The Political Economy of International Trade Cooperation

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The Political Economy of International Trade
Cooperation

• READING ASSIGNMENT
• Oatley Chapter 3
• Suggested (not required) further reading
• Grieco, Joseph M. and John Ikenberry. 2003. The
  Economics of International Trade. In Grieco and
  Ikenberry, State Power and World Markets The
  International Political Economy. New York W.W.
  Norton Co. pp19-56.

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Plan

1. Building blocks (indifference curves, MRS,
   production frontiers MRT)
2. Opportunity costs Comparative advantage
3. Factor endowments Hecksher-Ohlin Model
4. Prisoners dilemma
5. (Schools of thought?)

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Building blocks

1. Consumption indifference curves
2. Production possibility frontiers
3. Analysis of optimized production-consumption
   equilibrium (without trade)

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Consumption indifference curves

• Consumption ? happiness ? (UTILITY)
• More is better!
• But indifferent between some baskets
• E.g.
• U (2 pairs of shoes 2 Dell desktop computers)
• U (6 pairs of shoes 1 Dell desktop computer)
• For our purposes, well consider aggregate
  "national" consumption indifference curves

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• Points A, B, C, D provide the country with the
  same level of satisfaction.
• Why curved?
• Declining marginal utility from consumption
• D to C
• If you are at D, youll sacrifice 2 million
  computers for just 10 million shoes
• B to A
• If you are at B, youll sacrifice 2 million
  computers only if compensated with 40 million
  shoes
• DECLINING MARGINAL RATE OF SUBSTITUTION (MRS)
• Any point along U1 beats any point along U0 you
  want to move to the highest indifference curve

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Budget Constraint?
Slope of this line is the MARGINAL RATE OF
PRODUCT TRANSFORMATION (MRT)
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Putting the two together
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Production possibilities frontier

• Opportunity costs ? negative slope
• Straight line ? constant opportunity costs
• Increasing opportunity costs?
• Arise under decreasing returns to scale
• Suppose a trade-off between rice and grapes
• Some land more suitable for rice than grapes and
  vice versa
• Suppose you start out with all grapes
• If you want to switch to rice, you begin with the
  best land for rice/worse land for grapes
• Eventually, you will run out of good-rice-land,
  and start taking good-grape-land
• The opportunity cost of switching to rice
  increases and increases

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• Movement from P to C (increasing computer
  production from 0 to 4 million computers) reduces
  shoe production only by 10 million
• But movement from D to Q (again increasing
  computers by 4 million) reduces shoe production
  by 100 million!
• INCREASING MARGINAL RATE OF PRODUCT TRANSFORMATION

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Optimizing under autarky (no trade)

• Given our preferences (consumption indifference
  curves)
• And our production possibility frontier,
• Where to we maximize our utility?

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Answer

• MARGINAL RATE OF SUBSTITUTION
• MARGINAL RATE OF PRODUCT TRANSFORMATION
• MRS MRT

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Why do countries engage in trade?

• Ricardian model 2 countries, 2 goods CONSTANT
  opportunity costs
• Logic of COMPARATIVE ADVANTAGE

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Example is a lil out of date

• One American worker can produce more computers or
  more shoes than one Brazilian worker
• US has an ABSOLUTE ADVANTAGE in both computers
  and shoes
• So why trade?

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Differences in opportunity costs!

• Suppose we move one American worker from
  Computers to Shoes
• We lose 50 computers for 200 shoes
• For each additional pair of shoes produced, the
  US must forgo 0.25 computers (50/200¼)
• The (constant) opportunity cost of each pair of
  shoes is ¼ computer
• The (constant) opportunity cost of each computer
  is 4 pairs of shoes (200/504)

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Differences in opportunity costs!

