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International Economics

Group 7 : Karunesh Mathur ( 17) , Abhishek Thakur (1) ,


Anubhav Singhal(3) , Diwakar Gupta (12)

A Direct Test of the Theory of Comparative Advantage:


The Case of Japan
Theory of comparative advantage and analyze the issues

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Case Study
International Economics/ Session: 3

The Case Study, the Comparative Advantage from


empirical point of view. We would not only show net
exports valued at Autarky Prices ,But also valued at Free
Trade Prices , are needed to test the Theory of
Comparative Advantage , when Trade is Unbalanced.

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Introduction
International Economics/ Session: 3

In Japan the Tokugawa Government had prohibited all international trade &
contracts in 1641 except at Dejima, a tiny island off Nagasaki where Dutch
and Chinese Merchants are allowed to trade.

Only a negligibly small amount of trade was conducted, and thus Japan was
virtually in Autarky for more than 200 years. In 1859, following the visit the
US Commodore Mathew Perry in 1853, the Tokohawa government decided
to open the Japanese Economy.

Accordingly, the Shift from Autarky to free trade occurred rapidly. It was in
this context that Bernhofen & Brown tested the validity of the Deardorffs
Theorem, using price data for 1851-53 before opening up the Autarky
situation , and trade data for 1868-75, just after the opening up the Free
Trade , and this strongly supports the Theory of Comparative Advantage

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Trade Imbalance of Theory of


Comparative Advantage

International Economics/ Session: 3

1.
2.
3.
4.
5.
6.

A theorem for the law of comparative advantage when trade is balanced as simplified
version of this theorem is as follows :
Consider a world of M countries (i=1M) and N goods (j=1..N) . To simplify the
analysis ,we focus on two extreme cases autarky and free trade.
Assumptions :
Let Qai & Qfi be the vectors of the goods produced in the country i in autarky and
free trade , respectively.
Let pai & pfi be the corresponding vectors of the prices at autarky & free trade
respectively.
Consumption vectors similarly , Cai & Cfi at Autarky & Free
Let Ti(=Qfi- Cfi) be the vector the net exports in free trade.
Each country has its own production possibility set., Fi.
Producers are assumed to behave competively such that the producers maximize
the net production on a given production possibility set :
psi *Qsi >= psiQi for all Qi = Fi ( s =a,f)..(1)

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Continue.
International Economics/ Session: 3

Also , assuming the consumer preferences follow the weak ,axiom


of the revealed preferences ;
pai*Cai >=pai*Cfi
pfi*Cai >pfi *Cfi
..(2)
Finally , assume that trade is balanced :
pfi *T= 0(3)
Given these assumptions , the following Theorum, is dervied in
Deardoff , we omit the country subcript in what follows to focus on a
single country .

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Continue..
International Economics/ Session: 3

Theorem(Deardorff,1980)
Net Exports valued at Autarky prices is equal to or less than zero :paT>0
Combing this theorem with ( 3) we get : (pa pf)T <=0

This Theorem states the Relative-autarky-price measures of comparative


advantage a country is more likely to export good (ie T/0)if the autarky
prices are lower than the free trade prices ( paj - pfj<=0) & import good j
( i.e. Tj <0 ) if the autarky prices are higher than the free trade ( i.e. paj pfi
>=0)

Assume now that each country has homothetic preferences. When trade is
not balanced the following proposition can be derived

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Continue..
International Economics/ Session: 3

Proposition(Deardorff,1994)
Under the assumption of the Theorem as well as homothetic
preferences but without balanced trade the net exports valued at the
difference between autarky and free trade prices are less than or
equal to zero :
(pa pf )T <=0
The Implication of the Theroem & Proposition is twofold ;
1. Autarky Price Vector pa.
2. Free Trade Prices Vector pf.
3. Net Trade T
4. Inner Products paT & pfT.
In this the test of theory of comparative advantage is ( pa-pf)T<=0

MBA(IB) 2014-17 Weekend

International Economics/ Session: 3


Theory of Comparative Advantage hold in the
shaded portion , which corresponds to
Deardorff s Proposition .
When pf*T=0 & PaT<=0 , Deadorffs
Theorem holds.
If there is trade surplus , the theory of
comparative advantage could hold when
paT>0 as (pa-pf)T<=0 covers only C but also
Area D.
if there is trade deficit ,the theory of
comparative advantage does not necessarily
hold when paT<=0 because Area A is in ( pa
pf)T >0
The larger the trade deficite becomes ,its
more likely is to mistakenly accept the theory
of CA , as A Area does not support the validity
of the theory of CA.
like wise, larger the trade surplus becomes,
its more likely To reject the validity becomes
Area D in not included in paT <=0

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Empirical Implication
International Economics/ Session: 3
I . Data
Till now we understood that Japan or one needs net exports valued at
Autarky prices (paT) & (pfT) at free trade. Net Exports Prices as per
Berhofen & Brown ;

The prices from various sources , which cover about 95% of epxorts & 2/3 of
imports

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Data Continue
International Economics/ Session: 3

Japan was in Autarky before 1859 and in free trade for


1868-75, it means that the inner product of free trade
prices (pf) and trade vector (T) during 1868-75 is
equivalent to nominal net exports (pfT) in that period.

Note that the currency denominations of these sources


are different each other Ryo- and Yen. In1871 the Meiji
Government introduced a new currency the Yen Also in
the early Meiji period both gold based Yen and silver
based Yen were used.

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Data Continue
International Economics/ Session: 3

While Bernhofen and Brown reported in Ryo- (gold)


&Sugiyama(1988) reported in Yen(silver) Although the exchange
rates among Ryo- (gold) and Yen (gold) were 1Ryo=1Yen =1US
dollar(Yamamoto 1994 p 59andp 79) the exchange rates among
Ryo- (gold) and Yen(silver) were 0.773Ryo=1Yen(silver) .We applied
the latter exchange rate and converted from Yen(silver) to Ryo(gold)so that the net exports data are comparable to the data of
Bernhofen and Brown.

Data of Bernhofen & Brown pointed out that the free trade should
be compared to the autarky at one point in time. In Order to remove
the effects of inflation of export and import prices, counterfactual net
exports are estimated. Deflating exports and imports using the
indexes prices.

nshipbetween paT and p T thatcorrespondstoFigure 1Theresults indicate that although paT <0holds inall years paT-p T<0doesnotnec

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Empirical Implication
International Economics/ Session: 3

II. Results
The results of the inner products paT and pfT for1868-75 The law of comparative advantage
holds if (paT-p T)<0 , Figure presents the actual relationship between paT and p T that
corresponds to .The results indicate that although paT <0 holds in all years paT-p T<0 does
not necessarily hold In two out of eight years paT-p T/0 is confirmed This in turn means
that the law of comparative advantage does not always hold in Japan once trade imbalance
is taken into account

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Hypothesis Testing
International Economics/ Session: 3

A simple T Test of H0 : ( pa pf )T >0 is


conducted . The result indicates the null H0 is
rejected as ( p value =0.016),if the 1st 2 years
1868 & 69 are excluded, the null hypothesis can
be rejected at 0.3 % significance level. Also, if
last 2 years 1874-75 are excluded , the H0cant
be rejected by null hypothesis .

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Conclusion
International Economics/ Session: 3

Bernhofen & Brown gave a insightful


analysis via empirical test for the law of
comparative advantage & Combining the
theory with history.
The Case also shows the not only the net
exports valued at Autarky prices but also
those valued at free trade prices to test
law of CA, when trade is unbalanced.

MBA(IB) 2014-17 Weekend

International Economics/ Session: 3

THANKS .