International Trade Theory and Trading with United States Discussion Topic: International trade theory – After you have read the literature posted under un

International Trade Theory and Trading with United States Discussion Topic: International trade theory – After you have read the literature posted under unit two, the assignment is to write a two (2) page paper discussing your understanding and controversies related to the topic. As you write, choose a country that trades with the United States. What is it that we trade with this country, why do we trade for it, what would life be in America without this product? Are we able to make this product ourselves? If so, what would it cost? Is this trade a result of absolute or comparative advantages? If trade was stopped, what would happen to the country and its people who trade with America? First of all, you will have to show you have read the readings and some additional sources. This does not mean to just quote from all the material, but go beyond that in presenting/discussing the arguments made in each reading. I would like your informed opinions included in the paper.Specifications:Additional Research – Demonstrate that you have done additional Internet research on this topic by including three additional cited sources in your paper. By this, I mean three sources beyond the readings I listed in the Course Documents link. Proper citing of these sources in the narrative of your paper is required. Two pages, double spaced, not including Title or Works Cited Page. This means the paper should be 600-750 words. As with all papers prepared for this course, content in individual papers is expected to be supported by globally acknowledged, peer-reviewed, refereed research citations and sources. All written submissions should adhere to APA standards for writing, formatting, and citations/references. International Trade Theory
James E. Anderson
Boston College
S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave Macmillan, reproduced with permission of
Palgrave Macmillan. This article is taken from the author’s original manuscript
and has not been reviewed or edited. The definitive published version of this
extract may be found in the complete New Palgrave Dictionary of Economics
in print and online, forthcoming.
Abstract
International trade theory provides explanations for the pattern of international trade and the distribution of the gains from trade. The theory
convinces most economists of the benefits of liberal trade. But many noneconomists oppose liberal trade. Opponents include some who may have
encountered trade theory but nevertheless fall prey to fallacious reasoning.
This essay attempts to convey why trade theory is so persuasive to economists
and also to deal with why many non-economists are not persuaded.
1
International Trade Theory
Why do nations trade what they do? Is trade a good thing? The theory of
international trade provides answers. The answers are both convincing and
elegant, hence the vast majority of economists agree about the desirability
of liberal trade. But the argument is also subtle and often misunderstood
or distorted. Thus a large proportion of the general population tends to
oppose liberal trade from confusion. This essay will attempt to convey why
the answers convince most economists and why their liberal trade position
is so often misunderstood. The essay’s focus is theory, but theory convinces
when it succeeds in fitting the data. Thus passing reference will be made
to empirical findings, a sensibility much more thoroughly developed in the
graduate textbook of Feenstra (2003).
“Buy low, sell high” logic leads economists to comparative advantage theory. Comparative advantage means the comparison of relative price differences between nations to explain the pattern of trade. For example, compare
the relative price of wheat in terms of cheese at home to the same relative
price in the foreign economy in a hypothetical equilibrium with no trade
(autarky) or with restricted trade. The country with the lower relative price
of wheat is said to have a comparative advantage in wheat while the other
country has, symmetrically, a comparative advantage in cheese. Buy low,
sell high logic predicts that a country will export the good in which it has a
comparative advantage.1
Notice that the focus on relative prices tends to cancel out forces (exchange rate manipulations, environmental or labor standards) which cause
national differences in levels of nontraded factor (or goods) prices. Note also
that by this reasoning a country must have a comparative advantage in some
good. Prices of nontraded factors of production adjust in general equilibrium
so that each country ends up in the trade equilibrium with a competitive or
absolute cost advantage in the good in which it has a comparative advantage.
Partial equilibrium thinking takes factor prices as given and does not impose
the external budget constraint that requires exports to pay for imports. Partial equilibrium reasoning leads to misunderstandings explored below as the
1
In the case of many goods, the prediction is that a country will on average export goods
which are relatively cheap in the absence of trade and import goods which are relatively
expensive in the absence of trade. The prediction is about correlation. Bernhofen and
Brown (2005) show that Japan’s opening to trade in the 1850’s reveals data consistent
with the prediction.
2
absolute advantage fallacy.
