Chapter Five Outline
1. Introduction
2. Questions to be answered
3. How do we know if a theory about trade is correct?
4. Testing the Hecksher-Ohlin model
5. Intra-industry trade
6. Trade with economies of scale
7. Technology-based theories of trade: The product cycle
8. Overlapping demands as a basis for trade
9. Transporting costs as a determinant of trade
10. Location of industry
Introduction
• After studying several theories to explain
international trade patterns (Ricardian,
neoclassical, and Heckscher-Ohlin models),
must we adopt a single theory of trade, or
might different theories best explain various
aspects of trade?
– Should empirical testing be used to decide?
– Do we need to modify any of these theories to
explain today’s economic patterns?
Questions To Be Answered
1. Is one explanation from one of the economic
theory models sufficient to explain why
Colombia exports coffee, Taiwan color tvs, or
Brazil steel?
•
What part does intra-industry trade (trade in which
each country both imports and exports products from
the same industry) play?
2. How do international trade patterns change over
time?
•
U.S. used to be the world’s largest manufacturer of
tvs…now it’s Taiwan. Why?
How Do We Know If a Theory About
Trade Is Correct?
• Economists turn to empirical testing of
international trade theories in order to strengthen
their arguments about the important influences on
various types of trade.
– Both Adam Smith and David Ricardo used rudimentary
empirical testing to support their claims.
– Certain difficulties exist with empirical testing:
• Empirical evidence can appear to support a theory, but it
cannot prove it true (and vice versa).
• Most useful outcome of empirical test is refinement of both
theory and test.
Testing the Heckscher-Ohlin
Model
• Hurdles to empirical testing
– Heckscher-Ohlin model implies that exports as
a group should be more intensive in use of the
abundant factor than imports as a group.
• Virtually impossible to test for this.
– Simple observations do not necessarily comprise definitive
evidence in the model’s favor.
The Leontief Tests
• Leontief used 1947 data for the united states in the first
test of Heckscher and Ohlin’s key proposition (since U.S.
was capital-abundant, it was expected that the U.S. Would export
capital-intensive goods).
– Since data on the factor intensity of imports was not available,
he used data on import substitutes (the U.S.-Produced versions
of the import goods).
– Empirical results showed the opposite of what was expected.
• U.S. Exports were 30% more labor intensive than us import substitutes.
– Known as Leontief paradox.
The Leontief Tests
• Possible explanations of this paradox:
– In 1947 most of world’s economies were still in a
highly disrupted state.
– Further tests in the early 1950s reduced the magnitude
of the paradox.
• Fair to state that simplest version of HeckscherOhlin model does poor job of explaining trade
patterns.
– Modifications and extensions have been made in the
model.
Fine-Tuning the HeckscherOhlin Model
• Role of Tastes
– Heckscher-Ohlin model assumed tastes were identical
across countries.
• This is not true.
– Large differences in tastes among countries can introduce a taste
bias that can dominate the production bias.
» Should this occur, a country will have a comparative
advantage in production of the good that uses its scarce
factor intensively.
» Evidence does exist for a “home bias” in consumption
(consumers in a given country tend to consume more
domestically produced goods than we would expect).
Fine-Tuning the HeckscherOhlin Model
• Classification of Inputs
– Original theory used only two inputs: capital
and labor.
• Inputs are now classified in several ways…most
common:
–
–
–
–
–
Arable farmland
Raw materials or natural resources
Human capital
Man-made or nonhuman capital
Unskilled labor
•
Fine-Tuning the HeckscherOhlin
Model
Technology, Productivity and Specialization
– The original theory assumed identical technologies
across countries when it predicted countries would
export goods that used their abundant factors
intensively.
• We clearly observe different technologies across countries.
– The theory must be amended to take these production process
differences into account.
What Is Intra-Industry Trade
and How Big Is It?
• Defined as trade in which a single country both
imports and exports products in the same industry.
– Comprises a significant share of world trade.
• The Intra-Industry Trade (IIT) index is used to
estimate the extent of this trade within an industry
or within a country trade as a whole.
– Table 5.1 (page 144) shows that IIT indexes tend to be
higher for industrialized countries than for developing
countries.
Intra-Industry Trade in
Homogenous Goods
• Homogenous (non-differentiated) goods that
are most likely to be involved in intraindustry trade include items that are heavy
or for some other reason expensive to
transport.
– In Figure 5.1, each country both exports and
imports the product because of the greater
proximity of consumers to the foreign than to
the domestic producer.
Figure 5.1: Location Can Cause IntraIndustry Trade in Homogeneous Goods
Country A
A
F
Country B
CB
CA
FB
Intra-Industry Trade in
Differentiated Goods
• Product differentiation is the most obvious
explanation for intra-industry trade.
– Consumers have a variety of tastes, some best
served by domestically produced goods and
others by imports.
