GLOBAL TRADE AND INVESTMENT ENVIRONMENT INTERNATIONAL TRADE THEORY [R/H, Ch.6, ] [Head, pp.33-44] Various economic theories try to explain observed patterns in international trade -- NO SINGLE THEORY can explain all observed trade patterns ABSOLUTE ADVANTAGE (ADAM SMITH): -- You can produce a good more efficiently than all other countries ---> Trade goods for which you don't have absolute advantage ---> “you and trade partners” better off

Example. Suppose both Ghana (G) and South Korea (SK) have each 200 units of resources. To produce 1 ton of cocoa, G requires 10 units of resources. SK requires 40 units. To produce 1 ton of rice, G requires 20 units; SK requires 10 units. Resources required to produce 1 ton of cocoa and rice CocoaRice G1020 SK4010 Figure: Production Possibility Frontier (PPF)

G has an absolute advantage in producing cocoa. SK has an absolute advantage in producing rice. At Points A and B: half of each country's resources devoted to production of each of the two goods; no trade What happens to the consumption if both countries trade with each other? --> Specialization

COMPARATIVE ADVANTAGE (DAVID RICARDO): You are more efficient in producing some goods than other countries. Then the theory of “absolute advantage” says you gain from trade. If you have an absolute advantage in the production of all goods, then this theory says you gain nothing from international trade. DAVID RICARDO SAYS: Even if a country has an absolute advantage in the production of all goods, it still makes sense for the country to specialize in the goods it produces most efficiently and to buy the goods from other countries that it could produce more efficiently itself.

Historical Background “Corn law” in England in the 1830s protected English grains from cheap, continental (mainly French) grains The English landed gentry wanted to keep it that way Industrialists including Ricardo argued for the repeal of the law Because imported cheaper grains would lower prices of bread, flour, etc., the repeal of the law would lead to lower wage payments to workers by industrialists Ricardo's example: wine and wool for England and Portugal Wool ….. manufactured good Wine ….. agricultural good

THE ISSUE: Evaluating the impact of international trade upon the overall economic health of the U.K. This issue keeps arising in modern contexts; in general a country in no trade situation (called "autarky") can be improved by trade. EXAMPLE (continued) Suppose G has an absolute advantage in producing both cocoa and rice. To produce 1 ton of cocoa, G requires 10 units of resources; SK requires 40 To produce 1 ton of rice, G requires 13 and a third; SK requires 20 The total 200 units of resources divided equally between cocoa and rice without trade in G and SK. Why should G trade with SK when G has an absolute advantage in both goods ?

Resources required to produce 1 ton of cocoa and rice: CocoaRice G SK4020 G can produce 4 times more cocoa than SK, but only 1.5 times more rice than SK. Thus, G is “comparatively more efficient” at producing cocoa than it is at producing rice. Suppose specialization takes place. G produces 15 tons of cocoa and 3.75 tons of rice. SK produces 0 tons of cocoa and 10 tons of rice. Then G trades 4 tons of cocoa for 4 tons of SK rice

Both will have more for consumption! The theory of comparative advantage argues that: - potential world production greater without trade restrictions - trade is a positive-sum game in which all countries gain Ricardo's theory is a major intellectual weapon for those who argue for free trade Theories of “absolute advantage” and “comparative advantage” are theories of specialization Question: how could multinational corporations use comparative advantage theories in planning for their global production activities?

Theory of comparative advantage Calculation corner Countries gain from trade because of differences in the relative costs of producing different commodities. Example (cont’d) Relative costs measured as the price of 1 ton of cocoa in terms of tons of rice Resources required to produce 1 ton of cocoa and rice: CocoaRiceRelative costs (=price of 1 ton of cocoa) G tons of rice (= 10/13.33) SK40202 tons of rice (= 40/20) Relative costs are also called opportunity costs in the following sense: what (“Rice”) has to be given up in order to consume something else (“Cocoa”) In the example the opportunity cost of a ton of Cocoa in Ghana is 0.75 tons of Rice

Another example 2 countries: France and UK 2 commodities: beef and cheese 1 production input (factor): labour Technology matrix: Units of labour required to produce one ton of output beef cheeserelative prices in terms of tons of cheese France ( = 5/2) UK ( = 2/4) We can say: without trade, In France one ton of beef costs 2.5 ton of cheese In the UK one ton of beef costs 0.5 ton of cheese

Recall: units of labour required to produce one ton of output beef cheeserelative prices in terms of tons of cheese France ( = 5/2) UK ( = 2/4) If trade is permitted: France gains from trade if it can buy a ton of beef for less than 2.5 tons of cheese UK gains if one ton of beef is sold for more than 0.5 tons of cheese Mutually beneficial trade can take place at any price between 0.5 and 2.5 tons of cheese per ton of beef. (I.e. a range of possible "exchange rates" allow both countries to gain from trade.) Note that what matters is relative costs, not actual levels of cost.

