Introduction to International

Economics
 Introduction

• International economics is about how nations interact through trade

of goods and services, through flows of money and through
investment.
• International economics is growing in importance as a field of study
because of the rapid integration of international economic markets.
Increasingly, businesses, consumers, and governments realize that
their lives are affected not only by what goes on in their own town,
state, or country but also by what is happening around the world.
• The growth of international trade and investment has been
stimulated partly by the steady decline of trade barriers since the
Great Depression of the 1930s. In the post–World War II era, the
General Agreement on Tariffs and Trade, or GATT, prompted regular
negotiations among a growing body of members to reciprocally
reduce tariffs (import taxes) on imported goods.
• Another international push for trade liberalization has come in the
form of regional free trade agreements.
International trade and International Finance
• International trade focuses on transactions of real goods and
services across nations.
• These transactions usually involve a physical movement of goods
or a commitment of tangible resources like labor services.
• International finance focuses on financial or monetary
transactions across nations.
For example, purchases of US dollars or financial assets by
Indians.
• International trade is a field in economics that applies microeconomic
models to help understand the international economy. Its content includes
basic supply-and demand analysis of international markets; firm and
consumer behavior; perfectly competitive, oligopolistic, and monopolistic
market structures; and the effects of market distortions. The typical course
describes economic relationships among consumers, firms, factory owners,
and the government.
• International finance applies macroeconomic models to help understand
the international economy. Its focus is on the interrelationships among
aggregate economic variables such as GDP, unemployment rates, inflation
rates, trade balances, exchange rates, interest rates, and so on. This field
expands basic macroeconomics to include international exchanges. Its focus
is on the significance of trade imbalances, the determinants of exchange
rates, and the aggregate effects of government monetary and fiscal policies.
The pros and cons of fixed versus floating exchange rate systems are among
the important issues addressed.
World exports (as per cent of world GDP)
World Inward FDI
India’s exports as per cent of GDP
 Patterns of Trade
• Differences in climate and resources can explain why Brazil
exports coffee and Australia exports iron ore.
• But why does Japan export automobiles, while the US exports
aircraft?
Differences in labor productivity may explain why some
countries export certain products.
• How relative supplies of capital, labor and land are used in the
production of different goods may also explain why some
countries export certain products.
 Determinants of international trade
• Size- Larger economies produce more goods and services, so they have
more to sell in the export market. Larger economies generate more
income from the goods and services sold, so people are able to buy
more imports.
• Distance between markets influences transportation costs and
therefore the cost of imports and exports. Distance may also influence
personal contact and communication, which may influence trade.
• Cultural affinity: if two countries have cultural ties, it is likely that they
also have strong economic ties.
• Geography: ocean harbors and a lack of mountain barriers make
transportation and trade easier.
• Multinational corporations: corporations spread across different
nations import and export many goods between their divisions.
• Borders: crossing borders involves formalities that take time and
perhaps monetary costs like tariffs.
These implicit and explicit costs reduce trade.
The existence of borders may also indicate the existence of different
languages or different currencies, either of which may impede trade
more.
 The Effects of Government Policies on Trade
• Policy makers affect the amount of trade through
tariffs: a tax on imports or exports,
quotas: a quantity restriction on imports or exports,
export subsidies: a payment to producers that export,
or through other regulations (e.g., product specifications) that exclude
foreign products from the market, but still allow domestic products.
• Relevant questions- which policy to use, how much to restrict, what if
foreign governments respond likewise?
 Gravity Model
• The gravity model, first introduced by Walter Isard, assumes that only size
and distance are important for trade in the following way:
Tij = A x Yi x Yj /Dij
where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i, Yj is the GDP of country j
Dij is the distance between country i and country j
Estimates of the effect of distance from the gravity model predict that a 1%
increase in the distance between countries is associated with a decrease in
the volume of trade of 0.7% to 1%.
• The negative effect of distance on trade according to the gravity
models is significant, but it has grown smaller over time due to modern
transportation and communication.
• But history has shown that political factors, such as wars, can change
trade patterns much more than innovations in transportation and
communication.
• Today, most of the volume of trade is in manufactured products such
as automobiles, computers, clothing and machinery.
• Services such as shipping, insurance, legal fees and spending by tourists
account for 20% of the volume of trade.
• Mineral products (e.g. petroleum, coal, copper) and agricultural
products are a relatively small part of trade.
Composition of world trade
Changing composition of developing country
exports
 Outsourcing
• Outsourcing occurs when a firm moves business operations out of the domestic
country.
The operations could be run by a subsidiary of a multinational corporation.
Or they could be subcontracted to a foreign firm.
• Outsourcing of either type increases the amount of trade.

Global Value Chains-International production, trade and investments are

increasingly organized within so-called global value chains (GVCs) where the
different stages of the production process are located across different countries.
Globalization motivates companies to restructure their operations internationally
through outsourcing and offshoring of activities. The past decades have witnessed
a strong trend towards the international dispersion of value chain activities such
as design, production, marketing, distribution, etc.
 Gains from Trade
• When a buyer and a seller engage in a voluntary transaction,
both receive something that they want and both can be made
better off.
• With a finite amount of resources, countries can use those
resources to produce what they are most productive at
(compared to their other production choices), then trade those
products for goods and services that they want to consume.
• Countries can specialize in production, while consuming many
goods and services through trade.
• Trade is predicted to benefit a country by making it more
efficient when it exports goods which use abundant resources
and imports goods which use scarce resources.
• When countries specialize, they may also be more efficient due
to large scale production.
• Countries may also gain by trading current resources for future
resources (lending and borrowing).
• Trade is predicted to benefit countries as a whole in several ways,
but trade may harm particular groups within a country.
• International trade can adversely affect the owners of resources
that are used intensively in industries that compete with imports.
• Trade may therefore have effects on the distribution of income
within a country.
• Conflicts about trade should occur between groups within
countries rather than between countries.
Labour Productivity and
Comparative Advantage
 Mercantilism
• Mercantilism is an economic policy that is designed to maximize the
exports and minimize the imports for an economy. It
promotes imperialism, colonialism, tariffs and subsidies on traded
goods to achieve that goal.
• The policy aims to reduce a possible current account deficit or reach a
current account surplus, and it includes measures aimed at
accumulating monetary reserves by a positive balance of trade,
especially of finished goods. Historically, such policies frequently led
to war and motivated colonial expansion.
 Tariffs
• Tariffs have been applied by countries for centuries and have been
one of the most common methods used to collect revenue for
governments. Largely this is because it is relatively simple to place
customs officials at the border of a country and collect a fee on goods
that enter.
• Because tariffs raise the cost of importing products from abroad but
not from domestic firms, they have the effect of protecting the
domestic firms that compete with imported products. These domestic
firms are called import competitors.
• There are two basic ways in which tariffs may be levied: specific tariffs
and ad valorem tariffs. A specific tariff is levied as a fixed charge per
unit of imports.
• An ad valorem tariff is levied as a fixed percentage of the value of the
commodity imported. “Ad valorem” is Latin for “on value” or “in
proportion to the value.”
• Different tariffs are generally applied to different commodities.
Governments rarely apply the same tariff to all goods and services
imported into the country.
• Instead of one tariff rate, countries have a tariff schedule that
specifies the tariff collected on every particular good and service.
• Generally speaking, average tariff rates are less than 20 percent in
most countries, although they are often quite a bit higher for
agricultural commodities. In the most developed countries, average
tariffs are less than 10 percent and often less than 5 percent. On
average, less-developed countries maintain higher tariff barriers, but
many countries that have recently joined the WTO have reduced their
tariffs substantially to gain entry.
 Reasons for trade
• The five basic reasons why trade may take place are summarized
below. The purpose of each model is to establish a basis for trade and
then to use that model to identify the expected effects of trade on
prices, profits, incomes, and individual welfare.
• Advantageous trade can occur between countries if the countries
differ in their technological abilities to produce goods and services.
Technology refers to the techniques used to turn resources (labor,
capital, land) into outputs (goods and services). The basis for trade in
the Ricardian model of comparative advantage is difference in
technology.
• Advantageous trade can occur between countries if the countries differ in
their endowments of resources. Resource endowments refer to the skills
and abilities of a country’s workforce, the natural resources available
within its borders (minerals, farmland, etc.), and the sophistication of its
capital stock (machinery, infrastructure, communications systems). The
basis for trade in both the pure exchange model and the Heckscher-Ohlin
model is differences in resource endowments.
• Advantageous trade can occur between countries if demands or
preferences differ between countries. Individuals in different countries
may have different preferences or demands for various products. For
example, the Chinese are likely to demand more rice than Americans, even
if consumers face the same price.
• The existence of economies of scale in production is sufficient to
generate advantageous trade between two countries. Economies of
scale refer to a production process in which production costs fall as the
scale of production rises. This feature of production is also known as
“increasing returns to scale.”
• Government tax and subsidy programs alter the prices charged for
goods and services. These changes can be sufficient to generate
advantages in production of certain products. In these circumstances,
advantageous trade may arise solely due to differences in government
policies across countries.
 Absolute Advantage
• The concept of absolute advantage is generally attributed to the Scottish
economist Adam Smith in his 1776 publication The Wealth of Nations, in
which he countered mercantilist ideas. “If a foreign country can supply us
with a commodity cheaper than we ourselves can make it, better buy it of
them with some part of the produce of our own industry, employed in a
way in which we have some advantage”.
• Smith argued that it was impossible for all nations to become rich
simultaneously by following mercantilism because the export of one nation
is another nation’s import and instead stated that all nations would gain
simultaneously if they practiced free trade and specialized in accordance
with their absolute advantage. Smith also stated that the wealth of
nations depends upon the goods and services available to their citizens,
rather than their gold reserves.
 Ricardian Model
• The Ricardian model uses the concepts of opportunity cost and
comparative advantage.
• The opportunity cost of producing something measures the cost of
not being able to produce something else. A country faces
opportunity costs when it employs resources to produce goods and
services. For example, a limited number of workers could be
employed to produce either roses or computers.
• The opportunity cost of producing computers is the amount of roses
not produced. The opportunity cost of producing roses is the amount
of computers not produced.
• A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in the country than it is
in other countries.
• A country with a comparative advantage in producing a good uses its
resources most efficiently when it produces that good compared to
producing other goods.
• In his example, Ricardo imagined two countries, England and Portugal,
producing two goods, cloth and wine, using labor as the sole input in
production. He assumed that the productivity of labor (i.e., the quantity
of output produced per worker) varied between industries and across
countries. However, instead of assuming, as Adam Smith did, that
England is more productive in producing one good and Portugal is more
productive in the other, Ricardo assumed that Portugal was more
productive in both goods.
Hours of work necessary to produce one unit

Produce
Cloth Wine
Country

England 100 120

Portugal 90 80
• Note that trade based on comparative advantage does not contradict
Adam Smith’s notion of advantageous trade based on absolute
advantage. If, as in Smith’s example, England were more productive in
cloth production and Portugal were more productive in wine, then we
would say that England has an absolute advantage in cloth
production, while Portugal has an absolute advantage in wine.
• If we calculated comparative advantages, then England would also
have the comparative advantage in cloth and Portugal would have the
comparative advantage in wine. In this case, gains from trade could
be realized if both countries specialized in their comparative and
absolute advantage goods.
 One factor Ricardian Model- Assumptions
• Labor is the only resource important for production.
• Labor productivity varies across countries, usually due to differences in
technology, but labor productivity in each country is constant across time.
• The supply of labor in each country is constant.
• Only two goods are important for production and consumption: wine and
cheese.
• Competition allows laborers to be paid a ―competitive wage, a function of
their productivity and the price of the good that they can sell, and allows
laborers to work in the industry that pays the highest wage.
• Only two countries are modelled: domestic and foreign.
• Because labor productivity is constant, define a unit labor requirement as
the constant number of hours of labor required to produce one unit of
output.
• aLW is the unit labor requirement for wine in the domestic country. For
example, if aLW = 2, then it takes 2 hours of labor to produce one litre of
wine in the domestic country.
• aLC is the unit labor requirement for cheese in the domestic country. For
example, if aLC = 1, then it takes 1 hour of labor to produce one kg of
cheese in the domestic country.
• A high unit labor requirement means low labor productivity.
• Because the supply of labor is constant, denote the total number of labor
hours worked in the domestic country as a constant number L.
 Production Possibilities
• The production possibility frontier (PPF) of an economy shows the
maximum amount of a goods that can be produced for a fixed
amount of resources
• If QC represents the quantity of cheese produced and QW represents
the quantity of wine produced, then the production possibility
frontier of the domestic economy has the equation
aLCQc+ aLWQw=L
• To produce an additional kg of cheese requires aLC hours of work.
• Each hour devoted to cheese production could have been used to
produce a certain amount of wine instead, equal to
1 hour/(aLW hours/litre of wine) = (1/aLW) litre of wine
• For example, if 1 hour is moved to cheese production, that additional
hour of labor could have produced
1 hour/(2 hours/litre of wine) = 1/2 litre of wine
• The trade-off is the increased amount of cheese relative to the
decreased amount of wine: aLC /aLW
 Production, Prices and Wages
• In general, the amount of the domestic economy’s production is defined by
aLC QC + aLW QW ≤ L. This describes what an economy can produce, but to
determine what the economy does produce, we must determine the prices
of goods.
• Let PC be the price of cheese and PW be the price of wine. Because of
competition,
hourly wages of cheese makers are equal to the market value of the cheese
produced in an hour: Pc /aLC .
Hourly wages of wine makers are equal to the market value of the wine
produced in an hour: PW /aLW
• Because workers like high wages, they will work in the industry that pays a
higher hourly wage.
• If PC /aLC > PW/aLW workers will make only cheese.
If PC /PW > aLC /aLW workers will only make cheese.
The economy will specialize in cheese production if the price of
cheese relative to the price of wine exceeds the opportunity cost of
producing cheese.
• If PC /aLC < PW/aLW workers will make only wine.
If PC /PW < aLC /aLW workers will only make wine.
If PW /PC > aLW /aLC workers will only make wine.
The economy will specialize in wine production if the price of wine
relative to the price of cheese exceeds the opportunity cost of
producing wine.
• If the domestic country wants to consume both wine and cheese (in
the absence of international trade), relative prices must adjust so that
wages are equal in the wine and cheese industries.
If PC /aLC = PW/aLW workers will have no incentive to flock to either the
cheese industry or the wine industry, thereby maintaining a positive
amount of production of both goods.
• When PC /PW = aLC /aLW ,
Production (and consumption) of both goods occurs when relative
price of a good equals the opportunity cost of producing that good.
 Trade in the Ricardian Model

