INTERNATIONAL ECONOMICS

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SECTION 8. THE EXPANSION OF WORLD TRADE

Francisco L. Rivera-Batiz

BAU International University

April 4, 2018

Assignment #3 is due now!!!

Assignment #4 will be distributed next week.

Note that the final exam is on Wednesday, April 25th, from 6 to 9 PM. I will give you sample questions for the exam next week.

Because we need to make up the class we missed last week, we will be extending the class for 15 minutes each day, so we will end at 9:15 PM tonight and for the following weeks.

Section 8. The Expansion of World Trade: Multilateral and Regional Policies, Technology and Geography

Multilateral and regional trade agreements, the World Trade Organization (WTO), non-tariff barriers to trade, protectionism in high-income and developing countries, customs unions, trade creation versus trade diversion.

Readings: Krugman, Obstfeld and Melitz, chapter 2.

Michele Ruta and Mika Saito, “Chained Value,” Finance & Development, March 2014, 1-4.

Jagdish N. Bhagwati, “Dawn of a New System,” Finance & Development, December 2013.

Hans Peter Lankes, “Market Access for Developing Countries,” Finance and Development, Vol. 39, No. 3, September 2002.

By any measure, the last 20 years have seen a historic rise of international trade in goods and services almost anywhere in the world.

We talked a little bit about this at the beginning of this course.

Why has there been such a rise of international trade?

Barriers to International trade:

Transportation costs
Information and marketing costs
Barriers created by the public sector:

Tariffs

Non-tariff barriers (quotas,

licensing requirements, etc.)

The major reason why international trade has risen over the last 40 years has been the reduction in government barriers to international trade.

There are tariff and non-tariff barriers to trade.

Let us look first at tariff barriers.

Tariff Rate, t

Cost of Import Duties

t = --------------------------------------------------

Total value of Imports

Which country in the world has the highest average tariff rate on imports?

Which one has the lowest?

Countries with Lowest and highest

Average Tariff Rates on Imports, 2015

__________________________________________________

Lowest Tariff Highest Tariff

__________________________________________________

Switzerland 0.0% The Bahamas 27.6%

Singapore 0.0 Iran 18.7

Hong Kong 0.0 Bermuda 16.9

Georgia 0.2 Sudan 15.8

Iceland 0.3 Laos 14.3

Chile 0.6 Gabon 14.0

Mauritius 0.9 Central Af. Rep. 13.8

United States 1.7 Togo 13.7

European Union 1.8 Bangladesh 13.3

__________________________________________________

Weighted average, includes only manufactured products.

Source: United Nations, United Nations Conference on Trade and Development Handbook of Statistics, 2017.

But even countries with

high tariff rates today

have had a process of

tariff reductions

over time.

Average Tariff Rate, 1990-2015

________________________________________________

Country 1990 2015

________________________________________________

Bangladesh 106.6% 13.3%

Pakistan 50.9 11.5

Brazil 38.0 10.3

China 36.5 4.1

USA 4.1 1.7

European Union 5.8 1.8

Switzerland 0.0 0.0

Singapore 0.6 0.0

Hong Kong, China 0.0 0.0

________________________________________________

Weighted average; includes only manufactured products.

Source, UNCTAD, 2017.

Tariffs are just one type of barrier imposed by governments on international trade.

Non-tariff barriers to trade can be as effective in restricting trade.

Import quotas, strict sanitary requirements, subsidies given to domestic producers, import license requirements, all create barriers to trade.

To assess more carefully the extent of

liberalization of international trade over time,

to incorporate both tariff and non-tariff

barriers to trade, economist Jeffrey Sachs

–a colleague at Columbia-- joined

economist Andrew Warner in proposing

the following set of guidelines

in order to consider whether an economy

was open or closed.

They defined an economy to be open to international trade if:

Average tariff rates are less than 40 percent

Non-tariff barriers cover less than 40 percent of trade

Any black market premium on the exchange rate is less than 20%

4. Government has no monopoly of major exports.

Sachs and Warner then proceeded to compute whether various economies in the world were open or not in the period of 1970 to 1990.

At the time they compiled data for 93 countries.

