International Issues 1
Trade Theory
(Chapters 12 and 13)
Comparative Advantage.
The Economist example.
Two countries; east and
west.
Two products are produced in
each country: wheat and bicycles.
Each country has 100 workers
and different production environments.
East produces 4 bushels of
wheat per worker, 2 bicycles.
West produces 1 bushel of
wheat per worker, 1 bicycle.
Production functions are
thus:
Autarky.
Assume that each country
divides the labor force into equal shares for each product (50 / 50).
|
|
Wheat |
Bicycles |
|
East |
200 (50*4) |
100 (50*2) |
|
West |
50 (50*1) |
50 (50*1) |
Total world production is 250
bushels of wheat and 150 bicycles.
Note difference between
absolute and comparative advantage.
Every country has to have a
comparative advantage – the thing at which they are least bad at producing /
the thing they are better at producing than any other thing.
East can produce 4 times as
much wheat as west per worker.
East can produce 2 times as
many bicycles as west per worker.
There are still gains to
specialization and trade.
Gains to specialization:
Assume that east moves some
laborers to the production of the good in which they have comparative advantage
– 10 laborers taken from the bicycle factory and sent to the farm.
West moves some laborers (25)
to production of the good which they are comparatively less bad at producing –
bicycles.
|
|
Wheat |
Bicycles |
|
East |
(50+10)*4 = 240 |
(50-10)*2 = 80 |
|
West |
(50-25)*1 = 25 |
(50+25)*1=75 |
Total world production is 265
bushels of wheat and 155 bicycles.
Specialization allows more
total world production, but east has fewer bicycles and west has less wheat
than before they specialized.
Specialization is not all
that great a deal if you can’t trade across countries.
Total world production of
both goods goes up, true, but east has fewer bikes than before, and west has
fewer bushels of wheat.
In autarky, East residents
will trade two bushels of wheat for one bicycle. West will trade one bushel of wheat for one
bicycle (based on equivalent labor inputs).
Trade will be attractive to both east and west if east residents can get
a bicycle for less than two bushels of wheat, and west residents can get more
than one bushel of wheat for one bicycle.
East and west see this, and
agree to the following experiment. Let’s
split the difference, and trade one bicycle for one and a half bushels of
wheat. I, east, promise to trade you,
west, 33 bushels of wheat for 22 bicycles from what we produce if we
specialize.
|
|
Wheat |
Bicycles |
|
East |
240 – 33 = 207 |
80 + 22 = 102 |
|
West |
25 + 33 = 58 |
75 – 22 = 53 |
Compared to autarky, both
east and west have gained by specializing and trading.
[consider a different price, and say west asks 1 bushel of wheat for one bicycle since that is the price pre trade and specialization in west. I, east, will trade you, west, 25 bushels of wheat for 25 bicycles.
|
|
Wheat |
Bicycles |
|
East |
240 – 25 = 215 |
80 + 25 = 105 |
|
West |
25 + 25 = 50 |
75 – 25 = 50 |
Alternatively, say east asks 2 bushels of wheat for one bicycle according to the prevailing prices there. I, east, will trade you, west, 40 bushels of wheat for 20 bicycles.
|
|
Wheat |
Bicycles |
|
East |
240 – 40 = 200 |
80 + 20 = 100 |
|
West |
25 + 40 = 65 |
75 – 20 = 55 |
Price can vary without challenging overall result]
This is a static model, based
on one variable factor (labor), developed by Ricardo and Mill. The core element of this model is that countries
differ in their labor productivity.
Hecksher-Ohlin models look at
a broader set of factor endowments (land, labor, and capital). There may be factor endowments that explain
the differences in labor productivity.
Trade arises because
countries differ in their factor endowments, which lead to factor prices
reflecting relative scarcity.
Different products require
different relative proportions of factors of production.
You specialize in the one
that utilizes your comparative advantage in factor endowments.
Produce goods that use your
abundant resources intensively, import goods that use resources that are
relatively scarce.
What do we like about trade
in theory?
1) Improve economic well being with the factors already
at hand. Compared to autarky,
specialization and exchange can improve welfare with existing resources.
2) Trade makes factor prices efficient, since it allows
factor prices to reflect global abundance or scarcity.
3) Every country has to have a comparative advantage, so
there is a path to growth through trade.
4) The market signals of free trade provide an accurate
read of where the country should head without requiring research and planning.
What might be questionable
about basic trade theory?
1) Productive resources are fixed, fully utilized, and
production functions are the same in all countries? What if factor endowments are not static, but
dynamic?
2) Technology is
fixed? What if technology can lead to substitution of what a country produces? Rayon, nylon developed, how does that work
out for your jute and sisal plantation?
