Recent Developments in Trade
Theory
Rod Falvey
March 2009
Introductory comments
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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 Model
Comparative 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) Model
Trade 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
But
Specialisation - 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 Factors
Also 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 Firms
Melitz (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.
2.
3.
Most don’t export. Those that do export little and not
very widely;
Exporters are larger, more productive, more skill and
capital intensive and pay higher wages than domestic
firms; and
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
Autarky
Costs
Entry fixed cost
Production fixed cost
Production 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
Pay irreversible
investment to enter
Entrants
High
productivity
entrants
Pay fixed production cost
and serve the domestic
market
unable to earn positive
operating profit
Leave immediately
Lowest
productivity
entrants
Flow chart 1: Productivity uncertainty and firm entry/exit
Randomly draw
their productivity
levels
Trade
Costs
Export fixed cost
Unit 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
Exiters
Purely
domestic
firms
Exporters
Leave
Domestic threshold
autarky
Contract
Domestic
threshold
open
Expand
Export
threshold
Firm level Productivity
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 Firms
Why 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 Geography
Other 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 Geography
Perfect 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 Trade
Interpret “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 contracts
Standard 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 institutions
Quality 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
dV
Welfare  T S pp dT  TdT 
2
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