Topic 3

Beyond Comparative Advantage: Empirical Evidence and New Trade Theories

Chapter Five Outline

1. 2. 3. 4. 5. 6. 7. Introduction Questions to be answered How do we know if a theory about trade is correct? Testing the Hecksher-Ohlin model Intra-industry trade Trade with economies of scale Technology-based theories of trade: The product cycle 8. Overlapping demands as a basis for trade 9. Transporting costs as a determinant of trade 10.Location of industry

Introduction
After studying several theories to explain international trade patterns (Ricardian, neoclassical, and Heckscher-Ohlin models), must we adopt a single theory of trade, or might different theories best explain various aspects of trade?
Should empirical testing be used to decide? Do we need to modify any of these theories to explain todays economic patterns?
3

Questions To Be Answered
1. Is one explanation from one of the economic theory models sufficient to explain why Colombia exports coffee, Taiwan color TVs, or Brazil steel?
What part does intra-industry trade (trade in which each country both imports and exports products from the same industry) play?

2. How do international trade patterns change over time?

U.S. used to be the worlds largest manufacturer of TVsnow its Taiwan. Why?
4

How Do We Know If a Theory About Trade Is Correct?

Economists turn to empirical testing of international trade theories in order to strengthen their arguments about the important influences on various types of trade.
Both Adam Smith and David Ricardo used rudimentary empirical testing to support their claims. Certain difficulties exist with empirical testing:
Empirical evidence can appear to support a theory, but it cannot prove it true (and vice versa). Most useful outcome of empirical test is refinement of 5 both theory and test.

Testing the Heckscher-Ohlin Model

Hurdles to empirical testing
Heckscher-Ohlin model implies that exports as a group should be more intensive in use of the abundant factor than imports as a group.
Virtually impossible to test for this.
Simple observations do not necessarily comprise definitive evidence in the models favor.

The Leontief Tests

Leontief used 1947 data for the united states in the first test of Heckscher and Ohlins key proposition (since U.S. was capital-abundant, it
was expected that the U.S. Would export capitalintensive goods). Since data on the factor intensity of imports was not available, he used data on import substitutes (the U.S.-Produced versions of the import goods). Empirical results showed the opposite of what was expected.
U.S. Exports were 30% more labor intensive than us import substitutes.
7

The Leontief Tests

Possible explanations of this paradox:
In 1947 most of worlds economies were still in a highly disrupted state. Further tests in the early 1950s reduced the magnitude of the paradox.

Fair to state that simplest version of Heckscher-Ohlin model does poor job of explaining trade patterns.
Modifications and extensions have been made in the model.
8

Fine-Tuning the Heckscher-Ohlin Model

Role of Tastes
Heckscher-Ohlin model assumed tastes were identical across countries. This is not true.
Large differences in tastes among countries can introduce a taste bias that can dominate the production bias.
Should this occur, a country will have a comparative advantage in production of the good that uses its scarce factor intensively. Evidence does exist for a home bias in consumption (consumers in a given country tend to consume more domestically produced goods than we would expect).

Fine-Tuning the Heckscher-Ohlin Model

Classification of Inputs
Original theory used only two inputs: capital and labor.
Inputs are now classified in several waysmost common:
Arable farmland Raw materials or natural resources Human capital Man-made or nonhuman capital Unskilled labor

10

Fine-Tuning the Heckscher-Ohlin Model

Technology, Productivity and Specialization
The original theory assumed identical technologies across countries when it predicted countries would export goods that used their abundant factors intensively.
We clearly observe different technologies across countries.
The theory must be amended to take these production process differences into account.

11

What Is Intra-Industry Trade and How Big Is It?

Defined as trade in which a single country both imports and exports products in the same industry.
Comprises a significant share of world trade.

The Intra-Industry Trade (IIT) index is used to estimate the extent of this trade within an industry or within a country trade as a whole.
Data shows that IIT indexes tend to be higher for industrialized countries (almost 75% plus) than for developing countries.
12

Intra-Industry Trade in Homogenous Goods

Homogenous (non-differentiated) goods that are most likely to be involved in intraindustry trade include items that are heavy or for some other reason expensive to transport.
In Figure 1, each country both exports and imports the product because of the greater proximity of consumers to the foreign than to the domestic producer.
13

Figure 1: Location Can Cause Intra-Industry Trade in Homogeneous Goods

Country A
F
A

Country B
CB

CA

FB

14

Intra-Industry Trade in Differentiated Goods

Product differentiation is the most obvious explanation for intra-industry trade.
Consumers have a variety of tastes, some best served by domestically produced goods and others by imports.

