CFJ8 - TRADE, GROWTH, AND PRODUCT VARlETY lie twocommodity,...

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Unformatted text preview: TRADE, GROWTH, AND PRODUCT VARlETY lie twocommodity, two—factor version of the HeckschenOhlin modei de- scribed. in Chapter 7 has for decades served as the workhorse for thinking about competitive trade situations. But a much more useful, and not much more difficult, variant on the HeckschenOhlin theme allows for the world to be inhabited by lots of countries and iots of commodities. in such a framework it is possible to investigate how the ability to trade goods in world markets affects the process of growth and development. And the existence of great degrees of concen- tration in production, a characteristic of Ricardian trade models, is seen to he a more general phenomenon. The first halt of this chapter adheres strictly to the competitive assumption of the way markets behave, just as in the previous three chapters. . In the second halic of the Chapter we focus on ultra-industry trade among a number of countries and commodities, with each country narrowing its produc- tion selection to only a few varieties of goods in each industry. This behavior is supported in markets characterized by monopolistic Competition with production processes exhibiting some degree of increasing returns to scale. With. production details supplied, we are in a position to expand on the kind of intradndustry trade outlined in Chapters 2 and 3. TRADE PATTERNS: WHAT TO PRODUCE We lead up to our discussion of a inanyvcommodity world by introducing a new _ kind of diagram in the context of Chapter 7’s discussion of production and trade in the two-commodity, food and clothing setting. Unit-Value Esoquants The new diagram is shown in Figure 8.1. This diagram assumes that world prices for food. and clothing are known, so that the isoquants displayed are those for $1 worth of each commodity. Once again. clothing is assumed to be the commodity that always uses laborwintensive techniques compared with food. With world prices given, certain production techniques would not be observed, regardless of the country’s endowment bundle. For example, clothing would not be produced using the input bundle shown by point C, because there are better ways of earning $E—e.g., any number of techniques of producing food. What is less obvious is that technique D for clothing production also would not be sustained in a free~trade i2? l30 CHAPTER 8 * TRADEGROWTH, AND PRODUCTVARiETr Figure 8.! Capital UnitNalue lsoquants This diagram assumes world prices for food and clothing are given and the iso- quants show quantities of each commod- ity that would sell for iii in world man kets. Producing a combination of the two products if the endowment ratio lies in cone BOA is preferable to producing just a single commodity. equilibrium, despite the fact that there is no other single way of earning $1 dominates it. The tangent chord, BA, captures a phenomenon familiar from Chapter 7: trading economy may produce both food and clothing. For example, if the c: try’s endowment point lies on a ray from the origin through point P, a dollar ecu be earned by devoting the amount of capital and labor indicated by vector t produce clothing, and by the vector OH to produce food. These vectors add-up; point F, indicating that less labor and less capital than required to produce i clothing at point D can be allocated in the manner described in order to produc $1 on world markets. That is, although point D is not dominated by any other 5? gle production process, it is dominated by the blend of clothing and food produ tion shown by point F. We have seen in the previous chapter that if a country pt duces both goods, 2. knowledge of both commodity prices determine ' : b for capital and labor. Figure 8.1 shows the wage/rental ratio by the ( of the) slope of chord BA. However, if the endowment ray is steeper economy must be specialized in food production. Similarly, an economy'W lower capitalllabor endowment ratio than shown by GA must produce 9 clothing. _ __ Figure 8.2 continues this line of argument in a situation in which five C? modities are capable of being produced in this country. Each of the five isGEifia” shows input combinations oi labor and capital capable of yielding enough 0“ ‘ to be worth $1 on world markets at the given commodity prices. Note that ‘39 modity 5 would not be produced at these prices, regardless of the factor end“? merits; there would always be a better way of earning a dollar. This reflects"t Labor 51 that er 7: A : coun- r could ‘ 06 to :l up to ice just roduCe 1er sin— iroduc— ry pro- .