STANDARD & NEW TRADE
THEORY
AND POLICY MAKING
Jacob A. Jordaan
Utrecht University School of Economics
j.a.jordaan@uu.nl
Outline
• Literature
• Introduction
• Standard trade theory
• Origins
• Main findings
• Policy implications
• New trade theory
• Why?
• Main components
• Policy implications
• Current state of affairs
• Discussion on policy implications
Lecture 2 - Trade theory and policy 2
Literature
• Sen, S. (2005) International trade theory and policy: What
is left of the free trade paradigm? Development and
Change, vol. 36.6, p. 1011-1029
• Krugman, P. (1987) Is free trade passé? The Journal of
Economic Perspectives, vol. 1.2, p. 131-144
• Deraniyagala, S. and Fine, B. (2001) New trade theory
versus old trade policy: A continuing dilemma. Cambridge
Journal of Economics, vol. 25, p. 809-825
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Introductory question
Why is there no free trade?
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Introduction
• Trade theory core component of field of international
economics
• Standard theory on free trade increasingly accepted
• Following WWII, great progress has been made
towards freer international trade
• (and in line with this, also capital, services, people)
• Key role of standard free trade theory
• Show that, when moving from a case of no trade to free trade,
welfare improves
• Should apply to all participating countries
• Policies should facilitate the materialisation of the benefits from free
trade
• Neo-liberal economics at the national and international level
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Mercantilism
• Prior to free trade: Mercantilism
• Popular policy in 15th-17th century
• Goal: maximise net exports to increase gold and silver
• Trade seen as zero-sum game
• Why? To strengthen the nation
• Also: use gains from international trade to invest in
economy
• Mercantilist ideas, policies and attitudes are still around
• e.g. Recent discussion in US on the need to make sure that NAFTA
provides a good deal for US citizens
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Origins of free trade
• Adam Smith (1776) “The Wealth of Nations”
• Founder of classical economics
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Absolute advantage and trade
• Key idea: specialisation necessary to increase
production
• = ↑Production = ↑Consumption = ↑ Welfare
• Country maximises production through
specialisation, intra-country trade required to allow
increased welfare to materialise
• Same principle applies to international trade!
• But: trade only beneficial when countries have
absolute advantage in product that they export
• (nowadays we would say productivity advantage)
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Concept of comparative advantage
• David Ricardo (1817) “On the principles of political
economy and taxation”
• Concept of comparative advantage
• “Specialise in what you relatively do best”
• Trade can be beneficial for a country even when trading with
another country that has an absolute disadvantage
• Can you benefit from trading with a country through
importing a product that you can make more efficiently
yourself?
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Concept of comparative advantage
This is still true today; confusion and
misunderstanding about concept of comparative
advantage is very persistent!
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Trump’s misunderstanding of
comparative advantage
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Ricardo’s example
• England and Portugal
• Cheese and Wine; England is more productive in both
• To consume wine, England has two options
a) Produce wine → 1/2 bottle with 1 cloth
b) Import wine → 2 bottles with 1 cloth
c) Actual quantity of wine will lie somewhere between the 2
Unit labour
requirements
Cloth Wine
England 1 hour 2 hours
Portugal 6 hours 3 hours
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Ricardo’s example
England Portugal
Quantity of
Cloth
Quantity of
Cloth
England specialises fully in Cloth, Portugal in Wine to
maximise joint production;
Trade necessary for welfare maximisation!
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Heckscher-Ohlin Model
• Ricardo’s contribution big breakthrough!