15

Why Does It Matter?

Intra-industry trade involves trade in goods in the same industry and produced using similar factor intensities.
Therefore, changes in factor demands and relative factor prices from such trade tend to be smaller.
Provides one explanation for global trade liberalization in last fifty years.
Greatest success in lowering trade barriers has occurred in manufactured-goods industries in which the developed countries engage in large amounts of intra-industry trade.
16

Trade with Economies of Scale

For some goods, the average cost of production depends on the number of units produced.
If the average cost per unit falls as the scale of production rises, production exhibits increasing returns to scales, or Economies of Scale.
Internal economies occur when the firms average costs fall as the firms output rises (panel [a] of Figure 2).
Primary sources are large fixed costs that can be spread over all the firms output. 17 Example: R&D expenses

Figure 2a: Internal and External Economics of Scale

Firm's ACX

AC S AC L AC X

XS

Firms Output of X

(a) Internal Economies of Scale

18

Trade with Economies of Scale

External economies occur when the firms average costs fall as the industrys output rises, as in panel (b) of Fig. 2.
For example, when the output of the computer industry rises, computer firms costs fall because the industry becomes large enough to support a pool of skilled labor.

See Figure 5.2

19

Figure 2b: Internal and External Economics of Scale

Firms ACX

AC 0 AC 1 AC X

X1

Industry Output of X

(b) External Economies of Scale

20

Trade with Economies of Scale

Implications of economies of scale
Create additional incentive for production specialization.
Rather than producing a few units of each good domestic consumers want to buy, a country can specialize in producing large quantities of a small number of goods (in which the industries achieve economies of scale) and trade for the remaining goods.
Therefore, economies of scale provide a basis for trade even between countries with identical production possibilities and tastes.
21

Trade with Economies of Scale

Figure 3, which assumes countries A and B are identical in tastes and production possibilities, shows the potential of mutually beneficial trade based solely on economies of scale rather than comparative advantage.

22

Figure 3: Mutually Beneficial Trade Based Solely on Economics of Scale

Y
Slope = (PX/PY)tt

BP

Ac = Bc A* = B*
B UA 1 = U1 B UA 0 = U0

0 AP

23

Internal Economies of Scale

With internal economies of scale, trade allows consumers to consume larger varieties of goods at lower prices.
Trade helps to increase variety by expanding the consuming population for any firms product.
Firms in one country specialize in one set of varieties, and firms in the other to another set. Consumers then have access to all the varieties through trade.
Each firm achieves economies by specializing.

24

Figure 4a, b: Internal Economics of Scale as a Basis for Trade between Identical Countries
Firms ACA X Firms ACA Y

AC Y AC X AC X
1 0

AC

A X

AC 2 Y

AC Y DA X
0 X0
A

DX XA 1

A+B

DA
0 YA 0

A+B

Firms Output of X

Firms Output of Y

(a) X Industry in A

(b) Y Industry in A

25

Figure 4c, d: Internal Economics of Scale as a Basis for Trade between Identical Countries
Firms ACB X Firms ACB Y

AC X AC 2 X D 0 XB 0
B

AC Y

AC X D
A+B

1 AC Y

AC Y

D
0 YB 0

B
B

A+B

Firms Output of X

Y 1 Firms Output of Y

(c) X Industry in B

(d) Y Industry in B
26

External Economies of Scale

External economies of scale can help explain the observed phenomenon of industrial agglomeration the tendency of firms in an industry to cluster geographically.
Watch industry in Switzerland Movie industry in Hollywood and Mumbai Financial industry in New York and London Economies occur when the clustered industry reaches a size adequate to support specialized services.
For example, skilled labor markets

27

Figure 5: External Economics of Scale and Comparative Advantage

Firms AC
B

AC AC 3

AC2 A AC
AC AC 1 D =D 0 X 0 X0
B A A B

AC A D
A+B

X 2 X 1 Industry Output
28

External Economies of Scale

Would protection help in cases such as the one in Figure 5 where economies of scale result in trade that runs counter to comparative advantage?
Figure 6 illustrates two possibilities: 1. Panel (a) combines weak scale economies and strong comparative advantage. Temporary protection of As market could allow country-A firms to capture the market even if country-B firms enjoyed a head start. 2. Panel (b) combines strong scale economies and weak comparative advantage. Temporary protection would not allow country-A firms to capture the market 29 from already established country-B firms.

