International Economics - Module 1 PDF

INTERNATIONAL ECONOMICS - Module 1 Laura Bottazzi GLOBALIZATION: Why do we care and less developed economies What determines the flow of capital among countries? When we talk about globalization we think about two different elements: Globalization in...

INTERNATIONAL ECONOMICS - Module 1 Laura Bottazzi GLOBALIZATION: Why do we care and less developed economies What determines the flow of capital among countries? When we talk about globalization we think about two different elements: Globalization in goods → countries exchange goods and they are open to it. Globalization of capital → money goes from one country to the other. This index of globalization was built by the IMF because they try to gather all the data. Trying to understand what was the capital flow in the 1860s is very difficult. When the index goes up it means that capital is being exchanged, so there is a globalization in capital movements; when it goes down it means that there is no globalization. ➔ 1860 → Globalization is rather small but it increases through time. ➔ 1914 → The level of globalization of capital movements was almost at the same level as today. This means that globalization is not a recent phenomenon. However, we started to discuss globalization a lot only in the 1990s. Who was behind globalization before 1WW? → The colonists (like France, even though it was not really wealthy financially), but especially the UK. The UK was the big engine of globalization. It invested in Egypt, making Cairo the most relevant financial center at that time. 1 ➔ First World War → The globalization index goes almost to 0 because countries had to finance the war and pay for their public expenditure. They had no interest in investing in other countries and financing the rest of the world. ➔ Interwar period → The globalization index increases until 1929, the year of the crisis. ➔ Second World War → The globalization index goes down again. ➔ After 2WW → The globalization index increases. Countries are no more invested in the war so they tend to invest in other countries. Why did we start to talk about globalization only later in the 1990s? Discussion surrounding globalization gained prominence in the 1990s. This shift was influenced by the exploration of the concept of liberalizing capital movements to foster economic growth. If a less developed economy has no capital and somebody invests in that country and moves capital, the country is gonna grow. The International Monetary Fund (IMF) played a pivotal role in initiating this discussion. The underlying rationale was that injecting capital into less developed economies could spur economic growth. Historically, countries faced restrictions on investing abroad, but this changed over time. While there has been an increase in cross-border investments, challenges persist in achieving perfect capital movements (there is a cost in translating different currencies). Despite efforts to open up economies and facilitate capital movements, the anticipated convergence in economic growth did not materialize. Instead, capital tends to flow toward more industrialized nations, such as the United States. The expectation of growing economies reaching the same level as developed countries remains unmet. Exchange rate systems Money moves from one direction to another (if we want to invest in the US we need to translate the euros into dollars). In order to do that we need an exchange rate (the price to pay). Gold Standard (1880-1914) → Under the Gold Standard the exchange rate is fixed. The dollar was backed by gold. The value of a currency was directly linked to a specific amount of gold, providing stability. Capital movements were facilitated under this system. Bretton Woods (1945-1971) → The US Civil War strained the Gold Standard as the US needed to finance the war effort. Insufficient gold reserves led to dilution of currency value by backing it with other metals. This dilution undermined the stability of the Gold Standard. In response to economic challenges post-World War II, the Bretton Woods Agreement introduced a more flexible exchange rate system. While not entirely flexible, exchange rates were allowed to fluctuate within a set range. The Central Bank intervened to manage extreme fluctuations, maintaining a degree of stability. Float (1971-2000) → In 1971, the Bretton Woods system collapsed, leading to the adoption of floating exchange rates. Under this system, exchange rates were determined by market forces, without fixed pegs to any specific currency or commodity. This period saw greater flexibility in exchange rates, with minimal intervention from central banks. The impossible trinity Independent monetary policy Fixed exchange rate Free capital movement All together they cannot coexist. 2  1860 During the war After WW2 Independent Monetary Policy ❌ ✅ ✅ Fixed Exchange Rate ✅ ✅ ❌ Free Capital Movement ✅ ❌ ✅ Effects of Financial Globalization on Developing Countries 1. Does financial globalization help developing countries grow faster? 2. How does it affect macroeconomic volatility in these countries? → fluctuation is negative because it brings instability, we want steady growth that we can control. 3. How can the benefits of financial globalization be fully harnessed? When measuring financial integration, we have to distinguish between: De jure integration → Capital account liberalization, measured by official restrictions on capital flows. It is an integration due to the law and policies on capital account liberalization. De facto integration → Estimated gross stocks of foreign assets and liabilities as a share of GDP. The actual capital movement that exists. Italy implemented a law imposing taxes on domestic investors for investing domestically, effectively limiting capital movements within the country. However, there are loopholes allowing companies in Italy and the UK to bypass this tax by purchasing bonds through London. This loophole enables capital movements to occur overcoming the limitations imposed by the Italian law. There are examples of: - Financial integration without capital account liberalization - Liberalization without successful integration Measures of Financial Integration Industrial Countries 3 Here we see a decrease in legal restrictions imposed on capital movements (blue line). This decrease corresponds to an increase in the flow of capital. The trend of decreasing legal restrictions and increasing capital movements began around 1970. This period marked a significant opening up of capital movements. Developing economies Here, while the law is still imposing a strict limitation on capital movement, the de facto integration goes up. Net Private Capital Flows We need to be careful regarding the nature of the capital movement: Bank lending → banks lending to investors. Portfolio flows → portfolio flows entail individual investors investing in bonds or equities, typically for shorter durations. Investors may quickly invest and disinvest (sudden stop), 4  leading to potential fluctuations in capital flows. Sudden stops, such as observed in Mexico (when all the investors rushed away after the presidential candidate was killed), can occur when investors rapidly withdraw investments due to unforeseen events, causing significant market volatility. Foreign Direct Investment (FDI) → FDI involves long-term investments in productive assets in foreign countries. These investments contribute to the establishment or something that is productive into the other country such as firms, hotels, or services. Unlike portfolio flows, FDI is characterized by its lasting impact and contribution to economic development. Contrary to portfolios, they cannot be easily liquidated because they become productive afterwards, so if you sell it, it costs you more because you have already invested without having a return yet. The graph indicates a lower weight of the banking sector concerning its relevance in investments. Portfolio investments dominate the investment landscape, constituting a significant portion of the total investments. The composition of investments reflects the involvement of different actors in the economy. Beyond traditional banking institutions, diverse entities contribute to investment activities, shaping the economic landscape. However, it is important to notice that investments are not homogeneous. We can distinguish: More financially integrated (MFI) economies → where the financial market is sufficiently developed (Asian countries). In these economies, investment opportunities are abundant, and financial transactions are more seamless due to the maturity of the financial infrastructure. Since they are more integrated (for example they have a stock market), they have more portfolio flows. Less financially integrated (LFI) economies → where the financial market is less developed (African countries). Investments in LFI economies may face greater challenges due to limited access to financial services and less developed capital markets. In these countries the weight of bank lending and FDI is higher. 