International Business Environment – Midterm + Final summary 2017 PDF

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Vivian Veelenturf International Business Environment Midterm summary 2017 Lecture 1 The basics of International Trade International export to foreign markets or import of intermediate goods. Foreign direct setting up production sites or branch offices abroad (multinational activity). An investment i...

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Vivian Veelenturf

International Business Environment – Midterm summary 2017 Lecture 1 The basics of International Trade International trade= export to foreign markets or import of intermediate goods. Foreign direct investment(FDI)= setting up production sites or branch offices abroad (multinational activity). An investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate). FDI implies that the investor exerts a significant degree of influence on the management of the enterprise resident in the other economy. Such investment involves both the initial transaction between the two entities and all subsequent transactions between them and among foreign affiliates, oth iopoated ad uiopoated Most FDI flows from developed countries to developed countries. International portfolio investment= Auisitio of foeig fiaial assets. R efers to passive holdings of securities and other financial assets, which do not entail active management or control of the securities' issuer. Five dimensions of globalization:     

Cultural: Homogenization of cultual alues, gloal ultue? e.g. speadig of Adeia ultue Geographical: Compressed time and space due to more efficient transportation and communication technology. Institutional: Spread of universal institutional arrangements. Political: Declining role of nation-states, growing importance of global markets, increased international coordination and cooperation. Economic: Increased interdependence between national economies, rise of global markets (goods, labour, capital) > trade, multinational activity, international capital flows.  Rising international trade, capital flows, and globally fragmented production processes are the key manifestations of increasing economic globalization. This is the focus of this course.

Vivian Veelenturf

Traditional vs. Global production processes

The demand curve  shows the highest price a consumer is willing to pay for each unit. Low elasticity  . High elasticity  flat demand curve. The supply curve  shows the lowest price at which firms are willing to sell each unit (i.e. the marginal cost of producing this unit) Low elasticity  steep supply curve. High elasticity  flat supply curve.

Total welfare: Consumer surplus (A) + Producer surplus (B)

Vivian Veelenturf

National market with trade: - Imports change the consumer and producer surplus. - Consumer surplus: increases - Producer surplus: falls - Total effect: welfare gain (trade triangle C)

The net welfare gain (triangle C) can be separated into: 1. Consumption effect (red) = welfare gain due to increase in quantity consumed. 2. Production effect (blue) = welfare gain due to shifting to cheaper foreign producers.

Vivian Veelenturf

The excess demand in the national market is compensated by imports (as in previous example).

The excess supply in the national market is compensated by exports.

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Producer surplus increases by D+E Consumer surplus decreases by D Total effect: net gain of E (trade triangle)

The equilibrium is reached, when the demand for imports equals the supply of exports. The demand for imports (MD) curve shows the excess of domestic demand over domestic supply at prices below the autarky price level (P*). MD = 0 at P = P* The supply of exports (XS) curve shows the excess of domestic supply over domestic demand at prices above the autarky price level (P*). XS = 0 at P = P* World market equilibrium condition: MD = XS

Vivian Veelenturf

 Trade makes every country better off!  The lage the pie hage ΔP fo tade, the igge the elfae gai:  Gai i out X / Gai i out Y = ΔP i X / ΔP i Y  A steep import demand or export supply curve implies a larger price change.  Therefore, the country with the less elastic (steeper) curve gains more from free trade.

Lecture 2 Classical Trade Theory: Ricardo and Heckscher-Ohlin  Issue 1: What determines if and which products countries trade:  Absolute advantages (Smith): Produce and export what you can produce at lower costs than other countries. Import the rest.  Comparative advantage (Ricardo): Produce and export what you can produce relatively cheaper than other countries, so what you can produce at lower

Vivian Veelenturf opportunity costs than other countries. Import what involves higher opportunity costs.  Measured by using the opportunity costs of a good.  Production possibility curve = all combinations of two products that can be produced with the available resources. CLOTH WHEAT

US 4 units per hour of labour 6 units per hour of labour

ROW 2 units per hour of labour 1 unit per hour of labour

Opportunity cost Cloth US: (W/hour) / (C/hour) Opportunity cost Wheat US: (C/hour) / (W/hour) Opportunity cost Cloth ROW: Opportunity cost Wheat ROW:

= (6) / (4) = 1.5 Wheat per Cloth = (4) / (6) = 2/3 Cloth per Wheat = (1) / (2) = 0.5 Wheat per Cloth = (2) / (1) = 2 Cloth per Wheat So: - US is better at producing both goods. - US is relativelly better at producing wheat. - ROW is relativelly better at producing cloths.