In a more recent and comprehensive paper, Stanford University economists, Romain Wacziarg and Karen Horn extended the series up to 1998 and added countries excluded by Sachs and Warner in their original paper, expanding the sample to 141 countries.

(Romain Wacziarg and Karen Horn Welch, “Trade Liberalization and Growth: New Evidence,” World Bank Economic Review, Vol. 22, No. 2, June 2008, 187-231).

So, clearly, globalization has increased over time, but the process seems to have accelerated since 1985.

Before that date, most economies were closed to trade.

What happened in 1985 or 1986 that led to an acceleration of trade liberalization?

In 1986, the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) started.

This round started a process of global trade liberalization that is behind the globalization we have seen in recent decades.

Reductions in barriers to trade have occurred mostly through trade agreements among countries.

There are three types of trade agreements:

Multilateral Trade Agreements, which have occurred through the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization.

Regional or Bilateral Accords, such as Free Trade Zones (NAFTA, etc.) or Customs Unions (such as the European Union) or Free Trade Agreements between two or more countries.

The GATT was created in 1947, as an institutional means to foster international trade after the end of the Second World.

From 1947 to 1994, GATT functioned through rounds of negotiations which, over the years, led to multilateral agreements to reduce trade barriers among many countries.

The so-called Uruguay Round of multilateral trade talks began in 1986 and ended in 1994.

It was one of the most productive in terms of reductions in trade barriers and it established the basis for the acceleration of globalization over the last 20 years.

The GATT ended in 1994 and was replaced by the World Trade Organization (WTO) in 1995, which supervises the GATT agreements.

The WTO is constituted as an organization of over 150 member countries.

The most important decisions are adopted at the so-called Ministerial Conferences, in which WTO representatives from member countries meet to ratify agreements and to agree on new initiatives.

But the WTO has become the focus of criticism by many in poor countries, and has become a focus of attack from activist groups.

One of the major problems faced by the WTO is that many in developing countries see the process of trade liberalization generated by the WTO as having provided great benefits to rich countries not to poor countries.

Why?

The WTO sharply reduced barriers to the trade

of manufactured products, but the Agricultural Trade

Agreement reached by GATT was very weak and left

most protectionist measures in place.

¿And why is this unequal?

The problem is that rich countries use their economic policies to strongly support their agricultural sectors.

So, agricultural producers in low and middle-income countries cannot compete effectively in international markets with the heavily-subsidized producers in the rich countries, which can sell their products at lower prices.

Expenditures on Subsidies and Other Programs Protecting the Agricultural Sector, 2015

_______________________________________________

Millions of US Dollars

_______________________________________________

Japan 50,395

USA 90,849

European Union 111,591

Republic of Korea 22,930

______________________________________________

Source: OECD, Agricultural Policies in OECD Countries, 2017.

Professor Xavier

Sala-i-Martin has calculated

that the subsidies given by the European Union to cattle farmers add up to almost $6,000 per year per cow.

Given that a lot of these subsidies are not in the form of tariffs, the tariff rates discussed above do not reflect them.

It looks like the markets of rich countries are wide open to the products of developing countries.

But they are not.

So, the data suggests that high-income countries do have major policies that prevent agricultural producers in developing countries from competing in those markets.

But some economists object to the view that there is unequal trade in agricultural products.

On the one hand, high-income countries do have significant non-tariff barriers to agricultural imports from developing countries.

On the other hand, low-income countries also have their own barriers to agricultural imports from other countries, often at higher levels than those in high-income countries.

Tariff rates on agricultural imports

2010/2011

______________________________________________

Country Average Tariff rate

______________________________________________

Egypt 66.3

Tunisia 65.1

Morocco 42.9

India 38.5

Brazil 37.2

Iran 28.9

Algeria 23.3

______________________________________________

Source: UNCTAD, 2013.

And many developing countries also protect heavily their agricultural sectors through subsidies and other means.

