I BUS Concept Check 2

Law of one price

identical products sold in different countries must sell for the same price when expressed in the same currency in a competitive market that is free from transportation and trading costs

purchasing power parity (PPP)

in the absence of trade barriers, the same basket of goods should cost the same amount in different countries after converting currencies

efficient market

a market where prices reflect all available information

international monetary system

institutional arrangements that countries adopt to govern exchange rates

Mercantilism

• economic philosophy advocating that countries should simultaneously encourage exports and discourage imports

• it is in a country’s best interest to maintain a trade surplus (AKA exports > imports)

• government should intervene to achieve a surplus in the balance of trade protectionism

• viewed trade as a zero-sum game; for 1 person to win, another person has to lose

• the international finance system at that time was based on the gold/silver standard

Why do countries trade?

• specialization increases productivity, and exchange allows for the benefits of specialization (Absolute advantage)

• the efficiency of resource utilization leads to more productivity; should import even if the country is more efficient in the product’s production than the country from which it is buying (comparative advantage)

Theory of absolute advantage

• the capability of one country to produce more of a product w/ the same amount of input as another country; more efficient than any other country at producing it

• produce only goods where you are the MOST efficient, trade for those where you are NOT efficient → thus, trade between countries is beneficial

Autarky

• self sufficient

• no trade, poor employment of resources

Trade

better use of resources; more total output

Assumptions of the Smith-Ricardian theory of trade

• only two countries and two goods

• no transportation costs

• countries have similar prices and values

• fixed amounts of resources

• resources are mobile between goods within countries, but not across countries

• constant returns to scale

• no effects on income distribution within coountries

product life cycle

comparative advantage initially resides with the lead innovation nation and goes to others as the product goes through its life cycle stages

Porter’s Diamond Theory

competitive advantage of certain industries in different nations

Hecksher-Ohlin Theorem

countries have advantages in different goods due to factor endowments (land, capital, labor)

new trade theory

• the observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages

• economies of scale, first mover advantage

Smith-Ricardian Theory of Trade

• simple proof that specialization and trade lead to greater overall welfare even if one producer is more productive in all goods

• think in terms of opportunity cost

win-win perspective

• from a free trade perspective, best not to see world as “us” vs “them

• instead, free trade theory suggests that everyone is better off over the long run through free trade

• better to open rather than close borders

Protectionism

barriers to trade

Leontief Paradox

• based on Heckscher-Ohlin, the US should import labor-intensive goods and export capital-intensive goods

• but the opposite is the reality: export (skilled labor-intensive) software, import capital-intensive heavy machinery

Non-tariff barriers to trade

• subsidies/”cheap” exports

• trade-related aspects of intellectual property rights

• trade-related investment measures (TRIMS)

Subsidies/cheap exports

• in the US: cotton is subsidized

• in the EU: European cows

Trade-related aspects of Intellectual Property Rights

• TRIPs

• patent protection is essential to the recovery of R&D costs

• problems with the lack of enforcement/keep companies from trading

Trade-related investment measures

• TRIMS

• CKU: completed knockdown unit

• local content requirements; ex → USMCA and 75% rule for automobiles: if you make the cars in the US, you get a 75% tax advantage BUT reality: cars made elsewhere, disassemble, send it to the US, resemble in the US to qualify

Bretton woods system

• US dollar as the “world currency”

• all others are pegged to the dollar

• dollar was convertible to gold at $35 per oz

• why?: US economy accounted for 70% of global GDP in 1944 → had highest productivity and greatest trade surplus

Collapse of the Gold Standard

• 1973: end of Bretton woods

• gold standard abandoned: USD floats

• how to redeem all those USD at $35 per ounce?

• Vietnam: petro-dollar; inflation out of control; weakening export position; deteriorating current account

• first gas crises that we’ve ever had in the US

After Bretton Woods

• following the collapse of the Bretton Woods Agreement, a floating exchange rate regime was formalized in 1976 in Jamaica

• the rules for the international monetary system that were agreed upon at the meeting are still in place today

Foreign Exchange

• one the the key issues that differentiates international business from domestic business

• a commodity that consists of currencies issued by countries other than one’s own

Currency

• a strong dollar buys more foreign currency

• a weak dollar buys less foreign currency

Exchange rates

• the price of your currency in terms of my own currency

• why does it matter to me or my company? → determines how much I have to export to pay for my imports, so it affects the terms of trade!

