Trade liberalization, Openness and Growth
Table of Contents
1. The gains from trade
1.1 Comparative advantage in Ricardo’s model
1.2 Comparative advantage with two factors: Heckscher-Ohlin
1.2.1 Concepts
1.2.2 Measurement
1.2.3 Do countries specializeor diversify?
1.3. Monopolistic competition and product variety
1.3.1 Homogenous firms
1.3.2 Heterogeneous firms
2. The openess-growth debate between 1995 and now
2.1 Trade liberalization in a Solow model
2.2 The «East Asian Miracle»
2.3 The cross-sectional evidence
2.3.1 Trade openess index of Sachs-Warner
2.3.2 The critique of Rodriguez et Rodrik
2.4 The evidence in panel
3. Structural adjustment and resource allocation
References
List of tables
Table 1: Productivity and endowment data in a Ricardian example
Table 2: candidate equilibrium for the integrated world economy
Table 3: Estimated TFPG in the East Asian Miracle
Table 4: Estimation results of Young (1993)
Table 5: Growth and openness: Cross-section regression results 1980-90
Table 6: TFP growth regressions with various openness indices
Table 7: Regression results of Rodrik Rodriguez with the decomposed SW index
Table 8: Trade liberalization dates in Wacziarg and Welsh
Table 9: Details of trade reforms by country
Table 10: SW results reproduced
Table 11: SW results on a different time period
Table 12: Growth and openness in panel
Table 13: Growth regressed in the liberalization indicator
Table 14: Growth regressed on tariff changes
Table 15: Approach 1 with instrumental variable
List of figures
Figure 1: Production Possibility Frontier and autarky equilibrium: Portugal
Figure 2: Production Possibility Frontier and autarky equilibrium: Great Britain
Figure 3: The gains from trade
Figure 4: The gains from specialisation
Figure 5_ Factor Endowment and PPF: The Rybczynski Theorem
Figure 6: Factor Endowment and Comparative Advantage: The Heckscher-Ohlin Theorem
Figure 7: Factor endowments and revealed factor intensities
Figure 8: Comparative advantage and the survival of exports
Figure 9: Fuel exports and GDP volatility
Figure 10: Export concentration and the level of income
Figure 11: Concentration: Individual country trajectories
Figure 12: The export re-concentration at high levels of income
Figure 13: What are the closing export lines?
Figure 14: Effect of an increase in the custom duty rate on capital equipment in the Solow model
Figure 15: Average growthe for closed and open economies
Figure 16: convergence among closed economies
Figure 17: Convergence among open economies
Figure 18: Growth and import tariffs
Figure 19: Growth and NTB coverage ratios
Figure 20: Time profile of growth around liberalization year
Figure 21: Time profile of investment around the liberalization year
Figure 22: Decomposition of productivity growth: within-sector vs. Structural adjustment
Figure 23: Correlation between productivity and variation in employment per sector
1. The gains from trade
The tradional theory of international trade suggests that:
- Trade among countries generates efficiency gains for all countries, whatever their level of productivity.
- Countries specialize according to their comparative advantage, generating efficiencies.
1.1 Comparative advantage in Ricardo’s model
In the Ricardian model (not to be confused with the Ricardo-Viner model as we will see later, and which has nothing to do!), The assumptions are
•Two countries (Portugal et GB)
•Two sectors (wine and drape)
•Only one factor of production (labor), perfectly mobile between the two sectors
•Constant returns to scale
•No transport costs
•No government intervention
•Perfectcompetition (price = cost)
• At the same price, consumers share their budget equally between wine and drape
Thus, in the Ricardian model comparative advantage is determined by the relative productivity of labor, which is the only factor of production.
Table 1: Productivity and endowment data in a Ricardian example
Productivity / Endowments (labor)Wine / Drape
Portugal / 8 / 4 / 5
UK / 1 / 2 / 20
Figure 1: ProductionPossibility Frontier and autarkyequilibrium: Portugal
Figure 2: Production Possibility Frontier and autarky equilibrium: Great Britain
Equilibrium in the world market after openess of the two economies
Table 2: candidate equilibrium for the integrated world economy
Figure 3: The gains from trade
Figure 4: The gains from specialisation
1.2 Comparative advantage with two factors: Heckscher-Ohlin
1.2.1 Concepts
Figure 5_ Factor Endowment and PPF: The Rybczynski Theorem
Figure 6: Factor Endowment and Comparative Advantage: The Heckscher-Ohlin Theorem
1.2.2 Measurement
When there are more goods than factors of production, in general the direction of trade (who exports what) is not determined.[1] However, overall countries tend to export goods corresponding more or less to their factor endowments
Traditionally, we calculate the Balassa index of revealed comparative advantage: denotethe exports of product n by country i, the total exports of country i, world exports of product n, and world exports. The Balassa index thenis:
The problem with this index is that it assumes that if country i exports product n, it has a comparative advantage in this product; but the index does not use the factor endowment of country i. Using data on factor endowments from UNCTAD, we can determine the «revealed» factor intensity of each product by taking the average endowments of the countries that are exporting it. If is the endowment of capital of country i, the capital intensity of the good n is:
where is a modified version of the Balassa index since .[2] The advantage of this normalization is that it allows us to put together national factor endowments and the products’ revealed intensities in the same formula. If the theory is true, the exports of countries should be relatively less scattered around their endowments.
Figure 7: Factor endowments and revealed factor intensities
Costa Rica 1993 / Pakistan 2003-5Figure 7(ctd)
Tunisie 2003-5 / Tunisie: new export productsMoreover, the more the exported goods are far away from the factoral endowment of the countries, the less they survive on the world markets, despite the effect is quantitatively small:
Figure 8: Comparative advantage and the survival of exports
1.2.3 Do countries specializeor diversify?
On the other hand, the theory suggests that countries should specialize in their comparative advantage rather that to diversify. But specialization in raw materials, for example, can be synonymous of "imported volatility":
Figure 9: Fuel exports and GDP volatility
Recent studies also suggest that the decline in the volatility of GDP observed in recent decades in the United States is largely linked to the diversification of the economy (in services).
On the other hand, generally the concentration of exports follows a non-monotone path as countries develop:first diversification, then reconcentration. We measure the concentration of exports in similar way as we measure the concentration in income, by three indices: (i) Gini, (ii) Herfindahl, and (iii) Theil. Here we considered the index of Theil, whose formula is:
(1)
Figure 10: Export concentration and the level of income
And the reconcentrationocurred in the individual trajectories of countries:
Figure 11: Concentration: Individual country trajectories
Which countries are those that re-concentrate?
Figure 12: The export re-concentration at high levels of income
How can we explain the reconcentration? Essentially the inertia of trade flows, export lines that are closed have factor intensities corresponding to weaker endowments than those of countries that close.For example, the average of trade lines closed by the EU corresponds to the combined endowment of human and physical capital of Indonesia.These lines should be long gone, but they remain open by inertia.
Figure 13: What are the closing export lines?
In short, the theory seems to stick quite well with empirical observation, although the "content factors" does appear to explain only a small part of international trade. We therefore need other models to have a more complete view of its determinants.
On the other hand, so far everything discussed was essentially static: allocative efficiency considerations tell us nothing about the growth. In the models of endogenous growth, growth is mainly due to innovation; international trade plays only an indirect role (i.e. through innovation). So we will discuss the relationship between trade and growth from an essentially empirical point of view, except a small detour to the Solow model in Section 3
1.3. Monopolistic competition and product variety
1.3.1 Homogenous firms
The monopolistic competition model
The Heckscher-Ohlin model explains trade by differences in factor endowments. It cannot explain the trade between countries with similar endowments, and even less intra-industrial trade. We will now focus on an alternative model proposed by Krugman (1980), called «monopolistic competition».
