Chapter 5

1. Chapter 5 Beyond Comparative Advantage

2. Chapter Objectives • Explain why many countries import the same goods they export • Analyze the development of regional clusters of production of many exported goods and services • Examine some preliminary arguments for trade activism.

3. Introduction • Problems with models of trade based exclusively on comparative advantage: • Perform relatively poorly in empirical application; • In particular, they don’t provide a completely compelling account of intra-industry trade. • Besides, countries often seek to alter their comparative advantages through industrial policies • While competitive models provide useful warnings about such policies; • Restricting ourselves to such models makes it difficult to enter certain kinds of policy discussion.

4. Intra-Industry Trade • Inter-Industry trade– international trade of products between two different industries (steel-for-bread) • Intra-Industry trade– international trade of products made within the same industry (steel-for-steel, bread-for-bread)

5. Measuring Intra-Industry Trade:The Grubel-Lloyd Index • Grubel-Lloyd (GL) index– Divide IITj by total trade in j (TTj = Xj + Mj) to get: • Xj = Mj→ GLj= 1, all trade is IIT; • Xjor Mj = 0 → GLj= 0, all trade is inter-industry.

6. Problems in Evaluating IIT • Categorical Aggregation • IIT is a statistical phenomenon, reflecting the fact that trade data are collected at some level of aggregation, but • We are interested in its implications for the theory of international trade. • Thus, we implicitly assume that these are technologically identical goods, but • It is entirely possible that some component of measured IIT is just trade in different goods that fall in the same category. • Trade Imbalance

7. Magnitude of IIT • IIT is a growing share of total trade • Across sectors, for the US IIT is greatest in industries that we would think of as comparative advantage industries.

8. Average Level of IIT:US, Selected Industries, 1993

9. Average Levels of IIT:By Country, By Year

11. Magnitude of IIT (continued) • IIT is a growing share of total trade • Across sectors, for the US IIT is greatest in industries that we would think of as comparative advantage industries. • IIT is most prevalent in trade between industrial countries, but • N-S IIT is not insignificant (though not clear how to interpret N-S IIT).

12. Explaining Intra-Industry Trade, 1: Perfectly Competitive Markets • No Puzzle: Pure Categorical Aggregation • As an empirical matter, IIT does fall with disaggregation. • HOS Intra-Industry Trade • Technology differences • m < n (“flats”→ specialization), similar factor-intensities • Many countries

13. Explaining Intra-Industry Trade, 2: Oligopoly & Reciprocal Dumping, A • Suppose that there is a national monopolist in each of two countries. • Suppose that the firms produce an identical product (say, automobiles). • Suppose that the opportunity to trade involves paying a transportation cost to reach the other market. • The opportunity to trade will lead each national monopolist to enter the other’s market. • Since each monopolist is pricing above marginal cost, each observes profit opportunity in the other market.

14. Explaining Intra-Industry Trade, 2: Oligopoly & Reciprocal Dumping, B • As long as the oligopoly price, taking transportation cost into account yields a profit, both firms will enter the other’s market. • The transportation cost will mean the foreign firm in each market will have a lower market share; but • There will be intra-industry trade in identical products. • Due to transportation costs, trade is strictly wasteful; but • Since the competition lowers prices to consumers, there are gains from trade.

15. Explaining Intra-Industry Trade, 3: The Linder Hypothesis • Staffan Burenstam Linder (1961) developed a preference based account of intra-industry trade: • Certain goods in every country are produced according to local tastes; • Similarity in per capita income yields similarity in taste (at least for non-standard goods); • As a result, trade in these national varieties will occur, and that trade will be greatest between countries at similar levels of development • Empirical work based on the gravity equation seems consistent with this account

16. Explaining Intra-Industry Trade: 4, The Gravity Equation, A • This econometric model explains the bilateral trade between countries in terms of their GNPs (Γ) and the distance between them (D): • Why “gravity”? • Newton’s law of gravitation: the attraction between two heavenly bodies is proportional to the product of their masses (i.e. GNPs) and inversely related to their distances.

17. Explaining Intra-Industry Trade: 4, The Gravity Equation, B • The gravity equation is usually estimated in log-linear form as: • This is usually extended by including: • Cultural distance (e.g. common language); • Historical factors, e.g. common empire; • Political factors, e.g. common currency or customs area • Geographical factors like common border.

18. Explaining Intra-Industry Trade: 4, The Gravity Equation, C • Characteristic Results: • Two countries with large GNPs trade a lot (as predicted by Linder); • Distance is important; • Borders are important (i.e. there is a Home Market Bias); • At a more disaggregated level, there is some evidence that intra-industry trade is greater in differentiated, rather than standard, products.

19. Explaining Intra-Industry Trade, 5: Monopolistic Competition, A • A somewhat more formal version of Linder’s approach is based on monopolistic competition • Products are differentiated in some way; • Consumers have a preference for variety; and • There are internal economies of scale in producing any given variety. • The increasing returns to scale in production of varieties means that a single firm, in a single location, will produce each variety.

