Preparing for the Exam: Summarizing the Essentials

1. Preparing for the Exam: Summarizing the Essentials

2. Exam • Final: 27.10.2008 at 8 - 10 ECO, lecture room • Retake: 24.11.2008 at 8 - 10 ECO, lecture room • Requirements: (a) Lectures, (b) Krugman (1993): What Do Undergrads Need to Know About Trade? American Economic Review 83(2): 23–26 (available from JSTOR) • Three questions (answer all) • You may answer in English or Finnish. Dictionaries are not allowed.

3. Previous results (final exam)

4. The most important things to learn • Why trade is mutually beneficial? • Comparative advantage, economies of scale • Where do the world prices come from? • Terms-of-trade analysis • What does trade and international factor mobility do to distribution of income? • Factor-price-equalization theorem • What trade policy instruments do? • Implications of subsidies, tariffs, quotas • Arguments for activist trade policy Please note that these are just the most important things. To pass the exam you will need to know a bit more…

5. Cloth 9,000 3,000 3,600 Wine Gains from Trade:Ricardian Model Suppose that the international price turns out to be 2,5 yard per barrel and England produces only cloth Slope of the CPF = the amount of consumption of one good that must be given up to obtain one additional unit of the other good England

6. Gains from Trade:The Neoclassical/HO Model (PX/PY)FT Good Y Equilibrium: MRT = (PX/PY)FT = MRS YC Imports YA YP (PX/PY)A XC XP XA Good X Exports

7. Gains from Trade:Krugman Model • Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases • i.e. a larger variety of products is available for smaller price • everybody are better off even if the countries are identical Price ACA ACFT pA pFT P nA nFT Number of firms

8. Imports of good Y Exports of good X Prices:Deriving the Offer Curve Offer Curve Good Y YC (PX/PY)1 = TOT1 Imports1 YP (PX/PY)2= TOT2 (PX/PY)1 XC XP Good X Exports1 Potential price lines: PX*QX=PY*QY  QY=(PX/PY)*QX i.e. given the prices, the value of exports equals the value of imports Good Y YC Imports1 Imports2 YP Imports2 (PX/PY)2 Exports2 XC XP Good X Exports1 Exports2

9. Offer Curve Offer Curve Offer Curve Imports of good X Imports of good Y Exports of good Y (PX/PY)1 (PX/PY)1 (PX/PY)2 (PX/PY)2 Imports of good X Exports of good X Exports of good Y Prices:Putting the Offer Curves to One Graph Country 2 Country 1

10. Prices:Trading Equilibrium (PX/PY)E = TOTE (PX/PY)’ Country 2’s offer curve Good Y: Imports to country 1 exports from country 2 Country 1’s offer curve Good X: Exports from country 1 Imports to country 2

11. Distribution of Income:Factor Price Equalization • Autarky → Free trade • relative prices of final goods become identical • relative price of paper increases (=relative price of clothes decrease)in Finland → Finland produces more paper, China more clothes • Since producing paper is more capital intensive, demand for capital increases and demand for labour decreases in Finland→ w ↓ r ↑ • Similarly in China, demand for labour increases and demand for capital decreases → r ↓ w ↑ • In equilibrium all prices (including factor prices) areidentical

12. Distribution of Income:the Stolper-Samuelson Theorem • Trade affects both the prices of goods and the prices of factors of production: What then is the impact of trade on distribution of real income? • wages decrease in Finland, but also the price of clothes decreases (i.e. you need less money to buy the same amount of clothes). Which effect dominates? • Stolper-Samuelson Theorem: real income of the owners of abundant factor increases andthe real income of owners of scarce factor decreases • Think about the labour abundant country (e.g. China): Free trade → r ↓ w ↑ → capital/labour ratio ↑ → labour productivity ↑ → real wages ↑ W. Stolper & P. Samuelson (1941): International Factor-Price Equalisation Once Again. Economic Journal 59, no. 234.

13. Distribution of Income: Impact of Migration Country 1: MPPL, w Country 2: MPPL, w Country 2: (receiving immigrants) • wages decrease →transfer of income from labour to capital owners • total output increases more than what is paid to the immigrants → immigration surplus • However, there is a decrease in per capita output (given diminishing marginal productivity) Country 1: • wages increase →transfer of income from capital to labour • total output decreases more than the wage sum of those who left → immigration deficit • But, there is a increase in per capita output (given diminishing marginal productivity) Country 1’s eq’m employment Country 2’s eq’m employment wA2 transfer from labour to capital in country 1 immigration surplus w* w* transfer from capital to labour in country gain for the immigrants wA1 Country 1’s initial employment Country 2’s employment Total world labour force

14. Trade Policy:Import Tariff, Small-Country, Partial Equilibrium Increase of producer surplus and government income Loss of consumer surplus SD SD P P (1+τ)Pint (1+τ)Pint increase of producer surplus tariff to the government Loss of consumer surplus deadweight loss deadweight loss Pint Pint DD DD Q imports after tariff Q imports after tariff imports in free trade imports in free trade

15. Trade Policy:Import Quota Small-Country, Partial Equilibrium • For every quota there is an equivalent tariff(and for every tariff there is an equivalent quota) • The changes in consumer and produce surplus are equivalent to that of a tariff • However, the increase of government revenue may be lost (at least partially) SD P PQ Pint DD Q quota imports in free trade

16. Trade Policy:Subsidy, Small-Country, Partial Equilibrium SD SD P P increase of producer surplus Cost to the government efficiency loss P P DD DD imports after the subsidy Q imports after the subsidy Q imports in free trade imports in free trade

17. Trade Policy:Single Market, Two Countries, Free Trade Country B Country A P P SA SB DB DA Q Q

18. Trade Policy:Single Market, Two Countries, Free Trade Country B Country A P P SA SB DB DA Q Q Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

19. Trade Policy:Single Market, Two Countries, Tariff Country B Country A P P SA SB DB tariff DA Q Q Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

20. Trade Policy:Single Market, Two Countries, Tariff Country B Country A P P DA SA DB SB PA e D a b tariff PFT price decrease in country B C PB Q Q Country A: Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).

21. General Equilibrium Effects of a Tariff for a Small Country • Import tariff on good Y changes the price ratio • Producers adjust from point PFT to Pt • Since the tariff doesn’t change world prices, country’s real income changes to (PX/PY)t • Consumers maximize given domestic prices and real income and move to a lower utility level • Note that real income is determined by the world prices Good Y CFT Ct Pt PX/(1+τ)PY PFT (PX/PY)t (PX/PY)FT Ct CFT Pt Good X PFT

22. General Equilibrium Effects of a Subsidy for a Small Country • Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff • The real income of the country remains the same • Consumers face world prices and are able to consume at a higher utility level Good Y CFT CS PS PX/(1+τ)PY PFT (PX/PY)FT CS CFT PS Good X PFT