Intl Micro ECN 160A
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Popular in Economcs
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Lecture 5 After World War 1 laws were passed severely limiting immigration Only atrickle of immigrants has been admitted since then By keeping labor supply down immigration policy tends to keep wages high Paul Samuelson Ecurlumzcs 1964 International Factor Movements amp Multinationals Introduction c I form of integration is international movements offactors ofproduction factor movements I Factor movements include Labormigration Transfer ofcapital via intemational borrowing and lending lntematinnal quot corporations Effects of Immigration 1 Short Run Analzsi Speci cFactors Model Effect of immigration on wage rate VageV W PAMIPLA Wquot P 39MPL A A t PM PLM OM LM L L LA CA OA i AL Figure 42 Increase in Home Labor When the amo o abor Home increases by the amount AL then origin for agriculture is shifted to the right y that amount from OAto on The marginal product of We in agriculture also shifts right by the amount AL from PA MPLAto PA MPLA The I m rt i u 39 39 B39 th as 11 n in W to w39 Then OML39 units oflabor are used in manufacturing and OAL39 units oflabor are used in agriculture Case Study Immigration to the US and Europe Tod Between 1870 and 1913 some thirty million Europeans left their homes in the Old world to emigrate to the New World ofNorth and South America and Australia The population of Argentina rose by 60 due to immigration and Australia and Canada a39 o e ople The population of the United States increased by 17 due to immigration and it absorbed the largest number ofpeople over 15 million The immigrants left the Old World for the opportunities present in the New and most importantly for the higher real wages In Figure 43 we show an index of average real wages in European countries and in the New World an average of the United States Canada and Australia In 1870 real wages were nearly three times higher in the New World than in Europe 7120 as compared to 40 Real Wage Index 1570779 mamas 1890795 190D713 Ye ars actual a European leal wage actual 0 New Wand real wage Smllce AlallM Taylor and Jeffrey G VVlIliamsoll quotConvelgence in the Age of Mass Mlgmtion Europem Renew DfECurwimc Him 1 Apn l 1997 2753 Large scale migration from Europe to the New World in America and Australia closed the wage gap between the two locations In 1870 wages in the New World were almost three times as higl1 as in Europe whereas in 1910 they were about twice as high Migration into the New World also slowed the growth ofwages below what would have occurred otherwise while allowing slightly faster growth of wages in Europe Real wages in both locations grew over time as capital accumulated raising the marginal product of labor But due to the largescale emigration to the New World wages grew more slowly there By 1913 just before the onset of World War I the wage index in the New World was at 160 so real wages had grown by 160120120 33 over 43 years But in Europe the wage index reached 75 by 1913 an increase of 754040 88 over 43 years In 1870 real wages in the New World were three times as high as those in Europe but by 1913 this wage gap was substantially reduced and wages in the New World were only about twice as high as those in Europe Largescale migration therefore contributed towards a convergence of real wages across the continents In Figure 43 we also show estimates of what the real wages would have been if immigration had not occurred Those estimates are obtained by calculating how the marginal product of labor would have grown with capital accumulation but without the immigration Comparing the actual real wages with the predictions we see that the growth of wages in the New World was slowed due to immigration while wages in Europe grew slightly faster due to emigration 80 70 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 Share ofForeign 60 39 39 39 39 Born Workers 0 7 7 7 7 ofUS 50 4 Workforce in 40 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 Each Education Group 30 7 7 7 7 7 7 7 7 7 7 7 20 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 1077 7777 777739 77777l 7777 7777 77777 77 0 08years 8 11years th School 1315years College Masters and PhD39s G39aduates Graduates Fi39ofessional Degrees 10 of Natives 80 of Natives 10 of Natives Figure 44 Share of Foreign Born in US Workforce 2004 This figure shows the share of foreignbom workers in the Us workforce categorized by educational level For example among workers with only 0 8 years of education about 70 were foreign born for those with 811 years of education slightly more than 20 were foreign born At the other end of the spectrum the foreign born make up 17 of workers with masters and professional degrees and 30 of those with PhD s In the middle educational levels high school and college graduates there are much smaller shares of foreignbom workers ranging from 10 7 15 In contrast only about 10 of USbom workers are categorized in each of the low education and high education groups most USbom workers are either high school graduates or college graduates Effect of Immigration on Earnings of Capital and Land 0 See effects of an increase in labor endowment on Output return on land and return on capital in Speci cfactors Model Shift in Home PPF due to immigration Output of Agriculture Q A Home PPF Relative price of manufactured goods PMPA Output of Manufacturing QM Figure 45 Shift in Home Production Possibilities Curve With the increase in labor at Home due to immigration the production possibilities frontier shifts outward and the output of both industries increases from point A to point B Output in both industries increases because of the shortrun nature of the specific factors model because land and capital do not move between the industries in the short run adding labor to both industries increases the output in both industries 2 Effects of Immigration in the Long Run 0 Suppose only labor and capital are used to produce two goods computers and shoes 0 The amount of capital used in computers is Kc and the amount of capital used in shoe production is Ks These quantities add up to the total capital available in the economy Kc Ks K Because capital is fully mobile between the two sectors in the long run it must earn the same rental R in each 0 The amount of labor used to manufacture computers is Lc and the labor used in shoe production is Ls Total amount of capital in the lt economy K 0 These amounts add up to the total labor in the economy LC Ls L and all labor earns the same wage ofW in both sectors we assume that more labor per machine is used in shoe production than in computer production That assumption means that shoe production is laborintensive compared to computer production so the laborcapital ratio in shoes is higher than it is in computers LsKs gt LcKc Computer production then is capitalintensive compared to shoes and the capital labor ratio is higher in computers KcLc gt KsLs Labor allocated to computers r Box Diagram lt c L 0c Kc i Capital allocated to computers Capital K A K allocated to shoes T Ks Os L LS gt Labor allocated to shoes Total amount of labor in the economy L Figure 47 Allocation of Labor and Capital in a Box Diagram The top and bottom axes of the box diagram measure the amount of labor L in the economy and the side axes measures the amount of capital K At point A OsL units of labor and 03K units of capital are used in shoe production and OcL units of labor and OCK units of capital are used in computers Determination of the Real Wage and Real Rental Increase in the Amount of Home Labor 3 Decrease in labor in the computer industry 2 Increase Decrease in capital in capital m the in the Shoe computer mdusny industry K Ki K K 1 Increase in Home labor 3 Additional due to increase in immigration 0398 0s labor in the all additional shoe industry labor AL J allocated to shoes Figure 48 Increase in Home Labor With an increase in Home labor from f to f AL the origin for the shoe industry shifts from Os to 0339 In the longrun industry outputs adjust so that the KL ratio in each industry and hence the slopes of O39SB and OcB remain unchanged from their initial equilibrium at point A First all new labor due to immigration is allocated to the shoe industry decreasing KL in shoes Then capital is transferred from computers to shoes increasing K L in shoes and decreasing KL in computers Finally to equalize industry KL s at their preimmigration levels additional labor is transferred into shoes from computers In sum the only way to keep KL ratios the same is to allocate the new labor as well as both labor and capital from the computer industry to the shoe industry At point B O39SL units of labor and O SK units of capital are used in shoes while OcL39 units of labor and OcK39 units of capital are used in computers Relative price of comuters PcPs Output of Shoes Qs An increase of both labor and capital in shoe production cause an increase in shoe output and a decrease in computer output Shift in Home PPF due to immigration Output of Computers QC Figure 49 The Long Run Effect on Industry Ouputs of an Increase in Home Labor With an increase in the amount of labor at Home the PPF shifts outward The output of shoes increases while the output of computers declines as the equilibrium moves from point A to B The prices of goods have not changed so the slopes ofthe PPF s at points A and B ie the relative price of computers are equal 0 The nding that an increase in labor will expand one industry but contract the other only holds in the long run in the short run as we saw in Figure 4 5 both industries will expand This nding shows how much the longrun model differs from the shortrun model The longrun result is named after the economist TN Rybczynski who first discovered it Rybczynski Theorem The Rybczynski Theorem states that an increase in the amount of a factor found in an economy will increase the output of the industry using that factor intensively and decrease the output of the other industry CASE STUDY The Effects of the Mariel Boat Lift on Industry Output in Miami The Mariel boat lift to Miami in 1980 We know that the Cuban refugees were less skilled than the average labor force in Miami According to the Rybczynski Theorem then we expect some unskilledlabor intensive industry such as footwear or apparel to expand In addition we expect that some skillintensive industry such as the hightech industry will contract Figure 410 shows how this prediction lines up with the evidence from Miami and some comparison cities Panel a of Figure 410 shows real valueadded in the apparel industry for Miami and for an average of comparison cities Real value added measures the payments to labor and capital in an industry corrected for in ation Thus real valueadded is a way to measure the output of the industry We divide output by the population of the city to obtain real valueadded per capita which measures the output of the industry adjusted for the city size Panel a shows that the apparel industry was declining in Miami and the comparison cities before 1980 After the boatlift the industry continued to decline but at a slower rate in Miami the trend of output per capita for Miami has a smaller slope and hence smaller rate of decline in output than that of the trend for comparison cities from 1980 onward Notice that there is an increase in industry output in Miami in 1984 which may be due to new data collected that year but even when averaging this out as the trend lines do the industry decline in Miami is slightly slower than in the comparison cities This graph provides some evidence of the Rybczynski Theorem at work the reduction in the apparel industry in Miami was slower than it would have been without the in ow of immigrants What about the second prediction of the Rybczynski Theorem did the output of any other industry in Miami fall due to the immigration Panel b of Figure 410 shows that the output of a group of skillintensive industries including motor vehicles electronic equipment and aircraft fell more rapidly in Miami after 1980 These data may also provide some evidence in favor of the Rybczynski Theorem However it also happened that with the in ux of refugees there was a ight of homeowners away from Miami and some of these were probably highskilled workers So the decline in the group of skillintensive industries shown in panel b could instead be due to this population decline The change in industry outputs in Miami provide some evidence in favor of the Rybczynski Theorem Do these changes in industry outputs in Miami also provide an adequate explanation for why wages of unskilled workers did not decline or is there some other explanation An alternative explanation for the nding that wages did not change comes from comparing the use of computers in Miami with national trends Beginning in the early 1980s computers became increasingly used in the workplace The adoption of computers is called a skillbiased technological change That is computers led to an increase in the demand for highskilled workers and reduced the hiring of low skilled workers This trend occurred across the United States and in other countries In Miami however computers were adopted somewhat more slowly than in cities with similar industry mix and ethnic populations One explanation for this nding is that rms in many industries not just apparel employed the Mariel refugees and other low skilled workers rather than switching to computer technologies Evidence to support this nding is that the Mariel refugees were in fact employed in many industries only about 20 worked in manufacturing 5 in apparel and the remainder worked in service industries The idea that the rms may have slowed the adoption of new technologies to employ the Mariel emigrants is hard to prove conclusively however We suggest it here as an alternative to the Rybczynski Theorem to explain how the refugees could be absorbed across many industries rather than just in the industries using unskilled labor like apparel mm Tzead cbmpmm Tuad Ra 6 1972 157A 1575 me rseu 1552 me was was JsSu 1592 1994 1956 3 Apparel Indllsn39 awRik mmr cbmween e 1972 me me new rear use 1954 was me 199a 1992 1994 1996 h HighrSkilled Industries Source mm Lem quotHow did the Miami Labor Market Absorb the Manel mmgram