20. Explaining Intra-Industry Trade, 5: Monopolistic Competition, B • Under autarky, each country produces and consumes its own varieties. • Opening to trade gives a country access to more varieties: • Even identical countries will now trade, in fact, there will be pure IIT. • Countries which differ in endowments will have: • Inter-industry trade based on endowments; and • Intra-Industry trade based on the preference for variety.

21. Explaining Intra-Industry Trade, 5: Monopolistic Competition, C • The intra-industry trade creates additional sources of gain from trade: • Lower prices for consumers: If existing producers increase output, their average costs will fall, and monopolistic competition ensures that this will lead to lower prices; and • Increased varieties: which directly increase welfare.

22. Explaining Intra-Industry Trade, 5: Monopolistic Competition, D • We have been considering trade in varieties of consumer goods, but a large share of trade is in differentiated intermediate goods • The equivalent of a preference for variety is increased division of labor yielding macroeconomic (external) economies of scale. • Adam Smith: Division of labor limited by the extent of the market; • Allyn Young: Greater roundaboutness in production; • Formalized by Wilfred Ethier.

23. Explaining Intra-Industry Trade, 5: Monopolistic Competition, E • Models including both a HOS and a monopolistic competition basis for trade perform quite well empirically. • Whether monopolistic competition is based on preference for variety or division of labor, there are additional sources of gains from trade. • However, it should be noted that, especially with trade based on monopolistically competitive division of labor, the external economies of scale permit: • Gains from an active trade policy; and • Potential losses from trade

24. IIT and Economic Adjustment • It has been widely hypothesized that increases in IIT cause less pressure for adjustment than an equivalent increase in inter-industry trade. • This is an empirically plausible hypothesis • Informal evidence seems broadly supportive, but • Systematic empirical evidence is very weak, and • Recent research suggests that the theoretical foundations of this claim are rather weak as well.

25. Trade and Geography, 1 • Research on international trade has long had direct connections with economic geography. • Ohlin in particular was well-aware of the links • Northern European economic geographers were interested in international trade. • What is distinctive about contemporary work is an interest in the endogenous emergence of economic structure. • In particular, endogenous agglomeration is a central interest.

26. Trade and Geography, 2 • Endogenous agglomeration emerges in the interaction of: • Internal economies of scale (in varieties); • External (macroeconomic) economies of scale, and • Frictional costs (tariffs, transportation, etc.)

27. Trade and Geography, 3 • Endogenous Cores and Peripheries • Over time, frictional costs have fallen from very high to very low. • In the very high frictional cost regime, economic activity was relatively evenly spread in space; • As costs fell, local agglomerations arose to take advantage of economies of scale; but • As costs fall further, peripheries rise at the expense of cores in response to diseconomies.

28. Justifying Trade Policy: Two Dimensions • Economic v. Noneconomic justifications: • Economic justifications for policy intervention emphasize the capacity for such intervention to improve the efficiency of the market. • This implies that there is some distortion that causes the market equilibrium under free competition to diverge from the socially optimal outcome • Non-economic justifications for policy intervention are related to goals other than economic efficiency that might be pursued via intervention in the economy.

29. Justifying Trade Policy: Two Dimensions (continued) • First-best v. Second (nth)-best justifications: • An argument which demonstrates that trade intervention is the best (i.e. most efficient) way to achieve a policy goal (economic or non-economic) is a "first-best" argument for trade intervention • An argument which demonstrates that, although it is not first-best, trade intervention can achieve a particular policy goal and raise welfare is a second-best (or nth-best) argument for intervention.

30. Theory of Policy, 1:Identifying the Distortion • What is a “distortion”? • An undistorted small economy is characterized by: • In a distorted economy, at least one of these equalities fails to hold • Some examples of distortions: • Production Externalities: MRSij= p≠ MRTij; • Domestic Monopoly: MRSij≠ p= MRTij; • Non-Operation on PPF: factor market distortion

31. Theory of Policy, 2:Comparing Policy Instruments • Tariffs and Tax-cum-subsidy Policies • The effects of a tariff can be replicated by a production subsidy and a consumption tax at the same ad valorem rate; • The effects of an export subsidy can be replicated by a production tax and a consumption subsidy at the same ad valorem rate. • This means that the production and consumption effects of a tariff can be separated. • Lerner Symmetry Theorem: An import tariff and an export tax, at the same ad valorem rate, have equivalent economic effects.

32. Theory of Policy 3:Instrument Ranking • Theorem: When responding to distortions in the economy, the policy interventions that do this may be welfare ranked. • Theorem: When responding to distortions in the economy, the optimal (least cost) method of doing this is to choose the intervention that operates most directly on the relevant distortion.

