International Economics CH 1 & 2 Student Notes PDF

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This document provides an overview of fundamental international economic concepts. It discusses topics such as microeconomics, macroeconomics, and the cost-benefit principle.

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INTERNATIONAL ECONOMICS CH 1 By professor Cristina Vinyes What is Economics about? Is the social science of satisfying unlimited wants with scarce resources - trade-offs – having more of one good thing usually means having less of another. Two perspectives: Microecono...

INTERNATIONAL ECONOMICS CH 1 By professor Cristina Vinyes What is Economics about? Is the social science of satisfying unlimited wants with scarce resources - trade-offs – having more of one good thing usually means having less of another. Two perspectives: Microeconomics ▪ Decision making ▪ How individual decisions interacts ▪ The study of cost and benefits in decisions process, markets and prices, public intervention, etc. Macroeconomics ▪ Evolution of the economy ▪ The study of macroeconomic aggregates (GDP, price levels, income distribution, etc.) and their evolution in the short and long-run (i.e., economic growth) Cristina Vinyes How is economics analyzed? With scientific methods  Observe reality  Try to understand it  Test, correct, test again,… Theory (economic models) And data (econometrics) Understand problems, predict, recommend (policy), etc. Cristina Vinyes The Cost-Benefit Principle ❑ What is the additional benefit of taking an action? ❑ What is the additional cost of taking an action? ❑ An individual should take an action if, and only if, the extra benefits (MB) from taking the action are at least as great as the extra costs (MC). ❑ Should we reduce the class size from 100 students to 10 students? Reduce if, and only if, the value of the improvement in instruction outweighs its additional cost. Cristina Vinyes The Not-All-Costs-and-Benefits- Matter-Equally Principle ❑ Some costs and benefits matter in making decisions e.g., opportunity costs, marginal costs, marginal benefits ❑ Some costs and benefits do not matter in making decisions e.g., sunk costs, average costs, average benefits Cristina Vinyes Failure to Understand the Average-Marginal Distinction When the problem is to discover the proper level at which to pursue an activity, the cost-benefit rule is to: Keep on increasing the level of activity as long as marginal benefit of the activity exceeds its marginal cost. The decision process does not involve the concept of “average.” That is, a comparison between the average benefit and average cost is not relevant to the decision making. The average benefit and average cost comparison may be very favorable. But, so what! It is the next thing that would happen that matters. Cristina Vinyes How Many Space Shuttles Should NASA Launch? Number of Total Cost Average Cost Marginal Cost Launches ($ billion) ($ billion/launch) ($ billion) 0 0 0 3-0=3 1 3 3/1 = 3 7-3=4 2 7 7/2 =3.5 12-7=5 3 12 12/3=4 20-12=8 4 20 20/4=5 32-20=12 5 32 32/5=6.4 Cristina Vinyes Number of Total Cost Average Cost Marginal Cost Launches ($ billion) ($ billion/launch) ($ billion) 0 0 0 3-0=3 1 3 3/1 = 3 6 7-3=4 2 7 7/2 =3.5 6 12-7=5 3 12 12/3=4 6 STOP 20-12=8 4 20 20/4=5 6 32-20=12 5 32 32/5=6.4 Suppose the benefit of each launch is $6 billion. That is, the marginal benefit of the launch stays at $6 billion, regardless of the number of launches. How many space shuttles should NASA launch? Cristina Vinyes Characteristics of Perfectly Competitive Markets Four conditions that best describe perfectly competitive markets: All firms sell the same standardized product. Probably not ever satisfied but it holds as a rough approximation for many markets. It implies that buyers are willing to switch from one seller to another if can obtain a lower price. The market has many buyers and sellers, each of which buys and sells only a small fraction of the total quantity exchanged. It implies that individual buyers and sellers will be price takers, taking the market price as a fixed number beyond their control. Productive resources are mobile (free entry/exit). Its implies that if a potential seller identifies a profitable business opportunity in a market, he or she will be able to obtain the labor, capital, and other productive resources necessary to enter that market. By the same token, sellers who are dissatisfied with the opportunities they confront, are free to leave the market and employ their resources elsewhere. Buyers and sellers are well informed. This condition implies that buyers and sellers are aware of the relevant opportunities available to them. Cristina Vinyes Perfectly