International Economics_Project_Group 7_MBA IB 14-17

International Economics

A Direct Test of the Theory of Comparative Advantage: The Case of Japan

Theory of comparative advantage and analyze the issues

Group 7 : Karunesh Mathur ( 17) , Abhishek Thakur (1) , Anubhav Singhal(3) , Diwakar Gupta (12)

MBA(IB) 2014-17 Weekend

International Economics/ Session: 3

Case Study

• 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.



Introduction

• 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 Deardorff’s 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



Trade Imbalance of Theory of Comparative Advantage

• 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=1……M) and N goods (j=1…..N) . To simplify the analysis ,we focus on two extreme cases autarky and free trade.

• Assumptions :1. Let Qai & Qfi be the vectors of the goods produced in the country i in autarky and

free trade , respectively.2. Let pai & pfi be the corresponding vectors of the prices at autarky & free trade

respectively.3. Consumption vectors similarly , Cai & Cfi at Autarky & Free4. Let Ti(=Qfi- Cfi) be the vector the net exports in free trade. 5. Each country has its own production possibility set., Fi.6. 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)



Continue….

• 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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Theorem(Deardorff,1980)

Net Exports valued at Autarky prices is equal to or less than zero :paT>0Combing 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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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 <=0The 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



• Theory of Comparative Advantage hold in the shaded portion , which corresponds to Deardorff ‘s Proposition .• When pf*T=0 & PaT<=0 , Deadorff’s 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



Empirical Implication

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



Data Continue…

• 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.


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.

Data Continue…



Empirical Implication

II. Results

theresults oftheinnerproducts paTandp Tfor1868-75 Thelawofcompar- ativeadvantageholdsifpaT-p T<0 Figure 2presents theactualrelationshipbetween paT and p T thatcorrespondstoFigure 1Theresults indicate that althoughpaT <0holds inall years paT-p T<0doesnotnecessarilyhold Intwooutofeight years paT-p T/0is confirmed This inturnmeans thatthelawofcomparativeadvantagedoesnotalways hold inJapanoncetradeimbalanceistakenintoaccount

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



Hypothesis Testing

• 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 .



Conclusion

• 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.



THANKS ….

International Economics_Project_Group 7_MBA IB 14-17

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