TÀI LIỆU ÔN TẬP KINH TẾ QUỐC TẾ (E)

1.*Absolute advantage is the ability of an individual, company, region, or country to

produce a greater quantity of a good or service with the same quantity of inputs per unit
of time, or to produce the same quantity of a good or service per unit of time using a lesser
quantity of inputs, than its competitors.

Absolute advantage can be accomplished by creating the good or service at

a lower absolute cost per unit using a smaller number of inputs, or by a more efficient
process.

*Comparative advantage is an economy's ability to produce a particular good or service

at a lower opportunity cost than its trading partners. Comparative advantage is used to
explain why companies, countries, or individuals can benefit from trade.

When used to describe international trade, comparative advantage refers to the products
that a country can produce more cheaply or easily than other countries. While this usually
illustrates the benefits of trade, some contemporary economists now acknowledge that
focusing only on comparative advantages can result in exploitation and depletion of the
country's resources.

*Absolute advantage can be contrasted with comparative advantage, which is when a

producer has a lower opportunity cost to produce a good or service than another producer.
An opportunity cost is the potential benefits an individual, investor, or business misses
out on when choosing one alternative over another.

Absolute advantage leads to unambiguous gains from specialization and trade only in
cases where each producer has an absolute advantage in producing some good. If a
producer lacks any absolute advantage, then Adam Smith’s argument would not
necessarily apply.

However, the producer and its trading partners might still be able to realize gains from
trade if they can specialize based on their respective comparative advantages instead.

*Put simply, an opportunity cost is a potential benefit that someone loses out on when
selecting a particular option over another. In the case of comparative advantage, the
opportunity cost (that is to say, the potential benefit that has been forfeited) for one
company is lower than that of another. The company with the lower opportunity cost, and
thus the smallest potential benefit which was lost, holds this type of advantage.

2.*The Ricardian model explained international trade using differences in labor

productivity. Ricardo explained the variances in relative imports and exports of different
countries within similar industries. He based his model on the comparative costs of
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production, with a single factor of production used to explain the benefits of international
trade. This however, neglected the variations in the factors of production of each country.
The Heckscher-Ohlin expands on the Ricardian model to include: two factors of
production, comparative advantage due to relative variations in more than one factor, and
the production reliance of each country on the resources it has in abundance. In general,
unlike the Ricardian model, the Heckscher-Ohlin theory focused on the efficiency of the
production process as a whole based on the country’s factor endowment. As such, based
on differences in assumptions on variables, comparative cost theory, theories of
international trade, cost differences, factors of production and …show more content…

In Ricardo’s model, everyone within the country gains from trade whereas in the
Heckscher - Ohlin model, the abundant factor stands to gain more while the scarce factor
loses

* Assumptions of the Heckscher Ohlin Model

 There are two countries in the picture. It is used to make the model plainer and
simpler.
 There are two factors – capital and labor. There is a constraint in aspects, i.e., the
factors are limited to the funding (endowment) of the country.
 Countries have similar production technology. Therefore, governments will share
the same technologies. Though it is not realistic, this assumption eliminates the trade
differences because of technological differences.
 Prices are the same everywhere.
 The tastes in the two countries are identical. Similar to technology, this is assumed
to eliminate the difference in preferences.
The two countries have different relative factor endowments: capital, land, and
labor. Based on the relative factor endowments, countries are classified as capital
abundant, labor abundant, or land abundant.
 Factor Intensities may vary. Similar to above, based on relative factor intensities,
goods are classified as capital intensive, labor-intensive or land-intensive.

* Components of the Heckscher Ohlin Model

The four major components of the theory are as follows

 Factor Price Equalization Theorem – The most fragile of all, The FPE states that
the prices of factors of production will be equalized among countries because
of international trade.
 Stolper-Samuelson Theorem – The Stolper-Samuelson theorem (SST) proposed
that, in any particular country, an increase in the relative prices of the labor-
intensive goodwill make labor better off and capital worse-off, and the converse
also applies.

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  Rybczynski Theorem – make labor better off and capital worse-off, and the
converse also applies.
At constant prices, an increase in endowment of one factor will lead to an expansion
in the sector’s output that uses that factor and will lead to a complete decline in
production of the other goods.
 Heckscher-Ohlin Trade Theorem – This is a critical theorem of this model, which
boils down to this statement “a country having capital in abundance will produce
goods that are capital intensive, and a country having abundant labor will produce
labor-intensive goods. ”

* How is the Heckscher Ohlin Model Superior to Classical Theory?

 It is a better explanation of the world economy after the second world war.
 The traditional Ricardian theory overlooked the demand factors and completely
focused on the supply factors. The H-O model is relatively better and considers both
supply and demand.
 The classical theory ignored capital and assumed labor as the only factor of
production.
 Hence, the classical theory accredits any difference in costs to the differences in
labor.
 The H-O model is more specific and realistic when compared to the classical
approach.
 This model also brings about integration between trade theories and value theories.

* labor - intensive commodity: Labor intensive refers to a process or industry that

requires a large amount of labor to produce its goods or services.

*The term "capital intensive" refers to business processes or industries that require large
amounts of investment to produce a good or service and thus have a high percentage of
fixed assets, such as property, plant, and equipment
*Capital to Labour ratio measures the ratio of capital employed to labour employed.
The capital-labour ratio (K/L) can measure the capital intensity of a firm.
*In a capital-abundant nation, the price of capital (r) increases and the price of labor
(w) decreases. (The reverse happens for a labor-abundant nation.) However, because trade
increases overall income, the loss of income by workers is exceeded by the gain in income
by owners of capital.
*labor-abundant nation in the Hecksher-Ohlin model :The Heckscher-Ohlin (H-O)
theorem states that a country that is capital abundant will export the capital-intensive good.
Likewise, the country that is labor abundant will export the labor-intensive good. Each

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country exports that good that it produces relatively better than the other country. In this
model, a country’s advantage in production arises solely from its relative factor abundancy.
*The factor-price equalization theorem says that when the prices of the output goods are
equalized between countries, as when countries move to free trade, the prices of the factors
(capital and labor) will also be equalized between countries.
3. Economies of scale occurs when more units of a good or service can be produced on
a larger scale with (on average) fewer input costs. External economies of scale can also
be realized whereby an entire industry benefits from a development such as improved
infrastructure.
Product differentiation is what makes your product or service stand out to your target
audience. It's how you distinguish what you sell from what your competitors do, and it
increases brand loyalty, sales, and growth. Focusing on your customers is a good start to
successful product differentiation.
overlapping demands suggests that international trade in manufactured goods will be
stronger between countries with similar per capita income levels.
Difference between Inter-industry and Intra-industry trade

Although their wording is very similar the terms ‘inter-industry’ and intra-industry’ trade
have a very different meanings.

