Economic Interdependence

Overview

• Under free trade, the supply and demand determines prices, thus, the flow of
goods.

• Economists agree that free trade is better for consumers and for the economy as a
whole. But politicians and interest groups regularly argue for protectionist policies.

• Why do some countries hardly restrict trade while others come close to prohibiting
it?

• Who are the winners of Free Trade and Protectionism?

• What is governments’ role in regulating and facilitating trade?

Absolute vs Comparative Advantage (Ricardo)

• Some countries can produce some products more efficiently than any other
country (absolute advantage).

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 Comparative
Advantage
Not every country has an absolute advantage, but all countries have a comparative
advantage.
Opportunity Cost determines the comparative advantage: what do we give up to
produce this good?
How much cloth (wine) each country must give up to make only wine (cloth).

• If Portugal uses all of its labor (12 hours)

– to make wine, it can produce 12/1=12 bottles of wine.
– to make cloth, it can produce 12/2=6 units of cloths.
– In producing one unit of cloth, Portugal forgoes 2 units of
wine.
– Portugal’s comparative advantage is wine.

• If England uses all of its labor (12 hours)

– to make wine, it can produce 12/6=2 bottles of wine.
– to make cloth, it can produce 12/3=4 units of cloths.
– In producing one unit of wine, England forgoes 2 units of
clothes.
– England’s comparative advantage is cloth.

• Portugal has an absolute advantage in both wine and

cloths.

Who Should Produce What?

• If both each country specializes in its comparative advantage,
– Portugal produces 12 wines, England produces 4 cloths
– 12 wines, 4 cloths= 16 products

• If each tries to be self-sufficient in both wine and clothes and divide labor equally,
– England produces 1 wine, 2 clothes
– Portugal produces 6 wine, 3 clothes
– 7 wines, 5 cloths=12 products

• The addition of one unit of cloth costs the market 5 units of wine

• Specialization frees up resources that would be used to produce something relatively

inefficiently.

• As a result, under free trade each country should specialize in its comparative
advantage for more products and higher return for labor.
– Agricultural production
– Producing industrial goods
– Producing natural resources
– Generating high-technology, value-added products and services (e.g., financial services,
intellectual property)

Who Should Produce

What?

Which country has an absolute advantage in producing bells?

• Earth
Which country has an absolute advantage in producing whistles?
• Earth
Which country has a comparative advantage in producing bells?
• Vulcan
Which country has a comparative advantage in producing whistles?
• Earth
Under free trade, which country would produce bells?
• Vulcan
Under free trade, which country would produce whistles?
• Earth

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 What Explains Trade Patterns?
• Swedish economists Heckscher and Ohlin tried to explain
national comparative advantage.

• Heckscher-Ohlin trade theory

– Characterizes states in terms of national factor endowments – the
material and human resources they possess

What Explains Trade Patterns?

• Basic factors of production:

– Land (essential for agricultural production; natural resources)

– Labor (skilled vs. unskilled)

– Capital for investment (technology, equipment and financial assets)

• Relative endowments determine comparative advantage

The Heckscher-Ohlin Model

Capital-abundant
Capital Intense Product

Labor-abundant

Labor Intense Product

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 What Explains Trade Patterns?

• A country will export goods that make intensive use of the

resources the country has in abundance

• A country will import goods that make intensive use of the

resources in which the country is scarce

• The pattern of specialization explains trade patterns

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What Explains Trade Patterns?

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What Explains Trade Patterns?

• Industrial countries are rich in

capital and skilled labor
– Therefore, they export goods that
make intensive use of these
endowments

• Developing countries are rich in

land, raw materials or unskilled
labor
– So they export agricultural products,
minerals, and labor-intensive products
like textiles

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 Trade Policy:

• According to the US Census Bureau, in 2018 the US imported apparel and

household items (textiles) worth almost $37 billion. In the same year, the US
exported about $6 billion worth of commodities in this category. Explain this
empirical finding in terms of the Hecksher-Ohlin theorem.

