume identical technology from now on.

International Economics Page 53 Paul Samuelson (1915–2009) “Funeral by funeral, theory advances”

International Economics Page 54 Assumptions of the neoclassical (HOS) model Two countries(Austria and Bolivia) Two final goods(Food and Manufactures) Two factors of production(Capital and Labour) Constant returns to scale production functions Perfect competition in all markets Capital and Labor is mobile between sectors, but not between countries Costless trade in final goods (no impediments to trade) Identical production technology in the two countries No factor-intensity reversal Identical homothetic tastes in the two countries Countries differ in their (relative) factor endowments General (example)

International Economics Page 55 Main results of the neoclassical (HOS) model The HOS model derives 4 main propositions in Chapters 5-7: Factor Price Equalization: Trade in goods (which equalizes final goods prices) leads to the equalization of factor prices. Stolper-Samuelson theorem: An increase in the price of a final good increases the (real) reward to the factor used intensively in the production of that good and reduces the (real) reward to the other factor of production. Rybczynski theorem: An increase in the quantity of a factor of production, at constant final goods prices, leads to an increase in the production of the good using that factor intensively and a decreased production of the other good. Heckscher-Ohlin theorem: A country will export the final good which makes relatively intensive use of the relatively abundant factor of production.

International Economics Page 56 Neoclassical production functions Characteristics of our neoclassical production functions Two inputs: capital (K) and labour (L) Substitutability: a given output level can be produced using different combinations of inputs, i.e. the use of one input can be substituted for the use of another input Positive marginal product: if more capital or more labour is used output increases Diminishing marginal product: given the use of capital, an increase in the use of labour leads to ever smaller increases in output (similarly for capital) Constant returns to scale: an increase in the use of both inputs by z% also leads to an increase in output of z%

International Economics Page 57 capital owners labourers consumers production manufactures production food producers capital services (rental income) labour services (wage income) delivery of food (spending (1-  m ) on food) delivery of manufactures (spending  m on manufactures) direction of goods and services flows (direction of money flows) Structure of the equilibrium

International Economics Page 58 Production functions: substitutability and isoquant Let M be the output of Manufactures, K m the input of capital, L m the input of labour and  m a capital intensity parameter (0 <  m < 1); this is a possible production function: Capital Labour The figure on the left depicts an isoquant for this function; note the substitutability between capital and labour isoquant

International Economics Page 59 M=0.7 Production is constant returns to scale (CRS) At point A 1 production M = 1 Capital Labour M=1 A1A1 A2A2 B2B2 B1B1 Reducing inputs by 30% leads to point A 2 CRS implies at point A 2 production M = 0.7 Similarly for points B 1 and B 2 Conclusion: isoquant M = 0.7 is a radial blow-up of isoquant M = D 0.3 D D

International Economics Page 60 Profit maximization: two-step procedure Producer profits = revenue – production costs Maximizing profits is a two-step procedure First, given how much you want to produce: minimize production costs Second: determine the optimal output level

International Economics Page 61 Cost minimization Suppose you want to produce M=1 at minimum cost taking wage rate w and rental rate r as given Total cost = wL m + rK m, a straight line in (labour, capital) space with slope = - w/r Capital Labour Minimum costs are achieved at a point of tangency between the isocost line and the isoquant; point A, using K capital and L labour M=1 slope = -w/r L K A

International Economics Page 62 Constant returns to scale and production costs Under constant returns to scale (CRS) the isoquants are radial blow-ups of one another Minimizing production costs is now simple: First, we determine the cost-minimizing input combination for producing one unit of output, say K and L Second, determine the output level, say z units. Proportionally adjust the unit inputs to produce z output, so using: zK and zL Under CRS: total cost = (per unit cost)  output

International Economics Page 63 Profit maximization, CRS, and perfect competition Profits = [price – (per unit cost)]  output There are three possibilities price < unit cost:  optimal output level = 0, no profit price = unit cost:  optimal output level undetermined (can be determined by other factors); profit level = 0 price > unit cost:  optimal output level = infinite, profit level is infinite  not possible in economic equilibrium Conclusion: CRS + perfect competition implies: price  unit cost output > 0price = unit costs

International Economics Page 64 Impact of a fall in the wage rate The figure shows the cost- minimizing input combination at point A for the ratio w 0 /r Suppose the wage rate falls to w 1 ; rotates the isocost line Capital Labour Minimum costs are now achieved at point B with a lower capital/labor ratio M=1 slope = -w 0 /r A slope = -w 1 /r B K/L 0 K/L 1

International Economics Page 65 Food production with lower capital intensity The figure shows the cost- minimizing input combination at point A for M=1 and w/r Suppose Food production has a lower capital-intensity parameter:  F <  M Capital Labour For the same w/r minimum costs for Food production are at point B with a lower capital/labour ratio M=1 A K/L M slope = -w/r K/L F F=1 B

International Economics Page 66 Empirical Evidence Figure 4.4 Capital stock per worker×1000 $; 1990 in 1985 $

International Economics Page 67 Empirical Evidence – continued

International Economics Page 68 Concluding remarks Production Structure The neoclassical (HOS) model explains trade flows based on differences in relative factor abundance The HOS model derives 4 main propositions Production uses 2 inputs (substitution between inputs) under constant returns to scale (CRS) The cost-minimizing input combination depends on: –The capital-intensity parameter(  ) –The wage-rental ratio (w/r) With CRS and perfect competition: –if a good is produced price = unit production costs