Recent Developments in Trade Theory Rod Falvey March 2009

Introductory comments Theory follows practice Recent is relative Will not cover all recent developments Will not necessarily cover even all the most important recent developments General equilibrium Some borrowed material Begin with context

Trade Theory - Issues Gains/losses from trade Pattern of trade Effects on outputs, income distribution etc

Trade Policy - Issues Effects of protection Costs of protection Optimal policies – second best Piecemeal reform

Sources of Gains from Trade [static] New Products/Improved Inputs Economies of Scale - in manufacturing Comparative Advantage - resource re-allocation

Sources of Gains from Trade [dynamic] Learning by doing/exporting Technology transfer (broadly defined) Need spillovers for sustained growth Need analysis at firm/worker level

Ricardian Model Comparative Advantage (technology based) - distinct from absolute advantage - all countries can compete/trade (if wages low enough) - all can gain from trade - smaller countries tend to gain more But - complete specialisation - no internal income distribution

Heckscher-Ohlin (H-O) Model Trade pattern resource based –Countries export goods that use intensively their relatively abundant factors (H-O Thm) –Trade draws factor prices closer together across countries, becoming equal in certain circumstances (FPE Thm) –Trade changes real factor returns (S-S Thm) Benefiting owners of abundant factors Hurting owners of scarce factors –Trade and output effects of factor accumulation (Rybczynski Thm )

Extensions of HO Increase numbers of goods and factors (from 2x2 to nxm) Theorems generalise – but weaker Can add technology differences But Specialisation - potential production indeterminacy Resulting trade patterns very sensitive to trade costs No Intra-industry trade (prominent in EU liberalisation)

CGE modelling - issues Models based too closely on HO dont fit the data Models predict too much specialization These problems have been dealt with in a variety of ways:

Specific Factors Also called the Ricardo-Viner Model Each sector has its own specific factor Implications –Supplies likely remain positive at all prices –Supplies increase smoothly with price –There is no production indeterminacy –Trade does not equalize factor prices

Specific Factors But –Makes more sense for short run, than for long run –Explanation of trade based on specific factors close to tautological –Still no intra-industry trade

Armington Preferences Armington (1969) Products are differentiated by country of origin – popular in CGE models Implications –Trade need not equalize prices of same good from different countries –Have intra-industry trade

Armington Preferences But –Why are products differentiated by country? Ad hoc – but can allow close substitutes –Preferences give every country market power in trade – CGE policy results dominated by terms of trade effects

Monopolistic Competition (New Trade Theory) Krugman (1979, 1980) Helpman and Krugman (1985) in HO trade models Uses love of variety preferences – e.g. Dixit-Stiglitz Goods are differentiated by firm, while increasing returns at the firm level limit product variety

Monopolistic Competition Implications –Trade gains through new products consumed –Model explains intra-industry trade –Product-differentiated bilateral exports remain positive from any country that produces - less sensitive to trade costs –Model has a role for firms – in form of a representative firm

Monopolistic Competition But –Only makes sense for some manufactures and services, not for agricultural products, raw materials etc –Implications for specialization and factor prices are the same as the standard HO model –Doesnt necessarily mean trade gains from increasing firm size

Heterogeneous Firms Melitz (2003) in a Ricardian context. Bernard, Redding, and Schott (2005) in the HO model Individual firms produce differentiated products under monopolistic competition, but have different productivities Important role for trade costs – fixed and per unit Based on characteristics inferred from firm level data sets

Stylised Facts about Firms (in large countries) 1.Most dont export. Those that do export little and not very widely; 2.Exporters are larger, more productive, more skill and capital intensive and pay higher wages than domestic firms; and 3.Knowing a firms industry is not very informative about export participation. Suggest limitations of representative firm approach. Bernard/Jensen/Redding/Schott JEP 21(3) 2007

Autarky Costs Entry fixed cost Production fixed cost Production marginal cost (inverse of productivity) Entry as long as expected profits positive Autarky equilibrium productivity threshold for production Firms above threshold produce; firms below exit

Potential Entrants Entrants Randomly draw their productivity levels Lowest productivity entrants High productivity entrants Leave immediately Pay fixed production cost and serve the domestic market Pay irreversible investment to enter unable to earn positive operating profit Flow chart 1: Productivity uncertainty and firm entry/exit

Trade Costs Export fixed cost Unit trade cost (iceberg) Most productive firms export – use more resources – drawn from less productive firms – least productive exit Industry average productivity rises

Heterogeneous Firms Domestic survival productivity threshold in autarky Domestic and export survival thresholds in trade (export threshold higher due to trade costs) Domestic survival threshold higher in trade than in autarky Industry more productive – due to intra-industry resource reallocation – no change in individual firms productivities

Effects of trade Probability Firm level Productivity Export threshold Domestic threshold open Domestic threshold autarky Exporters Purely domestic firms Contract Leave Expand Exiters

Heterogeneous Firms Implications –Trade improves industry productivity relative to autarky – additional source of gains from trade – but number of varieties available may rise or fall. –Improved technology in one country may lead to reduced industry efficiency in its trading partner (but still gains from trade) –Can get specialization if technology or market size differences large enough –Supply responds to demand through entry and exit

Combined with HO Productivity growth stronger in comparative advantage industry - exporting opportunities greater in CA industries – bids up relative price of their intensive factor - greater exit of low productivity firms - industry productivity effects magnify effects of CA

Combined with HO If productivity increases strong enough – both factors real incomes can rise with trade liberalisation.

