International Political Economy

Introduction: The State and the Market

We are developing our political economy in stages. The first model, where there is one
individual state is explained by the circular flow model. Marxian model doesnt look that
much different, which is an important point, it was also explored. What drives IPE is that
states and markets have different principles and the state has certain imperatives it must
fulfil.
What is the problem? If the system always worked: the amount of labour (if we just think
of employment) the households wanted to provide was the same as the amount that the
firms wanted to hire, we have full employment, so the system must be growing (growth
function if they are all weighted equally high the system must be growing) at whatever
the technological rate of change demands, historical 3-4%, the state wouldnt have to do
very much in a political economic sense, it still has to solve the problem of buying out
various interest groups, but provided it has growth it can do that, so really all the state has
to do is provide the rules of the market provide security externally and internally by
providing and enforcing the rules of the market. That is the theory of the state and
basically of political economy, which isnt too far removed from an extreme view of the
liberal perspective.
The Market: Supply and Demand

The obvious question is why would we assume that this will happen, why would we live
in a world where everything produced was demanded and everything that was demanded
was produced by someone. We need to look at a simple supply/demand curve. Standard
idea is this: we are looking at whether the supply of labour for households and demand of
labour from firms satisfies the condition that the state needs which is theyre equal
The way they draw the curves: we have q the quantity of some good, start at 0, quantity of
the good increases as we move out horizontally, price increases on the vertical axis. What
we want is to know what the demand curve looks like. What will happen if I went into the
store and they were selling CDs for 5c each, you would buy a lot. So if price is very low
then the quantity demanded is really high. If you go back the next day and CDs are $500
each, you would not buy any, so if price is very high quantity demanded is very low. So
the curve is downward sloping.
It is almost an axiom of social science that the normal goods demand curve slopes down.
But if the good is not normal, ie is a status good or Giffen Good (French perfume) dont
follow that rule. But how does the good slope down?
The curve for the demand for labour tends to slope down. If you are manufacturing
computer chips which require high level of expertise the curve will not slope down as the
price for the good may be high because the people are highly educated but you may still
need the same quantity. On the other hand if you have people cleaning your house the
cheaper they are the more you will hire.
Neoclassical economics assumes that the supply curve slopes up. The assumption is
necessary for the model to work as when the curves intersect at q*p* there is an
equilibrium so NOTHING shifts

What if the supply curb isnt horizontal or doesnt slope up: there is no equilibrium then
which is a big problem
What about the supply of labour: the Marxian assumption is that the supply of labour is
more or less as large as you want it to be for a fixed price. This is an interesting
assumption because if you were looking for labour internationally, this assumption is
closer to being correct. So this would look like the following: (in red, which is p* and
there will be an equilibrium at q*)
L = q* the labour will be paid some amount (star on e*) they will use the amount of
money e* = g* So the system would be an equilibrium.
What happens if the amount of labour (l bar) people want to sell is at a different point
the system is equilibrated which is what the diagram says, but at the wrong point. So there
is unemployment and nothing in the system itself to shift it. So what has to happen is that
the demand for labour curve outwards so it meets where the new wage point is. Rudd
government can print it and give money to households, they go out and buy stuff, keep
doing this until you get supply demand equilibrium
Alternatively it can give money to firms, but that wouldnt work with the classical model,
because the firms have already satisfied demand, so you need to buy things from firms.
So the government can buy shovels from me and I will have to employ more people so
unemployment is lowered.
Alternatively the government may wish to get the sorts of returns that best fulfil its
imperatives (instead of buying shovels, buy healthcare). What the state has to do is to
shift the demand curve. There are lots of ways to do this.
What happens when the rest of the world is involved. In that case we have an external
sector and so a number of possibilities. Clearly one possibility is that households could
give money to the rest of the world and buy things. Firms could give money to the rest of
the world and buy things. Alternatively firms could actually sell things to the rest of the
world and get money in return and households might sell something to the rest of the
world shifting an asset and getting a return.

The State: Lack of control over the Market

Now the state has a problem, which is that it doesnt control so much of the system
anymore. So it can give the money to households because the demand isnt high enough
and the households may buy computers which Australia doesnt produce, similarly if you
try and buy things for firms, they might externally outsource labour needs. So the demand
curve for labour doesnt shift.
So what we need to do is to analyse the entire system when it becomes more messy. What
we now are going to do is call the whole box s1 but there are a lot of things going on in
that (the relationship between the external market and internal structure of the state). In
this case our problem is that we have a bunch of these states, s1 s2 and s3 and we have the
rest of the world which all of them are interacting with and each other, and the rest of the
world is acting back on them.
Here the state is subject to two forms of anarchy the anarchy of the international system
(security, threats, violence) but also the anarchy of the market. The outcomes of the state
are also now subject to the anarchy of the market due to these sorts of things. So the state
is trying to control its external environment where the environment is very anarchical.
States respond by trying to create rules and institutions and so making the market behave
in an orderly way.

The international system itself as a result of trade, technical change, shifts in geopolitical
realities, differential rates of growth among states changes for various reasons. These
changes themselves (many are unintended environmental problems, differential growth
in states creating problems for security or unemployment creating a political backlash
moving the state to a protectionist government, etc and others intended tariffs, foreign
exchange rules, cross border shipping of goods rules)

These changes impinge back on states, they influence domestic politics and as a result
states try to change the system again shift their rules again in order to avoid their
problems or meet their imperatives, so this is a dynamic model

The Three Key Questions in International Political Economy

1. What are these rules and institutions and how do they come about? It is important how
they come about because states are locked into the international system and that is structure they
have to work with.
2. So who actually benefits from these rules? This is an important question because the fact is
that everyone is trying to change the rules to satisfy its own imperatives and maximise its own
benefits, but so is everybody else. This question of course is hotly contested: that the rich
countries benefit, and poor countries suffer is one strong body of argument.
3. What are the consequences? When you think of rules you think of a game, a game is
something done according to rules, so you get outcomes. If you tell me how much wealth you
want every individual to have, I can adjust the rules to give you that outcome, although you
wouldnt want to do it with 8 billion people. So according to rules you get certain consequences,
and the market impacts back on the states. There is an issue of stability: is the system stable? It
has crashed before, with disastrous consequences, the worst being the Great Depression. What
about poverty? It is a problem. What about the environment? According to a set of trading rules,
you have certain goods produced in different ways, and there is a claim that there is a claim that
environmentally the planet is turning into a catastrophe: fisheries are going extinct, that
productive resources are being rapidly depleted, and global temperatures will be increased
significantly in our lifetime. These things are all consequences of the market which is a
consequence of the things that the states do to achieve their imperatives.
As mentioned, the fundamental problem is the constant tension between states and markets.

The origins of Institutions

World population is est. 6.79 billion (2008) GDP per head is US $10,500 (2008),
GWP is 69.62 trillion, and total world trade (2008, imports plus exports) is 31.77
trillion, compared to Americas GDP (2008) which is 14.26 trillion
How did we get here? Here is the IPE view of how this system is structured by the
actions of states: States dont start with a completely uninhabited planet, it has already
been carved up and interactions are already going on

o The first stage is the period up until 1914, the period of State Rivalry.
o Next period is between 1914 1950 which is War and Collapse.
o Then 1950 1974 is the Long Boom, at least for the developed countries;
things seem to be growing infinitely, and for the developed countries there is
not that much internal instability, but if you happen to live in countries like
Vietnam, you are not so lucky
o But in the period from 1974 1990s things begin to change, with a slow
down in the world economy and the beginning of instability. Capitalism seems
to be doing very well in this period, but ironically while it was still being
heavily criticised in 1950-1974, Capitalism as an ideology is not criticised
nearly as much in this period
o 1990 2000s there is a lot of financial instability and India and China begin
to emerge. The collapse of USSR in 1991 doesnt seem to make a lot of
difference on the international economy from a global perspective.
o 2000 onward: before the economic crash, we wouldve called this China,
India and environmental (really energy) problems.
But now what we seem to get is a re-emergence of the financial instability that people
thought was sorted out in the 2000s with third world debt being restructured, and the
peso crisis being overcome. Again it seems that there is a new wave of instability,
there are new sources of instability, not just a continuation, not the same kind of
instability

Period 1: Development of the system to 1914

The Napoleonic wars are over by 1815, and the European state system begins to structure
internally, though not very successfully
The first world war occurs, but there is internal restructuring and emergence of strong
states
Also emerging is capitalism and along with that the industrial revolution, the rise of the
industrial powers
The first state to really start restructuring upon this basis is the UK it structures first
and becomes the dominant industrial power which means it also becomes the dominant
trading and military power
This puts pressure on other states (which have to react to this) and there is a period of
European expansion across the globe
Prior to 1870s Britain is the leading industrial power, and has something around 40% of
world trade in this period a staggering figure. Britain mainly through the British East
India company controls and trades with India and invests 5% of GDP overseas (US
currently invests 1-2%.)
So here in this period you have a degree of globalisation measured in terms of
investment and trade going on between the UK and the rest of the world which in some
ways is of the order of magnitude and by some measures larger than the order of
magnitude than what we now see. Keynes has a passage saying that the world economy
would keep growing and nothing would change.
This continues for the British at least up until about 1914. Things begin to change,
because driven by their own imperatives, the other European states in particular attempt
also to expand across the globe, to try and industrialise, and to catch up with Britain. In
order to industrialise they must access raw materials and markets for their commodities,
and so they seek to control sectors of the globe in order to fulfil their own ambitions

So you get essentially what you get is a period of rival imperialism, with the major British
powers all trying to establish empires to use them to support their own industrialisation
programs and economic development
Part of the impetus behind this is that the very active industrialisation enormously
increases the cost of war (a lesson of American Civil War was that wars fought by
industrial powers became more and more expensive, although this was not obviously
learned by 1914. When in the American Civil War battleships (ironclads) driven by
motors began being used, the whole war was redefined and European fleets became
redundant. Cannons and modern warfare implements also caused this arms race. So the
naval supremacy of the US caused European powers to need to develop similarly
After being forced out of America, the European powers could either move into new
areas, or expand into existing settled areas, obviously all for their own benefit Clearly, the
impact on the areas will be different.
The East India company essentially had complete political dominance of India backed by
the British government, and so logically the UK wanted to expand as much as they can as
an industrial power
So the UK imports raw materials from India and then sends back manufactured goods to
pay for them. If the UK could get the terms of trade right, they would still have enough
manufactured goods to sell of to the rest of the world
The UK did not want to sell raw goods to India and import manufactured goods because
they wanted industrial development, which meant military dominance, because the
literature states that this confers gives greater growth, a more highly skilled workforce,
and a basis for greater industrial development. (Note that the UK physically destroyed
Indian cotton industry but cutting off peoples thumbs: they didnt want to buy goods
from India)
Britain had lost USA, but they still had Australia, NZ, African colonies, and some of
Latin America. Australia is intended to be a producer of raw materials for the UK; all of
these colonies sent goods to UK and then UK sent manufactured products back to pay for
them. Obviously the UK had extra manufactured products so they made a profit. In those
days this was the entrenched trading pattern among the UK, France, Germany (the
Imperial powers).
The imperatives of these Imperial powers were to develop their own manufacturing and
industries as much as they possibly could, and so they established the abovementioned
trading pattern with already controlled or newly settled areas
The result is that the Globe is divided up with the Imperial powers retaining political
control over various sectors and the conflicts between European powers are largely
external, so fought in foreign lands (Africa, Asia, etc) in small scale wars over Imperial
territory
Obviously as a result of the Imperial expansion of countries such as Germany, France,
Belgium etc, the power of the UK declines and the percentage of world trade taken up by
Britain falls from 40% to around 15%
At this point the US is expanding, but not as imperial power; in the early period this
expansion is enormous but takes place to the West, taking large portions of Mexico
The whole global situation is fraught with instability due to this rivalry between states,
causing the explosion of war in 1914
An interesting question is why this happened in Europe? Why not China, it was
developed for a longer time, as a part of the industrial revolution there were advances in
science, why didnt China experience the industrial revolution expand across the globe?

One hypothesis is that it is simply political European powers were at war with each
other so they needed to expand (imperatives of the state) Chinas problems were different,
they wanted only to maintain an existing empire and keep things stable, and so didnt
want to expand.
What institutions are there to manage this global instability?

If we have two states trading, S1 and S2. Assume that S1 produces chairs, and S2
produces computers. So they swap their products for each others products, and there is an
exchange rate based on this exchange of chairs and computers
There is some sort of circular flow, and equilibrium between how many chairs a computer
is worth
The problem however is that states are not like firms or households, because S1 not only
produces chairs but it also produces dollars, households cant produce money, but states
can
S2 also produces computers and yen. So if S1 sends dollars to get computers, and S2
sends yen to get chairs.
If what S2 really wants is dollars, what will happen if I just print dollars and send them to
S2 and still get computers. We have this problem in the system, which is called a moral
hazard problem
In a very complicated world it takes a while to get found out if you are producing money
for nothing (because there is so much money, capital and trade), and essentially you are
getting value for nothing
The value of money was and still is a huge problem, and it lies at the heart of the system,
and some of the financial crises that have occurred. The other problem is the value of
capital. How does S2 know S1 has the chairs to back their money up?
To remedy this problem the UK introduced something called the gold standard, they idea
being that money is a token to be backed by actual gold.
So if S2 sent S1 some computers, S1 would have to send them some gold in return, and if
S1 sent S2 some chairs, S2 would have to send theme gold in return. The idea is that if I
am not producing enough chairs I cant get enough gold and therefore I cant get any
more computers because I cant pay for them
The problem was that people didnt want to carry around bags of gold (being so heavy),
and that each dollar had to be backed by a unit of gold
Assume that $1 is one gold and 1 yen is one gold. S1 has 100 units; they are buying
computers and not selling any chairs. So the amount of gold it has is going to go down to
50. As a result one dollar will only be equivalent to half the amount of gold, a gold,
because we only have half the amount of gold left
1 dollar therefore will be worth 2 yen because S2 have twice the amount of gold. S1 has a
deficit which means that the value of gold goes down, and the amount of dollars go down,
so the computers are more expensive. Once the price of something goes up, demand goes
down
S2 used to have to pay one yen for a chair, but it can now get two chairs for a yen. So
chairs are cheaper, S2 can import more so it does (rule of demand), and at the same time
the demand for S2s products goes down because S1 doesnt have enough money to buy
the computers as the value of their currency has fallen: and so equilibrium is reached
again

The system has therefore a self-equilibrating mechanism. By fixing the value of money to
gold, you not only know its value (so the states cant print money), but that in world trade
if the states run deficits, the states economies will balance themselves. If the state buys
too much, the dollar becomes weaker, which means that they can buy less of other states
goods, which also means other states can buy more of their goods, which means that the
balance returns
In a simple world the gold standard creates a basis for stable trade, and it was the
foundation of trade until 1914. From 1914 until the end of WW2 its use among countries
as a form of monetary system declined linearly, until it was replaced after WW2, and
eventually abolished by the USA in 1971 when Nixon eliminated the fixed gold price,
which meant that all nations had in 1971 completely switched to full fiat money
Going back to the gold standard is not a completely dead issue, and it does overcome the
fatal problem in the system. During the Reagan years some American economists talked
about going back to the gold standard. But there are problems with this, such as the
instant shocks that would through the system upon reintroduction
The Gold Standard is a solution to problems created by such market activities as why do
we have floating exchange rates, why can people speculate on currency, why is their
foreign exchange trading; because the gold standard provides an instant point of
comparison: the value of the currency is simply determined by how much gold that
country holds

There is increasing internationalisation, there is travel around Europe without passports,

Britain is trading at about 40% of GWP, there is more globalisation in some areas than we
currently see
WW1 occurs and there is a catastrophic collapse of the international political system
Realists argue that the collapse occurred because the international political system is
fundamentally anarchical, it is always on the brink of collapse. Also this is a period in
which Europe is carved up into the old Empires and the boundaries of political enemies
do not coincide with boundaries of nationalist aspirations and groups
Marxists argue that the collapse is as a result of the struggle between rival capitalists who
are attempting to carve up the globe in order to maximise their industrial expansion to
maximise profits, and their military potential (which Marxism is less occupied with)
It is not clear how WW1 fits into a liberal perspective because during this period trade is
increasing, people are travelling, there is a lot more commerce, therefore people are more
integrated and since trade is a more peaceful way of doing things than war it is unknown
why WW1 occurred
Several commentators in the last year have stated that just as WW1 was unexpected, so
was the recent global stock market crash; no one believed that the systems could fall apart
so badly. The fact is that the systems can be exceptionally fragile and it does not take a lot
to fracture them. Therefore we shouldnt necessarily believe that the system we live under
is necessarily self-stabilising
1914-1950: War and Collapse

The spectacular thing that happens is that the gold standard was abandoned in the first
world war, because countries needed more money and so there was the emergence of
hyper-inflation, particularly in Germany

