International Politics and Market Economy Economics Part Tutorial 1 PDF

International Politics and Market Economy Economics Part Tutorial 1 Tim Hug University of St. Gallen 12th November 2024  The Marginal Principle «Process of making decisions by considering the...

International Politics and Market Economy Economics Part Tutorial 1 Tim Hug University of St. Gallen 12th November 2024  The Marginal Principle «Process of making decisions by considering the incremental changes that result from a small, incremental change in a variable.» What happens if we do a little more (or a little less)? Simple examples A rm is deciding whether to produce one additional pencil or not. A rm is deciding whether to hire one additional worker or not. I am deciding whether I am drinking another glass of water or not. … Tim Hug International Politics and Market Economy – Tutorial I Slide 2 fi fi  Important Concepts Marginal Cost Additional cost incurred from producing (or consuming) one additional unit of a good or service e.g., producing one additional pencil requires an additional hour of work Marginal Bene t Additional bene t incurred from producing (or consuming) one additional unit of a good or service e.g., selling one additional pencil yields $20 in revenue ⇒ When does it make sense to produce an additional pencil? Tim Hug International Politics and Market Economy – Tutorial I Slide 3 fi fi  Optimal Decision Making Individuals should continue producing pencils until the marginal bene t equals the marginal costs → At this point, pro ts (or utility) are maximised Example Suppose that a price-taking rm can produce an additional pencil at the cost of $0.5q where q is the quantity produced. Moreover, assume that the market price for pencils equals $4.00. What is the optimal amount of production? Tim Hug International Politics and Market Economy – Tutorial I Slide 4 fi fi fi  Sunk Cost Fallacy Suppose you are watching a movie and after 30 minutes you realise it’s not what you expected. → Would you continue watching or not? Rationale I continue watching because I already invested 30 minutes into watching the movie. I stop and switch to another movie that is more exciting. Tim Hug International Politics and Market Economy – Tutorial I Slide 5  Sunk Cost Fallacy Suppose you are watching a movie and after 30 minutes you realise it’s not what you expected. → Would you continue watching or not? Rationale I continue watching because I already invested 30 minutes into watching the movie. ⇒ Sunk cost fallacy I stop and switch to another movie that is more exciting. ⇒ Rational under marginal thinking Tim Hug International Politics and Market Economy – Tutorial I Slide 6  Supply & Demand Tim Hug International Politics and Market Economy – Tutorial I Slide 7  Supply and Demand Law of Demand. Quantity that an individual is willing to buy is decreasing in the price. Law of Supply. Quantity that an individual is willing to sell is increasing in the price. Price Quantity Tim Hug International Politics and Market Economy – Tutorial I Slide 8  Neoclassical Labor Market Theory Perfectly competitive market Firms Demand labor to produce goods → Maximise pro ts: max p ⋅ F(L, ⋅ ) − w ⋅ L L Households Decide on their consumption and their labor supply → Maximise utility: max U(C, L) s.t. p⋅C=w⋅L L,C Tim Hug International Politics and Market Economy – Tutorial I Slide 9 fi  Firms LABOR DEMAND Demand another unit of labor if it will raise more revenue than it costs Optimum: MPL = MC Remember the pro t function: Π = p ⋅ F(L, ⋅ ) − w ⋅ L Y w L L Tim Hug International Politics and Market Economy – Tutorial I Slide 10 fi  Households LABOR SUPPLY Consumption–labor–decision Labor is costly in terms of utility An increase in income allows for more consumption w L L N Tim Hug International Politics and Market Economy – Tutorial I Slide 11  Equilibrium LABOR MARKET CLEARS w w1 Excess demand L w1: excess demand driving wages up Tim Hug International Politics and Market Economy – Tutorial I Slide 12  Equilibrium LABOR MARKET CLEARS w Excess supply w2 w1 L w1: excess demand driving wages up w2: excess supply driving wages down Tim Hug International Politics and