1.1 Introduction
Economic globalisation process = The increased interdependence of national economies and the trend towards greater integration of goods, labour and capital markets.
The economic globalisation process influences managerial decisions and market organisation.
International economics analyses the interactions in the global economic environment, meaning it analyses the managerial decisions taken of the basis of a cost-benefit analysis in the global economic environment.
This book is all about the global economy; what is it, how big is it, how functions it and how do participants interact are central questions. This first chapter gives some basic background information about the global economy. It forms the basis for the rest of the chapters.
1.2 The universe and population - history
Refer to Figure 1.1 on page 5 in the book. It shows the history of our planet. Mankind appeared on our planet 1.8 million years ago, taking the Homo Erectus who invented tools as a starting point.
Population size
All estimates made of the global population prior to 200 Before Christ (BC) are based on archaeological and anthropological evidence. From the nomadic time (before 8000 BC) we know that people lived from gathering berries and that it took five square kilometres to feed a human being. According to data sources in Kremer, there were around 125.000 people 1 million years ago. The next 700.000 years the population grew to 1 million and reached about 170 million in the year zero. In Figure 1.2 on page 6, the developments of world population over the last 2500 years are shown. All stagnations in growth can be explained historically by wars and other phenomena. Table 1.1 shows population and population density for 20 big countries.
Population projections
Refer to Table 1.2 on page 8 in the book. About 60% of the world total population lives in Asia (as of measures in 2010). It is expected that this share falls to 55% in 2050. The African population is expected to increase most dramatically (from 1.02 billion to 2.19 billion) and the European population is expected to decline from 738 to 719 million. This can be explained by the higher African total fertility rate (average number of children per woman); Europe has a rate of 1.59 and Africa of 4.37. As a result of better health care systems and availability of food and safe water supplies, life expectancy at birth I higher in developed countries than in developing countries (78 years versus 67 years in 2010). Life expectancy is particularly low in Africa (57.4 years), partly due to the HIV/AIDS epidemic. In the 35 most highly affected countries of Africa, life expectancy at birth would be 6.5 years less than it would have been in the absence of AIDS.
Population ageing will be the major demographic trend for the next fifty years. The rise in life expectancy at birth and the decline in fertility rates will lead to rapid increases in the share of older people. The median age is used as an indicator. The median splits a population in two equal halves. Whereas half of the world population was younger than 29.2 and a half was older than 29.2 in 2010, the median is expected to be 38.5 in 2050.
Population and business
Firms study demographic trends very closely, as they have to adapt their products and services to those trends. They also want to know what impact trends have on their core activities and strategies. A few examples;
Many automobile firms started production and assembly plants in China since 2000, due to the rapidly growing Chinese population and thus market
Investment firms are increasing the share of investments in firm activities that will benefit from the ageing process (health care, travel, etc.)
Business and population
Businesses are also important drives of much that happens at the population level. Policy makers thus take account of business developments and try to influence them so that the whole population takes advantage of them. A few examples;
Businesses are the key drivers of employment and growth, particularly in capitalist societies
The pharmaceutical industry is the key producer of new medicine
1.3 GNP and GDP- income levels
The total value of goods and services produced in a certain time period is the best indicator of economic power. You should estimate this total value and compare results across nations, taking three steps;
A well-functioning statistics office must gather information about goods and services produced
What should be compared? Gross domestic product GDP or gross national product GNP?
How to compare the outcome?
Point 2- GDP or GNP?
Gross domestic product (GDP) = The market value of the goods and services produced by labour and property located in a country.
Gross national product (GNP) = The market value of the goods and services produced by labour and property of residents of a country.
Example; A Mexican worker is providing labour services in the USA > These services are American GDP and Mexican GNP. Note that the GNP GDP difference does not only hold for labour services, but also for other factors of production.
GDP + Net receipts of factor income = GNP
For big countries the difference between GDP and GNP is ignorable. For small countries it can be very high. Throughout the book, GDP is used.
Point 3- How to compare?
When GDP level in each country is converted to the same international standard currency (USDollar mostly) on the basis of the average exchange rate in the period of observation, you can see in Table 1.3 on page 12 in the book that the US has the world’s largest economy. However, a ranking based on values measured in current USDollar is deceptive, because it overestimates production in high-income countries relative to low-income countries. For this, we have to distinguish between tradable and non-tradable goods.
Tradable goods = Can be transported or provided in another country, perhaps at some cost. Providers of tradable goods compete with one another, implying that prices can be compared effectively.
Non-tradable goods = Have to be provided locally and do not compete with international providers (housing services, getting a haircut, going to the cinema).
Getting a haircut in the USA may cost you Dollar15 and only Dollar1.50 in Tanzania, making the value of production in a high-income country relative to a low-income country being overestimated by a factor of 10.
To solve this problem, the UN International Comparison Project collects data on the prices of goods and services for all countries in the worlds and calculates PPP exchange rates. See Table 1.3.
Income per capita
Income per capita = Gives an idea of the well-being for the average person in a country, but gives no information about income distribution within that country. Table 1.3 on page 12 also lists per capita incomes.
Income and business
Managers of large firms do concern the income level in a country, as they want to know how large the demand will be for a certain product in a certain region. So not only population size and density are important, but also GDP per capita. Take people’s first needs like food and drinks. In India GDP per capita may be low, but food and drinks will be bought. As soon as GDP per capita starts growing, total spending on food and drinks will rise quite gradually and more money is left for luxurious items. This is crucial information for firms.
Business and income
Business developments are a key determinant of a country’s GDP. Profitable businesses create jobs and profitable businesses pay well, the other way around for loss making businesses. In an international context, the locations of multinationals influence cross-country distributions of income and hence of GDP per capita.
1.4 The global economy- Some general information
There is no one standard answer to the question: “What is globalisation?”. Globalisation means different things to different people. Take farm leaders, trade unionists and human rights activists as an example ; they all see different pros and cons for globalisation.
Based on this argumentation, there are five key issues to be considered:
An example that illustrates this debate: there are people afraid of ‘McDonaldisation’ (hige multinationals are the carriers of culture globalisation) and there are people seeing enough room for local traditions.
Economic globalisation > Which is about the decline of national markets and the rise of global markets. Drivers for economic globalisation are fundamental changes in technology which permit more efficient ways of internationally organizing production processes.
Geographical globalisation > Which is about the result of ‘joint time and space’ due to reduced travel times and the rapid (electronic) exchange of information. Some neo-liberals named this development the ‘end of geography’ in which location no longer matters.
Institutional globalisation > Which is about the spread of universal institutional regulations across the world, triggered by US President Reagan’s and UK Prime Minister Thatcher’s ‘revolution’ of neo-liberalism. These neo-liberal policies are represented by institutions such as the IMF (International Monetary Fund), the WB (World Bank) and the WTO (World Trade Organisation). These universal institutional regulations are not only on macro-economic level, but also on the micro-economic level: multinationals adopt similar policies under the pressure of competition and regulation.
Political globalisation > Which is about the relationship between the power of the market (multinational corporations) versus the nation-state, which continuously has to make changes and updates in reaction to economic and political forces. Popular anti-globalists stress that large multinationals become more and more powerful, out-powering the majority of nation-states. In contradiction, others point out that real evidence for these fears is lacking, as the state has to provide security, a legal system, education and infrastructure, which are all of vital importance for economic activity and growth.
Keynes once said that the master economist should “examine the present in light of the past, for the purpose of the future”, by which the common opinion about economic globalisation was that it was a totally new phenomenon with overwhelming power. Later research, however, showed that it is historically seen not a new phenomenon at all.
1.5 Globalisation and welfare
Before explaining the topic of this section, let’s first take a look at logarithmic graphs:
Note: This explanation of logarithmic graphs is based on Figure 1.7 in the book
A logarithmic scale is a scale that divides the vertical axis in steps of ten-fold increases: 1-10-100-1000-10000.
The important advantage of a logarithmic graph is that it can simultaneously show the developments in the level of a variable and its growth rate, where the slope (rise/run) of the line reflects the variable’s growth rate. In Figure 1.7, Variable A grows constantly by 14,7% per year. Variable B has no constant growth rate (-5% for the first 30 years and then 8%). C, finally, does not grow at all: 0%, so a straight line.
The important disadvantage of logarithmic graphs is that they can be misleading concerning the difference in levels for variables at the same point in time and for the same variable at different points in time. Let’s illustrate this;
In 1950, the difference between variables A and B is about twice that between the variables B and C, because the vertical difference is twice as large. However, this is a logarithmic graph, so these differences are multiplicative: the level of variable C is 100 times higher than the level of A
In 2000, if the variables all measure something positive, variable A obviously has fared better than variables B and C. But how much better? This is hard to tell from the figure
Now, back to the theory: globalisation and welfare.
To describe the evolution of income over time, researcher Angus Maddison uses so-called ‘1990 international dollars’. Maddison collects data for virtually all countries in the world . The development of the world per capita income is illustrated in Figure 1.6, using a logarithmic scale. The logarithmic scale shows the level of income and the growth rate of the income. As you can see in the figure ; world income per capita only started to increase from the year 1000-1800 approximately. Since 1800, per capita world income rose more than eleven-fold in a period of 188 years. Maddison made a note: not only per capita incomes are a measure of welfare, life expectation also is.
Leading and Lagging nations in terms of relative GDP/capita index
The calculations of the deviation index of GDP per capita can be split in above the world average and below the world average. The calculations over 2000 years are available for 28 individual countries and 6 country groups, together covering the global economy. See Figure 1.8 + description: at the beginning of our calendar (year 0): the leading country was Italy, where many other countries were laggards. Later on, the Netherlands, the USA, Switzerland, Australia and the UK became leaders, where Africa, China, India and Iraq became laggards.
1.6 Globalisation’s manifestation on international trade and business
The most significant manifestation of the idea of a global economy is the rise in international trade and capital flows. Capital flows are not a completely new phenomenon, in the ancient cultures of Egypt and Greece for example such flows have always been central in economic interactions. According to Maddison, capital flows have been the most important for the economic rise of Western Europe the past millennium (Recap: Figure 1.8)
Historical overview of the developments in the world economy
Venice: key figure in the economic rise of Western Europe (1000-1500):
Based on improved techniques of shipbuilding and navigation (the compass), Venice opened up trade routes within Europe, the Mediterranean and to China via the caravan routes, bringing in products and new technology (relevant for that time)
By establishing a system of public finance, Venice became the lead economy of the period
Portugal: more ambitious interactions between Europe and the rest of the world (second half of the 15th century)
By opening up trade and settlement in the Atlantic islands
By developing trade routes around Africa, to China, Japan and India
Portugal’s geographic location enabled its fishermen to gather knowledge of Atlantic winds, weather and tides
Portugal soon became the dominant player in the intercontinental trade due to the gained knowledge, maritime experience and the inventions Venice already did (improved techniques of shipbuilding and navigation)
The Netherlands: most dynamic economy (1400-mid 17th century)
By creating large canal networks
By developing shipping, shipbuilding and commercial services > Figure 1.9 shows how the carrying capacity of Dutch merchant shipping was about the same as the combined fleets of Britain, France and Germany.
By providing property rights, education and religious tolerance
Only 40% of the labour force in agriculture > a financial and entrepreneurial elite from Flanders and Brabant emigrated to Holland on a large scale > Holland became the centre for banking, finance and international commerce
Britain: leading economy (18th century)
By improving its financial, banking, fiscal and agricultural institutions along the lines pioneered by the Dutch
By accelerating technical progress and investing in physical capital, education and skills
By reformations in commercial trade policies: reducing protective duties on agricultural imports and eventually removing all trade and tariff restrictions
Europe (18th century-current) > Figure 1.10:
Massive outflow of capital for overseas investment (end 19th – beginning 20th centuries)
Collapse of trade, capital and migration flows and slow economic growth due to the two world wars and the Great Depression (mid-20th century)
The world economy starts growing again, and becomes more closely connected than ever before (end 20th century)
International trade and MNEs
After the before provided historical overview of the world economy, it is clear that there are two waves of globalisation: the end of the 19th century until the beginning of the 20th century and after the Second World War.
Globalisation is not only due to macro-economic forces, but also to effects of micro-level enterprises.
1.7 The global economy- a detailed analysis
Economic globalisation = ‘The increased interdependence of national economies and the trend towards greater integration of flows of goods, labour and capital markets’.
Only focusing on the volume of these flows gives a biased view of the degree of globalisation. Two examples to illustrate this: the price wedge and fragmentation.
The price wedge
Basic economic picture: a downward-sloping demand curve (people buy less if a product becomes more expensive) and an upward-sloping supply curve (firms produce more if the price rises). Take Figure 1.11, international trade flows can also be depicted in this most basic framework, with two twists:
There may be a number of reasons for a deviation between Home’s and Foreign’s price > The price wedge = for example, because foreign firms have to overcome certain transport costs, tariffs, trade impediments, cultural differences, et cetera.
Point A: price wedge = paH – paF > 0, resulting in volume qa. From point A, rises in international trade flows can occur for two basic reasons:
A shift to the right in either demand or supply at a constant price wedge will result in increasing trade flows. In Figure , demand shifts to the right > international economy moves to point B, trade flows move from qa to qb (constant price wedge: paH – paF = pbH – pbF). Generally: increased globalisation if the rise in trade flows is larger than the rise in production
Price wedge diminishes, resulting from for example lower tariffs or lower transportation costs. If the price wedge completely disappears, the international economy would move to point C
The price wedge in history
Trade
According to O’Rourke and Williamson, early growth of international trade was of the first kind: a shift to the right in either demand or supply, as the importing countries themselves could not produce the goods then exported (spices, coffee, tea and sugar). Usually, these were expensive luxury items and their buyers could afford to pay the price wedge.
The two waves of globalisation (Figure 1.10) explain the second kind of growth in international trade: decreasing transport costs, technology improvements, falling trade restrictions, international cooperation, the removal of trade restrictions and improved communication possibilities all led to a decreasing price wedge.
Capital
The development of the price wedge in between the two waves of globalisation (decrease in the first wave, increase during the World Wars and a decrease in the second wave) is also visible on the capital market. As you compare Figure 1.10 with Figure 1.13, there are two waves of globalisation in the capital market as well.
Migration
Generally, real wage differences between countries explain the direction of migration flows to a very large extent.
Fragmentation
Fragmentation = Technological and communication advances have enabled many production processes to be subdivided into various phases which are physically separable > Figure 1.15. The fragmentation process is facilitated by service links such as transportation, telecommunications, insurance, quality control and management control. Fragmentation helps to clarify why some phases of the production will be internally organised and why some phases will be outsourced.
2.1 Introduction
This chapter will first go into trade and international activity, trade and the current account, then the capital account, sales and types of data, concluding with measuring international capital mobility.
2.2 Firms going abroad- multinational activity
Note: This paragraph is made clear with the help of Figure 2.1 in the book.
Firms go abroad and cross their national border to generate value added. In this context, the first question to be asked is whether a firm wishes to serve foreign clients or source from abroad.
The most important reason for firms starting to engage in international business activities is their wish to sell their goods in a new market in order to make a profit. Serving this new market can be done in two ways (horizontal multinational):
Sourcing from abroad can be done in two ways (vertical multinational):
Horizontal multinational = market seeking, a firm starts producing and selling products or services to clients in a host country (the value chain moves horizontally to a different location)
Vertical multinational = efficiency seeking, a specific part of the production process can be done more efficiently in another country, so only a part of the value chain is moved to another country
> See Figure 2.2
2.3 The current account
The decision tree in Figure 2.1 of the book told that if a firm decides to internationalize by producing at home and selling abroad, an export flow is created from home > host.
See table 2.1 ; The table depicts US imports and exports in US dollars.
Export flows need to be accounted for at micro- and macro level. In both cases, the bookkeeping is based at double entry bookkeeping = The process of identifying, measuring and communicating economic information about an organisation or other entity, in order to permit judgements by users of the information.
The key accounting event for any firm is the publication of the annual report, which records the firm’s performance over a book year. See table 2.2 for a statement of income.
For firms engaging in exports (international trade), micro level accounting is very complicated, because:
An internationally operating firm must decide how to account for foreign-currency transactions
The exporting firm is confronted with diverging country-specific accounting regulations (See Box 2.1 for Dutch regulations versus American regulations)
At the country level, all firm-level exports are recorded on the current account on the balance of payments, which consists of two main parts: the current account and the capital and financial account, each with subdivisions > See Figure 2.4
The current account = Income-related transactions originating from produced goods and services, incomes from investments and unilateral transfers (amounts of money sent or received as gifts). Exports are recorded as credit items (+, as it is earned) and imports as debit items (-, as it is spent) > Trade balance = Exports – imports
2.4 The capital and financial account
When firms decide to internationalize (either horizontal or vertical multinational activity), and they have subsidiaries in other countries, this triggers all kinds of capital flows between home and host country. Each firm with a production subsidiary in a foreign country needs to incorporate the financial performance an figures of its foreign subsidiaries in the overall annual report of the whole firm. This creates difficulties, but also opportunities:
Multinational activity:
Greenfield investments = Starting a brand new investment by building a new factory
Acquisitions = Buying an already existing firm abroad
Joint venture = Starting a cooperation with a firm in another country
See Table 2.3 for ways to finance international activities.
In order to allow for a proper comparison of these capital flows between countries, FDI (Foreign Direct Investment) became the universal definition and measurement of multinational activity data.
Keep in mind the difference between Foreign Direct Investment and Foreign Portfolio Investment. FDI is about acquisitions for the purpose of control, whereas FPI refers to passive holdings of securities and other financial assets.
FDI flows = Cross-border flows of financial capital that usually measure the difference between the funds that multinational parents provided to their foreign subsidiaries and the funds that foreign subsidiaries provided to their parents in a given year.
Three components:
Equity capital transactions = Purchases and sales by parents of the shares of enterprises registered in foreign countries
Reinvested earnings = The parent’s part of its foreign affiliates’ earnings that are neither distributed as dividends by affiliates nor remitted to their parent, but instead are retained and reinvested
Intra-company debt transactions = Short- and long-term borrowing and lending of funds between parents and affiliates
FDI stock = Accumulated FDI flows, measure the value of a subsidiary’s shares and reserves attributable to the parent, plus the net indebtedness of the affiliate to the parent.
See Table 2.5 for FDI flows and stocks.
