managerial economics lecture global standard 0200000

8/6/2019 Managerial Economics Lecture Global Standard 0200000

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Managerial Economics

Lecture Twelve:

Standard theories ofinternational competition

Theory & Reality…



Free Trade and Specialisation

• Ricardo’s “Comparative Advantage”

– Took case Mercantilists argued would meanrival (Portugal) would “defeat” England in opentrade• Portugal assumed better than England atPortugal assumed better than England at

producingproducing everythingevery

thing

• Argued that England would still benefit fromfree trade

– The Model:



Free Trade and Specialisation

• Two countries producing 2 commodities

• Assume Portugal– Absolutely more efficient at producing both

wine and cloth

– Relatively more efficient at producing winethan cloth

• More of both wine and cloth produced if

– England specialises in cloth

– Portugal specialises in wine

• Countries trade surpluses and increaseconsumption of both goods in both countries



Comparative Advantage

• Portugal (per 1000 men)

– 90 men to produce x units of cloth– 80 men to produce y units of wine

– can produce

• 11.1 units of cloth; or• 12.5 units of wine; or

• any “straight line” combination of the two

• England (per 1000 men)

– 100 men to produce x units of cloth– 120 men to produce y units of wine

– can produce 10 units cloth, 8.5 units of wine, or

any linear combination:




• So with no trade:

– Portugal Max. 11.1 cloth, or 12.5 wine– England Max 10 cloth, or 8 1/3 wine

• Trade

– Portugal 12.5 wine, England 10 cloth– Exchange surpluses, total output greater

• Putting Ricardo’s arguments in a diagram…




Wine

Cloth

P o r t u g

a l

E n g l a n d

Wine outputWine outputwithout tradewithout trade

Cloth output without tradeCloth output without trade

Cloth output with tradeCloth output with trade

Wine outputWine outputwith tradewith trade

Trade: England producesTrade: England produces onlyonly Cloth,Cloth,

PortugalPortugal onlyonly Wine; output higherWine; output higher




• “Under a system of perfectly free commerce, each

country naturally devotes its capital and labour to suchemployments as are most beneficial to each. This pursuitof individual advantage is admirably connected with theuniversal good of the whole. By stimulating industry, byregarding ingenuity, and by using most efficaciously thepeculiar powers bestowed by nature, it distributes labourmost effectively and most economically.” (Ricardo 1817)

• Clever logical argument aided repeal of Corn Laws

• Identical to modern economic belief

– (Ricardo’s model is economics’ “one big trick”)• Show increase in output by reallocating static resources

• But behind Ricardo’s rhetoric, a Realpolitik…



Ricardo’s Realpolitik

• “It has been my endeavour to shew throughout this work,

that the rate of profits can never be increased but by afall in wages, and that there can be no permanent fall ofwages but in consequence of a fall of the necessaries onwhich wages are expended. If, therefore, by the extensionof foreign trade, or by improvements in machinery, thefood and necessaries of the labourer can be brought tomarket at a reduced price, profits will rise.” (Ricardo 1817)

• Ricardo’s real interest not efficiency, but

– shift income from landlords to capitalists (workersirrelevant to Ricardo)

– Real objective to increase rate of investment Real objective to increase rate of investment



Modern Comparative Advantage

• If price of wheat falls

– Rents fall– Money wages fall (cheaper wheat) while real wages

remain constant

– Increased profits

– Greater accumulation– Objective: promote growth by redistributing income

• Neoclassical Heckschler-Ohlin-Samuelson trade model

– Exclusively static

– Therefore ignores income distribution & hence growthissue

– Basic theory by Heckscher, Ohlin, Samuelson, Vanek

– Best shown using “Edgeworth Box” analysis:




PCs (“capital intensive”)

Shoes

(“lab

orinte

nsi

ve”)

Price ratio

“Production

possibilitycurve”

“Social

indifferencecurves”

T r a d

e p r i c e r a t i o

production

ConsumptionConsumption

outside PPCoutside PPC

consumptionconsumption

PCs (“capital intensive”)

Sho

es(“lab

ori

ntensi v

e”)




• Fervently believed in by most economists:

– “The principle of comparative advantage holds thateach country will benefit if it specializes in theproduction and export of those goods that it canproduce at relatively low cost. Conversely, eachcountry will benefit if it imports those goods which itproduces at relatively high cost. This simple principleprovides the unshakable basis for international trade.”(Samuelson 300)

– “Notwithstanding its limitations, the theory of

comparative advantage is one of the deepest truths inall of economics. Nations that disregard comparativeadvantage pay a heavy price in terms of their livingstandards and economic growth.” (308)




• But model makes some extreme assumptions

– Full employment of all factors of production• Otherwise countries would not be on “ProductionPossibility Frontier”

