Basic trade theory needed for policy analysis

1. Basic trade theory needed for policy analysis November 5, 2007

2. Objectives of this set of lectures • Provide an overview of reasons for trade. • Explain “opportunity cost” • Explain comparative advantage and absolute advantage • Discuss three sources of comparative advantage: differences in (i) technology, (ii) factor endowments, and (iii) institutions. • Introduce “Theory of the second best”. • Introduce the “Principle of Targeting”

3. Why do countries trade? • Because they are different: i) Different relative labor productivity across sectors. ii) Different relative endowments of inputs (e.g., capital, labor, natural resources) iii) Different institutions (e.g. property rights) and different laws (e.g. environmental protection)

4. A caveat • Similarities across countries can also promote trade. • Volume of trade amongst “similar” countries is greater than volume amongst “very different” countries. • “Intra-industry trade” (e.g. importing and exporting autos) takes advantage of specialization and decreasing average costs. • Similar countries may also benefit from being part of a network of production.

5. Nevertheless…. • “Differences” rather than “similarities” are probably a more fundamental reason for trade, and are certainly more important for North-South trade. • Differences are the basis for comparative advantage. • A country’s comparative advantage depends on its “opportunity costs”

6. What are opportunity costs? • The opportunity cost of any action is the value of the best alternative to that action: it is what you give up in order to perform the action. • Ricardo-like example: Table shows amount of labor needed in each country to produce food or cloth

7. Absolute vs. Comparative Advantage (CA) • In example in previous slide, US has absolute advantage in both sectors • US opportunity cost of one unit of food is one unit of cloth • Canada’s opportunity cost of one unit of food is ½ unit of cloth. • Canada has lower opportunity cost (compared to US) in production of food, Therefore Canada has comparativeadvantage in production of food. • US has lower opportunity cost = comparative advantage in production of cloth • Comparative advantage results from difference, across countries, in relative productivity between sectors. • Pattern of trade driven by CA, not by absolute advantage. • See online lecture notes “Ricardian Model” for more details

8. Compare two examples • Example on the right: opportunity cost of food is the same in both countries. Neither country has a CA in production of either commodity. These countries do not benefit from trade. This is a “knife-edge” example, since a perturbation of any of the four parameters eliminates the equality (across countries) of relative labor requirements in the two sectors.

9. Factor endowments: Another source of CA Heckscher-Ohlin-Samuelson (HOS) model • Stick with two-country two-commodity example. Food and cloth production both require capital and labor (K,L). The countries have the same technologies, but different aggregate capital/labor ratios. • Suppose the K/L ratio higher in cloth sector than in the food sector: cloth is more “capital intensive” than food. • Suppose that US aggregate capital/labor ratio is higher than Canada’s: the US is relatively well endowed in capital and Canada is relatively well endowed in labor. • Under additional technical assumptions this difference in relative factor endowments implies that US has lower opportunity cost in cloth production. US therefore has comparative advantage in cloth production. Canada has CA in food. • In general, a country has the comparative advantage in the commodity that uses relatively intensively the factor in which the country is relatively abundant.

10. A third source of comparative advantage • Suppose that two countries are identical with respect to relative endowments and technology. • Only difference is that one country has weak environmental laws. • If food production is “relatively environment-intensive”, country with weak laws has an (apparent) CA in food production.

11. What does it mean to say that the “country” gains from trade? • It can only means that the citizens (or inhabitants), possibly including those living in the future, gain. But in general some people gain and some lose from any policy change. • We say that the “country” gains if trade liberalization increases “efficiency”, by which we mean that the gain for winners is great enough to compensate the loss for losers, leaving both groups better off. • Many people think that this criterion is not useful, because in practice the losers are seldom compensated (although policies such as Trade Adjustment Act(s) are an attempt to do just that).

12. Who are the winners and who are the losers (from trade liberalization) within a country? • Remember the partial equilibrium story – where we have producers, consumers and tax payers. This model is useful because it shows that there are winners and losers from a policy change, but the model is unsatisfactory because many people are in all three groups. • An alternative model recognizes that people rent their “factors of production”, i.e. their land, labor and capital, and get utility from consumption. • With this approach, we ask how a policy reform (such as trade liberalization) affects owners of different factors (e.g., capitalists or workers). • Of course, many people own both kinds of factors, e.g. workers own capital through their savings/retirement funds.

