1. International Trade: Theory and Policy Andrzej Cieślik LECTURE 1

2. 2 Introductory Remarks Several reasons why you should study international trade: International trade is now more important to any economy than it used to be in the past due to ongoing globalization of national economies There is an increasing perception among the general public that international trade is a vital subject We live in times in which everybody is obsessed with international competition and “international competitiveness” Problem: The problem is that most of what students are likely to hear or read in popular press about international trade is nonsense. Solution: Your primary task in this class will be to learn how to detect that nonsense and to vaccinate your minds against the common misconceptions about international trade. You should be equipped to respond intelligently to popular discussions of international trade.

3. 3 “Typical” statement on international trade from popular press: “We need a new economic paradigm because today our country is a part of a truly global economy. To increase its standards of living our country now has to learn to compete in an even tougher world market place. That’s why high productivity and product quality have become essential. We need to move our economy into the high value sectors that will generate jobs for the future. And the only way we can be competitive in the new global economy is if we forge a new partnership between government and business”. Paul Krugman “What do the undergrads need to know about trade?”, American Economic Review (May 1993), pp. 23-26.

4. 4 COMMON MISCONCEPTIONS: “International competition” - Firms compete, countries do not! International trade is not about competition but about mutually beneficial exchange. Imports and not exports are the purpose of international trade. (as imports allow us to get what we want) National economy is not a corporation that can be driven out of business. “High productivity” High productivity is beneficial not because it helps a country to compete with other countries, but because it lets a country produce and consume more. (this is true both in the closed and the open economy)

5. 5 Consider a following thought experiment: “Imagine a world in which productivity rises by 1 per cent annually in all countries. What will be the trend in our standards of living?. Does everybody agree that it will rise by 1 per cent per year? Now, imagine that while our country continues to raise its productivity by 1 per cent per year the rest of the world manages to achieve 3 per cent productivity growth. What is the trend in our standard of living? It is still 1 per cent! (but there might be some terms of trade effects – to be discussed later in the course” “High value sectors” “High value sectors” is a silly concept! You can take a look at the simplest version of Ricardian 2x2x1 model (two countries, two goods, one factor) in which one country is more productive in both industries than the other. The more productive country will have a higher wage rate and therefore whatever sector it specializes in will be “high value”, (i.e. will have a higher value added per worker). Does this mean that country’s high living standard is the result of being in the right sector? Or the poorer country will be richer if it tried to emulate the other’s pattern of specialization? Of course, NOT!

6. 6 “Jobs” Employment is a macroeconomic issue, you should study the determinants of the natural rate of unemployment in the long run (and the aggregate demand in the short run). Microeconomic policies like tariffs have little effect on employment! Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost. “A new partnership” Many industries want protection or some other sort of against the foreign rivals (and actually buy protection from politicians). Always remember that the real competition takes place WITHIN the country and between industries where firms compete at factor markets to get scarce resources of capital, skills and labor. Government support of one industry may help that industry compete against foreigners but it also draws resources away from other domestic industries (i.e. it hurts the rest of the economy). The increased importance of international trade does not change the fact that the government cannot favor one domestic industry except at the expense of other industries.

7. 7 USEFUL READINGS: Krugman P., 1993, “What do the undergrads need to know about trade?”, American Economic Review (May), pp. 23-26. Krugman P., 1993, “The narrow and broad arguments for free trade”, American Economic Review 83, pp. 362-366. Krugman P., 1994, “Does third world growth hurt first world prosperity?”, Harvard Business Review, pp. 113-121. Krugman P., 1994, “Competitiveness: A dangerous obsession”, Foreign Affairs.