– Costless mobility of factors of production between

sectors• Labour and capital can be moved from computerproduction to shoe production without loss ofproductivity

– Immobility of factors between countries• Otherwise gains in one country would accrue to factor

owners in another country

– Identical technology used in production everywhere

• Initially, even Samuelson admitted qualms about them:




• “The Ohlin analysis explains much; but there is much that it fails toexplain; and if adhered to inflexibly, there is much that it can

obscure. Its two central tenets are open to grave doubt:• Is it reasonable and useful to set up the hypothesis that production

functions are the same the world over? Is it possible to findreasonably homogeneous and commensurable factors of production indiverse parts of the world, so that relative proportions can be

defined and compared?• Certainly no strong affirmative answers to these two questions can

be given—as Ohlin himself has pointed out in a number of places. Thelaws of nature may be the same “everywhere,” but the laws of natureand the economically relevant production function relating maximum

output obtainable from specified concrete inputs are two quitedifferent things…” (Samuelson 1948 “International Trade And TheEqualisation Of Factor Prices”, Economic Journal Vol. 63)

• So maybe the “unshakable basis” isn’t all that sound…

• Let’s consider the data…




• Model makes several empirical predictions:

– Direction of trade determined by relative factorabundance• Country with relative abundance of capital should export

capital intensive goods• Country with relative abundance of labour should export

labour intensive goods– Incomes and trade• Trade should cause “factor price equalization”: wages

and return on capital should tend to equality throughoutworld under freer trade

– Trade surpluses should be counterproductive• Trade surplus should only lead to inflation since

economies in full employment

– Free Trade best route for development

• Exploits country’s comparative advantage



Direction of Trade: “Leontief’s Paradox”

• Wassily Leontief (father of input-output analysis)analysed US trade flows in 1953– Found that US exports were labour intensive &

imports capital intensive• Exports capital component $14K per man-year• Imports capital component $18K per man-year

• Reverse of Heckscher-Ohlin-Samuelson prediction!– Composite “export” & “import” commodities defined– Composite “labour” and “capital” factors– Later generalisations (more disaggregated

commodities & factors) generally reached same result:• Pattern of trade opposite to predictions of HOS theory

– Some recent results find theory valid but only ifanother result of theory dropped: factor priceequalization”…




• “The Heckscher-Ohlin-Vanek (HOV) model of factor service trade is a mainstay of international economics.Empirically, though, it is a flop…” (Davis et al. AER 1997)

• “Starting with the classic "paradox" of Wassily W.Leontief (1953) … the Heckscher-Ohlin (HO) model hasconsistently performed poorly in empirical tests. This led

Trefler (1993) to aver that "its predictions are alwaysrejected empirically.“• In spite of these empirical failures, the Heckscher-Ohlin

model remains ubiquitous in theory, empirics, and policyanalysis. In part, this reflects an a priori belief that the

model embodies fundamental general equilibrium linksbetween primary factors and production structure thatwe believe will be part of any fully articulated andempirically relevant theory…” (421)




• Davis et al. test theory in “regions that exhibit factorprice equalization (FPE)”– Find that “the theory may do quite well as a simple

description of the data.”• Choi & Krishna 2004 “The Factor Content of Bilateral

Trade: An Empirical Test” Journal of Political Economy

– Nearly all the tests of the factor content predictionsof the model … have assumed full factor priceequalization (FPE) across countries and identicalhomothetic preferences across countries”

– Their paper “relies neither on FPE nor on anyrestrictions on preferences”

• since “even casual evidence suggests that full FPE doesnot hold … and that preferences are nonhomothetic andvary substantially with income level…”



“Factor Price Equalization”

• FPE: prediction that trade would equalise wages & profits

worldwide…– Clearly false: “even casual evidence suggests that fullFPE does not hold” (Choi & Krishna)

• But if FPE dropped & HOS “tested”…

– Results could simply mean “countries where labour ischeap export labour intensive goods…” etc.• Trade driven by absolute advantage rather than

comparative

• Essential aspect of comparative advantage is realignmentof internal prices & incomes to global prices & incomes



Trade surpluses

• Theory says trade surplus futile because

– With fixed exchange rates causes increase in moneysupply• drives up prices

• Domestic inflation makes commodities more expensive onworld market

• Restores equilibrium

– With floating exchange rate• Causes currency appreciation

• Restores equilibrium• What is the empirical record?

– According to Samuelson, it’s conclusive:



Trade surpluses

• “while economic protection may raise employment, it does

not constitute an effective program to pursue highemployment, efficiency, and stable prices….

