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The Theory of International Trade An Alternative Approach

Branko Horvat

THE THEORY OF INTERNATIONAL TRADE

Also by Branko Horvat HISTORY OF THE YUGOSLAV OIL INDUSTRY, 3 Vols. ECONOMICS OF THE YUGOSLAV OIL INDUSTRY TOWARDS A THEORY OF PLANNED ECONOMY INTERINDUSTRY ANALYSIS ECONOMIC MODELS ECONOMIC SCIENCE AND NATIONAL ECONOMY AN ESSAY ON THE YUGOSLAV SOCIETY BUSINESS CYCLES IN YUGOSLAVIA AN INTEGRATED SYSTEM OF SOCIAL ACCOUNTING FOR THE YUGOSLAV ECONOMY (with assistants) THE YUGOSLAV ECONOMIC SYSTEM: The First Labour-Managed Economy in the Making INTRODUCTION IN THE THEORY OF PRODUCTION ECONOMIC ANALYSIS SELF-GOVERNING SOCIALISM (co-edited with R. Supek and M. Markovic), 2 vols. ECONOMIC POLICY OF STABILIZATION THE POLITICAL ECONOMY OF SOCIALISM THE CRISIS OF THE YUGOSLAV SOCIETY THE LABOUR THEORY OF PRICES ABC OF YUGOSLAV SOCIALISM THE KOSOVO QUESTION ENTREPRENEURSHIP AND THE MARKET TRANSFORMATION OF ‘SOCIAL’ OWNERSHIP THE THEORY OF VALUE, CAPITAL AND INTEREST

The Theory of International Trade An Alternative Approach Branko Horvat Director The Institute for Advanced Studies Zagreb Croatia

First published in Great Britain 1999 by

MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 0–333–73409–2 First published in the United States of America 1999 by ST. MARTIN’S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 0–312–22003–0 Library of Congress Cataloging-in-Publication Data Horvat, Branko. The theory of international trade : an alternative approach / Branko Horvat. p. cm. Includes bibliographical references and index. ISBN 0–312–22003–0 1. International trade—Econometric models. I. Title. HF1379.H675 1998 382'.01—dc21 98–30661 CIP © Branko Horvat 1999 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 08

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

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Contents viii

List of Figures

ix

Preface List of Symbols

xiv

List of Abbreviations

xvi

1

Introduction PART I

1

THE MAINSTREAM INTERNATIONAL TRADE THEORY

2

The Evolution of International Trade Theory

3

The Heckscher–Ohlin Theory

10

3.1 3.2 3.3 3.4 3.5

10 12 15 21 22

4

Preliminaries The Heckscher–Ohlin Theorem The Factor–Price Equalization Theorem The Stolper–Samuelson Theorem The Rybczynski Theorem

7

Critique

24

4.1 4.2 4.3 4.4

24 27 28 29

The validity of underlying assumptions The validity of neoclassical economic theory Empirical evidence The Evaluation of the Heckscher–Ohlin theory

Appendices to Part I 1 2

32

Empirical evidence Leamer’s attempt at reconciliation of the theory with facts

32 33

PART II THE SYSTEMIC THEORY OF VALUE 5

Diachronic vs Synchronic Labour Input: The Two-Century Old Misunderstanding v

39

vi

Contents

6

The Employment Effect

42

7

The Replacement Effect

45

8

The Interplay of Employment and Replacement Effects

50

9

The Traverse

54

PART III 10

11

THE BASIC THREE-INDUSTRY MODEL

Steady State

59

10.1 10.2 10.3

59 62 63

Integrated world economy Open economy Growing economy

The Wage–Rental Curve

Appendix to the Part III 1 A note on price movements

67 70 70

PART IV AN ALTERNATIVE THEORY 12

Three Models

75

12.1 12.2 12.3

75 77 79

The two received models An alternative model of internationl trade Comparative advantage

13

Intra-Industry Trade

82

14

Four Hypotheses

85

14.1 Comparative advantage hypothesis 14.1.1 Two commodities 14.1.2 Many commodities 14.2 Equalization of factor prices hypothesis 14.3 Hypothesis about the changes due to the opening of trade 14.4 Increased factor supply speciﬁc effect

85 85 88 89

PART V 15

90 92

THE GAINS FROM TRADE

The Pattern of Specialization

95

15.1 15.2

95 99

Given autarkic prices Primary and secondary specializations

Contents 16

17

The Gains from Trade

104

16.1 16.2 16.3 16.4

104 106 108 111

Autarky vs. trade Domestic and international prices Import and export gains Wage–rental curve again

Unequal Exchange

116

17.1 17.2 17.2

116 118 120

Marxian values Unequal exchange I Unequal exchange II PART VI

18

19

vii

TARIFFS

Tariffs and Subsidies

125

18.1 18.2 18.3 18.4 18.5 18.6

125 127 127 129 132 133

Effects of a tariff in a single market Prohibitive tariff and subsidy The pattern of specialization with tariff Nominal and effective tariffs Subsidies Infant industry support

Customs Union

136

19.1 19.2 19.3 19.4

136 137 140 144

Degrees of economic integration Trade creation and trade diversion Customs unions in a more realistic setting Dynamic effects

Appendices to Part VI 1 2

Empirical evidence Economic integration of Eastern Europe: The Project Bridge I Introduction II The Organization III The Customs Union IV The Monetary Union

150 150 155 155 160 162 172

Notes

190

References

192

Name Index

197

Subject Index

199

List of Figures 2.1 3.1 3.2 4.1 7.1 7.2 8.1 11.1 15.1 15.2 16.1 16.2 16.3 18.1 18.2 19.1 19.2 19.3 19.4 A-1 A-2 A-3

International and domestic prices of goods X and Y Factor prices, commodity prices and factor proportions Isoquants, factor-proportion rays and isocost line Factor-intensity reversal Replacement effect Replacement and rental curves The growth rates of labour and capital and capital cost saved Two wage curves α and β The pattern of specialization for Δw* 0 The regions of primary and secondary specialization The gain from trade (1) Wage lines for P*3 and αP*3 given The gains from trade (2) Imposition of a tariff t No-trade regions The effects of a customs union Increased elasticity of the customs union supply curve Reduced costs of customs union Economics of scale The proﬁtability distribution of ﬁrms General equilibrium with internal and external balances Demand and supply of reserve currency

viii

8 12 19 26 48 48 53 68 96 101 105 110 113 125 129 139 143 145 148 164 167 181

Preface The theoretical foundation for the present study was established in my book on Value, Capital and Interest. The book dealt exclusively with a closed economy. Now, the same theory is applied to an open economy, becoming thus the The Theory of International Trade. The two books are intended to establish an alternative theoretical paradigm. There is also a difference between the two books. While the ﬁrst book is more or less deﬁnitive, the second one is the ﬁrst attempt to apply the same theory to international trade. Joseph Schumpeter noticed that different theoretical systems in economics are determined by different value theories. Classical economics was based on the labour theory of value and neoclassical economics on the utility or scarcity theory of value. To avoid a frequent misunderstanding, it stands to repeat that utility theory and marginalism are two different things. The former is a theory, the latter is a technique of analysis. Ricardo was a marginalist (when developing the theory of land rent) but not a subjectivist utilitarian. Marginalism is compatible with any theory. The theory I am trying to develop is based on the theory of value which differs from the other two paradigms in that its starting point is the operation of the economic system rather than the behaviour of individual economic agents. It may, therefore, be called systemic economics. Consequently, macroeconomics cannot be based on micro foundations, but rather the other way round. Technically, the systemic theory differs from the classical labour theory in that it does not aggregate labour inputs diachronically but synchronically. What that means will be explained in Chapter 5. Perhaps a note of clariﬁcation is necessary. This systemic approach is not identical to sociological functionalism which ends up in functional determinism. On the contrary, individual economic agents are free to follow their separate interests and their individual choices are not predetermined. But the mechanical aggregation of individual actions does not and cannot explain the functioning of the system. A system is a whole of interdependent parts and therefore more than a mere summation of individual actions. I was led to begin thinking about an alternative theory of value by my experience as a chief methodologist of the Yugoslav Federal ix

x

Preface

Planning Bureau. As is well known, the classical labour theory cannot explain the formation of prices. Values and prices differ, both theoretically and at the market place, and for that reason the theory is not of a great use. But neither could I make much use of the neoclassical theory because it is largely ideological, tautological and/or subjective. A revealing episode is the neoclassical theory of the ﬁrm when applied to the labour-managed ﬁrm. It produced predictions of the perverse behaviour on the market which has never been observed in reality. The conclusion drawn was not that the neoclassical theory – at least as practised by its adherents – was a poor theory, but that the theory was correct and the labour-managed ﬁrms do not conform to it because they do not behave rationally (Horvat, 1986)! Similar is the episode known as ‘Leontief Paradox’ which will be treated in Chapter 4. For my planning business, I needed an objective standard. And also, I needed explanations and not tautologies, science and not ideology. Thus, a systemic approach was a natural course to take. At that time I was unaware that it will take an entire professional life to formulate the ﬁrst version of a coherent theory. However, once formulated, it turned out to be very simple. And simplicity is usually considered to be one of the characteristics of good theory. The present book is intended to be short, simple and empirically relevant. As for the ﬁrst aim, I covered only essential problems. The possible numerous extensions and formalizations are obvious. I resisted the temptation to lengthen the text whenever it was not necessary to complete the argument. In relation to the second target, I used mathematics only as much as it seemed necessary to provide rigorous argument. Finally, the aim of every good theory is to be empirically relevant in order to improve our prediction capabilities. The reader will judge to what degree the three aims were achieved. Since I do not ﬁnd neoclassical theory of great use, not much of it will be found in this book. But I made every effort not to neglect any good scholarly work as the list of references demonstrates. On the other hand, Neo-Ricardian theory naturally ﬁts into my theoretical framework much better and I did not hesitate to use the research results of Neo-Ricardians. At the time of writing, I was not aware how dangerous that was. Later I observed that NeoRicardians are mostly ignored and rarely if ever quoted in the mainstream literature. The reason for this neglect was explained to me in a letter by Christopher Bliss after he had negatively reviewed

Preface

xi

my book on value and capital – without having given himself the trouble of reading it! Professor Bliss advises me of the fact that ‘in this ﬁeld there is a large divide between the broadly “Neo-Ricardian” writers and those of a more “Neoclassical” inclination,’ classiﬁes me among unpleasant Neo-Ricardians (which I am not) and states that he does not belong to the ‘same school (sic!),’ adds that ‘reviews ought to be entertaining’ and observes that ‘ultimately such issues are matters of opinion,’ leaving no doubt that his opinion is negative. A nice set of ‘scientiﬁc’ criteria. Professor Bliss is one of the editors of Economic Journal and a former editor of Oxford Economic Papers. Neo-Ricardians, however, do themselves a dis-service in constantly attacking the labour theory of value trying to show how Sraffa demolished it. It seems to me that they believe that only one labour theory imaginable is that of Ricardo and Marx. In Chapter 17, I showed what motivated Marx to use the value theory that was at hand, namely that of Ricardo. If Neo-Ricardians drop the assumption of one possible labour theory, they will realize that a poor labour theory may be replaced by a better one and that Sraffa could have written a simpler book free of artiﬁcial constructs. Perhaps, some day Srafﬁans may attempt to accomplish that. But that will not endear them to the dominant academic coterie. My two pure theory books on closed and open economies were intended to be two parts of a tetralogy. The other two parts are an institutional book and a book on macroeconomics. The former was published in 1982 as The Political Economy of Socialism. It was inspired by the institutions of a labour managed economy. At that time the only labour-managed economy in the world was that of Yugoslavia. As I was living in that country and participated in shaping its institutions, I could use my ﬁrst-hand experience. The other planned book was to be on macroeconomics based on labour management. This book has not yet been written and probably will not be written by myself. The only labour-managed economy has recently been destroyed and no other (on the national scale) has evolved so far. It might be thought that the economy that failed is not worth while studying. For surely, it failed because it was not efﬁcient and economics is about efﬁciency. That seems to be prevailing opinion, but it is contrary to facts. For four decades, the Yugoslav economy was developing at the fastest rate in Europe. The transfer of population from agriculture to urban occupations – transforming peasants

xii

Preface

into citizens – was probably the fastest in the world (one to one and a half per cent of total population annually). Technological progress, as conventionally measured, was also probably the highest in the world for the period for which the measurement exists (in 1954–67 at the rate of 4.4 per cent annually, Horvat, 1969). The quality of life – measured by the life-expectancy at birth, medical care and education, relative to the level of development – was unambiguously the highest in the world. Income distribution was among the most egalitarian in the world. Clearly, the Yugoslav historical experiment did not fail because of economic reasons. It failed because of political and cultural reasons (for explanations see Horvat, 1992b). This is a sad remainder to economists that their profession plays only a minor role in the life of nations and the development of their economies. As the book on labour-managed macroeconomics will never be written by myself, it may be worth while to record some ﬁndings from my extensive research. Already in my ﬁrst book on economic planning (Horvat, 1964), I discovered that the textbook recipe for the volume of investment being determined by the willingness of consumers to reduce their consumption – is a macroeconomic nonsense. In European economies investment cannot be increased so much as to reduce consumption, assuming rational calculus. The share of investment in GNP can be annually increased at most by 1–2 per cent. This magnitude is too small for individual consumers to be aware of the difference, and also consumption per capita never stops growing. This fact is due to what I called ‘the limited absorptive capacity of an economy.’ Investment can be productively absorbed only up to about 35 per cent of GNP, increasing the share in GNP to this limit only gradually from the starting position. This is the closest that economics can come to the physicists’ notion of ‘world constants.’ If it is invested either less or more that the absorptive limit, consumption will be reduced and this has nothing to do with saving/consumption propensities. If on the daily or monthly basis consumers cannot discriminate between smaller and greater consumption, the time horizon must be extended. How much? The rational choice seems to be to maximize consumption for the period of one’s life. That implies maximizing the rate of growth of production. The theoretical implications of these ideas were examined in my two early Economic Journal articles (1958, 1965). The most extensive preparation for the intended future labourmanaged macroeconomics was undertaken in my book on business

Preface

xiii

cycles (Horvat, 1971). I examined in some detail how a labourmanaged market economy operates. Not unexpectedly, I found that it operates differently from an etatist command economy and differently from a capitalist market economy. As far as the latter is concerned, the capitalist market is just one and not the only type of market. That does not seem to be generally understood. The market of a labour-managed economy is an alternative one. The space allows me to mention only three interesting differences. The ﬁrst is about the role of inventories in business cycles. In the capitalist and etatist economies, inventories move in conformity with production cycle (although for entirely different reasons). In this way movements of inventories intensify cyclical oscillations. In the labourmanaged economy of Yugoslavia, inventories move inversely to production cycle and so exert stabilizing inﬂuence (Horvat, 1971, ch. 9). The second difference in related to the familiar Keynes– Hicks IS–LM mechanism. In a capitalist economy, monetary restriction reduces inﬂationary pressure, in the labour-managed economy it stimulates inﬂation (Horvat, 1991). The third difference lies in the realm of ﬁscal policy. In a capitalist economy, taxes on proﬁts are unavoidable but at the same time do not represent a policy tool of great importance. In a labour-managed economy, productive capital is socially owned. Thus, proﬁts may be left in the ﬁrm without any taxation. In fact, the greater are proﬁts, the greater are possibilities of enlarging social capital and that, of course, is desirable. Taxes are levied on the wage-bill in order to insure that investment is neither smaller nor greater than necessary for full employment. Besides, the wage-bill tax produces some additional effects that make economic monitoring more efﬁcient than in a capitalist economy (Horvat, 1992a). The four summary observations must replace the non-existent fourth book of tetralogy. They may prove to be useful preliminary research for an unknown future author. I wish to express thanks to Dr Mia Mikic´ for many helpful comments. B. Horvat Zagreb

List of Symbols aij x ij/Xj A [aij] D D K/n E, e g g* g ρ G 1 g G H I k K/L K L M, m n p, ph P, pw P p*i pi/p1, Pi* Pi/P1 p/P r π ρ R s t T 1 t U w w* w/p1 W X1, X2, X3 α, β κ K/X λ L/X μ

input coefﬁcients matrix of input coefﬁcients developed depreciation export growth rate gross growth rate growth factor gross investment home country new investment capital-labour ratio (intensity) capital labour import life span of ﬁxed assets home prices world prices partner country relative prices in terms of consumer goods terms of trade, exchange rate rental rate replacement subsidy rate tariff rate tariff factor Underdeveloped wage rate real wage world consumer, capital and intermediate (materials) goods combination of techniques capital coefﬁcient labour coefﬁcient mark-up factor xiv

List of Symbols μ πK/wL ν π ρ 1/ν τ ω P2K/L P2 k

rate of surplus value number of ‘dynamic years’ rate of proﬁt replacement rate time organic composition of resources

xv

List of Abbreviations CEFTA CMEA EC ECU EDB EFTA EM EMI EMS EMU EPU ESCB EU GATT GDP GMP GNP IMF SDR SECI VAT

Central European Free Trade Area Council On Mutual Economic Assistance (COMECON) European Community European Currency Unit European Development Bank European Free Trade Association European Money European Monetary Institution European Monetary System Economic and Monetary Union European Payments Union European System of Central Banks European Union General Agreement on Tariffs and Trade Gross Domestic Product Gross Material Product Gross National Product International Monetary Fund Special Drawing Rights South-east European Cooperative Initiative Value Added Tax

xvi

1 Introduction The conceptual and analytical apparatus to be used in this study was developed in my book The Theory of Value, Capital and Interest (1995). In order to avoid repetition, the original book will be frequently referred to. For this reason the proper understanding of this study requires the reading of the original book. If the reader cannot read the whole book, he may select the absolutely necessary chapters 1–5. Nevertheless it is still necessary to repeat certain derivations to make the argument comprehensive. The original book dealt entirely with the closed economy. Now the economy is opened, which is the essence of international trade. The canonical model will consist of two primary factors (labour and capital), three commodities (consumption, capital and intermediate goods) and two countries: a small country (A) and the rest of the world (W). Of the two factors, only labour is nonproduced. So is land, but it plays an inessential role in modern economies and will be neglected. The customary 2 2 2 model will be replaced by a 2 3 2 model in order to increase dimensionality and meet some of the objections raised by Ethier (1984) concerning low dimensionality. Three products are analytically desirable per se in any case because they have very different economic properties. One of them is a consumer good, the other two represent producer goods. Of the latter two, one has time dimension (capital) which generates important economic effects to be discussed later. The last is free of that dimension: it represents all other goods (raw materials prepared for trade, intermediate goods, goods in process) and will be referred to as ‘materials’. Materials, customarily neglected in other theoretical treatises, represent the bulk of international trade. Except for a short section on stationary economy, whose purpose it is to clarify basic concepts, the rest of the book deals with steady state growth. If the rate of growth is changed, it takes n years – n being the replacement period of ﬁxed assets – until economy reaches new equilibrium. Consequently, only long-run equilibria are explored and in this sense ‘gravitational’ prices are used. Transitions from one steady state path to the other are not researched 1

2

The Theory of International Trade

(except in one case, in Chapter 9) and have been left for some future date. Problems of (rational) transition really belong to the theory of planning. ‘Gravitational prices’ are not necessarily constant if technological progress takes place even at a constant rate. Short-run prices result from an interplay of supply and demand. Long-run – gravitational – prices also imply equality of supply and demand, but this equality does not inﬂuence price movements (which may be due to technological progress). If there is an excess demand or supply, in a production economy the market equilibrium is achieved through changes in supply, not prices. Given enough time, the supply can always be changed as required. The analysis will mostly imply the existence of the general equilibrium though this state will be deﬁned differently than is usual. The mathematization of economics grossly overstressed the equalization of marginal (that is, inﬁnitesimal) quantities because algebraic derivations of maxima proceed in this way. However, business people and government planners do not use marginal equations. The only related, practically relevant, concept is opportunity cost, and this is a very helpful concept. Equilibrium position may be deﬁned in two different ways: (1) as a position where there is no incentive to change, or (2) as a position where plans (expectations) and realizations coincide. Deﬁnition (1) mimics equilibrium in mechanics. Since the real-world economy is subject to continual changes, this deﬁnition has hardly any meaning in economics. In (2) change can be incorporated, because it can be planned (expected). Nevertheless, it is still too empty to give useful guidance for our explorations. In order to move closer to the real world, I deﬁne general equilibrium as a state in which overall supply and demand are equalized, as demonstrated by the following observable facts:

• Full employment in which demand and supply of labour are equal – that is, working hours and shifts do not change and all those who wish to work are employed. In this way also excess demand (supply) is deﬁned: working hours and the number of shifts increase (if they decrease, there is unemployment). Unemployment is deﬁned as workers being out of work or undergoing learning processes. The ‘natural’ rate of unemployment makes no sense

Introduction

3

if it is not absolutely voluntary – and then it is not unemployment but leisure. Unemployment and general equilibrium in the sense of Pareto optimum represents a contradictio in adjecto. • Productive capacity is used at the economically justiﬁed rate and there is no accumulation or decumulation of inventories (apart from seasonal variations). • The appearance of excess demand (supply) is not corrected by changes in prices but by changes in quantities (out of inventories or changed production). Continuous changes in prices would incur too great transaction costs (administrative and information costs, loss of business credibility, the confusion of customers, retaliation and so on). For these reasons businessmen and planners avoid price changes at all costs. If output is not speedily forthcoming, even some queuing might be preferable. To put it differently, the lengthening of the list of orders is a sign of excess demand and an invitation to increase supply. • If the business conditions have changed permanently then, of course, prices must be adjusted accordingly. The main cause of such permanent changes is technological progress. Thus, as already hinted, technological progress changes (gravitational) prices while the shortrun supply-demand divergencies are remedied by changes in quantities. • Prices of factors of production are also formed differently from textbook recipes. It is not marginal productivity of labour that determines the wage, it is the wage that determines marginal productivity or whatever is used in business calculations. My salary at an American university is ten times greater than at a Croatian one – not because my marginal productivity increases ten times after my travel to the United States, but because America is so much richer than Croatia. The other assumptions used throughout most of the book are: 1. There is vigorous competition preventing effective monopoly. 2. There are no transaction and transportation costs. 3. Labour and capital are fully mobile nationally and immobile internationally. 4. International prices (Pi ) are given. 5. Consequently, national wages and proﬁt rate differ (w w, r r). 6. Balanced trade. 7. Constant returns to scale. If they are not constant, they are treated as different technologies.

4

The Theory of International Trade

8. All goods are reproducible. 9. The economy grows at a constant rate. Mainstream economics deals almost exclusively with allocational efﬁciency, although this is comparatively unimportant. The few attempts to measure welfare losses due to allocational imperfections indicate that they are probably not greater than a fraction of one per cent (Leibenstein, 1966, p. 393). The much more important production efﬁciency is generally left unexplored. The current unemployment rate in Europe is higher than ten per cent. That implies a production loss more than twenty times higher than probable allocational losses. For this reason, I shall not be much concerned with allocational efﬁciency. If we abstract from motivation (I have dealt with that in my book on the political economy of socialism, 1982), the establishment of general equilibrium means maximizing net output. The theory developed in this book is ‘pure’ theory in the sense in which the free fall formula s gt2/2 is pure physics. Formula indicates the distance covered by a particle in a vacuum. The conditions do not obtain in reality: the formula is only a very rough approximation to reality and is accurate only as a limiting case. In economics pure theory often means theory that disregards reality, pure deduction from a certain number of axioms (assumptions). That is deﬁnitely not the case here. In the physical formula, the gravitational constant g is determined by experiments. Similarly, economic formulae must contain measurable quantities and make sense only if they can be refuted, but are not (so far). Pure economic theory is a source of a potentially rich collection of empirically relevant hypotheses which can be corroborated or refuted by recourse to economic facts. Assuming logical consistency, we aim to deal with measurable facts. The derivation of results will (it is hoped) be achieved in the simplest possible way. The three main features of a good theory are: (a) logical consistency, (b) simplicity and (c) empirical relevance.

The Evolution of International Trade Theory

Part I The Mainstream International Trade Theory

5

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The Evolution of International Trade Theory

7

2 The Evolution of International Trade Theory Trade will open up between two formerly autarkic economies if differences in production conditions warrant a proﬁtable exchange of goods under the ruling terms of trade. In particular, a ﬁrm will decide to export its product x when the domestic price is lower than the international one. px Px

(2.1)

Torrens (1808) and Ricardo (1821) developed this commonsense proposition into a general theory of comparative advantage. Even if domestic costs of production in all lines of production are higher than the international ones, it pays to export if the costs of production are not uniformly higher. Differently higher (or lower) costs make for comparative advantage which is expressed in different ratios of costs/prices px Px py Py

(2.2)

If the international price ratio is higher than the domestic one, it is cheaper to import Y and produce domestically X. The same idea is portrayed in Figure 2.1. In the area A, Px /Py px /py and commodity X will be exported. By contrast, px /py Px /Py in B and this is an import area for X. At the point C, international and domestic prices are equal and there is no incentive for trade. If the line px py is uniformly above the line Px Py, the prices of both X and Y are internationally uncompetitive. Yet, the trade will still be proﬁtable since the slopes of the lines (representing price ratios) are different. By changing the units of measurement (exchange rate), the domestic price line may be shifted downwards to the position C where domestic and international price ratios are equal. 7

8

The Theory of International Trade

Px

A

px

c

B Py

Figure 2.1

py

International and domestic prices of goods X and Y

In the long run, trade between two countries must be balanced (the value of export is equal to the value of import, all evaluated at international prices). Px X Py Y The same balance may be expressed in terms of the price ratios Px X Y Py

or

Py Y X Px

(2.3)

where (2.3) represents the trade transformation curve. Since international prices are given and countries and their industries are of unequal size, the complete specialization in X and/or Y are exceptions and not a rule. This is the essence of the classical theory. Ricardo, like all classical economists, used the labour theory of value. Value was measured by costs of production and, in this case, by the diachronic labour input, since labour was the only factor of production. As the labour theory fell into disrepute, it was replaced by the utility theory of value. When it was invented, the new theory was meant to explain consumers’ behaviour that was neglected by the classical theory. It was observed that utility increases with the scarcity of goods relative to demand (except for inferior goods and habit-forming drugs). From the consumption of goods, the theory was later extended to the production of goods as well. This was, of

The Evolution of International Trade Theory

9

course, illegitimate, because production is a technological and not a taste-determined process, but that was overlooked or neglected. I dealt with the resultant great confusion in theoretical approaches in my book on value theory (1982). Now only the consequences for foreign trade theory will be explored. The alternative (scarcity) theory of value rests on the following assumptions. Just as the marginal utility of consumption decreases when the quantity of the good consumed increases, the marginal product of the increasing factor input also decreases – which is equivalent to increasing marginal costs. In other words, the analytical apparatus developed for an exchange economy, with a downward sloping demand curve, has been applied to a production economy with an upward sloping supply curve. Generalization meant treating all factors of production as formally equal and similarly production and exchange were postulated as formally equal processes. This is the essence of the neoclassical theory of value, which became the basis for the current theory of foreign trade. Neoclassical theory has been an analytical advancement and conceptually a step backwards. Labour theory deals with labour time which can be measured objectively, and this is vitally important – or should be so – for an empirically oriented science such as economics. Scarcity theory deals with utility, which is subjective and cannot be measured. Consequently, a great part of the modern theory is metaphysically oriented and so nearly useless. Next, scarcity theory often plays with tautologies pretending to be explanations. For instance, if price is low, commodities are said to be abundant; if it is high, they are proclaimed to be scarce. No exceptions are made: the theory is always true and irrefutable, which means that these statements are tautologies. If something is always true, it cannot be tested: it explains nothing. It represents a translation of words: abundant means cheap, scarce means expensive. These quid pro quos are the source of many misunderstandings. Ricardo’s labour theory of value is certainly not correct. The neoclassical utility (scarcity) theory is not usable. It remains for us to replace them with something which may be called the modern theory. But before we try to do that, let us examine the mainstream (neoclassical) theory of foreign trade in greater detail.