Arbitrage Buy low, sell high Profits can be made from the fact that autarky prices are different, you buy 1 Cloth in ROW for 0.5 Wheat, and sell this Cloth in US for 1.5 W, which yields a profit of 1 W! - EVENTUALLY PRICES WILL CONVERGE, in between the two prices before trade US should specialize in wheat production, export wheat and import cloth. ROW should specialize in cloth production, export cloth and import wheat. Free trade expands the consumption possibilities in both countries.  Issue 2: Trade patterns based on comparative advantages:  With constant Marginal Costs  In the absence of trade, each country can consume only combinations of wheat and cloth that are on its PPC.  With free trade, each country can consume combinations of wheat and cloth that are on its trade line these involve more consumption of both goods.  Trade is worthwhile as long as the relative prices (opportunity costs) in the two countries differ.

Vivian Veelenturf  As countries trade, the relative prices converge: wheat will become relatively cheaper (less scarce) in ROW and more expensive (more scarce) in US.  Implies that the equilibrium international relative price must fall within the two autarky price ratios:

 Specialization according to comparative advantages is efficient: World production increases.  Absolute advantages (=the absolute level of labour productivity) determine the level of wages. Real wage = wage expressed in units of a good rather than money. Nominal wage: w = P x labour productivity. Real wage:  = w / P = labour productivity.  Low productivity countries have low real wages and therefore lower living standards.  Absolute advantage is not relevant for trade. Comparative advantage is.  Liitatio Riados theo: Costat agial osts.

 With rising Marginal Costs Constant marginal costs are unrealistic, because: Labour is not the only production factor; capital, land, skilled labour, unskilled labour.

Vivian Veelenturf  Iplies ieasig agial osts ad oed out podutio possiilit curves

 Wheat: land-intensive. Cloth: labour-intensive  Shifting production, changes proportions, e.g.: Reducing wheat production always releases relatively more land than labour (land-intensive good)  Initially, factors can be used relatively efficiently in cloth production, so cloth production expands a lot.  Subsequently, with too much land / too little labour, cloth production becomes increasingly more inefficient.  Less and less extra cloth is produced for each unit reduction in wheat production.  Firm profits are maximized when the opportunity costs equal the relative price. Optimal production point:

Vivian Veelenturf  Cosues idiffeee ues: The oiatios of osuptio quantities that deliver the same level of utility.

 Why bowed inward? Due to decreasing marginal utility from each good. First unit of cloth gives lots of extra utility, so consumption of wheat has to fall a lot to keep the utility level unchanged. Subsequent units of cloth generate less and less utility: wheat consumption has to fall less and less to keep the utility level constant.  Optimal consumption point: Utility maximization  Without trade: Find the indifference curve that just touches the production curve.  Before trade, wheat is cheap relative to the rest of the world  International trade raises the relative price of wheat. Cloth becomes cheaper, wheat more expensive.

Vivian Veelenturf  Country specializes in wheat and exports its surplus  Imports cloth from the rest of the world  Country achieves a higher indifference curve, thus gains.  Trade leads to an expansion of production of the now more expensive goods and an expansion of consumption of the now cheaper good.  The excess production is exported and the excess demand is imported.  The international equilibrium is achieved when the two trade triangles are the same size (XS = MD)  What determines the gains from trade?  The Terms of trade = price of exports / price of imports. A higher price of exports means you can buy more imports: larger gains from trade.

