Early Beginning Of Trade Theory Economics Essay WARNING: This Essay Has No Title! COURSE ID : 4231 COURSE NAME : Growth, Inequality and Poverty LECTURER : Mansoob Murshed OF PAPER: New Trade and Growth Theories STUDENT ID: SB 1635 What is “new” about the new trade and growth theories? To what extent are the two concepts intertwined? If trade an engine for growth, why do we see so much divergence in per-capita income levels? 1. Introduction: After a long lasting debate with standard trade theory, the new models came with an offer of alternative approach of viewing international trade. These new approaches break down traditional approaches by imposing the importance of increasing returns to scale and imperfect competition in understanding current trade phenomena. But it is not something that happens suddenly. The old theories fail to explain most of the variation in recent trade pattern based on their limited assumptions. So, those theories are challenged in the last few years as a process of innovation to take place. In this context, this study tries to find out the process of innovation in trade and growth theories by critically examining the old and traditional theories. At the same time, based on the view of new theories of international trade and growth, an attempt is made to find out the reasons behind huge diverge in per-capita income among the trading countries. For doing this, this paper is organized as follows: Section 2 overviews the traditional trade theory following the background behind emergence of new trade theories in Section 3; Section 4 and 5 discuss the features of new trade theories; Section 6 and 7 describe elements of endogenous growth theories; data and offers some basic descriptive statistics; Section 8 presents the link between new trade and growth theories; Section 9 explains the trade and growth phenomena with a continuation of reasons behind divergence in per-capita income in Section 10 while Section 11 concludes the study by summarizing the finding from explained before. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2. Early Beginning of Trade Theory ‘What was the “old” trade theory?…Countries are different – they have different levels of productivity in particular industries, they have different resources, and those differences drive trade’- Krugman in The New York Times. The discussion about trade theory begins with the theory of comparative advantage theory by David Ricardo. In Ricardian model, welfare gains come through specialization of producing that good in which a country has a comparative advantage relative to other goods. (Feenstra 2002:1-2). On the other hand, the Heckscher -Ohlin model (H-O) identified difference in factor endowment as the determining factor for trade. The corollary of H-O model is factor price equalization across countries under the assumption of decreasing returns to each factor and constant returns to scale (Feenstra 2002: 2-2). The Stolper-Samuelson theory generalizes the H-O model by introducing the concept of trade protection. According to this model, a country’s scarce factor is going to lose under the condition of free trade and factor price equalization. Thus, scarce factor of production was considered to be benefit from protection and not from free trade (as cited in Sen 2010:4). Thus, countries trade with each other to take benefit from their differences in their culture, climate, skills, geography and resources. 3. Background behind Emergence of New Trade Theory It’s true that countries underlying characteristics plays a vital role for shaping their trade pattern. Now-a-days, it is difficult to explain a country’s trade pattern only based on its underlying advantage and difference in relative endowment as most of the countries are now exporting and importing the same commodities. Conventional trade theory ignores this kind of two way specialization. Besides, in some intra-industry comparative advantage seems to be determined by the knowledge of firms through experience and research and development (R&D) (Krugman 1986: 8). According to Helpman and Krugman (1986: 2), we can identify four major gaps in which the previous trade theories fail to account empirical observation. Trade between countries that are similar in relative factor endowment. Two way trade in goods with similar factor intensity. Intra firm trade and foreign direct investment (FDI). Important aspects of welfare impact of trade are missed. These four empirical weakness of previous trade theories reinforces the need of adopting new theory that would be based on more realistic assumptions and incorporate all these awkward facts. 4. New Trade Theories: Discard from Limited Assumption The new trade theories relax the restrictive assumptions of perfect competition and the absence of market failures, which are considered as the key element of traditional trade theory. These theories provide us the clear explanation of the puzzle of why countries with similar factor endowments trade with each other without considering pre trade difference in comparative costs. The explanations are hidden in: A. Increasing Returns to Scale: Both Ricardo and Heckscher-Ohlin assumed constant returns to scale in production in their theory. But a firm or industry may experience increasing returns to scale or economies of scale in production, which can enable them to produce a bulk amount in a relatively cheaper cost. If difference in factor endowment and technology fail to generate any incentive for trade and specialization then the advantage of large scale production