International trade and the inequality of nations'

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International trade and the inequality of
nations. Tony Venables, London School of
Economics UK Department for International
Development
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Is international trade a force for the
convergence of real incomes across countries?
for the divergence of real incomes? What is
the historical record? What does economic
analysis suggest? Is there a tension between
the evidence and the theory? Should
international economics be reformulated to
capture massive and persistent international
inequalities?
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Argue that In different time periods and
different contexts the effects of trade have been
quite different. To understand this need a
theory which recognises that the productivity of
labour and hence comparative advantage
depends on inputs that are complementary with
labour. Supply of these complementary inputs
is endogenous Some are supplied publicly, some
privately. They may be internationally
mobile. They are often associated with
cumulative causation processes.
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Plan of lecture Review of evidence.
Development of simple analytical frameworks to
think about the role of complementary inputs
Capital Institutions, infrastructure and
investment climate Intermediate goods
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1 Historical record the great divergence
Ratio of per capita incomes of richest to poorest
nations increased from around 8 in 1870 to 50 in
2000 Decline in shipping costs and increasing
role of trade

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An interpretation of the evidence Rich club/
poor club convergence clubs Rich club has
captured most of the benefits of trade.
Coexistence of these clubs for extremely long
periods of time. Economic development in
sequence not in parallel NB Not seeking to
argue that all changes in international
inequality due to trade. But, need analysis
that recognises (a) ambiguous effects of trade
and (b) trade is consistent with persistent
inequalities.
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Benchmark model Goods Agriculture XA
A(LA, KA), numeraire Manufactures XM M(LM,
KM), price p. Inputs KA Complementary input
in agric return rA KM Complementary input
in manuf return rM L LA LM Fixed
endowment of labour wage w. Equilibrium w
a(LA/KA) pm(LM/KM) Also rA A(LA/KA) -
wLA)/ KA rM pM(LM/KM) - wLM/ KM
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Model I Trade and factor flight Capital as
the complementary input. Consider a small open
economy that has a comparative disadvantage in
manufactures. Source of comparative
disadvantage? Land abundance Technical
inefficiency Complementary factor in
manufactures may be internationally mobile eg,
human or physical capital. Question What is
effect of opening to trade?
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Key points Under autarky, the cost of a
technical inefficiency or comparative
disadvantage is spread across the entire
population, via goods prices. With trade,
this cost is concentrated on owners of specific
factors in the sector with disadvantage. If
this factor is internationally mobile, then this
will cause capital flight and a fall in the
wage. Gain to initial residents
national real income Loss to domestic
real income.
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Key points (continued) Trade lets a
country move factors out of sector with
comparative disadvantage but how are they
absorbed elsewhere? Can capital be employed
elsewhere? Heckscher-Ohlin versus specific
factors model. Can labour be redeployed
without running into diminishing returns?
The more things are tradable the easier it is to
redeploy factors from contracting sectors without
running into diminishing returns.
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Application and policy Lagging regions?
Increased trade denudes regions of skills/
capital. Mono-crop agriculture and import
competing manufacture? Export
diversification a necessary accompaniment to
import liberalization.
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Model II Infrastructure and institutions
publicly provided complementary inputs.
Institutions matter Acemoglu et al.
Institutions are a complementary input to
production. Institutions are more important
for some activities than others. Countries
with better contract enforcement specialise in
industries that rely heavily on relationship
specific investments, (Nunn, 2005)
Investment in institutions a public good, and
usually cannot be made sector specific
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• What are these institutions?
• Rule of law, property rights, limits to
  corruption
• Infrastructure
• Investment climate
• NB
• Matter particularly for modern manufacturing
  exports
• Importance of reliability and quality control
• Just-in-time delivery.
• O-rings and supermodularity value of a
  product is determined by its weakest link.

