Category Archives: International Trade

Globalization and Inequality

[Over the next week I might be posting stuff on trade theory. In part, I think readers will find some aspects of it interesting, but this is also a form of “note taking” for me — it helps me better remember the specifics of the different models.]

The Heckscher–Ohlin model of international trade, named after the Swedish economists Eli Heckscher and Bertil Ohlin — the latter later received a Nobel prize for his work on trade theory —, is an equilibrium model that helps us understand the importance of relative factor endowments in deciding the pattern of international trade. It has been criticized for “poor predictive power,” meaning that some think it doesn’t explain the real world very well, but I think it’s still interesting to study it and its implications. One of the things it implies is that international trade might contribute to wealth gaps in a countries that are not abundant in unskilled labor.

The Heckscher–Ohlin theory can be modeled relatively easily if you simplify some of the assumptions. This is usually called the “2 × 2 × 2” model: two outputs (bread [B] and cheese [C]), two factors of production (capital [K] and labor [L), and two countries (Home and Foreign, the latter denoted with an asterisk [*]). These factors are mobile in the long-run, meaning their rate of return will tend to equilibrate. This is an addition to the basic Ricardian model, which assumes that there is only one factor of production and that labor will specialize in the area it has a comparative advantage in.

First, we can see the effect of price changes on the distribution of factors of production in Home markets. Let’s establish some basic relationships and definitions,

  • The mixture of factors of production to produce one unit of cheese ≡ QC (L, K); for bread ≡ QC (L, K);
  • aKC ≡ the amount of capital used to produce one unit of cheese;
  • aLC ≡ the amount of labor used to produce one unit of cheese;
  • aKB ≡ the amount of capital used to produce one unit of bread;
  • aLB ≡ the amount of labor used to produce one unit of bread;
  • PC & PB ≡ the given prices of cheese and bread, respectively.

Let’s assume that cheese is a labor intensive industry and bread is capital intensive. Note, when we talk about intensity we’re talking about relative, not absolute, intensity. For example, suppose that each unit of bread requires two labor hours and six capital hours and that each unit of cheese uses five labor hours and ten capital hours. We see that cheese uses more of both goods, but bread is still capital intensive relative to cheese. This is more easily seen when we compare ratios of inputs: 1:3 for bread and 1:2 for cheese. This relationship between the two industries can be modeled algebraically: aLC/aKC > aLB/aKB (the relative amount of labor is greater in the production of cheese than it is in the production of bread).

In equilibrium the ratio of prices ( PC/PB ) is equal to the opportunity cost of the factors going towards the production of the two goods. The relationship between relative prices ( PC/PB ) and the production of the different outputs can be graphed abstractly on a production possibilities frontier (PPF). The point of production will have a slope of –PC/PB (the opportunity cost),

Heckscher-Ohlin PPF

Another set of relationship we can graph are those between relative prices, relative returns to the factors of production (wages [w] for labor and rent [r] for capital), and the relative allocation of these factors in each industry,

Heckscher-Ohlin Prices and Inputs

The left hand panel (where a leftward movement along the abscissa [x-axis] represents increase) shows a hypothetical relationship between the relative price of cheese and the relative price of wages. It depicts relative wages increasing as does the relative price of cheese. Why is this? Remember that we said cheese is labor intensive and bread is capital intensive. An increase in the relative price of cheese will impact labor more than capital, because the change in relative prices is favoring a labor intensive industry.

The panel on the right (where a rightward movement along the abscissa represents increase) shows the relationship for each output between the ratio of labor to capital (L/K). The CC curve shows different L/K ratios corresponding to different w/r ratios for the cheese industry, and BB for the bread industry. Note that curve CC is to the right of curve BB. We know this because we assumed that cheese is the labor intensive industry — this condition will always be true: LC/KC > LB/KB (it’s the same as saying aLC/aKC > aLB/aKB). An increase in relative wages will induce producers to increase the employment of capital relative to labor, which makes sense if you think of a demand curve for labor: the higher the price of labor the less of its quantity will be demanded.