10

The Theory of International Trade

3 The Heckscher–Ohlin Theory The central question of foreign trade theory is how to determine the pattern of foreign trade: which commodities will be exported and imported and where. The answer provided is based on the work of two Swedish economists, Eli Filip Heckscher (1919) and Bertil Ohlin (1933). Their propositions were later formulated as the Heckscher–Ohlin Theorem (HO). Subsequently three additional theorems have been posited. These four propositions represent the core of the mainstream theory of foreign trade. Of these, two refer to comparisons between two countries (the HO theorem proper and the factor price equalization theorem). The other two deal with relationships within a single country (the Stolper–Samuelson and Rybczynski theorems). The latter two can dispense with the assumption of identical technology.

3.1

PRELIMINARIES

The main idea of the theory is very simple, although not all the derived consequences are: It is observed that (1)) countries have different factor endowments and (2) industries use factors at different intensities. These two sets of differences make international trade proﬁtable. Comparative advantage based on (1) is a quite trivial proposition. If the supply of fertile land is plentiful, the country will produce and export agricultural products. The consequences of observation (2) are not so straightforward. The theory is next constrained by a number of assumptions such as (1) the absence of factor intensity reversals; (2) the absence of demand reversals (a strong preference for a good in country A, although it is more expensive than in country B); (3) same constant returns technology with convex isoquants; (4) similar and unique community preferences; (5) perfect competition. Given the constraints, two conclusions follow: (a) the country will export that commodity whose production uses, relatively intensively, a relatively 10

The Heckscher–Ohlin Theory

11

plentiful factor of production (‘plentiful’ being the same as ‘cheap’) and (b) although factors are not mobile internationally, free trade will equalize commodity prices and so also factor prices. Next, assumption (1) implies that industries are equally ﬂexible. Since they are not, the assumption will almost certainly be vitiated (see Fig. 4.1). Technologies are different. Competition is not perfect. Thus, claim (a) will certainly be refuted, and so will (b), which may additionally be invalidated by complete specialization and trade impediments (this simpliﬁed description of HO theory relies on Hefferman and Sinclair, 1990, pp. 25–38). Consequently, we should expect to ﬁnd that HO theory has no predictive value. We will proceed to analyse HO theory in more detail. After that, we shall deduce a number of more fundamental theoretical objections. Perhaps the essential idea underlying HO theorizing consists in the unique determination of commodity prices by factor prices – given a technology which determines quantities – and factor prices depend on factor proportions. If it is assumed that production functions are identical in the two countries compared, then the only difference between them is to be found in factor endowments. If constant returns prevail, then marginal rates of substitution – determining prices – will depend only on the proportions of the factors employed. The basic relations are derived in the following way. Let two goods (X, Y ) be produced by means of two factors (L, K). Let X be labour-intensive, that is, in the production of X to the same factor price ratio w/r corresponds higher factor ratio L/K than in the production of Y. The relevant functions are assumed to be monotonic (it will later be shown that they need not be: see Section 4.2) and therefore all variables are uniquely determined. The factor price ratio is positively related to the product price ratio, w/r f (px /py), and inversely related to factor proportions, w/r g (L/K). In this way all important factor proportions (L/K) uniquely determine relative factor (w/r) and commodity (p x /p y) prices. The functional relationships are shown in Figure 3.1 (Chacholiades, p. 246). Fig. 3.1 is the basis for all the four theorems – Hecksher–Ohlin, Stolper–Samuelson, factor price equalization and Rybczynski – underlying the neoclassical theory of international trade. The ﬁrst theorem determines comparative advantage (exports of commodities). The other three follow directly from Fig. 3.1: there are three monotonically interrelated variables – px /py, w/r, L/K – and when one is ﬁxed, the other two are uniquely determined.

12

The Theory of International Trade w r

X Y Px/Py

L/K

Factor prices, commodity prices and factor proportions

Figure 3.1

The relationships in Fig. 3.1 are obvious from the assumptions stated: given the production functions assumed, px /py falls as w/r falls and w/r falls as L/K increases. This can easily be derived from price equations for commodities X and Y: px wλx rκx,

L λx x x ,

K κx x x

py wλy rκy ,

λy

Ly , y

Ky κy y

| pp λ |λ

x

w r

y x y

κx κy px py

| |

px py

κy κ x

(3.1)

(3.2)

p λx x λ y py

As px /py increases, so does w/r. For the relation w/r g (L/K), see (3.7).

3.2

THE HECKSCHER–OHLIN THEOREM

The HO theory is based on the following more complete set of assumptions:

The Heckscher–Ohlin Theory 1. 2. 3. 4. 5. 6. 7. 8. 9.

13

Factor endowments are given. Constant returns to scale. No joint production. The number of factors of production not greater than the number of commodities, m n. Identical production functions. Strong competition prevails in both factor and product markets. Identical and homothetic tastes (no inﬂuence of consumer preferences). No factor-intensity reversals (the same type of factor intensity for all variations of w/r). Before trade opens, both commodities are produced and consumed in both countries.

Ricardo and the classical theorists assume nothing in particular (except labour as the only input and strong competition) and derive international trade from the differences in production functions. HO theory implies nine restrictive assumptions. In particular, it assumes identical production functions and derives trade from the differences in factor endowments. Ricardo predicts that relatively cheaper commodities will be exported and HO predicts which commodity will be cheaper and that the labour- (that is, factor-) abundant country exports labour- (factor-) intensive commodities and increases their production. The comparison of assumptions and predictions make it easy to establish which theory is superior. Taking into account the assumptions stated, the HO theorem may be formulated in the following way: Production of the commodity, that uses the relatively abundant factor more intensively, enjoys comparative cost advantage. Thus, each country will export the commodity for which production is used relatively intensively the more abundant factor. Note the link provided between factor intensity of production and the factor abundance of the country in which the commodity is produced. Yet this is not a mathematical but an empirical relationship (short of a tautology). For this reason some authors distinguish factor intensity of a production process (Fi /Fj, F factor) from factor abundance of a country (Fhi /Fwi, h home country, w world). That, however renders the analysis rather messy while reasonable empirical data are not available.

14

The Theory of International Trade

There are two versions of the theory depending on how factor intensity is deﬁned.

• Price

deﬁnition of the factor endowments as measured by w/r (capital intensity is expressed by high w/r). • Physical deﬁnition, when factor endowments are measured by factor proportions, L/K (capital intensity of a process is expressed by high K/L). The problem, of course, is that capital cannot be measured in physical units and, moreover, neoclassical capital cannot be measured independently of distribution. Both deﬁnitions are straightforward in a two-factor model. When there are several factors, it is not clear what ‘factor intensity’ means. Similarly, factor intensity becomes meaningless when there are more than two countries. If country A is capital-abundant in relation to country B, and labour-abundant in relation to country C, HO theory predicts that it will export both capital- and labour-intensive commodities (Bhagwati, 1964, p. 20). The price deﬁnition is a near-tautology. Given the identical technology, it says that cheaper production entails comparative advantage. The physical deﬁnition of factor abundance is non-tautological and more involved. Now, the argument is reversed. Instead of showing that the cheaper factor (more abundant by deﬁnition) is used more intensively, we must show that the factor used more intensively (more abundant by deﬁnition) is also cheaper. Then the price of the labour-intensive commodity will be lower in the labour-abundant country and so indicate comparative advantage. Now, if the factors are fully used, the production functions in the two countries are identical and comparatively more labour is available, then the price of labour in terms of capital, w/r, must fall. The continuation of the argument is the same as with the price deﬁnition of intensity: cheaper labour makes for cheaper labour-intensive commodity production and for comparative advantage. The same result may be derived algebraically (cf. Chacholiades, 1978, p. 261). Full employment equations under constant returns are λ x X λy Y L

λx Lx /X, λ y Ly /Y

κ x X κy Y K

κ x K x /X, κ y K y /Y

(3.3)

15

The Heckscher–Ohlin Theory The factor proportion is equal to L K

λ λ (X/Y) λy

(3.4)

κ x(X/Y ) κy

The factor-price ratio must be identical for the production of two commodities w/r MRS XLK

Y

w/r MRS LK

dκ x dλx

(3.5)

d κy

(3.6)

dλy

Differentiation of (3.4) and substitution of (3.5) and (3.6), when X/Y is kept constant, gives d(L/K) 0 d(w/r)

(3.7)

Consequently, when w/r increases, L/K falls. Clearly, all these derivations depend on monotonic relationships among variables and lose meaning if there is factor intensity reversal.

3.3

THE FACTOR–PRICE EQUALIZATION THEOREM

Assuming free trade, strong competition will lead to an equalization of commodity prices. Since, in contrast to commodities, factors are not supposed to be internationally mobile, it is legitimate to ask what will happen to their prices. Many economists take the view that free trade will also equalize factor prices – wages, rents and interest rates (Samuelson, 1948, 1949; Land, 1959; Chipman, 1966 and others; Pierce, 1959, is critical). Competition in the market for products leads to indirect competition in the market for factors. Ignoring transportation costs, the following propositions emerge: free trade leads to commodity-price equalization and (a) complete specialization in production if factor prices remain unequal, or

16

The Theory of International Trade

(b) incomplete specialization in production in each country and the equalization of factor prices between countries. Fig. 3.1 shows how factor-price ratios are uniquely related to commodity-price ratios. Since competition equalizes commodity prices (which are thus given), and production functions are identical, factor prices will also be equalized. J.R. Hicks provides a simple derivation of the theorem (1983, p. 226). Suppose we have commodity X and commodity Y and each of them is produced in economies A and B in equilibrium. Consequently, unit costs of production (under competition equal to the value of one unit of output) must be the same in both countries: λxw A κx r A λx w B κx r B

(3.8)

λ y w A κy r A λ y w B κy r B From these two equations we derive the condition r B r A (λx /κ x)(w A wB ) (λy /κ y) (w A w B)

(3.9)

Since labour–capital ratios are presumably different in the production of two commodities, λx /κ x λy /κ y, the condition can only be satisﬁed if the factor prices are the same, w A w B, r A r B. It is here where Hicks leaves the theorem as proved. One should, however, notice that the result holds only if the technical coefﬁcients (λi, κi ) are the same in both countries (as Hicks cold-bloodedly assumes). However, empirical technical coefﬁcients are notoriously different. It is worse than that: it is impossible to deﬁne two identical production functions empirically (except for two isolated projects). Using the awe-inspiring language of theorems, the theory says that the factor prices will be the same, if the two economies are sufﬁciently similar (same GNP per capita, same rate of growth, same system of taxation, same methods of production and so on). And that is hardly very enlightening. It is not quite clear how rents are supposed to be equalized, since the plots of land are very heterogeneous and so not comparable. The authors of the proposition are mysteriously silent about the details. The same international price for wheat may be related to widely different areas of land used in its production. Rent must be determined per unit of land and so agricultural land of different

The Heckscher–Ohlin Theory

17

countries is assumed to have the same productivity on the average. Since, usually, data on land values are more reliable than information about rents, the latter may be derived from the former: the land value is a discounted inﬁnite stream of rents at some interest rate. The latter is presumably an internationally equalized interest rate. In this case rent equalization depends doubly on interest equalization (interest as production cost and interest as evaluation criterion). Even so, the assumption of the same average productivities of land is highly arbitrary: high land-labour ratios on the Ukrainian chernozëm may still be economically lower than low labour-land ratios in the Arabian desert. Here we may mention an interesting empirical study (K.H. O’Rourke et al., 1996). The authors document a convergence of wage– rental ratios in the late nineteenth century. ‘Wage–rental ratios boomed in the Old World and collapsed in the New, moving the resource-rich, labour-scarce New World closer to the resource-scarce, labour-abundant Old World.’ (p. 499). They then carried out an econometric analysis which showed that there was commodity–price convergence which accounted for about a quarter of wage–rental convergence, but changing land-labour ratios accounted for none (p. 515). The whole idea of rent equalization is based on an elementary confusion. If land is a factor of production, then rent per unit of surface is the price for its services. Since land is not homogeneous, the differences in quality are measured by differential rents. That much already Ricardo knew. No amount of competition will equalize differential rents. An escape route is to consider only margins. Thus, Samuelson in his ﬁrst article (1948) compares marginal physical products. This procedure raises at least three questions. First, if marginal physical product is deﬁned as quantity of wheat per marginal acre, than equal MPPs would mean unequal marginal net value (revenue) products because costs of production differ if plots of land are not homogeneous. On the other hand, equal marginal revenue products would imply unequal physical size of plots and so unequal rent per acre. Next, at the margin we cannot talk of rent as usually deﬁned (generated by all intramarginal land units) but of something that might be called ‘marginal rent’. Finally, marginal differential rent is zero by deﬁnition of competition and by the fact that land is a non-produced asset that involves no costs. If something is left over, it must be assumed that competition is imperfect and there is also absolute rent. To assume away all such problems, in his second article Samuelson simply declares that land is ‘qualitatively identical’ (1949,

18

The Theory of International Trade

p. 182). Yet qualitatively identical land is not real land but an arbitrary construct. It may sometimes be represented as a broad average, as in empirical research by O’Rourke quoted above. This, however, renders marginalist analysis meaningless. A refuge may be taken in replacing physical land by land value. Now, of course, rents per unit of land value are equal, given the interest rate. But that is merely a tautology: land is deﬁned as capitalized value of rents and rent as capital income from land. Physical land disappears and with it the meaning of factor price. All that can be concluded is as follows: if commodity prices, wages and interest are determined competitively, so is rent. But competitive rent is not equal rent per physical unit of land. A different general critique of factor-price equalization proposition comes from I.F. Pierce (1959). He shows that the likelihood of unique solution rapidly decreases as the number of traded goods increases. In a multi-commodity world, this likelihood is zero. Identical technologies are generally assumed in the HO theorizing and we shall not dwell on that longer. But there are four problems worth noticing: (1) Full prices. In (3.8) not full prices but only value added parts are equalized. Material costs are left out. It is clear that it cannot be simply assumed that they do not matter. Competition equalizes market prices and may or may not equalize valueadded parts of them. The additional constraint to be imposed is that value-added always represents the same proportion of market prices. (2) Dimentionality. The number of factors (m) must be equal to the number of commodities (n). If m n, there is not a sufﬁcient number of equations to determine factor prices. If m n, the outcome is indeterminate and may lead to an even greater divergence in factor prices than the absence of trade (Land, 1959, p. 141). If we think of speciﬁc factors, m n may represent the usual case. Roy Harrod remarked: ‘I believe that the true explanation of the ﬂow of trade springs from the number of commodities . . . being less that the number of factors, owing to the existence of at least one speciﬁc factor for every commodity . . .’ (1958, p. 255). (3) Cone of diversiﬁcation. Let X and Y represent two unit value revenue curves for commodities X and Y produced by capital and labour. Prices are given and determined in the international

19

Capital

The Heckscher–Ohlin Theory

v1

x y

v

c

v2

c Labour

Figure 3.2

Isoquants, factor-proportion rays and isocost line

markets. Let cc be the isocost line whose points of tangency with cures X and Y represent minimum costs of producing X and Y and so determine factor proportion rays V1 and V2. Under perfect competition prices and costs are equal. V10 V2 represents the Land-Chipman ‘cone of diversiﬁcation’ (Land, 1959; Chipman, 1966). V denotes some average factor proportion when both X and Y are produced. It is visible that along V, cost of producing X and Y are lower than along V1 and V2 in isolation. This will be always so when the vector V lies inside the cone of diversiﬁcation. The line cc denotes equal factor prices in the production of X and Y. If a second country is added, the picture will be similar and the problem of the exchange rate may be avoided by expressing prices in terms of X and Y. The common tangent determines factor prices as long as factor rays of different countries are inside the same come of diversiﬁcation. If two isoquants cross twice, this will represent factor intensity reversal and two different cones of diversiﬁcation will be created. If they do not overlap at least partly, factor prices cannot be equalized (Chipman, 1966, p. 24–25). If every country does not produce every commodity, the specialization will result and again factor prices need not be equalized. (4) Speciﬁcity of factors. As already mentioned, authors conspicuously avoid clarifying what the equalization of rents means. Samuelson

20

The Theory of International Trade remarked: ‘Land and labour are assumed to be qualitatively identical inputs . . .’ (1949, p. 182). Yet, the essence of land is that it is not ‘qualitatively identical’ since in this case differential rent would disappear. The problem may be circumvented by noting that the value of land is capitalized rent at the ruling interest rate. Yet in this case rent is eliminated as a separate factor price and we are left only with the interest rate. The factor price ‘wage rate’ poses a different problem. Minhas notes that wages varied from some $250 in poor countries to $3 600 in advanced countries (1962, p. 146). This does not look like equal factor prices. No amount of free trade will iron out this difference. It is obvious that wages can be equalized only by means of economic development of those countries which lay behind and not by market exchange.

We are left with capital (assuming that it can be unequivocally measured). Minhas reports that the proﬁt rate varies among countries from 22 per cent to 15 per cent. Part of this difference may be attributed to differences in risk. However, the speciﬁc feature of capital is that it has double nature. Physical factories are not exported or imported (at least not usually). But the value of capital they do or will represent enters international trade. As a result, here we have direct, not indirect competition. World ﬁnancial markets inﬂuence interest – and therefore proﬁt – rates. The same conclusion may be reached via a slightly different route. Neoclassical theory assumes that factors of production are symmetrical. But they are not. Labour is not a symmetrical factor of production compared with capital or land. Wages are not determined by marginal productivity of labour but by the level of development, which may be measured by per capita GNP. Workers – as members of society, and not as dead instruments – insist on participating in the beneﬁts of social wealth. After an initial low level of development, there is an empirically documented convergence in per capita GNP which is caused by technological progress and has nothing to do with the HO scarcity hypothesis (Horvat, 1974). Neither is capital symmetrical. Its quasi-price – proﬁt – is a source of ﬁnancing growth. Since the growth rates are different, so must be proﬁt rates as well (unless the planning authority intervenes). Finally, land is a non-human non-produced factor, notoriously heterogeneous. Rents represent the remainder of income after wages and proﬁts have been deducted.

The Heckscher–Ohlin Theory

21

Summing up the argument, the theorem evaporates in the thin air of artiﬁciality.

3.4

THE STOLPER–SAMUELSON THEOREM

According to neoclassical economics, as reﬂected in HO theory, the scarcer a factor the higher its price. When two autarkic economies begin to trade – assuming always full employment – the labour-abundant one will export labour-intensive commodities, since they are supposed to be relatively cheaper. The converse is true for a relatively capital-abundant economy. Consequently, the opening up of trade raises the relative price of labour in the labour-abundant economy – because labour now becomes scarcer – and reduces it in the capital-abundant economy, because labour there becomes more abundant through trade. Or, in the original words of the authors: ‘International trade necessarily lowers the real wage of the scarce factor expressed in any good’ (1941, p. 66). It may be added in passing that joint production destroys the theorem. In this context we may adduce an exercise of Murray Kemp. Two commodities are produced, X1 and X2. Under perfect competition, the value of the marginal product of a factor is equal to the reward of that factor r pi f i ,

f i

δfi (Li Ki ) δKi

i 1, 2

(3.10)

w pi ( fi ki f i ), ki Ki /Li where r is rental rate per unit of capital and w is the wage rate. What we would like to do is to express changes of factor prices in terms of factor intensity differences. Assuming constant returns to scale, Xi ⬅ Fi (Ki, Li ) Li fi (ki )

(3.11)

Divide by L xi li fi (ki )

xi Xi /L

l i Li /L

(3.12)

22

The Theory of International Trade

Let l i be the proportion of labour force employed in ith industry. Then the average labour capital ratio may be expressed as a weighted sum of sectoral ki Ki/Li. k k1 l 1 k2 l2 k1(1 l2) k2 l 2 k1l1 (1 l1 )k2

(3.13)

Differentiate to get: dli (1)i dk k2 k1

(3.14)

As full employment is maintained throughout, K and L are given and ﬁxed. Differentiate (3.12) and use (3.14): dxi dl i dk dk

fi (1)

i

fi k2 k1

(3.15)

Finally, differentiate (3.10) with respect to commodity prices and use (3.15): dr fi i f i (1) k2 k1 dpi

(

dw k1 f1 k1 f 1 f 1 1 dp1 k2 k1 dw k 1 f2 dp k2 k1

(3.16)

)

k2 f1 k2 k1

(3.17)

(3.18)

The conclusion is that ‘an increase in the price of any commodity gives rise to an increase in the real reward of whichever factor is used relatively intensively in the production of that commodity, and to a decline in the real reward of the other factor’ (Kemp, 1969, p. 17).

3.5

THE RYBCZYNSKI THEOREM

While the Stolper–Samuelson theorem deals with factor and commodity prices (holding ﬁxed factor supplies), the Rybczynski theorem represents its dual and is concerned with factor and commodity

The Heckscher–Ohlin Theory

23

quantities (given commodity prices). In an incompletely specialized economy factor prices are supposed to be internationally equalized and ﬁxed by the factor-price equalization theorem. Thus, the production technology chosen is also constant. When the available factors of production are fully employed, an increase in the supply of one factor – the supply of the other factor remaining ﬁxed – raises the output of the commodity which uses that factor intensively and reduces the output of the other commodity. This happens because the expanded production, using the increased quantity of the factor that has become more abundant, must also use the other factor as determined by ﬁxed technology. In this way less is left for the production of the second commodity and it must contract. It also follows that the terms of trade (relative commodity price) of the commodity using relatively much of the factor whose quantity has increased will deteriorate (Rybczynski, 1955, pp. 339, 340). If, for example, manufacturing is capital-intensive, the accumulation of capital will increase manufacturing production and reduce agricultural production at constant terms of trade (Johnson, 1962, p. 89). Solving the equations (3.3), we identify labour and capital constraints for commodities X and Y. Y

L λ κ K x X x X λy κy κy λy

(3.19)

When λ x /λy kx /ky, Y is more labour intensive than X. Solving the two equations for X and Y. X

Y

Lκ y Kλ y λ xκ y κ x λ y Kλ x Lκ x λx κ y κ x λ y

(3.20)

(3.21)

When industry X is more labour-intensive, λx κ y κ x λ y, the denominator is rendered positive. If the supply of labour increases, the labour-intensive output of X increases and the capital-intensive Y is reduced.

24

The Theory of International Trade

4 Critique The scarcity theory suffers from a fatal ambiguity. When it was originally formulated in relation to consumption, scarcity was correctly deﬁned with respect to demand. As the theory was extended to cover production, scarcity came to be deﬁned as a technological relationship. As the ratio of two factors declines, the factor in the numerator becomes relatively scarce. The two concepts of scarcity may coincide, but they need not. They may be made identical by special restrictive assumptions, but this is artiﬁcial. If a country is technologically capital abundant (K/L high), it may nevertheless be economically labour-abundant when tastes in the two countries are different or if there is permanently high unemployment. Thus, it will try to export labour, not capital, in terms of commodities. Also, the theory is in difﬁculties when more than two factors of production are involved. The third main point of confusion is that the scarcity theory with respect to factors of production was developed for single industries. Thus, the composition effect was not noticed. Any real-world economy is composed of different industries that may vary substantially in their capital intensity. If technology remains unchanged, but industry mix changes for whatever reason unconnected with factor proportions, the capital intensity of the economy will change. After these general remarks, let us now examine that formidable battery of restrictive assumptions underlying the HO theorem given in Section 3.2.

4.1

THE VALIDITY OF UNDERLYING ASSUMPTIONS

Assumptions (1) (given factor endowment in the short-run), (6) strong competition (no impediments to adjustments), (7) identical tastes, and (9) both commodities produced in the pre-trade situation, seem to be relatively harmless simpliﬁcations. Assumption (2) (constant returns to scale) is harmless in the short run but dangerous in the long run, because output depends not only on factor proportions but also on the quantity of inputs and, also, the assumption 24

Critique

25

of perfect competition is logically unwarranted. With perfect competition production cannot be optimal, the economy will produce inside its production-possibilities frontier (Chacholiades, 1978, pp. 199–200). Assumption (3) (no joint production) is an admissible simpliﬁcation for some purposes and not for others. Assumption (4) (m n) is important for the deﬁnition of the factor of production used. It is admissible in the usual case of assuming two or three general factors (labour, capital and land). It becomes arbitrary in the speciﬁc factor models since the number of speciﬁc factors may be greater than the number of commodities, m n. Assumption (5) (identical technologies) is perhaps the most farfetched and critical one. It implies three logical steps: (1) productive knowledge is available at no cost and instantaneously; (2) that makes possible identical production functions in use; and (3) countries will always choose positions on the frontiers of neoclassical production. Even if we neglect information imperfections, obviously none of the steps is warranted. In the real world, production functions are not identical and it is not clear how can they be analytically adjusted to look identical (except by means of tautologies). One obvious consequence is that trade will not equalize factor prices. This conclusion has already been reached by other economists (cf. Haberler, 1961, p. 19; Harrod, 1973, p. 37). Wages in poor countries are much lower than in the rich ones and no amount of free trade will equalize Indian and American wages, even if they ﬁnd themselves in the same ‘cone of diversiﬁcation’. What is necessary is economic development, and this is not a matter of trade but of investment. Productive capital is extremely unevenly distributed around the world (Olson, 1996, p. 19). Assumption (8) postulates the absence of factor intensity reversals for the same commodity originating in different countries or produced at different prices. If the production of a commodity is labour-intensive in one country or at one set of prices, it must remain so in all countries and at all factor-price ratios. Already two different isoquants represent factor intensity reversals at the point where they touch each other, a fortiori when they cross. In both cases the elasticities of substitution of the two curves are different (Fig. 4.1). This led Minhas to observe: ‘In the case . . . of any two industries with different elasticities of substitution, the reversal of relative factor-intensity is as inevitable as the meeting of two straight lines with different slopes’ (1962, p. 143). Therefore there is no

26

The Theory of International Trade K

Isoquants

L

Figure 4.1

Factor-intensity reversal

unique relationship between commodity and factor prices and ‘a reversal of capital intensity of two commodities at ω* the same commodity price consistent with two different factor-price ratios, one on each side of ω*’ (1962, p. 150). (ω* corresponds to the crossover point in the relative capital intensity.) It is clear that all the four theorems break down in their generality if the relative factor intensities are not monotonically related to relative prices (as in Figure 3.1) because the fundamental assumption is that they are technologically and so uniquely determined (cf. Steedman and Metcalfe, 1979, pp. 38–45, 64–75). In addition to assumptions quoted, there are several hidden general theoretical assumptions practically never quoted. They are: (1) analytical identity of ﬁnancial and real capital, (2) analytical identity of one-commodity and many-commodity economies, (3) instantaneous adjustments, (4) symmetry of labour, capital and land, (5) no role for human initiative and other stochastic factors. As shown in my theory book, none of them is justiﬁed (Horvat, 1995, p. 16). To this list of assumptions at least one other may be added, (6) no information imperfections. Joseph Stiglitz shows that this assumption is particularly damaging for neoclassical analysis (Stiglitz, 1995). Apart from assumptions, there are further logical and empirical difﬁculties. Value and physical deﬁnitions of the HO theorem may contradict each other. In such a case, which is the relevant one? There are necessary conditions for them to contradict each other and there is just one sufﬁcient condition: the labour-intensive commodity must be cheaper in the capital abundant country (Chacholiades,

Critique

27

1978, pp. 271–72). The relative factor abundance of compared countries may also change because of differential rate of growth of constituent industries.

