Intra-Industry Trade, Adjustment of Labor and Welfare ...
Transcript of Intra-Industry Trade, Adjustment of Labor and Welfare ...
Intra-Industry Trade, Adjustment of Labor and Welfare Gains
In Asymmetric Liberalization Policies:The Case of Europe Agreements
Yener Kandogan†
Department of Economics, University of Michigan, Ann Arbor, MI 48109, USA
February 1, 2001
† Address: 611 Tappan Street. Ann Arbor, MI 48109, USA. E-mail: [email protected] Phone: (734) 7415852 Fax: (734) 7642360
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Abstract
This paper modifies the two-industry, two-country Heckscher-Ohlin model with intermediate
goods to obtain horizontal and vertical intra-industry trade, as well as inter-industry trade.
Acknowledging that liberalization affects each type of trade differently, and that changes in each
imply labor adjustment of different magnitudes, the paper analyzes the effects of asymmetries
across countries or industries in liberalization. The paper concludes with the implications of the
model for the liberalization between the East and the West through the Europe Agreements.
JEL classification: F11, F15
Keywords: Intra-Industry Trade, Adjustment, Asymmetric Liberalization, Europe Agreements
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1. Introduction
Since the end of the World War II, countries all over the world have been engaging in
tremendous efforts to integrate their economy with the rest of the world by liberalizing their
international trade. We observe this at various degrees throughout the world, especially in Europe
and North America. It is often stated that the increases in trade in past decades are mostly intra-
industry, where we see two-way trade in the same industry. This phenomenon started in
industrialized countries almost three decades ago (Canali 1996; Menon 1994; Globerman 1992)
with the exception of Australia until the formation of ANZCERTA2 (Ratnayake 1992). But later,
Australia, Japan and the newly industrialized nations of the Asia-Pacific region also experienced
rapid growth in their intra-industry trade (Menon 1994; Wakasugi 1997; Chow et al. 1994). This
trend is also observed in other regional integration efforts, such as Latin America (Guell 1998),
West Africa (Agboli 1996), and Sub-Saharan Africa (Oyejide 1997). There are empirical work
suggesting that that steps toward regional integration so far have been almost adjustment cost free
(Menon 1994 and 1997; Menon and Dixon 1995; Gonzales 1995). These claims rest on the fact
that most of the increase in trade has been intra-industry, which is assumed to result in small
adjustment.
However, integration leads to economic restructuring, not only across industries but also
within an industry. As Nickell (1987) pointed out, there are considerable costs associated with
changing jobs during this restructuring. An adjustment occurs since the factors used in the
production of a good are specific, and cannot be used in the production of other goods without
transformation. Intra-industry-type changes in trade are conventionally treated as free of
adjustment costs in the literature. Menon and Dixon 1996; Hamilton and Kniest 1991; Greenaway
et al. 1994, and Brulhart 1994 all argue that adjustment costs associated with trade liberalization
2 ANZCERTA: Australia New Zealand Closer Economic Relations Trade Agreement
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are lower if most of the increase in trade is intra-industry. The critical assumption in their
argument is that jobs in the same industry require similar skills.
Intra-industry trade (IIT), however, can result from completely different causes. The factors
causing two-way trade of final goods in the same industry, i.e. horizontal IIT, are totally different
from those that lead to trade of goods in the same industry but at different stages of production,
i.e. vertical IIT. In general, the exchange of similar products as a consequence of scale
economies, product differentiation or reciprocal dumping is considered as horizontal IIT. Vertical
IIT, on the other hand, is identified as the exchange of different products in the same industry,
due to vertical disintegration of production process based on varying factor intensities within an
industry. In other words, in vertical IIT, the production of each commodity traded requires a
different input mix. Different skills are involved. Reallocating labor into jobs requiring different
skills will be costly, even if the jobs in question are in the same industry. Therefore, I find it
debatable that vertical IIT type changes in trade does not cause an adjustment in labor markets.
Empirical findings of Feenstra, and Hanson (1995), Findlay et al. (1992), and Buhr (1997)
support this view. Vertical IIT changes involve some labor adjustment, and thus they are costly,
but maybe less costly than inter-industry-type changes.
Bhagwati and Dehejia (1994), Krugman (1996), Leamer (1996) and Antweiler and Trefler
(1997) refer to the importance of disintegration of production internationally, which creates
vertical IIT, during an economic integration process. Given the importance attached to vertical
IIT, intra-industry trade should be separated into its vertical and horizontal parts to get a better
judgment on adjustment costs. Analyzing only the overall inter-industry trade will underestimate
the implied magnitude of adjustment in labor markets and the implied adjustment costs.
Incidentally, Greenaway et al. (1995) warn about the consequences of failing to separate these
two types of IIT in interpreting the empirical results.
The idea that integration implies small adjustment in labor markets relies on models that
allow trade only in final goods. Such models result in only horizontal IIT, and use it to represent
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the overall IIT. By allowing trade in intermediate goods, the model in this paper will be better
able analyze the adjustment effects of integration.
In Section 2, I develop a two-region, two-industry Heckscher-Ohlin type model of
international trade with intermediate products. The conventional model is modified to allow for
horizontal and vertical intra-industry trade, as well as inter-industry trade. The labor adjustment
implications and the associated welfare gains of liberalization policies, which typically involve
some asymmetries across countries or industries, are examined in Section 3. The paper concludes
with an application of the model to the European Union’s integration with Central and Eastern
European countries (CEEC).
