International economics - theories and policy. Krugman, Appunti di Economia Internazionale

Scarica International economics - theories and policy. Krugman e più Appunti in PDF di Economia Internazionale solo su Docsity! International economics: Chapter 1: Introduction: Historians of economic thought often describe the essay “Of the Balance of Trade” by the Scottish philosopher David Hume as the first real exposition of an economic model. Hume published his essay in 1758, almost 20 years before his friend Adam Smith published The Wealth of Nations. Yet the study of international economics has never been as important as it is now. In the early 21st century, nations are more closely linked than ever before and the global economy created by these linkages is a turbulent place. What is international economy about? International economics uses the same fundamental methods of analysis as other branches of economics because the motives and behaviour of individuals are the same in international trade as they are in domestic transactions. The subject matter of international economics, then, consists of issues raised by the special problems of economic interaction between sovereign states. Seven themes recur throughout the study of international economics: (1) the gains from trade, (2) the pattern of trade, (3) protectionism, (4) the balance of payments, (5) exchange rate determination, (6) international policy coordination, and (7) the international capital market. The gains from trade Everybody knows that some international trade is beneficial. Many people are sceptical, however, about the benefits of trading for goods that a country could produce for itself. Shouldn’t Americans buy American goods whenever possible to help create jobs in the United States? Probably the most important single insight in all of international economics is that there are gains from trade—that is, when countries sell goods and services to each other, this exchange is almost always to their mutual benefit. The range of circumstances under which international trade is beneficial is much wider than most people imagine. Although nations generally gain from international trade, it is quite possible that international trade may hurt particular groups within nations—in other words, that international trade will have strong effects on the distribution of income. The pattern of trade Economists cannot discuss the effects of international trade or recommend changes in government policies toward trade with any confidence unless they know their theory is good enough to explain the international trade that is actually observed. As a result, attempts to explain the pattern of international trade—who sells what to whom—have been a major preoccupation of international economists. How much trade? If the idea of gains from trade is the most important theoretical concept in international economics, the seemingly eternal debate over how much trade to allow is its most important policy theme. Since the emergence of modern nation-states in the 16th century, governments have worried about the effect of international competition on the prosperity of domestic industries and have tried either to shield industries from foreign competition by placing limits on imports or to help them in world competition by subsidizing exports. The single most consistent mission of international economics has been to analyse the effects of these so-called protectionist policies - and usually, though not always, to criticize protectionism and show the advantages of freer international trade. The debate over how much trade to allow took a new direction in the 1990s. After World War II the advanced democracies, led by the United States, pursued a broad policy of removing barriers to international trade; this policy reflected the view that free trade was a force not only for prosperity but also for promoting world peace. In the first half of the 1990s, several major free trade agreements were negotiated. Since then, however, there has been considerable backlash against “globalization.” In 2016, Britain shocked the political establishment by voting to leave the European Union, which guarantees free movement of goods and people among its members. In the real world, however, governments do not necessarily do what the cost-benefit analysis of economists tells them they should. This does not mean that analysis is useless. Economic analysis can help make sense of the politics of international trade policy by showing who benefits and who loses from such government actions as quotas on imports and subsidies to exports. The key insight of this analysis is that conflicts of interest within nations are usually more important in determining trade policy than conflicts of interest between nations. Balance of payments In 1998, both China and South Korea ran large trade surpluses of about $40 billion each. In China’s case, the trade surplus was not out of the ordinary—the country had been running large surpluses for several years, prompting complaints from other countries, including the United States, that China was not playing by the rules. So is it good to run a trade surplus and bad to run a trade deficit? Not according to the South Koreans: Their trade surplus was forced on them by an economic and financial crisis, and they bitterly resented the necessity of running that surplus. This comparison highlights the fact that a country’s balance of payments must be placed in the context of an economic analysis to understand what it means. Exchange rate determination For historical reasons, the study of exchange rate determination is a relatively new part of international economics. For much of modern economic history, exchange rates were fixed by government action rather than determined in the marketplace. Before World War I, the values of the world’s major currencies were fixed in terms of gold; for a generation after World War II, the values of most currencies were fixed in terms of the U.S. dollar. The analysis of international monetary systems that fix exchange rates remains an important subject. International policy coordination The international economy comprises sovereign nations, each free to choose its own economic policies. Unfortunately, in an integrated world economy, one country’s economic policies usually affect other countries as well. Differences in goals among countries often lead to conflicts of interest. Even when countries have similar goals, they may suffer losses if they fail to coordinate their policies. A fundamental problem in international economics is determining how to produce an acceptable degree of harmony among the international trade and monetary policies of different countries in the absence of a world government that tells countries what to do. While cooperation on international trade policies is a well-established tradition, coordination of international macroeconomic policies is a newer and more uncertain topic. Attempts to formulate principles for international macroeconomic coordination date to the 1980s and 1990s and remain controversial to this day. Nonetheless, attempts at international macroeconomic coordination are occurring with growing frequency in the real world. Why does the gravity model work? Broadly speaking, large economies tend to spend large amounts on imports because they have large incomes. They also tend to attract large shares of other countries’ spending because they produce a wide range of products. So, other things equal, the trade between any two economies is larger - the larger is either economy. Using the gravity model: looking for anomalies It’s clear from Figure 2-2 that a gravity model fits the data on U.S. trade with European countries pretty well—but not perfectly. In fact, one of the principal uses of gravity models is that they help us to identify anomalies in trade. Indeed, when trade between two countries is either much more or much less than a gravity model predicts, economists search for the explanation. In the case of both the Netherlands and Belgium, geography and transport costs probably explain their large trade with the United States. Both countries are located near the mouth of the Rhine, Western Europe’s longest river, which runs past the Ruhr, Germany’s industrial heartland. So the Netherlands and Belgium have traditionally been the point of entry to much of north-western Europe. Impediments to trade: distance, barriers and borders All estimated gravity models show a strong negative effect of distance on international trade; typical estimates say that a 1 percent increase in the distance between two countries is associated with a fall of 0.7 to 1 percent in the trade between those countries. This drop partly reflects increased costs of transporting goods and services. Economists also believe that less tangible factors play a crucial role: Trade tends to be intense when countries have close personal contact, and this contact tends to diminish when distances are large. In addition to being U.S. neighbours, Canada and Mexico are part of a trade agreement with the United States, the North American Free Trade Agreement, or NAFTA, which ensures that most goods shipped among the three countries are not subject to tariffs or other barriers to international trade. It’s important to note, however, that although trade agreements often end all formal barriers to trade between countries, they rarely make national borders irrelevant. Even when most goods and services shipped across a national border pay no tariffs and face few legal restrictions, there is much more trade between regions of the same country than between equivalently situated regions in different countries. The Canadian–U.S. border is a case in point. The changing pattern of world trade: Has the world gotten smaller? In popular discussions of the world economy, one often encounters statements that modern transportation and communications have abolished distance, so that the world has become a small place. But have such effects grown weaker over time? The answer is yes—but history also shows that political forces can outweigh the effects of technology. Economic historians tell us that a global economy, with strong economic linkages between even distant nations, is not new. In fact, there have been two great waves of globalization with the first wave relying not on jets and the Internet but on railroads, steamships, and the telegraph. What do we trade? When countries trade, what do they trade? For the world as a whole, the main answer is that they ship manufactured goods such as automobiles, computers, and clothing to each other. However, trade in mineral products - a category that includes every-thing from copper ore to coal, but whose main component in the modern world is oil - remains an important part of world trade. Agricultural products such as wheat, soybeans, and cotton are another key piece of the picture, and services of various kinds play an important role and are widely expected to become more important in the future. Meanwhile, service exports include traditional transportation fees charged by airlines and shipping companies, insurance fees received from foreigners, and spending by foreign tourists. The current picture, in which manufactured goods dominate world trade, is relatively new. In the past, primary products - agricultural and mining goods - played a much more important role in world trade. A more recent transformation has been the rise of third-world exports of manufactured goods. The terms third world and developing countries are applied to the world’s poorer nations, many of which were European colonies before World War II. As recently as the 1970s, these countries mainly exported primary products. Since then, however, they have moved rapidly into exports of manufactured goods. Service offshoring One of the hottest disputes in international economics right now is whether modern information technology, which makes it possible to perform some economic functions at long range, will lead to a dramatic increase in new forms of international trade. When a service previously done within a country is shifted to a foreign location, the change is known as service offshoring (sometimes known as service outsourcing). In addition, producers must decide whether they should set up a foreign subsidiary to provide those services (and operate as a multinational firm) or outsource those services to another firm. The question is how big it might become, and how many workers who currently face no international competition might see that change in the future. One way economists have tried to answer this question is by looking at which services are traded at long distances within the United States. Do old rules still apply? Given all the changes in world trade since Ricardo’s time, can old ideas still be relevant? The answer is a resounding yes. Even though much about international trade has changed, the fundamental principles discovered by economists at the dawn of a global economy still apply. It’s true that world trade has become harder to characterize in simple terms. The sources of modern trade are more subtle. Human resources and human-created resources (in the form of machinery and other types of capital) are more important than natural resources. Political battles over trade typically involve workers whose skills are made less valuable by imports - clothing workers who face competition from imported apparel and tech workers who now face competition from Bangalore. Chapter 3: Labour productivity and comparative advantage: the Ricardian model: Countries engage in international trade for two basic reasons, each of which contributes to their gains from trade. First, countries trade because they are different from each other. Second, countries trade to achieve economies of scale in production. That is, if each country produces only a limited range of goods, it can produce each of these goods at a larger scale and hence more efficiently than if it tried to produce everything. The concept of comparative advantage: A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries. We therefore have an essential insight about comparative advantage and international trade: Trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage. This is a statement about possibilities - not about what will actually happen. In the real world, there is no central authority deciding which country should produce roses and which should produce computers. Nor is there anyone handing out roses and computers to consumers in both places. Instead, international production and trade are determined in the marketplace, where supply and demand rule. This approach, in which international trade is solely due to international differences in the productivity of labour, is known as the Ricardian model. A one-factor economy: To introduce the role of comparative advantage in determining the pattern of international trade, we begin by imagining that we are dealing with an economy - which we call Home - that has only one factor of production. (In Chapter 4 we extend the analysis to models in which there are several factors.) We imagine that only two goods, wine and cheese, are produced. The technology of Home’s economy can be summarized by labour productivity in each industry, expressed in terms of the unit labour requirement, the number of hours of labour required to produce a pound of cheese or a gallon of wine. Production Possibilities. Because any economy has limited resources, there are limits on what it can produce, and there are always trade-offs; to produce more of one good, the economy must sacrifice some production of another good. These trade-offs are illustrated graphically by a production possibility frontier (line PF in Figure 3-1), which shows the maximum amount of wine that can be produced once the decision