Lecture Economics for investment decision makers: Chapter 8 - CFA In stitute

Chapter 8 - International trade and capital flows. This chapter compare gross domestic product and gross national product, describe the benefits and costs of international trade, distinguish between comparative advantage and absolute advantage, explain the Ricardian and Heckscher–Olin models of trade and the source(s) of comparative advantage in each model,...

1 Introduction

International trade enhances economic growth by

• increasing the efficiency of the allocation of resources,

• providing larger capital and product markets,

• assisting specialization based on comparative advantages, and

• increasing the efficiency of the flow of capital among countries

2 International trade

Gross national product (GNP)

Add Production of goods and services by foreigners within the

country

Subtract Production of goods and services by the country’s citizens

outside the country

Equals Gross domestic product (GDP)

We can measure aggregate output of a country by using the gross national product (GNP) or the gross domestic product (GDP), which differ with

respect to goods and services produced by foreigners and by its citizens abroad:

• The terms of trade is the ratio of the price of exports to the price of imports.

- Increasing terms of trade indicate improvement

- Decreasing terms of trade indicate deterioration

• Net exports = Exports – Imports

- If positive, there is a trade surplus

- If negative, there is a trade deficit

• A country that does not trade with other countries is referred to as a closed

economy or being in autarky; the price of goods and services is the autarkic price.

• An economy that is not closed is an open economy.

- If there are no restrictions to trade, the price of goods and services is the

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• Free trade is the case in which there are no restrictions on a country’s trade

with other countries

- Trade protections are restrictions on trade that prevent pricing based on

supply and demand

- Capital restrictions are limits on the flow of funds into or out of a country

• Measure of international trade:

- Trade as a percentage of GDP

- Foreign direct investment (FDI): the amount of the investment by a firm in

one country in the assets in another country

• A multinational corporation (MNC) is a company that operates in more than

one country

Benefits and costs of International trade

BENEFITS

• Gain from exchange and

specialization

• Greater economies of scale

• Greater product variety

• Increased competition

• More efficient resource allocation

COSTS

• Greater income inequality

• Loss of jobs in developed countries

• Adjustments as resources are reallocated

Comparative advantage

• An absolute advantage exists if the country is able to produce a good at a

lower cost or use fewer resources

• A comparative advantage exists if the country’s opportunity cost of producing

a good is less than its trading partner

• It is possible to have a comparative advantage while not having an absolute advantage in producing a good

• The greater the difference between the world price of a good and its autarkic price, the more potential to gain from trade

• A country’s comparative advantage can change over time

Advantages: Example

Assume identical feed and labor supply.

Can produce 5 cows or 25 hogs Can produce 5 cows or 12 hogs

• Relative price for a cow: 5 hogs

• Relative price for a hog: 0.20 cow

• Relative price for cow: 2.4 hogs

• Relative price for a hog: 0.42 cow

• Comparative advantage in hogs • Comparative advantage in cows

• Absolute advantage in hogs

• Specialize in hogs • Specialize in cows

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Sources of comparative advantage

RICARDIAN

• Countries specialize in the goods and

services for which they have a

comparative advantage

• The source of comparative

advantage is labor productivity

- Labor productivity is attributed to

differences in technology

• Countries trade because of

differences in labor productivity

HECKSCHER–OHLIN

• Comparative advantages arise from different endowments of capital and labor

• Capital and labor are variable factors

of productivity

• Countries trade because of different relative amounts of capital and labor

- Efficiency of production matters

• This model allows for income redistribution between owners and capital and labor through trade

3 Trade and capital flows:

restrictions and agreements

• A tariff is a tax levied by a government on imported goods.

- Intended to protect domestic industries

- Increases welfare of domestic country if (1) there is no retaliation, and (2) the deadweight loss is less than the benefit from improving trade

• An import quota is a restriction on the quantity of a good that can be imported.

- Controlled through import licenses

- Importers earn quota rents if they charge a higher price with a quota

• An export subsidy is a payment by a government to a firm when it exports a

specified good

- Encourages firms to shift to export goods, increases the domestic price

- A voluntary export restraint (VER) is a voluntary limit on goods exported to

a specific country

- Allows exporter to earn quota rents

Trade and capital restrictions

• Domestic content provisions are requirements that a specific portion of

value-added or components be produced domestically

• Capital restrictions are controls placed on ownership of assets, either of

foreign assets or of ownership of domestic assets by foreign persons or firms

• The effect of restrictions on trade and capital depends on whether the country

is a price taker or can affect price:

- A small country in the context of international trade is a price taker

- A large country in this context can influence the price.

Summary of effects

Tariff Import Quota Subsidy Export

Voluntary Export Restraint (VER)

Trading blocs

A trading bloc is an agreement among countries to work toward eliminating

trade barriers Trading blocs may be regional (e.g., NAFTA, EU), yet there are different degrees of integration possible

Why trading blocs?

