Ricardian comparative advantage
Hecksher-Ohlin factor endowments
U.S. exports to Japan
Japan exports to U.S.
???
Intra-industry trade: share of international trade (exports + imports) that takes place within the same industry (across countries) rather than across industries
Measured by the Grubel-Lloyd Index (GLI):
GLI=1−|Xi−Mi|Xi+Mi
where X is exports, M is imports, for industry i
GLI=1−|Xi−Mi|Xi+Mi
Example: suppose a country exports good i but does not import good i:
GLI=1−1=0
GLI=1−|Xi−Mi|Xi+Mi
Example: same for a good a country imports but does not export:
GLI=1−1=0
GLI=1−|Xi−Mi|Xi+Mi
Example: what if a country’s exports of i≈ its imports of i?
GLI=1−0Xi+Mi=1
GLI=1−|Xi−Mi|Xi+Mi
GLI=1−|Xi−Mi|Xi+Mi
Example: In 2010, the U.S. exported $170 million and imported $1.9 billion worth of raw sugar cane.
GLI=1−|0.170−1.900|0.170+1.900=0.164
GLI=1−|Xi−Mi|Xi+Mi
Example: In 2010, the U.S. exported $1 billion and imported $1.2 billion worth of aircraft.
GLI=1−|1.000−1.200|1.000+1.200=0.909
Brulhart, Marius, 2009, “An Account of Global Intra-industry Trade, 1962-2006,” The World Economy 32(2):401-459
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.169
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.169
Total share of IIT by country (out of 100%): sum over all industries, weighing each industry by its share of total trade
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture, p. 336-7
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture, p.337
One way to estimate the volume of trade flows is with a gravity model of trade
Almost identically analogous to Newton’s model of gravitational attraction
F1,2=Gm1m2r2
Tradei,j=AMiMj(Di,j)n
A: a universal constant
M: size of a country's economy (often GDP)
D: distance between country i and country j
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.12
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.14
Consider trade between Australia & New Zealand and between Austria & Portugal
Both pairs have roughly same distance apart and roughly same GDPs
Trade between Australia and New Zealand is 9x higher than trade between Austria & Portugal!
Fewer alternatives in isolated Pacific Ocean relative to European countries with many trading partners
Feenstra and Taylor (2017)
Feenstra and Taylor (2017)
Tradei,j=AMiMj(Di,j)2
Trade is becoming more sensitive to distance over time!
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture
Lai, Huiwen and Daniel Treffler, 2002, “The Gains from Trade with Monopolistic Competition: Specification, Estimation, and Mis-Specification”, NBER Working Paper 9169
1) Larger countries trade more with larger countries
2) Closer countries trade more than distant countries
Is gravity consistent with H-O theory?
It used to be that most international trade was between countries very far apart for different things
Now it seems to be that trade is dominated by very close countries trading very similar goods!
In a Neoclassical world, only differences in relative autarky prices cause international trade via specialization by comparative advantage
Suggests that:
The real world (particularly last 50 years) shows:
The bulk of international trade is between similar countries
These countries tend to trade similar goods
Countries are more likely than ever before to trade more with less-distant countries
Explanations for similar trade and a "new paradigm" of trade are collectively called New Trade Theory (NTT)
Primarily rests upon the idea of increasing returns to scale (IRS) or economies of scale (EOS) as an alternative rationale for international trade
Division of labor strikes back!
Importance is still specialization, just not labor productivity, factor content, etc.
Economies of scale come in two flavors:
Internal economies: firm-level features that improve a firm's productivity, often leading to market power for that firm
External economies: industry-wide features that spill over to the productivity all firms in the industry
Recall: economies of scale: as ↑q, ↓AC(q)
Minimum Efficient Scale (MES): q with the lowest AC(q)
Recall: economies of scale: as ↑q, ↓AC(q)
Minimum Efficient Scale (MES): q with the lowest AC(q)
If MES is small relative to market demand...
Minimum Efficient Scale: q with the lowest AC(q)
Economies of Scale: ↑q, ↓AC(q)
Diseconomies of Scale: ↑q, ↑AC(q)
If MES is large relative to market demand...
