International trade and the inequality of
nations.
Tony Venables,
London School of Economics &
UK Department for International Development
• Is international trade a force
– for the convergence of real incomes across countries?
– for the divergence of real incomes?
• What is the historical record?
• What does economic analysis suggest?
• Is there a tension between the evidence and the theory?
• Should international economics be reformulated to capture
massive and persistent international inequalities?
Argue that:
• In different time periods and different contexts the effects
of trade have been quite different.
• To understand this need a theory which recognises that the
productivity of labour – and hence comparative advantage –
depends on inputs that are complementary with labour.
• Supply of these complementary inputs is endogenous:
Some are supplied publicly, some privately.
They may be internationally mobile.
They are often associated with cumulative causation
processes.
Plan of lecture
• Review of evidence.
• Development of simple analytical frameworks to think about
the role of complementary inputs:
– Capital
– Institutions, infrastructure and investment climate
– Intermediate goods
1: Historical record – the great divergence:
• Ratio of per capita incomes of richest to poorest nations
increased from around 8 in 1870 to 50 in 2000
• Decline in shipping costs and increasing role of trade
Real cost of ocean shipping World merchandise exports
% GDP
1790
376
1820
1%
1830
287
1870
4.6%
1870
196
1913
7.9%
1930
107
1929
9.0%
1960
47
1950
5.5%
1990
51
1973
10.5%
1998
17.2%
Figure 2: Regions' share in world population
100%
80%
R est W o rld
B r. India
Other E .A sia
Japan
C hina
N .A merica
R est W .E u
UK
60%
40%
20%
0%
1820
1870
1913
1950
1998
Figure 1: Regions' share of world GDP
100%
80%
Rest World
Br. India
Other E.Asia
Japan
China
N.America
Rest W.Eu
UK
60%
40%
20%
0%
1820
Phase I
1870
1913
Phase II
1950
1998
Phase III
Figure 2: Regions' share in world industrial production
100%
80%
Rest World
Br. India
Other E.Asia
Japan
China
N.America
Rest W.Eur
UK
60%
40%
20%
0%
1750
1830
1880
1913
1953
1998
Figure 4: Regions' share in world manufactured exports
100%
80%
Rest World
Other Asia
Japan
China
N.America
Rest W.Eu
UK
60%
40%
20%
0%
1876-80
1913
1955
1997
An interpretation of the evidence:
• Rich club/ poor club – ‘convergence clubs’
• Rich club has captured most of the benefits of trade.
• Coexistence of these clubs for extremely long periods of
time.
• Economic development in sequence not in parallel
NB:
• Not seeking to argue that all changes in international
inequality due to trade.
• But, need analysis that recognises:
(a) ambiguous effects of trade and
(b) trade is consistent with persistent inequalities.
Benchmark model:
Goods:
Agriculture:
XA = A(LA, KA),
numeraire
Manufactures:
XM = M(LM, KM),
price p.
Inputs:
KA
‘Complementary input’ in agric; return rA
KM
‘Complementary input’ in manuf; return rM
L = LA + LM Fixed endowment of labour; wage w.
Equilibrium:
w = a(LA/KA) = pm(LM/KM)
Also:
rA = [A(LA/KA) - wLA)]/ KA
rM = [pM(LM/KM) - wLM]/ KM
Model I: Trade and factor flight:
Capital as the complementary input.
Consider a small open economy that has a comparative
disadvantage in manufactures.
Source of comparative disadvantage?
Land abundance
Technical inefficiency
Complementary factor in manufactures may be
internationally mobile: eg, human or physical capital.
Question: What is effect of opening to trade?
initial
endowment
K
agric
rm=1, autarky
Ka , Km with
autarky and
Km mobility
Ka , Km with
trade and Km
mobility
world
endowment
ratio
rm=1, free trade
rm>1
rm<1
K manuf
Trade and capital mobility in a land abundant economy
Rate of return,
agriculture
Real wages &
domestic income
Autarky values
=1
Rate of return,
manufactures
K manuf
Fig xx: Factor returns relative to autarky:
Ka abundant country
Rate of return,
agriculture
Rate of return,
manufactures
Real wages &
domestic income
Autarky values
= 0.95
K manuf
Fig xx: Factor returns relative to rest of world: country
with technical inefficiency in manufactures (10%).
Key points:
• Under autarky, the cost of a technical inefficiency or
comparative disadvantage is spread across the entire
population, via goods prices.
• With trade, this cost is concentrated on owners of
specific factors in the sector with disadvantage.
• If this factor is internationally mobile, then this will
cause capital flight and a fall in the wage.
• Gain to initial residents – ‘national’ real income
Loss to ‘domestic’ real income.
Key points (continued):
• Trade lets a country move factors out of sector with
comparative disadvantage – but how are they
absorbed elsewhere?
Can ‘capital’ be employed elsewhere?
Heckscher-Ohlin versus specific factors model.
Can labour be redeployed without running into
diminishing returns?
• The more things are tradable the easier it is to redeploy
factors from contracting sectors without running into
diminishing returns.
Application and policy
• Lagging regions?
Increased trade denudes regions of skills/ capital.
• Mono-crop agriculture and import competing
manufacture?
• Export diversification a necessary accompaniment
to import liberalization.
Model II: Infrastructure and institutions: publicly
provided complementary inputs.
• Institutions matter – Acemoglu et al.
• Institutions are a ‘complementary input’ to production.
• Institutions are more important for some activities than
others. ‘Countries with better contract enforcement
specialise in industries that rely heavily on relationship
specific investments’, (Nunn, 2005)
• Investment in institutions a public good, and usually
