Lecture 7 ECONOMIC GEOGRPAHY AND INTERNATIONAL TRADE

By Carlos Llano, References for the slides:

• Fujita, Krugman y Venables: Economía Espacial. Ariel Economía, 2000. • Materiales didácticos de diferentes autores: Baldwin; Allen C. Goodman; Bröcker; J. Sánchez

Index

1. Agglomeration with borders (L is fixed)

1. Border effect: a summary.

2. The Core-Periphery model and international trade

1. An intuitive view. 2. The model.

3. Implications.

3. Application.

4. Extensions.

5. Conclusion

Tema 5 -EE

1. Introduction

1. What is a country?

• Some space separated by borders. • What is a border? • Edges behaving as obstacles to movement and information.

2. What is a region?

• A space separated by “weak borders” inside the “strong” borders. • There is more factor, goods and service mobility between regions.

3. Has distance died?, Is the transport cost insignificant?

4. What’s the importance of borders as barriers for trade?; and to migration?

3

Tema 5 -EE

The World is flat

1. Introduction

Cross Borders in a World where differences still matter

4

Tema 5 -EE

1. Introduction: Border Effect

1. McCallum (AER, 1995):

1. On average, the exports of Canadian provinces to other Canadian provinces are 20 times larger than their exports to an equivalent state in the U.S. (same size and distance).

2. Engels and Rogers (AER, 1996):

1. Evidence from urban price movements suggests that the border imposes barriers to arbitrage comparable to 1.700 miles of physical space.

3. Gil et al (World Economy, 2005):

1. The Spanish CCAA trade between them is 20 times the trade with other countries. 1. Border effect?, physical differences, accessibility, cultural, legal differences…?, specific effects of sector agglomeration (clusters)?

5

Tema 5 -EE

1. Introducción: Border Effect

1. How does boundaries influence the mobility of people between countries/regions?

1. Helliwell (AER, 1997): “For every resident in a Canadian province, who was born in a U.S. state, you will meet close to 100 people who were born in some other Canadian province of similar size, distance, and personal income per capita.

2. Conclusion:

1. Boundaries have an important role in the reduction of trade and the movement of people between regions and between countries 2. This importance holds even when the physical boundaries (customs,…) are suppressed (i.e.: Canada-USA; borders between European countries) or when they have not existed as such (borders between regions) or recently (borders in German Empire) 6

Tema 5 -EE • Until now the Core-periphery Model (FKV, 1999): – 2 regions (north-south); 2 sectors (A agriculture. & Manufacturing) – 1 factor Labor. 2 specializations: agricultural L and manufacturing L.

• Only L

M

is mobile; migration is seeking differences in wages.

– There are only transport costs for M: iceberg costs (T

rs

) • Valid view to explain

inter-regional trade and manufacturing agglomeration in certain regions country: of a

– High labor mobility between regions.

– Manufacturing can easily reallocate.

7

Tema 5 -EE • The new Core-Periphery Model (FKV, 1999, Chapter 13): – 2 countries; 2 sectors (A agriculture & M manufacturing) – 2 factors: labor + intermediate goods .

• There is no labor mobility between countries ( L

r

is fixed).

• There is mobility between sectors Lr can move from agriculture to manufacturing, seeking for differences in wages.

– There are only transport costs for M: iceberg costs (T

rs

) • Valid view to explain the manufacturing agglomeration in

one country against another one: specialization + international trade

8

Tema 5 -EE

2. The CP Model and IT: an intuitive view

• Without labor mobility there cannot be agglomeration as in the

Core-Periphery Model. For it to be possible:

– We extend the model by assuming that manufacturing firms produce intermediate and

final goods.

– We allow L mobility between sectors.

• The agglomeration in manufacturing in a country provides “intermediate goods” in abundance and more diversity (Forward Linkages): – Firms that produce final goods that use intermediate goods, buy cheaper and with more variety.

• Agglomeration of “final goods” in manufacturing in a country attracts “intermediate goods” manufacturing, (backward linkages): – It can lead to a process of specialization that concentrates manufacturing or particular industries in each of the countries, but not an agglomeration of labor in a single country.

Tema 5 -EE

2. The CP Model and IT: the model

• How does “intermediate goods” work? – Input-Output Model (TIO). – Simply view. Hypothesis: • Manufacturing only uses itself as an input.