A natural monopoly that can produce higher q∗ and lower p∗ than a competitive industry!
Example: Imagine a single isolated condo complex with 1,000 units far from any other buildings or telco infrastructure
Average cost=$100,000100=$1,000/subscriber
Average cost=$100,0001000=$100/subscriber
When all firms produce more/less; or firms enter or exit an industry, this affects the equilibrium market price
Think about basic supply & demand graphs:
If the size of the entire industry affects all individual firm’s costs, then there are external economies effects
Decreasing cost industry has external economies, costs fall for all firms in the industry as industry output increases (firms enter & incumbents produce more)
A downward sloping long-run industry supply curve!
Determinants:
Examples: geographic clusters, public utilities, infrastructure, entertainment
Tends towards "natural" monopoly
Industry equilibrium: firms earning normal π=0,p=MC(q)=AC(q)
Exogenous increase in market demand
Short run (A→B): industry reaches new equilibrium
Firms charge higher p∗, produce more q∗, earn π
Long run: profit attracts entry ⟹ industry supply will increase
But more production lowers costs (MC,AC) for all firms in industry
Long run (B→C): firms enter until π=0 at p=AC(q)
Firms charge higher p∗, producer lower q∗, earn π=0
Alfred Marshall
1842-1924
“...are dependent on the resources of individual houses of business engaged in [the industry], on their organization and the efficiency of their management,” (p.220).
“...are dependent on the general development of the industry [some of which] depend on the aggregate volume of production of the kind in the neighborhood while others again, especially those connected with the growth of knowledge and the progress of the arts, depend chiefly on the aggregate volume of production in the whole civilized world,” (p.220).
Alfred Marshall
1842-1924
“The most important of these result from the growth of correlated branches of industry which mutually assist one another, perhaps being concentrated in the same localities, but anyhow availing themselves of the modern facilities for communication offered by steam transport, by the telegraph and by the printing press,” (p.264).
Marshall, Alfred, 1890, Principles of Economics
150 Firms in Dalton, Georgia (pop. 33,000) supply over 70% of entire world’s carpet. Carpet has been made there since 1895.
990 firms in Hangji China (pop. 36,000) produce 3 billion toothbrushes a year, 80% of Chinese toothbrush production. Toothbrushes have been made there since 1827.
Alfred Marshall
1842-1924
“[G]reat are the advantages which people following the same trade get from near neighborhood...The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvement in machinery, in process and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas.”
Marshall, Alfred, 1890, Principles of Economics, Ch. 10
“[In Silicon Valley] engineers left established semiconductor companies to start firms that manufactured capital goods such as diffusion ovens, step-and-repeat cameras, and testers, and materials and components such as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector promoted the continuing formation of semiconductor firms by freeing individual producers from the expense of developing capital equipment internally and by spreading the costs of development. It also reinforced the tendency toward industrial localization, as most of these specialized inputs were not available elsewhere in the country.”
“[In Silicon Valley] engineers left established semiconductor companies to start firms that manufactured capital goods such as diffusion ovens, step-and-repeat cameras, and testers, and materials and components such as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector promoted the continuing formation of semiconductor firms by freeing individual producers from the expense of developing capital equipment internally and by spreading the costs of development. It also reinforced the tendency toward industrial localization, as most of these specialized inputs were not available elsewhere in the country.”
“it wasn’t that big a catastrophe to quit your job on Friday and have another job on Monday. . . . You didn’t even necessarily have to tell your wife. You just drove off in another direction on Monday morning”
Saxenian, Annalee, 1994, Regional Advantage. Cambridge: Harvard University Press, p.40
Adam Smith's pin factory illustration
Adam Smith
1723-1790
"As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by...the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men's labour as he has occasion for," (Book I, Chapter 3).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Economies of scale are inconsistent with perfect competition!
Requires us to drop an assumption of perfectly competitive markets
Instead, new trade theory begins with a foundation of monopolistic competition
We will begin next class with a review of this
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Ricardian comparative advantage
Hecksher-Ohlin factor endowments
U.S. exports to Japan
Japan exports to U.S.