Primary currency wants

• stable

• convertible

• commonly traded

Hard currencies

• currencies that are freely tradable, or convertible

• tend to maintain value

• ex: Euro, US dollar, Canadian dollar, Japanese yen

Soft currencies

• currencies that are not freely tradable b/c of domestic laws or the unwillingness of foreigners to hold them

• often lose value

• ex: Ruble, Dong, Cuban Peso

Exchange rate regimes

• free float

• dirty float

• fixed

• pegged

Free float

• leave it to supply and demand

• can be subject to high volatility/unpredictability

Dirty float

• allow float within a certain bandwidth

• how “dirty” depends on the bandwidth

• gov will intervene if it believes the currency has deviated too far from its fair value

Fixed

• set at a rate specified by governments

• a system under which the exchange rate for converting one currency into another is fixed

pegged

• linked to a single strong currency

• currency value is fixed relative to a reference currency

money supply

• the aggregated value of the money supply should reflect the value of the national economy

• changes in the money supply will put pressure on exchange rates

trade

• current account balance affects exchange rates:

• trade surplus: more money coming into the country than leaving it, this pushes $

• trade deficit: more money leaving the country, this pushes the $

• US used to have a current account surplus: it exported more than it imported, which propped up the dollar’s value

is a strong $ good or bad?

• appreciating currency is both good and bad

• a strengthening dollar helps: importers (& consumers of imported goods); US firms with offshore outsourcing; foreign debt holders

• a weakening dollar helps: domestic, import-competing industries; exporters; MNEs repatriating income from abroad

Managing exchange rates

• spot transactions

• currency hedging through forward contracts

• strategic hedging through geographic spread

• also: shifting x-rate risk onto your trading partner

spot transactions

see what you get when the account is due

currency hedging through forward contracts

hinges on prediction of x-rate fluctuations

strategic hedging through geographic spread

by spreading sales/production over many currency areas, it all “balances out in the end”

the Global Patchwork of Institutions

• institutions can be made at multiple levels

• patchwork of rules: which levels matter for firms?

• how do they facilitate or constrict international expansion by firms?

• e.g., less national, more global rule-making → more international expansion

multilateral institutions

organizations formed by three or more nations to coordinate policies, manage shared interests, and solve global challenges through collective action

various terrains:

• security (UN, NATO)

• Labor (ILO)

• Development (FAO, UNDP)

• Financial stability (IMF, World Bank, BIS)

• Trade (GATT/WTO)

GATT

• international treaty that committed signatories to lowering barriers to the free flow of goods across national borders and led to the WTO

• predecessor WTO

• General agreement on tariffs and trade

• dates from 1948

• aimed to address isolation/protectionism, which were seen as causes of WWII

• first round (1948) among 23 original members led to 45,000 concessions affecting 20% of world trade

Development of the GATT

three rounds

1. Kennedy round

2. Tokyo round

3. Uruguay round

Kennedy round

• 1960s

• focused on anti-dumping

Tokyo round

• 1970s

• limited; tariff reduction but general economic crisis precipitated new protectionism, esp. in agriculture

Uruguay round

• 1960s

• aimed at transforming GATT into the WTO

Moving to the WTO

GATT antiquated

• trade more complex

• trade in services growing

• international investment growing

• failure to liberalize agriculture, other non-tariff barriers

World Trade Organization (WTO)

154 Rue de Lausanne, Geneva

• responsible for setting international trade standards and settling trade disputes

• a forum for trade negotiations (166 members) with a secretariat

• DSPs (dispute settlement procedures): ‘binding’ through counter-measures

• includes services & intellectual property (GATS/TRIPS)

• reviews national policies to check for discrimination other members

• assists less-developed countries (LDCs) in trade policy through technical assistance and training

When multilateral institutions fail

When the WTO talks in Seattle collapsed: what did this mean for companies?

• US Fortune 500 firms lost a little over 1% of their market value, or about $200 million each

Why?

• lost opportunities stemming from stalled multilateral trade and investment regime

• firms with no overseas activity lost 0.9%; MNEs lost 1.8%

WTO Problems & Challenges *

what went wrong?

• Doha talks collapsed due to disagreement on how to move forward on reducing barriers to trade

• WTO bargaining structure unwieldy and complex

• decision making is not democratic in practice: biased towards big, economically powerful countries

Regional economic integration

• agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other

• over 50% of world trade today occurs under some form of preferential trade agreements signed by groups of countries

cooperating nations obtain:

• increased product choices, productivity, living standards

• lower prices

• more efficient resource use

Free Trade Area

• a group of countries committed to removing all barriers to the free flow of goods and services between each other but pursuing independent external trade policies

• simplest most common arrangement

• member countries agree to gradually eliminate formal trade barriers within the bloc, while each member maintains an independent international trade policy with countries outside the bloc

• Example: USMCA (NAFTA) → used to be

Customs Union

• a group of countries committed to 1) removing all barriers to the free flow of goods and services between each other and 2) the pursuit of a common external trade policy