• Limitations
• Only one production factor
• No explanation for comparative advantage
• Technology is key
• Heckscher-Ohlin model
• Factor proportions model
• 2 x 2 x 2
• 2 countries, 2 products, 2 inputs
• Comparative advantage explained by interplay between
relative abundance of inputs and intensity of use of inputs to
produce products
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Heckscher-Ohlin model
• England and Portugal
• Cloth and Food
• Labour and land
• Cloth is labour intensive, food land intensive
• England has relative abundance of labour
• Portugal relative abundance of land
• Substitution of inputs determines shape of production possibilities
frontier
• (see next slide)
• England will specialise in cloth and trade cloth for food
• Portugal opposite process
• Again: specialisation required to maximise joint
production
• Trade allows gains from trade to be shared
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No full specialisation
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Trade allows higher level of consumption
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Key findings standard trade theory
• HO-theorem: countries export goods that use inputs that
country has in relative abundance
• Country should pursue free trade irrespective of actions
other countries
• International trade affects the income distribution
• Stolper-Samuelson theorem
• Two income groups: labour and land owners
• Trade: change in relative price of the goods
• Specialisation in e.g. cloth industry creates relative wage increase for
labour w.r.t. land owners
• Winners and losers, but overall welfare gain
• Strong policy implications: redistribution?
• North-South trade effects not in line with this
(see tomorrow’s class)
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Schematic linkages
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Skill content exports
Source: NBER-CES U.S. Manufacturing Productivity Database, U.S.
Census Bureau, and Peter K. Schott, “The Relative Sophistication of
Chinese Exports,” Economic Policy (2008), pp. 5–49.
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Skill content exports
Source: NBER-CES U.S. Manufacturing Productivity Database, U.S.
Census Bureau, and Peter K. Schott, “The Relative Sophistication of
Chinese Exports,” Economic Policy (2008), pp. 5–49.
Lecture 2 - Trade theory and policy 21
Policy implications
• Countries should pursue policy of trade liberalisation
• All countries benefit from trade due to concept of comparative
advantage
• Stronger: countries need to trade in order for gains from
trade to materialise
• Each country should facilitate trade liberalisation
• International organisations should promote and
facilitate trade liberalisation
• World Trade Organisation, European Union
• In addition, apply neo-classical policies that make
economy more efficient
• World Bank, Washington Consensus
• More efficient = more production = more gains from trade
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Lecture 2 - Trade theory and policy
Financial Times
23
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Financial Times
24
Limitations standard trade theory
• Static analysis from no trade to free trade
• Dynamism not clear
• One-off effects
• Consensus that these effects are now limited
• (Not surprising, given large progress!)
• Adding dynamic gains makes a stronger case for larger gains
• Increasing returns to scale, competition effects, productivity, innovation,
entrepreneurship
• Standard trade theory limited explanatory power for these issues
• Only provides explanation for inter-industry trade
• Reality is a growing importance of intra-industry trade
• Similar countries importing and exporting similar products!
• Assumptions: perfect competition, constant returns to
scale, etc.
• Large shares of international trade are linked to industries with very
different characteristics
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Intra-industry trade
• Grubel-Lloyd index
Inter-industry trade
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Source: Tadashi Ito and Toshihiro Okubo (2012) New aspects
of intra-industry trade in EU countries. The World Economy,
vol. 35(9), p. 1126-1138
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New trade theory
• Starting from the late 1970s-early 1980s
• Main question: Can there be welfare gains when two
countries that are completely similar engage in trade in
similar products?
• Yes!
• Captures aspects that STT ignores
• Scale economies
• Imperfect competition
• Heterogeneous products (within same industries)
• Heterogeneous firms
• Growing importance of technology spillovers
• Models become more complex
• Rejection of simple principle that free trade is always best
option
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Paul Krugman
• Nobel price winner 2008
• Increasing returns, monopolistic competition, and
international trade (1979) Journal of International
Economics, vol.9, p. 469-479
• Later on: increasing importance of location
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Scale economies
• TC = 10 + 1*Labour (wages=1)
• AC = TC/Y
• Scale of production creates competitive advantage
compared to competitors
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Sources of scale economies (1)
• Internal to the firm
• Production costs mixture of fixed and variable costs
• A company that produces more than its competitors will be able
to export due to lower AC
• Location: the location of the firm determines which
country is the exporter
• Tricky case, because imperfect competition!
• Possibility of strategic behaviour (collusion, etc.)
