INTERNATIONAL ECONOMICS THEORY

INSTRUMENTS OF TRADE POLICY (CH9)

TARIFF: A tariff is a tax levied when a good is imported.
• A specific tariff is levied as a fixed charge for each unit of imported goods.
– For example, $3 per barrel of oil.
• An ad valorem tariff is levied as a fraction of the value of imported goods.
For example, 25% tariff on the value of imported trucks
Consider how a tariff affects a single market, say that of wheat. Suppose that in the absence of trade the
price of wheat is higher in Home than it is in Foreign. With trade, wheat will be shipped from Foreign to
Home until the price difference is eliminated.

An import demand curve is the

difference between the quantity
that home consumers demand
minus the quantity that home
producers supply, at each price.
The Home import demand curve:
MD = D – S intercepts the price axis
at PA and is downward sloping: As
price increases, the quantity of
imports demanded declines. As the
price of the good increases, home
consumers demand less, while
Home producers supply more, so
that the demand for imports
declines.

An export supply curve is the

difference between the quantity
that foreign producers supply
minus the quantity that Foreign
consumers demand, at each price.
The foreign export supply curve:
XS = S – D; As price increases, the
quantity of exports supplied rises.
As the price of the good rises,
Foreign producers supply more
while Foreign consumers demand
less, so that the supply available
for export rises.
In equilibrium, import demand = export supply,
home demand − home supply = foreign supply − foreign demand,
home demand + foreign demand = home supply + foreign supply,
world demand = world supply.

EFFECTS OF A TARIFF
A tariff acts like a transportation cost, making sellers unwilling to ship goods unless the home price exceeds
the foreign price by the amount of the tariff: P T – t = P*T . A tariff makes the price rise in the home market
and fall in the Foreign market. Because the price in the home market rises from P W under free trade to PT
with the tariff, home producers supply more and home consumers demand less, so the quantity of imports
falls from QW under free trade to QT with the tariff. Because the price in the foreign market falls from P W
under free trade to PT* with the tariff. Foreign producers supply less, and foreign consumers demand more,
so the quantity of exports falls from QW to QT.

When a country is “small,” it has no effect on the foreign (world) price because its demand is an
insignificant part of world demand for the good. The foreign price does not fall but remains at P w .The price
in the home market rises by the full amount of the tariff, to P T = Pw + t . When a country is small, a tariff it
imposes cannot lower the foreign price of the good it imports. As a result, the price of the import rises from
PW to PW + t and the quantity of imports demanded falls from D1 − S1 to D2 − S2.

MEASURING THE AMOUNT OF PROTECTION

The effective rate of protection measures how much protection a tariff (or other trade policy) provides. It
represents the change in value that firms in an industry add to the production process when trade policy
changes, which depends on the change in prices the trade policy causes. Effective rates of protection often
differ from tariff rates because tariffs affect sectors other than the protected sector, causing indirect effects
on the prices and value added for the protected sector.

For example, suppose that automobiles sell in world markets for $8,000, and they are made from factors of
production worth $6,000, the value added of the production process is $8,000 − $6,000. Suppose that a
country puts a 25% tariff on imported autos so that home auto assembly firms can now charge up to
$10,000 instead of $8,000. The effective rate of protection for home auto assembly firms is the change in
value added:
$4,000  $2,000   100%
$2,000
In this case, the effective rate of protection is greater than the tariff rate.

Costs and benefits of tariffs: A tariff raises the price of a good in the importing country, so it hurts
consumers and benefits producers there; In addition, the government gains tariff revenue.
How to measure these costs and benefits? By using the concepts of consumer surplus and producer
surplus.

CONSUMER SURPLUS: measures the amount that consumers gain from

purchases by computing the difference in the price actually paid from the
maximum price they would be willing to pay for each unit consumed.
Consumer surplus is equal to the area under the demand curve and above
the price.

