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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

2. WHY DO WE TRADE?- Part II


2 why do we trade

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


From trade theory to practice

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


Problems with h o model

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


Problems with h o model continued

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


Problems with h o model continued1

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


The composition of world exports

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


The composition of world exports 2012

The composition of world exports, 2012

Source: WTO International Trade Statistics 2013

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


Strong challenges to the traditional trade theories

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


Intra industry trade by country 2006

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


Intra industry trade in manufactures 1997 2008 average selected countries

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


New trade theories ntt

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


Modification of h o model

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


    New trade theories

    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


    New trade theories cont economies of scale in imperfectly competitive markets

    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


    New trade theories cont economies of scale in imperfectly competitive markets continued

    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


    New trade theories continued

    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


    Intra industry trade cont

    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


    New trade theories continued1

    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


    New trade theories cont product cycle

    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


    Product cycle cont

    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


    New trade theories cont product cycle cont

    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


    New trade theories product cycle cont

    New Trade Theories…Product Cycle cont.

    IProduct development and sale in domestic market

    IIGrowth in exports as foreign demand springs up

    IIIDecline in exports as foreign firms begin to produce for their home markets

    IVCountry 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


    At each stage different inputs dominate

    At each stage different inputs dominate

    IProduct development and sale in domestic market

    • innovative, skilled labor, and financial resources needed

      IIGrowth in exports as foreign demand springs up

    • marketing skills and financial resources needed

      IIIDecline 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

      IVCountry 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


    New trade theories cont

    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


    New trade theories cont the gravity equation

    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


    New trade theories cont the gravity equation continued

    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


    New trade theories cont 5 external economies of scale

    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


    New trade theories cont external economies of scale cont

    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


    Gains from division of labor the finnish case

    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


    Gains from division of labor finnish case cont

    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


    International division of labor how is it changing

    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


    International division of labor how is it changing continued

    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


    International division of labor how is it changing continued1

    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


    Number of employees of finnish companies in finland and abroad 2002 2011

    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


    Investments to and from finland million euros

    Investments to and from Finland, million euros

    Source: EK, investointitiedustelut

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


    2 why do we trade part ii

    Hi-Tech Exports,

    % of exports in some OECD countries


    Hi tech imports and exports in finland

    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


    2 why do we trade part ii

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


    Price of international division of labor finnish case

    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


    Price of international division of labor finnish case continued

    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


    Price of international division of labor finnish case continued1

    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


    Price of international division of labor finnish case continued2

    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


    Price of international division of labor finnish case continued3

    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


    Nokia plans 4 000 job cuts to shift phone assembly to asia

    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.


    That s all folks

    That’s all folks!

    On next lecture:

    3. INTERNATIONAL TRADE POLICY

    2. Why Do We Trade?


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