4.2 THE VALIDITY OF NEOCLASSICAL ECONOMIC THEORY Difﬁculties and logical contradictions in neoclassical theory are analyzed in my theory book as ‘neoclassical aporiae’. I shall not repeat the analysis here; the interested reader may consult the original book (Horvat, 1955, pp. 12–27; pages quoted below refer to this book). More relevant to the present discussion is a different approach. The HO structure has been erected on the neoclassical foundation. And the foundation is basically composed of seven postulates. Neoclassical theory postulates an inverse monotonic relationship between prices and quantities of commodities and factors of production. It is said that the use of capital, land and labour decreases if interest rate, rent and real wage increase. It has already been observed that the composition effect is ignored when two or more industries are present. Now we consider the seven neoclassical postulates in some detail. First postulate: If the rate of interest is lowered, capital intensity increases. Finding: Capital intensity may decrease but also increase depending on whether producer good industries are less or more capital-intensive than consumer good industries. When the producer good industries are more capital intensive, the overall capital intensity is an increasing function of the rental rate (p. 133). Second postulate: An increased rent-wage ratio decreases land intensity (land per worker). Finding: Increased rent may also increase land intensity (pp. 184–91). Third postulate: There is a monotonic relation between factor prices and factor quantities. Finding: There is not, because reswitching of land and capital occur. In other words, factor-intensity reversal is a distinct possibility, theoretical and empirical (Steedman, 1979, p. 70). Fourth postulate: If labour supply increases (decreases), real wage rate decreases (increases). Finding: If labour is always fully employed, then – for a given labour force – an increased output of investment goods reduces the output of consumer goods. Consequently,

28

The Theory of International Trade

the real wage will be reduced regardless of no changes in labour supply. This is so even if an economy is open, because consumption (wages) cannot be increased if it cannot be paid for. Fifth postulate: The supply of commodities and their prices are inversely related. Finding: For inferior goods and habit-forming drugs that is certainly not so. This has been known for a long time. Yet, such goods are not very important and may be safely ignored. But now a new class of very important commodities is added. Prices are increasing functions of interest rate (p. 113). Interest (proﬁt) is used to ﬁnance investment and so, in a fully employed economy, production of investment goods increases when their prices increase. Sixth postulate: Assuming constant returns and diminishing marginal productivity of labour, there is an inverse monotonic relation between the rate of proﬁt and labour productivity (output per worker). Finding: That holds true if consumer good industries are more capital-intensive, otherwise not (p. 113). Seventh postulate: There is an inverse relation between the rate of proﬁt and consumption per capita. Finding: True, since the wage– proﬁt curve is downward sloping (see Chapter 11). As six fundamental postulates are theoretically false, it will come as no surprise if none of the four core HO propositions survives. This is the conclusion already reached by Steedman, Metcalfe and Mainwaring after having carefully scrutinized ‘the internal logic of the HOS analysis’ (Steedman, 1979, p. 64).

4.3

EMPIRICAL EVIDENCE

The theory predicts that similar countries will trade less while in fact similar advanced countries engage disproportionally much in mutual trade. Also, the intra-industry trade is expected to be negligible. In reality, intra-industrial trade expands much faster than the inter-industrial trade. More important than factor proportions is the structure of economy. Norway and Greece are relatively capitalabundant not because capital is relatively cheap but because Norway relies on hydroelectric power generation and the extraction of oil from the seabed and Greece has one of the largest merchant ﬂeets in the world. All three activities are highly capital-intensive. By now it should be clear that the predictions of the theory are not likely to come true. When in 1954, Wassily Leontief decided to test the theory empirically, he was greatly surprised to ﬁnd that

Critique

29

the result was negative. Leontief used the 50-sector 1947 American input–output table and estimated capital labour requirements for one million dollars’ worth of export and import competing commodities. He found that US import replacement required 30 per cent more capital per worker than exports. Capital-abundant America was importing capital-intensive commodities (and exporting labourintensive ones). Leontief and others repeated computations for American trade compositions in 1951, 1962 and 1972: two ﬁndings again refuted the theory, while the last one slightly corroborated it (Caves et al., 1993, p. 130). Leontief was persuaded – and so was the profession, almost without exception – that the theory was correct and that the use of his empirical data was faulty. Several years after Leontief, I performed the same exercise for the obviously labour-abundant Yugoslav economy using the 27-sector input–output table for 1955 (Horvat, 1962, pp. 154–56). It turned out that Yugoslavia was exporting capital-intensive commodities (and services). I did not ﬁnd it difﬁcult to explain these test results by the structure of the economy (the great share in export earnings of highly capital-intensive railway transit and maritime shipping, and in the imports of labour-intensive agricultural products). In the subsequent years, a number of empirical studies were performed (A-1). The results showed no clear direction: refutations and conﬁrmations showed a stochastic pattern. The theory was found not to have any predictive value. If economics were natural science, it would have been concluded that the theory was deﬁnitely empirically refuted. Not so in economics. The literature on HO and related theorems is swelling; the textbooks and university courses pay great attention to this useless theory and Leontief’s ﬁnding – characteristically enough – was not considered (even by himself) a falsiﬁcation but a ‘paradox’ of an otherwise good theory. The ‘Leontief paradox’ has become a standard item in university textbooks and exams and the HO theorem holds the place of honour. This phlogiston theory of foreign trade poses an interesting question for the methodology of economic science.

4.4 THE EVALUATION OF THE HECKSCHER–OHLIN THEORY The analysis revealed that the HO theory is either logically inconsistent or empirically refuted or both. In the tradition of serious

30

The Theory of International Trade

science, it must be discarded, although an enormous effort has been invested in its reﬁnements. The discarded theory necessitates that it be replaced by a better one. Subsequently we shall explore some of the possible ways in which this might be done. If neoclassical theory is problematic and HO theory, built on that basis, is unsustainable, that does not imply that all elements of these theories must be discarded. For instance, the concept of factor proportions contains a rational idea, both logically and empirically. Given endowments and technological knowledge, there is, presumably, some optimal combination of factors of production. Deviations in either direction impair labour productivity. Further, it is an empirical fact that advanced countries displaying high labour productivity are more capital-intensive than poor countries. It must not be deduced, however, that this is due to a mere quantity of capital (although quantity plays a role, too) – to the mechanical addition of identical units of capital. It is primarily due to superior technological knowledge embodied in the stock of capital per worker. Then again, the value of capital, expressed in current labour productivity (measured, say, in wage rates) may be the same in a poor and in an advanced country, and yet it is clear that in an advanced country workers produce greater quantities of commodities. Similarly, a comparable stock of labour is not simply an aggregation of individual workers. Rigorously deﬁning such distinctions is vital for clear thinking. The ﬁrst precondition for that is an adequate theory of value. Since in the six (out of seven) fundamental relations the dependent variables may move in the opposite direction to that predicted, the theory that arbitrarily assumes just one type of relationships is itself arbitrary. It will generate ‘paradoxes’ and cannot be empirically corroborated. Even less can it be meaningfully mathematized. Mathematical relations require precise deﬁnitions and do not allow ambiguities for an uniquely determined model. Finally, one might ask why was it necessary to demonstrate that HO theory is no theory at all in the usual sense but an arbitrary construct when this has already been accomplished. For instance, Ian Steedman demolished HO theorizing effectively in his article in the New Palgrave (1987). The answer is that such critique has simply been ignored. Perhaps the best illustration of this fact is provided by the articles by R.W. Jones on HO theory and J.S. Chipman on international trade theory. Although both articles were published in the same volume of the New Palgrave, both authors

Critique

31

managed to write their learned treatises without even mentioning Steedman’s critique. Nor was any other serious critique included in the list of more than 200 references. The ignored critique must be repeated. The second reason is that my approach is somewhat different and, I believe, simpler and more straightforward. Also, I had to justify my not using the mainstream constructs in my own work.

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The Theory of International Trade

Appendices to Part I 1

EMPIRICAL EVIDENCE

Bhagwati (1964, pp. 4–17) surveys various empirical tests of the Ricardian theory, whereby export–import prices are related to different labour productivity. He ﬁnds no clear refutation. Except for simple linear regressions, he ﬁnds corroboration of the hypothesis to be from mild to substantial. He concludes that ‘all we could say is that, if the pattern of exports and imports changes in any way, the new pattern will also be characterized by the postulated Ricardian ranking in terms of comparative labour productivities and/or unit wage ratios’ (p. 17). A rough empirical test of Ricardo’s criteria was conducted by Robert Stern in 1950. Wages in the USA were 3.4 times higher than in Great Britain. Therefore the per worker output in individual industries was increased 3.4 times. If the value obtained was lower than the actual empirical value, the industry was considered to have export advantage. British and American exports to France were considered and it was found that out of 26 industries enjoying calculated comparative advantage in Britain, 22 exported to France more than the same American industries (Stern, 1962). Chacholiades (1978, pp. 298–306) surveys various empirical studies of export–import intensities crucial for the HO theory. He reports refutation of the theory in Japan (Tatemoto and Ichimura, 1959), conﬁrmation in East Germany (Stolper and Roskamp, 1961), refutation in Canada (Wahl, 1961), conﬁrmation and refutation in India. Leontief tried to save the theory by arguing that American workers were three times more effective than those abroad, which was just an arbitrary exaggeration. Others involved human capital and natural resources (De Marchi, 1976, and others). Still others engaged in conceptual hair-splitting, although to no avail (Bowen et al., 1987). A number of economists attributed the Leontief paradox to factor intensity reversals. The other explanations offered were: (1) capitalbiased consumption, (2) tariffs and (3) technological differences. Minhas observes that factor intensity reversals are quite likely and so ‘it is not legitimate to deduce a country’s relative factor endowments from the relative factor intensities of export and import substitutes.’ (1962, p. 152). Yeung and Tsang (1972) found strong indications in the studied variable elasticity of substitution (VES) production function for the U.S. manufacturing and found factor-intensity reversals very likely. Jones and Neary observe, concerning the HO model, that ‘in the simplest form – two goods, two factors and identical technologies worldwide – the model’s predictions are overwhelmingly rejected by the data’. As already observed, such empirical refutations would be more than sufﬁcient to discard a theory in natural sciences. Not so in economics, since the authors in the same passage say that this does not diminish the usefulness of the HO model whose ‘rela-

32

33

Critique

tively rich production structure . . . has made it a source of fruitful hypotheses for empirical testing . . . as well a useful vehicle for the study of a wide range of theoretical issues (1984, p. 20). D. Treﬂer observes that the HO theorem ‘performs terribly. Factor endowments correctly predict the direction of factor service trade about 50 per cent of the time, a success rate that is matched by a coin toss . . . Also, rich countries appear scarce in most factors and poor countries appear abundant in all factors, a fact that squares poorly with the HOV prediction that abundant factors are exported’ (1995, p. 1029). Treﬂer ﬁnds a pattern in the deviations from the HOV theorem and suggests that such data patterns may be used for a new theoretical analysis. James and Elmslie(1996) select only those countries which have similar relative factor endowments, a condition necessary to achieve factor price equalization. Yet the empirical results are poor again (p. 153). Backer concludes that ‘factor endowments may not even be a particularly important inﬂuence on trade’ (1995, p. 63). 2 LEAMER’S ATTEMPT AT RECONCILIATION OF THE THEORY WITH FACTS One attempt at reconciliation, that of Leamer (1980, 1987, pp. 166–67), deserves a few more lines because it was included in the prestigious The New Palgrave Economic Dictionary and in some widely used textbooks (Caves et al., 1993, p. 133) and is considered by many economists (Porter, 1990, p. 776) as a deﬁnitive solution. Leamer argues that a country is revealed capital abundant if one of three conditions holds A. Ke Km 0, Le Lm 0 B. Ke Km 0,

Le Lm 0,

(Ke Km)/(Le Lm) Kc/Lc

(A-1)

C. Ke Km 0, Le Lm 0, (Ke Km)/(Le Lm) Kc/Lc where Ke, Km, Le, Lm, Kc, Lc are capital and labour embodied in exports, import substitution and consumption (deﬁned as production minus export). Leontief’s Ke /Le K m/Lm as a condition for capital intensive export is in Leamer’s view a theoretical mistake and therefore no paradox exists. All one has to do is to use differences instead of ratios. A. If embodied K exported is greater than embodied K imported, while L exported is less than embodied labour imported, then export is revealed capital intensive relative to import. Ke a Km,

L e b Lm ,

a 1,

b 1

(A-2)

Traditional measure of capital intensity is a Km Ke K a m, 1 Le b Lm Lm b

(A-3)

34

The Theory of International Trade

If net K is exported and net L imported, Leamer agrees with the tradition. B. If both K and L intensities are greater in export than in import, Ke a K m,

a 1

L e b Lm ,

b 1

(A-4)

the intensity ratio is no longer uniquely determined. For a/b 1, import is capital intensive. For a/b 1, export is capital intensive as in (A-3). To avoid ambiguity, Leamer imposes additional condition: the ratio of net export of embodied capital and labour, (Ke Km)/(Le Lm), must be greater than some standard c Kc/Lc, where c is capital intensity in consumption which is taken to represent world endowments under somewhat fanciful assumption of identical and homothetic tastes on the world scale. Similar conditions hold for the case C. Without B-condition we have a seeming contradiction since (A-4) implies Ke Km,

Le Lm

(A-5)

that both embodied capital and labour are exported. That may be interpreted as if export is revealed both capital and labour intensive. All we need to avoid such a contradictory interpretation is to postulate a 1 b

(A-6)

which means that for capital intensity of exports, exports must embody relatively more capital than imports. Leamer chooses a different route. Instead of using ratios, he uses differences K (a 1) Ke Km K m c Le Lm Lm(b 1) Lc

(A-7)

The ratio (A-6) is replaced by the ratio (A-7) with respect to the same standard. The relation (A-7) may be satisﬁed regardless of whether a b or a b. The use of ratios of differences instead of prime ratios expressing factor proportions – the basis of the HO theory – is likely to lead to a new paradox. One is obvious. The ratio of differences in (A-7) requires additional that trade be balanced. If it is not, anything may happen. The second paradox was discovered by Brecher and Choudhri (1982). Net export of labour embodied – shown in the denominator of (A-7) – is equal to the differences between home supply of and home demand for labour: T L L e L m SL D L 0

(A-8)

Critique

35

If this difference is positive, the country is revealed as labour-abundant. Domestic labour demand (consumption), given homothetic tastes, is proportional to the world consumption ( world output): DL sW L

(A-9)

where s is the share of domestic in world consumption. Assuming identical and homothetic tastes, we may write: s

GNP S L WL GNPW

(A-9)

since net labour supply is positive: SL DL SL sW L 0 Rearranging (A-9): GNP/SL GNPW /WL,

(A-10)

we ﬁnd that domestic per capita product is smaller than the world one. If a country is capital-abundant and both net factor exports and imports are positive, then consistency requires that it must have smaller than world average per capita output. We may now apply the ﬁndings. The United States is well endowed with capital; K/L ratio is higher than in the world on the average. Contrary to HO theoretical prediction, US exports are found to be labourintensive and not capital-intensive: Ke K m Le Lm

(A-11)

As the United States exports both capital and labour embodied, Ke Km, L e L m its exports are revealed as both capital- and labour-intensive. To solve the problem, Leamer constructs the measure B: Ke Km K c Le Lm Lc

(A-12)

which indicates that US exports are capital-intensive although in (A-11) they were not. Using (A-12), capital intensity of exports is shown to be the same as that of US home production. However, the argument implies that the US must have per capita GNP smaller than the world average. Since this is not the case, one paradox is substituted by another. How is it possible to have capital-intensive total output and labour-

36

The Theory of International Trade

intensive export (which is a fraction of the total)? It is possible because the industrial compositions of GNP and exports differ and individual industries vary greatly in K-intensity. A composition of highly K-intensive total output and the predominance of labour-intensive commodities in exports will indicate ‘Leontief’s paradox’. Since capital intensity is not uniform across industries, the composition effect is always present. Industries produce export and import goods and not net export. That is similar to the rather late realization in the capital theory that when using more than one capital good, various composition effects become apparent (Horvat, 1995, pp. 133–35). The merit of Leamer’s article is that it pointed out the possible ambiguity in the deﬁnition of capital abundance/intensity. But it did not resolve the ‘Leontief paradox’.

Part II The Systemic Theory of Value

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5 Diachronic vs Synchronic Labour Input: The Two-Century Old Misunderstanding A certain amount of human labour must be invested in order that any object of nature can acquire use value and be appropriated by someone. Even picking readily available fruits requires labour. If two man-made objects are exchanged, their owners will determine the common value by estimating the labour expended. The value of reproducible objects depends exclusively on labour expended; that of nonreproducible ones on scarcity relative to demand. The former value can be measured by the labour time necessary for production; the latter is purely subjective and therefore nonmeasurable. Since most of commodities are reproducible, the objective measure of exchange value is labour-time expended. This is the common sense basis of the labour theory of value. It has been assumed that the labour embodied in a commodity represents the simple addition of the labour time expended in the production process. That is fairly correct for the stationary economy with its unchanged structure and repetitive processes when variously dated labour inputs are economically identical. It is also approximately correct for the production processes of short duration. Both conditions prevailed in early times when labour theory was invented. But in a changing economy with substantial amount of ﬁxed capital, the underlying assumptions are patently wrong and so are labour–time calculations of exchange value based on such assumptions. The basic insight of classical economists such as Smith, Ricardo, Mill and Marx was correct. The mistake committed lies in the fact that they added diachronic labour, which is necessarily heterogeneous because it pertains to different points in time. What should have been done is to sum up synchronic labour, i.e. labour at the same point in time. Since economic changes can be twofold (labour 39

40

The Theory of International Trade

productivity can change and the quantity of labour can change), synchronization procedure must also be twofold. I shall call these procedures: time synchronization and systemic synchronization. The former is quite obvious: only labour of the same productivity (which changes in time) can be considered homogeneous and so can be summed up. In this case technological progress is the source of interest. The latter is not so obvious and has far-reaching consequences. We must replace production by individuals by societal production. Not an individual Robinson but the society is the paradigmatic entity for the new theory. In this case the growth (decline) of labour force is the source of positive (negative) interest. Capital inputs as embodied labour costs must also be doubly synchronized.1 Now we need again social economy instead of individual ﬁrms. Synchronic labour and capital costs represent the foundation of a new theory of value in which value is a measurable quantity. Also, by reducing diachronic to synchronic labour input, the labour theory achieves an important analytical advantage. As is well known, ﬁxed capital has time dimension which causes innumerable analytical difﬁculties. Synchronic labour input eliminates time dimension and transforms ﬁxed capital into circulating capital amenable to simple analytical treatment. The celebrated Marxian schemes of reproduction (Marx, 1967; symbols are his): c v m w also for the decomposition of prices: c v m p i.e. value per unit of a commodity, are theoretically faulty in a fundamental way because the dimensions are not right. Fixed capital (c) is a stock and the surplus value (m Mehrwert) certainly is not. Variable capital (v) is sometimes treated as a stock (of wage goods available ex ante or ex post) and sometimes as a ﬂow (wages paid between two points of time). Obviously, stocks and ﬂows cannot be summed up. Modern writers use circulating capital as a simpliﬁcation because they do not know how to deal with ﬁxed capital in a reasonably simple way. But circulating capital is akin to intermediate goods and not to capital with its time dimension. Thus, an important feature of real economic processes is lost. Systemic synchronization reveals that a changing economy displays

Diachronic vs Synchronic Labour Input

41

two important dynamic effects, which I call the employment effect and the replacement effect. The former determines the rate of interest even when output per capita remains constant; the latter determines ﬁxed capital cost. Both of them are of considerable theoretical and practical importance. They are best analysed within the framework of the corrected labour theory of value. The ‘corrected’ means that diachronic labour inputs of classical theory are replaced by synchronic labour inputs. The same applies to capital (embodied labour) inputs. Output per unit of capital input increases due to a mere fact of growth and so produces a rare phenomenon of ‘free lunch.’

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The Theory of International Trade

6 The Employment Effect Even an economy with constant per capita output will produce interest if quantity of labour changes. The source of interest is neither productivity of capital nor the roundaboutness of the production process (Böhm-Bawerk) nor the abstinence nor any other fancy explanation, but the growth of employment. Additional workers must be employed if we are to have full employment, which is a necessary condition for rational (optimal) social production. In this sense, the theory of proﬁt is a normative theory. Pareto optimality and unemployment are, clearly, contradictions. And resources necessary for the establishment of additional working places are obtained from the reduction of consumption (given production), i.e., from the generation of surplus which corresponds to proﬁt. Even with constant labour productivity (no technological progress), mere changes in employment create positive or negative surplus. If technological progress occurs, the surplus will be correspondingly greater. Labour growth increases, while technological progress decreases the amount of labour necessary for the production of the same ﬁnal output and that must be born in mind. The problem will be reduced to bare essentials.2 Let us consider the Austrian world of roundabout processes in which labour is the only input. Production is of distributed-inputspoint-output type. Suppose all processes last two years and use identical technology with one unit of labour input each year per unit of ﬁnal output called B(asket). In two years one unit of commodity B is produced by total input of labour of two units, one per year. Suppose labour expands by factor G 1 g and economy consists of two processes operating simultaneously. The columns indicate diachronic summation of labour inputs, which is always two labour units per unit of commodity B. The rows indicate synchronic summation of labour inputs, which is G(1 G) G(2 g) per unit of B. The synchronic input is greater than the diachronic one, G(2 g) 2, because of the growth of labour force. The reverse is true for a declining labour force. If employment expands at the rate g, each dated labour input must be 42

43

The Employment Effect Processes Years

0 1 2 3

1 1 B

G G GB

Employment

G2 G2

G3

1 1 G G(1 G) G 2(1 G)

expanded at the same rate in order to evaluate all inputs in ‘present’, synchronic labour values. In year zero labour input is one. By the time output is delivered in year two, it will expand to G2. In year one labour input in the same process is also 1, and since it is frozen in the production only one year, by the time B is delivered it will have expanded to G. For this reason, while diachronic labour costs are two labour units, the synchronic costs amount to G G 2 G(1 G) labour units. The rate g plays the role of interest rate. No ﬁxed assets are around and so this time interest is generated by the growth of labour. Thus the appelation ‘employment effect’. The synchronic summation of labour inputs represents systemic costs of producing net output in any given year. We still have to show why this is relevant for price formation. The Ricardo–Marx labour price for commodity B is p 2. That is not a correct price because, by violating the principle of synchrony, it leads to misallocation of resources. The allocational efﬁcient price is p G(2 g). For example, for g 10 per cent the correct labour price is p 2.31. Ricardo uses a similar example to derive a different conclusion: Suppose I employ twenty men at an expense of £1000 for a year in the production of a commodity, and at the end of the year I employ twenty men again for another year, at a further expense of £1000 in ﬁnishing or perfecting the same commodity, and that I bring it to market at the end of two years, if proﬁts be 10 per cent, my commodity must sell for £2310; for I have employed £1000 capital for one year, and £2100 capital for one year more. Another man employs precisely the same quantity of labour, but he employs it all in the ﬁrst year; he employs forty men at an expense of £2000, and at the end of the ﬁrst year he sells it with 10 per cent proﬁt, or for £2200. Here then are two commodities having precisely the same quantity of labour bestowed on them, one which sells for £2310 – the other for £2200 (1821, p. 37).

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The Theory of International Trade

The reasoning is quite illustrative for the mistake usually committed by the labour theorists and their critics. First of all, the summation of labour inputs must not be diachronic (as visualized by a single ﬁrm) but synchronic (pertaining to the system as a whole). As demonstrated above, the systemically necessary labour is not 2 (i.e. 2 20 workers) but 2.31, which is exactly the ﬁgure reported by Ricardo for the value of output. Next, the alternative (one-year) technique sells output at £2200 because the labour input is lower (2 20 workers plus 10 per cent for the increase of the labour force). Under competition, both techniques cannot coexist and the systematically less productive twoyear technique will be abandoned. Finally, Ricardo does not ask himself why the rate of proﬁt should be ten per cent. Evidently, he takes it as exogenously determined quantity simply given at the market. However, if (1) technology applied does not change, (2) all proﬁts are invested in the creation of new jobs and (3) all workers are employed, the equilibrium rate of proﬁt is equal to the rate of increase of active population. Consequently, labour theory is a general equilibrium normative theory. Obviously, if there is unemployment and there exists a class of capitalists who consume part of proﬁts, prices will be different. But such a price structure makes optimal allocation of resources impossible.

7 The Replacement Effect Labour input is measured by labour time. If economic systems – similarly to physical systems – move (change) in time, the measuring rod of time itself will change. Dynamic systems involve time in an essential way and so there is no absolute time independent from the rate of change (speed of movement). Let the unit investment expand at the rate g per year. If machines have the rectangular life-time proﬁle – the productive capacity is fully used and remains unimpaired over n years at the end of which machines are scrapped without cost or beneﬁt – then at time t n replacement amounts to3 R n Il 1

(7.1)

The number of machines in operation is equal to the number of all machines installed in the last n years: n

Kn

ΣI 1

t

Gn 1 g

(7.2)

For t n, the system achieves balanced steady growth and its structure does not change any more. From (7.1) and (7.2) we derive the relation between current replacement and the stock of machines: 1 R g n ν K G 1

(7.3)

where 1/ν represents a diminishing function of the rate of growth, which follows from the properties of the geometric series: ν 1 G G2 . . . G n1 n1 1 δ 1 δ (1 G . . . G ) 0, δg ν δg

()

g 1

(7.4)

1/ν represents dynamic replacement cost, which corresponds to replacement cost in the stationary economy: 45

46

The Theory of International Trade lim g→0

1 1 R0 0 ν n K

(7.5)

For positive rates of growth, 1/ν 1/n and the difference is the greater the higher the rate of growth. Both ν and n have the dimension of time. We thus encounter an economic relativity effect whereby n static years are lengthened into ν dynamic years. To contraction of capital cost corresponds the dilatation of economic time. The effect varies quantitatively very little if time proﬁles of output are different. The rectangular time proﬁle has been chosen because of mathematical convenience and also because there is some evidence that it approximates the average case better than the other pure proﬁles. If it is compared with linear and proportional decay proﬁles (for g 5% and n 30), dynamic replacement as a fraction of static replacement for the three proﬁles appears to be 0.43 as against 0.35 and 0.38 (Horvat, 1973, p. 102). These ﬁgures also indicate that the effect is rather strong. For high rates of growth, replacement costs practically disappear (n/ν is between 0.03 and 0.05 for g 15%, i.e. 30 static years are lengthened into more than 600 dynamic years, which means that for all practical purposes ﬁxed assets last forever). Now, the gross rate of proﬁt consists of the rate of growth and the dynamic rate of replacement: π g

1 ν

(7.6)

For high rates of growth, 1/ν tends to disappear, and the gross rate of proﬁt is approximately equal to the rate of growth. This is of considerable practical importance for economies expanding at rates higher than, say, ﬁve per cent (such as the ‘Asian Tigers’ and the former Yugoslavia). The faster they expand, the less costly it is, even regardless of technological progress This is also theoretically quite important. Capital cost is not only technologically determined but also determined by the mere rate of change of capital. Technological (static) replacement cost for unit of ﬁxed assets is 1/n. Economic (dynamic) replacement cost is 1/ν and it decreases as the rate of growth increases. Since technology does not change, capital cost per unit of output decreases in the same proportion as per unit of ﬁxed capital. In other words, it

47

The Replacement Effect

is possible to obtain larger for the same cost of smaller output, i.e. at no additional cost. This is a clear case of a ‘free lunch’ in economics. Two other cases merit attention. If an asset is fully expended in one production cycle, which means that service life is reduced to n 1, then ν 1 whatever g, and the asset is really an intermediate good, i.e. raw material or semi-ﬁnished product. An intermediate goods is an asset whose service life is one production period. If the service life is extended into inﬁnity, n ν ∞ , replacement disappears. In both cases there is no replacement effect. Thus, the frequent assumption in economic models that capital is circulating or that its duration is inﬁnite implies neglecting an essential dynamic effect. We may now systematize our ﬁndings. If the rate of growth is different from zero, dynamic capital cost (R) will diverge from the static capital cost (R0). The transformation factor β: β

Rt 1/ν n ng n 1/n ν G 1 R0t

(7.7)

transforms greater static cost into smaller dynamic cost or, what is the same, longer dynamic time into shorter static time (assuming g 0). The characteristics of β are: lim β 1

δβ 0 δg

limβ 0

limβ 1

δβ 0 δn

limβ 0

g→0

n1

g→∞

limβ n g 1

(7.8) n→∞

There is no transformation and, consequently, no replacement effect in stationary economy (g 0) and for intermediate goods (n 1), which do not last in time. Faster growth and longer durability reduce capital cost below its stationary value of the base period. Very high rates of growth and very long service life of ﬁxed assets eliminate capital cost. Finally, for negative rates of growth (g 0), capital cost increases above the stationary level (β 1) up to the limit of full amount of the existing capital (nR0 for g 1). The replacement effect is portrayed in Fig. 7.1 in which discrete analysis, used so far, is replaced by continuous analysis to make the explanation simpler.

