1 Chapter 5 -- Tests of Trade Models INTERNATIONAL ECONOMICS, ECO 486.

1Chapter 5 -- Tests of Trade Models

• INTERNATIONAL ECONOMICS,ECO 486

2Learning Objectives

• Understand the results of well-known tests of the Classical and HO Models.

• Become familiar with new theories concerning the source of comparative advantage

• Understand intra-industry trade, and calculate IIT.

4Tests of the Classical Model

• MacDougall compared US and British exports for 1937.

– Calculated APL

– Compared relative APL to relative wage• America’s wages were twice those in Britain

• Classical model predicts that US would export a good if its labor is more than twice as productive.

5Table 5.1, MacDougall’s Test

Industry APLUS

APLUK

EXUS

EXUK

Radios > 2 8

Cigarettes 1.4-2 0.5

Beer 1.4-2 0.06

Men's woolens < 1.4 0.04

Margarine < 1.4 0.03p. 123

7Tests of the Classical Model

• Of 25 products tested, 20 fit this theory

• Supports a relationship between labor productivity and exports

• Does not rule out the HO Model

• Did not control for differences in other factors (e.g., transportation costs, resource intensity,…)

8Leontief’s Test of the HO Model

• Leontief, Wassily – {lay-ohn’-tyef, vah-sil’ee}– born 5 Aug 1906 St. Petersburg, Russia

• Leontief developed input-output (I-O) model• Assumed that US was most K-abundant country in

1947• HO Model predicts US exports K-intensive• Used I-O Model to Test HO Theory

9Leotief’s Test of the HO Model

• Test:– Cut US exports by $1 million– Raise US production of import-competing

goods by $1 million

10Leontief’s Test (continued)

• Reducing production of exports released more labor than required to expand the production of import-competing goods.

• US imports were more capital intensive than US exports!

• This surprising result is known as the Leontief Paradox

12Attempts to Resolve the Paradox

• Technology differs -- Leontief assumed that US technology was used to produce US imports

– High W/R firms use K-intensive methods

• Tastes differ -- Table 5.2 shows that consumption patterns differ.

– But enough to reverse direction of CA???

13Table 5.2, Consumption Patterns

Category High Low Mean

Food India (59.7%) US (14.4%) 33.3%

Beverages Ireland (14.4%) Libya (1.1%) 5.1%

Clothing & Shoes Ghana (14.2%) Jamaica (4.3%) 8.8%

Medical Care Netherlands &France (11.2%)

UK (1.0%) 4.9%

p. 129

14

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.5-14

15Other Tests of the HO Model

• Leontief examined ‘51 data, found paradox

• Baldwin examined ‘62 data, found paradox

• Stern & Maskus examined ‘72 data, paradox gone (assuming US was still K abundant)

16Test Results: Domestic Capital Required per Labor Year per Million Dollars of …Year Exports Import-Competing Goods Ratio of

Imports toExports

1947 $14,010 $18,180 1.30

1951 $12,977 $13,726 1.06

1962 $14,200 $18,000 1.27

1972 $14,989 $14,218 0.95

Caves, World Trade and Payments, p. 301

18Recent Tests of the HO Model

• Leontief linked factor intensities and trade patterns

• Leamer linked factor endowments and trade patterns

• HO Model links all three

19Recent Tests of the HO Model

• Maskus – Results contradict many HO predictions– Used US I-O table to identify factor intensities

of US exports and imports

• Bowen (et al) looked at more countries– Mixed results– Used US I-O table as well, but noted that other

countries may use other technologies

20


More Recent Tests of HO Model

• Since the 1980s, more tests have been conducted because:

– Earlier studies were incomplete since these did not link trade patterns with factor endowments

– Using a multifactor version of the HO model, Leamer (1980) showed that trade patterns and factor endowments were related to each other

21


More Recent Tests (cont.)

• Two studies attempted to test the links between endowments and intensities to trade patterns:– Maskus (1985)– Bowen, Leamer, and Sveikauskas (1987)

• Both studies found contradictory results.

• Other studies which relaxed HO assumptions had better results.