• A firm’s actions are influenced by another firm’s (expected) actions
• Models of monopolistic competition required
• Countries trade in different varieties of the same product
• Each producer specializes in one variety to maximise scale economies
• e.g. car industry
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Sources of scale economies (2)
• External to firm, but internal to industry of firm
• A spatial concentration of firms creates scale economies
that each firm in the cluster benefits from
• Country that has the cluster of firms will be the exporter to
other countries
70% of world production of
cigarette lighters
concentrated in Whenzou
(Used to be higher, but has
been affected by trading
restrictions!)
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Industry of hand-blown glass products
• Qianxian county
• Industry of 20,000 workers
• Over 50% of Chines exports of handblown glass products
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Industrial districts
Alfred Marshall (1890) Principles of Economics
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Implications of new trade theory
• Importance of ‘historical accidents’ and
and path dependence
• Qwerty keyboard good example
• Why do we use this lay out of keyboard?
• Is this still valid today?
• Advantages when everyone uses same lay out
• What would it costs to change?
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Sweden September 3 1967
Stockholm, morning rush hour
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First mover advantage
We would like to have Vietnam produce
the buttons, but if China comes first, it will
take the market
Lecture 2 - Trade theory and policy
Even more tricky:
Suppose that China is producing the buttons
a) China can show that it is achieving scale economies, so that looks good;
b) We don’t know what the AC curve of Vietnam looks like (because it is not producing)
39
Dynamic dimension: learning curve
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Implications for policy making
• NTT opens up the possibility of strategic trade policy
• Industrial policy becomes real option in trade policy
• Trade increases the pie, but can you implement policies that ensure that your
share of the pie is larger?
• Internal scale economies
• Supporting an industry at the right moment may give the industry a kick start,
allow it to move along the downward sloping AC curve and capture the entire
export market
• Promote exports and/or restrict imports
• e.g. dumping
• “Low cost policy” in terms of resources?
• External scale economies
• Every country wants to have high tech industries
• Investing in one industry may result in increasing competitive advantage of
other industries
• Very different message from free trade is the best option!
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Damage limitation by NTT
• Dealing with oligopolistic industries is difficult and full of
uncertainty
• How to design policies to facilitate external economies?
• Difficult to measure
• May have broader reach than expected
• General equilibrium concerns
• Promotion of one sector takes resources away from other sectors
• Retaliation and trade wars
• Subject to lobbying and special interests
• Is this sufficient to convince politicians, industries,
lobbyists, etc. to not pursue strategic trade policy?
• Probably not
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Current state of affairs (1)
• Mixture of Standard trade theory and new trade theory
• Growing complexity of new trade theory
• Developed versus developing countries
• Decreasing popularity of concept of free trade
• Why?
• Not surprising, given large progress that was made in the past?
• New static gains small
• Dynamic gains may be larger but take time and more difficult to link
to trade liberalisation
• Growing links between trade and other areas
• Slow down / stagnation of trade liberalisation under
WTO
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Current state of affairs (2)
• Difficult task to separate trade issues from other issues
• This is not easy for governments
• What is the alternative?
• Standard trade theory: trade maximises welfare
• New trade theory: trade increases welfare
• Krugman (1987): “It is possible, then, both to believe that
comparative advantage is an incomplete model of trade and to
believe that free trade is nevertheless the right policy. In fact,
this is the position taken by most of the new trade theorists
themselves. So free trade is not passé – but it is not what it
once was”.
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Main points
• Standard trade theory provides solid explanation of
why trade increases welfare
• Criticisms of STT only applicable as special cases
• See STT in context of post WW II developments
focusing on trade, liberalisation, globalisation and
international governance
• Starting in 1970s/80s: more and more “noncomparative
advantage” trade
• Intra-industry trade, imperfect competition, scale economies
(internal and external)
• New trade theory offers new explanations, at the
expense of rapidly increasing complexity
• Strategic trade policy has become real policy option
• Critics of international trade do have real point here
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Policy implications
• Policy making following STT
• Policy making following NTT
• Governance of international trade
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