5 North-South Capital Flows Since the mid-1980s, there has been a dramatic increase in net private capital flows from the North (industrialized countries) to the South (less developed economies). This was due by: Pull factors → they arise from changes in policies and other aspects of opening up by developing countries. Pull factors arise from changes within developing countries themselves. For example, if a country implements policies that encourage foreign investment by providing easier access to markets or resources, this would be considered a pull factor. ○ Stock market liberalizations → This includes the provision of access to foreign investors. This was especially done in Latin American countries which allowed foreigners, entrepreneurs to enter and invest in the local stock market. ○ Privatization → This is the process of transferring ownership of state-owned enterprises to private individuals or companies. Privatization can attract foreign investment by selling state-owned assets to foreign investors. These investors may bring in new technology, management practices, and capital, contributing to economic growth. Push factors → changes in global financial markets. ○ Business cycles conditions, interest rates in industrial countries → apples, when there is a shortage the price is higher, when there are a lot of apples the price goes down. ○ Emergence of institutional investors (mutual funds, pension funds, hedge funds) → they have assumed an important role in channeling capital flows from industrial to developing countries. ○ Demographic forces → These refer to factors related to the population characteristics of both developed and developing countries. For instance, if developed countries have aging populations with significant savings, they may seek higher returns on their investments, driving capital towards developing countries where investment opportunities may offer higher returns. Does financial globalization promote growth in developing countries? In principle, financial globalization could help to raise the growth rate in developing countries through a number of channels. It has proven difficult, however, to empirically identify a strong and robust causal relationship between financial integration and growth. Which are the channels? Capital goes from more developed to less developed economies. In theory, there are several channels through which financial integration can increase the growth rates in developing countries. ➔ DIRECT CHANNELS Increase of domestic savings → Financial integration allows developing countries to access savings from the rest of the world. When economies are open to capital movement, individuals can bring money into the country's banking system, increasing domestic savings available for investment. Lower cost of capital due to better risk allocation → In a closed economy where there is limited access to external capital, the cost of capital tends to be higher. This 6  means that if individuals or businesses want to invest in projects or ventures, they face higher borrowing costs, making it more difficult and expensive to finance investments. When a country opens up to financial integration and allows capital to flow in and out more freely, individuals and businesses have the opportunity to invest not only within their own country but also in other economies. This is beneficial for the cost of capital because there is a risk sharing: by investing in multiple economies, investors can diversify their risks. This means that if there is an economic shock or downturn in one country, their entire investment portfolio won't be severely affected because they have spread their investments across different countries. For example, if someone has 30% of their savings invested in their local economy and 20% invested in another country, a shock in the local economy will only impact the 30% portion, while the 20% invested elsewhere remains relatively unaffected. In case of an idiosyncratic shock (only to one country) I will not lose all my savings, unless there is a global shock. Transfer of technology → Foreign investment often brings with it technology and expertise that can be beneficial for the host country. This transfer of technology can contribute to productivity growth and economic development in developing countries. Development of the financial sector → Financial integration can lead to the development of the domestic financial sector, including banks, stock markets, and other financial institutions. This can improve access to finance for businesses and individuals, facilitating investment and economic growth. ➔ INDIRECT CHANNELS Promotion of specialization → Financial integration promotes specialization by allowing countries to focus on industries or sectors where they have a comparative advantage. With an open economy I am not going to produce everything and invest everything in my economy, but only in those sectors in which I am very good. This leads to increased efficiency and productivity, contributing to economic growth. Inducement for better policies → Opening up to capital flows can incentivize developing countries to adopt better economic policies. In order to attract foreign investment, countries may implement reforms to improve governance, reduce corruption, and create a more business-friendly environment. Whereas in a closed economy individuals cannot invest abroad and the government can do everything it wants in his economy. Enhancement of capital inflows by signaling better policies → Financial integration can signal to investors that a country has adopted sound economic policies, leading to increased capital inflows. This can further stimulate economic growth by providing additional resources for investment and development. You have become better and you show foreigners you are better. Overall, both direct and indirect channels of financial integration contribute to higher economic growth. 7 Effects on economic growth Empirically, it is hard to identify a strong and robust causal relationship between financial integration and higher growth rates for developing countries. There is no correlation, but causation. That could be due to chance. Fastest and slowest growing economies during 1980-2000 From this ranking we can see that many countries such as China, Mauritius, Botswana and India were highly growing without having financial markets integrated → this is just correlation, not causation! Financial integration is not a necessary nor sufficient condition for a high growth rate. Increase in Financial Openness and Growth of Real Per Capita GDP By looking at this graph, it looks flat. This means that there is no correlation. A few papers find a positive effect of financial integration on growth. A majority of the studies (11 out of 14) find no effect or, at best, a mixed effect. → An objective reading of the results of the research suggests that there is no strong, robust, and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth. Why is it so difficult to find a strong/robust effect? Most of the difference in income per capita stems not from difference in capital/labor ratio, but from difference in total factor productivity, which is explained by soft factors or social infrastructure. To allow for capital movement to foster growth is absorptive capacity → the capacity to absorb innovation. If nobody has the knowledge and the education to use the technology, it is useless. Production function → 𝑦 = 𝐴𝐹(𝐾, 𝐿) 8 y = output or quantity of goods or services produced. A = total factor productivity (TFP), which captures the efficiency of production that cannot be attributed to the inputs of capital K and labor L alone. It represents technological progress, innovation, improvements in management practices, and other factors that enhance productivity. K = quantity of physical capital input, such as machinery, buildings, equipment, etc. L = quantity of labor input, typically measured in terms of the number of workers or total labor hours. The function suggests that the output (y) is determined by the level of inputs (K and L) and the efficiency of production (A). It implies that increasing the inputs (K and L) would increase output, but the rate of increase depends on the efficiency of production (A). Technological progress and improvements in total factor productivity (A) can lead to more output even with the same levels of inputs. In simpler words, if A increases, with the same level of K and L, production increases. Contrast with studies on trade integration A majority of the studies find that trade integration does help to promote economic growth in developing countries. A lower trade barrier is associated with lower infant mortality, but higher financial integration is not. The effects are different. The two are connected: ➔ With high trade barriers, financial integration could reduce economic efficiency. ➔ Without trade integration, the ability to recover from a financial crisis is weakened. It is difficult to find a strong and robust effect of financial integration on economic growth in developing countries. On the other hand, advanced countries are financially open; and most developing countries that have embraced it do not go back. Long-run gain, but short-run pain? 9 Macroeconomic Volatility Average Volatility of Income Growth We are interested in the long-term fluctuations in income growth. We have subdivided data into subperiods because the first ten years countries had closed capital movements. During the period 1960-1999, LFI (Less Financially Integrated) countries exhibited higher volatility in income growth compared to MFI countries. As time progresses, particularly towards the 1990s, there is an increased openness in capital movement. With better access to open capital movements, we would expect MFI countries to experience lower volatility (because they can better exploit the open economy). Contrary to expectations, MFI countries actually showed higher volatility compared to LFI countries in 1990. Average Volatility of Consumption Growth Consumption tends to move in tandem with income; higher income typically leads to higher consumption levels. Fluctuations in income result in corresponding fluctuations in consumption. From this table, however, we can see that despite high income volatility, consumption volatility tends to be lower due to savings. More Financially Integrated (MFI) countries experienced fluctuations in consumption growth, initially decreasing and then increasing over time. Contrary to expectations, the opening up of capital movement does not necessarily lead to a decrease in consumption volatility. Lower Financially Integrated (LFI) countries, with limited capital movement, may exhibit better coping mechanisms in managing consumption volatility. Can we say that liberalizing capital movement is going to decrease consumption and income fluctuation? NO. 3. It cannot be definitively stated that liberalizing capital movement will decrease fluctuations in consumption and income. The relationship between financial integration, consumption, and income volatility is complex and may vary depending on various factors and country-specific circumstances. Ratio of Consumption Volatility to Income Volatility More Financially Integrated (MFI) countries tend to fluctuate more. Why? Opening up of capital movement increases interdependence between countries, meaning that economic