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The Mercantilists, 1500-1800

make few imports and many exports, thereby generating a net inflow of foreign exchange and maximizing the country’s gold stocks

▪ The world’s wealth was fixed ▪ Gain from trade at the expense of trading partners

Adam Smith: ▪ World’s wealth is not a fixed quantity ▪ All countries can benefit from international trade

Principle of absolute advantage: ▪ In a two-country, two product world, trade will be beneficial when one country has an absolute advantage in one good and the other country has an absolute advantage in the other good▪ A country will export the good in which it has absolute advantage and import the good in which it has absolute disadvantage

Ones looseness in the theory of absolute advantage: ▪ Mutually beneficial trade requires each country to be the least-cost-producer of at least one good

Comparative Advantage▪ The less efficient country should specialize in and export the good in which it is relatively less inefficient

• Differences ▪ absolute advantage emphasizes in labor productivity ▪ comparative advantage emphasizes opportunity cost

Comparative Advantage & Global Supply Chains • Ricardian theory assumes production cannot move to other nations• Global supply chains use outsourcing ▪ Subcontracting work to another firm, or ▪ Purchasing components rather than manufacturing them

Limits of the Ricardian Model• Labor is the only input of production• No trade cost ▪ Complete specialization• Cannot explain intra-industry trade (among industrial countries) ▪ Contradicts the theory of comparative advantage

Factor Endowment Theory• The ultimate determinants of comparative advantage are technology, resource endowments, and demand• Ricardo only focuses on differences of technology (labor productivity) across countries• Factor endowment theory focuses on the role of relative differences in resource endowments

Properties of Capital• Some forms of capital require investment (learning knowledge, building machines), others do not (natural resources) • Capital is only used in the production process

exports a good abundant resource and imports good scarce resource

By redirecting demand away from scarce resource and toward abundant resource, trade also leads to factor-price equalization in addition to product-price equalization

Gain and Loss from Trade• Ricardo assumes that labor is the only factor of production ▪ No difference within countries ▪ Cannot be used to analyze distributional effect of trade• What about factor-endowment theory? ▪ Involve two factors of production ▪ Can analyze the differential effect of trade on workers and owners of capital• The effects of trade on the distribution of income can be summarized in the Stolper-Samuelson Theorem

Stolper-Samuelson Theorem• An increase in the price of a product increases the income earned by resources that are used intensively in its production▪ Increased demand will make this resource more expensive in the domestic market ▪ Income of the owner will hence increase ▪ Conversely, income of the owner of the resource abundantly used in producing the imported good will decrease

Features • Theory of absolute and comparative advantage: ▪ Differences in labor productivity ▪ Everyone is the same within countries ▪ Product price equalization

• Factor endowment theory ▪ Differences in factor endowments ▪ Different groups within countries ▪ Product price equalization and factor-price equalization

Inter versus Intra-Industry Trade• factor endowment theory and the theory of comparative advantage only explain inter-industry trade▪ Based on inter-industry specialization • Each nation specializes in industries in which it enjoys comparative advantage

Intra-Industry Trade• Advanced industrial nations emphasize intra-industry trade ▪ Two way trade in a similar commodity▪ Most such trade conducted among industrial countries

Economies of Scale and Trade• Economies of scale can affect trade patterns through homemarket effect: countries will specialize in products that have a large domestic demand• Krugman constructs a international trade model that includes Dixit – Stiglitz demand function Feature: utility from consumption does not only depend on quantity consumed, but also the variety of goods consumed

Comparative advantage can also be affected by ▪ Industrial policy: strategy to develop certain industries ▪ Regulatory policy: regulations on business

• Specific tariff ▪ Fixed amount of money ▪ Consumer price = producer price + specific tariff

Ad valorem tariff ▪ Consumer price = producer price *(1+ ad valorem tariff rate)

Compound tariff: mixture of specific and ad valorem tariff

• Free-on-board (FOB) valuation ▪ Tariff is applied to a product’s value as it leaves the exporting country ▪ Used in the United States • Cost-insurance-freight (CIF) valuation ▪ Tariff is applied as a percentage of the imported commodity at its final destination ▪ Used in European countries

Two basic concepts ▪ If only one country is involved the “wholly obtained” concept will be applied▪ If two or more countries are involved in the production of goods, the concept of “last, substantial transformation” determines the origin of the goods.▪ change of product category▪ list of manufacturing or processing operations▪ By a value added rule

Product Standards• trade barriers associated with product standards• Differences ▪ Tariffs increase the marginal cost of products reaching consumers▪ Product standards can affect both the marginal cost and fixed cost of production• Two principles of GATT/WTO ▪Reciprocity ▪ Non-discrimination

Most favored nations (MFN) ▪ If GATT members granted lower tariffs to another member, it had to do the same for all other members

• 1964-67, Kennedy Round ▪ Focus shifted from product-by-product format to acrossthe-board format ▪ Tariffs negotiated on broad categories of goods; rate reduction applied to entire group ▪ Tariffs on manufactured goods cut by average of 35% to average ad valorem level of 10.3%

• 1973-79, Tokyo Round • Tariff rates cut across board from 7% to 4.7% • Tariffs so low that they are no longer a barrier to trade in industrial countries

• 1986-1993 – Uruguay Round ▪ Tariffs eliminated entirely in several sectors▪ Many nations agreed for first time to bind or cap significant portion of their tariffs▪ Progress in reducing non-tariff barriers • “Tariffication”: eliminate quotas and other forms of trade barriers and only use tariffs instead▪ The last successful round of multilateral negotiation

• Doha Round: 2002 – ▪ Goal: further reducing trade frictions▪ Need from developing countries is acknowledged▪ Center of debate: large reductions in developing countries’ industrial tariffs in exchange for greater access to agricultural markets of rich nations▪ Last straw: disagreement on Special Safeguard Mechanism • A measure designed to protect poor farmers by allowing countries to impose a special tariff on certain agricultural goods in the event of an import surge or price fall

National treatment: imported products must be treated the same as domestic products, at least after entering the customs territory ▪ The other pillar of the non-discrimination principle▪ Intended to ensure that tariff reductions would not be circumvented through the substitution of policy instruments▪ Most powerful weapon to deal with regulatory protection in the GATT era

First Wave of Globalization• Exports as share of world income nearly doubled to 8%• Per capita incomes increased 1.3% per year• Previous 50 years: 0.5% per year• Nations that actively participated in globalization became richest countries in world• Brought to an end by World War I

Second Wave of Globalization• 1945–1980• Horrors of retreat into nationalism renewed incentive for globalization• Falling transportation costs fostered increased trade• Trade liberalization not uniform ▪ Mainly developed countries ▪ Manufactured goods▪ Continuing trade barriers in developed countries ▪ Unfavorable investment climates ▪ Antitrade policies of developing country governments ▪ Dependence on agricultural and natural-resource products• Developing countries as group left behind

Third Wave of Globalization• 1980 to present• Many developing countries have participated, led by ▪ China, India, and Brazil, which entered world markets for manufactured goods• Other developing countries ▪ Increasingly marginalized in the world economy, with decreasing incomes and rising poverty• Significant international capital movements• World more globalized – international trade, capital flows • Global supply chain ▪ Production separated into stages or tasks that are undertaken in many countries ▪ International production network