Protectionism in the Agricultural Sector, Developing Countries, 2014-2016

_________________________________________________________________

Colombia Indonesia Turkey

________________________________________________________________

Tariff rate on imports (%) 12.0% 4.2% 42.2%

Weighted average, 2014

Milk Products tariff, 2014 (%) 43.5% 5.5% 129.6%

Subsidies to the agricultural 3,400 36,000 18,000

Sector (millions of $)

2016

Subsidies in 2016 13.7% 29.1% 29.2%

As a % of the value

of agricultural production)

__________________________________________________________________

Sources: OECD (2017) and WTO (2016)

The WTO has tried in the

last fifteen years to reduce

protectionism in the

agricultural sector of

high-income countries.

Just after the September 11

World Trade center attacks

In 2001, the WTO held a

ministerial conference in

Qatar.

This Conference led to the start of an initiative to use trade concessions from rich countries as a means for economic development of poor countries.

This was called the “Doha Road to Development.”

In the last WTO ministerial conference in Kenya, which ended in December 2015, there was an agreement that will reduce some export subsidies made to the agricultural sector in both high-income and low-income countries.

But the Doha negotiations did not lead to a comprehensive reduction of tariffs, import quotas and most other barriers to agricultural trade.

Despite the failure of multilateral trade negotiations in recent years, movements towards freer trade have continued in recent years through Regional and Bilateral Accords, such as Free Trade Zones (North American Free Trade Zone, etc.) or Customs Unions (such as the European Union or Mercosur).

In 1990 there were just 50 of these two types of trade agreements in the world.

But by the end of 2015 there were more than 325 such agreements.

China has 23 regional or bilateral free trade agreements, Japan has 24 and India has 28.

There is only one country in the world that did not have any major unilateral or regional trade agreement with other countries until recently.

Which country is this?

Mongolia is a member of the World Trade Organization, but until 2014 it did not have any major bilateral or regional trade agreement with any other country.

In July 2014, a bilateral trade agreement was signed by Mongolia with Japan.

Anyway, some economists are highly critical of regional free trade agreements.

They point out that these agreements are actually very dangerous.

Instead, they argue, trade liberalization should occur through multilateral agreements, as sponsored by the WTO.

So, what is the problem with regional trade agreements, or even with bilateral trade agreements?

Economist Jacob Viner, born

In 1892, was a professor of

Economics at Princeton

University in the U.S.

He was concerned about the

effects of customs unions on

International trade.

The problem he saw with customs unions –and other regional or bilateral trade agreements– is that they do not necessarily increase trade at a global level, they only promote trade among member countries.

In many cases, customs unions actually create barriers to –and reduce– trade with non-member countries.

Professor Viner concluded that customs unions have:

Trade creation effects with member countries

Trade diversion effects with non-member countries.

Let me give you an example

from Latin America.

The Andean Group

was created in 1969 and is

currently a customs union

between Bolivia,

Colombia, Peru, and

Ecuador.

An example of trade diversion is the impact that the creation of the Grupo Andino had in 1969 on international trade between Peru and Argentina (to the benefit of Colombia).

This case study is taken from research by:

A. Gupta and Maurice Schiff, Regional Integration and Agricultural Trade, Policy Research Working Paper No. 1805, The World Bank, Washington, D.C., 1997.

Exports of cattle to Peru

Millions of US$

________________________________________

Argentina Colombia

________________________________________

1966-1968 10.4 2.4

1970-1972 0.4 13.0

________________________________________

Gupta and Schiff (1997).

This issue of trade creation and diversion is very relevant

to one of the major recent developments in international

trade: Brexit, the decision by the United Kingdom to

leave the European Union.

Most observers argue that Brexit will have a strong negative effect on the international trade of the United Kingdom.

But Prof. Viner would argue instead that it may not be so bad for the United Kingdom.

He would argue that membership in the EU has created trade with the EU but reduced trade with other trading partners.

Exports of the United Kingdom,

Top Five Countries in 2014

__________________________________________________

% of Total U.K. Exports

of goods and services

__________________________________________________

World 100%

European Union 53.4%

United States 12.6

Switzerland 6.9

China 5.1

Hong Kong 2.4

__________________________________________________

Source: United Nations, World Integrated Trade System, 2016.