Why Does It Matter?
• Intra-industry trade involves trade in goods in the
same industry but produced using similar factor
intensities.
– Therefore, changes in factor demands and relative
factor prices from such trade tend to be smaller.
• Provides one explanation for global trade liberalization in last
fifty years.
– Greatest success in lowering trade barriers has occurred in
manufactured-goods industries in which the developed countries
engage in large amounts of intra-industry trade.
Trade with Economies of Scale
• For some goods, the average cost of production
depends on the number of units produced.
– If the average cost per unit falls as the scale of
production rises, production exhibits increasing returns
to scales, or Economies of Scale.
• Internal economies occur when the firm’s average costs fall as
the firm’s output rises (panel [a] of Figure 5.2).
– Primary sources are large fixed costs that can be spread over all
the firm’s output.
» Example: R&D expenses
Internal and External Economics of
Scale
Firm's AC
X
AC S
AC L
AC X
0
XS
X
L
(a) Internal Economies
Firm’s Output of X
Trade with Economies of Scale
• External economies occur when the firm’s
average costs fall as the industry’s output
rises, as in panel (b) of Fig. 5.2.
– For example, when the output of the computer
industry rises, computer firms’ costs fall
because the industry becomes large enough to
support a pool of skilled labor.
Figure 5.2b: Internal and External
Economics of Scale
Firm’s AC
X
AC
0
AC 1
AC X
0
X
0
X
1
Industry Output of X
(b) External Economies
Trade with Economies of Scale
• Implications of economies of scale
– Create additional incentive for production
specialization.
• Rather than producing a few units of each good domestic
consumers want to buy, a country can specialize in producing
large quantities of a small number of goods (in which the
industries achieve economies of scale) and trade for the
remaining goods.
– Therefore, economies of scale provide a basis for trade even
between countries with identical production possibilities and
tastes.
Trade with Economies of Scale
• Figure 5.3, which assumes countries A and
B are identical in tastes and production
possibilities, shows the potential of
mutually beneficial trade based solely on
economies of scale rather than comparative
advantage.
Figure 5.3: Mutually Beneficial Trade
Based Solely on Economics of Scale
Y
Slope = – (PX/PY)tt
BP
Ac = Bc
A* = B*
UA1 = UB1
UA0 = UB0
0
AP
X
Internal Economies of Scale
• With internal economies of scale, trade allows
consumers to consume larger varieties of goods at
lower prices.
– Trade helps to increase variety by expanding the
consuming population for any firm’s product.
• Firms in one country specialize in one set of varieties, and
firms in the other to another set. Consumers then have access
to all the varieties through trade.
– Each firm achieves economies by specializing.
Figure 5.4: Internal Economics of Scale as a
Basis for Trade between Identical Countries
Firm’s
ACAX
Firm’s
ACAY
0
AC Y
0
AC X
1
AC X
AC
A
X
AC 2Y
A
AC Y
DAX
0
A
X0
A+B
DA
DX
X A1
(a) X Industry in A
Firm’s Output
of X
0
Y A0
D
A+B
Firm’s Output
of Y
(b) Y Industry in A
Figure 5.4: Internal Economics of Scale as a
Basis for Trade between Identical Countries
Firm’s
ACBX
Firm’s
ACBY
0
AC Y
0
AC X
AC 2X
B
AC X
D
0
X B0
B
AC Y1
B
AC Y
A+B
D
Firm’s
Output of X
(c) X Industry in B
D
0
YB0
B
D
A+B
B
Y 1 Firm’s
Output of Y
(d) Y Industry in B
External Economies of Scale
• External economies of scale can help explain the
observed phenomenon of industrial agglomeration
– the tendency of firms in an industry to cluster
geographically.
–
–
–
–
Watch industry in Switzerland
Movie industry in Hollywood
Financial industry in New York and London
Economies occur when the clustered industry reaches a
size adequate to support specialized services.
• For example, skilled labor markets
Figure 5.5: External Economics of Scale and
Comparative Advantage
Firm’s AC
B
AC
AC 3
AC2
A
AC
AC
AC 1
AC A
A
B
D =D
0
B
B
A
X 0 X0
A+B
D
X 2 X 1 Industry Output
•
External Economies of Scale
Would protection help in cases such as the one in
Figure 5.5 where economies of scale result in trade
that runs counter to comparative advantage?
– Figure 5.6 illustrates two possibilities:
1. Panel (a) combines weak scale economies and strong
comparative advantage. Temporary protection of A’s market
could allow country-A firms to capture the market even if
country-B firms enjoyed a head start.
2. Panel (b) combines strong scale economies and weak
comparative advantage. Temporary protection would not
allow country-A firms to capture the market from already
established country-B firms.