In January 1919 the price index was 262 and in December 1923 it was
126,000,000,000,000. So anything you could buy for $262 would now cost the latter
figure: therefore something that used to cost $1 five years later cost 500,000,000,000
the heat content of the money was worth more than the wood you could buy with it so
people were burning money
This phenomenon of hyper-inflation is important because it haunts the Western
consciousness; it is the reason why the Bundesbank is so strict on inflation, it is
constitutionally required; otherwise money becomes worthless
When money becomes worthless peoples lives are devastated and the system falls apart,
and people become radical, causes political movements like Nazism
During this period the UK tried to return to the gold standard, this devastated its economy
and this was the end of the Gold Standard. The other reason for not returning to the gold
standard in the 1930s was because the world was going through the Great Depression,
people wanted to print money to try and solve the unemployment. Socialist parties were
growing, there was talk of expropriating wealth, countries had to attempt some sort of
expansion
At the end of the war, there was a concern with rebuilding. Even before the war ended in
1934 there was an agreement made at a conference in Bretton Woods in New Hampshire,
the Bretton-Woods agreement
Keynes represented the British, the French and the Americans were present, Germans
were not represented for obvious reasons. These talks explored what kinds of political
economic institutions these nations would put in place after the war. The parties involved
wanted to stabilise world trade, avoid economic conflict, solve the money problem, and
increase domestic political stability. Socialism was thriving and haunting their nations:
they needed to make the world safe for capitalism
1950-1974 War and Collapse

World is dominated by two superpowers, USA and USSR. Cold War begins when USSR
tested their first atomic bomb in August 1949, although USA always had a greater nuclear
arsenal even 15 years later (some ten times greater than the USSRs)
Essentially the world is divided into the camps of these two enormous powers and so the
US tries to rebuild the capitalist system which (in the very modified form of it that we
understand) only exists really USA in a few bits and pieces. USA was a command
economy, UK was a command economy (Economy planned and directed by
government, where resources are allocated to factories by the state through central
planning.) Europe is very devastated, and there is a command economy in the USSR
So US wants to strengthen its allies (its bloc) and the capitalist market system. The result
is that between 1950 and 1970 there is a period of long economic boom with spectacular
growth by Japan and Germany
In this period the US provides huge loans to European nations very devastated by the war
so that they can begin purchasing US goods: The Marshall Plan. In the non-command
economy the US economy is basically the worlds industrial sector
The Marshall Plan today is about 2% of US GDP which is 14.26 trillion, therefore 28.52
billion dollars
By the mid 1950s then growth of the OECD countries is taking place (that is, countries
that trade, and not those in the Soviet Bloc) but the USSR is actually growing faster than
the West, and it was thought at the time the USSR (a command economy) would take

over the West in terms of their output. They had the first man, dog, missile in space. The
total world product for USSR grows by a factor of 4 or 5, unprecedented in history, and
total world trade grows by a factor of 10, but it takes until the 1990s until there is a return
to that rate of growth in 1914
Japans economy grows at 10% a year, again a much faster rate of growth than what
China is currently experiencing, to bring Japan up to being the worlds second largest
economic power until recently; there is also a rise in multi-national corporations in this
period
The Bretton-Woods agreement: objectives were to stabilise the world economy, prevent
trade wars, and to try and solve the monetary system dilemma with the aim not only of
satisfying the imperative of states for economic development, but also (a smaller idea) to
rid the world of economic conflict, and by doing so ridding the world of one of the major
causes of war
There was a realignment of Europe by the end of WW2 the states were configured most
closely to national and ethnic groups; there was also a destruction of the European
(British and French) empires in Asia, which allowed Asia to realign much more
successfully, although the European powers fought bitterly to retain control but eventually
could not
So how to solve the worlds money problems? They realised that they could not return to
the gold standard because with the gold standard, when a nation begins to run a deficit,
shocks are sent through the system resulting in immediate unemployment which cannot
be remedied by inflationary measures (printing more money) nor by deficit spending. So
the problem with the gold standard is in a sense the transmission is too mechanical, there
is nothing to soften the blow; and major shocks to an economy cause political instability
which cause war
What they want is a mechanism that keeps money in balance but doesnt send such large
shockwaves through the system and create political instability
As a result those at the conference created the IMF or International Monetary Fund. The
idea was that each country has to nominate the value of its currency relative to some
benchmark currency, which is fixed over time, and the aim was to keep the currency
within + or 1%
Keynes actually wanted to create an international currency called the Bancor that would
be printed, but clearly for reasons of sovereignty the other countries did not agree
The point of the IMF is that it would be funded by its members deposits (who would give
some fixed portion of their GDP), and if a state went into deficit, they could get a
temporary loan to try and fix the problem as long as they could show by application what
they were doing to try and remedy the problem
The other obvious problem that needed to be remedied by the IMF was trade. In the
period between the wars, as depression set in, countries attempted to guard their own
national interests by putting up barriers to imports from other countries (placing tariffs on
foreign imports) and also by trying to make their exports cheaper
This made the depression worse because it quietened down world trade. So those at the
conference endeavoured to set up institutions to regulate trade.
The first institution that was set up was the ITO or International Trade Organisation,
which never fully got established. This was to prevent countries subsidising their exports
and putting up tariffs to imports, etc. This couldnt get through US Congress because the
US Mid-Western states wanted to allow subsidies on agriculture, which later became a
big problem for the US because the Europeans had big subsidies on agriculture

As a result a weaker version of this organisation was set up in the form of the GATT, the
General Agreement on Tariffs and Trade. The GATT has a MFN (Most Favoured Nation)
agreement which is at its heart, that says that I must offer anyone who wishes the same
terms of trade that I offer to the nation with whom or to whom I give the best terms of
trade. This stops states from choosing who they trade with and on what terms. One
problem here was the British Imperial Trade agreements with its colonies.
The MFN agreement aimed to break down restrictive trading agreements. The problem
with the GATT rules is that countries were able to form clubs whose members trade
together, and thereby exclude the MFN clause. Examples are the EU for the Europeans
and NAFTA for the US
The third institution set up was the World Bank, the point being was to establish loans
and credit to third world countries in the struggle to induct them into the Western sphere
of influence. The USSR, during the Cold War, who had immense capital, were offering
loans to third world countries and the West also needed some means of doing so, so as to
prevent the USSR from establishing alliances with third world nations upon this basis
In the late 1940s and early 1950s there is a new period of instability. The Europeans (the
biggest traders) are too poor to finance the IMF, their domestic problems are too great to
maintain this system, countries start to drop out of the agreement, so the IMF doesnt
have enough money to enforce the system it established to try and stabilise world
currencies
As a result there is need for a new solution, and the proxy gold standard is created.
(Mathematicians are still working on the ideal money solution). What makes this work
initially is that US is the only big economy and it is financing Europe, therefore everyone
wants dollars. Step 1 is therefore to fix every other currency to the US dollar, and Step 2,
you fix the value of the US dollar to gold. It is initially fixed at $35 = 1 ounce of gold.
This is often called the n-1 money problem. N is the number of the currencies in the
world, and so they cant all fluctuate or alter simultaneously, because the currency before
is needed to calculate the value of the currency after it
It turns out that the proxy gold standard also has some problems: 1) The Tiffen Dilemma,
which is that if you fix the amount of dollars, world trade and GDP cannot increase any
more, because there is no more money in the system. Tiffen said that there was a
dilemma, if world trade was going to expand a) and the amount of dollars were fixed,
there were not enough to facilitate the increase world trade, undercutting the whole
purpose of the system which is to develop and grow capitalist economies, and b) if dollars
increase, there is not enough gold to back up the value of those dollars as the resource is
not infinite
The second problem is the moral hazard problem (so named for game theorists) so the
American dollar is essentially as good as gold, so the US is still able to get away with
printing money

1950 1974 The Post War Foundations of the System (the Long Boom)

Reiterating; the institutions that were born out of Bretton Woods were the proxy gold
monetary system, the IMF, the ITO, the GATT (with the MFN as its basis) and the world
bank
As we saw the dollar gold or proxy gold standard leads to problems which are explained
by the Tiffen dilemma: if the amount of dollars in the world is fixed and the supply of

gold is fixed then there arent enough dollars to cover the expansion of GDP of the
western countries; and if you enable the amount of dollars to increase then the amount of
gold cant increase because there is a finite amount of it
Therefore there was a moral hazard problem: the US could print gold and buy their
way out of their political difficulties. This was done to finance the Vietnam war, and
Johnson and other Presidents tax cuts, so the US government was inclined to run budget
deficits which effectively led to an increase in the production of dollars
As a result there is a period of instability, and in 1968 there is a run on gold when the
central banks of France and Germany realised that these dollars they were holding were
not worth the gold they were said to represent ($35 ounce) and so they demanded the gold
to back the $US up
The Germans instigated this run, the French had no qualms with what the US was doing;
everyone knew that there were more dollars than gold but that everyone wanted the
system to stabilise. The French were the first to demand repayments in gold which led to
a run on gold
The nations tried to sort this out by putting in a two-tier gold standard. What this stated
was that central banks can buy and sell gold at the rate of $35 per ounce but outside of
that anyone else who wanted to buy and sell it had to do so on the open market (private
transactions had to take place at world price)
So when these nations realise that market price of gold ($35 an ounce) is much less than
what gold is worth, they try to buy it up and of course then the market price of gold goes
up
The system lurches along for a short period but it is clearly untenable, US deficits are
growing due to the Vietnam war and in a dramatic move, Nixon announces that the US is
off the gold standard. As a result there is lot of short term monetary instability (no one
knows what the rules are anymore) and there is the emergence of the current system (or
the current non-system) of floating exchange rates
Therefore we started off with gold standard, and then a number of different attempts to
stabilise the system, and now that everyone has given up, the world has floating exchange
rates. How do these work to give a commonly accepted value of currency? It is still not
really obviously how or if it works well at all
As a result of this there is a period of inflation; and matters get worse in 1973 when the
Arab-Israeli war begins, and as a consequence the oil producing states form an oil cartel
called OPEC
The OPEC argument is simple and persuasive Western powers are controlling the oil
production and paying much less for it than what it is worth. The war creates enough
unity for them to overcome their collective goods problem and they can form a trading
bloc. So they united and created OPEC, in order to be able to demand higher prices
The price of oil increased by factor of 5 immediately and so OPEC countries now had
transferred a staggering amount of wealth to themselves, around 2% of world GDP. This
creates a big problem later on
In response to this, most of the Western countries dont do anything but France and Japan
go nuclear in an attempt o try to reduce their reliance on imported energy by producing
nuclear power plants France is at about 80% of nuclear energy of total energy, and in
Japan 30% of energy is nuclear. Nuclear energy is one of Frances biggest exports
The OPEC countries have all this money which essentially they cant spend. They must
do something with it, and so they recycle it, and invest it back into the worlds banks. As
a result the banks now have flush of liquidity and need people to lend it to in order to get
a return

This is the beginning of the Euro dollar market. The US attempts to stabilise the system
by not allowing trading in petrol dollars, but London which has become a minor financial
centre sees a chance of re-establishing dominance.
The British immediately create institutions to recycle Euro or Petrol dollars, whereby they
insulate their domestic economy and only allow a quarantined group of institutions to
cycle dollars throughout the world. This creates asset bubbles, and third world debt
There are also more negotiations and reductions in trade barriers, but agriculture still
remains a problem
Between 1950 and 1974 although there was some instability, there was a long boom

1974 1990: Period of slow down and instability

The political system dominated by the gradual unravelling of USSR. Its importance as a
military and economic threat is decreasing so capacity of US to act as the sole superpower
is beginning to increase
There is an increased economic influence by Japan and Germany which are very big now,
with Japan as the second largest economy at this stage
There is some friction within the Western Alliance. In 1960s the Western countries and
US got on well because they were dependent on the US, and these other countries were
thankful and grateful to US for protecting them during the Cold War. However now the
other Western countries (newly emergent Industrial powers) are less inclined pander to
US whims and accept their policies
So there are rounds of trade negotiations and a lot of friction, including the Kennedy
Round, Tokyo Round, and the Uruguay round: 1986 1993
In the Uruguay round the WTO is formed which replaces the old GATT. It has the same
aims but is more extensive, and now has power to sanction states that break the laws
(sanctioning power). The WTO is essentially the institution that dominates and sets the
rules for world trade
In the financial system we have floating exchange rates but the US is accepted as the
world reserve currency. This means that we have got rid of the Tiffin dilemma, as dollar
is not fixed, but we still have the moral hazard problem. The US dollar has been accepted
as the solution to the n minus one money problem, but the US can still print money if it
wishes because the US dollar is accepted as essentially the monetary unit in which every
other unit is expressed
At this point the US goes into huge deficit and has been ever since. The US has a very
large deficit with Japan, who is a large surplus country. There is some with Germany also
There is also declining support for trade liberalisation, which we see now with China and
then with the Japanese who were apparently going to take everything over (they could do
anything better than the US could, etc)
Reaganomics and Thatchernomics emerge, the former involving running massive budget
deficits and massive deficits on current account. The US borrows heavily overseas, the
value of the dollar becomes very high which exacerbates the deficit on current account,
and there are increasing disputes with Japan and Europe over trade. Essentially by
maintaining a high dollar US consumers are allowed to consume more than they are
producing, so there is a conflict between the US on one side and Japan and Germany on
the other

The US state is accused of solving its political problems by running this large deficit, and
Japan and Germany are accused of not letting the value of their currency rise to maintain
trade surpluses with the US. So again a period of disturbance in the system and a fair
amount of conflict begins to emerge. Europe is now less likely to accept US policies due
to decline of military power of the USSR
This is a period of financial crises: OPEC have a massive surplus of dollars which they
are recycling into euro dollar market. Banks need someone to lend this money to (no
sub-prime mortgages) so the banks give it to third world countries under very lax
conditions at very low interest rates, without many checks and balances
There is also instability in Europe. This is important because before you had the euro,
Europeans had tried to synchronise their money: francs, pounds, deutschmarks, etc this
whole system starts to fall apart
Soros had more money than British government and speculated against the pound earning
him vast sums of money
In the third world countries find that they cannot repay their debts. The money given to
military regimes has caused the third world debt crisis (1980s). There are a series of
rolling crises in the early 1990s: 1992 the European exchange rate crisis, 1994 the Peso
collapses in Tequila crisis (Clinton uses IMF funds to rescue Mexico,) 1997 there is the
East Asian financial crisis (Thailand, Hong Kong, Indonesia) closely followed by Brazil
(real is attacked by speculators so the Brazilian government tries to clamp down, and the
speculators sensing weakness speculate harder, causing the real to collapse), South Korea.
The Russians have no assets so cannot finance their loans; they refuse to pay which
causes another period of financial instability
Beginning from 1974 there is crisis after crisis, all geared around foreign exchange trade
and financial institutions. There were three things were clear however: 1) floating
exchange rate mechanism would self-equilibrate so these things shouldnt happen, 2) if
they did happen, they would only affect little countries (third world countries) so it
wouldnt matter, as it was thought that the crisis couldnt hit large developed economies.
3) the nature of these financial crises was that in some ways they were isolated from the
real economy
It was thought that speculation would be insulated from the real economy. What seemed
to be emerging was a situation in which floating exchange rates, speculation and
international borrowing (obviously on a much smaller scale than we have seen recently)
seemed to be impacting on the real economy
People thought that they could drive down the value of the currency by speculating
against it. This is likely to cause all sorts of problems: if speculators drive the value of a
nations currency go down, if you are denominated, then your debts which are
denominated in $US immediately become larger because the value of your currency is
lessened.
Problems arise as a result of speculation for industry and government: remember that
governments also borrow. There are problems with debt repayment and some financial
instability. The government decides to take action by pushing up interest rates, increase
taxes; and so there is political and economic instability
In the case of Brazil the government acts and, people riot in the street, the governments
cant control them and so speculators observe that they are weak, therefore they believe
the economy is in trouble and so speculate more, and the problem thereby gets
exacerbated, and government acts more, and there is more instability

We see that it is fairly plausible how speculation can (unless you are a very strong state)
can destabilise these economies and polities right across the board and indeed government
action can cause greater speculation
What we observe emerging in this period (particularly in the Tequila crisis) was that the
IMF was called on for support. Mexico and Argentina called on the IMF for support but
this was not as forthcoming as it should have been; by the time that the
Asian countries called in the IMF for support (where there was a lot of domestic unrest)
they had learned from the problems of Argentina and Mexico and tried to prevent the
cycle from setting up by acting more quickly, although it did in some ways set up again
You can see how problems in finance can easily leak into the real economy and get
increasingly more damaging
1990 Present: The Modern System