PRODUCER SURPLUS: Producer surplus measures the amount that producers

gain from sales by computing the difference in the price received from the
minimum price at which they would be willing to sell. When price increases,
the quantity supplied increases as well as the producer surplus. Producer
surplus is equal to the area above the supply curve and below the price.

MEASURING THE COSTS AND BENEFITS OF TARIFFS

A tariff raises the price in the importing country: consumer surplus decreases (consumers worse off),
producer surplus increases (producers better off) and the government collects tariff revenue equal to the
tariff rate times the quantity of imports with the tariff.

t QT  PT  PT 
 D 2  S2 
The costs and benefits to different groups can be
represented as sums of the five areas a, b, c, d, and e. For
a “large” country, whose imports and exports affect world
prices, the welfare effect of a tariff is ambiguous.

• The triangles b and d represent the efficiency loss.

– The tariff distorts production and

consumption decisions: producers produce
too much, and consumers consume too little.

• The rectangle e represents the terms of trade gain.

– The tariff lowers the foreign price, allowing

Home to buy its imports cheaper.

Part of government revenue (rectangle e) represents the

terms of trade gain, and part (rectangle c) represents some
of the loss in consumer surplus. The government gains at the
expense of consumers and foreigners. If the terms of trade gain exceed the efficiency loss, then national
welfare will increase under a tariff, at the expense of foreign countries. However, foreign countries are apt
to retaliate.

Export Subsidy
An export subsidy can also be specific or ad valorem:

– A specific subsidy is a payment per unit exported.

– An ad valorem subsidy is a payment as a proportion of the value exported.

An export subsidy raises the price in the exporting country, decreasing its consumer surplus (consumers
worse off) and increasing its producer surplus (producers better
off). Government revenue falls due to paying SX s for the export
subsidy; an export subsidy lowers the price paid in importing
countries PS*= PS – S In contrast to a tariff, an export subsidy
worsens the terms of trade by lowering the price of exports in
world markets.

An export subsidy damages national welfare; The triangles b

and d represent the efficiency loss (The export subsidy distorts
production and consumption decisions: producers produce too
much and consumers consume too little compared to the
market outcome). The area b + c + d + f + g represents the cost
of the subsidy paid by the government.

Import Quota
An import quota is a restriction on the quantity of a good that may be imported. This restriction is usually
enforced by issuing licenses or quota rights. A binding import quota will push up the price of the import
because the quantity demanded will exceed the quantity supplied by Home producers and from imports.
When a quota instead of a tariff is used to restrict imports, the government receives no revenue. Instead,
the revenue from selling imports at high prices goes to quota license holders. These extra revenues are
called quota rents.

EXERCISE FOR THOSE ARGUMENTS

INTERNATIONAL NEGOTIATIONS OF TRADE POLICY (CH10)

After rising sharply at the beginning of the 1930s, the average U.S. tariff rate has decreased substantially
from the mid-1930s to 1998.
Since 1944, much of the reduction in tariffs and other trade restrictions has come about through
international negotiations. The General Agreement of Tariffs and Trade was begun in 1947 as a provisional
international agreement and was replaced by a more formal international institution called the World
Trade Organization in 1995.

Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade
restrictions. A trade war could result if each country has an incentive to adopt protection, regardless of
what other countries do. All countries could enact trade restrictions, even if it is in the interest of all
countries to have free trade. Countries need an agreement that prevents a trade war or eliminates the
protection from one.

In

this example, each country acting individually would be better off with protection (20 > 10), but both would
be better off if both chose free trade than if both choose protection (10 > −5). If Japan and the U.S. can
establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both
can be made better off. Or if the damage has already been done, both countries can agree to return to free
trade.

A Brief History Case: In 1930, the United States passed a remarkably irresponsible tariff law, the Smoot-
Hawley Act. Tariff rates rose steeply and U.S. trade fell sharply. Initial attempts to reduce tariff rates were
undertaken through bilateral trade negotiations: U.S. offered to lower tariffs on some imports if another
country would lower its tariffs on some U.S. exports. Bilateral negotiations, however, do not take full
advantage of international coordination. Benefits can “spill over” to countries that have not made any
concessions.