13. How do we measure welfare gains? (One possibility) • Suppose that you own one unit of labor, which you sell for $w, so your income is $w. You face prices pc and pf for cloth and food. • For simplicity, suppose that you consume food and cloth in fixed proportions: each consumption bundle consists of “a” units of cloth and “b” units of food, so a consumption bundle costs axpc + bxpf. You can afford to buy n = (axpc+bxpf)/w bundles with your income. • A policy change (e.g. trade liberalization) changes w and prices – since these are related. • Welfare increases (in this example) only if n, the number of bundles you can buy, increases.

14. Welfare gains from trade: comparison of Ricardian and H-O-S models • In Ricardian model, there is only one factor of production, labor. Trade always increases worker’s welfare (provided that prices under trade and under autarky are different). • In HOS model, trade always increases one agent’s (either the owner of capital or labor) welfare and decreases the welfare of the owner of the other factor. Thus, there is no sense in which “trade makes everyone better off”. • (Remember, for this discussion we have no market failures, or other “distortions” in the economy.)

15. When do “countries” gain from trade? • Recall that a country exports the commodity for which it has a CA. • Absent market failures, both countries gain from trade. (Recall the sense in which I use the expression “the country gains”; see earlier slide.) • Where trade is driven by differences in relative productivity or in relative factor endowments, “the country” gains from trade. • If trade is driven by differences in policies (e.g. different environmental laws) a country might gain or lose from trade.

16. What determines whether country gains or loses from trade in third case? • In the example where trade is driven by a difference in environmental laws, we need to ask what is the reason for this difference. • Are these the result of a market (or political) failure, or are the weak laws “socially efficient”? • Problem with my example: I assumed otherwise identical countries, so hard to explain reason for difference in environmental laws. • In the real world, these laws are “endogenous”.

17. A slightly more realistic example • Suppose that two countries have “usual” differences (technology, relative factor endowments) in addition to differences in (e.g. environmental) laws or institutions. • Two cases: • Environmental laws set at socially optimal level in both countries: MB(pollution)=MC(pollution). The policy could be different in these two countries because they have different MB or MC curves. • These laws are too lax (e.g. because the government is corrupt or inefficient) in only one country. In this country, MB(pollution)<MC(pollution)

18. Does trade improve welfare in both countries? • In case (i), the answer is YES. The fact that the environmental policies are different is irrelevant to the gains from trade, because the difference in policies is efficient. • In case (ii), the country with the efficient environmental policy definitely gains from trade, but the country with the inefficient policy might either gain or lose from trade. • In general, suppose we begin with a trade restriction and too-lax environmental laws. Think of these as two “distortions”. In this language, a “distortion” is anything that keeps the market economy from being at the first-best equilibrium.

19. Theory of the second best (TSB) • TSB: If there are two (or more) distortions, correcting one distortion might either increase or decrease social welfare. • In case (ii), there are 2 distortions (the trade restriction and the insufficiently strict environmental regulation). Removing (or reducing) the trade restriction has ambiguous welfare effects. • In general, removing one distortion (trade restriction) might worsen the effect of the other distortion (weak environmental laws).

20. More on TSB • In an economy “things are interconnected”. • e.g. a subsidy on fertilizer affects food production, which (possibly) affects food prices and wages and income and demand for other goods, and their prices…and (possibly) the environment. • Since “everything affects everything”, the (good and bad) consequences of policies are inter-related. • A trade reform (e.g. liberalization) can alter the effect of environmental policy. In particular, it is possible that trade liberalization might exacerbate (“make worse”) an inefficient environmental policy. • In the real world, every economy has multiple distortions, so the theory of the second best is almost always applicable. Therefore in the real world (as distinct from an economics textbook, where the author is free to make any assumptions), there is rarely a watertight theoretical basis for conclusions such as “trade liberalization increases economic efficiency (or welfare)”. The welfare effect of the trade reform depends on the specific context in which the trade reform (or other policy change) occurs.

21. The Principle of Targeting • The Principal of Targeting says that a “distortion” or “market failure” should be targeted as directly as possible. For example, a negative environmental externality arises from production (e.g. pollution) should be corrected using a tax on pollution, or some other policy that directly alters producers incentives to create pollution. • A trade policy is very seldom the correct policy for these kinds of externalities. • The net effect of a trade restriction might be positive, if it improves the environmental problem. However, a trade policy creates additional distortions. • (See online lecture notes “Theorem of the second best” for an example of this theorem, and of the Principal of Targeting.)

22. Summary • Environmental problems, or other “distortions” might either erode or increase the gains from trade. Environmental problems therefore might either undercut or strengthen the arguments in favor of trade liberalization. This fact means that the theoretical justification for trade liberalization is less clear than it might appear from Econ 100a. • However, trade restrictions are very seldom the best means of attacking environmental problems. In that sense at least, the presence of environmental problems has little bearing on the arguments for trade liberalization.