International Trade

Import Tariffs and Export Subsidies: Simultaneous Shifts in R S and R D

Import tariffs are taxes levied on imports. Export subsidies are payments given to domestic producers that export. Both policies influence the terms of trade and therefore national welfare. Import tariffs and export subsidies drive a wedge between prices in world markets and prices in domestic markets.

Factor Prices and Goods Prices (1 of 3)

In competitive markets, the price of a good should equal its cost of production, which depends on the factor prices. How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used. An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is the capital intensive industry.

The Theory of Imperfect Competition

In imperfect competition, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price. This situation occurs when there are only a few major producers of a particular good or when each firm produces a good that is differentiated from that of rival firms. Each firm views itself as a price setter, choosing the price of its product.

Firm Responses to Trade

Increased competition tends to hurt the worst-performing firms — they are forced to exit. The best-performing firms take the greatest advantage of new sales opportunities and expand the most. When the better-performing firms expand and the worse-performing ones contract or exit, overall industry performance improves. Trade and economic integration improve industry performance as much as the discovery of a better technology does.

International Borrowing and Lending

The standard trade model can be modified to analyze international borrowing and lending. Two goods are current and future consumption (same good at different times), rather than different goods at the same time. Countries usually have different opportunities to invest to become able to produce more in the future. A special kind of production possibility frontier, an intertemporal production possibility frontier, depicts different possible combinations of current output and future output.

Factor Price Equalization

Unlike the Ricardian model, the Heckscher-Ohlin model predicts that factor prices will be equalized among countries that trade. Free trade equalizes relative output prices. Due to the connection between output prices and factor prices, factor prices are also equalized. Trade increases the demand of goods produced by relatively abundant factors, indirectly increasing the demand of these factors, raising the prices of the relatively abundant factors. In the real world, factor prices are not equal across countries. The model assumes that trading countries produce the same goods, but countries may produce different goods if their factor ratios radically differ. The model also assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages/rates paid to these factors. The model also ignores trade barriers and transportation costs, which may prevent output prices and thus factor prices from equalizing. The model predicts outcomes for the long run, but after an economy liberalizes trade, factors of production may not quickly move to the industries that intensively use abundant factors. In the short run, the productivity of factors will be determined by their use in their current industry, so that their wage/rental rate may vary across countries

Production Possibilities and Relative Supply

What a country produces depends on the relative price of cloth to food Pc/Pf An economy chooses its production of cloth Qc and food Qf to maximize the value of its output V=PcQc+PfQf given the prices of cloth and food. The slope of an isovalue line equals -Pc/Pf Produce at point where P P F is tangent to isovalue line.

•Internal economies of scale result when

large firms have a cost advantage over small firms, causing the industry to become uncompetitive. Internal economies of scale imply that a firm's average cost of production decreases the more output it produces.

Two-Factor Heckscher-Ohlin Model

1.Two countries: home and foreign. 2.Two goods: cloth and food. 3.Two factors of production: labor and capital. 4.The mix of labor and capital used varies across goods. 5.The supply of labor and capital in each country is constant and varies across countries. In the long run, both labor and capital can move across sectors, equalizing their returns (wage and rental rate) across sectors

There is a political bias in trade politics

potential losers from trade are better politically organized than the winners from trade. Losses are usually concentrated among a few, but gains are usually dispersed among many. Each of you pays about $8/year to restrict imports of sugar, and the total cost of this policy is about $2 billion/year. The benefits of this program total about $1 billion, but this amount goes to relatively few sugar producers.

The standard trade model is built on four key relationships:

1.the relationship between the production possibility frontier and the relative supply curve, 2.the relationship between relative prices and relative demand, 3.the determination of world equilibrium by world relative supply and world relative demand, and 4.the effect of the terms of trade—the price of a country's exports divided by the price of its imports—on a nation's welfare.

Heckscher-Ohlin theorem

The country that is abundant in a factor exports the good whose production is intensive in that factor. This result generalizes to a correlation: Countries tend to export goods whose production is intensive in factors with which the countries are abundantly endowed.

But there may be increasing returns to scale or economies of scale:

This means that when inputs to an industry increase at a certain rate, output increases at a faster rate. A larger scale is more efficient: the cost per unit of output falls as a firm or an industry increases output

The models of comparative advantage thus far assumed constant returns to scale

When inputs to an industry increase at a certain rate, output increases at the same rate. If inputs to an industry were doubled, industry output would double as well.

Production Possibilities (1 of 11)

With more than one factor of production, the opportunity cost in production is no longer constant and the P P F is no longer a straight line. Why?

