Comparative Beyond Advantage Chapter 5: More
Why Comparative Advantage is Not Enough
1.
Trade models built exclusively on the idea of CA have a mixed record of success in predicting trade patterns. It's very difficult to measure a country's CA. Even if the CA is known, the country may have several products to choose from which utilize the abundant factor. It's difficult to large share of one they So, a predict which will produce. international trade is not based on CA.
2.
3.
Internal Economies of Scale
Internal Economies of Scale
Both of the previous models assumed constant returns to scale:
When
inputs doubled, outputs also doubled.
In practice, many industries are characterized by economies of scale:
Production Doubling
is more efficient the larger the scale at which it takes place. inputs more than doubles output. costs over a relatively large range
Decreasing
Definitions
Example: EOS and Benefits of Trade Hypothetical Industry
with EOS Total Labor Output Input 10 15 20 25 30 35 5 10 15 20 25 30 Average Labor Input 2 1.5 1.333 1.25 1.2 1.166
Two Country World One Country Concentration No Trade American production: 10 labor: 15 American production: 20 British production: +10 labor: 15 labor: 25 Result: More efficient Total world production: 20 labor: 30 production (same output at lower cost)
To take advantage of an EOS, America concentrates production in industry A. Industry A will need more labor.
That
labor will have to come from an industry
B.
Industry Industry
B will have to decrease or stop production. A will export some of the added production at a low price. Industry A in Britain will shrink.
EOS Can Lead to Trade
To take advantage of economies of scale, each of the countries must concentrate of producing only a limited number of goods.
International trade makes it possible for each country to produce a restricted range of goods and to take advantage of economies of scale without sacrificing
However...There is a Downside
Economies of scale typically lead to a market structure other than that of perfect competition. Internal economies of scale give large firms a cost advantage over small firms and lead to an imperfectly competitive market structure.
The Theory of Imperfect Competition
In imperfect competition, firms are aware they can influence the prices of their products: price setters. Can arise from industries with
Only
a few major producers
Many
producers but each strongly differentiates its product from rival firms.
Types are
Monopolistic Competition
Assumptions:
Each
firm differentiates its products from its rivals.
Gives each firm some monopoly power Insulates each firm somewhat from competition
Takes
rivals' price as given (they can't influence it changing their price doesn't change their rivals' price).
Real life example:
Equilibrium in MC
The more firms there are,
the
more intensely they compete, and the lower industry price (PP), but less each firm sells and the higher their costs (CC) not taking advantage of EOS.
the
MC and Trade
In industries with EOS, market size matters
because
mkt. size constrains the variety of goods that a country can produce and the scale of its production.
Trade forms an integrated market bigger than any individual market and loosens constraints.
Increased Market Size
The number of firms in a MC industry and the prices they charge are affected by the size of the market. Larger markets lead to
More More More
firms sales per firm variety of products prices
Lower
Oh, Goody, Another Graph!
An increase in size of market from trade allows each firm to produce more and have lower AC.trade leads to So
Increasing number of firms
more firms, more Downward shift of variety, lower price CC. by creating a larger market.
EOS, CA and the Pattern of Trade
Our example of MC industry predicts trade will lower costs, expand the number of firms, and increase variety. However, it says little about the pattern of trade that will result. To say more, we must look at how EOS interact with CA to determine the pattern of international trade.
Inter-industry Trade
According to the Heckscher-Ohlin model or Ricardian model, countries specialize in production.
Trade occurs only between industries: interindustry trade
In a Heckscher-Ohlin model suppose that:
The capital abundant domestic economy specializes in the production of capital intensive cloth, which is imported by the foreign economy.
Trade in a World without Increasing Returns
In a world without EOS, there would be a simple exchange of cloth for food.
Intra-industry Trade
Suppose now that the global
cloth industry: intra-
Companies will pursue market power through product differentiation: each country will produces different Trade occurs within the types of cloth.
If domestic country is capital abundant, it still has a comparative advantage in cloth.
It should therefore export more cloth than it imports.
Suppose that the trade in the food industry continues to be determined by comparative advantage.
Trade with Increasing Returns and MC
If cloth is a MC industry, Home and Foreign will produce differentiated products. As a result, even if Home is a net exporter of cloth goods, it will import as well as export cloth, giving rise to intra-industry trade.
Results
1.
