international trade & multinational business MIDTERM

L1-L4 stuff to understand & know

L1: 5 pillars of mercantilism and explanation and country application

Pillar	What it means	Connection to Country A
Strong and powerful governments	Economic wealth should strengthen the state’s political and military power.	Country A wants wealth to support its army, navy and merchant fleet.
Zero-sum nature of trade	Mercantilists viewed world wealth as fixed, so one country’s gain came at another country’s expense.	Its strategy aims to secure wealth and trading benefits for itself, including through control of colonial trade.
Labour theory of value	The value of goods is tied to the labour used to produce them; labour is a foundation of wealth creation.	Encouraging domestic production is consistent with this emphasis, although the scenario does not explicitly state this theory.
Regulation of economic activity	Government should direct economic activity towards national objectives.	Country A imposes tariffs, controls precious metals and grants exclusive trading rights.
Positive trade balance	Exports should exceed imports so that gold and silver flow into the country.	Country A encourages exports and restricts imported manufactured goods.

A strong state competes for fixed wealth, values labour, controls the economy and seeks a trade surplus.

L1: David Hume Mercantilism challenge (Hume’s Price–Specie–Flow Mechanism)

David Hume challenged the idea that a country could keep accumulating gold through a permanent surplus.

His argument was that the gold inflow itself would create changes that reduce the surplus.

Process:

1. The trade surplus brings gold and silver into Country A.

It receives more from exports than it pays for imports.

2. The inflow increases its money supply.
   In this historical system, precious metals form the monetary base.

3. Domestic prices rise; wages may also rise.
   In Hume’s model, more money relative to goods pushes prices upwards.

4. Country A becomes less internationally competitive.
   Its goods become more expensive relative to foreign goods.

5. Exports fall and imports rise.
   Foreign buyers purchase fewer of Country A’s goods. Buyers in Country A find foreign goods relatively cheaper.

6. The trade surplus shrinks towards balance.
   The changes in exports and imports reduce the original imbalance.

Surplus → specie inflow → money supply rises → prices rise → competitiveness falls → exports fall and imports rise → surplus shrinks.

L1: Adam Smith Mercantilism challenge

Idea	What it means
Self-interest	People and firms pursue their own benefits, such as income and profit.
Division of labour	Workers specialise in particular tasks, becoming more skilled and productive.
Invisible hand	Competition and market prices can coordinate self-interested decisions without government directing every activity.
Laissez-faire	Limited government interference in economic activity.
Absolute advantage	Countries benefit from specialising in goods they produce more efficiently and trading for other goods.

Adam Smith argued that countries could gain from trade by specialising in goods in which they have an absolute advantage and exchanging part of their output for goods produced more efficiently abroad. Specialisation improves resource allocation and can increase total output, allowing mutual gains from trade.

L1: absolute adv (smith) vs comparative adv (ricardian model)

Absolute advantage	Comparative advantage
Who uses fewer resources to produce the good?	Who sacrifices less of the other good to produce it?
Compare labour requirements across countries.	Calculate opportunity costs within each country, then compare them.

A country can have an absolute advantage in both goods and still benefit from importing one of them.

Assumptions of Ricardian Model

Assumption	Meaning
Fixed resources; identical units of each resource	The available resources do not change during the analysis.
Factors mobile within a country	Workers can move between domestic industries.
Factors immobile internationally	Workers do not move between countries in the model.
Labour theory of value	Relative labour requirements determine relative values in the basic model.
Fixed technology	Technology can differ between countries, but it does not change during the analysis.
Constant unit costs	Each additional unit requires the same labour input.
Full employment	Available resources are fully used.
Perfect competition	Firms are price takers, with free entry and full information.
No government trade barriers	No tariffs or other restrictions interfere with trade.
Zero transport costs	Moving goods does not add costs.
Two countries and two goods	The model simplifies the world to make the mechanism clear.

PPF and CPF

The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources.

The Consumption Possibilities Frontier (CPF) is a collection of points that represent combinations of cloths and wines that a country can consume if it trades.

Concept	Meaning
Production	What the country makes using its resources.
Consumption	What the country has available to use after exports and imports.
PPF	The frontier of combinations the country can produce with its resources and technology.
CPF	The frontier of combinations it can consume through trade, given its production and the international exchange rate.

Label on graph	Meaning
PPF	What the country can produce using its resources and technology.
F	Original production and consumption under autarky.
CPF1	Consumption possibilities with trade while production stays at F or H.
G	Production after complete specialisation.
CPF2	Consumption possibilities after specialisation and trade.