• Suppose that the domestic country has a comparative advantage in

cheese production: its opportunity cost of producing cheese is lower
than it is in the foreign country.
aLC /aLW < a*LC /a*LW
• When the domestic country increases cheese production, it reduces
wine production less than the foreign country does because the
domestic unit labor requirement of cheese production is low
compared to that of wine production.
• If the domestic country is more efficient in wine and cheese
production. It has an absolute advantage in all production: its unit
labor requirements for wine and cheese production are lower than
those in the foreign country:
aLC < a*LC and aLW < a*LW
• A country can be more efficient in producing both goods, but it will
have a comparative advantage in only one good—the good that uses
resources most efficiently compared to alternative production.
• Even if a country is the most (or least) efficient producer of all goods,
it still can benefit from trade.
• To see how all countries can benefit from trade, we calculate relative
prices when trade exists.
Without trade, relative price of a good equals the opportunity cost of
producing that good.
• To calculate relative prices with trade, we first calculate relative
quantities of world production:
(QC + Q*C )/(QW + Q*W)
 Relative Supply and Relative Demand
• Consider relative supply of cheese: the quantity of cheese supplied by all
countries relative to the quantity of wine supplied by all countries at each
relative price of cheese, PC /PW
• There is no supply of cheese if the relative price of cheese falls below
aLC /aLW .
Why? because the domestic country will specialize in wine production
whenever PC /PW < aLC /aLW
And we assumed that aLC /aLW < a*LC /a*LW so foreign workers won’t find it
desirable to produce cheese either.
• When PC /PW = aLC /aLW , domestic workers will be indifferent between
producing wine or cheese, but foreign workers will still produce only wine.
• When a*LC /a*LW > PC /PW > aLC /aLW , domestic workers specialize in
cheese production because they can earn higher wages, but foreign
workers will still produce only wine.
• When a*LC /a*LW = PC / PW, foreign workers will be indifferent
between producing wine or cheese, but domestic workers will still
produce only cheese.
• There is no supply of wine if the relative price of cheese rises above
a*LC /a*LW
 Relative Demand
• Relative demand of cheese is the quantity of cheese demanded in all
countries relative to the quantity of wine demanded in all countries at
each relative price of cheese, PC /PW.
• As the relative price of cheese rises, consumers in all countries will
tend to purchase less cheese and more wine so that the relative
quantity of cheese demanded falls.
 Gains from Trade
• Gains from trade come from specializing in production that use
resources most efficiently, and using the income generated from that
production to buy the goods and services that countries desire.
where ―using resources most efficiently means producing a good in
which a country has a comparative advantage.
• Domestic workers earn a higher income from cheese production
because the relative price of cheese increases with trade.
• Foreign workers earn a higher income from wine production because
the relative price of cheese decreases with trade (making cheese
cheaper) and the relative price of wine increases with trade.
• Think of trade as an indirect method of production or a new technology
that converts cheese into wine or vice versa.
• Without the technology, a country has to allocate resources to produce
all of the goods that it wants to consume.
• With the technology, a country can specialize its production and trade
the products for the goods that it wants to consume.
• Consumption possibilities expand beyond the production possibility
frontier when trade is allowed. Without trade, consumption is
restricted to what is produced.
• With trade, consumption in each country is expanded because world
production is expanded when each country specializes in producing the
good in which it has a comparative advantage.
Trade expands consumption possibilities
 Numerical Example

Hours of work necessary to produce one unit

Produce
Cheese Wine
Country

Domestic aLC= 1 hour/kg aLW= 2 hours/L

Foreign aLC*= 6 hour/kg aLW*= 3 hours/L

• The domestic country is more efficient in both industries, but it has a
comparative advantage only in cheese production.
• The foreign country is less efficient in both industries, but it has a
comparative advantage in wine production.
• With trade, the equilibrium relative price of cheese must be between
aLC /aLW = 1/2 and a*LC /a*LW = 2
• Suppose that PC /PW = 1 in equilibrium. In words, one kg of cheese
trades for one litre of wine.
• If the domestic country does not trade, it can use one hour of labor to
produce 1/aLW = 1/2 litre of wine.
• If the domestic country does trade, it can use one hour of labor to
produce 1/aLC = 1 kg of cheese, sell this amount to the foreign country
at current prices to obtain 1 litre of wine.
• If the foreign country does not trade, it can use one hour of labor to
produce 1/a*LC = 1/6 kg of cheese.
• If the foreign country does trade, it can use one hour of labor to
produce 1/a*LW = 1/3 litre of wine, sell this amount to the domestic
country at current prices to obtain 1/3 kg of cheese.
 Relative Wages
• Relative wages are the wages of the domestic country relative to the
wages in the foreign country.
• Although the Ricardian model predicts that relative prices equalize
across countries after trade, it does not predict that relative wages
will do the same.
• Productivity (technological) differences determine wage differences in
the Ricardian model.
• A country with absolute advantage in producing a good will enjoy a
higher wage in that industry after trade.
• Suppose that PC = Rs 12/kg and PW = Rs 12/L
• Since domestic workers specialize in cheese production after trade,
their hourly wages will be
(1/aLC)PC = (1/1) Rs 12 = Rs 12
• Since foreign workers specialize in wine production after trade, their
hourly wages will be
(1/a*LW)PW = (1/3) Rs 12 = Rs 4
• The relative wage of domestic workers is therefore Rs 12/ Rs 4 = 3
• The relative wage lies between the ratio of the productivities in each
industry.
The domestic country is 6/1 = 6 times as productive in cheese production,
but only 3/2 = 1.5 times as productive in wine production.
The domestic country has a wage rate 3 times as high as that in the foreign
country.
• These relationships imply that both countries have a cost advantage in
production.
The cost of high wages can be offset by high productivity.
The cost of low productivity can be offset by low wages.
• Because foreign workers have a wage that is only 1/3 the wage of
domestic workers, they are able to attain a cost advantage (in wine
production), despite low productivity.
• Because domestic workers have a productivity that is 6 times that of
foreign workers (in cheese production), they are able to attain a cost
advantage, despite high wages.
 Do Wages Reflect Productivity?

• In the Ricardian model, relative wages reflect relative productivities of

the two countries.
• Is this an accurate assumption?
• Some argue that low wage countries pay low wages despite growing
productivity, putting high wage countries at a cost disadvantage.
• But evidence shows that low wages are associated with low
productivity.
 Misconceptions about Comparative Advantage