2. The model
There are two factors of production: high- and low-skill labor, Lh and Ll. These are used in
producing four goods in two industries: goods x1 and y1 in industry 1, and goods x2 and y2 in
industry 2. An industry is defined as a group of goods with input-output relations. In this model,
each good y is an intermediate good used in the production of good x in the same industry.
Intermediate goods can be consumed directly as well. The production functions have constant
returns to scale, represented by the following unit-input requirements:
{ } { } { } (1) 1,2and)( i , x,y, gh,l, fQQ
, aQL
,wwaxi
yxiyxi
gi
fgilhfgi ∈∈∈==
where Lfgi is the amount of factor f used in the production of good g in industry i. Qgi is the
amount of good g production in industry i. ayxi is the per unit requirement of the intermediate
good y in the production of the final good x in industry i. wh and wl are wages of high- and low-
skill labor, respectively.
Production technologies respond to changes in wages in the following way:
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{ } { } { } (2) 1,2 and, i, x,y, gh,l m&f/ww/aa
ηff
mgimgigimf ∈∈∈
∂∂
=
where gimfη is the labor demand elasticity for high- or low-skill labor, in good g, industry i.
Using the identity∑ =f
gimfη 0 and assuming ig,η ηη gi
llgihh ∀∀== for simplicity, unit factor
requirements can be represented as follows:3
(3) constants arewherelglg c ww
c aww
ca fgi
η
h
lii
η
l
hhgihgi
=
=
Constants, cfgi are chosen such that intermediate good production in each industry is relatively
low-skill intensive, and production in industry 1 is relatively high-skill intensive:
(4) and , 2211 yxyxlyi
hyiyi
lxi
hxixi kkkki
aa
kaak >>>∀=>=
Full employment in both type labor markets requires:
(5) lg
LL
LL
i gli
i ghhgi
∑∑∑∑
=
=
There are two countries in the model, A and B, with the following relative factor abundance:
(6) 1 and 0 =+=+<≤−=== Bl
Bh
Al
AhAAB
l
Bh
BAl
Ah
A L Lv L , Lkss,kLL k
LLk
where s represents the degree of similarity in factor abundance between the two countries. By
assumption, A is relatively high-skill abundant. v represents the size of country A relative to B.
Total population in B is assumed to be 1. Thus, BlL shows the percent of the population with low
skills in country B.
3 For derivations, see Appendix A.
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Firms are profit-maximizers. In particular, in country A, the profit-maximizing prices of
goods in industry i will be as follows:
(7) )1(and)(min
min
min
tbtp p ,ppp wawap apwawap
Agi
Bgi
A(B)gi
A(B)yi
Ayi
A, yi
Al
Alyi
Ah
Ahyi
Ayi
yxiA, yi
Al
Alxi
Ah
Ahxi
Axi
++==+=
++=
where p Agi and )(BA
gip are the domestic price of good g and the price of the imported variety in
country A, respectively. Agit is the tariff rate that A applies to its imports of good g in industry i.
tb represents the non-resource-consuming trade barriers.4 Note that, for producers, domestic and
imported intermediate products are perfect substitutes: They choose the intermediate product with
the lowest price, either domestic or imported.
Representative consumers in each country have identical nested Cobb-Douglas/CES
preferences. In particular, for consumers in country A, the utility at tariff rate t is as follows:
( ) ( ) (8) )()(ln)1()()(ln11
CCαCCαβU ΘΘA(B)yi
ΘAyi
ΘΘA(B)xi
ΘAxi
ii
At
+−++=∑
where { } { } 2 1,∈∈ , ix,y gC Agi is consumption of good g in industry i produced in A. A(B)
giC is
country A’s consumption of the variety produced in B. 1=∑i
iβ .
Note first that the above utility function implies that the share of expenditures on industry i is
βi, whereas α is the share of expenditures on domestic and imported varieties of good x in the
budget allocated to an industry. Note further that consumers consider both countries’ products as
imperfect substitutes: Consumers, unlike producers, are conscious of the country of origin of the
products they consume, and they treat imports as differentiated varieties as in Armington (1969).
4 Here by non-resource consuming trade barriers, I refer to cultural differences (Dziembowska 2000),informational barriers (Raff 1999; Bureau 1998; Cawley 1996), exchange and capital controls (Tamirisa1998), preferential distribution networks (Casella 1997; Rauch 1996; Scherer 1997) and border effects(Helliwell 1997). In most contexts, such barriers would not be much interesting, since they are same astariffs. In this problem, however, given the results, a floor on liberalization due to these barriers holds someinterest.
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Solving the consumers’ problem, share of expenditures on a domestic good g in industry i,
Agis , and on the imported variety, A(B)
gis , from the budget allocated to that product in country A
are:5
(9)
1
1
111
1
pp
s
pp
pp
sΘΘ
A(B)gi
Agi
A(B)gi
ΘΘ
A(B)gi
Agi
ΘΘ
A(B)gi
Agi
Agi
−−
−
+
=
+
=
Because of the way preferences are formulated, countries will be importing and exporting
each product at the same time for consumption purposes. This way, the model allows for
horizontal IIT. But for production purposes, only the cheapest-producer country of an
intermediate good will export it –if the tariff rates are low enough to allow trade, among other
factors. Thus, inclusion of intermediate goods to the mode creates vertical IIT at low tariff rates.
