Lecture notes in international trade Istvan Konya Dept. of Economics Boston College Fall 2001
Lecture notes in International Trade Istv´an K´onya Dept. of Economics Boston College Fall 2001
Introduction What is international trade theory International trade theory is basically an exercise in applied general equi- librium modeling. This means that in many cases one can use the general theorems that apply for any Arrow-Debreu economy, most notably about the existence and welfare properties of equilibria. What makes international trade a separate field is that it utilizes some assumptions that allow for much sharper positive and normative results than what are possible in the theory of general equilibrium(hence the phrase "applied") What are the special assumptions? Since there are many different mod- els, let us try to summarize the common elements. The most basic postulate is that the world consists of separate geographic entities (regions or coun- than among them, because of physical, political and psychological barriers of movement. In most models factors and goods are perfectly mobile within countries, but factors are immobile across borders. The mobility of goods across countries is an important variable, and ranges from none(autarchy) to complete(free trade). Some of the basic results in trade theory come from analyzing the effect of goods mobility Questions and answers a good theory has both positive and normative applications, and interna- tional trade is usually useful for both purposes. The most important ques- tions in trade theory include the following oSitive
Introduction What is international trade theory? International trade theory is basically an exercise in applied general equilibrium modeling. This means that in many cases one can use the general theorems that apply for any Arrow-Debreu economy, most notably about the existence and welfare properties of equilibria. What makes international trade a separate field is that it utilizes some assumptions that allow for much sharper positive and normative results than what are possible in the theory of general equilibrium (hence the phrase “applied”). What are the special assumptions? Since there are many different models, let us try to summarize the common elements. The most basic postulate is that the world consists of separate geographic entities (regions or countries). Goods and factors of production are more mobile within countries than among them, because of physical, political and psychological barriers of movement. In most models factors and goods are perfectly mobile within countries, but factors are immobile across borders. The mobility of goods across countries is an important variable, and ranges from none (autarchy) to complete (free trade). Some of the basic results in trade theory come from analyzing the effect of goods mobility. Questions and answers A good theory has both positive and normative applications, and international trade is usually useful for both purposes. The most important questions in trade theory include the following: Positive: i
11 · Why do nations trade? e What do they trade? Can we use a small set of parameters to predict trade fows? e What is the effect of trade barriers on trade? Why do the man-made trade barriers exist? Can trade in goods substitute for factor mobility What is the effect of trade on factor rewards? Normative Is free trade better than autarchy Is free trade optimal for a country? What are the effects of trade on income distribution? . If there are winners and losers. can the former compensate the latter? If nations gain from trade, how are the gains distributed? If we change parameters, how are these gains redistributed, both within and across countries? What are the welfare effects of various trade policies? The most basic question is probably the first one, why do nations trade? There are three possible answers yet: comparative advantage, division of labor and oligopolistic conduct. The first concept, originated by David Ricardo, is one of the nicest insights in economics. It roughly says that trade is due to autarchy price differences. Because of differences in the underlying param- ters, some countries can produce some goods relatively more efficiently, so when trade is allowed they will specialize in those goods. Good anecdotes abound, for example the professor and the secretary. Much of traditional The story is as follows. Suppose the professor is more productive in both research and envelope stuffing than the secretary. Still, if his advantage is relatively bigger in research he should specialize in it and leave envelopes to the secretary