Federal Reserve Bank ofPhiladelphia 2003 i New in Mramr rose in 1984 andthe ueud decline of lis mdusuy in Mrmm was slower a er 39 39 Real valuemm 1m r r r 39 39 n v consistem wim me Rybczynksi Theorem Case Study Immigration and US Wages 19902004 In 1980 the share of foreignbom persons in the US population was slightly higher than 6 Since that time the share has grown in 12 in 2004 so there has been a doubling of foreignbom persons in about 25 years How has this wave of recent immigration affected ages Table 41 Immigration and Wages in me 15 Ca1ltalzlulla11l xed 79 0 72 4 08 n 750 Souu e G 11 onamuo and Giovanni Peli quotRellunluug gains from Immigration Theory and evidence ti39om the U S quot Unix ersuy ofCaljfonua Davis Jamme 1006 In part A of Table 41 we report the estimated impact ofthe immigration over 19902004 on the wages of various workers distinguished by their educational level The rst row in nart A 39 39 from quot1 p quot39 f 39 d when capital and land are kept xed within all industries As we discussed in an earlier case study the greatest negative impact is on workers with less than 12 years of education followed by college graduates followed by highschool graduates and those with some college Overall the average impact on US wages due to immigration over this period is 732 A different story emerges however if rather than keeping capital xed we instead held constant the real rental on capital Under this approach we allow capital to grow in each industry to accommodate the in ow of immigrants so that there is no change in the real rental This approach is similar to the longrun model we have discussed except that there are several types oflabor distinguished by the education levels and prices are not constant over the period examined In the second row of part A we see that total US immigration has a negative impact on only the lowest and highesteducation workers and a poritive impact on the other workers due to the growth in capital The average US wage now rises by 03 due to immigration combined with capital growth rather than falling In art B of Table 41 we focus on the illegal immigration to the US during 19902004 rather than total immigration In that case it is only the wages of the lowest educated persons that are negatively impacted All other workers gain from illeg immigration once we take into account the growth in capital that is expected to occur The Effects of FDI 0n the Earnings of Labor and Capital 0 Ifa US company acquires 10 or more ofa foreign rm then that is counted as an FDI out ow from the United States When a company builds a plant in a foreign country it is sometimes called green eld FDI since we imagine the site for the plant starting with grass on it When a rm buys an existing foreign plant it is called acquisition FDI or sometimes brown eld FDI Greenfield Investment 1 Short Run analysis Speci c Factors Model WageW gt w39 C A B w PMMPL M P MPL A A PMMPLM oM LM L L LA CA V Figure 412 The Effect of an Increase in Ca ital Stock on the Rental Rate of Capital Moving from point A to B the amount of capiial increases but the wage remains the same which implies that the marginal product of labor in manufacturing has not changed This in turn implies that the laborcapital ratio in manufacturing and hence the marginal product of capital and the rental of capital are unchanged as well Moving from point B to C the wage increases while the amount of capital remains the same which implies that the marginal product of labor in manufacturing and hence the laborcapital ratio has risen This means that the marginal product of capital and its rental have decreased between B and C Thus between A and B the rental on capital is unchanged but between B and C it declines in sum the rental on capital declines when the capital stock increases through FDI Effect of FDI on the Wage As a result of this shift the equilibrium wage increases from W to W39 More workers are drawn into the manufacturing industry and the labor u used39hexe messes Flam mm m um Eecame hese walkers he pu ed sum sgheumhe Lhz Tshsmsemhehe shnhhs Flam m mm messth Flam hgm m E ecl nl rm an the Industry Outputs Ins easyta determine Lhz effect huh hnww hm mxndmxy mpms Eeesese walkers he pu edaul hrsgmmhe and hangean mamtuflandused39hue Lhan manhe theman 3 5 use Lhammuf x g on mu These ehmgesmmpume shawanxgu eAlZ whuetthPF shl saulward At eshseshz pheesrw guads the equhbmxn ampuls sh fmm was as pmmE mm mm manufacunng hum Andless agxculuxal vutpu39 T 011qu hnhhuhsmms 0x Figure us unease in C111th Stuck W39th the mnhw hr espem mm mmufamxmg and the extra labm39 usedm that seem Lb mph afmamfacamngmcruses Eecause hhw hasbezn ahswh hut hf agxculuxe 39h when huh senmfa s These uhanges eh mpms he shhwhhyme smwsm shensnhe PPF the ehshesse eh capital shame m memem hm hm E m pmhm Lb changzs eh mpms I an the Rentals Fxm y we can delemnnz the mm huh ehn ehehm ehheahyhha use One R1 PAWTA Wth39he m m39he margnal mum unshaampm shuns Chang m the phee hf agxculuxal gaads the hem mlmdfa s 2 LongRun Analysis The heshhs afFDI m he lanng when capxtal andlabm ssh have betweenmdmmes mere Flam Lhasa we saw mun shmhh sheeehe facmxsmadel Ta made FDI mm a sme aganhAHhere Aretwamdmnesrcampuuxsmdshnesrbmhaf L L andeapttat as eornparedto shoes rneantng the KcLc exceeds KsLx output hummer Q Figure 415 Increase in Capital Stuck Effect of FDI on Dmputs and Factor Prices Suppose that the amount ofcapnal tn the eeonorny tnereases due to an tn ow ofHDI The changem outputs of shoes and eornputers ts shown by the shtftfrorn potntB to potnt B tn thure 415 In eeordanee stry Furth W or L L change 111 the capxtalrlaborranos m etther tndustry eeause the capitalrlaborrauos are unehangedtn the two mdusmes the wage and renta1 on eapttal are a1so unchanged Eaeh pers n has the sarne arnount of wtth tn hrs d the o at to work orhertn ustry and eaeh rnaehtne has the eaptt sarne number of Workers The r m factorpnces Thts outeorne ts basteany the sarne as that fonmmlgrahon tn the longrrun unehanged Figure hehrw 413 Increase in the Capital Stuck in the LnngrRlIn Tu n w t I the eeonorny and the nght andleft axes measure the arnount ofeapttat The tntttat o potnt B strnttar to the box dAagram fonmmlgrahon thure 4 8 the KL rattos rernatn unehangedby all e tang the new eapttat as well as both eaptta1 andlaborfrom shoes to eornputers AtpotntB there are OSL untts oflabor and OSK untts ofeapttat usedm oe p o o of or and OCK umts ofeapttat usedm eornputers In a a E yr 0 9 5 lt7 sh panel b wtth the tnerease tn the arnount ofeapttat at Horne due totnereased FDI the PPF shttts outward The output ofcomputers tnereases whtte the output ofshoes deehnes as the equilibrium moves from point A to B Because the prices of goods have not changed the slopes of the PPF s at points A and B are equal I L L O c AK 0c K A K K K B K Os L L a Effect on the allocation of labor and capital Relative price of Output of Home PPF computers PCPS Shoes Qs Shift in Home PPF due to FDI Output of Computers QC b Effect on industry outputs Gains from Labor and Capital Flows Wage W Ga1ns to I Home Fore1gn Wage W A W s B Wgtxlt A Home Wage Gains to Foreign 0 L L39 0 T T gtxlt L gt lt L j V World Amount of Labor Figure 414 World Labor Market Initially Home has OL workers and Foreign has OL workers The Home wage is W as determined at point A which is higher than the Foreign wage W at A Workers will move from Foreign to Home to receive higher wages The equilibrium with full migration is at point C where wages are equalized at W39 The gain to the Home from migration is measured by triangle ABC and the gains to Foreign is the triangle ABC Increase in the Home labor force amp thus reduction in the real wage in Home Reduction in the Foreign labor force amp increase in the real wage in Foreign The redistribution of the world s labor force gt 7 Increases the world s output as a whole 7 Leaves some groups worse off 7 Leads to a convergence of real wage rates in this example home national GDP is higher while that of foreign country is lower home workers are worse off lower wage rates foreign workers better off home land owners are better off higher rent because of higher MP of Land due to higher employment foreign land owners are worse o Gains from Foreign Direct Investment Gains to Rental R Foreign Foreign Rental R Aquot R B C Gains to Home R A Home Rental 0 K K 0 k E gt E J V World Amount of Capital Figure 415 World Capital Market With OK units of capital at Home then the Home rental is R at point A The remaining capital 0K is in Foreign and the Foreign rental is R at point A Capital will move from Home to Foreign to receive a higher rental The equilibrium with full capital ows is at point B where rentals are equalized at R39 The gains to the Home from the capital out ow is the triangle ABC and the gains to Foreign is the triangle A BC Reduce the Home labor force amp thus raise the real wage in Home Increase the Foreign labor force amp reduce the real wage in Foreign The redistribution of the world s labor force gt 7 Increases the world s output as a whole 7 Leaves some groups worse off 7 Leads to a convergence of real wage rates 7 in this example home national welfare in lower while that of foreign country is higher 7 home workers are better off higher wage rates foreign workers worse off home land owners are worse off lower rent because of lower MP of Land due to lower employment foreign land owners are better off Lecture 3 The SpecificFactors Model Trade and Income Distribution Overview The specific factor SF model was developed and formalized mathematically by Ronald Jones 1971 and Michael Mussa 1974 Jones referred to it as the 2 good3 factor model Mussa developed a simple graphical depiction of the equilibrium which can be used to portray some of the model results It is this view that is presented in most textbooks The model39s name refers to its distinguishing feature that one factor of production is assumed to be quotspecificquot to a particular industry A speci c factor is one which is stuck in an industry or is immobile between industries in response to changes in market conditions A factor may be immobile between industries for a number of reasons Some factors may be specifically designed in the case of capital or specifically trained in the case of labor for use in a particular production process In these cases it may be impossible or at least difficult or costly to move these factors across industries The specific factor model is designed to demonstrate the effects of trade in an economy in which one factor of production is specific to an industry The most interesting results pertain to the changes in the distribution of income that would arise as a country moves to free trade The model shows that opening a country to trade generates winners and losers Winners factors sector to export sector Losers factors specific to import competing sectors We can think of SpecificFactors models as a short or medium run version of HO model in which some factors of production are specific to some sectors and can not move to other sectors in the short run Assumptions of the Model I Two goods An economy can produce two goods Manufactures QM and Food QF I Two Countries Home and Foreign I Three Factors of Production Production of Manufacturing requires Labor L and Capital K 1 QM QM K LM Production of Food requires Labor L and Land T QF QF T LF Labor is perfectly mobile between the two sectors L M L F L 3 full employment condition Capital and Land and immobile between the sectors are sector speci c Supply of the Three inputs are given and xed I Technology Constant Returns to Scale CRS production functions I Perfect competition prevails in all mar e s I e two countries differ M in their factor endowments same tastes same tech Production Possibilities Frontier Use equations 13 to derive the PPF of the economy To analyze the economy s production possibilities we need only to ask how the economy s mix of output changes as labor is shifted from one sector to the other in The Speci c Factors Model Figure S1 The Production Function for Manufactures Output OM OM aMK L Labor Input LM Comm 2003 mm de 1m std 39 The shape of the production function re ects the law of diminishing marginal returns Adding one worker to the production process without increasing the amount of capital means that each worker has less capital to work w39th Therefore each additional unit of labor will add less to the production of output an the last Figure 32 shows the marginal product of labor which is the increase in output that corresponds to an extra unit of labor The Speci c Factors Model gure 3amp2 The Marginal Product ofLabor Marginal product of labor MPL MPLM Labor input LM momma ZDDZPearsanEducatmnlnc Slidelll Derivation of PPF from MP curves and total labor endowment The Specific Factors Model Figure 33 The Production Possibility Frontier in the Speci c Factors Model Output of food Production function QF increaSing 4 Economyys PFOdUCtion for food possibility frontier PP QFQFK LF Labor input in food L increasing Output of increasing Econom s allocat n PrOdUCt n funC n for manufactures of labor AA Labor input QMQMK LM in manufactures Copyright o 2003 Pearson Education Inc LM increasing 4 Slide 312 Prices Wages and Labor Allocation I W much labor will be employed in each sector To answer the above question we need to look at supply and demand in the labor market Demand for labor In each sector pro tmaximizing employers will demand labor up to the point where the value produced by an additional personhour equals the cost of employing that hour The demand curve for labor in the manufacturing sector can be written MPLM x PM W 4 The demand curve for labor in the food sector can be written MPLF XPF W 5 The wage rate must be the same in both sectors because of the assumption that labor is freely mobile between sectors The wage rate is determined by the requirement that total labor demand equal total labor supply L M L F L 6 The Specific Factors Model Figure 34 The Allocation of Labor Wage rate W Wage rate W curve for labor in food PMX MPLM emand curve for labor in manufacturing Labor used in Labor used manufactures LM in food L M L F Total labor supply L Cupynghro znnz Fearsun Educatmn In slide 3715 I At the production point the production possibility frontier must be tangent to a line