1 Specific factors and Costs of Adjustment International Trade – Session 2 Daniel TRAÇA

|2|2 A summary of the last session Globalization –Growth of Trade and Foreign Direct Investment; Mostly among rich countries; –Developing countries rising fast (East Asia) but still small; Comparative advantage: a key concept! –Global output increases when countries specialize in goods where the relative productivity is higher. –It can be due to relative differences in the productivity of labor.

|3|3 This session Competitiveness and Comparative Advantage Specific factors and costs of adjustment Decreasing returns and incomplete specialization

|4|4 The myth of competitiveness Free trade is beneficial only if your country is productive enough to stand up to international competition. –Not true! Trade is always possible and beneficial for both parties, if markets are at work. A country can always be competitive in the industry where it has comparative advantage. How? –Its wages will be lower than the more productive country. –It is different from firms. Countries do not compete for workers, like firms do! Firms that are not productive within a country cannot compete because, if they pay lower wages, they will not attract workers.

|5|5 Wages and productivity Less productive countries will compensate by paying lower wages. –Lower wages are the result of lower productivity. In most countries, this is due to: –Bad infrastructureInsufficient investment –Low educationPoor institutions Productivity (%US level) % increase ProductivityReal wages United States Germany (W) Japan South Korea n.a.

|6|6 The competitiveness of sectors of comparative advantage An industry is competitive if its productivity advantage vis-à-vis its foreign competitors is higher than the country’s wage disadvantage. This will happen in industries with comparative advantage. –The wage gap will among countries correspond to their average productivity gap. –In the industry of comparative advantage, the productivity gap will be wider than the wage gap. So, if in an industry we see differences in wages that are larger than the productivity differences, that is OK! It just means that one is the sector of comparative advantage.

|7|7 The case where FACTORS cannot adjust North 10 Food Manuf UNUN P N f =1 U N (Manuf) U N (Food) U N (average) Average [production = consumption] basket in autarky 1<P W <3 At home: do the same exercise for the South! U N → U N (average) are the gains from exchange. They occur because, in autarky, North had too much Manuf relative to Food, compared to the South. So, even if production does not change, there are incentives to exchange Manuf for Food with the South. U N (average) → U N (Manuf) are the gains from specialization. They occur when resources are able to move to the sector of comparative advantage (Manuf in the North).

|8|8 If Adjustment costs are high, trade becomes highly political Effects in the South Effects in the North The Food producers in North (exporters) are better off, but... Manuf producers (import-competing) are worse off The Manuf producers in the North (exporters) are better off, but... Food producers (import-competing) are worse off International Trade has positive benefits (gains from exchange), but is hot politics. It is similar to technological progress that displaces workers. The gains outweigh the losses and the average worker is still better off. The South is a net consumer of Manuf, for which the price has fallen. The gains outweigh the losses and the average worker is still better off. The North is a net producer of Manuf, for which the price has risen. The South imports Manuf, and the price of Manuf falls relative to autarky The North imports Food, and the price of Manuf rises relative to autarky

|9|9 The Political Economy What happened to the owners of the specific factors? –In the North, the rising price of Manuf has benefited Capital owners, but it has hurt Land owners. –In the South, the declining price of Manuf has hurt Capital owners, but it has benefited Land owners. –The impact for workers that are mobile is ambiguous. In the North, the wage grew for those that consume food, but declined for those that enjoy Manuf. But the net gains are positive. –It should be possible to take from the winners to compensate the losers, but this compensation is difficult. –Again, a political quagmire due to specific factors, that will lead to pressure for protection. Example: the plight of landowners

| 10 Dealing with Adjustment Costs Trade losers: a concern? –Is trade different from technological innovation? Losers may be able to find new jobs at lower wages: in the US, wage losses upon reemployment (+ or - 13%) are similar to the rest of manufacturing Trade politics –Organization matters, and losers are more likely to get organized. –The small gains of the many versus the large losses of the few. Temporary measures may help smooth the costs. –Subsidies and Protectionism –Without credibility, they become permanent and are very costly

