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Trade Exam Midterm 1
Textbook and Class Notes
Lecture 2: Rationale for Trade- Comparative Advantage
 Adam Smith- promote free trade by comparing nations to households- produce only some of product it consumes
and buy other products using proceeds from what household can sell to others- if foreign country can supply us
with a product cheaper than we can make it- buy it from them with a product from our own industry in a way that
we have the advantage
 2 country example: US and rest of world, wheat and cloth- each produced using 1 resource called labor
 “better at producing”- measure labor productivity- number of units of output worker can produce in 1 hr and
look at number of hrs it takes a worker to produce 1 unit of output (reciprocal of labor productivity)
 Absolute advantage- produce product at lower cost per unit: ex: accountant pays carpenter to build his house and
carpenter hires accountant to do his taxes (each better at own vocation and if accountant wants more money,
should get more clients instead of trying carpentry)
 If there is no trade, both countries produce both products to satisfy demand, with trade, each country shifts labor
resources to producing good in which it has absolute advantage
 Ricardo’s Theory of Comparative Advantage- There’s a basis for beneficial trade whether or not countries
have an absolute advantage: a country will export the goods that it can produce at a low opportunity cost and
import the goods it would otherwise produce at a high opportunity cost
 Comparative advantage- a company will export products that it can produce at a lower opportunity cost and
import products that would otherwise produce at high opportunity cost
 Assume constant cost model- amt produced doesn’t change costs or patterns of CA- fixed: resources,
technology, 0 transportation cost, factors mobile within but not between countries – only consider 1 input
at a time
 Opportunity cost of producing more of a product in a country is the amount of production of the other product
that is given up (benefits you would have received by taking an alternative action- want this to be low)
 Even if 1 country is absolutely more productive at producing everything and other country is absolutely
less productive, can both gain by trading as long as their relative/comparative (dis)advantages in making
different goods are different- country will have comparative adv even if it has no absolute adv
 Each country can benefit from trade by exporting products with greatest relative adv and importing
products with least relative adv
 As long as prices differ in 2 places, there is a way to profit through arbitrage- buy low, sell high
Chart p
...
25 < 1
...
5 < 0
...
5 C/W

Rest of World
0
...
5 C/W

4
...
0
2
...
5

Equilibrium international price: within range of 2 price ratios that prevailed in each country before trade began:
Cloth: 2
...
67W/C
Wheat: 0
...
5C/W
 If not, no equilibrium price possible because (ex
...
4W/C) rest of world would want
to import cloth because cheaper than making it at home for 0
...
US analyst paid
much more than Indian analyst but theory suggests salaries converge