8. 8 “For the bulk of our economics students, our objective should be to equip them to respond intelligently to popular discussion of economic issues. A lot of that discussion will be about international trade, so international trade should be an important part of the curriculum. What is crucial, however, is to understand that the level of public discussion is extremely primitive. Indeed, it has sunk so low that people who repeat silly clichés often imagine themselves to be sophisticated. This means that our courses need to drive home as clearly as possible the basics. Offer curves and Rybczyński effects are lovely things. What most students need to be prepared for, however, is a world in which TV “experts”, best-selling authors, and $ 30,000-a-day consultants do not understand budget constraints, let alone comparative advantage”. Paul Krugman “What do the undergrads need to know about trade?”, American Economic Review (May 1993), pp. 23-26. Approach:

9. 9 For most of you this will be the first and the last course on international trade, therefore, it is now more important than ever before that you receive a solid background in the principles of international trade. Although the last 30 years have seen “a golden age” of innovation in international trade theory and policy, this innovative stuff is NOT a priority for you! You still need to learn the basic insights of classical economists such as Ricardo or Hume. Approach:

10. 10 Sample issues to be discussed: What constitutes the basis for trade? Why do countries export and import certain products? At what terms of trade (relative prices) are products exchanged in the world market? What are the gains from international trade in terms of production and consumption? What are the gains from international flows of capital and labor in terms of production and consumption? What are the trade policy instruments? What are the welfare effects of trade liberalization?

11. 11 Two waves of globalization

12. 12 Global output and world trade

13. 13 Real world trade flows

14. 14 Intra- and Inter-regional merchandise trade flows (% of world total)

15. 15 Foreign direct investment

16. 16 Migration

17. 17 Course organization The course in organized in 2 parts covering both trade theory and trade policy. Required Reading: Krugman, P.R.; Obstfeld, M., Melitz M. 2012, International Economics: Theory and Policy, Addison Wesley, Boston. Recommended Reading: Marrewijk, Ch. van 2012, International Economics, Oxford University Press, Oxford. Markusen, J.R.; Melvin, J.R.; Kaempfer, W.H.; Maskus K.E. 1995, International Trade: Theory and Evidence, McGraw-Hill, Boston.

18. 18 Part 1. Trade theory Class 1. Introduction (06.10.2015) A historical overview of trade theory, the importance of international trade and investment, contemporary patterns of international trade and investment, classical trade theory, absolute advantage, gains from trade. Required Reading: KOM (2012), ch. 1&2. Recommended Reading: Markusen et al. (1995), ch. 1.; Marrewijk (2012), ch. 1&2. Class 2. Ricardian model (13.10.2015) Simple Ricardian 2x2x1 model, comparative advantage, excess demand functions, international equilibrium, the role of wages, gains from trade, extensions: 3 and more goods. Required Reading: KOM (2012), ch. 3. Recommended Reading: Markusen et al. (1995), ch. 7. Marrewijk (2012), ch. 3.

19. 19 Part 1. Trade theory Class 3. Modified Ricardian model (20.10.2015) 2x2x3 factor specific model, pattern of trade, commodity prices and factor prices, Haberler theorem, endowment changes and outputs, income distribution, gains from trade. Required Reading: KOM (2012), ch. 4. Recommended Reading: Markusen et al. (1995), ch. 9. Marrewijk (2012), ch. 6. Classes 4-5. Heckscher-Ohlin model (27.10.2015 and 03.11.2015) 2x2x2 factor abundance model, pattern of trade, Heckscher-Ohlin theorem, factor price equalization theorem, Stolper-Samuelson theorem, Rybczyński theorem, Jones magnification effects, extensions: many goods, many factors. Required Reading: KOM (2012), ch. 5-6. Recommended Reading: Markusen et al. (1995), ch. 8. Marrewijk (2012), ch. 7.

20. 20 Part 1. Trade theory Class 6. New trade theories (10.11.2015) External versus internal economies of scale, Marshallian externalities, market structure and increasing returns, monopolistic competition versus oligopoly, trade as a competition policy instrument, Dixit-Stiglitz preference for variety, intra-industry trade, demand similarity and Burenstam-Linder hypothesis, life cycle theories of international trade. Required Reading: KOM (2012), ch. 7. Recommended Reading: Markusen et al. (1995), ch. 11-13. Marrewijk (2012), ch. 9-10. Classes 7-8. International factor flows (17.11.2015 and 24.11.2015) Multinational corporations, foreign direct investment, Dunning OLI eclectic framework, knowledge capital model, FDI in developed and developing economies, international fragmentation of production, international labor migration, gains from FDI and labor flows. Required Reading: KOM (2012), ch. 8. Recommended Reading: Markusen et al. (1995), ch. 21-22. Marrewijk (2012), ch. 15&17.

