University of Malawi

Chancellor College Department of Economics

MASTER OF ARTS IN ECONOMICS (PARALLEL PROGRAMME)

ECO 690: INTERNATIONAL ECONOMICS

ZOMBA, MALAWI November 2009

Prepared by

Exley B.D. Silumbu

CORE COURSES

Microeconomics

Macroeconomics

Quantitative Methods

Policy Analysis

ELECTIVE COURSES

Agricultural Economics

Industrial Economics

Managerial Economics

Corporate Finance &

Investment

Public Finance

Environmental Economics

International Economics

Monetary Economics

Health Economics

UNIVERSITY OF MALAWI

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CHANCELLOR COLLEGE ECONOMICS DEPARTMENT

MASTER OF ARTS IN ECONOMICS PROGRAMME

ECO 690: International Economics Course Outline

Objectives

This course aims: (a) To acquaint the student with contemporary blend of fundamental principles of foreign trade under varying market structures; (b) To make the student appreciate the wide range and impact of policy instruments applied in strategic trade and financial policy choices; and, (c) To direct and motivate the student to constraints and opportunities to the conduct of business within the context of increasing international initiatives in the areas of regionalism, multilateralism and globalization facing Sub-Saharan Africa.

Main Course Texts Argy. International Macroeconomics Krugman, P. R. and M. Obstfelt International Economics, Harper Collins. Pugel, T. International Economics, Mac Graw-Hill. Vousden, N The Economics of Trade Protectionism. Cambridge University Press. Feenstra, R. C. Advanced International Trade, Princeton University Press. Agenor and Monttiel. Development Macroeconomics. Obstfeld, Foundations of International Economics. MIT Press.

Topics

1 Trade Theory and Policy under Perfect Competitive Markets Classical and Factor Proportions Comparative Advantage Main Results and Theorems The Specific Factor(s) Model Growth and Trade Orientation Trade Policy: Tariffs and Non-Tariff Barriers Empirical Evidence and Measurement of Policy Effects

2 Intra-Industry Trade under Imperfect Competition Pre-cursors: Product Cycles, Technological Gaps, Etc. Non-Factor Proportions Theories Trade Policy under Imperfect Markets Empirical Measurement

3 Trade Policies under Sub-Optimal Conditions

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Private versus Social Costs and Benefits Domestic Product and Factor Market Distortions Uncertainty and International Commodity Market Distortions Choice of Trade Regimes Trade and the Environment

4 International Trade Cooperation and Liberalization Endogenous Trade Policy Unilateral Trade Liberalization The Theory of Trade Preferences Regional Integration Arrangements The Generalized System of Preferences Multilateralism and Globalization: Options for the Least Developed Countries

5 International Factor Mobility and Trade in Services Capital Mobility: Foreign Direct Investment and Transnational Corporations Labour Migration Trade in Services Intellectual Property Rights

6 Exchange Rate Theories and Practice Interest Rate Parity Exchange Rate and Prices Exchange Rate Determination

7 Approaches to Open-Economy Macroeconomic Adjustment: Theory and Policy The Mundel-Flemming Model The Income-Absorption Approach The Monetary Approach to Balance of Payments Structuralist Models

8 International Monetary Arrangements and Institutions Evolution of the International Monetary System Choice of an Exchange Rate Regime Financial Markets Integration: Stability and Crises Optimum Currency Areas and International Monetary Cooperation and Unions

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CHAPTER 2

CLASSICAL THEORY OF COMPARATIVE ADVANTAGE

2.1 Key Assumptions of Classical Trade Theory

2.2 The Law of Classical Comparative Advantage

2.3 Money Wage Costs, Productivity and Comparative Advantage

2.4 Labour Standards and Trade Policy

2.5 Concluding Observations

The dominant theory of international trade which is based on the perfect competitive market structure is the theory of comparative advantage. It is traditionally presented in two parts; first, is the classical theory associated with David Ricardo (1817), which was based on one factor of production, labour, and constant costs; and second, is the multifactor-based factor endowment or factor proportions theory. This Chapter and Chapter 3 present the intellectual genesis and logical foundations of the comparative advantage theory since the classical phase. This Chapter is devoted to the demonstration of the classical comparative advantage theory and the gains from engaging in trade based on that theory. As pointed out in Chapter 1, classical thought, and in particular its foreign trade theory, was an attempt to reject the mercantilist practice of government control and protection or support of domestic industries and trading monopolies. Instead of this protectionist regime, classical economists championed the superiority of free enterprise system based on the competitive market structure as the most efficient way of allocating scarce resources in order to maximize income and the welfare of nations. In turn, as shown below, the Ricardian classical theory of comparative advantage emerged as a major correction to Adam Smiths concept of absolute advantage. Interest in the classical trade theory rests on a number of reasons. First, it is a stand alone scientific work which is amenable to extensions in various directions. Second, it has been supported by overwhelming empirical evidence even up to the first decade of the new millennium. As we discuss in Chapter 5, this is in sharp contrast to the H-O theory. Lastly, there are still substantial contemporary remnants of the theory in terms of the relationship between low wages and labour standards and international competitiveness, and also in the contemporary debates and policy circles regarding export products from developing countries (DCs) and the least developed countries (LDCs) and whether or not trade in such products should be regulated. These are development issues that are discussed variously in later sections.

2.1 Key Assumptions of Classical Trade Theory

In addition to the assumptions of free trade or absence of government interventions in economic transactions, zero transport costs and perfect competition, classical theory was premised also on the key assumptions of the labour theory of value (LTV), constant costs and imperfect international factor mobility. We next elaborate on the last three

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assumptions. By the LTV, labour played the double role of, one, as the only producer of new value and, therefore, as a measure or indicator of productivity; and, two, as a measure of the real costs and values of products. In order make comparisons, it has to be assumed that labour units are homogeneous domestically and internationally. For example, suppose that the number of labour units (say, labourdays) required to produce a metre of cloth or textiles (T) is lt; that is

[2.1a] lt = labourdays/metre of textiles

Then we can say that the cost of producing one metre of textiles is lt labourdays. If we have another product, say maize (Z) we can also write:

[2.1b] lz = labourdays/bag of maize

Labour costs are related to labour productivity, which in turn is defined as total units of output produced, say Q units, divided by the total number of units of labour, L, which produced that output. That is, Average Physical Product of Labour (APL) = Q/L = units of output per labour unit. Because of the assumption of constant (labour) cost in the relevant range of production, the reciprocal of a labour technical coefficient is the APL. Using equation [2.1b] for instance

[2.2] APLz = 1/lz = Bags of maize produced in one labourday

The assumption of imperfect international factor mobility was made by classical economists, especially Ricardo, in an attempt to account for cost and productivity differences across countries. By making a distinction between intra-country trade and international trade, Ricardo reasoned that in pursuit of a higher rate of profit, free capital mobility within a country would cause capital to move from regions with higher labour cost (low productivity) to low-cost regions, thereby leading to equalization of labour costs and commodity prices. If this capital were to occur internationally, it would also flow from high-cost countries to low-cost countries, thereby leading to cheaper goods, which would be exported in reverse to the capital-originating countries. This, to Ricardo, would undoubtedly be advantageous to the capitalist, as it would raise the rate of profit, but also to consumers in both the capital-sending and capital-receiving countries. Having built this complementarity scenario between capital mobility and flow of goods, Ricardo, nonetheless rejected its feasibility because of impediments to international capital mobility, which he explained in the following terms:

Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with natural disinclination which every man has to quit the country of his birth and connections, and instruct himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations (Ricardo, p.83).

Whether or not this assumption was valid in Ricardos time, classical economists made one of the most enduring assumptions in international trade theory; that which allows for perfect domestic mobility of factors and goods but imperfect factor mobility in order to allow for perfect mobility of goods internationally. In arriving at the assumption of no

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international factor flows but trade in goods, Ricardo also seems to have assumed that these were substitutes. This view, formalized by Mundell (1957), has been extended and generalized to specifying conditions under which factor mobility and trade flows could be substitutable or complementary (Wong, 1986). This issue is taken up in Chapter 5.

The assumption of constant costs means that every extra unit of a good is produced at the same unit cost, so that marginal cost is constant and is equal to average cost in the relevant range of the production process. This assumption is stated more formally in subsequent sections.

With these key assumptions, we are now ready to distinguish between the concepts of Absolute Advantage and Comparative Advantage. Suppose we have two countries, Home (h) and Foreign (f), and two products, textiles and maize, and that the respective labour requirements are as shown in Table 2.1 (the APLs are in parentheses). It is important to assume that labour units are equivalent across countries, so that commodity exchanges occur for equivalent products.