has been made to produce any given amount of cheese, and vice versa. price is determined by the intersection of RD and RS. First, as drawn, the RS curve shows that there would be no supply of cheese if the world price dropped below aLC/aLW. To see why, recall that we showed that Home will specialize in the production of wine whenever PC/PW < aLC/aLW. Similarly, Foreign will specialize in wine production whenever PC/PW < aLC*/aLW* . At the start of our discussion of equation (3-2), we made the assumption that aLC/aLW < aLC* /aLW* . So at relative prices of cheese below aLC/aLW , there would be no world cheese production. Next, when the relative price of cheese PC/PW is exactly aLC/aLW, we know that workers in Home can earn exactly the same amount making either cheese or wine. So Home will be willing to supply any relative amount of the two goods, producing a flat section to the supply curve. We have already seen that if PC/PW is above aLC/aLW, Home will specialize in the production of cheese. As long as PC/PW < aLC*/aLW* , however, Foreign will continue to specialize in producing wine. When Home specializes in cheese production, it produces L>aLC pounds. Similarly, when Foreign specializes in wine, it produces L*>aLW* gallons. So for any relative price of cheese between aLC>aLW and aLC* >aLW* , the relative supply of cheese is (L>aLC)>(L*>aLW* ). (3-4) At PC/PW = aLC* /aLW* , we know that Foreign workers are indifferent between producing cheese and wine. Thus, here we again have a flat section of the supply curve. Finally, for PC/PW > aLC*/aLW*, both Home and Foreign will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will become infinite. The gains from trade We have now seen that countries whose relative labour productivities differ across industries will specialize in the production of different goods. We next show that both countries derive gains from trade from this specialization. This mutual gain can be demonstrated in two alternative ways. The first way to show that specialization and trade are beneficial is to think of trade as an indirect method of production. Home could produce wine directly, but trade with Foreign allows it to “produce” wine by producing cheese and then trading the cheese for wine. This indirect method of “producing” a gallon of wine is a more efficient method than direct production. Another way to see the mutual gains from trade is to examine how trade affects each country’s possibilities for consumption. In the absence of trade, consumption possibilities are the same as production possibilities (the solid lines PF and P*F* in Figure 3-4). Once trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces. A note on relative wages Political discussions of international trade often focus on comparisons of wage rates in different countries. In our example, once the countries have specialized, all Home workers are employed producing cheese. Since it takes one hour of labour to produce one pound of cheese, workers in Home earn the value of one pound of cheese per hour of their labour. Similarly, Foreign workers produce only wine. The relative wage of a country’s workers is the amount they are paid per hour, compared with the amount workers in another country are paid per hour. It is precisely because the relative wage is between the relative productivities that each country ends up with a cost advantage in one good. Because of its lower wage rate, Foreign has a cost advantage in wine even though it has lower productivity. Home has a cost advantage in cheese, despite its higher wage rate, because the higher wage is more than offset by its higher productivity. We have now developed the simplest of all models of international trade. Misconceptions about comparative advantage: Productivity and competitiveness Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition. This argument seems extremely plausible to many people. The problem with this commentator’s view is that he failed to understand the essential point of Ricardo’s model - that gains from trade depend on comparative rather than absolute advantage. It is always tempting to suppose that the ability to export a good depends on your country having an absolute advantage in productivity. But an absolute productivity advantage over other countries in producing a good is neither a necessary nor a sufficient condition for having a comparative advantage in that good. In our one-factor model, the reason that an absolute productivity advantage in an industry is neither necessary nor sufficient to yield competitive advantage is clear: The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign wage rate. A country’s wage rate, in turn, depends on relative productivity in its other industries. The pauper labour argument Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. This argument, sometimes referred to as the pauper labour argument, is a particular favourited of labour unions seeking protection from foreign competition. People who adhere to this belief argue that industries should not have to cope with foreign industries that are less efficient but pay lower wages. This view is widespread and has acquired considerable political influence. Exploitation Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. This argument is often expressed in emotional terms. For example, one columnist contrasted the multimillion-dollar income of the chief executive officer of the clothing chain The Gap with the low wages - often less than $1 an hour - paid to the Central American workers who produce some of its merchandise. It can seem hard-hearted to try to justify the terrifyingly low wages paid to many of the world’s workers. If one is asking about the desirability of free trade, however, the point is not to ask whether low-wage workers deserve to be paid more but to ask whether they and their country are worse off exporting goods based on low wages than they would be if they refused to enter into such demeaning trade. Adding transport costs and nontraded goods: We now extend our model another step closer to reality by considering the effects of transport costs. Transportation costs do not change the fundamental principles of comparative advantage or the gains from trade. Because transport costs pose obstacles to the movement of goods and services, however, they have important implications for the way a trading world economy is affected by a variety of factors such as foreign aid, international investment, and balance of payments problems. First, notice that the world economy described by the model of the last section is marked by very extreme international specialization. At most, there is one good that both countries produce; all other goods are produced either in Home or in Foreign, but not in both. There are three main reasons why specialization in the real international economy is not this extreme: 1. The existence of more than one factor of production reduces the tendency toward specialization (as we will see in Chapters 4 and 5). 2. Countries sometimes protect industries from foreign competition (discussed at length in Chapters 9 through 12). 3. It is costly to transport goods and services; in some cases the cost of transportation is enough to lead countries into self-sufficiency in certain sectors. The important point is that nations spend a large share of their income on nontraded goods. This observation is of surprising importance in our later discussion of international monetary economics. Empirical evidence on the Ricardian model The Ricardian model of international trade is an extremely useful tool for thinking about the reasons why trade may happen and about the effects of international trade on national welfare. But is the model a good fit to the real world? The answer is a heavily qualified yes. Clearly there are a number of ways in which the Ricardian model makes misleading predictions. First, as mentioned in our discussion of nontraded goods, the simple Ricardian model predicts an extreme degree of specialization that we do not observe in the real world. Second, the Ricardian model assumes away effects of international trade on the distribution of income within countries, and thus predicts that countries as a whole will always gain from trade; in practice, international trade has strong effects on income distribution. Third, the Ricardian model allows no role for differences in resources among countries as a cause of trade, thus missing an important aspect of the trading system. Finally, the Ricardian model neglects the possible role of economies of scale as a cause of trade, which leaves it unable to explain the large trade flows between apparently similar nations. In spite of these failings, however, the basic prediction of the Ricardian model - that countries should tend to export those goods in which their productivity is relatively high - has been strongly confirmed by a number of studies over the years. More recent evidence on the Ricardian model has been less clear-cut. In part, this is because the growth of world trade and the resulting specialization of national economies means that we do not get a chance to see what countries do badly! In the world economy of the 21st century, countries often do not produce goods for which they are at a comparative disadvantage, so there is no way to measure their productivity in those sectors. Perhaps the most striking demonstration of the continuing usefulness of the Ricardian theory of comparative advantage is the way it explains the emergence of countries with very low overall productivity as export powerhouses in some industries. In sum, while few economists believe that the Ricardian model is a fully adequate description of the causes and consequences of world trade, its two principal implications - that productivity differences play an important role in international trade and that it is comparative rather than absolute advantage that matters - do seem to be supported by the evidence. As we have noted, in a two-factor model producers may have room for choice in the use of inputs. What input choice will producers actually make? It depends on the relative costs of capital and labour. If capital rental rates are high and wages low, farmers will choose to produce using relatively little capital and a lot of labour; on the other hand, if the rental rates are low and wages high, they will save on labour and use a lot more capital. If w is the wage rate and r the rental cost of capital, then the input choice will depend on the ratio of these two factor prices, w>r. The relationship between factor prices and the ratio of labour to capital use in production of food is shown in Figure 5-5 as the curve FF. There is a corresponding relationship between w>r and the labour-capital ratio in cloth production. This relationship is shown in Figure 5-5 as the curve CC. As drawn, CC is shifted out relative to FF, indicating that at any given factor prices, production of cloth will always use more labour relative to capital than will production of food. When this is true, we say that production of cloth is labour-intensive, while production of food is capital-intensive. The CC and FF curves in Figure 5-5 are called relative factor demand curves; they are very similar to the relative demand curve for goods. Their downward slope characterizes the substitution effect in the producers’ factor demand. As the wage w rises relative to the rental rate r, producers substitute capital for labour in their production decisions. Then competition among producers in each sector will ensure that the price of each good equals its cost of production. The cost of producing a good depends on factor prices. The importance of a particular factor’s price to the cost of producing a good depends, however, on how much of that factor the good’s production involves. If food production makes use of very little labor, for example, then a rise in the wage will not have much effect on the price of food, whereas if cloth production uses a great deal of labor, a rise in the wage will have a large effect on the price. We can therefore conclude that there is a one-to-one relationship between the ratio of the wage rate to the rental rate, (w>r), and the ratio of the price of cloth to that of food, PC>PF. This relationship is illustrated by the upward-sloping curve SS in Figure 5-6. Let’s look at Figures 5-5 and 5-6 together. In Figure 5-7, the left panel is Figure 5-6 (of the SS curve) turned counter clockwise 90 degrees, while the right panel reproduces Figure 5-5. By putting these two diagrams together, we see what may seem at first to be a surprising linkage of the prices of goods to the ratio of labour to capital used in the production of each good. Suppose the relative price of cloth is (PC>PF) 1 (left panel of Figure 5-7); if the economy produces both goods, the ratio of the wage rate to the capital rental rate must equal (w>r) 1 . This ratio then implies that the ratios of labour to capital employed in the production of cloth and food must be (LC>KC) 1 and (LF>KF) 1 , respectively (right panel of Figure 5-7). If the relative price of cloth were to rise to the level indicated by (PC>PF) 2 , the ratio of the wage rate to the capital rental rate would rise to (w>r) 2 . Because labour is now relatively more expensive, the ratios of labour to capital employed in the production of cloth and food would therefore drop to (LC>KC) 2 and (LF>KF) 2 . We can learn one more important lesson from this diagram. The left panel already tells us that an increase in the price of cloth relative to that of food will raise the income of workers relative to that of capital owners. But it is possible to make a stronger statement: Such a change in relative prices will at producing goods that are intensive in the factors with which the country is relatively well endowed Effects of international trade between two-factor economies: As always, Home and Foreign are similar along many dimensions. They have the same tastes and therefore have identical relative demands for food and cloth when faced with the same relative prices of the two goods. They also have the same technology: A given amount of labour and capital yields the same output of either cloth or food in the two countries. The only difference between the countries is in their resources: Home has a higher ratio of labour to capital than Foreign does. Relative prices and the pattern of trade: Since Home has a higher ratio of labour to capital than Foreign, Home is labour-abundant and Foreign is capital-abundant. Note that abundance is defined in terms of a ratio and not in absolute quantities. Since cloth is the labour-intensive good, Home’s production possibility frontier relative to Foreign’s is shifted out more in the direction of cloth than in the direction of food. Thus, other things equal, Home tends to produce a higher ratio of cloth to food. Because trade leads to a convergence of relative prices, one of the other things that will be equal is the price of cloth relative to that of food. Because the countries differ in their factor abundances, however, for any given ratio of the price of cloth to that of food, Home will produce a higher ratio of cloth to food than Foreign will: Home will have a larger relative supply of cloth. Home’s relative supply curve, then, lies to the right of Foreign’s. The relative supply schedules of Home (RS) and Foreign (RS*) are illustrated in Figure 5-9. The relative demand curve, which we have assumed to be the same for both countries, is shown as RD. If there were no international trade, the equilibrium for Home would be at point 1, and the relative price of cloth would be (PC >PF) 1 . The equilibrium for Foreign would be at point 3, with a relative price of cloth given by (PC >PF) 3 . Thus, in the absence of trade, the relative price of cloth would be lower in Home than