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International Trade
1
Midterm Examination Review
Whats on the Midterm Exam?
Content From Chapters 1 through 9 and
Possibly 10
Analysis of Midterm Exams from 2005 to
2009 Shows the Following Topics (see
2
2009 Shows the Following Topics (see
next slide):
Topics in Previous Midterm Exams:
Absolute Advantage Nontariff Barriers
Comparative Advantage
Acceptable and Unacceptable Arguments for
Trade Barriers
Ricardian Model New and Advanced Trade Theories
Heckscher-Ohlin Model Small Country Vs Large Country
General Equilibrium
3
General Equilibrium
Framework Nominal Rate of Protection
Standard Trade Model Effective Rate of Protection
Partial Equilibrium
Analysis Different Kinds of Trade Blocs
General Equilibrium
Analysis Customs Union
Tariffs; Seven effects of
a Tariff Import Substitution
What is the Exam Format?
3 Hours Long, 3 Sections A, B and C
Section A Short Answer, Choose One
Question from 4 or 5; 10% 0f the Grade
Section B Two Questions, You Must
4
Section B Two Questions, You Must
Answer Both of them; 30% of Grade
Section C Two Long Essay Questions
Two Questions, You Must Answer Both;
60% of Grade
Test Taking Strategy
Budget Your Time! Many students spend
too much time on one question in section
A or B and run out of time for Section C.
Be sure to write some kind of answer for
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Be sure to write some kind of answer for
every question dont leave any question
blank
When you first open the exam, quickly
look through it for questions in A, B and C
that are similar topics.
IELTS Test Skills
The Midterm Exam is also a test of writing ability. If
you studied for the IELTS, Remember the writing
and time budgeting skills you may have learned.
Skills you learned for Writing Task 1 and Writing
Task 2 Questions are often useful for Section A
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Task 2 Questions are often useful for Section A
and Section B questions on the exam:
Writing Task 1 Problems 150 Words in 20 Minutes
Writing Task 2 Problems 250 Words in 40 Minutes
Section C Questions require longer essay
answers
Answering Exam Questions
Follow the Pattern of Explain and Discuss.
First, Explain. Show that you know what
the question is about. For example if you
are writing about Customs Union, define
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are writing about Customs Union, define
what a Customs Union is.
Use Diagram or Simple Algebra Wherever
Possible to Answer Questions.
It is Possible to get a Passing Mark by
explaining well a model or theory.
Answering Exam Questions, Contd
Explain and Discuss Continued:
Discuss: After you have explained the basic
idea, write about:
The strengths and weaknesses the
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The strengths and weaknesses the
good and bad points. Critical Evaluation.
Evaluation of the Assumptions.
How Realistic is the theory or model?
Try to Provide at least 3 supporting facts
or reasons, especially in Section C.
INTERNATIONAL TRADE
9
INTERNATIONAL TRADE
THEORY
What makes International
Economics different?
International Economics Consists Of
Issues Arise From Problems of Economic
Interaction between Sovereign States.
10
Its Relations Differ from Interregional
Economics (Different Parts of the Same
Nation) Requiring It to Use Different Tools
of Analysis and Justifying Its Existence as
a Distinct Branch of Economics.
Concerns of International
Economics
Trade and investment occur between independent
nations
Countrys policies/restrictions disrupt trade and limit
imports
Foreign exchange fluctuations affect the relative prices
11
Foreign exchange fluctuations affect the relative prices
of countries imports and exports
Also, international flows of goods, services and
resources give rise to payments and receipts in foreign
currencies, which change in value over time.
International flows may be hampered by differences in
languages, customs, and laws
CHAPTER 2: THE LAW OF
COMPARATIVE ADVANTAGE
Why do countries trade?
The Mercantilists Views on Trade 17
th
&
18
th
Centuries
Adam Smiths Absolute Advantage Trade
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Adam Smiths Absolute Advantage Trade
Theory 18th Century
Absolute Advantage is the greater efficiency
that one nation may have over another in the
production of a commodity
Refer to Transparency Table 2.1
David Ricardos Comparative
Advantage Trade Theory
Comparative Advantage is when a Nation 1 has
absolute advantage in both commodities but has
comparatively greater advantage in producing
good A over than good B. As long as Nation 2
comparative advantage is in the good B for which
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comparative advantage is in the good B for which
Nation 1 has comparative disadvantage, but
nations can still gain from specialisation and trade.