48

The Theory of International Trade I

It(g > g)

It(g = 0)

It(g = 0) It(g < 0) t

Kt = ∫ I(t)dt

Rt

t–n

t–n

Figure 7.1

t

Replacement effect (rectangular time proﬁle of assets)

1 r= υ +g g

1 v

1 n

g

0

Figure 7.2

Replacement and rental curves

The Replacement Effect

49

Fixed capital consists of n yearly gross investments and is represented by the area under the investment curves. In a stationary economy It Rt constant. The higher g, the larger will be Kt. But Rt Itn does not change. Therefore 1/ν Rt/Kt will diminish as the rate of growth increases. Alternatively, for Rt It-1 1, it is simply the case ν Kt and ν will increase the faster the rate of economic growth of K. For g→∞ , the ‘mass’ of capital tends to inﬁnity and economic time becomes inﬁnitely long, K→∞ , ν→∞ . Rt and Kt are compared at the same point of time, which is an application of the synchrony principle. The resulting replacement curve is shown in Fig. 7.2.

50

The Theory of International Trade

8 The Interplay of Employment and Replacement Effects If only welfare generating part of ﬁnal output (i.e. consumer goods) is considered, two dynamic effects represent two opposing forces. The production of a given basket of consumer goods B requires more social labour time (increased demographic investment) when labour force is increasing under full employment. It also requires les social labour time when the rate of growth is higher because replacement per unit of capital decreases with the rate of growth (1/n for stationary economy, 1/v for the growing one). To disentangle these effects, consider two simple models, one for a stationary and one for a growing economy. Let gestation period of investment be ng 1 year and the life span of ﬁxed assets (of constant productivity and scrapped without cost or beneﬁt) n 3 years. After ﬁrst replacement at t 3, the balanced composition of capital is achieved and the system settles at a steady growth path. The productivity of installed capital – the output–capital ratio – is equal in both economies: one unit of capital produces one B(asket). Since we are interested in synchronic effects, we must consider investment–output ratios, and now the picture is very different. The balanced composition of capital of a stationary economy means that only 1/n K annual investment outlays are necessary for production of the same output as that by installed capital K and that lasts forever. In a growing economy additional complications occur. g 0

p0

output 3B nB investment

(8.1)

g 0

pg

1 G G2 Gn 1 v B B nB 3 gGn G G

(8.2)

In a growing economy, n static years are lengthened into v dynamic years and in the same proportion output is increased. At 50

51

The Interplay of Employment and Replacement Effects

Year

Processes

0 1 2 3 4

1 B B B

0 1 2 3 4

1 B B B GB

1 B B B

Stationary economy Investment

1 B B

1 B

1

Output

1 1 1 1 1

Productive Capital

0 B 2B 3B 3B

0 1 2 3 3

Growing economy G GB G 2 GB G 2B G2B G3B

G3 G4

1 G G2 G3 G4

0 B B(1 G) B(1 G G 2) GB(1 G G 2)

0 1 1G 1 G G2 G(1 G G 2 )

the same time the unit investment is increased to (1 g)n because of g 0 which reﬂects the growth of labour force. The net effect is given by (8.3): 1 v 1 Gn 1 pg 1 G n 1, g 0 po Gn n Gn gn gn

(8.3)

When g 0, the production coefﬁcient (output-investment ratio) declines, p g p0. Demographic investment grows slightly faster than v output, G n , 1 G G2 (G n 1)/g v, or faster than the n time lengthens. The mechanics of growth will be clearer if we reproduce the year 3 from the preceding table for both stationary and growing economy, remembering that n 3.

Stationary economy Growing economy

R3 1 1

I3 1 Gn

K3 n v

Y3 nB vB

The structure remains the same in the later years of the steady state growth. Since the ﬁrst batch of investment is the same, I0 1, the ﬁrst replacement at t 3 will be the same in both economies, Rn 1. In the stationary economy all investment is used to replace the scrapped capacity, while in the growing economy (G n 1) is used for the

52

The Theory of International Trade

enlargement of capacity. Capital expands as inverse values of capital costs, v : n, and that is also the expansion of the notional economic time. The same is the expansion of output, since technology remains unchanged. Capital cost per unit of output is reduced from 1/(nB) to 1/(vB). This means that in a growing economy, capital cost is smaller v/n times. This is slightly overcompensated by the increases of demographic investment Gn times. In the nth year the share of investment goods in output in the stationary economy is 1/(nB), in the growing economy is Gn/(vB), and the two shares relate as 1/(nB) v 1 G n/(vB) nGn and by (8.3) the ratio is smaller than one. Consequently, the ratio of the shares of consumer goods is greater than one in favour of the stationary economy. The same applies to per capita output since total output is growing at the same rate as labour force. Thus, in order to achieve full employment investment has to grow and total consumption will grow while per capita consumption will be slightly less than in a stationary economy. However, it will be much lower if labour force continues to grow while economy remains stationary. Thus, the relevant choice is between slightly smaller and much smaller consumption per capita. All this only in the case if per capital output remains constant. In the real world it grows, because investment induces technological progress and, therefore, growth. A possible alternative approach is as follows. If there are two equal productive capitals K 0 K g but with different balanced compositions corresponding to g 0 and g 0, then for equal addition to productive capacity gK, replacement costs are 1/n K resp. 1/v K. With constant technology, output is proportional to capital and so 1/n and 1/v are also comparable replacement costs (i.e. synchronic capital costs per unit of production). The faster growth of the system, the greater the difference (1/n 1/v) in Fig. 8.1. This difference represents the saving of capital cost due to a mere speed of change and is unrelated to any material input. In other words, it is a ‘free gift of nature’ or already noted ‘free lunch’. For small g, the ratio of investment cost to capital cost saved is 1 1 close to two, lim g/ 苲 2. g→0 n v

(

)

The Interplay of Employment and Replacement Effects

53

g

1 n 1 1 – n v

0

Figure 8.1

g

The growth rates of labour and capital and capital cost (per unit of capital) saved

If g is interpreted as interest rate, it becomes evident that it is always greater than capital cost saved. Capital (embodied labour) cost is likely to be saved not only because of growth as such but also because growth is likely to propel technological progress (Verdoorn effect). If technological progress is of a such magnitude as to expand output of K to that of K(1 1/v), then capital cost disappears and all investment is new investment enlarging output capacity.4 ‘Free lunch’ has various theoretical consequences, among them the following one. Suppose two economies have equal factor endowments and are equipped with exactly the same technology. Thus, production functions are the same. The economy expanding faster will enjoy absolute advantage by producing everything at lower capital cost. Or, in terms of the labour theory, the total expenditure of labour per unit of output will be reduced in the economy expanding faster. Since capital participates in the production of various commodities in different proportions, the uniform absolute advantage will also imply different comparative costs in different industries. These differences will be caused by comparatively higher gross proﬁt rates (replacement plus new investment relative to installed capital). That indicates comparative advantage of labour intensive industries. The conclusion is somewhat unexpected: the faster an economy grows, the more its export will be labour intensive. This, of course, is another logical refutation of the HO hypothesis.

54

The Theory of International Trade

9 The Traverse It might be thought that the ‘free gift of growth’ is really not free because there must be some initial investment somewhere. To ﬁnd out the traverse from a stationary to a growing economy, consider the following schematic example. Let replacement be rectangular and the life span of ﬁxed assets be n years. Let gestation period of investment be ng 1 year. The annual factor of growth is G 1 g. Starting from a stationary situation, the labour force begins to grow and so will investment at the same rate in order to preserve full employment: Year Investment, I Replacement, R

0 1 2 1 G G2 1 K 0 v

0

0

...

n Gn

n1 Gn1

n2 Gn2

...

0

1

G

n

Productive capital, K

0

11G...

Σ 1

n1

Gt1

Σ 2

n2

G t1

ΣG

t1

3

Because of the gestation period of one year, investment in t 0 becomes productive only in t 1 and remains so throughout the life span of n years. At t n 1, the ﬁrst batch of capital must be replaced. Investment grows at the rate g, but productive capital grows at a higher rate which in t 2 amounts to (1 G) 1 g 1, in t 3 the rate of growth is (1 G G 2 )/(1 G) 1 g 1/ (2 g). Since productive capital – the number of working places – for some time grows at a higher rate than the work force, a possible unemployment will be gradually eliminated. The rate of growth of productive capital gradually decreases and, after the end of service n1

life, becomes constant at (

Σ

n

G t1 /

2

Σ

G t1) 1 g. The system

1

settles at steady growth path. Output in t is proportional to productive capital K t. During the ﬁrst n years, productive capital grows at a decreasing rate higher than g, because there is no replacement and therefore no synchronic capital costs. 54

The Traverse

55

Individual investment projects are worthwhile if the discounted stream of quasi-rents is greater than the discounted stream of investments. This procedure is not applicable, and for two reasons. First, quasi-rents are accounting quantities, while we deal with real investment and consumer goods. This is the essence of synchronic calculation. Quasi-rents are replaced by consumer goods assuming that they determine economic welfare. Secondly, we deal with the national economy and not with individual investment projects. Therefore the discounted streams of consumption and investment are inﬁnite and so the difference between two is not deﬁned. There is a simple alternative approach. Output Y is proportional to produc1 tive capital K, Yt K , where κ 1 is capital–output ratio. κ t Output of consumer goods is given by Ct Yt I t. From the table describing traverse, we realize that around t 2 output becomes positive: 1/κ K t I t 0 From that date consumer goods output expands at a rate higher that g until t n, and at exactly g afterwards. It follows that in the ﬁrst 2–3 years, the consumption must be unambiguously reduced. The ‘saving sacriﬁces’ are equal to accumulated investments in the initial period. Afterwards, the situation is reversed forever. Thus, we have constant saving S to be compared with permanently increasing consumption, all values being discounted to t τ when consumer goods output becomes positive: S

lim

t

Σ

t→

τ

0 Ct

Initial ‘saving sacriﬁces’ may be safely neglected. It may be objected that the appropriate welfare measure is not consumption as such but consumption of people living at the time investments are made. In this case we must take into account the average expectation of life of all people living at a certain point in time which is about t 40 years (cf. Horvat, 1965). Therefore, S

苲 0

40

ΣC τ

t

The result is essentially the same. It pays to grow.

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Part III The Basic Three-Industry Model

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10 Steady State 10.1

INTEGRATED WORLD ECONOMY

Consider an integrated – and therefore closed – world economy consisting of three industries producing consumption goods X1, capital goods X2 and intermediate goods or materials X3. (Xi denotes the type of the good and its quantity). Table 10.1

Commodity ﬂows in an integrated world

Intermediate goods From Baskets Machines Material Labour

Final output

Total output

To

X1

X2

X3

x

X

X1 X2 X3

x 11 x 21 x 31 L1

– x 22 x 32` L2

– x 23 x 33 L3

x1 – –

X1 X2 X3 L

Consumption goods X1 may be conceived as the number of baskets of consumer goods in standard proportions, capital goods X2 as the number of standard machines (or plants) and intermediate goods X3 as the tons of reproduction materials in standard proportions. Standard proportions make possible the aggregation of goods in industries. More generally, goods incorporate the labour time of standard productivity. Since the labour time is homogeneous, it may be aggregated. Note that X 1 is not used as input in any of other industries, and X3 industry does not produce any commodity for ﬁnal use (consumption or investment). In a stationary economy even X 2 industry does not produce ﬁnal output since entire output is used to replace the scrapped machines. Stationary economy implies that labour L, capital K, output Xi and technology remain constant through time. Technology is deﬁned by technical coefﬁcients aij

xij Lj Kj , λj , κj Xj Xj Xj 59

60

The Theory of International Trade

Commodity ﬂows may now be transformed into material balances of labour, ﬁxed and circulating capital. Total labour force and capital stock are equal to the sum of labour and capital allocated to the three industries. λ 1 X1 λ 2 X2 λ 3 X 3 L κ 1X1 κ 2 X2 κ 3X 3 K nX 2

(10.1)

a31 X1 a32 X 2 a33X3 X 3 Xi are production ﬂows, K and L are stocks. It is assumed that capital goods last n years with full capacity and then they are scrapped without cost or beneﬁt. Therefore K nX2 and κ j /n a2 j. It is also assumed that the production cycle lasts one time unit and that all labour and capital are available at the beginning of the production cycle. Final output of consumer goods is fully used for real wages w x1 / L. The equations (10.1) will be slightly rearranged: λ 1X1 λ2X2

λ3X3

L

κ1X 1 (κ2n)X2 κ 3 X3

0

a31X 1 a32 X2

(10.2)

(a331)X 3 0

There are three equations and three variables X1, X2 and X3. Labour force is given. The determinant of the system is D

兩

λ1 λ2 λ3 κ1 (κ2n) κ3 a31 a32 (a331)

兩

D is determined by the technology of the system. The solution is now straightforward:

兩兩

兩兩

X1

λ3 L λ2 1 1 0 κ2n κ3 [(κ2 n)(a33 1)a32κ3]L D D 0 a32 a331 (10.3)

X2

λ 1 1 κ D 1 a31

L λ3 1 0 λ3 [(1 a 33)κ1 a31κ3]L D 0 a331

(10.4)

61

Steady State X3

兩

λ1 λ2 L 1 κ1 κ2n 0 D a31 a32 0

兩

1 [κ a a31(κ2 n)]L D 1 32

(10.5)

Production of any of the commodities is proportional to the number of workers employed. Assume that ﬁnal output of consumer goods represents a constant proportion of total output x1 b X1,

b 1

then real wage is given by w* b X1/L or from (10.3) w*

b [(κ2 n)(a33 1) a32κ3], D

b 1

(10.6)

and is, like all outputs, inversely proportional to D. Input-output Table 10.1 may be represented as a system of equations x1 X 1

a11 X 1

1/nκ1 X 1 1/nκ 2 X2 1/nκ 3 X3

1/nK X2

a31 X1 a32 X2 a33 X 3

X3

(10.7)

In more compact notation a11 0 0 AX x X, A 1/nκ1 1/nκ2 1/nκ3 , X a31 a32 a 33

[

X (1 A)1 x

] [ ] [] X1 X2 , x X3

x1 0 0

(10.8)

Denote the elements of the Leontief Inverse (1 A)1 as Aij and let x1 1. Then from (10.8) X1 A 11 X2 A 21 X3 A 31

(10.9)

62

The Theory of International Trade

For the production of one basket of consumption goods, the necessary output of commodities is equal to full coefﬁcients given by the Leontief Inverse. Adding up the rows of the input–output Table 10.1 gives material balances. Adding up the columns evaluated at appropriate prices [ p1, p2, p3, w] produces value balances which is the dual of the ﬁrst procedure. Prices’ solution is the dual of quantities’ solution: p A w λ p, p w λ (I A)

λ [λ 1 λ 2 λ 3] 1

(10.10)

p [ p1 p2 p3]

Any price pj is given by pj w Σ i λi A ij

(10.11)

Prices are directly proportional to wages. The factor of proportionality is the sum of products of labour coefﬁcients and full coefﬁcients. Putting w 1, we obtain labour prices which appear to be functions of technology exclusively. These prices may be called gravitational prices since it is assumed that all price and quantity adaptations have been carried out. Thus, quantities were found to be proportional to labour, while prices are proportional to the wage rate.

10.2

OPEN ECONOMY

We shall now disaggregate the world economy into small open economy A and the rest of the world W (also an open economy). In this context ‘small’ means that the home country cannot change international prices Pi, which are considered to be given. We now have two countries and three commodities and commodity ﬂows are represented in Table 10.2. In an integrated world the only ﬁnal (net) output consisted of baskets of consumer goods while machines or plants (as replacements of worn-out plants) and materials were fully used in the reproduction process in a stationary economy. Now the other two industries also have ﬁnal outputs which may be positive (surplus) or negative (deﬁcit). In the ﬁrst case we have exports, in the second imports. The world production of X 1, X2 and X3 is distributed

63

Steady State Table 10.2

Commodity ﬂows in an open world economy

Intermediate goods

From Baskets Machines Material

Final good

Intermediate goods

Final good

To

X A1

X A2

XA3

xA

X W1

X W2

X W3

xW

X1 X2 X3

x A11 x A21 x A31

– x A22 A x32

– x A23 A x33

x A1 x A2 xA3

x W11 x W21 xW 31

– xW 22 xW 32

– xW 23 xW 33

xW 1 xW 2 W x3

between country A and the rest of the world W. As trade must be balanced, exports Ei and imports M i Ei must cancel out E Ai E iW 0

(10.12)

If the two economies are completely specialized, then the export of Xi from A will be the import of the same commodity into W. If they are incompletely specialized, they will produce and trade (export and import) in the same commodities. Generally, if there is intra-industry trade, any ﬁnal output represents a balance between ﬁnal output for home consumption, exports and imports x iA (x iH x Ei x M i )A, i 1, 2, 3 and similarly for W. Now the typical balance equation reads Σ aij X j x i X i and it is possible to calculate export and import content of commodities. If the information on capital and labour intensities of various industries are available, we can also calculate factor intensities of export and import. This is how I found that Yugoslav export was less labour-intensive than the import substitution and Leontief found the export–import factor intensities to be the other way round in America.

10.3

GROWING ECONOMY

If the labour force increases, production must increase at the same rate in order to keep the labour force fully employed. Technology

64

The Theory of International Trade

does not change and all production proportions remain unchanged. This is known as the steady state growth. If at the same time technological progress takes place, output growth will be faster than labour growth. Technological progress consists in a continual lowering of technical coefﬁcients. Since coefﬁcients decrease at different rates, individual industries will expand at different rates. The total expansion must be such as to provide employment for the entire labour force of increased productivity. If individual industrial capitals expand at rates gi, the average rate of growth is given by Σ g i Ki g K

(10.13)

and g is interpreted as proﬁt rate π. This is correct provided that (a) all proﬁts are spent for investments and (b) individual industries use the same rate of proﬁt which is different from the individual growth rates, π g i (Horvat, 1995, pp. 247– 49). In the literature proﬁt is usually interpreted as a metaphysical entity (lengthening of the production process, preference for immediate gratiﬁcation, inherent creativity of capital, product of waiting or abstinence). Here proﬁt is uniquely determined as the amount of investment necessary to provide new jobs for the increasing labour force of increasing productivity. Gross investment consists of replacement investment and new investment G R I

(10.14)

The higher the rate of growth, the greater is the share of I and the smaller the share of R although technology remains unchanged. I labelled this effect the replacement effect and the emergence of proﬁt from increased employment the employment effect (see Chapters 6 and 7). At the beginning of the production year, the available resources and the corresponding stock technical coefﬁcients are K 1 K 2 K3 K L 1 L2 L3 L κ1, κ2 , κ 3, κj K j /X j λ 1, λ 2 , λ 3 , λ j L j / X j

(10.15)

65

Steady State

For simplicity reasons, it is assumed that there are no stocks of material: reproduction material is used as soon as it is produced and the production time is negligible. Since constituent industries grow at different rates, one might expect that the same applies to πK and wL. However, that does not happen in the real world. Statistical evidence indicates that the shares of proﬁts and wages remain approximately constant through time. This is because X 1, X2 and X3 are aggregates of constituent outputs – which may change widely differently – and these aggregates grow at the approximately the same rate. Under these conditions, steady state growth is quite realistic. But it cannot be assumed for individual industries in a disaggregated economy. We are now ready to incorporate the rate of growth into our three-industry model gross output

Xi(t1) Xi(t) (1g)

ﬁnal output

x1(t1) x1(t) (1g) increased consumption x2(t1) x2(t) (1g) increased new investment

(10.16)

x2 (1g) x2 (t) π rate of proﬁt (t1) K (1g) K(t) Final output now contains not only addition to consumption but also addition to capital. From (10.2) it is evident that all outputs Xi and L increase at the rate of growth g which leaves the structure of the system unchanged. It follows the conclusion of (10.3), (10.4) and (10.5) that all outputs X i are proportional to the labour force L. Since replacement and proﬁt rates make rental rate (R Π) ρ π r K

(10.17)

we may rewrite equations (10.7) so as to replace depreciation rate 1/n by the rental rate r in the price equations. wλ1 p1a11 p2 κ1 r p3 a31 p1 wλ2

p2 κ 2 r p3 a32 p2

wλ3

p2 κ 3 r p3 a33 p3

(10.18)

66

The Theory of International Trade

The structure of the system remains the same and, therefore, the same qualitative solutions follow: prices are proportional to the wage rate w and are functions of the same technology. If the technology does not change, prices will nevertheless change due to employment and replacement effects affecting the rental rate r.

11 The Wage–Rental Curve The wage–rental curve (also called wage–proﬁt frontier, wage curve or distribution curve) portrays the relation between real wages and gross proﬁts (cf. Horvat, 1995, pp. 119–26). Since value added consists of wages and gross proﬁts, one would expect that higher proﬁts will cause lower wages and vice versa – given the output possibilities of the economy. The latter are determined by the existing labour force L, installed output capacity represented by ﬁxed capital K and by the known technology (ﬁxed technical coefﬁcients λi, κi and a 3j. Since Srafﬁan analysis had become known, it has been accepted that wage–rental curves are falling. That is certainly true for oneand two-commodity economies. Given production possibilities, the more production goods are produced the less will be the output of consumer goods. However, in a three or many-commodity world, that is not so obvious. Consider again the system (10.1), but let economy grow at the gross rate π ρ r. The second equation in the system will be transformed into rκ 1 X 1 rκ 2 X 2 rκ 3 X 3 X 2

(11.1)

Determinant of (10.2) will now look as follows

兩

λ1 λ2 λ3 D κ1 (rκ 2 1) κ3 a31 a32 (a33 1)

兩

From (10.6) we have w*

x1 b [(rκ2 1)(a33 1) a32κ3], L D

b 1

(11.2)

The real wage w* in terms of consumer baskets is certainly positive and so D and the numerator must both the positive or negative. 67

68

The Theory of International Trade c, w*

w

α w* 2

w* 1

β r

Figure 11.1

r1

r

Two wage curves α and β

In (10.5), the numerator is clearly positive and so must be D. If D 0, so is the numerator in (11.2). We also know that (rκ2 1) 0, (a33 1) 0 After some tedious algebra we ﬁnd that real wage rate is a falling function of the rental rate w* f(r), d w*/dr 0

(11.3)

From (11.2) it is clear that each technology generates a different wage curve. Two of them are shown in Figure 11.1. The full employment growth rate corresponds to full employment rental, r– g– ρ–. That rental determines the choice of technology α which generates the maximum possible consumption per –. If technology β were chosen, wage (consumption) capita c w –. If proﬁts are greater than necessary, would be lower, w* w –. – r1 r, technology β is preferable and wages are reduced to w* w Excess proﬁts are spent unproductively (for instance, on luxuries for capitalists). Under full employment (r–), technology β would make – possible wages w *. 2 Due to excess proﬁts (r1 r ), wages are reduced by the amount (w *2 w*) 1 and that represents actual exploi–) tation. Because of wrong technology, potentially possible wages (w are reduced by a greater amount w– w*1 w *2 w*1 and the

The Wage–Rental Curve

69

difference represents virtual exploitation. If proﬁts are lower than necessary for full employment investment, r r– (not shown in Figure 11.1), yet another technology might be chosen. Wages of employed workers might (but need not) be increased but unemployment would be created and average per capita consumption would be reduced. Thus, gross proﬁt rate higher or lower than r leads to misallocation of resources and reduced consumption.

70

The Theory of International Trade

Appendix to Part III 1

A NOTE ON PRICE MOVEMENTS

It has been shown (in 10.10) that prices are determined by p w λ (I A)1

(A-1)

No monetary ﬂows are involved and yet there may be an inﬂation if nominal wage rate increases. Even increasing wages may not cause inﬂation if full labour coefﬁcients λ ((I A)1 sufﬁciently decrease. That will happen if either direct labour coefﬁcients λ i decrease, or input coefﬁcients in A decrease or both. Such decreases of technical coefﬁcients represent an overall productivity increase. If (I A)1 is held constant, prices change in proportion to w and λ. Since λ i L i / X i is the reciprocal value of labour productivity, an approximate criterion for the stabilization of prices is to allow wages to increase as much as labour productivity. Since w λi is unit wage cost, (I A)1 indicates mark-up added to wage costs to obtain prices. Kalecki, neo-Keynesians and many other economists argue that this is the way that prices are actually determined by businessmen. The practical value of this formula is whether the mark-up is relatively stable. Let the following empirical hypothesis be explored. According to (10.11), any price pj is given by pj w Σ i λ i A ij where Σ i λ i A ij represents individual mark-up to wages. Mark-ups for individual prices differ, but on the average for the entire economy they may represent a stable relationship. p– wλ– Σi Ai, p– 1/nΣ i pi, λ– 1/nΣ i λ i, Σ i A i 1/nΣ j Σ i A ij

(A-2)

n being the number of industries. Starting from the other end, Sidney Weintraub (1959) tried to show exactly that. He begins with the equation p Q μ w N

(A-3)

where Q is output and N employed workers. It means: business proceeds (p Q) equal wage bill (w N) times the mark-up factor μ. Divide both sides by Q p μ (w N / Q) μ R

or in my notation 70

The Wage–Rental Curve p μ (w λ)

71 (A-4)

which is identical with (A – 2). Weintraub quotes US statistics for the period 1929–1957 where μ (his k) appears to be remarkably stable. Out of 28 years, in 21 years μ does not change annually more than two index points. Computed price level p μ R is practically equal to the actual price level (p. 27). The empirical value of the average American markup factor is μ 苲 2.