WORLD TRADE ORGANIZATION (WTO)

• In 1947, a group of 23 countries began trade negotiations under a provisional set of rules that
became known as the General Agreement on Tariffs and Trade, or GATT. In 1995, the World Trade
Organization, or WTO, was established as a formal organization for implementing multilateral
 trade negotiations (and policing them). WTO negotiations address trade restrictions in at least 3
ways:

• Reducing tariff rates through multilateral negotiations.

• Binding tariff rates: a tariff is “bound” by having the imposing country agree not to raise it in the
future.

• Eliminating nontariff barriers: quotas and export subsidies are changed to tariffs because the costs
of tariff protection are more apparent and easier to negotiate (Subsidies for agricultural exports are
an exception; Exceptions are also allowed for “market disruptions” caused by a surge in imports).

The WTO is based on a series of agreements:

– General Agreement on Tariffs and Trade: covers trade in goods.

– General Agreement on Tariffs and Services: covers trade in services (ex., insurance,
consulting, legal services, banking).

– Agreement on Trade-Related Aspects of Intellectual Property: covers international

property rights (ex., patents and copyrights).

– The dispute settlement procedure: a formal procedure where countries in a trade dispute
can bring their case to a panel of WTO experts to rule upon.

Do Agricultural Subsidies in Rich Countries Hurt Poor Countries? We learned in Chapter 9 that subsidies
lower the world price of products. Since importing countries benefit from cheaper food, why would poor
countries want rich countries to remove their agricultural subsidies? Subsidies harm farmers in poor
countries who compete with farmers in rich countries.

Preferential Trading Agreements

Preferential trading agreements are trade agreements between countries in which they lower tariffs for
each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are
generally not allowed: Each country in the WTO promises that all countries will pay tariffs no higher than
the nation that pays the lowest: called the “most favored nation” (MFN) principle. An exception is allowed
only if the lowest tariff rate is set at zero. There are two types of preferential trading agreements in which
tariff rates are set at or near zero:

- A free trade area: an agreement that allows free trade among members, but each member can
have its own trade policy towards non-member countries. (An example is the North America Free
Trade Agreement “NAFTA”).
- A customs union: an agreement that allows free trade among members and requires a common
external trade policy towards non-member countries. (An example is the European Union).
 The net benefit of a tariff is equal to the area of the colored rectangle minus the area of the two
shaded triangles.

EXCHANGE RATES AND THE FOREING EXCHANGE MARKET: AN ASSET

APPROACH (CH14)
Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit
of foreign currency (How much can be exchanged for one dollar?) $0.01027/Yen. Exchange rates allow us to
denominate the cost or price of a good or service in a common currency, for example “how much does a
Nissan cost? Yen 2.500.000 or (0.01027$) 25672.5$.

- Depreciation: is a decrease in the value of a currency relative to another currency; A depreciated

currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller
amount of foreign currency. $1/€ → $1.20/€ means that the dollar has depreciated relative to the
euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable. The euro has
appreciated relative to the dollar it is now more valuable. A depreciated currency is less valuable,
and therefore it can buy fewer foreign produced goods that are denominated in foreign currency,
imports are more expensive and domestically produced goods and exports are less expensive. A
depreciated currency lowers the price of exports relative to the price of imports.
- Appreciation: is an increase in the value of a currency relative to another currency, an appreciated
currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger
amount of foreign currency. $1/€ → $0.90/€ means that the dollar has appreciated relative to the
euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable. The euro has
depreciated relative to the dollar: it is now less valuable. An appreciated currency is more valuable,
and therefore it can buy more foreign produced goods that are denominated in foreign currency;
imports are less expensive and domestically produced goods and exports are more expensive. An
appreciated currency raises the price of exports relative to the price of imports.