 Issue 3: Sources of comparative advantages:  Factor intensities and factor endowments (Heckscher-Ohlin)  Trade arises when autarky prices differ across countries  Generally, different prices can be the results of: Differences in production conditions, in demand, in factor endowments, in factor intensities. Heckscher-Ohlin theory:  Assumes technology is identical across countries  Assumes different factor intensities of production (land/labour-intensive)  Assumes different factor endowments across countries (land/labour abundant)

Vivian Veelenturf  Land is cheaper where it is abundant  Land-intensive goods can be produced relatively more cheaply where land is abundant: lower relative price of wheat.  Labour is cheaper where it is abundant  Relative produce of cloth is lower in labour-abundant countries.  Countries export the product that uses their abundant production factor intensively.  Couties ae epotig thei audat podutio fato.

Why...  ... is Chia the olds iggest to ake? Because toy production is labour intensive and China is labour abundant  ... are iPhoes desiged  Apple i Califoia, Asseled i Chia? Because assembly is unskilled labour intensive and design is human capital intensive  ... was Japan an important textile producer in the 1950s and an important electronics producer today? Because Japan went from being labour abundant to being capital abundant.

Lecture 3 Gains from trade and the impact of economic growth  Issue 1: Free trade causes winners and losers  Short-run: export (import) sector gains (loses)  Trade increases the relative price of the product in which a country has a comparative advantage (export-product).  Export-oriented sector expands, import-competing sector shrinks.  Factors of production used in the export-oriented sector gain (higher wages, land rents, capital rents), factors used in the import-competing sector lose.  Long-run: abundant (scarce) factor gains loses)  Production factors are mobile across sectors within a country. Factors move to the export-oriented sector because factor earnings are higher. Continues until factors are paid the same in all sectors. (see ppt.)  Winners: US landowners, foreign workers.  Losers: US workers, foreign landowners  Change in relative supply and demand of production factors changes earnings of factors: Stolper-Samuelson Theorem  Stolper-Samuelson theorem: an increase in the relative price of a good increases the real return to the factor used intensively in the production of this goods. Returns to the factor used intensively in the export- oriented sector (= abundant factor) increase, returns to the factor used intensively in the import-competing sector (= scarce factor) fall.

Vivian Veelenturf  Factor-price equalization (FPE): Assuming: (1) equal production technologies, (2) both goods are produced in both countries, (3) no transport costs. Then, free trade leads to: (1) equal product prices (wheat, cloth) (2) equal factor prices (wages, land rents). In real world: International factor prices are not the same, but evidence for convergence.

 Issue : Ipat of eooi goth o outs ell-being  Balanced growth Two sources of growth: (1) increase in outs edoet ith podutio factors. (2) improvements in production technology. Balanced growth= PPC shifts out in same proportions in direction of both goods. Proportionately, production patterns do not change.

 Unbalanced (biased) growth Biased growth = PPC shit biased in favour of one good. Production patterns change in favour of this good.  Biased growth may be in the extreme form of an expansion of just one production factor. This expands the production possibilities for both goods. But, the PPC shift is strongly biased in favour of the good that uses this factor intensively. Example: An increase in labour supply shifts the PPC in favour of cloth.

Vivian Veelenturf  Rybczynski Theorem:  In a two-good world, if the endowment of one factor (or its productivity) increases with the other factor and relative goods prices unchanged: (1) the production of the good that uses this factor intensively increases (2) The production of the other good declines. Duth disease: the disoe of the Goige gas fields i 5 led to a decline of the manufacturing sector.  Effect on terms of trade: If factor endowments increase, production possibilities expand  welfare increases. The factor that expands relatively more becomes relatively cheaper  the relative price of goods using this factor intensively falls. If this is the exported good, the term of trade ( Pex /Pim ) deteriorate: welfare falls. The net effect on welfare is unclear and depends on whether the country is a small or a large country. Small country  international relative price old P ill ot e affeted  the outs change in exports and imports. Implies that the terms of trade are unaffected. Therefore, outs elfae ieases. Large country  International relative price (world P) ill e affeted  the outs change in exports and imports. Decrease in exports and imports (smaller trade triangle): relative price of the export good increases, terms of trade improve. Even higher welfare gains than in the small-country case. Increase in exports and imports: relative price of export good falls, terms of trade deteriorate. The net effect on welfare is ambiguous. Immiserizing growth:  If growth is strongly biased toward expanding the supply of exports, the willingness to trade increases strongly.  If foreign demand for the outs poduts is e pie ielasti the relative price of this product will fall stogl ad the outs elfae decreases.  Mesmerizing growth less likely if a country has a balanced export portfolio  Policy implication: large countries should favour policies that expand the import-competing sector.