• This lesson was amply demonstrated in the 1990s. From1991 to 1999, the United States created 16 million netnew jobs while maintaining open markets and low tariffs;its trade deficit increased sharply during this period. Bycontrast … Japan had rising unemployment with a growingtrade surplus.” (Samuelson: 316)

• Really? Here’s the data (© WTO)

– http://stat.wto.org

• current (nominal) prices

http://stat.wto.org/





Trade surpluses

• US trade deficit began 1968– Accelerated in 1990s

• Japan surplus began 1981– Constant across 1990s– Falling in real terms:

Balance of Trade

-800

-700

-600

-500

-400-300

-200

-100

0

100

200

1945 1955 1965 1975 1985 1995 2005

Years

U S

$

B i l l i o n

Japan

USA

• Japan’s stagnation: 1989“Bubble Economy” collapse

• US boom: Internet Bubble

• Trade performances irrelevant



Free trade and development?• Correlation between trade barriers & growth:

“the slope oftherelationship isonly slightlynegative andnowhere nearstatisticalsignificance”

(2)



Free trade and development?

• Recent studies use more complicated indicators of “openness totrade” imply stronger relationship; but

– “In many cases, the indicators of "openness" used byresearchers are problematic as measures of trade barriersor are highly correlated with other sources of pooreconomic performance.

– In other cases, the empirical strategies used to ascertainthe link between trade policy and growth have seriousshortcomings, the removal of which results in significantlyweaker findings.” (4)

– “… the nature of the relationship between trade policy andeconomic growth remains very much an open question. Theissue is far from having been settled on empirical grounds.We are in fact skeptical that there is a general,unambiguous relationship between trade openness and

growth…” (6)




• HOS/Ricardian comparative advantage static

– “Optimal tariff” is zero• R&R present “dynamic” model

– Output=Agriculture + Manufacturing

– Agriculture productivity constant

– Manufacturing productivity• Rises over time

• Reflects “learning by doing”

– The higher output gets, the more learning occurs

– With otherwise neoclassical assumptions• Wage=marginal product

• Equilibrium across both sectors

– Small tariff increases manufacturing sector compared

to agriculture




• Causes greater growth of manufacturing productivity– But also devotes some of today’s inputs against

relative productivity today– “Hence the tariff exerts two contradictory effects on

growth. By pulling resources into the manufacturingsector, it enlarges the scope for dynamic scale

benefits, thereby increasing growth. But it alsoimposes a static efficiency loss, the cost of whichrises over time as the manufacturing sector becomeslarger.” (12)

• Working from neoclassical assumptions and “stylised

fact” that growth in manufacturing productivity exceedsgrowth in agricultural– Model suggests optimal tariff > 0 initially and then

should be cut as development occurs

– Thus even neoclassical theory shows…




• “there is no determinate theoretical link between tradeprotection and growth once real-world phenomena such aslearning, technological change, and market imperfections(here captured by a learning-by-doing externality) aretaken into account.” (13)

• R&R critique recent papers (e.g. Dollar 1992)

– Many technical aspects to critique

– Main practical one: “Law of one price” & “Purchasing-power parity”

• Dollar assumes trade barriers only source of nominalprice differences for same good in different countries

– “Law of one price” & “Purchasing-power parity”

• But this “Law” doesn’t hold empirically:




• “Rogoff (1996, 648) writes of the "startling empiricalfailure of the law of one price." … "commodities wherethe deviations from the law of one price damp out veryquickly are the exception rather than the rule" (Rogoff1996, 650).

• Rogoff (1996, 647) concludes … that the speed ofconvergence to purchasing-power parity (PPP) isextremely slow, of the order of roughly 15 percent per year.

– At this speed of convergence, averages constructed

over a time horizon of 10 years (the horizon used inDollar's paper) would exhibit substantial divergencefrom PPP in the presence of nominal shocks.” (18)




• Result: Dollar’s index of trade barriers highly distorted:

– “The ten least distorted countries by this measureinclude not only Hong Kong, Thailand, Malta, but alsoSri Lanka, Bangladesh, Mexico, South Africa, Nepal,Pakistan and Syria!

– Burma's rating (90) equals that of the United States.

– Taiwan (116) is judged more distorted than Argentina(113).” (20)

• Similar problems in other influential “trade promotesdevelopment” paper Sachs and Warner (1995)

– Proxies for trade protection closely related to otherissues that may be more important than trade policy:




• “Indeed, of the 48 economies ranked as closed accordingto the BMP criteria, 40 had one or more of the following

characteristics:– average inflation over 1975-1990 higher than 10

percent,– debt to GNP ratio in 1985 greater than 125 percent,

– a terms-of-trade decline of more than 20 percent,– an institutional quality index less than 5 (on a scale of

1 to 10), or– involvement in a war.

• In general, strong correlation results for trade openness& growth “arise either from obvious mis-specification orfrom the use of measures of openness that are proxiesfor other policy or institutional variables that have anindependent detrimental effect on growth.” (59)




• “The tendency to greatly overstate the systematicevidence in favor of trade openness has had a substantial

influence on policy around the world.• Our concern is that the priority afforded to trade policy

has generated expectations that are unlikely to be met,and it may have crowded out other institutional reforms

with potentially greater payoffs…• The effects of trade liberalization may be on balancebeneficial … the evidence provides no strong reason todispute this.