‘ prices e value )8, the with a e only e coin- quants output t com- :ndow- he fact 8.I * TRADE PATTERNS: WHAT TO PRODUCE f3! Figure 8.2 Many Commodities With given world prices, the home coun- rry’s technology determines for each com— mOdity the quantities of labor and capital that produce $l worth of output. Production takes place on the inner from tier ABCDEF (extended). Capital 0 Labor that there are other countries in the world with a Ricardian type of technological comparative advantage in producing this commodity. Which one or more of the other commodities the country with this technology would produce wouid depend upon its endowment proportions of capital through a tangent chord, e.g., at point I, the and 2 in this instance). But the endowment to labor. if the endowment ray passes country produces two commodities (1 Factor Prices and Growth Start by considering a Very labor abundant economy, one with capital that with these world prices the only commodity it can produce is com- modity 1, with the wage/rent ratio given by the slope of 1’s unit vaiue isoguant at the appropriate endowment ratio southeast of point A in Figure 8.2. Now suppose that the world prices and. technological knowledge in this country remain un- changed, but that it succeeds in raising its capital/labor endowment ratio. The lo— cus ABCDEF (extended at both ends) in Figure 8.2 represents a composite unit- uaiue isoquant, which is literally the set of input combinations revealing the most economical way of earning $1 on world markets. As this country’s capital/iabor endowment ratio grows, notice that the set of commodities it can produce changes, from just commodity 1, to commodities 1 and 2, and then no longer can it be com- petitive in producing the second commodity, etc. Figure 8.3 supplements this discussion by showing explicitly the dependence of the wage/rent ratio on the relatively so little o PRODUCT VARiETY CHAPTER 8 e TRADE. GROWTH. AN endowment ratio, the figures read off of Figure 8.2. The diagram explicitly reveais j ding its pro ' moving to- intensive ; that with growth a countr ward more capital intensiv ‘ from more laborm commodities. The growth process sometimes has the country completely speciah ' ized to a single commodity, with these positions alternating with being incom-_ pletely specialized to tvvo commodities.1 Figure 8.3 also reveals the general positive relationship between a country’s endowment of capital per laborer and the Wagelrent ratio. Certainly if a country is-_ specialized to producing'a single commodity the wage rate will be driven up by an increase in the capitalflabor ratio. The plateaus, along which factor prices do not change with increases in the iactor endowment ratio, are familiar from Chapter 7’s discussion of the 1 X 2 model: With commodity prices given, a change in factor be absorbed by a change in the composition of outputs without requiring any change in factor prices. The richer picture portrayed in Figure 8.3 re} veals that such a change in. the composition of outputs spills over to allow the country to cease producing some commodity, and atter a period of complete spel» cialiaatiori, to start producing yet a different commodity. ' ATwo-Country Comparison two small countries {arcing the same set of wor 1 knowledge. Must their wage rates be t Obviously, much depends on id prices and sharing he same? Their capi- Now consider factor endowments. the same technologica tai rents? Not necessarily. Figure 8.3 Wagefrent ratio Factor Endowments and Factor Prices Generally, the greater the capitalilabor endowment ratio, the higher the wageirent ratio for countries facing fixed world commodity prices.There are, however, plateaus of incomplete special- ization where factor prices are uniquely determined by world commodity prices. analysis in which a country has three, he general proposition emerges that with n factors and free good, or perhaps two, or three, but never is it required {0 Pr 5 have adjusted to fit this country‘s technology. WWW “inlthough we do not continue into an explicit more productive factors, t country may produce only one more than n uniess world price )1" 2C 8.! TRADE PATTERNS: WHAT TO Psooucs I33 Suppose the home country is labor abundant compared with the other country sharing its technology. For example, let OI at home and O] in the other country (Figure 8.3) depict factor—endowment proportions. With free trade the wage rate is higher abroad. Even if the other country’s endowment proportions allow it to he incompletely specialized leg, its ratio is now OM, with both countries producing commodity 2 in common), foreign abundance in capital still will be reflected in a higher wage rate abroad. The factor—price equalization theorem that free trade brings different nations” factor prices into equality is a strong result not apparently supported by the evidence. Even casual observation reveals that US. wages exceed those in Korea or Brazil. If countries do not share the same technological knowledge, then any presumption of factonprice equalization disappears, just as in a Ricardian world. As Figure 8.3 illustrates, even with the assumption. that two countries have access to the same technology, factor prices and techniques actually adopted need not be equalized. In this broader context of many commodities, the Hecl<scher~0hlin theory does not impose the assumption that techniques of production must be identical throughout the world. instead, it explains why techniques and produc— tivities differ systematically between countries. They do so, in part, because coun- tries differ in their supplies of productive factors. The Trade Pattern Trade patterns in this many—commodity world reflect the tendency of countries to concentrate production rather severely. Returning to Figure 8.3, consider the trading pattern of a country with some intermediate capitalllabor endowment raw tio, GM for example. The country produces only commodities Z and 3. It may ex- port either good 2 or good 3, or