Chapter 5

Transcript Chapter 5

Chapter 5 -- Tests of Trade Models

• INTERNATIONAL ECONOMICS, ECO 486

Learning Objectives

• Understand the results of well-known tests of the Classical and HO Models.

• Become familiar with new theories concerning the source of comparative advantage • Understand intra-industry trade, and calculate IIT.

Tests of the Classical Model

• MacDougall compared US and British exports for 1937. – Calculated APL – Compared relative APL to relative wage • America’s wages were twice those in Britain • Classical model predicts that US would export a good if its labor is more than twice as productive.

Table 5.1, MacDougall’s Test

Industry

Radios Cigarettes Beer Margarine

APL APL UK

> 2

EX US EX UK

8 1.4-2 0.5

1.4-2 Men's woolens < 1.4

< 1.4

0.06

0.04

0.03

p. 123

Tests of the Classical Model

• Of 25 products tested, 20 fit this theory • Supports a relationship between labor productivity and exports • Does not rule out the HO Model • Did not control for differences in other factors (e.g., transportation costs, resource intensity,…)

Leontief’s Test of the HO Model

• Leontief, Wassily – {lay-ohn’-tyef, vah-sil’ee} – born 5 Aug 1906 St. Petersburg, Russia • Leontief developed input-output (I-O) model • Assumed that US was most K-abundant country in 1947 • HO Model predicts US exports K-intensive • Used I-O Model to Test HO Theory

Leotief’s Test of the HO Model

• Test: – Cut US exports by $1 million – Raise US production of import-competing goods by $1 million

Leontief’s Test (continued)

• Reducing production of exports released more labor than required to expand the production of import-competing goods.

• US imports were more capital intensive than US exports!

• This surprising result is known as the Leontief Paradox

Attempts to Resolve the Paradox

• Technology differs -- Leontief assumed that US technology was used to produce US imports – High W/R  firms use K-intensive methods • Tastes differ -- Table 5.2 shows that consumption patterns differ. – But enough to reverse direction of CA???

Table 5.2, Consumption Patterns

Category

Food

High

India (59.7%)

Low

US (14.4%) Beverages Ireland (14.4%) Clothing & Shoes Ghana (14.2%) Libya (1.1%) Jamaica (4.3%) Medical Care Netherlands & France (11.2%) UK (1.0%)

Mean

33.3% 5.1% 8.8% 4.9% p. 129

Other Tests of the HO Model

• Leontief examined ‘51 data, found paradox • Baldwin examined ‘62 data, found paradox • Stern & Maskus examined ‘72 data, paradox gone (assuming US was still K abundant)

Test Results: Domestic Capital Required per Labor Year per Million Dollars of …

Year Exports

1947 $14,010

Import-Competing Goods

$18,180

Ratio of Imports to Exports

1.30

1951 $12,977 1962 $14,200 1972 $14,989 $13,726 $18,000 $14,218 1.06

1.27

0.95

Caves, World Trade and Payments, p. 301

Recent Tests of the HO Model

• Leontief linked factor

intensities

and trade patterns • Leamer linked factor

endowments

and trade patterns • HO Model links all three

Recent Tests of the HO Model

• Maskus – Results contradict many HO predictions – Used US I-O table to identify factor intensities of US exports and imports • Bowen (

et al

) looked at more countries – Mixed results – Used US I-O table as well, but noted that other countries may use other technologies

More Recent Tests of HO Model

• Since the 1980s, more tests have been conducted because: – Earlier studies were incomplete since these did not link trade patterns with factor endowments – Using a multifactor version of the HO model, Leamer (1980) showed that trade patterns and factor endowments were related to each other

More Recent Tests (cont.)

• Two studies attempted to test the links between endowments and intensities to trade patterns: – Maskus (1985) – Bowen, Leamer, and Sveikauskas (1987) • Both studies found contradictory results.

• Other studies which relaxed HO assumptions had better results.

