WEEK 7: MODEL OF TWO-FACTOR ECONOMY

 A two-factor economy is a simplified model of production where goods are produced using two
inputs (factors of production). These factors are usually:
 Labor (L) – human effort, both physical and mental.
 Capital (K) – machines, tools, buildings, and financial resources.
 In this model, output depends on how labor and capital are combined.
 Mathematically, it can be represented as: Q = f(KL) ; Q = output

KEY FEATURES
 Only two inputs are considered (capital & labor).
 The production function shows how inputs are transformed into output.
 Firms decide the optimal mix of labor and capital to minimize costs or maximize output.
 Often used in trade theory (Heckscher–Ohlin model) and macroeconomics.

EXAMPLE 1: COBB–DOUGLAS PRODUCTION FUNCTION

 One of the most common two-factor models:
Q=A x Kα x Lβ
 A= technology (productivity factor)
 α, β = output elasticities of capital and labor
Example:
 Q=10 x (1000.4) x (500.6) ≈ 10 x (6.31) x (10.46) = 660 units of output

If a firm uses 100 units of capital and 50 units of labor: This shows how increasing labor or capital changes
output.

EXAMPLE 2: HECKSCHER–OHLIN (TRADE THEORY)

Each country will export the good that uses its abundant factor intensively and import the good
that uses its scarce factor; showing how factor endowment shape trade patterns.
 Country A (labor-abundant) → produces and export textiles (labor-intensive).
 Country B (capital-abundant) → produces and export cars (capital-intensive).

EXAMPLE 3: SIMPLE FARMING ECONOMY

Suppose a farm produces rice using:
 Labor (workers to plant and harvest)
 Capital (tractors, irrigation systems)

If the farm increases capital (buys a tractor), fewer workers are needed to achieve the same output. If it
increases labor (hires more workers), output rises but may face diminishing returns if there aren’t enough
tractors.

PRICES AND PRODUCTION - When countries open to trade:

Specialization:
 Philippines → shifts resources into textiles (labor-intensive).
 Japan → shifts resources into cars (capital-intensive).

Relative Prices Converge (Law of One Price):

 Trade equalizes the world relative price between 0.5 and 2.0.
 Let’s say it settles at PT/PC=1.0

Factor Returns Adjust (Stolper–Samuelson Theorem):

 In the Philippines, demand for labor rises → wages go up.
 In Japan, demand for capital rises → returns to capital go up.
 Owners of the scarce factor in each country lose.

PRODUCTION POSSIBILITY
1. “WITHOUT FACTOR SUBSTITUTION” MEAN?
- Normally, in production, firms can substitute capital for labor (e.g., use more machines instead
of workers).
-
But without substitution, the ratio of capital (K) to labor (L) used in each industry is fixed.

TRADE IMPLICATIONS
In a two-factor H–O model without substitution:
 Countries are even more specialized, because factors can’t be smoothly shifted between
industries.
The PPF shows sharp specialization points instead of gradual trade-offs.

2. “WITH FACTOR SUBSTITUTION” MEAN?

Firms can change the mix of labor (L) and capital (K) used in production.
Example: If labor becomes expensive, firms can use more machines (capital) instead of hiring more
workers, and vice versa.
The production function allows for substitution — e.g., Cobb–Douglas or CES functions.
TRADE IMPLICATIONS
In a two-factor H–O model without substitution:
 In the H–O trade model:
 A labor-abundant country will produce more of the labor-intensive good, but not only that — it can
still shift gradually toward specialization.
 Factor substitution makes partial specialization possible (countries don’t always fully specialize).
 This is why most countries export some goods in both categories, but still lean toward goods that
use their abundant factor.

FACTOR PRICE EQUALIZATION (FPE)

 Trade will make wages (returns to labor) rise in labor-abundant countries.
 Returns to capital rise in capital-abundant countries.
Example:
 In the Philippines, textile exports increase → higher demand for labor → wages go up.
 In Japan, car exports increase → higher demand for capital → returns to machines & factories go up.

PATTERNS OF EXPORTS BETWEEN DEVELOPED AND DEVELOPING COUNTRIES

In the Heckscher–Ohlin Prediction
1. Developed countries are usually capital-abundant (lots of machines, advanced technology,
skilled workers).
2. Developing countries are usually labor-abundant (large populations, lower wages, less capital
per worker).