Inter-industry trade is a trade of products that belong to different industries. For instance,
the trade of agricultural products produced in one country with technological equipment
produced in another country can be classified to be an inter-industry trade. Countries
usually engage in inter-industry trade according to their competitive advantages.

Intra-industry trade, on the other hand, is a trade of products that belong to the same
industry. As it has been noted, “intra-industry trade (IIT), that is trade of similar products,
has been a key factor in trade growth in recent decades. These trends have mostly been
attributed to the fragmentation of production (outsourcing and offshoring) as a result of
globalisation and new technologies” (Handjiski et al, 2010, p.15).

Explanation of Intra-Industry Trade by Economic Theory

It first sight it may seem strange that countries do engage in importing and exporting same
type of products with their international partners. However, there are a range of benefits
intra-industry trade offers businesses and countries engaging in it in general.

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The benefits of intra-industry trade have been explained by various business researchers,
and all of these benefits can be summarised into three points that which is illustrated by
Johnson and Taylor (2009) in the following way:

Firstly, intra-industry trade increases the variety of products the same industry, which is
beneficial to both, businesses, as well as consumers. This benefit of intra-industry trade is
possible because today product range from the same industry can be highly differentiated,
and intra-industry trade will provide the opportunity of having a vast range of differentiated
products within the markets of trading partners.

Secondly, intra-industry trade gives opportunity for businesses to benefit from the
economies of scale, as well as use their comparative advantages. In other words countries
will get more economic benefits if they concentrate on producing specific types of products
within specific range, according to their comparative advantages rather than producing all
ranges of specific products.

Thirdly, inter-industry trade stimulates innovation in industry, and can assist the economy
in cases of short-term economic fluctuations.

The main benefit of intra-industry trade can be explained in simple terms by using an
example of car trade between Japan and Germany. Let’s suppose Toyota, a Japanese car
company mainly produces family cars, and German car manufacturer Audi concentrates
on producing sport cars. Accordingly, when Toyota produces more family cars, the lower
will be the unit cost, and similarly, more sports cars are produced by Audi, the lower unit
price of the car will be.

5. Understand the effect of import tariff imposed by a small nation on (i) the domestic price
of imported goods; (ii) the degree of specialization in production; (iii) the volume of trade;
(iv) the welfare of the nation. Evaluate the arguments in favour of trade restrictions.

i:The small country assumption means that the country’s imports are a very small share of
the world market—so small that even a complete elimination of imports would have an
imperceptible effect on world demand for the product and thus would not affect the world
price. Thus when a tariff is implemented by a small country, there is no effect on the world
price.The small country assumption implies that the export supply curve is horizontal at
the level of the world price. The small importing country takes the world price as
exogenous since it can have no effect on it. The exporter is willing to supply as much of
the product as the importer wants at the given world price.When the tariff is placed on
imports, two conditions must hold in the final equilibrium—the same two conditions as in

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the case of a large country.The most basic effect that an import tariff has is to raise
domestic prices in the country imposing the tariff. In “small countries” (defined for our
purposes as countries that do not have an influence on international prices), the rise in
domestic price is equivalent to the amount of the tariff.

iii: An import tariff will raise the domestic price and, in the case of a small country, leave
the foreign price unchanged. An import tariff will reduce the quantity of imports. An
import tariff will raise the domestic price of imports and import-competing goods by the
full amount of the tariff.

iv. Whenever a small country implements a tariff, national welfare falls. The higher the
tariff is set, the larger will be the loss in national welfare. The tariff causes a redistribution
of income. Producers and the recipients of government spending gain, while consumers
lose.

6. Understand the similarities and differences between an import quota and an import tariff
for the small country model. Indentify the protection and consumption effects of an import
quota.

The difference between quotas and tariffs

Quotas and tariffs are both used to protect domestic industries by artificially raising prices
in the domestic market. Their administration and effects, however, differ in specific ways.
Quotas restrict the quantity of a good imported from another country. Tariffs are a charge
levied on the value of goods imported from another country.

While tariffs generate revenue that is paid to the importing country’s treasury, the value of
a quota, also called “quota rents,” generally goes to the foreign exporters who are able to
sell goods subject to the quota at higher prices and collect higher per unit revenue. In both
cases, domestic consumers in the importing country pay the costs of tariffs and quota rents.
But with quotas, the government of the importing country receives no revenue. Quotas can
be much more complicated to administer than tariffs. Tariffs are collected by a customs
authority as goods enter a country. With quotas, customs authorities must either monitor
imports directly to ensure that no goods above the quota amount are imported, or can award
licenses to specific companies, giving them the right to import the amount allowed under
the quota. Quotas can also take the form of a voluntary export restraint (VER), where the
exporting country administers the quota.

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7. Understand export subsidies and analyze welfare effects of export subsidies in a small
economy. (Chap 9)
Export subsidies are direct payments (or the granting of tax relief and subsidized loans)
to the nation’s exporters or potential exporters and/or low-interest loans to foreign buyers
to stimulate the nation’s exports. As such, export subsidies can be regarded as a form of
dumping. Although export subsidies are illegal by international agreement, many nations
provide them in disguised and not-so-disguised forms.
Analyze:
Export subsidies can be analyzed with Figure 9.2, which is similar to Figure 8.1. In
Figure 9.2, DX and SX represent Nation 2’s demand and supply curves of commodity
X. If the free trade world price of commodity X were $3.50 (instead of $1.00, as in
Figure 8.1), Nation 2 would produce 35X (AC ), consume 20X (AB), and export the
remaining 15X (BC ). That is, at prices above $3 (point E in the figure), Nation 2 became
an exporter rather than being an importer of commodity X.
If the government of Nation 2 (assumed to be a small country) now provides a subsidy
of $0.50 on each unit of commodity X exported (equal to an ad valorem subsidy of 16.7
percent), PX rises to $4.00 for domestic producers and consumers of commodity X. At PX
= $4, Nation 2 produces 40X (GJ ), consumes 10X (GH ), and exports 30X (H J ). The
higher price of commodity X benefits producers but harms consumers in Nation 2. Nation
2 also incurs the cost of the subsidy. Specifically, domestic consumers lose $7.50 (area a
+ b in the figure), domestic producers gain $18.75 (area a + b + c), and the government
subsidy is $15 (b +c + d). Note that area d is not part of the gain in producer surplus because
it represents the rising
domestic cost of producing more units of commodity X. Nation 2 also incurs the protection
cost or deadweight loss of $3.75 (the sum of the areas of triangles BH N = b = $2.50
and C J M = d = $1.25)

