Trade Models & Asian Economic Growth

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INTERNATIONAL TRADE MODELS INTERNATIONAL TRADE MODELS

& ASIAN ECONOMIC GROWTH& ASIAN ECONOMIC GROWTH

CHIRANTAN CHATTERJEECHIRANTAN CHATTERJEE

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Key Notions in International Trade

1) Absolute Advantage

2) Comparative Advantage

3) Terms of Trade

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Some Basics in International Trade

1) David Hume’s Balance of Trade 1758

2) Puzzle for class:

Over the past few decades, East Asian economies have increased their share of world GDP. Similarly, Intra-Asian trade has also increased as a share of world-trade. Why?

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Inspired by Physics & Newton

Newton’s Model

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Some Basics in International Trade

1) Tinbergen’s (1962) Gravity Model

2) Economists show that 1% increase in distance between 2 countries -> fall in 0.7-1% trade.

3) So distance does matter – One of the most Robust Economic Relationships

4) The argument behind RTAs

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But Should Distance Matter?

1) Proxy for Transport Costs.

2) Proxy for ‘Time Elapsed’.

3) Proxy for ‘Transaction Cost’.

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Augmenting the Gravity Model

1) With Income per Capitao Many estimate gravity equations with the log of per-capita

incomes (lnM=POP) of the exporting and importing countries included as well as the log of aggregate incomes (ln M).

2) Adjacency Considerationso Examples of this phenomenon include India-Pakistan,

Tijuana–San Diego, and HongKong–Shenzhen3) Languages & Colonial Links

o Two countries that speak the same language will trade more than pairs that do not share a common language.

o Measures of Colonial Links & Similarity +vely correlated with Trade.

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Trade Policies & the Gravity Model

1) FTAs lead to tripling of trade between nations (Frankel & Rose 2000)

2) Mixed results on Monetary Agreements

o Countries that share a common currency trade like US & Panama three times more than expectation.

o But some other studies have found that the tripling-effect doesn’t pan out similarly with EURO in EU.

3) What about the effect of Import Tariffs or VERs?

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The Ricardian Model

o The Ricardian model uses the concepts of opportunity cost and comparative advantage.

o The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used.

o Example of Comparative Advantage?o A country has a comparative advantage in producing a

good if the opportunity cost of producing that good is lower in the country than in other countries. (US in computers & Bangladesh in textiles)

o Project Socrates. o Revealed Comparative Advantage

o (Eij / Eit ) / ( Enj / Ent )o 1 < (CA) ; >1 (RCA)

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The Ricardian Model

Suppose initially that Bangladesh produces computers and the U.S. produces textile, and that both countries want to

consume computers and textiles.

Can both countries be better off?

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The Ricardian Model

o Labor is the only factor of production.o Labor productivity varies across countries due to

differences in technology, but labor productivity in each country is constant.

o The supply of labor in each country is constant.o Two goods: wine and cheese.o Competition allows workers to be paid a “competitive”

wage equal to the value of what they produce, and allows them to work in the industry that pays the highest wage.

o Two countries: home and foreign.

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The Ricardian Model

The production possibility frontier of the home economy is:

aLCQC + aLWQW ≤ L

When does one have maximum cheese and maximum wine production?

Total gallons of wine produced

Labor required for each pound of cheese produced

Total pounds of cheese produced

Labor required for each gallon of wine produced

Total amount of labor resources

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Labor Productivity & the Ricardian Model

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Labor Productivity & the Ricardian Model

o Home has comparative advantage in ____, foreign in _____?o aLC /aLW < a*

LC /a*LW

o Relative price of ___ to ___ higher in foreign?o Home will ship ___ and foreign will ship ____?

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Labor Productivity & the Ricardian Model

o Home has comparative advantage in ____, foreign in _____?o aLC /aLW < a*

LC /a*LW

o Relative price of cheese to wine higher in foreign?o Home will ship cheese and foreign will ship wine?

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Steady State Prices Guided by the Following Rules

If

oPC /PW < aLC /aLW < a*LC /a*

LW then no cheese production at home or foreign

oPC /PW = aLC /aLW < a*LC /a*

LW , then domestic are indifferent, foreign produces wine.

oaLC /aLW < Pc /PW < a*LC /a*

LW , then?

o aLC /aLW < a*LC /a*

LW < PC /PW, & now?

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Broadly, Trade Enhances Consumption Possibilities in the Ricardian World

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Ricardo Tested in China’s Emergence

o China's emergence as an export powerhouse.o China's overall labor productivity in the mid-90s was still lower than some

American/European standards.o But in some specific industries, they did have comparative advantage with

the disadvantage dissipating.o In those industries, it was one of the largest producers and exporters.o China's relative productivity in apparel was higher than rest of

manufacturing. It had 8 times the size of Germany's apparel industry.

