International economics - mid term

International Economics

1° Lecture – 09/04/2019

International economics is the subject that studies the economic interactions between countries. These economic interactions might be: trade, migration, and capital flows. In this course, we will focus on trade. Trading is simply an exchange of goods, and countries do trade because they gain from it. Each country has a comparative advantage (CA), which is a good that differs from another in technology or factor endowments. Over the years, trade has grown and changed in terms of the composition of goods.

As we can see from the above chart, trade has grown rapidly and faster than GDP. Between 1998 and 2008, trading started to become more free and production became more fragmented. Only in 2001, which was a crisis year, was trade negative. Hence, this tells us that trade is more sensitive than total production during a period of crisis. Taking a long-run perspective, world trade has steadily grown since 1950. With the above graph, we can see that trade has grown steadily and more than GDP. This trend has been accelerated at the beginning of the new century thanks to China.

With this simple geographical chart, we can see the degree of importance of each country related to trade in 2013.

2° Lecture – 1°/04/2019

There are two types of trade:

• Intra-trade: This involves similar goods.
• Inter-industry trade: This involves completely different types of products.

After this distinction, we have to face two empirical regularities:

• Strong positive relationship between country size (GDP) and the volume of trade. Large countries spend more on imported goods because they are richer, and they also sell more abroad because they produce a wider range of goods. With the above graph, for example, it’s easy to say that Italy has 10% of trade between the EU and North America.
• A country trades much more with neighboring countries than with more distant economies of similar size. Distance substantially reduces trade flows. The reason is that a greater distance implies higher costs of moving goods and factors, as well as less intense personal contacts. For example, Canada has the same size as Spain, but due to their distance, they do not trade much.

Moreover, we have to discuss the gravity approach. This evidence suggests that the volume of trade between any pair of countries is increasing in the product of their sizes and decreasing in their distance.

Let’s start with an equation:

where:

• T is the value of trade between country i and country j.
• A is a constant.
• Y_i is the GDP of country i.
• Y_j is the GDP of country j.
• D_ij is the distance between country i and country j.

This simple equation predicts very well the actual size of trade flows between country pairs. However, it does not work perfectly because it sometimes under-predicts or over-predicts the actual volume of trade flows. Those failures depend on some variables, such as:

• Geography: The presence of big hubs and ports might be a positive variable for trade. An example is Belgium or the Netherlands.
• Membership in trade agreements: Trade agreements like WTO, and NAFTA tend to increase trade.
• Borders: For example, the one between the US and Canada. This has a negative effect on trade.

Ricardian Model

With this model, we are going to understand how countries realize gains from trade. The pattern of trade is determined by differences in comparative advantage: each country produces and exports the good in which it has comparative advantage or lower opportunity cost (OC). The opportunity cost is the amount of a good that must be sacrificed to produce an additional unit of another good. A country has a lower opportunity cost in a good because it is relatively more productive than the other country in that good.

Suppose that we have a world with two countries, say Home (H) and Foreign (F), and two goods, say Wine (W) and Clothing (C). Then we have that "a" is the unit labor requirement, in other words, the number of labor hours required to produce one unit of the good; and " " is the labor/productivity, in other words, the number of units of a good produced in one labor hour.

Both countries are equally productive in wine, but Foreign is more productive than Home in clothing. This means that Foreign has an absolute advantage (AA) in clothing and no one has absolute advantage in wine. A country has an absolute advantage in a good if it is more productive than the other country in that good.

Now let’s take a look at the opportunity costs. The one referred to wine in terms of clothing in country Home is computed by: in country Foreign is equal to:

Due to the lower opportunity cost of wine in terms of clothing, country Home has a comparative advantage in the production of wine. Clearly, then, Foreign must be relatively more productive than Home in clothing. Hence, country Foreign has a comparative advantage in the production of clothing.

The important conclusion of these computations is that any country can have a comparative advantage in both goods because comparative advantage arises from differences in relative labor productivity across countries in the two goods.

3° Lecture - 11/04/2019

Consider now the following scheme of unit labor requirements:

Taking a look at it, it’s easy to see that Home is more productive than Foreign in both goods: this means that Home has an absolute advantage in both productions. Remember that Home has a comparative advantage in good clothing. Even if Home is absolutely more productive than Foreign in both goods, it is relatively more productive in clothing than in wine. Clearly, then, country Foreign will have a comparative advantage in good wine. The important conclusion is that even if a country has an absolute advantage in both goods, it can have a comparative advantage only in one of them. Vice versa, even if a country does not have an absolute advantage in any good, it can still have a comparative advantage in some productions.

After these two numerical examples, let’s see which the assumptions of this model are:

• Only one production factor: labor (L).
• Two countries: Home (H) and Foreign (F).
• Two goods: clothing (C) and wine (W).
• Perfect mobility of labor across industries.
• Immobility of labor across countries.
• Perfect competition in goods and labor markets.
• Constant returns to scale in the production of both goods.
• Same preferences in both countries.
• Unit labor requirements: a_HC, a_HW, a_FC, a_FW.