events in one country can affect others. Contagious crises can occur, where economic 10 downturns spread across countries, even if they are not directly exchanging goods or capital. Income volatility has, on average, declined in the 1990s for all groups of countries. For MFI economies, however, consumption volatility increased in the 1990s. Ratio of consumption volatility to income volatility also rose for MFI economies. More formal econometric evidence is consistent with these results. Also some evidence of a threshold effect → beyond a certain level, financial integration reduces volatility. Corruption reduces FDI An increase in corruption in host country from a very low to a very high level in the sample has the negative effect on FDI as raising the tax rate by 50 percentage points. Attracting FDI: tax giveaways vs. better governance. Actual International Mutual Fund Investment vs. the Benchmark We can distinguish between Transparent and Opaque countries: Transparency refers to the clarity and openness of a country's policies, regulations, and economic data. Transparent countries provide reliable and accurate information to investors. Opacity, on the other hand, refers to the lack of transparency and the presence of uncertainty or ambiguity in a country's policies and data. ○ Macropolicy opacity → refers to the lack of transparency or clarity in macroeconomic policies adopted by governments or central banks. This can occur when governments or policymakers announce certain economic policies or reforms but fail to implement them effectively or transparently. Examples include situations where governments make promises to enact economic reforms to attract foreign investment or stimulate growth, but then fail to follow through, leading to uncertainty among investors and market participants. ○ Macrodata opacity → refers to the lack of transparency or reliability in macroeconomic data reported by government agencies or statistical offices. This can include issues such as inaccurate or incomplete economic statistics, manipulation of data for political reasons, or delays in the release of important economic indicators. When macrodata opacity is present, it becomes challenging for investors, policymakers, and analysts to make informed decisions and assessments about the state of the economy, leading to increased uncertainty and risk. 11 Herding and Opacity Herding behavior refers to the tendency of individuals or investors to follow the actions or decisions of the majority, without necessarily considering the underlying fundamentals or information available. This phenomenon is similar to how herds of animals move together without individual decision-making, simply following the movement of the group. In financial markets, herding behavior can occur when investors observe others making certain investment decisions and then follow suit without conducting their own independent analysis. For example, if a group of investors starts buying stocks in a particular sector, others may join in without evaluating the fundamentals of those stocks, simply because they see others doing the same. Similarly, if investors start selling en masse, others may follow suit without considering the reasons behind the sell-off. Especially where there is opacity in the macrostructure, individuals or investors may find it challenging to access accurate and reliable data to make informed decisions. This lack of transparency can lead individuals to rely more on herd behavior rather than conducting their own analysis or evaluation of the economic situation. International capital flows can be very volatile and subject to sudden stops, due to herding, contagion, or over-reliance on foreign borrowing. Previous results show that the degree of volatility of external capital is related to domestic governance. 12  THE DFS MODEL (RICARDIAN) The DFS model is named after its creators: Dornbusch, Fischer, and Samuelson. This model explains why countries exchange goods and why capital moves from one country to the other. The DFS model considers an economic scenario involving two countries, denoted as: L → my economy L* → the other country’s economy Both countries possess identical dimensions and utilize only one factor of production, which is labor. This model primarily focuses on analyzing differences between the two economies arising from disparities in technology rather than examining income distribution between factors (e.g., capital and labor) → The two economies are different because they have different technology. The model encompasses an infinite number of goods, denoted by n, allowing for a broad spectrum of economic activities. Goods are represented along an interval between 0 and 1, signifying the continuum of products available in the economies. All ns are squeezed in this interval. The model is visualized through a graph where the interval between 0 and 1 represents the spectrum of goods. Each point within this interval corresponds to a specific good, and as there are infinite points, there is an infinite variety of goods available. One country specializes in producing certain goods, while the other focuses on producing different goods and they exchange their goods. How do we see technology? In the DFS model, technology is represented by the parameter a(z), which denotes the unit labor requirement for producing a specific good, denoted as z. The unit labor requirement signifies the quantity of labor needed to produce one unit of the good "z," measured in terms of labor hours. A higher value of "a" indicates lower productivity for producing the good, as it requires more labor (hours) to produce each unit. Suppose that countries rank all the goods based on their respective unit labor requirements, with lower values of "a" indicating higher productivity and efficiency in production. In one country (denoted as L), goods are ranked from the lowest "a" (indicating better production capability) to the highest "a" (indicating lower productivity). 𝑎1 < 𝑎2 < 𝑎3... < 𝑎4 Conversely, in the other country (denoted as L*), goods are ranked from the highest "a" (representing worse production capability) to the lowest "a" (representing better production capability). * * * * 𝑎1 > 𝑎2 > 𝑎3... > 𝑎4 13 The parameter A reflects the comparative advantage of each country in producing specific goods relative to the other country. A lower value of A indicates a comparative advantage in production, as it signifies higher productivity and efficiency. 𝑎* 𝐴= 𝑎 The ratio of unit labor requirements between the two countries decreases as it approaches 1, indicating a diminishing comparative advantage for the country with the lower value of A (country L). So, as z increases, A decreases. For small z the numerator is high and the denominator is small; the more z increases, the more the numerator decreases and the denominator increases → hence the ratio is decreasing. What makes a(z) higher or lower? Technology. Countries are different because they have different technology that makes them able to produce some goods in a more productive way. In the DFS model, technology is exogenously given to each country. Lower values of "a" indicate higher productivity, suggesting that the country can produce goods efficiently. We expect each country to specialize in producing goods where it has a comparative advantage, typically those with lower unit labor requirements (a). For country L that is those goods that are close to 0, while for country L* that is those goods closer to 1, because if we move toward 1, the other country becomes increasingly more productive then me. With this model we are in a scenario of perfect competition, in which the price of a good is determined by its production cost. The cost of producing one unit of a good "z" in my country is calculated as the product of the number of hours worked and the wage: 𝑝 = 𝑤𝑎(𝑧) 14  Nominal wage VS Real wage → Nominal wage is the amount of money that a worker receives for their labor. → Real wage refers to the purchasing power of wages, the number of goods I can buy with my wage, taking into account changes in the general price level due to inflation or deflation. The DFS model is an equilibrium model, in which the price of producing a good domestically is equal to the price of importing the same good from the other country. This equilibrium condition is expressed as: 𝑤𝑎(𝑧) = 𝑤 * 𝑎 * (𝑧) If this is equal, I can find a z such that this condition (producing at home and importing has the same price) is true. We call this z, z bar → Z bar represents the threshold level of indifference between producing domestically or importing. At this threshold level, both countries find it equally advantageous to produce the good domestically or import it from the other country. Which goods does L produce and which goods does L* produces? L will produce all goods such that: 𝑤𝑎(𝑧) < 𝑤 * 𝑎 * (𝑧) That is to say, it will produce all those goods whose price of production is lower than the price of production of that same good in country L*. In other words, L will produce those goods on the left side of 𝑧. My country has a comparative advantage in producing that good because it is more cost-effective for my country to produce domestically rather than importing from the other country. The same condition can be written as: 𝑤 𝑎* <. 𝑤* 𝑎 𝑤 𝑎* If < country L will produce that 𝑤* 𝑎 good. In fact, we can see that if we take any 𝑎* 𝑤 possible z, is always higher than 𝑎 𝑤*. 15 The DFS model is a model equilibrium, wherein there is no unemployment. Where does the demand come from? Since we are in an open economy, demand originates from both the domestic economy and the other economy to which goods are exported. So, the demand will depend on my income and the income of the workers in the other country. Income is calculated as the product of the wage (w) and the total number of workers (L). 