Assume: US exports wheat and Rest of the World exports cloth
Short run effects of opening trade: wheat is the expanding industry in the US, cloth in the Rest of the
World: HIGH DEMAND FOR YOUR PRODUCT=CAN CHARGE HIGHER RENTS AS A LANDLORD,
CAN DEMAND HIGHER WAGES AS A WORKER
 Landlords in wheat growing areas can charge higher rents because their land is in high demand
 US farm workers likely to get temporarily higher wages because their labor is in high demand
 Foreign cloth workers can also demand/get higher wage rates
 Foreign landlords growing cotton for cloth can charge higher rents
Meanwhile
 Sellers of factors to the declining industries (cloth in the US and wheat in the Rest of the World) (US cloth
workers, US cotton landlords, foreign wheat landlords and foreign wheat farmers) lose income due to reduced
demand and receive reduced prices for their services
Long run factor-price response- more adjustment occurs
 Factors move between sectors in response to differences in returns: some US cloth workers will find better
paying jobs in wheat sectorsupply of labor in wheat sector increaseswages in wheat sector decline, as
remaining labor in cloth sector shrinkswages in cloth sector increase, cotton land will get better rents by
converting to wheat production bringing rents back in line and foreign workers/landlords will find better pay
in cloth sector
 All wages/rents won’t go back to pre-trade levels but wage rates will end up lower for all US workers and
higher for all foreign workers and all land rents end up higher in US and lower in rest of the world
Because^ wheat growing is more land-intensive and less labor-intensive than cloth making- amounts of each
factor being hired in expanding sector don’t match amounts being released in other sectorimbalance causes
factor prices to adjust
 Production shift towards land-intensive, labor-sparing wheat raises rents and cuts wages throughout US in
long run- rise in rents and fall in wages continue until come up with land-saving/labor-using ways of making
wheat/clothrents/wages will stabilize but US rents still end up higher and wages lower than before trade
opened up
 Long run results: product prices equalized between 2 countries
Winners: US landowners, foreign workers
Losers: US workers, foreign landowners
Stolper-Samuelson Theorem- opening to trade splits country into gainers and losers in the long run; theorem
states that given assumptions (2 goods, 2 factors of production: W/C, land/labor, factors are mobile between
sectors- land/labor can be used to make both W/C, competition prevails in mkts, production technology involved
constant returns to scale), an event that changes relative product prices in a country has 2 effects:
 Event raises real return to the factor used intensively in rising-price industry (ex
...
Land that
grows only 1 type of crop
IN SHORT RUN, THE 2 GROUPS (LANDOWNERS/LABORERS) SPECIALIZING IN THE EXPORTED
GOOD BENEFIT
IN LONG RUN, LAND CAN BE CONVERTED TO NEW USES, WORKERS CAN SWTICH JOBS AND
ECONOMY ADJUSTS
SINCE DIFF QUANTITIES OF FACTORS (LAND/LABOR) ARE USED IN PRODUCTION, PRICE
FACTOR USED MORE INTENSIVELY IN EXPORTED GOODS WILL RISE
TRADE HELPS/HURTS SECTORS (AG/MANUF, W/C) IN SHORT RUN AND FACTORS/CLASSES
(LAND/LABOR, OWNERS/WORKERS) IN LONG RUN
SHIFT FROM NO TRADE TO FREE TRADE CHANGES PRODUCT PRICES
 The factor used intensively in production in the rising price sector (land) rises even faster than the product
price rises so its real return (purchasing power w/ respect to either product) rises
Factor-price equalization theorem- given assumptions (same in stolper plus: both countries produce positive
amts of both goods w/ free trade, no barriers to trade, no transport costs, same available tech for both countries, no
factor intensity reversals) free trade equalizes not only product prices but also prices of individual factors between
the 2 countries
...
OPENING
OF TRADE=LOWERING WAGE RATE IN US AND RISE OF WAGE RATE IN REST OF WORLDImplies that laborers end up earning same wage rate in all countries
Trade makes US export wheat/import cloth, since W is land intensive and cloth is labor intensive, trade sends
land-rich commodity to rest of world in exchange for labor-rich cloth- each factor migrates toward the country in
which it was scarcer before trade

Lecture 4: Alternative Theories of Trade- imperfect competition
Standard theory of trade assumes constant returns to scale- input use and total cost rise in the same proportion as output
increases (if 2 labor inputs and 1 land input give 2 cloth then 4 labor and 2 land give 4 cloth)- a factory 2 times as big isn’t
2 times as productive, avg cost (total cost/#units produced) is constant- if total cost and output double then avg cost is
unchanged
 Economies of scale- lower input costs/volume discounts- may lead to concentration of an industry into a few
large firms (apple, Samsung)- if industry is sufficiently large in developed country and scale matters in that
industry then costs will be lower than a factory In developing country even if wages are much lower
 Diseconomies of scale- factories can get too large=shortages of space/workers/raw materials, slower to execute,
smallness=speed, higher costs but faster to hit mkt with new products
 Scale economies- output quantity goes up by larger proportion than does total cost as output increases (large
size/more output=lower per unit costs of production) and if output quantity expands faster than cost increases then
average cost of producing a unit decreases as output increases (denominator gets larger so average cost gets
smaller)
 Internal scale economies- scale economies internal to the individual firm
Larger firm may have lower avg cost because:
1) There are upfront costs before production occurs & the upfront costs are spread over the # produced
2) Using large specialized capital equipment that produce at high volume