Comparative advantage differences between nations are explained by exogenous differences in national characteristics. Labor differs in its productivity internationally and different goods have different labor requirements, so
comparative labor productivity advantage was Ricardo’s predictor of trade
patterns. Ricardian trade theory is useful in its simplicity and even rather
loosely confirmed by empirical evidence. The factor proportions theory added
relative factor endowment differences to the exogenous explanation of comparative advantage (Jones, 1987). More capital abundant countries have
higher labor productivity, but the advantage gained relative to the less abundant countries varies with the relative capital intensity of the good’s technology. Combining technology and endowment differences appears to account
well for actual trade patterns (Davis and Weinstein, 2002).
Trade theory also encompasses endogenous differences between countries.
One focus is on economies of scale. The wider market due to trade induces
a cost advantage in an industry in one of the countries. Another theory
is based on monopolistic competition, whereby the wider markets due to
trade increase product variety as buyers seek the special characteristics of
foreign brands. Differentiated products trade flows both ways within product
categories.
Trade costs also shape the pattern of trade. The economic theory of gravity explains the complex bilateral trade patterns among countries. Actual
trade is much lower than gravity predicts in a frictionless world, providing evidence of trade costs much larger than those due to policy or transportation.
The costs are well explained by geography and a set of national differences.
The stability of the relationships over time suggests that these costs change
slowly.
There are gains from trade in all these models. But the division of the
gains will be uneven and there will be losers. Distribution matters in two
ways, between and within nations. Internationally, with only mild qualifications, gains are shared between nations: some trade is better than none.
Each nation can act through trade policy to take more of the gain, however, leading to destructive trade wars with mutual losses. Within national
economies, there are gains on average but there are ordinarily losers. National
institutions act to redistribute some of the gains (U.S. Trade Adjustment Assistance) or provide temporary relief from losses due to trade (escape clause
protection), at the cost of lowering the overall gain from trade.
The topics of this outline are developed below in more detail. Section
3
1 examines the causes of comparative advantage. Section 2 exposes the
absolute advantage fallacy. Section 3 reviews endogenous advantage. Section
4 sets out the economic theory of gravity and its implications. The concluding
section examines the gains from trade.
1
Comparative Advantage
Ricardo explained comparative advantage as due to differences in labor productivity. Suppose that it takes two hours of labor to produce a bushel of
wheat in the home country, while it takes four hours of labor to produce a
bushel of wheat in the foreign country. Also, it takes three hours of labor to
produce a pound of cheese in the home country while it takes eight hours of
labor to produce a pound of cheese in the foreign country.
Ricardo saw that the world trade equilibrium would result in the home
country exporting cheese and the foreign country exporting wheat. This is
because in the absence of trade, a pound of cheese is worth 1.5 bushels of
wheat (3 hours per pound of cheese divided by 2 hours per bushel of wheat)
in the home country while a pound of cheese is worth 2 bushels of wheat in
the foreign country. The labor market equilibrium which accompanies such
a trade equilibrium must have a foreign wage of at most one-half of the home
wage (since with a foreign wage equal to one-half the home wage, a bushel
of wheat costs the same amount in each country, allowing production in
both). Considering a low wage foreign economy, the labor market equilibrium
accompanying the trade equilibrium could have a foreign wage no lower than
three-eighths of the home wage (since in this case a pound of cheese costs
the same amount in each country).
Notice that countries export the good in which they have the comparative
labor productivity advantage, cheese for the home country and wheat for the
foreign country. The numbers chosen make no difference to the logic, what is
essential is that comparative labor productivities differ. One special aspect
of the numbers deserves emphasis however: the home country has an absolute
labor productivity advantage in both goods yet trade occurs regardless.
Subsequent developments of trade theory generalized the production model.
The essence of comparative advantage theory remains: trade is due to differences in relative prices that would obtain in the absence of trade, and an
average of each country’s citizens gain from such trade. The Heckscher-Ohlin
analysis of the factor proportions model predicted that a country would have
4
a comparative advantage in the good which made relatively intensive use
of its relatively abundant factor. Thus if the home country were relatively
abundant in capital (explaining why its labor was so much more productive
in the preceding example), it would have a comparative advantage in the
good which used capital relatively intensively (cheese in the preceding example). Conversely the foreign country is relatively abundant in labor and has
a comparative advantage in the good which uses labor relatively intensively
(wheat in the example above).