33. A Typology of Arguments for an Active Trade Policy

34. International Oligopoly and Strategic Trade Policy, 1 • We have already considered international oligopoly as a possible explanation for intra-industry trade, now we consider it as a justification for strategic trade policy. • Consider the following simple model • Symmetric national monopolists in each of two countries (i.e. a global oligopoly). • Contra the text, suppose constant returns to scale. • The oligopolistic good is only exported to a third market (i.e. no consumption in the home markets).

35. International Oligopoly and Strategic Trade Policy, 2 • In this framework, it is straightforward to show that an export subsidy transfers profits from the Foreign oligopolist to the Home oligopolist. • This is usually called a rent shifting argument for trade policy; • The gain in profit can be shown to exceed the cost of the subsidy and, because there is no home consumption, there is no consumption effect to consider. • This is a first-best policy from a national point of view.

36. International Oligopoly and Strategic Trade Policy, 3 • Consider the following simple version of the above model in which: • Two firms • An incumbent: Canada’s Bombardier; and • A potential entrant: Brazil’s Embraer. • If Embraer enters the market and Bombardier stays, both will lose 10; • If only one firms produces, that firm will earn a profit of 25. • Non-Cooperative game under Nash equilibrium

37. International Oligopoly and Strategic Trade Policy, 4

38. International Oligopoly and Strategic Trade Policy, 5

39. International Oligopoly and Strategic Trade Policy, 6 • The previous analysis argues for an export subsidy. • If we suppose that both firms compete in the Home market, there is now a strategic trade policy justification for a tariff on imports: • A tariff will shift rents from the Foreign to the Home firm; but • If there are increasing returns to scale in production, a tariff will even function as export support. • Increased output allows the Home firm to reduce average costs • This makes the Home firm more competitive in export markets • We now need to take into account the effect on Home consumers.

40. International Oligopoly and Strategic Trade Policy, 7 • Effect on Consumers • In most cases home consumers will consume the good • As a result, consumption effects need to be included in the policy calculation. • Informational problems • Firms have the relevant information, but • They have an incentive to lie. • With too big a subsidy, there is not national gain (though of course the firm gains). • National Oligopoly: Tradeoff between intra-national and inter-national externalities • General equilibrium effects: Subsidies to one industry will draw resources from other industries

41. International Oligopoly and Strategic Trade Policy, 8 • Very few industries satisfy the—rather stringent—conditions required for a successful strategic trade policy. • A wide variety of industries have been studied. • The only obvious case where such policy can be successful is in aerospace. • In the other cases, this ends up looking like a fancy argument for a corporate handout. • In cases like aerospace the potential for trade war is large. (what determines order of moves?) • As a result, interest in this sort of argument seems to have waned.

42. External Economies of Scale, 1 • Externalities (“spillovers”) exist when utility functions or production functions are characterized by interdependence. • Interindustrial externalities: production in one industry affects production in another y1 = f1(K1,L1) and y2 = f2(K2,L2; y1) • Intraindustrial externalities: output by one firm in a sector increases productivity of all firms in the sector. y1 = f 1(K1,L1; y1) and y2 = f2(K2,L2).

43. External Economies of Scale, 2 • Externalities may be positive or negative • Negative externalities: spillovers reduce productivity—e.g. pollution. • Positive externalities: spillovers increase productivity—e.g. worker training, learning, etc. • From an efficiency point of view, positive (negative) externalities will generally be under (over) –priced, and under (over) –produced. • That is, externalities are an example of market failure: That is, the market fails to deliver the optimal quantity of output. • In this case, there is a divergence between private and social returns to activity in the sector with the production externality.

44. External Economies of Scale, 3 • For concreteness, suppose that sector S produces a positive externality • This means that the market undervalues output from sector S • This, in turn, means that too little of good S is produced • The optimal response is to subsidize output of the S sector.

45. External Economies of Scale: 4

46. External Economies of Scale: 5

47. Trade and External Economies of Scale • Geographical concentration may be self-reinforcing: an initial small move toward clustering may cause a chain reaction, resulting in industrial agglomeration • Examples: Aerospace manufacturing firms in Seattle and Southern California regions. • If the possession of the IRS sector yields higher national income, there may be benefits from an active industrial policy.

48. Industrial Policy • Industrial policy– a government’s policy designed to create new industries or support existing industries • Industrial policies seek to alter the country´s comparative advantage by picking winners and losers • To the extent that there will be winners and losers, such policy might well produce trade conflict among countries.

49. Industrial Policy and Market Failure • Market failure is a major justification for industrial policies • Knowledge spillover, for example, is cited as a reason for industrial policies: a certain industry can spread knowledge about new products and processes, making social returns greater than private returns • Similar spillovers occur in research and development (R&D) • Actually proving the existence of market failures in specific cases has proved quite difficult.

50. Industrial Policy Tools • Uruguay Round and WTO prohibit subsidies for competitive policies • However, governments can use other policies: providing information about foreign markets to domestic firms, helping negotiate contracts, lobbying foreign governments to adopt home country standards, or tying foreign aid to purchases from domestic firms