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Comparative Advantage

International Trade – Session 1

Daniel TRAÇA

Globalization I:
Increased trade in goods and services

•! International Trade involves mostly exchanges among high income


•! Developing countries have increased their relevance, particularly East Asia,

but are still a small part.

Trade in services and merchandise

•! Most of world trade is in goods Share of goods and commercial services in total trade

(merchandise) – 82%. (Percentages, based on balance of payments data)

Export Shares Import Shares

Commercial Commercial
•! Services trail behind, but are Goods Services Goods Services

the fastest growing World 81.4 18.6 81.4 18.6

North America 77.2 22.8 85.9 14.1

Latin America 86.0 14.0 84.1 15.9

–! Outsourcing is the latest trend Western Europe 78.8 21.2 79.4 20.6

Africa 81.5 18.5 76.8 23.2

Egypt 42.5 57.8 68.2 31.8

Nigeria 93.8 6.2 71.1 28.9

Asia 85.7 14.3 81.3 18.7

India 71.4 28.6 73.4 26.6

Indonesia 92.8 7.2 72.3 27.7

Japan 87.1 12.9 74.8 25.2

Globalization II:
Foreign Investment - complex strategies of

Drivers of Modern Globalization

•! Lower transport and

communication costs
•! Development of international
–! The WTO
–! Regional Trade Agreements

•! Political decisions toward de-

regulation and liberalization of
trade and FDI regulations

Theory and practice of international trade
and foreign investment

•! Why do countries export certain goods and imports others?

•! What do countries and populations gain and loose from trade?
•! Why do multinationals exist and what are their effects?
•! Why do governments protect their industries and what are the costs and
•! What are the effects of different protectionist instruments?
•! How do the institutions that regulate global trade work?
•! What have been the economic and social consequences of the rise in trade
and foreign investment with developing nations?
•! What has globalization brought to developing countries?

Organization of the course

•! Theories of international trade •! The effects of modern

–! Comparative advantage globalization
–! Gains from trade: static and –! Trade and the developing
dynamic countries
–! Losers and winners –! Multinationals and FDI
–! The effects in industrialized
•! Trade policy countries
–! Policy Instruments
–! The case for free-trade and •! Institutions of global trade
exceptions –! The W.T.O
–! Policies for Strategic sectors –! Regional agreements
–! Political economy and the realist

Materials and exams

course website: www.danieltraca.com

•! Download class slides before class from website

–! Also available at GES

•! Practice exams and answer keys available at website.

List of required sections available from website

•! Recommended textbook
–! “International Economics, 6th ed”by Krugman P. and Obstfeld M., Addison-Wesley
•! Older edition available in French version
•! Additional readings available at website

The theory of Comparative Advantage

Absolute Advantage

•! “It is the maxim of every prudent master of the

family, never attempt to make at home what it will
cost him more to make than buy … What is prudent
in the conduct of every family can scarce be folly in
that of a great kingdom If a foreign country can
supply us with a commodity cheaper than we
ourselves can make it, better buy it of them …”
–! Adam Smith 1776

Absolute Advantage

Output per worker (productivity)

Manufacturing Food
(pieces) (bushels)

NORTH 10 8


Gains from specialization

Output •! North specializes in

Manufacturing and South in
before after Food

•! There is more of both goods, if

1 northerner
specialization follows absolute
(FOOD to 8 Food 10 Manuf
MANUF) advantage

1 southerner
(MANUF to 3 Manuf 9 Food

Comparative Advantage

•! "A country … enabled to manufacture

commodities with much less labour that her
neighbours may, in return for such commodities,
import a fraction of the corn required for its
consumption, even if … corn could be grown
with much less labour than in the country from
which it was imported."
–! David Ricardo

Comparative Advantage
North is MORE productive in both goods

Output per worker (Productivity)

Manuf Food
(pieces) (bushels)

NORTH 10 10


Even so, there are gains from

Output •! A country has Comparative

Advantage in a given good if
before after its relative productivity in
that good is higher than in
other goods
1 northerner
(Food to 10 Food
Manuf) Manuf
•! Specialization according to
Comparative Advantage
creates value, by increasing
2 southerners
2x3 2x9 output.
(Manuf to
Food) 6 Manuf 18 Food

How does the market work?

•! Does the decentralized international market achieve this pattern of

specialization? How?

•! Who benefits and who looses from international trade in the free-market?
–! Among individuals within a country?
–! Among countries?

In Autarky...

Northern worker
They work in both
sectors, and trade
among them at the
autarky relative price

The relative price

P=p Manuf/pFood

•!In equilibrium, workers

must be indifferent
Manuf between the two
•!They must get the
same wage

The Production Possibility Frontier, the
price and the choice of consumers

Manuf Production
10 frontier

Consumer choice…
…determines the allocation of labor
in Manuf in autarky

Slope = -1
Northern workers

-ProdF / ProdM MRS=MUFood/ MUManuf = 1/P =1

UN In equilibrium
P=1, to ensure
that both goods
are produced
-1/PN = -1

10 workers in Food
Food in autarky

The prices in autarky (closed)

The relative price of Manuf (P) denotes how many bushels of

Food for one piece of Manuf.

Manuf Food
(pieces) (bushels)

NORTH 10 10 10/10 = 1

SOUTH 3 9 9/3 = 3

In Autarky...

Northern worker Southern worker

North South

Food The Northerners

Food The Southerners
trade among them trade among them
at the autarky price at the autarky price
PN = 1 PS= 3

Manuf Manuf

Production Possibility Frontier

North South
Manuf Manuf

Average [production =
consumption] basket in autarky


PN =1 -1

UN +1

PS =3 -3

-1/PN -1/PS

10 Food 9 Food

Wages and productivity

•! Are the wages the same in both sectors? Why?

–! If not, where are they higher? Why?

•! Are they the same in both countries? Why?

–! If not, where are they higher? Why?

The beginnings of Trade…

•! Manuf is relatively cheaper in the North.

–! An enterprising Northerner takes 1 Manuf to the South and
exchange it for 3 Foods.
–! Back in the North, she could sell 1 Foods for 1 Manuf with a net
gain of 1 Food.

•! There are gains from exchange because prices are

different: Trade occurs!
–! What happens to the relative price of Manuf in North? …
–! And in the South?

Openness in the Short Run...

North 2 . Prices adjust to South

new scarcity
PN >10/10 P rises in the North and PS < 9/3
Food falls in the South

1 . Trade
starts due
to arbitrage
Manuf Manuf

In the Long-Run, there is re-
North South
Each country specializes
PN >10/10 PS < 9/3
completely in, and exports, the
Food good in which it has Food
comparative advantage

Manuf Manuf
There is one world price,
which is between the
initial prices
10/10 < PW <9/3

3 . Factors (workers) respond to new prices and profitability -- specialization

In the Long-Run, there is re-
North South
Each country specializes
PN >10/10 PS < 9/3
completely in, and exports, the
Food good in which it has Food
comparative advantage

Manuf Manuf
There is one world price,
which is between the
initial prices
10/10 < PW <9/3

3 . Factors (workers) respond to new prices and profitability -- specialization

How to determine the world price?

North and South produce


only Manuf
Relative Supply (RSW)
3 World
North and South specialize North produces Manuf only
completely South produces both

1<PW <3

North and Relative Demand (RDW)
South South produces Food only World
produce North produces both
only Food


The Gains from Trade according to
Comparative Advantage

North South
Manuf Manuf


UN US(Food)

-1/PW US
10 Food 9 Food

The Gains from Trade according to
Comparative Advantage

North South
Manuf Manuf


UN US(Food)

-1/PW US
10 Food 9 Food

Some unrealistic features of the
model, so far…

•! What if there are transport costs?

•! What if there are more than two goods?

•! What if factors cannot adjust to other sectors?

•! What if there are more than one factor?

•! Why is there always complete specialization?

Transport Costs and Non-traded

•! If there are transport costs, the competitiveness edge of a country

must more than make up for this transport cost.

•! Otherwise, the good will not be traded, even if it is cheaper to

produce in one country. This good is called non-tradable.
–! In reality, economies spend large proportions of their income in these
type of goods.

•! It can become tradable, if transport costs fall or the productivity

advantages widen (globalization).

Global markets vs. local markets

•! Tradable goods can travel

across borders and have Non-
international markets that set tradables
•! Non-tradable goods have their •! Cement •! Textiles
prices set by supply and •! Housing •! Machinery
demand in local markets. Goods •! McDonalds •! Almost all
Hamburger goods
–! Often, the same good exists in
different countries because it
is produced locally. •! Hairdressers •! Consulting
•! Government •! Banking
•! With globalization, many goods Services •! Telecom’s
•! Auto-repair •! Tourism
and services have become •! Almost all
tradable. services


•! Comparative advantage:
–! Consumers react to price differences and buy from lower price
foreign producers the goods in which their country does not have
comparative advantage (gains from exchange).
–! Producers react to price differences and allocate resources to
industries where relative productivity is higher, exporting those
goods (gains from specialization).

•! Every country always has an industry in which it has

Comparative Advantage and it is competitive in world
markets for that industry.

Specific factors and Costs of
International Trade – Session 2

Daniel TRAÇA

A summary of the last session

•! Globalization
–! Growth of Trade and Foreign Direct Investment; Mostly among rich
–! Developing countries rising fast (East Asia) but still small;

•! Comparative advantage: a key concept!

–! Global output increases when countries specialize in goods where the
relative productivity is higher.
–! It can be due to relative differences in the productivity of labor.

This session

•! Competitiveness and Comparative Advantage

•! Specific factors and costs of adjustment

•! Decreasing returns and incomplete specialization

The myth of competitiveness

•! Free trade is beneficial only if your country is productive enough to

stand up to international competition.
–! Not true! Trade is always possible and beneficial for both parties, if
markets are at work.
•! A country can always be competitive in the industry where it has
comparative advantage. How?
–! Its wages will be lower than the more productive country.
–! It is different from firms. Countries do not compete for workers, like
firms do! Firms that are not productive within a country cannot compete
because, if they pay lower wages, they will not attract workers.

Wages and productivity

•! Less productive countries will compensate by paying lower wages.

–! Lower wages are the result of lower productivity.
•! In most countries, this is due to:
–! Bad infrastructure Insufficient investment
–! Low education Poor institutions

Productivity (%US level) 1963-1996 % increase

1963 1996 Productivity Real wages

United States 100 100 49 34
Germany (W) 58 91 133 220
Japan 32 76 260 220

South Korea 14 50 432 n.a.

The competitiveness of sectors of
comparative advantage

•! An industry is competitive if its productivity advantage vis-à-vis its foreign competitors

is higher than the country’s wage disadvantage. This will happen in industries with
comparative advantage.
–! The wage gap will among countries correspond to their average productivity gap.

–! In the industry of comparative advantage, the productivity gap will be wider than the wage

•! So, if in an industry we see differences in wages that are larger than the productivity
differences, that is OK! It just means that one is the sector of comparative advantage.

The case where FACTORS cannot
UN! UN(average) are the gains from
North exchange.
•! They occur because, in autarky, North
Manuf had too much Manuf relative to Food,
compared to the South.
•! So, even if production does not change,
10 1<P W
<3 there are incentives to exchange Manuf
for Food with the South.
UN(Manuf) UN(average) ! UN(Manuf) are the gains
from specialization.
•!They occur when resources are able to
UN(average) move to the sector of comparative
consumption] basket in
Average [production =

UN advantage (Manuf in the North).


UN(Food) At home:
do the same exercise
for the South!
10 Food

If Adjustment costs are high, trade
becomes highly political

Effects in the North Effects in the South

The North imports Food, and the price of Manuf The South imports Manuf, and the price of Manuf
rises relative to autarky falls relative to autarky

•!The Manuf producers in the North (exporters) •!The Food producers in North (exporters) are
are better off, but ... better off, but ...
•! Food producers (import-competing) are worse •! Manuf producers (import-competing) are worse
off off

•!The gains outweigh the losses and the average •!The gains outweigh the losses and the average
worker is still better off. worker is still better off.
•!The North is a net producer of Manuf, for which •!The South is a net consumer of Manuf, for which
the price has risen. the price has fallen.

International Trade has positive benefits (gains from exchange), but is hot politics. It is similar to
technological progress that displaces workers.

The Political Economy

•! What happened to the owners of the specific factors?

–! In the North, the rising price of Manuf has benefited Capital owners, but it has
hurt Land owners.
–! In the South, the declining price of Manuf has hurt Capital owners, but it has
benefited Land owners.
–! The impact for workers that are mobile is ambiguous. In the North, the wage
grew for those that consume food, but declined for those that enjoy Manuf.

•! But the net gains are positive.

–! It should be possible to take from the winners to compensate the losers, but this
compensation is difficult.
–! Again, a political quagmire due to specific factors, that will lead to pressure for
•! Example: the plight of landowners

Dealing with Adjustment Costs

•! Trade losers: a concern?

–! Is trade different from technological innovation?
•! Losers may be able to find new jobs at lower wages: in the US, wage losses upon
reemployment (+ or - 13%) are similar to the rest of manufacturing

•! Trade politics
–! Organization matters, and losers are more likely to get organized.
–! The small gains of the many versus the large losses of the few.

•! Temporary measures may help smooth the costs.

–! Subsidies and Protectionism
–! Without credibility, they become permanent and are very costly

Costs of Protectionism

United Japan Korea European

States 1989 1990 Union
1994 1990
# industries surveyed 21 47 49 20

Consumer cost
Billions of US$ 70* 74 - 110 12 - 13 67 - 100

Share of GDP (%) 1.2* 2.6 – 3.8 3.8 – 4.3 1.1 – 1.6
Average tariff equivalent (%) 35 180 170 40
Jobs “saved” (‘000) 190 180 174 - 405 1,500

Share of total employment 0.2 0.3 0.9 – 2.0 1.1

Cost per job saved

170 600 33 – 67 70
(‘000 US$)
* Estimates for the whole economy. The 21 highly protected industries were responsible for $32b.
(incl. $24b for textile and apparel). The remaining data concerns only the highly protected industries.

Short-term protection… becomes
long-term! An example

Dealing with Adjustment Costs

•! Unemployment subsidies
•! e.g. the Trade Adjustment Assistance in the US
–! Danger: discouraging job-search and creating long-term

•! Retraining
–! The difficulty is that the mean worker displaced in manufacturing
in the US is aged 38.6, has 12.3 years of education, and has a
job tenure of of 6.5 years
–! Life-long learning is a better option.

Incomplete specialization I
Decreasing returns and the concavity of the PPF

•! Reasons for decreasing returns

to labor
–! Specific factors (e.g. Land,
–! Labor is increasingly less
productive (exhaustion,
L2 L1
breaks) Employment


Employment in Manuf

Incomplete specialization II
The equilibrium with decreasing returns
Recall that P is the relative
price of manufactures

w = MPLF = MPLM x P w

•! Workers must be indifferent

between the two sectors

•! In each sector, workers must be

hired until the marginal worker’s
cost (the wage) is equal to its
marginal product.

•! For any given price (P), we can

find out the employment and
output of Food and Manuf ! LF LM
total labor force

Incomplete specialization III
Decreasing returns and the concavity of the PPF

•! We can obtain the PPF, for the

case of decreasing returns.
–! The PPF is concave. The
opportunity cost of Food is
-1/P now increasing.
Slope =
•! For any price (P), we can
-6 obtain the Relative Supply of


Incomplete specialization IV
Supply and demand

Relative Supply
•!Assume that the North is more
productive in Manufacturing than the
•!How do its supply and demand look like,
relative to the South?


Relative Demand


Incomplete specialization II
•! The PPF of North is larger, because the
marginal productivity is higher in the North.
•! The change in the PPF is not parallel:
–! The marginal product is relatively higher in
manufacturing, the same relative employment
MN •! The comparative advantage (productivity
differential) of the North is larger in
MS manufacturing.
Equilibrium: P = MPLF/MPLM
•! For any given price (P), the relative supply
of Manuf is larger in the North (MN/FN>MS/FS).
–! The higher MPL in Manuf encourages higher
employment is this sector.

Incomplete specialization II
World prices from supply and demand
•! The equilibrium price of Manuf is lower in
the North.
P –! Because the supply of Manuf is relatively
larger there.


RSN •! The world RS is the average of the two

PS countries, weighted by their size:


RD is the same for

both countries and
for the World, as a


Incomplete specialization III
The gains from trade in the North

•! The prices of manufactures rises

in the North,
Manuf –! Due to its comparative advantage
in manufacturing
-1/PN •! Production of manufactures for
export increases;

–! Effects on consumption of
Gains from manufactures depend on income
(+) and substitution effect.
•! But there is incomplete
–! The North still produces some
Food for its own consumption


Equilibrium productivity and
comparative advantage

•! In the trade equilibrium, we have:

–! If the price is the same, the relative productivities are the same.

•! With similar relative productivities, how can comparative

advantage emerge?
–! It must be measured out of equilibrium, for the same relative
employment level.


•! In countries with lower productivity, competitiveness in world markets arises

from lower wages.
–! The gains from trade mean potential gains for workers.

•! The political argument is due to adjustment costs (specific factors)

–! Factors that are specific to import-competing industries will loose out from trade.
–! Those that are specific to exporting industries will be winners.
–! But the gains of winners always outweigh the loses of losers.
–! Compensating losers is a difficult task!

•! Incomplete specialization arises when marginal productivities are

–! In this case, the relative marginal products are the same with trade.
–! Comparative advantage must be seen for the same relative employment levels.

The Factor-Proportions Model
International Trade – Session 3

Daniel TRAÇA
A summary of the last session II

•! The two jobs of price system in global markets:

allocation & distribution
–! The global price/market system gives the incentives for countries to
specialize to comparative advantage (good allocation!).
–! The price system also distributes the gains from trade in way that every
country and every person benefits (good distribution!).
•! Even the low productivity countries can benefit from trade. They will be
competitive because their wages are smaller.
–! When there is difficult adjustment, trade is still good for the country,
because there are gains from exchange (on average, we become net
consumers of a good where the price is falling).
•! But it is a political hot potato, because the workers that are facing import-
competition (and cannot adjust) are worse off. (distributional problems!)
•! Protection to allow losers from trade to keep their jobs, for social reasons, is
very costly and often lasts much longer than initially expected.
The Hecksher-Ohlin (HO) model

•! 2 sectors: Manuf and Food

•! 2 factors: Capital (K) and Labor (L)
–! Factors can freely move between Manuf and Food. This mobility
captures long term (no adjustment costs)
•! 2 countries: North(N) and South (S);
–! Differ in relative abundance of Capital and Labor
The substitutability of factors

•! The Kapital/Labor ratio (K/L) used

combinations of
T inputs that
produce the in production depends on the
prices of the factors.
same quantity of
the good



The substitutability of factors

combinations of
•! Manuf is a Capital Intensive sector.
K inputs that
produce the
–! It uses a higher ratio of K/L, for any given
same quantity of
the good
factor prices.



Concavity of the PPF

•! With two factors, and

different factor intensities
Manuf the PPF is concave
–! similarly to decreasing
-1/P1 returns
•! For any price, there is
incomplete specialization
P1 >P2

The factor-price ratio (w/r) and the
relative price of manufacture (P)

•! What is the effect of a rise in P

on w/r? w/r

•! An increase in the price of a

good raises the relative factor-
price of the factor that is used
intensively in that sector.
–! e.g. an increase in the relative
price of Manuf (Kapital SS
intensive) lower the relative
price of labor (w/r)

Prices, relative factor returns and
factor intensities




K/L P2 P1 P
•! For any given relative price of goods, there is an equilibrium
relative factor price and a given distribution of factor
intensities in production.
•! This is independent of the abundance of resources in the economy.
Prices and the real factor-returns
- An intuitive scheme
A rise in the relative price of Manuf (P)

Food output falls; Manuf output expands

Food output decline releases too much Labor (excess supply)

Manuf expansion requires mostly Kapital (excess demand)

Real wage must fall due to excess demand

Kapital rents must rise due to excess supply

All sectors become more labor intensive.

Full employment of Kapital and Labor is preserved.

An increase in factor abundance
when prices do not change

•! An increase in Abundance of
–! The PPF becomes larger, but the
Manuf change is not parallel:
–! Since Manuf is the main user of
M1 Kapital, the difference is relatively
larger in Manuf.
•! For the same price, the output of
Manuf rises and that of Food
F2F1 Food
An interesting theorem (Rybczinsky)

•! An increase in the
supply of a factor,
with prices •! A rise in L lowers K/L (right-hand side).

unchanged, raises the •! With given prices, factor intensities (in

square brackets) do not change.
output of sectors that •! Since K/LF < K/LM , employment in
use intensively that Food (LF/L) must rise, and in Manuf
(LM/L) must fall.
sector and lowers the –! Since LM falls and TM= [T/LM]xLM falls,
output of sectors that the production of Manuf must fall

do not use intensively

The effects of international trade

P •! If the North has more Capital, the

relative supply of Manuf is higher
than in the South.
RSW –! Use the Rybczinsky theorem

RSN •! The autarky price of Manuf (P) is

PS higher in the South.
–! This means that the South has the
PW Comparative Advantage in Food.
•! With trade, relative price of Manuf
PN rises in the North

•! Comparative Advantage arises

RD is the same for
both countries and
because the South is relatively
for the World, as a LABOR ABUNDANT and has
whole. Comparative Advantage in the
The gains from trade,
in the North

•! The prices of manufactures rises

Manuf in the North,
-1/Pw –! Due to its comparative advantage
-1/PN in manufacturing

•! Production of manufactures for


Gains from
export increases;
–! Effects on consumption of
manufactures depend on income
(+) and substitution effect.

•! There are gains from trade

Resource Abundance, Comparative
Advantage and the Pattern of Trade

SOUTH •! If technologies are

Relatively Labor Abundant
Specializes in Food identical, a country has

Labor Intensive
comparative advantage in
Kapital Intensive

the sectors that use

relatively INTENSIVELY
the factors that are
relatively ABUNDANT.
Kapital Abundant
Specializes in Manuf
Dynamic Comparative Advantage
- Accumulating Skills and Capital
Education, Investment, Infrastructure

Knowledge & R&D Knowledge Intensive

Economic Development


Skilled Labor Skilled labor Intensive


Capital Capital Intensive


Labor Unskilled Unskilled labor Intensive


Resource Intensive
Natural Resources (Rice, Oil)
Real Factor Returns and Factor

•! With competitive markets, real factor returns are:

r = pM MPKM = pF MPKF ! r/pM = MPKM and r/pF =MPKF
w = pM MPLM = pF MPLF !w/pM = MPLM and w/pF = MPLF
•! With constant returns to scale and identical technologies
the marginal product is determined only by factor intensities
MPKM (K/LM) and MPKF (K/LF) are decreasing
MPLM (K/LM) and MPLF (K/LF) are increasing
•! Real factor returns are an average of the marginal
product in the different sectors
–! w/["pM+(1- ")pF] and
–! r/["pM+(1- ")pF]
Prices and real factor returns in




•! All else constant, a higher relative price of a good…
–! … means a higher relative factor-price of the factor used intensively in that good
–! … and a lower the productive intensity in that factor in both sectors.
•! This has implications for real factor returns:
From goods’ prices to real factor

•! The Stolper-Samuelson theorem

–! An increase in the relative price of the good raises the real return to the
factor used intensively, and lowers the relative return to the factor not
used intensively
•! Changes in P causes lower in K/LM and K/LF,…
•! …raising the return to capital and lowering the wage

•! Comparing Real Factor Returns in the two regions, in Autarky

–! Due to higher capital abundance in the North,…
•! the price of Manuf is lower in the North, and…
•! Kapital intensity in Manuf and Food is higher than in the South. As a result,…
–! labor wages are lower and Kapital rents are higher, in the South.
Unfair Competition

•! If the items entering this country in such volumes were better

designed or more attractive, more durable or more efficiently produced,
we would have little reason to object. But the vast majority of imports
sell here primarily because they are cheaper; and they are cheaper for
one reason only - they are made at wages and under working conditions
that would be illegal and intolerable in this country’.
»! from the President of American Textile Manufacturers Institute

Good working
Rich Abundance in conditions
High returns for
coun skilled labor
unskilled labor High unskilled
tries and capital

Poor working
Poor conditions
coun Abundance in Low returns for
tries unskilled labor unskilled labor Low unskilled
Unfair Competition and Comparative

•! Low wage competition is comparative advantage in goods that are

intensive in educated/skill labor for industrialized countries
–! Trade creates value because returns to unskilled workers are lower in
developing countries
•! The mix between wages and working conditions is mostly market
–! Legal constraints have a cost that depends on how restrictive they are,
relative to market outcomes.
–! Part of this cost is borne by workers in the form of unemployment and
lower net wages.
–! It is a cost that rich, industrialized societies have accepted to pay to
promote social justice and avoid exploitation.
Trade and real factor returns




•! Convergence of factor returns
–! With no impediments to trade, capital intensities are the same in both countries,
hence real wages and real rents will converge
•! There are winners and losers, within a country – the price changes due to
trade, causes changes in factor intensity.
–! North: K-intensity falls in both sectors; real wages fall and capital rents rise
–! South: K-intensity rise in both sectors; real wages rise and capital rents fall
Trade and Factor flows are

•! Factor price tend to converge among countries, under free-trade.

–! With more openness to trade, the pressure of factor (e.g. labor)
migration will fall

•! Exports of goods that are INTENSIVE in the ABUNDANT factor

replicate the effects of emigration of the ABUNDANT factors, i.e.
they raise its return.
•! Imports of goods that are INTENSIVE in the SCARCE factor replicate
the effects of immigration of the SCARCE factors, i.e. they lower its
(More) Political implications of trade

•! International trade expands the return to the abundant

factor, while the return to the scarce factor falls.

•! The average citizen, with the average resource

endowment, is better off, due to the gains from trade.
–! But the citizens that are endowed only with the scarce factor are
worse off.
•! These are long term implications, unlike the costs of
Worrying trends for inequality in
industrialized economies
Explaining rising inequality in
Industrialized Countries

Abundant in Educated (Skilled) Labor, Scarce in Unskilled Labor

Openness to Unskilled Labor Abundant Poor

Flexible labor markets

Countries lowers the price of unskilled intensive goods

Rigid labor markets


France, Germany
Unskilled-intensive sector shrinks, releasing too much unskilled labor

Skill-intensive sector expands, requiring too much skilled labor

Real unskilled wage is depressed Unskilled wage does not adjust.

All sectors become more

unskilled labor intensive
unemployment rises
Full employment is
Although, in theory, globalization can cause
these trends, Empirical Studies...

•! Point to a small impact of globalization on wages

–! The relative price of skill-intensive goods has been declining
–! Trade with developing countries is still small.
•! 3 to 8% of GDP; 20 to 40 % of all merchandise imports
•! The most favorable studies claim that trade explains no more than 30%, of
the increase in the wage-skill gap. The most credible ones fall between 10
and 20%.
–! FDI of industrialized countries is only 6% of total investment, and only
2/5 goes to developing countries.
•! Alternatively, the blame has fallen on the technological change of
the last twenty years.
•! The main reason for recent wage declines, increases in the wage skill gap
and unskilled unemployment seems to be technological change, and not
trade with low wage (developing) countries.

•! Comparative Advantage (and gains from trade) may arise from differences
in the relative abundance of factors, if they are used with different
intensities across sectors
•! Comparative advantage in sectors the used intensively the abundant factor.
–! Changes in factor abundance due to economic development will affect the
country’s comparative advantage.
•! Low wages in poor countries are due, in part, to low capital abundance.
–! These low wages are the source of gains from trade and not unfair competition
•! Trade causes adjustments in factor returns
•! Trade and factor flows are substitutes.
–! Factors that are used intensively in import-competing sectors, i.e. the relatively
scarce factors, loose out.
–! However, recent increases in the wage-skill gap and unskilled unemployment are
most likely caused by technological change.
Extensions of the competitive trade model
International Trade – Session 4

Daniel TRAÇA
Three models of international trade

Source of The exporting Distributional

comparative sector (w/ Common Consequences
advantage Comparative Advantage) features WHO Looses?
is the one that…

wealthy), even with costs of adjustment

those that are less productive or less
Gains From Trade for all countries (even
Returns to Scale
Perfect Competition and Non-increasing
Labor …Has higher Workers with high costs
Classical Productivity relative of adjustment in import-
(e.g. productivity comp sectors
…Uses more Factors that are used
proportions Relative
intensively the intensively in import-
(Factor intensities Endowment
relatively more comp sector (i.e. scarce
differ across of Factors
abundant factor factor)
Relative …Uses the
Endowment Specific Factor Factor that is specific in
factors (to each of Specific that is relatively import-comp sector.
sector) Factors more abundant Mobile factor ambiguous
The Open Economy

•! In the Closed economy, the welfare of

the representative consumer is
constrained by the PPF.
U U adjust –! The price must equate domestic
1/PW no-adj
consumption and demand.

•! In the Open economy, the consumer

Exports can exchange with the rest of the world
manuf Imports
at the world price.
of food
–! The Welfare is constrained by the World
Uaut Price.


1/PN (autarky) •! When the World Price is different from
the autarky price, there is trade and
there are gains from trade:
Food –! Gains from exchange: Uaut ! Uno-adj
–! Gains from specialization: Uno-adj ! Uadjust
In the North, the price of Manuf is higher in
the World Market than in Autarky.
Hence the North exports of Manuf.
The Terms of Trade

•! The important price are the

–! They measure the price of U2
exports relative to imports.
•! In the example, it corresponds
to the relative price of
•! A rise in the terms of trade 1/PW1
increases a country’s welfare,
while a decline reduces U1
•! In the example, a rise in PW is
an increase in the terms of
The small and the large economy

•! In the small open economy (e.g. Belgium, Singapore), the terms of

trade are given by the rest of the world and unaffected by domestic

•! In the large economy, with heavy weight in world markets (e.g.

China, United States, Brazil), the terms of trade are affected by local
–! The effects work through the World Relative Supply and Demand.
–! This is the case we saw, when we looked at trade between two

•! Example: China and the World price of Oil

Terms of trade effects I
Export-Biased growth and the TOT
Export-Biased growth:
U1! Usoe2 Small Open Economy
TOT effect of export-biased
Usoe2! Utot2 TOT effect; Large Economy
growth for the large country
Relative Supply


1/PW1 Utot2
Relative Demand

Terms of trade effects II
Immiserizing growth?

•! Export-biased growth tends to worsen the country’s TOT.

–! Immiserising growth: It is theoretically possible that the TOT effect is stronger and the
country ends up worse off.
•! Import-biased growth tends to improve the TOT.
–! Import-substitution as a development strategy?...

•! What about the growth in the Rest of the World?

–! If there is growth in biased toward our exporting sector, our terms of trade worsen, and we
are worse off.
–! If there is growth biased toward our import sector, our terms of trade improve, and we are
better off.
•! Example:… The implications for Belgium’s Terms of Trade of
•! of growth in China
•! of growth in Japan
•! of growth in Bangladesh
Terms of trade effects III
Biased demand shifts and the TOT
- The Transfer Problem

•! Transfers of income between countries with different preferences

have terms of trade effects.
–! Countries that receive transfers will see their terms of trade rise…
•! Residents’ rise in demand will fall mostly on exportable goods, or non-traded
goods that compete for resources with exportables.
•! Consumers tend to spend a higher than average proportion of spending on
domestic goods:
–! The US produce 25% of global output, but US consumers spend 89% of their
expenditure in US produced goods. This may be due to preferences or barriers to
–! Donor countries will see declining terms of trade

•! Example:
–! The German War reparations
Shortcomings of theories of
Comparative Advantage

•! Most trade is among industrialized countries, which are quite

similar and do not have much scope for comparative advantage.
Trade between rich and poor countries, where there are more
noticeable differences, should generate stronger comparative

•! Many countries export and import from each other goods that are
very similar and belong to the same sector (e.g Autos).

•! Many world markets are not competitive, and have instead a few
players that operate strategically.

•! The traditional theory cannot explain this!

New Trade Theories

•! Imperfect Competition •! Increasing Returns

–! Firms operate strategically, –! External: A firm’s unit cost
setting prices and quantities in falls, when industry output
reaction to the strategy of rises
competitors and the •! Specialized Suppliers
preferences of consumers. (clusters)
They do not take prices as •! Labor Market Pooling
given. •! Knowledge Spillovers
•! Monopoly, Oligopoly –! Internal: A firm’s unit cost fall,
•! Monopolistic Competition when its own output rises
•! Learning by doing
•! Capital Requirements

Automobiles; Semiconductors; Civil Aviation; Software; Banking…

International Trade and Imperfect
•! With imperfect competition, prices are no
longer a good way to assess Comparative
Advantage, because they may not reflect
p Autarky: MR=MC costs!
E –! In the figure, the autarky price (paut) is higher
than the world price (p*) and the country
Trade: p*=MC becomes an exporter.
•! There are gains from trade (DBCJ)

paut F D

Marginal Marginal
Rev Cost
p* C

A exports

qaut qc* q p* q
International Trade and Imperfect
•! With imperfect competition, prices are no
longer a good way to assess Comparative
Advantage, because they may not reflect
p Autarky: MR=MC costs!
E –! In the figure, the autarky price (paut) is higher
than the world price (p*) and the country
Trade: p*=MC becomes an exporter.
•! There are gains from trade (DBCJ)
–! Gains due to competition: The competitive
Paut F D pressure of foreign competitors prevents
the monopolist from creating deadweight
•! Emerge even if there is no trade (e.g. a
Marginal Marginal prohibition to export)
Rev Cost
•! The competitive force of trade represents a loss to
p* G H C producers (FDGH-HBC), but a gain to consumers
(FDGC), and a net social gain (DBIC)
J –! Gains due to Comparative Advantage: The cost
I of producing at home is lower than the
price obtained abroad, suggesting a new
B export market
A exports •! The monopolist’s sector would become a net
Demand exporter (p* is higher than marginal cost when
supplying the home market). This benefits
producers (CIJ)
qaut qc* q p* q
Imperfect competition and
international trade

North South
p p
Autarky prices are identical.
Will there be trade?

pN pS

Marginal Marginal
Rev Rev

Marginal Cost Marginal Cost


Demand Demand

qaut q qaut q
Reciprocal dumping

•! Since the price in export markets is larger than the marginal cost,
each monopolist has an incentive to sell in the export market (if it is
able to price-discriminate)
–! The equilibrium will be such that both monopolists will fall back to
–! There will be trade, due to the aggressive strategies of the monopolists.
•! The gains include the loss of market power of the monopolists
–! There may be some losses due to useless trade (if the goods are
•! Domestic firms often accuse foreign firms that export at prices lower
than in their home markets of UNFAIR TRADE
–! This may simply be due to segmented markets and the price-
discrimination strategy of firms
Increasing returns and the gains
from integration

•! Monopolistic Competition:
–! Firms produce differentiated goods
price •! MR=MC for each firm
of –! Free entry drives away profits
each Average Cost –! In equilibrium, there are n identical firms in
is declining due to increasing returns each country.
•! With trade, they become integrated
Initial autarky equilibrium –! INCREASED VARIETIES
•! With more varieties, the elasticity of demand will
rise, as closer substitutes will arise
long-run eq. w/ trade
paut •! In the short-run, this will increase competition,
short-run eq. w/ trade leading to lower prices and higher output.
•! But firms are now in loss
•! In the long-run, some firms will drop out, to
p* ensure the return to profitability of survivors.
•! Surviving firms increase size and lower unit costs

Marginal Cost

qaut q* q** q for each firm

New Trade Theory: Reasons for, and
the Gains from, Trade

Increasing Reasons for Trade Gains From

Specialization is
returns Aggressive Trade
•!Economies of Scale determined by:
strategies of firms •! Pro- •!Luck
•!Labor Market
Pooling •!To enter foreign competitive •!Home Market Effect
•!Specialized inputs markets where effects (fewer
•!Sillicon Valey
•!Civil Aviation prices are higher deadweight
than marginal costs losses) The gains from
(e.g. reciprocal •! Rationalization trade are
dumping) (Lower Unit independent of the
•! Monopoly •!To go down cost Costs) pattern of trade,
unlike comparative
curves by •!More Varieties advantage
•!Monopolistic Costs of protectionism
Competition expanding output (choice) are weaker
New Trade vs. Comparative
•! With increasing returns, no country is able to
produce the full range of manufactured
products. SOUTH Relative Labor
•! Although both countries produce some Abundant - Specializes in Food
manufactures, they will be differentiated


d Manuf
•! There will be intraindustry trade!
–! The pattern of trade is ambiguous. Determined
by luck or first-mover advantage (e.g. Labor
semiconductors). intensive intensive

•! There is simultaneously interindustry trade,
explained mostly through Comparative
NORTH Relative Capital
–! Here, the pattern of trade is unambiguous.
Abundant - Specializes in Manuf
Measuring intraindustry trade

•! A traditional measure of Intraindustry trade in several US

intraindustry trade compares industries, 1993
net trade with total trade, in Inorganic chemicals 0.99
each industry: Power-generating machinery 0.97
Electrical machinery 0.96
Organic chemicals 0.91
I=1-|exp-imp|/(exp+imp) Medical and Pharmaceutical 0.86
Office machinery 0.81
Telecom equipment 0.69
–! With only interindustry
Road vehicles 0.65
Iron and Steel 0.43
•! |exp-imp|/(exp+imp)=1
Clothing and Apparel 0.27
and I=0
Footwear 0.00
Case discussion:
The US/Japan semiconductor battle
The semiconductor industry

•! Very cyclical: boom and bust

•! Highly Capital and Research Intensive
•! Two main types of products
–! DRAM’s
•! Almost a commodity: Competitive advantage is cost-based.
•! Limited market power and very steep learning curve
–! Microprocessors
•! Knowledge is proprietary: Competitive advantage is knowledge- and design-
based. Innovation is key.
•! Market structure
•! US: Merchant market was very fragment; IBM and AT&T were targets of
•! Japan: Six firms dominated the market. They were consumers and
producers, buying and selling from each other.
The Japanese takeover of the global
Semiconductor market

US Headquartered

1978 55% 28%

1986 40% 46%

The Japanese takeover of the global
Semiconductor market


Sources of Japanese competitive
advantage in DRAM’s
•! Government Support (NOT VERY IMPORTANT!)
–! Protectionism up to mid 70’s
–! Only light subsidies afterwards

•! Japanese excellence in manufacturing instead

of innovation Advantage ?