FDI flows are also recorded on a country’s balance of payments, on the capital account. An increase in claims on foreigners is a capital outflow, a debit. An increase in claims by foreigners is a capital inflow, a credit. If the claim is longer than a year, it’s called long-term capital. Shorter than a year of course is short term capital.
The balance of payments is zero, such that:
Current Account Balance = Capital and Financial Account Balance
2.5 FDI versus sales and value added data
To understand firm activity abroad, it is better to use output indicators instead of the foreign capital input that is measured by FDI data. Two of those operational output indicators are sales generated abroad and value added generated abroad
Difference in outcome when comparing FDI, sales and value added, considering the ranking of the top ten countries in which US multinationals invest > See Table 2.8
According to international business professor John Dunning, value added is ‘the best indicator of the overall or sectoral economic significance of multinational activity’. Multinationals locate parts of the production process in host country A and other parts of the process in host country C, whereas they locate their headquarters in home country C. Take the Apple iPad as an example: its sales price is about Dollar500 and it is produced in several countries > Not all countries generate the same value added, leading to an uneven distribution across these countries (See Box 2.5).
Rugman and Verbeke’s antithesis
Their claim is that we are not so much witnessing globalisation, as almost none of their firms of their research can be considered truly global, but a phenomenon they call regionalisation. Most of the global 500 firms have the biggest part of their sales in their home region (North America, Europe or Asia). So it is not so much globalisation, but a concentration of sales in certain regions, called a ‘triad’.
2.6 Choosing the right kind of data
The introduction to micro- and macro-level accounting systems may seem to make you assume that they are largely similar, the outcomes of both accounting systems, however, are likely to produce conclusions that look appealing at the first sight, but are actually plain wrong. Three examples may illustrate this observation:
A micro-level investment, reported on a firm’s annual account does not necessarily translate into a macro-level investment, reported on a country’s balance of payments. An investment on firm level is most of the time not an investment at the macro level
Take mergers and acquisitions between firms in the same country, where on micro level the amounts on annual accounts of both companies change, but on macro level only a shift in ownership takes place: no additional value-added creating capacity is generated
The powerful multinationals are larger than many nation-states, refer to Table 2.11. What you see is that Wal-Mart’s profits are approximately the same as Honduras’ GDP, where Wal-Mart employs 2.000.000 people and Honduras has 8.000.000 inhabitants. Such comparisons, however, are problematic:
Comparing a firm’s sales (volume sold times the price) to a country’s GDP (the sum of value added) is like comparing apples with oranges. For a true comparison, only value added counts, as that is the value really added by the firm itself.
2.7 Information on international capital mobility
Recap: current account balance = capital account balance. A current account surplus (deficit) goes hand in hand with a net capital outflow (inflow).
See table 2.12, where you can see the two waves of globalisation with a lot of capital flows and the interbellum and after Second World War where there was quite a collapse of capital flows. The main point to name is that there are considerable changes in the degree of international capital mobility over time. It is argued that one of the key features of our global economy is the high international capital mobility > Figure 2.9 on page 70 and Table 2.12 on page 69 show that this argument only holds if the recent period is compared with the first decades after the second world war.
Figure 2.10 on page 70 shows the evolution of capital outflows as a percentage of national savings for the UK, Germany and France. This ratio shows how important portfolio investment opportunities are as an outlet for savings; what is saved needs to finds a way to profitable investments either home or abroad. The UK, Germany and France were net capital exporters (current account surplus).
Table 2.13 on page 71 illustrates the development of the foreign capital stock-to-GDP ratios. After an increase in the period leading up to World War I, there was a sharp decline in the following years and it has been only from 1980 onwards that the international capital mobility grew again. The final two rows of the table show how much of foreign-owned capital stock is of the UK and the USA > Figure 2.11 on page 72 shows this.
The numbers on capital mobility do have their limitations;
Net capital flows are used to measure international capital mobility, but they may not tell us much about the degree of international integration of capital markets > One can have an increase in international capital market integration without an increase in capital flows
Table 2.12 only showed information on the net capital flows (inflow-outflow). This net flow underestimates the size of the actual capital flows
With respect to the distinction between net and gross capital flows, there is another issue. Assuming the relevant time period is one year, many financial transactions have a considerably shorter time horizon
The above discussion does not imply that the current phase of international capital mobility is nothing but a return to pre-1914 days
3.1 Introduction
International trade increases the degrees of freedom for an economy. Without trade, all domestic consumption must be supplied by domestic producers.
Advantages for consumers
Buying from foreign sources (more choice)
Comparing prices internationally
Rises in welfare (partly due to the above)
Advantages for firms
Disadvantages for firms
3.2 Comparative advantage- David Ricardo’s contribution
The concept of comparative advantage will be explained with the help of the following table (Table 3.1 in the book):
Hypothetical labour productivity, production per hour |
| | USA | EU |
Cloth | 6 | 1 |
Wine | 4 | 2 |
David Ricardo focused on technology differences between countries as a prime reason for countries to engage in international trade ;
Looking at the table, you see that the USA have an absolute advantage in both cloth and wine. Given that the USA are more efficient in the production of both goods, why would they still engage in international trade at all? > “By focusing on the production of those goods in which a country is relatively more efficient both countries can gain from international trade.”
Back to the table: The USA is six times more efficient in the production of cloth (6/1) and two times more efficient in the production of wine (4/2) than the EU.
Conclusions: The USA have a comparative advantage in the production of cloth and the EU has a comparative advantage in the production of wine, as it is least disadvantaged compared to the USA.
Now we know the comparative advantages of both countries, how is it beneficial for both countries? > Suppose: USA 4 hours available for wine and cloth, EU 12 hours available.
This leads us to table 3.2:
Production of cloth and wine in the EU and the USA |
Situation a; Autarky |
| | USA (4 Hours) | EU (12 Hours) | World production |
Cloth | 12 | 8 | 20 |
Wine | 8 | 8 | 16 |
Situation b; Specialisation with the first number according to CA and the second against CA |
| | USA | EU | World production |
Cloth | 24, 0 | 0, 12 | 24 Cloth or 12 Cloth |
Wine | 0, 16 | 24, 0 | 24 Wine or 16 Wine |
As you can see, if both countries specialize to their comparative advantage, world production is the highest. If they would produce against their comparative advantage, world production would be way less (12 cloth and 16 wine).
Price of a commodity = measure of how to be sure that specialisation takes place according to comparative advantage. Under perfectly competitive conditions, with constant returns to scale and only one factor of production:
PoC = wage rate per hour / labour productivity per hour
In the USA, only 1/6 hours of labour are needed to produce one unit of cloth, making the price of cloth 1/6 times the USA wage rate
In the EU, 1 hour of labour is needed to produce on unit of cloth, making the price of cloth 1 time the EU wage rate
Consumers will buy the cheapest product, so they will only buy USA cloth if the USA cloth are cheaper than EU cloth: Pus,cloth < Peu,cloth or 1/6*Wus < 1/1*Weu
The same goes for wine: Peu,wine < Pus,wine or ½*Weu < ¼*Wus
Combining the two inequalities leads to a range of possibilities for the wage rate in the EU relative to the wage rate in the USA:
1/6 = (1/6)/(1/1) < Weu/Wus < (1/4)/(1/2) = ½, the relative wage has to be within this range.
Box 3.1
See Figure 3.1 and keep the before explained Ricardo model in mind: countries with a low labour productivity (Brazil, Dollar11.48 per hour) have a low income level per capita (Dollar10.079). Countries with high labour productivity (Norway, Dollar76,76 per hour) have a high income level per capita (Dollar60.218).
> The line in Figure 3.1 is a regression line (Recap: Statistics I), where on average a one dollar higher level of productivity leads to an Dollar828 higher GDP.
3.3 Differences between comparative advantage and competitiveness
This paragraph stresses the differences between countries and firms when it comes to competitiveness. Later on in box 3.2, the difference between comparative advantage and competitiveness becomes clear.
First, if a firm is more expensive than another firm that makes a similar product, it cannot sell its product and will thus no longer be able to pay its workers, its owners or its bank and goes bankrupt. (Recap: Paragraph C.2, the USA and the EU). Countries where these firms operate in, however, never go bankrupt. They cannot close their doors and sell all their remaining assets > They will shift resources to other occupations.
Example : What happens if the wage ratio is not within the limits as imposed in paragraph 3.2? If the USA wage rate becomes seven times as high as the wage rate in the EU, all demand will shift to the EU. This leads to a decrease in labour demand and consequently to a decrease in wages. The USA can restore their competitiveness by making sure their wage rate is within the limits derived from comparative advantage again.
Conclusions : Market forces make the Ricardian model work. The fact that firms within a sector go bankrupt can be a sign that comparative advantage works.
Second, it might be bad news for firms if main foreign competitors gain market share, but this doesn’t have to hold for countries.
Example : For Sony (Japan) an increase in market share for Philips (the Netherlands) may be a sign that the Japanese production costs are relatively high and the Netherlands have a comparative advantage. Sony eventually will have to close its doors or move its production to a country that does have a comparative advantage in the electronics industry.
This type of reasoning does not hold for countries: a high growth rate in the Netherlands is good news for the Japanese firm, as they will face a larger export market in the Netherlands (the gain in market share also meant a gain in welfare).
Third, the process of specialisation according to comparative advantage may seem unfair to individual firms. It is important to understand that the theory of comparative advantage shows that even if a firm is more productive than its foreign competitor, it might still lose market share because other domestic firms might have a higher productivity advantage relative to foreign firms.
Fourth, many multinational firms in developed countries move (or plan to move) their low-skilled activities to low-wage countries. This is often seen as a very unpleasant effect of globalisation, as it drives home country wages down. This may happen for two reasons:
Firms relocate their activities in foreign countries > In the home market the employees of that activities lose their jobs
Even the threat of relocation may force wages in the home country down, as the home country wants to prevent relocation
What actually happens is that a low wage country is specializing according to its comparative advantage (low-skilled assembly activities) and the high-wage country loses a sector due to a comparative disadvantage (in low-skilled assembly activities).
Conclusions : Relocation of production activities may be a manifestation of comparative advantage
Finally, a current account deficit is sometimes seen as an indication that a country is less competitive than other nations. As a matter of accounting, the sum of the current account balance is always equal to zero. A current account surplus (profit) or deficit (loss) is determined by macro-economic forces (relation between savings, investment and international lending) and not by specialisation according to comparative advantage.
Box 3.2
Thomas Friedman: The World is Flat. In this book, fears around globalisation are reflected. Distance is no longer a dominant characteristic of the world economy. Competition is thought to be a race to the bottom, with the lowest wage countries as the big winners where the high-wage countries lose market share in favour of low wage countries. The world is getting smaller and the ICT revolution has only just began.
> Critics : The theory of comparative advantage tells us that this view is way too simple. Countries always have a sector in which they have a comparative advantage . Even if they are less productive on all accounts, they and their competitors all benefit from international specialisation according to comparative advantage (Recap: paragraph C.2).
3.4 Comparative advantage- another approach
Around the 1930s, neo-classical economists became unhappy with the notion that trade was explained by differences in productivity and technology alone. They started to realize that if technology itself might not be too different between countries, other factors could also be responsible for productivity differences.
Differences in factor endowments = Other factors than technology that determine the level of trade and which country is more productive than another. The France climate, for example, is better for growing grapes than the Dutch climate. Here not technology is determinant for export, but climate.
The Heckscher-Ohlin model
The H-O model, or the factor abundance model, explains international trade only through differences in endowments between countries. Six assumptions:
There are two countries, each producing two homogeneous products (Cloth (C) and Steel (S), using two production factors (capital (K) and labour (L)). Country 1 is said to be relatively well endowed with labour, compared to country 2
The production functions are identical for the two countries, but they have different factor intensities. We assume that steel is more capital-intensive than cloth
The supply of capital and labour differs between the two countries. Perfectly mobile within sectors within the country, perfectly immobile between countries > Factor prices are the same in the two sectors within a country
Production is perfectly competitive, constant returns to scale
Consumer preferences are the same in the two countries > the same price of cloth relative to steel, the consumption ratio of cloth relative to steel is the same
No barriers of trade
Factor price = the sale price set for a finished good or service is affected by the expense involved in the creation and manufacture of that product. The general idea is that the factor price is arrived at by taking into consideration all the factors of production.
Box 3.3
One of the most important assumptions of the H-O model is that countries use the same technology in each sector. Coe an Helpman did research on this and they found that if a country has trading partners with a large stock of R&D, the country benefits form that foreign R&D base through trade. So, technological knowledge tends to converge between countries. In a continued study, they found that developing countries benefited from developed countries’ R&D investments > For results, see figure 3.3.
Horizontal axis: education-weighted ratio of a country’s foreign knowledge stock
Vertical axis: ratio of factor productivity (efficiency of the production process)
Take Niger as an example: the change in foreign knowledge stock is 2.02, but only 4% of the population completed secondary education > the population cannot effectively use the foreign technology
3.5 Perfect competition and optimal production
Recap: micro economics ; price equals cost. In the long run, profits in perfectly competitive markets become zero, due to other suppliers constantly entering the market
Keep this theory in mind in this paragraph!!
The cost of production = labour needed to produce good X and the amount of capital needed to produce good X ; pX = costs = Labour for X * Wage + Capital for X * Rental rate
In short: pX = cost = Lx*w+Kx*r under the H-O model assumptions
Rewriting the formula > Kx = (costs/r) – (w/r) * Lx
This formula provides all combinations of labour and capital inputs with the same costs of production (w and r). Figure 3.5 shows these combinations as isocost lines. The slope of the lines is equal for every line > -w/r. The total costs are determined by the y-intercepts; more labour and capital means higher total cost and a higher y-intercept.
Now, if you want different combinations of labour and capital to yield the same level of total cost, you can use an isoquant. An example of an isoquant is illustrated in Figure 3.4.
Applying this theory
The lowest possible cost of production is determined by the intersection of the isoquant with one of the isocost lines ; Point A0 in Figure 3.5
If the slope changes (one cost of production becomes relatively more expansive than the other), the lowest possible cost of production also changes ; Point A1 in Figure 3.5
Unit-value isoquants = represent the production of each good that is worth one dollar of revenue when selling it. See Figure 1.6a, where the price of steel is pS and the price of cloth is pC0 and the isoquants for steel and cloth are 1/pS and 1/pC0.
If the price for steel is pS, we only have to produce 1/pS to get one dollar of revenue (pS*1/pS=1) ; so the unit value isoquant is inversely related to the price
The minimum cost combinations of capital and labour for both unit value isoquants must be points where both isoquants intersect a isocost line (steel0 and cloth0)
Price changes ; if the price for cloth increases from point pc0 to pC1, we have to produce less cloth to get one dollar of revenue, so its isoquant shifts more towards the origin (1/pC1). The minimum-cost output is now at cloth1,steel1 ; the slope of the isocost line has increased (w>r)
3.6 & 3.7 Appliance of the Heckscher-Ohlin model & Factor endowments
What happens in a trading equilibrium? When taking a look at Figure 3.5 and point A0 and A1, it is clear that country one is relatively more labour-abundant and country 2 is more capital-abundant. See Figure 3.7 (Figure 3.6b is copied in Figure 3.7) > as country 1 is more labour-abundant, (w/r)1 < (w/r)2. We can infer that in this case the price of labour-intensive cloth is lower in country one than in country 2: (pC/pS)1 < (pC/pS)2. This relative price difference is the basis for international trade.
Once international trade is possible:
Individual consumers exploiting arbitrage opportunities between the two countries will ensure that the price of cloth and steel will get the same in both countries
The trade equilibrium price will be anywhere between the two autarky prices (pC/pS)tr in Figure 3.7
(pC/pS)tr is above the trade equilibrium price for cloth in country one (excess supply) and below trade equilibrium for cloth in country two (excess demand) > Country one starts exporting cloth
(pC/pS)tr is above the trade equilibrium price for steel in country two (excess supply) and below trade equilibrium for steel in country one (excess demand) > Country two starts exporting steel
Conclusions : The above described is the Heckscher-Ohlin theorem > “A country will export the good that intensively uses its relatively abundant factor of production, and it will import the commodity that intensively uses its relatively scarce factor of production”
From the points of intersection of the unit value cost line and the isoquant with the axes we can determine the wage rate and the rental rate (must be the same in both countries)
Factor price equalisation = an effect observed in models of international trade that the prices of inputs to (factors of) production in different countries, like wages, are driven towards equality in the absence of trade barriers (open economies)
Wrap up: The difference between the Ricardian model and the Heckscher-Ohlin model is that the Ricardian model assumes that technology differences, resulting in wage differences between countries, cause international trade. The H-O model assumes that differences in factor endowments trigger international trade. In both models the prices of final goods will be equalised, but in the H-O model, also factor prices will be the same in equilibrium.
3.8 Conclusions
Section 2.2 elaborated on the differences between comparative advantage and competitive advantage for the Ricardian model. To a large extent, the same discussion goes for the H-O model, where firms producing the same commodity compete with each other in the international market. In equilibrium, they cannot be more expensive than their competitors in order to maintain market share. Once factor prices are equal, so will production cost be, but until factor prices are equalised, cost differences will determine the competitive position of firms.
4.1 Introduction
The previous chapter explained international trade via comparative advantage, which was driven by differences in technology or factor abundance. These theories are perfect to explain inter-industry trade flows = trade in different types of commodities (wine for cloth for example). A large part of international trade, however, is intra-industry trade = trade within one broader category, cars for cars for example.
This chapter focuses on explanations of intra-industry trade based on models of imperfect competition, instead of perfect competition.
4.2 Imperfect competition- the basics
The models in the previous chapter assumed that international trade flows occur under perfect competition. This assumption actually is quite implausible. It is safe to conclude that many competition in markets is far from perfect
The underlying main cause of international trade models of imperfect competition is the presence of increasing returns to scale, or economies of scale.
See figure 4.2 in the book
Profits are maximised at the point where mc=mr (See box 4.2), price then equals point G. Note that, under perfect competition, p=mr=mc, point A
As quantity increases, average costs decrease ; which is a prove for the economies of scale argument. In imperfect competition, cost would be equal to F, in perfect competition costs would equal B
Firms in imperfect competition make a profit of area FGHI, where firms in perfect competition would have made a loss of area ABCD
4.3 From monopoly to duopoly
In perfect competition, the market price cannot be affected by the behaviour of any of the firms. In a monopoly, knowing the behaviour of competitors is not important for the home monopolist as there is no competition in the home country. However, in oligopolistic markets, competitor’s behaviour is crucial.