in Foreign. When Home and Foreign trade with each other, their relative prices converge. The relative price of cloth rises in Home and declines in Foreign, and a new world relative price of cloth is established at a point somewhere between the pretrade relative prices, say at (PC >PF) 2. Home becomes an exporter of cloth because it is labour- abundant (relative to Foreign) and because the production of cloth is labour-intensive (relative to food production). Similarly, Foreign becomes an exporter of food because it is capital-abundant and because the production of food is capital-intensive Hecksher-Ohlin Theorem: The country that is abundant in a factor exports the good whose production is intensive in that factor. Trade and distribution of income: Previously, we saw that changes in relative prices, in turn, have strong effects on the relative earnings of labour and capital. A rise in the price of cloth raises the purchasing power of labour in terms of both goods while lowering the purchasing power of capital in terms of both goods. A rise in the price of food has the reverse effect. Thus, international trade can have a powerful effect on the distribution of income, even in the long run. In Home, where the relative price of cloth rises, people who get their incomes from labour gain from trade, but those who derive their incomes from capital are made worse off. In Foreign, where the relative price of cloth falls, the opposite happens: Laborers are made worse off and capital owners are made better off. The resource of which a country has a relatively large supply (labour in Home, capital in Foreign) is the abundant factor in that country, and the resource of which it has a relatively small supply (capital in Home, labour in Foreign) is the scarce factor. The general conclusion about the income distribution effects of international trade in the long run is: Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose. Skill-biased technological change and income inequality: We now extend our two- factor production model to incorporate technological change that is skill-biased. Consider the variant of our two-good, two-factor model where skilled and unskilled labour are used to produce “high-tech” and “low-tech” goods. Figure 5-10 shows the relative factor demands for producers in both sectors: the ratio of skilled-unskilled workers employed as a function of the skilled-unskilled wage ratio (LL curve for low-tech and HH for high- tech). We have assumed that production of high-tech goods is skilled-labour intensive, so the HH curve is shifted out relative to the LL curve. In the background, an SS curve (see Figures 5-6 and 5- 7) determines the skilled-unskilled wage ratio as an increasing function of the relative price of high- tech goods (with respect to low-tech goods). In panel (a), we show the case where increased trade with developing countries generates an increase in wage inequality (the skilled-unskilled wage ratio) in those countries (via an increase in the relative price of high-tech goods). The increase in the relative cost of skilled workers induces producers in both sectors to reduce their employment of skilled workers relative to unskilled workers. In panel (b), we show the case where technological change in both sectors generates an increase in wage inequality. This technology change is classified as “skill-biased” because it shifts out the relative demand for skilled workers in both sectors (both the LL and the HH curves shift out). Even though skilled labour is relatively more expensive, producers in both sectors respond to the technological change by increasing their employment of skilled workers relative to unskilled workers. We can now examine the relative assessed factor abundance by comparing a country’s endowment of a factor (as a share of the world’s supply of that factor) with the country’s share of world GDP. The Case of the Missing Trade. Another indication of large technology differences across countries comes from discrepancies between the observed volumes of trade and those predicted by the Heckscher-Ohlin model. In an influential paper, Daniel Trefler at the University of Toronto pointed out that the Heckscher-Ohlin model can also be used to derive predictions for a country’s volume of trade based on differences in that country’s factor abundance with that of the rest of the world (since, in this model, trade in goods is substituting for trade in factors). In fact, factor trade turns out to be substantially smaller than the Heckscher-Ohlin model predicts. A large part of the reason for this disparity comes from a false prediction of largescale trade in labour between rich and poor nations. Trefler showed that allowing for technology differences across countries helped to resolve the predictive success of both the sign test for the direction of the factor content of trade as well as the missing trade. A Better Empirical Fit for the Factor Content of Trade. Subsequently, an important study by Donald Davis and David Weinstein at Columbia University showed that if one relaxes this assumption on common technologies along with the remaining two assumptions underlying factor- price equalization (countries produce the same set of goods and costless trade equalizes goods prices), then the predictions for the direction and volume of the factor content of trade line up substantially better with the empirical evidence— ultimately generating a good fit. In the first column of Table 5-4, all three assumptions behind factor-price equalization are imposed. This test is very similar to the one performed by Bowen et although the predictive success for the sign test is substantially worse. This is due to the different sample of countries and factors considered, and data cleaning procedures based on the newly available information on production techniques. We also see the extent of the missing trade: virtually all of the predicted volume of factor trade is missing. These results confirm once more that this strict test for the Heckscher-Ohlin model performs very poorly. The results in the second column were obtained once the assumption of common technologies was dropped, as in the study by Trefler. There is a substantial improvement in both empirical tests, although their overall predictive success is still quite weak. In the third column, the assumption that countries produce the same set of goods is also dropped. We see how this induces a massive improvement for the predictive success of the sign test for the direction of the factor content of trade. The extent of missing trade is also vastly reduced, though the observed trade volume still represents only 19 percent of predicted trade. In the fourth and last column, the assumption of goods-price equalization via costless trade is also dropped. The predictive success for the direction of trade increases further to 91 percent. At this point, we can say that the Leontief paradox is relegated to a statistical anomaly. Patterns of Exports between Developed and Developing Countries: Another way to see how differences in factor proportions shape empirical trade patterns is to contrast the exports of labour-abundant, skill-scarce nations in the developing world with the exports of skill-abundant, labour-scarce nations. In our “2 by 2 by 2” theoretical model (2 goods, 2 countries, 2 factors), we obtained the Heckscher-Ohlin theorem stating that the country abundant in a factor exports the good whose production is intensive in that factor. A paper by John Romalis at the University of Sydney showed how this prediction for the pattern of exports can be extended to multiple countries producing multiple goods: As a country’s skill abundance increases, its exports are increasingly concentrated in sectors with higher skill intensity. Figure 5-13 contrasts the exports of three developing countries (Bangladesh, Cambodia, and Haiti) at the lower end of the skill-abundance spectrum with the three largest European economics (Germany, France, and the United Kingdom) at the upper end of the skill-abundance spectrum. The countries’ exports to the United States by sector are partitioned into four groups in increasing order of skill intensity. These are the same four sector groups used in Figure 5-11. Figure 5-13 clearly shows how the exports of the three developing countries to the United States are overwhelmingly concentrated in sectors with the lowest skill-intensity. Their exports in high skill-intensity sectors are virtually nil. The contrast with the export pattern for the three European countries is apparent: The exports to the United States for those skill-abundant countries are concentrated in sectors with higher skill intensity. Changes over time also follow the predictions of the Heckscher-Ohlin model. Consider the experience of China over the last three decades, where high growth (especially in the last decade and a half) has been associated with substantial increases in skill abundance. Figure 5-14 shows how the pattern of Chinese exports to the United States by sector has changed over time. We clearly see how the pattern of Chinese exports has fundamentally shifted: As predicted by the Chinese change in factor proportions, the concentration of exports in high-skill sectors steadily increases over time. In the most recent years, we see how the greatest share of exports is transacted in the highest skill-intensity sectors—whereas exports were concentrated in the lowest skill-intensity sectors in the earlier years. Implication of tests: We do not observe factor-price equalization across countries. When we test the “pure” version of the Heckscher-Ohlin model that maintains all the assumptions behind factor-price equalization, we find that a country’s factor content of trade bears little resemblance to the theoretical predictions based on that country’s factor abundance. However, a less restrictive version of the factor proportions model fits the predicted patterns for the factor content of trade. The pattern of goods trade between developed and developing countries also fits the predictions of the model quite well. Lastly, the Heckscher-Ohlin model remains vital for understanding the effects of trade, especially on the distribution of income. Chapter 4: Specific factor and income distribution: The Ricardian model of international trade developed before illustrates the potential benefit from trade. In that model, trade leads to international specialization, with each country shifting its labour force from industries in which that labour is relatively inefficient to industries in which it is relatively more efficient. Because labour is the only factor of production in that model, and it is assumed that labour can move freely from one industry to another, there is no possibility that individuals will be hurt by trade. In the real world, however, trade has substantial effects on the income distribution within each trading nation. There are two main reasons why international trade has strong effects on the distribution of income. First, resources cannot move immediately of without cost from one industry to another. Second, industries differ in the factor of production they demand. While trade may benefit a nation as a whole, it often hurts significant groups within the country in the short run, and potentially, but to a lesser extent, in the long run. In this chapter we focus on the short-run consequences of trade on the income distribution when factors of production cannot move without cost between sectors. To keep our model simple, we assume that the sector switching cost for some factors is high enough that such a switch is impossible in the short run. Those factors are specific to a particular sector. diminishing returns to labour in each sectors. These diminishing returns are the crucial difference between the specific factors and the Ricardian model. The slope of PP, which measures the opportunity cost of cloth in terms of food, that is the number of units of food output that must be sacrificed to increase cloth output by one unit, is therefore: The economy always produces at the point on its production possibility frontier (PP) where the slope of PP equals minus the relative price of cloth. Thus an increase in Pc>Pf causes production to move down and to the right along the production possibility frontier corresponding to higher output of cloth and lower output of food. Owners of capital are definitely better off. The real wage rate in terms of cloth has fallen so the profit of capital owners in terms of what they produce rises more than proportionately with the rise in Pc. Conversely, landowners are definitely worse off. The effect of a relative price change on the distribution of income can be summarized as follows: the factor specific to the sector whose relative price increases is definitely better off, the factor specific to the sector whose relative price decreases is definitely worse off, the change in welfare for the mobile factor is ambiguous. We now want to link the relative price change with international trade and match up the predictions for winners and losers with the trade orientation of a sector. For trade to take place, a country must face a world relative price that differs from the relative price that would prevail in the absence of trade. Why might the relative supply curve for the world be different from that for our specific factor economy? The other countries in the world could have different technologies as in the Ricardo model. Now that our model has more than on factor of production, however, the other countries could also differ in their resources: the total amounts of land, capital and labour available. When the economy is open to trade, the relative price of cloth is determined by the relative supply and demand for the world (point 2). If the economy could not trade then the relative price would be lower at 1. The increase in the relative price from 1 to 2 induces the economy to produce relatively more cloth. At the same time, consumers respond to the higher relative price of cloth by demanding relatively more food. At the higher relative price 2 the economy thus exports cloth and imports food. An economy exports the good whose relative price has increased and imports the good whose relative price has decreased. Trade often produces losers as well as winners. This insight is crucial to understanding the considerations that actually determine trade policy in the modern world economy. Those who stand to lose most from trade are the immobile factors in the import- competing sector. In spite of the real importance of income distribution, most economist remain strongly in favour of more or less free trade. There are three main reasons why economists do not generally stress the income distribution effects of trade: 1.     Income distribution effects are not specific to international trade. Every change in a nation’s economy affects income distribution. 2.     It is always better to allow trade and compensate those who are hurt by it than to prohibit the trade. 3.     Those who stand to lose from increased trade are typically better organized than those who stand to gain, because the former are more concentrated within regions and industries. Typically, those who gain from trade in any particular product are a much less concentrated, informed , and organized group than those who lose.  