1. Material I use chapter 5, but par.: ‘Measures of Intraindustry trade’; the part on ‘Trade and Geography’ is also taken from other sources. I added a lot of additional material 5-1 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

2. Chapter 5: beyond comparative advantage Empirical evidence shows that comparative advantages and associated patterns of trade mainly depend upon technological differences among countries, especially among developed countries. These technological differences depend, in turn, on a long process of building up know-how and expertise and on historical events. 5-2 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

3. Examples of changes in comparative advanatage. Change in the patterns of trade of developing countries. Change in the patterns of trade of the four Asian miracle (Hong Kong, Singapore, South Korea and Taiwan). 5-3 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

4. Fig. 5-13: Changing Patterns of Comparative Advantage

5. Fig. 5-13: Changing Patterns of Comparative Advantage (cont.)

6. 2-6 Changing Composition of Trade: worldwide What kinds of products do nations trade now, and how does this composition compare to trade in the past? Today, most (about 55%) of the volume of trade is in manufactured products such as automobiles, computers, clothing and machinery. –Services such as shipping, insurance, legal fees, and spending by tourists account for about 20% of the volume of trade. –Mineral products (ex., petroleum, coal, copper) and agricultural products are a relatively small part of trade.

7. 2-7 Fig. 2-5: The Composition of World Trade, 2008 Source: World Trade Organization

8. 2-8 Changing Composition of Trade (cont.) Low- and middle-income countries have also changed the composition of their trade. –In 2001, about 65% of exports from low- and middle- income countries were manufactured products, and only 10% of exports were agricultural products. –In 1960, about 58% of exports from low- and middle- income countries were agricultural products and only 12% of exports were manufactured products.

9. 2-9 Fig. 2-6: The Changing Composition of Developing-Country Exports Source: United Nations Council on Trade and Development

10. 2-10 Changing Composition of Trade: an historical example In the past, a large fraction of the volume of trade came from agricultural and mineral products. –In 1910, Britain mainly imported agricultural and mineral products, although manufactured products still represented most of the volume of exports. –In 1910, the U.S. mainly imported and exported agricultural products and mineral products. –In 2002, manufactured products made up most of the volume of imports and exports for both countries.

11. 2-11 Table 2-3: Manufactured Goods as a Percent of Merchandise Trade For both the US and the UK, the manufacturing sector represents a large share of both imports and exports. Is this fully consistent with HO model?

12. New Trade THeory http://www.youtube.com/watch?v=fb6- PIM0NtQhttp://www.youtube.com/watch?v=fb6- PIM0NtQ 5-12 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

13. Lecture objective In this lecture we will focus on certain particular aspects of the broad picture just presented. In particular: Part 1: how to explain why countries tend all to specialize and trade more in the same sector (manufacturing)? Part 2: how and why comparative advantages can change so that a new industry emerges in a certain country? 5-13 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

14. 5-14 Lecture Objectives (cnt.) MORE PRECISELY, I WILL TRY TO SHED LIGHT ON THE FOLLOWING: –Why many countries import the same goods they export (intra- industry trade, especially important among developed countries): why US exports Ford to Italy and Italy FIAT to the US? –The development of regional clusters of production of many exported goods and services –How well-targeted industrial policies can alter the comparative advantage of a country

15. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-15 More Reasons to Trade 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 –Comparative advantages based on resource endowments can well explain trade between developed and developing countries, no trade between similar countries Besides, countries often seek to alter their comparative advantages through industrial policies

16. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-16 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)

17. 8-17 The Significance of Intra-industry Trade About 25–50% of world trade is intra-industry. Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade. –For the United States, industries that have the most intra-industry trade—such as pharmaceuticals, chemicals, and specialized machinery—require relatively larger amounts of skilled labor, technology, and physical capital.