• What we dispute is the view, increasingly common, that

integration into the world economy is such a potent forcefor economic growth that it can effectively substitutefor a development strategy.” (62-63)




• R&R make one interesting positive observation:

– “Recent research … has already shed new light on therelationship between trade and firm performance…

– these papers … find little evidence that firms derivetechnological or other benefits from exporting per se;

– the more common pattern is that efficient producerstend to self-select into export markets.

– In other words, causality seems to go fromproductivity to exports, not vice versa…” (62)

• i.e., successful innovators end up exporting • Implies Schumpeterian approach to trade:



“Schumpeterian” Trade Theory…

• Schumpeterian conjecture– Trade mainly in innovated products

• 85% of world trade in manufactures, only 15% isagriculture/raw materials

• Japan’s MITI calculates products invented before 1950constituted < 20% of sales in 1990

– Exports non-domestic avenue for entrepreneurialproducts• Not constrained by local demand/finance

– Surplus means rest of world funds part of domesticentrepreneurial activity

• Potential for more growth• Could be maintained indefinitely so long as maintain

entrepreneurial edge



Trade and growth in general?

• Overall message– Conventional (neoclassical) theory argues getting

prices “right” is the “one-size-fits-all” economic policy– Careful analysis of the data doesn’t support this

conjecture: many other factors appear to matter:• “There are, in fact, reasons to be skeptical about the

existence of a general, unambiguous relationshipbetween trade openness and growth. The relationship islikely to be a contingent one, dependent on a host ofcountry and external characteristics. The fact that practically all of today’s advanced countries embarked on

their growth behind tariff barriers and reduced protection only subsequently surely offers a clue of sorts .” (Rodrik 2002, “Trade Policy Reform asInstitutional Reform” Development, Trade, And TheDevelopment, Trade, And TheWTO: A HandbookWTO: A Handbook, p. 9)



Trade and growth in general?

• “One can cite other instances of heterodox trade reformsthat proved successful because they suited existing political

and institutional realities.• Korea’s outward orientation during the 1960s … was achieved

not through import liberalization (of which there was little),but through export subsidization (of which there was a lot).

– … now prohibited under existing WTO rules on subsidies.• … China’s two-track reform strategy … which maintainednonmarket institutional forms while aligning incentivescorrectly at the margin, has been wildly successful.

• These are cases in which imaginative experimentation with

institutional reform has had, in all likelihood, greater payoffsthan the wholesale transplantation of institutions fromadvanced industrial countries would have had.” (Rodrik 2002:8)



Whatever happened to…?

• Trade theory assumptions seriously at odds with realworld

– Theory: Factors of production “immobile betweencountries, perfectly mobile within”

• Reality: capital (both financial & physical) highly mobile

• Enormous international financial capital flows

• Large percentage of “Exports” & “Imports” actuallytransfers of components between branches of one firmacross national borders: “intrafirm trade”

– “In 1994, … intrafirm trade … accounted for more

than one third of U.S. exports of goods and for morethan two fifths of U.S. imports of goods.” (Zeile1997, "U.S. Intrafirm Trade in Goods", Survey Of Current Business , Vol 75: 52–61)




• Intrafirm trade breaches income & welfare aspects of theory

– Comparative advantage

• income from trade accrues to factors in country

• Relatively abundant factor benefits (workers in 3rd world)

– Intrafirm transfers

• Capital income sometimes partly captured locally (jointventures, “asset transfer rules” [common in China]); but

• Often profits remitted to “home” (1st world) country from“host” (3rd world) country

– Transfer of production done to take advantage of low

wages, different pollution rules, etc.– May cause rise in wages but depends on

• Unemployment levels

• Institutional factors (export processing zone

labour laws, unions, etc.)




– Theory: Trade balanced• Value of imports=value of exports

• Exchange rates adjust to maintain equilibrium

• Reality: Most countries have sustained trade pattern fordecades—surplus (Japan, Germany…); deficit (USA,Australia)

• Exchange rates haven’t adjusted to achieve tradeequilibrium

– 99% of world currency trade speculative, not tosupport exports/imports

• Capital (finance) flows to counterbalance tradeimbalances substantial

– Often speculative capital & major cause of currencyvaluations (including, e.g., 500% devaluation ofIndonesian rupiah in 1 week in late 1990s)

d



Trade or innovation?

• Conjecture: policies that promote innovation may be moreimportant than policies that promote “level playing field”

• Next week: Porter’s management-oriented theory ofcompetitive advantage

managerial economics lecture global standard 0200000

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