Transcript WORLD INCOME DISTRIBUTION AND TRADE PATTERN How

INTRODUCTION
1-In this chapter we are going to apply general equilibrium
analysis to the subject of international trade .
2-When Tariff is levied , we want to investigate that who
loose and who gain , and how the pattern of trade will be
determined .
3-In the first place we assume that the country is small and
accept the world price . In this manner the behavior of
citizens can not affect the world price .
4-After that we release this assumption and assume that the
country is not small in the world trade and terms of trade is
not fixed and will be determined endogenously and we will
find out about the mechanism of determination.
Walters & Layard CH 4
Application to international trade
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WORLD PRICES CONSTANT , ONE COUNTRY’S GAIN FROM
TRDE
E= No trade equilibrium point
Consumption of x&y after trade= (x0,
y0 )
Y
d
C= after trade equilibrium point
U=U(X,Y)
World price = (∏x / ∏y) =domestic
price after trade =(Px/Py)
P
Yp
Production point after trade = P
Consumption point after trade = C
export
Yc
C
U1
E
Y0
(∏x / ∏y) =(px/py)
U0
import
d
Xp
Walters & Layard CH 4
x0
X
xc
Domestic price before
Application to international tradetrade=(px/py)’
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WORLD PRICES CONSTANT ,
ONE COUNTRY’S GAIN FROM TRDE
At point E , (X0,Y0) → MRSxy = MRTxy = (px/py)’
When trade takes place , production moves from point E to point P in
order to ;
Max GNP = Y Py + X Px
S.T. G( X , Y ) =0
P.P.F. → Yp & Xp is the solution .
At point P we notice that
Rate of transformation through trade= (∏x/∏y)=(px/py) =MRT
MRT = domestic rate of transformation .
domestic rate =(Px/Py)’ > (∏x/∏y)= foreign rate →
Y can be produced domestically cheaper and X can be obtained cheaper
through foreign trade ( import) . Domestic production of Y increase and
domestic production of X decrease . Production point moves to point P
and consumption point moves to point C . Consequently social welfare
will increase to U1 .
Walters & Layard CH 4
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WORLD PRICES CONSTANT ,
ONE COUNTRY’S GAIN FROM TRDE
Since social welfare ( welfare of capital and labor
owners )has increased , there is a potential Pareto
improvement by moving from point E to point C .
In moving from point E to C relative price of X or (Px/Py)
decrease and make labor owners worse off and capital
owners better off ( Stopler – Samulson Theorem ) .
There is a possibility for government intervention , and levy
tax on capital and subsidize on labor .
Walters & Layard CH 4
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
Efficient compensation is rare , and disadvantaged groups
may seek for inefficient way of compensation , namely
tariff.
The effect of tariff is to increase the domestic price of x
(Px/Py) .
→
(Px/Py) = ( ∏x/∏y) (1+t)
( ∏x/∏y)= foreign rate or foreign price of x .
t = tariff rate .
After tariff x becomes more profitable , and production
moves from point P to point P’ on the PPF .
At P’ → MRT = (Px/Py) = (∏x/∏y ) (1+t) > MRTf = (∏x/∏y )
→ production inefficiency
Walters & Layard CH 4
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
Y
From P’ , trade take place along PR .
Consumption equilibrium point will be
C’ . So ;
P
MRS = ( Px/Py)= (∏x/∏y)(1+t)>MRTf
C
P’
C’
X
R
Slope = ∏x/∏y
Slope = Px/Py
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
I - Production inefficiency
In moving from point P to point P’ , cost of producing
additional x ( MRTxy) is greater than cost of buying it
through foreign trade ( MRTf ).
II – consumption inefficiency ;
In moving from point P to P’ , value of additional x to
consumers (MRSxy) is greater than cost of providing it
through international trade (MRTf= international value).
Consumption and production inefficiency could be seen
clearly in the following diagram per unit diagramm.
Walters & Layard CH 4
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
Px/Py
S
Domestic supply
Foreign supply
(∏x /∏y)(1+t)
Sf + t
a
c
b
∏x/∏y
d
Sf
D
x
P
Import before tariff
Walters & Layard CH 4
P’
C’
Import after tariff
Application to international trade
C
Total demand for x
Without income effect
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
As it is shown from the figure , after tariff consumption
decrease from OC to OC’ , and production increase
from OP to OP’ , and import will decrease too . Welfare
changes are as follows ;
Consumer surplus decrease = - ( a+b+c+d)
Producer Surplus increase = + a
Taxpayers gain = +c
Total welfare change = - (b+d)
-b = production inefficiency from producing PP’ units
more expensive at home .
-d = consumption inefficiency from consuming PP’ units
less at home .
Considering the above argument , is there any argument in
favor of tariff .