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But Trade Can Happen Not Just because Labor Productivity Differs

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Could Happen Because Of Differences in Resources Endowments

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Enter Heckscher-Ohlin Model

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H-O: Broad Intuition from the Nobel Foundation

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H-O: Broad Intuition from the Nobel Foundation

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Notice the H-O set up

o 2 Countries having different relative abundance of factors of production.

o Production processes use factors of production with different relative intensity.

o One can classify these countries: home and foreign. Two goods: cloth and food. Two factors of production: labor and capital.

o The mix of labor and capital used varies across goods.

o The supply of labor and capital in each country is constant and varies across countries.

o In the long run, both labor and capital can move across sectors, equalizing their returns (wage and rental rate) across sectors.

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H-O Differs from the Ricardian World

o All agents gain from trade in the Ricardian world but is that true?

o Why then some are anti-trade and some are pro-trade?

o Is a single-factor of production a realistic assumption?

o For that matter 2 factors of production?

o Ricardian world advocates ‘complete specialization’ – but is that realistic?

o But H-O also extends the Ricardian notion of ‘comparative advantage’ but conditional on resource endowments – we will shortly see how.

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Samuelson on Comparative Advantage – A Detour

o A mathematician, Stan Ulam, once challenged Paul Samuelson to name one proposition in the social sciences that is both true and non-trivial.

o His reply was: ‘the theory of comparative advantage’.

o “That it is logically true need not be argued before a mathematician; that is not trivial is attested by the thousands of important and intelligent men (and women) who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them. ”

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Building Blocks: 4 Key Ideas in the H-O Model

1) The Stolper Samuelson Theorem:

o A rise in the relative price of a good will lead to a rise in the

return to that factor which is used most intensively in the

production of the good, and conversely, to a fall in the return to

the other factor.

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Building Blocks: 4 Key Ideas in the H-O Model

2) The Rybczynski theorem:

o When only one of two factors of production is increased there is

a relative increase in the production of the good using more of

that factor. This leads to a corresponding decline in that good's

relative price as well as a decline in the production of the good

that uses the other factor more intensively.

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Building Blocks: 4 Key Ideas in the H-O Model

3) The Factor-Price Equalization Idea

o The relative prices for two identical factors of production will

eventually be equalized across countries because of

international trade.

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Building Blocks: 4 Key Ideas in the H-O Model

.

4)The Heckscher-Olin Theorem:

o It states that a country will export goods that use its abundant

factors intensively, and import goods that use its scarce factors

intensively. In the two-factor case, it states: "A capital-

abundant country will export the capital-intensive good, while

the labor-abundant country will export the labor-intensive

good."

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Let’s go through the nitty-gritties of H-O: Set-Up Again

Source: Klaus Desmet Lectures

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Production of Food

Source: Klaus Desmet Lectures

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Prices & Uses of Inputs

Source: Klaus Desmet Lectures

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Prices & Relative Uses of Inputs

Source: Klaus Desmet Lectures

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The Lerner Diagram

Source: Klaus Desmet Lectures

o This is the lowest possible cost, an UNIQUE same isocost, tangent to the two isovalue curves.

o Here :

• r*Kf + w*Lf = r*Kc + w*Lc

• Slope = w/r.

• We should be able to find for each Pf/Pc , w/r

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Remember Stolper-Samuelson!

1) The Stolper Samuelson Theorem:

o A rise in the relative price of a good will lead to a rise in the

return to that factor which is used most intensively in the

production of the good, and conversely, to a fall in the return to

the other factor.

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Understanding Stolper-Samuelson

Source: Klaus Desmet Lectures

o LHS panel indicates relationship between prices and w/r. How?

o RHS panel indicates given w/r, relative use of K/L.o Pf/Pc w/r Kf/Lf & Kc/Lc

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Allocation of FOPs: The Edgeworth Box Diagram

Source: Klaus Desmet Lectures

Given Pf/Pc, we know Kf/Lf and Kc/Lc.

From Origin Of we draw a line with slope of Kf/Lf and from Oc with slope Kc/Lc.

Intersection point is point of allocation of Kf, Lf, Kc, Lc.

Can we end up outside the box? How

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Recap: Rybczynski Theorem

When only one of two factors of production is increased there is a

relative increase in the production of the good using more of that

factor. This leads to a corresponding decline in that good's

relative price as well as a decline in the production of the good

that uses the other factor more intensively.

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Rybczynski Theorem in a Edgeworth Box

o And you can then take the new Kf/Lf and Kc/Lc to that 2-sided diagram to back out new Pf/Pc

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Rybczynski Theorem through a PPF

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But we have still not discussed H-O’s key idea

A country will export goods that use its abundant factors

intensively, and import goods that use its scarce factors

intensively. In the two-factor case, it states: "A capital-abundant

country will export the capital-intensive good, while the labor-

abundant country will export the labor-intensive good."

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To understand H-O we need to understand World RS-RD

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Remember our Set-Up Again

Source: Klaus Desmet Lectures

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Remember our Set-Up Again

Source: Klaus Desmet Lectures

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World RS-RD & Autarky

What is an autarky? Examples of autarky in today’s world? Synonym for an autarkic economy?

Source: Klaus Desmet Lectures

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H-O, World RS-RD & Free Trade

Source: Klaus Desmet Lectures

Relative prices converge. Spain exports computers, Poland food: H-O QED.

