Topics in Trade: Slides

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1 Topics in Trade: Slides Alexander Tarasov University of Munich Summer 2014 Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

2 Organization Lectures (Prof. Dr. Dalia Marin and Alexander Tarasov, Ph.D.): Tuesday (Ludwigstr. 28, VG, 221) Tutorials (Alexander Tarasov, Ph.D.): Friday (Ludwigstrasse 28, Vgb., Room 221) Ofce hours: Prof. Dalia Marin: Monday, , Alexander Tarasov: Tuesday, and by appointment Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

3 Requirements Final exam (50%), the in-class presentation (40%), short quizzes (10%) Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

4 Preliminary Course Outline 5 Lectures on trade models: classical theory, New Trade theory, "New New" Trade theory (Tarasov) 4 Lectures on trade and rm organization (Marin) Presentations Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

5 Course Outline: Classical Trade Theory 1817: Ricardo's Principles of Political Economy and Taxation THEORY OF COMPARATIVE ADVANTAGE: a country exports products in which its labor productivity is high relative to its labor productivity in other products. 1920s: Heckscher-Ohlin FACTOR ENDOWMENTS DETERMINE THE PATTERN OF TRADE: a country should export the product that is relatively intensive in using the factor with which the country is relatively well-endowed. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

6 Course Outline: New Trade Theory and "New New" Trade Theory Krugman (1979): new, complementary theory based on ECONOMIES OF SCALE and PRODUCT DIFFERENTIATION. Motivated by: Large volumes of trade between countries with similar factor proportions. Large volumes of intra-industry trade. None of this seems motivated by factor endowment and technology differences "New New" Trade Theory: the role of rm heterogeneity Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

7 The Heckscher-Ohlin Model: Motivation A dramatic rise in trade from about 1890 until 1914 (improvements in transportation) Heckscher and Ohlin wanted to explain the large increase in trade Machines (technology) could be transported =) distribution of resources across countries was a reason for trade Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

8 The Heckscher-Ohlin Model: Motivation Nowadays, resources still matter: Canada (endowed with land) exports agriculture, oil, forestry products USA, Western Europe, Japan have many high skilled workers and capital and, therefore, export sophisticated manufactured goods Asian countries have a large number of workers and moderate amount of capital and, thereby, export less sophisticated manufactures Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

9 The Main Idea The Heckscher-Ohlin theory explains why countries trade goods with each other One condition for trade between two countries is that the countries differ with respect to the availability of the factors of production one country can have many machines (capital) but few workers, while another country has a lot of workers but few machines According to the H-O theory, a country specializes in the production of goods that it is particularly suited to produce countries in which capital is abundant and workers are few specialize in production of goods that require capital Specialization in production and trade between countries generates a higher standard-of-living for the countries involved Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

10 The Heckscher-Ohlin Model: The Model How do factor endowments form trade patterns? Framework: two factors of production (two inputs): labor and capital two sectors: y i = f i (L i, K i ) where i = 1, 2 is the sector index, L i is labor, K i is capital. f i (, ) is increasing in both arguments, concave (diminishing marginal returns), homogenous of degree one: f i (λl i, λk i ) = λf i (L i, K i ) Labor and capital are full mobile between sectors, but not between countries. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

11 The Heckscher-Ohlin Model: The Model Resource constraint: Production Possibility Frontier: subject to L 1 + L 2 L K 1 + K 2 K max y 2 = f 2 (L 2, K 2 ) fl 2,K 2 g L 1 + L 2 = L K 1 + K 2 = K y 1 = f 1 (L 1, K 1 ). Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

12 The Heckscher-Ohlin Model: The Model From the maximization problem: y 2 = h(y 1, L, K ), this is the PPF (PICTURE). The economy can produce any amount of goods within the PPF. Additional assumptions: perfect competition in the product and factor markets product prices are given exogenously (a small open economy), there are some world prices this assumption will be omitted later Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

13 The Heckscher-Ohlin Model: The Model Industry outputs are such that max fy 1,y 2 g GDP = p 1y 1 + p 2 y 2 subject to y 2 = h(y 1, L, K ). Why do in competitive equilibrium industry outputs maximize GDP (tutorial)? PICTURE Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

14 The Heckscher-Ohlin Model: Equilibrium Switch to unit-cost function: c i (w, r) = min L i,k i fwl i + rk i j f i (K i, L i ) = 1g where w and r are prices of labor and capital, respectively. c i (w, r) is the cost of one unit of y i (given the optimal choice of labor and capital) We can write c i (w, r) = wa il + ra ik, where a il and a ik is the rm optimal choices (endogenous variables): a il = a il (w, r), a ik = a ik (w, r). Envelope theorem: c i w = a il and c i r = a ik. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

15 The Heckscher-Ohlin Model: Equilibrium Both goods are produced! Perfect competition implies that prots are equal to zero: p 1 = c 1 (w, r) p 2 = c 2 (w, r) Full employment of both resources: a 1L y 1 + a 2L y 2 = L a 1K y 1 + a 2K y 2 = K Four equations and four unknowns ((w, r) and (y 1, y 2 )). Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