both. Look at its imports, however. This country relies on the rest of the world for commodity 1 (more labor intensive than either of the goods it might export) and commodity 4 {more capital intensive than either 2 or 3), as well as for commodity 5 (which, by the assumption in Figure 8.2, it can— not produce competitively because of inferior technology, even though its capital/labor requirements are close to those of 2 and 3). The trade pattern revealed by this example suggests that a country may not export all commodities with a capital/labor ratio higher than some crucial value, or import all commodities with lower capital/labor ratios. Such a view of trading patterns is inappropriate for a world that consists of many countries and many commodities. instead, the basic proposition is: Trade allows countries to concentrate productive activities exclusively on a few traded commodities whose factor requirements closely mirror the particu— lar capital/labor proportions found locally, and to satisfy their demands by importing a variety of commodities whose factor requirements {if they were produced at home) would range the entire spectrum from very low to very high capital/labor ratios. 134 CHAPTER 8 s TRADE, GROWTH, AND PRODUCT VARIETY 8.2 CONCENTRATION 1N PRODUCTiON Although our discussion of competitive pressures in the muiticommodity model predicrs that trade will enforce a high degree of concentration. in a country’s productive activities, a glance at production patterns in the real world suggests that this conclusion is partially blunted in practice. Consider some of the reasons. Transportation Costs Commodities cannot be moved from one location to another without incurring costs of transport, such as shipping charges, insurance costs, and the real costs involved. in time required to transport goods. The impact of transport costs On. patterns of trade is that they provide a natural protective umbrella for local pro—j duction. For some items, transport costs bulk large relative to production costs; thus most localities produce their own bricks and pour their own cement. The in«_ troduction of refrigerated trains and ships allowed much greater worldwide con+ centration in meat packing, vegetable farming, and related areas of commerce. _' If transport costs are greater than the cost spread between countries, that commodity does nor enter international trade. In this case economists speak of non- traded goods. The distinction between traded and non‘traded goods is especially lin- portant for small trading communities. Local prices of nonetraded goods are deter- mined by local conditions affecting demand and supply. Local prices of traded goods (whether exportables or importahles) are determined for this country by Corr ditions in the rest of the world. Through policy changes, the home country can af— fect local prices of non—traded goods, but it cannot affect prices of traded goods.2 I Protection of Local Industries While transport costs represent nature’s way of providing protection for load” industries, import duties and discriminatory taxes are artificial ways of achieving - the same end. One consequence of protective policyr is that a nation will engage in a wider variety of productive activities than could be sustained in the brisk cli mate of free trade. This leads to the obvious question: What costs (or benefits does a nation incur by stimulating this wider productive has . picks up this theme. Specific Factors: Short Run and Long Run The Heckscher—Ohlin account of trade often has been referred to as theory.3 It implicitly assumes that sufficient time is allowed for factofS 0 2This distinction has been discussed in Chapter 5 and is also important in such questions 35 ill effect of exchange rate changes for a small country. See Part IV. 'j- 3For example, see Wolfgang Mayer, “Short-Run and Long—Run Equilibrium for a Small OW Economy,“ Joamai of Political Economy, 82 (September/October 1974): 955v968; andleha. Mussa, “Tariffs and the Distribution of Income: The Importance of Factor Specific . Suhstitutability, and Intensity in the Short and Long Run,” journal of Political 560W”?! 3 (NoveinberfDecemher 1974): “91-4 204. " model untry‘s .iggests :asons. :utring l costs ists on ad pro~ costs; Fine in- le con- :e. s, that )f non- iiy im- deter" traded ay C0n~ :an af- :oods.2 ' local ieving age in sk cii- nefits) it text ig-rim ms of : as the 3 Open Aichael cifi city, my, 82 l l l 8.2 CONCENTRATEONEN PRODUCTtON E35 production, such as skilled iahor, various kinds of capitai goods, and entrepre~ neurs, to avoid becoming trapped in depressed industries if possible returns eise~ where in the economy are superior. It also assumes that these factors cannot suc— cessfully heat off competition from new productive factors entering an industry with the required skills. Factors are mobiie from industry to industry. Chapter 6 provided an illustration of short~mn theory. There capital and land represented separate productive factors. However, alternative scenarios had either capital or iahor specifically tied to their occupations only in the short run. Examples abound of workers who can be retrained with new skills to enter new occupations oniy after a number of months or years, or of textile machines that must be scrapped or allowed to depreciate before they can