“Changing Policy Environment and International Business”

1. “Changing Policy Environment and International Business” Prepared by Vassily K. Dermanov Some theory of international trade

2. International Trade • Buying and selling goods and services from other countries • The purchase of goods and services from abroad that leads to an outflow of currency from the UK – Imports (M) • The sale of goods and services to buyers from other countries leading to an inflow of currency to the UK – Exports (X)

3. Labour productivity and comparative advantage: the Ricardian model

4. Why countries are engaged in international trade? • First, countries trade because they are different from each other. • Second, countries trade to achieve economies of scale in production.

5. The concept of comparative advantage

6. The concept of comparative advantage • Is it possible to grow roses in Saint Petersburg? • It is a lot easier to grow roses in the South America. • A given amount of resources used in generator production yields fewer generators in South America than in Russia.

7. Opportunity cost and trade-off: the opportunity cost of roses in terms of electric generators is the number of generators that could have been produced with the resources used to produce a given number of roses.The trade-offin South America might be something like 10 millionroses for 100 generators, and 10 millionroses for 500 generators in Russia.

8. National Production

9. National Production

10. National Production

11. Let Russia stop growing roses and devote the resources to produce generators. • Let South America grow those roses instead. • Look what has happened: Russia concentrating on generatorsand South America concentrating on roses, increases the size of the world's economic pie.

12. Hypothetical Changes in Production

13. International trade increases world output because it allows each country to specialise in producing the good in which it has a comparative advantage. • A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.

14. Specialisation and Trade • Different factor endowments mean some countries can produce goods and services more efficiently than others – specialisation is therefore possible: • Absolute Advantage: • Where one country can produce goods with fewer resources than another • Comparative Advantage: • Where one country can produce goods at a lower opportunity cost – it sacrifices less resources in production

15. South America has a comparative advantage in roses and Russia has a comparative advantage in generators. • The standard of living can be increased in both places if South America produces roses for Russia, while the Russia produces generators for the South America. So, trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage.

16. The Terms of Trade • The Terms of Trade looks at the relationship between the price received for exports and the amount of imports we are able to buy with that money. Average Price of Exports Terms of Trade = --------------------------------- Average Price of Imports

17. This approach, in which international trade is solely based on international differences in the productivity of labour, is known as the Ricardian model.

18. A One-Factor Economy

19. A One-Factor Economy • An economy (Home) has only one factor of production - labour. • Only two goods - wine and cheese - are produced. • The technology of Home's economy can be summarised by labour productivity in each industry, expressed in terms of the unit labour requirement.

20. A One-Factor Economy • It might require: - 1 hour of labour to produce a kg of cheese, - 2 hours to produce a litre of wine. • For future reference, we define: • alw as the unit labour requirements in wine production, • alcas the unit labour requirements in cheese production, respectively. • The economy's total resources are defined as L, the total labour supply.

22. PPF

23. RELATIVE PRICES AND SUPPLY

24. RELATIVE PRICES AND SUPPLY • Let PСand PW be the prices of cheese and wine, respectively. Costs: • It takes aLCperson-hours to produce a kg of cheese. • It takes aLW person-hours to produce a litre of wine.

25. RELATIVE PRICES AND SUPPLY • The economy will specialise in the cheese production if PC /PW > aLC / aLW; • it will specialise in the production of wine if PC /PW < aLC / aLW. • Only when PC /PW is equal aLC / aLW, will both goods be produced.

26. The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost. • It will specialise in the production of wine if the relative price of cheese is less than its opportunity cost.

27. In the absence of international trade, Home would have to produce both goods for itself. But it will produce both goods only if the relative price of cheese is just equal to its opportunity cost. • In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements.

28. Trade in a One-Factor World

29. Suppose that there are two countries: Home and Foreign. • We denote Home's labor force byL and Home's unit labor requirements in wine and cheese production by aLW and aLC, respectively. • We denote Foreign's labor force L*; Foreign's unit labor requirements in wine and cheese will be denoted by a*LW and a*LC , respectively. • Let as assume that: aLC/aLW< a*LC / a*LW • or, equivalently, that aLC/ a*LC < aLW/ a*LW .