The main political feature now is that the US is a single superpower, although there are
other contenders emerging
The US in fact starts to act in this way (see the Bush administrations rhetoric on the
invasion of Iraq; there was a real sense that they could act without any constraints at all)
The Cold War with two superpowers is the counterfactual of this situation; a completely
different political and economic environment
The EU converts to a single currency (which is not really that much of a difference
because they had been trying to tie their currencies for a decade in some way)
China emerges and begins to grow rapidly, there are environmental and energy problems,
and again as in the previous period, financial instability continues
There is increasing resentment of US dominance and foreign policy in this period, as per
what happened up until 1990. (Maybe finally being addressed under the current
administration). But the US is still running massive deficit, which is a feature but not
necessarily a problem
China is growing at 10% per year, its GDP per head is smaller than the US, but the total
GDP is roughly the same as US, which is what counts as far as military power is
concerned. Consequences of Chinas growth are the displacement of much of the global
manufacturing industry (clothing, textiles, electronics) to China
What we have happening (since 1974) is increasing inequality, concentrations of wealth
in the top 5% . For around 50 years the wage of the average American worker has
remained flat
So what do we do about that stability problem? China is now exporting inflation, meaning
that it is exporting consumer goods to the US that are becoming cheaper and cheaper.
Before one needed two weeks of work to buy a TV, and now you only need one week.
Everything is made in China and it is getting cheaper and cheaper.
What is happening is that emergence of China is also helping US solve its political
problem. They can escape with decreasing tax rates on the rich, not increasing incomes
and benefits for lower income earners, and at the same time not suffering backlash
because they can still buy what they want: a political compromise
The demand for raw materials and energy emanating from china is increasing and
therefore (Australia comes in here) again oil prices are destabilised for a time. They have
gone down now but will go up again. It is estimated that total world demand for energy
(which is the most important of all commodities) will increase by a factor of 2 in the next

20 years, with the demand for electrical energy increasing even more than a factor of 2,
maybe by 3 or more.
About 75% of this increase (most of it) will come from India and China. China is building
roughly an entire British energy generating capacity every 6 months or so. Therefore there
is a massive demand for materials and even more importantly, for energy. The
consequences of this havent really been accounted for in the World system
Regarding environmental and energy problems, the big issue is CO2 emissions. Most of
the energy we use except nuclear energy is a big emitter of CO2. At the Copenhagen
conference this was major issue and is clearly not going to go away. To solve this
problem involves agreement between states
Another issue that comes out of the CO2 energy issue is energy security. Europe is now
heavily dependent on Russia for oil who would quite cheerfully close off the pipelines.
China also needs energy security. The US is a big importer of security, and thus energy
security problems are starting to affect geopolitical environments and that way states are
interacting with each other

Financial Instability: 1990 - Present

In the 1930s, 1940s and 1950s the state steps in to try and control the economy
By the 1970s there is a strong move towards deregulation (especially under Thatcher in
Britain and Reagan in the USA), the rise of an argument and a group of vested interests
(therefore suggesting that these groups did not necessarily think that this argument was
correct) designed to benefit heavily many of the groups advocating this argument
The argument is that regulation is bad and putting things on the market is good: magic of
the market, which used to be thought of as a deep intellectual debate
So there is a deregulation of financial markets, and within and alongside the existing
banking system, a large number of financial institutions and operators engaged in
financial transactions and speculative transactions: the rise of a shadow banking system
As a result of this and a conjunction of other effects particularly surplus $US in the world
and policies of the US Federal Reserve Bank under Alan Greenspan, Federal Chairman,
such as pushing down interest rates: basically there is a lot of money cycling through the
system and a lot of financial institutions with very little regulation looking to take
advantage of this
The result is that there is a development of a large number of exotic financial derivatives,
and the development of a housing loan market without the normal constraints
The immediate consequence is a downturn in US housing prices, which flows through
quickly initially to a strain on some of the new financial instruments like mortgagebacked securities, collateralised loan obligations, packaged mortgage assets, etc
Because these lose their value, the problem flows on to credit default swaps, etc and
eventually in the matter of a few weeks and months, there is a run on the shadow banking
system, and institutions begin collapsing
Northern Rock collapses in the UK, Bear Sterns and Lehmann Brothers collapse in the
US, government-backed mortgage institutions Freddie Mac (FDMC) and Fannie Mae
(FNMA) get into huge financial trouble

These require all sorts of government intervention to save them. At some point around
50% of the entire US financial system becomes frozen because entities cannot repay their
loans, everyone wants their money back and no one can pay up
The US, UK, Aus, German, French governments step in to try and support these
institutions so they dont fail, to try and maintain liquidity in the financial system. The
end result (looking at the US) is that US households lose around of their wealth, thus
they are only about 75% as rich as they thought they were before
Housing wealth cumulatively in 2006 was around #13 trillion and in 2009 it is worth
around $8.9 trillion
The latest news indicates that there is some kind of recovery taking place
The deeper-rooted problem is the lack of balance of payments between the US and rest of
the world, and the deficit of balance of payments with China. In a simple two state world
China can either buy things from the US with the money the US is giving to its industries
for goods, or alternatively it can use this money to invest in US markets
So China is almost in a position where it is saving on behalf of the US
With these investments back in the US, the banks and financial institutions still have to do
something with this money, so they look for ways to invest it and things to invest it in. In
this case much of this investment was speculative
The supply of dollars is going up which drives down the price of dollars, which is the
interest rate, and because the interest rate is low, people are borrowing money, and they
are doing so to speculate
Speculation has its own dynamic; because people are speculating in Xs, the price of Xs
goes up, because they price of Xs is going up, everyone decides to buy more Xs, and so
on
The other thing the state could do (China) is keep the dollars and do nothing. This is
possibly a great idea for the US because this is tantamount to the US writing IOUs on
pieces of paper for goods and services they receive from China, and then China not
cashing them in. But it is very unlikely that China or any other state would do such a
thing as it is not in their long-term commercial arrangement interests
Marxian explanation of the financial crisis: in the Marxian circular flow diagram owners
are included as an extra element, and take the surplus from firms. This diagram therefore
allows for an imbalance in the system, so you might get a situation where the profitable
investment opportunities available to the owners (that is in productive activities) are too
low so the surplus is then used for speculative activity. So the Marxian take on the current
financial crisis is that this could be a second form of structural imbalance in the system
which is likely to drive financial crises such as the present one
We are in an interesting period as a result of this crisis: everyone is now talking about
regulation and transparency instead of the magic of the markets. We are beginning to
see now many serious commentators making the point that as the world economy comes
out of this brief period of instability, the appetite for regulation and transparency seems
to have largely dissipated. There is a tendency to get back to business as usual, the sort of
business that was being conducted prior to the crisis.
The difficult question to answer is what the consequences of non-regulation of the
shadow banking system and non-remedying of the root causes of the crisis will be. One
might suspect that unless institutions are reconfigured, we are likely to see a repeat of this
crisis in the future
One of the problems is that the sorts of trades and financial schemes that were taking
place were in fact contrary to what neo-classical economic theory tells us that we can get
away with. The people formulating these schemes did not properly understand the theory

behind them, as there is nothing in neo-classical economics that says these schemes are
sound. So therefore this crisis does not require a revision of neo-classical economics as a
theory: the mathematical theory that is
The Present Period

So the system emerges into the current period with two big problems: the first is
adjustment of the US trade deficit. We have a situation where US is doing all of the
consuming, and China is doing all of the saving. How will this unbalance be solved? The
Chinese are saving to much, and the US is saving too little. It is not easy for a state to
save less, unlike a household. There is no point saying that the US isnt saving enough,
the US isnt saving enough because China is saving too much, it is not a morality tale, it
doesnt work like individuals work
The second big problem is how the world deals with its energy problems and with getting
secure sources of energy that are sufficient in terms of their output to drive the sort of
demand that currently exists, and the expansion in production that we are likely to see. It
is estimated that the world demand for electricity will double by 2020. These problems
are being talked about, but only in a peripheral sort of way
1) Problems of Trade Imbalances

So the US has a deficit on balance of trade of about 500 billion dollars a year,
almost 2/3 of Australias GDP which is 800,200,000,000, not a large amount
The problem is that this deficit accumulates such that the US now owes the rest of
the world around 4 trillion dollars; or, the rest of the world owes about 4 trillion
dollars in Americas assets
So how can this be the case, because according to the mathematics surrounding
the gold standard, the system is supposed to equilibrate, if there is a deficit this
will be felt in the strength of the US dollar immediately

The workings of the Trading System

Modern exchange rates

Money is being bought and sold on the open market now, there is no gold standard, so
does this system equilibrate? The theory is that the value of the $US is meant to
converge to what represents its true value, if such a thing exists, so therefore some
reasonable approximation of what its value is
If we didnt believe that the value was supposed to converge, we would clearly not be
very happy with using speculation to determine the value of currency
The law of one price or PPP (purchasing power parity): Things should cost the same
price everywhere, disregarding transport costs. This is because if bread was $1 in
Fremantle and $3 in Nedlands, people would drive up to Fremantle, purchase all of
the bread and then sell it in Nedlands for $3, which means that other sellers in
Nedlands would have to lower their prices due to the competition, and so then you
would also have to lower your prices. The Fremantle bread sellers would realise you
were doing this and so raise their prices because they realise they can charge more and

then eventually it wouldnt be profitable for you to buy the Fremantle bread and sell it
in Nedlands anymore because the prices will have converged.
So the ratio of the value of two currencies, ie. dollar over yen should equal the ratio
over prices of goods. Assuming a hamburger costs $2 in the US and 1 yen in Japan
then you would expect the ratio of dollars to yen to be 2:1, or that one yen can buy
you $2
The McDonald Index: McDonalds hamburgers all have the same ingredients
everywhere so it should cost roughly the same everywhere, so if a hamburger costs
cheaper in one state, the currencies are not balanced and the state where the price is
cheaper has the value of its currency set too low. This has been written about and used
fairly extensively
If in fact currencies are in parity, in a simple model, there would be no surplus or
deficit on balance of payments at all. Two countries, S1 importing more than it
exports, and S1 is on the dollar currency and S2 is on the yen currency. So there is an
imbalance in balance of payments. Why would S1 purchase more from S2? The
simple answer is that things are cheaper in S2 than in S1. But if PPP holds, goods
must be the same price. So if the hamburger costs $1 in S1 and 0.5 yen in S2 (where
1 yen = $1) and this is observed by speculators the value of yen will increase to
restore parity, as speculators see that the yen is worth more than what it is set at. It
will increase until 1 yen = $2. So because buying things in Japan has become more
expensive, the US will not buy as much from them, and Japan will buy more from the
US. So provided that PPP holds, the balance of payments will be re-established
But the story has become more complicated because we have money in the middle
instead of gold. Under floating exchange rates, one mechanism to stop a state from
going into deficit is speculation. If foreign currency traders observe that a state has a
deficit on balance of payments (importing more than they export,) this is a signal that
the currency of S1 is overvalued, or the currency of S2 is undervalued and so they will
begin buying yen and selling dollars. The more yen they buy, the more the price of the
yen will rise as sellers will realise that there is demand for the yen and so raise prices,
and on the other hand as sellers begin selling $US, people will realise that they are
losing their value and so also sell their $US at lower and lower prices to compete. As
the price of yen goes up and the price of dollars goes down eventually they will meet
and it will not be profitable anymore to sell either. So the market for money will
adjust according to the signals it observes and will adjust in a way that restores the
balance of payments. So the whole mechanism is self-equilibrating. Also individuals
from S1 will begin to demand yen because they want to buy cheaper things from S2
which will also have the same effect as what the speculators do
So how well do these mechanisms work? Will speculation always restore the value of
currency such that there is no imbalance between states in the world market. We know
by observation of the US that it doesnt work very well. But there could be many kind
of intervening factors here influencing the mechanism, for example not all currencies
are floating properly, or something else that is going on that we havent looked at to
restore the balance working against speculation
Speculation: how does it work? When I buy yen, I am buying a future value, and what
is important about the future value is that what everyone else thinks the future value is
in the next round of the game, and it is mathematically true in some circumstances
that this will bring a convergence to a value that somehow represents the true value of
the currency
All of this depends on the efficient markets hypothesis, which has been much
discussed lately.

Theories of Trade
Ricardian Theory (Comparative Advantage)

S1 and S2, two goods, A1 and A2 in this case the outcome is obvious, S1 should
specialise in A1 because it can produce 10:1 of A1 as compared to S2 and S2 should
specialise in A2: this is list theory, a theory of absolute advantage
What if however we have a situation where S2 is bad at producing everything, what
happens then? People are scared that this is the case with China and Japan at the
moment, that these states will take over the world. Already we have some reasons to
doubt this, because we experimented with an accounting identity
This is the Ricardian Theory, the most important theory within trade theory, which is
a theory of comparative advantage, which is both true and non-trivial
We will construct the theory so that we have two states and two goods (where there
are more than 2 the theory encounters problems). Ricardos theory is that you should
trade in the good in which you have a comparative advantage, and Smith believes that
you should trade in the good in which you have an absolute advantage
We need to express the costs of these goods relative to each other, and we do this by
constructing a price. If I bought 10 bottles of wine and they cost me $100, they cost
$10 each. So divide total price by the number of units, A1/A2, $100/$10 = 10.
Consider the price of A2 in A1 units if A1 is money and A2 is wine. So for S1, one
bottle of wine (A2) costs $10 (10 units of A1). For S2, A1/A2 = 2/1 which equals $2,
So S2 should specialise in A2, because it is cheaper to produce in S2, and S1 should
specialise in A1: this is the theory of comparative advantage
In order to get a unit of A2, S2 has to go without 2 units of A1, and in order to get a
unit of A2, S1 has to go without 10 units of A1, so the cost or opportunity cost for S1
to produce A2 is much higher (5 times in fact)
But even with this situation where S1 is bad at producing everything, there are still
gains in trade
For one unit of A2, S1 gets 10 units of A1, so S1 would be happy with any trade
which for a given unit of A1 gave it more A2
S2 for one unit of A1, gets two units of A2, now S2 would be happy if for any given
units of A2, it could get more A1
S2 wouldnt accept any trade outside a certain area because it can get more A1 by
producing it itself, and the same for S1, but within the jaws of the crocodile, both with
be as well off as they were or better by trading
The question is whereabouts in this region are you likely to end up? We dont know
what kind of factors may have bearings on that
What are the implications of Ricardian Theory? (This underpins a lot of the neoliberal trade theory also). Everyone is better off if they trade at their comparative
advantage. So where does comparative advantage come from? There are a number of
obvious sources, and one is natural endowments (coal, a lot of land, raw materials of
various sorts, land that naturally lends itself to tourism). You can also have
comparative advantage from geographical location (trade routes), or from a highly
skilled population, or if you are rich and have a lot of capital (remembering that we

still havent dealt with the problem of capital mobility) because you can produce
capital intensive goods, the sort of government that supports a lot of infrastructure
(good roads, healthcare, communications) this will make your economy more efficient
through a more efficient workforce, which gives you a comparative advantage
So natural advantage is only part of the story. Why are most of the worlds aircraft
built in Seattle? It rains all of the time, there are no mines or smelters, or a good
airport. Until recently most of the worlds watches were built in Switzerland why is
this? Perfume, France why France? So this story is slightly complicated

Influence of Situation or Path Dependency on Comparative Advantage

One element that becomes important is the notion of situation or path dependency.
Consider the following: If we have t time of the horizontal axis, and d is development
on the vertical axis, then a country that starts producing earlier on has an advantage
because it gets on a path with a steep upward trajectory and in a sense this is a sort of
crude approximation to what might be happening with some developed/undeveloped
problems
Two factors that are important in determining why beginning production earlier gives
an advantage are economies of scale and agglomeration.
Economies of Scale (First Mover Advantage)

If I decide to build planes, I need a big factory to build them, I have to invest vast
amounts of money into machinery, etc, and lets say that I only build one plane
and its costs me 40 billion, my first plane is very expensive because of the initial
outlay, and I sell it to you for 40 billion. Lets say that you want to buy 2 planes,
then I could sell them for 20 billion each, if I sold four, I could sell them for 10
billion, etc. So for each plane I produce after that the cost price per plane lessens.
But what if there is only a world market for 100 of these planes and 90% of the
market is already taken up? Then because of the enormous initial outlays it will
not be worth my effort to enter into the market as I will not be able to make a
profit by only producing 10 planes
Therefore because of economies of scale and production, new producers will find
it very difficult to get into the market. So if the good markets have already been
captured, late entrants are going to have a very difficult time; early entrants are
going to have a first mover advantage
We can see this played out particularly in the airbus industry; European
manufacturers went to the WTO and said that in order to break the near monopoly
that Boeing has on aircraft, we need to have our manufacturing subsidised until we
get economies of scale. There were a lot of arguments in the WTO over this as we
might expect
There are cases where new entrants manage to break in, for example watches,
where now many are built in Japan. What has happened there is Japan had an
electronic watch industry, which they built up very quickly, whereas the Swiss
only manufactured mechanical watches, and were complacent because they were
the market leaders. Therefore by the time they got into the watchmaking business,
the Japanese had already got the first mover advantage, and then used their
reputation to make inroads into the mechanical watch market