whose slope is minus the price of manufactures divided by that of food Opportunity Cost and Prices As in the Ricardian model the slope ofthe PPF which is the opportunity cost of manufacturing also equals the relative price of manufacturing The Speci c Factors Model Figure 35 Production in the Speci c Factors Model ompu of food a slope PM my Output manufactures GM 31ml 01M cwwezmi madman m I Relationship between relative prices and output MPLFMPLM PMPF 7 International Trade in the Specific Factors Model Let s assume Home is capital abundant and Foreign is land abundant They have an equal amount of labor endowment Trade Relative Prices and Patterns of Trade 39 ce c mpared to Foreign Home is capital abundant the pretrade relative price Sin of manufactures in Home is lower than the pretrade relative price in Foreign International trade leads to a convergence of relative price Foreign will export Food and Home will export manufacturing QF U1 SlopePMPF QM I Gains from Trade In absence of international trade the economy produces and consumes at point A With trade the economy produces at point B and consumes at point C The rice of utility from U1 to U2 is a measure of the gains from trade for the economy The Effect of Trade on Factor prices a Wage rate and Labor allocation What happens to the allocation of labor and the distribution of income when the prices of food and manufactures change Consider an increase manufacturing prices increase in Home When only PM rises labor shifts from the food sector to the manufacturing sector and the output of manufactures rises while that of food falls The wage rate W does not rise as much as PM since manufacturing employment increases and thus the marginal product of labor in that sector falls Suppose that PM increases by 10 Then we can show that the wage rate increase by a lesser percentage say by 7 Wa e Wage g A APM LM10 W2 7 P2 MPL M M W1 A PFMPLF PlMMPLM 0M L1 L2 0F Are workers better off as a result of intentional trade Let s look at the change in real wage rates W PM amp W PF W PM i because APM gt AW W PF T because AW gt 0 APF We cannot say whether workers are better or worse off this depends on the relative importance of manufactures and food in workers consumption a Price change and Change of return on Speci c Factors What is the economic effect of PM T on owners of specific factors when PMT gt LM T KLi gt MPKT RKPMT and LFL TL T gt MPTL RTPFL for RKPM T it must be that ARKgt APM gt0 eg 12 gt 10 gt 0 and for RTPF i it must be that ARTlt APM 0 eg 8 lt 0 In general If APF gt 0 and APM 0 then ARK lt 0 lt AW lt APF lt ART If APM gt0 and APM 0 then ART lt 0 lt AW lt APM lt ARK Income Distribution and the Gains from Trade To assess the effects of trade on particular groups the key point is that international trade shifts the relative price of manufactures and food Trade benefits the factor that is specific to the export sector of each country but hurts the factor that is specific to the importcompeting sectors Trade has ambiguous effects on mobile factors Could those who gain from trade compensate those who lose and still be better off themselves If so then trade is potentially a source of gain to everyone The fundamental reason why trade potentially benefits a country is that it expands the economy s choices This expansion of choice means that it is always possible to redistribute income in such a way that everyone gains from trade Manufacturing and Services N From 1999 to 2001 about 13 million workers were displaced in manufacturing and 858000 in services as shown in Table 31 Of those laid off in manufacturing 56 were reemployed by January 2002 but most ofthese 64 ea1ned less in their newjob For services however 70 were reemployed by January 2002 and more than half ofthese 55 earned the same or more in their newjobs Four lessons Wages dz39 r across different sectors in the economy so our theoretical assumption that wages are the same in both industries is a simplification Many workers are displaced each year and must find jobs elsewhere Some of these workers may be laid off due to competition from imports but there are other reasons too for instance products that used to be purchased go out of fashion firms reorganize as computers and other technological advances become available and firms change locations 37 The majority of dlsplaced workers flnd a new Job wrthrn two years but not e aged 25 to 24 are otten able to nd anewjob wrth the same or hrgherwages 47 The real wagempmductmn warkzrs m the Unrted States between 1979 and 1995 andrn later ehapters we wlll examlne the reasons for that fall Table 31 Jul Loss m lhnuf rluriug and Service Industries Janna 2001 Total P Hugues lnnusrn nlrplsrerl n ken ottlre tr an ns neenphred z nlus arnsnmenr quot quot dquot m Wquot m nvi inh mm in In N m maunfncmlmg murmur m 35 54 35 ulnaml mac39muery 238 41 48 52 huemun uupuknrntal 204 59 73 2 Txmlspnnmmuqmpmzm m 55 74 26 Fabnuled mam pxcdnu 7g 51 92 E Srnius 858 7D 45 anfeltslnunlsznlcelt 41 73 4S Source US Burerueunhor Sinnshc hm 39luvw hls Eo neurelerse rhs m lmn Unemployment one realrstre feature that we have rgnoredrn the speclflcrfactors model ls unemployment one ofthe reasons we rgnore unemploymentrn thrs model ls thatmany u db buslness eyeles andrtrs hardto eombrne buslness eyele models wrth rntematronal trade models B utt e other srmpler reason ls that even when people are lald off due to rmport eompeuuon many ofthem do d thrn a reasonable penod oftlme and someumes they ndrobs n newabswl at hxgher wages Therefore even lfwe take rnto l e eould not eonelude that trade ls neeessarrly good or bad for workers Trade Adjustment Assistance Shouldthe go ment step m to eompensate workers who are lookmg forjobs or who do not flndthem m areasonable perrod oftlme7 The unemployment rnsuranee program m the Unrted States proyrdes some eompensauon regardless ofthe reason for the layo 1n addruon there ls a Trade AdjustmentAsslstanee TAA program that offers addruonal unemploymentrnsuranee payments for up to one year to workers who are lald off due to rmport eompetrtron and who are enrolledrn a retrarnrng program 0 Since 1993 there has also been a special TAA program under the North American Free Trade Agreement NAFTA for workers who are laid off due to import competition from Mexico or Canada Other countries too have programs like TAA to compensate those harmed by trade A particularly interesting example occurred with the uni cation of East and West Germany on June 30 1990 On that date all barriers to trade between the countries were removed as well as all barriers to the movement of labor and capital between the two regions The pressure from labor unions to achieve wage parity ie equality between the East and West meant that companies in former East Germany were faced with wages that were far above what they could afford to pay According to one estimate only 8 of former East German companies would be pro table at the same high wages paid in the West In the absence of government intervention it could be expected that severe bankruptcy and unemployment would result leading to migration to the former West Germany Economists studying that situation proposed that deep wage subsidies 7 or flexible employment bonuses 7 should be given in former East Germany thereby allowing factories to employ their workers while only paying a fraction of their wages Furthermore it was argued that the wage subsidies would essentially pay for themselves because without them the government would have to provide unemployment insurance on a massive scale to the persons left without jobs As it turns out wage subsidies of this type were not used and unemployment in the East along with migration to the West continues to be a policy issue Programs like TAA are intended to share the overall gains from trade with workers who lose their jobs because of trade competition but not all economists or policy makers agree with these programs Why should workers who are laid off because of import competition be treated any differently from someone who is laid off for any other reason And would the compensation provided to workers just allow them to remain unemployed Regardless of whether you agree or disagree with the idea that workers laid off due to import competition deserve special treatment it is useful to think about the best way to design a compensation program A Preliminary View of The Political Economy of Trade Trade often produces losers as well as winners I Optimal Trade Policy The government must somehow weigh one person s gain against another person s loss 7 Some groups need special treatment because they are already relatively poor eg shoe and garment workers in the United States 7 Most economists remain strongly in favor of more or less free trade Any realistic understanding of how trade policy is determined must look at the actual motivations of policy I Income Distribution and Trade Politics Those who gain from trade are a much less concentrated informed and organized group than those who lose 7 Example Consumers and producers in the Us sugar industry Summary International trade often has strong effects on the distribution of income within countries so that it often produces losers as well as winners Income distribution effects arise for two reasons Factors of production cannot move instantaneously and costlessly from one industry to another Changes in an economy s output mix have differential effects on the demand for different factors of production A useful model of income distribution effects of international trade is the specific factors model In this model differences in resources can cause countries to have different relative supply curves and thus cause international trade In the specific factors model factors specific to export sectors in each country gain from trade while factors specific to importcompeting sectors lose Mobile factors that can work in either sector may either gain or lose Trade nonetheless produces overall gains in the sense that those who gain could in principle compensate those who lose while still remaining better off than before Economists do not normally count the costs of unemployment as a loss from trade because people are able to nd jobs elsewhere In the United States for example about onehalf of persons laid off from manufacturing find new jobs within two years though often at lower wages For persons laid off from service industries about 70 find jobs within two years and often at the same or higher wages Trade Adjustment Assistance policies are intended to compensate those who are harmed due to trade by providing addition income during the period of unemployment Lecture 8 The Instruments of Trade Policy Tariff Introduction I This chapter is focused on the following questions What is a trade policy What is WTO What does it do What are the effects of various trade policy instruments Who will bene t and who will lose from each trade policy instrument What is a trade policy President George Bush promise of using a tariff on imports of steel in 2000 presidential campaign That promise was made for political purposes it helped Bush secure votes in Pennsylvania West Virginia and Ohio states producing large amounts of steel The steel tariff is an example of a trade policy a government action meant to in uence the amount of international trade Opening of trade normally creates both winners and losers Because the gains from trade are unevenly spread it follows that rms industries and labor unions often feel that the government should do something to help limit their losses or maximize their gains from international trade I That something is trade policy including the use of tariffs ie taxes on imports quotas ie limits on imports and also subsidies for exports Because trade policies in one country affect the trade ows and terms of trade of its trading partners there is an international governing body called the World Trade Organization WTO which acts as a forum for countries to come to agreement on trade policies among them and resolve policyrelated disputes when they arise Brief History of the World Trade Organization Following World War II representatives of 45 countries met at the United Nations Monetary and Financial Conference in Bretton Woods New Hampshire to discuss the rebuilding of Europe and issues such as high trade barriers and unstable exchange rates I The outcome was an agreement referred to as the Bretton Woods Agreement The trade component of the Bretton Woods Agreement formalized as the GATT in 1947 was intended to reduce barriers to trade between countries and in general to promote the goal of free trade among nations as a means of fostering cooperation integration and mutual gains from trade Under the GATT countries meet periodically for negotiations called rounds to lower trade restrictions between countries The name of the GATT was changed on January 1 1995 to the World Trade Organization WTO as it is known today I GATT vs WRO 7 GATT is just a set of rules for how to conduct trade I WTO formal international institution governing global interactions including trade in services and intellectual property protection through binding agreements 39 Jgt Some of the main stipulations are as follows N E 4 V39 0 Article I of the GATT the most favored nation clause states that every country belonging to the WTO must be treated the same ie same tariff Article VI of the GATT states that an importing country may impose a tariff on goods being dumped into its country by a foreign exporter Countries should not limit the guantity of goods and services that they import Article XI states that countries should not maintain quotas against imports An import quota is a limit imposed by the importing country on the quantity of a particular import good from abroad There are many exceptions to this rule Countries should declare export subsidies provided to particular rms sectors or industries Article XVI deals with exp01t subsidies bene ts such as tax breaks or other incentives for rms that produce goods speci cally for export The article states that countries should notify each other of the extent of subsidies and discuss the possibility of eliminating them Under the Doha Round of WTO negotiations the elimination of agricultural subsidies has been discussed recently Countries can temporarily raise tariffs