Summary with International Economics and Business. Nations and Firms in the Global Economy by Beugelsdijk

CHAPTER A: ECONOMIC GLOBALIZATION- WHAT, HOW AND WHEN?

§A.1 ‘The global economy- Some general information’

There is no one standard answer to the question: “What is globalization?”. Globalization 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 globalization.

Based on this argumentation, there are five key issues to be considered:

• Cultural globalization > Which is about the debate whether there is one big global culture or a set of universal cultural variables, and the degree  to which these universal cultural variables displace embedded national cultures and traditions.

An example that illustrates this debate: there are people afraid of ‘McDonaldization’ (hige multinationals are the carriers of culture globalization) and there are people seeing enough room for local traditions.

• Economic globalization > Which is about the decline of national markets and the rise of global markets. Drivers for economic globalization are fundamental changes in technology which permit more efficient ways of internationally organizing production processes.
• Geographical globalization > 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 globalization > 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 Organization). 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 globalization > 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 globalization 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.

§A.2 ‘Globalization 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: globalization 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.

§A.3 ‘Globalization’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 15^th 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 17^th 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 (18^th 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 (18^th century-current) > Figure 1.10:

• Massive outflow of capital for overseas investment (end 19^th – beginning 20^th centuries)
• Collapse of trade, capital and migration flows and slow economic growth due to the two world wars and the Great Depression (mid-20^th century)
• The world economy starts growing again, and becomes more closely connected than ever before (end 20^th century)

* International trade and MNEs

After the before provided historical overview of the world economy, it is clear that there are two waves of globalization: the end of the 19^th century until the beginning of the 20^th century and after the Second World War.

Globalization is not only due to macro-economic forces, but also to effects of micro-level enterprises. 

§A.4 ‘The global economy- a detailed analysis’

Economic globalization = ‘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 globalization. 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:

• Home’s demand curve for imports is the home’s demand for the good not provided by the home’s domestic suppliers. Similarly, this applies for the Foreign’s export supply curve

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 globalization 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 globalization (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 globalization (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 globalization 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 organized and why some phases will be outsourced.

CHAPTER B: GETTING THE NUMBERS RIGHT

§B.1 ‘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):
  • Produce at home > export
  • Produce in the host country > directly sell
• Sourcing from abroad can be done in two ways (vertical multinational):
  • Importing
  • Owning and controlling activities abroad

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

§B.2 ‘The current account’

The decision tree in Figure 2.1 of the book tod us 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 organization 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:
1. An internationally operating firm must decide how to account for foreign-currency transactions

2. 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

§B.3 ‘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:

• Firms can turn exchange risks into benefits via different hedging strategies
• Firms can shift profits to low tax level locations

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

CHAPTER C: INTERNATIONAL TRADE- DRIVERS AND CONSTRAINTS

§C.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
  • Bigger (export) market
• Disadvantages for firms
  • More competition

§C.2 ‘Comparative advantage- David Ricardo’s contribution’

The concept of comparative advantage will be explained with the help of the following table See Table 1 in attachment

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 2 in attachment  

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 specialization 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, $11.48 per hour) have a low income level per capita ($10.079). Countries with high labour productivity (Norway, $76,76 per hour) have a high income level per capita ($60.218).

> 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 $828 higher GDP.

§C.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 specialization 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 globalization, 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 specialization according to comparative advantage.

* Box 3.2

Thomas Friedman: The World is Flat. In this book, fears around globalization 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 specialization according to comparative advantage (Recap: paragraph C.2).

§C.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

§C.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)

§C.6 ‘Appliance of the Heckscher-Ohlin model’

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 equalization = 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 equalized, but in the H-O model, also factor prices will be the same in equilibrium.

§C.7 ‘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 equalized, cost differences will determine the competitive position of firms.

CHAPTER D: OTHER INSIGHTS ON INTERNATIONAL TRADE

§ D.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.

§ D.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 maximized 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

§ D.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.

§ D.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.

§ D.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:

• The increase in the variety attracts new customers
• The entry of new firms increases competition
  • Individual suppliers face more elastic demand curves because they face closer substitutes to the products they supply
  • The intersection with the y axis becomes smaller

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.

