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ECON 4040: Exam 2
Reasons Comparative Advantage is not enough
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1. trade models built exclusively on the idea of CA have a mixed record of success in predicting trade patterns
2. Difficult to measure a country's CA
3. Country may have several products to choose from which utilize the abundant factor. Difficult to predict which one they will produce
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Economies of Scale
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production is more efficient the larger the scale at which it takes place, doubling inputs more than doubles outputs, decreasing costs over a relatively large range of output
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Internal Economies of Scale
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when the cost per unit depends on the size of the individual firm
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EOS can lead to trade
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each of the countries must concentrate in producing only a limited number of goods, but will need a larger market
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What does a larger market mean in relation to trade and economies of scale
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the larger market means a country can specialize in a narrow range of products, with lower production costs. Trade means consumers actually have a larger variety of goods to choose from
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Market Size with EOS
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market size constrains the variety of goods that a country can produce and the scale of its production
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Internal EOS and Trade
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1. size matters
2. trade forms an integrated market bigger than any individual market and loosens constraints
3. trade offers an opportunity for material gain even when countries do not differ in technology
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EOS and Market Structure
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Internal Economies of Scale give large firms a cost advantage over small firms and lead to an imperfectly competitive market structure
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Price Setters
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In imperfect competition, firms are aware they can influence the prices of their products
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How can a firm be a price setter
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can arise from industries with only a few major producers or many producers but each strongly differentiates its product from rival firms
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Monopoly
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single seller
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oligopoly
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few large sellers
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Monopolistic competition
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many firms but each selling a slightly different variation of a product
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Assumptions of Monopolistic Competition
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1. each firm differentiates its product from rivals
2. takes rivals' price as given (can't influence price)
3. Many firms in the industry
4. Firms produce with a technology that exhibits increasing returns to scale
5. Firms can freely enter and exit the industry
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Real Life Example of Monopolistic Competition
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automotive industry in Europe
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Limitations of Monopolistic Competition
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few industries well described by monopolistic competition, most common is small group oligopoly
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Gains from Trade under Monopolistic Competition
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1. Lower price: reflects increasing returns to scale, average costs fall as output rises, surviving firms are further along their AC
2. Increased Variety: consumers gain higher surplus when there are more varieties available, may be fewer domestic firms, but consumers can also purchase from abroad
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P>AC
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profits and entry, more firms
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P<AC
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losses and exits, fewer firms
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What does trade lead to?
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more firms, more variety, lower price by creating a larger market
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Inter industry trade
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trade occurs between industries
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intra industry trade
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trade occurs within the same industry
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If two companies/countries want to export products from the same industry
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companies will pursue market power through product differentiation: each country will produce different types of a product
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to obtain a high index of intra-industry trade
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a good must be both differentiated and costs must be similar in both the Home and Foreign country
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Results of Inter-industry
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gains reflect comparative advantage
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Results of Intra-industry
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gains reflect economies of scale (lower costs) and wider consumer choices
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Characteristics of industries who take part in intra-industry trade
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requiring relatively large amounts of skilled labor, technology, and physical capital
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Grubel-Lloyd Index
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empirical measurement depends on how broadly an industry is defined, the broader the definition of an industry the more trade appears to be intra-industry
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GL=1-(|X-M|)/(X+M)
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if exports of a domestic industry are equal to imports from the same industry, the numerator is zero and GL=1 and trade is completely intr-industry
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Benefits of Intra-Industry Trade
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1. prices for exports and imports decline because firms can lower their costs by producing for a larger market
2. the number of firms increases, so employment increases
3. consumer choice increases
4. fewer income redistribution effects
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Consequences of Imperfect Competition
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1. firms do not necessarily charge the same price for goods that are exported and those that are sold to domestic buyers
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Dumping
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the practice of charging a lower price for exported goods than for goods sold domestically
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Price discrimination
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the practice of charging different customers different prices
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Price discrimination and dumping may occur only if
