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Top ic 3Beyond Comparative
Advantage:
Empirical Evidence andNew Trade Theories
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Chapter Five Outline
1. Introduction
2. Questions to be answered
3. How do we know if a theory about trade is correct?
4. Testing the Hecksher-Ohlin model5. Intra-industry trade
6. Trade with economies of scale
7. Technology-based theories of trade: The productcycle
8. Overlapping demands as a basis for trade
9. Transporting costs as a determinant of trade
10.Location of industry
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Introduction
After studying several theories to explain
international trade patterns (Ricardian,
neoclassical, and Heckscher-Ohlin
models), must we adopt a single theory of
trade, or might different theories best
explain various aspects of trade?
Should empirical testing be used to decide?
Do we need to modify any of these theories to
explain todays economic patterns?
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Questions To Be Answered
1. Is one explanation from one of theeconomic theory models sufficient toexplain why Colombia exports coffee,
Taiwan color TVs, or Brazil steel? What part does intra-industry trade (trade in
which each country both imports and exportsproducts from the same industry) play?
2. How do international trade patternschange over time? U.S. used to be the worlds largest
manufacturer of TVsnow its Taiwan. Why?
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How Do We Know If a Theory About Trade
Is Correct?
Economists turn to empirical testing ofinternational trade theories in order tostrengthen their arguments about theimportant influences on various types of
trade.Both Adam Smith and David Ricardo used
rudimentary empirical testing to support theirclaims.
Certain difficulties exist with empirical testing:Empirical evidence can appear to support a theory, but it
cannot prove it true (and vice versa).
Most useful outcome of empirical test is refinement of
both theory and test.
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Testing the Heckscher-Ohlin Model
Hurdles to empirical testing
Heckscher-Ohlin model implies that exports as
a group should be more intensive in use of the
abundant factor than imports as a group.Virtually impossible to test for this.
Simple observations do not necessarily comprise
definitive evidence in the models favor.
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The Leontief Tests
Leontief used 1947 data for the united statesin the first test of Heckscher and Ohlins keyproposition (since U.S. was capital-abundant, itwas expected that the U.S. Would export capital-
intensive goods).Since data on the factor intensity of imports was
not available, he used data on import substitutes(the U.S.-Produced versions of the import goods).
Empirical results showed the opposite of what wasexpected.U.S. Exports were 30% more labor intensive than us
import substitutes.
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The Leontief Tests
Possible explanations of this paradox:
In 1947 most of worlds economies were still in
a highly disrupted state.
Further tests in the early 1950s reduced themagnitude of the paradox.
Fair to state that simplest version of
Heckscher-Ohlin model does poor job ofexplaining trade patterns.
Modifications and extensions have been made
in the model.
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Fine-Tuning the Heckscher-Ohlin Model
Role of TastesHeckscher-Ohlin model assumed tastes were
identical across countries. This is not true.
Large differences in tastes among countries can
introduce a taste bias that can dominate theproduction bias. Should this occur, a country will have a comparative
advantage in production of the good that uses its scarcefactor intensively.
Evidence does exist for a home bias in consumption(consumers in a given country tend to consume moredomestically produced goods than we would expect).
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Fine-Tuning the Heckscher-Ohlin Model
Classification of Inputs
Original theory used only two inputs: capital and
labor.
Inputs are now classified in several waysmostcommon:
Arable farmland
Raw materials or natural resources
Human capital Man-made or nonhuman capital
Unskilled labor
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Fine-Tuning the Heckscher-Ohlin
Model
Technology, Productivity and SpecializationThe original theory assumed identical technologies
across countries when it predicted countries would
export goods that used their abundant factorsintensively.
We clearly observe different technologies across
countries.
The theory must be amended to take these productionprocess differences into account.
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What Is Intra-Industry Trade and How Big Is It
Defined as trade in which a single country bothimports and exports products in the same
industry.
Comprises a significant share of world trade.
The Intra-Industry Trade (IIT) index is used to
estimate the extent of this trade within an
industry or within a country trade as a whole.Data shows that IIT indexes tend to be higher for
industrialized countries (almost 75% plus) than for
developing countries.
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Intra-Industry Trade in Homogenous
Goods
Homogenous (non-differentiated) goods
that are most likely to be involved in intra-
industry trade include items that are heavy
or for some other reason expensive totransport.
In Figure 1, each country both exports and
imports the product because of the greaterproximity of consumers to the foreign than to
the domestic producer.