• The manufacturing good is uses both as an intermediate/final good. • The new production function : – 2 factors: labor + intermediate goods

F F

 

cq s cq s

  

l s

  ( 1   )   1 

l s

1     

r n r x



rs

   /  • l

s

: factor labor in s;

• X

rs

: input of each variety produced in r the sectors in s CES sum of the intermediate goods inputs

10

Tema 5 -EE

2. The CP Model and IT: the model

Rather than defining the production function through the “intermediate goods”, we introduce them through the price index:

• • Price index of the intermediate goods produced in r: – The input composite is a Cobb-Douglas function of labor and intermediate goods.

• α (alpha)= share of the intermediate goods.

• Price of the input p r  w 1  r G  r G r      n s (p s T sr ) 1  σ 1    1  σ

n s

= number of varieties produced in s.

p s

= FOB price of the variety.

T sr

: transport cost.

σ(sigma)= elasticity of substitution among varieties of manufacture is the same for firms as it is for consumers

The more > agglomeration in manufacturing therefore : + abundance of varieties, < price index of producing intermediate goods and < production costs for manufacturing. 11

Tema 5 -EE

2. The CP Model and IT: the model

• Sales in manufactures: – Now part of each firm’s output goes to consumers as final consumption (final demand) and part to firms for intermediate usage (intermediate demand). – E E r r = location r’s expenditure on manufactures  

Y r

 

n r p r q

*

Sales in the final demand

μ= % that manufactures represent in the expenditure

Sales in the intermediate demand

• Sales equal the total value of production in region r. • The higher > the number of firms in r, > the larger the

intermediate goods demand and > the larger the total expenditure on manufactures

12

Tema 5 -EE •

2. The CP Model and IT: the model

Labor mobility between sectors (A y M).

– 2 countries. – L r = 1. Labor is mobile between sectors.

– λ r = share of country r’s labor force in manufacturing.

– n r p r q* r = total value of manufacturing output in country r .

– The manufacturing wage bill in country r is a share (1-α) of the previous quantity: w r  r  ( 1   )

n r p r q

* – We choose units such that q* r = 1/ (1-α) so that:

n r



w r p r λ r

Tema 5 -EE •

2. The CP Model and IT: the model

Now we want to direct attention to the allocation of labor among sectors (λr) and to wages: Price index in r=1 Price index in r=2

G

1 1

-α



λ

1

w

1 1 

σ(

1

-α

)

G

1 

ασ



λ

2

w

2 1 

σ(

1

-α

)

G

2 

ασ T

1 

σ G

2 1

-α



λ

1

w

1 1 

σ(

1

-α

)

G

1 

ασ T

1 

σ



λ

2

w

2 1 

σ(

1

-α

)

G

2 

ασ

– Now the price indices in r=1 depend not just on wages in r=1 but also on the price indices of the manufactured goods that are also used as intermediate for other manufactures. 14

Tema 5 -EE •

2. The CP Model and IT: the model

Wages:

Firms make zero profit when the price they charge is such that they sell 1/(1-α). The wage equations are now:

Wages in r=1 Wages in r=2

(w 1  1 1 

G

1   )  (w 1  2 1 

G

2   )   E 1 G 1 σ  1  E 2 G σ 2  1 T 1  σ  E 1 G 1 σ  1 T 1  σ  E 2 G 2 σ  1 E 1  

Y

1  

w

1 1    1 E 2  

Y

2   1

w

2    2 • Agricultural production depends on agricultural employment (1-λ). • With this, the income in each country is:

Income in r=1 Income in r=2

Y 1  w 1 λ 1 

A

( 1  λ 1 ) Y 2  w 2 λ 2 

A

( 1  λ 2 ) 15

Tema 5 -EE

2. The CP Model and IT: the model

• •

The agricultural wage is the labor marginal product A’(1-λ r ). The difference in wages between sectors (v r

) will be:

Wages in r=1 Wages in r=2

v

1

v

2  

w

1

A



(

1

-λ

1

w

2

A



(

1

-λ

2

) )

• Labor moves from agriculture to industry if there are differences in wages ( v1>0) and vice versa.

• The long run equilibrium occurs when there are no differences in wages: • Long-run equilibrium manufacturing wages therefore satisfy:

v

1  0 ;

v

2  0 • When both sectors operate, wages are equalized.

• If there is only manufacturing, it may have w > than the agricultural marginal product.

