International Economics Assignment

1. Composition Structure

2. Part A
2.1. Introduction
2.2. Optimum Tariff Argument
2.2.1. Definition
2.2.2. Assumptions
2.2.3. Process
2.2.4. Probability of Assumptions
2.3. Strategic Trade Theory
2.3.1. Definition
2.3.2. Assumptions
2.3.3. Process
2.3.4. Probability of Assumptions

3. Part B
3.1. Introduction
3.2. Heckscher-Ohlin Model
3.2.1. Definition
3.2.2. Assumptions
3.2.3. Process
3.2.4. Probabilility of Assumptions
3.3. Specific Factors Model
3.3.1. Definition
3.3.2. Assumptions
3.3.3. Process
3.3.4. Probability of Assumptions

4. Conclusion

5. Appendix
5.1. Tariff
5.2. Import Quota
5.3. Subsidy
5.4. Non-tariff barrier (NTB)
5.5. Indifference Curve
5.6. Isoquant
5.7. Production Possibility Frontier
5.8. Trade Blocs in the World
5.9. Perfect Competition

6. References

1. Composition Structure

Mainly the composition is divided into two parts, the two questions of the essay issues. Each treats a short introduction and suggests the theories being used to explain the answer. In order to do that first a definition of the theories is used, then the assumptions are supplied, followed by a detailed description of the process. In the end the probability of the assumptions is discussed.

Some of the economic terms used in the essay are assumedly known. Nonetheless they are explained in the appendix.

2. Part A

Making use of diagrams, carefully explain all of the circumstances under which protecting a domestic industry from overseas competition could improve the overall economic welfare of the country imposing that protection. How likely is it that each of these circumstances exist?

2.1. Introduction

First of all it is necessary to explain some key words used in the question.

Protection can be seen as any form of trade barriers to free trade that can be imposed on a country in various ways. There exist tariffs, import quotas, subsidies, as well as non-tariff barriers.

The improvement of the welfare of a country can be shown through higher indifference curves or isprofit lines in an economy.

There are two theories used to explain how protection can improve a country’s welfare. Those are the optimum tariff argument and the strategic trade theory.

2.2. Optimum Tariff Argument

2.2.1. Definition

“The optimum tariff rate is the rate that maximises the country’s welfare.”¹

2.2.2. Assumptions

This theory holds if the country imposing the tariff is a large country and therefore a price maker. Furthermore the other country is not allowed to retaliate. The knowledge of the other country’s offer curve is also essential.

2.2.3. Process

The optimum tariff can be best shown with in an offer curve diagram. In box1 the situation under free trade is examined. Two countries I and II are trading two products X and Y under a certain terms of trade (ToT). Country I exports good X at x0 and imports good Y at y0 to and from country II. On the other hand country II exports good Y at y0 and imports good X at x0.

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Then country I imposes a tariff on good Y (box2). This shows its decreased willingness to trade and its offer curve shifts to the left (OC’). Therefore the exports of good X decrease to x1. Since country I is a large country it can influence the price of the goods X and Y the terms of trade decrease and also change to the left (ToT’).

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The implications for the economy are shown in box 3. The tariff allows country I to consume on a higher indifference curve under the new terms of trade (ToT’). This means that the economic wellbeing of country I has improved.

Box 3

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2.2.4. Probability of Assumptions

The assumption of the existence of a large country to be able to influence prices is very realistic. In the 90-ies the forming of regional trading blocks began. Nowadays they are acting like one “country”, e. g. the North American Free Trade Agreement or the European Community (see appendix 4.8).

It is very unlikely to believe that a country having a tariff imposed on their export good is not retaliating. It does not want to be forced to be consuming on a lower indifference curve and therefore also imposes a tariff in order to get to a higher indifference curve to be “better off”.

The knowledge of another country’s offer curve is in practical terms simply impossible. Too many factors are influencing a country’s willingness to trade. And as soon as an incorrect offer curve is assumed the tariff cannot be an optimum one.

2.3. Strategic Trade Theory

2.3.1. Definition

The strategic trade theory is a new approach to explaining the advantages of protectionism. It relaxes the assumption of perfect competition. The government of a country transfers profit to the its country due to protection.

2.3.2. Assumptions

Various assumptions to this theory exist. In the world market there are two firms competing in an oligopolistic market. Each firm assumes that the other firm’s output is fixed. Furthermore the home government has a superior understanding of the foreign firm’s behaviour than the domestic firm. The foreign government does not react. And the home firm has to be domestically owned.

