1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Beyond Comparative Advantage

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-2 Chapter Objectives Explain why many countries import the same goods they export Analyze the development of regional clusters of production of many exported goods and services Examine how and why many countries select and plan the development of their export industries

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-3 Introduction Trade models built exclusively on comparative advantage do not always serve to predict a country´s trade patterns –Comparative advantage is very difficult to measure –Large share of international trade is not, in fact, based on comparative advantage Besides, countries often seek to alter their comparative advantages through industrial policies

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-4 Intraindustry Trade Intraindustry trade: international trade of products made within the same industry (steel-for-steel, bread- for-bread) Interindustry trade: international trade of products between two different industries (steel-for-bread) Intraindustry trade is growing increasingly important in international trade especially between industrial countries

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-5 Measures of Intraindustry Trade Grubel Lloyd (GL) index: (If X i = M i, GL = 1; all trade is intraindustry) Problem: Product categories are difficult to define (are computers office supplies like pencils?) Depending on the definition, intraindustry trade is 1/3 or 2/3 of U.S. merchandise trade

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-6 Characteristics of Intraindustry Trade Economies of scale: decreasing average costs over a relatively large range of output (as opposed to constant or increasing costs) –Internal economies of scale: lead to larger firms because size confers a competitive advantage –External economies of scale: lead to larger industries (however, larger firms have no inherent advantage over smaller ones)

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-7 TABLE 5.1 Increasing Returns to Scale for a Single Firm

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-8 Internal Economies of Scale (cont.) When larger firms are more competitive, market structure changes –Oligopoly: handful of firms produce the entire market output, with each firm formulating its strategies in response to those of its competitors –Monopolistic competition: unlike under pure monopoly, competition among many firms exists However, competition is attenuated by the practice of product differentiationeach firm produces a slightly different product

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-9 Gains from Intraindustry Trade Lower costs: increase in the size of the market allows for scale economies, which lowers production costs and eventually costs to consumers Potential expansion of production: there is a high likelihood that intraindustry trade expands the number of domestic firms and the quantity of domestic output Increase in consumer choices: intraindustry trade tends to give access to a much greater variety of goods than produced domestically

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-10 Trade and Geography Two connections between trade and geography 1.When tariffs fall, certain industries may relocate production to take advantage of lowered trade costs 2.Geographical concentration may give an industry competitive advantage: it will join a regional industrial cluster (agglomeration) to strengthen its export performance

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-11 External Economies of Scale External economies of scale: advantage of larger size applies to the industry as a whole, not to individual firms –If a firm in a region produce similar products, they will benefit from knowledge spillovers –When the presence of a large number of producers in one area creates a deep labor market for specialized skills –If an area holds a dense network of input suppliers, manufacturers locate near the suppliers

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-12 Trade and External Economies of Scale Geographical concentration may be self- reinforcing: an initial small move toward clustering may cause a chain reaction, resulting in a massive industrial agglomeration –Examples: Aerospace manufacturing firms in Seattle and Southern California regions

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-13 Industrial Policy Industrial policy: a governments policy designed to create new industries or support existing industries –Industrial policies seek to alter the country´s comparative advantage by picking winners and losers –However, they can have a profound impact on trade patterns

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-14 Market Failure Market failure: failure by the market economy to deliver an optimal quantity of goods and services (the value of a good to private consumers and the society fails to equal to its cost of production) –A divergence between private returns and social returns –In a market failure, some costs or benefits of an activity are externalizedoutside the area of concern of the economic agents engaged in the activity Externality: market failure that results from the externalization

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-15 FIGURE 5.1 Market Failure: Externalities

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-16 Market Failure (cont.) Market failure is a major justification for industrial policies –Knowledge spillover, for example, is cited as a reason for industrial policies: a certain industry can spread knowledge about new products and processes, making social returns greater than private returns –Similar spillovers occur in research and development (R&D)

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-17 Strategic Trade Strategic trade policy: selective use of trade barriers and industry subsidies in order to capture some of the profits of foreign firms –Strategic trade policy requires that (1) industry has economies of scale and (2) firms in the industry have market power –Strategic trade policy is, like market failure, a justification for industrial policies

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-18 TABLE 5.3 A Hypothetical Payoff Matrix

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-19 TABLE 5.4 The Payoff Matrix after a Subsidy of 15

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-20 Industrial Policy Tools Uruguay Round and WTO prohibit subsidies for competitive policies However, governments can use other policies: providing information about foreign markets to domestic firms, helping negotiate contracts, lobbying foreign governments to adopt home country standards, or tying foreign aid to purchases from domestic firms

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-21 Problems with Industrial Policies Difficult to obtain information for measuring market failure Difficult to determine which industry to support: positive externalities may not be readily visible Rent seeking: activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-22 U.S. Industrial Policies Until World War II, the U.S. used high tariffs to support specific industries The use of direct subsidies, however, was used only in agriculture and defense industries Most common form of U.S. government support for certain industries has been through new research and dissemination of information

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Additional Chapter Art

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-24 TABLE 5.2 U.S.-Canadian Merchandise Trade, 2004 (Billions of US$)

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Appendix A Graphical Illustration of Prices and Costs with Monopolistic Competition

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-26 FIGURE 5.2

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-27 FIGURE 5.3