There is an interesting implication of the model relevant to the subject of economic inequality. An increase in relative wages means that the return to labor will rise and the return to capital will fall. Remember that wages are equal to marginal product in equilibrium. A fall in L/K implies an increase in the marginal product of labor. This is because the capital intensity of that industry is rising. Since this is true for both industries, we see that capitalists (capital owners) lose and laborers gain purchasing power in terms of both goods.

Second, how does all of this relate to international trade. Take a look at the following graph,

Heckscher-Ohlin TradeThis graph may be a little difficult to follow at first, because relative supply and demand curves are not customary. The logic is that as the relative price of cheese falls, the relative quantity of cheese demanded rises. Think about like this: if the price of cheese (the numerator) falls, all else equal quantity demanded will increase. If the price of bread rises, all else equal the quantity demanded for bread will fall — there is only one other good, so people substitute bread with cheese. Think of relative supply in similar terms. This graph assumes that relative demand in both countries is the same, and that foreign (RS*) is better endowed in capital than home. This means that, all else equal, at any price ratio home will produce more of the labor intensive good than foreign. This follows from our previous explanation of the relationship between relative prices and resource allocation: countries will tend to produce goods that use factors of production they’re relatively well endowed with.

The main takeaway, though, is that relative prices will tend to converge with trade — it has to do with the equalization of the rate of profits. People will take advantage of price differences until prices are the same. Following the graph, we see that the relative price of cheese in foreign falls (they can buy it for relatively cheaper prices from Home) and it rises at Home (they can sell cheese for higher prices at Foreign). How does this impact the distribution of income at Home? Well, we know from the previous graphs that a rise in PC/PB will, all else equal, raise relative wages: laborers gain at the expense of capitalists. In Foreign the opposite is true: capitalists gain at the expense of laborers.

This version of the Heckscher–Ohlin model predicts that laborers in capital abundant countries will suffer as a result of international trade, and capitalists will gain. That is, there will be a bifurcation of income. If we think about skilled labor versus unskilled labor, as opposed to capital versus labor, then unskilled labor in countries well endowed with skilled labor will suffer from international trade. To put this in the context of the real world, it means that unskilled labor in the United States (a capital intensive economy) will be hurt by globalization that lowers the prices of the goods unskilled labor produces (if countries like, say, China are relatively abundant in unskilled labor). In other words, this model predicts that trade will contribute to a growing inequality gap.

My challenge to this prediction is that it ignores the fact that the use of “skilled” and “unskilled” is often relative, not absolute. For example, let’s say that a U.S. farmer represents unskilled labor, and a U.S. computer engineer represents skilled labor. The same is true in Mexico: farmers are unskilled labor and computer engineers are skilled labor. But, farming in the U.S. is still much more capital intensive than farming in Mexico. U.S. farmers have better equipment. The same is probably true of U.S. computer engineers. Another way of saying the same thing is that the U.S. benefits from better technology. So, it doesn’t follow that skilled/unskilled labor in the U.S. are analogous to their counterparts in Mexico.

If we assume that the skills gap will continue to exist with trade, but that these gaps are somewhat incomparable between countries, then what we’d see is an increase in the domain of goods being manufactured. Both nations still gain: unskilled labor in countries where it’s abundant gain from an increase in demand for their products, and skilled labor in countries well endowed with it gain from an increased demand for their products. Note that if PC/PB converge internationally, then so will w/r. In other words, labor will tend to allocate where the returns are highest. It’s important to remember, though, that demand for a particular skill is dependent on the profitability of producing goods which use this skill. It also depends on the fact that the skill can be employed given certain endowments. This suggests that increases in skill follow increases in capital accumulation, which is consistent with the observation that different countries tend to have different absolute capital endowments.

How to Identify a Brilliant Model

Comparative Advantage Simple ModelI’m taking a class on international trade theory, and we’re going over a number of models that help us understand the globalized allocation of resources. The Krugman–Obstfeld–Melitz textbook we’re using — which is great, since I find it clearer than a lecture — starts with the gravity model, which graphically depicts some relationships between aggregates that we might expect, and then moves on to the Ricardian model of comparative advantage (henceforth referred to as RCA) before dipping into 20th century trade theory. I’m reading these early chapters on my own to inculcate the models into my memory. Now that I’m farther in my studies than I was four years ago, looking at RCA again really allows me to enjoy the characteristics of a great model. It’s no wonder that Ludwig von Mises held the “law of association” (the law of comparative advantage) in such high esteem.