18. 8-18 Table 8-2: Indexes of Intra-Industry Trade for U.S. Industries, 2009

19. Evidence on Intraindustry Trade (cont.) Evidence suggests that intraindustry trade is greater - in high technology industries - where there is more scope for product differentiation (what does it mean product differentiation?) - in countries more open to trade, so where competition is higher - in nations that have received larger amounts of foreign direct investment Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-19

20. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-20 Characteristics of Intraindustry Trade Economies of scale: –This means that when inputs to an industry increase at a certain rate, output increases at a faster rate. –A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output. External economies of scale occur when cost per unit of output depends on the size of the industry> geographically concentrated industries more efficient. Internal economies of scale occur when the cost per unit of output depends on the size of a firm > larger firms are more efficient.

21. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-21 TABLE 5.1 Increasing Returns to Scale for a Single Firm

22. Internal economies of scale Internal economies of scale are usually based on engineering, research and marketing aspects of production and are associated with products that have a large fixed cost component, usually high-tech sectors. Examples: 1.Cars 2.Drugs 3.Software 4.Aircrafts 5-22 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

23. 5-23 Internal Economies of Scale When larger firms are more competitive, market structure changes (and profits are no longer zero as they have to cover fixed costs): –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

24. Key question Why intraindustry trade emerges? Why there are gains from intraindustry trade? 5-24 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

25. 5-25 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 (both for imports and exported goods): –This is a difference with the HO and the Ricardian model where the prices of the exported good increased after trade. 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 –see the case study on US-Canada on autos: by opening trade with US, Canadian consumers can choose among more car models.

26. The Gains from Intraindustry Trade Another important effect of trade between developed countries is the ‘selection effect’. –Definition: when the better-performing firms expand and the worse- performing ones contract or exit, overall industry performance improves. –Since the decision to export involves a fixed cost (e.g. for commercials, retail activities, etc.), only highly productive firms decide to export and benefit from the larger market share.> these firms benefit from economies of scale and become even more efficient> so efficient to kick less productive firms out of the market. Canada-Us Free trade agreement on the manufacturing productivity (Trefler 2004): –In Canada, productivity increases by a dramatic 15% in most affected industries. –Of this 15%, half is due to the contraction and exit of worst-performing firms 5-26 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

27. REMARK As in the Ricardian and the HO models, an increase in the market size is again the fundamental mechanism that brings about gains from trade. Here, however, a larger market has also a dynamic positive effect on productivity and technological levels. 5-27 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

28. 5-28 Trade and Geography Two fundamental links exist between trade and geography: Demand: a location (or a region) may pull in economic activities because it is close to a market (cities are low cost for expansion) Supply: a location/region may offer firms the opportunity to find critical complementary inputs (i.e. skilled labor) Main implication: concentrating production of an industry in one or a few locations can reduce the industry’s costs, even if the individual firms in the industry remain small.

29. 7-29 In this case we are in presence of external economies of scale: Relationship of Input to Output for a Hypothetical Industry (not firm)

30. 7-30 Why External Economies of scale are relevant? Many modern examples of industries that seem to be powerful external economies: –In the United States, the semiconductor industry is concentrated in Silicon Valley, investment banking in New York, and the entertainment industry in Hollywood. http://www.youtube.com/watch?v=WerdGKq2Icohttp://www.youtube.com/watch?v=WerdGKq2Ico –During the first industrial revolution, textile industry was concentrated in Manchester/Liverpool. –Knowledge intensive spinoffs (small firms opened by scientists) are usually clustered near top universities such as Stanford or Cambridge. –Design industry in Italy is concentrated near Milan. In developing countries such as China, external economies are pervasive in manufacturing. One town in China produces most of the world’s underwear, another nearly all cigarette lighters. –External economies played a key role in India’s emergence as a major exporter of information services. Indian information services companies are still clustered in Bangalore.

31. 7-31 External economies may exist for a few reasons: 1.Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. –For example, Silicon Valley in California has a large concentration of silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips. –These machines are cheaper and more easily available there than elsewhere. –The same argument holds for specialized suppliers of intermediate goods in virtually all industries (cars, electric equipment etc.)