figuratively be beaten into tractors or iathes. Both short» and long~run models function simultaneousiy in describing a na- tion’s trade patterns. Some factors of production are genuinely specific, both in the short and the long ran; naturai resources provide the obvious exampies. {A nation’s position can change over time, however, from net exporter to net im- porter as reserves or supplies become scarcer and iocai incomes and demands grow. Oii and iron ore were formerly exported from the United States.) Airhough the strict Heckscher—Ohlin setting, with mobile capital and. labor, suggests oniy one or two traded goods produced (ignoring transport costs and tariff protece tion), a wider variety of production obviously can be supported by the existence of natural resources. Aside from natural resources, there is another way in which the specifio factors model can help to explain why a nation produces more traded goods than the small number suggested by the Heckscher—Ohlin theory. Return to Figure 8.2. Assume that the current capital/labor endowment ratio cuts the composite unit~ value isoquant at M, so that the Heckscher-Ohlin solution for this country would (in the absence of transport costs) suggest production only of tradeable good 3. However, in the recent past the prices of both goods 2. and 4 might have been somewhat higher (enough to have made them the recipients of capitai investment, just as good 3 is currentiy the favored industry). If real capital were literally mobile, machines in industries 2 and 4 would have shifted into 3 as soon as their prices fell. In reality, however, capitai in 2 and 4 can be trapped in the short run, with production of goods 2 and 4 simultaneously carried on with 3. Something has to give—wand it is the rate of return to capital and entrepreneurs in industries 2 and 4. A stylized picture emerges from this example. A factor such as capitai is not instantaneously shiftable. At any time some traded activities earn higher returns to capitai than others. Over time, variations in worid commodity prices and/or a country’s owu technoiogy help to account tor the presence of production in sec— tors of the economy whose rationaie for existence lies in the past. With the pas— sage of time certain industries disappear from the scene, and new ones emerge. Every period carries with it echoes of the past. However, the range of such activi— ties in generally capitaiwrich countries should differ from that in. countries abun- dant in unskilled labor. l36 CHAPTER 8 r TRADE, GROWTH, AND PRODUCT VAREETY 8.3 ECONOMic GROWTH AND CHANGING COMPARATIVE ADVANTAGE Growth experience in today’s world varies widely from country to country. In North America and Europe relatively moderate growth rates {2 or 3 percent) al- ternate with periods of much slower growth. In many parts of Africa the situa- tion appears more grim, with long periods of zero or negative growth. In the past two decades (barring the iinanciai collapse in 1997—4998) the success sto- .. ties were to be found primarily in Asia. Japan in earlier years comes readily to ‘_ mind, but even more rapid rates of growth were being experienced by the so- called tigers of Southeast Asia: South Korea, Taiwan, Hong Kong, and Singapore, all exceeding 6 percent annual rates as an average over the past 28:: years. These countries were joined by Thailand, Malaysia, Indonesia, and, espe; cially in its coastal areas, mainland China. More recently, some countries in' Latin America are experiencing high growth rates. All these countries are “outward-looking,” with-export activity fueling the growth process. But more is involved, and Figures 8.2 and 8.3 help to tell the story. Growth is accompanied by high rates of capital accumulation, both physical capi- tal and human capital (education).4 Such capital accumulation raises wage rates, and during this process a country’s comparative advantage shifts away from more labor-intensive activities. Thus years ago Japan saw its shipbuilding and textile dustties lost to South Korea and Taiwan. As these NICs (newly industrializing countries) grew, they in turn lost their comparative advantage to more labor-abun— dant countries further behind. in the growth process. Taiwan is losing its grip as the worid’s leader in umbrellas, as well as its established position in shoes and textiles. The very success of industries like these in raising wage rates in Taiwan now sup- ports a shift toward higher technology and capital—intensive sectors. Taiwanese businesspeople eye wage rates in mainland China that are less than 10 percentof those prevailing in Taipei’s tight labor market. A significant characteristic of mod- ern trade patterns is the great increase in trade in intermediate products, natural resources, and producer goods, facilitating an international fragmentation of 13m- duction processes whereby more labor-intensive activities get placed in lowwwage areas. . This pattern, wherein growth leads to higher real wages, entailing shift-i3 in comparative advantage and actual declines in previously active labor~intez_1_'SiVe industries, is often accompanied by rapid technological progress and quality'up' grading of exports. Sometimes it is American commercial policy that encouragES these moves. In the 1980s the United States urged the use of VERs (voluntary BX‘ port restraints) on Japan to stem the flow of Japanese exports of automobiles W the American market. With such quantity restraints in operation, the Japanese response was to raise quality, and whole new lines of more luxurious automfl‘ biles posed a threat to Detroit’s more expensive models. By century’s _ American automobile industry was winning back market share with better? quality products. 