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1. imperfect competition exists: firms must be able to set market prices rather than take them as given
2. markets are segmented: goods cannot easily be bought in one market and resold in another
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Incentive to Price Exports Lower
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Since international markets are imperfectly integrated due to both transportation costs and protectionist trade barriers, domestic firms usually have a larger share of home markets than they do foreign- foreign sales more affected by their pricing than domestic sales
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When will firms use price discrimination
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when sales are more price-responsive in one market than another (more elastic)
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When will firms use dumping
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if they perceive a higher elasticity on export sales than on domestic sales
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Protectionism and Dumping
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A US firm may appeal to the Commerce Department to investigate if dumping by foreign firms has injured the US firm- Commerce Department may impose anti-dumping duty
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Anti-dumping duty
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tax that equals the difference between the actual and fair price of imports, where fair means price the product is normally sold at in the manufacturer's domestic market
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International Trade Commission
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determines in injury to the US firm has occurred because of dumping or is likely to occur; if injury has occurred the anti dumping duty remains
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External Economies of Scale
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when the cost per unit depends on the size of the industry but not necessarily on the size of any one firm
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Sources of External Economies of Scale
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Specialized equipment, labor pooling, knowledge spillover
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Specialized Equipment
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equipment needed for one industry, but only supplied by other firms if the industry is large and concentrated
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Labor Pooling
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a large and concentrated industry may attract a pool of skilled workers, reducing employee search and hiring costs for each firm
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Knowledge Spillovers
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workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists
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External Economies of Scale and patterns of trade
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External economies potentially give a strong role to historic accident in determining who produces what, they may allow established patterns of specialization to persist even when they run counter to comparative advantage
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External Economies effect on National Welfare
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there may be gains to the world economy by concentrating production of industries with external economies, but no guarantee that the right country will produce a good subject to external economies; even possible that a country is worse off with trade than it would have been without
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Dynamic Increasing Returns to Scale
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-exist if average costs fall as cumulative output overtime rises
- could arise if the costs of production depends on the accumulation of knowledge and experience, which depend on the production process over time
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Learning Curve
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a graphical representation of dynamic increasing returns to scale, provided that the first country has a sufficiently large head start, the potentially lower costs of the second country may not allow it to enter the market
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Infant Industry Argument
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temporary protection of industries enables them to gain experience
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Industrial Policy: government policy designed to create new industries or support existing industries
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1. can have an impact on trade patterns
2. highly controversial, recent international agreements limit their scope
3. can be politically motivated and waste huge amounts of money
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Strategic Trade Policy
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the selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms
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Requirements of Strategic Trade Policy
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1. the industry has economies of scale
2. the firms in the industry have market power
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World Industrial Policy (subsidies)
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Uruguay Round and WTO prohibit direct subsidies- can subsidize "precompetitive" activities like R&D
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Governments can use other policies (other than subsidies)
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providing information about foreign markets to domestic firms, helping negotiate contracts, lobbying foreign governments to adopt home country standards, tying foreign aid to purchases from domestic firms
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Problems with Industrial Policy
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requires governments to know the costs of production for foreign firms and correctly predict their reactions; difficult to determine which industry to target (hard to predict success); encourages rent seeking
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Rent Seeking
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any activity of firms designed to alter the distribution of income without adding to income (lobbying)
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Tariff
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tax levied on an imported good
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Revenue Tariff
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imposed on good not produced domestically
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Protective Tariff
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imposed to protect domestic industry
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Intent of Tariffs
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revenue and protective tariffs
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Administration of Tariffs
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Ad valorem and specific tariffs
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Ad valorem tariffs
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percentage charge per value imported
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Specific Tariff
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fixed charge per unit imported
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Consumer Surplus
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the value received by consumers over and above what they are required to pay- the difference between what a consumer was willing to pay and what they actually paid
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What causes consumer surplus?
