Contemporary and Emerging Issues in Trade Theory and Policy: Volume 4

This series is aimed at economists and financial economists worldwide and will provide an in depth look at current global topics. Each volume in the series will focus on specialized topics for greater understanding of the chosen subject and provide a detailed discussion of emerging issues. The target audiences are professional researchers, graduate students, and policy makers. It will offer cutting-edge views on new horizons and deepen the understanding in these emerging topics.

The collection of essays in this volume provides fairly comprehensive analyses of contemporary theoretical and policy issues in international trade. As technological revolution eliminates communications costs and the countries gear towards more open trade regimes through negotiations at the WTO, the world effectively gets smaller. The evolution of research in trade theory and policy has closely followed the trends in global economy. Issues such as how trade affects distribution of income across and within nations, generates resources for growth, leads to bilateral and multilateral cooperation and conflicts, and many others have been picked up and analyzed systematically in various chapters of this volume. Before we go into the details of the relevant sections and constituent chapters, it is worthwhile to emphasize two special features of this volume.

This chapter presents a general equilibrium model that embeds the issue of national security within a two-country Heckscher–Ohlin model of international trade. “National security” is defined as a public good that is an increasing function of a country's own defense expenditure and a decreasing function of the other country's defense expenditure. Defense is a non-traded public good produced by capital and labor, along with two tradable private goods in each country. The model is solved as a Nash equilibrium in defense expenditures and a Walrasian equilibrium for the two traded goods and the factors of production. It is shown that opening to international trade raises defense expenditures in each country since national security is a normal good in each of them. If defense is more capital-intensive than both tradable goods then trade lowers the cost of defense for the labor-abundant country and raises it for the capital-abundant country.

The dominant paradigm of world trade patterns posits two principal features. Trade between North and South arises due to traditional comparative advantage. Trade within the North, largely intra-industry trade, is based on economies of scale and product differentiation. The paradigm specifically denies an important role for endowment differences in determining North–North trade. We demonstrate that trade in factor services among countries of the North is systematically related to endowment differences and large in economic magnitude. Intra-industry trade, rather than being a puzzle for a factor endowments theory, is instead the conduit for a great deal of this factor service trade.

This chapter investigates the structure of a simple vertical competition model by exhibiting the competitive links among assemblers, component producers, and integrated firms in a generalization of Cournot's model of the vertical integration by allowing any degree of competition among cohorts. Vertical integration in the model can take place by vertical mergers, forward or backward integration. Vertical integration is highly profitable and always reduces the price of the final product. The cost-raising strategy of an integrated firm buying out unneeded component producers is profitable and detrimental to consumers only if the firm faces no competition from other integrated firms.

Nearly all international trade takes place in middle products, rather than in finished goods as it is assumed in most models of international trade theory. Recognition of this fact has some far-reaching consequences for the measurement of real value added, real domestic income, and productivity, and it brings forward the role of a number of related, yet distinct, key price ratios: the terms of trade, the real exchange rate, and the trading gains. Production theory, rather than consumer theory, is therefore the appropriate setting for analyzing issues such as openness, trade imbalances, and income distribution.

We develop a simple two-country model of international trade that assumes that there is a fixed cost of doing international trade. We show that this leads to multiple equilibria that can be Pareto-ranked. We examine the stability properties of these equilibria.

Regardless of extent of substitutability and complementarity in a conventional general equilibrium model with three factors and two sectors, there is no possibility that factor rewards of the extreme factors will reverse their ranking in response to a change in relative prices.

The effect of changes in commodity prices on factor rewards is studied in the multi-commodity, multi-factor case. It is shown that the inverse of the distributive share matrix must satisfy the following restriction: it cannot be anti-symmetric in its sign pattern. This means that one cannot partition the commodities into two groups (I and II) and factors into two groups (A and B), such that all factors in group A benefit (nominally) from all commodity price increases in group I, and simultaneously all factors in group B suffer from all commodity price increases in group II. It turns out that this is also the only sign-pattern restriction imposed by the general nature of the relationship of commodity prices and factor rewards.

When the factor endowments of two trading countries do not lie in the same diversification cone, trade in commodities may not reduce the international factor return differentials. This chapter specifies some conditions of the demand function in a two-factor, infinite-good model that guarantee partial factor price equalization. The wage-rental ratios of two trading countries are convergent if goods farther apart are poorer substitutes than goods closer together in the factor-intensity ranking. This generalizes the result in the literature, which is usually obtained under the assumption of Cobb–Douglas utility and production functions.

We extend the Jones (1971) analysis of the effects of distortions in 2×2 trade models to the case of a two-sector dynamic general equilibrium model of a small open economy with capital accumulation. We do a comparative steady state analysis for the effect of policy changes on factor prices and the capital stock, and examine the dynamics of the system in the neighborhood of the steady state. We also show that the system will have multiple equilibria when value and physical factor intensity rankings of the sectors do not agree.

Based on the Jones (1971) model, we construct two dynamic models of international trade in which the rate of time preference is either constant or time-varying. The main purpose is to study whether and under what conditions the results derived in the Jones model still hold in the dynamic framework. It is shown that the results of dynamic models may be similar or different to those obtained in the static model. For example, it is possible that, in both static and dynamic models, an increase in the commodity price raises this commodity's output and the return to the specific factor in this sector. However, the effects on the wage rate may be different due to the factor accumulation impact in the dynamic framework.

This chapter builds up a simple general equilibrium trade model where, in the absence of a credit market for human capital formation, initial distribution of capital endowment and relevant factor prices determine the size of the three income classes. The poor, with little capital, invests in traditional manufacturing, the middle-income group invests solely in human capital and the rich invests in both. Chances are that such an economy will export both high- and low-skilled goods, importing the middle one. Conventional wisdom suggests that greater skill premium encourages skill formation. In contrast, we show that higher unskilled wage and lower degree of income inequality are consistent with greater skill formation. We also show that protection discourages skill formation and may aggravate inequality.

The existing theoretical literature does not adequately take into consideration the existence of non-traded goods and the nature of capital mobility between the traded and the non-traded sectors in analyzing the consequences of liberalized investment policies on the relative wage inequality in the developing countries. The present chapter purports to fill in this gap by using two four-sector general equilibrium models reasonable for a developing economy. We have examined the outcome of foreign capital inflows on wage inequality when non-traded goods are intermediate inputs and final goods. Appropriate policy recommendations for improving the wage inequality have also been made.

Most models attempting to give an account of trade-induced symmetric increase in wage inequality have abandoned the factor price equalization (FPE) framework. The present chapter retains the FPE framework and identifies a plausible route through which trade might increase wage inequality in all trading countries. A two-sector model with one constant returns sector producing basic goods and another increasing returns to scale sector producing fancy goods is developed. A quasi-linear utility function is used to capture the divide between basic and fancy goods. There are two types of productive factors, skilled and unskilled labour, and they differ with respect to their occupational options. Skilled labour can work both in the skill using fancy goods sector and in the unskilled labour using basic good producing sector, whereas unskilled labour is tied down to unskilled job. The model holds possibilities of multiple equilibria and under reasonable parameterization skill premium increases in all countries following trade.

With product labelling has already been in vogue in the developed countries to distinguish products produced by child labour from those that are “child labour free” to influence the buyers’ choice, one might be tempted to suggest that such labels should contain more information regarding the extent to which child labour has been used in a product. But, as this chapter shows, if labels contain such information and the buyers react to this by offering increasingly lower prices for the varieties containing more child labour per unit of output, it may do more harm than helping the cause. That is, a trade sanction against child labour content of a good exported by developing countries may not be a good idea since it may, in fact, raise the incidence of child labour in those countries. This result is established in a simple general equilibrium framework where parents are altruist.

This chapter examines the impact of urban development through the government provision of public inputs in a developing economy. When a financing constraint is taken into account, an increase in public inputs may worsen urban unemployment and hence reduce welfare of the economy. Further, the optimal level of public-input provision is larger (smaller) than that under full employment, if there exits a positive (negative) employment effect. The theoretical results are confirmed by numerical simulations.

We present a model that allows us to compare the effects that frictions involved in immigration and international outsourcing have on the skilled–unskilled wage inequality. We show that, for any given level of contractual friction in the production of intermediate goods, the wedge between the wages of the skilled and unskilled workers widens as the frictions in immigration wear out. The skilled–unskilled wage gap, for any given level of friction in immigration, is sensitive to variations in contractual frictions in intermediates that affect international outsourcing.

In this chapter, I explore the impacts of international capital movements on income distribution within countries and the value of trade in goods. Jones (1980) introduces sector-specific capital into a simple Ricardian setting and examines the role of comparative and absolute advantage in determining the allocation of capital between countries. I introduce a simple structure of the demand for commodities into Jones (1980) so that commodity prices are determined endogenously in commodity markets. This extension allows us to show how the pattern of demand plays a crucial role in the effects of capital movements on income distribution and goods trade.

We show that, even with flexible domestic wages, international outsourcing may worsen the welfare of the home country and reduce the profits of all firms. If wages are rigid, outsourcing is welfare-improving if and only if the sum of the “trade creation” effect and the “exploitation effect” exceeds the “trade diversion” effect. A wage subsidy may improve welfare. We also extend the model to a two-period framework. Delaying outsourcing can be gainful because the fixed cost of outsourcing may fall over time. A social planner would choose a different speed of outsourcing than that achieved under laissez-faire.

We develop a 2×2×2 model of international trade in which one of the sectors is oligopolistic. The oligopolistic sector consists of a given number of a priori identical firms belonging to one of the two countries, but some deciding to locate in the other country so as to realize higher profits. If a firm locates in the foreign country, its technological capability is assumed to go down due to the alien environment. In this framework we examine the effect of the environment on the level of foreign direct investment and on factor prices in the two countries.

Over the last 60 years, multilateral trade liberalization has reduced tariffs to historically low levels. The dominant theory of multilateral trade agreements, based solely on terms-of-trade externalities between national governments, is the conventional wisdom among international trade theorists. But it features two defects that render it inconsistent with reality. This chapter proposes a simple formulation of the political economy of protection that dispenses with terms-of-trade externalities, predicts the properties that empirical work has confirmed, and is free of the counterfactual implications of the dominant approach. The model is applied to trade agreements.

In the real world, developed countries are permitted to impose tariffs only on a small range of imports (partial tariff). For this reason, tariff policies have been replaced in many countries by other policy devices such as a competition policy. This study compares a competition policy with a partial tariff policy. It demonstrates that if a country can impose a tariff on only a small part of the imports and at sufficiently low tariff rates, optimal partial tariff policy may not create as large a protective effect as optimal competition policy.

This chapter provides a formal analysis of the economic welfare effects for large and small partners to free trade agreements. Michaely (1998) has demonstrated that large country welfare is U-shaped in the small country's size. I derive the welfare for the large country for all possible small country sizes, and show that the maximum possible loss for the large country is twice its tariff revenue. I identify the data necessary to estimate the welfare effects and consider how initial trade volumes, tariffs, and international price differences affect the large country's welfare.

In the Jones–Kierzkowski world of fragmented production, we address a strategic trade issue for development: how to industrialize under the WTO regime. One solution is to generate cross-border externalities, such as becoming the hub of a network of countries, so as to attract foreign investment with collective comparative advantage. Thus the small, remote and pre-industrial Singapore managed to organize a hub–spokes game: achieving a win-win solution for all and gaining the most as the hub. In servicing the spokes for fee, Singapore has earned First World income levels, by the twin patterns of the flying geese and the triangular accord.