1 international trade - rainer maurerlighter box: various stones and plant fibres for making fire...

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- 1 -Prof. Dr. Rainer Maurer

International Economics

1. International Trade

Lecture notes: www.rainer-maurer.deE-Mail: [email protected]

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1. International Trade1.1. The History of Trade1.2. The Theory of International Trade

1.2.1. Trade Caused by Comparative Advantage1.2.2. Winners and Losers of International Trade1.2.3. Trade caused by Economies of Scale

1.3. International Trade Policy1.3.1. Instruments of Trade Policy1.3.2. Trade Policy Doctrines

1.3.2.1. Classical Free Trade Doctrine1.3.2.2. Import Substitution Policy1.3.2.3. Export-oriented Industrialization1.3.2.4. Globalization Critique

1.3.3. The Development of the World Trade Organization1.4. Questions for Review

Additional literature: Chapter 6, 8, 9, 10, 11, Paul Krugman and Maurice Obstfeld, Prentice Hall; 10th Revised edition. Global Edition. (25. April 2014)

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- 3 -Prof. Dr. Rainer Maurer - 3 -Prof. Dr. Rainer Maurer

1. International Trade1.1. The History of trade

Appearance Homo sapiens 170 000 (?) year ago

First traces of long-distance trade about 150 000 years ago

Homo Habilis

Homo Erectus Homo Sapiens

Source: Stephen Oppenheimer (2003)

Long-distance trade is not a modern invention:

The first traces of long-distance trade are to be found, shortly after the appearance of Homo sapiens

Sea shells far away from coasts orflint stone or obsidian tools far awayfrom regions with natural deposits.

Long-distance exchange

Barbed hooks, Bone tools, Fishing,

Microliths

Beads

Gravettian art and high-quality painting

Writing

Metal Age

Musical notation

Shellfishing

100k250k300k1M

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➤ Who invented the trade?■ According to current paleoanthropological research, traces of long-

distance trade are found only in relation to Homo sapiens. Other Hominians - even the highly developed Neanderthals - have not practiced long-distance trade as it seems.

■ A explanation for this could be another peculiarity of Homo sapiens:

◆Gender and age-specific division of labor within small groups (Kuhn & Stiner 2006):

● Men engage in hunting large animals.

● Women and children engage in collecting vegetables and small animals.

◆At the end of the day the different groups meet and share and prepare their food = inner-group exchange!

■ A similar division of labor is still to be found in the currently existing stone age cultures: the "Hadza" and "San" in Africa.



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➤Who invented exchange of goods by trade?■ By specializing in different ways of food production, total

productivity grows:

◆Development of special hunting weapons and acquisition of special skills for hunting of large animals

◆Development of special tools and accumulating the knowledge for finding edible plants

■ Thus division of labor and exchange of the different goods of production increases the total supply of food.■ Some paleoanthropologists hold this as one of the reasons,

why among all representatives of the tribe Hominini only Homo sapiens survived.



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Prof. Dr. Rainer Maurer -6-

Numerical example of David Ricardo(1817) Principles of Political Economy and Taxation

The exploitation of comparative advantages (= differences in relative productivity) increases total productivity of production:

Fred Barney

Flintstone blade 3 hours 2 hours

Fur coat . 6 hours 1 hour

Productiontime withoutdivision oflabor

9 hours 3 hours


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Fred Barney

Flintstoneblade 6 hours -

Fur coat . - 2 hours

Productiontime 6 hours 2 hours

Costsof a blade

½ Fur coat 2 Fur coat Gain 3 hours 1 hour

Fred Barney

Flintstoneblade 3 hours 2 hours




Numerical example of David Ricardo (1817) Principles of Political Economy and Taxation

If Fred specializes in flintstone blades and Barney specializes in fur coats and both goods are exchanged at a barter rate of 1:1, Fred and Barney increase their economic welfare: Trade is a „win-win“ game.

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Fred Barney

Flintstone blade 6 hours -



Costsof a blade ½ Fur coat 2 Fur coats Gain . 3 hours 1 hour

Fred Barney






However, Fred will have to work 4 hours more than Barney!Is that “fair”?

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➤Who invented the trade?■ After the idea of "division of labor by exchange" was invented

within a small group, it was probably only a small step to apply this idea between different groups.

■ This should not only have caused additional productivity gains by deepening inter-group specialization, but also made Homo sapiens more peaceful:◆ Individuals or groups of individuals, who trade with other, become

dependent on each other. This increases the opportunity costs of martial conflicts.

◆Martial conflicts, very often in combination with cannibalism, is often observed between other hominids, e.g. within chimpanzee populations.

■ Higher productivity combined with more cooperation within and between groups could indeed be the reason why our species has crowded out other hominians like the Neanderthals. - 9 -Prof. Dr. Rainer Maurer


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Digression: Trade makes people more cooperative

➤Behavioral experiments show: Communities, which practice division of labor, tend to be more cooperative::■ Ultimatum Game: One player receives an amount of cash and must

share it with another player. The first player decides about the shares of money. But only if the second player agrees, this shares of money will be paid out to both players.

■ Results: People from cultures, where cooperation by trade plays an important role, are more generous in terms of sharing (Henrich, J. et al., 2005):◆ Hazda (self-sufficient hunters and collectors, Tanzania): ᴓ-offer ≈ 15%◆Machiguenga (self-sufficient fire-farmers, Amazon) : ᴓ-offer ≈ 15%◆Orma Nomads (nomads, Kenya) : ᴓ-offer ≈ 50%◆ Anchuar (mercantile farmers, Equador): ᴓ-offer ≈ 50%◆ American undergraduate students: ᴓ-offer ≈ 50%◆ Lamalera (grouping organized whale hunter, Indonesia): ᴓ-offer ≈ 58%

=> Conclusion: Trade makes people more cooperative!

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Digression: Trade makes people more cooperative

:

At the end of the middle ages, the emergence of Mercantilism caused a significant decrease in the rate of homicides per inhabitant.

Spierenburg, P. 2008. A History of Murder.

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Fred Barney

Flintstoneblade 3 hours ∞

Fur coat . ∞ 1 hour


Historically important cause for long distant trade :

Due to a lack of raw materials and / or knowledge, trade partners can produce only one good:

In this case, long-distancetrade is, of course,especially profitable forparticipants, becauseotherwise they would notbe able to consume thegoods they are not able toproduce themselves.

From an historical point of view, this type of trade was very important as the following survey indicates:

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Known trade networks of the past:

Years B.C . Where ? Merchandise goods

6000 “Stone Age EU": Network of trade routes along rivers travelled by logboats.

Flintstone, furs, clothing,jerky

6000 Mesopotamia : Uruk, first known city, organized irrigation system, trade with population living in the hills of its hinterland.

Cereals, clothing, pottery in exchange for wood, furs, animals

6000 Indus Valley : usage of ox carts & sailingboats

Lapislazuli, copper, cotton, wood

4000 Ägypten : Pharao Skorpion II, organizationof the Nile irrigation system

Cereals, clothing, pottery in exchange for copper,cotton, wood, precious metals

3000 Peru: Norte Chico culture: Exchange between coastal reagion and its hinterland

Dried fish in exchange forfish nets made of cotton

2000 Akkadian Empire in Mesopotamia : traderelations from Anatolia (Silver) to North India(copper)

Cereals, leather, textiles, parfume, gold, silver, copper

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Known trade networks of the past:

Years B.C . Where ? Merchandise goods

1500 Emergence of centralized „national states “: Egypt, Creta, Babylonian Empire, Shang-Dynasty

Taxes, trade restrictions,national monopolies

1200 Phoenicians:

Biremic galley (rowing & sailing vessel with keel): basis of the Mediterranean trade,

Division of labor by maritime trade

Iron (Philistine), glass (Phoenician), wheat (Egypt), wool (Anatolia), olive oil (Crete), wine, honey, resin, spices, Ivory, ebony, leather, wool, clothes, purple paint, copper, tin, lead, silver, gold, horses, slaves

1100 Phoenician traders from Tyros founded the spanish city Cadiz to trade with the Tartan silver mines & melting works in the hinterland

Silver in exchange for theabove merchendise goods

600 Greek traders founded Marseille (Massalia ), development of a regional trade network: Rhone, Durance, Burgundy, Switzerland, England (!)

Wine, salmon, fish, medicinal and spice herbs, corals, cork

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Digression: Marseille – The Greek „Bartertown“ Structuring International Trade Flows across Antique Europe

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Tin

Tin

Copper, Tin, Lead

Olive Oil

Olive OilCeramic

Ceramic

Cadiz

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➤ Antique means of transportation:

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Digression: The man from Hauslabjoch (Ötzi):➤ The man from Hauslabjoch (Ötzi) ■ Died ≈ 3345 BC■ Walking encyclopedia of the economy of his time:◆ Tools made of copper from Tuskan (not local !) mines,

Flint, bone and 6 species of wood (ash, snow ball, lime tree, Horn shrub, yew, Birch) ◆ Clothes: cloak (woven grass), coat, leggins, loin-

cloth (made of various materials: bark, tendons, bear leather, deer skin, goat skin, calf leather)◆ Shoes: distinctive mountain boots, made of calf,

bear and deer leather◆ first-aid kit: various dried mushrooms and medicinal herbs◆ lighter box: various stones and plant fibres for making fire

■ Extraction and processing of all these materials requires the existence of a well developed system of division of labor.

■ Division of labour requires specialization of production made possible by trade.

"Because the shoes are actually quite complex I'm convinced that even 5,300 years ago people had the equivalent of a cobbler who made shoes for other people.“ (Petr Hlavacek, footwear expert, according to The Telegraph (2005))

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Digression: The Roman Empire Free Trade Zone (510 BC - 480 BC)

➤ The Roman Empire (510 BC - 480 BC), resulted in a wide-spread reduction of transaction costs (expansion of trade routes, reduction in the risk of robbery). The resulting intensification of trade relations caused typical "globalization effects", as they are also known from the modern times:

➤ Example: Terra Sigillata tableware

TS was the "porcelain of Roman times".

Arezzo in Tuscany was the original production site.

Because it was a status symbol for wealthier officers, it had to be transported over the Alps to the Germanic military garrisons.

This was expensive and risky.

Therefore craftsmen from Arezzo started a local production of TS, when in Gaul (later Lyon, La Graufesenque...) and Germania (later Nürtingen, Rheinzabern, Waiblingen,...) where deposits of red clay were discovered.

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Digression: The Roman Empire Free Trade Zone (510 BC - 480 BC)

➤ Example: Terra Sigillata tableware

As raw materials and workforce in Germanic and Gallic TSproduction facilities were much cheaper than in the industrially advanced Arezzo, mass production of TS was started and exported to Italy.

The production of TS in Arezzo collapsed. Specialization changed to the production of higher-quality pottery and jewellery.

➤ These kinds of „globalization effects“ are observed until today:

In the 80s : relocation of textile and fashion jewelry production to Southeast Asia.

In the 90's: Relocation of furniture production to Eastern Europe.

➤ What are the consequences of such globalization effects to the welfare of people? Who are the winners & losers? We will discuss this in detail in section 1.2. of this chapter.

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Development of per capita GDP and export share of the early industrialized countries*) from 1820 to 1990

*) Average values up to 1870: Austria, Belgium, Denmar k, France, Germany, Italy, UK, USA; starting with 1871 addionally included: Australia, Canada, Finland, Netherlands, Norway,

Sweden. Source: Maddison (1992) Dynamic Forces in C apitalist Development.

Per capita GDP in PPP US-$ of 1985

Industrial exports in % of GDP

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1. International Trade1.1. The History of trade1.2. The theory of International Trade

1.2.1. Trade Caused by Comparative Advantage

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Fred Barney

Flintstone blade 6 hours -



Costsof a blade ½ Fur coat 2 Fur coats Gain . 3 hours 1 hour

Fred Barney






However, Fred will have to work 4 hours more than Barney!Is that “fair”?

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➤ To examine the welfare effects of international trade on a market, the distinction between

■ Consumer surplus■ Producer surplus■ Cooperation surplus

is useful. In the following, these terms are graphically explained. Theoretical backbone is so called "welfare analysis" - well known from the microeconomics.

1. International Trade1.2.1. Trade Caused by Comparative Advantage

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Demand

€/Piece

Q

Supply


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Demand

€/Piece

Q

How high is the willingness to pay of these consumers for the first piece of this good?


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Demand

€/Piece

Q


1 * 17€ = green column


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Demand

€/Piece

Q


1 * 16€ = next green column


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Demand

€/Piece

Q


1 * 15€ = next green column


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Demand

€/Piece

Q

etc.…

What represents the sum of all green columns?


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Demand

€/Piece

Q

The maximum willingness to pay for 17 pieces of this good

= 153 €


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Demand

1. International Trade1.2.2. Winners and Losers of International Trade

€/Piece

Q

SupplyThe maximum willingness to

pay for 8 pieces = 108 €

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Demand

€/Piece

Q

Supply

Consumption expenditure for 10 pieces at a market price of 10 € = 10 € * 8 = 80 €

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Demand

€/Piece

Q

SupplyWhat represents the area

above consumption expenditure = 108 € - 80 €

= 28 € ?

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Demand

€/Piece

Q

SupplyThis „excess willingness to pay“ is called „consumer surplus“ or

„net consumer wellfare“.

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Demand

€/Piece

Q

SupplyConsumer surplus

What area represents producer wellfare?

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Das Bild kann zurzeit nicht angezeigt werden.

Demand

€/Piece

Q

Supply

Consumer expenditures = producer sales


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Demand

€/Piece

Q

Supply

Variable Costs?

Consumer expenditures = producer sales


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Demand

€/Piece

Q

Supply

Remember: The supply curve represents the mar-ginal costs of producers.