See Figure 4.3 in the book:
In autarky (no trade), the Home firm as a monopolist chooses the maximum profit point (point H where MR=MC) and a price of point I. Its profit, then, equals IJKL.
A foreign firm can now sell its good in home market: international trade. We assume that the foreign firm assumes that the home firm will continue the same quantity as before (at maximum profit)
The residual demand curve for the foreign curve is from point I downwards, as home already produces J-I
The MR-foreign curve shows the marginal revenue curve of residual demand
The foreign firm maximises profit at point A at a price of point B, where its total profit is CBFG
Home and foreign produce a homogeneous product > point B is the market-clearing price in the home market. At that price DB is the total production, DC produced in home country, CB imported from foreign country. For the foreign firm DC is produced and CB is exported to the home country
Conclusions: Profitability for the home country has decreased, as price has fallen from J to D. The change in total profits as a result of introducing international trade flows is the net result of four different effects ;
Area I (KDCL), part of the initial monopoly profits that is not affected by the foreign firm entering the market
Area II (EKLF), increase in the initial monopoly profits resulting from larger sales reducing average costs
Area III (FCBG), increase in profits resulting for sales to the export market for the foreign firm
Area IIII (DJIC), decrease in the initial monopoly profits due to increased competition
The net welfare effect under these circumstances is positive, as the increase in consumer’s surplus > decrease in producer’s surplus
In the final equilibrium, home market sales are higher and the price is lower. Also, both firms have the incentive to enter each other’s market as they both think they can consolidate profits in the home market and gain some extra profit in the foreign market. The result is not only increased competition, but also increased trade in similar final goods.
4.4 Monopolistic competition
The framework of monopolistic competition does not rely on the assumption of identical goods. The central idea is illustrated in figure 4.5 in the book. Country A and country B each produce many varieties of a single product (take beer or cars for example).
Love-of-variety effect = Once one of the countries produces a new variety within the single product, there is always a market for this new product as it adapts to the needs of a specific group of clienteles.
Each car manufacturer has a monopoly power in its own market due to the variety of products. However, it does face competition from other manufacturers that produce similar, but slightly different products
The behaviour of a typical firm in this kind of market is illustrated in Figure 4.6 in the book for the monopolistic competition equilibrium, which is based on three assumptions:
The number of sellers is such that each firm takes the behaviour of another firm as a given
Products are heterogeneous
There is free entry and exit for firms
The demand curve in monopolistic competition is downward-sloping > by decreasing price you can increase market power
See figure 4.6. Each firm assumes that its competitors do not react if it lowers its price
The demand curve location of a producer depends on the pricing behaviour of all other producers. If they decide to reduce prices ; the demand curve shifts downwards
New firms entering the market makes the demand curve shift downwards
Firms exiting the market makes the demand curve shift upwards
Profits are maximised at point B and a price of point C and a quantity of point A, where price equals average cost > Caused by the competitive pressure of other firms freely entering and exiting the market
Chamberlin’s tangency solution = There is a difference between average cost (C) and minimum average cost (F). This implies that there are unexploited economies of scale.
4.5 Trade with monopolistic competition
What happens in the previous monopolistic competition model if it becomes possible for two countries to engage in international trade?
As for the effects on consumers, the most important thing to remember is the love-of-variety effect > If consumers from country A can choose between varieties produced at home and abroad, their welfare will increase.
For the producers, however, each producer will lose half of its domestic sales to competitors. At the same time, each producer will gain half of its sales by entering the foreign market and selling to foreign customers.
Generally:
See Figure 4.7
In the pre-trade situation profits are maximised at point B and a price of point C and a quantity of point A, where price equals average cost > Caused by the competitive pressure of other firms freely entering and exiting the market
In the post-trade situation profits are maximised at point B’ and a price of point C’ and a quantity of point A’, where price equals average cost. Those new points are determined by the more elastic demand curve and thus a changed marginal revenue curve. The following then happens:
With changing demand and MR and other things remaining equal, the firm leads a loss
The loss makes other firms exiting the market > increases demand for remaining firms > continues until profits are zero
In trade equilibrium, consumers benefit from lower prices and more variety
In trade equilibrium, the two countries engage in two-way trade in similar products
How do the models in this chapter differ from the models in chapter B?
The essence of models in this chapter is that trade arises in similar or identical commodities between similar or identical countries, so no differences in productivity or endowment in the production processes between firms. In the models of chapter 3, the lack of these differences implies that there is no reason for trade. Also, increasing returns to scale imply imperfect competition, which makes positive profit and thus entering the market possible. With constant returns to scale (perfect competition), the assumption of identical firms and identical countries do not give rise to an underlying reason to engage in international trade.
4.6 Other views on intra-industry trade
A lot of research is done to investigate drives for intra-industry trade.
One expects that intra-industry trade between two countries will be high if:
Incomes per capita are high
Differences in level of development are low
The average of the countries’ GDP is high
Here, it is assumed that if incomes per capita are high and basic needs are thus fulfilled, a relatively large share of income will be spent on luxury goods. Furthermore, if countries differ in development, it is expected that consumers have different tastes.
In addition, intra-industry trade will also be high if:
Barriers to trade are low
Pairs of countries share a common border on language
Countries are part of some type of a preferential trade agreement
All these variables stimulate trade flows between countries.
Finally, intra-industry trade will be high if:
The level of product differentiation within sectors is high
Economies of scale are present
Transaction costs are low
Leamer and Levinsohn discussed problems to the measure of intra-industry trade
It is often unclear which of the above variables to include and which to exclude
It is often difficult to find proxies for variables that are important in theory
4.7 Differences in productivity and impact on profitability
Marc Melitz developed a monopolistic competition model in which firms differ in terms of productivity.
See Figure 4.11, where three firms are compared
There are no fixed costs, for simplifying reasons
All three firms have different levels of productivity, leading to three different marginal cost lines: c1, c2 and c3 ; c3 is the least efficient, as c1 < c2 < c3
Firm 1 reaches maximum profit at point E1 where profit equals (p1-c1)*q1, firm 2 at E2 where profit equals (p2-c2)*q2 and firm 3 at E3 where profits equal zero as mc=mr=price
The right panel of the figure shows the relationship between efficiency (height of marginal costs) and profitability
What happens if the country opens its borders and enables international trade?
See Figure 4.12
Price elasticity of demand increases, so lowering prices means selling more products for each individual producer
The profit levels also change, as the maximum price a firm can charge is now lower than before
The least efficient firms will have to exit the markets (firms with marginal costs in between c3 and c4)
The firms with rather low productivity, the firms with costs in between c4 and c6, are able to survive, but will have to accept lower profits
The most efficient firms are able to expand production and earn higher profits
Suppose, it is proven that entering the domestic market is way less expensive than entering a foreign market, as for entering a foreign market you have to build a sales network, learn a new language and get to know the culture. Becoming a multinational firm is even more expensive. We can easily apply this to the model in figure 4.12:
Fixed costs for entering a domestic market equal zero
Fixed costs for entering a foreign market are a bit higher
Fixed costs for becoming a multinational firm are way higher
These fixed costs have to be deducted from operating profits > The intersection of the profit curve with the vertical axis shifts downwards
Conclusions: Some firms can profitably serve the domestic market, but are not efficient enough to export ; Some firms are profitable enough to export but cannot become a multinational firm
4.8 Conclusions
This chapter discussed several models based on imperfect competition and economies of scale. Usually, increased competition leads to lower marginal costs, lower prices, larger volumes and welfare gains for consumers ; even if two countries are identical. Also, firms can engage in international trade of similar, not identical products for better use of economies of scale and a greater variety.
5.1 Introduction
Despite the obvious advantages of free trade flows and a gradual reduction of trade barriers since the 1980s, there are still many governmental restrictions to trade, such as tariffs, quotas and minimum standards. The same goes for capital. The main question we address in this chapter is why trade restrictions even exist if theory often says they should not.
5.2 Tariffs and trade restrictions- general information
See Figure 5.1 in the book.
Trade restrictions have been falling on a global scale for a long time. To a large extent this can be attributed to the WTO, the World Trade Organisation. In a long series of negotiations, the average tariff rate (all goods) has fallen from 8.71% in 1988 to 2.69% in 2010.
The reasons for the introductions and reductions of tariffs can be varied for individual countries, where Figure 5.2 illustrates the US. The tariffs, on average, have been declining, but there were also periods where the tariffs were raised:
At the beginning of the nineteenth century, the tariff revenue was very high (more than 50% of total imports around 1830) > tariff of Abominations, southern congressmen included high tariffs on raw materials in the hope that their northern colleagues would reject it (northern manufacturers used those raw materials), but they didn’t
1833: comprise law, tariffs started to decline
1861: stop of the decline, the Morrill rate was passed and the rates on iron and steel raised. This continued until 1864 and the raises were also done to finance the Civil War
At the beginning of the twentieth century, tariff rates came down when Wilson put many items on the so called free list
First recession (after World War I): free list was reversed and in 1922 the Fordney-McCumby tariff was passed, intended to help the farmers. This tariff was followed by the Hawley Smoot tariff in 1930. Kenen said it was “once called the Holy-Smoke Tariff”.
After World War II: a series of GATT negotiations resulted in the current low average tariff rate of around 1.8%
There are not only differences between countries in tariffs (Figure 5.3), but also within countries between commodities. Think of tobacco.
Non-tariff measures (NTM) = All non-price and non-quantity restrictions on trade in goods, services and investments, at federal and state level. This includes border measures (customs procedures), as well as domestic laws, regulations and practices. Two examples:
Differences in testing requirements for new cars in different countries that have the purpose of creating safety for passengers ; may lead to extra costs for multinationals, which are in turn passed on to the customers via the price of the car
Differences in rules regarding animal testing in the cosmetics industry
5.3 Effects of tariffs
Figure 5.4 in the book illustrates the most important effects of trade restrictions by analysing the economic consequences of imposing a tariff on imported goods
> The figure shows a perfectly competitive market
With free trade, the world market price equals p0, which is way lower than the equilibrium autarky price p2
This way lower price means an excess demand, so import is represented by q0-q4
Imposing an ad valorem on imports (t) means there origins a price wedge between the price foreign producers receive (p1) and the price on the domestic market ((1+t)p1)
The consequences of the above described phenomenon on four different economic agents:
Domestic consumers are confronted with higher prices ((1+t)p1) instead of p0; which reduces their demand by q4-q3. The welfare loss (the loss in consumer’s surplus) is represented by D+E+F1+G
Domestic producers perceive less competition from abroad, so they are able to increase their price to ((1+t)p1) instead of p0. Quantity supplied increases with q1-q0. The increase in producer’s surplus is represented by D
The domestic government receives the tariff. The total revenue is the difference between import price p1 and the domestic price (1+t)p1 multiplied by the amount of imports, q3-q1 in this case. The total government revenue is F1+F2
The rest of the world faces a reduction in demand: from q0-q4 to q1-q3. If this reduction in demand is substantial enough on a global scale (the economy imposing the tariff is large), the world price for the good falls from p0 to p1 (area F2 of government revenue is paid for by the rest of the world), which means the rest of the world now receives less for its exports. Note that, if the economy imposing the tariff is small, no changes in world price level will occur
Terms-of-trade gain = a positive welfare contribution due to a drop in price. In Figure 5.4 equal to F2.
The total welfare can now be calculated by adding the individual welfare effects;
D+F1+F2 – (D+E+F1+G) = F2 – (E+G)
The right hand of this equation is the terms-of-trade gain F2 minus the sum of the Harberger Triangles E+G
Harberger Triangle = The waste of protection ; les efficient domestic producers increase production at the expense of more efficient foreign competitors, which is paid for by domestic consumers
Box 5.1
Various reasons have been put forward to explain why removing protectionist measures (liberalisation) leads to small estimates of welfare gains based on the Harberger triangles
Those estimates are static, while there is not dealt with the dynamic effects of liberalisation
Harberger triangles can be measured only if products are actually present in the economy and of a given quality. This can seriously underestimate the true cost of protection, as some products are not even imported and thus not measured and some products are of lower quality (less expensive) than would otherwise be the case
Estimates of the Harberger triangles assume that products are homogeneous. After reading chapter 4, we know that most intra-industry trade is with heterogeneous goods, so the Harberger triangles can only be estimated for a limited set of goods
All types od estimates underestimate the true cost of trade restrictions, as they ignore the transaction costs of protection
Note: One should bear in mind that moving from protection to liberalisation also involves costs. The cost of adjustment for firms and workers dealing with the new situation without protection for example.
5.4 Imposing a trade restriction- the effect on the world’s welfare
What is the effect of a tariff for the world as a whole? > See Figure 5.5
The supply curve shows the difference between quantity produced and consumed for different prices in the rest of the world ; the demand curve shows the difference between quantity demanded and supplied domestically for different domestic prices
Trade0 in Figure 5.5 equals q4-q0 in Figure 5.4 and trade 1 in Figure 5.5 equals q3-q1
Now, a country that is large enough imposes a tariff, which makes the price drop from p0 to p1
F1+F2 are still the tariff revenues for the government
E+G still represents the sum of the two Harberger triangles
E+F1+G represents the loss for domestic producers and consumers
The welfare effect for the rest of the world is equal to the area between p0 and p1 up to the foreign export supply curve > that is F2+H
Change in world welfare caused by the tariff = the sum of the welfare loss for domestic consumers and producers (F1+E+G), the welfare loss for foreign producers and consumers (F2+H) and the welfare gain for the domestic government (F1+F2).
Conclusions : The net welfare effect for the two countries combined is a welfare loss equal to E+G+H. So for the world as a whole, the welfare effects of tariffs are always negative.
5.5 Other protectionist effects
So, for the world as a whole, protection reduces welfare. Usually, the same goes for individual countries. Then why do countries still impose trade restrictions?
One clear answer ; even if the net effect is negative, the impact of the tariff will benefit specific groups such as domestic producers or the government. There are, however, other reasons for protectionism;
Government finance ; some (developing) countries set trade restrictions as a matter of easily financing government expenditures.
Income distribution ; from figures 5.4 and 5.5 we know that trade restrictions influence income distribution > domestic producers gain at the expense of consumers and foreign producers. Moreover, changes in prices caused by tariffs also influences the income distribution.
Infant industry ; it is argued that some industries need protections in their early existence, until a certain scale of production has been reached and the firm can compete on the world market for example. Three problems with the infant industry argument:
It is not easy to identify infant industries
If it is possible to identify them, why would government support be necessary? The private sector could do the same as profit-seeking banks could give these firms a credit > consumers will not be confronted with higher prices
Firms in the protected industry will get addicted to the protection
Employment considerations ; protecting an industry raises production and thus employment in that industry. The question is, of course, if this is the best way to influence employment > the answer is no
Strategic behaviour ; the shift in profits from foreign firms to domestic firms due to trade restrictions such as tariffs and export subsidies. Drawbacks:
The optimal type of policy depends on the type of competition between two rivals (on prices or quantities)
The optimal type of policy also depends on knowledge regarding production costs and demand
The same as for the infant industry argument: Why can’t the private sector provide support?
5.6 Trade agreements
The central aim of the WTO is to promote free trade. It tries to achieve this by organizing the so-called trade rounds (See box 5.3).
The Most Favoured Nation (MFN) principle = central in the WTO negotiations. Is about all countries to be treated alike. For example: if one country decides to reduce its tariff to another country, it must apply the sae to all WTO members.
Preferential Trade Agreements (PTAs) = important exception to the MFN principle. It means a group of countries may decide to lower their tariffs between group members, but still apply tariffs to imports from the rest of the world. This can take several forms (we name only two examples):
A group of countries can stop all tariffs internally, but maintain an own tariff for the rest of the world: Free Trade Area (FTA)
A group of countries can stop all tariffs internally and have identical tariffs against the rest of the world: a Customs Union
Some very well-known PTAs are the EU, the NAFTA and ASEAN.
The question now becomes: is a partial reduction of tariffs in a PTA also welfare-increasing?
The answer is quite complicated, as there are three or more countries involved instead of 2 as in sections D.3&D.4.
To answer the question, we take Australia (A), Brazil (B) and China (C) as an example. We assume that Australia once decides to form a trade agreement with Brazil; before the agreement Australia imposed tariff t in imports from both countries. We also assume that Australia is not large enough to influence prices in other countries with their tariff t. For Brazil and China, import prices inclusive of the tariff are pBt and pCt in Figure 5.7, where the autarky equilibrium counts for Australia.
> Our welfare analysis has two possible situations (there are three countries): Brazil is the most efficient or China is the most efficient
Brazil- trade creation (Figure 5.7)
First, we assume that Australia forms a customs union with Brazil > tariffs disappear for Brazil, but not for China. Brazil is a more efficient supplier of the product : pB < pC
Before the customs union, Australia imported q3-q1 from Brazil (at a domestic price of pB + t < pC + t). After the customs union, Australia imports q4-q1 from Brazil (at a domestic price pB). This increase in imports due to the formation of a PTA is called trade creation.
Actually, in this situation the reverse of what happened in section D3 happens: producer’s surplus decreases by area D because of increased competition. The consumer’s surplus increases by DEFG. Moreover, the government revenue is decreased by F
Conclusions: The net welfare effect is (DEFG) – D – F = E + G > 0, so a positive trade creation
China- trade diversion (Figure 5.8)
We again assume that Australia forms a customs union with Brazil, but now China is the most efficient supplier (pC < pB). Before customs union, Australia imports q3-q1 from China, the most efficient supplier. After the customs union, Australia imports q4-q1 from Brazil, not because it is more efficient, but because it receives PTA > trade creation effect.
Trade diversion effect = supplier switching effect. Where Australia first imported from China it now imports from Brazil.
The welfare effects are similar as before:
Producer’s surplus reduced by area D
Consumer’s surplus increased by are D E F1 G
Government revenue is decreased by F1 + F2, where the term F2 reflects a decrease in government revenue not compensated by an increase in consumer’s surplus, so the negative F2 term is caused by the trade-diversion effect, as imports no longer come from the most efficient supplier
Net welfare effect: (D + E + F1 + G) – D – (F1 + F2) = E + G – F2, so an increase in welfare only occurs if the trade creation effect surpasses the trade diversion effect.
