Chapter 5

Modern International Trade Theories

广东省省级精品课程《国际贸易》

刘 芹

Chapter 4

Modern International Trade Theories

In this chapter, we will examine(1) The emergence and development of modern

trade theories;

(2) Intra-industry trade based on economies of scale and imperfect competition;

(3) Int’l trade based on differences in dynamic changes in technology among nations;

(4) Int’l trade based on demand preference.

§1 Introduction

1.1 Background H-O model faces two difficulties in modern

time. One is that some questions remain regarding the empirical validity of the theory. More important is that some of the assumptions on which the theory leaves a great deal of today’s international trade unexplained.

H-O

New trade’s characters after World War II:

(1) an increase in trade volume between similar products;

(2) an increase in trade volume among the nations who have similar development level;

(3) an increase in transfer speed in the advanced sectors.

1.2 the Development Track of Modern Trade Theories In the 1950s, the query on Leontief Paradox. In the 1960s, new trade basis on dynamic

technology change supposed by Linda and Vernon.

In the end of 70s or the beginning of 80s, “New Trade Theory” advanced by Krugman, who was the first economist exploring modern trade and building trade model based on economy of scale and imperfect competition, is the greatest man of modern trade theories.

•Paul Krugman was born in American middle-class family in 1953. He graduated from John F Kennedy high school and studied economy in famous MIT. Now he is professor of economics. His main researches lie within international trade, international finance, monetary crisis and exchange rate’s fluctuation. New trade theory built by Krugman explained income increase and incomplete competition’s impacts on international trade.

1.3 the relationship between H-O Model and New Trade Theories Modern trade theories are generated and developed

on the basis of traditional trade theories. They are complementary, not substitute, enriching and developing international trade theory system together.

As for the study object, the former explain intra-industry trade among developed countries, the latter explain inter-industry trade between developed and developing countries. As for the theory basis, the former is based on economies of scale and imperfect competition, the latter is based on constant returns to scale and perfect competition.

In the following five prerequisites, the relative prices across nations are same in isolation.

(1) no differences in technological change among nations;

(2) same factor abundance;(3) equal tastes across nations;(4) constant returns to scale; (5) perfect competition.

§2 Intra-industry Trade on Economies of Scale and Imperfect Competition

2.1 Economies of Scale Economies of Scale, that is, increasing returns to

scale mean that the output grows proportionally more than the increase in inputs or factor of production, e.g. a 10% increase in input leads to more than 10% increase in output.

It occurs because at a large scale of production a greater division of labor and specialization becomes possible. A larger scale of operation may permit the introduction of more specialized and productive machinery than at a smaller scale of operation.

About a third of all goods-producing industries are characterized by increasing returns to scale in the world today.

Two Forms of Economies of Scale:

Internal economies of scale refer to the reduction in the average costs of production as the firm’s output expands. Increasing returns to scale are internal to a firm.

External economies of scale refer to the reduction in each firm’s average costs of production as the entire industry output expands.

For example:

External economies of scale arise because a larger and more geographically concentrated industry is likely to provide more specialized labor and other services, thus leading to higher productivity and lower average costs for all the firms in the industry.

This is the reason that so many computer companies are clustered in California’s Silicon Valley and financial institutions and banks are concentrated in New York City.

2.2 Trade Based on Economies of Scale

With identical and convex to the origin (because of economies of scale) production frontiers and indifference maps, the no-trade equilibrium-relative commodity price in the two nations is identical and given by PA. With trade, Nation 1 could specialize completely in the production of commodity X and produce at point B. Nation 2 would then specialize completely in the production of Y and produce at point B’. By then exchanging 60X for 60Y with each other, each nation would end up consuming at point E on indifference curve II, thus gaining 20X and 20Y.

We must clarify the following: First of all, it is a matter of complete indifference as

to which of the two nations specializes in the production of commodity X or Y. In the real world, this may result from historical accident.

Second, the two nations need not be identical in every respect for mutually beneficial trade to result from increasing returns to scale.