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Part IV An Alternative Theory

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12 Three Models 12.1

THE TWO RECEIVED MODELS

So far only two models of foreign trade have been developed and fully explored. The classical or Ricardian model is the older one. The neoclassical or Heckscher–Ohlin model is the contemporary one. Following the lead provided by J. Bhagwati and T.N. Srinivasan (1983, pp. 9, 50), I shall describe them in the somewhat modiﬁed fashion indicating the essential characteristics in Table 12.1. Ricardo ﬁnds comparative advantage in greater relative labour productivity. That determines the pattern of trade: a country will export commodities produced by comparatively more productive labour. For Heckscher and Ohlin, abundance of a factor determines comparative advantage. Consequently, a country will export the commodity which uses intensively its abundant factor. The neoclassical model uses much greater number of restrictive assumptions and, as we saw, its predictive value is close to zero. Therefore, it is obviously an inferior model to be discarded. There have been numerous attempts to salvage the neoclassical model. Perhaps the most interesting is the redeﬁnition of abundance. In the neoclassical model the crucial role is played by factor proportions. Therefore, Heckscher and Ohlin deﬁned factor abundance in terms of ratios: greater K/L ratio, called capital intensity in a process, indicates greater capital abundance in a country. The ‘Leontief paradox’ indicated that this could not be squared with facts. Leamer tried to remedy the problem by replacing ratios by absolute differences (see Appendix I-2). If net export (export minus import) of embodied factor is positive, the factor is considered to be abundant. In other words, it is assumed that an economy will export its abundant factors and import its scarce factors. The analysis showed that such a ‘common sense’ deﬁnition leads to new paradoxes. In other words, it has been empirically falsiﬁed. Besides, as Treﬂer observes (1995, p. 1029), ‘rich countries appear scarce in most factors and poor countries appear abundant in all factors, a fact that squares poorly with the HOV prediction that abundant factors are exported’. In conclusion, abundance-scarcity characterization 75

76

Table 12.1

Three models of foreign trades Models of Foreign Trade

Consumption: Trade:

Neoclassical (Heckscher–Ohlin)

One primary factor of production (Labour). Constant returns to scale.

Two or three primary factors given (Labour, Capital and Land). Identical production functions. Constant returns to scale. Nonreversibility of factor intensity ranking.

Two or three factors of production: two primary ones (Labour and Land) and one produced one (Capital). Three basic commodities: one consumption and two producer (capital and material) goods. (Non-) constant returns to scale.

–

Identical homothetic utility functions.

–

Systemic (Horvat)

Commodities perfectly mobile; factors mobile domestically, immobile internationally. No transaction and international transportation costs. Two countries, two traded The same. Two countries: The World (which is the goods. price setter) and the Home country. Three traded goods.

Market type:

Pure competition

Comparative advantage: More productive labour.

More abundant factor.

Lower integrated labour costs of production.

Value theory: Diachronic private labour

Utility or scarcity theory of value.

Synchronic social labour theory of value.

The Theory of International Trade

Production:

Classical (Ricardo)

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77

of economies in either ratio or absolute difference form have no place in economic theory.

12.2 AN ALTERNATIVE MODEL OF INTERNATIONAL TRADE The analysis shows that the improvement of the HO model is pointless. On the other hand, it seems possible that the Ricardian model be improved upon and developed into a relatively satisfactory theory. The basic underlying idea is that comparative advantage consists in relatively lower integrated labour costs. On inspection of Table 12.1, it will be noticed that the differentia speciﬁca of each of the three models of foreign trade is the value theory. This need not be surprising since the theory of value is generally crucial for an economic theory. Classical theory is based on a simple labour theory theory of value: only living labour counts. It is incorrect not because its authors were unaware of its deﬁciences but because they did not know how to cope with them. Besides, it served as a very rough approximation to long-run equilibrium prices. The utility theory is based on subjective valuations and is therefore entirely subjective. The attempt to make it objective and measurable by linking it with material scarcity failed disastrously. The concept of scarcity is either tautological (scarcer means more valuable), and so has no explanatory value, or cannot be utilized in empirical investigations. In fact, the empirical scarcity theory is much worse than the simple labour theory of value. The concept of opportunity cost is helpful but does not explain the source of value. The systemic labour theory of value contains two main ideas: (1) Only labour inputs at the same point of time can be added up (synchronic labour costs). (2) Apart from live labour, also labour embodied in materials and synchronic capital inputs must be included. The latter are deﬁned as those capital inputs which are necessary to keep all workers fully employed. For both reasons, not only separate activities, but the operation of the economic system as a whole must be taken into account. This consideration introduces a new concept of general equilibrium and makes economics a systemic science. The economy is a system which means that it is a whole of interdependent parts and not merely an aggregate of parts. One consequence of this fact is that all attempts ‘to build macroeconomics on microfundations’ must necessarily fail.

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The labour prices considered are full prices that include value added and material costs. Current labour produces only new value represented by the ﬁnal output x. Consequently p x w L L if w 1

(12.1)

Notice that here w is not real wage but a numéraire. This result is easily derived from the price equations p w λ (I A)1 兩· (I A)X p (I A)X w λ X w(L 1 L 2 L 3) w L

(12.2)

From the balance equations A X x X it follows that x (I A) X Using this in (12.2) we get p x L q. e. d. The labour prices p include all costs as shown in (10.8) not only value added. Recall (10.9) pj w Σ i λ i A ij w λ*, j j 1, 2, 3 As price ratios and not absolute prices play the role of trade criteria, we may write pj λ*j , λ*j Σi λi A ij pi λ*i

(12.3)

Instead of Ricardian direct labour coefﬁcients λi, we must use integrated labour coefﬁcients λ*i which represent full labour cost and are calculated as a weighted sum of all direct labour coefﬁcients weighted by the corresponding inversion coefﬁcients A ij. Prices are clearly greater than direct labour coefﬁcients, pi λi L i /X i, and Ricardian ratios of direct coefﬁcients are different from price ratios pj Σi λi Aij λj λi pi Σj λj Aji

Three Models

79

For ratios to be equal, prices would have to contain equal markups, pi μ λi. The matrix A A

[

a11 0 0 r κ1 r κ2 r κ3 a31 a32 a33

]

is the same matrix A from (10.8) except that the elements κ j/n are replaced by r κ j . Our method makes it possible to treat stationary and growing economy formally in the same way. That is because the synchronic calculation of inputs takes care of the time dimension.

12.3

COMPARATIVE ADVANTAGE

It has already been mentioned that by comparative advantage is meant that costs of production – integrated labour costs – are comparatively lower than elsewhere. Costs are based on the gravitational product prices. Elements of costs are not treated as factor rewards but as structural elements of the production / valuation process. Real wages represent institutionally determined remuneration of labour and their sum is equal to available amount of consumer goods. Rental represents capital outlays necessary to replace worn out capital goods plus additional outlays to equip the growing work force. The value of land is treated as capitalized rent at the ruling interest rate so that annual rent represents annual interest charged with respect to land value. Treating land as capital, we may forget it in the ﬁrst approximation. Material costs represent the part of price earmarked to cover the value of material inputs. At present, comparative advantage is a normative concept in the sense that it gives a criterion for rational action. As such, it is a hypothesis. Once it is found that economic agents actually behave in the expected way, the hypothesis will be transformed into a positive theory. International trade will take place if two countries produce different products demanded in both of them. Or if costs of production differ. In that case cheaper products will be exported and comparatively expensive ones imported. The problem then boils down to ascertain the conditions under which a product will be produced more cheaply. We may enumerate them as follows: 1. Inherited climatic and production conditions that made both wine and cloth cheaper in Portugal than in England while wine was

80

2.

3.

4.

5. 6.

7.

The Theory of International Trade relatively cheaper of the two as in Ricardo’s example. Thus, wine will be exported from Portugal in exchange for cloth from England. This is a static case (in the sense that conditions do not change) which leads to interindustry trade. Economies of scale represent a dynamic case which is illustrated by intra-industry trade. Since every country is too small to produce all varieties of a product – say a private car – there will develop an international division of industrial production. One country may produce large cars (say the USA) and exchange some of them for small cars produced elsewhere (say in Korea). Economic development increases accumulated stock of capital per unit of labour employed and so increases GNP per capita. This is not because of changed factor proportions but because advanced technology, made possible by the accumulation of capital, is more efﬁcient (embodied technological progress). That is the source of rising wages. Higher wages render labour-intensive industries unproﬁtable and they migrate to less developed countries with low wages (for instance, textile industry). The result is increased foreign trade. In general, technological progress represents a classic case for cost changes. It affects individual industries very unequally and so they change their positions of comparative advantage. Growth as such changes capital costs per unit of output due to replacement and employment effects. Cheap natural resources (fertile land, rich oil wells) which are abundant in the sense that the home supply is greater than the home demand, result in export of surpluses. It is the other way round with expensive and scarce resources. This is the only clear case where abundance (scarcity) generates neoclassical results. In order to avoid misleading conclusions, point 6 must be seriously qualiﬁed. Switzerland and Japan are two countries with great paucity of natural resources. Yet, Switzerland is the most developed – which means that it enjoys many industrial comparative advantages1 – country in Europe as Japan is in Asia. Due to cheap transport and the globalization of the economy, even poorly endowed countries can easily obtain the necessary resources. Moreover, although abundant resources can enhance trade, so can scarce resources by providing pressure for substitution and innovation. Michael Porter observes that ‘Japan’s natural resource disadvantages have played considerable role in

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81

the process of creating and upgrading competitive advantage’ (1990, p. 395). Apart from natural resources, simple quantities of labour and capital do not determine comparative advantages. Labour can be upgraded by education and training and capital by research creating new technologies and improved industrial organization (embodied and unembodied technological progress). 8. The chance plays also a non-negligible role. A gifted innovator – or simply an excellent businessman – located in a favourable national environment and expanding industry at the appropriate time may generate national industrial advantage. Substantial changes in international production conditions (for instance, oil shock) and demand conditions (for instance, war) will change comparative advantages. Chance events may also be caused by arbitrary (mistaken, wrong, uninformed) decisions. And, as Amendola et al. ﬁnd, ‘arbitrary patterns of specialization, once established, tend to persist and extend over time’ (1992, p. 182). It may also be said that international trade is caused by the differences (a) in the technology used (different production functions) given factors of production and same preferences (inter-industry trade), (b) in the factors of production when the same technology is used and preferences are the same (inter-industry trade), (c) in the consumer preferences and the size of domestic market when the technology is the same (intra-industry trade). Ricardian theory includes (a) and (b) because factors are different (climate) and so is technology (cloth industry more advanced in Portugal than in England). Heckscher–Ohlin theory is based on (b). The systemic theory expounded in this book includes all three conditions, (a), (b) and (c).

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13 Intra-Industry Trade Intra-industry trade is trade among countries with similar factor endowments and in commodities with similar factor intensities (Davis, 1995, p. 204). According to the HO theory, such trade must be nonexistent. 2 Not so in the real world. Trade among countries in the European Union has been developing fast, and intra-industry trade much faster than the rest of the trade. Thus, countries are not only specializing in products of different industries but also in different varieties of the same commodity from within the same industry. What are the reasons for intra-industry trade? The reasons are many and they have nothing to do with factor proportions. Before answering the question posed, it may be useful to note another failure of the HO theory. The standard model yields two important predictions regarding the relation between factor endowments and the volume of trade. The ﬁrst is that, ceteris paribus, the greater the difference between the factor endowment ratios, the greater the volume of trade. The second is that ‘relative country size has no effect on the volume of trade’ (Davis, 1995, p. 219). These predictions may or may not hold in the real world. In other words, the HO model proves again not to have predictive value. Economists seem to agree that empirically scale economies, product differentiation and imperfect competition are typically important (Helpman and Krugman, 1989, p. 133; Greenaway, Hine and Milner, 1995). Take again as a representative example the production of automobiles. Apart from expensive custom-made (or produced in small series) luxury cars, the production of standard cars must reach the volume of a few hundred thousand cars per year in order to be proﬁtable. That implies three important consequences: (a) in an average country only a couple of makes can be produced as there is simply no market for more, (b) by efﬁcient competition in the international market, the small domestic market can be enlarged (but that works in the opposite direction also) and (c) customers demand differentiated and not uniform product, and even the largest country in the world would not be able to supply all technical varieties imaginable. For instance, I drive Citroën because of its hydraulics. Yet I live on the slope of a mountain outside a city and 82

Intra-Industry Trade

83

I need four-wheel drive for the winter season. However, the car with the two characteristics mentioned is now not produced in the entire world. The Citroën managers probably guess – rightly or wrongly – that the market is too small in the entire world. In other words, even the world is too small for such a relatively simple technical combination. Where the HO theory fails completely, the theory of Ricardian comparative advantage has no difﬁculty. The trade criterion for exports from France is Pi /Pj pi /pj where i is Citroën and j is another commodity. This is the familiar criterion for inter-industry trade. We now consider the trade in cars. A car is a technical package of various characteristics such as speed, acceleration, security, petrol consumption, service consumption, traction, durability, design and some others. The package has its objective costs in terms of resources used in production. But different features will be valued differently by different consumers. Consequently the sellers will confront two decision variables, price and speciﬁcation, instead of taking into consideration only price. The market structure will be monopolistic competition, either perfect or imperfect (Lancaster, 1980, pp. 156–57). Some Frenchmen will prefer driving Mercedes ( j), even if it is no cheaper than Citroën, Pj Pi. Since Mercedes is not produced in France, its price is mathematically inﬁnite, pj . The inequality is still valid, indicating that commodity j (Mercedes) will be imported into France. This is now an intra-industry trade. Assuming that the two cars embody an equal amount of resources – whatever that means – international competition will equalize prices, Pi /Pj 1. The ratio of domestic prices, one actual ( pi for Citroën) and the other imputed ( pj for Mercedes) will be less than one, pi / pj 1. The old comparative advantage inequality re-emerges: Pj / Pi pj / pi and Mercedes will be imported into France. If the trade in cars is not balanced in values, some other commodities will be exported / imported. The import of German Mercedes – and vice versa for Citroëns – will proceed as long as consumer budgets (given preferences) can tolerate it. When the budgets

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earmarked for Mercedeses in France and Citroëns in Germany are exhausted, intra-industry trade stops in a temporary equilibrium. It is possible to think of various complications, but the basic principle is clear. In the ﬁnal analysis, intra-industry trade boils down to the simple fact that both red and blue pencils are bought because consumers have different preferences for colours. Consequently, technologically same products may be economically different products. However, differently from pencils, not all cars can be produced in one country. There is a world supply of cars, some of which are produced in France and some others in Germany. Some Frenchmen prefer German cars and they will be imported into France, some Germans prefer French cars and they will be imported into Germany. The trade is balanced by imports/exports of other commodities. Such a trade is inter-industry trade. The theory suggested predicts that large countries will engage in intra-industry trade less; so will more distant countries. Also countries with different levels of per capita incomes will participate less because consumers’ demands are different and satisﬁed by different industries, that is, by inter-industry trade. On the other hand, advanced economies with afﬂuent consumers demanding differentiated and sophisticated products and industries with product differentiation will participate more. These predictions have been conﬁrmed by empirical evidence offered by the World Bank (Kenen, 1989, p. 130). It has also been found that complexity favours intra-industry trade while foreign direct investment tends to reduce it (Caves, 1981, p. 208).

14 Four Hypotheses The mainstream trade theory revolves around the four theorems described earlier: (1) the Heckscher–Ohlin theorem determining the pattern of trade, (2) the factor–price equalization theorem, (3) the Stolper–Samuelson theorem on changes in relative factor prices depending on different factor intensities of countries starting to trade with each other and (4) the Rybczynski theorem determining output changes when the supply of a particular factor increases depending on factor intensity of output. All four theorems are deduced from a single (arbitrary) assumption on price determining factor proportions. It will be convenient to formulate corresponding theorems on the basis of labour theory. Also, it is highly desirable to derive simple explanations. Instead of focusing on factor proportions, our main criterion is labour input, as it is costs of production that determine gravitational prices. There are two primary factors of production, labour and land, while capital is produced. Land is generally not very important in modern economy and so we are concerned with just one nonproduced factor, labour. Also, we want to give the theory empirical content, so it is not purely deductive. For that reason, I prefer not to talk about theorems but to formulate a set of hypotheses.

14.1

COMPARATIVE ADVANTAGE HYPOTHESIS

This is actually the original Ricardian theory based on labour values but now correctly deﬁned as synchronic social (systemic) labour input and not diachronic individual labour input. The criterion is to minimize labour input. That is achieved when the commodity with the lowest relative labour input is selected for export and that with the highest domestic labour input for import. We proceed then down the scale until trade is balanced. 14.1.1

Two Commodities

A closed economy will open itself to trade if it enjoys comparative advantage in the production of certain commodities. In the framework 85

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of the labour theory of value, Ricardo’s principle of comparative advantage (Ricardo, 1821) can be generalized in the following way: A country will export if it can at least recoup the labour time spent in producing the last batch of export commodities by the labour time saved in importing other commodities. In other words, it pays to export if the net saving of domestic labour time is positive. The optimum volume and structure of trade are obtained when the value of output in international prices relative to domestic prices is maximized. If pi are domestic prices and Pi are international prices, it clearly pays to export if pi Pi and to import if pi Pi. This is the criterion of absolute advantage. As Ricardo already noticed, such a criterion would not be precise enough and would apply only to countries at similar levels of development (and, therefore, of similar labour efﬁciency). It will also apply to an economic union of several countries using the same monetary unit (such as the euro in the European Union). In a backward country, most domestic prices will be higher than international prices of the same commodities and this does not mean that everything must be imported. A very developed country will face a reverse situation. Whatever the absolute prices, the general criterion is expressed in relative prices. Commodity i will be exported and j imported if Pi / pi Pj / pj or pj / pi Pj / Pi. The ﬁrst inequality indicates that domestic prices of export commodities are relatively lower and the second that domestic prices of import commodities are relatively higher. By opening up the trade, domestic labour time will be expanded increasing the production possibilities. Balanced trade at international prices means a net import of labour at domestic productivity if Ricardo’s principle of comparative advantage is followed. Net import of labour is a free gift of the exchange. The same applies to both trading partners. This can be seen in the following way. Let e stand for export, m for import and Xe and X m for commodities exchanged and let the trade be balanced in international prices Pe Xe Pm X m Since domestic prices of import commodities must be relatively higher pm /pe Pm / Pe

Four Hypotheses

87

labour time that might have been spent on the production of import commodities amounts to more than the labour time actually spent on the production of export commodities pm X m pe X e

(14.1)

The difference is labour time saved due to exchange. Labour time saved – the net import of labour – can be used to enhance production. Even this is not the end of the story. Assume that countries A and B use exactly the same technology, but that A grows faster – and therefore invests more – than B. More investment requires higher proﬁt to ﬁnance it. Higher proﬁt implies lower wages. Since the labour and capital intensities of individual industries are different, even the same technology and the same factor endowments will generate different prices. Different relative prices make trade proﬁtable. Consequently, the mere difference in growth rates leads to trade. We can be even more explicit. From (10.18) we can ﬁnd the ratio of prices of intermediate and capital goods: p3 r(κ3λ 2 λ 3κ 2 ) λ3 p2 λ2(1 a33) λ3a32

(14.2)

Since a33 1, the denominator is positive. The numerator is then positive because p3 / p2 0. Let capital intensity of material production be greater then that of capital goods production, κ3 / λ3 κ2 / λ2 . Consequently, (κ3λ 2 λ 3κ 2 ) 0. It follows that the ratio of prices is a positive function of r. Suppose that the initial situation is p3 / p2 P3 / P2 Reproduction material will be exported and capital goods imported. If technology remains the same, but accumulation (r) increases, at certain point the ratio of prices will be equalized and the trade will cease to be advantageous. Beyond that point, exports and imports will be reversed. Note that export or imports of capital good X2 does not inﬂuence r. The economy must change its growth rate, that is, the growth of labour force plus an increase in the productivity of labour. Differently from Ricardian times, the gold standard no longer

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automatically determines the exchange rate. A country may fully exploit comparative advantages only if foreign trade is properly guided. Individual traders are mainly stimulated to react to absolute prices and not to relative prices. The economic policy authority must design the exchange rate so as to make domestic and foreign prices comparable and that must provide information and incentives for traders so that they are induced to use proper relative prices. 14.1.2

Many commodities

Suppose we observe the following relations referring to prices of commodities X1, X2 and X3 p1/p2 P1/P2 , p2 /p3 P2 /P3 Since domestic price ratios are lower than the international ones, we can conclude that X1 will be exported and X 3 imported. Nothing can be concluded about X2: the ﬁrst relation says that it is imported and the second that it enjoys comparative advantage and, consequently, will be exported. That is contradictory and our criterion must be reformulated. By simple algebraic operations we obtain p1 /P1 p2 /P2 p3 /P3

(14.3)

All commodity prices can be ordered in that way p4/P4 p5/P5 ... pn/Pn We know that X1 will be exported and Xn imported. But what about other commodities? To settle the issue, we need additional informations. Price ratios are not sufﬁcient, we need to know demand conditions. Since the price ratios in the sequence are decreasing, so is the relative proﬁtability (with respect to international prices) of respective commodities. We must select more proﬁtable commodities for exports and less proﬁtable for imports. Suppose that demand condition is exports equal imports (balanced trade). Then the sequence has to be cut at the point when this condition is satisﬁed: ﬁrst m exports equal last n m imports.

Four Hypotheses 14.2

89

EQUALIZATION OF FACTOR PRICES HYPOTHESIS

Factor prices are a misnomer. Commodities are bought and sold, not factors. Their use in time is priced. Therefore commodities have prices and factors have rentals. That ought to be born in mind when we loosely speak of ‘factor prices’. Wages of labour will tend to be equalized internationally because they are positive functions of per capita income. Since the national wage bill makes for three fourth or more of national income, wages and per capita income – reﬂecting the degree of development – are closely correlated. It is not that marginal products determine wages, it is wages (made possible by the national economic development) that determine marginal products in a rationally organized production. A university professor in the United States is paid ﬁve to ten times more than one in Croatia, regardless of his/her productivity. That can easily be veriﬁed by observing the same (wo)man teaching alternatively in the two countries. Since in modern economies (wo)men produce in order to improve their economic welfare, they will seize every opportunity to increase their wages. And since the wealthiest nations tend to have lower rates of growth than those behind them (Horvat, 1974), there is a clear tendency for equalization of national development levels and so of per capita incomes and wages. Apart from international equalization of average wages, there is also a tendency for national reduction of wage differentials. People want to be paid equally for equal work. We may conclude that wage rates are socially determined in such a way that they converge to absolute international wage standards. Yet this convergence is a very, very long process, due to economic development and not to market competition. Money capital is quite mobile both nationally and internationally. For this reason one may assume competition that equalizes prices of capital services nationally and internationally. The price of a commodity is deﬁned as value per unit of quantity. In this sense interest rate does not have price dimensions (dinars per kilogram of something). Interest rate is a percentage and as such a pure number. Nevertheless, for certain purposes it can be conceived as a quasi-price (the value of money stock is quantity and money interest is price. Under perfect competition, the value of money capital reﬂects physical capital and interest rate is the price for it use. In general, competition tends to equalize interest rates nationally and internationally.

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Land is notoriously heterogeneous and is not traded internationally. The existence of Ricardian differential rent renders the idea of rent equalization meaningless. It is still possible to argue in the following way. If commodity prices, interest rates and wages are equalized and technology is freely accessible, under competitive conditions rent differentials reﬂect unit cost differentials which are due to land exclusively. The value of land (V) is capitalized rent (R) and so R V

(1 i)11 (1 i)n1

(14.4)

Since the number of years of capitalization (n) and interest rate (i) are equalized by competition, the ratio of rent and the value of land (R/V) is the same for all lands and countries. If n is sufﬁciently large i lim R V 1 i n→∞

(14.5)

rent is equal to the ‘discounted’ interest on capital value of land. Yet that eliminates physical land and replaces it by capital, and rent is replaced by interest. In addition, capital value does not embody labour since land is not produced. How such cases can be handled, see Horvat (1995, pp. 198–9). There is still one problem. If all proﬁt is invested, interest rate and proﬁt are equal, i π. Interest rate may be equalized by international competition but proﬁt rate is determined by the national rate of growth. If the two rates differ, economic policy measures must make them compatible. In general, for the same reason that wages tend to be equalized in the very long run, the proﬁt rates converge as well. In the process of catching up, less advanced countries achieve higher rates of growth and, therefore, higher rates of proﬁt. As they approach the front line of technological development, the rate of growth gets lowered and, consequently, proﬁt rates converge.

14.3 HYPOTHESIS ABOUT THE CHANGES DUE TO THE OPENING OF TRADE Let two autarkic countries engage in mutual trade. Country U is labour-intensive and underdeveloped (lower per capita output).

Four Hypotheses

91

Country D is capital-intensive and more developed (higher per capita output). Evidence indicates that greater capital intensity is correlated with greater productivity. More formally: (K/L)U (K/L)D Let capital-output ratios be approximately equal (which is not unlikely in the real world) (K/Y)U ~ (K/L)D Since Y is approximately proportional to K, it follows (Y/L)U (Y/L)D

(14.6)

Labour productivity is lower in an underdeveloped country as compared with a developed country. And its reciprocal value, labour input per unit of output (L/Y), is higher. The HO theory postulates that country U, being labour-intensive, will export labour-intensive commodities in exchange for the capitalintensive commodities from country D changing, thus, factor endowment proportions (and factor prices). Empirical evidence related to the ‘Leontief paradox’ revealed that this is not so and that the postulate has no predictive value. However, another conclusion may be derived with certainty. If all labour coefﬁcients λi in country U are higher, than from (10.11) and (12.3) pj i λi Aij,

w 1

(14.7)

labour prices will be higher even if material input matrices A are the same for both countries. Since country U is likely to be less efﬁcient in non-labour inputs (technical coefﬁcients aij higher) and develop at a greater speed (rate of growth r higher), elements of A are likely to be larger and so will elements Aij of (I A)1. Labour prices measure labour embodied in unit output and so the following theorem ( deductive hypothesis) may be formulated: When the trade opens, the labour-intensive country will export more labour than it will receive in return if trade is balanced at some international prices and labour is embodied in commodities. Since trade is following the principle of comparative advantage,

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this is the least disadvantageous result that the undeveloped country can achieve. As both countries gain from trade, their per capita incomes increase. A net export of capital goods only means that the composition of output has changed, but gives no information on the change of factor intensities. If export becomes more capital-intensive, that only indicates that capital intensity of export has increased. If the rate of growth increases – given the labour force – then the country’s endowments become more capital-intensive. Finally, increased output per capita–given the rate of growth-leads to increased wages.

14.4

INCREASED FACTOR SUPPLY SPECIFIC EFFECT

Since labour is assumed always fully employed, capital supply can increase in only three cases: (a) labour supply increases, (b) labour productivity increases and (c) capital-intensive commodities are exported in exchange for labour-intensive commodities. In the case (c) we have a simple composition effect. Since capital can always be expanded as necessary (investments), nothing important happens except in a very short run when there is a traverse from one state to the other. Much more interesting are the cases (a) and (b). If the rate of growth of effective labour supply increases, either because of physical growth of labour force or due to technological progress, the rate of growth of capital must increase also. Now we encounter effects discussed in Part II. The replacement element (ρ) of price will decrease less than the increase of net proﬁt (π), and the net effect will be the increase of gross proﬁts (r ρ π) and so the increase of all prices. Since industries are very unequally capital intensive, this will change relative prices. As a result, comparative advantages will change as well and so the pattern of trade will become different. Clearly, comparative advantage of capital intensive commodities will be reduced and that of labour intensive increased. Unless technical progress is strongly capital augmenting.