Competitive Markets: Examples The market for wheat closely approximates a perfectly competitive markets. If an individual wheat farmer were to charge, even just 10 cents more than the prevailing market price for a bushel of wheat, he would not be able to sell any of his wheat at all. And since he can sell as much wheat as he wishes at the prevailing market price, he has no motive to charge less. Because of their inability to influence market price, perfectly competitive firms are often described as price takers. By contrast, the market for operating systems for desktop computers does not approximate a perfectly competitive market. If Microsoft were to raise the price of its latest edition of Windows by, say, 20 percent, some consumers might switch to Macintosh or Linux, and others might postpone their next upgrade; but many – perhaps even most – would continue with their plans to buy Microsoft. Cristina Vinyes Supply and Demand Model Markets and prices Supply, demand and the equilibrium 5 key elements: Demand curve Supply curve Factors shifting the curves Market equilibrium Changes in the equilibrium Cristina Vinyes Cotton market Cristina Vinyes What Is International Economics (IE) About? Old subject! But it continues to grow in importance as countries become tied to today’s global economy. ▪ It studies how nations interact with each other ▪ Mainly through trade of goods and services (International Trade) but also through flows of money and through investment (International Money). ▪ IE also deals with international issues like migration, management of global resources, global conflicts and cooperation, etc. Cristina Vinyes GDP comparison challenge across countries Purchasing Power Parity (PPP) Adjustment: PPP is the amount of adjustment needed on the exchange rate between countries for the rate to be equivalent to each currency’s purchasing power. PPP adjustment allows to make a fair international comparison by using a common set of prices. A logo of a fast food restaurant Description automatically generated The richer the country, the smaller the adjustment needed, for example Sweden and the U.S. Cristina Vinyes GDP comparison challenge across countries Purchasing Power Parity (PPP) Adjustment: Cristina Vinyes GDP comparison challenge across countries Purchasing Power Parity (PPP) Adjustment: India’s GDP: ₹295 trillion Current market exchange rate: ₹84/$ India’s GDP using market exchange = Numerical example Nontraded goods sell for 1/10 the price in India than in USA PPP Adjustment: And 80% of India’s GDP does not enter world trade: Purchasing power adjusted exchange rate = India’s GDP in ppp dollars = Cristina Vinyes GDP comparison challenge across countries Purchasing Power Parity (PPP) Adjustment: YOUR TURN Brazil’s GDP: R$12 trillion Current market exchange rate: R$5.25/$ Brazil’s GDP using market exchange = Numerical example Nontraded goods sell for 1/8 the price in Brazil than in USA: PPP Adjustment: And 70% of Brazil’s GDP does not enter world trade: Purchasing power adjusted exchange rate = Brazil’s GDP in ppp dollars = Cristina Vinyes Basics of International Economics Basic concepts: ❑ Imports: purchase of goods or services from another country ❑ Exports: sale of goods or services to other countries ❑ Trade Balance: the difference between the total value of exports and the total value of imports ❑ Trade Surplus: when a country exports more than it imports ❑ Trade Deficit: when a country imports more than it exports Cristina Vinyes Relevance of international trade: ❑ International trade as a fraction of the national economy has tripled for the US in the past 40 years. ❑ Compared to the U.S., other countries are even more tied to international trade. ❑ Trade links societies and people and is a force for prosperity and world peace! ❑ Trade as an engine for development Cristina Vinyes Relevance of international trade in USA Average of Exports and Imports as Percentage of National Income in 2021 Cristina Vinyes Relevance of international trade in USA Exports and Imports as a Percentage of U.S. National Income Cristina Vinyes Why do we trade? Gains from Trade Several ideas underlie the gains from trade 1. A voluntary transaction, both receive something that they want, and both can be made better off. Example: ❑ Norwegian consumers could buy oranges through international trade that they otherwise would have a difficult time producing. ❑ The producer of the oranges receives income that it can use to buy the things that it desires. Cristina Vinyes Gains from Trade (cont.) Differences in climate and resources can explain why Brazil exports coffee and Australia exports iron ore. But why does Japan export automobiles, while the US exports aircraft? 