Table 2.1: Labour requirements in labour days (APL in brackets)

Country Textiles Maize

Home lth (APLth) lzh (APLzh)

Foreign ltf (APLtf) lzf (APLzf)

2.1.1 Absolute Advantage

Adam Smith laid down a supply-side microeconomic foundation for trade theory in his dictum:

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. (Adam Smith, 1776, pp. 478-479)

According to this Smithian concept of absolute advantage, suppose we observe in autarky that:

[2.3] lth < ltf and lzh > lzf or:

[2.4] APLth > APLtf and APLzh < APLzf

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In terms of labour costs, we would record that textiles are less costly produced and therefore cheaper in Home than abroad and, vice versa, that maize is less costly and cheaper in Foreign than in Home. The home country would be said to have an absolute cost advantage over the foreign country in the production of textiles, while the foreign country has an absolute cost advantage in production of maize over the home country. In terms of labour productivities, this would mean that Home is absolutely more productive or efficient in textile production than Foreign, while Foreign is absolutely more efficient in maize production than Home. Under these pre-trade or autarky supply conditions, therefore, the direction of bilateral trade would involve Home exporting textiles to foreign, and, vice versa, Foreign would export maize to and import textiles from Home.

How do countries gain from trade based on absolute advantage? Let us assume that the labourdays required to produce a metre of textiles or a bag of maize for Home and Foreign are as given in Table 2.2.

Table 2.2: Classical Absolute Advantage

(labour days)

Country Textiles Maize

Home 2.0 5.0

Foreign 6.0 1.5

We see that Home has absolute cost advantage in textiles, lth = 2 < 6 = ltf, while Foreign has an absolute cost advantage in maize, lzf = 1.5 < 5 = lzh. If Home shifted the 5 days from maize to the production of textiles, it would realize 2.5 metres (= 5 days per bag/2 days per metre), instead of 1 metre. This means that in autarky one bag of maize will be going for 2.5 metres of textiles in Home, which in days equivalence is: 1 bag = 2.5 metres = 5 days. For Foreign, by shifting the 6 days from textiles into maize sector, it could produce 4 bags of maize with them. Foreigns autarky exchange ratio would be 4 bags of maize per metre of textiles, which in labour equivalence is: 1 metre = 4 bags = 6 days. In terms of productivities, verify that Home is more productive or efficient in the production of textiles than Foreign because with one labourday Home produces 0.5 of a metre while Foreign can only produce 0.17 of a metre. The reverse is true in the case of maize, as it can be easily demonstrated that the foreign country is more productive in maize than the home country; that is 0.4 of a bag is greater than 0.2 of a bag in Foreign and Home, respectively.

Suppose there is an opportunity for these countries to freely exchange 1 metre of textiles for 1 bag of maize. By opening to free trade the days equivalence for the home country translates to: 1 bag = 1metre = 2 days. The advantage in the home country with free trade is that a bag of maize which in autarky costs 5 days to produce, only costs 2 days to purchase from the foreign country, so that the saving of 3 days can be used to produce 1.5 metres (at the domestic production rate of 2 days per metre) for domestic consumption.

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With trade, Foreigns labour equivalence ratio would be: 1 metre = 1 bag = 1.5 days, which yields a labour saving of 4.5 days that (at the production rate of 1.5 days per bag) can be used to produce extra 3 bags of maize for local use. Certainly this is a mutually beneficial or gainful trade, which Adam Smith used to advocate trade liberalization during his time, and the doctrine of absolute advantage reigned for almost forty years.

2.2 The Law of Classical Comparative Advantage

Although Ricardo was not an academic scholar as Smith had been, he nonetheless made lasting inroads to the theory of international trade. While adopting the LTV, he observed that even if a country, say Home, had absolute advantage in the production of both goods, say, lth < lzf and lzh < lzf, the basis for trade may still exist if comparative costs or productivities were used instead of absolute costs or productivities. Ricardo used an example whereby England required 100 men to produce cloth and 120 men to produce wine per year, while Portugal required 90 men and 80 men in cloth and wine, respectively. It is evident that Portugal has absolute advantage in both goods. Ricardo, however, argued that gainful trade, even to Portugal, could still take place between the two countries due to specialization, which he articulated along the following reasoning:

If Portugal had no commercial connection with other countries, instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth and hardware of other countries, she would be obliged to devote a part of that capital to the manufacture of those commodities, which she would thus obtain probably inferior in quality as well as quantity

The quantity of wine which she shall give in exchange for cloth from England is not determined by the respective quantities of labour devoted to the production of each, as it would if both commodities were manufactured in England, or both in Portugal

This exchange might take place notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth. (Ricardo, p. 82)

We then proceed to formally present this Ricardian proposition of comparative advantage. A comparative cost of a country is expressed as a ratio of the unit cost of producing one product with respect to the unit cost of another product. If we use the textile unit labour as the numerator, then the comparative cost for each of the two countries would be calculated using the following ratios:

[2.5] Home country :zh

th

ll

; Foreign country : zf

tf

ll

These ratios may be interpreted as the cost of textiles relative to maize, or simply as the relative cost of textiles. With the assumption of competitive factor and product markets,

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the autarky equilibrium relative product prices in each country will closely reflect relative costs. For Home:

zh

thh

hz

t

ll

pPP

a =

]6.2[

And for Foreign:

zf

tff

fz

t

ll

pPPb =

]6.2[

These equilibrium ratios would be the ruling autarky domestic trading relative prices or autarky terms of trade when textiles and maize are exchanged or traded for one another in the domestic market of each country before opening up to foreign trade. According to the Ricardian system, the basis for mutually gainful trade exists if the autarky comparative costs and therefore autarky terms of exchange differ across potentially trading countries. Suppose in autarky we observe the following inequality in comparative costs or exchange ratios.

fz

ftfh

zh

th

ll

ppll

=

10

We have compared costs by calculating a ratio for each country for the two products. Let us instead calculate ratios across countries for each product as follows: lth/ltf and lzh/lzf. Using labour costs for England as numerators, we get for cloth, 100/90 = 1.11, and for wine, 120/80 = 1.5. Surprisingly, we see again that England produces cloth with relatively fewer labour units than in wine. Does this mean that if the inequality stated in [2.7] holds, then the inequality, lth/ltf < lzh/lzf, will also be valid to determine comparative advantage?

With these observations, we can make the following statements:

A country has comparative advantage in a product (products) which it can produce at a relatively lower cost than other courtiers in the rest of the world (ROW).

A country will export to the ROW a product (products) in which it has comparative advantage and import from the ROW a product (products) in which it has comparative disadvantage.

2.2.1 Ricardian Gains from Trade

So far we have been concerned with the basis for international trade. The next question is: Why do countries engage in trade? The rationale for countries to engage in free trade rather than remain in isolation is that there are concrete net gains that can be derived from such trade. We demonstrate more rigorously two such gains than we did in the context of absolute advantage. These gains are due to:

The improvement in the terms of trade, from autarky to international terms of trade, as a country opens up to free trade as shown in this section.

The expansion of consumption possibilities beyond the autarky production possibilities as shown in the next section

Improvement in the Terms of Trade In order to demonstrate the terms of trade gains, let us show initially what would happen if each country traded at the other countrys autarky relative price. Note first that we can express the Homes autarky relative price of textiles as:

hhll

pzh

thh

=

==

textilesof metre maize of bags

maize of /baglabourdays textilesof /metrelabourdays]8.2[

This means that the relative price of textiles is the number of bags of maize that a metre would fetch in the Home market in autarky. With this definition, the pre-trade comparative cost advantage gap, ph < pf, of inequality [2.7] can then be restated as:

fh pfhpa

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From Homes point of view, the gain from trading at Foreigns autarky relative price of textiles is that a metre of textiles would fetch more bags of maize than at Homes relative price. Vice versa, Foreigns improvement in terms trade by trading at Homes relative price is given by the inverse, 1/ph > 1/pf; or:

etcp

pforpfhpbf

ffh ,1

;maize of bag textilesof metres

maize of bag textilesof metres]9.2[ =

>

=

That is, a bag of maize from the foreign country would purchase more meters of textiles when traded at Homes relative price than at its autarky relative price. With negligible transport costs, government taxes and other trade hindrances, then with free international commodity arbitrage, some common world or international terms of trade, (Pt/Pz)w, would settle somewhere between the two autarky exchange ratios as follows:

fwwz

th ppP

Pp 0. With similar reasoning, Foreign as maize exporter and textile importer would gain as follows:

''

maize of bags textilesof metres

maize of bag textilesof metres]11.2[ fw phwpb =

>

=

where .)/(/1' wtzww PPpp =

This result is demonstrated in Figure 2.1a in which the relative cost ratios are translated into relative price lines. Homes autarky price line is flatter than Foreigns because of the

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Figure 2.1a: Classical TOT Improvement

comparative advantage gap. Below price line ph, a metre of textiles would be purchasing less bags of maize than at the competitive equilibrium price in the home country; that is, a metre of textiles would be selling at a loss and therefore firms in the home country would not be willing to offer textiles in exchange for maize. In order to exploit gains from exchange Home would supply textiles for steeper price lines than ph. For example, T0 of textiles would fetch more bags maize at point B on pf of Z1 than Z0 at point A on ph. Similarly Foreign would not supply any maize for textiles to the left of pf, but stands to gain for flatter price lines as Z1 would exchange for T1 at point C than at point B for only T0. The autarky price ratios demarcate the region of mutually advantageous trade and for any world price line such as pw, both countries gain in TOT improvement.