will lead countries to specialize and trade with each other (Helpman and Krugman 1985: 3). Increasing returns also give us the explanation of two way trade (intra industry) in goods with similar factor content. Krugman (2000:3) has very clearly elucidated that trade in similar commodities can arise for taking the advantage of increasing returns not for taking the advantage of their differences. According to him, new trade theory acknowledges the difference of endowment between countries can be one of the reasons for trade. But most important is to capture the inherent advantage to specialize in a world of initially identical countries. B. Monopolistic Completion: New trade theory introduces economies of scale in production which makes efficiency difference between small and large farms. For this difference industry may consist of only a few numbers of efficient firms. Production may be imperfectly competitive in the sense that excess or super normal profits are captured by the large farms. So presence of economies of scale breakdowns perfect competition in the market and leads more efficient firms to stay and expand their market as a result of increased output (Krugman 2000:11). C. Product Variety The New Trade Theory introduces the concept of greater variety of product in international trade. This is because of the industry experiencing economies of scale consists of a few no of firms acting as monopolistic competitor. The products that are coming to the market are same but firms differentiate their product so that they are not perfect substitute for either existing product or new product of potential entrants (Helpman and Krugman 1985: 35). Consumers benefit from having greater variety of product as they get the liberty of choosing among different variety. So, welfare increases for variety and also for reduction of prices from decrease average cost in an industry consists of monopolistic competitors. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order The heart of the New Trade Theory is that, countries trade with each other not only for the comparative advantage or difference in factor endowments. But also for the economies of scale that capture the center of the argument of validating all missing link that previous theories of factor endowments and comparative advantage cannot explain. 5. Protectionism within New Trade Theories ‘The potential gains from trade are even larger in a world of increasing returns, and thus, in a way, the case for free trade is all the stronger. New trade models show that it is possible (not certain) that such tools as export subsidies, temporary tariffs, and so on, may shift world specialization in a way favorable to the protecting nation’- Krugman (2000:3). In old theories, trade protection policies (like: tariff or quota restrictions) have been used as a tool of reducing import of a particular commodity. These kinds of trade policy hurt domestic consumers and producers. As an example, in 1981 US government asked Japan for limiting its export of autos to United States. This decision increased the price of imported cars in U.S. Consumers are supposed to buy high priced domestic autos although their choice is inferior for it (Krugman and Obstfeld 2000:218). Old theory strongly supports free trade rather than any kind of restrictions over trade (Krugman 2000:3). Still now many economists support free trade policy. Because they believe free trade produces additional gains from trade ‘beyond elimination of production and consumption distortions’. Some of them who think free trade is less than a perfect policy but it is better than any other policy a government likely to follow (Krugman and Obstfeld 2000:218) . According to new theories, the result is not that much straight forward. It can be either much worse or much better Krugman (2000:3). It would be worse when protection fragmented the world market with no specialization and inefficient scale production. It would be good when protecting an industry increase the scale of that industry and reduce the price offered by that industry to domestic consumers. Thus protection works when there are economies of scale in production. But it works through different dimensions as mentioned by Krugman (2000). It increases domestic sales in one market for the benefit of lowering foreign sales in all other market. (2000:191) It increases domestic Research and Development (R&D) at foreign expenses. As a result, domestic sales not only increase in protective market but also increase even in unprotected market (2000:195). For the effect of learning by doing, protection leads to an increase in cumulative output of domestic firms while reducing that of foreign firms. It doesn’t depend on whether they are protected or not (2000:97). Trade protection can generate both static and dynamic gains from trade (Lehmann 2000:5). First, static gains can be gained from providing market power by government through trade restriction. When domestic producers got the market power, they can underprice the product to get rid of foreign competitors. Thus, producers can increase output and market share at decreasing average cost in industries characterized by economies of scale. Second, dynamic gains are possible if entry is costly and high learning effects and externalities prevail in the protected industries and other firms or other sectors benefit from their existence. 