THE DEMAND OF CURRENCY DEPOSITS

What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency?
factors that influence the return on assets determine the demand of those assets. (Rate of Return è il Tasso
di interesse, sai come si calcola).

- Real Rate of Return: inflation-adjusted rate of return, which represents the additional amount of
goods & services that can be purchased with earnings from the asset. The real rate of return for the
above savings deposit when inflation is 1.5% is 2% − 1.5% = 0.5%. After accounting for the rise in
the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year
(If prices are fixed, the inflation rate is 0% and (nominal) rates of return = real rates of return).
- Risk: the risk of holding assets also influences decisions about whether to buy them
 - Liquidity: liquidity of an asset, or ease of using the asset to buy goods and services, also influences
the willingness to buy assets.

We assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the
same, regardless of their currency denomination. We therefore say that investors are primarily
concerned about the rates of return on currency deposits. Rates of return that investors expect to earn
are determined by:

– interest rates that the assets will earn

– expectations about appreciation or depreciation

A currency deposit’s interest rate is the amount of a currency that an individual or institution can earn by
lending a unit of the currency for a year. The rate of return for a deposit in domestic currency is the interest
rate that the deposit earns. To compare the rate of return on a deposit in domestic currency with one in
foreign currency, consider the interest rate for the foreign currency deposit the expected rate of
appreciation or depreciation of the foreign currency relative to the domestic currency.

Example: Suppose the interest rate on a dollar deposit is 2%. Suppose the interest rate on a euro deposit is
4%. Does a euro deposit yield a higher expected rate of return? Suppose today the exchange rate is $1/€1,
and the expected rate one year in the future is $0.97/€1. $100 can be exchanged today for €100, these
€100 will yield €104 after one year, these €104 are expected to be worth $0.97/€1 × €104 = $100.88 in one
year; The rate of return in terms of dollars from investing in euro deposits is 0.88%. Let’s compare this rate
of return with the rate of return from a dollar deposit, the rate of return is simply the interest rate, after 1
year the $100 is expected to yield $102 so the real interest rate is 2%. The euro deposit has a lower
expected rate of return: thus, all investors should be willing to dollar deposits, and none should be willing
to hold euro deposits.

Note that the expected rate of appreciation of the euro was -3% ($0.97/1€),
We simplify the analysis by saying that the dollar rate of return on euro E e $ / €  E$ / €
deposits approximately equals the interest rate on euro deposits plus the
R€ 
expected rate of appreciation of euro deposits (4% + −3% = 1% ≈ 0.88%)
E$ / €
The difference in the rate of return on dollar deposits and euro deposits is:
Model of Foreign Exchange markets:
Construct model of foreign exchange markets using the demand of (rate of return on) dollar denominated
deposits and the demand of (rate of return on) foreign currency denominated deposits. This model is in
equilibrium when deposits of all currencies offer the same expected rate of return: interest parity. Interest
parity implies that deposits in all currencies are equally desirable assets and also that arbitrage in the
foreign exchange market is not possible.

Interest parity says: E e $ / €  E$ / €

R$  R€ 
E$ / €

E e $ / €  E$ / €
Why should the interest parity condition hold? Suppose it did not. Suppose: R$  R€ 
E$ / €
Then no investor would want to hold euro deposits, driving down the demand and
price of euros. Then all investors would want to hold dollar deposits, driving up the demand and price of
dollars, the dollar would appreciate and the euro would depreciate, increasing the right side until equality
was achieved How do changes in the current exchange rate affect the expected rate of return of foreign
currency deposits? Depreciation of the domestic currency today lowers the expected rate of return on
foreign currency deposits. When the domestic currency depreciates, the initial cost of investing in foreign
currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits.

Determination of the equilibrium dollar/euro exchange rate:

Equilibrium in the foreign exchange market is at point 1, where
the expected dollar returns on dollar and euro deposits are
equal. The effects of changing interest rates:

– an increase in the interest rate paid on deposits

denominated in a particular currency will
increase the rate of return on those deposits.

– This leads to an appreciation of the currency.