Imports of the United Kingdom,

Top Five Countries in 2014

__________________________________________________

% of Total U.K. Imports

of gods and services

__________________________________________________

World 100%

European Union 52.7%

China 9.2

United States 8.4

Canada 2.0

Japan 1.5

__________________________________________________

Source: United Nations, World Integrated Trade System, 2016.

Brexit might lead to lower trade with the EU but greater trade with other trading partners, including the United States, Canada, China and Japan.

Overall, the international trade of the U.K. with the rest of the world may not be affected that much in the long-run.

So, we have seen how international trade has grown dramatically since the 1980s.

Part of this growth of trade was due to the reduction or elimination of tariff and non-tariff barriers to trade imposed by governments.

This was done mainly through multilateral trade agreements forming part of the GATT and the WTO.

But there have been other forces in the growth of trade.

Technological changes in global production have given a sharp boost to global trade.

What are these technological changes in production?

Beginning in the eighties, world production has been revolutionized by the computer and information technology revolutions that have made possible a growing fragmentation or unbundling of production.

In manufacturing industries --such as the automobile, electronics, airline, and clothing industries, among many others– there is a rising tendency to subdivide the production of final goods into separate components –or activities– that can then be produced in various countries, with the final assembly also occurring in a different country.

The Boeing 787 airliners are assembled in the U.S. but the parts and components are produced mainly outside the United States.

The center fuselage is made by Alenia (a company in Italy); the flight deck seats by Ipeco (United Kingdom); the tires by Bridgestone (Japan); the landing gear by Messier-Bugatti- Dowty (France); and the cargo doors by Saab (Sweden).

This is one example of what economists call global value chains (GVCs) or multi-country manufacturing.

All over the world, final products—from automobiles and cell phones to pharmaceuticals and medical devices—are produced in one country using inputs from many others, organized mostly by large multinational companies.

According to UN-WTO data, close to 80 percent of global exports of goods and services now occur through global value chains.

The third major factor behind the growth of global trade has been the sharp drop in transportation and communications costs seen in the last few decades.

High transportation costs have been a deterrent for the growth of international trade.

It was Professor

Jeffrey Sachs, who

first examined in

detail the claims that

geography has an

important negative

effect on trade and,

therefore, on economic

development.

He finds that access to

coasts and navigable

rivers reduces transport

costs and raises

trade.

XXXXXXXXXXXX

But the information technology revolution has made the costs of transportation much lower in some sectors of the economy, specially in services.

The supply of some medical services, such as diagnostic radiology, for example, can be made over the internet, with patients or technicians sending X-rays, laboratory results, etc. over the internet, for the evaluation of doctors located far away.

American radiology units, for example, can send to India (Mumbai or Bangalore) their images, for a careful analysis by an Indian radiologist.

The cost of transmission is small and the analysis by the Indian radiologists can cost one-tenth of the cost of a radiologist in the United States.

Indeed, radiology companies in India do this now not only in the US but also in the United Kingdom, Singapore and other countries.

Trade in Services, as a % of Gross Domestic Product

__________________________________________________

Trade in Services(as a % of GDP), 2015

__________________________________________________

World Average 13%

Singapore 97%

Honk Kong, China 58%

Switzerland 30%

Panama 30%

United Kingdom 19%

India 14%

__________________________________________________

Source: World Bank, World Development Indicators, 2017.

INTERNATIONAL ECONOMICS

SECTION 9. THE DETERMINANTS OF AND THE GAINS/LOSSES FROM INTERNATIONAL TRADE

Francisco L. Rivera-Batiz

BAU International University

April 4, 2018

9. The Theory of the Determinants and Gains/Losses from Trade

Ricardian and Hecksher-Ohlin theories of comparative advantage, the potential gains and losses from trade, the sectoral effects of trade liberalization, the effects on wages and income distribution, the Stolper-Samuelson theorem, intra-industry trade, dynamic comparative advantage.

Readings:

Krugman, Obstfeld and Melitz, chapter 11.

Giorgio Barba Navaretti and Paolo Epifani, “Trade Policy Principles,” training module of the World Bank Course on “Trade Policy and WTO Accession for Economic Development: Application to Russia and the CIS,” Moscow, Russia, July 2004.