Market Economy – Tutorial I Slide 13  Equilibrium LABOR MARKET CLEARS w w2 w* w1 L L* w1: excess demand driving wages up w2: excess supply driving wages down → in equilibrium there is no involuntary unemployment Tim Hug International Politics and Market Economy – Tutorial I Slide 14  Labor & Capital Production function: F(L, K) Upward-sloping and concave MPL is increasing in K implying FLK > 0 → What happens to labor demand when K increases? w L Tim Hug International Politics and Market Economy – Tutorial I Slide 15  High-Skilled & Low-Skilled Labor Production function: F(Ll, Lh) Pro t function: Π = F(Ll, Lh) − wL ⋅ Ll − wh ⋅ Lh → Assume low- and high-skilled labor is complementary → What happens if there is low-skilled immigration? wl wh w* h w* l Ll Lh L* l L* h Tim Hug International Politics and Market Economy – Tutorial I Slide 16 fi  Introduction to International Trade Tim Hug International Politics and Market Economy – Tutorial I Slide 17  Why do Countries Trade? Countries are different from each other in terms of technology, geography, endowment, … Specialisation allows to achieve economies of scale ⇒ Trade allows to mutually bene t from these differences and economies of scale Tim Hug International Politics and Market Economy – Tutorial I Slide 18 fi  Why do Countries Trade? Countries are different from each other in terms of technology, → Ricardo geography, → Ricardo endowment, → Heckscher-Ohlin … Specialisation allows to achieve economies of scale → Krugman ⇒ Trade allows to mutually bene t from these differences and economies of scale Tim Hug International Politics and Market Economy – Tutorial I Slide 19 fi  Differences in Technology Opportunity Costs. The opportunity costs (OC) of producing a certain good are how much other goods could have been produced with the same resources. Differences in technology drive differences in opportunity costs Example Portugal produces 100l of wine With the same resources, Portugal could produce 10 units of cloth ⇒ What are the opportunity costs of producing 100l of wine? Tim Hug International Politics and Market Economy – Tutorial I Slide 20  Comparative Advantage OC of producing 100l of wine in Portugal are 10 units of cloth Conversely, OC of 10 units of cloth is 100l of wine Suppose this trade-off in England is 100l of wine for 20 units of cloth ⇒ OC of producing wine is higher in England than in Portugal Comparative Advantage. A country has a comparative advantage (CA) in a good if it can produce that good with lower OC relative to another country. ⇒ Portugal has a CA in producing wine and England in producing cloth Tim Hug International Politics and Market Economy – Tutorial I Slide 21  Gains from Trade Portugal could stop producing cloth (rel. high OC) and instead focus on wine (rel. low OC) England could stop producing wine (rel. high OC) and instead focus on producing cloth (rel. low OC) Wine Cloth Portugal + 100l -10 England - 100l 20 World 0 10 ⇒ World economy gained from the specialisation according to CA Tim Hug International Politics and Market Economy – Tutorial I Slide 22  Exercise I: Comparative Advantage Suppose an attorney provides legal services worth $175 per hour and secretarial duties worth $25 per hour. A secretary can provide legal services worth $0 per hour and secretarial duties worth $20 per hour. Who has a comparative advantage in secretarial duties? What about the absolute advantage? Suppose there is one hour of time available, how should they allocate tasks to maximise output? Tim Hug International Politics and Market Economy – Tutorial I Slide 23  Ricardian Trade Model Source of comparative advantage: Technology Two countries. Home and foreign (denoted by *) Identical preferences Labor L and L* is the only factor of production, fully mobile across sectors Perfectly competitive markets Two goods – wine and cheese denoted by w and c Lc Produced with constant returns to scale, e.g. Qc = ac Countries differ in their unit labor requirement ac i.e., how much labor is used to produce one unit of the good Tim Hug International Politics and Market Economy – Tutorial I Slide 24  Production Possibility Frontier CLOSED ECONOMY PPF determines all