Econ 310, Week 5 notes
Econ 310, Week 5 notes Eco 310
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This 8 page Class Notes was uploaded by Tori Notetaker on Wednesday March 2, 2016. The Class Notes belongs to Eco 310 at Murray State University taught by Mary Reed in Spring 2016. Since its upload, it has received 27 views. For similar materials see Issues in the Global Economy in Economcs at Murray State University.
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Date Created: 03/02/16
Week 5, Chapter 6 Key Terms https://quizlet.com/124155355/eco310chapter6termsflashcards/ Key Concepts (Taken from text and lecture) Understand why nations trade with each other. Economists have long argued that free trade creates economic growth and raises living standards o If the US and EU can reach an agreement brought about by the free trade proposal (talked about in the opening case), it could potentially boost economic growth and bring down unemployment rates without any additional government expenditures An Overview of Trade Theory o Adam Smith proposed the theory of absolute advantage in 1776 Explains why unrestricted free trade is beneficial to a country; the invisible hand of the market mechanism should determine what a country imports and exports; and that a laissezfaire stance towards trade is in the best interests of a country o Based off of absolute advantage, David Ricardo brought about the theory of competitive th advantage in the 19 century Trade patterns reflect differences in labor productivity Is the intellectual basis for the argument of unrestricted free trade o Later Eli Heckscher and Bertil Ohlin created the HeckscherOhlin theory Trade allows different countries to piece together their factors of production that are available to them to produce specific goods o The Benefits of Trade HeckscherOhlin International trade is beneficial o Gives example of Iceland, where it’s not practical to grow and sell products (like oranges) that it cannot produce, but instead trading out stuff that it can produce a lot of (fish) and trading them for oranges! Even when a country can produce for itself, international trade is still beneficial o It allows a country to specialize in the manufacture and export of products that can be produced most efficiently and importing products that are produced more efficiently in another country Limits on imports are often in the interests of domestic produces, but not domestic consumers o The Pattern of International Trade Comparative Advantage The explanation as to why some countries export manufactured goods rather than natural resources o Some countries have more land, labor, and capital available, which are needed to produce such goods In the 1980’s economists like Paul Krugman developed the New Trade Theory, winning him the Nobel Peace Prize Some countries specialize in the production and export of particular products because in certain industries the world market can support only a limited number of firms Trade will skew towards those countries that have firms that were able to capture firstmover advantages o Trade Theory and Government Policy Mercantilism makes a case for government involvement in promoting exports and limiting imports Smith, Ricardo, and HeckscherOhlin make a case for unrestricted free trade Import controls and export incentives are selfdefeating and result in wasted resources New Trade Theory and Porter’s Theory of National Competitive Advantage justify limited government intervention to support the development of certain export oriented industries Summarize the different theories explaining trade flows between nations. Mercantilism o What is it? th Cropped up in England in the Mid16 century when gold and silver were the mainstays of national wealth It was in the best interest of a country to trade surplus, exporting more than it imports, increasing national wealth, prestige, and power Achieved by limiting imports through tariffs and quotas, and subsidizing exports Advocates government intervention to achieve a surplus in the balance of trade Veiwed as a zerosum game: one country results in a loss by another However, David Hume argued that the balanceoftrade surplus would lead to inflation, and the opposite strategy would have the opposite effect and drain a countries accounts making their products too expensive and other products too cheap. This points out the flaw of Mercantilism as a zerosum game o NeoMercantilists Equate political power with economic power and economic power with a balanceoftrade surplus Strategy designed to simultaneously boost exports and limit imports Absolute Advantage o Adam Smith, The Wealth of Nations Attacked mercantilist assumption that trade is a zerosum game Countries differ in their ability to produce goods efficiently Countries should specialize in the production of goods for which they have an absolute advantage and then trade for goods produced in other countries Uses examples of Textile production being the absolute advantage of England and trading for wine, France’s absolute advantage This way both countries benefit from trading (and production is more effective) o Production Possibility Frontier → graph depicting different combinations of goods a country can produce given limited resources Comparative Advantage o David Ricardo, Principles of Political Economy It makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently form other countries, even if it means buying goods that it could produce more efficiently itself Without trade, a country must consume strictly what it produces, but with trade, it can increase production in the goods in makes more efficiently and buy the goods that it produces less efficiently o Gains From Trade Potential world production is greater with unrestricted free trade than it is with restricted trade Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. The theory of comparative advantage suggests that trade is a positivesum game in which all countries that participate realize economic gains Provides a strong rationale for encouraging free trade HeckscherOhlin Theory o Argues that comparative advantage arises from differences in national factor endowments Explains differences in factor costs; the more abundant a factor. The lower its cost o Predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce o The Leontief Paradox Postulates that because the US was relatively abundant in capital compared to other nations, the US would be an exporter of capitalintensive goods and an importer of laborintensive goods However, Leontief found that US exports were less capitalintensive than US imports o U.S, has a special advantage in producing products made with innovative technology that are less capital intensive o Differences in technology lead to differences in productivity which then drives trade patterns The Product LifeCycle Theory o Proposed by Raymond Vernon in the 1960’s o As products mature, both the sales and optimal production location will change affecting the flow and direction of trade th o Based on the observation that for most of the 20 century a large portion of the world’s new products had been developed by US firms and sold first in the US market Due to the high cost of labor for these products, the US had developed the incentive to create costsaving process innovations o Product LifeCycle Theory in the 21 Century Not as relevant in the US today Much of production is outsourced New Trade Theory o Emerged in the 1970’s when economists pointed out that the ability of firms to attain economies of scale night have important implications for international trade o Economies of scale Include the ability to spread fixed costs over a large volume and the ability of largevolume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment Major source of industry cost reductions o Two points of New Trade Theory Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods In those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises National Competitive Advantage: Porter’s Diamond o Michael Porter’s (Harvard strategy professor) essential task was to explain why a nation achieves international success in a particular industry o Country factors explain a nations dominance in the production and export of certain products o Porter theorizes four broad attributes of a nation shape the environment in which local firms compete; Makes up Porter’s