The Welfare Effects of Changes in the Terms of Trade

The terms of trade refers to the price of exports relative to the price of imports. When a country exports cloth and the relative price of cloth increases, the terms of trade rise. Because a higher relative price for exports means that the country can afford to buy more imports, an increase in the terms of trade increases a country' s welfare. A decline in the terms of trade decreases a country's welfare.

Determining Relative Prices

-World supply of cloth relative to food at each relative price. -World demand for cloth relative to food at each relative price. -World quantities are the sum of quantities from the two countries in the world: Qc+Qc*/Qf+Qf* and Dc+Dc*/Df+Df*

Standard trade model

.is a general model that includes Ricardian, specific factors, and Heckscher-Ohlin models as special cases. Two goods, food (F) and cloth (C). Each country's PPF is a smooth curve Differences in labor services, labor skills, physical capital, land, and technology between countries cause differences in production possibility frontiers. A country's P P F determines its relative supply function. National relative supply functions determine a world relative supply function, which along with world relative demand determines the equilibrium under international trade.

Protectionism and Dumping

A U.S. firm may appeal to the Commerce Department to investigate if dumping by foreign firms has injured the U.S. firm. The Commerce Department may impose an "anti-dumping duty" (tax) to protect the U.S. firm. Tax equals the difference between the actual and "fair" price of imports, where "fair" means "price the product is normally sold at in the manufacturer's domestic market." Next, the International Trade Commission (I T C) determines if injury to the U.S. firm has occurred or is likely to occur. If the I T C determines that injury has occurred or is likely to occur, the antidumping duty remains in place. Most economists believe that the enforcement of dumping claims is misguided. Trade costs have a natural tendency to induce firms to lower their markups in export markets. Such enforcement may be used excessively as an excuse for protectionism. In the early 1990s, the bulk of antidumping complaints were directed at developed countries. But since 1995, developing countries have accounted for the majority of antidumping complaints. Among those countries, China has attracted a particularly large number of complaints. A nonmarket economy with substantial export growth, China has been subject to antidumping duties on: T Vs, furniture, crepe paper, hand trucks, shrimp, ironing tables, plastic shopping bags, iron pipe fittings, saccharin, solar panels, tires, and cold-rolled steel. These duties are as high as 78% on color T Vs, 266% for cold-rolled steel, and 330% on saccharin. Chinese cost data likely distorted by subsidized loans, rigged markets, and the controlled yuan. Data from other developing nations regarded as market economies used instead. Because antidumping protection is directed at a particular firm producing in a given country, often circumvented by firms switching production location or new firms that were not originally targeted by the antidumping filing. When U.S. tire manufacturers successfully lobbied for antidumping duties on Chinese tires in 2009, production shifted to South Korea, Thailand, and Indonesia. Exports from those countries doubled, offsetting the decrease in tire imports from China. Similarly L G and Samsung moved washing machine production from Korea to China and then Vietnam and Thailand to avoid paying antidumping duties.

Monopoly: A Brief Review

A monopoly is an industry with only one firm. An oligopoly is an industry with only a few firms. In these industries, the marginal revenue generated from selling more products is less than the uniform price charged for each product. To sell more, a firm must lower the price of all units, not just the additional ones. The marginal revenue function therefore lies below the demand function (which determines the price that customers are willing to pay). Assume that the demand curve the firm faces is a straight line Q=A-B(P), where Q is the number of units the firm sells, P the price per unit, and A and B are constants. Marginal revenue equals MR=P-Q/B Suppose that total costs are C=F+c(Q) where F is fixed costs, those independent of the level of output, and c is the constant marginal cost. Average cost is the cost of production (C) divided by the total quantity of production (Q). AC=C/Q=F/Q+c Marginal cost is the cost of producing an additional unit of output. A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale. The profit-maximizing output occurs where marginal revenue equals marginal cost. At the intersection of the M C and M R curves, the revenue gained from selling an extra unit equals the cost of producing that unit. The monopolist earns some monopoly profits, as indicated by the shaded box, when P>AC

Monopolistic Competition and Trade

Because trade increases market size, trade is predicted to decrease average cost in an industry described by monopolistic competition. Industry sales increase with trade leading to decreased average costs: AC=n(F/s)+c Because trade increases the variety of goods that consumers can buy under monopolistic competition, it increases the welfare of consumers. And because average costs decrease, consumers can also benefit from a decreased price. Product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage differences between them. This is a very different kind of trade than the one based on comparative advantage, where each country exports its comparative advantage good

Intra-Industry Trade in Action: The North American Auto Pact of 1964 and N A F T A