𝑦 = 𝑤𝐿 This is the value of my production. The equilibrium condition necessitates that income equals consumption to avoid excess demand, ensuring that all produced goods are consumed. Let’s call G(z) the share of world income spent on my goods (produced domestically). Why is G indexed by z? G is indexed by z because the more goods I produce, the higher is the share of income spent on my goods. Since it is a model of equilibrium, demand = supply (S=D) and supply = income. I can also say that production = consumption and income = consumption. This means that what I produce is given back, redistributed to the workers. Equilibrium is maintained when demand equals supply, which is equivalent to ensuring that imports equal exports. The value of imported goods is equal to the value of exported goods. 16 As production levels increase (z ↑ moves to the right) from 0 to 1, G(z) – the share of world income spent on domestically produced goods – increases, leading to higher demand. If the numerator is increasing, also the ratio ( 𝐺(𝑧) 1−𝐺(𝑧) ) is increasing. To maintain the equilibrium, 𝑤 𝑤* has to be higher. 𝑤 → The more I move to the right, the higher is 𝑤*. 17 Welfare Analysis in the DFS Model: Trade Opening with a More Productive Country What happens when a country (like Italy) opens up trade with a more technologically advanced country (like China)? Are we better off or worse off? We would expect to be worse off because if the other country is more productive and has better technology, it could take over some of my sectors and I would lose a part of my production. Effects on Production: While the productivity of the more advanced country (China) improves (a* decreases), Italy's productivity (a) remains unchanged. In fact, For each z, the number of hours needed is lower, so a* is lower. The B curve is not going to change because it has no a* in it, while the A curve is going to change. A ( ) is decreasing, so the curve is moving DOWN. 𝑎* 𝑎 The new point of equilibrium determines the new z (𝑧') that is shifted to the left. 𝑤 There is also a decrease in 𝑤* because there is a higher demand for workers, so their wage is higher (wage is based on productivity). Now they are producing more, from 𝑧' to 1. 18 Ricardian Model with Transportation Costs When introducing transportation costs (g), buying goods from another country involves additional expenses. Normally, in a condition of indifference: Domestic Production Cost → 𝑝 = 𝑎𝑤 Foreign Production Cost → 𝑝 *= 𝑎 * 𝑤 * Now, when importing, transportation costs (g) are added. Total Cost for Imported Goods → 𝑝 = 𝑎 * 𝑤 * (1 + 𝑔) where 𝑔 > 0 𝑎𝑤 = 𝑎 * 𝑤 * (1 + 𝑔) 𝑝=𝑝 * 𝑤 𝑎* 𝑤* = 𝑎 (1 + 𝑔) The introduction of transportation costs shifts the production and consumption dynamics. Due to higher costs of importing (because of g), domestic production becomes relatively more attractive. Higher transportation costs make importing less economical, leading to a decrease in the volume of imports. The A curve will shift upwards due to the transportation costs (1+g). The point 𝑧' will move to the right, indicating an increase in domestic production. The economy will produce more domestically and import less. Also the other country has to pay transportation costs. His costs of importing will be: 𝑝 *= 𝑤 * 𝑎 *= 𝑎𝑤(1 + 𝑔) 𝑎* 1 𝑤 𝑎 (1+𝑔) = 𝑤* 𝐴 𝑤 (1+𝑔) = 𝑤* Also the other country will produce more domestically because the added cost of importing (g) makes foreign goods more expensive. Higher transportation costs lead to reduced imports as both countries prefer to produce goods domestically. 19 The interval 𝑧'' − 𝑧' represents NON-TRADABLE GOODS → goods produced in both economies but not exchanged due to high trading costs. These goods are produced locally because the cost of trading (importing or exporting) them is prohibitive. When production costs are similar between the two countries, adding transportation costs (or any trade tax) makes domestic production more economically viable. Countries prefer to produce at home rather than import because transportation costs nullify the price advantage of importing cheaper goods. 20  THE HO MODEL The HO (Heckscher-Ohlin) model focuses on the interaction between two economies. The HO model is particularly useful in analyzing patterns of trade between two countries that have the same technology, but differences in factor endowments, such as labor and natural resources. The model is sometimes referred to as the "2x2x2" model due to its structure: 2 countries → The model involves the interaction between two countries. 2 factors of production → The model distinguishes between two factors of production, namely Labor (L) and Terrain (T). Terrain here refers to land or natural resources. 2 goods → Unlike the Ricardian model which assumes an infinite number of goods, the HO model simplifies to two goods: Cloth (C) and Food (F). Both goods require the use of both Labor and Terrain in their production processes. Each country has been endowed with a certain amount of Labor (L) and Terrain (T). The amount of Labor (L) used in the production of Cloth (C) and Food (F) equals the total number of workers in the economy: 𝐿 = 𝐿 + 𝐿 𝐶 𝐹 Similarly, the amount of Terrain (T) used in the production of Cloth (C) and Food (F) equals the total available terrain: 𝑇 = 𝑇 + 𝑇 𝐶 𝐹 However, there exists a disparity in the intensity of the utilization of these two inputs: C uses more L than T in production F uses more T than L in production In economic terms we say that: The production of C uses relatively more intensively L than T. The production of F uses relatively more intensively T than L. 𝐿𝐶 𝐿𝐹 Expressed as: > 𝑇𝐶 𝑇𝐹 This implies that the ratio of workers over terrain in the C sector is greater than the ratio of workers over terrain in the F sector. In essence, the distinguishing factor between the two economies lies in the relative abundance of their factor endowments – whether one possesses more Labor (L) or more Terrain (T). 21  𝐿𝐶 𝐿𝐹 Let's focus on MY economy. We can rewrite the inequality > by dividing both sides by 𝑇𝐶 𝑇𝐹 the quantity of Cloth produced (𝑄𝐶). How much of QC and how much of QF will I produce? It depends on L and T. We need to distinguish between: Endogenous variables → These are the variables that I find by solving the economic problem. They lie along the axes (y and x) of the graph. In the context of this model, the endogenous variables are QC and QF, representing the quantities of Cloth and Food produced, respectively. These values are derived through the equilibrium of the model. Exogenous variables → These are the variables that are given and remain constant when drawing the model's graph. They are external to the model and influence the endogenous variables. In this case, the exogenous variables include: A (technology), L (labor), T (terrain) and aTC, aLC, aTF, and aLF. Remember the formula to find the slope in a graph: 1) We said that 𝐿 = 𝐿 + 𝐿. 𝐶 𝐹 This equation can be rewritten using the production quantities QC and QF. 22 The slope is negative because of the principle of opportunity cost. Since Labor (L) is a limited resource, using it to produce more of one good necessarily means producing less of the other. Now, to determine the points where I am producing: When QC = 0, implying no Cloth production, QF equals the total available Labor (L) divided by the amount of Labor required to produce one unit of Food (aLF). This point indicates the maximum possible production of F when all resources are devoted to its production. 𝐿 𝑄𝐶 = 0 → 𝑄𝐹 = 𝑎𝐿𝐹 Conversely, when QF = 0, meaning no Food production, QC equals the total available Labor (L) divided by the amount of Labor required to produce one unit of Cloth (aLC). This point indicates the maximum possible production of C when all resources are allocated to its production. 𝐿 𝑄𝐹 = 0 → 𝑄𝐶 = 𝑎𝐿𝐶 2) We said that 𝑇 = 𝑇 + 𝑇. This equation can be rewritten using the production quantities QC 𝐶 𝐹 and QF. Now, to determine the point of production: When QC = 0, implying no Cloth production, QF equals the total available Terrain (T) divided by the amount of Terrain required to produce one unit of Food (aTF). This point indicates the maximum possible production of F when all resources are devoted to its production. 𝑇 𝑄𝐶 = 0 → 𝑄𝐹 = 𝑎𝑇𝐹 Conversely, when QF = 0, meaning no Food production, QC equals the total available Terrain (T) divided by the amount of Terrain required to produce one unit of Cloth (aTC). This point indicates the maximum possible production of C when all resources are allocated to its production. 𝑇 𝑄𝐹 = 0 → 𝑄𝐶 = 𝑎𝑇𝐶 23 In terms of positioning on the graph, we can compare the two slopes: 𝑎𝐿𝐶 𝑎𝑇𝐶 if 𝑎 is higher than 𝑎 , it indicates a steeper slope, suggesting that the production of C uses 𝐿𝐹 𝑇𝐹 relatively more intensively T compared to Food production. 𝑎𝐿𝐶 𝑎𝑇𝐶 Conversely, if if 𝑎 is lower than 𝑎 , it suggests a flatter slope, indicating that the production 𝐿𝐹 𝑇𝐹 of F uses relatively more intensively T compared to Cloth production. 𝑎𝐿𝐶 𝑎𝑇𝐶 → 𝑎 is higher than 𝑎 , so the slope of the first equation is STEEPER. 𝐿𝐹 𝑇𝐹 Where do I produce? At point 1. The point of intersection represents the point where I produce if I want to use all possible L and all possible T. This point is the optimal allocation of resources where both L and T are fully utilized, highlighting the maximum attainable production levels for C and F. 24 Increase in T (Terrain) Suppose there is an increase in the exogenous variable T. How does this affect production? Initially, the first equation, representing the total available Labor (L), remains unchanged as the number of workers remains constant. However, the second equation, representing the total available Terrain (T), shifts UPWARD due to the increase in T. This implies that there is more Terrain available for production. As a result: The production of F (QF) increases, as F production uses relatively more intensively T than L. Conversely, the production of C (QC) decreases, as C production uses relatively more intensively L than T. This phenomenon of specialization in production occurs due to the relative abundance of factor endowments. In economies with a greater relative abundance of Terrain (T) compared to Labor (L), there's a tendency to specialize in goods that utilize Terrain more intensively. In the context of international trade: - Terrain (T) can be likened to capital, representing more developed economies. - Labor (L) represents the workforce, indicative of developing economies. 