Domino theory = The world may end up in one large trading bloc, so that PTAs eventually lead to free trade
5.7 The theory of games- Airbus and Boeing as an example
All previous sections assumed perfect competition, which very often is not a very realistic assumption. Some markets are better characterised by imperfect competition.
Recap: Chapter 4 > Government support (a subsidy) led to a downward shifting supply curve. Production increased, the profit-maximising price decreased and the firm’s profits increased. In this situation, it became hard for a foreign firm to enter the home market and to compete with the home firm. A subsidy can thus be (mis)used to manipulate the market outcome.
The previous argumentation opens doors to lobbyists for government support for specific industries. > See Table 5.2:
Airbus-Boeing strategic interaction pay-off matrix |
(Boeing pay-off,Airbus pay-off) | Airbus Strategy |
Produce | Do not produce | |
Boeing Strategy | Produce | (loss,loss) | (profit,0) |
Do not produce | (0,profit) | (0,0) | |
We take the following assumptions:
Each firm alone can make a profit in the market
If the firms both enter the market, they both make a loss
If the firms both do not enter the market, the situation remains the same and profits for both are zero
The EU now decides to offer Airbus a subsidy that is large enough to cover potential losses. This has two effects: positive profit for Airbus, no entry from Boeing.
Table 5.3:
Airbus-Boeing strategic interaction pay-off matrix after Airbus subsidy |
(Boeing pay-off,Airbus pay-off) | Airbus Strategy |
Produce | Do not produce | |
Boeing Strategy | Produce | (loss,profit) | (profit,0) |
Do not produce | (0,large profit) | (0,0) | |
This table shows that whatever Boeing does, it is optimal for Airbus to enter the market. This also ensures that Boeing won’t enter the market > Insures Airbus’ profits.
5.8 Conclusions on trade protectionism
The complete analysis of this chapter now allows us to draw some conclusions regarding protection. First, consumers are always worse off and producers are always better off. Particularly governments might be tempted to introduce protectionist measures, because of the terms-of-trade effect.
6.1 & 6.2 Information on transport costs
Recap: Core of international economics and business = goods and services are being produced and/or sold outside a firm’s home country. The distance between home country and there where products are produced and/or sold generates transport costs.
See Table 6.1 in the book, it shows the origin and destination composition of trade flows for Europe as a whole between 1860 and 2009. Two conclusions can be drawn:
Shares of destination countries for exports and origin countries for imports are quite stable over time. Furthermore, intra-European trade is dominant.
The intra-European trade explains that distance is quite important in explaining trade flows, as more distance means higher transport costs.
The exact quantification of transport costs is not easy. Many measures of transport costs arose the past years, and the most straightforward one was the difference between CIF (Cost, Insurance, Freight) and FOB (Free on Board).
CIF = Measures he value of imports at the point of entry in a country and covers the costs of carriage, insurance and freight.
FOB = Measures the value of the same commodities ‘free on board’, that is, the value inclusive of all costs, of the merchandise in the exporting port
Note: these measure underestimate the real costs > commodities need to be transported to the port and from the importing port to the final destination.
[(CIF/FOB)-1]*100 > measure of the transport cost rate on imports. One expects, that goods with high value added will have relatively low CIF/FOB ratios.
The importance of transport costs is also reflected in the ratio of freight costs relative to other trade costs, like tariffs as transport costs seem to be at least as important as policy-induced trade barriers.
Transport modes can be either by sea, air, road and rail. Traditionally, shipping costs have been used as key determinant to understand international trade patterns.
6.3 Different models of distance’s impact on firms
This paragraph focuses on the impact of distance and transport costs on micro-economic level. The decision tree already introduced in chapter A shows five potential outcomes (See Figure 6.4): Stay Domestic, Export, Horizontal Multinational Activity, Vertical Multinational Activity, Import. The Stay Domestic option is deleted in this section and we take export and import together, as import is the inverse of export. Furthermore, the models we are going to discuss are based on the idea in chapter C (see: Midterm summary or chapter 4 in the book) > imperfect competition and increasing returns to scale.
Some simplifying assumptions:
Firms can locate their production in one or two identical countries (no country-specific effects)
Home and foreign markets are segmented > Price can be set independently without the risk of arbitrage
Only labour is used as production factor
Four types of costs, all in terms of labour:
Firm-specific fixed costs F (investments in R&D, marketing, management services and headquarters’ costs). Incur only once
Plant-specific fixed costs P (finding a suitable location, hiring the right people, buying machines and office equipment. These costs are incurred only once; total costs of all plants = total plants * P
Marginal costs MC, constant per unit of production and identical in both countries
Transportation costs t, exporting unit X goes along with transportation costs t the amount of t in terms of labour
Take Figures 6.5-6.7, where various options for internationalizing firms are depicted. Left hand of the panel: Home market, right hand: Foreign market.
Exporting; Figure 6.5
Profits are derived in the usual way: Taking MR=MC as the maximum profit volume, then projecting the maximum profit volume to the Demand-curve D and the Average Cost curve AC. Profits then equal the shaded area A. Average Cost curve AC consists of both fixed costs F and P > the shape shows the increasing returns to scale argument.
When exporting to the foreign country, profits are again derived in the usual way. Exporting means your marginal costs per unit became higher by transport costs t due to the geographical distance involved with exporting. MCh+t gives the new MC curve. Maximum profit then arises where MR=MCh+t, leading to area B being the profit. Of course you noticed area B being way higher than area A, even with the transport costs being added to the marginal costs > Fixed costs are assigned to the Home Country; matter of accounting principles.
Total Firm profits = A + B
Horizontal Multinational Activity; Figure 6.6
Horizontal Multinational firms are market seeking firms, like McDonalds setting up different restaurants all over the world. The choice between exporting and HMA is driven by the degree to which a firm benefits form increasing returns to scale and has to deal with transport costs.
In the horizontal case, firms set up production plants in each country they operate in. Now refer to Figure 6.6. Firm fixed costs F are assigned to the home country, so home country’s total fixed cost become F+P, whereas foreign country’s total fixed costs are ‘only’ P. Also, the foreign firm does not have to deal with transport costs, due to locating the production in the foreign country > Total profits for the home country are represented by C, foreign country’s profits are again higher with area D.
Total Firm profits = C + D
Vertical Multinational Activity; Figure 6.7
Vertical Multinational firms are efficiency or natural resource seeking firms, as these firms want to benefit from differences in factor endowments (see Chapters B&C from the midterm, or Chapters 3&4 in the book). The value chain of VMFs are split up into different parts, each part located in the country that is most endowed in performing the tasks of that part.
When the Home firm has a plant in the Foreign country, it owns and controls the foreign firm (note the crucial difference with just importing here!!). The Foreign firm is part of the overall organisational structure of the Home firm. Suppose, for example that Volkswagen (Home country = Germany) sets up a plant in China and exports cars produced in China (China is endowed in low skilled labour) to the German market. These flows are intra-firm trade flows > Refer to Figure 6.7.
Fixed costs at home only consist of fixed costs F, as there are no production plants at home; only headquarters. Fixed costs at the Foreign plant only consist of fixed cost P, as it is only a plant. The home firm has to be served from abroad, resulting in Marginal Costs at home to be influenced by transportation costs t, resulting in MCf+t as Marginal Cost curve. Profits in the Home country thus equal area E.
Note: Vertical Multinational activity is only attractive if the marginal costs of producing at home and serving the market from there are higher than MCf+t. This could be the case if, for example, wages are substantially higher abroad than at home. Another decision consists of how to organize the foreign sourcing; do you as a Home firm simply order a certain product, set a contract and agree on a price or are you going to do it yourself?
Hybrid cases of horizontal and vertical multinational activity
Horizontal and vertical multinational activity can also be combined. Several cases:
Export Platform multinational activity = Firms internationalize and locate in a certain country to serve customers in a third country. This is a combination of market seeking and efficiency seeking.
Strategic Asset Seeking multinational activity = It resembles the natural resource seeking type because it also concerns the need to have access to crucial inputs. In this case it is not based on natural resources, but on crucial knowledge of a product or how to produce a product.
Extensions on the previous models
The book assumed that Home and Foreign are identical, which is highly seldom in reality of course. Suppose The book drops this decision, but The book still assumes that MC are the same in both countries and that Fixed costs can be assigned to any market. For total profits, it does not matter where to assign them to. For the decision to either export or become a Horizontal Multinational firm market size does matter > If Foreign is way smaller than Home, exporting might be way more profitable, as the Foreign market sells less than the Home market, but pays the same Plant costs P.
Another issue in the book is the possibility of domestic firms reacting on foreign firms entering the market > The success of these reactions depends on the market power of each firm and how the entry affects market conditions.
6.4 The gravity model
Gravity model = Generally, it relates the mass of two bodies to each other, and weighs them by the distance between them to calculate the gravity. In trade terms, bilateral trade between two countries is large if the two economies are large and if they are close to each other. > The smaller the countries and the more distant, the smaller the bilateral trade flow.
The Gravity model was introduced by Nobel prize winner Jan Tinbergen and became really popular but was also criticised a lot, because;
It lacked strong theoretical framing
It lacked micro foundations
It could be derived from different existing models like the Ricardian trade model and the Heckscher-Ohlin model, making it impossible to test which theory applies
The gravity equation developed by Anderson and Bergstrand:
Where; i and j are country indices, Y is income, disij is the distance between countreis I and j and Z represents other possible variables that may affect the trade or FDI flow between home and host countries (being member of NAFTA or WTO, having a port or not having a port and volatility in exchange rates for example). Note: About 70% in the variance of trade flows is explained by this particular model and the model assumes that there are no differences within countries for simplifying reasons.
6.5 Other types of distance
So far, The book focused on geographical distance. Other distances, however, are also of influence on international trade and investment patterns. Take cultural, economic and institutional differences for example, which result in internationalizing firms incurring costs that domestic firms don’t have.
Zaheer identified four sources of the liability of foreignness as being of significant importance:
Costs that are directly related to spatial distance (travel, transportation and coordination over distance and across time zones)
Firm-specific costs based on a firm’s unfamiliarity with a new, local environment
Costs as a result of the host country environment (lack of legitimacy of foreign firms)
Costs from the home country environment
As you can see, the first source refers to geographical distance, the second and the third to cultural distance and the fourth to institutional distance.
An explanation of all kinds of distances is as follows:
Geographic distance = Directly related to transport costs. Measurement of geographic distance between a home and a host country is frequently based on the distance between the capital cities of these countries.
Figure 6.8 shows the relation between geographic distance and the foreign sales of US multinationals. As you can see, for all countries there is a flat line, meaning no relationship. Recap: Chapter A, Rugman and Verbeke’s antithesis > multinationals concentrate sales in regions (Americas, Europe&Africa and Asia), making working relationships.
Cultural distance = Differences in norms and values between the home and the host country. When firms cross the border, they face a different set of informal ‘rules of the game’.
Research on cultural distance is now dominated by Geert Hofstede’s framework, which knows four dimensions. The cultural distance between countries is often measured by comparing he scores of a home country and a host country on the different culture dimensions and taking the average distance along all dimensions > See Box 6.3.
Institutional distance = Reflects differences in formal rules and regulations. Such legal differences between countries are smaller when countries share a common history or when they are both members of trade agreement such as NAFTA or EU. Institutional distance does not per se have to mean something negative, it may create opportunities too: countries with less strict legal norms and protectionist measures may be attractive locations for multinationals, also with higher quality institutions, the rule of law improves and corruption goes down.
Economic distance = The difference in welfare and economic development stage between home and host country. If you want to sell products in a less rich country you have to take into account that it is likely that people won’t buy your product if it’s too expensive.
> How can these distances be included in the models discussed in paragraph 2?
Liability of foreignness = Affects the costs of doing business by affecting the choice between staying domestic and becoming internationally active. LoF effects exist for export, horizontal- and vertical multinational activity.
Example: The LoF is higher for horizontal multinational activity than for exports, as cultural distance creates a LoF in the case of horizontal multinational activity (foreign employees, trade unions) but not in the case of exports (no factory abroad). In the same way, LoF will be higher for horizontal multinational activity than for vertical multinational activity, as output generated abroad in horizontal multinational firms is target at culturally different foreign customers, whereas vertical multinational firms output generated abroad is targeted at home country customers.
Refer to Figure 6.2 > Local firm’s profits equal cbp0f and the foreign firm’s profits equal dbp0e, meaning the LoF equals cdef. How, then, can the multinational compete with the local? The multinational should offset the costs resulting from LoF via a firm specific advantage that raises revenues or decreases costs.
6.6 Porter’s diamond and Dunning’s OLI models
So far the book discussed both firms and countries, as firms become internationally active to generate value added that is based on country- or location specific characteristics (exporting, horizontal multinational activity or vertical multinational activity). The book discusses two frameworks that integrate firm- and national-level factors.
Porter’s diamond model
Porter’s diamond = Ideas on how firms can compete and be successful globally and on how to push economic development.
The resulting model is depicted in Figure 6.12
The essence of Porter’s theory is to explain why for example the Dutch flower industry and the Japanese electronics industries are global winners. According to Porter, this is because of the four related factors in his diamond model. The factors are as follows:
Production factors = Include labour, capital, infrastructure, technology and entrepreneurial spirit. This is similar to resource endowments discussed in chapter 3 and chapter 4.
Demand conditions = The size of the market (a large home markets creates economies of scale) and the quality of demand, which refers to consumers pushing firms to continuously satisfying their demand by coming up with new products and services.
Related and supporting industries = A strong home base of suppliers, which adds to the continuous development of new products.
Firm strategy, structure and rivalry = The way firms are created, organised and managed.
A fifth factor not included in the model is the role of the government. The role of the government is of influence to all four factors. Take as an example the government developing policies for the capital market
Dunning’s Ownership-Location-Internalisation (OLI) framework
Dunning wondered whether differences in productivity between the US and the UK were due to the superior resources of the US economy (location-effect) or whether it was due to more efficient management of these resources across national borders by the US (ownership-specific effect). The final effect is related to the organisation of cross-border activities. To fully explain the extent and pattern of foreign value adding, Dunning argued that an explanation was required of why some firms exploited their ownership-specific advantages internally, rather than selling or acquiring these, the internalisation-effect.
Thus:
Ownership dimension = Why a firm goes abroad
Location dimension = Where firms go when they go abroad
Internalisation dimension = How firms go abroad
7.1 Introduction
Recap: liability of foreignness (chapter 6); different types of distance that affect international business activity. This chapter elaborates on how firms an overcome their liability of foreignness. We focus on the role of firm-specific advantages (FSAs from now on), as FSAs make it possible to overcome the liability of foreignness. This chapter focuses on international management, rather than international business. The difference;
International business = The study of enterprises crossing national borders, which includes cross-border activities of business, interactions of business with the international environment and comparative studies of business as an organisational form in different countries.
International management = The study of the process of planning, organizing, directing and controlling the organisation. Managers use this to achieve an organisation’s goals when it is involved in cross-border activities or functions outside its nation-state.
Key question; How can firms organize their foreign activities in the most efficient and effective way, such that it contributes to their firm-specific advantage?
7.2 The resource-based view
The main view on competitive advantages is that it is the result of the application of a bundle of valuable resources (resource-based view). A firm is thus nothing more than a bundle of productive resources, namely the both tangible and intangible (human resources for example) assets it uses. Assets can be bought and used by other firms as well, so it is crucial how to handle them. As such, resources need to be complemented with capabilities. The combination of the right resources and capabilities offer a sustainable competitive advantage (FSA).
A resource can be a lot; tangible, intangible, it can include physical, financial or knowledge-related resources. A resource can only be part of an FSA if;
It is valuable
It is rare
It is inimitable
It is non-substitutable
You can conclude from this that FSAs should always be seen relative to a firm’s rivals.
FSAs can be derived from efficient use of infrastructure, a favourable financial position or specific know-how. Now about those capabilities, who are way more important than resources on their own. Capabilities are needed to bundle the resources present in a firm. One of the most important capabilities of firms is the entrepreneurial ability to constantly reinvent themselves. To stay ahead of your rivals, you should constantly develop new products, services or ways of working.
Critics on the resource- based view;
It is tautological > a kind of circular reasoning
It is very difficult to find resources that satisfy all four criteria
The theory has limited practical implications
The theory tends to underestimate the role of industry factors external to the firm
7.3 A classification of firms- domestic, multi-locational or multinational
How are FSAs related to internationalizing firms; firms that want to gain a competitive advantage abroad or firms that want to create added value in another country > Refer to Table 7.2 on page 194. This Table classifies firms among two dimensions [number of locations a firm has] [number of countries a firm is active in]. The two dimensions provide domestic firms, the simplest case, multi-locational domestic firms, a bit harder, and multinational firms, the hardest form as the transfer of firm-specific advantages across borders shows up here and not just the having of FSAs.
Take a New-York jeweller who only operates in New-York and its FSA is its excellent service and communication with the customer. If this jeweller wants to expand to Los Angeles it has to expand its FSA within a country but to another location, so no big difficulties involved. Communication styles and language do not differ between New-York and Los Angeles. If the jeweller now wants to expand to Berlin, the transfer becomes much harder due to cultural distance. In this case, there are a lot of costs involved in training staff and finding out what the appropriate way of communication with customers is.
7.4 The tension between global integration and local responsiveness
Each multi-locational and especially each multinational firm is confronted with a tension between the pressure to be cost effective (standardize within the entire firm) and the pressure to be locally responsive for local tastes and styles (adapt). The tension between global integration and local responsiveness is illustrated in Table 7.3 on page 197 of the book, among two dimensions [pressure for global integration] and [pressure for local responsiveness] which can either be low or high. The two dimensions offer four possible outcomes;
International strategy = A firm internationalizes by copy-pasting their home operations. Firms that produce goods or services that serve universal needs
Localisation strategy = Also called a multi-domestic strategy. This strategy is focused on maximising profits by customizing the firm’s products and services to the host country market. Each host market is treated separately and functional units like R&D, marketing and sales can be found in each market. In a way this means multiple domestic markets
Global standardisation strategy = Concentrating functional activities and achieving economies of scale, learning effects and location economies. Instead of customizing products, firms standardize products worldwide, where R&D may be concentrated in one host country and production in another country
Transnational strategy = Both high pressure for global standardisation and high local responsiveness is demanded. The key to this strategy is the ability to organize knowledge flows within the multinational group as a whole, not just from headquarter to subsidiary, but also between subsidiaries. These knowledge flows should be organised such that local learning feeds back in to the global FSA for the multinational as a whole. Subsidiaries adapt to be locally responsive. Figure 7.1 on page 198 illustrates the complexity of this strategy.
