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International Trade TheoryInternational trade is the exchange of goods and services across different countries. International trade theory has helped to understand the pattern of trade that prevails between the countries. It may be explained with the help of several economic models as under:
Ricardian Model of International Trade
Ricardo had propounded the comparative advantage theory of international trade. According to this theory countries would specialise in the production of commodities which they can produce at a comparatively cheaper rate. Exchange of goods between two countries would be based on this principle of comparative advantage, each exchanging goods that they produce the best. The ratio of labour to capital in a particular country does not enter into the theory of comparative advantage.
Heckscher-Ohlin Model
Heckscher-Ohlin formulated the international trade theory as an alternative to the theory of comparative advantage as propounded by Ricardo. According to this model the trade pattern is governed by the difference in the ratio of labour to capital between the two countries. The country abundant in a particular factor of production would intensively use it to produce a particular good. The good will then be exported to countries which has the alternative factor abundance. Similarly goods would be imported from countries that have the alternative factor abundance. This is how trade relations would be set between these countries. The Leontief Paradox invalidated the model proposed by Heckscher-Ohlin. It was seen that the United States exported labour intensive products even when it was a capital abundant country.
Gravity Model
According to the gravity model trade between countries would be governed by the distance between countries and the size of the economy of the trading countries. Econometric analysis shows that the model was full proof on empirical grounds.
Model of Specific Factors
According to this model labour is mobile across different industries. The case is not the same for capital. Capital is mobile only in the long run. This model is appropriate for understanding the distribution of income but it is difficult to infer the trade pattern
Heckscher (1919) - Olin (1933) Theory
Export goods that intensively use factor endowments which are locally abundant
o Corollary: import goods made from locally scarce factors
Note: Factor endowments can be impacted by government policy - minimum wage
Patterns of trade are determined by differences in factor endowments - not productivity
Remember, focus on relative advantage, not absolute advantage
Factor proportions theory
… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply
Example:
o Australia – lot of land and a small population (relative to its size)
o So what should it export and import?
Factor Proportions Trade Theory Considers Two Factors of Production Labor
Capital
Factor Proportions Trade Theory A country that is relatively labor abundant ( capital abundant ) should specialize in the production
and export of that product which is relatively labor intensive ( capital intensive )
The Leontief Paradox The Test:
Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?
The Method:
Input-output analysis
The Leontief Paradox The Findings:
The U.S. exported labor-intensive products and imported capital-intensive products.
The Controversy:
Findings were the opposite of what was generally believed to be true!
Product life-cycle Theory R.Vernon (1966) … trade theory holding that a company will begin by exporting its product and later undertake
foreign direct investment as the product moves through its lifecycle
As products mature, both location of sales and optimal production changes
Affects the direction and flow of imports and exports
Globalization and integration of the economy makes this theory less valid
Product life cycle theory Fig 4.5 The Product Cycle and Trade Implications
Increased emphasis on technology’s impact on product cost
Explained international investment
Limitations
o Most appropriate for technology-based products
o Some products not easily characterized by stages of maturity
o Most relevant to products produced through mass production
New trade theory In industries with high fixed costs:
o Specialization increases output, and the ability to enhance economies of scale increases
o Learning effects are high. These are cost savings that come from ‘learning by doing’
New trade theory - applications Typically, requires industries with high, fixed costs
o World demand will support few competitors
Competitors may emerge because of “ First-mover advantage”
o Economies of scale may preclude new entrants
o Role of the government becomes significant
Some argue that it generates government intervention and strategic trade policy
Theory of national competitive advantage The theory attempts to analyze the reasons for a nations success in a particular industry
Porter studied 100 industries in 10 nations
o postulated determinants of competitive advantage of a nation based on four major attributes
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
Porter’s diamond Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing
Factor endowments Factor endowments:- A nation’s position in factors of production such as skilled labor or
infrastructure necessary to compete in a given industry
Basic factor endowments
Advanced factor endowments
Basic factor endowments Basic factors: Factors present in a country
o Natural resources
o Climate
o Geographic location
o Demographics
While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success
Advanced factor endowments Advanced factors: Are the result of investment by people, companies, government and are more
likely to lead to competitive advantage
If a country has no basic factors, it must invest in advanced factors
Advanced factor endowments communications
skilled labor
research
Technology
education
Demand conditions Demand:
o creates capabilities
o creates sophisticated and demanding consumers
Demand impacts quality and innovation
Related and supporting industries Creates clusters of supporting industries that are internationally competitive
Must also meet requirements of other parts of the Diamond
Firm Strategy, Structure and Rivalry Long term corporate vision is a determinant of success
Management ‘ideology’ and structure of the firm can either help or hurt you
Presence of domestic rivalry improves a company’s competitiveness
Determinants of Competitive Advantage in nations Fig 4.8 Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Chance Two external factors that influence the four determinants. Porter’s Theory-predictions
Porter’s theory should predict the pattern of international trade that we observe in the real world
Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable
Implications for business Location implications :
o Disperse production activities to countries where they can be performed most efficiently
First-mover implications:
o Invest substantial financial resources in building a first-mover, or early-mover advantage
Policy implications:
o Promoting free trade is in the best interests of the home-country, not always in the best interests of the firm, even though, many firms promote open markets
India in the global competitiveness report
International Trade Theory
Key Trade Theories
Comparative Advantage Absolute Advantage Mercantilism National Competitive Advantage
A Little RACHMANINOF ?
Trade Theories Mystify Students!Let me try to explain the key ones in plain simple, maybe too simple, English with simple, maybe stupid,
examples:1. COMPARATIVE ADVANTAGE. This is the fundamental theory explaining trade between
nations. It was first developed by David Ricardo in 1817. Try to follow this~ o There are two people in the world, Jesus [pronounced hey Dr. Seuss without the Dr.] in
Mexico and Kim [pronounced excellent student] in the USA.o There are two jobs in the world, hand sewing the leather on auto transmission knobs and
writing software for Windoz.
o Both Jesus and Kim are dedicated, bright people willing to do either job, but Kim is much better educated and has the advantage of a more modern "infrastructure" to support her. Infrastructure is things like computers, phones, transportation, suppliers, colleges, etc.
o In scenario #1, Jesus writes software and Kim sews knobs. They both try their best. At the end of the day, Jesus has produced software worth $4 and Kim has produced knobs worth $400.
o In scenario #2 they switch jobs. Jesus sews knobs worth $350, and Kim produces software worth $3,500.
o Note that SuperKim was better than Jesus at both jobs. Way to go SuperKim!o Now answer two questions: [1] Would Jesus bring more money home to his family if he
wrote software [value $4] or sewed knobs [value $350] for a day? [2] Would Kim make more each day sewing knobs [value $400] or writing software [value $3,500]?
o Now ask yourself a third question. Is the WORLD better off in scenario #1 with the total production of $404 in goods and services each day, or in scenario #2 with a daily production of $3,850?
In summary, the theory of comparative advantage shows that everyone wins if each country produces what it does best, and trades with other countries even if they are trading for things THEY COULD MAKE THEMSELVES. The USA could excel at hand-making bath sandals out of old tires. Should we?
2. ABSOLUTE ADVANTAGE. Adam Smith explained this in 1776. This is easy! Michigan can't grow coffee efficiently and Brazil can't grow tart cherries efficiently. Each country has an absolute advantage(in efficienty). It's easy to see we should trade cherries for coffee!
3. MERCANTILISM. This earliest and dumbest theory says that the goal of trade is to accumulate the biggest pile of gold or money by simultaneously encouraging exports and discouraging imports. This theory says trade is a win/lose game where the winner is rich but lives poor [without imports]. As stupid as this sounds, this is Japan's current practice!
4. NATIONAL COMPETITIVE ADVANTAGE. Michael Porter of Harvard introduced this in 1990. He says countries gain a competitive advantage over other countries in certain areas, and trade those goods and services. There are four determinants:
o Factor Endowment. Argentina has better farm land than Saudi Arabia and will export more farm products.
o Home Demand. The French love wine and will tend to export it.o Related Industries. The USA exports its music in good part due to the earlier success of its
movies.o Firm Strategy. Japan exports a lot of vcr's because Sony is just plain good at making and
selling them!