2.3.3. Process

Two countries, the home country and the foreign country, are competing in the world market. In box 4 H is the home country’s reaction function and F the foreign country’s. A reaction function indicates the profit-maximising level of a firm’s sales for any given level of the other firm’s sales.² If two firms are producing at A in a market then the home country would be satisfied with its sales at xA because A is on its reaction function and therefore at a profit-maximising point. For the foreign firm this is not true. To achieve its profit maximum it reduces production from yA to yB. Hence the home firm is cutting its production from xA to xB to get back to its reaction function. In the end the firms will settle at the equilibrium point E with sales of xE for the home firm and yE for the foreign firm.

Box 4

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In box 5 there are also isoprofit lines (IPs) considered. They show all combinations of sales by the home firm and the foreign firm in this market that generate a given level of profit for the home firm.³ The further away from the home firm sales axis the isprofit line of the home country is shifting the smaller is the profit, e. g. the profit along IPH1 is greater than at IPH2. Since the two companies are selling at point E the home firm is generating its profits along IPH2 at xE.

Box 5

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In box 6 one can now see how government imposed protection works in the strategic trade policy model. In this model the government subsidises the home firm. Therefore the home firm’s reaction function shifts to the right and a new equilibrium point is reached at W. Because W is on a higher isoprofit line (IPH1) as E (IPH2) the profit of the home firm has increased. Due to the higher profit generated in the home country the overall welfare of the home country also increases.

Box 6

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The effect of the trade policy on the foreign firm is pictured in box 7. It moved to a lower isoprofit line from IPF1 to IPF2, hence decreasing its profits. This means that the increase in profits of the home country is only possible at the costs of the foreign country.

Box 7

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2.3.4. Probability of Assumptions

Oligopolistic markets do exist in the world, e. g. Airbus and Boeing. In fact the strategic trade policy evolved because it took into considerations the improbability of the assumption of imperfect competition.

But as soon as the foreign firm changes its output the theory does not hold any more. Firms can change their output weekly, daily or even every hour.

The government’s superior knowledge is questionable. This would imply that a company does not know the market it is operating in. Furthermore it would be easier for the government to simply share its knowledge with the home firm instead of “tricking them into the right action.” As already explained in the optimum tariff argument it is doubtful not to expect any retaliation of the foreign government.

With the investment possibilities of stock markets nowadays capital is flowing quite freely throughout the financial world markets. It is very likely that the stockowners of one company are from different parts of the world.

3. Part B

Carefully explain how imposing protection can improve the welfare of an individual factor of production.

3.1. Introduction

In order to answer this question it is necessary to describe the relation between trade and factors of production. In fact the Heckscher-Ohlin Model and the specifics factors model show this interdependence.

3.2. Heckscher-Ohlin Model

3.2.1. Definition

The Heckscher-Ohlin Model consists of three theorems: the Heckscher-Ohlin theorem, the factor price equalisation theorem and the Stolper-Samuleson theorem.

The Heckscher-Ohlin theorem states that “a country will export the commodity that uses relatively intensively its relatively abundant factor of production, and it will import the good that uses relatively intensively its relatively scarce factor of production.”⁴ Which factor the scarce or abundant one is depends on the factor endowment of a country. This can be indicated using Edgeworth boxes.

“In equilibrium, with both countries facing the same relative (and absolute) product prices, with both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalised. The only way this can happen is if, in fact, factor prices are equalised,”⁵ says the following theorem, the Factor Price Equalisation theorem.

The Stolper-Samuelson theorem furthermore claims that “with full employment both before and after trade takes place, the increase in the price of the abundant factor and the fall in the price of the scarce factor because of trade imply that the owners of the abundant factor will find their real incomes rising and the owners of the scarce factor will find their real incomes falling.”⁶

3.2.2. Assumptions

- There are two countries, two homogeneous goods, and two homogeneous factors of production whose initial levels are fixed. Each country has a different factor endowment.

- Technology is identical in both countries. Therefore isoquants are the same in both countries.

- Production is characterised by constant returns to scale for both commodities in both countries.

- The two commodities have different factor intensities, and the respective commodity factor intensities are the same for all factor price ratios.

- Tastes and preferences in both countries are the same.

- Prefect competition exists in both countries.

- Factors are perfectly mobile within each country but not in between countries.

- There are no transportation costs.

- There are no policy restricting the movement of goods between countries or interfering with the market determination of prices and output.⁷

3.2.3. Process

In box 8 the factor endowments of country I and II are shown in Edgeworth boxes. Its shape leads to the conclusion that country I’s abundant factor is K. Factor K is used relatively intensively in the production of good Y. Applying the Heckscher-Ohlin theorem means that country I will be exporting good Y and importing good X while trading with country II. On the other hand country II’s abundant factor is L. Factor L is used relatively intensively in the production of good X. In this case country I will export good X and import good Y.

