Aim of This Presentation

I.Introduction

This is a multimedia course on The WTO and Trade Economics: Theory and Policy. The course comprises this explanatory text, Frequently Asked Questions and self-assessment quizzes which you can use to measure your understanding of their course. It is also supported by a video presentation of this material entitled "The WTO: Economic Underpinnings".

Aim of this presentation

The aim of this multimedia presentation is to provide a theoretical background for understanding the effects of trade liberalization and those of protection. We will try to understand also why countries pursue polices of trade liberalization within the context of the WTO, that is why countries negotiate with each other and commit to bound tariffs, for example, rather than liberalizing unilaterally. The presentation is divided into four parts. In the first part I will be providing some insights on what are the most important results of theoretical literature on international economics on the effects of trade liberalization.

I. Gains from Trade

In particular, initially I will be looking at gains from trade in different setups, ranging from situations where countries trade because they are different in their level of technology, to situations where they are different because of their different endowment factors – different endowments in capital, labour or land. And finally, two situations where countries trade even when they are similar.

II. Income distribution Effects

In all these cases, I will explain that there are gains from trade, but that trade may, at the same time, have income distribution effects. So that, within each country, there will be some groups that make gains and some other groups that may lose. Trade liberalization also entails adjustment costs. We will explain what does this mean and we will look at what governments can do to minimize these adjustment costs.

III. Trade policy and development

In the third part, we will look at the evidence on the importance of trade liberalization for development.

IV. Need of a multilateral commitment

In the last part, we will explain the rationale behind engaging in multilateral negotiations and commit trade liberalization to international agreement.

II.Gains from Trade

II.A.The three most important insights from the theory of international trade

Let's start with what the theory of international trade tells us about the effects of trade liberalization.

1. There are gains from trade

The three most important results of international trade theory are: one, that there are gains from trade; the second one is that when countries sell goods or services to each other, this exchange is always beneficial; and the third, that two countries that trade will benefit from trade even if one of them is more efficient than the other one at producing everything.

2. Trade is mutually beneficial

Therefore, not only are there gains, but there are gains for both countries. At the same time, while nations generally gain in aggregate from international trade, it is quite possible that international trade may hurt particular groups within a nation.

3. Trade has income distribution effects, but gains outweigh losses

Therefore there are income distribution effects, some groups, some people, will gain, some people will loose and it is very likely that the loosing part of the society will put pressure on the government to pursue protectionist policies, even if overall gains outweigh overall losses.

II.B.Where do these gains come from?

Gains from better utilization of resources

Economic theory suggests that gains from trade can come from better utilization of resources.

... from specialization

What does trade do? Trade allows countries to specialize in the production of the goods that they can produce relatively MORE efficiently and import the goods that they produce relatively LESS efficiently. The exchange of these goods benefits both countries.

… from exploitation of economies of scale

Gains from better utilization of resources may also come from the fact that trade allows firms to produce on a larger scale. When barriers to trade are eliminated, firms will face the demand of a larger market. Therefore, firms will be able to choose to produce at a more efficient level of production, and save costs. These lower costs will benefit the country as a whole.

Gains from specialization

Let's now turn to the analysis of the gains from specialization in a little bit more detail. Everybody probably understands that if a country, which is very efficient in producing computers, trades with another country which is very efficient in producing roses, then it is probably to their benefit that the country more efficient in computers produces and exports computers, while the other country produces and export roses.

But, what about a country that is more efficient in producing both – computers and roses – trading with a country that is less efficient in the production of both? Is trade still beneficial? – the important result from the theory is that there are GAINS from trade and that BOTH countries gain from trade. These gains will arise from each country specializing in the production of the good for which they have a comparative advantage.

• Comparative advantage (CA)

What does comparative advantage mean? Economists say that a country has a comparative advantage in producing a certain good, if the opportunity costs of producing that good in terms of other goods, is lower in that country than it is in the other country. Note that while defining comparative advantage, we have introduced a new term: "opportunity cost".

• Opportunity cost

What is the opportunity cost? – The opportunity cost of a certain good, let's say roses, in terms of another good, let's say computers, is the number of roses that could have been produced with the resources used to produce a given number of computers. Opportunity costs differ across countries because of differences in technologies.