As business people we pragmatically focus on the bottom-line advantages of foreign trade, but an understanding of the underlying theories will help us make better decisions-----and help us put down a protectionist at a party! >;->
University of Washington Geography 349 (Professor Harrington)
International Trade Theory Contents:
MercantilismAbsolute advantage
Comparative advantageFactor proportions
Gains from tradeLeontief paradoxProduct life cycle
Technology and trade Summary: no all-purpose trade theory
Trade trapsOptimally, a trade theory would help us explain or predict
what nations export and import what goods with what other nations under which economic, geographic, and political circumstances, with what consequences.
This would allow us to predict and prescribe the content, direction, and size of multilateral trade flows.
MERCANTILISM 1500-1800
not a full-blown trade theory (see above); rather, an economic policy of governmental accumulation of wealth, in the form of gold bouillon for:o domestic controlo investmento international expansion reflects the era of nation-building and the shifting of European political power from feudal lords and the
church to national sovereigns; also reflects and supports the principal source of wealth -- trading
The trade-policy implication of this economic policy was the generation of a national trade surplus, paid for by accumulation of gold reserves. Before fully developed financial systems, there was little international credit. Therefore, a current-account surplus was not matched by net capital outflow (net loans or investment overseas); rather, it was matched by a net inflow of gold to pay for the excess of goods exported from the country. Some of this gold found its way to overseas investment by the sovereign. ABSOLUTE ADVANTAGE 1776: Adam Smith's The Wealth of Nations
Political and economic liberalism found their expression in Smith's argument that the wealth of nations depends upon the goods and services available to their citizens, rather than the gold reserves held by the sovereign.
Maximizing this availability depends, first, on putting all resources to use, and then, on the ability --
to obtain goods and services from where they are produced most cheaply (because of “natural” or “acquired” advantages), and
to pay for them by production of the goods and services produced most cheaply in the country, with costs measured in terms of direct and "embedded" labor inputs.
This principle fit the development of capitalist economies based on production via wage labor (rather than trading commodities for profit); reflects the manufacturing dominance of Britain; reflects manufacturing economies of scale based on: - development of specialized equipment; - labor training and specialization; - long "runs" of one product. These are sources of acquired advantage.
The consequent trade policy is relatively free trade, so that a country should import goods that would be produced more expensively internally, where expense is measured according to the labor theory of value.
These imports are to be paid for by the production of goods that the country can produce with less use of labor per unit. Exports flow from the country that can produce a product most cheaply.
COMPARATIVE ADVANTAGE • 1817: David Ricardo's On the Principles of Political Economy and Taxation • The possibility of system-wide gains from trade persists, even when a given country has an absolute advantage in the production of no product. • Specialization and trade should occur according to the relative opportunity costs of production in each country, measured in terms of the alternative production given up to produce a tradable good.
Example:
resources required per unit output:
Tea Wheat
Sri Lanka 10 10
United States 5 4
The opportunity cost of tea in Sri Lanka is 1 unit wheat; the opportunity cost of tea in the US is 1.25 units wheat. Sri Lanka has comparative advantage in tea production, despite its absolute disadvantage in the production of each commodity.
To test for comparative advantage in the production of commodity A in a 2X2 model: for which country is the opportunity cost of A smaller -- which is to say, for which country is the ratio of resources required for a unit of A to the resources required for a unit of B smaller?
10/10 < 5/4, thus, the comparative advantage of Sri Lanka is commodity 1, tea. Although the US has an absolute advantage in the production of both tea and wheat, the US has a comparative
advantage only in the production of wheat. This is because its advantage in wheat is comparatively greater than its advantage in tea [Daniels and Radebaugh, 8th ed., p. 202].
• In Root's phrasing, "gainful trade will occur between countries when their pretrade relative price structures are different" [F.R. Root, 1990, International Trade and Investment, p.45].
How are the gains from trade divided between two trading partners? If xi refers to the domestic cost of producing x (a or b) within country i, and Ci/Cj refers to the exchange rate between currencies i and j (how many units of Currency i equals one unit of Currency j), then:
trade is gainful when ai/bi (the ratio of the costs of producing a and b in country i) is not equal to aj/bj (the ratio of the costs of producing a and b in country j)
if ai/bi < aj/bj, then i will export a and import b, so long as exchange rates allow: ai/aj < Ci/Cj < bi/bj (which is to say that the exchange rate is not so extreme as to wipe out the differences in
opportunity costs for each item across the two countries).
For example: US beef costs $10 in the US US cameras cost $20 in the US Japanese beef costs ¥5000 in Japan Japanese cameras cost ¥1000 in Japan · Without a common numeraire (such as labor-value), we don't know the absolute advantages. However, the relative values within the two countries, 1/2 and 5/1, tells us that the US comparative advantage is beef and the Japanese comparative advantage is cameras. Why? Because if costs are accurately measured, then the opportunity costs of beef (in terms of cameras foregone, since there are only two possible products) are lower in the US than in Japan: 1/2 a camera foregone in the US; 5 cameras foregone in Japan. · Despite this clear comparative advantage, trade will only occur if 10/5000 < $/¥ < 20/1000, which is the same as 0.002 < $/¥ < 0.02, which is the same as
1/500 < $/¥ < 1/50.
Q: What would make the dollar fall so much against the yen that a dollar would buy fewer than 50 yen, and this bilateral trade would end? (That is, in a world where neither currency was used for other international purposes, and where there was no monetary policy). A: Such a low Japanese demand for US beef and such a high American demand for Japanese cameras that the exchange rate fell this low.
This relative demand for products from trading partners, expressed via its effect on exchange rates, determines the division of gains from trade.
At $1 = ¥200, the US will import 2 cameras for each unit of beef it exports; this is 1.5 more cameras than it could make domestically in lieu of one unit of beef; the US gain from trade is 1.5 cameras per unit of beef.
At $1 = ¥183.33, the US will import 1.83 cameras for each unit of beef it exports; the gain from trade becomes 1.33 cameras per unit of beef.
At $1 = ¥120, the US will get $10 = ¥1200 for each unit of beef it exports to Japan; this would allow the US to import 1.2 cameras (at ¥1000 each); this is 0.7 more camera than the US could make domestically at the opportunity cost of 1 unit beef, so the US gains from trade is 0.7 camera/beef.
The equation below notes that the gains to country 1 from exporting commodity a is the amount of commodity b that can be imported from country 2 (per unit of commodity a that is exported) minus the cost of producing commodity a for export (expressed as the amount of commodity b that is foregone).
Simplified, country 1's gains from trade = G1 = (A1/B2)(C2/C1) - a1/b1
The first ratio (A1/B2) is the ratio of (i) the unit price that Country 1's exports fetch on the world market (in terms of Country 1's currency) to (ii) the unit price that Country 2's exports fetch on the world market (in its currency).
The second ratio (C2/C1)is the exchange rate: the "price" of the exporting country's currency, which (without capital or money markets) is also a measure of the relative demand for that country's exports.
The third ratio (a1/b1) is the opportunity cost of producing the exported product in the exporting country. (A1/B2)(C2/C1) is what Country 1 can get in return for exporting a unit of a a1/b1 is what Country 1 gives up as it produces a unit of a So can you see why (A1/B2)(C2/C1) - a1/b1 is the "gains from trade"? Wait, ask yourself -- can you see why?
Note, then, that G1 (the exporting country's gains from trade): increases with the relative unit price of Country 1's vs. Country 2's export items (this reflects the global
supply/demand balance for these items), increases with strength of the Country 1's currency, and decreases with the opportunity costs (in Country 1) of producing the exported item.
Let's run through the Japan/US example, above, using this formula. a1 = the cost of producing the US export item, beef, in the US = $10/beef. For now, let's assume that costs equal prices: a1 = A1 .
b2 = the cost of producing the Japanese export item, cameras, in Japan = ¥1000/camera. For now, let's assume that costs equal prices: b2 = B2 .
C2/C1 = the exchange rate, varied; let's take the example where it's ¥200/$1. b1 = the cost of producing the alternative product, cameras, in the US = $20/camera.
Thus, our formula G1 = (A1/B2)(C2/C1) - a1/b1 suggests that the US gain from trade = ($10/beef / ¥1000/camera) (¥200/$1) - $10/beef / $20/camera = ($10/beef) (camera/¥1000) (¥200/$1) - ($10/beef) (camera/$20) = 2 cameras/beef - .5 camera/beef = 1.5 cameras/beef, or
1.5 cameras gained by the US in return for each unit of beef exported.