• According to the same source as in part a, in 2018 the US exported over $36 billion
worth of plastic materials, and imported about $14 billion worth of commodities in
this category. Explain this empirical finding in terms of the Hecksher-Ohlin
theorem.

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What Explains Trade Patterns?

• Other economic links (e.g., shared currencies like Euro)
encourage trade.

• Noneconomic factors such as diplomatic relations also

influence trade patterns:
– Trade between hostile nations is riskier than trade with friendly
nations.

– Governments often pursue economic ties with their allies.

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Governments’ Role in Trade

Governments do not engage directly in much trade but usually:

• guarantee contract enforcement through the legal system,

• monitor compliance with international rules (IMF, WTO, EU)

• provide the necessary infrastructure such as ports, customs agents,

• secure and stable currencies

• tax and regulate cross-border exchanges.

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 Trade Restrictions
• Forms of barriers:
– Tariff
A tax on imports levied at the border and paid by the importer
– Quota
limits the quantity of a foreign good that can be sold domestically
– Nontariff barriers to trade
standards targeted at foreign goods | exchange rate manipulations
– Subsidies
government payments to businesses producing goods and services to
export
– Prohibitions
some exports are prohibited.

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Why Do Governments Restrict Trade?

Who are the winners and the losers if government decides to regulate foreign competition
in widgets?

Winners:
• Investors and workers employed in the domestic widget industry sell more widgets at a
higher price.
• Short-term restrictions allow an infant industry develop and be competitive with foreign rivals.
• But insulation from competition means less efficient practices, requiring a longer-term trade
protection.

Losers:
• Foreign producers are now at a disadvantage.
• The domestic consumers of the widgets now pay more for the same product.
• Investors and workers employed in the domestic gadget industry suffer because higher
price for widgets reduces the consumer budget for gadgets.
• This is particularly true if consumers have an inelastic demand for widgets.

Redistributive effect: income is redistributed from domestic consumers to the protected

domestic industry

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Economic Interests and Trade Policy

• There are two leading theories of trade-policy

interests.
– The Stolper-Samuelson approach
– The Ricardo-Viner (specific-factors) approach

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 The Stolper-Samuelson Approach
• Trade benefits owners of factors of production used to
produce exported goods
– Heckscher and Ohlin suggest that this will be the abundant factor
– Political pressure for protectionism will come from the owner of the
scarce factor of production.

• Assuming interindustry mobility of capital and labor,

– Protectionism benefits the scarce factor of production
– But protection hurts the abundant factor

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The Stolper-Samuelson Approach

Poorland Richland

• Under free trade, export more labor-intensive • Under free trade, export more capital-
products to Richland. intensive products to Poorland.

• This increases the demand for more labor, • This increases the demand for more capital,
hence, its price. hence, its price.

• Capital is less demanded and capital owners • Labor is less demanded and labor owners will
will compete to find uses for their less in- compete to find jobs for their relatively less in-
demand factor. demand factor.

As a result, As a result,
• Labor owners are wealthier, support free • Labor owners relatively worse off and oppose
trade. free trade.

• Capital owners are relative worse off and • Capital owners are wealthier, support free
oppose free trade. trade.

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Factor Mobility and Protectionism

• Consider two countries: Computerland and Carpetland and there are two
products: computers and carpets. Capital is relatively abundant in Computerland,
and labor is relatively abundant in Carpetland. Computerland is thus more
competitive at producing computers and Carpetland at making carpets. Suppose
both labor and capital can move freely between industries in the same country.
• If Computerland’s government decides to abolish the tariff on imports of carpets,
who will profit from this abolishment, and who will be hurt, according to the
Stolper-Samuelson theorem? Consumers? Labor? Capital? Why?

• Labor
– Labor in Carpetland will profit, and labor in Computerland will get hurt because imported
carpets from Carpetland will become cheaper.
• Capital:
– Capital owners in computerland will profit because their own domestic customers now
have a greater budget to afford computers.
• Consumers:
– Consumers of carpets in Computerland will profit.

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 No Interindustry Factor Mobility

• What happens when we introduce a politically motivated tariff when neither

capital nor labor is mobile across industries?

• If neither capital nor labor can be moved around, the effect felt from a tariff will be
industry-specific.

• Capital and labor owners in one industry (widget) is pitted against those in another
industry (gadget).

• With factor mobility, we expect class warfare over trade policy.

• With factor immobility, we expect interindustry warfare.

– Capital and labor owners in non-favored industry oppose free-trade.

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Tariffs

Assume that all factors of production are immobile (neither capital nor labor can
move across industries or borders). Also assume that there is full employment in
the economy (all factors are fully used).
Suppose the government of Computerland imposes a new tariff on imports of
carpets. Who will the new tariff benefit, and who will it hurt? Why?

• Winners: The entire carpet industry (labor and capital) in Computerland will
benefit.
• Losers: The carpet industry (both labor and capital) in Carpetland will get
hurt and Consumers of carpets in Computerland will have to spend more.

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The Ricardo-Viner Approach

• Perfect factor mobility or perfect immobility are extremes and almost impossible.

• In most cases one factor is mobile, and the other is specific and not mobile.

• In these cases, we are in the world of Ricardo-Viner theorem.

• Let's assume labor is mobile and capital is immobile.

• This means capital cannot move from one industry to another. As a result, there
are three factors:
1. Labor
2. Specific Capital in Industry 1 (Export Industry)
3. Specific Capital in Industry 2 (Import Industry)

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 Specific Factor Mobility

• Production in Export Industry needs Labor + Capital in Industry 1.

• Production in Import Industry needs Labor + Capital in Industry 2.

When capital is immobile, a movement to free-trade will cause a redistribution.

• Owners of capital in the export industry will benefit from free trade because
export will raise the profits.

• Owners of capital in the import industry will lose from free trade because they
need to increase the wages to keep their employees.

• Workers benefit from free trade because their wages increase.

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Domestic Institutions and Trade Policy

• Let's look at social welfare: Governments need to choose between policies that
– advance efficiency (free-market - lower prices, large supply).
– advance equity (free market can be cruel: less competitive sectors suffer).

• We can look at governments’ receptivity to trade and income inequality –that is,
the Gini index.
– Protectionists have a higher inequality score (46)
– Free-trade societies have a lower inequality score (30)

• Protectionism keeps poor poorer, rich richer.

– Do you agree? Domestic inequality vs international inequality?

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How do domestic institutions affect trade?

• More democratic regimes rely on many people, as a result, they have a higher
trade openness.

• Because small coalition leaders depend on the support of selected groups, we

should expect more protectionism in autocratic systems.

• Empirically, the average democracy is 25% more open to trade than the average
autocracy.

• Even among democracies, there are variations that can be traced back to their
electoral rules.
– When representatives are elected in districts (US, UK), firms operating in districts with
high political competition tend to get more trade protection.
– Proportional representation systems (Norway, Germany, Spain) have less trade
protection.

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 Summary

Mobile Labor and Mobile Capital

Heckscher-Ohlin Theorem
• Under free-trade, you export products with abundant factors.

Stolper-Samuelson Theorem
• Under free-trade, since you export products with abundant factors, the worth of
abundant factors increase.
• Proponents of free-trade are
– capital owners in rich countries
– labor owners in poor countries.
• Opponents of free-trade are
– labor owners in rich countries
– capital owners in poor countries.

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Summary
Immobile Labor and Immobile Capital
• When factors are immobile, policy pressures for protection arise
• Governments generally favor one industry over another
• Capital and Labor owners in non-favored industry oppose free-trade.

Mobile Labor and Immobile Capital

Ricardo-Viner Theorem
• Labor moves to export industries as companies are willing to pay more now.
• Proponents of free-trade are
– Labor as companies start competing with one another to hire them.
– Capital owners in export industries favor free trade because they sell their products.
• Opponent of free-trade is
– Capital owners in import industries - labor becomes more expensive under free-trade.

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