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 Since domestic producers gain less than the sum of the loss of domestic consumers and
the cost of the subsidy to Nation 2’s taxpayers (i.e., since Nation 2 incurs a net loss equal
to the protection cost or deadweight loss of $3.75), the question is: Why would Nation
2 subsidize exports? The answer is that domestic producers may successfully lobby the
government for the subsidy or Nation 2’s government may want to promote industry X, if
industry X is a desired high-technology industry (this will be discussed in Section 9.5).
Note
that foreign consumers gain because they receive 30X instead of 15X at PX = $3.50 with
the subsidy. If Nation 2 were not a small nation, it would also face a decline in its terms of
trade because of the need to reduce PX in order to be able to export more of commodity X

8. Understand technical barriers to trade (TBT), Sanitary and Phytosanitary (SPS) Measures,
dumping and their impacts on exporting country. (chap 9)

Dumping is the export of a commodity at below cost or at least the sale of a commodity at
a lower price abroad than domestically. Dumping is classified as persistent, predatory, and
sporadic
Persistent dumping, or international price discrimination, is the continuous tendency of a
domestic monopolist to maximize total profits by selling the commodity at a higher price

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in the domestic market (which is insulated by transportation costs and trade barriers) than
internationally (where
it must meet the competition of foreign producers)
Predatory dumping is the temporary sale of a commodity at below cost or at a lower
price abroad in order to drive foreign producers out of business, after which prices are
raised
to take advantage of the newly acquired monopoly power abroad. Sporadic dumping is the
occasional sale of a commodity at below cost or at a lower price abroad than domestically
in order to unload an unforeseen and temporary surplus of the commodity without having
to reduce domestic prices
SPS Measures as any measure applied to:
• protect animal or plant life or health within the territory of the Member from risks arising
from the entry, establishment or spread of pests, diseases, disease-carrying organisms or
diseasecausing organisms;
• protect human or animal life or health within the territory of the Member from risks
arising from additives, contaminants, toxins or disease-causing organisms in foods,
beverages or feedstuffs;
• protect human life or health within the territory of the Member from risks arising from
diseases carried by animals, plants or products thereof, or from the entry, establishment or
spread of pests; • prevent or limit other damage within the territory of the Member from
the entry, establishment or spread of pests.
Technical barriers to trade (TBT)
This agreement deals with all technical requirements, voluntary standards and conformity
assessment procedures, except when these measures are covered by the SPS Agreement,
and ensures that they do not create unnecessary obstacles to trade. To do so, the agreement
calls upon Members to use international standards (Article 2.4). It also encourages
Members to recognize as equivalent the requirements of other Members, even if they differ
from their own, provided that they fulfil the same final objective (Article 2.7). Similarly,
in order to avoid the multiplication of tests, Members are encouraged to recognize other
Members’ conformity assessment procedures (Article 6.1). Furthermore, Members should
not discriminate between countries: the same requirements should be applied to imported
and domestic products. If a measure is applied to imports from one source, then it also has
to be applied to imports from all other sources.

Both the SPS and TBT agreements contain provisions on technical assistance (Article 9 in
the SPS Agreement and Article 11 in the TBT Agreement), and special and differential
treatment (Article 10 in the SPS Agreement and Article 12 in the TBT Agreement) to help
developing countries and LDCs to implement and take advantage of the agreement. Despite
this support, developing countries and LDCs encounter difficulties in the implementation
of the SPS and TBT agreements. One of their main concerns arises from the definition of

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 standards, shaped largely by the interests of developed countries, which are the main
players in the standards-setting bodies.
9. Understand the distictions between different regional trading agreements: free trade area,
customs union, common market, economic union; Understand and analyze the costs and
benefits from joining a trading bloc; understand trade creation and trade diversion effects.
(chap 10)
A free trade area is the form of economic integration wherein all barriers are
removed on trade among members, but each nation retains its own barriers to
trade with nonmembers.
A customs union allows no tariffs or other barriers on trade among members (as in a free
trade area), and in addition it harmonizes trade policies (such as the setting of common
tariff
rates) toward the rest of the world
A common market goes beyond a customs union by also allowing the free movement of
labor and capital among member nations. The EU achieved the status of a common market
at the beginning of 1993
An economic union goes still further by harmonizing or even unifying the monetary and
fiscal policies of member states. This is the most advanced type of economic integration.
An example is Benelux, which is the economic union of Belgium, the Netherlands, and
Luxembourg, formed after World War II (and now part of the EU). An example of a
complete economic and monetary union is our own United States.
Difference between free trade area and customs union

A customs union has a common external tariff on imports. This means that it doesn’t matter
which country the imports enter – because all countries have the same import tariff. This
means there doesn’t need to be internal checking on ‘Rules of origin‘. For example, if
imports from Africa enter Spain then if goods travel across the border from Spain to France,
there is no need to check whether goods are paying the correct import tariff – because the
import tariffs are all the same.
A disadvantage of joining a customs union is that a country is not able to pursue its own
independent trade deals. However, since trade deals are complicated and take several years,
there is an advantage to negotiating trade deals as part of a regional trade block – rather
than separate individual countries.

Trading blocks are groups of countries who form trade agreements between themselves.
Trading blocks can include

 Free trade areas – elimination of tariffs between economies in the trading block
 Customs union – free trade area + a common external tariff with non-members
 Economic union/Single market – Customs union + common rules and regulations.

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Different types of trading blocks

Trading blocks have become increasingly influential for world trade.

 They have advantages in enabling free trade between geographically close

countries. This can lead to lower prices, increased export potential, higher growth,
economies of scale and greater competition.
 However, it can lead to compromise as countries pool economic sovereignty. Also,
the move to free trade tends to create winners and losers – with some domestic
industries losing out to lower-cost imports.
Advantages of trading blocks

 Tariff removal leads to trade creation – lower prices for consumers and greater
opportunity for exporters.
 Increased trade enables increased specialisation – which gives benefits
of economies of scale (lower average costs from increased output)
 Catch-up effects. Countries joining a rich trading block can benefit from inward
investment and increased trade opportunities. Countries in Eastern Europe have
made considerable progress in catching up with average income levels in Western
Europe.
 Gravity theory of trade suggests that trade with countries in close proximity is the
most important due to lower transport and similar cultural and economic ties.
 Gives small countries a greater say in global trade agreements
 Increased competition. The removal of tariffs creates greater choice for consumers.
Therefore domestic firms have a greater incentive to cut costs to remain competitive.
Disadvantages of trading blocks

 Joining a customs union may lead to increased import tariffs – which leads to trade
diversion. For example, when the UK joined the EEC customs union, it required
higher import tariffs on imports from former Commonwealth countries. This led to
switch in demand towards higher-cost European countries and caused loss of
business for Commonwealth countries

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  Increased interdependence on economic performance in other countries in trading
block. If Eurozone goes into recession, it will affect all countries in the Eurozone.
However, this is almost inevitable even if countries are not formally in a trading
block due to a close relationship between trade cycles in different countries.
 Loss of sovereignty and independence. A trading block needs to make decisions for
the whole area. This may go counter to the particular wishes of a country.
 Increased influence of multinationals. In a bilateral deal between the US and South-
East Asian trading block. Free trade may come at the price of allowing free
movement of capital. This can have benefits in terms of inward investment. But, can
also have costs for higher-cost domestic producers. Free trade can lead to structural
unemployment as resources shift from uncompetitive industries to newer industries.

