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Econ 420: Final Exam Studyguide

by: Laura Kunigonis

Econ 420: Final Exam Studyguide Econ 420

Laura Kunigonis

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Complete study guide for the final exam
International Economics
Werner Baer
Study Guide
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This 6 page Study Guide was uploaded by Laura Kunigonis on Sunday May 15, 2016. The Study Guide belongs to Econ 420 at University of Illinois at Urbana-Champaign taught by Werner Baer in Spring 2016. Since its upload, it has received 13 views. For similar materials see International Economics in Economcs at University of Illinois at Urbana-Champaign.


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Date Created: 05/15/16
Econ 420 Final Exam Heckscher Ohlin What is the 'Heckscher­Ohlin Model' The Heckscher­Ohlin model is an economic theory that states that countries export what they can most easily  and abundantly produce. The Heckscher­Ohlin model is used to evaluate international trade, specifically trade  equilibriums between countries that may have different features. The model emphasizes how countries with  comparative advantages should export goods that require factors of production that they have in abundance,  while importing goods that it cannot produce as efficiently. Despite sounding reasonable, economists have had difficulty finding evidence that supports the Heckscher­ Ohlin model. Other models have tried to explain how industrialized countries tend to trade with each other more than they trade with developing countries, as outlined in the Linder hypothesis Heckscher­Ohlin theorem: An economy has a comparative advantage in producing, and thus will export,  goods that are relatively intensive in using its relatively abundant factors of production, and will import goods  that are relatively intensive in using its relatively scarce factors of production. Factor­Price Equalization:  The factor­price equalization theorem says that when the product prices are equalized between countries as  they move to free trade in the H­O model, then the prices of the factors (capital and labor) will also be equalized between countries. Factor­price equalization arises largely because of the assumption that the two countries have the same  technology in production. Factor­price equalization in the H­O model contrasts with the Ricardian model result in which countries could  have different factor prices after opening to free trade. Stolper­Samuelson theorem: If the relative price of a good increases, then the real wage or rental rate of the  factor used intensively in the production of that good increases, while the real wage or rental rate of the other  factor decreases. Any change in the relative price of goods alters the distribution of income. In the real world, factor prices are not equal across countries. The model assumes that trading countries produce the same goods, but countries may produce different goods if their factor ratios radically differ. The model also assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages/rates paid to these factors. Rybczynski theorem: If you hold output prices constant as the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases. Unlike the Ricardian model, the Heckscher­Ohlin model predicts that factor prices will be equalized among  countries that trade. Free trade equalizes relative output prices. Due to the connection between output prices and factor prices, factor prices are also equalized.  Trade increases the demand of goods produced by relatively abundant factors, indirectly increasing the demand  of these factors, raising the prices of the relatively abundant factors. The model also ignores trade barriers and transportation costs, which may prevent output prices and thus factor  prices from equalizing. The model predicts outcomes for the long run, but after an economy liberalizes trade, factors of production may  not quickly move to the industries that intensively use abundant factors. In the short run, the productivity of factors will be determined by their use in their current industry, so that their  wage/rental rate may vary across countries. Distribution Implications Changes in income distribution occur with every economic change, not only international trade. Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of new ones  all affect income distribution. Economists put most of the blame on technological change and the resulting premium paid on education as the  major cause of increasing income inequality in the US. It would be better to compensate the losers from trade (or any economic change) than prohibit trade. The economy as a whole does benefit from trade. There is a political bias in trade politics: potential losers from trade are better politically organized than the  winners from trade. Losses are usually concentrated among a few, but gains are usually dispersed among many. Each of you pays about $8/year to restrict imports of sugar, and the total cost of this policy is about $2  billion/year. The benefits of this program total about $1 billion, but this amount goes to relatively few sugar producers. ….. In the H­O model, when countries implement free trade, output prices, wages, and rents on capital change. If a country is abundant in capital (labor), then a movement to free trade will increase real rents (wages) and  decrease real wages (rents). In other words, income is redistributed from workers (capital owners) to capital  owners (workers). Because labor and capital are assumed to be homogeneous factors, workers (capital owners) in both industries  realize identical real income effects. The redistribution of income in the H­O model is based on which factor an individual owns, not on which  industry an individual works in (as it is in the immobile factor model). Over the last 40 years, countries like South Korea, Mexico, and China have exported to the U.S. goods intensive in unskilled labor (ex., clothing, shoes, toys, assembled goods). At the same time, income inequality has increased in the U.S., as wages of unskilled workers have grown  slowly compared to those of skilled workers. Did the former trend cause the latter trend? The Heckscher­Ohlin model predicts that owners of relatively abundant factors will gain from trade and owners  of relatively scarce factors will lose from trade. Little evidence supporting this prediction exists. According to the model, a change in the distribution of income occurs through changes in output prices, but  there is no evidence of a change in the prices of skill­intensive goods relative to prices of unskilled­intensive  goods. Tariffs  Specific tariffs Taxes that are levied as a fixed charge for each unit of goods imported Example: A specific tariff of $10 on each imported bicycle with an international price of $100 means that  customs officials collect the fixed sum of $10. Ad valorem tariffs Taxes that are levied as a fraction of the value of the imported goods Example: A 20% ad valorem tariff on bicycles generates a $20 payment on each $100 imported bicycle. ­A compound duty (tariff) is a combination of an ad valorem and a specific tariff.  ­Modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such  as: ­Import quotas (Limit the quantity of imports) ­Export restraints (Limit the quantity of exports) Import Quotas: Theory An import quota is a direct restriction on the quantity of a good that is imported.  Example: The United States has a quota on imports of foreign cheese. The restriction is usually enforced by issuing licenses to some group of individuals or firms.  Example: The only firms allowed to import cheese are certain trading companies. In some cases (e.g. sugar and apparel), the right to sell in the United States is given directly to the governments  of exporting countries. An import quota always raises the domestic price of the imported good. License holders are able to buy imports and resell them at a higher price in the domestic market.  The profits received by the holders of import licenses are known as quota rents. Welfare analysis of import quotas versus of that of tariffs  The difference between a quota and a tariff is that with a quota the government receives no revenue. In assessing the costs and benefits of an import quota, it is crucial to determine who gets the rents. When the rights to sell in the domestic market are assigned to governments of exporting countries, the transfer  of rents abroad makes the costs of a quota substantially higher than the equivalent tariff. Economic Integration Trade Creating Custom Unions Trade creation occurs when domestic production in a member nation is replaced by lower­cost imports from another member nation. Leads to increased welfare for members as nations specialize in comparative advantages. Leads to increased welfare for non­members as increased real income spills over into increased imports from rest of the world. Trade Diverting Custom Unions Trade diversion occurs when lower­cost imports from  non­members are replaced by higher cost imports from  members. By itself, trade diversion lowers welfare as it shifts  resources away from comparative advantages. Trade diverting customs union also results in trade  creation.  Change in welfare depends on relative  magnitude of creation and diversion. Developing Trade Comparative advantage and Prebisch Critique ­ Comparative advantage states that countries should specialize in industries where they have the most  comparative advantage. ­ This means that a country will export goods where they have comparative advantage and import goods  that do not have a comparative advantage. ­ In the past, for developing countries (third world countries) this meant that they specialize in agriculture  goods while developed countries specialize in manufacturing goods. ­ Prebisch was one of the first economists to show that this world division of labor would hurt economic  prospects of the developing countries. ­ Moreover, Prebisch argued that the world division as Center­Periphery harmed