This theoretical analysis of the gains in TOT can be further concretized using Ricardos example of Portugal and England as shown in Figure 2.1b. The pre-trade relative prices are plotted as ray (Pc/Pv)E = (lc/lv)E = 0.83 for England and (Pc/Pv)P = (lc/lv)P = 1.125 litres of wine per metre of cloth. The autarky exchange ratios set the minimum acceptable rates of exchange for each country. At point A for instance, England cannot accept to trade 1 metre of cloth for less than 0.83 of a litre of wine, while at point D Portugal will not accept to offer 1 litre of wine in exchange for less than 0.89 of a metre of cloth (or at point B to offer 1.125 litres for less than 1 metre of cloth). Each country however stands to gain most at each others autarky TOT. For example, 1 litre of wine which exchanges for 0.89 of a metre in Portugal (at point D) would be worth 1.2 metres at Englands autarky TOT (at point E), which is an improvement by 20%. For England, a metre,

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Figure 2.1b: Ricardos Terms of Trade Gain

which trades for 0.83 of a litre at home, can fetch 1.125 litres of Portuguese wine, yielding a TOT gain of 36%. This then means that each country would indeed gain if the world TOT were established somewhere in between their autarky exchange ratios, and a candidate is a 1 to 1 rate which passes through point F.

Consumption Gains and Complete Specialization

In order to illustrate the result that opening up to trade creates expanded consumption possibilities beyond the autarky consumption set, we first develop the analytical tool of the production possibilities (feasibility) frontier (PPF). A PPF traces combinations of maximum levels of output of a given number of products when fixed amounts of resources are fully and most efficiently employed. In order to get the full-employment equations, assume that Foreign and Home have each a maximum number of labour units, LF and LH, respectively, which are allocated to the two sectors as follows:

zhthH

zftfF

LLLbLLLa

+=

+=

]12.2[]12.2[

If all Home labourdays were exclusively fully employed in textile production, the maximum metres produced would be TH = LH/lth, or, alternatively if all labour were exhausted to maize production, the maximum number of bags produced would be ZH = LH/lzh. Note, for example, that labour employment is expressed as LH = lzhZH. Capitalizing on this idea, full employment to the two sectors to produce any mix of the two products for each of the two countries would be:

Hhzhhth

Ffzfftf

LZlTlbLZlTla

=+

=+

]13.2[]13.2[

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For purposes of furthering our understanding, let us introduce a numerical example of this employment system by adopting these figures: LF = 18 million labour hours, LH = 40 million hours, and the labour requirements as: ltf = 6, lzf = 3, lth = 8, and lzh = 10. The full-employment equations in [2.13] are calibrated as:

40108]14.2[1836]14.2[

=+

=+

hh

ff

ZTbZTa

It can be seen that the foreign country has absolute advantage in the production of both products and yet it has comparative advantage only in maize while the home country has comparative advantage in textiles. We use the information on employment in [2.14] to derive first the Homes PPF as summarized diagrammatically in Figure 2.2. The Home equation 2.12b is depicted by line LHLH in Panel (A). Panels (B) and (C) plot the production functions for maize and textiles, respectively. In general, a production function depicts the technological relationship between inputs and output, and in our case, with only labour and the assumption of constant costs, the production functions for maize and textiles are linear, which for Home are as follows:

LLLAPLlLTPFb

LLLAPLlLZPFa

thth

TH

zhzh

ZH

125.081

:]15.2[

1.0101

:]15.2[

====

====

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Figure 2.2: Classical Production Possibilities

Since in Home labour is more productive in textiles than in maize, APLth > APLzh, the PFTH is drawn with a steeper slope (closer to the textile axis) than the PFZH is to the maize axis. To derive the PPF for Home, note that if all the labour were exclusively employed in the maize sector, production would be at point A on the PFZH, which translates to intercept ZH on the maize axis in Panel (D). In textiles, this would be point B on the textile PF or TH on the textile axis. If labour were employed in the production of both products as in equation 2.13b, full employment would be at point C0 which when traced through the respective home production functions, translates into point C3 in Pane (D). With constant costs, we derive a straight-line curve traced by points ZHC3TH as Homes PPF. Foreigns PPF can be similarly derived. Note that Foreigns labour, with a labour requirement of 3, is more productive in maize than Homes labour; thus, APLzh = 1/3 = 0.33 > 0.1 = APLzh. The resulting steeper PFZF than PFZH means that, given the same labour supply, Foreign will produce a higher maize output, at ZF, than Homes ZH. If given the same labour force one country is more productive than others, the difference

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would be accounted for by a technological gap between them, and most modern trade theorists argue that this is what classical theorists assumed to be the major basis for comparative advantage.

In order to facilitate subsequent analyses, the PPFs for the two countries have been redrawn in Figure 2.3, with ZFTF and ZHTH for Foreign and Home, respectively. The equations of these autarky lines with maize as the subject are:

fffzf

tf

zf

ff TTTl

llL

Za 2636

318]16.2[ ===

hhzh

th

zh

hh TTl

llL

Zb 8.04108

1040]16.2[ ===

The slopes of these lines represent the given autarky comparative costs:

28.0]17.2[ ==

==

zf

tf

f

f

zh

th

h

h

ll

TZ

andll

TZ

The lines have been drawn in order to respect the comparative advantage inequality lth/lzh < ltf/lzf, so that the Foreigns PPF is steeper than the Homes.

Economic Meaning of the Slope of a PPF The slope of a PPF measures the rate at which products are traded off in the production process as resources are shifted between

Figure 2.3: Classical Complete Specialization

production lines and is known as the marginal rate of product transformation. This measures the opportunity cost (OC) of one product in terms of the other product. In our case the slope measures the OC of textiles; that is, the number of bags of maize that

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should be sacrificed as resources are withdrawn from the production of maize in order to increase production of textiles by one metre. The constant slope of our PPF embodies the assumption of constant costs or constant OC between the two products. In this sense a country has a comparative advantage in the product that it can produce at a lower OC than another country. The concept of opportunity cost is more relevant in the case of many factors of production as demonstrated more rigorously in the next Chapter than in the case of the classical labour theory of value. In the limited sense used here it can be verified that Homes PPF is flatter than Foreigns, thereby indicating that it has a comparative advantage in textiles throughout the range of the PPF and vice versa for the Foreign country.

Production and Consumption Changes In order to show the consumption gains from trade, let us first record the autarky equilibrium positions as follows: Foreign produces and consumes at point U, with foZ and foT of maize and textiles, respectively, which is autarky set U(Tof, Zof). The respective autarky production and consumption set for Home is V(Toh, Zoh). As TOT improves with the opening up to free trade, producers in each country increasingly find it profitable to expand production of the product in which they have comparative advantage. At Home, for example, labour will be withdrawn from maize production to increase successive units of textiles at constant cost (in a constant number of bags of maize lost) in order to take advantage of profits offered by improvement in terms of trade until no maize is produced and all labour if fully committed to textile production at point TH. The opposite will be happening in the Foreign with no production of textiles as labour will be fully employed in maize production at ZH. This extreme classical production effect of trade under constant cost assumption is known as complete specialization as each country completely specializes in the production of the good in which it has comparative advantage.

Although Ricardo used the concept of comparative advantage as the basis for advantageous trade, he nonetheless reached the same conclusion that countries will exclusively specialize in the product of their comparative advantage, a result which Adam smith had also envisaged, though based on absolute advantage. The possibility of this phenomenon was clearly described by Ricardo as follows:

Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats he can exceed his competitor by one-fifth or 20%, and in making shoes he can excel him by one-third or 33%; - will it not be for the interest of both that the superior man should employ himself exclusively in making shoes, and the inferior man in making hats? [Our emphasis or italics]. (Ricardo, p. 83).

In order to locate the free-trade consumption bundles we should realize that once trade opens up the world prices will be ruling in both countries markets and exchange between them will be taking place at those world TOT. Since we know that the world TOT will be juxtaposed between the pre-trade TOT which have now become obsolete, ph < pw < pf, the world price line is flatter than the Foreigns autarky PPF but steeper than Homes autarky PPF (Figure 2.3). The world price line emanates form each countrys point of complete specialization in production. In the numerical example, it has been assumed that pw = 1.125 bags of maize per metre, so that: 0.8 < 1.125 < 2.

