GLOBAL TRADE AND INVESTMENT ENVIRONMENT INTERNATIONAL TRADE THEORY [R/H, Ch.6, 150-159] [Head, pp.33-44] Various economic theories try to explain observed patterns in international trade  -- NO SINGLE THEORY can explain all observed trade patterns   ABSOLUTE ADVANTAGE (ADAM SMITH):

-- You can produce a good more efficiently than all other countries  ---> Trade goods for which you don't have absolute advantage  ---> “you and trade partners” better off  

Example. Suppose both Ghana (G) and South Korea (SK) have each 200 units of resources.

To produce 1 ton of cocoa, G requires 10 units of resources.SK requires 40 units.

To produce 1 ton of rice, G requires 20 units;SK requires 10 units.

Resources required to produce 1 ton of cocoa and rice

Cocoa RiceG 10 20SK 40 10 

Figure: Production Possibility Frontier (PPF)

 

G has an absolute advantage in producing cocoa.SK has an absolute advantage in producing rice.

At Points A and B: half of each country's resources devoted to production of each of the two goods; no trade 

What happens to the consumption if both countries trade with each other?

--> Specialization  

COMPARATIVE ADVANTAGE (DAVID RICARDO):  You are more efficient in producing some goods than other countries. Then the theory of “absolute advantage” says you gain from trade. If you have an absolute advantage in the production of all goods, then this theory says you gain nothing from international trade.  DAVID RICARDO SAYS:

Even if a country has an absolute advantage in the production of all goods, it still makes sense for the country to specialize in the goods it produces most efficiently and to buy the goods from other countries that it could produce more efficiently itself.

 

Historical Background

“Corn law” in England in the 1830s protected English grains from cheap, continental (mainly French) grains The English landed gentry wanted to keep it that way Industrialists including Ricardo argued for the repeal of the law

Because imported cheaper grains would lower prices of bread, flour, etc., the repeal of the law would lead to lower wage payments to workers by industrialists Ricardo's example: wine and wool for England and Portugal Wool ….. manufactured goodWine ….. agricultural good  

THE ISSUE: Evaluating the impact of international trade upon the overall economic health of the U.K.

This issue keeps arising in modern contexts; in general a country in no trade situation (called "autarky") can be improved by trade.

EXAMPLE (continued)Suppose G has an absolute advantage in producing both cocoa and rice.To produce 1 ton of cocoa, G requires 10 units of resources;SK requires 40

To produce 1 ton of rice, G requires 13 and a third; SK requires 20 The total 200 units of resources divided equally between cocoa and rice without trade in G and SK. Why should G trade with SK when G has an absolute advantage in both goods ?

Resources required to produce 1 ton of cocoa and rice:

Cocoa Rice

G 10 13.33

SK 40 20

G can produce 4 times more cocoa than SK, but only 1.5 times more rice than SK.

Thus, G is “comparatively more efficient” at producing cocoa than it is at producing rice.

Suppose specialization takes place.

G produces 15 tons of cocoa and 3.75 tons of rice.

SK produces 0 tons of cocoa and 10 tons of rice.

 Then G trades 4 tons of cocoa for 4 tons of SK rice

Both will have more for consumption!

The theory of comparative advantage argues that:- potential world production greater without trade restrictions

  - trade is a positive-sum game in which all countries gain Ricardo's theory is a major intellectual weapon for those who argue for free trade Theories of “absolute advantage” and “comparative advantage” are theories of specialization Question: how could multinational corporations use comparative advantage theories in planning for their global production activities?

Theory of comparative advantage

Calculation corner

Countries gain from trade because of differences in the relative costs of producing different commodities.

