international rade,t 31e00500 - aalto...despite obvious inter-industry specialization various goods...

International Trade, 31E00500Lecture 1: Introduction

Saara Tamminen1

1VATT Institute of Economic Research, Finland

Winter 2016

Tamminen (VATT) Lecture 1 5.1.2016 1 / 57

Table of contents

1 Intro and Practicalities

2 Facts to be explained1: Interindustry specialization2: Intra-industry trade3: Multinationals, services trade and labor markets4: Firm Heterogeneity, trade and income inequality

3 Foundations of the classical theories of international tradeConstant returns to scaleProduction possibility frontierProduction in the competitive economyPreferences, demand and welfare


Intro and Practicalities

Practicalities 1/2

Textbook:Charles van Marrewijk (CvM), 2012:International economics, theory, application andpolicy,2nd edition, Oxford university press

Charles van Marrewijk is Dutch and a Professor of

International Economics (since 2008) at Utrecht

University School of Economics and a Professor of

Economics (since 2014) at the International Business

School Suzhou (IBSS) of Xi'an Jiaotong - Liverpool

University (XJTLU) in Suzhou, China.



Practicalities 2/2

Passing the course:

1 Exam 50 % (compulsory to pass the course),

2 Term paper 35 % (compulsory to pass the course),

3 Exercises 15 %.

Lectures:

Tue 10-12(Arkadia E-124)

Thurs 12-14 (Arkadia E-124)

some Fridays 10-12 (Arkadia E-124), see:https://mycourses.aalto.�/course/view.php?id=3611


https://mycourses.aalto.fi/course/view.php?id=3611


Course schedule

11 "normal" lectures (3 di�erent lecturers)

Last (12th) lecture for the presentation of student's draft termpapers (11.2.2016)

3 exercise packages and 3 exercise lectures (the correct answers areonly provided during the exercise lessons)

Exercise lectures by the course's teaching assistant: AnnaliinaKotilainen, Aalto (annaliina.kotilainen@aalto.�)



Important notes

1 You are expected to read all chapters and articles allocated to eachlecture before the lectures. See the syllabus.

2 Lecture notes will be published online after the lectures.

3 Active classroom participation is very much appreciated.



Term paper 1/3

Important dates:

Deadline for sending the main research question and name of people inyour research team to Saara (saara.tamminen@vatt.�): Friday22.01.2016 at 23.59

Presentation of draft term papers Thursday 11.2.2016, 12-14

Deadline for sending the full Term Papers to Saara: Sunday28.02.2016 at 23.59



Term paper 2/3

Other instructions:

Create a team of 2-3 persons

Think of a research question, not research topic

Choose research methodology and present draft results 11.2.2016

15 mins per presentation + time for comments

Consider the feedback and �nalise your term paper

Detailed instruction on how to write the term paper in MyCourses



Term paper 3/3

Examples of past research questions:

How trade policies have a�ected the imports of cars to Finland?

Determinants of Foreign Direct Investments to sub-Saharan Africa?

Impact of EU membership on the new members' trade?

How trade has a�ected the incomes of the poorer versus the richer indeveloped countries?

New ideas and suggestions in MyCourse:

E.g. How a 5% decrease in labor costs is expected to a�ect Finland'sglobal trade �ows?



Lecturers 1/3: Saara Tamminen

PhD International macroeconomics, Utrecht University (the Netherlands)

MSc International Economics, Erasmus University (the Netherlands)

BSc Economics, Helsinki School of Economics

Senior Researcher, Government Institute of Economic Research, Finland(VATT), 2011 →Economist, Ecorys Nederland, 2006-2011, research e.g. for EC, DG Trade

Research interests:

Firm heterogeneity, Services exports, Income inequality, Trade policies(e.g. NTMs in EU-US trade; Services exports and labor marketstructures in Finland)Computable General Equilibrium modelling, Ex-ante policy analyses(e.g. Trade Sustainability Impact Assessments)