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Gains from Trade & It’s Political Economy

Source: Klaus Desmet Lectures

Spain can export some computers now! Relative price of food falls in Spain – what about in Poland? Spain’s real wage ____ and rental rate _____? Poland’s real wage ____ and rental rate ____ ? Who will be pro-trade/against-trade in Spain? In Poland?

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Gains from Trade & It’s Political Economy

Source: Klaus Desmet Lectures

Spain can export some computers now! Relative price of food falls in Spain – in Poland it rises. Spain’s real wage falls and rental rate rises. Poland’s real wage rises and rental rate falls. Workers in Spain protest. Capital owners in Poland protest.

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What have we still not covered in H-O?

Source: Klaus Desmet Lectures

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4th Tenet in H-O : Factor Price Equalization

Source: Klaus Desmet Lectures

The Factor-Price Equalization Idea

o The relative prices for two identical factors of

production will eventually be equalized across

countries because of international trade.

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FPE explained in a slide

Source: Klaus Desmet Lectures

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FPE explained in a slide

Source: Klaus Desmet Lectures

o Since:

o With Free Trade:

o Therefore:

o Or

o Similarly we can show that that the rental rate r also converges.

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FPE explained in a slide

Source: Klaus Desmet Lectures

o Since:

o With Free Trade:

o Therefore:

o Or

o Similarly we can show that that the rental rate r also converges.

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FPE explained in a slide

Source: Klaus Desmet Lectures

o Since:

o With Free Trade:

o Therefore:

o Or

o Similarly we can show that that the rental rate r also converges.

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FPE explained in a slide

Source: Klaus Desmet Lectures

o Since:

o With Free Trade:

o Therefore:

o Or

o Similarly we can show that that the rental rate r also converges.

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FPE explained in a slide

Source: Klaus Desmet Lectures

o Since:

o With Free Trade:

o Therefore:

o Or

o Similarly we can show that that the rental rate r also converges.

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When can FPE not apply?

o What if there are strategic barriers to trade?

o Could result in incomplete price equalization.

o Or if technology changes – Remember the Trade Contest!

o + Do countries produce both goods always?

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Guess Who?

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Wassily Leontief

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Quiz Question!

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The Leontief Paradox

o Leontief's paradox in economics is that the country with the world's highest capital-per worker has a lower capital/labor ratio in exports than in imports. This econometric finding was the result of Leontief's attempt to test the Heckscher–Ohlin theory empirically.

o In 1954, Leontief found that the United States—the most capital-abundant country in the world—exported labor-intensive commodities and imported capital-intensive commodities, in contradiction with Heckscher–Ohlin theory.

o Stern & Maskus (1981) later find that the answer lies by factoring in a 3rd factor of production.

o Guess which?o Factoring in Natural Resources makes the Leontief Paradox

go away – some other day.

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H-O & it’s empirical relevance in Asia

Source: Bowen et.al AER 1987

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H-O & it’s empirical relevance in Asia

Source: Bowen et.al AER 1987

The authors calculated the ratio of each country's endowment of each factor to the world supply of that factor.

They then compared this ratio with the country's share of world income.

If FPE is correct, countries would always export factors, for which the factor share > income share.

But for 2/3rd of the FOPs trade ran in the predicted direction less than 70% of time.

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Asia & ROW trade

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H-O Effect in Bangladesh & German Exports to US

A country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In the two-factor case, it states: "A capital-abundant country will

export the capital-intensive good, while the labor-abundant country will export the labor-intensive good."

Source: Romalis (2004)

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Rybczynski Effect in the 4 Tigers

When only one of two factors of production is increased there is a relative increase in the production of the good using more of that factor. This leads to a

corresponding decline in that good's relative price as well as a decline in the production of the good that uses the other factor more intensively.

Source: Romalis (2004)

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Changing Patterns in Comparative Advantage

In 1960 4 Tigers specialized in low-skilled intensity goods & so was it in Japan.

By 1998, the situation was starting to change in both.

The role of public policy

Source: Krugman et.al (2011)

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What did we learn today?

1) Trades induces gains.

2) The principle behind why so, lies in understanding ‘comparative advantage’ & its link to resource endowments.

3) The gravity model is one of the most robust relationships in economics.

4) Which is why Asia’s intra-regional trade is very high.

5) H-O model has 4 predictions

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What did we learn today?

The Stolper Samuelson Theorem: A rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor.

The Rybczynski theorem:When only one of two factors of production is increased there is a relative increase in the production of the good using more of that factor. This leads to a corresponding decline in that good's relative price as well as a decline in the production of the good that uses the other factor more intensively.

The Factor-Price Equalization Idea Factor Prices Equalize in the long run due to trade.

The Heckscher-Olin TheoremCountries exports goods conditional on its resource abundance. Capital-intensive countries will export capital goods (US-computers) and labor-abundant country exports the labor-intensive goods (Bangladesh–textiles).

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What did we learn today?

The Leontief Paradox

H-O has mixed evidence in Asia. Japan is an exception too

4-Tigers changes the terms-of-trade over time.

Next Class: Strategic Trade Policies & Protectionism & Globalization of the Value Chain & Implications for Trade.