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Berkeley ENVECON 131 - Notes on linking trade and non- trade issues

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Notes on linking trade and non-trade issues, with an excursion to Ricardo’s model of trade November 8, 2006Should negotiations be “linked”?• Should trade negotiations be linked with non-trade issues?• They already have been linked. For example, the Trade Related Intellectual Property (TRIPs) Agreement was tied to OECD “concessions” on agricultural trade during the Uruguay Round that led to WTO.• Some people want to link trade negotiations to non-trade issues such as: investment, environmental protection, labor rights.The objective of this lecture• Explain (using a formal model) why nations can benefit from linking disparate issues in a single negotiation.• Show that the argument in favor of linked negotiations is similar to the argument in favor of trade in goods. For this purpose, I review the Ricardian trade model.• Explain how economists model bargaining in a non-cooperative framework.An example of linked negotiations• Two agents North and South have differing interests regarding two issues: (i) liberalization of agricultural trade, and (ii) stricter environmental laws.• South cares most about (i) and North cares most about (ii).• Should the agents bargain over the issues separately, or should the issues be linked in a single bargain?• By adding an issue to a bargain, a country may be able to extract concessions on other issues, improving its own payoffs.• Consider extreme case: S cares only about (i) and N cares only about (ii). Here there is no basis for separate negotiations. In this (trivial) case, linked negotiations are necessary in order to reach an agreement.A digression to the Ricardian trade modelReasons to go through this model:(i) It is the basic trade model. You should understand it in order to understand comparative advantage and the gains from trade.(ii) This model provides a helpful analogy for understanding the gains from linked negotiations.(iii) Its good exercise for your brain.Basic assumptions of (this version of) Ricardian model (a review)• Labor is the only input to production, and production has constant returns to scale.• Markets are competitive, so profits are 0 in equilibrium.• There are two regions, N and S, and two goods, food and cloth.• Labor is perfectly mobile between sectors within a country, but immobile across countries. Therefore, within a country the wage is the same in both sectors (when both operate). Wages can be different in the two countries.• See online lecture notes for more information on the Ricardian model.An example of comparative advantage (review)42South11NorthFoodCloth• Table shows number of units of labor needed to produce one unit of the commodity in N and S.• What is opportunity cost of food (in units of cloth) in N? What is opportunity cost of food (in units of cloth) in S?• Which region has lower opportunity cost for food – and therefore has the comparative advantage in food?Example continued, Autarchic prices• Normalize by setting price of cloth = 1 (cloth is “numeraire good”). With this normalization, the price of food is a “relative price”. • Use 0 profit condition to find autarchic relative price of food in both countries.• Show that the country (N in my example) that has the lower opportunity cost of food also has the lower autarchic (relative) price of food.• When countries begin to trade, N exports food and S exports cloth.Example continued, production possibility frontiers.• Suppose that North has 100 units of labor and South has 80 units of labor. • Draw production possibility frontier for each region under autarchy.• Draw production possibility frontier when the countries trade.• Pick an (arbitrary) autarchic consumption level for each country (A and B in next figure).• Show that total autarchic consumption (C in next figure) lies inside world production possibility frontier.• Conclude that by reallocating production, both countries can be made better off under trade.Autarchic consumption is at A and B. Total autarchic consumption is C. World can produce more than C.4010014020100120foodcloth...ABCWelfare• A country is better off under trade (compared to autarchy) if and only if the relative price is faces under trade is different than the autarchic relative price.• Example for North. 0 profit conditions under autarchy imply p=w and 1=w. (Recall normalization: 1 = price of cloth. Each unit of output requires 1 unit of labor in N.)• Suppose that a worker consumes x units of food and y units of cloth under autarchy. The worker sells one unit of labor, so her income is w. Budget constraint requires px+y=w. Using 0 profit conditions (the fact that p=1) this relation simplifies to x+y=1.• The consumption bundle under autarchy is (x,1-x).• Suppose that both goods are consumed, so that 0<x<1.Welfare, continued• Suppose that under trade the relative price of food is p’>1. (So that N exports food.)• 0 profit conditions require that country specializes in food production, which implies: p’=w.• Show that if a worker consumes the original consumption bundle, she has income left over, so her welfare is higher under trade.• Cost of original consumption bundle (x,1-x), at the newprice is p’x+(1-x)=(p’-1)x+1. Show that this cost is less than income, which equals w=p’:(p’-1)x+1<p’ if and only if(p’-1)x<p’-1 if and only if(p’-1)(x-1)<0which is true because p’>1 and x<1.Welfare, finished• Students should repeat this proof for the case in which the relative price of food under trade is less than the autarchic relative price, i.e. for the case in which p’<1.• In this case, the country specializes in cloth, rather than in food.• Again, the point is that a country gains from trade if and only if the relative price at which it is able to trade is different from its autarchic price. (Remember that I used a partial equilibrium model to show gains from trade for an importer or an exporter.)• If the world equilibrium price under trade lies between autarchic prices, both regions benefit from trade.What does this have to do with a model of bargaining?• I want to show that the source of gains from trade (a difference across countries in opportunity costs of production) is very similar to the source of gains from linking negotiations over different issues.• (This section of lecture based on Hortsomann et al paper, online under Topic #8)How do economists model bargaining?• There are two


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Berkeley ENVECON 131 - Notes on linking trade and non- trade issues

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