Understand trade creation and trade diversion effects

Trade diversion occurs when lower-cost imports from outside the customs union are
replaced
by higher cost imports from a union member. This results because of the preferential
trade
treatment given to member nations. Trade diversion, by itself, reduces welfare because
it
shifts production from more efficient producers outside the customs union to less
efficient
producers inside the union. Thus, trade diversion worsens the international allocation
of
resources and shifts production away from comparative advantage.

Trade Creation and Trade Diversion

In this section, we present an analysis of trade diversion and trade creation. The analysis
uses a partial equilibrium framework, which means that we consider the effects of
preferential trade liberalization with respect to a representative industry. Later in the
section we consider how the results from the representative industry cases can be extended
to consider trade liberalization that covers all trade sectors.

We assume in each case that there are three countries in the world: Countries A, B, and C.
Each country has supply and demand for a homogeneous good in the representative
industry. Countries A and B will form a free trade area. (Note that trade diversion and
creation can occur regardless of whether a preferential trade agreement, a free trade area,
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or a customs union is formed. For convenience, we’ll refer to the arrangement as a free
trade area [FTA].) The attention in this analysis will be on Country A, one of the two FTA
members. We’ll assume that Country A is a small country in international markets, which
means that it takes international prices as given. Countries B and C are assumed to be large
countries (or regions). Thus Country A can export or import as much of a product as desired
with Countries B and C at whatever price prevails in those markets.

We assume that if Country A were trading freely with either B or C, it would wish to import
the product in question. However, Country A initially is assumed not to be trading freely.
Instead, the country will have an MFN-specific tariff (i.e., the same tariff against both
countries) applied on imports from both Countries B and C.

In each case below, we will first describe an initial tariff-ridden equilibrium. Then, we will
calculate the price and welfare effects that would occur in this market if Countries A and
B form an FTA. When the FTA is formed, Country A maintains the same tariff against
Country C, the non-FTA country.

Trade Diversion

In general, a trade diversion means that a free trade area diverts trade away from a more-
efficient supplier outside the FTA and toward a less-efficient supplier within the FTA. In
some cases, trade diversion will reduce a country’s national welfare, but in some cases
national welfare could improve despite the trade diversion. We present both cases below.

Figure 9.10 "Harmful Trade Diversion" depicts the case in which trade diversion is harmful
to a country that joins an FTA. The graph shows the supply and demand curves for Country
A. PB and PC represent the free trade supply prices of the good from Countries B and C,
respectively. Note that Country C is assumed to be capable of supplying the product at a
lower price than Country B. (Note that in order for this to be possible, Country B must
have tariffs or other trade restrictions on imports from Country C, or else all of B’s market
would be supplied by C.)

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Table 9.16 Welfare Effects of Free Trade Area Formation: Trade Diversion Cases

Country A
Consumer Surplus + (a + b + c + d)
Producer Surplus −a
Govt. Revenue − (c + e)
National Welfare + (b + d) − e

Free trade area effects on Country A’s consumers. Consumers of the product in the
importing country benefit from the free trade area. The reduction in the domestic price of
both the imported goods and the domestic substitutes raises consumer surplus in the
market. Refer to Table 9.16 "Welfare Effects of Free Trade Area Formation: Trade
Diversion Cases" and Figure 9.10 "Harmful Trade Diversion" to see how the magnitude of
the change in consumer surplus is represented.

Free trade area effects on Country A’s producers. Producers in the importing country
suffer losses as a result of the free trade area. The decrease in the price of their product on
the domestic market reduces producer surplus in the industry. The price decrease also
induces a decrease in the output of existing firms (and perhaps some firms will shut down),

14
a decrease in employment, and a decrease in profit, payments, or both to fixed costs. Refer
to Table 9.16 "Welfare Effects of Free Trade Area Formation: Trade Diversion
Cases" and Figure 9.10 "Harmful Trade Diversion" to see how the magnitude of the change
in producer surplus is represented.

Free trade area effects on Country A’s government. The government loses all the tariff
revenue that had been collected on imports of the product. This reduces government
revenue, which may in turn reduce government spending or transfers or raise government
debt. Who loses depends on how the adjustment is made. Refer to Table 9.16 "Welfare
Effects of Free Trade Area Formation: Trade Diversion Cases" and Figure 9.10 "Harmful
Trade Diversion" to see how the magnitude of the tariff revenue is represented.

Free trade area effects on Country A’s national welfare. The aggregate welfare effect for
the country is found by summing the gains and losses to consumers, producers, and the
government. The net effect consists of three components: a positive production efficiency
gain (b), a positive consumption efficiency gain (d), and a negative tariff revenue loss (e).
Notice that not all the tariff revenue loss (c + e) is represented in the loss to the nation.
That’s because some of the total losses (area c) are, in effect, transferred to consumers.
Refer to Table 9.16 "Welfare Effects of Free Trade Area Formation: Trade Diversion
Cases" and Figure 9.10 "Harmful Trade Diversion" to see how the magnitude of the change
in national welfare is represented.

Figure 9.11 Beneficial Trade Diversion

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Generally speaking, the larger the difference between the nondistorted prices in the FTA
partner country and in the rest of the world, the more likely it is that trade diversion will
reduce national welfare.

Trade Creation

In general, trade creation means that a free trade area creates trade that would not have
existed otherwise. As a result, supply occurs from a more-efficient producer of the product.
In all cases, trade creation will raise a country’s national welfare.

Figure 9.12 "Trade Creation" depicts a case of trade creation. The graph shows the supply
and demand curves for Country A. PB and PC represent the free trade supply prices of the
good from Countries B and C, respectively. Note that Country C is assumed to be capable
of supplying the product at a lower price than Country B. (Note that in order for this to be
possible, Country B must have tariffs or other trade restrictions on imports from Country
C, or else all of B’s market would be supplied by C.)

