International economics - mid term

TOTAL EFFECT: POSITIVE TOTAL EFFECT: POSITIVE

Notice that on the vertical cells, we see where growth occurs and on the horizontal cells we

see the bias of growth. Remember that we are looking to the effects on welfare in Home.

1- This is the case in which growth occurs in Home and is biased in terms of wine, therefore

labour increases. Notice that wine is the import good for Home. 19

With these simple graphs, we might see that an increase in labour implies a direct effect

that is a shift of the production possibility frontier bias in favour of wine. After this

change, we have to consider that now there are significantly less production of clothing

and more production of wine: this implies an indirect effect that is an increase in the

terms of trade. An increase in it means a change in the relative price ratio, therefore the

slope of the isovalue line. The total effect of this growth is computed by the sum of the

two previous effects and is clearly positive.

2- This is the case in which growth occurs in Home and is biased in terms of clothing,

therefore capital increases. As we can see from the above table, here we have two

possible results:

a. Direct effect higher than the indirect effect: obviously, the higher is the capital,

the higher is the quantity of clothing produced. This means that the production

possibility frontier has shifted rightward, biased in favour of clothing. We know

that in this case the direct effect, born by the shift of the production possibility

frontier, is higher than the indirect effect, thanks to the shift in the relative supply

curve. Notice that, the total effect of this case is positive which means that the

value of clothing is dropping while the supply is increasing.

This is obviously the standard case, in which Home is better off even if there is a

negative indirect effect and a reduction of the terms of trade.

b. Direct effect lower than the indirect case: here we have that the decrease in the

terms of trade is higher than the shift of the production possibility frontier.

In here the indirect effect is strictly higher than the direct effect, therefore the

green isovalue line has a slope flatter than in the other two cases. As a result,

Home is worst off and this case is called immiserizing growth. 20

9° lecture – 08/05/2019

3- This is the case in which the country that is growing is Foreign and is biased in favour of

wine, this means that labour is increasing. Taking into memory that we are interested in

the welfare changes in Home, we should compute either the direct effect and the

indirect effect. The direct effect in Home is zero because the growth is occurring in

Foreign, so there is no effect on the production possibility frontier. Surely, if labour

increases, the production of clothing decreases whereas the production of wine

increases.

As we can see, the indirect effect is positive because the terms of trade is positive too.

The total effect is positive as well: this means that clothing is more valuable because

Foreign decides to produce more wine and less clothing.

4- This is the case in which growth occurred in Foreign and is biased in terms of clothing. As

in the third case, there is no direct effect.

The isovalue line has a slope flatter than before: this implies a reduction in the value of

the export good. The indirect effect is negative due to the reduction in the terms of trade;

as a consequence, the total effect is negative too. Remember, when growth is biased in

terms of the import good, the total effect is positive, whereas when is biased in terms of

the export good, the total effect is negative.

2. International transfers of income: implies shifts in the international relative demand curve

(RD). We have many different types of international transfers:

a. Cancellation of a debt: that is a transfer of income.

b. Foreign aid: transfers that typically a country made for other countries that are in a

lower stage of development.

Those two types of transfers are linked because no one requires a repayment at a precise

moment in the future. Suppose that we are in a world with two countries: a donor, the

21

country that makes transfers (in our case Home) and the recipient, the country that receives

the income (in our case Foreign). As in the previous case, we have to distinguish between

small countries and large countries:

If the countries are small: transfers have only a direct effect: this means no changes

o in terms of trade.

Donor: has a negative direct effect because has less income to consume.

§ Recipient: has a positive direct effect because has more income to spend on

§ consumption.

For both countries there is no indirect effect because the terms of trade remains

unchanged.

If countries are large: here we have both effects:

o Donor: has a negative direct effect because has less income to consume.

§ Recipient: has a positive direct effect because has more income to spend on

§ consumption.

Here, the indirect effect depends on the marginal propensity to spend in wine and

clothing, that means that for any unit of income, say dollar, how does that dollar get

spent. 40¢ in wine

1$ 60¢ in clothing

In particular, we have three cases:

i. Marginal propensity to spend for wine and clothing equal in both Home and

Foreign: suppose that Home transfers income to Foreign for an amount of 1$.

In Home the demand for clothing drops for 70¢ and in Foreign increases for

70¢, therefore the total demand for clothing in the world is equal to zero.

