2. WHY DO WE TRADE? - Part II

TU-91.2043 International Economics

by

Hannele Wallenius

Aalto University School of Science

Department of Industrial Engineering and Management

2. WHY DO WE TRADE?- Part II

International Economics

Hannele Wallenius

2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 2

2. WHY DO WE TRADE?

2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage

2.2 Modern Trade Theory: Heckscher-Ohlin Model

2.3 Alternative Trade Theories: Results from Practical Evidence


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From Trade Theory To Practice

Many researchers have tried to test the Ricardian and Heckscher-Ohlin theories First simply by observing: Adam Smith and

Ricardo

Latter statistical calculations (data collection)

In many cases they have indeed found evidence which supports these theoriesFinland does not grow bananas!

But also contradicting evidence has been found Trade in manufactured goods, intra-industry

trade


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Problems with H-O Model Why does not a country with cost

advantage capture the whole export market? imperfect markets (monopolistic

and oligopolistic) nonhomogeneous products

(product differentiation) transportation costs trade barriers

These were not considered in H-O model!


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Problems with H-O Model continued

Furthermore, Heckscher-Ohlin theorem based on factor endowments would imply that trade should occur primarily between pairs of countries with very different relative factor endowments


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Problems with H-O Model continued

HO theory seems to explain quite well the trade between industrialized and developing countries, but a large volume of trade takes place among industrialized countries that often have similar relative factor endowments


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The composition of world exports

Source: WTO, International Trade Statistics

0 %10 %20 %30 %40 %50 %60 %70 %80 %90 %

100 %

1955 2006

Food, Agriculture

Fuels

Other primary commodities (e.g. minerals)Manufactures

Largest part of trade in manufactured goods.


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Other

Agricultural products

Fuels and mining products

Manufactures

0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 %

4.0%

9.5%

21.8%

64.7%

World merchandise exports by major product group (% of world merchandise exports), 2013

The composition of world exports, 2013


Source: WTO International trade statistics 2014

http://www.wto.org/english/res_e/statis_e/its2014_e/its2014_e.pdf

http://www.wto.org/english/res_e/statis_e/its2014_e/its2014_e.pdf


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Strong Challenges to the Traditional Trade Theories

1. Trade among similar economies For instance, who are Finland's

largest trading partners?

2. Intra-industry trade What do we export, for instance, to

Sweden and what do we import from there?


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Intra-industry Trade by Country, 2006*


* The index ranges from zero to 100 with a value of 100 indicating all trade of a country is intra-industry.


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Intra-industry Trade in Manufactures, 1997-2008 average, selected countries


0 20 40 60 80 100

IcelandRussia

IndiaGreeceJapan

TurkeyBrazil

IrelandNorway

ChinaFinland

SwitzerlandEstonia

United StatesSwedenMexico

GermanySpain

United …Netherlands

FranceBelgium

Source: OECD Economic Globalization Indicators 2010


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New Trade Theories (NTT)

Next we present some new trade theories, which base international trade on economies of scale, network effects, imperfect competition, taste of variety, and differences in the development and spread of new technologies over time among nations


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Modification of H-O Model

A. The role of taste - production bias vs. taste bias

B. The role of trade barriersC. Classification of inputs

i) capital – laborii) arable farmland, raw materials,

human capital, man-made capital, high-skilled labor, unskilled labor

If these modifications are made to H-O model, a larger proportion of trade can be explained by the model…

WSJ, 19.8. 2010

China Cultivates Taste for German Cars


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New Trade Theories

1. Increasing returns to scale in the production process* economies of scale

Indivisibilities Division of labor Geometrical reasons Inventories Once-and-for-all inputs

International trade allows a country to specialize in industries where average costs fall as additional resources are utilized

* Increasing returns to scale exist when a proportionate increase in use of factors of production results in a greater than proportionate increase in output.


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New Trade Theories cont.

