Lecture 23: International Dimensions II

Trade

Dave Donaldson and Esther Duo

14.73 Challenges of World Poverty

International Dimensions II: Plan for the lecture

Short lm: The Trade Trap

Discussion of lm.

Overview of trade theory

The Trade Trap?

Given all of the disadvantages and hassles, should developing

countries just close their borders and go it alone?

Why do Countries Trade?

Two broad categories of answers

1. Because theyre dierent. (Comparative Advantage.)
2. Increasing returns to scale.

Comparative Advantage

General idea: countries trade to exploit dierences.

What dierences? Dierences in relative costs.

Key intuition:

US is better (ie higher output per worker) than China at

producing both iPods and iPod design/marketing services.
Yet the US doesnt export both of these to China. It exports
the design services and imports the actual iPods. (Designed
in California. Made in China.)
Why?

Sources of Comparative Advantage I

Why do countries have dierent productivities?

First answer from theory: Ricardo.

Workers have access to dierent technologies.

For example: English workers have access to good
textile-producing technologies and terrible wine-producing
technologies. Portuguese workers have the opposite. England
has CA in textiles, and exports textiles (and imports wine);
Portugal has vice versa.

Sources of Comparative Advantage II

Second answer from theory: Heckscher-Ohlin.

Technologies are dierent, but countries have access to

dierent endowments of factors of production.
For example: England has lots of workers and very few
vinyards (ie arable land); Portugal has the opposite. So
England will export relatively more of the labor-intensive good
(textiles) and Portugal will export relatively more of the
vinyard-intensive good (wine).
This is just a re-labeling of the denition of what is a
technology and what is a factor of production. The dierence,
however, comes about here because now there are two types of
people in the world (workers and vinyard-owners) and trade
may aect them dierently.

NB: Both the Ricardian and H-O theories imply that countries
trade dierent commodities. And that most trade occurs
among countries that are dierent.

Increasing Returns to Scale

Very dierent motivation for countries to trade. Commonly

associated with work of Paul Krugman.
Key example:

Suppose that the minimum ecient scale for production of a

good (eg a car) is larger than the market size in a given
country.
If this country were unable to trade, it would never be able to
enjoy this car.
But suppose 2 identical countries are in this situation, and that
the minimum ecient scale is smaller than the combined
market size of these two countries.
If the two countries could trade with one another, they could
both open the car factory and both be able to consume the car.

NB: This theory implies that countries trade very similar

commodities. Eg: France, Germany and Italy all trade very
similar cars between each other.

Do Countries Gain from Trade? I

Do states of the United States gain from trade with each

other? How about cities, or zip codes? Or individuals?

Why might countries be any dierent?

Do Countries Gain from Trade? II

The above theories (CA and IRTS) both predict (more or less)
that a country as a whole will be better o open to trade than
closed to trade.

Additional mechanisms for why countries may gain from trade

that are not included in these theories:

Promoting competition

Allowing essential imports (technology, capital goods,

machines) to be paid for via exports. (Though this can be
thought of as just comparative advantage.)

Does Everyone in a Country Gain from Openness?

No. But should this surprise us?

Consider an example:

Trade is just like a technology. (Recall that a technology just

turns inputs, eg workers, into output.)
The technology of trade just turns exports (eg textiles) into
imports (eg wine).
When a new technology (eg digital cameras) gets invented,
does everyone (including Kodak) benet?

The key question is: do the winners (digital camera producers,

and all camera consumers) win by more than the losers lose?

If so, then aggregate GDP is higher. And (in principle) the

winners from trade can compensate the losers, and still have
some money left over.

However, these compensating transfers are rarely seen in

practice.

Why Might Countries Be Made Worse O from Openness

to Trade? I

Infant Industry Protection (aka Import Substitution):

Suppose industries need time to grow (eg, they learn by

producing).
Then an infant industry would not be able to compete with
less infant foreign rms.
The optimal policy would temporarily protect this industry
through prohibitions on imports that compete with this
industry.
At some point in the future (ie after the industrys productivity
is high enough), this industry should be exposed to foreign
competition via a reduction of import taris.

Caveats:

Import substitution has a terrible track record.

Identifying industries with large propensities to learn is hard.
For a rm to be productive, it needs cheap input materials
(from other industries). So do we open up the industries that
make these inputs, or do we protect them too?

Why Might Countries Be Made Worse O from Openness

to Trade? II

Tari revenue:

A large country may want to set a tari higher than zero

because doing so will budge the world price in its favor (this is
called the terms of trade eect). But if a country is too small
for its actions (eg its taris) to aect the world price, the
optimal tari (in all CA-style models) is zero.
In many developing countries, it is hard to tax economic
activity (eg, income taxes are very rarely used). Imports may
be among the easiest things to tax (via taris). So if a xed
amount of government revenue is required (eg to fund schools)
then taris may be the least bad thing to tax.

Other arguments:

Destruction of cultural goods

Loss of political sovereignty.
Spread of disease.

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14.73 The Challenge of World Poverty

Fall 2009

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