MODERN COMPLICATIONS (BEYOND H–O)

The simple H–O predictions don’t always perfectly fit today because of:
 Technology gap – Developed countries also export high-tech, skill-intensive goods.
 Intra-industry trade – Countries trade similar goods (e.g., Germany exports cars to Japan while
importing Japanese cars).
 Global value chains (GVCs) – Production is fragmented: developing countries export labor-
intensive stages of production (assembly), while developed countries export capital-intensive parts
(design, engines, chips).

WEEK 8: THE STANDARD TRADE MODEL

Standard trade model

- unifying framework in international trade theory that combines insights from several earlier models
(like Ricardian, Specific factors, and Heckscher–Ohlin) into a single, more general model of trade.
- It focuses on how differences between countries—whether in technology, resources, or preferences
—create the basis for trade, and how trade affects prices, welfare, and income distribution.

Two goods and two countries

 Countries trade two different goods (say, cloth and food).
 Each country can produce both, but relative costs differ.

Production Possibility Frontier (PPF)

 Shows the maximum combinations of goods a country can produce given its resources and
technology.
 Shape depends on assumptions:
 Straight line (Ricardian model) → constant opportunity cost.
 Bowed out (Heckscher–Ohlin with factor substitution) → increasing opportunity cost.

Relative Prices & Terms of Trade

 A country’s exports and imports are determined by relative world prices.
 The terms of trade (TOT) measure how much imports a country can obtain for a unit of its
exports.
 Changes in TOT directly affect national welfare.

Welfare Effects of Trade

 Trade allows countries to consume beyond their PPF.
 A rise in the relative price of a country’s export good makes it better off (improves TOT).
 A fall makes it worse off (deteriorates TOT).

Sources of trade
 Differences in technology (Ricardo),
 Differences in factor endowments (Heckscher–Ohlin),
 Differences in demand preferences (love for variety, etc.).

EXAMPLE:
Suppose the U.S. Is relatively capital-abundant and produces aircraft cheaply, while Bangladesh is
relatively labor-abundant and produces textiles cheaply.

 Autarky (no trade) - each country consumes what it produces.

 Trade - U.S. Exports aircraft (capital-intensive good) and imports textiles (labor-intensive good).
 Price of aircraft rises on world markets - the U.S. Gains (better terms of trade), while
Bangladesh may lose (worse terms of trade).
TARIFFS VS EXPORT SUBSIDIES
In the Standard Trade Model, both tariffs and export subsidies affect the terms of trade:
 Tariff - can sometimes improve a large country’s terms of trade (because it reduces world
demand for imports, lowering world prices).
 Export Subsidy - always worsens terms of trade (because it lowers the world price of the
export good)

WHY DO GOVERNMENT INTERVENE IN THE ECONOMY?

1. INCOME DISTRUBUTION
- Reduce inequality and ensure a fairer distribution of wealth.
- Free markets often create winners and losers (e.g., trade may benefit capital owners but hurt
unskilled labor).
Instruments:
 Progressive taxes (higher earners taxed more).
 Social transfers (welfare, pensions, unemployment benefits).
 Minimum wage laws.
 Education and healthcare subsidies (improving access for the poor).

Example: Scandinavian countries use high taxation and strong welfare systems to reduce inequality.

2. PROMOTION OF CRUCIAL SUBSIDIARIES

- Support industries considered strategic or essential for long-term development and national
security.
- Some industries (e.g., steel, energy, technology, defense) have spillover benefits, or are vulnerable
to foreign competition.
Instruments:
 Tariffs and import quotas to protect infant industries.
 Export subsidies to make domestic goods competitive abroad.
 Direct subsidies, tax incentives, or government procurement.
 Industrial policies (funding R&D, training workers, infrastructure).

Example: South Korea and Japan heavily supported their automobile and electronics sectors in the 20th
century → global competitiveness today.

3. BALANCE OF PAYMENTS
- Correct imbalances when a country imports more than it exports (trade deficit) or faces pressure on
foreign reserves.
- Persistent deficits can weaken a currency, reduce investor confidence, and lead to crises.
Instruments:
 Tariffs and quotas to reduce imports.
 Export promotion policies (subsidies, trade agreements).
 Exchange rate management (devaluation to make exports cheaper, imports costlier).
 Monetary and fiscal policies to reduce excess spending on imports.