4Accotding to the Economist (November 16, 1991), Taiwan recently accounted for a big-5 i’ cent of doctorates in engineering at American universities. 8.5 Paooucr VARIETY AND lNTRA—INDUSTRY TRADE i37 8.4 PREVALENCE or Invaaniwousrav TRADE 8.5 The traditional theories of a nation’s comparative advantage in. international trade imply that a traded good is either imported or exported, but not both. However, ~ economists have come to realize that many very similar commodities are both ex~ ported from and imported into most industrial countries. This phenomenon was first noticed empirically among the European countries as they eliminated trade restric— tions among themselves to form the European Common Market (now European Union}. it soon became ciear that two—way trade is a fairly general phenomenon. The simpiest way to measure intra-industry trade is by means of the foliowing formula, where X indicates exports of some commodity or class of goods and M indicates imports: 1—(lX—~Ml}/{X+M) If a country only exports or only imports an articie, the second term reduces to X/X (or M/M'} : 1, and the whole expression equals zero. If X equals M, the second term equals zero and the whole expression equals one. Thus, the index ranges from. zero, where no intra-indnstry trade occurs, to one {or 100, if expressed as a per- centage) when exports and imports are balanced and intra~industry trade is at its maximum. - Table 8.1 illustrates the amount of intra—industry trade that takes place. it was caiculated by applying a version of the formula to each standard statistical classi— fication of commodities and then averaging the values over ail commodities for each. country (and year). The amount of intra-industry trade evidently rose by about one third over the years 1964—1985. It is over onemhaif for ali the countries shown except japan and Australia, which differ from the others in having very sharpiy distin~ guished comparative advantages or disadvantages in wide ranges of commodities. The extent of intra~industry trade varies a good deal from industry to industry. Casuai examination of intra-industry trade ratios for US. industries suggests that they are low for simple, undifferentiated products in which the country has either a strong comparative advantage (corn) or disadvantage {crude petroieum). They are high for nearly all complex, differentiated goods (photographic equipment), whatever the apparent state of our comparative advantage. They are also high for some simple goods (fertilizers, inorganic chemicals) for which the country seems to have neither a strong advantage or disadvantage. Psooucr VARierv AND lNTRA-iNDUSTRY TRADE The phenomenon of intra~industry trade was introduced in Chapters 2. and 3. A desire for variety in. types of clothing, whether by individuals or as an aggregate of individuals with different tastes, could support simultaneous consumption of a range of clothing types, with some varieties produced at home and others abroad. Recall from our earlier discnssion that internationai trade patterns then couid re— flect an exchange of one country’s varieties for those of the other conntry (intra— industry trade), and also a net outflow or inflow of clothing balanced by net trade in other products, such as food (inter—industry trade). Formai models designed to :38 CHAPTER 8 * TRADE, GROWTH, AND PRODUCTVARlETY capture this mixed type of trade have been introduced in recent years, in a {ram work that makes use of the Heckscher—Ohiin model.5 increasing Returns Not included in our earlier discussion of intra-industry trade is the mechanism by which the number of different varieties produced or consumed in any country is de- termined. If consumers value variety, why does the market not respond with a prolif- eration of countless products, each differing only slightly from competitors? The answer lies in cost reductions made possible by a iarger scale of economic activity the phenomenon of increasing returns to scale. This characteristic of technolo refers to the possibility that a doubling of expenditure devoted to producing a com modity (at constant input prices) may result in a more than double consequent e pansion of output, whereas the previous production models (Ricardo, specifiofacto and Heckscher—Ohlin) all assumed constant returns to scale. _ Suppose now that in some productive activities an increase of 10 percent l' bor and capital inputs would result in an expansion of output in excess of 10 pe cent. If variety is not valued per se, the existence of such increasing returns to sea would encourage the entire ievel of output to be organized in a single productive tivity in a single firm. it is the joint presence of a desire for variety and increasing turns that leads to markets in which a large, but finite, number of differential products emerges, each product serving some segment of a national or world mar In pursuing the formal details of such a trading