cannot be made sector specific
What are these ‘institutions’?
•
•
•
Rule of law, property rights, limits to corruption
Infrastructure
Investment climate
NB:
Matter particularly for modern manufacturing exports:
• Importance of reliability and quality control
• Just-in-time delivery.
• O-rings and supermodularity – value of a product is
determined by its weakest link.
• Public investments in institutions/ infrastructure/
investment climate, have properties that:
i) Public goods, not easily targeted to particular sector.
ii) Productivity effect varies across sectors – high in
modern manufacturing?
• How does the provision of these services shape trade, and
how does trade shape the provision of these services?
• Show that two economies that are ex ante identical can be
different ex post – just one of them captures all the gains
from trade.
Model II:
• Two sectors, A and M, as before, using labour and a
public service, s.
• Marginal (and average) products of labour in each sector,
a(si), pm(si)
• One unit of labour produces one unit of public service.
In country i, if both sectors active:
Labour market clearing:
Real income of country i:
wi = a(si) = pm(si)
1 - si = LA + LM .
ui = (1 - si)wi p-μ
Autarky:
ui = (1 - si) a(si)1-μ m(si)μ
Optimal choice of s:
si /(1 - si) = (1- μ)ηA + μηM
Can there be an asymmetric equilibrium?
Suppose so: in equilibrium,
country 1 has only manufactures;
L1M = 1 – s1,
w1 = pm(s1) > a(s1)
country 2 has agriculture and manufactures;
L2M + L2A = 1 – s1,
w2 = pm(s2) = a(s2)
This means that world price is,
p = a(s2) /m(s2)
Real income levels, u1, u2:
u1 = (1–s1)w1 p-μ = (1–s1) m(s1)[a(s2) /m(s2) ]1-μ
optimal choice of s1:
s1 /(1 – s1) = ηM
u2 = (1–s2)w2 p-μ = (1–s2)a(s2)1-μ m(s2)μ
optimal choice of s2:
s2 /(1 – s2) = (1- μ)ηA + μηM
Optimal choice of s1 :
Optimal choice of s2 :
s1 /(1 – s1) = ηM
s2 /(1 – s2) = (1- μ)ηA + μηM
This is an equilibrium if ηM > ηA:
In this case country choices imply, s1 > s2, and therefore
productivity levels such that country 1 specialised in
manufactures.
Country 2 has no incentive to deviate.
Real income levels?
Country 2: No gains from trade (same choice of s2, and
same prices as under autarky).
Country 1: Gains from trade (higher level of s1, same
prices as under autarky).
The game between
countries:
Remove discontinuities
by adding a specific
factor in agriculture:
a(si , LiA/KA)
s1
s2 =R(s1)
E
Eqm where country 1 takes
all the gains from trade.
Compute best response
functions.
Multiple equilibria.
E
s1 =R(s2)
s2
Gains/ losses from trade.
Best response functions and equilibria
Key points:
• Economies may be identical ex ante, but asymmetric ex
post, with one taking all the gains from trade.
• If one country has already made the investments that give
it comparative advantage in manufacturing, then it is not
worthwhile for the other country to investment.
• I.e., for a country with a small modern sector it is rational
to invest little in the public goods that raise productivity
in this sector (…..and therefore it will turn out to have a
small modern sector).
•
Target provision of infrastructure/ institutional
investments?
Model III: Intermediate goods: linkages and clustering.
• Third sort of complementary input: intermediate goods.
• Draw on ‘new economic geography’, Fujita, Krugman &
Venables.
• Productivity depends on local supply of intermediates
• Intermediate goods create the possibility of forward and
backward linkages -- old idea from the development
literature (Hirshman, Myrdal).
• Forward (cost) linkages: downstream firms gain from
proximity to their suppliers (eg, save transport costs).
• Backward (demand) linkages: upstream firms gain
from proximity to their customers (transport costs).
• Can produce outcomes where activity ‘clusters’ in one
country.
Key assumptions to get clustering?
• Many types of intermediate goods, and each type only
produced in one place – presumably because of
increasing returns to scale. (Without this assumption,
have ‘backyard capitalism’).
• Proximity advantage – eg transport costs.
The model:
• Agriculture: labour productivity: a(LiA)
• Manufactures: Each country produces its own variety of final
good, output prices = unit cost, p1, p2 (perfect competition)
• Inputs to manufacturing:
• Labour, with share in costs 1 – v.
• Continuum of intermediate goods, share v, elasticity of
substitution between intermediate varieties = 1 (CobbDouglas).
• Intermediate goods can be produced in one country or the
other, using just labour. Let θ denote the fraction of the types
produced in country 1.
• Intermediates’ prices, w + ε, transport costs t.
• Final goods prices,
p1 = w11-vw1vθ (w2t)v(1- θ) ,
p2 = w2(1-v)w2v(1- θ) (w1t)vθ
Price of final goods produced in country 1, country 2;
p1 = w1[1-v(1-θ)] (w2t) v(1-θ), p2 = w2[1-vθ] (w1t)vθ
Demand for final goods from both countries, exports have transport cost ;
X1= D(p1, p2+) + D(p1+, p2), X2 = D(p2, p1+) + D(p2+, p1)
yi is quantity of each variety of intermediate produced in country i.
Derived demand for intermediate goods (in value terms);
w1y1θ = θv(p1X1+p2X2/t),
w2y2(1- θ) = (1- θ)v(p2X2+p1X1/t).
Each variety of produced in country from which it makes largest total sales,
i.e. θ adjusts until y1 = y2.
How does varying the location of intermediate good production change
profitability, y1, y2? Increase θ implies ↓p1 and ↑p2.
•
Crowding effect: Given X, if more locally supplied then each sold in
smaller quantity. Depends on value of t.
•
Cost/ sales effect: Reduction in p1 expands sales, X1, and hence increases
y1. Depends on values of t and .
•
Will get clustering of activity if cost/ sale effect dominates crowding.
t = 1.7
t = 1.58
y1
y2
y1
y2