Figure 9.12 Trade Creation

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Table 9.17 Welfare Effects of Free Trade Area Formation: Trade Creation Case

Country A
Consumer Surplus + (a + b + c)
Producer Surplus −a
Govt. Revenue 0
National Welfare + (b + c)

Free trade area effects on Country A’s consumers. Consumers of the product in the
importing country benefit from the free trade area. The reduction in the domestic price of
both imported goods and the domestic substitutes raises consumer surplus in the market.
Refer to Table 9.17 "Welfare Effects of Free Trade Area Formation: Trade Creation
Case" and Figure 9.12 "Trade Creation" to see how the magnitude of the change in
consumer surplus is represented.

Free trade area effects on Country A’s producers. Producers in the importing country
suffer losses as a result of the free trade area. The decrease in the price of their product in
the domestic market reduces producer surplus in the industry. The price decrease also
induces a decrease in output of existing firms (and perhaps some firms will shut down), a

17
 decrease in employment, and a decrease in profit, payments, or both to fixed costs. Refer
to Table 9.17 "Welfare Effects of Free Trade Area Formation: Trade Creation
Case" and Figure 9.12 "Trade Creation" to see how the magnitude of the change in
producer surplus is represented.

Free trade area effects on Country A’s government. Since initial tariffs were prohibitive
and the product was not originally imported, there was no initial tariff revenue. Thus the
FTA induces no loss of revenue.

Free trade area effects on Country A’s national welfare. The aggregate welfare effect for
the country is found by summing the gains and losses to consumers and producers. The net
effect consists of two positive components: a positive production efficiency gain (b) and a
positive consumption efficiency gain (c). This means that if trade creation arises when an
FTA is formed, it must result in net national welfare gains. Refer to Table 9.17 "Welfare
Effects of Free Trade Area Formation: Trade Creation Case" and Figure 9.12 "Trade
Creation" to see how the magnitude of the change in national welfare is represented.

10. Understand the difference between foreign direct investment (FDI) and portfolio
investment; understand the basic motives for FDI, and effects of FDI on host countries and
home countries. (chap 12)
Portfolio investments are purely financial assets, such as bonds, denominated in a
national currency. With bonds, the investor simply lends capital to get fixed payouts or a
return at regular intervals and then receives the face value of the bond at a prespecified
date.
Most foreign investments prior to World War I were of this type and flowed primarily from
the United Kingdom to the “regions of recent settlement” for railroad construction and the
opening up of new lands and sources of raw materials. The U.S. government defines as a
portfolio investment stock purchases that involve less than 10 percent of the voting stock
of a corporation. (A purchase of 10 percent or more of the voting stock of a corporation
is regarded as a direct investment.) With stocks the investor purchases equity, or a claim
on the net worth of the firm. Portfolio or financial investments take place primarily through
financial institutions such as banks and investment funds. International portfolio
investments
collapsed after World War I and have only revived since the 1960s.
Direct investments, on the other hand, are real investments in factories, capital goods,

18
land, and inventories where both capital and management are involved and the investor
retains control over use of the invested capital. Direct investment usually takes the form of
a firm starting a subsidiary or taking control of another firm (for example, by purchasing a
majority of the stock). Any purchase of 10 percent or more of the stock of a firm, however,
is defined as direct investment by the U.S. government. In the international context, direct
investments are usually undertaken by multinational corporations engaged in
manufacturing, resource extraction, or services. Direct investments are now as important
as portfolio
investments as forms or channels of international private capital flows.
Motives for FDI
The motives for direct investments abroad are earn higher returns (possibly resulting from
higher growth rates abroad, more favorable tax treatment, or greater availability of
infrastructures) and to diversify risks. Indeed, it has been found that firms with a strong
international orientation, either through exports or through foreign production and/or sales
facilities, are more profitable and have a much smaller variability in profits than purely
domestic firms.
Another important reason for direct foreign investments is to obtain control of a needed
raw material and thus ensure an uninterrupted supply at the lowest possible cost. This is
referred to as vertical integration and is the form of most direct foreign investments in
developing countries and in some mineral-rich developed countries.
Still other reasons for direct foreign investments are to avoid tariffs and other restrictions
that nations impose on imports or to take advantage of various government subsidies
to encourage direct foreign investments.
Other possible reasons for direct foreign investments are to enter a foreign oligopolistic
market so as to share in the profits, to purchase a promising foreign firm to avoid its future
competition and the possible loss of export markets, or because only a large foreign
multinational corporation can obtain the necessary financing to enter the market.
Effects of FDI on host countries and home countries
Foreign direct investment can make a positive contribution to a host economy by supplying
capital, technology and management resources that would otherwise not be available. Such
resource transfer can stimulate the economic growth of the host economy
Technologies that are transferred to developing countries in connection with foreign direct
investment tend to be more modern, and environmentally ‘cleaner’, than what is locally
available. Moreover, positive externalities have been observed where local imitation,
employment turnover and supply-chain requirements led to more general environmental
improvements in the host economy
The effects on employment associated with FDI are both direct and indirect. In countries
where capital is relatively scarce but labour is abundant, the creation of employment
opportunities – either directly or indirectly – has been one of the most prominent impacts
of FDI. The direct effect arises when a foreign MNE employs a number of host country

19
citizens. Whereas, the indirect effect arises when jobs are created in local suppliers as a
result of the investment and when jobs are created because of increased local spending by
employees of the MNE.
FDI’s effect on a country’s balance of payment accounts is an important policy issue for
most host governments. There are three potential balance of payments consequences of
FDI. First, when an MNE establishes a foreign subsidiary, the capital account of the host
country benefits from the initial capital inflow. However, this is a one-time only effect.
Second, if the FDI is a substitute for imports of goods or services, it can improve the current
account of the host country’s balance of payment. A third potential benefit to the host
country’s balance of payment arises when the MNE uses a foreign subsidiary to export
goods and services to other countries. The evidence based on empirical research on the
balance of payments effect of FDI, indicates that there is a difference between developed
and developing countries, especially with respect to investment in the manufacturing
industries.
The impact of FDI on host country international trade will differ, depending on its motive
– whether it is efficiency-seeking, market-seeking, resource-seeking or strategic asset-
seeking. FDI can have a great contribution to economic growth in developing countries by
supporting export growth of the countries. Output resulting from efficiency-seeking FDI is
typically intended for export, and therefore the impact of such FDI is likely to be an
increase in exports from the host country. If local firms provide inputs to affiliates
producing goods for exports, the local content of value added exports would be much
greater. In cases where intermediate goods are imported from outside the host economy,
efficiency-seeking FDI will increase export as well as imports.
Tham khảo thêm phần 12.4A Effects on the Investing and Host Countries (gt trang 375)
11. Exercise: Absolute advantage, comparative advantage and import tariff.