Chapter 6: The standard trade model: A standard model of a trading economy: The standard trade model is built on four key relationships: (1) the relationship between the production possibility frontier and the relative supply curve; (2) the relationship between relative prices and relative demand; (3) the determination of world equilibrium by world relative supply and world relative demand; and (4) the effect of the terms of trade - the price of a country’s exports divided by the price of its imports—on a nation’s welfare. Production possibilities and relative supply: For the purposes of our standard model, we assume that each country produces two goods, food (F ) and cloth (C), and that each country’s production possibility frontier is a smooth curve like that illustrated by TT in Figure 6-1.1 The point on its production possibility frontier at which an economy actually produces depends on the price of cloth relative to food, PC>PF. We can indicate the market value of output by drawing a number of isovalue lines - that is, lines along which the value of output is constant. Now suppose that PC>PF were to rise (cloth becomes more valuable relative to food). Then the isovalue lines would be steeper than before. In Figure 6-2, the highest isovalue line the economy could reach before the change in PC>PF is shown as VV1; the highest line after the price change is VV2, the point at which the economy produces shifts from Q1 to Q2. Thus, as we might expect, a rise in the relative price of cloth leads the economy to produce more cloth and less food. The relative supply of cloth will therefore rise when the relative price of cloth rises. This relationship between relative prices and relative production is reflected in the economy’s relative supply curve shown in Figure 6-2b. QC*. The food market is also in equilibrium so that Home’s desired imports of food, DF - QF, match up with Foreign’s desired food exports, QF*-DF*. The production possibility frontiers for Home and Foreign, along with the budget constraints and associated production and consumption choices at the equilibrium relative price (PC>PF) 1, are illustrated in panel (b). Now that we know how relative supply, relative demand, the terms of trade, and welfare are determined in the standard model, we can use it to understand a number of important issues in international economics. Economic growth: a shift of the RS curve: The effects of economic growth in a trading world economy are a perennial source of concern and controversy. The debate revolves around two questions. First, is economic growth in other countries good or bad for our nation? Second, is growth in a country more or less valuable when that nation is part of a closely integrated world economy? In assessing the effects of growth in other countries, common sense arguments can be made on either side. On one side, economic growth in the rest of the world may be good for our economy because it means larger markets for our exports and lower prices for our imports. On the other side, growth in other countries may mean increased com- petition for our exporters and domestic producers, who need to compete with foreign exporters. We can find similar ambiguities when we look at the effects of growth at Home. Economic growth and the production possibility frontier: Economic growth means an outward shift of a country’s production possibility frontier. This growth can result either from increases in a country’s resources or from improvements in the efficiency with which these resources are used. The international trade effects of growth result from the fact that such growth typically has a bias. Biased growth takes place when the production possibility frontier shifts out more in one direction than in the other. Growth may be biased for two main reasons: - The Ricardian model of Chapter 3 showed that technological progress in one sector of the economy will expand the economy’s production possibilities in the direction of that sector’s output. - The Heckscher-Ohlin model of Chapter 5 showed that an increase in a country’s supply of a factor of production will produce biased expansion of production possibilities. The bias will be in the direction of either the good to which the factor is specific or the good whose production is intensive in the factor whose supply has increased. World relative supply and the terms of trade: Suppose now that Home experiences growth strongly biased toward cloth, so that its output of cloth rises at any given relative price of cloth, while its output of food declines. Then the output of cloth relative to food will rise at any given price for the world as a whole, and the world relative supply curve will shift to the right, just like the relative supply curve for Home. It results in a decrease in the relative price of cloth from (PC>PF) 1 to (PC>PF) 2, a worsening of Home’s terms of trade and an improvement in Foreign’s terms of trade. Growth that disproportionately expands a country’s production possibilities in the direction of the good it exports (cloth in Home, food in Foreign) is export-biased growth. Similarly, growth biased toward the good a country imports is import-biased growth. Our analysis leads to the following general principle: Export-biased growth tends to worsen a growing country’s terms of trade, to the benefit of the rest of the world; import- biased growth tends to improve a growing country’s terms of trade at the rest of the world’s expense. International effects of growth: Using this principle, we are now in a position to resolve our questions about the international effects of growth. Is growth in the rest of the world good or bad for our country? In each case the answer depends on the bias of the growth. Export-biased growth in the rest of the world is good for us, improving our terms of trade, while import-biased growth abroad worsens our terms of trade. Export-biased growth in our own country worsens our terms of trade, reducing the direct benefits of growth, while import-biased growth leads to an improvement of our terms of trade, a secondary benefit. During the 1950s, many economists from poorer countries believed that their nations, which primarily exported raw materials, were likely to experience steadily declining terms of trade over time. They believed that growth in the industrial world would be marked by an increasing development of synthetic substitutes for raw materials, while growth in the poorer nations would take the form of a further extension of their capacity to produce what they were already exporting rather than a move toward industrialization. That is, the growth in the industrial world would be import-biased, while that in the less-developed world would be export-biased. Some analysts even suggested that growth in the poorer nations would actually be self-defeating. They argued that export-biased growth by poor nations would worsen their terms of trade so much that they would be worse off than if they had not grown at all. This situation is known to economists as the case of immiserating growth. Tariffs and export subsidies: simultaneous shift in RS and RD: Import tariffs (taxes levied on imports) and export subsidies (payments given to domestic producers who sell a good abroad) are not usually put in place to affect a country’s terms of trade. These government interventions in trade usually take place for income distribution, for the promotion of industries thought to be crucial to the economy, or for balance of payments. The distinctive feature of tariffs and export subsidies is that they create a difference between prices at which goods are traded on the world market and prices at which those goods can be purchased within a country. The direct effect of a tariff is to make imported goods more expensive inside a country than they are outside the country. An export subsidy gives producers an incentive to export. It will therefore be more profitable to sell abroad than at home unless the price at home is higher, so such a subsidy raises the prices of exported goods inside a country. Note that this is very different from the effects of a production subsidy, which also lowers domestic prices for the affected goods. Relative demand and supply effects of a tariff: Tariffs and subsidies drive a wedge between the prices at which goods are traded internationally (external prices) and the prices at which they are traded within a country (internal prices). This means that we have to be careful in defining the terms of trade, which are intended to measure the ratio at which countries exchange goods. When analysing the effects of a tariff or export subsidy, therefore, we want to know how that tariff or subsidy affects relative supply and demand as a function of external prices. If Home imposes a 20 percent tariff on the value of food imports, for example, the internal price of food relative to cloth faced by Home producers and consumers will be 20 percent higher than the external relative price of food on the world market. Equivalently, the internal relative price of cloth on which Home residents base their decisions will be lower than the relative price on the external market. At any given world relative price of cloth, then, Home producers will face a lower relative cloth price and therefore will produce less cloth and more food. At the same time, Home consumers will shift their consumption toward cloth and away from food. The extent of this terms of trade effect depends on how large the country imposing the tariff is relative to the rest of the world: If the country is only a small part of the world, it cannot have much effect on world relative supply and demand and therefore cannot have much effect on relative prices. Effect of an export subsidy: Tariffs and export subsidies are often treated as similar policies, since they both seem to support domestic producers, but they have opposite effects on the terms of trade. Suppose that Home offers a 20 percent subsidy on the value of any cloth exported. For any given world prices, this subsidy will raise Home’s internal price of cloth relative to that of food by 20 percent. The rise in the relative price of cloth will lead Home producers to produce more cloth and less food, while leading Home consumers to substitute food for cloth. Implications of terms of trade effect: who gains and who loses? efficient than an individual firm in isolation: the ability of a cluster to support specialized suppliers; the way that a geographically concentrated industry allows labour market pooling; and the way that a geographically concentrated industry helps foster knowledge spillovers. These same factors continue to be valid today. Specialized suppliers: In many industries, the production of goods and services—and to an even greater extent, the development of new products—requires the use of specialized equipment or support services; yet 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 collectively provide a large enough market to support a wide range of specialized suppliers. Key inputs are cheaper and more easily available because there are many firms competing to provide them, and firms can concentrate on what they do best, contracting out other aspects of their business. Labour market pooling: A second source of external economies is the way that a cluster of firms can create a pooled market for workers with highly specialized skills. Such a pooled market is to the advantage of both the producers and the workers, as the producers are less likely to suffer from labour shortages and the workers are less likely to become unemployed. Knowledge spillovers: It is by now a cliché that in the modern economy, knowledge is at least as important an input as are factors of production like labour, capital, and raw materials. This is especially true in highly innovative industries, where being even a few months behind the cutting edge in production techniques or product design can put a company at a major disadvantage. But where does the specialized knowledge that is crucial to success in innovative industries come from? Companies can acquire technology through their own research and development efforts. They can also try to learn from competitors by studying their products and, in some cases, by taking them apart to “reverse engineer” their design and manufacture. An important source of technical know-how, however, is the informal exchange of information and ideas that takes place at a personal level. And this kind of informal diffusion of knowledge often seems to take place most effectively when an industry is concentrated in a fairly small area, so that employees of different companies mix socially and talk freely about technical issues. External economies and market equilibrium: As we’ve just seen, a geographically concentrated industry is able to support specialized suppliers, provide a pooled labour market, and facilitate knowledge spillovers in a way that a geographically dispersed industry cannot. But the strength of these economies presumably depends on the industry’s size: Other things equal, a bigger industry will generate stronger external economies. What does this say about the determination of output and prices? If we ignore international trade for the moment, then market equilibrium can be represented with a supply-and-demand diagram. widgets. In an ordinary picture of market equilibrium, the demand curve is downward sloping, while the supply curve is upward sloping. In the presence of external economies of scale, however, there is a forward-falling supply curve: the larger the industry’s output, the lower the price at which firms are willing to sell, because their average cost of production falls as industry output rises. External economies and international trade: External economies drive a lot of trade both within and between countries. But what are the implications of this kind of trade? External economies, output, and prices: Imagine, for a moment, we live in a world in which it is impossible to trade buttons across national borders. Assume, also, there are just two countries in this world: China and the United States. Finally, assume button production is subject to external economies of scale, which lead to a forward-falling supply curve for buttons in each country. In both China and the United States, equilibrium prices and output would be at the point where the domestic supply curve intersects the domestic demand curve. Now suppose we open up the potential for trade in buttons. What will happen? It seems clear that the Chinese button industry will expand, while the U.S. button industry will contract. And this process will feed on itself: As the Chinese industry’s output rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. In the end, we can expect all button production to be concentrated in China. Notice the effects of this concentration of production on prices. Because China’s supply curve is forward-falling, increased production as a result of trade leads to a button price that is lower than the price before trade. And bear in mind that Chinese button prices were lower than American button prices before trade. What this tells us is that trade leads to button prices that are lower than the prices in either country before trade. This is very different from the implications of models without increasing returns. External economies and the pattern of trade: In our example of world trade in buttons, we simply assumed the Chinese industry started out with lower production costs than the American industry. What might lead to such an initial advantage? One possibility is comparative advantage—underlying differences in technology and resources. Button production is a labour-intensive industry, which is best conducted in a country where the average manufacturing worker earns less than a dollar an hour rather than in a country where hourly compensation is among the highest in the world. However, in industries characterized by external economies of scale, comparative advantage usually provides only a partial explanation of the pattern of trade. It was probably inevitable that most of the world’s buttons would be made in a relatively low-wage country, but it’s not clear that this country necessarily had to be China. The answer, often, is historical contingency: Something gives a