Example: India in the 1990s imposed import restrictions and devalued the rupee to stabilize its balance of
payments before liberalizing trade.

INTERNATIONAL BORROWING AND LENDING

 International borrowing and lending is a form of intertemporal trade — instead of exchanging
goods across countries today, countries exchange consumption across time.
 A country that borrows is essentially importing goods today and promising to repay (export) in the
future.
 A country that lends is exporting goods today (giving up consumption) and will import (consume)
more in the future when repaid.
 It’s like how individuals borrow money for current needs and repay later — but applied at the
country level.

Countries borrow and lend internationally because of differences in:

1. Time preferences → Some countries value current consumption more (borrowers), others prefer
saving for the future (lenders).
2. Investment opportunities → Capital-scarce countries may borrow to invest in infrastructure,
factories, or education (higher returns to capital). Capital-rich countries lend abroad to earn
interest.
3. Shocks and crises → Countries borrow during wars, natural disasters, or recessions to smooth
consumption.

Borrowing = running a current account deficit (imports > exports).

Lending = running a current account surplus (exports > imports).

In financial terms:
Borrower receives foreign capital inflows (loans, investments).
Lender sends out capital (savings invested abroad).
For Borrowers: Gain higher consumption today but must repay in future (risk of debt crises if repayment
is difficult).
For Lenders: Sacrifice some current consumption but gain interest and future imports.
Globally: Resources are allocated more efficiently — capital flows from where it’s abundant (low returns)
to where it’s scarce (high returns).
WEEK 9: EXTERNAL ECONOMIES OF SCALE

External economies of scale

 refer to cost advantages that accrue to firms because of the growth of the entire
industry, not just the growth of a single firm. In other words, when an industry expands, all firms
within it benefit from lower average costs—even if each firm’s own output hasn’t increased.

KEY FEATURE
 They are external to the firm but internal to the industry.
 Occur when the average cost per unit of production decreases as the industry grows.
 Different from internal economies of scale, which are cost savings a firm experiences by itself as it
expands output.

EXAMPLE
 Hollywood (film industry): The concentration of actors, producers, and suppliers reduces
production costs for all studios.
 Automobile clusters (e.g., Detroit in the past, Japan, Germany): Specialized suppliers and
skilled workers reduced costs for all car manufacturers.
 Textile industry in China or Bangladesh: Growth of the industry led to better infrastructure,
suppliers, and lower costs for all firms.

INTERNATIONAL TRADE
Explain why industries cluster geographically and why historical advantage can shape trade
patterns, sometimes overriding natural comparative advantage.

Industry Clustering & Comparative Advantage

 A country that develops an industry early may achieve lower costs because of industry-wide
benefits (specialized suppliers, skilled labor, spillovers).
 This advantage can persist, even if another country could produce the same good more efficiently
at the firm level.
→ Trade patterns may reflect historical accidents or path dependence, not just natural resource or
factor endowments.

Example: Silicon Valley dominates global tech not because the U.S. has the lowest labor cost, but because
of clustering, knowledge spillovers, and supplier networks that reduce costs for all U.S. firms.

Multimedia Equilibria
 If two countries could both potentially develop an industry, the one that reaches a large scale first
will dominate due to lower costs.
 The other may never enter the market, even if it could produce efficiently at scale.
 → Explains why some industries concentrate in one country or region.

Example: Taiwan and South Korea built strong semiconductor industries early on. Their accumulated
external economies make it very hard for latecomers to compete, locking in trade patterns.

Trade and Welfare Effects

 Specialization: Countries may specialize in industries where external economies already exist,
leading to strong export sectors.
 Welfare: Trade can make a country worse off if it ends up importing a good it could have produced
more efficiently at scale—because external economies mean costs depend on where production is
concentrated, not only on resource endowments.
 Example:
 If a developing country has the resources to produce electronics but enters the market too late, it
may import them from East Asia, even though with scale it could have produced them more
cheaply.

Effect on Market Structure

External economies of scale influence how industries are organized and how competitive they are:
Competitive Market Structure Possible
 Since cost reductions come from the industry’s size (not the firm’s size), many small firms can
coexist and still benefit from lower costs.
 → Unlike internal economies of scale (which encourage large firms and monopolies), external
economies allow industries to remain more competitive.

