Goods Prices and Factor Prices: The Distributional Consequences of International Trade

International Economics

Nothing is accomplished until someone sells something.

(popular business saying)

Chapter 4

The Goals of this Chapter for ECN 665

• Use the general equilibrium model to understand how price changes lead to winners and losers.

• Use different models to identify these winners and losers.

• Introduce a two-country partial equilibrium model to see how shocks to supply and demand affect the terms of trade.

• Use the partial equilibrium model to illustrate how consumers and producers are affected by international trade.

Who Wins and Who Loses?

• Trade affects relative prices.• Changes in domestic relative prices

influence factor rewards (e.g. wages) as well as the prices of goods we buy.

• We can use different characterizations of the economy (i.e. models) to predict how real factor rewards respond to a price change.

Trade in a one-factor model

• The Ricardian model assumes there is only one factor, labor.

• Trade occurs because of differences in labor productivity.

• Trade raises real GDP. Because everyone is alike, everyone gains.

• Distribution is simple and unrealistic!

Trade based on factor proportions

• Opening a country to trade (or reducing tariffs or quotas) raises the relative price of the exportable relative to the importable.

• What happens to factor rewards depends on how this price change affects the demand and supply of each factor.

The Heckscher-Ohlin Model

• Two industries: labor-intensive and capital-intensive

• Two factors: labor and capital

• Both factors are assumed to be in fixed supply and perfectly mobile across sectors. THIS MOBILITY ASSUMPTION IS VERY IMPORTANT.

The Heckscher-Ohlin Model (2)

• Suppose freer trade raises the relative price of the labor-intensive good ( as it would in a labor-abundant country).

• The higher price for the labor-intensive good leads this industry to expand and the capital-intensive industry to contract.

• These production responses raise the wage and lower the rental on capital.

The Heckscher-Ohlin Model (3)

• We summarize this analysis with the Stolper-Samuelson Theorem: an increase in the relative price of the labor (capital) intensive good raises the real return to labor (capital) and lowers the real return to the other factor.

• Notice the REAL return is driven up or down.

What if factors are not mobile?

• Then the demand for factors is linked only to the sector in which the factor works.

• We summarize this insight in the specific factors model: specific factors gain in real terms when the price of the product they produce increases (and lose when it falls).

What if gains come because trade increases scale and/or variety?

• We need to introduce increasing returns to scale and differentiated products.

• It is possible for everyone to gain when trade is based on IRS industries.

• There is a danger only in a small subset of cases: when countries are large enough to produce IRS goods but not large enough to do so on a big scale.

Measuring the Welfare Gains from Exchange:Producer Surplus and Consumer Surplus

• Producer surplus: The net gains to producers of a product, equal to the total revenue minus the sum of marginal (variable) costs.

• Consumer surplus: The net gains for consumers of a product, equal to the sum of all marginal gains minus the market price paid for the products.

The Market for T-shirts

• Equilibrium price = $6

• Equilibrium quantity = 50 S

T-shirts 0 50

Producer Surplus

• Equilibrium quantity = 50

• Producer surplus = $125 ($5x50 = $250/2 = $125)

T-shirts 0 50

ProducerSurplus

Consumer Surplus

• Equilibrium quantity = 50

• Producer surplus = $125 ($5x50/2 = $250/2 = $125)

• Consumer surplus = $75 (3x50/2 = $150/2 = $75)

T-shirts 0 50

Consumer Surplus

The Total Gains from Exchange

• Equilibrium price = $6• Equilibrium quantity = 50• Producer surplus =

($5x50)/2 = $250/2 = $125

• Consumer surplus = $75 ($3x50)/2 = $150/2 = $75

• Total gains from exchange equals consumer surplus plus producer surplus

• Gains from exchange = ($8x50)/2 = $400/2 = $200

T-shirts 0 50

Consumer Surplus

Producer Surplus

The Two-Country Partial equilibrium Model

• The textbook emphasizes two-country models in order to remind you that what happens in one country affects markets in other countries.

• Partial equilibrium models assume “all other things remain equal” in other markets, obviously an unrealistic assumption.

• But, a two-country partial equilibrium model can isolate how, all other things equal, a change in a market in one country affects the market for the same product in another country.

• Specifically, the two-country partial equilibrium model lets us estimate the changes in consumer and producer surplus in the two countries.