Walters & Layard CH 4
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
Since X is labor intensive and y is capital intensive , after tariff (Px/Py)
increase , and labor will be better off and capital becomes worse off
. Since total welfare decrease , if whole gain goes to capital owners ,
still capital owners will loose .
If the intension of the tariff was raising the welfare of labor owners, tariff
is not the proper way . Free trade with subsidy and taxes is the
proper one .
If the intention is to encourage the development of the production of x
(infant industry) , the best way is to set a minimum production level (
at P’ ) with providing a production subsidy instead of levying tariff
.with production subsidy the producer’s price will raise to (1+t)∏x/∏y
. Domestic production increase to OP’ , while the consumer’s price
remain at the lower international price of (∏x/∏y) . So consumption
will not be reduced . Intended production inefficiency is present
while , unintended consumption inefficiency is not present .
Walters & Layard CH 4
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THE EEFECT OF A TARRIF ,
WORLD PRICE CONSTANT .
If the intention is to lower the consumption of luxuries, the
alternative policy tariff is to levy the consumption tax on
luxuries. This will increase the price of x from
Px/Py = ∏x/∏y to (1+t)∏x/∏y . This will lower the
consumption to C’ . But production price remain at ∏x/∏y
and production inefficiency is not present . But intended
consumption inefficiency is present .
Now suppose that there is a export tax on Y . This means
to lower the price of Y in compare to international price
of Y . This means lowering Py in ( Px/Py ) which means
increasing ( Px/Py ) ,which acts like an import tax on X
,and consequently increasing the production of X and
decreasing the production of Y .
Walters & Layard CH 4
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THE DETERMINATION OF
WORLD PRICE
terms of trade is not fixed and it is variable . Not even large
countries , but also small countries could have significant
effect on the terms of trade, if small countries produce a
large portion of the world production .
In order to see how the terms of trade are affected by
commercial policies ( tariffs , export subsidies ) we need
to know how the world prices are determined . For
analyzing these effects we consider the case of pure
exchange .
Consider the following diagram.
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THE DETERMINATION OF
WORLD PRICE
E = initial equilibrium
Offer curve A
Y exported by A
OA
E
P
X imported by A
(∏x/∏y)=(px / py )
Offer curve B
OB
Is P an unique equilibrium point ? Or does a rise in (∏x /∏y ) always decrease the
excess demand for x ? When (∏x/∏y ) increase substitution effect in both countries
reduce the excess demand for x . there will be income gain to the one who export x
and income lose to the one who import x . Until marginal propensity to spend on x
differ sharply, these effects will be canceled out And excess demand will be reduced.
Walters & Layard CH 4
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OPTIMUM TARIFF, WORLD PRICE variable
A’s export of Y
Neither of the countries is price taker . A will impose tariff to lower the relative
world price of importing good X assuming that B does not retaliate ; it is
assumed that after tariff world price will change from (∏x/∏y) to (∏x/∏y)1
and domestic price will change from Px/Py to ( Px/Py ) 1
Before tariff → (∏x/∏y) = Px/Py
After tariff → new world price = (∏x/∏y)1 = ( Px/Py ) 1 / (1+t) ,
New domestic price = ( Px/Py ) 1 = (1+t) (∏x/∏y)1
TA0 = trade indifference curve
E
B’s offer
A’s offer
P
TA1
(∏x/∏y) = (Px/Py)
R
A’s import of X
Walters & Layard CH 4
The best that
A could do is
to bring the
trade to point
R
(∏x/∏y) 1 =(Px/Py) 1 / (1+t)
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OPTIMUM TARIFF, WORLD PRICE
variable
Y per x
MC of import to A
(Px /Py)1
B’s supply of X
e
ef= optimum tariff rate
g
An individual importer who
buys more imports forces
up the price faced by other
importers.
(∏x / ∏y)1
f
A’s demand for x
X1*
X1
The externality mentioned
above could be overcome
by government through
imposing tax on imports .
A’s import of X
Walters & Layard CH 4
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OPTIMUM TARIFF, WORLD PRICE
CONSTANT
If M = volume of imports
Π = (Πx/c)= international terms of trade .
ΠM= total cost of imports (social cost of imports).
d(ΠM)/dM = Π + M dΠ/dM = Π(1+1/ μs)
μs = supply elasticity of imports .
d(ΠM)/dM = additional cost imposed because of buying one
more unit of x .(externality imposed ).
Π = (Πx/Πy)= the cost which will be paid by the importer for
one more unit of X .
(Π/μs ) = the cost which will be imposed on others when
one more unit of x will be bought.
the optimum tariff rate = 1/μs
When country is price taker → μs = ∞ → tariff rate =0
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OPTIMUM TARIFF, WORLD PRICE
CONSTANT
for optimality we should have ;
Marginal cost the importer impose on society [Π(1+1/ μs)]
= marginal value which the society puts on X { demand
price}
Export subsidy to Y → domestic price of Y (Py) < world
price of Y (Πy ) → ( Px/Py )↑ → the same effect will
result as increase in domestic price of X with respect to
tariff imposed on import of X
We had (K/L)x < (K/L)y or X is labor intensive , so when
relative price of x will increase , this will lead to increase
in (WL/WK) → real wage of labor increase, or real wage
of capital decrease .