for certain products Article XIX is called the safeguard provision or the escape clause and is our focus in this chapter Article XIX lists the conditions under which a country can temporarily raise tariffs on particular products The importing country can temporarily raise the tariff when domestic producers are suffering from import competition The steel tariff of March 2002 is an example of a tariff that was applied by the United States under Article XIX of the GATT Regional trade agreements are permitted under Articles XXIV of the GATT The GATT recognizes the ability of blocks of countries to form two types of regional trade agreements 1 free trade areas in which a group of countries voluntarily agree to remove trade barriers between themselves and ii customs unions which are free trade areas that also adopt identical tariffs between themselves and the rest of the world Gains from Trade The analytical framework will be based on either of the following A small country trading with the rest of the world Two large countries trading with each other Tariffs can be classi ed as Speci c tariffs Taxes that are levied as a xed charge for each unit of goods imported Example A speci c tariff of 10 on each imported bicycle with an international price of 100 means that customs of cials collect the xed sum of 10 Ad valorem tariffs Taxes that are levied as a fraction of the value of the imported goods Example A 20 ad valorem tariff on bicycles generates a 20 payment on each 100 imported bicycle Some Basic Concepts Consumer and Producer Surplus I Consumer surplus It measures the amount a consumer gains from a purchase by the difference between the price he actually pays and the price he would have been willing to pay It can be derived from the market demand curve Graphically it is equal to the area under the demand curve and above the pr1ce I Producer surplus Graphically it is equal to the area under the price line above the supply curve Note that area under the supply curve up the quantity exchanged z is production cost to the rm but for the whole economy it represents opportunity cost 7 the value of other goods and services that are not produced because resources are instead used to produce this product PS revenue received cost incurred return to inelastic factors Price CS Price S PS P1 D 2 D1 Quantity S 1 Quantity Consumer surplus Producer surplus Trade in a Single Industry in a Small Open Economy Price S Price S CS PA PS PA D PW quotI a a D Q0 Quantity S 1 D1 Quantity No trade Free Trade Measuring the Cost and Benefits assuming there is no externalities I Is it possible to add consumer and producer surplus In general we cannot compare the welfare effects on different groups without imposing our subjective weights to the economic stakes of each group Economists have tended to resolve the matter by imposing a value judgment that we shall call the onedollaronevote metric the value of any gain or loss is treated equally regardless of how experiences it Here we are assuming that at the margin a dollar s worth of gain or loss to each group is of the same social worth onedollar one vote metric You need not accept this value judgment With this assumption we can algebraically add consumer and producer surplus Gains from Trade Rise in Consumer Surplus b d Fall in Producer Surplus d Net effect on Home Welfare d Basic Tariff Analysis Figure 871 Deriving Home s Import Demand Curve Pri eP 5 M e P V A PA 2 r 1 A m I I I MD I I D I I I I I I I s1 be 739 Quantity 0 D2 52 m 54 Quantity 0 pryngrt 2003 PearsnnEducaLWn In she as To nd the world price Pw and the quantity trade Qw two curves are de ned I Home import demand curve Shows the maximum quantity of imports the Home country would like to consume at each price of the imported goo That is the excess of what Home consumers demand over what Home producers supply MD DP 7 SP Properties of the import demand curve I It intersects the vertical axis at the closed economy price of the importing country I It is downward slo i I It is atter than the domestic demand curve in the importing country Prlee s Prlee Xt w W P abek e i D i 5152 D1 D2 Quantrty M M Imports Home market Import market Tariff fur a Small Cnumry Cast and Bene ts nf a Tari A tanffralses tlne pnee ofagoodln tlne lmpomng eountry As aresult of tlnese pnee changes Consumers lose ln tlne lmpomng eountry and gam ln tlne expomng eountry ment lmposlng tlne tanffgalns re To measure and eompare tlnese eosts and bene ts we neeolto deflne eonsumer and proolueer surplus Lass rr nm tarllr Fall ln Consumer Surplus rabcd Rlse ln Produeer Surplus a Rlse ln govemmentrevenue e Net effect on Home Welfare 7 b ol 39 39 Tariff T b tanffs ln steel we neeolto esumate tlne area ofthe mangle len tlne Flgure above The base of tlus mangle ls tlne elnange ln rmports clue to tlne tarlffs or AM eMl Th nerglnt ofthe mangle ls tlne lncrease ln tlne olomestr nee clue to tlne tanff or AP t s tlne deadwerglntloss equals DW39L V2 tAM wlueln ls PWM We wlll also use tlne pereentage tarlff whlch ls tPW and tlne pereentage elnange ln n e value oflmpons ean then be rewntten as PW M Case Study US Tariffs on Steel I Tariff of steel 30 gt the percentage increase in the price tPw 03 I The quantity of steel imports also fell by 30 in the rst year so that AM 03 I Therefore the deadweight loss is DWLPM 12 03 X 03 0045 or 45 ofthe import value 39 47 b value of steel imports in the year prior to March 2002 39 35 b value of steel imports in the year after March 2002 I 1247 35 41 b average imports over the two years tariffs not included I APM 47 35 12 b fall in import value gt AMM 1241 30 I DWLPM X PM DWL 0045 X 41 billion 185 m price of job protection of steel workers temporarily loss to consumer of steel such as rms producing automobiles 7 did object to the tariffs and encouraged President Bush to end them early Response of WTO members I The tariffs on steel most heavily affected Europe Japan and South Korea along with some developing countries that were eXporting a significant amount to the US I These countries objected to the restriction on their ability to sell steel to the US I The 25 EU countries plus Brazil China Japan South Korea New Zealand Norway and Switzerland took action by bringing the case to the WTO I The WTO has a formal dispute settlement procedure under which countries who feel that the WTO rules have not been followed can bring that complaint and have it evaluated I The WTO in early November 2003 ruled that the US had failed to prove that its steel industry had been harmed by a sudden increase in imports and therefore it did not have the right to impose safeguard tariffs I The WTO ruling entitled the EU and other countries to retaliate against the US by imposing tariffs of their own against US eXports I The EU countries drew up a list of products itotaling some 22 billion in US eXports 7 against which they would apply tariffs I The threat of tariffs being imposed on these products led President Bush to reconsider the US tariffs on steel and on December 5 2003 he announced that they would be suspended after being in place for only 19 months rather than the three years as initially planned Import Tariff for a Large Economy I Assumptions There are two countries Home and Foreign or rest of the world Both countries consume and produce a homogenous product under a CRTS technology which can be transported between the countries with no costs There is no eXtemalities I the production and consumption of the product In each country the product is a competitive industry many buyers and sellers with no market power Fnreign Expan Supply world at each nce That 15 the ercess ofwhat Forexgi producers supp 1y overwhat forelgi consumers demand Xquot mp quot D YPquot Pnce Pnte 4 0 Du Sr P u I P M M v D s39 Quautu x Bpnns E ecu UT a Taxi sume that two lagge couhmes trade thh each otha Suppose Home mp 056 a Lax of 1 on every bushel ofwheat unp otted between the two markets 15 at least t Pnce Pnre g X39wr e r x4 P C Pu a A r k P l I k r E D quot C x1 5 s D D Quaunr M M Imports 2 Dumestic market b Wurld market re 77 Tarifffur szrge C unLr The Laan shttts up the erpo Supp x to Xt As a result theHomepnce maeases from Forexgi pnce falls r Pwto PM and the omPWLo 19 The deadwetght loss at Home is the area of the triangle bd and Home also has a terms oftrade gain of area e Foreign loses the area e so the net loss in world welfare is the triangle bd In Home producers supply more and consumers demand less due to the higher price so that fewer imports are demanded In Foreign producers supply less and consumers demand more due to the lower price so that fewer exports are supplied Thus the volume of wheat traded declines due to the imposition of the tariff The increase in the domestic Home price is less than the tariff because part of the tariff is re ected in a decline in Foreign s export price If Home is a small country and imposes a tariff the foreign export prices are unaffected and the domestic price at Home the importing country rises by the full amount of the tariff Cost and Bene ts of Tariff for the Importing Country LossGain from tariff Fall in Consumer Surplus a b c d Rise in Producer Surplus a Rise in government revenue c e Net effect on Home Welfare e b d The areas of the two triangles b and d measure the loss to the nation as a whole efficiency loss and the area of the rectangle 6 measures an offsetting gain terms of trade gain The efficiency loss arises because a tariff distorts incentives to consume and produce Producers and consumers act as if imports were more expensive than they actually are Triangle b is the production distortion loss and triangle d is the consumption distortion loss The terms of trade gain arises because a tariff lowers foreign export prices If the terms of trade gain is greater than the efficiency loss the tariff increases welfare for the importing country In the case of a small country the tariff reduces welfare for the importing country Foreign and World Welfare While Home might gain from the tariff Foreign the exporting country definitely loses In panel b of Figure 77 the Foreign loss is measured by the area e Notice that the area 6 is the terms of trade gain for Home but an equivalent terms of trade loss for Foreign Home s gain comes at the expense of Foreign In addition the large country tariff incurs an extra deadweight loss in Foreign of f so that the combined total outweighs the benefits to Home For this reason we sometimes call a tariff imposed by a largecountry a beggar they neighbor tariff 39 rr L cancels b This area is adeadweigh loss for he world 0p imum ariiifor a large country The ariffra e ha maximizes nan39onal welfare 1 isar a quot quot 1 is zero for a small country because i canno affec i s erms of rade m opn39mum arimhe marginal gain from improved TOT jus equals he Importer s WeLfar n cpumal Prunlbluu Tanff Innfi Ianfr Optimal Tariff Formula ere is a simple formula for he opn39mal ariff The formula depends on he elas jci y ofForeign expon supply which we call Ea E n n n n in he world price of he export Opuinal mn 39 run I I and so o imal anffis zero For a large imporn39ng country however he Foreign expon supplyis less haninfini e and we can use his formula o compu e he opn39m an As he elas ici y ofForeign expon supply decreases which means ha he Foreign p r suppl L 39 39 39 39 39 will lower heir price more in response o he anff Example IfEx i from 3 o 2 gt op jmal tariffT from V 33 o v2 50 o 39 me willing o lower heir 39 39 share oflhe tariffburden 0 me oun o tains alarger terms oftrade increase and hence me gtH c try b opn39mal level of he ariffis higher Optimal Tariffs for Steel For the three produet eategorres m Table 7 2 where the U s applledtanffs m 2 produets the ToT gam gt DW39L butrn atlurd ease the DW39Lls hlgher casef r tarru e rrnporter ean nse due to atarlff whlle the thrrd produet rllustrates the smallr eountry ease where the rrnporter loses from the tan From the lnformanon gwen m Table 7 2 we do notknow whether the U s gamed or Butrn the end we shouldkeep m rnrndthat any nse m U s welfare eornes at the expense ofexpomng eountnes Table 7 139 Opnm l Tau 39s or Sxeel Pxoducvs anduu Cnregm Ilnsu cltp nI Uprluunl Tariff Auunl Tm u pran Suppl pe enrl percent 27 370 n ammo Elm And Smel halls And Rama Track 0 so 23 o hmAndSlzelBan Rad Angles shapes use us ls em FmousWaneAndScmp l7 5 o hon And steel Tubegt Plps And megs Em l 13 715 um And Nmallnv steel Funmen menu 750 o o The Infant Industry Argument The Case at a Mssing Market What ls an lnfant rndustry7 r There ls anew rndustry thathas ahlgh startrng eost falls wth eurrent output ru Average costfalls enough to make the lndustxy pro table Net Present Valuegt0 w But pnvate rnvestrnent may not ha pen because nsnme erztfmlme parueularly rrnperfeeuons m the eaprtal rnarket gt Then a temporary mm 1715 just ed beeause rt euts down on rrnports whlle the lnfant dornestre lndustxy learns howto produee low enough eosts to eornpete wrthout the help ofatanff future costs This allows me rmto survive whereas omerwise it would not Three conclusions emerge in most case There can be a case for some sort ofgovemment encouragement A tariffmay or may not ne1 Some other form ofhelp is better infant industry policy than tariff an initial period ofprotection Cost and Benefits calculus of infant industry Pn39ce MC Price MCquot AC Pw AC PW D D sis D1 Di Quamity S Di Quaumy a Today 1 Future Figure 79 Infant Industry Protection In the situation today panel a the average cost curve is AC and the industry would make losses at the world price of PW A tariff increases the price from PW to PWt allowing the industry to produce at S2 with the net loss in welfare of bal But producing today allows the average cost curve to fall through learning So in the future panel b the rm can produce and the price P without tariff protection and earns producer surplus of 6 Market Failure Justi cations for Infant Industry Protection I Imperfect capital markets justification If a developing country does not have a set of nancial institutions that would allow savings from traditional sectors such as agriculture to be used to nance investment in new sectors such as manufacturing then growth of new industries will be restricted I Appropriability argument Pioneering firms in a new industry generate social benefits which they are