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Specific factors and Costs of AdjustmentInternational Trade – Session 2

Daniel TRAÇA

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A summary of the last session

• Globalization– Growth of Trade and Foreign Direct Investment; Mostly among

rich countries; – Developing countries rising fast (East Asia) but still small;

• Comparative advantage: a key concept!– Global output increases when countries specialize in goods

where the relative productivity is higher.– It can be due to relative differences in the productivity of labor.

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This session

• Competitiveness and Comparative Advantage

• Specific factors and costs of adjustment

• Decreasing returns and incomplete specialization

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The myth of competitiveness

• Free trade is beneficial only if your country is productive

enough to stand up to international competition.

– Not true! Trade is always possible and beneficial for both

parties, if markets are at work.

• A country can always be competitive in the industry where it

has comparative advantage. How?

– Its wages will be lower than the more productive country.

– It is different from firms. Countries do not compete for workers,

like firms do! Firms that are not productive within a country

cannot compete because, if they pay lower wages, they will not

attract workers.

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Wages and productivity

• Less productive countries will compensate by paying lower wages. – Lower wages are the result of lower productivity.

• In most countries, this is due to:– Bad infrastructure Insufficient investment

– Low education Poor institutions

Productivity (%US level) 1963-1996 % increase

1963 1996 Productivity Real wages

United States 100 100 49 34

Germany (W) 58 91 133 220

Japan 32 76 260 220

South Korea 14 50 432 n.a.

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The competitiveness of sectors of comparative advantage

• An industry is competitive if its productivity advantage vis-à-vis its

foreign competitors is higher than the country’s wage disadvantage.

This will happen in industries with comparative advantage.

– The wage gap will among countries correspond to their average

productivity gap.

– In the industry of comparative advantage, the productivity gap will be

wider than the wage gap.

• So, if in an industry we see differences in wages that are larger than

the productivity differences, that is OK! It just means that one is the

sector of comparative advantage.

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The case where FACTORS cannot adjust

North

10

10 Food

Manuf

UN

P N f =1

UN(Manuf)

UN(Food)

UN(average)

Ave

rag

e [

pro

du

ctio

n =

co

nsu

mp

tion

] b

ask

et

in

au

tark

y

1<PW <3

At home:do the same exercise for the South!

UN→ UN(average) are the gains from exchange. • They occur because, in autarky, North had too much Manuf relative to Food, compared to the South.• So, even if production does not change, there are incentives to exchange Manuf for Food with the South.

UN(average) → UN(Manuf) are the gains from specialization.•They occur when resources are able to move to the sector of comparative advantage (Manuf in the North).

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If Adjustment costs are high, trade becomes highly political

Effects in the SouthEffects in the North

•The Food producers in North (exporters)

are better off, but ...

• Manuf producers (import-competing) are

worse off

•The Manuf producers in the North

(exporters) are better off, but ...

• Food producers (import-competing) are

worse off

International Trade has positive benefits (gains from exchange), but is hot politics. It is

similar to technological progress that displaces workers.

•The gains outweigh the losses and the

average worker is still better off.

•The South is a net consumer of Manuf, for

which the price has fallen.

•The gains outweigh the losses and the

average worker is still better off.

•The North is a net producer of Manuf, for

which the price has risen.

The South imports Manuf, and the price of

Manuf falls relative to autarky

The North imports Food, and the price of

Manuf rises relative to autarky

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The Political Economy

• What happened to the owners of the specific factors?– In the North, the rising price of Manuf has benefited Capital owners, but it

has hurt Land owners.

– In the South, the declining price of Manuf has hurt Capital owners, but it has benefited Land owners.

– The impact for workers that are mobile is ambiguous. In the North, the wage grew for those that consume food, but declined for those that enjoy Manuf.

• But the net gains are positive.– It should be possible to take from the winners to compensate the losers,

but this compensation is difficult.

– Again, a political quagmire due to specific factors, that will lead to pressure for protection.

• Example: the plight of landowners

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Dealing with Adjustment Costs

• Trade losers: a concern?– Is trade different from technological innovation?

• Losers may be able to find new jobs at lower wages: in the US, wage losses upon reemployment (+ or - 13%) are similar to the rest of manufacturing

• Trade politics– Organization matters, and losers are more likely to get

organized.– The small gains of the many versus the large losses of the few.

• Temporary measures may help smooth the costs. – Subsidies and Protectionism– Without credibility, they become permanent and are very costly

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Costs of Protectionism

7033 – 67600170Cost per job saved (‘000 US$)

1.10.9 – 2.00.30.2Share of total employment

1,500174 - 405180190Jobs “saved” (‘000)

4017018035Average tariff equivalent (%)

1.1 – 1.63.8 – 4.32.6 – 3.81.2*Share of GDP (%)

67 - 10012 - 1374 - 11070*Billions of US$

Consumer cost

20494721# industries surveyed

European Union1990

Korea1990

Japan

1989

United States1994

* Estimates for the whole economy. The 21 highly protected industries were responsible for $32b. (incl. $24b for textile and apparel). The remaining data concerns only the highly protected industries.

