Global Economics Eco 6367 Dr. Vera Adamchik

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Global EconomicsEco 6367Dr. Vera Adamchik

• Sources of Comparative Advantage

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• In this chapter, we will discuss the factors that
  ultimately determine why a country has a
  comparative advantage or comparative disadvantage
  in a product.

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In Chapter 2 we learned

• Trade begins as someone conducts arbitrage to
  earn profits from the price difference between
  previously separated markets.
• With no trade, product prices differ because
• supply conditions differ (different PPFs,
  technologies and resource endowments)
• demand conditions differ (tastes and preferences).

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Labor theory of value

• Adam Smith viewed the determination of
  competitiveness from the supply side of the
  market (labor theory of value ? labor is the only
  factor ? the cost or price of a good depends
  exclusively on the amount of labor required to
  produce it) p. 31 in the textbook

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Labor theory of value

• Like Smith, David Ricardo emphasized the
  supply-side of the market. In his model, he
  relied on the following assumptions p. 32 in the
  textbook
• (2) In each nation, labor is the only input
• (5) Costs are proportional to the amount of
  labor used.

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In-class exercise

• However, Smiths and Ricardos theories fail to
  explain international trade when technology is
  identical in both countries, that is, production
  functions and PPFs are the same in both
  countries.
• Exercise 1 (handout).

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The Factor-Endowment Theory (a.k.a. the
Heckscher-Ohlin theory of trade) -- the basis for
the orthodox modern theory of comparative
advantage
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• The leading theory of what determines nations
  trade patterns emerged in Sweden.
• Eli Heckscher (an economic historian) developed
  the core idea in a brief article in 1919.
• A clear overall explanation was developed and
  publicized in the 1930s by Heckschers student
  Bertil Ohlin (a professor and politician, a Nobel
  laureate).
• Ohlins arguments were later reinforced by Paul
  Samuelson (a Nobel laureate), who derived
  mathematical conditions under which the H-O
  prediction was strictly correct.

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• The H-O theory emphasizes the role of
  relative differences in resource endowments as
  the ultimate determinant of comparative
  advantage. The H-O theory explains comparative
  advantage in terms of underlying
• differences across countries in the availability
  of factor resources (factor endowment) abundant
  vs scarce factors
• differences across products in the use of these
  factors in producing the products
  labor-intensive, capital-intensive,
  land-intensive, etc.

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Factor abundance

• The phrase different factor endowments refers to
  different relative factor endowments, not
  different absolute endowments.
• In other words, different factor endowments
  different factor proportions.

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Relative factor abundance

• May be defined in two ways
• The physical definition (in terms of the physical
  units of two factors). For example, (K/L)I gt
  (K/L)II ? Country I is capital-abundant
• The price definition (in terms of the relative
  prices. The greater the relative abundance of a
  factor, the lower its relative price). For
  example, (r/w)I lt (r/w)II ? Country I is
  capital-abundant.

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Commodity factor intensity

• A commodity is said to be factor-X-intensive
  whenever the ratio of factor X to a second factor
  Y is larger when compared with a similar ratio of
  factor usage of a second commodity.

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• For example, consider labor
• A country is relatively labor-abundant if it has
  a higher ratio of labor to other factors than
  does the rest of the world.
• A product is relatively labor-intensive if labor
  costs are a greater share of its value than they
  are of the value of other products.

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How does the relative abundance of a resource
determine comparative advantage?

• When a resource is relatively abundant, its
  relative cost is less than in countries where it
  is relatively scarce.
• Difference in relative resource costs causes the
  pre-trade differences in relative product prices
  between two countries.

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• The H-O theory says, in Ohlins own words
• Commodities requiring for their production
  much of abundant factors of production and
  little of scarce factors are exported in
  exchange for goods that call for factors in the
  opposite proportions. Thus indirectly, factors in
  abundant supply are exported and factors in
  scanty supply are imported.
• (Ohlin, Bertil. International and
  Interregional Trade, MA Harvard University
  Press, 1933)

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• Or, in other words, the H-O theory predicts
  that a country exports the product(s) that use
  its relatively abundant factor(s) intensively and
  imports the product(s) using its relatively
  scarce factor(s) intensively.