25 Return to the factor How much am I going to pay the workers (w) and the rantier (r)? Endogenous variables: w = wage paid to workers. r = return to rentier, i.e., the return to owning capital or land. Endogenous variables we want to know (along the axis) Exogenous variables: PC = price of good C. PF = price of good F. These prices are exogenously given. We are in a scenario of perfect competition → the price of goods covers the cost of production. Since this model involves two factors of production (L and T), the cost of production is a combination of payments to workers and payments for land or capital (w + r). 1) The slope is negative because of the principle of substitution: if the return to the rentier (r) increases, wages have to be reduced and vice versa. Now, to determine the points in the graph: When r = 0, implying no return to the rentier, w equals the price of Cloth (PC) divided by the amount of Labor required to produce one unit of Cloth (aLC). This point represents the maximum possible wage when all resources are allocated to Cloth production. 𝑃𝐶 𝑟 = 0→𝑤 = 𝑎𝐿𝐶 Conversely, when w = 0, indicating no wages paid to workers, r equals the price of Cloth (PC) divided by the amount of Terrain required to produce one unit of Cloth (aTC). This point represents the maximum possible return to the rentier when all resources are allocated to Cloth production. 𝑃𝐶 𝑤 = 0→𝑟 = 𝑎𝑇𝐶 2) Now, to determine the points in the graph: 26  When r = 0, implying no return to the rentier, w equals the price of Food (PF) divided by the amount of Labor required to produce one unit of Food (aLF). This point represents the maximum possible wage when all resources are allocated to Food production. 𝑃𝐹 𝑟 = 0→𝑤 = 𝑎𝐿𝐹 Conversely, when w = 0, indicating no wages paid to workers, r equals the price of Food (PF) divided by the amount of Terrain required to produce one unit of Food (aTF). This point represents the maximum possible return to the rentier when all resources are allocated to Food production. 𝑃𝐹 𝑤 = 0→𝑟 = 𝑎𝑇𝐹 In terms of positioning on the graph, we can compare the two slopes: 𝑎𝑇𝐶 𝑎𝑇𝐹 if 𝑎 is higher than 𝑎 , it indicates a steeper slope. 𝐿𝐶 𝐿𝐹 𝑎𝑇𝐶 𝑎𝑇𝐹 Conversely, if if 𝑎 is lower than 𝑎 , it suggests a flatter slope. 𝐿𝐶 𝑇𝐹 𝑎𝑇𝐶 𝑎𝑇𝐹 → 𝑎 is higher than 𝑎 , so the slope of the first equation is STEEPER. 𝐿𝐶 𝐿𝐹 27 Increase in PC Consider the scenario where the price of Cloth (PC) increases. This increase in PC implies a higher level of nominal wages (w) and a lower return to landowners (r). While we expected an increase in w, why do we also have a decrease in r even though PF remains unchanged? The higher price of C incentivizes firms to allocate more resources towards C production compared to F production. Consequently, there is an increase in the quantity of Cloth produced (QC), which uses relatively more intensively L than T and a decrease in the quantity of Food produced (QF) which uses relatively more intensively T than L. This change in production leads to: An excess demand for Labor (L), as there are fewer workers available than needed due to the increased demand for Cloth production. This results in an increase in the price of Labor, i.e. the nominal wages (w). → the prices for L goes UP. Conversely, there's an excess supply of Terrain (T), as there's more land available than needed for production. This leads to a decrease in the return to landowners (r). → the prices for T goes DOWN. The change in r is bigger than the change in w. Why? → Magnification effect The magnification effect for prices shows that if the product prices change by particular percentages with one greater than the other, then the factor prices will change by percentages that are larger than the larger product price change and smaller than the smaller. 28 Integration of the Two Economies Now, let's put the two economies together and consider the interaction between them. World Demand for the Good When the relative price of Cloth to Food ( ) 𝑃𝐶 𝑃𝐹 increases, there is a tendency for the world to demand less of Cloth (QC), and vice versa. This relationship results in a negatively sloped demand curve for Cloth. World Supply for the Good My economy is relatively more abundant in Labor (L) than Terrain (T). Consequently, it will produce more Cloth (QC) than Food (QF), leading to a lower price ratio ( ) 𝑃𝐶 𝑃𝐹 in the world market. Conversely, the other economy is relatively more abundant in Terrain (T) than Labor (L). This economy will produce more Food (QF) than Cloth (QC), resulting in a higher price ratio ( ) 𝑃𝐶 𝑃𝐹 compared to my economy. 29 Analysis of Wage Differentials In comparing the domestic and foreign economies, who is paying the worker more? In the domestic economy, Terrain (T) is scarce, but there's a relative abundance of workers (Labor, L). As a result, wages are relatively low, and the ratio of wages to returns to land ( ) is lower. 𝑤 𝑟 Conversely, in the foreign economy, wages are higher while returns to land are lower. This reflects the relative scarcity of labor compared to terrain in the foreign economy. Effects of Trade Opening on Relative Prices What happens when we open the trade between the two countries? Suppose there's no movement of factors between the economies, (i.e. workers cannot move): In the domestic economy there will be a demand for Cloth (C) from the foreign economy due to the lower price. This leads to an increase in the price of Cloth (PC) domestically → In my economy the price of C goes UP. Similarly, in the foreign economy, there will be a demand for Food (F) due to the higher price in the domestic economy, leading to an increase in the price of Food (PF) in the foreign economy → In the other economy the price of F goes UP. This dynamic continues until prices reach a convergence between the two economies. 30 Effects of Trade Opening on Relative Return to the Factor The same would happen for wages (w) and return to the landowners (r). Upon opening up the domestic economy to trade, the increase in the price of Cloth (PC) will result in an increase in wages (w) and a decrease in returns to land (r) → In the domestic economy, workers benefit from the increase in wages, while landowners experience a decline in returns. Conversely, in the foreign economy, landowners benefit from the increase in returns, while workers experience a decrease in wages. This process continues until wages and returns to land converge. Now suppose that: L are skilled workers; T are unskilled workers. The domestic economy is relatively more abundant in L than T → more skilled workers. The foreign economy is relatively more abundant in T than L → more unskilled workers. Upon opening up the economy to trade, skilled workers in the domestic economy benefit from increased demand, leading to higher wages. However, unskilled workers may face challenges as they have to compete with foreign unskilled workers who may offer lower wages. This situation highlights the different impact of trade liberalization on different segments of the labor force based on skill levels and factor endowments. Discrepancies in Capital Movement and Convergence The domestic economy in this model represents more developed economies, which are relatively more abundant in capital compared to workers. Thus, we would expect the return to capital to be lower than the return to workers (higher wages). 31  Conversely, less developed economies are relatively more abundant in workers, with capital being scarce. In such economies, we would expect a higher return to capital and lower wages. In the 1970s, discussions about liberalizing capital movements were centered on the idea that capital would flow from more developed to less developed economies. This movement was expected to lead to a convergence in relative prices and returns to factors between economies. However, despite the anticipation of convergence, when capital movements were liberalized, no significant convergence was observed. 32  THE SPECIFIC FACTOR MODEL The model is sometimes referred to as the "3x2x2" model due to its structure: 3 factors of production → The model distinguishes between three factors of production, namely Labor (L), Terrain (T), and Capital (K). Labour is the shared factor, while T and K are the specific factors. 2 countries → The model involves the interaction between two countries. 2 goods → Unlike the Ricardian model which assumes an infinite number of goods, the Specific Factor Model simplifies to two goods: Manufacturing (M) and Food (F). They both use L (= shared factor), but they have specific factors: ○ K is specific to the production of M; ○ T is specific to the production of F. Technology is the same in the two economies. What is different is the factor endowment and mainly the endowment in the specific factors (K and T). How can we graphically represent the production function? In the graph we are going to see QM and L, but not K (the specific factors), otherwise we should draw a tridimensional graph. To do that, we are going to fix the K and treat it as an exogenous variable (given). The higher is L, the higher is QM for a given quantity of K (capital). When I increase L, QM increases less than proportionally. 33 In economic terms, we say that when I increase L, the MARGINAL PRODUCTIVITY OF LABOUR (MPL) decreases → The marginal productivity of labor quantifies how much production changes when there's a small increase in labor input. To illustrate this concept, consider a scenario where you have 10 workers (L) and 2 machines (K). All the workers are assigned to work on those same 2 machines. Now, if we keep the number of machines constant (K) and increase the quantity of workers (L), the productivity of each worker is likely to decrease. This happens because with more workers competing for the same limited number of machines, they end up "competing" or "crowding out" each other's productivity. It's like having too many people trying to use only 2 machines simultaneously; they end up getting in each other's way and efficiency decreases as a result. Increase in K If I increase K, with the same quantity of L (always keep one dimension fixed!), QM will increase. In real terms, if I have the same workers, I can produce more if I have more capital. → The curve shifts UP. Marginal Productivity of Labor (MPL) The MPL represents the additional output produced when one additional unit of labor is employed while keeping other factors of production constant. In other words, the more we move to the right (as L increases), the more the MPL (marginal productivity of labor) decreases. 