The ingredients for a model of monopolistic competition are:
- Product differentiation that generates a finite elasticity for each firm
- Economies of scale
The gains of trade in the MC model come from competition,which compresses margins and prices. Consider the following example from Krugman, Obstfeld and Mélitz (2012), pp 168-177
Let S be the volume of national trade, which we take as exogenously given (independant of the prices of the firms active in this market) which is of course unrealistic but simplifies the analysis greatly. Let n be the number of firms active in the market, b a parameter of demand (linear), Qi the quantity sold per company i, pi its price and the average price in the market.
Total cost is the sum of a fixed cost F and a marginal cost c:
which gives average cost of:
(2)
Demand function facing firm i:
(3)
In a «symmetric equilibrium» where all firms set the same price,it can be seen from (12) that ; market shares are equal.
Optimal pricing by profit-maximizing firms equalizes marginal cost and marginal revenue. To derive marginal revenue, invert (3)to get the demand price:
(4)
Revenue is price multiplied by quantity
(5)
and marginal revenue is the derivative of revenue w.r.t. quantity:
(6)
Marginal cost is simply c. Optimal pricing is therefore
(7)
Or
(8)
In the symmetric equilibrium where all firms adopt the same price, Q = S/n, optimal pricing simplifies to
(9)
In this equilibrium, average cost is found by substituting Q = S/n in (4), which yields
(10)
With free entry, profits must be zero, which means that price has to equal average cost:
(11)
or
(12)
which determines the number of firms compatible with zero profits in the market (no incentive for additional entry). In this model, gains from trade arise because of
- Economic integration that creates a bigger market
- Increasingcompetition, reducingmargins
This can be seen by «merging» two countries with equal size S as part of a big-bang trade-liberalization experiment.
Effects of trade liberalization
We do the comparison that is commonly done in international trade between an equilibrium in autarky and an equilibrium with free trade where all barriers are eliminated. The effect is illustrated in a numerical example in the excel file Exemple concurrence monopolistique.xlsx. Suppose that the two countries are of equal size and that there is no transportation cost. Then their combined size is , so the total number of firms is
and the equilibrium price and quantity are
So:
- The total number of varieties available to any consumer in the two-country area increases (there are fewer in each country but consumers have access to both)
- The equilibrium price is lower, and so are profit margins (not shown but easy to calculate)
- Output per firmincreases.
Damn it, everything is fine in this world?
1.3.2 Heterogeneous firms
Note that the trade liberalization induces firm exit, since . In a symmetric equilibrium, which firms will exit is indeterminate. But suppose now that potential entrants differ in their marginal cost ci, in accordance with new “heterogeneous-firm” models. Those with marginal cost higher than the «choke price» don’t enter.
Intercept of demand facing each firm: Using (13), Qi = 0 implies
And the slope of the demand curve is:
Trade liberalization means that goes down as n goes up, while the slope becomes “less negative” as S goes up. Thus, under the effect of an increase in S and the induced increase of n, the demand curve rotates anticlockwise.
- The demand increases for big firms with low marginal cost
- But it decreases for firms with higher marginal cost, which leads to the exit of some firms.
2. The openess-growth debate between 1995 and now
2.1 Trade liberalization in a Solow model
Everything that we saw at the beginning of this chapter was static. Is there any reason to think that trade liberalisation could accelerate the growth? Yes if trade liberalization affects the price of capital goods, for example.To see this, we take the Solow model and assume that the domestic price of capital goods (the capital) is:
where is the world price of one unit of capital (one «machine») and is the customs duty on imported capital. Assume, to simplify, that , that is if we measure the capital in dollars, then one unit is worth a dollar . Rewrite the law of motion of capital as:
Thenwe have:
A high customs duty therefore lowers the curve in Figure 14; the steady state (the intersection of the curves, that are respectively representing the first term on the right of the equation above, and the second term) moves to the left (at a level of capital per worker lower) and the rate of growth during the transition to steady state, slows.
Figure 14: Effect of an increase in the custom duty rate on capital equipment in the Solow model
In the particular case of capital goods, the link between trade liberalization is therefore direct (and obvious). This explains the 'climbing' structures of tariffs, prevailing in most developing countries:low or zero tariff on capital goods, moderate tariff rates on intermediate products used as inputs in the industry, and the highest rates on consumer goods.