•! Advantages of the Keiretsu (vs. US anti-trust)

–! Deep pockets to fund: research, price-wars, Increasing
capital-intensity, counter-cyclical investment, returns ?
–! Closing the fast growing Japanese market
•! First down learning curve (agglomeration), !
Competitive advantage in the U.S. market
The US industry in the 1990’s
After the semiconductor trade agreement

Profitability of US semiconductor firms

1990 1992 1994

AMD -3.4 16.2 16.0

Analog Devices -2.7 2.6 9.6

Agreement Goal INTEL 16.6 18.4 22.3

1.0 1.3 24.6

Motorola 4.6 4.3 7.0

-1.7 1.7 11.3

0.0 3.6 7.0

DATA SOURCE: MITI - USTR (see http://www.eiaj.org/charts/trends.html)

It was all about Comparative Advantage
within the Semiconductor Industry

•! Restrictive
•! Competence and
competition policy United
higher returns in
•!Focus on innovation States
(defense contracts)

•! Lax competition
•! Competence and
Japan •!Excellence in
higher returns in

Comparative advantage is much more than abundance of resources, like

capital, land and labor!.... It can be institutions, culture, preferences,
traditional knowledge
Summary I

•! A summary model of comparative advantage: the pivotal role of the

terms of trade
–! Export-biased growth and immiserization
–! The transfer problem
•! The restrictions
–! Perfect competition + Non-increasing returns
–! Trade must arise between different countries and across different
•! Comparative Advantage can be a lot more than abundance of
–! Excellence in manufacturing, Innovation, Anti-trust
Summary II

•! New theories of trade

–! Imperfect competition and economies of scale may create trade, even if
countries are identical.
•! Reciprocal dumping.
•! Exploiting increasing returns
–! New gains of trade:
•! Pro-competitive effects
•! Rationalization
•! Varieties
–! Pattern on trade is indeterminate and does not matter for gains from
•! Reality: Comparative Advantage + Increasing returns
–! Distinguishing them is important for the effects of protectionism on the
gains from trade
From Free Trade to Strategic Sectors
International Trade – Session 5

Daniel TRAÇA

The Gains from International Trade

•! Gains from Comparative Advantage

–! Gains from exchange
–! Gains from specialization
•! Gains from Scale
–! Lower Unit Costs
–! More varieties
•! Gains from competition
–! More competition lowers mark-ups and stimulates innovation
•! Gains from Knowledge Transfer
–! Imports of advanced intermediate goods
–! Flow of information, including reverse engineering

Free-Trade is better for the
economy, because…

Supply, MC

Consumer surplus
Free-trade price


Output Cons

…Protectionism imposes losses on
consumers ...

Supply, MC

Tariff Tariff price


FT price
Loss of consumers Tariff


Output w/ Output w/ Cons w/ Cons w/

FT Tariff Tariff FT

… some of which are deadweight
A – loss of gains
Deadweight loss B – loss of gains
from exchange

Tariff Tariff price

FT price Gains Loss of consumers
A Revenue B


Output w/ Output w/ Cons w/ Cons w/

FT Tariff Tariff FT

A simple example:
Portugal and the textile industry

•! The sector represents more than 200,000 jobs, 16% of total exports and 2%
of GDP
•! What are the net effects of trade with China?
–! Assumptions:
•! With free-trade in textiles, wholesale prices fall by around 30%
•! At this Free-Trade price, no domestic producers will survive
•! Workers will not find jobs elsewhere

Costs of Protectionism

United Japan Korea European

States 1989 1990 Union
1994 1990
# industries surveyed 21 47 49 20

Consumer cost
Billions of US$ 70* 74 - 110 12 - 13 67 - 100

Share of GDP (%) 1.2* 2.6 – 3.8 3.8 – 4.3 1.1 – 1.6
Average tariff equivalent (%) 35 180 170 40
Jobs “saved” (‘000) 190 180 174 - 405 1,500

Share of total employment 0.2 0.3 0.9 – 2.0 1.1

Cost per job saved

170 600 33 – 67 70
(‘000 US$)
* Estimates for the whole economy. The 21 highly protected industries were responsible for $32b.
(incl. $24b for textile and apparel). The remaining data concerns only the highly protected industries.

The case for unilateral free-trade

Free-trade is the best

policy, regardless of
the policy of our
trading partners
Protection in General Equilibrium
Lerner Symmetry

•! t is a tariff
Manuf The case where t > s –! On imports of food
–! pTF= pwF(1+t)

•! s is an export subsidy
–! On exports of Manufactures
- 1/PW
Consumption –! pTM= pwM(1+s)
with T
•! PT= pwM(1+s)/pwF(1+t) = Pw(1+s)/(1+t)
with FT

Exports of
manuf •! Lerner symmetry: Import- and export-
Imports of - 1/PT taxes are equivalent.
food - 1/PT UT
Production –! What matters is resource allocation!
with FT
Production •! Both, a rise in t or a decline in s,
with T promote the import-competing sector at
the expense of the exporting sector.


Anti-competitive effects of Quantitative
Restrictions: the monopolist case

Demand Supply, MC
More losses to consumers with QUOTA
Tariff Tariff price
Losses of consumers with TARIFF Tariff
FT price


Output Output w/ Output w/ Cons w/ Cons w/ Cons w/

w/ FT QUOTA Tariff QUOTA Tariff FT

Anti-competitive effects of Quantitative
Restrictions: the monopolist case

Demand Supply, MC
Price Additional
More lossesgains
Producer to consumers with QUOTA
Tariff Tariff price
Producer (-) B
Gains Revenue w/ tariff Tariff
FT price A QUOTA Rents

Output Output w/ Cons w/ Cons w/


Higher Deadweight losses

Instruments of Protection

other than the distribution of the revenue

All these forms are equivalent under competitive markets,
Instrument What they do: Who keeps the revenue Other aspects

Imports / exports Government Budget

Tariffs and must pay/receive a
export fee (specific or ad- Important in countries
valorem) to cross the
without reliable tax systems
border (e.g. Africa)

Owners of import licenses Anti-competitive

Impose limits on effects.
Quotas the volume of Generates important rent-
seeking activities by With constraints on
importers quantities, domestic
firms are ‘isolated’
from the effects of
changes in world
Foreign Exporters
Voluntary prices.
governments accept
Export to impose Can be used to persuade More rent-seeking
constraints on their exporters to reduce behavior
own exports competitive pressure Importers benefit
also from protection

Reasons for protectionism

1.! Terms of Trade effects (the large country case)

2.! The Trade balance

3.! Unfair trade: Anti-dumping duties

4.! Political and social pressure

5.! Protect and Promote “Strategic Industries”

1. Terms of Trade effect

•! For a large economy that affects world prices, a tariff

may improve welfare.
–! By reducing imports it lowers the demand for the imported good
leading to a lower price.
–! This improves the country’s terms of trade. These gains in the
terms of trade must be weighted against the deadweight losses.

–! Example: OPEC and the price of Oil

2. The trade balance

•! Mercantilism: an old doctrine on the trade surplus …

–! Maximize trade surplus in order to accumulate wealth.
–! Exports are good, Imports are bad! - Erect barriers and promote exports
•! … that was doomed to failure!
–! If all countries export,… none imports. No Trade
–! The accumulation of wealth is not a meaningful goal.
–! In the long-run, the trade balance is self-corrective, through the
exchange rate and wages, and is independent of trade policy.
•! The effects of trade policy only work in the very short-run

•! There is value in trade, regardless of the trade balance.

–! That Value is: Improving consumption opportunities.
–! Exports are the cost of imports.

3. Unfair Trade: Anti-Dumping I
Legal Analysis: WTO rules on anti-dumping and
countervailing duties; Article VI of the GATT, 1994

•! Selling in export markets below •! Process of implementation of

‘fair value’! anti-dumping duties:
•! Fair value is –! Did the dumping cause or
–! Price in exporter’s market threaten material injury?
•! Linked to surge in dumped
–! Price in third markets
–! Measure based on cost –! Are the Anti-dumping Duties in
estimate and fair return to
public interest?

•! Duties applied to all producers

from dumping country

3. Unfair Trade: Anti-Dumping II
Economic Analysis

Causes Consequences
•! Foreign government practices •! Benefits consumers and hurts domestic
–! foreign subsidies producers
–! protected home markets
•! Net gains for the economy (improved
•! Firm strategy: terms of trade)
–! market segmentation
–! forward pricing
•! Caveat: Predatory Dumping
–! If used to monopolize the industry,
–! predatory dumping dumping has costs, in the long run.
–! There are important conditions for
predatory success
•! Large size of foreign producer or cartel.
•! High barriers to re-entry by domestic
•! High barriers to entry by other foreign
–! These conditions are not required in the
WTO law and are very difficult to exist.

3. Unfair Trade: Anti-Dumping III
Anti-Dumping on the rise

•! Like tariffs, AD duties:

–! Benefit producers and hurt consumers;
–! Create deadweight losses for the economy.
•! But they are worse than tariffs:
–! Protection at very high rates:
•! On average AD duties are 10 to 20 times higher
than the tariff level.
–! Create Uncertainty
•! Trade disruption arises as soon as action is
–! Easy to capture by political interests
•! The Byrd amendment

4. Political and Social Factors

Trade policy is not determined by an enlightened leader, but by politics.

Examples: Agriculture, Textiles and Clothing, Steel
•! Re-distribution of the gains from trade is difficult
–! Administrative costs, Tax evasion, Budgetary concerns

Several factors affect the politics of trade policy

•! Special interests matter
–! Capacity to organize (collective action)
•! Consumer’s ability to organize is less than producers

–! Support for political campaigns / Corruption

4. Political and Social Factors (cont)

Several factors affect the politics of trade policy

•! Income distribution matters
–! Losers from trade (costs of adjustment + scarce factor) tend to find sympathy
–! Society’s may enjoy social harmony and social peace

•! Revenues and finances matter

–! Source of government revenue

•! Interest groups matter

–! Source of transfers/redistribution to certain groups through hidden taxes

•! But welfare matters too

–! Because governments need to improve standards of living to get re-elected.

5. Enter the Strategists…
Protectionism that raises GDP!
Expanding output with a tariff

Private MC

Social MC
Tariff price

Tariff Rev dwl FT price
dwl (-)
Social Demand
Lower Cons.

FT output Socially Optimal output

Social gains from increased production Deadweight losses distorting

Achieved with tariff
5. Enter the Strategists…
Protectionism that raises GDP!
Expanding output with a tariff
•! There are MARKET FAILURES. Most
Supply markets are imperfect.
Private MC
–! Social Cost/Benefit may differ from
Private Cost/Benefit
Consumer Social MC –! Trade intervention may increase
Welfare, in this case.
Tariff price
In the figure:
Tariff Rev dwl •! The social cost is lower because the
FT price production of the good provides
Prod dwl (-) Demand
Social •! A tariff raises welfare if the Social
surplus gains from increased production are
larger than the deadweight loss from
Socially reduced consumption.
Optimal Social gains
output Deadweight
from increased losses from
production reduced
with tariff
5. Market failures and Strategic

•! The case for Unilateral Welfare Increasing Protection

•! The domestic market failure argument:

–! Market imperfections imply the Social Marginal Benefit/ Cost differ from the
Private Marginal Benefit/ Cost
•! Examples: Pollution, Cultural Goods

•! The theory of the second best

–! If Social Benefit is greater than Private Benefit, Output should be higher than in
the free-market.
•! This can be achieved through a tariff or an export subsidy
–! If Social Benefit is lower than Private Benefit, Output should be lower than in the
•! This can be achieved through an import subsidy or an export tax


•! Tools of protectionism: tariffs, export subsidies, quotas, VER’s

•! The cost of protectionism:
–! Deadweight losses in consumption and production from diminished gains
of comparative advantage
–! Anti-competitive effects, if domestic competition is weak, particularly
with quantitative restrictions
–! Rent-seeking and other unproductive activities

•! The case for free-trade is independent of the trade policy of our

trading partners


•! Exceptions to free-trade
–! Large countries may benefit from terms-of-trade effects.
–! Protectionism and the Trade Balance are independent, in the long-run.
–! Unfair trade: Anti-dumping duties only make sense in the very unlikely
case of predatory dumping.
–! Political and social issues: responding to special interests,
•! Redistribution is difficult
•! Organization matters, Revenues matter, Social peace matters
–! Promoting Strategic Industries (with market failures)
•! Protection may help but is almost never the best policy
•! The best policy targets distortions through minimal intervention

From Classicist,… to Strategist,… to
International Trade – Session 6
Daniel TRAÇA

From Mercantilist to Classical

•! The Mercantilist view: Accumulate wealth

–! Exports are good; imports are bad
•! But, protection only improves the trade balance in the short-run. In the long-
run it must balance out, or the wealth will never be consumed.

•! The Classical view

•! The trade balance is not a worthy objective, consumption possibilities are the
–! The case for UNILATERAL Free-Trade
•! Free-trade is the best policy (to maximize consumption opportunities),
regardless of the policy of our trading partners.
•! Even if our trading partners hurt us with their protection, our best policy may
be to do nothing (unless we can dissuade them)

The Classical view

•! A fundamental assumption is that markets function well.

•! The case for Free-Trade is Unilateral.
•! The only accepted exception to Free-Trade
–! Terms of trade effects (for large countries)
•! In all other cases, protection reduces welfare.
–! It can emerge from POLITICAL and SOCIAL power of special
interests (lobbies).
–! Accusations of Unfair Trade are an excuse for the special
interests to claim protection (e.g. anti-dumping, social dumping).

Enter the Strategists…
Protectionism may raise welfare!
Expanding output with a tariff
•! There are MARKET FAILURES. Most
Supply markets are imperfect.
Private MC
–! Social Cost/Benefit may differ from
Private Cost/Benefit
Consumer Social MC –! Trade intervention may increase
Welfare, in this case.
Tariff price
In the figure:
Tariff Rev dwl •! The social cost is lower because the
FT price production of the good provides
Prod dwl (-) Demand
Social •! A tariff raises welfare if the Social
surplus gains from increased production are
larger than the deadweight loss from
Socially reduced consumption.
Optimal Social gains
output Deadweight
from increased losses from
production reduced
with tariff
5. Arrivée des Stratégistes…
Le protectionnisme qui augmente le PIB!