The concept of Absolute Advantage is
concerned with differences between actual
efficiency of production.
The concept of Comparative Advantage is
about the relative efficiency of production.
Ricardos Assumptions:
1. Two Nations and Two Commodities
2. Free trade
3. Perfect mobility of labour within each nation
but immobility between nations
4. Constant Costs of Production
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4. Constant Costs of Production
5. No transport costs
6. No technical change, and
7. The labour theory of value
See Table 2.2, Table 2.3
Comparative Advantage:
Opportunity Costs
Law of Comparative Cost
1939 by Haberler
Opportunity Costs
(Constant Cost) and Relative Prices
15
(Constant Cost) and Relative Prices
Comparative Advantage:
Opportunity Costs -Contd
Assumptions one to six can be easily relaxed
but assumption #7 (Labor Theory of Value) is
not valid and should not be used to explain
comparative advantage.
Production Possibility Frontier (PPF)
16
Production Possibility Frontier (PPF)
demonstrates the alternative
combinations of the two commodities that
a nation can produce by fully utilising all
of its resources with the best available
technology.
Comparative Advantage:
Opportunity Costs -Contd
MRT Opp cost
for
Wheat
Relative
price for
Wheat
Opp
Cost for
Cloth
Relative
price for
Cloth
17
Wheat Wheat Cloth Cloth
USA 120/180
=2/3
6/4 =
1.5
Pw/Pc =
2/3
4/6 =
2/3
Pc/Pw =
1.5
UK 120/60
= 2
1/2 Pw/Pc =
2/1=2
2/1 = 2 Pc/Pw =
1/2
Comparative Advantage:
Opportunity Costs CONTD
The difference in relative commodity prices between two
nations is a reflection of their comparative advantage and
provides the basis for mutually beneficial trade.
The equilibrium-relative commodity price with trade is the
common relative price in both nations at which trade is
balanced: Nation 1 Price = Nation 2 Price
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balanced: Nation 1 Price = Nation 2 Price
Figure 2.2: Trade Under Constant Cost
Figure 2.3: Equilibrium-Relative Commodity Prices with
Demand and Supply
Small-Country Case with Constant Costs
Empirical Tests of the Ricardian Model
Empirical Tests of the Ricardian Model by
MacDougall in 1951
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Figure 2.4 Relative Labor Productivities and Comparative Advantage
CHAPTER 3: THE STANDARD
THEORY OF INTERNATIONAL
TRADE
20
TRADE
The Production Frontier with
Increasing Costs
Increasing opportunity costs mean that the nation
must give up more and more of one commodity to
release just enough resources to produce each
additional unit of another commodity.
21
The marginal rate of transformation (MRT) of X for
Y refers to the amount of Y that a nation must give
up to produce each additional unit of X. since the
PPF is concave, it represents increase opportunity
cost as one more down the PPF.
Community Indifference Curves (3.3A)
The Indifference Curve represents all
combinations of market baskets that
provide a consumer with the same level
of satisfaction.
22
Equilibrium in Isolation (Autarky) and with
Trade
Figure 3.3: Equilibrium in Isolation
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 3-3 Equilibrium in Isolation.
Revealed (Real World)
Comparative Advantage (3.4B)
Case Study 3-1 shows the revealed
comparative advantage
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Gains from Trade with Increasing
Costs (3.5)
Figure 3.4: The Gain from Trade with
Increasing Costs
Differences between Constant Costs and
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Differences between Constant Costs and
Increasing Costs
Small-Country Case with Increasing
Costs(3.5D)
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 3-4 The Gains from Trade with Increasing Costs.
Gains from Exchange and from
Specialization
27
FIGURE 3-5 The Gains from Exchange and from Specialization.
Trade Based on the Differences
in Tastes (3.6A)
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FIGURE 3-6 Trade Based on Differences in Tastes.