1. Increased competition

- Lowers prices and increases quantity

2. Cost of production declines

- Easier access to natural resources and technology

3. Increased access to technology and knowledge

4. Increased specialization

5. Greater opportunity for economies of scale

6. Increased employment

7. Increased income

8. Increased interdependence among members

- Less chance of conflicts

Trading blocs and capital restrictions

• Possible results of trading blocs:

- Trade creation: Replacement of higher-cost domestic production by

lower-cost imports

- Trade diversion: Replacement of lower-cost imports from nonmembers by

higher-cost imports from members

• Impediments to effectiveness of trading blocs:

- National sovereignty concerns

- Differences in tastes, culture, and competitive conditions among members

• Capital restrictions may affect inflows, outflows, or both:

- May be in the form of taxes, price or quantity controls, or prohibitions

CREDITSDecrease in Assets, Increase in LiabilitiesValue of imported goods and

Balance of trade components

International monetary fund

• The purpose of the International Monetary Fund is to stabilize exchange

rates and the system of international payments

- Provides a forum for cooperation

- Facilitates growth in international trade

- Promotes employment, economic growth, and poverty reduction

- Lends foreign currencies to member countries that are experiencing trade deficits

• In response to the global financial crisis, the IMF has expanded its scope to include monitoring of economies, risk, capital market developments, and financial sector vulnerabilities

The World Bank Group

• The objective of the World Bank is to help developing countries fight poverty and enhance environmentally sound economic growth

• Economic development in developing nations requires strong governmental system, developed legal and judicial systems, individual and property rights, support of contracts, financial systems robust enough for all sizes of business, and willingness and ability to fight corruption

• It provides funds, as well as technical and financial expertise, to developing nations

- It helps to create the basic economic infrastructure for a developing nation

• Nonprofit affiliates:

- International Bank for Reconstruction and Development (IBRD)

- International Development Association (IDA)

The World Trade Organization

• The purpose of the World Trade Organization is to provide the legal and

institutional foundation for the multinational trading system

• It addresses barriers to trade and subsidies that inhibit trade

• The WTO implements and administers individual agreements, which

encourages trade by providing a platform for negotiations and settling of disputes

Conclusions and summary

• The benefits of trade include gains from exchange and specialization, gains from economies of scale, a greater variety of products available to households and firms, increased competition, and more efficient allocation of resources

• A country has an absolute advantage in producing a good (or service) if it is able to produce that good at a lower absolute cost or use fewer resources in its production than its trading partner

• A country has a comparative advantage in producing a good if its opportunity

cost of producing that good is less than that of its trading partner.

- In the Ricardian model of trade, comparative advantage and the pattern of trade are determined by differences in technology between countries

- In the Heckscher–Ohlin model of trade, comparative advantage and the

pattern of trade are determined by differences in factor endowments between countries

• Trade barriers prevent the free flow of goods and services among countries Governments impose trade barriers for various reasons, including to promote specific developmental objectives, to counteract certain imperfections in the

Conclusions and summary

• In a small country, trade barriers generate a net welfare loss arising from

distortion of production and consumption decisions and the associated

inefficient allocation of resources

• Trade barriers can generate a net welfare gain in a large country if the gain

from improving its terms of trade (higher export prices and lower import prices) more than offsets the loss from the distortion of resource allocations But the large country can only gain if it imposes an even larger welfare loss on its

importing country is generally greater with a quota

A voluntary export restraint is imposed by the exporting country It has the

Conclusions and summary

• An export subsidy encourages firms to export their product rather than sell it in the domestic market The distortion of production, consumption, and trade

decisions generates a welfare loss The welfare loss is greater for a large

country because increased production and export of the subsidized product reduces its global price—that is, worsens the country’s terms of trade

• Capital restrictions are defined as controls placed on foreigners’ ability to own domestic assets and/or domestic residents’ ability to own foreign assets In

contrast to trade restrictions, which limit the openness of goods markets,

capital restrictions limit the openness of financial markets

• A regional trading bloc is a group of countries that have signed an agreement

to reduce and progressively eliminate barriers to trade and movement of

factors of production among the members of the bloc

• From an investment perspective, it is important to understand the complex and dynamic nature of trading relationships because they can help identify potential profitable investment opportunities as well as provide some advance warning signals regarding when to disinvest in a market or industry

Conclusions and summary

• The major components of the balance of payments are the current account balance, capital account balance, and the financial account

• Created after WWII, the International Monetary Fund, the World Bank, and the World Trade Organization are the three major international organizations that provide necessary stability to the international monetary system and facilitate international trade and development

- The IMF’s mission is to ensure the stability of the international monetary

system

- The World Bank helps to create the basic economic infrastructure essential for creation and maintenance of domestic financial markets and a well-

functioning financial industry in developing countries

- The World Trade Organization’s mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules