International Political Economy & Bahrain Economy PDF

504: International Political Economy and Bahrain Economy Lectures 3 & 4 Why Countries Trade Heterogeneous Preferences Countries have di erent needs and preferences, leading to demand for goods and services they don’t produce e ciently. This...

504: International Political Economy and Bahrain Economy Lectures 3 & 4 Why Countries Trade Heterogeneous Preferences Countries have di erent needs and preferences, leading to demand for goods and services they don’t produce e ciently. This drives trade between nations, where each focuses on what they can produce best. Comparative Advantage The principle of comparative advantage explains that countries bene t from trade when they focus on producing goods they can make at a lower opportunity cost than others. This specialization increases global e ciency and overall output. Economies of Scale Specialization leads to economies of scale, where increasing production lowers the per-unit cost, making goods cheaper for everyone. U.S. vs. Colombia: (Comparative Advantage Example) It is much costlier for the U.S. to grow roses in greenhouses than to produce computers. Meanwhile, Colombia can grow roses easily due to its climate but produces fewer computers. By trading roses for computers, both countries bene t from increased global production (seen in the table of hypothetical changes in production). A One-Factor Economy In a one-factor economy, opportunity cost refers to the amount of one good that must be given up to produce an additional unit of another good, using the same factor of production, labor. If it takes 2 units of labor to produce 1 unit of cheese, and 3 units of labor to produce 1 unit of wine, the opportunity cost of producing cheese in terms of wine is: 𝑎𝐿𝑊 2 opportunity cost of cheese = 𝑎𝐿𝐶 3 units of wine This means producing 1 unit of cheese requires sacri cing 2/3 of a unit of wine. Conversely, the opportunity cost of producing wine in terms of cheese is: 𝑎𝐶 3 opportunity cost of wine = 𝑎 𝐿𝑊 2 units of cheese 𝐿 This concept of opportunity cost helps determine which good a country should specialize in to maximize e ciency and trade bene ts. In this example, Home should specialize in producing the good with the lower opportunity cost, such as cheese, while Foreign might specialize in wine if its opportunity cost is lower for that good. A country will specialize in the good where it has the lower opportunity cost. For example: Home produces cheese if the opportunity cost of cheese (in wine) is lower. Foreign produces wine if its opportunity cost of wine (in cheese) is lower. By specializing and trading, both countries can bene t and consume more than they could alone. Relative Prices and Supply Production Possibility Frontier (PPF): shows the maximum combination of two goods a country can produce, but it doesn’t determine what the country will actually produce. What a country does produce depends on the relative prices of the goods in the market. 1. Market Prices and Specialization Suppose cheese sells for $4 per unit and wine sells for $7 per unit. Workers will produce the good that o ers them the higher hourly wage. In this case, since cheese brings in $4 per unit and wine brings in $7 per unit, producing wine seems more pro table. However, what matters is the relative price of cheese compared to wine. The economy will produce more of the good that provides the higher return relative to its opportunity cost.  2. Specialization Based on Relative Prices If the relative price of cheese (P_C) compared to wine (P_W) is greater than the opportunity cost (calculated using labor requirements, a_LC/a_LW), the country will specialize in cheese. In other words, the country will allocate all labor to cheese if: 𝑃𝐶 𝑎𝐿𝐶 𝑃𝑊 > 𝑎𝐿 𝑊 Conversely, if the relative price of cheese falls below the opportunity cost of producing it, the country will shift to producing wine. Example: If the price of cheese falls to $3 while wine remains at $7, the economy will switch to producing wine because it now yields a higher return relative to cheese. The decision to produce one good over another depends on which good o ers more value in terms of the resources (labor) spent on it. 3. No Trade Scenario: Without trade, the country must produce both goods, as it cannot rely on importing one in exchange for the other. In this case, the relative price of the goods will equal their opportunity cost, ensuring that both are produced domestically to meet the country’s needs. Trade in a One Factor World Two Countries, Two Goods. Home and Foreign produce both cheese and wine using only labor. Each country has di erent labor requirements for producing each good. Comparative Advantage: Home has a comparative advantage in cheese if its opportunity cost of cheese is lower than in Foreign: 𝑎𝐿𝐶 𝑎*𝐿 𝐶 (Home’s opportunity cost) 𝑎𝑊 < 𝑎*𝐿𝑊 (Foreign’s Opportunity Cost) 𝐿 a_LC: The amount of labor needed to produce one unit of cheese in Home. a_LW: The amount of labor needed to produce one unit of wine in Home. a_LC*: The amount of labor needed to produce one unit of cheese in Foreign (the asterisk denotes the foreign country). a_LW*: The amount of labor needed to produce one unit of wine in Foreign. Absolute Advantage: means using less labor to produce a good, but trade is based on comparative advantage. Trade and Prices: Trade happens when one country can sell a good for more in the other country due to di erences in relative prices. Equilibrium Price: Trade continues until the relative prices of cheese and wine are equal across countries, reaching an equilibrium where no further trade adjustments are needed. Determining the Relative Price after Trade Assumption: Home has an absolute advantage in both goods (cheese and wine). Foreign’s unit labor requirements are: 𝑎 * 𝐶 = 6 for cheese. 𝐿 𝑎 * 𝑊 = 3 for wine. 𝐿 Opportunity cost of cheese in Foreign: 𝑎* 𝐶 6 𝑂𝐶 = 𝑎* 𝑊 𝐿 = 3 =2 𝐿 𝑎𝐿𝐶 1 Home’s opportunity cost of cheese is 𝑎𝐿𝑊 = 2 , so Home has a comparative advantage in cheese, while Foreign has a comparative advantage in wine. Trade and Single International Price  Trade leads to a single relative price for cheese ( 𝑃𝐶 / 𝑃𝑊). If the relative price of cheese is less than 1/2, neither country will produce cheese because it’s too cheap to be worth producing. If the relative price is greater than 2, both countries will only produce cheese because it becomes highly pro table. Specialization and Complete Specialization When the relative price of cheese is between 1/2 and 2, only Home produces cheese because it has a lower opportunity cost. Foreign specializes in wine, leading to complete specialization for both countries in their comparative advantage goods. Demand Curve and Price Range The equilibrium relative price is determined by world supply and demand. If the demand curve intersects the relative supply curve within the price range (between 1/2 and 2), there will be specialization: Home produces only cheese, and Foreign produces only wine. Conclusion: If the relative price of cheese is higher than the opportunity cost of cheese, produce cheese. Trade Expands Consumption Possibility Key Concept: Trade allows countries to consume beyond their own Production Possibility Frontier (PPF) by specializing in the goods where they have a comparative advantage and then trading for the other goods. This expands the total goods available for consumption. Autarky refers to a situation where a country does not engage in international trade and must rely entirely on its own resources to produce and consume goods. Under autarky, a country’s consumption is limited to its Production Possibility Frontier (PPF), meaning it can only consume what it can produce.  Specialization and Trade In Krugman and Obstfeld’s International Economics: Theory and Policy, specialization and trade are key concepts. When countries specialize in goods where they have a comparative advantage, like Home in cheese and Foreign in wine, they can trade to consume more of both goods than they could without trade. This expands their consumption possibilities beyond their individual PPFs. Numerical Example (Japan and India) Without trade (50/50 split): Japan: 100 units of rice, 100 TVs. India: 200 units of rice, 10 TVs. Total: 300 units of rice, 110 TVs. With specialization (Japan specializes in TVs, India in rice): Japan: 100 TVs. India: 200 units of rice. Total: 200 units of rice, 100 TVs. This shows how specialization based on comparative advantage increases total production and consumption. Example with Double Absolute Advantage Even if India has an absolute advantage in both goods, specialization bene ts both countries: Without trade (50/50 split): 75 units of rice, 55 TVs. With specialization: 80 units of rice, 70 TVs. This proves that trade based on comparative advantage is mutually bene cial, even when one country has an absolute advantage in both goods. The Corn Laws (History) 1815 – After the defeat of Napoleon at the Battle of Waterloo, the Corn Laws were enacted to restrict grain imports into the UK. These laws imposed high tari s on imported grain to protect domestic farmers and keep grain prices high, bene ting landowners.  1832 – The Great Reform Act addressed political imbalances in Britain. Before this, areas like London, Manchester, and Newcastle were underrepresented, while rotten boroughs had disproportionate in uence, giving power to landowners who supported the Corn Laws. Industrial Revolution – During this period, Britain was a global leader in industries like textiles, coal, and steel. While industrialization thrived, population growth increased the demand for food, making the Corn Laws unpopular among urban workers, as food prices soared due to the tari s. Ireland and Food Crises – The Corn Laws worsened food shortages in Ireland, contributing to famine and increasing calls for reform. 1846 – Following widespread discontent and economic hardship, especially due to the Irish famine, the Corn Laws were repealed, marking Britain’s shift towards free trade. Impact By keeping imported grain prices high through steep import duties, the Corn Laws raised food prices and increased the cost of living for British citizens, especially the working class. It also stunted other sectors like manufacturing by limiting disposable income and reducing demand for manufactured goods. Political Outcome Opposition to the Corn Laws came from urban groups seeking reform. They were repealed in 1846 by Prime Minister Sir Robert Peel, largely due to the food crisis from the Great Famine in Ireland. Repeal marked a shift toward free trade in Britain and bene ted the majority of the population economically, while the wealthy landowners saw losses. The Peterloo Massacre Following the Napoleonic Wars, Britain faced a severe economic downturn worsened by the Corn Laws and poor harvests. Voting rights were limited, and industrial areas, especially in northern England, were heavily a ected. In 1819, the Manchester Patriotic Union organized a large rally advocating for parliamentary reform and broader su rage. Authorities responded violently by ordering the Manchester and Salford Yeomanry and the 15th Hussars to break up the crowd, resulting in between 9 and 17 deaths and hundreds of injuries. This event became known as the Peterloo Massacre, named ironically after the Battle of Waterloo. Aftermath: Peterloo was a signi cant political event that led the government to pass the Six Acts, which aimed to suppress future meetings and reform movements. It also contributed to the founding of the Manchester Guardian newspaper. What Happens When You Don’t Trade US Embargo Act of 1807: During the early 19th century, as Britain and France were at war, both countries placed embargoes on each other, and the US wanted to remain neutral. However, American ships were frequently caught in the middle, and US sailors were impressed (forced into military service). Embargo Act: In response, President Thomas Je erson enacted the Embargo Act of 1807 to hurt the British economy. However, this act severely back red, costing the US 8% of its GDP and was repealed a year later. Impressment continued, contributing to the start of the War of 1812. Weaknesses of the Ricardian Model Single Factor of Production: The Ricardian model assumes labor is the only factor of production, ignoring the roles of capital, land, and technology in modern economies. This oversimpli cation makes the model less applicable to real-world trade, where multiple factors interact. Transport Costs: The model ignores transportation costs, assuming frictionless trade, which is unrealistic. High transportation costs can inhibit trade, especially for bulky or perishable goods. Diseconomies of Scale: The model does not account for the fact that beyond a certain point, increasing production can lead to ine ciencies and higher per-unit costs. Specializing too much can create complexities in management and production, raising costs instead of lowering them. Structural Unemployment: Specialization based on comparative advantage may cause job losses in sectors where a country does not have an advantage, leading to structural unemployment. The Ricardian model overlooks the social and economic costs of displaced workers. Exchange Rate Risk: The model assumes stable exchange rates and does not consider the risks associated with uctuating exchange rates, which can impact trade ows and pro tability signi cantly. Static Nature: Comparative advantage in the model is treated as static, ignoring how technological advances, shifts in resource availability, or global demand can change over time, thereby altering a country’s competitive edge. Food Security: Over-specialization in certain goods can leave a country vulnerable to food shortages or supply chain disruptions if it does not produce enough of its own essential goods, such as food. Simplicity: The model typically considers only two goods and one factor (labor), which does not re ect the complexity of real-world trade involving multiple goods, services, and production factors. Why Actual Specialization Is Less Than Predicted by the Ricardian Model Multiple Factors of Production: In reality, countries use a mix of labor, capital, land, and other inputs, unlike the Ricardian model’s single factor (labor) assumption. This diversity reduces the extreme specialization predicted by the model.  Government Protection: Countries often implement tari s, subsidies, and other protectionist measures to protect domestic industries from foreign competition, reducing the level of specialization the model predicts. Transport Costs: High transportation costs make local production or self-su ciency more attractive, especially for services or perishable goods, thus limiting trade and reducing the level of specialization expected in the Ricardian model. Bahrain-Saudi Trade: Exports/Imports Crude Oil Absence: The crude oil pipeline trade between Bahrain and Saudi Arabia is surprisingly missing from the data. This could be due to underrepresentation or a di erence in how this trade is categorized. Similar Goods: Both countries show signi cant overlap in traded goods such as iron and steel, aluminum, and mineral fuels. The presence of the same goods on both sides indicates the speci c and malleable nature of modern specialization, where countries produce and trade very speci c products rather than large categories. Modern Specialization: This overlap re ects how modern specialization is not about broad sectors but highly specialized goods, with limited spillover e ects to other sectors. Economic Homogeneity: Trade between Bahrain and Saudi Arabia is constrained by the homogeneity of their economies. Both countries have similar primary resources and economic strategies, limiting the range of trade between them. This is a common issue among GCC countries that share a reliance on oil and related industries, leading to less diversi ed trade.  Bahrain US-Trade: Exports 2018 vs. 2004 1. Expansion in Aluminum (Alba): Signi cant growth in aluminum exports is linked to the expansion of Alba’s production capacity. This, along with the utilization of the US-Bahrain Free Trade Agreement (FTA), has boosted aluminum exports substantially. In 2018, raw aluminum, aluminum plating, and aluminum wire collectively dominated Bahrain’s exports to the US, re ecting this industrial focus. 2. Textile Decline: There was a diminished role of textiles, particularly non-knit women’s and men’s suits, by 2018. This decline is largely due to the expiration of tari exemptions that had previously bene ted Bahrain’s textile sector. 3. Changes in Oil and Chemical Products: Oil and chemical product exports decreased, impacted by uctuating oil prices and the US increasing its own homegrown oil capacity. The role of re ned petroleum in Bahrain’s exports also declined between 2004 and 2018 due to these changing dynamics.  Bahrain US-Trade: Imports 2018 vs. 2004 Homogeneity Over Time: Imports from the US to Bahrain remained more consistent in comparison to exports, with key product categories staying relatively stable. Excavation Machinery: In 2004, excavation machinery was a much larger portion of imports due to projects like Tatweer EOR (Enhanced Oil Recovery), re ecting the in uence of Bahrain’s infrastructure projects at the time. Cars and Outsourcing: The US has continued to outsource car manufacturing, leading to a decrease in the contribution of car imports to Bahrain between 2004 and 2018. New Technologies: The introduction of new technologies, such as cheap LCD production, allowed for the rapid growth of imports in certain tech-related products during this period. Growth in Fleets: Bahrain’s civilian and military eets grew substantially during this time, leading to increased imports in sectors such as aircraft parts and special purpose ships. Updated Trade Model Gravity Model: Helps explain the volume of trade between two countries, often determined by factors like the size of their economies and proximity. Comparative Advantage Model: Explains the content of trade, focusing on how countries specialize in goods they can produce more e ciently. Other Factors: Both models can be re ned to account for political barriers and other arti cial factors that can in uence trade dynamics between countries.