32. 7-32 External economies may exist for a few reasons: 2.Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. –Workers with specific skills can be more easily relocated if a firm is doing bad. Firms that want to expand can more easily find workers with the specific skills they need. 3.Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists.

33. 7-33 The Theory of External Economies (cont.) Represent external economies simply by assuming that the larger the industry, the lower the industry’s costs. There is a forward-falling supply curve: the larger the industry’s output, the lower the price at which firms are willing to sell. Without international trade, the unusual slope of the supply curve doesn’t matter much.

34. 7-34 External Economies and International Trade Prior to international trade, equilibrium prices and output for each country would be at the point where the domestic supply curve intersects the domestic demand curve. Suppose Chinese button prices in the absence of trade would be lower than U.S. button prices.

35. 7-35 Fig. 7-2: External Economies Before Trade

36. 7-36 External Economies and International Trade (cont.) What will happen when the countries open up the potential for trade in buttons? The Chinese button industry will expand, while the U.S. button industry will contract. This process feeds on itself: as the Chinese industry’s output rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. In the end, all button production will be in China.

37. Remark Here, patterns of trade are dynamic and driven again by an increase in the market size. Once two countries start trading they do not reach at once the final equilibrium but a dynamic self- reinforcing process of specialization takes place. Trade leads to prices that are lower than the prices in either country before trade!

38. 7-38 External Economies and International Trade (cont.) What might cause one country to have an initial advantage from having a lower price? Now ‘initial advantages’ are important! 1.One possibility is comparative advantage due to underlying differences in technology and resources. 2.If external economies exist, however, the pattern of trade could be due to historical accidents or path dependency: –Countries that start as large producers in certain industries tend to remain large producers even if another country could potentially produce more cheaply. –Example of historical accident: film industry in LA, financial sector in NY.

39. Initial advantage and protectionism The fact that the initial advantage matters in determining the comparative advantage in strategic sectors implies that free trade is not always the best option for developing countries. Developing countries may temporarily use tariff to protect the infant industry. –Positive examples of this policy: US and Germany nineteen century –Partially negative: Latin American countries 5-39 Copyright © 2011 Pearson Addison-WesleL. All rights reserved.

40. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-40 Summary: Trade and External Economies Geographical concentration may be self- reinforcing: An initial small move toward clustering may cause a chain reaction, resulting in a massive industrial agglomeration, so historical accidents matter a lot. However, good industrial policies can alter existing patterns of trade as for the case of South Korea and the Asian tigers.

41. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-41 Industrial Policy Industrial policy: A government’s 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

42. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-42 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 –In the case of 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

43. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-43 FIGURE 5.1 Market Failure: Externalities

44. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-44 Industrial Policies and 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. Especially ‘enabling industries’, i.e. industries producing general purpose technologies, such as energy and ICT. –Similar spillovers occur in research and development (R&D): followers can copy and imitate as enforcement of property right is often difficult and costly. –Capital market imperfections: difficult to attract no start-up capital, need for government subsidies. –A market failure can be ‘dynamic’: a country that developed earlier has more know-how so it is more productive; firms in a developing country needs a subsidy to start the production and gradually becomes competitive.

45. Problems with Industrial Policies A basic problem is that it is difficult to obtain the information necessary to measure the extent of market failure (invisible) 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 Keep the knowledge within national boundaries (benefit foreign firms)

46. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 5-46 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 in the defense industry http://www.youtube.com/watch?v=S1BLPCgh0wk Most common form of U.S. government support for certain industries has been through new research and dissemination of information

47. Key Concepts/summary Intraindustry trade Economies of scale: external and internal Gains from intraindustry trade Firm clusters and reasons why external economies of scale emerge Effects of industrial policies on the country comparative advantage 5-47 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.