Example (cont’d)

Relative costs measured as the price of 1 ton of cocoa in terms of tons of rice

Resources required to produce 1 ton of cocoa and rice:

Cocoa Rice Relative costs (=price of 1 ton of cocoa)

G 10 13.33 0.75 tons of rice (= 10/13.33)

SK 40 20 2 tons of rice (= 40/20)

Relative costs are also called opportunity costs in the following sense:

what (“Rice”) has to be given up in order to consume something else (“Cocoa”)

In the example the opportunity cost of a ton of Cocoa in Ghana is 0.75 tons of Rice

Another example

2 countries: France and UK

2 commodities: beef and cheese

1 production input (factor): labour

Technology matrix:

Units of labour required to produce one ton of output

beef cheese relative prices in terms of tons of cheese

France 5 2 2.5 ( = 5/2)

UK 2 4 0.5 ( = 2/4)

We can say: without trade,

• In France one ton of beef costs 2.5 ton of cheese

• In the UK one ton of beef costs 0.5 ton of cheese

Recall: units of labour required to produce one ton of output

beef cheese relative prices in terms of tons of cheese

France 5 2 2.5 ( = 5/2)

UK 2 4 0.5 ( = 2/4)

If trade is permitted:

• France gains from trade if it can buy a ton of beef for less than 2.5 tons of cheese

• UK gains if one ton of beef is sold for more than 0.5 tons of cheese

Mutually beneficial trade can take place at any price

between 0.5 and 2.5 tons of cheese per ton of beef.

(I.e. a range of possible "exchange rates" allow both countries to gain from trade.)

Note that what matters is relative costs, not actual levels of cost.

Example (The U.K. enjoys absolute advantage over France)

France might be less efficient in producing both commodities, but could still gain from trade, as shown below. Suppose:

Units of labour required to produce one ton of output

beef cheese relative prices in terms of tons of cheese

France 15 6 2.5 ( = 15/6) tons of cheese per ton of beef

UK 2 4 0.5 ( = 2/4) tons of cheese per ton of beef

In this example cheese requires more labour to be produced in France than in the UK, but mutually beneficial trade is still possible, because France's productivity disadvantage is less in one commodity (cheese) than the other (beef).

As before, we can say: If trade is permitted,

• France gains from trade if it can buy a ton of beef for less than 2.5 tons of cheese

• UK gains if one ton of beef is sold for more than 0.5 tons of cheese

Mutually beneficial trade can take place at any price

between 0.5 and 2.5 tons of cheese per ton of beef.

Example (Text R/H, p.153)

2 products: Cloth and Grain

2 countries: North and South

Labour cost (hours) of production for one unit of each product

Cloth Grain Relative prices of 1 unit of Cloth in # of units of GrainNorth 10 20 0.5 ( = 10/20)South 20 10 2.0 ( = 20/10)

Example (Text R/H, p.154)

Labour cost (hours) of production for one unit of each product

Cloth Grain Relative costs of 1 unit of Cloth in # of units of Grain

North 50 100 0.5 ( = 50/100)

South 200 200 1.0 ( = 200/200)

Example (no trade is possible)

Only if relative costs are the same in two countries, is it impossible to find gains from trade.

Units of labour required to produce one ton of output

beef cheese relative prices in terms of tons of cheese

France 3 6 0.5 ( = 3/6) tons of cheese per ton of beef

UK 2 4 0.5 ( = 2/4) tons of cheese per ton of beef

Here the pre-trade price of beef in terms of cheese is the same in France as in the UK, and trade opens up no possibilities for improvement for either country.

Example (trade and exchange rate application to multinational firms [Head, pp.33-44]

Assumptions

300 workers in Thai factory300 workers in Korean factoryIn the short run, you cannot add or subtract workers, or move them between plants.One sole and one upper needed for each finished shoe.Transport costs are negligible

Shoe terms

Sole

Upper

Productivity Matrix

Factory Activity

Uppers Soles

Korea 200 400

Thailand 100 100

Korean factory worker can make 200 uppers per day, or 400 soles per day.Thai factory worker can make 100 uppers per day, or 100 soles per day.(Korean factory has an absolute advantage.)

