A prescient note on the home-market effect by Max Corden

11 October 2013 by

Paul Krugman’s 1980 AER paper formally introduced the home-market effect. In introducing his result, he mentions (p.955):

Notice that this argument is wholly dependent on increasing returns; in a world of diminishing returns strong domestic demand for a good will tend to make it an import rather than an export. But the point does not come through clearly in models where increasing returns take the form of external economies (see W. M. Corden). One of the main contributions of the approach developed in this paper is that by using this approach the home market can be given a simple formal justification.

I doubt that very many people have looked at the Corden reference, as it appeared in a 1970 conference volume titled Studies in international economics. Monash Conference papers. Here’s an excerpt from the surprisingly prescient three-page note:

A note on economies of scale, the size of the domestic market and the pattern of trade

Professor Grubel suggests that a country will tend to produce and export those products or ‘styles’ of products for which it has a relatively large domestic market. He explains this in terms of economies of scale. This is essentially the ‘Linder hypothesis’ which has obtained some empirical support, as well as being intuitively plausible. But it does raise an interesting theoretical question which has not, to my knowledge, been explored, in a simple static two-product two-country model with no transport costs, with economies of scale and with the demand patterns differing between the two countries it does not follow that a country will export that product to which its own demand pattern is biased. In that sort of model, as is well-known, one can say only that at least one of the two countries, and possibly both, will specialise, but one cannot say which country will specialise in which good. From the point of view of maximising potential world income there will be an optimum pattern of specialisation, but this will not depend in any simple predictable way on differences between the demand patterns of the two countries. Thus we cannot obtain the Linder hypothesis from this simple model. The question then is: What else must we put into the model? Is it transport costs, or is it rather something ‘dynamic’ ? In order to focus on the main point I shall now assume that the two countries are of equal size, that their factor endowments and production functions are identical, and that any differences between the factor-intensities of the two products are not large. Hence the two countries have identical convex production transformation curves. They differ only in their demand patterns. Country A’s demand pattern is biased towards product X and country B’s towards product Y. Needless to say, the discussion to follow is very tentative…

A third approach might be to introduce transport costs. Transporting goods from one country to another uses up resources, and from the point of view of maximising world income it will pay to minimise transport costs. Given that in the final equilibrium both countries will specialise, each country should then specialise on the good for which it has the relatively greater demand, since this will minimise transporting. This seems obvious. Provided we do not introduce other complications, trade along Linder lines will maximise potential world income. But it does not seem so easy to prove that trade will actually assume that pattern. Suppose that, for some reason, one starts with the trade flow in the opposite direction. One might explain this in terms of some dynamic considerations. Will there then be a natural tendency for the pattern of specialisation and hence the flow of trade to reverse itself? It does not seem obvious that this would be so. There is scope for further theoretical explorations here.

As Krugman himself has commented: “Now it is always tricky to reread old texts in the light of subsequent information; knowing what actually happened, you can probably find a prophecy of Nostradamus that fits the event, and knowing subsequent developments in economic theory, you can probably find most of it hinted at in Ibn Khaldun.” Still, I think Corden was onto something in 1970.

Well, that took a while…

14 August 2013 by

In August 1935, Gottfrieb Haberler wrote (Theory of International Trade, Preface to the English Edition):

[I]t seems to me that the theory of international trade, as outlined in the following pages, requires further development, in two main directions. The theory of imperfect competition and the theory of short-run oscillation (business cycle theory) must be applied to the problems of international trade. It will soon be possible to do this in a systematic way, since much progress has been made in both fields in recent years.

With regard to the first of these questions, there is the literature which centres around the two outstanding books, Monopolistic Competition by Professor E. Chamberlin and Imperfect Competition by Mrs. Joan Robinson. In the second field where further development is required, it is not so easy to refer to a body of accepted theory.

 Of course, the monopolistic competition revolution did not reach international trade until the late 1970s.

Melitz and Redding on heterogeneous firms and gains from trade

6 June 2013 by

In a recent VoxEU column, Marc Melitz and Stephen Redding describe the logic of Melitz (Ecma, 2003) and Arkolakis, Costinot, and Rodriguez-Clare (AER, 2012). Those should be familiar to Trade Diversion readers (e.g. ACR 2010 wp, Ossa 2012 wp). They then explain their new paper:

In Melitz and Redding (2013b), we show that firm-level responses to trade that generate higher productivity do in fact represent a new source of gains from trade.

  • We start with a model with heterogeneous firms, then compare it to a variant where we eliminate firm differences in productivity while keeping overall industry productivity constant.

We also keep all other model parameters (such as those governing trade costs and demand conditions) constant.

  • This ‘straw man’ model has no reallocations across firms as a result of trade and hence features no productivity response to trade.

Yet it is constructed so as to deliver the same welfare prior to trade liberalisation. We then show that, for any given reduction in trade costs, the model with firm heterogeneity generates higher aggregate welfare gains from trade because it features an additional adjustment margin (the productivity response to trade via reallocations). We also show that these differences are quantitatively substantial, representing up to a few percentage points of GDP. We thus conclude that firm-level responses to trade and the associated productivity changes have important consequences for the aggregate welfare gains from trade.

How can these findings be reconciled with the results obtained by Arkolakis, Costinot, and Rodriguez-Clare (2012)? Their approach compares models that are calibrated to deliver the same domestic trade share and trade elasticity (the sensitivity of aggregate trade to changes in trade costs). In so doing, this approach implicitly makes different assumptions about demand and trade costs conditions across the models that are under comparison (Simonovska and Waugh 2012). By assuming different levels of product differentiation across the models, and assuming different levels of trade costs, it is possible to have the different models predict the same gains from trade – even though they feature different firm-level responses. In contrast, our approach keeps all these ‘structural’ demand and cost conditions constant, and changes only the degree of firm heterogeneity (Melitz and Redding 2013b). This leads to different predictions for the welfare gains from trade.