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In order to pin down the consumption effects of this Ricardian model, let us assume that each country consumes the same level before and after trade of the product in which it has comparative advantage, say Zof = 1.5 million bags and Toh = 1 mil meters, respectively for Foreign and Home. This means that the free-trade consumption bundles are: V'(T1f, Zof) and U'(Toh, Z1h), for Foreign and Home respectively. It should be noted that these free-trade consumption sets are beyond the pre-trade PPF for each country when they were then infeasible. But with trade, the consumption possibilities have expanded beyond the autarky possibilities. This means that the post-trade consumption sets are superior to the autarky consumption sets.

Table 2.3: Production and Consumption Trade Effects

Product Production Consumption

Country Autarky After trade

Change Autarky After trade

Change

Home Textiles Toh TH TH-Toh > 0 Toh Toh Toh-Toh = 0

Maize Zoh 0 0 Zoh < 0 Zoh Zoh Z1h Zoh> 0

Foreign Textiles Toh 0 0 Tof < 0 Toh Toh T1f Tof > 0

Maize Zof ZF ZF- Zof > 0 Zof Zof Zof - Zof = 0

The feasibility of the free-trade consumption set is made possible by trade which takes place through excess demand and supplies that are reported in Table 2.3 as read with Figure 2.3 in terms of production and consumption effects. These can be read as follows:

Home country increases textiles production to TH, but still consumes Toh to give domestic excess supply of TohTH as its exports to Foreign. Home country reduces maize production to zero so that there is excess demand for maize of OZ1h = TohV1, which is satisfied by imports from Foreign.

Foreign country increases maize production to ZF, yielding excess supply of maize of ZofZF, which constitute Homes maize imports of TohV1. Foreign country produces zero textiles, so that its excess demand for textiles of OT1f = ZofU1 is satisfied by imports from Home of TohTH.

These exchanges yield the right-angle trade triangles ZofZHU1 and TofV1TH which share the pw as the hypotenuse.

Opening up to trade has increased consumption possibilities as with the same fixed labour resources which prevailed in autarky, each countrys free trade consumption bundle is beyond the autarky PFF and which is superior to the autarky bundle. This means that for each country, real income has risen with free trade, as at world terms of trade a larger bundle is affordable over the autarky bundle which was then unattainable.

19

Overall, free international trade has led to a better allocation of a given set of resources, thereby achieving the highest possible efficiency due to specialization at the world free-trade relative price which is superior to the autarky relative prices.

2.2.2 Maximization of World Output

The result stated in the last bullet refers to the maximization of output or real income at the world level, which is demonstrated here using the world PPF as done in Figure 2.4. We first review the principles used to construct such a transformation frontier, which is drawn with two PPFs labeled as RBS and RAS. The distance on the vertical axis OR is the total that could be realized if both countries completely specialized in maize production, so that OR = ZF + ZH. Similarly, the distance for textiles on the horizontal axis is OS = TF + TH. The inward-kinked line RBS consists of two triangles. The top triangle ZoRB is Foreigns feasible space OZFTF of Figure 2.3 while the bottom triangle ToRA is the Homes feasible space OZHTH of Figure 2.3. For the outward-kinked line, the top triangle ZFRA is Homes feasible space, while the bottom one THAS is Foreigns space. It can be visibly observed that the outward-bending PPF labeled RAS is superior to the inward-bending frontier RBS as the latter is enveloped by the former. For instance, the production point A consists of greater levels of production of both goods and therefore reflects better resource utilization than the production mix at point B. Point A can be shown to be a joint position of complete specialization at the world TOT as follows.

20

Figure 2.4: Constant cost World Possibilities Frontier

We know by assumption thatzh

th

zf

tf

ll

ll

> , so that if we had a relative price of textiles greater

than zf

tf

ll

(that is, steeper than both frontiers), then both countries would specialize in

textile production. However, as the price ratio gets flatter and coincides with the slope of Foreigns frontier, the Foreign would trade-off production of the two goods, and when the price ratio becomes less than its Frontier, then Foreign would not compete in textiles while Home would not compete in maize and each country would completely specialize according to comparative advantage. The world price ratio is represented by line YwYw and is tangent to the world PPF at point A, known as the Ricardian point, meaning that world income is maximized there in the classical comparative advantage tradition.

Classical Equilibrium Price

We can extend this analysis to gauge where the world TOT would settle using the supply and demand framework. The trickiest part is to develop the supply schedule. Instead of

21

using the absolute supply curves separately for the two goods as we did in Chapter 1, we construct the relative textile supply curve (RS) as the ratio T/Z. The constant-cost assumption and complete specialization mean that any departure from autarky TOT, a country switches into complete specialization. To turn around the above analysis, recall that if the world price ratio is below Homes autarky textile relative cost, both countries wont supply textiles, Th = Tf = 0, and world textile supply would be zero, Two = Th +Tf = 0. However, both countries would be able to supply maize, with Foreign at its complete specialization level, ZF, and Home at some level Zh, so that total maize supply would be Zwo = Zh + ZF > 0. This means that the RS will be Two/Zwo = 0. In Figure 2.5, this result is on the vertical distance from the origin to Homes autarky relative cost.

For any world TOT between the two autarky relative costs, each country completely specializes so that Tw/Zw = TH/ZF and the RS curve is the vertical distance between points H and F. At the Foreigns autarky relative cost, Home is completely specialized with TH and Foreign can supply any Tf textiles, and world textile supply will be Tw1 = TH + Tf > TH. However, Home produces zero maize, while Foreign produces some Zf which is below ZF; that is, Zf = Zw1 < ZH. Since world textile supply is greater than TH while maize supply is below ZF, then Tw1/Zw1 > TH/ZF, which yields the infinitely elastic RS curve beyond point F.

The relative demand (RD) of the model is depicted as a continuously downward-sloped curve in Figure 2.5. It is drawn on the basis of a normal or standard demand curve for each product, so that in each country, as the relative price of textiles falls, more textiles will be bought and less maize will be consumed, thereby causing the relative quantity of textiles to rise both domestically and worldwide.

Figure 2.5: Classical Relative Demand and Supply

General equilibrium relative world price will be the one that equates RS to RD, and in the figure this is at point W, which is juxtaposed between the two autarky relative costs. We

22

would expect this to be the theoretical classical expectation that opening to mutually gainful free trade will lead to TOT gain, from H and F for Home and Foreign, respectively. But suppose equilibrium is on the RS of one of trading partner, such as at W1 or W2 for Home or Foreign, respectively. At W2, that would indicate strong world preference for maize, in which case Foreign will completely specialize in Maize while Home would be producing both goods on its frontier and be indifferent to foreign trade.

2.2.3 The Ricardian Theorem and Many Goods

The Ricardian comparative advantage theory that a country specializes in the product(s) in which it has a lower relative labour cost or higher relative productivity can be intuitively demonstrated as is done next for two goods and two countries, and then with two goods and many countries. Starting with the former scenario, we know, by assumption in inequality 2.7, that Foreign has comparative disadvantage in textile production, so that if we cross multiply the comparative cost gap or inequality we get:

.thzfzhtf llll > From the employment equation system 2.13, we can form the following matrix system:

0;;]18.2[ >==

=

=

thzfzhtf

zhth

zftf

zhth

zftf

h

f

zhth

zftf llllllll

DAllll

ALL

ZT

llll

Matrix A is the coefficients matrix whose elements are the labour requirements and the |A| is the determinant (D) of matrix A, which in this simple 2 by 2 square matrix, is calculated as the difference between the cross-products of the diagonal elements of the coefficients matrix in the order shown. The determinant of our system is positive due to the assumed comparative labour costs. Since D is non-zero, then a unique solution for the unknowns T and Z is guaranteed. To solve for T, replace the column vector of the textile labour costs in A matrix by the column vector of the labour quantities, compute the associated determinant, and then divide the result by the determinant of the coefficients matrix. This procedure, known as Cramers Rule, leads to the solutions for T and Z as follows:

DLlLlDLlLl

Zb

DLlLlDlLlL

Ta

hthhtfhth

ftf

hzffzhzhh

zff

/)(/]19.2[

/)(/]19.2[

==

==

Divide both the top and bottom parts of the right hand side of T by lthLf and those of Z by lzfLh, so that:

23

hzfh

f

zf

th

zf

tf

fthf

h

th

zf

th

zh

LlD

LL

ll

ll

Zb

LlD

LL

ll

ll

Ta

/]20.2[

/]20.2[

=

=

Take derivatives of T and Z with respect to the first item inside their respective parentheses to obtain:

0)/(]21.2[

0)/(]21.2[

>=

>=

DLl

llZb

DLl

llT

a

hzf

zftf

fth

thzh

Note that for each product, the denominator in the deferential term on the left-hand side (LHS) is its relative labour cost for the respective country. For textiles, it can be verified that the higher is the ratio lzh/lth, the less competitive Home becomes in maize production and therefore the more it should specialize in textile supply. The opposite will be the case for Foreign, as it will specialize in maize the higher is the ratio ltf/lzf.