– Higher interest rates on dollar-denominated

assets cause the dollar to appreciate.

– Higher interest rates on euro-denominated

assets cause the dollar to depreciate.

Effect of a Rise in the euro interest rate:

A rise in the interest rate paid by euro deposits causes the dollar
to depreciate from point 1 to point 2. (this figure also describes
the effect of a rise in the expected future $/€). If people expect
the euro to appreciate in the future, then euro-denominated
assets will pay in valuable euros, so that these future euros will
be able to buy many dollars and many dollar-denominated
goods. The expected rate of return on euros therefore increases.
An expected appreciation of a currency leads to an actual
appreciation (a self-fulfilling prophecy). An expected
depreciation of a currency leads to an actual depreciation (a self-
fulfilling prophecy).
COVERED INTEREST PARITY
Covered interest parity relates interest rates across countries and the rate of
change between forward exchange rates and the spot exchange rate: Where R  R  $ / €
F  E$ / €
$ €
F$/€ is the forward exchange rate, it says that rates of return on dollar E$ / €
deposits and “covered” foreign currency deposits are the same. How could you earn a risk-
free return in the foreign exchange markets if covered interest parity did not hold? Covered positions using
the forward rate involve little risk.
PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN (CH16)
- The Behaviour of Exchange Rate

What models can predict how exchange rates behave? In last chapter we developed a short-run model and
a long-run model that used movements in the money supply. In this chapter, we develop 2 more models,
building on the long-run approach from last chapter. Long run means a sufficient amount of time for prices
of all goods and services to adjust to market conditions so that their markets and the money market are in
equilibrium. Because prices are allowed to change, they will influence interest rates and exchange rates in
the long-run models. The long-run models are not intended to be completely realistic descriptions about
how exchange rates behave, but ways of representing how market participants may form expectations
about future exchange rates and how exchange rates tend to move over long periods.

LAW OF ONE PRICE

The law of one price simply says that the same good in different competitive markets must sell for the same
price, when transportation costs and barriers between those markets are not important. Why? Suppose the
price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across
the street is $40. What do you predict will happen? Many people will buy the $20 pizza, few will buy the
$40 one. Due to the price difference, entrepreneurs would have an incentive to buy pizza at the cheap
location and sell it at the expensive location for an easy profit. Due to strong demand and decreased
supply, the price of the $20 pizza would tend to increase. Due to weak demand and increased supply, the
price of the $40 pizza would tend to decrease. People would have an incentive to adjust their behaviour
and prices would tend to adjust until one price is achieved across
markets (across restaurants). Consider a pizza restaurant in  
P pizzaUS = EUS$/C$ × P pizza Canada
Seattle and one across the border in Vancouver. The law of one P pizzaUS = priceof pizzainSeattle
price says that the price of the same pizza (using a common
P pizza Canada = priceof pizzain Vancouver
currency to measure the price) in the two cities must be the same
if markets are competitive and transportation costs and barriers EUS$/C$ = U.S.dollar/Canadiandollar exchangerate
between markets are not important.

PURCHASING POWER PARITY

Purchasing power parity is the application of the law of one price PUS = EUS$/C$ × PCanada 
across countries for all goods and services, or for representative PUS = level of average prices in the U.S.
groups (“baskets”) of goods and services. Purchasing power parity PCanada = level of average prices in Canada
(PPP) implies that the exchange rate is determined by levels of EUS$/C$ = U.S.doller/Canadian doller exchange rate
average prices. If the price level in the U.S. is US$200 per basket,
while the price level in Canada is C$400 per basket, PPP implies that the P
C$/US$ exchange rate should be C$400/US$200 = C$2/US$1. Predicts that E US$  US
people in all countries have the same purchasing power with their
currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, C$
P Canada
since prices in Canada are twice as high. PPP comes in 2 forms:

