Development Economics: Trade and Income Growth

• Development Economics involves comparative advantage, economies of scale, trade policy.

Trade and Income Growth

• World trade and income have shown consistent growth since the 1980s.
• Trade volume grows faster than world GDP.

Interconnectivity in Modern Economies

• Complex global supply chains characterize modern economies.
• A hard disc drive assembler in Thailand purchases components from 11 countries.

International Trade Patterns

• Developing countries export primary products like raw materials.
• Developed countries export manufactured goods, specialized services, business, and finance.
• Developing countries' exports value often falls short of imports, causing balance of payments deficits.
• Reliance on foreign savings, aid, remittances, FDI, and loans for development is common.
• A key question is to what extent international trade drives economic growth.
• International trade affects income distribution.
• Outward-looking (free trade) versus inward-looking (protectionist) policies should be considered.
• Look to understand the consequences of a trade war

Today's Lecture

• Focus includes the necessity of international trade.
• Also trade theories like comparative advantage and economies of scale.
• Trade policy and related concerns will be examined.

The Pencil Analogy

• The "I, the pencil" concept illustrates the need for international trade.
• Similar analogies include "I, the phone" and "I, the vaccine".
• It highlights that no single person can make a pencil, phone, or vaccine alone
• No one person knows how to make these complex products from scratch

Friedman's Perspective

• Milton Friedman (1980) emphasizes the miracle of how a pencil is made.
• This is not that nobody knows how to make one, but how it gets made.
• It underscores the complexity of global production.

Comparative Advantage

• Paul Samuelson considered comparative advantage both true and non-trivial in economics.
• It's a concept many intelligent individuals struggle to grasp or believe initially.

Elementary Trade Model: Ricardo's Principles (1817)

• England (Home) and Portugal (Foreign) are the two countries in this model.
• Cloth (C) and Wine (W) are the two goods.
• Labor (L) is the single production factor.
• England has a labor productivity of aC = 2 for cloth and aW = 8 for wine, with L = 8 labor force.
• Portugal has a labor productivity of aC* = 1 for cloth and aW* = 1 for wine, with L* = 2 labor force.
• Portuguese workers have higher productivity, so the question arises why they enter trade.

Autarky or Trade

• The relative price of cloth in England is pC /pW = 1/4
• The relative price of cloth in Portugal is pC /pW = 1.
• Assuming 50-50 taste for Cloth and Wine (U(QC, Qw) = QC0.5 Qw0.5 where pC QC = pw Qw), England produces (QC , Q W) = (2, 0.5) with labor allocation (L C , L W ) = (4, 4).
• In autarky, Portugal produces = (1, 1) and labor allocation (LC, LW*) = (1, 1).
• If TRADE occurs, England produces (QC, Q W) = (4, 0) with labor allocation (LC, L W ) = (8, 0).
• Portugal produces (QC*, QW*) = (0, 2) with labor allocation (LC*, LW*) = (0, 2).
• World produces more than in autarky with specialization and trade.
• Terms of trade on the world market where pC QC = pw Qw result in pC /pW = 1 / 2.

Equilibrium Terms of Trade

• Equilibrium is determined by world relative supply (RS) and demand (RD) curves.

Ricardian Model Benefits

• Comparative advantage drives international trade and counters misconceptions.
• Free trade is not only beneficial if a country is strong enough.
• Foreign competition is not unfair even when based on low wages.
• Trade does not exploit a country if its workers receive lower wages.

Lessons from Ricardo

• Even a poor country benefits from trading, despite its partner's higher productivity.
• Even a rich country benefits by trading with trading partner who pays lower wages.
• Trade results from low productivity and low wages, but it is not the cause.
• Trade can increase local wages.

Trade Consequences

• Trade leads to specialization.
• Specialization leads to factor reallocation.
• Factor reallocation causes income redistribution.
• Income redistribution is not an issue in the basic Ricardo model

Heckscher-Ohlin Model

• Labor abundance: Country with the highest labor-capital ratio (L/K).
• Capital abundance: Country with the highest capital-labor ratio (K/L).
• Labor-abundant country (RED) has lower autarky prices in labor intensive goods
• Capital-abundant country (BLUE) has lower autarky prices in capital intensive goods.
• Heckscher-Ohlin Theorem states both countries' income increases with trade.
• The labor-abundant country exports labor-intensive goods for capital-intensive goods, vice versa.

Income Redistribution

• Trade increases income for factors employed in the export sector.
• Trade decreases income for factors in the import-competing sector.
• Opposition to free trade usually comes from import-competing sectors.
• Winners are able to still compensate the losers while remaining better off
• Trade may require income redistribution.
• Opening trade involves migration to the export sector requiring training.