There is entry into industries with electronic change; or, another way to look at it
is to treat electronic and mechanical watches as different industries

Agglomeration

Nevertheless, the problem still remains because of agglomerations. You are good
at doing something today because you have done it yesterday, and anyone that
wants to enter into the market and hasnt done it before is not going to be as good
as it
So if you get a critical concentration and you want to build something that is
complicated, it is easy to do it in a place where it is already been done; you need
to build it where all of the skilled workers are already. That is why you might
manufacture perfume in France even though it might not be geographically
advantageous
The problem with trading the things that you have a comparative advantage in is
that the things that you are trading might not be things that you want to have a
comparative advantage in. For example, S2s only comparative advantage is
growing turnips. But it might be the case that S2 (perhaps for realist or other
reasons) doesnt feel particularly comfortable with trading turnips because the
terms of trade are consistently moving against turnips, as they do with agricultural
products and commodities, so S2 needs to produce more and more turnips to get a
plasma TV, or a Swiss watch, etc. In other words it may be a low growth area.
Secondly, it may be the case that if all you produce is turnips, you dont reap the
rewards from externalities that you reap if you produce goods with a lot of
intellectual value added. So as turnip producing is a low skilled activity, the
population is going to be unskilled and as such it is unlikely that you get a lot of
the flow ons that you do from education (art, culture, science etc) which also
means that it is unlikely that you will develop other value industries because you
dont have a basic skill level to build on

Why trading in goods of Comparative Advantage is not always preferable

So for the reasons of low growth, a lack of externalities, and security producing the
good that you have the comparative advantage in may not be preferable (if all you
produce is turnips, what are you going to do about your security problems? You are
going to have to buy your security from somebody else, which clearly makes you
vulnerable because the flow of security can simply be turned off by a power you cant
control. The need to have complete control over your security apparatus is an
important point in discussion of essential industries.)
US comparative advantage in the past was high-tech industry, but more recently it
has been moving towards agriculture. A US Nobel Prize winning Economist makes
the point that the previous advocates of comparative advantage 5 or 10 years ago who
wanted to move towards agriculture because it provided the best comparative
advantage which makes everyone better off, have not been right in doing so because
they will not be able to reap the externalities associated with education. So this
doesnt seem to be such a good idea anymore, and this can be because what you have
comparative advantage in may not be desirable, and secondly, looking at the causes of
comparative advantage, a lot of comparative advantages seem to be as a cause of
something over which the state may have control; ie some are merely constructs. On

these grounds you enter into the debate about whether or not states should be in any
way attempting to shift comparative advantage into certain directions in order to foster
the interests of the state in long term government imperatives, and in terms of security
interests

Trade Theory and Politics: Constructing a unified Political Economic Theory

1) The Effect of Trade on Domestic Political Coalitions
Theory of Abundant and Scarce Factors of Production

Ricardian Theory of Trade is still the backbone of all trade theory, and what we
derive from this theory is the idea of abundant and scare factors of production
We first identify the factors of production as land, labour and capital, and then to
get some sense of whether labour is abundant or scarce is to tie the abundance or
scarcity of labour to land; that is, if labour was abundant then land was scarce, if
land was abundant then labour was scarce
The rationale for this inverse proportionality is that otherwise it becomes too
difficult to measure whether or not labour is an abundant or scarce factor of
production. Is population of 2 billion, scarce or abundant in terms of labour: this
depends on the amount of land. If you have a very small population and a very
small amount of land then labour may become a scarce factor of production.
Because we have tied land and labour together there are only four possibilities:
capital and land, and labour (possibility 1) capital and labour, and land (possibility
2), land abundant and capital, and labour (possibility 3), labour, and capital and land
(possibility 4). These are the four possibilities in factors of production theory
The forms of conflict that arise from this are: Possibility 1 (abundant capital and
land, and scarce labour), class conflict and varieties of urban rural conflict. Some
examples that may fit into that group are Australia, the US and NZ. If we have a
possibility 2 situation where there is lots of capital and labour, and scarce land,
countries that might fit into this are some European states
Some literature tries to extrapolate from these four sets of possibilities, political
struggle. Rogowski: Commerce and Coalitions. What this matrix does is to identify
interests. That is, if the Ricardian theory is correct, this would be a map of interests,
but interests are not the same as coalitions. That is in order to win in a political
struggle, you need to solve the n/1+2 problem that is you must put together a winnin
coalition
In order to do this you need some sort of majority. Consider for example the Liberal
party in Australia, if the model were correct, we would predict for the period after
WW2 when the Liberal party in coalition with the then Country Party won a large
number of elections (given the ideological map of Australia) that the liberal party
would be capital and land, and the labour party would be a coalition of labour
The problem is that if you are the Liberal party in the 1950s or 1960s, that isnt
going to give you a winning coalition. So what you would predict out of this is that
the liberal/country party would form a coalition of capital and land with some
elements of labour. An interesting question which the theory of trade doesnt give
you is which elements of labour you would find in each coalition. Clearly
(remembering that we are hinging our theory on scarce and abundant factors of

production) what you would expect is that labour that is abundant in Australia (as
the abundant factor of production will be traded: from Ricardian theory) would be
more likely to be found in that coalition and in this sense the abundant factor of
production in Australia in that period would be skilled labour
This is roughly how we would construct a unified political economic model starting
with the theory of trade and moving into a proper political economy
So if the Ricardian theory of trade is correct then interests form that way, and if
interests form that way then coalitions will form that way. Furthermore, you could
trace the dynamics of coalition formation in the US or Australia, or France or Japan
over time. As trading patterns change, so you would expect the dynamics of
coalitions to change
What could you say about this as a political economic statement? Take the case
where all labour is scarce. If our 1950s liberal party is a free trade party, then what
you have is a coalition of free trade, capital and land. But labour is not free trade
because in the simple model, all labour is scarce. Previously we were trying to
differentiate between labour but in the simple model all labour is scarce, so what we
now have is a coalition made up of elements benefiting from trade, and elements
that would benefit from restricting trade. So side payments must be made by ? to ?,
and side payments are very important in politics. What we predict is that this
coalition is likely to be unstable as the costs of maintaining ? in the coalition
increase. The coalition is likely to be unstable because it has elements that are
dissimilar. Our prediction is really one about the stability of coalition formation
driven by data about interests rather than simply a prediction about coalitions. So
the trade theory gives you interests which informs coalitions, coalitions are not
directly informed
But is this the only model of trade that we have? This is the basic model, but other
models have been derived for this that are also important for a political economy of
coalitions. One is the specific factors model which argues that it is generally the
case that capital and labour are not completely mobile. If we think about it, the basic
model requires that capital and labour are mobile all capital goes into exporting
industries if it is an abundant factor of production (just considering possibility 1
here) and labour is harmed by exporting. If in fact, which seems to be slightly more
realistic capital and labour are not mobile, if you have two industries, is industry F1
(which has a production function made up of capital type one and labour type one)
and industry 2 F2 (capital type two and labour type two) noting that this must be the
case because the specific factors model says that capital in type one is in the
essentially locked into producing that product for a reasonable amount of time (if
you are producing motorcars cant switch overnight to producing ice-cream); so the
production functions are set as described, but the political economic prediction is
that owners of capital of type one and labour of type one (labour used for producing
motorcars which are F1, assuming that F1 is not an exporting industry which
motorcars in Australia are not and F2 is an exporting industry) then capital and
labour have the same interests so capital and labour in industry of type 1 are likely
to be in the same coalition and capital and labour in industry of type two are also
going to have the same interests, and their interests are going to be different from
the interests of capital and labour in industry of type 1. In the Ricardian factors
model there is capital on one side and labour on the other but in the specific factors
model, capital and labour of different types line up. Labour of type one forms and
interest with capital of type one, and the same for type 2

If the specific factors model gives a better prediction of the way in which
international trade works, then what we derive from it is a different political
economy and a different set of predictions
So thus it is a straightforward empirical question to be tested by facts from research
as to whether factors are lining up according to the Ricardian model orf abundance
and scarcity, or they are lining up specifically according to whatever industries they
are in

Effect of Comparative Advantage on Domestic Politics and Growth

So according to this model, S1 should specialise in A1 and S2 in A2. An

implication of the theory is that comparative advantage may be artificially created,
although in some places it is naturally given
It also may be that for security reasons states would wish to try and create a
comparative advantage in which they dont have one. So what we typically see is
that states that dont have a comparative advantage in military instruments produce
their own fighter planes, weapons, naval ships, etc in order to be independent of
other suppliers, in order to have independent military capacity
Another possibility is that you may have a comparative advantage in areas that are
low growth areas. This is a difficult problem because it is inconsistent with most
simple models. But there is a good deal of evidence and some mathematical
modelling to show that some areas of specialisation are associated with much
slower rates of economic growth, remembering that growth is one of the
imperatives of the state. This has been shown most sharply in specialisation in
commodity exports (the Dutch disease, the curse of commodities, etc) and there is
some argument that if you depend largely on the export of natural resources and
other sorts of commodities with a very low element of specialised labour, in the
long to medium term your rate of growth is likely to be much slower than if you
specialise in areas with a very high value ?added? and a fairly high content of
skilled labour
The reasons for this are not immediately obvious, but intuitively, if you have a
highly skilled population with lots of engineering or film production skills it then
becomes easier to use those skills in space programs, computer hardware, medical
research: there a lot of linkages. So it is likely you can keep scanning around
peripheral areas of production opportunities
It may also be the case that specialisation in the sort of goods that require a very
highly skilled labour input also gives you a lot of social benefits considered more
pleasant and desirable to live in a country where people are more highly educated,
as you have a richer culture: better music, better restaurants, better art, better
theatre, architecture, and these all feed in different ways into the social welfare
function
These sorts of things come important when we are looking at the structure of the
WTO. It may be the case that some states wish to try and move away from their
existing area of comparative advantage into new areas by intervening in the trade
cycle: by protecting industries at a basic stage, or by fostering new industries that
cant develop industries under conditions of pure competition (prime example is
Europes production of passenger aircraft large subsidies to airbus industries, a lot
of fights with the US through the mechanism of the WTO and the eventual
establishment of a rival centre of construction to Boeing which had essentially

dominated the industry prior to the entry of Europe refer back to economies of
scale where if Airbus tries to enter the industry in the gap that exists they will be
making a loss because the set up costs are so astronomical. So the idea is to
subsidise Airbus until they are able to enter the industry and capture some of the
market. Again if all trade is purely free market then it may not be possible for
Airbus to enter the industry
So the Ricardian theory of comparative advantage does not necessarily provide an
argument that it might not be in the interests of governments to intervene in various
ways in the production cycle

The Terms of Trade Problem

So what happens to S2 if it is poor at doing everything? The Ricardian theory tells

us that S2 can still trade and increase its welfare because of comparative advantage.
If so what we would expect is that even poor countries that arent very production
could still find a place in the world trading system and possibly increase their
welfare, and we observed that this isnt happening
How can we make the observation, given that this is our only real theory of trade
that we understand, consistent with out theory of trade. What if S2 has a production
function A2, it trades turnips. It cant really produce any technology for open heart
surgery, etc. We saw that in this case we can actually draw a map of the region
(crocodile) in which trade might take place. So if S1 gives up one unit of A2 they
get 10 units of A1, so the trade off curve is a straight line and they will be happy
trading anywhere in ?that? region. For S2, no matter how much A2 it gives up, it
cant get any A1, so essentially for any amount of A2 it gets 0 of A1. It is better off
anywhere of the right hand side of the red jaw. How would the Ricardian theory
explain underdevelopment? One explanation is that if A2 is fairly easy to produce
what the theory tells us is that trade could take place anywhere in ?this? region, but
if S2 is producing a commodity which can be produced in a lot of areas, (like most
agricultural commodities) the terms of trade may take place very close to ?this?
line, and depending on the ease with which other states produce, A2, S2 may
actually get ?this? production ratio, that even though under the Ricardian theory it
benefits, these are exceptionally small
So therefore we can also exploit the Ricardian theory to explain the persistence of
underdevelopment even give that the theory tells us that a state may have a
comparative advantage in something and it is going to benefit from trade

2) The Effect of Trade on the Capacity of the State to raise taxes and distribute revenues
Capital Mobility

With trade you can shift anything that you like around, which means that you can also
shift capital. What we want to do is to look at how trade effects the capacity of the
state to raise taxes through capital mobility
Consider the following problem: In liberal democracies, 5-10% own around 80% of
the wealth, so it is very unevenly distributed
On the other hand, political power is evenly distributed: almost everyone gets a vote.
The obvious question, and one of the central questions in political economy, is the

n/2+1 problem. Why dont the 80% vote to redistribute the wealth? Remember where
we started, we said that the state and market have different imperatives. In the state, if
it is a liberal democratic state, people can vote for whatever they like, so if these
people are rational (they can vote according to their own interests) why dont they
vote to redistribute the wealth?
This has been a problem in political economy for several hundred years. Hume,
Bourke and the founding fathers of the US constitution worry about it, Mathieson
does. They all say, we cant give these poor people a vote because if we give them a
vote, theyll take away our wealth so we have to restrict the franchise. There is a big
debate about this with human rights and equality supporters on one side and selfinterest on the other
There are a lot of possible answers to this question. The most common is the
preference distortion response that something is happening to distort their
preferences something is happening so they dont realise that it is in their interests to
distribute wealth, and this is basically why sociology was invented, to answer this
question
There is a second minority response which says that this is a stupid question, these
people have misunderstood the mathematics. There is a third response, the one that
interests us, which says that the reason that you see little distribution and why you see
inequality seems to be increasing over the last several decades is that compared with
labour, capital is relatively mobile, and it is the mobility of capital which places a
limit on the capacity of the state to reallocate resources. This is interesting for us
because it is a political economic explanation, or at least a political economic
explanation in international political economy and is known as the structural
dependency thesis.

Structural Dependency Thesis

For the problem to be interesting, we would want it to be over more than one period
because we have to explain where capital comes from
Capital, just like everything else, depends on what was produced in the last period, so
we have a two period model. (What we should have is a problem that runs out for a
very long number of periods, a dynamic model. It requires more mathematics than
most people know.)
So we will assume two periods, P0 and P1 and consider time. K0 is the capital in the
first period: what is the capital stock, how many people will vote for us. K1 is the
capital at time 1. The idea is that the capital at time 1 depends on the capital at time 0,
the economy grows. If you are a rich developed today, you are likely to be rich
tomorrow because you have a lot of capital to help you to keep growing. Assume K1
= A multiplied by K0 where A is greater than 1. This function represents what
happens with an economy, the amount of capital you have next year increases (or
decreases) as a percentage, ie it may be 4% and so A will be 1.04 or 200% and so A
will be 2
Back to our political problem: what happens if the government taxes the capital we
have now at time 0. Then K1 = A multiplied by K0 minus the amount taken out in tax.
A multiplied by 1 X of K0. If the tax rate therefore was 50%, X = 0.5 then K1 = A1
0.5 times K0 = A times 0.5 K0. So growth only depends on the capital that is left
after tax