20
Question 2 The following table describes the production possibilities of two cities in the
country of Baseballia:

(a) Without trade, what is the price of white socks (in terms of red socks) in Boston? What
is the price in Chicago?
From the table we see that 1 worker-hour (1 worker working for 1 hour) employed in the
production of white socks is necessary to produce 3 pairs of white socks in Boston. If this
worker-hour was employed instead in producing red socks, exactly 3 pairs of red socks
would be produced. Thus the price of 3 pairs of white socks is just 3 pairs of red socks --
or equivalently -- the price of one pair of white socks is one pair of red socks.
Similarly, in Chicago, freeing up 1 worker-hour from producing 1 pair of white socks and
employing it instead in red socks production, 2 pairs of red socks can be produced. Thus,
the price of 1 pair of white socks is 2 pairs of red socks, or equivalently, the price of a pair
of white socks is two pairs of red socks. Note that the price reflects the opportunity cost of
worker-hours spent in the production of the types of socks.
(b) Which city has an absolute advantage in the production of each color sock?
Which city has a comparative advantage in the production of each color sock?
Recall that a city has an absolute advantage over another in the production of a good if
it can produce the same good with fewer resources than the other country. A city has a
comparative advantage in the production of a good over another city if it has a lower
opportunity cost in its production relative to the other city.
To produce 1 pair of red socks, Boston requires 1/3 worker-hours whereas Chicago
needs 1/2 worker hours. Thus Boston has an absolute advantage in the production of
red socks since it needs fewer worker-hours per pair.
Similarly, Boston also has an absolute advantage in the production of white socks since
it needs fewer worker-hours per pair of white socks (1/3 to 1).
From part (a) above, we see that the opportunity cost of producing a pair of white socks
is higher in Chicago than in Boston. Thus Boston has a comparative advantage in white
socks production (give up only 1 pair of red socks as opposed to 2 pairs for Chicago).
Chicago has a comparative advantage in red socks production (give up 1/2 pair of white
socks as opposed to 1 pair for Boston).
Note: the comparative advantage result differing across cities is not an accident. In a
two-good, two-city case, if one city has a comparative advantage over another in the

21
production of one good, it necessarily means that the other city has a comparative
advantage in the production of the other good.
(c) If the cities trade with each other, which color sock will each export?
When opened up to trade, each city will specialize in the production of the good in
whose production it has a comparative advantage, and will export that same good. Thus
Boston will export white socks and Chicago will export red socks.
(d) What is the range of prices at which trade can occur?
A city will remain no worse-off from trade if its terms of trade (the ratio of the price of the
exported good to the price of the imported good) are higher than or equal to the ratio of
the domestic prices of the same two goods before opening up to trade. If the terms of
trade do not meet this condition for either or both of a pair of cities, the city for which
this is not met will prefer not to trade since it will be better off without trade. In such a
situation, mutually agreeable trade cannot take place.
Therefore, Boston – who will export white socks -- will only agree to trade if the price of
white socks is more than or equal to 1 pair of red socks. Similarly, Chicago – who will
import white socks – will only agree to trade if the price of white socks is less than or equal
to 2 pairs of red socks. Thus, the range of prices at which trade can occur is when the price
of a pair of white socks is between 1 and 2 pairs of red socks inclusive, ie. 1 pair red socks
≤ price of 1 pair white socks ≤ 2 pairs red socks.
Question 3
Suppose that in a year an American worker can produce 100 shirts or 20 computers,
while a Chinese worker can produce 100 shirts or 10 computers.
Similar to question 2, we can describe the production possibilities of the Americans and
the Chinese in a table:

(a) In America, what is the opportunity cost of producing an additional shirt

(measured in terms of foregone computers)? In China, what is the opportunity
cost of producing an additional shirt (measured again in terms of foregone
computers)?
Following the logic presented in the answer to 2(a) above, we find that an additional
shirt in America costs 1/100 worker-years (1 worker working for 1 year), and freeing up
the necessary 1/100 worker-years in America would mean (1/100 * 20) = 0.2 fewer
computers produced. Therefore the relevant opportunity cost is 0.2 computers.
Similarly, in China, an additional shirt also costs 1/100 worker-years that would have to

22
come at the expense of the production of (1/100 * 10) = 0.1 fewer computers. Thus the
relevant opportunity cost in China is 0.1 computers.
(b) Suppose that America and China each have 100 workers. If each country
devotes half its workers to each industry, how many shirts and computers
does each country produce? What is world output of shirts and computers? Devoting
half of 100 workers to work in each industry, each country will have 50 workeryears in
either industry over a year. From the table it is clear that this would mean:
Americans produce 50*100 = 5,000 shirts and 50*20 = 1,000 computers
The Chinese produce 50*100 = 5,000 shirts and 50*10 = 500 computers
World output is thus 5,000+5,000 = 10,000 shirts and 1,000+500 = 1,500 computers.
(c) Suppose now that each country specializes by devoting all of its workers to
the industry in which it has a comparative advantage. In this case, what is
world output of shirts and computers?
From (a) above, we note that China has a comparative advantage in shirt production (to
get an additional shirt, China needs to give up a fewer number of computers than
America). America then must have a comparative advantage in producing the other
good, ie. computers. Thus China specializes in shirt production while the US specializes
in computer production.
With 100 worker-years in computer production, Americans produce 100*20 = 2,000
computers.
With 100 worker-years in shirt production, China produces 100*100 = 10,000 shirts
World output is therefore 10,000 shirts and 2,000 computers.
Thus we see that world production has not fallen in either industry. Rather, world shirt
production has stayed the same while world computer production has actually
increased, meaning in total the world now produces more.
(d) Now allow American and China to trade with each other. Find a mutually
agreeable trade that makes each country better off than it was before it
specialized. What are the terms of trade?
We saw in 2(d) that trade can only feasibly occur if the terms of trade (the ratio of the
price of the exported good to the price of the imported good) must be higher than or
equal to the ratio of the domestic prices of the same two goods before opening up to
trade.
Therefore in this question, we know from part (a) above the relevant range of prices at
which mutually agreeable trade can occur is if the price of a shirt is between 1/5 and
1/10 computers inclusive, ie. 0.1 computer ≤ price of 1 shirt ≤ 0.2 computers. However,
because this question
requires each country to be better off (instead of just no worse off), we need to exclude
the two boundary prices and the inequalities become < instead of ≤, ie. we will require
0.1 computer < price of 1 shirt < 0.2 computers.
The question asks for “a” mutually agreeable trade, so a range of answers are possible

