International Political Economy & Bahrain Economy Lectures 5, 6, & 7 PDF

504: International Political Economy and Bahrain Economy Lectures 5 & 6 & 7 The Specific Factors Model The Specific Factors Model builds on the Ricardian model by incorporating more complexity, addressing the fact that different sectors of an economy can...

504: International Political Economy and Bahrain Economy Lectures 5 & 6 & 7 The Specific Factors Model The Specific Factors Model builds on the Ricardian model by incorporating more complexity, addressing the fact that different sectors of an economy can be affected differently by trade. In contrast to the Ricardian model, which assumes only one factor of production (labor) and views the economy as a single entity, the Specific Factors Model includes two goods and three factors of production: Two factors are specific to each good, meaning they cannot be transferred between industries. For example, land might be specific to agriculture, and capital to manufacturing. The third factor, typically labor, is mobile between sectors but subject to diminishing marginal returns in each sector. In this model, different sectors of the economy can be winners or losers from trade. For instance, the sector that exports goods (with rising demand) will benefit, while the sector facing import competition will lose. This creates distributional effects within the economy, which the Ricardian model does not address. Price Changes Under Autarky In autarky (no trade), prices are determined by domestic supply and demand, and the specific factors (land, capital) are used exclusively in the production of the good to which they are tied: When demand increases for one of the goods, its price rises, which increases profitability in that sector. The mobile factor (labor) shifts to the more profitable sector with higher prices. Wages and returns to the specific factor in the expanding sector rise, while they decrease in the other sector. As a result, the specific factor in the growing sector benefits, while the specific factor in the shrinking sector loses. The effect on the mobile factor is indeterminate, as it depends on the magnitude of shifts between sectors. Distributional Impacts of International Trade International trade alters the relative prices of goods. Under autarky, a country produces the good in which it has a comparative advantage at a lower cost, while the other good is more expensive. When trade is allowed: Prices equalize at an intermediate level between countries.  The price of the exported good rises, benefiting the sector producing that good, while the price of the imported good falls, harming the sector that competes with imports. As with autarky, the specific factors in the exporting sector benefit, while those in the import-competing sector suffer. The mobile factor (labor) experiences wage adjustments based on where it is employed, but the overall effect on its welfare is mixed. While trade boosts overall economic growth compared to autarky due to specialization, there are clear winners and losers within each economy. In theory, the winners could compensate the losers, leaving everyone better off (Pareto compensation), but this doesn’t always happen in practice. Japan and India Example Goods: Rice and TVs. Factors: - Land (specific to rice production) - Capital (specific to TV production) - Labor (mobile between sectors) Before Trade (Autarky) Japan focuses on TVs (comparative advantage), using more capital and some labor for TV production, while using land for rice. India focuses on rice (comparative advantage), using more land and some labor for rice production, while using capital for TVs. After Trade Japan specializes in TVs, so the price of TVs falls and rice rises (as it imports rice from India). Returns to capital rise (TV production), but landowners (rice sector) lose. India specializes in rice, so the price of rice rises and TVs fall (as it imports TVs from Japan). Returns to land rise (rice production), but capital owners (TV sector) lose. Distributional Impacts In both countries, the specific factors tied to the expanding sector benefit (capital in Japan, land in India). The specific factors tied to shrinking sectors lose (land in Japan, capital in India). Labor, as a mobile factor, shifts between sectors based on demand.  The Political Economy of Trade The Specific Factors Model explains why certain groups, like unskilled labor in import-competing industries, may oppose trade due to their relative immobility. However, blocking trade to protect these groups is not advisable for three reasons: 1. Income distribution effects are not unique to international trade. Changes in preferences, technological advancements, or resource shifts also lead to winners and losers within an economy. 2. Instead of blocking trade, we should encourage compensation mechanisms for those negatively affected, while still allowing overall economic gains to take place. 