• similar to a free trade area except the members enact common tariff and non-tariff barriers on imports from non-member countries

• example: MERCOSUR

Levels of regional integration

• common market

• economic union

• political union

common market

• a group of countries committed to 1) removing all barriers to the free flow of goods, services, and factors of production between each other and 2) the pursuit of a common external trade policy

• like customs union, except products, service, capital, labor, and technology can move freely among the member countries (ex. the EU)

economic market

• like a common market, but members also aim for common fiscal and monetary policies, and standardized commercial regulations

• also included the adoption of a common currency, harmonization of tax rates

• the EU is moving toward an economic union by forming a monetary union w/ a single currency, the Euro

Political union

political organization coordinates the economic, social, and foreign policy of its member states

gains from trade

the economic benefits realized when countries specialize in the production (and export) of goods and services that they can produce most efficiently, while importing goods and services that they cannot produce so efficiently from other nations

free trade

the absence of barriers to the free flow of goods and services between countries

new trade theory

the observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages

factor endowments

a country’s endowment with resources such as land, labor, and capital

zero-sum game

situation in which an economic gain by one country results in an economic loss by another

constant returns to specialization

• units of resources required to produce a good are assumed to remain constant no matter where one is on a country’s production possibility frontier

• assumes constant cost of production, so specialization brings consisting efficiency rather than increasing/decreasing returns

economies of scale

cost advantages associated with large-scale production

first-mover advantages

economic and strategic advantages that accrue to early entrants into an industry

balance of payments accounts

national accounts that track both payments to and receipts from foreigners

current account

• in the balance of payments, records transactions involving the export or import of goods and services

• records transactions that pertain to four categories: goods, export and import of services, primary income receipts or payments, secondary income receipts or payments

current account deficit

the current account of the balance of payments is in deficit when a country imports more goods, services, and income than it exports

current account surplus

the current account of the balance of payments is in surplus when a country exports more goods, services, and income than it imports

capital account

in the balance of payments, records transactions involving one-time changes in the stock of assets

financial account

in the balance of payments, transactions that involve the purchase or sale of assets

import tariff

a tax levied on imports of goods or services

specific tariffs

a tariff levied as a fixed charge for each unit of good imported

Ad valorem tariffs

a tariff levied as a proportion of the value of an imported good

export tariff

a tax placed on the export of a good

export ban

a policy that partially or entirely restricts the export of a good

subsidy

government financial assistance to a domestic producer

import quota

a direct restriction on the quantity of a good that can be imported into a country

tariff rate quota

lower tariff rates applied to imports within the quota than those over the quota

voluntary export restraint (VER)

a quota on trade imposed from the exporting country’s side, instead of the importer’s; usually imposed at the request of the importing country’s government

quota rent

extra profit producers make when supply is artificially limited by an import quota

local content requirement (LCR)

a requirement that some specific fraction of a good be produced domestically

administrative trade policies

administrative policies, typically adopted by government bureaucracies, that can be used to restrict imports or boost exports

dumping

selling goods in a foreign market for less than their cost of production or below their “fair” market value

antidumping policies

designed to punish foreign firms that engage in dumping and thus protect domestic producers from unfair foreign competition

countervailing duties

antidumping duties

infant industry argument

new industries in developing countries must be temporarily protected from international competition to help them reach a position where they can compete on world markets with the firms of developed nations

strategic trade policy

government policy aimed at improving the competitive position of a domestic industry and/or domestic firm in the world market

• theorists argue that a gov can help raise national income if it can somehow ensure that the firm(s) that gain first-mover advantages in an industry are domestic rather than foreign enterprises

• it may pay a gov. to intervene in an industry by helping domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages

Smoot-Hawley Act

enacted in 1930 by the U.S. Congress, this act erected a wall of tariff barriers against imports into the United States

bilateral or multilateral trade agreements

reciprocal trade agreements between two or more partners

regional economic integration

agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other

rules of origin

a certain percentage of the value of a good has to be produced by countries within the free trade area

European Free Trade Association (EFTA)

a free trade association including Norway, Iceland, Liechtenstein, and Switzerland

Trade creation

• trade created due to regional economic integration

• occurs when high-cost domestic producers are replaced by low-cost foreign producers within a free trade area

trade diversion

• trade diverted due to regional economic integration

• occurs when low-cost foreign suppliers outside a free trade area are replaced by higher-cost suppliers within a free trade area

European Union (EU)

an economic and political union of 27 countries (2020) that are located in Europe

product of two political factors

• devastation of western Europe during two world wars and the desire for a lasting peace and

• the European nations’ desire to hold their own on the world’s political and economic stage; in addition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries