International Trade and Economic Growth

1. International Trade and Economic Growth The international trading system...has enhanced competition and nurtured what Joseph Schumpeter a number of decades ago called “creative destruction,” the continuous scrapping of old technologies to make way for the new. (Alan Greenspan, 2001)

2. The Goals of this Chapter • Extend the analysis of trade beyond the traditional static models of international trade and analyze the relationship between international trade and economic growth. • Show how the power of compounding makes international trade’s effect on economic growth much more important for human welfare than the static gains in welfare. • Familiarize students with the recent statistical evidence on the relationship between trade and economic growth. • Introduce the Solow growth model and use it show how international trade affects economic growth when investment is subject to diminishing returns and depreciation. • Explain the Schumpeterian model of technological progress and use it to show how international trade affects the determinants of long-run technological progress.

3. Trade and Growth Achieve Similar Gains in Welfare • Trade and growth both enable the economy to reach a higher indifference curve. • Trade leads to a new consumption point at C. • Growth leads to a new consumption point at D. • Both points lie on the same higher indifference curve.

6. An economy with the red production possibilities frontier can reach the indifference curve I2 with trade. • However, it takes continued growth (a large shift in the indifference curve) to reach the much higher level of welfare given by I20. • Can trade help stimulate such economic growth?

10. The Power of Compounding If per capita real GDP (PCGDP) grows at an annual rate of R, then after T years PCGDP will be: PCGDPT = PCGDPt=0(1 + R)T (5-1)

11. The Power of Compounding For a country with a per capita real GDP of $2,000, a 2.5 percent annual growth rate implies that in 10 years per capita real GDP will grow to: PCGDPt=10 = $2000(1 + .025)10 = $2,560

12. The Power of Compounding Suppose that another country grows a little faster at 3.5 percent per year. After ten years, this economy’s per capita real GDP will be: PCGDPT=10 = $2000(1 + .035)10 = $2,821 After ten years, a difference of 1% per year causes a per capita income difference greater than 10%.

13. The Power of Compounding Two countries that grow at 2.5 percent and 3.5 percent, respectively, for 100 years will find their standards of living growing far apart: PCGDPT=100 = $2000(1 + .025)100 = $23,627 PCGDPT=100 = $2000(1 + .035)100 = $62,383 The power of compounding is great.

14. The statistical analysis of the relationship between international trade and economic growth shows that: !International trade is closely and positively related to economic growth. !The potential size of trade’s “growth effect” is large. Statistical analysis thus suggests that international trade is very important for future human welfare.

15. Production function Y = f(K,L) with diminishing returns. • If labor supply is fixed, then the function can be written as Y = f(K). • Diminishing returns implies a decreasing slope; each additional unit of capital adds less to output than the previous unit

16. Solow assumes that the saving rate is constant and between 0 and 1. • The saving function is a reduced image of the production (income) function. • The saving function depends on the production function and the saving rate.

17. Depreciation is assumed to be a constant fraction  of the stock of capital K. • Thus, depreciation is a straight-line function of K.

18. Saving and investment are equal where the depreciation line and the savings function intersect. • In equilibrium, a capital stock of K* results in output Y* = f(K*). • K* and Y* are referred to as the steady state levels of capital and output/income.

19. The steady state level of K* is a stable equilibrium. • If K < K*, investment exceeds depreciation and K grows. • If K > K*, depreciation exceeds investment and K shrinks.

20. The Solow model depicts an economy with a stable equilibrium. • Output/income depends on the rate of saving, the rate of depreciation, and the shape of the production function.

22. The static gain from trade raises the production function, which raises output to Y’ = g(K*). • Given a constant saving rate, the saving function shifts up proportionately to the production function. • Trade therefore leads to transitional growth as the economy adjusts to a new steady state equilibrium at K** and Y** = g(K**).

23. Technological progress raises the production function • Technological progress neutralizes diminishing returns; output doubles when the capital stock is doubled, as from a to b • Without technological progress, the increase in capital from 1 to 2 would only take the economy to point c, where output rises by only 40%

25. Trade and Growth • International trade seems to produce only temporary growth according to the Solow model. • Indeed, the Solow model suggests that continued economic growth is not possible without technological progress. • Hence, for trade to raise standards of living in the long run, it must influence technological progress.

26. The statistical analysis of the relationship between international trade and economic growth shows that: • International trade is closely and positively related to economic growth. • The potential size of trade’s “growth effect” is large. The statistical analysis thus strongly suggests that international trade is very important for future human welfare.

27. The statistical evidence on trade and growth is not entirely convincing, however: • Statistical studies cannot provide definitive proof that international trade causes economic growth. • It is difficult for statistical procedures and the available data to accurately distinguish between the effects of trade and those of the other factors. • Statistical research has not yet distinguished why trade and growth are positively related. For further insights, we need logical reasoning and consistent models that can explain the statistical relationship between trade and growth.

28. The Solow Model and Technological Progress • The Solow growth model shows that for a given production function economic growth will eventually stop when the economy reaches its steady state. • Continued economic growth is only possible if the production function continually shifts up, which requires continued technological progress. • The Solow model highlights the importance of technological progress, but it does not explain what determines technological change. • Several insightful models of models of technological progress have been developed to complement the Solow growth model.

29. Many studies of industrial productivity have noted that unit costs tend to decline in proportion to accumulated experience. • This process is often referred to as learning by doing. • The learning curve depicts the learning process, but it does not explain its causes.

30. The Schumpeterian Model of Technological Progress In Schumpeterian innovation models R&D activity depends on: !The productivity with which R&D activity generates innovations. !The costs of acquiring the resources to carry out R&D activities. !The benefits that entrepreneurs expect to reap from an innovation. The first two items above determine the costs of innovation. The latter item reflects the gains from innovation. The equilibrium level of R&D activity is found by maximizing benefits subject to the costs of innovation.

31. The quantity of innovations depends on the quantity of resources applied to R&D activity and the productivity of R&D activity. • Defining q as the quantity of innovations, $ as the quantity of resources per innovation, and RR&D as the resources applied to innovation, then: q = 1/$(RR&D).

32. The cost of innovation (CoI) depends on the cost of resources and the productivity of R&D activity • The cost of resources depends on total resources R and the demand by innovators RR&D • Therefore: CoI = h(RR&D, R, $).

33. The present value of innovation (PVI) depends on the size of the profit box B and on how long a successful innovator enjoys its monopoly position. • The life of a monopoly is the inverse of the number of innovations per year, q. • Expected profit from an innovation is equal to B/q = B/[RR&D / $] = B$ / RR&D.

34. PVI is a negative function of the rate of interest with which future profit is discounted, r, and the amount of resources employed in R&D activity RR&D.. • PVI is a positive function of the profit markup B and the resource requirements in R&D activity, $. • The present value of innovation is: PVI = f( B, r, RR&D, $ ).

35. The intersection of the CoI and PVI curves determines the amount of resources devoted to R&D activity, RR&D. • The curve 1/$ in the bottom half of the figure relates the amount of resources to the expected number of actual innovations.

36. An increase in B shifts the PVI curve upward to PVI1, and, all other things equal, the number of resources devoted to innovative activity increases. • The increase in RR&D in turn raises the number of innovations per year from q to q1.

37. An increase in R lowers the cost of resources. • The lowering of resource costs imply a downward shift in the CoI curve, say to CoI1. • This causes profit-motivated entrepreneurs to employ more resources in R&D, which increases the number of innovations q.

38. A change in $ is complex because it affects all curves. • An increase in $ rotates the 1/$ line counterclockwise. • An increase in $ implies that R&D activity requires more costly resources, which shifts the CoI curve up. • The PVI curve also shifts up because creative destruction slows when it becomes harder to innovate, which makes each innovation that does occur more profitable.

39. The number of innovations per year is determined by the function: + ! + !q = f( B, r, R, $ ) All other things equal, innovation in the economy will be greater: ! The larger is the potential profit for the successful innovator; ! The more innovators value future gains relative to current costs; ! The greater is the supply of resources available to innovators; ! The more efficiently innovators use resources in R&D activity.

40. How Trade Influences Technological Progress • For example, integrating two identical economies through trade doubles the market, effectively shifting the demand curve from D to Dt. • The marginal revenue curve also shifts, doubling the equilibrium quantity. • This doubles the potential profit accruing to innovators from B to 2B.

41. How Trade Influences Technological Progress • The doubling of the profit area, all other things equal, shifts the PVI curve up. • The amount of resources that profit-seeking innovators apply to R&D activity expands, and the number of innovations rises.

42. How Trade Influences Technological Progress • The supply of resources in the combined economy is doubled, making more resources available to innovators. • The CoI curve slopes up less steeply because the price of resources rises less rapidly. • This expands R&D activity and innovation further.

43. How Trade Influences Technological Progress • Trade and specialization furthermore improves the allocation of resources, thus increasing the effectivestock of resources. • An effective increase in R lowers the CoI curve. • This efficiency of resource use is in addition to profit and resource effects already described.

44. How Trade Influences Technological Progress • Finally, comparative advantage also applies to innovative activity. • The improvement in the overall productivity of innovation decreases $ • A decrease in $ shifts all three curves. • Shifts in CoI and PVI are likely to cancel each other out, but 1/$ also shifts out, likely causing an overall increase in innovation.