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Demand

€/Piece

Q

Supply

Costs of the production of the first piece = 3 €



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Demand

€/Piece

Q

Supply

Costs of the production of the second piece = 4 €



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Demand

€/Piece

Q

Supply

Costs of the production of the third piece = 5 €


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Demand

€/Piece

Q

Supply

What represents the sum of the blue columns ?


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Demand

€/Piece

Q

Supply

Sum of the blue columns = variable costs of the

production of 8 pieces = 52 €


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Demand

€/Piece

Q

Supply

How can we call the red area

= 80 € – 52 € = 28 €?

Sales – variable costs = „producer surplus“ = „producer welfare“


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➤ Formal definition of producer surplus:

■ Producer surplus is sales minus variable costs.

■ Why are fix costs neglected?

◆For the sake of simplicity, the assumption is made that all producer have already paid the fix costs such that these represent irreversible investment aka “historical costs”.

◆Since such type of “historical costs” cannot be avoided, they will not affect future investment decisions – at least, if people act completely rational.


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Demand

Supply

€/Piece

Q

For simplicity we assume in the

following perfect divisibility of goods, such that we have

straight lines instead of „steps“.


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Demand

€/Piece

Q

Consumer surplus Supply

Producer surplus

Variable costs

Pe

Qe


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➤ Consumer surplus + Consumer surplus = Total Return of cooperation = Total surplus

➤ In a market equilibrium with complete competition and absence of external costs total surplus is maximal:■ An increase of production above Qe causes an increase of

production costs above the willingness to pay of consumers => Total surplus falls.

■ A reduction of production below Qe causes the willingness to pay to be higher than the production costs. => Total surplus falls.

➤ In the following we can use these relationships to analyze the welfare effects of trade:


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1. International Trade1.1. The History of trade1.2. The theory of International Trade

1.2.1. Trade Caused by Comparative Advantage1.2.2. Winners and Losers of International Trade

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1.2.2. Winners and Losers of International Trade

O

P

Q

SInland

DInland

QAutarky

PAutarky

Market equilibrium without international trade (autarky)

Consu-mer surplus

Producer-surplus

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O

P

Q

SInland

DInland

Consu-mer surplus

Producer-surplus

S World marketPw

QAutarky

PAutarky


Let‘s assume first that the World market price is below the autarky price and that this country is that

small that its demand cannot significantly affect the World

market price.

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O

P

Q

SInland

DInland

SWorld marketPw

QConsumptionQAutarky

PAutarky

Free trade


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O

P

Q

SInland

DInland

SWorld marketPw

QConsumptionQProduction QAutarky

PAutarky

Free tradeFree trade


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O

P

Q

SInland

DInland

S World marketPw


PAutarky

Import



Market equilibrium withinternational trade

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O

P

Q

SInland

DInland

S World marketPw


PAutarky

Import



Welfare effect ofinternational trade

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O

P

Q

SInland

DInland

A

B

S World marketPw

D

C

QConsumptionQProduction

PAutarky




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O

P

Q

SInland

DInland

A

S World marketPw

D

C


Autarky Free trade Change

Consumer surplus A A+B+D B+D

Producer surplus B+C C -B

Total surplus A+B+C A+B+C+D +D

PAutarky

B



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O

P

Q

SInland

DInland

A

S World marketPw

D

C



Consumer surplus A A+B+D B+D

Producer surplus B+C C -B

Total surplus A+B+C A+B+C+D +D

Welfare effect of free trade

PAutarky

B



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➤ Result: ➤ The transition of whole countries from autarky to free trade (and

not only single persons like Fred and Barney) generates winners & losers:

■ If the world market price is below the autarky price, consumers will be the winners and producers will be the losers.

■ However, the net effect on total welfare is positive: The consumers gain more as the producers lose!

■ The consumers gain a part of the former producer surplus (Area B) plus additional surplus from the consumption of the imports (Area D).

■ Since producers produce less goods as before, they will typically demand less production factors – especially labor force. If these workers cannot find immediately a new job at the old wage rate, additional welfare losses will emerge!


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O

P

Q

SInland

DInland

QAutarky

PAutarky

Market equilibrium without international trade (autarky)

Consu-mer surplus

Producer surplus


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O

P

Q

SInland

DInland

Consu-mer surplus

Producer surplus

SWorld marketPw

QAutarky

PAutarky


Let‘s assume now that the worldmarket price is above the autarky

price and that this country issmall enough such that its supply

cannot significantly affect theworld market price.

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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky


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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QProduction


QConsumption


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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QProduction

Export


QConsumption


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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QProduction

Export

Market equilibrium withinternational trade


QConsumption


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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QProduction

Export

Welfare effect of international trade


QConsumption


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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QConsumption QProduction

Export

A

B

D

C




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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QDemand QProduction

Export

D

C


Consumer surplus C+A C -A

Producer surplus B B+A+D +A+D

Total surplus C+A+B C+A+B+D +D

A

B



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O

P

Q

SInland

DInland

SWorld marketPw

QAutarky

PAutarky

QDemand QProduction

Export

D

C

Welfare effect of free trade


Consumer surplus C+A C -A

Producer surplus B B+A+D +A+D

Total surplus C+A+B C+A+B+D +D

A

B



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Digression: The welfare effects of immigration

We can also use welfare economics to analyzethe welfare effects of immigration:

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O

Wage

Working time

Labor supply without immigration

Labor demand

Lb.I.

So.I

Labor market equilibriumwithout immigration

Demand surplus

Supply surplus

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O

Wage

Working time


Labor demand

Lb.I.

S.b.I

Labor supply with immigration

Labor market equilibriumwith immigration

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O

Wage

Working time


Labor demand

Lb.I.

S.b.I.

labor supply with immigration

Lw.I.

Sw.ISdom.


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O

Wage

Working time


Labor demand

Lb.I...

S.b.I.

Lw.I.

Sw.I

Demand surplus

Supply surplus

Sdom.



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O

Wage

Working time


Labor demand

Lb.I..

S.b.I.

Lw.I..

Sw.I

Demand surplus

Dom. supply surplus

Sdom.



Immigrant surplus

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O

Wage

Working time


Labor demand

Lb.I.

Ao.I

Lw.I.

Am.IAInl

A

B

D

C

E

WithImmigration

WithoutImmigration

Change

Demand surplus A A+B+C B+C

Domestic supply surplus B+D D -B

Immigrant surplus - E E

Total surplus A+B+D A+B+C+D C+E

Increase ofwelfare by

Immigration



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➤ Result: ➤ The transition of whole countries from autarky to free trade (and

not only single persons like Fred and Barney) generates winners & losers:

■ If the world market price is above the autarky price, producers will be the winners and consumers will be the losers.

■ However, the net effect on total welfare is positive: The producers gain more as the consumers lose!

■ The producers gain a part of the former consumers surplus (Area B) plus additional surplus from the export of goods (Area D).

■ In principle the winners gain enough to compensate losers for their losses and still keep a surplus compared to autarky.

■ In reality such a compensation does not take place.

■ There is no market mechanism, which keeps care for a compensation of losers!


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➤ From a pure scientific point of view, there exists no necessity to make the transition from autarky to free trade.

➤ Therefore a normative decision has to be made: ■ According to the so called Pareto Principle (= a change shall always

be made, if it improves the situation of at least one person without worsen the situation of another person) a transition from autarky to free trade cannot be made:

■ Since the loser of free trade will not be compensated by the winners, a transition from autarky to free trade does not correspond with thePareto Principle.


Vilfredo Pareto

(1848 – 1923, Italian economist)

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➤ Kaldor and Hicks (1939) proposed another normative principle, which allows a transition from autarky to free trade:

■ Kaldor-Hicks-Criterion: „A change shall always be made, if the winners of this change can potentially compensate the losers and still keep a net gain, even if this compensation does not take place.”

➤ This normative principle implies a strong value judgement, since it accepts that losers are not compensated. This is certainly not compatible with many ethical value systems.

➤ Many people will therefore not accept the Kaldor-Hicks-Criterium.➤ Of course, alternative criteria are possible, e.g.:


… Kaldor-Hicks-Criterium plus „No loser shall ever face an existential threat“

Modified Kaldor-Hicks -Criterion

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➤ To make up your mind, it is probably useful to consider the different consequences of a transition from autarky to free trade can have depending on the degree of economic development:■ If for example: farmers in a developed country with a well functioning

social security system, financial sector and education system, might suffer from a transition to free trade, but they will not face an existential threat. The social security system will provide them a minimum income and the education system and the possibility to receive credits will allow them to find a new job or reorganize their production.

■ If, however, farmers in a developing country have to close their production, because of new competition from a transition to free trade, their families will very often face an existential threat, since they cannot rely on a social security system, the possibility to receive credits or vocational training.


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➤ As always, when it comes to ethical value judgments, the existence of universally binding rules is incapable of proof. In last instance, everybody has to make a personal decision.

➤ However, if decisions are inevitable, which concern the whole society, societal compromises have to be found.

➤ Therefore the interests of consumers and producer have to be balanced somehow.

➤ In a constitutional democracy, this is the task of parliaments.


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➤ As the previous analysis has shown, it always comes to international trade, if the world market price and the autarky price are different.

➤ If the world market price and the autarky price are identical, it will not come to international trade.

➤ This demonstrates the following graph:


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O

P

Q

SInland

DInland

SWorld market

Pw

QAutarky

PAutarky


Domestic demand

Domestic supply

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➤ As the foregoing explanations for the gains from trade have shown, the difference between autarky and world market prices is the crucial point.

➤ In the following we will see that autarky and world market prices can diverge for different reasons:

1. Production technologies are different in different countries, which causes differences in productivity (Ricardo 1817).

2. Demand for certain goods is different in different countries.

3. The endowment with certain production factors is different in different countries (Heckscher/Ohlin 1933).


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1. Differences in production technologies:

■ Today technological differences between countries play a less important role as in the times, when Ricardo developed his theory in his famous book “On the Principles of Political Economy and Taxation” published in the year 1817.

■ The reason is that today technological knowledge has become a mobile and therefore tradable good itself.

■ Mostly climatic differences can cause significant productivity differences mainly in the production of food. For example: the production of pineapples in Germany vs production in Brazil.

■ Nevertheless, the assumption is useful as a theoretical starting point, as the following diagram shows:


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Country A

X

International Trade Caused by Differences in Productivity

PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

S(P)

XAutarky

PTradel

PAutarkyExport

Import

Country A and country B have different production technologies: Country A is more productive in the production of good X as country B. Therefore, the supply curve of country A lies more to the right as the supply curve of country B. The demand curves of both countries are assumed to be identical. As a result, the autarky price of country A is lower than the autarky price of country B. After a transition to free trade, the price in country A grows above the autarky price due to the additional demand from country B, while the price in country B falls below its autarky level due to the additional supply from country B. As a result, exports from country A equal imports to country B.

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Country A

X


PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

S(P)

XAutarky

PTradelPAutarky

Export

Import


PTrade too high:

ExportCountryA > ImportCountryB

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Country A

X


PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

S(P)

XAutarky

PTradel

PAutarkyExport

Import


PTrade too low:

ExportCountryA < ImportCountryB

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Country A

X


PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

S(P)

XAutarky

PTradel

PAutarkyExport

Import


PTrade = Equilibrium Level

ExportCountryA = ImportCountryB

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2. Differences in demand preferences:■ Differences between autarky price and foreign price can also

emerge if only demand preferences between two countries differ, even if both countries are identical with regard to all other aspects.

■ In this case, differences in the strength of demand can cause differences in autarky prices:

◆ If consumption preferences for chocolate are higher in country B than in country A, country B will have higher autarky prices for chocolate than country A.

◆ After a transition to free trade, country A will export as much chocolate to country B such that prices in both countries will equalize, as the following graph shows:


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Country A

X

International Trade Caused by Differences in Preferences

PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

XAutarky

PTrade PAutarky

Export

Import

Country A and country B have only differences in the strength of demand: Country B has a higher demand for chocolate than country A. Therefore, the demand curve D(P) of country B lies more to the right than the demand curve of country A. The supply curves of both countries are perfectly identical. Therefore, the autarky price in country B is higher than in country A. After a transition to free trade, the price in country B falls below its autarky price due to the chocolate imports from country A. In country B the opposite happens. In the end, both countries face the same price and the chocolate exports of country A equal the chocolate imports of country B.

S(P)

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3. Different endowment with production factors:

■ In their book "Interregional and International Trade" published in 1933, Heckscher and Ohlin point out that a different endowment with production factors can also be a cause for diverging autarky prices and thus for mutal benefical trade:

◆ Heckscher/Ohlin demonstrated that in a country A, which has relatively more skilled workers and relatively few unskilled workers, the autarky prices of goods, were skilled workers are needed (e.g. high-tech goods) are lower than in country B, which has relatively more unskilled workers and relatively few skilled workers.

◆ Therefore, when a transition to free trade takes place, high-tech goods are exported from country A to country B, while country B exports to country A low-tech goods.


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Country A

X

International Trade Caused by Differences in Factor Endowments

PAutarky

P

D(P)

S(P)

XAutarky

Country B

X

P

D(P)

S(P)

XAutarky

PTrade

PAutarkyExport

Import

Country A and country B differ only in the endowment with production factors: Country A has more production factors necessary for the production of Gut X. These production factors are therefore cheaper in country A. As a result, its supply curve S(P), which equals the marginal cost curve, is further to the right than the supply curve of country B. The demand curves D(P) of both countries are identical. In autarky, the price in country A is lower because of its higher supply. When a transition to free trade takes place, the price in country A increases due to the additional demand from country B over the autarky price of country A. In country B the price falls due to the additional supply from country A under the its autarky price. In the end both countries face the same price and the exports of country A equal the imports of country B.