21. 21 Part 2. Trade policy Class 9. Instruments of trade policy (01.12.2015) Import tariffs, import quotas, quotas versus tariffs, optimum tariff, non- tariff barriers, effective protection, export taxes, export subsidies, voluntary export restraints, effects of trade liberalization. Required Reading: KOM (2012), ch. 9. Recommended Reading: Markusen et al. (1995), ch. 15-16. Marrewijk (2012), ch. 8. Class 10. Strategic trade policy (08.12.2015) Import protection as export promotion, export rivalry, quotas and VERs as facilitating practices, evaluation of strategic trade policy. Required Reading: KOM (2012), ch. 12. Recommended Reading: Markusen et al. (1995), ch. 17. Marrewijk (2012), ch. 11.

22. 22 Part 2. Trade policy Class 11. Political economy of trade policy (15.12.2015) Free trade and efficiency, political arguments for free trade, income distribution and trade policy, protection for sale, median voter model, empirical evidence. Required Reading: KOM (2012), ch. 10. Recommended Reading: Markusen et al. (1995), ch. 19. Class 12. Preferential trading agreements (12.01.2016) Neoclassical theory of economic integration, types of regional economic integration, trade creation versus trade diversion, European integration, regionalism and the new trade theory. Required Reading: Markusen et al. (1995), ch. 18. Recommended Reading: Marrewijk (2012), ch. 13.

23. 23 Part 2. Trade policy Class 14. International trade organizations (19.01.2016) International institutions and rules, bilateralism versus multi multilateralism, GATT/WTO, United Nations and UNCTAD, OECD, administered protection, safeguards, trade policy and environmental regulations. Required Reading: Markusen et al. (1995), ch. 20. Recommended Reading: Marrewijk (2012), ch. 12.

24. 24 METHODOLOGY & TOOLS – OPEN ECONOMY MICROECONOMICS? International trade theory is an extension and application of microeconomic theories of production and exchange to study economic transactions between agents in different countries. Therefore, we will use profit and utility maximization paradigm to explain why countries trade, what goods they import and export, how trade affects allocation of resources within and between nations, and whether a country benefits from international trade. Two main characteristics distinguish theoretical analyses of international trade from those of microeconomics: - The use of general equilibrium (macro view) - The focus on the country as a whole (macro view)

25. 25 Historical background: Early developments in trade theory The modern theory of international trade and trade policy is the product of an evolution of ideas in economic thought. Now, we will review briefly the development of the theory from the seventeenth century through the first part of the twentieth century. The historical approach is useful not because we are interested in the history of economic thought as such but because it is a convenient way of introducing the concepts and theories of international trade from the simplest (and not very realistic) to the most complete (and more realistic). As new knowledge builds on old knowledge you need to become acquainted with the classic concepts and theories. In particular, the writings of the mercantilists, and later those of Adam Smith and David Ricardo have been instrumental in providing the framework of the modern theory of international trade.

26. 26 Mercantilism versus classical trade theory The ideas of classical trade theorists such as Smith and Ricardo can be best understood if they are regarded as reactions to mercantilist views on trade and the role of government. Therefore, we begin with a brief review of the economic doctrine known as mercantilism that prevailed in most European countries during the seventeenth and eighteenth centuries. Then we go to discuss the ABSOLUTE advantage. It was, however, David Ricardo, who explained the pattern and the gains from trade with his law of COMPARATIVE advantage. The law of comparative advantage is one of the most important laws in economics and applies both to nations and individuals (later on we illustrate it with some concrete examples).

