Agricultural Trade and Policy – Continuous Assessment Exercise

Continuous Assessment Exercise

Prepared for Module CB9003

“Agricultural Trade and Policy”
by
Carlos Ferreira

Submitted on the 12th December, 2008

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 Agricultural Trade and Policy – Continuous Assessment Exercise

a1. the composition of trade (in terms of categories of goods)

We consider country A, with abundant low-skilled labour relative to its potential

trading partners. X is the bundle of capital-intensive products and Y is the bundle of
labour-intensive products.
In autarky, country A must produce all products consumed, either labour-intensive or
capital-intensive. Chart 1 shows this situation. Considering maximum efficiency in
production, country A's citizens will only be able to consume a bundle of goods
somewhere along the Production Possibility Frontier (point PA=CA). Since for this country
producing capital-intensive products has a high opportunity cost, when in trade it will move
some of the resources used in producing capital-intensive products into producing labour-
intensive products. As a result, production will move from PA (production in autarky) to PT
(production with trade), and consumption will move from CA to CT. Therefore, country A will
export the difference between YT and YC and import the difference between XT and XC.
As a result, when in a situation of trade, the country will specialise in producing the
products in which it has a comparative advantage (Y), and obtain the capital-intensive
products by trade.

Good Y
(L)

YT PT

YA PA=CA
CT
YC
CPFT
Production
Possibility
CPFA
Frontier

XT XA XC
Chart 1 Good X
(K)

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 Agricultural Trade and Policy – Continuous Assessment Exercise

a2. the effects on real wages for low-skilled work

Considering that Country A is endowed with abundant low skilled, low-wage labour
relative to its potential trade partners, by rejecting autarky and engaging in trade it will
increase its demand for labour (Q1 to Q2). As a result, the nominal wages will rise (from P1
to P2).

Price

Supply of
Labour

P2
P1
Demand for
Labour
(Trade)

Demand for
Labour
(Autarky)

Q1 Q2 Quantity
Chart 2

However, real wages also depend on inflation. Even with nominal wage increases, it
is possible for real wages to drop, if the prices rise enough to undercut the gains from
trade.
When country A moves from autarky into trade, it experiences an increase in the
cost of the factor with which it is more endowed (labour), because of the discussed
increase in nominal wages, and a simultaneous reduction in the cost of the factor with
which it is less endowed (capital), because capital-intensive goods can be imported at
world market prices, inferior to the cost of producing them locally.
The change in the prices of the two factors are shown in the tilt of the price ratio
line, whose slope gives us the relative prices of labour and capital. This goes from the
slope of line RA (rate of prices in Autarky) to RT (rate of prices with Trade) (Chart 2).
This is partly made possible because, in trade conditions, the people from country A

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 Agricultural Trade and Policy – Continuous Assessment Exercise

can shift their preferences to adapt to the new situation: by moving from CA (consumption
in autarky) to CT (consumption in trade), they consume more of the products X (capital-
intensive) and less of products Y (labour-intensive).
Therefore, we conclude that, in the absence of any macroeconomic policies that
result in increases in inflation, the real wages in country A will increase, thanks to a
combination of increasing nominal wages and reduced inflation of the overall consumed
bundle of goods. This is shown in Chart 3 by the fact that consumers move into a higher
indifference curve (from U1 to U2).

Good Y
(L)

RT
PT
YT U1 U2

YA PA=CA
CT
YC

RA

XT XA XC
Chart 3 Good X
(K)

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 Agricultural Trade and Policy – Continuous Assessment Exercise

a3. the distribution of income between households

We consider that country A, as described above, has in place trade barriers, and
that the factors of production are capital and labour. What is normal in this situation is that
the barrier is in place to protect that part of the economy at which the country does not
enjoy a comparative advantage. In the case of country A, that means the barrier is
protecting the income of the people who own capital, the wealthier members of society.
Trade liberalisation results in domestic prices for goods to converge towards the
international market prices. In this situation, the capital-intensive activities become less
profitable, because cheaper foreign goods are available, shifting the economy towards
labour intensive activities, increasing the demand for labour in the process, as discussed
above.
As a result, the price of capital decreases and the price of labour increases – factor
price equalisation. Consequently, capital owners are worse-off and wage earners are
better-off. Since the wage earners are usually the less well-off members of a society, trade
liberalisation – in a perfectly competitive market, with undistorted labour markets and
ignoring further factors as described above – would promote a shift of income from the
richest members of a society and towards its poorer members.

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 Agricultural Trade and Policy – Continuous Assessment Exercise

b1. how the simple extensions of H-O to include human capital and to take account of
natural resource differences resolve the problem.

Heckscher-Ohlin predicts that a capital-rich country would export mainly capital-

intensive products, and that a labour-rich country would, conversely, export mainly labour-
intensive products. This would be the result of specialization on both sides, with each
country making the most out of the comparative advantage it possesses. However, the
results from empirical testing have not confirmed the theory: this fact has been called the
Leontief Paradox. Various attempts have been made at improving the model, such as to
expand the factors of production considered in order to include natural resources and
human capital (skilled labour). However, these attempts are not problem-free.
Natural resources do not fit the model well, so resource-based industries are
omitted from the analysis, which helps improve its predicting capacity. Natural resources
present the problem that they can't be easily transfered between industries, one of the
basic assumptions of the Heckscher-Ohlin model.
As for human capital, it is an attempt to account for differences in skills among
labour. Human capital (specialized skills) would be seen as a kind of physical capital.
However, theory questions whether the two kinds of capital are interchangeable, and
statistics seem to show that human capital is a better predictor of trade flows when treated
as a third, separate factor.
In the end, the extensions to Heckscher-Ohlin model do not completely solve the
questions that result from the Leontief Paradox. Human capital, by not conforming to being
added to capital, becomes a third factor of production. Research and development can
help a country gaining advantage in the production of a certain good by increased
productivity of technology, but technology is usually capital intensive, and capital has not
shown to be the best predictor of agricultural trade flows.
Also, natural resource endowment has proven difficult to account for, since natural
resources are not directly substitutable with other inputs of production. Natural resources
are a source of comparative advantage in agricultural production, and failure to account for
them, although it adjusts the model to reality in a better fashion, is hardly acceptable. So,
one could say that the increase of prediction capacity by the model without natural
resources comes at the expense of its fit to reality.