Figure 6a, b: Interaction of External Scale Economics and Comparative Advantages

Firms AC Firms AC AC 6 AC2 AC ACA
B

AC 2 AC 4 AC5

AC AC
A

D = DB 0 X4 X2 X5

A+B

Industry Output

X6

D = DB X2

A+B

Industry Output

(a) Small Scale Economies, Large Comparative Advantage

(b) Large Scale Economies, Small Comparative Advantage

30

Dynamic External Economies

In some cases, firms average costs depend not on the industrys current output, but on its cumulative output.
Downward-sloping curve in Fig. 7 captures the negative relationship between cumulative industry output and firms average costs.
That curve is called the Learning Curve.
Associated economies called dynamic external economies.

31

Figure 7: Dynamic External Economics and the Learning Curve

Firms AC

AC 2 AC1 AC 3 AC0 D =D
A B

LCB
LC A D
A+B

X 1 X0

Cumulative Industry Output

32

Scope of Economies and Learning

At times, a firms costs depend on the output of the worldwide industry, either current or cumulative.
Most arguments for protection based on external economies of scale, like the one in Fig. 6 (a), would disappear.
Example: semiconductors recent evidence suggests effective learning may take place based on foreign as well as domestic production experience.

33

Scope of Economies and Learning

Trade based on external economies of scale can be beneficial or harmful depending on:
1. Importance of scale economies relative to comparative advantage; 2. Whether historical production patterns follow or run counter to comparative advantage; or 3. Whether domestic or worldwide industry output provides the basis for scale economies.
34

Technology-Based Theories of Trade

The Product Cycle
Technological innovation and new-product development tend to occur in major industrialized economies.
Reflects highly educated and skilled workforce, and the relatively high level of R&D expenditures.

Primary implication of this theory is that as each product moves through its life cycle, the geographic location of its production will change.
35

Technology-Based Theories of Trade

Stages in the Product Cycle:
1. Actual production needs to be located close to consumers so they can provide feedback on its refinement. Only the domestic firm owns the technology, so production occurs only in the firm's home country. 2. Eventually, the firm perfects the product and production accelerates, first for the domestic market and then for export. 3. As production technology becomes standardized, the innovating firm may find it profitable to license its technology to firms abroad. Production may relocate to other countries with lower 36 costs of production.

Technology-Based Theories of Trade

Stages in the Product Cycle:
4. Next, imports rather than domestic production begin to serve the domestic market of the innovating country.
The technology has diffused completely.

5. Finally, the product completes its cycle. Although domestic consumption of the good may continue, imports satisfy that consumption.
37

Overlapping Demands as a Basis for Trade

Linder suggested that similarities in demand between two countries can form a basis for trade, especially for manufactured goods.
States that firms typically do not produce goods solely for export most produce goods for which domestic demand exists.
Linder argues that for many manufactured goods, the quality of the good that consumers in a specific country demand depends primarily on their income.
Consumer with higher incomes tend to demand goods of 38 higher quality.

Figure 8a: The Overlapping-Demand Hypothesis

Product Quality

QA max

QA min

IA min

IA max

Income

(a) Income Overlap Determines Quality Overlap

39

Figure 8b: The Overlapping-Demand Hypothesis

Product Quality
QB max QA max
Trade

(b) Quality Overlap Determines Trade

B min

QA min
Income overlap

IA min

Imin

IA max

IB max

Income
40

Overlapping Demands as a Basis for Trade

Figure 9 demonstrates that most merchandise exports go from one highincome economy to another.
In 1995, only 33% of exports went from a highincome economy to a developing one or viceversa.