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Figure 1: Location Can Cause Intra-Industry
Trade in Homogeneous Goods
CB
FA
CA
FB
Country A Country B
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Intra-Industry Trade in Differentiated
Goods
Product differentiation is the most obvious
explanation for intra-industry trade.
Consumers have a variety of tastes, some best
served by domestically produced goods andothers by imports.
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Why Does It Matter?
Intra-industry trade involves trade in goods
in the same industry and produced using
similar factor intensities.
Therefore, changes in factor demands and
relative factor prices from such trade tend to be
smaller.
Provides one explanation for global trade
liberalization in last fifty years.
Greatest success in lowering trade barriers has occurred
in manufactured-goods industries in which the developed
countries engage in large amounts of intra-industry trade.
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Trade with Economies of Scale
For some goods, the average cost of
production depends on the number of
units produced.
If the average cost per unit falls as the scale of
production rises, production exhibits increasing
returns to scales, orEconomies of Scale.
Internal economies occur when the firms average
costs fall as the firms output rises (panel [a] of Figure
2).
Primary sources are large fixed costs that can be spread
over all the firms output.
Example: R&D expenses
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Figure 2a: Internal and External
Economics of Scale
0 Firms Output of X
ACL
ACS
XS X
L
(a) Internal Economies of Scale
ACX
Firm's ACX
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Trade with Economies of Scale
External economies occur when the firms
average costs fall as the industrys output
rises, as in panel (b) of Fig. 2.
For example, when the output of the computer
industry rises, computer firms costs fall
because the industry becomes large enough to
support a pool of skilled labor.
See Figure 5.2
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Figure 2b: Internal and External
Economics of Scale
Firms ACX
0Industry Output of X
AC1
AC0
ACX
X0 X
1
(b) External Economies of Scale
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Trade with Economies of Scale
Implications of economies of scale
Create additional incentive for production
specialization.
Rather than producing a few units of each gooddomestic consumers want to buy, a country can
specialize in producing large quantities of a small
number of goods (in which the industries achieve
economies of scale) and trade for the remaininggoods.
Therefore, economies of scale provide a basis for trade
even between countries with identical production
possibilities and tastes.
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Trade with Economies of Scale
Figure 3, which assumes countries A and
B are identical in tastes and production
possibilities, shows the potential of
mutually beneficial trade based solely oneconomies of scale rather than
comparative advantage.
Fi 3 M t ll B fi i l T d B d
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Figure 3: Mutually Beneficial Trade Based
Solely on Economics of Scale
0
Slope = (P
UA
1
Y
X
= UB
1
UA
0 = UB
0
AP
= B*
A*
X/PY)tt
BP
Ac = Bc
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Internal Economies of Scale
With internal economies of scale, trade allowsconsumers to consume larger varieties of
goods at lower prices.
Trade helps to increase variety by expanding theconsuming population for any firms product.
Firms in one country specialize in one set of varieties, and
firms in the other to another set. Consumers then have
access to all the varieties through trade. Each firm achieves economies by specializing.
Fi 4 b I t l E i f S l
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Figure 4a, b: Internal Economics of Scale as
a Basis for Trade between Identical Countries
Firms
ACAX
AC0X
AC1
X
XA
00 XA1
DAX DA+BX
ACAX
Firms
ACAY
AC 0Y
AC 2Y
YA00
DA DA+B
ACAY
(a) X Industry in A (b) Y Industry in A
Firms Output
of X
Firms Output
of Y
Fi 4 d I t l E i f S l
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Figure 4c, d: Internal Economics of Scale as
a Basis for Trade between Identical Countries
FirmsAC
BX
AC0
X
AC2X
XB00
D
B
D
A+B
ACBX
FirmsOutput of X
(c) X Industry in B
FirmsAC
BY
AC0
Y
AC1Y
YB00
DB
DA+B
ACB
Y
FirmsOutput of Y
(d) Y Industry in B
YB1
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External Economies of Scale
External economies of scale can helpexplain the observed phenomenon ofindustrial agglomeration the tendency of
firms in an industry to clustergeographically.Watch industry in Switzerland
Movie industry in Hollywood and Mumbai
Financial industry in New York and London
Economies occur when the clustered industryreaches a size adequate to support specializedservices.For example, skilled labor markets
Fi 5 E t l E i f S l d
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Figure 5: External Economics of Scale and
Comparative Advantage
Firms AC
ACB
AC3
XB00 X1
DA D
A+B
ACB
Industry Output
AC2
AC1
ACA
XA0 X2
= DB
ACA
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External Economies of Scale
Would protection help in cases such as the
one in Figure 5 where economies of scale
result in trade that runs counter to
comparative advantage?