Most Recent Tests Combine Models

• Trefler – By allowing for differing technology, found support for Factor Price Equalization – Technology and tastes included in model, resolved many of the discrepancies • Harrigan – Differing technology and factor endowments explain observed specialization in production

Human Skills Theory

• Kravis found that the bulk of US exports are provided by high-wage industries – In ’56, but still true • Keesing (’65-6) argues that differing endowments of K & L are less important than differing endowments skilled and unskilled labor

Product Life-cycle Theory

• Vernon argues that some countries have CA in innovation. US has CA in developing new products, a labor-intensive activity • As products “mature,” production becomes automated (K-intensive) and CA may shift

Product Life-cycle Theory (cont.)

• Applies only to some goods • Cannot predict when shift will occur • Gagnon & Rose (’95) – few shifts (‘62 v. ’88 data)

Similarity of Preferences

• Linder focused on demand and hypothesized that consumers prefer variety, which trade provides • Countries with similar standards of living will produce (& trade) similar goods.

Similarity of Preferences

• “In each country, industries produce goods designed to please the tastes of consumers in that country.” • Some people prefer products that differ  trade • Factor endowments influence standard of living • Standard of living influences tastes • Rich countries will trade with other rich countries

Similarity of Preferences (SP)

• Linder rejects HO for trade in manufactured goods – No paradox • SP explains intra-industry trade • SP applies only to differentiated products – Linder explains trade in other goods using HO

Conclusions

• The world is a very complicated place.

• Developing direct tests of international trade models is difficult due to restrictive assumptions, data, and measurement problems.

• International economics is an evolutionary science.

Good, Why Would the Country Import It?

• Transportation costs • Data aggregation and categorization problems • Increasing returns to scale and imperfect competition

Intra-industry Trade (IIT)

• Occurs when countries both export and import the products of an industry • Not predicted by Classical or HO Models • Some IIT is consistent with the HO Model – Transportation costs – Data aggregation • Linder’s hypothesis predicts IIT

Intra-industry Trade (IIT)

• Grubel-Lloyd index (see p. 137 in Husted) • Let e j = exports of j, i j = imports of j

IIT

 100  50 

j n

  1

e j j n

  1

e j



i j j n

  1

i j

Calculate IIT, example 1

j Industry e j i j

1 Beverages $50 $0 2 Crude materials $50 $0 3 Mineral fuels 4 Fats & oils Total $0 $50 $0 100 100

Calculate IIT, example 2

j Industry e j i j

1 Beverages $10 $10 2 Crude materials $10 $10 3 Mineral fuels 4 Fats & oils Total $10 $10 $10 $40 $40

Table 5.3 Intra-industry Trade, 1983

Rank Country

1 2 53 54 United Kingdom Belgium - Luxembourg 67.2

Gabon Algeria

IIT

68.5

5.4

2.0

See page 137, Husted & Melvin, 7 th edition

The Long-run Average Cost Curve

• The long run average total cost curve is derived from the short-run average total cost curves.

• The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.

Long-run Average Cost Curve

Short-run and Long-run Cost Curves

• If plant size can be varied by tiny amounts,

LRAC

curve is a smooth, U-shaped curve • The

SRAC

curve for each plant just touches the

LRAC

curve at a single output level

Short-run and Long-run Cost Curves

•

SRAC

touches

LRAC

• LRAC shows economies and diseconomies of scale

Returns to Scale -- Internal to the Firm

• Describes changes in average cost as a firm expands (literally, when a one-plant firm builds a bigger plant)

Holding factor prices constant

• A multi-plant firm may realize some economies as it adds additional plants • A multi-product firm may realize some

economies of scope

as it adds products

Slope of Long-run Industry Supply • Increasing Cost Industry – positive slope • Constant Cost Industry – zero slope • Decreasing Cost Industry – negative slope

Describes how factor prices change as an industry expands

Long-run Changes in Price and Quantity

Constant-cost industry Increasing-cost industry Decreasing-cost industry

P s P 0 S 0 D 1 D 0 Q 0 Q s Quantity P s P 0 S 0 D 1 D 0 Q 0 Q s Quantity P s P 0 S 0 D 1 D 0 Q 0 Q s Quantity