• Suppose we move one Brazilian worker from
  Computers to Shoes
• We lose 5 computers for 175 shoes
• For each additional pair of shoes produced,
  Brazil must forgo 0.03 computers (5/1750.029)
• The (constant) opportunity cost of each pair of
  shoes is 0.03 computer
• The (constant) opportunity cost of each computer
  is 35 pairs of shoes (175/535)

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Critical point

• Where is it RELATIVELY cheaper to produce
  computers?
• In the US it costs 4 shoes
• In Brazil it costs 35 shoes
• Where is it RELATIVELY cheaper to produce shoes?
• In the US it costs ¼ computer
• In Brazil it costs 0.03 computer

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Under trade, we may negotiate terms of trade
where MRT 100/10 10 or 175/17.5 10
In autarkic Brazil, the (constant) MRT 175/5
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In autarkic US, the (constant) MRT 200/50 4
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Terms of trade

• Obviously the US wants more than 4 pairs of shoes
  per computer (because this is its autarkic MRT)
• Obviously Brazil wants computers for less than 35
  pairs of shoes
• How do we get to the compromise of 10?

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Key problems

• Why dont we observe full specialization in one
  good per country?
• Why do some countries have a comparative
  advantage in some goods and not others?

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Neoclassical model 2 countries, 2 goods,
increasing opportunity costs
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• US is at EaA (autarkic America)
• Brazil is at EaB (autarkic Brazil)
• Satisfaction is at U0A U0B, respectively
• With trade, US shifts towards more computer
  production, Brazil towards shoes
• As they shift, however, OPPORTUNITY COSTS INCREASE

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Where do they stop?

• We continue until MRT(A)MRT(B)MRS(A)MRS(B)
• Suppose markets clear at an exchange ratio of 1
  computer for 6 pairs of shoes (light line in the
  figures)
• Countries move to CtA and CtB, respectively, and
  get U1A and U1B

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Why dont we get complete specialization?

• Specialization and trade eventually eliminate the
  differences with regard to opportunity costs
  between goods (because of increasing opportunity
  costs)

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WHY does one country have a comparative advantage
in one area?

• Heckscher-Ohlin
• Two basic kinds of countries

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Why does one country have a comparative advantage
in one area?

• Heckscher-Ohlin
• Compared to the availability of capital labor
  in one country, another country will have
  relatively more or less
• Capital-abundant countries Cost of capital
  relative to wages is lower
• Labor-abundant countries Wages relative to cost
  of capital is lower
• H-O suggests that countries have an advantage in
  producing different commodities because of the
  different factor endowments of countries and the
  different mixtures of these factors involved in
  production of different commodities
• Question regarding relatively capital abundant
  vs relatively labor abundant relative to
  what?
• Other countries? Or relative to the other factor?
• (Both)

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Recall a key point

• What drives comparative advantage?
• It is not differences in the cost of any single
  factor of production,
• but differences in the cross-national
  relative-abundance
• and thus the cross-national relative costs of
  factors of production
• So, even if Americans can make more shoes and
  more computers (absolute advantages in both),
  they should still shift to exporting computers
  and importing shoes

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So why is there protectionism?

• Well talk about Stolper-Samuelson and LOSERS
  from trade next time
• For now prisoners dilemma?
• Discuss is unilateral trade opening
  advantageous?

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PD settings?

• Prisoner's dilemma
• http//www.youtube.com/watch?vED9gaAb2BEwfeature
  related
• http//www.youtube.com/watch?vp3Uos2fzIJ0

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Prisoner's Dilemma

• A non-cooperative, non-zero-sum game. (Mixed game
  of cooperation and conflict.)
• Individual rationality brings about collective
  irrationality.

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• Example
• You're reading Tchaikovsky's music on a train
  back in the USSR.
• KGB agents suspect it's secret code.
• They arrest you a "friend" they claim is
  Tchaikovsky.
• "You better tell us everything. We caught
  Tchaikovsky, and he's already talking"

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• You know that this is ridiculous they have no
  case.
• But they may be able to build a case using your
  testimony and "Tchaikovsky's."
• If you "rat" out your "friend" they will reduce
  your sentence.
• If not, they will throw the book at you.