Rewrite the above in terms of the # of workers needed to produce one item of each product:

# of workers needed to produce one item Uppers Soles relative prices of an upper in terms of # of soles

Korea 1/200 1/400 2.0 (=(1/200)/(1/400)) soles per upper

Thailand1/100 1/100 1.0 (=(1/100)/(1/100)) soles per upper

So, it would make sense for Korea to buy uppers from Thailand.

Compute total shoe output for four production plans

Plan A: (self-sufficient factories): Each country combines workers to produce completed shoes. There is no trade.

Plan B: Thailand produces only uppers, Korea produces only soles.

Plan B*: Thailand produces only uppers, Korea produces soles and uppers.

Plan C: Thailand produces only soles, Korea produces soles and uppers.

No trade: Plan A

Trade: Plans B, B* and C

Plan A (no trade). Total world output = 15000+40000 = 55000 shoes per day.

Thailand:

150 workers mold soles

150 workers stitch uppers

---> 150*100 =15000 shoes per day

Korea:

Twice as many workers on uppers as soles

2S+S = 300 S =100 workers mold soles

300-100=200 workers stitch uppers

---> 100*400 = 40000 shoes per day

Plan B (TU & KS specialization): 30000 shoes per day

Thailand: 300 workers stitch 30,000 uppersSoles imported from KoreaKorea: 300 workers mold 120,000 solesCombined (T+K) output: 30000 shoes

90,000 wasted soles or 225 (=90000/400) idle Korean workers

Plan B* (TU & K{S,U} partial specialization): 60000 shoes per day

Thailand: 300 workers stitch 30000 uppersSoles imported from KoreaKorea: 150 workers mold 60000 soles150 workers stitch 30000 uppersCombined (T+K) output:30000 shoes stitched in Thailand using imported soles

+ 30000 finished shoes made in Korea

Plan B* increases shoe output by 9%, compared with Plan A:

(60000-55000)/55000 = .0909

Firm-level productivity risesfrom 55000/600 = 92 shoes per worker per day (Plan A)to 60000/600 = 100 shoes per worker per day (Plan B*)

No new machinery, no new skills, no extra effort.Trade is like a new technology!

Plan C (TS & K{U,S} partial specialization): world output = 50000 shoes per day

Thailand: 300 workers mold 30000 soles. Soles exported to KoreaKorea: 50 workers mold 20000 soles250 workers stitch 50000 uppers

Combined (T+K) output: 30000 shoes stitched in Korea using imported soles+ 20000 finished shoes made in Korea

Moving from no trade (Plan A) to trade (Plan C) lowers global output. Why?

Specialization is not enough

Plan C, involves specialization but it lowers output by 9% relative to Plan A.Only “specialization based on comparative advantage” yields gains from trade.

Recall: comparative advantage = low opportunity costs (relative prices).

Since Thailand’s comparative advantage lies in uppers, Thailand need to specialize in uppers.

Recall: # of workers needed to produce one item

Uppers Soles relative prices of an upper in terms of # of soles

Korea 1/200 1/400 2.0 (=(1/200)/(1/400)) soles per upper

Thailand1/100 1/100 1.0 (=(1/100)/(1/100)) soles per upper

So, it would make sense for Korea to buy uppers from Thailand.

Summary

• Korea gains from trade if it can buy an upper for less than 2 units of soles

• Thailand gains if one upper is sold for more than 1 unit of sole

Mutually beneficial trade can take place at any price between 1.0 and 2.0 units of soles per upper.

Example (cont’d) Wages and exchange rate

# of workers needed to produce one item Uppers Soles relative prices of an upper in terms of # of soles

Korea 1/200 1/400 2.0 (=(1/200)/(1/400)) soles per upper

Thailand1/100 1/100 1.0 (=(1/100)/(1/100)) soles per upper

As of now these numbers represent # of workers needed per unit of product.