Vivian Veelenturf Technology and trade:  As we just saw, changes in the production technology will affect the PPC and alter production and trade pattern. Countries that used to have a comparative disadvantage in the production of a good can overtime develop a comparative advantage in it.  New production technologies usually come from R&D. R&D activity is intensive in high-skilled labour. Industrialized countries are abundant in high-skilled labour. Heckscher-Ohlin prediction: R&D done in industrialised countries. But, new technologies can be used anywhere (global diffusion). Product life-cycle:  As product and technology become more standard, relatively less skilled labour is needed in production: production location shifts to poorer countries abundant in low-skilled labour.  The original inventor (and exporter) of the good becomes an importer of it. Trade and Growth:  Eooi goth epads outies podutio possiilities ad their ability to trade. But expanding trade also promotes economic growth: (1) better access to foreign technologies (2) access to new and improved intermediate goods raises productivity of domestic production (3) higher competitive pressure creates incentives to innovate. Trade and income inequality:  Stolper-Samuelson theorem: predicts that trade will reduce real wages of low-skilled workers in industrialized countries relative to those of highskilled workers. Implies that trade will cause rising income inequality.  Research shows that extent of international trade and the resulting changes in relative prices are too small to explain the large shifts in the income distribution.  Production in industrialized countries has become even more high-skilled labour intensive despite falling wages of low-skilled labour.  Explanation rising income inequality  technological progress: (1) technological progress is typically skill-biased (2) it complements highskilled labour and replaces low-skilled labour (3) reduces the relative demand for low-skilled labour and increases the productivity of high-skilled workers: wage inequality increases.

Vivian Veelenturf

Lecture 4 Trade under imperfect competition Classical trade theories assume perfect competition: - Large number of small firms that are price-takers. - Predicts that trade is driven by differences in relative prices/comparative advantages - Implies that countries should export and import different products (no inter-industry trade) - Implies that similar countries (with similar factor endowments, production technology, etc.) should trade very little. In reality: - Substantial trading among similar countries - Countries export and import the same of very similar products (example: cars, cosmetic products)  intra-industry trade To understand this, we need imperfect competition Three theories that differ from perfect competition: 1. Product differentiation / monopolistic competition 2. Oligopoly 3. Firm clustering Intra-industry trade (IIT) = trade within industries; export and import products that are close substitutes. Two components of total trade (EXP + IMP) in given a product category/industry: Net Trade and IIT.  Net trade = absolute difference between EXP and IMP (so, |EXP – IMP|)  Implies IIT = EXP + IMP - |EXP – IMP|

 IIT share has increased over time.  Higher in high-income countries and where trade barriers and transport costs are low  Some IIT may be driven by comparative advantages (very broad product categories)  Could also be driven by seasonal fluctuations (agricultural products)  Most of IIT driven by product differentiation (e.g. different variants of cell phones, cars)

Vivian Veelenturf Imperfect competition = implies that firm has some market power; can influence the price of its products. The main underlying cause are the increasing returns to scale = falling average cost of production. Two sources of increasing returns to scale (scale of economies): - Internal scale economies:  Implies that large firms have lower average costs than small firms. Reasons:   up-front costs (fixed costs) of production   specialized equipment that only operates economically at high volumes  If internal scale economies are modest, there will be many firms.  If scale economies are substantial, there will be a few very large firms (oligopoly) - External scale economies:  Based on size of an entire industry in a certain area. Average costs of all firms in that industry and region fall as the output of the industry increases.  Implies that average costs in an area where the industry is large are low...