particular location an initial advantage in a particular industry, and this advantage gets “locked in” by external economies of scale even after the circumstances that created the initial advantage are no longer relevant. One consequence of the role of history in determining industrial location is that industries aren’t always located in the “right” place: Once a country has established an advantage in an industry, it may retain that advantage even if some other country could potentially produce the goods more cheaply. As this example shows, external economies potentially give a strong role to historical accident in determining who produces what, and may allow established patterns of specialization to persist even when they run counter to comparative advantage. Trade and welfare with external economies: In general, we can presume that external economies of scale lead to gains from trade over and above those from comparative advantage. The world is more efficient and thus richer because international trade allows nations to specialize in different industries and thus reap the gains from external economies as well as from comparative advantage. However, there are a few possible qualifications to this presumption. the importance of established advantage means that there is no guarantee that the right country will produce a good subject to external economies. In fact, it is possible that trade based on external economies may actually leave a country worse off than it would have been in the absence of trade. Dynamic increasing returns: Some of the most important external economies probably arise from the accumulation of knowledge. When an individual firm improves its products or production techniques through experience, other firms are likely to imitate the firm and benefit from its knowledge. This spillover of knowledge gives rise to a situation in which the production costs of individual firms fall as the industry as a whole accumulates experience. Notice that external economies arising from the accumulation of knowledge differ somewhat from the external economies considered so far, in which industry cost depend on current output. In this alternative situation, industry costs depend on experience, usually measured by the cumulative output of the industry to date. For example, the cost of producing a ton of steel might depend negatively on the total number of tons of steel produced by a country since the industry began. This kind of relationship is often summarized by a learning curve that relates unit cost to cumulative output. They are downward sloping because of the effect on costs of the experience gained through production. When costs fall with cumulative production over time rather than with the current rate of production, this is referred to as a case of dynamic increasing returns. Dynamic scale economies, like external economies at a point in time, potentially justify protectionism. Suppose a country could have low enough costs to produce a good for export if it had more production experience, but given the current lack of experience, the good cannot be produced competitively. Such a country might increase its long-term welfare either by encouraging the production of the good by a subsidy or by protecting it from foreign competition until the industry can stand on its own feet. The argument for temporary protection of industries to enable them to gain experience is known as the infant industry argument; this argument has played an important role in debates over the role of trade policy in economic development. Interregional trade and economic geography: External economies play an important role in shaping the pattern of international trade, but they are even more decisive in shaping the pattern of interregional trade - trade that takes place between regions within countries. To understand the role of external economies in interregional trade, we first need to discuss the nature of regional economics - that is, how the economies of regions within a nation fit into the national economy. Resources, then, play a secondary role in interregional trade. What largely drives specialization and trade, instead, is external economies. But if external economies are the main reason for regional specialization and inter-regional trade, what explains how a particular region develops the external economies that support an industry? The answer, in general, is that accidents of history play a crucial role. A question you might ask is whether the forces driving interregional trade are really all that different from those driving international trade. The answer is that they are not, especially when one looks at trade between closely integrated national economies, such as those of Western Europe. In recent years, there has been a growing movement among economists to model interregional and international trade, as well as such phenomena as the rise of cities, as different aspects of the same phenomenon—economic interaction across space. Such an approach is often referred to as economic geography. Chapter 8: firms in the global economy: export decisions, outsourcing, and multinational enterprises: The theory of imperfect competition: In a perfectly competitive market—a market in which there are many buyers and sellers, none of whom represents a large part of the market—firms are price takers. That is, they are sellers of products who believe they can sell as much as they like at the current price but cannot influence the price they receive for their product. In imperfect competition, then, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price. This products than consumers in small markets. The size of the market does not enter into this equation, so an increase in S does not shift the PP curve. Figure 8-4 uses this information to show the effect of an increase in the size of the market on long-run equilibrium. Initially, equilibrium is at point 1, with a price P1 and a number of firms n1. An increase in the size of the market, measured by industry sales S, shifts the CC curve down from CC1 to CC2, while it has no effect on the PP curve. The new equilibrium is at point 2: The number of firms increases from n1 to n2, while the price falls from P1 to P2. Clearly, consumers would prefer to be part of a large market rather than a small one. The significance of intra-industry trade: The proportion of intra-industry trade in world trade has steadily grown over the last half-century. The measurement of intra-industry trade relies on an industrial classification system that categorizes goods into different industries. Depending on the coarseness of the industrial classification used, intra-industry trade accounts for one-quarter to nearly one-half of all world trade flows. Intra- industry trade plays an even more prominent role in the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade. What about the new types of welfare gains via increased product variety and economies of scale? Prior to integration, production there was particularly inefficient, as the economy could not take advantage of economies of scale in production due to the country’s small size. This is exactly what happened when the United States and Canada followed a path of increasing economic integration starting with the North American Auto Pact in 1964 (which did not include Mexico) and culminating in the North American Free Trade Agreement (NAFTA, which does include Mexico). Similar gains from trade have also been measured for other real-world examples of closer economic integration. One of the most prominent examples has taken place in Europe over the last half-century. In 1957, the major countries of Western Europe established a free trade area in manufactured goods called the Common Market, or European Economic Community (EEC). Firm responses to trade: winners, losers and industry performance: In the real world, however, performance varies widely across firms, so the effects of increased competition from trade are far from inconsequential. As one would expect, increased competition tends to hurt the worst-performing firms the hardest because they are the ones who are forced to exit. If the increased competition comes from trade (or economic integration), then it is also associated with sales opportunities in new markets for the surviving firms. Again, as one would expect, it is the best-performing firms that take greatest advantage of those new sales opportunities and expand the most. These composition changes have a crucial consequence at the level of the industry: when the better-performing firms expand and the worse-performing ones contract or exit, then overall industry performance improves. This means that trade and economic integration can have a direct impact on industry performance: it is as if there was technological growth at the level of the industry. Empirically, these composition changes generate substantial improvements in industry productivity. Performance differences across producers: We now relax the symmetry assumption we imposed in our previous development of the monopolistic competition model so that we can examine how competition from increased market size affects firms differently. The symmetry assumption meant that all firms had the same cost curve and the same demand curve. Suppose now that firms have different cost curves because they produce with different marginal cost levels ci. We assume all firms still face the same demand curve. Product-quality differences between firms would lead to very similar predictions for firm performance as the ones we now derive for cost differences. The effects of increased market size: Panel (b) of Figure 8-6 summarizes the industry equilibrium given a market size S. It tells us which firms survive and produce (with cost ci below c*) and how their profits will vary with their cost levels ci. What happens when economies integrate into a single larger market? As was the case with symmetric firms, a larger market can support a larger number of firms than can a smaller market. This leads to more competition in addition to the direct effect of increased market size S. As we will see, these changes will have very different repercussions on firms with different production costs. Figure 8-7 summarizes those repercussions induced by market integration. In panel (a), we start with the demand curve D faced by each firm. All else equal, we expect increased competition to shift demand in for each firm. On the other hand, we also expect a bigger market size S, on its own, to move demand out. This intuition is correct and leads to the overall change in demand from D to D′ shown in panel (a). Notice how the demand curve rotates, inducing an inward shift for the smaller firms as well as an outward shift for the larger firms. In essence, the effects of increased competition dominate for those smaller firms whereas the effects of increased market size are dominant for the larger firms. The direct effect of increased market size S flattens the demand curve (lower slope), leaving the intercept unchanged: This generates an outward rotation of demand. Combining these two effects, we obtain the new demand curve D′, which has a lower vertical intercept and is flatter than the original demand curve D. Panel (b) of Figure 8-7 shows the consequences of this demand change for the operating profits of firms with different cost levels ci. The decrease in demand for the smaller firms translates into a new, lower-cost cut off, c*: some firms with the high cost levels above c* cannot survive the decrease in demand and are forced to exit. On the other hand, the flatter demand curve is advantageous to some firms with low cost levels: They can adapt to the increased competition by lowering their markup (and hence their price) and gain some additional market share. This translates into increased profits for some of the best-performing firms with the lowest cost levels ci. Trade costs and export decisions: Up to now, we have modelled economic integration as an increase in market size. This implicitly assumes that this integration occurs to such an extent that a single combine market is formed. In reality, integration rarely goes that far: Trade costs among countries are reduced, but they do not disappear. Trade costs associated with this border crossing are also a salient feature of firm-level trade patterns. In our integrated economy without any trade costs, firms were indifferent as to the location of their customers. We now introduce trade costs to explain why firms actually do care about the location of their customers and why so many firms choose not to reach customers in on the production cost differentials on one hand, and the fixed cost of operating a foreign affiliate on the other hand. Only those firms operating at a scale above that cut-off will choose to perform vertical FDI. Outsourcing: Our discussion of multinationals up to this point has neglected an important motive. We discussed the location motive for production facilities that leads to multinational formation. However, we did not discuss why the parent firm chooses to own the affiliate in that location and operate as a single multinational firm. This is known as the internalization motive. As a substitute for horizontal FDI, a parent could license an independent firm to produce and sell its products in a foreign location; as a substitute for vertical FDI, a parent could contract with an independent firm (supplier) to perform specific parts of the production process in the foreign location with the best cost advantage. This substitute for vertical FDI is known as foreign outsourcing (sometimes just referred to as outsourcing, where the foreign location is implied). Offshoring represents the relocation of parts of the production chain abroad and groups together both foreign outsourcing and vertical FDI. Offshoring has increased dramatically in the last decade and is one of the major drivers of the increased world-wide trade in services (such as business and telecommunications services); in manufacturing, trade in intermediate goods accounted for 40 percent of worldwide trade in 2008. Licensing another firm to perform the entire production process in another location (as a substitute for horizontal FDI) often involves a substantial risk of losing some proprietary technology. On the other hand, there are no clear reasons why an independent firm should be able to replicate that production process at a lower cost than the parent firm. This gives internalization a strong advantage; so horizontal FDI is widely favoured over the alternative of technology licensing to replicate the production process. The trade-off between outsourcing and vertical FDI is much less clear-cut. There are many reasons why an independent firm could produce some parts of the production process at lower cost than the parent firm (in the same location). First and foremost, an independent firm can specialize in exactly that narrow part of the production process. As a result, it can also benefit from economies of scale if it performs those processes for many different parent firms.33 Other reasons stress the advantages of local ownership in the alignment and monitoring of managerial incentives at the production facility. But internalization also provides its own benefits when it comes to vertical integration between a firm and its supplier of a critical input to production: This avoids the potential for a costly renegotiation conflict after an initial agreement has been reached. Consequences of multinational and foreign outsourcing: What are the consequences for welfare of the expansion in multinational production and outsourcing? We just saw how multinationals and firms that outsource take advantage of cost differentials that favour moving production (or parts thereof) to particular locations. In essence, this is