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					          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
• 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
   •   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
• 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
   – Modifications and extensions have been made in the
  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
        –   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
       • 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
      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
  – 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


         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
   – 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

    AC S

    AC L

                                          AC X

         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
          Economics of Scale


     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
      • 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
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
Figure 5.3: Mutually Beneficial Trade
Based Solely on Economics of Scale
           Slope = – (PX/PY)tt


                            Ac = Bc

               A* = B*                 UA = UB
                                        1    1

                                       UA = UB
                                        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

                                              AC Y
  AC X
  AC X                                  A     AC 2
                                   AC   X
                                                                           AC Y
                              DX                              DA      D

                               Firm’s Output                       Firm’s Output
     0         X0        XA
                          1                      0       YA
                                    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

                                         AC Y

  AC 2
     X                                       1
                             AC X         AC Y
                                                                           AC Y
                  B       A+B
                  D      D                                D

    0        XB
              0          Firm’s             0        YB
                                                                  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
   –   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

           AC 3
           AC                                       B
           AC 1                            AC A
                          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
 AC 2
 AC 4                                  AC

 AC5                                   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

           AC 3                           LCB
                                        LC A
                    D =D   B        D
                0          X 1 X0       Cumulative
    Scope of Economies and
• 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
• 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
     • 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
 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
  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
        Figure 5.8: The Overlapping-
Product Quality Demand Hypothesis



        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-
      Figure 5.10: Transportation Cost and the
           International Market for Good X
PX                                        PX

PB                    ExportsA
                                                                  Exports A

                                                E        F

                                                H    G
 X                                    T   Ptt

                                           1    M    J
                                          PX                        Imports B


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
– 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.