not compensated e g startup costs of adapting technology to local circumstances or of opening new markets Some evidence on infant industry I Historical evidence Example The US and Germany had high tariff rates on manufacturing in the 19th century while Japan had extensive import controls until the 1970s Example The case of US tariff on imports of heavyweight motorcycles It is well documented see Reid 1990 that HarleyDavidson was on the brink of bankruptcy in 198283 and was able to secure a bank loan only after receiving protection So the tariff may well have contributed to its continued survival 7 Its nearbankrupt status was due to problems of poor management and lagging productivity while its revival after 1983 was due to the introduction of improved products and production techniques 7 It cannot be argued that this broad change in company practices was caused by the tariff but it appears that the temporary tariff bought it some breathing room 7 Its improved products later offered by HarleyDavidson which were emulated by its Japanese rivals the temporary tariff may well have contributed to longrun welfare gains for consumers In contrast the compact trucks introduced by American firms after the tariff were quite similar to the existing Japanese models and brought little additional welfare gain Feenstra 1988 Problems with the Infant Industry Argument for protection in LDC s Timing is important It is not always good to try to move today into the industries that will have a comparative advantage in the future Example In the 1980s South Korea became an exporter of automobiles whereas in the 1960s its capital and skilled labor were still very scarce The implementation of policy is important in the success 13 Example Pakistan and India have protected their heavy manufacturing sectors for decades and have recently begun to develop signi cant exports of light manufactures like textiles Reciprocal Dumping I I there is a case to be made for infant industry protection whereby an increase in the import price allows a rm to survive then the reverse should also be true a decrease in the importpriees might lead afirm to shut down This would be an example of predatory dumping whereby a foreign exporter would lower its prices in anticipation of driving rivals in the domestic country out of business Dumping can be a natural occurrence under imperfect competition as oligopolists enter each other s markets This is can be demonstrated using the reciprocal dumping of Brander and Krugman Tariffon Imports from a Foreign Monopol When the home country imports from a foreign monopolist with constant MC then a small tariff raises home welfare when the slope of MRltD Po initial equilibrium domestic and foreign price P1 the import price a er tax on imports P1 t the foreign price received by the exporters Consumer Surplus loss area c d Revenue gain area e c Net gain e d Price Increase in P is less than t the inrrease in MC Increase in MC due to tariff t X2 X1 Foreign exports 14 0 Note that in both cases above foreign producer absorbs part of the tariff not fully passed through to home prices 0 Most studies suggest that the passthrough of tari is less than complete and average about 06 for US for other countries it is typically larger though this depends on the industry being studied The Case ofDomestic Production Externalit Suppose firms in an industry generate knowledge that other rms can also use Without paying for it In hightech industries firms face appropriabili problems Example In electronics it is common for rms to reverse engineer their rivals designs The Case for Government Support of HighTechnolog Industries Subsidize the activity With externalities not all activities in an industry For instance RampD as opposed to manufacturing should be subsidized Production externalities and tariffs A tari may raise welfare if there is a marginal social bene t to production of a good that is amp captured by producer surplus measures There is no cure allprescription for all trade policy problems in a second ibest world National Welfare Arguments Against Free Trade Figure 93 The Domestic Market Failure Argument for a Tariff Price P a I I I I I S1 82 De D1 Quantity Q Dollars i i I I I I 39 Marginal b social bene t 51 Quantity Q Copyright 2003 Pearson Education In Share 9716 Pdt PM Note that the first term on the RHS is the slope of SX So optimal tariff as a fraction of the world price 7 the price paid to foreigners is equal to the inverse of the elasticity of foreign export supply t 18 8 gt infinity as t gt 0 The larger the elasticity of foreign export supply the smaller the optimal tariff rate Lecture 2 Chapter 2 Labor Productivity and Comparative Advantage The Ricardian Model The Concept of Comparative Advantage using a modern example On Valentine s Day the US demand for roses is about 10 million roses Growing roses in the US in the winter is dif cult o Heated greenhouses should be used 0 The costs for energy capital and labor are substantial Resources for the production of roses could be used to produce other goods say computers 0 Suppose that in the US 10 million roses can be produced with the same resources as 100000 computers 0 Suppose also that in Mexico 10 million roses can be produced with the same resources as 30000 computers Table 2 1 Hypothetical Changes in Production Million Roses Thousand Computers United States 10 100 South America 10 30 Total 0 70 The example in Table 21 illustrates that o If US shifts the resources employed in Rose production into Computer production and Mexico shifts the resources employed in Computer production to Rose production and trade in total there will be 70 thousand more computers produced which can be shared between the two countries But what the source of this extra production What makes this trade mutually bene cial Obviously if US specialize in Rose instead of computers and Mexico on computers instead of Rose the countries make loss and not gain So only certain specialization is bene cial But what kind of specialization Absolute Advantage 0 Note that resources used in making 10 million roses in US are not necessarily equal to the resources employed to make that many roses in Mexico 0 This example assumes that Mexico is relatively less productive in computer production compared to US Now let s assume that it takes the same amount of resources to produce 10million roses in both countries Then we say US has absolute advantage in computer production because it takes less resources to produce computers in US than in Mexico Why Because US must be more productive 7 have a better technology or has more skilled labor 7 in computer production Then it seems that US absolute advantage in computer production is the reason for trade Now let s assume that it takes fewer resources to produce roses in US compared to that in Mexico Then we say US has absolute advantage in the production of both goods because it can produce both goods using less resources compared to Mexico But if a country has absolute advantage in both goods which one it exports if any It seems that absolute advantage does not provide a general guidance and who exports what and why countries trade Comparative Advantage In the table above we see that trade between the two countries does not hinge on absolute advantage It does not matter whether the resources employed in the production of roses in the two countries are the same or different What makes mutually advantages trade possible is alz erence in opportunity cost of production The opportunity cost of roses in terms of computers is the number of computers that could be produced with the same resources as a given number of roses Opportunity cost is defined as the value of the next best option foregone US 100000 Mexico Opportunity cost of 10 million roses 30000 In terms of computers not produced Clearly the opportunity cost of rose production is higher in US lower in Mexico If each country specializes in the production of the good with lower opportunity costs trade can be beneficial for both countries 0 Roses have lower opportunity costs in Mexico 0 Computers have lower opportunity costs in the US A country is said to have a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries Thus Mexico has comparative advantage in rose production and US has comparative advantage in computer production Once every country specializes in production of goods that has a comparative advantage in and then trades its excess supply for the goods that it does not have a comparative advantage more goods will be produced between all the countries 0 The extra production is the result of better allocation of resources This extra production can be divided between the trading countries allowing them to achieve higher consumption levels What determines comparative advantage Opportunity cost is related to relative productivity Why opportunity cost of computer production is lower in US and higher in Mexico Because US is relatively more productive in computer production compared to Mexico That is US productivity in computers relative to roses is higher than that of Mexico The Formal Model Assumptions of the model This is a lx2x2 model one factor two countries Home Foreign and two goods say wine and cheese 0 Labor homogeneous within every country mobile domestically between the two industries and immobile internationally Supply of labor is xed in each country 0 Technology Productivity of labor in each good is w and given by ULR The unit labor requirement is the number of hours of labor required to produce one unit of output This is represented by a for home and a for the foreign country I Note that aLQ thus laQL or simply labor productivity 0 Perfect competition prevails in all market ere are no other costs involved transportation costs etc A numerical illustration Unit Labor Requirement Cheese Wine Home a 1 hour per pound am 2 hours per gallon Foreign ofC 6 hours per pound afw 3 hours per gallon In Home one would have to give up 2 pounds ofcheese to get 1 gallon ofwine The OC ofl gallon ofwine is 2 pounds ofcheese OC ofW the amt ofC you have to give up in order to have 1 gallon ofW In Foreign give up 05 pound of cheese to get one gallon of wine The OC ofl gallon ofwine is 05 pound ofcheese Opportunity Cost 1 no trade C in terms of W W in terms of C In Home 1L mm 05 gl Wlb C any aLc 2 In Foreign a LCaHLW 2 a 1W a LC 05 7 Here Home has absolute advantage both goods because it takes fewer resources to produce wine and cheese in Home country MPL is higher in Home that is am lt aLc and aLW lt aLW or MPLC gt MPLC and MPLW gt MPLW But absolute advantage is irrelevant to trade In the example Home has comparative advantage in Cheese production because opportunity cost of Cheese production is lower 05lt 2 that is aLc CILW lt aLc 61Lw gt MPLWMPLC lt MPLW WMPLCgtxlt 7 Home is relatively less productive in Wine production Foreign is relatively more productive in Wine production 7 Home has a comparative advantage in cheese and will export it to Foreign in exchange for wine 0 there is only one price ratio in each country 0 Opcost W and C are just reciprocal of each other I In Home W in expensive and C is cheap I In Foreign C is expensive and W is cheap 0 Now trade and make money sell one gallon of foreign W in US mkt in exchange for 2 pounds ofUS cheese and then sell each pound ofUS cheese for 2 gallons of foreign wine in foreign mkt and make 3 gallons of wine profit David Ricardo39s Numerical Example In his example Ricardo imagined two countries England and Portugal producing two goods cloth and wine using labor as the sole input in production He assumed that the productivity of labor ie the quantity of output produced per worker varied between industries and across countries However instead of assuming as Adam Smith did that England is more productive in producing one good and Portugal is more productive in the other Ricardo assumed that Portugal was more productive in both goods Based on Smith39s intuition then it would seem that trade could not be advantageous at least for England However Ricardo demonstrated numerically that if England specialized in producing one of the two goods and if Portugal produced the other then total world output of both goods could rise If an appropriate terms of trade ie amount of one good traded for another were then chosen both countries could end up with more of both goods after specialization and free trade then they each had before trade This means that England may nevertheless bene t from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything As it turned out specialization in My good would not suf ce to guarantee the improvement in world output Only one of the goods would work Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production To identify a country39s comparative advantage good requires a comparison of production costs across countries However one does not compare the monetary costs of production or even the resource costs labor needed per unit of output of production Instead one must compare the opportunigg costs of producing goods across countries A country is said to have a comparative J in the r J quot ofa good say cloth if it can produce cloth at a lower opportunity cost than another country The opportunity cost of cloth production is de ned as the amount of wine that must be given up in order to produce one more unit of cloth Thus England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give up to produce another unit of cloth All in all this condition is rather confusing Suf ce it to say that it is quite possible indeed likely that although England may be less productive in producing both goods relative to Portugal it will quot 39 have a 39ve J in the r J quot of one of the two goods r Another wav to de ne r quot V J is by comparing productivities across industries and countries Thus suppose as before that Portugal is more productive than England in the production of both cloth and wine If Portugal is twice as productive in cloth production relative to England but three times as productive in wine then Portugal s comparative advantage is in wine the good in which its productivity advantage is greatest Similarly England39s comparative advantage good is cloth the good in which its productivity disadvantage is least This implies that to bene t from specialization and free