3. Regulatory capture occurs when small, concentrated groups, such as producers in industries threatened by imports, are able to lobby more effectively to maintain protection. These groups are often better organized, and their concentrated losses make them more politically active. Example: The American Sugar Lobby The U.S. sugar industry provides a real-world example of how regulatory capture can distort trade policy: The U.S. has maintained import quotas on sugar for decades, keeping the domestic price of sugar around twice the world average. A 2000 study found that these quotas cost U.S. consumers around $2 billion annually, rising to $3.5 billion in 2015, which translates to $30 per year per consumer. Despite these significant consumer losses, the political process remains biased toward the sugar producers, who benefit from the quotas due to the concentration of gains. The gains to U.S. sugar producers, however, are much lower than the losses to consumers, as the industry is far less efficient due to comparative disadvantage. Most consumers are unaware of the quota, and even if they knew, the small cost per person ($30/year) is not enough to motivate political action. On the other hand, a small number of sugar producers, particularly 17 large farms, account for over half of the industry’s profits and have organized lobbying efforts through trade associations like the American Sugar Alliance, which spent $20 million between 2005 and 2014 to influence policy. This lobbying successfully led to the 2014 reauthorization of the U.S. Farm Bill, which maintained sugar import restrictions.  The cost of saving each sugar industry job is around $3 million, and higher domestic sugar prices have even caused some industries, such as candy manufacturing, to relocate to countries like Canada, where sugar prices are lower due to the absence of protectionist policies. This example shows how regulatory capture allows a small, concentrated group to maintain trade barriers, even when they result in inefficiencies and costs to the broader economy. Does Trade Cause Unemployment? Unemployment is best addressed using macro-level policies, as it’s not solely driven by trade. The graphs show no clear, direct relationship between rising imports and manufacturing unemployment. Graph 1 Analysis (U.S. Manufacturing Employment and Imports from China) Manufacturing Employment has been declining since the 1970s, well before China’s entry into the WTO in 2001, suggesting other factors like technological advancements and automation have played a larger role. While imports from China rose sharply after 2001, the decline in manufacturing jobs continued at a similar pace, indicating that import penetration was not the sole cause. The predicted employment line shows that the trend of declining manufacturing jobs would have likely continued even without China’s WTO accession. Graph 2 Analysis (Unemployment and Import Penetration in the U.S.) The graph shows no clear correlation between rising import penetration (as a percentage of GDP) and U.S. unemployment rates. Even during periods of increased imports, such as the early 2000s, unemployment did not rise sharply, suggesting that imports are not the key driver of unemployment. Other factors, such as economic recessions (highlighted in grey bars), had a more significant impact on unemployment trends.  Macroeconomic Interventions: Trade doesn’t directly cause aggregate unemployment, but it can lead to redistribution of jobs. The economy adjusts as some sectors shrink due to imports, while others grow through exports. Redistribution Effects of Trade: Trade forces countries to specialize based on comparative advantage. This leads to job losses in sectors competing with imports (e.g., manufacturing) and job gains in sectors tied to exports (e.g., high-tech or agriculture). The result is a shift in employment across sectors. Manufacturing Employment and Imports: The decline in U.S. manufacturing jobs has been ongoing since the 1970s, and while Chinese imports rose after 2001, other factors like automation also played a major role. Workers in industries exposed to imports can experience job displacement, while those in export-oriented sectors may see higher wages. Governments can mitigate these effects through retraining programs and other policies to support displaced workers. Migration as a Substitute for Trade Migration reallocates labor, similar to how trade reallocates goods, improving economic efficiency by moving workers to where they are most productive. This boosts overall productivity in destination countries and can raise wages in origin countries due to reduced labor supply. Economic Effects Efficiency Gains: Migrants fill labor shortages in sectors like agriculture or construction, increasing productivity. This mimics the benefits of trade by allowing countries to specialize in sectors with comparative advantage. Wage Impacts: In destination countries, increased labor supply may reduce wages for low-skill workers, while remittances and reduced unemployment in origin countries boost local economies. Remittances: Migrants send remittances home, supporting consumption and investment, crucial for many developing economies. Regulatory Capture: Groups negatively affected by migration, such as low-skill workers, may lobby to influence immigration policy, even when migration benefits the economy overall. This is similar to regulatory capture in trade, where industries seek protectionist policies at the expense of broader economic gains.  