Since the factor abundance is different for each country, we also have inter-industry trade.
The amount of exports, AgiX , and imports, A
giM , of each good g in industry i will be as
follows for country A:
(10) )1(
QazCM CM
QazCQX CQX
Axiyxi
Ai
A(B)yi
Ayi
A(B)xi
Axi
Axiyxi
Ai
Ayi
Ayi
Ayi
Axi
Axi
Axi
+==
−−−=−=
where Aiz is 1 if country A imports the intermediate product in industry i. That is:
(11) 1 and otherwise0
)1(10)1(1
z ≤+
=++<++
= Bi
Ai
Ayi
Ayi
Byi
Ayi
Ayi
Byi
Ai zz
ptbt] p.. [
ptbt if p
5 For derivations, see Appendix B.
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Income in each country is:
(12) 222222111111
222222111111
MPtMPtMPtMPtLwLwY
MPtMPtMPtMPtLwLwYBy
Ay
By
Bx
Ax
Bx
By
Ay
By
Bx
Ax
Bx
Bl
Bl
Bh
Bh
B
Ay
By
Ay
Ax
Bx
Ax
Ay
By
Ay
Ax
Bx
Ax
Al
Al
Ah
Ah
A
+++++=
+++++=
where the first two terms denote labor incomes and the last four terms represent tariff revenues
from imports.
Using the following goods-market-equilibrium conditions, the model now can be solved:
(13)
iXM
iXM
iMX
iMX
Byi
Ayi
Bxi
Axi
Byi
Ayi
Bxi
Axi
∀=
∀=
∀=
∀=
Since the focus of the model is the adjustment of labor and welfare gains implied by different
types of trade, there is a need to decompose the total trade into its types. This is done using the
following steps: The intra-industry trade, IIT, is the amount of matched trade in each industry.
This makes, inter-industry trade, INT, the difference between total trade, TT, and IIT. Horizontal
intra-industry trade, hIIT, is the amount of matched trade in each good. Thus, the amount of
vertical intra-industry trade, vIIT, will be the difference between IIT and horizontal IIT. Detailed
expressions are given below:
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(14)
22222222
22222222
11111111
11111111
22222222
22222222
11111111
11111111
22222222
11111111
IIT- hIITvIIT
PMPXPMPX
PMPXPMPX
PMPXPMPX
PMPXPMPXhIITTT-IIT INT
PMPMPXPX
PMPXPMPX
PMPMPXPX
PMPXPMPXIIT PMPXPMPX
PMPXPMPXTT
By
Ay
Ay
Ay
By
Ay
Ay
Ay
Bx
Ax
Ax
Ax
Bx
Ax
Ax
Ax
By
Ay
Ay
Ay
By
Ay
Ay
Ay
Bx
Ax
Ax
Ax
Bx
Ax
Ax
Ax
By
Ay
Bx
Ax
Ay
Ay
Ax
Ax
By
Ay
Ay
Ay
Bx
Ax
Ax
Ax
By
Ay
Bx
Ax
Ay
Ay
Ax
Ax
By
Ay
Ay
Ay
Bx
Ax
Ax
Ax
Bx
Ay
Ay
Ay
Bx
Ax
Ax
Ax
By
Ay
Ay
Ay
Bx
Ax
Ax
Ax
=
−−++
+−−++
+−−++
+−−+==
−−+−
−++++
+−−+−
−+++=++++
++++=
Labor is mobile across industries and firms within an industry. As they move due to
liberalization, their relocation will be costly due to moving costs, training costs, and other costs
known as adjustment costs. In this paper, aggregate amount of labor relocations within an
industry or across industries is used to proxy the adjustment costs. 6 Note that the adjustment costs
here are not modeled into the behavior of the labor to be displaced. Labor in certain good’s
production in certain industries will be laid off due to adjustments, but that is not a decision made
by labor. They do not decide whether to move or not based on the size of the costs involved
relocation. Size of labor adjustment relative to total labor force associated with a decrease in the
tariff rates from t1 to t2 will be measured as follows:
(15) )(
0
lg
0 lg
2
1 ∆L∆L-L
i
∆L
gi
∆L
ghgi
tt
ihgi
∑ ∑∑<<
+=∆
where ∆Lfgi is the decrease in the amount of factor f employed in the production of good g in
industry i resulting from the decrease in tariff rates. When labor is relocated, a decrease in the
6 I recognize that the elapsed time until finding a new job will vary from one type of labor to another, andso will the resource costs of moving. However, for simplification, I assume that the adjustment costs
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employment of a firm implies an increase in the employment of another. This is the reason why
the summation is carried out only over the goods (firms) where there are decreases in
employment. This is done separately for each type of labor.
Cline et al. (1978), Baldwin, Mutti and Richardson (1980), de Melo and Tarr (1988) use a
similar method: They calculate the amount of labor that moves between industries between two
long-run equilibria and then calculate what adjustment costs are implied by this change, just like
in this model. However, they take into account only inter-industry factor allocations, ignoring the
adjustment costs of intra-industry labor movements resulting from vertical IIT changes.
