Recent Developments in Trade Theory

Rod FalveyMarch 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 ModelComparative 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) ModelTrade 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

ButSpecialisation - 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 don’t fit the data

Models predict too much specialization

These problems have been dealt with in a variety of ways:

Specific FactorsAlso 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

– Doesn’t necessarily mean trade gains from increasing firm size

Heterogeneous FirmsMelitz (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 don’t 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 firm’s industry is not very informative about export participation.

Suggest limitations of “representative firm” approach.

Bernard/Jensen/Redding/Schott JEP 21(3) 2007

AutarkyCosts

Entry fixed costProduction fixed costProduction 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

TradeCosts

Export fixed costUnit 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

Domesticthresholdopen

Domestic thresholdautarky

Exporters

Purely domestic firms

ContractLeave 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 FirmsWhy 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 GeographyOther 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 GeographyPerfect 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 TradeInterpret “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 contractsStandard 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 institutionsQuality 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

2pp

dVWelfare T S dT TdT