What makes it so great in my eyes is that the RCA starts from a very simple premise that holds true empirically almost self-evidently and explains so much: the division of labor, also providing a basis to study how factors of production are allocated (the models that follow comparative advantage in an international trade theory textbook will usually further develop this relationship between input allocations, relative prices, and productivity). But most models aggregate their foundations in a way that requires homogeneity; the RCA is based on heterogeneity, and I think this is really one of its greatest attributes. These are probably the reasons why this model has persisted for so long and why it’s almost universally accepted: this is an excellent example of something that’s incredibly close to Mises’ a priori theorizing, and of the power of such theories.

If there’s one thing I’d add to the textbook exposition of the RCA it’d be to stress that it explains exchange between individuals — whether inside or outside a country’s national borders. Then the true power of the theory is made obvious, and it becomes easier for the student to conceptualize why it’s nonsense to treat trade with foreigners as different than trade with compatriots (except for whatever relevant political contingencies). What the RCA in the context of nations helps us look at is the globalization of the division of labor. A world where the RCA works best is a world where the nation, politically defined, is essentially irrelevant.

Textile Protectionism

textile factory

I’m taking a graduate course on international trade (using the Krugman, Obstfeld, Melitz [2011] textbook) and the professor opened by asking: why are industries like textiles, apparel, and agriculture usually amongst the most protected? My answer has to do with path-dependency and his, much better, explanation has to do with low market entry barriers. Being as stubborn as I am, though, I think both answers together explain more than each alone.

The path-dependency theory may run as follows. More competitive and productive agriculture, along with industries like textile, are generally characteristic of economies just beginning to industrialize. Textile, specifically, was a huge sector of the markets of countries such as England and Spain. As early as the 16th and 17th centuries these were already amongst the most protected industries. Agriculture gradually lost its competitive edge to manufacturing as rural productivity grew, but farming interests were historically well represented in governments of the time (and still are). Textiles faced a similar fate with growing productivity and the diversification of industrializing economies, but these industries were also protected from competing with each other — England and Spain, in particular, are well known for their protections of the textile sector from foreign competition (isolating their colonies as export partners). My argument is that these protections, and the culture that evolved around them, have never faded, suggesting a significant degree of path-dependency in our regulatory framework. (Maybe the fact that these early centuries are usually known for the spread of mercantilist thought reinforces my idea.)

My professor’s theory is more sophisticated and helps explain why there has never been an interest in ratcheting back these protections. Agriculture and textiles aren’t only a staple of a 16–17th century economy, but also of emerging markets in the present day and throughout the 20th century. The firms involved in these sectors are usually labor intensive, making it preferable to produce where wages are relatively low. In “advanced economies” wages are typically higher than elsewhere, meaning that labor-intensive textile and agricultural firms become gradually less competitive as economies grow. Thus, in order to avoid having these firms lose out to competitors abroad, the government affords them comparatively broad barriers.

If these two theories aren’t complimentary, then they should part of the same, more complete, explanation. One thing which the second answer doesn’t quite explain is the protection of capital-intensive versions of the same industries — I have in mind capital intensive agriculture. This is where my path-dependency idea comes into play. I think that, to a substantial degree, modern farmers have inherited the political pull that American farmers enjoyed during the 19th century and early 20th centuries, which was an era during which agriculture lost its dominance in national production. Farmers sought protection not just from foreign competitors, but also from reductions in incomes as a result of the centralization of the industry into increasingly larger firms (farms) and the flow of labor and capital to manufacturing. To get an idea of how much power agriculture inherited think of the bracero program.

These protections are harmful to all, including the protected in the long-run. The most recognizable consequence is the impact they have on the developing world; related industries in third world markets don’t have access to all the exporters they may otherwise have (e.g. buyers who are, in a sense, forced to purchase more expensive, local products instead). As a result, they also hurt consumers in protected economies. There’s another way consumers are hurt, other than paying a higher price for the same goods. Means of production that are retained in relatively unproductive sectors are disallowed from being applied towards higher priority ends. The cost is unseen (it’s an opportunity cost): we forgo the satisfaction of more pertinent ends. In the long-run, this hurts all incomes, because it affects the wealth of society as a whole. None of this is particularly controversial (or should be), which to me reinforces the “path dependency” facet; these industries have considerable political clout, accumulated over the decades (if not centuries).