ii • Why do nations trade? • What do they trade? • Can we use a small set of parameters to predict trade flows? • What is the effect of trade barriers on trade? • Why do the man-made trade barriers exist? • Can trade in goods substitute for factor mobility? • What is the effect of trade on factor rewards? Normative: • Is free trade better than autarchy? • Is free trade optimal for a country? • What are the effects of trade on income distribution? • If there are winners and losers, can the former compensate the latter? • If nations gain from trade, how are the gains distributed? • If we change parameters, how are these gains redistributed, both within and across countries? • What are the welfare effects of various trade policies? The most basic question is probably the first one, why do nations trade? There are three possible answers yet: comparative advantage, division of labor and oligopolistic conduct. The first concept, originated by David Ricardo, is one of the nicest insights in economics. It roughly says that trade is due to autarchy price differences. Because of differences in the underlying parameters, some countries can produce some goods relatively more efficiently, so when trade is allowed they will specialize in those goods. Good anecdotes abound, for example the professor and the secretary1 . Much of traditional 1The story is as follows. Suppose the professor is more productive in both research and envelope stuffing than the secretary. Still, if his advantage is relatively bigger in research, he should specialize in it and leave envelopes to the secretary
111 trade theory is concerned with explaining the cause of autarchy price differ ences. Candidates include technology, factor endowments and tastes The second concept is even older, and (like almost everything in eco- nomics)goes back to Adam Smith. His idea was that nations trade in order to exploit economies of scale that arise from specialization. The finer the division of labor is, the richer countries are. By increasing the size of the market, trade allows for more specialization, and hence leads to gains for the participants. This argument, in contrast to comparative advantage, works even if the trading countries are identical in all respects. This explains why it received much attention in the last two decades, when trade is increasingly among seemingly similar countries. In fact specialization due to increasing returns forms the basis for most of the " New Trade Theory The third concept is fairly recent, and it was first advanced by James Brander in the early '80s. While specialization explains trade in similar but differentiated products, oligopolies can lead to trade in identical goods. If, for example, two firms in two countries compete in a Cournot-setting, they will export to each other's markets even if their products are identical. If there are transportation costs, firms will charge a lower price abroad than at home, which can lead to reciprocal dumping. While theoretically intriguin trade in identical products and reciprocal dumping are usually thought to be less important in explaining trade than comparative advantage and spe- cialization. Nevertheless, such models yield useful insights that should be incorporated in a general model of trade Plan of the course Most of the course will be about answering the positive questions, although we will venture a little into the normative ones. The first part will focus on comparative advantage, or the"classical" theory of trade. Twenty-five years ago this was pretty much the trade theory, and it still forms the backbone of the field. We will inquire into the questions about the pattern of trade income distribution, factor rewards etc. There are various interesting spec cases that received much attention, and we will look at them in some detail. We will also summarize some of the evidence about trade models based on comparative advantage, and the Heckscher-Ohlin model in particular. As we will see, there is fairly solid support for the theory in general, but once one looks at the data in more detail, many puzzling questions emerge. Thus
iii trade theory is concerned with explaining the cause of autarchy price differences. Candidates include technology, factor endowments and tastes. The second concept is even older, and (like almost everything in economics) goes back to Adam Smith. His idea was that nations trade in order to exploit economies of scale that arise from specialization. The finer the division of labor is, the richer countries are. By increasing the size of the market, trade allows for more specialization, and hence leads to gains for the participants. This argument, in contrast to comparative advantage, works even if the trading countries are identical in all respects. This explains why it received much attention in the last two decades, when trade is increasingly among seemingly similar countries. In fact specialization due to increasing returns forms the basis for most of the “New Trade Theory”. The third concept is fairly recent, and it was first advanced by James Brander in the early ’80s. While specialization explains trade in similar but differentiated products, oligopolies can lead to trade in identical goods. If, for example, two firms in two countries compete in a Cournot-setting, they will export to each other’s markets even if their products are identical. If there are transportation costs, firms will charge a lower price abroad than at home, which can lead to reciprocal dumping. While theoretically intriguing, trade in identical products and reciprocal dumping are usually thought to be less important in explaining trade than comparative advantage and specialization. Nevertheless, such models yield useful insights that should be incorporated in a general model of trade. Plan of the course Most of the course will be about answering the positive questions, although we will venture a little into the normative ones. The first part will focus on comparative advantage, or the “classical” theory of trade. Twenty-five years ago this was pretty much the trade theory, and it still forms the backbone of the field. We will inquire into the questions about the pattern of trade, income distribution, factor rewards etc. There are various interesting special cases that received much attention, and we will look at them in some detail. We will also summarize some of the evidence about trade models based on comparative advantage, and the Heckscher-Ohlin model in particular. As we will see, there is fairly solid support for the theory in general, but once one looks at the data in more detail, many puzzling questions emerge. Thus
