Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Beyond Comparative Advantage.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 5

Beyond Comparative Advantage

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-2

Chapter Objectives

• Explain why many countries import the same goods they export

• Analyze the development of regional clusters of production of many exported goods and services

• Examine how and why many countries select and plan the development of their export industries


Introduction

• Trade models built exclusively on comparative advantage do not always serve to predict a country´s trade patterns– Comparative advantage is very difficult to measure– Large share of international trade is not, in fact, based on

comparative advantage

• Besides, countries often seek to alter their comparative advantages through industrial policies


Intraindustry Trade

• Intraindustry trade: international trade of products made within the same industry (steel-for-steel, bread-for-bread)

• Interindustry trade: international trade of products between two different industries (steel-for-bread)

• Intraindustry trade is growing increasingly important in international trade especially between industrial countries


GL i =1 −X i −M i

X i −M i

Measures of Intraindustry Trade

• Grubel Lloyd (GL) index:

(If Xi = Mi, GL = 1; all trade is intraindustry)

• Problem: Product categories are difficult to define (are computers “office supplies” like pencils?)

• Depending on the definition, intraindustry trade is 1/3 or 2/3 of U.S. merchandise trade


Characteristics of Intraindustry Trade

• Economies of scale: decreasing average costs over a relatively large range of output (as opposed to constant or increasing costs)

– Internal economies of scale: lead to larger firms because size confers a competitive advantage

– External economies of scale: lead to larger industries (however, larger firms have no inherent advantage over smaller ones)


TABLE 5.1 Increasing Returns to Scale for a Single Firm


Internal Economies of Scale (cont.)

• When larger firms are more competitive, market structure changes

– Oligopoly: handful of firms produce the entire market output, with each firm formulating its strategies in response to those of its competitors

– Monopolistic competition: unlike under pure monopoly, competition among many firms exists

• However, competition is attenuated by the practice of product differentiation—each firm produces a slightly different product


Gains from Intraindustry Trade

• Lower costs: increase in the size of the market allows for scale economies, which lowers production costs and eventually costs to consumers

• Potential expansion of production: there is a high likelihood that intraindustry trade expands the number of domestic firms and the quantity of domestic output

• Increase in consumer choices: intraindustry trade tends to give access to a much greater variety of goods than produced domestically


Trade and Geography

• Two connections between trade and geography

1. When tariffs fall, certain industries may relocate production to take advantage of lowered trade costs

2. Geographical concentration may give an industry competitive advantage: it will join a regional industrial cluster (agglomeration) to strengthen its export performance


External Economies of Scale

• External economies of scale: advantage of larger size applies to the industry as a whole, not to individual firms– If a firm in a region produce similar products, they will

benefit from knowledge spillovers

– When the presence of a large number of producers in one area creates a deep labor market for specialized skills

– If an area holds a dense network of input suppliers, manufacturers locate near the suppliers


Trade and External Economies of Scale

• Geographical concentration may be self-reinforcing: an initial small move toward clustering may cause a chain reaction, resulting in a massive industrial agglomeration

– Examples: Aerospace manufacturing firms in Seattle and Southern California regions


Industrial Policy

• Industrial policy: a government’s policy designed to create new industries or support existing industries

– Industrial policies seek to alter the country´s comparative advantage by picking winners and losers

– However, they can have a profound impact on trade patterns


Market Failure

• Market failure: failure by the market economy to deliver an optimal quantity of goods and services (the value of a good to private consumers and the society fails to equal to its cost of production)

– A divergence between private returns and social returns

– In a market failure, some costs or benefits of an activity are externalized—outside the area of concern of the economic agents engaged in the activity

• Externality: market failure that results from the externalization


FIGURE 5.1 Market Failure: Externalities


Market Failure (cont.)

• Market failure is a major justification for industrial policies

– Knowledge spillover, for example, is cited as a reason for industrial policies: a certain industry can spread knowledge about new products and processes, making social returns greater than private returns

– Similar spillovers occur in research and development (R&D)


Strategic Trade

• Strategic trade policy: selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms– Strategic trade policy requires that (1) industry has

economies of scale and (2) firms in the industry have market power

– Strategic trade policy is, like market failure, a justification for industrial policies


TABLE 5.3 A Hypothetical Payoff Matrix


TABLE 5.4 The Payoff Matrix after a Subsidy of 15


Industrial Policy Tools

• Uruguay Round and WTO prohibit subsidies for competitive policies

• However, governments can use other policies: providing information about foreign markets to domestic firms, helping negotiate contracts, lobbying foreign governments to adopt home country standards, or tying foreign aid to purchases from domestic firms


Problems with Industrial Policies

• Difficult to obtain information for measuring market failure

• Difficult to determine which industry to support: positive externalities may not be readily visible

• Rent seeking: activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor


U.S. Industrial Policies

• Until World War II, the U.S. used high tariffs to support specific industries

• The use of direct subsidies, however, was used only in agriculture and defense industries

• Most common form of U.S. government support for certain industries has been through new research and dissemination of information


Chapter 5

Additional Chapter Art


TABLE 5.2 U.S.-Canadian Merchandise Trade, 2004 (Billions of US$)


Appendix

A Graphical Illustration of Prices and Costs with Monopolistic Competition


FIGURE 5.2


FIGURE 5.3

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Beyond Comparative Advantage.

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comparative advantage

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scale economies

introduction trade models

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