So, what are the determinants of international trade, and what are the consequences of trade?

We will examine first the theory and then the evidence on this topic.

We use a simple market analysis that focuses on the demand for and supply of a product in a market.

We shall look at the market for the product –let us say, sugar– before and after the economy opens to international trade (or before it eliminates barriers to trade).

The theoretical framework

that we use is the one

that most economists

adopt and it is part

of the discussion in

the classical

textbook on this topic,

written by Paul Krugman, professor of economics

at NYU, and Maurice

Obstfeld, who is a professor at the University

of California at Berkeley

but also is currently

research director at the IMF.

We start by analyzing a market that is not initially involved in any international trade (we call it autarky).

We will then analyze what happens to this market if it allows (opens up) to international trade.

Let us assume that the country (or nation) is Puerto Rico and the market is the market for sugar.

As you know, a market consists of two sides: demand and supply.

Let us look first at the demand for sugar in Puerto Rico.

What determines the demand for sugar

in Puerto Rico or any other place. That is,

what factors influence the demand for sugar?

Consumers in Puerto Rico buy sugar based on their tastes but of course limited by the budget (income) that they have available and the price of sugar.

Usually, as the price of a product rises, the quantity demanded for that product declines.

So, as the price of sugar rises, the quantity demanded of sugar drops.

Demand for Sugar
in Puerto Rico

Price of

a pound

of sugar

in dollars

In Puerto

Rico

Quantity demanded of sugar in Puerto Rico

during a week, in thousands of tons of sugar

2. Supply of Sugar in Puerto Rico.

What are the factors that determine the supply of sugar in Puerto Rico (remember the economy is under autarky)?

Agricultural producers in Puerto Rico produce sugar by using inputs or factors of production, such as workers (laborers), land, fertilizers, machinery, etc.

They determine how much sugar they are going to produce with the objective of maximizing profits.

If the price of sugar in Puerto Rico rises, suppliers have an incentive to increase production, so that they can make more profits.

The positive relationship between price and quantity produced in the market is represented diagrammatically by the supply curve.

Supply curve of sugar in Puerto Rico

Quantity of sugar produced in Puerto Rico,

in thousands of tons a week.

Price of

sugar in

Puerto

Rico

The price and quantity sold in a market is established through the interaction of demand and supply.

The market is in equilibrium when demand and supply are equal to each other.

If the market is not in equilibrium, then prices will change, moving demand supply towards their equilibrium value.

Domestic Market Equilibrium

QD,QS

- - - - - - - - - - - - -

Thousands of tons of sugar sold in Puerto Rico in a week

Domestic Supply Curve

Domestic Demand curve

So far, we have carried out our analysis within the context of an economy that is closed to international trade, that is under autarky.

What happens to this analysis when

there is international trade?

The most important change is that, once the product is available from world markets, domestic or internal prices must adjust to international market prices.

If the price of sugar is higher in world markets than it is initially in Puerto Rico, then it must rise to match the world market price of sugar.

No producer of sugar in Puerto Rico would be willing to sell their sugar below the world market price, since they can always ship the product abroad and obtain the world market price (minus the transportation costs, which are very small).

If the price of sugar is lower in world markets than in Puerto Rico initially, then the price of sugar in Puerto Rico will go down to match world market prices.

No buyer of sugar in Puerto Rico will pay more than the global market price since he or she can always import the product more cheaply from abroad (plus some minor transportation costs).

Let us examine the changes diagrammatically.

We first choose the case when the price of sugar in world markets is below the price of sugar in Puerto Rico under autarky.

The domestic (internal) price of sugar in Puerto Rico under autarky was P*, as a previous diagram showed.

Let us assume that the world market price is PFT .

Let us therefore look at the changes in the sugar market in Puerto Rico, as the market opens up to international trade.

Market Equilibrium under Free Trade

QD,QS

- - - - - - - - - - - - -

E (equilbrium under autarky)

Domestic Supply Curve

Domestic demand curve

PFT

In this case, the local price of sugar in Puerto Rico goes down, which raises the quantity consumed but reduces the quantity produced.

