Chapter Five Outline 1. Introduction 2. Questions to be answered 3. How do we know if a theory about trade is correct? 4. Testing the Hecksher-Ohlin model 5. Intra-industry trade 6. Trade with economies of scale 7. Technology-based theories of trade: The product cycle 8. Overlapping demands as a basis for trade 9. Transporting costs as a determinant of trade 10. Location of industry Introduction • After studying several theories to explain international trade patterns (Ricardian, neoclassical, and Heckscher-Ohlin models), must we adopt a single theory of trade, or might different theories best explain various aspects of trade? – Should empirical testing be used to decide? – Do we need to modify any of these theories to explain today’s economic patterns? Questions To Be Answered 1. Is one explanation from one of the economic theory models sufficient to explain why Colombia exports coffee, Taiwan color tvs, or Brazil steel? • What part does intra-industry trade (trade in which each country both imports and exports products from the same industry) play? 2. How do international trade patterns change over time? • U.S. used to be the world’s largest manufacturer of tvs…now it’s Taiwan. Why? How Do We Know If a Theory About Trade Is Correct? • Economists turn to empirical testing of international trade theories in order to strengthen their arguments about the important influences on various types of trade. – Both Adam Smith and David Ricardo used rudimentary empirical testing to support their claims. – Certain difficulties exist with empirical testing: • Empirical evidence can appear to support a theory, but it cannot prove it true (and vice versa). • Most useful outcome of empirical test is refinement of both theory and test. Testing the Heckscher-Ohlin Model • Hurdles to empirical testing – Heckscher-Ohlin model implies that exports as a group should be more intensive in use of the abundant factor than imports as a group. • Virtually impossible to test for this. – Simple observations do not necessarily comprise definitive evidence in the model’s favor. The Leontief Tests • Leontief used 1947 data for the united states in the first test of Heckscher and Ohlin’s key proposition (since U.S. was capital-abundant, it was expected that the U.S. Would export capital-intensive goods). – Since data on the factor intensity of imports was not available, he used data on import substitutes (the U.S.-Produced versions of the import goods). – Empirical results showed the opposite of what was expected. • U.S. Exports were 30% more labor intensive than us import substitutes. – Known as Leontief paradox. The Leontief Tests • Possible explanations of this paradox: – In 1947 most of world’s economies were still in a highly disrupted state. – Further tests in the early 1950s reduced the magnitude of the paradox. • Fair to state that simplest version of Heckscher- Ohlin model does poor job of explaining trade patterns. – Modifications and extensions have been made in the model. Fine-Tuning the Heckscher- Ohlin Model • Role of Tastes – Heckscher-Ohlin model assumed tastes were identical across countries. • This is not true. – Large differences in tastes among countries can introduce a taste bias that can dominate the production bias. » Should this occur, a country will have a comparative advantage in production of the good that uses its scarce factor intensively. » Evidence does exist for a “home bias” in consumption (consumers in a given country tend to consume more domestically produced goods than we would expect). Fine-Tuning the Heckscher- Ohlin Model • Classification of Inputs – Original theory used only two inputs: capital and labor. • Inputs are now classified in several ways…most common: – Arable farmland – Raw materials or natural resources – Human capital – Man-made or nonhuman capital – Unskilled labor Fine-Tuning the Heckscher- • Ohlin Model Technology, Productivity and Specialization – The original theory assumed identical technologies across countries when it predicted countries would export goods that used their abundant factors intensively. • We clearly observe different technologies across countries. – The theory must be amended to take these production process differences into account. What Is Intra-Industry Trade and How Big Is It? • Defined as trade in which a single country both imports and exports products in the same industry. – Comprises a significant share of world trade. • The Intra-Industry Trade (IIT) index is used to estimate the extent of this trade within an industry or within a country trade as a whole. – Table 5.1 (page 144) shows that IIT indexes tend to be higher for industrialized countries than for developing countries. Intra-Industry Trade in Homogenous Goods • Homogenous (non-differentiated) goods that are most likely to be involved in intra- industry trade include items that are heavy or for some other reason expensive to transport. – In Figure 5.1, each country both exports and imports the product because of the greater proximity of consumers to the foreign than to the domestic producer. Figure 5.1: Location Can Cause Intra- Industry