Coincidentally, Mises’ life offers an excellent example of the kind of agricultural pressures that have plagued most advance economies. In Mises: The Last Knight of Liberalism, Jörg G. Hülsmann discusses Mises’ stint at the executive office the Lower Austrian Chamber of Commerce and Industry, abbreviated Kammer (pp. 187–193). The Kammer itself was not an institution of free trade, having been known for essentially cartelizing some of the key industries of the Austro-Hungarian Empire, but during Mises’ tenure much effort was expended in balancing out regulations which affected the agricultural and industrial sectors. Specifically, Mises fought a great deal against things like taxes and regulations by pointing out the fact that they challenged each sector differently — in other words, agriculture was being treated much more favorably than manufacturing. In fact, Hülsmann points out that much of the legislation Mises fought against was proposed, or in some way induced, by farming interests. While Austria-Hungary is not the United States, the status of American farmers has not been much below that of Austria’s, if at all.

While I stress path dependency, it’s important to acknowledge that my professor explains why such strong path dependency exists. Industries that enjoy relatively high protections tend to be those that have been around the longest, which also implies that they are some of the easiest to form as markets industrialize. This explains the heavy competition between different European markets as these industrialized, and the modern competitive pressures from emerging markets. There has always been something pushing representatives from these industries to use their political power to weave legislation in their favor. Another way of framing how our two ideas compliment each other is to say that competitive pressures explain the motivation behind the actions of farming and textile representatives. Path-dependency, or focus on the accumulated political power, explains why these efforts have been so difficult to slow and repeal — that is, why free trade interests (and, in my opinion, fact) have not been able to liberalize some traditional sectors of our economy.

For the sake of spinning these concepts to explore a related topic: I wonder what kind of consequences come from capital flow liberalization (not just inflows, but outflows, which can also be regulated by means of the tax code [i.e. penalizing firms for moving operations abroad]). There are various industries that are affected by globalization, but some of these in different ways. Firms might not ask for trade barriers if they reduce their costs of production, and therefore their competitive edge, by moving some of their labor-intensive manufacturing to low-wage countries. Suppose that emerging market restrictions on farming (a lot of the third world has restrictive farming policies to protect local farmers) were lifted to one degree or another, allowing large U.S. agricultural firms to invest abroad. How would this affect the agricultural political platform in the U.S.? How has it affected traditionally relatively heavily regulated industries? Is there a sort of political feedback loop between a growing share of multinational firms and falling trade barriers?

Busy Work

Posting has been slow, because I’ve been preoccupied with an assignment for my International Monetary Theory course. The prompt asks to explain the convergence of Eurozone yields on sovereign bonds,

I didn’t have as much time as I wanted, or should have taken, as the paper is due today. But, here is a skeleton of my rationale,

  1. Capital market liberalization doesn’t have sufficient explanatory power, because it predicts that interest rates will converge at a point between the lowest and highest rates. Instead, what we see is that all rates fall to around 4 percent;
  2. One caveat to the above rejection is the possibility of a German balance sheet recession between 2000–05 (Koo [2009]), where debt repayment led to an increase in savings, used to buy foreign assets. I argue that it’s unlikely that an increase in German savings alone accounts for the extent of the Eurozone-wide drop in sovereign bond yields;
  3. I argue that the spread between the yields reflects differences in risk premiums. I focus mostly on Greece and Spain, noting that both have similar macroeconomic trajectories: economic booms between ~1950–70, and then stagnation, high inflation, and public debt accumulation between ~1975–1990;
  4. The Maastricht Treaty, in 1992, imposed upon soon-to-be Eurozone members certain fiscal and monetary requirements. These, along with rapidly improving fundamentals in Spain and Greece, may have assuaged investors’ concerns;
  5. Finally, the European Central Bank (ECB) accommodated German needs during their balance sheet recession, signalling to investors that the ECB is willing to intervene to support struggling markets. Recent experiences provide some evidence for this explanation, knowing that rates on PIIGS’ bonds skyrocketed when it was clear that the ECB would push for internal devaluation and fiscal austerity over monetary devaluation. Yet, when the ECB declares its “limitless” intentions to buy sovereign bonds from struggling markets, some of these countries experienced sudden reductions in borrowing costs.