Third, during the past decade or so, there has been a sharp increase in international trade in parts and components, as well as in setting up of production facilities abroad, and these have been the source of new and significant international economies of scale. CASE STUDY 4-3

LAC LAC

0 100 200

2.0

1.5

C,P C,P

2.0

100Truck Truck0

Export to U.S

Japan U.S.

2.3 Internal Economy of Scale, Monopoly Corporation and Intra-industry Trade

LAC

1000

2.0

Car

C,P C,P

LAC

2.0

1.5

100 200

Export to Japan

Car0

The meanings of economies of scale: whether there is a difference in relative prices across nations, it will bring the nations to specialize in the production of some commodities so that they can obtain more gains from economies of scale. In addition, as to the commodities the consumers require, some is from domestic supply, others from abroad.

2.4 imperfect competition market

Commodity structure in all sectors (differentiated products);

Producers’ scale and their impacts on market.

A great deal of international trade can and does involve the exchange of differentiated products of the same industry or broad product group. That is intra-industry trade, as opposed to inter-industry trade in completely different products.

differentiated products are the somewhat different products (such as automobiles, cigarettes, and soaps) produced by different manufacturers in the same industry or general product group. The difference can be in brand, quality, design, performance, packing, terms of payment, advertisement, services, and so on.

Different Demand Curves in Different Market Structure

P

Q

Perfect competition

Monopolistic competition

monopoly

2.5 Price Discrimination

Price Discrimination refers to the situation that monopoly or monopolistic competition corporations regulate different price in different markets or to different consumers when they sell the same products. It is called “Dumping” in international trade.

Dumping is possible under three conditions: ◆imperfect competition ◆market division ◆different demand elasticity in different market (Df

＞ Dh)

Economics analysis of dumping

Foreign Market Domestic Market

The horizontal axis shows quantities and the vertical axis shows prices. The left represents the situation in foreign market and the right in domestic market.

When MR=MC, producers get a maximum profit. Producers supply Qh at Ph in domestic market and supply Qf at Pf in foreign market.

Since Df>Dh, the demand curve is flatter in foreign market. That is to say, producers can sell more goods in foreign market than in domestic market if they reduce prices at the same rate in both markets. So producers are willing to sell their goods at a lower price in foreign market to get more benefit.

Enlarge market share domestically or Enhance Export Abroad?

A manufacturer sells 1000 units in domestic market and 100 units in foreign market. Ph=$20 ， Pf=$15.

Wherever the manufacturer sells one more unit at home or abroad, he must decline the price.

If he decline ¢1 in both markets, that is, Ph=$19.99 ， Pf=$14.99

MRh=1001×19.99 － 1000×20=9.99 MRf=101×14.99 － 100×15=13.99

◆MR ： Although Pf is lower than Pd, MRf is larger------To expand export is better than to enlarge market share; MRh decreases more quickly------the manufacturer must control domestic quantities.

◆the relation between market share and price: Owing to transportation cost, trade barriers and large domestic market share ， the extent of decreasing price is different in both market.

◆monopoly power: Owing to small foreign market share, the manufacture has no power to decide the price.

2.6 Intra-industry Trade

Inter-industry trade and Intra-industry tradeInter-industry trade and Intra-industry trade The former means the international trade

taken place between industries and the latter means the trade in the same industry.

Intra-industry trade involves the exchange of differentiated products. They are produced in the same industry but with different designs and brands.

Reasons for Intra-industry tradeReasons for Intra-industry trade Intra-industry trade arises in order to make use of

economies of scale in production. That is, international competition forces each firm or plant to produce few varieties of the same product rather than many different varieties to reduce the costs. With few varieties and styles, more specialized and faster machinery can be developed for a continuous operation and a longer production run.

Who will benefits from the trade?Who will benefits from the trade? The producers will benefit because they can produce

at lower costs. The consumers will have wider range of choices and will buy them at lower prices.

Comparative advantage seems to determine the pattern of inter-industry trade, while economies of scale in differentiated products give rise to intra-industry trade.

The more similar nation are in factor endowments and technology (as among developed countries), the smaller is the importance of inter- relative to intra- industry trade, and vice versa.