Example (The U.K. enjoys absolute advantage over France) France might be less efficient in producing both commodities, but could still gain from trade, as shown below. Suppose: Units of labour required to produce one ton of output beef cheese relative prices in terms of tons of cheese France ( = 15/6) tons of cheese per ton of beef UK ( = 2/4) tons of cheese per ton of beef In this example cheese requires more labour to be produced in France than in the UK, but mutually beneficial trade is still possible, because France's productivity disadvantage is less in one commodity (cheese) than the other (beef). As before, we can say: If trade is permitted, France gains from trade if it can buy a ton of beef for less than 2.5 tons of cheese UK gains if one ton of beef is sold for more than 0.5 tons of cheese Mutually beneficial trade can take place at any price between 0.5 and 2.5 tons of cheese per ton of beef.

Example (Text R/H, p.153) 2 products: Cloth and Grain 2 countries: North and South Labour cost (hours) of production for one unit of each product ClothGrainRelative prices of 1 unit of Cloth in # of units of Grain North ( = 10/20) South ( = 20/10) Example (Text R/H, p.154) Labour cost (hours) of production for one unit of each product ClothGrainRelative costs of 1 unit of Cloth in # of units of Grain North ( = 50/100) South ( = 200/200)

Example (no trade is possible) Only if relative costs are the same in two countries, is it impossible to find gains from trade. Units of labour required to produce one ton of output beef cheese relative prices in terms of tons of cheese France ( = 3/6) tons of cheese per ton of beef UK ( = 2/4) tons of cheese per ton of beef Here the pre-trade price of beef in terms of cheese is the same in France as in the UK, and trade opens up no possibilities for improvement for either country.

Example (trade and exchange rate application to multinational firms [Head, pp.33-44] Assumptions 300 workers in Thai factory 300 workers in Korean factory In the short run, you cannot add or subtract workers, or move them between plants. One sole and one upper needed for each finished shoe. Transport costs are negligible

Shoe terms Sole Upper

Productivity Matrix FactoryActivity UppersSoles Korea Thailand Korean factory worker can make 200 uppers per day, or 400 soles per day. Thai factory worker can make 100 uppers per day, or 100 soles per day. (Korean factory has an absolute advantage.) Rewrite the above in terms of the # of workers needed to produce one item of each product: # of workers needed to produce one item UppersSolesrelative prices of an upper in terms of # of soles Korea1/2001/ (=(1/200)/(1/400)) soles per upper Thailand1/1001/ (=(1/100)/(1/100)) soles per upper So, it would make sense for Korea to buy uppers from Thailand.

Compute total shoe output for four production plans Plan A: (self-sufficient factories): Each country combines workers to produce completed shoes. There is no trade. Plan B: Thailand produces only uppers, Korea produces only soles. Plan B*: Thailand produces only uppers, Korea produces soles and uppers. Plan C: Thailand produces only soles, Korea produces soles and uppers. No trade: Plan A Trade: Plans B, B* and C

Plan A (no trade). Total world output = = shoes per day. Thailand: 150 workers mold soles 150 workers stitch uppers ---> 150*100 =15000 shoes per day Korea: Twice as many workers on uppers as soles 2S+S = 300  S =100 workers mold soles =200 workers stitch uppers ---> 100*400 = shoes per day

Plan B (T  U & K  S specialization): shoes per day Thailand: 300 workers stitch 30,000 uppers Soles imported from Korea Korea: 300 workers mold 120,000 soles Combined (T+K) output: shoes 90,000 wasted soles or 225 (=90000/400) idle Korean workers Plan B* (T  U & K  {S,U} partial specialization): shoes per day Thailand: 300 workers stitch uppers Soles imported from Korea Korea: 150 workers mold soles 150 workers stitch uppers Combined (T+K) output: shoes stitched in Thailand using imported soles finished shoes made in Korea

Plan B* increases shoe output by 9%, compared with Plan A: ( )/55000 =.0909 Firm-level productivity rises from 55000/600 = 92 shoes per worker per day (Plan A) to 60000/600 = 100 shoes per worker per day (Plan B*) No new machinery, no new skills, no extra effort. Trade is like a new technology!