very similar to the relocation of production that occurred across sectors when opening to trade. We can therefore predict similar welfare consequences for the case of multinationals and outsourcing: Relocating production to take advantage of cost differences leads to overall gains from trade, but it is also likely to induce income distribution effects that leave some people worse off. Yet some of the most visible effects of multinationals and offshoring more generally occur in the short run, as some firms expand employment while others reduce employment in response to increased globalization. The costs associated with displacements linked to offshoring are just as severe for workers with similar characteristics. Policies that impede firms’ abilities to relocate production and take advantage of these cost differences may prevent these short-run costs for some, but they also forestall the accumulation of long-run economy wide gains. Chapter 9: The instruments of trade policy: Basic tariff analysis: A tariff, the simplest of trade policies, is a tax levied when a good is imported. Specific tariffs are levied as a fixed charge for each unit of goods imported. Ad valorem tariffs are taxes that are levied as a fraction of the value of the imported goods. In either case, the effect of the tariff is to raise the cost of shipping goods to a country. Tariffs are the oldest form of trade policy and have traditionally been used as a source of government income. Their true purpose, however, has usually been twofold: to provide revenue and to protect domestic sectors. In the early 19th century, for example, the United Kingdom used tariffs (the famous Corn Laws) to protect its agriculture from import competition. The importance of tariffs has declined in modern times because modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such as import quotas (limitations on the quantity of imports) and export restraints (limitations on the quantity of exports—usually imposed by the exporting country at the importing country’s request). Supply, demand, and trade in a single industry: Let’s suppose there are two countries, Home and Foreign, both of which consume and produce wheat, which can be costlessly transported between the countries. In each country, wheat is a simple competitive industry in which the supply and demand curves are functions of the market price. Normally, Home supply and demand will depend on the price in terms of Home currency, and Foreign supply and demand will depend on the price in terms of Foreign currency. However, we assume the exchange rate between the currencies is not affected by whatever trade policy is undertaken in this market. Thus, we quote prices in both markets in terms of Home currency. Trade will arise in such a market if prices are different in the absence of trade. Suppose that in the absence of trade, the price of wheat is higher in Home than it is in Foreign. Now let’s allow foreign trade. Since the price of wheat in Home exceeds the price in Foreign, shippers begin to move wheat from Foreign to Home. The export of wheat raises its price in Foreign and lowers its price in Home until the difference in prices has been eliminated. To determine the world price and the quantity traded, it is helpful to define two new curves: the Home import demand curve and the Foreign export supply curve, which are derived from the underlying domestic supply and demand curves. Home import demand is the excess of what Home consumers demand over what Home producers supply; Foreign export supply is the excess of what Foreign producers supply over what Foreign consumers demand. Figure 9-1 shows how the Home import demand curve is derived. At the price P1, Home consumers demand D1, while Home producers supply only S1. As a result, Home import demand is D1 - S1. If we raise the price to P2, Home consumers demand only D2, while Home producers raise the amount they supply to S2, so import demand falls to D2 - S2. These price-quantity combinations are plotted as points 1 and 2 in the right-hand panel of Figure 9-1. The import demand curve MD is downward sloping because as price increases, the quantity of imports demanded declines. At PA, Home supply and demand are equal in the absence of trade, so the Home import demand curve intercepts the price axis at PA (import demand = zero at PA). Figure 9-2 shows how the Foreign export supply curve XS is derived. At P1 Foreign producers supply S*1, while Foreign consumers demand only D*1, so the amount of the total supply available for export is S*1 - D*1. At P2 Foreign producers raise the quantity they supply to S*2 and Foreign consumers lower the amount they demand to D*2, so the quantity of the total supply available to export rises to S*2 - D*2. A tariff raises the price of a good in the importing country and lowers it in the exporting country. As a result of these price changes, consumers lose in the importing country and gain in the exporting country. Producers gain in the importing country and lose in the exporting country. In addition, the government imposing the tariff gains revenue. To compare these costs and benefits, it is necessary to quantify them. The method for measuring costs and benefits of a tariff depends on two concepts common to much microeconomic analysis: consumer and producer surplus. Consumer and producer surplus: Consumer surplus measures the amount a consumer gains from a purchase by computing the difference between the price he pays and the price he would have been willing to pay. if P is the price of a good and Q the quantity demanded at that price, then consumer surplus is calculated by subtracting P times Q from the area under the demand curve up to Q (Figure 9-7). If the price is P1, the quantity demanded is D1 and the consumer surplus is measured by the areas labeled a plus b. If the price rises to P2, the quantity demanded falls to D2 and consumer sur- plus falls by b to equal just a. Producer surplus is an analogous concept. If P is the price and Q the quantity supplied at that price, then producer surplus is P times Q minus the area under the supply curve up to Q (Figure 9- 8). If the price is P1, the quantity supplied will be S1, and producer surplus is measured by area c. If the price rises to P2, the quantity supplied rises to S2, and is measured by area c. if the price rises to P2, the quantity supplied rises to S2, and producers surplus rises to equal c plus the additional area d. Measuring the costs and benefits: Figure 9-9 illustrates the costs and benefits of a tariff for the importing country. The tariff raises the domestic price from PW to PT but lowers the foreign export price from PW to P*T. Domestic production rises from S1 to S2 while domestic consumption falls from D1 to D2. The costs and benefits to different groups can be expressed as sums of the areas of five regions, labeled a, b, c, d, e. Consider first the gain to domestic producers. They receive a higher price and therefore have higher producer surplus. Domestic consumers also face a higher price, which makes them worse off. There is a third player here as well: the government. The government gains by collecting tariff revenue. This is equal to the tariff rate t times the volume of imports QT = D2 - S2. Since t = PT - P*T, the government’s revenue is equal to the sum of the two areas c and e. Since these gains and losses accrue to different people, the overall cost-benefit evaluation of a tariff depends on how much we value a dollar’s worth of benefit to each group. A useful way to interpret these gains and losses is the following: The triangles represent the efficiency loss that arises because a tariff distorts incentives to consume and produce, while the rectangle represents the terms of trade gain that arise because a tariff lowers foreign export prices. The gain depends on the ability of the tariff-imposing country to drive down foreign export prices. If the country cannot affect world prices, region e, which represents the terms of trade gain, disappears, and the tariff reduces welfare. A tariff distorts the incentives of both producers and consumers by inducing them to act as if imports were more expensive than they are. The cost of an additional unit of consumption to the economy is the price of an additional unit of imports, yet because the tariff raises the domestic price above the world price, consumers reduce their consumption to the point at which that marginal unit yields them welfare equal to the tariff- inclusive domestic price. This means that the value of an additional unit of production to the economy is the price of the unit of imports it saves, yet domestic producers expand production to the point at which the marginal cost is equal to the tariff-inclusive price. Thus, the economy pro- duces at home additional units of the good that it could purchase more cheaply abroad. The net welfare effects of a tariff are summarized in Figure 9-10. The negative effects consist of the two triangles b and d. The first triangle is the production distortion loss resulting from the fact that the tariff leads domestic producers to produce too much of this good. The second triangle is the domestic consumption distortion loss resulting from the fact that a tariff leads consumers to consume too little of the good. Against these losses must be set the terms of trade gain measured by the rectangle e, which results from the decline in the foreign export price caused by a tariff. In the important case of a small country that cannot significantly affect foreign prices, this last effect drops out; thus, the costs of a tariff unambiguously exceed its benefits. the same amount. The difference is that what would have been revenue under a tariff becomes rents earned by foreigners under the VER, so that the VER clearly produces a loss for the importing country. Numerical examples suggest that voluntary export restraints can be beneficial for the exporting country and damaging to the importing country. A study that examines the welfare effect of VERs on the world economy suggests that a government’s preference for VERs offers a short- term expansion effect on the exporting country. The effects of VERs can only bring positive results in the case of perfect competition for the goods market or when the exporting country is larger than the importing country. Overall, a VER not only damages the domestic economy in the long run but also has a deteriorating effect on the overall welfare of the world economy. Local content requirements: A local content requirement is a regulation that requires some specified fraction of a final good to be produced domestically. In some cases, this fraction is specified in physical units, like the U.S. oil import quota in the 1960s. In other cases, the requirement is stated in value terms by requiring that some minimum share of the price of a good represent domestic value added. Local content laws have been widely used by developing countries trying to shift their manufacturing base from assembly back into intermediate goods. In the United States, a local content bill for automobiles was pro- posed in 1982 but was never acted on. From the point of view of the domestic producers of parts, a local content regulation provides protection in the same way an import quota does. From the point of view of the firms that must buy locally, however, the effects are somewhat different. Local content does not place a strict limit on imports. Instead, it allows firms to import more, if they also buy more domestically. This means that the effective price of inputs to the firm is an average of the price of imported and domestically produced inputs. The important point is that a local content requirement does not produce either government revenue or quota rents. Instead, the difference between the prices of imports and domestic goods in effect gets averaged in the final price and is passed on to consumers. An interesting innovation in local content regulations has been to allow firms to satisfy their local content requirement by exporting instead of using parts domestically. This is sometimes important. Other trade policy instruments: 1. Export credit subsidies. This is like an export subsidy except that it takes the form of a subsidized loan to the buyer. The United States, like most other countries, has a government institution, the Export-Import Bank, devoted to providing at least slightly subsidized loans to aid exports. 2. National procurement. Purchases by the government or strongly regulated firms can be directed toward domestically produced goods even when these goods are more expensive than imports. The classic example is the European telecommunications industry. The nations of the European Union in principle have free trade with each other. The main purchasers of telecommunications equipment, however, are phone companies—and in Europe, these companies have until recently all been government-owned. These government-owned telephone companies buy from domestic suppliers even when the suppliers charge higher prices than suppliers in other countries. The result is that there is very little trade in telecommunications equipment within Europe. 3. Red-tapebarriers. Sometimes a government wants to restrict imports without doing so formally. Fortunately, or unfortunately, it is easy to twist normal health, safety, and customs procedures in order to place substantial obstacles in the way of trade. Chapter 10: The political economy of a trade policy: The case for free trade: Few countries have anything approaching completely free trade. Nonetheless, since the time of Adam Smith, economists have advocated free trade as an ideal toward which trade policy should strive. The reasons for this advocacy are not quite as simple as the idea itself. At one level, theoretical model suggest that free trade will avoid the efficiency losses associated with protection. Many economists believe free trade produces additional gains beyond the elimination of production and consumption distortions. Finally, even among economists who believe free trade is a less-than- perfect policy, many believe free trade is usually better than any other policy a government is likely to follow. Free trade and efficiency: The efficiency case for free trade is simply the reverse of the cost-benefit analysis of a tariff. Figure 10-1 shows the basic point once again for the case of a small country that cannot influence foreign export prices. A tariff causes a net loss to the economy measured by the area of the two triangles; it does so by distorting the economic incentives of both producers and consumers. Conversely, a move to free trade eliminates these distortions and increases national welfare. Additional gains from free trade: There is a widespread belief among economists that such calculations, even though they report substantial gains from free trade in some cases, do not represent the whole story. In the case of small countries in general and developing countries in particular, many economists would argue that there are important gains from free trade not accounted for in conventional cost-benefit analysis. One kind of gain involves economies of scale. Protected markets limit gains from external economies of scale by inhibiting the concentration of industries; when the economies of scale are internal, they not only fragment production internationally, but by reducing competition and raising profits, they also lead too many firms to enter the protected industry. With a proliferation of firms in narrow domestic markets, the scale of production of each firm becomes inefficient. Another argument for free trade is that by providing entrepreneurs with an incentive to seek new ways to export or compete with imports, free trade offers more opportunities for learning and innovation than are provided by a system of “managed” trade, where the government largely dictates the pattern of imports and exports. These additional arguments for free trade are difficult to quantify, although some economists have tried to do so. Rent seeking: When imports are restricted with a quota rather than a tariff, the cost is sometimes magnified by a process known as rent seeking. To enforce an import quota, a government must issue import licenses and economic rents accrue to whoever receives these licenses. In some cases, individuals and companies incur substantial costs—in effect, wasting some of the economy’s productive resources—to get import licenses. Political argument for free trade: A political argument for free trade reflects the fact that a political commitment to free trade may be a good idea in practice even though there may be better policies in principle. Economists often argue that trade policies in practice are dominated by special- interest politics rather than by consideration of national costs and benefits. Economists can sometimes show that in theory, a selective set of tariffs and export subsidies could increase national welfare, but that, any government agency attempting to pursue a sophisticated program of intervention in trade would probably be captured by interest groups and converted into a device for redistributing income to politically influential sectors. The three arguments outlined in the previous section probably represent the standard view of most international economists, at least those in the United States:  The conventionally measured costs of deviating from free trade are large.  