3. Results of the model
In this section, using the above model, I analyze the effects of different trade liberalization
policies on the types of trade they result in, the adjustment of labor and the welfare gains. In most
real cases, trade liberalization occurs in an asymmetric way. That is, we can find one partner
country lowering its tariff barriers faster than the other partner.7 Or, tariffs for one industry might
be lowered faster than tariffs for others -the case of sensitive industries. All these are likely to
yield different implications than a symmetric liberalization, where all tariff rates for both
countries are lowered at the same rate. Symmetry is the typical treatment in the literature in
modeling trade liberalization. Furthermore, this section analyzes the effects of similarity between
two countries in terms of factor endowments, and the relative size of countries, as well as those of
non-resource-consuming trade barriers.
Given the complexity of the issues we are dealing with in this model, an algebraic solution to
the model is not practical. Therefore, the results come from simulations. The plots presented in
this section assume certain values for the constants of the model. Accordingly, ayxi is assumed to
be 1 in both industries. This implies that the production of a unit of final good requires one unit of
associated with relocation of both high- and low-skill labor are the same.
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the intermediate good in the same industry. The factor demand elasticity8,η, is assumed to be –1.
βi is assumed to be ½, which implies that the share of consumer expenditures on each industry is
50%. α is chosen to be ¾ such that the a bigger share of the expenditures within an industry goes
towards purchases of final goods, compared those on intermediate goods. Furthermore, Θ is
assumed to be 65 , implying that the elasticity of substitution is 6.9 The constants, cfgi, are chosen
such that the factor intensity assumptions in (4) are met.10 AlL is chosen to be 0.2 such that 20% of
the population in country A has low skills. This implies that the relative factor abundance in A,
kA, is 4. Degree of similarity, s, is initially assumed to be 2.5, implying that the relative factor
abundance in B is 1.5; that is, 40% of the population in country B has low skills. The relative size
of country A, v, is assumed to be 1, which implies the same size for the population of both
countries. Non-resource-consuming trade barriers are initially assumed to be zero. Later,
robustness of the results will be checked by varying the constants assumed here.11
Liberalization policies are analyzed as tariff rates are lowered from 50% down to 0%, in
decrements of one percentage point. In each step, first, certain wage rates are assumed for high-
and low-skill labor in both countries. Using these wage rates, we find the unit factor requirements
from Equation (3). Then, using the Equation (7), prices of goods in every industry for both
countries are computed. Later, with the help of Equation (11), we find out whether any country
will be importing an intermediate product for production purposes. Using Equations (10) and
7 In GATT, typically the more developed countries were lowering their tariff barriers faster. This is alsotrue in the trade liberalization agreements made between the EU and CEEC.8 Slaughter (1997) analyzes the effects of trade liberalization on labor demand elasticity and finds mixedresults for whether trade liberalization increases elasticity. His empirical analysis finds the elasticity to bearound –0.6 and –1.3 for the manufacturing sector. Therefore, presented results will assume that theelasticity does not change during liberalization and is equal to –1.9 Empirical literature consensus on elasticity of substitution between imported and domestic varieties is 6.See Feenstra (1994) and Hanson (1999).10 [chx1, chy1, chx2, chy2 ]=[3.8, 3.6, 1.4, 1.2] clgi =1 ∀ g, and ∀ i.11 The following values are tried in computations to check the robustness of the model’s results:ayxi={0.5, 1, 2}; η={-0.8, -1, -1.2}; βi={0.25, 0.50, 0.75}; α={0.25, 0.50, 0.75}; A
lL ={0.1, 0.2, 0.25};v={0.5, 1, 2} s={1, 2.5, 3, 3.25, 3.75}; [chx1, chy1, chx2, chy2 ]={[3.8, 3.6, 1.4, 1.2], [8, 6, 4, 2],[0.8, 0.7, 0.3, 0.2 ], [8, 6, 0.4, 0.2]}; Θ={1/2, 5/6}.The results reported assume the bold printed parameters.
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(13), we write the goods-market-equilibrium conditions in terms of just consumption variables.
Consumption amounts are found using the shares from the budget given in Equation (9), and the
income equations given in Equation (12). At this point, different wage rates are tried until we find
the wage rates that satisfy the goods-market-equilibrium conditions that we set up, by an
insignificant amount of excess, which is set at 0.1%.12 Finally, shares of different types of trade,
and adjustment of labor, are computed according to Equations (14) and (15), respectively.
Welfare gains are calculated using the utility function in Equation (8).
a. Symmetric liberalization
Figure 1 shows the effects of a symmetric liberalization: Both countries are initially levying
the same tariff rates on all of their imports and these tariffs are lowered at the same rate. It is seen
that at high tariffs there is only inter-industry and horizontal intra-industry trade. As trade
liberalization lowers the tariffs for the imports, the share of horizontal IIT increases smoothly.
This is a direct result of Equation (9), where for both countries, imports become relatively
cheaper. They start importing and exporting different varieties of the same product more,
resulting in increased horizontal IIT. Then, we see an increase in the share of inter-industry trade
as countries specialize in the industry that intensively uses their relatively abundant factor. This
specialization does not become significant until tariff rates are low enough. To observe inter-
industry trade between countries C and C� in good g in industry i, tariff rates should be low
enough to satisfy the following, where country C is the imported of the good:
)16( )1(
)'(
Cgi
Cgi
C'gi
Cgi
CCgi
PtPPP<+
<
When the rates are further lowered, we start observing vertical IIT. As implied by Equation
(11), to exploit the intra-industry advantages and start importing the intermediate products for
production purposes, tariffs should be very low. In particular, the following must be satisfied to
12 This explains the wiggles in the figures showing the results. Sometimes, the markets clear with aninsignificant excess supply, sometimes with an insignificant excess demand.