Economies of Scale

• External economies of scale arise from agglomeration and geographic clustering.
• Firms have quicker, easier access to specialized suppliers.
• Firms gain access to a labor market pool with specialized workers.
• Firms utilize knowledge spillovers in the pool of workers.
• Silicon Valley exemplifies returns to scale at the cluster level.

Economies of Scale and Autarky

• Two countries share the same linear demand curve.
• Each country's industry has its own economy of scale, represented by decreasing average cost (AC) curves.
• Fixed costs give rise to economies of scale.
• Consider which country has the biggest external economies of scale.

Trade and Lower Prices

• Foreign starts exporting with its lower unit cost and higher price in Home.
• Its exports outcompete the Home industry, lowering prices.
• Lowering the unit cost leads to the Foreign takeover of the industry.

Historical Advantage Considerations

• History causes another factor at play.
• Suppose an industry was in existence earlier in Home than in Foreign.
• Foreign could be deterred from setting up its own industry if the production cost (AC) exceeds Home price.
• An established industry dominates, even if competitors abroad could become more efficient.

AC Learning Curve

• Unit cost reduction is seen dynamically, caused by gained experience.
• This is captured by how average cost reduces with cumulative production.
• A country with more experience can continue to dominate the market.
• The rest of the world lacks critical experience and faces higher unit costs.

Economies of Scale Theory

• Winners are scale industries, industrial clusters, and early adopters.
• At risk are small industries and countries lacking industrial presence/experience.

Trade Policy Through Tariffs

• Tariffs protect domestic industries, driving a wedge between domestic and world market prices.
• The wedge is transmitted to a higher domestic price and potentially a lower world market price for big players.
• Tariffs can raise government revenues and reduce imports.
• An import tariff compares the world with and without the tariff.

Free Trade of Imports

• Home starts to import when the world price is lower than the domestic price.

Supply of Exports XS

• Foreign starts to export when the world price is higher than the domestic price.

World Market Equilibrium

• The world market equilibrium is where Foreign exports match Home imports.

Import Tariffs

• Import tariffs drive a wedge between domestic and trading partner markets.
• For a small country, trading partners find other outlets, passing tariff costs to consumers.
• For a big country, partners face difficulty selling elsewhere, and the tariff lowers the world market price.

Efficiency Losses

• Producers and consumers respond to the price increase to PT.
• Producers increase their production and consumers decrease their consumption.
• The extra supply could have been imported at the lower free-trade price.
• At the free trade price, the reduced demand could've been met.

Beggar-thy-Neighbor Effects

• Tariff efficiency losses are offset by lower import prices for large countries due to large market power.
• Terms of trade are gained.

Main Points of Import Tariffs

• Tariffs increase welfare losses from higher domestic prices.
• Consumers/users of imported merchandise are the losers.
• Foreign producers suffer loss.
• Protection primarily benefits employees, capitalists, and the government.
• Welfare losses because tariffs are inevitable for small countries on the world market.
• Welfare losses are (partly) compensated by terms-of-trade gains for big countries.
• Decreased imports lower the world market price.
• Both consumers and foreign producer pays a price.

Free Trade Benefits

• Free trade yields higher global production, efficient production efficient production.
• Leads to consumption at lowest prices.
• Free trade promotes scale economies.
• Supports innovation and learning.
• Promotes innovation and learning.
• Free trade avoids rent-seeking and lobbying.

Protectionism

• Protectionism can protect Losers when overall income gain is possible
• Can happen trade shifts cost to trade partners
• It may increase overall income.
• It can give gains in the social-externalitiy
• Stimulate infant industries for long-run potential comparative advantage gains
• It can capture large profits when only few companies dominate the world market
• Arises from concerns for low-wages, environment and culture

Infant Industries

• Countries have a potential comparative advantage, where industries grow up over time.

Strategic Subsidies

• Suppose EU decides to give a subsidy of 25 for Airbus to start production.

Drawbacks of strategic intervention

• Can arise from Information bias
• May give rise to Trade war
• May bring out and be manipulated by Specific interest politics

Concerns about low wages

• Often workers in import countries are paid low
• Arises from views on high labor standards put on rich countries, and the pushback this meets in poorer countries

Environment and Trade

• Very simular to low wage arguement
• Concern that degradation and pollution are mainly due to development levels, not much to trade itself.

Environmental trade off

• Inverse kuznets curve
• Trade creates environmental damage
• Also gives governments the ability to combat this

Trade and Culture

• The argument to oppose free trade for cultural reasons is somewhat different.
• The thought that poor countries would destroy their culture by producing the goods that we import.

Trade Pros and cons

• Trade has optimists as well as pessimists
• Offers benefits as well as potential problems
• Comes down to what side you listen to and what your perception is