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I. International Trade and development

Raul Caruso

Università Cattolica del Sacro Cuore di Milano

raul.caruso@unicatt.it

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Let’s Start

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The main question of this course is:

Does trade help economic development?

How?

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World Trade and World Income

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World Trade and World Income

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World Trade and World Income

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World Trade and Income

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Trade and World Income

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The question is still:

Does Trade cause GDP growth?

The answer seems to be YES

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Trade and Income (Frankel and Romer 1999)

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Frankel and Romer 1999

Frankel and Romer (1999) find that:

(1) There is a positive effect of trade on income- (economic factors). The levl of income is increasing in trade share

(2) Increased size of the countries raises income. (geography matters)

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Trade Share or Trade Openess Ratio

Trade Openess RatioThe trade-to-GDP-ratio is the sum of exports and imports divided

by GDP. This indicator measures a country's "openness" or "integration" in the world economy. It represents the combined weight of total trade in its economy, a measure of the degree of dependence of domestic producers on foreign markets and their trade orientation (for exports) and the degree of reliance of domestic demand on foreign supply of goods and services (for imports).

Trade Openess RatioX M

GDP

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For example consider these countries

Australia 48,6Austria 102,4France 57,8Germany 76,42Italy 51,37Japan 23,62Poland 69,75UK 60,2USA 26,5Belgium 173,7

Source: OECD

Trade/GDP 2004Constant prices

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Trade and Income, One more time…Harrison (2006)

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However,….

Even if cross-country studies point to a positive relationship between globalization and overall growth, such growth may lead to unequal gains across different levels of income. If the growth effects on average are small trade-induced growth could be accompanied by a decline in incomes of the poor.

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Trade and PovertyHarrison (2006)

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Finally

Therefore it seems that:

There is an association between poverty reduction and trade.

But aggregate studies sometimes are misleading

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Main points or main questions?According to Harrison (2006) the evidence suggests that the

poor are more likely to share in the gains from globalization when there are complementary policies in place:

(1)investments in human capital and infrastructure;(2)policies to promote credit and technical assistance to

farmers (3)policies to promote macroeconomic stability. (4)trade and foreign investment reforms have produced

benefits for the poor in exporting sectors and sectors that receive foreign investment.

(5)Financial crises are very costly to the poor.

Finally, evidence suggests that globalization produces both winners and losers among the poor.

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To continue….

Therefore,

(1) Trade and development exhibit a complex association

(2) Nowadays in 2010 in the aftermath of the global crises the picture could be completely different

(3) We have first to go back to the basic economic theories of trade

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Consider that USA is the largest country in the world

with over the 21% of world income17% of world imports and

10% of world exports

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Basic Economics of Trade The Ricardian Model

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Comparative Advantage Ricardo (1817)

(1)A country(region) has a comparative advantage in producing a good (say clothing) if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.

(2)Eventually this country specializes in the production of clothing.

(3)It will export clothing.

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Assumptions of Ricardian World

(1) There are 2 countries: Home and Foreign

(2) Consider only two goods: cheese and wine

(3) There is only one factor of production: Labor

(4) Labor Productivity are constant

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Some notations

• The Home economy can be described by the following relation (see Krugman):

• Where LC c LW Wa Q a Q L

, ,Lia i c wdenote Unit Labour Requirements. In other words, they are coefficients capturing costs and technology of production. In this simplest case they denote how many hours are needed to produce a unit of a good.

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More….

• Note also that the ratio:

LC

LW

a

a

Can be defined as the opportunity cost of cheese in terms of wine. That is how many units of wine I have to give up in order to have 1 unit of cheese

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For example…..

• If 1

2LC

LW

a

a

This means that in order to have 1 extra unit of cheese I have to give up 1/2 units of wine.

In one hour of work a person is supposed to produce 1 unit of cheese or ½ unit of wine.

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Identifying Comparative Advantage

• To have CA we must have:

*

*LC LC

LW LW

a a

a a (1)

That is, Home country has a comparative advantage in Cheese.

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What about Prices?

• Assume prices depending upon (1) cost ; (2) demand and supply.

• In autarky the relative prices of goods equal their relative unit labour requirements:

c LC

w LW

p a

p a

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What about Prices?

• Note that if:

c LC

w LW

p a

p a

The Economy will specialize in the production of cheese if the relative price of cheese exceeds its opportunity cost

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Prices and CA

• In the presence of CA we have:

*

*LC

LW

LC c

LW w

aa p

a p a

In the presence of trade the relative price of cheese must lie between the opportunity cost of cheese in terms of wine in Home and the opportunity cost of cheese in terms of wine in Foreign

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Prices and CA

• Consider the case:

*

*LC

LW

LC c

LW w

aa p

a a p

Both Home and Foreign will produce cheese. There will be no wine. The supply of cheese goes to infinity.

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A numerical example of CA

Cheese WineHome 1 2Foreign 6 3

See Krugman-Obstfeld, chap. 2

Unit Labor Requirements

Note: Home has higher labor productivity in both industries

In H the opportunity cost of producing cheese in terms of wine = ½

In F the opportunity cost of producing cheese in terms of wine =2

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Production and Consumption in Autarky

Home Foreign WorldCheese 70 11 81

Wine 15 10 25

Units produced in AutarkyLabor Supply=100,

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A numerical example of CA

Cheese WineHome 1 2Foreign 6 3

See Krugman-Obstfeld, chap. 2

Unit Labor Requirements

Assume that in world equilibrium the relative price is Pc/Pw=1

Home will specialize in cheese production.