Tariffs usually is imposed by poor countries, and will be
only justified by the notion of equity ground .
Walters & Layard CH 4
Application to international trade
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
Factor price equalization and Heckscher-Ohlin
theorem
How far can a theory explain the pattern of world trade and
income distribution in the world and what will be the
welfare implications of free trade and international
migration . Theorems will be built based upon the
following assumptions ;
1- Technology (production function) is the same in both of
the countries.
2-constant return to scale is present.
3-perfect competition is prevailing.
4-no factor intensity reversal is present
5- no specialization is present ( each country produce
some of each good )
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
Above five assumptions we will have unique relation
between (Px/Py) and MPL and MPK in each industry .
Each (Px/Py) → unique (K/L) in each industry → unique
MPL and MPK in each industry → (WL/WK) will be unique.
Under free trade (Px/Py) is the same in both countries , so
(WL/WK) will be the same in both countries .
Given assumptions 1 through 5 , free movements of goods
will bring the equality in factor prices and movement of
the factors of production is not necessary .
once (WL/WK) is known in each country , (K/L) is known in
each industry . Knowing (K0/L0) and the following
relation, the product mix will be known . The equilibrium
point on the contract curve will be known , so the product
mix will be known )
(K0/L0) = (K/L)x (Lx/L) + (K/L)y (Ly/L)
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
in a country where (K0/L0) is high ( capital rich country like
country A in page 22 ) and knowing that x is labor
intensive , [(K/L)x < (K/L)y ] , higher weights should be
attached to (K/L)y . So,
(Ly /L0) > (Lx /L0) →
production of Y with respect to X is high . So more Y will
be produced with respect to X ( in country A with
respect to country b in page 22 )
Weak version of Hecscher-Ohlin theorem ;
Under free trade and given assumptions 1-5 , the
capital rich country will produce relatively more of
the capital intensive good.
But this says nothing about the pattern of trade (export and
imports). We need to introduce the strong version of the
theorem .
Walters & Layard CH 4
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
Having strong taste (demand) for capital intensive good ,
the capital intensive country could import the capital
intensive goods except when taste are the same in each
country . When taste are the same , for given (Px/Py) the
same proportion will be spent for each good in each
country. This will happens when we assume homothetic
utility functions in the countries.
Strong version of the H.O. theorem ;
Given free trade ,assumption 1-5 , and identical
homothetic tastes in both countries, the capital rich
country will export the capital – intensive goods and
vise versa.
Walters & Layard CH 4
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
XB
OB
. C’
A’s export
C= world consumption
equilibrium point
P
Under free trade
MRTAxy=MRTBxy=(Πx/Πy)=Px/Py
C
Walters & Layard CH 4
As it is seen world equilibrium is
prevailing → world excess
demand for each good is zero.
X is labor intensive and y is
capital intensive . If A is capital
A,s import
abundant country and B is labor
abundant country , we expect
XA
that
(Y/X)A>(Y/X)B→P should
lie above the diagonal → if c lies
below the diagonal , H.O. theory
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istrade
working .
YB
OA
P=world production equilibrium
point
B’s export
B’s import
YA
WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
This is the special case of the more general theory of
comparative advantage which says that that country
which has comparative advantage in any good will
produce that good when free trade is prevailing .
We should note that point C , the equilibrium consumption
point should not lie above the point P ( like C’ ). Since in
this case the capital rich country would import capital
intensive good. This happens if taste differ sharply in two
countries. That is , consumers should have very strong
preference for capital intensive goods in country A and
very strong preference for labor intensive good in
country B . This will not happen if taste were homothetic
in both countries.
Walters & Layard CH 4
Application to international trade
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
What does the theory says about optimality of trade of
free trade ?
Even without the five assumption that we have made any
competitive equilibrium would be fully efficient , if all
agents were free to do the best for themselves . But
there are international barriers on migration of labor or
sometimes for capital movements .
When these barriers are present , the five assumptions
would guarantee the efficiency of world economy under
free trade . Because they insure that the marginal
product of given factor is the same in all countries. The
equality of marginal product is needed for he equality of
real wages .
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Application to international trade
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
How realistic is all this ? How realistic is the strong
version of the Hecher Ohlin theorem . Do countries
export goods which is intensive in their abundant factor ?
Taking into account labor and capital as two relevant
factor ,we would expect the densely populated countries
to import grain from sparsely populated countries .it is
found that they do .