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occurs because firms cannot charge each consumer a different price
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Producer Surplus
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the difference between the minimum price a producer would accept and the price it actually receives
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Effects of Tariff on Trade
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Domestic Consumption falls (domestic demand) and Domestic Production rises (domestic supply)
Imports fall
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Graph effects of Tariff on Small Nation
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producer surplus grows, deadweight loss, government revenue, Consumer Surplus shrinks
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Potential Costs of Tariffs
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Retaliation, Innovation, Rent Seeking
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Terms of trade gain in large country tariff
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the redistribution of income from the foreign country to the US, improves welfare of US at expense of foreign country
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Net effect of large country tariff
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indeterminate depending on relative size of deadweight and efficiency losses and terms of trade
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Infant Government
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in developing countries, tax revenue is relatively easy to collect and tariffs are an attractive method of raising government revenue
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National Defense
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certain industries need to be protected to ensure adequate output in case of war
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Problem with National Defense argument
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1. difficult to identify essential industries
2. costly means of accomplishing this end. Better to offer domestic industry production subsidy
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Infant Industry
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new industries in developing countries initially need protection to allow them to grow in the face of foreign competition
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Problem with Infant Industry Argument
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1. difficult to predict industries which will become internationally competitive
2. difficult to determine industries with falling costs
3. infant industry may never grow up. manufacturing sector may become permanently unproductive
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Senile Industry Protection
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to provide a method for older, comparatively disadvantaged to move resources to new industries without hurting the economy
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Problem with Senile Industry
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1. difficulty in execution
2. more efficient to directly aid firms and workers
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Create and Protect Jobs Argument
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to create jobs, since tariffs increase domestic output and protect jobs from low wages abroad
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Problem with Job Creation Argument
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1. Jobs in non-protected industries fall, rearrangement of jobs instead of a net gain
2. may be a long-run decrease in employment due to inefficient use of resources in protected industries
3. it's expensive- other solutions less costly
4. economies with more tariffs usually grow more slowly
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Retaliation Argument
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retaliation for unfair trade practices, if a tariff now will induce others to lower theirs all eventually benefit
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Problems with Retaliation
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1. can lead to escalating trade wars
2. free trade benefits all
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Export Subsidy
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A payment to a firm or individual that ships a good abroad
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Effects of Prices with a subsidy
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price in importing country will fall because supply of the good has increased; the price in exporting country will rise because supply of the good has decreased
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Quota
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quantitative restrictions that specify a limit on the quantity of imports
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Types of Quotas
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1. Outright quantity limitation
2. Import licensing requirement
3. Voluntary Export Restraint
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Import Licensing Requirement
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forces importers to obtain government licenses, less transparent than quota
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Voluntary Export Restraint
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not always entirely voluntary, use limited by Uruguay Round
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Economic Effects of Quotas
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no government revenue, foreign producers earn greater profits: quota rent
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Similarities between quotas and tariffs
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1. domestic consumption falls
2. domestic production rises
3. consumer price rises
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Differences between quotas and tariffs
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1. Quotas lack government revenue
2. If eventually demand of quota good rises, price rises, and producer surplus rises (with tariff the price would stay constant)
3. domestic firms prefer quotas to tariffs
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Nontariff Measures
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any regulatory or policy rule other than tariffs and quotas that limit imports
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Examples of Non-tariff Measures
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1. complicated customs procedures
2. environmental/ consumer health regulations
3. Technical Standards
4. Procurement Rules
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The welfare effect can be measured by
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efficiency loss from consumption and production; terms of trade gain or loss
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Countervailing Duty
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tariff granted to a US industry hurt by a foreign country's subsidizing its firms
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Uruguay Round definition of subsidies
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1. direct loan or transfer
2. preferential tax treatment
3. the supply of goods or services other than general infrastructure
4. income and price supports
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Antidumping duty
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tariff levied on an import that is selling at a price below the products fair value
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Problems with anti-dumping
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1. defining fair value is subjective
2. a source of tension between countries
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WTO policy on dumping
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dumping occurs when an exporter sells a product at a price below the one it charges in its home market
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Problem with WTO Policy on dumping
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comparing domestic and foreign market prices is difficult due to differences in the price of transportation, wholesale, and other add-ons
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Determining whether a good is being dumped
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1. compare to price in 3rd world country
2. estimate cost of production
3. estimate foreign production costs
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Dumping Problem: economic theory and legal definitions are not in agreement
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1. If a firm is not earning above average profits somewhere, it cannot maintain a price somewhere else that is below the cost
2. firms often sell below costs: to penetrate market
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Escape Clause Relief
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temporary tariff on imports to allow a domestic industry to escape the pressure of imports and obtain a period of adjustment (extremely uncommon)
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Section 301
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a section on the US 1974 Trade Act that requires the US Trade Representative to take action against any nation that persistently engages in unfair trade practices
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Shallow Integration
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the elimination or reduction of tariffs, quotas, etc. that restrict the flow of goods across borders
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Deep Integration
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economic integration beyond removal of barriers at each country's borders. Requires a change in domestic laws that may inadvertently restrict trade
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Harmonization of Standards
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share common standards
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Mutual Recognition of Standards
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keep domestic standards, recognize foreign standards
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Separate Standards
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keep domestic standards, refuse to recognize foreign standards
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Race to the Bottom
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Countries with high standards are forced to lower their standards or experience a loss of jobs and industry
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Unfair Trade Practice Complaint
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Failure to enact or enforce standards gives firms in the countries with lower standards a commercial advantage
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Basic Labor Rights
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1. Prohibition of forced labor
2. Freedom of association
3. Right to organize and bargain collectively
4. end to the exploitation of child labor
5. Nondiscrimination in employment
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How do economists view trade barriers?