there is a more or less general consensus among researchers that comparative advantage is an important, but partial explanation for international trade The second part of the course will deal with "New Trade Theory". Most of it elaborates the division of labor explanation for trade, with a detour towards oligopolies and reciprocal dumping. As we will see, comparativ dvantage and increasing returns can coexist peacefully, each explaining a different pattern of the data. There is some supportive evidence for this richer model, presented at the end of the topic. An important branch of ew Trade Theory"is the "New Economic Geography", that is concerned about the location of economic activity. It is a fascinating topic, although it is a bit easy to get carried away. Nevertheless, it deserves some serious attention Most of trade theory is essentially static. There are some questions however, that require us to explicitly consider dynamics. First, in many cases comparative advantage seems to be acquired, and not given by unchanging fundamentals. Thus we will incorporate learning-by-doing into trade models and see how specialization emerges in the long run. Second, trade can have a large influence on economic growth. Open economy extensions of endogenous growth theory shed some light on how international trade and growth are related, and we will study such models. Third, much of trade(and even more trade policy debate) is between rich and poor countries, thus we will look at models of North-South trade. Finally, some evidence will be presented about the connections among trade, technology and growth The last topic can be thought of as an exercise in applying the tools learned in the first three parts. The world seems to be more and more pre- occupied by "globalization, and who else but trade theorists can provide some insight into the debate. We will limit ourselves to questions that in- terested researchers in the rich world. Much attention has been focused on the trinity of immigration, trade and factor prices(wages). There is ample evidence in the US(and also in some other industrial countries) of increasing wage inequality, which coincides with globalization in the last two or three decades. Thus this part will mainly look at theory and evidence on how immigration, trade and wages are related. There is no definite answer but it is important to understand the framework of the debate, and-as I said- it is also a good exercise
iv there is a more or less general consensus among researchers that comparative advantage is an important, but partial explanation for international trade. The second part of the course will deal with “New Trade Theory”. Most of it elaborates the division of labor explanation for trade, with a detour towards oligopolies and reciprocal dumping. As we will see, comparative advantage and increasing returns can coexist peacefully, each explaining a different pattern of the data. There is some supportive evidence for this richer model, presented at the end of the topic. An important branch of “New Trade Theory” is the “New Economic Geography”, that is concerned about the location of economic activity. It is a fascinating topic, although it is a bit easy to get carried away. Nevertheless, it deserves some serious attention. Most of trade theory is essentially static. There are some questions, however, that require us to explicitly consider dynamics. First, in many cases comparative advantage seems to be acquired, and not given by unchanging fundamentals. Thus we will incorporate learning-by-doing into trade models, and see how specialization emerges in the long run. Second, trade can have a large influence on economic growth. Open economy extensions of endogenous growth theory shed some light on how international trade and growth are related, and we will study such models. Third, much of trade (and even more trade policy debate) is between rich and poor countries, thus we will look at models of North-South trade. Finally, some evidence will be presented about the connections among trade, technology and growth. The last topic can be thought of as an exercise in applying the tools learned in the first three parts. The world seems to be more and more preoccupied by “globalization”, and who else but trade theorists can provide some insight into the debate. We will limit ourselves to questions that interested researchers in the rich world. Much attention has been focused on the trinity of immigration, trade and factor prices (wages). There is ample evidence in the US (and also in some other industrial countries) of increasing wage inequality, which coincides with globalization in the last two or three decades. Thus this part will mainly look at theory and evidence on how immigration, trade and wages are related. There is no definite answer yet, but it is important to understand the framework of the debate, and - as I said - it is also a good exercise