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Criticism The Leontief paradox

• Wassily Leontief theorized that since the U.S.
  was relatively capital-abundant (and
  labor-scarce) compared to other nations, the US
  would be an exporter of capital intensive goods
  and an importer of labor-intensive goods.
  However, he found that US exports were less
  capital intensive than US imports. Since this
  result was at variance with the predictions of
  the H-O theory, it became known as the Leontief
  Paradox.

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• The post-Leontief studies showed that the US was
  also abundant in farm-land and highly skilled
  labor. And the US was indeed a net exporter of
  products that use these factors intensively, as
  H-O predicts.
• The trade patterns of some other developed
  countries (Japan, Canada) and of many developing
  countries (China) are broadly consistent with
  H-O.
• In general, trade patterns fit the H-O theory
  reasonably well but certainly not perfectly.

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• Who gains and who loses
• from trade
• within a country?

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• According to H-O, opening to trade alters
  domestic production. There is expansion in the
  export-oriented sector, and there is contraction
  in the import-competing sector.
• The changes in production have one set of effects
  on incomes in the short run, but another in the
  long run.

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• In the short-run (when labor and capital are
  immobile / cannot move easily from one industry
  to another), the specific-factor theory predicts
  the effects of trade on factor prices and
  incomes.
• In the long run (when labor and capital can move
  freely among industries), the factor-price
  equalization theorem and the Stolper-Samuelson
  theorem predict the effects of trade on factor
  prices and incomes.

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Trade and the Distribution on Income in the Short
Run

• The types of factors that cannot move easily from
  one industry to another are called specific
  factors.
• In the short run laborers, plots of land, and
  other inputs are tied to their current lines of
  production.

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In-class exercise

• See The Specific-Factor Theorem handout.
• Conclusions
• for the short-run, gains and losses divide by
  output sector All groups tied to rising sectors
  gain, and all groups tied to declining sectors
  lose.

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• Trade and the Distribution on Income in the Long
  Run

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Factor-Price Equalization

• By redirecting demand away from the scarce
  resource and toward the abundant resource in each
  nation, trade leads to facto-price equalization.
• In each nation, the cheap resource becomes
  relatively more expensive, and the expensive
  resource becomes relatively cheaper, until price
  equalization occurs.

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In-class exercise

• See The Factor-Price Equalization Theorem The
  Stolper-Samuelson Theorem handout.
• Conclusions
• given certain conditions and assumptions, free
  trade equalizes not only product prices but also
  the prices of individual factors between the two
  countries.

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The Stolper-Samuelson Theorem
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• If countries gain from opening trade, why do
  free-trade policies have so many opponents year
  in and year out?
• The answer is that trade does typically hurt some
  groups within any country.
• Hence, a full analysis of trade requires that we
  identify the winners and losers from freer trade.

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• Wolfgang Stolper and Paul Samuelson developed the
  Stolper-Samuelson theorem in an article published
  in 1941.

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The Stolper-Samuelson theorem

• With full employment both before and after trade
  takes place, the increase in the price of the
  abundant factor and the fall in the price of the
  scarce factor because of trade imply that the
  owners of the abundant factor will find their
  real incomes rising and the owners of the scarce
  factor will find their real incomes falling.

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In-class exercise

• See The Factor-Price Equalization Theorem The
  Stolper-Samuelson Theorem handout.
• Conclusion
• Net gains for both countries but different
  effects on different groups
• Winners landowners in Farmland and workers in
  Peopleland.
• Losers workers in Farmland and landowners in
  Peopleland.

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• It is not surprising that owners of the
  relatively abundant resources tend to be free
  traders while owners of relatively scarce
  resources tend to favor trade restrictions.

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Criticism

• We may not see the clear-cut income distribution
  effects with trade because relative factor prices
  in the real world do not often appear to be as
  responsive to trade as the H-O and S-S imply.
• In addition, income distribution reflects not
  only the distribution of income between factors
  of production but also the ownership of the
  factors of production. Since individuals or
  households often own several factors of
  production, the final impact of trade on personal
  income distribution is far from clear.

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The product life-cycle theory
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• The explanations of international trade presented
  so far are similar in that they presuppose a
  given and unchanging state of technology.
• The product cycle hypothesis attempts to offer a
  dynamic theory of technology and trade.

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• Technology-based comparative advantage can arise
  over time as technological change occurs at
  different rates in different sectors and
  countries.
• Hence, a country can develop a comparative
  advantage based on its technological improvements
  or innovations (that mainly come from RD).