Suppose these workers’ wages per day are measured as follows:W(K)=wage rate per worker per day in Korea (in Won)W(T)=wage rate per worker per day in Thailand (in Baht)e=exchange rate (baht/won) = # of Baht per Won

Then we can rewrite the above table in terms of labour costs in Thai Baht as follows:

Labour costs in Tahi Baht per unit produced Uppers Soles relative prices of an upper in terms of # of soles

Korea eW(K)/200 e W(K)/400 2.0ThailandW(T)/100 W(T)/100 1.0

Labour costs in Tahi Baht per unit produced Uppers Soles relative prices of an upper in terms of # of soles

Korea eW(K)/200 e W(K)/400 2.0ThailandW(T)/100 W(T)/100 1.0

Thai plant gains competitive advantage

(1) in uppers when Korea pays more than twice the Thai wage

e W(K)/200 > W(T)/100, or

eW(K)/W(T) > 2

(2) in soles when Korea pays more than four times the Thai wage

e W(K)/400 > W(T)/100, or

eW(K)/W(T) > 4

Relative wages and Competitive Advantage

Increasing returns and trade

Comparative advantage is not the only way to obtain gains from trade.

Plant-level economies of scale are important in many industries.

To illustrate the gains from exploiting plant-level economies of scale through trade, we assume that there is no comparative advantage or absolute advantage

Example. # of items produced per workerUppers Soles

Korea 100 100Thailand 100 100

Factory workers are supported by services of non-production employees, also known as “overhead.” E.g. accounting, logistics and input procurement, machinery maintenance.

Some minimum number of overhead workers are required for any positive level of production.

Let overhead be 30 workers per “product” (soles or uppers) per plant.

A factory that produces both products (that is, a factory that is not fully specialized) has overhead of 30+30= 60, leaving 300-60=240 workers for production.

A factory that specializes has 300-30=270 workers for production.

Plan A (self-sufficiency): 60 overhead workers in each country

Sole output in each factory: (240/2)*100 = 12000

Upper output in each factory: (240/2)*100 = 12000

Combined (T+K) output = 2*12000=24000 shoes

Plan B (full specialization, KS,TU): 30 overhead workers in each country

Sole output in Korea: 270*100 = 27000

Upper output in Thailand: 270*100 =27000

Combined (T+K) output = 27000 shoes (12.5% gain!) [(3000/24000)x100]

Trade between T and K increases global output by 3000 shoes due to returns to scale (economies of scale).

Plan C (full specialization KU and TS) is just as good (27000 shoes) as plan B

No such thing as specializing in the “wrong” thing in this Example.

The key for plant-level economies of scale is to avoid duplicative overhead, rather than to “match” products with skills (as in the CA case).

The assumptions underlying these theories

(1) full employment: all resources are assumed to be fully employed  (2) economic efficiency objective: some countries may want to retain production skill in both products (3) division of gains: some countries may not want to share gains from trade with other countries (4) mobility of resources:AA and CA theories assume that resources (e.g. labour) are mobile within the domestic economy but are not internationally

If any of these assumptions fail to hold, would you still specialize and trade?

Any examples where these assumptions fails to hold?

HECKSCHER-OHLIN THEORY (factor-proportions theory):An extension of the comparative advantage theory  

Explains international trade patterns bydifferences in factor endowments rather than differences in efficiency/productivity as in CA examples above

 

Factors (inputs) of production: land, labour, capital, etc.[But in comparative advantage theory we usually assume only one factor (e.g. labour)] Countries will export goods that make intensive use of locally (or relatively) abundant factors and will import goods that make intensive use of factors that are locally (relatively) scarce

 

Hechscher-Ohlin theoryCalculation corner

H-O theory means: “factor advantages” is a matching process. A location is agood match for an activity if it has a relative abundance in the factors usedrelatively intensively by the activity.

“Relative abundance” defined in terms of ratios or shares:

Case 1. 2 country, 2 factor case (Home and Foreign, Capital and Labour):(K) is “relatively abundant” in H if Kh/Lh > Kf/Lf (I.e. more capital per worker in H than in F).