Plan C (T  S & K  {U,S} partial specialization): world output = shoes per day Thailand: 300 workers mold soles. Soles exported to Korea Korea: 50 workers mold soles 250 workers stitch uppers Combined (T+K) output: shoes stitched in Korea using imported soles finished shoes made in Korea Moving from no trade (Plan A) to trade (Plan C) lowers global output. Why?

Specialization is not enough Plan C, involves specialization but it lowers output by 9% relative to Plan A. Only “specialization based on comparative advantage” yields gains from trade. Recall: comparative advantage = low opportunity costs (relative prices). Since Thailand’s comparative advantage lies in uppers, Thailand need to specialize in uppers. Recall: # of workers needed to produce one item UppersSolesrelative prices of an upper in terms of # of soles Korea1/2001/ (=(1/200)/(1/400)) soles per upper Thailand1/1001/ (=(1/100)/(1/100)) soles per upper So, it would make sense for Korea to buy uppers from Thailand.

Summary Korea gains from trade if it can buy an upper for less than 2 units of soles Thailand gains if one upper is sold for more than 1 unit of sole Mutually beneficial trade can take place at any price between 1.0 and 2.0 units of soles per upper.

Example (cont’d) Wages and exchange rate # of workers needed to produce one item UppersSolesrelative prices of an upper in terms of # of soles Korea1/2001/ (=(1/200)/(1/400)) soles per upper Thailand1/1001/ (=(1/100)/(1/100)) soles per upper As of now these numbers represent # of workers needed per unit of product. Suppose these workers’ wages per day are measured as follows: W(K)=wage rate per worker per day in Korea (in Won) W(T)=wage rate per worker per day in Thailand (in Baht) e=exchange rate (baht/won) = # of Baht per Won Then we can rewrite the above table in terms of labour costs in Thai Baht as follows: Labour costs in Tahi Baht per unit produced UppersSoles relative prices of an upper in terms of # of soles KoreaeW(K)/200e W(K)/ ThailandW(T)/100W(T)/1001.0

Labour costs in Tahi Baht per unit produced UppersSoles relative prices of an upper in terms of # of soles KoreaeW(K)/200e W(K)/ ThailandW(T)/100W(T)/ Thai plant gains competitive advantage (1) in uppers when Korea pays more than twice the Thai wage e W(K)/200 > W(T)/100, or eW(K)/W(T) > 2 (2) in soles when Korea pays more than four times the Thai wage e W(K)/400 > W(T)/100, or eW(K)/W(T) > 4

Relative wages and Competitive Advantage

Increasing returns and trade Comparative advantage is not the only way to obtain gains from trade. Plant-level economies of scale are important in many industries. To illustrate the gains from exploiting plant-level economies of scale through trade, we assume that there is no comparative advantage or absolute advantage Example. # of items produced per worker UppersSoles Korea Thailand Factory workers are supported by services of non-production employees, also known as “overhead.” E.g. accounting, logistics and input procurement, machinery maintenance. Some minimum number of overhead workers are required for any positive level of production.

Let overhead be 30 workers per “product” (soles or uppers) per plant. A factory that produces both products (that is, a factory that is not fully specialized) has overhead of 30+30= 60, leaving =240 workers for production. A factory that specializes has =270 workers for production. Plan A (self-sufficiency): 60 overhead workers in each country Sole output in each factory: (240/2)*100 = Upper output in each factory: (240/2)*100 = Combined (T+K) output = 2*12000=24000 shoes Plan B (full specialization, K  S,T  U): 30 overhead workers in each country Sole output in Korea: 270*100 = Upper output in Thailand: 270*100 =27000 Combined (T+K) output = shoes (12.5% gain!)[(3000/24000)x100] Trade between T and K increases global output by 3000 shoes due to returns to scale (economies of scale).

Plan C (full specialization K  U and T  S) is just as good (27000 shoes) as plan B No such thing as specializing in the “wrong” thing in this Example. The key for plant-level economies of scale is to avoid duplicative overhead, rather than to “match” products with skills (as in the CA case).

The assumptions underlying these theories (1) full employment: all resources are assumed to be fully employed (2) economic efficiency objective: some countries may want to retain production skill in both products (3) division of gains: some countries may not want to share gains from trade with other countries (4) mobility of resources: AA and CA theories assume that resources (e.g. labour) are mobile within the domestic economy but are not internationally If any of these assumptions fail to hold, would you still specialize and trade? Any examples where these assumptions fails to hold?

