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TU-91.2043 International Economics
by
Hannele Wallenius
Aalto University School of Science
Department of Industrial Engineering and Management
2. WHY DO WE TRADE?- Part II
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 2
2. WHY DO WE TRADE?
2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage
2.2 Modern Trade Theory: Heckscher-Ohlin Model
2.3 Alternative Trade Theories: Results from Practical Evidence
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 3
From Trade Theory To Practice
Many researchers have tried to test the Ricardian and Heckscher-Ohlin theories First simply by observing: Adam Smith and
Ricardo
Latter statistical calculations (data collection)
In many cases they have indeed found evidence which supports these theoriesFinland does not grow bananas!
But also contradicting evidence has been found Trade in manufactured goods, intra-industry
trade
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 4
Problems with H-O Model Why does not a country with cost
advantage capture the whole export market? imperfect markets (monopolistic
and oligopolistic) nonhomogeneous products
(product differentiation) transportation costs trade barriers
These were not considered in H-O model!
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 5
Problems with H-O Model continued
Furthermore, Heckscher-Ohlin theorem based on factor endowments would imply that trade should occur primarily between pairs of countries with very different relative factor endowments
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 6
Problems with H-O Model continued
HO theory seems to explain quite well the trade between industrialized and developing countries, but a large volume of trade takes place among industrialized countries that often have similar relative factor endowments
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 7
The composition of world exports
Source: WTO, International Trade Statistics
0 %10 %20 %30 %40 %50 %60 %70 %80 %90 %
100 %
1955 2006
Food, Agriculture
Fuels
Other primary commodities (e.g. minerals)Manufactures
Largest part of trade in manufactured goods.
International Economics
Hannele Wallenius
Other
Agricultural products
Fuels and mining products
Manufactures
0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 %
4.0%
9.5%
21.8%
64.7%
World merchandise exports by major product group (% of world merchandise exports), 2013
The composition of world exports, 2013
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 8
Source: WTO International trade statistics 2014
http://www.wto.org/english/res_e/statis_e/its2014_e/its2014_e.pdf
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 9
Strong Challenges to the Traditional Trade Theories
1. Trade among similar economies For instance, who are Finland's
largest trading partners?
2. Intra-industry trade What do we export, for instance, to
Sweden and what do we import from there?
International Economics
Hannele Wallenius
Intra-industry Trade by Country, 2006*
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 10
* The index ranges from zero to 100 with a value of 100 indicating all trade of a country is intra-industry.
International Economics
Hannele Wallenius
Intra-industry Trade in Manufactures, 1997-2008 average, selected countries
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 11
0 20 40 60 80 100
IcelandRussia
IndiaGreeceJapan
TurkeyBrazil
IrelandNorway
ChinaFinland
SwitzerlandEstonia
United StatesSwedenMexico
GermanySpain
United …Netherlands
FranceBelgium
Source: OECD Economic Globalization Indicators 2010
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 12
New Trade Theories (NTT)
Next we present some new trade theories, which base international trade on economies of scale, network effects, imperfect competition, taste of variety, and differences in the development and spread of new technologies over time among nations
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 13
Modification of H-O Model
A. The role of taste - production bias vs. taste bias
B. The role of trade barriersC. Classification of inputs
i) capital – laborii) arable farmland, raw materials,
human capital, man-made capital, high-skilled labor, unskilled labor
If these modifications are made to H-O model, a larger proportion of trade can be explained by the model…
WSJ, 19.8. 2010
China Cultivates Taste for German Cars
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 14
New Trade Theories
1. Increasing returns to scale in the production process* economies of scale
Indivisibilities Division of labor Geometrical reasons Inventories Once-and-for-all inputs
International trade allows a country to specialize in industries where average costs fall as additional resources are utilized
* Increasing returns to scale exist when a proportionate increase in use of factors of production results in a greater than proportionate increase in output.
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 15
New Trade Theories cont.
Economies of Scale in Imperfectly Competitive Markets Perfect competition, as assumed by H-
O model, can exist only if economies of scale are not extensive
Economies of scale are common in the real world of manufacturing and in some parts of services sector
Increasing returns to scale (economies of scale) and imperfect competition can explain some of the intra-industry trade
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 16
New Trade Theories cont.