There are other benefits from free trade that add to the costs of protectionist policies.  Any attempt to pursue sophisticated deviations from free trade will be subverted by the political process. National welfare arguments against free trade: Most tariffs, import quotas, and other trade policy measures are undertaken primarily to protect the income of particular interest groups. Politicians often claim, however, that the policies are being undertaken in the interest of the nation, and sometimes they are even telling the truth. Although economists frequently argue that deviations from free trade reduce national welfare, there are some theoretical grounds for believing that activist trade policies can sometimes increase the welfare of the nation. The term of trade argument for a tariff: One argument for deviating from free trade comes directly out of cost-benefit analysis: For a large country that can affect the prices of foreign exporters, a tariff lowers the price of imports and thus generates a terms of trade benefit. This benefit must be set against the costs of the tariff, which arise because the tariff distorts production and consumption incentives. It is possible, however, that in protection can happen is that dairy producers form a relatively small, well-organized group that is well aware of the size of the implicit subsidy members receive, while dairy consumers are a huge population that does not even perceive itself as an interest group. The problem of collective action, then, can explain why policies that not only seem to produce more costs than benefits but that also seem to hurt far more voters than they help can nonetheless be adopted. Modeling the political process: While the logic of collective action has long been invoked by economists to explain seemingly irrational trade policies, the theory is somewhat vague on the ways in which organized interest groups go about influencing policy. A growing body of analysis tries to fill this gap with simplified models of the political process. While politicians may win elections partly because they advocate popular policies, a successful campaign also requires money for advertising, polling, and so on. It may therefore be in the interest of a politician to adopt positions against the interest of the typical voter if the politician is offered a sufficiently large financial contribution to do so; the extra money may be worth more votes than those lost by taking the unpopular position. Modern models of the political economy of trade policy therefore envision a sort of auction in which interest groups “buy” policies by offering contributions contingent on the policies followed by the government. International negotiation and trade policy: The advantages of negotiation: There are at least two reasons why it is easier to lower tariffs as part of a mutual agreement than to do so as a unilateral policy. First, a mutual agreement helps mobilize support for freer trade. Second, negotiated agreements on trade can help governments avoid getting caught in destructive trade wars. The effect of international negotiations on support for freer trade is straightforward. We have noted that import-competing producers are usually better informed and organized than consumers. International negotiations can bring in domestic exporters as a counterweight. International negotiation can also help to avoid a trade war. To those who have studied game theory, this situation is known as a Prisoner’s dilemma. Each government, making the best decision for itself, will choose to protect. These choices lead to the outcome in the lower right box of the table. Yet both governments are better off if neither protects: The upper left box of the table yields a payoff that is higher for both countries. By acting unilaterally in what appear to be their best interests, the governments fail to achieve the best outcome possible. If the countries act unilaterally to protect, there is a trade war that leaves both worse off. Trade wars are not as serious as shooting wars but avoiding them is like the problem of avoiding armed conflict or arms races. International trade agreements: a brief history: Internationally coordinated tariff reduction as a trade policy dates to the 1930s. In 1930, the United States passed a remarkably irresponsible tariff law, the Smoot- Hawley Act. Under this act, tariff rates rose steeply, and U.S. trade fell sharply; some economists argue that the Smoot-Hawley Act helped deepen the Great Depression. Within a few years after the act’s passage, the U.S. administration concluded that tariffs needed to be reduced, but this posed serious problems of political coalition building. To reduce tariff rates, tariff reduction needed to be linked to some concrete benefits for exporters. The initial solution to this political problem was bilateral tariff negotiations. Such bilateral negotiations helped reduce the average duty on U.S. imports from 59 percent in 1932 to 25 percent shortly after World War II. Bilateral negotiations, however, do not take full advantage of international coordination. For one thing, benefits from a bilateral negotiation may “spill over” to parties that have not made any concession. Multilateral negotiations began soon after the end of World War II. Originally, diplomats from the victorious Allies imagined such negotiations would take place under the auspices of a proposed body called the International Trade Organization, paralleling the International Monetary Fund and the World Bank. In 1947, unwilling to wait until the ITO was in place, a group of 23 countries began trade negotiations under a provisional set of rules that became known as the General Agreement on Tariffs and Trade, or GATT. In 1995, the World Trade Organization, or WTO, was established, finally creating the formal organization envisaged 50 years earlier. However, the GATT rules remain in force, and the basic logic of the system remains the same. The principal ratchet in the system is the process of binding. When a tariff rate is “bound,” the country imposing the tariff agrees not to raise the rate in the future. At present, almost all tariff rates in developed countries are bound, as are about three- quarters of the rates in developing countries. There is, however, some wiggle room in bound tariffs: A country can raise a tariff if it gets the agreement of other countries, which usually means providing compensation by reducing other tariffs. In addition to binding tariffs, the GATT-WTO system generally tries to prevent non- tariff interventions in trade. Export subsidies are not allowed. The lever used to make forward progress is the somewhat stylized process known as a trade round, in which a large group of countries get together to negotiate a set of tariff reductions and other measures to liberalize trade. Eight trade rounds have been completed since 1947, the last of which —the Uruguay Round, completed in 1994— established the WTO. In 2001, a meeting in the Persian Gulf city of Doha inaugurated a ninth round, but despite many years of negotiations this never led to an agreement. The Uruguay round: The eighth round of global trade negotiations carried out under the GATT began in 1986, with a meeting at the coastal resort of Punta del Este, Uruguay. The participants then repaired to Geneva, where they engaged in years of offers and counteroffers, threats and counterthreats, and, above all, tens of thousands of hours of meetings so boring that even the most experienced diplomat had difficulty staying awake. The round had been scheduled for completion by 1990 but ran into serious political difficulties. In late 1993, the negotiators finally produced a basic document. As the length of the document suggests, the end results of the Uruguay Round are not easy to summarize. The most important results, however, may be grouped under two headings, trade liberalization and administrative reforms. Trade liberalization: The Uruguay Round, like previous GATT negotiations, cut tariff rates around the world. More important than this overall tariff reduction were the moves to liberalize trade in two important sectors: agriculture and clothing. World trade in agricultural products has been highly distorted. A final important trade action under the Uruguay Round was a new set of rules concerning government procurement, purchases made not by private firms or consumers but by government agencies. Such procurement has long provided protected markets for many kinds of goods, from construction equipment to vehicles. The Uruguay Round set new rules that should open a wide range of government contracts for imported products. Administrative reforms: from the GATT to the WTO: Much of the publicity that surrounded the Uruguay Round, and much of the controversy swirling around the world trading system since then, has focused on the round’s creation of a new institution, the World Trade Organization. In 1995, this organization replaced the ad hoc secretariat that had administered the GATT. The WTO has become the organization that opponents of globalization love to hate; it has been accused by both the left and the right of acting as a sort of world government, undermining national sovereignty. How different is the WTO from the GATT? From a legal point of view, the GATT was a provisional agreement, whereas the WTO is a full-fledged international organization; however, the actual bureaucracy remains small. An updated version of the original GATT text has been incorporated into the WTO rules. The GATT, however, applied only to trade in goods; world trade in services—that is, intangible things like insurance, consulting, and banking—was not subject to any agreed-upon set of rules. As a result, many countries applied regulations that openly or de facto dis- criminated against foreign suppliers. The GATT’s neglect of trade in services became an increasingly glaring omission, because modern economies have increasingly focused on the production of services rather than physical goods. So, the WTO agreement includes rules on trade in services. In practice, these rules have not yet had much impact on trade in services; their main purpose is to serve as the basis for negotiating future trade rounds. In addition to a broad shift from producing goods to producing services, advanced countries have also experienced a shift from depending on physical capital to depending on “intellectual property,” which is protected by patents and copyrights. Thus, defining the international application of international property rights has also become a major preoccupation. The most important new aspect of the WTO, however, is generally acknowledged to be its “dispute settlement” procedure. A dispute can arise when one country adopts a trade policy or violates the WTO agreements. WTO member countries use a multilateral system of settling disputes instead of taking actions unilaterally, meaning abiding by the agreed WTO procedures and respecting judgments. However, the WTO’s priority is to settle disputes through consultations and not to pass a judgment. Benefits and costs: The economic impact of the Uruguay Round is difficult to estimate. The most widely cited estimates are those of the GATT itself and of the Organization for Economic Cooperation and Development, another international organization. Both estimates suggest a gain to the world economy of more than $200 billion annually, raising world income by about 1 percent. As always, there are dissenting estimates on both sides. Some economists claim that the estimated gains are exaggerated, particularly because the estimates assume that exports and imports responded strongly to the new liberalizing moves. In any case, the usual logic of trade liberalization applies: the costs of the Uruguay Round were felt by concentrated, often well-organized groups, while the benefit accrued to broad, diffuse populations. The end of trade agreements? that would allow savings from traditional sectors (such as agriculture) to be used to finance investment in new sectors (such as manufacturing), then growth of new industries will be restricted by the ability of firms in these industries to earn current profits. Thus, low initial profits will be an obstacle to investment even if the long-term returns on the investment will be high. The first-best policy is to create a better capital market, but protection of new industries, which would raise profits and thus allow more rapid growth, can be justified as a second-best policy option. The appropriability argument for infant industry protection can take many forms, but all have in common the idea that firms in a new industry generate social benefits for which they are not compensated. Both the imperfect capital markets argument and the appropriability case for infant industry protection are clearly special cases of the market failure justification for interfering with free trade. The difference is that in this case, the arguments apply specifically to new industries rather than to any industry. The general problems with the market failure approach remain, however. In practice it is difficult to evaluate which industries really warrant special treatment, and there are risks that a policy intended to promote development will end up being captured by special interests. Promoting manufacturing through protection: Although there are doubts about the infant industry argument, many developing countries have seen this argument as a compelling reason to provide special support for the development of manufacturing industries. In principle, such support could be provided in a variety of ways. In most developing countries, however, the basic strategy for industrialization has been to develop industries oriented toward the domestic market by using trade restrictions such as tariffs and quotas to encourage the replacement of imported manufactures by domestic products. The strategy of encouraging domestic industry by limiting imports of manufactured goods is known as the strategy of import-substituting industrialization. The reasons why import substitution rather than export growth has usually been chosen as an industrialization strategy are a mixture of economics and politics. First, until the 1970s many developing countries