This case is graphi-cally identical with the case of different productivity!

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3. Different endowment with production factors:■ Today, this mechanism is called „Heckscher/Ohlin Theorem“:

◆ „A country exports the goods, whose production needs more those production factors, whose supply is relatively larger in this country. “


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➤ Examples for differences in the endowment with capital and labor force between selected developing and developed countries:

Country Capital stock (BN. $) Labor force (Mill.) K/L (Th. $)

India 482 254 1,9Brazil 507 53 9,5

Mexico 353 23 15,3USA 3 696 116 32,4Germany 1 018 26 39,1

Switzerland 120 3 40

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3. Different endowment with production factors:

■ Another important theorem, which can be derived from the assumptions of the Heckscher/Ohlin model is the so called Stolper/Samuelson-Theorem:

◆ „In transition to free trade, the remuneration of those production factors grows, whose supply is relatively large, while the remuneration of those production factors falls, whose supply is relatively scarce.”

■ Explication: According to the Heckscher/Ohlin theorem, the exports of those goods grow in transition to free trade, whose production needs more of those production factors, whose supply is relatively large. Consequently, the demand for these production factors grows in transition to free trade.

■ For production factors, whose supply is relatively scarce, the opposite happens.


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3. Different endowment with production factors:■ Question: What are the consequences of a transition to free trade

on income distribution in developed countries according to the Stolper/Samuelson theorem?

◆ Skilled workers with relatively high income, receive an even higher income, because the export of goods grows, whose production needs more skilled workers. To the contrary, unskilled workers with relatively low income, receive an even lower income , because the imports of goods, whose production needs relatively more unskilled workers grows, such that the domestic production of those goods falls.

=> According to the Heckscher-Ohlin Modell a transition to free trade causes the income distribution of a developed country to become more unequal!

◆There are however also other factors of influence like production technologies or tax policy, which affects the income distribution.


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3. Different endowment with production factors:■ Question: What are the consequences of a transition to free trade

on income distribution in developing countries according to the Stolper/Samuelson theorem?

◆ ???


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1.1. The History of trade

1.2. The theory of International Trade



1.2.3. Trade caused by Economies of Scale

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1. International Trade1.2.3. Trade caused by Economies of Scale

➤ According to the classical trade theory considered so far, a country should mainly export goods which it does not import and vice versa (= inter-industrial trade).

➤ However, most developed countries export goods of the same industries of which they also import goods (intra-industrial trade) as the following Diagrams show:

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Percentage Share of German EU Trade in total German Trade

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➤ The Grubel-Lloyd Index (also called IIT = Intra-Industrial Trade index) can be used to measure whether a country undertakes more inter- or more intra-industrial trade in an industry:

➤ In case of only intra-industrial trade (Xi = Mi), this index is equal to unity; in the case of exclusively inter-industrial trade (Xi > 0 => Mi = 0), the index equals zero.

➤ Interpretation:■ If a country exports in industry i just as much as it imports (i.e. intra-

industrial trade), Xi = Mi, the index is equal to one.■ If a country either exports only or imports only in an industry (i.e.

undertakes inter-industrial trade), then [(Xi> 0 and Mi = 0) or (Xi = 0 and Mi> 0)], such that the index is zero.


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➤Numerical examples for the Grubel-Lloyd Index:


X M M

1 1

0,5

X M X M X M

GL=1 GL=0 GL=0.66

1 1

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Country Values for the Grubel-Lloyd Index (IIT) (Average Values Across all Industries)

Developing Countries IIT Emerging Markets IIT Develope d Countries IIT

Algeria .01 Argentinia .42 Australia .25Camerun .06 Brazil .38 Austria .74Central African Republic .01 Greece .21 Benelux .79Chile .10 Hong Kong .41 Canada .67Columbia .20 India .37 Denmark .67Malawi .06 Israel .62 Finnland .45Dominican Republic .07 South Korea .35 France .80Egypt .07 Mexico .32 Germany .63Morocco .11 Portugal .33 Ireland .61Ghana .04 Singapore .67 Italy .59Guatemala .33 Spain .52 Japan .56Guyana .20 Taiwan .35 U.K. .81Haiti .46 Jugoslavia .51 USA .59Ivory Coast .13 Norway .44Average .15 Average .42 Average .59

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➤ As these empirical data show, a large part of international is trade between countries which are very similar.

➤ This trade is not explained by classical foreign trade theory.

➤ Paul Krugman has addressed this problem in a series of research papers and explained how trade between relatively similar countries can be explained by economies of scale in production.


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➤ This empirical trade pattern can be explained by economies of scale in production, as will be explained below.

➤ Internal economies of scale: The average costs depend on the company size: Larger companies can produce at lower average costs than smaller companies.

➤ Reasons for the existence of internal or advantages:

■ Reasons for internal economies of scale:

◆ Fixed costs of production plants◆ Quantity discounts for production factors (purchasing power)◆ Lumpy Production Factors (Advertising, R & D)


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Digression: Reasons for external economies of scale.

Interestingly, external economies of scale can also exist. In this case the average costs depend on the size of an industry in a region: in countries where an industry is larger, individual firms can produce at lower average costs than in countries where the same industry is smaller.

■ Reasons for external economies of scale :◆ Specialized suppliers (industry-specific service providers)◆ Knowledge spillover (knowledge of other companies can be used

via informal local channels)◆ Labor force pooling (If demand increases, free skilled workers are

available on the local labor market, released by other firms in the same industry.)

◆ Infrastructure effects (industry-specific schools or transport infrastructure (habour, airport, specialized express companies),

◆ Examples: Silicon-Valley, Hollywood, London City, Pforzheim (!)…

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Example: Economies of Scale in the Film Industry

The first film studio was established in the year 1911 in Hollywood. In the sameyear 15 independent film studios moved from New York to Hollywood. Incontrast to New York, Hollywood had better light conditions (artificial light didnot exist in those times) and granted "geographical protection" against the"Motion Picture and Patents Company", which was notorious for its licensepenalties. This helped to reach a critical mass, which led to the foundation offurther studios. In 1912 Carl Lämmle, born in Laupheim in Upper Swabia,founded the "Universal Pictures", which under his leadership produced around2000 films until 1939.

The reasons for the rise of Hollywood to a center of the world film industry canbe well explained by internal and external economies of scale:

Internal economies of scale: Film costs consist largely of fixed costs, the consumption of a film in the cinema, television internet causes comparatively small variable costs. The American film market was then the largest film market with a uniform language. This led to a considerable fixed-cost decline in production of films for the American market. However, internal economies of scale are not sufficient to explain the development of Hollywood. Fixed cost

degression could have been used at any other production site in the USA as well. External economies of scale must have played an important role either.

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Example: Economies of Scale in the Film Industry

External economies of scale: Two eeasons for external economies of scale arelikely to have been important for the development of Hollywood:

1. Specialized subcontractors: The production of a movie is usually undertakenby network of very diverse companies - think of the usual length of the movieend titles: filmstudios, actors agencies, craftsmen specializing in scenery,lighting companies, special effects companies, film laboratories, cateringcompanies, etc. If such an infrastructure has to be built up from the scratch foreach single film, high fixed costs result each time. However, if the variousinfrastructure modules already exist locally, it is possible to use thesecompanies for various film projects.

2. Labor-Force-Pooling: Once a critical number of film-studios has settled in aregion, specialized workers like directors, actors, extras, cameramen, stuntmen,makeup artists will follow. This way, a pool of specialized workers released fromjust completed film projects will always be available for new projects.

Experiences in other countries show that external economies of scale in the filmindustry are not Hollywood-specific. For the Indian cultural area, "Bollywood"has established itself at Bombay, a large part of the Chinese-speaking films areproduced in Hong-Kong.

The Spanish language area is supplied withTelenovelas made in Caracas and in the Germanfilm industry is regionally concentrated aroundBabelsberg.

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➤ As the following example shows, economies of scale can be a further reason for gains from trade.

➤ They represent a kind of gains from trade which are completely independent of the "classical" gains from trade found by Ricardo. To understand this, let's analyze a simple numerical example. Let's assume that the following input/output relationship is caused by economies of scale:


Laborinput (L)

Car output (Y)

Labor pro-ductivity (Y/L)

10 100 10

20 300 15

30 600 20

40 1200 30

50 2400 48

60 4800 80

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➤ To simplify the analysis in the following the assumption is made that only two countries exist, where

■ all cars are produced with an identical production technology,■ as a consequence of increasing labor productivity, avergage costs

are decreasing,

■ two equally large consumer groups with different preferences for cars exist:

◆ One consumer group with ideal product called „Ferrari“◆ One consumer group with ideal product called „Porsche“◆ Identical demand curves for both car types.

■ an identical number of car production workers of 60 is available.


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➤ Under autarky the following production structure results:

■ Italy: 30 worker per car type Porsches = 600 units; Ferraris = 600 units => Total: 1200 units■Germany: 30 units worker per car type

Porsches = 600 units; Ferraris = 600 units => Total: 1200 units■World production:

Porsches = 1200 units; Ferraris = 1200 units

➤ After transition to free trade every country specializes in the production of one car type, caused by economies of scale:■ Italy: 60 workers for the production of Ferraris:

Ferraris = 4800 units■Germany: 60 for the production of Porsches:

Porsches = 4800 units■world production:

Porsches = 4800 units & Ferraris = 4800 units


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Germany

Ferraris

Porsches

Car production under autarky

Germany

Italy

Italy

C1

Average costs

C1

600

Average costs

Ferraris

Porsches

C1

Average costs

C1

600

Average costs

Under autarky the assumption of identical production technologies and equal demand strength implies that Porsche &

Ferrari production has the same size in both countries.

600 600

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Germany

Porsches

Car production under free trade

Italy

Italy

C1

600

Average costs

Porsches

C1

600

Average costs

4800

C2

0

Ferraris

Germany Italy

C1

600

Average costs

Ferraris

C1

600

Average costs

Under free trade, an accidental increase in Porsche production in Germany is sufficient to cause lower average costs and thus a

further expansion of Porsche production.

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Germany

Ferraris

Porsches


Germany

Italy

Italy

C1

600

Average costs

C1

600

Average costs

Ferraris

Porsches

C1

600

Average costs

C1

600

Average costs

4800

C2

0

German Porsches are now cheaper than Italian, so workers are dismissed in the Italian Porsche production move into the Italian

Ferrari production.

Since the Porsche production in German can pay higher wages due to higher labor productivity, the workers are moving into Porsche

production and leave the German Ferrari production.

4800

C2

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Germany

Ferraris

Porsches


Germany

Italy

Italy

C1

600

Average costs

C1

600

Average costs

Ferraris

Porsches

C1

600

Average costs

C1

600

Average costs

4800

C2

0

4800

C2

Since demand strength is the same in both countries, Italy exports half of its Ferrari production to Germany and Germany exports half

of its Porsche production to Italy.

The increase in total production from 1200 to 4800 cars corresponds to the gains from trade, which is caused by declining average costs

and, in this case, divided equally between both countries.

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➤ Free trade allows a better exploitation of economies of scale, such that 4800 units per car type can be produced instead of only 1200 units per car type under autarky.

➤ With the same number of workers, more Ferraris and Porsches can be built under free trade.

➤ In presence of economies of scale specialization by free tradeallows for productivity gains.

➤ The example shows how economies of scale cause gains from trade. However trade (=import and export of Porsches and Ferraris) is organized by the companies not because they want to realize gains from trade, but because gains from trade increase the company profits. The extent to which company profits grow due to the gains from trade, depends on the competitive situation and the strength of demand.


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➤ This example also demonstrates:

■ Trade emerges between Germany and Italy, caused by economies of scale, even though two identical goods are produced with identical production factors.

■ Both goods belong to the same industry, so the resulting trade is intra-industrial trade.

■ For countries which have reached the same level of development with regard to their◆productions technologies◆consumer preferences◆ relative factor endowment

economies of scale can still give rise to international trade.

➤ However, the example is boldly simplified. The effects resulting from the incomplete competition which arise due to economies of scale have not been taken into account.


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Digression: The North American Auto Pact & its impact on intra-industrial tradeA kind of "natural experiment" for the emergence and consequences of intra-industrial trade is the auto-pact between the USA and Canada of 1964.

By 1964, import tariffs were that high that there was a only relatively volume oftrade in cars between the US and Canada. With the same companies operatingin Canada as in the US, the Canadian auto industry was actually a 1/10 smallerversion of the US auto industry.

The productivity of the Canadian plants was about 30% lower than in the USindustry due to the existence of economies of scale. The reason for this getsobvious by taking into account that more than one model per production facilityhad been produced in Canada due to the smaller sales volumes. This made itnecessary to close complete production facilities on a regular base for severalweeks in order to retool the production lines.

When the free trade zone for cars between the USA and Canada wasestablished in 1964, a restructuring of the entire industry followed: In Canada,General Motors' product range was reduced by nearly a half. Nevertheless, theCanadian car industry did not dismiss workers, because the productionvolumes for the remaining Canadian car types was extended. The resultingincrease in production of these car types was then exported to the USA, whilethe car types previously produced in Canada were now imported from the USA.Thus, massive intra-industrial trade emerged.

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Car production before the North American Auto Pact :


USA Canada

Production for the US market:

=>

Large demand

=>

Large production quantities

=>

Strong impact of economies of scale

=>

30% higher productivity

Production for the canadian market

=>

10x smaller demand

=>

10x smaller production quantities

=>

Weak impact of economies of scale

=>

30% lower productivity

N

O

T

R

A

D

E

= by factor 10 smaller version of

US production

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Car production after the North American Auto Pact :

F R E E T R A D E


USA Canada

=> Exploitation of economies of scale by local concentration of production:

=> Common car market = no restriction of trade!