Box 8

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Trade takes place at an international price ratio (Px/Py)Int, as indicated in box 9. Here production possibility frontiers are used to explain trade. Country I will export the amount of yI to yt of good Y and import the amount of xI to xT of good X. This implies that its production of good Y increased. In country II the same happens visa versa. Here production of good X increases. Trade enables both countries to to consume at the indifference curve IC.

Box 9

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Since the production of good Y is increasing the demand for factor K which is used relatively intensively in its production is also increasing. Hence the price for factor K in country I must increase as well. On the contrary the production of good X is declining. Therefore demand for factor L is decreasing and in turn its factor price. To country II the same is happening visa versa as verified in box 10. This process takes place until the comparative advantage ceases to exist and the factor prices are equalised.

Box 10

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Let us now consider the changes for the owners of the factors of productions. In country I the price of factor K is rising and of factor L is falling. Since good Y uses intensively factor K its price is also increasing. But because also a little bit of factor L is employed in its production the price of good Y is not rising as much as the rise in the factor of production. The price for good X on the other hand is falling in country I because it uses intensively factor L. But since also a part of factor K is necessary to produce it the price of factor L is falling more than the price of good X. This leads to the following relation: increase in P(K) > increase in P(Y) > fall in P(X) > fall in P(L). Therefore the owners of factor K are clearly better of and the owners of factor L are worse off.

In country II a change also takes place which leads to: increase in P(L) > increase in P(X) > fall in P(Y) > fall in P(K). This has the adverse effect on the owners of the factors in country II.

If the government would now protect the industry that uses relatively intensive the factor of production that is worse off under trade it would change the whole scenario. Since in country I factor L is worse off it can for example put a tariff on good X. This increases the price of good X in the domestic market and the quantity that can be supplied domestically from xDS to xDS’ (see box 11.A).

Box 11.A

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An import quota has the same effect as a tariff. By limiting the amount of good X in the domestic market by xFS to xQuota the price of X changes and therefore the ability of the home country to supply the good increases to xDS’. All the other trade barriers basically aim to achieve the same, that is, limiting the quantity supplied by foreigners.

Box 11.B

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Due to the increase in production of good X the demand for factor L increases again, hence pushing up the price for factor L like stated in box 12. Consequently the owners of this particular factor would be better off again.

Box 12

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Trade always has to take place between two countries. Therefore this assumption is not crucial to the theorem. On the other hand to assume to trade two homogeneous goods is quite challenging. Also the factors of production can differ between countries in perspective to their quality. The different factor endowment is not the only reason for trade. Also the different factor intensities of the commodities are not crucially necessary for trade to take place. Due to the mobility of technology the assumption of isoquants being the same in both countries is truer than it used to be.

When trade occurs markets always grow. Therefore companies can make use of increasing economies of scale. The assumption of constant returns no longer holds. Tastes and preferences depend on many factors, e. g. culture, income composition and so on. To assume that they would be the same in both countries is very vague.

The assumption of perfect competition is always ideal one (see appendix 5.9). In the real world there is almost no market working under those circumstances. Most products are differentiated. Entry barriers to markets can be legislative requirements or a high amount of capital required starting a business.

That factors are perfectly mobile within each country is very likely. On the other hand the mobility of factors in between countries depends on the factor. Since many countries have strict immigration laws the factor labour is limited in its mobility. For capital the assumption is not true any more because capital can flow quite freely around the globe.

Of course there will always be transportation costs involved in trade since goods have to be transferred from the producing country to the consuming country.

Every trade bloc or country is protecting their industries in one way or another. The United States us non-tariff barriers, e. g. unreasonable health or safety standards. Australia protects its manufacturing and clothing sector through tariffs. The European Cmmunity also uses tariffs to help its agriculture.

3.3. Specific Factors Model

3.3.1. Definition

The Specific Factors Model explains the equalisation of factor prices on basis of the free flow of one factor of production.

3.3.2. Assumptions

The assumptions are the same as in the Heckscher-Ohlin model. The modifications in this model are the following. It is assumed that there exist three factors of production. Two of them can only be used in one particular industry each. The third factor is used for both industries.

3.3.3. Process

Country I contains the factor L abundantly. Two industries producing goods X and Y exist whereby good X uses exclusively factor K and good Y specifically J. Factor L is used intensively in the production of good X. As shown in box 13 factor L is mobile in between industries. Therefore the return to it is the same in the two industries. Country I imposes protection on good Y because of a lack of comparative advantage according to the Heckscher-Ohlin Model. Therefore the price of good X rises (see box 11 for relation of prices and protection). And since the value of marginal product of factor L of good Y (VMPLY) equals the price of Y (PY) times the marginal product of good Y (MPLY) the VMPLY increases proportionally. Therefore the amount of factor L employed in industry Y increases by FF’. The return to factor L does not increase proportionally from w0 to w1.