Gains from inter-industry trade reflect comparative advantage. Gains from intra-industry trade reflect economies of scale (lower costs) and wider consumer choices. The monopolistic competition model does not predict in which country firms locate, but a comparative advantage in producing the differentiated good will
2.
3.
4.
The relative importance of intraindustry trade depends on how similar countries are.
Countries with similar relative amounts of factors of production are predicted to have intra-industry trade. Countries with different relative amounts of factors of production are predicted to have inter-industry trade.
5.
Unlike inter-industry trade Heckscher-Ohlin model,
in the income
About 25% of world trade is intraindustry trade according to standard industrial classifications.
But some industries have more intra-industry trade than others: those industries requiring relatively large amounts of skilled labor, technology, and physical capital exhibit intraindustry trade for the U.S. Countries with similar relative amounts of skilled labor, technology, and physical capital engage in a large amount of intra-industry trade with the U.S.
Grubel-Lloyd index
Empirical measurement depends on how broadly an industry is defined.
The broader the definition of an industry, the more trade appears to be intra-industry.
GLi = 1 -
Xi - Mi
Xi + Mi
If exports of a domestic industry are
Indexes of Intra-industry Trade for U.S. Industries, 1993
Note: an index of 1 means that all trade is intra-industry trade. An index of 0 means that all trade is inter-industry trade.
U.S. Canadian Merchandise Trade, 2008
Benefits of Intra-industry Trade
Prices for exports and imports decline because firms can lower their costs by producing for a larger market.
Recall in previous models, the price of imports fell but the price of exports rose.
The number of firms increases, so employment increases.
Could be in either country, however.
Dumping
Consequences of Imperfect Competition
Economies of scale can lead to an increase in international trade. Economies of scale can also lead to imperfect competition. Imperfect competition has consequences itself for international trade.
The Economics of Dumping
Dumping is the practice of charging a lower price for exported goods than for goods sold domestically. Dumping is an example discrimination: the practice of charging customers different prices. of price
different
Dumping is a controversial issue in trade
Necessary Conditions for Dumping to Occur
Price discrimination and dumping may occur only if
imperfect competition exists: firms must be able to set market prices rather than take them as given. markets are segmented: goods cannot be easily bought in one market and resold in another (can't buy domestically goods intended for export).
Example of Dumping as a ProfitMaximizing Strategy
Firm's Initial Conditions Home Sales revenue Abroad Sales 1,500 1,000 units $20,000 100 units $15 $20 total total revenue $
Firm wishes to expand sales and maximize profits. Because industry is imperfectly firm competitive, must lower price in order to sell more. Firm reduces price by $0.01
Home sales total revenue
1,001 units $20,009.99
$19.99
The Incentive to Price Exports Lower
Since international markets are imperfectly integrated due to both transportation costs and protectionist trade barriers, domestic firms usually have a larger share of home markets than they do foreign. This means their foreign sales are more affected by their pricing than their domestic sales.
Dumping Illustrated
Firm is a monopolist at home with domestic demand of DDOM and MRDOM.
The firm faces competition abroad and takes price as given. Foreign demand is DFOR = MRFOR .
Additional output can always be sold at
Dumping, Price Discrimination and Elasticity
Dumping is an extreme example of price discrimination. Firms will price-discriminate when sales are more price-responsive in one market than another (more elastic). Firms will dump if they perceive a higher elasticity on export sales than on domestic sales.
Protectionism and Dumping
Dumping (as well as price discrimination in domestic markets) is widely regarded as unfair. A US firm may appeal to the Commerce Department to investigate if dumping by foreign firms has injured the US firm.
The Commerce Department may impose an "anti-dumping duty," or tax, as a precaution against possible injury. This tax equals the difference between the actual and "fair" price of imports, where
Protectionism, con't.
Next the International Trade Commission (ITC) determines if injury to the U.S. firm has occurred or is likely to occur. If the ITC determines that injury has occurred or is likely to occur, the antidumping duty remains in place.
External Economies of Scale
The Theory of External Economies
Definition: When the cost per unit depends on the size of the industry but not necessarily on the size of any one firm. If external economies exist, a country that has a large industry will have low costs of producing that industry's good or service.
Sources of External Economies
1.
Specialized equipment or services
May be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. For example, Silicon Valley in California has a large concentration of silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips. These machines are cheaper and more easily available for Silicon Valley firms than for firms elsewhere.