Augmentation de la production avec un tarif

CM privé
•! Il y a des ECHECS DE MARCHE dans la plupart
des marchés.
–! les coûts / bénéfices sociaux peuvent diverger des
Surplus du CM social coûts / bénéfices privés
Consommateur –! Dans ce cas, une intervention commerciale peut
améliorer le bien-être.
Prix a/Tarif

Rec. Tarif pm Sur la figure:

Prix LE
Prod pm (-) Demande •! Le coût social est moins élevé parce que la
production du bien génère des externalités
Surplus •! Un tarif augmente le bien-être si les gains
social sociaux liés à l’augmentation de la production
sont plus élevés que le poids mort dû à la
réduction de la consommation.
Prod Prod
LE Socialement Gains sociaux Poids mort
optimale d’augmenter la dus à la
production réduction de
la conso
avec tarif
Enter the Strategists…
The Classical Response
Expanding output with a production subsidy
•! Can Free-Trade be rescued? Supply
–! Yes! A production subsidy is Private MC
better than tariffs
•! The deadweight losses from
Consumer Social MC
reduced consumption disappear.
•! The Classical response: FT price + subs
–! Trade intervention is hardly Outlays from
FT price
ever the best policy. Prod dwl (-) Demand

–! The best policy deals directly

with the market failure surplus
•! But a production subsidy costs
money to the government FT
Optimal Social gains
–! While protection is paid for by output from increased
consumers! Achieved
5. Echecs de marché et secteurs

•! En défense d’une protection unilatérale augmentant le bien-être

•! L’argument de l’échec de marché domestique:

–! Les imperfections de marché impliquent que le bénéfice / coût marginal social soit
différent du bénéfice / coût marginal privé
•! Exemples: Pollution, Culture

•! La théorie du second best

–! Si le bénéfice social est plus élevé que le bénéfice privé, la production devrait être
plus élevée que si le marché était libre.
•! Ceci peut être atteint au moyen d’un tarif à l’importation ou d’un subside à l’exportation
–! Si le bénéfice social est plus faible que le bénéfice privé, la production devrait
être moins élevée que si le marché était libre.
•! Ceci peut être atteint au moyen d’une taxe à l’exportation ou d’un subside à

The Fundamental Argument of the Strategists I:
Low Costs of Protection

From Classical… …To Strategist

•! Comparative advantage •! Increasing returns and
drives trade Imperfect Competition drive
–! Natural or acquired differences trade
in the abundance of resources –! Luck
–! Technological Differences –! First-mover advantage
–! Home demand

•! Entailing High cost of •! Entailing Low cost of

protection protection
–! Loss of gains from –! Provided gains from scale are
specialization not undermined

The Fundamental Argument of the Strategists II:
Some industries are Strategic

From Classical… …To Strategist

•! Under perfect markets, all •! In imperfect markets,
industries pay the same industries are different.
returns in equilibrium: –! The economy may benefit
–! Zero (economic) profits and more from one than from the
wages equal productivity. other.
•! Unilateral FREE TRADE Strategic industries add more
value to the economy, than a
normal industry.
•! Government intervention may
benefit the economy, if it
promotes a strategic sector.

What makes a sector strategic?


•! Resources add more to the •! Gains do not accrue to the owners
economy in strategic industries of the resources, but to other
industries than in others. stakeholders.
•! Profits, Wages, Rents
–! The private sector will never
•! Why don’t resources flow into
pursue those allocations.
high-rent industries by
themselves? •! Examples
–! Imperfect markets –! Technological Spillovers
•! … –! Consumer gains from competition
•! Imperfect capital markets.
•! High barriers to entry –! Non-Economic objectives:
national security, national

Assessing Strategic Sectors I

•! Rents are above market returns

–! They are different from compensating differences, which
compensate the resources for some extra costs in the sector
(e.g. uncertainty, dangerous work, high skills).

•! Why don’t resources fly automatically to industries that

pay more (i.e. where there are rents)?
–! Imperfect capital markets: Infant industry argument
–! Barriers to entry: Airbus

Rents and the role of the gov’t
1. The entry of Airbus without government
Given that Boeing will fight,
Airbus does not enter.
Enter No Entry

Since Airbus will

Boeing (100,0)
exit, Boeing fights.

Fight Accommodate
Airbus (60,40)

Stay Exit
If Boeing fights,
(50,-10) (80,-5) Airbus exits.
Boeing’s threat keeps Airbus out of the market, and gives it monopoly profits.
Rents and the role of the gov’t
2. But with a Government subsidy of 20 ...

Since Boeing accommodates,

Airbus enters.

Enter No Entry
Since Airbus resists, Boeing
Boeing (100,0)

Fight Accommodate
Airbus (60,40)
If Boeing fights, Airbus
stands up to it.
Stay Exit
(50,-10) (80,-5)
Boeing accommodates, and Airbus enters with profits, - even after paying back the subsidy.
Rents and the role of the gov’t
3. But…, are there really High Rents in Civil

•! The government may have

created the conditions for entry
of Airbus.
–! Improving coordination
–! Increasing credibility of entry

•! However, the industry does not

show a tendency for above-
normal returns for incumbents,

Assessing Strategic Sectors II
External effects (1)

•! Non-economic benefits (social peace, national prestige,

–! The trade-off is political.
–! Economists can quantify the costs!
•! e.g. cost per job saved

Assessing Strategic Sectors II
External effects (2)

•! Competition gains
–! The conditions for industry domination are difficult.
•! Large size of foreign producer or cartel.
•! High barriers to re-entry by domestic producers.
•! High barriers to entry by other foreign producers.
–! Overall, markets are quite competitive.
•! Anti-dumping
•! Semiconductors (see the case): Although the US feared that six
Japanese firms would end up dominating the market in a cartel,
these firms were quite aggressive and, when prices rose, there was
entry by Korean and Taiwanese firms.

Assessing Strategic Sectors II
External effects (3)

•! Spillovers
•! Technological know-how benefits other firms and industries
•! Increased demand to other industries (pecuniary)

–! Distinguish:
•! Spillovers (not appropriated by the innovator)
•! Private returns to innovation (licensing, market-share gains)
–! Only spillovers, often associated with basic R&D, are a reason for government

–! Two concerns:
•! The guessing game: What will be the spillovers?
•! Only Local spillovers warrant intervention.
–! Technological spillovers can often be obtained through trade and information
–! Demand spillovers are dissipated by international outsourcing.

Technological spillovers
The spillover effects of R&D travel with trade

Effect of 1% increase in domestic R&D stock on productivity*, 1990, %

Effect of 1% increase in foreign R&D stock on productivity*, 1990, %

The external effects of R&D travel across

borders. Small countries capture more
spillovers from foreign than from domestic

source: Of strategies, subsidies and spillovers, The Economist, March 18th 1995

Demand spillovers
International outsourcing dissipates local spillovers

The Classic View of Strategic Trade Policy
A balance sheet: perfect markets

Free-Trade is the best policy,

come from political pressure

and protectionism can only
No benefits Comparative Advantage
all sectors pay normal returns attempts at distorting

and normal wages (perfect world markets destroy

markets). value.

The Strategist View of Strategic Trade Policy
A balance sheet: imperfect markets (strategic sectors)

if costs and loss of gains from trade are

smaller than the benefits of strategic
Strategic trade policy is a
Comparative Advantage
Strategic Sectors are attempts at distorting world

good policy
better than others markets destroy value.

•!Shifts (capture) rents Economies of scale
and/or external changes in trade patterns do
economies from trading not destroy value, unless:
partners. •!loss of economies of scale.
•!hinder competition

Costs of the policy

•!Subsidy outlays

Raising the burden of proof on the
strategic nature of an industry

•! Tough questions..
–! What is the evidence on strategic sectors?… Are some industries better
than others?
–! If there are rents, why isn’t the private sector investing?
–! What will be the non-financial benefits? Can we guess them?
•! Can we ensure that they are only local?
–! What is the best way to obtain those benefits?
–! Will the resources not come from other strategic sectors?
–! Will the money not be better spent in the fundamentals of growth?
•! The Realist’s answer:
–! The practical, real-world answer to these questions undermines the
strategist’s case

The Realist’s critique
From market failures to government failures

The Realist’s view: too many failures, too much money wasted

1.! Weak evidence of strategic sectors

–! Spillovers that travel through trade and the flow of ideas
–! Fashionable but unprofitable industries (auto-industry)
–! Foreign market power when foreign industry is competitive …
and more.

2.! Stress Comparative Advantage:

–! New sources of comp. advantage:
•! Competition law
•! Manufacturing/ innovation

The Realist’s critique
From market failures to government failures

3.! Implementation difficulties

–! Picking Winners!
•! Information requirements (markets and technologies)
•! Status quo bias favors old technologies and firms. Innovation
comes from small, entrepreneurial firms
–! Agency Problems
•! Capture by interests and the objectives of bureaucrats
•! Monitoring and influencing the private sector.
•! Credibility of temporary support
–! Retaliation
•! The reaction of trading partners
•! Risk to the World Trading system

The Realist Critique

•! The Realist Critique: The Strategist’s case, even if theoretically

correct, fails in most of the real world
•! The reasons are
–! Weak evidence of strategic sectors
–! Comparative advantage is very important
–! Implementation is very difficult due to government failures
•! The consequences are:
–! Too much money and welfare wasted.
–! Trade wars that hurt the trading system (e.g. Automobiles)
•! Given the failures of governments, the better default policy is free-
–! Free-Trade is the right policy is most cases.
–! The exceptions need to be argued convincingly

Markets vs. Governments in International
Trade: Historical context

•! Classic Case for Free-Trade

–! Post industrial revolution (David Ricardo, Adam Smith)
•! Strategist approach
–! Post WWII (J.M. Keynes): The government can solve the market failures and
create value
•! Industrial and Trade policy in Europe, Japan since 1950’s to 1980’s
–! Theorization of strategic trade policy 1970’s, 1980’s (L. Thurow, P. Krugman)
•! Industrial policy in US 1970’s to 1980’s (fighting back Japan)
•! Realist view (an on-going struggle)
–! Post Reagan and Thatcher revolution (F. Hayek): Government’s failures are
unable to correct market failures. Better off with imperfect markets
•! Caveat: Industrial policy in US 1970’s to 1980’s (fighting back Japan)
–! The Political case for Free-Trade (J. Bhagwati, P. Krugman)

How to explain the Japanese success
in implementation up to the 1970’s

1.! Technological laggards have an easier time picking

•! Even so, there were many mistakes (e.g. Honda)
2.! Good civil service ensured efficient, corruption-free
–! Credit to the private sector (not state-owned companies)
–! Good monitoring mechanisms and reliance of objective,
functional indicators (e.g. exports)
–! Gov’t able to backtrack when financial situation became
unsustainable or non-performing.
3.! As a small country, it avoided retaliation

Was the Japanese industrial policy
responsible for the growth miracle?
Relative levels of Targeting and growth rates of Japanese industries
(1 highest government support ... 13 lowest support)

•!Industries that received most

government support in Japan,
were not the fastest growing.
•!The allocation was driven by
market forces, and not by the
government policies.
•!What mattered for Japanese
growth were the fundamentals,
even if some policies were
implementation successes.

Source: Beason and Weinstein (1996) - Growth: Annual average rates of growth; Subsidized loans from JDB as a percent of total loans; Subsidies
net of indirect taxes; Tariff measure based on Shouda (1982); Total taxes paid by the sector as a proportion of of the taxable component of
corporate earnings.

•! Mercantilists: protect to improve trade balance and accumulate

–! Doomed to failure but still very fashionable

•! Classical: unilateral free-trade to improve consumption possibilities,

under perfect markets

•! Strategist: markets are not perfect!

–! There are strategic sectors that should be promoted
•! Rents and External effects
–! Costs are small, as comparative advantage is no longer key.

•! Realist: governments are more imperfect than markets

–! Raising the burden of proof by asking tough questions

If government failures are more serious than market failures,
Free Trade is the best better policy

Raising the burden of proof

•! On rents •! On the costs of distorting global trade
–! If there are rents, why isn’t the –! Can we really become as efficient as our
private sector investing? trading partner?
–! Why pay workers above market –! What are all sources of comparative
•! On external effects
–! What are the costs of undermining
–! What will be the non-financial
benefits? economies of scale?
–! Can we ensure that they are only –! Won’t our trading partners retaliate?
local? Then what?
–! What is the best way to obtain
those benefits? •! On the ability to implement successfully
•! On the opportunity cost –! What are the prospects of capture by
–! How high are the costs? private interests?
–! Isn’t the money better spent in –! Will temporary support not become
building resources: infra-structure, permanent?