The advantages of protection in this model therefore are that the return to factor L increases in terms of good X.

Factor J, used exclusively in the production of good Y, will be better off due to its increased usage of factor L. The return to J increased in terms of Y and even more in terms of X.

Box 13

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3.3.4. Probability of Assumptions

It is quite common that one factor like labour can be used in two different industries like agriculture and manufacturing. In this case agriculture would relatively exclusively use the factor land and manufacturing capital.

4. Conclusion

The optimum tariff argument and strategic trade theory explain how protectionism can improve the economic welfare of a country. The assumptions underlying both theories are very tight and therefore in reality not achievable.

Furthermore protection can be used to enhance an individual factor of production. The Heckscher-Ohlin model and the specific factors model demonstrate this correlation. Although this is true it has to be considered that the gain of an individual factor of production is achieved only at the cost of another one. Using protection under these circumstances can only be regarded as the redistribution of welfare in a nation.

Another crucial factor is the difference between the nominal and the effective rate of protection to understand the real impact of protection imposed on an industry.

5. Appendix

5.1. Tariff

Specific tax imposed on imported products to improve the competitive position of domestic producers of the same or similar products.⁸

5.2. Import Quota

Quantitative restriction on the level of specified foreign-produced product allowed to be imported over a specific period. A zero level of quota represents a complete prohibition of the product.⁹

5.3. Subsidy

Payment to businesses to encourage production of a particular commodity or use of a particular resource. Effectively negative indirect taxes.¹⁰

5.4. Non-tariff barrier (NTB)

Licensing, standards, or procedures designed with the primary purpose of protecting local production against foreign competition.¹¹

5.5. Indifference Curve

A curve showing the different combination of two products that give a consumer the same satisfaction or utility.¹²

5.6. Isoquant

Is a concept that relates output to the factor inputs. An isoquant shows the various combinations of the two inputs that produce the same level of output.¹³

5.7. Production Possibility Frontier

A curve that shows the different combinations of two goods or services that can be produced in a full-employment and full-production economy in which the available of resources and technology are constant.¹⁴

5.8. Trade Blocs in the World

“The world is increasingly dividing into trade blocs. The world's two most powerful economies, the United States, and the European Union, have each sought to forge links to neighbouring countries and deny access to rivals. Other major trading countries, like the fast growing exporters on the Pacific Rim and the big agricultural exporting nations, have also sought to create looser trade groupings to foster their interests.

The formation of free trade zones and trade blocs is one of the major issues facing the world trading system - whether it will lead to increased protectionism, or whether the trade blocs will promote trade liberalisation.¹⁵ ”

5.9. Perfect Competition

“A market in which a very large number of firms sell a standardised product, into which entry is easy, in which the individual seller has no control over the price at which the product sells, and in which there is a large number of buyers.”¹⁶

6. References

- Dennis R. Appleyard and Alfred J. Field, JR. “International Economics”; 1998; 3rd edition, The McGraw-Hill Companies, Inc.

- John Jackson, Ron McIver, Campbell McConnell and Stanley Brue “Macro Economics”; 1998; 3rd edition; The McGraw-Hill Companies, Inc.

- BBC News “Trade Blocs in the world”; 2000 [online] http://news.bbc.co.uk/hi/english/static/special_report/1999/11/99/seattle_trade_talks/default. stm

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¹ Appleyard and Field (1998) page 303

² Appleyard and Field (1998), page 330

³ Appleyard and Field (1998), page 329

⁴ Appleyard and Field (1998), page 134

⁵ Appleyard and Field (1998), page 137

⁶ Appleyard and Field (1998), page 138

⁷ Appleyard and Field (1998), page 128

⁸ Jackson, McIver, McConnel, Brue (1998); page 35:3

⁹ Jackson, McIver, McConnel, Brue (1998); page 35:4

¹⁰ Jackson, McIver, McConnel, Brue (1998); page GL:25

¹¹ Jackson, McIver, McConnel, Brue (1998); page 35:4

¹² Jackson, McIver, McConnel, Brue (1998); page GL:12

¹³ Appleyard and Field (1998), page 73

¹⁴ Jackson, McIver, McConnel, Brue (1998); page GL:22

¹⁵ http://news.bbc.co.uk/hi/english/static/special_report/1999/11/99/seattle_trade_talks/default.stm

¹⁶ Jackson, McIver, McConnel, Brue (1998); page GL:20