• Theory of comparative advantage

The theory of comparative advantage states that when two countries specialize in producing the good in which they have a comparative advantage, both economies gain from trade, even if one country has an absolute advantage in both goods. In particular, each country will export the good for which they have a comparative advantage.

1. Specialization from technological differences: the Ricardian Model

The best way to understand the idea of comparative advantage is through a specific example – a model that demonstrates this. A model of comparative advantage that relies on differences of labour productivity was first introduced in the early nineteenth century by an economist named David Ricardo, and therefore it is also referred to as the Ricardian Model. In its simplest form the Ricardian Model can be shown with the following example: Suppose that there are only two countries in the world, Country A and Country B – and two sectors – roses and computers. A worker employed in the roses sector would produce five million roses in Country A, and eight million roses in Country B. Another worker employed in the computer sector would produce 200 computers in Country A and one thousand computers in Country B. In other words, whatever the sector, one worker would produce more units of each good when employed in Country B. In this case, Country B has an absolute advantage in the production of both goods.

Roses / Computers
Country A / 5 million / 200
Country B / 8 million / 1,000

What about comparative advantages?Let's look at the opportunity costs for each country in terms of roses, of giving up the production of a thousand computers. For Country B the opportunity costs, in terms of roses, of producing one thousand computers less, is eight million roses.

What about Country A?If Country A had to produce one thousand computers, it would have to employ five people in the computer sector, because each employee produces only two hundred computers in Country A. In terms of roses, this would imply a cost of 25 million roses. To sum up, while in Country B the opportunity costs of one thousand computers is eight million roses, in Country A the opportunity costs of one thousand computers is 25 million roses. Since the opportunity costs, in terms of roses, of producing computers are lower in Country B, Country B has a comparative advantage in computers, while Country A has a comparative advantage in roses. The theory of comparative advantage tells us that if Country A and B open up to trade, then Country A will specialize in the production of roses and Country B will specialize in the production of computers.

What will be the effect of specialization? …the Ricardian Model

Changes in output from specialization:

Roses / Computers
Country A / +10 million / -400
Country B / -8 million / +1,000
TOTAL / +2 millions / +600

Specialization increases global production of both goods. All countries can gain from trade.

Suppose now that in Country A two workers are moved from the production of computers to the production of roses. This implies that Country A would produce four hundred computers less, and will produce ten million roses more. Suppose also that at the same time, Country B will move one worker from the production of roses to the production of computers, therefore Country B would produce eight million roses less and one thousand computers more. Overall the global production of roses will increase by two million units. This is because there will be an increase of ten million roses in Country A and a reduction of eight million in Country B.

In the computer sector there would be six hundred computers more produced globally. One thousand computer more produced by Country B and four hundred computers less produced by Country A. Since specialization increases the global production of both goods, all countries can gain from trade. Trade makes available to each country a higher quantity of each of the goods.

Obviously the Ricardian Model is a very simple simplified model to explain all facts of liberalization of trade. However, it provides two very powerful insights. One is that labour productivity differences are very important in explaining patterns in trade and the other one is that it is comparative advantage and not absolute advantage that is important for trade. In the Ricardian Model there is only one factor of production: labour. Therefore, comparative advantages only arise because of differences in labour productivity, which result from differences in technology.

2.Specialization from differences in endowments: Factor Proportion Theory (the Heckscher-Ohlin Model)

In reality, in the real world, trade is not just determined by technological differences, but it also reflects differences in resources endowments across countries. Therefore, for example, Canada exports forestry products to the United States not because its workers are more efficient in forestry, but because Canada is more endowed with forests. To explain the importance of resources in trade two economists, Heckscher and Ohlin, have developed a theory where trade is determined by the interaction between the relative abundance of factors of production (such as capital, labour or land) and the relative intensity with which these factors of production are used in the production of different goods. Since in this theory, comparative advantages are determined by the proportion of factors endowments and the proportion in which these factors are used in the production of goods, the theory is known as the "factor proportion theory".

Comparative advantage depends on countries’ relative endowment of factors of production

According to the factor proportion theory, the country which is relatively abundant in labour will have a comparative advantage in the production of relatively labour intensive goods. The nation which is relatively capital abundant will have a comparative advantage in the production of the relatively capital intensive goods. In particular, for example, Country A has a comparative advantage in a capital intensive good relative to Country B, if its capital labour ratio is greater than in Country B.

