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ECON0007 (The World Economy) Summary - UCL Economics BSc
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Summary of module ECON0007 The World Economy.
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UNIVERSITY COLLEGE LONDONDEPARTMENT OF ECONOMICS
Economics BSc (Econ)
First Year – Term 2
THE WORLD ECONOMY
ECON0007
Rodrigo Antón García
rodrigo.garcia.20@ucl.ac.uk
London, 2021
,ECON0007 – The World Economy Rodrigo Antón García
Contents
Introduction. 1
Week 1 – Old trade theory. 2
Week 2 – Old trade theory continues. 7
Week 3 – New trade theory. 10
Week 4 – Quiz.
Week 5 – Multinational Enterprises and Foreign Direct Investment. 12
Week 6 – Quiz.
Week 7 – Migration. 15
Week 8 – Quiz.
Week 9 – International finance under flexible exchange rate. 25
Week 10 – International finance under fixed exchange rate. 29
Week 11 – Quiz.
,ECON0007 – The World Economy Rodrigo Antón García
ECON0007: THE WORLD ECONOMY
Introduction.
Four aspects of globalisation: goods, finance, firms and people.
• Episodes of globalisation.
- First globalisation. From the beginning of the 19th century to the First World War.
(1800 – 1914). Victorian globalisation.
This was followed by a decline of globalisation between World War I and World War II.
- Flexible globalisation. From the end of the Second World War to the 1980s.
(1945 – 1980). Revival of globalisation.
- Hyper-globalisation. Massive acceleration of trade integration across countries.
(1980 – Now).
Characteristics of hyper-globalisation.
- Rise of outsourcing & global value chains.
- Creation of WTO.
- Liberalisation of trade.
- Liberalisation of financial flows.
- Free movement of firms across borders.
- BUT Restrictions on migrations.
• The result of globalisation.
- Unprecedented poverty reduction in developing countries. One billion people
have come out of poverty since 1988.
- Global income convergence across nations. Overlapping lifestyle between
countries. The world is no longer that divided.
- Growing inequality within nations. Divergence of incomes at the national level.
Nations are becoming more divided. Income inequality is growing within nations. Seen
by: bell shaped distributions of income have become more stretched.
1
,ECON0007 – The World Economy Rodrigo Antón García
Week 1 – Old trade theory.
• Types of trade. Start of Chapter 5.
Trade has seen a dramatic increase in the amount trade across all regions in the world
since 1980.
Inter-industry trade. Trade in dissimilar goods. Happens between a developed country
and a developing country. North – South.
Horizontal Intra-industry trade. Trade in similar goods. Happens between developed
countries or between developing countries. North – North. South – South.
Vertical intra-industry trade. Outsourcing of tasks. Trade in dissimilar goods/tasks in the
same sector. Happens between a developed country and a developing country. North –
South.
• Theory of absolute advantage. Chapter 2.
Absolute advantage: a person or country has an absolute advantage in the production
of a good or service if the inputs it uses to produce this good or service are less than in
some other person or country. The country can produce at a lower cost.
‘Free trade enables countries (or firms) to specialise in production of goods in which they
have an absolute price advantage (i.e., cost advantage) and import goods or tasks in
which they have a price disadvantage relative to other countries. Specialisation enables
countries to maximise their joint production and consumption.’ Adam Smith.
If the two countries move out of autarky and
begin to trade, the world price of rice PW will
be somewhere between the two autarky
prices, as follows:
!! < !" < !#
2
,ECON0007 – The World Economy Rodrigo Antón García
- Assumptions of absolute advantage.
The fact that drives trade across countries according to this theory is the difference is
prices, the differences in absolute prices between countries. The reason that you export
something is that you can produce it a lower price.
This is a supply-side theory. It assumes that the main factor that shapes the prices of
countries is the cost of production; the prices are determined by the cost of production.
- The only factor of production is labour (no capital or land). For simplification
purposes.
- Tastes are the same across countries. The differences in prices are therefore not
driven by difference in taste (composition of their consumption basket is the same). The
demand is identical between countries.
- Perfect competition and constant returns to scale.
- No transportation costs
- No transaction costs.
- No government interference in prices.
- Factor mobility. Labour can effortlessly move between sectors, can effortlessly
move to the exporting sector.
- Gains from trade.
Let us first consider Vietnam. In its movement from autarky to exporting in the rice market,
producers experience both an increase in price and an increase in quantity supplied
along the supply curve. This should be good for producers, and as you can see in the
following figure, there has been an increase in producer surplus of area A + B as a result
of the movement from autarky to trade.
Consumers, on the other hand, experience an increase in price and a decrease in
quantity demanded along the demand curve. This should harm consumers, and you can
see in the figure that there has been a decrease in consumer surplus of area A.
What do these effects mean for Vietnam? Producers have gained area A + B, whereas
consumers have lost area A. The gain to producers exceeds the loss to consumers. For
the economy as a whole, then, there is a net welfare increase of area B. Vietnam gains
from its entry into the world economy as an exporter.