2.2 The «East Asian Miracle»
Empirically, what can we say about the relationship between trade and growth?The «East Asian miracle» is the title of a World Bank report published in 1994 and dedicated to the spectacular growth of the Asian tigers (compared to other continents, in particular Africa and Latin America). This report had considerable visibility although it was highly controversial.
The approach was a “growthaccounting” one based on a Cobb-Douglass production function:
(0.13)
Log-linearizing gives an estimable growth equation
(14)
where ui is the error term. Let ei be the residual of the estimation in(14), i.e.
(0.15)
We will give a name to this residual: TFP (Total Factor Productivity). Taking first differences (i.e. growth rates, sinceeverythingis in logs)wedefine Total Factor ProductivityGrowth (TFPG) as
(0.16)
This gives us a decomposition of sources of growth in two components:
- Accumulation, i.e. whatispredicted by (14),
- TFPG or improvedEfficiency (the residual)
This decomposition is very important. If accumulation (especially capital) is the dominant contribution to growth, the recipe for economic policy is the "mobilization of savings" for investment.This can be done - and has been historically - abruptly by taxing agriculture to generate the resources needed for investment. Extreme cases: the Soviet Union under Stalin. It is also what inspired many economic policies in Africa.
On the other hand, if the TFPG is dominant, then is something else. The problem is that as the TFPG is a residual, by definition it is not known what it is, and we could put what we want as interpretation.
Table 3: Estimated TFPG in the East Asian Miracle
There is clearly a difference in the nature of growth between the SE Asia and the remainder (AL and ASS). The TFPG is dominant in Asia, not elsewhere. Explanation: trade openness that forces local businesses to restructure and improve the efficiency.
Unfortunately, the same year when the preliminary draft of the «East Asian Miracle» circulated, Alwyn Young published a paper that showed the labour factor was improperly measured (underestimated) for SEA (South East Asia) countries in the report of the Bank, the residual measured correctly was a bit smaller for these countries. Even more of a miracle!
Table 4: Estimation results of Young (1993)
Source: Young, 1993
2.3The cross-sectional evidence
2.3.1 Trade openess index of Sachs-Warner
Idea: correlate the growth in the period 1980-90 with a measure of trade openess. Bianary measure: either open or closed country. «Closed» if one of more of the following criteria are satisifed:
- Averagetariffgreaterthan 40%
- Rate of coverage of non-tariff barriers (quotas etc.) greater than 40% of imports
- Black market currency premium greater than 20% during the decade
- Export State Monopoly
- SocialistEconomy
SW found a strong correlation between growth and their measurement of the opening. Already in descriptive statistics, the difference is clear:
Figure 15: Average growthe for closed and open economies
Source: Sachs Warner (1995)
In addition there is convergence among the open countries but not closed countries:
Figure 16: convergence among closed economies
Source: Sachs Warner (1995)
Figure 17: Convergence among open economies
Source: Sachs Warner (1995)
The cross-section regression results confirm the descriptive statistics (table 5).
Table 5: Growth and openness: Cross-section regression results 1980-90
Source: Sachs Warner (1995)
Edwards (1998) attempted to show that the results of Sachs and Warner were robust and not the effect of a particular approach. It includes all of the openess measures (Sachs and Warner and other) and systematically explores the correlation between these measures and the TFPG.
OPEN / Sachs-WarnerWDR / Openess Index of the World Bank (composite)
LEAMER / Residual of an equation of openess
BLACK / Balck market premium on currrencies
TARIFF / Average import tariff
QR / Rate of coverage of quantitative trade barriers
HERITAGE / Trade-distortion perception index
CTR / Revenue on import taxes in proportion of the value of imports
WOLFF / Another residual of a regression of openess
SW results are robust; several other similar exercises give the same results
Table 6: TFP growth regressions with various openness indices
Source: Edwards 1998.
Basically, the message is that regardless of the measure of openess that we take, the correlation with the TFPG seems well-established. The message of the East Asian Miracle was fundamentally correct even if the measures are differentgood this is.