§ D.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

1. It is often unclear which of the above variables to include and which to exclude

2. It is often difficult to find proxies for variables that are important in theory

§ D.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

§ D.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.

CHAPTER E: TRADE IMPEDIMENTS 

§E.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.

§E.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 Organization. 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:
1. 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

2. Differences in rules regarding animal testing in the cosmetics industry

§E.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:

1. 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

2. 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

3. 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

4. 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 (liberalization) 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 liberalization
• 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 liberalization also involves costs. The cost of adjustment for firms and workers dealing with the new situation without protection for example.

§E.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.

§E.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?

§E.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

§E.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 characterized 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 3 in attachment  

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.

See Table 4 in attachment

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.

§E.8 ‘Conclusions’

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.

CHAPTER F: EXCHANGE RATES

§F.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 $1000. 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 $1000; 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 $1000 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

§F.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.

US$0.9915-18 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

§F.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

§F.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

LIST OF IMPORTANT TERMS

Globalization = The process of integration across world-space. Has 5 dimensions.

Cultural globalization = The debate whether there is one big global culture or a set of universal cultural variables, and the degree  to which these universal cultural variables displace embedded national cultures and traditions.

Economic globalization = The decline of national markets and the rise of global markets.

Geographical globalization = The result of ‘joint time and space’ due to reduced travel times and the rapid (electronic) exchange of information.

Institutional globalization = The spread of universal institutional regulations across the world.

Political globalization = 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.

GDP per capita GDP per capita = Gross domestic product divided by the population. The GDP is the sum of gross value added by all producers in the economy.

Price wedge = Deviation between home-and foreign’s price, due to for example foreign firms having to overcome certain transport costs, tariffs, trade impediments, cultural differences, et cetera.

Fragmentation = Technological and communication advances have enabled many production processes to be subdivided into various phases which are physically separable.

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.

Double entry bookkeeping = The process of identifying, measuring and communicating economic information about an organization or other entity, in order to permit judgements by users of the information.

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

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

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.

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.

Comparative advantage = The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Absolute advantage = The ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources

David Ricardo = Focused on technology differences between countries as a prime reason for countries to engage in international trade in his Ricardian model.

Price of a commodity = Measure of how to be sure that specialization takes place according to comparative advantage. Under perfectly competitive conditions, with constant returns to scale and only one factor of production.

Differences in factor endowments = Other factors than technology that determine the level of trade and which country is more productive than another.

The Heckscher-Ohlin model = The factor abundance model, explains international trade only through differences in endowments between countries under six assumptions

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.

Perfectly competitive markets = No participants are large enough to have the market power to set the price of a homogeneous product.

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.

Isocost lines = Represent different combination of factors of production with the same total cost, given the factor prices.

Isoquants = A graph depicting different combinations of factors of production yielding the same level of total cost.

Unit-value isoquants = Represent the production of each good that is worth one dollar of revenue when selling it.

Factor price equalization = 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).

Residual demand curve = The market demand curve minus the quantity supplied by other firms.

Market-clearing price = The price of a good or service at which quantity supplied is equal to quantity demanded, also called the equilibrium price.

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.

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.

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.

Terms-of-trade gain = a positive welfare contribution due to a drop in price. In Figure 5.4 equal to F2.

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.

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.

Trade creation effect = Increase in imports due to the formation of a PTA.

Trade diversion effect = supplier switching effect. Where Australia first imported from China it now imports from Brazil for example.

Domino theory = The world may end up in one large trading bloc, so that PTAs eventually lead to free trade.

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.

Translation risk = The risk of having assets and liabilities on a firm’s balance sheet denominated in a foreign currency.

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

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

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 activity = Making a profit by buying currencies where they are cheap and selling them where they are expensive.

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.

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.

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.

Relative Purchasing Power Parity = Differences in the rates of inflation between two countries.

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.

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Source

This Summary of International Economics and Business. Nations and Firms in the Global Economy (Beugelsdijk) is written in 2013-2014.