Long-run Changes in Price and Quantity

Constant-cost industry Increasing-cost industry Decreasing-cost industry

P s P 0 Q 0 S 0 S 1 LS A P s P 2 P 0 Q s D 1 D 0 Q 1 Quantity Q 0 S 0 S 2 LS B P Q s D 1 D 0 Q 2 Quantity P 0 P 3 s S 0 S 3 Q 0 Q s LS C D 1 D 0 Q 3 Quantity

Decreasing Cost Industry • The entry of new firms causes falling input prices. Falling input prices shift the cost curves downward, and the short-run industry supply curve shifts to the right.

• Long-run Industry Supply has a

negative

slope.

• This describes a Decreasing Cost Industry ,

Economies of Agglomeration

• Plants in a single industry cluster • Three types – A Marshallian cluster – A North Italian cluster – A Chandlerian firm

Advancing Technology

• Technological change – New technology allows firms to produce at lower costs • This causes their cost curves to shift downward – Firms adopting the new technology make an economic profit • More new technology firms enter – Old technology firms disappear, the price falls, and the quantity produced increases

Learning by Doing

• People learn through on-the-job experience – Learning curve analysis explores this phenomenon • Plot labor/unit against cumulative units produced • Has been observed to fall by some regular percentage for each doubling of cumulative output • Examples from WWII – hours per destroyer fell by 52.3% from 1943-45 with no increase in K or L.

Ladder of Comparative Advantage

Industrial Countries Newly Industrializing Countries Knowledge intensive K-intensive Computers Machinery Electronics

Created Comp.

Adv.

Developing Countries Skilled L intensive Unskilled L intensive Resource intensive Textiles

HO Model

Commodities

Ricardian

Innate Comp.

Adv.

IRS in both S & T

(p. 140)

With one-half of the resources in each industry, less than one-half of the potential output is produced.

F/2 0 H E/2 E

SOYBEANS, S (bushels per year)

Increasing Returns and CA

• Direction of CA is

indeterminate

and

contingent

– Historical accident determines the direction • Example: If B’s textile industry expands before A’s, then B gains CA in T. B will specialize in T • With imperfect information, and differing endowments, they

could

specialize in the wrong goods

Conclusions

• Tests are inconclusive – Results (paradox) may due to data problems – Or, assumptions of the (2x2x2) be too unrealistic HO Model may • Direct tests of the HO Model are difficult • Economic theory is still evolving • Trefler found differing technology, factor endowments & preferences explain trade

The Theory of External Economies

• Economies of scale that occur at the level of the industry instead of the firm are called external economies.

• There are three main reasons why a cluster of firms may be more efficient than an individual firm in isolation: –

Specialized suppliers

–

Labor market pooling

–

Knowledge spillovers

The Theory of External Economies

• Specialized Suppliers – In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services.

– An individual company does not provide a large enough market for these services to keep the suppliers in business.

• A localized industrial cluster can solve this problem by bringing together many firms that provide a large enough market to support specialized suppliers.

– This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley.

The Theory of External Economies

• Labor Market Pooling – A cluster of firms can create a pooled market for workers with highly specialized skills.

– It is an advantage for: • Producers – They are less likely to suffer from labor shortages.

• Workers – They are less likely to become unemployed.

The Theory of External Economies

• Knowledge Spillovers – Knowledge is one of the important input factors in highly innovative industries.

– The specialized knowledge that is crucial to success in innovative industries comes from: • Research and development efforts • Reverse engineering • Informal exchange of information and ideas

The Theory of External Economies

• External Economies and Increasing Returns – External economies can give rise to increasing returns to scale at the level of the national industry.

–

Forward-falling supply curve

• The larger the industry’s output, the lower the price at which firms are willing to sell their output.

External Economies and Trade

• External Economies and the Pattern of Trade – A country that has large production in some industry will tend to have low costs of producing that good.

– Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply.

• Next figure illustrates a case where a pattern of specialization established by historical accident is persistent.