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expensive, grossly inefficient, and incur deadweight and efficiency losses
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Primary Issues with Trade Barriers
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1. Questionable Effectiveness
2. Concern or Protection
3. Little Agreement on Standards
3. Potential Trade War
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Questionable Effectiveness
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only large countries can hope to use trade barriers successfully; as more countries join trade barrier- effectiveness increases
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Line between protectionism and concern
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low income countries tend to view labor standards and using trade barriers as enforcement measures-way to undermine the comparative advantage of low income countries with abundant supplies of unskilled, low wage labor
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Agreement on Standards
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little agreement on specific content of labor standards (ex. definition of a child)
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Trade War Potential
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use of trade sanctions to enforce labor standards places a country out of compliance with WTO and MFN, opens countries up to retaliation
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Evidence of Using Low Standards to Capture Markets
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empirical evidence suggest low standards can reduce costs of production, but not change a country's inherent comparative advantage
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Example of Globalization and Low Wage Labor
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Maquiladoras of Northern Mexico- factories near the border after NAFTA
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Ricardian Model prediction on low wage
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wages in Mexico remain lower than in US because of low productivity in Mexico but they will rise relative to their pre-trade level
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H-O Model prediction on low wage
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unskilled workers in US will lose, while unskilled workers in Mexico will gain
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Environmental Standards in Trade
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opposed by governments of low and middle income countries, standards set by high income countries would be expensive for low and middle income producers
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Transboundary Effect
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environmental impacts that affect neighboring or other countries
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Non-transboundary Effects
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environmental impacts that affect only the home country
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Non-transboundary environmental arguments
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Race to the Bottom and pollution havens
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Transboundary environmental arguments
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pollution spillovers
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Race to the Bottom- environmental standards
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without standards, countries engage in an environmental race to the bottom to boost industrial competitiveness
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Environmental Kuznets Curve
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as poor countries grow richer, production and consumption increase and pollution starts to increase, but they eventually want more environmental protection
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Biggest Single Beneficiary of Globalization
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China
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Biggest Environmental Issue
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Climate Change
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Pollution Havens
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a place which attracts a degrading economic activity by offering less strict environmental regulation
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Evidence of Pollution havens
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shows pollution havens are insignificant relative to the pollution that occurs without international trade
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Pollution Spillovers
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a successful use of sanctions to counter them is possible only by a large country or a coalition of countries, and may lead to trade wars
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Alternatives to Trade Measures
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labels for exports, requiring home country standards, and increasing international negotiations
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Labeling for exports
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a certification process to indicate the good was produced under humane and environmentally sound conditions
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Problems with labeling
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1. many countries resist labeling as an infringement of their sovereignty
2. consumers must be convinced the label provides accurate information
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Pro to requiring home country standards be followed when operating abroad
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impedes the race to the bottom, avoids the problem of high income countries' dictating standards
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Cons to requiring home country standards be followed when operating abroad
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addresses only firms of high standard countries: low country producers are not affected and a high standard country may outsource to a low standard country producer
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