34 Where do I see the MPL in the graph? In the graphical representation of the production function, the MPL is the slope of the curve at each point. To visualize the MPL graphically, consider taking a small change in the quantity of labor (ΔL). The resulting change in output (ΔQM) divided by the change in labor (ΔL) gives us the slope of the tangent line at that point, representing the MPL. As we move to the right along the production function curve (increasing the quantity of labor), the MPL decreases. This is reflected by the flatter slope of the tangent line at each point, indicating diminishing marginal productivity of labor. Wages of Workers in the Specific Factors Model How much am I going to pay the workers? In perfect competition, the amount we pay workers depends on their productivity (how much they produce). What we need to take into consideration is the Marginal Product of Labor (MPL), and in particular the value of the MPL → The MPL indicates the increase in the quantity of the good produced (in physical units). However, since workers are compensated in monetary terms, we must convert this physical productivity into monetary value by multiplying the MPL by the price of the good (PM). Wage Calculation Formula → 𝑤 = 𝑃 𝑀𝑃𝐿 𝑀 𝑀 When we multiply the MPL by PM (a constant), the curve shifts to the RIGHT. This reflects an increase in the monetary value of the workers' productivity. When examining the production of good F, we apply the same principles and utilize the same graphs as those used for good M. 35 Allocation of Labor in the Production of Goods M and F How much L is used in the production of M (QM) and the production of F (QF)? The total labor (L) is allocated between the production of goods M and F. This allocation can be represented as: 𝐿 = 𝐿𝑀 + 𝐿𝐹. To analyze how labor is distributed between these two goods, we use two graphs together: one for the production of M and one for the production of F. To effectively compare the labor usage, we rotate the graph for the production of good F by 180°. This way, the graphs can be viewed together to show the allocation of labor. The two curves must be compatible because the total labor (L) is fixed. The quantity of labor used in the production of M ranges from 0 to LM. The quantity of labor used in the production of F ranges from L to LM. Wage Equilibrium The wages in the two sectors (M and F) are equal. At the point of intersection of the two curves: 36 Value of MPLM = Value of MPLF Value of MPL = Wage Workers are paid the same in both sectors. This equality is natural because if one sector offered higher wages, workers would migrate to that sector. Increase in PM What happens if PM increases? When the price of good M (PM) increases, PF MPLF remains unchanged. However, the product PM MPLM shifts to the RIGHT because we are multiplying the MPL by a higher price (PM’). The value of what workers produce increases, not because their productivity has increased, but because the price of good M has risen. Consequently, the wages in the sector producing good M must increase to reflect the higher value of their output. Due to the increase in wages in sector M, workers in sector F must also be paid more. If wages in sector F do not increase, workers will migrate to sector M, where wages are higher. Overall, an increase in PM results in higher wages across both sectors, maintaining equilibrium in the labor market. Welfare Analysis To determine if the purchasing power (ability to buy) of workers has changed, we need to consider the prices of both goods M (PM) and F (PF), since workers buy both. 37  Both wages (w) and the price of good M (PM) have increased. However, the increase in wages (Δw) is less than the increase in the price of good M (ΔPM).Since the increase in w is smaller than the 𝑤' increase in PM, the ratio 𝑃𝑀' decreases. → Workers are less able to buy good M because their wages have not increased sufficiently to keep pace with the rising price of good M. Since w has increased while PF has remained the 𝑤' same, the ratio 𝑃𝑀' has increased. → Workers are more able to buy good F. What can we say about the wellness of the workers? Nothing. We cannot make a definitive statement about the overall wellness of the workers because their purchasing power has changed in opposite directions for the two goods. The net effect on their welfare depends on their consumption preferences between goods M and F. If workers prefer good F more, their welfare might have improved. Conversely, if they prefer good M more, their welfare might have declined. Return to Factor When the price of good M (PM) increases, this price increase is redistributed among the factors of production (L, T and K). 𝑤' Workers (L) → Despite an increase in wages (w), the ratio 𝑃𝑀' has decreased, meaning workers effectively receive a smaller portion of the increased price in terms of purchasing power for good M. Capitalists (T) → Capitalists benefit from the increased price as their return on capital increases (they are paid more). In sector F, the price of good F (PF) remains unchanged. Workers (L) → Wages in sector F have increased due to the overall wage increase (w) 𝑤' caused by the rise in (PM). This makes the ratio 𝑃𝐹' higher. Capitalists (T) → The increased wages mean a larger share of the income in sector F goes to workers, reducing the share going to the specific factor of production in this sector (T). Who is going to increase its own welfare? The factor that is specific to the production of the good whose price has increased (terrain in the production of good M and labor in the production of good F) will see an increase in welfare. 38 Production Possibility Frontier (PPF) How much am I going to produce of QM and QF given the factor endowment? The production possibility frontier (PPF) illustrates the trade-off between the production of two goods (QM and QF), given the factor endowment. The PPF shows all the different combinations of outputs of two goods that can be produced using available resources and technology ( = factor endowment). I am going to produce along the curve. The PPF is negatively sloped because the total amount of labor (L) is fixed and shared between the two sectors. Producing more of M requires reallocating labor from the production of F, thus reducing QF. The curve demonstrates the opportunity cost of reallocating labor between the two goods. Any point on the PPF (like point 1) represents a specific combination of QM and QF that can be produced given the factor endowment. At each point on the PPF, the equality 𝑃𝐹 𝑀𝑃𝐿𝐹 = 𝑃𝑀 𝑀𝑃𝐿𝑀 holds, meaning the marginal revenue product of labor is the same in both sectors. This can also be expressed as: The ratio of the marginal productivity of labor ( ) 𝑃𝑀 𝑃𝐹 in the two sectors is given by the slopes at different points along the PPF. As we move to the right along the curve, more labor is employed in the production of QM and less in and QF. Consequently: The marginal product of labor in sector M decreases (𝑀𝑃𝐿𝑀 ↓). The marginal product of labor in sector F increases (𝑀𝑃𝐿𝐹 ↑). Therefore, the ratio increases ( 𝑀𝑃𝐿𝐹 𝑀𝑃𝐿𝑀 ) ↑. This implies that the relative price must also increase to maintain equilibrium ( ) 𝑃𝑀 𝑃𝐹 ↑. 39 Suppose the price of good M (PM) increases. This would lead to a shift in the production point along the production possibility frontier (PPF) to a new point. With the increase in (PM), the value of producing good M increases. As a rational producer, I would want to produce more of good M to capitalize on the higher price and increased value. The new production point would be located to the right of the initial point, indicating an increase in the production of M and a decrease in the production of F. Demand and Supply Where do prices come from? In an economy, prices are determined by the interaction of demand and supply forces in the market. DEMAND The demand curve for a good is negatively sloped. This means that as the relative price of one good increases compared to another, the quantity demanded of the first good decreases. In this case, as the relative price of good M (PM) increases compared to good F (PF), the demand for QM decreases relative to QF. 40  ​ For simplicity, let's assume that the demand for goods in my country is equal to the demand in other countries. SUPPLY The supply curve for a good is positively sloped. This means that as the price of a good increases, the quantity supplied of that good also increases. The supply of goods will depend on factor endowment. The availability of these factors will determine the production capacity and thus the supply of goods. Prices in the market are determined at the point where the demand and supply curves intersect, known as MARKET EQUILIBRIUM. At this equilibrium point, the quantity demanded equals the quantity supplied, and there is no tendency for prices to change unless there is a shift in either the demand or supply curve. Now put the two economies together: Remember that the two economies have no difference in technology, but only in the supply of the specific factor (T and K): One country is relatively more abundant in K. The other country is relatively more abundant in T. 41 As a consequence: My country → has the same amount of workers (L) but is relatively more abundant in capital (K). This country tends to produce more of good M, which uses labor (L) and capital (K). The price of good M (PM) is lower due to higher production, so the ratio (PM/PF) is lower. Other country* → has the same amount of workers (L) but is relatively more abundant in land (T). This country tends to produce more of good F, which uses labor (L) and land (T). The price of good F (PM) is lower due to higher production, so the ratio (PM/PF) is higher. When the two economies open up to trade, there is going to be an increased demand for the good that each country specializes in: My country → Because the price of M is lower than the other economy, I am going to see a high demand for M, so PM is going to increase. PM/PF increases. Other country* → Because the price of F is lower than my economy, they are going to see a high demand for F, so PF is going to increase. PM/PF decreases. This dynamic goes on until they reach a convergence in prices. Effects on Wages and Purchasing Power (Welfare Analysis) My country When the price of good M (PM) increases, the increase in wages (w) is less than 𝑤 𝑤 proportional. Real wages, measured as 𝑃𝑀 and 𝑃𝐹 , show different impacts: 𝑤 𝑃𝑀 → Although w increases, PM increases even more, leading to a decrease in real wages in terms of good M. Workers can buy less of good M with their wages. 