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 Agricultural Trade and Policy – Continuous Assessment Exercise

b2. the applicability of the New Trade Theory to trade in these products

New Trade Theory (NTT) points out several aspects that affect trade and that are
unaccounted for in Heckscher-Ohlin Theorem: that most trade occurs between firms (not
countries), that some of the specialisation might develop by chance instead of comparative
advantage and that, once this happens, increasing returns to scale may arise, resulting in
imperfect competition and maintaining the cumulative advantage. Other observations
included in NTT are the fact that there is frequent intra-industry trade, and how this is
accounted for by product differentiation and consumer preferences – both variables are
absent from the H-O model's assumptions. Finally, the NTT also tries to account for the
possible positive impacts of trade distortions for a country's industry.
One advantage of the NTT for analysing agricultural trade is that it allows for intra-
industry trade in situations where nations have specific and unique tastes, where
economies of scale develop and the resulting product adds variety to the trading partners'
choices or when seasonal factors occur (such as when the time of crop for a given
products are different along the trading partners).
All these possibilities violate the assumptions of Heckscher-Ohlin Theorem, but
account well for some of the observations in reality.
According to the New Trade Theory, specialisation in agricultural production might
be a consequence of either chance or some comparative advantage, followed by
imposition of a trade barrier in the right time, therefore defending an infant industry from
external competitors. As a result, that industry might gain bulk and, consequently, returns
to scale. The increasing returns would lock-in the cumulative advantage.
However, the applicability of New Trade Theory to agricultural commodities trade
remains limited. First, raising barriers to protect a national industry is appealing, but might
trigger negative reactions from the trading partners, causing them to raise their own
barriers in return, resulting in losses for both sides. Also, the scope for economies of scale
or network effects is relatively small in agricultural production itself, although some gains
might exist relatively to support industries, like transport and storage. However, the fact
that little or no economies of scale develop eliminates most rationale for raising barriers.
Also, the bulk of trade in agricultural products is in undifferentiated commodities, allowing
little scope for product differentiation. The specific tastes, that do exist, act as isolated

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 Agricultural Trade and Policy – Continuous Assessment Exercise

exceptions, while most of the trade develops around standard products.

As a result of these facts, for agricultural trade NTT is relatively flawed and less
useful than H-O; protectionism for a country's agricultural production eventually leads to
disinvestment, less productivity and a general negative outcome, possibly because there
are little to no economies of scale in agriculture. The fact that trading partners might raise
trade barriers as a result of protectionism, and that this way the losses are for both
partners only shows the limits in applicability of this model to agricultural trade.

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 Agricultural Trade and Policy – Continuous Assessment Exercise

b3. where do these developments leave the trade analyst?

A trade analyst working on the field of agricultural products has a difficult work. Not
only the field of study has many specificities, the relevant models – especially the
Heckscher-Ohlin model and the New Trade Theory model – fail to live up to the empirical
observations. Reality, it seems, contradicts these models, rendering them useless or near.
The problem with the Heckscher-Ohlin model, either the original formulation or its
extensions, is that the assumptions on which it is based are not realistic. In reality, and
even if we consider a partial equilibrium model of only two countries and two goods, free
trade very rarely happens – there are trade barriers and various costs, like transportation;
competition is not perfect, so not all the participants in trade are price-takers; tastes vary,
even if not by much, between countries; and, especially, there are factors of production
other than capital and labour, and these factors are hardly perfectly mobile between
industries, although they can be partially mobile between countries.
The extensions to Heckscher-Ohlin to include human capital and natural resources
are a way to try going around this last set of limitations. Both manage to improve
somewhat the prediction capability of the original model, but at the expense of leaving
important factors for agricultural production out of the picture (natural resources), or of
increasing the complexity with the analysis with a variable previously unaccounted for
(human capital). As a result, none manages to provide a framework that far surpasses the
original model or that overcomes the rest of the limitations (the assumptions) of it.
On the other hand, New Trade Theory tries to explain trade from a different
perspective, and provides some valuable insights in the process. Its focus is not on factor
endowment but on the result of a combination of lucky historical coincidences, protectionist
policies and economies of scale. However, because of the low scope for economies of
scale in agricultural production, possible gains are wiped out by the probable trade wars
that follow protectionist policies.
In the end, trade analysts keep going back to Heckscher-Ohlin for a framework on
trade in bulk agricultural products. It has not been possible to demonstrate empirically the
basic soundness of the model because some of the assumptions fail when confronted with
a varied and political economy-ridden reality. However, the model provides the most
powerful insight available and, most importantly, shows that trade barriers are welfare-

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 Agricultural Trade and Policy – Continuous Assessment Exercise

diminishing and that trade liberalisation would achieve a higher overall welfare for all
participants. It points the way to a greater efficiency in the distribution of scarce resources
and, once it accounts for differences in the kinds of labour, also accounts (indirectly) for
technology development and the role it can play.
As a result, the Heckscher-Ohlin model is still the best model available for
examining trade in agricultural products.

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