t = 1.1
t = 1.55
y1
y2
y1

Trade liberalisation causes concentration of activity
y2

, share of
intermediate
production in
country 1
Stable eqm
Unstable eqm
= 1
 = 1/2
= 0
Trade costs
Spatial bifurcation
Summary:
• At high trade costs, each country has industry to supply
local consumers – crowding effect dominates cost/sales
expansion effect. Symmetry, θ = ½.
• At intermediate trade costs, sales more responsive to cost
differences – cost/ sales effect dominates.
Agglomeration, θ = 1 or θ = 0.
So far, assumed wages fixed: what if they respond to
employment levels (upward sloping labour supply curve
from other sectors)?
t = 1.52
t = 1.7
y1
y1
y2
y2


t = 1.4
y1
t = 1.1
y2
y1

y2

Divergence and convergence
, share of
intermediate
production in
country 1
= 1
Stable eqm
Unstable eqm
 = 1/2
= 0
Trade costs
The tomahawk: Spatial bifurcation with wage flexibility
Real
wages
1, 2
1
1 = 2
2
Trade costs
Real wages, if country 1 has the cluster
Cut trade costs: – deindustrialises 2 & cuts its real wage
– globalization phase, rapid catch up by 2,
possible fall real wage in 1.
Summary – the general theory of location:
• At high trade costs: location determined by demand:
θ = ½. Equal real wages.
• At intermediate trade costs: location determined by
clustering forces: θ = 1 or θ = 0. Real wages unequal.
• At low trade costs: location determined by factor costs
θ = ½. Equal real wages.
• Implications for real wages and the distribution of the
gains from trade.
• In multi-country setting, have ‘rich club’ / ‘poor club’.
Extensions – other clustering mechanisms:
• ‘Timeliness’ as a trade cost: (Harrigan & Venables)
• One assembly plant in each country.
• Range of intermediate goods, each type produced in just one
country.
• Probability of remotely produced int. arriving on time, q < 1.
• Probability of all ints. arriving on time for plant in country 1 is
q1-θ, where θ is no. of intermediates prod. in 1.
• This probability is increasing and convex in θ.
• If delaying production is costly, then it is efficient to put all
intermediate production next to one assembly plant – ie.,
clustering.
Timeliness:
• Intermediate producers
cluster, because it is
better to have one
assembly plant
working well and the
other badly, than both
‘1/2 well’
V1 + V 2
V2
Arrival time uncertainty
V1

• Intuition – if one part is
delayed, matters less
that second is also
delayed.
Extensions:
• Other clustering mechanisms?
• Thick labour markets -- matching
-- skill acquisition
• Knowledge spillovers.
• What is their interaction with trade?
Trade liberalization facilitates clustering – all the way to
free trade (i.e., not tomahawk case)?
• What is their spatial scale? Urban rather than international
economics?
Conclusions:
• Need to recognise that trade has not always brought a balanced
distribution of benefits.
• Have offered some reasons why this is so – organised around
the theme of the supply and/or location of complementary
inputs to production.
• Absolutely NOT a rejection of the case for trade liberalization;
many of these models yield much larger world gains from
trade liberalisation than do standard models.
BUT: Recognise that opening to trade can create problems.
• Alternative employment of resources displaced from import
competing sector may mean lower income. Even in a ‘perfect’
economy, trade can increase incentives for factor flight and
redeployed labour may run into diminishing returns and lower
wages. Need more tradable goods – diversification (Model I)
• Incentives to improve institutions and the investment climate may
be low. Need cost effective ways to target these expenditures.
Aid for trade. (Model II)
• Small trade frictions combined with ‘linkages’ mean that large
wage differences are not enough to attract industry. But
optimistic message – globalization reduces the value of
proximity and facilitates relocation of stages of the production
process. (Model III)