3) Preferences are fixed?
Preferences can be influenced by producers; it is not just producers
responding to fixed consumer preferences.
4) Politics, society, social institutions, infrastructure
are not relevant? Political structure,
social institutions, infrastructure may not be easily adapted in response to
price signals. Response to price signals
may be blocked by policy in both developing and developed countries.
5) Are returns to scale decreasing or constant? What if returns to scale are increasing. Production may not take place under the
assumptions of perfect competition, but may be monopolistic or
oligopolistic.
6) Risk and uncertainty were not included in the basic
model.
7) With foreign ownership of companies, and
multinationals, do the benefits of trade flow to the nationals of the trading
country, or the owners of the firm in the trading country?
8) Note that the
HO model implies factor prices will tend to equalization across countries if
free trade is established. Wage rates
and capital rental rates should converge.
This does not seem to be happening.
9) A high and rising share of international trade is
between high income countries in “similar” manufactured products.
Outward looking strategies.
Export Promotion
Outward looking development
policies. Free movement of capital, workers,
enterprises, students, open to multinationals…
Access to larger
international markets. Growth and
efficiency benefits of free trade.
Prices are set by markets.
“Openness” from Penn World
Tables. Exports plus imports divided by
GDP.
What are we seeing if we look
at patterns in developing country trade?
It has been argued that developing
countries tend to have a high percentage of their GDP accounted for by
exports. “Export dependence”. Developing ~30% overall. But we can see that this is not that
different from high income overall.
Export of Goods and Services
as % of GDP: WDI Online.
Another issue is concentration of exports in a few commodities.
An issue may arise if a developing
country has a lower percentage of their export earnings coming from
manufactured goods and a higher percentage coming from primary products than
developed countries.
Primary products. Products derived from all extractive
occupations – farming, timbering, fishing, mining, and quarrying. Composed of foodstuffs and raw materials.
US exports: 10% ag, 4% minerals and fuels.
See table 12.1 (p. 581)
However, overall pattern is
less stark
|
2003
data from WB WDI |
High Income |
Middle |
Low |
|
Agricultural
raw materials exports (% of merchandise exports) |
2 |
2 |
3 |
|
Fuels
Exports (% of merchandise exports) |
6 |
18 |
28 |
|
Manufactures
exports (% of merchandise exports) |
80 |
64 |
50 |
|
Ores
and metals exports (% of merchandise exports) |
2 |
4 |
3 |
Income elasticity of demand –
the percentage increase in quantity demanded by consumers brought about by a 1%
increase in income.
Manufactured goods have
higher income elasticities than do
primary products. For example, a 1%
increase in developed country GNP brings about a less than 1% increase in the
demand for cashews, but a greater than 1% increase in demand for DVD players.
[show S and D graph with
shift in D]
Both go up, but the demand
for foodstuffs goes up at a relatively slower rate. The relative price of primary products will
decrease over time if this is true (not the absolute, but the relative).
Commodity terms of trade.
Price index of exports
divided by price index of imports.
Price indices are constructed
on the basis of a reference year.
Commodity terms of trade deteriorate for a country if the commodity
terms of trade ratio falls.
|
1995=100 |
Export index |
Import index |
Terms of Trade |
|
|
100 |
100 |
100 |
|
Burkina Faso 2000 |
96 |
126 |
76 |
|
2002 |
96 |
118 |
81 |
Historically, Prebisch looked
at the terms of trade that were declining for primary product exporters from
1870 to WWI.
Prebisch-Singer thesis. Primary product export orientation results in
a decline in terms of trade. This will
lead to a long term transfer of income from poor to rich countries.
Show Prebish-Lewis graph from
Hadass and Williamson.
Another argument is about
variability. This is based on the idea
that price elasticities of primary
products tend to be more inelastic than those found for manufactured goods. Think of oil vs. manufactured goods. A price elasticity of demand largely reflects
the availability of substitutes, and oil has fewer close subs than a DVD player. Increased volatility of prices. Export earnings instability.
[show S and D graph with
different slopes on D and shift in S]
Other takes on the issue:
transport technology improving?
Reinforce comparative
advantage?
Resource curse (Dutch
disease, immiserizing growth, or other)?
Inward looking strategies
Import Substitution (ISI – import
substitution industrialization)
Encourage indigenous
industries, greater self reliance, restrict trade as part of an overall
strategy of development.
The infant industry argument.
Since firms learn by doing, costs curves will fall as firms gain
experience.
·
Industry grows to
be self reliant, and will be able to compete in world market at the end of the
process.