Free trade is beneficial only if a country is more productive than

foreign countries.
But even an unproductive country benefits from free trade by
avoiding the high costs for goods that it would otherwise have to
produce domestically.
High costs derive from inefficient use of resources.
The benefits of free trade do not depend on absolute advantage,
rather they depend on comparative advantage: specializing in
industries that use resources most efficiently.
Free trade with countries that pay low wages hurts high wage
countries.
• While trade may reduce wages for some workers, thereby affecting
the distribution of income within a country, trade benefits consumers
and other workers.
• Consumers benefit because they can purchase goods more cheaply
(more wine in exchange for cheese).
• Producers/workers benefit by earning a higher income (by using
resources more efficiently and through higher prices/wages).
Free trade exploits less productive countries.
• While labour standards in some countries are less than exemplary
compared to Western standards, they are so with or without trade.
• Are high wages and safe labor practices alternatives to trade? Deeper
poverty and exploitation (e.g., involuntary prostitution) may result
without export production.
• Consumers benefit from free trade by having access to cheaply
(efficiently) produced goods.
• Producers/workers benefit from having higher profits/wages—higher
compared to the alternative.
 Comparative Advantage with many goods
• Suppose now there are N goods produced, indexed by i = 1,2,…N. The
domestic country’s unit labor requirement for good i is aLi , and that
of the foreign country is a*Li
• Goods will be produced wherever it is cheaper to produce them. Let
w represent the wage rate in the domestic country and w* represent
the wage rate in the foreign country. If waL1 < w*a*L1 then only the
domestic country will produce good 1, since total wage payments are
less there.
Or equivalently, if a*L1 /aL1 > w/w*
• If the relative productivity of a country in producing a good is higher
than the relative wage, then the good will be produced in that
country.
Suppose there are 5 goods produced in the world
• If w/w* = 3, the domestic country will produce apples, bananas, and caviar,
while the foreign country will produce dates and enchiladas.
The relative productivities of the domestic country in producing apples,
bananas and caviar are higher than the relative wage.
• If each country specializes in goods that use resources productively and
trades the products for those that it wants to consume, then each benefits.
If a country tries to produce all goods for itself, resources are ―wasted.
• The domestic country has high productivity in apples, bananas, and caviar
that give it a cost advantage, despite its high wage.
• The foreign country has low wages that give it a cost advantage, despite its
low productivity in dates.
 Determination of relative wages
• How is the relative wage determined?
• By the relative supply and relative (derived) demand for labor services.
• The relative (derived) demand for domestic labor services falls when w/w*
rises. As domestic labor becomes more expensive relative to foreign labor,
goods produced in the domestic country become more expensive, and
demand for these goods and the labor to produce them falls.
fewer goods will be produced in the domestic country, further reducing the
demand for domestic labor.
• Finally, suppose that relative supply of labor is independent of w/w* and is
fixed at an amount determined by the populations in the domestic and
foreign countries.
• Suppose w/w* increases from 3 to 3.99:
The domestic country would produce apples, bananas, and caviar,
but the demand for these goods and the labor to produce them falls
as the relative wage rises.
• Suppose w/w* increases from 3.99 to 4.01:
Caviar is now too expensive to produce in the domestic country, so
the caviar industry moves to the foreign country, causing a discrete
(abrupt) drop in the demand for domestic labor.
Transportation costs and non-traded goods
• The Ricardian model predicts that countries should completely
specialize in production.
• But this rarely happens for primarily 3 reasons:
More than one factor of production reduces the tendency of
specialization
Protectionism
Transportation costs reduce or prevent trade, which may cause each
country to produce the same good or service
• Non-traded goods and services (e.g., haircuts and auto repairs) exist
due to high transportation costs.
Countries tend to spend a large fraction of national income on non-
traded goods and services.
This fact has implications for the gravity model and for models that
consider how income transfers across countries affect trade.
Resources, Comparative
Advantage and Income
Distribution
 Introduction
• If labour were the only factor of production, as the Ricardian model assumes,
comparative advantage could arise only because of international differences
in labour productivity. In the real world, however, while trade is partly
explained by differences in labour productivity, it also reflects differences in
countries’ resources.
• Thus a realistic view of trade must allow for the importance not just of
labour, but also of other factors of production such as land, capital, and
mineral resources.
• To explain the role of resource differences in trade, we 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 (the relative abundance of factors of production) and the
technology of production (which influences the relative intensity with which
different factors of production are used in the production of different goods).
• That international trade is largely driven by differences in countries’
resources is one of the most influential theories in international
economics. Developed by two Swedish economists, Eli Heckscher and
Bertil Ohlin (Ohlin received the Nobel Prize in economics in 1977), the
theory is often referred to as the Heckscher-Ohlin theory.
• Because the theory emphasizes the interplay between the
proportions in which different factors of production are available in
different countries and the proportions in which they are used in
producing different goods, it is also referred to as the factor-
proportions theory.
 Model of a two factor economy
• The simplest version of the factor-proportions model, sometimes referred
to as “2 by 2 by 2”: two countries, two goods, two factors of production.
The two countries Home and Foreign, produce the same two goods, cloth
(measured in metres) and food (measured in calories).
• Both cloth and food are produced using capital and labour. The amount of
each good produced, given how much capital and labour are employed in
each sector, is determined by a production function for each good. Overall,
the economy has a fixed supply of capital K and labour L that is divided
between employment in the two sectors
QC= QC(KC,LC)
QF=QF(KF,LF)
• The following expressions that are related to the two production
technologies
aKC = capital (machine hours) used to produce one metre of cloth
aLC = hours of labour used to produce one metre of cloth
aKF = capital (machine hours) used to produce one calorie of food
aLF = hours of labour used to produce one calorie of food
• These unit input requirements are very similar to the ones defined in
the Ricardian model (for labour only). However, there is one crucial
difference: In these definitions, we speak of the quantity of capital or
labor used to produce a given amount of cloth or food, rather than the
quantity required to produce that amount.
• Production possibilities are influenced by both land and capital
(requirements):
aKFQF + aKCQC ≤ K
aLFQF + aLCQC ≤ L
• Let’s assume that each unit of food production uses capital intensively and
each unit of cloth production uses labour intensively
aKF /aLF > aKC /aLC or aKC /aKF < aLC /aLF
• Or, we consider the total resources used in each industry and say that cloth
production is labour intensive and food production is capital intensive if
KF /LF > KC /LC
• This assumption influences the slope of the production possibility frontier.
• Consider the following numerical example: Production of one metre of
cloth requires a combination of two work-hours and two machine-
hours. The production of food is more automated; as a result,
production of one calorie of food requires only one work-hour along
with three machine-hours. Thus all input requirements are fixed and
factor substitution is not possible aKC = 2; aLC = 2; aKF = 3; aLF = 1;
• The respective resource constraints are given by:
2QC + 3QF < 3,000 (total K)
2QC + QF < 2,000 (total L)
PPF without factor substitution
• Each resource constraint is drawn in the same way that we drew the
production possibility line for the Ricardian case. In this case, however, the
economy must produce subject to both constraints. So the production
possibility frontier is the kinked line shown in red.
• The important feature of this production possibility frontier is that the
opportunity cost of producing an extra metre of cloth in terms of food is
not constant. When the economy is producing mostly food (to the left of
point 3), then there is spare labour capacity. Producing two fewer units of
food releases six machine-hours that can be used to produce three metres
of cloth: The opportunity cost of cloth is 2/3.
• When the economy is producing mostly cloth (to the right of point 3), then
there is spare capital capacity. Producing two fewer units of food releases
two work-hours that can be used to produce one metre of cloth: The
opportunity cost of cloth is 2. Thus, the opportunity cost of cloth is higher
when more units of cloth are being produced.
• Now let’s make the model more realistic and allow the possibility of
substituting capital for labour and vice versa in production. This
substitution removes the kink in the production possibility frontier;
instead, the frontier PP has the bowed shape.
 Production and Prices
• The production possibility frontier describes what an economy can
produce, but to determine what the economy does produce, we must
determine the prices of goods.
• In general, the economy should produce at the point that maximizes
the value of production, V:
V = PCQC + PFQF
where PC is the price of cloth and PF is the price of food.
• Define an isovalue line as a line representing a constant value of
production. 𝑉 = PCQC + PFQF
PF QF = 𝑉 − PC QC
• After rearranging we get that the slope of an isovalue line is –PC/PF
• Given prices of output, one isovalue line represents the maximum
value of production, say at a point Q.
• At that point, the slope of the PPF equals – (PC/PF), so the opportunity
cost of cloth equals the relative price of cloth.
 Choosing the mix of inputs
• In a two-factor model producers may have room for choice in the use
of inputs. A farmer, for example, can choose between using relatively
more mechanized equipment (capital) and fewer workers, or vice
versa.
• What input choice will producers actually make? It depends on the
relative costs of capital and labour. If capital rental rates are high and
wages low, farmers will choose to produce using relatively little
capital and a lot of labour; on the other hand, if the rental rates are
low and wages high, they will save on labour and use a lot more
capital.
Isoquants
Factor prices and input choices
In each sector, the ratio of labour to
capital used in production depends
on the cost of labour relative to the
cost of capital, w/r . The curve FF
shows the labour-capital ratio
choices in food production, while the
curve CC shows the corresponding
choices in cloth production.
At any given wage-rental ratio, cloth
production uses a higher labour-
capital ratio; when this is the case,
we say that cloth production is
labour-intensive and that food
production is capital-intensive.
• The CC and FF curves are called relative factor demand curves; they
are very similar to the relative demand curve for goods. Their
downward slope characterizes the substitution effect in the producers’
factor demand. As the wage w rises relative to the rental rate r,
producers substitute capital for labour in their production decisions.
• The previous case we considered with no factor substitution is a
limiting case, where the relative demand curve is a vertical line: The
ratio of labour to capital demanded is fixed and does not vary with
changes in the wage-rental ratio w/r.
 Factor prices and Goods Prices
• The cost of producing a good depends on factor prices: If wages rise, then
other things equal, the price of any good whose production uses labour
will also rise.
• The importance of a particular factor’s price to the cost of producing a
good depends, however, on how much of that factor the good’s production
involves. If food production makes use of very little labour, for example,
then a rise in the wage will not have much effect on the price of food,
whereas if cloth production uses a great deal of labour, a rise in the wage
will have a large effect on the price.
• We can therefore conclude that there is a one-to-one relationship between
the ratio of the wage rate to the rental rate, w/r, and the ratio of the price
of cloth to that of food, PC/PF
Stolper-Samuelson theorem: if
the relative price of a good
increases, then the real wage or
rate of return of the factor used
intensively in the production of
that good increases, while the real
wage or rate of return of the other
factor decreases.
From goods prices to input choices
• The left panel in the previous figure shows the SS curve turned
counterclockwise 90 degrees, while the right panel shows factor
prices and input choices. By putting these two diagrams together, we
see what may seem at first to be a surprising linkage of the prices of
goods to the ratio of labour to capital used in the production of each
good.
• If the relative price of cloth were to rise to the level indicated by
(PC/PF)2 the ratio of the wage rate to the capital rental rate would rise
to (w/r)2 . Because labour is now relatively more expensive, the ratios
of labour to capital employed in the production of cloth and food
would therefore drop to (LC/KC)2 and (LF/KF)2
• An increase in the price of cloth relative to that of food will raise the
income of workers relative to that of capital owners. But it is possible
to make a stronger statement: Such a change in relative prices will
unambiguously raise the purchasing power of workers and lower the
purchasing power of capital owners by raising real wages and
lowering real rents in terms of both goods.
 Resources and Output
• We investigate how changes in resources (the total supply of a factor)
affect the allocation of factors across sectors and the associated changes in
output produced.
• A given relative price of cloth, say (PC/PF)1 , is associated with a fixed wage-
rental ratio (w/r)1 (so long as both cloth and food are produced). That ratio,
in turn, determines the ratios of labour to capital employed, in both the
cloth and the food sectors: (LC/KC)1 and (LF/KF)1, respectively.
• Now we assume that the economy’s labour force grows, which implies that
the economy’s aggregate labour to capital ratio, L/K , increases. How can
the economy accommodate the increase in the aggregate relative supply of
labour if the relative labour demanded in each sector remains constant?
• The labour-capital ratio in the cloth sector is higher than that in the
food sector, so the economy can increase the employment of labour
to capital (holding the labour-capital ratio fixed in each sector) by
allocating more labour and capital to the production of cloth (which
is labour-intensive). As labour and capital move from the food sector
to the cloth sector, the economy produces more cloth and less food.
• The economy can produce more of both cloth and food than before.
The outward shift of the frontier is, however, much larger in the
direction of cloth than of food—that is, there is a biased expansion of
production possibilities, which occurs when the production
possibility frontier shifts out much more in one direction than in the
other.
• The biased effect of increases in resources on production possibilities
is the key to understanding how differences in resources give rise to
international trade. An increase in the supply of labour expands
production possibilities disproportionately in the direction of cloth
production, while an increase in the supply of capital expands them
disproportionately in the direction of food production.
• An economy with a high relative supply of labour to capital will be
relatively better at producing cloth than an economy with a low
relative supply of labour to capital. Generally, an economy will tend to
be relatively effective at producing goods that are intensive in the
factors with which the country is relatively well endowed.
 Relative Prices and Pattern of trade
• Since Home has a higher ratio of labour to capital than Foreign, Home is
labour-abundant and Foreign is capital-abundant. Note that abundance is
defined in terms of a ratio and not in absolute quantities.
• Since cloth is the labour-intensive good, Home’s production possibility
frontier relative to Foreign’s is shifted out more in the direction of cloth
than in the direction of food. Thus, other things equal, Home tends to
produce a higher ratio of cloth to food.
• Because trade leads to a convergence of relative prices, one of the other
things that will be equal is the price of cloth relative to that of food.
Because the countries differ in their factor abundances, however, for any
given ratio of the price of cloth to that of food, Home will produce a higher
ratio of cloth to food than Foreign will: Home will have a larger relative
supply of cloth.
• The relative supply schedules of Home (RS) and Foreign (RS*). The
relative demand curve, which we have assumed to be the same for
both countries, is shown as RD. If there were no international trade,
the equilibrium for Home would be at point 1, while the equilibrium
for Foreign would be at point 3. That is, in the absence of trade, the
relative price of cloth would be lower in Home than in Foreign.
• When Home and Foreign trade with each other, their relative prices
converge. The relative price of cloth rises in Home and declines in
Foreign, and a new world relative price of cloth is established at a
point somewhere between the pre-trade relative prices, say at point
2.
Trade leads to convergence of prices
• Home becomes an exporter of cloth because it is labour-abundant
(relative to Foreign) and because the production of cloth is skill-
intensive (relative to food production). Similarly, Foreign becomes an
exporter of food because it is capital-abundant and because the
production of food is capital-intensive.
• These predictions for the pattern of trade (in the two-good, two-
factor, two-countries version that we have studied) can be generalized
as the following theorem, named after the original developers of this
model of trade:
• Hecksher-Ohlin Theorem: The country that is abundant in a factor
exports the good whose production is intensive in that factor.
• In the more realistic case with multiple countries, factors of
production, and numbers of goods, we can generalize this result as a
correlation between a country’s abundance in a factor and its exports
of goods that use that factor intensively: Countries tend to export
goods whose production is intensive in factors with which the
countries are abundantly endowed.
 Trade and distribution of income
• Changes in relative prices, in turn, have strong effects on the relative
earnings of labour and capital. A rise in the price of cloth raises the
purchasing power of labour in terms of both goods while lowering the
purchasing power of capital in terms of both goods. A rise in the price
of food has the reverse effect.
• Thus international trade can have a powerful effect on the
distribution of income, even in the long run. In Home, where the
relative price of cloth rises, people who get their incomes from labour
gain from trade, but those who derive their incomes from capital are
made worse off. In Foreign, where the relative price of cloth falls, the
opposite happens: Labourers are made worse off and capital owners
are made better off.
• The resource of which a country has a relatively large supply (labour in
Home, capital in Foreign) is the abundant factor in that country, and the
resource of which it has a relatively small supply (capital in Home, labour in
Foreign) is the scarce factor.
• The general conclusion about the income distribution effects of
international trade in the long run is: Owners of a country’s abundant
factors gain from trade, but owners of a country’s scarce factors lose.
• Thus income distribution effects that arise because labour and other
factors of production are immobile represent a temporary, transitional
problem (which is not to say that such effects are not painful to those who
lose). In contrast, effects of trade on the distribution of income among
land, labour, and capital are more or less permanent.
Increased Wage Inequality: Trade or Skill-
Biased Technological Change?
• The LL and HH curves show the skilled-unskilled employment ratio, SL/UL , as
a function of the skilled-unskilled wage ratio, ws/wu, in the low-tech and
high-tech sectors. The high-tech sector is more skill-intensive than the low
tech sector, so the HH curve is shifted out relative to the LL curve. Panel (a)
shows the case where increased trade with developing countries leads to a
higher skilled-unskilled wage ratio. Producers in both sectors respond by
decreasing their relative employment of skilled workers: and both decrease.
• Panel (b) shows the case where skill-biased technological change leads to a
higher skilled-unskilled wage ratio. The LL and HH curves shift out (increased
relative demand for skilled workers in both sectors). However, in this case
producers in both sectors respond by increasing their relative employment
of skilled workers: SL /UL and SH/UH both increase.
• We can examine the relative merits of the trade versus skill-biased
technological change explanations for the increase in wage inequality
by looking at the changes in the skilled-unskilled employment ratio
within sectors in the United States. A widespread increase in these
employment ratios for all different kinds of sectors (both skilled-
labour-intensive and unskilled-labour-intensive sectors) in the U.S.
economy points to the skill-biased technological explanation.
 Factor price Equalization
• When Home and Foreign trade, the relative prices of goods converge.
This convergence, in turn, causes convergence of the relative prices of
capital and labor. Thus there is clearly a tendency toward equalization
of factor prices.
• Although Home has a higher ratio of labour to capital than Foreign
does, once they trade with each other, the wage rate and the capital
rent rate are the same in both countries. Given the prices of cloth and
food, we can determine the wage rate and the rental rate without
reference to the supplies of capital and labor.
• If Home and Foreign face the same relative prices of cloth and food,
they will also have the same factor prices.
• To understand how this equalization occurs, we have to realize that
when Home and Foreign trade with each other, more is happening
than a simple exchange of goods. In an indirect way, the two
countries are in effect trading factors of production.
• Home lets Foreign have the use of some of its abundant labour, not by
selling the labor directly but by trading goods produced with a high
ratio of labour to capital for goods produced with a low labour-capital
ratio. The goods that Home sells require more labour to produce than
the goods it receives in return; that is, more labour is embodied in
Home’s exports than in its imports.
• Thus Home exports its labour, embodied in its labour-intensive
exports. Conversely, since Foreign’s exports embody more capital than
its imports, Foreign is indirectly exporting its capital.
• In the real world, factor prices are not equalized. For example, there is
an extremely wide range of wage rates across countries. While some
of these differences may reflect differences in the quality of labor,
they are too wide to be explained away on this basis alone.
• To understand why the model doesn’t give us an accurate prediction,
we need to look at its assumptions. Three assumptions crucial to the
prediction of factor-price equalization are in reality certainly untrue.
These are the assumptions that (1) both countries produce both
goods; (2) technologies are the same; and (3) trade actually equalizes
the prices of goods in the two countries.
 Empirical evidence
• One would expect the United States to be an exporter of capital-
intensive goods and an importer of labor-intensive goods.
Surprisingly, however, this was not the case in the 25 years after
World War II. In a famous study published in 1953, economist Wassily
Leontief (winner of the Nobel Prize in 1973) found that U.S. exports
were less capital-intensive than U.S. imports. This result is known as
the Leontief paradox.
United States may be exporting goods that heavily use skilled labour
and innovative entrepreneurship, while importing heavy
manufactures (such as automobiles) that use large amounts of
capital.
• Bowen et al. calculated the ratio of each country’s endowment of
each factor to the world supply of that factor. They then compared
these ratios with each country’s share of world income. If the factor-
proportions theory was right, a country would always export factors
for which the factor share exceeded the income share, and import
factors for which it was less.
• This result confirms the Leontief paradox on a broader level: Trade
often does not run in the direction that the Heckscher-Ohlin theory
predicts. As with the Leontief paradox for the United States,
explanations for this result have centered on the failure of the
common technology assumption.
• Consider the United States, on one side, and China on the other. In 2008, the
United States had about 23 percent of world income but only about 5
percent of the world’s workers; so a simple factor-proportions theory would
suggest that U.S. imports of labor embodied in trade should have been huge,
something like four times as large as the nation’s own labor force. In fact,
calculations of the factor content of U.S. trade showed only small net
imports of labor.
• Conversely, China had 7 percent of world income but approximately 20
percent of the world’s workers in 2008; it therefore “should” have exported
most of its labour via trade—but it did not.
• Allowing for technology differences also helps to resolve this puzzle of
“missing trade.” The way this resolution works is roughly as follows: If
workers in the United States are much more efficient than those in China,
then the “effective” labour supply in the United States is much larger
compared with that of China than the raw data suggest.
 Patterns of exports between developed and
developing countries
• Although the overall pattern of international trade does not seem to
be very well accounted for by a pure Heckscher-Ohlin model,
comparisons of the exports of labour-abundant, skill scarce nations in
the third world with the exports of skill-abundant, labour-scarce
nations do fit the theory quite well.
• Consider the following figure, which compares the pattern of U.S.
imports from Bangladesh, whose work force has low levels of
education, with the pattern of U.S. imports from Germany, which has
a highly educated labour force.
Skill intensity and pattern of US imports
 Conclusion
• The empirical testing of the Heckscher-Ohlin model has produced mixed
results. The factor content of a country’s exports does not always reflect
that country’s abundant factors; and the volume of trade is substantially
lower than what would be predicted based on the large differences in
factor abundance between countries. However, the pattern of goods trade
between developed and developing countries fits the predictions of the
model quite well.
• The Heckscher-Ohlin also remains vital for understanding the effects of
trade, especially its effects on the distribution of income. Indeed, the
growth of North-South trade in manufactures—a trade in which the factor
intensity of the North’s imports is very different from that of its exports—
has brought the factor-proportions approach into the center of practical
debates over international trade policy.
The Standard Trade Model
 Introduction
• The standard trade model combines ideas from the Ricardian model and
the Heckscher-Ohlin model.
Differences in labour, labour skills, physical capital, land and technology
between countries cause productive differences, leading to gains from
trade.
These productive differences are represented as differences in production
possibility frontiers, which represent the productive capacities of nations.
A country’s PPF determines its relative supply curve.
National relative supply curves determine world relative supply, which
along with world relative demand determines an equilibrium under
international trade.
• Recall that when the economy maximizes its production possibilities,
the value of output V lies on the PPF.
• V = PCQC + PFQF describes the value of output in a two good model,
and when this value is constant the equation’s line is called an
isovalue line.
• The slope of any equation’s line equals – (PC /PF), and if relative prices
change the slope changes.
Value of Production

An economy whose production

possibility frontier is TT will
produce at Q, which is on the
highest possible iso-value line.
How an increase in relative price of cloth
affects relative supply?