Economies of Scale in Imperfectly Competitive Markets Perfect competition, as assumed by H-

O model, can exist only if economies of scale are not extensive

Economies of scale are common in the real world of manufacturing and in some parts of services sector

Increasing returns to scale (economies of scale) and imperfect competition can explain some of the intra-industry trade


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Economies of Scale in Imperfectly Competitive Markets continued

Ddom

MRdom

ACMC

Dworld

MRworldQe

P

AC

Trade can also create an otherwise unsustainable industry where large economies of scale exist.


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New Trade Theories continued

2. Intra-Industry TradeCan be explained by Taste of Variety and Differentiated

Products People have a tremendous diversity of

taste and are willing to pay for it at the marketplace• Product differentiation and variety of taste

leads to specialization and imperfect competition

Taking advantage from division of labor in industries that exhibit economies of scale we can consume a larger variety of products and services on a lover cost


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Intra-Industry Trade cont.

Border trade when countries share a long border (transportation cost)

FA

FB

CA

CB

Country A

Country B


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New Trade Theories continued

3. Technological Gap and Product Cycle

Heckscher-Ohlin theory is static

Some economists have suggested that perhaps the composition of trade depends on dynamic factors, such as technological change


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New Trade Theories cont.:

Product Cycle

One interesting hypothesis is that new products pass through a series of stages in the course of their development, and their comparative advantage position changes as they move through this product cycle


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Product Cycle cont.

Some countries seem to have ability to supply a constant flow of new products: innovation – imitation

Product cycle: new product maturing product standard product

the comparative advantage of production changes during the product cycle


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Product Cycle cont.

I II III IV

Imports,foreignproduction

Exports,domesticproduction

Domestic production

(X-M)D

Foreign production

Time


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New Trade Theories…

Product Cycle cont.

I Product development and sale in domestic market

II Growth in exports as foreign demand springs up

III Decline in exports as foreign firms begin to produce for their home markets

IV Country becomes a net importer as foreign prices fall

At each stage different inputs dominate

II IIII IIIIII IVIV

Imports,foreignproduction

Exports,domesticproduction

Domestic production

(X-M)D

Foreign production

Time


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At each stage different inputs dominate

I Product development and sale in domestic market• innovative, skilled labor, and financial resources

needed

II Growth in exports as foreign demand springs up• marketing skills and financial resources needed

III Decline in exports as foreign firms begin to produce for their home markets• product starts to be mature and know-how

penetrates to other markets, cheap labor becomes important

IV Country becomes a net importer as foreign prices fall• standard product, mass production, cheap labor

dominates



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4. The Gravity Equation

Why does one country trade a great deal with one trading partner and far less with others?

Compare, for example, Finland trading with Sweden, Russia, Germany and rest of the EU... and on the other hand with some African countries


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The Gravity Equation

According to this formula a country's trade shares are

a) positively related to the size of other national economies (measured as GNP)

R = Resistance variablesR = Resistance variables),,( RGNPfT

Ti

tot

i Ti = trade with country i


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The Gravity Equation continued

b) and negatively related to so-called resistance variables, factors that discourage a particular trade flow

· such factors can be transportation cost, trade barriers that are not the same for all trading partners, among others


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5. External Economies of Scale Internal scale economies occur when a

firm's AC falls as the output of the firm increases

External scale economies occur when firms AC falls when the output of the industry increasesReasons for a cluster of firms to be more efficient than an individual firm in isolation may be 1) the ability of a cluster to support specialized suppliers; 2) the way a geographically concentrated industry allows labor market pooling; and 3) the way that a geographically concentrated industry helps foster knowledge spillovers.


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External Economies, Output, and Price


External Economies before Trade


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Trade and Price


DChina DWorld

ACChina

P, C (per button)

Quantity of buttons produced, demanded

P1

P2

Q1 Q2

When trade is opened, China ends up producing buttons for the world market (both to the domestic and the foreign market). Output rises from Q1

to Q2, leading to a fall in the price of buttons from P1 to P2, which is lower than the price of buttons in either country before trade.


