Lecture 19: Effects of International Trade November 29, 2016 Prof. Wyatt Brooks
Summary from Last Time Quick summary of last time: The U.S. has a large trade deficit About half of that is the deficit with China A large part of that is consumer electronics So to understand the U.S. trade deficit, a large part is attributed to just that one thing! 1
The International Allocation Puzzle One puzzling feature of international capital flows: Typically, capital flows from poor, fast growing countries to rich, slow growing countries This is a puzzle for macroeconomic models Meaning it does not happen in our usual models, but it does in the data The reason we have trouble rationalizing this: If you are going to be much richer in the future, you should prefer to borrow today to consume and pay it off in the future when you re rich OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 2
Example: China China has an extremely high savings rate and very fast growth They use their savings to buy low return US assets and send a lot of Chinese goods to the US Normally we think of people wanting to smooth their consumption over time Would prefer constant consumption today and tomorrow to very low consumption today and very high consumption tomorrow Yet this would predict that the US should be lending to China now OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 3
Possible Explanations Many possible explanations have been proposed: Unusual age structure in China from the one child policy (Modigliani and Gao, 2004) In the near future, Chinese population will be very old so they are saving now to support consumption then Bad financial markets in China require entrepreneurs to save (Buera and Shin, 2011) Better insurance markets in the US make foreigners want to save here (Mendoza, Quadrini, Rios-Rul, 2009) OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 4
Possible Explanations Many possible explanations have been proposed: Currency manipulation strategy: Normally if trade deficits are large, currency prices adjust to balance trade With high taxes and capital controls, the Chinese government uses dollars that enter the economy to purchase US government assets Keeps the RMB from adjusting in value Great example of a policy that maximizes Chinese GDP but is bad for Chinese welfare OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 5
Why do countries gain from trade? There are many reasons countries can be better off with international trade: Classical gains: Easier to produce in one place than in another Oil in Saudi Arabia Cars in Germany? Gains from varieties: Better off having many types of goods instead of a few Pro-competitive effects: Opening to trade reduces the monopoly power of domestic firms 6
Comparative vs Absolute Advantage Classical gains from trade depend on comparative advantage Absolute Advantage: A smaller number of inputs used to produce a good or service Comparative Advantage: A lower opportunity cost to produce a good or service Opportunity cost here is in terms of the other good that the country could produce instead 7
Remote Island Example Simple example: Remote island with Jim and Jenny, both can catch fish and find coconuts Both have only 10 hours to work per day Jim can find 2 coconuts per hour and catch 1 fish per hour Jenny can find 5 coconuts per hour and catch 2 fish per hour Jenny has an absolute advantage in both fish and coconuts 8
Remote Island Example Simple example: Remote island with Jim and Jenny, both can catch fish and find coconuts Both have only 10 hours to work per day Jim can find 2 coconuts per hour and catch 3 fish per hour Jenny can find 4 coconuts per hour and catch 4 fish per hour Opportunity cost of 1 fish: for Jenny it is 1 coconuts, and for Jim it is 2/3 coconuts Therefore, Jim has a comparative advantage in fish and Jenny has a comparative advantage in coconuts 9
Specialization and Trade In this case, Jim should spend his time fishing and Jenny should spend her time looking for coconuts Then they can trade fish for coconuts and both be better off Example: Suppose they do not trade, and both spend 6 hours on coconuts and 4 hours fishing Then Jim has 12 coconuts and 12 fish Then Jenny has 24 coconuts and 16 fish 10
Specialization and Trade In this case, Jim should spend his time fishing and Jenny should spend her time looking for coconuts Then they can trade fish for coconuts and both be better off Example: Suppose they specialize and trade Jenny gets 40 coconuts and Jim catches 30 fish Jenny trades 14 coconuts for 17 fish Then Jenny has 26 coconuts and 17 fish Then Jim has 14 coconuts and 13 fish Both have 2 more coconuts and 1 more fish 11
Comparative vs Absolute Advantage Classical gains from trade have nothing to do with absolute advantage These gains from trade depend only on their difference in comparative advantage If they have the same opportunity cost, then there is nothing to gain from trade If they have very large differences in opportunity costs, then they have very big gains from trade 12
Continued Example Simple example: Remote island with Jim and Jenny, both can catch fish and find coconuts Both have only 10 hours to work per day Jim can find 1/3 coconuts per hour and catch 3 fish per hour Jenny can find 4 coconuts per hour and catch 4 fish per hour Opportunity cost of 1 fish: for Jenny it is 1 coconuts, and for Jim it is 1/9 coconuts Therefore, Jim has a comparative advantage in fish and Jenny has a comparative advantage in coconuts 13
Specialization and Trade Example: Suppose they do not trade, and both spend 6 hours on coconuts and 4 hours fishing Then Jim has 2 coconuts and 12 fish Then Jenny has 24 coconuts and 16 fish If instead they specialize: Jenny gets 40 coconuts and Jim gets 30 fish Jenny trades 9 coconuts for 17 fish Jim ends up with 9 coconuts and 13 fish Jenny ends up with 31 coconuts and 17 fish Now both have 7 more coconuts and 1 more fish Much bigger gains from trade than before 14
Country Differences and Gains Classical gains from trade are driven by differences between countries This predicts that the most different countries should have the most to gain from trade Also the implied pattern of specialization means they should trade very different products with each other 15
Evidence in Favor of Classical Gains Example: Saudi Arabia and the United States Saudi Arabia exports oil to the United States Cheap to produce oil in Saudi Arabia, hard to produce other things like food and cars Expensive to produce oil in the US, easy to produce food and cars Therefore, the United States sells food and cars to Saudi Arabia and they sell oil to us Both countries are better off 16