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Public investments in institutions/
infrastructure/ investment climate, have
properties that i) Public goods, not easily
targeted to particular sector. ii) Productivity
effect varies across sectors high in modern
manufacturing? How does the provision of these
services shape trade, and how does trade shape
the provision of these services? Show that two
economies that are ex ante identical can be
different ex post just one of them captures all
the gains from trade.
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Model II Two sectors, A and M, as before,
using labour and a public service, s.
Marginal (and average) products of labour in each
sector, a(si), pm(si) One unit of labour
produces one unit of public service. In country
i, if both sectors active wi a(si)
pm(si) Labour market clearing 1 - si LA LM
. Real income of country i ui (1 - si)wi
p-µ Autarky ui (1 - si) a(si)1-µ
m(si)µ Optimal choice of s si /(1 - si)
(1- µ)?A µ?M
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Can there be an asymmetric equilibrium? Suppose
so in equilibrium, country 1 has only
manufactures L1M 1 s1, w1 pm(s1) gt
a(s1) country 2 has agriculture and
manufactures L2M L2A 1 s1, w2
pm(s2) a(s2) This means that world price is,
p a(s2) /m(s2) Real income levels, u1, u2 u1
(1s1)w1 p-µ (1s1) m(s1)a(s2) /m(s2)
1-µ optimal choice of s1 s1 /(1 s1) ?M
u2 (1s2)w2 p-µ (1s2)a(s2)1-µ m(s2)µ
optimal choice of s2 s2 /(1 s2) (1- µ)?A
µ?M

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Optimal choice of s1 s1 /(1 s1) ?M
Optimal choice of s2 s2 /(1 s2) (1- µ)?A
µ?M This is an equilibrium if ?M gt ?A In
this case country choices imply, s1 gt s2, and
therefore productivity levels such that country 1
specialised in manufactures. Country 2 has no
incentive to deviate. Real income
levels? Country 2 No gains from trade (same
choice of s2, and same prices as under
autarky). Country 1 Gains from trade (higher
level of s1, same prices as under autarky).
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The game between countries Remove
discontinuities by adding a specific factor in
agriculture a(si , LiA/KA) Compute best
response functions. Multiple equilibria. Gains/
losses from trade.
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• Key points
• Economies may be identical ex ante, but
  asymmetric ex post, with one taking all the gains
  from trade.
• If one country has already made the investments
  that give it comparative advantage in
  manufacturing, then it is not worthwhile for the
  other country to investment.
• I.e., for a country with a small modern sector
  it is rational to invest little in the public
  goods that raise productivity in this sector
  (..and therefore it will turn out to have a
  small modern sector).
• Target provision of infrastructure/ institutional
  investments?

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Model III Intermediate goods linkages and
clustering. Third sort of complementary input
intermediate goods. Draw on new economic
geography, Fujita, Krugman Venables.
Productivity depends on local supply of
intermediates Intermediate goods create the
possibility of forward and backward linkages --
old idea from the development literature
(Hirshman, Myrdal). Forward (cost) linkages
downstream firms gain from proximity to their
suppliers (eg, save transport costs). Backward
(demand) linkages upstream firms gain from
proximity to their customers (transport costs).
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Can produce outcomes where activity clusters
in one country. Key assumptions to get
clustering? Many types of intermediate goods,
and each type only produced in one place
presumably because of increasing returns to
scale. (Without this assumption, have backyard
capitalism). Proximity advantage eg
transport costs.
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The model Agriculture labour productivity
a(LiA) Manufactures Each country produces its
own variety of final good, output prices unit
cost, p1, p2 (perfect competition) Inputs to
manufacturing Labour, with share in costs 1
v. Continuum of intermediate goods, share
v, elasticity of substitution between
intermediate varieties 1 (Cobb- Douglas).
Intermediate goods can be produced in one country
or the other, using just labour. Let ? denote
the fraction of the types produced in country
1. Intermediates prices, w e, transport
costs t. Final goods prices, p1 w11-vw1v?
(w2t)v(1- ?) , p2 w2(1-v)w2v(1- ?)
(w1t)v?
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• Price of final goods produced in country 1,
  country 2
• p1 w11-v(1-?) (w2t) v(1-?), p2
  w21-v? (w1t)v?
• Demand for final goods from both countries,
  exports have transport cost ?
• X1 D(p1, p2?) D(p1?, p2), X2 D(p2,
  p1?) D(p2?, p1)
• yi is quantity of each variety of intermediate
  produced in country i.
• Derived demand for intermediate goods (in value
  terms)
• w1y1? ?v(p1X1p2X2/t), w2y2(1- ?)
  (1- ?)v(p2X2p1X1/t).
• Each variety of produced in country from which it
  makes largest total sales, i.e. ? adjusts
  until y1 y2.
• How does varying the location of intermediate
  good production change profitability, y1, y2?
  Increase ? implies ?p1 and ?p2.
• Crowding effect Given X, if more locally
  supplied then each sold in smaller quantity.
  Depends on value of t.
• Cost/ sales effect Reduction in p1 expands
  sales, X1, and hence increases y1. Depends on
  values of t and ?.
• Will get clustering of activity if cost/ sale
  effect dominates crowding.