Two Goods and Many Countries The classical case of 2 2 commodities and countries can be easily extended to multidimensional case of many commodities and countries. We only demonstrate the case of two goods and many countries, where the commodities are j = 1, 2, and for reference purposes these are textiles and maize, respectively, and countries are c = 1, 2, , m. Then at some world TOT, pw, the comparative cost advantages, l1c/l2c, will be ordered as follows:

m

m

m

m

c

c

w

c

c

ll

ll

ll

pll

ll

ll

ll

2

1

12

11

12

11

2

1

23

13

22

12

21

11......]22.2[

24

Figure 2.6: Two-Goods Many-Countries Specialization

2.3 Money Wage Costs, Productivity and Comparative Advantage

Classical comparative advantage has been demonstrated in terms of real comparative labour costs and inverse labour productivities without regard to monetary wages. Under competitive markets, commodity prices will closely reflect the unit costs of production, which is the nominal wage or money wage rate, W, multiplied by the labour requirement as follows:

[2.23] Pjc = Wcljc

The product Wl is the monetary labour cost required to produce one unit of product j or in short the unit labour cost of product j. The nominal wage rate is expressed as money units per unit of labour; for example, it is equal to units of our currency per hour of labour worked, MK/hr. Then the product on the right side of equation [2.23] defines the price as: Pjc = (MK/hr) (hour per unit of product j) = (MK/unit of product j). Given the inverse relationship between l and APL, we get these expressions:

jcjcjc

c

jcccjcjcjcjc

c

jcjc

ACLPAPL

WlWWVAPLAPLPPWAPL

l====== .

1]24.2[

The term W/Pj is the real wage or wage unit and is measured in units of product j per labour hour as:

unitMK

hrMK

PW

wj

j /== = units of j per hour. The term VAPL is the value of the APL. The last relationships to the right define the unit labour cost in terms of the

25

ratio of W/APL, which is also the average cost due to labour (ACL). Under competitive markets, the price of each product is equalized and in the labour market, the nominal wage rate is equalized across industries in the whole economy, so that each employer faces the same money wage for equivalent labour. The only control variable to the firm is the APL, and when Pj.APLj > W, then a labour unit, one hour of labour, is contributing more to revenue than to total costs and that would induce firms to hire more labour. Conversely, for Pj.APLj < W, means that profitability is undermined and firms will reduce employment. Therefore, in equilibrium all prices will be proportionately tied to wages so that across countries we can make comparisons of relative productivities with respect to relative nominal wage rates. Now, suppose we see the following inequality between our two countries and two products:

zf

zh

f

h

tf

th

APLAPL

WW

APLAPL

>>25.2[

It should be immediately realized that, unlike in earlier analyses, now we have taken ratios of APLs for each product but for different countries. This inequality states that Home has a cost advantage in textiles as the comparative wage is less than the relative productivity in textiles, and it can be verified that Foreign has cost advantage in maize. In the case of two countries and n number of products, we can rank these products as follows:

2

1

2)1(

1)1(

2)1(

1)1(

2

1

2

1

22

21

12

11......]26.2[

n

n

n

n

j

j

j

j

APLAPL

APLAPL

APLAPL

WW

APLAPL

APLAPL

APLAPL

>>>>>>

+

+

And in terms of relative real labour costs, we get the inverse ordering:

2

1

2)1(

1)1(

2)1(

1)1(

2

1

2

1

22

21

12

11......]27.2[

n

lll

ll

WW

ll

ll

ll n

n

n

j

j

j

j

26

Figure 2.7: Wages, Productivity and Comparative Advantage

This ranking is depicted in Figure 2.7 for five products with the productivity ratios recorded on the vertical axis and the relative costs on the horizontal axis. In this scheme of things, efficiency means either a higher relative productivity or a lower relative cost in the same product than the wage ratio between countries. As an example, we have made the actual wage ratio between products 3 and 4 at point E. This would signal country 1 or Home to specialize in electronics, textiles and bicycles, while Foreign specializes in sugar and maize.

2.3.1 How China has Juggled Low Wages with Productivity

Chinas niche in aggressively penetrating world export markers since mid-1980s has been partially, but very importantly, based on domestic low wage rates and a large pool of labourforce capable of adapting to productivity competitiveness. Even firms from the first-generation NICs of East Asia of Taiwan, South Korea, Hong Kong and Singapore, which in the late1960s and 1970s were Japans suppliers of cheap components have joined the major global firms over a cross-section of industries from the HICs to use China as their platform to enhance their global competitiveness. Due to this low-wage advantage, some elements in the HICs had pointed to alleged flouting of labour standard and pressed for Chinas admission into the framework of the WTO in order to subject it to more transparent labour employment practices. However, Chinas accession to the

27

world trade body (in December 2001) has generated even more tremors, especially with the dismantling, in January 2005, of the Multi-Fiber Agreement (MFA), a regime that had since the 1960s regulated the world market for textiles and garments through quotas.

Table 2.4: Chinas World Comparative Labour Costs (1998) Ratio of hourly labour costs Ratio of unit labour costs Country National Textiles

Col (2) Clothing Col (3)

National Col (4)

United States 47.8 20.9 23.1 1.3 Japan 29.9 1.2 Singapore 23.4 1.3 Taiwan (1997) 20.6 9.4 2.3 Korea, Rep. of 12.9 5.9 6.3 0.8 Chile 12.5 0.8 Mexico 7.8 4.0 3.4 0.7 Turkey 7.5 0.9 Malaysia 5.2 1.1 Philippines (1997) 4.1 0.7 Egypt 2.8 1.5 Kenya 2.6 2.0 Indonesia (1996) 2.2 9.1 12.1 0.9 Zimbabwe 2.2 1.2 Hong Kong 9.1 12.1 China: Productivity Indicators in Textile and Clothing Industries (1999) Textile Industry Clothing Industry All firms SOEs FFEs All firms SOEs FFEs Number of firms 10,981 3,011 3,033 6,611 792 2,864 Share of VA to sales (%) 24.7 26.9 24.4 24.8 28.4 24.9 VA per worker (yuan per year)

21,900 15,300 38,500 24,500 16,800 25,800

Profits share in sales (%) 0.94 -0.09 1.46 3.36 0.96 2.96 Sources: UNCTAD, Trade and Development Report, 2002, Box 5.2, p. 152 and Tables 5.4 and 5.5. Notes: Wages and unit labour costs include social charges and in the calculation of unit labour costs, average wages were divided by manufacturing value added (VA). Ratios are average wages and unit labour costs of each country to Chinese levels. Hourly labour costs in China for 1998 were US$0.62 and US$0.43 in textiles and clothing industries, respectively. SOEs and FFEs are state Owned Enterprises and Foreign Funded Enterprises, respectively. Exchange rate in 1998 was 8.28 Yuan per US$ (IMF, International Financial Statistics: Yearbook, 2002, p.355)

But how cheaper and productive has been the Chinese labour? Comparative wage rate can be measured as a ratio between the average wage in China relative to foreign average wage rates, such as, wf/wc, so that the higher this ratio the relatively cheaper Chinese labour would be. Using this ratio Table 2.4 gives comparative wage costs between China and selected DICs, NICs and other DCs at the close of the 1990s. As ranked under column (1), the national ratio ranged from the highest wage gap of about 50 times with the USA to the lowest with India of only 1.5. The gaps with the Asian NICs were also high from 23 times with Singapore to 13 times with South Korea. These were, however, lower in the textile and clothing industries with the highest being 12 with Hong Kong and the lowest of 4 times with South Korea.

28

A better measure of comparative wage gap has to take into account Chinas relative productivity and, using manufacturing value added (MVA), the following index can be useful:

f

c

c

f

cc

ff

MVAMVA

WW

MVAWMVAW

=

//]28.2[

The interpretation if this index is that lower Chinas MVAc relative to a foreign MVAf has the effect of reducing the comparative wage gap, and therefore making Chinas effective comparative cost to be smaller. As can be seen from column (4) of Table 2.4, indeed Chinas unit labour costs were relatively higher than those of major competing DCs such as South Korea, Chile, Mexico, Turkey, Philippines and Indonesia.

China has steered its economy to the top elite of the global economy. In terms of manufacturing performance the share of its MVA to total world MVA has moved it from a rank position of below the top ten in 1980 to number 8 in 1990 with 2.7% share and to number 4 in 2000 with 7% which was surpassed only by the USA, Japan and Germany, respectively, with 24.1%, 14% and 8.5% shares. Among the DCs, China ranked number 2 with 10% in 1980, number 1 in 1990 with 15.7%, and maintained the position in 2000 with a share of 29.4%. (UNIDO, Industrial Development Report, 2004, pp.183). In terms of export integration, China has effectively competed even in products embodying high skill-requiring technologies. As shown in Table 2.5, Chinas position globally rose by at least six notches across all exports of manufactures during the 1990s and shot to the top among DCs with gains in high-technology export products.

