Chapter 5 Beyond Comparative Advantage

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-2 Learning Objectives Explain the differences between interindustry and intraindustry trade. Describe the gains from intraindustry trade. Draw a graph illustrating the gains from trade in a monopolistically competitive market.

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-3 Learning Objectives (cont.) Distinguish internal and external economies of scale. Analyze the impact of transportation costs and internal economies of scale on trade. Present the pros and cons of industrial policies

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-4 Introduction: More Reasons to Trade Trade models built exclusively on the idea of comparative advantage have a mixed record when it comes to predicting a country’s trade patterns. –It is exceedingly difficult to precisely measure a country’s comparative advantage –Large share of international trade is not, in fact, based on comparative advantage A large share of international trade is not based on comparative advantage.

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-5 Intraindustry Trade Intraindustry trade: International trade of products made within the same industry (steel-for-steel, bread-for-bread) Intraindustry trade is growing increasingly important in international trade especially between industrial countries Interindustry trade: International trade of products between two different industries (steel-for-bread)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-6 Characteristics of Intraindustry Trade Intraindustry trade between industrial countries is common Fundamental problem is defining an industry. For example, if computers are defined as office machinery, then computers and pencil sharpeners are in the same industry, More broadly an industry is defined, the more trade appears to be intraindustry

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-7 Characteristics of Intraindustry Trade (cont.) Evidence suggests that intraindustry trade is greater –in high technology industries –where there is more scope for product differentiation –in countries more open to trade –in nations that have received larger amounts of foreign direct investment

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-8 Characteristics of Intraindustry Trade (cont.) The production of many goods is characterized by economies of scale, or decreasing costs, over a relatively large range of output New Trade Theory -new models of international trade based on economies of scale -newest and most significant developments in trade theory moves beyond traditional trade theory

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-9 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) Characteristics of Intraindustry Trade (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-10 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 differentiation—each firm produces a slightly different product Characteristics of Intraindustry Trade (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-11 TABLE 5.1 Increasing Returns to Scale for a Single Firm

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-12 FIGURE 5.1 Monopolistic Competition

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-13 FIGURE 5.2 Price and Average Cost

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-14 The Gains from Intraindustry Trade Lower prices: An increase in the size of the market allows for scale economies, which lowers production costs and eventually prices to consumers Increase in the number of firms : 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-15 TABLE 5.2 U.S.-Canadian Merchandise Trade, 2011 (Billions of U.S. $)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-16 Trade and Geography Two fundamental links exist between trade and geography: A place may pull in economic activity because it is close to a market (cities are low cost for expansion) A place may offer firms the opportunity to find critical inputs (skilled labor)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-17 Geography, Transportation Costs, and Internal Economies of Scale For most manufactured goods, it is not practical to produce next to each market due to economies of scale (producing cars next to dealerships) Not all types of manufacturing have same level of transportation costs (presence of scale economies makes near market production impractical)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-18 Geography, Transportation Costs, and Internal Economies of Scale (cont.) Most foreign investment today is directed towards high income countries (to access larger markets), not developing countries All else equal, lower transportation costs often outweigh other costs that might be higher (southward shift of U.S. car manufacturing to be closer to final assemblers)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-19 External Economies of Scale External economies of scale occur when firms become more productive as the number of firms in an industry increases –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

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-20 Trade and External Economies Geographical concentration may be self- reinforcing: For example, as firms attract skilled workers or specialized input suppliers, the increased availability of high-quality inputs creates feedback leading to more firms in the same industry locating in the area. -Examples: Jet engines

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-21 Trade and Economic Policies (cont.) In theory, trade could stifle the development of a new industry that is more efficient than the existing one For example, that Europeans are potentially more efficient at making commercial aircraft than Americans.

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-22 Trade and Economic Policies (cont.) The aircraft example is instructive because it illustrates a case in which trade may not be beneficial. In every other case we’ve examined so far, trade is beneficial. The aircraft example also illustrates how trade patterns can be a result of completely unpredictable accidents of history.

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-23 Industrial Policy Industrial policy: A government’s policy designed to create new industries or support existing industries –industrial policies are controversial –in some cases they clearly are politically motivated and end up wasting huge amounts of money.

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-24 Industrial Policies and 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 (private returns) and to society (social returns) fails to equal to its cost of production –A divergence between private returns and social returns

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-25 Industrial Policies and Market Failure (cont.) In a market failure, some costs or benefits of an activity are externalized—outside the area of concern of the economic agents engaged in the activity Externality: market failure that results from the externalization of the costs or benefits

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-26 Market failure is a major justification for industrial policies Two simple rules for analyzing cases of market failure. One, social returns are greater than private returns, a free-market economy produces less than the optimal amount Industrial Policies and Market Failure (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-27 Two, when social returns are less than private returns, a free-market economy produces more than the optimal amount. In this case, economic agents do not take into account the costs that spill over onto others and that reduce the value to society of the good or service Industrial Policies and Market Failure (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-28 FIGURE 5.3 Market Failure: Externalities

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-29 Industrial Policies and Market Failure (cont.) Reasons why social returns and private returns differ: - Knowledge spillover - Coordination problems - Capital market imperfections

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-30 Industrial Policy Tools The 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-31 Industrial Policy Tools (cont.) Common practices used by governments in some newly industrializing countries: 1.sell foreign exchange to targeted firms at below-market prices 2.provide government loans to private firms at below-market interest rates 3.provide government guarantees on loans obtained from the private sector

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-32 Industrial Policy Tools (cont.) 4.governments provide special tax treatment to targeted industries 5.Governments use their own purchases as a way to develop an industry. 6.firms are guaranteed a profit on the development of new products

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-33 Industrial Policy Tools (cont.) 7.Governments often support industries by encouraging firms to work together, either -through the direct funding of the research done by consortia and/or -through the relaxation of antitrust laws. 8.governments may directly

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-34 Problems with Industrial Policies A basic problem is that it is difficult to obtain the information necessary to measure the extent of market failure. Second problem is determining which industry to target. Industrial policies encourage rent seeking. Rent seeking: An activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor

Copyright ©2014 Pearson Education, Inc. All rights reserved.5-35 Problems with Industrial Policies (cont.) Opponents of industrial policies: Sound macroeconomic policies, High rates of saving and investment, and High levels of schooling were the keys to success, not industrial policies Proponents: Opponents reasoning is ideological