The iso-value lines become

steeper when the relative price of
cloth rises from (PC/PF)1 to
(PC/PF)2. As a result, the economy
produces more cloth and less food
and the equillibrium output shifts
from Q1 to Q2
 The Value of Consumption
• The value of the economy’s consumption is constrained to equal the
value of the economy’s production.
PCDC + PFDF = PCQC + PFQF = V
• Production choices are determined by the economy’s PPF and the
prices of output.
• What determines consumption choices (demand)?
• Consumer preferences and prices determine consumption choices.
• Consumer preferences are represented by indifference curves:
combinations of goods that make consumers equally satisfied
(indifferent).
Domestic Country Trade

The economy produces at point Q,

where the production possibility
frontier is tangent to the highest
possible iso-value line. It consumes
at point D, where the iso-value line is
tangent to the highest possible
indifference curve. The economy
produces more cloth than it
consumes and therefore it exports
cloth; correspondingly it consumes
more food than it produces and
therefore imports food.
• Indifference curves are downward sloping to represent the fact that if
a consumer has more cloth he could have less food and still be
equally satisfied.
• Indifference curves farther from the origin represent larger quantities
of food and cloth, which should make consumers more satisfied and
better off.
• Indifference curves are flatter when moving to the right: the more
cloth and the less food that is consumed, the more valuable an extra
calorie of food becomes relative to an extra metre of cloth.
 Prices and the value of consumption
• Prices also determine the value of consumption.
When the price of cloth rises relative to the price of food, the
economy is better off when it exports cloth: a higher indifference
curve results.
A higher price for cloth exports means that more food can be
imported.
A higher relative price of cloth will also influence consumption
decisions about cloth versus food: a higher relative price of cloth
makes consumers willing to buy less cloth and more food.
Effects of a rise in the relative price of cloth
• The slope of the iso-value lines is equal to minus the relative price of
cloth PC/PF. When the relative price rises, iso-value lines become
steeper. In particular, the maximum iso-value line rotates from VV1 to
VV2. Production shifts from Q1 to Q2, consumption shifts from D1 to D2.
If the economy cannot trade, then it produces and consumes at point
D3 .
• Panel (b) shows the effects of the rise in the relative price of cloth on
relative production (move from 1 to 2) and relative demand (move
from 1’ to 2’. If the economy cannot trade, then it consumes and
produces at point 3.
• The change in welfare (income) when the price of one good changes
relative to the price of another is called the income effect.
The income effect is represented graphically by shifting the
indifference curve.
• The substitution of one good for another when the price of the good
changes relative to the other is called the substitution effect.
This substitution effect is represented graphically by a moving along a
given indifference curve.
 Welfare and the terms of trade
• The terms of trade refers to the price of exports relative to the price
of imports.
• When a country exports cloth and the relative price of cloth
increases, the terms of trade increase or “improve”.
• Because a higher price for exports means that the country can afford
to buy more imports, an increase in the terms of trade increases a
country’s welfare.
• A decrease in the terms of trade decreases a country’s welfare.
 Determining Relative Prices
• To determine the price of cloth relative to the price food in our
model, we again use relative supply and relative demand.
relative supply considers world supply of cloth relative to that of food
at each relative price
relative demand considers world demand of cloth relative to that of
food at each relative price
In a two country model, world quantities are the sum of quantities
from the domestic and foreign countries.
Relative Supply and Demand
Equillibrium relative price and trade flows
 Effects of Economic Growth
• Economic growth means an outward shift of a country’s production
possibility frontier. This growth can result either from increases in a
country’s resources or from improvements in the efficiency with which
these resources are used.
• Is growth in a country more or less valuable when it when it is integrated in
the world economy? The standard trade model gives us precise answers to
these questions.
• Growth is usually biased: it occurs in one sector more than others, causing
relative supply to shift.
According to the Ricardian model, technological progress in one sector
causes biased growth.
According to the Heckscher-Ohlin model, an increase in one factor of
production (e.g., an increase in the labour force, arable land, or the capital
stock) causes biased growth.
Biased Growth
• Biased growth and the resulting shift in relative supply causes a
change in the terms of trade.
• Biased growth in the cloth industry (in either the domestic or foreign
country) will lower the relative price of cloth and lower the terms of
trade for cloth exporters.
• Biased growth in the food industry (in either the domestic or foreign
country) will raise the relative price of cloth and raise the terms of
trade for cloth exporters.
• Suppose that the domestic country exports cloth and imports food.
Growth and World Relative Supply
• Notice that the important consideration here is not which economy
grows but rather the bias of that growth. If Foreign had experienced
growth strongly biased toward cloth, the effect on the world relative
supply curve and thus on the terms of trade would have been similar.
• On the other hand, either Home or Foreign growth strongly biased
toward food will lead to a leftward shift of the RS curve for the world
and thus to a rise in the relative price of cloth.
• Export-biased growth is growth that expands a country’s PPF
disproportionally in production of that country’s exports.
Biased growth in the food industry in the foreign country is export-
biased growth for the foreign country.
• Import-biased growth is growth that expands a country’s PPF
disproportionally in production of that country’s imports.
Biased growth in cloth production in the foreign country is import-
biased growth for the foreign country.
• Export-biased growth reduces a country’s terms of trade, generally
reducing its welfare and increasing the welfare of foreign countries.
• Import-biased growth increases a country’s terms of trade, generally
increasing its welfare and decreasing the welfare of foreign countries.
• The standard trade model predicts that import biased growth in China
reduces the US terms of trade and the standard of living in the US.
Import biased growth for China would occur in sectors that compete
with US exports.
• But this prediction is not supported by data. There should be
negative changes in the terms of trade for the US and other high
income countries.
In fact, the terms of trade for high income countries have been
positive and negative for developing Asian countries.
 Import Tariffs and Export Subsidies
• Import tariffs are taxes levied on imports. Export subsidies are
payments given to domestic producers that export. These
government interventions in trade usually take place for income
distribution, for the promotion of industries thought to be crucial to
the economy, or for balance of payments.
• Both policies influence the terms of trade and therefore national
welfare
• The terms of trade refers to the relative value of a country’s exports
and a country’s imports.
• The distinctive feature of tariffs and export subsidies is that they create a
difference between prices at which goods are traded on the world market
and prices at which those goods can be purchased within a country.
• The direct effect of a tariff is to make imported goods more expensive
inside a country than they are outside the country. An export subsidy gives
producers an incentive to export. It will therefore be more profitable to sell
abroad than at home unless the price at home is higher, so such a subsidy
raises the prices of exported goods inside a country.
• When countries are big exporters or importers of a good (relative to the size
of the world market), the price changes caused by tariffs and subsidies
change both relative supply and relative demand on world markets. The
result is a shift in the terms of trade, both of the country imposing the
policy change and of the rest of the world.
Relative Demand and Supply effects of a tariff
• Tariffs and subsidies drive a wedge between the prices at which goods are
traded internationally (external prices) and the prices at which they are
traded within a country (internal prices).
• This means that the terms of trade correspond to external, rather than
internal, prices. When analyzing the effects of a tariff or export subsidy,
therefore, we want to know how that tariff or subsidy affects relative
supply and demand as a function of external prices.
• If Home imposes a 20 percent tariff on the value of food imports, for
example, the internal price of food relative to cloth faced by Home
producers and consumers will be 20 percent higher than the external
relative price of food on the world market. Equivalently, the internal
relative price of cloth on which Home residents base their decisions will be
lower than the relative price on the external market.
• At any given world relative price of cloth, then, Home producers will
face a lower relative cloth price and therefore will produce less cloth
and more food. At the same time, Home consumers will shift their
consumption toward cloth and away from food.
• From the point of view of the world as a whole, the relative supply of
cloth will fall while the relative demand for cloth will rise.
• Clearly, the world relative price of cloth rises and thus Home’s terms
of trade improve at Foreign’s expense.
Effects of an import tariff on terms of trade

.
• When the domestic country imposes an import tariff, the terms of
trade increases and the welfare of the country may increase.
• The magnitude of this effect depends on the size of the domestic
country relative to the world economy.
If the country is small part of the world economy, its tariff (or
subsidy) policies will not have much effect on world relative supply
and demand, and thus on the terms of trade.
But for large countries, a tariff rate that maximizes national welfare at
the expense of foreign countries may exist.
 Export Subsidies and Distribution of Income
• Tariffs and export subsidies are often treated as similar policies, since they
both seem to support domestic producers, but they have opposite effects
on the terms of trade.
• Suppose that Home offers a 20 percent subsidy on the value of any cloth
exported. For any given world prices, this subsidy will raise Home’s internal
price of cloth relative to that of food by 20 percent. The rise in the relative
price of cloth will lead Home producers to produce more cloth and less
food, while leading Home consumers to substitute food for cloth.
• The subsidy will increase the world relative supply of cloth and decrease
the world relative demand for cloth, shifting equilibrium from point 1 to
point 2. A Home export subsidy worsens Home’s terms of trade and
improves Foreign’s.
Effects of an export subsidy on terms of trade
• The two country, two good model predicts that
an import tariff by the domestic country can increase domestic
welfare at the expense of the foreign country.
an export subsidy by the domestic country reduces domestic welfare
to the benefit of the foreign country.
Import tariffs by foreign countries on goods that
India exports reduce the world price of India’s exports and decrease
India’s terms of trade.
India also imports reduce the world price of India’s imports and
increase India’s terms of trade.
Export subsidies by foreign countries on goods that
India imports reduce the world price of India’s imports and increase
India’s terms of trade.
India also exports reduce the world price of India’s exports and
decrease India’s terms of trade.
• Generally, a domestic import tariff increases income for domestic
import-competing producers by allowing the price of their goods to
rise to match increased import prices, and it shifts resources away
from the export sector.
• Generally, a domestic export subsidy increases income for domestic
exporters, and it shifts resources away from the import-competing
sector.
Economies of Scale, Imperfect
Competition and International
Trade
 Introduction
• When defining comparative advantage, the Ricardian model and the
Heckscher-Ohlin model both assume constant returns to scale:
If all factors of production are doubled then output will also double.
• But a firm or industry may have increasing returns to scale or
economies of scale:
If all factors of production are doubled, then output will more than
double.
Larger is more efficient: the cost per unit of output falls as a firm or
industry increases output.
• The Ricardian and Heckscher-Ohlin models also rely on competition
to predict that all income from production is paid to owners of factors
of production: no “excess” or monopoly profits exist.
• But when economies of scale exist, large firms may be more efficient
than small firms, and the industry may consist of a monopoly or a few
large firms.
Production may be imperfectly competitive in the sense that excess
or monopoly profits are captured by large firms.
 Types of Economies of Scale
• Economies of scale could mean either that larger firms or that a larger
industry (e.g., one made of more firms) is more efficient.
• External economies of scale occur when cost per unit of output depends
on the size of the industry.
• Internal economies of scale occur when the cost per unit of output
depends on the size of a firm.
• External economies of scale may result if a larger industry allows for more
efficient provision of services or equipment to firms in the industry.
• Many small firms that are competitive may comprise a large industry and
benefit from services or equipment efficiently provided to the large group
of firms.
• Internal economies of scale result when large firms have a cost advantage
over small firms, which leads to an imperfectly competitive market.
 A Review of Monopoly
• A monopoly is an industry with only one firm.
• An oligopoly is an industry with only a few firms.
• A characteristic of a monopoly (and to some degree an oligopoly) is
that is marginal revenue generated from selling an additional unit of
output is lower than the price of output.
• Without price discrimination, a monopoly must lower the price of an
additional unit sold, as well as the prices of other units sold.
• The marginal revenue curve lies below the demand curve (which
determines the price of units sold).
Monopolistic pricing and production decisions
• If monopolistic firms have linear demand curves, then the relationship
between price and quantity may be represented as:
Q = A – B.P where A and B are constants
and marginal revenue may be represented as
MR = P – Q/B
• When firms maximize profits, they set marginal revenue = marginal cost:
MR = P – Q/B = c
• Average cost is the cost of production (C) divided by the total quantity
of output produced (Q) at a time.
AC = C/Q
• Marginal cost is the cost of producing an additional unit of output.
• Suppose that costs are measured by C = F + c.Q, where F represents
fixed costs, independent of the level of output. c represents a
constant marginal cost: the constant cost of producing an additional
unit of output Q.
AC = F/Q + c
• A larger firm is more efficient because average cost decreases as
output Q increases: internal economies of scale.
Average versus Marginal cost

This figure illustrates the average

and marginal costs corresponding
to the total cost function C= 5+x.
Marginal cost is always 1; average
costs decline as output rises.
 Monopolistic Competition
• Monopolistic competition is a model of an imperfectly competitive
industry which assumes that
• Each firm can differentiate its product from the product of competitors.
• Each firm ignores the impact that changes in its own price will have on the
prices competitors set: even though each firm faces competition, it
behaves as if it were a monopolist.
• A firm in a monopolistically competitive industry is expected:
to sell more the larger the total sales of the industry and the higher the
prices charged by its rivals.
to sell less the larger the number of firms in the industry and the higher its
own price.
• These concepts are represented by the mathematical relationship
Q = S[1/n – b(P –𝑷)]
Q is an individual firm’s sales
S is the total sales of the industry
n is the number of firms in the industry
b is a constant term representing the responsiveness of a firm’s sales to
its price
P is the price charged by the firm itself
𝑃 is the average price charged by its competitors
• To make the model easier to understand, we assume that all firms
have identical demand functions and cost functions.
• Thus in equilibrium, all firms charge the same price: 𝑷 =P. In
equilibrium,
Q = S/n + 0
AC = C/Q = F/Q + c = F(n/S) + c
The Number of Firms and Average Cost
AC = F(n/S) + c
• The larger the number of firms n in the industry, the higher the average
cost for each firm because the less each firm produces.
• The larger the total sales S of the industry, the lower the average cost
for each firm because the more that each firm produces.
The Number of Firms and the Price
Q = S[1/n – b(P – 𝑷)]
Q = S/n – Sb(P – 𝑷)
Q = S/n + Sb𝑷 – SbP
Let A= S/n + Sb𝑷 and B ≡ Sb
Q = A – BxP
 MR = P – Q/B = c
MR = P – Q/Sb = c
P = c + Q/Sb
P = c + (S/n)/Sb
P = c + 1/(nxb)
• The larger the number of firms n in the industry, the lower the price
each firm charges because of increased competition.
• At some number of firms, the price that firms charge (which decreases in
n) matches the average cost that firms pay (which increases in n).
• This number of firms is the number at which each firm has zero profits:
price matches average cost. This number is the equilibrium number of
firms.
Equillibrium in a monopolistically competitive
market
The number of firms in a monopolistically
competitive market, and the prices that
they charge are determined by two
relationships. On the one hand, the more
firms there are, the more intensely they
compete, and hence lower is the industry
price. This relationship is described by PP.
On the other side, more firms there are, the
less each firm sells and therefore higher is
its average cost. This relationship is
described by CC. If price exceeds average
cost, industry will be making profits and
new firms will enter; if PP lies below CC
industry will be making losses and firms will
exit.
• If the number of firms is greater than or less than n2, then in industry
is not in equilibrium in the sense that firms have an incentive to exit
or enter the industry.
• Firms have an incentive to enter the industry when profits are greater
than zero (price > average cost).
• Firms have an incentive to exit the industry when profits are less than
zero (price < average cost).
• Because trade increases market size, trade is predicted to decrease
average cost in an industry described by monopolistic competition.
• Industry sales increase with trade leading to decreased average costs:
AC = F(n/S) + c
• Because trade increases the variety of goods that consumers can buy
under monopolistic competition, it increases the welfare of
consumers.
• Because average costs decrease, consumers can also benefit from a
decreased price.
Effects of a Larger Market
An increase in the size of the market
allows each firm, other things equal, to
produce more and thus have lower
average cost. This is represented by a
downward shift from CC1 to CC2. The
result is a simultaneous increase in the
number of firms and hence in the variety
of goods available and fall in the price of
each.
As a result of trade, the number of firms
in a new international industry is
predicted to increase relative to each
national market. But it is unclear if firms
will locate in the domestic country or
foreign countries.
 Inter-industry Trade