Table 2.5: Chinas Export Integration into World Markets

Product Group

Top 25 World Exporters

Leading Developing Countries

1990 2000 1990 2000

Resource based 20 11 4 1

Low technology 8 1 3 1

Medium technology 16 11 3 3

High technology 21 9 7 4

All manufactures 4 1

Source: UNIDO, Industrial and Development Report, 2004, pp. 183, 191-193

In order to solve the productivity problem, Chinas openness has blended national state owned enterprises (SOEs), local private firms, with foreign firms through foreign direct

29

investment (FDI). As can be seen in Table 2.4 (bottom section), the productivity of SOEs (in VA per worker) in the clothing and textile sectors was substantially lower than in foreign-connected units. The inferior performance of the SOEs is due to institutional obligations and practices they inherited from the communist era with the tendency to over-employment and gradual technological upgrading.

Chinas spectacular export performance in manufacturing caused widespread concern during the early part of the year 2005 from a cross section of countries ranging from the richest to the poorest of them, from importers as well as export competitors, and the low-cost labour has been the alleged cause this competitive advantage. Mexico is a typical case of a competitor whose plight the International Herald Tribune said Mexico, long the king of low-cost plants and exporter to the United States of everything from Ford Trucks to Tommy Hilfiger shirts to IBM computers, is being rapidly supplanted by Chinas hundreds of millions of low-wage workers.In all, 500 of Mexicos 3,700 so-called macquiladora (tax-free export-oriented) plants have shut down since 2001, at a cost of 218,000 jobs, the Mexican government saysNow China, whose American-bound exports grew 20% last year (in 2002) while Mexicos remained flat, is expected to surpass this country as No. 2 exporter (after Canada) to the United States ( Mexico manufacturers lose business to China. IHT, September 3rd, 2003, p.11; Quoted in UNIDO, 2004, p. 142). Also hardly affected were LDCs from SSA that benefit from the USAs African Growth and Opportunity Act (AGOA) passed in 2000 by which qualifying countries can export a range of products to the US market duty free. Hardest affected has been the garments industry after the removal of the MFA. In Malawi, one of the ten poorest countries in the world, the largest garment exporter lost 33% of its exports to the USA at a cost of 28% of its 3,000 workforce in mid-2005 and this was attributed to the cheaper Chinese exports to the US market. (Chirimba Garments lays off 850, The Malawi Nation, 13 July, 2005, Business page 5)

While low wage costs have been cited as key to Chinas competitive advantage, productivity differences especially with most SSA countries seems to be a better explanation for the loss of the duty-free preferential advantage of AGOA. Evidence suggests that the worker productivity in Lesotho, a shining performer under AGOA in garments, was between 30% and 70 % lower than in China. Given that wages are not very different from Chinese, it would be difficult for such countries to sustain competitiveness especially once AGOA expires. The explanation for this lower productivity in the apparel manufacturing in Lesotho, which is representative for most poor SSA countries

lies in the wage system (time rather than piece work), low levels of formal skills, the lack of training (apart from basic on-the-job instruction) and poor employer-worker relationships. Asian firms do not invest much in employee training, preferring to use Chinese supervisors and technicians. The government has done nothing to encourage skill formation by firms (say, through fiscal incentives), nor has it set up any training facilities for the industry. Its main efforts have been directed to getting AGOA extended rather than to using the remaining grace period to raise capabilities to competitive levels. There is thus a real risk that the industry will evaporate once AGOA ends, unless the government launches targeted capability-building measures and provides the basic public goods that the industry needs (UNIDO, 2004, p. 13)

30

2.3.2 The Exchange Rate, Labour Costs and Trade

Since the adoption of the flexible exchange rate system in the early 1970s by the Developed Industrialized Countries (DICs), traders and governments have become very sensitive to exchange rate movements, especially how they affect international competitiveness. We use a simplified example to illustrate the sensitivity of trade to various exchange rates using our example of employment equations of [2.14]. Assume that the hourly wage rates between the two countries are US$6 and MK210 in the foreign and home country, respectively. At an exchange rate of MK140 per dollar the absolute costs of one metre will be: 6 hours times $6 per hour or $36 in Foreign and in the Home we get 8 hours times MK210 per hour or MK1, 680 per metre, which at the exchange rate gives $12 per metre. The results for both products and countries at various exchange rates are given in Table 2.6.

Table 2. 6: Exchange Rate (ER) and Trade

ER MK40 = 1$ MK100 = 1$ MK140 = 1$ MK200 = 1$

Country Textiles Maize Textiles Maize Textiles Maize Textiles Maize Home $42 $52 $16.8 $21 $12 $15 $8.4 $10.5

Foreign $36 $18 $36 $18 $36 $18 $36 $18

The home currency at the exchange rate of MK100 is consistent with complete specialization example we have used between the two countries, as textiles will be cheaper in Home than in foreign countries while maize will be cheaper in the latter countries than in the home country. An exchange such as MK40 makes home country to be a net importer of both products and under flexible exchange rate system, excess demand for both products will lead to depreciation of the local currency. At MK40, the currency would be said to be overvalued; meaning that it is priced below its equilibrium level that is consistent with comparative advantage. However, some exchange rates such as MK140 and MK200 per dollar reverse the trade imbalance in favour of the home country in both products as the home currency would be said to be undervalued; that is, it is unnecessarily too cheap vis - a - vis other currencies. An overvalued currency penalizes its countrys exports in favour of imports while an undervalued currency promotes its countrys exports at the expense of its imports from other countries. This is exactly the allegation leveled at Chinas exchange rate management by its major trading partners, especially the DICs. The contention has been that Chinas export performance and accumulation of huge trade surpluses and foreign reserves have been, inter alia, due to deliberate undervaluation of the Yuan. The pressure on China to revalue its currency was intensified during the year 2005 under various diplomatic flurries subsequent to the phasing out of the MFA. Although the US Treasury had estimated that the yuan was 40% undervalued after ten years of fixed parity with the US dollar, China revalued it by only 2% on 21 July 2005 and promised to move to a tunnel exchange rate management system against a basket of currencies. In the 1970s through the 1980s, most currencies of LDCs

31

were at their overvalued levels in order to encourage import substitution industrialization (ISI) strategy and to satisfy the import-dependent consumption habits of the emerging powerful middle class, a policy stance which turned out to be a major cause for the dismal export performance of these countries. As a result, these countries have variously adopted more cautious exchange rate management systems.

2.3.3 Empirical Tests of the Classical Trade Theory

How well does the classical comparative advantage theory fit the real world-trading situation? Recall that the Ricardian theory, in its productivity version, predicts that a country will export commodities in which it has the highest relative labour productivity (i.e., average product of labour).

The earliest work in this regard was by MacDougal (1951, 1952), who set out to empirically test whether the classical comparative advantage theory of trade was supported by data on the bilateral trade between the United Kingdom (k) and the United States of America (s). As a measure of comparative productivity advantage, MacDougal used the ratio of the average product of labour in the USA (APLs) to the UKs average product of labour (APLk) using the 1937 data for each of the 25 products in his sample. To measure the export pattern, he used the ratio of USAs exports (Xs) to UKs exports (Xk) of each product. He found that there was a positive linear pattern shown by a scatter diagram for a cross-section of commodities between the relative average products (APLs/APLk) and relative export performance indexes (Xs/Xk). This meant that the products in which the USA exhibited a higher labour productivity, the export shares were also higher than the UKs. This tended to support the classical prediction of trade pattern from comparative advantage based on comparative labour productivities. Subsequent studies conducted by Stern (1962) for 1950 data and Balassa (1963) for 1951 data yielded the same findings as MacDougals. Bhagwatis (1964) findings, however, contradicted the above results. Using linear regression technique, he found that there was no statistically significantly linear relationship between relative export price (Ps/Pk) and relative labour productivities (APLs/APLk) or between average labour costs (ALCs/ALCk) and (Ps/Pk) in the bilateral trade between the US and the UK. However, the intuitive appeal of Balassas and Sterns findings seems to have overshadowed Bhagwatis study.

Sterns study unlocked MacDougals observation on the inconsistence in his data which indicated, contrary to expectation, that in third country markets the share of UKs exports were higher that USAs relative productivity advantage. Using 1950 data set, Stern found that even in third country markets the USAs productivity advantage was consistent with its market dominance. This seemed to corroborate MacDougals own speculation made earlier on that UKs market advantages in third country markets may have been due to imperial trade preferences, which started weakening after the post-Second World War period.

