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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

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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 today’s economic patterns?
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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. Taiwan color TVs. Why? 4 . How do international trade patterns change over time? • U. used to be the world’s largest manufacturer of TVs…now it’s Taiwan.S.Questions To Be Answered 1. Is one explanation from one of the economic theory models sufficient to explain why Colombia exports coffee.

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.  Most useful outcome of empirical test is refinement of 5 both theory and test. Certain difficulties exist with empirical testing:  Empirical evidence can appear to support a theory. but it cannot prove it true (and vice versa). Both Adam Smith and David Ricardo used rudimentary empirical testing to support their claims. .

6 .  Virtually impossible to test for this. • Simple observations do not necessarily comprise definitive evidence in the model’s favor.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.

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

 Fair to state that simplest version of Heckscher-Ohlin model does poor job of explaining trade patterns. 8 . Modifications and extensions have been made in the model. Further tests in the early 1950s reduced the magnitude of the paradox.The Leontief Tests  Possible explanations of this paradox: In 1947 most of world’s economies were still in a highly disrupted state.

9 . 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  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.

 Inputs are now classified in several ways…most common: • • • • • Arable farmland Raw materials or natural resources Human capital Man-made or nonhuman capital Unskilled labor 10 .Fine-Tuning the Heckscher-Ohlin Model  Classification of Inputs Original theory used only two inputs: capital and labor.

11 . • The theory must be amended to take these production process differences into account. Productivity and Specialization The original theory assumed identical technologies across countries when it predicted countries would export goods that used their abundant factors intensively.Fine-Tuning the Heckscher-Ohlin Model  Technology.  We clearly observe different technologies across countries.

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.  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. Comprises a significant share of world trade. 12 . Data shows that IIT indexes tend to be higher for industrialized countries (almost 75% plus) than for developing countries.

In Figure 1.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. 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 .

some best served by domestically produced goods and others by imports.Intra-Industry Trade in Differentiated Goods  Product differentiation is the most obvious explanation for intra-industry trade. Consumers have a variety of tastes. 15 .

• 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 .  Provides one explanation for global trade liberalization in last fifty years.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.

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 firm’s average costs fall as the firm’s output rises (panel [a] of Figure 2).
• Primary sources are large fixed costs that can be spread over all the firm’s output. 17  Example: R&D expenses

Figure 2a: Internal and External Economics of Scale
Firm's ACX

AC S AC L AC X

0

XS

X

L

Firm’s Output of X

(a) Internal Economies of Scale

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Trade with Economies of Scale
 External economies occur when the firm’s average costs fall as the industry’s 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
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Figure 2b: Internal and External Economics of Scale Firm’s ACX AC 0 AC 1 AC X 0 X 0 X1 Industry Output of X (b) External Economies of Scale 20 .

• Therefore.Trade with Economies of Scale  Implications of economies of scale Create additional incentive for production specialization. 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.  Rather than producing a few units of each good domestic consumers want to buy. 21 . economies of scale provide a basis for trade even between countries with identical production possibilities and tastes.

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 X .

Internal Economies of Scale  With internal economies of scale.  Firms in one country specialize in one set of varieties. • Each firm achieves economies by specializing. Trade helps to increase variety by expanding the consuming population for any firm’s product. and firms in the other to another set. trade allows consumers to consume larger varieties of goods at lower prices. 24 . Consumers then have access to all the varieties through trade.

b: Internal Economics of Scale as a Basis for Trade between Identical Countries Firm’s ACA X Firm’s ACA Y AC Y AC X AC X 1 0 0 AC A X AC 2 Y AC Y DA X 0 X0 A A DX XA 1 A+B DA 0 YA 0 D A+B Firm’s Output of X Firm’s Output of Y (a) X Industry in A (b) Y Industry in A 25 .Figure 4a.

d: Internal Economics of Scale as a Basis for Trade between Identical Countries Firm’s ACB X Firm’s ACB Y AC X AC 2 X D 0 XB 0 B 0 AC Y 0 AC X D A+B B 1 AC Y AC Y B D 0 YB 0 B B D A+B Firm’s Output of X Y 1 Firm’s Output of Y (c) X Industry in B (d) Y Industry in B 26 .Figure 4c.

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. skilled labor markets 27 .  For example. 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.

Figure 5: External Economics of Scale and Comparative Advantage Firm’s AC B AC AC 3 AC2 A AC AC AC 1 D =D 0 X 0 X0 B A A B B AC A D A+B X 2 X 1 Industry Output 28 .

2. Temporary protection of A’s market could allow country-A firms to capture the market even if country-B firms enjoyed a head start. . Panel (a) combines weak scale economies and strong comparative advantage.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. Temporary protection would not allow country-A firms to capture the market 29 from already established country-B firms. Panel (b) combines strong scale economies and weak comparative advantage.

Figure 6a. Large Comparative Advantage (b) Large Scale Economies. Small Comparative Advantage 30 . b: Interaction of External Scale Economics and Comparative Advantages Firm’s AC Firm’s AC AC 6 AC2 AC ACA B AC 2 AC 4 AC5 AC AC A B D = DB 0 X4 X2 X5 A D A+B Industry Output 0 X6 D = DB X2 A D A+B Industry Output (a) Small Scale Economies.

 That curve is called the Learning Curve. Downward-sloping curve in Fig.Dynamic External Economies  In some cases. 31 . 7 captures the negative relationship between cumulative industry output and firms’ average costs. but on its cumulative output. • Associated economies called dynamic external economies. firms’ average costs depend not on the industry’s current output.

Figure 7: Dynamic External Economics and the Learning Curve Firm’s AC AC 2 AC1 AC 3 AC0 D =D A B LCB LC A D A+B 0 X 1 X0 Cumulative Industry Output 32 .

like the one in Fig. would disappear. 33 . either current or cumulative.Scope of Economies and Learning  At times. a firm’s costs depend on the output of the worldwide industry.  Example: semiconductors – recent evidence suggests effective learning may take place based on foreign as well as domestic production experience. 6 (a). Most arguments for protection based on external economies of scale.

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

Primary implication of this theory is that as each product moves through its life cycle. 35 .  Reflects highly educated and skilled workforce.Technology-Based Theories of Trade  The Product Cycle Technological innovation and new-product development tend to occur in major industrialized economies. and the relatively high level of R&D expenditures. the geographic location of its production will change.

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

37 . imports satisfy that consumption. 5.  The technology has diffused completely.Technology-Based Theories of Trade  Stages in the Product Cycle: 4. the product completes its cycle. Next. imports rather than domestic production begin to serve the domestic market of the innovating country. Finally. Although domestic consumption of the good may continue.

 Linder argues that for many manufactured goods. especially for manufactured goods.Overlapping Demands as a Basis for Trade  Linder suggested that similarities in demand between two countries can form a basis for trade. . 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. States that firms typically do not produce goods solely for export – most produce goods for which domestic demand exists.

Figure 8a: The Overlapping-Demand Hypothesis Product Quality QA max QA min 0 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 Q B min QA min Income overlap 0 IA min Imin B 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 .

Very heavy goods tend to be more costly to transport. 43 . transportation costs may not be prohibitive. but still may be high enough to have a significant impact on the pattern of trade. Called nontraded goods…reason usually involves a prohibitive cost of transporting them from one country to another.Transportation Costs as a Determinant of Trade  Some goods are not traded internationally.  For other classes of goods.

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 0 X* T X* Trade in X (a) Trade with No Transportation Costs (b) Trade with Transportation Costs 44 .

who pays for these costs? Generally. High transportation costs can contribute to agglomeration effects common in industries characterized by external economies. 45 .  Another question. exporter and importer share the costs.Transportation Costs as a Determinant of Trade  Transportation costs also play an important role in trade with external economies of scale. the larger the share of transportation costs the importer will bear.  The less price responsive the demand for the good by the importing country.

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

Location of Industry Market-oriented industries  Example: Retail sales operations like to be near their customers.  Example: semiconductors. Software etc 47 . • Their products typically neither gain nor lose a significant amount of weight or volume as they move through the stages of production. Footloose or light industries  Has no need to locate near either raw material sources or markets.

48 . The United States and Japan together accounted for about 60% of the total world production.Conducting Semiconductor Trade  Figure 11 illustrates the industry shares of the world’s semiconductor market in 2000.

Figure 11: Country Shares of World Semiconductor Memory-Chip Market. 2000 49 .

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

S. Trade Routes Tokyo New York Los Angeles Pacific Route 51 .Figure 12: Asia-U.

Figure 12: Asia-U.S. Trade Routes New York Singapore Suez Route 52 .

 Between 35 and 45% of U. 53 . trade occurs within firms. including both affiliate-parent and affiliateaffiliate shipments.Multinationals and Intra-Firm Trade  The share of U. trade accounted for by intra-firm trade in the 1982-1994 period is shown in Figure 13.S.S.

Trade Accounted for by Intra-Firm Trade.Figure 13: Share of U. parent companies to their foreign affiliates 15 10 5 Exports from U. 1982–1994 Percent 45 40 35 (a) Exports Total intra-firm exports 30 25 20 Exports from U.S.S. affiliates to their foreign parent groups 0 1982 83 84 85 86 87 88 89 90 91 92 93 94 54 .S.

Trade Accounted for by Intra-Firm Trade.S. 1982–1994 Percent 45 40 35 Imports from U.S. parent companies from foreign affiliates 0 1982 83 84 85 86 87 88 89 90 91 92 93 94 55 . affiliates from their foreign parent groups Total intra-firm imports (b) Imports 30 25 20 15 10 5 Imports from U.S.Figure 13: Share of U.

S.S. especially with developedcountry trading partners.  Intra-firm trade accounts for large shares of U. imports and exports. 56 . trade with selected partners are indicated in Figure16.Multinationals and Intra-Firm Trade  The intra-firm trade shares of U.

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

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