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2. WHY DO WE TRADE? - Part II

2. WHY DO WE TRADE? - Part II. 2. WHY DO WE TRADE?. 2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage 2.2 Modern Trade Theory: Heckscher-Ohlin Model 2.3 Alternative Trade Theories: Results from Practical Evidence. From Trade Theory To Practice.

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2. WHY DO WE TRADE? - Part II

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  1. 2. WHY DO WE TRADE?- Part II

  2. 2. WHY DO WE TRADE? • 2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage • 2.2 Modern Trade Theory: Heckscher-Ohlin Model • 2.3 Alternative Trade Theories: Results from Practical Evidence 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  3. From Trade Theory To Practice • Many researchers have tried to test the Ricardianand Heckscher-Ohlin theories • First simply by observing: Adam Smith and Ricardo • Latter statistical calculations(data collection) • In many cases they have indeed found evidence which supports these theories • Finland does not grow bananas! • But also contradicting evidence has been found • Trade in manufactured goods, intra-industry trade 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  4. Problems with H-O Model • Why does not a country with cost advantage capture the whole export market? • imperfect markets (monopolistic and oligopolistic) • nonhomogeneous products (product differentiation) • transportation costs • trade barriers This were not considered in H-O model! 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  5. Problems with H-O Model continued • Furthermore, Heckscher-Ohlin theorem based on factor endowments would imply that trade should occur primarily between pairs of countries with very different relative factor endowments 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  6. Problems with H-O Model continued • HO theory seems to explain quite well the trade betweenindustrialized and developing countries, but a large volume of trade takes place among industrialized countries that often have similar relative factor endowments 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  7. The composition of world exports Largest part of trade in manufactured goods. Source: WTO, International Trade Statistics 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  8. The composition of world exports, 2012 Source: WTO International Trade Statistics 2013 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  9. Strong Challenges to the Traditional Trade Theories 1.Trade among similar economies • For instance, who are Finland's largest trading partners? 2.Intra-industry trade • What do we export, for instance, to Sweden and what do we import from there? 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  10. Intra-industry Trade by Country, 2006* *The index ranges from zero to 100 with a value of 100 indicating all trade of a country is intra-industry. 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  11. Intra-industry Trade in Manufactures, 1997-2008 average, selected countries Source: OECD EconomicGlobalizationIndicators 2010 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  12. New Trade Theories (NTT) • Next we present some new trade theories, which base international trade on economies of scale, network effects, imperfect competition, tastes of variety, and differences in the development and spread of new technologies over time among nations 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  13. WSJ, 19.8. 2010 China Cultivates Taste for German Cars Modification of H-O Model A. The role of taste - production bias vs. taste bias B. The role of trade barriers C. Classification of inputs • capital – labor • arable farmland, raw materials, human capital, man-made capital, high-skilled labor, unskilled labor • If these modifications are made to H-O model, a larger proportion of trade can be explained by the model… 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  14. New Trade Theories 1. Increasing returns to scale in the production process* economies of scale • Indivisibilities • Division of labor • Geometrical reasons • Inventories • Once-and-for-all inputs • International trade allows a country to specialize in industries where average costs fall as additional resources are utilized * Increasing returns to scale exist when a proportionate increase in use of factors of production results in a greater than proportionate increase in output. 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  15. New Trade Theories cont.Economies of Scale in Imperfectly Competitive Markets • Perfect competition, as assumed by H-O model, can exist only if economies of scale are not extensive • Economies of scale are common in the real world of manufacturing and in some parts of services sector • Increasing returns to scale (economies of scale) and imperfect competition can explain some of the intra-industry trade 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  16. P Dworld AC Qe MRworld New Trade Theories cont.Economies of Scale in Imperfectly Competitive Markets continued Trade can also create an otherwise unsustainable industry where large economies of scale exist. Ddom AC MC MRdom 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  17. New Trade Theories continued 2. Intra-Industry Trade Cab be explained by • Taste of Variety and Differentiated Products • People have a tremendous diversity of taste and are willing to pay for it at the marketplace • Product differentiation and variety of taste leads tospecialization and imperfect competition • Taking advantage from division of labor in industries that exhibit economies of scale we can consume a larger variety of products and services on a lover cost 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  18. Intra-Industry Trade cont. • Border trade when countries share a long border (transportation cost) FA Country A CA CB Country B FB 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  19. New Trade Theories continued 3. Technological Gap and Product Cycle • Heckscher-Ohlin theory is static • Some economists have suggested that perhaps the composition of trade depends on dynamic factors, such as technological change 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  20. New Trade Theories cont.:Product Cycle • One interesting hypothesis is that new products pass through a series of stages in the course of their development, and their comparative advantage position changes as they move through this product cycle 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  21. Product Cycle cont. • Some countries seem to have ability to supply a constant flow of new products: innovation – imitation • Product cycle: new product maturing product standard product the comparative advantage of productionchangesduring the product cycle 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  22. New Trade Theories cont.:Product Cyclecont. Domestic production Exports, domestic production I II III IV (X-M)D Time Imports, foreign production Foreignproduction 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  23. New Trade Theories…Product Cycle cont. I Product development and sale in domestic market II Growth in exports as foreign demand springs up III Decline in exports as foreign firms begin to produce for their home markets IV Country becomes a net importer as foreign prices fall • At each stage different inputs dominate 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  24. At each stage different inputs dominate I Product development and sale in domestic market • innovative, skilled labor, and financial resources needed II Growth in exports as foreign demand springs up • marketing skills and financial resources needed III Decline in exports as foreign firms begin to produce for their home markets • product starts to be mature and know-how penetrates to other markets, cheap labor becomes important IV Country becomes a net importer as foreign prices fall • standard product, mass production, cheap labor dominates 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  25. New Trade Theories cont.: 4. The Gravity Equation • Why does one country trade a great deal with one trading partner and far less with others? • Compare, for example, Finland trading with Sweden, Russia, Germany and rest of the EU... and on the other hand with some African countries 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  26. New Trade Theories cont.:The Gravity Equation R = Resistance variables Ti=trade with country i • According to this formula a country's trade shares are a) positively related to the size of other national economies (measured as GNP) 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  27. New Trade Theories cont.The Gravity Equation continued b) and negatively related to so-called resistance variables, factors that discourage a particular trade flow • such factors can be transportation cost, trade barriers that are not the same for all trading partners, among others 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  28. New Trade Theories cont.5. External Economies of Scale • Internal scale economies occur when a firm's AC falls as the output of the firm increases • External scale economies occur when firms AC falls when the output of the industry increases 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  29. New Trade Theories cont.External Economies of Scale cont. AC The advantage of a long-established industry where scale economies are important. • ACC • ACJ ACJapan ACChina QC QJ QCars Cumulative 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  30. Gains from Division of Labor: The Finnish Case • By taking advantage of comparative advantage and international trade, Finland has successfully increased the standard of living far beyond the point where it would be if it had tried to produce everything itself • However, the proportion of exports to GDP is still relatively low in Finland compared to some other small industrialized countries 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  31. Gains from Division of Labor: Finnish Case cont. • In order to maintain its position in the international income comparisons, Finland has to expand further its foreign trade • What could be some of the possible new areas to expand? 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  32. International Division of Labor: How Is It Changing? • International division of labor does not only mean trade of commodities and services • It also allows us to follow the scientific, technological as well as other societal developments which take place elsewhere 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  33. International Division of Labor: How Is It Changing? continued • For internationalization of companies these type of dynamic advantages are equally important as are the static advantages gained from the trade of goods • There are clear signs that the participation of Finnish companies in international division of labor has changed over time 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  34. International Division of Labor: How Is It Changing? continued • By simplifying we can say that up till 1980s Finns were exporting and importing goods • Since then Finnish companies have also started producing internationally • This is not really a new phenomenon, but lately it has become more intense than ever before 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  35. Number of Employees of Finnish Companies in Finland and Abroad, 2002 - 2011 Abroad in Finland 2012, forecast in Finland 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  36. Investments to and from Finland, million euros Source: EK, investointitiedustelut 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  37. Hi-Tech Exports, % of exports in some OECD countries

  38. Hi-Tech Imports and Exports in Finland Imports Exports Source: www.tulli.fi 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  39. 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  40. Price of International Division of Labor: Finnish Case • As pinpointed above, we have gained a lot by participating in the international division of labor. But it has also caused some problems • The dependence of countries on each other has increased, and at the same time individual countries have become more vulnerable to changes in the world economy 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  41. Price of International Division of Labor: Finnish Case continued • Finland has been affected not only by the worldwide economic fluctuations, but also by changes in"the rules of the game" in world trade as well as by monetary and exchange rate disturbances 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  42. Price of International Division of Labor: Finnish Case continued • For instance the fluctuations in the US dollar and the debt problems of developing countries have affected Finnish economy in past • and EU debt problem now!!! • By using exchange rate policy Finland was from time to time successful to eliminate the losses in its export income, but individual firms or industries often got hurt by fast changing exchange rates 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  43. Price of International Division of Labor: Finnish Case continued • In EMU there is not any more the possibility of national exchange rate policy • Price changes of some natural resources, such as crude oil, have often had an influence on employment and inflation rates • Also the joint environmental problems are an increasing concern 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  44. Price of International Division of Labor: Finnish Case continued • Changes in world's production patterns: due the technological diffusion the production of many products moves where the production costs are lowest (this happens when in the production cycle the standard product stage has been reached; after that capital and factor costs are about the same in all countries because of international trade and so labor costs become most important) • BUT this might change dramatically when even larger part of production is produced by robots in the future! 2. Why Do We Trade? - 2.3 New Approaches to Trade Theory

  45. Nokia Plans 4,000 Job Cuts to Shift Phone Assembly to Asia By Diana ben-Aaron - Feb 8, 2012 Bloomberg Nokia Oyj will eliminate 4,000 jobs, including at its oldest factory in Finland, as the mobile-phone maker shifts manufacturing to Asia, its largest market. Handset production will end in Hungary, Mexico and Finland, where the plants will focus on final adjustments to finished phones, Espoo, Finland-based Nokia said today. Most of the production will move to existing factories in Beijing and Masan, South Korea, spokesman James Etheridge said.

  46. That’s all folks! On next lecture: 3. INTERNATIONAL TRADE POLICY 2. Why Do We Trade?

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