2. Efficient use of time (labour productivity) ❑ Countries can specialize in production, while consuming many goods and services through trade. 3. More efficient use of endowments. Relative supplies of capital, labor and land. ❑ Exports goods which use its abundant resources and imports goods which use its scarce resources. 4. More efficient due to large scale production. Cristina Vinyes Protectionism vs free trade Trade is predicted to benefit countries in several ways, but trade may harm has within a country. ❑ International competition on domestic industries (import- competing industries). ❑ Trade may therefore have effects on the distribution of income within a country. ❑ Less-skilled workers in the US have seen their salaries decline although the country has become richer. ❑ Some attribute this to the growing exports of manufactured goods from low-wage countries. Cristina Vinyes WORLD TRADE: AN OVERVIEW CH2 By professor Cristina Vinyes Cristina Vinyes Preview 1. Outlook on Main trends: Map of World Trade A. Largest trading partners of the United States 2. Gravity model: A. Influence of an economy’s size on trade B. Distance and other factors that influence trade C. Borders and trade agreements 3. Changing pattern of World Trade A. Globalization: then and now B. Changing composition of trade C. Service outsourcing Cristina Vinyes WORLD MAP Cristina Vinyes Peter’s World map Presents countries in their true proportion to one another: 28 1. Outlook on Main Trends: Map of World Trade World Trade in Goods, ($ billions) No services taken into account Cristina Vinyes 1. Outlook on Main Trends: Map of World Trade European Trade Trade within Europe is the largest, about 21% of world trade. ▪ EU trade within because there are many countries located near to each other. ▪ EU countries have eliminated internal trade barriers ▪ EU has 27 members Cristina Vinyes 1. Outlook on Main Trends: Map of World Trade European & US Trade European and the US account for 26% of world trade flows. Why? ▪ Differences among these countries explain some of the trade between them: “old” trade theory ▪ Despite this, industrialized countries like U.K. and US have many similarities and trade more among them: “new” trade theory. Cristina Vinyes 1. Outlook on Main Trends: Map of World Trade Trade in the Americas Trade between North, Central and South America and the Caribbean totals 8% of world trade flows. ▪ One-half the trade within EU ▪ Mostly within USMCA (US, Mexico & Canada) 2020 Unlike the EU, USMCA is unlikely to add new countries (distances are large) Cristina Vinyes 1. Outlook on Main Trends: Map of World Trade Trade with Asia All exports from Asia total 29% of world trade. ▪ Historically Japan has been the largest exporting country. ▪ Exports from China alone has increased so much that since 2014, is the largest export country in the world! Cristina Vinyes World’s top exporters, 1995-2014 China has become the world’s leading exporter. Source: WTO 2014 Cristina Vinyes 1. Outlook on Main Trends: Map of World Trade Other Regions Middle East and Russia (and clos by countries) export around 9% of world trade: ▪ Oil and natural gas are important goods exported from these regions. Africa accounts for only 2% of world trade ▪ Very small given its size ( 20% of world land) and population (17% of world population). ▪ Getting Africa out of poverty may require improve its linkages with the world through trade ( trade as an engine for development). Cristina Vinyes World trade Shares of World Trade, Accounted for by Selected Regions, 2018 36 1A. Largest trading partners of the US Explaining the arrows in the map: ❑The 5 largest trading partners with the U.S. in 2015 were Canada, China, Mexico, Japan, and Germany. ❑The largest 20 trading partners of the U.S. accounted for 80% of the value of U.S. trade in 2021. Cristina Vinyes Fig. 2-1: Total U.S. Trade with Major Partners, 2022 Total US Trade with major trade partners (billion $, 2022) Belgium Italy Netherlands Saudi Arabia India Brazil Taiwan France United Kingdom South Korea Germany Japan Mexico China Canada 0 100 200 300 400 500 600 700 Source: U.S. Department of Commerce Cristina Vinyes 2. The Gravity Model ❑ 3 of the top 10 trading partners with the U.S. were also the 3 largest European economies: Germany, U.K., and France. ❑ These countries have the largest gross domestic product (GDP) in Europe. ▪ GDP measures the value of goods and services produced in an economy. ❑ Why does the U.S. trade most with these European countries and not other European countries? Cristina Vinyes 2. The Gravity Model In fact, the size of an economy is directly related to its volume of imports and exports. ❑ Larger economies produce more