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have vertical IIT between countries C and C� in industry i, where country C imports the
intermediate good in industry i, processes it further and exports the final good back to C�:
)17( )1)()1(( and )1(
)1( and )1( and
''''
'''
')(')'(
Cxi
Cxi
Cyxi
Cyi
Cyi
Clxi
Cl
Chxi
Ch
Cyi
Cyi
Cyi
Cxi
Cxi
Cxi
Cyi
Cyi
Cyi
Cxi
CCxi
Cyi
CCyi
PtatPawawPtPPtPPtP
PPPP
<++++<+<+<+
<<
Figure 1b shows the joint labor adjustment and welfare gains for both countries throughout
the liberalization. Here, the adjustment of labor, LLt
50∆ , show the share of aggregate labor
relocations in both countries to total labor force in both, according to Equation (15), as tariff rates
are lowered from 50% to a particular rate t. Welfare gains plotted, 5.05.0 UU t∆ , show the
percentage change in the utility in both countries form the utility at the beginning of
liberalization, U50. Individual labor adjustments and welfare gains for each country are not
plotted, but will be given in numbers.
Initially, we see very small adjustment of labor associated with the increase in horizontal IIT.
Then, adjustment of labor increases faster during the period of increases in inter-industry trade.
At low tariffs, we see further labor relocations, simultaneously with the emergence of vertical IIT.
This finding supports the proposition that vertical IIT is costlier than horizontal IIT. The amount
of labor relocations due to vertical IIT, however, is not as high as costs associated with inter-
industry trade. At the end of the liberalization, 29% of labor force in both countries is relocated in
other firms. In particular, the labor adjustment in the more skilled country A is about 22% of its
labor force, and it is more, around 37% of labor force in country B.
Welfare follows a similar increase. Most of the benefits of integration are observed towards
the end of liberalization, where we see increase in specialization, as seen by the increase in inter-
industry trade, and increase in outsourcing, as observed by the increase in vertical IIT. Overall
gains in welfare are about 14%. The high-skill abundant country A experiences around 8%
increase in its welfare, whereas B experiences more than 21% increase in its welfare.
14
Interestingly, low-skill country experiences higher adjustment costs, but this is associated with
larger gains in welfare. It is also worthwhile to note that the biggest changes in both benefits and
costs of integration occur at the end of liberalization with increased inter-industry trade and
vertical IIT.
b. Industry-asymmetric liberalization
Figure 2 shows the effects of having sensitive sectors in a liberalization policy. In this case,
each country liberalizes only the industry in which it has comparative advantage. Country A,
being relatively high-skill abundant, has comparative advantage in industry 1, which uses the
relatively high-skill-intensive production technology. Similarly, country B has an advantage in
industry 2. The tariff rates in these industries are assumed to be the same in both countries, and
are lowered at the same rate, while sensitive sectors of each country are kept protected at tariff
rates of 50%.
There are three main differences between this case and symmetric trade liberalization: First,
we do not observe vertical IIT, even at low tariff rates. Obviously, keeping the sectors that the
partner country has advantage out of liberalization does not allow for intra-industry specialization
through vertical IIT. Second, the adjustment of labor is higher than that in symmetric
liberalization, about 78% versus 29% of total labor force. In particular, labor relocations amount
to 84% of the labor force in country A, 66% of the labor force in B. Higher labor adjustments in
this case can be explained by the fact that at low tariff rates the increase in just inter-industry as if
the vertical IIT observed in symmetric liberalization is replaced with an increase in inter-industry
trade only. This observation provide further evidence that even if vertical IIT changes causes
some labor relocations, they are not as high as the one caused by inter-industry trade changes.
Lastly, welfare gains are smaller, about 12% of the welfare at the beginning of liberalization.
High-skill country A did not experience a significant increase in its welfare, whereas low-skill
country B experienced an increase by about 19%. Lower gains in this case is quite intuitive since
this industry-asymmetric liberalization does not allow much room for exploiting trade partner’s
15
comparative advantage through specialization, which would have led to higher welfare gains. It is
interesting to see that in this case, even if low-skill country B has lower adjustment than A, B is
the country that collects most of the benefits of integration.
c. Country-asymmetric liberalization
Figure 3 shows the case where only the more developed country liberalizes its trade. This
case is intended to illustrate what happens when one partner liberalizes its trade faster than the
other. Country A’s population is relatively more skilled, i.e. more developed by assumption
Therefore, we are going to assume that A lowers its tariff barriers at the same rate for all
industries and goods. B’s tariff rates are kept at 50%. As tariff rates are lowered we see an
increase in the share of horizontal IIT due to lower relative prices of imported varieties. However,
in this case, we neither observe a sharp increase in the share of inter-industry trade at low tariff
rates, nor any vertical IIT. Intuitively, with only one country liberalizing its trade, there is not
much room for inter-industry or intra-industry specialization. Since the changes in inter-industry
trade are small, we have small labor adjustments in this case, only about 4% of total labor force.
The adjustment in country A amount to around 5% of its labor force, whereas they are about 4%
of the labor force in B. This result is also intuitive: The country that liberalizes its market bears
more adjustment. Without much specialization, the welfare gains are also small, about 11%,
compared to 14% in symmetric liberalization. In particular, country A’s welfare gains are at
around 4%, and 16% for country B. Once again, the gains in low-skill country B are higher.