7.5 Examples of how to manage the global-local challenge
In general, the need to be locally responsive depends on the nature of the product/service in combination with the demand from the local business environment. Three specific examples to illustrate this;
International marketing
A crucial aspect of marketing is the understanding of consumer preferences. In international marketing, the key question is whether or not consumer preferences can be assumed to be the same all over the world. This is a very important question, as if consumer preferences are the same all over the world, economies of scale through standardisation can be achieved. When preferences differ between countries, the whole marketing mix (product, place, price, promotion) needs to be adapted. A deep understanding of local differences in values and practices is crucial for the success of international marketing. When explaining the role of cultural distance, the work of Hofstede should be used. He developed four dimensions of national culture;
Power distance = Power distance is about the hierarchy in an organisation, high power distance means that employees rely largely on their bosses
Uncertainty avoidance = About how people react to change, challenges and risk. Strong uncertainty avoidance means people are more likely to avoid risk and to rely on authorities to solve problems. It also means a preference for bureaucracies and routines
Individualism = About how people think about themselves and society. Individualist societies tend to put family and self-interest first and society second. Self-respect and independence are dominant factors. In collectivist cultures, people put the group first and group harmony is more important that individual freedom and success
Masculinity versus femininity = About how people see gender differences. Feminine cultures are associated with gender roles overlap. Man and women are equal. Masculine cultures are associated with traditional macho-type values implying that man are in charge
See Table 7.4 for the highest three and lowest three scores on all dimensions and Figure 7.2 for the correlations in cultural characteristics.
To come back to the main question of this section, whether or not consumer preferences are the same all over the world, is related to the question of whether cultures are converging or not. Some scholars argue that our world is characterised by increased similarity, which is also referred to as McDonaldisation, given the position of American brands. At the same time, researchers have argued that this may be true for some products, but not for all. According to Inglehart, there is a general development mostly driven by economic progress (people becoming richer which leads to changing preferences) that holds for all countries, but there are country-specific aspects of culture that are historically grown. This means there is no full global cultural convergence.
Finding out whether a global or a local approach is most appropriate is important for the marketing mix. The need for global integration or local responsiveness affects market segmentation possibilities between countries and within countries. It also affects product attributes, distribution strategies, communication and pricing strategies. Apart from exchange rate risks and trade restrictions, an internationalizing firm should consider their chargeable price really well, as for example what price to ask for one same Ford car in Germany, France and Japan is quite an important decision. Price discrimination (asking the maximum price in each market taking into account local competition) is affected by arbitrage possibilities. If Ford sells its Focus model in Germany for 2000€ more than in France and people can go easily to France to buy their Focus there, arbitrage possibilities are high and Ford’s pricing strategy is not effective.
Country of origin effect = Certain products/services are appreciated more or less by foreign consumers because they are offered by a firm coming from a specific foreign country. The product than may be superior or inferior, even if this is objectively not the case.
Corporate social and environmental responsibility
The present view on corporate social and environmental responsibility is well reflected in three 2006 movies; Blood Diamond (social conditions of the exploration of diamonds), An Inconvenient Truth (environmental aspects and sustainability) and Enron, the Smartest Guys in the Room (societal responsibility). Today’s corporate social and environmental responsibility policies should deal with the global-local tension;
Are ethical standards universal? Take Figure 7.3 on page 206 of the book. It shows people’s opinions in different countries on the question if taxes should be used to prevent environmental pollution. Significant differences exist within the opinions. Also take the giving of gifts as a token of appreciation and networking or paying government officials money to get things done. In some countries this is totally normal, whereas in other countries it is inappropriate or even illegal
Interdependencies; local events triggering global responses. Take horizontal multinationals with different subsidiaries in different countries who are hardly linked. If one subsidiary pays fees to government officials (which is normal in the country that particular subsidiary operates in) it can lead to major global responses, which hurts the overall image of the multinational
The discussion of global footprints. Take a vertical multinational which has to develop a global value chain. This firm has to track all their global value chain footprints at all stages of production, which requires them to be knowledgeable of all their different subcontractors and how this affects the overall global footprint of the multinational as a whole.
Total carbon footprint = The production, transportation, consumption and waste disposal of for example a can of food. For each of the mentioned stages, the total amount of energy used can be approximated.
Human resource management
Human resource management refers to how employees are being treated. For internationalizing firms that deal with different cultures this is also an important aspect. Again, Hofstede’s dimensions should be taken into account.
7.6 Different entry modes
What we have discussed so far is illustrated in Table 7.7 on page 212. There are 6 possible entry modes for firms when they go abroad, each of them having advantages and disadvantages. Three non-equity (exporting, licensing and franchising) and three equity modes (greenfields, acquisitions and joint ventures) are discussed.
Licensing
Firm A licenses to Firm B in another country the right to use Firm A’s technology or trademark for a certain fee.
Dissemination risk = The firm that licenses the technology, knowledge or trademark may be confronted with a licensee that uses the technology, knowledge or trademark for something else than what the licence was intended to deal with.
Franchising
Firm B in a host country uses the business model developed by Firm A, and Firm A provides assistance in making the local activity a success. The franchisee has the right to use the franchisor’s logo, trademark and way of working for which the franchisor receives a fee. Here, the degree of control is higher than for licensing. An example is McDonald’s.
Greenfield
When a firm expands to a foreign country by establishing a completely new firm that it fully owns. Full control and 100% entitlement to the profits is generated. A crucial disadvantage is the high cost and risk involved.
Acquisition
When a firm buys shares of a firm established in a foreign country. Full acquisition means buying all shares, partial acquisition means buying some shares. An acquisition does not add additional production capacity, but instead changes the ownership of existing capacity. A popular way to obtain an immediate position in a foreign market is acquiring a foreign competitor, which offers reduced risk as an acquisition does not only involve buying tangible assets like factories, but also intangible assets like employees with certain local know-how.
Joint venture
Firm A from country 1 and Firm B from country 2 join forces and jointly establish a firm C in a foreign country (which can be either country 1, 2 or a third country). The advantages are that both firms pool their FSAs in order to both benefit. Moreover, costs can be shared and partnering with a local firm offers knowledge of the local market. A major disadvantage is the risk of knowledge spillovers due to the pooling of FSAs. Joint ventures also have a big risk of failing due to conflicts between the partners.
7.7 The optimal entry mode
When making the entry mode decision, a lot of factors should be taken into account. These factors can be categorised into three main factors;
Each factor changes for different entry modes. Take greenfields and acquisitions, where the degree of control is very high and low for licensing and franchising. Depending on which aspect is most important for a firm, an entry mode is chosen. For many high technology firms for example, the risk of knowledge leaks to partners may be so big they choose an entry mode with full control and minimum dissemination risks.
The most robust theory to predict the entry mode is the transaction costs theory. It deals with the fundamental question, what is the most efficient way of organizing a transaction: market or hierarchy? In the first case, a transaction is organised by setting a price using a contract and in the second case, the transaction is best organised by pooling the resources of the two individuals within one organisational unit. Transaction costs theory predicts that firms arise when they are the most efficient way to organize the transaction.
Despite the predicting theories, managers may deviate from them in their actual decision due to bounded rationality issues. Bounded rationality = Not all necessary information can be processed to make the optimal decision. Also note that not only managers determine the entry mode, as governments of host countries may also have strict rules concerning the way they allow foreign firms to enter their country.
Apart from where and how to enter, when to enter also plays a role. According to the Uppsala model of internationalisation, firms need to learn and internationalisation is a dynamic learning process. Learning is based on learning-by-doing, experience.
- International business is the study of enterprises crossing national borders, which includes cross-border activities of business, interactions of business with the international environment and comparative studies of business as an organisational form in different countries.
- International management is the study of the process of planning, organizing, directing and controlling the organisation. Managers use this to achieve an organisation’s goals when it is involved in cross-border activities or functions outside its nation-state.
8.1 Introduction
This chapter focuses on the monetary aspects of the interactions between nations, firms and consumers in the global economy, with the focus on exchange rates.
Due to different countries having their own currency, international business activity is associated with a risk. This risk is two-fold: there is a transaction risk and a translation risk.
Exchange rate = Price of one currency in terms of another currency.
Economic exposure = Exposure of a firm’s value to changes in the exchange rates.
Transaction risk = Gains and losses that may be incurred when monetary transactions are settled in a foreign currency.
Example: A British firm buys cars from a German firm with a contracted price of €1.000.000, where the payment has to be done within 60 days. At day one (contract date), pound/euro exchange rate is 1:1. However, on day 60 the pound/euro exchange rate is 1.1:1, meaning that the pound decreased in value > To get one euro, more pounds are needed. In other firms, the British firm has to pay €1.100.000 instead of €1.000.000 and the German firm receives €1.000.000.
Translation risk = The risk of having assets and liabilities on a firm’s balance sheet denominated in a foreign currency.
For example: You are travelling from Paris to the USA (euros to dollars). To get some dollars, you go to ATM in New York to get Dollar1000. At the time of this transaction, the exchange rate is 1.25, meaning you get €800. Now, your friends’ card won’t work in New York, so you offer to lend her the money and go to ATM again for Dollar1000; she will pay back as soon as the card works, so you have a liability. After one week, she pays you back, so now you have Dollar1000 in assets. In the meantime, the exchange rate became 1.40, meaning you get back only €714 instead of the €800 you expected.
For the adapted version of the decision tree, see Figure 8.1 in the book.
Exporters face transaction risks
Horizontal multinationals face translation risks
Vertical multinationals face both transaction and translation risks
Importers face transaction risks
8.2 Exchange rates- general information and definitions
Recap: Exchange rate = Price of one currency in terms of another currency.
The price is determined by supply and demand in the foreign exchange market. A rise in exchange rate means that the item being traded has become more expensive > If the exchange rate of a Singapore dollar in terms of a European euro rises, the Singapore dollar has become more expensive.
Spot exchange rates
Spot exchange rate = The price of buying or selling a particular currency at this moment. They are extremely variable, they change in a matter of seconds. See Figure 8.2
See Table 8.2:
Bid rate = The price at which banks are willing to buy one US dollar for example.
Ask rate = The price at which banks are willing to sell one US dollar for example.
Spread = bid rate – ask rate ; generates revenue for the currency trading activities of the banks (margin). In practice, the spread is quoted relative to the bid price.
USDollar0.9915-18 means a bank is willing to buy dollars at 0.9915 and to sell dollars at 0.9918
See Figure 8.2
Depreciation = a currency to become less expensive. In Figure 8.2, over the period as a whole, the US dollar has depreciated.
Appreciation = a currency to become more expensive. In Figure 8.2 the US dollar appreciated particularly at the end of 2008
Arbitrage
Exchange rates vary very quickly over time, but the same is not true for the exchange rate at different locations for a given point in time.
Arbitrage activity = Making a profit by buying currencies where they are cheap and selling them where they are expensive.
Suppose: we know the price of one US dollar at noon on 3 august, 2011 in terms of Canadian dollars (0.9581), Swiss francs (0.7759) and South African rand (6.7849). In view of arbitrage opportunities, this suffices to calculate all cross-exchange rates as given in Table 8.3
For example: We know one Swiss franc must cost 8.7446 South African rand, because >
6.7849 rand = 1 US dollar
1 US dollar = 0.7759 Swiss francs
6.7849 rand = 0.7759 Swiss francs
1 Swiss franc = 6.7849 / 0.7759 = 8.7446 rand
Players and markets
The main players on the foreign exchange market:
Commercial banks = All major international transactions involve the debiting and crediting of accounts at commercial banks (most transactions relate to the exchange of bank deposits). Commercial banks thus are intermediaries for their clients by bringing together their demands and supplies.
Firms = The exchange of goods and services almost always involves foreign exchange trading to pay for these activities.
Non-bank financial institutions = As a result of financial deregulation, foreign exchange transactions are also offered by institutions such as pension funds and other investors
Central banks = Depending on various circumstances (think of the unemployment rate, economic growth rate, inflation) the central bank of a country may decide to buy or sell foreign exchange.
Forward rates and hedging
As we already know, the extreme variability of exchange rates creates transaction and translation risks. If you sell for 20.023.500 Yen on one day and your cost are 19.000.000, you account for a profit. However, the currency of the country you are trading with might depreciate, making the amount you receive on your bank account 18.051.000 Yen for example; a loss. Could you avoid this loss?
Yes you could have > If you had made an agreement to sell on a forward price of the value of the currency on the day of the sell or a pre-determined value of the currency, you could have avoided the loss. This is Hedging = passing your own foreign exchange risk exposure on to the forward exchange market.
Speculating = Taking a gamble on the direction and size of changes in the exchange rate, a whole range of forward looking markets has developed, with associated rather exotic technology, such as:
Plain vanilla instruments = Instruments which are traded in generally liquid markets according to more or less standard contracts and market conventions
Forward = Price at which you agree upon today to buy or sell an amount of a currency at a specific date in the future
Swap = Simultaneous buying and selling of an amount of currency at some point in the future and a reverse transaction at another point in the future
Option = The right to buy or sell a currency at a given price during a given period
Selling at premium = Forward rate > Spot rate
Selling at discount = Forward rate < Spot rate
8.3 Effects of exchange rates on prices
Suppose, the exact same product is freely traded between America and Britain. There are no transportation costs, no tariffs, etc. needed for arbitrage. Should the price in Britain be exactly the same as in America?
Law of One Price = Identical goods should under certain conditions sell for the same price in two different countries at the same time.
Absolute Purchasing Power Parity = A bundle of specific goods should cost the same in France and the US once you take the exchange rate into account.
> When calculating PPP, you should use price indices that are constructed in the same way in the different countries.
Relative Purchasing Power Parity = Differences in the rates of inflation between two countries.
> The rate of inflation in France is higher than that in the USA, causing the price of the basket of goods in France to rise. PPP says the baskets have to cost the same in each country, so the French currency has to depreciate against the USA currency.
So far, no distinction was made between nominal and real exchange rates.
Real exchange rate is defined as Z, nominal exchange rate is denoted as S (how many euros you have to pay for one dollar).
In this example we take the EU as home country and the USA as foreign country.
Z = S * (Pus/Peu), where Pus/Peu is the price ratio (price of American goods relative to European goods).
The real exchange rate Z increases if:
The nominal exchange rate S increases
The price level in America increases
The price level in Europe decreases
We expect an increase in Z to cause a substitution of consumption away from American goods towards European goods in both countries. This of course will affect import and export flows between Europe and the US, where export equals X and import equals M. So if Z increases, the European demand for imports decreased and the demand for European exports increases. We can summarize both effects in the current account balance (Recap: Ch. 2)
CA(Z) = X (Z+) – Z * M (Z-)
See Figure 8.7 in the book
Initial equilibrium is at point A at an exchange rate equal to s0
SM(S) curve shifts to the right, so imports increase
Under flexible exchange rates (monetary institutions do not intervene) this shift leads to a new equilibrium in point B > Appreciation of the US dollar
If the European Central Bank now wants to fix the value of the euro at s0 level, so they only allow the dollar to appreciate within limits > A band width arises around the parity rate and the dollar exchange rate will appreciate to
s0 + (band/2) with the difference of demand and supply (D-C) supplied by the ECB in order to make that happen
8.4 Effective exchange rates
Most of the time a certain currency is appreciating relative to one currency and depreciating relative to some other currencies. Has the currency then become more or less valuable over time?
Effective exchange rate = It is useful to distil the divergent movements in (bilateral) exchange rates into a key (index) number summarizing the overall movement of a country’s exchange rate.
> Countries are interested in the general development of their competitive position relative to various countries . The real effective exchange rate does that by calculating the weighted average of the bilateral real exchange rates
See Figure 8.9 in the book:
Panel a shows the development of the real and nominal exchange rate in a broad range of currencies (high-inflation countries included)
Panel b shows the development of the real and nominal exchange rate in the major foreign currencies
Can we now deduce from Figure 8.9 that PPP holds? > Yes and no:
If relative PPP were hold to for every time period and for all countries, the real effective exchange rate would have to be a horizontal line
If absolute PPP holds, the level of this line would be determined
Taking a look at panel c, there clearly is no horizontal line, therefore relative PPP does not hold
However, there is not a consistent upward or downward movement; two large upward deviations in 1981-1988 and 1997-2004 with peaks in 1985 and 2002
Short run PPP does not hold
However, we do not see a consistent upward/downward movement >
Relative PPP tends to return to some base level, so in the long run relative PPP does hold
Reasons for short run deviations are / Reasons why arbitrage does not always work well:
Transaction cost ; An obvious reason for the failure of the Law of One Price are transaction costs (shipping, insurance, tariffs)
Differentiated goods ; In deriving the Law of One Price we assumed homogeneous goods, while in practice very few goods are perfectly homogeneous > Very much types of wine and cars for example. The one car is not the other
Fixed investments and thresholds ; Before one can take advantage of arbitrage, investments such as establishing reliable contacts, building networks, organizing shipping and having a distribution network have to be made
Non-traded goods ; A large share of income is spent on non-tradable goods, or services actually. Examples are health care services and recreational activities
Composition issues ; We assumed that the price indices in the two countries when deriving the PPP exchange rate were constructed in an identical way, which in practice is not always the case
8.5 Issues around portfolio investments
Fisher equation = Explains the real interest rate r (how many goods you can buy with a certain amount of money) by taking a nominal interest rate i, your reward in terms of money and substracting the Geek letter pi, denoting the inflation rate in the economy.
r = i – pi > See Figure 8.11 for a relationship between nominal and real interest rates.
Notes: The real interest rate can be higher than the nominal interest rate and the real interest rate can be negative.
Covered interest parity
The discussion of this section is based on two options for a European investor: buying European bonds or American bonds. The two assets are perfect substitutes, meaning that the one carries not more or less risk than the other. Assume: large sum of L euros, return in euros. Figure 8.13 shows your investment options:
Option I > You purchase a European bond. End of the period: L*(1+iEU) euros of return
Option II > You purchase an American bond. These are in dollars, so: first you have to exchange your L euros for L/E US dollars, where E is the spot exchange rate of the US dollar (its price in euros). Second, you have to invest these L/E US dollars in American bonds. End of the period: L/E*(1+iUS) dollars by the end of the period. Then, you have to convert these dollars back to euros again, and this forms the risk: at the point of making your investment choice, you do not know yet what the future spot exchange rate of the dollar is going to be
If the two assets are perfect substitutes and both are held in equilibrium, the return to those assets must therefore be the same. The following equilibrium condition:
Uncovered interest parity
The previous section The book assumed that there was no difference in riskiness involved. There are more options available and one of these options (option III) is not to hedge your risk on the forward exchange market, but adding a subindex t to denote time in your formula.