The WTO and The Multilateral
Trading System
International Trade – Session 8
Daniel TRAÇA


•! The basic principles

–! Origins and achievements
–! The WTO and the Dispute settlement Mechanism
–! Key elements of the system
•! The Uruguay Round
•! The New Round: From Seattle to Doha
–! Singapore Issues
–! The post-Uruguay round complaints of developing nations
•! Anti dumping, TRIP’s and Agricultural Subsidies
•! The Cancun debacle
–! The new assertiveness of developing countries


Location: Geneva, Switzerland

Established: 1 January 1995
Created by: Uruguay Round negotiations (86-94)
Membership: 144 countries (as of 1 January 2002)
Budget: 143 million Swiss francs for 2002
Secretariat staff: 550
Head: Director-general (current: Pascal Lamy)
•! Administering WTO trade agreements
•! Forum for trade negotiations
•! Handling trade disputes
•! Monitoring national trade policies
•! Technical assistance and training for
developing countries
•! Cooperation with other international

Why the GATT/ WTO exists

•! Trade wars are likely to arise, if Japan

countries do not engage in
negotiations. Free Trade Protection

United States
•! But, why do trade wars arise, if 10 20


–! Large country terms of trade -10 -5
–! Strategic Trade Policy
20 -5
–! Political pressures from
interest groups

Origins of GATT/WTO (Bretton Woods,

•! Post WWII: Expansion of

global trade was deemed key
to peace and prosperity Year Round Countries
–! Protectionism of the thirties,
worsened the depression 1947 Geneva 23
–! Trade, integration and 1949 Annecy 13
interdependence was the road 1951 Torquay 38
to lasting peace 1956 Geneva 26
•! Simultaneous creation of 1960-61 Dillon 26
–! IMF (for stability of global 1964-67 Kennedy 62
financial flows) and
1973-1979 Tokyo 102
–! World Bank (to promote
1986-1994 Uruguay 123
economic development)
Dec, 1999 Seattle 140
Nov, 2001 Doha,QT 142

The system has worked!

•! Progressive liberalization:
–! Very low tariffs
–! Commitment to free-trade
(even during economic crisis) Canada EU Japan

•! Increased membership: Total 7.2 6.9 6.5 5.7

–! 22 to 148
–! China’s accession agriculture
22.9 17.3 18.2 11.0

WTO non-
•! Disciplines and new areas agriculture 4.4 4.5 4.0 4.7
–! Services, Investment
–! Agriculture Petroleum 2.6 2.9 6.5 2.3

Key elements of GATT

•! Rules based system

–! Better than power, particularly for small countries
–! Brings stability

•! Increase predictability and transparency

–! Set bound (maximum) tariffs
–! Remove quantitative restrictions (e.g. VER’s)

•! Contracts between governments of members countries

–! Governments negotiate to reflect all domestic interests, with no representation of
constituencies from within countries
–! Negotiate market access by reducing bound tariffs, based on reciprocity

•! Special and differentiated treatment for developing countries

–! From no reciprocity to delayed adjustment
The dispute settlement mechanism

How long to settle a dispute? (approximate times)

•! Consultations 60 days Consultations, mediation, etc

45 days Panel set up and panelists appointment by DSB
•! Panel Report
(or secretary general)
–! 3 experts
6 months Final panel report to parties
•! Appellate Body 3 weeks Final panel report to WTO members
(appeal possible)
–! 3 members of 7-member
Appellate Body No appeal
60 days Dispute Settlement Body adopts report
•! Rulings adopted automatically
Total = 1 year (without appeal)
–! Rejected only by “consensus” Appeal
•! Implications for losing party: 60-90 days Appeals report

–! compliance 30 days Dispute Settlement Body adopts appeals report

Total = 1y 3m (with appeal)
–! retaliation

The WTO and global governance

•! WTO: a first in global governance

–! dispute settlement
–! sovereignty foregone
•! WTO: a victim of its own success ?
–! UN agencies do not have WTO power
–! Increased demand for WTO intervention
•! environment, labour standards, …
•! Increased access of civil society (NGO’s file briefings in DSM cases)

–! This may be a slippery slope!

•! WTO is small and does not have expertise in many of these areas

Two Principles of Non-Discrimination

•! MFN treatment (GATT, Article 1)

–! …any benefit in connection with exporting or importing a product that is
given to one country,has to be given to the like product of all WTO
member countries.
–! Exceptions
•! Regional trade
•! Developing country preferences

•! National treatment (GATT, Article 3)

–! …any imported product, after entering the country of import, should be
treated as a national like product.

Are these like products ?

Mexican tuna caught causing death to

US tuna caught in dolphin safe environment

US beef produced with hormones, that are European beef produced in hormone free
not proven to harm consumer environment

Thai shrimp caught w/out turtle friendly US shrimp caught with turtle excluding
devices devices

Pakistani clothes produced with child labor US textiles produced in plants with high-
in sweatshops cost working conditions

US products produced with GMO’s, that are European products produced in GMO free
not proven to harm consumer environment

WTO Rules

•! Like products Should countries be allowed to

–! products that are physically have different standards?
the same must not be treated
differently under WTO rules •! The problem: Although they may
respond to local conditions,
different standards can also be
disguised (technical) barriers to
•! Product and non- product trade
related production processes
–! must not discriminate between
•! The solution: WTO rules require
products on the basis of how notification and scientific
they were produced
justification if national standards
are more restrictive than
international standards.

Trade Conflict due to Standards

•! Beef Hormones and Science

–! EU production and imports ban.
–! EU Standards higher than
international standards – Codex.
–! EU lost to US and Canada, in WTO
panel. No scientific evidence. On-
going attempts to comply.

•! GMOs and Societal Choice

–! Frankenstein food or Standards
based on science?
–! Is it protectionism or societal
–! On-going WTO panel.

The Uruguay Round (1995)
Commitments achieved

•! Changes in preferential status of Developing Countries

developing nations
•! Erosion of S&D treatment
•! Prohibition of export subsidies in
•! Investment measures
industrial goods
•! Intellectual Property
•! Elimination of local-content requirements
and VER’s
•! Reduction of barriers to trade-related - The grand bargain -
investment measures
•! Implementation of TRIP’s
(intellectual property rights)
Industrialized Countries
•! Disciplines in agriculture •! Improved Market Access in textiles

•! Reduce protection in in textiles •! New disciplines in Agriculture

Seattle, 1999 - An Unpopular WTO

•! Environmentalists

•! NGOs

•! Organized labor

•! Protectionists

•! Consumer groups

•! Human rights

•! Developing

•! Anti business forces

Need for new round

•! New issues (Singapore) •! Bicycle Theory

–! Foreign Investment –! No negotiations means protectionism
•! Protect MNC’s from expropriation and
discrimination from host-governments •! Developing countries have their own
–! Competition Policy agenda
•! Breaking Japan’s protection (e.g. Kodak
–! Making up for losses in the Uruguay
vs. Fuji)
•! Coordinate International Policies

–! Government procurement –! Global politics

•! Increasing transparency on government •! The war on terrorism

–! Trade facilitation
•! Reducing the costs of customs clearance

Difficulties in access to markets in
rich countries

Source: Finger, Ingco, and Reincke (1996)

Developing countries’ requests in the
Doha Round

•! Market access to rich countries •! No to Labor standards and

–! Agriculture and Textiles Environmental standards
–! Tariff escalation •! Permission for special treatment of
•! Export subsidies in Agriculture infant-industries (export subsidies)
•! Constraints on Anti-dumping •! Technical assistance in complaints
•! Intellectual property to the WTO and in international

–! Patent rights and public health negotiations

–! Protecting indigenous

The debacle in Cancun, September 2003

Industrialized Countries Developing countries (G-22)

•! Focus on Singapore issues (EU, •! Increasing market access and

lowering subsidies in Agriculture,
Japan, South Korea)
without reciprocity.
•! Lack of commitment in
•! Opposition to Singapore issues
–! Developing nations conceded
enough in Uruguay round, - no
more concessions.

International Trade – Session 9
Daniel TRAÇA
Preferential Trading Agreements
•! Two or more countries decide to reduce their bilateral
rates of protection.
–! Among the best known:
Brunei Darussalam Cambodia Indonesia Laos Malaysia Myanmar Philippines
AFTA ASEAN Free Trade Area Singapore Thailand Vietnam

CACM Central American Common Market Costa Rica El Salvador Guatemala Honduras Nicaragua

Azerbaijan Armenia Belarus Georgia Moldova Kazakhstan Russian Federation

CIS Commonwealth of Independent States Ukraine Uzbekistan Tajikistan Kyrgyz Republic

EAEC Eurasian Economic Community Belarus Kazakhstan Kyrgyz Republic Russian Federation Tajikistan

EC European Communities …

EEA European Economic Area EC Iceland Liechtenstein Norway

EFTA European Free Trade Association Iceland Liechtenstein Norway Switzerland

GCC Gulf Cooperation Council Bahrain Kuwait Oman Qatar Saudi Arabia United Arab Emirates

MERCOSUR Southern Common Market Argentina Brazil Paraguay Uruguay

NAFTA North American Free Trade Agreement Canada Mexico United States

Southern African Development Angola Botswana Lesotho Malawi Mauritius Mozambique Namibia South Africa
SADC Swaziland Tanzania Zambia Zimbabwe
West African Economic and Monetary Benin Burkina Faso Côte d'Ivoire Guinea Bissau Mali Niger Senegal Togo
PTA’s and the GATT/WTO

•! These agreements contradict the Evolution of Regional Trade

Agreements in the world, 1948-2002
MFN clause of the GATT.
–! Since Non-member countries are Number of RTAs
no longer MFN
•! WTO members must notify the
regional trade agreements (RTAs)
in which they participate.
•! The WTO accepts PTAs only if
–! They have broad sectoral coverage
–! Members cut their tariffs to zero,
–! Tariffs to non-members do not
increase Source: WTO Secretariat
PTA’s and the road to Free Trade

•! Building blocks
–! PTA’s can grow and merge, in a path to global
FT (domino)
–! Facilitate negotiations in the Multilateral
•! Lower number of negotiating partners
•! Provide experience with new, difficult topics Free-Trade
•! Stumbling blocks
–! Lower bargaining power of developing
countries will force them to accept worse Stumbling
RIAs blocks
•! This will make US and Europe loose interest in

–! Large powers will find themselves large

enough Unilateral Multilateral

Customs Unions and Free Trade Areas

•! Customs Union (e.g. European Union)

–! Free-Trade within members states
–! Adopt a common external tariff

•! Free Trade Area

–! Free-Trade within member states
–! Each country sets its own external tariff
–! “Rules of origin” requirements are necessary to prevent
Why do countries engage in PTA’s?

•! Political arguments
–! Economic interdependence raises the cost of wars
–! Economic integration may pave the way to political integration
–! Increase global bargaining power: Small countries benefit from
negotiating as a merged entity
–! Lock-in economic and political reform

•! Increased gains from trade

•! Attract FDI with promise of larger market

Are PTA’s welfare enhancing for
member countries?

•! Trade Creation (positive effect) Pr

–! Lower tariffs lead to increased
Trade creation
trade, lowering deadweight losses. Sup
–! Gains from Trade
•! Trade diversion (negative effect)
Prod Trf
–! Substitution of PTA partners’

FTA Partner
producers for efficient producers surplus rev price

reduces welfare.
–! Knowledge transfers are also lost, FT price
if imports of advanced Trade diversion Dem
intermediates are displaced

Welfare loss due to trade diversion

•! Trade diversion is large if
–! External tariff is very high Cons
–! FTA partner is not efficient, but
imports will come from there. Prod Trf

surplus rev
–! Imports from PTA partner and
FT price
other countries are strong Trade diversion Dem

Trade diversion and government

Customs revenue for SADC members (% of Total Gov. Rev.), 1996

•! The costs of trade
Duties’ rev (% Change in rev. from SADC
diversion can be Country government
revenue) in % of in % of total
duties’ rev. rev.
particularly strong in
Malawi 14.3 -36.7 -5.3
countries where tariffs
Mauritius 29.8 -18.2 -5.4
are an important source South
3.6 4.9 0.2
of government revenue,
Tanzania 24.0 -8.3 -2.0
and the tax system is
Zambia 12.3 -45.3 -5.6

Zimbabwe 18.4 -53.3 -9.8
Internal and external comparative
advantage in a PTA I

Uganda Kenya World Relative Capital


•! For simplicity, assume there are two goods:

–! Manufactures is capital intensive; Agriculture is resource intensive

Before PTA The consequences of a PTA:

Internal tariff on manufactures disappears
•!Both countries import •!Within the PTA, Kenya has comparative advantage in
manufactures, export Manufacture, and will export it to Uganda.
agriculture from Rest of the –! Kenya will clearly benefit from PTA, but
World –! Uganda (the poorest country) may loose, due to trade
diversion in manufacturing.
•!They have tariffs on
–! PTA can cause divergence among poor countries!
imports of manufactures
Internal and external comparative
advantage in a PTA II

World Spain France Relative Skill


•! For simplicity, assume there are two goods:

–! High-tech is skill-intensive; Textiles is labor intensive

Before PTA The consequences of a PTA:

Internal tariff on textiles disappears
•!Both countries import •!Within the PTA, Spain has comparative advantage in
textiles from Rest of the Textiles, and will export it to France.
World –! Spain will clearly benefit from PTA, but

•!They have tariffs on –! France (the rich country) wins less (or may loose), due to
trade diversion in textiles.
imports of textiles
–! PTA causes convergence among rich countries!
FDI and PTA’s

•! PTA’s create large markets that

attract FDI
–! Mexico in Nafta,
–! East-European members of EU

•! Clustering, due to increasing

returns, may lead to
concentration of economic
activity in more developed
Globalization and Development

International Trade – Session 10

Daniel TRAÇA
Rich countries, Poor countries (2000)

Country and Country and

Income status GDP per capita, PPP Income status GDP per capita, PPP
(% of world pop) (% of world pop)
Low Income (40%) 1,918 Lo-Mid. Inc. (35%) 4,345
Tanzania 500 Russian Federation 7,473
Nicaragua 2,279 China 3,617
Vietnam 1,860 Turkey 6,380
India 2,247 Thailand 6,132
Up-Mid. Inc. (10%) 8,970 High Income (15%) 25,706
Brazil 7,036 Australia 24,574
Chile 8,651 Germany 23,741
Malaysia 8,208 France 22,896
South Korea 15,712 United States 31,871
Poland 8,449 Japan 24,897
South Africa 8,908 Singapore 20,766
Mauritius 9,106
Is there convergence?