Contact details: saara.tamminen@vatt.� / 040-3045537 / Economicum 1st�oor (make an appointment)



Lecturers 2/3: Yao Pan

PhD Economics, George Washington University(US)

B.A in economics, Renmin University of China

Assistant Professor of Economics, AaltoUniversity, 2013 →Research interests: Development and laboreconomics (e.g. Migration issues; Worker levelconsequences of import shocks)

Contact details: yao.pan@aalto.� /050-3824818 / Economicum A208



Lecturers 3/3: Katariina Nilsson-Hakkala

Associate Professor (Docent), Aalto university, Helsinki(since 2009)

PhD Economics, Stockholm School of Economics

Senior Researcher, VATT Institute of EconomicResearch, 2010 →Research interests: Labor and international economics(e.g. Multinational Firms and Job Tasks; Cross-BorderAcquisitions, Multinationals and Wage Elasticities)

Contact details: katariina.nilsson-hakkala@vatt.� /0295-519434 / Economicum


Facts to be explained 1: Interindustry specialization

Facts to be explained 1: Outline 1

What do we want to explain?

Real analysis vs. monetary analysis

Real analysis:

Why trade takes place?Implications of commodity and factor price changes on real variablessuch as labour and capital?Bene�ts from international trade?E�ects of trade restrictions and trade agreements on economies?

Focus on equilibrium determination and change in real trade �owsand welfare



Facts to be explained 1: Outline 2

Issues:

Debate on the structures of world markets and their impact oneconomic development.

Integration of world trade. North-South trade, North-North trade andSouth-South trade

Inter-industry trade, intra-industry trade and value added fromtrade.

E�ects of trade policies and regional trade agreements.

Multinationals, o�-shoring (outsourcing abroad) and labor markets.

Firm heterogeneity and income inequality.



Most countries are specialized in their production

Figure: Net exports of Finland 2013 (milj euro)



Facts to be explained 1: Inter-industry specialization 1

Competitive general equilibrium theory, the backbone of the (classical)trade theories

We'll use mostly the simplest two-industry versions of the theory.

Production possibility frontier = possible combinations of output withfull capacity

Shape of the production possibility frontier a�ected by the availabilityof resources in the economy, technological knowledge (e�ectivelyused) and inter-sectoral di�erences in technologies.

These can di�er across countries and lead to the comparativeadvantage of nations.



Facts to be explained 1: Inter-industry specialization 2

Classical trade theories focus on the supply side determinants ofinter-industry trade patters, e.g. factor endowments.

Two countries: Country A has more capital and country B morelabour.→ country A will export capital-intensive products and importlabour-intensive product from country B.

General equilibrium theory needed when one wants to discuss thedetermination of poverty, aggregate income and its distribution tofactors and people, and especially how trade a�ects these.

Classical trade theories also emphasize the structural changes impliedby e.g. reductions of trade barriers and international transport costs.



Trade policies

Old fashioned trade policy: tari�s, quantitative restrictions or importquotas, tari�-quota systems and anti-dumping policies (e.g. EUimport restrictions for sugar)

New trade policy: non-tari� measures (NTMs) and non-tari� barriers(NTBs)

NTMs: all non-price and non-quantity restrictions on trade in goods,services and investment (e.g. technical standards and testing, licencerequirements, IPR rules, di�erences in regulations from one state toanother)NTBs: NTMs that can be considered protectionists restrictions andcan be disputed in WTO (e.g. excessive custom delays, �rm subsidies,embargoes)

Trade disputes and WTO: Bananas, Steel, Shrimps, Meat (hormones),lately mostly NTB disputes (e.g. subsidies to Boeing and Airbus)



The classical trade theories to explain inter-industryspecialization

Lecture 2: Ricardian theory of Comparative advantage (from year1817)

Lecture 3: Factor intensity and the Heckscher-Ohlin model (from year1933) + Stolper-Samuelson proposition and Rybczynski proposition

Lecture 4: Trade policy: tari�s, quotas and NTMs (with perfectcompetition models)


Facts to be explained 2: Intra-industry trade

Facts to be explained 2: Intra-industry trade and 'new tradetheory'

Despite obvious inter-industry specialization various goods andservices are both exported and imported.

