Introduction to the International Political Economy Frederick University 2013

The subject of IPE IPE is concerned with the ways in which political forces (states, institutions, individuals) shape the systems through which economic interactions are expressed, and the effects that economic interactions have upon political structures and outcomes.

The scope of IPE International trade policies International finance International economic integration The process and problems of globalization

The main economic problems and the international trade theory Main economic problems: Efficiency in allocation Efficiency in motivation Efficiency in distribution How international trade flows contribute to: efficiency in allocation, in motivation, and in distribution of scarce resources domestically and world- wide.

The main economic questions of the international trade theory Efficiency in allocation - what goods are traded internationally and what are the fundamental laws that govern the international allocation of resources and the flow of trade? - How international trade contributes to rational utilisation of resources world-wide? Efficiency in motivation - at what prices are the goods and services exchanged, or what are the terms of trade? - How international trade is related to the efficient use of scarce resources? Efficiency in distribution - what are the gains from trade and where do they come from? How are these gains divided among the trading countries? - What is the impact of international trade in equitable distribution world-wide?

Why do nations trade? The mercantilist answer: Gold (money) is the immanent form of wealth The amount of gold is fixed in the short run More gold can be earned through exports Protectionist policies contribute to the growth of the national economy

Why do nations trade? Adam Smith’s answer: Specialization raises labor productivity A higher productivity creates an absolute advantage in production and trade Free trade makes both parties better-off

Why do nations (people exchange)? David Ricardo’s answer: Specialization is based not on absolute but on relative productivity Exchange is based on comparative advantages

Comparative Advantage – an Example Robinson can catch 12 birds or 5 fish per day. Friday can catch 16 birds or 10 fish per day Robinson’s opportunity costs of catching 5 fish are 12 birds; the opportunity cost of catching 1 fish is 12/5 = 2,4 birds Friday’s opportunity costs of catching 10 fish are 16 birds; the opportunity cost of catching 1 fish is 16/10 = 1,6 birds. Friday has a lower opportunity cost in fishing. Friday has a comparative advantage in fishing.

Comparative Advantage Robinson’s opportunity costs of catching 12 birds are 5 fish; the opportunity cost of catching 1 bird is 5/12 = 0,42 fish Friday’s opportunity costs of catching 16 birds are 10 fish; the opportunity cost of catching 1 bird is 10/16 = 0,62 fish. Robinson has a lower opportunity cost in hunting. Robinson has a comparative advantage in hunting.

Absolute and Comparative Advantage Having an absolute advantage – being able to do something with less resources than someone else Having a comparative advantage – being able to do something at a lower opportunity cost

Why do nations (people exchange)? David Ricardo’s answer: Specialization is based on relative productivity Comparative advantages in production and trade expand production possibilities of both parties and make them better of Arbitrage tends to equalize prices in the world economy Gains from trade are enjoyed under the conditions of free trade

Arbitrage and speculation P Q Oz widget market D S P Oz Q Oz P Q Zo widget market D S P Zo Q Zo Demand shifts to Zo market Supply shifts to Oz market Shifts in Supply and Demand until price differences are eliminated exports imports

The Gains from trade Oz widget market P Q D S P o= 4 a b No trade: Oz price = 4; Q = 30 consumer surplus = a producer surplus = b Q o = 30 P w = 2 4 a c d e Trade: world price = 2; Q o = 16, Q imports = 28, Q = 44 Consumer surplus = a+d+e Producer surplus = c } Imports = 28 Q o =16Q = 44 Local consumer's extra gains = d+e Local producer’s extra gains = -d

The Gains from trade Zo widget market P Q D S P z = 1.5 Q z = 60 No trade: P = 1.5; Q = 60 Consumer surplus = f Producer surplus = g f g D S P = 2 } Exports = h i j Trade: P = 2; Q = 78 Consumer surplus = h = f – i Producer surplus = g + i + j g Zo consumer’s extra gain = -i Producer’s extra gains = i + j 1.5

The Gains from trade Oz consumers Oz producers Zo consumers Zo producers Surplus before trade ac + dh + ig Surplus after trade d + e + a chg + i + j Total: + e + j

Why do nations trade? The factor endowment model – Heckscher-Ohlin theory Differences in relative factor endowments of nations Differences in relative price levels Differences in the pattern of factor intensities Product prices equalize in both trading parties and they both gain from trade Different effects on different groups engaged in factor abundant and factor intensive industries

International Trade and International Investment International Good Movements vs. International Factor Movements Intraindustry Trade - Stefan Linder ‘s theory – greater trade between the nations with similar levels of income