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International Economics Revision Notes

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International Economics Revision Revision

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INTERNATIONAL ECONOMICS MT2010 TUTORIAL 1 - POSITIVE AND NORMATIVE TRADE THEORY UNDER PERFECT COMPETITION Tutorial 1


Why do countries trade?
o Countries trade because they can reach a higher indifference curve through specialisation
 World production will unambiguously increase
 All countries will 'win' o Ricardo - comparative advantage - countries trade in goods which they have a lower opportunity cost. Focus on comparative advantage not absolute advantage so that countries can specialise o Why do countries have a comparative advantage?
 Not clear
 Technology should be quite easily transferable


Heckscher-Ohlin theorem - capital abundant countries will export capital intensive goods etc


Rybczynski theorem - increase in endowment of one factor increases the output of that factor
- PPF skewed outward when growth


Price equalisation - if UK starts importing labour intensive goods from China, price of labour intensive goods will decrease in the UK and vice versa in China (demand stays the same)


Stolper-Samuelson theorem - factor price equalisation - wages are a mark up of prices


Leontief paradox - forgot about human capital 'Trade policy and economic welfare' Corden 1997


3 stages of thought o Benefits from completely free trade came to be appreciated o Argument for tariffs o The link between the case for free trade and the case for laissez- faire was broken


Theory of domestic distortions -restores argument for free trade, though always subject to some exceptions


'upon positive theory rests normative theory - the theory of policy'


'the foundation of the normative theory is the familiar argument that countries can mutually gain from trade' o Given certain assumptions, free trade is optimal


The theory of domestic divergences: o A simple model o Figure 1 o DD' is domestic demand curve o PP' is foreign supply curve for imports o GG' is supply curve of domestic importcompeting producers o If no intervention, domestic production is OA, demand is OB, AB is imports o o o Then, marginal divergence between private and social cost (justifies government intervention)
- GG' can be regarded as indicating the marginal private cost of production. HH' is marginal social cost of production (external economies - below GG')
 OB is socially desirable level of consumption
 MSC of production = MC of imports at output OC (> actual output in absence of intervention so intervention is required)
 Subsidy of PS per unit/ad valorem rate PS/OP

Output would increase, price received by producers increases MPC becomes CJ Total subsidy cost = PSJL Consumers still pay OP From a social point of view, pure income distribution effects either cancel out or are costlessly offset


Social cost = AKLC


Social gain is KNL
 Or, tariff at rate SP/OP


Increase domestic price to OS


Increase production to OC


Decrease consumption to OB' (imports decrease to CB')


Production (or protection) effect = that of a subsidy o Social gain = KNL o BUT, also a consumption effect - LOSS o Social costs and benefits no longer equal o 'tariff would impose a new divergence between private and social cost in the process of offsetting an existing divergence'
 By product distortion
 Loss FEQ could be greater than KNL


Therefore subsidy preferable to tariff If a divergence (between marginal private and marginal social costs/benefits) is caused by government policy = DISTORTION Partial equilibrium model described above is very simplified, perhaps even naive Consumption divergence o E.g. oil - external diseconomy - private and social valuations diverge o Figure 2 o Social valuation curve (RR') to the left of the private demand curve (DD')
 Social optimum consumption = OB'
 First best policy = tax on consumption at rate PS/OP (for imports and domestic producers)
 If just tariff on imports - by product distortion (extra output cost ANJC would replace imports that only cost ANLC therefore excess cost If marginal divergence in domestic production (social cost < private cost) o Production subsidy is first best, tariff is second best (but by product distortion) o Optimum second best tariff rate = PP*/OP 2 sector general equilibrium model shown in Appendix 2.1 Home market bias -subsidise development of manufacturing without encouraging export o 3 product model:
 Xa - agricultural product exported and consumed domestically
 Xm - manufactured product
 Mm - manufactured imported and also produced domestically
 No intervention - Xa production too high and Xm and Mm too low
 Could subsidise manufactures equal to rate of external economies financed by nondistorting tax - optimum output


Or tax agricultural production (exports of X a would decrease, exports of Xm would increase, imports of Mm would decrease)

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