• If there is not manufacturing , w will be less or equal to the agricultural wage.

w r w r w r   

A

 ( 1  λ r ), λ r

A

 ( 1  λ r ), λ r

A

 ( 1  λ r ), λ r   16  ( 1 0 0 , 1 )

Tema 5 -EE

2. The CP Model and IT: el modelo

The equilibrium: how does the differences in wages and movements between A↔M influence the variation in the agglomeration of M in a country (λ r

)?: • •

FOUR FORCES: 2 Stabilizing forces (they induce symmetry; avoid agglomeration)

The response of the marginal product function in agriculture: if the agricultural production function is concave, then ▼ L A ▲ the marginal product [A’(1-λ r )] and the W a . This ▼ the incentive for a further movement of labor into manufacturing.

Product market competition: a more varieties in the country and it reduces the price index G the manufacturing wage.

▲ λ 1 is associated with the supply of 1 , this shifts the demand curve for each firm’s output downward and reduces 17

Tema 5 -EE

2. The CP Model and IT: the model

There are also 2 agglomeration forces (“vertical linkages”: FL + BL)

3. FL (supply): a ▼ G 1 induced by the ▲ λ r reduces the cost of intermediates, tending to increase the instantaneous equilibrium wage. 4. BL (demand): a ▲ manufacturing wage.

λ r rises the expenditure on manufactures in country 1, shifting firms’ demand curves up and tending to rise the

1er ASSUMPTION:

Simplifications for equilibrium: ¡¡¡¡¡IMPORTANT¡¡¡¡¡ • The agricultural production function is lineal in output: A(1-λ)= (1-λ) , therefore the agricultural wage =1 and so it is the equilibrium manufacturing wage.

• μ<1/2. This is, the level of demand for manufactures is small enough for all of manufacturing to fit in one country, and thus ensures that, even if all manufacturing is concentrated in a single country, this country also has some agriculture.

• THERE ARE NO DIFFERENCES IN WAGES BETWEEN COUNTRIES. 18

Tema 5 -EE

2. The Core-Periphery Model: implications

High transport costs;

T=3 λ 2 “wiggle diagram” W 1

=1 0,8 λ 1 decreases w 1 <1 w 2 <1 W 1 Curve • It shows combinations of (λ 1 , λ 2 ), with wages=1 in country1. • To the right , w 1 <1; and to the left w 1 >1. w 1 >1 W 2 >1

W 2

=1 λ 1 increases 0 0,8

λ 1

= = percentage that represents manufacturing in country 1

Tema 5 -EE

2. The Core-Periphery Model: implications

Low transport costs;

T=1,5 λ 2 “wiggle diagram”

0,8

W 2

=1

W 1

=1 λ 1 Increases 0 0,8

λ 1

= = percentage that represents manufacturing in country 1

Tema 5 -EE

2. The Core-Periphery Model: implications

Intermediate transport costs;

T=2,15

0,8

W 1

=1

W 2

=1 0 λ 1 Increases 0,8 21

λ 1

Tema 5 -EE

2. The Core-Periphery Model: implications

“wiggle diagram”

• We assume that manufacturing is concentrated in country 1 (λ2=0) and (λ1=2μ). • The concentration of manufacturing in country 1 will be stable as long as this agglomeration is less or equal to the agricultural wage (=1).

2. When does symmetry break and agglomeration is sustainable (break point)?

• At the symmetric equilibrium in agriculture).

, manufacturing wages in each country equal the agricultural wages (which are = to the marginal product of labor • The equilibrium is stable if increasing manufacturing employment drives manufacturing wages below agricultural, (the DISPERSION economies defeat) causing the movement of labor towards agriculture.

The equilibrium is unstable when AGGLOMERATION economies defeat.

Tema 5 -EE

2. The Core-Periphery Model: implications

“wiggle diagram” :

unstable equilibrium. With high transport costs: there is an stable equilibrium (λ1= λ2).

λ1,λ2 1 0,5 0 1 λ1 λ2 T(B) λ1= λ2 T(S)

Making the hypothesis flexible:

• The agricultural production function

is lineal.

• But now μ>1/2. The level of manufactures demand is large. Not all the manufacturing fits in a country if we want wages to be equal in both countries: – T If it is attempted to concentrate manufacturing in 1, wages in the country with low manufacturing will rise . When this wage gap arises remain in 2.