However Leontief calculated the capital labor ratio for US
export and found that it is 25 percent lower than for US
import competing goods . The first problem with this
analysis was dismissing the natural resource as a factor.
The second problem is heterogeneity of the labor .
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
These factors are very difficult to measure . Concerning the
heterogeneity of labor more research has shown that US
export are more skill intensive than US imports .
The evidence of factor price equalization is very weak .
The real wage of a given quality of labor is much higher
in capital rich countries .
These evidence against the theorem may happen because
of the failure of the assumptions which we were made .
First – we relax the assumption about the factor intensity
reversal ;
Agricultural sector (x) is labor intensive in labor abundant
countries and is capital intensive in capital intensive countries.
This would mean that at given world product price (Px / Py) ,
relative factor prices differ between countries .
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WORLD INCOME DISTRIBUTION AND
TRADE
PATTERN
/ W ) > (W / W )
1
0
(WL
K
L
K
In capital abundant country
(1) , capital labor ratio is
higher in x and y industries
compared to labor
abundant country (0)
X
X is labor intensive in labor abundant country , so x will
be exported by country 0 . X is also capital intensive in
capital abundant country , so x will also be exported by
capital abundant country .theory breaks down .
An inefficiency will be present in the world economy
since relative factor prices differ in two countries .
Y
(WL / WK )1
agriculture
manufacture
(WL/WK)0
(K/L)x0
(K/L)x1
(K/L)y1
(K/L)y0
1 = capital abundant country
Walters & Layard CH 4
(Px/Py)0
0 = labor abundant country
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WORLD INCOME DISTRIBUTION AND
TRADE PATTERN
Inefficiency will also be present if either of the countries
specialize entirely in any of the commodities .
X
(WL/WK)0
y
(WL/WK)’
(K/L)A
(K/L)y
/
(K/L)x
(K/L)B
O
(Px/Py)0
Country B is starving of
capital so that she is
not able to produce
capital intensive good ,
and will be specialized
on producing labor
intensive good (x) . As
it is seen , there should
be two different relative
wage rates. Inefficiency
will be present . Theory
does not work
World prices
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WORLD INCOME DISTRIBUTION
AND TRADE PATTERN
When wages are differ in two countries , labor migration will
be encouraged and if it is allowed this may eliminate the
wage differential in two countries . But the very fact that
unsatisfied migration pressure will exist , this suggest
that free trade is not sufficient to produce efficiency in
the world .
If taste differ or if expenditure patterns differ with income,
we may get different pattern of trade than the one
predicted by Heckscher-Ohlin theorem . But the income
distribution predictions and efficiency implications of the
theory will be unaffected.
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Application to international trade
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WORLD INCOME DISTRIBUTION
AND TRADE PATTERN
Allowing differences in technology can make more
difference . One country may excel over others in all
industries or only in some .
Suppose that Swiss can make 25 percent more than the
others with any given input bundles in either industries (
X or Y ). This would not alter the shape of Swiss
transformation curve , but push it only out along every
ray from origin to a point 25 percent beyond that
occupied by another country with the same endowment .
So production pattern would follow the H.O. theorem .but
the real marginal product of all factors will be 25 percent
higher in Swiss than another country .
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WORLD INCOME DISTRIBUTION
AND TRADE PATTERN
But suppose that Swiss is better in 25 percent in labor
intensive good ( Watch making) only .
Iso-quant for
K
Y=1
(K/L)YN
(K/L)YS
(K/L)XS
XN
(K/L)XN
watch map in
Swiss is the same
as elsewhere but
each Is-oquant
correspond to a
higher output.
XS
L
(WL/WK)s > (WL/WK)N
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WORLD INCOME DISTRIBUTION AND TRADE PATTERN
Xs shows the one dollar value of Swiss watches (
y=income)
XN shows one dollar value of other country watches .
As it is seen Swiss use less Labor and Capital for
producing one unit of X, because Swiss is more efficient
in watch making. As it is seen (K/L) is also higher for
Swiss in both industries ( X ,Y ). This will imply higher
real wage in Swiss in compare to other country.
Having higher (K/L) in labor intensive commodity (X) in
Swiss compared to other country, Swiss will employ
higher fraction of both factors in Watch making industry
since it employs higher fraction of capital and its
productivity is higher in watch industry ). Since Swiss is
more efficient in making watches, it would produce
higher ratio of watches to other goods. With identical
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homothethic taste Swiss will export watches.
WORLD INCOME DISTRIBUTION
AND TRADE PATTERN
Now suppose that the assumption concerning constant
return to scale relaxed.
Increasing return to scale certainly help to explain the fact
of some inter-country specialization in production . But
assuming that the scale economies are the same for all
countries , they do not explain which country concentrate
on which products . The country that will reap the
economies of scale in particular industries will be the one
that has comparative advantage in it , due to its
endowments or its relative technological superiorities .
THE END
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