Chapter 5 Beyond Comparative Advantage. Copyright ©2014 Pearson Education, Inc. All rights...

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Describe the gains from intraindustry trade.
Draw a graph illustrating the gains from trade in a monopolistically competitive market.
Copyright ©2014 Pearson Education, Inc. All rights reserved.
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Distinguish internal and external economies of scale.
Analyze the impact of transportation costs and internal economies of scale on trade.
Present the pros and cons of industrial policies
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Introduction:
More Reasons to Trade
Trade models built exclusively on the idea of comparative advantage have a mixed record when it comes to predicting a country’s trade patterns.
It is exceedingly difficult to precisely measure a country’s comparative advantage
Large share of international trade is not, in fact, based on comparative advantage
A large share of international trade is not based on comparative advantage.
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Intraindustry trade: International trade of products made within the same industry (steel-for-steel, bread-for-bread)
Intraindustry trade is growing increasingly important in international trade especially between industrial countries
Interindustry trade: International trade of products between two different industries (steel-for-bread)
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Fundamental problem is defining an industry.
For example, if computers are defined as office machinery, then computers and pencil sharpeners are in the same industry,
More broadly an industry is defined, the more trade appears to be intraindustry
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Evidence suggests that intraindustry trade is greater
in high technology industries
in countries more open to trade
in nations that have received larger amounts of foreign direct investment
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Intraindustry Trade (cont.)
The production of many goods is characterized by economies of scale, or decreasing costs, over a relatively large range of output
New Trade Theory
new models of international trade based on economies of scale
newest and most significant developments in trade theory moves beyond traditional trade theory
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Economies of scale: Decreasing average costs over a relatively large range of output (as opposed to constant or increasing costs)
Internal economies of scale: lead to larger firms because size confers a competitive advantage
External economies of scale: lead to larger industries (however, larger firms have no inherent advantage over smaller ones)
Characteristics of
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When larger firms are more competitive, market structure changes
Oligopoly: handful of firms produce the entire market output, with each firm formulating its strategies in response to those of its competitors
Monopolistic competition: unlike under pure monopoly, competition among many firms exists
However, competition is attenuated by the practice of product differentiation—each firm produces a slightly different product
Characteristics of
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Intraindustry Trade
Lower prices: An increase in the size of the market allows for scale economies, which lowers production costs and eventually prices to consumers
Increase in the number of firms: There is a high likelihood that intraindustry trade expands the number of domestic firms and the quantity of domestic output
Increase in consumer choices: Intraindustry trade tends to give access to a much greater variety of goods than produced domestically
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Two fundamental links exist between trade and geography:
A place may pull in economic activity because it is close to a market (cities are low cost for expansion)
A place may offer firms the opportunity to find critical inputs (skilled labor)
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Geography, Transportation Costs, and Internal Economies of Scale
For most manufactured goods, it is not practical to produce next to each market due to economies of scale (producing cars next to dealerships)
Not all types of manufacturing have same level of transportation costs (presence of scale economies makes near market production impractical)
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Geography, Transportation Costs, and Internal Economies of Scale (cont.)
Most foreign investment today is directed towards high income countries (to access larger markets), not developing countries
All else equal, lower transportation costs often outweigh other costs that might be higher (southward shift of U.S. car manufacturing to be closer to final assemblers)
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External Economies of Scale
External economies of scale occur when firms become more productive as the number of firms in an industry increases
If a firm in a region produce similar products, they will benefit from knowledge spillovers
When the presence of a large number of producers in one area creates a deep labor market for specialized skills
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Geographical concentration may be self-reinforcing:
For example, as firms attract skilled workers or specialized input suppliers, the increased availability of high-quality inputs creates feedback leading to more firms in the same industry locating in the area.
-Examples: Jet engines
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Trade and Economic Policies (cont.)
In theory, trade could stifle the development of a new industry that is more efficient than the existing one
For example, that Europeans are potentially
more efficient at making commercial aircraft than Americans.
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Trade and Economic Policies (cont.)
The aircraft example is instructive because it illustrates a case in which trade may not be beneficial. In every other case we’ve examined so far, trade is beneficial.
The aircraft example also illustrates how trade patterns can be a result of completely unpredictable accidents of history.
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Industrial Policy
Industrial policy: A government’s policy designed to create new industries or support existing industries
industrial policies are controversial
in some cases they clearly are politically motivated and end up wasting huge amounts of money.
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Market Failure
Market failure: Failure by the market economy 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
A divergence between private returns and social returns
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Industrial Policies and
Market Failure (cont.)
In a market failure, some costs or benefits of an activity are externalized—outside the area of concern of the economic agents engaged in the activity
Externality: market failure that results from the externalization of the costs or benefits
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Market failure is a major justification for industrial policies
Two simple rules for analyzing cases of market failure.
One, social returns are greater than private returns, a free-market economy produces less than the optimal amount
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Two, when social returns are less than private returns, a free-market economy produces more than the optimal amount. In this case, economic agents do not take into account the costs that spill over onto others and that reduce the value to society of the good or service
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- Knowledge spillover
- Coordination problems
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The Uruguay Round and WTO prohibit subsidies for competitive policies
However, governments can use other policies:
providing information about foreign markets to domestic firms,
helping negotiate contracts,
tying foreign aid to purchases from domestic firms
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Common practices used by governments in some newly industrializing countries:
sell foreign exchange to targeted firms at below-market prices
provide government loans to private firms at below-market interest rates
provide government guarantees on loans obtained from the private sector
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governments provide special tax treatment to targeted industries
Governments use their own purchases as a way to develop an industry.
firms are guaranteed a profit on the development of new products
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Governments often support industries by encouraging firms to work together, either
through the direct funding of the research done by consortia and/or
through the relaxation of antitrust laws.
governments may directly
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Problems with Industrial Policies
A basic problem is that it is difficult to obtain the information necessary to measure the extent of market failure.
Second problem is determining which industry to target.
Industrial policies encourage rent seeking.
Rent seeking: An activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor
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Opponents of industrial policies:
High rates of saving and investment, and
High levels of schooling were the keys to success, not industrial policies
Proponents:

Chapter 5 Beyond Comparative Advantage. Copyright ©2014 Pearson Education, Inc. All rights...

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