L1: PPF–CPF drawing procedure

1. Label the axes and units.
   Wine horizontally; cloth vertically.

2. Calculate maximum production of each good.
   Total labour divided by labour required per unit.

3. Draw and label the PPF.
   Join the intercepts with a straight line for this constant-cost model.

4. Mark the original autarky point.
   Verify that it satisfies the resource constraint.

5. Draw CPF1 through that point using the world price.
   Calculate its intercepts rather than guessing.

6. Identify comparative advantage and mark specialised production.
   A at the cloth endpoint; B at the wine endpoint.

7. Draw CPF2 through the specialised production point.
   Keep it parallel to CPF1 if the world price is unchanged.

8. If asked, mark consumption and calculate exports and imports.
   Explain why the consumption point demonstrates a gain.

A concise explanation accompanying Country A’s completed diagram could be:

Country A’s PPF has a slope of −3, indicating that producing one additional barrel of wine costs three yards of cloth. At the international exchange rate of one wine for 2.5 cloth, A can obtain wine more cheaply through trade. It specialises in cloth at G and trades along CPF₂, which has a slope of −2.5. By exporting 3,000 cloth for 1,200 wine, A can consume 6,000 cloth and 1,200 wine, compared with 6,000 cloth and 1,000 wine under autarky. Its consumption possibilities therefore expand beyond its unchanged PPF.

the PPF shows what the country can make; the CPF shows what that production can buy through trade.

L2: DIFF diagrams n what theyre abt

Decision	What is being chosen?	Diagram
Consumer	Quantities of goods X and Y	Indifference curves and budget line
Firm	Quantities of labour and capital	Isoquants and isocost line
Country	Production and consumption of X and Y	PPF, community indifference curves and price lines

L2: indifference curves have these properties:

Property	Explanation
Downward sloping	To receive more X while keeping satisfaction unchanged, the consumer gives up some Y.
Convex towards the origin	The willingness to sacrifice Y for additional X decreases as the consumer obtains more X.
Higher curves represent greater satisfaction	A curve farther northeast represents a preferred level of consumption.
They do not cross for consistent individual preferences	Crossing would give contradictory rankings of bundles.

Convex towards the origin means the curve is steep near the vertical axis and becomes flatter as you move right.

L2: What is the marginal rate of substitution?

The MRS measures how much Y the consumer is willing to sacrifice for one additional X while maintaining the same satisfaction.

Diminishing MRS means that willingness falls as the consumer gets more X and less Y. X becomes less scarce to the consumer, while the remaining Y becomes more valuable.

L2: CONSUMER VS PRODUCER DIAGRAM INFO

• Horizontal: labour, L

• Vertical: capital, L

The firm wants to obtain the greatest output from its production budget.

Consumer diagram	Producer diagram
Goods X and Y	Inputs L and K
Indifference curve: equal satisfaction	Isoquant: equal output
Budget line: equal spending	Isocost: equal production cost
Highest attainable satisfaction	Highest attainable output

L2: IMPORTANT abbreviations

• MRS: substitution between consumption goods.

• MRTS: substitution between production inputs.

• MRT: transformation between outputs on a PPF, which we’ll use shortly

L2: The isocost line and producer equilibrium

An isocost line shows input combinations with the same total cost.

Let:

• T = total production budget.

• w = wage per unit of labour.

• r = rental price per unit of capital.

The producer chooses the highest attainable isoquant.

equilibrium when: MPL/MPK=w/r

The last unit of money spent on either input produces the same additional output.

L2: Main four equilibrium conditions:

L3: Terms of trade shocks and economic effects

A terms-of-trade (TOT) shock refers to a sudden and significant change in the ratio of a country’s export prices to its import prices. Since TOT directly influences a nation’s real income and purchasing power in world markets, such shocks can have substantial and long-lasting macroeconomic consequences.

Economic Implications of TOT Shocks

•Income Effects: A decline in export prices relative to imports reduces the value of national output, lowering real income, GDP, and welfare.

•Balance-of-Payments Effects: Export revenues fall, potentially causing current account deficits and currency depreciation.

•Fiscal & Policy Impacts: Reduced government revenue from export taxes, increased borrowing, and the need for macroeconomic adjustments.

Investment & Growth Effects: Lower export earnings weaken investment capacity, reduce capital accumulation, and slow long-term growth

Lower export prices relative to import prices → weaker purchasing power → pressure on income, spending and investment.

L3: terms of trade and its measurement

Terms of trade measure the price of a country’s exports relative to the price of its imports.

TOT = Export price index / Import price index x 100

L3: Supply changes & restrictions can shift offer curves for ex:

Offer curves can shift because of changes in:

• Productivity.

• Available resources.

• Preferences and import demand.

• Trade restrictions.

• TARRIFFS: A tariff can reduce a country’s willingness to import and therefore reduce trade.