Relocation of production to the USA

Relocation of production to Canada

=>Strong increase in productivity in Canada, because of a strong in-crease in produc-tion volumes per car type!

=> Increase in produc-tivity in the US, be-cause of a increase in production volumes per car type!

=> Settlement of local excess production by export!

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Digression: The North American Auto Pact & its impact on intra-industrial trade

In the year 1962, Canada exported only cars worth 16 million US-$ to theUnited States and imported cars worth 519 million US-$ from the US.

In the year 1968 Canada exported cars worth 2.4 billion US-$ to the US andimported cars worth 2.9 billion US-$ . Both imports and exports increaseddrastically.

Intra-industrial trade also affected the development of productivity as implied bythe theory: In 1970, the Canadian auto industry had almost completely caughtup with the productivity level of US.

(Source: Krugman/Obstfeld (2006, S. 130-131)

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Country B: High capital stock, large supply of skilled and low supply of unskilled worker


Case (1): Trade between two countries with the same endowment of production factors, if economies of scale exist and only "Porsches" and "Ferraris" are tradable (industrial country vs. industrial country):


Country A: High capital stock, large supply of skilled and low supply of unskilled worker

Porsche Ferrari

Value of goods

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Country B: Low capital stock, low supply of skilled worker & high supply of unskilled worker



Case (2): Trade between two countries with the different endow-ment of production factors, if no economies of scale exist and only “machines" and “Food" are tradable (industrial country vs. developing country)


Machines Food

Value of G

oods©

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Country B: Low capital stock, low supply of skilled worker & high supply of unskilled worker



Case (3): Trade between two countries with a different endowmentof production factors, if economies of scale in the production of machines exist and only machines and food are tradable (industrial country: developing country):


Machines Food

Value of G

oodsMachines

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➤ As the last case shows, in the presence of economies of scale, it is no longer possible to predict which industry settles in which country.

➤ If economies of scale are strong enough, they can overcompensate the cost disadvantages resulting from comparative disadvantages. Therefore, despite a comparative disadvantage, an industry can gain ground in such a country.


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➤ To sum up:■ There are two different reasons for international trade:

1. “Differences” in

production factor endowment, consumer preferences or

productivity of technologies = „Classical Trade Theory“

2. “Economies of Scale” in production = „New Trade Theory“

■ As the empirical results for the Grubel-Lloyd Index show, bothreasons play an important role in explaining the actual international trade.

■ In the following, we will examine how government trade policy can intervene in international trade and what kind of consequences this might bring.


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1.3. International Trade Policy

1.3.1. Instruments of Trade Policy

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➤ In section 1.2.1. we compared the "ideal types” autarky and free trade only.

➤ In reality, however, such "ideal types" rarely found. Practical trade policy deals primarily with the impact of tariff and non-tarifftrade barriers in mixed trade regimes.

➤ In most countries tariffs are not levied as uniform import tariffs, but are very differentiated according to individual product groups.

➤ The EU has agreed on a single system of import tariffs in the year 1993. The EU is therefore a "customs union" not only a "free trade zone". A customs union practices free trade inside and has the same import tariff every product against outside countries.

➤ The extreme differentiation of this tariff system stems from the influence of industrial associations and lobby groups.

➤ It leads to a very cumbersome customs bureaucracy, which devours a large part of the tariff income...

1. International Trade1.3.1. Instruments of Trade Policy

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➤ Under „https://www.tariffnumber.com/“

➤ an extremely differentiated list with special tariffs for all kind of goods can be found.

TARIC = Tarif Intégré Communautaire

= Integrated Tariff of the European Communities

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…e.g.

rubber boots

In the following:What are the welfare effects of import tariffs?

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Welfare Effects of Trade Policy: Import Tariffs

O

P

Q

SInland

DInland

S World marketPw


Imports

Production and consumption before import tariff


Consumer surplus

Producer surplus

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O

P

Q

SInland

DInland

S World marketPw

QConsumptionQProductionFree tradeFree trade

PTariff

QProductionTariff QConsumption

Tariff

Imports tariff

Production and Consumption after implementation of import tariff

Imports after tariff

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariffImports after tariff

Imports before implementation of tariffs

Production and Consumption after implementation of import tariff

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

A

Welfare effect of import tariffs

Consumer surplus

B

Imports tariff

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A

B


Producer surplusG

C

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A


Tax revenue of government

G

C E

B

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A

EG

C D F

Welfare loss


B

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A

EG

C D F

B


Before Tariff After Tariff Change

Consumer surplus A+B+C+D+E+F A+B -C-D-E-F

Producer surplus G G+C +C

Tax revenue Nothing E E

Total surplus A+B+C+D+E+F+G A+B+C+E+G -D-F

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O

P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A

EG

C D F

B


Before Tariff After Tariff Change

Consumer surplus A+B+C+D+E+F A+B -C-D-E-F

Producer surplus G G+C +C

Tax revenue Nothing E E

Total surplus A+B+C+D+E+F+G A+B+C+E+G -D-F

Welfare loss cause by import tariff

ÜA

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➤ Beside import tariffs, quantitative restrictions (import quotas) still play a role in practical trade policy.

➤ However, the WTO is proposing for decades to transformquantitative restrictions in equivalent import tariffs, because import tariffs can be reduced more easily.

➤ It is therefore difficult to find examples for quantitative restrictions on the current TARIC database of the EU.

➤ Nevertheless, we will analyze the impact of quantitative restriction in the following:

TARIC = Tarif Intégré Communautaire = Integrated Tariff of the European Communities

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The Welfare Effects of Trade Policy: Quantitative R estrictions

O

P

Q

SInland

DInland

S World marketPw


Imports

Production and consumption before import quota


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O

P

Q

SInland

DInland

S World marketPw

QConsumption

Imports

Free trade

Import quota


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O

P

Q

SInland

DInland

Pw


Import quota= Bestimmte Menge des

Gutes, die importiert werden darf.


S World market

QConsumptionImport quota

QQ

Production and consumption after import quota

PImport quota

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O

P

Q

SInland

DInland

Pw


Import quota

Welfare effect of import quota


SInland+ Import quota

S World market


Consumer surplus

A

PImport quota

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O

P

Q

SInland

DInland

Pw


Import quota




S World market


A

Producer surplus

B D

G

PImport quota

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O

P

Q

SInland

DInland

Pw


Import quota




S World market


Profit of the owner of the import quota

B D

G

C E F

A

PImport quota

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O

P

Q

SInland

DInland

Pw


Import quota




S World market


Welfare loss

PImport quota

B D

G

C E F

A

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O

P

Q

SInland

DInland

Pw


Import quota




S World market


Welfare loss

B D

G

C E F

Before import quota After import quota Change

Consumer surplus A+B+C+D+E+F A -B-C-D-E-F

Producer surplus G G+B+D +B+D

Owner of import quota Nothing C C

Total surplus A+B+C+D+E+F+G A+G+B+D+C -F-E

A

PImport quota

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- 154 -


O

P

Q

SInland

DInland

Pw


Import quota




S World market


Welfare loss

B D

G

C E F

A






Prof. Dr. Rainer MaurerWelfare loss of import quota

PImport quota

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➤ Alternative approach to import quota

■ The following alternative solution is mathematically equivalent to the previous one.

■ It can help deepen understanding of the analysis.

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O

P

Q

SInland

DInland

S World marketPw


Import



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O

P

Q

SInland

DInland

S World marketPw

QConsumption

Import


Free trade

Import quota

Supply curve before import

quota

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O

P

Q

SInland

DInland

Pw

QConsumption

Import quota= Bestimmte Menge des

Gutes, die importiert werden darf.


Free trade


S World market

Supply curve after import

quota

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O

P

Q

SInland

DInland

Pw



Free tradeImport quota


S World market


PImport quota

Import quota

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O

P

Q

SInland

DInland

Pw





S World market


PImport quota

Import quota

A

Consumer surplus

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O

P

Q

SInland

DInland

Pw





S World market


PImport quota

A

B

Producer surplus (The size of areas G+B+D is identical with the size of the areas G+B+D in the

first solution approach!)

B D

G

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O

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SInland

DInland

Pw





S World market


PImport quota

Import quota

AProfit of the owner of

the import quotaCB D

G

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O

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DInland

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S World market


PImport quota

A

CE F

Welfare loss

(The size of the areas E and F is identical with the size of the areas E and F in the first solution approach!)

B D

G

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O

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SInland

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Pw





S World market


PImport quota

A

CE FB D

G






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1.3.2. Trade Policy Doctrines

1.3.2.1. Classical Free Trade Doctrine

ÜA

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1. International Trade1.3.2.1. Classical Free Trade Doctrine

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➤ There is only one country practicing a regime of nearly free trade: the city of Hong Kong. Nevertheless, the free trade doctrine has many supporters among economists since Adam Smith and David Ricardo.


P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Import tariff

A

EG

C D F

B

Welfare loss by too little production

Welfare loss by too much production

➤ The standard argument of the free trade doctrine is the welfare loss described in section 1.3.1.: A restriction of free trade by tariffs or quotas causes too little consumption and too much production compared to a free trade regime. ©

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➤ Attempts to measure these efficiency losses led to the following results:

Gains of a transition to free trade in % of GDP

USA 0,57 %

EU 0,61 %

Japan 0,85 %

Developing countries 1,4 %

World 0,93 %Source: William Cline (2004), Trade and Global Poverty, Washington

Costs of trade restrictions in % des NDP

Brazil (1966) 9,5 %

Turkey (1978) 5,4 %

Philippines (1978) 5,4 %

USA (1983) 0,26 %Source: nach Krugman/Obstfeld (2004, S. 209)

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➤ However, the advocates of the free trade doctrine point out that there are additional arguments for free trade:

1. Strengthening competition: In many markets, economies of scale play an important role. As a result, without free trade there are often close national oligopolies or monopolistic competition with only a few national suppliers. Free trade increases the number of suppliers. The resulting increased competition is leads to

◆ lower prices,

◆higher supply quantities and

◆more product diversity / quality

In addition competition is increasing the pressure for innovation.

Increasing R&D activities lead to more technological progress,

which have a positive impact on productivity growth.

- 169 -Prof. Dr. Rainer Maure

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2. Increase in R&D profitability (1):

■ R&D expenditures are "lumpy" production factors. It is therefore always necessary to have a certain minimum size of the research activities, in order to be successful. A single researcher is typically not as creative as a group of researchers. In addition, in many research areas, the equipment needed has a certain minimum size (the smallest optimum capacity is "large").

■ R&D expenditures are therefore typical fixed production factors.

◆Therefore "fixed cost degression" arises: The larger the production quantity, the smaller the average R&D costs.

■ Since free trade allows companies to have a larger sales and hence higher production volumes, the average R&D are smaller under free trade.


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2. Increase in R&D profitability (2):

■ Under free trade, there is more R & D investment:

■ The more technical progress results from R & D investments, the more productivity growth results for the whole economy.

■ In models of the so-called "New Growth Theory", it is possible to show mathematically that free trade causes a higher GDP growth rate than autarky.

■ This means that the transition to free trade can not only result in one-time "efficiency gains" (= welfare gains of the static analysis (slides 47-67)), but to permanently higher economic growth.

■ If the assumptions of the New Growth Theory are correct, free trade has much more importance for long-run welfare than the static analysis of the classical trade theory shows.


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3. Reduction of lobbying effects: A government that is not clearly committed to free trade signals implicitly to business associations that there is a "cake" to distribute.

◆ Therefore, companies have an incentive to invest in lobbying activities which target trade policy in order to establish of import restrictions.

◆ Consequences for welfare:

1. Trade restrictions result in the already mentioned welfare losses.

2. In addition, production factors (especially: high skilled workers) are used for unproductive lobbying activities. These production factors are not available to produce goods or services, which would increase welfare. Therefore, additional welfare losses result in terms of opportunity costs.


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➤ To sum up:

4 arguments can be made in favor of the free trade:

1. Efficiency gains of classical trade theory

2. Strengthening competition

3. Increase in R & D profitability

4. Reduction of unproductive lobbying-effects


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➤ It is also possible to put forward a number of economically sound arguments against the free trade doctrine:

1. In case of market imperfections, a restriction of free trade can lead to net efficiency gains.

2. If a country is large enough to influence the world market price, the government can organize a de facto monopsony via an "optimal" import tariff.

3. In the case of imperfect competition, monopolistic gains can redirected from foreign markets to domestic markets via government subsidies ("strategic trading policy").


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1. If there are market imperfections, a restriction of free trade can sometimes lead to net efficiency gains:

■ Causes for such market imperfections are:

1. Classical Unemployment (Chap. 5.1.3, Macroeconomics): Institutions that raise the market wage over the market equilibrium wage cause unemployment. As a consequence, workers dismissed, because of a transition to free trade, will find no new employment.

2. Technological externalities: The production of a good causes cost advantages for other industries, for which the producer receives no compensation ("positive externalities").


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1. Classical Unemployment (Chap. 5.1.3, Macroeconomics): Institutions that raise the market wage over the market equilibrium wage cause unemployment. As a consequence, workers dismissed, because of a transition to free trade, will find no new employment.


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O

P

Q

SInland

DInland

SWorld marketPw


PAutarky


(1) Welfare Effect of Imports in Case of Classical Unemployment

BB

F

D

A

CE

Production costs = Labor income, ifonly workers but no otherproduction factors is used

G

H

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O

P

Q

SInland

DInland

SWorld marketPw


PAutarky



F

D

Producer welfare loss of free trade

Loss of labor income, ifworkers find no new jobs

A

CE J

B

G

H

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O

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SInland

DInland

SWorld marketPw


PAutarky



FD



A

CE J

B

G

H Autarky Free trade Change

Consumer surplus A A+B+C+E+J B+C+E+J

Producer surplus B+C+D D -B-C

Worker surplus G+H+E+F G+H -E-F

Total surplus A+B+C+D+E+F A+B+C+E+J+D+G+H J-F

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O

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SInland

DInland

SWorld marketPw


PAutarky



FD



A

CE G


Consumer surplus A A+B+C+E+G B+C+E+G

Producer surplus B+C+D D -B-C

Worker surplus E+F - -E-F

Total surplus A+B+C+D+E+F A+B+C+D+E+G G-F

Welfare loss by free trade !

