International trade and the inequality of nations.

Tony Venables,

London School of Economics &

UK Department for International Development

• Is international trade a force – for the convergence of real incomes across countries?– for the divergence of real incomes?

• What is the historical record?

• What does economic analysis suggest?

• Is there a tension between the evidence and the theory?

• Should international economics be reformulated to capture massive and persistent international inequalities?

Argue that:

• In different time periods and different contexts the effects of trade have been quite different.

• To understand this need a theory which recognises that the productivity of labour – and hence comparative advantage – depends on inputs that are complementary with labour.

• Supply of these complementary inputs is endogenous:

Some are supplied publicly, some privately.

They may be internationally mobile.

They are often associated with cumulative causation processes.

Plan of lecture

• Review of evidence.

• Development of simple analytical frameworks to think about the role of complementary inputs:

– Capital

– Institutions, infrastructure and investment climate

– Intermediate goods

1: Historical record – the great divergence:

• Ratio of per capita incomes of richest to poorest nations increased from around 8 in 1870 to 50 in 2000

• Decline in shipping costs and increasing role of trade

Real cost of ocean shipping World merchandise exports % GDP

1790 376 1820 1%

1830 287 1870 4.6%

1870 196 1913 7.9%

1930 107 1929 9.0%

1960 47 1950 5.5%

1990 51 1973 10.5%

1998 17.2%

Figure 2: Regions' share in world population

0%

20%

40%

60%

80%

100%

1820 1870 1913 1950 1998

Rest World

Br. India

Other E.Asia

Japan

China

N.America

Rest W.Eu

UK

Figure 1: Regions' share of world GDP

0%

20%

40%

60%

80%

100%

1820 1870 1913 1950 1998

Rest World

Br. India

Other E.Asia

Japan

China

N.America

Rest W.Eu

UK

Phase I Phase II Phase III

Figure 2: Regions' share in world industrial production

0%

20%

40%

60%

80%

100%

1750 1830 1880 1913 1953 1998

Rest World

Br. India

Other E.Asia

Japan

China

N.America

Rest W.Eur

UK

Figure 4: Regions' share in world manufactured exports

0%

20%

40%

60%

80%

100%

1876-80 1913 1955 1997

Rest World

Other Asia

Japan

China

N.America

Rest W.Eu

UK

An interpretation of the evidence:

• Rich club/ poor club – ‘convergence clubs’

• Rich club has captured most of the benefits of trade.

• Coexistence of these clubs for extremely long periods of time.

• Economic development in sequence not in parallel

NB:

• Not seeking to argue that all changes in international inequality due to trade.

• But, need analysis that recognises:

(a) ambiguous effects of trade and

(b) trade is consistent with persistent inequalities.

Benchmark model:Goods:

Agriculture: XA = A(LA, KA), numeraireManufactures: XM = M(LM, KM), price p.

Inputs: KA ‘Complementary input’ in agric; return rA

KM ‘Complementary input’ in manuf; return rM

L = LA + LM Fixed endowment of labour; wage w.

Equilibrium:w = a(LA/KA) = pm(LM/KM)

Also:rA = [A(LA/KA) - wLA)]/ KA

rM = [pM(LM/KM) - wLM]/ KM

Model I: Trade and factor flight: Capital as the complementary input.

Consider a small open economy that has a comparative disadvantage in manufactures.

Source of comparative disadvantage?Land abundanceTechnical inefficiency

Complementary factor in manufactures may be internationally mobile: eg, human or physical capital.

Question: What is effect of opening to trade?

K agric

K manuf

rm=1, autarky

rm=1, free trade

initialendowment

Ka , Km withtrade and Km

mobility

Ka , Km withautarky andKm mobility

worldendowmentratio

Trade and capital mobility in a land abundant economy

rm>1rm<1

K manuf

Rate of return,agriculture

Real wages &domestic income

Rate of return,manufactures

Fig xx: Factor returns relative to autarky: Ka abundant country

Autarky values = 1

K manuf

Rate of return,agriculture

Real wages &domestic income

Rate of return,manufactures

Fig xx: Factor returns relative to rest of world: countrywith technical inefficiency in manufactures (10%).

Autarky values = 0.95

Key points:

• Under autarky, the cost of a technical inefficiency or comparative disadvantage is spread across the entire population, via goods prices.

• With trade, this cost is concentrated on owners of specific factors in the sector with disadvantage.

• If this factor is internationally mobile, then this will cause capital flight and a fall in the wage.

• Gain to initial residents – ‘national’ real income Loss to ‘domestic’ real income.

Key points (continued):

• Trade lets a country move factors out of sector with comparative disadvantage – but how are they absorbed elsewhere?

Can ‘capital’ be employed elsewhere? Heckscher-Ohlin versus specific factors model.

Can labour be redeployed without running into diminishing returns?

• The more things are tradable the easier it is to redeploy factors from contracting sectors without running into diminishing returns.

Application and policy

• Lagging regions? Increased trade denudes regions of skills/ capital.