???
Intra-industry trade: share of international trade (exports + imports) that takes place within the same industry (across countries) rather than across industries
Measured by the Grubel-Lloyd Index (GLI):
GLI=1−|Xi−Mi|Xi+Mi
where X is exports, M is imports, for industry i
GLI=1−|Xi−Mi|Xi+Mi
Example: suppose a country exports good i but does not import good i:
GLI=1−1=0
GLI=1−|Xi−Mi|Xi+Mi
Example: same for a good a country imports but does not export:
GLI=1−1=0
GLI=1−|Xi−Mi|Xi+Mi
Example: what if a country’s exports of i≈ its imports of i?
GLI=1−0Xi+Mi=1
GLI=1−|Xi−Mi|Xi+Mi
GLI=1−|Xi−Mi|Xi+Mi
Example: In 2010, the U.S. exported $170 million and imported $1.9 billion worth of raw sugar cane.
GLI=1−|0.170−1.900|0.170+1.900=0.164
GLI=1−|Xi−Mi|Xi+Mi
Example: In 2010, the U.S. exported $1 billion and imported $1.2 billion worth of aircraft.
GLI=1−|1.000−1.200|1.000+1.200=0.909
Brulhart, Marius, 2009, “An Account of Global Intra-industry Trade, 1962-2006,” The World Economy 32(2):401-459
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.169
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.169
Total share of IIT by country (out of 100%): sum over all industries, weighing each industry by its share of total trade
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture, p. 336-7
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture, p.337
One way to estimate the volume of trade flows is with a gravity model of trade
Almost identically analogous to Newton’s model of gravitational attraction
F1,2=Gm1m2r2
Tradei,j=AMiMj(Di,j)n
A: a universal constant
M: size of a country's economy (often GDP)
D: distance between country i and country j
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.12
Krugman, Paul, Maurice Obstfeld, and Mark Melitz, 2011, International Economics: Theory & Policy, 9th ed., p.14
Consider trade between Australia & New Zealand and between Austria & Portugal
Both pairs have roughly same distance apart and roughly same GDPs
Trade between Australia and New Zealand is 9x higher than trade between Austria & Portugal!
Fewer alternatives in isolated Pacific Ocean relative to European countries with many trading partners
Feenstra and Taylor (2017)
Feenstra and Taylor (2017)
Tradei,j=AMiMj(Di,j)2
Trade is becoming more sensitive to distance over time!
Krugman, Paul, 2008, “The Increasing Returns Revolution in Trade and Geography,” Nobel Prize Lecture
Lai, Huiwen and Daniel Treffler, 2002, “The Gains from Trade with Monopolistic Competition: Specification, Estimation, and Mis-Specification”, NBER Working Paper 9169
1) Larger countries trade more with larger countries
2) Closer countries trade more than distant countries
Is gravity consistent with H-O theory?
It used to be that most international trade was between countries very far apart for different things
Now it seems to be that trade is dominated by very close countries trading very similar goods!
In a Neoclassical world, only differences in relative autarky prices cause international trade via specialization by comparative advantage
Suggests that:
The real world (particularly last 50 years) shows:
The bulk of international trade is between similar countries
These countries tend to trade similar goods
Countries are more likely than ever before to trade more with less-distant countries
Explanations for similar trade and a "new paradigm" of trade are collectively called New Trade Theory (NTT)
Primarily rests upon the idea of increasing returns to scale (IRS) or economies of scale (EOS) as an alternative rationale for international trade
Division of labor strikes back!
Importance is still specialization, just not labor productivity, factor content, etc.
Economies of scale come in two flavors:
Internal economies: firm-level features that improve a firm's productivity, often leading to market power for that firm
External economies: industry-wide features that spill over to the productivity all firms in the industry
Recall: economies of scale: as ↑q, ↓AC(q)
Minimum Efficient Scale (MES): q with the lowest AC(q)
Recall: economies of scale: as ↑q, ↓AC(q)
Minimum Efficient Scale (MES): q with the lowest AC(q)
If MES is small relative to market demand...