Trade in Homogeneous Goods Country A Country B A F CB CA FB Intra-Industry Trade in Differentiated Goods • Product differentiation is the most obvious explanation for intra-industry trade. – Consumers have a variety of tastes, some best served by domestically produced goods and others by imports. Why Does It Matter? • Intra-industry trade involves trade in goods in the same industry but produced using similar factor intensities. – Therefore, changes in factor demands and relative factor prices from such trade tend to be smaller. • Provides one explanation for global trade liberalization in last fifty years. – Greatest success in lowering trade barriers has occurred in manufactured-goods industries in which the developed countries engage in large amounts of intra-industry trade. Trade with Economies of Scale • For some goods, the average cost of production depends on the number of units produced. – If the average cost per unit falls as the scale of production rises, production exhibits increasing returns to scales, or Economies of Scale. • Internal economies occur when the firm’s average costs fall as the firm’s output rises (panel [a] of Figure 5.2). – Primary sources are large fixed costs that can be spread over all the firm’s output. » Example: R&D expenses Internal and External Economics of Firm's AC X Scale AC S AC L AC X L 0 XS X Firm’s Output of X (a) Internal Economies Trade with Economies of Scale • External economies occur when the firm’s average costs fall as the industry’s output rises, as in panel (b) of Fig. 5.2. – For example, when the output of the computer industry rises, computer firms’ costs fall because the industry becomes large enough to support a pool of skilled labor. Figure 5.2b: Internal and External Firm’s AC X Economics of Scale 0 AC AC 1 AC X 0 1 0 X X Industry Output of X (b) External Economies Trade with Economies of Scale • Implications of economies of scale – Create additional incentive for production specialization. • Rather than producing a few units of each good domestic consumers want to buy, a country can specialize in producing large quantities of a small number of goods (in which the industries achieve economies of scale) and trade for the remaining goods. – Therefore, economies of scale provide a basis for trade even between countries with identical production possibilities and tastes. Trade with Economies of Scale • Figure 5.3, which assumes countries A and B are identical in tastes and production possibilities, shows the potential of mutually beneficial trade based solely on economies of scale rather than comparative advantage. Figure 5.3: Mutually Beneficial Trade Based Solely on Economics of Scale Y Slope = – (PX/PY)tt BP Ac = Bc A* = B* UA = UB 1 1 UA = UB 0 0 0 AP X Internal Economies of Scale • With internal economies of scale, trade allows consumers to consume larger varieties of goods at lower prices. – Trade helps to increase variety by expanding the consuming population for any firm’s product. • Firms in one country specialize in one set of varieties, and firms in the other to another set. Consumers then have access to all the varieties through trade. – Each firm achieves economies by specializing. Figure 5.4: Internal Economics of Scale as a Basis for Trade between Identical Countries Firm’s Firm’s ACAX ACAY 0 AC Y 0 AC X 1 AC X A AC 2 Y AC X A AC Y DA X A+B DX DA D A+B Firm’s Output Firm’s Output A 0 X0 XA 1 0 YA 0 of X of Y (a) X Industry in A (b) Y Industry in A Figure 5.4: Internal Economics of Scale as a Basis for Trade between Identical Countries Firm’s Firm’s ACBX ACB Y 0 0 AC Y AC X AC 2 X 1 B AC X AC Y B AC Y B A+B D D D B D A+B 0 XB 0 Firm’s 0 YB 0 B Y 1 Firm’s Output of X Output of Y (c) X Industry in B (d) Y Industry in B External Economies of Scale • External economies of scale can help explain the observed phenomenon of industrial agglomeration – the tendency of firms in an industry to cluster geographically. – Watch industry in Switzerland – Movie industry in Hollywood – Financial industry in New York and London – Economies occur when the clustered industry reaches a size adequate to support specialized services. • For example, skilled labor markets Figure 5.5: External Economics of Scale and Comparative Advantage Firm’s AC B AC AC 3 AC2 A AC B AC AC 1 AC A A+B D =DA B D B A 0 X 0 X0 X 2 X 1 Industry Output External Economies of Scale • Would protection help in cases such as the one in Figure 5.5 where economies of scale result in trade that runs counter to comparative advantage? – Figure 5.6 illustrates two possibilities: 1. Panel (a) combines weak scale economies and strong comparative advantage. Temporary protection of A’s market could allow country-A firms to capture the market even if country-B firms enjoyed a head start. 