Since industrial nations have become more similar in factor endowments and technology over time, the importance of intra- relative to inter-industry trade has increased.

Lancaster (1980): Inter-industry trade reflects natural comparative advantage while intra-industry trade reflects acquired comparative advantage.

2.7 Measuring Intra-Industry Trade

Intra-industry trade index ( IIT )

• IIT = 1 - IX – MI / (X + M) Where X and M represent, respectively, the

value of exports and imports of a particular industry or commodity group.

If X=0,or M=0, IIT=0, NO intra-industry trade. If X=M IIT=1, intra-industry trade is

maximum. CASE STUDY 4-4

Note: There is a serious shortcoming in using the index IIT to measure the degree of intra-industry trade. This results from the fact that we get very different values for T, depending upon how broadly we define the industry or product group. Specifically, the more broadly we define an industry, the greater will be the value of T. Thus, the T index must be used with caution. It can, nevertheless, be very useful in measuring differences in intra-industry trade in different industries and changes in intra-industry trade for the same industry over time.

§3 Trade Based on Dynamic Technological Differences

Apart from differences in the relative availability of labor, capital, and natural resources (stressed by the H-O theory) and the existence of economies of scale and product differentiation, dynamic changes in technology among nations can be a separate determinant of international trade. These are examined by the technological gap and product cycle models. Since time is involved in a fundamental way in both of these models, they can be regarded as dynamic extensions of the static H-O model.

3.1 Technological Gap Model

According to the technological gap model sketched by Posner in 1961, a great deal of the trade among industrialized countries is based on the introduction of new products and new production processes. These give the innovating firm and nation a temporary monopoly based on patents and copyrights, which are granted to encourage inventions.

As the most technologically advanced nation, U.S. exports a large number of new high-technology products. However, as foreign producers acquire the new technology, they eventually are able to conquer markets abroad, and even the U.S. market for the product, because of their lower labor costs. Meanwhile, U.S. producers may have introduced still newer products and production processes and may be able to export these products based on the new technological gap established.

CASE STUDY 4-5

To---T1: Demand lag; To---T2: Response lag; To---T1: Demand lag; To---T2: Response lag; T2---T3: Control lag in technology; T2---T3: Control lag in technology; To---T3: Imitation lag; T1---T3:Trade periodTo---T3: Imitation lag; T1---T3:Trade period

To T1 T2 T3 T4 Time

Nation A’s Production and Consumption

Nation B’s Production and Consumption

Nation B’s Production

Nation B’s Export Nation A’s

Imports

Nation A’s Production

3.2 Product Cycle Model

A shortcoming of the technological gap model, however, is that it does not explain the size of technological gaps and does not explore the reason that technological gaps arise or exactly how they are eliminated over time.

A generalization and extension of the technological gap model is the product cycle model developed by Vernon in 1966.

When a new product is introduced, it usually requires highly skilled labor to produce. As the product matures and acquires mass acceptance, it becomes standardized; it can then be produced by mass production techniques and less skilled labor.

Comparative advantage in the product shifts from the advanced nation that originally introduced it to less advanced nations, where labor is relatively cheaper.

eg: radio This may be accompanied by technology trade, foreign direct investments and foreign trade from the innovating nation to nations with cheaper labor.

A product goes through three stages:

(1) The phase of introduction: The product is produced and consumed only in the innovating country. production is increased rapidly to accommodate rising demand at home and abroad.

(2) The phase of maturation: The innovating firm may find it profitable to license other domestic and foreign firms to also manufacture the product. The imitating country begins to undersell the product in third markets, and production of the product in the innovating country declines.

(3) The phase of standardization: The imitating country starts underselling the product in the innovating country where the production declines rapidly or collapses.