30. Wine production, QW*, in litres Wine production, Qw, in litres L*/a*lw L/alw PF PF* Cheese production, Qc, in kg Cheese production, Qc, in kg L/alc L*/a*lc

31. Foreign's relative productivity in wine is higher than it is in cheese. • Foreign has a comparative advantage in wine. • Home's relative productivity in cheese is higher than it is in wine. • Home has a comparative advantage in cheese.

32. When one country can produce a unit of a good with less labor than another country, we say that the first country has anabsolute advantage. • One of the most important sources of error in discussing international trade is to confuse comparative advantage with absolute advantage.

33. In the absence of foreign trade the relative prices in each country would be determined by the relative unit labor requirements. • In case of international tradeprices will no longer be determined purely by domestic considerations.

34. The World Relative Supply and Demand

35. World Relative Supply and Demand Relative prices of cheese Pc/Рw RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

36. There will be no world cheese production and no world supply of cheese if the world price drops below аLC /аLW. Home and Foreign will produce wine only wheneverPc/Pw <аLC /аLW . World Relative Supply and Demand Relative prices of cheese Pc/Рw RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

37. World Relative Supply and Demand When the relative price of cheese, Pc/Pw, is exactly аLC /аLW, workers in Home can earn exactly the same amount making either cheese or wine. So Home will be willing to supply any relative amount of the two goods, producing a flat section to the supply curve. Foreign will produce wine wheneverPc/Pw <а*LC /а*LW . Relative prices of cheese Pc/Рw RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

38. If Pc/Pw is above аLC /аLW Home will specialize in the production of cheese. As long as Pc/Pw < а*LC /а*LW , however. Foreign will continue to specialize in producing wine. World Relative Supply and Demand Relative prices of cheese Pc/Рw RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

39. World Relative Supply and Demand Relative prices of cheese Pc/Рw RS a*LC / a*LW AtPc Pw = а*LC /а*LW, Foreign workers are indifferent between producing cheese and wine. Thus here we again have a flat section of the supply curve. aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

40. World Relative Supply and Demand Finally, for Pc/Pw >а*LC /а*LW, both Home and Foreign will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will become infinite. Relative prices of cheese Pc/Рw RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC Qc + Qc* L* / а*LW Qw + Qw*

41. Russia and Germany: mutual trade case Oil Oil from Russia Cars from Germany Map courtesy of http://www.theodora.com

42. Russia and Germany: Relative Supply and Demand in oil and cars Relative prices of cars Pc/Рoil aruLC / aruLoil RS agerLC / agerLoil RD Relative quantity of cars Qruc + Qcger Lru / аruLC Lger / аgerLoil Qruoil + Qoilger

43. The Gains From Trade

44. THE GAINS FROM TRADE Trade as an indirect method of production • Home could produce wine directly, but trade with Foreign allows it to "produce" wine by producing cheese and then trading the cheese for wine. • This indirect method of "producing" wine is a more efficient method than direct production.

45. Trade affects each country's possibilities for consumption. • In the absence of trade, consumption possibilities are the same as production possibilities. • Once trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces. • Trade makes residents of each country better off.

46. Resources and Trade: The Heckscher-Ohlin Model

47. Introduction • Comparative advantage could arise because of international: • differences in labor productivity; • differences in countries' resources. • Canada exports forest products to the United States because Canada has more forested land per capita than the United States.

48. Labor is important, but what about of other factors of production(such as land, capital, and mineral resources)? • We will examine a model in which resource differences are the only source of trade. • This model shows that comparative advantage is influenced by the interaction between nations' resources and the technology of production. What does it mean efficiency?

49. Developed by two Swedish economists, Eli Heckscher and Bertil Ohlin (Nobel Prize in economics in 1977), the theory is often referred to as theHeckscher-Ohlin theory (H-O theory). • H-O theory emphasises the interplay between the proportionsin which different factors of production are available in different countries and the proportions in which they are used in producing different goods. Due to it is also referred to as the factor-proportions theory.

50. A Model of a Two-factor Economy • The model is in many ways very similar to thespecific factors model. • It is assumed that each economy is able to produce two goods and that production of each good requires the use of two factors of production. • The same two factors are used in both sectors. (It is a more difficult model, but with some new insights.