2.
Labor pooling
A large and concentrated industry may attract a pool of skilled workers, reducing employee search and hiring costs for each firm.
3.
Knowledge spillovers
Workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists.
External EOS and Trade
Strong external economies tend to confirm existing patterns inter-industry trade.
Countries that start as large producers in certain industries tend to remain large producers even if another country could potentially produce more cheaply.
External Economies and Specialization
The AC curve for Thailand lies below the AC curve for Switzerland. Thailand could potentially supply the world market more cheaply than Switzerland. But if the Swiss
External economies potentially give a strong role to historical accident in determining who produces what They may allow established patterns of specialization to persist even when they run counter to comparative advantage.
National Welfare
Trade based on external economies has an ambiguous effect on national welfare.
There may be gains to the world economy by concentrating production of industries with external economies. But there is no guarantee that the right country will produce a good subject to external economies. It is even possible that a country is worse off with trade than it would have been without trade: a country may be better off if it produces everything for its domestic market rather than pay for imports.
External Economies and Losses from Trade
Thailand imports watches from Switzerland, which is able to supply the world market DWORLD at a price (P1) P1 blocks entry by Thai producers who must initially produce the watches at cost C0. If Thailand were to block all trade in watches, it would be able to supply its domestic market DTHAI at the lower price of P2.
A Case for Protectionism?
There is an incentive for Thailand to protect its potential watch industry from competition. However, it is extremely difficult to identify these situations in practice.
Hard enough that most economists would not find this justification for protectionism.
The world as a whole is more efficient and thus richer because international trade allows nations to specialize in
Dynamic Increasing Returns to Scale
External economies may also depend on the amount of cumulative output over time. Dynamic increasing returns to scale exist if average costs fall as cumulative output over time rises.
Dynamic increasing returns to scale imply dynamic external economies of scale.
Dynamic increasing returns to scale could arise if the cost of production depends on the accumulation of knowledge and experience, which depend on the production process over time.
Learning Curve
A graphical representation of dynamic increasing returns to scale is called a learning curve. Provided that the first country has a sufficiently large head start, the potentially lower
Dynamic increasing returns to scale can also lock in an initial advantage or a head start in an industry. Dynamic increasing returns to scale are sometimes used to justify protectionism.
Infant industry argument: Temporary protection of industries enables them to gain experience. But temporary is often for a long time, and it is hard to identify when external economies of scale really exist.
Industrial Policy
Definition
Industrial policy: Government policy designed to create new industries or support existing industries.
Industrial policies seek to alter the country's comparative advantage by picking winners and losers. They can have a profound impact on trade patterns. Highly controversial. Recent international
Justification #1: Market Failure
Market failure: When the market fails to deliver an optimal quantity of goods and services.
The value of a good to private consumers (private returns) and to society (social returns) fails to equal to its cost of production. Not all of the costs or benefits of an activity go to the people engaged in the activity. Some are externalized--outside the area of concern of the economic agents engaged in the activity.
When social returns > private returns, a free-market economy produces less than the optimal amount.
Not all the benefits are captured by the firm, so they are not included when making their production decision.
When social returns < private returns, a free-market economy produces more than the optimal amount.
Externalities Illustrated
The market solution is P1, Q1. From the standpoint of the social optimum, the price is too high and the quantity too low. Some advocate govt. intervention to increase the
Justification #2: Strategic Trade
Strategic trade policy is the selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms.
Requires that
The The
industry has economies of scale and firms in the industry have market power.
It tries to convince foreign firms to leave the industry by starting a well-publicized and credible system of subsidies to new domestic firms.
Example
Embraer is considering entering an industry with an existing dominant firm Bombardier. The existing firm is already in the market and not likely to leave.
The Brazilian government offers a subsidy (sufficient to make Embraer profitable whether or not Bombardier stays).
With this subsidy, Bombardier knows for certain that Embraer will enter. Bombardier's dominant decision in this case is to leave the
Industrial Policy Tools
The Uruguay Round and WTO prohibit direct subsidies.
Can subsidize "precompetitive" activities like R&D. providing information about foreign markets to domestic firms, helping negotiate contracts, lobbying foreign governments to adopt home country standards, tying foreign aid to purchases from domestic
However, governments can use other policies: