Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 5 Beyond Comparative Advantage

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-2 Chapter Objectives Explain why many countries import the same goods they export Analyze the development of regional clusters of production of many exported goods and services Examine how and why many countries select and plan the development of their export industries

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-3 Introduction: More Reasons to Trade Trade models built exclusively on comparative advantage do not always serve to predict a country's trade patterns –Comparative advantage is very difficult to measure –Large share of international trade is not, in fact, based on comparative advantage Besides, countries often seek to alter their comparative advantages through industrial policies

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-4 Intraindustry Trade Intraindustry trade: International trade of products made within the same industry (steel-for- steel, bread-for-bread) Intraindustry trade is growing increasingly important in international trade especially between industrial countries Interindustry trade: International trade of products between two different industries (steel- for-bread)

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-5 Measures of Intraindustry Trade Grubel Lloyd (GL) index: (If X i = M i, GL = 1; all trade is intraindustry) Problem: Product categories are difficult to define (are computers “office supplies” like pencils?) Many European countries and the United States have a large share of their total trade that is intraindustry

Measures of Intraindustry Trade (cont.) Evidence suggests that intraindustry trade is greater - in high technology industries - where there is more scope for product differentiation - in countries more open to trade - in nations that have received larger amounts of foreign direct investment Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-6

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-7 Characteristics of Intraindustry Trade Economies of scale: Decreasing average costs over a relatively large range of output (as opposed to constant or increasing costs) –Internal economies of scale: lead to larger firms because size confers a competitive advantage –External economies of scale: lead to larger industries (however, larger firms have no inherent advantage over smaller ones)

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-8 Internal Economies of Scale When larger firms are more competitive, market structure changes –Oligopoly: handful of firms produce the entire market output, with each firm formulating its strategies in response to those of its competitors –Monopolistic competition: unlike under pure monopoly, competition among many firms exists However, competition is attenuated by the practice of product differentiation—each firm produces a slightly different product

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-9 TABLE 5.1 Increasing Returns to Scale for a Single Firm

Table 5.2 U.S.-Canadian Merchandise Trade, 2008 (Billions of U.S. $) 5-10 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

5-11 The Gains from Intraindustry Trade Lower prices: An increase in the size of the market allows for scale economies, which lowers production costs and eventually prices to consumers Increase in the number of firms : There is a high likelihood that intraindustry trade expands the number of domestic firms and the quantity of domestic output Increase in consumer choices : Intraindustry trade tends to give access to a much greater variety of goods than produced domestically

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Trade and Geography Two fundamental links exist between trade and geography: A place may pull in economic activity because it is close to a market (cities are low cost for expansion) A place may offer firms the opportunity to find critical inputs (skilled labor)

Geography, Transportation Costs, and Internal Economies of Scale For most manufactured goods, it is not practical to produce next to each market due to economies of scale (producing cars next to dealerships) Not all types of manufacturing have same level of transportation costs (presence of scale economies makes near market production impractical) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-13

Geography, Transportation Costs, and Internal Economies of Scale (cont.) Most foreign investment today is directed towards high income countries (to access larger markets) All else equal, lower transportation costs often outweigh other costs that might be higher (southward shift of U.S. car manufacturing to be closer to final assemblers) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-14

Copyright © 2011 Pearson Addison-Wesley. All rights reserved External Economies of Scale External economies of scale occur when firms become more productive as the number of firms in an industry increases –If a firm in a region produce similar products, they will benefit from knowledge spillovers –When the presence of a large number of producers in one area creates a deep labor market for specialized skills –If an area holds a dense network of input suppliers, manufacturers locate near the suppliers

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Trade and External Economies Geographical concentration may be self- reinforcing: An initial small move toward clustering may cause a chain reaction, resulting in a massive industrial agglomeration -Examples: Aerospace manufacturing firms in Seattle and Southern California regions

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Industrial Policy Industrial policy: A government’s policy designed to create new industries or support existing industries –Industrial policies seek to alter the country's comparative advantage by picking winners and losers –However, they can have a profound impact on trade patterns

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Industrial Policies and Market Failure Market failure: Failure by the market economy to deliver an optimal quantity of goods and services; the value of a good to private consumers (private returns) and to society (social returns) fails to equal to its cost of production –A divergence between private returns and social returns –In a market failure, some costs or benefits of an activity are externalized—outside the area of concern of the economic agents engaged in the activity -Externality: market failure that results from the externalization of the costs or benefits

Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 5.1 Market Failure: Externalities

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Industrial Policies and Market Failure (cont.) Market failure is a major justification for industrial policies –Knowledge spillover, for example, is cited as a reason for industrial policies: a certain industry can spread knowledge about new products and processes, making social returns greater than private returns –Similar spillovers occur in research and development (R&D)

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Strategic Trade Strategic trade policy is selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms –Strategic trade policy requires that (1) industry has economies of scale and (2) firms in the industry have market power –Strategic trade policy is, like market failure, a justification for industrial policies

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 5.3 A Hypothetical Payoff Matrix

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Industrial Policy Tools The Uruguay Round and WTO prohibit subsidies for competitive policies However, governments can use other policies: - providing information about foreign markets to domestic firms, - helping negotiate contracts, - lobbying foreign governments to adopt home country standards, or - tying foreign aid to purchases from domestic firms

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 5.4 The Payoff Matrix after a Subsidy of 15

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Problems with Industrial Policies It is difficult to determine which industry to support since positive externalities may not be readily visible One strategy advocated, however, is to target high value added industries Rent seeking: An activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor

Copyright © 2011 Pearson Addison-Wesley. All rights reserved U.S. Industrial Policies Until World War II, the U.S. used high tariffs to support specific industries The use of direct subsidies, however, was used only in agriculture and defense industries Most common form of U.S. government support for certain industries has been through new research and dissemination of information

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Appendix A Graphical Illustration of Prices and Costs with Monopolistic Competition

Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 5.2

Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 5.3

5-30 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.