Diamond as seen on page 181 Factor Endowments→ a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry Basic Factors: natural resources, climate, location, and demographics o Provides initial advantage that is subsequently reinforced and extended by investment in advanced factors o Disadvantages can cause pressure to invest in advanced factors Advanced Factors: communication, infrastructure, sophisticated and skilled labor, research facilities, and technological know how o Most significant for competitive advantage o Product of investment by individuals, companies, and governments Demand Conditions→ the nature of home demand for the industry’s product or service. Firms are most typically sensitive to the needs of their closest customers creating pressure for innovations and quality The firm gains competitive advantage if their domestic consumers are sophisticated and demanding which pressures local firms to meet high standards of product quality and to produce innovative products Related and Supporting Industries→ the presence or absence of supplier industries and related industries that are internationally competitive The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, helping is achieve a strong competitive position internationally Successful industries within a country tend to be grouped in to clusters of related industries Firm Strategy, Structure, and Rivalry→ The conditions governing how companies are created, organized, and managed and the nature of domestic rivalry Different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage There is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry o Induces firms to look for ways to improve efficiency o Creates pressure to innovate, improve quality, reduce costs, and invest in upgrading advanced factors o Additional variables that can influence the national diamond Chance and Government Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system. Comparative Advantage o Qualifications and Assumptions Unrealistic assumptions of free trade: A simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods. There is no transportation costs between countries There are no differences in the prices of resources in different countries. Nothing has been mentioned of exchange rates, simply assuming that cocoa and rice (Ghana and South Korea analogies) could be swapped on a onetoone basis. Resources can move freely from the production of one good to another within a country. Constant returns to scale; specialization by one country has no effect on the amount of resources required to produce a certain amount of a good. In reality, both diminishing and increasing returns to specialization exist Each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade There are no effects of trade on income distribution within a country o Extensions of the Ricardian Model Immobile Resources Resources do not always move easily from one economic activity to another o Some producers may lose their job due to greater demand of a product that they’re not qualified to produce Political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk o Governments may help retain displaced workers Diminishing Returns Occurs when more units of resources are required to produce each additional unit Reasons to assume diminishing returns o Not all resources are of the same quality As a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed→ it requires more resources to produce an equal increase in output o Different goods use resources in different proportions To absorb additional resources of labor and land, a shift towards more laborintensive methods of production will have to occur In effect, the efficiency of the labor will decline, and returns will diminish Shows that it’s not realistic for a country to specialize to the degree the Ricardian model suggests Dynamic Effects and Economic Growth Opening an economy to trade is likely to generate dynamic gains of two sorts: o Free trade may increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country Occurring in Eastern Europe with western businesses investing in the former communist countries o Free trade might also increase the efficiency with which a country uses its resources Gains in the efficiency of resource utilization could arise from a number of factors Economies of largescale production might become available as trade expands the size of the total market available to domestic firms Trade may create better technology from abroad available to domestic firms; better technology can increase labor productivity or the productivity of the land o Could also stimulate domestic producers to look for ways to increase their efficiency Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward The Samuelson Critique Looks at what happens when a rich country enters into a free trade agreement with a poor country that rapidly improves its productivity after the introduction of a free trade regime. o Creates a dynamic gain in the efficiency with which resources are used in the poor country o The book uses the example of US trade with China “Being able to purchase groceries 20% cheaper at WalMart (due to international trade) does not necessarily make up for the wage losses (in America).” o Samuelson’s model suggests that the lower prices that US consumers pay for goods imported from China may not be enough to produce a net gain for the US economy if the dynamic effect of free trade is to lower real wage rates in the US Notes that free trade historically has benefited the US Evidence for the Link Between Trade and Growth Studies suggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade o Higher growth raises income levels and living standards New Trade Theory o Increasing the Product Variety and Reducing Costs By buying goods that a country does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods→ provides mutual gain o Economies of Scale, FirstMover Advantages, and the Pattern of Trade Products were economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale based cost advantage that later entrants find almost impossible to match Countries may dominate in the export of certain goods because economies of scale are important in their production, and because firms located in those countries were the first to capture scale economies o Implications of New Trade Theory Nations may benefit from trade even when they do not differ in resource endowments or technology Allows a nation to maintain specialization in a product Allows a nation to buy products it doesn’t produce Average prices should fall according to this theory, freeing other resources of a nation to produce other goods and resources A country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good (Firstmovers really get all the perks) Provides an economic rationale for a proactive trade policy that is at variance with other free trade theories Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries. New Trade Theory o Implications It generates for government intervention and strategic trade policy Creates a proactive trade policy where the government of the country helps and possibly creates infratstructure Some firms simply get lucky through firstmover advantages Porter’s Diamond o Evaluating Porter’s Theory The degree of the nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry The presence of all four is necessary to boost competitive performances If he’s correct Porters theory should predict the pattern of international trade in the real world Countries should export products from industries where the diamond is favorable Countries should import products from industries where the diamond is not favorable Understand the important implications that international trade theory holds for business practice. Location, FirstMover Advantages, and Government Policy o Location From a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where they can be performed most efficiently This results in a global web of productive activities with different activities being performed in different locations around the globe depending on considerations of comparative advantage o FirstMover Advantages Firms that establish firstmover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product Makes it easier for firms to get into economies of scale and keep other firms out of it. o Government Policy
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