• According to the Heckscher-Ohlin model or Ricardian model, countries

specialize in production.
Trade occurs only between industries: inter-industry trade
• In a Heckscher-Ohlin model suppose that:
The capital abundant domestic economy specializes in the production
of capital intensive cloth, which is imported by the foreign economy.
The labour abundant foreign economy specializes in the production of
labour intensive food, which is imported by the domestic economy.
 Intra-industry Trade
• Suppose now that the global cloth industry is described by the
monopolistic competition model.
• Because of product differentiation, suppose that each country produces
different types of cloth.
• Because of economies of scale, large markets are desirable: the foreign
country exports some cloth and the domestic country exports some cloth.
• Trade occurs within the cloth industry: intra-industry trade
• If domestic country is capital abundant, it should therefore export more
cloth than it imports.
• Suppose that the trade in the food industry continues to be determined by
comparative advantage.
Trade with increasing returns and
monopolistic competition
If cloth is a monopolistically
competitive industry, Home and
Foreign will produce differentiated
products. As a result, even if
Home is a net exporter of cloth
goods, it will import as well as
export cloth, giving rise to intra
industry trade.
 Inter-industry trade and intra-industry trade
Gains from inter-industry trade reflect comparative advantage.
Gains from intra-industry trade reflect economies of scale (lower costs)
and wider consumer choices.
The monopolistic competition model does not predict in which country
firms locate, but a comparative advantage in producing the differentiated
good will likely cause a country to export more of that good than it
imports.
The relative importance of intra-industry trade depend on how similar
countries are.
Countries with similar relative amounts of factors of production are
predicted to have intra-industry trade.
Countries with different relative amounts of factors of production are
predicted to have inter-industry trade.
Unlike inter-industry trade in the Heckscher-Ohlin model, income
distribution effects are not predicted to occur with intra-industry
trade.
• About 25% of world trade is intra-industry trade according to
standard industrial classifications.
But some industries have more intra-industry trade than others:
those industries requiring relatively large amounts of skilled labour,
technology and physical capital exhibit intra-industry trade.
Countries with similar relative amounts of skilled labour, technology
and physical capital engage in a large amount of intra-industry trade.
 Dumping
• Dumping is the practice of charging a lower price for exported goods
than for goods sold domestically.
• Dumping is an example of price discrimination: the practice of
charging different customers different prices.
• Price discrimination and dumping may occur only if
imperfect competition exists: firms are able to influence market
prices.
markets are segmented so that goods are not easily bought in one
market and resold in another.
• Dumping may be a profit maximizing strategy because of differences
in foreign and domestic markets.
• One difference is that domestic firms usually have a larger share of
the domestic market than they do of foreign markets.
Because of less market dominance and more competition in foreign
markets, foreign sales are usually more responsive to price changes
than domestic sales.
Domestic firms may be able to charge a high price in the domestic
market but must charge a low price on exports if foreign consumers
are more responsive to price changes.
• We can see how dumping occurs when a firm is a monopolist in the
domestic market but a small competitive firm in foreign markets.
Because the firm is a monopolist in the domestic market, the
domestic market demand curve is downward sloping, and the
marginal revenue curve lies below that demand curve.
Because the firm is a small competitive firm in foreign markets, the
foreign market demand curve is horizontal, representing the fact that
exports are very responsive to small price changes
• The figure shows a monopolist that faces a demand curve DDOM for
domestic sales, but which can also sell as much as it likes at the
export price PFOR. Since an additional item can always be sold at PFOR,
the firm increases output until the marginal cost equals PFOR. This
profit maximizing output is shown as QMONOPOLY . Since the firm’s
marginal cost at QMONOPOLY is PFOR, it sells output in the domestic
market upto the point where marginal revenue equals PFOR. This profit
maximizing level of domestic sales is shown as QDOM. The rest of its
output QMONOPOLY - QDOM is exported.
• The price at which domestic consumers demand QDOM is PDOM. Since
PDOM> PFOR, the firm sells exports at a lower price than it charges
domestic consumers.
• To maximize profits, the firm will sell a low amount in the domestic
market at a high price PDOM , but sell in foreign markets at a low price
PFOR
Since an additional unit can always be sold at PFOR , the firm will sell
its products at a high price in the domestic market until marginal
revenue there falls to PFOR.
Thereafter, it will sell exports at PFOR until marginal costs exceed this
price.
• In this case, dumping is a profit-maximizing strategy.
 Protectionism and Dumping
• Dumping (as well as price discrimination in domestic markets) is
widely regarded as unfair.
• The Commerce Department may impose an “anti-dumping duty”, or
tax, as a precaution against possible injury.
• This tax equals the difference between the actual and “fair” price of
imports, where “fair” means “price the product is normally sold at in
the manufacturer's domestic market ”.
 External Economies of Scale
• If external economies exist, a country that has a large industry will have
low costs of producing that industry’s good or service.
• External economies may exist for a few reasons:
Specialized equipment or services may be needed for the industry, but are
only supplied by other firms if the industry is large and concentrated.
For example, Silicon Valley in California has a large concentration of silicon
chip companies, which are serviced by companies that make special
machines for manufacturing silicon chips.
These machines are cheaper and more easily available for Silicon Valley
firms than for firms elsewhere.
Labour pooling: a large and concentrated industry may attract a pool
of workers, reducing employee search and hiring costs for each firm.
Knowledge spillovers: workers from different firms may more easily
share ideas that benefit each firm when a large and concentrated
industry exists.
• If external economies exist, the pattern of trade may be due to
historical accidents:
countries that start out as large producers in certain industries tend
to remain large producers even if some other country could
potentially produce the goods more cheaply.
External economies and specialization
The average cost curve for Thailand
ACTHAI, lies below the average cost curve
for Switzerland ACSWISS. Thus, Thailand
could potentially supply the world
market more cheaply than Switzerland.
If the Swiss industry gets established
first, however, it may be able to sell
watches at the price P1, which is below
the cost C0 that an individual Thai firm
would face if it began production on its
own. So a pattern of specialization
established by historical accident may
persist even when new producers could
potentially have lower costs.
• Trade based on external economies has an ambiguous effect on
national welfare.
• There may be gains to the world economy by concentrating
production of industries with external economies.
• But there is no guarantee that the right country will produce a good
subject to external economies.
• It is even possible that a country is worse off with trade than it would
have been without trade: a country may be better off if it produces
everything for its domestic market rather than pay for imports.
External economies and losses from trade
When there are external economies,
trade can potentially leave a country
worse off than it would be in the
absence of trade. Thailand imports
watches from Switzerland, which is
able to supply the world market
DWORLD at a price P1 low enough to
block entry by Thai producers who
must initially produce watches at
cost C0. Yet if Thailand were to block
all trade in watches, it would be able
to supply its domestic market DTHAI at
a lower price P2.
• We have considered cases where external economies depend on the
amount of current output at a point in time.
• But external economies may also depend on the amount of cumulative
output over time.
• Dynamic external economies of scale (dynamic increasing returns to
scale) exist if average costs fall as cumulative output over time rises.
• Dynamic increasing returns to scale could arise if the cost of production
depends on the accumulation of knowledge and experience, which
depend on the production process over time.
• A graphical representation of dynamic increasing returns to scale is
called a learning curve.
The Learning Curve
The learning curve shows that unit
cost is lower the greater the
cumulative output of a country’s
industry to date. A country that
has extensive experience in an
industry may have a lower unit
cost than other country with little
or no work experience, even if the
second country’s learning curve
(L*) is lower is lower, for example,
because of lower wages.
• Like external economies of scale at a point in time, dynamic
increasing returns to scale can lock in an initial advantage or head
start in an industry.
• Like external economies of scale at a point in time, dynamic
increasing returns to scale can be used to justify protectionism.
Temporary protection of industries enables them to gain experience:
infant industry argument.
But temporary is often for a long time, and it is hard to identify when
external economies of scale really exist.
Instruments of Trade Policy
 Introduction
• A specific tariff is levied as a fixed charge for each unit of imported goods.
For example, Rs 1 per kg of cheese
• An ad valorem tariff is levied as a fraction of the value of imported goods.
For example, 25% tariff on the value of imported cars.
• Let’s construct a model measuring how a tariff affects a single market, say
that of wheat.
• Suppose that in the absence of trade the price of wheat in the foreign
country is lower than that in the domestic country.
With trade the foreign country will export: construct an export supply
curve.
With trade the domestic country will import: construct an import demand
curve.
• An export supply curve is the difference between the quantity that
foreign producers supply minus the quantity that foreign consumers
demand, at each price.
• An import demand curve is the difference between the quantity that
domestic consumers demand minus the quantity that domestic
producers supply, at each price.
• In equilibrium, import demand = export supply
domestic demand – domestic supply = foreign supply – foreign demand
• In equilibrium, world demand = world supply
Deriving Foreign’s Export Supply Curve
Deriving Home’s Import Demand Curve
World Equillibrium
 The Effects of a Tariff
• A tariff acts as an added cost of transportation, making shippers
unwilling to ship goods unless the price difference between the
domestic and foreign markets exceeds the tariff.
• If shippers are unwilling to ship wheat, there is excess demand for
wheat in the domestic market and excess supply in the foreign
market.
The price of wheat will tend to rise in the domestic market.
The price of wheat will tend to fall in the foreign market.
• Thus, a tariff will make the price of a good rise in the domestic market
and will make the price of a good fall in the foreign market, until the
price difference equals the tariff.
• PT – P*T = t ; PT = P*T + t
• The price of the good in foreign (world) markets should fall if there is
a significant drop in the quantity demanded of the good caused by
the domestic tariff.
• Because the price in domestic markets rises (to PT), domestic
producers should supply more and domestic consumers should
demand less.
• The quantity of imports falls from QW to QT
• Because the price in foreign markets falls (to P*T), foreign producers
should supply less and foreign consumers should demand more.
• The quantity of exports falls from QW to QT
• The quantity of domestic import demand equals the quantity of
foreign export supply when PT – P*T = t
• In this case, the increase in the price of the good in the domestic
country is less than the amount of the tariff.
Part of the tariff is reflected in a decline of the foreign country’s
export price, and thus is not passed on to domestic consumers.
Effects of Tariff in a small country
When a country is “small”, it has
no effect on the foreign (world)
price of a good, because its
demand for the good is an
insignificant part of world demand.
Therefore, the foreign price will
not fall, but will remain at Pw
The price in the domestic market,
however, will rise to PT = Pw + t
 Effective Rate of Protection
• The effective rate of protection measures how much protection a
tariff or other trade policy provides domestic producers.
It represents the change in value that an industry adds to the
production process when trade policy changes.
The change in value that an industry provides depends on the change
in prices when trade policies change.
Effective rates of protection often differ from tariff rates because
tariffs affect sectors other than the protected sector, a fact which
affects the prices and value added for the protected sector.
• For example, suppose that an automobile sells on the world market for
Rs 8000, and the parts that made it are worth Rs 6000.
• The value added of the auto production is Rs 8000- Rs 6000
• Suppose that a country puts a 25% tariff on imported autos so that
domestic auto assembly firms can now charge up to Rs 10000 instead
of Rs 8000.
• Now auto assembly will occur if the value added is up to Rs 10000-
Rs 6000.
• The effective rate of protection for domestic auto assembly firms is the
change in value added: (Rs 4000 - Rs 2000)/ Rs 2000 = 100%
In this case, the effective rate of protection is greater than the tariff
rate.
 Costs and Benefits of Tariffs
• A tariff raises the price of a good in the importing country, so we expect it to
hurt consumers and benefit producers there. In addition, the government
gains tariff revenue from a tariff.
• How to measure these costs and benefits? We use the concepts of
consumer surplus and producer surplus.
• Consumer surplus measures the amount that a consumer gains from a
purchase by the difference in the price he pays from the price he would
have been willing to pay.
• The price he would have been willing to pay is determined by a demand
(willingness to buy) curve.
• When the price increases, the quantity demanded decreases as well as the
consumer surplus.
Consumer Surplus
 Producer Surplus
• Producer surplus measures the amount that a producer gains from a sale
by the difference in the price he receives from the price he would have
been willing to sell at.
The price he would have been willing to sell at is determined by a supply
(willingness to sell) curve.
When price increases, the quantity supplied increases as well as the
producer surplus.
• A tariff raises the price of a good in the importing country, making its
consumer surplus decrease (making its consumers worse off) and making
its producer surplus increase (making its producers better off).
• Also, government revenue will increase
Costs and benefits of tariffs for an importing
country
• For a “large” country that can affect foreign (world) prices, the
welfare effect of a tariff is ambiguous.
• The triangles b and d represent the efficiency loss.
• The tariff distorts production and consumption decisions: producers
produce too much and consumers consume too little compared to
the market outcome.
• The rectangle e represents the terms of trade gain.
• The terms of trade increases because the tariff lowers foreign export
(domestic import) prices.
• Government revenue from the tariff equals the tariff rate times the
quantity of imports.
t = PT – P*T
QT = D2 – S2
Government revenue = t x QT = c + e
• Part of government revenue (rectangle e) represents the terms of
trade gain, and part (rectangle c) represents part of the value of lost
consumer surplus.
• The government gains at the expense of consumers and foreigners.
• If the terms of trade gain exceeds the efficiency loss, then national
welfare will increase under a tariff, at the expense of foreign
countries.
• However, this analysis assumes that the terms of trade does not
change due to tariff changes by foreign countries (i.e., due to
retaliation).
Net Welfare effects of Tariff
 Export Subsidy
• An export subsidy can also be specific or ad valorem
• A specific subsidy is a payment per unit exported.
• An ad valorem subsidy is a payment as a proportion of the value
exported.
• An export subsidy raises the price of a good in the exporting country,
making its consumer surplus decrease (making its consumers worse
off) and making its producer surplus increase (making its producers
better off).
• Also, government revenue will decrease.
• An export subsidy raises the price of a good in the exporting country,
while lowering it in foreign countries.
• In contrast to a tariff, an export subsidy worsens the terms of trade by
lowering the price of domestic products in world markets.
• An export subsidy unambiguously produces a negative effect on
national welfare.
• The triangles b and d represent the efficiency loss.
The tariff distorts production and consumption decisions: producers
produce too much and consumers consume too little compared to
the market outcome.
• The area b + c + d + f + g represents the cost of government subsidy.
In addition, the terms of trade decreases, because the price of
exports falls in foreign markets to P*s.
 Import Quota
• An import quota is a restriction on the quantity of a good that may be
imported.
• This restriction is usually enforced by issuing licenses to domestic firms that
import, or in some cases to foreign governments of exporting countries.
• A binding import quota will push up the price of the import because the
quantity demanded will exceed the quantity supplied by domestic
producers and from imports.
• When a quota instead of a tariff is used to restrict imports, the government
receives no revenue.
Instead, the revenue from selling imports at high prices goes to quota
license holders: either domestic firms or foreign governments.
These extra revenues are called quota rents.
 Voluntary Export Restraint
• A voluntary export restraint works like an import quota, except that
the quota is imposed by the exporting country rather than the
importing country.
• However, these restraints are usually requested by the importing
country.
• The profits or rents from this policy are earned by foreign
governments or foreign producers.
Foreigners sell a restricted quantity at an increased price.
 Local Content Requirement
• A local content requirement is a regulation that requires a specified
fraction of a final good to be produced domestically.
• It may be specified in value terms, by requiring that some minimum
share of the value of a good represent domestic valued added, or in
physical units.
• From the viewpoint of domestic producers of inputs, a local content
requirement provides protection in the same way that an import
quota would.
• From the viewpoint of firms that must buy domestic inputs, however,
the requirement does not place a strict limit on imports, but allows
firms to import more if they also use more domestic parts.
• Local content requirement provides neither government revenue (as
a tariff would) nor quota rents.
• Instead the difference between the prices of domestic goods and
imports is averaged into the price of the final good and is passed on
to consumers.
 Case for Free Trade