Minimum Efficient Scale: q with the lowest AC(q)
Economies of Scale: ↑q, ↓AC(q)
Diseconomies of Scale: ↑q, ↑AC(q)
If MES is large relative to market demand...
A natural monopoly that can produce higher q∗ and lower p∗ than a competitive industry!
Example: Imagine a single isolated condo complex with 1,000 units far from any other buildings or telco infrastructure
Average cost=$100,000100=$1,000/subscriber
Average cost=$100,0001000=$100/subscriber
When all firms produce more/less; or firms enter or exit an industry, this affects the equilibrium market price
Think about basic supply & demand graphs:
If the size of the entire industry affects all individual firm’s costs, then there are external economies effects
Decreasing cost industry has external economies, costs fall for all firms in the industry as industry output increases (firms enter & incumbents produce more)
A downward sloping long-run industry supply curve!
Determinants:
Examples: geographic clusters, public utilities, infrastructure, entertainment
Tends towards "natural" monopoly
Industry equilibrium: firms earning normal π=0,p=MC(q)=AC(q)
Exogenous increase in market demand
Short run (A→B): industry reaches new equilibrium
Firms charge higher p∗, produce more q∗, earn π
Long run: profit attracts entry ⟹ industry supply will increase
But more production lowers costs (MC,AC) for all firms in industry
Long run (B→C): firms enter until π=0 at p=AC(q)
Firms charge higher p∗, producer lower q∗, earn π=0
Alfred Marshall
1842-1924
“...are dependent on the resources of individual houses of business engaged in [the industry], on their organization and the efficiency of their management,” (p.220).
“...are dependent on the general development of the industry [some of which] depend on the aggregate volume of production of the kind in the neighborhood while others again, especially those connected with the growth of knowledge and the progress of the arts, depend chiefly on the aggregate volume of production in the whole civilized world,” (p.220).
Alfred Marshall
1842-1924
“The most important of these result from the growth of correlated branches of industry which mutually assist one another, perhaps being concentrated in the same localities, but anyhow availing themselves of the modern facilities for communication offered by steam transport, by the telegraph and by the printing press,” (p.264).
Marshall, Alfred, 1890, Principles of Economics
150 Firms in Dalton, Georgia (pop. 33,000) supply over 70% of entire world’s carpet. Carpet has been made there since 1895.
990 firms in Hangji China (pop. 36,000) produce 3 billion toothbrushes a year, 80% of Chinese toothbrush production. Toothbrushes have been made there since 1827.
Alfred Marshall
1842-1924
“[G]reat are the advantages which people following the same trade get from near neighborhood...The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvement in machinery, in process and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas.”
Marshall, Alfred, 1890, Principles of Economics, Ch. 10
“[In Silicon Valley] engineers left established semiconductor companies to start firms that manufactured capital goods such as diffusion ovens, step-and-repeat cameras, and testers, and materials and components such as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector promoted the continuing formation of semiconductor firms by freeing individual producers from the expense of developing capital equipment internally and by spreading the costs of development. It also reinforced the tendency toward industrial localization, as most of these specialized inputs were not available elsewhere in the country.”
“[In Silicon Valley] engineers left established semiconductor companies to start firms that manufactured capital goods such as diffusion ovens, step-and-repeat cameras, and testers, and materials and components such as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector promoted the continuing formation of semiconductor firms by freeing individual producers from the expense of developing capital equipment internally and by spreading the costs of development. It also reinforced the tendency toward industrial localization, as most of these specialized inputs were not available elsewhere in the country.”
“it wasn’t that big a catastrophe to quit your job on Friday and have another job on Monday. . . . You didn’t even necessarily have to tell your wife. You just drove off in another direction on Monday morning”
Saxenian, Annalee, 1994, Regional Advantage. Cambridge: Harvard University Press, p.40
Adam Smith's pin factory illustration
Adam Smith
1723-1790
"As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by...the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men's labour as he has occasion for," (Book I, Chapter 3).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Economies of scale are inconsistent with perfect competition!
Requires us to drop an assumption of perfectly competitive markets
Instead, new trade theory begins with a foundation of monopolistic competition
We will begin next class with a review of this