trade Portugal should specialize and trade the good in which it is quotmost bestquot at producing while England should specialize and trade the good in which it is quotleast worsequot at producing Note that trade based on comparative does not contradict Adam Smith s notion of advantageous trade based on absolute advantage If as in Smith s example England were more productive in cloth production and Portugal were more productive in wine then by we would say that England has an absolute advantage in cloth production while Portugal has an absolute advantage in wine If we calculated comparative advantages then England would also have the comparative advantage in cloth and Portugal would have the comparative advantage in wine In this case gains from trade could be realized if both countries specialized in their comparative and absolute advantage goods Advantageous trade based on comparative advantage then covers a larger set of circumstances while still including the case of absolute advantage and hence is a more general theory Ricardian Model Highlights Trade occurs due to differences in production technology Trade is advantageous for everyone in both countries Even a technologically inferior country can bene t from free trade A developed country can compete against some low foreign wage industries General Equilibrium Analysis Now let us looking at the whole economy 0 General Equilibrium vs Partial Analysis 0 PE is a study of a mkt for a commodity in isolation I Increase in Supply of C leads to a decrease in Price of C 0 GE incorporates impact on other goods Wine and factors like L 0 Production Possibilities The production possibility frontier PPF of an economy shows the maximum amount of a good say wine that can be produced for any given amount of another say cheese and Vice versa The PPF of our economy is given by the following equation aLCQCaLWQWL 1 Note that opportunity cost re ected by the slope of PPF is constant in each country and given by the ratio of ULR in the two sectors that is aLc aLW Figure 31 Home39s Production Possibility productionv OW Frontier 39 The line PFshows the maxi mum amount of cheese Home can produce given any pro duction of wine and vice versa F Absolute value of slope equals opportunity cost ol cheese in rerms 0 wine UaLW l Us Home cheese production QC Relative prices before trade 0 Denote with PC the dollar price of cheese and with PW the dollar price of wine Denote with WW the dollar wage in the wine industry and with WC the dollar wage in the cheese industry 7 Under perfect competition price of each good is equal to its marginal cost ie PC MCC 7 MCC WC aLC wage rate in Cheese industry X labor required to produce a unit of wine that is am 7 SO PC WC am 7 Thus WC PcCILC 01 WC PC I That is the hourly wage in Cheese Wine industry is equal to the value of what a worker can produce in an hour 7 Ich gt WW that is lch ac gtPwCIW OI PC Pwgtac aW then no Wine will be produced QW 0 and QC LaLc I ie when the relative price of cheese PCP W exceeds its opportunity cost aLc on W then the economy will specialize in the production of cheese 7 Ich lt WW that is lch ac ltPwCIW OI PC Pwlt ac aW then no Cheese will be produced QC 0 and QW LaLW 7 Iow WC that is lfPW CIW Pc ac orPWPc awac then both QC and QWwill be produced 7 In the absence of trade both goods are produced and therefore PC PW aLcaLw Or PC PW MPLwMPLc Home Equilibrium with N0 Trade From our previous example we have em l aLW 2 and L120 in Home country Home QC ZQW 120 Qw Home amaLw 05 60 Qc LaLc 1201 120 In absence of trade consumption in every country is constrained to its production Before trade Home country produces and consumes at point A where its production possibility frontier is tangent the highest social indifference curve in autarky U1 We will refer to point A as the notrade or the pretrade equilibrium for Home We are assuming that there are many firms in each of the wine and cheese industries so the firms act under perfect competition ie taking the market prices for wine and cheese as given The idea that perfectly competitive markets lead to the highest level of well being for consumers 7 as illustrated by the highest level of utility at point A 7 is an example of the invisible hand that Adam Smith 17231790 wrote about in his famous book The Wealth of Nations Like an invisible hand competitive markets lead firms to produce the amount of goods that results in the highest level of wellbeing for consumers Foreign Equilibrium with N0 Trade 0 In Foreign country we have a 6 612W 3 and L 300 so the production possibility frontier for foreign country is given by Foreign 6QC 3Q W 300 2QC QW 100 0 Similarly the Foreign country produces and consumes at point a 0 Before trade prevailing prices in every country is equal its opportunity cost Foreign Qw LlilakLw P cPiw aim391W 2 100 l 100 Case Study Us Comparative Advantage in Wheat Production The US textile and apparel industry faces intense import competition especially from Asia and Latin America Employment in this industry in the United States fell from about 15 million people in 1990 to less than 1 million in 1999 One example ofthis import competition is the response of a US fabric manufacturer Burlington Industries which announced in January 1999 that it would reduce its production capacity by 25 due to increased imports from Asia Burlington closed seven plants and laid off 2900 people about 17 of its domestic force After the layoffs Burlington Industries employed 17400 persons in the United States With 1999 sales of 16 billion this means that its sales per employee were 16 billion17400 92000 per worker This is exactly at the average for all US apparel producers as shown in Table 22 The textile industry is even more productive with annual sales per employee of 140000 In comparison the average worker in China produces 13500 of sales per year in the apparel industry and 9000 in the textile industry Thus a worker in the United States produces 7 times more apparel sales than a worker in China and 16 times more textile sales If the United States clearly has an absolute advantage in both of these industries why does it import so much of its textiles and apparel from Asia including China The answer can be seen by comparing the productivities of cloth and textiles to those in other industries for example in the wheat industry Table 22 Apparel Textiles and Wheat in the US and China Absolute United States China quot SaleEmployees SaleEmployees USl China Ratio Apparel 92000 13500 7 Textile 140900 9000 16 BushelsHour BushelsHour USl China Ratio Wheat 275 01 Comparative Advantage opportunity cost Bushelsl Bushelsl WheatApparel Ratio x 1000 275009200003 10013500001 Wheat Textile Ratio x 1000 2750014000002 100900001 Note Data are for years around 1995 The typical wheat farmer in California devotes only 135 hours per acre to growing a crop of wheat and an acre provides 37 bushels of wheat This works out a marginal product of 37 135 275 bushels per hour of labor In comparison the typical wheat farmer in China obtains only one tenth of a bushel per hour of labor so the US farmer is 27501 275 times more productive The United States has an absolute advantage in all of these industries but it clearly has the comparative advantage in wheat Thus it exports wheat to the China while importing textiles and apparel just as predicted by the Ricardian model The Patterns of the International Trade Pos Te De Th t Trade Equilibriu If countries r 39 39 this specialization and trade Since by assumption Home has CA in Cheese it will specialize in Cheese production and exports its excess supply of Cheese to the world market and purchases imports all the Wine it needs from the work market Similarly Foreign country will specialize in Wine production World price ratio will be something between the pretrade domestic price ratio of the two countries Pc Pw lt Pc Pw world lt Pc Pw Note that in Home before trade WPC am and W PW aLW With trade PCT and PWL That increases wages in the Cheese and reduces them in the wine industry Thus all the workers in Home move to Cheese Home produces at point P and sells its Cheese in world market at Pc Pw Wm This allows Home to achieve consumption possibility frontier beyond its PPF Recall the consumption possibility frontier states the maximum amount of consumption of a good a country can obtain for any given amount of the other commodity With trade Home can consume at point C along PC where its post trade CPF is just tangent the highest social indifference curve 39 J39 to their A they all gain from Foreign ms of Trade and Relative Wage Rates mand determines terms of trade TOT TOT PX P1 where PX price of exports amp P1 price of imports e relative wage is linearly related to the terms of trade TOT PX P1 PC P W for Home where PC and PW are world prices ofC and W Home makes Cheese only so w Pc aLc Foreign makes Wine only so w Pw aw V V xlt PC aLcPW am aLw aLcPC PW aLw aLc TOT or WW MPLC MPL W TOT the higher the TOT the higher the home wages the higher the productivity in export industry ie 1aLg for home country the higher the wage rate 0 Because there are technological differences between the two countries trade in goods does not make the wages equal across the two countries 0 A country with absolute advantage in both goods will enjoy a higher wage a er trade Solving for Wages Across Countries Unit Labor Requirement Cheese Wine Home aLC 1 hour per pound aLw 2 hours per gallon Foreign a39ZC 6 hours per pound fw 3 hours per gallon Home produces and exports cheese so we canthink of Home workers being paid in terms of that good their real wage is MPLc 1 pound of cheese We refer to this payment as a real wage because it is measured in terms of a good that workers consume and not in terms of money The workers can then sell the cheese they earn on the world market at the relative price of Fe Pw Wm 1 Thus their real wage in terms of units ofwine is Pc Pw Wm MPLc 1 1 1 gallons Summing up the Home wage is MPLc 1 pound of cheese or Pc Pw Md MPLc 1 gallons of wine 05 without trade What happens to Foreign wages Foreign produces and exports wine and the real wage is MPLW 13 gallons ofwine Because wine workers can sell the wine they earn for cheese on the world market at the price of 1 their real wage in terms of units of cheese is PW Pc Wm MPUW 13 pounds Thus the Foreign wage is Pw Pc Wm MPL XN 13 pound of cheese 0167 without trade or MPLW 13 gallons ofwine Foreign workers earn less than Home workers as measured by their ability to purchase either good Predictions of the Ricardian Model 0 With free trade countries specialize completely in goods with lower opportunity cost of production or relatively higher labor productivity export excess production in those sectors and import the other goods 0 Free trade increases the national and the individual welfare consumption income or wage rates in all trading countries No one will be worse off Why do not see extreme specialization 0 There are three main reasons 1 The existence of more than one factor of production This implies that MPL is not constant as assumed in the model That makes PPF nonlinear That is opportunity cost might be increasing Countries sometimes protect industries from foreign competition It is costly to transport goods and services In some cases transportation is virtually impossible 4 Example Services such as haircuts and auto repair cannot be traded internationally introducing transport costs makes some goods non traded 9 Empirical Evidence Can get an accurate prediction about actual international trade ows McDougall study using early Post WWII period data 1951 Comparing British and American Productivity and Trade British Labor productivity was than US in almost every sector 12US America had absolute advantage in almost everything Yet the amt of British overall export was equal to that of US US productivity exceeded British in all 26 sectors by margin of 11 to 366 US exports were larger than UK exports only in industries where US productivity advantage was larger than twice as much Figure 36 Productivity and Expuns A comparative study showed that US exports were high relative to British exports in industries in which the United States had high relative labor productivity Each dot represents 6 mt ferent industry Ratio of IBriIish productivity US exports goods in sector X if its cost of production is lower than UK WaX ltwquot aX or WWltaXaX That is US exports x if WWquot lt 1 Ig 1 aX MPLxMPLX U SUK relative wages lt US UK relative labor productivity in sector X Since USUK relative wages WWquot 2 U S exports in sectors in which U S UK relative labor productivity gt 2 And UK exports in sectors in which U S UK relative labor productivity lt 2 Question Why the most productive rm in the most productive coun does not necessarily prevail in international competition Answer Because there might be rms in other industries with even a stronger productivity advantage than the rms in question driving wage rates cost of production so high that the rm in question cannot compete internationally Signi cance ofRicardian Assumptions Assumption of only 1 factor of production akes everyone in the society exactly the same in terms of skill amp income with more factors trade can distort income distribution through factors I one factor model makes everyone in the society Relative factor abundance alone can cause trade Technological differences are exogenous and comparative advantage is unchanging If capital explains tech difference for instance then dynamic investment accumulation should be included in the model before evaluating the merits of trade Labor is perfectly mobile between industries and perfectly immobile between countries There are actually large transition costs to specialization 50 year old auto worker has grave difficulties in nding a job in another sector say IT The model assumes he can and he will earn an income no less than the one he was earning on his previous job he is as productive as any existing worker in the IT sector Constant Returns to Scale Double labor double outputs Strategic industries like airplane manufacture that face increasing returns to Scale learning by doing Homogenous Products Intraindustry trade trade within a single industry relies on product differentiation so comparative advantage does not explain it well Wages re ect Productivity