• The first case for free trade is the argument that producers and
consumers allocate resources most efficiently when governments do
not distort market prices through trade policy.
National welfare of a small country is highest with free trade.
With restricted trade, consumers pay higher prices.
With restricted trade, distorted prices cause overproduction either by
existing firms producing more or by more firms entering the industry.
 However, because tariff rates are already low for most countries,
estimated benefits of moving to free trade are only a small fraction of
national income for most countries.
Efficiency case for Free Trade
• A second argument for free trade is that allows firms or industry to
take advantage of economies of scale.
• A third argument for free trade is that it provides competition and
opportunities for innovation.
• A fourth argument, called the political argument for free trade, says
that free trade is the best feasible political policy, even though there
may be better policies in principle.
• Any policy that deviates from free trade would be quickly
manipulated by special interests, leading to decreased national
welfare.
 Case Against Free Trade
• The possibility that a tariff could improve national welfare for a large
country in international markets was first noted by Robert Torrens (1844).
Since the welfare improvement occurs only if the terms of trade gain
exceeds the total deadweight losses, the argument is commonly known as
the Terms of Trade Argument for protection.
• For a “large” country, a tariff or quota lowers the price of imports in world
markets and generates a terms of trade gain.
This benefit may exceed production and consumption distortions.
• In fact, a small tariff will lead to an increase in national welfare for a large
country.
But at some tariff rate, the national welfare will begin to decrease as the
economic efficiency loss exceeds the terms of trade gain.
Components of Welfare and Tariff
Optimum Tariff
For a large country, there is an
optimum tariff t0 at which the
marginal gains from improved
terms of trade just equals the
marginal efficiency loss from
production and consumption
distortion.
Trade liberalization?
International Resource
Movements and MNCs
 Introduction
• We have dealt almost exclusively with commodity trade and have assumed
no international resource movement. However, capital, labor, and
technology do move across national boundaries.
• As in the case of international trade, the movement of productive
resources from nations with relative abundance and low remuneration to
nations with relative scarcity and high remuneration has a tendency to
equalize factor returns internationally and generally increases welfare.
• International trade and movements of productive factors, however, have
very different economic effects on the nations involved. Since multinational
corporations are an important vehicle for the international flows of capital,
labor, and technology, we also devote a great deal of attention to this
relatively new and crucial type of economic enterprise.
• There are two main types of foreign investments: portfolio investments
and direct investments. Portfolio investments are purely financial assets,
such as bonds, denominated in a national currency. With bonds, the
investor simply lends capital to get fixed payouts or a return at regular
intervals and then receives the face value of the bond at a pre-specified
date. Portfolio or financial investments take place primarily through
financial institutions such as banks and investment funds.
• Direct investments, on the other hand, are real investments in factories,
capital goods, land, and inventories where both capital and management
are involved and the investor retains control over use of the invested
capital. Direct investment usually takes the form of a firm starting a
subsidiary or taking control of another firm (for example, by purchasing a
majority of the stock)
Inward and Outward FDI India
 Motives for International Capital Flows
• The basic motive for international portfolio investments is to earn
higher returns abroad. Thus, residents of one country purchase bonds
of another country if the returns on bonds are higher in the other
country.
• The explanation that international portfolio investments occur to take
advantage of higher yields abroad is certainly correct as far as it goes.
The problem is that it leaves one important fact unexplained. It
cannot account for observed two-way capital flows.
• To explain two-way international capital flows, the element of risk
must be introduced. That is, investors are interested not only in the
rate of return but also in the risk associated with a particular
investment.
 Motives for Direct Foreign Investments
• The motives for direct investments abroad are generally the same as for
portfolio investments, that is, to earn higher returns (possibly resulting
from higher growth rates abroad, more favourable tax treatment, or
greater availability of infrastructures) and to diversify risks.
• Although they cannot explain why the residents of a nation do not borrow
from other nations and themselves make real investments in their own
nation rather than accept direct investments from abroad.
• There are several possible explanations for this. The most important is that
many large corporations (usually in monopolistic and oligopolistic markets)
often have some unique production knowledge or managerial skill that
could easily and profitably be utilized abroad and over which the
corporation wants to retain direct control. In such a situation, the firm will
make direct investments abroad. This involves horizontal integration, or
the production abroad of a differentiated product that is also produced at
home.
• Another important reason for direct foreign investments is to obtain
control of a needed raw material and thus ensure an uninterrupted supply
at the lowest possible cost. This is referred to as vertical integration and is
the form of most direct foreign investments in developing countries and in
some mineral-rich developed countries.
• Still other reasons for direct foreign investments are to avoid tariffs and
other restrictions that nations impose on imports or to take advantage of
various government subsidies to encourage direct foreign investments.
• Other possible reasons for direct foreign investments are to enter a foreign
oligopolistic market so as to share in the profits, to purchase a promising
foreign firm to avoid its future competition and the possible loss of export
markets, or because only a large foreign multinational corporation can
obtain the necessary financing to enter the market.
• Two-way direct foreign investments can then be explained by some
industries being more advanced in one nation (such as the computer
industry in the United States), while other industries are more efficient in
other nations (such as the automobile industry in Japan).
• Direct foreign investments have been greatly facilitated (in a sense made
possible) by the very rapid advances in transportation (i.e., jet travel) and
communications (i.e., international telephone lines and international data
transmission and processing) that have occurred since the end of World
War II.
• These advances permit the headquarters of multinational corporations to
exert immediate and direct control over the operations of their subsidiaries
around the world, thus facilitating and encouraging direct investments
abroad.
 Welfare Effects of International Capital Flows
• We examine the welfare effects of international capital flows on the
investing and host countries. In order to isolate the effect of capital
flows, we assume here that there is no trade in goods.
• The VMPK1 and VMPK2 curves give the value of the marginal product
of capital in Nation 1 and Nation 2, respectively, for various levels of
investments. Under competitive conditions, the value of the marginal
product of capital represents the return, or yield, on capital.
Of the total capital stock of OO’ , Nation
1 holds OA and its total output is OFGA,
while Nation 2 holds O’A and its total
output is O’JMA.
The transfer of AB of capital from
Nation 1 to Nation 2 equalizes the
return on capital in the two nations at
BE. This increases world output by EGM
(the shaded area), of which EGR accrues
to Nation 1 and ERM to Nation 2.
Of the increase in total domestic
product of ABEM in Nation 2, ABER goes
to foreign investors, leaving ERM as the
net gain in domestic income in Nation 2.
• From the point of view of the world as a whole (i.e., the two nations
combined), total product increased from by ERG + ERM = EGM (the
shaded area of the figure). Thus, international capital flows increase
the efficiency in the allocation of resources internationally and
increase world output and welfare.
• Note that the steeper the VMPK1 and VMPK2 curves are, the greater
is the total gain from international capital flows.
 Other Effects
• Assuming two factors of production, capital and labor, both fully employed
before and after the capital transfer, it can be seen that the total and
average return on capital increases, whereas the total and average return
to labour decreases in the investing country.
• While the investing country as a whole gains from investing abroad, there
is a redistribution of domestic income from labour to capital. It is for this
reason that organized labour in developed countries is opposed to
investments abroad. On the other hand, while the host country also gains
from receiving foreign investments, these investments lead to a
redistribution of domestic income from capital to labour.
• If we allow for less than full employment, foreign investments tend to
depress the level of employment in the investing country and increase it
in the host country and, once again, can be expected to be opposed by
labour in the former and to benefit labour in the latter.
• International capital transfers also affect the balance of payments of the
investing and host countries. A nation’s balance of payments measures its
total receipts from and total expenditures in the rest of the world.
• In the year in which the foreign investment takes place, the foreign
expenditures of the investing country increase and cause a balance-of-
payments deficit (an excess of expenditures abroad over foreign receipts).
• The initial capital transfer and increased expenditures abroad of the
investing country are likely to be mitigated by increased exports of capital
goods, spare parts, and other products of the investing country, and by the
subsequent flow of profits to the investing country. It has been estimated
that the “payback” period for the initial capital transfer is between five and
ten years on average.
• Another effect to consider in the long run is whether foreign investments
will lead to the replacement of the investing country’s exports and even to
imports of commodities previously exported. Thus, while the immediate
effect on the balance of payments is negative in the investing country
and positive in the host country, the long-run effects are less certain.
• Since foreign investments for most developed countries are two-way, these
short-run and long-run balance-of-payments effects are mostly neutralized,
except for the United Kingdom, the United States, Germany, and Japan,
with investments abroad greatly exceeding foreign investments received,
and for most developing countries that are primarily recipients of foreign
investments and chronically face serious balance-of-payments difficulties.
 Multinational Corporations
• One of the most significant international economic developments of the postwar
period is the proliferation of multinational corporations (MNCs). These are firms
that own, control, or manage production facilities in several countries. Today
MNCs account for about 25 percent of world output, and intrafirm trade (i.e.,
trade among the parent firm and its foreign affiliates) is estimated to be about
one-third of total world trade in manufacturing.
• The basic reason for the existence of MNCs is the competitive advantage of a
global network of production and distribution. This competitive advantage arises
in part from vertical and horizontal integration with foreign affiliates. By vertical
integration, most MNCs can ensure their supply of foreign raw materials and
intermediate products.
• By horizontal integration through foreign affiliates, MNCs can better protect and
exploit their monopoly power, adapt their products to local conditions and tastes,
and ensure consistent product quality.
• The competitive advantage of MNCs is also based on economies of
scale in production, financing, research and development (R&D), and
the gathering of market information. The large output of MNCs allows
them to carry division of labor and specialization in production much
further than smaller national firms.
• Product components requiring only unskilled labor can be produced
in low-wage nations and shipped elsewhere for assembly.
• Furthermore, MNCs and their affiliates usually have greater access, at
better terms, to international capital markets than do purely national
firms.
• The large corporation invests abroad when expected profits on
additional investments in its industry are higher abroad. That is,
differences in expected rates of profits domestically and abroad in the
particular industry are of crucial importance in a large corporation’s
decision to invest abroad. This explains, for example, Toyota
automotive investments in the United States and IBM computer
investments in Japan.
• Finally, by artificially overpricing components shipped to an affiliate in
a higher-tax nation and underpricing products shipped from the
affiliate in the high-tax nation, an MNC can minimize its tax bill. This is
called transfer pricing and can arise in intrafirm trade as opposed to
trade among independent firms or conducted at “arm’s length.”
 Problems with MNCs (at home)
• The most controversial of the alleged harmful effects of MNCs on the home
nation is the loss of domestic jobs resulting from foreign direct
investments. These are likely to be unskilled and semiskilled production
jobs in which the home nation has a comparative disadvantage.
• A related problem is the export of advanced technology to be combined
with other cheaper foreign factors to maximize corporate profits. It is
claimed that this may undermine the technological superiority and future
of the home nation.
• Another possible harmful effect of MNCs on the home country can result
from transfer pricing and similar practices, and from shifting their
operations to lower-tax nations, which reduces tax revenues and erodes
the tax base of the home country.
 In Host countries
• Foreign domination is felt in many different ways in host countries,
including
the unwillingness of a local affiliate of an MNC to export to a nation
deemed unfriendly to the home nation or the requirement to comply
with a home-nation law prohibiting such exports
the borrowing of funds abroad to circumvent tight domestic credit
conditions and the lending of funds abroad when interest rates are
low at home; and
the effect on national tastes of large-scale advertising for such
products as Coca-Cola, jeans, and so on.
• In developing nations, foreign direct investments by MNCs in mineral
and raw material production have often given rise to complaints of
foreign exploitation in the form of low prices paid to host nations
the use of highly capital-intensive production techniques
inappropriate for labor-abundant developing nations
lack of training of local labor
overexploitation of natural resources, and
creating highly dualistic “enclave” economies.
• Most of these complaints are to some extent true, particularly in the
case of developing host countries, and they have led many host
nations to regulate foreign investments in order to mitigate the
harmful effects and increase the possible benefits. Thus, Canada
imposed higher taxes on foreign affiliates with less than 25 percent
Canadian interest.
• India specified the sectors in which direct foreign investments are
allowed and set rules to regulate their operation. Some developing
nations allow only joint ventures (i.e., local equity participation) and
set rules for the transfer of technology and the training of domestic
labor, impose limits on the use of imported inputs and the remission
of profits, set environmental regulations, and so on.
 International Labour Migration
• Some of the international migrations that occurred in the nineteenth
century and earlier were certainly motivated by the desire to escape
political and religious oppression in Europe.
• However, most international labor migration, particularly since the
end of World War II, has been motivated by the prospect of earning
higher real wages and income abroad.
• Migration, just like any other type of investment, involves both costs
and benefits. The costs include the expenditures for transportation
and the loss of wages during time spent relocating and searching for
a job in the new nation. In addition, there are many other less
quantifiable costs.
• The economic benefits of international migration can be measured
by the higher real wages and income that the migrant worker can
earn abroad during his or her remaining working life, over and above
what he or she could have earned at home. Other benefits may be
greater educational and job opportunities for the migrants’ children.
• From the excess of returns over costs, an internal rate of return for
the migration decision can be estimated, just as for any other type of
investment. If this rate of return is sufficiently high to also overcome
the noneconomic costs associated with migration, then the worker
will migrate.
 Welfare Effects of International Labour Migration