22Most Recent Tests Combine Models

• Trefler– By allowing for differing technology, found

support for Factor Price Equalization– Technology and tastes included in model,

resolved many of the discrepancies

• Harrigan– Differing technology and factor endowments

explain observed specialization in production

25Human Skills Theory

• Kravis found that the bulk of US exports are provided by high-wage industries– In ’56, but still true

• Keesing (’65-6) argues that differing endowments of K & L are less important than differing endowments skilled and unskilled labor

26Product Life-cycle Theory

• Vernon argues that some countries have CA in innovation. US has CA in developing new products, a labor-intensive activity

• As products “mature,” production becomes automated (K-intensive) and CA may shift

27Product Life-cycle Theory (cont.)

• Applies only to some goods• Cannot predict when shift will occur• Gagnon & Rose (’95)

– few shifts (‘62 v. ’88 data)

28Similarity of Preferences

• Linder focused on demand and hypothesized that consumers prefer variety, which trade provides

• Countries with similar standards of living will produce (& trade) similar goods.

29Similarity of Preferences

• “In each country, industries produce goods designed to please the tastes of consumers in that country.”

• Some people prefer products that differ trade• Factor endowments influence standard of living• Standard of living influences tastes• Rich countries will trade with other rich countries

30Similarity of Preferences (SP)

• Linder rejects HO for trade in manufactured goods– No paradox

• SP explains intra-industry trade

• SP applies only to differentiated products – Linder explains trade in other goods using HO

31


Conclusions

• The world is a very complicated place.

• Developing direct tests of international trade models is difficult due to restrictive assumptions, data, and measurement problems.

• International economics is an evolutionary science.

32


If a Country Has Comparative Advantage in a Good, Why Would the Country Import It?

• Transportation costs• Data aggregation and categorization problems• Increasing returns to scale and

imperfect competition

34Intra-industry Trade (IIT)

• Occurs when countries both export and import the products of an industry

• Not predicted by Classical or HO Models

• Some IIT is consistent with the HO Model– Transportation costs– Data aggregation

• Linder’s hypothesis predicts IIT

35Intra-industry Trade (IIT)

• Grubel-Lloyd index (see p. 137 in Husted)

• Let ej = exports of j, ij = imports of j

n

jj

jn

jn

jj

j

i

i

e

eIIT

1

1

1

50100

36Calculate IIT, example 1

j Industry ej ij

1 Beverages $50 $0

2 Crude materials $50 $0

3 Mineral fuels $0 $50

4 Fats & oils $0 $50

Total 100 100

38Calculate IIT, example 2

j Industry ej ij

1 Beverages $10 $10

2 Crude materials $10 $10

3 Mineral fuels $10 $10

4 Fats & oils $10 $10

Total $40 $40

40Table 5.3 Intra-industry Trade, 1983

Rank Country IIT

1 United Kingdom 68.5

2 Belgium - Luxembourg 67.2

53 Gabon 5.4

54 Algeria 2.0

See page 137, Husted & Melvin, 7th edition

41


42The Long-run

Average Cost Curve• The long run average total cost curve is

derived from the short-run average total cost curves.

• The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.

43Long-run Average Cost Curve

44

• If plant size can be varied by tiny amounts, LRAC curve is a smooth, U-shaped curve

• The SRAC curve for each plant just touches the LRAC curve at a single output level

Short-run and Long-run Cost Curves

45

• SRAC touches LRAC

• LRAC shows economies and diseconomies of scale

Short-run and Long-run Cost Curves

46Returns to Scale -- Internal to the Firm

• Describes changes in average cost as a firm expands (literally, when a one-plant firm builds a bigger plant)