Figure 6 illustrates two possibilities:1. Panel (a) combines weak scale economies and
strong comparative advantage. Temporary protection
of As market could allow country-A firms to capture
the market even if country-B firms enjoyed a head
start.
2. Panel (b) combines strong scale economies and
weak comparative advantage. Temporary protection
would not allow country-A firms to capture the market
from already established country-B firms.
Fi 6 b I t ti f E t l S l
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Figure 6a, b: Interaction of External Scale
Economics and Comparative Advantages
FirmsAC
AC6AC2
X 60
DA+B
ACA
IndustryOutput
(b) Large Scale Economies,
Small Comparative Advantage
X 2
ACB
DA= DB
FirmsAC
AC2
AC4
X40 X2
DA+B
ACA
IndustryOutput
(a) Small Scale Economies,
Large Comparative Advantage
AC5
X5
ACB
DA= D
B
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Dynamic External Economies
In some cases, firms average costs
depend not on the industrys current
output, but on its cumulative output.
Downward-sloping curve in Fig. 7 captures the
negative relationship between cumulative
industry output and firms average costs.
That curve is called the Learning Curve.
Associated economies called dynamic external
economies.
Figure 7: Dynamic External Economics
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Figure 7: Dynamic External Economics
and the Learning Curve
AC3
0 X1
DA DA+B
LCB
Cumulative
Industry
Output
AC2
AC1
X0
= DB
AC0LC
A
Firms AC
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Scope of Economies and Learning
At times, a firms costs depend on the
output of the worldwide industry, either
current or cumulative.
Most arguments for protection based on
external economies of scale, like the one in Fig.
6 (a), would disappear.
Example: semiconductors recent evidence
suggests effective learning may take place based on
foreign as well as domestic production experience.
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Scope of Economies and Learning
Trade based on external economies of
scale can be beneficial or harmful
depending on:
1. Importance of scale economies relative to
comparative advantage;
2. Whether historical production patterns follow
or run counter to comparative advantage; or3. Whether domestic or worldwide industry
output provides the basis for scale economies.
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Technology-Based Theories of Trade
The Product Cycle
Technological innovation and new-product
development tend to occur in major
industrialized economies.Reflects highly educated and skilled workforce, and
the relatively high level of R&D expenditures.
Primary implication of this theory is that as each
product moves through its life cycle, thegeographic location of its production will
change.
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Technology-Based Theories of Trade
Stages in the Product Cycle:1. Actual production needs to be located close to consumers
so they can provide feedback on its refinement.
Only the domestic firm owns the technology, so
production occurs only in the firm's home country.
2. Eventually, the firm perfects the product and production
accelerates, first for the domestic market and then for
export.
3. As production technology becomes standardized, theinnovating firm may find it profitable to license its
technology to firms abroad.
Production may relocate to other countries with lower
costs of production.
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Technology-Based Theories of Trade
Stages in the Product Cycle:
4. Next, imports rather than domestic production
begin to serve the domestic market of the
innovating country. The technology has diffused completely.
5. Finally, the product completes its cycle.
Although domestic consumption of the good
may continue, imports satisfy thatconsumption.
Overlapping Demands as a Basis for
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Overlapping Demands as a Basis for
Trade
Linder suggested that similarities indemand between two countries can form a
basis for trade, especially for
manufactured goods.States that firms typically do not produce goods
solely for export most produce goods for
which domestic demand exists.
Linder argues that for many manufactured goods, thequality of the good that consumers in a specific
country demand depends primarily on their income.
Consumer with higher incomes tend to demand goods of
higher quality.
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Figure 8a: The Overlapping-Demand
Hypothesis
0
QA
max
QA
min
IA
min IA
max
Product Quality
Income
(a) Income Overlap
Determines Quality Overlap
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Figure 8b: The Overlapping-Demand
Hypothesis
0
QA
min
IB
max Income
QB
max
QAmax
QB
min
IA
min IB
min IA
max
Income
overlap
Trade
(b) Quality Overlap Determines TradeProductQuality
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Overlapping Demands as a Basis for
Trade
Figure 9 demonstrates that most
merchandise exports go from one high-
income economy to another.
In 1995, only 33% of exports went from a high-income economy to a developing one or vice-
versa.
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Figure 9: Direction of Merchandise
Exports, 1998
7%
18%
High-income to high-
income
High-income to developing
Developing to high-income
Developing to developing
18%
57%
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Transportation Costs as a Determinant of
Trade
Some goods are not traded internationally.