Economies of Scale in Imperfectly Competitive Markets continued
Ddom
MRdom
ACMC
Dworld
MRworldQe
P
AC
Trade can also create an otherwise unsustainable industry where large economies of scale exist.
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 17
New Trade Theories continued
2. Intra-Industry TradeCan be explained by Taste of Variety and Differentiated
Products People have a tremendous diversity of
taste and are willing to pay for it at the marketplace• Product differentiation and variety of taste
leads to specialization and imperfect competition
Taking advantage from division of labor in industries that exhibit economies of scale we can consume a larger variety of products and services on a lover cost
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 18
Intra-Industry Trade cont.
Border trade when countries share a long border (transportation cost)
FA
FB
CA
CB
Country A
Country B
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 19
New Trade Theories continued
3. Technological Gap and Product Cycle
Heckscher-Ohlin theory is static
Some economists have suggested that perhaps the composition of trade depends on dynamic factors, such as technological change
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 20
New Trade Theories cont.:
Product Cycle
One interesting hypothesis is that new products pass through a series of stages in the course of their development, and their comparative advantage position changes as they move through this product cycle
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 21
Product Cycle cont.
Some countries seem to have ability to supply a constant flow of new products: innovation – imitation
Product cycle: new product maturing product standard product
the comparative advantage of production changes during the product cycle
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 22
New Trade Theories cont.:
Product Cycle cont.
I II III IV
Imports,foreignproduction
Exports,domesticproduction
Domestic production
(X-M)D
Foreign production
Time
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 23
New Trade Theories…
Product Cycle cont.
I Product development and sale in domestic market
II Growth in exports as foreign demand springs up
III Decline in exports as foreign firms begin to produce for their home markets
IV Country becomes a net importer as foreign prices fall
At each stage different inputs dominate
II IIII IIIIII IVIV
Imports,foreignproduction
Exports,domesticproduction
Domestic production
(X-M)D
Foreign production
Time
International Economics
Hannele Wallenius
At each stage different inputs dominate
I Product development and sale in domestic market• innovative, skilled labor, and financial resources
needed
II Growth in exports as foreign demand springs up• marketing skills and financial resources needed
III Decline in exports as foreign firms begin to produce for their home markets• product starts to be mature and know-how
penetrates to other markets, cheap labor becomes important
IV Country becomes a net importer as foreign prices fall• standard product, mass production, cheap labor
dominates
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 24
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 25
New Trade Theories cont.:
4. The Gravity Equation
Why does one country trade a great deal with one trading partner and far less with others?
Compare, for example, Finland trading with Sweden, Russia, Germany and rest of the EU... and on the other hand with some African countries
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 26
New Trade Theories cont.:
The Gravity Equation
According to this formula a country's trade shares are
a) positively related to the size of other national economies (measured as GNP)
R = Resistance variablesR = Resistance variables),,( RGNPfT
Ti
tot
i Ti = trade with country i
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 27
New Trade Theories cont.
The Gravity Equation continued
b) and negatively related to so-called resistance variables, factors that discourage a particular trade flow
· such factors can be transportation cost, trade barriers that are not the same for all trading partners, among others
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 28
New Trade Theories cont.
5. External Economies of Scale Internal scale economies occur when a
firm's AC falls as the output of the firm increases
External scale economies occur when firms AC falls when the output of the industry increasesReasons for a cluster of firms to be more efficient than an individual firm in isolation may be 1) the ability of a cluster to support specialized suppliers; 2) the way a geographically concentrated industry allows labor market pooling; and 3) the way that a geographically concentrated industry helps foster knowledge spillovers.
International Economics
Hannele Wallenius
External Economies, Output, and Price
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 29
External Economies before Trade
International Economics
Hannele Wallenius
Trade and Price
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 30
DChina DWorld
ACChina
P, C (per button)
Quantity of buttons produced, demanded
P1
P2
Q1 Q2
When trade is opened, China ends up producing buttons for the world market (both to the domestic and the foreign market). Output rises from Q1
to Q2, leading to a fall in the price of buttons from P1 to P2, which is lower than the price of buttons in either country before trade.