27. 27 Mercantilism versus classical trade theory During the period 1500-1800 a group of “political writers” (from various backgrounds such as merchants, bankers, philosophers, government officials) wrote pamphlets on international trade that advocated an economic philosophy known as mercantilism. You need to remember about the historical context in which these pamphlets were created! This was a time when many countries were transforming themselves from the city states into modern national states and these writers were concerned with the process of nation building. According to the mercantilists the key question was how a nation could regulate its domestic and international affairs as to promote its own interests, i.e. “NATIONAL” interest (which is practice often means an interest of a specific group of people who do lobbying). According to them the solution lays in the “strong” foreign trade sector.

28. 28 Mercantilism versus classical trade theory Mercantilists maintained that the way for a nation to become rich and powerful was to export more than to import. The resulting export surplus would then be offset by an inflow of precious metals (gold and silver) into the country. The more gold and silver the country had the more powerful it was. Mercantilists used to measure the wealth of a nation by the stock of precious metals it possessed. How do we measure nation’s wealth today? By the stock of factors of production, such as the stock of human, physical (man-made) capital, natural resources and knowledge available for producing goods and services to satisfy human wants (potential GDP). Remember that mercantilists were writing their pamphlets mainly for autocratic rulers with the aim of enhancing their military power. With more gold and silver, these rulers could maintain bigger and better armies and consolidate their power. Improved armies and navies made it possible for them to conquer their neighbors and/or to acquire more colonies and increase their tax base. The increased tax base would allow maintaining even bigger and better armies and so on.

29. 29 To promote a trade surplus the mercantilists advocated government regulation of trade. The government had to do all in its power to stimulate exports and restrict imports, i.e. to follow the export promotion and import restriction policy. Tariffs, quotas and other trade barriers were proposed to minimize imports and to promote domestic production (Import substitution development strategy). Since all nations could not simultaneously have an export surplus and the amounts of gold and silver were fixed (in a given moment) one nation could gain only at the expense of other nations, i.e. international trade was seen as the WIN-LOSE (zero-sum) game. Mercantilists were preaching ECONOMIC NATIONALISM as they believed that “national interests” were basically in conflict. Mercantilism versus classical trade theory

30. 30 THOMAS MUNN (1571-1641) – a “representative” mercantilist, the author of “England’s Treasure by Foreign Trade”- wrote: “Although a kingdom may be enriched by gifts received, or purchase taken from other nations, yet these things are uncertain and of small consideration when they happen. The ordinary means to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule; to sell more to the strangers yearly than we consume of theirs in value. For … that part of our stock (exports) which is not returned to us in wares (imports) must necessarily be brought home in treasure (bullion) … We may … diminish our importations, if we would soberly refrain from excessive consumption of foreign wares in our diet and raiment … In our exportations we must not only regard our superfluities, but also we must consider our neighbors necessities, that so … we may … gain so much of the manufacture as we can, and also endeavor to sell them, dear so far forth as the high price cause not a less rent in the quantity (of our exports). But superfluity of our commodities which strangers use, and may also have the same from other nations, or may abate their vent by the use of some such like wares from other places, and with little inconvenience; we must in this case strive to sell as cheap as possible we can, rather than to lose the utterance of such wares”.

31. 31 Critique of mercantilist arguments Mercantilists claimed that one nation’s gains from trade came at the expense of its trading partners, i.e. not all nations could simultaneously enjoy the benefits of international trade. They were attacked for their static view of the world economy. This view was challenged with the publication of Adam Smith’s (1723- 1790) “An Inquiry into the Nature and Causes of the Wealth of Nations”. Smith started with the simple observation that for two nations to trade with each other voluntarily, both nations must gain! If one nation gained nothing or lost it would simply refuse to trade. Smith argued that international trade permits nations to take advantage of specialization and division of labor, which increase the general level of productivity within a country and thus increase world output (i.e. there are PRODUCTIVITY gains from international SPECIALIZATION in production). The dynamic view of international trade advocated by Smith suggested that both trading partners could simultaneously enjoy higher level of production and consumption with free trade.