Exports of Nokia phones, import of iPhones

A growing share of world trade is intra-�rm trade. About 60 percentof US imports from EU were trade within multinationals in 2009.(Lanz & Miroudot, 2011)



Figure: Finland, exports and imports of some product categories 2013 (millioneuro)



Flows of sugar trade



Facts to be explained 2: Intra-industry trade 2

Several ways to understand intra-industry trade:1 Product di�erentiation and consumer's love-of-variety:

Competitive theory for a �xed number of goods: Eaton and Kortummodel.Number of goods not �xed: Need for a theory of productdi�erentiation.

2 Theory of monopolistic competition and increasing returns to scale.

3 Strategic behavior of large oligopolistic �rms: incentive to enter eachothers' markets even if they produce identical goods.

4 Global fragmentation of production processes



The 'new trade theories' and applied models to explainintra-industry trade

Lecture 5: Increasing returns to scale and imperfect competition(theories from year 1977 onwards)

Lecture 6: Intra-industry trade (theories from 1970's and 1980's) andGravity modelling (theories from 2002 & 2003 )

Lecture 7: Strategic (theories from 1980's) & applied trade policy,including applied partial and general equilibrium models' basics(developed especially after 1990's)


Facts to be explained 3: Multinationals, services trade and labor markets

Boeing 787 is produced in USA?



Facts to be explained 3: O�-shoring (outsourcing abroad) 1

Lot of research in the last 15 years on analysing the fragmentation ofproduction processes (outsourcing of some stages of production toother �rms located possibly in foreign countries).

One measure of international outsourcing is the share of importedintermediates in production.

An increase in the share may be an indication of o�-shoring

Factories of Nokia and Kone abroad increased imported intermediateinput use



Facts to be explained 3: O�-shoring 2

Especially small countries such as Denmark, Finland, Netherlands andSweden have a high share of imported intermediates.

The increases have been highest in Denmark, Finland, Germany andSweden (largest percent increase in Japan).

What explains the increasing fragmentation and o�-shoring ofproduction?

Liberalisation of world trade, communication technologies, integrationof Eastern Europe and China in the world economy, increasinginternational competition.

The other side: increasing exports of services.



Facts to be explained 3: Services exports

Services exports, di�erent modes:

Mode 1: Cross-border supply;

Mode 2: Consumption abroad;

Mode 3: Commercial presence; and

Mode 4: Presence of natural persons.

(Mode 5: Domestic indirect services value added embodied in goodstrade, Cernat 2014)

Note: Services exports vs. service sectors' exports



Figure: Examples of services trade



Figure: Extent of services trade and recent trends



Trade and labor markets

How does trade a�ect our job markets?

Does o�-shoring shift our jobs to China?

Global fragmentation of production processes and 'trade in tasks'

What statistics should be look when we want to analyse the e�ects oftrade on labor markets? Gross exports vs. domestic value added ofexports?

Does general decrease in salary costs help Finnish exports'competitiveness and increase our employment?