CHAPTER 4: DEMAND AND
SUPPLY, OFFER CURVES, AND
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SUPPLY, OFFER CURVES, AND
THE TERMS OF TRADE
DEMAND AND SUPPLY, OFFER
CURVES, AND THE TERMS OF
TRADE
The Equilibrium-Relative Commodity Price
with Trade Partial Equilibrium Analysis
30
with Trade Partial Equilibrium Analysis
Figure 4.1: The Equilibrium-Relative
Commodity Price with Trade with Partial
Equilibrium Analysis
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 4-1 The Equilibrium-Relative Commodity Price with Trade with Partial Equilibrium
Analysis.
The Offer Curve (4.3)
Offer Curve (reciprocal demand curve) shows
how much of its import commodity the nation
demands for it to be willing to supply various
amounts of its export commodity.
The Offer curve shows a nationss willingness
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The Offer curve shows a nationss willingness
to import and export at different commodity
prices.
The Offer Curve can also be derived from a
Nations PPF, its indifference maps, and the
various hypothetical commodity prices where
trade could take place.
Derivation of Offer Curves
Figures 4.3 & 4.4: Derivation of the Offer
Curves of Nations 1 & 2
The Equilibrium-Relative Commodity Price
with Trade General Equilibrium Analysis
33
with Trade General Equilibrium Analysis
Figure 4.5: Equilibrium-Relative
Commodity Price with Trade
Figure 4.6: Equilibrium-Relative
Commodity Price with Partial Equilibrium
Analysis
Derivation of Offer Curves
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 4-3 Derivation of the Offer Curve of Nation 1.
Derivation of Offer Curves
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 4-4 Derivation of the Offer Curve of Nation 2.
Equilibrium-Relative Commodity Price with Trade
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 4-5 Equilibrium-Relative Commodity Price with Trade.
Equilibrium-Relative Commodity Price with Partial
Equilibrium Analysis
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 4-6 Equilibrium-Relative Commodity Price with Partial Equilibrium Analysis.
The Terms of Trade (4.6)
In a world with two-nations and two commodities
situation, the Terms of Trade of a nation is defined as
the ratio of the price of its export commodity to the
price of its import commodity the relative trading
prices.
Generally with many nations and commodities, the
38
Generally with many nations and commodities, the
terms of trade of a nation (commodity or net barter
terms of trade) are given by the ratio of the price index
of its exports to the price index of its imports multiplied
by 100 to express it as a percentage.
Case Study 4-3 Terms of Trade of the G-7 Nations
Case Study4-4 Terms of Trade of Industrial and
Developing Countries for selected years: 1972 0 2001.
CHAPTER 5: FACTOR
ENDOWMENTS AND THE
39
ENDOWMENTS AND THE
HECKSCHER-OHLIN THEORY
Assumptions
We will extend the trade model in two
directions:
To identify the basis for what
determines- comparative advantage
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To examine the effect of international
trade has on the earnings of factors of
production in two trading nations earnings
of labour and cause for the international
differences in earnings.
11 Assumptions, (5.2A)
Factor Intensity, Factor Abundance, and
the Shape of the Production Frontier (5.3)
Factor Intensity (5.3A): commodity Y is
capital intensive if the capital-labour ratio
K/L used in the production of Y is greater
the K/L used in the production of X.
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the K/L used in the production of X.
For Examples:
To produce 1Y requires 2K & 2L (2/2 = 1)
To produce 1X requires 1K & 4L (1/4 = )
To produce 1X require 3K & 12L (3/12 = )
Factor Intensity
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Figure 5.1: Factor Intensity for Commodity
X and Y in Nations 1 2
FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
Factor Intensity
Nation 1 Nation 2
Commodity
Y (K/L)
1 4
43
Y (K/L)
Commodity
X (K/L)
1
Labour
Intensive
Capital
Intensive
What happen if the relative price
of capital falls?
K-Intensity refers to the ratio in terms of
the technology K/L used in the production
process.
44
Factor Abundance (5.3B)
Two ways to define factor abundance
In terms of physical units overall amount
of capital and labour available in the
nation. This definition considers only
45
nation. This definition considers only
the supply of factors.
Physical K-Abundance refers to the
physical amount of capital/labour ratio
used in the production process.
Factor Abundance (5.3B) Contd
In terms of relative factor prices
rental price of capital & price of labour time in
each nation.
46
This definition considers both the supply
and the demand of factors under perfect
competition. Also, the demand for a factor
of production is a derived demand from
the final commodity that requires it in the
production process.