Part V The Gains from Trade

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15 The Pattern of Specialization According to (10.18), the price formation in the three industries considered in terms of p1 (divided by p1) is given by (15.1). 1. Baskets: w*λ1 p*a 3 31 p* 2 κ1r a 11 1 p1 /p 1 2. Machines: w*λ2 p*3 a32 p*2 κ2 r

p*2 p2 /p1

3. Material: w*λ3 p*3 a33 p*2 κ3r

p*3 p3 /p1 (15.1)

In the analysis that follows, the reader will notice the similarities with the approach pioneered by Ian Steedman (1979, pp. 35–40). Yet my regionalization is somewhat different. The price equations (15.1) apply to an autarkic economy. Suppose it is opened up. The international exchange will take place if domestic and international prices measured in baskets differ, p*i P*i. Depending on the industry where this difference occurs, producers will be induced to specialize in production. The proﬁt rate is given because it is determined by the requirement to equip additional workers. Consequently all gains (if any) go to the increase of wages. Input coefﬁcients λi, aij and κi are ﬁxed. 15.1

GIVEN AUTARKIC PRICES

For the given technology, autarkic prices are given. As far as the home economy is concerned, international prices vary and may be greater or smaller than the autarkic ones. When the economy opens up, free trade will transform equations (15.1) into inequalities until competition establishes new equilibrium with different prices and higher wages. When autarkic and international prices are equal, p*i P*i at the point E in Fig. 15.1, everything is produced at home and nothing is either exported or imported (intra-industry trade is neglected). The sides of the box are measured by P*3 and P*2. The ﬁxed autarkic prices p3 and p2 divide the box into four quadrants, two of which will be further subdivided into two regions. It will turn 95

96

The Theory of International Trade (P* – p*)a > (p* – P*)κ r 3 3 31 2 2 1

P*3 I

(b) X3 Produced X1, X2 imported

II X2, X3 produced X1 imported

(a) X1, X3 produced X2 imported p*3 E (b) X2 produced X1, X3 imported

X1 produced X2, X3 imported

IV

(a) X1, X2 produced X3 imported

0

p*2

Figure 15.1

(p* – P*)α > (P* – p*)κ r 3 3 31 2 2 1

III

P* 2

The pattern of specialization for Δw* 0

out that the Ricardian criterion P*i p*i is insufﬁcient for an unambiguous classiﬁcation and must be complemented by the proﬁtability criterion on the basis of price equations (15.1). The production and import regions for X2 and X3 are determined directly by comparing home and world prices. The same is not possible for X1 because the prices are equal by deﬁnition p*1 P*1 1. Thus, a different procedure must be used. For that purpose original equations (15.1) will be rearranged. w*λ1 (1 a11) p*3 a31 p* 2 κ1 r w*λ2 p*2

p*3 a32 p*2 κ2r

w*λ3 p*3

p*3 a33 p*2 κ3r

(15.2)

If any input is obtained at a lower price, wages in all industries will increase although unequally. Actually, only the ﬁrst equation

The Pattern of Specialization

97

will be needed. In a comparable equation, replace home prices by world prices: W*λ1 (1 a11) P* 3 a 31 P* 2 κ 1r

(15.3)

To ﬁnd out whether this generates an improvement, deduct (15.2) from (15.3) (W* w*) λ1 ( p*3 P*3) a31 ( p*2 P* 2)κ 1r 0

(15.4)

For an improvement, wages must increase, Δw* 0. A reduction of wages means deterioration, Δw* 0. For Δw* 0, we have a diagonal in Fig. 15.1 Consequently, below the diagonal, the ﬁrst industry generates a surplus, above it a deﬁcit. In the surplus region baskets are produced, in the deﬁcit region they are imported. The Ricardian criterion sufﬁces when both international price ratios are either higher or lower than autarkic price ratios. This is the case with the second and the fourth quadrants. II Quadrants. If both P*3 p*3 and P*2 p*2 , then it is proﬁtable to export both X3 and X2 and use the proceeds to pay for the import of X1 since the autarkic price of consumer goods is relatively unproﬁtable. Namely, P3/P1 p3/p1 implies p1/p3 P1/P3 and similarly for P*2 p*2. Inserting higher international prices into prices into price equations (15.2) produces smaller wages and this conﬁrms Ricardian conclusions. IV Quadrant. Both international price ratios are lower than autarkic price ratios, P*3 p*3, P*2 p*2, and therefore X3 and X2 will be imported. That can be paid by the export of X1. The conclusion is conﬁrmed by expanded wages for smaller P*2 and P*3. Next we consider mixed cases when one international relative price is higher and the other lower than the corresponding autarkic prices. In such cases supplementary criterion of relative proﬁtability becomes necessary. I Quadrant. For P*3 P3/P1 p*3 p3/p1, the Ricardian criterion indicates that it is more proﬁtable to export X3 and import X1 at world prices. For P*2 p*2 , it is more proﬁtable to import X2 and export X1. Thus in the quadrant limited by (P*3 p*3) (P* 2 p* 2 ), the non contradictory conclusion is to export X3 and import X 2. X1 can be either imported or exported but the Ricardian criterion does not indicate under what conditions. We already encountered this problem when discussing the case of many commodities in Section

98

The Theory of International Trade

14.1.2. Now we shall provide an alternative solution to the problem. The ﬁrst equation of (15.2) will show the surplus (deﬁcit) if import at international prices makes costs of production lower. P*3 a31 P* 2 κ1r p* 3 a 31 p* 2 κ 1r

(15.5)

It is more convenient to put the inequality in the following form (P*3 p*3) a31 ( p*2 P* 2)κ 1r

(15.6)

which is identical to (15.4). In (15.6) differences of international and domestic prices are weighted by technical coefﬁcients in the price formation of the ﬁrst industry. In case of an equality sign in (15.6), we have a straight line representing a diagonal which subdivides Quadrant I in two regions: (a) below the diagonal where X1 is produced (together with X3, whereas X2 is imported) and (b) above the diagonal where it is not proﬁtable to produce X1 and therefore it is imported. The diagonal passes through the point ( p*2, p*3), denoted as E, which indicates equality of domestic and international prices, P*i p*i , when the economy is indifferent between autarkic production of all commodities and imports or exports. The slope of the diagonal separating regions Ia and Ib is given by κ1r/a 31. III Quadrant. P*2 p*2 , P*3 p*3. The ﬁrst price equation will show surplus as long as P* 3 a 31 P* 2 κ 1r p* 3 a 31 p* 2 κ1 r which is the same condition as before. The diagonal subdivides Quadrant III into the region (a) below the diagonal and (b) above it. In IIIa, X1 is produced together with X2. In IIIb, X1 will be imported together with X3. Given constant parameters λi, aij, κj, r and constant home prices p1, p2 and p3, international prices in terms of baskets P*2 and P*3 determine regions of specialization. If home and international prices differ, trade will increase real wages above the autarky level in each region of specialization. Fig. 15.1, based on the basket industry real wage, shows a clear pattern. Production (export) of X2 and X3 are determined by simple Ricardian criteria. Above the horizontal line p*3 for P*3 p*3 X3 is produced, and is imported below that line. On the right of the vertical line p*2 for P*2 p*2 X2 is

The Pattern of Specialization

99

produced and is imported on the left from that line. The production of X1 is determined by the proﬁtability diagonal. Above the diagonal, X1 is imported, below the diagonal it is produced (exported). At the point E equality of domestic and international prices – all three commodities may be produced. In this sense, this is the point of autarky. Technological progress changes all technical coefﬁcients. Thus, all lines will change positions and the diagonal will change its slope. Increases in the rate of growth (r), increases surpluses in (15.4). Since technology is not absolutely identical for all ﬁrms, lines may be replaced by bands in the real world economy. It turns out that, when Ricardian criteria are supplemented by proﬁtability criteria and lines are replaced by bands, incomplete specializations are more likely than complete specializations and that is quite different from the usual presentation of the Ricardian model. When the number of commodities increases, complete specializations are rather exceptional.

15.2

PRIMARY AND SECONDARY SPECIALIZATIONS

When the criteria applied indicate two (or more) commodities as candidates for export or import, it makes sense to ask which one of them is the most proﬁtable. The economy is facing two kinds of constraints: limited resources and balanced trade. It is, therefore, important to know with which commodity to start before constraints are hit. So far we were interested in the possibilities available, now we shall inquire into the order in which they should be used. Regions Ib, IIIb and IV specialize in one commodity for production and export; therefore, there is almost nothing to be changed. The same regions may import two commodities. Regions Ia, II and IIIa may produce two commodities and it is important to know which of them will be produced ﬁrst. In the previous section and in Fig. 15.1, we examined regionalization by comparing international and domestic prices. Costs of production are ﬁxed at domestic prices and international prices were allowed to vary. If the costs of production in international prices, for the same real wage, were lower, a surplus was generated that indicated higher proﬁtability and the reason for importing inputs. Now the value of production in international prices (free trade) of the two industries is compared. Given the same real wage,

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The Theory of International Trade

the industry that generates (greater) surplus is more proﬁtable and will be operated in this region. In the former case two industries might have been operated simultaneously (as against imports). Now we choose only the most proﬁtable one. Following I. Steedman, this will be called primary specialization. When the production possibilities are exhausted, we choose second most proﬁtable industry for operation. This will be called secondary specialization. Primary and secondary specializations make together domestic (as opposed to import specialization. These ideas form the basis for Figure 15.2. The former specialization pattern is here superimposed on the onecommodity (primary) regionalization. Given the real wage and the rental rate, the X3 industry will be more proﬁtable than the X1 industry (will show a surplus) if the p*3 equation of (15.1) shows lower unit costs than the p*1 equation at international prices. w*1 w*3: 1/λ1[(1 a11) P*3 a31 P* 2 κ1r] 1/λ3 [P* 3(1a33) P* 2 κ 3r] P*3

(λ1κ3 λ3κ1)r P*2 C1, λ1(1 a33) λ3 a31 C1

(1 a11)λ3 0 λ1(1 a33) λ3a31

(15.7)

Since aij are input coefﬁcients, (1 aij) 0. The denominator of the fraction is positive, whereas the numerator may have any sign. Since I have no strong empirical reasons to the contrary, I shall assume that the numerator is negative – for aesthetic reasons. Negative numerator really means that the consumer-good industry is more capital intensive that the industry of materials, κ1/λ1 κ3 /λ3. As only the slope is important, the equation (15.7) can be put in the form (P*3 p*3) B1 (P*2 p*2), B1

(λ1κ3 λ3κ1)r 0 λ1(1 a33) λ3a31

(15.8)

and similarly for the other two cases with different values for B.

101

The Pattern of Specialization B P*3 (X1) X3

C1

X3 (X2)

X3

(X3) X1

p*3

(X2) X3 E

X2

X1

C2

X1 (X2) 0

p* 2

Figure 15.2

X2 (X1) P* 2

A –C B

Three regions of primary [X1, X2 , X3] and secondary [(X 1), (X2), (X3)] specialization

The separating line passes through the point ( p*2, p*3) with the negative slope. Above the separating line, X3 is more proﬁtable, below the line X1 is more proﬁtable. Next we have to separate X2 and X3 regions. w*3 w*2: 1/λ2 [1 κ2r) P*2 P3a32] 1/λ3[P*3(1 a33) P*2 κ3r] P*3

(λ2κ3 λ3κ2)r P C 2, λ2(1 a33) λ3a32 2

C2

λ3 0 λ2(1 a33) λ3a32

(15.9)

Again the numerator denotes relative mechanization and, again for aesthetic reasons, I shall assume that it be positive rendering the

102

The Theory of International Trade

slope of the dividing line positive. Materials are now more capital intensive than machines, κ3/λ3 κ2/λ2. X 3 region is above the dividing line and X2 below it. The remaining region will have to be separated from X 1 region – which was already accomplished – and from the X2 region – which will be done now. w*2 w*1: 1/λ2[(1 κ2r) P*2 P3a32] 1/λ1 [(1 a11) P*3a31 P*2κ1r] P* 3

(λ2κ1 λ1κ2)r λ1 P*2 C3, C3 0 λ2 a31 λ1a32 λ2a31 λ1a32 (15.10)

Again the relative mechanization plays the role but not decisive one because the denominator may have any sign. I shall assume that the denominator is positive and the slope is negative. In conclusion, one-commodity primary specialization depends on technical coefﬁcients, rental rate and the relative capital intensity of the sectors compared. In Fig. 15.2, primary specialization in X1 is shown in the region C10A, that in X 2 in AP*2B and in X3 in the region BP*3C1. Each region consists of three adjacent segments. Primary and secondary specialization partly overlap. If taken together, the regions are enlarged. The X1 region is delimited by the points P*30P*2, the X2 region captures the right-hand side of the diagram, the X3 region the upper part of the diagram. Consider the price system (10.18), which may be represented in compact notation p pA wλ wλ (I A)1

(15.11)

Suppose the growth rate is increased and so the rental rate is now r. The input matrix will change to A which is the same as A except that the second column of coefﬁcients of (10.18) is now p2κir and all prices are higher. p wλ(I A)1 p

(15.12)

However, an increase in absolute prices pi and pj does not indicate anything of their ratios p*i pi /pj. If both prices increase, the ratio may increase, decrease or stay constant depending on which price

The Pattern of Specialization

103

move faster. Now price ratios are given by p*i

pi p1

Σj λi Aji Σj λj Aj1

,

i 2, 3

(15.13)

Price ratios will change because individual prices will change differently. They will also change because of technological progress that affects individual prices differently. If r deviates from the full employment rental rate, wrong technology will be chosen (Horvat, 1995, pp. 154–55), and again prices will change. Thus there are three reasons why price ratios may change and that will change the pattern of specialization. Figure 15.1 also indicates what will happen if P*i remain constant while p*i change. If p*2 increases, vertical line passing through E will move to the right. If p*3 increases, the horizontal line will move upwards. In either case, all regions of specialization will change. The greater difference (P*3 p*3), the more will be enlarged the region of X3 specialization. This should be obvious because the lower home price p*3 is relative to P*3, the more proﬁtable it is to export X3. The same reasoning applies to the lowering of p*2 in relation to P*2. The region of X1 will be increased if both vertical and horizontal lines move outwards, that is, both p*2 p2/p1 and p*3 p3/p1 increase. That means that p1 must be relatively lower which implies an increased proﬁtability of X1 production. If the proﬁtability of an economy is increased in any region of specialization, it must be possible to calculate the magnitude of that improvement. This is the subject of the next chapter.

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The Theory of International Trade

16 The Gains from Trade The gain from trade may be unambiguously deﬁned in two different ways. Technological version requires more of one good and no less of the other for every set of autarkic outputs. In utilitarian version, one consumer must be better off and none of the others worse off. The latter deﬁnition is not operational and so we shall concentrate our attention on the former. Generally, it is also not operational. The problem arises when increased quantity of one good is accompanied by reduced quantity of another. Here our labour prices help to solve the problem.

16.1

AUTARKY VS. TRADE

Countries engage in trade because they beneﬁt from it. The textbook explanation of the gain from trade is usually given in terms of indifference and transformation curves. Consider an autarkic economy producing goods X 1 and X2. Relative prices p1 and p2 are given by the transformation line. Quantities demanded are determined by the tangency of the difference curve and the transformation line as shown in Figure 16.1. After the trade is opened, the good X 2 with lower international price, given by the slope of the new transformation line, will be imported in greater quantities than was produced before. This is determined by the new point of tangency E2. If the quantity of the other good X 1 also increases, the gain from trade is obvious. If it diminishes, as shown in Fig. 16.1, the situation is not so obvious because we have to compare Δ X1 with Δ X2 which are different goods. The dilemma is resolved by the indifference curve U2 which indicates higher economic welfare. A conclusion follows: whenever domestic and international prices differ, trade will increase economic welfare. Similar welfare analysis resulted in the following propositions: (1) free trade is superior to no trade, (2) tariff restricted trade is superior to no trade, (3) lower tariff is superior to higher tariff, (4) free trade is superior to restricted trade (Bhagwati, 1964, pp. 59–61; 1968). To this list it may be added that (5) tariffs are superior to 104

105

The Gains from Trade X2

E2 ΔX2

E1

U2

U1

0

–ΔX1

Figure 16.1

X1

The gain from trade (1)

quantitative restrictions. All propositions are valid only on assumptions of perfect competition, complete markets and all proﬁts invested. The ﬁrst two propositions seem to be generally accepted. Under imperfect competition, prevailing in the real world, anything may happen (Helpman and Krugman, 1992). Besides, (1) may be contested for reasons adduced in Section 16.4. The third proposition is also not generally valid. If a country has monopoly power, it may do better than free trade by imposing the so called optimum tariff. This is because by restricting trade – which is what the tariff does – the improvements in the terms of trade may outweigh the losses in the volume of trade. There is a snag in the welfare analysis. Utility curves are psychological concepts and therefore not measurable. At best, it is only possible to order various levels of welfare, it is not possible to measure them. Given fully employed labour and capital, together with constant returns technology, the economy can produce either X 1 or X2 or some combination of them. For trade to be desirable, it must hold p1 Δ X1 p2 Δ X 2 0

(16.1)

Because prices are labour prices, this simply means that some labour will be saved as a result of exchange. Since also

106

The Theory of International Trade p2/p1 X1/X2 ⬖ p1 p2 X2 /X1

(16.2)

Inserting into (16.1), we obtain p2 (X 2 /X1) Δ X1 p2 Δ X2 0 Δ X2 /Δ X1 X 2 / X1

(16.3)

Inspection of Fig. 16.1 shows that condition (16.3) holds because the slope determined by the increments is really steeper than the slope of the original transformation line. Thus we can dispense with the unmeasurable utility.

16.2

DOMESTIC AND INTERNATIONAL PRICES

In the real world we generally cannot make comparisons of countries without trade and with trade. Trade is registered statistically and we must measure the effects implied. The comparative advantage theory makes this possible. The smaller domestic relative prices compared with international ones open the trade (and vice versa) pi / pj Pi / Pj In this caste Xi is exported and X j is imported. Multiply domestic price by a positive constant a 1 to equalize relative prices (pi / pj) a Pi / Pj ,

a 1

(16.4)

where a indicates purchasing power parity. Multiply both sides by X i / Xj a ( p i Xi / p j Xj) P i Xi / P j Xj 1

(16.5)

For the trade balanced in international prices Pi Xi Pj Xj which is the standard case – the gain from trade in home prices is Γh pj Xj pi Xi (a 1) pi Xi, a 1

(16.6)

For the same export quantity, it is possible to obtain greater import quantity evaluated at home prices. Remembering that piXi in

The Gains from Trade

107

labour prices represent embodied labour, the gain may be understood as labour saved – or available labour time augmented – by international trade. If trade is balanced in domestic prices pi Xi Pj Xj

(16.7)

net export labour will be zero. But the gain evaluated in international (world) prices will be different form zero Γw Pj Xj Pi X i (1/a 1) Pi Xi 0, a 1

(16.8)

In fact, it will be loss, which means that more goods were given away than necessary and so foreign exchange proceeds are less than possible. The trade indicator may be made positive in both cases if it is deﬁned as a ratio instead of as a difference. In this case Γ 1 represents a gain and Γ 1 a loss. Γh pj Xj /pi Xi a 1, Pi X i Pj X j Γw Pj Xj /Pi Xi 1/a 1, pi Xi pj Xj

(16.9)

where a 1 means an import surplus at home prices and balanced trade at international prices, whereas 1/a indicates an export surplus at international prices when trade is balanced at home prices. Clearly the gain can be repeated in the successive years, as long as structural conditions remain appropriate. Total gain from trade may be deﬁned as the discounted value of annual gains. If the rate of production growth of all commodities remains unchanged, and the country always has net export of capital because of capital intensity of export, domestic stock of capital will increase, but its rental rate (r) will not change. If imported capital goods are cheaper than those domestically produced, wages will increase (representing gains from trade) but their rate of growth will not. If imported raw material is cheaper, the production of all three commodities can increase on account of the emerging labour surplus (given L). If imported consumption basket is cheaper, more of it can be imported and wages will increase. Each effect can be used to calculate gains from trade either in domestic or international prices or in the domestic labour saved.

108 16.3

The Theory of International Trade IMPORT AND EXPORT GAINS

The gains from trade may result from (1) cheaper import (Pj pj) resulting in the substitution of the more expensive home-industry output; (2) expanded export which is dearer in international prices (Pi pi). Effects (1) and (2) are direct effects. There are also indirect effects: (3) Lower import prices of inputs feed into home production costs and, as a result, all prices are lowered (in an interdependent economy). The determination of the regions of specialization (Chapter 15) is the natural introduction into the analysis of the gains from trade. Unlike in the welfare analysis, we are now able to measure the gains in either international or home prices (in terms of labour time expanded). The gain is deﬁned as a net addition to consumption. If labour force does not change, that means an increase in real wage, w* w/p1. It will be remembered that for w 1 we have labour time prices and real wage is w* 1/p1 x 1/L. Region IV: P*2 p*2 , P*3 p*3 , X 1 produced. Consider a semi-developed country that imports machines (X2) and materials (X3), whereas consumer goods (X1) produces at home and exports (e.g., agricultural products). In Fig. 15.1 that is the region IV. The corresponding price conﬁguration is P2 /P1 P*2 p*2 and P3/P1 P*3 p*3. From (15.2) we see that, by importing X2 and X3 more cheaply, the country gains. Autarky:

w* a λ1 (1 a11) p* 3 a31 p* 2 κ1r

Import of X2 and X3: w*t λ1 (1 a11) P*3 a31 P*2 κ1r Consequently Δw* 1/λ1 [ ( p*3 P*3) a31 ( p*2 P*2) κ1r]

(16.10)

Due to reduced production costs, real wage increased by Δw* as in (16.10). Total gain is equal to the quantity of output multiplied by unit output gain

The Gains from Trade X1 λ1Δw*

109 (16.11)

Total output is now larger than before and consists of home consumption and export X1 X1h Δ X1

(16.12)

In the same way the aggregate gain may be proportionally divided into import and export gain. In region IV only X1 is produced and so all effects emerge in the consumer goods industry, whereas home prices p*2 and p*3 remain unaffected because there is no production. Region IIIa: P*2 p*2 , P*3 p*3, X1 and X2 produced. We next select a region where two goods are produced. Let it be region IIIa. X 1 and X2 are produced and exported in exchange for the imported X3. That looks like a resource-poor advanced Japanese economy. Because two commodities are produced, cheaper input of X3 will affect two output prices but only one price ratio, p*2 p2/p1. Since X3 is not produced, we take only the ﬁrst two equations from (15.2) to get w* 1/λ1 [(1 a11 P*3 a31) p*2κ1r w* 1/λ2 [ p*2(1 κ2 r) P*3 a32]

(16.13)

These are two straight lines which cross for equal value of w*t after trade (Figure 16.2): Since import price is P*3 p*3, cheaper import will reduce p*2 from the autarkic ap*2 to the smaller post-trade tp*2. After trade opens, real wage is greater than the autarkic one, w*t w*a. The difference Δ*w w*t w*a

(16.14)

is the gain from trade due to cheaper import. This is not the whole story. Not only unit output is cheaper, but also the quantity of output has increased in order to pay for imports. So there is an additional gain due to the difference between higher international and lower pre-trade home price. For balanced trade

110

The Theory of International Trade w*

(2)

w*t w*a

(1) 0

t

Figure 16.2

p*2

a

p*2

p*2

Wage lines for P*3 and αP*3 given.

P*3 X3 P*1Δ X1 P*2Δ X2

(16.15)

where X3 is import and ΔX1 and Δ X2 are exports. Since P*1 p*1 1, only P*2 is important. The total export gain amounts to (P*2 p*2 )Δ X2

(16.16)

where p2 is pre-trade price. The total import gain is equal to Δw* (λ1X1 λ2 X 2)

(16.17)

The sum of import and export gain represents the aggregate gain from trade. Region Ib: P*2 p*2 , P*3 p*3 , X3 produced. We may imagine an oil-exporting country that imports machines and consumer goods. Now both import and export gains are present separately.

The Gains from Trade

111

Cheaper import of X2. Only X3 is produced and so insert P*2 into the price equation for material in (15.2). Δw*m 1/λ3 ( p*2 P*2) κ3r

(16.18)

Expanded export of X3. Again the value of import must be covered by expanded export, all at international prices. Δw*e 1/λ3 (P*3 p*3) a33

(16.19)

Cumulative gain is equal to Δw* mλ3 X3 Δw* e λ3Δ X3 λ 3 (Δw* m X3 Δw* e Δ X3)

(16.20)

The total wage increase consists of import and export additions (16.18) and (16.19) Δ*w Δw* (16.21) m Δw* e 1/λ3 [( p* 2 P* 2)κ3r (P* 3 p* 3 a33] The reader may undertake the analysis of import and export gains in the remaining regions in a similar fashion for himself.

16.4

WAGE–RENTAL CURVE AGAIN

Free trade between two countries may not always lead to gains from trade for one or both of them. To show that, we again usewage-rental curve from chapter 11 with slight modiﬁcations. In chapter 11 wages and prices were expressed in terms of p1. w* w/p1 x1/L,

wL p1x1

(16.21)

Now they will be expressed in terms of p3. Because we have three goods and three prices, there are more dimensions than we can use in the graphic presentation. We can reduce one dimension by taking into account that X1 is not used in the other two industries. As a consequence, in (10.18) two last equations are sufﬁcient for calculating p2 and p3. They can then be inserted in the ﬁrst equation to calculate p1. Since there are two more variables, w and r, we have one degree of freedom which can be used to calculate the price ratio p p2/p3. Wage rate and prices are now expressed in

112

The Theory of International Trade

terms of p3, and the relevant part of the price system (10.18) is transformed into (16.22): w*λ2 p (κ2r 1) a32 w*λ3 pκ3r

0,

(a33 1) 0,

w* w/p3

(16.22)

p p2/p3

Eliminate p to obtain w* as a function of r. w*

1 a33 r(λ2κ3 κ2λ3) λ3

r

κ2(1 a33) κ3 a32 r(λ2κ3 κ2λ3) λ3

(16.23)

For r 0, w* takes the maximum value of W (1 a33)/λ3. For w* 0, the maximum r is R 1/(κ2 κ3d), d a32 /(1 a33). Since for empirical values of parameters both fractions of (16.23) are positive, w* is a falling function of r. The wage rate w* w/p3 represents the wage equivalent of materials. This is obvious from the relations w p1 w*1 p3w* where w*1 is real wage in terms of baskets and w*3 is real wage in terms of materials. Since we use labour prices, a wage-basket of consumer goods is equivalent to a wage-basket of materials if they contain the same quantity of embodied labour. This will be assumed, and from now on we may treat w* as the usual real wage rate. Consider two countries, A specializing in X2, and B specializing in X3. They exchange their products at the international price P P2 /P3. They use the same technology and therefore face the same wage curve. But they grow at different rates and use different rates of proﬁt. Therefore per capita consumption (c) and wage rates (w*) will differ. As they specialize in different commodities, relative prices in the two countries will differ except at the point of exchange. Assume that X2 is produced under such conditions that p p2/p3 increases as the rental rate increases. These assumptions are incorporated in Figure 16.3, which I borrow, somewhat modiﬁed, from Lynn Mainwaring (1984, p. 99). Since pa is lower than the international price, pa P, country A will specialize in the commodity X2 whose export price is P2. For similar reasons country B will specialize in X3. Internatônal price must lie between two domestic prices, pa P pb , for otherwise

113

The Gains from Trade w*, c

A (X2)

Δca Δw*a

Δcb Δw*b

0

g*a

ra

ro

g*b

B (X3)

rb

r, g*

pa P

pb

p p = p2 3

Figure 16.3

The gains from trade (2)

there would be no exchange (both countries would try to export or import the same commodity). Gross growth rates (gi ) determine consumption per capita (ci ), rental rates (ri ) determine prices (pi ) and wages (wi ). Usually r g and the difference (r g) indicates capitalist consumption out of proﬁts. Wage equation for X2 in A is a straight line in r w*λ2 P κ2r a32 P, P P2 /P3 const.