world, it is extremely convent to impose arbitrary but naturai symmetry conditions with regard to both technol and consumer taste patterns. More explicitly, assume that the technology describ how any variety of clothing is produced is identicai to that of any other variety example, at comparable output levels the same capital/labor ratio would be used produce blue blazers and tan sportcoats. Assume symmetry in taste patterns as W- so that output levels are kept comparable: The demand curve facing the producer one variety is assumed to be identical to that facing a producer of any other vans As a consequence, any potential new entrant would consider producing only a ya that differs from those already on the market. _ These symmetry assumptions allow us to describe a world in which inc ing returns and factor endowments iointly determine output patterns in tw__ gregate industries: food and clothing. Suppose the food industry in each can consists of coantiess competitive firms, each producing a homogeneous p uct, with technology similar in both countries, and characterized by was returns to scale, as in the discussion in Chapters 5, 6, and 7. By contra sume the clothing sector consists of a number of differentiated varieties of ing, each produced by a single firm. ' 55cc especially E. Helpman, “international Trade in the Presence of Product Diffeten Economies of Scale, and Monopolistic Competition: A Chamberlin-I—ieckschenOhlin Ap I journal oflntemarional Economics {1981); and also the monograph by Helpman and-Kr Market Structure and Foreign Trade (Cambridge, MA: M.I.T. Press, 1985). 8.5 PRODUCT VARIETY AND lNTRAthDUSTRY TRADE £39 Tabie 8.i Average Levels of intro—industry Trade, All Commodities, Selected Countries, E9644 985 (percentages) Country 1964 1967 1973 1979 1985 Canada 37 49 57 56 683 United States 48 52 48 52 72a Belgium/Luxembourg 62 66 69 73 74 Netherlands 65 66 63 65 67 Germany 44 51 6G 60 65 France 64 67 7O 70 72, iraiy 49 45 54 48 55 United Kingdom 46 55 71 80 '76 Austraiia 18 I7 .29 22 25 Mean of above countries 46 49 5 55 66 “These unusualiy high vaiues probably reflect the enormous voiume of trade in automobiles and parts between the United Starr-:5 and Canada under a special freon-ado arrangement for this sector. Source: Organization for Economic Cooperation and Development, Structural Adjustment and Economic Performance (Paris: OECD, 3987}, p. 273. Monopolistic Eompetition and increasing Returns Most intermediate theory texts describe markets with a high degree of competition— high enough to drive equilibrium profits to zero with free entry of firms—but with products of all firms distinguished from one another by the typical consumer. Demand for the variety produced by any one firm is characterized by a downward— sloping demand curve; if the firm were to raise the price of its variety while prices of competing varieties were held fixed, its saies wouid be drastically reduced but not al- together eliminated. _ Figure 8.4 describes the determinants of equilibrium output for a typical firm in this monopolisticaily competitive market. The demand curve (the AR, or average rev— enue curve) facing the firm is downward sloping, implying that marginal revenue, MR, iies below average revenue. With the firm producing in the range of increasing returns, the average cost curve, AC, is declining. This, of course, implies that the mar— ginai cost curve, M C, iies below the average cost curve. The typical firm seeks the out put level at which its profits are maximized. T his entails selecting the output for which marginal costs are equal to marginal revenue—level qA in Figure 8.4. If, as as- sumed, new firms are free to enter the clothing sector, the resulting maximum profits are driven to zero. This is shown in Figure 8.4 by the tangcncy of the average cost and average revenue curves at point A. (If a temporary equilibrium revealed positive prof- its, entry of new firms would cause this firm’s demand curve to shift downward or ieftward until such a tangency is obtained.) Output 5],, and price pA represent the best the firm can do; any other output results in losses, I40 CHAPTER 8 e TRADEGROWTH. AND PRODUCTVARlETY Figure 8.4 Price Monopoiistic Competition E A firm in a monopolisticaily competitive equilibrium produces at qA, with marginal revenue equal to marginal cost. Free entry wipes out all positive profits at price pA. equal to average costs. IWWUkrmWMn$ mtnvmmménnmn Firm Size and ProductVariety in Autarky Consider, now, how the autarky situation differs between countries with respect-to the ciothing sector. Consumers seek variety in product styles, but too much variety is costly because average costs are high if each firm produces a smail amount. The-re? quirement that marginal cost and revenue be equal on the one hand (profit max mization on the part of every firm), and that average cosr equal average revenue-on the other (entry forces a zero—profit equilibrium), helps to determine how many dif- ferent varieties (one firm per variety) are produced and how iarge output is forest- and all firms in a single country. . Figure 8.5 focuses on relationships between the number of clothing firms, n,‘ and the size of any individual firm, at. Consider first the upward-sloping RC cu'fv I common to both countries because they are assumed to share identical techno gies and demand conditions everywhere are the same.6 This curve shows for 3 closed economy the possible combinations of firm size and number of varieties f0?