Top Ten Categories: UK-Spain UK sells Spain: 1) Pharmaceuticals 2) Cars 3) Cars 4) Car Parts 5) Whiskey 6) Jet Engines 7) Scrap Iron 8) Cars 9) Enriched Uranium 10) Video Games Spain sells the UK: 1) Cars 2) Cars 3) Cars 4) Pharmaceuticals 5) Car Parts 6) Cargo Trucks 7) Jet Engines 8) Color Televisions 9) Cars 10) Wine 17
Evidence Against Classical Gains Again, this is a general pattern Countries that trade a lot with each other actually tend to trade the same things in both directions This is not obviously consistent with the classical view of gains from trade Instead we call this a gains from variety effect 18
Gains from Variety SEAT sells cars in Spain and Jaguar sells cars in the UK Although both sell cars they are different SEAT sells economical cars and Jaguar sells luxury cars Suppose a Spanish consumer wants a luxury car and a British consumer wants an economical car Trade allows them to buy the variety of the product that they would most like to have 19
Varieties Examples Another example: after joining NAFTA, Mexican consumers had many more varieties of breakfast cereal available Mexico could produce any of those varieties themselves If it was not trading, the Mexican cereal market isn t big enough to support many varieties However, the US + Canada + Mexico cereal market is big enough to support lots of varieties Therefore, trade allows consumers to be part of a bigger market and get more product varieties 20
Conceptual Difference: Classical vs. Varieties Classical gains derive from fundamental differences in the two countries Geography, weather, resources, culture Varieties of the same product could, in principle, be produced in either place Consumers prefer to have access to more varieties to find a product better matched to their tastes and needs Trade makes it so that you are part of a bigger market, which supports more varieties 21
Pro-Competitive Effects of Trade Suppose the economy is closed to trade, and the UK has Jaguar and Spain has SEAT Then SEAT and Jaguar are monopolists within their own countries Monopoly power has many effects: Monopolists charge high prices Monopolists have little incentive to innovate Monopolists make high profits, which allows them to influence politics Monopolists high profits empower unions to become powerful 22
Example: US Auto Industry In the 1960s-70s, the US automakers had a commanding share of the US and world car markets Cars produced during this time period are notorious for their low quality Period of extremely low innovation In the 1980s-90s, competition from Japanese automakers forced the US auto industry to innovate, increase efficiency, etc. Without international trade, may not have happened 23
Example: US Cement Industry From Dunne, Klimek and Schmitz (2009): Until the early 1980s there was essentially no foreign trade of cement The cement industry had extremely powerful unions that had strong work rules 24
Example: US Cement Industry Examples of work rules: If a senior worker is temporarily laid off, they may instead take the job of any junior worker doing any job, regardless of if the senior worker is trained to do it A sufficiently senior worker cannot be laid off for any reason, even elimination of their job duty Workers cannot work on other workers job duties, even if the other worker isn t present Cannot eliminate any functions within the firm currently done within the firm 25
Example: US Cement Industry These work rules helped workers within the plant, but greatly limited plant productivity In the mid-1980s, cement began to be imported from abroad in large quantities Due to this competitive pressure, the price of cement fell, and many US cement plants were faced with shutdown Union rules were relaxed or removed, and productivity of cement producers grew dramatically 26
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Pro-Competitive Effects International trade can force domestic monopolists to: Innovate on their product (US automakers) Increase efficiency (US cement industry) Lower prices All of these things are bad for the monopolist themselves, but are good for the economy as a whole May also be bad for the workers who work for that monopolist 28
Summary of the Effects of Trade Trade is good for: Classical gains: Countries can specialize in the goods that they have a comparative advantage in producing Gains from variety: Countries can get types of goods that are not available domestically Pro-competitive effects: Domestic monopolists increase innovation, increase efficiency and decrease prices due to foreign competition Trade is bad for: Workers and firm owners in industries that face competitive pressure from abroad 29
Trading Off the Short Run and the Long Run Trade is just an example of a policy choice that has long run benefits and short run costs Another example: suppose a factory is losing money and it s owners are planning to close it The factory employs 5,000 workers If it shuts down, those workers will lose their jobs, as will workers in another factory who supply intermediates to it Should the government step in to, for example, subsidize the plant to keep it open? 30
Long Run Effects It is tempting to subsidize them, because in the short run the loss of jobs is very bad What are the long run effects? The workers stay in a factory producing goods that loss money; an unproductive activity The government must continue to take money from people/profitable businesses to pay for this What if this was an ongoing policy of the government? In the long run, only unproductive firms are operating and the government spends a ton of money keeping them going 31
Case of India India pursued policies that had these effects for decades, from independence until the early 1990s Ultimately, this huge program of spending plunged the economy into financial crisis With an IMF loan, the government had to abandon these programs, allowing many factories to fail Led to very fast growth in the economy and, after a few years, much better outcomes for workers 32
Lesson of India We cannot always trade off short run benefits for long run losses If we do, then we are getting worse and worse off International trade is an example of this Workers and industries may be worse off in the short run Rather than taking that as a reason to not open to trade, we should focus on ways to mitigate the harmful short run effects 33