(16.24)

P2 is export and P3 is import price in A and, as international prices, are given and ﬁxed. Consumption is equal to the value of output minus the value of inputs. From (16.24) consumption per capita is

114

The Theory of International Trade c a w/P3 1/λ2 [P(1 κ2g) a32]

(16.25)

where g is gross (including replacement) growth rate. The wage rate is obtained by replacing g by r w*a 1/λ2 [P(1 κ2r) a32]

(16.26)

Similarly for the industry X3 in B where X2 will be imported and X 3 exported. c b w/P3 1/λ3 [P(1 κ3 g) a33], P P2/P3

(16.27)

The w* and c equations at ﬁxed international prices are linear. Slopes of the straight lines are determined by capital intensities. Since the production of X2 is assumed more capital intensive than the production of X3, κ2 /λ2 κ3 /λ3, its slope will be steeper. The post-trade addition to consumption per capita is greater than increased wage rate in A, Δc Δw*, and smaller in B, Δc Δw*. A and B cross for (r, g) corresponding to P. As product minus consumption equals investment, if the wage bill differs from consumption (because wage rate is different from per capita consumption), proﬁt will be different from investment necessary to employ additional workers. In order to make them compatible with full employment equilibrium, policy measures are necessary. However, consideration of such complications lies outside the present study and properly belongs to the theory of foreign trade policy. As the wage-rental curve and w* c lines differ, except at the point of intersection of r0(P), surplus and deﬁcit will arise as a result of exchange. Positive additions to consumption Δca and Δcb are trade gains. But there may be also losses. For ra r0 rb, both countries gain in terms of wages (or proﬁts), because they export at higher, international, price and import at lower, also international, price. This is a generally accepted conclusion: if prices differ, free trade generates gains. But these gains may be chimerical. Output is determined by full employment of resources and consists of investment and consumption. Growth rate of labout force g determines the necessary investment and so also consumption. If rb ro , B will gain in terms of proﬁts. If at the same time g b ro, B will suffer loss because of reduced consumption. Even regardless of the position of g, both countries may lose

The Gains from Trade

115

from trade (negative Δc) if technologies differ (Mainwaring, 1984, p. 100). Unemployment introduces new complications. It is only when labour prices are used, i.e. ra ga and rb rb, that both countries always gain from trade. A general conclusion follows: any deviation from labor prices (r g) may lead to loss from trade even if trade is completely free and the other usually assumed conditions obtain. As a rule, market prices differ from labour prices (r g) and also technlogies differ, and so loss from trade in the real world appears quite likely.

116

The Theory of International Trade

17 Unequal Exchange 17.1

MARXIAN VALUES

Most of unequal exchange theorizing is based on Marxian schemes of value formation. Value (w Wert) is composed of constant (c) and variable (v) capital and of the surplus value (m Mehrwert) w c v m

(17.1)

Constant and variable capital are advanced at the beginning of the production period and are completely used in production. In the process of production, workers add to the used means of production (c) new value (v m). The surplus value (m) is that part of value added which is not appropriated by the workers but by capitalists and so may serve as a measure of exploitation. For further analysis, is will be helpful to translate Marxian concepts into those used in the present study. Thus, variable capital is the sum of wages paid during the production period. v wL and the surplus value is equal to proﬁt m πK In Marx’s view capitalists appropriate (because of competition) the same surplus per unit of their invested capital, and so the common rate of proﬁt is π m/c

(17.2)

if v is paid ex post. If it is paid ex ante π m/(c v). Workers invest their labour power and also require a common rate of surplus value μ m/v πK / wL

(17.3) 116

Unequal Exchange

117

Since π μ and the organic composition of capital ω v/c varies from industry to industry and from country to country, the difference between two rates makes labour intensive production valued less than necessary (consequently, capital intensive production appears more valuable) and this is the cause of unequal exchange. This theory may be criticized on several scores. It shares with the most of the modern theory the inability to account for ﬁxed capital. Both c and v represent circulating capital because stocks and ﬂows could not be summed up in the value equation. Further, whatever the requirement for justice, market transactions involve ‘prices of production’ (based on common rate of proﬁt π) and not ‘value prices’ (based on the common rate of the rate of surplus value μ). Next, since ﬁxed capital is produced and labour is not, full employment requires sufﬁcient production of ﬁxed capital (investment) to equip the necessary work places. If this capital is to be allocated in an efﬁcient way, it must generate the same surplus per (last unit) of investment in all uses. And this is the function of the common rate of proﬁt. Finally, it is implied that Marxian values measures the labour content of commodities. This is deﬁnitely not the case as the analysis in this study demonstrates (Part II). Marxian labour theory of value is not ‘metaphysical’ as (for instance) Joan Robinson thought. It is simply a product of mistaken bourgeois ideas of ‘ownership rights’. Capitalists own capital and therefore are entitled to share in produced surplus proportionately to their invested capital. Workers own labour power and are therefore entitled to share in the surplus proportionately to invested labour. Capitalism is dominated by capitalists and therefore proﬁt per unit of capital (π) is the pricing rule. Socialism is dominated by working people and therefore the pricing rule is surplus per unit of labour (μ). The fact of the matter is that ownership entitlements have nothing to do with rational pricing. Regardless who is the owner, investment should be made in such a way as to generate the largest surplus per invested resource. How the surplus is to be distributed and used is no longer the role of prices but of social system and prevailing values. For this reason, the old Marxian apparatus is inappropriate for judging the existence of unequal exchange and of measuring its intensity.

118 17.2

The Theory of International Trade UNEQUAL EXCHANGE I

In 1972 Arghiri Emmanuel published a book on unequal exchange which initiated lively international dabate. Emmauel was primarily interested in the consequences for underdeveloped countries. International trade is conducted at international prices and international values embody more labour in underveloped than in developed countries. Exploitation is magniﬁed because of international monopolies and political domination and so no meaningful competition may be assumed. Typically wages in less developed countries are low and proﬁts are high, and most of the exports to advanced countries are controlled by international monopolies located in advanced countries (Sau, 1978, p. 205). This is the second ingredient of unequal exchange determined by unequal international economic and political power. Observe also that underdeveloped countries tend to export raw materials and developed countries export ﬁnal products. Without monopoly power, less developed countries cannot exploit the relatively low elasticity of demand for raw materials and are badly hurt by competition in these markets. On the other hand, the pyramiding effect of tariffs relatively increases prices of ﬁnal products. Thus, less developed countries export cheaply and import dearly. In this way advanced countries tip the terms of trade in their favour. This does not mean that terms of trade are constantly deteriorating for less developed countries (although this is possible as well). It only means that at any time terms of trade are worse than they could be. If underdeveloped countries have monopoly in production of some commodities – for instance, in production of tropical products – and price elasticities are less than unity, they may recoup some of the labour lost through unequal exchange by charging appropriate export taxes that would bring national wages closer to those in advanced countries. Thus, the analysis of unequal exchange provides an argument in support of international distributive justice and OPEC demonstrates a possible empirical solution. Here, I am not interested in economic policy repercussions, but in the logic of the argument. Emmanuel deﬁnes unequal exchange as the proportion of equilibrium prices established through the equalization of proﬁts between regions in which rates of surplus value differ (p. 64). Suppose that X D is the export product of a developed country and XU the export product of an underdeveloped country. If the trade is to be balanced, mutual exports at world prices must be equal

Unequal Exchange PXD PXU

119 (17.4)

where P and X are vectors. Assume also that prices of developed country are also world prices. The rate of surplus value was by (17.3) deﬁned as μ πK/wL that is, as the ratio of proﬁts and wages. Take the case in which the total wage bill in the two countries is equal w DL D w U L U

(17.5)

and proﬁt rate π is equal by deﬁnition of equilibrium prices. Developed country is endowed with more ﬁxed capital KD KU. It follows πKD D

w L

D

πKU

(17.6)

w ULU

the rates of surplus value are different, D μU, and also different from the proﬁt rate π. Developed country charges greater surplus value which makes exchange unequal to the detriment of the under developed country. It is also possible to argue in an alternative way which is probably closer to the exploitation theory. Capital transmits its value to the gross product in the form of depreciation. It does not add anything to the net value of the product, whose only source is live labour. Suppose that two countries have the same labour force LD LU

(17.7)

Consequently, they must produce the same net product (also per worker) value price: wD(1 μ) w U(1 μ)

(17.8)

Since the rate of surplus value μ is equal by deﬁnition in both countries, so must be wages (for equal work) to satisfy the equation (18.8) w D wU

(17.9)

120

The Theory of International Trade

As wD is higher than w U in the real world, the difference represents exploitation (of the poor working class by the worker’s elite in advanced countries). If proﬁt prices are used, (17.8) becomes proﬁt price: w D πkD wU πkU, k K/L

(17.10)

since w w , k k . D

U

D

U

Note the symmetry in the two arguments. Proﬁt prices imply equal proﬁt rate, πD πU. Since KD KU, this implies lower rate of surplus value in underdeveloped countries, μD μU. Surplus value prices imply equal rate of surplus value, μD μU. To achieve that, proﬁts in advanced countries must be reduced, π D π U. The postulates of the same rates of surplus values and value prices involve a complicated recalculation of prices and are, of course, arbitrary. It is much more convenient and straightforward to follow a different procedure developed in the next section. If labour is embodied in commodities and the exchange is carried out at world prices, underdeveloped country must export more of its labour in order to receive in return less of foreign labour. In this sense the exchange is unequal and domestic labour is exploited. The situation is completely objectively described. If we wish to remedy it, we must introduce a subjective criterion of how much the unequal exchange ought to be corrected. This is the rationale of foreign aid given to underdeveloped countries by developed countries.

17.3

UNEQUAL EXCHANGE II

Let our economy consist of three industries: production of consumer goods (X1), machine industry (X2) and raw materials production (X3). Summing up the input-output table’s columns, we may reproduce the familiar set of price equations p1a11 p2κ1r p3a31 wλ1 p1 p2κ2r p3a32 wλ2 p2 labour prices p2κ3r p3a33 wλ3 p3

w 1 for exact (17.11)

Unequal Exchange

121

Remembering that consumption goods x 1 X 1(1 a11) represent net or ﬁnal product of the system, p1x1 wL and p1 L / x1, w 1, so pj (j 1, 2, 3) are clearly labour prices. The difference pj wλj p1a1j p2κ j r p3a3j, j 1, 2, 3, a12 a13 0, w 1 represents labour embodied in worn out machines and raw material input. The solution of the system of three equations represents prices in terms of labour time and is given by (10.10) and (10.11) p wλ(I A)1, pj w

ΣλA i

i

ij

The value of output p j X j, w 1 represents total – live and embodied – labour spent on the production of Xj during, say, one year. In other words, the value pj X j represents so many worker-years. Any set of competitive prices can be transformed into labour prices by division through the wage rate w. However, note that this is only an approximation because generally consumption differs from the wage bill and investment is different from proﬁts

Σ

C p1x1 wL, I rp2 κj Xj and the choice of techniques and prices will consequently be different (Horvat, 1995). Also, in reality we do not have perfect competition. If competitive prices divided through wages approximate labour time prices – which also Keynes, using this device, suspected – we get a means for computing internationally comparable absolute prices in terms of labour time. Consequently, an equal exchange in terms of international prices becomes an unequal exchange in terms of labour time (which measures the quantity of labour input). Consider again our two countries. Mirroring real world relations, developed country D has high per capita product evaluated in international prices Pj

ΣP X

D j j D

L

a

ΣP X j

L

U

U j

,a 1

(17.12)

122

The Theory of International Trade

In other words, productivity of labour is a times higher in D than in U. Assume that the same proportion holds for the goods entering international trade, xj. Balanced trade implies

ΣP x

D j j

ΣP x

U j j

(17.13)

Form (17.12) and (17.13) it follows LU aLD

(17.14)

For balanced trade in international prices, U exports a times more embodied labour than D. We reach the following conclusion: Balanced trade in international prices means unequal exchange because international values contain less of foreign more productive labour and more of domestic less productive labour of less developed country. It follows that equal exchange in international prices implies exploitation of underdeveloped countries.1 Nevertheless, trade is still beneﬁcial for underdeveloped countries (in the absence of monopolies) because imports make possible use of less costly commodities and so net output and consumption increase.

Part VI Tariffs

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18 Tariffs and Subsidies 18.1

EFFECTS OF A TARIFF IN A SINGLE MARKET

If tariff is imposed on the import of one commodity, we can ascertain effects as shown in Figure 18.1. price

S

E P(1 + t)

a

d

b

c

Po P

0

q2

Figure 18.1

q3

f

q4

D

quantity

Imposition of a tariff t

Price must be higher than po before domestic production becomes proﬁtable. As shown in Fig. 18.1, world price is lower than that. In order to stimulate home production, ad valorem tariff t is imposed. The greater import price is now P(1 t), which increases domestic supply from q 0 to q2. That is still not sufﬁcient to cover domestic demand q3 q2. Consequently import is q3 q2. The pre-tariff consumption was q4, which means that tariff-reduced consumption is Δq q4 q3. That implies the loss of consumer surplus dcf. Yet consumption is still higher and consumer surplus loss smaller than under autarkic equilibrium price-quantity conﬁguration. The waste of resources due to tariff is apoPb. Because of positive production effect and negative consumption effect, import is reduced 125

126

The Theory of International Trade

from q4 to (q3 q2). Increased production q2 is also called protective effect, and reduced import – which consists of production and consumption effects – measures restrictive effect. The tariff revenue of the government is tPx import quantity or abcd. It may be used for various purposes depending on the goals of economic policy. We may summarize. Tariffs raise price of the commodity and so stimulate production. They reduce domestic demand contributing further to reduced import. Reduced import – production plus consumption effects – improves balance of trade, saves foreign exchange and contributes to economic independence. Tariffs may also be used to increase military preparedness or as a bargaining instrument. If a large country imposes tariffs, it will change international prices and thus change terms of trade. Countries whose competitiveness is deteriorating move towards increased protectionism (as Great Britain did after the First World War). Tariff represents an import tax whereby the lower international price of importables is equalized with the domestic price pm (1 t)Pm Similarly an export tax reduces domestic price of exportables pe(1 t) Pe where m stands for importables and e for exportables. Already Abba Lerner (1934) noticed that a general export tax has the same effect as a general import tax, ceteris paribus. The ratio of domestic prices remains the same pe 1 Pe , p Pm(1 t) or pe (1 t) Pe pm 1 t Pm m

(18.1)

(the conclusion is not valid when non-traded goods are included). The imposition of export tax reduces domestic export prices but leaves intact import prices. That may also be interpreted as unchanged domestic export prices and increased import prices. In the short run an export tax operates in a depressive way (for exportables) and tariff in an expansionary way (for import substitutes). The latter seems preferable for policy purposes.

Tariffs and Subsidies 18.2

127

PROHIBITIVE TARIFF AND SUBSIDY

A tariff that stops imports is called prohibitive. Imports will be stopped when the ratio of home prices is equalized with the ratio of world prices with tariffs p1 / p2 (1 t)P1 / P2

(18.2)

Tariff rate t is prohibitive. Lower than that is insufﬁcient because X1 will continue to be imported. A higher rate is not necessary. That would mean pure revenue collecting for the government and there are more efﬁcient instruments for that purpose (for instance, value added tax). Home and world prices may also be made equal by introducing an export subsidy. As this subsidy (for instance, in the form of tax exemptions) generates export possibilities where none existed before, it may be called an opening subsidy. Such a subsidy must not be greater than the domestic value added. A subsidy may also be called prohibitive, if former import of a commodity is arrested and replaced by subsidized home production.

18.3

THE PATTERN OF SPECIALIZATION WITH TARIFF

The need for tariff may arise when home price is higher than the international one and the home industry needs protection. Consider a less developed country that tries to increase the rate of growth in order to catch up with more advanced countries. In order to be competitive, it will try to keep wages as low as possible in the conditions of abundant labour. Therefore no tariff is imposed on wage goods X1. On the other hand, in order to develop productive capacity, it will protect X2 and X3 industries. Other combinations are also possible. Whatever combination is chosen, the main point is to show how the regions of specialization change when tariffs are imposed. Let tariffs t2 and t3 be imposed p*i P*(1 ti), i 2, 3 i X1 specialization is described by the following equations:

128

The Theory of International Trade X 1 produced, X2 and X3 imported, T2 1 t 2, T3 1 t3 autarky:

wa*λ1 p*a 3 31 p*κ 2 1r 1 a 11

with tariffs: w*λ t 1 T 3P 3*a 31 T 2P 2*κ 1r 1 a 11

(18.3)

Import of X2 and X3 will be more proﬁtable as long as costs are lower T3P3*a31 T2P2* κ1 r p3*a31 p2*κ1r That at the same time means that X 1 will be produced because Pi / P1 pi / p1 implies p1 / pi P1 / Pi Rearrange the inequality in the familiar way (T3P3* p3*)a31 (p2* T2P2*)κ1r

(18.4)

That is similar to (15.4) except that now international prices are increased by tariffs and the separating straight line passes through the point E2(p*2 / T2, p3* / T3). Rearrange (18.4) to get P3* as a function of P2* P3 (1 / T3a31)(p*2 κ1r p*a 3 31 T 2P2*κ1r) The slope of the line is (1 t2) κ1r (1 t3) a31 and is equal to the former slope modiﬁed by the ratio of tariff factors. Again, below the line X 1 will be produced and exported. There is, however, a novel effect not existing before because above the line X1 will also be produced but not exported. The reason is to be found in the tariff imposed: though in this region world prices are lower than home prices, they are expanded by the imposition of tariffs and so production is still proﬁtable for home producers but export is not. Thus, in the region demarcated by p*2 / T2 P*2 p*, 2 p* 3 / T 3 P* 3 p* 3

129

Tariffs and Subsidies P* 3 X3 produced X1, X2 imported X2, X3 produced X1 imported X1, X3 prod. X2 imported E1

A

p* 3

p3*/T3

No trade in X3 B

E2

X1 produced X2, X3 imported

X2 produced X1, X3 imported

No trade in X2

No trade in X1

X1, X2 produced X3 imported p*/T2 2

Figure 18.2

p2*

P2*

No-trade regions

there will be no trade for X 2 and X3. Besides, between the two separating lines in Fig. 18.2, there will be no trade for X1. In this way the autarkic point E1 is expanded into an autarkic region E1A E2B. This region is the larger the higher are tariffs. A similar effect as import tariffs (or export taxes) have relatively high transport costs that render commodities non-tradeable. A cheap bulky commodity, such as bricks, will be exported only if the export price is sufﬁciently higher to cover transport costs. It will be imported if the import price is sufﬁciently lower than the home price so that transport costs can be covered. That, however, is rarely the case. As one should have expected, tariffs reduce the volume of trade. Also, one general rule must be modiﬁed. The rule that different home and world prices lead to proﬁtable exchange is not generally valid when tariffs are imposed.

18.4

NOMINAL AND EFFECTIVE TARIFFS

The difference between the (lower) international prices and (higher) domestic prices generates differences between nominal tariff (imposed on commodities) and the effective rate of protection of value

130

The Theory of International Trade

added in the respective industry. Let the home production of consumer goods be valued at international prices P1 wλ1 P11a11 P21κ1r P3 a33

(18.5)

or more generally Pj wλj

Σ Pa

(18.6)

i ij

where aij are all input coefﬁcients including κ j r. Social accounting value added consists of wages and proﬁts, vi wλi P2 κ i r. In this book, net value added consists of wages only because proﬁts are not value addition but real cost: gross proﬁts are equal to replacement plus new investment necessary to keep labour fully employed in the economy as a whole. In other words, they are reproduction costs incurred by the expenditures on intermediate goods. Valueadded without the just mentioned real cost component will be denoted as v*, and v will be value-added as it appears in the individual ﬁrm or industry as an imputed cost. In a competitive decentralized economy, v is important and so the social accounting value added concept will be used in order to study tariff protection of individual processes. It is easy to transform vi* into v v*i wλi v i wλi P2κir v*i P2κi r

(18.7)

Unit value added at world prices is the difference between price and unit cost. In the ﬁrst industry

ΣP a , κ r not included in a

v 1w P1

1 i

i

i

(18.8)

Value added in home prices is obtained if tariffs are imposed on output and inputs v 1h (1 t1)P1 (t1P1

Σt P a ) i

i i

Σ(1 t )P a i

i

i

v1w (18.9)

If the difference of values added in home and international prices is divided by vw, we obtain the effective rate of protection τ

131

Tariffs and Subsidies τ1

v1h v1w v1w

t 1P1 P1

Σ tPa ΣP a i

i i

i i

t1 1

Σt P*a ΣP*a i

i

i

i

(18.10)

i

Effective protection τi may be positive, zero or negative depending on whether the tariff rates on output are high or low relative to the tariff rate on inputs. If tariff is uniform, ti tj, the effective rate equals the nominal rate, τi ti. In actual practice, the difference between nominal tariff rates (levied on the purchasing value of commodities) and effective rates of protection of production processes (of the value added) may be quite large and the effective protection may be positive and negative. This may be illustrated by the American tariff rates for 1958 (Johnson, 1972, p. 316):

Rice milling Watches and clocks

Tariff rate (%) Effective protection (%) 14.3 27.9 51.9 143.1

Negative protection is the result of relatively high nominal tariff rates on inputs and very high positive protection results from relatively low rates on inputs. The latter is usually the case when tariff rates escalate with successive stages of production. Positive protection on export products is an effective subsidy. The policy textbooks suggest and common practice implements these suggestions that low or no tariffs be imposed on early stages of production and that ﬁnal products be protected by higher tariffs. That produces a pyramiding effect, which can be seen from a simple example of two-stage production. In the ﬁrst stage raw material is produced or imported and in the second stage ﬁnal product is produced. Suppose q1 of primary products is used to produce one unit of ﬁnal product q2. Since domestic prices are higher, q1 is imported and q2 is protected. P1q1 v p2 (1 t2)P2

(16.11)

It is then decided to protect also q1. If wages and other input prices remain approximately unchanged, v will not change and we may write (1 t1)P1q1 v p2 (1 t2 )P2

(16.12)

132

The Theory of International Trade

The new protective tariff t2 must be greater than t2. Deduct (10.11) from (10.12) to obtain t 1P1q1 (t 2 t 2)P2 (t2 t2) t1q1P1 / P2 0 ∴ t 2 t 2, p2 p2 As a consequence, home prices must increase as well. In the later stages of production the magnifying effect of increased tariff rates and prices may be considerable. It is a positive function of the number of production stages with successive tariffs imposed.

18.5

SUBSIDIES

A tariff is added to an international price of imported commodity to make home production competitive. A subsidy is subtracted from the higher home price in order to make it equal to international price. The rates of subsidy and tariff for a given pair of prices are approximately equal. tariff: Pi(1 t) pi subsidy: Pi (1 s)pi Consequently, s ~ t because s t ~ 0. Although formally subsidy is no different from tariff, economically differences are important. Eight of them may be mentioned: 1. Tariffs bring money to the treasury, subsidies take it away. Thus, subsidies are politically and administratively much more cumbersome. 2. Tariffs make domestic prices different from international prices. Subsidies reduce differences between home and international prices and generate differences between producer and consumer prices because part of the supply price is paid by the treasury. 3. Subsidies decrease prices, whereas tariffs inﬂate prices. Industries producing intermediate goods, when subsidized, render inputs to other industries cheaper and so lower their prices. 4. Just because the effect 3, cheaper inputs may cause formerly imported commodities to be produced at home and exported.

Tariffs and Subsidies

133

5. Tariffs protect home industries but cannot enable them to export and, say, reap economies of scale. Subsidies do one and the other. 6. Subsidies may lead an economy to adapt itself to the structure of world prices and become so better prepared for customs union formation. Tariff tend to conserve domestic price structure. 7. Welfare theorists prefer direct subsidies to tariffs because they avoid the loss of consumer surplus in Fig. 18.1 (Corden 1974, p. 13; Johnson, 1972, p. 243; Cloves et al., 1993, p. 221). 8. The GATT rules do not allow explicit export subsidies in order to prevent dumping foreign markets. The proceeds from tariffs must somehow be distributed. But spending money is always easy. Expenditures caused by subsidies must somehow be ﬁnanced. That can be done in various ways but two of them seem obvious: by excise taxes and tariff revenues. Subsidies may be direct or implicit such as easier credit terms, investment credit, the deduction of value added tax on export commodities and various selective beneﬁts. In either case wages will be reduced and this is the common features of tariffs and subsidies. Subsidies can easily be incorporated into (18.1) and then regions of specialization determined. That will not be undertaken here. To prohibitive tariff, prohibitive subsidy corresponds as described in Section 18.2. The separating lines for the regions of specialization are different and no trade region is no longer present. However, the rationality of subsidized export may be questioned. Taxes on production (the extension of tariffs to domestic production), consumption and wages do not pose new problems. An import quota may be shown to be equivalent to a tariff except that the tariff revenue is collected by the holders of import licenses and not by the government. The government tries to ﬁnd compensation in selling the licenses at an appropriate price.

18.6

INFANT INDUSTRY SUPPORT

Let out three-industry economy be competitive and self-sufﬁcient in X1 and X2. That implies an equalization of absolute home and international prices at an appropriate exchange rate, p1 P1 , p2 P2. Raw material X3 is imported in exchange for, say, machinery X2. Consequently, P3 / P2 p3 / p2, where p3 is expected home

134

The Theory of International Trade

price of X3 once the production starts. Since international P3 is given, p1 and p2 can be found by solving two price equations: p1 wλ1 P3a31 p2κ1r p1a11

(18.13)

p2 wλ2 P3a32 p2κ2r

If a tariff is imposed on any commodity, all prices will have to change, including the real wage because of w* 1 / p1. Thus, it may be proﬁtable to grant a subsidy because then prices do not change. In either case, importation of X3 will stop and home production will begin if home and international prices are equalized. Consider a tariff support for infant industry X3, p3 (1 t3) P3. The relevant price equations are p1t wλ1 (1 t3)P3a31 p2tκ 1r p1ta11 p2t wλ2 (1 t 3)P3a32 p2tκ2 r

(18.14)

(1 t3)P3 wλ3 (1 t 3)P3a33 p κ r t 2 3

The increase of price P3 to (1 t 3)P3 makes production of X1 and X2 more expensive and reduces nominal wage w. Since this is not a feasible policy politically, it will be assumed that nominal w is kept constant and real wage is reduced by inﬂation. In this way our data are w, P3 and r, and unknowns are t3 and tariff affected higher prices p1t and p2t. These three unknowns can be determined by solving the three equations (18.14). Since p1t p1, the real wage will be reduced to w / p1t. Production of X1 and X2 will become uncompetitive and will need protection, p1t (1 t1)P1, p2t (1 t 2) P2. Since P1 and P2 are given, t1 and t2 are also determined. If formerly the economy was fully competitive, p1 P1, p2P2, now it is no longer competitive in both products but only in one, depending on the price ratio p2t / p1t P2t / P1t The introduction of inefﬁcient production X3 makes the whole system less efﬁcient. With the given labour force, all three goods are now available in smaller quantities. An alternative policy is to grant subsidy to the X3 industry in order to reduce home price to the international level.