Trade in goods compensates for the international immobility of factors.
The factor content extension of Heckscher-Ohlin trade theory predicts that
trade patterns permit each country to consume factor services as if it were
in a completely integrated world, smoothing out differences in national factor endowments. Recent empirical work has met with striking success in
combining factor endowment differences with technology differences as an
explanation of observed trade patterns (Davis and Weinstein, 2002).
Comparative advantage theory is much more general than the preceding
discussion of special cases (Deardorff, 1984), but predictions about the pattern of trade weaken with generality. On average a country will import goods
that would be relatively expensive in the absence of trade. See the Appendix
for a technical statement. See Bernhofen and Brown (2004) for confirming
evidence based on Japan’s opening to trade in the 1850’s. The assumptions of the general model are that (i) price taking consumers minimize the
expenditure needed to realize any level of utility (real income), and (ii) producers behave so as to maximize the national product given the resource
endowments. Assumption (i) implies downward sloping demand curves in
the generalized form. Assumption (ii) leads to upward sloping supply curves
in the generalized form. Scale economies and imperfect competition, treated
below in the section on endogenous advantage, can lead to the violation of
assumption (ii).
2
The Absolute Advantage Fallacy
Businessmen naturally compare the money cost of the same good in different
locations to draw inferences about the direction of trade. Absolute cost
advantage appears to imply that a nation imports goods that are cheaper
abroad and exports goods that are more expensive abroad. The reasoning
is insidious because it makes sense in many contexts. Absolute advantage
5
appropriately addresses the householder’s question of which good should be
purchased, the businessman’s question of how tough are my competitors?
The individual businessman can appropriately take all other prices as given
when contemplating his own actions, such as entering a new export market.
To see the difference between absolute and comparative advantage reasoning clearly, return to the Ricardian example above. If wages (measured
in a common currency) were equal in the two countries prior to the opening
of trade, the home country would have a ‘competitive’ or absolute advantage in both goods: it could undersell the foreign country in both wheat and
cheese. Foreign businessmen would naturally be worried that they would all
be driven from the market. This universal bankruptcy could not be an equilibrium, however, because the foreign workers would have no income to pay
for home produced goods. The imbalance between expenditure and income
would also mirror the absence of exports to pay for imports. Market equilibrium would be reached through price changes, lowering the foreign wage
or raising the home wage until the foreign workers could be employed in the
industry in which the foreign economy has the comparative advantage. (Unless the two currencies were pegged, the exchange rate of the foreign economy
could depreciate and create the same effect.) More general models of production lead to the same conclusion: equilibrium costs will adjust to confer
absolute advantage in the good in which each country has a comparative advantage.2 The absolute advantage is weak in the mathematical sense in the
case where both countries continue to produce the good.
Another illustration of the absolute advantage fallacy arises in popular
concerns about the rapid productivity growth of China compared to the US.
A 10% improvement in productivity will indeed secure a 10% cost advantage
2
Imports need not equal exports bilaterally in a many country world; overall balance
only is required. Imports also need not equal exports in any single time period, with the
aggregate trade imbalance offset by international borrowing or lending. Balanced trade
in the aggregate at a point in time is a simplifying assumption appropriate to analyzing
the causes of trade and the gains from trade. When allowing for intertemporal trade, the
expected present value of trade balances must be equal to zero (if not, trade is a Ponzi
scheme). With full-blown intertemporal trade, essentially the same forces determine the
pattern of trade and the gains from trade. Naturally, however, the time path of prices,
especially the factor prices in the two countries, has important implications for trade
volume and the gains from trade.
With many goods, comparative advantage applies to ranges of goods rather than to
a single good, and the dividing line between comparative advantage and disadvantage is
endogenous.
6
for the businessman over his competitor. A 10% improvement in all Chinese
productivity relative to the US is unlikely to change comparative advantage
(indeed, in the Ricardian example, comparative labor productivity advantage
is unchanged) because Chinese wages will rise relative to US wages. Similarly
a 10% drop in all US productivity due to tighter environmental regulations
will be unlikely to change comparative advantage because US factor returns
will fall.