Figure: Gross value of exports vs. their domestic value added (VA), Finland(OECD, TiVA indicators)



Figure: The Great Structural change in Finnish exports (OECD, TiVA indicators)



Share of exports' value added from services

Figure: Share of export's domestic value added originating from service sectors(OECD, TiVA indicators)



Models on multinationals and trade in tasks to explain thesephenomena

Lecture 8: Multinational Firms and Fragmentation of Production(theories from 2004 onwards)

Lecture 9: O�shoring and labor markets (theories developed duringthe last 10 years)


Facts to be explained 4: Firm Heterogeneity, trade and income inequality

Figure: The long term view on trade developments, (Source: ourworldindata.org)



Trade & Income inequality

Income inequality has decreased between many country pairs, but has

increased within-countries in the majority of countries during last 30 years

(Anand & Segal, 2008)(Galbraith & Kum, 2005)

Helsingin Sanomat, 20.1.2014: �85 richest persons own as much wealth as

the the poorest half of the world's population in total. �

Helsingin Sanomat, 25.1.2014: �World Economic Forum in Davos warned

about the political instabilities caused by income inequality. In the streets of

Bangkok, in the barricades of Kiova and even in the war in Syria this threat

is already a reality. �

The Washington Post, 24.1.2014: �Income inequality hurts economic growth,

researchers say. �



Only a fraction of �rms export

Finland has around 200 000 �rms (excluding self-employed)

Around 10% of all �rms are exporting in Finland

But around 21% of �rms in "export sectors" are exporting

Among medium and large �rms these share are signi�cantly higher,but vary from sector to sector



Figure: Exporting �rms vs. export value by number of products and destinations(Marrewijk, 2012, �gure 17.3)

Comparison: 18 �rms created 50% of Finland's gross exports in 2010. 2.3% of

export �rms (0.35% of all �rms) accounted for 89% of Finland's gross exports in

2010.Tamminen (VATT) Lecture 1 5.1.2016 39 / 57


Facts to be explained 4: Firm Heterogeneity and 'new newtrade theory'

Exporting �rms are more productive,larger, pay better wages and do moreR&D than domestically oriented �rms inthe same sector. (Figure 4: Mayer &Ottaviano, 2008)

Learning-by-exporting or self-selection?

What is the e�ect of this �rmheterogeneity on economic structures?



Trade policy: The Banana trade war

The Banana War in 1990's and the structure of banana trade

Who won and who lost in the deal?



Melitz model and its extensions to explain the e�ects oftrade on economic structures

Lecture 10: Firm heterogeneity and the Melitz model (empirics from1995 onwards and Melitz model from 2003)

Lecture 11: Trade and income inequality (theoretical explanationsdeveloped from 2008 onwards)


Foundations of the classical theories of international trade

Quick review of microeconomic basics

Basics of supply in the general equilibrium of a perfectly competitiveeconomy:

Constant returns to scale (CRS), production possibility set, theprinciple of value maximization in a competitive economy.

Basics of demand:

From individual demand to aggregate demand, (quasi)-homotheticpreferences.

→ General equilibrium in a small open economy


Foundations of the classical theories of international trade Constant returns to scale

Constant returns to scale 1

Constant returns to scale (or perceived so at the �rm level), CRS, areintimately linked to perfect competition.

Increasing returns to scale: often in monopolistic competition.

Decreasing returns to scale: a "short run" phenomenon due to somefactor �xed in the short run.

Assume all �rms in any industry j have identical CRS technologies.Then the industry production can be presented by the same functionwith industry-level inputs as inputs in this production function.


Foundations of the classical theories of international trade Constant returns to scale

Constant returns to scale 2

The function is said to be homogeneous of degree 1 w.r.t. inputs if

Fj (λVj) = λFj (Vj) , λ > 0

where Vj = inputs (capital, labour, land etc.): if all inputs arechanged proportionately (λ), output will change in the sameproportion and production is characterised by CRS.

E.g: Cobb-Douglas

Fj (Kj , Lj) = Kαj L

1−αj , 0 ≤ α ≤ 1

E.g: LeontiefFj (Kj , Lj) = min {aKj , bLj}

, where a, b ≥ 0 are technology parameters


Foundations of the classical theories of international trade Production possibility frontier

Production possibility set

Assume now that in the given economy all sectors j have CRSproduction functions, identical within each sector but possibly di�eringbetween sectors.

Assume that the total factor supplies in the economy are V , e.g.(K , L).

