Recent Developments in Trade Theory Rod Falvey March 2009.
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Recent Developments in Trade Theory
Rod FalveyMarch 2009
Introductory comments
• Theory follows practice• “Recent” is relative• Will not cover all recent developments• Will not necessarily cover even all the
most important recent developments• General equilibrium• Some borrowed material• Begin with context
Trade Theory - Issues
Gains/losses from trade
Pattern of trade
Effects on outputs, income distribution etc
Trade Policy - Issues
• Effects of protection
• Costs of protection
• Optimal policies – second best
• Piecemeal reform
Sources of Gains from Trade[static]
New Products/Improved Inputs
Economies of Scale
- in manufacturing
Comparative Advantage
- resource re-allocation
Sources of Gains from Trade[dynamic]
Learning by doing/exporting
Technology transfer (broadly defined)
Need spillovers for sustained growth
Need analysis at firm/worker level
Ricardian ModelComparative Advantage (technology based)
- distinct from absolute advantage
- all countries can compete/trade (if wages low enough)
- all can gain from trade
- smaller countries tend to “gain more”
But
- complete specialisation
- no internal income distribution
Heckscher-Ohlin (H-O) ModelTrade pattern resource based
– Countries export goods that use intensively their relatively abundant factors (H-O Thm)
– Trade draws factor prices closer together across countries, becoming equal in certain circumstances (FPE Thm)
– Trade changes real factor returns (S-S Thm)• Benefiting owners of abundant factors• Hurting owners of scarce factors
– Trade and output effects of factor accumulation (Rybczynski Thm )
Extensions of HO
Increase numbers of goods and factors (from 2x2 to nxm)Theorems generalise – but weaker
Can add technology differences
ButSpecialisation - potential production indeterminacy
Resulting trade patterns very sensitive to trade costs
No Intra-industry trade (prominent in EU liberalisation)
CGE modelling - issues
Models based too closely on HO don’t fit the data
Models predict too much specialization
These problems have been dealt with in a variety of ways:
Specific FactorsAlso called the Ricardo-Viner Model
Each sector has its own “specific factor”
Implications– Supplies likely remain positive at all prices– Supplies increase smoothly with price– There is no production indeterminacy– Trade does not equalize factor prices
Specific Factors
But– Makes more sense for short run, than for long
run
– Explanation of trade based on specific factors close to tautological
– Still no intra-industry trade
Armington Preferences
Armington (1969)
Products are differentiated by country of origin – popular in CGE models
Implications– Trade need not equalize prices of same
“good” from different countries– Have intra-industry trade
Armington Preferences
But– Why are products differentiated by country?
Ad hoc – but can allow close substitutes
– Preferences give every country market power in trade – CGE policy results dominated by terms of trade effects
Monopolistic Competition(New Trade Theory)
Krugman (1979, 1980)
Helpman and Krugman (1985) in HO trade models
Uses “love of variety” preferences – e.g. Dixit-Stiglitz
Goods are differentiated by firm, while increasing returns at the firm level limit product variety
Monopolistic Competition
Implications– Trade gains through “new products”
consumed– Model explains intra-industry trade– Product-differentiated bilateral exports remain
positive from any country that produces - less sensitive to trade costs
– Model has a role for firms – in form of a representative firm
Monopolistic Competition
But– Only makes sense for some manufactures
and services, not for agricultural products, raw materials etc
– Implications for specialization and factor prices are the same as the standard HO model
– Doesn’t necessarily mean trade gains from increasing firm size
Heterogeneous FirmsMelitz (2003) in a Ricardian context.
Bernard, Redding, and Schott (2005) in the HO model
Individual firms produce differentiated products under monopolistic competition, but have different productivities
Important role for trade costs – fixed and per unit
Based on characteristics inferred from firm level data sets
Stylised Facts about Firms(in large countries)
1. Most don’t export. Those that do export little and not very widely;
2. Exporters are larger, more productive, more skill and capital intensive and pay higher wages than domestic firms; and
3. Knowing a firm’s industry is not very informative about export participation.
Suggest limitations of “representative firm” approach.
Bernard/Jensen/Redding/Schott JEP 21(3) 2007
AutarkyCosts
Entry fixed costProduction fixed costProduction marginal cost (inverse of productivity)
Entry as long as expected profits positive
Autarky equilibrium productivity threshold for production
Firms above threshold produce; firms below exit
Potential Entrants Entrants
Randomly draw their productivity
levels
Lowest productivity
entrants
High productivity
entrants
Leave immediately
Pay fixed production cost and serve the domestic market
Pay irreversible investment to enter
unable to earn positive operating profit
Flow chart 1: Productivity uncertainty and firm entry/exit
TradeCosts
Export fixed costUnit trade cost (“iceberg”)
Most productive firms export – use more resources – drawn from less productive firms – least productive exit
Industry average productivity rises
Heterogeneous Firms
Domestic survival productivity threshold in autarky
Domestic and export survival thresholds in trade
(export threshold higher due to trade costs)
Domestic survival threshold higher in trade than in autarky
Industry more productive – due to intra-industry resource reallocation – no change in individual firms’ productivities
Effects of trade
Probability
Firm level Productivity
Export threshold
Domesticthresholdopen
Domestic thresholdautarky
Exporters
Purely domestic firms
ContractLeave Expand
Exiters
Heterogeneous Firms
Implications– Trade improves industry productivity relative to
autarky – additional source of gains from trade – but number of varieties available may rise or fall.