At the same time, Japan has a gain from this trade:(¥1000/camera / $10/beef) ($1 / ¥200) - ¥1000/camera / ¥5000/beef = (¥1000/camera) (beef/$10) ($1 / ¥200) - (¥1000/camera) (beef/¥5000) = .5 camera/beef - .2 camera/beef, or.3 unit of beef gained by Japan in return for each camera exported.
As you think about this, and view the graphs in the textbook (Figs. 6.2 and 6.3), you'll recognize that we're making some assumptions:
1. We assume that national production is on the production possibility frontier (PPF), with no un-used factors (e.g., no unemployment). If some available and relevant factors are not being used (e.g., labor unemployment in the export sector), then we can't clearly say that producing more of the export item would mean producing less of other items.
2. We assume that factors are homogeneous within a country (e.g., L is perfectly substitutable across individuals and across sectors), so that workers, capital, and resources not used in one sector can work in another.
3. To make the numerical example simpler, I've assumed that prices equal costs (including a standard rate of return to capital and entrepreneurship). That's not always the case: sometimes prices are much higher than costs (e.g., in a monopoly), and sometimes international prices are lower than domestic costs (that's called "dumping"). We can deal with this by recognizing that a1 might differ from A1 and b2 might differ from B2.
4. We've ignored transportation costs -- but we could implicitly include them in A1 and B2 in the first term of our gains-from-trade equation -- or we could add them in as a variable in the first term -- this would allow us to show what happens with transportation costs fall (e.g., with containerization) or rise (e.g., with higher fuel prices).
5. We assume that factor prices reflect the value of marginal product attributable to the factors. In reality, this is affected by the competitive structure of the industry (higher but declining in a monopolistic or oligopolistic industry), the nature of the factor markets (supply is restricted in the case of unionized L or the guild professions), and finally, wages/salaries are not solely determined by economic forces.
These are all problems with using traditional trade theory to understand and to prescribe trade flows in the current economy.
FACTOR PROPORTIONS 1935: Bertil Ohlin's Interregional and International Trade, based on earlier work by Eli Heckscher
What explains the differences in opportunity costs for producing the same product in different countries? Possibilities include skill or technology (including a preference for producing in different ways), availability of materials or resources, or the pricing of inputs.
Assuming: 1) mobile technology, 2) general preferences to use the best available methods, 3) perfect competition in domestic factor markets (which should push factor prices to reflect their opportunity costs), 4) input requirements that differ across different products, but 5) only one particular mix of inputs for each different product, and 5) immobility of factors, comparative advantage should depend on relative factor availability.
• "A country has a comparative advantage in the production of goods that use relatively large amounts of its abundant factors of production and a comparative disadvantage in the production of goods that use relatively large amounts of its scarce factors of production." Goods trade can be considered the indirect trade of factor
services [Root, p.69]. --> What is meant by abundant and scarce? Measured by relative prices received by an additional unit of two factors, in one country versus that relationship in another country -- in other words, geography.
Complications: 1) heterogeneous factors -- of differing quality for specific production processes 2) substitution within a production function 3) raw-material extraction is based on absolute advantage
The principles of comparative advantage and factor proportions form the basis of the traditional, neoclassical theory of international trade. Note that this is a normative theory, in that it asks the question "If we had a goal of maximizing world production (the goods and services available to citizens of each country), how would we proceed?" If we assume that
resources (a.k.a. factors of production) are immobile, but that goods are mobile and technology is stable and ubiquitous,
then we maximize world production and the goods and services available to each country by using resources for the production of goods that face the lowest opportunity cost within each country, and trading the locally unneeded products for other goods, produced with the lowest opportunity cost for resources in other countries.
LEONTIEF PARADOX 1953: Wasily Leontief published "Domestic production and foreign trade: the American capital position re-examined" in Proceedings of the American Philosophical Society (v.97). 1956: Wasily Leontief published "Factor proportions and the structure of American trade: further theoretical and empirical analyses" in Review of Economics and Statistics (v.38):
Using data available from the 1947 input-output (I-O) model of the US economy, Leontief calculated the K and L requirements for the production of $1 million of US exports and $1 million of US production in import-competing industries. He found that the former required a higher proportion of L than the latter. [paraphrased from Hirsch, 1967: pp.8-9]. · explain I-O and how such a model could be used to identify export sectors (rows with large entries in the X column); L and K inputs; US imports from trade data
• The paradox: the US is considered K-rich, and US L was very expensive compared to L in other countries. Analogous results were found in Japan, which was then L-rich and K-poor, yet Japanese exports were more K-intensive than Japanese production in sectors that faced import competition.
Possible explanations of the Leontief paradox (see a similar exposition by E.K. Choi)
1. US demand for K-intensive products outstripped its capacity to provide them domestically. [No.]
2. "Factor-intensity reversal" — Leontief had no idea of the input mix for manufacturing in other countries; he measured the K-intensity of US production in import-competing industries, not of US imports. If L is expensive in the US, then US industries facing import competition would have to reduce their use of L, by substituting K. However, this would mean that production functions (i.e., input mix; technology) vary for the same products in different places, which renders the Heckscher-Ohlin theorem nearly useless. [Insufficient data, but this is a powerful argument for limiting empirical conclusions to the specifics of the data used].
3. Perhaps international trade flows were not rationalized according to comparative advantage in 1947,
immediately after the destruction and disruption of WW2. After all, comparative advantage is a normative concept. [Empirically, a partial explanation, when nations' import restrictions were considered].
4. The US imported natural-resource commodities whose extraction is K-intensive, but in which other nations have an absolute advantage. [Empirically, a partial explanation; the paradox was more apparent in US bilateral trade with resources-rich countries (e.g., Canada), and was less strong when natural-resource sectors were excluded.]
5. "Human-skills theory" — L is a heterogeneous factor, and should be analyzed as separate factors according to skills levels. Perhaps the US is actually skilled- and technical-L rich, and therefore has a comparative advantage in production that requires much skilled or technical L. H-O formulations should be expanded to allow for more than one L factor. [Difficult to test, but can be added to the H-O theorem]. Related to this is the recognition of international differences in factor productivity. US labor is more productive than the labor of most countries (because of skills, work organization, capital/worker, and technology), and is paid more per hour; this helps explain why US labor looms larger as a cost in US exports.
6. Technology itself is a nation-specific factor of production, rather than being a universal attribute of production. Furthermore, technology is a factor that is produced within a given nation (much like a commodity), but is not perfectly mobile or tradable. This kind of thinking has led to "neo-technology theories of trade" (see below).
7. The US Government and private companies lent (or otherwise invested) so much capital in particular sectors of particular foreign economies, that these enclaves became, essentially, capital-rich. [Thanks, Mike, for this suggestion. Empirically, it probably doesn't play an important role in Leontief's 1947 data, but it (a) does conceptual damage to the factor-proportions theory because it implies that capital, a factor, is mobile, and (b) it presages the model of the international product life cycle, below].
PRODUCT LIFE CYCLE • Raymond Vernon, 1966, "International trade and investment in the product life cycle"
• Concepts of product cycles had been developed in industrial economics and in marketing since the 1920's. Vernon, however, became concerned with the technological bases for PLCs in the late 1950s. with his work on the New York Regional Plan. He later extended these concerns to the international realm. • Concerned with only certain products:
· manufactured goods (or services that can be produced remotely from consumption, like call centers) · income-elastic demand · L-saving in use • His original formulation also assumed a ranking of nations by income and wage levels, with steadily rising income and wage levels of the ranked nations. • Assumes that product innovation is market-led [define product versus process innovation; technology-push versus market-pull models of innovation]. • Assumes that process technology undergoes stages distinguished by labor-intensity, standardization, unit cost, and ability for technology to be embodied in capital equipment and standard operating procedures.
With these assumptions, Vernon built a story of these particular kinds of products facing 1) introduction in the highest-income, highest-wage country where the products found their first demand; production is small-scale, changing, expensive, and uses highly skilled L; demand is not very price-elastic, because of differentiation, and the nature of pioneering adopters 2) growth of demand and production in the original country, with declining costs and prices; some export demand from countries with lower incomes and wages — the high-wage, L-scarce country is exporting L-intensive products 3) maturity of demand in the original country, with standardized and increasingly K-intensive production; establishment of foreign operations in newer markets to serve them and to overcome real or threatened trade
barriers 4) decline of product demand in the original country, with increasing competition from other suppliers and other products; the cost pressure and the ability to embody the technology in K equipment and SOP pushes production "offshore" to low-wage countries, using financial K and K equipment from the originating country — the high-wage, L-scarce country is importing K-intensive products, because the K and technology are mobile within the MNC, while the less-expensive L is not mobile.