32. 32 “The importation of gold and silver is not the principal, much less the sole benefit which a nation derives from its foreign trade. Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries out that surplus part of the produce of their land and labor for which there is no demand among them, and it brings back in turn for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants, and increase their enjoyments. By means of it, the narrowness of the home market does not hinder the division of labor in any particular branch of art or manufacture from being carried to the highest perfection. By opening a more extensive market for whatever part of the produce of their labor may exceed the home consumption, it encourages them to improve its productive powers, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of the society.” (Smith, 1776, p. 326) ADAM SMITH (1723-1790) – a classical economist, the author of “An Inquiry into the Nature and Causes of the Wealth of Nations (1776)”- wrote:

33. 33 PRINCIPLE OF ABSOLUTE ADVANTAGE Smith argued that trade between nations is based on the principle of ABSOLUTE advantage. When one nation is more efficient in the production of one commodity but less efficient than the other nation in production of another commodity, then both nations can gain by each specializing in the production of the commodity of its absolute advantage. By this process world resources are utilized in the most efficient way and the output of both commodities will rise. The increase in the output of both commodities measures the gains from specialization in production available to be divided between two nations through trade (i.e. the GAINS from TRADE). Where do the productivity differences across countries come from? Natural advantages can be related to climate, soil, mineral wealth, etc. Acquired advantages include skills, capital and technology.

34. 34 EXAMPLE. Trade in agricultural goods (wheat and bananas) Because of differences in climatic conditions Canada is efficient in growing wheat but inefficient in growing bananas (greenhouses would have to be used). On the other hand, Nicaragua is efficient in growing bananas but inefficient in growing wheat. Thus Canada has a natural absolute advantage over Nicaragua in growing wheat but a natural absolute disadvantage in growing bananas while the reverse holds for Nicaragua. Therefore, under these circumstances both nations would benefit if each specialized in the production of the commodity of its absolute advantage and then traded with other nation. In this situation Canada would specialize in production of wheat (i.e. produce more than needed for domestic consumption) and exchange some of it for (additional) bananas grown in Nicaragua. As a result both more wheat and more bananas would be grown and consumed and both Canada and Nicaragua would gain from specialization in production and trade.

35. 35 Trade between England and Portugal in cloth and wine Numerical Example. EnglandPortugalTotal Labor hours necessary to produce 1 unit of Cloth (industrial good) 12 Labor hours necessary to produce 1 unit of Wine (agricultural good) 21 Potential output of cloth given total labor endowment – 24 hours 241224 Potential output of wine given total labor endowment – 24 hours 1224 Actual preferences concerning allocation of time to the production of cloth- 8 hours 8412 Actual preferences concerning allocation of time to the production of wine - 16 hours 81624 Trade in cloth 10 England gains 6, Portugal gains 6 Trade in wine 88No gains

36. 36 Executive summary of Smith’s arguments and policy recommendations While mercantilists believed that one nation could gain only at the expense of other nations and advocated a strict government control of all economic activity and trade Smith and his followers believed that all nations would gain from free trade and strongly advocated a policy of “laissez-faire” (i.e. as little government interference with the economic system as possible). Free trade would cause the world resources to be utilized most efficiently and would maximize world welfare. According to Smith a nation behaves no differently from an individual who does not attempt to produce all commodities he/she needs. Rather he/she produces one that commodity that he/she can produce most efficiently and then exchanges a part of his/her output for other commodities he/she needs. In this way, total output in the society and welfare of all individuals are maximized.

37. 37 Trade policy in contemporary world Aside from England during the period 1815-1914 no Western nation has ever been completely free of mercantilist ideas. In particular, this historically applied to big European (mostly continental) nations such as Germany or France and presently to the European Union (eg. The Common Agricultural Policy), as well as the United States (eg. The Sugar Lobby). Trade restrictions are advocated by some well organized industries who form powerful lobbying groups and are often rationalized in terms of national welfare (“national interest”, “national security”, “strategic industries”, etc.). Always remember that trade restrictions benefit the few at the expense of the many!