Other studies confirming the Ricardian prediction are by Golub (1995) and Golub and Hsien (2002). Golub sought to establish the relationship between relative unit labour costs and relative export performance between the USA relative to those of the UK, Japan, Germany, Canada and Australia. A relative unit labour cost is defined with

32

respect to the UK, for example, as the ratio: .//

kk

ss

APLWAPLW

Computing similar ratios with

respect to the other countries and using 33 industries, Golub (1995) found a negative correlation between relative unit labour costs and export ratios, thereby indicating that the higher the relative unit labour costs of the USA the lower its export performance relative to other countries. This result was vindicated by the Golub-Hsien (2002) study for products of 39 sectors between the USA and nine countries those included in Golubs (1995) study plus France, Italy, Mexico and S. Korea, covering the period 1972-1991.

In spite of this powerful predictive regularity of the Ricardian theory, it still fails to stand up to some real life situations. First, other factors of production and resources are not accounted for to explain trade patterns. Second, complete specialization is an extreme or rare phenomenon among trading nations. In actual economies non-traded goods exist even under relatively free trading regimes. Complete specialization may exist in the case of 100% export oriented processing zones (EPZs) and only for specialized products and not the whole industry. The third observation is the reliance on fixed coefficients in the production process when there is great potential for more flexible and variability in the combination of inputs. These three aspects recognition of other factors of production, incomplete specialization and flexible factor intensities are tackled in the next Chapters.

33

CHAPTER 3

THE FACTOR PROPORTIONS THEORY OF COMPARATIVE ADVANTAGE

The factor endowment theory was proposed by Eli Heckscher (1918) and elaborated by Ohlin (1933) with a view to providing an explanation for the commodity composition of international trade. While in the Ricardian theory, which had been unrivaled for 100 years, the basis for comparative advantage is the difference in autarky relative labour costs or labour productivities, the factor endowment or Heckscher-Ohlin (HO) approach goes further to propose that such pre-trade relative cost differences are in turn due to differences in relative resource endowments; that is, differences in proportions in which factors of production are available in different countries.

According to the HO theory, a country has comparative advantage in the product which utilizes most intensively; that is, which is heavily biased in the use of the factor which is in relative abundance in that country compared to other countries. Therefore, the direction of trade will be that a country exports products which are intensive in the relatively abundant factor(s) and import products which are intensive in the relatively scare factor(s). This statement, also referred to as the HO Theorem, has spawned some key corollaries, including the Stolper-Samuelson Theorem (1947) on the distribution of income and the Factor Price Equalization Theorem (Samuelson 1948, 1949), both of which are presented in the next Chapter. With the rigorous application of neoclassical marginalist analysis (especially by Samuelson in the 1940s), the factor proportions model became to be known (and is still known) also as the (traditional) orthodox theory of trade or the HOS model.

We review next the assumptions of the model and then present the logical flow of the proof of the theorem.

3.1 Assumptions of the HO Model

The HOS model is based on a set of restrictive assumptions, leaving other possible features which alternative economies may assume as the basis for alternative theories of trade. In this regard, the material covered in this Chapter serves as a reference guide for judging the points of departure from the HO theory of such alternative theories of trade which are covered in later Chapters. The HO models assumptions fall into three broad classes: those related to market and general economic environment; and demand-side assumptions about consumption of welfare patterns; and the supply-side assumptions; which are about technology and factor or production conditions.

This is a two-factor, two-product and two-country (2 by 2 by 2) trade model. These factors are capital and labour which are fully employed to produce textiles and maize in Home and Foreign countries. These countries possess the following characteristics.

34

1. Perfect competition prevails in both factor and commodity markets and the firms objective is to maximize profits.

2. There are indrances and frictions to the the achievement of this objective and trade when it opens between the two countries such that there are no transport costs; perfect information prevaials and absence of government interference or enhancement through any policy or institutional instruments in the market place.

3. Commodities are perfectly mobile within each country and between then when trade opens. However, while factors of production are perfectly mobile between the two industries in each country, they are completely immobile internationally even when trade in commodities opens.

4. Prefernces and tastes are similar between the countries so that their community indifference map and social welfare functions are similar. This means that consumers in these countries can consume the two products in the same proprtion when confronted by the same relative price for the products.

5. Countries are exposed to the same state of technology which is different in the production of each commodity. That is, while each commodity is produced by a different production function, countries will use the same production function for each product. Further, firms in each country will use the same factor intensity or technique when contfronted by the same relative factor price.

6. There are diminishing returns to each factor of production and both production function exhibit constant retaurns to scale. This set of production conditions guarantees strictly convex isoquants and concave production possibilities frontiers in producing both products.

7. There is no factor intensity reversal in the production of the two commodities as factor prices change. This requires that at each factor price commodities can be uniquely and unambiquously ranked, classified or identified by their respective factor intensities. Assumptions 5 and 7 are further explained next.

3.1.1 Technology and Absence of Factor Intensity Reversal

With this background we are now at an advantageous stage to demonstrate two pivotal HOS assumptions regarding technology and relative factor costs; namely, the assumptions of identical technologies and absence of factor intensity reversal.

Identical Technologies

In terms of technology, the HOS model assumes that countries have access to identical production functions but which are different for each commodity and that the factors of production are identically productive across countries. If technology is uniform internationally, then the isoquants for each commodity, as those shown in Figure 3.5, will be the same across countries. This means also that the same quantities of the factors employed in the production of a particular commodity would yield the same level of output in each country. Further, if countries had equal quantities of capital and labour, or if the endowment ratio were equal, they would employ the factors with the same technique. Even more so, each country would apply the same technique in the production

35

of a given good if relative input prices were equal. For example, at the relative wage given in Figure 1.6, firms in each potential trading partner would produce Qo at point X using factor intensity OX. The result would be that the ratios of the marginal products, MPL/MPK, would be equalized across countries.

Absence of Factor Intensity Reversal

This assumption requires that goods be uniquely and unambiguously ordered or identified according to factor intensities at all possible relative factor prices. That is, if a good is capital intensive while another one is less capital intensive (is labour intensive) at a relative wage such as wo/ro, these goods should be similarly classified or ranked in terms of their factor intensities should the relative wage change to (w1/r1). Let the relative wage rise as: w1/r1 > wo/ro); and, further, let maize production be more capital intensive than textiles as: Kz/Lz > Kt/Lt. The assumption of "no factor intensity reversal" is demonstrated with the aid of Figure 3.7. Panel (A) shows firm optimization in the capital-labour plane with maize isoquant ZoZo and textile isoquant ToTo. The initial techniques with initial relative wage, o wo/ro, are, respectively, at points A and B for maize and textiles. Maize is more capital intensive than textiles as the technique represented by ray OA = (Kzo/Lzo) is greater than (Kto/Lto), which is ray OB. That is:

[3.25] For: o wo/ro (Kzo/Lzo) = OA > OB = (Kto/Lto)

At the higher relative wage, 1 w1/r1, which has a steeper slope than that for wo/ro, labour becomes relatively more expensive, so that in the process of economizing its use, less of it will be employed and more capital will be used. The new optimization positions are C on ZoZo and D on ToTo. We can record two observations. First, as a result of a rise in the relative wage, both products have become more capital intensive; thus for maize:

[3.26a] Kz1/Lz1 = OC > OA = Kzo/Lzo

and for textiles:

[3.26b] Kt1/Lt1 = OD > OB = Kto/Lto

Second, in accord with the assumption of no factor intensity reversal, still maize production remains more capital intensive than textiles at the higher relative wage. That is:

[3.27] For: w1/r1 Kz1/Lz1 = OC > OD = Kt1/Lt1

Panel (B) records the same result of non-reversibility of factor intensities using a unique mapping between the various relative wage rates to factor intensities.

Recall that the factor equilibrium condition which is representsd by a positive proportionate relationship between relative wage and factor intensities as (w/r) = (MPL/MPK) = (K/L), > 0. This relationship is represented by lines TT and ZZ for

36

textiles and maize, respectively, in Panel B of Figure 3.7. The relative wage is measured along the vertical axis and factor intensity on the horizontal axis. These functions show that as the relative wage rises (falls), production becomes more capital (labour) intensive for each good. At the initial lower relative wage o wo/ro, maize at A1 is more capital intensive than textiles at B1; or zo Kzo/Lzo > Kto/Lto to. At the higher relative wage 1 w1/r1, it can be observed that, although production has become more capital intensive in general, still maize production is more capital intensive than textile production, z1 Kz1/Lz1 > Kt1/Lt1 t1, thereby sustaining the assumption of absence of factor intensity reversal. The possibility of the occurrence of factor intensity reversal is considered in Chapter 5.