the periphery as they  became dependent on the Center. ­ If the Center faced some recession, the periphery was strongly negatively a affected by the Center  recession while the opposite was not true. ­ This meant vulnerability and instability of the Periphery to international trade fluctuations. ­ Raw materials and agriculture supply is difficult to adjust. Hence, changes in demand strongly affect  prices. ­ Prebisch noted that economies are dynamic and are able to change their structure over time, thus  revealing comparative advantages that could not be explored in the past. ­ This idea was closely associated with the Infant­Industry argument for protection. ­ Hence, one of the major policy implications of the Prebisch (ECLAC) was the Import­Substituting  Industrialization. ­ The main objective was to diversify the economy (increasing the manufacturing sector), as a way to  reduce the dependency of the Periphery on the Center, improving its terms of trade. ISI ­ I From World War II until the 1970s many developing countries attempted to accelerate their  development bylimiting imports of manufactured goods to foster a manufacturing sector serving the  domestic market. ­ Protection through tariffs, exchange controls. ­ State enterprises and development banks. ­ Attraction of multinationals (wanted investors from the center to invest in periphery) ­ It had a growth impact ­ industry as leading sector, change in GDP structure. ­ Many economists are now harshly critical of the results of import substitution, arguing that it has  fostered high­cost, inefficient production ­ Manufacturing sector was very inefficient in most cases and could not compete abroad. ­ Dual economy is exacerbated. ­ I Import coefficient is sticky downwards and the compositional change in imports can make the  Periphery economies even more vulnerable to recessions in the Center. Foreign Direct Investment Before 1930 ­ Investment in infrastructure: Transportation, energy, etc. ­ Direction of FDI From Center to Periphery: in the early stages, investment from Center in their  respective Colonies; in later stages, from developed countries to developing countries. ­ Hosting governments gave investors guaranteed rate of return. Also they paid low taxes and charged  high rates to exploit developing countries. ­ Foreign investors did not have good reputation because the investment did not improve well­being of  those countries. ­ Hosting country did not accumulate human capital. The majority of local labor used was unskilled. Foreign Direct Investment After 1930 ­ Nationalization of infrastructure and primary resources be the developing countries changed the nature  of FDI from infrastructure and primary resources to manufacturing. ­ Import­Substitution policies also accelerated this process. ­ The rise of Multinationals corporations after WWII. FDI after 1930 was mainly constituted of  investment in companies (purchasing shares) and establishment of subsidiaries by Multinationals. Positive Impact of Multinational Corporations on host country  1. Infow of foreign exchange 2. Access to technology 3. Access to modern organization 4. Human capital development 5. Stimulate local supplying firms 6. Help diversify exports Negative Impact of Multinational Corporation on Host Country  1. Balance of payments profit remittances and import increase (pieces and components). 2. Transfer pricing 3. Little R&D 4. Consumption distortion 5. Denationalization 6. Transfer of decision making centers abroad Foreign Direct Investment Before 1930: Investment in infrastructure: Transportation, energy, etc. Direction of FDI From Center to Periphery: in the early stages, investment from Center in their respective  Colonies; in later stages, from developed countries to developing countries. Hosting governments gave investors guaranteed rate of return. Also they paid low taxes and charged high rates  to exploit developing countries. Foreign investors did not have good reputation because the investment did not improve well­being of those  countries. Hosting country did not accumulate human capital. The majority of local labor used was unskilled. After 1930: Nationalization of infrastructure and primary resources be the developing countries changed the  nature of FDI from infrastructure and primary resources to manufacturing. Import­Substitution policies also accelerated this process. The rise of Multinationals corporations after WWII. FDI after 1930 was mainly constituted of investment in  companies (purchasing shares) and establishment of subsidiaries by Multinationals. Positive impact: 1. Inflow of foreign exchange 2. Access to technology 3. Access to modern organization 4. Human capital development 5. Stimulate local supplying firms 6. Help diversify exports Negative Impact: 1. Balance of payments profit remittances and import increase (pieces and components). 2. Transfer pricing 3. Little R&D 4. Consumption distortion 5. Denationalization 6. Transfer of decision making centers abroad


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