Holding factor prices constant• A multi-plant firm may realize some

economies as it adds additional plants• A multi-product firm may realize some

economies of scope as it adds products

49Slope of Long-run Industry Supply

• Increasing Cost Industry – positive slope

• Constant Cost Industry – zero slope

• Decreasing Cost Industry – negative slope

Describes how factor prices change as an industry expands

50Long-run Changes in

Price and Quantity

Constant-cost industry Increasing-cost industry Decreasing-cost industry

Quantity

Pri

ce

Ps

P0

Q0

D0

D1

S0

Quantity

Pri

ce

Ps

P0

Q0

D0

D1

S0

Quantity P

rice

Ps

P0

Q0

D0

D1

S0

Qs Qs Qs

59Long-run Changes in

Price and Quantity

Constant-cost industry Increasing-cost industry Decreasing-cost industry

Quantity

Pri

ce

Ps

P0

Q0

D0

D1

S0

Quantity

Pri

ce

Ps

P0

Q0

D0

D1

S0

Quantity P

rice

Ps

P0

Q0

D0

D1

S0S1

Qs Qs QsQ1

LSALSC

P2

Q2

S3LSB

S2

P3

Q3

60Decreasing Cost Industry

• The entry of new firms causes falling input prices. Falling input prices shift the cost curves downward, and the short-run industry supply curve shifts to the right.

• Long-run Industry Supply has a negative slope.

• This describes a Decreasing Cost Industry,

61Economies of Agglomeration

• Plants in a single industry cluster

• Three types– A Marshallian cluster – A North Italian cluster – A Chandlerian firm

63Advancing Technology

• Technological change

– New technology allows firms to produce at lower costs

• This causes their cost curves to shift downward

– Firms adopting the new technology make an economic profit

• More new technology firms enter

– Old technology firms disappear, the price falls, and the quantity produced increases

64Learning by Doing

• People learn through on-the-job experience

– Learning curve analysis explores this phenomenon

• Plot labor/unit against cumulative units produced

• Has been observed to fall by some regular percentage for each doubling of cumulative output

• Examples from WWII – hours per destroyer fell by 52.3% from 1943-45 with no increase in K or L.

65Ladder of Comparative Advantage

Industrial Countries

Knowledge intensive

Computers

Created Comp.

Adv.

Newly Industrializing

Countries

K-intensive Machinery

Skilled L-intensive

Electronics

Developing Countries

Unskilled L-intensive

TextilesHO Model Innate

Comp.Adv.

Resource intensive

CommoditiesRicardian

68

F/2

E/20

F

E

TE

XT

ILE

S, T

(yar

ds

per

yea

r)

SOYBEANS, S (bushels per year)

IRS in both S & T (p. 140)

With one-half of the resources in each industry, less than one-half of the potential output is produced.

G

H

G

71Increasing Returns and CA

• Direction of CA is indeterminate and contingent– Historical accident determines the direction

• Example: If B’s textile industry expands before A’s, then B gains CA in T. B will specialize in T

• With imperfect information, and differing endowments, they could specialize in the wrong goods

77Conclusions

• Tests are inconclusive– Results (paradox) may due to data problems– Or, assumptions of the (2x2x2) HO Model may

be too unrealistic

• Direct tests of the HO Model are difficult• Economic theory is still evolving• Trefler found differing technology, factor

endowments & preferences explain trade

78The Theory of External Economies

• Economies of scale that occur at the level of the industry instead of the firm are called external economies.

• There are three main reasons why a cluster of firms may be more efficient than an individual firm in isolation:– Specialized suppliers– Labor market pooling– Knowledge spillovers

79• Specialized Suppliers

– In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services.

– An individual company does not provide a large enough market for these services to keep the suppliers in business.

• A localized industrial cluster can solve this problem by bringing together many firms that provide a large enough market to support specialized suppliers.

– This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley.

The Theory of External Economies

80

• Labor Market Pooling– A cluster of firms can create a pooled market

for workers with highly specialized skills.– It is an advantage for:

• Producers– They are less likely to suffer from labor shortages.

• Workers– They are less likely to become unemployed.


81• Knowledge Spillovers

– Knowledge is one of the important input factors in highly innovative industries.

– The specialized knowledge that is crucial to success in innovative industries comes from:

• Research and development efforts

• Reverse engineering

• Informal exchange of information and ideas


82

• External Economies and Increasing Returns– External economies can give rise to increasing

returns to scale at the level of the national industry.

– Forward-falling supply curve• The larger the industry’s output, the lower the price

at which firms are willing to sell their output.


83• External Economies and the Pattern of Trade

– A country that has large production in some industry will tend to have low costs of producing that good.

– Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply.

• Next figure illustrates a case where a pattern of specialization established by historical accident is persistent.