Good Empirical Evidence points to Yes Conclusion and Summery Two surprising conclusions A country may bene t from free trade even if it is less efficient than all other countries in every industry It makes sense that one firm would be more successful than another firm in a local market if it could produce its output more efficiently that is at lower cost than the second firm If the two firms produce identical products then the less efficient firm is likely to be driven out of business generating losses If we extend this example to an international market then it would also make sense that a more efficient foreign firm would absorb business from a less efficient domestic firm Finally suppose all firms in all industries domestically were less efficient than all firms in all industries in the foreign countries It would then seem logically impossible for any domestic firms to succeed in competition in the international market with the foreign firms International competition would seemingly have only negative effects upon the less efficient domestic firms and the domestic country A domestic firm may lose out in international competition even if it is the lowest cost producer in the world This result is a corollary of the previous point As argued there it seems reasonable to think that a more efficient firm ie one who produces at lower cost would drive its less efficient competitors out of business The same would seem to follow if the two firms are domestic and foreign and the two firms compete in international markets However the Ricardian model of comparative advantage argues that a firm in one country even if it is the lowest cost producer in the world may be forced out of business once the country liberalizes trade with the rest of the world Even more surprising despite the decline of this industry the move to free trade can generate welfare improvements for everybody in the country In other words losing production in a highly efficient industry can be consistent with an improvement in welfare for everyone This contradicts the logic above which would suggest that more ef cient lower cost rms should always win It is important to note that this result does not imply that every decline of an ef cient industry will improve welfare Instead the model merely suggests that one should not jump to the conclusion that the loss of an ef cient industry will have negative effects for the country as a whole Appendix Production and Consumption Ef ciency Gains from Free Trade Consumption Ef ciency Gains Shift of the indifference curve from I Am to Ic When production is still at the autarky position A and trades at free trade prices Production Ef ciency Gains Shift of the indifference curve from Ic to IFT When the country has specialized in the production of the good that it has comparative advantage in that is in Wine in this example point P and trades at free trade prices Lecture 7 Economies of Scale and International Trade Introduction Trade between countries need not depend upon country differences under the assumption of economies of scale Indeed it is conceivable that countries could be identical in all respects and yet nd it advantageous to trade For this reason economies of scale models are often used to explain trade between countries like the US Japan and the European Union For the most part these countries and other developed countries have similar technologies endowments and to some extent similar preferences Using classical models of trade Ricardian HeckscherOhlin these countries would have little reason to engage in trade And yet trade between the developed countries makes up a significant share of world trade Economies of scale can provide an answer for this type of trade Japan s Top exports Japan s top exports to US Japan s top imports Japan s top imports from US India s top exports to US India s top imports from U S SIMgt95 SIM59K SIM59K 959 959 UIAUJNE Road vehicles Electrical and electronic equipment and components Office machines and computers Telecom and audio equipment Power generating equipment and engines Road vehicles Office machines and computers Electrical and electronic equipment and components Photographic equipment Telecom and audio equipment Oil Office machines and computers Fish and seafood Electrical and electronic equipment and components Road vehicles Office machines and computers Electrical machinery and components Cereals Road vehicles Aircraft Nonmetalic minerals gems Clothing Textiles Jewelry Metal manufactures Aircraft Office machines and computers Industrial machinery Power generation equipment and engines Scientific equipment What explains intra industry trade Comparative advantage theories such as Recardian and H0 models predict that in any given industry countries either export or import or do no trade but not both That is comparative advantage theories explain inter industry trade between economies with differences in technology or factor endowment However about oneforth of world trade consists of intra industry trade exports and imports in the same industry Presents of complete and incomplete specializations both Ricardian and H0 models assume the all countries can produce all goods Ricardian model predicts complete specialization that is each country will produce only a subset of all products the ones it has a comparative advantage in and will import the rest HO model predicts incomplete specialization that is all countries produce all goods But in the real world we observe complete specialization in some products and incomplete specialization in others Plus we see that larger countries produce a larger variety of products Trade based on Economies of Scale I Will argue that countries can engage in international trade in order to achieve scale 39 or 39 39 returns in r quot I Two models of international trade in which economies of scale and imperfect competition play a crucial role Monopolistic competition model Dumping model The Significance of Intraindustry Trade About one fourth of world trade consists of intraindustry trade Intraindustry trade plays a particularly large role in the trade in manufactured goods among advanced industrial nations which accounts for most of world trade Index of intraindustry trade I l 7 Abstract value of exports 7 importsexport imports I 0 when an industry has either exports or imports and not both I 1 when exports of an industry is equal to its imports Table 63 Indexes ofIntraindustry Trade for Us Industries 1993 Inorganic chemicals 099 Powergenerating machinery 097 Electrical machinery 096 Organic chemicals 09 1 Medical and pharmaceutical 086 Of ce machinery 08 1 Telecommunications equipment 069 Road vehicles 065 Iron and steel 043 Clothing and apparel 027 Footwear 000 cnpyngmg 2003 Pearson Educazmn Inn snag Economies of Scale An Overview I Models oftrade based on comparative advantage eg Ricardian and H0 models used the assumptions of constant returns to scale and perfect competition Doubling all inputs leads to doubling output In practice many industries are characterized by economies of scale also referred to as increasing returns The larger the scale of production the higher the ef ciency and the lower average price Under increasing returns to scale u u grows proportionately more than the increase in all inputs Average costs costs per unit decline with the size of the market Models of Imperfect Competition I Monopoly A Brief Review MR the extra revenue the rm gains from selling an additional unit MR curve always lies below the demand curve D 7 In order to sell an additional unit of output the rm must lower the price of all units sold not just the marginal one F 61 39gu39e Costcand Munnpnhsnc Pnclng and Pmduclmn Price P Denisinns A monopollstic mquot chooses an output an a all Monopoly pro ts umLTms pru rmaxlmlzlng ampulls AC shnwn as W me once alwhich this Dumutis demanded is PM The margin because for a anopnly marginal revenue IS always lessthan the price The monopoly39s l l shaded rectanglethe di erence QM Quantity 0 belwa n pnee and average costumes Monopolistic Competition A special case of oli o oly Firms produce di erentiated products and charge the same price Free entryexit of rms intro and out of the industry Equilibrium condition in the Short Run Pro t maximization mr MC Price P Demand facing monopoly o AC MC Pro t max cond n Q0 Quantity Short Run Equilibrium Without Trade Equilibrium Condition in the long run mr MC amp Pro t 0 free entry condition A Total market Demand for the D N diff product shared by NA domestic rms before A Z Pr ft 1 em 0 1 con 11 PA AC Pro t max qo n MC mr 1 QA Quantity Long Run Equilibrium Without Trade As new rms enter the market demand facing the monopoly d shifts in and becomes atter in the long run DNA is the total market demand D divided by the number of domestic rms NA producing differentiated product Why Curve DNA is steeper than curve 1 Similarity of the products makes the demand facing each rm much more elastic than the demand facing the industry Price Firm demand when all firms charge the same price Shortrun equilibrium without trade p0 Longrun equilibrium PA without trade AC MC all do I39I II391 01 00 Quantity Opening trade Price Longrun equilibrium without trade Shortrun equilibrium with trade I AC MC 5 W2 01 0392 02 Quantity ShortRun Equilibrium with Trade When trade is opened the larger market makes the rm s demand curve more elastic as shown by d39 By lowering its price to P39 with sales of Q39 the rms expect to make pro ts However when all rms lower their price to P then the quantity sold is instead Q and the rms make losses The losses lead some rms to exit thereby shi ing both demand curves to the right Price Longrun equilibrium without trade DNT Longrun equilibrium with trade AC MC 01 03 Quantity LongRun Equilibrium with Trade The longrun equilibrium with trade occurs at point C with the quantity Qc and price PC As compared to the notrade equilibrium at point A there is a reduction in price and expansion of sales by all surviving rms Let Nc be the umber of rms in each country after trade Nc ltNA but the number of world variety after trade is larger than the number of varieties in autarky 2NC gtNA An alternative presentation of the concept UC1 Unit Cost no trade Price UCz Unit Cost A A free trade P PC C P Price NA Nc Number of varieties The Price curve shows the relationship between the Number of varieties available in the market and the price that a rm can charge for its variety As the number of varieties increase the price decreases because the demand for each variety becomes more elastic the demand curve facing each rm becomes atter The Unit cost curve UC shows the relationship between the unit or average cost level for each variety and the number of varieties produced Given the size of the market unit cost increases as the number of varieties increases because the production level for each variety declines as more varieties crowd out into the market Impact of trade under Monopolistic competition I Little impact on domestic distribution of factor income I Some rms go bankrupt and some expand in each country Factors employed in losing rms will bear dislocation costs Countries will completely specialize in different product varieties All countries gain from trade There are two sources of such gain Decrease in prices due to scale economies Increase in consumer welfare due to greater product variety Consumers like greater variety in their consumption Against these longrun gains from trade there are shortrun adjustment costs when some rms in each country shut down and eXit the industry The workers in those rms will experience a spell of unemployment as they look for newjobs Over the longrun however we eXpect that these workers can nd new positions so we view these costs as temporary Empirical Test of the Krugman Model Recall that the Krugman model contains two predictions concerning the impact of trade on the productivity of rms I The scale effect as surviving rms eXpand their outputs and I The selection effect as leastef cient rms are forced to eXit the average industry productivity is eXpected to increase 0 Which one of these effects is most important in practice This is a question of importance since the dislocation of workers caused by the bankruptcy of rms is bound to bring costs to them Gains and Losses for Mexico MeXico Joined NAFTA with the US and Canada in 1994 Under NAFTA Mexican tariffs on US goods declined to very low levels by 2001 from relatively high levels in 1990 As a result the variety of imports from MeXico to the US increased substantially in many industries At the same time US tariffs on MeXican imports fell as well though from levels which were lower to begin with Changes in Mexico39s Export Variety Table 103 show estimates ofMeXico s eXport variety to the United States in 1990 and 2001 To interpret these gures start with the 1990 eXport variety in agriculture of 415 That gure means that MeXico eXported to the US 415 ofthe product varieties in agriculture that are listed in the Harmonized system and imported by the US Mexico s Export Variety t0 the US All gures are in percent Agriculture Textiles Wood Petroleu Minin Machinery Electronics Average and Garments and Paper and Plastics and Metals and Transport 1990 42 71 47 55 47 66 40 52 2001 51 83 63 73 56 76 66 67 Annual growth 19 14 26 25 17 13 46 22 a Labor Productivity in Mexican Manufacturing Plants Productivity 150 index Maquiladora Non maquiladora 75 x l l l l l l i l l I 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Figure 68 Labor Productivity and Wages in Mexico Productivity in Me i o x c 0 Panel A in gure 68 shows the productivity over time for two types of manufacturing rms I Maquiladora plants close to the border and produce almost I onMaquiladora plants 0 Maquiladora plants should be most affected by NAFTA b Real Wages and Income in Mexican Manufacturing Plants Wage 150 index Maquiladora real monthly income Maquiladora real wages 100 r onrmaquiladora real monthly income 7 l l lt l y l l l y 1990 1991 1992 1993 1994 1995 1995 1997 1998 1999 2000 2001 2002 2003 Figure 68 Labor Productivity and Wages in Mexico Panel B in gure 68 shows what happened to real wages and real income over time 0 99999 For the maquiladora plants productivity rose 45 from 1994 to 2003 compound growth rate of 41year For non