Factor Abundance (5.3B) Contd
K-Abundance in terms of relative prices
refers to the ratio of capital/labour in terms
of costs (r/w) used in the production
process.
47
process.
Factor Endowments and the
Shape of the PPF (5.3C)
Figure 5.2: The Shape of the Production
Frontier of Nation 1 & 2 (same as Fig 3.1)
Case Study 5-1: Relative Resource
Endowments of Various Countries and
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Endowments of Various Countries and
Regions
Case Study 5-2: Capital-Labour Ratios of
Selected Countries
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 5-2 The Shape of the Production Frontiers of
Nation 1 and Nation 2.
Factor Endowments and the
Heckscher-Ohlin Theory (5.4)
The Heckscher-Ohlin Theory can be
presented in the form of two theorems:
The Heckscher-Ohlin Theorem deals
with and predicts the pattern of trade
50
with and predicts the pattern of trade
Factor-Price Equalization Theorem deals
with the effect of international trade on
factor prices.
In addition, Theorem 2 holds only if 1
holds.
The Heckscher-Ohlin Theorem
(5.4A)
Figure 5.3: The General Equilibrium
Framework of the Heckscher-Ohlin Theory
Figure 5.4: The Heckscher-Ohlin Model
51
Figure 5.4: The Heckscher-Ohlin Model
Now compare Fig. 5.4 with Fig. 3.4
Figures 5-4 and 3-4
Salvatore: International
Economics, 8th Edition
2004 John Wiley & Sons, Inc.
FIGURE 5-4 The Heckscher-Ohlin
Model.
FIGURE 3-4 The Gains from Trade with
Increasing Costs.
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 5-4 The Heckscher-Ohlin Model.
Principle of H-O theorem:
It requires that if tastes differ, they do not
differ sufficiently to neutralize the tendency
of different factor endowments and
production possibility in the two nations.
55
Case Study 5-3: examines the Pattern of
revealed Comparative Advantage and
disadvantage of Various Countries or
Regions.
Factor-Price Equilization and
Income Distribution (5.5)
Heckscher-Ohlin-Samuelson (H-O-S)
Proven by Paul Samuelson
56
The H-O-S Theorem
International trade will bring about
equalization in the relative and absolute
returns to homogeneous factors across
nations.
57
nations.
Thus, international trade is a substitute for
international mobility of factors.
Figure 5.5: The Relative Factor-Price
Equalization
Salvatore: International Economics, 8th
Edition 2004 John Wiley & Sons, Inc.
FIGURE 5-5 Relative FactorPrice Equalization.
Absolute Factor-Prices
Equalization
Means that free international trade also
equalizes the real wages for the same
type of Labour and the real rate of interest
for same type of Capital in the two nations.
59
for same type of Capital in the two nations.
Absolute Factor-Prices
Equalization, Contd
Trade operates on the demand for factors
Factor mobility operates on the supply of
factors
International trade causes real
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International trade causes real
wages/income of labour to fall in a capital-
abundant and labour-scarce nation (USA),
If So, Shouldnt U.S., the EU, and
Japan Restrict Trade?
If international trade causes real wages/income
of labour to fall in a capital-abundant and labour-
scarce nation (USA), shouldnt they have trade
restrictions?
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No, because the loss that trade causes in those
countries is less than the gain received by
owners of capital. Appropriate taxes on owners
of capital and subsidies for labor can bring
benefit to both factors from international trade.
The Specific-Factors model
(5.5D)
Says that trade will:
Have an ambiguous effect on the nations
mobile factors.
Benefit the immobile factors specific to the
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Benefit the immobile factors specific to the
nations export commodities or sectors.
Harm the immobile specific factors to the
nations import-competing commodities or
sectors.
Empirical Relevance of Factor-Price
Equilibrium
Theorem- H-O-S
Has international trade equalized the
returns to homogeneous factors in
different nations in the real world?
63
different nations in the real world?
If it has not, why?
Because the many simplifying
assumptions of the model are true, do not
hold in the real world. Identical
technology, no transportation costs, etc.
Empirical Test of the Heckscher-
Ohlin Model - Leontief (1951)
Assumption: USA most K-abundant nation in the world
RESULT