Before 1965, tariff protection by Canada and the United States produced a Canadian auto industry that was largely self-sufficient, neither importing nor exporting much. The Canadian auto industry was about one-tenth the size of the United States and had a labor productivity about 30% lower than that of the United States. Most Canadian plants produced several different things, requiring the plants to shut down periodically to change over from producing one item to producing another, to hold larger inventories, to use less specialized machinery. The United States and Canada agreed in 1964 to establish free trade in automobiles, which allowed the auto companies to reorganize their production. The overall level of Canadian production and employment was maintained. Canadian subsidiaries cut how many products were made in Canada. Production levels for the models produced in Canada rose dramatically, as those Canadian plants became one of the main (or only) supplier of that model for the whole North American market. Canada imported the models from the United States that it was no longer producing. Both exports and imports increased sharply. By the early 1970s, the Canadian industry was comparable to the U.S. industry in productivity. Later on, this transformation of the automotive industry was extended to include Mexico. This process continued with the implementation of N A F T A (the North American Free Trade Agreement between the United States, Canada, and Mexico). For each model of car, there is typically a plant in one of these three countries that sells to the whole North American market. The manufacture of auto parts was also consolidated throughout the North American market. In the first decade following N A F T A, trade in automotive parts between the United States and Mexico more than doubled in both directions, and then doubled again in the ensuing decade, highlighting the increasing importance of intra-industry trade. Concerns raised over a few final assembly plants relocating from the United States to Mexico rarely mentions the large growth of U.S. autos and parts exports to Mexico: Over two-thirds of Mexican automotive imports originated in the United States in 2002. Ending N A F T A likely would not would not result in higher car production in the United States. Lower demand for U.S. imports in Mexico and Canada (along with higher prices for all consumers) would lead to lower car production in the United States. Only car production outside North America would increase.

Integration

Causes the better-performing firms to thrive and expand, while the worse-performing firms contract. Additional source of gain from trade: As production is concentrated toward better-performing firms, the overall efficiency of the industry improves. Study why those better-performing firms have a greater incentive to engage in the global economy

Trade and the Distribution of Income (1 of 5)

Changes in relative prices can affect the earnings of labor and capital. A rise in the price of cloth raises the purchasing power of labor in terms of both goods while lowering the purchasing power of capital in terms of both goods. A rise in the price of food has the reverse effect Thus, international trade can affect the distribution of income, even in the long run: Owners of a country's abundant factors gain from trade, but owners of a country's scarce factors lose. Factors of production that are used intensively by the import-competing industry are hurt by the opening of trade—regardless of the industry in which they are employed.

Dumping

Dumping is the practice of charging a lower price for exported goods than for goods sold domestically. Dumping is an example of price discrimination: the practice of charging different customers different prices. Price discrimination and dumping may occur only if imperfect competition exists: firms are able to influence market prices. markets are segmented so that goods are not easily bought in one market and resold in another. Dumping can be a profit-maximizing strategy: A firm with a higher marginal cost chooses to set a lower markup over marginal cost. Therefore, an exporting firm will respond to the trade cost by lowering its markup for the export market. This strategy is considered to be dumping, regarded by most countries as an "unfair" trade practice.

Economies of Scale and Market Structure

Economies of scale could mean either that larger firms or a larger industry would be more efficient. External economies of scale occur when the cost per unit of output depends on the size of the industry. Internal economies of scale occur when the cost per unit of output depends on the size of the firm. Both external and internal economies of scale are important causes of international trade. They have different implications for the structure of industries: An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive. Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become imperfectly competitive

Skill-Biased Technological Change and Income Inequality

Even though skilled labor becomes relatively more expensive, in panel (b) producers in both sectors respond to the skill-biased technological change by increasing their employment of skilled workers relative to unskilled workers. The trade explanation in panel (a) predicts an opposite response for employment in both sectors. A widespread increase in the skilled labor ratios for most sectors in the U.S. economy points to the skill-biased technological explanation. Trade likely has been an indirect contributor to increases in wage inequality, by accelerating the process of technological change. Firms that begin to export may upgrade to more skill-intensive production technologies. Trade liberalization can then generate widespread technological change by inducing a large proportion of firms to make such technology-upgrade choices. Breaking up the production process across countries can increase the relative demand for skilled workers in developed countries similar to skill-biased technological change.

Interregional Trade and Economic Geography

External economies may also be important for interregional trade within a country. Many movie producers located in Los Angeles produce movies for consumers throughout the United States. Many financial firms located in New York provide financial services for consumers throughout the United States. Some nontradable goods like veterinary services must usually be supplied locally. If external economies exist, the pattern of trade may be due to historical accidents: Regions that start as large producers in certain industries tend to remain large producers even if another region could potentially produce more cheaply. More broadly, economic geography refers to the study of international trade, interregional trade, and the organization of economic activity in metropolitan and rural areas. Economic geography studies how humans transact with each other across space. Communication changes such as the Internet, e-mail, text mail, video conferencing, and mobile phones (as well as modern transportation) are changing how humans transact with each other across space.

Capital-Skill Complementarity (1 of 2)

Figure 5.12 shows that the trend toward lower labor income share (and higher capital shares) is a worldwide phenomenon. Experienced in labor-abundant countries (including China, India, and Mexico) to the same extent as it has been for capital-abundant countries such as the United States. The evidence supports an explanation based on technological changes within sectors—not increased import competition. Technological change often takes the form of new and better machines (capital) that displace unskilled workers but still require skilled workers. This generates higher returns for both capital and skilled workers while depressing the returns to unskilled workers. Increased automation can explain the observed worldwide increases in both wage inequality and the returns to capital, as well as the within-sector increases in the employment share of (relatively skilled) non-production workers.

Multinationals and Outsourcing

Foreign direct investment refers to investment in which a firm in one country directly controls or owns a subsidiary in another country. If a foreign company invests in at least 10% of the stock in a subsidiary, the two firms are typically classified as a multinational corporation. 10% or more of ownership in stock is deemed to be sufficient for direct control of business operations. The controlling (owning) firm is called the multinational parent, while the "controlled" firms are called the multinational affiliates. Greenfield F D I is when a company builds a new production facility abroad. Brownfield F D I (or cross-border mergers and acquisitions) is when a domestic firm buys a controlling stake in a foreign firm. Greenfield F D I has tended to be more stable, while cross-border mergers and acquisitions tend to occur in surges. Developed countries have been the biggest recipients of inward F D I. much more volatile than F D I going to developing and transition economies. Steady expansion in the share of F D I flowing to developing and transition countries. Accounted for half of worldwide F D I flows since 2009. Sales of F D I affiliates are often used as a measure of multinational activity. Two main types of F D I: Horizontal F D I when the affiliate replicates the production process (that the parent firm undertakes in its domestic facilities) elsewhere in the world. Vertical F D I when the production chain is broken up, and parts of the production processes are transferred to the affiliate location. Vertical F D I is mainly driven by production cost differences between countries (for those parts of the production process that can be performed in another location). Vertical F D I is growing fast and is behind the large increase in F D I inflows to developing countries. Horizontal F D I is dominated by flows between developed countries. Both the multinational parent and the affiliates are usually located in developed countries. The main reason for this type of F D I is to locate production near a firm's large customer bases. Hence, trade and transport costs play a much more important role than production cost differences for these F D I decisions.

Has the Growth of Newly IndustrializingEconomies Hurt Advanced Nations?

Has the United States suffered from a deterioration in its terms of trade as some of its main trading partners (such as China) experienced rapid growth? This would represent an aggregate income loss for the United States. The standard trade model predicts that if the growth in China is mainly import-biased, the growth in sectors that compete with U.S. exports would reduce the U.S. terms of trade. But data indicates that changes in the U.S. terms of trade have been small with no clear trend over last few decades. The U.S. terms of trade in 2014 was essentially at the same level as it was in 1980. The terms of trade for China have deteriorated over the past decade, suggesting their recent growth may have been export-biased. Like the United States, most developed countries tend to experience mild swings in their terms of trade, around 1 percent or less a year (on average). Some developing countries' exports are heavily concentrated in mineral and agricultural sectors. The prices of those goods on world markets are very volatile, leading to large swings in the terms of trade. These swings in turn translate into substantial changes in welfare.

Effects of an Export Subsidy

If the home country imposes a subsidy on cloth exports, the price of cloth relative to the price of food rises for domestic consumers. Domestic producers will receive a higher relative price of cloth when they export, and therefore will be more willing to switch to cloth production: relative supply of cloth will increase. Domestic consumers must pay a higher relative price of cloth to producers, and therefore will be more willing to switch to food consumption: relative demand for cloth will decrease. When the home country imposes an export subsidy, the terms of trade decrease and the welfare of the country decreases to the benefit of the foreign country.

Relative Price and Supply Effects of a Tariff

If the home country imposes a tariff on food imports, the price of food relative to the price of cloth rises for domestic consumers. Likewise, the price of cloth relative to the price of food falls for domestic consumers. Domestic producers will receive a lower relative price of cloth, and therefore will be more willing to switch to food production: relative supply of cloth will decrease. Domestic consumers will pay a lower relative price for cloth, and therefore will be more willing to switch to cloth consumption: relative demand for cloth will increase. When the home country imposes an import tariff, the terms of trade increase and the welfare of the country may increase. The magnitude of this effect depends on the size of the home country relative to the world economy. If the country is a small part of the world economy, its tariff (or subsidy) policies will not have much effect on world relative supply and demand, and thus on the terms of trade. But for large countries, a tariff may maximize national welfare at the expense of foreign countries.

Stolper-Samuelson theorem

If the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases.

Rybczynski theorem

If you hold output prices constant as the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases.

The Significance of Intra-Industry Trade

Intra-industry trade refers to two-way exchanges of similar goods. Two new channels for welfare benefits from trade: Benefit from a greater variety at a lower price. Firms consolidate their production and take advantage of economies of scale. A smaller country stands to gain more from integration than a larger country. About 25-50% of world trade is intra-industry. Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade. For the United States, industries that have the most intra-industry trade—such as pharmaceuticals, chemicals, and specialized machinery—require relatively larger amounts of skilled labor, technology, and physical capital.

International Effects of Growth (1 of 5)

Is economic growth in China good for the standard of living in the United States? Is growth in a country more or less valuable when it is integrated in the world economy? The standard trade model gives us precise answers to these questions. Growth is usually biased: it occurs in one sector more than others, causing relative supply to change. Rapid growth has occurred in U.S. computer industries but relatively little growth has occurred in U.S. textile industries. In the Ricardian model, technological progress in one sector causes biased growth. In the Heckscher-Ohlin model, an increase in one factor of production causes biased growth. Growth is biased when it shifts production possibilities out more toward one good than toward another. In case (a), growth is biased toward cloth, while in case (b), growth is biased toward food.

Whose Trade Is It?

Large bilateral trade deficit between the United States and China. $344 billion in 2019, accounts for 56% of the overall U.S. trade deficit (in goods and services) with the rest of the world, prominently featured in the press and by politicians (often as a sign of unfair trade practices). Buying an iPhone 11 Pro Max from Apple in the United States is recorded as a $490 import from China (where the iPhone is assembled and tested). Of this total manufacturing cost, less than $10 stems from assembly and testing performed in China. The remaining $480 represents the iPhone's component costs, which are overwhelmingly produced outside China. spread throughout Asia (Korea, Japan, and Taiwan are the largest suppliers), Europe, and the Americas. Seventy-five sites in the United States contribute to the production of iPhone components and employ 257,000 U.S. workers. For example, the glass screens are produced in Kentucky and the Face I D chips in Texas. Many of the component producers outside the United States employ U.S. researchers and engineers. For example, the Korean company Samsung operates research facilities in Texas and California that employ several thousand workers. The true bilateral deficit between the United States and China (at value added) is estimated to be roughly half of the reported bilateral trade deficit based on gross value. The trade deficits with Germany, Japan, and Korea are magnified when measured as value added, because those countries manufacture many of the components that are assembled in China and then imported as final goods into the United States. Leaves the overall U.S. trade deficit (with the rest of the world) unchanged.

Choosing the Mix of Inputs (1 of 2)

Producers may choose different amounts of factors of production used to make cloth or food. Their choice depends on the wage, w, paid to labor and the rental rate, r, paid when renting capital. As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth.

Monopolistic Competition

Monopolistic competition is a simple model of an imperfectly competitive industry that assumes that each firm 1.can differentiate its product from the product of competitors, and 2.takes the prices charged by its rivals as given. A firm in a monopolistically competitive industry is expected to sell more as total sales in the industry increase and as prices charged by rivals increase. less as the number of firms in the industry decreases and as the firm's price increases. These concepts are represented by the function: Q=S(1/n-b(P-Pbar)) -Q is an individual firm's sales S is the total sales of the industry n is the number of firms in the industry b is a constant term representing the responsiveness of a firm's sales to its price Pbar is the price charged by the firm itself P is the average price charged by its competitors

Trade Costs and Export Decisions

Most U.S. firms do not report any exporting activity at all — sell only to U.S. customers. In 2007, only 35% of U.S. manufacturing firms reported any exports. Even in industries that export much of what they produce, such as chemicals, machinery, electronics, and transportation, fewer than 40% of firms export. A major reason why trade costs reduce trade so much is that they drastically reduce the number of firms selling to customers across the border. Trade costs also reduce the volume of export sales of firms selling abroad. Trade costs added two important predictions to our model of monopolistic competition and trade: Why only a subset of firms export, and why exporters are relatively larger and more productive (lower marginal costs). Overwhelming empirical support for this prediction that exporting firms are bigger and more productive than firms in the same industry that do not export. In the United States, in a typical manufacturing industry, an exporting firm is on average more than twice as large as a firm that does not export. Differences between exporters and nonexporters are even larger in many European countries Consider the response of firms in a world with two identical countries (Home and Foreign). Let the market size parameter S reflect the size of each market. Assume that a firm must incur an additional cost t for each unit of output that it sells to customers across the border. Due to the trade cost t, firms will set different prices in their export market relative to their domestic market. In Figure 8-8, firm 2 profitably operates in its domestic market as its cost there c2 is below the threshold c* -However, it cannot profitably operate in the export market because its cost there c2+t is above the threshold c* Firm 1 has a low enough cost that it profitably operates in both the domestic and the export markets. Overall, the lowest-cost firms export; the higher-cost firms produce for their domestic market but do not export; the highest-cost firms cannot profitably operate in either market and thus exit.

North-South Trade and Income Inequality

Over the last 40 years, countries such as South Korea, Mexico, and China have exported to the United States goods intensive in unskilled labor (e.g., clothing, shoes, toys, assembled goods). At the same time, income inequality has increased in the United States , as wages of unskilled workers have grown slowly compared to those of skilled workers. Did the former trend cause the latter trend? The Heckscher-Ohlin model predicts that owners of relatively abundant factors will gain from trade and owners of relatively scarce factors will lose from trade. According to the model, a change in the distribution of income occurs through changes in output prices, but there is no evidence of a change in the prices of skill-intensive goods relative to prices of unskilled-intensive goods. According to the model, wages of unskilled workers should increase in unskilled labor abundant countries relative to wages of skilled labor, but in some cases the reverse has occurred: Wages of skilled labor have increased more rapidly in Mexico than wages of unskilled labor. But compared to the United States and Canada, Mexico is supposed to be abundant in unskilled workers. Even if the model were exactly correct, trade is a small fraction of the U.S. economy, so its effects on U.S. prices and wages prices should be small.

External Economies and International Trade

Prior to international trade, equilibrium prices and output for each country would be at the point where the domestic supply curve intersects the domestic demand curve. Suppose Chinese button prices in the absence of trade would be lower than U.S. button prices. What will happen when the countries open up the potential for trade in buttons? The Chinese button industry will expand, while the U.S. button industry will contract. This process feeds on itself: As the Chinese industry's output rises, its costs will fall further; as the U.S. industry's output falls, its costs will rise. In the end, all button production will be in China. How does this concentration of production affect prices? Chinese button prices were lower than U.S. button prices before trade. Because China's supply curve is forward-falling, increased production as a result of trade leads to a button price that is lower than the price before trade. Trade leads to prices that are lower than the prices in either country before trade! This is very different from the implications of models without increasing returns. In the standard trade model, relative prices converge as a result of trade. If cloth is relatively cheap in the home country and relatively expensive in the foreign country before trade opens, the effect of trade was to raise cloth prices in Home and reduce them in Foreign. With external economies, by contrast, the effect of trade is to reduce prices everywhere. What might cause one country to have an initial advantage from having a lower price? One possibility is comparative advantage due to underlying differences in technology and resources. If external economies exist, however, the pattern of trade could be due to historical accidents: Countries that start as large producers in certain industries tend to remain large producers even if another country could potentially produce more cheaply. A tufted blanket, crafted as a wedding gift by a 19th-century teenager, gave rise to the cluster of carpet manufacturers around Dalton, Georgia. Silicon Valley may owe its existence to two Stanford graduates named Hewlett and Packard who started a business in a garage there. Assume that the Vietnamese cost curve lies below the Chinese curve because Vietnamese wages are lower than Chinese wages. At any given level of production, Vietnam could manufacture buttons more cheaply than China. One might hope that this would always imply that Vietnam will in fact supply the world market. But this need not always be the case if China has enough of a head start. No guarantee that the right country will produce a good that is subject to external economies. Trade based on external economies has an ambiguous effect on national welfare. There will be gains to the world economy by concentrating production of industries with external economies. It's possible that a country is worse off with trade than it would have been without trade: a country may be better off if it produces everything for its domestic market rather than pay for imports. Imagine that Thailand could make watches more cheaply, but Switzerland got there first. The price of watches could be lower in Thailand with no trade. Trade could make Thailand worse off, creating an incentive to protect its potential watch industry from foreign competition. What if Thailand reverts to autarky? Note that it's still to the benefit of the world economy to take advantage of the gains from concentrating industries. Each country wanting to reap the benefits of housing an industry with economies of scale creates trade conflicts. Overall, it's better for the world that each industry with external economies be concentrated somewhere.

The Firm's Decision Regarding Foreign Direct Investment

Proximity-concentration trade-off: High trade costs associated with exporting create an incentive to locate production near customers. Increasing returns to scale in production create an incentive to concentrate production in fewer locations. F D I activity concentrated in sectors with high trade costs. When increasing returns to scale are important and average plant sizes are large, we observe higher export volumes relative to F D I. Multinationals tend to be much larger and more productive than other firms (even exporters) in the same country. The horizontal FDI decision involves a trade-off between the per-unit export cost t and the fixed cost F of setting up an additional production facility. If t(Q)>F costs more to pay trade costs t on Q units sold abroad than to pay fixed cost F to build a plant abroad. When foreign sales large Q>F/t exporting is more expensive and F D I is the profit-maximizing choice. Low costs make more apt to choose F D I due to larger sales. The vertical F D I decision also involves a trade-off between cost savings and the fixed cost F of setting up an additional production facility. Cost savings related to comparative advantage make some stages of production cheaper in other countries. Foreign outsourcing or offshoring occurs when a firm contracts with an independent firm to produce in the foreign location. In addition to deciding the location of where to produce, firms also face an internalization decision: whether to keep production done by one firm or by separate firms. Internalization occurs when it is more profitable to conduct transactions and production within a single organization. Reasons for this include: 1.Technology transfers: transfer of knowledge or another form of technology may be easier within a single organization than through a market transaction between separate organizations. Patent or property rights may be weak or nonexistent. Knowledge may not be easily packaged and sold.2.Vertical integration involves consolidation of different stages of a production process. Consolidating an input within the firm using it can avoid holdup problems and hassles in writing complete contracts. But an independent supplier could benefit from economies of scale if it performs the process for many parent firms. Foreign direct investment should benefit the countries involved for reasons similar to why international trade generates gains. Multinationals and firms that outsource take advantage of cost differentials that favor moving production (or parts thereof) to particular locations. F D I is very similar to the relocation of production that occurred across sectors when opening to trade. There are similar welfare consequences for the case of multinationals and outsourcing: Relocating production to take advantage of cost differences leads to overall gains from trade.

Dynamic Increasing Returns

So far, we have considered cases where external economies depend on the amount of current output at a point in time. But external economies may also depend on the amount of cumulative output over time. Dynamic increasing returns to scale exist if average costs fall as cumulative output over time rises. Dynamic increasing returns to scale imply dynamic external economies of scale. Dynamic increasing returns to scale could arise if the cost of production depends on the accumulation of knowledge and experience, which depend on the production process over time. A graphical representation of dynamic increasing returns to scale is called a learning curve. Like external economies of scale at a point in time, dynamic increasing returns to scale can lock in an initial advantage or a head start in an industry. Can also be used to justify protectionism. Temporary protection of industries enables them to gain experience: infant industry argument. But temporary is often for a long time, and it is hard to identify when external economies of scale really exist.

Empirical Evidence on the Heckscher-Ohlin Model

Tests on U.S. data Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the United States is the most capital-abundant country in the world: Leontief paradox. Tests on global data Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model on data from 27 countries and confirmed the Leontief paradox on an international level. Because the Heckscher-Ohlin model predicts that factor prices will be equalized across trading countries, it also predicts that factors of production will produce and export a certain quantity goods until factor prices are equalized. In other words, a predicted value of services from factors of production will be embodied in a predicted volume of trade between countries. But because factor prices are not equalized across countries, the predicted volume of trade is much larger than actually occurs. A result of "missing trade" discovered by Daniel Trefler. The reason for this "missing trade" appears to be the assumption of identical technology among countries. Technology affects the productivity of workers and therefore the value of labor services. A country with high technology and a high value of labor services would not necessarily import a lot from a country with low technology and a low value of labor services. An important study by Donald Davis and David Weinstein showed that if relax the assumption of common technologies, along with assumptions underlying factor price equalization (countries produce the same goods and costless trade equalizes prices of goods): then the predictions for the direction and volume of the factor content of trade line-up well with empirical evidence and ultimately generate a good fit. Difficulty finding support for the predictions of the "pure" Heckscher-Ohlin model can be blamed on some of the assumptions made. Contrast the exports of labor-abundant, skill-scarce nations in the developing world with the exports of skill-abundant, labor-scarce (rich) nations. The exports of the three developing countries to the United States are concentrated in sectors with the lowest skill intensity. The exports of the three skill abundant countries to the United States are concentrated in sectors with higher skill intensity. Or compare how exports change when a country such as China grows and becomes relatively more skill-abundant: The concentration of exports in high-skill sectors steadily increases over time. In the most recent years, the greatest share of exports is transacted in the highest skill-intensity sectors, whereas exports were concentrated in the lowest skill-intensity sectors in the earlier years.

U.S. Consumer Gains from Chinese Imports

The aggregate gains from trade are in large part driven by consumers' access to cheaper imported goods. •Increased trade between the United States and China has increased the purchasing power of U.S. consumers. A recent study finds that increased trade with China between 2000 and 2007 induced large reductions in prices, generating substantial increases in the purchasing power of U.S. households. On average those gains represented $1,500 per household per year. Over half of those gains were generated by price reductions of U.S. produced goods in response to the increased competition from Chinese imports. And because those price decreases were more pronounced for goods consumed by relatively poorer households with annual incomes below $30,000, the average $1,500 gain was 36 percent higher for those households relative to richer households with income above $100,000.

Trade in the Heckscher-Ohlin Model (1 of 5)

The countries are assumed to have the same technology and the same tastes. With the same technology, each economy has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed. With the same tastes, the two countries will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade Since cloth is relatively labor intensive, at each relative price of cloth to food, Home will produce a higher ratio of cloth to food than Foreign. Home will have a larger relative supply of cloth to food than Foreign. Home's relative supply curve lies to the right of Foreign's. Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices with trade. With trade, the relative price of cloth rises in the relatively labor abundant (home) country and falls in the relatively labor scarce (foreign) country. Relative prices and the pattern of trade: In Home, the rise in the relative price of cloth leads to a rise in the relative production of cloth and a fall in relative consumption of cloth. Home becomes an exporter of cloth and an importer of food. The decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food.

Implications of Terms of Trade Effects: Who Gains and Who Loses?

The standard trade model predicts that an import tariff by the home country can increase domestic welfare at the expense of the foreign country. an export subsidy by the home country reduces domestic welfare to the benefit of the foreign country. Additional effects of tariffs and subsidies that can occur in a world with many countries and many goods: A foreign country may subsidize the export of a good that the United States also exports, which will reduce the price for the United States in world markets and decrease its terms of trade. The E U subsidizes agricultural exports, which reduce the price that American farmers receive for their goods in world markets. A foreign country may put a tariff on an imported good that the United States also imports, which will reduce the price for the United States in world markets and increase its terms of trade. Export subsidies by foreign countries on goods that the U.S. imports reduce the world price of U.S. imports and increase the terms of trade for the United States the U.S. also exports reduce the world price of U.S. exports and decrease the terms of trade for the United States Import tariffs by foreign countries on goods that the U.S. exports reduce the world price of U.S. exports and decrease the terms of trade for the United States the U.S. also imports reduce the world price of U.S. imports and increase the terms of trade for the United States. Export subsidies on a good decrease the relative world price of that good by increasing relative supply of that good and decreasing relative demand of that good. Import tariffs on a good decrease the relative world price of that good (and increase the relative world price of other goods) by increasing the relative supply of that good and decreasing the relative demand of that good.

Relative Prices and Demand (1 of 6)

The value of the economy's consumption must equal the value of the economy's production. PcDc+PfDf=PcQc+PfQf=V •Assume that the economy's consumption decisions may be represented as if they were based on the tastes of a single representative consumer. An indifference curve represents combinations of cloth and food that leave the consumer equally well off (indifferent).

The Theory of External Economies

This chapter deals with a model of external economies; the next chapter will cover internal economies. Many modern examples of industries that seem to be powerful external economies: In the United States, the semiconductor industry is concentrated in Silicon Valley, investment banking in New York, and the entertainment industry in Hollywood. In developing countries such as China, external economies are pervasive in manufacturing. One town in China produces most of the world's underwear production, another produces nearly all cigarette lighters. External economies played a key role in India's emergence as a major exporter of information services. Indian information services companies are still clustered in Bangalore. For a variety of reasons, concentrating production of an industry in one or a few locations can reduce the industry's costs, even if the individual firms in the industry remain small. External economies may exist for a few reasons: 1.Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. For example, Silicon Valley in California has a large concentration of silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips. These machines are cheaper and more easily available there than elsewhere. 2.Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. 3.Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists. Represent external economies simply by assuming that the larger the industry, the lower the industry's costs. There is a forward-falling supply curve: the larger the industry's output, the lower the price at which firms are willing to sell. Without international trade, the unusual slope of the supply curve doesn't matter much.

Perfect competition that drives the price of a good down to marginal cost

would imply losses for those firms because they would not be able to recover the higher costs incurred from producing the initial units of output. As a result, perfect competition would force those firms out of the market. In most sectors, goods are differentiated from each other and there are other differences across firms.