So we want to maximise welfare. We have seen that if we only have one period, then
you set X as 1 and you distribute everything, but this is not realistic nor interesting.
Suppose government wants to maximise welfare (b bar) at time one and sets the same
tax rate for each period. Suppose there are elections at time one. Voters are pretty
stupid so we give them all of the benefits we have from taxing them at T1 this is a
classic strategy that political parties use. Then the problem is that if we want to
maximise, what are we going to maximise? The amount of benefits we give them at
T1 = X x the amount of capital available at T1
We have a problem because we dont know what X of K1 is. It cant be just anything
because we already have a prior period in K0, and if I dont give you as much as I can
somebody else will, and the most I can is the greatest amount I can get at time one, by
taxing the workers. We dont know what the total capital at time one is do we? Yes
we do, so we can work out what capital is at time one. Wbar = X A x K0. This is
wrong because we have to take account of the fact that the government is also taxing
capital at time zero. K1 = X x A x 1-X x K0. This is telling us that the amount of tax
by the amount of growth by inverse amount of tax (ie if tax is 4% 1.004 then will be
multiplying by 0.004) by total capital at T0 = total capital at T1
What makes sense in the world is that if you cant control something then dont worry
about it, you use that idea (in standardised optimisation theory) to drop the Wbar
because the government didnt control the Wbar
What cant the government control? K0 it cant control, it can only control the tax
rate. It cant control A, the growth, which it is a technical parameter of production
What is the X likely to be? What if X = 0? You would get no welfare. What if X = 1,
then there would also be no welfare as (1 x 1-1) = 0. What if we started at 0 and just
increase it a little bit 0.1. 1 x 1-0.1 is 0.9. You could keep doing this but it is easy to
see that the graph goes up for a while gets to a maximum and then goes down again
If X is 0 I have nothing to offer the workers so I lose. If my opposition taxes at X = 1 I
will win because I am not taxing them at all. So we both offer the optimum tax rate,
X*. This is interesting because if the tax rate is greater than 0 and less than 1. In the
simple model there is only 0.5. Also, if you tax high in the first period then you will
have no capital to tax in the second period so you must tax low at first while the
capital is building and then as capital increases you can tax higher; thereby you are
allowing the capital its best chance to grow while still providing welfare.
This is in essence what the structural dependency theory says. We could do this for
two periods Phi bar bar = (X x K0) + (X x 1-X) x (A x K1) Tax of capital in first
period, multiplied by lower tax rate, times growth by capital in first period
If you do it for more than one period the size of the growth parameter becomes
important and now the relationship between the two in terms of growth matters
In terms of the imperatives of the state, there is a great deal of debate about optimal
distribution, capitalism, socialism, etc. A lot of it is to do with ideology, but for us the
only debate is the debate about the shape of this curve. We have set up the curve to
represent voting lines but you can also set it up to represent welfare you could tell the
same story. What the debate depends on is the shape of the curve given by X. If you
assume the curve looks one way, you will maximise the welfare of the workers by
lowering tax. If you assume the opposite, you will maximise the welfare of the
workers by a very high rate of tax. So for political economists, the debate about
distribution in capitalist economy is really a debate about the shape of this curve.
There is a lot of literature about this

So with structural dependency the problem for the state is to maximise the payoff for
the workers which is taxes out of capital
But we are still living in our unitary S1 model, if we put the international sector back
in (the rest of the world) then there is a potential for capital mobility between
countries and one of the determinants may be the rate of tax. If this happens, the
amount of capital mobility you get is going to start influencing the shape of this curve

Assume profits are on after tax capital. So P1 (total profit in state one) = 1-X1 x K1
There are two things that are going to affect total profit: the rate of profit and the tax
rate
If it were the case that P2 was greater than P1, then if we also assume that capital is
perfectly mobile, then what would happen is that all capital would be shifted to S2 and
workers welfare would be driven to 0 because there is no profit to tax in S1
Clearly unless you find some way of stabilising taxes, the tax rate would be driven to
0 all over the world, and all of the worlds capital would go to Bangladesh or some
such country
It would be reasonable to assume however that there are some impediments to capital
flow. Empirically capital doesnt seem to flow in quantities as large as we would
anticipate, and poor countries particularly dont seem to be able to benefit enormously
from capital flows from the rich country, which is why they are failing to develop
If we leave China out of the equation, most capital flows from rich country to rich
country and back again, not from abundant capital countries to scarce capital countries
Why? One reason is opportunity cost which is captured in the equation above, which
says that the rate of return on capital might be much lower in the alternative locations
than you can get in your current location there may not be good investment
opportunities. China seeks to export capital, but a lot of what it invests in are
government bonds which give a very low rate of return; maybe there simply arent
enough investment opportunities to shift their capital so they have to shift it into low
rate of return activities
So X1 may be higher than X2, but if you shift into S2 you will get a lower return so
overall you wont be better off by moving your capital into S2
Back to the Ricardian theory, it may be the case that industries where there is some
comparative advantage in S2 are already fully capitalised or invested in, so the
opportunities for moving capital into these industries are not that good
Transaction costs are another impediment. Imagine BHP or Rio Tinto decide they
dont like the government tax, it isnt that simple to sell everything and invest in
Casinos in the south of China. It is expensive because you have to liquidate assets, etc
Another impediment is risk it can often be risky to shift this capital into another
industry in another country because you dont have experience with that industry and
therefore may misjudge your ability or bungle your attempt to capitalise. The intuition
is that risk is also going to affect the rate of return. I could give you $10, or I could
say lets flip a coin, if it is heads Ill give you $15 and tails nothing. The higher the
risk the higher the return, but the lower the certain capital return. Risk, particularly
political and sovereign risk (ie investing in the USSR) can therefore be a very
significant impediment
So there are a lot of good reasons why we expect that capital flow isnt going to be
instantaneous even if this situation (of perfect mobility?) holds and in some cases it

wont. What we would expect to happen is that international capital mobility would
push this curve in ?this? direction because as x goes up the amount of capital on
which the tax can be raised is going down as it is shifting out, and this will produce
the optimal level of tax
There is a lot of literature on this problem, which is known as the race to the bottom
thesis and the argument is that as a result of this phenomenon it becomes difficult for
states to have welfare systems, and transfer payments and equalising payments that
are remarkably out of step with other states. There was a capital flight from France in
the 1980s and there is some evidence that the problems had an impact on US and
other world taxes on capital and such like. There is some argument is that what the
effect has been is to reduce welfare and transfer payments to a level below what you
would anticipate they were as a result of the operation of liberal democracy
Some implications: this thesis is often used to justify is the idea of competitiveness: if
we tax things, or do things in a certain way, we wont be competitive. This argument
is used extensively, and is currently being used extensively by the energy industry in
Australia, to argue that there shouldnt be a cost on carbon, or that they shouldnt have
to pay it. QLD coal fired electricity generating industry threatened to move off-shore
We know that this is idea is wrong because trade is based on comparative advantage,
and not competition. States trade their comparative advantage, and you cannot have a
comparative advantage in everything
Efficiency is a different thing. It may be good to be efficient because we could by
handovers more cheaply or produce medicines more cheaply. We could be more
efficient, and this would effect our standard of living, but the idea that we are trying to
become more competitive in relation to other states simply violates what we know
from the theories of trade
In regards to industry particularly and not society, then competition makes sense,
provided that the countries have the same comparative advantage in that industry. But
even if they do, it is not a problem for Australia for example to lose out in
comparative advantage as compared to China in the coal industry is not necessarily
bad for the society because our comparative advantage will just shift elsewhere, and
moreover somewhere that will be more beneficial for the society, ie have collaterals
such as highly educating the populace, than extracting lumps of coal
Finally, competition is also used as a political threat against government action
The rate of profit itself may also be a function of the tax. So if the tax is used for
things like education, and I am an industry that wants a highly educated workforce,
then that will increase my rate of profits because I do not have to train them myself,
the government has already done it for me. If I have to pay because there is no
healthcare system, the workers wages wont have to be pushed up to pay for their
healthcare privately. One way to see rates of taxes therefore is that they are simply a
mechanism of shifting the way that things are provided from one state to another. So a
hypothetical Scandinavian state may have a high rate of tax with all of the healthcare
provided, a hypothetical non-Scandinavian state may have a lower rate of tax with no
healthcare, but essentially there is no point shifting from S1 to S2 to S1 because the
labour costs are higher. So we see that we cant read directly off the tax rate whether
or not the state is more or less conducive to capital investment, and so on.
So profit might also depend on the tax rate
Ricardos Theory: two identities: total output is consumption + savings, and total
output must also = consumption + investment + exports imports which means that
investment savings = imports exports. This means that if investment is going to
flow into a country, then the country must have a deficit on balance of payments, so it

must be saving less. So in a macro model such as this, a macro transfer as opposed to
individual firms investing relatively small amounts also has to deal with our balance
of payment identities
The theory may still however make sense for specific or individual industries, such as
a car manufacturer or a car producer, etc, but at a macro level there is seen to be some
serious impediments to large-scale capital flight. This doesnt mean that people wont
stop threatening it, but it is not quite so easy to close down all of the coal mines in
NSW if there is a cap and trade scheme, or to close down BHP or Rio Tinto if there is
some increase in tax

The Collective Goods Problem

So far we have S1 making decisions and the rest of the world, so S1 is only interacting
with the rest of the world through the theory of trade, through pure trade, through
comparative advantage and through what gets traded
Payoff for S1 = something that state one does (A1) where A1 is a strategy or an
action, and P where P is a given price. This is the standard equation for a pure market.
Prices are given in the pure international market simply by comparative advantage and
world trade. Prices are given and the strategy or action of the state is simply to
respond to prices
We now want to look at where there is another state that is a conscious decision
maker. In this case the payoff to the state depends on what it does and what the other
state does. In this case we have strategic interaction, the payoff for S1 depends on
what S2 does. This is outside the pure theory of trade and within the pure theory of
politics although we do not want to separate them
Strategic interaction covers a class of actions which are strategic or political, and is
generated by a class of goods that are known as collective or strategic goods
These goods are crucial for an understanding of the International Political Economy
system, and in some respect is can just be seen as a gigantic collective/strategic goods
problem, and we see this coming up with regard to the Copenhagen agreement and the
discussions taking place in the UN
A good is strategic or collective if most of the actors in the system can benefit from its
provision. This could be contrasted with a private good: a mobile phone, laptop, pair
of shoes, in which only you benefit
In the previous theory we have been dealing with private goods which have been
traded, and traded at a price, and you benefit from the provision according to the
price, for individuals similarly with states
This means that if we all benefit from the good, then we have some room to
manoeuvre, because my benefit doesnt depend solely on what I do, it also depends on
what somebody else does this is the characteristic of strategic goods
Consider the conditions required for the international system. We need free markets,
rules of property, a stable currency (monetary stability), fiscal stability, and these
rules are created and maintained by governments. Everyone benefits from the rules,
but not everyone contributes. What I want from the money situation is a situation
where you are not allowed to print money so there is a stable currency, but I can print
money. So I would benefit if everyone else contributed to making a world system with
a currency that was stable, even if I didnt contribute to that stability (provided I
wasnt big enough to overwhelm the world currency)

We saw this with the hegemonic stability thesis: the free trade system is a collective
good and the problem is that states wouldnt necessarily contribute to it because they
could benefit from it by opting out of the system but the hegemonic stability thesis
held that because of the particular political conjuncture, the US was prepared to act as
a benign hegemon and provide the good. We saw it in the setting up of Bretton
Woods, the WTO, the GATT and so on. All of these things are collective goods, they
all come under the general definition of strategic/political interaction
The second large class of examples is nuclear disarmament, again a collective good
because we all collectively benefit from not being obliterated, but it would be nice if
one state could have nuclear weapons and nobody else did (this is just a rerun of the
Hobbesian problem which is just a collective goods problem)
Thirdly, apart from state or financial goods, there are environmental goods. Firms
maximising profits have to be restrained from destroying the environment, because
the cost is to somebody else and not to themselves, or to be more accurate, or they
dont bear the full cost so it isnt going to fit into their balance sheets
There are problems with overexploitation of fisheries because whether or not a fishing
stock is preserved is partly independent of my actions and we have seen that with
Bluefin Tuna stocks. If you have 5 or 10 states the existence of tuna isnt necessarily
going to depend on the actions of any one state. Currently the issue of global warming
is of most pressing concern
Note crucially that S1 gets some payoff, but the amount of the payoff S1 gets doesnt
depend completely on S1s actions, it depends also on the actions of the other states,
so clearly then S1 is going to have an incentive to under-provide the good
The simplest case is what is known as the pure collective (Strategic is the technical
name because it involves game theory) good. In this case, everyone gets the good, and
the contribution of any one individual doesnt effect the outcome
Definition: A good is a pure collective good for some set of agents (not all, as some
people may enjoy being obliterated, might think there is a reward such as going to
heaven) S if every member of S can get the payoff independently of its contribution
The standard example is the sunset, we can all look at it whether we have contributed
to the sunset by putting pollution in the sky or not. Another almost purse collective
good is defence I pay substantial taxes, but if I didnt pay them, my defence
wouldnt be any less (probably only buys a few minutes of helicopter time) although
technically if I didnt pay any taxes Id get a minute bit less security, it comes pretty
close to being a pure collective good
A lot of goods come close, but if a good isnt a pure collective good, this means that
my contribution is going to affect my payoff slightly. But it makes no difference, as if
we understand the pure case, it is simply a complication that it is non-pure

If we move to the final stage of our analysis where states start acting strategically, we
get a problem of the collective goods form, and it is this form that typifies
international political economy. That is, to an extent, anything that is outside the pure
market (remembering that a pure market is very strictly defined, it has to have an
infinite number of traders) is a collective/strategic goods problem, or it is a problem in
politics
The key definition of a strategic good is that everybody can enjoy the benefits, and the
amount of benefits they enjoy dont depend on their contributions. For example, if

producing carbon is a benefit, if global warming is a problem, then we all enjoy the
benefits of the rest of the world producing its carbon emissions whether or not we
contributed. This is not the way a market operates; in a market a good has a price, you
pay the price on your own and derive the benefit on your own. A misunderstanding of
these two different mathematical structures of these problems that have led to a lot of
very ill-advised international and government policy
Pure collective good is a limiting type, most arent pure although many are. In a lot of
cases we have a situation where there is some collective good which would have a
structure such that the value of the good, G, minus the cost of the contribution is less
than 0. What does that mean? Take the example of defence. If I decided to unilaterally
donate 10,000 to the ADF, the extra defence I got probably wouldnt be worth the
$10,000. Your contributions mostly dont repay the costs, and the ADF example is an
extreme example of this
If we have a fishery, if the good is the pleasure you get from the knowledge that there
are whales in the ocean (assuming whales have a commercial value), if every state
doesnt fish for whales, the whale stock is guaranteed (environmental threats aside). If
however every state except for one fishes for whales and the rest of the world doesnt,
the whales are still in the ocean you get most of the good, but you dont bear any of
the cost. If you decide to stop fishing for whales as well, the good you get doesnt
increase very much, but presumably we have a big blubber industry, so you pay the
cost
If there is only one state in existence and X is the number of whales you kill, if you
kill no whales (X = 0), if you kill them all you get 0, and you will get a curve and you
can work out how many whales to kill by optimising
As soon as there is more than one state, it becomes more complicated. A big issue in
Scotland is the cod fishery industry: the fisherman would argue that if they didnt
catch the cod, then the Spanish, or Norwegian fisherman would catch them: so this
becomes a political problem rather than just a straightforward, individual optimising
problem
Game theory is important for political science because it is the backbone for analysis
of conflict and strategic interaction. Assume that everybody, all individuals, attempt to
maximise their payoff, whatever it is. There is a great confusion in the literature here.
People often talk about this in terms of self-interest issues. I might get a pay-off from
saving whales, that may be a strategic good, as above; so to maximise a payoff is not
the same as self-interest in any sensible context. You are just maximising the payoff
there is not necessarily anything self-interested about it
It is a theoretic assumption in order to simplify the world that everybody acts that way
to maximise their payoff) under those circumstances
Definition: An interaction is a game (mathematically) if it has the form (Player I = I,
AI = an action or strategy, VI = the payoff for I) VI = an action for I and an action for
I which is some other player. Anything that has this form is mathematically
described as a game. We have known for a very long time that things exist in this
form. The Art of War by Sun Tzu for example 800BC
This is how we define any game: your payoff depends on what the other players do. If
it didnt, why would you bother doing it, it wouldnt be very interesting
It is easy to define but not very easy to understand, in fact we didnt really understand
how to analyse games until the 1940s, when John Von Neumann wrote Theory of
Games and Economic Behaviour

The simplest possible game is one with two players and two moves. The market is a
one player game
P1 can make two moves, A1 and A2 then if we have P2 that can make two moves, B1
or B2 and then there might be some payoffs like A1 B1 A2 B2 A3 B3 A4 B4 the
first payoff goes to the first player, and the second to the second player
If I move A1 you might respond by B1 or B2. Standard form or strategic form is
another way to depict this. If P1 moves A1 and P2 moves B1 P1 gets A1(represents a
number) and P2 gets B1, if P1 moves A1 and P2 moves B2 P1 gets A2 and P2 gets B2,
if P1 moves A2 and P2 moves B1 P1 gets A3 and P2 gets B3, and if P1 moves A1 and
P2 moves B2 then P1 gets A4 and P2 gets B4. This says the same thing because we are
not using equalities, but essentially it says my payoff depends on what you do and
vice versa
So G is the good and K is cost, so what is the problem? Moves or strategies there are
only two, cooperate C, or defect, D. So in the climate change discussions you may C
and cut emissions by n% or defect, we are only 2% of the world emissions so we
wont cut them at all. Tuna fishing you may C we wont catch them, or D we will still
catch them. As we know, in the real world, there are lot more options in between but
the models dont reflect the real world so we must stick with C and D
What are the possibilities? If we define a collective good as a good that has the
property that you get its benefit without any contribution. Lets call P2 the rest of the
world, which mathematically covers every possibility
What if I cooperate and so do you; we both cut down on whaling or emissions, etc,
then the payoff for P1 is the good, because everyone has cooperated, g minus the cost,
k. What if P1 were to contribute unilaterally and nobody else contributed. One story is
that P1 pays the cost and gets nothing at all if you are the only one who pays
defence taxes in Australia, you lose 10,000 and you dont get much defence, so you
have k. What would happen if P1 defected and everybody cooperated, then P1 gets
the G at no cost at all. If everyone defected, P1 would get 0
It appears intuitive that the payoffs you get will depend on a number of players. If you
only have P1, the payoffs are straightforward. If you have two large states, you may
have one set of payoffs, and if you have thousands of tiny states, you will get a
different set of payoffs
Case A1: if the world were made up of a large number of interactive state of roughly
equal size, Case A2: if the world was made up of one large state (HST) and Case A3:
a small number of large states (especially pertinent in terms of global warming.)
Case A1: millions of small states. The general form will be P1 who will C or D, P2
who can do the same. If P1 cooperates and everyone else cooperates, P1 gets G K,
and this is true for every game. If P1 cooperates and P2 defects, P1 gets K. If P1
defects and P2 cooperates, then P1 gets G with no cost at all, if both defect, then no
one gets anything
How to analyse this? We know how to because our assumption is that every player
tries to maximise the payoff. Here if you are player one, if the rest of the world
cooperates, you defect. If the rest of the world defects, you defect. Either way, no
matter what everyone else does, P1 defects