L3: Heckscher–Ohlin model

A country exports the good that uses its relatively abundant factor intensively and imports the good that uses its relatively scarce factor intensively.

Term	Describes
Factor abundance	A country’s resources relative to another country
Factor intensity	A good’s input requirements relative to another good

L3: A limitation of the H-O model (and why actual exports may differ from H–O predictions)

The basic H–O model assumes identical technology across countries. In reality, superior technology can reduce production costs and create export competitiveness independently of relative factor abundance, causing observed exports to differ from the model’s prediction.

differences in technology.

The basic H–O model assumes countries have the same technology. In reality, a country may possess superior technology that makes a product cheaper to produce.

That productivity advantage can influence exports independently of relative factor abundance.

L3: determining country abudance based on w/r (labor wages over capital returns)

Country’s resources	Relative factor-price relationship
Labour relatively abundant	Labour relatively cheap; lower (w/r)
Capital relatively abundant	Capital relatively cheap; higher (w/r)

• (w): wage, the price of labour.

• (r): rental rate or return to capital.

L3: factor-price equalisation

Under the model’s restrictive conditions, trade in goods can bring wages and capital returns towards equality across countries, even though workers and capital do not move internationally.

The connection is:

Trade changes goods prices → changes production incentives → changes factor rewards.

L3: SS relationship or how international trade affects w/r

Stolper–Samuelson relationship: a rise in the relative price of a good raises the real reward of the factor used intensively in that good and lowers the other factor’s real reward.

for ex: Under the Stolper–Samuelson relationship, trade raises the real reward of a country’s abundant factor and lowers that of its scarce factor. Vietnam specialises further in labour-intensive textiles, whose relative price rises with trade. Consequently, real wages increase, while real returns to relatively scarce capital decrease under the standard model’s assumptions.

Remember: Vietnam → labour abundant → workers gain; capital owners lose in real-return terms. National gains from trade do not mean everyone gains equally.

L3: SUMMARY OF MEANINGS CHART

Concept	What to check
Terms of trade	Export prices relative to import prices
Offer curve	Desired exports and imports at different exchange rates
Trade equilibrium	The countries’ desired exchanges match
TOT on an offer-curve graph	Slope of the ray from the origin
Factor abundance	Compare countries’ \(K/L\) ratios
Factor intensity	Compare industries’ \(K/L\) ratios
H–O prediction	Export goods intensive in the relatively abundant factor

L4: Modern trade theories to know!!!

Explanation	Relevant theory
One country develops technology before others (imitation then demand lag)	Technological Gap Theory
Production conditions change as a product develops	Product Life Cycle Theory
Countries have similar consumer demand	Linder’s Hypothesis
Larger markets reduce unit costs and offer greater variety	Krugman’s model
Firms compete internationally and differ in productivity	Firm-focused trade models

examples:

Example using electric vehicles:

• Imitation lag: complex battery technology or strong patent protection can make it take longer for foreign firms to develop a comparable EV.

• Demand lag: limited charging infrastructure can make foreign consumers slower to accept EVs.

L4: Product Life Cycle Theory: production locations change over time

Stage	What happens?	Trade and location pattern
New product	Innovation, experimentation and small-scale production; close contact with customers matters	Production initially concentrated in the innovating developed country; little trade
Maturing product	Demand expands, production becomes more established and economies of scale develop	Exports expand; firms may establish foreign production to serve growing markets
Standardised product	Technology becomes widely understood and price competition intensifies	Production can relocate to lower-cost developing countries; the original innovating country may import the product

Vernon’s theory explains how a product’s development can change where it is produced and traded.

main diff:

• Maturing: growing demand and established production encourage international expansion.

• Standardised: widely available technology and price competition encourage production in lower-cost locations.

L4: Linder’s Hypothesis: similar incomes create overlapping demand

Linder focuses on consumer demand.

The reasoning is:

1. Firms initially develop goods that satisfy their domestic customers.

2. Countries with similar income levels often have overlapping demand.

3. Products successful at home may therefore find customers in those similar foreign markets.

Linder’s hypothesis suggests that countries with similar per capita incomes tend to have overlapping consumer demand, encouraging trade in manufactured goods that meet those shared preferences.

L4: Krugman: economies of scale plus product differentiation

1. economies of scale: As a firm produces more, its average cost per unit falls.

2. product differentiation: Goods within an industry are similar but not identical.

Trade lets a country:

• Specialise in particular varieties.

• Sell those varieties to a larger market.

• Import other varieties for its consumers.

Larger markets → greater scale and lower unit costs.

Differentiated imports → greater choice and better matches with consumer preferences.

Possible disadvantages include:

• Foreign competition may reduce domestic firms’ sales, causing contraction or job losses.