6. New Growth or Endogenous Growth Theory Neoclassical growth model like Solow’s growth model (1986:66) assumed constant returns to scale to factor of production with diminishing marginal productivity. Growth, in this model is driven by increases in capital labor ratio. The level of per-capita income depends on capital and its growth depends on the marginal productivity of capital. That means countries with low volume of capital stock relative to labour (as the LDCs) would experience lower per-capita income but faster per capita growth than countries with high capital. However, since per-capita growth in the steady state is solely determined by exogenous technical progress, in the long run all countries will grow at the same rate. Policy in this neo-classical setting has little scope to affect long-run growth of a country as savings and investment have only level effect but not growth effect. Policies can affect the long-term growth rate only by speeding up technical innovation or knowledge accumulation. But these theories don’t tell any us any mechanisms of achieving that target. Also there are neither invention costs of development of new technologies nor adoption costs of using new technologies (Mayer 1996:6). This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order The inability to explain growth solely by means of capital deepening or technological progress considered to be highly unsatisfactory among economists, and raise the need of a genre of models to remedy this kind of ad hoc treatment of technology. New growth theories (called endogenous growth theory) came with a power of endogonising technological progress through: Innovation and Invention; Knowledge accumulation; Learning by doing and Human capital formulation. Romer (1986) is one of the earlier writers of endogonize technical progress in the growth model. He explained that growth might be sustainable in the long run as long as returns to the accumulation of knowledge do not diminish. But it can be affected by government policies and market mechanism itself. Because government policies change the incentive to invest and due to positive externality through spillover effects, market would allocate a suboptimal amount of capital formation. In Grossman and Helpman’s (1991) models, technological progress is endogenously determined through economic incentives and allocation of economic resources. According to them technological progress come from entrepreneurs resource allocation to research and development in response to their expected returns on their investments. But it’s difficult for firms to keep knowledge limited among them for spillover of knowledge. So the process of knowledge creation generates endogenous gains in productivity which will then lead the growth to be sustained. Arrow (1962) introduces learning by doing model an example of endogenising technological progress in the growth process. Firms continuously gather new knowledge while in the process of production. Such knowledge then enters into economy and contributes to the productivity of other manufacturing processes. 7. Policy implication for New Trade Theories Most important part of neo-classical growth model is the convergence hypothesis, which creates well debate among economists about its empirical testing. But finding are sensitive towards some specific fast growing countries of East Asia, it would seem that when those countries are included in the model, growth of per capita output has been too high to be explained solely by increases in the capital-labor ratio (Brander, 1992: PP). Within the new (endogenous) growth theories, trade openness can bring higher economic growth through externalities associated with capital accumulation, especially human capital and knowledge that allows constant or increasing returns to scale. But a subset of countries may experience diminished growth depending on their initial factor endowments and levels of technological development. (Rodriguez and Rodrik 2000: 264) 8. Link between New Trade and Growth The contribution of new trade and endogenous growth theory is that these allow the formal modeling of divergences from standard neoclassical assumptions. Both theories move together in the sense of technological innovation and human-capital accumulation. Combining the finding of both theories we can sum up as follows: A. Capital flow developed to developing countries: The newer theories emphasize that long run growth between countries can differ even if the capital flows are unstrained. Technological progress would create that difference according to country’s human capital. B. Spillovers of knowledge and technology National or international spillovers of knowledge and technology can be crucial for the diversification experience. Basically, from developed countries to less diversified developing countries or from more diversified developing and industrialized countries to relatively less diversified developing countries. C. Policy implications An important feature of the theories viewed above is positive external effects on production possibilities. As a result, the government has an active role to play through improving the inter-temporal allocation of resources to shape a country’s dynamic comparative advantage and influence its rate of long-term growth. 