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INTERNAL SCALE ECONOMIES CAN CAUSE IMPERFECT COMPETITION IN AN INDUSTRY
BECAUSE THEY DRIVE INDIV FIRMS TO BE LARGER THAN THE SMALL FIRMS IN
PERFECTLY COMPETITVE INDUSTRIES
 Monopolistic competition- (room in industry for large number of firms, products are differentiated)large number of firms compete vigorously with each other in producing/selling varieties of the basic
product- because each firm’s product is somewhat different it has some control over the price it charges
for its product- contrasts with perfect competition- each of industry’s many small firms produces identical
commodity-like product, takes the mkt price as given and believes it has no direct control over mkt price
IF SCALE ECONOMIES ARE SUBSTANTIAL OVER LARGE RANGE OF OUTPUT THEN IT’S
LIKELY THAT A FEW LARGE FIRMS WILL GROW TO BE LARGE IN ORDER TO REAP SCALE
ECONOMIES
 Oligopoly- a few large firms dominate the global industry perhaps due to substantial scale economies; the
large firms know they can control/influence prices
IF THE FIRMS DON’T COMPETE TOO AGGRESSIVELY THEN ITS POSSIBLE FOR FIRMS TO
EARN ECONOMIC/PURE PROFIT GREATER THAN NORMAL RETURN TO INVESTED
CAPITAL
External scale economies- based on the size of the entire industry within specific geographic area- AVG COST
OF TYPICAL FIRM PRODUCING PRODUCT IN THIS AREA DECLINES AS THE OUTPUT OF THE
INDUSTRY WITHIN THE AREA IS LARGER (ie
...
all set
design/hair makeup people are in Hollywood) and can arise through knowledge diffusion
 In industries that can reap external economies (knowledge spillover from firm to firm) a rise in D triggers
big expansion of supply and lowers costs and priceincreasing trade brings gains to domestic/foreign
consumers and to exporting producers
 With no trade, each country produces for its own consumption; with trade production tends to be
concentrated in small number of locations
Inter-industry trade- country exports some products for imports of other very different products (comparative
advantage)
Intra-industry trade (CARS)- 2 way trade where country imports/exports the same/similar products (ex
...

Net trade of differentiated products may still be based on CA
1 means imports=exports, 0 means pure importer or pure exporter (ex
...
26-protectionist)


Monopolistic competition- unique product, internal scale economies of producing a product, easy
entry/exit
 As more models come on mkt each firm loses some pricing power as mkt becomes more rivalrous; the
price a firm can charge for its model decreases as number of models available on mkt increases and Price
curve is downward sloping, Unit Cost curve is upward sloping because cost inc as number of models inc
 Opening to trade pushes World Unit Cost curve farther to the right; price dec and number of models inc
(larger size of overall global mkt)
 BASIS FOR TRADE= PRODUCT DIFFERENTIATIONDRIVES INTRA-INDUSTRY TRADE
 Opening of trade has little impact on total output of domestic industry-doesn’t change domestic factor
income
 Consumers of exportable products gain because of: variety, additional competition lowers product prices
(firms leave the mkt, sales per firm inc, quantity of each model demanded increases, avg cost dec)
MONOPOLISTIC COMPETITION MODEL SUGGESTS THAT PRODUCT DIFFERENTIATION IS
BASIS FOR EXPORTING/IMPORTING DIFF VARIANTS/MODELS OF SAME PRODUCT;
ECONOMIC MODELS BASED ON SUBSTANTIAL SCALE ECONOMIES (INTERNAL/EXTERNAL)

INDICATE PRODUCTION TENDS TO BE CONCENTRATED IN SMALL # OF LOCATIONS (CA,
HISTORICAL LUCK, GOVT POLICY)
 Monopolistic competition vs Monopoly
Monopolistic competition (D isn’t as steep- can’t get away with charging a higher price): firm faces limited
competition and can determine how many of its products to sell, as quantity inc, price dec for all units sold until
MR from an additional unit=MC
Monopoly- steep demand curve, can command price


Global oligopoly- a few firms account for most of world’s production; ARISE WHEN THERE ARE
SUBSTANTIAL SCALE ECONOMIES INTERNAL TO EACH FIRM- trade patterns driven by
historical factors (where industry started) rather than CA
 Prisoner’s dilemma- compete aggressively by setting low prices or restrain competition by setting
high price
 Firms may punish new entrants by cutting prices to drive them out of mkt
Trade gains/losses:
Standard Competition: losers: export consumers, import-competing producers
Monopolistic Competition: no impact: export producers, import-competing producers (because firms under pressure from
import competition also have opportunity to export to foreign mkts)
External Economies: losers: import-competing producers (filmmakers in Kansas)
Lecture 5: Trade Policy: Tariffs
 Specific tariff- money per unit import
 Ad valorem tariff- on the value- percentage of the estimated mkt value of the goods when they reach the
importing country
FOR SMALL COUNTRY, THE PRICE COUNTRY PAYS FOREIGN SELLERS IS NOT AFFECTED BY HOW
MUCH THE SMALL COUNTRY IMPORTS OF THE PRODUCT


Producer surplus- amt that producers gain from being able to sell at going mkt price: AREA ABOVE
SUPPLY CURVE AND BELOW MKT PRICE/WP/DOMESTIC PRICE LINE- PRODUCTION
EFFECT (AREA B)
 When tariff is implemented (ex
...

Consumers pay it but neither govt nor domestic bike producers gain it; it’s the amount by which cost of
drawing domestic resources away from other uses exceeds the savings from not paying foreigners to sell
extra units



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