Figure 5.6: Interaction of External Scale
Economics and Comparative Advantages
Firm’s
AC
Firm’s
AC
AC 6
AC2
AC 2
AC 4
AC5
AC
ACA
B
B
AC
AC
A
D = DB
0
X4
X2 X5
A+B
D
Industry
Output
(a) Small Scale Economies,
Large Comparative Advantage
A
0
X6
D = DB
X2
A
A+B
D
Industry
Output
(b) Large Scale Economies,
Small Comparative Advantage
Dynamic External Economies
• In some cases, firms’ average costs depend
not on the industry’s current output, but on
its cumulative output.
– Downward-sloping curve in Fig. 5.7 captures
the negative relationship between cumulative
industry output and firms’ average costs.
• That curve is called the Learning Curve.
– Associated economies called dynamic external economies.
Figure 5.7: Dynamic External Economics
and the Learning Curve
Firm’s AC
AC 2
AC1
AC 3
AC0
LCB
LC A
A
D =D
0
B
X 1 X0
A+B
D
Cumulative
Industry
Output
Scope of Economies and
Learning
• At times, a firm’s costs depend on the
output of the worldwide industry, either
current or cumulative.
– Most arguments for protection based on
external economies of scale, like the one in Fig.
5.6 (a), would disappear.
• Example: semiconductors – recent evidence
suggests effective learning may take place based on
foreign as well as domestic production experience.
Scope of Economies and
Learning
• Trade based on external economies of
scale can be beneficial or harmful
depending on:
1. Importance of scale economies relative to
comparative advantage;
2. Whether historical production patterns follow
or run counter to comparative advantage; or
3. Whether domestic or worldwide industry
output provides the basis for scale economies.
Technology-Based Theories of
Trade
• The Product Cycle
– Technological innovation and new-product
development tend to occur in major industrialized
economies.
• Reflects highly educated and skilled workforce, and the
relatively high level of R&D expenditures.
– Primary implication of this theory is that as each
product moves through its life cycle, the geographic
location of its production will change.
Technology-Based Theories of
Trade
•
Stages in the Product Cycle:
1. Actual production needs to be located close to consumers so
they can provide feedback on its refinement.
•
Only the domestic firm owns the technology, so production
occurs only in the firm's home country.
2. Eventually, the firm perfects the product and production
accelerates, first for the domestic market and then for export.
3. As production technology becomes standardized, the
innovating firm may find it profitable to license its
technology to firms abroad.
•
Production may relocate to other countries with lower costs of
production.
Technology-Based Theories of
Trade
• Stages in the Product Cycle:
4. Next, imports rather than domestic production
begin to serve the domestic market of the
innovating country.
•
The technology has diffused completely.
5. Finally, the product completes its cycle.
Although domestic consumption of the good
may continue, imports satisfy that
consumption.
Overlapping Demands as a
Basis for Trade
• Linder suggested that similarities in demand
between two countries can form a basis for trade,
especially for manufactured goods.
– States that firms typically do not produce goods solely
for export – most produce goods for which domestic
demand exists.
• Linder argues that for many manufactured goods, the quality of
the good that consumers in a specific country demand depends
primarily on their income.
– Consumer with higher incomes tend to demand goods of higher
quality.
Figure 5.8: The OverlappingProduct Quality Demand Hypothesis
QAmax
QAmin
0
IAmin
IAmax
(a) Income Overlap
Determines Quality Overlap
Income
Overlapping Demands as a
Basis for Trade
• Figure 5.9 demonstrates that most
merchandise exports go from one highincome economy to another.
– In 1995, only 33% of exports went from a highincome economy to a developing one or viceversa.
Figure 5.10: Transportation Cost and the
International Market for Good X
PX
PX
Exports AX
PBX
Exports A
X
P0X
PttX
T
PttX
1
ImportsBX
PX
Trade in X
0
E
F
H
G
M
J
Imports BX
P AX
0
X*
(a) Trade with
No Transportation Costs
X *T
X*
Trade in X
(b) Trade with
Transportation Costs
Transportation Costs as a
Determinant of Trade
• Transportation costs also play an important role in
trade with external economies of scale.
– High transportation costs can contribute to
agglomeration effects common in industries
characterized by external economies.
• Another question; who pays for these costs?
– Generally, exporter and importer share the costs.
• The less price responsive the demand for the good by the
importing country, the larger the share of transportation costs
the importer will bear.
Location of Industry
– Market-oriented industries
• Example: Retail sales operations like to be near their
customers.
– Footloose or light industries
• Has no need to locate near either raw material
sources or markets.
– Their products typically neither gain nor lose a significant
amount of weight or volume as they move through the
stages of production.
» Example: semiconductors.
Conducting Semiconductor Trade
• Figure 5.11 illustrates the industry shares of
the world’s semiconductor market in 1996.
– The United States and Japan together accounted
for 80% of the total world production.