𝑤 𝑃𝐹 → Since PF remains constant, the increase in w leads to an increase in real wages in terms of good F. Workers can buy more of good F with their wages. Therefore, we cannot say anything about the workers’ welfare because: - They have higher purchasing power in terms of good F. - They have lower purchasing power in terms of good M. The other country* The price of good F (PF) increases while PM remains unchanged. 𝑤 𝑤 Real wages, measured as 𝑃𝑀 and 𝑃𝐹 , show different impacts: 42  𝑤 𝑃𝐹 → Although w increases, PF increases even more, leading to a decrease in real wages in terms of good F. Workers can buy less of good F with their wages. 𝑤 𝑃𝑀 → Since PM remains constant, the increase in w leads to an increase in real wages in terms of good M. Workers can buy more of good M with their wages. Again, we cannot say anything about the workers’ welfare because: - They have higher purchasing power in terms of good M. - They have lower purchasing power in terms of good F. Effects on Return to Factor My country In the M sector → Although wages (w) have increased, the increase in PM means that the fraction going to workers has decreased. Capital owners in the M sector gain, as the returns to capital increase with the higher price of M. In the F sector → Prices remain unchanged, but increased wages mean a larger share of income goes to workers. Landowners, the specific factor owners in the F sector, see a decrease in their return because the remaining slice of income for them has shrunk. The other country* In the M sector → With constant prices, wages have increased, benefiting workers. Capitalists see a decrease in their relative returns as a larger portion of income goes to wages. In the F sector → The increase in PF benefits landowners as their specific factor becomes more valuable. Workers may have reduced purchasing power for good F, but better purchasing power for good M. In conclusion, opening up economies leads to increased demand for the goods that each country specializes in. Prices for these goods increase, benefiting the owners of the specific factors: capitalists in the economy abundant in capital (your country), landowners in the economy abundant in land (the other country). Total Welfare of the Economy While the purchasing power of workers in terms of individual goods (M and F) is ambiguous, we can analyze the total welfare of the economy using the production possibility frontier (PPF). 43 In equilibrium, prices are determined by the intersection of demand and supply. So the quantity demanded must be equal to the quantity supplied. To find the line in which demand = supply, we use the linear equation: 𝑦 = 𝑚𝑥 + 𝑞 x axis represents QM (quantity of good M). y axis represents QF (quantity of good F). We need to find the intercept (q) and the slope (m): The PPF curve represents all possible combinations of QM and QF that the economy can 𝑃𝑀 produce given its resources. The equilibrium line 𝑄𝐹 = 𝑞 − 𝑃𝐹 𝑄𝑀 indicates where the economy is producing and consuming in equilibrium (demand = supply). The line is negatively sloped 𝑃𝑀 because 𝑚 =− 𝑃𝐹. The point where this line intersects the PPF curve represents the optimal production and consumption point (point A). 44 Now let’s suppose that I open up my economy. When the economy opens up, the price of good M (PM) increases due to higher demand from the other country. The increase in PM results in a steeper slope. This reflects the higher relative price of M compared to F. In autarky, the point where the economy produces is also the point where it consumes. When the economy opens up, the point of consumption differs from the point of production. The economy can consume more, benefiting from trade. The ability to trade allows the economy to consume more than it could produce alone. This is because it can now import goods from the other country, taking advantage of lower prices there. We know that the specific factor of M (capital) is better off, while the specific factor of F (terrain) is worse off. So capital owners benefit from the higher price of M, increasing their returns. Landowners instead are worse off due to relatively lower returns as the economy shifts production towards M. Overall Economic Impact Despite lower returns for landowners, the economy as a whole can consume more due to trade. This results in a higher overall level of welfare. The ability to import goods from the other economy at lower prices increases the real purchasing power of consumers. Although landowners may see a decrease in nominal income, they may still benefit from lower prices. Difference with the HO Model In the Heckscher-Ohlin (HO) model, opening up the economy leads to convergence in prices and factor returns between countries. The model can predict which groups (workers, landowners) will gain or lose from trade. Here, instead, we can say that opening up leads to a higher level of happiness and welfare, as the economy can consume more and at lower prices compared to autarky. 45 The Ricardian Model, the Heckscher-Ohlin (HO) model and the specific factors model are real models that were introduced in an era when there was no financial market and no international capital movements. These models operate entirely in real terms, focusing on physical goods and relative prices, without considering monetary aspects. 46  THE LUCAS MODEL The Lucas model explains why we don’t see convergence between industrialized and less developed countries when we liberalize the economy. In theory, when capital movements are liberalized, capital should flow from industrialized countries (where capital K is abundant) to less developed countries (where capital is scarce). This expectation is based on the Heckscher-Ohlin (HO) model, which suggests that return to capital (K) is higher in countries where K is scarce. Over time, this movement should lead to a convergence in wages (w) and returns to capital between industrialized and less developed countries. This convergence would lead to higher wages and a higher return to capital in less developed economies and the reverse in industrialized countries. Despite these theoretical expectations, the liberalization of capital movement in the 1970s did not result in convergence. Why? Imperfection. The Lucas model introduces the concept of worker QUALITY. The quality of workers depends significantly on human capital accumulation, which includes education, skills, and training. Human capital cannot be substituted. High-quality education and training are crucial for improving worker productivity and overall economic growth. And this is the role of the government in the economy: invest in education and training programs to improve the human capital of their citizens. By increasing the level of education and skills, governments can stimulate economic growth and productivity. Explicit Production Function → it links the production to the factor of production. This is also known as the Cobb-Douglas production function. Where: Y = production. K = capital. The share of labor into the production is usually ⅓. L = labor. The share of labor into the production is usually ⅔. θ = weight of capital (K) and labor (K) in the production process. The production function can be enhanced by including a factor for innovation, A: A is a constant (>1) representing innovation, also known as Total Factor Productivity (TFP). A allows for higher production with the same quantity of capital and labor, so it is the element that increases the total productivity of the economy. 47 In this model, the quality of workers (human capital accumulation) is more relevant than the number of workers. This can be represented as: Where h represents human capital accumulation of the workers. Now we can measure the return to the economy (to L and K) directly from the production function. To focus on capital (K), we can express the production per worker by dividing everything by L: The production per worker (y) can vary between different economies due to: 1. Different technology (A) – as in the Ricardian model. 2. Different capital (k) – as in the Specific Factor model. 3. Different workers (h) – as in the Heckscher-Ohlin (HO) model. However, in this case we do not want to look at the number of workers, but at the human capital accumulation. What happens when capital moves? When capital moves between countries, several factors come into play, including different legislations, cultural similarities or differences, and historical contexts. Different legislations can create challenges in the exchange of capital. So we are going to take the case of the UK and India because they share some cultural commonalities due to their historical relationship; India was a British colony. The UK has invested significantly in India. However, this investment has not led to a convergence in the two economies as might be expected. Despite significant investment from the UK, the income per capita in the UK remains 13% higher than in India. Similarly, the income per capita in the US is 15% higher than in India. This means that workers in the US earn, on average, five times more than their counterparts in India. This discrepancy highlights that factors beyond capital investment influence economic outcomes. Several reasons can explain why capital movement alone does not result in economic convergence: 48 Capital Differences Let’s suppose the difference between the two economies is capital (k). Consider two countries where h1 = h2 and A1 = A2. 