Contents I The classical theory of international trade Basic issues 1 Comparative advantage with two goods 1.2 Explaining comparative advantage 2 Analytical tools 2.1 The revenue function 2.2 The cost function 122366790 2.3 Consumer choice 2.4 The Meade utility functions 3 Equilibrium and the gains from trade 3. 1 Defining the equilibrium 3.2 Gains from trade 4 Factor price equalization 4.1 General results 4.1.1 Comparative advantage 4.1.2 Factor proportions 4.1.3 Factor prices 55678 4.2 Factor price equalization 4.2.1 More factors than goods 4.2.2 At least as many goods as factors 4.3 The pattern of trade under FPE 5 Comparative statics and and welfare 5.1 The transfer proble 5.2 The effect of a small tariff
Contents I The classical theory of international trade 1 1 Basic issues 2 1.1 Comparative advantage with two goods . . . . . . . . . . . . . 2 1.2 Explaining comparative advantage . . . . . . . . . . . . . . . . 3 2 Analytical tools 6 2.1 The revenue function . . . . . . . . . . . . . . . . . . . . . . . 6 2.2 The cost function . . . . . . . . . . . . . . . . . . . . . . . . . 7 2.3 Consumer choice . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.4 The Meade utility functions . . . . . . . . . . . . . . . . . . . 10 3 Equilibrium and the gains from trade 11 3.1 Defining the equilibrium . . . . . . . . . . . . . . . . . . . . . 11 3.2 Gains from trade . . . . . . . . . . . . . . . . . . . . . . . . . 12 4 Factor price equalization 15 4.1 General results . . . . . . . . . . . . . . . . . . . . . . . . . . 15 4.1.1 Comparative advantage . . . . . . . . . . . . . . . . . . 15 4.1.2 Factor proportions . . . . . . . . . . . . . . . . . . . . 16 4.1.3 Factor prices . . . . . . . . . . . . . . . . . . . . . . . 17 4.2 Factor price equalization . . . . . . . . . . . . . . . . . . . . . 18 4.2.1 More factors than goods . . . . . . . . . . . . . . . . . 20 4.2.2 At least as many goods as factors . . . . . . . . . . . . 20 4.3 The pattern of trade under FPE . . . . . . . . . . . . . . . . . 20 5 Comparative statics and and welfare 23 5.1 The transfer problem . . . . . . . . . . . . . . . . . . . . . . . 23 5.2 The effect of a small tariff . . . . . . . . . . . . . . . . . . . . 26 v
CONTENTS 5.3 Growth in factor endowments 5.4 Technological change 6 Simple trade models 6.1 The Heckscher-Ohlin model -the role of factor endowments. 30 6.2 The generalized Ricardian model -the role of technology 6.3 The specific factors model - income distribution Empirical strategies 7. 1 The basic equation 40 7.2 Extensions with Fpe 40 7.3 Results without FPE II Increasing returns and the "New Trade Theory'45 8 External economies of scale 47 8.1 Gains from trade 4 8. 2 An example 8.3 Factor price equalization 51 9 Oligopoly, dumping and strategic trade 9.1 Reciprocal dumping 9.2 Strategic trade policy 10 Monopolistic competition 10.1 Basics 10.1.1 Consumption 59 10.1.2 Productio 61 10.2 The trading equilibrium 61 0.2.1 The integrated equilibrium 61 10.2.2 Factor price equalization 10.3 Transport costs and the home market effect 63 0.3.1 Autarch 64 10.3.2 Trade equilibrium 11 The New Economic Geography 67 11.1 A model of agglomeration 11.2 Specialization in international trade
CONTENTS vi 5.3 Growth in factor endowments . . . . . . . . . . . . . . . . . . 28 5.4 Technological change . . . . . . . . . . . . . . . . . . . . . . . 28 6 Simple trade models 30 6.1 The Heckscher-Ohlin model – the role of factor endowments . 30 6.2 The generalized Ricardian model – the role of technology . . . 33 6.3 The specific factors model – income distribution . . . . . . . . 36 7 Empirical strategies 39 7.1 The basic equation . . . . . . . . . . . . . . . . . . . . . . . . 40 7.2 Extensions with FPE . . . . . . . . . . . . . . . . . . . . . . . 40 7.3 Results without FPE . . . . . . . . . . . . . . . . . . . . . . . 41 II Increasing returns and the “New Trade Theory” 45 8 External economies of scale 47 8.1 Gains from trade . . . . . . . . . . . . . . . . . . . . . . . . . 47 8.2 An example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 8.3 Factor price equalization . . . . . . . . . . . . . . . . . . . . . 51 9 Oligopoly, dumping and strategic trade 54 9.1 Reciprocal dumping . . . . . . . . . . . . . . . . . . . . . . . . 54 9.2 Strategic trade policy . . . . . . . . . . . . . . . . . . . . . . . 57 10 Monopolistic competition 59 10.1 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 10.1.1 Consumption . . . . . . . . . . . . . . . . . . . . . . . 59 10.1.2 Production . . . . . . . . . . . . . . . . . . . . . . . . 61 10.2 The trading equilibrium . . . . . . . . . . . . . . . . . . . . . 61 10.2.1 The integrated equilibrium . . . . . . . . . . . . . . . . 61 10.2.2 Factor price equalization . . . . . . . . . . . . . . . . . 62 10.3 Transport costs and the home market effect . . . . . . . . . . 63 10.3.1 Autarchy . . . . . . . . . . . . . . . . . . . . . . . . . 64 10.3.2 Trade equilibrium . . . . . . . . . . . . . . . . . . . . . 65 11 The New Economic Geography 67 11.1 A model of agglomeration . . . . . . . . . . . . . . . . . . . . 67 11.2 Specialization in international trade . . . . . . . . . . . . . . . 71