Obviously, the more advanced country does not have much to gain from liberalization with a low-
skill abundant country.
d. Effect of similarity of countries’ factor abundance
The effect of similarity is explored in Figure 4. The percent of low-skill labor in country A is
kept at 20%. Different factor abundance degrees, s = kA-kB = 1, and 3 are analyzed. The
corresponding percent of B’s population with low skill is 25%, and 50%, respectively. The
former case will be used to analyze the effects of liberalization between two fairly similar
16
countries, and the latter for those of significantly different ones. Tariff rates for all goods in both
countries are lowered at the same rate as in the case of symmetric liberalization.
In both cases, we see exactly the same trend throughout the liberalization: First, the share of
horizontal IIT increases, then the inter-industry trade, and at very low tariff rates, we start
observing vertical IIT. In the first case, however, countries are very similar and therefore we do
not observe much inter-industry trade. We see an increase in its share only at very low tariff rates.
Consistent with this observation, adjustment of labor is somewhat smaller. In country A they
amount to about 35% of labor force, whereas they are around 22% of the labor force in country B.
Furthermore, since there is not much room to exploit each other’s comparative advantage due to
high similarity, welfare gains are also relatively low. In particular, country A gains 6%, B gains
19%. In the second case, countries are very different from each other, we see more inter-industry
specialization, and intra-industry specialization, i.e. more inter-industry trade and vertical IIT,
respectively. Since countries are different from each other, there are higher welfare gains, through
inter- and intra-specialization, which are costly. Country A gained about 13% increase in its
welfare, whereas B gained around 24%. One more time, low-skill country gained more. There are
a lot of labor relocations when countries are different in terms of factor abundance. In particular,
Country A experienced adjustments of labor amounting to about 67% of its labor force, and B
faced costs around 106% of its labor force.
e. Effect of relative population size
The analysis carried out so far assumed that the two countries had the same population size.
Now, we analyze the effect of changing the relative size of countries. Country A’s population is
first assumed to be half of the population of B, and then twice that of B. A symmetric
liberalization is applied. The shares of different types of trade during the path of a symmetric
liberalization are shown in Figures 5a and 5c for each case. First, we see some similarities: At
first, the share of horizontal IIT increases, then the share of inter-industry trade increases. Finally,
at low tariff rates we observe vertical IIT.
17
Combined labor adjustments and welfare gains throughout the liberalization are plotted in
Figures 5b and 5d, respectively for each case. When the skill abundant country A’s population is
half that of low-skill country B, welfare gains in A are about 38%, and approximately 16% in B.
However, when country A is twice as populated as B, the welfare gains in A fall down to 4%, the
gains for B increase to 43%. The model suggests that small countries benefit more from trade
liberalization. When country A is the smaller of the two, adjustment of labor are about 67% of its
labor force, and that in country B is about 53% of its labor force. However, when country A is
twice as populated as B, the labor adjustments in A fall down to 28% of its labor force, the
adjustments for B fall to 48% of labor force. Intuitively, when the bigger country is skill
abundant, liberalization does not result in much labor relocations. Furthermore, more labor
adjustments are born by the low-skill country, but it also captures higher welfare gains. When the
low-skill country is bigger adjustment for both are higher, but so are the welfare gains.
f. Non-resource consuming trade barriers
These trade barriers work as ad-valorem tariffs that do not go down to zero. That is, even if
the tariff rates are zero, these barriers might prevent the changes observed at low tariff rates. For
example, in the case of symmetric liberalization, we may not see the increase in inter-industry
trade nor the vertical IIT at low tariff rates. This partly explains why the share of vertical IIT is
higher for neighboring countries, which presumably experience lower trade barriers. Furthermore,
previous analysis showed that most of the adjustment of labor and welfare gains occur at low
tariff rates. If the size of these trade barriers is large enough, we may not see the welfare gains
associated with integration, neither will there be much structural adjustment, and the
accompanying costs.
When robustness of the results is checked, we see that the general patterns of changes are the
same. Under the symmetric liberalization, we first see an increase in share of horizontal IIT, then
an increase in the share of inter-industry trade. At low tariff rates, we see an increase in the share
of vertical IIT. Furthermore, most of the adjustment and the welfare gains are again observed
18
towards the end of liberalization. However, using different constants alters the magnitude and
timing these changes.13
4. East-West Integration in Europe
Since the fall of socialism in Eastern Europe, there have been lots of efforts to integrate
Central and Eastern European countries (CEEC) to Western Europe. The Europe Agreements
(EA) signed in the early 1990s are often seen as dramatic improvements in the EU’s trade policy
towards CEEC (Kaminski 1995; Tarr 1992). It is argued that they provide rapid extensions of
liberalized market access for industrial imports from CEEC. Furthermore, the EA are seen as
catalysts for exploiting highly skilled but cheap labor in CEEC, and the proximity between the
EU and CEEC, to outsource certain stages of production to the CEEC, and thus have substantial
increases in vertical IIT.
However, the EA have certain distinguishing characteristics, which might let down these
expectations. These agreements are country-asymmetric, i.e. liberalization is slower on the part of
CEEC than the EU. About 70% of EU imports were freed upon signature, and all EU imports
were scheduled to be free by the end of 1997. 10-20% of CEEC imports were freed upon
signature, all CEEC imports were scheduled to be free in 2002. Apart from this, the EA also kept
some sectors out of liberalization. These sensitive sectors are textiles and apparel, iron and steel,
and chemicals, where CEEC have comparative advantage (Winters 1993; Messerlin 1993). These
industries take about 20% of the manufacturing output in both EU and CEEC. In sum, the EA
involves both country- and industry-asymmetric features.
In terms of relative factor abundance, CEEC could be as skill intensive as the EU,
considering the importance given to education for many years under central planning.
Furthermore, the EA opened an EU market of about 350 million people compared to total of 100
13 The results of the robustness analysis, and the associated graphs are available from the author uponrequest.
19
million people in the CEEC. This size difference as well as similarity in terms of factor
abundance, will affect the results of the EA.
Figure 6 shows the effects of all these characteristics of the EA and the economies of EU and
CEEC altogether. It gives the results of a country- and industry-asymmetric liberalization
between two similar countries in terms of factor endowments (s=0.5), but the more developed is
three and a half times as large as the other (v=3.5) in terms of population. The size of the industry
where the smaller country has comparative advantage is set at 20% of its economy (β2=20%).
According to the results of the model, such a liberalization policy will merely increase the
share of horizontal intra-industry trade without resulting in vertical IIT because of its industry-
asymmetric feature. Due to country-asymmetry, there will be increases in horizontal IIT. These
factors combined with high similarity in factor abundance will not yield much inter- or intra-
industry specialization.
Not much specialization will also imply small adjustment, as well as small welfare gains, as
suggested by the results of liberalization between two similar countries. All of these results are
observed in Figure 6b. The smaller CEEC captures most of the benefits of integration. The
welfare gains in the EU are insignificant, whereas welfare increases by 42% in CEEC. Because
of small size of CEEC, and their low initial welfare, the combined gains for Europe as a whole
are at 7%. Higher welfare gains, however, imply higher costs for CEEC. In particular the
adjustment in the EU are about 3% of its labor force, whereas the costs in CEEC are at about 11%
of labor force.
Empirical analyses on CEEC-EU trade find some increase in inter-industry trade with
substantial increase horizontal IIT, but no significant increase in vertical IIT. This observation is
supported by the findings of Daviddi (1992), Cadot and de Melo (1995), and de Melo and Tarr
(1988). These results are in accordance with the model’s outcome.
It is suggested that fears of very large adjustment costs are behind the EU’s approach in the
Europe Agreements, where some sensitive sectors are protected. Cadot et al. (1995) find no
20
evidence for this by analyzing the period 1990-93 using the Grubel-Lloyd index. However, the
period they analyzed corresponds to the early stage of liberalization. The model in this paper
shows that the labor adjustments may start increasing faster when liberalization is almost
complete. Furthermore, the degree of similarity between the EU and CEEC reduces both the
benefits and costs of liberalization.
5. Conclusion
In this paper, I have first argued that since different skills are involved in vertical IIT, it
should involve some adjustment of labor, even if the trade occurs within the same industry. Later,
using a model that allows for both vertical and horizontal IIT as well as inter-industry trade, I
analyzed the effects of symmetric, and country- and industry-asymmetric liberalization policies
on the shares of different types of trade, the associated adjustment of labor and welfare gains. I
also explored the effects of factor-abundance similarity, different population size, and non-
resource-consuming trade barriers. Model’s results are suggestive, but interesting.
Accordingly, in early stages of liberalization, changes in trade are mainly horizontal intra-
industry, because of cheapening imported varieties. Tariff rates at this stage are too high to allow
for specialization. Inter-industry and intra-industry specialization through increased inter-industry
and vertical IIT occur at later stages. Both type changes in trade cause some adjustment of labor.
In vertical IIT, however, the adjustment is smaller. These two types of trade are also more welfare
increasing than horizontal IIT. In sum, specialization, labor adjustments and welfare gains all
occur at advanced stages of liberalization.
Country- or industry-asymmetric liberalization, which I call restrictive liberalization policies,
are not conducive of any type of specialization. Industry-asymmetric liberalization does not allow
for vertical intra-industry specialization, whereas country-asymmetric liberalization does not
allow for inter-industry specialization. The model also suggests that liberalization among similar
countries does not lead to much specialization. Therefore, the adjustment of labor and welfare
21
gains are smaller. It is also observed that low-skill partner typically gains more. When country
sizes differ, the welfare gains in smaller countries are higher. The liberalization leads more labor
adjustments if the bigger partner is low-skill abundant. Finally, the model suggests that high non-
resource consuming trade barriers can prevent countries from capturing the benefits of
liberalization.
Based on this model, I can also provide a rationale for the argument that the integration
experience in the developed world so far has been relatively cost free. First of all, there is need to
separate the intra-industry trade into its vertical and horizontal parts to get a better understanding
of the implied adjustment costs. Analyses of overall IIT have underestimated the adjustment
costs. Furthermore, considering that the developed countries have similar relative factor
abundance, at the early periods of liberalization we observe just an increase in the share of
horizontal IIT. Inter-industry trade starts increasing later, and at low levels we should start
observing an increase in vertical IIT. In other words, the results depend on where we are in terms
of liberalization. The developed world could be at the period where we would observe just
increases in the horizontal IIT. Besides, trade barriers could have prevented the changes that we
should have observed at low tariff rates as well.
Acknowledgements
I have benefited a great deal from the comments and suggestions by Alan Deardorff, Robert
Stern, Gordon Hanson, Jan Svejnar, Katherine Terrell and other seminar participants at the
University of Michigan.
