Chapter 5
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)
International
Economics
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. International
Economics
Trade and Growth Achieve
Similar Gains in Welfare
• Trade and growth both
Food
enable the economy to reach
400 P
a higher indifference curve.
D
• Trade leads to a new 300
A
C
consumption point at C.
200
• Growth leads to a new CPL
p
consumption point at D. 100
• Both points lie on the same
0 100 200 300 400 500 Clothing
higher indifference curve.
International
Economics
The Gains from Trade
Food
400 P
300
A
C
200
CPL
p
100
0 100 200 300 400 500 Clothing
International
Economics
The Gains from Growth
Food
400
D
300 A
200
p
100
0 100 200 300 400 500 Clothing
International
Economics
iu 2
g 5
e
Fr .
t kG h lsh p
T e o oo G
w e
I asr t t C tea
e e i n o an
t nc d o t
w h r i
b e Ra P N s o
• An economy with the red
production possibilities
frontier can reach the F
indifference curve I2 with o
o
trade. d
• However, it takes
continued growth (a large
shift in the indifference I20
curve) to reach the much
higher level of welfare
given by I20.
I2
• Can trade help stimulate
I1
I1
Clothing
such economic growth?
International
Economics
Figure 5.3
World Economic Growth During the
Past 200 Years Has Been Impressive
Per Capita
Real Output
$5,000
$4,000
$3,000
$2,000
$1,000
0 1,000 AD 150 0 1820 2000 Time
Based on data from Angus Maddison (2001)
International
Economics
Figure 5.4
The Recent Growth Has Varied
Greatly Across Regions of the World
Per Capita Real GDP Western
Offshoots
Western
Europe
$15000
$10000
Southern
Europe
Latin America
$5000 Eastern Europe
World
Asia
Africa
1820 1870 1900 1929 1950 1973 1992
Source: Angus Maddison (1995), Monitoring the World Economy 1820-1992, Paris: OECD, Table 1-1(a), p.
19, and Tables G-1, G-2, G-3, pp. 226-8. International
Economics
Figure 5.5
Are Economic Growth and
International Trade Related?
Exports/
Per Capita
GDP
Real GDP
$6,000 14%
$5,000 12%
10%
$4,000
Exports/GDP 8%
$3,000
6%
$2,000
4%
Per Capita
$1,000 Real GDP 2%
1820 1870 1900 1929 1950 1973 1998 International
Economics
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)
International
Economics
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
International
Economics
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%.
International
Economics
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.
International
Economics
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.
International
Economics
The Solow Growth Model
• Production function Y =
f(K,L) with diminishing
returns. Y f(K)
• 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 0 K
International
Economics
The Solow Growth Model
• Solow assumes that
Y
the saving rate is f(K)
constant and
between 0 and 1.
Consumption
• The saving function
is a reduced image f(K)
of the production
(income) function.
Saving
• The saving function
depends on the
production function 0 K
and the saving rate.
International
Economics
The Solow Growth Model
• Depreciation is Y f(K)
assumed to be a
constant fraction
of the stock of capital
K
K. f(K)
• Thus, depreciation is
a straight-line
function of K.
0 K
International
Economics
The Solow Growth Model
• Saving and investment
are equal where the
depreciation line and
Y f(K)
the savings function
intersect. Y*
• In equilibrium, a
K
capital stock of K*
f(K)
results in output
Y* = f(K*).
• K* and Y* are referred
to as the steady state
levels of capital and
0 K* K
output/income.
International
Economics
The Solow Growth Model
• The steady state level
of K* is a stable Y f(K)
equilibrium. Y* b
• If K K*, depreciation
exceeds investment and
K shrinks.
0 K1 K* K2 K
International
Economics
The Solow Growth Model
• The Solow model Y f(K)
depicts an economy
with a stable Y*
equilibrium.
K
• Output/income C*
f(K)
depends on the rate I*
of saving, the rate of
depreciation, and the
shape of the
production function.
0 K* K
International
Economics
Figure 5.8
A Rise in the Saving Rate
Increases the Steady State
Y f(K)
Y2*
Y1*
K
f(K)
2
I2* f(K)
1
I1*
0 K1* K2* K
International
Economics
Figure 5.12
Trade’s Transitional Effect on Output
According to the Solow Growth Model
• The static gain from trade
raises the production Y
function, which raises g(K)
output to Y’ = g(K*). Y**
f(K)
Y’
• Given a constant saving Y*
rate, the saving function K
shifts up proportionately
g(K)
to the production function. f(K)
• Trade therefore leads to
transitional growth as the
economy adjusts to a new
steady state equilibrium at
0
K** and Y** = g(K**). K* K**
International
Economics
Figure 5.9
The Role of Technological Progress
• Technological progress
raises the production
Y f2(K)
function
200
• Technological progress b
neutralizes diminishing
f1(K)
returns; output doubles 140 c
when the capital stock is
doubled, as from a to b 100 a
• Without technological
progress, the increase in
capital from 1 to 2 would
only take the economy to
point c, where output 0 1 2 K
rises by only 40%
International
Economics
Figure 5.10
Continual Technological Progress
Y
Y*** c f3(K)
Y** f2(K)
b
f1(K)
Y* a
K
3(K)
f
2 (K)
f
1(K)
f
0
K* K** K*** International
Economics
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.
International
Economics
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.
International
Economics
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.
International
Economics
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.