41

Figure 9: Direction of Merchandise Exports, 1998

7% 18% High-income to highincome High-income to developing 18% 57% Developing to high-income Developing to developing

42

Transportation Costs as a Determinant of Trade

Some goods are not traded internationally.
Called nontraded goodsreason usually involves a prohibitive cost of transporting them from one country to another.

For other classes of goods, transportation costs may not be prohibitive, but still may be high enough to have a significant impact on the pattern of trade.
Very heavy goods tend to be more costly to transport.
43

Figure 10: Transportation Cost and the International Market for Good X
PX PX

PB X

Exports A X E H M G J F

Exports A X

P0 X Ptt X T Ptt X PX
1

ImportsB X
PA X 0 X* Trade in X

Imports B X

X* T

X*

Trade in X

(a) Trade with No Transportation Costs

(b) Trade with Transportation Costs

44

Transportation Costs as a Determinant of Trade

Transportation costs also play an important role in trade with external economies of scale.
High transportation costs can contribute to agglomeration effects common in industries characterized by external economies.

Another question; who pays for these costs?

Generally, exporter and importer share the costs.
The less price responsive the demand for the good by the importing country, the larger the share of transportation costs the importer will bear.
45

Location of Industry
Distance from consumers can affect transportation costs for some products. Firms decision about where to locate depends on, among other things, the characteristics of the production process in the industry.
Resource-oriented industries
Tend to locate near sources of their inputs or raw materials.
Example: mining operations.
46

Location of Industry
Market-oriented industries
Example: Retail sales operations like to be near their customers.

Footloose or light industries

Has no need to locate near either raw material sources or markets.
Their products typically neither gain nor lose a significant amount of weight or volume as they move through the stages of production. Example: semiconductors. Software etc

47

Conducting Semiconductor Trade

Figure 11 illustrates the industry shares of the worlds semiconductor market in 2000.
The United States and Japan together accounted for about 60% of the total world production.

48

Figure 11: Country Shares of World Semiconductor Memory-Chip Market, 2000

49

Asia-United States Trade Routes

Figure 12 shows the Pacific route and the Suez Canal route for Asia-U.S. trade.
Growth of Southeast Asian exporters and increased ship speeds have shifted some Asia-U.S. trade from the Pacific to the Suez route.

50

Figure 12: Asia-U.S. Trade Routes

Tokyo New York Los Angeles

Pacific Route
51

Figure 12: Asia-U.S. Trade Routes

New York

Singapore

Suez Route
52

Multinationals and Intra-Firm Trade

The share of U.S. trade accounted for by intra-firm trade in the 1982-1994 period is shown in Figure 13.
Between 35 and 45% of U.S. trade occurs within firms, including both affiliate-parent and affiliateaffiliate shipments.

53

Figure 13: Share of U.S. Trade Accounted for by Intra-Firm Trade, 19821994
Percent
45 40 35

(a) Exports
Total intra-firm exports

30
25 20

Exports from U.S. parent companies to their foreign affiliates

15
10 5

Exports from U.S. affiliates to their foreign parent groups

0 1982 83 84 85 86 87 88 89 90 91 92 93 94

54

Figure 13: Share of U.S. Trade Accounted for by Intra-Firm Trade, 19821994
Percent
45 40 35 Imports from U.S. affiliates from their foreign parent groups

Total intra-firm imports

(b) Imports

30
25 20

15
10 5 Imports from U.S. parent companies from foreign affiliates

0 1982 83 84 85 86 87 88 89 90 91 92 93 94

55

Multinationals and Intra-Firm Trade

The intra-firm trade shares of U.S. trade with selected partners are indicated in Figure16.
Intra-firm trade accounts for large shares of U.S. imports and exports, especially with developedcountry trading partners.

56

Figure 14: Intra-Firm Trade Shares of U.S. Trade with Selected Partners, 1992
Percent 80
70 60 50 40 30 20 10 0 Canada Germany Exports Imports

U. K.

Mexico Japan Taiwan

57

Key Terms
Intra-industry trade Import substitutes Leontief paradox Homogenous good Product differentiation Decreasing costs (increasing returns to scale, economies of scale)
58

Key Terms
Internal scale economies External scale economies Learning curve Dynamic external economies Product cycle hypothesis Nontraded goods Transportation costs
59

Key Terms
Resource-oriented industries Market-oriented industries Footloose (light) industries

60