Figure 4.5 The Markets for Corn in Heartland and Orient

0 Tons 0 Tons 0 Tons

Heartland The International Market Orient

The International Market for Corn: Heartland’s International Supply Curve

PS S S

The International Market for Corn: Orient’s International Demand Curve

The International Market for Corn: Where Heartland’s International supply and Orient’s International Demand Meet

PS S S

60 75 90 25 35 5530

Exports Trade Imports

The International Market for Corn: Heartland’s Producers Gain Surplus

PS S S

60 75 90 25 35 5530

Added Producer Surplus

The International Market for Corn: Heartland’s Consumers Lose Surplus,But Heartland’s Net Welfare Gain Is Positive

PS S S

60 75 90 25 35 5530

Heartland’s Net Welfare Gain

ConsumerSurplus Lost

The International Market for Corn: Orient’sConsumers Gain Surplus

PS S S

60 75 90 25 35 5530

Gain in Consumer Surplus

The International Market for Corn: Orient’s Producers Lose Surplus, But Orient’s Net Welfare Gain Is Positive

PS S S

60 75 90 25 35 5530

Orient’s Net Welfare Gain

Loss of Producer Surplus

The Welfare Gains from Trade

• Heartland producers gain surplus.

• Heartland consumers lose surplus.

• Orient producers lose surplus.

• Orient consumers gain surplus.

• But remember that we do not trade in one good – these changes are only for one market.

Applying the Two-Country Partial Equilibrium Model

• Now that you understand the two-country partial equilibrium model and how to calculate the welfare gains from international exchange, you are ready to apply the model.

• One interesting case is to examine the welfare effects of an increase in foreign demand for a product.

• Specifically, suppose that in a certain market, demand increases in the foreign country that currently imports the good.

The International Market for Corn: An Increase in Demand in Orient

P P PS S S

60 75 90 25 35 5530

The International Market for Corn:Adjustments in Heartland and the International Market after the increase in demand in Orient

P P PS S S

60 75 90 25 35 5530 40

27 6755 95

The International Market for Corn:

In both countries, the net gains from trade increase after the rise in demand in Orient

P P PS S S

60 75 90 25 35 5530 40

27 6755 95

The Net Gains from Trade Increase in Both Countries after the Rise in Demand in Orient

• An increase in foreign demand raises the price of corn in both countries.

• Producers in Heartland gain welfare.

• Consumers in Orient gain welfare.

• The net gains from exchange increase in both countries.

P P PS S S

60 75 90 25 35 5530 40

27 6755 95

Analyzing the Effect of Transport Costs on International Trade

• The partial equilibrium model can be used to analyze how transport costs affect international trade.

• Transport costs in effect drive a wedge in between the price received by an exporter and the price paid by a foreign importer.

• Transport costs increase the cost of products to the final user, and it should not be surprising that they reduce both the volume of trade and the gains from trade.

• The analysis of transport costs uses the concepts of consumer and producer surplus.

• Consumer surplus is equal to the area A

• Producer surplus is equal to the area B

• The net gains from exchange are equal to the areas A + B

Figure 4.10The Market Equilibrium in the Absence of Transport Costs

0 40 Q

Figure 4.11 Transport Costs Reduce theVolume of International Trade

• Transport costs of $40 raise the effective international supply curve from S to ST.

• Transport costs drive a “wedge” between what suppliers receive and consumers pay.

• The volume of trade falls from 40 to 20.

• Producer surplus is reduced to area b.

• Consumer surplus is reduced to area a.

0 20 40 Q

Figure 4.12A Decline in Transport Costs from $40 to $20

• Decreasing transport costs increase trade.

• The international supply curve shifts down to ST2.

• The equilibrium price falls to $60.

• The gains from trade rise from a + b to a + b + c + d.

0 20 30 40 Q

Trade and Transport Costs

• An increase in transport costs reduces the gains from trade for both the importing and exporting countries.

• A decline in transport costs increases the gains from trade.

• Most of the increase in trade during the past two centuries is due to improvements in the efficiency of transportation.

The Effect of Trade on Price Competition

• The partial equilibrium model is also useful for analyzing the gains from trade under imperfect competition.

• International trade increases the number of potential suppliers, which tends to increase price competition.

• Increased price competition reduces monopoly profit and deadweight losses.

• The effect of increased competition can be visualized by comparing consumer and producer surplus under imperfect competition and under perfect competition.

Figure 4.16Profit in an Imperfectly-Competitive Market

• Imperfectly competitive firms face a downward-sloping demand curve D.

• Profit-maximizing firms equate marginal revenue equal marginal cost.

• Prices exceed marginal cost.• The quantity supplied, q, is

less than the quantity, Q, that would be supplied under perfect competition.

• Total welfare is reduced by the “deadweight” loss, which is equals to area D.

Quantityq

Figure 4.17International Competition Can Eliminate the Deadweight Loss of Imperfect Competition

• When firms face the horizontal demand curve in a competitive global market, price declines from p to P.

• Consumption shifts from c to C.

• The competitive market eliminates the deadweight loss.

Quantityq

DINTPC

Goods Prices and Factor Prices: The Distributional Consequences of International Trade

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