Then the production possibilities are de�ned as the collection of allsectoral production levels Qj that are feasible: these production levelscan be obtained by some allocation of inputs between the sectors.

Thus (Q1,Q2, ...,QM) is in the production possibility set, ifQj ≤ Fj (Vj) in all sectors j and V1 + V2 + ...+ VM ≤ V (or∑M

j=1 Vj ≤ V ).



Production possibility frontier 1

The production possibility frontier gives the maximum production levelof one good for any given level of production of other goods.

Production possibility frontier is the boundary of the productionpossibility set.

For a two sector economy for general production functions theproduction possibility set can have almost any "shape"

With CRS PPF is concave, with increasing returns to scale (IRS) it isconvex

With CRS the production possibility set is convex (with IRSnon-convex): If two allocations of factors of production and theimplied levels of production are feasible then any mixture of theseallocations is also feasible.



Example of PPF with a funny shape



The convexity of the production possibility set means thefollowing shape:



Production possibility frontier 4

In addition to CRS we assume that the production functions have thefollowing properties:

Marginal product of each input is non-negative (in most relevant casesalways positive). This is equivalent to saying that the �rst derivativeof the production function with respect to each input is non-negative.

They are (quasi-) concave.

This assumption just generalizes the idea that the marginal product ofeach input is declining.


Foundations of the classical theories of international trade Production in the competitive economy

Production in the competitive economy 1

Why do we pay attention to the production possibility frontier?

The competitive economy is Pareto-e�cient: from that equilibriumnobody's welfare can be improved without reducing somebody else'swelfare.

This implies that at the equilibrium prices the aggregate income ismaximized.

Thus, if p is the competitive equilibrium price (vector) and Q theequilibrium output (vector) then

pQ ≡∑

pjQj ≥ pQ′

for any other output (vector) in the production possibility set.

This implies that the competitive equilibrium output is always in theproduction possibility frontier.



Production in the competitive economy 2

In the two sector economy we know that at the equilibrium incomep1Q1 + p2Q2 ≡ Y is maximized subject to the constraintQ2 ≤ P (Q1;V ), where P (Q1;V ) is the production possibility frontier,with ∂Q2

∂Q1= P ′ (Q1;V ) < 0,P” ≤ 0.

Graphically: Let Y be any level of income. Then the combinations ofoutputs that yield this level of income is

Q2 =Y

p2− p1

p2Q1

This can be called the iso-income line.

The output levels are chosen to maximize the income Y given theproduction possibility set.



The optimal choice, Y max, is described as:


Foundations of the classical theories of international trade Preferences, demand and welfare

From preferences to individual demand

Consumers maximize utility U = U(X1,X2, ...,Xi )

Utility function increasing in all commodities

Bundles that create the same level of utility belong to the sameindi�erence curve

Slope of the indi�erence curve = marginal rate of substitution (MRS)

Most functions induce diminishing MRS

Homothetic demand → indi�erence curves next to each other, nointersections



Demand and welfare

Max utility U = U(X1,X2, ...,Xi ), subject to budget constraintI = p1 ∗ X1 + p2 ∗ X2 + ...+ pi ∗ Xi

Utility maximised when MRS = p1p2

(prove this to yourselfmathematically)

Aggregate demand function, X = D(pi , I ) exists if preferences areidentical and homothetic

Higher utility indi�erence curve = higher aggregate welfare, but notnecessarily for all individuals



General equilibrium, autarky

Y

X

U(1)

U(0)

B

A

Budget constraint: 𝑌 =𝐼

𝑝𝑦−

𝑝𝑥

𝑝𝑦𝑋

𝐼

𝑝𝑦

𝐼

𝑝𝑥

PPF



Next lecture

Thursday 7.1, 12-14, on Comparative advantage with Yao Pan


international rade,t 31e00500 - aalto...despite obvious inter-industry specialization various goods...

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