Home workers can earn more by producing cheese

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Production and Consumption with Trade

Home Foreign WorldCheese 100 0 100

Wine 0 33 33

Units produced in tre presence of TradeLabor Supply=100

**

*;C W

LC LW

L LY Y

a a

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Production and Consumption with Trade

• Consumption and Production Possibilities are higher in the presence of trade

• Supply of both goods is larger

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A trick?

Note that in the example above we have:

*LW LWa a

That is, Home is more productive also in the production of wine, because it needs only two hours of work whilst Foreign country needs three (see the table). This is a case of Absolute Advantage

Is it a Trick? NO. The CA theory suggests that each country specializes in the production of good in which it has the RELATIVELY lower unit labor requirements

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Another Example

Ham PeppersHome 200 8Foreign 100 25

20025

8ham

peppers

a

a

*

*

1004

25ham

peppers

a

a

*

*ham ham

peppers peppers

a a

a a

80.04

200peppers

ham

a

a

*

*

250.25

100peppers

ham

a

a

*

*

peppers peppers

ham ham

a a

a a

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Another example

(1) Foreign has CA in Ham

(2) Home has CA in Peppers

Foreign does specialise in Ham

Home does specialise in Peppers

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CA Theory’s Legacy

• Productivity differences play a role in international trade

• Comparative Advantage rather than Absolute advantage matters

• Evidence confirms that countries tend to export goods in which they have relatively high productivity

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Measuring Comparative Advantage• Belassa Index of Comparative Advantage

where – for every time period t considered – i denotes a specific country, w indicates the world economy (i.e. the entire set of countries considered in the analysis), and j is a specific sector. b is, therefore, a sectoral relative export measure in terms of share of world exports. Since the numerator ranges from 0 (the country is not exporting products belonging to that particular sector) to 1 (the country is an international monopolist in such category of products), and the denominator which is the economic dimension of the country, in export terms – also ranges from 0 to 1, then b ranges between 0 and ED.

/ /

/ijt wjt ijt wjt

ijtit wt

X X X Xb

X X ED

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Some Elaborations

Source: De Benedictis (2005)

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A very simple model to explain competitiveness

• Consider only one factor of production: Labor.

• This assumption holds in the short-run

• The Unit labour cost is the key factor

• The ULC can help us for a prediction of CA

• Prices depend upon ULC

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Notations

ConsiderEmployement =NAverage Hours=AHProduction = YLabor Productivity= LPWage = WUnit Labor Cost =ULCExchange Rate = E

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A very simple model

You have N, Y, AH, W and E Then, The total hours worked (TH) are simply:

TH=N*AH

and the Labor Productivity (LP) is:

LP=Y/TH

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• Then, consider wages. [Note that differently from neoclassical predictions in many countries (ex. European contries) wages are sticky].

• The unit labour cost then is given by: ULC=W/LP

• (1) when wages go up ULC goes up as well; (2) when LP goes up ULC goes down.

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Identifying CA

Then, consider the relation (1) and use ULC. It becomes:

*

*C C

W w

ULC ULC

ULC ULC

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A very simple model

• To have a trend consider growth rates. Take Natural Logs of our variables. Then, we have:

th n ah

lp y th

ulc w lp

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Therefore…

Therefore in the short run we easily find that prices depend upon ULC as:

)1( KULCP

Where K denotes a mark up which in the shot run can be easily assumed to be constant [especially within industries]. Then we write simply that:

ULCP

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International CompetitivenessTo be sold on the world market goods have to be

converted into an international currency. (say the $).

Where E denotes the exchange rate between the home country and the american dollar assumed to be the international currency. Therefore P* is the international price of goods to be exported. Namely a key factor for international competitiveness

ULCEP *

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Taking natural logs we can easily compute the growth rate of ULC expressed in dollars. This is a good proxy for evaluating international competitiveness.

ulcep *

Namely, the growth rate of international price of goods to be exported equals the sum of growth rate of exchange rate and the growth rate of ULC. That is, the international competitiveness depends upon (i) rate of change of exchange rate; (ii) change of productivity.

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Labor Productivity and Unit labour costs

Average Hours

Hourly Productiv

ityexchange

rate

Italy -1,2 -0,2 -0.3 -0,6 -0,6 3,1 3,7 6,2 10Germany 1,7 -1,5 -0,3 -1,8 3,5 2 -1,5 6,2 4,7France 1,2 -1,8 -0,5 -2,3 3,6 3,2 -0,4 6,2 5,8Sweden 3,9 -1,7 -0,2 -1,9 5,9 4,3 -1,6 4,2 2,7USA 1,5 -3,7 0,1 -0,3 5,8 4,6 -1,1 // -1,1Source: figures collected from Bureau of Labor Statistics 

Productivity and Unit Labour Costs in some OECD coutries growth rates 2000-2005

Production

Employement

Total Hours

Hourly Wages

Unit Labour Costs

ULC in dollars

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Productivity in OECD countries (growth rates)

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EU-15

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USA

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Sweden

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Poland