23
here. I explain in words one possibility and add another two in a table below:
Example: Suppose the terms of trade are 1 shirt = 0.15 computers (within the range
above):
China specializes in shirts and produces 10,000 shirts and no computers.
Suppose she exports 5,000 of them to the US.
In return, she then imports (0.15*5,000) = 750 computers from the US.
∴ China produces (10,000 shirts, 0 computers)
China consumes (5,000 shirts, 750 computers).
The US -- on the other hand – specializes in computer production, thus produces
0 shirts and 2,000 computers.
If she exports 750 computers to China, she gets 5000 shirts at the current terms
of trade. This means she has (2000-750) =1250 computers left to consume
domestically.
∴ The US produces (0 shirts, 2,000 computers)
The US consumes (5,000 shirts, 1,250 computers).
Thus both China and the US are better off than before they specialized, since,
recalling from (b) above, the autarky (no trade) production and consumption
bundles were:
China (5,000 shirts, 500 computers)  note the fewer number of computers
US (5,000 shirts, 1,000 computers)  note the fewer number of computers
The following table shows the possibilities for two other terms of trade.
Note: the first term in parentheses is always shirts in the table below, and the terms of
trade is always presented as the price of computers relative to the price of shirts. Also,
in the table below, I have always assumed that China exports exactly 5,000 shirts, this
need not necessarily be the case.
Terms of trade
0.11 0.15 0.19
US autarky production
(5000, 1000) (5000, 1000) (5000, 1000)
= US autarky consumption
US specialized production (0, 2000) (0, 2000) (0, 2000)
US trade (5000, -550) (5000, -750) (5000, -950)
US consumption after
(5000, 1450) (5000, 1250) (5000, 1050)
trade
China autarky production
= China autarky (5000, 750) (5000, 750) (5000, 750)
consumption
China specialized
(10000,0) (10000,0) (10000,0)
production
China trade (-5000, 550) (-5000, 750) (-5000, 950)

24
 China consumption after
(5000, 550) (5000, 500) (5000, 950)
trade
Note also that as the terms of trade approach the autarkic price ratio for the US (ie. 1/5
or 0.20), the relative gains from trade is smaller for the US than for China. Conversely,
when the terms of trade approach the Chinese autarkic price ratio (ie. 1/10 or 0.10), the
relative gains from trade is smaller for China than for the US. This can be seen most
easily by comparing the consumptions of computers for each of the countries before
and after trade.
(e) Suppose that productivity in the Chinese computer industry increases to the
point where a Chinese worker can produce 20 computers per year. In this case,
are there any gains from trade between American and China? Explain.
No, this is the limiting case where neither country has a comparative advantage in the
production of either good. With trade in such a case, neither country is strictly better off,
although neither country will be quite worse off after trade either. More complex
economic models can show how countries may still benefit from trade if a shirts and/or
computers are not identical for the US and China and the consumers in either country /
both countries have taste for variety. This, however, is beyond the scope of an intro
course.
Holding national saving constant, does an increase in net capital outflow increase,
decrease, or have no effect on a country's accumulation of domestic capital?
Recall that we can rearrange the equation for national income determination to give us the
equation in terms of national saving. Starting from:
Y = C + I + G + NX
Subtracting C and G from both sides, and both adding and subtracting T to the left hand
side, we get:
(Y-T-C) + (T-G) = I + NX
National saving
The term on the left hand side is national saving, ie. the sum of private saving and
government saving (the two terms in parentheses, respectively). Also, a trade deficit is a
net capital inflow whereas a trade surplus is a net capital outflow. Thus, leaving national
saving unchanged, if net capital outflow increases, it means the trade balance would be
going into more surplus, that is, Net Exports (NX) would be becoming more positive, ie.
NX would rise. If I remained constant as well as the left hand side, this would mean the
two sides of the equation would no longer be equal but the right hand would be larger than
the left hand side. Therefore, for the equality to hold, I cannot remain unchanged but must
fall. In fact, I would fall by exactly enough to offset the rise in NX, so that the sum of both
terms, in equilibrium, remains exactly what it had been before the rise in capital outflow.
Because I measures the country’s accumulation of domestic capital, a resultant fall in I
would mean the country’s accumulation of domestic capital would decrease.

25
18. Explain Adam Smith’s reasoning for why free trade would lead to economic prosperity
Smith believed that free trade increased the extent of the market, which would increase
gains to specialization, which would motivate a greater degree of specialization, leading to
greater economic productivity and, in the long run, greater national prosperity.

Class Topics CLO Learning and teaching activities

[1] [2] [3] [4]
1. What is the main focus of International
Chapter 1:
economics?
Introduction
Week 1 CLO 1.1 2. What are the main ideas of Adam Smith on
about the course
absolute
Chapter 2
advantage?
1. What are the main ideas of David Ricardo
on those two
Chapter 2:
theories?
Week 2 International Trade CLO 2.1
2. What are implications from comparative
Theory
advantage and
empirical results?
1. What are the main ideas of the Hecksher-
Ohlin theory?
Chapter 2:
2. What is the Factor Price Equalization?
Week 3 International Trade CLO 3.1
3. What are implications of H-O theory and its
Theory
empirical
studies?
1. What is international trade policy and its
instruments?
Chapter 2:
2. What are the main effect of tariff?
Week 4 International Trade CLO 4.1
3. What are the other instruments in
Policy
international trade
policy?
1. What are main supporting arguments for
free trade?
Chapter 3:
2. What is income distribution effect of
Week 5 International Trade CLO 4.2
international trade policy?
Policy
3. What are implications for developing
countries?
Case studies in Chapter 9 in Paul R. Krugman
Chapter 3: and
Week 6 International Trade CLO 4.2 others (2018): Europe common Agricultural
Policy policy and
Tariff-Rate Quota Origin and its Application
26
 in Practice
with Oilseeds
1. What is the concept of economic
integration?
Chapter 4: Economic 2. What are the stages of economic
Week 7 CLO 5.1
Integration integration?
3. What is the trade diversion and trade
creation in FTA?
1. What is second best theory ?
2. What is static welfare of custom union?
Chapter 4: Economic
Week 8 CLO 5.2 3. What are dynamic welfare of custom union?
Integration
4. Case study: Gains from the Single EU
Market
1. What are motives for international capital
Chapter 5:
flow?
Week 9 International Direct CLO 6.1
2. What are welfare effect of international
Investment
capital flow?
Case study:
Fluctuations in Foreign Direct Investment
Chapter 5: Flows to the
Week
International Direct CLO 6.2 United States and
10
Investment Case study: The Stock of Foreign Direct
Investments
Around the World

27
7. Export Subsidies: Large Country Welfare Effects

LEARNING OBJECTIVES

1. Use a partial equilibrium diagram to identify the welfare effects of an export subsidy
on producer and consumer groups and the government in the exporting and
importing countries.
2. Calculate the national and world welfare effects of an export subsidy.