- the clothing industry in a monopolistically competitive equi of the market is iarger for points farther out along the RC curve, which sugges that any one firm will face stiffer competition as more brands Assuming demand becornes more elastic and profits once again are squeezed 0 by the entry of new firms, as in the tangency soiution of Figure 8.4, the size 0f typical firm also expands. (That is, the tangency solution in Figure 8.4 slides f? ther down the average cost curve.) As a consequence, the number of va’rifiti changes positively with the size of the representative firm. With the expat-ile market size, any one brand faces closer substitutes and firms become larger-'5 5A discussion of this curve is found in Helpman and Krugman, op. cit, pp. 153—157. \J J? )utout ect to iety is he re maxi- ue on iy difw it any ns, 72, :urve, ' inolo- for a es for ii size ggests Euced. -d out 6 of a is far— rieties ion in i Figure 8.5 Size and Number of Firms The RC curve shows how in each country sharing a common technology. larger firm site goes hand in hand with the produc- céon of a greater number of varieties. In autarky. the smaller home market is served by firms (at H) that are fewer in number and smailer in size than in the larger foreign market (F ).With trade, if the same resources are devoted to cloth~ ing as in autarky, producers concentrate {at H’ and 2‘”). all firms are the same (Earger) size, and a larger number of vari— eties is availabie for consumers (at W). 8.5 u PRODUCT VARIETY AND lNTRA—INDUSTRY TRADE I 4! Number of oiothing firms in) (H+F) Size of firm (x) The two points on the RC curve labeled H and F correspond to auterky po- sitions at home and in the foreign country, assuming that the home autarky mar“ i<et for this industry is smaller. T hat is, if the two countries share a common technology, in autarky the smaller market will be served by a smaller number of firms, each simiiar in size to any other firm in that country but smaller in size rel“ ative to firms in the larger foreign market. Thus differences in country size would be reflected in differences in firm size. Consumers and Producers of Differentiated Products in aWorid Market A common theme running through all the previous chapters is that the possibility of trading in world markets frees iocai consumers from a lockstep dependence on the output of national firms. Such a theme is especially relevant to countries producing differentiated products once the countries move from autarky to en- gage in world markets, The composition of trade depends on cost conditions and tastes for both the clothing and food sectors at home and abroad. Postpone for the moment a full analysis of free—trade patterns by considering oniy how each country’s consumers and producers of clothing respond to the possibilities of in- ternational trade if each country makes the same commitment of total resources to the clothing industry as it did in autarky. (It will then be asked how this alloca— tion of resources can be altered by trade.) Figure 8.5 iiiustrates a free—trade equiiihrium for producers and consumers in both countries. Free trade creates a singie world market for differentiated prod- ucts. As a consequence, the output of each and every firm anywhere in the world is the same, with each producing its own variety. [42 CHAPTER 8 9 TRADE,GROWTH, ANo PRODUCT VARIETY The curves HH’ and FF’ show, for home and foreign country, respectively, a given allocation of resources to the clothing sector—the same level as in autarky positions H and F. A move toward the southeast represents, for each country, a cutback in the number of varieties produced but an increase in the scale of opera— -. tions for each variety. Now add these curves vertically to obtain the (H ~i~ F) lo- cus, which cuts the RC curve at W. Point W depicts the situation for consumers in either country and shows how, with trade, every consumer has a larger menu of varieties from which to select. This expansion in consumption possibilities is espe- cially large for the smaller home market. Producers in each country feel the in-. creased competition from producers abroad; greater elasticities of demand result in a smaller number of firms in each country, but each firm is of a iarger scale Given the (arbitrary) restraint on the allocation of expenditures to the clothing: sector in each. country, home supply response to trade is shown by point H’ and the foreign response by point P'. The dashed rectangular hyperbolas through points H and F show combina- tions of firm size and number of firms that yield the same aggregate clothing out- put {that is, points for which mt is a constant). The move by the home country from H to H’ {and the foreign country from P to F’) cuts higher and higher rectan- gular hyperbolas and thus shows that for a constant expenditure of resources in _' each, the move to higher volume firms and fewer varieties aiiows each country to _ expand aggregate clothing production. This corresponds to Chapter 3’s illustration ' of how the existence of increasing returns serves to shift a country’s production -_ possibilities schedule with trade out from its