This helps resolve the Leontief paradox by explaining, for a limited class of goods, US exports of these goods while they are L-intensive and import of these same goods when they are K-intensive.
However, this model differs from the Heckscher-Ohlin theorem:
technology changes over time, from L toward K; the mobility of technology changes over time standardized technology and financial K are mobile factors within the MNC
Today, of course, international differences in incomes and wages do not form a neat ranking, and improvements in communication make it easier to engage in new-product production anywhere within a MNC's global production network.
TECHNOLOGY AND TRADE The “new growth theory” and “new trade theory”: Romer, Krugman, Helpman: 1980s.See The Royal Swedish Academ
1. Leontief Paradox
The Heckscher-Ohlin theory states that each country exports the commodity which uses its abundant factor intensively. The HO theory was generally accepted on the basis of casual empiricism. Moreover, there wasn't any technique to test the HO theory until the input-output analysis was invented.
The first Empirical Test of the HO theory
The first serious attempt to test the theory was made by Professor Wassily W. Leontief in 1954.
Result: Leontief reached a paradoxical conclusion that the US—the most capital abundant country in the world by any criterion—exported labor-intensive
commodities and imported capital- intensive commodities. This result has come to be known as the Leontief Paradox. Leontief took the profession by surprise and stimulated an enormous amount of empirical and theoretical research on the subject.
How
To perform the test, Leontief used the 1947 input-output table of the US economy (He received his Nobel prize for his contribution to input-output analysis later). He aggregated industries into 50 sectors, but only 38 industries produced commodities that enter the international markets, and the remaining 12 sectors were created for accounting identities and nontraded goods. He also aggregated factors into two categories, labor and capital. He then estimated the capital and labor requirements to produce:
One million dollars' worth of typical exportable and importable bundles in 1947.
Capital Requirement
Labor Requirement
Exports
aKx = 2.550780
aLx = 182.313 man-years
Imports
aKm = 3.091339
aLm = 170.114 man-years
capital-labor ratios
kx = aKx/aLx = $14,300 (exports)
km = aKm/aLm = $18,200 (imports)
The US seems to have been endowed with more capital per worker than any other country in the world in 1947. Thus, the HO theory predicts that the US exports would have required more capital per worker than US imports. However, Leontief was surprised to discover that US imports were 30% more capital-intensive than US exports,
km = 1.30 kx.
Criticism
At first, Leontief was criticized on statistical grounds.
Swerling (1953) complained that 1947 was not a typical year: the postwar disorganization of production overseas was not corrected by that time.
Leontief's Second Test
In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951. In his second study, Leontief aggregated industries into 192 industries. He found that US imports were still more capital-intensive than US exports. US imports were 6% more capital-intensive(km = 1.06 kx).
Baldwin's Third Test
More recently, Professor Robert Baldwin (1971) used the 1962 US trade data and found that US imports were 27% more capital-intensive than US exports. The paradox continued.
km = 1.27 kx.
3. Trade Patterns of Other Countries
JAPAN
Tatemoto and Ichimura (1959) studied Japan's trade pattern and discovered another paradox. Japan was a labor-abundant country, but exported capital-intensive goods and imported labor- intensive goods. Japan's overall trade pattern was inconsistent with HO.
Explanation: They said that Japan's place in the world was somewhere between advanced and LDCs.
25% of Japan's exports went to advanced industrial countries.75% of exports went to LDCs.
For the US-Japan trade, the trade pattern was consistent with HO prediction.
Japan-LDC, consistent.
East Germany
Stolper and Roskamp (1961) applied Leontief's method to the trade pattern of East Germany. East Germany's exports were capital-intensive. About 3/4 of EG's trade was with the communist bloc, and EG was capital abundant relative to its trading partners. Thus, the EG case was consistent with the HO theory.
South KoreaHong (1975) analyzed Korea's trade pattern (1966-72), which was consistent with the HO theory.
CANADA
Wahl (1961) studied Canada's trade pattern. Canadian exports were capital-intensive. Most of Canadian trade was with the US. The result was inconsistent with HO.
INDIA
Bharawaj (1962) studied India's trade pattern. India's exports were labor-intensive. Consistent with HO theory.
However, Indian trade with the US was not. Indian exports to the US were capital-intensive.
Explanations for the LP
1. Leontief: US was more efficient
Leontief
Leontief himself suggested an explanation for his own paradox. He argued that US workers may be more efficient than foreign workers. Perhaps U.S. workers were three times as effective as foreign workers. Note that this increased effectiveness of the American workers was not due to a higher capital-labor ratio, because we assume that countries have identical technologies and hence identical capital- labor ratios.
It means that the average American worker is three times as effective as he would be in the foreign country. Given the same K/L ratio, Leontief attributed the superior efficiency of American labor to superior economic organization and economic incentives in the U.S. However, Leontief found very few believers among economists.
Empirical evidence
Kreinin (1965) conducted a survey of engineers and managers, and tried to test whether an average American worker is three times as effective as a foreign worker. A realistic difference in effectiveness between
the representative workers in the U.S. and those in the foreign countries were about 20-25%. Obviously, this difference does not explain the Leontief Paradox.
When comparing trade patterns of a market economy and a command economy, this explanation may be important. Modern technology is available to Russians, but production in the former Soviet Union is still inefficient due to lack of incentives.
Evaluation
There might have been some difference in labor efficiency or productivity between the US and the rest of world in 1947. But this should have been relatively insiginficant. This was probably a bad theory.
Trefler (1993) resurrects Leontief's theory and has proved that when quality indices of factors are incorporated, US exported capital and imported labor services in 1947 (HOV Theorem). This still does not prove, however, that US exports had been more capital intensive than its imports that year.
2. Factor Intensity Reversal
If a commodity is produced by a labor-intensive process in the labor-rich country and also by the capital-intensive process in the capital-rich country, then factor intensities are reversed in the production of that commodity.
Example: agriculture is labor-intensive in India but capital-intensive in US.
If the US imports agricultural products, then
an LP occurs in the US, because a capital abundant country is importing the capital-intensive product.
If the US exports agricultural products, then an LP occurs in India, because a labor-abundant country, India, is importing the labor-intensive good.
LP is inevitable
In the presence of FIR, the HO theory cannot hold for both countries. That is, an LP always occurs in one of the countries. Thus, Jones (1956) and Robinson (1956) argued that FIR could have been responsible for the LP in the US.
Empirical relevance
The question is whether FIR is common in the real world. Minhas (1963) investigated 24 industries for which comparable data were available for 19 countries. He found FIRs only in 5 countries.
Leontief (1964) reviewed Minhas's book and pointed out that only 17 out of 210 possible reversals did occur for the relevant range of factor prices. Moroney (1967) concluded that FIR has much less empirical importance, albeit theoretically interesting.
Agriculture Remark: Moroney was probably correct when comparing trade patterns with similar countries, or among developed economies. Capital-labor ratios are likely to be similar among developed economies and their resource endowments might be in the same cone of diversification.
While there has not been much empirical evidence about the possibility of factor
intensity reversals, FIR is real. It may be important when comparing trade patterns between developing and developed economies (e.g. China vs. US).
3. Natural Resources
Leontief may have oversimplified the production functions and failed to recognize the endowments of natural resources. With three factors of production, the HO model does not predict much. This is because the notion of abundance and intensity must be redefined.
"Factor intensities" are difficult to define
It is possible to have K1/L1 > K2/L2 and K1/N1
< K2/N2.
Jaroslav Vanek's Argument (1963)
Suppose the US is poor in natural resources. Assume that the import-competing industry uses capital and natural resources in fixed proportions, i.e., K and L are perfect complements in production. Then apply the HO theory. The US imports natural resource-intensive products, but it appears that the US is importing capital- intensive goods.
Evaluation
Empirical studies have shown that the natural resource content in typical US imports is greater than that in US exports. But it is difficult to believe that US is poor in natural resources. Vanek's explanation is not empirically convincing.