| 11 Costs of Protectionism 7033 – Cost per job saved (‘000 US$) – Share of total employment 1, Jobs “saved” (‘000) Average tariff equivalent (%) 1.1 – – – * Share of GDP (%) * Billions of US$ Consumer cost # industries surveyed European Union 1990 Korea 1990 Japan 1989 United States 1994 * Estimates for the whole economy. The 21 highly protected industries were responsible for $32b. (incl. $24b for textile and apparel). The remaining data concerns only the highly protected industries.

| 12 A simple example: Portugal and the textile industry The sector represents more than 200,000 jobs, 16% of total exports and 2% of GDP What are the net effects of trade with China? –Assumptions: With free-trade in textiles, wholesale prices fall by around 30% At this Free-Trade price, no domestic producers will survive Workers will not find jobs elsewhere

| 13 Short-term protection… becomes long-term! An example Establishing the MFA

| 14 Dealing with Adjustment Costs Unemployment subsidies e.g. the Trade Adjustment Assistance in the US –Danger: discouraging job-search and creating long-term unemployment. Retraining –The difficulty is that the mean worker displaced in manufacturing in the US is aged 38.6, has 12.3 years of education, and has a job tenure of of 6.5 years –Life-long learning is a better option.

| 15 MPL F MPL M x P AUT Incomplete specialization I The equilibrium with constant returns In each sector, workers must be hired until the marginal worker’s cost (the wage) is equal to its marginal product. Workers must be indifferent between the two sectors w = MPL F = MPL M x P Recall that P is the relative price of manufactures In autarky, the price must equate the relative marginal product, to ensure both goods are produced. If the trade price ( of manufactures ) is lower than in autarky, the country will specialize completely in Agro/Food LFLF LMLM w total labor force MPL M x P TRADE

| 16 Incomplete specialization II The equilibrium with decreasing returns Once again, the equilibrium entails w = MPL F = MPL M x P For any given price (P), we can find out the employment and output of Agro/Food and Manufactures. If the trade price (of manufactures) is lower than in autarky, the country will specialize, but not completely, in Agro/Food LFLF MPL F LMLM MPL M x P AUT w total labor force MPL M x P TRADE

| 17 Incomplete specialization III Decreasing returns and the concavity of the PPF We can obtain the PPF, for the case of decreasing returns. –The PPF is concave. The opportunity cost of Food is now increasing. Equilibrium: P = MPL F /MPL M For any price ( P ), we can obtain the Relative Supply of Manuf Food Manuf +1 Slope = -MPL M / MPL F -1/P

| 18 Incomplete specialization III The gains from trade in the North The prices of manufactures rises in the North, –Due to its comparative advantage in manufacturing Production of manufactures for export increases; –Effects on consumption of manufactures depend on income (+) and substitution effect. But there is incomplete specialization, –The North still produces some Food for its own consumption Food Manuf -1/P N -1/P w Gains from trade Imports Exports

| 19 Equilibrium productivity and comparative advantage In the trade equilibrium, we have: [MP M /MP F ] N = P w = [MP M /MP F ] S –If the price is the same, the relative productivities are the same. With similar relative productivities, how can comparative advantage emerge? –It must be measured out of equilibrium, for the same relative employment level.

| 20 Summary In countries with lower productivity, competitiveness in world markets arises from lower wages. –The gains from trade mean potential gains for workers. The political argument is due to adjustment costs (specific factors) –Factors that are specific to import-competing industries will loose out from trade. –Those that are specific to exporting industries will be winners. –But the gains of winners always outweigh the loses of losers. –Compensating losers is a difficult task! Incomplete specialization arises when marginal productivities are decreasing. –In this case, the relative marginal products are the same with trade. –Comparative advantage must be seen for the same relative employment levels.