Heterogeneous Firms Why do firms differ in productivity? luck managerial ability/entrepreneurship producing products of different quality What leads to a better productivity distribution? human capital Do more productive firms export – or does exporting make firms more productive? Evidence (for developed countries) suggests former.

Heterogeneous Firms & Many Countries Distinguish extensive margin of trade – number of products exported and number of markets exported to; intensive margin of trade – volume of a particular product exported to a particular market. Trade liberalisation can affect both margins

New Economic Geography Other area where trade costs seem to be important. Geographical concentration of industries Advantages from a large number of competitors producing in an area (external and internal economies of scale) Agglomeration forces: Technological spillovers (e.g. silicon valley) Labour market pooling (e.g. City of London) Demand linkages (i.e. backward linkages) Supply linkages (i.e. forward linkages)

New Economic Geography Perfect Competition Comparative advantage implies countries specialise in sectors Monopolistic Competition New trade theory implies that agglomeration arises with integration if initial asymmetries across countries exist – home market effect New economic geography implies that integration tends to concentrate economic activity spatially (even without initial asymmetries across countries)

Propositions Home market effect Regions with large demand for increasing returns industries account for an even larger share of their production. Market potential raise local factor prices. A location whose access to major markets and suppliers is not impeded by large trade costs will tend to reward its factors with higher wages and land rentals.

Propositions 3. Market potential induces factor inflows (a) Firms (re)locate to areas with good access to major markets for final goods and major suppliers of intermediate inputs (backward linkages). (b) Workers migrate to locations with good access to suppliers of final goods (forward linkages). 4. Shock sensitivity: A temporary shock to economic activity in a location can permanently alter the pattern of agglomeration.

Institutions and Trade Interpret institutions broadly Structure of analysis: Use theory to examine the differential dependence of industries on the quality of this institution Derive measures of institutional dependence Find measures of institutional quality Test hypotheses using cross-industry and cross-country data

Incomplete contracts and firm boundaries Institution: property rights and contract enforcement Ownership structure indeterminate and irrelevant when contracts are complete and fully enforced Which activities take place within the firm and which are purchased in markets? Helpman Trade, FDI and the Organization of Firms, JEL September 2006

Firm Boundaries - Questions Which firms serve foreign markets? How do they serve them (exports or FDI)? How do they choose to organise production (outsource or integrate)? When do they outsource abroad rather than at home? When do they integrate abroad (FDI) rather than at home?

Incomplete contracts Standard approach is to assume relationship-specific investment by the trading parties, which in the absence of an enforceable contract leads to the holdup problem e.g. Some inputs are highly specific to a final product and their supply is not fully contractible – extent may vary across industries Relationship yields a surplus – to be bargained over

Credit market institutions Quality of financial market institutions can affect pattern of trade through industry differences in financial dependence - Bardhan and Kletzer (1987) Firms in countries where firms face tighter credit rationing, have a comparative disadvantage in financially dependent industries

Labour market institutions Davidson, Martin, and Matusz (1999): efficiency of labour market search differs across countries. Country with more efficient search technology then has comparative advantage in sector with higher separation rate, hence higher vacancy rate Cuñat and Melitz (2007): firms in countries with inflexible labour market institutions must contract on employment in advance of realizations of productivity shocks. These countries wind up with a comparative disadvantage in high volatility industries.

Trade Policy Positive – effects of standard instruments (tariffs, quotas etc.) Normative – welfare effects – optimum tariff only first best argument etc. Policy rankings

Actual Institutions Explaining GATT/WTO – why does it exist? Benefits of multilateral vs bilateral trade negotiations – multilateral retaliation Internal benefits of external constraints

Political Economy of Trade Policy Protection for Sale by Grossman and Helpman (1994) – used menu auction theory to explain industry tariff levels. Lobby groups offer contributions to a policy maker who is concerned about contributions and aggregate welfare. Policies set as if to optimise a welfare function in which groups that lobby receive a disproportionate weight.

Political Economy Approach can be applied to a range of other policies – trade and non-trade. Testing of a particular theory difficult because different theories tend to have similar predictions

Piecemeal Trade Policy Reform Gradual removal of trade restrictions, ensuring that welfare (of a representative agent) increases at each step. Two types of reform known: [A] Proportional tariff cuts [B] Concertina reform – reduce highest tariff to next highest (requires this good be a net substitute for all other goods).

Anderson & Neary (2005) Extend range of welfare improving reforms Consider generalised moments of tariff distributions Generalized moments are weighted moments where the weights are the elements of the substitution matrix

An increase in the generalized mean reduces welfare An increase in the generalized variance reduces welfare. Gives a range of welfare improving tariff reforms – e.g. uniform absolute tariff reduction