The widespread practice of making international comparisons of ‘competitive advantage’ is essentially misguided because it suggests the metaphor
of a race. The race metaphor is extended in concerns about ‘a race to the
bottom’, which supposedly expresses the dilemma of countries seeking to implement pollution or labor standards but being pressured to lower standards
by their competition with foreign countries that have low standards. But
nations do not ‘compete’ as firms do. A firm may well be unable to survive
after implementing pollution reduction when its competitors abroad do not
follow suit and no other prices change in the new equilibrium. Nations cannot similarly put themselves out of business because factor prices will change
in the new equilibrium. Polluting industries may or may not survive at the
new factor prices under the new regulations, but the nation’s factors will
be productively employed somewhere in the economy. Pollution reduction is
costly with or without trade; nothing about the nature of a trading economy
makes any essential difference to the nation’s ability to implement desired
standards. The desirability of trade is an essentially separate matter.
3
Endogenous Advantage
Many goods are traded because they are simply unavailable from local production. Some kinds of availability are exogenous to the interaction of nations — diamonds and oil are found only in a few locations. Endogenous
availability is in contrast driven by advantage arising from the economic
interaction of nations. Endogenous advantage normally coexists with comparative advantage but it is simpler to consider special cases independent of
comparative advantage. Theory focuses on endogenous advantage resulting
from economies of scale.3
3
In a formal but trivial sense, oil or diamond trade can be seen as comparative advantage trade — big oil deposits lead to a low relative price of oil where they are found.
Moreover, comparative advantage trade is often associated with the disappearance of some
7
Trade based on scale economies features the possibility of multiple equilibria — one country will produce a good with scale economies but which
nation ends up producing can be a matter of chance. Since advantage is
endogenous, it appears attractive in developing countries to attempt to reverse the historical head start of rich countries by starting up production
behind protection and then later being able to compete on world markets.
The record of success in such efforts is mixed.
Openness to trade will generally allow economies of scale to be more thoroughly exploited, so this is a new source of gains from trade. Moreover, wider
markets may support a wider range of products, still another source of gains
from trade. Each country shares in the gains from trade with scale economies
under conditions that appear to be met in practice.4 The theoretical possibility that a country can lose from trade based on scale economies has drawn a
lot of attention from development economists in particular (Ethier, 1982b).5
Gains can be guaranteed if a country expands production in goods with scale
economies, so it looks more attractive to use policy to promote production
of such goods.
Scale economies come in two forms: external to the firm and internal to
the firm. External scale economies are typified by specialized labor markets
such as Silicon Valley, where the concentration of the market reduces search
costs for computer engineers. External scale economies need not be locationspecific, however. Increases in the scale of downstream final production can
permit carrying on upstream input production with a specialized process
that is cheaper at large enough scale. Such scale economies can operate at
the level of the world economy and appear to be bound up with the recent
phenomenon of outsourcing (Ethier, 1982a). Global scale economies tend to
guarantee mutual gains from trade among countries.
Internal scale economies are associated with imperfect competition when
the size of the firm looms large relative to the market size. Trade tends
to intensify competition and thus to reduce the inefficiency of monopoly,
industries in some countries. Neither of these associations of comparative advantage with
availability is essential to the model, however.
4
This claim is based on the results from numerous simulation models of trading
economies that have been developed since the mid-70’s.
5
Losses result when a trading equilibrium has a country importing the good with scale
economies while still producing it. Since domestic scale is smaller, unit costs are higher,
meaning that market forces perversely ‘choose’ to import a good with higher price than
in autarky. Simulation models have not found such equilibria but they are possible.
8
another gain from trade.
The most fruitful form of imperfect competition for trade theory has
been monopolistic competition. Only Ford Motor Co. produces Ford autos
(monopoly) but dozens of brands compete for auto buyers. Each design has
a fixed cost of design (and marketing) which must be covered by sales net
of variable cost. The total market size limits the number of designs which
can profitably be produced. A signal accomplishment of trade theory in the
1980’s was the embedding of monopolistic competition in a general equilibrium trade model (Helpman and Krugman…
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