possible options when employing the total amount of labor L at given productivities ac and aw L ac acQc + awQw = L ⇔ Qw = − Qc aw aw Qw Qc Tim Hug International Politics and Market Economy – Tutorial I Slide 25  Firm’s Problem CLOSED ECONOMY Key assumptions Perfect competition ⇒ Firms take prices as given Constant returns to scale ⇒ Together with perfect competition implies zero pro ts ! Πi = Pi Qi − wi ai Qi = 0 ⇔ Pi = wi ai ⇒ Prices equal marginal costs Tim Hug International Politics and Market Economy – Tutorial I Slide 26 fi  Relative Prices CLOSED ECONOMY Key assumption Labor is fully mobile across sectors ⇒ Identical wages in both sectors wc = ww = w Tim Hug International Politics and Market Economy – Tutorial I Slide 27  Relative Prices CLOSED ECONOMY Key assumption Labor is fully mobile across sectors ⇒ Identical wages in both sectors wc = ww = w Combine this result with the optimality condition Pi = wi ⋅ ai Pc ac ⇒ = Pw aw ⇒ Relative prices equal OC of production Tim Hug International Politics and Market Economy – Tutorial I Slide 28  Open Economy Suppose countries start to trade No trade barriers/costs (without much loss of generality) Assume that ac a* < c aw a*w i.e., Home has a CA in cheese, while Foreign has a CA in wine. World market clears World relative demand equals world relative supply → Relates relative prices and relative quantities Tim Hug International Politics and Market Economy – Tutorial I Slide 29  World Relative Demand & Supply World relative demand (RD) Simplifying assumptions: RD is differentiable and downward-sloping Decrease in relative price → increase in relative demand World relative supply (RS) (Pc /Pw)W < ac /aw : No cheese is produced. Home with CA should produce the rst unit but won’t do it because the relative price is below the OC. (Pc /Pw)W = ac /aw : Home supplies any relative amount of the two goods. (Pc /Pw)W > ac /aw : Home exclusively produces cheese, leading to full specialisation. Further- more, as long as (Pc /Pw)W < a* c /a* w Foreign will only produce wine. Tim Hug International Politics and Market Economy – Tutorial I Slide 30 fi  World Relative Demand & Supply Pc /Pw a* c /a* w RS ac /aw RD RD’ Qc + Q* c Qw + Q* w W aw ( Pw ) ac Pc a* c World prices satisfy: ≤ ≤ a* w Countries are (fully) specialised: Home exports cheese, Foreign exports wine Tim Hug International Politics and Market Economy – Tutorial I Slide 31  Gains from Trade UNDER FULL SPECIALISATION Qw Qw Qc Qc Home Foreign Trade enlarges the consumption possibilities ⇒ Both countries strictly gain by opening to trade Tim Hug International Politics and Market Economy – Tutorial I Slide 32  Exercise II: Ricardian Model Home has 1'200 units of labor available. It can produce two goods, apples and bananas. The unit labor requirement in apple production is 3, while in banana production it is 2. This means that producing an apple in Home requires 3 units of labor, while producing a banana requires 2 units of labor. 1. Draw Home's production possibility frontier. 2. What is the opportunity cost of apples in terms of bananas? 3. In the absence of trade, what would be the price of apples in terms of bananas? Suppose there is a second country Foreign, with 1’000 units of labor available. The unit labor requirement for producing apples equals 4 and for producing bananas it equals 8. 4. Determine the world relative supply curves. Illustrate it graphically. 5. Suppose the world relative demand curve is downwardsloping. What happens to equilibrium prices? Hint: Distinguish three different cases. Tim Hug International Politics and Market Economy – Tutorial I Slide 33  Wrap Up Trade patterns are explained by differences in technology Countries specialise in producing the good where they have a comparative advantage Model predicts full specialisation of at least one country → seems not to hold in the data! Labor is not fully mobile across sectors Trade frictions (e.g., transportation costs) reduce or prevent trade Political interventions distort trade More than one factor of production reduces the tendency to specialise ⇒ Heckscher-Ohlin model Tim Hug International Politics and Market Economy – Tutorial I Slide 34