Comparison of revenues from option I with option III, which is buying the American bond and not hedging on the forward exchange market.
End of the period: (L*(1+iEU,t).
Before purchasing the American bond, convert euros in dollars at exchange rate Et, which offers you L/Et dollars and a revenue of L/Et*(1+iUS,t) dollars. You don’t hedge your foreign exchange risk, so: next period exchange currency on the spot exchange market. In this period, you have to make your investment decision and you don’t know next period’s spot exchange rate > Form expectation about the future spot exchange rate.
Expected revenue end of the period:
, where is the expected value of the forecasting process
Uncovered interest parity then is: Interest parity, risks, transaction costs, exchange rates and capital mobility
The book expects individuals to be risk averse: other things equal, they prefer less risk to more risk. Risk premium = Risk averse investors will demand for a compensation for holding risk carrying assets. Rises if: risk aversion rises, perceived riskiness increases. > Firms with bad credit must pay a higher interest rate than those with a good credit.
In The book’s analysis, it distinguishes between home and foreign and under a system of fixed exchange rates that is fully credible the future exchange rate E^e is equal to the spot exchange rate (so E^e/E=1).
rHome = rForeign + risk + Transaction Costs
Transaction Costs TC only concern home, so TC > 0. The risk difference may relate to political and expected exchange rate risks. If Home’s currency depreciates to Foreign’s currency, portfolio investors want a higher return for carrying a risk. If risk = dE and TC = 0
rHome = rForeign + dE, with E = exchange rate
9.1 Introduction
When firms trade with or invest in different countries, they are confronted with multiple currencies. Supply to and demand for currencies can have implications for exchange rates. This chapter focuses on an issue affecting internationalizing firms directly: currency crises; the potential drawbacks of international capital mobility for firms and the economy and the economy as a whole.
9.2 Currency crises- general information
Exchange rate E = The price of the local currency per unit of foreign currency.
Exchange rate changes = A rise in exchange rate E means a depreciation of the local currency. A fall means an appreciation of the local currency.
A currency crisis now consists of significant appreciations or depreciations of a currency.
Two players: Portfolio investors and local monetary authorities (central banks), where central banks care about the level of the exchange rate > They want to keep it fixed, due to maintained certainty. Internationalizing firms love this certainty.
Now the book wants to know the relevance of a currency crisis for explaining a financial crisis and here The book is mostly interested in the impact of exchange rate depreciations.
Speculative attack = Investors lose confidence in a currency and start to sell their investments in that currency on a large scale within a very short period of time. If attacks like this succeed, the currency depreciates.
In chronological order:
Pressure on the exchange rate to depreciate for some (unknown and irrelevant) reason
Investors immediately and collectively start to sell their investments in that currency
Authorities start to support the present exchange rate, as they don’t want a depreciation > Either done by raising interest rates or selling part of foreign exchange reserves and thus buying their own currency
Speculative attack continues and the authorities have to give in > Depreciation starts
Other aspects of currency crises that are less obvious:
Eichengreen, Rose and Wyplosz developed a currency crisis indicator for empirical research. Bordo et al. analyse whether currency crises have become more frequent over time. To answer this, they define for each period the probability of a crisis as the total number of crises in period divided by the total number of country-year observations during that period. It turns out that the frequency has increased, leading to a 7% probability these days.
9.3 Currency crises- characteristics
Emerging economies are much more a prone to currency crises than developed countries, as they have a low level of domestic savings and offer a quite high return on investment. Before a currency crisis, emerging economies typically had a net capital inflow and a current account deficit. A currency crisis then is very much like huge capital withdrawal, leading to the need for a current account surplus. This reversal in capital flows and the accompanying exchange rate depreciation may contribute really strong to a financial crisis, as a sharp decrease in capital inflows means that fewer funds will be available to finance domestic investment. With many loans denominated in foreign currencies such as the US dollar, a depreciation of exchange rates means an increase in the real value of the debt of domestic firms and banks.
9.4 Explanations of currency crises- First Generation Models
Models of currency crises can be classified into:
The first dimension > Concerns the role that international investors play in bringing about the crisis: How do they react to a changed outlook for the exchange rate? Do they even react or do they themselves determine what this outlook looks like?
The second dimension > This dimension is the rationale for the crisis. Is the crisis due to flaws in the domestic economy or are the fundamentals of the economy sound and is the attack on the currency purely speculative?
In the earliest models (or first-generation models) developed by Krugman (1979) and Flood&Garber (1984), investors are quite passive and the crisis is totally due to bad economic conditions, which are incompatible with the fixed exchange rate.
(9.1) P = m(M), with dP/dM > 0 ; The domestic price level P is a positive function of domestic money supply M
(9.2) P = EfP*, with P* = Ef = 1 ; Shows that in the long run PPP holds (See chapter A in midterm summary, chapter 1 in the book), as if the domestic price level exceeds one, this equation shows us that as long as the foreign price level remains unchanged, the exchange rate has to increase (depreciate) in order to maintain PPP.
(9.3) dM = dF + dR ; This equation shows that this country finances deficits F by lending from the central bank, which increases money supply. This equation can be looked upon as a balance sheet of the central bank > F is loans to the government; asset, R is foreign exchange reserves; asset and M is the money supply; liability.
dF > 0 means an increase in governments budget deficit and thus an increase in money supply, which leads to an increasing domestic price level and makes sticking to a fixed exchange rate thus impossible : Domestic economic conditions are incompatible with the fixed exchange rate. The monetary authorities might also sell part of its foreign exchange reserves R to the public in exchange for the domestic currency, so money supply M shrinks. As long as dF = -dR, money supply does not increase and the fixed exchange rate can be maintained.
Problem: R is limited. Once R = 0, money supply will start to increase, dF = dM, meaning exchange rate can’t stay fixed.
What will investors do in this situation? > if they wait for R = 0 to happen, they lose money as their investments will be worth less. So before R = 0, investors start to attack the currency, which is selling their investments in the currency. This means the currency crisis will occur at some point when the foreign exchange rates start to run down.
So, first generation models = There is one possible outcome; devaluation of the currency and investors simply bring home the bad news a bit earlier by attacking the currency than would have been the case if government had had its way. Also, the currency crisis is due to the fact that domestic economic conditions are at odds with the fixed exchange rate objective. Is this model useful?
Most economist think that currency crises are at least to some degree the result of bad fundamentals > Speculative attacks are not random
The model explains why a currency crisis can occur at a time when the authorities still seem to be able to stick to the fixed exchange rate
A speculative attack can only succeed if a sufficiently large number of investors decides to sell their investments at the same time. But how do these investors coordinate their believes? First, the willingness of central banks to keep the exchange rate fixed produces a focal point for individual investors. Here, the fundamentals of the economy are the signal to investors. Second, investors use information as a focal point that is not necessarily related to the actual economy. One example here might be a large single investor with a good reputation selling its investments in a particular currency.
9.5 Explanations of currency crises- Second Generation Models
Some of the shortcomings of the first generation models of currency crises are named in the more recent models, in which the expectations of investors and policy-makers determine whether or not a currency crisis takes place. Currency crises thus also depend on the behaviour of investors.
Three assumptions on these second-generation models;
Policy makers have a reason to give up the fixed exchange rate > Policy makers may have various reasons to devalue, boosting exports for example
Policy makers also have a reason to maintain the fixed exchange rate > Enhancing credibility of their domestic policies
The costs for policy makers to hold on to the fixed exchange rate increase if investors expect that at some point in the future the currency will be devalued
The basic mechanism of these models is quite simple: assumptions one and two tell us that there is a trade-off for policy makers; there are costs and benefits of sticking to a fixed exchange rate. Assumption three then shows us that investors determine the position of the policy maker in this trade-off.
Suppose: investors think the fixed exchange rate is credible (they don’t expect a future devaluation) > Policy makers also conclude the fixed exchange rate is credible and the situation won’t be changed. Also possible: investors expect a future devaluation and demand for higher interest rates, the higher interest rate raises the costs of sticking to a fixed exchange rate, so policy makers decide to devalue the currency.
9.6 Other models and thoughts on currency crises
In both models, investors never get it wrong > The currency market is an efficient market where there is no room for surprises.
Evidence for currency crises not always being self-fulfilling:
Once a crisis arises, it is shown that not only until very late that investors see the crisis coming
Once the crisis is there, policy-makers can behave differently than was expected before the crisis
So in previous models, the role of expectation and self-fulfilling mechanisms is quite high. Empirical research, however, shows that on average crises can be attributed to economic fundamentals being at odds with the fixed exchange rate objective that many countries have.
Contagion = A case where knowing that there is a crisis elsewhere increases the probability of a crisis at home
> See research Kaminsky and Reinhart in the book ; Table 9.3 gives evidence for contagion to happen.
Evidence of contagion does not mean that currency crises are self-fulfilling due to mass behaviour of investors. It can also be explained by the fundamentals when the country that is hit by a crisis is linked to other countries, via international trade for example. If A and B, both developing countries have a fixed rate against the US dollar and they compete on the same export market, a devaluation of country A’s currency for improving competitiveness, this means a less good competitive position for country B. > The fundamentals of country B weaken and provoke a currency crisis; capital flows drop and the currency crisis arises. This is an example of fundamentals-based contagion.
Pure contagion = Contagion that is of a pure self-fulfilling nature.
9.7 What can be done about crises? - Policy trilemma
What actually can be done about currency crises? Authorities can limit the crises, but they are confronted with a dilemma. To understand this, you first should know that policy makers care about three policy objectives: A fixed exchange rate, Monetary policy independence, Capital mobility. They care about these objectives, because:
A fixed exchange rate benefits international trade, because traders don’t have to deal with uncertainty
Monetary policy is a powerful tool to guide the economy
Capital mobility stimulates a better allocation of savings and investments and more risk spreading
The dilemma: only two of the three objectives can be achieved in one point of time, at the expense of the third. Recap: uncovered interest rate parity condition
rHome = rForeign + dE + TC
If there is capital mobility, transaction costs are low. Taken rForeign as given, rHome = rForeign + dE > Exchange rate changes are the only reason for interest rate differentials between home and foreign. So choosing for capital mobility, leaves policy makers with a choice between a fixed exchange rate and monetary policy independence. If for example, they choose for a fixed exchange rate, so dE = 0, then rHome = rForeign, which makes monetary policy independence impossible.
Figure 9.6 illustrates Robert Mundell’s policy trilemma, where the squares are the choices and the circle can’t be met.
Until recently, policy makers in small, open economies for sure want a fixed exchange rate to protect the exporting sector. As a consequence, policy autonomy for these countries reduced. Now, three questions arise:
Is the loss of policy autonomy really a cost from the perspective of a country’s social welfare?
Is the policy trilemma vindicated empirically?
What made countries in the late 1990s reconsider their position with respect to the trilemma?
Is the loss of policy autonomy really a cost?
A decrease in policy autonomy means that policy makers have less pressure on the domestic economy. If you take it in the social welfare perspective, the loss of autonomy only means a cost if policy makers used their autonomy to increase social welfare. The costs of the loss of policy autonomy depend on the credibility of the domestic monetary policy and on their preferences.
Does the trilemma really exist?
Obstfeld, Shambaugh and Taylor developed an equation that confirms the hypothesis that policy autonomy decreases when capital mobility is high. They confirmed the hypothesis with this formula using data for three important periods: gold standard, Bretton Woods and post-Bretton Woods.
I is the country, t is the year of observation, r^b is the benchmark interest rate and mu is the error term. The benchmark interest rate fulfils the role of our theoretical interest rate rForeign. With capital mobility and fixed exchange rated, we expect beta to be 1. If capital mobility is less than perfect and/or exchange rates aren’t fixed, beta < 1. To confirm the hypothesis, beta should be lowest for Bretton Woods and highest for gold standard.
Around 1990, most developed countries were characterised by almost full international capital mobility. At the same time, most countries had a fixed exchange rate. From 1999. A floating exchange rate started to become popular, as in that period many currency crises occurred > The trilemma was reduced to a dilemma ; Countries should choose. Or full capital mobility or a fixed exchange rate (Recap: speculative attacks, if investors don’t have confidence, they sell investments and fixed exchange rate cannot be maintained).
10.1 Introduction
This chapter focusses on the potential gains from international capital market integration, as chapters 3 and 4 mainly focused on the potential losses. The two main benefits:
The possibility that international capital flows lead national savings to their most productive investment opportunities
International capital mobility permits an improved allocation of investment risk
10.2 International capital mobility- consequences
Recap: chapter 2, book chapter 2 > Current Account balance = Savings S – Investments I. Also remember that a CA-surplus means a capital outflow and a CA-deficit means a capital inflow.
From this accounting identity it becomes clear that if S – I > 0, this surplus has to be invested abroad (capital outflow). In other words: If exports are larger than imports, the excess capital has to go somewhere. But what causes these capital flows? To answer this , we need a model.
A macroeconomic model of international savings and investment
Recap: Trade models in chapters 2, 3 and 4 from the midterm and chapters 3, 4 and 5 in the book. Financial transactions are different from goods transactions, where the main difference is the risk involved. Savings are channelled towards investment opportunities (direct or indirect via intermediaries like banks) in the assumption that the investments will yield a positive return. If you want agents to save more, interest rate r has to increase, also to compensate savers for the higher risk involved.
sH = sH (rH+); sF = sF (rF+)
Where: sH is the savings function for the home country, sF for the foreign country. This equation shows that if r goes up, savings go up.
In investments, the interest rate is important too. Each investment increases the existing capital stock, which raises the productivity of capital. Each new contribution to the capital stock market also makes a smaller contribution to the productivity of capital, due to the law of diminishing marginal returns (paragraph D.3). What, now, is the optimal level of investments?
iH = iH (rH-) ; iF = iF (rF-)
This equation shows that an increase in interest, investments decrease
Refer to Figure 10.1. Savings curves are upward sloping, investment curves are downward sloping, see the equations. In the absence of international capital mobility, the equilibrium interest rate equals rH0, point 1 and rF0, point 2 for Home and Foreign respectively. Note: without mobility rH > rF. In equilibrium, there is a current account balance, no net inflow or outflow of capital. Now The book introduces international capital mobility. The worldwide interest rate will be somewhere in between rH0 and rF0 for both countries. If this would not be the case: arbitrage. The world interest rate becomes rH1 and rF1 > Net gains are illustrated with shaded triangles, which can be explained:
In autarky, Home is in situation 1. International capital mobility leads to a lower interest rate at rH1, which makes a loss for the suppliers of funds of rH0,1,3a,rH1 and a gain for the demanders of funds equal to rH0,1,3b,rH1 > Net gain = 1,3a,3b.
In autarky, Foreign is in situation 2. International capital mobility leads to a lower interest rate at rF1, which makes a gain for the suppliers of funds of rF0,2,4a,rF1 and a loss for the demanders of funds equal to rF0,2,4a,rF1 > Net gain = 2,4a,4b.
Time preference = Assume: for any interest level, home saves less than foreign. Present consumption in home decreases, and increases in the future. The relative price of present consumption in terms of future consumption is (1+r), as by giving up 1 unit of present consumption, your return is (1+r) units of future consumption. The higher the degree of time preference, the higher will be the interest rate.
Inter-temporal trade = Trade in goods over time. By lending to home, foreign van increase its future consumption, whereas home can increase its present consumption > Both countries are better off. That’s exactly the conclusion of international capital mobility.
10.3 The direction of capital flows
Paragraph 10.3 in the book describes the findings of Feldstein and Horioka, who found that the correlation between national savings and investment ratios were very high and thus international capital mobility actually was rather limited. This was a puzzling finding, as the popular conviction is that the world is highly globalised and the capital market is highly integrated. See Tables 10.2&10.3 for results.
Refer to Figure 10.2 in the book.
Diminishing marginal productivity = An economic principle that states that while increasing one input and keeping other inputs at the same level may initially increase output, further increases in that input will have a limited effect, and eventually no effect or a negative effect, on output.
Assume that Home is capital rich, kH > kF. In other respects, the two countries are alike. The horizontal axis is world capital stock, which is divided between Home and Foreign, as indicated by point E0. An increase in kH must lead to a decrease in kF and vice versa. The left vertical axis is the Marginal Product of Capital MPC for Home, the right hand one is for Foreign. Given the initial capital distribution at point E0, the respective interest rates are rH0 and rF0. This is all under autarky. When allowing for capital mobility, agents see that return on capital is higher in foreign, as foreign is capital scarce. So it is beneficial to reallocate capital from Home to Foreign. The size of reallocation equals the distance between E0 and E1. The reallocation stops at point A, where an equilibrium is achieved and interest equals rH1 = rF1. The net gain is represented by triangle ABC, where the gai for Foreign equals E0, E1, A, C and the loss for Home equals E0, E1 A, B.
10.4 What is happening to the direction of capital flows?- Historical overview
First era of globalisation, 1870-1914 > Capital flows were mainly long term, from rich countries like Europe to poor countries.
Currently > Short term flows of capital between developed countries, which is puzzling, as moving capital from rich to poor is even more attractive now than it was during the first era of globalisation. But what can account for this? Three qualifications:
The assumption of diminishing returns to capital may not be correct
Potential gains from international capital mobility need not be realised
The overall conclusion as to the fairly limited degree of capital flows to developing countries masks large cross-country differences
10.5 & 10.6 The risk diversification benefit, firm investment & asymmetric information
This paragraph deals with the second main benefit: The improved risk diversification.
Suppose, The book permits international capital mobility, but the current account is in balance, which means there are no net flows of capital. This doesn’t imply that there are no international capital transaction, domestic investors probably only have bought foreign shares and domestic banks have most likely used their funds to provide loans to foreign firms. Furthermore, savings and investments refer only to S and I out of this year > A large part of international capital flows are not included in S and I as such.