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Summary At high trade costs, each country has
industry to supply local consumers crowding
effect dominates cost/sales expansion effect.
Symmetry, ? ½. At intermediate trade costs,
sales more responsive to cost differences cost/
sales effect dominates. Agglomeration, ? 1 or
? 0. So far, assumed wages fixed what if
they respond to employment levels (upward sloping
labour supply curve from other sectors)?
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Cut trade costs deindustrialises 2 cuts its
real wage globalization phase, rapid catch
up by 2, possible fall real wage in 1.
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Summary the general theory of location At
high trade costs location determined by
demand ? ½. Equal real wages. At
intermediate trade costs location determined by
clustering forces ? 1 or ? 0. Real wages
unequal. At low trade costs location
determined by factor costs ? ½. Equal real
wages. Implications for real wages and the
distribution of the gains from trade. In
multi-country setting, have rich club / poor
club.
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Extensions other clustering mechanisms
Timeliness as a trade cost (Harrigan
Venables) One assembly plant in each
country. Range of intermediate goods, each type
produced in just one country. Probability of
remotely produced int. arriving on time, q lt 1.
Probability of all ints. arriving on time for
plant in country 1 is q1-?, where ? is no. of
intermediates prod. in 1. This probability is
increasing and convex in ?. If delaying
production is costly, then it is efficient to put
all intermediate production next to one assembly
plant ie., clustering.
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Timeliness Intermediate producers cluster,
because it is better to have one assembly plant
working well and the other badly, than both 1/2
well Intuition if one part is delayed,
matters less that second is also delayed.
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Extensions Other clustering mechanisms?
Thick labour markets -- matching -- skill
acquisition Knowledge spillovers. What is
their interaction with trade? Trade
liberalization facilitates clustering all the
way to free trade (i.e., not tomahawk case)?
What is their spatial scale? Urban rather than
international economics?
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Conclusions Need to recognise that trade has
not always brought a balanced distribution of
benefits. Have offered some reasons why this
is so organised around the theme of the supply
and/or location of complementary inputs to
production. Absolutely NOT a rejection of the
case for trade liberalization many of these
models yield much larger world gains from trade
liberalisation than do standard models.
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BUT Recognise that opening to trade can create
problems. Alternative employment of resources
displaced from import competing sector may mean
lower income. Even in a perfect economy, trade
can increase incentives for factor flight and
redeployed labour may run into diminishing
returns and lower wages. Need more tradable goods
diversification (Model I) Incentives to
improve institutions and the investment climate
may be low. Need cost effective ways to target
these expenditures. Aid for trade. (Model
II) Small trade frictions combined with
linkages mean that large wage differences are
not enough to attract industry. But optimistic
message globalization reduces the value of
proximity and facilitates relocation of stages of
the production process. (Model III)