• We examine the welfare effects of international labour migration on

the investing and host countries.
• The welfare effects of international labour migration on the nations of
emigration and immigration can be analyzed with the same
diagrammatic technique used to analyze the welfare effects of
international capital movements.
• The VMPL1 and VMPL2 curves give the value of the marginal product
of labour in Nation 1 and Nation 2, respectively. Under competitive
conditions, VMPL represents the wages of labour.
With a supply of labor of OA, Nation
1 has a real wage rate of OC and a
total output of OFGA. With a supply
of labor of O’A, Nation 2 has a real
wage rate of O’H and a total output
of O’JMA.
The migration of AB of labor from
Nation 1 to Nation 2 equalizes real
wages in the two nations at BE. This
reduces total output to OFEB in
Nation 1 and increases it in Nation 2
to O’JEB, for a net increase in world
output of EGM (the shaded area).
• The question then arises as to the welfare effects of the migration of
a highly skilled worker on the nations of emigration and immigration.
These welfare effects are likely to be significantly different from those
arising from the migration of unskilled labour.
• Indeed, more and more U.S. high-tech industries, from
semiconductors to biotechnology, are depending on immigrant
scientists and engineers to remain competitive in the increasingly
global marketplace. The problem of the migration of highly skilled
workers is vividly conveyed by the term brain drain.
Balance of Payments
 Introduction