2. Panel (b) combines strong scale economies and weak comparative advantage. Temporary protection would not allow country-A firms to capture the market from already established country-B firms. Figure 5.6: Interaction of External Scale Economics and Comparative Advantages Firm’s Firm’s AC AC AC 6 AC2 AC 2 AC 4 AC B B AC5 AC A AC A AC A+B A+B D =D A B D A D =D B D 0 X4 X2 X5 Industry 0 X6 X2 Industry Output Output (a) Small Scale Economies, (b) Large Scale Economies, Large Comparative Advantage Small Comparative Advantage Dynamic External Economies • In some cases, firms’ average costs depend not on the industry’s current output, but on its cumulative output. – Downward-sloping curve in Fig. 5.7 captures the negative relationship between cumulative industry output and firms’ average costs. • That curve is called the Learning Curve. – Associated economies called dynamic external economies. Figure 5.7: Dynamic External Economics and the Learning Curve Firm’s AC AC 2 AC1 AC 3 LCB AC0 LC A A+B A D =D B D 0 X 1 X0 Cumulative Industry Output Scope of Economies and Learning • At times, a firm’s costs depend on the output of the worldwide industry, either current or cumulative. – Most arguments for protection based on external economies of scale, like the one in Fig. 5.6 (a), would disappear. • Example: semiconductors – recent evidence suggests effective learning may take place based on foreign as well as domestic production experience. Scope of Economies and Learning • Trade based on external economies of scale can be beneficial or harmful depending on: 1. Importance of scale economies relative to comparative advantage; 2. Whether historical production patterns follow or run counter to comparative advantage; or 3. Whether domestic or worldwide industry output provides the basis for scale economies. Technology-Based Theories of Trade • The Product Cycle – Technological innovation and new-product development tend to occur in major industrialized economies. • Reflects highly educated and skilled workforce, and the relatively high level of R&D expenditures. – Primary implication of this theory is that as each product moves through its life cycle, the geographic location of its production will change. Technology-Based Theories of Trade • Stages in the Product Cycle: 1. Actual production needs to be located close to consumers so they can provide feedback on its refinement. • Only the domestic firm owns the technology, so production occurs only in the firm's home country. 2. Eventually, the firm perfects the product and production accelerates, first for the domestic market and then for export. 3. As production technology becomes standardized, the innovating firm may find it profitable to license its technology to firms abroad. • Production may relocate to other countries with lower costs of production. Technology-Based Theories of Trade • Stages in the Product Cycle: 4. Next, imports rather than domestic production begin to serve the domestic market of the innovating country. • The technology has diffused completely. 5. Finally, the product completes its cycle. Although domestic consumption of the good may continue, imports satisfy that consumption. Overlapping Demands as a Basis for Trade • Linder suggested that similarities in demand between two countries can form a basis for trade, especially for manufactured goods. – States that firms typically do not produce goods solely for export – most produce goods for which domestic demand exists. • Linder argues that for many manufactured goods, the quality of the good that consumers in a specific country demand depends primarily on their income. – Consumer with higher incomes tend to demand goods of higher quality. Figure 5.8: The Overlapping- Product Quality Demand Hypothesis QA max QA min 0 IA min IA max Income (a) Income Overlap Determines Quality Overlap Overlapping Demands as a Basis for Trade • Figure 5.9 demonstrates that most merchandise exports go from one high- income economy to another. – In 1995, only 33% of exports went from a high- income economy to a developing one or vice- versa. Figure 5.10: Transportation Cost and the International Market for Good X PX PX PB ExportsA X Exports A X X E F P0 X H G Ptt X T Ptt X 1 M J ImportsB X PX Imports B X PA X 0 X* Trade in X 0 X* T X* Trade in X (a) Trade with (b) Trade with No Transportation Costs Transportation Costs Transportation Costs as a Determinant of Trade • Transportation costs also play an important role in trade with external economies of scale. – High transportation costs can contribute to agglomeration effects common in industries characterized by external economies. • Another question; who pays for these costs? – Generally, exporter and importer share the costs. • The less price responsive the demand for the good by the importing country, the larger the share of transportation costs the importer will bear. Location of Industry – Market-oriented industries • Example: Retail sales operations like to be near their customers. – Footloose or light industries • Has no need to locate near either raw material sources or markets. – Their products typically neither gain nor lose a significant amount of weight or volume as they move through the stages of production. » Example: semiconductors. Conducting Semiconductor Trade • Figure 5.11 illustrates the industry shares of the world’s semiconductor market in 1996. – The United States and Japan together accounted for 80% of the total world production.