HECKSCHER-OHLIN THEORY (factor-proportions theory): An extension of the comparative advantage theory Explains international trade patterns by differences in factor endowments rather than differences in efficiency/productivity as in CA examples above Factors (inputs) of production: land, labour, capital, etc. [But in comparative advantage theory we usually assume only one factor (e.g. labour)] Countries will export goods that make intensive use of locally (or relatively) abundant factors and will import goods that make intensive use of factors that are locally (relatively) scarce

Hechscher-Ohlin theory Calculation corner H-O theory means: “factor advantages” is a matching process. A location is a good match for an activity if it has a relative abundance in the factors used relatively intensively by the activity. “Relative abundance” defined in terms of ratios or shares: Case 1. 2 country, 2 factor case (Home and Foreign, Capital and Labour): (K) is “relatively abundant” in H if K h /L h > K f /L f (I.e. more capital per worker in H than in F). Case 2. Multi-factor, multi-country case (Home vs. World): given Y h and Y w (GDP for H and the World), (K) is “relatively abundant” in H if K h /K w > Y h /Y w (I.e. H’s share of K exceeds its share of world income).

Example: factor abundance in 3 countries CanadaUSJapanWorld Factor Supply Crop Land, m hec (as % of world) 3.1% 12.8% 0.3% 100.0% Pasture Land, m hec % 7.0% 0.0% 100.0% Forest Land, m hec % 7.1% 0.6% 100.0% Water, th km % 6.0% 1.3% 100.0% Labour, m % 4.9% 2.4% 100.0% Factor Demand GNP, tr US$ % 25.6% 17.9% 100.0% Sources: Head, p.60.

Some observations: - crop land: US has “absolute” abundance compared to Canada because m hec > 45.5 m hec - cropland per labour: Canada is relatively abundant since 45.5/16 > 188/ crop land: relative to the world, Canada is crop-land abundant because its share of world crops (3.1%) > its share of world income (2.1%). - US appears crop-land scarce since 12.8% 2.1%). US not so.

Factor proportions in various manufacturing industries Industry(I + P)/VL/V H/V H/L Telephony 32.5% 30.2% 37.3% 1.23 Footwear48.8% 39.0% 12.2% 0.31 Furniture52.5% 38.1% 9.4% 0.25 All Manufacturing61.9% 27.9% 10.2% 0.36 Pharmaceuticals63.0% 16.2% 20.8% 1.28 Agri-Chemicals66.8% 21.4% 11.8% 0.55 Aluminum 74.5%21.5% 4.0% 0.19 Petroleum Refining88.5% 7.2% 4.3% L = $expenditures on production workers H = $expenditures on administrative workers V = $value-added I + P = $(intellectual and physical capital), calculated as V − L − H. H/L = a proxy for the skill intensity of the workforce. Source: Head (p.61)

Application of H-O theory: How can we generate comparative advantage using “factor abundance?” The key: the right matching between country and product and/or industry: Choose the right country for each product “Intensive user seeks abundant factor” Caution: “absolute abundance” is not enough. Bigger isn’t better in the HO-based comparative advantage world. Proportions are the key. Examples CountryItems massively exportedFactors in relative abundance Canadanewsprintforest land / capital Canadaaluminumelectricity Chinaclothinglow-skilled labour Suppose 50% of China’s work force had college degrees. Would China then still have absolute / relative abundance in low-skilled labour?

The leontief paradox U.S. exports are less capital intensive than U.S. imports Why is this inconsistent with the Hechscher-Ohlin theory?

Empirical evidence: more for comparative advantage less for Heckscher-Ohlin theory The “CA and H-O theories” generally call for free trade but ignores the following: Dynamic growth of economies and associated changes in industrial structures of trading nations. Example. Prussia, a developing country during the Ricardo's era, did not think the C.A. theory applies to her. Prussia's “Historical Development Stage School” argued for: "protection of infant industries for catching up industrially with advanced England"

Put it another way, Portugal does not want to be locked in as the producer of wine; rather Portugal would like to develop a wool industry as efficient as England's some time in the future These issues raised by the historical school still haunts us today Any examples? Any examples of the assumptions which are not realistic underlying the comparative advantage and Heckscher-Ohlin theories? Any other realistic situations where the CA and H-O theories do not seem to be applicable?