3
,ECON0007 – The World Economy Rodrigo Antón García
Next, consider Japan. In its movement from autarky to importing in the rice market,
producers experience a decrease in price and a decrease in quantity supplied along the
supply curve. This should harm these producers, and you can see in the figure, there
has been a decrease in producer surplus of area C. Consumers, on the other hand,
experience a decrease in price and an increase in quantity demanded. These contribute
to an increase in consumer surplus of area C + D.
What do these effects mean for Japan? Consumers have gained C + D, whereas
producers have lost area C. The gain to consumers exceeds the loss to producers. For
the economy as a whole, then, there is a net welfare increase of area D. Japan gains
from its entry into the world economy as an importer.
Vietnam: Japan:
Producer surplus ↑ ! A + B. Consumer surplus ↑ ! C + D
Consumer surplus ↓ ! A. Producer surplus ↓ ! C.
Gain to producers exceeds the loss to Gain to producers exceeds the loss to
consumers. consumers.
Net welfare! B. Net welfare! D.
Moving from autarky to either importing or exporting involves a net increase in welfare
for the country involved. This net increase in welfare is known as the gains from trade.
The notion of gains from trade is an important concept. To judge from the tone and
content of many popular writings on the world economy, trade relationships are a win-
lose proposition for the countries involved. To export is to win; to import is to lose. The
gains from trade idea, however, tells us that trade can be mutually beneficial to the
countries involved. For this reason, we need to be cautious in our assessment of some
popular writing of the win-lose variety. Although there are specific instances in which
trade can be a win-lose proposition, this is not the case for trade in general.
• Theory of comparative advantage. Chapter 3.
Comparative advantage: a person or country has comparative advantage in the
production of a good or service, if the cost of producing an additional unit of that good or
service relative to the cost of producing another good or service is lower than another
person on country’s cost to produce the same two goods. It can produce at a lower
opportunity cost.
‘It will appear ... that a country possessing very considerable advantages in machinery
and skill, and which may therefore be enabled to manufacture commodities with much
less labour than her neighbours, may, in return for such commodities, import a portion
of its corn required for its consumption, even if its land were more fertile, and corn could
be grown with less labour than in the country from which it was imported’ David Ricardo.
As a result of theory of comparative advantage, whenever you have differences in
relative prices there is room for arbitrage.
4
,ECON0007 – The World Economy Rodrigo Antón García
Consider the demand for rice and motorcycles in both Vietnam and Japan.
If we use the same assumptions as for the model of absolute advantage (same
preferences and the only factor of production being labour for example), the PPF for
these countries will have different slopes as a result of difference in relative technological
efficiency; that is relative prices. These are caused by relative differences in production
costs (wage, production cost, productivity, etc.).
The slope of the resource constraint gives the opportunity cost of the item in the
horizontal axis of the diagram, in this case the opportunity cost of rice.
This is expressed as the
number of units of motorcycles
the countries would need to
forgo or give up in order to
increase rice output by one unit.
QM/QR.
The opportunity cost of
motorcycles is the inverse of the
opportunity cost of rice, or
QR/QM.
Therefore, Vietnam has the lower opportunity cost of producing rice since it has the flatter
PPF. And since the opportunity costs of motorcycles is the inverse of the slope of the
PPF, this would imply that the country with the lower opportunity cost of producing
motorcycles would have the steeper-sloped PPF, Japan.
So, Vietnam has a lower opportunity cost in producing rice, and Japan has a lower
opportunity cost in producing motorcycles.
- Therefore, the autarky equilibria will be the following:
From the PFF we can see that the
relative prices are lower in Vietnam
than Japan.
!$ ! !$ #
& ' <& '
!% !%
However, the central idea of comparative advantage is that even if a country has
absolute advantages in the production of both goods, as Japan may have, both countries
would be better off if trading takes place.
If both countries specialise, then each country will produce what it is best at; trading
goods to obtain the good(s) that it does not produce.
5
, ECON0007 – The World Economy Rodrigo Antón García
- With international trade the equilibria will be the following:
The change in relative prices has an effect on production in each of the two countries,
moving the production points from A to B. Trade then takes us to C.
In the case of Vietnam, the relative
prices have increased from autarky to
trade, and this provides increased
incentive to produce rice.
In Japan, the relative prices have
decreased, and this provides an
increased incentive to produce
motorcycles.
With international trade, each country can use the relative price of a neighbouring country.
And, by exporting each country can import more goods than it could have produced
locally.
If Vietnam and Japan abandon autarky in favour of trade, the world relative price of rice
& "
(& ! ) will be somewhere between the two autarky price ratios:
"
!$ ! !$ " !$ #
& ' <& ' <& '
!% !% !%
Note: Here the PPF linear because we assume the costs are constant. This leads to
complete specialisation when a country pursues to trade with another. However, this is
not fully realistic.
In a normal PPF (curved), as trade
moves a country to specialize in the
production of the good in which it has
comparative advantage, the
opportunity costs of producing more of
that good increase progressively (the
tangent becomes steeper).
This increase in opportunity cost acts a sort of brake on complete specialization.
• Shortcomings of these theories.
- As long as absolute or relative cost of production is different across countries,
trade and specialisation is good for all countries.
- These theories do not explain the sources of advantages; the differences in
production costs.
- These theories do not explain the winners and losers of trade inside countries.
6
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