One potential criticism of our approach is that one can estimate the trade elasticity (the sensitivity of aggregate trade to changes in trade costs) using aggregate trade data only – without requiring any specific assumptions about the firm-level responses to trade. Whatever assumptions are made about those firm-level responses (and the demand and trade-cost conditions), they should then be constructed so as to match that estimated aggregate elasticity. However, recent empirical work has shown that those underlying assumptions radically affect the measurement of the aggregate trade elasticity, and that this trade elasticity varies widely across sectors, countries, and the nature of the change in trade costs (see for example Helpman et al. 2008, Ossa 2012, and Simonovska and Waugh 2012). There is thus no single empirical trade-elasticity parameter that can be held constant across those different models.

Given the lack of a touchstone set of elasticities, we favour our approach to measuring the gains from trade arising from different models; one that maintains the same assumptions about demand and trade costs conditions across those models.

Follow @TradeDiversion on Twitter

15 May 2013 by

You’ve no doubt noticed that recently I’ve only been posting once or twice per month. However, I am regularly sharing links and brief comments on Twitter, so you should follow @TradeDiversion. Recently on the Twitter feed (but not the blog):

AFT on Railroads of the Raj

13 May 2013 by

A Fine Theorem has a nice write-up of Dave Donaldson’s Railroads of the Raj. He’s put in more effort than I did when writing it up in 2009.

Harry Johnson on Staffan Linder

29 April 2013 by

I haven’t seen a book review like this in some time. Harry Johnson didn’t hold back while expressing his opinion of Linder (1961). This is the closing paragraph of his rather blunt five-page review:

In summary, this is at once an ambitious, provocative, and provoking book-ambitious in the breadth and depth of the problems in trade theory it propounds and seeks to solve, provocative in the hypotheses it propounds, and provoking on account both of the perverse misinterpretations of existing theory that the author produces to support his claims to novelty and of the careless botch he makes of the exposition of his own alternative theories. The result is a volume that ought to be read by specialists looking for seminal ideas and interesting research problems,but that cannot be recommended for use by students insufficiently trained to be alert to the substitution of emotive debating points for reasoned argument and of irrelevance for logical analysis. [Economica, 1964]

KAL on current trade politics

14 February 2013 by

The Chinese government didn’t allocate its MFA quotas efficiently

15 January 2013 by

Amit Khandelwal, Pete Schott, and Shang-Jin Wei have a nice VoxEU column describing their forthcoming AER article on Chinese textile exports under the Multifibre Arrangementquotas. In short, inefficiently implemented policy can substantially amplify the economic distortions introduced by trade barriers:

If trade barriers are managed by inefficient institutions, trade liberalization can lead to greater-than-expected gains. We examine Chinese textile and clothing exports before and after the elimination of externally imposed export quotas. Both the surge in export volume and the decline in export prices following quota removal are driven by net entry. This outcome is inconsistent with a model in which quotas are allocated based on firm productivity, implying misallocation of resources. Removing this misallocation accounts for a substantial share of the overall gain in productivity associated with quota removal.

Mead and Drezner on EU-US trade prospects

11 January 2013 by

Alan Beattie and Joshua Chaffin in the FT:

This month, a working group led by EU trade commissioner Karel De Gucht and US trade representative Ron Kirk is likely to suggest starting formal negotiations…

“The stars are almost aligned,” says Greg Slater, director of global trade policy at Intel, the chipmaker. The US and EU “have the opportunity to try to set the gold standard” in areas such as intellectual property protection, he says, which emerging markets like China and India would then have to respect.

Yet the deal faces complex challenges. Trade policy has moved from focusing on simple import tariffs on goods – already low for most transatlantic commerce – to often complicated “behind-the-border” domestic regulation. Technical standards, not tariffs, are the biggest barriers to integrating fast-growing US and European markets such as pharmaceuticals, medical services and advanced electronics…

“The aim in many instances is not to drive immediately for full regulatory convergence but to try to make sure that regulators on both sides of the Atlantic are making decisions with their eyes wide open,” says Sean Heather, vice-president of the [US Chamber of Commerce] chamber’s centre for global regulation. “The idea that negotiators are going to sit down with a big list and say: ‘We’ll give you that if you give us this,’ is probably not going to work for most regulations.”

Yet even agreeing an approach on convergence confronts bureaucratic and philosophical barriers. Regulation in both economies is frequently divided among different agencies, some jealous of their independence and unused to considering international implications.

Walter Russell Mead:

A U.S.-EU trade deal is essentially a way to ignore countries like Brazil and India while crafting rules that will govern some of the high-tech industries and information-based services that play a growing role in US-EU trade. Once those rules are set, the BRICs will be hard pressed to avoid signing onto them later on down the road.

Dan Drezner:

Two things have changed.  First, the traditional method of multilateral trade liberalization has died.  Second, while both the US and EU are major trading states, they’re not quite as pivotal as they used to be.  Ironically, it’s their declining (though still appreciable) importance in global trade that makes a US-EU agreement feasible now.  The BRIC economies are now sufficiently large that a transatlantic trade deal doesn’t seem like an existential threat.

And here’s Richard Baldwin, “Regulatory Protectionism, Developing Nations, and a Two-Tier World Trade System ,” Brookings Trade Forum: 2000.

John McLaren – International Trade

5 January 2013 by

I haven’t seen the inside of John McLaren’s new international trade textbook, but I really like the cover:


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