Starting with the sample of OECD economies:

There is convergence (poor countries grew faster than rich countries)
Is there convergence?

… we add some Asian economies. There is still some pattern of convergence

but there are countries that violate the rule: they were poor and the stayed

Is there convergence?

… when we put together over 100 economies there is no pattern of

convergence. Countries that were poor in 1960 did not do better than rich
countries. If any, we see a pattern of divergence.
The benefits of trade for developing

•! Comparative advantage in natural-resource- and unskilled-intensive

–! Specialization in unskilled intensive products will raise wages and create
jobs, which will improve the income distribution.

•! Gains from increased competition and economies of scale

–! Pressure from global markets forces productivity and innovation

•! Knowledge transfers through the imports of intermediate goods

and prospects for imitation (reverse-engineering)
–! The gains from trade can expand income today (static gains from trade)
and in the future (dynamic gains from trade)
Dangers from trade-based growth

•! Specialization in primary commodities

–! Other sectors displaced by Dutch disease and higher trade costs

•! Difficult access to markets in industrialized countries

•! Market failures: Infant industry argument

Dutch disease

•! Appreciation of the exchange

rate and competition for
skilled labor and capital
•! Hurts the competitiveness of
non-primary exports,
•! Raising barriers to
industrialization and hurting
traditional exporters.
For many developing countries, which
export mostly primary commodities…

Exports of Agricultural raw materials, Fuel and Ores

and metals (% of merchandise exports)
•! The price of these goods are
1965 1980 1998 Main
India 17.8 12.9 4.5
Indonesia 75.6 89.9 28.0 Petroleum
very volatile and show a
Brazil 24.2 15.1 14.2 Coffee, Soybeans, Iron ore
Nigeria 43.3 97.4 97.1 Petroleum
Mexico 39.2 75.6 8.5
Philippines 35.3 27.3 2.7
Coconut products
secular declining trend,
Egypt 64.5 82.3 41.0 Coffee, hides
Malaysia 83.2 65.9 10.4 Rubber, Palm Oil, Petroleum
Venezuela 97.2 97.9 77.6 Petroleum
which will deteriorate their
Chile 90.7 75.4 52.3 Copper
Guatemala 21.6 22.4 6.4 Coffee, Sugar
Bolivia 93.9 89.0 40.1 Tin, gas, zinc, silver terms of trade.
Sri Lanka 34.4 Tea, Rubber, Coconut
Korea 23.9 2.7 6.5
USA 13.5 14.0 5.9
UK 9.4 19.6 7.1
Japan 4.5 2.9 2.2
Terms of trade and commodity prices

•! A key factor for the decline in

the TOT of many developing
nations is their reliance in
exports of primary products.
•! The price of these commodities
has been declining in real
terms, for two reasons:
–! Low income elasticity (Biased
–! High productivity gains than in Terms of trade of non-fuel commodities to
manufacturing (Biased growth)
1980 147
1985 100
1990 80
1992 71
Infant industry argument

•! Strong market failures in developing nations

–! Very weak capital markets, unable to fund short-term costs
–! Poor appropriability, pioneering, innovative firms cannot reap the returns
from their investments

•! Protection and subsidies in early life provide space for growth

–! Dynamic comparative advantage: long-term goal must be global
competitiveness, free of protection

•! But also stronger government failures

–! Weak institutions and Corruption
–! Competence and skills of bureaucrats
–! Protection provides safe-haven for lack of productivity
–! Firms used to protection will seek continued protection
There are more than flows of goods.
There are also flows of factors:

•! Flows of labor
–! Migration
•! Flows of capital
–! Official flows: Aid
–! Private capital flows
•! Short-term speculative flows
–! e.g. Hedging exchange-rate misalignments
•! Long-term flows
–! Searching for higher rates of return
Unskilled Labor from developing
countries searches for higher wages
in industrialized countries
•! Migration of unskilled workers is explained by the differences in the
abundance of unskilled labor and capital between rich and poor
–! Developing countries are abundant in unskilled labor. Hence unskilled
wages are lower there, because the marginal product of unskilled labor
is lower.

•! Unskilled migration depresses the relative wage in industrialized

countries, and raises it in the developing countries, leading to
convergence around the world and benefiting both countries.
–! In the United States, migration accounts for 1/3 of the decline in the
wages of unskilled workers. These have fallen 10%, compared to wages
of skilled workers.
There is also migration of Skilled
Labor (e.g. computer technicians, doctors)

•! Developing countries are

poorly endowed in skilled
labor. How can they export it?
–! There are complementarities
with capital. Their productivity
may be higher in industrialized
countries, even if they are
more abundant.
•! For developing countries this
may cause a BRAIN DRAIN
–! These skilled workers are
necessary for development.
They have an external effect in
their home country.
Flows of capital

countries Capital flows
•!Relatively abundant in
from rich to poor •!Capital is scarce
•! Capital
countries •!Lack of
accumulation development
through the
development •!High returns to
process capital
•!Low return to capital •! decreasing
•! decreasing returns returns

With trade there should be some convergence in returns to

capital, but there will be no complete equalization
Higher profits will be remitted
to shareholders in the country
of origin,… but workers there
will lose, as investment is
moved abroad
Types of private flows and benefits
to host-countries

Types of flows Benefits to host-country

Portfolio flows
–!Bond financing
–!Equity flows
•!Funds to be used for
Bank lending consumption and/or
–!Sovereign borrowing: by local government or with investment
an explicit government guarantee
–!Private sector borrowing; directly or through
domestic banking system
Foreign direct investment •!Funds for investment
Foreign companies obtain managerial interest, and/or consumption
through acquisition or greenfield project •!Knowledge transfer from
The lower bound is usually taken as 10% of capital. MNC
Understanding FDI of multinationals

•! (location) What determines where a good is produced?

–! Proximity to markets
–! Availability of resources of low cost (i.e. abundant) factors
•! (internalization) Why will the same firm produce in
different locations?
•! Why is the good not produced by local firms, who could license the
–! MNC’s have some competences/technologies that can only be
deployed trough internalization
•! Technology transfers: concerns with loss of control of know-how
•! Vertical integration: problems of coordination
Downsides of Capital Inflows

•! Bank lending and Portfolio Flows

–! Macroeconomic instability
–! Volatility and currency crisis
•! Foreign Direct Investment through
–! Foreign multinationals are very
powerful. Often more powerful
than host-nations.
–! Foreign investors may bring down
local firms, transferring profits
–! If there is no competition policy,
foreign investors can become
monopolists and create
deadweight losses.
FDI flows mostly within industrialized countries
… And among a few developing nations
FDI (net inflows), % of Total flows for Developing Countries
1980 1985 1990 1995 2000 2002 •! FDI flows are heavily
Argentina 10.8 7.5 7.6 5.3 6.4 0.5 concentrated on top
Brazil 30.4 11.7 4.1 4.6 20.2 11.3
Chile 3.4 1.2 2.8 2.8 2.2 1.2
China 13.5 14.5 34.0 23.7 33.5 •! East Asia, Eastern
Hong Kong, China 38.2 8.7 Europe and Latin
America are main
India 1.3 0.9 1.0 2.0 1.6 2.1
regional destinations
Mexico 33.3 16.2 10.6 9.0 9.9 9.9
Malaysia 14.9 5.7 9.7 4.0 2.3 2.2
•! Low income countries
Poland 0.4 3.5 5.8 2.8
received 10% of FDI
Singapore 19.7 8.5 23.2 10.9 7.7 4.1
to developing
Venezuela, RB 0.9 0.6 1.9 0.9 2.9 0.5 countries
South Africa 1.2 0.6 0.5
Total (exc HK) 114.6 65.7 75.8 77.2 82.8 68.1
East Asia & Pacific 20.9 24.0 43.7 48.2 27.3 37.3
Europe & Central Asia 0.5 1.1 5.1 16.6 18.1 22.4
Latin America & Caribbean 101.3 48.7 34.0 29.0 47.5 30.4
Middle East & North Africa -27.7 16.2 10.8 -0.7 1.5 1.8
South Asia 3.1 2.2 2.2 2.8 2.1 2.8
Sub-Saharan Africa 1.9 7.9 4.0 4.1 3.6 5.3
Low income 6.6 15.9 11.5 12.8 3.6 8.8
Middle income 93.4 84.1 88.5 87.2 96.4 91.2
Source: WDI 2003
The role of FDI in host-countries
FDI (net inflows) % GDP •! The role of FDI in
1980 1985 1990 1995 2000 2002 China is not larger
Argentina 0.88 1.04 1.30 2.17 3.67 0.77 than in other
Brazil 0.81 0.65 0.21 0.69 5.45 3.66 countries.
Chile 0.77 0.88 2.18 4.53 4.82 2.67
China 0.54 0.98 5.12 3.55 3.89
•! FDI has played a large
Hong Kong, China 37.45 7.92
role in recent Latin
India 0.04 0.05 0.07 0.60 0.58 0.59
American development
Mexico 1.08 1.08 0.97 3.33 2.77 2.29 (Brazil, Chile,
Malaysia 3.75 2.19 5.30 4.70 4.20 3.38 Argentina).
Poland 0.15 3.31 5.69 2.19
Singapore 10.55 5.92 15.11 13.71 13.63 7.01
•! FDI plays a small role
Venezuela, RB 0.08 0.11 0.93 1.27 3.88 0.73
in India and South
South Africa 0.83 0.76 0.71
East Asia & Pacific 0.57 1.58 3.99 2.81 3.06
Europe & Central Asia 0.11 1.73 3.11 2.91
Latin America & Caribbean 0.87 0.86 0.74 1.82 3.91 2.69
Middle East & North Africa -0.62 0.42 0.56 -0.17 0.38
South Asia 0.08 0.09 0.13 0.62 0.58 0.65
Sub-Saharan Africa 0.89 1.42 1.85 2.49

Source: WDI 2003

Why doesn’t capital move to poor

•! Risk
–! Political instability
–! Security

•! Knowledge
–! Low availability of skilled workers

•! Lack of infrastructure
Managing globalization in developing
International Trade – Session 11
Daniel TRAÇA
What policies for developing

•! From 1950’s to 1980’s

–! Import-substitution
•! Latin America, India, Africa
–! Export-promotion
•! East Asia

–! Diverse attitudes to Capital Flows and FDI

•! The debt crisis in the 1980’s

•! From 1980’s to the end 1990’s

–! Washington Consensus: Free-trade and Capital Flows

•! The 21st century

–! Reforming the World Trading System
Tools of import-substitution

The effective rate of subsidy measures the

•! Protectionism of industries such as
food processing, automobile assembly net protection received by the industries,
–! Protection of domestic markets discounting the taxes on upstream industries
–! Taxes on exports
–! Subsidies and duty-drawbacks on Effective rates of subsidy
•! Overvalued exchange rates to lower All industries Manufacturing
the prices of imports of capital goods Exports Domestic Exports Domestic
•! High Government Expenditure
(subsidies and infrastructure) Import-substitution
•! Diverse policies regarding Argentina -17 55 -29 116
Multinationals and FDI Colombia -12 -1 10 32
–! Brazil was open, India was closed
•! The volume of exports declined S. Korea 9 10 14 7
dramatically for these countries, as
resources were absorbed by import- Singapore 1 8 -1 4
competing sectors Taiwan 16 2 21 17
Dismal Results of import-substitution

•! Most protected sectors never became efficient, because

the country had no comparative advantage
•! Lobbying for protection fueled rent-seeking and
•! Lack of competition in home-markets created
comfortable monopolies below minimum efficient scales
•! High inflation and continuous current account deficits due
to macroeconomic mismanagement and government
The East Asian Miracle

•! Macroeconomic rigor Per capita

Pop Income Growth rates, 1960-94
•! High investment and high savings Region
country (103 1985 US$)
•! Expansion of human capital, 1990
through basic education 1960 1990 GDP Pop

•! Rapid growth of exports, due to China 1,134 0.6 1.3 6.8 1.8 2.3
explicit promotion East Asia
(exc. China)
308 0.9 3.6 6.8 2.2 2.5
•! Diverse approach to FDI: Korea 43 0.9 6.7 8.5 1.7 2.6
–! Japan and Korea constrained it Singapore 3 1.6 11.7 8.3 1.7 2.7
–! Singapore strongly encouraged it Taiwan 20 1.3 8.1 8.7 2.1 2.7
•! State guidance and industrial South Asia 1,130 0.8 1.1 4.2 2.3 1.9
policy, but flexible and with small Africa 432 0.6 0.7 2.9 2.8 2.6
role. Middle East 175 1.9 3.0 4.5 2.9 2.9
•! Declining income inequality and Latin
421 2.4 4.1 4.2 2.4 2.7
reduced poverty America
853 6.4 14.9 3.5 0.9 1.1