• International transport and distribution add costs, potentially offsetting some consumer benefits.

L4: INTRA VS INTER INDUSTRY

Type	Meaning	Example
Inter-industry	Exchange between different industries	Exporting palm oil and importing machinery
Intra-industry	Simultaneous exports and imports within the same industry	Exporting some car models and importing others

L4: Reciprocal dumping

Under oligopoly, firms based in different countries may enter each other’s markets with similar products.

Each seeks additional sales and profits abroad, creating two-way trade.

The welfare effect can be mixed:

• Competition may benefit consumers.

• Transporting similar goods in opposite directions adds costs.

L4: Productivity differences and multiproduct exporting firms

Firms differ in efficiency. More productive firms are better able to cover the costs of entering foreign markets.

They can expand internationally, while less productive firms may remain domestic.

Trade can increase average industry productivity as market share shifts towards more efficient producers.

firms within the same country n industry dont have the same export opportunities.

L4: 2 types of economic growth

Economic growth: what changes on a PPF?

Growth expands the economy’s production possibilities.

It can come from:

• Technological improvement: producing more effectively with existing resources.

• Factor growth: obtaining more labour, capital or other productive resources.

However, the PPF does not always expand equally towards both goods.

L4: Production n consumption effects: protrade and antitrade growth

• X is the export good.

• Y is the import-competing good.

Region	Production change	Classification
I	Both outputs rise, but X grows proportionately faster than Y	Protrade
II	X output rises while Y output falls	Ultra-protrade
III	Both outputs rise, but Y grows proportionately faster than X	Antitrade
IV	Y output rises while X output falls	Ultra-antitrade

AND to find out consumption change, just replace output to consumption

Region	Consumption change	Classification
I	Both rise, but export-good consumption grows proportionately faster	Antitrade
II	Export-good consumption rises; import-good consumption falls	Ultra-antitrade
III	Both rise, but import-good consumption grows proportionately faster	Protrade
IV	Import-good consumption rises; export-good consumption falls	Ultra-protrade

L4: Income elasticity of demand for imports (YEM)

L4: Sources of Growth

Type	Meaning
Factor-neutral technological change	Improves the effectiveness of labour and capital without favouring one in the relevant comparison
Labour-saving technology	Encourages a more capital-intensive production method, such as automation
Capital-saving technology	Encourages a less capital-intensive method
Commodity-specific technology	Improves productivity in one good or sector
Factor growth	Increases available labour, capital or both

A manufacturing innovation might be:

• Labour-saving, because its method uses relatively more machinery.

• Commodity-specific, because it benefits manufacturing.

• Export-biased, because manufacturing produces the export good.

L4: Rybczynski theorem: more of one factor changes both outputs

An increase in one factor raises output of the good using that factor intensively and reduces output of the other good.

IF

X is labour-intensive.

Y is capital-intensive.

Factor increases	Output response
Labour increases	X rises; Y falls
Capital increases	Y rises; X falls

This theorem concerns actual output at unchanged prices, rather than simply changes in the PPF intercepts.

Now identify the trade effect.

If X is the export good:

• More labour → X rises, Y falls → ultra-protrade production effect.

• More capital → Y rises, X falls → ultra-antitrade production effect.

But the classification depends on the export pattern. If the capital-intensive good were the export good, capital growth would favour exports instead.

L4: SMALL vs LARGE countries growth effect

“small” means the country cannot influence world prices. not abt population or geographical size

	Small country	Large country
Can its trade changes influence world prices?	No	Yes
World-price lines after growth	Same slope	Slope may change
Terms-of-trade effect	None	May improve or deteriorate
Welfare assessment	Expanded possibilities at unchanged prices	Expanded possibilities plus the TOT effect

Small-country growth

World prices stay unchanged.

Growth expands production possibilities and, in the standard case, allows consumption on a higher community indifference curve.

The world-price lines are parallel.

Large-country export expansion

If growth substantially increases export supply:

1. More exports enter the world market.

2. Their relative price may fall.

3. The country’s TOT deteriorates.

4. The adverse price effect reduces the benefit from greater productive capacity.

In the diagram shown in your lecture, welfare still rises, but by less than it would have at unchanged world prices.

Growth towards import-competing production

If the country replaces more imports with domestic production, its import demand may fall. For a country with market power, this can improve its terms of trade.

L4: growth questions order

For the growth questions, use this decision order:

1. Identify the export good.

2. Identify what changed: technology, labour or capital.

3. Draw the correct PPF expansion.

4. Check whether world prices stay constant.

5. Identify the production changes.

6. Classify the production effect: protrade, ultra-protrade, antitrade or ultra-antitrade.

7. Include consumption and TOT effects if the question asks for the overall trade or welfare outcome.