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A simple example: Portugal and the textile industry

• The sector represents more than 200,000 jobs, 16% of total exports and 2% of GDP

• What are the net effects of trade with China?– Assumptions:

• With free-trade in textiles, wholesale prices fall by around 30%• At this Free-Trade price, no domestic producers will survive• Workers will not find jobs elsewhere

Item / Year 2001 2002 2003A Total Annual Salaries 1,478,561,061 € 1,460,088,852 € 1,231,216,573 € B Nbr. Workers 225,869 243,263 223,723C Turnover 8,339,000,000 € 8,198,000,000 € 7,784,000,000 € D Sales Margin 1.63% 2.08% 1.74%E Producer Surplus (A+D*C) 1,614,210,624 € 1,630,345,581 € 1,366,632,932 €

F Consumption (C) 6,574,000,000 € 6,420,000,000 € 6,247,000,000 € G % Var. Price 30% 30% 30%H Gains Consumer Surplus (F*G) 1,972,200,000 € 1,926,000,000 € 1,874,100,000 €

per job saved (H/B) 8,732 € 7,917 € 8,377 €

Gains from Trade (H-E) 357,989,376 € 295,654,419 € 507,467,068 €

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December, 1955 November, 1960 February, 1962 April, 1967 October, 1970 December, 1973 December, 1977

Japan (MITI) unilaterally restrains exports of cotton fabrics and clothing to USA "to promote mutually beneficial relations". GATT Contracting Parties recognize the problem of "market disruption", even if it is just threatened. The Long Term Arrangement (LTA) is agreed, to commence October 1, 1962, to last for five years. Agreement is reached to extend the LTA for three vears. Agreement is reached to extend the LTA for three years. It was later extended three months more, to fill the gap until the MFA came into effect. The MFA is agreed, to commence January 1, 1974, and to last for four years. The MFA is extended for four years.

December, 1981 July, 1991 December, 1993 January 1, 1995 January 1, 1998 January 1, 2002 January 1, 2005

The MFA is renewed for five years. The Reagan administration, under pressure from increased imports resulting, from dollar appreciation, negotiates tough quotas. The MFA is extended pending outcome of the Uruguay Round negotiations. The Uruguay Round draft final act provides for a l0 year phase-out of all MFA and other quotas on textiles in Agreement on Textiles and Clothing (ATC). 1st ATC tranche liberalized by importing countries -16% of 1990 import volume. 2nd ATC tranche liberalized by importing countries - 17% of 1990 import volume. 3rd ATC tranche liberalized by importing countries -18% of 1990 import volume. 4th ATC tranche liberalized by importing countries - 19% of 1990 import volume.

Short-term protection… becomes long-term! An example

Establishing the MFAEstablishing the MFA

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Dealing with Adjustment Costs

• Unemployment subsidies• e.g. the Trade Adjustment Assistance in the US

– Danger: discouraging job-search and creating long-term unemployment.

• Retraining– The difficulty is that the mean worker displaced in

manufacturing in the US is aged 38.6, has 12.3 years of education, and has a job tenure of of 6.5 years

– Life-long learning is a better option.

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MPLFMPLM x PAUT

Incomplete specialization IThe equilibrium with constant returns

• In each sector, workers must be hired until the marginal worker’s cost (the wage) is equal to its marginal product.

• Workers must be indifferent between the two sectors

w = MPLF = MPLM x PRecall that P is the relative price of manufactures

• In autarky, the price must equate the relative marginal product, to ensure both goods are produced.

• If the trade price (of manufactures) is lower than in autarky, the country will specialize completely in Agro/Food

LF LM

w

total labor force

MPLM x PTRADE

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Incomplete specialization IIThe equilibrium with decreasing returns

• Once again, the equilibrium entails w = MPLF = MPLM x P

• For any given price (P), we can find out the employment and output of Agro/Food and Manufactures.

• If the trade price (of manufactures) is lower than in autarky, the country will specialize, but not completely, in Agro/Food LF

MPLF

LM

MPL M x P AUT

w

total labor force

MPL M x P TRADE

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Incomplete specialization IIIDecreasing returns and the concavity of the PPF

• We can obtain the PPF, for the case of decreasing returns.– The PPF is concave. The

opportunity cost of Food is now increasing.

Equilibrium: P = MPLF/MPLM

• For any price (P), we can obtain the Relative Supply of Manuf.

-6

+1

Food

Manuf

+1

-1

Slope = -MPLM / MPLF

-1/P

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Incomplete specialization IIIThe gains from trade in the North

• The prices of manufactures rises in the North,– Due to its comparative

advantage in manufacturing

• Production of manufactures for export increases;– Effects on consumption of

manufactures depend on income (+) and substitution effect.

• But there is incomplete specialization,– The North still produces some

Food for its own consumption

Food

Manuf

-1/PN-1/Pw

Gains from trade

Imports

Ex

po

rts

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Equilibrium productivity and comparative advantage

• In the trade equilibrium, we have:[MPM/MPF]N = Pw = [MPM/MPF]S

– If the price is the same, the relative productivities are the same.

• With similar relative productivities, how can comparative advantage emerge?– It must be measured out of equilibrium, for the same

relative employment level.

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Summary

• In countries with lower productivity, competitiveness in world markets arises from lower wages.– The gains from trade mean potential gains for workers.

• The political argument is due to adjustment costs (specific factors)– Factors that are specific to import-competing industries will loose out

from trade. – Those that are specific to exporting industries will be winners.– But the gains of winners always outweigh the loses of losers.– Compensating losers is a difficult task!

• Incomplete specialization arises when marginal productivities are decreasing.– In this case, the relative marginal products are the same with trade.– Comparative advantage must be seen for the same relative

employment levels.