External Economies and Trade External Economies and Specialization

Price, AC ($/watch)

1 1 2

The Swiss industry has lower AC because the industry is large, even though the individual firms are small.

AC SWISS AC THAI D Q

1 Quantity of watches produced and demanded

External Economies and Trade

• Trade and Welfare with External Economies – Trade based on external economies has more ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies of scale at the level of the firm.

• An example of how a country can actually be worse off with trade than without is shown next.

External Economies and Trade External Economies and Losses from Trade

Price, AC ($/watch)

If the Thai industry can be encouraged, it

might

have a lower AC.

2 2 1

AC SWISS AC THAI D THAI D WORLD

Quantity of watches produced and demanded

External Economies and Trade

• Dynamic Increasing Returns –

Learning curve

• It relates unit cost to cumulative output.

• It is downward sloping because of the effect of the experience gained though production on costs.

–

Dynamic increasing returns

• A case when costs fall with cumulative production over time, rather than with the current rate of production.

– Dynamic scale economies

may

justify protectionism.

• Temporary protection of industries enables them to gain experience (

infant industry argument

External Economies and International Trade • Dynamic Increasing Returns (continued) –

Learning-by-doing example: Liberty ships

• 1941-1944, US produced 2,500 Liberty cargo ships.

– 1941: 1.2 million person-hours to build a ship – 1942: 0.6 million person-hours to build a ship – 1943: 0.5 million person-hours to build a ship • Physical capital used changed only slightly • Much human capital was accumulated, more than doubling productivity.

External Economies and Trade

The Learning Curve – Home’s experience gives it a cost advantage over Foreign, even though Foreign has, say, lower wages.

AC ($/ship)

* 0

L L

Q L

Cumulative output

Monopolistic Competition and Trade

• The monopolistic competition model can be used to show how trade leads to: – A lower average price due to scale economies – The availability of a greater variety of goods due to product differentiation – Imports and exports within each industry (intra-industry trade, IIT)

Monopolistic Competition and Trade

• The Effects of Increased Market Size – The number of firms in a monopolistically competitive industry and the prices they charge are affected by the size of the market.

Monopolistic Competition and Trade

Effects of a Larger Market

Average Cost, AC, and Price, P

: AC = n (F/S) + c 92

2 2

c PP: P = c + 1 / (bn) n

2 Number of firms, n

Monopolistic Competition and Trade

– If manufactures is a monopolistically competitive sector, world trade consists of two parts: •

Intraindustry trade

– The exchange of manufactures for manufactures •

Interindustry trade

– The exchange of manufactures for food

Monopolistic Competition and Trade

Trade with Increasing Returns and Monopolistic Competition

Home (capital abundant) Manufactures Food Interindustry trade Intraindustry trade Foreign (labor abundant)

Monopolistic Competition and Trade

– Main differences between interindustry and intraindustry trade: • Interindustry trade reflects comparative advantage, whereas intraindustry trade does not.

• The pattern of intraindustry trade itself is unpredictable, whereas that of interindustry trade is determined by underlying differences between countries.

• The relative importance of intraindustry and interindustry trade depends on how similar countries are.

Monopolistic Competition and Trade

• The Significance of Intraindustry Trade (IIT) – About 1/4 of world trade consists of IIT – IIT plays a particularly large role in the trade in manufactured goods among advanced industrial nations, which accounts for most of world trade.

Monopolistic Competition and Trade • Why Intraindustry Trade Matters – Intraindustry trade allows countries to benefit from larger markets.

• The case study of the North American Auto Pact of 1964 indicates that the gains from creating an integrated industry in two countries can be substantial.

– Gains from intraindustry trade will be large when economies of scale are strong and products are highly differentiated.

• For example, sophisticated manufactured goods.

Monopolistic Competition and Trade • Why Intraindustry Trade Matters (continued) – Consumers gain more variety at a lower prices than those that would prevail without trade.

– Production is more efficient. (Larger market allows full exploitation of economies of scale.) – When similar countries trade, the resulting change in the income distribution (capital v. labor) will be small – Thus, everyone may gain from trade.