𝑦1 If the GDP per capita in both economies were equal, the ratio 𝑦2 would be equal to 1, but it is 𝑦1 not. The US's GDP per capita is 15 times higher than India’s: 𝑦2 = 15. Using the Cobb-Douglas production function for both economies. Human capital and technology are the same so I can get rid of them. If capital per worker is different, also the Marginal Product of Capital (MPK) should be different (return to capital). MPK is higher where capital is lower. The Marginal Product of Capital (MPK) measures the increase in income (y) resulting from a marginal increase in capital (k). To compute MPK, we take the derivative of the production function with respect to (k): 49 Let country 1 be the US, and country 2 be India. 1 𝑦1 Suppose Θ = 3 and 𝑦2 = 15. 1 The return to capital (k) in the first country (the US) should be 225 that in the second country (India). This means that if you invest €1 in India you get €225 back. Given this amount of money you would receive, you would immediately invest in India. → It is not a problem of capital. If we look at different technology, different capital or different human capital accumulation only, the 3 cannot justify the difference in production per capita in the two economies. Even all of them together. So what is it? What is the missing factor? When an industrialized economy invests in a less developed economy, it can enjoy: Lower wages → labor is cheaper in the less developed economy. Higher return to capital → due to the scarcity of capital, the return on investment is higher. However, as more jobs are created, the demand for labor increases, leading to a gradual rise in wages. In the same way, initially, the return to capital is high due to scarcity, but as more capital is invested, the marginal product of capital decreases, leading to lower returns. This dynamics goes on until there is a convergence between the two economies. However, economic convergence (where return on capital and wages equalize with the industrialized economy) is undesirable for the capitalist because it erodes the benefits of investment. He would no longer benefit from lower wages and higher return to capital, so he is not interested in closing the differential and reaching a convergence. The capitalist strategically stops investing at a point where the return on capital is still higher than in the industrialized economy, and wages are still lower. Over-investing would reduce the return on capital and increase wages, eliminating the exploitation benefit. The lack of convergence between a less developed economy and an industrialized economy can be attributed to imperfect competition. The capitalist has a monopolistic power, 50 controlling both the supply of capital ( = monopolist) and jobs ( = monopsolist), so he is not interested in reaching a convergence because he prefers to exploit the high return to capital and lower wages. In perfect competition → the return to each factor is determined by the productivity of the factors. Workers are paid the MPL (their productivity); capitalists are paid their own MPK. In imperfect competition → there is only one monopolist supplying capital and jobs, so that capitalist is interested in getting the highest return to capital, so he borrows capital at a low interest rate from the world economy and invests it in less developed economies where capital is scarce and therefore return to capital is higher. So I am not interested in closing the gap 𝑀𝑃𝐾𝑖 = 𝑟𝑖 → industrialized economy 𝑀𝑃𝐾𝐿𝐷 = 𝑟𝐿𝐷 → less developed economy 𝑀𝑃𝐾𝐿𝐷 > 𝑀𝑃𝐾𝑖 Maximization of Profits The general form of the production function is 𝑌 = 𝐴𝐹(𝐾, 𝐿), where Y is production. For simplicity, let's assume that 𝐴 = 1 → 𝑌 = 𝐹 (𝐾, 𝐿) Since we are particularly interested in the role of capital (K), we can express the production function per worker by dividing by the number of workers (L): The primary goal of a capitalist is to maximize profits. Profit is the remaining amount after covering the costs of labor and capital from the revenue generated by sales. In perfect competition, the value of the production covers exactly the workers and the capital. To achieve maximum profit, it is essential to determine the optimal levels of capital (K) to invest and the optimal number of workers to employ. The profit (π) is given by: 51 Now consider the price a constant (𝑝 = 1) and divide everything by L, concentrating on profit per worker. In perfect competition, the amount you are going to pay for capital (r) is determined by the Marginal Product of Capital (MPK) → 𝑀𝑃𝐾 = 𝑟 MPK tells you how much the production changes when there is a small change in the quantity of capital. Mathematically, MPK is the derivative of the production function with respect to capital. 𝑀𝑃𝐾 = 𝑓'(𝐾) = 𝑟 The First Order Condition (FOC) is used to determine the optimal point where the profit is maximized. Optimality is achieved at a point where you do not want to move because you are sufficiently happy with the outcome. At this optimal point, the change in profit should be zero, meaning the derivative of the profit function with respect to capital should be zero. - If the derivative was positive, you would increase K. - If the derivative was negative, you would decrease K. - At the optimum, the derivative (change in profit) is zero. However, in imperfect competition, the capitalist's decisions on how much to pay workers and the return on capital differ from those under perfect competition. In perfect competition, wages (w) are determined by the marginal product of labor (MPL). In imperfect competition, instead, w is residual → the capitalist pays the return to capital first and then allocates the residual (what is left of the slice) to wages. Given the production function per worker: 𝑦 = 𝑓'(𝑘) The capitalist pays the return to capital - 𝑓'(𝑘)𝑘 - and the residual is allocated to wages: 𝑤 = 𝑦 − 𝑓'(𝑘)𝑘 Profit Maximization Previously, the profit maximization condition under perfect competition was: 𝑀𝑎𝑥 π = 𝑦 − 𝑤 − 𝑟𝑘 Considering that 𝑤 = 𝑦 − 𝑓'(𝑘)𝑘, the profit maximization for a monopolist under imperfect competition is: 𝑀𝑎𝑥 π = 𝑦 − [𝑦 − 𝑓'(𝑘)𝑘] − 𝑟𝑘 What is the change in y (production) when K changes? MPK which is = 𝑓'(𝑘). 52 So, considering that 𝑦 = 𝑓'(𝑘): Using the product rule → the derivative of the product of two functions is the first function times the derivative of the second function plus the derivative of the first function times the second function. Result: Simplifying: 𝑓''(𝑘)𝑘 is the only element that is different between the perfect and imperfect competition. Rewriting to highlight the impact of imperfect competition: 53 SUMMARY Perfect Competition Wages (w) are determined by the marginal product of labor (MPL). The condition for maximum profit is 𝑀𝑃𝐾 = 𝑟 Imperfect Competition (monopoly) Wages (w) are the residual after paying the return to capital. The condition for maximum profit incorporates the second derivative of the production function: 𝑓'(𝑘) = 𝑟 − 𝑓''(𝑘)𝑘. This additional term 𝑓''(𝑘)𝑘 in the condition for profit maximization under imperfect competition accounts for the monopolistic power of the capitalist and reflects the influence of diminishing returns to capital. This results in a different allocation of resources compared to perfect competition, where wages are determined by the marginal product of labor and the return to capital equals the marginal product of capital. 54  THE FINANCIAL MARKET Investors can invest in financial activities, such as the bond market, by purchasing financial assets. This type of investment is known as financial investment, as opposed to real investment in machinery or other physical assets that are also part of the financial market. In economics, in fact, we distinguish between: Financial investment → investment in financial assets. Real investment → investment in physical capital (K) used in the production function. Why do people save? People save to protect themselves against economic instability and potential future shocks. By consuming less today, they save for future consumption. This behavior helps smooth consumption over time, avoiding large fluctuations such as consuming 100 units one day and 0 units the next. Ideally, consumption should increase steadily over time without shocks. Investment Strategies If I want to invest my savings into assets, I have two possible strategies: 1. Invest in domestic assets. 2. Invest in foreign assets. Let's consider a simplified model where the world consists of two countries: Domestic country (Italy) → The currency is the euro. Foreign country (the US) → The currency is, for example, the dollar. The key decision is whether to buy assets at home or in the US. The equilibrium is reached when I am indifferent to the choice because the returns are equalized. Investment in Domestic Assets 𝑖 → Return on an asset (nominal interest rate) Suppose I invest €1 in my domestic economy at time t. Tomorrow, I will have: 1 + 1𝑖 → 1 + 𝑖. This represents my gain, where i is the nominal interest rate. Why do we use the nominal interest rate (i) instead of the real interest rate (r)? The nominal interest rate (i) is used in these comparisons because it directly reflects the actual rate of return without adjusting for inflation (change in price). The real interest rate, on the other hand, adjusts the nominal rate by accounting for expected inflation (πe). 𝑒 The formula for the real interest rate (r) is: 𝑅 = 𝑖 − π As an Italian investor, the inflation rate (πe) affects you equally whether your returns are in euros or dollars, because you are consuming in Italy. Therefore, when comparing the returns from domestic and foreign investments, the inflation adjustment would be the same on both sides. Example → If the nominal interest rate at home is 5% and the nominal interest rate abroad is 8%, and the expected inflation rate is 2%, the real interest rates would be: - Domestic real interest rate: 5% − 2% = 3% - Foreign real interest rate: 8% − 2% = 6% 55  Since the inflation rate is constant for both investments, comparing the nominal interest rates (5% vs. 8%) directly gives the same relative outcome as comparing the real interest rates (3% vs. 6%). Investment in Foreign Assets To invest €1 in the US, I first need to convert it into dollars. This conversion depends on the exchange rate, which is the relative price between two currencies. 𝑢𝑛𝑐𝑒𝑟𝑡𝑎𝑖𝑛 𝐸 → Nominal exchange rate → 𝐸 = 𝑐𝑒𝑟𝑡𝑎𝑖𝑛 "Certain" means the number of euros I get for a given quantity of dollars. The exchange rate can €0.90 fluctuate daily. Example: 𝐸 = ＄1 If