Source: Bosworth and Collins, 1996

Non-traditional Export Push in East Asia

•! Exports were a key criterion for

credit allocation in contests Share of Four Tigers in developing
–! Those that did not export did economies’ exports
not have access to credit
•! Access to imports (Duty 1965 1980 1990
drawbacks, free-trade zones)
•! Exchange rate focused on All goods
competitiveness 6.0 13.3 33.9
•! Export financing and Support Manufactures
of trade missions 13.2 44.9 61.5

Source: The East Asian Miracle, World Bank

The road to the Debt Crisis

Poor adjustment
Debt crisis (1982)
•! Failed macro Import substitution
Mexico and other Latin
adjustment and
American countries
borrowed abroad
•! Increased •! Inflation, Capital flight,
Protectionism Low investment

Latin America, Korea

Good adjustment
Good Adjustment
•!Did not borrow Outward oriented
Singapore, Taiwan Korea, Chile

Early 70’s Stagflation in Early 80’s

•!Oil Shock industrialized •! Second Oil Shock
•!Collapse of countries •! Volker’s interest rate shock
Bretton Woods •! World recession
The road to the Washington

Closed countries
•! Trade restrictions
•! Socialist
•! Distorted exchange rate
•! Marketing boards for
agricultural exports
Sachs and Warner (1997)
The Washington Consensus

The tenets of the

Washington Consensus
•! Macroeconomic rigor
•! Privatization
•! Unilateral liberalization of
trade and investment

Latin American growth did not do better than under import-substitution

East Asia had not only strong trade but also strong institutions.
Latin America is lacking those!
Openness, FDI and Development
Lessons learnt in the 1990’s

•! Priorities of reform should be the strength of institutions and the

macroeconomic rigor
•! Free-trade is better for growth, but should be a long-term objective
–! Trade liberalization induces costs of adjustment, that generate poverty
and social disruption.
–! No country has ever succeeded without integration in the global trading
•! Foreign investment brings capital and know-how. It benefits host-
–! But, it is not a magic bullet. And countries have succeeded without FDI
•! The global trading system must be reformed to help developing
–! The Doha round.
Anti-dumping (Article VI)

•! Large exporting countries (e.g. Korea) and Developing countries

would like a revision of anti-dumping legislation to reduce abuse.
•! Commitment to clarify and improve disciplines while preserving the
basic concepts, principles and effectiveness of the agreements
–! Taking into account the needs of developing and least-developed
•! But industrialized countries, particularly United States, are against
revisions that undermine their current discretion to impose duties.
–! Recently, the US congress has amended fast-track authority to exclude
trade-remedy clauses, like ADD.
–! Trade officials must give Congress advance notice if they agree to any
changes in these rules.
Agriculture export subsidies I:

•! Of the 51,000 sugar cane growers in South Africa, most of them farming in
the lush terrain beside the Indian Ocean, 49,000 are small farmers. Another
85,000 South Africans depend on jobs in the sugar industry - harvesting,
milling or transporting sugar cane.
•! It costs between US$250 and US$300 to produce one tone of sugar in South
Africa. In Europe, it costs US$600. But EU subsidies enable European
farmers to continue growing sugar beet and dumping their excess on the
world market.
•! The South African Sugar Association estimates that over the past decade,
the EU has depressed the world sugar price by 20 to 40 per cent, forcing
small farmers out of business.
–! "If there were changes in the subsidy regime, European farmers would no longer produce sugar.
It might increase our chance of competing in the world market."
Vish Suparsad, director of external affairs for the South African Sugar Association
Agriculture export subsidies II
The players

•! Intensive farming hurts environment $U.S. millions

and creates health risks (e.g. mad-
•! Unfair competition to efficient countries
(e.g. Australia, Argentina)
•! Fewer imports of agricultural products
from developing countries
•! Lower world prices undermine
livelihoods in many rural developing
•! Massive expenditure in EU budget

remove subsidies = “Win Win”

–! Except for the EU agricultural lobby
Tariff escalation

•! Processed food products

attract tariffs at least twice as
high as those on unprocessed
•! Higher value-added activities
are more protected

•! This inhibits value creation in

developing countries and slows
down transition to higher value
added products
Source: Hoekman, Mattoo and English
The Double Standards of Western

Tariff peaks Tariff Textiles and Clothing Anti-

(over 15%) escalation Agriculture (TC) dumping

Prod. MFA # against

Av. Av tariff: Sup. Average Av tariff
% imp % imp Highest Ph.Out: % dev c’s
MFN processed / (% farm agricultural TC
DC’s LDC’s tariff unproce. (bound) tariff
of target
bound (1/7/95-
tariff inc,
(2002) 30/6/00)

EU 4.9 2.8 40.3 252 2.75 40 20.0 24 7.9 145

meat prod.

US 6.6 15.0 20.8 ground 1.25 23 9.0 23 8.9 89

CAN 4.8 30.2 30.5 120 3.00 18 8.8 n.a. 12.4 22

meat prod.

JAP 2.8 2.6 27.8 170 raw

3.75 63 29.7 - 6.8 0
cane sugar

Source OXFAM
Trade-Related Intellectual Property’s

•! The UR included a sweeping agreement to Number of Patents

create patents for a minimum of 20 years.
–! LDC’s by 2005

•! Developing countries must set legislation to

comply. This
–! is expensive

–! may hurt local industry and technology


–! may conflict with public health policies

Indigenous knowledge
protection and developing
countries: the case of BASMATI

•! Rice grown in Punjab provinces of •! Patenting of Texmati

India and Pakistan –! genetic modification to copy
•! Basmati means fragrant earth Basmati
–! innovative step can be patented
•! India grows 650 thousand metric
tones –! no rewards to India for the
–! exported 523 thousand in 1997,
worth $277 million dollars •! Regional Appellation
–! Rice Tec selling Texmati rice in US, –! Basmati means “fragrant” earth so
capturing local market and no recourse to regional appellation
international market with Kasmati •! Trademark
and Jasmati –! No facilities to register trademarks
in India
Review Session
International Trade – Session 12
Daniel TRAÇA
The final exam

Duration: 2 h 30’

•! 3 short questions with direct answer (max 10 lines)
•! 2 open ended question, asking for a comment on current
events (real or simulated) (max 1 page)

•! Answers accepted in English or French

Three classical models of
international trade

Source of The exporting Distributional

comparative sector (w/ Common features Consequences
advantage Comparative Advantage) WHO Looses?
•!Perfect Competition
and Non-increasing Workers with high
Relative Labor …Has higher Returns to Scale costs of adjustment
Classical Productivity relative
in import-comp
(e.g. technology) productivity
•!Gains From Trade for sectors
all countries (even
those that are less
productive or less
wealthy), even with
costs of adjustment
…Uses more Factors that are
proportions Relative
intensively the used intensively in
(Factor Endowment of •!The Terms of trade
relatively more capture the import-comp sector
intensities differ Factors
abundant factor implications for (i.e. scarce factor)
across sectors)
domestic welfare of
foreign shocks
New Trade Theory

Increasing Reasons for Trade Gains From

Specialization is
returns Aggressive Trade
•!Economies of Scale determined by:
strategies of firms •! Pro- •!Luck
•!Labor Market
Pooling •!To enter foreign competitive •!Home Market Effect
•!Specialized inputs markets where effects (fewer
•!Sillicon Valey
•!Civil Aviation prices are higher deadweight
than marginal costs losses)
(e.g. reciprocal •! Rationalization
The gains from
Imperfect trade are
dumping) (Lower Unit
Competition independent of
•! Monopoly •!To go down cost Costs) the pattern of
curves by •!More Varieties trade, unlike
comparative advantage
Competition expanding output (choice)
The costs of protection

•! The cost of protectionism:

–! Deadweight losses in consumption and production from diminished gains
of comparative advantage
–! Anti-competitive effects, if domestic competition is weak, particularly
with quantitative restrictions
–! Rent-seeking and other unproductive activities
•! Free-trade is the best policy, regardless of the policy of our trading

•! Preferential Trade: Lowering protection by discriminating across

trading partners may be harmful, due to trade diversion
Instruments of Protection

other than the distribution of the revenue

All these forms are equivalent under competitive markets,
Instrument What they do: Who keeps the revenue Other aspects

Imports / exports Government Budget

Tariffs and must pay/receive a
export fee (specific or ad- Important in countries
valorem) to cross the
without reliable tax systems
border (e.g. Africa)

Owners of import licenses Anti-competitive

Impose limits on effects.
Quotas the volume of Generates important rent-
seeking activities by With constraints on
importers quantities, domestic
firms are ‘isolated’
from the effects of
changes in world
Foreign Exporters
Voluntary prices.
governments accept
Export to impose Can be used to persuade More rent-seeking
constraints on their exporters to reduce behavior
own exports competitive pressure Importers benefit
also from protection
Exceptions to free-trade

Bogus arguments Protection has social/ Protection has economic

political benefits benefits
•!Protectionism and •! Responding to •!Large countries may benefit
the Trade Balance special interests from terms-of-trade effects.
are independent, in matters •!Promoting Strategic
the long-run. –!Visible loosers, Industries (with market
hidden winners failures)
•!Preserving social –!Protection may help but is
•!Unfair trade: Anti- peace
dumping duties only almost never the best policy
–!Redistribution is
make sense in the difficult –!The best policy targets
very unlikely case of •!Very high costs of distortions through minimal
protection intervention
predatory dumping.
From Classic Free-Trader to

Costs of protection Benefits from protection Policy prescription

Classical Strategist

High… Low…
because Unilateral
because all industries
advantage drives pay the same returns
trade (perfect markets)

Low… High…
because the economy Promote/
because Increasing
benefits more from protect
returns and
Strategic Industries
Imperfect than from traditional strategic
Competition drive ones (imperfect sectors
trade markets).
sector strategic


•! Resources add more to the •! Gains do not accrue to the
economy in strategic industries owners of the resources, but to
industries than in others. other stakeholders.
•! These external effects
•! Resources may not flow into constitute market
these industries by themselves, imperfections:
due to market imperfections … –! Technological Spillovers
–! Imperfect capital markets. –! Consumer gains from
–! High barriers to entry competition
–! Non-Economic objectives:
national security, national
The Realist’s critique: From market
failures to government failures

•! Weak evidence of strategic •! Implementation difficulties

sectors –! Picking Winners!
–! Spillovers that travel through •! Information requirements
trade and the flow of ideas (markets and technologies)
–! Agency Problems
•! Stress Comparative Advantage •! Capture by interests
•! Bureaucrats’ objectives
–! Nuances of differences across
•! Credibility and controlling the
private sector.
–! Retaliation
•! Even if successful, strategic
trade policy plays a limited
empirical role in development
–! The case of Japan
If government failures are more serious than market failures,
Free Trade is the best better policy

Raising the burden of proof

•! On rents •! On the costs of distorting global trade
–! If there are rents, why isn’t the –! Can we really become as efficient as our
private sector investing? trading partner?
–! Fashionable is not profitable! –! What are all sources of comparative
•! On external effects advantage?
–! What will be the non-financial –! What are the costs of undermining
benefits? economies of scale?
–! Can we ensure that they are only •! On the ability to implement successfully
–! What are the prospects of capture by
–! What is the best way to obtain
private interests?
those benefits?
–! Won’t our trading partners retaliate?
•! On the opportunity cost
Then what?
–! How high are the costs?
–! Will temporary support not become
–! Isn’t the money better spent in
building resources: infra-structure,
Understanding the WTO

The fundamental principles The complaints of developing nations

•! Market access
•! Transparency (tariffs)
–! Tariff peaks
•! National treatment •! Agriculture

–! The fundamental definition of •! Textiles and Clothing

–! Tariff escalation
•! Export subsidies
•! MFN treatment •! Agriculture
–! The exception to regionalism •! TRIP’s agreement
•! The Dispute Settlement –! Access to important technologies (e.g.
–! Patenting of traditional knowledge
Developing Countries… Can globalization

No evidence of convergence, on average, despite some success stories.

Globalization Pro’s Con’s
•!Gains from trade.
•!Specialization in primary commodities,
with declining real prices
•!Knowledge transfers •!Difficult access to markets in
Trade flows through the imports of industrialized countries
intermediate goods and
•!Market failures: Infant industry
prospects for imitation

•!Ability to export abundant •!Outflow of skilled labor

Labor flows
unskilled labor (BRAIN DRAIN)

•!Access to Capital and, more •!Expatriation of profits

important, to Knowledge from •!Size of MNC may distort the local
MNC’s (firm-specific assets) economy (corruption, market power).
The experience of developing nations

•! Import substitution •! Outward oriented

•! Poor macroeconomic management •! Macroeconomic rigor and high

and over-borrowing savings rate
–! On the road to the debt crisis –! Stimulate investment by reducing
the cost of capital
•! High Protection of domestic firms
to replace foreign producers •! Export push through active policies
–! Inefficient producers given lack of –! Only efficient producers survive,
competition forcing productivity gains
–! Widespread corruption for –! Access to international know-how
protection in export markets
–! Undermining comparative –! Less rampant corruption,
advantage organized in pro-trade lobbies
Lessons from the 1990’s

The failed Washington Consensus A modern, nuanced view

•! Macroeconomic rigor •! Priorities of reform should be
•! Privatization institutions and macroeconomic
•! Unilateral liberalization of trade and rigor
investment flows •! Free-trade is better for growth,
but should be a long-term
•! Foreign investment brings
capital and know-how that
benefits host-countries
–! But, it is not a magic bullet.

•! The global trading system must

be reformed to help developing