9. Is Trade an engine of Growth? Trade plays an important role in shaping a country’s economic and social performance. At the same time, it enlarges the prospects of countries around the world, especially those of developing countries. Now-a-days, it is impossible for a country to behave like an autarky situation and grow up without international trade. But the contribution of trade to a country’s development depends not only on trade but also a great deal on the context in which it works and the objectives it serves. If we look at the history, in recent decades, a number of developing countries, especially the East Asian newly industrializing countries, have been able to use the elemental force of trade purposefully to improve growth and development within a short span of time. On the other hand, many least developed countries (LDCs) followed liberalization policies in recent years with very limited success in terms of boosting growth and development. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order Before going to find out the other factors, it is necessary to look at trade and growth nexus according to existing evidence. But the evidences are mixed as some support convergence, other supports divergence. Moreover, due to methodological limitations the evidence on convergence is highly criticised. Trade and Per capita income convergence The neoclassical growth model (Solow, 1956) predicts income convergence among similar countries, even there is no evidence of trade. According to (static) traditional theories (i.e., the Ricardian, Hecksher-Ohlin theories), trade liberalization in the form of lower barriers improve welfare through the specialization gains and exchange gains that could not be possible under restricted trade regime. The dynamic versions of these traditional models suggest that trade accelerate the accumulation of additional resources which lead to a productivity gains over the time. This can be possible due to higher savings generated from higher output levels or enhanced technology. So, countries that open up trade should experience higher output growth in the long run. Recent studies by Ben-David (1993, 1996) and Sachs and Warner (1995) represent evidence in fabor of income convergence among the trading countries. Ben-David finds convergence across a group of counties that follow a liberalized trade policy among each other (1993) or trade a lot with each other (1996:16) especially EC; Denmark, Ireland and United Kingdom. The findings suggest that convergence tendency is higher among the wealthier countries that trade with each other than randomly grouped counties. On the other hand, Sachs and Warner (1995) explain convergence across a group of countries when they open international trade to each other. According to them, ‘the convergence club is the club of economies linked together by international trade (1995:41)’ But these studies are highly criticized by Rodriguez and Rodrik (2000: 281) for methodological and measurement problems. According to them, Sachs and Warner’s (S-W) study has a sample selection bias as not all countries in the sample have data on all S-W criteria. Recently, Matthew Slaughter (1997:7) has argued that a great part of the convergence experienced by the European economies studied by Ben- David and by Sachs and Warner’s occurs because of convergence in capital labor ratios rather than factor prices. Trade and Per capita income divergence New growth theories endogonize technological progress through innovation, invention, increasing returns to scale and human capital formulation. Since the values of these structural variables differ widely across countries, so do disparities in predicted steady-state income levels (Jones, 1997, pp. 28–31). Bernard and Jones (1996) find that sine 1970 cross country productivity levels for manufacturing for individual manufacturing industries have been diverging. ‘in trade able-goods sectors, comparative advantage leads to specialize and to the extent that countries are producing different goods, there is no a prior reason to expect the technologies of production to be the same or to converge over time’ (PP: 1237). Slaughter (2001) argues that after 1945, trade liberalization caused income divergence among liberalized countries. The analysis is based on comparison between the convergence patterns among the liberalizing countries before and after liberalization with the convergence pattern among control countries. A business-cycle model is employed by Hallet and Piscitelli (2002) to capture this trade growth relationship. He found that large, stable and well-integrated economies are likely to diverge. Smaller, volatile or less well-integrated economies will converge. 10. Reasons for Divergence Empirical studies fail to find support of income convergence among the developing countries. Only a few countries grown faster than the others, namely the so-called emerging economies (Brazil, China, India, Mexico, South-East Asian countries, oil-exporting countries in the Middle East, Central and Eastern European countries). The most remarkable example of the widening gap is in Sub-Saharan Africa where Nigeria and Madagascar, suffered a decline in per-capita output of about 10 and 40 percent respectfully over the period 1960-88 (Brander 1992:796). Azariadis and Drazen (1990: 503) are explicit on this point: ‘One explanation, of course, is that persistent differences in national economic performance are due entirely to systematic variations across countries in culture, religion, national economic policies, or broadly defined social institutions, that is, to economically ‘exogenous’ factors.’ (a) Structural and institutional factors Structure and nature of institution that provoke policy environment could lead one nation to develop more rapidly than another. If their internal institutions of civil law and property rights failed to insure security for economic actors, incentives for productive activity and capital accumulation will not exist (Smith, 1937 pp. 95, 268). Similarly, restricted policies on exchange activity would limit the extent of the market and the division of labor and, hence, the pace of economic growth. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order In a cross-section analysis, Dollar (2002: 25) finds that high levels of trade and good institutions go together in the long run with rapid growth. This suggests that both trade and institutions are important in understanding cross-country differences in growth rates in the very long run. But the problem is lack of information on cross-country variation. (b) Trade policies and processes Lower trade restriction fosters trade by reducing transaction costs and enhances economic growth. But it is also argued that some forms of protectionism, e.g., infant industry protection to develop certain industries or sectors or a strategic trade policy in key sectors, can be beneficial for economic development. According to Rodriguez and Rodrik (2001), trade policies can be seen as responses to market imperfections or as mechanisms of rent seeking. But such policies have a different impact on trade volumes than other constraints due to transport costs or shifts in consumer preferences. (c) Level of development A country’s level of development would matter for growth to sustain in the long run. As Ronald Findlay (1984, p. 222) observed some basic asymmetry related to the stage of development between the two regions. Northern and Southern economies may differ with regards to their macroeconomic structures or due to the impact of specializing in products with sharply different microeconomic characteristics (returns to scale, demand elasticities). Bhagwati (1982) tells the same paradoxical immiserising growth result can occur only if a country’s export activity influences the terms of trade or if there are one or more pre-existing distortions in the structure of relative domestic prices which breakdowns perfectly competitive conditions. In North–South analysis, growth and trade have a general immiserising quality for the South that is controlled by North. So, South would always lag behind the North. (d) Nature of product Trade and growth relationship depends on the nature of product a country specializing in producing. Prices of primary commodities, particularly tropical products and food crops, fluctuate sharply with the changes in global supply and demand. So, countries whose trade baskets are concentrated on exportation of primary product, would generally suffer in the long run. Mansoob (2004: 1) pointed out that, countries placing a heavier reliance on natural resources in their production structure will also experience grate cyclical fluctuations in their national income account. As an example, many African countries obtain over half their export their export earnings from one or two primary commodities like Nigeria, Algeria and Libya. But if we look at the history of Nigeria, we find that in 1980s this country was caught by a ‘Dutch disease’ phenomenon because of expansion in exports till date was singularly accounted for by petroleum and hydrocarbon. But after independence in 1960s, the trend and pattern of exports tended to suggest that the country was moving from a mono-cultural agrarian economy to a more diversified economy. (e) Geography Recent burning issue explaining the divergence phenomena is geography. Because lack of natural access to markets due to the presence of mountains or deserts or the absence of waterways, could lead to relatively slower growth in some regions compared with others. Smith’s (1937: 20–1) explains one of the geographically disadvantaged regions as inland Africa and the interior of Asia. He contended that the first evidence of the division of labor appeared on seacoasts or on navigable rivers, especially the ancient nations of the Mediterranean coast. Gallup, et al. (1998:1) find that location and climate have large effects on income levels and income growth through their effects on transport costs, disease burdens, and agricultural productivity, among other channels. (f)   Culture, Religion and Trust The link between growth and culture has been ignored by neo-classical economist. Cuesta (2004:17-18) shows that development role attributed to culture in general and specific values, beliefs and behaviours. Because specific values of trust and civic, participatory and associational behaviours have a significant impact on national economic development and community welfare. But the problem is lack of supporting evidence. As an example he uses, Honduras where interpersonal trust and participation in community management are strong determents of household economic welfare. 11. Conclusion Trade and development performance of a country is not simple the sum of its economic growth and export performance. To act as an engine of development, trade must lead to steady improvements in human conditions by expanding the range of people’s choice among the trading countries. The extent of such choice depends much on the interplay among other factors that determine both trade outcomes and development outcomes. That’s why although most of the countries engage in international trade, we see a lot of divergence in case of per-capita income among trading countries. If trade is an engine of growth the systematic gap between the developed and developing countries would be narrower by trade. So, growth is not always derived by trade, there are other factors that play a vital role with trade to accelerate economic growth.