maquiladora plants productivity rose overall by 25 compound growth rate of 25year The difference 16year is an estimate of the impact of NAFTA on the productivity of maquiladora plants over and above the increase in productivity that occurred in the rest of Mexico From 1994 to 1997 there was a fall of over 20 in real wages in both sectors even with increase in productivity This is not predicted by the monopolistic competition model Why did it happen Shortly after joining NAFTA Mexico suffered a nancial crisis that led to a large devaluation of the peso This makes it more expensive for Mexico to import goods Therefore the Mexican consumer price index also goes up leading to a fall in real wages The maquiladora sector was more affected than others by devaluation of the peso and did not experience much productivity gain Workers in both areas had to pay higher prices for imported goods higher Mexican consumer prices Decline in real wages was similar for both sectors The decline was however short lived Real wages in both sectors began to rise again in 1998 By 2003 real wages were almost back to their 1994 value But since real wages were not higher than in 1994 any productivity gains from NAFTA were not shared with workers If we look at real monthly income the picture is a little better I This includes other sources of income beside wages especially for higher income persons For non maquiladora sector data on real wages and real monthly income move together closely In the maquiladora sector real incomes were higher in 2003 than in 1994 I Some gains for workers in plants most affected by NAFTA Higher income workers fared better than unskilled workers in Mexico I Higher income workers in the maquiladora sector are principal gainers due to NAFTA in the long run Adjustment Costs in Mexico 0 When Mexico joined NAFTA it was expected that the agricultural sector would fare the worst due to competition from the US I Tariff reductions in agriculture were phased in over 15 years 0 The evidence to date shows the corn farmers did not suffer as much as was feared Why I The poorest farmers consume the corn they grow rather than sell it 99 99 99 O 11 I Mexican government was able to use subsidies to offset the reduction in income for other corn farmers Total production of corn in Mexico rose following NAFTA For maquiladora plants employment grew rapidly following NAFTA to a peak of 129 million in 2000 After that this sector entered a downturn I The US entered a recession decreasing demand for Mexican exp01ts I China was competing for US sales by exp01ting goods similar to those sold by Mexico I The Mexican peso became over valued making it dif cult to export abroad Employment in the maquiladora sector fell after 2000 to 11 million in 2003 The maquiladora sector faces increasing international competition not all due to NAFTA This can be expected to raise the volatility of its output and employment The volatility can be counted as a cost of international trade for workers who are displaced Study of Canada US Free Trade Agreement TFA Head and Ries 1999 unfortunately nd no supp01t for the Scale effect Tre er 2001 nds considerable labor productivity increase in the long run He nds that in the SR employment declines 15 and Q declines 10 but in the LR labor productivity increase 17 However this is not due to rising output plan increased investment or market share shifts to highproductivity plants Instead half of the 17 labor productivity growth appears due to favorable plant turnover entry and exit and rising technical ef ciency The Gravity Equation The model monopolistic competition predicts that under free trade countries are r39 39J r 39 quot J in the r J quot of each variety in sectors that products are differentiated This trade patter can be described by Gravity Equation Assuming that countries are specialized in different goods the Gravity Equation states that the bilateral trade between two countries is directly proportional to the product of the countries GDP 3 Thus Larger countries will tend to trade more with each other Countries that are more similar in their relative sizes will also trade more GDR GDPZ distquot Trade 2 B 0 The constant term can also be interpreted as summarizing the effects of all factors other than distance and size that in uence the amount of trade between two countries You can see from the equation that the larger the two countries are or the closer they are the greater the amount of trade 9 0 This is an implication of the monopolistic competition model we studied in this chapter I Larger countries export more because they produce more product varieties and import more because their demand is higher I But why happens One theory to explain this is the home market effect This theon maintains a larger home market will attract disproportionately more rms and hence more variety and therefore becomes a net exporter With two countries trading the larger market will produce a greater number of products and will be a net exporter of the differentiated good People in larger countries have larger income thus can afford larger variety of goods That is why more variety is produced there have assumed no transportation cost a Trade between US States and Canadian Provinces Trade 100000 US million 10000 1000 l l I I i I 0001 001 01 1 10 100 GDP1 GDP distrzs Higher GDP or farther apart closer together Figure 69 Gravity Equation for the United States and Canada 1993 Lower GDP or Grawty term The Gravity Equation and the Economies of Scale I Gravity equation performs extremely well empirically for the industrialized countries and not well at all for nonOECD countries I This suggests that industrialized countries are specialized in di erent products for whatever reason I Davis and Weinsten 1996 1999 using OECD data finds that The impact of local demand on production exceeds unity in a majority of industries In particular they find that having a 10 greater demand for production will lead to 16 additional production in that country meaning that net exports will rise I This lends support to the idea that monopolistic competition explains national product specialization Economies of Scale and Comparative Advantage I Countries can engage in mutually bene cial trade based on both comparative advantage based on their differences in factor endowments and production technology and returns to scale technologies both Suppose There are two countries Home the capitalabundant country and Foreign There are two industries manufactures the Kintensive industry and food Neither country is able to produce the full range of manufactured products by itself due to economies of scale Home manufacturers are a monopolistically competitive sector Then world trade consists of two parts 7 Intraindustry trade e exchange of manufactures for manufactures 7 Interindustry trade 7 The exchange of manufactures for food 7 Capital abundant country exports manufacture and imports manufactures and food from the labor abundant country 7 The capital abundant country is a net exporter of manufactures products 7 The manufactures export of the labor abundant country is not necessarily labor intensive as the HO model would have predicted Cannot tell which country exports what manufactured variety Figure 66 0 m F d a 00 Trade in anld Home Without Increasing camelabundant Returns exchange ofcmmvm M Foreign laborabundam Main differences between interindustry and intraindustry trade Interindustry trade re ects comparative advantage whereas intraindustry trade does not The pattern of intraindustry trade itself is unpredictable whereas that of interindustry trade is determined by underlying differences between es The relative importance of intraindustry and interindustry trade depends on how similar countries are Cloth Food Home capitalabundant imerlnduslvy Ede intralndustry trade Foreign iabor abundanl Figure 67 Trade with Increasing Returns and Monopalislic Compeliiion timed nmrliiri A a re Hit 39 39 in ill imnnrr well as export clam giving rise to inlraindustry trade The Theory of External Economies conomies of scale can be either Internal The cost per unit depends on the size of an individual rm but not necessarily on that of the industry The market structure Will be impeifectly competitive With large firms having a cost advantage over small as of Kurgman Model External The cost per unit depends on the size of the industry but not necessarily on the size of any one An industry Will typically consist of many small firms and be perfectly competitive Both types of scale economies are important causes of international trade Why a cluster of rms may be more ef cient than an individual rm in isolation 1 Specialized Suppliers any industries the production of goods and services and the development of new products require the use of specialized equipment or support services An individual company does not provide a large enough market for these services to keep the suppliers in business A localized industrial cluster can solve this problem by bringing together many rms that provide a large enough market to support specialized suppliers This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley 2 Labor Market Pooling A cluster of rms can create a pooled market for workers with highly specialized skills It is an advantage for I Producers They are less likely to suffer from labor shortages I Workers They are less likely to become unemployed 3 Knowledge Spillovers Knowledge is one of the important input factors in highly innovative industries The specialized knowledge that is crucial to success in innovative industries comes from I Research and development efforts I Reverse engineering I Informal exchange of information and ideas External Economies and Increasing Returns EXtemal economies can give rise to increasing returns to scale at the level of the national industry Forward falling supply curve I The larger the industry s output the lower the price at which firms are willing to sell their output External Economies and Patterns of Trade A country that has large production in some industry will tend to have low costs of producing that good Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply 812MCiforiton P D1 D2 Sz 2 MCifori to n gtn ACLR Industry Q Figure 69 below illustrates a case where a pattern of specialization established by historical accident is persistent External Economies and Cr Internat10nal Trade Figure 69 External Economies and Specialization cost per wmch on 1 P1 ADSW55 2 ACTHAI D c 1 Quantity of wmches produced and demanded Cnpyngqt 2003 Pearsnn Educatmn In sis12654 I Trade and Welfare with External Economies Trade based on external economies has more ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies ofscale at the level ofthe r n example of how a country can actually be worse off With trade than Without is shown in Figure 61 External Economies and International Trade Figure 6 10 External Economies and Losses from Trade Price cost per watch A Cs WISS A CTHAI DWORLD DTHAI Quantity of watches produced and demanded Slide 656 Copyrigqt 2003 Pearson Education Inc I Dynamic Increasing Returns L a 39 7 It relates unit cost to cumulative output 7 It is downward sloping because ofthe effect ofthe experience gained though production on costs Dynamic increasing returns 7 A case When costs fall With cumulative production over time rather than With the current rate of production Dynamic scale economies justi protectionism 7 Temporary protection of industries enables them to gain experience infant industry argument External Economies and International Trade Figure 611 The Learning Curve Unit cost QK QL Cumulati ve output Cupyngmo znnz Fearsun Educatmn In suaesss Dumping The most common form of price discrimination in international trade Price discrimination is the practice of charging different customers different price 5 A pr39cing practice in Which a rm charges a lower price for an exported good 39 y than it does for the same good sold domesticall It is a controversial issue in trade policy and is Widely regarded as an unfair practice in international trade 7 Example As of April 2002 the United States had antidumping duties on 265 items from 40 different countries Price P AF in he local market Marginal cost Ml Local price P39 Average cost A39 AC Export demand D and exuurt Export price E B marginal revenue MR Local demand 039 Plt Ac lt P m the export market Local marginal revenue MR 02 31 Foreign quantity Local Exports 3a les Figure 610 Foreign Discriminating Monopoly Dumping can occur only if two conditions are met lmperfectly competitive industry Segmented mark ets Given these conditions a monopolistic rm may nd that it is pro table to engage in dumping Reciprocal Dumpin A 39 ation in which dumping leads to twoway trade in the same product It increases the volume of trade in goods that are not quite identical lts net welfare effect is ambiguous It is likely to bring gains to consumers through lower prices domestic monopolist will face higher competition These gains are likely to be offset by the use of antidumping utre s It wastes resources in transportation Summary In general trade may be divided into two kinds I Twoway trade in differentiated products within an industry intraindustry de I Trade in which the products of one industry are exchanged for products of another interindustry trade Trade can result from increasing returns or economies of scale that is from a tendency ofunit costs to be lower at larger levels of on t The presence of scale economies leads to a breakdown of perfect competition Trade in under IRS must be analyzed using models of imperfect competition In monopolistic competition an industry contains a number of rms producing differentiated products Intraindustry trade bene ts consumers through greater product variety and lower prices Economies of scale can be internal or external Dumping occurs when a rm charges a lower price abroad than it charges domestically Dumping can occur only if two conditions are met I The industry must be imperfectly competitive I Markets must be geographically segmented EXtemal economies give an important role to history and accident in determining the pattern of international trade When external economies are important countries can conceivably lose from trade
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