• The balance of payments is a summary statement in which, in

principle, all the transactions of the residents of a nation with the
residents of all other nations are recorded during a particular period
of time, usually a calendar year.
• The main purpose of the balance of payments is to inform the
government of the international position of the nation and to help it
in its formulation of monetary, fiscal, and trade policies.
• Governments also regularly consult the balance of payments of
important trade partners in making policy decisions.
• As a summary statement, the balance of payments aggregates all
merchandise trade into a few major categories. Similarly, only the net
balance of each type of international capital flow is included.
• Furthermore, the balance of payments includes some transactions in which
the residents of foreign nations are not directly involved—for example,
when a nation’s central bank sells a portion of its foreign currency holdings
to the nation’s commercial banks.
• An international transaction refers to the exchange of a good, service, or
asset (for which payment is usually required) between the residents of one
nation and the residents of other nations. However, gifts and certain other
transfers (for which no payment is required) are also included in a nation’s
balance of payments.
• The current account records trade in goods and services, as well as
transfer payments. The trade balance simply records trade in goods.
Services include freight, royalty payments, and interest payments.
• Services also include net investment income , the interest and profits on
our assets abroad less the income foreigners earn on assets they own in
India. Transfer payments consist of remittances, gifts, and grants. Adding
trade in services and net transfers to the trade balance, we arrive at the
current account balance.
• The current account is in surplus if exports exceed imports plus net
transfers to foreigners, that is, if receipts from trade in goods and services
and transfers exceed payments on this account.
• The capital account records purchases and sales of assets, such as stocks,
bonds, and land. There is a capital account surplus—also called a net
capital inflow—when our receipts from the sale of stocks, bonds, land,
bank deposits, and other assets exceed our payments for our own
purchases of foreign assets.
 Accounting principles
• International transactions are classified as credits or debits. Credit
transactions are those that involve the receipt of payments from
foreigners. Debit transactions are those that involve the making of
payments to foreigners. Credit transactions are entered with a positive
sign, and debit transactions are entered with a negative sign in the nation’s
balance of payments.
• The export of goods and services, the receipt of unilateral transfers, and
financial inflows are credits (+) because they all involve the receipt of
payments from foreigners. On the other hand, the import of goods and
services, unilateral transfers to foreigners, and financial outflows are debits
(–) because they involve payments to foreigners.
• Financial inflows can take either of two forms: an increase in foreign assets
in the nation or a reduction in the nation’s assets abroad.
 Double entry bookkeeping
• In recording a nation’s international transactions, the accounting
procedure known as double-entry bookkeeping is used. This means
that each international transaction is recorded twice, once as a
credit and once as a debit of an equal amount. The reason for this is
that in general every transaction has two sides.
• Examples
 External Accounts must balance
• The central point of international payments is very simple: Individuals and
firms have to pay for what they buy abroad. If a person spends more than
her income, her deficit needs to be financed by selling assets or by
borrowing.
• Similarly, if a country runs a deficit in its current account, spending more
abroad than it receives from sales to the rest of the world, the deficit needs
to be financed by selling assets or by borrowing abroad.
• This selling or borrowing implies that the country is running a capital
account surplus. Thus, any current account deficit is of necessity financed
by an offsetting capital inflow:
Current account + Capital account = 0
• If a country has no assets to sell, if it has no foreign currency reserves to
use up, and if nobody will lend to it, the country has to achieve balance in
its current account, however painful and difficult that may be.
• It is often useful to split the capital account into two separate parts: (1) the
transactions of the country’s private sector and (2) official reserve transactions,
which correspond to the central bank’s activities.
• A current account deficit can be financed by private residents selling off assets
abroad or borrowing abroad. Alternatively, or as well, a current account deficit can
be financed by the government, which runs down its reserves of foreign exchange,
selling foreign currency in the foreign exchange market.
• Conversely, when there is a surplus, the private sector may use the foreign
exchange revenues it receives to pay off debt or buy assets abroad; alternatively,
the central bank can buy the (net) foreign currency earned by the private sector
and add that currency to its reserves.
• The increase in official reserves is also called the overall balance-of-payments
surplus . We can summarize our discussion in the following statement:
Balance-of-payments surplus = increase in official exchange reserves
=current account surplus + net private capital
inflow
• If both the current account and the private capital account are in
deficit, then the overall balance of payments is in deficit; that is, the
central bank is losing reserves.
• When one account is in surplus and the other is in deficit to precisely
the same extent, the overall balance of payments is zero—neither in
surplus nor in deficit.
• Several important points must be kept in mind in examining a nation’s
balance of payments. First, too much attention is generally placed on
the balance on goods and on short-term data. The reason may be that
data on the quarterly trade balance on goods are the first to become
available.
• It is also dangerous to extrapolate for the year based on quarterly data.
Even the notion of a positive trade balance on goods being favourable
is somewhat misleading because a positive trade balance means that
the nation has fewer goods to consume domestically.
• On the other hand, a large and persistent trade deficit (say, in excess of
2 or 3 percent of GDP) may not be sustainable in the long run for an
individual country.
Foreign Exchange Markets
and Exchange Rates
 Introduction
• The foreign exchange market is the market in which individuals, firms,
and banks buy and sell foreign currencies or foreign exchange. The
foreign exchange market for any currency—say, the U.S. dollar—is
comprised of all the locations (such as London, Paris, Zurich,
Frankfurt, Singapore, Hong Kong, Tokyo, and New York) where dollars
are bought and sold for other currencies.
• These different monetary centers are connected electronically and
are in constant contact with one another, thus forming a single
international foreign exchange market.
• The principal function of foreign exchange markets is the transfer of funds
or purchasing power from one nation and currency to another. This is
usually accomplished by an electronic transfer and increasingly through the
Internet.
• A nation’s commercial banks operate as clearing houses for the foreign
exchange demanded and supplied in the course of foreign transactions by
the nation’s residents. In the absence of this function, a Indian importer
needing British pounds, for instance, would have to locate a Indian
exporter with pounds to sell.
• A nation pays for its tourist expenditures abroad, its imports, its
investments abroad, and so on with its foreign exchange earnings from
tourism, exports, and the receipt of foreign investments.
• If the nation’s total demand for foreign exchange in the course of its
foreign transactions exceeds its total foreign exchange earnings, the rate at
which currencies exchange for one another will have to change to
equilibrate the total quantities demanded and supplied. If such an
adjustment in the exchange rates were not allowed, the nation’s
commercial banks would have to borrow from the nation’s central bank.
The nation’s central bank would then act as the “lender of last resort” and
draw down its foreign exchange reserves (a balance-of-payments deficit of
the nation).
• On the other hand, if the nation generated an excess supply of foreign
exchange in the course of its business transactions with other nations (and
if adjustment in exchange rates were not allowed), this excess supply
would be exchanged for the national currency at the nation’s central bank,
thus increasing the nation’s foreign currency reserves (a balance-of-
payments surplus).
• Four levels of transactors or participants can be identified in foreign
exchange markets. At the bottom, or at the first level, are such traditional
users as tourists, importers, exporters, investors, and so on. These are the
immediate users and suppliers of foreign currencies.
• At the next, or second, level are the commercial banks, which act as
clearing houses between users and earners of foreign exchange. At the
third level are foreign exchange brokers, through whom the nation’s
commercial banks even out their foreign exchange inflows and outflows
among themselves (the so-called interbank or wholesale market).
• Finally, at the fourth and highest level is the nation’s central bank, which
acts as the seller or buyer of last resort when the nation’s total foreign
exchange earnings and expenditures are unequal. The central bank then
either draws down its foreign exchange reserves or adds to them.
• Today the U.S. dollar is the dominant international currency, serving
as a unit of account, medium of exchange, and store of value not only
for domestic transactions but also for private and official international
transactions.
• The US dollar is a vehicle currency; that is, the dollar is also used for
transactions that do not involve the United States at all, as, for
example, when a Brazilian importer uses dollars to pay a Japanese
exporter.
Relative importance of major currencies
• Another function of foreign exchange markets is the credit function.
Credit is usually needed when goods are in transit and also to allow
the buyer time to resell the goods and make the payment. In general,
exporters allow 90 days for the importer to pay.
• Still another function of foreign exchange markets is to provide the
facilities for hedging and speculation. Today, about 90 percent of
foreign exchange trading reflects purely financial transactions and
only about 10 percent trade financing.
 Foreign Exchange Rates
• Assume for simplicity that there are only two economies, the United
States and the European Monetary Union (EMU), with the dollar ($)
as the domestic currency and the euro (€) as the foreign currency. The
exchange rate (R) between the dollar and the euro is equal to the
number of dollars needed to purchase one euro.
• Under a flexible exchange rate system of the type we have today, the
dollar price of the euro (R) is determined, just like the price of any
commodity, by the intersection of the market demand and supply
curves for euros.
Exchange rate under flexible rate system
• If the exchange rate were not allowed to rise to its equilibrium level (as
under the fixed exchange rate system that prevailed until March 1973),
then either restrictions would have to be imposed on the demand for
euros of U.S. residents or the U.S. central bank (the Federal Reserve
System) would have to fill or satisfy the excess demand for euros out
of its international reserves.
• The U.S. demand for euros is negatively inclined, indicating that the
lower the exchange rate (R), the greater the quantity of euros
demanded by U.S. residents.
• On the other hand, the U.S. supply of euros is usually positively
inclined indicating that the higher the exchange rate (R), the greater
the quantity of euros earned by U.S. residents and supplied to the
United States.
• If the U.S. demand curve for euros shifted up (for example, as a result
of increased U.S. tastes for EMU goods), the dollar is then said to have
depreciated. Depreciation thus refers to an increase in the domestic
price of the foreign currency.
• Conversely, if the U.S. demand curve for euros shifted down so as to
intersect the U.S. supply curve for euros, the dollar is said to have
appreciated (because fewer dollars are now required to purchase one
euro). Appreciation thus refers to a decline in the domestic price of
the foreign currency.
• An appreciation of the domestic currency means a depreciation of the
foreign currency and vice versa.
• While we have dealt with only two currencies for simplicity, in reality
there are numerous exchange rates, one between any pair of
currencies. Once the exchange rate between each of a pair of
currencies with respect to the dollar is established, however, the
exchange rate between the two currencies themselves, or cross-
exchange rate, can easily be determined.
• We must also distinguish between the nominal exchange rate and the
real exchange rate.
• Since over time a currency can depreciate with respect to some
currencies and appreciate against others, an effective exchange rate is
calculated. This is a weighted average of the exchange rates between
the domestic currency and that of the nation’s most important trade
partners, with weights given by the relative importance of the nation’s
trade with each of these trade partners.
 Arbitrage
• The exchange rate between any two currencies is kept the same in different
monetary centers by arbitrage. This refers to the purchase of a currency in
the monetary center where it is cheaper, for immediate resale in the
monetary center where it is more expensive, in order to make a profit.
• When only two currencies and two monetary centers are involved in
arbitrage, as in the preceding example, we have two-point arbitrage. When
three currencies and three monetary centers are involved, we have
triangular, or three-point, arbitrage.
• Arbitrage increases the demand for the currency in the monetary center
where the currency is cheaper, increases the supply of the currency in the
monetary center where the currency is more expensive, and quickly
eliminates inconsistent cross rates and the profitability of further arbitrage.
 Exchange rate and Balance of Payments
• We have seen that the U.S. demand for euros arises from the U.S.
demand for imports of goods and services from the European Union
and from U.S. investments in the European Monetary Union (a capital
outflow from the United States). These are the autonomous debit
transactions of the United States that involve payments to the
European Monetary Union.
• On the other hand, the supply of euros arises from U.S. exports of
goods and services to the European Monetary Union and from the
EMU investments in the United States (a capital inflow to the United
States). These are the autonomous credit transactions of the United
States that involve payments from the European Monetary Union.
Disequilibrium under fixed and flexible systems
• With D€ and S€, the equilibrium exchange rate is R = $/ € = 1 (point E)
at which € 200 million are demanded and supplied per day. Now
suppose that for whatever reason (such as an increase in U.S. tastes
for EMU products) the U.S. autonomous demand for euros shifts up
to D€
• If the United States wanted to maintain the exchange rate fixed at R =
1, U.S. monetary authorities would have to satisfy the excess demand
for euros of TE (€ 250 million per day) out of its official reserve
holdings of euros. the U.S. official settlements balance would show a
deficit of € 250 million at R=1
• Under a freely flexible exchange rate system, the exchange rate would
rise (i.e., the dollar would depreciate) from R = 1.00 to R = 1.50, at
which the quantity of euros demanded (€ 300 million per day) exactly
equals the quantity supplied.
• In this case, the United States would not lose any of its official euro
reserves. Indeed, international reserves would be entirely
unnecessary under such a system (€ 300 million exactly equals the
quantity supplied (point E).
• However, under a managed floating exchange rate system of the
type in operation since 1973, U.S. monetary authorities can intervene
in foreign exchange markets to moderate the depreciation (or
appreciation) of the dollar. For instance, the United States might limit
the depreciation of the dollar to R = 1.25 (instead of letting the dollar
depreciate all the way to R = 1.50 as under a freely fluctuating
exchange rate system.
• Under such a system, part of the potential deficit in the balance of
payments is covered by the loss of official reserve asset, and part is
reflected in the form of a depreciation of the currency.
 Spot and Forward Rates
• The most common type of foreign exchange transaction involves the
payment and receipt of the foreign exchange within two business days
after the day the transaction is agreed upon.
• The two-day period gives adequate time for the parties to send instructions
to debit and credit the appropriate bank accounts at home and abroad.
This type of transaction is called a spot transaction, and the exchange rate
at which the transaction takes place is called the spot rate.
• Besides spot transactions, there are forward transactions. A forward
transaction involves an agreement today to buy or sell a specified amount
of a foreign currency at a specified future date at a rate agreed upon today.
• The equilibrium forward rate is determined at the intersection of the
market demand and supply curves of foreign exchange for future
delivery. The demand for and supply of forward foreign exchange
arise in the course of hedging, from foreign exchange speculation,
and from covered interest arbitrage.
• At any point in time, the forward rate can be equal to, above, or
below the corresponding spot rate. If the forward rate is below the
present spot rate, the foreign currency is said to be at a forward
discount with respect to the domestic currency. However, if the
forward rate is above the present spot rate, the foreign currency is
said to be at a forward premium.
 Foreign Exchange Swaps
• A foreign exchange swap refers to a spot sale of a currency combined with
a forward repurchase of the same currency—as part of a single transaction.
• An Foreign Exchange (FX) swap agreement is a contract in which one party
borrows one currency from, and simultaneously lends another to, the
second party. Each party uses the repayment obligation to its counterparty
as collateral and the amount of repayment is fixed at the FX forward rate
as of the start of the contract. Thus, FX swaps can be viewed as FX risk-free
collateralized borrowing/lending.
• For example, at the start of the contract, A borrows X·S USD from, and
lends X EUR to, B, where S is the FX spot rate. When the contract expires, A
returns X·F USD to B, and B returns X EUR to A, where F is the FX forward
rate as of the start
• FX swaps have been employed to raise foreign currencies, both for financial
institutions and their customers, including exporters and importers, as well
as institutional investors who wish to hedge their positions. They are also
frequently used for speculative trading, typically by combining two
offsetting positions with different original maturities.
• A cross-currency basis swap agreement is a contract in which one party
borrows one currency from another party and simultaneously lends the
same value, at current spot rates, of a second currency to that party. The
parties involved in basis swaps tend to be financial institutions, either
acting on their own or as agents for non-financial corporations. When the
contract expires, A returns X·S USD to B, and B returns X EUR to A, where S
is the same FX spot rate as of the start of the contract.
 Currency Futures and Options
• A foreign exchange futures is a forward contract for standardized currency
amounts and selected calendar dates traded on an organized market
(exchange).
• The futures market differs from a forward market in that in the futures
market only a few currencies are traded; trades occur in standardized
contracts only, for a few specific delivery dates, and are subject to daily
limits on exchange rate fluctuations; and trading takes place only in a few
geographical locations, such as Chicago, New York, London, Frankfurt, and
Singapore.
• Futures contracts are usually for smaller amounts than forward contracts
and thus are more useful to small firms than to large ones but are
somewhat more expensive. Futures contracts can also be sold at any time
up until maturity on an organized futures market, while forward contracts
cannot.
• A foreign exchange option is a contract giving the purchaser the right,
but not the obligation, to buy (a call option) or to sell (a put option) a
standard amount of a traded currency on a stated date (the European
option) or at any time before a stated date (the American option) and
at a stated price (the strike or exercise price).
 Foreign Exchange Risks
• Through time, a nation’s demand and supply curves for foreign exchange
shift, causing the spot (and the forward) rate to vary frequently. A nation’s
demand and supply curves for foreign exchange shift over time as a result
of changes in tastes for domestic and foreign products in the nation and
abroad, different growth and inflation rates in different nations, changes
in relative rates of interest, changing expectations, and so on.
• For example, if U.S. tastes for EMU products increase, the U.S. demand for
euros increases (the demand curve shifts up), leading to a rise in the
exchange rate (i.e., a depreciation of the dollar).
• On the other hand, a lower rate of inflation in the United States than in the
European Monetary Union leads to U.S. products becoming cheaper for
EMU residents. This tends to increase the U.S. supply of euros (the supply
curve shifts to the right) and causes a decline in the exchange rate (i.e., an
appreciation of the dollar).
• The frequent and relatively large fluctuations in exchange rates
impose foreign exchange risks on all individuals, firms, and banks that
have to make or receive future payments denominated in a foreign
currency.
• In general, businesspeople are risk averse and will want to avoid or
insure themselves against their foreign exchange risk. (Note that
arbitrage does not involve any exchange risk since the currency is
bought at the cheaper price in one monetary center to be resold
immediately at the higher price in another monetary center.)
• A foreign exchange risk arises not only from transactions involving
future payments and receipts in a foreign currency (the transaction
exposure), but also from the need to value inventories and assets
held abroad in terms of the domestic currency for inclusion in the
firm’s consolidated balance sheet (the translation or accounting
exposure), and in estimating the domestic currency value of the
future profitability of the firm (the economic exposure).
 Hedging
• Hedging refers to the avoidance of a foreign exchange risk, or the covering
of an open position. For example, the importer of the previous example
could borrow € 100,000 at the present spot rate of SR = $1/ € 1 and leave
this sum on deposit in a bank (to earn interest) for three months, when
payment is due.
• The cost of insuring against the foreign exchange risk in this way is the
positive difference between the interest rate the importer has to pay on
the loan of € 100,000 and the lower interest rate he or she earns on the
deposit.
• Covering the foreign exchange risk in the spot market as indicated above
has a very serious disadvantage, however. The businessperson or investor
must borrow or tie up his or her own funds for three months.
• To avoid this, hedging usually takes place in the forward market,
where no borrowing or tying up of funds is required. Thus, the
importer could buy euros forward for delivery (and payment) in three
months at today’s three-month forward rate.
• A foreign exchange risk can also be hedged and an open position
avoided in the futures or options markets.
• In a world of foreign exchange uncertainty, the ability of traders and
investors to hedge greatly facilitates the international flow of trade
and investments. Without hedging there would be smaller
international capital flows, less trade and specialization in production,
and smaller benefits from trade.
• Note that a large firm, such as a multinational corporation, that has to
make and receive a large number of payments in the same foreign
currency at the same time in the future need only hedge its net open
position.
• Similarly, a bank has an open position only in the amount of its net
balance on contracted future payments and receipts in each foreign
currency at each future date. The bank closes as much of its open
positions as possible by dealing with other banks (through foreign
exchange brokers), and it may cover the remainder in the spot,
futures, or options markets.
 Speculation
• Speculation is the opposite of hedging. Whereas a hedger seeks to cover a
foreign exchange risk, a speculator accepts and even seeks out a foreign
exchange risk, or an open position, in the hope of making a profit. If the
speculator correctly anticipates future changes in spot rates, he or she
makes a profit; otherwise, he or she incurs a loss.
• As in the case of hedging, speculation can take place in the spot, forward,
futures, or options markets—usually in the forward market.
• Speculation can be stabilizing or destabilizing. Stabilizing speculation refers
to the purchase of a foreign currency when the domestic price of the
foreign currency (i.e., the exchange rate) falls or is low, in the expectation
that it will soon rise, thus leading to a profit. Stabilizing speculation
moderates fluctuations in exchange rates over time and performs a useful
function.
• On the other hand, destabilizing speculation refers to the sale of a
foreign currency when the exchange rate falls or is low, in the
expectation that it will fall even lower in the future, or the purchase
of a foreign currency when the exchange rate is rising or is high, in the
expectation that it will rise even higher in the future.
• Destabilizing speculation thus magnifies exchange rate fluctuations
over time and can prove very disruptive to the international flow of
trade and investments.
 Interest Arbitrage and the Efficiency of Foreign
Exchange Markets
• Interest arbitrage refers to the international flow of short-term liquid
capital to earn higher returns abroad. Interest arbitrage can be
covered or uncovered.
• Since the transfer of funds abroad to take advantage of higher
interest rates in foreign monetary centers involves the conversion of
the domestic to the foreign currency to make the investment, and the
subsequent reconversion of the funds (plus the interest earned) from
the foreign currency to the domestic currency at the time of maturity,
a foreign exchange risk is involved due to the possible depreciation of
the foreign currency during the period of the investment. If such a
foreign exchange risk is covered, we have covered interest arbitrage;
otherwise, we have uncovered interest arbitrage.
• Related to uncovered interest arbitrage is carry trade. Carry trade
refers to the strategy in which an investor borrows low-yielding
currencies and lends (invest in) high-yielding currencies. That is, an
investor borrows a currency with a relatively low interest rate and
uses the funds to purchase another currency yielding a higher interest
rate. If the higher-yielding currency depreciates during the period of
the investment, however, the investor runs the risk of losing money.
 Covered Interest Arbitrage
• Investors of short-term funds abroad generally want to avoid the
foreign exchange risk; therefore, interest arbitrage is usually covered.
To do this, the investor exchanges the domestic for the foreign
currency at the current spot rate in order to purchase the foreign
treasury bills, and at the same time the investor sells forward the
amount of the foreign currency he or she is investing plus the interest
he or she will earn so as to coincide with the maturity of the foreign
investment.
• Thus, covered interest arbitrage refers to the spot purchase of the
foreign currency to make the investment and the offsetting
simultaneous forward sale (swap) of the foreign currency to cover
the foreign exchange risk.
• Since the currency with the higher interest rate is usually at a forward
discount, the net return on the investment is roughly equal to the
interest differential in favor of the foreign monetary center minus
the forward discount on the foreign currency. This reduction in
earnings can be viewed as the cost of insurance against the foreign
exchange risk.
• However, as covered interest arbitrage continues, the possibility of
gains diminishes until it is completely wiped out. This occurs for two
reasons. First, as funds are transferred from home to foreign, the
interest rate rises in domestic(since the supply of funds in home
diminishes) and falls in foreign (since the supply of funds in foreign
increases).
• Second, the purchase of euros in the spot market increases the spot
rate, and the sale of euros in the forward market reduces the forward
rate. Thus, the forward discount on the euro (i.e., the difference
between the spot rate and the forward rate) rises.
• With the interest differential in favour of foreign diminishing and the
forward discount on the euro rising, the net gain falls for both reasons
until it becomes zero. Then the euro is said to be at covered interest
arbitrage parity.
• Here, the interest differential in favour of the foreign monetary center
is equal to the forward discount on the foreign currency (both
expressed on an annual basis).
• If the euro is instead at a forward premium, the net gain to the home
investor will equal the extra interest earned plus the forward
premium on the euro. However, as covered interest arbitrage
continues, the interest differential in favour of foreign diminishes (as
indicated earlier) and so does the forward premium on the euro until
it becomes a forward discount and all of the gains are once again
wiped out.
• Thus, the spot rate and the forward rate on a currency are closely
related through covered interest arbitrage.
 Covered Interest Arbitrage Parity
• The following figure illustrates in a more general and rigorous way the
relationship, through covered interest arbitrage, between the interest rate
differentials between two nations and the forward discount or premium on
the foreign currency.
• The solid diagonal line indicates all points of covered interest arbitrage
parity (CIAP). Thus, when (i−i*) equals −1, the foreign currency is at a
forward discount of 1 percent per year. A positive interest differential of 1
is associated with a forward premium of 1 percent.
• When the interest differential is zero, the foreign currency is neither at a
forward discount nor at a forward premium (i.e., the forward rate on the
foreign currency is equal to its spot rate), and we are on the CIAP line at the
origin.
• Below the CIAP line, either the negative interest differential (in favour of
the foreign monetary center) exceeds the forward discount on the
foreign currency or the forward premium exceeds the positive interest
differential (see the points A and A’ respectively). In either case, there
will be a net gain from a covered interest arbitrage (CIA) outflow.
• Above the interest parity line, either the positive interest differential
exceeds the forward premium on the foreign currency (point B in the
figure) or the negative interest differential is smaller than the forward
discount on the foreign currency (point B’). In either case, it pays for
foreigners to invest in our country, and there will be an arbitrage inflow.
• In reality, interest arbitrage (inflow and outflow) will come to an end
when the net gain reaches about 1/4 of 1 percent per year (1/16 of 1
percent for three months). This range is shown by the white area
between the diagonal dashed lines in the figure.
 Covered Interest Arbitrage Margin
• Points on the CIAP line indicate either that the negative interest differential
(in favour of the foreign monetary center) equals the forward discount (FD)
on the foreign currency or that the positive interest differential (in favor of
the home monetary center) equals the forward premium (FP) on the
foreign currency. This can be expressed as:
i − i* = FD if i < i ∗ or
i − i* = FP if i >i ∗
• But since the forward rate minus the spot rate divided by the spot rate [i.e.,
(FR−SR)/SR] measures the forward discount (if SR > FR) or the forward
premium (if FR > SR), the foregoing condition for CIAP can be rewritten as
i − i* = (FR − SR)/SR
• We can now define the covered interest arbitrage margin (CIAM) or
the percentage gain from covered interest arbitrage as
CIAM = (i − i*) − FD or FP
or more precisely as
CIAM = (i − i* )/(1 + i* ) − (FR − SR)/SR
Q. The interest rate on a three-month treasury bill is 6 percent on an
annual basis in New York and 8 percent in Frankfurt, while the spot
rate of the euro is $1/ € 1 and the three-month forward rate on the
euro is $0.99/ € 1 on an annual basis. Find CIAM
• In the real world, significant covered interest arbitrage margins are
sometimes observed. The reason is not that covered interest arbitrage
does not work, but it may be the result of other forces at work. For
example, higher tax rates abroad may exceed the CIAM in favour of the
foreign monetary center so that no arbitrage outflows take place.
• Similarly, investors may not take advantage of a CIAM in favour of the
foreign monetary center if they fear that the foreign government might
default or impose exchange restrictions on the repatriation of profits and
principal on the foreign investment.
• Or simply, large and persistent CIAM may exist because of lack of
information on foreign investment opportunities in developing countries’
financial markets.
 Efficiency of Foreign Exchange Markets
• A market is said to be efficient if prices reflect all available information. The
foreign exchange market is said to be efficient if forward rates accurately
predict future spot rates; that is, if forward rates reflect all available
information and quickly adjust to any new information so that investors
cannot earn consistent and unusual profits by utilizing any available
information.
• By their very nature, tests of market efficiency are very difficult to
formulate and to interpret. Even if foreign exchange markets were efficient,
we cannot expect the forward rate of a currency to be identical to the
future spot rate of the currency because the latter also depends on
unforeseen events. However, if the forward rate exceeds the future spot
rate as often as it falls below it, then we could say that the market is
efficient in the sense that there is no available information that investors
could systematically use to ensure consistent and unusual profits.