Tariffs and Subsidies

135

p3s p3(1 s) P3 The necessary money for subsidizing the unproﬁtable production can be obtained by taxing consumers which will leave nominal wage unchanged. Now we have the third set of equations. p1 wλ1 (1 s1 )p3a31 p2κ1r p1 a11 p2 wλ2 (1 s2)p3a32 p2κ2r

(18.15)

(1 s3)p3 wλ3 (1 s 3)p3a33 p2κ3r The ﬁrst two equations are the same as in (18.13) but that does not mean that the prices are the same because then the system would be overdetermined. In the system (18.13), P3 was given; in (18.15), p3 is a variable. The same was true for (18.14) and there each industry needed a different tariff protection applied to respective outputs. Now each industry needs a different subsidy applied to dearer X3 inputs. In both cases all absolute prices increase. By changing the exchange rate, in either case at least one tariff/ subsidy rate may be rendered unnecessary. The whole procedure is justiﬁed if it can be expected that within reasonable time industry X3 will improve its efﬁciency, and greater domestic price will converge gradually to lower international price lim τ➝n

p3(τ) P3 , τ time

Grounds for that are learning by doing, economies of scale, increasing skills by training and purposeful research leading to technological progress. Each time that the efﬁciency of X3 production improves, p3 will decline and real wages will increase. All prices will decrease and tariff protection will have to be revised. These adaptations involve considerable transaction costs. In the case of subsidies, prices will remain unchanged but subsidy rates will have to be continually revised. It is appreciably easier to administer tariffs than subsidies. On the other hand, price stability as against continual market adaptations represents an important economic gain.

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19 Customs Union 19.1

DEGREES OF ECONOMIC INTEGRATION

The situation in which the independent political units, called states, and their economic agents compete on the world market, may be denoted as zero economic integration. The liberal epoch of 19th-century Europe corresponds institutionally most closely to such a state of affairs. Although various attempts at integration were made already in the last century, it is only in the second half of this century that the world began to move gradually towards economic integration. Various international agreements are the milestones on this path. Sufﬁce it to mention the General Agreement on Tariffs and Trade (GATT), whose rules are obeyed by all important trading nations. Nevertheless, the world arrangements, just because they are so encompassing, will be taken as a basis from which the various, less general, integration schemes start. Various preferential trading agreements, in the ascending order of economic integration, are: 1. A preferential trading club, in which member countries agree to reduce import duties on the mutual trade. A paradigmatic example is the Commonwealth Preference System; similar arrangements have obtained between imperial centres and their former colonial dependencies. The problem encountered is to exclude the outside world from mutual preferential system. For that it is necessary to distinguish effectively between goods originating inside and outside the Club. Trading Clubs are no longer in existence because they are not allowed by the GATT rules. 2. A free-trade area is created when the member countries abolish all import duties and quantitative restrictions on their mutual trade. They retain their national protection schemes against the rest of the world. An obvious example is the European Free Trade Area (EFTA), created in 1960, which consisted of seven countries that did not join the European Community. The policing problem mentioned in (1) exists here too because exporters may use their national protective schemes, enter the area 136

Customs Union

137

where protection is the lowest and resale the commodity in more protected markets of the area. 3. A customs union eliminates the policing problem of intra-union trade of commodities originating in other countries. The Union abolishes all import duties on the trade among member countries and establishes the common external tariff on import from the rest of the world. Duties are charged as soon as commodities enter one of the Union countries. The custom proceeds are redistributed to member countries according to an agreed upon scheme. 4. A common market is established when in addition to free movement of commodities also free movement of labour and capital is allowed. European Economic Community reached that stage of integration. 5. Economic union is the ﬁnal stage of integration, now attempted by the EEC countries and intended to integrate the whole of Europe. The member countries proceed to integrate their ﬁscal, monetary and socioeconomic policies. Short of political integration into a federal state, the Union was established by the Benelux Treaty countries (Belgium, Netherlands and Luxembourg). The three countries formed a customs union in 1948 and converted it into an economic union in 1960. Between the trading arrangements (4) and (5), Molle (1990, p. 13) interpolates monetary union, which establishes full convertibility or common currency and undertakes the integration of macro-economic and budget policies. These various schemes are characterized by different intensities of cooperation. The lowest intensity, practised in (1) and (2), consists of co-operation, which means voluntary and unenforceable alignments of national policies in various ﬁelds. Harmonization is the second degree of co-ordination and involves agreements on how member countries will exercise policy instruments over which they retain control. This is practised in (3), Customs Union and (4), Common Market. If various policy instruments are assigned to (5), Economic Union, this is integration.

19.2

TRADE CREATION AND TRADE DIVERSION

Our 3 2 2 model has served us well so far. Now we must add the third country and consider 3 (commodities) 2 (factors) 3

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(countries). Each of the three countries has its special function. H is the home country, P is the union partner and W is the rest of the world. In order to avoid possible confusion, international price will now be denoted as pw. Although customs unions have existed for a long time – the best known example is the German Zollverein created in 1834 – the systematic theoretical study of customs union issue began with Jacob Viner’s book published in 1950. Viner distinguishes trade creation from trade diversion effects of a union. If both H and P are high cost producers protected from international competition by tariffs but P’s production costs are lower, the removal of intraunion tariff will enable P to export to H and so trade will increase on the basis of lower costs. If, however, H used to import a commodity from the low cost W, but now intra-union tariff is abolished whereas the common union tariff protects high cost producer P, import will be diverted from the low cost W to the high cost P. Viner calls the former effect trade creation and the latter trade diversion. The switch to lower prices (trade creation) is obviously desirable; the switch to higher prices (trade diversion) is generally not desirable or welfare improving but may be made so as with infant industry support or the creation of a customs union. The effects of forming a customs union are represented in Figure 19.1 which I borrow from P. Robson (1987, p. 17). The usual assumptions apply: vigorous competition, transport costs ignored, factors mobile within the country and not between countries, tariffs as the only form of trade restrictions, balanced trade and full employment of resources. The home country is a high cost producer and needs tariffs for protection. Let it be prohibitive tariff t h generating autarkic equilibrium at A. Low-case letters stand for home, customs union partner and world. Now the customs union is formed. The union, supply curve is a horizontal aggregation of supply curves of the two countries, Sh Mp, where partner’s supply is denoted as import from the partner’s country, Mp. The common union tariff t u is set so that Su D h. Thus, union price will be lower than in H, higher than in P, while all three prices are higher than the world price pw. In the home country output declines from q2 to q1, and consumption increases from q2 to q3. Tariff rate t p is set so as to equilibrate S and D in the partner’s country. With tu imposed, output increases to q3

and consumption declines to q1 in P. Trade creation in H consists of production effect ABC (reduction of production costs) and

Home country p

Partner country p

Dh Sh

Dp

A

Sp

Su = Sh + Mp B

pw(1 + tu)

C

D

pu

pw(1 + tp)

pp

pw

pw

0

q1

q2

q3

Figure 19.1

Customs Union

pw(1 + th)

q

b

a

0

q q

1

2

q

3

q

The effects of a customs union

139

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The Theory of International Trade

consumption effect ACD (consumers’ surplus), due to imports. In P, there is a loss of resources b and a consumption loss a. This is overcompensated by export earnings (q3 q1 ) (pu pp) represented by the hatched rectangle. The union is assumed to be selfsufﬁcient and so the partner’s export (q3 q1 ) is equal to home country import (q3 q1). Since the rest of the world remains undisturbed, there is only trade creation effect ABC. If initial tariff was not prohibitive, so that there was some import from W, and the union import from P replaced cheaper import from W, there would have been also trade diversion. In this case the starting position would not be an autarkic equilibrium at A but an excess demand calling for imports prior to the formation of union. If P’s production involves increasing or decreasing returns, its supply price will fall or increase as output expanded. In the European Economic Community of six members, trade creation appeared to be substantially higher than trade diversion. Robson (1987, p. 246) quotes estimates of six authors for the period between 1967 and 1970 indicating trade creation from 13 to 23 per cent of total imports (about 0.15 per cent of GNP) and trade diversion from 1 to 6 per cent. If this is at all representative case, trade diversion can be neglected as a problem for economic policy. A common market is one stage further along the integration path. It will not be attempted here (see, however, Appendix VI-2), but one empirical test deserves attention. Herbert Glejser compares EEC countries in 1958 – which is the year preceding the initiation of Common Market – with the same countries, now members of Common Market, in 1966. He ﬁnds that both rank correlation and regression analysis support comparative costs theory and that partner countries behave as expected (negative correlation between prices and shares of export to the home country; Glejser, 1972, pp. 247–58).

19.3 CUSTOMS UNIONS IN A MORE REALISTIC SETTING Our 3 2 3 model implies that three goods are exported or imported or neither from three different countries. This makes for 27 possible combinations. It would be cumbersome to analyze all of them. Obviously this is an exercise for applied trade analysis having in mind concrete practical problems. But we may construct

Customs Union

141

a representative case which will give us the feeling for what is all about. H is a high-cost producer and all its prices are higher than in P. H produces all three commodities and P only two, while machines X2 are entirely imported at world prices. P produces materials at world prices, p3p p3w, and since the other input X2 is also available at world prices, the price of ﬁnished goods may be lower than in H. Being entirely imported in P, X2 needs no tariff protection. X3 is also exported from P. W absorbs all surpluses and deﬁcits. Besides, countries are small and whatever they do, the world equilibrium will not be disturbed (international prices remain constant). Before forming the union, prices in the two countries are: Home country p1h p1w(1 t1h) p2h p2w(1 t 2h) p3h p3w(1 t3h)

Partner country p1p p1w(1 t1p), t1p t1h p2w (only for imports) p3p p3w, t 3p 0

The union eliminates internal tariffs and retains the lowest national tariffs, protecting the already existing production: t1 t1p, t2 t2h, t3 0. Such an arrangement corresponds to the Article XXIV of GATT which stipulates that union duties must not be higher than those existing prior to the formation of union. Since H and P belong to the same cultural environment, it may be assumed that if P can have lower costs, so can H. If not immediately, costs can be lowered in stages. In the meantime, production in H can be subsidized out of proceeds from tariffs. Consequently, after customs union formation, the single set of internal prices are as follows: p1 p1w(1 t 1p) p1p p1h p2 p2w(1 t 2h) p2w p2h p3 p3w(1 t 3) p3p p3h Note: substantially lower by design slightly greater because of more expensive inputs Because of industrial interrelations, the union protection must be slightly higher than P’s tariff rates (if relevant cost changes are to be absorbed). By design, union prices p1, and p3 are substantially lower than H prices because of P’s lower protection rates. But these rates will have to be slightly increased because cheap X2 import is replaced by more expensive X2 production. Tariff t2h is

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chosen for the union tariff because X2 was not produced in P and therefore no tariff existed. Union tariff rate t 3 0 must be imposed because of increased union costs as compared with earlier P’s costs. The customs union is created by a high-cost producer H and a low-cost producer P. In reality it is not likely that all prices will be higher in H and lower in P. We consider on purpose such an extreme case to see whether the union will be beneﬁcial for both countries even under such conditions. In the union, H prices will be substantially reduced (by design) and P prices will be somewhat increased (because of higher union prices for inputs). Protection rates will change in the same direction. The union tariff rates will be between high H and low P rates, closer to the latter. This means that the creation of the described union is a move towards free trade and the average price level is lowered. If at least some of H producers are more efﬁcient, this move will be stronger. It is also stronger with the large number of member countries. Because of import substitution, union output will increase beyond the aggregate output of individual members before integration. The home country will gain from the union with a low-cost partner: all prices will be reduced and production increased because of import substitution. It is not immediately obvious that P will gain from the union with the high-cost country H. All its prices will increase but so will its outputs since even inﬂated prices pip are still lower than pih. P will replace the entire import of materials into H assuming adequate elasticity. Machines were not produced in P and so change in p2 may possibly induce P to start producing X2. Price of consumer good increased, p1 p1p, but it is still lower than p1h and so P will be able to capture a part of H’s consumer good market. There is still one effect left. The combined supply schedule of H and P has ﬂatter slope and, therefore requires less import (Figure 19.2). At the world price p w, home production is negligible (q7) and almost all required quantities are imported. When tariff t h is imposed, supply increases to q2, demand decreases to q4, reducing import to (q4 q2). When the customs union is created including the low-cost producer P, the aggregate supply curve becomes more elastic and something is produced even at pw. Even if the union imposes much smaller common tariff t u t h, output will increase from q2 to q3 and also import from (q4 q2) to (q6 q3). This is beneﬁcial trade creation effect because the high cost source

143

Customs Union price Dh Sh

Su

p (1 + th)

p (1 + t) u p (1 + t ) u pw

0 q1

Figure 19.2

q2

q3 q4

q5

q6

q7

quantity

Increased elasticity of the customs union supply curve

pw(1 th) is replaced by the low-cost source pw t u. If tariff is increased to t u, the resulting trade diversion to union products will eliminate imports altogether. In general, prices in the low-cost P will somewhat increase, in the high-cost H substantially decrease, output will expand and imports will be substituted (at least to a degree) by member countries’ production. The union supply curve (and similarly the union demand curve) becomes more elastic and this is a move towards free trade without tariff barriers. Conditions favouring the creation of a customs union are those that are lowering prices and increasing production and trade. Such conditions appear to be: 1. Much mutual trading among prospective members so that gains can be achieved by eliminating internal tariffs of formerly separated countries. 2. Overlapping of tariff protection. 3. Large volume of foreign trade in relation to total expenditures so that the elimination of trade impediments generates large gains.

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The Theory of International Trade

4. If two countries produce the same commodity, the gain from forming a union will be larger the larger is the difference in production costs between two countries. 5. Similar economies. The more they are alike, the more scope there is for specialization turning economies to become complementary to each other. When member countries produce completely different goods, there is little scope for further complementary specialization. 6. Different from the rest of the world. The more different they are from the outside world, the more likely it is for member countries to gain from the union because possible losses from trade diversion are smaller (Johnson, 1962, pp. 44, 57–60). 7. The larger the union, the greater its bargaining power and so, unlike a small country, may beneﬁt from improved terms of trade or at least not suffer from imposed upon conditions for trade. 8. Large internal market, brought about by the union, makes for more efﬁcient allocation of production and consumption (for instance, the elimination of empty stretches along former borders), more efﬁcient transportation network, more effective competition lowering costs and prices and possibilities for exploiting economies of scale. 9. Countries at similar stages of economic development (similar GNP per capita) will ﬁnd it easier to equalize tariff rates and harmonize economic policies because of similar productivity and similar organizational experience. An advanced country in a less developed environment would enjoy monopoly position and exert disruptive inﬂuences on the union. A less developed country in a developed environment would not be able to compete successfully when internal tariffs are eliminated and so would create both economic and political problems. 10. Long historical contacts and sharing cultural values facilitate cooperation even if at some earlier times countries were involved in bloody confrontation. Mutual understanding is crucial for successful communication.

19.4

DYNAMIC EFFECTS

Almost all trade theory literature is concerned with allocational effects on the welfare, although they constitute only a fraction of one per cent of GNP (Leibenstein, 1976, pp. 29–34). That is so

145

Customs Union Dp

S p

Sp

price Su S u w

p (1 + t) pw(1 + t )

pw

0

q1

Figure 19.3

q2

q3

quantity

Reduced costs of customs union

because allocational effects lend themselves easily to analytical treatment. Dynamic effects – structural changes in time – are much more important but also much more difﬁcult to analyze rigorously. In fact, no general approach has been developed as yet. For an exception see Molle (1990, pp. 103–12). Here only the more important effects will be described. Improvement of efﬁciency. Greater pressure of competition will result from reduced union tariff and elimination of separate tariffs of member countries. This will stimulate intraunion specialization which will reduce costs. Because of reduced costs, supply curve will shift downwards (Figure 19.3). At world price even the low-cost partner country – and so the union too – will produce nothing. Because of increased efﬁciency, it will produce q1 at some later time. When high-cost producer H joins the union, tariff t will have to be imposed in order that the union produces q2 and eliminates imports. At some later day, union supply curve will shift downwards, to S u and now it will sufﬁce to impose lower tariff t t in order to achieve self-sufﬁciency and produce greater quantity q3 q2. Cost will be reduced not only because of greater competition and specialization but also because of free movement of labour and capital (in common market). Increased competition and reduced

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The Theory of International Trade

costs are likely to foster economic development. As a result, costs will be further reduced because of technological progress and replacement effect. At ﬁrst the outside world might lose because of reduced exports. But eventually W will gain as well because of higher rate of growth of union members and consequential increase in trade. Economies of scale may be internal and external to the ﬁrm. Internal economies are best exempliﬁed by a chemical factory. Containers used in the production process incur investment costs proportional to the surface of the container (S 6 x2 if containers are boxes), while production is proportional to the volume (V x3). Let capacity be increased λ times V1 λV0 (λ1/3x)3 The investment cost (surface) will increase to S1 6(λ1/3x)2 S0λ2/3 where λ2/3(2/3 1) indicates economies of scale. Production costs will also decrease because of large series. Thus, internal economies of scale can be pervasive in modern industries. External economies are due to the complementarity of processes on the same area (repair shops, power generation, transport, ancillary production transferred to independent specialized ﬁrms). Next, bulk transactions are cheaper, inventories vary with the square root of output, large quantities facilitate the use of specialized equipment such as assembly lines. The main analytical characteristics of economies of scale is falling supply curve. In the upper part of Figure 19.4, the partner’s supply curve is below Home’s supply curve because the partner produces at lower cost. Imposing the tariff rate th, Home country achieves self-sufﬁciency producing q1. A similar prohibitive tariff in P determines q2 production. Both countries enjoy economies of scale and therefore the S curves are falling. They cannot be falling indeﬁnitely and eventually they ﬂatten out. It is assumed that Sp stops falling after the world price pw has been reached. Neither country can exploit economies of scale because of the lack of demand. Abstractly speaking, lack of home demand may be compensated by foreign demand (export). In reality, the precondition for substantial export is sufﬁciently large home demand and/or export subsidies.

Customs Union

147

In the lower part of Figure 19.4 the two countries have formed a union. The combined union demand curve D u is more elastic than either Dh or Dp in isolation. The combined supply curve is identical to Sp since the partner country is more efﬁcient of the two. This means that the entire union output will be produced by P and H will be eliminated. Since H produced originally only a small output q1, this might not be a great loss. H might also demand compensating transfers in order to remain in business until improving own efﬁciency (the infant industry case). Or it may beneﬁt from the union created economies of scale in some other business by expanding output. Or its inefﬁcient ﬁrms may be taken over by more efﬁcient P producers. In any case, economies of scale exert additional pressure on high cost producers to reduce costs. After the union creation, consumption in H and P increases to q3 and q4. In the lower part of Figure 19.4 two possible cases are considered. First, it is assumed that P’s economies of scale are exhausted at pw and also that at this price the union self-sufﬁciency is achieved. Of course, the combined demand can be smaller or greater and also the Sp curve may ﬂatten out at a different p pw. The alternative case, represented by dashed line, assumes the same Du but somewhat less efﬁcient S p. For self sufﬁciency, union imposes prohibitive tariff tu which reduces union consumption to q5. Even so, the union price is lower than either of the two pre-union prices and, consequently, more is produced at reduced cost. Tariff rates th and t p are reduced to a lower common t u. The situations described may be affected by oligopolistic and monopolitic behaviour and so not the lowest possible union cost (price) is established (Robson, pp. 39–41). To prevent such distortions, the intervention of the economic policy authority is necessary. Large market effects. Economies of scale reduce cost of additional units of output. Improved efﬁciency shifts supply curve downwards. Large markets are likely to generate both effects. The uniﬁcation of business regulations is likely to reduce risk and transaction costs. The latter will be reduced because of eliminated border formalities, abolished internal custom duties and more rational transportation network. The transportation system in a large area can be organized more rationally than on the aggregation of transportation systems in many small, separated areas. Locational advantages tend to be more fully exploited (areas along numerous previous borders remained without productive capacities). Important technological break-throughs are likely to occur in large countries and

148

The Theory of International Trade H and P separately price

Pw(1 + th)

Sh

Pw(1 + tp)

Sp

pw Dp D n

0

q1

q2

q3 q4

q6

Union (H + P) price

S p

p(1 + tu)

Sp

pw

Du

0

q1

q2

Figure 19.4

q3 q4

q5

q6

Economics of scale

large companies. They are able to accumulate sufﬁcient human and material resources necessary for technological progress. Most natural sciences and medicine Nobel Prize laureates come from two dozen or so universities located in a couple of countries (although the respective scientists were born in many more countries).

Customs Union

149

In a large market, local disruptions are more easily repaired, and so can full employment of labour and capital be maintained. Full employment and technological progress make for a higher rate of growth. The emergence of national markets that superseded former feudal economic atomization and local monopolies was a great advancement in macroeconomic organization. Similarly, customs unions and related forms of economic integration are second great enlargement of national markets and improvement in the macroeconomic organization. The great thing about this development is that political national states may remain preserved while reaping the beneﬁts of international economic integration.

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Appendices to Part VI 1

EMPIRICAL EVIDENCE

There are two paradigmatic cases that may illustrate the effects of customs union creation and its dissolution. The former is the creation of the European Economic Community (now union) in 1957 (enlarged in 1973, 1980, 1986 and 1996). It will illustrate beneﬁcial effects of the union creation. The other is the dissolution of the Soviet and Yugoslav federations which generated predictable negative consequences. The formation of the European Union has been a singular success. There is an enormous literature on it and for this reason only a few summary statements will sufﬁce. As the name indicates, the EE passed stages of Customs Union and Common Market and is now building Monetary and fully integrated Economic Union. The empirical evidence for the ﬁrst two steps is given in Table 1. The share of export in European GDP was reduced to one half in the period of trade restrictions in the 1930s as compared with the liberal 1880s. Already the ﬁrst steps towards integration recovered the share in 1960 and then doubled it to 26 per cent in 1985. The message is very clear. From 1880–1910 to 1938 trade was expanding at a lower rate than output. Europe was moving towards autarkic states. From 1960 onwards, trade was expanding faster than output. Particularly fast was the expansion of intratrade. Europe has been gradually integrating and this trend continues. At the same time, trade with the rest of the world also expanded faster than output and the share of EC export in GDP increased from 9 in 1960 to 11 per cent in 1980 (Molle, 1991, p. 179). The medium-term macroeconomic consequences from market integration for the EC were estimated by Paolo Cecchini to be an increase in GNP of 3.2 to 5.7 per Table 1

The effects of European integration 1880 1890 1910 1920 1938 1960 1970

European exports as % GDP 13 Intra-trade as % of total export –

13

13

9a

6a

14a

–

–

–

–

34.6b 48.9b

a

17a

Only European Economic Community (EEC) of 12 countries. EEC 6. c EEC 9. b

Sources: Molle, 1991, pp. 42, 46, 179. Robson, 1987, p. 235.

150

1980 23a 52.8c

Appendices to Part VI

151

cent and an increase in employment by 1.3 to 2.3. million (EC, The European Challenge, 1992). While there is a great amount of literature on the beneﬁts of integration, the costs of disintegration have hardly been discussed. In the Soviet Union in 1988, ﬁfteen republics exported to each other on the average 52 per cent of net material product. This is a non-weighted average and the extreme individual cases are Russia with 29.3 per cent and Belorussia with 69.6 per cent (Havrylyshyn, Williamson, 1991). The reported 52 per cent of GMP is equivalent to 42 per cent of GDP. Table 1 shows that 52.8 per cent of 23 per cent share or about 12 per cent of GDP was absorbed by mutual trade of EU members. It follows that the Soviet Union was much more economically integrated than Western Europe. The disintegration of such an economy must have catastrophic consequences. Unfortunately, I do not have reliable data to document this conclusion. Therefore, I turn to Yugoslavia. Absorption of output within each republic, internal shipments to other republics and export to the rest of the world are shown in Table 2. Intrayugoslav trade (26.4 billion $) appears to be 2.5 times larger than export to foreign countries. It follows again that disintegration of the common Yugoslav market will have disastrous consequences for each of the constituent republics. This time I am in the position to ascertain these consequences. The same data are not available for the post-disintegration period for all republics. And even if they were available, they would be highly distorted. Serbia and Montenegro were badly hit by sanctions imposed by international community because of atrocities committed in slaughtering other ethnic groups. Bosnia-Herzegovina has not yet recovered from a devastating civil war. Macedonia was squeezed between Serbia under sanctions and unfriendly Greece that exercised various forms of boycott. Also, Macedonian economy is very small. Only Croatia and Slovenia remained and the relevant data are displayed in Table 3. These data are not strictly comparable because now separate states use different methodologies in their foreign trade statistics. But even so, they will serve our purpose. As soon as the former federal republics separated themselves from the federation, they closed borders, introduced mutual passports and imposed tariffs. None of the governments undertook to estimate the costs of such policies. When compared with the display of nationalist symbols, the costs looked completely unimportant. Even economists did not raise the question. In the same way as Yugoslavia was established seven decades earlier as a unitarian kingdom with complete ignorance about the consequences, so it was now dissolved with equally complete ignorance about consequences. And the consequences have been really disastrous. The mutual trade between Croatia and Slovenia was reduced 2–4 times. Exports to other Yugoslav republics were reduced even more drastically. These reductions were partly compensated by trade with the rest of the world. Slovenia reached the nominal level of 1985 exports by 1996 (Slovenian exports to other republics in 1985, shown in the table, seem to be underestimated). Croatia was unable to reach even the nominal level. In constant 1985 US dollars, both republics achieved signiﬁcantly lower level of

152

Table 2 Exports in Yugoslavia in 1985 (Billions of current US dollars)

From

Croatia Slovenia Macedonia Serbia Montenegro Bosnia-Herzegovina Yugoslavia a

Croatia

Slovenia

1

2

24.6a 2.1 0.4 2.4 0.2 1.5 31.2

2.6 17.3a 0.3 2.3 0.1 0.9 23.6

Macedonia 3 0.4 0.3 5.7a 1.0 0.1 0.2 7.7

Serbia

Montenegro

4 2.2 1.5 1.0 38.2 0.6 1.8 45.4

Local absorption of shipments. b Intra-yugoslav shipments minus local absorption

Source: Courtesy of Dr Marta Bazler-Madzˇar, Institute of Economics, Belgrade.

5 0.1 0.0 0.1 0.3 1.5a 0.1 2.1

BosniaHerzegovina 6 1.2 0.7 0.2 1.6 0.1 12.9a 16.7

Yugoslavia 1–6 31.0 21.9 7.7 46.0 2.7 17.3 126.6

Rest of the world

Export to the rest of Yugoslaviab

7

8

2.4 2.2 0.5 3.6 0.2 1.6 10.5

6.4 4.6 2.0 7.8 1.2 4.4 26.4

The Theory of International Trade

To

153

Appendices to Part VI Table 3

Exports of Croatia and Slovenia in 1985 and 1996 (Billions of current US dollars)

To

Croatia

Slovenia

Former Yugoslav republics

Rest of the world

Total

1985 1996 1985 1996

– – 2.1 0.9

2.6 0.6 – –

3.8 0.6 2.5 0.5

2.4 6.6 2.2 6.9

8.8 7.8 6.8 8.3

From Croatia Solvenia

Sources: Table 1. Priopcˇenje Drzˇavnog zavoda za statistiku Hrvatske, January 1997. Statisticˇni ured Republike Slovenije.

exports in 1996 as compared with exports