In order to see how these two countries are working in this model, we have to draw the production possibility frontier for each country:

Home: Rearranging terms yields to:

Foreign: Rearranging terms yields to:

As we can see, the slope is exactly equal to the opportunity cost of wine in terms of clothing. This implies that a country with a comparative advantage in wine will have a flatter production possibility frontier.

4° Lecture – 16/04/2019

Consider a world in which there are two countries, say Home (H) and Foreign (F), and two goods, say Wine (W) and Cloths (C). Now we have to find the different prices using autarky or a free trade market. Using the concepts of relative price and opportunity cost, we might compute whether or not the country has to fully specialize. If the opportunity cost is greater than the relative price, the country has to fully specialize into the good we’re talking about. Let’s assume that in Home, the opportunity cost of wine is greater than its relative price. In this case, this country has to fully specialize in wine.

In this model, when there is full specialization, there is only one good produced. For instance, if Home fully specializes in Wine and Foreign fully specializes in Clothing, the result will be:

Home:

Foreign:

Now we have a new price that is settled between the two opportunity costs. But how can we determine exactly where the price is? The demand and the supply curve. Let’s assume that we’re talking about wine in terms of the number of clothing. How might we determine the value of ? By using the equality between relative demand and relative supply of wine; obviously in the international market. We might describe separately each curve:

• Supply curve: It is an upward-sloping function but in particular is going to be step-wise increasing. This means that it is truly upward-sloping, but some segments are vertical and others are horizontal.
• On the horizontal axes, we might see the total production of wine, and on the vertical axes, we might see, conversely, the total production of clothing. corresponds to the total production of wine in Home if it is fully specialized over the total production of clothing if Foreign is fully specialized in it. This is exactly the result: it’s the relative supply curve of wine if both countries are fully specialized in their comparative advantage goods. Now let’s focus on the supply curve: it has four segments:
• First vertical segment: Along this segment, the relative price of wine in the international market is smaller than the opportunity cost in Home. Clearly, if we are taking into consideration that the opportunity cost in Home is higher than the opportunity cost in Foreign, the relative price of wine is smaller than both. In that case, no one is willing to produce wine due to its cost, hence they are both going to produce clothing. The final result is that the relative supply of wine is equal to zero, and this is the reason for which this vertical segment is exactly the vertical axes.
• Second vertical segment: Here we are considering a range of prices that are between the range of prices. As we can see, the relative price is strictly smaller than the opportunity cost in Foreign and strictly higher than the opportunity cost in Home. Obviously, Home is fully specialized in wine; conversely, Foreign will be fully specialized in clothing.
• First horizontal segment: In this segment, the relative price of wine is exactly equal to the opportunity cost in Home, but smaller than the opportunity cost in Foreign. For Foreign, it is better to fully specialize in clothing, whereas for Home it is indifferent to producing wine or clothing, so it will produce both goods without specialization. Let’s see what happens in two particular points, say A and B, that are respectively close to the first vertical segment and to the second vertical segment. In A, Home produces little wine; in B, Home procures much more wine and is close to the full specialization.
• Second horizontal segment: The relative price of wine in the international market is equal to the opportunity cost in Foreign and strictly larger than the opportunity cost in Home. In this case, Home is fully specialized in wine and Foreign is indifferent in producing one good than the other, so it will produce both goods.
• If the price of wine is higher than the opportunity cost of both countries, both Home and Foreign fully specialize in wine, and there is no supply for clothing: this is exactly the case in which the relative supply for wine is infinite.

Demand curve: It is simply a downward-sloping function. It will intercept the second vertical segment in which both countries are fully specialized in just one good.

Let’s take a look at the second vertical segment in which the relative price is between the two opportunity costs: here both countries might gain from trade. In order to understand the ways for gaining from trade, we have to compare two opposite situations: autarky and free trade. In which situation do countries consume less? In order to understand which the preferred situation is, we have to take care of three points:

1. Trade offers countries an indirect and more efficient way of producing the comparative disadvantage good. Let’s assume that Home produces wine and there is no production of clothing: in this case, Home will buy clothing, exchanging wine for it, and the result is an indirect production of clothing by selling wine in exchange.
• Autarky: In here, the quantity produced is.
• Free trade: Into this indirect way, the quantity produced is With a simple computation, the result is that in a free trade world, a country does gain, otherwise in autarky it does not gain.

5° Lecture – 17/04/2019

2. Trade expands the consumption possibilities frontier of each country. As we have done above, we have to take into relation autarky and free trade:
• Autarky: Here, the consumption possibility frontier is going to be the set of combinations of the two goods that are available for consumption in a given country. Taking into memory that Home has a comparative advantage in wine, that means that under free trade, Home fully specializes in wine. The horizontal intercept is exactly the same for both cases (autarky and free trade) and tells us how much wine can be consumed by Home. The hypothetical situation regarding the vertical intercept is that in this case, Home decides to produce only clothing without producing any unit of wine. In a world in which trade is not allowed, the total amount of wine that can be produced by Home is; and the total amount of clothing that can be produced is.
• Free trade: In free trade, the horizontal intercept is exactly the same as the autarky’s situation. What is changing in this case is the vertical intercept due to the possibility to trade: The country shifted the total.