Portfolio investment and risk sharing
The second main advantage of capital mobility is risk diversification. This is best understood from the perspective of the individual portfolio investor. Suppose, a portfolio investor can invest savings in loans to firms in Home or Foreign. In both countries the interest rate is r and they do not differ in country risk (political uncertainty for example). Also assume that the exchange rate is irrevocably fixed. > You would say the investor is indifferent of where to invest. This is not the case!! What is Home and Foreign are specialised in the production of different goods? The associated risks of lending to either Home or Foreign are different in this case. Country-specific risk = If there is no capital mobility and Home is hit by a negative shock (economic downturn), the stock values decrease and the investment portfolio of the investor decreases too. So with international capital mobility, there is a possibility for risk diversification. Also, as long as investor differ in risk profile and outlook, the diversification, or ‘don’t put all your eggs in the same basket’ argument makes perfect sense.
Home-bias puzzle = If a country has a share of 15% in world GDP, investors invest 15% of their savings into domestic financial assets and 85% abroad, so a large share of wealth is held in domestic assets. The actual degree of cross-country risk diversification now turns out to be rather limited. Explanations:
The supply of funds for individual firms
Figure 10.1 suggested that firms, when they seek funds to finance the expansion of their capital stock face a supply of fund that is the macroeconomic savings function S. This is not the case > National assets are used to buy all kinds of assets and funds to finance firm investment is only a small part of where total savings are put. Also, households and the government also engage in investment activities. Households invest in cars and houses for example and the government in infrastructure. Therefore, the macroeconomic savings curve S is not suited to describe the supply of funds to individual firms.
What does a supply of funds for the individual firm then look like? Remember that investment projects of firms are risky in the sense that they are large and unique and they are associated with incomplete information about the return on investment. Risk diversification is not possible in this case!! Information is not only incomplete, but also distributed asymmetrically, as all suppliers of finance want to be compensated for the risks involved.
Refer to Figure 10.3. Fd gives the demand for funds, its like the I curve on macroeconomic level, but then on firm level. R0 is the risk free interest rate of internal finance (the firm financing their investments themselves). Only when firms run out of internal finance, they seek external finance, where they prefer debt over equity. The partly upward-sloping supply curve depends on the extent of the asymmetric information problem. The problem of asymmetric information can be divided into:
The adverse selection problem = The situation where the supplier of external finance through his own actions ends up with firms that it wishes to avoid.
The moral hazard problem = After funds have been granted to the firm, the supplier can observe only in an imperfect manner if the funds are being put to good use.
The supply of funds and international capital mobility
The problems of asymmetric information are to be seen in Figure 10.3 through the Fs schedule on a firm’s net worth, which equals assets – liabilities. A fall in net worth means in increase in both information problems: In the adverse selection problem, because the firm enters financial trouble and there is less to reclaim > Suppliers of money may cut back their lending or apply even more strict borrowing conditions. The more the firm is in trouble, the higher the chance the firm can’t meet these stricter conditions. In the moral hazard problem, because if the net worth falls, there is less money and the firms start to engage in even more risky behaviour. Changes in net worth shift the supply of funds schedule.
What is the relevance of international capital mobility for firms willing to invest, using the supply of funds Fs?
The access to international capital increases the availability of external funds, making the supply curve shift to the right
Access to international capital mobility may increase the efficiency of the supply of external funds (operating costs are too high, lack of competition, etc.) Figure 10.4 shows bank efficiency > Differences in efficiency can be included in Figure 10.3. Take a level of funds X, the costs of intermediation are given by the distance between a and b. The corresponding interest rates are then rA and rB. You see there is a wedge between rA and rB; The supplier asks rB but gets rA and the demander pays rB. A decrease of this wedge would boost both supply and investments. Equilibrium: wedge = 0 and Fs = Fd, point c
International capital mobility is also relevant for the sensitivity of the supply of funds curve in NW and hence for changes in the problems of asymmetric information
11.1 Introduction
Currency crisis = A disruption on the currency market in which a speculative attack on a currency leads to a devaluation and/or to the monetary authorities defending the exchange rate by depleting their foreign exchange reserves and/or raising interest rates
Capital account crisis = The mirror image of a currency crisis, focusing on the sudden reversal of capital flows that accompanies the currency market disruption.
Currency and capital account crises are potential external channels for a financial crisis. Internal channels for financial crises are banking rises.
Twin crisis = Banking crisis and currency crisis occur at the same time
Note: not every currency or banking crisis really is a financial crisis!!
Financial crisis = Consists of disruptions on the financial markets that impair the working of these markets to such an extent that they can no longer perform their main function: the efficient channelling of funds (savings S) to their most productive uses (investments I)
Banking crises (most banking crises are actually financial crises) are hard to measure, but some simple measures can be bankruptcy, (forced) mergers, government assistance, etc.
See Table 11.1 > You see that banking crises occur more often in developing countries and emerging markets. The costs of crises could be credit injected into the banking systems or fiscal costs to close down banks.
Apart from currency- and bank crises (or twin crises, both occurring at the same time) there is a third form: Sovereign debt crises = When a national government is (expected to) renege on its debt obligations or when the interest rates on its debt have become so high that it is effectively shut off from access to international capital markets. This is what happened to Greece, Spain and Portugal. Being hit by a currency- banking- and sovereign debt crisis is a triple crisis.
11.2 Asymmetric information and financial crises
Recap: Risk associated with financial transactions is the existence of incomplete and asymmetric information. Asymmetric information leads to adverse selection and moral hazard. In a well-developed system, banks develop ways to reduce the asymmetric aspect of information through monitoring and screening activities. Also remember, that a firm’s net worth NW is determinant for the asymmetry of information. A fall in NW means increase of asymmetric information problems and a reduction in efficiency of the financial system.
In this section, The book uses Mishkin’s definition of financial crises:
“A financial crisis occurs when, due to disruptions on financial markets, the increase of the adverse selection and moral hazard problems is such that the financial system can no longer efficiently perform its main job of channelling funds to the most productive investment opportunities”
Disruptions, here, are external like an earthquake hitting a city. They are not caused by the financial system itself.
The book’s definition on a financial crisis refers to a systemic financial crisis. Where 5 categories of disruption are named:
Increase in interest rate
Increase in uncertainty
Decrease in asset prices
Deflation
Bank panic or bank run
How do these disruptions lead to an increase in the asymmetric information problems?”
Suppose: Firm finances via bank loans, The book deals with a closed economy (no international context). Take Figure 11.2 > left hand are assets, right hand liabilities.
Increase in interest rate ; Loan applicants become more risky, banks cut back their supply of loans, firms can’t carry out investing plans (increase in adverse selection problem). Moral hazard also rises, as due to the increased interest rate, firms are triggered to engage in more risky behaviour.
Increase in uncertainty ; Similar effects, supplier of funds gets a hard time in distinguishing between more and less risky investment projects
A decrease in asset prices ; Like a fall in stock prices decreases the NW for owners of the assets. From chapter E The book knows the consequences of drops in NW
Deflation ; A fall in price level, has similar effects as a fall in asset prices. Deflation also implies an increase in the real value of the debt, worsening the balance sheets of both firms and banks
Bank panic or bank run ; Bank deposit holders rightly or wrongly start to doubt whether the bank might or might not be able to repay its deposit holders, they may ask for their money back. If that happens on large scale at the same time, there is panic > Lehman Brothers collapse September 2009
11.3 Financial crises- A graphical depiction; closed economy
Figure 11.2 shows how the above disruptions on financial markets may develop into a financial crisis.
Suppose: The supply of funds that firms face is the supply of banks loans as far as external financing is concerned. In a risk free world, the economy is at point 1 with interest rate r0. With incomplete and asymmetric information, beyond the point where the firm can finance investing activities internally, the supply curve’s position depends on the firm’s NW. A fall in NW shifts supply to the left, leading to point 3. The disruption of financial markets may also imply that the supply curve becomes steeper, which takes the economy to point 4. A steeper slope means an increased risk. Due to bank runs, firm investment will fall even further and without a properly functioning banking system, efficiency cannot be maintained and a positive wedge arises (arrow C, cost of capital for firms – return for suppliers), bringing the economy at point 5. Note; point 2 and 5 of disruptions do not lead to a drop in NW and thus do not shift the Fs curve, but make it steeper.
11.4 Financial crises- A graphical depiction; open economy
The primary source of a financial crisis is the intrinsic weakness of the domestic financial system. In opening up the economy for capital mobility, a number of additional channels come into play through which disruptions on financial markets may occur.
See Figure 11.3, large differences in current account balances in the euro-zone may lead to tensions between countries. Recap: surplus current account <> net capital and financial outflow, and vice versa.
Take the analysis and framework from paragraph F.3, and assume The book now takes an open economy with international capital flows.
If domestic investment is to a large extent financed by foreign lending, due to a lack of domestic savings, a decrease in capital inflows means less funds available. Also, if domestic banks get into trouble, financial intermediation’s quality may decrease. Thus, by allowing for international capital mobility, decreased external capital inflows lead to:
Result of the above: Investments fall, economy suffers.
Are the contraction in the supply of funds (savings) and the demand for funds (investments) inevitable? > One needs to know underlying economic fundamentals. Do the fundamentals create over investment? Over investment is due to a too low level of private risk, but how can it be too low?
The governments in lender and borrower countries and international financial institutions might take over the risks by guaranteeing them to help them out if they get in trouble > Lenders and borrowers behave more risky > Moral hazard problems
Lenders and borrowers are too optimistic about the future of the economy
11.5 Other negative effects
What if, due to over enthusiastic foreign lenders and over guaranteed domestic banks the economy really has ended up at point 1? Any doubts that arise at this point lead the economy to point 2 and might cause a financial crisis. Box 11.1 suggests two negative effects next to the already mentioned affects around Figure 11.2: The investment curve might also shift to the left when government guarantees are in doubt and an interest increase on savings depresses borrowers’ NW and thus leads to problems of asymmetric information. If the interest rate goes up, people save more and the supply of funds goes up. But what if the increase is significantly high that borrowers get less return on savings. This can happen if the firms who want to invest were not able to repay their loan due to an increase in interest > Depicted in Figure 11.6, where is assumed that if r > r*, the savings cure has a negative slope.
11.6 Twin crises
Almost all recent financial crises happened in emerging economies, where the banking sector denominates the domestic financial sector and where it plays the role as financial intermediary in the process of making sure that funds go to investment opportunities. Financial crises are here thus mainly banking crises.
Refer to Figure 11.7 > Currency crises tend to come in waves and banking crises show the same development; Prove for twin crises
A typical ‘modern’ financial crisis develops as is illustrated in Figure 11.8
Stage I: Banking crisis
Domestic financial fragility > Under regulated and over guaranteed banks
Large capital inflows, but poor quality of bank loans > Possible bank runs
1. Firm and bank’s balance sheet deteriorate
Asset prices drop
Uncertainty increases
Total effect: Asymmetric information problems increase
Stage II: Currency crisis
Debt-deflation
Interest rate increases
Total effect: Asymmetric information problems increase
11.7 Other approaches to crises
The illiquidity approach
Radelet and Sachs and Jeanne came up with a view where financial crises are not due to domestic economic conditions, but to the self-fulfilling expectations of investors, who attack currencies by bank runs or selling their investments in a certain currency. Financial crisis are thus the consequence of a liquidity shortage by investors, as contagion cannot always be explained by bad economic fundamentals. Investors trigger crises in trying to make a speculative gain
Financial crises as liquidity crises
An example: An emerging market economy in which firms invest during this period (period I) for a total amount of 500. The investment yields a return in the next period (period II). The domestic savings are scarce, so the 500 is financed by international investors. This loan was already granted in a previous period (period 0), so that the firms had to refinance their loan in period I and the international investors have to agree on this. The loan must be paid back for a total amount of 500 in period II. The investment yields a certain return of 750 so the firms in this economy are solvent, nut they do face liquidity problems in period I. Insolvency isn’t that much of a deal because the 750 return in period II is large enough (bigger than the debt). Liquidity problems may arise if the firms need to roll over their debt before the investment has paid off.
Now suppose: The individual international investors are relatively small, they each contribute to 5 of 500 so that there are 100 investors. All 100 investors must be willing to refinance the loan at the end of period I, which triggers a coordination problem as all investors depend their decision on other investors. If the new loan is not granted, a liquidity crisis develops into a financial crisis, as firms already committed themselves by buying the investment goods now lack the finance to back up this investment.
12.1 Introduction
Recap: Financial crisis = A situation where the financial system no longer functions properly to the extent that the negative consequences are felt in the real or non-financial sector of the economy as well. This chapter elaborates on the Great Recession, the largest financial crisis in the post-Second World War period. To many people this crisis stated with the collapse of Lehman Brothers in September 2008, but as you can see in Table 12.1 on page 334, the rumblings of the meltdown date back to at least 2007. What started as a problem on the US housing market turned into a global banking crisis in 2008, which in turn led to a government debt crisis and in into a currency crisis (especially in euro countries).
12.2 The origins of the crisis
As already stated in section 12.1, several events preceded the Great Recession;
The housing bubble; Refer to Figure 12.1 on page 336. It depicts the median price of new houses using monthly data for the period 1987-2012. 3 main periods in which the median price declines > 4% around 1990, about 12.5% around 2007-8 and more than 6% since August 2010. Since these prices are not adjusted for inflation, the prices are divided by the median household income level for more realistic results. While housing prices are rising significantly, banks encourage home owners to take more loans with their house. People are thus able to spend more than they earn. This created the US housing bubble, which burst and made it more difficult to refinance outstanding loans
The role of financial innovation; A Subprime mortgage = Lending money to borrowers with a weak credit history and a greater risk of default than prime borrowers. During the housing bubble, the share of subprime mortgages exceeded 20% of new mortgages. Banks realised that they were taking higher risks, so they developed financial products to offset a particular risk exposure; financial innovation. The lack of adequate supervision of the banking system by the monetary authorities gave the origin for financial instability of the system. Once the US housing market got from bad to worse from 2006 onwards, the degree of uncertainty increased sharply and banks were unwilling to lend each other and they didn’t trust each other
The advantages of financial innovations were oversold; Here, the ‘this time is different’ argument pops up, where over-optimism invariably creeps into the financial system where too much faith is placed on the structural improvements to mike the financial system work better. The result was, however, that the financial system became more unstable as time passed
The large imbalances between countries in the world economy; Enormous amounts of capital flew from one country to another and as explained in chapter B, of inhabitants consume more than their income allows them to, their imports are higher than their exports. These higher expenditures should be financed by either borrowing or reducing claims on foreigners. These imbalances became enormous in the period from 2000-2006; while the US had a Dollar801 bn deficit in 2006, the Arab world, China and Japan respectively had Dollar282, Dollar421 and Dollar159 bn surpluses to finance the American deficit. Capital flows from surplus countries to deficit countries are only effective if these flows are put to productive use, which was not the case.
12.3 A banking crisis
The events that preceded the Great Recession as discussed in section 12.2 created an unstable global financial and economic environment in the run-up to the banking crisis in 2008. The collapse in housing prices undermined the value of a big amount of securitised mortgages in the USA, leading to lots of borrowers who couldn’t refinance their loans, which again led to further declining house prices. The billions of dollars needed to finance the housing bubble came from China, Japan and the Arab world, being recycled back to the USA and the EU as portfolio investments. Financial innovations enabled that these flows got into the subprime mortgage sector and towards weak borrowers, which made the problem even worse.
The banking crisis quickly spread to other countries outside the USA in 2008 and on, becoming a financial crisis.
12.4 Financial crisis- The first impact
The first signs that the banking crisis were about to start the real economy came from declines in the volume of international trade. Refer to Figure 12.4 on page 342. It illustrates how devastating the trade collapse really was. In the period after World War II, the world economy first only faced rising world trade flows. Since the second half of the 20th century, there were only four periods in which trade flows declined;
1974-1975 in the aftermath of the first oil crisis; The first oil crisis started on 16 October 1973, when the members of OPEC decided to raise the price of oil by 70%
1981-1982 in the aftermath of the second oil crisis; This second crisis started in 1979 with the Iranian Revolution, which was followed in 1980 with the Iran-Iraq war. As a consequence, oil prices increased again
2000-2001 the collapse of the Internet bubble; The Internet bubble refers to a period during which Internet companies were able to attract significant amount of capital simply by putting .com at the end of their names
2008-2009 the Great Recession; The biggest fall in trade flows
Figure 12.5 illustrates the developments of the volume of import and export flows for the advanced economies and the emerging markets.
12.5 Financial crisis- The second impact
Shortly after the drop in trade volumes, output and income levels started to decline. Although services are the most important economic component for the advanced economies, it is most useful to investigate the manifestation of industrial production, as this reacts more to changes in demand and it is an indicator for the demand in business services > For a discussion of the bullwhip effect, go to section 12.6.
Refer to Figure 12.7 on page 347, it shows growth rates of industrial production for the same countries as shown in Figure 12.5. See panel a, industrial production first starts to decline in the USA, namely April 2008. Import volume already started to decline in 2007, so it took over a year before production level was also affected. See panel b, which focuses on emerging markets.
Now the consequences of output decline for the economy as a whole by studying changes in income per capita levels > See Figure 12.8 on page 348 and Table 12.2 on page 349.
12.6 The bullwhip effect and the crisis
Bullwhip effect = A trend of larger and larger swings in inventory in response to changes in demand, as one goes upstream in the value chain of a product. The underlying reason for such effects is the need for all firms in the separate stages of the value chain to keep inventory.
What about the bullwhip effect and the current crisis? A study for the Belgian manufacturing sector showed that final demand (retail sales) only dropped by 1.5% and that industrial production in a reaction dropped by 15%. As you can see in Figure 12.9 on page 351, both retail and manufacturing sales drop after the Lehman crash in September 2008, but the extent to which manufacturing sales drop is larger than the extent to which retail sales drop.
12.7 Government’s role in the current crisis
Governments in a crisis can be compared with a fire brigade that tries to stop the fire if it’s already there. Governments in advanced economies responded to the financial crisis in three main ways;
Providing liquidity and monetary support; The US Federal Reserve, the European Central Bank and other central banks were forced to inject Dollar1500 billion into financial institutions and Dollar2500 billion into the credit markets.
Fiscal stimuli; These are illustrated in Figure 12.11 for the USA, Japan and the euro area
More structural measures aimed at reforming or strengthening the financial sector; Trying to improve banking regulations, capital requirements and limiting the functioning of certain financial derivatives.