In short, my explanation is that it’s all about the risk.

Outsourcing Question


Writing for Industry Week, Adrienne Selko reports on the state of the American manufacturing sector. Essentially, the point is that while the manufacturing sector has recovered jobs since 2007, it’s still facing a net loss when compared to its state in 2002. My question revolves around the very last paragraph in the article,

“We look forward to hearing exactly what Mitt Romney and President Obama propose to do to strengthen manufacturing in the weeks ahead. And, we call on Congress to pass legislation to deter China’s currency manipulation, which has contributed to the loss of nearly 3 million American jobs over the past decade.”

This seems to me a rather unique take. It certainly seems sensible enough, since currency devaluation drives China’s export market to some extent, but is it enough to account for 3 million American jobs?  What are the statistics on this? How many jobs did we lose to China, as compared to the Philippines, Mexico, Malaysia, et cetera?

Edit: Check out this summary of a UC Berkeley study on the potential impact of outsourcing on various job types. Note the extent of impact on service sector jobs. Also, while I’m not sure on sources, this website popped up high during a Google search.


European Mercantilism

While it was Raghuram Rajan’s piece that received the most attention, another note-worthy essay published in the May/June edition of Foreign Affairs is Andrew Moravcsik’s “Europe After the Crisis” (both are gated).  Moravcsik’s article is a pretty good overview of the European dilemma which has unfolded as a result of the recent recession, but it is difficult to agree with the policy prescriptions.

I thought mercantilism, for the most part, was discredited by the past two hundred and fifty years of economic thought.  But, Moravcsik suggests — and he is serious — for Germany and debt-heavy European member states (e.g. Greece, Italy, Spain, Portugal, et cetera) to meet halfway, so to speak.  Indeed, apart from heavy currency devaluation (which, I admit, is not so controversial for most), he argues that Germany ought to raise real wages and increase public spending (the last part I understand least of all — what is the relationship between public spending and parity on trade terms between different European countries?).

I would have thought much more acceptable to instead push debt-ridden states to become more competitive, instead of forcing Germany to become less competitive.  It is true that, partially, Moravcsik is discussing it as a short-term solution, but the true short-term solution should be structural readjustment that will allow other European countries to gain competitive advantages.  After two hundred years, the worst of mercantilism has not died.

Schiff is not an Economist

Peter Schiff has come under fire from a lot of economists for his predictions of hyperinflation, or at least very high inflation.  I have tried to emphasize that Schiff is not an economist.  Schiff is an investor with some knowledge of economic theory.  This does not make him, however, a professional economist or anybody whose opinion on  economic theory carries much weight.

This is not entirely fair, since he is not the only person to predict hyperinflation (unfortunately), but I have some evidence outside of this field to prove my point that Schiff is not an economist, Austrian or otherwise.  The evidence comes from; I am surprised that the editor(s) decided to run such a poorly reasoned piece.

Recovery? What Recovery?,

Large and persistent trade deficits were a primary reason that the U.S. economy imploded in the first place. If we fail to build an economy that can pay for imports with an equal number of exports, we will simply revisit the pain of last few years.

Despite some marginal improvement in manufacturing employment, new hires have been overwhelmingly in the service sector. We need a shrinking service sector and a shrinking trade deficit. As it is, newly employed Americans are spending money on imported products that America should be producing.

How did “large and persistent”  trade deficits cause (in conjunction with other factors?) the economy to ” implode?”

With a globalized division of labor, why is it bad that other countries focus on labor-intensive manufacturing and the United States retool towards a growing service sector?  In the 1870s, should have the United States put a stop to growth in manufacturing and instead focused on reviving the local agricultural sector (and by reviving, I mean returning to a labor-intensive agricultural technique, rather than a capital-intensive one)?

I am not that surprised that Schiff is making arguments like these.  I am more surprised that an Austrian website like is publishing them.