In a closed economy, the good that uses more intensively the relatively abundant factor will be cheaper

If a country is capital abundant, then the cost of capital will tend to be relatively low. As a consequence, the cost of production of the capital intensive product, and its price, will tend to be relatively low. The opposite will occur in a labour abundant country – wages will tend to be relatively low and the cost of the labour intensive products will be relatively low. Differences in relative prices of the two goods will lead to trade.

With trade:

• The prices of the traded goods will be the same across countries
  When countries start to trade, the prices of the two goods, the labour intensive good (say, the agricultural) and the capital intensive good (say, the manufacturing goods) will tend to be the same in the two countries. Therefore, for example, the price of the labour intensive good in the labour intensive country will tend to rise relative to the price of the capital intensive good.
• The labour intensive country will export the labour intensive good
  Both countries will produce more of the good, they have a comparative advantage for. They will tend to specialize. The capital abundant country will tend to specialize in the production of the capital intensive goods and export this product, while the labour abundant country will tend to specialize in the labour intensive good and export that product. Like in the case of the Ricardian Model, also in the H-O model, it is possible that the global production of both goods may increase with trade. It is therefore possible for both trading economies to consume more of both goods than in the absence of trade and therefore both countries gain from trade.

III.Income distribution effects

Trade affects income disbribution

There is, however, a very important difference between the results of the Ricardian Model and the results of Heckscher-Ohlin Model. In the Ricardian Model, labour is the only factor of production in the model, it is assumed that labour within each country can move freely without costs from one sector to another one. To the single individual, it does not make a difference whether he is employed in one sector or another one. This implies that a simple Ricardian model not only predicts that ALL countries gain from trade, but also within each country EVERY INDIVIDUAL is better off as a result of international trade.

In the factor proportion theory, industries differ in the mix of the production factors they require. In the simplest case, there are two production factors: capital and labour and two sectors – one capital intensive and the other one labour intensive. The specialization in one of these two sectors, say the specialization in the production of the capital intensive good, increases the demand for one factor (capital in our example) while lowering demand for the other factor of production (labour). In the H-O model, it is not necessarily true that each individual in each country will gain from trade liberalization. Trade generates income redistribution effects, so that there will be groups who will gain and groups who will lose.

Who gains and who loses? The Stolper-Samuelson Theorem

Who will gain and who will lose? The Stolper-Samuelson Theorem helps us to identify winners and losers. Two economists, Stolper and Samuelson, showed that free trade raises the earnings of the country's relatively abundant factor and lowers the earnings of the relatively scarce factor. Let's consider the example of a capital abundant country: what will happen in this country after liberalization? In the capital abundant country, trade induces a reallocation of resources towards the capital intensive goods – therefore more capital will be demanded and this will increase the domestic price of capital. Owners of the capital will therefore gain more because returns to capital increase. What will happen to the demand of labour in this country? – This is the relatively scarce factor, where the country hasn't got a comparative advantage. The demand for labour will go down and wages will go down. To sum up, in the capital abundant country, owners of capital will gain and owners of labour will lose.

In practice, there are costs to move from one sector to another one. Therefore, it is likely that resources employed in the import-competing sector suffer the consequences of a restriction shrinking of that sector. This explains why in industrialized countries at the moment where a labour intensive sector, like the textiles sector, is liberalized both capital owners and workers in that sector oppose free trade. The important result of the theory to bear in mind, though, is that despite income distribution effects, the country overall gains – that is gains outweigh losses. Costs of adjustment will be discussed in more detail later.

III.A.Trade between similar countries

Similar countries trade similar goods: Intra-industry trade

An important point to bear in mind is that the Ricardian Model and the Heckscher-Ohlin Model explain trade between different countries and different goods. In both models countries trade because they are different – they are either different in terms of their technological level or in terms of factor endowments. Countries specialize in the production of the good for which they have a comparative advantage and export that product. However, in reality most of the trade occurs between similar countries. And, between one quarter and one half of world trade is intra-industry trade. That is trade between goods that fall in the same industrial classification. This is particularly true, if one considers trade among developed countries and in particular trade in manufacturing. In that case, intra-industry trade is most of the trade occurring. The Heckscher-Ohlin and the Ricardian Model do not explain intra-industry trade.