Example: In the textile industry of Bangladesh or India, thousands of small firms coexist. Each benefits
from shared suppliers, trained workers, and infrastructure created by the overall industry cluster.

INDUSTRY CLUSTERING (AGGLOMERATION)

External economies encourage geographic concentration of firms.
Once an industry establishes itself in one region, clustering makes it hard for rivals in other regions to
compete.
→ Creates something like a localized natural monopoly at the country/region level, but still with many firms
inside that region.

Example: Hollywood (film industry) or Silicon Valley (tech industry) — many competing firms exist, but all
benefit from being in the same place.
PATH DEPENDENCE AND LOCK IN
If one region develops the industry first, its firms benefit from external economies.
Other regions face higher average costs (no established suppliers or skilled labor), so they struggle to
enter.
→ Market structure can be “locked in,” even if another region has better natural conditions.

Example:
The semiconductor industry is heavily concentrated in Taiwan and South Korea, making entry difficult for
other countries despite global demand.

THEORY OF EXTERNAL ECONOMIES

 This theory explains how the cost of producing a good falls as the size of the entire industry
grows, not just when a single firm expands.
 These cost reductions are external to each firm but internal to the industry.
 As an industry clusters and expands, all firms benefit from lower costs, even small ones.

This idea helps explain:

 Why industries concentrate geographically.
 Why trade patterns sometimes depend on history and accidents, not just natural resources or
technology.
 Why multiple equilibria (different possible outcomes) exist in global production.

SOURCES
1. Specialized Suppliers - As the industry grows, suppliers of inputs (materials, components,
services) emerge, lowering costs for all firms.
Example: In Detroit’s auto industry (20th century), specialized parts suppliers clustered around car
manufacturers.

2. Labor Market Pooling - A large industry attracts workers with specialized skills.
Firms benefit from a ready supply of talent, and workers benefit from more job opportunities.
Example: Hollywood attracts actors, directors, and technicians, making it cheaper for film studios to find
talent.

3. Knowledge Spillovers - Firms learn from each other by observation, mobility of workers, or
informal exchange.
This speeds up innovation and reduces production costs.
Example: Silicon Valley — startups benefit from the tech knowledge environment, even if they don’t invent
everything themselves.

WEEK 10: POLICIES AND LAWS IN THE CONDUCT OF INTERNATIONAL BUSINESS AND TRADE

International Trade Policies

These are frameworks that regulate trade between nations:
 Free Trade Policy – promotes minimal restrictions, tariffs, and quotas (e.g., WTO’s free trade
principles).
 Protectionist Policy – imposes tariffs, quotas, and subsidies to protect local industries.
 Fair Trade Policy – ensures ethical trading practices, sustainability, and social justice.

These laws govern the exchange of goods, services, capital, and technology across borders:
 World Trade Organization (WTO) Agreements
 GATT (General Agreement on Tariffs and Trade) – rules for trade in goods.
 GATS (General Agreement on Trade in Services) – rules for service industries.
 TRIPS (Trade-Related Aspects of Intellectual Property Rights) – protection of IP rights in
international trade.
 United Nations Commission on International Trade Law (UNCITRAL) – develops model laws
(e.g., arbitration, electronic commerce).
 International Chamber of Commerce (ICC) – creates rules like Incoterms (international
commercial terms for shipping/trade).
 Bilateral and Regional Trade Agreements – e.g., ASEAN Free Trade Area (AFTA), NAFTA/USMCA,
EU Trade Laws, RCEP.

National Laws Affecting International Business

Countries apply domestic laws that impact foreign trade:
 Customs and Tariff Laws – duties, import/export restrictions.
 Foreign Investment Laws – ownership rules, restrictions on foreign direct investment (FDI).
 Competition and Antitrust Laws – to prevent monopolies and unfair competition.
 Intellectual Property Laws – patents, copyrights, trademarks.
 Taxation Laws – withholding taxes, transfer pricing, double taxation treaties.
 Labor and Environmental Regulations – compliance with local employment and sustainability
standards.

Policies on Dispute Resolution

 Arbitration and Mediation – governed by UNCITRAL Model Law, ICC Arbitration Court, and
London Court of International Arbitration (LCIA).
 International Court of Justice (ICJ) – settles disputes between states.
 WTO Dispute Settlement Body – resolves trade disputes between member countries
Ethical and Global Governance Policies
 OECD Guidelines for Multinational Enterprises – standards on human rights, labor, and
environment.
 UN Global Compact – encourages businesses to adopt sustainable and socially responsible
policies.
 Anti-Corruption Laws – e.g., US Foreign Corrupt Practices Act (FCPA), UK Bribery Act.