Case 2. Multi-factor, multi-country case (Home vs. World):given Yh and Yw(GDP for H and the World), (K) is “relatively abundant” in H if Kh/Kw > Yh/Yw (I.e. H’s share of K exceeds its share of world income).

Example: factor abundance in 3 countries

Canada US JapanWorld----------------------------------------------------------------------------------------------Factor SupplyCrop Land, m hec 45.5 187.8 4.5 1465(as % of world) 3.1% 12.8% 0.3% 100.0%Pasture Land, m hec 27.9 239.2 0.66 3410

0.8% 7.0% 0.0% 100.0%Forest Land, m hec 453 296 25 4177

10.8% 7.1% 0.6% 100.0%Water, th km3 2849.5 2459.1 547 41022

6.9% 6.0% 1.3% 100.0%Labour, m 16 136 67 2784

0.6% 4.9% 2.4% 100.0%Factor DemandGNP, tr US$ 0.57 7.1 4.96 27.7

2.1% 25.6% 17.9% 100.0%----------------------------------------------------------------------------------------------Sources: Head, p.60.

Some observations:- crop land: US has “absolute” abundance compared to Canada because 187.8 m hec > 45.5 m hec- cropland per labour: Canada is relatively abundant since 45.5/16 > 188/136.- crop land: relative to the world, Canada is crop-land abundant because its share of world crops (3.1%) > its share of world income (2.1%).

- US appears crop-land scarce since 12.8% < 25.6%.

- forest land: relative to the world, Canada’s forest land is abundant (10.8% > 2.1%). US not so.

Factor proportions in various manufacturing industries------------------------------------------------------------------------------------Industry (I + P)/V L/V H/V H/L

Telephony 32.5% 30.2% 37.3% 1.23Footwear 48.8% 39.0% 12.2% 0.31Furniture 52.5% 38.1% 9.4% 0.25All Manufacturing 61.9% 27.9% 10.2% 0.36Pharmaceuticals 63.0% 16.2% 20.8% 1.28Agri-Chemicals 66.8% 21.4% 11.8% 0.55Aluminum 74.5% 21.5% 4.0% 0.19Petroleum Refining 88.5% 7.2% 4.3% 0.60-------------------------------------------------------------------------------------L = $expenditures on production workersH = $expenditures on administrative workersV = $value-addedI + P = $(intellectual and physical capital), calculated as V − L − H. H/L = a proxy for the skill intensity of the workforce.Source: Head (p.61)

Application of H-O theory: How can we generate comparative advantage using “factor abundance?”

The key: the right matching between country and product and/or industry:

Choose the right country for each product“Intensive user seeks abundant factor”

Caution: “absolute abundance” is not enough.Bigger isn’t better in the HO-based comparative advantage

world. Proportions are the key.

ExamplesCountry Items massively exported Factors in relative abundanceCanada newsprint forest land / capitalCanada aluminum electricityChina clothing low-skilled labour

Suppose 50% of China’s work force had college degrees. Would China thenstill have absolute / relative abundance in low-skilled labour?

The leontief paradox 

U.S. exports are less capital intensive than U.S. imports

Why is this inconsistent with the Hechscher-Ohlin theory?

Empirical evidence:more for comparative advantage

  less for Heckscher-Ohlin theory  The “CA and H-O theories” generally call for free trade but ignores the following: Dynamic growth of economies and associated changes in industrial structures of trading nations.

Example.Prussia, a developing country during the Ricardo's era, did not think the C.A. theory applies to her. Prussia's “Historical Development Stage School” argued for: "protection of infant industries for catching up industrially with advanced England"

Put it another way,

Portugal does not want to be locked in as the producer of wine; rather Portugal would like to develop a wool industry as efficient as England's some time in the future These issues raised by the historical school still haunts us today Any examples? Any examples of the assumptions which are not realistic underlying the comparative advantage and Heckscher-Ohlin theories? Any other realistic situations where the CA and H-O theories do not seem to be applicable?