- Absolute PPP: purchasing power parity that has already been discussed. PUS
Exchange rates equal the level of relative average prices across countries. E$ / € 
PEU
 - Relative PPP: changes in exchange rates equal changes in prices (E$ / €,t  E$ / €, t 1 )
(inflation) between two periods (Where the pigreco difference is   US,t   EU,t
E$ / €, t 1
the delta between inflation rate from the 2 periods:

MONETARY APPROACH TO EXCHANGE RATE

M S EU
Monetary approach to the exchange rate uses monetary factors to predict how exchange PEU 
rates adjust in the long run, based on the absolute version of PPP. It predicts that levels of L R€ ,YEU 
average prices across countries adjust so that the quantity of real monetary assets supplied
will equal the quantity of real monetary assets demanded: M S US
PUS 
To the degree that PPP holds and to the degree that prices adjust to equate the L R$ ,YUS 
quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we
have the following prediction: The exchange rate is determined in the long run by prices, which are
determined by the relative supply and demand of real monetary assets in money markets across
countries.

Predictions about changes in:

1. Money supply: a permanent rise in the domestic money supply

- causes a proportional increase in the domestic price level,
- thus causing a proportional depreciation in the domestic currency (through PPP).
- This is same prediction as long-run model without PPP.
2. Interest rates: a rise in domestic interest rates
- lowers the demand of real monetary assets,
- and is associated with a rise in domestic prices,
- thus causing a proportional depreciation of the domestic currency (through PPP).
3. Output level: a rise in the domestic level of production and income (output):
- Raises domestic demand of real monetary assets,
- And is associated with a decreasing level of average domestic prices (for a fixed quantity of money
supplied)
- thus causing a proportional appreciation of the domestic currency (through PPP).

All 3 changes affect money supply or money demand, and cause prices to adjust so that the quantity of real
monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange
rates to adjust according to PPP. A change in the money supply results in a change in the level of average
prices.

- A change in the growth rate of the money supply results in a change in the growth rate of prices
(inflation). A constant growth rate in the money supply results in a persistent growth rate in prices
(persistent inflation) at the same constant rate, when other factors are constant.Inflation does not
affect the productive capacity of the economy and real income from production in the long run.
Inflation, however, does affect nominal interest rates. How?

THE FISHER EFFECT

The Fisher effect (named affect Irving Fisher) describes the relationship between nominal interest rates and
inflation. Derive the Fisher effect from the interest parity condition: If financial markets expect (relative)
PPP to hold, then expected exchange rate changes will equal expected inflation between countries,
e e
therefore, R$ - R€ = π US−π EU. The Fisher effect: a rise in the domestic inflation rate causes an equal rise in
the interest rate on deposits of domestic currency in the long run, when other factors remain constant.
Suppose that the U.S. central bank
unexpectedly increases the growth rate of
the money supply at time t0. Suppose also
that the inflation rate is π in the US before
t0 and π + Δπ after this time, but that the
EU inflation rate remains 0%. According to
fisher effect, the interest rate in US will
adjust to the higher inflation rate.

The increase in nominal interest rates

decreases the demand of real monetary
assets. In order for the money market to
maintain equilibrium in the long run, prices
S
M US
must jump so that PUS = .
L ( R $ ,Y US )
In order to maintain PPP, the exchange
rate must jump (the dollar must
PUS
depreciate) so that E $/ € = .
PEU
Thereafter, the money supply and prices are predicted to grow at rate π + Δπ and the domestic currency is
predicted to depreciate at the same rate.

THE ROLE OF INFLATION AND EXPECTATION

In the long-run model without PPP: Changes in money supply led to changes in the level of average prices.
No inflation is predicted to occur in the long run, but only during the transition to the long-run equilibrium.
During the transition, inflation causes the nominal interest rate to increase to its long-run value.
Expectations of higher domestic inflation cause the expected return on foreign currency deposits to
increase, making the domestic currency depreciate before the transition period. In the monetary approach
(with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases
permanently. With persistent domestic inflation (above foreign inflation), the monetary approach also
predicts an increase in the domestic nominal interest rate. Expectations of higher domestic inflation cause
the expected purchasing power of domestic currency to decrease relative to the expected purchasing
power of foreign currency, thereby making the domestic currency depreciate. In the long-run model
without PPP, the level of average prices does not immediately adjust even if expectations of inflation
adjust, causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its
long-run value. In the monetary approach (with PPP), the level of average prices adjusts with expectations
of inflation, causing the domestic currency to depreciate, but with no overshooting.