16 The Heckscher-Ohlin Model: Factor Intensity Reversals Suppose a 1L a 1K > a 2L a 2K, then industry 1 is labor intensive for given (w, r). If the inequality holds for all possible (w, r), there is no Factor Intensity Reversals!! for any values factor prices, industry 1 is labor intensive. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

17 The Heckscher-Ohlin Model: Analysis of Equilibrium Proposition: If both goods are produced and Factor Intensity Reversals do not occur then (p 1, p 2 ) corresponds to a unique (w, r) Corollary: Factor prices do not depend on the amount of endowments PICTURE (two equilibria)! Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

18 The Heckscher-Ohlin Model: Analysis of Equilibrium Does the no Factor Intensity Reversals condition always hold? Example (the textbook): Footwear industry in the United States A "New Balance" plant produces in the US, pays 14$ per hour, and uses high-tech equipment (automated stitchers, etc.): capital-intensive production Nike, Reebook, and other employ Asia labor force, pay 1$ per hour, and use century-old equipment: labor-intensive production Hence, if wage is low, production is labor-intensive. If wage is high, then production is capital-intensive We observe Factor Intensity Reversals! Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

19 The Heckscher-Ohlin Model: Factor Price Equalization Assume for the moment that there are two countries technologies are identical different factor endowments If both countries produce both goods and FIRs do not occur, then (w, r) are equalized across the countries. Comments: the number of goods is equal to the number of factors: important! technology is the same, both good should be produced! Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

20 The Heckscher-Ohlin Model: Stolper-Samuelson Theorem (1941) How product prices affect Factor prices? Theorem A rise in the relative price of a good will increase the real return to the factor used intensively in that good, and reduce return to the other factor. Proof. In the class! NOTE: There are strong distributional consequences, making some people worse off and some better off! See also the picture in the class. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

21 The Heckscher-Ohlin Model: Rybczynski Theorem (1955) How factor endowments affect product outputs? Theorem An increase in a factor endowment will increase the output of the industry using it intensively, and decrease the output of the other industry. Proof. In the class! NOTE: The factor-intensive industry not only absorb the entire amount of the extra factor endowment, it also absorbs further labor and capital from the other industry! As a result, the output of the other industry falls. Example: Dutch Decease, industries making use of oil expanded, other industries contracted. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

22 The Heckscher-Ohlin Model: Factor Price Equalization Revisited Before (for two countries): if both countries produce both goods and FIRs do not occur, then (w, r) are equalized across the countries. Now: for any allocation of labor and capital (of both countries) within the cones of diversication =) both goods are produced!! =) Factor price equalization Moreover, the equilibrium is the same as in the integrated world. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

23 The Heckscher-Ohlin Model The goal of the model is to predict the pattern of trade in goods between the two countries, based on their differences in factor endowments. Assumptions: identical technologies identical and homothetic preferences different factor endowments trade in goods (factors are not mobile across the countries) no FIRs (factor intensity reversals) Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

24 The Heckscher-Ohlin Model Assumptions: FPE: endowments are in the "cone of diversication" home country is labor abundant: good 1 is labor intensive: a 1L a 1K L K > L K : L = L, K < K > a 2L a 2K Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

25 The Heckscher-Ohlin Model The Heckscher-Ohlin Theorem: Each country will export the good that uses the abundant factor intensively. That is: the home country will export good 1, while the foreign country will export good 2. Intuition: Since the home country is labor abundant and good 1 is labor intensive, the home country has a comparative advantage in producing good 1. That is, the autarky relative price of good 1 in the home country is lower than that in the foreign country. As a result, the home country will export "cheaper" good 1 and import good 2, which is "cheaper" abroad. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

26 The Heckscher-Ohlin Model More formal: a representative consumer with homothetic preferences. Let us denote p a as the relative price of good 1 at home in the autarky equilibrium (no trade equilibrium): p a = pa 1 p2 a. In the same manner, p a is the relative price abroad. Then (see the picture drawn in the class), p a < p a. Let us also denote z(p) as the excess demand for good 1 in the home country (given the relative price p), z (p) is the excess demand abroad. Then, in the trade equilibrium: z (p w ) + z(p w ) = 0. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

27 The Heckscher-Ohlin Model As we can infer from the picture: z(p a ) = 0 z (p a ) > 0 =) z (p a ) + z(p a ) > 0. Given p a, there is world excess demand for good 1. By analogy, z (p a ) = 0 z(p a ) < 0 =) z (p a ) + z(p a ) < 0. Therefore, p a > p w > p a. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28

28 The Heckscher-Ohlin Model Gains from trade: as it can be seen from the pictures (trade triangles), both economies gain from trade. In fact, trade "improves" the consumer budget constraints and agents in both countries receive higher utility. However!!!! Not everybody gains. Consider the home country. In the trade equilibrium, the relative price of good 1 goes up compare to the autarky price. Then, according to the Stolper-Samuelson Theorem, this will increase the real return to labor (the factor used intensively in the production good 1) and will decrease the real return to capital. Workers gain, but holders of capital lose. Inequality decreases. Trade is good and can increase (decrease) inequality. Alexander Tarasov (University of Munich) Topics in Trade (Lecture 1) Summer / 28