Called nontraded goodsreason usually
involves a prohibitive cost of transporting them
from one country to another.For other classes of goods, transportation
costs may not be prohibitive, but still may
be high enough to have a significantimpact on the pattern of trade.
Very heavy goods tend to be more costly to
transport.
Figure 10: Transportation Cost and the
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Figure 10: Transportation Cost and the
International Market for Good X
ExportsAX
0
ImportsBX
Trade in XX*
PAX
Ptt
X
PB
X
PX
ExportsAX
0
Imports BX
Trade in XX*
PX
Ptt
X
P0X
P1
X
X*
T
M
H
E F
G
J
T
(a) Trade with
No Transportation Costs
(b) Trade with
Transportation Costs
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Transportation Costs as a
Determinant of Trade
Transportation costs also play an important
role in trade with external economies of scale.
High transportation costs can contribute toagglomeration effects common in industries
characterized by external economies.
Another question; who pays for these costs?
Generally, exporter and importer share the costs.
The less price responsive the demand for the good by the
importing country, the larger the share of transportation
costs the importer will bear.
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Location of Industry
Distance from consumers can affect
transportation costs for some products.
Firms decision about where to locate
depends on, among other things, the
characteristics of the production process in
the industry.
Resource-oriented industriesTend to locate near sources of their inputs or raw
materials.
Example: mining operations.
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Location of Industry
Market-oriented industries
Example: Retail sales operations like to be near their
customers.
Footloose or light industriesHas no need to locate near either raw material
sources or markets.
Their products typically neither gain nor lose a significant
amount of weight or volume as they move through the
stages of production. Example: semiconductors. Software etc
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Conducting Semiconductor Trade
Figure 11 illustrates the industry shares of
the worlds semiconductor market in 2000.
The United States and Japan together
accounted for about 60% of the total worldproduction.
Figure 11: Country Shares of World
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Figure 11: Country Shares of World
Semiconductor Memory-Chip Market, 2000
A i U it d St t
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Asia-United States
Trade Routes
Figure 12 shows the Pacific route and the
Suez Canal route for Asia-U.S. trade.
Growth of Southeast Asian exporters and increased
ship speeds have shifted some Asia-U.S. trade from
the Pacific to the Suez route.
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Figure 12: Asia-U.S. Trade Routes
Pacific Route
TokyoNew York
Los Angeles
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Figure 12: Asia-U.S. Trade Routes
Suez Route
New York
Singapore
M lti ti l d
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Multinationals and
Intra-Firm Trade
The share of U.S. trade accounted for by
intra-firm trade in the 1982-1994 period is
shown in Figure 13.
Between 35 and 45% of U.S. trade occurs withinfirms, including both affiliate-parent and affiliate-
affiliate shipments.
Figure 13: Share of U.S. Trade Accounted for
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Figure 13: Share of U.S. Trade Accounted for
by Intra-Firm Trade, 19821994
(a) ExportsPercent45
40
35
30
25
20
15
10
5
01982 83 84 85 86 87 88 89 90 91 92 93 94
Exports from U.S. affiliates to their
foreign parent groups
Exports from U.S. parent companies
to their foreign affiliates
Total intra-firm exports
Figure 13: Share of U.S. Trade Accounted for
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Figure 13: Share of U.S. Trade Accounted for
by Intra-Firm Trade, 19821994
(b) ImportsPercent 45
40
35
30
25
20
15
10
5
01982 83 84 85 86 87 88 89 90 91 92 93 94
Imports from U.S. parent companiesfrom foreign affiliates
Imports from U.S. affiliates from their
foreign parent groups
Total intra-firm imports
M lti ti l d
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Multinationals and
Intra-Firm Trade
The intra-firm trade shares of U.S. trade with
selected partners are indicated in Figure16.
Intra-firm trade accounts for large shares of U.S.
imports and exports, especially with developed-
country trading partners.
Figure 14: Intra-Firm Trade Shares of
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g
U.S. Trade with Selected Partners, 1992
Percent 80
70
60
50
40
30
20
10
0
Canada Germany U. K. Mexico Japan Taiwan
Exports Imports
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Key Terms
Intra-industry trade
Import substitutes
Leontief paradox
Homogenous good
Product differentiation
Decreasing costs (increasing returns to
scale, economies of scale)
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Key Terms
Internal scale economies
External scale economies
Learning curve
Dynamic external economies
Product cycle hypothesisNontraded goods
Transportation costs
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Key Terms
Resource-oriented industries
Market-oriented industries
Footloose (light) industries