SHORTCOMINGS OF PPP
There is little empirical support for absolute purchasing power parity. The prices of identical commodity
baskets, when converted to a single currency, differ substantially across countries. Relative PPP is more
consistent with data, but it also performs poorly to predict exchange rates.
Reasons why PPP may not be accurate: the law of one price may not hold because of

1. Trade barriers and nonreadable products

2. Imperfect competition

3. Differences in measures of average prices for baskets of goods and services

Trade barriers and non-tradable products:

- Transport costs and governmental trade restrictions make trade expensive and in some cases
create non-tradable goods or services.
- Services are often not tradable: services are generally offered within a limited geographic region
(for example, haircuts).
- The greater the transport costs, the greater the range over which the exchange rate can deviate
from its PPP value.
- One price need not hold in two markets.

Imperfect competition may result in price discrimination: “pricing to market.” A firm sells the same product
for different prices in different markets to maximize profits, based on expectations about what consumers
are willing to pay. One price need not hold in two markets.

Differences in the measure of average prices for goods and services. levels of average prices differ across
countries because of differences in how representative groups (“baskets”) of goods and services are
measured. Because measures of groups of goods and services are different, the measure of their average
prices need not be the same. One price need not hold in two markets.
GLOBAL VALUE CHAINS
The value chain concept refers to the range of activities required in the production of a good or service,
including design, procurement of inputs, production, marketing, distribution, and after-sales service. Since
the 1970s, international production, trade and investments are increasingly organized within so-called
global value chains (GVCs) where the different stages of the production process are located across different
countries. Even more than before, trade is determined by strategic decisions of firms. About 70% of
international trade today involves global value chains (GVCs), as services, raw materials, parts, and
components cross borders – often numerous times. GVCs magnify the costs of tariff protection since tariffs
are cumulative when intermediate inputs are traded across borders multiple times. One of the salient
features of the 'third globalization' is represented by fragmentation of international production, which led
to an intense geographical dispersion of the phases of production necessary for the realization of a
product. Relocation of industrial plants, the outsourcing of large stages of product production and the use
of independent suppliers located abroad for the procurement of intermediate goods necessary for the
production process → disintegration of production chains (unbundling) on a transnational scale. The
production processes are fragmented into sequences or "chains" (value chains) of "tasks", which in turn
they correspond to certain phases of the processing of a product.

DRIVERS OF GVCs SUCCESS

Major drivers of these changes:

• economic restructuring and market liberalization in many countries in Eastern Europe, Asia,
and elsewhere.

• financial deregulation and the integration of world financial markets;

• trade and investment liberalization—including the proliferation of preferential trading

arrangements (multilateral and bilateral);

• technological advances, particularly in information and communication technologies (ICT)

and transportation.

OUTSOURCING AND OFFSHORING

• Outsourcing is a process that involves the firm externalizing elements of its value chain—that is,
there is an organizational fragmentation of production.

• Offshoring refers to the relocation of the production of goods and/or services overseas—that is,
there is an international
fragmentation of production.

• Outsourced activities may take

place within the same country
or involve the relocation of
production overseas.