22
Appendices
A. Unit factor requirements
Unit factor requirements are defined as follows:
{ } { } { } (A.1) 1,2 and )( ∈∈∈= i ,x,y, gh,l, fQL
,wwagi
fgilhfgi
where Lfgi is the amount of factor f used in the production of good g in industry i. Qgi is the
amount of good g production in industry i.
Labor demand elasticity defined below is assumed to be the same for all factors and goods:
{ } { } { } (A.2) 1,2 and where ∈∈∈∂∂
= i,x,y, gh,lm&f/ww/aa
ηff
mgimgigimf
For m=h we have:
(A.3) aa
ww
ηhgi
hgi
f
fgihf
∂=
∂
Taking the integral of both sides we get:
(A.4) lnln
cawη
aa
ww
η
hgifgihf
hgi
hgi
f
fgihf
+=
∂=
∂∫ ∫
where c is independent of wf . For f=h and l we have the following two equations respectively:
(A.5) lnln
lnln
cawη
cawη
hhgilgihl
lhgihgihh
+=
+=
where cl is independent of wh and ch is independent of wl. Combining these two equations, we get:
(A.6) lnlnln cwηwηa hgilgihlh
gihhhgi ++=
23
where chgi is a constant. Using∑ =f
gimfη 0 , and assuming that labor elasticities are the same,
denoted by η, for all factors, we can solve for ahgi as follows:
(A.7)
)lnln(lnlnlnln
wwca
cw-wηa cwηwηa
η
l
hhgihgi
hgilhgihhhgi
hgilgihhh
gihhhgi
=
+=+−=
B. Shares of domestic and imported varieties from the budget
Representative consumers in each country maximize their nested Cobb-Douglas/CES type
utilities subject to a budget constraint. In particular, for consumers in country A, the consumers’
problem is:
( ) ( )(B.1)
such that
)()(ln)1()()(lnmax11
YCPCPCPCP
CCαCCαβ U
i
AA(B)yi
A(B)yi
Ayi
Ayi
A(B)xi
A(B)xi
Axi
Axi
ΘΘA(B)yi
ΘAyi
ΘΘA(B)xi
ΘAxi
ii
At
∑∑
=+++
+−++=
where { } { } 2 1,∈∈ , ix,y gC Agi is consumption of good g in industry i produced in country A.
A(B)giC is country A’s consumption of the variety produced in B. A
giP and A(B)giP are the prices of
domestic and imported varieties of good g in industry i in country A, respectively.
Taking the derivative of the Lagrangian with respect to AgiC , we get:
( ) ( ) (B.2) )()()(1)()( 1111A
giΘA
giΘΘA(B)
giΘA
giΘΘA(B)
giΘA
gii λPCΘCCΘ
CCαβ =++ −−−
After simplifications, the expenditure on country A’s production of good g in industry i is:
(B.3) )()(
)( CP
CCC
λαβ A
giA
giΘA(B)gi
ΘAgi
ΘAgii =+
Similarly the expenditure on the imported variety of the same product will be:
24
(B.4) )()(
)( CP
CCC
λαβ A(B)
giA(B)
giΘA(B)gi
ΘAgi
ΘA(B)gii =+
(B.3) and (B.4) together imply:
(B.5) CPCPλαβ A(B)
giA(B)
giAgi
Agi
i +=
where the right hand side is the total expenditures on varieties of good g in industry i. Since βis
sum to 1, Y1λ = . Taking the ratio of (B.3) to (B.4) we get:
(B.6) 1
1
PP
CC Θ-
A(B)gi
Agi
A(B)gi
Agi
=
After multiplying both sides by the price ratio and adding one, and then taking the reciprocal
of each side, we get the share of expenditures on the imported variety from the budget allocated
to good g in industry i, A(B)gis . The rest will be the share of the domestic variety A
gis :
(B.7)
1
1
1
1 1
1
1
pp
pp
s s
pp
sΘΘ
A(B)gi
Agi
ΘΘ
A(B)gi
Agi
A(B)gi
Agi
ΘΘ
A(B)gi
Agi
A(B)gi
−
−
−
+
=−=
+
=
25
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28
(a)
(b)
Figure 1. Symmetric trade liberalizationAll tariff rates are lowered at the same rate
29
(a)
(b)
Figure 2. Industry-asymmetric liberalizationCountry A protects its industry 1.Country B protects its industry 2.
All other tariff rates are lowered at the same rate.
30
(a)
(b)
Figure 3. Country-asymmetric liberalizationOnly country A liberalizes its trade at the same rate for all goods.
31
(a) (b)
(c) (d)
Figure 4. Similarity in factor abundanceAll tariff rates are lowered at the same rate in both countries.
s=1Ll
A=20% LhA=80% Ll
B=25% LhB=75%
s=3Ll
A=20% LhA=80% Ll
B=50% LhB=50%
32
(a) (b)
(c) (d)
Figure 5. Difference in population sizeAll tariff rates are lowered at the same rate in both countries.
LA and LB are the total population sizes in A and B, respectively.
v=0.5LA=0.5LB
v=2LA=2LB
33
(a)
(b)
Figure 6. CEEC-EU Liberalization
v=3, s=0.5, β1=80%, β2=20%, LlA=40%, Lh
A=60%, LlB=50%, Lh
B=50%