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• In some ways this technology-based explanation is
  an alternative that competes with the H-O theory.
• However, there is also a link to the H-O theory
  the suitable location of RD matches the factor
  proportions of production using the new
  technology to the factor endowments (that is,
  availability of highly skilled labor and venture
  capital) of the national locations.

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• The product life-cycle theory, proposed by
  Raymond Vernon in the mid-1960s, suggested that
  as products mature both the optimal production
  location and the location of sales will change
  affecting the flow and direction of trade
• Initially, RD, production and consumption are
  likely to be in an advanced developed country.
• Later, as demand grows in other developed
  countries, the innovating country begins to
  export.

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• Over time, demand for the new product will grow
  in other advanced countries making it worthwhile
  for foreign producers to begin producing for
  their home markets.
• The innovating country might also set up
  production facilities in those advanced countries
  where demand is growing, limiting the exports
  from the innovating country.

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• Over time, the product and its production
  technology become more standardized and familiar
  (mature). Factor intensity in production tends to
  shift away from skilled labor and toward
  less-skilled labor.
• The technology diffuses and production locations
  shift into other countries, eventually into
  developing countries that are abundant in cheap
  less-skilled labor.

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• Trade patterns change in the manner consistent
  with shifting production locations. The location
  of production of a product shifts from the
  leading developed countries to developing
  countries as the product moves from its
  introduction to maturity and standardization.
• The innovating country is initially the exporter
  of the new product, but it eventually becomes an
  importer.

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• The product life cycle theory accurately
  explains what happened with a number of high
  technology products developed in the US in the
  1960s and 1970s. For example,
• Pocket calculators were pioneered by Texas
  Instruments and Hewlett-Packard in the US in the
  early 1970s.
• Soon Sharp and other Japanese firms began to
  dominate a product whose characteristics had
  begun to stabilize.
• More recently, assembly production shifted into
  the developing countries.

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The product life-cycle theory
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• Nonetheless, the usefulness of the product
  cycle hypothesis is limited due to the
  difficulties in determining the phases of the
  cycle
• 1. In many industries especially high-tech
  product and production technologies are
  continually evolving because of ongoing RD.
• 2. International diffusion often occurs within
  multinational (global) corporations. In this
  case, the cycle can essentially disappear. New
  technology can be transferred within the
  corporation for its first production to other
  countries, including developing countries.

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Alternative models of tradeNew trade theory
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• Standard theories of international trade
  (developed by Adam Smith, David Ricardo, and
  Heckscher-Ohlin) focus on production-side
  differences as the basis for comparative
  advantage. According to these theories, the
  sources of production-side differences are
  differences in technologies, differences in
  factor productivities, differences in factor
  endowments, and differences across products in
  the use of productive factors in producing the
  products.

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• Hence, according to these theories, the more
  different the countries are regarding
  productivity, technology, or capital-to-labor
  ratio the greater the economic gain from
  specialization and trade. Thus, we may expect
  that the predominant portion of international
  trade will occur between countries that are
  different in these regards. In other words, we
  may expect that developed countries
  (capital-abundant, high productivity, advanced
  technologies) will trade with developing
  countries (labor-abundant, low-productivity,
  outdated technology).

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In-class exercise

• Conduct a simple test of the standard theories of
  international trade. Go to the U.S. Census Bureau
  webpage http//www.census.gov/foreign-trade/statis
  tics/highlights/index.html click on the Top
  trading partners linkclick on December of the
  previous year (because the December data show the
  annual values for each year).What countries
  were the top 10 purchasers of U.S. exports? What
  countries were the top 10 suppliers of U.S.
  imports? Compare these lists. Does the overall
  pattern of the U.S. trade partners appear to
  match well with the predictions of the standard
  trade theories? Why or why not? Are there any
  features of the data that appear to violate
  strongly these predictions?

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In-class exercise

• Conclusions
• Industrialized countries (which are similar in
  many aspects in their technologies, technological
  capabilities, and factor endowment) trade
  extensively with each other.
• Trade between industrialized countries is nearly
  half of all world trade.
• These facts appear to be inconsistent with
  comparative-advantage theory.

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Intra-industry trade

• An increasing fraction of world trade consists of
  intra-industry trade, in which a country both
  exports and imports the same or very similar
  products (products in the same product category /
  industry).
• Even very subtle production-side (i.e.,
  technology-based) comparative advantages seem to
  be unable to explain the phenomenon of
  intra-industry trade.