Suppose that there are only two trading countries: one importing country and one exporting
country. The supply and demand curves for the two countries are shown in Figure 7.32
"Welfare Effects of a Subsidy: Large Country Case". PFT is the free trade equilibrium price.
At that price, the excess demand by the importing country equals the excess supply by the
exporter.

Figure 7.32 Welfare Effects of a Subsidy: Large Country Case

The quantity of imports and exports is shown as the blue line segment on each country’s
graph (the horizontal distance between the supply and demand curves at the free trade
price). When a large exporting country implements an export subsidy, it will cause an
increase in the price of the good on the domestic market and a decrease in the price in the

28
rest of the world (RoW). Suppose after the subsidy the price in the importing country falls
to PTIM and the price in the exporting country rises to PTEX. If the subsidy is a specific
subsidy, then the subsidy rate would be S=PSEX−PSIM, equal to the length of the green
line segment in Figure 7.32 "Welfare Effects of a Subsidy: Large Country Case".

Table 7.10 "Welfare Effects of an Export Subsidy" provides a summary of the direction
and magnitude of the welfare effects to producers, consumers, and the governments in the
importing and exporting countries. The aggregate national welfare effects and the world
welfare effects are also shown.

Table 7.10 Welfare Effects of an Export Subsidy

Importing Country Exporting Country

Consumer Surplus + (E + F + G) − (a + b)
Producer Surplus − (E + F) + (a + b + c)
Govt. Revenue 0 − (b + c + d + f + g + h)
National Welfare +G − (b + d + f + g + h)
World Welfare − (F + H) − (b + d)

Refer to Table 7.10 "Welfare Effects of an Export Subsidy" and Figure 7.32 "Welfare
Effects of a Subsidy: Large Country Case" to see how the magnitudes of the changes are
represented.

Export subsidy effects on the exporting country’s consumers. Consumers of the product in
the exporting country experience a decrease in well-being as a result of the export subsidy.
The increase in their domestic price lowers the amount of consumer surplus in the market.

Export subsidy effects on the exporting country’s producers. Producers in the exporting
country experience an increase in well-being as a result of the subsidy. The increase in the
price of their product in their own market raises producer surplus in the industry. The price

29
increase also induces an increase in output, an increase in employment, and an increase in
profit, payments, or both to fixed costs.

Export subsidy effects on the exporting country’s government. The government must pay
the subsidy to exporters. These payments must come out of the general government budget.
Who loses as a result of the subsidy payments depends on how the revenue is collected. If
there is no change in total spending when the subsidy payments are made, then a
reallocation of funds implies that funding to some other government program is reduced.
If the subsidy is funded by raising tax revenues, then the individuals responsible for the
higher taxes lose out. If the government borrows money to finance the subsidy payments,
then the budget cut or the tax increase can be postponed until some future date. Regardless
of how the subsidy is funded, however, someone in the domestic economy must ultimately
pay for it.

Export subsidy effects on the exporting country. The aggregate welfare effect for the
country is found by summing the gains and losses to consumers and producers. The net
effect consists of three components: a negative terms of trade effect (f + g + h), a negative
consumption distortion (b), and a negative production distortion (d).

Since all three components are negative, the export subsidy must result in a reduction in
national welfare for the exporting country. However, it is important to note that a
redistribution of income occurs—that is, some groups gain while others lose. The likely
reason governments implement export subsidies is because they will benefit domestic
exporting firms. The concerns of consumers must be weighed less heavily in their
calculation since the sum of their losses exceeds the sum of the producers’ gains.

Export subsidy effects on the importing country’s consumers. Consumers of the product in
the importing country experience an increase in well-being as a result of the export subsidy.
The decrease in the price of both imported goods and the domestic substitutes increases the
amount of consumer surplus in the market.

30
Export subsidy effects on the importing country’s producers. Producers in the importing
country suffer a decrease in well-being as a result of the export subsidy. The decrease in
the price of their product on the domestic market reduces producer surplus in the industry.
The price decrease also induces a decrease in the output of existing firms, a decrease in
employment, and a decrease in profit, payments, or both to fixed costs.

Export subsidy effects on the importing country’s government. There is no effect on the
importing country’s government revenue as a result of the exporter’s subsidy.

Export subsidy effects on the importing country. The aggregate welfare effect for the
country is found by summing the gains and losses to consumers, producers, and the
government. The net effect consists of three components: a positive terms of trade effect
(F + G + H), a negative production distortion (F), and a negative consumption distortion
(H).

Although there are both positive and negative elements, the net national welfare effect
reduces to area G, which is positive. This means that an export subsidy implemented by a
large exporting country in a perfectly competitive market will raise national welfare in the
importing country.

This result has inspired some economists to argue that the proper response for an importing
country when its trading partner implements an export subsidy is simply to send along a
thank you note.

It is worth noting here that the World Trade Organization (WTO) allows countries to
impose countervailing duties to retaliate against its trading partners when it can be shown
that an exporting country’s government has used export subsidies.

It is also important to note that not everyone’s welfare rises when there is an increase in
national welfare. Instead, there is a redistribution of income. Consumers of the product will
benefit, but producers and payers of government taxes will lose. A national welfare

31
increase, then, means that the sum of the gains exceeds the sum of the losses across all
individuals in the economy. Economists generally argue that, in this case, compensation
from winners to losers can potentially alleviate the redistribution problem.

Export subsidy effects on world welfare. The effect on world welfare is found by summing
the national welfare effects on the importing and exporting countries. By noting that the
terms of trade gain to the exporter is equal to the terms of trade loss to the importer, the
world welfare effect reduces to four components: the importer’s negative production
distortion (B), the importer’s negative consumption distortion (D), the exporter’s negative
consumption distortion (f), and the exporter’s negative production distortion (h). Since each
of these is negative, the world welfare effect of the export subsidy is negative. The sum of
the losses in the world exceeds the sum of the gains. In other words, we can say that an
export subsidy results in a reduction in world production and consumption efficiency.

32