• Mono-crop agriculture and import competing manufacture?

• Export diversification a necessary accompaniment to import liberalization.

Model II: Infrastructure and institutions: publicly provided complementary inputs.

• Institutions matter – Acemoglu et al.

• Institutions are a ‘complementary input’ to production.

• Institutions are more important for some activities than others. ‘Countries with better contract enforcement specialise in industries that rely heavily on relationship specific investments’, (Nunn, 2005)

• Investment in institutions a public good, and usually cannot be made sector specific

What are these ‘institutions’?

• Rule of law, property rights, limits to corruption• Infrastructure• Investment climate

NB:Matter particularly for modern manufacturing exports:

• Importance of reliability and quality control • Just-in-time delivery.• O-rings and supermodularity – value of a product is

determined by its weakest link.

• Public investments in institutions/ infrastructure/ investment climate, have properties that:i) Public goods, not easily targeted to particular sector.ii) Productivity effect varies across sectors – high in modern manufacturing?

• How does the provision of these services shape trade, and how does trade shape the provision of these services?

• Show that two economies that are ex ante identical can be different ex post – just one of them captures all the gains from trade.

Model II:• Two sectors, A and M, as before, using labour and a

public service, s.• Marginal (and average) products of labour in each sector,

a(si), pm(si)

• One unit of labour produces one unit of public service.

In country i, if both sectors active: wi = a(si) = pm(si)

Labour market clearing: 1 - si = LA + LM .

Real income of country i: ui = (1 - si)wi p-μ

Autarky: ui = (1 - si) a(si)1-μ m(si)μ

Optimal choice of s: si /(1 - si) = (1- μ)ηA + μηM

Can there be an asymmetric equilibrium?Suppose so: in equilibrium, country 1 has only manufactures;

L1M = 1 – s1, w1 = pm(s1) > a(s1)

country 2 has agriculture and manufactures;L2

M + L2A = 1 – s1, w2 = pm(s2) = a(s2)

This means that world price is, p = a(s2) /m(s2)Real income levels, u1, u2:

u1 = (1–s1)w1 p-μ = (1–s1) m(s1)[a(s2) /m(s2) ]1-μ

optimal choice of s1: s1 /(1 – s1) = ηM

u2 = (1–s2)w2 p-μ = (1–s2)a(s2)1-μ m(s2)μ

optimal choice of s2: s2 /(1 – s2) = (1- μ)ηA + μηM

Optimal choice of s1 : s1 /(1 – s1) = ηM Optimal choice of s2 : s2 /(1 – s2) = (1- μ)ηA + μηM

This is an equilibrium if ηM > ηA: In this case country choices imply, s1 > s2, and therefore

productivity levels such that country 1 specialised in manufactures.

Country 2 has no incentive to deviate.

Real income levels?Country 2: No gains from trade (same choice of s2, and same prices as under autarky).

Country 1: Gains from trade (higher level of s1, same prices as under autarky).

The game between countries:

Remove discontinuities by adding a specific factor in agriculture: a(si , Li

A/KA)

Compute best response functions.

Multiple equilibria.

Gains/ losses from trade.

E

s2

Eqm where country 1 takesall the gains from trade.

s1 =R(s2)

s1

E

Best response functions and equilibria

s2 =R(s1)

Key points:

• Economies may be identical ex ante, but asymmetric ex post, with one taking all the gains from trade.

• If one country has already made the investments that give it comparative advantage in manufacturing, then it is not worthwhile for the other country to investment.

• I.e., for a country with a small modern sector it is rational to invest little in the public goods that raise productivity in this sector (…..and therefore it will turn out to have a small modern sector).

• Target provision of infrastructure/ institutional investments?

Model III: Intermediate goods: linkages and clustering.

• Third sort of complementary input: intermediate goods.• Draw on ‘new economic geography’, Fujita, Krugman &

Venables.• Productivity depends on local supply of intermediates• Intermediate goods create the possibility of forward and

backward linkages -- old idea from the development literature (Hirshman, Myrdal). • Forward (cost) linkages: downstream firms gain from proximity to their suppliers (eg, save transport costs).• Backward (demand) linkages: upstream firms gain from proximity to their customers (transport costs).

• Can produce outcomes where activity ‘clusters’ in one country.

Key assumptions to get clustering?

• Many types of intermediate goods, and each type only produced in one place – presumably because of increasing returns to scale. (Without this assumption, have ‘backyard capitalism’).

• Proximity advantage – eg transport costs.

The model:• Agriculture: labour productivity: a(Li

A)

• Manufactures: Each country produces its own variety of final good, output prices = unit cost, p1, p2 (perfect competition)

• Inputs to manufacturing: • Labour, with share in costs 1 – v.

• Continuum of intermediate goods, share v, elasticity of substitution between intermediate varieties = 1 (Cobb-

Douglas). • Intermediate goods can be produced in one country or the

other, using just labour. Let θ denote the fraction of the types produced in country 1.• Intermediates’ prices, w + ε, transport costs t.• Final goods prices, p1 = w1

1-vw1vθ (w2t)v(1- θ) ,

p2 = w2(1-v)w2

v(1- θ) (w1t)vθ

Price of final goods produced in country 1, country 2;

p1 = w1[1-v(1-θ)] (w2t)

v(1-θ), p2 = w2[1-vθ] (w1t)vθ

Demand for final goods from both countries, exports have transport cost ; X1= D(p1, p2+) + D(p1+, p2), X2 = D(p2, p1+) + D(p2+, p1)

yi is quantity of each variety of intermediate produced in country i.Derived demand for intermediate goods (in value terms);

w1y1θ = θv(p1X1+p2X2/t), w2y2(1- θ) = (1- θ)v(p2X2+p1X1/t).

Each variety of produced in country from which it makes largest total sales, i.e. θ adjusts until y1 = y2.

How does varying the location of intermediate good production change

profitability, y1, y2? Increase θ implies ↓p1 and ↑p2.

• Crowding effect: Given X, if more locally supplied then each sold in smaller quantity. Depends on value of t.

• Cost/ sales effect: Reduction in p1 expands sales, X1, and hence increases y1. Depends on values of t and .

• Will get clustering of activity if cost/ sale effect dominates crowding.

y2

t = 1.7

y1

y2

t = 1.58

y1

y2

t = 1.55

y1

y2

t = 1.1

y1

Trade liberalisation causes concentration of activity

Spatial bifurcation

= 0

Trade costs

, share ofintermediateproduction incountry 1

= 1

= 1/2

Stable eqmUnstable eqm

Summary:

• At high trade costs, each country has industry to supply local consumers – crowding effect dominates cost/sales expansion effect. Symmetry, θ = ½.

• At intermediate trade costs, sales more responsive to cost differences – cost/ sales effect dominates. Agglomeration, θ = 1 or θ = 0.

So far, assumed wages fixed: what if they respond to employment levels (upward sloping labour supply curve from other sectors)?

y2

t = 1.7

y1

y2

t = 1.52

y1

y2

t = 1.4

y1

Divergence and convergence

y2

t = 1.1

y1

The tomahawk: Spatial bifurcation with wage flexibility

= 0

Trade costs

, share ofintermediateproduction incountry 1

= 1

= 1/2

Stable eqmUnstable eqm

Real wages, if country 1 has the cluster

Realwages 1, 2

Trade costs

2

1 = 2

1

Cut trade costs: – deindustrialises 2 & cuts its real wage – globalization phase, rapid catch up by 2,

possible fall real wage in 1.

Summary – the general theory of location:

• At high trade costs: location determined by demand:θ = ½. Equal real wages.

• At intermediate trade costs: location determined by clustering forces: θ = 1 or θ = 0. Real wages unequal.

• At low trade costs: location determined by factor costsθ = ½. Equal real wages.

• Implications for real wages and the distribution of the gains from trade.

• In multi-country setting, have ‘rich club’ / ‘poor club’.

Extensions – other clustering mechanisms:

• ‘Timeliness’ as a trade cost: (Harrigan & Venables)

• One assembly plant in each country.• Range of intermediate goods, each type produced in just one

country.• Probability of remotely produced int. arriving on time, q < 1.• Probability of all ints. arriving on time for plant in country 1 is

q1-θ, where θ is no. of intermediates prod. in 1.• This probability is increasing and convex in θ.• If delaying production is costly, then it is efficient to put all

intermediate production next to one assembly plant – ie., clustering.

V2

V1 + V 2

V1

Arrival time uncertainty

Timeliness:

• Intermediate producers cluster, because it is better to have one assembly plant working well and the other badly, than both ‘1/2 well’

• Intuition – if one part is delayed, matters less that second is also delayed.

Extensions:

• Other clustering mechanisms?

• Thick labour markets -- matching-- skill acquisition

• Knowledge spillovers.

• What is their interaction with trade?Trade liberalization facilitates clustering – all the way to free trade (i.e., not tomahawk case)?

• What is their spatial scale? Urban rather than international economics?

Conclusions:

• Need to recognise that trade has not always brought a balanced distribution of benefits.

• Have offered some reasons why this is so – organised around the theme of the supply and/or location of complementary inputs to production.

• Absolutely NOT a rejection of the case for trade liberalization; many of these models yield much larger world gains from trade liberalisation than do standard models.

BUT: Recognise that opening to trade can create problems.

• Alternative employment of resources displaced from import competing sector may mean lower income. Even in a ‘perfect’ economy, trade can increase incentives for factor flight and redeployed labour may run into diminishing returns and lower wages. Need more tradable goods – diversification (Model I)

• Incentives to improve institutions and the investment climate may be low. Need cost effective ways to target these expenditures. Aid for trade. (Model II)

• Small trade frictions combined with ‘linkages’ mean that large wage differences are not enough to attract industry. But optimistic message – globalization reduces the value of proximity and facilitates relocation of stages of the production process. (Model III)