Trade Protection Basic Tariff Analysis Tariffs: Can be specific (fixed amount) or ad valorem (percentage of value). Historically used to generate revenue and protect domestic industries. Examples: 19th-century UK agricultural imports and U.S. manufactured imports. Tariffs have declined in favor of quotas and Voluntary Export Restraints (VERs). Static Impact of a Tariff Tariffs raise import prices but lead to deadweight loss by reducing consumer and producer surplus. Domestic producers gain a cost advantage, imports decrease, and government revenue rises, though less than the overall loss in economic welfare. Tariffs produce inefficiencies in resource allocation, similar to other trade barriers like health, safety, or environmental standards. Dynamic Impact of a Tariff Retaliatory tariffs harm local exporters and create rent-seeking behavior, where resources are diverted to avoid tariffs or influence policy. Example: The U.S. light truck tariff (in retaliation to European poultry tariffs) caused long-term distortions, including inefficient production strategies by firms like Ford to evade the tariff. Lobbying by domestic industries can make these tariffs difficult to reverse, leading to persistent economic inefficiencies. Export Subsidies: European Common Agricultural Policy (CAP) Food security concerns led to subsidies in European agriculture, despite a comparative disadvantage. Early policies like guaranteed prices caused overproduction (food surpluses). Later policies aimed at reducing overproduction (e.g., set-aside programs) required complex coordination. Lump-sum payments may be more efficient, but are harder to defend politically. Trade Policy in the Global South Import-Substituting Industrialization (ISI): In the Global South, post-WWII trade policy focused on import-substituting industrialization to develop domestic manufacturing sectors, limiting imports to protect local industries.  The infant industry argument supported this approach, suggesting that emerging industries needed temporary protection to develop a comparative advantage. Countries like the U.S. in the 19th century and Japan until the 1970s followed this strategy. Challenges: Countries like Pakistan and India protected heavy industries but saw export growth primarily in light manufacturing (e.g., textiles), which likely would have developed even without tariffs. Reasons for Failure: Underlying Issues: Tariffs alone cannot address deeper challenges, such as a lack of skilled labor, infrastructure, and managerial competence. In some cases, tariffs were so high that they distorted the economy. For example, Pakistan had tariffs of over 250% in the 1960s, which hindered competitiveness. Small economies struggle to achieve economies of scale, making it hard to compete internationally. Rent-seeking behavior and lobbying further dissipate resources, preventing long-term industrial growth. Global South vs. Global North The Global South (developing countries) continues to face significant income disparities with the Global North (developed countries), driving development policy aimed at reducing these gaps. Early post-WWII strategies focused on building manufacturing sectors in the Global South, but many of these efforts faced challenges due to the issues noted above. Trade Liberation since 1985 In the mid-1980s, many developing countries began to shift away from import-substituting industrialization toward trade liberalization. Increased Trade Volume: This shift led to a substantial rise in the volume of trade, with both exports and imports increasing significantly as a percentage of GDP (as shown in Figure 11-2). Manufacturing Exports: There was also a notable rise in the manufacturing share of exports, with developing countries becoming more integrated into global production chains. Growth Impact: The effect on economic growth is mixed, with some countries benefiting more than others. However, enough success stories exist (e.g., South Korea, Mexico) to challenge the idea that import substitution alone can drive development. Graph Analysis: Figure 11-2: Shows a sharp rise in both exports and imports in developing countries since the 1980s, reflecting increased global integration following trade liberalization. Figure 11-1: Tariff rates in developing countries, including India and Brazil, have fallen dramatically since the early 1980s, moving from high protectionism (60%+ tariffs) to more open trade policies (below 10%). These charts illustrate the move away from protectionism and the success of trade liberalization in fostering economic integration and growth in developing nations. Asian Take-off Economic Growth: Countries like South Korea, China, and India have experienced significant economic growth, particularly through export-led development. As shown in Figure 11-3, South Korea’s GDP per capita rose sharply from the 1960s, with China and India following later. This aligns with the East Asian model of growth described in Krugman and Obstfeld’s framework, emphasizing industrialization and export promotion. Inequality Concerns: While rapid growth has raised living standards, there are concerns about rising income inequality within these countries. However, the critique that this growth was “rigged” to benefit elites is not strongly supported by evidence, as rising middle classes have also benefited. Graph Analysis: Figure 11-3 (The Asian Takeoff): Shows the rapid rise in GDP per capita relative to U.S. levels, particularly in South Korea, which began its ascent in the 1960s. China started its rise in the late 1970s, with India following in the 1990s. Figure 11-4 (Asia’s Surging Trade): Illustrates the growth in exports as a percentage of GDP, with South Korea leading this surge since the 1970s, followed by China in the 1990s. India’s export growth has been slower, though steady. This reflects the export-oriented strategies that have been central to the economic success of these countries, as discussed in the book.