The market for sugar becomes an import market, where sugar is imported.

The result is that different groups in the economy are affected differently.

The impact on consumers is positive: they can consume more sugar at a lower price.

But the impact on producers is negative: they have to sell at a lower price, which reduces their profits and may force them to cut production or even close down.

So we have seen what happens when a market opens up to international trade when there is an import market.

What happens when the local market becomes an export market?

In an export market, the price of the product in world markets is higher tan the initial domestic price.

Market Equilibrium under International Trade:
An Export Market

QD,QS

- - - - - - - - - - - - -

E (equilibrium under autarky)

Domestic Supply Curve

Domestic Demand Curve

PLC

In this case, domestic producers gain since they can now sell their product at higher prices.

But consumers in this export market are actually hurt because they have now to pay more for sugar.

Sometimes it is said that consumers always benefit from free trade. It is not true.

In fact, this is exactly the case in some countries where international trade bring higher prices of agricultural products, which hurts consumers, especially the poor.

As a conclusion, then, the impact of trade on production depends on whether the sector is an export or import sector.

The producers of export products gain because their prices are higher in world markets.

But the producers of import products lose because the prices at which they can sell their products go down.

But which industries grow and which disappear? That is, which industries become export industries and which become import industries?

In other words, what determines the competitiveness of domestic industries (whether they can sell at a price below or above the world market price) and, therefore, whether they become export or import industries?

The British economist

David Ricardo (1772-1823)

was the first to seriously

examine this issue.

Ricardo argued that the most important factor in determining what products a country should export and import is based on the comparative or relative productivity of different firms or industries in the country.

In other words, if the country can produce computer chips or software at a lower cost relative to producing steel or aluminum, then it should be exporting computer chips and software and importing steel and aluminum.

This was called the theory of comparative advantage because it says that a country will export products in which it has a comparative –or relative– advantage in producing.

Note that it does not say that countries will export products in which they are more productive relative to other countries.

It says that countries will export those products in which they are more productive relative to other products that can be manufactured within the country.

This is important because there is the fear that, if some countries are more productive than others in producing everything (they can produce computers more cheaply, or produce clothing more cheaply, or anything else), then they will export everything, and countries that are not as productive will end-up importing everything from the most productive countries.

This type of viewpoint, which Ricardo argues is fallacious, leads policymakers in some countries to impose tariffs on imports from countries that are highly productive or have lower costs of production.

But Ricardo argued that, for international trade, countries that are the most productive in everything compared to other countries, will not find it profitable to export everything but instead, they will profit by specializing in what they themselves do best, that is, those sectors in which they have the greatest productivity.

The reason is because they can compete more effectively and profit more by focusing on producing those products that they themselves can produce at the lowest cost.

If they focus instead on producing everything, there will be many firms that will be producing and exporting products that generate much lower profits than those of the sectors in which the economy is the most productive.

Note that this is a concept that applies to many other fields and to life itself.

It is best understood by using a life-example.

Even if, as a person, you are more talented than others in every field , you should focus your career in the field in which you are the most talented and relatively more productive (can derive the most profit).

For example, suppose you are very talented with your hands. No one else in your university and even in the country has the hand skills you have and so you could be a great medical surgeon. But you are also very fast at typing, among the best in your school and maybe top-twenty in the country.

Should you follow both careers: surgery and secretarial assistant? Maybe spend half a week as a surgeon and half a week as secretarial assistant?

So, Ricardo argued that countries will export goods that they have a comparative advantage in producing, that is industries in which they can produce relatively more efficiently or at relatively low cost.

But what Ricardo did not discuss that much was what are the factors that make a country most productive in some sectors of production relative to others.

One could argue that the United States is more productive in producing high-tech products, such as Intel chips, and less productive in producing steel and aluminum.

So, according to the theory of comparative advantage, the US should export high-tech products and import steel and aluminum from other countries.

But what makes the US relatively more productive in producing computer chips relative to steel or aluminum?

This is the issue that two Swedish economists,

Eli Hecksher and Bertil Ohlin, decided to examine.

We will discuss their contribution in the next class.