Factor In a world of many factors (K, L, N, .... Z),
Abundance is meaningful
factor abundance can be ranked:
K/K* > N/N*> ...> L/L*.
In this case, we can say that the HC is (most) abundant in capital, and least abundant in labor.
Heckscher-Ohlin-Vanek Theorem
A country exports its abundant factors through trade in goods.
Let = Y/(Y + Y*) be the home country's share of world income. Then the HC is abundant in capital, if
K/(K + K*) > .
Of course, this definition can be extended to any other factors. According to this definition, it is possible for a country to be abundant in more than one factors. The HOV Theorem states that if trade is balanced a country exports its abundant factors through trade in goods.
Remark 1. If factor prices are equalized, the definition of factor abundance makes sense, since income is the sum of factor incomes.
Y = wL + rK + sN + ...
In a world of two factors, if factor prices are equalized (w = w* and r = r*)
K/K* > Y/Y* if and only if K/K* > L/L*.
Thus, one can say that the above is a more general definition of factor abundance.
2. Trade theory is supposed to predict the patterns of output trade. As the number of
outputs increases, it becomes exceedingly difficult to predict the patterns of output trade. Thus, HOV was not even a result that economists were looking for.
3. Nevertheless, HOV theorem predicts the indirect trade of factors through output trade. If HOV prediction is not materialized in the real world, it is an indication that there is a serious distortion in the economy. In this sense, HOV Theorem does provide a guide to trade policy; a trade policy should not encourage exports of scarce resources and imports of abundant resources.
Responses to the paradox
For many economists, Leontief's paradox undermined the validity of the Heckscher-Ohlin theorem (H-O) theory, which predicted that trade patterns would be based on countries' comparative advantage in certain factors of production (such as capital and labor). Many economists have dismissed the H-O theory in favor of a more Ricardian model where technological differences determine comparative advantage. These economists argue that the U.S. has an advantage in highly skilled labor more so than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using this definition, the exports of the U.S. are very (human) capital-intensive, and not particularly intensive in (unskilled) labor.
Some explanations for the paradox dismiss the importance of comparative advantage as a determinant of trade. For instance, the Linder hypothesis states that demand plays a more important role than comparative advantage as a determinant of trade--with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the U.S. and Germany are developed countries with a significant demand for cars, so both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries trade different brands of cars between them. Similarly, New Trade Theory argues that comparative advantages can develop separately from factor endowment variation (e.g. in industrial increasing returns to scale).
Leontief's Paradox
Early on, input-output analysis was used to estimate the economy-wide impact of converting from war production to civilian production after World War II. It has also been used to understand the flow of trade between countries.
Indeed, a 1953 article by Wassily Leontief showed, using input-output analysis, that United States exports were relatively labor-intensive compared to United States imports. This was the opposite of what economists had expected at the time, given the high level of U.S. wages and the relatively high amount of capital per worker in the United States. Leontief's finding was termed the Leontief paradox.
Since then, the paradox has been resolved. It has been argued that the US has an advantage in highly skilled labor more so than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using this definition, the exports of the U.S. are very (human) capital-intensive, and not particularly intensive in (unskilled) labor.
Others have explained the paradox by reducing the importance of comparative advantage as a determinant of trade. For example, demand may play a more important role than comparative advantage as a determinant of trade—with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the United States and Germany are developed countries with a significant demand for cars and both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries may trade different brands of cars between them.
4. Tariffs and Transport Costs
Travis (1964) argued that tariff may have been responsible for the LP. However, tariffs tend to reduce trade volume, but not reverse commodity trade pattern. In other words, an import tariff cannot induce a country to export goods that intensively use its scarce factor. It would only reduce the volume of goods which it would export in the absence of a tariff.
Baldwin (1971) showed that this indeed was the case. Without tariff, the capital-labor ratio of imports would have fallen by 5%, which is not sufficient to resolve the LP.
Remark Tariffs and transport costs tend to reduce the volume of trade, but not reverse the pattern of trade.
5. Demand Bias
A capital abundant country need not export the capital-intensive good if her tastes are strongly biased toward capital-intensive goods. Thus, LP can be
explained if the US had a strong consumption bias toward the capital-intensive goods.
Example of demand bias
In 1819 Francois-Louis Cailler established one of the first chocolate factories in Switzerland. Cailler Swiss Chocolate is the oldest brand of Swiss chocolate still in existence, and Switzerland leads the world in per capita annual chocolate consumption, 22.5 pounds per person! (History of Swiss Chocholate). Per capita consumption of chocolates is less than 5 pounds in the United States. Per capita consumption of seafood in Japan is 60 kg per year while that of the US was about 15 pounds in 2001. Thus, the Japanese people consumes 10 times as much seafood as Americans per person. When commodities are narrowly classified, there exists a considerable difference in tastes and consumption patterns between trading countries.
Jones
Jones (1956, University of Rochester) argued that demand bias could be an explanation. However, no one argued that demand bias was a cause of the LP.
(1) Houtthakker's studies (1957, 1960, 1963) suggest that there is considerable similarity in demand functions among countries.
(2) As per capita income increases, consumption of the labor-intensive goods (such as services) tends to increase while that of the capital- intensive goods
decreases. (That is, labor intensive goods are luxury goods. Consumers develop sweet teeth for labor-intensive goods as income increases.) If there had been a consumption bias in the US in 1947, the bias must have been toward increased consumption of the labor-intensive goods. Therefore, consumption bias would have reinforced the HO prediction that US would import labor-intensive goods. Thus, demand bias is NOT a good explanation for the LP.
Nihonbashi (Japan bridge) fish market is the predecessor of today's Tsukiji fish market with over 60,000 employees. Its annual sales exceeds $40 billion.
As GDP increases, the share of services increases. The share of services was only 60% in 1960, but has since steadily increased to 77% in 2007. Services tend to be nontraded goods.
6. Human Capital
Human capital has not been taken into account in evaluating LP. The idea is simple. Human capital is created by education. Education, like investment in physical
capital, requires time and uses up resources.
Leontief did not include the value of human capital in his calculations. But he argued that US exports were skilled labor- intensive than US imports.
(i) there are two ways to incorporate human capital. Labor may be divided into to two or more groups: unskilled labor, semi-skilled labor, and skilled labor. First, the US may have been abundant in skilled labor. The US may have been exporting skilled labor-intensive goods.
(However, a 3 x 3 HO model does not predict that a labor abundant country will export the labor intensive good, because which good is "labor-intensive" or "capital-intensive" is not clearly defined in a higher-dimensional world.)
(ii) A second way to include human capital: add human capital to physical capital:
K = Ko + Kh
(i) Kravis (1956) found that American workers in the export industries earned a higher wage than those in the import competing industries. This difference in wage reflects the existence of human capital.
It is more likely that human capital had existed in both industries. However, it is the extra human capital embodied in labor in the export sector that counts here. The value of (extra) human capital embodied in labor is:
(wx - wm)/r = Kh.
(ii) Kenen (1965) used 9% discount rate and showed that if the value of human capital were included, the US exports were capital- intensive relative to US imports. This would reverse the LP.
However, estimates of human capital is sensitive to the interest rate chosen. Specifically, a lower interest results in a greater amount of human capital in the export sector. If the discount rate is over 12%, this theory does not explain the LP.
The wage gap between the two sectors may be due to other factors. Attributing it to only human capital is unsatisfactory.
(iii) Baldwin's (1971) analysis shows that Human capital alleviates the LP, but it does not resolve the paradox.
Evaluation
These analyses show that presence of human capital can play an important role in determining trade patterns between coutries. However, available empirical evidence is not very conclusive either way.
7. Trade Imbalance
The HO theory based on the assumption that trade is balanced. To predict the trade pattern when trade is not balanced, much more information might be necessary. In general, in the presence of trade imbalance, a capital abundant country may not export capital-intensive goods. With a trade
surplus, a capital abundant country such as the US may not only export the capital- intensive goods but also the labor-intensive goods.
Leontief's data show that US exports in 1947 amounted to $16,678 million and imports were $6,177 million. GNP of the US that year was $198,688 million. Thus, trade surplus was more than 5% of national income.
Suppose that there are three goods, 1, 2, and 3, so that k1 > k2 > k3.
Assume further that when trade is balanced, the US exports good 1 and imports 2 and 3. Then this trade pattern would be consistent with the HO theory.
Suppose now that the US is maintaining a large trade surplus. This trade surplus means that US consumers must reduce consumption of all three goods proportionately (due to homothetic preferences). In the presence of a large trade surplus, it is possible for the US to export the most labor-intensive good. That is, the US may export 1 and 3 and import 2.
In this case, the average capital-labor ratio of the exports (1 and 3) can be lower than that in imports and a Leontief paradox occurs.
Balanced Trade
Industries
ki
Production
Consumption
Export
1 2 400 200 2
00
2 1 50 200
-150
30.5
150 200-50
Trade Surplus
Industries
ki
Production
Consumption
Export
1 2400
100300
2 1 50 100-50
30.5
150
10050
If trade is not balanced, the HO theory does not predict the trade pattern.
kx = (300 K1 + 50K3)/(300 L1 + 50L3) > or < 1 = km = k2
Question Had trade been balanced in 1947, would the US
have exported capital-intensive goods and imported labor-intensive goods?
Among the 38 industries examined by Leontief, only three industries were importers in 1947. In the remaining 35 industries, the US was an exporter. Casas and Choi (1984) computed the trade pattern that would have prevailed had trade been balanced in 1947. They concluded that the US would have exported capital-intensive goods in the balanced trade situation. That is, US exports would have been more capital-intensive than US imports.
kx = $12,338 per man year
km = $11,231 per man year
References
Bharawaj, R., "Factor Proportions and the Structure of India-U.S. Trade," Indian Economic Journal, October 1962.Casas, François and E. Kwan Choi, "Trade Imbalance and the Leontief Paradox," Manchester School 52 (1984).Casas, François and E. Kwan Choi,"The Leontief Paradox: Continued or Resolved?" Journal of Political Economy 93 (1985)Wahl, D. F., "Capital and Labor Requirements for Canada's Foreign Trade," Canadian Journal of Economics and Political Science, August 1961.Stolper, Wolfgang F. and Karl Roskamp, "Input-Output Table for East Germany, with Applications to Foreign Trade." Bulletin of the Oxford Institute of Statistics, November 1961.Trefler, Daniel, "International Factor Price Differences: Leontief Was Right!," Journal of Political Economy 101 (1993), 961-87.
Optimally, a trade theory would help us explain or predict what nations export and import what goods with what other nations under which economic, geographic, and political circumstances, with what consequences.
This would allow us to predict and prescribe the content, direction, and size of multilateral trade flows.
MERCANTILISM 1500-1800
not a full-blown trade theory (see above); rather, an economic policy of governmental accumulation of wealth, in the form of gold bouillon for:
o domestic controlo investmento international expansion
reflects the era of nation-building and the shifting of European political power from feudal lords and the church to national sovereigns; also reflects and supports the principal source of wealth -- trading
The trade-policy implication of this economic policy was the generation of a national trade surplus, paid for by accumulation of gold reserves. Before fully developed financial systems, there was little international credit. Therefore, a current-account surplus was not matched by net capital outflow (net loans or investment overseas); rather, it was matched by a net inflow of gold to pay for the excess of goods exported from the country. Some of this gold found its way to overseas investment by the sovereign.
ABSOLUTE ADVANTAGE 1776: Adam Smith's The Wealth of Nations
Political and economic liberalism found their expression in Smith's argument that the wealth of nations depends upon the goods and services available to their citizens, rather than the gold reserves held by the sovereign.
Maximizing this availability depends, first, on putting all resources to use, and then, on the ability --
to obtain goods and services from where they are produced most cheaply (because of “natural” or “acquired” advantages), and
to pay for them by production of the goods and services produced most cheaply in the country, with costs measured in terms of direct and "embedded" labor inputs.
This principle fit the development of capitalist economies based on production via wage labor (rather than trading commodities for profit); reflects the manufacturing dominance of Britain; reflects manufacturing economies of scale based on:
- development of specialized equipment; - labor training and specialization; - long "runs" of one product.
These are sources of acquired advantage.
The consequent trade policy is relatively free trade, so that a country should import goods that would be produced more expensively internally, where expense is measured according to the labor theory of value. These imports are to be paid for by the production of goods that the country can produce with less use of labor per unit. Exports flow from the country that can produce a product most cheaply.
COMPARATIVE ADVANTAGE • 1817: David Ricardo's On the Principles of Political Economy and Taxation • The possibility of system-wide gains from trade persists, even when a given country has an absolute advantage in the production of no product. • Specialization and trade should occur according to the relative opportunity costs of production in each country, measured in terms of the alternative production given up to produce a tradable good.
Example:
resources required per unit output:
Tea Wheat
Sri Lanka 10 10
United States 5 4
The opportunity cost of tea in Sri Lanka is 1 unit wheat; the opportunity cost of tea in the US is 1.25 units wheat. Sri Lanka has comparative advantage in tea production, despite its absolute disadvantage in the production of each commodity.
To test for comparative advantage in the production of commodity A in a 2X2 model: for which country is the opportunity cost of A smaller -- which is to say, for which country is the ratio of resources required for a unit of A to the resources required for a unit of B smaller?
10/10 < 5/4, thus, the comparative advantage of Sri Lanka is commodity 1, tea. Although the US has an absolute advantage in the production of both tea and wheat, the US has a
comparative advantage only in the production of wheat. This is because its advantage in wheat is comparatively greater than its advantage in tea [Daniels and Radebaugh, 8th ed., p. 202].
• In Root's phrasing, "gainful trade will occur between countries when their pretrade relative price structures are different" [F.R. Root, 1990, International Trade and Investment, p.45].
How are the gains from trade divided between two trading partners? If xi refers to the domestic cost of producing x (a or b) within country i, and Ci/Cj refers to the exchange rate between currencies i and j (how many units of Currency i equals one unit of Currency j), then:
trade is gainful when ai/bi (the ratio of the costs of producing a and b in country i) is not equal to aj/bj (the ratio of the costs of producing a and b in country j)
if ai/bi < aj/bj, then i will export a and import b, so long as exchange rates allow: ai/aj < Ci/Cj < bi/bj (which is to say that the exchange rate is not so extreme as to wipe out the
differences in opportunity costs for each item across the two countries).
For example: US beef costs $10 in the US US cameras cost $20 in the US Japanese beef costs ¥5000 in Japan Japanese cameras cost ¥1000 in Japan · Without a common numeraire (such as labor-value), we don't know the absolute advantages. However, the relative values within the two countries, 1/2 and 5/1, tells us that the US comparative advantage is beef and the Japanese comparative advantage is cameras. Why? Because if costs are accurately measured, then the opportunity costs of beef (in terms of cameras foregone, since there are only two possible products) are lower in the US than in Japan: 1/2 a camera foregone in the US; 5 cameras foregone in Japan. · Despite this clear comparative advantage, trade will only occur if
10/5000 < $/¥ < 20/1000, which is the same as 0.002 < $/¥ < 0.02, which is the same as 1/500 < $/¥ < 1/50.
Q: What would make the dollar fall so much against the yen that a dollar would buy fewer than 50 yen, and this bilateral trade would end? (That is, in a world where neither currency was used for other international purposes, and where there was no monetary policy). A: Such a low Japanese demand for US beef and such a high American demand for Japanese cameras that the exchange rate fell this low.
This relative demand for products from trading partners, expressed via its effect on exchange rates, determines the division of gains from trade.
At $1 = ¥200, the US will import 2 cameras for each unit of beef it exports; this is 1.5 more cameras than it could make domestically in lieu of one unit of beef; the US gain from trade is 1.5 cameras per unit of beef.
At $1 = ¥183.33, the US will import 1.83 cameras for each unit of beef it exports; the gain from trade becomes 1.33 cameras per unit of beef.
At $1 = ¥120, the US will get $10 = ¥1200 for each unit of beef it exports to Japan; this would allow the US to import 1.2 cameras (at ¥1000 each); this is 0.7 more camera than the US could make domestically at the opportunity cost of 1 unit beef, so the US gains from trade is 0.7 camera/beef.
The equation below notes that the gains to country 1 from exporting commodity a is the amount of commodity b that can be imported from country 2 (per unit of commodity a that is exported) minus the cost of producing commodity a for export (expressed as the amount of commodity b that is foregone).
Simplified, country 1's gains from trade = G1 = (A1/B2)(C2/C1) - a1/b1
The first ratio (A1/B2) is the ratio of (i) the unit price that Country 1's exports fetch on the world market (in terms of Country 1's currency) to (ii) the unit price that Country 2's exports fetch on the world market (in its currency).
The second ratio (C2/C1)is the exchange rate: the "price" of the exporting country's currency, which (without capital or money markets) is also a measure of the relative demand for that country's exports.
The third ratio (a1/b1) is the opportunity cost of producing the exported product in the exporting country.
(A1/B2)(C2/C1) is what Country 1 can get in return for exporting a unit of a a1/b1 is what Country 1 gives up as it produces a unit of a So can you see why (A1/B2)(C2/C1) - a1/b1 is the "gains from trade"? Wait, ask yourself -- can
you see why?
Note, then, that G1 (the exporting country's gains from trade): increases with the relative unit price of Country 1's vs. Country 2's export items (this reflects
the global supply/demand balance for these items), increases with strength of the Country 1's currency, and decreases with the opportunity costs (in Country 1) of producing the exported item.
Let's run through the Japan/US example, above, using this formula. a1 = the cost of producing the US export item, beef, in the US = $10/beef. For now, let's assume that costs equal prices: a1 = A1 .
b2 = the cost of producing the Japanese export item, cameras, in Japan = ¥1000/camera. For now, let's assume that costs equal prices: b2 = B2 .
C2/C1 = the exchange rate, varied; let's take the example where it's ¥200/$1.
b1 = the cost of producing the alternative product, cameras, in the US = $20/camera.
Thus, our formula G1 = (A1/B2)(C2/C1) - a1/b1 suggests that the US gain from trade = ($10/beef / ¥1000/camera) (¥200/$1) - $10/beef / $20/camera = ($10/beef) (camera/¥1000) (¥200/$1) - ($10/beef) (camera/$20) = 2 cameras/beef - .5 camera/beef = 1.5 cameras/beef, or 1.5 cameras gained by the US in return for each unit of beef exported.
At the same time, Japan has a gain from this trade:(¥1000/camera / $10/beef) ($1 / ¥200) - ¥1000/camera / ¥5000/beef = (¥1000/camera) (beef/$10) ($1 / ¥200) - (¥1000/camera) (beef/¥5000) = .5 camera/beef - .2 camera/beef, or.3 unit of beef gained by Japan in return for each camera exported.
As you think about this, and view the graphs in the textbook (Figs. 6.2 and 6.3), you'll recognize that we're making some assumptions:
1. We assume that national production is on the production possibility frontier (PPF), with no un-used factors (e.g., no unemployment). If some available and relevant factors are not being used (e.g., labor unemployment in the export sector), then we can't clearly say that producing more of the export item would mean producing less of other items.
2. We assume that factors are homogeneous within a country (e.g., L is perfectly substitutable across individuals and across sectors), so that workers, capital, and resources not used in one sector can work in another.
3. To make the numerical example simpler, I've assumed that prices equal costs (including a standard rate of return to capital and entrepreneurship). That's not always the case: sometimes prices are much higher than costs (e.g., in a monopoly), and sometimes international prices are lower than domestic costs (that's called "dumping"). We can deal with this by recognizing that a1 might differ from A1 and b2 might differ from B2.
4. We've ignored transportation costs -- but we could implicitly include them in A1 and B2 in the first term of our gains-from-trade equation -- or we could add them in as a variable in the first term -- this would allow us to show what happens with transportation costs fall (e.g., with containerization) or rise (e.g., with higher fuel prices).
5. We assume that factor prices reflect the value of marginal product attributable to the factors. In reality, this is affected by the competitive structure of the industry (higher but declining in a monopolistic or oligopolistic industry), the nature of the factor markets (supply is restricted in the case of unionized L or the guild professions), and finally, wages/salaries are not solely determined by economic forces.
These are all problems with using traditional trade theory to understand and to prescribe trade flows in the current economy.
FACTOR PROPORTIONS 1935: Bertil Ohlin's Interregional and International Trade, based on earlier work by Eli Heckscher
What explains the differences in opportunity costs for producing the same product in different countries? Possibilities include skill or technology (including a preference for producing in different ways), availability of materials or resources, or the pricing of inputs.
Assuming: 1) mobile technology,
2) general preferences to use the best available methods, 3) perfect competition in domestic factor markets (which should push factor prices to reflect their opportunity costs), 4) input requirements that differ across different products, but 5) only one particular mix of inputs for each different product, and 5) immobility of factors, comparative advantage should depend on relative factor availability.
• "A country has a comparative advantage in the production of goods that use relatively large amounts of its abundant factors of production and a comparative disadvantage in the production of goods that use relatively large amounts of its scarce factors of production." Goods trade can be considered the indirect trade of factor services [Root, p.69]. --> What is meant by abundant and scarce? Measured by relative prices received by an additional unit of two factors, in one country versus that relationship in another country -- in other words, geography.
Complications: 1) heterogeneous factors -- of differing quality for specific production processes 2) substitution within a production function 3) raw-material extraction is based on absolute advantage
The principles of comparative advantage and factor proportions form the basis of the traditional, neoclassical theory of international trade. Note that this is a normative theory, in that it asks the question "If we had a goal of maximizing world production (the goods and services available to citizens of each country), how would we proceed?" If we assume that
resources (a.k.a. factors of production) are immobile, but that goods are mobile and technology is stable and ubiquitous,
then we maximize world production and the goods and services available to each country by using resources for the production of goods that face the lowest opportunity cost within each country, and trading the locally unneeded products for other goods, produced with the lowest opportunity cost for resources in other countries.
LEONTIEF PARADOX 1953: Wasily Leontief published "Domestic production and foreign trade: the American capital position re-examined" in Proceedings of the American Philosophical Society (v.97). 1956: Wasily Leontief published "Factor proportions and the structure of American trade: further theoretical and empirical analyses" in Review of Economics and Statistics (v.38):
Using data available from the 1947 input-output (I-O) model of the US economy, Leontief calculated the K and L requirements for the production of $1 million of US exports and $1 million of US production in import-competing industries. He found that the former required a higher proportion of L than the latter. [paraphrased from Hirsch, 1967: pp.8-9]. · explain I-O and how such a model could be used to identify export sectors (rows with large entries in the X column); L and K inputs; US imports from trade data
• The paradox: the US is considered K-rich, and US L was very expensive compared to L in other countries. Analogous results were found in Japan, which was then L-rich and K-poor, yet Japanese exports were more K-intensive than Japanese production in sectors that faced import competition.
Possible explanations of the Leontief paradox (see a similar exposition by E.K. Choi)
1. US demand for K-intensive products outstripped its capacity to provide them domestically. [No.]
2. "Factor-intensity reversal" — Leontief had no idea of the input mix for manufacturing in other countries; he measured the K-intensity of US production in import-competing industries, not of US imports. If L is expensive in the US, then US industries facing import competition would have to reduce their use of L, by substituting K. However, this would mean that production functions (i.e., input mix; technology) vary for the same products in different places, which renders the Heckscher-Ohlin theorem nearly useless. [Insufficient data, but this is a powerful argument for limiting empirical conclusions to the specifics of the data used].
3. Perhaps international trade flows were not rationalized according to comparative advantage in 1947, immediately after the destruction and disruption of WW2. After all, comparative advantage is a normative concept. [Empirically, a partial explanation, when nations' import restrictions were considered].
4. The US imported natural-resource commodities whose extraction is K-intensive, but in which other nations have an absolute advantage. [Empirically, a partial explanation; the paradox was more apparent in US bilateral trade with resources-rich countries (e.g., Canada), and was less strong when natural-resource sectors were excluded.]
5. "Human-skills theory" — L is a heterogeneous factor, and should be analyzed as separate factors according to skills levels. Perhaps the US is actually skilled- and technical-L rich, and therefore has a comparative advantage in production that requires much skilled or technical L. H-O formulations should be expanded to allow for more than one L factor. [Difficult to test, but can be added to the H-O theorem]. Related to this is the recognition of international differences in factor productivity. US labor is more productive than the labor of most countries (because of skills, work organization, capital/worker, and technology), and is paid more per hour; this helps explain why US labor looms larger as a cost in US exports.