There are a number of ways to develop this game; by increasing the number of moves,
by increasing the number of players and by creating more strategies apart from just
cooperate and defect
You could make G (the good) a function of the number of states which we call N, but
the story will be more or less the same
The game we are exploring should be called a simple game with a dominant strategy
solution and a collectively sub-optimal outcome usually called the prisoners
dilemma, this label being given by John Nash. The reason why the game is really
necessary is that it is the most powerful and simple representation of the collective
goods problem. The game is only being played once (a one shot game) and in order to
play the game we dont need to know P2s payoffs, we only need to know our own, so
it is not even a game of perfect information
Assume the good is the continued existence of a fishing stock of lobsters, G. If you
are one individual fisherman and you are worried about overfishing to extinction, and
so you decide to reduce the number you take. So if all of the fisherman reduce the
number of lobsters then take they get the good G, minus the cost of the lost profit, K.
But there are hundreds of fisherman, so if you give fishing up, then you bear the cost,
but everyone else keeps fishing everyway, so you get very little G. If you keep fishing
and everyone else reduces their rate, then you get G at no cost. If everyone keeps
fishing then the lobsters become extinct and you get no G. Same story with pumping
extracting water from a river system, putting CO2 into the atmosphere, pollutants into
the sea, logging rainforests, etc
Remember that the assumption 1 is that players will always try to optimise their
payoff, therefore I must defect which is also true for every other player, therefore the
outcome is 0 which is perverse, everyone is getting the very outcome that they dont
want. This is the problem that Hobbes encounters in regards to security, this is also
the arms race problem, the nuclear problem, etc
Case A1: a large number of small states. What is the implication, how can we solve
the problem? If it is a one shot game and this is the payoff, you cant wriggle out of it
with philosophy, the mathematics says that this is the solution, end of story. The only
way to make people cooperate or give them a chance of cooperating mathematically is
to make defecting more costly than cooperating, so by altering the payoff. So we
could add a penalty here, G P. Provided we make the penalty large enough, then if
everyone else cooperated, you would be better off also cooperating because if P is
greater than K, you would be better off cooperating because the penalty for not
cooperating is bigger than the cost of you cooperating. This would solve the problem,
which is to get people to cooperate, but it wouldnt solve the prisoners dilemma
because that is a different game. Hobbes says without the state you have the war of all
against all, so you are better off with a sovereign because he penalises everyone for
defecting. Similarly with the case of fisheries, all of the fisherman would prefer to be
cooperating, but because of the structure of the payoffs they all end up defecting. So
all of the fisherman should vote for something which enforces a penalty upon them all
to force them to cooperate: everyone should support the sovereign because the
sovereign extricates us from the defect defect all against all. But the problem is that
we need a state to enforce to penalty, otherwise the penalty is immediate. Anything
that can enforce a penalty is either a state or an institution (like the WTO) that would
have to be supported by states
This is an outcome that many people would find undesirable. Realists would find it
undesirable because it reduces state power, neo-liberals would find it undesirable
because it is interfering with the market. So there will be a number of attempts to try

and avoid this outcome the only way you can avoid it is to change the game because
there is only one outcome to this game (the literature suggests that there are other
solutions but it is terribly confused)
The obvious thing to do is to look at the assumption that the game is only played once,
as a more realistic assumption is that the game is played more than once. For example
at the height of the Cold War, the USSR and USA exchanged a number of strategic
moves, they played the game more than once. Because fisherman, states, etc interact
over time
We call games played more than once repeated games. The possibilities with
repeated games are that 1) the players might be allowed to communicate. A lot of the
literature says that the players are not able to communicate, which is incorrect. What
happens if move one is that the players communicate and move two is that the game is
played. Write this game out in the extensive form, and then convince yourself that if
the players are able to communicate that there is no difference made whatsoever: this
is impossible to do. Communication does make a difference. As an aside, this is
technically not a repeated game because the first game is communication (two
messages are sent, which is interaction, which is the definition of the game) and the
second is the game itself
2) If the same game is played more than once; over and over. Here there are two
possibilities. One is that the game might terminate at some stage and the second is that
it might not terminate. So it could be the case that you only play the game some
number of times so you die, or your UN mandate runs out, or you have made enough
money from wiping out rock lobsters so you retire. G1, G2, G3 G1000. If the
payoffs look as follows: if we both cooperate we get $1,000,000 each and it costs us
both $1 to play the game. (remember that the payoffs for P2 are the same as those for
P1). If you cooperate and P2 defects (ie put up your hand or dont put up your hand,)
you get $1. If you both defect, you get 0. And if I defect and the P2 cooperates I get
1,000,000. If you both cooperate every round of the game and you play 1000 times:
the payoff for CC= 1,000,000 - 1000. The payoff for DD = 0, the payoff for DC =
1,000,000 and payoff for CD is -1000. So you could get 1,000,000,000 1000 if you
both cooperate every time and the worst payoff would be you could lose 1000
Exercise One: You could communicate beforehand and both promise to cooperate
every time and get 1,000,000 each every time we play. I could also threaten you and
say that if you try and defect against me so you get $1, Ill punish you by defecting
against you until you cooperate which means youll lose at least 1,000,000. The
question is, what is the payoff? Both players will be 1 billion minus 1000 playing
costs. One player could C and other could D so one player loses 1,000,000
Exercise Two: what happens if there is no termination time and the game goes on
infinitely. In the case where there is no finite termination, it is possible that players
could cooperate, and you will get a spontaneous equilibrium where players would
both play the cooperate strategy. They are not cooperating in each this smaller
individual game, they are cooperating in the bigger game where the smaller game is
being played over and over. In this case it is possible that players might cooperate,
and a number of strategies have been suggested in this situation. One is called a tit for
tat strategy, the most common one you will encounter. Axelrod had the idea to have
one computer playing another computer, and he designed a tournament where
strategies submitted by mathematicians would play each other to find out which was
the winner. The winning strategy was designed by a mathematical political scientist
called Anatol Rackethorn, called the tit for tat strategy which says if you cooperate Ill
cooperate, and if you defect against me, I will immediately defect against you and

continue to do so until you cooperate. So if we have a game with a finite termination

date then I could remind you of this at the beginning of the game and throughout it.
Therefore if at any stage you try to defect to get an extra $1, then I will immediately
defect against you and continue to until you cooperate which means you will lose $1
million
A lot has been written about this and many see it as a way out of the problem that you
need some sort of structure of enforcement in order to avoid the tragedy of the
commons/strategic/collective goods problems. If you dont like authoritarian
solutions, that is you dont like intervention by the state then this tit for tat strategy is
very important. So this is important therefore particularly for neo-classical
economists. But the problem is that this strategy only works under very special
conditions. So it isnt a real solution. For the tit for tat strategy, you need information
on your own payoffs, and you need to know that your opponent is playing the same
game, but you dont need perfect information. The problem is this: If you do
something bad and defect, and then I defect and there are two players in the game who
are playing it over and over against each other without a finite termination date, then
there is a possibility that the tit for tat strategy might work. If however there are more
than two players, three for example then if I defect to punish P2, how do the other
players know if I defect to punish P2 or to get an advantage over the other two
players? So once there are more than two players the tit for tat strategy falls apart
So we allow two possibilities: communication or a repeated game with a finite
termination or no termination; unless these players will cooperate in a finite
termination game, the argument that they will cooperate or the argument that they will
come close to the optimal outcome is very weak. There is no easy way out of this
prisoners dilemma except by importing structural authority
If the world has a large number of players, the problem that you are going to have to
overcome is that it is always in the interests of every player to defect, unless you can
find a spontaneous equilibrium, and with a large number of players it is very difficult
to find a plausible story that gives you a spontaneous equilibrium

Case A2: one large state (HST). Essentially the HST argument says that if there is a
single large state, you wont get the prisoners dilemma problem, because the single
large state has an incentive to provide the good for itself. After the Cold War you have
a dominant market power in the US, but also a dominant political power caused by the
dissolution of the USSR and so the victory of the US two came together at once and
plausibly US acted as a hegemon in that period
What will the payoff matrix look like? S1 single large state, and S2 is the rest of the
world. If both cooperates, we get G K and if everyone defects we get 0. The mystery
payoffs are x and y. These depend on the view of the world you have realists would
see S1 wanting to build a bloc against the rest of the world so it will be
overwhelmingly advantaged by cooperation and seriously disadvantaged if it defects.
If you are a neo-classical theorist/economist, the problem with the Ricardian theory is
that you benefit outright from trade, it is better for you no matter what the other player
does, so you will get a payoff where G K is bigger than X. If S1 defects and
everybody else cooperates, X would be the payoff from destroying the system. So in
terms of HST, after the end of WW2, all of the other states wanted to cooperate and

build the world market system, and the US defects by not allowing them to trade,
providing them with aid, etc. Essentially this leaves the world market system in tatters
and from and realist and neo-classical perspective that is a very bad outcome
What if S1 cooperates and the other states defect. If you a neo-classical, you would
still believe that the gains from trade would be greater than the gains from putting up
tariffs barriers and protection, so you would have some sort of positive gain here, we
would have y = unilateral gains from trade, and the specification would be that Y is
greater than 0. So under both the realist and neo-classical (liberal) perspective G K
is bigger than X, Y is bigger than 0, so in this case the optimal strategy for S1 is to
cooperate/provide the good
A better way to look at this problem is to observe the extensive form of the game. S1
can C or D. What it would be reasonable to assume is that the hegemon moves first,
because what a hegemon wants to do is to build a system of a certain sort. S2 could
either C or D, if they C the payoff would be G K for the hegemon and Gbar Kbar
for S2, and the collective good is worth more than the cost in both cases
If the hegemon cooperates and the state defects in the one shot game, the hegemon
would get some of the good minus the cost and looking to the single individual state
(assuming now that S2 is a single individual state) you could get a payoff in the form
of ?that?
What is going wrong? It tells us that the hegemon should cooperate all of the time and
the smaller individual states should defect. But that is not what the hegemonic
stability theory tells us. So are we making a mistake? No the problem is that we have
analysed it as a one shot game. The hegemon says at this point what I want to do is
provide the collective good in this case the stability of the market system, to give
everybody access to the US economy, G K is the cost of that access, and what I
want you to do in return is to open up your economies. What if you choose to defect?
In that case, we have made the mistake in making it a one shot game, really it is a two
shot game. What would happen if you were the US and I was Lichtenstein and said I
was going to keep up my barriers, what you can now do which is implicit in this game
is punish or not punish, if you punish, you get G-K but the defective state gets
whatever the punishment is, Z for cost of punishment. So essentially what the US says
is that theyll put up barriers against your exports, not going to give you defence, not
going to allow technology transfers, etc. If it doesnt punish it gets G-K and P2 gets G
Once we get to the second move in the game, the game terminates here if everybody
cooperates, so all of the other moves are blanks. So once we get to the second moves
is that S1 gets the same payoff whether it punishes or doesnt punish, so essentially
the assumption we have made is that S1 is indifferent between punishing/not
punishing. But if we go back to our original story, this cant be the case because the
hegemonic state is deriving some sort of benefit from building this world trade
system. Either from a realist viewpoint as a bloc against the soviet bloc and/or from
the neo-liberal viewpoint as an expanded trading system. So we havent finished
because we havent sufficiently differentiated our payoffs. So we need a three stage
game, first stage I say I want to provide free trade and you defect, as the second move
I punish you or threaten to punish you, and I have to wait and see what you do in the
third move. So we need a three stage game. S2 moves in the third stage to either
cooperate or defect. If S2 cooperates we have Gbar Kbar, if S2 defects we have
Gbar Kbar Z. In this case though we have assumed that the US is indifferent to
whether S2 has defected or not. The payoff for S2 cooperating and the payoff for S2
defecting are the same, again this is not consistent with out HST story. So we have to
add one more payoff, G K E is the payoff if all states except S2 cooperate. If

fewer states cooperate, S1 is worse off if everyone cooperates. So now, we have G

K E, and S2 gets Gbar Kbar. The way you solve these games is backwards. Where
do I want to be if I am S1? I want the G K payoff, so I want S2 to cooperate, so I
have to play ?that? strategy, if I play that strategy S2 if it cooperates gets Gbar-Kbar if
it fails to cooperate it gets Gbar Kbar Z, the first leaves S2 with more than the
second, so If S1 plays the threat strategy, S2 plays Gbar K bar and S1 gets what they
want, which is cooperation. If S1 plays the non-threaten to punish strategy, S1 is
worse off. What we would expect is that if the punishment strategy is already
announced, that your partner simply cooperates, cooperates. What you might expect
under more sophisticated reasoning on credibility of threats is that in some instances,
cooperate, defect, threaten to punish, cooperate. That is a three stage extensive form
analysis of the single large state case, which has been found by a lot of mathematical
political scientists to be the number at which the analysis went through
Case A3: a small number of large states. What you might reasonably say that with a
situation such as global warming you have neither the case where there is a large
number of small states, or one single dominant hegemon; the world is now developing
back into a multi-polar system with a small number of large players, and what counts
as a large player depends on the particular subject under discussion. If it were military
power, you might argue it is still unipolar, but when it comes to producing CO2, then
there are still a number of large players in the game. Therefore neither the analysis of
A1 (the prisoners dilemma nor the analysis of the single large state is appropriate, we
need a new analysis for case A3
Lighthouse problem: Scottish coast is very rocky causing around 25% of ships to
crash. Suppose I am losing 1 million of shipping every year. I could build a lighthouse
for 500,000 to protect my ships. But there are two shipping companies. So the other
company could also build a lighthouse for 500,000. So both firms or players could
build a lighthouse and both could benefit but if one builds the lighthouse then the
other will benefit without having to pay for it. So the collective good is a lighthouse
because everyone will benefit even if the good is only provided by a few. The
question is whether the lighthouses get built?
Assume S1 and S2 can both can provide the good on their own (as would be the case
with cutting CO2 emissions if the states were the US and the UK. So if both cooperate
then they halve the cost, 250,000 each and the lighthouses get built: G- - 1/2K. If S1
provides the lighthouse and S2 doesnt, SI gets G K. If S2 provides the lighthouse
then S1 gets G. Now we have a problem, because this isnt like the prisoners
dilemma where S1 can use the punishment strategy. If S2 defects then S1 will want to
cooperate and if S2 cooperates then S1 will want to defect. There is no single
dominant strategy for the game anymore. As an aside, this is essentially where game
theory was when Nash came along. The solution is the Nash equilibrium, which Nash
won the Nobel prize for. What we have been doing so far is looking what is bigger
and smaller in the columns, the numbers dont matter, only the ratio matters. The
definition of the Nash equilibrium is: Pi (payoff for player one) ai (strategy used by
player I) *A I (strategy used by everyone else who isnt i) * is greater than Pi Ai AI*.
The idea behind the Nash equilibrium is that the payoff for Pi with one strategy
against some strategy of some other player is greater than the payoff it gets from using
some other strategy. So the best I can do against you against the best you can do
against me. So the Nash equilibrium says that you always have to play strategy that
assumes that the other player is equally capable and using the best strategy that they
can possibly use against you. So Ai* is the best against an opponent doing the best

against Pi. Ai* is a Nash equilibrium if given the opportunity to play a game i would
use Ai*
So looking at the strategies for S1, what would the Nash equilibrium be for S1? Well
the best P2 can do is to defect and the best you can do is to defect, but if they are as
good as you then they both know this and so they know that if they both defect then
they will both lose, so they cooperate because they are both as good at the game as
each other and know the best they can do is to defect and the best the other can do is
to defect and if this happens they both lose so the best they can then do is to
cooperate. Possibility 1 is that S2 plays C, they build the lighthouse, and so you will
defect. Possibility 2: If P2 defects then I should cooperate. So there are two pure
strategies for the game
If you were S1 would you prefer the outcome where you defect and the other guy
cooperates, or the outcome where you cooperate and the other guy defects? You
would obviously prefer the first where you, S1 defects and if you were S2 you would
prefer the second, where you, S2 defects. This is known as a Hawk-Dove game the
first simple game that starts to get interesting from political economy and all of the
things people are starting to talk about in relation to the environment

