topic 3 - new trade theories

7/28/2019 Topic 3 - New Trade Theories

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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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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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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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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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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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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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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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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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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



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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

topic 3 - new trade theories

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