International
Economics
Figure 5.14
The Learning Curve
• Many studies of industrial
productivity have noted Unit Costs
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
Cumulative Output
does not explain its
causes.
International
Economics
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.
International
Economics
Figure 5.16
The Innovation Function
• The quantity of
innovations depends on
the quantity of resources
applied to R&D activity q
and the productivity of (
1/$ R R&D )
R&D activity.
• Defining q as the quantity
of innovations, $ as
the quantity of resources
per innovation, and RR&D 0 R R&D
as the resources applied to
innovation, then:
q = 1/$(RR&D).
International
Economics
Figure 5.17
The Cost of Innovation
• The cost of innovation
(CoI) depends on the cost
of resources and the
productivity of R&D CoI
activity
,
CoI [$R]
• The cost of resources
depends on total resources
R and the demand by
innovators RR&D 0 RR&D
• Therefore:
CoI = h(RR&D, R, $).
International
Economics
Profit in an Imperfectly-Competitive Market
• The present value of
innovation (PVI) depends on Price
the size of the profit box B
and on how long a successful
innovator enjoys its p f
monopoly position. B
• The life of a monopoly is the C e MC
inverse of the number of
innovations per year, q. MR D
0 a Quantity
• Expected profit from an
innovation is equal to B/q
= B/[RR&D / $] = B$ /
RR&D. International
Economics
The Present Value of Innovation (PVI) Curve
• PVI is a negative function of
the rate of interest with
which future profit is
discounted, r, and the
amount of resources PVI
employed in R&D activity
RR&D..
• PVI is a positive function of
the profit markup B and the PVI (B, r, $
)
resource requirements in
R&D activity, $. RR&D
• The present value of
innovation is:
PVI = f( B, r, RR&D, $ ).
International
Economics
Figure 5.20
Equilibrium Innovation
CoI,
• The intersection of the PVI
CoI and PVI curves
determines the amount , R)
CoI ($
of resources devoted to
R&D activity, RR&D.
PVI (B, r, $
)
• The curve 1/$ in the
bottom half of the RR&D
figure relates the q
amount of resources to
the expected number of 1/$
actual innovations. Innovations
per Year
International
Economics
Figure 5.21
The Effects on Innovation
of an Increase in B or R
CoI,
PVI
• An increase in B shifts the
PVI curve upward to PVI1,
and, all other things equal,
the number of resources CoI
devoted to innovative PVI1
PVI
activity increases.
• The increase in RR&D in RR&D
q
turn raises the number of q1
innovations per year from q
1/$
to q1.
Innovations
per Year
International
Economics
Figure 5.22
The Effects on Innovation
of an Increase in R
CoI,
• An increase in R lowers PVI
the cost of resources.
• The lowering of
resource costs imply a CoI
downward shift in the CoI1
CoI curve, say to CoI1. PVI
• This causes profit- RR&D
motivated entrepreneurs q
to employ more q1
resources in R&D, which
1/$
increases the number of
innovations q. Innovations
per Year
International
Economics
Figure 5-21
The Effects on Innovation
of an Increase in $
• A change in $ is complex CoI,
PVI
because it affects all curves.
• An increase in $ rotates
the 1/$ line
CoI2
counterclockwise.
CoI
• An increase in $ implies
that R&D activity requires PVI2
PVI
more costly resources,
which shifts the CoI curve q1
RR&D
up. q
1/$
1
• The PVI curve also shifts up
because creative destruction Innovations
1/$
slows when it becomes per Year
harder to innovate, which International
makes each innovation that Economics
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.
International
Economics
How Trade Influences Technological Progress
• For example, integrating
two identical economies
through trade doubles Price
the market, effectively
shifting the demand
curve from D to Dt. p
• The marginal revenue Dt
curve also shifts, B B
MC
C
doubling the equilibrium
quantity.
MR 2 D
• This doubles the 0 a
MR
2a Quantity
potential profit accruing
to innovators from B to
2B.
International
Economics
How Trade Influences Technological Progress
• The doubling of the CoI,
PVI
profit area, all other
things equal, shifts the
PVI curve up. CoI
• The amount of
PVI
resources that profit- RR&D
seeking innovators q1
apply to R&D activity q2
expands, and the
number of innovations
rises.
1/$
Innovations
per Year
International
Economics
How Trade Influences Technological Progress
• The supply of CoI,
PVI
resources in the
combined economy is
doubled, making more
CoI
resources available to CoI2
innovators.
• The CoI curve slopes PVI
up less steeply because RR&D
q1
the price of resources q2
rises less rapidly. q3
• This expands R&D
activity and innovation
further. 1/$
Innovations
per Year
International
Economics
How Trade Influences Technological Progress
• Trade and specialization CoI,
PVI
furthermore improves the
allocation of resources,
thus increasing the CoI
CoI2
effective stock of
resources.
PVI
• An effective increase in R q1
RR&D
lowers the CoI curve. q2
q3
• This efficiency of resource q4
use is in addition to profit
and resource effects
1/$
already described. Innovations
per Year
International
Economics
How Trade Influences Technological Progress
• Finally, comparative CoI,
PVI
advantage also applies to
innovative activity.
• The improvement in the CoI
overall productivity of CoI2
innovation decreases $
• A decrease in $ shifts PVI
RR&D
all three curves. q1
q2
• Shifts in CoI and PVI are q3
q4
likely to cancel each other
q5
out, but 1/$ also shifts
out, likely causing an 1/$
overall increase in Innovations
per Year
innovation.
International
Economics