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The Importance of Established Advantage

ACJapan

ACChina

QCars Cumulative

ACC

ACJ

QJQC

AC

•

•

The advantage of a long-established industry where scale economies are important.

A pattern of specialization established by historical “accident” may persist even when new producers could potentially have lower costs.


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Group Exercise 2

Above we mentioned 5 possible newer explanations for international trade. Find some examples of such trade patterns.

Newer explanations of trade:

1. Increasing returns to scale2. Intra-Industry Trade3. Technological Gap and Product Cycle4. The Gravity Equation5. External Economies of Scale



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Gains from Division of Labor: The Finnish Case

By taking advantage of comparative advantage and international trade, Finland has successfully increased the standard of living far beyond the point where it would be if it had tried to produce everything itself

However, the proportion of exports to GDP is still relatively low in Finland compared to some other small industrialized countries


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Gains from Division of Labor: Finnish Case cont.

In order to maintain its position in the international income comparisons, Finland has to expand further its foreign trade

What could be some of the possible new areas to expand?


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International Division of Labor: How Is It Changing?

International division of labor does not only mean trade of commodities and services

It also allows us to follow the scientific, technological as well as other societal developments which take place elsewhere


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International Division of Labor: How Is It Changing? continued

For internationalization of companies these type of dynamic advantages are equally important as are the static advantages gained from the trade of goods

There are clear signs that the participation of Finnish companies in international division of labor has changed over time


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International Division of Labor: How Is It Changing? continued

By simplifying we can say that up till 1980s Finns were exporting and importing goods

Since then Finnish companies have also started producing internationally

This is not really a new phenomenon, but lately it has become more intense than ever before


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Number of Employees of Finnish Companies in Finland and Abroad, 2002 - 2011


in Finland Abroad in Finland 2012, forecast


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04 05 06 07 08 09 10 11 12 130

20000

40000

60000

80000

100000

120000

140000

Stock of FDI abroad

Stock of FDI received

Foreign Direct Investments to and from Finland, million euros


Source: Tilastokeskus


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90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 125

10

15

20

25

30

35

High-tech exports, % of manufactured exports

Switzerland

France

United Kingdom

Norway

United States

Japan

Germany

Sweden

Finland

Italy

%

Hi-Tech Exports, % of exports in some OECD countries

Source: World Development Indicators


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Price of International Division of Labor: Finnish Case

As pinpointed above, we have gained a lot by participating in the international division of labor. But it has also caused some problems

The dependence of countries on each other has increased, and at the same time individual countries have become more vulnerable to changes in the world economy


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Price of International Division of Labor: Finnish Case continued

Finland has been affected not only by the worldwide economic fluctuations, but also by changes in "the rules of the game" in world trade as well as by the monetary and exchange rate disturbances


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For instance the fluctuations in the US dollar and the debt problems of developing countries have affected Finnish economy in past• and lately EU debt problems and

consequences of the Ukrainian crises


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By using exchange rate policy Finland was from time to time successful to eliminate the losses in its export income, but individual firms or industries often got hurt by fast changing exchange rates

In EMU there is not any more the possibility of national exchange rate policy

Price changes of some natural resources, such as crude oil, have often had an influence on employment and inflation rates

Also the joint environmental problems are an increasing concern


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Changes in world's production patterns: due the technological diffusion the production of many products moves where the production costs are lowest (this happens when in the production cycle the standard product stage has been reached; after that capital and factor costs are about the same in all countries because of international trade and so labor costs become most important)• BUT this might change again dramatically

when even larger part of production is produced by robots in the future!

• But on the other hand, firms may want to be there where the markets are…


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2. Why Do We Trade? 47

That’s all folks!

On next lecture:

3. INTERNATIONAL TRADE POLICY

2. WHY DO WE TRADE? - Part II

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