·
In long run,
engage world market from stronger position than without adopting this strategy.
Replace goods that are currently
being imported with domestic sources.
Erect tariff barriers or
quotas, then set up a local industry to produce a similar product.
This means the protection
should be temporary.
Place to note:
External structure: Underdevelopment theory / Dependency theory.
(Frank mid 1960’s, late 1970’s)
The
west was not underdeveloped, it was undeveloped when it started the
industrialization process.
Underdevelopment
is not characterized by having traditional economic, political, and social
institutions, but by a state of being on the periphery of the world economic
system.
There
are core countries, and there are periphery countries.
Economic
development of the rich at least in part arose from the periphery (slaves,
colonial extraction, markets), and the status of the developed countries
contributes to the position of the underdeveloped countries.
Local
elites can never be the engine for change as they are comprador
bourgeoisie.
The
greatest hope for development is to be the least dependent on the world
capitalist system as possible:
withdrawal if possible. Since
the structure of the world capitalist economy is the cause of underdevelopment,
the only chance for true development is to disengage.
Can be sequenced as an
overall strategy:
1st stage: substitute domestic production for imports
for simple consumer goods. “light
industry”, “basic manufactured goods”.
2nd stage: move to more sophisticated manufactured
goods.
Both stages occur with the
protection of tariffs and quotas.
·
This helps reduce
the current account imbalance (reduces imports).
·
This helps with
government revenue, as imports are relatively easy to tax (tariff leads to
government revenue).
Show graph 13.1 on page 628.
Issues of import substitution
during the period the protection is in place.
1) Protection is to protect them from competition. What is going to drive them to reduce
costs? Also, is promise to remove
protection compatible with the “commitment problem” discussed earlier?
2) Foreign firms move in behind tariff walls and benefit
from strategy. Multinational partners,
not domestic capital.
3) Capital intensive production systems often brought in
behind tariff protection. Costly, and not
the most appropriate for labor rich developing country environment.
4) The high price of products from a protected industry
and the reliance on imported capital goods for the production process limits
both forward and backward linkages.
Forward – high price of output.
Backward – bring in technology and capital from outside.
One other inward looking
strategy is to overvalue the domestic currency to develop industry (as opposed
to explicit trade barriers).
·
Encourage capital
intensive production methods.
·
Inhibit primary
product sector.
Show overvaluation on a supply
and demand graph– show excess demand.
13.2, page 636.
Sometimes see the emergence
of a “dual / parallel exchange rate”.
There are different exchange rates depending on what you want to use the
money for.
Black markets.
What are the prospects for
trying to export manufactured goods
if the infant industry “grows up”?
“Light industry”. Make use of unskilled labor – rugs, textiles,
shoes, sporting goods,…
Developed countries have
import restrictions on these types of products frequently to protect domestic
industry.
Tariff – tax on a product
that enters a given market.
Quota – limit on the quantity
of the product allowed into a given market.
Tarrifs higher for processed
goods than raw primary products.
The price of basic
manufactured goods (the kind that tend to be exported by developing countries –
think textiles for example) have been falling relative to the price of advanced
manufactured goods. Decline in developing
country export prices of about 30% in the 1980’s.
Anti-dumping investigations.
Dumping is international
price discrimination in which an exporting firm sells at a lower price in a
foreign market than it sells for in its home country market. The idea is to use this to eliminate
competitors, later rising prices after the competition is gone. You use your monopoly power in the home
market to fund this attempt at getting monopoly power in the world market.
Estimates made in 2000 that trade
restrictions by developed countries cost LDC’s more than 100 billion per year. In contrast, 2002 official development
assistance was 58 billion.
Has the inward looking or
outward looking approach been more successful?
There is not an unambiguous
answer to this.
Export promotion seems to
have had a more positive impact on GDP growth than ISI when world economic
growth (and hence demand for exports) was strong.
Outward looking is more
successful when the world economy is growing, not very good when world economy
is stagnant.
Increasingly, the argument is
heard that it is not either / or, but the degree of consistency between
government intervention and market forces that determines success.
If outward looking and inward
looking have problems, what about semi-outward / semi – inward strategies?
Regional integration. There is a growing trend towards regional
trade agreements. Note contrast to WTO.
What are some examples?
Free trade area. Internal trade among member countries is
free, but each member’s tariff barriers against non-members vary by
country.
Customs unions. Internal trade among member countries is free
and there are common tariff barrier against non-members.
Common market. Internal trade among member countries is free
and there are common external tariffs against non—members, plus there is free
movement of labor and capital among member states.
But growth of regional trade
agreement can take place at the expense of Multilateral agreements.