were skeptical about the possibility of exporting manufactured goods (although this skepticism also calls into question the infant industry argument for manufacturing protection). They believed that industrialization was necessarily based on a substitution of domestic industry for imports rather than on a growth of manufactured exports. Second, in many cases, import-substituting industrialization policies dovetailed naturally with existing political biases. It is also worth pointing out that some advocates of a policy of import substitution believed that the world economy was rigged against new entrants—that the advantages of established industrial nations were simply too great to be overcome by newly industrializing economies. The 1950s and 1960s saw the high tide of import- substituting industrialization. Developing countries typically began by protecting final stages of industry, such as food processing and automobile assembly. In the larger developing countries, domestic products almost completely replaced imported consumer goods (although the manufacturing was often carried out by foreign multinational firms). Once the possibilities for replacing consumer goods imports had been exhausted, these countries turned to protection of intermediate goods. In most developing economies, the import- substitution drive stopped short of its logical limit: Sophisticated manufactured goods such as computers, precision machine tools, and so on continued to be imported. Nonetheless, the larger countries pursuing import-substituting industrialization reduced their imports to remarkably low levels. Result of favoring manufacturing: problems of import-substituting industrialization: Import-substituting industrialization began to lose favor when it became clear that countries pursuing import substitution were not catching up with advanced countries. In fact, some developing countries lagged further behind advanced countries even as they developed a domestic manufacturing base. Why didn’t import-substituting industrialization work the way it was supposed to? The most important reason seems to be that the infant industry argument is not as universally valid as many people had assumed. A period of protection will not create a competitive manufacturing sector if there are fundamental reasons why a country lacks a comparative advantage in manufacturing. Experience has shown that the reasons for failure to develop often run deeper than a simple lack of experience with manufacturing. With import substitution failing to deliver the promised benefits, attention turned to the costs of the policies used to promote industry. On this issue, a growing body of evidence showed that the protectionist policies of many less-developed countries badly distorted incentives. Part of the problem was that many countries used excessively complex methods to promote their infant industries. That is, they used elaborate and often overlapping import quotas, exchange controls, and domestic content rules instead of simple tariffs. A further cost that has received considerable attention is the tendency of import restrictions to promote production at an inefficiently small scale. The domestic markets of even the largest developing countries are only a small fraction of the size of that of the United States or the European Union. Often, the whole domestic market is not large enough to allow an efficient-scale production facility. Those who criticize import-substituting industrialization also argue that it has aggravated other problems, such as income inequality and unemployment. Trade liberalization since 1985: Beginning in the mid-1980s, several developing countries moved to lower tariff rates and removed import quotas and other restrictions on trade. The shift of developing countries toward freer trade is the big trade policy story of the past two and a half decades. After 1985, many developing countries reduced tariffs, removed import quotas, and in general opened their economies to import competition. Trade liberalization in developing countries had two clear effects. One was a dramatic increase in the volume of trade. The other effect was a change in trade. Before the change in trade policy, developing countries mainly exported agricultural and mining products. But trade liberalization, like import substitution, was intended to an end rather than a goal in itself. One thing is clear, however: The old view that import substitution is the only path to development has been proved wrong, as a number of developing countries have achieved extraordinary growth while becoming more, not less, open to trade. Trade and growth: takeoff in Asia: As we have seen, by the 1970s there was widespread disillusionment with import-substituting industrialization as a development strategy. But what could take its place? A possible answer began to emerge as economists and policy makers took note of some surprising success stories in the developing world—cases of economies that experienced a dramatic acceleration in their growth and began to converge on the incomes of advanced nations. At first, these success stories involved a group of relatively small East Asian economies: South Korea, Taiwan, Hong Kong, and Singapore. Over time, however, these successes began to spread; today, the list of countries that have experienced startling economic takeoffs includes the world’s two most populous nations, China and India. What caused these economic takeoffs? Each of the countries experienced a major change in its economic policy around the time of its takeoff. This new policy involved reduced government regulation in a variety of areas, including a move toward freer trade. What is less clear is the extent to which trade liberalization explains these success stories. As we have just pointed out, reductions in tariffs and the lifting of other import restrictions were only part of the economic reforms these nations undertook, which makes it difficult to assess the importance of trade liberalization per se. So, the implications of Asia’s economic takeoff remain somewhat controversial. One thing is clear, however: The once widely held view that the world economy is rigged against new entrants and that poor countries cannot become rich have been proved spectacularly wrong. Never in human history have so many people experienced such a rapid rise in their living standards. Chapter 12: Controversies in trade policy: Sophisticated arguments for activist trade policy: The problem with many arguments for activist trade policy is precisely that they do not link the case for government intervention to any failure of the assumptions on which the case for laissez-faire rests. The difficulty with market failure arguments for intervention is being able to recognize a market failure when you see one. Economists studying industrial countries have identified two kinds of market failure that seem to be present and relevant to the trade policies of advanced countries: (1) the inability of firms in high-technology industries to capture the benefits of that part of their contribution to knowledge that spills over to other firms and (2) the presence of monopoly profits in highly concentrated oligopolistic industries. Technology and externalities: If firms in an industry generate knowledge that other firms can use without paying for it, the industry is in effect producing some extra output—the marginal social benefit of the knowledge— that is not reflected in the incentives of firms. Where such externalities (benefits that accrue to parties other than the firms that produce them) can be shown to be important, there is a good case for subsidizing the industry. At an abstract level, this argument is the same for the infant industries of less-developed countries as it is for the established industries of the advanced countries. In advanced countries, however, the argument has a special edge because in those countries, there are important high-technology industries in which the generation of knowledge is in many ways the central aspect of the enterprise. Because patent laws provide only weak protection for innovators, one can reasonably presume that under laissez-faire, high-technology firms do not receive as strong an incentive to innovate as they should. The case for government support of high-technology industries. Two questions arise: (1) Can the government target the right industries or activities? And (2) How important, quantitatively, would the gains be from such targeting? Although high-technology industries probably produce extra social benefits because of the knowledge they generate, much of what goes on even in those industries has nothing to do with generating knowledge. There is no reason to subsidize the employment of capital or nontechnical workers in high-technology industries; on the other hand, One recurrent theme in the anti-globalization movement is that the drive for free trade and free flow of capital has undermined national sovereignty. In the extreme versions of this complaint, the World Trade Organization is characterized as a supranational power able to prevent national governments from pursuing policies in their own interests. How much substance is there to this charge? The short answer is that the WTO does not look anything like a world government; its authority is basically limited to that of requiring countries to live up to their international trade agreements. However, the small grain of truth in the view of the WTO as a supranational authority is that its mandate allows it to monitor not only the traditional instruments of trade policy—tariffs, export subsidies, and quantitative restrictions—but also domestic policies that are de facto trade policies. And since the line between legitimate domestic policies and de facto protectionism is fuzzy, there have been cases in which the WTO has seemed to some observers to be interfering in domestic policy. Globalization and environment: Inevitably, then, environmental issues are playing a growing role in disputes about international trade as well. Some anti-globalization activists claim that growing international trade automatically harms the environment; some also claim that international trade agreements—and the role of the World Trade Organization in particular—have the effect of blocking environmental action. Most international economists view the first claim as simplistic and disagree with the second. That is, they deny that there is a simple relationship between globalization and environmental damage and do not believe that trade agreements prevent countries from having enlightened environmental policies. Nonetheless, the intersection of trade and the environment does raise several important issues. Globalization, growth and pollution: Both production and consumption often lead, as a byproduct, to environmental damage. Factories emit pollution into the air and sometimes dump effluent into rivers; farmers use fertilizer and pesticides that end up in water; consumers drive pollution-emitting cars. As a result—other things equal—economic growth, which increases both production and consumption, leads to greater environmental damage. However, other things are not equal. For one thing, countries change the mix of their production and consumption as they grow richer, to some extent in ways that tend to reduce the environmental impact. In addition, growing wealth tends to lead to growing political demands for environmental quality. As a result, rich countries generally impose stricter regulations to ensure clean air and water than poorer countries—a difference that is apparent to anyone who has gone back and forth between a major city in the United States or Europe and one in a developing country and taken a deep breath in both places. In the early 1990s, Princeton economists Gene Grossman and Alan Krueger, studying the relationship between national income levels and pollutants such as sulfur dioxide, found that these offsetting effects of economic growth led to a distinctive “inverted U” relationship between per-capita income and environmental damage known as the environmental Kuznets curve. However, the environmental Kuznets curve does not, by any means, necessarily imply that globalization is good for the environment. In fact, it’s easy to make the argument that at a world level, globalization has indeed harmed the environment—at least so far. The problem of “pollution havens”: Thanks to international trade, an economic activity subject to strong environmental controls in some countries can take place in other countries with less strict regulation. Some activist groups are very concerned about the problem of pollution havens. Indeed, the environmental group Greenpeace made a cause celebre out of Alang, demanding that higher environmental standards be imposed. There are really two questions about pollution havens: (1) Are they really an important factor? and (2) Do they deserve to be a subject of international negotiation? The carbon tariff dispute: In 2009, the U.S. House of Representatives passed a bill that would have created a cap-and-trade system for greenhouse gases—that is, a system under which a limited number of emissions licenses are issued, and firms are required to buy enough licenses to cover their actual emissions, in effect putting a price on carbon dioxide and other gases. The Senate failed to pass any comparable bill, so climate-change legislation is on hold for the time being. Nonetheless, there was a key trade provision in the House bill that may represent the shape of things to come: It imposed carbon tariffs on imports from countries that fail to enact similar policies. Critics of carbon tariffs argue that they would be protectionist, and violate international trade rules, which prohibit discrimination between domestic and foreign products. Supporters argue that they would simply place producers of imported goods and domestic producers on a level playing field when selling to domestic consumers, with both required to pay for their greenhouse gas emissions. And because carbon tariffs create a level playing field, they argue, such tariffs—carefully applied—should also be legal under existing trade rules. At this point, the issue of carbon tariffs is hypothetical, since no major economy has yet placed a significant price on greenhouse gas emissions. Correspondingly, the WTO hasn’t issued any rulings on the legality of such tariffs, and probably won’t until or unless a real case emerges. Trade shocks and their impact on communities Contrary to the widespread caricature, the economic analysis of international trade does not say that free trade is good for everyone. As we’ve seen, it’s well understood that increased trade can shift the distribution of income within countries and create losers as well as winners. But do standard models fully account for the losses caused by rapid shifts in trade? The Autor et al. analysis rested on three key observations: 1. Chinese export growth was very uneven across industries; 2. Many U.S. manufacturing industries are or were very highly concentrated geographically; 3. Finally, U.S. workers and families are much less willing or able to move away from depressed regions than one might have expected. For these reasons, they argue, surging Chinese exports had a bigger impact on American workers than looking at overall numbers might have suggested. Autor et al. estimated that the “China shock” displaced, in total, around a million U.S. manufacturing jobs. This kind of analysis suggests that rapid changes in international trade are more painful than economists had realized. And this reality may partly explain the political backlash against globalization that was visible in 2016, when Britain voted to leave the European Union and the United States elected a candidate with a strongly protectionist platform.