• Offshored activities may take

place under the control of the
lead firm (FDI) or independently
(Strange, 2011).
INTERNATIONAL DIVISION OF LABOUR (SMILE CURVE HYPOTESIS)

First proposed at the beginning of the Nineties by Stan Shih, the founder of the IT company Acer Inc.
headquartered in Taiwan, and built on his analysis of the personal computer industry (Shih, 1996; Shin et
al., 2012). Agents specialized in the most upstream and downstream value added activities gain economic
rents thanks to their position along the value chain at the expense of economic actors situated in the
middle-part of it performing manufacturing and assembly functions Rationale: different degree of
competitiveness which prevails in value added functions the value chains are composed by knowledge
intensive activities featured by strong dynamic returns to scale and high barriers to entry, as well as post-
production activities capture the largest share of the final product value added in the form of monopoly
rents (Stollinger, 2019). Manufacturing and assembly functions, involve the most labour-intensive and
routinary activities, mostly performed by relatively lower skilled workers and, with the advent of
automation, potentially substituted by highly advanced machinery and robots

EXAMPLE
Global value chains challenge the way statistics on trade and output are collected. There is a growing
awareness that current statistics can give the wrong picture (Maurer and Degain, 2010). Trade statistics in
particular are collected in gross terms and record several times the value of intermediate inputs traded
along the value chain. As a consequence, the country of the final producer appears as capturing most of the
value of goods and services traded, while the role of countries providing inputs upstream is overlooked.
Bilateral trade statistics and output measures at the national level make it difficult to visualise the “chain”
or the production network.

DOUBLE COUNTING PROBLEM

Country A exports 100$ worth of goods to country B, which processes them further before exporting them
to C, where they are consumed. B adds 10$ value to the goods that are exported to C for 110$.
Conventional trade measures show that the total global exports and imports are 210$. C has a trade deficit
of 110$ with b, and no trade with A. If instead of measuring trade in gros value we measure it in value
added, we get:

The value added generated by the production of the goods is 110$ (100+10); the trade deficit of C is equal
to 10$. Trade value overestimate (i.e. multiple counting): 100$= (210-110)

TRADE IN VALUE ADDED (TiVA)

Global input-output matrices make it possible to break down exports in terms of value-added, that is, to
trace the value-added produced by each sector and country involved in the GVCs. This allows, in other
words, to break down the value of gross exports into a series of components in order to distinguish the
value-added produced by a given sector / country, the value-added produced by foreign countries and the
value of multiple counts. Computing international trade in terms of value-added makes it possible to
measure more correctly what is the degree of participation and the positioning of countries (and sectors)
within the GVCs, as well as to trace more precisely the countries production specialization.
(https://www.oecd.org/industry/ind/global-value-chains.htm).

Participation in GVCs: what is the share of exports involved in a vertically fragmented production process?

The first question that comes to mind when thinking about GVCs is to what extent countries are involved in
a vertically fragmented production. One way to measure it is to measure the vertical specialisation share,
which can be understood as the import content of exports. The indicator measures the value of imported
inputs in the overall exports of a country. However, the vertical specialisation (VS) share only looks at the
importance of foreign suppliers backward in the value chain. As a country also participates in GVCs by being
a supplier of inputs used in third countries for further exports, the literature has also introduced the ‘VS1’
share, which is the percentage of exported goods and services used as imported inputs to produce other
countries’ exports. Combining the VS and VS1 shares, one can have a comprehensive assessment of the
participation of a country in GVCs, both as a user of foreign inputs and supplier of intermediate goods and
services used in other countries’ exports.

The length of GVCs: how many production stages in the GVC?

While the imported foreign inputs and domestically-produced intermediates used in third countries for
exports give an idea of the importance of vertical specialisation, they do not indicate how “long” value
chains are, i.e. how many production stages are involved. For example, a high VS share could correspond
to the use of expensive raw materials in a very simple value chain, while conversely a high VS1 share could
be added in one go at the final stage of the production process. This is why an indication on the “length” of
GVCs would be useful and complementary.

The distance to final demand: what is the position of a country in the value chain?

Once the depth and length of particular GVCs is assessed, the important question is where countries are
located in the value chain. A country can be upstream or downstream, depending on its specialisation. Fally
(2011) and Antràs et al. (2012) have introduced a measure of “upstreamness” that we can refer to as the
“distance to final demand”.