3.2 The Logical Basis and Flow of the HO Theorem

3.2.1 Factor Endowments

With these assumptions, countries are will be dissimilar only in relative factor abundance. There are two definitions of relative factor abundance, namely, the physical and the relative price definitions. We use next the former dfiniiton, by which factor endowment is measured by the autarky proportions in which aggregate fixed resource endowments are available. As demonstrated henceforth, this dissimilarity is the source of comparative advantage. Suppose in terms of absolute physical units the pre-trade aggregate capital stocks and labourforces for two countries can be somehow computed as follows: KH and LH units for Home country and KF and LF units for Foreign country. In terms of proportions, these countries respective endowments can be presented as: KH/LH and KF/LF. Suppose further we observe this inequality in autarky in these countries endowment proportions:

H

H

F

F

LK

LK]62.3[ >

Then we would conclude that Foreign is more relatively endowed with capital than Home and therefore Foreign is a capital rich (but a labour scarce) economy. Conversely, Home is a relatively labour endowed but a capital scarce economy. As long as pre-trade differences in factor endowments exist as in inequality [3.62], then the basis for comparative advantage and therefore trade has been established. The model then makes a series of logical deductions:

From relative factor endowments to autarky relative factor prices/costs.

Product factor intensities to autarky relative product prices through relative factor costs.

Relative autarky product prices to comparative advantage.

3.2.2 Factor Abundance and Autarky Relative Factor Costs

37

When all adjustments have been made through perfect competition in factor markets, each economy will be at its autarky full employment position and equilibrium relative factor prices will be established by equating them to the ratios of marginal productivities. We need to invoke the variable proportions theory here. We also assume that maize is more capital intensive than textile producton (which is labour intensive). Since technologies and production functions are the same, efficiency in resource use will dictate that firms in the Foreign country adopt higher capital-intensive techniques in both products than Home. Since Foreign has relative abundance of capital than Home, the scarce labour in the Foreign would tend to be relatively more productive than at Home where it is in comparative abundance. In other words, the relative scarce capital in the Home will be more productive combining with the abundant labour than in the Foreign where it is abundant. We expect this ratio to hold in autarky:

.

MPKMPL

MPKMPL]63.3[

hf

>

In this case, the cost minimization rule will hold such that the relative wage will be higher in Foreign than in Home. Thus

hff r

w

MPKMPL

MPKMPL

r

w]64.3[

=

>

=

This result is illustrated using isoquant analysis in the Edgeworth-Bowley Box diagram of Figure 3.16. Take first the Box for Home country. The capital-labour plane for textiles has its origin at the bottom left point Oth, with capital allocations to textiles measured vertically along the left axis labour horizontally to the right. Textile isoquants indicate rise in output such as from Toh to T4h, and vice versa for reductions. Maize origin is from point Ozh, top right, with labour in maize measured horizontally to the left and capital in maize read to the right downward. Maize production increases from isoquant such as ZhZh to ZohZoh. Joint optimization positions in factor allocations are shown by infinite isoquant tangencies such as at points Ho and H1. Such optimal positions are traced by the efficiency locus OthHo/H1Ozh. The Box for Foreign can be similarly described although the efficiency locus is missing. The lengths and widths of the Boxes indicate relative factor endowments, with Foreign as a capital abundant country according to endowment inequality [3.62].

The autarky factor optimization positions are at Ho for Home and Fo for Foreign at which equilibrium relative wage lines are tangent to the isoquants for textiles and maize. It can be verified that the relative wage line for Foreign, f, is steeper than that for Home, h, as per inequality [3.62]. At the respective optimal points, full factor employments are:

Home:

[3.65a] LH = Lot + Loz = Lot + (LH Lot)

[3.65b] KH = Kot + Koz = Kot + (KH Kot)

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Foreign:

[3.65c] LF = Lot + Loz = Lot + (LF - Lot)

[3.65d] KF = Kot + Koz = Kot + KF - Lot)

Factor Intensities. The assumption that maize production is more capital intensive than textile production can be verified in the Box diagrams, whereby for Home, technique HZ = OzhHo for maize is steeper than for textiles, HT = OthHo; and for Foreign, FZ = OzfFo > OtfFo = FT.

3.2.3 Autarky Relative Factor Prices and Opportunity Costs

Let us now make a direct link between autarky relative factor costs and opportunity costs in each country. Taking the Home country first, we recall that this is labour abundant with a lower relative wage (labour is relatively cheap) as per inequality [3.62]. Since textiles are labour intensive they will be produced at a relatively lower cost in Home than in Foreign which is labour scarce with a higher relative wage. But maize, which is capital intensive, will be produced expensively in Home which is capital scarce. In the Foreign, maize will be produced there relatively cheaper since it is intensive in capital which than in Home.

In terms of opportuinity costs this result means that the marginal cost of textiles relative to that for maize will be lower in Home than in Foreign economy; that is, textiles will be produced with lower opportunity cost (OC) at home than abroad. Thus:

THZH

TH

ZF

TFTF OCMC

MCMCMCOC =>=]66.3[

3.2.4 Opportunity Costs, Relative Product Prices and Comparative Advantage

Under the perfect competitive market mechanism commodity prices are equated to marginal costs and relative prices to opportunity costs. This is established when each country is maximizing its national welfare subject to its PPF and the solution is obtained at the optimum product mix. This solution is set out in Figure 3.17, which portrays the autarky general equilibria of the two countries. In terms of the shape of the PPFs, we observe the following features: since Home is labour endowed and textiles are labour intensive while Foreign is capital endowed and maize is capital intensive, the increasing opportunity cost PPFs reveal that the relative maximum outputs, or intercepts, are such that FZ/FT > HZ/HT, meaning that Foreign will be producing relatively more maize with respect to textiles than Home, and vice versa. The respective autarky general equilibrium optimization positions are as follows: Home is producing and consuming at point Ho of Toh textiles and Zoh of maize while Foreign is in autarky equilibrium at point Fo. Inequality [3.66a] is depicted by the higher slope of PPF at point F0 than at point H0. Each country is maximizing welfare with highest possible welfare indifference curve of

39

UoUo. In both situations the general equilibrium optimization condition for optimum product mix is satisfied as the three curves are simultaneously tangent to each other. Techically this requires that the slope of the PPF (the rate of produc transformation, RPT), the slope of the indifference curve (rate commodity substitution in consumption or exchange, RSC0 and the slope of the price line (product relative price) be equal.

The comparative advantage gap will be determined by MC pricing by which the autarky relative prices ph = (Pt/Pz)h, and pf = (Pt/Pz)f, will be equal to the respective OCs. Accordingly, it can be observed that the autarky price line for Foreign is steeper than for Home, pf > ph. We then deduce that textiles will be relatively cheaper at Home than in Foreign or that textiles will be relatively more expensive in Foreign than at Home (maize will be relatively cheaper in Foreign than at Home). Thus

HZTHZTTHfTFFZTFZT RSCRPTOCpOCRPTRSC )()(p )()(]67.3[ f ===>===

The logical flow of the HO model of comparative advantage we have just mapped out leads us to state that:

Foreign, which is capital abundant, has comparative advantage in maize, which is capital intensive. Foreign has comparative disadvantage in textile supply which is intensive in labour which is scarce in that country.

Home has comparative advantage in textile production which is intensive in labour, the abundant in that country.

Foreign will export its capital-intensive maize to Home and import the labour intensive textiles in which labour-rich Home has comparative advantage.

Although factors of production are immobile internationally, each country will be indirectly exporting the services of its abundant factors embodied in its exports of goods, and will be indirectly importing the services of scarce factors embodied in its imports of goods.

3.2.5 The Fundamental HO Theorem

The purpose here is to demonstrate algebraically the HO theorem whose logical flow has just been illustrated. We use a general formulation and then be more specific in conclusion. We start with the full-employment equations:

LTlZlbKTkZka

tz

tz

=+

=+

]68.3[]68.3[

This, in matrix form, is represented as:

=

LK

TZ

llkk

tz

tz]69.3[

40

By our working assumption of factor intensities, we know that:

zttzt

t

z

z lklklk

lk

>>]70.3[

We want to get a relationship between commodity ratio Z/T and endowment ratio K/L, and since the latter is known, by the endowment assumption [3.62], we can for now solve for the commodity ratio using the steps that follow. The determinant of the coefficients matrix is: D = kzlt ktlz > 0, by the factor intensities assumption. The solutions for Z and T are:

DKlLkDLlKk

T

DLkKlDlLkK

Za

zz

z

z

ttt

t

/)(/]71.3[

/)(/]71.3[

==

==

Taking the commodity ratio and dividing the result by L, we obtain:

)/()/(]72.3[

LKlkkLKl

KlLkLkKl

TZ

zz

tt

zz

tt

=

=

Differentiating the ratio Z/T with respect to K/L, and simplifying by using factor intensities, the desired result becomes:

tzzz

ttzz

zz

tzzt llLKlklklk

LKlkklkl

LKdTZd

22 )]/([//

)]/([)/()/(]73.3[

=

=

The denominator is unequivocally positive and non-zero while the numerator is the expression for the determinant and factor intensities. It is positive, kz/lz > kt/lt