B

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➤ What has to be taken into consideration with respect to this result?


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2. Technological externalities: The production of a good causes cost advantages for other industries, for which the producer receives no compensation ("positive externalities").


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P

Q

SInland

DInland

S World marketPw


PTariff


Tariff

Imports tariff

A

EG

C D F

B

Welfare loss by too little

production

Welfare loss by too much production

€

Q

Marginal social return of domestic production

QProduction QProduction

Additional welfare gain by domestic production (externality)

H

The lower diagram reveals the welfare gains of domestic

production, which are caused by the above-

mentioned market imperfections. The

example is chosen such that the area H is larger

than the sum of the welfare losses D and F caused by the import tariff. However, this

does not have to be so necessarily. The size of area H depends on the

size of the market imperfections.

Free trade Tariff

(2) Welfare Effect of Imports in Case of positve Ext ernalities

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➤ The example shows that, in the case of market imperfections, an artificial support of domestic production by import duties can increase welfare.

➤ However: Criticism of criticism

■ However, there are also alternatives to an import tariff that would lead to fewer welfare losses such as

◆ encouragement of domestic production with a subsidization of production (s. next graph) or

◆ a „causal therapy": Reduction of market imperfections on the labor market.


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P

Q

SInland

DInland

S World marketPw

QConsumptionQProductionSubventionFree trade

QProductionSubventionQConsumption

Tariff

€

Q

Marginal social return of domestic production

QProduction QProduction

Additional welfare gain by domestic production (externality)

H

Instead of an import tariff, a subsidization of

production could be paid. In this case the welfare loss would

equal only the area G.

G is the part of the domestic production

costs, higher than the production costs on the world market. Therefore it represents a welfare

loss.

Since the domestic price is equal to the

world market price, the same quantity is

consumed as under free trade: F is therefore not

a loss of welfare.

J

SInland

Subsidy

Welfare loss by domestic

production

G F

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2. If a country is large enough such that its demand and supply can influence the world market price, the government can organize a kind of domestic "purchasing monopoly" via an "optimal import tariff":■ It is possible to prove mathematically that in the case of a large

country the optimal import tariff for a country is always larger than zero.

■ However, this is not a "win-win" policy, because such an import tariff reduces the welfare of other countries.

■ If foreign countries retaliate with "optimal" import tariffs of their own, the net effect of "optimal" import tariffs can be negative for all countries..

■ To prevent such a "optimal tariff race", mutually binding free trade agreements (see section 1.3.3).

■ The following graphs explain, why the implementation of an optimal tariff can increase the welfare of a country, if the other countries do not retaliate.


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- 188 -Prof. Dr. Rainer Maure - 188 -Prof. Dr. Rainer Maurer

Digression: Simplified Numerical Example of an „Optimal Tariff“

■ World market price of coffee under free trade: 8 € / kg

If country A is large enough to influence the world market price with its demand, the introduction of an import tariff in country A will reduce the demand of country A and hence the world market price:

■ Imports tariff of country A: 4 € / kg

■ World market price under the import tariff of country A: 5 € / kg

■ Price in country A under the import tariff: 9 € / kg

=> Burden for domestic consumers caused by import tariff: 1 € / kg = 9 € - 8 €=> Burden for foreign producers caused by import tariff: 3 € / kg = 8 € - 5 €

________________

Imports tariff revenues of country A: 4 € / kg

=> If the welfare losses for the domestic consumers are smaller than 3 € / kg, the import tariff will increase the domestic welfare, because of the higher import tax revenues of the domestic government!

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Impact of an "optimal import tariff"


Country A

X

PFree trade

P

D(P)

S(P)

Country B

X

P

D(P)

S(P)

In the initial situation a free trade regime is given. In order to balance the market in country A and country B, the world market price must be at a level where the exports of country A equal to the imports of country B. In this case, the demanded quantities of country A and country B add up to a value that corresponds to the sum of the production volumes of country A and country B. (This can easily be checked with a ruler in the above graphic!). The overall demand of both countries is thus equal to the total supply of both countries, such that a global market equilibrium prevails.

XFree tradeProductionXFree trade

Consumption XFree trade

Production XFree tradeConsumption

World market price: ExportCountry A= ImportCountry B

ExportFree trade

ImportFree trade

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Country A

X

P

D(P)

S(P)

Country B

X

P

D(P)

S(P)

ExportFree trade

ImportFree trade

If country B now implements an import tariff, the import volume of country B falls from "ImportFree trade" to "ImportTariff", because of the higher domestic price level. Consequently, the export volume of country A also decreases. This causes a reduction of the world market price! This shows that country B can lower the world market price via the implementation of an import tariff. This is the crucial point of the functioning of an optimal import tariff.


Consumption XFree tradeProduction XFree trade

Consumption

Imports tariff

ImportTariff

PFree trade

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Country A

X

PTariff

P

D(P)

S(P)

Country B

X

P

D(P)

S(P)

ExportTariff

ImportTariff

As a result of the lower world market price, the domestic price of country B, which is equal to the world market price plus the import tariff, also drops. As a result, the demanded volume of imports from Country B will rise again. The new world market price is reached when the import volume of country B (= ImportTariff) is equal to the export volume of country A (= ExportTariff). It is obvious that, after the introduction of the import tariff, the equilibrium world market price (PTariff) lies at a lower level.


Consumption XFree tradeProduction XFree trade

Consumption

Imports tariffPB,Tariff


PFree trade

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Country A

X

P

D(P)

S(P)

Country B

X

P

D(P)

S(P)

ExportTariff

ImportTariff

Welfare analysis: The import tariff revenues for the government of country B correspond to area A + B. The area A belonged before the introduction of the tariff to the consumer surplus of country B. It therefore represents a redistribution from the domestic consumers to the government. Area B has been created by the reduction of the world market price! It is financed from the welfare loss of the producers of country A (= area E). Since the area E is larger than the area B, part of the former wellfare of the producers fo country A are lost. It's a net welfare loss. The same applies to areas D and C, which were previously part of the consumer surplus of country B.

X TariffProductionXTariff

Consumption XTariffProduction XTariff

Consumption



A DCBEPTariff

PFree trade

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Country A

X

P

D(P)

S(P)

Country B

X

P

D(P)

S(P)

ExportTariff

ImportTariff

Welfare analysis: The same applies to areas D and C, which were previously part of the consumer surplus of country B. Since the sum of the areas D and C is smaller than area B, which is redistributed by the foreign producers to the domestic state, the introduction of import tariff leads to a net welfare gain of country B that equals the amount of B minus C minus D.

The import tariff therefore increases the welfare of country B at the expense of the welfare of Country A!

XTariffProductionXTariff

Consumption XTariffProduction XTariff

Consumption


World market price: ExportCountry A= ImportCountry

B

A DCBEPTariff

PFree trade

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3. In the case of imperfect competition, monopolistic profits of foreign companies can be redirected towards domestic companies by means of government subsidies. This is the basic result of the theory of "strategic trade policy":

■ If economies of scale are that large that imperfect competition results even on the world market level, monopolistic profits can be redirected completely or partly to domestic companies via government subsidies.

■ A well-known example for such a market is the market for airliners, which today is mostly occupied by Boeing and Airbus.

■ Before the European Union has pushed the establishment of Airbusvia subsidies, Boeing was (almost) monopolist on the market for large airliners.

■ The following analysis, which is based on a mathematical model by Brander and Spencer (1985), can provide a justification for such a kind of subsidization policy.


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➤This payment matrix provides a simplified scheme of distribution of profits between Airbus and Boeing.

➤ If Boeing and Airbus take up production at the same time, monopoly profits fall to the level of duopoly profits. Here the assumption is made that the duopoly turnover is that low and the costs are that high that the duopoly profit is negative (-5).


Airbus

Boeing

Production No Production

Production

-5

-5

0

100

No Production100

0

0

0

➤ If only one company starts production, the monopoly turnover is that high and the costs are that low that the company makes a significant positive profit.

=>If Boeing is already in the market and Airbus not, Boeing has a "first mover advantage": The red marker then indicates the corresponding equilibrium point.

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➤ If, however, the European Union pays a subsidy of 25 to Airbus, the profit of Airbus will be positive even in the case of simultaneous production with Boeing = 20 = -5 + 25.

➤As a consequence, Boeing would make the loss of -5. ➤Consequently, it would be more profitable for Boeing to shut down the

production.


Airbus

Boeing


Production

-5+25

-5

0

100

No Production

100+25

0

0

0

➤However, when Boeing shuts down production, Airbus can achieve the monopoly profit of 100 plus the subsidy of 25.

=> Paying a subsidy is therefore profitable for the EU: it spends 25 and helps the EU economy to acquire a profit of 100 - at the expense of foreigners.

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➤ Against this result of Brander and Spencer (1985) at least one important argument can be put forward:

■ It is based on the assumption that the US will stand idly by, if the EU pushs Boing out of the market by means of subsidies.

➤ It is questionable, if this assumption is very realistic.

➤ If the assumption does not apply, a net loss may result for the EU as well.

➤ This is revealed by the following graphs:


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➤ If the US government decides to "save Boing for strategic reasons", and pays a subsidy of 25 to Boing, Boing will make a profit even if Airbus enters the market.

➤ In this case, both Boing and Airbus would make a profit of 20, but taxpayers in both countries would have to pay 25.


Airbus

Boeing


Production

-5+25

-5+25

0

100+25

No Production

100+25

0

0

0

➤A net value of 5 would thus be destroyed in both countries.

➤The result would be an inefficient "subsidization race".

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➤However:

■ Reality has proven that another scenario is possible:■ Even though Airbus received subsidies in the beginning, now both

companies, Airbus and Boing, have remained in the market and make profits even without a (net) payment of government subsidies!


Airbus

Boeing


Production

10

10

0

100

No Production100

0

0

0

➤Reality can be different than all theoretical considerations!

➤But it is not possible to know in advance, what the result of such kind of industrial policy will be.

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➤ This example thus shows that the strategic trade policy can also fail, because of the necessary information requirements.

➤ In reality, however, the information requirements go beyond the industry in question:

■ As Airbus needs production factors to start its production, the prices of these production factors may increase.

■ This increases the costs for other industries, which will make them less competitive on their world market.

■ For example, the production of Airbus is increasing the demand for engineers and skilled workers, such that other industries where the EU has a comparative advantage (e.rg. Automobile Industry, Mechanical Engineering or Electrical Engineering) have higher labor costs.


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1.3.2.2. Import Substitution Policy

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- 202 -

1. International Trade1.3.2.2. Import Substitution Policy

Import

Substitution Policy

Export-oriented

Industrialization

World Eco-nomic Crisis

90s

Latin America

Asia

Africa

Japan

End of 2nd World War

South CoreaTaiwan

80s

SingaporeMalaysia

ThailandAsia

Latin AmericaAfrica

Eastern Europe

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➤ In the time period starting with the global economic crisis in the year 1929 to the 70s, most developing countries practiced a trade regime called "import substitution policy" ("IS-policy").

➤ The target of this policy is to build up a domestic industry which is able to produce imported goods from developed countries - i.e. to substitute imports by local production.

➤ The theoretical justification of the IS-policy is:■ Most industries for technologically superior goods are determined

by strong economies of scale.■ As a result of import competition from developed countries, these

industries cannot reach a competitive size in the developing countries.

■ Therefore developing countries should protect their industries from import competition until they have reached a competitive size.

■ The argument is similar to that of "strategic trading policy".

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➤ This theoretical justification of the IS-policy reaches back to the German economist Friedrich List, who in his 1841 book "The National System of Political Economy" had propagated the IS-policy as a "policy of educational tariff".

➤ However, from a historical point of view the IS-policy was notintroduced for theoretical considerations but because of practical necessity:■ World trade collapsed after the World Economic Crisis until the end

of the Second World War, mainly because of the import restrictions introduced by the United States (Smoot Hawley Act: 60% peaks) and Europe (restrictions on foreign exchange) to support domestic production by the domestic demand.

■ As a result, many developing countries did not have the opportunity to earn foreign exchange to buy imported goods by their exports.

■ Therefore they started to substitute formerly imported goods by domestic production.

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➤ The first countries that introduced this policy were Latin American countries, which had previously sold agricultural products and raw materials mainly to the USA and financed imports of industrial goods (machines, consumer goods) with the proceeds.

➤ As a result, well-organized stakeholders of employers' and workers' associations in the IS industries emerged in Latin America, which continued to pursue this kind of policy after the Second World War, when the US and Europe opened up again for international trade.

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➤ Large Asian countries like India and Pakistan copied the IS-policyafter their independence in the year 1947.

➤ India was particularly successful in pushing back imports. Its non-oil imports amounted to only 3% of its GDP in the early 1970s.

➤ In IS-countries, effective import tariffs (= import tariffs plus quantitative trade restriction converted to import tariffs) reached very high average values:

Effective import tariffs for industrial goods

Mexico (1960) 26 %

Philippines (1965) 61 %

Brazil (1966) 113 %

Chile (1961) 182 %

Pakistan (1963) 271 %Source: Balassa (1971), The structure of protection in developing countries

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➤ The results of the IS-policy were not really convincing:1. Too small local industries, unable to take advantage of their

economies of scale due to the limitation of their domestic markets. As a result, their productivity was much lower than that of the industries in developed countries.