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In-class exercise

• Go to http//www.census.gov/foreign-trade/statisti
  cs/highlights/index.html, click on
  Country/Product Data, then on NAICS web
  application, then choose World in the lower
  window, then choose December of the previous
  year to get cumulative annual data. Analyze
  intra-industry trade of the US with the ROW.

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Spread of technology

• Furthermore, technology quickly spreads
  internationally because it is difficult for a
  country to keep its technology secret.
• Hence, many countries usually have access to the
  same technologies for production and are capable
  of achieving similar levels of resource
  productivity.

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Global industries dominated by a few large firms

• Boeing and Airbus commercial aircraft.
• Sony, Nintendo, and Microsoft videogame
  consoles.

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Trade facts in search of better theory

• Substantial trade among industrialized countries,
  much of which is intra-industry trade.
• The dominance of a few large firms in some world
  industries.
• We turn next to the theories that focus not
  only on the supply side differences (technology,
  endowment, etc.) but also on the demand side
  differences as the source of trade.

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The Linder Theory

• The theory was proposed by the Swedish economist
  Staffan Burenstam Linder in 1961.
• The Linder theory is a dramatic departure from
  the H-O model because it is almost exclusively
  demand oriented.

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• The Linder theory postulates that tastes of
  consumers are conditioned strongly by their
  income levels the per capita income level of a
  country will yield a particular pattern of
  tastes.
• Trade will occur in goods that have overlapping
  demand, meaning that consumers in both countries
  are demanding the particular item.

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In-class exercise

• Figure 2 (handout).
• Exercise 2 (handout).

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• The important implication is that international
  trade in manufactured goods will be more intense
  between countries with similar per capita income
  levels than between countries with dissimilar per
  capita income levels.

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• The Linder theory identifies the goods that would
  be traded between any pair of countries. However,
  the theory does not identify the direction in
  which any given good will flow. Linder made it
  clear that a good might be sent in both
  directions both imported and exported by the
  same country! (That is, intra-industry trade.)

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• The Krugman Model

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• The Krugman theory of trade focuses on
• product differentiation monopolistic
  competition
• substantial internal scale economies and global
  oligopoly
• external scale economies (industries that
  concentrate in a few places).
• The major alternative theories of international
  trade relax assumptions 4, 5, and 6 (p. 32) and
  use the existence of economies of scale as a
  major departure from the standard theory.

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• Increasing returns to scale (IRS), or economies
  of scale, exist if increasing expenditures on all
  inputs (with input prices constant) increases the
  output quantity by a larger percentage.
• Therefore, the average cost of producing each
  unit of output declines, as output increases.

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The PPF with decreasing opportunity costs /
increasing returns

• The PPF is bowed inward rather than outward
  that is, opportunity costs decrease the higher
  the level of production in an industry.

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Internal economies of scale

• Scale economies are internal if the expansion of
  the size of the firm itself is the basis for the
  decline in its average cost.
• Ways to reduce the average cost
• greater specialization of workers
• more specialized machines
• spreading of up-front fixed costs (RD or
  production setup costs) over more units of output.

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External economies of scale

• Scale economies external to the individual firm
  relate to the size of the entire industry within
  a specific geographic area.
• The average cost of the typical firm declines as
  the output of the industry in the area is larger.
  (Better input markets specialized services and
  labor swift diffusion of new knowledge about
  product and technology through direct contacts
  among the firms or as skilled workers transfer
  from firm to firm).

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Demand Product differentiation

• Growth in intra-industry trade over time and
  higher intra-industry trade for higher-income
  countries can be understood partly from the
  demand side.
• Income growth shifts demand toward luxuries, and
  product variety is a luxury. Affluent people vary
  their choices of wines, beers, automobiles,
  music, clothing, travel expenses, and so on.

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• Full customization of production in a single
  country would be too costly.
• Hence, some varieties will be imported, while the
  varieties produced in the country can be exported
  to affluent consumers in other countries.
• When all firms face similar downward-sloping
  average cost curves, so there may be no
  comparative advantage.
• Rather, a countrys trade is based on product
  differentiation.

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• The basis for exporting is the domestic
  production of unique models (or varieties)
  demanded by some consumers in foreign markets.
• The basis for importing is the demand by some
  domestic consumers for unique models produced by
  foreign firms.
• Intra-industry trade in different products can be
  large, even between countries that are similar in
  their general production capabilities.

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Economies of scale

• Yet, demand effects cannot be the whole story.
• Economies of scale play a supporting role, by
  encouraging production specialization for
  different varieties.
• With trade, firms in each country produce only a
  limited number of varieties of the basic product,
  but in greater quantities (domestic market
  exports), which leads to a lower unit production
  costs.

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• If internal scale economies are modest or
  moderate, then there is room in the industry for
  a large number of firms. If, in addition,
  products are differentiated, then we have a mild
  form of imperfect competition called monopolistic
  competition.

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• If internal scale economies are substantial over
  a large range of output, then it is likely that a
  few firms will grow to be large in order to reap
  the scale economies. If a few large firms
  dominate the global industry, then we have an
  oligopoly.
• The countries in which these firms are located
  will then tend to be net exporters of the
  product, while other countries are importers.

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• External scale economies appear to explain the
  clustering of some industries
• Silicon Valley high-tech semiconductor,
  computer, and related producers.
• New York City banking and finance.
• Hollywood (Bollywood in Bombay) filmmaking.
• Italy stylish clothing, shoes, and accessories.
• Switzerland watches.

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Gains from trade

• A major additional source of national gains from
  trade is the increase in the number of varieties
  of products that become available to consumers
  through imports.
• Without trade, nations might not be able to
  produce those products where economies of scale
  are important. With trade, markets are large
  enough to support the production necessary to
  achieve economies of scale.

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Implications of new trade theory

• Nations may benefit from trade even when they do
  not differ in resource endowments or technology.
• The theory does not contradict comparative
  advantage theory, but instead identifies a source
  of comparative advantage.
• Governments should consider strategic trade
  policies that nurture and protect firms and
  industries where first mover advantages and
  economies of scale are important.

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Criticism of new trade theory

• 1. The monopolistic-competition model suggests
  that product differentiation can be a basis for
  successful exporting, although it does not
  predict which specific varieties of a
  differentiated product will be produced by which
  country.

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Criticism of new trade theory

• 2. The models based on substantial scale
  economies (internal or external) indicate that
  production tends to be concentrated at a small
  number of locations, but they do not precisely
  identify which specific countries will be the
  production locations. History, luck, and perhaps
  early government policy can have a major impact
  on the actual production locations.

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The gravity model of trade
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• The analysis of the major trade partners has led
  to the development of the gravity model of trade,
  so called because it has similarity to the
  Newtons law of gravity, which states that the
  force of gravity between two objects is larger as
  the sizes of the two objects are larger, and as
  the distance between them is smaller.

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• The gravity model of trade posits that trade
  flows between two countries will be larger as
• the economic sizes of the two countries are
  larger
• the geographic distance between them is smaller
• other impediments to trade are smaller.

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Economic size

• Economic size is usually measured by a countrys
  GDP, which represents both its production
  capability and the income that is generated by
  its production.
• In statistical analysis, the elasticity of trade
  values with respect to GDP is usually found be
  about 1.

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Distance

• In statistical analysis, a typical finding is
  that a doubling of distance between partner
  countries tend to reduce the trade between them
  by one-third to one-half. This is actually a
  surprisingly large effect, one that cannot be
  explained by the monetary costs of transport
  alone, because these costs are not that high.

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Other impediments

• Government policies like tariffs can place
  impediments to trade.
• However, perhaps the most remarkable finding from
  statistical analysis using the gravity model is
  that national borders matter much more than can
  be explained by government policy barriers.
• Even for trade between the US and Canada (where
  government barriers are generally very low), this
  border effect is very large.

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• A series of studies (McCallum, 1995 Anderson and
  van Wincoop, 2003) examined trade between the US
  and Canada and show that GDP and distance are
  important.
• The key finding is that there is also an
  astounding 44 less international trade than
  there would be if the provinces and states were
  part of the same country.
• Hence, there is something about the national
  border.

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• Other kinds of impediments (or removal of
  impediments) to trade
• Countries that share a common language trade more
  with each other.
• Countries that have historical links (for
  example, colonial) trade more with each other.
• Countries that are members of a preferential
  trade area trade more with each other.
• Countries that have a common currency trade more
  with each other.

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• A country with a higher degree of government
  corruption, or with weaker legal enforcement of
  business contracts, trade less with other
  countries.