autarky position. _' So far we have only suggested how opening the market to world trade alter the size and number of firms in the clothing sector for a given allocation of re sources. We must add to this the response of resources in each country to the pos sibility that the home country, say, has a comparative advantage in producing clothing varieties relative to food (and relative to the foreign country). That is, Heckscher—Ohlin considerations of relative cost differences between industries based on differences in factor endowments combine with this discussion offlin— creasing returns in the clothing sector to determine the pattern of trade. This trade pattern now reveals both infra-industry trade in varieties of ciothing and inter: industry trade in which the labor-abundant country is a net exporter of ciothing and importer of food. " I Heckscher-Ohlin considerations also come into play if the varieties of com‘ modities in any sector are not produced in exactly the same manner. For exa ple, if varieties differ by quality, production. techniques will then tend to di-ifei accordingly. That is, products may differ in a vertical direction, with quality 0f- product improving for types produced with higher capital/labor ratios. The Cap tal used in this comparison includes human capital, and higher—quality produ types may indirectly require higher capitalilabor ratios via resources devoted research and development. Clothing, automobiles, audio and video equipmt’rn and machine tools provide examples. in automobiles, some countries (e.g.,r'5_0u pectiveiy, a ii’i’lautarky country, a c of opera- IH ~i~ F) lo- nnsumers in er menu of ties is espe— feel the in- nand resuit arger scaie. he clothing )int H’ and v combina— othing out- me country gher rectan- 'esources in country to illustration production trade aiters ation of re- ' to the pos- E producing 'y). That is, i industries ssion of in 3. This trade ; and inter- of clothing :ies of com— . For exam- nd to differ h quaiity of s. The capi— lity product 4 devoted to equipment, (e.g., South 8.6 8.6 4 SUMMARY E43 Korea and, earlier, Japan) produce lower~quality products compared with Germany, the United States, or (later) Japan. Fixed costs, economies of scaie, and a love for variety ail conspire to explain intra—industry trade among coun— tries producing roughly comparable quality products; but factor endowments, inciuding human capital and production technology, are crucial in explaining trade in iow—, medium—, or high~quality products. SUMMARY The pattern of trade in a Heckscher—Ohlin worid of many countries and many commodities shares much in common with a Ricardian world. Countries concenm trate their productive activities around a few commodities whose demands for facu tors closely reflect total factor availability and import commodities representing a wide dispersion in factor requirements (if they were produced at home) compared with those adopted for the export sectors. Factor intensities in a nation’s aggregate output bundle reflect that country’s factor-endowment proportions. Factor intensi— ties in a nation ’3 aggregate consumption bundle reflect average world factor en— dowments if countries have similar tastes. Since trade flows represent the differ— ence between output and consumption, reiatively capitaiubundant countries, on the average, import relatively labordntensive commodities. This is an average result however; the wide dispersion in imports still remains. As countries grow over time, the range of goods produced for export changes systematically. Growth in physical and human capital ieads to higher real wage rates, which alters comparative advantage away from traditional iahor-intensive commodities toward commodities reflecting higher capital/labor ratios and supeu rior quality. This pattern was strongly reflected in the particularly high—growth economies of Southeast Asia. Transport costs and tariffs serve to widen a country’s range of productive ac~ tivities. Resources specific to certain activities also convey a comparative advan- tage not captured solely by capital/labor rankings. in the short run, many types of capitai (and perhaps skilled iabor) are not mobiie between sectors. This tends to lessen the concentration of production. The spirit of the Heckscher-Ohiin theory still remains to suggest that differences between countries in their endowment of broad classes of productive factors such as capital and labor will be reflected in differences in patterns of production and trade. Industries in which consumers’ tastes support a wide variety of qualities are often characterized by monopolistic competition. The demand curve facing the producer of any given variety is siightiy downward sloping; in equilibrium such a firm. wiil produce in the range where average costs are declining {increasing re- turns to scale in the technology). If differences in technology among varieties is ignored, and if it is further supposed that demand is evenly balanced over all va— rieties produced, it is possible to model both autarky and free-trade positions in a Heckscher-Ohiin framework. Conclusions that emerge include: l l l ' l ! ...
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CFJ8 - TRADE, GROWTH, AND PRODUCT VARlETY lie twocommodity,...

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