2. High prices and low quality of goods of domestic IS-industries, because of oligopolistic or monopolistic market structures due to a lack of world market competition.

3. Most surprisingly, countries with IS policies did not develop an export sector . The "Learner Symmetry Theorem" provides an explanation for this. It says:

◆ In the presence of import tariffs, the strong labor demand of the import substitution industries push wages and prices for other immobile production factors upwards.

◆ This increases the production costs for the export industries such that they can not take advantage of their comparative advantages.

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X

The Impact of Import Tariffs on the Export Sector

PExport Sector

D(P)

S(P)

X

PImport Sector

D(P)

S(P)

PWorld market

Export

Import

Starting point: Specialization of the country under free trade.

XConsumptionFree trade

XProduction

Free trade

PWorld market

XProductionFree trade


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X


D(P)

S(P)

XD(P)

S(P)

PWorld market

Export

Import


XProduction

Free trade

PWorld market

Prohibitive Import tariff

XProductionFree trade

XConsumption

Free trade

If an import tariff is implemented, domestic production in the import sector will grow. If the tariff is high enough, the imports shrink to zero because domestic consumption decreases and the domestic production increases due to the higher domestic price.

PExport Sector PImport Sector

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X


D(P)

S1(P)

XD(P)

S(P)

PWorld market

Export


XProduction

Free trade

PWorld market

Prohibitive import tariff

XImports tariff

The increase in domestic production increases the demand for domestic production factors. As a result, the prices of immobile domestic production factors, such as labor, real estate, etc., are beginning to rise..

This increases the production costs of the export industries!

This means that the supply of the export industry is shrinking such that exports are shrinking! Import tariffs are thus crowding out domestic exports!

S2(P)


Increase of production => Increase of demand for domestic workers

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X


D(P)

S1(P)

XD(P)

S(P)

PWorld market

Export


XProduction

Free trade

PWorld market

Prohibitive import tariff

XImports tariff

S2(P)

XProduction

Imports tariff


The increase in domestic production increases the demand for domestic production factors. As a result, the prices of immobile domestic production factors, such as labor, real estate, etc., are beginning to rise..

This increases the production costs of the export industries!

This means that the supply of the export industry is shrinking such that exports are shrinking! Import tariffs are thus crowding out domestic exports!

Increase of production => Increase of demand for domestic workers

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➤ Due to the lack of an export sector, many IS-countries had difficulties to earn foreign exchange to finance their energy imports, when energy prices rose in the 1970s caused by the oil price shocks.

➤ This drove many IS-countries into a "debt trap"::■ In order to pay their oil imports, these countries had to borrow on

international capital markets.■ As creditors of developing countries do not normally want to accept

the risk of exchange rate shocks, developing countries have to sell loans denominated in US-dollar.

■ When the dollar appreciated against most other currencies at the beginning of the 1980s, indebted developing countries had to pay much more domestic currency to repay their debts ("original sin effect"). Suddenly, they were overindebted:

[ D$ / (e$€ ↓) ] ↑ = D€ ↑

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➤ From the debt crisis of the 1980s, many IS counties drew consequences and changed their trade regime.

➤ To increase their foreign exchange revenues, they followed the example of the Asian "Tiger States" and switched to the strategy of "export-oriented industrialization".

➤ Example for the reduction of the import restrictions by two former IS-countries:

➤ Overall, this policy swing deepened the trade integration of most developing countries after the end of the 1980s and led to what is now called "globalization".


Effective Import Tariffs für Industrial Goods

End of 80s End of 90s

Brazil 77 % 19 %India 126 % 40 %

Source: Abreu (2004); Rodrik & Subramian (2002)

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1.3.2.3. Export-oriented Industrialization

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1. International Trade1.3.2.3. Export-oriented Industrialization

➤ South Korea was one of the first countries to implement in the 1960s reforms that led to the transition from an import substitution regime to a trade policy called "export-oriented industrialization" ("EOI-policy").

➤ The policy was very successful: from the year 1963 to the year 2003 its per capita income grew by factor 10.■ Relatively soon, Hong Kong, Taiwan and Singapore followed the

South Korea. They were called the "Four Tigers".■ In the 1970s and 1980s, Malaysia, Thailand and Indonesia and

finally China followed.➤ All these countries achieved high real GDP growth rates, which

went along with high export and import shares in GDP.➤ Whether this growth success was mainly caused by free trade is,

however, disputed.➤ The success of these countries, however, is seen by many as

evidence that a successful development of a country is possiblewithout IS-policy.

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Percent of the year 1970

Per Capita GDP (based on constant prices of the Year 1990; Index: 1970 =100)

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Percent of GDP

Development of the Investment Share in GDP (based on current prices in national currency)

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1. International Trade1.3.2.3. Export-oriented Industrialization

➤ The theoretical justification of the EOI policy is, in principle, based on the same arguments as the free trade doctrine.

➤ The literature is, however, controversial concerning the question to what extent active industrial subsidies were involved in the success of the EOI-countries.

➤ Recent work also attributes a large part of the growth success of these countries to a stable legal system, high savings rates and the government-led expansion of the education system.

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1.3.2.4. Globalization Critique © R

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1. International Trade1.3.2.4. Globalization Critique

➤ The anti-globalization movement became noticed by a larger public for the first time at the 1999 WTO conference in Seattle.

➤ The critique of international trade concerns mainly the following points:

1. Wages: Workers in the developing countries receive much lower wages for the same work than workers in developed countries. This is caused by multinational firms, which exploit the immobility of workers in developing countries.

2. Environment: In a similar way, lower environmental protection standards in the developing countries are exploited.

3. Culturs: Globalization leads to a destruction of regional cultures by a uniform commercial culture.

4. Sovereignty: Globalization undermines the political sovereignty of countries.

➤ The following counter-arguments are discussed:

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1. Wages: How does international trade affect the wage level?■ To measure the impact of international trade on wages, one has to

compare wages under a regime of free international trade with wages without free trade.

■ A comparison of the wages between developing countries and developed countries under free trade does not reveal the impact of free trade of wages.

■ In case of free trade, developing countries primarily export goods, whose production depends on production factors that are relatively abundant in developing countries (Heckscher/Ohlin Theorem). Additonal exports, caused by free trade, increase therefore the demand for low-skilled workers such that their wages rise compared to the situation under autarky. For the same reason, the wages of the higher qualified workers in the developing country falls (Stolper/Samuelson Theorem).

■ In developed countries, the opposite is the case: wages for low-skilled workers are declining and wages for high-skilled workers are rising.

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1. Wages: How does international trade affect the wage level?■ Thus, even so the wages of low-skilled workers in developing

countries are lower than the wages of low-skilled workers in developed countries, the difference between the wage levels of low-skilled workers in developing and developed countries would be even higher without free international trade.

◆ As a consequence low-skilled workers (i.e. the majority of all workers in the developing countries) are "winners" of free trade.

◆ Only the difference between the wage levels of high-skilled workers in developing countries and developed countries would be smaller without free trade.

◆ Only the high-skilled workers (i.e. the minority of all workers in the developing countries) are therefore "loser" of the free trade.


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Effect of Free Trade on Wage Levels in the Export & Import Sector


Export Sector

X

P

D(P)

S(P)

Import Sector

X

P

D(P)

S(P)

Labor Market Export Sector

L

w

L

w

LAutarky

Labor Market Import Sector

LD(P, XAutarky)

LS(P)

LAutarky

wAutarky

wAutarky

XAutarkyXAutarky

LD(P, XAutarky)

PAutarky

PAutarky

High supply => low autarky

price

Low supply => high autarky

price

High supply => low autarky

wage

Low supply => high autarky

wage

LS(P)

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Effect of Free Trade on Wage Levels in the Export & Import Sector


Export Sector

X

PFree trade

P

S(P)

Import Sector

X

P


Consumption XFree trade

ProductionXFree tradeConsumption

ExportFree trade

ImportFree trade

Labor Market Export Sector

L

wLS(P)

L

w

LAutarky

Labor Market Import Sector

LD(P, XAutarky)

LS(P)

LAutarky

LD(P, XAutarky)

S(P)

LD(P, XFree trade)

LFree trade

wAutarky

wAutarky

LD(P, XFree trade)

wFree trade wFree trade

=> Import sector wages fall because of free trade

=> Export sector wages grow

because of free trade

D(P) D(P)

PFree trade

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1. Wages: How does international trade affect the wage level?

■ Associations engaged in development policy often demand the implementation of minimum wages in developing countries (see newspaper clipping below).

■ Given the above theoretical background, what consequences would the implementation of minimum wages in developing countries have? Here, two cases have to be distinguished:

1. Normal labor supply curves

2. „Pathological“ labor supply curves

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Why are the Jeans from Lidl & Co. that cheap ? (1)

(...) Discounter like Lidl and Kik buy their textile assortments mainly fromproduction facilities in Bangladesh - and do not care much about the workingconditions there. As an investigation shows, they are massively violatinginternational social standards.

In Germany, trousers made in Bangladesh are sold at dumping prices KikandLidl. Lidle sells a ladies jeans currently at 9.99 Euros; Lidl sells ajeans for childrenfor 5.99 Euros. Boy's leisure pants are sold for 2.99 Euros.

"Since discounters want to offer their goods here in Germany at absolute lowprices, they exert enormous pressure on the manufacturers. And this means thatthe workers in the production countries must work under precarious conditions",says Gisela Burckhardt from the „Campaign for Clean Cloath" (CCC).

Together with partners in Bangladesh, CCC has investigated the workingconditions of six factories belonging to the suppliers of Lidl and Kik.Almost 140workers were interviewed concerning their working conditions and wages for thestudy. (...) "The survey identifies massive violations of internationallyacknowledged social standards", reports the study. For example, with exception ofsix workers only, none of the employees had a labor contract, the working timegenerally amounted to 9 and 14 hours, the six-day-working week was onlyrespected by two factories.

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Why are the Jeans from Lidl & Co. that cheap ? (2)

Overtime is obligatory, but is paid only irregularly - if it is at all paid.

Only 7 respondents received a wage between 35 Euros and 55 Euros, and over 90per cent of all workers earned between 14.30 and 29.70 Euros per month.

Additionally: Social standards in case of disease are completely missing. Workerthat fall sick must take unpaid leave. "After the birth of a child, work ers areallowed to work again in the same factory, but their previous employment isnotaccounted for. They are classified as newcomers with the corresponding lowerwage level.“ the study reports. A workers' council or trade unions, which demandmore rights, are not allowd by the factory owners. (…)

According to the market research company GfK, the share of discounters in totaltextile turnover of Germany has now reached a level of almost 25 percent. Aboveall pure textile discounter like Kik are growing the fastest. (…)

(Source: Newspaper clipping from Spiegel Online of November, 21, 2008)

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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

Labor market of export sector

L

wLS(P)

LMin.Wage

LD(P, XFree trade)

LFree trade

wFree trade

D(P)

Minimum Wage

Case 1: Given normal labor supply curves, a minimum wage causes decline in labor demand and an increase in the labor supply and thus unemployment.

(see my Lecture Macroeconomics, Section 5.1.3.4.)

Unemployment

How does a minimum wage affects trade & labor market?

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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

L

wLS(P)

LMin.WageLFree trade

wFree trade

D(P)

Case 1: The total sum of salaries can rise or fall depending on the wage elasticity of the labor demand curve. The higher the wage elasticity, the greater the probability of a fall in the wage sum.

In this graph, the sum of salaries falls, because the green rectangle is smaller than the red rectangle (= what the workers who gest unemployed lose).

In any case, however, some of the former employees will lose their jobs and thus their complete income..

Unemployment

+

- LD(P, XFree trade)



Minimum Wage

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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

L

wLS(P)


wFree trade

D(P)

Case 1: Caused by the increase in labor costs per working hour, the production costs of the export industry are rising such that the minimum wage also causes a reduction in the supply of the export good.

The possibilities of the country to join the international division of labor according to its comparative advantage are therefore reduced by a minimum wage.Unemployment

+

-

S(P, ML)

LD(P, XFree trade)



Minimum Wage

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Export sector

X

PFree trade

P

S(P)


Consumption

ExportMinimum Wage

L

wLS(P)


wFree trade

D(P)

Arbeitslosigkeit

+

-

S(P, ML)

LD(P, XFree trade)



Minimum Wage

Case 1: Caused by the increase in labor costs per working hour, the production costs of the export industry are rising such that the minimum wage also causes a reduction in the supply of the export good.

The possibilities of the country to join the international division of labor according to its comparative advantage are therefore reduced by a minimum wage.

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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

L

wLS(P)


D(P)

Case 2: In the case of a "pathological" labor supply curve, a minimum wage does not necessarily cause unemployment.

A "pathological" labor supply curve results when a "working poor effect” exists:

From a certain wage level (wcritical) the income of households is that low that they do no longer substitute consumption by leisure time, but instead offer more work in order to maintain a consumption level indispensable for survival.

LD(P, XFree trade)

LS(P)wkritisch



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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

L

wLS(P)


D(P)

Case 2: Therefore, the labor supply curve starts to offer more work, when wages decrease!

Therefore, there is a second intersection point with the demand curve. The result is a market with two equilibrium points!

(For a further explanation seeappendix slides 272-278)

LD(P, XFree trade)

LS(P)wkritisch

Multiple equilibria



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Export sector

X

PFree trade

P

S(P)


Consumption

ExportFree trade

L

wLS(P)


wFree trade

D(P)

Case 2: If, in the initial situation. the wage is equal to the equilibrium with the lower wage level, a minimum wage will cause labor supply to fall more stronger than labor demand.

This causes excess demand for labor, which then causes an increase of the wage level above the minimum wage level, until the equilibrium with the higher wage level is reached.

In this labor market equilibrium, the wage level is higher as beforeand no unemployment results!

LD(P, XFree trade)

LS(P)wMindestWage

Excess demand



Minimum Wage

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- 237 -Prof. Dr. Rainer MaurerL

wLS(P)


wFree trade

Case 2: However, as companies now have to pay a higher wage for less labor input, the average labor costs are rising.

As a result, production costs are likely to rise also and there will be a decline of the exports.

LD(P, XFree trade)

LS(P)

wMindestWage

X

S(P)


Consumption

ExportMindestWage

D(P)

S(P, ML)



Minimum Wage

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1. Wages: How does international trade affect the wage level?

■ From an empirical point of view, there is some evidence that developing countries typically start with a low wage standard, when they open for free international trade, but then experience an above-average growth in real wages over the course of time. The result is a catch-up process.

■ This is revealed by the following graphs, which are described in more detail in my blog „Volxwirtschaft“ under the following link:

■ http://volxwirtschaft.blog.de/2011/10/25/unternehmensinvestitionen-billigWagelaendern-grund-fuchsteufelswild-12067461

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Example: Southeast Asian „Tiger States“:

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Example: East European „Transformation Countries“:

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Digression: Globalization Critique – Prohibition of child labor? (1)As the following Spiegel-Online documentation shows: Child labor is worldwide objected as unacceptable exploitation. But in Bolivia, one of the poorest countries in South America, child workers fight for their right to work.

How to assess a ban on child labor?

A "generally binding" assessment is hardly possible, because the evaluation depends on normative and empirical value judgements:

Normative Evaluation : What is the „correct“ ethics?

The German sociologist Max Weber (1919) has derived the following classification of ethics :

o Ethics of Conviction (Gesinnungsethik): When judging an action, only the attitude underlying the action is decisive.

o Ethics of Responsibility (Verantwortungsethik): When judging an action, only the result of the action, for which an agent is responsible, is decisive...

Max Weber (1919), Politik als Beruf, in: Gesammelte Pol. Schriften, Hrsg. Winckelmann, 5. Auflage Mohr Siebeck 1988, S.551-552.

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Digression: Globalization Critique – Prohibition of child labor? (3) (2)

Gesinnungsethiken Verantwortungsethiken

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Digression: Globalization Critique – Prohibition of child labor? (4)


Application of these different ethics to the problem of child labor:

o Ethics of Conviction : Children must not work under any circumstances, because child labor can endanger the health of children. Instead of working, children should play or learn as it corresponds to their state of development.

o Ethics of Responsibility : Decisive are the consequences of a prohibition of child labor: child labor shall be prohibited only, if the prohibition does not worsen the actual welfare of children.

/ => Conclusion:

o Anyone who decides for a pure ethic of conviction, will in any case object child labor!

o Anyone who decides for an ethics of responsibility must first analyze the consequences of a prohibition of child labor! This can be cumbersome and requires empirical assessments as the following shows:

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- 248 -- 248 -

What are the consequences of a ban on child labor? Results of empirical research indicate the following:

(1) The most important reason for child labor is the poverty of parents.

With growing per capita income, child labor typically declines. Children are not sent to work by their parents with the intention to exploit them, but because they have not enough income to feed them:

• In China, the child labor rate decreased from 48% in 1950 to 12% in 1995 (Basu(2004)) with increasing per capita income of the population.

• In countries with a stagnating economy such as Cambodia, child labor decreased only from 29% to 25% in the same period (Basu (2004)).

• The same is true for Vietnam and India. In Vietnam, child labor declined sharply in the 1990s as the country opened up to international trade and the price of rice (which determines the income of the majority country's population) began to rise (Edmonds and Pavcnik (2002)).

/ => Conclusion: These families obviously need the income of their children to survive. The prohibition of child labor would therefore worsen the income situation of these families and their children.

Basu (2004), Kaushik Basu, Die Ökonomie der Kinderarbeit, Spektrum der Wissenschaft, Nr. 1. 2004, S. 70-76.

Edmonds und Pavcnik (2002), E. Edmonds, N. Pavcnik, Does Globalization Increase Child Labor? Evidence from Vietnam, NBER Working Paper No. 8760; URL: www.nber.org/papers/w8760.

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- 249 -- 249 -

What are the consequences of a ban on child labor? Results of empirical research indicate the following:

(2): A ban on child labor can not be enforced effectively in practice and typically leads to a decline in the wages of children:

• In Great Britain, a couple of laws were adopted in the first half of the nineteenth century, in order to penalize companies, which employ children. As a result, employers had to bear additional costs, which they tried to compensate by lower wages for the children ("risk premium"). Consequently, children had to work even longer in order to receive the same income as before (Basu (2004)).

• In the 1990s, opponents of child labor organized a global trade boycott against hand-knotted carpets from Nepal. Many Nepali carpet manufacturers reacted by releasing all child workers. As a result, some 6000 girls who had previously worked in the carpet industry were forced into prostitution (Basu (2004)).

• Following a ban on child labor in India through the Child Labor Act of 1986, the employment of children younger than the legal age of 14 years in relation to children of legal age increased by 12%. This increase was caused by a "working-poor-effect" triggered by the decline in wages of children of 4% compared to the wages of adults (Bharadwaj et al. (2013)).

Bharadwaj et al. (2013), P. Bharadwaj, L. Lakdawala, N. Li, Perverse Consequences of Well Intentioned Regulation: Evidence from India’s Child Labor Ban, NBER Working Paper 19602. URL: http://www.nber.org/papers/w19602.

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- 250 -- 250 -

(b) However, in case of an effective enforcement of a ban on child labor, the welfare of children would probably fall even more. In this case, the children would completley lose their income. The fact that the children offer more work despite lower wages shows, that they are in urgently need of this income (working-poor-effect).

(c) Bharadwaj et al. (2013) arrive at the following conclusion: „ Not only is the ban ineffective in the short run (by not increasing household welfare and by not decreasing child labor), it can have perverse long run consequences by affecting human capital investments, asset accumulation and perhaps also affecting fertility. Future research on child labor bans could focus on some of these long run effects. There are many options available to policy makers who wish to reduce the incidence of child labor (like cash transfers, increasing investments in and returns to education, etc).”However, in many developing countries government lack the money to do this. What else then can be done?

/ => Conclusions:

(a) A simple ban on child labor often leads to a deterioration in children's living conditions: they must work more for a lower wage.

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- 251 -- 251 -

Political reactions towards the demands of children's associations in Bolivia:

In July 2014 the Bolivian parliament approved a new law. According to this law, the official minimum age for regular work remains an age of 14 years, as determined by the International Labor Organization (ILO (1973, Article 2.4)). However, exceptions can now be granted for employees over 12 years of age. Children who work on their own account, for example in the street trade, are allowed to do so already from an age of 10 years.

The public response to the new law had been quite diverse:

• One of the "union leaders" of the organized children from La Paz, the 15-year-old Rodrigo Medrano, is quoted by tagesschau.de (2014) with the following statement "If the law is implemented as we imagine it, the children are protected. They can not be forced to work, they can do it voluntarily, and even their own parents can not force them to work.“

• On the other hand, in a press release of the CDU/CSU parliamentary group of the German Bundestag the following statement is made "We reject the decision of the Parliament of Bolivia to legalize child labor from ten years onwards.“ (...) "Child labor must not be recognized by policy as a systematic solution to existing poverty, not even by way of transition. Child labor can lead to physical and psychological damage that can not be remedied."

tagesschau.de (2014), Neues Gesetz in Bolivien Kinderarbeit - ganz legal, URL: http://www.tagesschau.de/ausland/bolivien-kinderarbeit-102.html, Abrufdatum: 10.11.2014.CDU/CSU (2014), Boliviens Entscheidung für Kinderarbeit ist falsch, URL: www.cducsu.de/presse/pressemitteilungen/boliviens-entscheidung-fuer-kinderarbeit-ist-falsch, Abrufdatum: 08.07.2014.

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2. Environment: How does international trade affect the environment?■ In most developing countries, the environment is a relatively abun-

dant production factor, which on one hand caused by its natural availability but on the other hand also caused by a lack of environmental protection legislation.

■ Due to this abundant supply, a transition to free trade causes typically an increased usage of environmental production factors (air and water for intake of pollutants, forests for timber or agricultural production).

■ If environmental protection laws, which charge polluters for the costs of environmental damage, are missing, the usage of the environment as production factor is inefficient. Since free trade increases the incentives for production, these inefficiencies a likely to grow further in transition to free trade.

■ Here one again the question arises weather a "causal therapy" or a "symptom therapy" should be applied: Should the free trade be restricted or the environmental protection laws be improved? It can be argued that developing countries have the right to make more use of their relatively abundant environmental production factors in order to generate higher incomes. Many developed countries have done so in their history. - 252 -Prof. Dr. Rainer Maure

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Digression: Recycling or environmental protection?

Recycling of disused ocean liners is not profitable under the environmental protection laws of Europe. Most of these ships are therefore scrapped in developing countries (India, Bangladesh, Ivory Coast). In Alang on the West coast of India lies beach of about 6 km length, on which such ships are wrecked. The chemicals released during the scrapping flow untreated into the sea or poison the beach. The working conditions are very poor as measured by European standards. In the year 1998, Greenpeace and anti-globalization


groups launched a wrecking facilities. Thisunpopular not only companies, but also local population. Despite poor working conditions, have an above-average

campaign against Alang's campaign was, however, very among the Indian scrapping among their workers and the the local pollution and the the workers on Alang's shipyard income as measured by

Indian conditions. Furthermore, a lot of other companies in the region rely on the supply of cheap scrap from the beach of Alang.

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3. Culture: How does international trade affect culture?

From a historical point of view, free trade has always caused more homogenous cultural spaces.■ In this way, not only production technologies spread but also art

styles and religious ideas became more similar.■ The interpenetration of cultures through trade may have the

disadvantage of a loss of cultural diversity.■ However, if people voluntarily decide to adopt new production

technologies, art styles, religious ideas from other cultures, one can also ask whether it would be justified to limit this individual freedom by trade restrictions.

■ The impact of globalization on culture is also not one-sided: In Germany there are not only McDonald and Burger King, but also sushi and doner restaurants. And, as is well known, not only are Asian martial arts movies popular in Germany but also Derrik-thriller in Japan and so on....


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Digression: Loss of Cutural Diversity in the Neolithic Age?

Corded Ware cultureThe “corded ware culture” is the oldest neolithic culture in Central Europe and originated from the neolithic migration movements: About 7000 BC ago, farming cultures in the region of Greece and the Balkan existed, which started to spread westward around 5500 BC, along the Danube River towards Central Europe. About 4500 BC, they reached the Rhine valley, the Netherlands, the North German Plains and Poland. The pre-existing cultures of hunters-gatherers dissolved. At the end of the expansion of the corded ware culture, the old hunter-gatherer cultures were crowded out to the Atlantic coast of Europe, the British Isles and Scandinavia. As it seems, culture is not static but in a state of constant change.

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4. National sovereignty: How does international trade affect the sovereignty of a country?■ When a country has signed treaties with the World Trade

Organization (WTO), the International Monetary Fund (IMF) or the World Bank, these institutions can review the economic policies of the country on the basis of the treaties. To this extent, there is a loss of sovereignty. However any country can, cancel the contracts and leave these institutions. In this sense there is no loss of sovereignty.

■ However, as we will see in a more detailed way in chapter 2, the international mobility of capital, which goes hand in hand with free trade, puts a limitation on the possibilities to tax capital: In the presence of capital mobility, the owners of the production factor capital have the privilege to select the country with the lowest capital taxes.◆ Since the beginning of the 1980s this has led to a trend-wise

decline in capital taxation at the expense of the less mobile production factors – especially labor.


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1.3.1. Instruments of Trade Policy1.3.2. Trade Policy Doctrines




1.3.2.4. Globalization Critique

1.3.3. The Development of the World Trade Organization

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1. International Trade1.3.3. The Development of the World Trade Organizati on

➤ Without a contractual solution, there is the risk that the decision about the trade regime between two countries will result in the uncooperative solution of a prison dilemma.

➤ The decision matrix describes in an idealized form the logic of the situation: when both countries are practicing free trade, both can

Country A

Country BFree trade Protectionism

Free trade

10

10

20

-10

Protectionism

-10

20

-5

-5

profit from the gains of trade. However, if country A decides for protectionism and country B stays with free trade, the advantage for country A will grow above that under free trade. One reason for this could be revenues from an "optimal tariff" (s. section 1.3.2.1.).

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or – from a government's perspective - financial support for election campaign by the lobby of a protected industry. Since this incentive structure applies to both countries, the decision for free trade is not stable: both countries have an incentive to opt for protectionism. In this case, the trade gains from trade get lost, so that both countries

Country A

Country BFree trade Protectionism

Free trade

10

10

20

-10

Protectionism

-10

20

-5

-5

receive only very low returns. In order to overcome this dilemma, a contract conclusion could be established, which stabilizes the free trade solution legally. The WTO in the international institution that controls compliance of such treaties. ©

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Since the WTO can penalize countries that deviate from their free trade obligation , it can reduce the payments that countries achieve by protectionist behavior (see below, "WTO Court"). If the reduction is strong enough, in the below strategy matrix a penalty of 12 in case of protectionism, the choice for "free trade" becomes a stable equilibrium.

Country A

Country B

Free trade Protectionism

Free trade

10

10

8=20-12

-10+12

Protectionism

-10+12

8=20-12

-5

-5

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1.3.3. The Development of the World Trade Organizati on

➤ The predecessor of the WTO, the "GATT", was founded in 1947.➤ The reason for this was the steady decline in world trade between

1930 and 1945 (see next chart).➤ The decline was thus not only caused by World War II, but also by

the foreclosure of domestic markets, which was implemented in the 1930s by many countries.■ The Smoot-Hawley Act, for example, became law in the US in the

year 1930. It raised the import tariffs of the USA to an average of 59%.