External Economies and Trade

84

External Economies and Specialization


ACSWISS

Q1

P1

Price, AC ($/watch)

Quantity of watchesproduced and demanded

ACTHAI

2

1AC0

D

The Swiss industry has lower AC because the industry is large, even though the individual

firms are small.

85

• Trade and Welfare with External Economies– Trade based on external economies has more

ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies of scale at the level of the firm.

• An example of how a country can actually be worse off with trade than without is shown next.


86

External Economies and Losses from Trade


ACSWISSP1

Price, AC ($/watch)

Quantity of watchesproduced and demanded

ACTHAI

2

1

AC0

DTHAI

DWORLD

P2

If the Thai industry can be encouraged, it might have a lower AC.

87• Dynamic Increasing Returns

– Learning curve• It relates unit cost to cumulative output.

• It is downward sloping because of the effect of the experience gained though production on costs.

– Dynamic increasing returns• A case when costs fall with cumulative production over time,

rather than with the current rate of production.

– Dynamic scale economies may justify protectionism.• Temporary protection of industries enables them to gain

experience (infant industry argument).


88

• Dynamic Increasing Returns (continued)– Learning-by-doing example: Liberty ships

• 1941-1944, US produced 2,500 Liberty cargo ships.– 1941: 1.2 million person-hours to build a ship

– 1942: 0.6 million person-hours to build a ship

– 1943: 0.5 million person-hours to build a ship

• Physical capital used changed only slightly

• Much human capital was accumulated, more than doubling productivity.

External Economies and International Trade

89The Learning Curve – Home’s experience gives it a cost advantage over Foreign, even though Foreign has, say, lower wages.


L

AC ($/ship)

Cumulativeoutput

L*

AC*0

AC1

QL

90

• The monopolistic competition model can be used to show how trade leads to: – A lower average price due to scale economies– The availability of a greater variety of goods due to

product differentiation– Imports and exports within each industry (intra-industry

trade, IIT)

Monopolistic Competition and Trade

91

• The Effects of Increased Market Size– The number of firms in a monopolistically

competitive industry and the prices they charge are affected by the size of the market.


92

Effects of a Larger MarketAverage Cost, AC, andPrice, P

Numberof firms, n

CC1: AC = n (F/S) + c

n1

P1

1

PP:

n2

P2

2

CC2


cP = c + 1 /(bn)

93

– If manufactures is a monopolistically competitive sector, world trade consists of two parts:

• Intraindustry trade– The exchange of manufactures for manufactures

• Interindustry trade– The exchange of manufactures for food


94

Trade with Increasing Returns and Monopolistic Competition

Home (capital abundant)

Foreign (labor abundant)

Manufactures Food

Interindustrytrade

Intraindustrytrade


95

– Main differences between interindustry and intraindustry trade:

• Interindustry trade reflects comparative advantage, whereas intraindustry trade does not.

• The pattern of intraindustry trade itself is unpredictable, whereas that of interindustry trade is determined by underlying differences between countries.

• The relative importance of intraindustry and interindustry trade depends on how similar countries are.


96

• The Significance of Intraindustry Trade (IIT)– About 1/4 of world trade consists of IIT– IIT plays a particularly large role in the trade in

manufactured goods among advanced industrial nations, which accounts for most of world trade.


97

• Why Intraindustry Trade Matters– Intraindustry trade allows countries to benefit from

larger markets.• The case study of the North American Auto Pact of

1964 indicates that the gains from creating an integrated industry in two countries can be substantial.

– Gains from intraindustry trade will be large when economies of scale are strong and products are highly differentiated.

• For example, sophisticated manufactured goods.


98

• Why Intraindustry Trade Matters (continued)– Consumers gain more variety at a lower prices

than those that would prevail without trade.– Production is more efficient. (Larger market

allows full exploitation of economies of scale.)– When similar countries trade, the resulting change

in the income distribution (capital v. labor) will be small

– Thus, everyone may gain from trade.


1 Chapter 5 -- Tests of Trade Models INTERNATIONAL ECONOMICS, ECO 486.

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Transcript of 1 Chapter 5 -- Tests of Trade Models INTERNATIONAL ECONOMICS, ECO 486.