Product Cycle Model

净出口

净进口

第一阶段：创新领先国家出口

第二阶段：技术扩散跟随者出口

第三阶段：技术停滞欠发达国家出口

Time

欠发达国家

其它工业国

领先国：美国

t0t1 t2 t3

t4 t5

Characters Change in Each Stage:

Production Location: The most advanced nation --- other

developed nations ---the developing nations; Comparative Advantage: Technology-intensive products --- Capital-

intensive products --- Labor-intensive products

Demand Change: Innovative nation and other developed

nations --- all developed nations --- all the world

3.3 Difference between Technological Gap Model and Product Cycle Model•Technological gap model emphasizes the time lag in the imitation process. The product cycle model stresses the standardization process. •According to these models, the most highly industrialized nations are expected to export non-standardized products embodying new and more advanced technologies and import products embodying old and less advanced technologies. On the other hand, developing nations import non-standardized products and export standardized products.

Note that in these two models trade is originally based on new technology developed by the relatively abundant factors in industrialized nations (such as highly skilled labor and expenditures on research and development).

Subsequently, through imitation and product standardization, less developed nations gain a comparative advantage based on their relatively cheaper labor.

As such, trade can be said to be based on changes in relative factor abundance (technology) among nations.

§4 Trade Based on Demand

4.1 Factors of Deciding Demand

Real Demand Preference Income

4.2 Income Elasticity and Engle Law

Income Elasticity (η)

1. η ＞ 1 ， luxuries

2. 0<η<1 ， necessities

3. η ＜ 0 ， inferior goods Engle Law: With income increasing, the

ratio of expenditure on foods will decrease more and more.

4.3 Preference Similarity theory

The hypothesis was advanced by Linder in 1961 that a nation exports those manufactured products for which a large domestic market exists.

These are products that appeal to the majority of the population. In the process of satisfying such a market, the nation acquires the necessary experience and efficiency to be able subsequently to export these commodities to other nations with similar tastes and income levels. The nation will then import those products that appeal to its low- and high-income minorities.

Pw

Overlapping Demand

O Nation 1 Nation 2 Income

b

a

Product Quality

Similar Income

According to preference similarity or overlapping demands hypothesis, trade in manufactures is likely to be the largest among countries with similar tastes and income levels.

If their incomes and tastes are similar, they would consume the same kind of commodities. So there would be some trade among them.

While confirmed for his native Sweden, Linder’s hypothesis has not been confirmed for other nations. It also cannot explain, for example, why China exports artificial Christmas trees in the absence of a domestic market for these products.

4.4 Trade Based on Different Taste

The basis for trade is the difference in tastes or demands. The nation with a smaller demand for a commodity will have a lower autarky relative price for, and a comparative advantage in the commodity.

If the production possibility frontiers If the production possibility frontiers are identical, is there any basis for trade?are identical, is there any basis for trade?

wheat

rice

Key Terms

Increasing returns to scale External economies Differentiated products Intra-industry trade Intra-industry trade index Technological gap model Product cycle model

Questions for Review1. What are two important limitations of the H-O

theory?2. What is meant by economies of scale? How

can they be the basis for international trade?3. What is meant by product differentiation?

Why does this result in imperfect competition? How can international trade be based on product differentiation?

4. How can intra-industry trade be measured? What are the shortcoming of such a measure?

5. How can international trade take place according to the technological gap model? What criticisms are leveled against this model? What does the product cycle model postulate? What are the various stages in a product life cycle?

6. what is the empirical relevance of the H-O model and the new trade theories?

Problems

1. Draw a figure similar to the figure “Trade Based on Economies of Scale”, showing how mutually beneficial trade can take place between two nations based on economies of scale if the nations have identical production frontiers but different tastes.

Classical Trade TheoryAbsolute Advantage Theory

Comparative Advantage Theory

Neo-classical Trade Theory(H-O Model)

H-O Theorem

H-O-S Theorem(Factor-price Equalization Theorem)

Reciprocal Demand Theorem

Specific-factor Model

Stolper-Samuelson Theorem

Leontief Paradox

Modern Trade Theory

Intra-industry Trade theoryBased on Economy of Scaleand Incomplete Competitiveness

Technological Gap theorem and Product Cycle Theory

Overlapping Demand Theory(Preference Similarity Theory)

Economic Growth and Trade

Demand: Engel Law

Supply: Rybczyski Theorem(Dutch Disease and ImmiserizingGrowth)

Improvement in Technology