6. Technology itself is a nation-specific factor of production, rather than being a universal attribute of production. Furthermore, technology is a factor that is produced within a given nation (much like a commodity), but is not perfectly mobile or tradable. This kind of thinking has led to "neo-technology theories of trade" (see below).
7. The US Government and private companies lent (or otherwise invested) so much capital in particular sectors of particular foreign economies, that these enclaves became, essentially, capital-rich. [Thanks, Mike, for this suggestion. Empirically, it probably doesn't play an important role in Leontief's 1947 data, but it (a) does conceptual damage to the factor-proportions theory because it implies that capital, a factor, is mobile, and (b) it presages the model of the international product life cycle, below].
PRODUCT LIFE CYCLE • Raymond Vernon, 1966, "International trade and investment in the product life cycle"
• Concepts of product cycles had been developed in industrial economics and in marketing since the 1920's. Vernon, however, became concerned with the technological bases for PLCs in the late 1950s. with his work on the New York Regional Plan. He later extended these concerns to the international realm. • Concerned with only certain products:
· manufactured goods (or services that can be produced remotely from consumption, like call centers) · income-elastic demand · L-saving in use
• His original formulation also assumed a ranking of nations by income and wage levels, with steadily rising income and wage levels of the ranked nations.
• Assumes that product innovation is market-led [define product versus process innovation; technology-push versus market-pull models of innovation]. • Assumes that process technology undergoes stages distinguished by labor-intensity, standardization, unit cost, and ability for technology to be embodied in capital equipment and standard operating procedures.
With these assumptions, Vernon built a story of these particular kinds of products facing 1) introduction in the highest-income, highest-wage country where the products found their first demand; production is small-scale, changing, expensive, and uses highly skilled L; demand is not very price-elastic, because of differentiation, and the nature of pioneering adopters 2) growth of demand and production in the original country, with declining costs and prices; some export demand from countries with lower incomes and wages — the high-wage, L-scarce country is exporting L-intensive products 3) maturity of demand in the original country, with standardized and increasingly K-intensive production; establishment of foreign operations in newer markets to serve them and to overcome real or threatened trade barriers 4) decline of product demand in the original country, with increasing competition from other suppliers and other products; the cost pressure and the ability to embody the technology in K equipment and SOP pushes production "offshore" to low-wage countries, using financial K and K equipment from the originating country — the high-wage, L-scarce country is importing K-intensive products, because the K and technology are mobile within the MNC, while the less-expensive L is not mobile.
This helps resolve the Leontief paradox by explaining, for a limited class of goods, US exports of these goods while they are L-intensive and import of these same goods when they are K-intensive.
However, this model differs from the Heckscher-Ohlin theorem:
technology changes over time, from L toward K; the mobility of technology changes over time standardized technology and financial K are mobile factors within the MNC
Today, of course, international differences in incomes and wages do not form a neat ranking, and improvements in communication make it easier to engage in new-product production anywhere within a MNC's global production network.
TECHNOLOGY AND TRADE The “new growth theory” and “new trade theory”: Romer, Krugman, Helpman: 1980s.See The Royal Swedish Academy of Sciences descriptions of Paul Krugman's contributions to trade theory and economic geography: general; technical.See two short videos on Paul Krugman and "new trade theory: (1) (2)
Six assumptions: 1) Technology is an explicit factor of production, but one that is itself produced with inputs of capital and labor (and thus endogenous to the model of growth). 2) However, the production of new technology reflects decreasing returns to the application of capital and labor (doubling the resources allocated to new technology does not immediately double the rate of technological advance). 3) The production of new technology creates externalities: all the benefits of new technology can't be appropriated by the entity (firm) that invests the resources to create the technology. 4) There are increasing returns to scale in the use of technology (a little technology goes a long way -- can be used to improve quality or reduce cost of infinite number of units). More generally, there are increasing returns (economies of scale) for the facility, organization (company), and country that specializes in a specific product.5) While technology is mobile (across companies and countries), there is imperfect mobility of the ability to use technology, based on localized investments in infrastructure, institutions, and labor.
6) Most importantly, says Krugman, is the assumption of increasing returns to scale (unit costs of production fall with increased scale of output). For advanced manufactures and for many services, this results in benefits from specialization (the more a company or country produces of a very specific item, the lower the opportunity costs of production). These benefits include the ability to use and reuse specialized technology, equipment, and even reputation, at little additional cost. This helps explain a country importing and exporting in the same industry -- the imports and exports can actually be different specific forms of the same type of product (automobiles, aircraft, financial services...).
Results: 1) To the extent that individual companies cannot appropriate all the returns to their investment in new technology (because of externalities in the development and deployment of technology),
companies may under-invest in technology (R&D) -- and are very likely to under-invest in "technology infrastructure" (e.g., education and communications). 2) A country may gain comparative advantage in a product because it was quick to gain economies of scale in that product. As a result, it can produce the product more efficiently, relative to other products, than can its trading partners -- not because of factor endowments, but because of the skilled labor, specialized infrastructure, networks of suppliers, and localized technology that have developed to support that industry.
3) With the additional assumption (which is empirically based) that purchasers benefit from a choice among similar products, we can see how more than one country might gain comparative advantage in similar products, based on (a) similar factor endowments and (b) economies of scale in the production of particular variants of the products. This helps explain the cross-trade in similar products, usually with national variations -- think of the typical variations among German, Japanese, Swedish, and US-based automobiles.
Policy implications:Thus, there may be a role in government support of technology, via measures such as
o R&D tax creditso trade policy to support key, technology-improving sectorso "technology infrastructure"
1980s: strategic trade policy (industrial policy) based on differential technological linkages among sectors (some sectors lead to development of skills, infrastructure, and institutions that foster further innovation across a range of related industries) c.f. the importance that Porter places on “related and supporting industries” to national competitiveness.
SUMMARY: NO ALL-PURPOSE THEORYThis may all seem bewildering, but so is the prospect of trying to predict and/or prescribe the myriad international trade flows. Trade in different products is likely to be best interpreted by different models, as I implied when I noted the characteristics of "product-cycle" goods. Here's a stab at such a typology:
TRADABLE PRODUCT APPROPRIATE TRADE MODEL
BASIS FOR EXPORT CAPABILITY
extracted resources absolute advantage (1) natural advantage: is the resource available, and can it be extracted and transported at reasonable cost?(2) K availability for extraction
region-specific goods and services (products such as Champagne or Roquefort, services such as
absolute advantage (1) natural advantage
tourism requiring luxury hotels on sunny, warm white-sand beaches)
(2) K availability(3) trademarking and reputation
commodity goods and services (agricultural products, basic manufactures)
comparative advantage
(1) "factor proportions": factor intensity of production and factor endowments of countries(2) scale economies
innovative products or services with income-elastic demand
product life cycle (1) innovative capacity in early stages(2) standardized technology, K availability, scale economies in later stages
ideas, innovation or technology itself new trade theory sustained application of resources (risk K, highly skilled L) toward creation of new technology or ideas
What trade or development policies are implied by a desire to promote these different types of export capabilities?
TRADE TRAPS Specialization and trade according to comparative advantage may maximize world production, but under some circumstances it may not lead to increased wealth and living standards in poorer countries. Two of these "trade traps":
IMMISERATING TRADE (concept developed by Jagdish Baghwati): If a country's imports depend on its export of basic, raw commodities, the country may face an inability to increase export earnings for three reasons, each related to the first term in our "gains from trade" model, above:
1. Raising prices will reduce demand by a greater proportion (because most raw commodities can be accessed from other countries, and because most raw commodities have substitutes)
2. Lowering prices will not increase demand by an equal proportion (because world demand for many commodities does not increase substantially because of a price decline: think about world demand for copper)
3. As the world economy increases, the world demand for many raw commodities increases at a slower rate (demand is income inelastic).
OVER-ABUNDANCE OF POTENTIAL LABOR: If the supply of labor is limited, then an increase in labor demand (e.g., because of export growth) will yield an increase in wages (and if the general price level doesn't rise as fast because productivity is increasing, real wages and living standards will rise). However, some countries have a seemingly inexhaustible supply of additional labor, because of a slow but steady shift of people from subsistence or agricultural activity to an industrial labor force. Thus, export increases may increase national income but not wage levels -- leaving little incentive for businesses to increase labor productivity.
copyright James W. Harrington, Jr. revised 26 October 2010