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 31
The Importance of Established Advantage
ACJapan
ACChina
QCars Cumulative
ACC
ACJ
QJQC
AC
•
•
The advantage of a long-established industry where scale economies are important.
A pattern of specialization established by historical “accident” may persist even when new producers could potentially have lower costs.
International Economics
Hannele Wallenius
Group Exercise 2
Above we mentioned 5 possible newer explanations for international trade. Find some examples of such trade patterns.
Newer explanations of trade:
1. Increasing returns to scale2. Intra-Industry Trade3. Technological Gap and Product Cycle4. The Gravity Equation5. External Economies of Scale
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 32
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 33
Gains from Division of Labor: The Finnish Case
By taking advantage of comparative advantage and international trade, Finland has successfully increased the standard of living far beyond the point where it would be if it had tried to produce everything itself
However, the proportion of exports to GDP is still relatively low in Finland compared to some other small industrialized countries
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 34
Gains from Division of Labor: Finnish Case cont.
In order to maintain its position in the international income comparisons, Finland has to expand further its foreign trade
What could be some of the possible new areas to expand?
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 35
International Division of Labor: How Is It Changing?
International division of labor does not only mean trade of commodities and services
It also allows us to follow the scientific, technological as well as other societal developments which take place elsewhere
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 36
International Division of Labor: How Is It Changing? continued
For internationalization of companies these type of dynamic advantages are equally important as are the static advantages gained from the trade of goods
There are clear signs that the participation of Finnish companies in international division of labor has changed over time
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 37
International Division of Labor: How Is It Changing? continued
By simplifying we can say that up till 1980s Finns were exporting and importing goods
Since then Finnish companies have also started producing internationally
This is not really a new phenomenon, but lately it has become more intense than ever before
International Economics
Hannele Wallenius
Number of Employees of Finnish Companies in Finland and Abroad, 2002 - 2011
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 38
in Finland Abroad in Finland 2012, forecast
International Economics
Hannele Wallenius
04 05 06 07 08 09 10 11 12 130
20000
40000
60000
80000
100000
120000
140000
Stock of FDI abroad
Stock of FDI received
Foreign Direct Investments to and from Finland, million euros
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 39
Source: Tilastokeskus
International Economics
Hannele Wallenius
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 125
10
15
20
25
30
35
High-tech exports, % of manufactured exports
Switzerland
France
United Kingdom
Norway
United States
Japan
Germany
Sweden
Finland
Italy
%
Hi-Tech Exports, % of exports in some OECD countries
Source: World Development Indicators
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 41
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 42
Price of International Division of Labor: Finnish Case
As pinpointed above, we have gained a lot by participating in the international division of labor. But it has also caused some problems
The dependence of countries on each other has increased, and at the same time individual countries have become more vulnerable to changes in the world economy
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 43
Price of International Division of Labor: Finnish Case continued
Finland has been affected not only by the worldwide economic fluctuations, but also by changes in "the rules of the game" in world trade as well as by the monetary and exchange rate disturbances
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 44
Price of International Division of Labor: Finnish Case continued
For instance the fluctuations in the US dollar and the debt problems of developing countries have affected Finnish economy in past• and lately EU debt problems and
consequences of the Ukrainian crises
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 45
Price of International Division of Labor: Finnish Case continued
By using exchange rate policy Finland was from time to time successful to eliminate the losses in its export income, but individual firms or industries often got hurt by fast changing exchange rates
In EMU there is not any more the possibility of national exchange rate policy
Price changes of some natural resources, such as crude oil, have often had an influence on employment and inflation rates
Also the joint environmental problems are an increasing concern
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.3 New Approaches to Trade Theory 46
Price of International Division of Labor: Finnish Case continued
Changes in world's production patterns: due the technological diffusion the production of many products moves where the production costs are lowest (this happens when in the production cycle the standard product stage has been reached; after that capital and factor costs are about the same in all countries because of international trade and so labor costs become most important)• BUT this might change again dramatically
when even larger part of production is produced by robots in the future!
• But on the other hand, firms may want to be there where the markets are…
International Economics
Hannele Wallenius
2. Why Do We Trade? 47
That’s all folks!
On next lecture:
3. INTERNATIONAL TRADE POLICY