goods and services, so they have a wide range of products to export. ❑ Larger economies generate more income from the goods and services sold, so they are able to buy more imports. Cristina Vinyes Fig. 2-2: The Size of European Economies, and the Value of Their Trade with the United States GRAVITY MODEL: Relation among international trade volume and the size of EU economies. No strong outliers Source: U.S. Department of Commerce, European Commission Cristina Vinyes 2. The Gravity Model In its basic form, the gravity model assumes that only size and distance are important for trade in the following way: Tij = Yi x Yj /Dij where Tij is the value of trade between country i and country j Yi the GDP of country i Yj is the GDP of country j Dij is the distance between country i and country j Cristina Vinyes 2. The Gravity Model ❑ Despite its simplicity, the gravity model works fairly well in predicting actual trade flows, as figure 2-2 above representing U.S.–EU trade flows suggested. ❑ Trade flows are well predicted by the gravity model but there are many other factors fostering and limiting trade. ❑ Gravity model helps us to see when two countries trade more than expected (or less than expected) ❑ We then look for explanations Cristina Vinyes Fig. 2-2: The Size of European Economies, and the Value of Their Trade with the United States Netherlands and Belgium: Geography and transportation costs Ireland: language, cultural affinity and US-based corporations Source: U.S. Department of Commerce, European Commission Cristina Vinyes DISTANCE: Fig. 2-3: Economic Size and Trade with the US Distance: 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0.7% to 1%. Source: U.S. Department of Commerce, European Commission. Cristina Vinyes 2. The Gravity Model Other things besides size and distance matter for trade and are NOT explained in the gravity model: 1. Cultural affinity: if two countries have cultural ties, it is likely that they also have strong economic ties. 2. Geography: ocean harbors and a lack of mountain barriers make transportation and trade easier. 3. Multinational corporations: corporations spread across different nations import and export many goods between their divisions. Cristina Vinyes 2. The Gravity Model 4. Borders: crossing borders involves formalities that take time and perhaps monetary costs like tariffs, or different languages, currencies… which reduce trade. For example, US and Canada: ▪ There is a free trade agreement ▪ Share common language, still, borders reduce trade. The gravity model can assess the effect of trade agreements on trade: does a trade agreement lead to significantly more trade among its partners than the gravity model would predict? ▪ Because of NAFTA and distance, the amount of trade between the U.S. and Mexico and Canada as a fraction of GDP is larger than between the U.S. and EU countries. Cristina Vinyes 3.Changing Composition of Trade WHAT DO WE TRADE? What kinds of products do nations trade now, and how does this composition compare to trade in the past? ❑ Today, most (about 53%) of the volume of trade is in manufactured products such as automobiles, computers, clothing and machinery. ❑ Services such as shipping, insurance, legal fees, and spending by tourists account for about 20% of the volume of trade. ❑ Mineral products (ex., petroleum, coal, copper) and agricultural products are a relatively small part of trade. Cristina Vinyes Fig. 2-5: The Composition of World Trade, 2011 Cristina Vinyes Is Trade Today Different from the Past? The Changing Face of U.S. Import Industries, 1925–2018. The types of goods imported by the United States have changed drastically over the past century. Foods, feeds, and beverages and industrial supplies were 90% of imports in 1925 but represented only 30% in 2018. 50 Is Trade Today Different from the Past? The types of goods exported by the United States have also changed drastically over the past century. Capital plus consumer goods plus automobiles have increased from 20% of exports in 1925 to 60% of exports in 2018. 51 3C. Service Potential Service has the great potential to become the sector with the biggest share in trade as many services can be outsourced (which occurs when a firm that provides services moves its operations to a foreign location). For example, a firm’s customer service centers. Although service outsourcing is currently not a significant part of trade ❑ About 40% of jobs are “tradable” and thus have the potential to be outsourced, of which 20% are in services. (e.g. Doctor’s opinion) ❑ Around 60% of jobs are non-tradable because they need to be done close to the customer. (e.g. Dentist) Cristina Vinyes

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