Hawk-Dove game: to be a dove is to be friendly and cooperative and to be a hawk is

to be hostile and uncooperative. So you can you Dove for Cooperate and H for defect.
Also called a prisoners dilemma in some of the more modern literature
Prisoners dilemma s (more than one prisoner) and they both have the same
dilemma. The basic characteristic of the prisoners dilemma is that no matter what
everyone else does, I should defect. It is not a moral statement, it is just one that
follows from the assumption we have made. So the game has a single dominant
strategy. But with this A3 case, this game doesnt have a single dominant strategy
because if you play dove I should play hawk, and if you play hawk I should play
dove. The solution is what is known as a Nash equilibrium it is not a single
dominant strategy. A dominant strategy is a strategy you should always play because
it dominates all other strategies
In the Hawk-Dove game there are two possible equilibria: where you defect, I
cooperate, and where you cooperate I defect. Why is this an equilibrium? How you
check for one ask if you were allowed to move the game you wouldnt change the
move it is stable. So we have two possible equilibria in pure strategies: 1 and 2.
Whenever you talk about a solution to a game you talk about a strategy the answer
to the question is a strategy and not a numerical value
What makes this game interesting and much richer from a social science viewpoint,
because if you were P1 you would prefer the strategy where you were the hawk and
P2 was the dove, and for P2 you would prefer the strategy where you were the hawk
and P1 was the dove. Why the game differs so much from A1 because now we have
two pure possible strategy equilibria and each of the players want to play the game a
different way. As an aside, there is also at least one other strategy in this game called
a mixed strategy
If the game is played only once then that is it, there are only two possible outcomes.
What if we have two moves, we communicate and then we play the game, which is
called . Consider two moves: M1 we communicate, and M2 we play

So communication as we discovered from the prisoners dilemma does not work. So

what difference do you expect communication will make in this game. The first
intuition is that it will not make any difference: consider the following
Hawk-Dove aka Chicken game: an essential game to evolutionary biology because for
the simple case it is one way of explaining how different sorts of animals evolve.
Consider hawks and doves, hawks are always aggressive and fight, and doves always
surrender. Assume you have two units of some good, G. There might be a territory or
a nesting sight or something. What would happen if two doves came into contact? In
that case by definition they wouldnt fight, so each of the creatures would keep their
own single unit. If a dove came into contact with a hawk, the dove would surrender
and the hawk would get to keep its units and get the other available unit. These are the
payoffs for one only. If P1 is the dove it surrenders when coming into contact with a
hawk, and if P2 is a hawk it takes the doves unit when coming into contact with the
hawk. When a hawk comes into contact with a hawk they fight, and the payoff is -1,
not good. This is an interesting story from the viewpoint of evolutionary biology
because it tells us that if the only birds in the world were doves and one mutated into a
hawk, the hawk would start doing very well for itself, and the population of doves
would never be stable because the hawk will always be better. If however every bird
is a hawk, then theyll all be busy fighting with each other, but as soon as one of the
becomes a dove, the dove will start getting a bigger payoff because it can have more
food, lay more eggs, etc. So immediately the population of all doves is never stable
and the population of all hawks is never stable, and if we had time we could calculate
from the payoffs what the optimum mix would be and what evolution would converge
to
Chicken game: used to be played years ago by young men mostly, and the point of
this game is that two people get in two cars and they drive the cars at high speed
towards each other. The first person to swerve loses and is a chicken. This is
important for us from a social sciences viewpoint. Anything which has the same
formal structure is the same game, whether it is animals, whether people are decided
to invade Russia, it has the same structure because it is the same game. Suppose I am
the hawk, I dont swerve and you are the dove so you swerve, you I get 2 units of
good. What happens on the other hand if I am the dove and I swerve and you dont
because you are the hawk, I get 0 units. But what if we both swerve, we both come
out relatively even which is a bit better than getting 0 so we both get 1. What happens
if neither of us swerve, in this case we both get -1. It is the same game, it describes the
same situation. Think of it in terms of this chicken story. What would happen if you
and I were playing this game and we were allowed to communicate, what you know is
that you would prefer the outcome whereby you are the hawk and I am the dove, and
if you play hawk, I must play dove. What would you tell me? You would tell me that
you would play hawk, and I would tell you the same. So if we communicate unlike in
the prisoners dilemma, it is not clear whether we have an incentive to lie, but we
strike another problem in game theory, and the general body of analysis under which
this falls is cheap talk, because anyone can say anything the message doesnt have
any information content at all because you are not hearing something that you already
know. As with the prisoners dilemma, once you have delivered your message, you
are just going to act in way that will maximise your payoffs. The message doesnt
have any content because it doesnt have an credibility, so the cheap talk problem is
also the credibility problem
What would make your message credible? Nothing you say will make the message
credible. So consider this: suppose we communicate in S1, and in S2 we act, and S3

we play the game, so we now have a three stage game. Suppose you can send a
message and act, or act and send a message. What is a reasonable action? You can
weld your steering wheel, and say, Im not going to swerve, you youve made your
message credible. There are a lot of other actions. You could stand outside the car and
put something on the accelerator, strap down your arms and body and sit in the back
seat and put something on the accelerator. These are all tantamount, in international
political economy, to invading another nation. The other way to do something is to
intimidate by reputation. You could intimidate the other player with examples of past
moves of being a hawk or being tough. If you play the same game subsequent times
and never swerve no matter what, or you might develop a reputation for being
mentally unstable, convincing your opponent that you have no future payoffs after the
game ends so it doesnt matter whether you are alive or dead. These sound extreme,
but they have been used in international negotiations, and in some cases, especially
during the Cold War, having a couple of seemingly unstable people on your side who
would scare the other side into thinking that one of them would push the button would
not be such a bad idea. So the problem here is cheap talk, and what happens in the
three stage game is that you can build credibility
So lets say that you weld your steering wheel (intimidate or assure without exception)
The potential problem is that the other player also welds their steering wheel. So the
problem is that the logic of the game induces people to make credible threats or send
credible messages, and often in terms of outright conflict, both sides might decide to
adopt the political analogue of welding their steering wheel. I might as in WW2 sign a
binding agreement with some third party, that in some situation of conflict against that
third party, I am immediately at war. In that case I have welded my steering wheel.
The only thing we have remember is gamma which is our game, and the only things
we are allowed to do is communicate and act in our own strategy, otherwise we have
to write a different game
So once we introduce the hawk-dove structure, we then introduce the problem of
credibility, and credible threats and credible messages. In the examples above what
we have is pre-commitment. Suppose we have S1 and S2. Territorial integrity say
S2 filches a bit of S1s territory, and S1 tells S2 they dont like it, and S2 asks if S1 is
really going to start a war over it and kill millions of people. S1 looks at the game and
decides that S2 is being a hawk and they are being a dove, and then tomorrow S2
takes another bit of land. This is a problem that states face on a daily basis. One
solution to this is that states pre-commit themselves through constitutions or public
undertakings. Definition of a state is having the ability to exercise a preponderance of
violence in a defined territory. So S1 might have a constitution that says that its
territory is inviolate and as soon as someone takes its territory, they are at war with
them they have already welded the steering wheel. In relation to the financial crisis,
the reason that reserve banks maintain independence is that states can say we are precommitted to keep the rate of inflation down. The independent reserve bank needs to
say that because if a political party said that it has a cheap talk problem, because you
realise that if you have an election coming up, you realise that it is a really great time
to spend lots of money and boom the economy so everyone thinks youre creating
wealth for them. These sorts of actions turn up all of the time but they are not without
risks. US President could say that they would like to bring about situation X, but they
cant promise it because it depends on the bill getting through congress. The precommitment which is that the bill must go through congress, something that at first
seems negative, can actually strengthen the bargaining position of a political leader

In summary: So we know that if have a prisoners dilemma problem, it is very

difficult to ensure cooperation, spontaneous equilibria by and large wont get us out of
the problem. If there is a single state, the problem is mostly trivial, it is governed by
the hegemonic stability thesis, although we understand the HST because the whole
point of it is to explain how states could get out of this situation where we were
providing the international system of finance, free trade as a collective good, how in
fact the free rider problem associated with this could be avoided. Where there are a
small number of equally large states we encounter problems of pre-commitment,
communication, credibility to build a reputation, etc
How do we avoid these problems in the case of a small number of equally large
states there doesnt seem except in exceptional circumstances, there doesnt need to
be a solution outside the Hobbesian solution, there needs to be some structure of
authority. If you have a large number of small states, then there are ways in which
you might avoid the problem. Recall cheap talk, credibility and pre-commitment: one
of the important elements in this is repeated interactions. If you are playing a game
where your opponent of whom you have no knowledge, then it is difficult to establish
credibility; if you have repeated interactions, each of the players can establish some
sort of credibility: tough, honest, reliable, whatever the want to establish credibility
for. This is the bread and butter of international diplomacy, and it is part of the reason
why in political economy that you see the establishment of regional trade blocs and
regional networks. Small blocs of states can establish credibility and make side
payments to each other and can achieve collective goods which much more difficult
to achieve for a larger state system The Warwick Commission

The problem of the instability in the international financial system in the context of
political economics
This doesnt seem to have been solved adequately yet, there are still major imbalances in
the system of trade and production

The international environmental problem in the context of political economics

Global Warming (there are many others but the structure for all of these are the same as
we have already seen)

So we are in the final stage and so we are looking at the system as a whole, and global
warming in particular
We assume from the overwhelming evidence of climate scientists we have a problem
with the environment: authoritative reports are the ICCP reports: the
Intergovernmental Panel on Climate Change set up by the UN which brought down
reports in 1990, 1995, 2001 and 2007 most recently, where every report has more
severe predictions than the former and there are now probabilities in excess of 95%
that global warming is produced by human action, there is also the Stern report and
our own Garnaut report which all say the same sorts of things
The story is that we are looking at a band of increase in temperature somewhere
between 1 and 6 degrees centigrade well before 2100 if emissions continue at teir

current levels. If we get about 500ppm of CO2 then there is 2 degree centigrade +
increase in temperature
If it is kept below 450ppm possibly 2 degrees, if it goes above 600ppm ranges at the
higher end of the 1 6 degree range
One of the major problems with this is feedbacks in the system apparently if the
earth became warmer, and a lot of Co2 that is already sequestered in dirt will be
released, and worse, apparently methane that is trapped will also be released which
has roughly 12 times the impact on the climate as the release of CO2 and that will
lead to some sort of runaway increase in climate change with massive species
extinction there is some talk of death into the billions as a result of starvation and a
lack of water, etc
As far as responses go, the concern of a conservative institution like the
meteorological association in the UK say that as a minimum rich countries would
have to reduce their CO2 at about 6% a year to have a 95% reduction by 50-50 which
would mean doubling the amount they reduce so a 50% reduction in the first 10
years
The Garnaut report is much more conservative, and the top end of the Australian
government offer is only 25%, which is only half of what the UK meteorological
bureau believe is necessary to avoid positive feedback in the system
This is an interesting problem what we have is very high levels of uncertainty which
is some problem, and the second problem is that the costs are immediate but the good
is received in the future, so we have a Henry Ford type What did the future ever do
for me response in the vein of, why should we go without things so the next
generation can have a nice life. So a lot of rates, like rates of discount are also feeding
through the analysis
Our problem is risk: the probability of some future event. One thing you would do
normally with risk, is simply laying off your bets (insurance, hedge funds, etc) but
insurance only works because you can lay off your bets by spreading the risks. The
problem with climate change however is that the risks are all bundled together- known
as catastrophe bundles. In the case of my house burning down, insurance will spread
the risk because other people have also insured their houses, and so when my house
burns down a little bit of my money and everyone elses money will go into replacing
it. But the problem with climate change is that, in this analogy, either my house burns
down, and everyones house burns down, or no ones house burns down at all. So
standard insurance markets, or standard ways of hedging against risk or uncertainty
arent going to work. Therefore this option is not really available to us. If we have
massive climate change problems, it is impossible to insure against them and it is in
the nature of these things that you get them or you dont
Consider what future payoffs look like: For a transaction that takes place immediately
involving $10, after it has happened if I look in my hands I know immediately
whether I have $0 or $10, I know what has happened instantaneously. If we are
dealing with a future payoff, you are dealing with what is called an expectation. This
is what derivatives (future contracts etc) and hedge funds involve: trading things in
the future, trading expectations. Consider the following problem. We want to play a
gambling game if the coin lands heads you get $10 and tails you get nothing, and we
will play it tomorrow. What is the games expected value? What is it worth before you
play it. If I were to say to you, if you give me $7 well play this game. $3? $4? $4.90?
$5.02c? The game is worth $5 because you have 50% probability of getting $10 so
$10 is $5. So expected value is x 10 and x 0 = 5. Note that if the coin is not fair
for example, generally the probability of a head, (ph x 10) + (pt x 0) = ph x 10 =

expected value. So this tells us what we would expect at some future time, so it is very
important when we consider global warming, because any good we will gain from a
cost incurred will be in the future, and so it is just like a coin toss except much more
complicated the theoretical structure is the same, which is what we are interested in.
ph + pt = 1. It turns out that by definition the probabilities of every event in a
probability space they must add up to one. Why is that true? If we have a set of
possible events where the coin could land tail or head, and 1 = certainty, so adding the
two together must equal one because it is certain that one of the two is going to
happen. If we had a 7 sided coin the equation would be p1 + p2 + p3 + p4 + p5 + p6 +
p7 = 1. The sum of the probabilities = sum across every event that could occur
So we have established a way of thinking about future events an expectation
(expressed in probability). So what does this mean for climate change? Consider our
possible temperature range: 1 to 6. We could put these in bands and say the
probability of 1 degree c = p1, 2 degrees c = p2, etc. And if there were no other bands
all of these would add up to 1. So you could write down climate change as P1A1 +
P2A2 + P6A6 where A1 is the cost of the climate change. So for example A1
world goes up 1 degree, a few thousand things of extinct, more bushfires, 10 million
people die, etc. This might be a probability of 1/10. Probability of 2/10 get A2.
Probability of 1/10 get A5. Add these things up and that would be our expected cost
of loss of climate change taking place across these spread of degrees provided by
climate science (we havent said how to calculate these, but the Stern report makes
estimates in GDP, loss of life, species extinction)
Note that another way to write this is (sum) pi ai (where I = 1 6) this just means
that you add everything up. Probabilities are always added to get the expectation.
Australian newspapers often report that there is a great deal of uncertainty about the
climate science, so the implication is that we shouldnt do anything. But this is
ridiculous because even though the probability of it happening may be low, the effects
are so catastrophic that we need to do something because otherwise we will all be in
dire trouble. By saying we should do nothing people are erroneously focusing on the
low probability supposedly of it happening and not realising that what action really
relates to is how much damage and loss climate change will cause, which is
something that no one disagrees on. No one disagrees that as the temperature
increases, the cost keeps increasing because of positive feedback somewhere between
quadratically and exponentially (not linearly). Suppose that we believe because the
probabilities are given by these organisations (ICCP) that x is the temperature, or x
prime (something different) with probability 1or probability 2. We could calculate the
expected cost of that. Using A and Abar for temperature: P1A1 + P2A2 = our
expected cost at this range of variation. What if the models really arent very certain.
This is another way of saying that the spread is uncertain, if might go between
Abarbar and Abarbarbar. In this case we have a different expectation Ebar A =
P1Abar + P2Abar and this is what is known as a convex curve, on one side it is flat
and the other side it is steep, and either with calculus or a brute force approach you
can prove that this must be the case. What must be true if we have uncertainty is that
Ebar of A (the expected cost with uncertainty) is greater than E (the expected cost
without uncertainty.) So uncertainty doesnt get us off the hook, because uncertainty
given the nature of the climate change problem simply makes the expected cost of
future changes worse than it would be without uncertainty
The question that remains is how we will analyse whatever actions we may take to
mitigate climate change using the framework we have learnt? If we are talking about
doing something to reduce climate change, we are essentially talking about giving up

some resources. This is a lot trickier that what it is represented as in public discussion
it is normal to attach a cost to mitigating climate change, but it is not clear what the
cost is. The cost could be a net increase to GNP rather than a decrease (ie in the case
where a state starts investing in industries or activities that would have the effect of
mitigating climate change, you might cause your GNP to grow) but we will treat it as
a cost because it might be sensible to assume that at some level (ie to increase the cost
of fuel or the cost of energy) it would probably lower your standard of living. So we
have to deal with an expected value which has to take into account the cost of our
actions and the benefits of whatever actions we take to reduce climate change. So this
gives us a problem: we need to analyse an expected return, which will depend on g
where g = good of reduction and c where c = cost of reduction. We need to analyse
this function, which we know from our knowledge of expectations will involve
probabilities and cost. E(expected return) = Pi (probability of a certain temperature
increase, i) g (good of reduction) c (cost of reduction)