CONTENTS 2 Empirical strategies 12.1 Testable predictions 12.2 The gravity equation 77 Iii Trade and growth 13 Trade, growth and factor proportions 13. 1 The model 81 13. 2 A small open economy 13. 3 A large country 14 Learning-by-doing 14.1 A Ricardian model 14.1.1 The model 14.1.2 Dynamics and the steady state 86 14.1.3 Industrial policy 14.2 Agriculture and the Dutch Disease 14. 2. 1 The closed economy 14.2.2 A small open economy 8g0 14.3 North-South trade 14.3.1 The model 14.3.2 Autarchy 14.3.3 Free trade 15 Endogenous growth and trade 98 15.1 Autarchy 15.2 International knowledge diffusion 102 15.3 Trade with knowledge diffusion 103 15.4 Trade with no knowledge diffusion 105 15.5 Imitation and North-South trade 107
CONTENTS vii 12 Empirical strategies 75 12.1 Testable predictions . . . . . . . . . . . . . . . . . . . . . . . . 75 12.2 The gravity equation . . . . . . . . . . . . . . . . . . . . . . . 77 III Trade and growth 80 13 Trade, growth and factor proportions 81 13.1 The model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 13.2 A small open economy . . . . . . . . . . . . . . . . . . . . . . 83 13.3 A large country . . . . . . . . . . . . . . . . . . . . . . . . . . 83 14 Learning-by-doing 85 14.1 A Ricardian model . . . . . . . . . . . . . . . . . . . . . . . . 85 14.1.1 The model . . . . . . . . . . . . . . . . . . . . . . . . . 85 14.1.2 Dynamics and the steady state . . . . . . . . . . . . . 86 14.1.3 Industrial policy . . . . . . . . . . . . . . . . . . . . . 88 14.2 Agriculture and the Dutch Disease . . . . . . . . . . . . . . . 88 14.2.1 The closed economy . . . . . . . . . . . . . . . . . . . 89 14.2.2 A small open economy . . . . . . . . . . . . . . . . . . 90 14.3 North-South trade . . . . . . . . . . . . . . . . . . . . . . . . 91 14.3.1 The model . . . . . . . . . . . . . . . . . . . . . . . . . 91 14.3.2 Autarchy . . . . . . . . . . . . . . . . . . . . . . . . . 93 14.3.3 Free trade . . . . . . . . . . . . . . . . . . . . . . . . . 94 15 Endogenous growth and trade 98 15.1 Autarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 15.2 International knowledge diffusion . . . . . . . . . . . . . . . . 102 15.3 Trade with knowledge diffusion . . . . . . . . . . . . . . . . . 103 15.4 Trade with no knowledge diffusion . . . . . . . . . . . . . . . . 105 15.5 Imitation and North-South trade . . . . . . . . . . . . . . . . 107
Part I The classical theory of international trade
Part I The classical theory of international trade 1
Chapter 1 Basic issues The basic questions in the classical theory of international trade can be ana- lyzed in the two-by-two model. Thus we will assume here that there are two factors of production(indexed by i) and two goods(indexed by j). Factors are mobile across sectors but not across countries, both goods can be traded We do not always have to worry about the trade equilibrium explicitly, when we do, we will assume that there are two countries(Home and Foreign) 1.1 Comparative advantage with two goods The doctrine of comparative advantage links autarchy price ratios with trade We can illustrate it by a simple exchange ny with resentative agent. Let good l be the numeraire, and let pa and pf stand for the autarchy and free trade relative price of good 2. We can summarize an equilibrium by the net import vector m of the agent and the equilibrium price vector p. Let m and ms be the autarchy and free trade net import vectors. A competitive equilibrium is efficient, so that consumption maximizes utility given the value of endowments. At any price vector, agents can consume their endowment, so that m must be on the budget line. In particular mi+pmg=mi+pm Since m is affordable at free-trade prices, m must be revealed preferred to You can find a graphical treatment in DN Ch. 1, p.7
Chapter 1 Basic issues The basic questions in the classical theory of international trade can be analyzed in the two-by-two model. Thus we will assume here that there are two factors of production (indexed by i) and two goods (indexed by j). Factors are mobile across sectors but not across countries, both goods can be traded. We do not always have to worry about the trade equilibrium explicitly, when we do, we will assume that there are two countries (Home and Foreign). 1.1 Comparative advantage with two goods The doctrine of comparative advantage links autarchy price ratios with trade patterns. We can illustrate it by a simple exchange economy with one representative agent.1 Let good 1 be the numeraire, and let p a and p t stand for the autarchy and free trade relative price of good 2. We can summarize an equilibrium by the net import vector m of the agent and the equilibrium price vector p. Let ma and mt be the autarchy and free trade net import vectors. A competitive equilibrium is efficient, so that consumption maximizes utility given the value of endowments. At any price vector, agents can consume their endowment, so that ma must be on the budget line. In particular: ma 1 + p tma 2 = mt 1 + p tmt 2 . Since ma is affordable at free-trade prices, mt must be revealed preferred to 1You can find a graphical treatment in DN Ch. 1, p.7. 2