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Player 2
Player 1 Cooperate w/friend Defect (rat)
Cooperate w/friend -3, -3 -25, -1
Defect (rat) -1, -25 -10, -10
Player 2s suckers payoff
Player 1s suckers payoff
Nash equilibrium (Pareto sub-optimal)
Pareto optimal
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• Pareto optimality
• No one can be made better off without someone
  being made worse off
• Any change to make any person better off would
  make someone else worse off
• Nash equilibrium
• Every individual pursues his best strategy set,
  given the strategies of all other players
• No one would unilaterally defect
• If each player has chosen a strategy and no
  player can benefit by changing his or her
  strategy while the other players keep theirs
  unchanged, then the current set of strategy
  choices and the corresponding payoffs constitute
  a Nash equilibrium

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Individual rationality ? collective sub-optimality

• The same situation can occur whenever collective
  action is required
• The collective action problem is also called the
  n-person prisoner's dilemma
• Also called the free rider problem
• Tragedy of the commons
• All have similar logics and a similar result
• Individually rational action leads to
  collectively suboptimal results

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Is cooperation ever possible in Prisoner's
Dilemma?

• Yes ?
• In repeated settings
• Axelrod, Robert M. 1984. The Evolution of
  Cooperation. New York Basic Books.
• Example set of strategies?
• Tit-for-tat

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PD Example from the book

• Trade liberalization between US and China

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US
CHINA Liberalize Protect
Liberalize L,L L,P
Protect P,L P,P
China P,LgtL,LgtP,PgtL,P US L,PgtL,LgtP,PgtP,L
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Root of the imbalance between China and
USaccording to different theoretical approaches
Mercantalism Liberalism Marxism Interests Institutions
How do we describe the imbalance? What is the problem?
Solution? What is the appropriate policy response?
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Root of the imbalance between China and
USaccording to different theoretical approaches
Mercantalism Liberalism Marxism Interests Institutions
How do we describe the imbalance? What is the problem? China trying to gain power over the US
Solution? What is the appropriate policy response? Protectionism (buy American)
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Root of the imbalance between China and
USaccording to different theoretical approaches
Mercantalism Liberalism Marxism Interests Institutions
How do we describe the imbalance? What is the problem? China trying to gain power over the US Chinese and American intervention in the market
Solution? What is the appropriate policy response? Protectionism (buy American) Reduce the role of the state in the economy
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Root of the imbalance between China and
USaccording to different theoretical approaches
Mercantalism Liberalism Marxism Interests Institutions
How do we describe the imbalance? What is the problem? China trying to gain power over the US Chinese and American intervention in the market Chinese and American capitalists exploiting labor
Solution? What is the appropriate policy response? Protectionism (buy American) Reduce the role of the state in the economy Workers abandon nationalism and unite in revolution
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Root of the imbalance between China and
USaccording to different theoretical approaches
Mercantalism Liberalism Marxism Interests Institutions
How do we describe the imbalance? What is the problem? China trying to gain power over the US Chinese and American intervention in the market Chinese and American capitalists exploiting labor Leaders pursuing short-run goals of surviving in office
Solution? What is the appropriate policy response? Protectionism (buy American) Reduce the role of the state in the economy Workers abandon nationalism and unite in revolution Design institutions to structure proper incentives
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Next time

• Who loses from free trade?

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Take-homes

• Building blocks
• Consumption indifference curves
• Production possibility frontiers
• (Declining) Marginal Rate of Substitution
• (Constant or Increasing) Marginal Rate of Product
  Transformation
• Comparative advantage
• Opportunity costs
• Factor endowments
• Hecksher-Ohlin Model
• Prisoners dilemma
• Suckers payoff
• Tit-for-tat (cooperation possible in repeated
  PDs)
• Nash equilibrium
• Pareto sub-optimality

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Thank youWE ARE GLOBAL GEORGETOWN!