We have uncertainty about climate change and so we know we have different

situations of the world and we need to add them up, and we need to take into account
the cost of some action. If c = cost and E = expected return from the cost, g = good
where the good is improving the climate. We also have to take account is how we
measure this cost, and the standard way of doing so is in utilities = what it is worth to
individuals, u. C is cost, and we know therefore that the function will include c u.
We could just lump everything together so as we have to deal with a probability, and
this will be slightly complicated, as it will be based on our guess on what climate
change will do to us and our guess on what spending money is going to do to stop it
happening. So we have a probability and the easiest way to think about it is in
different states (situations) of the world, one where there is a lot being done and one
where not very much is being done.) P1 x (U1 C1) + P2 x (U2 - C2)
Another way of writing this E = Cbar Pi x Gi(C) C so the expected value of
spending c is the probability that event 1 occurs multiplied by the amount of goods of
type 1 you would buy, plus the probability that event 2 occurs multiplied by the
amount of goods of type 2 you would buy, minus the cost. So you could buy goods of
type one, or goods of type two
We know for sure that E(C) = G C [expected cost is the expected gain minus the
expected cost]
Political parties in a liberal democracies are dealing with a problem with an uncertain
future game and immediate payment, and this is likely to be a problem because there
is certainty in the cost, but uncertainty in the benefit. You would get diminishing
returns from mitigating climate change if everyone mitigated climate change a little
bit the gains would be huge, but if everyone was emitting no or only 1kg of carbon
every year then you would expect by this point the gains to taper off, so a curve with
diminishing returns for E of C
Immediately we know it wouldnt be rational to spend anything greater than where
these two curves cross, because you would be getting less future gain than the
expected return. Where you are really going to spend is initially the idea is that
where the cost is going up faster than the gain, for every extra dollar you are spending
you are getting less than a dollar return, and where the gain has a greater gradient than
the cost, you are getting a greater return, above 1 dollar, for every dollar you spend

Expected Gain

Expected Cost
QuickTime and a
TIFF (Uncompressed) decompressor
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There are two components on every graph of returns on mitigation of climate change
action: an uncertain component, the expected gains, and a certain component, the
expected costs
Whenever there is a cost in politics it becomes political economy: economy because
there is cost, and politics because people are going to fight about who pays it
So we need to use what we know to explore this problem: States (assumptions about
them and their imperatives), trade theory (from these theories: coalition formation,
structural dependency theory, accounting identities), interaction between states (basic
game theory)

Political economic model with cost in it, and the expected return for the cost is going
to be E(X) C where this was the probability of returns from expenditure; an
alternative model was P1 x (U1 C1) + P2 x (U2 - C2) or E = Cbar Pi x Gi(C)
Global warming from the viewpoint of imperatives of states. Recall that we turned out
formula for expected value into a diagram and so if C was going along here, is just a
straight line. It would be reasonable to assume that our expected return would increase
quickly for initial amounts of expenditure but then increase less and less slowly: just
doing the easy things first like increasing household efficiency, transport efficiency,
better light globes, etc
The liberal democratic process: how good are liberal democratic states at solving
problems like this? The fundamental simple model is two competing parties, and we
assume that each party offers goods to the voters in an attempt to buy votes, almost a
supply and demand situation. There are three points we might make about this: 1)

given we have this uncertainty in return, what we might expect in a straight out simple
vote competition is that political parties could exploit this. There is some research and
a mathematical model that say it pays for politicians to lie in equilibrium. The two
parties are appealing for your votes, P1 says vote for me, I will cut consumption
immediately, some of you will lose your jobs, you will consume less, we have to do
something about this. P2 says its not such a bad problem, there is uncertainty and so
the probabilities of things are not so terrible, it doesnt really matter if we dont do
anything, its not going to happen for 10 or 20 years anyway, so vote for us and well
reduce CO2 by 2050, if you vote for P1 theyll reduce it immediately and thats bad
So if we think seriously about the way a liberal democracy works we see that we have
a vote bidding competition in offering goods for votes, and there is tendency in the
vote bidding competition for the parties to exploit uncertainty, remember the costs are
immediate and certain, the gains are uncertain, to exploit the uncertainty in the gains
in order to offer a program which gives very little cost and immediate input. A lot of
what is happening in liberal democracies is very much driven by that
1)a the first problem is whether liberal democratic institutions: buying votes, offering
goods, are very good at solving these sorts of problems. Is that necessarily a good way
to solve these sorts of problem: Liberal Democratic Institutions. Is democracy a good
idea in some cases?
1)b The complexity issue: what you are doing is to ask voters to make a decision on
issue with a great deal of complexity. This works well when the issues are
straightforward (we are being attacked, should we begin a war?) But what we are
dealing with in regards to global warming are quite complex future issues, and there is
some interesting research to be done on whether liberal democracies have ever shown
any capacity to deal with any of these issues. Take for example interest rates: we dont
get voters to vote on interest rates because the issue is too complex and if we got
voters to vote on interest rates, they will divide between people with mortgages who
have low interest rates, and those with money in the bank who want high interest
rates. So essentially what we do with interest rates is put the decision into the hands of
a expert panel (Reserve Bank) which is independent of political parties. So we have
already enshrined this idea that in relation to complex issues, we get experts to deal
with them and dont let people vote on them, because we know that when we get
people to vote on them, they will vote for them to go down. So you might have a
complicated issue which popular assessment doesnt do a particularly good ob at
solving or bringing down a good decision
1)c Special interests: We have touched on this when we looked at trade and coalitions
created around trade, and similarly we get interests developing around all sorts of
other things. In a political process, special interests always tend to outweigh general
interests. If a group of fishermen always vote to kill fish, and a general group votes
on a number of diffuse issues, you can almost be certain that as a consequence of
political party competition, all parties will offer a platform that allows people to kill
fish, because if you support the environment and are in a general group, you care
about a whole lot of things: clearing bushland and rainforest, species preservation,
water resources, better aged care, better mental health care, etc. These people will get
what they want because no matter what else is in your platform, they will vote for
killing fish, so in a sense their votes are easy to get they can be bought with a single
policy. As happens with trade, special interests cluster around particular economic
issues. In Australia for example there are special interests clustering around coal and
over everything else to do with energy built with coal. There are no special interests
around nuclear energy; there are special interests around coal because you have the

interests of the capitally invested, and the interests of the workers whose livelihood
depends on extracting coal, transporting coal and burning coal. If coal as a form of
energy is abandoned then these workers lose their jobs and their livelihoods, so either
you will vote for coal because you feel sorry for these people that will lose their jobs
knowing that by doing so you are hurting the environment but looking firsts to the
immediate interests of others, or because it is very easy to convince someone that
what is it their interests is right. So for all sorts of reasons special interests around coal
will tend to vote for the party supporting it no matter what, and if there is no support
for an alternative these special interests will outweigh general interests. It is easy to
convince special interests that because of this uncertainty, there isnt a problem, and
so the spokespeople for these interests can use this as part of an argument. Social or
political economic flexibility (this comes back to the imperatives of the state and the
link between the state and the market): if you had a state that offered a comprehensive
welfare system, then it is possible that people with special interests would not worry
so much about losing their jobs because if the state pursues the general interest, it
wont harm you as a special interest. So we see that these states with comprehensive
welfare systems possibly have more flexibility in their social programs and ability to
pursue social welfare. Essentially special interests go to the problem of coalition
formation, and as we dealt with special interests in regards to trade, scarce and
abundant factors of production or industry specific factors of production, so the same
story is going to run for global warming. This essentially covers what we might look
at under 1).
2)a Trade theory. Begin with the single state model with the market. Here we can see
different interests developing between the trade and goods sector, and the non-trade
and goods sector. The trade and goods sector is going to face international
competition, and the non-trade and goods sectors (although in the long run it may lose
a comparative advantage) is not as likely to be affected by imposing a cost on CO2.
That will depend though on what other states do. If everybody put the same price on
carbon, at first approximation, you wouldnt expect it to be a big problem. That is, and
this is one argument in favour of carbon tax, that if there were a unit for (or unified?)
carbon tax across the globe, then at first approximation if you went back to the simple
Ricardian model, you wouldnt expect comparative to alter, because that factor price
would go up by the same amount for everybody. Clearly there would be some work to
be done to ensure there wouldnt be much difference, but generally you would expect
that there wouldnt be much difference. If however you get a differential price for
carbon, through various cap and trade mechanisms, then the outcome will be quite
different. One consideration that not many people are talking about is the WTO, under
the current rules except for agriculture, you cant put tariffs up on imported goods
from other countries. Assume S1 sets a high price on carbon because they are worried
about this issue and S2 doesnt, they decide not only to have a low price on carbon but
to subsidise carbon (states do this all of the time they subsidise fuel, fishing fleets,
QLD used to subsidise petrol). What is S1 likely to do then? If S1 is a big actor like
the EU, which is most likely the large actor to have a high carbon price, then it is
likely to try and protect its own domestic industries by breaking the WTO, or trying to
alter the rules. So one possibility is that a state with a high carbon tax on all imported
entry from carbon products. So essentially there is a threat to dismantle the WTO as it
is currently put together and understood. So this is one implication that we have from
our descriptive trade theory. Another important element here is capital mobility which
we talked about extensively in relation to the structural dependency thesis, and we
see again that it is being rerun in relation to putting a cost on carbon (carbon taxes).

Firms will invariably threaten to go somewhere else, and what you would have here is
threats from carbon intensive industries to move to low carbon cost areas. Again (and
there has been a lot of debate over this, in fact some business spokespeople have been
the target of considerations to charge them with contempt of parliament because what
they have been saying publicly and what they have been telling their shareholders
have been two different things, and you cant do this, but what the debate goes to is
the capacity of different sorts of industries to move: it goes to credible threats.
Anyone can say theyll move, the question is, can they move? One case particularly is
a coal fired QLD plant threatening to move, although how it would produce electricity
for QLD offshore is unknown) as with structural dependency we have the threat from
industries to relocate, but the real question is what is mobile, and what are the
transaction costs. We see that the problem looks the same as the structural dependency
problem; a price on carbon looks the same as a tax so essentially the political
economic dynamics are the same. 2)b Will this be a problem for an entire society?
(use trade theory to think about this). It is true that in a small state like Tasmania, an
aluminium smelt which is very energy intensive, and the energy comes from Victoria.
This may threaten to move, and maybe it could, because the energy costs are much
higher than the raw material costs, regardless of where you get the raw materials from.
This could be a local problem, but would it be a global problem. Circular flow
diagram: y is output, y = c (consumption) + s (surplus) for households and firms are
over here, this is a closed circuit like things flowing through a pipe. Y (output) = C
(consumption) + I (investment) + E (exports) I (imports), if this is true it must be the
case that S (surplus) I (imports) = X N. This tells us that if we have a surplus on
current account, we are saving more than we invest. We can switch this around and
say that I S = N X. In that case if we are getting investment coming into the
country, it must be the case that we are importing more goods than we are exporting.
Is this a problem for the entire society? This is not clear. For substantial amounts of
Australian investment to go somewhere else, you would have to start altering the
entire balance of payments schedule. It is not clear whether this is a society wide
problem, it might be a problem for a particular industry, which might be high energy
cost, and particularly small industry could relocate, but it is not clear that you could
get bulk relocation because of the implications it has from the balance of trade
problem from the work we already did on this. So that is what trade theory tells us.
3) Game Theory: We know that if the global environmental problem involved lots of
states and each state has a roughly equal contribution, then we can tell the story that
for any individual state, given that all of the other states combined can give the good,
if we had a simple game with only C and D, we would get a game looking something
like this: the prisoners dilemma. If this is being played once only then the chances of
an agreement are slight, more realistically you would expect that with major
environmental problems, the game would be played in some repeated way. If we have
a finite termination date it wont make any difference to the outcome, but if we dont
have one there is some possibility either that states might cooperate or as they have
done with the WTO, International Banking Regulations, etc with our without some
hegemonic actor, set up some kinds of institutions whereby no cooperation attracts a
penalty, so they agree to penalise non-cooperative parties. So if there are many states,
we have to analyse the problem as above, and if you were giving advice to the UN or
Australian delegation you would tell them that if the problem looked like this, you
need to seriously think about an authoritative structure. Case 2, HST not very
interesting, the other interesting case is case 3, and few large states. In this case we
know what they are, the US, China, the EU, (if we treat that as a single political

entity) Japan, and India. Attention is currently focused on China but India with its
incredibly rapid growth rate means that its CO2 is growing very fast. India however is
very anxious to switch to a nuclear based economy. Here essentially we should look at
the Hawk-Dove game, (although empirical research is necessary to go further)
particularly you might want to think that the EU for various domestic reasons seems
to be relatively inclined to accept high carbon costs, and Japan is relatively moderate
on this, but the two big players are the EU and China. So it might be the case that in
the current period it looks like a two player game with the US and China setting the
agenda. Hawk-Dove game, where time is not included, we are just assuming a set
payoff. Dove Dove (both cut carbon say by 50%), Payoff(S1) = G K/2, Dove Hawk
(P1 cuts by 100%), P(S1) = G K, Hawk Dove, P(S1) = G, Hawk Hawk, P(S1) = 0 or
status quo ante, no one cuts carbon emissions and they both keep producing. Here you
might model the problem as a Hawk-Dove game so you get a different dynamic from
the prisoners dilemma because there are repeated plays of the game and credible
threats, so you have negotiation, bargaining and players trying to convince their
opponent is that they wont back down. So a strategy for China may be to convince
the US that because the West is responsible for the majority of carbon currently in the
atmosphere, on moral and development grounds China is not going to back down and
the US and developed countries have to slash their carbon for 10 years and then China
will start cutting its carbon. The strategy for the US should be to use a hawk strategy
and that unless China bears a proportion of the cost, it is not possible to get any
carbon abatement legislation through the congress so they have to keep a hawk
strategy. Related are some more difficult questions to do with equity responsibility
for the amount of carbon already in the atmosphere, the right of underdeveloped
countries to develop through a low-cost path and of emissions per head. China has
more emissions than the US but only a fraction of the emissions per head. Do you deal
with this by treating states or people the same?

Annex 1: Supply and Demand

Wage
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Supply Curve
for Labour P*
so there is an
equilibrium at
Q*

Labour Supply
DEMAND: Amount of a good, service or resource that people are willing and able to buy
at a series of prices at a moment in time. The curve represents the maximum price
consumers will be willing to pay for a particular quantity of the good/service/resource
Law of Demand: Assuming ceteris paribus (all external things remain constant except
price) the lower the price, the more demand there is in quantity for the
good/service/resource (not demand among a greater number of consumers) so there is a
move up or down the existing demand curve.
Rationale: Consumers are willing to buy something because they value its opportunity
cost, the value of the best alternative they could buy for the same price and so if a g/s/r is
cheaper than its competitors assuming they all satisfy the same basic want, the consumer
will buy more of the cheaper g/s/r at a lesser price
SUPPLY: Amount of a good, service or resource that people are willing and able to sell
at a series of prices at a moment in time.
Law of Supply: Assuming ceteris paribus (all external things remain constant except
price) the higher the price, the higher the quantity producers will make available for sale
so there is a move up or down the existing supply curve. The curve represents the
minimum price producers will be willing to sell a particular good/service/resource for.

Rationale: producers have to make a profit so keep producing and so the higher the price
they can charge for that good the more they are able to produce because there is a higher
profit margin
Product Market (consumers point of view in buying goods/services from businesses)
Factor Market (producers point of view in buying resources from households)
Equilibrium or Market-Clearing Price: the price at while the consumer can buy as
much as they demand and the producer can sell as much as they want to produce;
therefore the best compromise between the interest of consumers (demand) and producers
(supply.) Example: I am auctioning cars which cost me 10,000, the buyer bids $12,000
and wants to buy 6 but I can only produce 3 because I am not making enough profit. So
the product becomes scarce because there is not enough supply for the demand, and
consumers are willing to pay more. So a consumer bids 15,000 which means $5000 profit
for me, and at this market price, I can produce even more. So on and so forth until I am
producing exactly as much is demanded so the price isnt pushed up and more by scarcity,
I am making enough of a profit and the consumers are getting as much as they want. At
this point the market is cleared and stable because the consumers do not need to bid to
push the price up anymore in order to have the producer supply their needs, demands are
completely supplied. This is the only price for which consumers have no reason to offer
a higher price and producers have no reason to offer a lower price.