– Improved technology in one country may lead to reduced industry efficiency in its trading partner (but still gains from trade)
– Can get specialization if technology or market size differences large enough
– Supply responds to demand through entry and exit
Combined with HO
Productivity growth stronger in comparative advantage industry
- exporting opportunities greater in CA industries
– bids up relative price of their intensive factor
- greater exit of low productivity firms
- industry productivity effects magnify effects of CA
Combined with HO
If productivity increases strong enough – both factors’ real incomes can rise with trade liberalisation.
Heterogeneous FirmsWhy do firms differ in productivity?
luck
managerial ability/entrepreneurship
producing products of different quality
What leads to a better productivity distribution?
human capital
Do more productive firms export – or does exporting make firms more productive? Evidence (for developed countries) suggests former.
Heterogeneous Firms & Many Countries
Distinguish
“extensive margin” of trade – number of products exported and number of markets exported to;
“intensive margin” of trade – volume of a particular product exported to a particular market.
Trade liberalisation can affect both margins
New Economic GeographyOther area where trade costs seem to be important.
Geographical concentration of industries
Advantages from a large number of competitors producing in an area (external and internal economies of scale)
Agglomeration forces:Technological spillovers (e.g. silicon valley)Labour market pooling (e.g. City of London)Demand linkages (i.e. backward linkages)Supply linkages (i.e. forward linkages)
New Economic GeographyPerfect Competition
Comparative advantage implies countries specialise in sectors
Monopolistic Competition
New trade theory implies that agglomeration arises with integration if initial asymmetries across countries exist – home market effect
New economic geography implies that integration tends to concentrate economic activity spatially (even without initial asymmetries across countries)
Propositions
Home market effect
Regions with large demand for increasing returns industries account for an even larger share of their production.
Market potential raise local factor prices. A location whose access to major markets and suppliers is not impeded by large trade costs will tend to reward its factors with higher wages and land rentals.
Propositions
3. Market potential induces factor inflows
(a) Firms (re)locate to areas with good access to major markets for final goods and major suppliers of intermediate inputs (backward linkages).
(b) Workers migrate to locations with good access to suppliers of final goods (forward linkages).
4. Shock sensitivity: A temporary shock to economic activity in a location can permanently alter
the pattern of agglomeration.
Institutions and TradeInterpret “institutions” broadly
Structure of analysis:Use theory to examine the differential dependence of industries on the quality of this institution
Derive measures of institutional dependence
Find measures of institutional quality
Test hypotheses using cross-industry and cross-country data
Incomplete contracts and firm boundaries
Institution: property rights and contract enforcement
Ownership structure indeterminate and irrelevant when contracts are complete and fully enforced
Which activities take place within the firm and which are purchased in markets?
Helpman “Trade, FDI and the Organization of Firms”, JEL September 2006
Firm Boundaries - Questions
Which firms serve foreign markets?
How do they serve them (exports or FDI)?
How do they choose to organise production (outsource or integrate)?
When do they outsource abroad rather than at home?
When do they integrate abroad (FDI) rather than at home?
Incomplete contractsStandard approach is to assume relationship-specific
investment by the trading parties, which in the absence of an enforceable contract leads to the “holdup problem”
e.g. Some inputs are highly specific to a final product and their supply is not fully contractible – extent may vary across industries
Relationship yields a surplus – to be bargained over
Credit market institutionsQuality of financial market institutions can affect pattern of
trade through industry differences in financial dependence - Bardhan and Kletzer (1987)
Firms in countries where firms face tighter credit rationing, have a comparative disadvantage in financially dependent industries
Labour market institutions
Davidson, Martin, and Matusz (1999): efficiency of labour market search differs across countries. Country with more efficient search technology then has comparative advantage in sector with higher separation rate, hence higher vacancy rate
Cuñat and Melitz (2007): firms in countries with inflexible labour market institutions must contract on employment in advance of realizations of productivity shocks. These countries wind up with a comparative disadvantage in high volatility industries.
Trade Policy
Positive – effects of standard instruments (tariffs, quotas etc.)
Normative – welfare effects – optimum tariff only first best argument etc.
Policy rankings
Actual Institutions
Explaining GATT/WTO – why does it exist?
Benefits of multilateral vs bilateral trade negotiations – multilateral retaliation
Internal benefits of external constraints
Political Economy of Trade Policy
“Protection for Sale” by Grossman and Helpman (1994) – used menu auction theory to explain industry tariff levels.
Lobby groups offer “contributions” to a policy maker who is concerned about contributions and aggregate welfare.
Policies set as if to optimise a welfare function in which groups that lobby receive a disproportionate weight.
Political Economy
Approach can be applied to a range of other policies – trade and non-trade.
Testing of a particular theory difficult because different theories tend to have similar predictions
Piecemeal Trade Policy Reform Gradual removal of trade restrictions,
ensuring that welfare (of a representative agent) increases at each step.
Two types of reform known:
[A] Proportional tariff cuts
[B] Concertina reform – reduce highest tariff to next highest (requires this good be a net substitute for all other goods).
Anderson & Neary (2005)Extend range of welfare improving reforms
Consider “generalised moments” of tariff distributions
Generalized moments are weighted moments where the weights are the elements of the substitution matrix
An increase in the generalized mean reduces welfare
An increase in the generalized variance reduces welfare.
Gives a range of welfare improving tariff reforms – e.g. uniform absolute tariff reduction
2pp
dVWelfare T S dT TdT
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