, some part of the manufactures will • Notice that the curve (λ2) is above 0.

23

Tema 5 -EE

2. The Core-Periphery Model: implications

ω 1 , ω 2 ω 1 1 ω 2 ω 1 =ω 2 • • 1

T

The concentration in manufacturing in 1, rises the country1 wages and drives the decline of the ones in 2. Two causes: • • Demand in L in 1 increases wages in1.

Country 1 with more manufacturing varieties have lower prices.

Eventually, the wage gap declines with transport costs. 24

Tema 5 -EE

2. The Core-Periphery Model: implications

“wiggle diagram” History of the World, Part I (KV, 1995):

1. From an initial position in which the two countries are identical (North and South), an international division of labor spontaneously arises through a process of uneven development. North immediately gains from this division of labor, while South, which suffers deindustrialization, initially loses. The world economy tends to a Core-Periphery structure.

2. Eventually, further reductions in transport cots move the world into a globalization phase: the value of proximity to customer and supplier firms (intermediate L and c) diminishes as transport costs fall, and so the sustainable gap between N and S narrows. The world tends again to symmetry and to price equalization.

25

Tema 5 -EE

2. The Core-Periphery Model: implications

What happens if the importance of the intermediate goods in the production function (

▲

α) increases ?

ω 1 , ω 2 λ 2 =0 ω 1 1 ω 1 =ω 2 • • ω 2 1

T

This increases the transport costs and it induces a larger wage gap between the two countries.

Agglomeration is more persistent and the wage gap is larger. 26

Tema 5 -EE

2. The Core-Periphery Model: implications

What happens if the importance of manufactures in consumption in the country (

▲

μ) increases?

ω 1 , ω 2 1 ω 1 ω 1 =ω 2 ω 2 • • • 1

T

Now country 2 holds more manufacturing (not all manufacturing fits in country 1).

The wage gap between the two countries is lower. During the globalization phase, country 1 does not suffer a fall of w1 (it always grows).

27

Tema 5 -EE

2. The Core-Periphery Model: implications

What happens if agriculture has a decreasing returns?

λ 1 , λ 2 1 λ 1 = λ 2 λ 1 λ 2

Making the hypothesis flexible:

• The agricultural production

function is decreasing.

• μ>1/2. – An increase of manufacturing labor increases the manufacturing wage but also it increases the agricultural one.

1

T

• When T is high (autarky): manufacturing is dispersed. Equilibrium is symmetric and stable. • With intermediate levels of T: there is agglomeration. Symmetric equilibrium is unstable.

• When T is low: the symmetric equilibrium is stable again. 28

Tema 5 -EE

2. The Core-Periphery Model: implications

ω 1 , ω 2 1 ω 1 =ω 2 ω 1

Making the hypothesis flexible:

• The agricultural

production function is decreasing.

• μ>1/2. ω 2 1

T

29

Tema 5 -EE

2. The Core-Periphery Model: implications

agriculture tends to decreasing returns): by reducing transport costs, the equilibrium goes through 3 phases: 1. At high transport costs , the dominant force in determining location is the need to be close to final consumption, preventing any strong geographical concentration of manufacturing.

2. At low transport costs , the dominant determinant of location is wage costs, again mandating dispersed manufacturing to keep labor costs down (it makes that the centripetal forces rule over the centrifugal, the opposite of having intermediate transport costs). 3. The bifurcation is continuous and smooth pitchfork shaped. 30

Tema 5 -EE

2. The Core-Periphery Model: implications

“wiggle diagram”

the concentration in manufactures is possible: 1. Vertical linkages (FL and BL) between industries can lead to a concentration in manufacturing. This concentration can also vary with the transport costs ( and other factors).

2. Not only an uneven distribution of manufactures can rise but also inequalities in wage rates and living standards.

3. Questions: 1. Do these processes have something to do with the division between rich and poor countries while T has reduced?; 2. Can we expect that a higher European integration leads to a (at least initially) inequality growth?

31

Tema 5 -EE

2. Application

“wiggle diagram”

Economic Review 43 (1999) 303—334.

• ELISENDA PALUZIE,* JORDI PONS² and DANIEL A. TIRADO³: Regional Integration and Specialization Patterns in Spain. Regional Studies, Vol. 35.4, pp. 285 ± 296, 2001 32