RATIONALE FOR REGULATION OF INTERNATIONAL BUSINESS BEHAVIOR:

1. Fairness in Trade & Competition – prevents monopolies, dumping, and unfair practices.
2. Protection of Stakeholders – safeguards consumers, workers, and local industries.
3. Sustainability & Ethics – enforces environmental protection, labor rights, and anti-corruption
standards.
4. Global Stability & Trust – creates predictable rules that reduce conflicts and encourage
investment.

ROLE OF INTERNATIONAL LAW IN THE CONDUCT OF INTERNATIONAL BUSINESS

1. Creates a Common Legal Framework
 International law sets uniform rules that guide cross-border transactions.
 Example: WTO agreements establish the same trade rules for all member countries.
 This reduces confusion caused by differing national laws.

2. Facilitates Trade and Investment

 Treaties and conventions lower barriers like tariffs, quotas, and restrictions.
 Ensures protection of foreign investments through agreements (e.g., Bilateral Investment
Treaties).
 Encourages global economic cooperation and growth.

3. Protects Rights and Obligations of Businesses

 Guarantees intellectual property rights (through TRIPS).
 Protects companies from unfair expropriation by host states.
 Defines obligations on labor, environment, and taxation.

4. Provides Mechanisms for Dispute Resolution

 International arbitration (UNCITRAL, ICC, ICSID) resolves disputes fairly without bias to one country.
 WTO’s Dispute Settlement Body handles trade conflicts between nations.
 This reduces risks and uncertainty for businesses.

5. Promotes Fair Competition and Ethics

 Prevents anti-competitive behavior (dumping, subsidies, monopolies).
 Encourages compliance with anti-bribery and anti-corruption laws.
 Supports ethical conduct through OECD guidelines and UN Global Compact.

6. Balances Sovereignty with Globalization

 International law respects each nation’s sovereignty while ensuring that states honor global
commitments.
 Example: environmental treaties limit harmful trade practices but allow states flexibility in
implementation.

TRADE RISKS
1. Commercial Risks - Non-payment, buyer default, breach of contract, poor product quality
 Possible Effects: Loss of revenue, disputes, and damaged reputation
2. Financial & Currency Risk - Exchange rate fluctuations, high interest rates, credit shortage, transfer
restrictions
 Possible Effects: Profit loss, higher costs, and difficulty in repatriating earnings
3. Political & Country Risks - Expropriation, trade embargoes, war, terrorism, unstable government
 Possible Effects: Business shutdown, loss of assets, and disruption of operations
4. Legal & Regulatory Risks: Changing trade laws, customs barriers, weak IP protection, complex
contracts
 Possible Effects: Penalties, shipment delays, and unenforceable agreements
5. Logistical & Operational Risks - Shipping delays, strikes, port congestion, damaged or lost goods,
supply chain breakdown
 Possible Effects: Missed deadlines, extra costs, and dissatisfied customers
6. Cultural & Communication Risks - Language barriers, negotiation style differences, marketing
blunders
 Possible Effects: Misunderstandings, failed partnerships, and poor market entry
7. Environmental & Natural Risks - Typhoons, earthquakes, floods, climate change, sustainability rules
 Possible Effects: Supply shortages, disrupted trade routes, and compliance costs

TRADE ROUNDS - series of multilateral negotiations among countries; trade barriers improving global
trade rules.
 They are formal negotiation meetings (sometimes lasting years) where member countries agree on
lowering tariffs, reducing quotas, addressing subsidies, and setting global trade rules.
 Each "round" focuses on expanding and deepening trade liberalization across different sectors.
 Results from a trade round are binding on all participating countries.

OBJECTIVE
1. Reduce tariffs and trade barriers to encourage freer trade.
2. Expand global market access for goods and services.
3. Establish rules on issues like intellectual property, agriculture, and subsidies.
4. Resolve disputes and create fairer conditions for all members.
5. Strengthen global economic cooperation and prevent trade wars.

SIGNIFICANCE
 They expand world trade by reducing protectionism.
 Provide a platform for multilateral cooperation.
 Help avoid trade wars by creating common rules.