30¢ in wine

1$ talking about Home

70¢ in clothing

in wine

30¢ talking about Foreign

1$ 70¢ in clothing

There are no shifts in relative supply and relative demand curves because the

terms of trade relative to each country are unchanged. The will be a negative

total effect for Home and a positive total effect for Foreign. 22

ii. Marginal propensity to spend for wine and clothing larger in Home than in

Foreign: suppose that Home transfers income to Foreign for an amount of 1$.

In Home the demand for wine drops for 30¢ and in Foreign increases for 70¢,

therefore the total demand for wine in the world is equal to 40¢.

There is a shift in the relative supply curve because the terms of trade has

decreased. There will be a negative total effect for Home and a positive total

effect for Foreign.

iii. Marginal propensity to spend for wine and clothing larger in Foreign than in

Home: suppose that Home transfers income to Foreign for an amount of 1$.

In Home the demand for wine drops for 70¢ and in Foreign increases for 30¢,

therefore the total demand for wine in the world is equal to -40¢. 23

There is a shift in the relative supply curve because the terms of trade has

increased. The total effect is ambiguous for both countries due to the direct

effect. Here, the transfer is making the export good more valuable, hence in

Home better indirectly.

Transfers can also change the relative supply curve: when countries produce and consume also

some non – traded good. A non – traded good is one for which trade is not allowed, therefore we

have to think about it as a good in autarky. Suppose that there is same marginal propensity to spend

for wine and clothing in both countries:

30¢ in clothing

1$ 30¢ in wine talking about Home

40¢ in non – traded good

30¢ in clothing

1$ 30¢ in wine talking about Foreign

40¢ in non – traded good

Suppose that Home transfers 1$ to Foreign: the relative demand curve remains unchanged because

there is the same marginal propensity to spend for wine and clothing in each country, this means

that there are no effects on terms of trade.

Suppose now for simplicity that Home produces only clothing and non – traded good whereas

Foreign produces only wine and non – traded good.

- Home: its income is dropping; this implies that it can consume less and therefore the

demand for the non – traded good drops as well. The result is that the production of the non

– traded good decreases. If the production factors of the non – traded good are decreasing,

for the Rybczynski theorem the production factors of clothing will increase.

- Foreign: there is a raise in income, this means an increase in the demand of the non – traded

good and also in the production factors of it. In opposite of Home, the production factors of

the other good produced, that is wine, will decrease.

In fact, there is a reduction in the terms of trade of Home and a consequently expansion in

the terms of trade of Foreign. 24

10° lecture – 09/05/2019

INTRA – INDUSTRY TRADE

The intra – industry trade is composed by transfers of similar goods in similar countries. It is

characterized by the total absence of a comparative advantage good.

The model that will describe in detail this type of trade is the Krugman model, in which we have

three new ingredients:

1. Product differentiation: production of different varieties of the same good.

2. Economies of scale: they are not able to live with perfect competition, therefore we will use

monopolistic competition.

3. Love for variety: consumers prefer differentiating consumption and, hence, they want to

consume a large number of varieties. This implies that consumers import varieties that are

produced only abroad.

The first problem that we have to face with these new ingredients is that if I have economies of

scale, I cannot assume perfect competition anymore. This because firms have an incentive to

become large in order to pay less for the production. Therefore, we can no longer assume that they

are price – taker: this means that firms no longer take the price of the product, but a larger

production affects the price of a good.

Firms usually interact strategically: for example, in oligopoly there is strategic interaction between

firms.

The market structure in which we are working is the so called monopolistic competition: here firms

are price – makers and there is no strategic interaction; in fact, is a mixture between monopolist

and perfect competition. The characteristics of this market structure are:

- Each firm produces only one variety: this means that each firm is a monopolist in the

production of its variety.

- Varieties are differentiated: consumers do not perceive them exactly as identical

- In this industry there is free entry: this means that until firms make positive profits, new

firms have incentive to enter the industry and produce. The new entrance will produce

different varieties. This free entry is important because implies that profits are driven down

to zero. Home Foreign

Red

White Green

Red

The table above is referring to an autarkic situation. What would happen under free trade? Initially,

what they would find is that both firms are producing the same thing with the same colour. This

isn’t good for both firms because they have to share the market. The result is that one firm has to

change the variety due to e