■ In Germany and other European countries there have been similar developments, based on government foreign exchange controls.

➤ Initially, the victorious states intended the foundation of the so called "International Trade Organization" similar as the IMF or the World Bank. However, this was delayed for political reasons. Therefore 23 states temporarily agreed on the "General Agreement on Trade and Tariffs" (GATT), which then remained in force for 41 years.


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Development of per capita GDP and export share of the early industrialized countries*) from 1820 to 1990

*) Average values up to 1870: Austria, Belgium, Denmar k, France, Germany, Italy, UK, USA; starting with 1871 addionally included: Australia, Canada, Finland, Netherlands, Norway,

Sweden. Source: Maddison (1992) Dynamic Forces in C apitalist Development.

Per capita GDP in PPP US-$ of 1985

Industrial exports in % of GDP

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Mitgliedsländer der WTO 2012

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➤ Over the years, GATT gained more and more members and was then transformed into the World Trade Organization (WTO) in the "Uruguay Round" of year 1986, which took over the seat of the GATT in Geneva and the GATT rules.

➤ These rules define a mechanism that can be described as a combination of the ratchet and lever:

■ The principle of "bound tariffs" acts as a ratchet: If a tariff is established by a WTO contract, a country is not allowed to increase this tariff evermore. Quantitative import quotas are in general fixed, but may be temporarily increased. Export subsidies are generally prohibited, with the exception of agricultural subsidies.

■ Permanent trading rounds, which try to reduce trade barriers, serve as lever.

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The "ratchet mechanism" and the "lever" lead to a permanent reduction of trade restrictions in the long-run.

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Percent

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81 F A I L E D

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➤ Eight "trading rounds" have been organized so far. The durationof a trading round has grown from 7 months to more than 6 years, which is also due to the fact that instead of 23 countries in the beginning, now 141 countries are involved.

➤ The first 5 trading rounds were almost pure "tariff reduction rounds". In the following rounds more difficult complex issues were tackled such as dumping, non-tariff trade barriers or property rights.

➤ The Uruguay Round (1986-1994) can be split up in two parts:1. Trade reform: Reduction of average import tariffs from 6.3% to

3.9%, a 36% reduction in agricultural subsidies, the conversion of agricultural import quotas into equivalent import tariffs, and the abolition of the multi-fiber arrangement on import of textiles over a period of 10 years. The latter resulted in a large increase in textile imports from China and other Asian countries in many industrialized countries in the noughties.


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➤ The Uruguay Round (1986-1994) can be split up in two parts:

2. Organizational reform: ◆ Transition from GATT to WTO; ◆ Extending the purview of the WTO from trade in goods to trade

in services (finance, insurance, consulting, transport) and fixing the status quo in the so called "GATS " (General Agreement on Trade in Services);

◆ Extending the purview to trade with in property rights cand the establishment of the status quo in the so called "TRIPS" (Agreement on Trade-Related Aspects of Intellectual Property Rights).

◆ Establishment of the "Dispute Settlement Mechanism": Invoking a "WTO Court" (= expert panel) by one of conflicting parties. Decision within one year. Principle: In case of a violation of WTO rules, the disadvantaged party is entitled to retaliation.


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Digression: The WTO Dispute Settlement Mechanism in Practice

In March of the year 2002, the US government imposed a 30% import tariff on all steel products. The official justification was "the need to adapt the US industry at the competition pressure resulting from new imports". Political background was however the critical importance of the certain US states, where the US steel industry is concentrated (West Virginia, Ohio, Pennsylvania) for the 2004 US presidential election.

The steel exporters EU, Japan, China and South Korea immediately called for the WTO settlement dispute mechanism. In July 2003, the WTO court decided that the increase in US import duties was a breach of WTO rules. Therefore the EU was entitled to impose a penalty of $ 2 billion on US exports.

However, it did not come to a trade war between Europe and the USA, as expected by some observers. The US actually lifted the import tariffs again in December 2003. The EU had recognized the political backdrop of the US steel tariffs and concentrated its penalties on products imported to Europe from the three mentioned US steel states.

In a similar process in March 2005 the WTO decided in favor of Brazil that US subsidies for cotton producers were a breach of WTO rules. As a consequence, the USA lifted the export subsidies for cotton, but maintained production and credit subsidies for cotton.

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➤ The Doha-Round (2001 – † 2004):■ The main objective of the Doha round was trade facilitation for:

◆ Agricultural and industrial goods,

◆ Services (GATS)

◆ Intellectual property rights (TRIPS):

■ The Doha round failed in 2004 on the demand of developing countries to reduce agricultural subsidies in developed countries, which were parried by developed countries with the demand for a reduction of industrial goods tariffs of the developing countries.

■ A compromise proposal was drafted at a subsequent ministerial conference in Hong Kong in the year 2005: Agricultural export subsidies should be completely abolished in the industrialized countries by the year 2013.

■ However, no agreement could be reached at the other negotiating points. Therefore, no agreement was filed ("single undertaking principle").


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➤ The Doha-Round (2001 – † 2004):■ There are still efforts at ministerial conferences to revive the Doha

Round and reach a final conclusion.

■ Since the Ministerial Conference in Geneva in 2008, the dispute about the so called "Special Safeguard Mechanism" has been treated with special effort. The "Special Safeguard Mechanism" would allow poor farmers in developing countries to be protected in the short-run by import tariffs against price slumps.

■ The basic conflict: The USA in particular is calling for a significantly improved access to agricultural and industrial goods markets in Brazil, China and India. These countries, however, are not willing to make further concessions without additional concessions of the US.

■ This blockade has put the WTO in a crisis.

■ This has led to a world-wide trend towards regional free trade agreements on a bilateral base, where the WTO is bypassed.


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Stability properties of a market equilibrium with n ormal and "pathological" supply curves

Appendix: Stability properties of market equilibria

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Stability properties of a market equilibrium with normal and "pathological" supply curves

O

P

X

S(P)

D(P)

If a price rises randomly over the market equilibrium

price, a excess supply results. In

the case of excess supply, there are suppliers who are

willing to supply the demanded quantity

at a lower price.

P*

X*

Excess Supply

That is why providers are competing with each other, so that the price moves back towards the market

equilibrium price.

XD XS

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O

P

X

S(P)

D(P)

If the price falls randomly below the market equilibrium

price, excess demand results. If there is a excess demand, there

consumer which are willing to buy

the supplied quantity at a higher

price.

P*

X*

Excess Demand

For this reason, the buyers overbid each other, so the price moves back in the direction of market equilibrium price.

XS XD

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O

P

X

S(P)

D(P)

Under these assumptions, a

market equilibrium is thus stable:

There are "market forces" which

cause a return to the market

equilibrium in case of stochastic

deviations from the market equilibrium

price!

P*

X*

Excess Demand

Excess Supply

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O

P

X

D(P)

However, if the supply curve has a

negative slope (="pathological

case"), the same market forces have

a destabilizing effect.!

P*

X*

S(P)

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O

P

X

D(P)

If the price rises randomly over the market equilibrium price, there is now excess demand. In the case of excess demand, there are buyers who would

buy the offered quantity at an even

higher price.

P*

X*

Excess Demand

XDXS

S(P)

For this reason, the buyers overbid each other, so that the price moves more and

more away from the market equilibrium price.

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O

P

X

D(P)

If the price happens to fall randomly

below the market equilibrium price,

excess supply results. In case of

excess supply, there are suppliers who would sell the demanded quantity

at even lower prices.

P*

X*

Excess Supply

XD XS

S(P)

For this reason, the buyers underprice each other, so that the price moves

more and more away from the market equilibrium price.

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1.4. Questions for Review

➤You should be able to answer the following questions at theend of this chapter. All of the questions can be answered withthe help of the lecture notes. If you have difficulties in answeringa question, discuss this question with me at the end of thelecture, attend my colloquium or send me an E-Mail.

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1. Since when is long distance trade practiced?

2. Explain the effect of the free trade on the production sites of the Terra Sigillata dinnerware in the Roman Empire.

3. What are the causes for gains from trade and how do they work?

4. Explain verbally the concept of Consumer surplus, Producer surplus and Total surplus.

5. Why are there winners and losers in the transition from autarky to free trade?

6. Does the transition from autarky to free trade meet the conditions for a Pareto improvement?

7. Explain the Kaldor-Hicks criterion.

8. What condition must be met if the transition from autarky to free trade shall result in gains from trade?

9. When is mutually beneficial trade possible according to David Ricardo ?

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1.4. Questions for Review11. Determine the welfare effects of a transition from autarky to free trade for

consumers and producers.P

Q

SInland

DInland

S World marketPw


Consumer surplus

Producer surplus

Total surplus

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1.4. Questions for Review12. Determine the welfare effects of a transition from autarky to free trade for

consumers and producers.P

Q

SInland

DInland

S World market

Pw


Consumer surplus

Producer surplus

Total surplus

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1.4. Questions for Review13. Determine the welfare effects of the drafted import tariff for consumers,

producers & the government if free trade is possible in the initial situation.P

Q

SInland

DInland

S World marketPw

Import tariff

Free trade Tariff Change

Consumer surplus

Producer surplus

Tax revenue

Total surplus

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1.4. Questions for Review14. Determine the welfare effects of the drafted import quota for consumers,

producers & the government if free trade is possible in the initial situation.

P

QDInland

S World marketPw

Free trade Tariff Change

Consumer surplus

Producer surplus

Owner of import quota

Total surplus

Import quota

SInland

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Developed Countries Want to Use Global Trade for Their Own Advantag Only

...A couple of weeks after the failure of the Doha conference the US Congress has decided to increase the already highsubsidies for US farmers by an additional increase of 80 Percent. Somewhat more than 180 Billion US-Dollar will bepaid as production subsidies for soya, maize, peanuts, cotton and wheeze.

Europe applies the same type of policies. According to calculations of Oxfam, the EU subsidizes every EU-cow with anaverage payment of two US-Dollar a day. These subsidies help European farmers to export milk powder at low pricesto Africa or the Caribbean, where local farmer lose their clients.

(Newspaper clipping of “Die Zeit” 01.11.2003)

15. Determine the consequences of the agricultural policy measures in Europe and the USA for the welfare of consumers and producers in developing countries, which have a comparative advantage in agricultural production.

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O

P

Q

SDeveloping Country

DDeveloping Country

S World marketPw

Change

Consumer surplus

Producer surplus

Total surplus

15. .

ÜA

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1.4. Questions for Review16. Determine the welfare effects of the drafted import tariff for consumers,

producers & the government if autarky is given in the initial situation.P

Q

SInland

DInland

S World marketPw

Imports tariff

Autarky Tariff Change

Consumer surplus

Producer surplus

Tax revenue

Total surplus

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1.4. Questions for Review17. Determine the welfare effects of the drafted import quota for consumers,

producers & the government if autarky is given in the initial situation

P

QDInland

S World marketPw

Autarky Quote Change

Consumer surplus

Producer surplus

Owner of import quota

Total surplus

Importquote

SInland

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18. When is mutually beneficial trade possible according to the Hecker/Ohlin theorem?

19. Name three reasons, why autarky prices can differ.

20. What kind of trade is usually undertaken between developing countries and industrialized countries and why?

21. What kind of trade is usually undertaken between industrialized countries and why?

22. Explain the Stolper/Samuelson theorem.23. What consequences has international trade for the income distribution

of countries according to the Stolper/Samuelson theorem?24. What measures the Grubel/Lloyd-Index?25. What consequences on international trade have economies of scale?26. Name two reasons for the emergence of economies of scale.27. Explain the emergence of economies of scale in the film industry.

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28. Why can international trade lead to intra-industrial trade?

29. Why can international trade lead to inter-industrial trade?

30. Why can consumers gain from international trade caused by economies of scale?

31. Explain the consequences of the North American Auto Pact of 1964 on the trade between the US and Canada.

32. What kind of trade is observable between countries with a relative similar endowment of production factors, what kind of trade is observable between countries with a relative different endowment of production factors.

33. Name 4 reasons in favor of free trade according to the free trade doctrine.

33. Name 3 economic reasons against free trade. Explain these reasons.

34. Explain the arguments in favor and against strategic trade policy.

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35. Explain the concept of import substitution policy.

36. What reasons speak in favor of import substitution policy, what reasons speak against import substitution policy.

37. Explain the concept of export-oriented industrialization.

38. What are the experiences of the Southeast Asian “Tiger States” with export-oriented industrialization?

39. Explain the incentive structure of a prisoners dilemma, which may emerge, if a government has to decide between free trade and protectionism. How can such a prisoners dilemma be overcome?

40. What are the consequences of international trade on the wage level, according to the classical trade theory?

41. What are the consequences of an implementation of minimum wages on international trade, according to the classical trade theory?

42. Under what conditions does the implementation of minimum wages cause unemployment?

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43. What are the consequences of international trade on the environmental burden of a country?

44. Why was the GATT founded after World War II?

45. Explain the two policy mechanisms used by the GATT / WTO ?

46. For what kind of goods is the WTO responsible?

47. Explain the WTO “Dispute Settlement Mechanism” with the example of the steel dispute between the USA and the EU.

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O

Wage

Working time


Labor demand

Labor supply with immigration

48. Explain the consequences of immigration on economic the welfare of labor demand, labor supply and immigrants, if the drafted minimum

wage is legally binding:

Minimum Wage

Without immigration With immigration Change

Dom. labor demand

Dom.. labort supply

Immigration

Total surplus

1 international trade - rainer maurerlighter box: various stones and plant fibres for making fire...

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