The government’s responses to the current crisis led to an increase in public debt and made the banking crisis to become a government debt crisis in a number of countries. As illustrated in Figure 12.11 on page 355, the fiscal stimulus packages caused large government budget deficits. Japan’s government debt for example is more than twice its GDP level.
12.8 The European currency crisis
A large part of the Great Recession problems is created by imbalances in the euro area, the group of countries that decided to introduce a single currency. The solution to the European currency crisis as discussed in this section involves;
Euro area countries transferring decisions on fiscal policy to a European institute;
Euro area countries giving up on international capital mobility
Some countries exiting from the euro area
One indication of structural differences within the euro area is provided in Figure 12.14 on page 358. It shows the evolution of an index of total factor productivity for seven countries. Productivity in some countries increased, in some countries it declined > The large frictions within the euro area questioned the continuation of the fixed exchange rate. As a consequence, the EU and the ECB had to orchestrate emergency rescue operations, like two times packages of hundreds of billions euros to Greece in 2010 and 2011.
12.9 & 12.10 Tax systems that reduce financial fragility
The current crisis makes clear that international capital mobility can transmit a banking crisis from one country to another. For this reason, various proposals have been introduced to restrict capital mobility, either to prevent financial crises or as a cure for them.
Tobin tax
The Tobin tax stipulates that all foreign exchange transactions should be taxed (0.5% of the value of the transaction). The purpose is to discourage short term capital flows who are said to increase financial fragility. So far the tax has never been introduced.
To be effective, the tax should be introduced on a global scale, which requires a significant amount of international policy coordination.
Once introduced, individual countries have a strong incentive not to comply with the tax in order to attract foreign funds.
The tax is too general in that it discourages all foreign exchange transactions.
Chile tax
Chile has installed a tax system that protects the national economy and stimulates stability. The part of the Chile tax that has received most attention is the requirement for domestic banks to hold a certain percentage of their foreign funding for a specified period as an unremunerated deposit at Chile’s central bank.
If r* is the international interest rate, λ is the proportion of foreign funds that has to be deposited, and ρ is the time period the deposits have to remain at the bank.
Implicit tax for k month deposits = r* (λ/1-λ)*(ρ/k).
The implicit tax rate thus increases if r* increases and decreases if k increases. The Chile tax thus stimulates long term funds instead of short term funds.
Drawbacks;
- Chilean banks found ways to evade the tax
- From the perspective of preventing massive capital outflows to ensure stability, the tax doesn’t brake on such outflows
Similarities between the Tobin tax and the Chile tax
Both the Tobin tax and the Chile tax are examples of capital restrictions to prevent an increase of financial fragility or a financial crisis. There are costs associated with capital restrictions.
Introduction
Like discussed in previous chapters, again there is a positive relationship between openness and prosperity in economies. Also, growth rates translate into differences in income levels in different ways.
Our standard of living are increased by innovation of firms and entrepreneurs, knowledge accumulation, knowledge spillovers and market power. These factors bring technological improvements which ultimately increase our standard of living.
Catching up
Table 13.1 shows the growth rates of India, China and the USA. There is a clear distinction between these countries. The USA had a major advantage over China and India in 2000, but the first decade of this century shows that China and India have much higher growth rates than the USA. It becomes clear that India and China will become more and more important due to their high growth rates and their large populations.
Table 13.2 shows that these differences in annual growth rates is not normal. Between the period of 1950 until 2000, it shows that China has a higher average annual growth rate, but it fluctuates very much per decade. There has not been one decade like 2000-2010 where differences have been this big. However, it is expected that this will also not happen again very quickly. The USA is expected to make more annual growth in the coming decades.
Production, capital, and investments
There can be many different types of investment in many different types of physical, human and knowledge capital. For simplicity, we lump all these investments together under the heading 'capital'. There are also many different types of labour, these are for simplicity again under the heading 'labour'.
Economists emphasize the importance of capital accumulation for the economic growth process. We make use of a technique called growth accounting. Which looks at the fundamental sources of economic growth. The breakdown starts by analysing the following standard production function:
Y= F(T, K, L) where Y= output, T= level of technology, K= capital stock and L= labour force.
From this equation we immediately see that growth can only come from growth of production factors.
When totally differentiating this equation, we can see that the marginal products and levels of progress of these factors are important as well. Also, we find that the marginal product of capital times the capital stock divided by the output equals the share of capital in national output.
Growth due to technological progress is also known as the Solow residual or as total factor productivity (TFP). Even if factors of production remain constant, economies can grow due to technological progress.
Robert Solow argued that output is a function of the three inputs discussed, namely capital, labour and TFP. Increases in labour force are determined by increases in the population.
Solow took a closed economy for his model. This means that domestic savings are equal to domestic domestic investment. However, research shows that this will never hold perfectly. But many economies do not fluctuate very much on this aspect (see figure 13.1). Research does also prove that as the capital stock per worker increases, output per worker rises as well. This is quite logical, since more and better equipment makes work easier.
Currency that is available for investment in the capital stock has to be compared to what is needed to maintain the current capital/labour ratio. Two forces are important here:
depreciation: newly purchased capital regularly depreciates, to maintain a given capital/labour ratio, therefore requires equiproportional replacement of depreciated capital.
population growth: an increasing population would make the capital/labour ratio as well. This means that there has to be invested in equipment constantly.
Empirical implications
When studying figure 13.2, where the capital/labour ratio evolves, other things equal to a constant ratio k*. This would imply that once this ratio is reached, output per worker does not change as well. Empirically, this does not hold, since output per worker has risen since 1800. Another implication that does not hold is that capital flows from countries with high k ratios to countries with low k ratios.
The model needs some extensions to be realistic:
When looking at figure 13.3, where the growth rates of the USA since 1870 can be seen, these steady growth rates become evident.
When comparing this with figure 13.2, the other figure implies that when k* is reached, poor countries will eventually be able to catch up with the rich countries. This hypothesis is called unconditional convergence is not very likely.
One of the factors that play a role in rising income levels is schooling, better known as human capital. One may however wonder if income causes schooling or schooling causes income. Experts have all very different opinions on this matter, even after their research. Recent work has found that this confusion is caused by the way human capital is measured and the measurement problems in general.
When looking at figure 13.6, we see that Japan and Indonesia do not have a steady growth line at all, this thus differs per country. It is, however, important to notice that not all economies can be characterized by balanced-growth paths.
When trying to explain economic growth rates and deviations in balanced-growth paths, the earlier discussed equation comes up again. It implies that:
Output growth = growth TFP + capital share x capital growth + labour share x labour growth.
Nicholas Klador listed sex stylized facts of economic growth, these show the importance of TFP growth, one of them is:
Steady capital / output ratios over long periods.
Kaldor argues that over long periods of time. The growth rate of capital is approximately equal to the growth rate of output. When realizing that labour share + capital share = 1, this implies that TFP growth is approximately labour share x (output growth – labour growth).
Two other implications have to be made to make table 13.4 understandable:
we assume that the labour force growth is equal to the population growth.
we assume that labour's share in output is two-thirds.
Consequently, table 13.4 underestimates the contribution of TFP growth to output growth. The contribution of TFP growth normally explains about half of a country's increase in output.
Technology, knowledge, innovation and TFP growth
TFP is a catch-all term for any increase in output that can not be directly attributed to a change in the capital stock or employment. Although many issues play a role in TFP growth, we need to highlight three such issues:
Endogenous R&D efforts: Solow associated rising TFP levels with increases in technology. These increases are of course not an exogenous action. Man can not just wait until the technology changes. The process is is the consequence of considerable R&D efforts by individuals and firms investing large sums of money and time. On the other hand, our standards of living will have to model R&D efforts endogenously. 2 actors play a role in R&D efforts:
Nations ( governments and government agencies) play a primary role in fundamental R&D. This is research which increases our understanding of the world we live in and the extent of our knowledge, without direct immediate practical implications.
Firms play a primary role in applied R&D. That is, research that can be directly applied in new goods and services, together with process and product development actually to bring these new goods and services to the market.
Knowledge, quality and new goods: knowledge is a remarkable input, unlike the use of capital and labour. These are rival inputs, inputs that can be used only by one person at the same time. Knowledge is a non-rival input, when I use my knowledge at this moment, it does not mean you can use your exact same knowledge at the same time. This also means that there are many different ways in which newly created knowledge can lead to quality improvements and to new goods and services.
Innovation and market power: Schumpeter emphasized that scientific and technical inventions require daring and imagination. These inventions have no use when they are not adopted, which also requires daring from entrepreneurs. He distinguished between invention (discovery) and innovation (implementation). He also emphasized that successful innovations can not take place without firms exercising some form of market power, because R&D costs are high and have to be earned back.
Open economies, TFP and economic growth
This section reviews some of the main arguments for a positive association between open economies, TFP levels, and economic growth.
Open economies can specialize according to comparative advantage: countries may have this comparative advantage for several reasons and for producing certain types of goods and services. When granting mutual access to the markets of foreign countries, open economies give themselves the opportunity to benefit from international arbitrage opportunities.
Open economies benefit from efficiency gains created by comparative advantage: in many cases, industrial or service sectors are characterized by increased returns to scale. By letting foreign firms enter the domestic markets, open economies can benefit from efficiency gains from increased competition.
Open economies have access to various financial sources and destinations: an autarky has domestic savings as a source of financing for its domestic investments. This makes their inter-temporal savings and investment adjustments very difficult. Open economies can also finance their investments from foreign sources (FDI, bank loans etc.)
Open economies can benefit from risk sharing: open economies can benefit from international risk sharing. This means that they are both able to spread financial sources and destinations over a wide range of countries as well as that they are able to have access to various foreign sources and destinations in case of catastrophe or rapidly changing circumstances.
Open economies have access to incorporated foreign knowledge: international trade enables countries to increase the range of intermediate capital goods and services in its production processes or to increase the quality level of such intermediate inputs, and thus raise the productivity of its resources. In essence, this allows a country to use scientific breakthroughs and knowledge created abroad incorporated in machinery and equipment imports effectively.
Open economies can benefit from knowledge created abroad: In open economies, international trade and capital flows provide a means to communicate with the outside world. This stimulates cross-border learning in a variety of ways, concerning production methods, market conditions, product design, and organizational methods.
A historical example: Japan
Japan can been seen as yesterday's growth miracle. Throughout their history, they have had several stages of economic openness. When looking at figure 13.12, there is however one large rise regarding their economy. This is after the second world war. Shortly before, they started looking at world economy drastically different. They started imitating foreign technology, there was a significant organized exchange of knowledge and there were rapidly rising international trade flows. This growth was a real example of export-led growth. In some sectors, Japan proved to be very strong by first imitating and later becoming one of the best in the world in these sectors.
A recent example: China
China can be seen as today's growth miracle. China is the most populous nation in the world. For their economic advancements, here again we can see that a more open economy leads to a stronger economy. When dictator Mao Zedong died. Standards of living have gone up from 4.4 percent in 1979 to 43.3 percent in 2011. For China, institutional and market-oriented reforms were very important as well, since it was no longer a country ruled by a dictator. China has also benefited from the fact that many Western countries have fragmented their value chains. Increasingly, not only the low-skilled parts but also the high-skilled parts of the value chain.
Conclusion
To conclude this chapter, we can easily say that a correlation has been found. Openness to trade and economic prosperity most of the time go hand in hand. This is, however, only when it is done properly. A lot of benefits can be found in comparative advantages and free cash flows.
Introduction
In general, there are winners and losers when talking about globalization. Advocates of globalization argue that the gains outweigh the losses, provided that free trade and financial stability operate under properly functioning international and domestic institutions. Critics of globalization state that the gains may not outweigh the losses. Critics mostly share a critical attitude towards modern capitalism and multinationals.
Globalization and income growth: the big picture
The seminal study of Sachs and Warner (1995) gave the first answer whether globalization leads to higher growth rates. For both developing and advanced countries, open economies have higher growth rates than closed economies. Critics were right that open economies are way more profitable for advanced countries than for developing countries. However, Sachs and Warner did use a distinction between open and closed economies that can be argued.
When studying figure 14.1, panel a, a particular view is given that might not be totally correct. Here, it seems like only most of the rich countries have experienced growth between 1980 and 2010, but when looking at panel b, it becomes clear that, when distinguishing larger countries from smaller countries. India and China stand out. This means that it is correct that poorer countries have experienced more growth.
Trade, skills, wages, and technology
The post-Second World War globalization wave made it inevitable to link adverse developments at home countries to the globalization process. Some sectors started to grow while others started to shrink. This, of course, meant that inputs had to be reallocated. Some people with specific skills in specific sectors were victims of these developments. Especially low skilled workers in advanced economies could not cope with these adjustments. Wage growth lagged behind drastically and unemployment increased.
Reasons for this are that the increased foreign demand, caused by opening up to free trade, makes prices in the export sector higher. This is in line with the idea of comparative advantages. The product or good the country will now be exporting attracts more factors of production like capital and labor from the import sector. The import sector releases relatively more low-skilled workers than high-skilled workers, which makes wages for low-skilled workers shrink.
Advanced countries have comparative advantages in high-skill-intensive products, whereas developing countries have these advantages in low-skill-intensive products. This explains why low-skilled workers in advanced countries might have to take the hit for globalization.
This also indirectly means that competition from low-wage countries has an effect on low-skilled workers from all over the advanced world. Even if these do not compete in the same world markets. Together with these theorem goes the fact that high-skilled workers form developing countries lose from international trade.
The technological process might hurt low-skilled workers in two ways as well:
The increased use of, for instance ICT, partially replaces low-skilled workers for high-skilled workers.
In the manufacturing sector, low-skilled workers are usually over-represented. In this sector, technological progress is much higher than in other sectors.
Globalization and labour migration
There are increased fears in advanced countries that domestic labour markets are becoming subject to fierce international competition. Not only are low-skilled workers worried about the fact that low-skill work is mainly outsourced to developing countries, like just discussed, but also are they afraid of the low-skilled workers who migrate.
To analyse the effects of migration on wages, it is instinctive to look at the motivation for migration. Many studies have found that differences in earnings between the destination country and the source country are the primary motive. This are corrected by two factors:
Home-Bias effect: indicates that people like to stay at home because of several reasons like friends, family and culture. Only a sufficient compensation matters more.
Direct migration costs: these are investments that are needed to actually migrate to the country of destination. The earnings difference should also compensate for this.
Even though it would seem logical, Africa is not the main source of migration to other countries. This is because of two reasons:
migration restrictions in the destination country
a poverty trap: migration is too costly for people, or in many cases, just not possible for people from these poor regions.
Figure 14.4 shows the percentage of the GDP for different countries that is made up of remittances. Here, for instance, the USA and Japan score very low because very few people work abroad. From this figure, it becomes clear that labour migration is country-specific.
Globalization and income distribution
To determine whether some is poor or rich, we generally focus on the goods and services this person can afford in the living location. Therefore, we correct the price differences in different locations by using purchasing power parity (PPP) exchange rates. Most countries and international organizations can determine a 'poverty line' of real income to determine poverty. If your income is below this line, you are considered poor. If it is above, you are not. It is referred to as the headcount index.
What to include here is arbitrary and subjective, but of course, enough nutrition, housing and clothing are normally things that are considered for the lower bounds of these indexes. In advanced economies, poverty lines will be higher than for developing economies.
Figure 14.6 depicts the number of poor people between 1980 and 2010 in the developing world. Here the poverty line has been drawn beneath 2 dollars. This line is defined by the World Bank. This only goes for the developing countries, since very little people in advanced countries have these kinds of low income. It shows that overall percentages have dropped. This decline is however, most impressive for the lower bounds, which is 1.25 dollars a day.
Although global fight against poverty has been successful, this does not hold for the whole world, or an equal distribution in the world. Figure 14.7 shows that, for instance, in the sub-Saharan African countries, poverty has hardly dropped at all.
However, figure 14.8 puts this all into perspective by showing actual numbers, here, sub-Saharan Africa still lags behind drastically, but other parts of the world show great progress. Judging from panel a and b, we can conclude that global distribution of income has shifted to the right.
Global income inequality
Income inequality is mostly measured by the Gini coefficient, this is explained in box 14.3. The coefficient goes from 0 (lowest inequality) to 1 (highest inequality). Figure 14.10 graphs the changes of the Gini coefficient in the BRIC countries and two African countries. It shows that for many countries it has actually gone up for these upcoming countries. But the degree of income inequality varies a lot from one country to another. It becomes clear that within-country income inequality has risen between 1981 and 2010.
Global income inequality, however, has declined. When using the mean logarithmic index (MLD) or the Theil index, like in figure 14.12a and figure 14.12b, again there is a clear distinction between across countries and within country income inequality.
When an economy is rising, within-country inequality, most of the times, rises as well. This is because of the concentration of economic activity in a country. The larger cities will benefit the most of the rising economy, which increases the inequality.
Outsourcing, skills, and development
An essential part of the globalization discussed in the book, is the fragmentation of the production process by multinational firms. Together with this fragmentation goes outsourcing of part of the production process, rising trade in intermediate goods, and increased foreign direct investment. Many times, outsourcing by multinationals is done by outsourcing their work to low-skilled labour abundant countries.
Even if trade flows remain unchanged, outsourcing can have an effect on wages in advanced countries because the demand for low-skilled labour declines and the demand for high-skilled, organizational, and management labour increases in the outsourcing countries. If the wages of high-skiled workers rise relative to those of low-skilled workers, there is an incentive to reduce the ratio of skilled to unskilled workers in all sectors of the advanced economies.
In most countries, the opposite is true, there is a rise in skill intensity. Technological change is thought to be the main underlying reason for this process. This change comes from actively investing in R&D and reorganizing production processes.
Outsourcing is one of the reasons that developing countries also gain form globalization. It provides a boost in demand for their labour in these countries. It also brings additional skills and production experience from the advanced world. So, every country does gain, but not everyone.
There are, however, several doubts about the theorem that globalization makes everyone gain:
Export pessimism: this theorem states that when all the low-skilled abundant countries open up to free trade, they can not all gain from globalization because they are with too many. This would drive export prices down. Than, also real income is lowered because of the terms-of-trade losses.
Developing countries lack bargaining power and have no union representation: wage conditions do not increase and work environment will not improve. However, evidence does show that wages paid by multinationals in developing countries are twice as high.
A lack of well functioning institutions: corruption, no property rights and a bad legal system hold developing countries back. These are mostly African countries.
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